Balance of Payments

Trade deficits

When a country imports more than it exports

(Net exports > 0)

Balance of Payments

Records all economic transactions between residents of a country and the rest of the world.

• Current Account (Net exports, income and transfers)

• Capital Account (Net inflows/outflows - buying and selling of assets)

How do trade deficits relate to the difference between national savings and domestic investment

• Relationship among the trade balance and net capital inflows

• Relationship among net capital inflows and the difference between savings and domestic investment

Net capital inflows

Money is flowing into a country from abroad to buy domestic assets, foreigners are investing in/lending into the domestic economy

Total domestic savings

Private Savings = Disposable income - consumption (Y-T)-C

+Public savings = (T-G)

S - I

X - M (trade balance)

Intuition as to why  S-I = X-M

• S−I is excess saving: how much your country saves beyond what it invests domestically.

• X-M is the net export: how much your country sells abroad minus what it buys from abroad.

So the identity says:

A country’s excess saving is equal to the net amount of resources it exports to the rest of the world.

• If you save more than you invest (S>I), you lend the difference abroad → your net exports X-M > 0 (surplus).

• If you invest more than you save (S <I), you borrow from abroad → your net exports X−M<0 (deficit).

Current Account

Section of the Balance of Payments that records all transactions involving goods, services, income and current transfers between a country and the rest of the world.

What makes up current account (formula)

Trade Balance + Net Foreign Income balance + Net Foreign transfers

Interpretation of Net Foreign Income

• If a country earns more from its foreign investments than it pays out - positive net foreign income

• If a country pays more to foreign investors - negative net foreign income

Transaction that decreases current account balances

Debit

Transaction that increases current account balances

credit

CA > 0

Current account surplus

• Country is earning more than it spends (lends to the rest of the world)

CA < 0

Current account deficit

Country spending more on foreign goods/services/transfers than earnings

How does a country finance a current account deficit?

By borrowing and/or selling assets to foreigners

• Money is flowing out of economy but since all international transactions must balance deficit must be financed

• —> International capital flows in equity and debt (financial capital)

Capital Account

Records financial transactions between residents and non residents.

• Tracks how money flows in or out of a country due to investments.

Net capital inflow

Capital inflow less capital outflow

Capital inflow

Purchase of domestic assets by foreigners

Capital outflow

Purchase of foreign assets by domestic households and firms

Changes in the central bank’s holding of international reserves

Buying foreign currency —> increases reserves —> decreases money from domestic economy

A transaction that decreases the capital account

debit

A transaction that increases the capital account

credit

Are large, persistent current account deficits a problem?

• pessimistic: Current account deficits because we have low savings, debt burden will grow, consumption will have to fall in the future

• optimistic: Capital account surplus because our economy is good place to invest, large flow of savings from low-growth countries

Risk of current account deficits (risk of sudden stops)

Happens when foreign investors suddenly stop lending to investors in a country

• need for sharp adjustment via combination of sudden domestic recession and sharp real exchange rate depreciation

Net Foreign Liabilties

Gross foreign liabilities - gross foreign assets

Gross foreign liabilities

foreign claims on domestic economy (what foreigners own in domestic company)

Gross foreign assets

Domestic claims on foreign economy (what domestic residents own abroad)

Determinants of net capital inflows

• real return on domestic asset r

• real return on foreign assets r*

• risk premia, both home and abroad

Real Return on domestic assets r

High real return on domestic assets r makes

•  Domestic assets relatively more attractive to foreign investors (which tends to increase inflows)

• Foreign assets relatively less attractive to domestic investors (which tends to decrease outflow)

• Together, higher r increases net capital inflow

There is net substitution towards domestic assets

Net capital inflows are increasing in r

*investors shift their money to where returns are higher

Real Return on foreign assets r*

High real return on foreign assets rf makes

• Foreign assets relatively more attractive to domestic investors (which tends to increase outflow)

• Domestic assets relatively less attractive to foreign investors (which tends to decrease inflow)

• Together, higher rf decreases net capital inflow

There is net substitution towards foreign assets

International risk premia

International investing involves additional country-specific risk

• Exchange rate risk (currency values might change)

• Sovereign risk (gov. might default/impose capital contracts)

Risk averse investors need a risk premium as ‘compensation’

Changes in risk premia change demand for home and foreign assets

• Increase in risk premium on domestic assets decreases capital inflows

In crisis, can be a flight to safety

Explain why Increase in risk premium on domestic assets decreases capital inflows

Domestic assets look riskier —> foreign investors pull out —> inflows drop —> domestic investors may send their money abroad (flight to safety)

r* < ra explain

Net capital inflow
- excess demand for capital (domestic investment at r* exceeds domestic savings) and capital flows in from abroad

r* > a explain

Net capital outflow

• excess supply for capital (domestic savings at r* exceeds domestic investment at r*) and capital flows out to the rest of the world

Changes in Direction of Capital Flow

• shocks to domestic savings or investment can change direction of capital flows

What happens if there is a large enough increase in domestic savings

Flip from importing capital to exporting capital 

Eurozone Debt Crisis

The European debt crisis was caused by a variety of factors, including excessive deficit spending by several European country governments, lax lending habits by banks, and the resulting loss of confidence in European businesses and economies, which led to a drop in capital inflows from foreign investors, who were in part helping to prop them up.