Balance of Payments: Accounts and Analysis

Balance of Balance of

Payments: Payments:

Accounts and Accounts and

AnalysisAnalysis

Thorvaldur Gylfason

Course on External Vulnerabilities and Policies Tunis, February 15-26, 2010

1. Balance of payments accountsaccounts How BOP accounts are put together Definitions, conventions, presentation Links to other macroeconomic

accounts2. Balance of payments analysisanalysis

Economics of exports, imports, capital flows, exchange rates, etc.

3. Balance of payments projectionsprojections4. External debt and the

international investment position

Accounting system for macroeconomic analysis in four parts

1. Balance of payments2. National income accounts3. Fiscal accounts4. Monetary accounts

First look at balance of payments accounts per se, and then look at linkages in a separate lecture

The balance of payments is a statistical statement statistical statement which systematically summarizes, for a specific period of timespecific period of time, the economic transactions of economic transactions of an economy with the rest of an economy with the rest of the worldthe world

The information on the economic transactions and financial flows between a country and the rest of the world, systematically summarized in its balance of payments, is necessary to analyze the external position external position of the country, including its debt

The mandate of the IMF is to assess the external position of the its member countries through surveillance (Article IV Article IV ConsultationsConsultations) as well as in the context of the use of Fund resources (program design and program design and reviewreview)

In a world where national economies are more and more closely integrated, owing to both trade and financial flows, policy makers and economists need to have balance of payments statistics that are recent, reliable, exhaustive, and comparable across countries based on a commonly accepted methodologycommonly accepted methodology

One of the roles of the IMF is to elaborate and standardize the methods needed to establish establish balance of payments statisticsbalance of payments statisticsSince 1948, the IMF has published a Balance of Payments Manual Balance of Payments Manual laying out the main principles behind the compilation of balance of payments statistics

Six editions: 1948, 1950, 1961, 1977, 1993, 2008

In this session, we discuss the the balance of payments accounting balance of payments accounting frameworkframework as well as the main main principles for the analysis of the principles for the analysis of the balance of paymentsbalance of payments based on the methodology detailed in the Balance of Payments Manual (6th ed., 2008)

The balance of payments records transactions between residents and nonresidents

The notion of residence is determined by the center of center of economic interesteconomic interest of units rather than their nationality

E.g., Turks in Germany

IndividualsResidents of a country if the length of their stay is longer than 12 months But not students and patients

Non-residentsVisitors (tourists, plane or boat crews, seasonal workers, etc.), trans-border workers (residents in the countries where they live), diplomats, members of the army, foreign students (regardless of the length of their stay)

EnterprisesResidents of the country where they realize their activity, given the presence of at least an establishment in the countryE.g., branches and subsidiaries of foreign enterprises are considered to be residents of the host country

Range of indictors, no definite rules

Public entitiesEmbassies, consulates, military bases, government entities are counted as residents of their country of origin

Double entry accounting Every transaction must result in two entries of equal amounts, one on the credit side and one on the debit side

Typically, a positivepositive sign (+) is associated with an amount recorded on the creditcredit side and a negativenegative sign (-) is associated with an entry on the debitdebit side CreditCredit refers to the lender whose loan to the debtor is an

assetassetDebitDebit refers to the debtor whose debt to the lender is a

liabilityliability

By convention, some transactions are recorded as creditcredit items(+) and others as debitdebit items (-)

Exports of goods and services Credit (+)

Imports of goods and services Debit (-)

Income and transfers received Credit (+) Income and transfers paid out Debit

(-) Increase in foreign liabilities Credit (+) Increase in foreign assets Debit (-)

A reduction in foreign liabilities is recorded on the debit side, with a negative sign (-)

A reduction in foreign assets is recorded on the credit side, with a positive sign (+)

Due to this convention, An increase in foreign reserves is recorded on

the debit side, i.e., with a negative sign (-)A reduction in reserves is recorded on the credit

side, i.e., with a positive sign (+) We “pay” for increased reserves like we pay for imports Likewise, a decrease in reserves generates “receipts”

Unrequited transfersTransactions that correspond to a

single flow are recorded as current transfers or as capital transfers resulting in a symmetrical entry under imports (transfers received) or under exports (transfers paid)

Example: EU provides a country with a gift of computers (food aid)The computers are recorded as

imports and capital transfers (current transfers)

Transactions in two major categories 1.1. Real transactionsReal transactions

Goods, services, and income Current account Current account of the BOP

Involve flowsflows

2.2. Financial transactionsFinancial transactions Reflect changes in foreign assets and

liabilities Capital and financial account Capital and financial account of the BOP

Involve changes in stocksstocks

Flows involve

changes in

underlying

stocks: X – Z +

F = RX = exports, Z = imports,F = capital account, R = reserves, F = DF with DF = net foreign debt

Double-entry recordingThe sum of credit entries must equal

the sum of debit entriesThe sum of all transactions is zero

Practical problems lead to errors and omissionsDiversity of data sourcesMissing data: e.g., financial

transactions outside banking system (informal sector)

Under- or overvaluation of transactions Smuggling

The recording period for balance of payments flows is determined by the frequency of data collectionAnnualQuarterlyMonthly

Transactions are recorded on the date of legal change of ownershipAccrual basis, not cash basis

Transactions must be valued at market price, reflecting “the terms of an exchange between a willing buyer and a willing seller”

The direct exchange of one item of property for another (barter) is valued at a fictitious price used to value traded goods

Exports and imports are recorded "free-on-board" (f.o.b.)Cost of insurance and transport beyond the

port of departure is not included in the value of the goods; they are recorded under services

If exports and imports are reported in customs data on a c.i.f. basis, i.e., including the cost of insurance and freight, then the cost of insurance and freight needs to be deducted before recording the items at issue in the balance of payments (e.g., on the basis of average costs and percentage)

Transactions recorded in the balance of payments must be expressed in a common unit of account (e.g., home currency or USD)National currency is used to compare BOP to

other developments in the domestic economy Dollar, SDR, or other major stable

currencies are used for cross-country comparisons, as a precaution in the event of rapid depreciation of the national currency which would make it difficult to interpret the balance of payments

24

In order to translate into the chosen unit of account the data that are expressed in the unit of transaction, the exchange rate at the time of the transaction is used

To translate the balance of payments from one unit of account to another (e.g., from US$ to national currency) we use the average exchange rate over the period for trade flows and end-of-period exchange rate for stocks of reservesStocks vs. flows

Two viewsviews of the balance of payments, that is:

Two ways to present ways to present the balance of paymentsStandard presentation

The accountant or statistician’s viewaccountant or statistician’s viewRecords grossgross amounts, credit and debit

Analytical presentationThe economist’s vieweconomist’s view

Records some items on netnet basis, credit minus debit

From the statistician or accountant’s point of view, the structure of the balance of payments reflects the recording of foreign transactions based on accounting principles accounting principles Standard presentation Standard presentation in which the

amounts recorded (credit and debit) are gross amounts

From the economist's point of view, a different presentation facilitates the use of the balance of payments for analytical purposes Analytical presentationAnalytical presentation

Established on the basis of the standard presentation

For certain groups of items the accounting balance is used, that is, the difference between the amounts on the credit and debit sidesE.g., net capital inflow = gross inflow less gross

outflow F = FX – FZ = DF

Current accountTransactions related to goods,

services, income, and current transfers between residents and non-residents Transactions related to goods are those

relative to the movements of merchandiseExports and imports of goods

Transactions involving services include different categories, e.g., transport, travel, etc.Exports and imports of services

Transactions related to income involve the remuneration of labor, capital, and landE.g., compensation paid to trans-border

workers, interest payments on external debt, etc.

Transfers are unrequited transactionsPublic and privateIn cash or in kindE.g., foreign aid

Since the sums of credits and debits offset one another, how can there be an "imbalance" in the external accounts?

Advantage of analytical presentationIt shows significant balances that are useful for economic analysis and shows a possible external imbalance

The overall balance of payments can be in surplussurplus or in deficitdeficit once we distinguish transactions into two sub-groups and draw a lineline between these two subgroups

When transactions above the line above the line sum up to a deficit, transactions below the below the lineline will sum up to a corresponding surplus, and vice versa

Trade balanceDifference between exports and

imports of goods (net exports) Current account balance

Difference between amounts recorded on the credit and debit side of goods, services, income, and current transfers

Overall balanceCurrent account balance plus capital and

financial operations account balance considered not to be “financing” items

External External transactionstransactions

GoodsGoods ServiceServicess

CapitalCapital

ExportExportss XXgg XXss FFxx

ImportImportss ZZgg ZZss FFzz

ExamplesReal Real transactions

Financial Financial transactions

Balance of paymentsBOP = XBOP = Xgg + X + Xss + F + Fxx – Z – Zgg – Z – Zss – F – Fz z

= X – Z + F= X – Z + F = current account + capital accountHereX = XX = Xgg + X + Xss Exports of good and servicesZ = ZZ = Zgg + Z + Zs s Imports of good and servicesF = FF = Fxx – F – Fzz Net exports of capital =

Net capital inflow = Net capital inflow = DDFF

Recording external Recording external transactionstransactions

Also called capital and financial

account

The term “capital account” is

1.Old language (BPM4)

2.Shorthand for new language

(BPM5)

Balance of paymentsBOP = BOP = XXgg + X + Xss + F+ Fxx – Z – Zgg – Z – Zss – F – Fz z

= = XX – Z + F – Z + F = current account + capital accountHereX = XX = Xgg + X + Xss Exports of good and servicesZ = ZZ = Zgg + Z + Zs s Imports of good and servicesF = FF = Fxx – F – Fzz Net exports of capital =

Net capital inflowNet capital inflow


Balance of paymentsBOP = XBOP = Xgg + X + Xss + F + Fxx – – ZZgg –– ZZss – F – Fz z

= X – = X – ZZ + F + F = current account + capital accountHereX = XX = Xgg + X + Xss Exports of good and servicesZ = ZZ = Zgg + Z + Zs s Imports of good and servicesF = FF = Fxx – F – Fzz Net exports of capital =



Balance of paymentsBOP = XBOP = Xgg + X + Xss + + FFxx – Z – Zgg – Z – Zss –– FFzz

= X – Z + = X – Z + FF = current account + capital accountHereX = XX = Xgg + X + Xss Exports of good and servicesZ = ZZ = Zgg + Z + Zs s Imports of good and servicesF = FF = Fxx – F – Fzz Net exports of capital =



AgainBOP = X – Z + F = BOP = X – Z + F = RRwhere

R = reservesR = reservesNote:

X, Z, and F are flowsR is a stock, R is a flow

Balance of Balance of payments and payments and reservesreserves

R = R – RR = R – R-1-1

BOP = X – Z + F = BOP = X – Z + F = RRwhere R = R – R-1

ImplicationsXX RRFF RRZZ RR

In practiceZZ FF or or RR

Balance of Balance of payments and payments and reservesreserves

From trade From trade balance to current balance to current accountaccount Trade balance

TB = XTB = Xgg + X + Xnfsnfs – Z – Zgg – Z – Znfsnfs

Xnfs = Xs – Xfs = exports of nonfactor servicesZnfs = Zs – Zfs = imports of nonfactor services

Balance of goods and servicesGSB = TB + YGSB = TB + Yff

Yf = Xfs – Zfs = net factor income Current account balance

CAB = GSB + TR = TB + YCAB = GSB + TR = TB + Yff + TR + TR TR = net unrequited transfers from abroad

Intermediate concept

GSB

Importance of net Importance of net factor income factor income Net factor income from labor

Compensation of domestic guest workers abroad (e.g., Pakistanis in the Gulf) minus that of foreign workers at home

Net factor income from capitalInterest receipts from domestic assets

held abroad minus interest payments on foreign loans (e.g., Argentina)

Includes also profits and dividends Transfers are unrequited transactions

Public or private, disbursed in cash or in kind (e.g., foreign aid)

YYff > 0 in Pakistan > 0 in Pakistan

YYff < 0 in Argentina < 0 in Argentina

Capital and Capital and financial accountfinancial accountTwo parts

1.1. Capital account Capital account (esp., capital transfers)

2.2. Financial accountFinancial account1.1. Direct investmentDirect investment

Involves influence of foreign owners2.2. Portfolio investmentPortfolio investment

Includes long-term foreign borrowingDoes not involve influence of foreign owners

3.3. Other investmentOther investmentIncludes short-term borrowing

4.4. Errors and omissionsErrors and omissionsStatistical discrepancy

Is the world’s BOP = 0?!

Foreign direct investment (FDI)Investments that a non-resident

entity realizes with the aim of acquiring a durable interest in a resident enterprise (long-term relationship and influence on the enterprise’s management)

The investor holds at least 10% of the shares or the voting rights in the enterprise

Capital and Capital and financial accountfinancial account

Portfolio investmentsEquity participation instruments and debt

instruments, money market instruments Financial derivatives: separate functional category

Other investmentsTrade credits, short-term and long-term

loans, including loans from World Bank Typically recorded on the basis of the

instrument or on the basis of their maturity (short term vs. long term)


Reserve assetsFinancing items Financing items below the line in the balance of payments

Transactions involving the assets of which monetary authorities consider that they dispose in order to finance finance the balance of paymentsthe balance of payments, including IMF loans E.g., to maintain adequate foreign

exchange reserves Most successful IMF loans are never “used”


Overall balance of Overall balance of paymentspaymentsFour main items below the line

1.1. GoldGold2.2. SDRsSDRs3.3. Reserve position in IMFReserve position in IMF4.4. Foreign exchangeForeign exchange

Three-month RuleThree-month Rule: Gross foreign reserve holdings should suffice to cover three months of importscover three months of imports of goods and services

Giudotti-Greenspan RuleGiudotti-Greenspan Rule: Central Bank foreign reserves should not decrease not decrease below short-term foreign commercial below short-term foreign commercial bank liabilities or total liabilitiesbank liabilities or total liabilities

Also included in

capital and financial

account

Changes in reserve position in IMFRecorded in financial operations

account under reserve assets, below the line

Use of IMF resourcesPurchase of foreign currency from IMF

leads to Increase in foreign assets of the Central

Bank (-, negative sign) Financial liability to the IMF (+, positive

sign) Gross reserves go up, net reserves stay put

Use of SDRsRecorded in financial account as reserve asset flows

Current accountCurrent account

A. Goods Exports Imports

Trade balanceTrade balanceB. Services

Transport Travel

C. Income Compensation of workers Investment income

D. Current transfers General government Other sectors

Current transactions balanceCurrent transactions balance

= (X-Z) + Y= (X-Z) + YF F + TR+ TRFF

CCapital and financial operations apital and financial operations accountaccount

A. CapitalCapital transfersPurchases/sales of nonproduced nonfinancial assets

B. Financial operations

Direct investment

Portfolio investment

Other investment

C. Errors and omissions

Overall BalanceOverall BalanceD. Net foreign assets

E. Exceptional financing

X-ZX-Z

YYFF

TRTRFF

FDIFDI

NFLNFL

NFNFAA

Y = C + I + G + X – ZY = C + I + G + X – Z= E + X – ZE + X – Zwhere E = C + I +GE = C + I +G

CAB = X – Z = Y – E CAB = X – Z = Y – E Ignore Yf and TR for simplicity

S = I + G – T + X – Z S = I + G – T + X – Z CAB = S – I + T – GCAB = S – I + T – GCAD = Z – X = E – Y = I – S + G – TCAD = Z – X = E – Y = I – S + G – T

National income National income accountsaccounts

Private

sector deficitPublic

sector

deficit

Y = C + I + G + X – Z Y = C + I + G + X – Z

GDP = C + I + G + TBGDP = C + I + G + TBGNP = C + I + G + CABGNP = C + I + G + CABGNP – GDP = CAB – TB = YGNP – GDP = CAB – TB = Yff (if TR = 0) (if TR = 0)

GNP = GDP + YGNP = GDP + Yff

GNP > GDP GNP > GDP in Pakistan GNP < GDP GNP < GDP in Argentina

GNDI = GNP + TR = GDP + YGNDI = GNP + TR = GDP + Yff + TR + TR

Links between BOP Links between BOP and national and national accountsaccounts

YY X - ZX - Z DefinitionDefinition

GDPGDP Trade balance

Goods and nonfactor services





GNPGNP Current account excl. transfers

Goods and services





GNPGNP Current account excl. transfers

Goods and services

GNDIGNDI Current account incl. transfers

Goods and services plus transfers


Fiscal accounts Fiscal accounts and links to BOPand links to BOP PublicPublic sector

G – T = G – T = B + B + DDGG + + DDFF

PrivatePrivate sectorI – S = I – S = DDPP –– M M –– BB

Now, add them upG – T + I – S = G – T + I – S = B + B + DDGG + + DDF F + + DDPP –– M M –– B B

== DDGG + + DDF F + + DDPP –– M =M = D D –– M + M + DDFF = - = -R + R + DDFF = Z - = Z -

XX ExternalExternal sector

X – Z = R - DF

M = D + RM = D + R

DDGG + D + DPP = D = D

X – Z + F = X – Z + F = RR

F = DF

Monetary accounts Monetary accounts and links to BOPand links to BOPMonetary survey

M = D + RM = D + RFrom stocks to flows

M = M = D + D + RRSolve for R

R = R = M M –– DDMonetary approach Monetary approach to balance

of paymentsStill holds that R = X – Z + F

Foreign exchangeForeign exchange

Real exch

an

ge r

ate

Real exch

an

ge r

ate

Imports

Exports

Earnings from Earnings from

exports of goods, exports of goods,

services, and services, and

capital capital

Payments for Payments for

imports of goods, imports of goods,

services, and services, and

capitalcapital

EquilibriumEquilibrium

Balance of Balance of payments analysispayments analysis

Real exchange rate = eP/P*Real exchange rate = eP/P*

Equilibrium between demand and supply in foreign exchange market establishesEquilibrium real exchange rateEquilibrium in the balance of

payments

BOP = X + FBOP = X + Fxx – Z – F – Z – Fz z

= X – Z + F= X – Z + F = current account + capital

account = 0

Balance of Balance of payments payments equilibriumequilibrium


Real exch

an

ge r

ate

Real exch

an

ge r

ate

ImportsImports

Exports

Overvaluation

Deficit

OvervaluationOvervaluationRR R moves

when e is fixed


Pri

ce o

f fo

reig

n e

xch

ang

ePri

ce o

f fo

reig

n e

xch

ang

e

Supply (exports)

Demand (imports)

Overvaluation

Deficit

Overvaluation

works like a price

ceiling

Overvaluation, Overvaluation, againagain

Difference between exports and imports of goodsProvides useful information on likely future developments in the current account

Distinction between goods and services may appear arbitrary

Data on merchandise trade can be quickly obtained from customs while data on services may take more time

Ratio of export prices to import prices: Px/Pz Typically expressed in as an indexPx = Export price indexPZ = Import price index

Expressed in the same currency as the prices included in the export price index

Indicator of the purchasing power of exports in terms of importsTerms of trade improve when Px/Pz

risesTerms of trade worsen when Px/Pz falls

Y = E + X – Z = EN/PE + XN/PX – ZN/PZ

(GNPGNP)= EN/PE + XN/PZ – ZN/PZ

(GNIGNI)

Crucial indicator used to assess the external position of a country

The current account balance is equal to the change in net foreign assets with respect to the rest of the worldIncludes change in net foreign assets of

Non-banking sector Banking sector (including monetary

authorities)CAB – F + R because X – Z + F = R

CAB – F + R because X – Z + F = R

Hence, current account deficit can be financed byAttracting foreign direct investmentforeign direct investmentAccumulating net foreign liabilitiesnet foreign liabilities

I.e., borrowing abroad Running down the net foreign assets net foreign assets

of the monetary authorities

When does a current account deficit become a source of concern?When it is a lasting (structural) deficit

rather than a temporary (cyclical) deficit

When it is financed by short-term external borrowing or by a protracted reduction in net foreign assets

When foreign exchange reserves are low in terms of months of imports or in terms of the Giudotti-Greenspan RuleGiudotti-Greenspan Rule

Other factorsCapacity to meet financial obligationsAvailability of external financing

When does a current account deficit become a source of concern?When continued current account deficits, reflecting the behavior of the government and the private sector, require drastic adjustment of economic policies in order to avoid a crisis, e.g., Collapse of exchange rate Default on external debt payments

Another crucial indicator used to assess the external position of a countryA deficitdeficit in the overall balance

means a decreasedecrease in the net net foreign assets foreign assets of the monetary authority except when exceptional exceptional financingfinancing becomes available

Foreign reserves are traditionally held by the monetary authorities in order to finance payments imbalances and to defend the currency

Exceptional financing Exceptional financing can be needed in an emergency where reserves have fallen to perilously low levels

Three main typesReschedulingRescheduling of external debt obligations

Scheduled payments postponed in agreement with creditors

Debt forgivenessDebt forgiveness Voluntary cancellation by creditors

Payments arrears Payments arrears on external debt service Scheduled payments postponed withoutwithout

agreement with creditors

Indicators of an appropriate level of foreign reservesRatio of reserves to monthly imports

of goods and services of more than 3

Guidotti-Greenspan Rule Other considerations

Capital mobilityExchange rate regimeComposition of external liabilitiesAccess to foreign borrowing Seasonal nature of imports and

exports

Current account Current account sustainability and sustainability and debtdebt

There are two ways to finance a deficit on current account

1. Run down foreign reserves But there is a limit Rule of thumb: Do not bring reserves

below three months of imports Another rule: Do not allow reserves to

fall below short-term foreign liabilities2. Run up debts abroad

Where is the limit? Is foreign debt always bad?

Not necessarily if the borrowed funds are used to finance profitable investments

Debt stockUsually measured in dollars or other

international currenciesbecause debt needs to be serviced debt needs to be serviced

in foreign currency Debt ratio

Ratio of external debt to GDPRatio of external debt to exports

More useful for some purposes, because export earnings reflect the export earnings reflect the ability to service the debtability to service the debt

External debt: External debt: Key conceptsKey concepts

External debt: External debt: Key Key conceptsconcepts

Debt burdenAlso called debt service ratiodebt service ratioEquals the ratio of amortization

and interest payments to exports

q = debt service ratioA = amortizationr = interest rate DF = foreign debtX = exports

X

rDAq

F

Interest burdenRatio of interest payments to

exports

X

Aa q = a + bq = a + b

Amortization burdenAlso called repaymentrepayment burdenRatio of amortization to

exports

X

rDb

F

External debt: External debt: Key conceptsKey concepts

Magnitude of the debtDebt should not become too large

How large is too large?

Measurement of the debtGross or net?

May subtract foreign reserves in excess of three months of imports

Composition of the debtFDI, portfolio equity, long-term loans,

short-term loans

External debt: External debt: Magnitude and Magnitude and compositioncomposition

Composition of the debt• Foreign direct investment• Least likely to flee, most desirable

• Portfolio equity• Long-term loans• Short-term loans• Most volatile, least desirable

As a rule, outstanding short-term debt should not exceed foreign reserves• Giudotti-Greenspan Rule

External debt: External debt: Magnitude and Magnitude and compositioncomposition

Indonesia and

Korea broke the

Giudotti-Greenspan Rule

in 1996

So did

Iceland, big

time, prior to

crisis in 2008

How can we figure out a country’s debt burden?Divide through definition of qq by

incomeNow we have expressed the debt service ratio in terms of familiar quantities: the interest rate rr, the debt ratio DDFF/Y/Y, and the export ratio X/YX/Y as well as the repayment ratio A/YA/Y

Y

XY

Dr

Y

A

q

F

External debt: External debt: NumbersNumbers

Suppose that r = 0.06DF/Y = 0.50A/Y = 0.05X/Y = 0.20

4.02.0

08.0

0.2

5.006.005.0q

Here we have a country that has to use 40% of its export 40% of its export earnings earnings to service its external debt

Heavy burden!Heavy burden!

Y

XY

Dr

Y

A

q

F

Numerical exampleNumerical example

Debt accumulation is, by its nature, a dynamicdynamic phenomenonA large stock of debt involves high

interest payments which, in turn, add to the external deficit, which calls for further borrowing, and so on Debt accumulation can develop into a

vicious circlevicious circle

How do we know whether a given debt strategy will spin out of control or not?To answer this, we need a little

arithmetic

External debt External debt dynamics dynamics

Recall balance of payments equation:BOP = X – Z + FBOP = X – Z + F

where

FF = capital inflow = = DDFF where

DDFF = foreign debtCapital inflow, F, thus involves an

increase in the stock of foreign debt, DF, or a decrease in the stock of foreign claims (assets)

So, F is a flowflow and DF is a stockstock

External External debtdebt dynamicsdynamics

Now assumeZ = ZZ = ZNN + r + rDDFF

ZZ = total importsZZNN = non-interest importsrrDDFF = interest payments

Further, assumeX = ZX = ZNN

BOP = 0 BOP = 0 A flexible exchange rate ensures equilibrium in balance of payments at all

times

Then, it follows thatBOP = X – Z + BOP = X – Z + DDFF = = 00so that

DDFF = = rDrDFF

In other words:

rD

ΔDF

F

External External debtdebt dynamicsdynamics

So, now we have:

rD

ΔDF

F

Now subtract growth rate of output from both sides:

g-rY

ΔY

D

ΔDF

F

Y

Yg

External debtExternal debt dynamicsdynamics

But what is

This is proportional change in debt ratio:

Y

ΔY

D

ΔDF

F

??

Y

D

Y

DΔ

Y

ΔY

D

ΔDF

F

F

F

This is an application of a simple rule of arithmetic:

%%(x/y) = (x/y) = %%x - x - %%yy

External debtExternal debt dynamicsdynamics

z = x/ylog(z) = log(x) – log(y)

log(z) = log(z) = log(x) - log(x) - log(y)log(y) But what is log(z) log(z) ?

So, we obtain

z

Δz

z

1

dt

dz

dt

dlog(z)Δlog(z)

y

Δy

x

Δx

z

Δz

Q.E.D.

Proof Proof

We have shown that

grd

Δd

where

Debt ratio

Time

r r g g

r = gr = g

r r g g

Need economic Need economic

growth to keep growth to keep

the debt ratio the debt ratio

under controlunder control

Y

Dd

F

Debt, interest, and Debt, interest, and growth growth

It is important to keep economic economic growth growth at home aboveabove – or at least not far below – the world rate of world rate of interest interest

Otherwise, the debt ratio keeps rising over time

External deficits can be OK, even over long periods, as long as external debt does not increase faster than output and the debt burden is manageable to begin with

A rising debt ratio may also be OK as long as the borrowed funds are used efficiently

Once again, high-quality investment high-quality investment is key

What can we learn What can we learn from this? from this?

Gross foreign debt is not all that matters

Foreign assetsassets matter as wellNet foreign debt equals gross

debt less gross assetsConversely, the difference

between gross assets and gross debt equals the international international investment position (IIP)investment position (IIP)

International International investment positioninvestment position

Changes in IIP involve changes in stocks measured at different points in timeTransactions (e.g., foreign borrowing)Non-transaction changes (price

changes, exchange rate movements, other changes)

Reconciliation statement: IIPIIPtt = IIP = IIPt-1t-1 + F + Ftt

Ft represents BOP financial account transactions during period t, including various non-transaction changes

International International investment positioninvestment position

ConceptsConceptsTransactions

Economic flows Economic flows that reflect the creation, transformation, exchange, transfer, or extinction of economic value and involve changes in ownership of financial assets

Non-transactionsPrice changes Price changes reflecting changes in market values of assets or liabilities

Zero for non-traded instrumentsE.g., trade credits, loans, currency and deposits

ConceptsConceptsNon-transactions

Exchange rate changes Exchange rate changes reflecting impact of changes in exchange rate between currency used for IIP (domestic currency) and currency in which assets or liabilities are denominated

Zero for assets and liabilities denominated in domestic currencyE.g., local equities, domestic currency bonds, etc.

Other changes in IIPNot a residual or ‘dump’ categoryIncludes appearance or disappearance of assets or liabilities Uncompensated seizure Bankrupties Write-offs Activation of guarantees Classification changes

Generally lumpy and small

ConceptsConcepts

Relationship to other Relationship to other statisticsstatisticsInternational accounts IIP + BoP = international accounts

o IIP is presented in terms of stocksstockso BoP is presented in terms of flowsflows

Ft in IIP reconciliation statement is the capital and financial account in BoP

Income in Current AccountCompensation of employees + investment incomeo Payments and receipts on investment measured in IIPo Interest, dividends, distributions yields on investment

Relationship to other Relationship to other statisticsstatistics

External debtDirect and portfolio debt liabilities and other investment liabilities from IIPo Only liabilities (no assets)o Only debt

Excludes equity (direct and portfolio)Excludes financial derivatives

Relationship to other Relationship to other statisticsstatistics

In conclusionIn conclusionExternal trade and investment are

crucial determinants of economic development

Excessive external imbalances can jeopardize the benefits of external trade and capital flows

Financial programs are designed to achieve external balance by fostering the buildup of adequate foreign exchange reserves

Need to maintain real exchange rates at levels that are consistent with BOP equilibrium, including sustainable debt Must avoid overvaluation

In conclusionIn conclusion

The EndThe EndExternal borrowing is a necessary

and natural part of economic developmentThis requires countries that borrow to invest

the funds borrowed in high-quality capitalhigh-quality capitalThis is necessary to be able to service the

debt

If debt burden becomes too heavy, must either reduce deficit or spur reduce deficit or spur growthgrowthIt is always desirable anyway to do

everything possible to encourage economic growth

Rapid growth allows more foreign borrowing without making the debt burden unmanageable

These slides will be

posted on my

website: www.hi.is/~gylfason

Documents

Balance of Payments: Accounts and Analysis