Current account imbalances and exchange ratesecon.sciences-po.fr/sites/default/files/file/cours6-7... · 2014-10-02 · Current account imbalances and exchange rates Lectures 6-7

Current account imbalances

and exchange rates

Lectures 6-7Nicolas Coeurdacier

[email protected]

International Macroeconomics

Master in International Economic Policy

– Global imbalances and the US current account

deficit

– Is there an “exorbitant privilege” of the dollar?

– Global imbalances and the financial crisis

– External adjustment in the Eurozone

Motivation

Lectures 6 and 7

Current account imbalances and exchange rates

1. Open economy accounting: balance of payments

2. The BOP theory of exchange rates

3. Global Imbalances: current account and net foreign

assets

4. Adjustment of global imbalances

Lectures 6 and 7





assets


Open economy national income identities

National Accounting

Y= C + I + G + EX - IM

• Y: GDP

• C: Consumption

• I: Investment

• G: public spending

• EX: Exports of goods and services

• IM: Imports

• Current account (sometimes net exports): CA= EX-IM

A Remark: GDP and GNI

• GDP (Gross Domestic Product): value of all final goods and services produced within national borders (on a given period)

• GNI (Gross national Income): value of all final goods and services produced by national factors of production (on a given period)

• GNP = GDP + net receipts of factor income from the ROW; (income domestic residents earn on wealth held in ROW –payments domestic residents make to foreigners who own wealth located in domestic economy)

• Usually small difference (except few well identified countries like Ireland)

• Here, we focus on GDP (in K&O, GNP) because Europe does (US more recent)

Deduct transfers from overseas

- remitted profits from foreign firms UK operations

- interest payments and dividends received from foreign investments in the UK

- remittances from overseas residents based in the UK

- grants paid by UK government

Add transfers from overseas

- remitted profits from UK firms foreign operations

- interest payments and dividends received from overseas investments

- remittances from UK residents based overseas

- grants received from foreign governments

From GDP To GNI

Difference between GDP and GNI (as % of GDP) 2007

-15 -10 -5 0 5 10 15 20

Bangladesh

Poland

Japan

Ireland

United States

% GDP

Source: OECD Main Economic Indicators and Quarterly National Accounts, International Monetary Fund, 2009.

National Accounting for US and France 2009

Y(GDP)= C+I+G+EX-IM

France in billions € US in billions $ (% of GDP)

Y:1 909 (1950 en 2008) Y: 14 119 (14 441 in 2008)

C: 1113 (58,3%) C: 10 001 (70.8%)

I: 298 (15,6%) I: 1589 (11.2%)

G: 534 (28,0%) G: 2915 (20,6%)

EX: 440 (23,0%) EX: 1578 (11.1%)

IM: 477 (25,0%) IM: 1964 (13.9%)

EX-IM= - 37 (-2%) EX-IM= -386 (-2,7%; -4.9% in 2008)

China: C (36%); I (41%); G (14%); EX (40%); IM (32%)

National Revenue = National Output

National output (Y) is:

Y ≡ I + C + G + [EX – IM]

with EX – IMP = CA = Current Account Balance

The use of national revenues : Y ≡ C + SP + T

Then: (I – SP) + (G – T) + (EX – IMP) ≡ 0

Introducing Public Savings (Fiscal Surplus): SG=T-G

CA ≡≡≡≡ SP + SG- I ≡≡≡≡ S-I

The Fundamental Balance of Payments Identity

The Fundamental Balance of Payments Identity

•Accounting identity (no behaviour, no explanation, no theory

here)

•A country whose savings exceed national investment tends to

run a current account surplus : the country is lending to the rest

of the world

•A current account deficit can reflect:

- Small saving rate (high consumption) (US from 2000)

- High investment (US 1995-2000)

- Budget deficit (US since 2001)

CA ≡≡≡≡ SP + SG- I ≡≡≡≡ S-I

(SP – I) and (SG) in the US

-8,0

-6,0

-4,0

-2,0

0,0

2,0

4,0

6,0

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

US Private Savings Investment Gap (% of GDP) US Fiscal Surplus (% of GDP)

Balance of Payments (BOP)

- Registers all transactions with foreign economic agents

- 3 main sorts of transactions:

- exports and imports of goods and services

current account (CA)

- sale and purchase of financial assets

financial account (FA)

- certain transfers of wealth (small)

capital account (KA)

A bit more of accounting…

The Balance of Payments

The Balance of Payments (BOP)

= Current Account + Financial Account+ Capital Account

The Balance of Payments has to balance:

BOP = 0

(abstracting from errors and omissions)

Why does the balance of payments have to balance?

•Essentially an accounting trick - every credit needs to be matched by a

debit: double entry book keeping principle!

•The current account shows overall situation in transactions of goods

and services. The capital and financial account shows how this is

financed.

•Consider the case of the U.K running a current account deficit, in

other words the U.K cannot pay its import bill from exports alone.

•One solution is for the U.K to sell any overseas assets and use the

money to pay the import bill. Another option would be to sell some U.K

assets (say Canary Wharf) which would count as Inward Direct

Investment. This would create a financial account surplus equal to the

current account deficit.

The Current Account

• Trade Balance = Exports of Goods and Services - Imports of Goods and Services = (X-M)

• Current Account =Balance on Goods and Services + Net Foreign Workers Remittances + Net International Aid+ Net Royalties + Net Investment Income = (X-M+NFI)

The Financial & Capital Accounts

• Financial account (FA): records flow of financial assets. These are Foreign Direct Investment, Net Portfolio Flows and Net Other (mainly bank loans and trade credits)

• Capital account (KA): records flow of non-financial assets between countries – debt forgiveness, purchase of royalty rights

• However because of measurement error also a category called “errors and omissions”

Capital Account -0.1

Current

Account

-471 Financial Account 254

Balance of

Trade

-646 Net FDI -115

Balance of

Services

146 Net Portfolio 225

Net inv.

income

165 Net Other (incl.

derivatives)

144

Net Transfers -136 Errors and

Omissions

217

US Balance of Payments ($bn 2010)

China Balance of Payments ($bn H1 2009)

Balance of Trade 118 Net FDI, Private and

Official Assets

32

Balance of Services -19 Reserves -186

NFI 31 Statistical Discrepancies 25

Current Account 130 Financial Account -129

Capital Account -1

Total Balance (CA+FA+KA) 0

Lectures 6 and 7





assets


BOP theory of exchange rates

• Develop a simple framework to examine how the

current account and exchange rate of a country is

affected by various macroeconomic events…

• … to explain some of the medium term deviations

from PPP documented in the previous lecture

The role of exchange rate

•But while the National Accounts show that:

CA = S-I

How does this happen?

•Variations in the real exchange rate ensure that

current account equals net savings.

•A theory of the current account is a theory of net

savings.

Focus on flexible exchange rates

Two country model: Europe-US.

CA€ = CA(q, Y€d, Y$

d)

q = E P$/P€ : real exchange rate; relative price of US goods with respect to European goods

q : real depreciation of euro

The Current Account

CA€ = EX€ - IM€ in euros = Net exports in euros

Suppose E ↑ (or equivalently q ↑ ):

How do exports (foreign demand for European goods) and imports

(European demand for foreign goods) react ?

Depends on two main factors:

1) In which currency exporters fix their prices?

How much ‘pass-through’ of exchange rates to consumer prices?

2) How large is the elasticity of substitution between domestic and

foreign goods?

The Current Account

• How much do consumers substitute from US to European goods?

• Depends on Pass-through: if exports are fixed in Local (Producer)Currency: small (large) effects

• Depends on the elasticity of substitution: if goods are highly(poorly) substitutable: large (small) effect

• May explain that € appreciation affects less German exports thanFrench exports: German exporters (machinery) are in sectors andproduce (high quality) goods less price sensitive (lower elasticity ofsubstitution)

• Aggregate elasticity of exports to real exchange rate movements islow: a bit more than 1 for OECD countries after one year

The Current Account

• If q ↑ → volume of imports↓, exports↑: substitution

• But if slow response of volumes (empirically 6 months-1 year):value of imports ↑

• volume versus value effect. In short term, the value effect candominate

• Net effect on the CA of q ?• J curve and the Marshall-Lerner condition such that a

depreciation generates an improvement in CA: the sum ofimport and export elasticities to exchange rate > 1

The Current Account

The J-Curve

J-curve: valueeffect dominatesvolume effect

volume effect dominatesvalue effect

Immediateeffect of real depreciationon the CA

We assume from now on:

€ nominal or real deprecia\on (E ↑ or q ↑)

generates an ↑ in demand via an ↑ in net exports :

CA€ (q)= (EX€ - IM€)

The Current Account

+

The Current Account

q

CA=Net Exports0

High real exchange rate means

European goods cheaper so Europe

export more and import less - net

exports increases with q

BOP Theory of Exchange Rates

q

CA=Net Exports

S-I

Real Exchange Rate determined by equality of net savings with net exports

BOP Theory of Exchange Rates

• A depreciation of real exchange rate means domestic goods

are more competitive on international markets.

• Real exchange rate adjusts to ensure net exports equals net

savings.

• If net savings > net exports, then real exchange rate

depreciates which decreases imports and boosts exports.

Eventually net exports equal net savings.

Increase in fiscal deficits (fall in public savings)

q

CA=Net Exports

S-I

Appreciation of the currency and deterioration of the current account

Source : Bureau of Economic Analysis

Reagan and Bush I Deficits

-1

0

1

2

3

4

5

6

1981 1982 1983 1984 1985 1986 1987 1988

% o

f GD

P

Current Account deficit Fiscal deficit

-1

0

1

2

3

4

5

1989 1990 1991 1992

% o

f GD

P

Drop in investment

q

CA=Net Exports

S-I

Depreciation of the currency and improvement of the current account

Argentina 2001-2002 Financial Crisis

-10

-5

0

5

10

15

20

25

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Current Account (% of GDP) Investment rate % of GDP Real GDP Growth

Increase in demand for European goods

q

CA=Net Exports

S-I

Lectures 6 and 7





assets


Global Imbalances

• Previous model useful to interpret how real exchangerate adjust to macroeconomic shocks. But very« static ».

• What happens when a country runs current accountdeficits for years (the US)? Should the country adjustand reduce its deficit? How does it happen? Whatare the consequences for the exchange rates?

• Should we worry about the persistent currentaccount deficit of some countries (in particular theUS)?

Blanchard and Milesi Ferretti, 2009

Saving and Investment Trends (in percent of domestic GDP)

Source Blanchard and Milesi Ferretti, 2009


EUR deficit: Greece, Ireland, Italy, Portugal, Spain, UK, Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, Turkey, UkraineEUR surplus: Austria, Belgium, Denmark, Finland, Germany, Luxembourg, Neth, Sweden,Switzerland.


Blanchard and Milesi Ferretti, 2009

« Good » and « bad » imbalances

No obvious normative judgment on sign (if not size) of CA

« Good » imbalances »:

S > I : ageing countries (anticipation of later dissaving); low expected growth in the future

I > S : high returns to investment: finance part of I through foreign saving (example: poor countries catching-up in terms of productivity)

« Bad » imbalances »:

1) Domestic Distortions

- « Too » high private saving : lack of social insurance, financial repression

- « Too » low private saving (US): asset bubbles (real estate)

- Too much public borrowing (dissaving)

2) Systemic Distortions

- After Asian crisis (1997-98), emerging markets ran large CA surpluses and accumulated large FOREX reserves. Partly insurance (precautionary saving) against speculative attacks (IMF did not help much). Individually rational but globally may lead to global imbalances

The Chinese Savings Puzzle?

China:

• Fast growing country. Very high productivity growth.

• As expected, very large investment rates.

• But savings growing at an even faster pace and China runs

current account surpluses.

Why?

• Domestic financial distortions: financial markets not very

developed (borrowing constraints).

• Precautionary motive (lack of social insurance…)

• Demographics (« one child » policy ; market for marriage)

Still very difficult to justify such a high saving rate.

The Chinese Savings Puzzle?

-5

0

5

10

15

20

25

30

35

40

45

50

55

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Savings % of GDP CA % of GDP Investment % of GDP

Savings, Investment and Current Account in China

Current accounts and net foreign assets

Accumulating CA deficits leads to a negative NFA (net foreign assets) position with the ROW (also called Net international investment position (NIIP))

Accounting (forget capital gains and losses, valuation effects):

If a country in year t has a CA deficit, its net external position (or NFA) B

tdeteriorates:

CAt= NFA

t- NFA

t-1(Flow)

Net external position (NFA) in t is NFA in t-1 + CA value

NFAt= NFA

t-1+ CA

tStock (wealth)

NFAt< 0 if debtor country: value of the foreign assets it holds <

value of domestic assets held by foreigners

Net foreign assets (in percent of world GDP)

Source: IMF

US as largest debtor country

Debtor and creditor countries before the crisis (% of GDP)

-120

-70

-20

30

80

130

180

230

Ice Gr Port Sp Lat Aus Ita UK Ire US Fr Chi Ger Jap Nor SA CH HK Kuw

Source: Lane Milesi Ferreti, 2009

NFA in % of GDP; 2007 (selected countries)

Link between global imbalances and the financial crisis (see Obsfeld and Rogoff, 2010)

• Global imbalances unsustainable (CA deficit in US in

part.) : low saving rate of US consumers (close to zero

before crisis) and high saving rate in China (relative to

inv.)

• Two other connected trends also unsustainable before

the crisis

– real estate values (bubble) rising in the US, UK,

Spain…(all countries with CA<0)

– extraordinary high levels of leverage (consumers in

the US and UK; financial entities in many countries)

Countries running CA deficit have larger real estate bubbles

Real estate appreciation and change in current acco unt, 2000-06, modified Aizenman-Jinjarak (2009) sample

-20,0

-15,0

-10,0

-5,0

0,0

5,0

10,0

15,0

20,0

-100,0 -50,0 0,0 50,0 100,0 150,0 200,0 250,0 300,0 350,0 400,0

Real cumulative real estate appreciation (percent)

Cha

nge

in C

A/G

DP

(pe

rcen

t of

GD

P)

Source: O&R (2010)

Change in current account and real estate prices over

2000-2006 for selected countries

-150,0

-100,0

-50,0

0,0

50,0

100,0

150,0

Japan

Germ

any

Singapore

Hong K

ong

United S

tates

New

Zealand

Italy

Greece

Iceland

Ireland

France

Spain

United K

ingdom

-30,0

-20,0

-10,0

0,0

10,0

20,0

30,0

real home price appreciation % (2000-2006) [left-axis] Change in current account balance % of GDP (2000-20006) [right axis]

What is the nature of the connection between global

imbalances and the financial crisis? Causal?

High savings in Emerging Asia and US monetary policy

⇒ ↓global real interest rates

⇒ fall in interest rates encourage investors/consumers to borrow and buildleveraged positions

⇒ US easy foreign borrowing: indirectly made it easier for consumers toborrow and for banks to finance this borrowing

⇒ Housing prices raising globally. Speculative bubble.

Note that easy borrowing was reinforced by the (unsustainable) real estatebubble.

Another interpretation is that real estate bubble (and lax regulation) madeconsumer borrowing and the consumption boom possible which drove theCA deficit.

“The global imbalances of the 2000s both reflected and magnified theultimate causal factors behind the recent financial crisis.” O&R (2010)

Valuation effects on external positions

• CA deficits only one factor of the evolution of the NFA position

• Valuation effects have become very large due to financial globalization and the increase in gross positions (assets and liabilities)

• NFAt - NFAt-1 = CAt + Capital gains (or losses) on external assets/liabilities

• Changes in exchange rate and/or movements in equity markets affect value of both foreign assets held by domestic agents (assets) and domestic assets held by foreign agents (liabilities)

• Capital gains on NFA are extremely volatile.

Bureau of Economic Analysis 2008

Valuation effects: Annual real returns (%) on foreign assets & liabilities

Source: Gourinchas-Rey (2005)

Valuation effects and the US deficits

• Growing divergence between accumulation of CA deficits and NFA (or NIIP, net international investment position) position in US

• Period 2002-2006: with CA deficits (>5% of GDP) the US NFA position (measures the difference between the value of foreign assets held by US agents and US assets held by foreigners) barely changed: cumulative of CA deficits around $3.4 trillion ⇒should have raised US net external liabilities to some $5.5 trillion (40% of GDP). The NFA deterioration was only $400 billion. As a ratio of GDP it actually improved.

• Where did those other $3 trillion of US net borrowing go?

The US becomes a net debtor

NFA, % of US GDP

Bureau of Economic Analysis 2008

Net International Investment Position of the US, 19 83–2008

How can that be?

• Foreign assets held by Americans (mostly

denominated in foreign currency) increased in value

much more than foreign-held assets in the US

(mostly denominated in $): why?

• $ depreciation 2002-2007

• foreign stocks did better than US stocks

• In 2008 (financial crisis): dollar appreciation and

foreign equity markets fared even worse than US

equity markets

The US Net foreign asset positions in 2004

Currency denomination of US assets and liabilities

• NIIP or NFA of US in 2002 ≈ 20% of GDP

• Foreign assets held in the US ≈ 125% GDP

• US held by foreigners ≈ 145% GDP

• Around 65% of foreign assets held by US are in foreign

currency (euro, yen…)

• Around 95% of US assets held by foreigners are in $

A numerical example and the role of the $

• $ depreciates by 10% (other currencies appreciate by

10%)

• Foreign assets (in foreign currency) gain:

(0.1)(0.65)(1.25) = 8,1% of US GDP

• US assets (in foreign currency) held by foreigners gain :

(0.1)(.05)(1.45) = 0.7% of US GDP

• In net: the net value of US debt to ROW decreases by

7.4% of US GDP (a transfer of more than $ 1000 billions

to U.S!)

• If (big if) repeated: can suggest that due to dollar role

(US debt in dollar) foreigners get a weak return on

American assets: « exorbitant privilege »

Lectures 6 and 7





assets


Adjustment of global imbalances

• Two adjustment mechanisms to close the deficit:

– Trade channel : depreciation helps exports and

decreases imports (J-curve)

– Financial channel (valuation effects):

• In the US: a depreciation facilitates the adjustment because

debts are in $ and assets are in foreign currency

• In emerging markets: a currency depreciation (against the

$) makes the adjustment more difficult because external

debts are in $ : the « original sin »


• Implications for the dollar

– Closing the current account deficit and reducing net external

debt implies a depreciation of the dollar in the future

• Boosts net exports

• Positive valuation effects for the US

– Adjustment started in the 2000’s: real depreciation of the

dollar of 20% over 2000-2007

– Estimates in the literature before last recession suggested at

least 30% more to go (Obstfeld and Rogoff 2007).

– Yet global imbalances did not vanish and financial crisis seems

to have slow downed the adjustment. Why?


• The Trade Adjustment

– Effect of the real exchange rate on the trade balance (NX)

∆NX/GDP = β ∆RER

Estimate of β: depends on the substitutability between US and foreign

goods (as well as the share of non tradables). Macro estimates β between

0.05 and 0.1. An improvement of 1% of the trade balance requires a

depreciation of 10 to 20%. Let’s use the value of 15%.

• The Financial Adjustment

– A 15% depreciation will reduce net US debt by about 10% of US GDP due to

positive valuation effects. Assuming a reasonable rate of return on assets of

4%, reduces interest payments by 0.4% of GDP.

From Blanchard, Giavazzi and Sa, 2005

• Adding the trade balance and the valuation effects together means

that a depreciation of 15% improves the CA by around 1.4%.

• Then a reduction of 5% of the current account deficit means a dollar

depreciation of around 50%. Without valuation effects, the

depreciation required would have been much larger, up to 75%.

• Note that this does not tells at what rate the depreciation would

occur: won’t happen overnight but the more we wait the larger is the

net US debt position and the larger must be the depreciation

• If “exorbitant privilege” (see below), smaller adjustment needed.

From Blanchard, Giavazzi and Sa, 2005


• Difficult exercice at short horizons:

Meese and Rogoff (1991): Fundamentals do not predict better than a random-walk

• But net foreign asset position can be used as a predictor of future exchange rate movements: financial and trade adjustment of large negative NFA in the case of the US requires a future depreciation of the USD.

• Gourinchas and Rey (2007) find that this works well for the USD.

NFA also help forecasting net external returns on foreign assets (financial adjustment)

Adjustment of global imbalances:

Implications for exchange rate forecasts



How large is the «exorbitant privilege»?

Gourinchas and Rey (2005): From world banker to world venture

capitalist: US external adjustment and the “exorbitant privilege”’

Total return on US assets held by foreigners (the US debt) <Return on foreign assets held by foreigners (particularly true

since 1971, end of Bretton Woods)

– US borrow at 3.6% and lend or invest at 5.7%: important

differential

– 2.1%! = (large) exorbitant privilege ; both a composition effect

(assets are riskier and less liquid than liabilities) and a return

effect (excess return within class of assets). Even larger (3.3%)

in post Bretton-Woods 1973-2004.

-Returns are not equated even within classes (no arbitrage)

- could be that assets and liabilities of US of different maturities

- role of dollar as reserve currency + liquidity of US financial markets(?): foreigners are

willing to hold underperforming US assets because more liquid (exorbitant privilege)

- composition effect: assets are in risky/high return (equity/fDI), liabilities are in low

returns bonds: plays a less important role (but more important through time)

Exorbitant privilege and duty

• Consequence of exorbitant privilege: US externalconstraint relaxed

→ CA deficits without worsening of external position

• Gourinchas, Rey and Govillot (2010):

financial crisis → dramatic worsening of US NFA (19%of GDP) : dramatic valuation adjustment (price of USholdings abroad contracted more than foreign holdingsin US): exorbitant duty during disasters (insurance)

• Find large exorbitant privilege in normal times

(New estimates: 3.47% excess returns of external assetsover liabilities for 1973-2009)

Exorbitant privilege

Source: Gourinchas et al. (2010)

Exorbitant duty

Source: Gourinchas et al. (2010)

• Eurozone as a whole roughly on balance externally.

• But hide a very large heterogeneity across countries: large

creditors (Germany, Finland, Netherlands) and large debtors

(Greece, Portugal, Spain, Ireland)

• In peripheral countries similar patterns than in the US in the

2000s: consumption and credit boom, housing prices boom.

• Easy foreign borrowing from the peripheral countries has

magnified the consequences of the financial crisis in these

countries (financial fragility)

Adjustment of ‘euro’ imbalances

Euro area heterogeneity

Average current account balances % of GDP (2002-2007)

Adjustment of ‘euro’ imbalances

• Two adjustment mechanisms

– Trade channel

– Financial channel (valuation effects)

• Requires a real depreciation of the currency for deficit countries

• Financial channel shut down with the euro zone unless default

• Real depreciation difficult in a monetary union: ‘competitive disinflation’ needed. Very costly (e.g France in the 90s)

• Particularly difficult for countries without a large traded sector.

• Nominal depreciation of the euro with other currencies might help (not for intra-European trade though).

• Real appreciation in Germany?

Brief Summary

• A depreciation of the exchange rate worsens the trade balance in the short-run

but improves it in the medium-run (J-curve).

• In the medium term, real exchange rate adjusts such that the BOP is in

equilibrium.

• Over the last 15 years, large global imbalances have emerged, with the US

running large current account deficits financed by borrowing to some

industrialized countries (Japan and Germany) and oil producers but more

surprisingly to some fast growing emerging markets (China…). These global

imbalances have magnified the factors behind the recent financial crisis.

• Adjustment of US current account imbalances requires a $ real depreciation,

which stimulates net exports (trade adjustment) and reduces the value of net

external debt for the US (capital gains on NFA= financial adjustment).

• The US earn higher returns on their external assets than what they pay on their

external liabilities (‘exorbitant privilege’). This relaxes their external constraint

and reduces the necessary adjustment.

• In period of financial crisis, the US tend to transfer large amount of wealth to

the rest of the world (‘exorbitant duty’), effectively acting as a world insurer.

Documents

Current account imbalances and exchange ratesecon.sciences-po.fr/sites/default/files/file/cours6-7... · 2014-10-02 · Current account imbalances and exchange rates Lectures 6-7