1. GROSS NATIONAL INCOME AND THE BALANCE OF PAYMENTS

Transcription

1 1. GROSS NATIONAL INCOME AND THE BALANCE OF PAYMENTS Gross National Income... 3 Investment, Savings and the Current Account... 6 U.S. Savings and Current Account Experience... 7 The Balance of Payments Overview Balance of Payments Accounting The Current Account The Basic Balance The Financial Account The Official Settlements Balance Errors and Omissions and the Reserves Transaction Balance Central Bank Reserves The Impact of the Balance of Payments on the Domestic Economy The BOP, Investment, and GNI The BOP and Money Supply Resource Allocation and Central Bank Intervention U.S. Balance of Payments Experience Conclusion References GNI-BOP Trade-Offs Figure 1 U.S. GNI and gni... 4 U.S. GNI Accounts... 4 Figure 2 U.S. Investment and Savings Figure 3 U.S. Exports and Imports U.S. Trade, Services, Current, and Financial Accounts, GNI, U.S. SF Rate Differential, and $/SDR Figure 4 U.S. Balance of Payments Table 1 Representative U.S. Balance of Payments Account Transactions Table 2 U.S. Balance of Payments Table 3 Illustrative Balance of Payments Transactions for the U.S J. Bodurtha, 1989, 1992, 2010, 2012, 2016, 2018 All Rights Reserved.

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3 GROSS NATIONAL INCOME AND THE BALANCE OF PAYMENTS At the country-aggregate level, the factors that affect output, interest rates, and currency prices can largely be classified by two accounting identities: Gross National Income (GNI) and the balance of payments (BOP). The Gross National Income (GNI) account provides information on the aggregate level of output and the allocation of this output. Output is allocated to current consumption of goods and services and to savings and investment across private, public, and foreign sectors. This allocation largely determines the trade-off between current and future output levels, which, in turn, determines interest rate levels. The balance of payments (BOP) account provides information on a country's demand for foreign country goods and services (imports), the demand for a country s goods and services by foreigners (exports), as well as cross-country investment. Relative import, export and investment demands across countries set currency values. Together, the GNI and BOP accounts paint a picture of crosscountry economic activity. The accounts also indicate relative international competitiveness. The links between the GNI and BOP accounts and competitiveness are direct. Our discussion will highlight three aspects of these links. First, the consumption-savings-investment allocation determines the concentration of output in the consumption goods and services sector relative to the investment-capital goods sector. Second, associated currency values and international competitiveness determine the output levels of export and import-competing industries relative to industries that are little affected by trade. Third, current consumption-savings and export-import decisions impact future resource allocation, output, interest rates, and currency prices. GNI and BOP Accounts- 1

4 As an introduction to our GNI and BOP discussions, we use an example to illustrate the three highlighted links: 1) A country with relatively high private and/or public consumption and low savings and investment should, all else equal, have high interest rates. Consumption goods producers will be doing well, while capital goods producers will be hurting. When domestic interest rates are relatively high, domestic long-term investment is, relatively, low. 2) The relatively high level of interest rates implies that some relatively productive domestic investment opportunities are not financed. However, these investments will be attractive to foreign investors. Foreigners will buy the domestic currency to make these investments, thus bidding up the value of the home currency relative to other currencies. The rising (or stabilized) currency value makes foreign goods less expensive domestically, and imports increase (beyond the level caused by the initial increase in consumption). Domestic firms, and especially those that export or compete directly with foreign importers, are less competitive at the relatively high exchange rate. 3) Increased domestic investments by foreigners will necessitate increased future payments of dividends, interest, and principal to foreigners. Due to the declining level of domestic savings and investment, this repayment to foreign investors will be more difficult. Sooner or later, the domestic currency value must, all else equal, fall to generate more competitive goods and service exports. This example indicates how the GNI and BOP accounts link international economies and business. Specifically, the example country is stable, but faces potential trouble. Unless productivity increases or savings accumulate to a relatively high level compared to current consumption, future consumption will fall. Gaining an understanding of the GNI-BOP links provides a means to understand the current business environment. More importantly, this understanding provides an integrated perspective for evaluating output, rate and currency outlooks. These outlooks help define current business and political trade-offs, as well as potential outcomes. GNI and BOP Accounts- 2

5 Gross National Income Gross domestic product (GDP) is broken out into consumption (C), government spending (G), investments (I), exports (EX) and imports (IM). Therefore, the GDP identity is the following: GDP = C + G + I + EX - IM The total value of all goods produced domestically plus the net amount earned from investment abroad is nominal Gross National Income (GNI). The largest component of GNI is gross domestic product (GDP). The smaller component, net income from foreign investments (interest and dividends), and similar payments earned out of the country, is called net foreign income (NFI). GNI= GDP + NFI = C + G + I + EX - IM + NFI We see that increases in consumption, government spending, investment, exports and net foreign investment income all raise current output. Higher imports lower output. 1 Nominal U.S. GNI and real U.S. gni are plotted in the first panel of Figure 1. As a convention, capital letters are used to abbreviate nominal quantities. Lower case letters are used to abbreviate real quantities. Nominal quantities are stated in domestic currency. The difference between nominal and real quantities are associated measures of accumulated inflaltion. Stated alternatively, nominal quantities are inflated above real quantities by general price level increases. Real quantity values are dollar values less inflation. Therefore, the cumulative difference of GNI and gni is accumulated inflation (as indicated in Figure 1). 1 Gross National Expenditure (GNE=C+I+G) is all national expenditure, and GDP = GNE + EX IM. GNP=GDP+NFP, NFP is net production income payments from the rest of the world. GNP-GNIas=NFP- NFI. GNI=GNP-statistical discrepancy. Concepts of the U.S. National Income and Product Accounts, BEA, Dept. of Commerce, November GNI is reported by the IMF-International Financial Statistics. GNI and BOP Accounts- 3

6 Figure 1 GNI and BOP Accounts- 4

7 The second panel of Figure 1 presents time-series of U.S. nominal GNI account shares: Consumption (Consume), investment (Invest), government spending (Gov't), government deficit (Deficit), Current Account (Current), and real gni growth (gni change). From an output standpoint, real gni is the quantity of most concern. Real gni represents the amount of real goods and services produced by the United States. Looking at real U.S. gni growth, we see that the U.S. experienced negative real growth in , 1980, 1982, , and slow-downs in 1991 and The behavior of the GNI components in recessions and expansion is interesting. We observe that the shares of consumption and government spending both rose as percentages of GNI in recessions. The investment share declined. Except for the 1974 recession, the government deficit increases in recessions and slow downs. Most recently, , the deficit is increasing while the economy is growing. The relative of share in U.S. economic activity is mixed in expansions. Through 2000, relative government spending fell with each expansion. From 2000 through the 2009 recession, government spending increased had the highest government spending share, 18.3%. Since 2010, relative government spending decreased to 13.9% in In 2000, government spending was in surplus (0.32%). In 2009, the government deficit reached 14.1%, and, then, fell to 4.5% in Interestingly, government spending and private investment appear to be inversely related throughout the sample period. In the 1991 and the 2009 recessions, the trade (bop-current account) deficit shrunk. After the 2009 recession, the trade deficit rose 2 The NBER Business Cycle Dating Committee identifies recessions. Recession dates are the following: November 1973(IV)-March 1975 (I), January 1980(I)-July 1980 (III), July 1981(III)-November 1982 (IV), July 1990(III)-March 1991(I), March 2001(I)-November 2001 (IV), and December 2007 (IV)-June 2009 (II) GNI and BOP Accounts- 5

8 and then fell through 2013, from which the current account deficit has been relatively constant (2-2.3%). Since 1970, the most pervasive aspect of U.S. GNI shares is that growth has occurred predominantly in the consumption-services sector. Government deficits and current account deficit-led foreign investment have funded this growth. The domestic U.S. investment share of GNI has varied, and not grown. To further examine this issue, we examine the investment, savings, and current account components of GNI. Investment, Savings and the Current Account In the GNI accounts, savings is defined as all output that is not expended on private and government consumption. Savings are invested either domestically or abroad. Therefore, a country's total saving is the sum of its domestic investment plus its net foreign investment (I f = capital outflow-capital inflow). With floating exchange rates, net foreign investment is (roughly) equal to the current account balance (CA). 3 Therefore, domestic investment, positive exports, relatively low imports, and investment earnings from abroad are the components of a nation's personal savings: Sav = GNI - C - G = I + EX - IM + NFP = I + CA = I + I f To gain more understanding of the sources of saving and investment, we can disaggregate total saving into government (Sav G ) and private (Sav P ) savings. Government savings are tax receipts (T) in excess of spending (G), or T-G. These "savings" are negative for countries that have government budget deficits. Private savings are whatever is left to the public out of GNI after consumption expenses and taxes are paid, GNI-C-T. By either direct substitution, or by 3 In the sequel, the BOP discussion explains the (roughly), which is due to international government transactions. In our figures, the financial account is negative If. GNI and BOP Accounts- 6

9 disaggregation of savings into its personal and government parts, we have Sav P = GNI - C - T = I + EX - IM + NFP - Sav G = I + CA - Sav G All else equal, high government expenditure (negative government saving or deficits) must be offset by personal savings. U.S. Savings and Current Account Experience The U.S. is currently plagued by high private and high government consumption levels. Current GNI accounts reveal low savings, low investment, trade deficits, and declining net foreign investment earnings. If we look to Figure 2, we see in five out of six recessions and slowdown, that savings fell as a proportion of. Though it is common wisdom about a recovery stage that individuals, effectively, replenished their savings levels, the data doesn t generally support this view: This phemenon occurred in only two out of six cases. Throughout the observed history, personal saving and government spending moved inversely. Figure 2 GNI and BOP Accounts- 7

10 Through 2009, the U.S. savings rate has had intermittent increases along a falling trend. In 2009, savings reached its minimum, 11.4%, and rose through For , savings fell slightly. Until 2009, personal savings were also falling, and were not offset by higher government saving. Since 2009, high government deficits (Deficits) have offset higher personal savings, and led to continued low levels of total savings. Through 2006, the only reason that investment in U.S. firms remained at its average historic level of 19% was due to foreign investment. This investment funded the U.S. current account deficit, and, effectively, traded the high level of U.S. consumption for foreign ownership of U.S. production capacity. Since 2009, U.S. investment rose back up toward 20% of GNI and foreign financial investment has also fallen by 2%. Coming out of the recession, a 2% recovery in investment share was matched by a 6% savings increase, an 9% government deficit decrease, while personal savings fell 6%. Over the long-run, this situation is not sustainable without significant increases in U.S. productivity or decreases in U.S. life styles. Though the U.S. deficit has shrunk from its 2009 recession level, to 5%, the associated U.S. government debt issuance continues to rise. 4 This massive government borrowing need crowds private investment. Should interest rates rise, the cost of U.S. government debt will rise commensurately. The domestic investment outlook remains clouded. Coming out of the 1990 recession, an improving U.S. trade deficit was a positive growth factor. This improvement was caused by the fall in the value in the dollar, and its impact on U.S. international competitiveness, and the recessions' negative income effect leading to 4 The proportion of government debt as a percentage of 2017 GNI is 104%, up from 93% in 2010 and 43% in Debt service consumes roughly 2.3% of GNI, less than the 3% of 1990 and Lower current, debt service is due to lower levels of interest rates and higher GNI growth since 1990 and Nevertheless, the absolute size of this indebtedness and the the potential for higher levels of future interest rates both cloud U.S. economic growth and government funding outlooks. GNI and BOP Accounts- 8

11 lower U.S. imports. The 2009 recession differed with the current account worsening, and the dollar depreciating then appreciating relative to the Special Drawing Right (SDR) currency Baskets. The 2010 recovery began both with substantial trade deficits and a dollar that had depreciated by 20% since 2001 relative to the SDR. Improving current account performance is not offseting other negative savings factors. The relatively low savings-low domestically funded investment situation has not been remedied, and soon may well cause significant economic pain. The sustained U.S. recovery provides some causes for concern. Further allocation of resources into the consumption-service oriented sector may well continue to the detriment of the capital goods sector. A final conjecture regarding U.S. resource allocation is that the much bally-hooed service sector growth has been stimulated by these very same negative factors, not by a fundamental competitiveness shift. In our discussion, the U.S. has been characterized as a nation with low levels of savings, high domestic consumption, and relatively high imports. In terms of resource allocation, the service and consumption sectors grew, while the capital goods and export sectors shrunk. This situation is portrayed as the first stage of our introductory example. Alone in the world, the U.S. could not long sustain this position. Historically, it has not. The U.S. has become more and more intertwined in an international economy. Relatively, the foreign sector has grown in importance. Proof that this change has occurred is found in current U.S. economic conditions. Without the ready availability of foreign goods and investments, post-1970 output growth, employment growth, consumption, relatively high interest rates, and low investment would not have been possible. Instead, the 2008 economic seizure would have occurred sooner. GNI and BOP Accounts- 9

12 There are, certainly, positive factors for the U.S. First, marketbased economies almost always adjust, and in the longer-run do so in positive ways. One likely source of improving growth and competitiveness may be in a falling dollar value. Another is development may be in energy exploration and extraction, and technology. Lastly, continuing dollar use as a global medium of exchange is extraordinarily important. Generally, U.S. dollar value indicates the relative state of foreign demand for current U.S. output, operations, companies and property. To gain a better understanding of the impact of the foreign sector of the U.S. economy, we outline currency value determinants. These determinants are laid out in the balance of payments accounts. The Balance of Payments Overview The balance of payments (BOP) accounts are linked directly to Gross National Income (GNI). As already emphasized, exports and imports of goods and services, primary and secondary income make up the current account portion of GNI. The current account can be significantly positive or negative. However, any GNI imbalances must be funded by private investment flows or government action (such as foreign exchange reserve sales.) The BOP settles for all of these transaction flows on a net basis. The net international flow of current, capital, and government transactions must equal zero. Hence the net BOP is zero. Conceptually, the BOP accounts for the supplies and demands of a country's product and investment with the rest of the world. Since the associated trade and investment must be paid for in the countries' currencies, the BOP accounts for the sources of a country s currency supply and demand. These BOP credits (demands) and debits (supplies) determine currency values. We emphasize this definition of the balance of payments. We also consider how balance of payments account changes impact output, interest rates, and exchange rates. GNI and BOP Accounts- 10

13 A supply of a country's currency is termed a debit on its balance of payments. A demand for a country s currency is a credit. The supply of a currency, debits, will occur whenever anyone holding a country's currency trades that domestic currency for another. In turn, demands for a currency, credits, will occur whenever a holder of a foreign currency trades that currency for the domestic currency. Because the BOP must balance, all international trade, service, or investment transactions lead to both a credit and a debit on a country's balance of payments. Using the United States as an example, and considering it to be the domestic country, we have, Demand for (purchase of) dollars by holder of foreign currency is a U.S. BOP credit. Supply (sale) of dollars by holder of dollars for foreign currency is a U.S. BOP debit. At a point in time, an increase in the number of credits on the domestic country BOP tends to lead to an appreciation in the value of its currency. This result occurs because excess credits lead to an excess currency demand. This excess demand is met in one of two ways, dependent on whether a country has a floating or fixed exchange rate policy. Under a floating exchange rate policy, the currency facing excess demand will appreciate. The currency will increase in value until its appreciation leads some of those interested in purchasing this country s goods, services and investments to lower their demand at the now higher price. Under a fixed exchange rate policy, the central bank of a country must sell the domestic currency that is needed to meet excess market demand. Analogously, it must sell foreign currencies or other reserves to meet excess market supply. GNI and BOP Accounts- 11

14 In the excess demand case, the central bank sells its currency to those wanting to sell foreign currency, receives that foreign currency, and accumulates foreign currency reserves. In the face of excess currency supply, these reserves would be used to buy back the excess domestic country currency. The accumulation or loss of foreign currency reserves by a country's central bank indicates that it is following a less than freely floating exchange rate policy. As a brief summary, Floating Rate Policy Fixed Rate Policy Dollar Foreign Currency U.S. reserves Foreign. reserves Dollar demand and and/or Dollar supply Balance of Payments Accounting Four BOP accounts are of most interest: the current account, the basic balance, the official settlements balance, and the reserves transaction balance. Of the transactions underlying the BOP, goods and services exports and imports, short-term and long-term capital inflows and outflows, and reserve flows are the most important ones. The first three types of transactions are reported by businesses to their associated government agencies, and reserve flows are managed by the Central Bank. For the U.S., the Fed tabulates and publishes reserve flows weekly. U.S. and other major country trade flows are tabulated monthly, and reported at this frequency with at least a month delay. The other BOP components are usually reported quarterly, sometimes with significant delays. GNI and BOP Accounts- 12

15 Table 1 presents a breakdown of the United States Balance of Payments. This breakdown is consistent with the Department of Commerce definition of the balance of payments. 5 The Current Account The current account is the net balance of current international transactions. The current account shows whether a country is a net producer or consumer on the world market. The two largest components of the current account are the trade account and the service account. The trade account is simply merchandise-goods exports less merchandise-goods imports. The service account balance is also a simple difference of service exports and service imports. However, the classification of service flows can be confusing. Some examples of service exports and imports, and their associated impact on the U.S. balance of payments, credit(+) and debit(-), are the following: Merchandise Trade Export (+) Import (-) Tourism American Abroad (-) Foreigner in U.S. (+) Transport United Airline Flight by Foreigner (+) U.S. Citizen on Lufthaunsa (-) Consulting Booz Allen for Paris firm (+) Insurance Premium by British to Aetna (+) Premium by Citibank to Lloyds (-) Dividends Paid by Sony to you (+) Paid by IBM to France (-) The service transactions are identified as credits or debits dependent on whether they will generally lead to a domestic currency demand or supply. 5 See the June 1978 issue of the Department of Commerce Survey of Current Business for a more detailed discussion. See also IMF BPM6. GNI and BOP Accounts- 13

16 The sum of all goods and services transactions is the balance on goods and services. This balance shows how a country is doing relative to the rest of the world in production of goods and services. In this balance, net service exports and imports are added to the trade balance. Unfortunately, the press tends to emphasize the trade balance in its reports on worldwide competitiveness. For example in the 1970 s, the U.S. was a net exporter of services and a net importer of goods. In this case, a basic competitiveness problem was often reported, but not clearly manifest. GNI and BOP Accounts- 14

17 Table 1 REPRESENTATIVE U.S. BALANCE OF PAYMENTS ACCOUNT TRANSACTIONS (table line numbers correspond to U.S. Dept. of Commerce definitions) (+) credits (-) debits 1. MERCHANDISE TRADE Export of good (2) + Import of good (18) - TRADE BALANCE +/- 2. SERVICES Export of transportation service (5-6), Tourist services (4), financial services (9), Capital services (11-15), military equipment (3) + Import of transportation service (21-22), tourist services (20), financial services (25), capital services (27-31), military expenditures (19) = BALANCE ON GOODS AND SERVICES +/- 3. PRIMARY INCOME Receipt of gift and income related flow to relative abroad (36) - Receipt of gift and income related flow t from foreign relative (36) + labor and investment (direct, portfolio, other loans/deposits) income to U.S or from abroad (35) - +/- 3. SECONDARY INCOME Current transfers refer to unilateral receipts and payments between residents and non-residents = CURRENT ACCOUNT +/- 4. LONG-TERM CAPITAL PRIVATE CAPITAL FLOWS FOREIGN DIRECT INVESTMENT FLOWS U.S. firm invests in foreign affiliate (49-50) - U.S. firm reduces claims on foreign affiliate (49-50) Foreign firm invests in U.S. affiliate (66-67) + Foreign firm reduces claim on U.S. affiliate (66-67) - LONG-TERM PRIVATE PORTFOLIO INVESTMENT FLOWS U.S. resident purchases or sells foreign stock or bond (51) + or - U.S. resident issues long-term credit to foreigner (52) - U.S. bank makes long-term foreign loan (54) - U.S. bank receives principal payment on foreign loan (54) + Foreign resident purchases U.S. Treasury security (68) + Foreign resident purchases non-treasury U.S. stock or bond (69) Foreign resident issues long-term credit to U.S. resident (70) + Foreign bank makes long-term U.S. loan (72) + Foreign bank receives principal on U.S. loans (72) = BASIC BALANCE +/- 5. SHORT-TERM PRIVATE INVESTMENT FLOWS U.S. resident invests in foreign commercial paper (53) - U.S. resident increases foreign deposits in foreign bank (55) - U.S. resident reduces foreign deposits in foreign bank (55) + Foreign resident invests in U.S. commercial paper (71) + Foreign resident increases dollar deposits in U.S. bank (73) + Foreign resident reduces dollar deposits in U.S. bank (73) = OFFICIAL SETTLEMENTS BALANCE +/- 6. ERRORS AND OMMISSIONS, STATISTICAL DISCREPANCY (75) +/- RESERVE TRANSACTIONS BALANCE +/- 7. OFFICIAL CAPITAL OR RESERVE FLOWS- GOVERNMENT CAPITAL FLOWS NON-OFFICIAL FLOWS U.S. government makes short or long-term foreign loans (44 or 46) - OFFICIAL OR RESERVE FLOWS U.S. government purchases gold (39), SDRs (40), foreign currencies (42) - U.S. government sells gold (39), SDRs (40), or foreign currencies (42) + Foreign government purchases Treasury bills (59), other U.S. government liabilities (61), private security (63) + Foreign government sells Treasury bills (59), other U.S. government liabilities (61), private securities (63) - GNI and BOP Accounts- 15

18 A good source of international balance of payments information is the International Monetary Fund's (IMF) International Financial Statistics (IFS), both the yearbook and monthly volumes. A broad range of economic and financial data is published in this source. The 2017 U.S. Balance of Payments section is reproduced in Table 2. As an example, we review these figures. Table 2 UNITED STATES BALANCE OF PAYMENTS Source: International Monetary Fund, International Financial Statistics (IFS) A05A558D9A42&sId= United States (IFS Country # 111) Balance of Payments 2017 GOODS, CREDIT (EXPORTS) (BXG_BP6_USD) GOODS, DEBIT (IMPORTS) (BMG_BP6_USD) BALANCE ON GOODS (BG_BP6_USD) SERVICES, CREDIT (EXPORTS) (BXS_BP6_USD) SERVICES, DEBIT (IMPORTS) (BXS_BP6_USD) BALANCE ON GOODS AND SERVICES (BGS_BP6_USD) PRIMARY INCOME: CREDIT (BXIP_BP6_USD) PRIMARY INCOME: DEBIT (BMIP_BP6_USD) BALANCE ON GOODS, SERVICES, AND PRIMARY INCOME (BTGSI_BP6_USD) UNITARY TRANSFERS/SECONDARY INCOME: CREDIT (BXISXF_BP6_USD) UNITARY TRANSFERS/SECONDARY INCOME: DEBIT (BMIP_BP6_USD) CURRENT ACCOUNT, N.I.E.(BCAXF_BP6_USD) CAPITAL ACCOUNT* (BKAA_BP6_USD) 24.8 DIRECT INVESTMENT (BFDA_BP6_USD & BFDLXF_BP6_USD) PORTFOLIO INVESTMENT (BFPA_BP6_USD & BFPLXF_BP6_USD) OTHER INVESTMENT (BFOA_BP6_USD & BFOLXF_BP6_USD) FINANCIAL DERIVATIVES: NET (CURRENT ACCOUNT, N.I.E.(111109BXZF)) FINANCIAL ACCOUNT* (BFXF_BP6_USD) OFFICIAL SETTLEMENTS BALANCE (1113DZLAZF) NET ERRORS AND OMISSIONS (1114Y9NAZF) 92.5 RESERVE TRANSACTION BALANCE (111409NAZF) -1.7 RESERVE ASSETS (1114Z9NAZF) The trade deficit was $807.5 billion. Service exports were $797.7 billion, while imports of services were a $542.5 billion debit. Therefore, the service balance was a $255.2 billion credit, which brought the 2017 GNI and BOP Accounts- 16

19 balance on goods and services to a deficit of $330.5 billion dollars. The U.S. imported more goods and services than it exported. Service income is distinguished from primary income, the next balance of payments account, by whether produced (service) assets or non-produced (primary income) assets are used to generate the income. Non-produced assets generate rent, and financial assets, which are also extant (not produced in the current period), and give rise to interest, dividend, and retained earnings classes of income. For the U.S., primary income the balance was $221.7 billion. The next category on the balance of payments is unilateral transfers, or secondary income. This category consists of gifts between countries. It is made up predominately of two components, foreign aid and wage remittances. For example in the first quarter of 1991, the U.S. balance swelled positively as foreign country payments in support of U.S. Gulf War efforts flooded into the U.S. Usually, the U.S. is a net giver of aid, and runs a deficit on this account. For the U.S., and generally, the case of foreign aid is not as important a debit item as may first appear. The reason for this observation is that approximately 95% of U.S. giving for agricultural products, military aid, etc. ends up being spent on U.S. goods. These unilateral transfers give rise to linked increases in U.S. exports. Without unilateral transfer debits, U.S. exports would be lower, and the same is true for other countries. For 2017, the net Secondary Income balance was negative $118.6 billion. GNI and BOP Accounts- 17

20 Remembering that debits lead to an excess supply of currency, and exports an excess demand, these "linked" unilateral transfer and export transactions partially net out in the Balance of Payments. Many are beginning to recognize that tying of aid to a country's own exports is not true philanthropy. A number of large-scale "foreign aid" funded development projects in emerging economies are criticized for this reason. Worker wage remittances are becoming a growing part of many countries' balances of payments. Turkish workers earn large amounts of foreign exchange by working abroad. When sent home, the foreign currency earnings are converted into the domestic currency yielding a credit (demand for home currency) and a debit on the foreign balance of payments. A large par of Yemen's balance of payments credits have, at times, come from foreign wage remittances. The large 2017 U.S. trade account component of the current account deficit was exacerbated by the unilateral transfers deficit. The 2017 U.S. current account balance was a deficit of $449.1 billion. We will see that this deficit was offset by net foreign investment and errors in BOP accounting. The Capital Account follows the Current Account, and is relatively small and variable. Non-produced, non-financial transactions between residents and non-residents enter this account. Generally, the entries will be transient, and some examples are debt forgiveness, permissions to use, but not own, natural resources, investment grants tied to specific project finance, large gifts and legacies, and sales of marketing brand names, logos, trademarks and domains separate from any sale of the entity that owns them. The Capital Account balance was $24.8 billion. GNI and BOP Accounts- 18

21 The Basic Balance Up until 1995, countries and international organizations segmented both the Portfolio Investment and Other Investment accounts into short-term and long-term components. Since the determinants of short-term and long-term investment have different motivations, the s/t and l/t investment dichotomy was helpful to see how the tenor of international investment was changing for a country. Unlike goods demands, which tend to be stable, investment demands can be quite volatile, and resultant swings in the investment accounts can cause large changes in currency values. Nonetheless, long-term investment flows are more stable than short-term investment flows. To create the basic balance, net long-term private cross-country investment is added to the current account. Long-term private investment includes all investment transactions with maturities over one year. All of Foreign Direct Investment (FDI) is included in the Basic Balance. If in any year, the domestic country makes more long-term investments abroad than foreigners invest long-term domestically, then a long-term investment account deficit results (and vice versa). The following transactions are examples of long-term private investment transactions: GNI and BOP Accounts- 19

22 Effect Long-term Offsetting Transaction Private Investment Double Entry U.S. investor buys Sony U.S. L/T capital outflow (-) Stock Issue Deposit U.S. S/T capital inflow (+) to Sony's U.S. bank account Foreign investor buys a Foreign Private L/T capital inflow (+) N.Y. Condo Payment U.S. S/T capital outflow (-) from foreign bank U.S. investor sells U.K. U.S. Private L/T capital inflow (+) Consol Deposit in investor's U.S. S/T capital outflow (-) U.K. account Foreign investor sells Treasury Foreign Private L/T capital outflow (-) Bond Deposit to foreigner's U.S. S/T capital inflow (+) U.S. bank As noted in the examples, long-term investment credits (FX inflows) are usually offset by short-term debits (FX outflows), and vice versa. In these examples, foreigners' dollar checking accounts are drawn down for the long-term investment in the U.S., and vice versa. A country that funds a current account deficit with long-term foreign investment is not viewed to be in an awful balance of payments situation. Examples in which this situation occurred consistently, while the BOP and exchange rates were relatively stable, are the U.S. in some periods of the 1800's, and more recently, post-war Europe, Japan, Korea, etc. In the long run, current account deficits have to be repaid. However, the accumulated current account deficit is likely to be repaid if original long-term foreign investments are productive. The balance of payments account which summarizes this condition is the basic balance. The basic balance is the sum of the current account and the long-term private investment accounts. The sum of direct investment, portfolio investment, and the long-term part of other investment. In order to estimate the long-term component of the Other Investment accounts, The Commercise Department Bureau of Economic Analysis and Finance regulators provide detailed BOP accounting that breaks out long-term and short-term components of the Other Investment Accounts. GNI and BOP Accounts- 20

23 The surplus $165.2 Other Investment Account has a long-term component of $153.8 billion. The short-term investment is $11.3 billion. Even though long-term investment partially offsets the negative Current Account, the Basic Balance, like the current account, has a large deficit, $85.2 billion. United States Basic Balance of Payments Year-End 2016 (adapted from Table 2 from BEA detailed Balance of Payments and Int l Investment Publication information) CURRENT ACCOUNT, N.I.E) CAPITAL ACCOUNT 24.8 DIRECT INVESTMENT PORTFOLIO INVESTMENT L/T OTHER INVESTMENT BASIC BALANCE S/T OTHER INVESTMENT 11.3 FINANCIAL DERIVATIVES: NET (CURRENT ACCOUNT, N.I.E.) FINANCIAL ACCOUNT* OFFICIAL SETTLEMENTS BALANCE NET ERRORS AND OMISSIONS 92.5 RESERVE TRANSACTION BALANCE -1.7 The Basic Balance deficit is largely funded by foreign short-term investment, and an account to be discussed below Errors and Omissions. The Financial Account The difference between long- and short-term investment is mostly perceived as one of the relative commitment to the investment. This commitment can be low due either to future needs for investment proceeds or short-term expectations regarding the long-term suitability of the investment. To state the difference in the language of relationships, long-term investment indicates a long-term commitment, and short-term investment may only be an investment fling. A long-term investment deficit indicates both U.S. investors seeking long-term investment relationships abroad, and foreign investors shrinking their long-term commitment to U.S. domestic GNI and BOP Accounts- 21

24 enterprise. Most simply, long-term dollar denominated investments are being traded in for short-term investments, or the investments are being liquidated. Traditionally, this change has been taken to indicate decreased confidence in an investment environment and the associated currency (in the U.S. case, meaning the dollar.) The next Basic Balance category is Other Short-Term Private Investment account. If the government does not intervene in foreign exchange markets, the short-term private investment account will offset any basic balance surplus or deficit. In 2017, the U.S. short-term private investment account was a $11.3 billion surplus, enough to offset about a third of the Basic Balance deficit. A potential problem exists if the short-term investment balance is large. Short-term investments can be volatile. Determined by relative interest rate differentials and perceptions of risk across countries, shortterm funds can be moved very rapidly between countries. Such capital mobility, in the face of changing relative returns and investor perceptions, is the most likely cause of increased volatility in currency demand and supply. Hence, volatile exchange rates have resulted from and will continue to be associated with large short-term capital account imbalances. 6 The Financial Account balance was significantly positive. With this additional information, we directly aggregate the Current, Capital, and Financial Accounts into the Official Settlements Balance. The Official Settlements Balance Incrementally, the Basic Balance plus net Other Short-Term Private Investments is the Official Settlements Balance. It is the sum of all private foreign exchange-related transactions. Under the more 6 Derivatives close the Basic Balance. Maturity differences are not reported for this account, and, hence, derivatives are not ibroken out as s/t or l/t. GNI and BOP Accounts- 22

25 common defintions of the Balance of Payments, as in Table 2, the Officials Settlements Balance is the sum of the Current Account, Capital Account, and Financial Account. The Official Settlemens Balance is given this name because any private currency demand and supply imbalance must be settled by an official agency of a government. Central banks are the official agencies that sell or buy currency. The sale or purchase depends on the respective positive or negative sign of the official settlements balance. Given the U.S. basic balance deficit of $101.3 billion and the private short-term investment surplus of $30.2 billion, the 2017 official settlements balance was a deficit of $94.2 billion. But how can the U.S. have a deficit (or a surplus)? During this time, wasn t the dollar floating and unsupported by the U.S. Fed? Errors and Omissions and the Reserves Transaction Balance Often times, a significant part of the answer to this question resides in the next account on the balance of payments, Errors and Omissions. This account is simply the difference between the official settlements balance, which is compiled by the Commerce and Treasury Departments from tariff and other trade and investment reports, and the Reserves Transactions Balance. The Reserves Transaction Balance is the net of actual foreign exchange transactions made by a central bank, which for the U.S. is the Federal Reserve Bank or Fed. The Fed knows its foreign exchange transactions. On a net basis in 2017, it spent $1.7 billion in reserves. Therefore, the 2017 reserves transaction balance was $1.7 billion dollars. Errors and omissions were equal to the Official Settlement Balance minus the Reserve Transaction Balance, or $92.5 billion. With the error account on this scale, it is an important determinant of the international supply and demand of dollars. Since determination of currency supplies and demands is necessary to GNI and BOP Accounts- 23

26 determine where a currency value is going, forecasting exchange rates can require some forecasting of errors and omissions. It is felt that a good part of the U.S. errors and omissions surplus is caused by illegal and unreported foreign investment, and investment income inflows. Revelations regarding some major banks unfiled currency transcations reports, such as the Bank of Boston's over one billion dollars from , some real estate transactions, e.g. Philippine Presidend Ferdinand Marcos, and Deutsche Bank s $600 billion fine for Russian-related business, tend to support this view. There is some worry that these missing investments are short-term. However, the errors and omissions account hasn t tended to move with the short-term investment account. It appears to be relatively return insensitive. Of course, other considerations could be more important than short-term returns when choosing to move funds or invest illegally. The other hypothesized source of the errors and omissions is poor reporting of export flows. (Often imports are restricted or generate tariffs and seem to be reported more accurately than exports.) Analysis of U.S.-Canada trade flows indicates significant understatement of U.S. exports. As a result, we understand that the U.S. now uses Canadian import data to adjust its trade statistics. Both the unreported investment flow and the misreported trade flow explanations of BOP errors and omissions are reasonable. Nevertheless, the transaction basis for the errors and omission account remains an open question. As stated above, the 2017 U.S. Reserve Transactions Balance shows that the U.S. didn t intervene in foreign exchange markets. Since the mid-1970s, the U.S. has not intervened heavily. Many countries did and do intervene, and consistently run substantial Reserve Transaction Account surpluses and deficits. Until the Euro was established, members of the European Monetary System Exchange Rate Mechanism (EMS-ERM) had fixed their currency values GNI and BOP Accounts- 24

27 relative to each other. France and Germany provided particular examples of intervention in Other countries, e.g. Brazil, the People's Republic of China, India, and Mexico, also fix or manage their exchange rates, as evidenced by their reserve transaction balances. 7 All of these countries have accumulated or lost reserves to offset their private sectors' balance of payments surplus or deficit, respectively. Central Bank Reserves Reserve transactions are made with one or more of three types of reserves: foreign exchange, gold, and IMF Special Drawing Rights (SDR's). Foreign exchange reserves are accumulated when a central bank pays out its own currency for foreign exchange. This accumulation occurs when excess demand for its currency prevails. If the central bank did not intervene and accumulate reserves, its currency would rise in value. The opposite occurs when foreign exchange reserves are drawn down. Central bank foreign exchange reserve transactions occur in both the interbank market and between central banks. Alternatively, central banks can support their currency by buying other central banks' excess holdings of their currency with other reserve currencies, like the U.S. dollar, or with gold and Special Drawing Rights (SDR's). SDR's are effectively paper gold issued by the International Monetary Fund (IMF) to its members. Therefore, SDR's are a part of the world money base and a source of world liquidity. SDR issues are made from time to time, based on the state of the world economy and liquidity. Another means of issuing SDR's are IMF special lending facilities for developing countries in need of reserves. SDR or reserve currency loans from these facilities are energy, food, basic commodity, and debtrelated. With regard to balance of payments accounting, increases in 7 To check, look up IFS line 409NAZF for these countries in the International Finance Statistics. The countries that intervene will have significant balances. GNI and BOP Accounts- 25

28 reserves are debits, and decreases are credits. This convention is followed to have the BOP balance. The Impact of the Balance of Payments on the Domestic Economy Exchange rate change is driven by Balance of Payments change. However, the Balance of Payments is also important for three other reasons. The first reason is derived from the links between the accounts of the BOP, Gross National Income (GNI), and investment. The second relates to the link between the balance of payments and money supply. The third reason is the impact of the balance of payments and the exchange rate on resource allocation in the economy. The BOP, Investment, and GNI When a country runs a balance of trade surplus (net credits), it is producing more than it is consuming. Domestic savings and investment is relatively high, and interest rates are relatively low. Over time, greater investment leads to more wealth and income. Higher wealth and income lead subsequently to increased consumption. Out of increased consumption, some expenditure will go to imports, which will lower the initial surplus. Other countries may be at different stages of this cycle. These differences lead to different patterns of savings, investment and growth across countries. The BOP and Money Supply Foreign short-term investment can affect a country's money supply. Table 3 shows example balance of payment credits and debits that illustrate this phenomenon. The exchange rate assumed for this illustration is one half Euro (EC) per dollar. In the first transaction, a German company buys $1,000,000 or 500,000 Euro (EC) worth of machinery from a U.S. manufacturer. This U.S. export is a credit on the U.S. Balance of Trade, and leads to an increase in U.S. GNI. GNI and BOP Accounts- 26

29 To treat the necessary offsetting balance of payments debit for the equipment export, we assume that the U.S. machinery manufacturer is paid in EC, and deposits the EC in a Frankfurt bank account. With the second transaction component, the U.S. manufacturer has expressed a short-term investment demand for the Euro, and a debit on the U.S. balance of payments results. This U.S. manufacturer is now subject to the foreign exchange rate risk that the EC may fall in value. In net terms, there is no effect on the excess supply and demand of Euro versus dollars. The two private transactions are offsetting. In the second transaction, the U.S. manufacturer decides to sell the EC for dollars. The sale of EC generates a credit of $1,000,000 on the U.S. Balance of Payments, because a holder of foreign exchange has expressed a demand for dollars. We assume the manufacturer's U.S. bank decides to hold the EC, which results in an offsetting dollar supply. The U.S. bank now bears the exchange rate risk from its shortterm investment in a EC bank account. Again, since there are two private U.S. entities willing to trade EC for dollars at the current exchange rate, there is no effect on the value of the dollar relative to the EC. GNI and BOP Accounts- 27

30 Table 3 Illustrative Balance of Payments Transactions for the U.S. Source: Robert M. Stein, The Balance of Payments, New York Aldine, 1973, pp ) German buys machinery for $1,000,000 pays from his bank Credit (+) Debit (-) export (goods) $1,000,000 S/T K outflow (deposit in Frankfurt bank) $1,00,000 (500,000 ½ EC=1$) 2) U.S. machinery maker wants $s for EC in transaction 1) (Buys them from U.S. bank which holds EC) S/T K inflow (corp.) $1,000,000 S/T K outflow (bank) $1,000,000 = 500,000 EC Floating Exchange Rates 3) U.S. bank wants $'s (and can't find a 1/2EC buyer at $1, gives up EC per dollar.) S/T K inflow $800,000 S/T K outflow $800,000 = 500,000 EC Fixed Exchange Rates (** Transactions below the line) 4) U.S. Bank wants $'s from Fed S/T K inflow $1,000,000 Official S/T K Outflow (Fed holds foreign currency) $1,000,000 = 500,000 EC 5) Fed demands payment from Bundesbank Official S/T K inflow $1,000,000 $ Reserves, SDR, or Gold settlement $1,000,000 = 500,000 EC GNI and BOP Accounts- 28

31 Under a floating rate policy, no official agency stands ready to pay a two dollars for one Euro. If the U.S. bank is to sell EC, then it may have to increase the number of EC that it will give up for each dollar bought. In this case, the resulting exchange ratio would set a new and higher floating exchange rate level (higher dollar value, lower EC value.) Under floating rates, such a mechanism yields the conclusion that a U.S. export leads to a fall in the foreign country's currency value. We assume a large depreciation to EC per dollar. (One EC fell from 0.5 EC to EC per dollar, as the EC dollar cost fell from $2.0 to $1.60.) With the EC sale, the U.S. bank has 800,000 dollars (500,000EC x $1.6), the BOP credit, and no longer any claim to the 1,000,000 EC account, the BOP debit. The dollar amount differs from the bank's EC deposit, and the $200,000 is an exchange rate loss. This loss decreases the U.S. firm s earnings. Even with the loss, the EC sale has a potential stimulative effect in the U.S. The dollar deposit increases the U.S. bank's reserves (and total U.S. bank reserves if bought from a non-u.s. entity.) Based on historical reserve ratios, 3%-18%,the bank could make 5 to 33 times as many loans as they have reserve deposits. Since loans are initiated as borrower demand deposits or cash, money supply expands with increased loans. Under a floating exchange rate policy, the U.S. export should led to a rise in the dollar's value. (If bought from a non-u.s. entity, then U.S. money supply increases also.) An import has the opposite effect (U.S. dollar down, U.S. money supply contracts). With a fixed exchange rate policy, either or both the U.S. and the European central banks agree to pay a fixed amount of dollars for EC. In our example, one dollar will be paid for every half EC. Under our assumed scenario, trying to sell the EC led to a price decline. Therefore, the U.S. bank probably couldn't get as good a price elsewhere, and it will sell off its EC exposure to its central bank, the Fed. However, this GNI and BOP Accounts- 29

32 sale becomes an official transaction. Therefore, this transaction goes below the line that separates private and official transactions. When a BOP transaction goes below the line, domestic bank reserves and money stock are also affected. As in the floating exchange rate policy case, the reason behind this effect is that a domestic bank deposit at its central bank is used as loan portfolio reserves. In Table3 - transaction four, the U.S. bank sells EC to the Fed, and is credited with a reserve deposit. The bank's expression of a demand for dollars increases its reserve deposits at the Fed. U.S. bank reserves are, therefore, increased by $1,000,000 with this transaction. These reserves add to the U.S. monetary base, and money supply would probably increase even more as additional loans are made. In turn, the Fed's foreign exchange reserves are increased by $1,000,000, a BOP debit. The Fed has demanded EC, and is exposed to EC risk. With fixed exchange rates, the U.S. export has led to an increase in U.S. money supply and U.S. foreign exchange reserves. However, the European/German economy has not yet been affected. The German economy is affected in the last transaction, five. The Fed sells EC to the Bundesbank, the German central bank (or any central bank in the Euo monetary union) for one of the following: dollars, a reserve currency other than EC, gold, or SDR's. Fed liabilities to foreign central banks go down if dollars are bought, or U.S. reserves go up if foreign currency, gold or SDR's are bought. However, the Bundesbank loses reserves. To compensate for this loss, it debits the Frankfurt bank that had the original 500,000 EC deposit, which was used to pay for the German import. Therefore, the effect of the German import is to lower both German central bank reserves (foreign currency, gold or SDR), and money supply. (The import also decreases German GNI.) GNI and BOP Accounts- 30

33 To summarize the impact of a U.S. export once it has worked through some of the system, Currency Money Dollar Reserves Supply Floating rates no effect no effect (or ) Fixed rates no effect Resource Allocation and Central Bank Intervention Changes in balance of payments accounts and exchange rates can have important effects on resource allocation in an economy. These allocation effects fall on two separate sectors of the economy, the traded and non-traded sectors. Firms in the traded sector export goods and services or compete with foreign producers of domestic imports. Firms in the nontraded sector do not compete directly with foreigners. A traded sector-nontraded sector dichotomy is brought out clearly in the case of non-traded products and services such as haircuts and lobbying, as well as certain types of purely national products, e.g. vegamite, peanut butter, or U.S. football (until recently). Resource allocation effects occur when traded product prices do not change quickly in response to exchange rate changes. Historically, many product prices have not adjusted quickly to exchange rate changes, and the traded and non-traded sectors have been affected differently. When a country's currency value is high in terms of the goods and services that it buys, the country will have a current account deficit. To fund this deficit, it will have either an investment surplus or run down its reserves. In the first case, the traded sector will be shrinking due to import competition from lower-priced foreign goods and services. Investment will be allocated to the most profitable ventures, i.e. those ventures that do not face foreign competition. In the short-run, these profitable ventures will be in the non-traded sector. Resources will shift GNI and BOP Accounts- 31

34 from the traded sector to the non-traded sector. If central bank reserves are run down, the traded sector is, at least in the short-run, less affected. Such resource shifts give rise to a potential cost of flexible exchange rates. Resources in the form of labor, technology and capital must follow the exchange rate. If this reallocation of resources is costly, then even though exchange rate-induced trade adjustment is good in the long run, the short-run reallocation costs may be high. This observation is one of the motivations behind Keynes' comment, that "In the long run, we are all dead." The U.S., which supports floating exchange rates, can be viewed as taking the position that exchange rate change-induced resource reallocation changes are neither overly costly nor slow. Under this view, floating exchange rates both won't kill, and will quickly induce efficient resource allocation. The alternative course is to hold currency values fixed by buying and selling reserves (or tariffs, subsidies, quotas, etc.). This action forestalls resource reallocation, and has two motivations. The first and most compelling motivation is that the exchange rate change maybe transitory, i.e. driven by short-run factors. If resources respond to shortrun change, they will only have to reverse course between the traded and non-traded sectors when the temporary change in the Balance of Payments and the exchange rate is reversed. This view effectively presumes that markets respond to short-run speculative pressures, which have no longer-run economic justification. The second major motivation for fixed exchange rates is that even though an exchange rate change does reflect the need to reallocate resources, this change must occur slowly. Otherwise, the short-term adjustment costs may be too high. Therefore, central banks support an undervalued or overvalued exchange rate to cushion adjustment to a new long-run exchange rate. In this case, the central GNI and BOP Accounts- 32

35 bank loses money to market participants who are profit- motivated, as opposed to welfare- motivated. This position seems to have been taken by the Chinese, Japanese, and French (though possibly less so recently). 8 In the end, the views supporting flexible and fixed exchange rates have merit. However, the appropriateness of either exchange rate system will evolve with changing economic and market conditions. For the U.S., flexible exchange rates have been the rule since In this light, we review the U.S. experience. U.S. Balance of Payments Experience Figure 3 depicts the U.S. Trade, Current, and Financial Accounts as well as rate, exchange rate and GNI information. Starting from the GNI accounts, the current account must be offset by capital or reserve flows. In 2017, the U.S. current account deficit was financed primarily by errors and omissions and a financial account surplus. With regard to the long-term viability of the U.S. BOP deficits, we recall that the Basic Balance was significantly negative. In Figure 4, the state of the U.S. balance of payments is depicted from 1970 through In recent years, we see that large trade deficits were funded by the following: a small services surplus, financial inflows, errors and omissions and reserve outflows. Across all periods on net, we identify some patterns for the U.S.: Goods importer (exports < imports) Service exporter (trade < current) Financial Capital exporter after 1983 Significant errors and omissions Large reserve outflows in , 1989, and From , the existence of this practice is evident in central bank profits. Central banks lost an estimated $12 billion. This observation is important because it shows that motives other than profit affect central bank behavior. Their market activities imply that foreign exchange trading may not be a zero sum game for private participants. GNI and BOP Accounts- 33

36 Figure 3 GNI and BOP Accounts- 34