INTERNATIONAL FINANCE LESSON 1

The Savings Gap One way of thinking about the current account is as the difference between investment and national savings  If the US is investing more than it is saving, these inv

National Income and

Product Accounts and the Current Account

 Course Webpage:

http://www.uwm.edu/~amurshid/finance.html

 Classes: Mon, Wed 11.00 am – 12.15 pm

 Office Hours: Wed 2.00 pm – 3.00 pm

 What causes large current account deficits?

 Current account deficits and crises

 The Asian and Latin American crises

National Income Accounting:

GDP and GNP

 Gross domestic product is the value of

and services

 Gross national product is the value of

production

Final Goods and Intermediate Goods

 What is a “final good”?

 A good used for final consumption, e.g

a loaf of bread that you consume

 Intermediate goods are inputs in the

production process, e.g steel used in the manufacture of a car

Double Counting

 Why are only “final goods and

services” counted?

 Because otherwise you would count the

same good more than once

 This is called double counting

Components of GDP

 Economists often split aggregate

expenditure into four components—

consumption (C), investment (I),

government spending (G), next

exports (NX)

 Hence we can write GDP = C + I + G +

NX

What’s the Difference Between

GDP and GNP?

 GDP is the value of all output produced @

home

 GNP is the value of all output produced using

domestically-owned factors of production

 Some output produced @ home is produced by foreigners

(this should not count in GNP)

 Some output produced abroad is produced by

domestically-owned factors (this should count in GNP)

 Hence GNP = GDP + net factor income from

abroad

How Big is the Difference?

 For the US the difference is small (0.08%)

 For Mexico (-4.9%) and Ireland the

difference is substantial (-10%)

 The numbers in brackets are (GNP-GDP)/GDP

in 1987

 Mexico has a large foreign debt on which it has

to pay interest to foreigners

 Due to heavy foreign investment in Ireland,

many firms in Ireland are foreign owned

What’s Debt Got to Do With It?

 In other words what has net factor

income got to with debt?

 Net foreign assets (NFA) = US assets–

US debt

 Define i as the average interest on NFA

 Then net factor income from abroad is

just iNFA

What’s Debt Got to Do With It?

 Hence the difference between GDP and GNP is proportional to NFA

 If a country is a debtor nation NFA<0

 If a country is a creditor nation NFA>0

The Trade Deficit and the

Current Account

 What is a trade deficit?

 A country runs a trade deficit when it

imports more than it exports, i.e NX<0

 Is the trade deficit synonymous with a

current account deficit?

 No

 The current account deficit measures a

country’s total (current-period) deficit to the world?

What’s the Difference Between the Two

 What’s missing in the trade deficit?

 Interest payments on your accumulated debt

 Alternatively if you are net creditor you receive interest on your accumulated

Definition of the Current Account:

Trade Deficit + Net Factor Income

 Current account = trade deficit + net

factor income from abroad: CA = NX+

iNFA

Definition of the Current

Account: Income - Expenditure

 We can write the current account as:

 CA = GNP – (C + I + G)

 GNP is simply a country’s income

 (C + I + G) (called “domestic absorption)

is simply what a country spends

 So countries run CA deficits when they

spend more than they produce

Definition of the Current

Account: Savings Gap

 We can also right the current account

as: CA = S N – I

 Here S N is just total national savings, and

I is domestic investment

Definition of the Current

Account: Savings Gap

 How do we derive this identity?

Talking Points About the

 We will organize answers primarily by

considering US recent experience

The US Trade Deficit

 “The United States recorded a $435.2 billion trade

deficit for 2002, the largest imbalance in history huge trade deficits represent the loss of millions of manufacturing jobs as U.S companies have been battered by what the critics say is unfair competition from low-wage countries that stifle labor rights and have lax environmental protections…the

administration contends that it is pursuing the

correct procedure in trying to cut global trade deals that will lower high [tariff] barriers in other countries

in a way that boosts American exports.” Source:

USA Today

Thrust of the USA Today

Article

 Current accounts are bad

 Associated with job losses

 Caused by tariff barriers and unfair

competition

 Solution is freer trade and a level

playing field

Root Causes of the US Deficit

 High tariff barriers and unfair

competition?

 Is this what causes a current account

deficit?

 Perhaps the removal of trade barriers

may mitigate the deficit, however the underlying reasons for the deficit has to

do with consumption, investment and savings patterns

Why Do Countries Run

Current Account Deficits?

 To start with write down the different

definitions of the current account

A Role for Tariffs?

 The current account is the trade deficit

plus net factor income from abroad

 For the US net factor income is relatively

small

 What causes trade imbalances

 High tariff barriers abroad

 Unfair practices and a level playing field

Solutions to the Deficit

 Remove tariff barriers

 Introduce similar production practices

 But labor is cheap in some countries,

so will free trade work

 Structural adjustment in the US

necessary in increasingly global world

Emphasis on Prices

 The current administrations places

emphasis on the relative prices of imports and exports

 Several factors drive imports and

exports not just relative prices

The Savings Gap

 One way of thinking about the current

account is as the difference between

investment and (national) savings

 If the US is investing more than it is saving,

these investments need to be financed by

foreign investors

 If we think about the current account in this

way, it helps emphasize that a fall in national savings or a rise in investment can cause a current account deficit

An example of foreign borrowing would be say when Microsoft issues a bond, which is

purchased by foreigners

+

How it Works?

 In this example

investment is greater than the sum of private savings and

government savings

 The shortfall is being

made up by foreign borrowing

 This shortfall is the

current account deficit

= 500

A Reduction in Government

Savings

 Investment and private

savings is unchanged however the

government is now running a budget deficit

 Part of private savings

is been used to finance purchases of

government bonds

 The larger shortfall is

being made up by foreign lending

= 2200

Without the increase in foreign investment in the

US, the government deficit would cause private

investment to contract (and interest rates to rise)

A Reduction in Private Savings

 Keeping investment

constant, we now assume that private savings falls

 Again the shortfall is

made up by a rise in foreign borrowing

= 2500

A Rise in Investment

 In this example

investment rises, with

no change in private or government savings

 The result is again a

sharper shortfall, which is made up by

an increase in foreign borrowing and a rise in the current account

= 2500

Is Investment Driving the US

Current Account Deficit?

 Some have argued (e.g William Poole

President of the Federal Reserve Bank

of St Louis) that the US current

account deficit increased in the 90s

because of a rise in investment This may be true, but the latest US CA

figures surely cannot be attributed to

rising investment!

Current Account and Domestic Absorption

 Alternatively we can think about the

current account as the difference

between earnings and expenditures

 This expenditure is referred to as

domestic absorption

 CA = Y - (C + I + G)

Current Account and Domestic

Absorption

 If we think about the current account in

this way, it helps emphasize that a

deficit is caused by either a rise in

consumption, a rise in government

spending, or a rise in investment

Two Ways of Saying the Same Thing

 A rise in consumption and government

spending of course corresponds to a fall in national savings

 Essentially then whether we think about the

CA as the savings-investment gap or as the difference between income and domestic absorption does not matter Although one approach emphasizes expenditures, while the other approach emphasizes savings

behavior

So What Has Driven the US

Current Account Deficit?

 Different things

 The US started running current

account deficits in 1982

 The cause was without a doubt a rise in

government spending and a fall in tax revenues, that is a rise in the Federal government budget deficit

US Current Account Deficit

and Budget Deficit

 Until about

1992 the current account deficit is highly correlated with the budget deficit

Current account deficit

Budget deficit

What Has Driven the Current

Account Deficit from 1992?

 From about 1992 onwards, the US budget

deficit has declined but the current account deficit has continued to rise

 This trend can be explained by the sharp

rise in US investment

 In addition to the rise in US investment a

spending binge by US consumers also

implied a sharp fall in national savings

Robust Climate for Investment

No More

 The CA deficit in the 1990s can be attributed

largely to a robust climate for investment

and the immense US expansion

 However in the last two years the budget

surplus has turned into a deficit, consumer spending and investment are at depressed levels, thus the driving force behind the CA deficit are again Federal and local

government deficits

Is the Trade/Current Account

Deficit Bad?

 The US Today article suggests that

current account deficits are bad, that they are associated with a loss of jobs and lower wages

 In fact a deficit may or may not be a

bad thing

The Current Account and Jobs

 First it is important to dispel a myth that the current

account deficit is somehow related to joblessness

 During the 1990s, US services and also

manufacturing grew, as the economy went through the longest period of expansion in history and

unemployment fell to its lowest levels

 Often we find that current account deficits rise

during periods of expansion, its unclear therefore what leads critics of the CA deficit to link it to

joblessness

When a Deficit Finances

Investment

 Sometimes a deficit arises because of

rise in investment Thus in the US a

robust climate for investment in the 90s caused the current account deficit to

increase

 This should be viewed as a good thing,

since investment will contribute to

future growth

Tradable and Export Goods

 When the investment is in the tradable

and export sectors, there is greater

justification for running a current

account deficit, since growth in these sectors will eventually help narrow the trade deficit

 If increases in investment are inducing

a current account deficit, it should be viewed as more sustainable

 However some investments can turn

out to be bad and this can have

implications for the terms at which

foreigners are willing to lend to the

deficit country

Bad Investments

 Not all investments are good investments

however

 Some investments are just speculative and

fuel asset price bubbles Other investments are in non-tradables, which do not

necessarily help lower future deficits

 The extent to which deficits finance bad

investments will depend on the extent of

development of the financial sector

Cheap Imports and Low

Inflation

 Another often overlooked reason as to

why a deficit may not be a bad thing is that an inflow of cheaper imports limits inflation and allows manufacturers to benefit from these cheaper imports by keeping costs of production low

 Current account deficits are not always

sustainable

 Lenders may stop lending abruptly

 May lead to a financial crisis

Recent Experience Asia 1997

 In 1997 prior to the Asian crisis several Asian

countries ran large CA deficits

 Many investments were in real estate

 Real estate price bubble burst

 Bankruptcy and bank failures

 Many investments turned out to be non-profitable

 Government tried to always encourage investment

 Not enough scrutiny by banks on who they were lending too (moral hazard arising from government loan guarantees)

Recent Experience Debt Crisis and Mexico 1994/95

 1970s many developing-country

governments borrowed to finance

spending

 Then in 1982 US raised interest rates,

which triggered a debt crisis

 Mexico 1995

 Optimistic outlook caused C↑ and S↓

 Unsustainable CA deficit and a crisis in

1994/95