Capital flows, exchange rate, trade balances, and all that stuff

1. Capital flows, exchange rate, trade balances, and all that stuff

2. Outline • Some very, very, very boring definitions and a little bit of theory • What do the data say? • Why? • Policy implications

3. The Balance of Payment • The BOP keeps track of a country's payments to foreigners and receipts from foreigners • Transactions resulting into a payment to foreigners are entered in the BOP as a debit (-). • Transactions resulting into a payment from foreigners are entered in the BOP as a credit (+).

4. The Balance of Payment • The BOP records two types of transactions: • Transactions that involve exports or imports of goods and services or transfers are registered in the current account • When a Lebanese citizen buys a US made product, this is recorded as a debit in the Lebanese BOP and as a credit in the US BOP. • And viceversa • Transactions that involve the purchase or sale of assets are registered in the capital account • When a Lebanese company buys a US company (building, bond, ..), the transaction is recorded in the Lebanese BOP as a debit in the capital account and is recorded in the US as a credit in the capital account • And viceversa • Why debit? Because Lebanon is "importing" the Asset

5. The Balance of Payment • By double-entry bookkeeping, every transaction enters into the BOP twice, once has a credit and once as a debit • Example: A US citizen buys hummus from Lebanon for USD2000 and pays with a check • Debit in US current account (import) credit in the Lebanese current account (export) • Credit in US capital account and debit in the Lebanese capital account (US sold a check to Lebanon)

6. The Balance of Payment • CAPITAL ACCOUNT+CURRENT ACCOUNT=0 • So, what does a Balance of Payment deficit mean?

8. CA deficit BOP deficit Trade balance: (1)+(2) = -500 Capital account balance: (7)+(12)+(8) = 350= Current account balance

9. Some Theory(but not too much)

10. very complicated equations ahead!!!

11. No, not that complicated!!!

12. Neoclassical growth • Assumptions: • Output (Y) is created by mixing capital (K) and labor (L) • Technology (A) determines the quantity of output generated by a given amount of K and L • If you like equations: Y=A*f(K,L) • If you believe in Cobb-Douglas Y=AKaL1-a • There is full employment (yeah, right!) • Growth (in per capita terms) is driven by investment (more K) or exogenous technological change (more A) • Since there are no unemployed resources, the only way to accumulate capital is to consume less • So, less consumption => higher savings=> more capital=> more growth • It's a bit more complicated than this

13. Neoclassical growth • In an open economy, investment can be financed with foreign savings • Closed economy • Y=C+G+I • Since S=Y-C-G • We have: S=I • Open economy • Y=C+I+G+EXP-IMP=C+I+G+CAB • Therefore: S=Y-C-G=I+CAB • And: S-CAB=I • Capital inflows are often referred to as foreign savings

14. Implications • Poor countries are poor because have a low capital stock • Return to capital should be higher in countries with a low capital stock • Capital should flow from rich to poor countries • Developing countries that receive more capital should grow at a faster rate • Capital account liberalization should lead to higher growth

15. Outline • Some very, very, very boring definitions and a little bit of theory • What do the data say? • Why? • Policy implications

16. Theory suggests that: • Capital should flow from rich to poor countries • Without capital controls rich countries should run current account surplus and poor countries should run current account deficits (capital should go South) • Capital account liberalization should lead to higher growth

17. Countries liberalized capital flows…

18. …but capital is going North! Current Account Balance (% of GDP) Global imbalances

19. ...still going 19

20. Current Account Balance (% of GDP)

21. Current Account Balance (% of GDP)

22. Current account Balance EMs (% of GDP)

23. But who is borrowing and who is lending? • Remember from our boring definitions: Current Account + + Nonreserve capital account + + Official reserves transactions = 0

24. The balance of payment in EMs The current account is positive (so DC don’t need capital) and yet the private sector is importing capital. Therefore, the official sector needs to export capital.

25. But who is borrowing and who is lending? • Remember from our boring definitions: Current Account + + Nonreserve capital account + + Official reserves transactions = 0 • The current account is positive (so DC don’t need capital) and yet the private sector is importing capital. Therefore, the official sector needs to export capital.

26. Stock of Internat. Res. (EMs)

27. But who is borrowing and who is lending? • Large gross flows but no net inflows • The traditional channel (developing countries need capital) is not at work • This is strange, but maybe there are efficiency gains associated with foreign private capital • Foreigners are better at allocating capital • FDIs have positive spillovers • … • If this were the case, we should observe that CAL has a positive effect on growth • (the second prediction)

28. Capital account liberalization and economic growth (IMF estimates)

29. Capital account liberalization and economic growth (Rodrik and Subramanian)

30. Capital account liberalization and economic growth (Rodrik and Subramanian)

31. Summing up • Theory • Capital should flow from rich to poor countries • The private sector should lend money to countries that need capital • Capital account liberalization should increase economic growth • Reality • Capital flows from poor to rich countries • The private sector lends money to countries that don’t need it • (and governments of developing countries lend it back to governments of rich countries) • Capital account liberalization has no effect on growth

32. Outline • Some very, very, very boring definitions and a little bit of theory • What do the data say? • Why? • Policy implications

33. Why doesn’t theory match the facts • Problems with the theory • Primacy of savings etc. • Yes, but not today • Problems with the international finanancial architecture • ILOLR does not work well and countries don’t trust it • Lack of cooperation

34. ILOLR does not work well and countries don’t trust it • When did global imbalances start? • Yes, after the Asian crisis • Why?

35. ILOLR does not work well and countries don’t trust it • If the global insurer does not work well, countries will self-insure with international reserves

36. Lack of cooperation • Consider two countries: • Country A has an inflation rate of 2% and an interest rate of 5% • Real interest rate 3% • Country B has an inflation rate of 8% and an interest rate of 11% • Real interest rate 3% • We expect that the currency of country B will depreciate • (if not country B will lose competitiveness and run larger and larger current account deficits) • By how much? • Approximately 6% per year • This is called uncovered interest parity (UIP) • This will also guarantee relative PPP

37. Lack of cooperation • We expect that the currency of country B will depreciate • But a smart investor can say: • I can borrow at 5% in A and lend at 11% in B. If the XR does not move too much, I can make easy money • This is called CARRY TRADE • Note that carry trade pushes money from A into B • By creating demand for the currency of B it prevents a depreciation of B. In fact, B may even appreciate • Exchange rates will move in the WRONG direction • Of course, this cannot last forever. • Country B will keep losing competitiveness and run larger and larger current account deficits • At the end they will be a currency crisis in B, • But, it may last for a while, and the longer it lasts the worst the crisis

38. Outline • Some very, very, very boring definitions and a little bit of theory • What do the data say? • Why? • Policy implications

39. Reform the International Financial Architecture • Self-insurance is inefficient and trade agreements cannot survive with "exchange rate disagreements“ • We need to re-establish trust in the global insurer • The world economy needs a new code of conduct going far beyond the existing framework of international rules of trade policy as agreed in the World Trade Organization (WTO) • We need mechanisms to prevent “wrong” movements of the exchange rate • UNCTAD PPP and UIP rules

40. Reform the International Financial Architecture • This reform process may take time • In the meantime, protect yourself: • If the risk taking behavior of financial intermediaries cannot be regulated perfectly, we need to find ways of reducing the volume of transactions… What this means is that financial capital should be flowing across borders in smaller quantities, so that finance is primarily national (Keynes) • members may exercise such controls as are necessary to regulate international capital movements.. (IMF Articles of Agreements)

41. Capital flows, exchange rate, trade balances, and all that stuff