Chapter 9

Balance of Payments, Debt,

Financial Crises, and Stabilization

Policies

Problems and Policies: international and macro

2

1 International Finance and Investment: Key Issues

• How major debt crises emerged during the 1980s

– Deficits of current accounts, financial account, and capital accounts

– Accumulation of debt and emergence of debt crisis

• Mostly international financial crises were viewed as “originating” in the developing world

- Latin American debt crisis of 1982

- Mexican Tequila Crisis of 1994

- East Asian contagion of 1998

• Main causes is weak financial markets and institutions and unstable political economy

• After their 1980s and 1990s debt crises affected countries were required by IMF and WB

to privatize state-owned enterprises, eliminate regulations, and reduce infant industry

protection

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 labour, capital, and other resources of a country within the

country as well as abroad

2. National Accounts

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• Imagine about the value of national income

that results from production and expenditure.

• Recalling the circular flow diagram

Producers earn income

from buyers who spend

money on goods and

services.

The amount of expenditure

= the amount of income

= the value of production.

National income is often

defined to be the income

earned by a nation’s factors of

production.

Money

Factors

Firms

Households

Factor

Markets

G&S

Factors G&S

Money Money

Money

4

What are factors of production? Inputs that are used to produce goods/services: workers

(labor), capital (buildings and equipment), land and others.

The value of final goods and services produced by Cambodia-owned factors of production are

counted as Cambodian GNP.

GNP is calculated by adding the value of expenditure on final G&S produced.

• GNP is one measure of national income, but a more precise measure of NI is GNP

adjusted for following:

1. Depreciation of physical capital (depreciation is subtracted from GNP).

2. Unilateral transfers to and from other countries can change national income.

• Another rough measure of NI is gross domestic product (GDP):

GDP = GNP – payments from foreign countries for factors of production

+ payments to foreign countries for factors of production

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3. Current account: what is it?

• There are 4 types of expenditure:

1. Consumption: expenditure by

home consumers

2. Investment: expenditure by firms

on buildings & equipment

3. Government purchases:

expenditure by governments on G&S

4. Current account balance (exports

minus imports): net expenditure by

foreigners on domestic G&S

GDP

C

I G

NX

6

GDP = Expenditure on a Country’s Goods and Services

NI = value

of domestic

production

NI = Expenditure

on domestic

production

Y = Cd + Id + Gd + EX

= (C-Cf) + (I-If) + (G-Gf) + EX

= C + I + G + EX – (Cf + If +Gf)

= C + I + G + EX – IM

= C + I + G + CA

Expenditure by domestic

individuals and institutions

Net expenditure by foreign

individuals and institutions

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Short-hand Long-hand

GDP Gross domestic product

GNP Gross National Product

C Consumption Expenditures

I Investment Expenditures

G Government spending

X Exports

M Import

NX Net export

CA Current account

S Savings (of households, firms, G)

T Tax (net tax)

Interplay of variables

1. GDP = C + I + G + X – M

2. GNP = GDP + (net foreign

investment income + net transfers)

3. In terms of current account balance:

GNP = C + I + G + CA

4. GNP as the value of total income:

GNP = C + S + T

5. Based on 3 & 4

C + I + G + CA = C +S + T

6. I + G + CA = S + T

7. S + (T – G) = I + CA

8

Expenditure and Production in an Open Economy

CA = X – M = Y – (C + I + G )

When production > domestic expenditure, exports > imports: then

current account > 0 & trade balance > 0

When a country exports more than it imports, it earns more income from

exports than it spends on imports

Net foreign wealth is increasing

When production < domestic expenditure, exports < imports: then

current account < 0 & trade balance < 0

When a country exports less than it imports, it earns less income from exports

than it spends on imports

Net foreign wealth is decreasing

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Current account balance (CAM)

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• National saving (S) = national income (Y) that is not spent

on consumption (C) and government purchases (G).

Saving and the Current Account

CA = Y – (C + I + G ) implies…

CA = (Y – C – G ) – I = Sp + Sg - I

= Sp + (T-G) – I

S = Y – C – G

S = (Y – C – T) + (T – G)

S = Sp + Sg

Current account = national saving – investment

Current account = net foreign investment

A country that imports more than it exports has

low national saving relative to investment.

Y = C + I + G + X – M

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CA = S – I or I = S – CA or I + CA = SP + (T-G)

Countries can finance investment either by saving or by acquiring foreign

funds equal to the current account deficit.

A current account deficit implies a financial asset inflow or negative net

foreign investment. [NFI = Investment to abroad – Investment from abroad]

When S > I, then CA > 0 so that net foreign investment and financial capital

outflows for the domestic economy are positive.

CA = Sp + Sg – I = Sp – budget deficit – I Sg = T - G

A high government deficit causes a negative current

account balance when other factors remain constant.

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Savings and Investment in Cambodia (2002-2010)

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• A country’s balance of payments is an accounting record of a country’s trade in

goods, services, and financial assets with the rest of the world during a particular

time period (a year).

•The balance of payments accounts are separated into 3 broad accounts:

current account: accounts for flows of goods and services (imports and exports).

financial account: accounts for flows of financial assets (financial capital).

capital account: flows of special categories of assets (capital): typically non-

market, non-produced, or intangible assets like debt forgiveness, copyrights and

trademarks.

4. Balance of Payments Accounts

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How Do the BOP accounts Balance?

Due to the double entry of each transaction, the balance of payments

accounts will balance by the following equation:

Current account +

Financial account +

Capital account = 0

Double-entry bookkeeping in BOP implies that…

1) A credit entry records an item or transaction that brings foreign exchange

into the country.

2) A debit entry represents a loss of foreign exchange.

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Credits and Debits in the Balance of Payments Account

• The current account includes the value of trade in merchandise, services, income from investments, and unilateral transfers.

• Merchandise — tangible goods.

Merchandise account = the value of goods exported – the value of imports

• Services — travel and tourism, royalties, transport costs, and insurance.

Services account = the value of services exported – the value of imports

• Income from investments — interest and dividends.

Investment income account = income from investments abroad – income paid to foreigners on their investments in Cambodia

• Unilateral transfers — foreign aid, gifts, and retirement pensions.

Unilateral transfers account = any foreign aid and transfers received by Cambodia – that given to foreigners

Current Account

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Components of the Current Account

Components of the current account (common practice)

Credit Debit

1. Goods and services Export Import

2. Investment income Income received on

investments abroad

Income paid to foreigners on

investments in Cambodia

3. Unilateral transfers Transfers received Transfers paid

In some literature you may see 4 components of CA : Goods & services are

separated into 2 accounts.

18

CA of Cambodia, 2009

Millions of USD

1 Trade balance (1,634)

Export (fob) 4,196

Import (fob) 5,830

2 Net services 607

Receipts 1,625

Payments 1,019

3 Net investment income (408)

Receipts 57

Payments 524

4 Net unilateral transfers 293

Current account w/o official transfer (1,203)

Official transfer 593

Current account (610)

CA deficit mainly caused by

merchandise import exceeds

merchandise export.

Cambodia has positive

balance in services and

transfers

Negative investment income

balance due to Cambodian

debts.

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2002 2003 2004 2005 2006 2007 2008 2009 2010

(359) (450) (440) (591) (578) (693) (1,382) (1,203) (1,238)

CA balance of Cambodia 2002-2010 (excluded OT)

• A current account

deficit is not a sign of

weakness: in

Cambodia, the

economic boom of the

2000s increased the

demand for imports,

while export is

expanding gradually. • However, everyone agrees that CA deficit

cannot continue in the long term 20

Financial Account

• Financial account: a record of the flow of financial capital to and from a

country.

• What is the Financial inflow ?

It is the foreigners loan to domestic citizens by buying domestic assets

Domestic assets sold to foreigners are a credit (+) because the domestic

economy acquires money during the transaction

Financial outflow

Domestic citizens loan to foreigners by buying foreign assets

Foreign assets purchased by domestic citizens are a debit (-) because the

domestic economy gives up money during the transaction

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• 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 causes fear about the various types of flows

Financial outflows include:

A. Official reserve assets: gold, SDRs, $US, €EU

B. Government assets: loans to foreign governments, payments received on

outstanding loans,

C. Private assets: DI, foreign securities, loans to foreign firms and banks

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Financial inflows include:

A. Foreign official assets: gold, SDRs, major currencies

B. Other foreign assets: FDI, Cambodian securities, loans to Cam firms and banks

C. Net change in financial derivatives

• So, generally, financial account is divided into three categories:

Net changes in the country’s assets abroad

Net changes in the foreign-based assets in the country

Net change in financial derivatives

• Assets, a.k.a. wealth, include bank accounts, stocks and bonds, and real

property such as factories, businesses, and real estate.

• Financial derivatives are complex financial contracts, only recently

included in BOP (Cambodia yet has no such financial instrument)

Value of derivatives depends such variables as IR, ER, or commodity prices

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Financial account in many statistics, has 3 subcategories:

1. Official (international) reserve assets

2. All other assets

Include FDI, Portfolio investment and other financial investment

3. Statistical discrepancy

• Official reserve assets: foreign assets own by CBs to cushion against

financial instability.

Assets include government bonds, currency, gold and accounts at the IMF.

Official reserve assets owned by (sold to) foreign CBs are a credit (+) because

the domestic CB can spend more money to cushion against instability.

Official reserve assets owned by (purchased by) the domestic CB are a debit (-)

because the domestic CB can spend less money to cushion against instability.

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Capital account is a record of transfers of specific types of capital, such as:

Debt forgiveness

Capital transfers from/to foreigners

The transfer of real estate and other fixed assets, such as an embassy building

Capital account

• The current, capital, and financial accounts are interdependent

• Current account measures flow of goods and services

• Capital and financial accounts measure flow of financing

• Theoretically, sum of capital account and financial accounts equal to current

account with opposite sign.

Remarks on interdependence

Usually, CA = FA + Cap A + Financing + Stat discrepancy

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Cambodian BOP 2010

$ Millions

1 Trade balance (1,697)

Export (fob) 4,687

Import (fob) (6,384)

2 Net services 633

Receipts 1,653

Payments (1,020)

3 Net investment income (481)

Receipts 58

Payments (540)

4 Net private transfers 308

Current account w/o official transfer

(1,238)

5 Net official transfer 800

Current account (438)

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.

Caveat

26

$ Millions

6 Medium and long term loans 188

Disbursement 200

Amortization (12)

7 Foreign direct investment 553

8 Short-term flows, errors and omissions (160)

Capital and Financial Account 581

BOP (w/o financing) 143

9 Financing (143)

Change in foreign reserves (283)

Financing gap 140

All flows are net changes

(differences between assets

given and assets received).

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.

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• Why study the balance of payments?

BOPs help understand the broader implications of current account imbalances

and how to repair current account deficits

BOPs give signal how nations can avoid crises brought by volatile financial flows

and how they can minimize the damage of financial crises if such occur

The BOP and the Macro-economy

• Open markets cause 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 are volatile, economists agree that free flows are best

for economic efficiency

Financial Account Liberalization

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• Is the Private Assets

• Subcomponents of private assets: FDI, foreign securities, loans from/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

What has the largest share of financial flows?

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• Shifts in expectations can lead to sudden stoppages of financial inflows

• The result is a destabilizing of outflows of financial capital

• This occurrence has been labeled a sudden stop

• Sudden stops have been involved in the most financial crises in last 30 years

• Until recently, most nations limited the movement of financial flows related

financial account transactions across their borders

The EU liberalized financial flows between member countries only in 1993

5. Expectations in financial flows and limit on them

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• Debt is defined as money owed to nonresidents which must be paid in a

foreign currency.

• CA 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

• In low/middle income countries, external debt can lead to financial problems

• Unsustainable debt occurs for numerous reasons:

6. International Debt

Falling commodity prices

Natural disasters

Corruption

Foreign lending behavior 31

TABLE 9.8

The Five Largest Developing Country Debtors, 2007

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• A country runs a CA deficit, it borrows from abroad and raises its indebtedness

• A country runs a CA surplus, it lends to foreigners and reduces its indebtedness

• International investment position

= domestically owned foreign assets – foreign owned domestic assets

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 2005, the U.S. international investment position

= $11,079 billion – $13,625 billion = –$2,546 billion

7. The International Investment Position

33

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Special notice: in some statistics, capital account and financial account are combined

Current Account

Surplus and Deficit

Surplus and Deficit

BOP

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A hypothetical balance of payments table for a developing nation

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Before and After the 1980s Debt Crisis: Current Account Balances and Capital Account

Net financial Transfers of Developing Countries, 1978-1990 (billions of dollars)

13-37

8. The Issue of Payment Deficits

• Some initial policy issues

– International reserves

– Restrictive fiscal and monetary policies:

• Structural adjustment

• Stabilization policies

– Special drawing rights (SDRs)

– Trends in the Balance of Payments

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Developing Country Current Account, 1980–2009 (billions of dollars)

13-39

Accumulation of Debt and Emergence of the Debt Crisis

• Background and analysis

– External debt

– Debt service

– Basic transfer

Net capital inflow, FN, is

dDFN =d is percent increase in total debt D is total debt

Where

Basic transfer, BT, is

DrdrDdDBT )( −=−=

r is the average interest rate

Where

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9 Accumulation of Debt and Emergence of the Debt Crisis

• Origins of the

1980s Debt Crisis

– OPEC oil price

increase

– Increased borrowing

– Excess of imports

– Lagging exports

Petrodollar Recycling

13-41

• Origins of the Debt Crisis (cont’d)

–Debt-servicing obligations

–Debt-service payments

–Debt-servicing difficulty

–Oil shocks

–Developing countries’ two options:

1. Curtail imports and restrictive fiscal and monetary measures

2. More external borrowing

13-42

10 Attempts at Alleviation: Macroeconomic Instability, Classic

IMF Stabilization Policies, and Their Critics

• The IMF stabilization program

– Macroeconomic instability

– Stabilization policies

– Four basic components of IMF

stabilization program:

• Liberalization of foreign exchange and

imports control

• Devaluation of the official ER

• Stringent domestic anti-inflation

program

• Opening up of the economy to

international commerce

- Such policies can be politically unpopular

because they hurt the lower- and middle-

income groups.

- Less radical observers view the IMF as

neither a developmental nor an anti-

developmental institution.

13-43

• The IMF stabilization program

(cont’d)

– Tactics for debt relief:

• Debtors’ cartel

• Restructuring

• Brady Plan

• Debt for equity swaps

• Debt for nature swaps

• Debt repudiation

What is odious debt?

- Sovereign debt used by

an undemocratic

government in a manner

contrary to the interests

of its people

- It should be deemed

invalid

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11 Resolution of 1980s-1990s Debt Crises and Continued

Vulnerabilities

• Highly indebted poor countries (HIPCs)

• Some progress but vulnerabilities remain

45

Global Imbalances

46

12 The Global Financial Crisis and the Developing Countries

• Causes of the crisis and challenges to

lasting recovery

• Economic impacts on developing countries

– Economic growth

– Exports

– Foreign investment inflows

– Developing-country stock MKTs

– Aid

– Worker remittances

– Poverty

– Health and education

– General policy framework

• Differing impacts across developing

regions

- China and the ER controversy

- East Asia and Southeast Asia

except China

- India

- Latin America

- Africa

• Prospects for recovery and stability

• Opportunities as well as dangers?

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Concepts for Review

• Amortization • Balance of payments • Basic transfer • Brady plan • Capital account • Capital flight • Cash account • Conditionality • Current account • Debt-for-equity swap • Debt-for-nature swap • Debtors’ cartel • Debt repudiation

• Debt service • Deficit/surplus • Euro • External debt • Hard currency • Highly indebted poor countries (HIPCs) • International reserve account • International reserves • Macroeconomic instability • Odious debt • Restructuring • Special drawing rights (SDRs) • Stabilization policies • Structural adjustment loans