Chapter 9
Trade and
the Balance
of Payments
Chapter Objectives
• Present the accounting system of a nation´s
international transactions: current, capital,
and financial accounts
• Explain the relationship among domestic
investment, domestic savings, and
international flows of goods, services, and
financial assets
• Examine the meaning of international
indebtedness and discuss its consequences
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-2
Introduction
• The international transactions of a nation are
divided into three separate accounts
– Current account: record of the goods and
services into and out of the country
– Financial account: record of the flow of financial
capital to and from the country
– Capital account: record of some specialized
types of relatively small capital flows
• Let’s examine each of these in
greater detail…
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-3
Merchandise Trade Balance
• Let’s first define merchandise trade
balance—part of the current account;
measures the difference between exports
and imports of goods, but not services
– Trade deficit: negative merchandise
trade balance
– Trade surplus: positive merchandise
trade balance
• In 2002, the U.S. had a trade deficit of $418.0 billion
• However, the U.S. had a large trade surplus in
services ($64.8 billion)
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-4
Current Account
• Current account balance: measures all current,
non-capital transactions between a nation and the
rest of the world
• Current account has three main components:
– Goods and services = the value of goods and services
exported – the value of imports
– Investment income = income from investments abroad –
income paid to foreigners on their U.S. investments
– Unilateral transfers = any foreign aid or other transfers
received by foreigners – that given to foreigners
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-5
Current Account (cont.)
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-6
U.S. Current Account Balance, 2002
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-7
FIGURE 9.1 U.S. Current Account
Balance, 1946–2002 (Percent of GDP)
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-8
U.S. Current Account Deficit
• U.S. current account deficit looks ominous
• However, the deficit is not a sign of
weakness: U.S. economic boom of the 1990s
increased the demand for imports, while
sluggish growth abroad limited the expansion
if
U.S. exports
• But the U.S. deficit is not sustainable in the
long term
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-9
Financial Account
• Financial account: record of the flow of
financial capital to and from a country
• Two main components
– Net changes in the country’s assets abroad
– Net changes in the foreign-based assets in
the country
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-10
Capital Account
• Capital account: record of the transfers
of specific types of capital, such as
– Debt forgiveness
– Personal assets that migrants take with
them abroad
– The transfer of real estate and other fixed
assets, such as a military base or an
embassy building
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-11
Balance of Payments
•
Balance of payments =
current account + capital
account + financial account
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-12
Balance of Payments
•
Three accounting caveats
1. Both the capital account and the financial
account present the flow of assets during the
year in question and not the stock of assets that
have accumulated over time
2. All flows are net changes (differences between
assets sold and bought, for example) rather than
gross changes
3. As long as the capital account balance is zero,
financial account balance = current account
balance, but with the opposite sign
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-13
Statistical Discrepancy
in Balance of Payments
• Statistical discrepancy: the amount by
which the sum of the current, capital, and
financial accounts is off the total of zero
• Statistical discrepancy is calculated as the
sum of the current, capital, and financial
accounts, with the sign reversed
– In 2002, U.S. statistical discrepancy was
[(–1)  (–480,861 – 1,285 + 527,998)] = –45,852
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-14
Statistical Discrepancy (cont.)
• Statistical discrepancy exists because
the record of all the transactions in the
balance of payments is incomplete
– Errors tend to lie in the financial account
calculation, as it is the hardest to
measure correctly
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-15
Financial Flows
• Financial flows originate in the public and
private sectors
• Some financial flows are very mobile: move
quickly in response to investor expectations
– Mobility of financial flows brings economic volatility
– Upon sudden financial outflows, a country can
sink into a financial crisis
– The volatility of financial flows has increased
concern about the various types of flows
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-16
Five Types
of U.S. Financial Flows (A–C)
1. U.S. assets abroad (outflows)
A. Official reserve assets: gold bullion, IMF’s special
drawing rights (SDRs), major currencies
B. Government assets: loans to foreign
governments, rescheduled loans to foreign
governments, payments received on outstanding
loans, changes in non-reserve currency holdings
(e.g., Mexican pesos)
C. Private assets: direct investment, foreign
securities, loans to foreign firms and banks
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-17
Five Types
of U.S. Financial Flows (D–E)
2. Foreign assets in the U.S. (inflows)
D. Foreign official assets: gold bullion, IMF´s
special drawing rights (SDRs), major
currencies
E. Other foreign assets: direct investment,
U.S. securities and currency, loans to
U.S. firms and banks
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-18
Components of the
U.S. Financial Account, 2002
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-19
Largest Share of Financial Flows:
Private Assets
• Private assets: foreign direct investment (FDI),
foreign securities, loans to foreign firms and banks
– FDI: tangible items: real estate, factories, warehouses,
transportation facilities, and other physical (real) assets
– Securities and loans can be considered foreign portfolio
investment—paper assets such as stocks and bonds
– Both FDI and foreign portfolio investment give their holders a
claim in a foreign economy’s future output
– However, holders of FDI have longer time horizons
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-20
U.S. Private Flows, 2002
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-21
Limits on Financial Flows
• Until recently, most nations limited the
movement of financial flows related
financial account transactions across
their borders
– The European Union liberalized financial
flows between member countries only
in 1993
– However, current account transactions
were less heavily regulated
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-22
Financial Account Liberalization
• The movement toward open markets over the
1980s and 1990s has resulted in the lifting of
controls on financial flows
– Developing countries, in particular, have
liberalized financial account transactions in order
to get access to financial capital for development
– Although financial flows can be volatile,
economists agree that free flows are best for
economic efficiency
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-23
The Current Account
and the Macroeconomy
• Why study the balance of payments?
– Balance of payments help understand the
broader implications of current account
imbalances and how to tame current
account deficits
– Balance of payments give cues how
nations can avoid crises brought by volatile
financial flows and how they can minimize
the damage of financial crises if such occur
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-24
National Income
and Product Accounts
• National income and product accounts:
accounting system for a country’s total production
and income
• Two fundamental concepts of the system:
– Gross domestic product (GDP): the value of all final goods
and services produced within a country´s borders during a
period of time (usually a year)
– Gross national product (GNP): the value of all final goods
and services produced by the labor, capital, and other
resources of a country within the country as well as abroad
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-25
National Income
and Product Accounts
• GNP = GDP + foreign investment
income received – investment
income paid to foreigners +
net unilateral transfers
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-26
National Account Variables
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-27
Understanding National Accounts
• Interplay of the variables of the national accounts
1. GDP = C + I + G + X – M
2. GNP = GDP + (net foreign investment income +
net transfers)
3. GNP = (C + I + G) + (X – M + net foreign investment income
+ net transfers)
4. GNP in terms of current account balance:
GNP = C + I + G + CA
5. GNP is also the value of income received: GNP = C + S + T
6. Since 4 and 5 are equivalent definitions of GNP,
C + I + G + CA = C +S + T
7. I + G + CA = S + T
8. S + (T – G) = I + CA
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-28
Understanding
National Accounts (cont.)
• S + (T – G) = I + CA summarizes the
current account balance, investment,
and public and private savings in the
economy
• The following figure illustrates the
equation in the U.S. in 1991–2002
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-29
FIGURE 9.2 U.S. Saving
and Investment, 1991–2002
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-30
Savings and Investment
in Other Countries
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-31
International Debt
• Current account deficits must be
financed through inflows of financial
capital (loans)
• Loans from abroad add to a country’s
stock of external debt and generate
debt service obligations
• All countries, rich and poor, have
external debt
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-32
International Debt (cont.)
• In many low and middle income countries,
external debt leads to financial problems
• Unsustainable debt occurs for numerous
reasons:
– Falling commodity prices
– Natural disasters
– Corruption
– Foreign lending behavior
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-33
International Debt (cont.)
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-34
The International Investment Position
• If a country runs a current account deficit,
it borrows from abroad and increases
its indebtedness
• If a country runs a current account surplus,
it lends to foreigners and reduces its
overall indebtedness
• International investment position =
domestically owned foreign assets –
foreign owned domestic assets
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-35
The International
Investment Position (cont.)
• A positive international investment position =
the home country could sell all its foreign
assets and have more than enough revenue
to purchase all the domestic assets owned
by foreigners
– In 2001, the U.S. international investment position
= $6,891 billion – $9,206 billion = –$2,315 billion
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
9-36