Capital flows, exchange rate, trade balances, and all

that stuff

Outline

• Some very, very, very boring definitions and a little bit of theory

• What do the data say?

• Why?

• Policy implications

The Balance of Payment

• The BOP keeps track of a country's payments to foreigners and receipts from foreigners– Transactions resulting into a payment to

foreigners are entered in the BOP as a debit (-).

– Transactions resulting into a payment from foreigners are entered in the BOP as a credit (+).

The Balance of Payment

• The BOP records two types of transactions:– Transactions that involve exports or imports of goods

and services or transfers are registered in the current account

• When a Lebanese citizen buys a US made product, this is recorded as a debit in the Lebanese BOP and as a credit in the US BOP.

– And viceversa

• Transactions that involve the purchase or sale of assets are registered in the capital account

• When a Lebanese company buys a US company (building, bond, ..), the transaction is recorded in the Lebanese BOP as a debit in the capital account and is recorded in the US as a credit in the capital account

– And viceversa• Why debit? Because Lebanon is "importing" the Asset

The Balance of Payment

• By double-entry bookkeeping, every transaction enters into the BOP twice, once has a credit and once as a debit

• Example: A US citizen buys hummus from Lebanon for USD2000 and pays with a check– Debit in US current account (import) credit in

the Lebanese current account (export)– Credit in US capital account and debit in the

Lebanese capital account (US sold a check to Lebanon)

The Balance of Payment

• CAPITAL ACCOUNT+CURRENT ACCOUNT=0

• So, what does a Balance of Payment deficit mean?

Current Account

(1) Exports Credit 200

(2) Imports Debit -700

(3) Uncle Walid from Montreal sends money to Karim in Beirut and Uncle Sam gives money to the Lebanese govt to fight drug dealers (remittances and aid are part of net unilateral transfer)

Credit 150

(4) Current account balance (1)+(2)+(3) -350

Nonreserve capital account

(5) Change in domestic assets held abroad* (increase: -) Debit -250

(6) Change in foreign assets held domestically* (increase: +) Credit 200

(7) Nonreserve Capital Account Balance (5)+(6) -50

(8) Errors and Omissions (shady figures take back some of the money they stashed in Dubai, it was a debit when they stashed the money)

Credit 10

(9) Official settlement balance (4)+(7)+(8) -390

Official reserves transactions

(10) Change in official reserves held abroad (increase: -) Credit +400

(11) Change in foreign official reserves held domestically (increase: +) Debit -10

(12) Net Change in official reserves +390

Trade balance: (1)+(2) = -500

Capital account balance: (7)+(12)+(8) = 350= Current account balance

BOP deficit

Current Account

(1) Exports Credit 200

(2) Imports Debit -700

(3) Uncle Walid from Montreal sends money to Karim in Beirut and Uncle Sam gives money to the Lebanese govt to fight drug dealers (remittances and aid are part of net unilateral transfer)

Credit 150

(4) Current account balance (1)+(2)+(3) -350

Nonreserve capital account

(5) Change in domestic assets held abroad* (increase: - ) Debit -250

(6) Change in foreign assets held domestically* (increase: +) Credit 200

(7) Nonreserve Capital Account Balance (5)+(6) -50

(8) Errors and Omissions (shady figures take back some of the money they stashed in Dubai, it was a debit when they stashed the money)

Credit 10

(9) Official settlement balance (4)+(7)+(8) -390

Official reserves transactions

(10) Change in official reserves held abroad (increase: -) Credit +400

(11) Change in foreign official reserves held domestically (increase: +) Debit -10

(12) Net Change in official reserves +390

CA deficit

Some Theory(but not too much)

very complicated equations ahead!!!

No, not that complicated!!!

Neoclassical growth

• Assumptions:– Output (Y) is created by mixing capital (K) and labor (L)– Technology (A) determines the quantity of output

generated by a given amount of K and L • If you like equations: Y=A*f(K,L)

– If you believe in Cobb-Douglas Y=AKL

– There is full employment (yeah, right!)– Growth (in per capita terms) is driven by investment

(more K) or exogenous technological change (more A)– Since there are no unemployed resources, the only

way to accumulate capital is to consume less• So, less consumption => higher savings=> more capital=>

more growth– It's a bit more complicated than this

Neoclassical growth• In an open economy, investment can be

financed with foreign savings• Closed economy

– Y=C+G+I– Since S=Y-C-G– We have: S=I

• Open economy– Y=C+I+G+EXP-IMP=C+I+G+CAB– Therefore: S=Y-C-G=I+CAB – And: S-CAB=I– Capital inflows are often referred to as foreign

savings

Implications

• Poor countries are poor because have a low capital stock

• Return to capital should be higher in countries with a low capital stock

Capital should flow from rich to poor countries

• Developing countries that receive more capital should grow at a faster rate

Capital account liberalization should lead to higher growth

Outline

• Some very, very, very boring definitions and a little bit of theory

• What do the data say?

• Why?

• Policy implications

Theory suggests that:

Capital should flow from rich to poor countries– Without capital controls rich countries should

run current account surplus and poor countries should run current account deficits (capital should go South)

Capital account liberalization should lead to higher growth

Countries liberalized capital flows…

Current Account Balance (% of GDP)

-8

-6

-4

-2

0

2

4

6

8

1980 1984 1988 1992 1996 2000 2004

A. Weighted averages

Developing countriesDeveloped countriesEmerging economies in Europe

…but capital is going North!

Global imbalances

19

...still going

-1500

-1000

-500

0

500

1000

1500

2000

2005 2006 2007 2008 2009 2010 2011

European Union, excl. Germany

Germany

Japan

United States

Fuel-exporting countries

China

Other transition economies

Other developing countries: Africa

Other developing countries: America

Other developing countries: Asia

Current Account Balance (% of GDP)

B. Simple averages and 25th and 75th percentiles of the distribution

-14

-12

-10

-8

-6

-4

-2

0

2

4

6

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

Developing countriesDeveloped countriesEmerging economies in Europe 25th percentile for all countries75th percentile for all countries

Current Account Balance (% of GDP)

-10

-8

-6

-4

-2

0

2

4

6

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

AfricaAsia

Latin AmericaEastern Europe and CIS

A. Emerging-market economies

Current account Balance EMs (% of GDP)

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.01

98

0

19

82

19

84

19

86

19

88

19

90

19

92

19

94

19

96

19

98

20

00

20

02

20

04

20

06

20

08

% o

f G

DP

But who is borrowing and who is lending?

• Remember from our boring definitions:

Current Account +

+ Nonreserve capital account +

+ Official reserves transactions = 0

The balance of payment in EMs

-1,500,000

-1,000,000

-500,000

0

500,000

1,000,000

1,500,000

19

85

19

87

19

89

19

91

19

93

19

95

19

97

19

99

20

01

20

03

20

05

20

07

20

09

mil

lio

n U

SD

Reserves (-increase)

Errors and omissions, net

Resident lending abroad, net

Official flows, net

Private flows, net

Current account balance

The current account is positive (so DC don’t need capital) and yet the private sector is importing capital. Therefore, the official sector needs to export capital.

But who is borrowing and who is lending?

• Remember from our boring definitions: Current Account + + Nonreserve capital account + + Official reserves transactions = 0

• The current account is positive (so DC don’t need capital) and yet the private sector is importing capital. Therefore, the official sector needs to export capital.

Stock of Internat. Res. (EMs)

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

3,500,000

4,000,000

4,500,000

5,000,000

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

mill

ion

US

D

But who is borrowing and who is lending?

• Large gross flows but no net inflows– The traditional channel (developing countries

need capital) is not at work

• This is strange, but maybe there are efficiency gains associated with foreign private capital– Foreigners are better at allocating capital– FDIs have positive spillovers– …

• If this were the case, we should observe that CAL has a positive effect on growth– (the second prediction)

Capital account liberalization and economic growth(IMF estimates)

Capital account liberalization and economic growth(Rodrik and Subramanian)

Capital account liberalization and economic growth(Rodrik and Subramanian)

Summing up

• Theory– Capital should flow from rich to poor countries– The private sector should lend money to countries

that need capital– Capital account liberalization should increase

economic growth• Reality

– Capital flows from poor to rich countries– The private sector lends money to countries that don’t

need it • (and governments of developing countries lend it back to

governments of rich countries)– Capital account liberalization has no effect on growth

Outline

• Some very, very, very boring definitions and a little bit of theory

• What do the data say?

• Why?

• Policy implications

Why doesn’t theory match the facts

• Problems with the theory– Primacy of savings etc.– Yes, but not today

• Problems with the international finanancial architecture– ILOLR does not work well and countries don’t

trust it– Lack of cooperation

ILOLR does not work well and countries don’t trust it

• When did global imbalances start?• Yes, after the Asian crisis• Why?

-8

-6

-4

-2

0

2

4

6

8

1980 1984 1988 1992 1996 2000 2004

A. Weighted averages

Developing countriesDeveloped countriesEmerging economies in Europe

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

19

80

19

82

19

84

19

86

19

88

19

90

19

92

19

94

19

96

19

98

20

00

20

02

20

04

20

06

20

08

% o

f G

DP

ILOLR does not work well and countries don’t trust it

• If the global insurer does not work well, countries will self-insure with international reserves

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

3,500,000

4,000,000

4,500,000

5,000,000

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

mill

ion

US

D

Lack of cooperation• Consider two countries:

– Country A has an inflation rate of 2% and an interest rate of 5%

• Real interest rate 3%– Country B has an inflation rate of 8% and an interest

rate of 11%• Real interest rate 3%

• We expect that the currency of country B will depreciate

• (if not country B will lose competitiveness and run larger and larger current account deficits)

– By how much?• Approximately 6% per year

– This is called uncovered interest parity (UIP)– This will also guarantee relative PPP

Lack of cooperation

• We expect that the currency of country B will depreciate – But a smart investor can say: – I can borrow at 5% in A and lend at 11% in B. If the XR does not

move too much, I can make easy money– This is called CARRY TRADE

• Note that carry trade pushes money from A into B• By creating demand for the currency of B it prevents a depreciation

of B. In fact, B may even appreciate

– Exchange rates will move in the WRONG direction– Of course, this cannot last forever.

• Country B will keep losing competitiveness and run larger and larger current account deficits

• At the end they will be a currency crisis in B,

– But, it may last for a while, and the longer it lasts the worst the crisis

Outline

• Some very, very, very boring definitions and a little bit of theory

• What do the data say?

• Why?

• Policy implications

Reform the International Financial Architecture

• Self-insurance is inefficient and trade agreements cannot survive with "exchange rate disagreements“– We need to re-establish trust in the global insurer– The world economy needs a new code of conduct

going far beyond the existing framework of international rules of trade policy as agreed in the World Trade Organization (WTO)

• We need mechanisms to prevent “wrong” movements of the exchange rate– UNCTAD PPP and UIP rules

Reform the International Financial Architecture

• This reform process may take time• In the meantime, protect yourself:

– If the risk taking behavior of financial intermediaries cannot be regulated perfectly, we need to find ways of reducing the volume of transactions… What this means is that financial capital should be flowing across borders in smaller quantities, so that finance is primarily national (Keynes)

– members may exercise such controls as are necessary to regulate international capital movements.. (IMF Articles of Agreements)

Capital flows, exchange rate, trade balances, and all

that stuff