10 the balance of payments

8/10/2019 10 the Balance of Payments

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10 The Balance of Payments

Introduction

Balance of payments

Record of the economic transactions between the residents of one country and the rest of the

world

International transaction

Exchange of goods, services, or assets between residents of one country and those of another

Double-Entry Accounting

Arrangement of international transactions into a balance-of-payments account

Credit: Receipt of a payment from foreigners

Debit: Payment to foreigners

Balance-of-payments accounts utilize a double-entry accounting system

Total balance-of-payments account must balance

Subaccounts may not balance

Surplus occurs when the balance is positive

Deficit occurs when the balance is negative

Balance-of-Payments Structure:

Current Account

Monetary value of international flows associated with transactions

Merchandise trade

Merchandise trade balance: Combining the exports and imports of goods

Exports and imports of services

Goods and services balance

Add services to the merchandise trade account

Income receipts and payments

Unilateral transfers


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Private transfer payments

Governmental transfers

Capital and Financial Account

All international purchases or sales of assets

Includes both private-sector and official transactions

Capital transactions

Capital transfers

Acquisition and disposal of certain nonfinancial assets

Private-sector financial transactions

Direct Investment

Securities

Bank Claims and Liabilities

Capital and Financial Account

Financial inflows and outflows

A capital (financial) inflow can be likened to the export of goods and services

A capital (financial) outflow is similar in effect to the import of goods and services.

Official settlements transactions

Movement of financial assets among official holders

Official reserve assets (Table 10.1)

Liabilities to foreign official agencies (Table 10.2)

Statistical discrepancy

Statistical discrepancy: Errors and omissions

Correcting entry or residual inserted to balance credits and debits

Prohibitive costs of accurate data collection

Figures based partly on information collected and partly on estimates


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Large numbers of transactions fail to get recorded

Treated as part of the capital and financial account

U.S. Balance of Payments

Balance-of-payments statistics (Table 10.3)

Merchandise trade balance

Offers limited policy insight

U.S. merchandise trade deficits (Table 10.4)

Effect on terms of trade

Impact on employment levels

Balance on goods and services

Surplus in service transactions

Current account balance

Capital and financial transactions

What does a Current Account Deficit (Surplus) Mean?

Total debits will always equal total credits

If the current account registers a deficit, the capital and financial account must register a

surplus, or net capital/financial inflow

If the current account registers a surplus, the capital and financial account must register a

deficit, or net capital/financial outflow

Net Foreign Investment and the Current Account Balance

Current account balance

Synonymous with net foreign investment in national income accounting

Current account surplus - net supplier of funds

Current account deficit - net demander of funds

Net borrowing of the nation:


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Impact of Financial Flows on the Current Account

Capital and financial flows may initiate changes in the current account

U.S. current account deficit can be caused by a net financial inflow to the United States

Appreciating dollar makes imports cheaper and exports costly

Declining exports and increasing imports results in a rise in the current account deficit, or a

decline in the current account surplus

Is a Current Account Deficit a Problem?

Benefit of a current account deficit

Ability to push current spending beyond current production

Cost of debt service

Debt: Good or bad for a nation?

Is the deficit used to finance more consumption or more investment?

Drivers of U.S. current account deficits in the 1980s and 1990s

Business Cycles, Economic Growth, and the Current Account

Current account and economic performance

Rapid growth of production and employment:

Large or growing trade and current account deficits

Slow output and employment growth

Large or growing surpluses

Holds for both short-term and long-term

Economic growth, employment growth, and trade balances (Figure 10.1)


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Can the United States Continue to Run Current Account Deficits?

No economic reason why it cannot continue indefinitely

U.S. as an attractive investment destination

Historical trends

U.S. current account balance as a percent of GDP (Figure 10.2)

Threat: Loss of confidence in the ability to generate the resources necessary to repay the

borrowed funds


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Can the United States Continue to Run Current Account Deficits?

Scenario: Reduction in savings sent to the U.S.

Possible repercussions

Sudden and large decline in dollar; increase in interest rates

Declining stock markets

Solvency issues

Productivity: Growing faster than debt

Reducing the deficit: Relevant principles

U.S. has an interest in policies that stimulate foreign growth

Reductions are better achieved through increased national saving than through reduced

domestic investment

Is there a Global Savings Glut?

Extra money accruing around the globe

Savings flowing from developing and emerging countries to developed countries

Excess money holding down interest rates

Cheap money risk: Overheated spending and a future bust

U.S. absorbed 75 percent of the excess world supply of savings in 2005

Funding the federal budget deficit

Argument of investment deficiency

Balance of International Indebtedness

Record of the international position of the U.S. at a particular time (stock concept)

Net creditor and net debtor positions

Breaks down holdings into several categories

Policy implications can be drawn from each separate category about the liquidity status

Amount of short-term liabilities held by foreigners


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Balance of official monetary holdings

Examples (Table 10.5)

United States as a Debtor Nation

Early stages of its industrial development

Net international debtor

After World War I

Net international creditor

By 1987

Net international debtor ($23 billion), for the first time since World War I

Net international debtor since then (Table 10.5)

Foreign inflows; issue of propriety

11Foreign ExchangeIntroductionPurchases of an international transaction:Buying foreign currencyForeign currency used to facilitate international transactionInstitutional arrangements required

Settling monetary claims with minimum inconvenience to partiesForeign-exchange marketsForeign-Exchange MarketOrganizational setting involving transaction of buying and selling foreign currencies andother debt instrumentsTransaction conducted by individuals, businesses, governments, and banksNot all currencies are traded for reasons ranging from political instability to economicuncertaintyForeign-Exchange MarketFunctions at three levels:Transactions between commercial banks and their commercial customers

Domestic interbank market conducted through brokersTransactions between trading banks and their overseas branches or foreign correspondentsTypes of Foreign-Exchange TransactionsSpot transactionOutright purchase and sale of foreign currency for cash settlement; immediate deliveryForward transactionBased on contracts, for future payment receiptsCurrency swap


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Conversion of one currency to another currencyDistribution of foreign-exchange transactions (Table 11.1)Interbank TradingBank transactions with each otherRetail transactions

Wholesale transactionsForeign-exchange departments of major commercial banks serve as profit centersLeading banks trading in the foreign-exchange market (Table 11.2)Interbank TradingEarning profits in foreign-exchange transactions:Bid rate: Price bank is willing to pay for a unit of foreign currencyOffer rate: Price at which the bank is willing to sell a unit of foreign currencyDifference between bid and offer rate:Size of the transactionLiquidity of the currencies being tradedReading Foreign-Exchange Quotations

Most daily newspapers publish foreign-exchange rates for major currenciesExchange rate: Price of one currency in terms of anotherExchange rates listed for November 2, 2005, in The Wall Street Journal (Table 11.3)Forward and Futures MarketsForward contracts:Made by those who will receive or make payment in foreign exchange in the weeks ormonths aheadThe New York foreign-exchange market is a spot market for most currencies of the world(Table 11.3)Futures market:Contracting parties agree to future exchanges of currencies; set applicable exchange rates inadvance

Example: International Monetary Market (IMM)Major differences between forward and futures market (Table 11.4)

Future Market: International Monetary Market (IMM)Foreign-exchange trading limited to major currenciesIMMs futures prices (Table 11.5)Size of contract on same line as currencys name and country


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First column shows the maturity months of the contractOpen: Price at which yen was first soldHigh, low, and settle columns indication of contracts closing prices for the dayChange compares closing pricesLifetime high and lowOpen interest: Total number of contracts outstanding

Foreign-Currency OptionsProvide options holder the right to buy or sell a fixed amount of foreign currency at aprearranged priceTwo types of foreign-currency options:Call optionPut optionStrike price: Price at which the option can be exercisedExchange-Rate DeterminationDemand for foreign exchangeDerived from the debit items on its balance of paymentsSupply of foreign exchange

All factors held constant, amount of foreign exchange offered to the market at variousexchange ratesRelationship between demand and supply (Figure 11.1)Exchange-Rate DeterminationEquilibrium rate of exchangeDetermined by the market forces of supply and demandExchange-market equilibrium occurs at pointE (Figure 11.1)

Is a Strong Dollar Always Good and a Weak Dollar Always Bad?Parties affected by strengthening or weakening dollar:ConsumersTouristsInvestorsExportersImporters


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Market fundamentals and market expectations. Long run exchange rates are best explained by factors

including real income differentials, inflation rate differentials, productivity changes, and the like. In the

short run, exchange rates respond to real interest rate differentials, news about market fundamentals,

and speculative opinion about future exchange rates.

Weighted averageDirect comparison of dollars exchangerate over time including all bilateral changesReferred to as: dollars exchange-rate index, or the effective exchange rate, or the trade-weighted dollarNominal exchange-rate indexBased on nominal exchange rates; does not reflect changes in price levels in trading partnersNominal exchange-rate index (Table 11.7)Indexes of the Foreign-Exchange Value of the DollarReal exchange rateNominal exchange rate adjusted for relative price levels

Formula:Real exchange-rate index (Table 11.7)ArbitrageFactor underlying consistency of the exchange ratesExchange arbitrageTwo-point arbitrageThree-point (triangular) arbitrageResult of this activity:Currency exchange rates consistent throughout the worldOnly minimal deviations due to transaction costsForward Market

Currencies bought and sold now for future deliveryPeriod range from date of transactionExchange rate agreed on at the time of the contractPayment made only when actual delivery takes placeBanks provide this service to earn profitsForward RateRate of exchange used in the settlement of forward transactionsPremium: Foreign currency worth more in the forward market than in the spot marketDiscount: Currency is worth less in the forward market than in the spot marketExamples of forward rates (Table 11.8)Forward Rate Differs from the Spot Rate

What determines the forward rate?Interest-rate differentials between countriesWhy might it be at a premium or discount compared to the spot rate?One countrys interest rates higher than anothers, currency is a forward discountOne countrys interest rates lower than another countrys, currency is a forward premiumForward Market FunctionsHedging: Protects international traders and investors from risks involved in fluctuations ofspot rate


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Case 1: U.S. importer hedges against a dollar depreciationCase 2: U.S. exporter hedges against a dollar appreciationHow Markel Rides Foreign-Exchange FluctuationsBusiness model to shield itself from exchange rates fluctuations:Charge customers relatively stable prices in their own currencies

Use forward currency markets to foster revenue stabilityCut costs and improve efficiencyRoll the dice and hope things turn out favorablyDoes Foreign-Currency Hedging Pay Off?Beneficial for firms that realize more than half of its sales in profits in foreign currenciesStandard argument for hedging:Increased stability of cash flows and earningsReasons companies may not view hedging as a benefit:Locks in an exchange rate costs up to half a percentage point per year of the revenue beinghedgedFluctuations in a firms business can detract from the effectiveness of foreign-currencyhedging

Interest ArbitrageProcess of moving funds into foreign currencies to take advantage of higher investmentyields abroadUncovered interest arbitrageInvestor does not obtain exchange-market cover to protect investment proceeds fromfluctuationsExample: Table 11.9Interest ArbitrageSteps in covered interest arbitrage:Investor exchanges domestic currency for foreign currencyAt the current spot rate

Uses the foreign currency to finance a foreign investmentInvestor contracts in the forward market to sell the amount of the foreign currency receivedas the proceeds from the investmentDelivery date to coincide with the maturity of the investmentExample: Table 11.10Interest ArbitrageInternational differences in interest ratesExerts a major influence on the relationship between the spot and forward rates because:Changes in interest-rate differentials do not always induce an immediate investor responseInvestors sometimes transfer funds on an uncovered basisFactors (governmental exchange controls and speculation) may weaken the connectionbetween the interest-rate differential, and the spot and forward rates

Foreign-Exchange Market SpeculationSpeculation: Attempt to profit by trading on expectations about prices in the futureStabilizing speculation: Goes against market forces by moderating or reversing a rise or fallin a currencys exchange rateDestabilizing speculation: Goes with market forces by reinforcing fluctuations in acurrencys exchange rateCurrency Markets Draw Day TradersForeign-exchange market has become a speculative arena for individual traders


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Determining Long-Run Exchange Rates

Long RunRelative Price Levels: assume: U.S. price level increases and UK price level

remains constant

U.S. consumers want relatively low-priced UK goods increasing demand for pounds

UK consumers want fewer U.S. goods decreasing supply of pounds

result: increase in U.S. price level leads to depreciation of dollar

Long RunRelative Productivity:assume: greater U.S. productivity growth than UK

U.S. goods become relatively less expensive. U.S. consumers want relatively low-priced UK

goods increasing demand for pounds

UK consumers want fewer U.S. goods decreasing supply of pounds

result: increase in U.S. price level leads to depreciation of dollar

Long RunForeign Preferences: assume: U.S. consumers develop strong preference for

goods from the UK

U.S. consumers purchase more pounds to buy UK goods

demand for pounds increases which decreases value of the dollar

result: increased demand for imports leads to depreciation of dollar


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Long RunTrade Barriers: assume: U.S. government imposes trade barriers on products

from the UK

UK goods become more expensive

U.S. consumers purchase fewer pounds to buy UK goods

decrease in demand for pound increases value of the dollar

result: trade barriers lead to appreciation of dollar

Four key factors - Summary (Table 12.2)

Relative price levels: (Figure 12.2(a))

Relative productivity levels: (Figure 12.2(b))

Preferences for domestic or foreign goods: (Figure 12.2(c))

Trade barriers: (Figure 12.2(d))


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Inflation Rates, Purchasing Power Parity, Long-Run Exchange Rates

Law of one price

An identical good should cost the same in all nations, assuming costless shipping andno barriers

Theory: Pursuit of profits and price equalization

Single price might not apply in practice

Big Mac index


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Primitive and has many flaws but widely understood

Serves as an approximation of currency strength

Price of a Big Mac (Table 12.3)

Purchasing Power Parity

Purchasing power parity theory

purchasing power parity theoryapplication of law of one price to national price levels

implies currency prices adjust to make goods & services cost the same everywhere

changes in relative national price levels determine changes in exchange rates over long run

Exchange rates are related to differences in the level of prices between two countries

Changes in relative national price levels determine changes in exchange rates

over the long run

Given in symbols as:

Application of the concept (Table 12.4)

Purchasing Power Parity

in theory:

exchange rate1= exchange rate0

1 = current year; 0 = base year

Limitations of the theory

Overlooks the fact that exchange-rate movements may be influenced by investment

flows

Choosing the appropriate price index

Determining the equilibrium period base

Government policy interference

Predictive power most evident in the long run

Purchasing power parity: U.S.-United Kingdom (Figure 12.3)

PUS1

/PUS0

P /P


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Determining Short-Run Exchange Rates: The Asset-Market Approach

Key factors governing investment decisions

Relative levels of interest rates

Expected changes in the exchange rate, over the term of the investment

Effects of these factors (Table 12.5)

Relative Levels of Interest Rates

Differences in the level of nominal interest rates affect investment flows

Relative interest rates as a determinant of exchange rates (Figure 12.4a)

Distinguishing between the nominal interest rate and the real interest rate

Short-term real interest rates (Table 12.6)

Expected Change in the

Exchange Rate

To determine the actual earnings from an investment in another currency

High interest rate may not be attractive enough if denominating currency is expected

to depreciate

If the denominating currency is expected to appreciate, the realized gain would be

greater

Effects of investor expectations of changes in exchange rates (Figure 12.4(b))

Diversification, Safe Havens, and Investment Flows

Diversification across asset types

Including the currencies in which they are denominated

Safe-haven effect

Sacrificing returns for lower risk

The Ups and Downs of the Dollar: 1980 to 2005

The 1980s

Path of appreciation and then depreciation


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Forecasting Foreign-Exchange Rates

Judgmental forecasts

Subjective or common sense models

Projections based on a thorough examination of individual nations

Use of economic indicators; political factors; technical factors; and

psychological factors

Technical forecasts

Involves the use of historical exchange-rate data to estimate future values (Figure

12.6)

Useful in explaining short-term movements

Forecasting Foreign-Exchange Rates

Fundamental analysis

Involves consideration of economic variables that are likely to affect a currencys

value

Uses computer-based econometric models

Best suited for forecasting long-run trends

Forecast Performance of Advisory Services

Better information about future exchange rates than is available to the market

Evaluating the performance of forecasters

Predict spot rates better than what is implied by the forward rate

Asset-Market Approach:

investors consider:

relative levels of interest rates

expected changes in exchange rate itself over term of investment

nominal interest rate is first approximation

however rate of inflation is significant factor


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real interest rate may be more important to investors

real interest rate= nominal interest rate- inflation rate

Relative Interest Rates:

assume: decrease in interest rates in U.S. and no change in interest rates in UK

U.S. investors demand pounds in order to purchase investments in UK

UK investors will invest less in U.S. decreasing supply of pounds

result: dollar depreciates (pound appreciates)

Expected Change in Exchange Rate:

assume: UK investors expect future increase in exchange value dollar

UK investors can buy dollars relatively cheaply now with return in more valuable dollars

later

U.S. investments are more attractive which increases supply of pounds

result: dollar appreciates (pound depreciates)

Exchange Rate Overshooting:

definitionshort run response to change in market fundamentals is greater than long run

response

changes in fundamentals exert greater short run impact on exchange rates

partially due to greater degree of elasticity in the short run


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Forecasting Exchange Rates:

judgmental forecasts

subjective or common sense models

wide array of political and economic data

technical forecasts

extrapolation from past trends

ignores economical and political determinants

analysis of short term movements

fundamental analysis

statistical estimation based on economic variables related to currency supply &

demand

best suited to long term forecasting

Traders and investors often participate in the forward market to protect their expected profits from the risk of

exchange rate fluctuations. Speculators also participate in the forward market.


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The spot market permits the buying and selling of foreign exchange for immediate delivery. Future contracts

are made by those who will make or receive foreign exchange payments in the weeks or months

ahead.

3. The supply and demand for foreign exchange is derive

Much concern has been voiced over the volume of international lending in recent

years. At times, the concern has been that international lending was insufficient.

Such was the case after the oil shocks in 19741975 and 19791980, when it was

feared that some oil-importing developing nations might not be able to obtain

loans to finance trade deficits resulting from the huge increases in the price of oil.

It so happened that many oil-importing nations were able to borrow dollars from

commercial banks. They paid the dollars to OPEC nations that redeposited the

money in commercial banks, which then re-lent the money to oil importers, and so

on. In the 1970s, the banks were part of the solution; if they had not lent large sums

to the developing nations, the oil shocks would have done far more damage to the

world economy.

By the 1980s, however, commercial banks were viewed as part of an interna-

tional debt problem because they had lent so much to developing nations. Flush

with OPEC money after the oil price increases of the 1970s, the banks actively

sought borrowers and had no trouble finding them among the developing nations.

Some nations borrowed to prop up consumption because their living standards

were already low and hard hit by oil-price hikes. Most nations borrowed to avoid

cuts in development programs and to invest in energy projects. It was generally rec-

ognized that banks were successful in recycling their OPEC deposits to developing

nations following the first round of oil-price hikes in 1974 and 1975. But the inter-

national lending mechanism encountered increasing difficulties beginning with the


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global recession of the early 1980s. In particular, some developing nations were

unable to pay their external debts on schedule.

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International Banking: Reserves, Debt, and Risk

Another indicator of debt burden is the debt service/export ratio, which refers

to scheduled interest and principal payments as a percentage of export earnings. The

debt service/export ratio permits one to focus on two key indicators of whether a

reduction in the debt burden is possible in the short term: the interest rate that the

nation pays on its external debt and the growth in its exports of goods and services.

All else being constant, a rise in the interest rate increases the debt service/export

ratio, while a rise in exports decreases the ratio. It is a well-known rule of interna-

tional finance that a nations debt burden rises if the interest rate on the debt

exceeds the rate of growth of exports.

Dealing with Debt-Servicing Difficulties

A nation may experience debt-servicing problems for a number of reasons: (1) It may

have pursued improper macroeconomic policies that contribute to large balance-

of-payments deficits, (2) it may have borrowed excessively or on unfavorable terms, or

(3) it may have been affected by adverse economic events that it could not control.

Several options are available to a nation facing debt-servicing difficulties. First, it

can cease repayments on its debt. However, such an action undermines confidence

in the nation, making it difficult (if not impossible) for it to borrow in the future.

Furthermore, the nation might be declared in default, in which case its assets (such


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as ships and aircraft) might be confiscated and sold to discharge the debt. As a

group, however, developing nations in debt may have considerable leverage in win-

ning concessions from their lenders.

A second option is for the nation to try to service its debt at all costs. To do so

may require the restriction of other foreign-exchange expenditures, a step that may

be viewed as socially unacceptable.

Also, a nation may seek debt rescheduling, which generally involves stretching

out the original payment schedule of the debt. There is a cost because the debtor

nation must pay interest on the amount outstanding until the debt has been repaid.

When a nation faces debt-servicing problems, its creditors seek to reduce their

exposure by collecting all interest and principal payments as they come due, while

granting no new credit. But there is an old adage that goes as follows: When a man

owes a bank $1,000, the bank owns him; but when a man owes the bank $1 million,

he owns the bank. Banks with large amounts of international loans find it in their

best interest to help the debtor recover financially. To deal with debt-servicing pro-

blems, therefore, debtor nations and their creditors generally attempt to negotiate

rescheduling agreements. That is, creditors agree to lengthen the time period for

repayment of the principal and sometimes part of the interest on existing loans.

Banks have little option but to accommodate demands for debt rescheduling because

they do not want the debtor to officially default on the loan. With default, the banks

assets become nonperforming and subject to markdowns by government regulators.

These actions could lead to possible withdrawals of deposits and bank insolvency.

Besides rescheduling debt with commercial banks, developing nations may

obtain emergency loans from the IMF. The IMF provides loans to nations experienc-

ing balance-of-payments difficulties provided that the borrowers initiate programs to


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trade and economic activity.

Reducing Bank Exposure to Developing-Nation Debt

When developing nations cannot meet their debt obligations to foreign banks, the

stability of the international financial system is threatened. Banks may react to this

threat by increasing their capital base, setting aside reserves to cover losses, and

reducing new loans to debtor nations.

Banks have additional means to improve their financial position. One method is

to liquidate developing-nation debt by engaging in outright loan sales to other banks

in the secondary market. But if there occurs an unexpected increase in the default

risk of such loans, their market value will be less than their face value. The selling

bank thus absorbs costs because its loans must be sold at a discount. Following the

sale, the bank must adjust its balance sheet to take account of any previously unre-

corded difference between the face value of the loans and their market value. Many

small and medium-sized U.S. banks, eager to dump their bad loans in the 1980s,

were willing to sell them in the secondary market at discounts as high as 70 percent,

or 30 cents on the dollar. But many banks could not afford such huge discounts.

Even worse, if the banks all rushed to sell bad loans at once, prices would fall further.

Sales of loans in the secondary market were often viewed as a last-resort measure.

Another debt-reduction technique is the debt buyback, in which the government

of the debtor nation buys the loans from the commercial bank at a discount. Banks

have also engaged in debt-for-debt swaps, in which a bank exchanges its loans for

securities issued by the debtor nations government at a lower interest rate or

discount.

Cutting losses on developing-nation loans has sometimes involved banks in

debt/equity swaps. Under this approach, a commercial bank sells its loans at a dis-


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count to the developing-nation government for local currency, which it then uses to

finance an equity investment in the debtor nation.

To see how a debt/equity swap works, suppose that Brazil owes Manufacturers

Hanover Trust (of New York) $1 billion. Manufacturers Hanover decides to swap


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some of the debt for ownership shares in Companhia Suzano del Papel e Celulose,

a pulp-and-paper company. Here is what occurs:

Manufacturers Hanover takes $115 million in Brazilian government-guaranteed

loans to a Brazilian broker. The broker takes the loans to the Brazilian central

banksmonthly debt auction, where they are valued at an average of 87 cents

on the dollar.

Through the broker, Manufacturers Hanover exchanges the loans at the central

bank for $100 million worth of Brazilian cruzados. The broker is paid a commis-

sion, and the central bank retires the loans.

With its cruzados, Manufacturers Hanover purchases 12 percent of Suzanos

stock, and Suzano uses the banks funds to increase capacity and exports.

Although debt/equity swaps enhance a banks chances of selling developing-

nation debt, they do not necessarily decrease its risk. Some equity investments in


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developing nations may be just as risky as the loans that were swapped for local fac-

tories or land. Moreover, banks that acquire an equity interest in developing-nation

assets may not have the knowledge to manage those assets. Debtor nations also

worry that debt/equity swaps will allow major companies to fall into foreign hands.

Debt Reduction and Debt Forgiveness

Another method of coping with developing-nation debt involves programs enacted

for debt reduction and debt forgiveness. Debt reduction refers to any voluntary

scheme that lessens the burden on the debtor nation to service its external debt.

Debt reduction is accomplished through two main approaches. The first is the use

of negotiated modifications in the terms and conditions of the contracted debt,

such as debt reschedulings, retiming of interest payments, and improved borrowing

terms. Debt reduction may also be achieved through measures such as debt/equity

swaps and debt buybacks. The purpose of debt reduction is to foster comprehensive

policies for economic growth by easing the ability of the debtor nation to service its

debt, thus freeing resources that will be used for investment.

Some proponents of debt relief maintain that the lending nations should permit

debt forgiveness. Debt forgiveness refers to any arrangement that reduces the value

of contractual obligations of the debtor nation; it includes schemes such as mark-

downs or write-offs of developing-nation debt or the abrogation of existing obliga-

tions to pay interest.

Debt-forgiveness advocates maintain that the most heavily indebted developing

nations are unable to service their external debt and maintain an acceptable rate of

per capita income growth because their debt burden is overwhelming. They contend

that if some of this debt were forgiven, a debtor nation could use the freed-up

foreign-exchange resources to increase its imports and invest domestically, thus


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increasing domestic economic growth rates. The release of the limitation on foreign

exchange would provide the debtor nation additional incentive to invest because it

would not have to share as much of the benefits of its increased growth and invest-

ment with its creditors in the form of interest payments. Moreover, debt forgiveness

would allow the debtor nation to service its debt more easily; this would reduce the

debt-load burden of a debtor nation and could potentially lead to greater inflows of

foreign investment.some of the debt for ownership shares in Companhia Suzano del Papel e

Celulose,

a pulp-and-paper company. Here is what occurs:

Manufacturers Hanover takes $115 million in Brazilian government-guaranteed

loans to a Brazilian broker. The broker takes the loans to the Brazilian central

banks monthly debt auction, where they are valued at an average of 87 cents

on the dollar.

Through the broker, Manufacturers Hanover exchanges the loans at the central

bank for $100 million worth of Brazilian cruzados. The broker is paid a commis-

sion, and the central bank retires the loans.

With its cruzados, Manufacturers Hanover purchases 12 percent of Suzanos

stock, and Suzano uses the banks funds to increase capacity and exports.

Although debt/equity swaps enhance a banks chances of selling developing-

nation debt, they do not necessarily decrease its risk. Some equity investments in

developing nations may be just as risky as the loans that were swapped for local fac-

tories or land. Moreover, banks that acquire an equity interest in developing-nation


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assets may not have the knowledge to manage those assets. Debtor nations also

worry that debt/equity swaps will allow major companies to fall into foreign hands.

Debt Reduction and Debt Forgiveness

Another method of coping with developing-nation debt involves programs enacted

for debt reduction and debt forgiveness. Debt reduction refers to any voluntary

scheme that lessens the burden on the debtor nation to service its external debt.

Debt reduction is accomplished through two main approaches. The first is the use

of negotiated modifications in the terms and conditions of the contracted debt,

such as debt reschedulings, retiming of interest payments, and improved borrowing

terms. Debt reduction may also be achieved through measures such as debt/equity

swaps and debt buybacks. The purpose of debt reduction is to foster comprehensive

policies for economic growth by easing the ability of the debtor nation to service its

debt, thus freeing resources that will be used for investment.

Some proponents of debt relief maintain that the lending nations should permit

debt forgiveness. Debt forgiveness refers to any arrangement that reduces the value

of contractual obligations of the debtor nation; it includes schemes such as mark-

downs or write-offs of developing-nation debt or the abrogation of existing obliga-

tions to pay interest.

Debt-forgiveness advocates maintain that the most heavily indebted developing

nations are unable to service their external debt and maintain an acceptable rate of

per capita income growth because their debt burden is overwhelming. They contend

that if some of this debt were forgiven, a debtor nation could use the freed-up

foreign-exchange resources to increase its imports and invest domestically, thus

increasing domestic economic growth rates. The release of the limitation on foreign

exchange would provide the debtor nation additional incentive to invest because it


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would not have to share as much of the benefits of its increased growth and invest-

ment with its creditors in the form of interest payments. Moreover, debt forgiveness

would allow the debtor nation to service its debt more easily; this would reduce the

debt-load burden of a debtor nation and could potentially lead to greater inflows of

foreign investment.






time if subsequent rights restrictions require it.Chapter 17

531

Debt-forgiveness critics question whether the amount of debt is a major limita-

tion on developing-nation growth and whether that growth would in fact resume if a

large portion of that debt were forgiven. They contend that nations such as Indonesia

and South Korea have experienced large amounts of external debt relative to national

output but have not faced debt-servicing problems. Also, debt forgiveness does not

guarantee that the freed-up foreign-exchange resources will be used productively

that is, invested in sectors that will ultimately generate additional foreign exchange.

The Eurodollar Market

One of the most widely misunderstood topics in international finance is the nature

and operation of the eurodollar market, also called the eurocurrency market. This

market operates as a financial intermediary, bringing together lenders and bor-

rowers. Originally, eurodollars were held almost exclusively in Europe, and thus the

name eurodollars. Most of these deposits are still held by commercial banks in Lon-

don, Paris, and other European cities; but they also are held in such places as the

Bahamas, Bahrain, Hong Kong, Japan, Panama, and Singapore. Regardless of where


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they are held, such deposits are referred to as eurodollars. The size of the eurodollar

market has increased from about $1 billion in the 1950s to more than $5 trillion in

the first decade of the 2000s.

Eurodollars are bank deposit liabilities, such as time deposits, denominated in

U.S. dollars and other foreign currencies in banks outside the United States,

including foreign branches of U.S. banks. Transactions in dollars constitute about

three-fourths of the volume of transactions. Eurodollar deposits in turn may be rede-

posited in other foreign banks, lent to business enterprises, invested, or retained to

improve reserves or overall liquidity. The average deposit is in the millions and has a

maturity of less than six months. Thus, the eurodollar market is out of reach for all

but the most wealthy. The only way for most individuals to invest in this market is

indirectly through a money market fund.

Eurodollar deposits are practically free of regulation by the host country, includ-

ing U.S. regulatory agencies. For example, they are not subject to the reserve require-

ments mandated by the Federal Reserve and to fees of the Federal Deposit Insurance

Corporation. Because eurodollars are subject to less regulation than similar deposits

within the United States, banks issuing eurodollar deposits can operate on narrower

margins or spreads between dollar borrowing and lending rates than can domestic

U.S. banks. This gives eurodollar deposits a competitive advantage relative to depos-

its issued by domestic U.S. banks. Thus, banks issuing eurodollar deposits can com-

pete effectively with domestic U.S. banks for loans and deposits.

The eurodollar market has grown rapidly since the 1950s, due in part to the U.S.

banking regulations that prevented U.S. banks from paying competitive interest rates

on savings accounts (Regulation Q), which have increased the costs of lending for U.S.

banks. Also, continuing deficits in the U.S. current account have increased the dollar


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holdings for foreigners, as did the sharp increase in oil prices that resulted in enor-

mous wealth in the oil-exporting countries. These factors, combined with the relative

freedom allowed foreign currency banking in many countries, resulted in the rapid

growth of the market.

As a type of international money, eurodollars increase the efficiency of interna-

tional trade and finance. They provide an internationally accepted medium of





learning experience. Cengage Learning reserves the right to remove additional content at anytime if subsequent rights restrictions require it.532


exchange, store of value, and standard of value. Because eurodollars eliminate the

risks and costs associated with converting from one currency to another, they permit

savers to search the world more easily for the highest returns and borrowers to scan

out the lowest cost of funds. Thus, they are a link among various regional capital

markets, helping to create a worldwide market for capital. 2

10 the balance of payments

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