EC563: International Finance

The Balance of Payments

Lecture of 21
st
January
Balance of payments accounts
Record all economic transactions between domestic
residents and foreigners
Current account: trade in goods and services plus
income flows
Capital account: activities involving transfers of
assets between countries
Financial account: transactions involving the
purchase/sale of financial assets
Official reserve transactions (official settlements
balance): transactions involving the central bank
Net errors and omissions
BOP: definitions and conventions
In the current account, credit items are exports of merchandise
and services, income inflows and current transfer receivables while
debit items are imports, income outflows and transfer payables.
In the capital account, capital transfer receivables are recorded
as credits and payables as debits.
The transactions in the financial account are generally presented
on an assets/liabilities basis. Increases in foreign assets or
reductions in foreign liabilities are shown with a minus sign, (i.e. as
debits), while decreases in assets or increases in liabilities are
shown as positive numbers (i.e. as credits).
In the case of direct investment, the asset/liability presentation
is replaced by the so-called directional one, i.e. direct investment
abroad (approximating to the assets concept) and direct
investment in Ireland (which closely equates to liabilities).
Definitions and conventions (cont)
Direct investment is a category of investment that, based on an
equity ownership of at least 10%, reflects a lasting interest by a
resident in one economy in an enterprise resident in another
economy.
Portfolio investment covers the acquisition and disposal of
equity and debt securities which cannot be classified under direct
investment or reserve assets transactions. The securities involved
are traded (or tradable) in financial markets. Debt securities cover
bonds and notes, with an original maturity term of more than one
year, and money market instruments with original maturity of one
year or less.
Other investment covers assets and liabilities other than those
classifiable to direct investment, portfolio investment or reserve
assets. It includes loans, currency and deposits, short and long-
term trade credits and financial derivatives.
http://www.cso.ie/en/media/csoie/surveysandmethodologies/surveys/bop/documents/pdfs/Background_notes_updated_jun2011.pdf
Ireland: BOP accounts
(m) Current Capital* Financial* Financial Errors etc
(Private) (Reserves)
2003 -2 93 -3,142 1,770 1,280
2004 -867 279 2,624 1,177 -3,212
2005 -5,690 264 -1,958 1,472 5,912
2006 -6,304 223 4,683 87 1,311
2007 -10,124 39 12,063 -12 -1,966
2008 -10,169 47 16,210 -78 -6,010
2009 -3,763 -1,252 -1,139 79 6,074
2010 1,782 -673 7,271 5 -8,384
2011 2,002 -263 9,746 329 -11,815
2012 7,250 -2,056 975 12 -6,182
NB: A minus sign connotes an outflow
Ireland: private financial
account payments balances
(bn) Direct* P/folio* Other*
2003 15.3 -40.0 21.6
2004 -23.1 14.3 11.4
2005 -37.0 52.7 17.7
2006 -16.6 8.1 13.2
2007 2.6 -7.3 16.7
2008 -24.2 -45.7 86.1
2009 -0.6 22.6 -23.1
2010 15.4 86.0 -94.1
2011 17.8 26.9 -34.9
2012 15.4 -0.2 -14.2
* Minus sign connotes an outflow i.e. where the net acquisition of overseas assets by
domestic residents exceeds the net acquisition of domestic assets by non-residents
Ireland:composition of
portfolio flows*
(bn) 2011 2012
Equity Assets 6.3 -11.5
Liabilities 61.3 81.8
Bonds etc Assets -2.5 -55.6
Liabilities -18.3 -11.6
MMIs Assets -6.5 -6.5
Liabilities -13.5 3.2
Total Assets -2.6 -73.6
Liabilities 29.6 73.4
* Note that the change in both assets and liabilities can be either positive or negative
Why net errors and omissions?
Sheer volume of transactions
Difference sources and methods
Underreporting because of tax
avoidance/evasion
Timing of trade-related payments
The BOP always balances
Sum of credits and debits should always be zero
Why? Because each payment is simultaneously a
receipt*
So, what is meant by a BOP surplus or deficit?
Significance of the current account
Relevance of the official settlements balance
* To understand this point it may be helpful to think of the BOP as a record
of all transactions involving the exchange of domestic currency
Some important relationships
Y = C + I + G
Y = C + I + G + X M
CA = X M
Y (C + I + G) = CA
S = Y C G
S = I [closed economy]
S = I + CA [open economy]
S I = CA*
*or, using Copelands notation and defining S as Y C:
S I = B + G
More important relationships
Sp = Y T C
Sg = T G
S = Y C G = (Y T C) + (T G) = Sp + Sg
Sp = I + CA Sg = I + CA (T G)
Sp* = I + CA + (G T)
CA = (Sp I) (G T)
(*): Private saving can take three forms
Significance of current account
Measures difference between national income
and domestic spending
Measures the extent of net borrowing from
the rest of the world
Measures the rate at which a countrys net
foreign wealth/indebtedness is growing
Net International Investment Position (NIIP):
if positive/negative, country is a net
creditor/debtor*
NIIP is also affected by exchange rate movements: consider the impact of
a dollar depreciation on the NIIP of the US
Factors behind changes in NIIP
Current account balances
Exchange rate movements
Movements in asset prices
Why did US net foreign liabilities grow more
slowly than current account deficit?
Why in general is the change in a countrys
net international investment position different
from its current account balance?

US current account deficit
(% of GDP)
0
1
2
3
4
5
6
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
Global current account
imbalances, 1996-2004
($bn) 1996 2004

US -120 -666
Japan 66 172
Euro zone 79 53
Asia -41 180
Mid East 1 116
Source: Bernanke (2005)

Does the current account
matter?
Very large US current account deficits
Suppose ROW became unwilling to finance
these what would happen?
Deficit would need to be reduced how
would this be brought about?
Combination of adjustment mechanisms: (i)
rise in US interest rates; (ii) dollar
depreciation; (iii) tightening of US fiscal
policy; (iv) faster growth in US trading
partners.
Current account imbalances
and the financial crisis
The excess savings view: Ben Bernanke and
the world savings glut
Excess of savings over investment in surplus
countries (China; oil producers)
That excess flowed into deficit countries (the
US), easing monetary conditions
Interest rates and risk premia fell and an
asset price bubble developed
The global financial crisis ensued
Bernankes 2005 speech*
Delivered against the backdrop of a large and
growing current a/c deficit (over 5% of GDP in 2004)
Common view at the time was that the deficit
was primarily home grown
Bernankes starting point was that it was
necessary to adopt an international perspective
Conclusion: there has been a big rise in the
global supply of saving; this helps to explain the
US deficit and the low level of interest rates

* The Global Saving Glut and the US Current Account Deficit
Bernanke: why did US national
saving fall?
Was it due to a (rising) government
deficit?
No: (i) consider 1996-2000; (ii) consider
other countries with budget deficits*
Ultimate source lies in the changing
patterns of saving in the rest of the world,
especially developing countries
* Consider Ireland in the mid-noughties: a large current account deficit
combined with a government budget surplus
The effect of fiscal policy on
the current account
CA = (Sp I) (G T)
A rise in the budget deficit will weaken the current account cet par.

But will an increase in the budget deficit leave (Sp I) unchanged?
Bernanke: why have developing
countries become large savers?
Experience of financial crises in late 1990s
Switch to building up large war chests of
external reserves
Promotion of export-led growth by preventing
currency appreciation
Strong precautionary motive amongst
households
Oil producers: sharp rise in oil prices
Bernanke: how did this result
in reduced saving in US?
Capital inflows initially raised equity
prices and, in turn, consumer spending
Subsequently, low real interest rates
became the main mechanism
followed by strongly rising house
prices
Something of the same pattern evident
in other countries e.g. Spain, UK

Policy implications of the
saving glut view
Combination of surpluses in developing
countries and deficits elsewhere not desirable
(Why?)
Lowering US government deficit would have a
modest effect on current account (Why?)
Create tax incentives to save
Encourage developing countries to re-enter
world capital markets in their more natural
role as borrowers
Evidence that casts doubt on
excess saving hypothesis
Supposed link between US deficit and long-term interest
rates looks tenuous (both deficit and bond yields fell
sharply post-2007)
Co-existence of depreciating dollar and growing appetite
for US assets through much of noughties looks odd.
Link between US deficit and emerging market saving
rate is weak (deficit falling since 2007, EM saving
continued to rise)
Absence of clear link between global savings rate and
real interest rates: the latter have been trending
downwards since early 1990s.
Credit booms have not been confined to deficit countries
e.g. Japans pre-banking crisis credit boom in 1990s; US
credit boom before Great Depression.

More evidence that casts doubt
on excess saving hypothesis
The countries seen at the origin of the net capital flows
were amongst those least affected by the crisis, at least
through their financial exposures. Financial institutions in
other countries (notably Europe) were hardest hit.
In fact, before the crisis erupted, the main concern was
that a flight from US dollar assets induced by unsustainable
current account deficits would precipitate turmoil. The
scenario that materialised was very different. Indeed, as
the crisis unfolded, the US dollar actually appreciated.

Borio and Disyatat (2012)
Critique of excess savings view
Does not distinguish clearly between saving
(a real concept) and financing (a cashflow
concept)
Does not distinguish between net and gross
financial flows
Global configuration of current account
balances is misleading guide to global pattern
of financial flows
Is not informative about potential risks
associated with financial flows
Back to the BOP identity
Current account = Change in resident holdings of foreign assets
- change in resident liabilities to non-residents

= Net capital outflow

= Saving - investment
Note: 1. Gross flows bear little relationship to net flows
2. Gross flows capture only a fraction of international transactions
because the gross flows are themselves net
3. Current account is silent on the financing of domestic investment
4. Pattern of global financial flows cannot be inferred from current
account pattern (that country A is running a deficit with country B
does not imply that B is financing As deficit)
5. Misleading to pair the current account with specific gross flows
(eg movements in external reserves)
Empirical evidence on global
financial flows (and stocks)
Growth of global gross capital flows has dwarfed current account
positions and is mostly attributable to flows amongst advanced
countries
Pre-crisis, the increase in gross financial claims on the US was
three times greater than the increase in net claims.*
Bulk of gross flows into the US were from private sector, not from
official sector.
The most important geographic source of inflows was Europe, not
emerging markets.
Global current account imbalances narrowed marginally in 2008,
but gross capital flows collapsed.
Pre-crisis holdings of privately-issued US mortgage-backed
securities were concentrated in advanced countries (even if total
holdings of US debt securities were very high in China and Japan)
* In other words, even without trade deficits, the US would have attracted
large financial inflows.
References
Ben Bernanke (2005): The Global Saving Glut and
the US Current Account Deficit, Homer Jones
Lecture, St Louis
Borio & Disyatat (2011): Global Imbalances and the
Financial Crisis Link or No Link?, BIS WP No. 3146
Copeland: Exchange Rates and International Finance
(5
th
ed), pp21-26
Krugman, Obstfeld & Melitz: International Economics,
Ch.13
Pilbeam: International Finance, Ch.2
Further reading
Blanchard and Milesi-Ferretti (2009): Global
Imbalances In Midstream?
Lane and McQuade (2013): Domestic Credit Growth
and International Capital Flows, ECB WP 1566
Obstfeld and Rogoff (2009): Global Imbalances and
the Financial Crisis Products of Common Causes
Obstfeld (2012): Does the Current Account Still
Matter?
Jorda, Schularick and Taylor (2011): Financial Crises,
Credit Booms and External Imbalances
Schularick and Wachtel (2012): The Making of
Americas Imbalances