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MIBE The economics of emerging economies The role of Finance in economic The role of Finance in economic development and the emerging development and the emerging economies economies Gianni Vaggi, April 2014 Finance 3-3 Finance 3-3 National accounting in National accounting in an an indebted indebted open economy open economy

MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

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Page 1: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

MIBEThe economics of emerging economies

The role of Finance in economicThe role of Finance in economic

development and the emerging development and the emerging economieseconomies

Gianni Vaggi, April 2014

Finance 3-3Finance 3-3

National accounting in an National accounting in an indebtedindebted open economy open economy

Page 2: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

The national accounting in an indebted open economy

Suppose D0 = 100 to be repaid in 10 years and i = 5%,

each year:

iD interest payments = 5

ΔD principal repayment = 10

iD + ΔD = DS Debt Service

Page 3: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies
Page 4: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

The national accounting in an indebted open economy

Remember: FA = NCF = Net Capital Flows = (Inflows – Outflows)

FA = [(Inflows - Other Outflows) -ΔD] = dD/dt

• ΔD<0 in an indebted economy ΔD is an outflow because debt must be repaid

• dD/dt is the change of the debt stock during the year, which depends also on inflows and other outflows in the FA.

CA = [(X-M) + (NPI – iD) + NSI]

Page 5: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

The national accounting in an indebted open economy

CA+FA = 0

Suppose an indebted economy where there are only foreign debt related flows:

(Inflows - Other Outflows) = 0

and no other item in NPI and NSI other than –iD

[(X-M) - iD] - ΔD = 0

(X-M) = iD + ΔD = DS

Take the example: DS = 5 +10 = 15

(X-M) - iD = ΔD

Page 6: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

The national accounting in an indebted open economy

IF IF the trade balance is 15 and exactly covers the debt service, thenthen the overall debt decreases by ΔD = D0 - D1 , according to the original scheduled payments or:

-ΔD = 90 -100 = -10 = -dD/dt

IF IF the trade balance is 5 and covers interests only, thenthen ΔD = 0 and the overall debt does not change:

dD/dt=0

IF IF the trade balance is less than 5 and, thenthen the overall debt increases:

dD/dt=>0

Page 7: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

The Current Account Balance

Now suppose there are other financial flows in the CA

In the BoP the Current account balance (CA) is the sum of three items:

Trade balance (X-M)

Net income transfers (interest payments, dividends, etc.;)= Net Primary Income = NPI

Net unilateral transfers (remittances, international aid, etc.)= Net Secondary Income = NSI

Page 8: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

The national accounting in an indebted open economy

Net primary income: Net primary income: Interests on foreign debt

Dividends (on portfolio investments);

Earnings of FDIs, profit repatriation

Rents on land and natural resources;

Compensation of employees (cross-border workers).

Net secondary income:Net secondary income:

Personal transfers (i.e. remittances);

Current) International cooperation,ODA

Page 9: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

The national accounting in an indebted open economy

Consider the following flows:

-iD are outflows in NPI = -5

Compensation of employees are often included in remittances

NSI includes -remittances

-international aid , ODA

Page 10: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

The national accounting in an indebted open economy

Remember:

[(X-M) + NPI + NSI] = CA Current Account Balance

and CA + FA = 0

[(X-M) - iD + NSI] + (-ΔD) = 0

[(X-M) + NSI] = iD + ΔD = DS = 15

Page 11: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

Debt sustainability - 1

D = overall foreign debt

Y = GDP

gn = (dY/dt)/Y is the nominal growth rate

Thresholds d(D/Y)/dt < 0< 0

The latter: Domar 1944

Page 12: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

Debt sustainability - 2

By total differentiation of D/Y:

d(D/Y)/dt = [ (dD/dt)*Y - (dY/dt)*D ]/ Y2

= (dD/dt)Y - [ (dY/dt)/Y ] * (D/Y)

= (1/Y) [dD/dt - gn * D ]

But dD/dt = [inD - (X – M)]

Page 13: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

Debt sustainability - 3

i = (in - dp/dt) and g = (gn - dp/dt)

dp/dt inflation rate on debt

d(D/Y)/dt = (i - g)D/Y - (X - M)/Yd(D/Y)/dt = (i - g)D/Y - (X - M)/Y

i, g are the real interest rate and the GDP growth rate

d(D/Y)/dt = inD/Y - gnD/Y - (X - M)/Y

Page 14: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

Debt sustainability - 4

But there are also other financial flows:

Current Account (CA)= [(X-M) + NPI + NSI ]

NICA = [CA – iD] = Non-Interest Current Account

NICA = [CA – iD] = [(X-M) + NPI + NSI] - iD

NICA largely depends on the trade balance, but not only.

Page 15: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

Debt sustainability - 5

The correct sustainability formula is

d(D/Y)/dt = (i - g)D/Y - d(D/Y)/dt = (i - g)D/Y - NICANICA/Y/Y

Page 16: MIBE The economics of emerging economies The role of Finance in economic development and the emerging economies development and the emerging economies

Debt sustainability – 6- and national public debt

NICA is the equivalent for foreign debt of the concept of Primary surplus (net of interests) for domestic(public) debt

(T – G) = Primary surplus

[(T – G) – iD] (<0) = overall Fiscal Deficit = FD

FD/Y must not exceed 3%