balance of payments

Global imbalances and how they occur.

Theory and evidence from reality

Balance of Payments.

http://www.uni-goettingen.de/de/1.html

http://www.uni-goettingen.de/de/die-universitaet/50217.html

Balance of payments. – Global imbalances

• Balance of payments; definitions• Current Account and Capital account; definitions• Imbalances of the partial balances• Savings as determinant• Types of foreign investment• Case analysis: USA

05.04.2011Dipl.- Kfm. Thomas Stiegler, University of Göttingen.2

Today‘s topics



• consists of two under balances: Current Account and Capital account• is qua definition always balanced• illustrates how real economic activity is backed by financial activity• In reality imbalances can occur. The so called “remainder” is due to problems in accounting

05.04.2011Dipl.- Kfm. Thomas Stiegler, University of Göttingen.3

Balance of payments – what is it?



• Global imbalances if the balance of payments is always balanced?• Balance of payment can show clearly the competitiveness of an economy and the results on the ownership of the stakes in this economy. • it allows conclusions about the sustainability of the behavior of the economic subjects (people) in an economy• All this we can see in having a look at the two under balances

05.04.2011Dipl.- Kfm. Thomas Stiegler, University of Göttingen4

Imbalances IN the Balance of payments?



• the current account shows the real economic balances of a country with its foreign trade partners it consists of:

• foreign trade balance: goods traded between an economy and abroad

• services account: services traded between an economy and abroad• balance of factor incomes: paid and received return on international

investments, earnings from international work• transfer balance: transfers to/from a country without being backed

by any economical activity (we won’t focus on this part further, as it is raher influenced by migrational issues than by economic ones)


The current account - definition



• the capital account shows the financial, monetary transactions between a country and abroad. It consists of:

• Foreign direct investment: investments in production facilities as 1) investment in existing firms or 2) greenflield investments

• balance of credits given and taken• portfolio investment: investments in shares and bonds.• change in Central Bank’s currency reserves


The capital account - definition



• Balance of payments: balanced. Current account equals capital account.

Why is that? we sell a product to the US (real economic transaction) we accept US Dollar (financial transaction)


Real vs. Financial transaction



• Let’s have a look at the last point again, as it is not intuitive:• If you go to a shop in Russia, you can’t pay anything with a Dollar bill. The US Dollar is NO MONEY in economical definition in Russia (no accounting unit, no mean of exchange)• However the firm selling its goods to the US accepts a

payment in Dollars. • A one Dollar bill is a promise of payment of the Federal

Reserve Bank of the US


Recieving foreign currency – a basic financial transaction (1)



• so a one Dollar bill means that the FED owes the bearer of the note the purchasing power of one Dollar. • as the Dollar is MONEY in the US, everybody there can use it and use this promise to exchange this bill into goods in any shop• If an American thus pays a Russian firm a Dollar bill, the economy of the US (namely the FED) now owes Russia GOODS in the purchasing value of one Dollar. (basic financial transaction)





• so a non intuitive situation occurs: if we accept a dollar bill as payment for exported goods, the US will be in debt with our firm, and thus with Russia. In TAKING a Dollar bill TO Russia, we EXPORTED capital!• We used capital to produce this product and now accept a promise of payment. As long as we don’t get the value of the goods back, we give a loan to the US and thus export our capital (we can use these Dollars in investments)





• the current account is in deficit, when the sum of trade balance, services account and balance of factor incomes is below zero.• any partial balance can cause a deficit or a surplus, even if two partial balances are in surplus, the overall balance can be in deficit. (trivial)• Let’s have a look at the determinants!


Imbalances of the Current Account



• Looking at the balance of factor incomes we can concentrate on the income of the factor capital. The income of workers from abroad is marginal in dimension.• If there is income from the factor capital which conclusion about earlier current accounts can be made?• Only if we exported capital, we can receive returns on investment from abroad. As we saw above, we export capital exactly then, when we export goods or services. So we can conclude: we had surpluses in current account in the past.


Balance of factor incomes



• we can thus conclude: The balance of factor incomes depends on trade and services balances of the past.

(as well as the given yield on our investments.)• Knowing that and searching for reasons of imbalances in the current account when can then exclude the balance of factor income as an dynamic factor. However this factor can be large in extend. We’ll focus on its origin: trade and services balances.(assumption: balance of factor income = 0)


It‘s not unimportant! However we exclude it.



• If the absorption of goods and services in a country is bigger than its production, the current account is in deficit.• we know the classical equation Investment = Savings for a balanced good’s marked in a closed economy.• For buying goods abroad, we need money. If buying from abroad, the savings will decline, as we spend money there. Leading to a new equation: Savings = Investment – Current Account (S = I – CA)


Determinants of trade and services balances



• if in deficit S = I +CA mirrors as well the capital balance: As the domestic savings are smaller than the demand for investments, we need to import capital.

• So the two variables domestic savings and investment are the real economic main determinants of the current account balance.


Determinants of the CA



• why are the savings going up, once I have a CA in surplus?

• remember: I get paid in Dollar, but can’t spend them!• I bring goods abroad and the foreigners are in dept with me• If doing so I can’t use the goods on my own, disclaim on consume I save.


Savings and the current account



• As said above, there are different types of transactions in the capital account. Through the balance of factor incomes they have relevance for the current account as well.• We assume, that the basic transaction shown above is of minor importance, as the opportunity costs of keeping foreign currency in cash are to high. Even Central Banks will only keep cash as reserves in very limited extend


Capital account. – types of transactions



• FDI are investments to gain operative influence on an existing firm or to found a new branch of foreign firm (greenfield investment)• FDI are usually long run investments• Profits are partially reinvested, the rest flows abroad• FDI can help less developed countries to develop (spill over effects)• In times of crisis they stabilize the situation


Foreign direct investments (FDI)



• foreign credits are often of medium term duration• as no sunk costs for building up a firm appear, they can be retracted far easier than FDI and are thus of more risk for the receiving country • due to insurances against currency fluctuations, the interest rates can be quite high• in times of crisis they destabilize situation (will be retracted)


Foreign credits


• Portfolio investments can be strategic long term participations in a firm or short term investments for speculation. • Dividend payments flow abroad• Can be retracted easily• In times of crisis can destabilize situation, but help stabilizing situation afterwards, as chance of buying shares of healthy companies for low prices will be used


Portfolio investments


• Currency reserves of the Central Bank appear once an exporting firm exchanges its foreign currency in local currency. Thus they are consequence of CA surpluses.• Currency reserves are usually not held in cash but in conservative investments, being easily realizable• By using currency reserves Central Banks can try to avoid crisis


Monetary reserves


• The savings quota in the US is usually very low. If not taking companies treasured gainings into account even below zero sometimes! Meaning: private Americans spend more money

for consummation than they earn. (unique situation in the world)• This high demand for consummation leads to a high demand for imports. Taking CA into deficit


Example USA


•


USA – Savings as a share of GDP

Source: www.worldbank.org


•


USA – Current Account as a share of GDP

Source: www.worldbank.org


• we clearly see, that the described situation leads to long term CA deficits of the USA• this means, the debt of the US economy is growing strong over the time, leading to a situation, where many US firms are owned by foreigners. Biggest shareholder: Chinese state funds! • The situation can become then critical, once foreigners are not willing anymore, to accept US Dollars as payment, or are not interested anymore in investments in the US in fright of the non sustainable situation


Analysis


• But is the “German way” the better one?• besides 1990-2001 (in consequence of the German reunification) Germany always has vast CA surpluses.• This means Germans are disclaiming on vast amount of what they are producing with their work and capital• The national wealth thus is at a lower level it could be• Danger of loosing foreign assets, in crisis dependent on

foreign economy, as domestic demand underdeveloped


Everlasting surplus – a gain?


• Foreign assets gained through exports should be used profitable and reduced again to spread the wealth in the country of its origin.• In bad times of business cycle exports should stabilize local production, in boom times imports should take place.• Over the time, the CA should be balanced.• In this respect France seems to do a rather good job.


Way out?


• One would expect to have the US big deficits in the balance of factor incomes, as they seem to have everlasting CA deficits.• In fact they have had SURPLUSES till the beginning of the actual crisis.• So is the theory I talked about all the time just wrong? What could be the reason for that?


US paradox. Balance of factor incomes


• Reason one: the US Dollar. • still leading currency in the world, so MAIN RESERVE currency

of Central Banks as said before, these are investing money very conservative often in US state bonds.

• Huge amounts of Dollars are in reserves in China, Russia, Japan. Absorbing the foreign debt at large scale but at low return payments to foreign investorsThe role of the US Dollar as No.1 currency reserve currency leads to a situation, in which the return on invested capital in the US is low, due to the large amount of Central Banks’ conservative investments.


US paradox. Reasons (1).


• Reason two: structure of US economy• The US economy is dominated by huge scale companies.

These companies are easily able to invest in expensive and highly lucrative projects

• There are values of world brands like “Coca Cola”, “Microsoft”, “Apple” etc. By exporting the “good” name the payback increases.

• Almost all the savings and thus the money available for foreign investment is on the site of companies (priv. savings near 0), which increases the efficency.The structure of the US foreign investments leads to an effective investment with high returns on investment.


US paradox. Reasons. (2)


• to sum it up, we have a situation in which there is low return of investment on average on capital invested in the US, and high roi on US capital abroad• So even if LESS US capital invested abroad the returns are in total higher, than of the capital invested in the US• The US are the only economy with this inverse structure. However it gets less and less, as dept goes up. Although the return on investment rate keeps higher.


US paradox. conclusion

balance of payments

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