Chapter 9 Balance of Payments, Debt, Financial Crises, and Stabilization Policies Problems and Policies: international and macro
1 International Finance and Investment: Key Issues How major debt crises emerged during the 1980s Deficits of current accounts, financial account, and capital accounts Accumulation of debt and emergence of debt crisis Mostly international financial crises were viewed as originating in the developing world - Latin American debt crisis of 1982 - Mexican Tequila Crisis of 1994 - East Asian contagion of 1998 Main causes is weak financial markets and institutions and unstable political economy After their 1980s and 1990s debt crises affected countries were required by IMF and WB to privatize state-owned enterprises, eliminate regulations, and reduce infant industry protection 2
2. National Accounts National income and product accounts: accounting system for a country s total production and income Two fundamental concepts of the system: Gross domestic product (GDP): the value of all final goods and services produced within a country s borders during a period of time (usually a year) Gross national product (GNP): the value of all final goods and services produced by the labour, capital, and other resources of a country within the country as well as abroad 3
Imagine about the value of national income that results from production and expenditure. Recalling the circular flow diagram Producers earn income from buyers who spend money on goods and services. Money Households Money The amount of expenditure G&S Factors = the amount of income Factor = the value of production. Markets G&S Money Firms Factors Money National income is often defined to be the income earned by a nation s factors of production. 4
What are factors of production? Inputs that are used to produce goods/services: workers (labor), capital (buildings and equipment), land and others. The value of final goods and services produced by Cambodia-owned factors of production are counted as Cambodian GNP. GNP is calculated by adding the value of expenditure on final G&S produced. GNP is one measure of national income, but a more precise measure of NI is GNP adjusted for following: 1. Depreciation of physical capital (depreciation is subtracted from GNP). 2. Unilateral transfers to and from other countries can change national income. Another rough measure of NI is gross domestic product (GDP): GDP = GNP payments from foreign countries for factors of production + payments to foreign countries for factors of production 5
3. Current account: what is it? GDP There are 4 types of expenditure: 1. Consumption: expenditure by home consumers C 2. Investment: expenditure by firms on buildings & equipment I G 3. Government purchases: expenditure by governments on G&S 4. Current account balance (exports minus imports): net expenditure by NX foreigners on domestic G&S 6
GDP = Expenditure on a Country s Goods and Services NI = value of domestic production Y = C d + I d + G d + EX = (C-C f ) + (I-I f ) + (G-G f ) + EX NI = Expenditure on domestic production = C + I + G + EX (C f + I f +G f ) = C + I + G + EX IM = C + I + G + CA Net expenditure by foreign individuals and institutions Expenditure by domestic individuals and institutions 7
Short-hand GDP GNP C I G X Long-hand Gross domestic product Gross National Product Consumption Expenditures Investment Expenditures Government spending Exports Interplay of variables 1. GDP = C + I + G + X M 2. GNP = GDP + (net foreign investment income + net transfers) 3. In terms of current account balance: GNP = C + I + G + CA 4. GNP as the value of total income: M Import NX Net export CA Current account S Savings (of households, firms, G) T Tax (net tax) GNP = C + S + T 5. Based on 3 & 4 C + I + G + CA = C +S + T 6. I + G + CA = S + T 7. S + (T G) = I + CA 8
Expenditure and Production in an Open Economy CA = X M = Y (C + I + G ) When production > domestic expenditure, exports > imports: then current account > 0 & trade balance > 0 When a country exports more than it imports, it earns more income from exports than it spends on imports Net foreign wealth is increasing When production < domestic expenditure, exports < imports: then current account < 0 & trade balance < 0 When a country exports less than it imports, it earns less income from exports than it spends on imports Net foreign wealth is decreasing 9
Current account balance (CAM) 10
Saving and the Current Account Y = C + I + G + X M National saving (S) = national income (Y) that is not spent on consumption (C) and government purchases (G). S = Y C G CA = Y (C + I + G ) implies S = (Y C T) + (T G) S = S p + S g CA = (Y C G ) I = S p + S g - I = S p + (T-G) I Current account = national saving investment Current account = net foreign investment A country that imports more than it exports has low national saving relative to investment. 11
CA = S I or I = S CA or I + CA = S P + (T-G) Countries can finance investment either by saving or by acquiring foreign funds equal to the current account deficit. A current account deficit implies a financial asset inflow or negative net foreign investment. [NFI = Investment to abroad Investment from abroad] When S > I, then CA > 0 so that net foreign investment and financial capital outflows for the domestic economy are positive. CA = S p + S g I = S p budget deficit I S g = T - G A high government deficit causes a negative current account balance when other factors remain constant. 12
Savings and Investment in Cambodia (2002-2010) 13
4. Balance of Payments Accounts A country s balance of payments is an accounting record of a country s trade in goods, services, and financial assets with the rest of the world during a particular time period (a year). The balance of payments accounts are separated into 3 broad accounts: current account: accounts for flows of goods and services (imports and exports). financial account: accounts for flows of financial assets (financial capital). capital account: flows of special categories of assets (capital): typically nonmarket, non-produced, or intangible assets like debt forgiveness, copyrights and trademarks. 14
How Do the BOP accounts Balance? Due to the double entry of each transaction, the balance of payments accounts will balance by the following equation: Current account + Financial account + Capital account = 0 Double-entry bookkeeping in BOP implies that 1) A credit entry records an item or transaction that brings foreign exchange into the country. 2) A debit entry represents a loss of foreign exchange. 15
Credits and Debits in the Balance of Payments Account
Current Account The current account includes the value of trade in merchandise, services, income from investments, and unilateral transfers. Merchandise tangible goods. Merchandise account = the value of goods exported the value of imports Services travel and tourism, royalties, transport costs, and insurance. Services account = the value of services exported the value of imports Income from investments interest and dividends. Investment income account = income from investments abroad income paid to foreigners on their investments in Cambodia Unilateral transfers foreign aid, gifts, and retirement pensions. Unilateral transfers account = any foreign aid and transfers received by Cambodia that given to foreigners 17
Components of the Current Account Components of the current account (common practice) Credit Debit 1. Goods and services Export Import 2. Investment income Income received on investments abroad Income paid to foreigners on investments in Cambodia 3. Unilateral transfers Transfers received Transfers paid In some literature you may see 4 components of CA : Goods & services are separated into 2 accounts. 18
CA of Cambodia, 2009 Millions of USD 1 Trade balance (1,634) Export (fob) 4,196 Import (fob) 5,830 2 Net services 607 Receipts 1,625 Payments 1,019 3 Net investment income (408) Receipts 57 Payments 524 4 Net unilateral transfers 293 Current account w/o official transfer (1,203) Official transfer 593 Current account (610) CA deficit mainly caused by merchandise import exceeds merchandise export. Cambodia has positive balance in services and transfers Negative investment income balance due to Cambodian debts. 19
CA balance of Cambodia 2002-2010 (excluded OT) 2002 2003 2004 2005 2006 2007 2008 2009 2010 (359) (450) (440) (591) (578) (693) (1,382) (1,203) (1,238) A current account deficit is not a sign of weakness: in Cambodia, the economic boom of the 2000s increased the demand for imports, while export is However, everyone agrees that CA deficit expanding gradually. cannot continue in the long term 20
Financial Account Financial account: a record of the flow of financial capital to and from a country. What is the Financial inflow? It is the foreigners loan to domestic citizens by buying domestic assets Domestic assets sold to foreigners are a credit (+) because the domestic economy acquires money during the transaction Financial outflow Domestic citizens loan to foreigners by buying foreign assets Foreign assets purchased by domestic citizens are a debit (-) because the domestic economy gives up money during the transaction 21
Financial flows originate in the public and private sectors Some financial flows are very mobile: move quickly in response to investor expectations Mobility of financial flows brings economic volatility Upon sudden financial outflows, a country can sink into a financial crisis The volatility of financial flows causes fear about the various types of flows Financial outflows include: A. Official reserve assets: gold, SDRs, $US, EU B. Government assets: loans to foreign governments, payments received on outstanding loans, C. Private assets: DI, foreign securities, loans to foreign firms and banks 22
Financial inflows include: A. Foreign official assets: gold, SDRs, major currencies B. Other foreign assets: FDI, Cambodian securities, loans to Cam firms and banks C. Net change in financial derivatives So, generally, financial account is divided into three categories: Net changes in the country s assets abroad Net changes in the foreign-based assets in the country Net change in financial derivatives Assets, a.k.a. wealth, include bank accounts, stocks and bonds, and real property such as factories, businesses, and real estate. Financial derivatives are complex financial contracts, only recently included in BOP (Cambodia yet has no such financial instrument) Value of derivatives depends such variables as IR, ER, or commodity prices 23
Financial account in many statistics, has 3 subcategories: 1. Official (international) reserve assets 2. All other assets Include FDI, Portfolio investment and other financial investment 3. Statistical discrepancy Official reserve assets: foreign assets own by CBs to cushion against financial instability. Assets include government bonds, currency, gold and accounts at the IMF. Official reserve assets owned by (sold to) foreign CBs are a credit (+) because the domestic CB can spend more money to cushion against instability. Official reserve assets owned by (purchased by) the domestic CB are a debit (-) because the domestic CB can spend less money to cushion against instability. 24
Capital account Capital account is a record of transfers of specific types of capital, such as: Debt forgiveness Capital transfers from/to foreigners The transfer of real estate and other fixed assets, such as an embassy building Remarks on interdependence The current, capital, and financial accounts are interdependent Current account measures flow of goods and services Capital and financial accounts measure flow of financing Theoretically, sum of capital account and financial accounts equal to current account with opposite sign. Usually, CA = FA + Cap A + Financing + Stat discrepancy 25
Cambodian BOP 2010 $ Millions 1 Trade balance (1,697) Export (fob) 4,687 Import (fob) (6,384) 2 Net services 633 Receipts 1,653 Payments (1,020) 3 Net investment income (481) Receipts 58 Payments (540) 4 Net private transfers 308 Current account w/o official transfer (1,238) 5 Net official transfer 800 Current account (438) Caveat Both the capital account and the financial account present the flow of assets during the year in question and not the stock of assets that have accumulated over time. 26
$ Millions 6 Medium and long term loans 188 Disbursement 200 Amortization (12) 7 Foreign direct investment 553 8 Short-term flows, errors and omissions (160) Capital and Financial Account 581 BOP (w/o financing) 143 9 Financing (143) Change in foreign reserves (283) Financing gap 140 All flows are net changes (differences between assets given and assets received). Statistical discrepancy exists because the record of all the transactions in the balance of payments is incomplete Errors tend to lie in the financial account calculation, as it is the hardest to measure correctly. 27
The BOP and the Macro-economy Why study the balance of payments? BOPs help understand the broader implications of current account imbalances and how to repair current account deficits BOPs give signal how nations can avoid crises brought by volatile financial flows and how they can minimize the damage of financial crises if such occur Financial Account Liberalization Open markets cause lifting of controls on financial flows Developing countries, in particular, have liberalized financial account transactions in order to get access to financial capital for development Although financial flows are volatile, economists agree that free flows are best for economic efficiency 28
What has the largest share of financial flows? Is the Private Assets Subcomponents of private assets: FDI, foreign securities, loans from/to foreign firms and banks FDI: tangible items: real estate, factories, warehouses, transportation facilities, and other physical (real) assets Securities and loans can be considered foreign portfolio investment paper assets such as stocks and bonds Both FDI and foreign portfolio investment give their holders a claim in a foreign economy s future output However, holders of FDI have longer time horizons 29
5. Expectations in financial flows and limit on them Shifts in expectations can lead to sudden stoppages of financial inflows The result is a destabilizing of outflows of financial capital This occurrence has been labeled a sudden stop Sudden stops have been involved in the most financial crises in last 30 years Until recently, most nations limited the movement of financial flows related financial account transactions across their borders The EU liberalized financial flows between member countries only in 1993 30
6. International Debt Debt is defined as money owed to nonresidents which must be paid in a foreign currency. CA deficits must be financed through inflows of financial capital (loans) Loans from abroad add to a country s stock of external debt and generate debt service obligations All countries, rich and poor, have external debt In low/middle income countries, external debt can lead to financial problems Unsustainable debt occurs for numerous reasons: Falling commodity prices Natural disasters Corruption Foreign lending behavior 31
TABLE 9.8 The Five Largest Developing Country Debtors, 2007 32
7. The International Investment Position A country runs a CA deficit, it borrows from abroad and raises its indebtedness A country runs a CA surplus, it lends to foreigners and reduces its indebtedness International investment position = domestically owned foreign assets foreign owned domestic assets A positive international investment position = the home country could sell all its foreign assets and have more than enough revenue to purchase all the domestic assets owned by foreigners In 2005, the U.S. international investment position = $11,079 billion $13,625 billion = $2,546 billion 33
Special notice: in some statistics, capital account and financial account are combined Current Account Surplus and Deficit Surplus and Deficit BOP 34
A hypothetical balance of payments table for a developing nation 35
Before and After the 1980s Debt Crisis: Current Account Balances and Capital Account Net financial Transfers of Developing Countries, 1978-1990 (billions of dollars) 36
8. The Issue of Payment Deficits Some initial policy issues International reserves Restrictive fiscal and monetary policies: Structural adjustment Stabilization policies Special drawing rights (SDRs) Trends in the Balance of Payments 13-37
Developing Country Current Account, 1980 2009 (billions of dollars) 38
Accumulation of Debt and Emergence of the Debt Crisis Background and analysis External debt Debt service Net capital inflow, F N, is FN = dd Where Basic transfer d is percent increase in total debt D is total debt Basic transfer, BT, is BT = dd rd = ( d r) D Where r is the average interest rate 13-39
9 Accumulation of Debt and Emergence of the Debt Crisis Origins of the 1980s Debt Crisis OPEC oil price increase Increased borrowing Excess of imports Lagging exports Petrodollar Recycling 40
Origins of the Debt Crisis (cont d) Debt-servicing obligations Debt-service payments Debt-servicing difficulty Oil shocks Developing countries two options: 1. Curtail imports and restrictive fiscal and monetary measures 2. More external borrowing 13-41
10 Attempts at Alleviation: Macroeconomic Instability, Classic IMF Stabilization Policies, and Their Critics The IMF stabilization program Macroeconomic instability Stabilization policies Four basic components of IMF stabilization program: Liberalization of foreign exchange and imports control - Such policies can be politically unpopular because they hurt the lower- and middleincome groups. - Less radical observers view the IMF as neither a developmental nor an antidevelopmental institution. Devaluation of the official ER Stringent domestic anti-inflation program Opening up of the economy to international commerce 13-42
The IMF stabilization program (cont d) Tactics for debt relief: Debtors cartel Restructuring Brady Plan Debt for equity swaps Debt for nature swaps Debt repudiation What is odious debt? - Sovereign debt used by an undemocratic government in a manner contrary to the interests of its people - It should be deemed invalid 13-43
11 Resolution of 1980s-1990s Debt Crises and Continued Vulnerabilities Highly indebted poor countries (HIPCs) Some progress but vulnerabilities remain 44
Global Imbalances 45
12 The Global Financial Crisis and the Developing Countries Causes of the crisis and challenges to lasting recovery Economic impacts on developing countries Economic growth Exports Foreign investment inflows Developing-country stock MKTs Aid Worker remittances Poverty Health and education General policy framework Differing impacts across developing regions - China and the ER controversy - East Asia and Southeast Asia except China - India - Latin America - Africa Prospects for recovery and stability Opportunities as well as dangers? 46
Concepts for Review Amortization Balance of payments Basic transfer Brady plan Capital account Capital flight Cash account Conditionality Current account Debt-for-equity swap Debt-for-nature swap Debtors cartel Debt repudiation Debt service Deficit/surplus Euro External debt Hard currency Highly indebted poor countries (HIPCs) International reserve account International reserves Macroeconomic instability Odious debt Restructuring Special drawing rights (SDRs) Stabilization policies Structural adjustment loans 47