Balance of Payments: Analysis and Forecasting

1. Balance of Payments: Analysis and Forecasting Thorvaldur Gylfason Tunis, February 2006

2. 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.

3. 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

4. External transactions Real transactions Financial transactions Examples

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. Capital account • Also called capital andfinancial 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

14. 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

15. 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 external arrears

16. 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

17. 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

18. Links between BOP and national accounts

19. Links between BOP and national accounts

20. Links between BOP and national accounts

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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 to 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

30. 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

31. Financial programming framework • For example, based on what we know in 1999, what will BOP be in 2000? • Exports • Imports • Including interest payments on foreign debt • Capital flows • Including foreign borrowing and FDI • Reserve movements • Including target for reserves

32. Role of forecasting • Exogenous vs. endogenous variables • All variables are endogenous, but some are more endogenous than others • Key exogenous BOP variables • Exports • Capital inflows • Reserves (target) • Chief endogenous BOP variable • Imports

33. Role of forecasting Forecasts of exogenous variables enable us to forecast endogenous variables For example, once we have forecast X, F, and DR, we can derive the forecast of Z as a residual: Z = X + F – DR Forecast of Z needs to be consistent with forecasts of inflation and growth

34. Role of forecasting • History and targets • Record history, establish targets • Forecasting • Make forecasts for balance of payments, output and inflation, money • Policy decisions • Set domestic credit at a level that is consistent with forecasts as well as foreign reserve target

35. Financial programming step by step Do this in the right order • Make forecasts, set reserve target R* • E.g., reserves at 3 months of imports • Compute permissible imports from BOP • More imports will jeopardize reserve target • Infer permissible increase in nominal income from import equation • Infer monetary expansion consistent with increase in nominal income • Derive domestic credit as a residual • D = M – R*

36. 2.25 months = 9 weeks History • Known at beginning of program period: • M-1 = 800, D-1 = 650, R-1 = 150 Recall: M = D + R • X-1 = 700, Z-1 = 800, F-1 = 150 Recall: DR = X – Z + F • So, DR-1 = 700 – 800 + 150 = 50 • Current account deficit, overall surplus R-1/Z-1 = 150/800 = 0.1875 • Equivalent to 2.25 months of imports • Weak reserve position

37. Forecast for balance of payments • X grows by 10%, so X = 770 • F increases by 20%, so F = 180 • Suppose R* is set at 220, up from 150 • Level of imports is consistent with R* is • Z = X + F + R-1 – R* • = 770 + 180 + 150 – 220 = 880 • Reserve target is equivalent to 3 months of imports R*/Z = 220/880 = 0.25 BOP fore-casts

38. Forecast for real sector • Increase in Z from 800 to 880, i.e., by 10%, is consistent with R* equivalent to 3 months of imports • Now, recall that Z depends on PY • where P is price level and Y is output • Hence, if income elasticity of import demand is 1, PY can increase by 10% • E.g., 3% growth and 7% inflation • Depends on aggregate supply schedule

39. Forecast for money Recall M = D + R • If PY can increase by 10%, then, if income elasticity of money demand is 1, M can also increase by 10% • Recall quantity theory of money • MV = PY • Constant velocity means that • %DM = %DPY = %DP + %DY • Hence, M can expand from 800 to 880 ˜

40. Determination of credit • Having set reserve target at R* = 220 and forecast M at 880, we can now compute level of credit that is consistent with our reserve target • So, D = 880 – 220 = 660, up from 650 • DD/D-1 = 10/650 = 1.5% • Restrictive: implies decline in real terms • Need to divide permissible credit expansion between public sector and private sector

41. Financial programming step by step: Recap Forecasts of X and F play a key role: Lower forecasts mean lower D for given R* Sequence of steps R*ZYMD Z = X + F + R-1 – R* MV = PY Z = mPY D = M – R* Notice that Z now means nominal imports, not real imports as before

42. Forecasting • Need BOP forecasts to be able to design financial programs • Specifically, need forecasts of • Exports (exogenous) • Imports (endogenous) • Capital movements (exogenous) • Forecasts must be consistent with economic developments at home and abroad, and with one another

43. Forecasting exports 1 • From supply side, disaggregate • View main categories of exports separately Obtain price forecasts from international organizations, industry groups Obtain volume forecasts by surveying domestic producers. Recall that supply depends on price • Exports of coffee: PcXc • Exports of tea: PtXt • Exports of rice: PrXr Total exports: PX = PcXc +PtXt +PrXr Small country assumption: Export prices are exogenous

44. Forecasting exports 1 Divide through export equation by X to get expression for export price P P = (Xc/X)Pc +(Xt/X)Pt +(Xr/X)Pr Hence, aggregate export price index is a weighted average of export prices for individual commodities, with weights reflecting their relative importance to total exports

45. Forecasting exports 2 From supply side, another method without disaggregation + + Standard supply equation: Supply depends on relative price as well as output capacity Now defined as price of foreign exchange X = export volume (real exports) e = nominal exchange rate (kw/$) px = price of exports in $ pd = price of domestically produced goods in kw Y = output capacity at home

46. Forecasting exports 2 General formulation Exponential formulation with price and income effects expressed as elasticities a = income elasticity of exports b = price elasticity of exports

47. Forecasting exports 2 General formulation Exponential formulation with price and income effects expressed as elasticities a = income elasticity of exports b = price elasticity of exports

48. Forecasting exports 2 Why?

49. Forecasting exports 2 So, if x rises by 15%, z rises by 10%, and w rises by 5%, then y rises not by 20% but by 20.5% because (115*110/105) = 120.476 Simpler formula works only for small changes

50. Forecasting exports 3 From demand side, yet another method without disaggregation - + Standard demand equation: Demand varies inversely with relative price and directly with income X = export volume (real exports) px = price of exports in $ Pw = price of similar goods in world markets in $ Yw = world demand