Lecture 1

Lecture 1: International ImbalancesDr. Petre Caraiani

Balance of payments International transactions are recorded in the balance of paymentsWhat are the components of the balance of payments:The current accountThe financial accountThe fundamental principle of balance-of-payments

Double Entry BookkeepingAssume a simple example: US resident buys a Samsung smart phone with a value of 500USDWhat are the effects on the balance of payments:US current account decreases by 500 USDWhat happens to the financial account:- Samsung will hold assets in value of 500 USD (in the form of currency)- the financial account records a positive entry of 500 USD

Fundamental BoP identityAny change in the current account will be reflected in the financial account too: the same magnitude but the opposite signThe same applies to changes in the financial accountWe can write:Current Account Balance= - Financial Account Balance

Current AccountA) Trade Balance- Balance on Goods- Balance on ServicesB) Income Balance- Net investment income- Net international compensation to employeesC) Net Unilateral Transfer (private remittances)

Financial AccountThis the difference between sales of assets to foreigners and purchases of assets from foreignersA) assets owned by a national economy abroadB) assets owned by foreigners in a certain national economy

The Current Account

The Current Account

The Current AccountAn explanation for this:- US has a comparative advantage in the production of human-capital-intensive services (higher education, R&D)- imports basic goods (commodities, consumer durables)Current account and the balance of trade are very close to each other. Any implications?

The Current AccountOther potential situations:Both positive current account and trade balancea) Argentina: the trade balance surplus is bigger than the current account balance surplus;explanation? (interest rate payments made for its external debt)b) China: the current account balance surplus is bigger than the trade balance surplus;explanation? China is a net creditor to the worldc) Philippines has a current account surplus but a trade balance deficit;explanation? (large remittances)

The Net International Investment PositionWhy is the CA important?A: it provides an image of a countrys borrowing position (in a net sense);Lets take the case of US: large current account deficit implications?A: either it must reduce its international asset position OR increase its liability position (or both);

The Net International Investment PositionHow can the Net International Investment Position change?- Deficits/surpluses in the current account- The price of the financial instruments changesWe can write that:NIIP=CA + valuation change

Valuation ChangesLets take a hypothetical example to see how valuation changes can have an impact on the Net International Investment PositionAssume a countrys international asset position, consists in 10 shares of BMW. The price of each share is 10 euros. The foreign asset position is 100 euros. We also assume that the total liabilities are in sum of 150 dollars. Further assuming an exchange rate of 2 dollars per euro, implies a NIIP of 200-150=150 USD.

Valuation ChangesWhat happens if there is a shock in the exchange rate. Assume that the new exchange rate is of 1 USD to 1 Euro.The net asset position change to 100 USD. The NIIP becomes -50 USD.The country moves from being a net creditor to the rest of the world to a net debtor.

Valuation ChangesWhat happens if the price of foreign stock changes?

Negative NIIP/Positive NII

Two potential explanationsDark Matter Ricardo Haussman and Federico SturzneggerReturn differentials

Dark MatterUS authorities (to be more precise, the Bureau of Economic Analysis) may underestimate the holdings of net assetsHow could this happen?The records might not register the intangible human capital which generates returns that are however recordedThis unrecorded US owned foreign assets was billed as dark matter

Dark MatterLets assume a simple exampleMicrosoft opens a research center in BucharestThis would be recorded as foreign asset taking into account the different investments (residential, equipment, etc.)But the actual value of this investment might be much higher than the recorded ones due to the high value of human capital, so that this asset would be recorded at a lower actual value!At the same time, the profits generated by this investments, would enter the income account of the balance of payments

Return DifferentialsThe second explanation, as already mentioned is that of return differentialsWhat does this mean?US earns higher returns for its assets than the foreigners earn for assets hold in USWhy would this happen?US holds a variety of instrumentsBut foreigners holds mostly US government bonds providing lower returns

Can this explain the paradoxLet A be the level of US owned foreign assetsLet B be the level of liabilities positionLet ra the interest rate on A, while rb is the interest rate on BWe can write then:NII = ra *A rb*BAs far as the spread is big enough, this can explain the paradox

Can this explain the paradoxExampleSet rb equal the return of one-year Treasury securities: rb=0.32Set A and B to correspond to the levels in US:A=20.3 trillions; B=22.3 trillions USDSet the level of net investment income for the case of US: NII=191 billionsThen ra=1.3%