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Slides 1: The Balance of Payments and GlobalImbalances

Ke Pang

Wilfrid Laurier University

Based on materials from Schmitt-Grohe and Uribe Chapter 1-2

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The Balance of Payments (BOP)

The Balance of Payments records a countrys international

transactions in goods, services, and assets.Current Account records trade transactions and income from abroad.

Trade Balance

Income Balance

Net Unilateral Transfers

Financial Account (sometimes called Capital Account) records netchanges in international ownership of assets.

Fundamental balance of payment identity

Balance of Payment = Current Account + Financial Account = 0

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Current Account (CA)The Current Account is the sum of the Trade Balance, the IncomeBalance, and Net Unilateral Transfers.

Current Account = Tade Balance + Net Income from Abroad (i.e.,Income Balance + Net Unilateral Transfers).

Trade Balance measures the difference between exports in goods andservices and imports of goods and services.

Trade Balance = Merchandize Trade Balance + Service Balance.Income Balance measures the difference between incomes receivedfrom the rest of the world and incomes paid to the rest of the world.

Income Balance = Net Investment Income + Net InternationalPayments to Employees.

Net Unilateral Transfers measures the difference between giftsreceived from the rest of the world and gifts given to the rest of theworld.

Net Unilateral Transfers = Private Remittances + Government

Transfers.Ke Pang (WLU) The Balance of Payments and Global Imbalances

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Current Account: Examples (from the perspective of theU.S.)

Trade BalanceMerchandize: Imports of Nokia phones from Finland (-) / Export of ipads to Germany (+)

Service: Drinks in a Paris bar (-) / British tourists watching Broadwayshows (+)

Income BalanceInvestment Income: General Mills subsidiary in Mexico makes protsand rebates them to the U.S. (+) / Dividends for Japaneseshareholders of U.S. stocks (-)

Compensation to employees: earnings of U.S. professionals temporarilyresiding in foreign countries (+) / earnings of foreign temporaryworkers in the U.S. (-)

Net Unilateral TransfersMexican citizens residing in the U.S. send money to relatives in Mexico

(-) / Foreign aid to U.S. for Katrina relief (+ )Ke Pang (WLU) The Balance of Payments and Global Imbalances EC450 4 / 39
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Financial Account (FA)

The Financial Account records the difference between sales of assetsto foreigners and purchases of assets from foreigners.

Financial Account = Change in foreign ownership of domestic assets -Change in domestic ownership of foreign assets.

Examples: purchasing a residence abroad (-) / purchase of U.S. stocksby foreigners (+)

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Fundamental Balance of Payment Identity

Every movement in the current account must be reected in abalancing movement in the countrys nancial account.

Examples: a U.S. retailer imports $1,000 of Japanese TVs; U.S.current account goes down by $1,000; at the same time, the JapaneseTV producer purchases a nancial asset (U.S. dollars) worth $1,000;hence, the U.S. nanical account increases by $1,000.

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Table 1.1

The U.S. Balance-of-Payments Accounts in 2012

Billions PercentageItem of dollars of GDPCURRENT ACCOUNT BALANCE -475.0 -3.0

Trade Balance -539.5 -3.4Merchandise Trade Balance -735.3 -4.7

Services Balance 195.8 1.2Income Balance 198.6 1.3

Net Investment Income 206.2 1.3Net InternationalPayments to Employees -7.6 -0.0

Net Unilateral Transfers -134.1 -0.9Private Remittances -77.6 -0.5U.S. Government Transfers -56.5 -0.4

Source: Bureau of Economic Analysis, U.S. Department of Commerce,

http://www.bea.gov .

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Observations of Table 1.1In 2012, the U.S. runs a large current account decit.

Most of the current account decit is accounted for by a large tradedecit.

The U.S. mostly imports low-tech manufactured goods (e.g., textilesand electronics) and exports human capital intensive services (e.g.,

higher education, R&D, health care, and professional consulting).Net investment income is positive which means that investments of U.S. residents in foreign assets paid more in interest, dividends, andprots than the investments of foreign residents in U.S. assets.

Net international payments to employees is quite small.

Net unilateral transfers are negative which means that the U.S. givesmore gifts to the rest of the world (mostly transfers of U.S.immigrants to foreign residents and government aids) than it received.


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Figure 1.1

The U.S. Trade Balance and Current Account As

Percentages Of GDP: 1960-2012

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 20106

5

4

3

2

1

0

1

2

P e r c e n

t o

f G D P

Year

TBt /GDP

t

CAt /GDP

t

Source: http://www.bea.gov

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Observations of Figure 1.1

Trade balance is the main driver of the current account.

This applies to most countries except in cases where debt forgiveness

and direct transfers are large.

Large deteriorations in U.S. current accounts and trade balances overtime.

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Figure 1.2

Trade Balances and Current Account Balances Across Countries

in 2005

15 10 5 0 5 10 1515

10

5

0

5

10

15

Arg

China

Ire

Mex

Philippines

USA

45o

100 TB/GDP

1 0 0

C

A / G D P

Data Source: World Development

Indicators. Note: TB denotes the trade

balance in goods and services and CA

denotes the current account balance.

There are 102 countries included in the

sample. Countries with trade balances

or current accounts in excess of 15

percent of GDP are not shown.

14


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Trade balances and current accounts comove closely across countries.

Countries with positive (negative) trade balances tend to be countrieswith positive (negative) current accounts as well. However, any signcombination is possible.

Most countries trade balance and current account are of the samesign and of roughly the same magnitude, which suggests that tradebalance is the main determinant of the current account.


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Table 1.2


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Observations of Table 1.2Recall CA = TB + Income Balance + Net Unilateral Transfers.

Argentina: TB / GDP > CA/ GDP > 0; Argentinasnet investment income < 0 (i.e., net debtor).

China: CA/ GDP > TB / GDP > 0; Chinasnet investment income > 0 (i.e., net creditor).

Mexico: TB / GDP < CA/ GDP < 0; Mexicos private remittance > 0.

U.S.: CA/ GDP < TB / GDP < 0; U.S.snet income from abroad < 0.

Philippines: TB / GDP < 0 < CA/ GDP because of large personalremittances received from overseas Filipino workers.

Ireland: CA/ GDP < 0 < TB / GDP ; Irelandsnet investment income < 0 (i.e., net debtor).

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Net International Investment Position (NIIP)

Net International Investment Position (NIIP) records the differencebetween a countrys foreign assets and its foreign liabilities. In otherwords, NIIP refers to a countrys net foreign wealth.

NIIP = U.S. owned foreign assets - foreign owned U.S. assets.

Note that NIIP is a stock while CA is a ow.

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The U.S. Net International Investment Position (NIIP):1976-2012

1980 1985 1990 1995 2000 2005 20104000

3500

3000

2500

2000

1500

1000

500

0

500

Year

B i l l i o n s o

f d o

l l a r s

25

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The U.S. Net International Investment Position (NIIP) asa Share of GDP: 1976-2012

1980 1985 1990 1995 2000 2005 201025

20

15

10

5

0

5

10

15

Year

P e r c e n

t o

f G D P

26

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The U.S. Net International Investment Position (NIIP)

The U.S. was a net creditor of the rest of the world until the late1980s.

The U.S. has been a net debtor since the late 1980s.

The U.S. NIIP has been falling both in levels and as a fraction of GDP.

The U.S. became the largest external debtor in the world in the 1990s.

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Determinants of NIIP

NIIP = CA + valuation changes

Valuation changes refer to changes in the market value of a countrysforeign asset and liability positions (e.g., due to changes in exchangerates or asset prices, etc.)

We know that the U.S. current account has been in decit since theearly 1980s. These current account decits should have resulted in alarge deterioration of the NIIP.

Are the valuation changes positive or negative in the U.S.? How bigare they?

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Figure 1.4

The U.S. CA and Changes in the NIIP: 1977-2012

7 6 5 4 3 2 1 0 1 212

10

8

6

4

2

0

2

4

6

8

1977

1978

1979

1980

1981 1982

1983

1984

1985 1986

1987

1988 1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

CAGDP

100

N I I P

G D P

1 0 0


U S V l i Ch
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U.S. Valuation Changes

For the U.S. mostly valuation gains since 1976:Valuation Changes as Share of GDP

1980 1985 1990 1995 2000 2005 20108

6

4

2

0

2

4

6

8

10

Year

P e r c e n

t o

f G D P


Fi 1 5
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Figure 1.5

The U.S. NIIP and the Hypothetical NIIP with No Valuation Changes Since 1976

1980 1985 1990 1995 2000 2005 201010000

9000

8000

7000

6000

5000

4000

3000

2000

1000

0

1000

Year

B i l l i o n s o

f d o

l l a r s Cumulative CA balances since 1976

NIIP


Ob ti f Fi 1 4 d Fi 1 5
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Observations of Figure 1.4 and Figure 1.5

Since 1976 the U.S. had mostly positive valuation changes.

Large valuation changes are a recent phenomenon (i.e., after 2000).

The U.S. external debt would be much larger today if it had notbeneted from these large positive valuation changes.

Sources of the positive valuation changes between 2002-2007:

depreciation of the U.S. dollar because most of U.S. owned foreignassets are denominated in foreign currecies, while foreign owned U.S.assets are mostly denominated in the U.S. dollar;

foreign asset markets outperform the U.S. asset market.

Abrupt change in 2008 due to losses in foreign equity markets.


Th N g ti NIIP P iti NII P d
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The Negative-NIIP-Positive-NII Paradox

Even though the U.S. is the largest external debtor in the world, itreceives positive net investment income (NII) from the rest of theworld.

Between 1976 and 2012, U.S. NII has always been positive, whereas

NIIP has been negative since 1986.

How can this paradoxical situation happen? There are two potentialexplanations:

dark matter;return differentials.


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Figure 1.6

Positive Net Investment Income AndNegative NIIP: A Paradox?

1980 1985 1990 1995 2000 2005 2010400

300

200

100

0

100

200

300

Year

U S N e

t I n v e s

t m e n

t I n c o m

e ,

$ b n

U S N I I P

, $ b n

4000

3000

2000

1000

0

1000

2000

3000

Data Source: Bureau of Economic Analysis.


Dark Matter
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Dark MatterThe Dark Matter hypothesis, proposed by Hausmann andSturzenegger (2005), suggests that in reality the U.S. NIIP is positive,but the Bureau of Economic Analysis (BEA) fails to account for all of it.

e.g., U.S. foreign direct investment contains intangible human capital,such as enterpreneurial capital and brand capital whose values are notcorrectly reected in the official Balance of Payment.

Assuming this theory is valid, how much dark matter is there in theU.S. NIIP? Lets make a simple calculation.

TNIP = truenet international investment position.

NIIP = observed net international investment position, -$4 trillions in2012.

NII = net investment income, $0.2 trillion in 2012.

r = rate of return on the NIIP, assume r = 5% per year.


Dark Matter (contd )
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Dark Matter (cont d...)

Dark matter is the difference between the true and the observedNIIPs.

Dark Matter = TNIIP - NIIP.

NII is the income from the TNIIP.NII = r TNIIP

0.2 = 0.05 TNIIP TNIIP = $4 trillions.

Dark Matter = 4-(-4)=$8 trillions! A number seems to be too big togo unnoticed by the BEA.


Return Differentials
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Return Differentials

An alternative explanation is that there is no dark matter, but theU.S. earns a higher return on its foreign asset holdings than foreignersearn on their U.S. asset holdings.

In fact, the gross international asset position of the U.S. is mostlycomposed of risky high-return assets, such as foreign stocks, whereasits gross international liability position is composed of safer low-returnassets, such as U.S. T-bills.

Let A denote the U.S. international asset position and L itsinternational liability position.

NIIP = A - L.

Let r A be the return on A and r L the return on L.

NII = r A A - r L L.


Return Differentials (contd )
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Return Differentials (cont d...)

How large the interest rate differential on assets and liabilities(r A r L ) have to be to explain the paradox?

In 2012, A = $21 trillions, L = $25 trillions, and NII = $0.2 trillion.Moreover, we use the average real rate of return on U.S. T-biils as aproxy for r L , r L = 2%.

Now lets solve for the value of r A that solves the paradox.

0.2 = r A 21 - 0.02 25 r A = 3 .3%.

An annual 1.3% interest rate differential seems to be quite reasonable.


Return Differentials (contd )
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Return Differentials (cont d...)

Why is such a small interest rate differential sufficient to explain thenegative-NIIP-positive-NII paradox?

Gross asset and liability positions have exploded in the past 30 years.They have roughly doubled every decade.

Therefore a small return differential can lead to a positive NII eventhough the NIIP is negative.


Figure 1 7
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Figure 1.7

Gross Positions Have Exploded over the past 20 YearsU.S.-Owned Assets Abroad (A) and Foreign-Owned Assets in the U.S. (L)

1980 1985 1990 1995 2000 2005 20100

20

40

60

80

100

120

140

160

180

P e r c e n

t o

f U

. S .

G D P

Year

U.S.owned assets abroadForeignowned assets in the United States


U S Current Account and China
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U.S. Current Account and China

A large fraction of the U.S. current account decit is accounted for byits trade with China.

A large part of the U.S. trade decit is accounted for by Chineseimports.

In 2008, U.S. trade balance with China is -$268 billions.

In 1985, it was only -$6 millions!

The fraction of the U.S. current account decit explained by decitswith China has increased steadily since the 1980s, reaching around

70% in recent years.

In this sense, a main driver of the U.S. current account imbalances isthe rise of the Chinese economy.


Figure 1.8
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Figure 1.8

The Bilateral Current Account Decit of the United States

With China

1998 2000 2002 2004 2006 2008 201020

25

30

35

40

45

50

55

60

65

70

Year

P e r c e n t

Source: http://www.bea.gov . Note: The U.S. current account decit with

China is expressed as a fraction of the total U.S. current account decit.


Who Lends and Who Borrows Around the World?
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Who Lends and Who Borrows Around the World?

It must be the case that CAUS + CAROW = 0.

So who is running current account surpluses and who is runningcurrent account decits?


Figure 1.10
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g

Cumulative Current Account Balances Around the World: 1980-2012, billions of U.S. dollars.


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g

The country with the biggest cumulative current account decit is theU.S..

The countries which have been nancing these decits are China,Japan, Germany, and oil exporting countries (e.g., Russia, SaudiArabia, Algeria, Libya, Norway, Sweden, and Venezuela).

Is the U.S. current account decit sustainable?


Four Expressions for Current Account
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p

In the absence of valuation changes, the current account measures

the change in the NIIP: CAt = B

t

B

t 1 , where B

t represents thecountrys NIIP at the end of period t .

In the absence of net international compensation to employees andnet unilateral transfers, the current account is equal to the sum of the

trade balance and NII: CAt = TB t + rB

t 1 .We can also show that the current account is equal to the differencebetween

saving and investment: CAt = S t I t ;

income and domestic absorption: CAt = Y t D t ;

see below for detailed derivations.


Four Expressions for Current Account (contd...)
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p ( )TB t = X t IM t , where X t and IM t denote exports and imports inperiod t , respectively.

Q t + IM t = C t + I t + G t + X t , where Q t , C t , G t , and I t are GDP (i.e.,the amount of goods and services produced domestically), privateconsumption, government consumption, and domestic investment inperiod t , respectively.

We can show that CAt = rB t 1 + Q t C t I t G t . Note thatrB t 1 + Q t represents national income (GNP, Y t ). Hence, we have

CAt = Y t C t I t G t

National savings equal the difference between national income andthe sum of private and government consumption, therefore,

CAt = S t I t


Four Expressions for Current Account (contd...)
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Finally, let D t denote a countrys domestic absorption in period t ,D t = C t + I t + G t .

We can show that CAt = Y t D t using the second last equation on

the previous page.Note that these four expressions represent accounting identities thatmust be satised at all times in any economy. They do not provideexplanations of the determinants of the current account. To do so,

we need a model, which is what we will focus on next.

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