MGE#12 The Balance of Payments

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1 MGE#12 The Balance of Payments The Current Account, the Capital Account and the Balance of Payments Introduction to the Foreign Exchange Market Savings, Investment and the Current Account 1

2 From last session In the long-run Money is Neutral and generates only inflation Central Banks affect long-run nominal rates through the effect on expectations of inflation The long-run real interest rate is determined by the structural conditions in the economy The two objectives of Central Banks Stabilization policy: Smoothing fluctuations in output gap Central Banks must react quickly, based on leading indicators. They must also manage the public s interpretation of events in the economy. Central Bank independence Protect from governments who over-stimulate in the short-run to win elections Prevent abuse of Inflation as a tax on the current holders on money Without credibility (e.g. high expectations), the objectives may conflict. 2

3 Road Map Introduction 1. GDP The Short-Run Demand and Fiscal Policy The Money Market 2. Labor Market Potential Output 9. Inflation Productivity Towards the Long-Run 10. The Long Run International Capital Mobility 11. Central Banks Demand converges back to Potential Output (through prices), creating short-run inflation (also rising Oil prices). Expectations of inflation contribute to actual inflation. Long-run inflation is expected and set by the growth of money supply. Reducing inflation (lower money growth) causes recessions, unless the Central Bank obtains instant credibility (expectations). In the long-run there is no trade-off of inflation and unemployment, and Money affects only nominal variables. Central Banks pursue low inflation and stabilization, through interest rate policies. Credibility is key to align the two objectives. Log scale Actual Output at time t Potential Output at time t Sessions 5-8 Business Cycle Oscillations Reversion to Potential 9-11 Actual Output Potential Output Y p The Current and Capital Accounts and Capital Mobility 15. Exchange Rates t time 3

4 A country s exchanges with the world I Current Account The Current Account (CA) involves transactions of goods and services 1. Trade balance or Net exports Includes all imports and exports of goods and services 2. Net foreign payments (NFP) Payments to domestic factors used abroad net of payments to foreign factors used domestically e.g. Repatriated profits of domestic multinationals Unilateral transfers Transfers of foreign workers Donations, Foreign Aid is affected by the Real Exchange Rate (RER) which depends on the nominal ER and the price level 4

5 A country s exchange with the world II Capital Account The Capital Account (KA) involve transaction of assets 1. Official Flows Lending by Multilateral institutions and Governments 2. Monetary Operations Short-term (less than 6 months) financial instruments Currency transactions (e.g. reserves of Central Bank) 3. Private Portfolio flows Bond and Equity financing 4. Bank lending Sovereign borrowing: by government or with an explicit government guarantee Private sector borrowing: directly or through domestic banking system 5. Foreign direct investment Foreign companies obtain managerial interest, through acquisition or joint-venture The lower bound is usually taken as 10% of capital. 5

6 Exchange rates Nominal Exchange rate (e) How many units of foreign currency one can buy with one unit of domestic currency the price of domestic currency The value of the domestic currency increases = the currency appreciates = the exchange rate rises The value of the domestic currency decreases = the currency depreciates = the exchange rate falls The Nominal Exchange Rate is set in the Foreign Exchange (FX) Markets, which trades more than USD 2 trillion/ day! If the authorities set the peg (fixed ER), the Central Bank must participate in the FX market, otherwise a parallel market will develop. Who are the private actors? What is the use of foreign exchange? Transactions of goods and services Transactions in domestic and foreign assets Holding foreign currency as an asset. 6

7 Fundamentals in the FX Market Demand for FX Supply of FX Importers pay foreign suppliers Foreign workers sending out remittances Exporters convert their revenues Domestic MNC s repatriate profits Residents buy foreign assets Foreign Bond and Stock Markets, Domestic Banks lending abroad Outward FDI Individuals and firms wish to hold foreign currency Central Bank expand its FX Reserves Foreigners sell domestic assets Including domestic currency Foreigners buy domestic assets Inbound FDI Inflows to domestic bond and equity markets Foreign banks lending to residents Individuals and firms wish to increase holdings of domestic currency Central Bank reduces its FX Reserves Residents sell foreign assets Including foreign currency 7

8 A first approach to the FX market Fundamentals: CA-flows are related to the competitiveness of the country (real exchange rate). K-flows (including Foreign Reserves of Central Banks and holdings of foreign currency as an asset) are determined by the relative, risk-adjusted returns to domestic and foreign assets. In the short-run, speculators may provoke fluctuations that are independent of fundamentals. Exchange rate Price of domestic currency appreciation depreciation Looking for FX K-outflows + Imports + CB Reserves Providing FX Exports + NFP K-inflows FX 8

9 The FX Market and the Balance of Payments Demand for FX Imports + K_outflows + C. Bank Reserves = Supply of FX = Exports + NFP + K_inflows K_outflows (Capital Outflows) are the purchases of foreign assets by residents and the sale of domestic assets by foreigners K_inflows (Capital inflows) are purchases of domestic assets by foreigners and the sale of foreign assets by residents C. Bank Reserves can be seen as the net purchase of foreign assets (e.g. China s purchase of US bonds). 9

10 The Capital Account and the Current Account K_outflows K_inflows + C. Bank Reserves = CA The capital account records K_outflows, K_inflows and C. Bank Reserves. KA= K_inflows - K_outflows - C. Bank Reserves The capital account is the symmetric of the current account (CA) CA = -KA The balance of payments captures the CA + KA. Hence it is always in equilibrium. Often, the press refers the Balance of Payments as the balance before the Changes in Central Bank Reserves. 10

11 The Balance of Payments Net Exports (trade balance) Merchandise trade balance: Exports - Imports of Goods Invisible balance: Exports - Imports of Services Net Capital Inflows (+) Payments to domestic appear with + sign; Payments to foreigners appear with sign CURRENT ACCOUNT Net Foreign Payments Income of Assets owned abroad (Local MNC profits) Pay ts to Foreign Assets (worker remittances) Net Unilateral Transfers (receiving Foreign Aid) CAPITAL ACCOUNT Change in Foreign Assets (FDI, Stocks, Bonds, Bank lending) Owned by Residents (increase with - sign) Change in Domestic Assets Assets (FDI, Stocks, Bonds, Bank lending) Owned by Foreigners (increase with + sign) Official interventions: Rise in Central Bank Reserves enters with ( ) sign An increase in Central Bank Reserves is equivalent to a purchase of a foreign asset (i.e. capital outflow) 11

12 Balance of Payments: China, 2001 (Millions USD) Payments to domestic appear with + sign; Payments to foreigners appear with sign CURRENT ACCOUNT Merchandise trade balance: Exports - Imports of Goods Invisible balance: Exports - Imports of Services Net Exports (trade balance) Net Foreign Payments CAPITAL ACCOUNT Net Capital Inflows (+) Foreign Direct Investment (Net Inflows) Other Asset Related Transactions (Net Inflows) Official interventions: Rise in Central Bank Reserves enters with ( ) sign Errors and Omissions (unrecorded transactions)

13 The Current Account, Savings and Investment The fundamental identity of macroeconomics Y = C + I + G + NX Y -T-C-I + T -G = NX Instead of the Trade Balance (NX), we often use the Current Account (CA); let s ignore differences between NX and CA, for now S p I + S g = CA S p (Private Savings) = Y T C S g (Government Savings) = Budget Surplus 13

14 Capital Inflows are Foreign Savings Y=C + I + G + NX (S p I) + S g = CA and CA = -KA Loanable funds market: S p + S g + KA = I Domestic Investment is the supply of loans. Domestic Savings (private or government) or foreign savings (which arrive through the Capital Account)] is the demand for loans. Domestic Investment is financed by Domestic or Foreign Savings. KA (Net capital inflows) is a domestic use of foreign savings. In other words, a Current Account deficit is a means of borrowing from abroad. 14

15 (S p I) + S g = CA = -KA Net Private Saving Government Balance Current Account United States Japan Euro Area Korea Slovakia (*) All numbers for year 2002 as % of GDP US Current Account, Saving and Investment As % of GDP Budget balance Net private saving Current Account Net private saving is the difference of private savings and investment (S p -I) 15

16 Economic Development and Current Account dynamics Singapore ( ) Savings, Investment (% GDP) Current Account (% GDP) Savings Investment Current Account In countries with high growth potential (developing countries), the inflow of foreign capital searching for high returns allows for high investment, without lower consumption. The current account should runs a deficit As the country becomes developed, and capital becomes abundant, it becomes a net exporter of capital. The current account should run a surplus 16

17 An awkward and unstable situation! Capital should flow from rich countries (where it is abundant, and returns are low) to developing countries (where it is scarce and returns are high). Rich countries should have CA surplus and poor countries should have CA deficits. The world is imbalanced (Global Savings Glut) Rich USA Current Account Balances, 1996 and 2003 (Bil of US dollars) Source. Bernanke s Global Savings Glut Countries Japan Euro Area France Asia Countries Developing China Hong Kong Korea Developing countries are saving too much. Germany Taiwan Savings are being absorbed by the US economy, creating CA deficit. and unstable! Italy Spain Other Australia Thailand Latin America Argentina Brazil Risk of a massive and sudden dollar Canada Mexico depreciation to reduce US imports and consumption! This may cause an increase in US inflation and a recession, that would spread around the world. Switzerl d UK M. East and Africa E. Europe and FSU Statistical discrepancy

18 Capital inflows have been financing the US current account deficit. 6% Net private capital inflows 4% 2% Net gov t bond purchases by private sector Interventions by foreign central banks As % of GDP 0% -2% -4% Interventions by US central bank Net increases in USD holdings by foreigners -6% Net exports 18

19 Summary The FX market: Flows of goods, but mostly flows of capital. The adjustment occurs through the nominal exchange rate, unless there are Reserve interventions by the Central Bank. The balance of payments accounting : CA + KA = 0. Flows of capital and Central Bank Interventions are captured in the Capital Account (KA). Capital flows are the symmetric of the current account, if we account for adjustments in Central Bank reserves S p + S g + KA = I The capital account (KA) as the domestic use of foreign savings. Foreign Savings can finance domestic investment, consumption or government expenditure. 19

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