Balance of Payments: Analysis and Forecasting

Balance of Payments: Analysis and Forecasting Thorvaldur Gylfason

Outline • Balance of payments accounting • How BOP accounts are put together and how they relate to monetary, fiscal, and national income accounts • Balance of payments analysis • Economics of exports, imports, exchange rates, etc. • Balance of payments forecasting • How to forecast exports, imports, capital flows, etc.

1 Balance of payments accounting • Accounting system for macroeconomic analysis, in four parts • Balance of payments • National income accounts • Fiscal accounts • Monetary accounts First look at balance of payments accounts, and then look at linkages

External transactions Real transactions Financial transactions Examples

Recording external transactions • Balance of payments • BOP = Xg + Xs + Fx – Zg – Zs – Fz • = X – Z + F • = current account + capital account • Here • X = Xg + Xs Exports of good and services • Z = Zg + ZsImports of good and services • F = Fx – Fz Net exports of capital = • Net capital inflow

Balance of payments and reserves • Again • BOP = X – Z + F = DR where • R = reserves • Note: X, Z, and F are flows R is a stock, DR is a flow DR = R – R-1

Balance of payments and reserves • Again • BOP = X – Z + F = DR where DR = R – R-1 • Implications XDR FDR ZDR In practice ZF or DR

From trade balance to current account • Trade balance • TB = Xg + Xnfs – Zg – Znfs • Xnfs = Xs – Xfs = exports of nonfactor services • Znfs = Zs – Zfs = imports of nonfactor services • Balance of goods and services • GSB = TB + Yf • Yf = Xfs – Zfs = net factor income • Current account balance • CAB = GSB + TR = TB + Yf + TR • TR = unrequited transfers from abroad

Importance of net factor income Yf > 0 in Turkey Yf < 0 in Argentina • Net factor income from labor • Remittances from domestic workers abroad (e.g., Turks in Germany)minus those of foreign workers at home • Net factor income from capital • Interest receipts from domestic assets held abroad minus interest payments on foreign loans (e.g., in Argentina) • Includes also profits and dividends • Transfers also matter

Capital account • Also called capital and financial account • Four main items • Direct investment • Involves control by owners • Portfolio investment • Includes long-term foreign borrowing • Does not involve control by owners • Other investment • Includes short-term borrowing • Errors and omissions • Statistical discrepancy

Overall balance of payments • Five main financing items below the line • Gold • SDRs • Reserve position in IMF • Foreign exchange • Convenient to measure gross foreign reserve holdings in terms of months of import coverage – e.g., 3 months • Exceptional financing • Debt rescheduling • Accumulation of payments arrears

Overall balance of payments • Five ways to finance a BOP deficit • Drawing on gold reserves • Using SDRs • Using IMF resources • Running down foreign exchange reserves • … by running down foreign assets or accumulating foreign liabilities • Resorting to exceptional financing • Deferring debt repayments via rescheduling or accumulation of arrears arrears

National income accounts Y = C + I + G + X – Z • = E + X – Z • where E = C + I +G • CAB = X – Z = Y – E • Ignore Yf and TR for simplicity • S = Y – C – T = I + G – T + X – Z • CAB = S – I + T – G • CAD = Z – X = E – Y = I – S + G – T Private sector deficit Public sector deficit

Links between BOP and national accounts Y = C + I + G + X – Z GDP = C + I + G + TB GNP = C + I + G + CAB GNP – GDP = CAB – TB = Yf (if TR = 0) GNP = GDP + Yf • GNP > GDP in Turkey where Yf > 0 • GNP < GDP in Argentina where Yf < 0 GNDI = GNP + TR = GDP + Yf + TR

Links between BOP and national accounts

Fiscal accounts and links to BOP M = D + R DG + DP = D • Public sector • G – T = B + DG + DF • Private sector • I – S = DP– M – B • Now, add them up • G – T + I – S = • B + DG + DF + DP– M – B = • DG + DF + DP– M = • D – M + DF = -R + DF = Z - X • External sector • X – Z = R - DF F = DDF X – Z + F = DR

Monetary accounts and links to BOP • Monetary survey • M = D + R • From stocks to flows • M = D + R • Solve for R • R = M – D • Monetary approach to balance of payments • Still holds that DR= X – Z + F • Two sides of the same coin

2 Balance of payments analysis Payments for imports of goods, services, and capital Imports Real exchange rate Equilibrium Earnings from exports of goods, services, and capital Exports Foreign exchange

Real exchange rate Increase in Q means real appreciation e refers to foreign currency content of domestic currency Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

Real exchange rate Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

Overvaluation R moves when e is fixed If not, e moves R Deficit Imports Overvaluation Real exchange rate Fixed vs. flexible e Exports Foreign exchange

Overvaluation, again Overvaluation works like a price ceiling Supply (exports) Excess demand for foreign exchange makes its price rise Price of foreign exchange Overvaluation Demand (imports) Deficit Foreign exchange

Balance of payments equilibrium • Equilibrium between demand and supply in foreign exchange market establishes • Equilibrium real exchange rate • Equilibrium in the balance of payments • BOP = X + Fx – Z – Fz • = X – Z + F • = current account + capital account • = 0 under a flexible exchange rate

Balance of payments adjustment and policy Price level Aggregate supply An increase in prices induces producers to produce more, so that aggregate supply increases P Equilibrium An increase in prices induces consumers to buy less, so that aggregate demand decreases Aggregate demand GNP Y

Experiment: Export boom Price level AS AD GNP

Experiment: Export boom Price level AS B Exports increase, so that aggregate demand expands A AD’ AD GNP

Experiment: Export boom Price level AS B Excess demand drives prices up A C AD’ AD GNP

Experiment: Export boom Price level AS B As the price level rises, so does GNP along the upward-sloping AS curve A AD’ AD GNP

Comment on experiment • An export boom stimulates aggregate demand because Y = C + I + G + X - Z • Therefore, all other comparable boosts to aggregate demand will have same effect: • Consumption C (e.g., through lower taxes) • Investment I (e.g., via lower interest rates) • Government spending G (directly!) • GNP will rise when AD increases as long as AS curve slopes up

Economic policy • Economic policy instruments • Exogenous variables • Fiscal policy: Government spending, taxes • Monetary policy: Money, credit, interest rates • Exchange rate policy: Exchange rate (if fixed) • Structural policy: Liberalization, privatization, etc. • Economic objectives or targets • Endogenous variables • GNP level or growth • Price level or inflation • Employment, unemployment • BOP, exchange rate (if flexible), external debt Demand management Supply management

Aims of economic policy • Apply policy instruments to attain given economic objectives • External balance: conduct monetary, fiscal, and exchange rate policy so as to make the balance of payments position sustainable • Key to financial programming • Not only crisis management in short run • Internal balance: conduct policy so as to foster rapid, sustainable economic growth with low inflation and unemployment • Key to economic and social prosperity

Internal balance The AS schedule is the economy’s cost curve Wages are an important part of domestic cost of production Price level AS W up M up; G up; t down; e down AD GNP

Credit expansion Price level An increase in M or G or a decrease in t increases both Y and P for given W AS B A AD’ M up; G up; t down AD GNP

Wage increase AS’ Price level An increase in W increases P, but reduces Y AS W up B An increase in the price of imported oil has the same effect: stagflation A AD GNP

Devaluation Price level When e decreases, W often also rises, so that P increases, but Y may either rise or fall. Even if W stays put, AS will shift to the left as devaluation raises the price of oil and other imported inputs. AS’ B AS W up AD’ A e down AD GNP

Effects of changes in policy and wages: An overview

Balance of payments adjustment I Price level Suppose, at A, there is a deficit in the balance of payments (B  0) Need to offset increase in demand by reducing M or G or raising t to prevent inflation from weakening B again AS Then, to reduce deficit, consider lowering e (devaluation) to strengthen current account: this increases demand (shifts AD right) End result is still point A, but now with balance of payments equilibrium (B = 0). Level of GNP is unchanged, but its composition has changed. A e or F up AD M or G down, t up GNP

Balance of payments adjustment II Price level Suppose, at A, there is a deficit in the balance of payments (B  0) Can offset decrease in aggregate demand by lowering e AS Then, to reduce deficit, consider reducing M or G or raising t to reduce demand (shift AD left) End result is still point A, but now with balance of payments equilibrium (B = 0). Level of GNP is unchanged, but its composition has changed A e down AD M or G down, t up GNP

Balance of payments adjustment III Price level • Choice among alternative policy packages depends on initial position • If reserves are low and output is low (unemployment is high), devaluation may be advisable • If reserves are low and inflation is high, monetary and fiscal restraint may be in order • As a rule, do both at once AS A e down AD M or G down, t up GNP

3 Balance of payments forecasting The baseline scenario is a financial program, based on policies already in place • Task at hand • Develop financial program for 2000 • Use information available up 1999, plus forecasts • Two steps • Prepare baseline scenario assumingunchanged economic policy • If baseline scenario is unsatisfactory, then design financial program with better policies and better results

Financial programming framework Mutually consistent, or interlocking, forecasts • To prepare baseline scenario, need to complete four sets of forecasts • National income accounts • Inflation, growth • Balance of payments accounts • Exports, imports, capital flows, reserves • Fiscal accounts • Government spending, tax revenues, credit • Monetary accounts • Money, credit, foreign reserves

Balance of Payments: Analysis and Forecasting