EC 380: Lecture 15

.title[
# EC 380: Lecture 15
]
.subtitle[
## Global Finance: Balance of Payments
]
.author[
### Philip Economides
]
.date[
### Winter 2024
]

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# Prologue

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# Recap

### Previously

* Contents of Balance of Payments

* Financial Account features

### Today

* International Debt

* Investment Position

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# Limits on Financial Flows

Last time we discussed financial account flows.

A .hi-pink[trade-off] exists with respect to allowing greater financial flexibility and increase exposure to international financial crises/capital flight.

* Countries risk becoming reliant on external sources of liquidity

* A quick change in the business cycle could result in a large-scale exodus of liquidity

* Asset prices drop, indebtedness intensifies

---

# National Accounts + Deficit

_Gross domestic product_ .hi-pink[(GDP)]: value of all final goods and services produced inside its borders during some time period.

_Gross national product_ .hi-pink[(GNP)]: value of all final goods and services produced by the labor, capital, and other resources of a country, regardless of where production occurred

`$$\text{GNP} = \text{GDP} + \text{foreign income received} - \text{income paid to foreigners} +\\ \text{foreign transgers received} - \text{transfers paid to foreigners}$$`

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# National Accounts + Deficit

`$$\text{GNP} = \text{GDP} + (\text{Net Primary Income} + \text{Net Secondary Income})$$`

Standard macro: `$GDP = C+I+G+X-M$`

`$$\text{GNP} = C+I+G+  \underbrace{(X-M+ \text{Net Primary} + \text{Net Secondary})}_{\text{Current Account}}$$`

GNP is also the value of income received

---

# National Accounts + Deficit

GNP is also the value of income received.

Individuals may .hi-pink[consume income (C)], .hi-pink[save it (S)], or use it to .hi-pink[pay taxes (T)]. In reality, all of us do a combination of the three.

`$$\text{National Income} = \text{GNP} = C + S + T$$`

Setting output equal to income:

$$ C + I + G + CA = C + S + T \ \ \implies \ \ I + G + CA = S + T$$

`$$S + (T-G) = I + CA$$`

Supposing .hi-pink[balanced government budget], savings are equal to total investment in the country plus current account net flows

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# National Savings

Nation’s savings (private plus public) is divided into .hi-pink[two uses].

* Source of funds for .hi-pink[domestic investment] (I).

* If government budgets are in deficit, overall LHS down, and all else being equal, investment falls.

* Govt budget surplus increase the funds available for investment.

* Source of funds for .hi-pink[foreign investment].

* If CA surplus, national savings finances purchase of domestic goods by foreign users of those goods. In return, domestic economy acquires foreign financial assets.

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# National Savings

Recall .hi-pink[financial account] reflects the same amount of lending or borrowing as CA.

If `$\text{CA}<0$`, financial account features net borrowing greater than net acquisition of financial assets (lending, or financial outflows).

* Negative current account `$\implies$` net borrowing in the financial account, inflow of financial capital.

* Surplus countries provide savings to rest of world, enabling sale of more goods abroad than they buy.

* Financial capital outflow is investment because involves acquisition of assets that are expected to pay a future return.

---

# National Savings

Hence, another name for the current account balance is .hi-pink[net foreign investment].

Negative balance implies that foreigners accumulate more home country assets than the home country accumulates abroad.

US has had a .hi-pink[CA deficit] every year since 1981. Financial crisis of 2007–2009 had a dramatic effect on savings, investment, and government budgets.

Savings rose, investment fell. Federal budgets fell into large deficits. Falling import levels represented improvement in .hi-pink[CA balance].

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# Current Account Deficit

The relationship between the current account balance, investment, and total national savings is an .hi-pink[identity].

Does not tell us why economy runs CA deficit or surplus.

`$$S + (T-G) = I + CA$$`

We cannot say CA in deficit because .hi-pink[saving is too low] any more than we can say it is because .hi-pink[investment is too high].

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# Current Account Deficit

General tendency in the media and public to interpret CA deficit as a sign of weakness and as harmful to the nation’s welfare.

Deficit .hi-pink[enables more investment] than would be possible otherwise (higher investment `$\implies$` higher living standards)

Capital inflows associated with current account deficits are .hi-pink[implicit vote of confidence by foreigners].

---

# Current Account Deficit

For example, between 1980 and 1991, Japan invested +$25 billion of .hi-pink[trade surplus] in US manufacturing.

By early 90s, employing more than 100,000 US workers. Investment came during major domestic layoffs.

Japanese firms acquired capital, built new plants w/ Japanese savings.

During the US CA deficits of the 1990s, foreign investors continued to pour in capital, enabling increased productivity despite declining savings rate.

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# Current Account Deficit

Capital inflows that occur with CA deficit increase stock of foreign-owned assets in home country.

Home now far more exposed to foreign policy/foreign business cycle conditions.

A sudden change in investor expectations about the home country’s future or their country's prospects can lead to a .hi-pink[sudden surge in capital outflows].

In .hi-pink[worst-case scenario], capital flight is followed by a depletion of international reserves and a financial crisis.

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# Current Account Deficit

Experience shared by a number of developing countries since the 1980s

Deficits allow countries to invest more, huge opportunity for developing countries where investment capital is scarce.

International financial crises, like some biological diseases, tend to be .hi-pink[contagious].

> When Mexico slipped into __peso crisis__ in late 1994 and early 1995, economists began to write about “Tequila effect” on Latin America. When Thailand’s currency lost a large share of its value in 1997, media reported crisis spreading across East Asia. In both cases, the size of a CA balances was not good predictor of whether it was drawn into the crisis.

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# International Debt

CA deficits financed through inflows of financial capital.

Capital inflows take different forms, from direct investment to purchases of stocks, bonds, and currency, to loans.

Loans from abroad add to a country’s stock of .hi-pink[external debt] and generate .hi-pink[debt service obligations].

---

# International Debt

Debt service becomes .hi-pink[unsustainable burden], holds back economic development.

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# International Debt

Most countries, rich and poor, have external debt.

In .hi-pink[high-income countries], debt service is rarely an issue.

Usually relatively small compared to the size of the economy. Able to borrow in their own currencies.

Size of the external debt burden is unsustainable, given the economy’s ability to make interest payments and to repay the principal.

---

# International Debt

Unsustainable debt occurs for many reasons.

* Sometimes, countries are .hi-pink[dependent on exports] of one or two basic commodities such as copper or coffee.

* Shock of a sudden drop in world commodity prices reduces value of exports and generates unexpectedly large current account deficits.

* In other cases, countries experience .hi-pink[natural disasters], such as hurricanes and earthquake

* .hi-pink[Corruption], too, can play a role, as autocrates empty national coffers.

* Even electoral politics may be a factor, as when officials try to gain support through .hi-pink[unsustainable expenditures] targeted at important constituents.

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# International Debt

Worsens budget position by adding repayments made to outsiders `$\implies$` reduces .hi-pink[availability of public funds] for important domestic needs such as infrastructure, schools, and health care.

In addition, many examples of excessive debt burdens that have .hi-pink[spiralled] intensified and spread economic crises.

Joint venture of WB, IMF, and various governments.

Provide debt forgiveness for select countries that must qualify based on .hi-pink[high levels of poverty and debt] and a .hi-pink[track record of economic reform].

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# Investment Position

If a nation runs a .hi-pink[current account deficit], it .hi-pink[borrows from abroad] and adds to its indebtedness to foreigner.

.hi-pink[International investment position]: _Domestic assets owned by foreigners subtracted from foreign assets owned by residents of Home._

International investment position of 2019 (USA) was 10,991 bn USD.

Each year a country experiences a .hi-pink[CA deficit], foreigners acquire more assets locally than its residents acquire abroad.

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# Brexit Investment Position

So what happened to the UK CA and capital flows during .hi-pink[Brexit]?

Quick recap:

* In 2016, the UK voted to leave the European Union and strike up their on trade relationships

* Wanted continued access to .hi-pink[free trade with EU] while deviating from common tariff schedule/regulatory standards and blocking free movement of labor.

* Negotiations were largely a source of embarrassment for the UK - quickly clear they did not have sufficient .hi-pink[bargaining power] to achieve ideal deal.

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# Brexit Investment Position

Severe loss of confidence in UK economic performance

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# Current Account

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# Summary

### Recapping

* National accounts and CA balance interconnected

* Deficit is not a sign of economic/geopolitical weakness

* A deficit implies borrowing from abroad, but investments can be very fruitful

### Next time

* Exchange Rate Adjustments (SR + LR)

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