Debt sustainability; balance of
payments
Session 10
MSc Economic Policy Studies
Alan Matthews
Lecture objectives
• Introduce debt dynamics and debt sustainability
• Describe and understand the balance of
payments accounts
• Do international payments imbalances matter?
• Addressing international payments imbalances
• Reading: McAleese Chapter 15 (pp. 384-7), 20
Source and forecasts: Goodbodys Sept 2010
The debt equation
(D/Y)t = (1 + (r - g)(D/Y)t-1 + d + b
• where D is debt, r is nominal interest rate, g is nominal
growth rate, d is primary deficit and b is bank
capitalisation costs
• The debt/GDP ratio this year is equal to the ratio last
year, plus the primary deficit, plus bank costs, plus
interest charged on last year’s debt less growth rate of
GDP
• Why the primary deficit? Because interest rates are not
something government can control
Solving for the stable debt-to-GDP ratio
•
•
•
•
•
•
(D/Y)t = (1 + (r – g))(D/Y)t-1 + d
Expanding,
(D/Y)t = (D/Y)t-1 + r(D/Y)t-1 - g(D/Y)t-1 + d
We set (D/Y)t = (D/Y)t-1 and cancel terms
0 = r(D/Y)t-1 - g(D/Y)t-1 + d
Moving d to the other side and dividing
through
• -d/(r-g) = (D/Y)*
Debt sustainability
• If g > r, we don’t have a problem
– If d is negative (primary surplus), debt/GDP ratio is
heading to zero
– If d is positive (primary deficit), debt/GDP ratio is
headed for a stable and well-defined number
• If r > g, then stable debt/GDP ratio requires we
run a primary surplus
– If primary surplus is too small (if when divided by (r-g)
it is less than current D/Y ratio), then debt/GDP ratio
will grow without bound
Debt sustainability
• Is there a magic number for the debt/GDP ratio beyond which
markets lose confidence in state’s ability to repay?
• Continued borrowing is consistent with varying levels of debt/GDP
ratio
• Solvency limit is historically conditioned by evidence of willingness
to run that primary surplus
• May also be important whether debt is owed to foreigners or to
domestic residents
• Recent IMF Staff Paper suggests that currently Greece, Italy, Japan,
and Portugal appear to have the least fiscal space, with Iceland,
Ireland, Spain, the United Kingdom, and the United States also
constrained in their degree of fiscal manoeuver
Comments on Irish situation
• Irish scenarios demonstrated in attached debt
spreadsheet
• Note distinction between gross and net debt
– Distinction is cash positions held by the NTMA and
financial assets held in the NPRF
• Adding interest expenditure to the required
primary surplus means overall government
budget may still be in deficit
– Interest payments may rise to 5.4% GDP in 2014
(Goodbodys)
– Overall deficit constrained by separate EU rules
Balance of payments
• The balance of payments is a set of accounts showing
all economic transactions between residents of the home
country and the rest of the world in any one year
• The current account in the balance of payments
records all visible and invisible trade
• The capital account covers mainly capital transfers (EU
grants and migrants’ net worth)
• The financial account in the balance of payments is a
record of a country’s transactions in foreign financial
assets and financial liabilities
CSO Student Corner on balance of payments
Balance of payments statement
Current account
Goods trade (merchandise trade)
Services
Trading and investment income
Current unilateral transfers
Balance on current account
Capital account
Financial account
Balance on financial account
Foreign direct investment
Portfolio capital
Other investment
Change in official reserves
Net errors and omissions
2010, €bn
37
-9
-29
-1
-1
-1
13
13
8
94
-89
0
-12
Irish data. Source: CSO Balance of international payments release, Mar 2011
Some definitions
• Merchandise trade similar to balance of trade account
(see Lecture 6) but valued at fob prices for both exports
and imports
• Invisibles refers to balance of services trade, investment
income and current transfers (net current receipts from
EU and Irish Aid expenditure)
• Capital account transfers refer mainly to capital receipts
under EU structural funds
• Financial account includes long-term capital flows (FDI
and portfolio investment) and other flows which are
mainly short-term loans and transactions in financial
derivatives
• Reserve assets are non-euro denominated liquid assets
and gold owned by the Central Bank
Further definitions
• Sometimes distinction is made between
autonomous and accommodating transactions
in the balance of payments
• Former are seen as ‘active’ transactions,
responding to real changes in competitiveness
conditions, while latter are ‘passive’
• Example: consider reactions to an increased
demand for imports
• Line is drawn under the basic balance, but
increasingly less distinct as capital markets
become more liquid
Irish balance of payments trends
Year
Merchandise
Invisibles
Services
Trading
& investment
income
Current
transfers
Total
Invisible
Balance
on
current
account
2001
30,494
-13,259
-18,295
305
-31,249
-757
2002
35,442
-13,779
-23,664
707
-36,736
-1,295
2003
32,604
-11,091
-21,947
432
-32,606
-2
2004
31,812
-9,721
-23,578
306
-32,993
-1,181
2005
28,218
-9,303
-24,870
265
-33,908
-5,690
2006
25,031
-6,797
-24,033
-506
-31,336
-6,304
2007
19,811
-1,121
-27,825
-990
-29,936
-10,124
2008
23,811
-7,670
-25,155
-1,154
-33,979
-10,169
2009
32,367
-8,416
-27,901
-901
-37,218
-4,853
2010
37,147
-8,520
-28,567
-1,172
-38,259
-1,113
Borrowers and lenders, debtors and
creditors
The balance of payments is a flow concept
It shows whether a country is a net borrower or a net lender in any year
A debtor nation is a country that during its entire history has borrowed
more from the rest of the world than it has lent to it.
A creditor nation is a country that has invested more in the rest of the
world than other countries have invested in it.
The difference between being a borrower/lender nation and being a
creditor/debtor nation is the difference between stocks and flows of
financial capital.
Does it matter if a country is a debtor nation? Depends on how the
borrowing has been used.
International Investment Position
• The international investment position (IIP) is a point in
time statement of the value and composition of the
balance sheet stock of an economy's foreign financial
assets (i.e. the economy's financial claims on the rest of
the world) and its foreign financial liabilities (or
obligations to the rest of the world).
• The change in the IIP between beginning and end of
period is equal by definition to the current account
balance over that period (allowing for valuation changes
reflecting changes in exchange rates and asset prices)
• Note reconciliation is also difficult due to large BOP
balancing item ‘net errors and omissions’
Ireland’s IIP
Source: CSO Quarterly International Investment Position, Dec 2010
Source: Honohan, 2006
Source: Honohan, 2006
Understanding the balance of
payments current account
• First, some national income accounting
• Recall total income Y is defined from
expenditure side as
Y=C+I+G+X–M
• Y can also be defined as
Y=C+S+T
• In equilibrium, these two definitions are identical
(I - S) + (G – T) = (M – X)
Balance of payments deficit = excess
investment over savings plus government
budget deficit
Interpreting a current account
deficit
• Two views
– A deficit is a sign that a country is spending
more than it earns, a weakness which must
be corrected by either/both reducing
expenditure or switching expenditure from
imports in favour of exports
– A deficit is a sign of strength because it
means the country is sufficiently profitable to
attract continued flows of foreign capital
(focus on the basic balance)
The importance of sustainability
• “A country is said to have a balance of payments
problem when the current account deficit and the
accumulated international investment position have
reached a level where continuance of the deficit is no
longer judged sustainable” – McAleese
• Issues
–
–
–
–
–
Time dimension
Size of deficit in relation to GDP and debt position
Method of financing of deficit
Related to use of deficit (investment or consumption?)
Growth position
• Sustainability a matter of market confidence
Source: http://www.voxeu.org/index.php?q=node/2820 EA = Euro Area
Why an unsustainable current
account deficit matters
– Adds to cost of foreign borrowing
– Greater exposure to the volatility of
international capital markets with potential for
lack of confidence scenario (Asian crisis
1997)
– Asset ownership moves into foreign hands
– Arguably, within the euro zone a country’s
balance of payments no longer matters, but it
remains an important symptom of underlying
problems
Interpreting a current account
deficit
• McAleese ‘tale of three deficits’
– US deficit
– Developing countries’ debt
– Deficits in Euroland
Sustainability of the US current
account deficit
• How sustainable is the deficit?
• Will it keep downward pressure on the US
dollar?
• US deficit was running at around 6% of US
GDP
• US dollar has depreciated by 40% relative
to the euro between Jan 2002 and Jan
2004
The US deficit is sustainable
“Some argue our large trade deficit (or current account
deficit) is responsible for the fall in the dollar's value.
They have it backward. It is the flow of foreign
investment dollars (the capital account) into the U.S.
economy that drives the trade deficit. The U.S.
economy's higher return on capital than Europe or Japan
for the last 20 years caused private foreign investors to
buy U.S. stocks and bonds and other assets. In addition,
foreign governments, particularly of China, Japan and
other Asian states, have steadily increased their
purchases of U.S. dollars as reserve backing for their
own currencies.”
- Cato Institute economist Richard Rahn, Jan 2004
Note similarity to Box 20.1 in MacAleese
The US deficit is not sustainable
• High productivity growth and booming
stock markets in the 1990s drove a wedge
between private investment and savings
• US household savings now fallen to 1% of
GDP
• US fiscal policy now hugely expansionary
• Foreigners will lose their appetite to hold
US assets, causing interest rates to rise
and restricting demand
Prospects for a soft US landing
• US economy insulated from the worst
effects of an international financial crisis
– Because of its size
– The fact that most of its obligations are
denominated in its own currency
– International role of the dollar underpins
demand for it
– Damage may be felt as much by other
countries as by the US
Correcting a balance of payments
imbalance
• Automatic adjustment mechanisms
– Start with adverse shock to exports
-> fall in demand for imports used as inputs to
production
-> fall in aggregate demand leads to fall in
imports
-> monetary factors such as fall in real balances
-> supply side adjustments through changes in
relative prices of traded/nontraded goods
Correcting a balance of payments
imbalance
• Recall (I - S) + (G – T) = (M – X), problem is to
reduce excessive (M-X)
• Expenditure reduction policies
– Increase S
– Reduce I
– Reduce G – T through restrictive fiscal policies
• Expenditure switching policies
– Commercial policy (tariffs, etc)
– Improved cost competitiveness
– Exchange rate changes
Restoring Ireland’s competitiveness
• Within the EU, commercial policy and
exchange rate changes are ruled out
• Expenditure reduction policies (i.e. fiscal
tightening) can lead to severe economic
contraction and rise in unemployment
• Reduction in nominal wages required to
mimic a real devaluation, but how to
achieve?
Financial balances
• Derived from flow-of-funds data (CSO institutional
accounts)
• Based on the identity that the three balances (private,
government and foreign) must sum to zero
• Households are highly indebted and need to deleverage
(i.e. run financial surpluses)
• Government is highly indebted and needs to run financial
surpluses
• Implies need for substantial current account surplus
• At eurozone level, implies strong depreciation in euro to
achieve, i.e. competitive devaluation
Global imbalances
Source: OECD Economic Outlook Nov 2010
Global imbalances
Global imbalances
Source: IMF World Economic Outlook, Oct 2010
Challenges for the G20
• How to address global imbalances when
OECD countries are undertaking
significant fiscal contraction?
– Excess of global savings
– Export-led growth model of China, Germany,
Japan
– Currency appreciation by surplus countries?
– Alternatives?