PRINCIPLES OF INTERNATIONAL

FINANCE AND OPEN ECONOMY Cristina Terra

MACROECONOMICS

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 CHAPTER 2
Cristina
DEFINITIONS Terra

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 PLAN

 Balance of Payments
 Current Account
 Capital Account
 Financial Account

 National Accounts

 Balance of Payments Equilibrium

 Sustainability of Current-Account Deficits

 Open Economy Models

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 PLAN

 Balance of Payments
 Current Account
 Capital Account
 Financial Account

 National Accounts

 Balance of Payments Equilibrium

 Sustainability of Current-Account Deficits

 Open Economy Models

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 BALANCE OF PAYMENTS

 Balance of Payments: registers transactions between the

residents and non-residents of a country for a specific period.
 Double-entry system: each transaction is a positive entry in one account
and a negative entry in another => the sum of the entries is equal to
zero.

 The BoP is divided into three main accounts according to the

nature of the transactions: Current Account, Capital Account
and Financial Account .
 Current account: the flows impacting the period in question
 Capital and financial accounts: the accumulation of assets and
liabilities in relation to the rest of the world.

 “Errors and Omissions”: closes the balance.

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6
 CURRENT ACCOUNT

 The Current Account registers the imports and exports of

goods and services, and the payments of income

 Trade of goods and services.

 Goods: physical items that are produced and for which ownership can be
established.
 The imports and exports of goods represent the exchange of ownership of those goods
between a resident and non-resident of a country.

 Services: the result of a productive activity that alters what is consumed,

or that facilitates the exchange of goods and financial assets.
 In general, there is not anything physical that can be possessed.
 Examples: transportation and communication services, royalties, the liquefaction of natural
gas, oil refinery, the packaging of goods, the assembly of electronics and clothes, among
others.

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 CURRENT ACCOUNT

 The sale of a good or service by a resident of a country to a

non-resident is an export, which is registered as a credit
(positive entry) in the goods and services account.
 Double-entry: the corresponding payment, be it an in cash or credit
transaction, appears as a debit on the financial account.

 An import is the purchase of a good or service from a non-

resident by a resident. It constitutes a debit (negative entry)
on the goods and services account.
 It has a corresponding credit on the financial account.

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 CURRENT ACCOUNT

 Income Flows:

 Primary income account: the payments to factors of production, the

returns to financial assets and the rent of natural resources.
 The income received is registered as a credit on this account
 Examples: dividends from multinational corporations; interest received from
international loans, among others.

 Secondary income: the redistribution of income by means of current

transfers.
 Two types of transfers: current, registered here, and capital, registered in the
capital account.
 Transfers of capital = transfer of ownership of an asset that is not currency.
 By exclusion, current transfers = not transfers of capital.
 Examples: international aid, personal transfers, such as lottery winnings, income tax paid by non-
residents, among others.

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 PLAN

 Balance of Payments
 Current Account
 Capital Account
 Financial Account

 National Accounts

 Balance of Payments Equilibrium

 Sustainability of Current-Account Deficits

 Open Economy Models

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 CAPITAL ACCOUNT

 Capital Account: registers the acquisitions or disposal of non-

financial and non-produced assets.
 Examples: the exploitation of natural resources (with change of
ownership of the right to exploit), brand names and trademarks, and
he amount paid by a foreign soccer club for a player.

 It also includes transfers of capital between residents and

non-residents.
 Examples: inheritance received, forgiveness of foreign debt between
countries.

 The capital and financial accounts explain the variations in

international investment positions.

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 PLAN

 Balance of Payments
 Current Account
 Capital Account
 Financial Account

 National Accounts

 Balance of Payments Equilibrium

 Sustainability of Current-Account Deficits

 Open Economy Models

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 FINANCIAL ACCOUNT

 Current account + capital account = the economy’s need of foreign

financing.

 Financial Account: how loans are made, or how debt is financed. It

registers the transactions between residents and non-residents that
involve financial assets and liabilities .

 A surplus in the financial account means an increase in the country’s

net indebtedness.

 The entries on the financial account have as a counterpart the entries

on the current account, the capital account, or even other items on the
financial account.
 Example: an export enters as a credit on the Goods and Services Account and as a
debit on the financial account, in the form of currency variation and deposits (if
the payment is made in cash), or in trade credit (if the payment is financed).

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 FINANCIAL ACCOUNT

 The financial account registers all transactions of financial

assets and liabilities, which are grouped into categories with
characteristics similar either in nature, or in their economic
motivations, or in their pattern of behavior.

 Transactions that imply an increase in assets are entered as

negative and operations that correspond to an increase in
foreign liability are entered as positive.

 The transactions are divided into direct investment, portfolio

investment, financial derivatives, other investments and
reserve assets.

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 FINANCIAL ACCOUNT

 Direct investment: results in the control, or significant degree of influence,

of the management of a company resident in another country.
 Portfolio investment: transactions involving debt or equity securities, not
including those referring to direct investment or reserve assets.
 Due to its characteristics, portfolio investment tends to be more volatile than direct
investment.
 Financial derivatives: deserve a separate grouping due to t heir nature as
instruments by which risk is negotiated. In general, derivatives do not
generate primary income, as is the case with other categories in the
financial account.
 Other investment s: despite its name giving the impression that it is a
remainders account, it is actually an important category in the financial
account. It involves operations of currency, deposits and trade and credits.
 Examples: payment in cash for an export or the trade credit for the importer, loans
made abroad by a domestic company, the allocation of special withdrawal rights
from the IMF, among others.

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 FINANCIAL ACCOUNT

 Reserve assets: foreign assets available to and under the

control of monetary authorities.
 The same instruments as in other categories of the financial account,
with the difference that they belong to the monetary authorities.
 Examples: deposits, bonds, gold, foreign currency and a reserve
position with the IMF.

 They can be used by the monetary authority to cover financial

needs in the balance of payments, intervene in the exchange
rate market and other correlated objectives.

 The IMF suggests that the variations in reserve assets be

registered in the financial account, but some countries opt for
registering it in a separate account.

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 PLAN

 Balance of Payments
 Current Account
 Capital Account
 Financial Account

 National Accounts

 Balance of Payments Equilibrium

 Sustainability of Current-Account Deficits

 Open Economy Models

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 NATIONAL ACCOUNTS

The
   BoP is part of the National Accounts system, which registers
economic activity based on a standardized accounting system across
nations.

 Gross Domestic Product (): the main aggregate of national accounts.

It measures all that is produced within the country’s borders.

 However, not all that is produced within the country belongs to the
residents of that country.
 Example: the profit generated by a factory belonging to a multinational
corporation.

 Gross National Income (): the value of all goods and services
produced by production factors resident in the country.

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 GDP AND GNI

  The difference between the two aggregates, GDP and GNI,

corresponds to the net payment of income of the factors used
in production but that are not residents in the country

 Defining PI as the primary income balance, we have that:

(2.1)

 If the primary income balance is negative, that is, if the

country makes net income payments, then the GDP is greater
than the GNI.

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 NATIONAL ACCOUNTS ACCOUNTING

 The
  goods and services available for use in a country correspond
to the sum of GDP ( Y) and the import of goods and services ( M).
 These goods and services can be used for private consumption
(C), investment (I), government consumption ( G), or to be
exported (X).

 This accounting can be represented by the equation:

which can be rewritten as:

(2.2)

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 NATIONAL ACCOUNTS ACCOUNTING

  Adding the primary income balance to both sides of equation

(2.2) and using equation (2.1), we have that:

(2.3)

 Finally, adding the secondary income balance to both sides,

we get:

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 NATIONAL ACCOUNTS: BASIC IDENTITY

  The previous equation we represent by:

(2.4)

 : Gross National Disposable Income = GNI + secondary income

balance.
 CA: current-account balance .

 Equation (2.4):the basic identity of national accounts

 the total disposable income of domestic residents is equal to the
uses for this income, which can be private consumption, investment,
government consumption, or transactions with the rest of the world.

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 CURRENT ACCOUNT, INCOME AND
EXPENDITURES
  We can write it as:

, (2.5)
 
 when the current-account balance is positive, income is greater than
expenditures in a country.

 In this case, the country can lend to the rest of the world.

 When the current-account balance is negative, the national income is

less than expenditures and the country borrows from the rest of the
world.

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 CURRENT ACCOUNT, SAVINGS AND
INVESTMENT
Another
   way to interpret equation (2.4) is by identifying private
savings () and government savings () in the equation.

 We add and subtract taxes () on the left side of equation (2.5), thus
obtaining:

A deficit in current account means that investment in the country is greater

than savings.

The equation also shows that a reduction of the account deficit has as a
counterpart an increase in savings and/or a reduction in investment.

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 THE CHINESE EXCHANGE RATE

 D ur in g t h e 2000s, C h in a was a c c u se d of m a in ta in in g its cu rr e n c y de pre c ia te d,

ge ne ra tin g tr a de s u rpl u se s a nd, c o n se qu e n tly, ve r y h igh cu rr e n t- a c c ou n t
s u rpl u se s.

 A c c or din g t o wh at we wi ll se e in C ha pte r 5, th e e xc h a n ge ra te is a s s oc ia te d
with th e cu rr en t accou n t in s u c h a way th a t th e c u r re nt- a cc o u nt s u rpl u s ha s a s
it s co u nt erpa rt a m ore depre c ia te d c u rr e n c y.

 Fro m ( 2. 6): th e hi gh C A su r pl us e s ( a n d o ve r- de pre c ia te d cu r re n c y) wa s,

a c tu a lly, th e re su lt of h igh s a vin gs .

 Th e re is n o wa y to a lte r t h e e xc h an g e r a te by bru te for c e t o so lve th e pr oble m .

 I t is n e c e s sa r y t o ch a n ge th e in c e n tiv e s for i nv e s tm e n t a nd sa vi ng s for th e

e co no m y to com e to s a ve le ss a n d in ve st m or e .
 Consequently, the surplus in current account will reduce and bring about a more
appreciated exchange rate.

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 ACCOUNTING IDENTITY

 Important: equation (2.6) is an accounting identity.

 It is true regardless of ideologies or viewpoints regarding how the
economy functions.
 It defines the relation between economic variables, but does not
indicate the causality between them.

 To know, for instance, what type of economic policy to use to

affect the current-account balance, one must understand the
way the economy works, what the motivations are for the
economic agents, and how the variables relate to each other.

 Any economic model must obey the rules of the economy,

among them the accounting identities of national accounts and
balance of payments.

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 PLAN

 Balance of Payments
 Current Account
 Capital Account
 Financial Account

 National Accounts

 Balance of Payments Equilibrium

 Sustainability of Current-Account Deficits

 Open Economy Models

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 BALANCE OF PAYMENTS:
ACCOUNTING IDENTITY
  Double-entry system: a credit in one account always
corresponds to a debit in another.
 Therefore, by construction, the sum of the balances in current
account (CA), capital account (KA), and financial account (FA) should
equal zero:

(2.7)
 
 Equation (2.7) is an accounting identity: it is always true by
the form of registry accounting. It can be written as:

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 FINANCIAL ACCOUNT AND
INDEBTEDNESS
  The financial account balance corresponds to the variation of
net indebtedness of a country.

 For example, a country with a current-account deficit needs foreign

financing: .

 If this country is already in debt, there is an increase in its foreign

debt, or in the case of a net creditor country, there is a net reduction
in loans by the country to the rest of the world.

 In terms of equation (2.8), the indebtedness of a country increases or

its credit decreases, according to the case, when .

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 CURRENT ACCOUNT AND
FINANCIAL-CAPITAL ACCOUNT
  Definition:
 financial-capital account = the sum of the capital and financial
balances, excluding registers of reserve assets
 variations in reserve assets.

 The balance of payments, in this way, would be written as:

(2.9)

 There is always a reduction in reserve assets when the deficit

in current account is not compensated by a corresponding
surplus in the capital and financial accounts, that is, if there
is insufficient external financing.

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 ARGENTINE CRISIS

 Based on equation (2.9), we can understand what happened in the 2001

Argentine crisis.

 Argentine had accumulated deficits in current account, which significantly

increased as of 1998.

 According to the currency board regime, in force in the country since

1991, the Argentine government would have to sell reserve assets when
the capital inflow was insufficient to cover the deficit in current account to
avoid the depreciation of the exchange rate.

 That actually happened when international investors began to question the

sustainability of the Argentine situation and the inflow of capital through
the financial account ceased to be sufficient.

 In 2001, the reduction of reserve assets reached almost 4% of GDP. 

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 BALANCE OF PAYMENTS EQUILIBRIUM

 We say the balance of payments is in equilibrium when its

composition can be sustained without intervention and
without sudden shocks to the economy .

 The condition of equilibrium can vary depending on domestic

economic conditions and the international scenario.

 Deficits in current account financed by foreign indebtedness

can be sustainable and even desirable, as we will see in
Chapter 4.

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 BALANCE OF PAYMENTS EQUILIBRIUM

 In general, it could be desirable for a developing country to

generate current-account deficits.

 If the rate of return for investment in the country is high, the country
can use foreign financing, by means of current-account deficits, to
investment more.

 The productive capability of the country will thereby increase and it

can, in the future, increase its savings without reducing consumption,
generating the surplus in current account necessary to pay its foreign
debt.

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 SUDDEN STOPS:
LATIN AMERICA AND EUROPE
 Latin America in the 1980s:

 Latin American countries had a high foreign debt

 Early 1980s: increase of the US interest rates, as part of the
campaign to fight inflation
 This generated a significant increase in the service of the foreign
debt in Latin America
 At the same time, available credit on the international markets was
reducing
 To avoid deficits in current account that could not be financed, these
countries had to generate trade surplus in a short period of time.
 Result: large currency depreciations

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 SUDDEN STOPS:
LATIN AMERICA AND EUROPE

 As Rudiger Dornbusch said, "it is not speed that kills, it is the

sudden stop”.

 The term “sudden stop” came to designate abrupt reversals to

the inflow of capital.

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 SUDDEN STOPS:
LATIN AMERICA AND EUROPE
 Europe after 2008:

 Contraction of world credit caused by the 2008 American crisis

 The scarcity of credit exposed the excessive indebtedness of several

European countries
 higher interest rates to compensate the perceived elevated risk, and
 difficulty of obtaining foreign financing.

 Different from the Latin American countries in their crises, the

Europeans obtained financial aid from the European Union and were
able to postpone the foreign adjustment.

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 PLAN

 Balance of Payments
 Current Account
 Capital Account
 Financial Account

 National Accounts

 Balance of Payments Equilibrium

 Sustainability of Current-Account Deficits

 Open Economy Models

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 SUSTAINABILITY OF
CURRENT-ACCOUNT DEFICITS
  When are deficits in current account and the foreign debt
resulting from them sustainable?

 Net International Investment Position (NIIP): the difference

between the amount of foreign assets held by domestic
residents and the amount of domestic assets held by
foreigners.

 Let be the NIIP at the beginning of period t

 : the country is a net lender
 : the country is a net borrower

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 CURRENT AND FINANCIAL ACCOUNTS

  Equation (2.5) can be therefore written as:  

. (2.10)

 assuming that and that

 To further simplify, we set the capital account balance as

equal to zero. We then have that

 Equations (2.10) becomes:

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 NIIP EVOLUTION

 

 and therefore:
(2.13)

 Using equation (2.13), we can compute as a function of and

the macroeconomic variables for the period , and substitute
the result in equation (2.13).
 Repeating this procedure indefinitely, we arrive at:

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 TRANSVERSALITY CONDITION

 We
  assume that the present value of the debt or credit of a
country () in the indefinite future is zero, that is, , which is
known as transversality condition .

 Intuition:
 A strictly positive value mean that the country’s credit grows
indefinitely at a rate greater than interest rates. The country could
increase welfare by consuming more and accumulating less credit.

 On the other hand, the country could become well satisfied with a
negative value for this limit, that is, an ever growing debt at a rate
greater than interest rates. But to have an explosive debt, another
country would need to have an equally explosive credit, which we have
seen would not happen.

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 NIIP AND TRADE BALANCE FLOWS

  Using equation (2.2) and the transversality condition, we have

the economy’s intertemporal restriction of resources:
(2.14)

 The amount of debt is equal to the present value of future

trade balances.
 An indebted country need, at some point , to generate trade
surpluses so that the debt does not become explosive.
 Deficits in current account are sustainable when the
generation of future trade surplus, to limit the foreign debt
generated by them, can be made without abrupt shocks.

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 STRATEGY TO A SUSTAINABLE DEBT

 What conditions are necessary for a debt strategy to be

sustainable?

1. The counterpart of a deficit in current account should be an

increase in the level of investment in the country, and not an
increase in consumption.

2. Investment should be effective in increasing production

capabilities, so that a higher level of investment would truly
increase the rate of growth for a country.

3. The inflow of capital should be stable during the investment period.

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 CONDITIONS FOR SUSTAINABILITY

 The sustainability of the composition of current and financial

accounts balances depends, among other factors, on:
 the conditions present in the international credit market,
 the perception of international investors in relation to a country’s
ability to pay,
 the composition of foreign financing,
 and the domestic use of foreign indebtedness or motivation for
foreign savings.

 What appears to be true is that the accumulation of high

deficits in current account tends to make the economy more
vulnerable to shocks, both domestic and foreign.

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 PLAN

 Balance of Payments
 Current Account
 Capital Account
 Financial Account

 National Accounts

 Balance of Payments Equilibrium

 Sustainability of Current-Account Deficits

 Open Economy Models

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 OPEN ECONOMY MODELS

 To model an open economy, one must consider its

transactions with the rest of the world, which are registered
in the balance of payments.

 Based on equation (2.9), we can describe the balance of

payments as the interaction between three markets:
 the goods and services market, represented by the current account,
 the assets market, by the financial-capital account, and
 the money market, by the reserve assets.

 The different open economy models provide for alternative

simplifying hypotheses, depending on which of the market
one intends to focus their analysis.

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 OPEN ECONOMY MODELS

 The intertemporal models of current-account adjustment :

 focus on the interaction of the current-account balance with domestic
aggregates. They model aggregate savings and investment over time, so that
the current-account balance can be analyzed as a result of these decisions.
 The monetary models:
 focus on the money market. By taking domestic and foreign assets as
perfect substitutes, only one non-arbitrage condition guarantees balance in
the asset market.
 Two categories:
 Flexible price: goods market is always in equilibrium => changes in nominal
exchange rate do not have an impact on the level of production or on the current-
account balance, given that prices immediately adjust to compensate for the
exchange rate changes.
 Fixed price models: the adjustment of prices to shocks is not immediate. The
goods market can temporarily remain out of its long-run equilibrium, while prices
gradually adjust.

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 OPEN ECONOMY MODELS

 The models of portfolio diversification:

 focus on the assets market. This is the only class of models where
domestic and foreign assets are not taken as perfect substitutes. The
objective of the model is to better understand the choice between
these two types of assets and how this choice is affected by different
economic variables.

 No model, by definition, is able to offer a complete

explanation of functioning of the economy in all its complexity.

 The object of a model is to simplify the economy, suppressing

lesser important elements in order to better understand the
object of study.

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