Debt sustainability; balance of payments

1. Debt sustainability; balance of payments Session 10 MSc Economic Policy Studies Alan Matthews

2. 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

3. Source and forecasts: Goodbodys Sept 2010

6. 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

7. 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)*

8. 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

9. 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

10. 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

11. 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

12. 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 Balance of payments statement Irish data. Source: CSO Balance of international payments release, Mar 2011

13. 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

14. 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

15. Irish balance of payments trends

16. 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.

17. 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’

18. Ireland’s IIP Source: CSO Quarterly International Investment Position, Dec 2010

19. Source: Honohan, 2006

20. Source: Honohan, 2006

21. 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

22. 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)

23. 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

24. Source: http://www.voxeu.org/index.php?q=node/2820 EA = Euro Area

25. 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

26. Interpreting a current account deficit • McAleese ‘tale of three deficits’ • US deficit • Developing countries’ debt • Deficits in Euroland

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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?

34. 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

36. Global imbalances

37. Source: OECD Economic Outlook Nov 2010

38. Global imbalances

39. Global imbalances Source: IMF World Economic Outlook, Oct 2010

40. 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?