1. Chapter 9
Balance of Payments, Debt,
Financial Crises, and Stabilization
Policies
Problems and Policies: international and macro
2. 2
1 International Finance and Investment: Key Issues
• How major debt crises emerged during the 1980s
– Deficits of current accounts, financial account, and capital accounts
– Accumulation of debt and emergence of debt crisis
• Mostly international financial crises were viewed as “originating” in the developing world
- Latin American debt crisis of 1982
- Mexican Tequila Crisis of 1994
- East Asian contagion of 1998
• Main causes is weak financial markets and institutions and unstable political economy
• After their 1980s and 1990s debt crises affected countries were required by IMF and WB
to privatize state-owned enterprises, eliminate regulations, and reduce infant industry
protection
3. 3
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)
Gross national product (GNP): the value of all final goods and services
produced by the labour, capital, and other resources of a country within the
country as well as abroad
2. National Accounts
4. • Imagine about the value of national income
that results from production and expenditure.
• Recalling the circular flow diagram
Producers earn income from buyers who spend money on goods and
services.
The amount of expenditure
= the amount of income
= the value of production.
National income is often
defined to be the income
earned by a nation’s factors of
production.
Money
G&S
4
Money
Factors
Firms
Households
Factor
Markets
FactorsG&S
Money Money
5. What are factors of production? Inputs that are used to produce goods/services: workers
(labor), capital (buildings and equipment), land and others.
The value of final goods and services produced by Cambodia-owned factors of production are
counted as Cambodian GNP.
GNP is calculated by adding the value of expenditure on final G&S produced.
•GNP is one measure of national income, but a more precise measure of NI is GNP
adjusted for following:
1. Depreciation of physical capital (depreciation is subtracted from GNP).
2. Unilateral transfers to and from other countries can change national income.
• Another rough measure of NI is gross domestic product (GDP):
GDP = GNP – payments from foreign countries for factors of production
+ payments to foreign countries for factors of production
5
6. 3. Current account: what is it?
• There are 4 types of expenditure:
1. Consumption: expenditure by
home consumers
2. Investment: expenditure by firms
on buildings & equipment
3. Government purchases:
expenditure by governments on G&S
4. Current account balance (exports
minus imports): net expenditure by
foreigners on domestic G&S
GDP
C
I
G
NX
6
7. GDP = Expenditure on a Country’s Goods and Services
NI = value
of domestic
production
NI = Expenditure
on domestic
production
Y = Cd + Id + Gd + EX
= (C-Cf) + (I-If) + (G-Gf) + EX
= C + I + G + EX – (Cf + If +Gf)
= C + I + G + EX – IM
= C + I + G + CA
Expenditure by domestic
individuals and institutions
Net expenditure by foreign
individuals and institutions
7
8. 8
Interplay of variables
1.GDP = C + I + G + X – M
2.GNP = GDP + (net foreign
investment income + net transfers)
3. In terms of current account balance:
GNP = C + I + G + CA
4. GNP as the value of total income:
GNP = C + S + T
5. Based on 3 & 4
C + I + G + CA = C +S + T
6. I + G + CA = S + T
7. S + (T – G) = I + CA
Short-hand Long-hand
GDP Gross domestic product
GNP Gross National Product
C Consumption Expenditures
I Investment Expenditures
G Government spending
X Exports
M Import
NX Net export
CA Current account
S Savings (of households, firms, G)
T Tax (net tax)
9. 9
Expenditure and Production in an Open Economy
CA = X – M = Y – (C + I + G )
When production > domestic expenditure, exports > imports: then
current account > 0 & trade balance > 0
When a country exports more than it imports, it earns more income from
exports than it spends on imports
Net foreign wealth is increasing
When production < domestic expenditure, exports < imports: then
current account < 0 & trade balance < 0
When a country exports less than it imports, it earns less income from exports
than it spends on imports
Net foreign wealth is decreasing
11. • National saving (S) = national income (Y) that is not spent
on consumption (C) and government purchases (G).
Saving and the Current Account
CA = Y – (C + I + G ) implies…
CA = (Y – C – G ) – I
= Sp + (T-G) – I
= Sp + Sg - I
S = Y – C – G
S = (Y – C – T) + (T – G)
S = Sp + Sg
Current account = national saving – investment
Current account = net foreign investment
A country that imports more than it exports has
low national saving relative to investment.
Y = C + I + G + X – M
11
12. CA = S – I or I = S – CA or I + CA = SP + (T-G)
Countries can finance investment either by saving or by acquiring foreign
funds equal to the current account deficit.
A current account deficit implies a financial asset inflow or negative net
foreign investment. [NFI = Investment to abroad – Investment from abroad]
When S > I, then CA > 0 so that net foreign investment and financial capital
outflows for the domestic economy are positive.
CA = Sp + Sg – I = Sp – budget deficit – I Sg = T - G
A high government deficit causes a negative current
account balance when other factors remain constant.
12
14. 14
•A country’s balance of payments is an accounting record of a country’s trade in
goods, services, and financial assets with the rest of the world during a particular
time period (a year).
•The balance of payments accounts are separated into 3 broad accounts:
current account: accounts for flows of goods and services (imports and exports).
financial account: accounts for flows of financial assets (financial capital).
capital account: flows of special categories of assets (capital): typically non-
market, non-produced, or intangible assets like debt forgiveness, copyrights and
trademarks.
4. Balance of Payments Accounts
15. How Do the BOP accounts Balance?
Due to the double entry of each transaction, the balance of payments
accounts will balance by the following equation:
Current account +
Financial account +
Capital account = 0
Double-entry bookkeeping in BOP implies that…
1)A credit entry records an item or transaction that brings foreign exchange
into the country.
2) A debit entry represents a loss of foreign exchange.
15
17. 17
•The current account includes the value of trade in merchandise, services,
income from investments, and unilateral transfers.
• Merchandise — tangible goods.
Merchandise account = the value of goods exported – the value of imports
• Services — travel and tourism, royalties, transport costs, and insurance.
Services account = the value of services exported – the value of imports
• Income from investments — interest and dividends.
Investment income account = income from investments abroad – income
paid to foreigners on their investments in Cambodia
• Unilateral transfers — foreign aid, gifts, and retirement pensions.
Unilateral transfers account = any foreign aid and transfers received by
Cambodia – that given to foreigners
Current Account
18. 18
Components of the Current Account
Components of the current account (common practice)
Credit Debit
1. Goods and services Export Import
2. Investment income Income received on
investments abroad
Income paid to foreigners on
investments in Cambodia
3. Unilateral transfers Transfers received Transfers paid
In some literature you may see 4 components of CA : Goods & services are
separated into 2 accounts.
19. 19
CA of Cambodia, 2009
CA deficit mainly caused by
merchandise import exceeds
merchandise export.
Cambodia has positive
balance in services and
transfers
Negative investment income
balance due to Cambodian
debts.
Millions of USD
1 Trade balance (1,634)
Export (fob) 4,196
Import (fob) 5,830
2 Net services 607
Receipts 1,625
Payments 1,019
3 Net investment income (408)
Receipts 57
Payments 524
4 Net unilateral transfers 293
Current account w/o official transfer (1,203)
Official transfer 593
Current account (610)
20. CA balance of Cambodia 2002-2010 (excluded OT)
•A current account
deficit is not a sign of
weakness: in
Cambodia, the
economic boom of the
2000s increased the
demand for imports,
while export is
expanding gradually.
•However, everyone agrees that CA deficit
cannot continue in the long term
20
2002 2003 2004 2005 2006 2007 2008 2009 2010
(359) (450) (440) (591) (578) (693) (1,382) (1,203) (1,238)
21. 21
Financial Account
•Financial account: a record of the flow of financial capital to and from a
country.
• What is the Financial inflow ?
It is the foreigners loan to domestic citizens by buying domestic assets
Domestic assets sold to foreigners are a credit (+) because the domestic
economy acquires money during the transaction
Financial outflow
Domestic citizens loan to foreigners by buying foreign assets
Foreign assets purchased by domestic citizens are a debit (-) because the
domestic economy gives up money during the transaction
22. 22
•Financial flows originate in the public and private sectors
•Some financial flows are very mobile: move quickly in response to investor
expectations
Mobility of financial flows brings economic volatility
Upon sudden financial outflows, a country can sink into a financial crisis
The volatility of financial flows causes fear about the various types of flows
Financial outflows include:
A.Official reserve assets: gold, SDRs, $US, €EU
B.Government assets: loans to foreign governments, payments received on
outstanding loans,
C. Private assets: DI, foreign securities, loans to foreign firms and banks
23. Financial inflows include:
A. Foreign official assets: gold, SDRs, major currencies
B. Other foreign assets: FDI, Cambodian securities, loans to Cam firms and banks
C. Net change in financial derivatives
•So, generally, financial account is divided into three categories:
Net changes in the country’s assets abroad
Net changes in the foreign-based assets in the country
Net change in financial derivatives
•Assets, a.k.a. wealth, include bank accounts, stocks and bonds, and real
property such as factories, businesses, and real estate.
•Financial derivatives are complex financial contracts, only recently
included in BOP (Cambodia yet has no such financial instrument)
Value of derivatives depends such variables as IR, ER, or commodity prices
23
24. 24
Financial account in many statistics, has 3 subcategories:
1. Official (international) reserve assets
2. All other assets
Include FDI, Portfolio investment and other financial investment
3. Statistical discrepancy
•Official reserve assets: foreign assets own by CBs to cushion against
financial instability.
Assets include government bonds, currency, gold and accounts at the IMF.
Official reserve assets owned by (sold to) foreign CBs are a credit (+) because
the domestic CB can spend more money to cushion against instability.
Official reserve assets owned by (purchased by) the domestic CB are a debit (-)
because the domestic CB can spend less money to cushion against instability.
25. 25
Capital account is a record of transfers of specific types of capital, such as:
Debt forgiveness
Capital transfers from/to foreigners
The transfer of real estate and other fixed assets, such as an embassy building
Capital account
•The current, capital, and financial accounts are interdependent
• Current account measures flow of goods and services
• Capital and financial accounts measure flow of financing
•Theoretically, sum of capital account and financial accounts equal to current
account with opposite sign.
Remarks on interdependence
Usually, CA = FA + Cap A + Financing + Stat discrepancy
26. 26
Cambodian BOP 2010
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.
Caveat
$ Millions
1 Trade balance (1,697)
Export (fob) 4,687
Import (fob) (6,384)
2 Net services 633
Receipts 1,653
Payments (1,020)
3 Net investment income (481)
Receipts 58
Payments (540)
4 Net private transfers 308
Current account w/o official
transfer
(1,238)
5 Net official transfer 800
Current account (438)
27. 27
All flows are net changes
(differences between assets
given and assets received).
Statistical discrepancy exists
because the record of all the
transactions in the balance of
payments is incomplete
Errors tend to lie in the
financial account calculation, as
it is the hardest to measure
correctly.
$ Millions
6 Medium and long term loans 188
Disbursement 200
Amortization (12)
7 Foreign direct investment 553
8 Short-term flows, errors and omissions (160)
Capital and Financial Account 581
BOP (w/o financing) 143
9 Financing (143)
Change in foreign reserves (283)
Financing gap 140
28. 28
• Why study the balance of payments?
BOPs help understand the broader implications of current account imbalances
and how to repair current account deficits
BOPs give signal how nations can avoid crises brought by volatile financial flows
and how they can minimize the damage of financial crises if such occur
The BOP and the Macro-economy
• Open markets cause lifting of controls on financial flows
Developing countries, in particular, have liberalized financial account
transactions in order to get access to financial capital for development
Although financial flows are volatile, economists agree that free flows are best
for economic efficiency
Financial Account Liberalization
29. 29
•Is the Private Assets
•Subcomponents of private assets: FDI, foreign securities, loans from/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
What has the largest share of financial flows?
30. 30
•Shifts in expectations can lead to sudden stoppages of financial inflows
• The result is a destabilizing of outflows of financial capital
• This occurrence has been labeled a sudden stop
• Sudden stops have been involved in the most financial crises in last 30 years
•Until recently, most nations limited the movement of financial flows related
financial account transactions across their borders
The EU liberalized financial flows between member countries only in 1993
5. Expectations in financial flows and limit on them
31. 31
•Debt is defined as money owed to nonresidents which must be paid in a
foreign currency.
• CA 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
• All countries, rich and poor, have external debt
• In low/middle income countries, external debt can lead to financial problems
• Unsustainable debt occurs for numerous reasons:
6. International Debt
Falling commodity prices
Natural disasters
Corruption
Foreign lending behavior
33. 33
• A country runs a CA deficit, it borrows from abroad and raises its indebtedness
• A country runs a CA surplus, it lends to foreigners and reduces its 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
7. The International Investment Position
34. 34
Special notice: in some statistics, capital account and financial account are combined
CurrentAccount
Surplus and Deficit
Surplus and Deficit
BOP
36. Before and After the 1980s Debt Crisis: Current Account Balances and Capital Account
Net financial Transfers of Developing Countries, 1978-1990 (billions of dollars)
36
37. 13-37
8. The Issue of Payment Deficits
• Some initial policy issues
– International reserves
– Restrictive fiscal and monetary policies:
• Structural adjustment
• Stabilization policies
– Special drawing rights (SDRs)
– Trends in the Balance of Payments
39. 13-39
Accumulation of Debt and Emergence of the Debt Crisis
• Background and analysis
– External debt
– Debt service
– Basic transfer
Net capital inflow, FN, is
FN dD
d is percent increase in total debt
D is total debt
Where
Basic transfer, BT, is
BT dD rD (d r)D
r is the average interest rate
Where
40. 9 Accumulation of Debt and Emergence of the Debt Crisis
•Origins of the
1980s Debt Crisis
– OPEC oil price
increase
– Increased borrowing
– Excess of imports
– Lagging exports
Petrodollar Recycling
40
41. 13-41
• Origins of the Debt Crisis (cont’d)
– Debt-servicing obligations
– Debt-service payments
– Debt-servicing difficulty
– Oil shocks
– Developing countries’ two options:
1. Curtail imports and restrictive fiscal and monetary measures
2. More external borrowing
42. 13-42
10 Attempts at Alleviation: Macroeconomic Instability, Classic
IMF Stabilization Policies, and Their Critics
• The IMF stabilization program
– Macroeconomic instability
– Stabilization policies
– Four basic components of IMF
stabilization program:
• Liberalization of foreign exchange and
imports control
• Devaluation of the official ER
• Stringent domestic anti-inflation
program
• Opening up of the economy to
international commerce
- Such policies can be politically unpopular
because they hurt the lower- and middle-
income groups.
- Less radical observers view the IMF as
neither a developmental nor an anti-
developmental institution.
43. • The IMF stabilization program
(cont’d)
– Tactics for debt relief:
• Debtors’ cartel
• Restructuring
• Brady Plan
• Debt for equity swaps
• Debt for nature swaps
• Debt repudiation
What is odious debt?
- Sovereign debt used by
an undemocratic
government in a manner
contrary to the interests
of its people
13-43
- It should be deemed
invalid
44. 44
11 Resolution of 1980s-1990s Debt Crises and Continued
Vulnerabilities
• Highly indebted poor countries (HIPCs)
• Some progress but vulnerabilities remain
46. 12 The Global Financial Crisis and the Developing Countries
•Causes of the crisis and challenges to
lasting recovery
• Economic impacts on developing countries
– Economic growth
– Exports
– Foreign investment inflows
– Developing-country stock MKTs
– Aid
– Worker remittances
– Poverty
– Health and education
– General policy framework
• Differing impacts across developing
regions
-China and the ER controversy
-EastAsia and SoutheastAsia
except China
- India
- LatinAmerica
- Africa
• Prospects for recovery and stability
• Opportunities as well as dangers?
46
47. 47
Concepts for Review
• Amortization
• Balance of payments
• Basic transfer
• Brady plan
• Capital account
• Capital flight
• Cash account
• Conditionality
• Current account
• Debt-for-equity swap
• Debt-for-nature swap
• Debtors’ cartel
• Debt repudiation
• Debt service
• Deficit/surplus
• Euro
• External debt
• Hard currency
• Highly indebted poor countries (HIPCs)
• International reserve account
• International reserves
• Macroeconomic instability
• Odious debt
• Restructuring
• Special drawing rights (SDRs)
• Stabilization policies
• Structural adjustment loans
