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Int Econ BoP


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Balance of Payments.

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Int Econ BoP

  1. 1. International Economics BoP SFC 7005 Spring 2012
  2. 2. Questions• What’s the BoP? What is it for?• What are the main categories in which the country’s international monetary transactions are organized in the BoP?• What’s the BoP’s current account and what are its main subcategories?• What’s the BoP’s capital account and what are its main subcategories? 1
  3. 3. • What’s the official settlement balance? What kind of information does it convey?• What happens when a country runs a BoP deficit under a fixed exchange rate regime? What happens under a pure flexible exchange rate regime?• What’s the relation between the BoP and the na- tional income accounts?• What are typical BoP problems and how do affected countries face them?
  4. 4. BoPStatistical record of a country’s international transac-tions over a given period of time. Any transaction thatresults in a nationals’ receipt from foreigners is recordedas a credit (plus sign) while any transaction resultingin a payment by nationals to foreigners is recorded asa debit (minus sign). 2
  5. 5. BoP’s categories1. Current account: (goods & services) trade balance, factor income, unilateral transfers2. Capital account: purchase/sale of assets (stocks, bonds, bank accounts, real estate, businesses)3. Official reserve account: Purchases/sales of inter- national reserve assets (USD, FX, gold, SDRs,∗ re- serves in the IMF) by central bank∗ TheSpecial Drawing Right is an IMF internal accounting cur-rency defined as a weighted average of USD (.43), EUR (.35),JPY (.11), and GBP (.11). Some countries use it to peg theircurrency and as an international reserve asset. 3
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  7. 7. Current account1. Merchandise trade (tangibles)2. Services (legal, engineering, consulting, tourism, etc.)3. Factor income (payments/receipts of interest, divi- dends, other income from prior foreign investments)4. Unilateral transfers (gifts, remittances, foreign aid, reparations) 4
  8. 8. Capital account1. Direct investment (acquires controlling interest)2. Portfolio investment (in foreign stocks and bonds with no control)3. Other investment (bank deposits, currency invest- ment, trade credit, etc.) 5
  9. 9. BoP’s identityBCA + BKA + BRA ≡ 0∗∗ BCAis the balance on the current account. BKA is the balance inthe capital account. BRA is the balance in the reserves accountor change in the official reserves. 6
  10. 10. Official settlement balanceBCA + BKA + Statistical discrepancy = BRA 7
  11. 11. It indicates the country’s BoP gap (deficit or surplus) that needs tobe accommodated by official reserve adjustments. When there’s adeficit, the country needs to pay foreigners somehow, by runningdown the official reserve assets (gold, FX, SDRs) or borrow anewfrom foreigners. (When there’s a surplus, the country will receiveassets and build up its reserves.)
  12. 12. Fixed exchange rate regimeCA + KA = −Change in official reserves∗∗ Assuming the statistical discrepancy is zero. 8
  13. 13. Flexible exchange rate regimeIf “pure,” the central bank doesn’t need reserves since the ex-change rate adjusts to induce the match of supply and demandfor FX. A current account deficit (suplus) is matched by a corre-sponding surplus (deficit) in the capital account. 9
  14. 14. Flexible exchange mechanismIn general, if the demand for home currency exceeds supply, there’sa surplus in the BoP. If the exchange rate adjusts, then the homecurrency value in terms of FX will go up. That should discourageexports and stimulate imports, which – other things constant –will lead to balancing the BoP.Vice versa, if the demand for home currency is lower than supply,then there’s a BoP deficit. If the exchange rate adjusts, the homecurrency value will drop in terms of FX. That should induce moreexports and less imports, which – other things constant – balancesthe BoP. 10
  15. 15. J effectHowever, this adjustment mechanism may have a perverse dy-namics. The J effect is the case when, at first, when a currencydepreciates, the BoP deficit gets worse. If the home currencycontinues its drop though, the BoP will eventually improve.Why? 11
  16. 16. J effectWhy?The BoP is not only the CA. There’s also the KA (FDI, portfo-lio investment, etc.). Suddenly expensive imports may contractthe economy, making it less attractive to foreign investors. Also,exports may take a while to grow. Thus, the KA inflows of FXmay go down while the reduction in imports and the stimulus toexports may not be large enough. As a result, the deficit may getworse!Much depends on expectations. What’s the nature of the BoPdeficit? Is it structural or temporary? Different responses. If it istemporary, then expectations may help. You may be able to borrowyour way out of the temporary problem. If it’s structural (andperceived as such), then you may need a large, painful adjustmentin the economy. 12
  17. 17. National income accounts and the BoPThe national income identity: Y ≡C+I +G+X −M (1) S ≡Y −C−T (2) S =I +G+X −M −TRearranging terms: (S − I) + (T − G) = (X − M ) = BCA (3) 13
  18. 18. External shocks on the BoP1. World business cycle led by rich countries2. Commodity price cycle (oil, raw materials, foodstuffs)3. Exchange rates4. Inflation & interest rates 14
  19. 19. International goods market shocks PXSudden, adverse changes in the ToT (= PM ) usually summarizethe impact of these schocks: 1. Export shocks (demand in rich countries fluctuates with busi- ness cycle) [prices (ToT) may not tell whole story, since some prices are sticky] 2. Import shocks (supply shortfalls, oil shocks for non-oil coun- tries, harvest failures) 3. Exchange rate changes between rich countries may have strange effects on developing countries’ BoP 15
  20. 20. International capital market shocksSudden increases in the cost of borrowing determined by interestrate, inflation rate, and institutional constraints: 1. Interest rate shocks (e.g. the late 1970s & early 1980s) [struc- ture of the debt matters: terms, fixed vs. floating rates] 2. Inflation & debt [what matters is debt in real terms] 3. Real interest rate (nominal interest rate minus inflation rate) 4. Institutional constraints on borrowing (crisis of confidence may compound the BoP problem) 16
  21. 21. Policy responses to external shocksIn poor countries, letting the exchange rate adjust may be brutal.Lower income in export sectors (usually the most dynamic sectorin the economy) has repercussions in whole economy.Three choices must be made: 1. Financing or adjusting? 2. Extent of adjustment 3. Lowering spending (reducing aggregate spending via fiscal/monetary policy) or switching spending (by devaluing or via trade poli- cies, e.g. import quotas, export subsidies, etc.)? 17
  22. 22. Financing or adjusting?It depends on availability of foreign capital.First, stop the drain of FX reserves.Is it temporary or structural? (How can we know?)If temporary, borrow and use counter-cyclical measures domesti-cally to foster domestic consumption & investment. If structural,adjust. This is choosing the lesser evil. Don’t adjust if shocktemporary, because you hurt your long-term growth chances.What if the shock is favorable (and temporary)? Don’t get usedto it. Save, invest in assets that will sustain growth in the future,even in the face of BoP problems. Build reserves for the bad times.(Mexico in the late 1970s, early 1980s.)Role of IMF. To use its credit line, the IMF often dictates thatthe country should adjust. That may be very stupid, but that’s ahard institutional constraint. 18
  23. 23. Lower spending or switching spending?How to improve the trade balance? • Tax increases (LS) • Cuts in government spending (LS) • Restrictions to credit in banking system (LS) • Export subsidies (SS) • Import controls (SS) • Devaluation (SS)See Paul Krugman’s paper (handout). 19