Transcript External Sector Accounts, Analysis, and Forecasting

International Monetary Fund/Asian Development
Bank Course on Financial Programming and Policies
Seoul, Korea, 17-28 May 2010
Thorvaldur Gylfason
1. Balance of payments accounts



How BOP accounts are put together
Definitions, conventions, presentation
Links to other macroeconomic accounts
2. Balance of payments analysis

Economics of exports, imports, capital
flows, exchange rates, etc.
3. Balance of payments forecasting
4. External debt and the international
investment position
Accounting system for macroeconomic
analysis in four parts
1.
2.
3.
4.
Balance of payments
National income accounts
Fiscal accounts
Monetary accounts
Now look at balance of payments
accounts per se, looked before at
linkages in a separate lecture
The balance of payments is a
statistical statement which
systematically summarizes, for a
specific period of time, the
economic transactions of an
economy with the rest of the
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 of
the country, including its debt
Double
 Every
entry accounting
transaction must result in two
entries of equal amounts, one on the
credit side and one on the debit side
 Typically, a positive sign (+) is
associated with an amount
recorded on the credit side and a
negative sign (-) is associated with
an entry on the debit side
By convention, some transactions are recorded as
credit items(+) and others as debit 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”
Transactions in two major categories
1. Real transactions
Goods, services, and income


Current account of the BOP

Involve flows
X = exports, Z = imports,
2. Financial transactions
F = capital account, R = reserves,
F = DDF with DF = net foreign debt
Reflect changes in foreign assets and
liabilities


Capital and financial account of the BOP

Involve changes in stocks
 Double-entry recording
 The sum of credit entries must equal the
sum of debit entries
 The sum of all transactions is zero
 Practical
problems lead to errors and
omissions
 Diversity of data sources
 Missing data: e.g., financial
transactions
outside banking system (informal sector)
 Under- or overvaluation of transactions

Smuggling
Current
account
 Transactions
related to goods, services,
income, and current transfers between
residents and non-residents
Transactions related to goods are those
relative to the movements of merchandise
 Exports 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 land
 E.g.,
compensation paid to trans-border
workers, interest payments on external
debt, etc.
 Transfers
 Public
are unrequited transactions
and private
 In cash or in kind
 E.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 presentation
 It
shows significant balances that are
useful for economic analysis and shows
a possible external imbalance
 The
overall balance of payments can
be in surplus or in deficit once we
distinguish transactions into two subgroups and draw a line between
these two subgroups
 When transactions above the line
sum up to a deficit, transactions
below the line will sum up to a
corresponding surplus, and vice versa
Trade
balance
 Difference
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

balance
Current account balance plus capital and
financial operations account balance
considered not to be “financing” items
External transactions
Goods
Exports
Imports
g
X
Z
g
Services Capital
s
X
Z
s
Real
transactions
F
x
z
F
Financial
transactions
Recording external
transactions
Balance of payments
 BOP = Xg + Xs + Fx – Zg – Zs – Fz

=X–Z+F
= current account + capital account
 Here
 X = Xg + Xs Exports of good and services
 Z = Zg + Zs Imports of good and services
 F = Fx – Fz Net exports of capital =
Net capital inflow = DDF

Recording external
transactions
Balance of payments
 BOP = Xg + Xs + Fx – Zg – Zs – Fz

=X–Z+F
= current account + capital account
 Here
 X = Xg + Xs Exports of good and services
 Z = Zg + Zs Imports of good and services
 F = Fx – Fz Net exports of capital =
Net capital inflow

Recording external
transactions
Balance of payments
 BOP = Xg + Xs + Fx – Zg – Zs – Fz

=X–Z+F
= current account + capital account
 Here
 X = Xg + Xs Exports of good and services
 Z = Zg + Zs Imports of good and services
 F = Fx – Fz Net exports of capital =
Net capital inflow

Recording external
transactions
Balance of payments
 BOP = Xg + Xs + Fx – Zg – Zs – Fz

=X–Z+F
= current account + capital account
 Here
 X = Xg + Xs Exports of good and services
 Z = Zg + Zs Imports of good and services
 F = Fx – Fz Net exports of capital =
Net capital inflow

Balance of payments
and reserves
Again
 BOP
= X – Z + F = DR
where
R
= reserves
 Note:
X, Z, and F are flows
R is a stock, DR is a flow
Balance of payments
and reserves
BOP
= X – Z + F = DR
where DR = R – R-1
Implications
X
F
Z
DR
DR
DR
In practice
Z
F
or DR
From trade balance
to current account
Trade balance
 TB = Xg + Xnfs – Zg – Znfs
Xnfs = Xs – Xfs = exports of nonfactor services
Znfs = Zs – Zfs = imports of nonfactor services
Balance of goods and services
 GSB = TB + Yf
Yf = Xfs – Zfs = net factor income
Current account balance
 CAB = GSB + TR = TB + Yf + TR

GSB
TR = net unrequited transfers from abroad
Importance of net
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 capital
 Interest
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)
Capital and financial
account
Two parts
1. Capital account (esp., capital transfers)
2. Financial account
1. Direct investment
Involves influence of foreign owners
2. Portfolio investment
Includes long-term foreign borrowing
Does not involve influence of foreign owners
3. Other investment
Includes short-term borrowing
4. Errors and omissions
Statistical discrepancy
Capital and financial
account
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 financial
account
 Portfolio
investments
 Equity
participation instruments and debt
instruments, money market instruments

Financial derivatives: separate functional category
 Other
 Trade
investments
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)
Capital and financial
account
 Reserve
assets
 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 the balance of
payments, including IMF loans
E.g., to maintain adequate foreign exchange
reserves
 Most successful IMF loans are never “used”

Overall balance of
payments
Four main items below the line
1.
2.
3.
4.
Gold
SDRs
Reserve position in IMF
Foreign exchange
 Three-month Rule: Gross foreign reserve
holdings should suffice to cover three
months of imports of goods and services
 Giudotti-Greenspan Rule: Central Bank
foreign reserves should not decrease
below short-term foreign commercial
bank liabilities or total liabilities
Changes in reserve position in IMF
 Recorded in financial operations account
under reserve assets, below the line
Use of IMF resources
 Purchase 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 SDRs
 Recorded in
financial account as
reserve asset flows
Current account
Capital and financial operations
A. Goods
Exports
Imports
Trade balance
B. Services
Transport
Travel
A. Capital
Capital transfers
Purchases/sales of nonproduced
nonfinancial assets
account
X-Z
C. Income
Compensation of workers
Investment income
D. Current transfers
General government
Other sectors
YF
TRF
Current transactions balance
= (X-Z) + YF + TRF
B. Financial operations
FDI
Direct investment
Portfolio investment
NFL
Other investment
C. Errors and omissions
Overall Balance
D. Net foreign assets
E. Exceptional financing
NFA
National income
accounts
Y=C+I+G+X–Z
=
E+X–Z
 where
E = C + I +G
CAB = X – Z = Y – E
 Ignore
Yf and TR for simplicity
S=I+G–T+X–Z
CAB = S – I + T – G
CAD = Z – X = E – Y = I – S + G – T
Links between BOP and
national accounts
Y=C+I+G+X–Z
GDP = C + I + G + TB
GNP = C + I + G + CAB
GNP – GDP = CAB – TB = Yf (if TR = 0)
GNP = GDP + Yf
 GNP > GDP in Pakistan
 GNP < GDP in Argentina
GNDI = GNP + TR = GDP + Yf + TR
Links between BOP and
national accounts
Y
X-Z
Definition
GDP
Trade
balance
Goods and
nonfactor
services
Links between BOP and
national accounts
Y
X-Z
Definition
GDP
Trade
balance
Goods and
nonfactor
services
GNP
Current
Goods and
account excl. services
transfers
Links between BOP and
national accounts
Y
X-Z
GDP
Trade
balance
GNP
GNDI
Definition
Goods and
nonfactor
services
Current
Goods and
account excl. services
transfers
Current
Goods and
account incl. services plus
transfers
transfers
Fiscal accounts and
links to BOP
 Public sector
G
– T = DB + DDG + DDF
 Private sector
I
– S = DDP – DM – DB
Now, add them up
G – T + I – S =
 DB + DDG + DDF + DDP – DM
 DDG + DDF + DDP – DM =
 DD – DM + DDF = -DR + DDF
 External sector
X
– Z = DR - DDF
– DB =
=Z-X
Monetary accounts
and links to BOP
Monetary survey
M
=D+R
From stocks to flows
 DM
= DD + DR
Solve for DR
 DR = DM – DD
 Monetary approach to balance of
payments
 Still holds that DR = X – Z + F
Real exchange rate
Balance of payments
analysis
Imports
Exports
Foreign exchange
Balance of payments
equilibrium
Equilibrium between demand and
supply in foreign exchange market
establishes
Equilibrium real exchange rate
Equilibrium in the balance of payments
BOP = X + Fx – Z – Fz
=X–Z+F
= current account + capital account
=0
Real exchange rate
Overvaluation
Deficit
R
Imports
Overvaluation
Exports
Foreign exchange
Price of foreign exchange
Overvaluation, again
Supply (exports)
Overvaluation
Deficit
Demand (imports)
Foreign exchange
Y=E+X–Z
= EN/PE + XN/PX – ZN/PZ (GNP)
= EN/PE + XN/PZ – ZN/PZ (GNI)
 Ratio
of export prices to import
prices: Px/Pz
 Typically
expressed in as an index
 Px = Export price index
 PZ = 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 imports
 Terms
of trade improve when Px/Pz rises
 Terms of trade worsen when Px/Pz falls
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 world
 Includes
change in net foreign assets of
Non-banking sector
 Banking sector (including monetary
authorities)

 CAB
 – F + DR because X – Z + F = DR
 – F + DR because X – Z + F = DR
 Hence, current account deficit can
be financed by
 CAB
 Attracting
foreign direct investment
 Accumulating net foreign liabilities

I.e., borrowing abroad
 Running
down the 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 Rule

 Other
factors
Capacity to meet financial obligations
 Availability 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

A
country is solvent if the present
value of future current account
surpluses is at least equal to its
current external debt
 The concept is simple, but putting
it into practice is complicated

If the projections of future surpluses
are sufficiently large, any current
account deficit could be consistent
with the notion of solvency
 Another
crucial indicator used to
assess the external position of a
country
A
deficit in the overall balance means
a decrease in the net foreign assets of
the monetary authority except when
exceptional financing becomes
available
 Foreign
reserves are traditionally
held by the monetary authorities in
order to finance payments
imbalances and to defend the
currency
 Exceptional
financing can be needed
in an emergency where reserves have
fallen to perilously low levels
 Three main types

Rescheduling of external debt obligations


Debt forgiveness


Scheduled payments postponed in agreement
with creditors
Voluntary cancellation by creditors
Payments arrears on external debt service

Scheduled payments postponed without
agreement with creditors
Indicators
of an appropriate level
of foreign reserves
 Ratio
of reserves to monthly imports of
goods and services of more than 3
 Guidotti-Greenspan Rule
Other considerations
 Capital mobility
 Exchange rate regime
 Composition of external liabilities
 Access to foreign borrowing
 Seasonal nature of imports and exports





DR = X - Z + F = CAB + FDI + NFL
Need projections of
Current account variable
Capital and financial operations
account variables
This gives projections of the
change in net foreign assets
 Developments in the global
economy
 Developments and policies in
the domestic economy
 Establish relations between the
components of the BOP and the
main factors that influence
them




Exports and imports of goods
Exports and imports of
services
Factor income
Unrequited transfers


Assume small open economy
Project volume of import demand


P
Z  f Y , Z 


P


Z = volume of imports
Y = domestic real GDP (+)
PZ/ P = import prices relative to
domestic GDP deflator (-)


Assume small open economy
Project volume of export demand
PX 

X  f  Y *,

P *

X = volume of exports
Y* = foreign real GDP (+)
PX/ P* = export prices relative to
foreign GDP deflator (-)


Assume small open economy
Project volume of export supply
 PX 
X  f Y ,

P 

X = volume of exports
Y = domestic real GDP (+)
PX/ P = export prices relative to
domestic GDP deflator (+)
 Transport
service (credit)
Sale of transport and other business services
(freight and insurance) by residents (carriers)
to nonresidents
 Depends on value of exports

 Transport


service (debit)
Purchase of transport and other business
services (freight and insurance) by residents
from nonresidents
Depends on value of imports
 Travel

Depends on domestic GDP and
competitiveness (prices, exchange rate)
Compensation of employees



Seasonal or border workers who work in
national territory but live in neighboring
countries or vice versa
Depends on trends
Interest payments


Estimated by entity responsible for
managing external debt (interest rates,
outstanding balance of debt, and new
borrowing)
Income from direct investment


Profits and dividends depend on stock of
foreign investment in the country (debit
side) or on the country’s investment
abroad (credit side)
 Private


Transfers from emigrant workers to their
country of origin
Depends on economic situation in country of
origin and host country, exchange rate, tax
regime
 Public



transfers
transfers
Grants in cash and in kind
Need information from donors
Need compatibility with grant projections in
government finance statistics
 Capital



Grants in cash (for investment) and in kind
having the nature of investments
Need information from donors
Need compatibility with grant projections in
government finance statistics
 Foreign

transfers
direct investment
Depends on investment opportunities,
profitability of investments, tax incentives,
economic growth, and political and social
stability of the country
Portfolio
 Equity
investment
participation instruments and
debt instruments, money market
instruments, and, separately, financial
derivatives
 Depends on access to international
markets, restrictions on capital flows,
relative interest rates, exchange rate,
political and social situation in the
country
Current account
sustainability and debt
There are two ways to finance a deficit on
current account
1.
2.
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 liabilities
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
External debt:
Key concepts
 Debt
stock
 Usually
measured in dollars or other
international currencies
 because debt needs to be serviced in
foreign currency
 Debt
ratio
 Ratio
of external debt to GDP
 Ratio of external debt to exports
More useful for some purposes, because
export earnings reflect the ability to
service the debt
External debt:
Key concepts
Debt burden
Also called debt service ratio
Equals the ratio of amortization and
interest payments to exports
A  rD
q
X
F
q = debt service ratio
A = amortization
r = interest rate
DF = foreign debt
X = exports
External debt:
Key concepts
Interest burden
Ratio of interest payments to exports
Amortization burden
Also called repayment burden
Ratio of amortization to exports
F
rD
b
X
A
a
X
q=a+b
External debt: Magnitude
and composition
Magnitude of the debt
Debt should not become too large
How large is too large?
Measurement of the debt
Gross or net?
May subtract foreign reserves in excess of
three months of imports
Composition of the debt
FDI, portfolio equity, long-term loans,
short-term loans
External debt: Magnitude
and composition
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: Numbers
How can we figure out a country’s
debt burden?
Divide through definition of q by
income
F
A
D
r
Y
q Y
X
Y
Now we have expressed the
debt service ratio in terms
of familiar quantities: the
interest rate r, the debt ratio
DF/Y, and the export ratio
X/Y as well as the
repayment ratio A/Y
Numerical example
Suppose that
r = 0.06
DF/Y = 0.50
A/Y = 0.05
X/Y = 0.20
Here we have a country
that has to use 40% of its
export earnings to
service its external debt
F
A
D
r
Y
q Y
X
Y
0.05  0.06  0.5 0.08
q

 0.4
0.2
0. 2
External debt dynamics
Debt accumulation is, by its nature, a
dynamic phenomenon
A 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
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 dynamics
Recall balance of payments equation:
BOP = X – Z + F
where
F = capital inflow = DDF
where
DF = foreign debt
Capital 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 flow and DF is a stock
External debt dynamics
Now assume
Then, it follows that
BOP = X – Z + DDF = 0
so that
DDF = rDF
Z = ZN + rDF
Z = total imports
ZN = non-interest imports
rDF = interest payments
Further, assume
X = ZN
BOP = 0
In other words:
ΔD F
r
F
D
A flexible exchange rate ensures
equilibrium in balance of payments at all
times
External debt dynamics
So, now we have:
ΔD F
r
F
D
Now subtract growth rate of output from
both sides:
ΔD
ΔY

 r-g
F
D
Y
F
DY
g
Y
External debt dynamics
But what is
ΔD F ΔY

F
D
Y
?
This is proportional change in debt ratio:
 DF 

Δ
F
Y 
ΔD
ΔY



F
DF
D
Y
Y
This is an application of a
simple rule of arithmetic:
%D(x/y) = %Dx - %Dy
Proof
z = x/y
log(z) = log(x) – log(y)
Dlog(z) = Dlog(x) - Dlog(y)
But what is Dlog(z) ?
dlog(z) dz 1 Δz
Δlog(z) 
  
dt
dt z
z
So, we obtain
Δz Δx Δy


z
x
y
Q.E.D.
Debt, interest, and growth
We have shown that
Δd
 rg
d
Debt
ratio
rg
where
F
D
d
Y
r=g
rg
Time
What to conclude?
It is important to keep economic growth at
home above – or at least not far below –
the world rate of 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 is key
Another perspective
rg
D / Y  const. in equilibrium
DD / D  DY / Y
a
g
D / Y  DD / DY  ( DD / Y ) /( DY / Y )
where
a = current account deficit/GDP
g = growth of GDP
What to conclude?
Must adjust policies
Must either
Reduce trade deficit by stimulating
exports or by reducing imports, or
Increase economic growth
Otherwise, the debt ratio will reach
unmanageable levels, automatically
No country can afford an external debt
equivalent to three times annual output
And why not?
Because the debt burden then
becomes unbearable
Recall our earlier numerical example
Where we looked at the relationship between
the debt ratio and the debt burden
Korea is a case in point
Its export-oriented growth strategy reduced the
numerator and increased the denominator of
the debt ratio, thereby quickly reducing the
country’s debt burden
An import-substitution strategy would reduce
both numerator and denominator with an
ambiguous effect on the debt burden
International investment
position
Gross foreign debt is not all that
matters
Foreign assets matter as well
Net foreign debt equals gross debt
less gross assets
Conversely, the difference between
gross assets and gross debt equals
the international investment
position (IIP)
International investment
position
Changes in IIP involve changes in stocks
measured at different points in time
Transactions (e.g., foreign borrowing)
Non-transaction changes (price changes,
exchange rate movements, other changes)
Reconciliation statement:
IIPt = IIPt-1 + Ft
Ft represents BOP financial account
transactions during period t, including
various non-transaction changes
In conclusion
 External 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 conclusion
External borrowing is a necessary and
natural part of economic development
This requires countries that borrow to invest the
funds borrowed in high-quality capital
This is necessary to be able to service the debt
If debt burden becomes too heavy, must
either reduce deficit or spur growth
It is always desirable anyway to do everything
possible to encourage economic growth
Rapid growth allows more foreign borrowing
without making the debt burden
unmanageable