TRADE AND BALANCE OF PAYMENTS

THE ACCOUNTS

Introduction •Balance of payments = current account + capital account + financial account

• The international transactions of a nation are divided into three separate accounts– Current account: record of the goods and services into and

out of the country– Financial account: record of the flow of financial capital to

and from the country– Capital account: record of some specialized types of

relatively small capital flows

Merchandise Trade Balance

• Let’s first define merchandise trade balance—part of the current account; measures the difference between exports and imports of goods, but not services– Trade deficit: negative merchandise trade balance– Trade surplus: positive merchandise trade balance

• In 2002, the U.S. had a trade deficit of $418.0 billion• However, the U.S. had a large trade surplus in services

($64.8 billion)

Current Account

• Current account balance: measures all current, non-capital transactions between a nation and the rest of the world

• Current account has three main components:– Goods and services = the value of goods and services exported – the

value of imports– Investment income = income from investments abroad – income paid to

foreigners on their U.S. investments– Unilateral transfers = any foreign aid or other transfers received by

foreigners – that given to foreigners

Components of the Current Account

IF A NATION’S PEOPLE INVEST IN ANOTHER NATION, THEN INCOME FROM FOREIGN NATION STOCKS, BONDS, DEPOSITS, COMMERCIAL PAPER IS A CREDIT IN THE CURRENT ACCOUNT --- FOREIGN INVESTMENTS IN ANOTHER NATION ARE A DEBIT TO THE CURRENT ACCOUNT

The U.S. Current Account Balance, 2005 (Millions of Dollars)

U.S. Current Account Balance, 1950–2005

• U.S. current account deficit looks ominous

• However, the deficit is not a sign of weakness: U.S. economic boom of the 1990s increased the demand for imports, while sluggish growth abroad limited the expansion if U.S. exports

• But the U.S. deficit is not sustainable in the long term

• With $ down in value– exports increase --- but oil payments paid out increase

• TRADE IN GENERAL AROUND THE WORLD IS DOWN IN THIS CURRENT DEPRESSION

Financial Account

• Financial account: record of the flow of financial capital to and from a country

• Two main components– Net changes in the country’s assets abroad– Net changes in the foreign-based assets in the

country

Capital Account

• Capital account: record of the transfers of specific types of capital, such as– Debt forgiveness– Personal assets that migrants take with them

abroad– The transfer of real estate and other fixed

assets, such as a military base or an embassy building

• Balance of payments = current account + capital account + financial account

U.S. BALANCE OF ACCOUNTS IN $MILLIONS 2005

• Three accounting caveats1. Both the capital account and the financial account

present the flow of assets during the year in question and not the stock of assets that have accumulated over time

2. All flows are net changes (differences between assets sold and bought, for example) rather than gross changes

3. As long as the capital account balance is zero, financial account balance = current account balance, but with the opposite sign

• Statistical discrepancy: the amount by which the sum of the current, capital, and financial accounts is off the total of zero

• Statistical discrepancy is calculated as the sum of the current, capital, and financial accounts, with the sign reversed– In 2005, U.S. statistical discrepancy was

[(–1) (–791,508 – 4,351 + 785,499)] = 10,410• current acc. Capital acc. Financial acc

RECORDS ARE INCOMPLETE--- HENCE THE PLACE OF THE STATISTICAL DISCREPANCY

Financial Flows

Five Types of U.S. Financial FLOWS

1. U.S. assets abroad (outflows)

A. Official reserve assets: gold bullion, IMF’s special drawing rights (SDRs), major currencies

B. Government assets: loans to foreign governments, rescheduled loans to foreign governments, payments received on outstanding loans, changes in non-reserve currency holdings (e.g., Mexican pesos)

C. Private assets: direct investment, foreign securities, loans to foreign firms and banks

2. Foreign assets in the U.S. (inflows)

D. Foreign official assets: gold bullion, IMF´s special drawing rights (SDRs), major currencies

E. Other foreign assets: direct investment, U.S. securities and currency, loans to U.S. firms and banks

2005 U.S. FINANCIAL ACCOUNT

Private assets: foreign direct investment (FDI), foreign securities, loans to foreign firms and banks

FDI: tangible items: real estate, factories, warehouses, transportation facilities, and other physical (real) assets

Securities and loans can be considered foreign portfolio investment—paper assets such as stocks and bonds

Both FDI and foreign portfolio investment give their holders a claim in a foreign economy’s future output

However, holders of FDI have longer time horizons

THE LARGEST SHARE OF FINANCIAL FLOWS IS PRIVATE ASSETS

PRIVATE FLOWS IN THE U.S. FINANCIAL ACCOUNT

2005

Until recently, most nations limited the movement of financial flows related financial account transactions across their borders

The European Union liberalized financial flows between member countries only in 1993 However, current account transactions were less heavily regulated

The movement toward open markets over the 1980s and 1990s has resulted in the lifting of controls on financial flows

Developing countries, in particular, have liberalized financial account transactions in order to get access to financial capital for developmentAlthough financial flows can be volatile, economists agree that free flows are best for economic efficiency

The Current Account and the Macroeconomy

Balance of payments help us to understand the broader implications of current account imbalances and how to tame current account deficits

Balance of payments give cues how nations can avoid crises brought by volatile financial flows and how they can minimize the damage of financial crises if such occur

National Income and Product Accounts

• National income and product accounts: accounting system for a country’s total production and income

• Two fundamental concepts of the system:– Gross domestic product (GDP): the value of all final goods

and services produced within a country´s borders during a period of time (usually a year) {add up value of goods and services}

– Gross national product (GNP): the value of all final goods and services produced by the labor, capital, and other resources of a country within the country as well as abroad {here you add up value of goods & services in country as well as abroad for a nation}

• GNP = GDP + foreign investment income received – investment income paid to foreigners + net unilateral transfers

Understanding National Accounts• Interplay of the variables of the national accounts

1. GDP = C + Id + G + X – M Using Id = domestic investment for I

2. GNP = GDP + (net foreign investment income + net transfers)

3. GNP = (C + Id + G) + (X – M + net foreign investment income + net transfers)

4. GNP in terms of current account balance: GNP = C + Id + G + CA = C + Id + G + (X – M) FOR CA ≈ (X – M)

5. GNP is also the value of income received: GNP = C + S + T6. Since 4 and 5 are equivalent definitions of GNP,

C + Id + G + CA = C +S + T

7. Id + G + CA = S + T

8. S + (T – G) = Id + CA = Id + (X – M)

• S + (T – G) = Id + CA summarizes the current account balance, investment, and public and private savings in the economy CA=S+(T-G) -Id

DEBT = (T – G)

• The following figure illustrates the equation in the U.S. in 1991–2005

• IF S IS LOW AND (T-G)< 0 --- YOU CAN SEE THE EFFECT ON CA BECAUSE OF THE -Id

International Debt

Current account deficits must be financed through inflows of financial capital (loans)

Loans from abroad add to a country’s stock of external debt and generate debt service obligations --- CA DEFICIT = NET BORROWER

All countries, rich and poor, have external debt

• In many low and middle income countries, external debt leads to financial problems

• Unsustainable debt occurs for numerous reasons:– Falling commodity prices– Natural disasters– Corruption– Foreign lending behavior

DEBT IN 2005SOME OF THE TOP NATIONS

IN DEBT

The International Investment Position

If a country runs a current account deficit, it borrows from abroad and increases its indebtedness

If a country runs a current account surplus, it lends to foreigners and reduces its overall indebtedness

International investment position = domestically owned foreign assets –foreign owned domestic assets

• A positive international investment position = the home country could sell all its foreign assets and have more than enough revenue to purchase all the domestic assets owned by foreigners

– In 2005, the U.S. international investment position = $11,079 billion – $13,625 billion = –$2,546 billion