Debt sustainability; balance of payments

Session 10

MSc Economic Policy Studies

Alan Matthews

Lecture objectives

• Introduce debt dynamics and debt sustainability• Describe and understand the balance of

payments accounts• Do international payments imbalances matter?• Addressing international payments imbalances

• Reading: McAleese Chapter 15 (pp. 384-7), 20

Source and forecasts: Goodbodys Sept 2010

The debt equation

(D/Y)t = (1 + (r - g)(D/Y)t-1 + d + b•where D is debt, r is nominal interest rate, g is nominal growth rate, d is primary deficit and b is bank capitalisation costs•The debt/GDP ratio this year is equal to the ratio last year, plus the primary deficit, plus bank costs, plus interest charged on last year’s debt less growth rate of GDP•Why the primary deficit? Because interest rates are not something government can control

Solving for the stable debt-to-GDP ratio

• (D/Y)t = (1 + (r – g))(D/Y)t-1 + d

• Expanding,

• (D/Y)t = (D/Y)t-1 + r(D/Y)t-1 - g(D/Y)t-1 + d

• We set (D/Y)t = (D/Y)t-1 and cancel terms

• 0 = r(D/Y)t-1 - g(D/Y)t-1 + d

• Moving d to the other side and dividing through

• -d/(r-g) = (D/Y)*

Debt sustainability

• If g > r, we don’t have a problem– If d is negative (primary surplus), debt/GDP ratio is

heading to zero– If d is positive (primary deficit), debt/GDP ratio is

headed for a stable and well-defined number

• If r > g, then stable debt/GDP ratio requires we run a primary surplus– If primary surplus is too small (if when divided by (r-g)

it is less than current D/Y ratio), then debt/GDP ratio will grow without bound

Debt sustainability

• Is there a magic number for the debt/GDP ratio beyond which markets lose confidence in state’s ability to repay?

• Continued borrowing is consistent with varying levels of debt/GDP ratio

• Solvency limit is historically conditioned by evidence of willingness to run that primary surplus

• May also be important whether debt is owed to foreigners or to domestic residents

• Recent IMF Staff Paper suggests that currently Greece, Italy, Japan, and Portugal appear to have the least fiscal space, with Iceland, Ireland, Spain, the United Kingdom, and the United States also constrained in their degree of fiscal manoeuver

Comments on Irish situation

• Irish scenarios demonstrated in attached debt spreadsheet

• Note distinction between gross and net debt– Distinction is cash positions held by the NTMA and

financial assets held in the NPRF

• Adding interest expenditure to the required primary surplus means overall government budget may still be in deficit– Interest payments may rise to 5.4% GDP in 2014

(Goodbodys)

– Overall deficit constrained by separate EU rules

Balance of payments

• The balance of payments is a set of accounts showing all economic transactions between residents of the home country and the rest of the world in any one year

• The current account in the balance of payments records all visible and invisible trade

• The capital account covers mainly capital transfers (EU grants and migrants’ net worth)

• The financial account in the balance of payments is a record of a country’s transactions in foreign financial assets and financial liabilities

CSO Student Corner on balance of payments

Balance of payments statement

Current accountGoods trade (merchandise trade)ServicesTrading and investment incomeCurrent unilateral transfersBalance on current account

Capital accountFinancial account

Balance on financial accountForeign direct investmentPortfolio capitalOther investmentChange in official reservesNet errors and omissions

2010, €bn37-9

-29-1-1-11313

894

-890

-12

Irish data. Source: CSO Balance of international payments release, Mar 2011

Some definitions

• Merchandise trade similar to balance of trade account (see Lecture 6) but valued at fob prices for both exports and imports

• Invisibles refers to balance of services trade, investment income and current transfers (net current receipts from EU and Irish Aid expenditure)

• Capital account transfers refer mainly to capital receipts under EU structural funds

• Financial account includes long-term capital flows (FDI and portfolio investment) and other flows which are mainly short-term loans and transactions in financial derivatives

• Reserve assets are non-euro denominated liquid assets and gold owned by the Central Bank

Further definitions

• Sometimes distinction is made between autonomous and accommodating transactions in the balance of payments

• Former are seen as ‘active’ transactions, responding to real changes in competitiveness conditions, while latter are ‘passive’

• Example: consider reactions to an increased demand for imports

• Line is drawn under the basic balance, but increasingly less distinct as capital markets become more liquid

Irish balance of payments trendsYear Merch-

andiseInvisibles Balance

on current account

Services Trading & invest-

ment income

Current transfers

Total Invisible

2001 30,494 -13,259 -18,295 305 -31,249 -757

2002 35,442 -13,779 -23,664 707 -36,736 -1,295

2003 32,604 -11,091 -21,947 432 -32,606 -2

2004 31,812 -9,721 -23,578 306 -32,993 -1,181

2005 28,218 -9,303 -24,870 265 -33,908 -5,690

2006 25,031 -6,797 -24,033 -506 -31,336 -6,304

2007 19,811 -1,121 -27,825 -990 -29,936 -10,124

2008 23,811 -7,670 -25,155 -1,154 -33,979 -10,169

2009 32,367 -8,416 -27,901 -901 -37,218 -4,853

2010 37,147 -8,520 -28,567 -1,172 -38,259 -1,113

Borrowers and lenders, debtors and creditors

The balance of payments is a flow concept

It shows whether a country is a net borrower or a net lender in any year

A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it.

A creditor nation is a country that has invested more in the rest of the world than other countries have invested in it.

The difference between being a borrower/lender nation and being a creditor/debtor nation is the difference between stocks and flows of financial capital.

Does it matter if a country is a debtor nation? Depends on how the borrowing has been used.

International Investment Position

• The international investment position (IIP) is a point in time statement of the value and composition of the balance sheet stock of an economy's foreign financial assets (i.e. the economy's financial claims on the rest of the world) and its foreign financial liabilities (or obligations to the rest of the world).

• The change in the IIP between beginning and end of period is equal by definition to the current account balance over that period (allowing for valuation changes reflecting changes in exchange rates and asset prices)

• Note reconciliation is also difficult due to large BOP balancing item ‘net errors and omissions’

Source: CSO Quarterly International Investment Position, Dec 2010

Ireland’s IIP

Source: Honohan, 2006

Source: Honohan, 2006

Understanding the balance of payments current account

• First, some national income accounting• Recall total income Y is defined from

expenditure side asY = C + I + G + X – M

• Y can also be defined asY = C + S + T

• In equilibrium, these two definitions are identical(I - S) + (G – T) = (M – X)

Balance of payments deficit = excess investment over savings plus government

budget deficit

Interpreting a current account deficit

• Two views– A deficit is a sign that a country is spending

more than it earns, a weakness which must be corrected by either/both reducing expenditure or switching expenditure from imports in favour of exports

– A deficit is a sign of strength because it means the country is sufficiently profitable to attract continued flows of foreign capital (focus on the basic balance)

The importance of sustainability

• “A country is said to have a balance of payments problem when the current account deficit and the accumulated international investment position have reached a level where continuance of the deficit is no longer judged sustainable” – McAleese

• Issues– Time dimension– Size of deficit in relation to GDP and debt position– Method of financing of deficit– Related to use of deficit (investment or consumption?)– Growth position

• Sustainability a matter of market confidence

Source: http://www.voxeu.org/index.php?q=node/2820 EA = Euro Area

Why an unsustainable current account deficit matters

– Adds to cost of foreign borrowing– Greater exposure to the volatility of

international capital markets with potential for lack of confidence scenario (Asian crisis 1997)

– Asset ownership moves into foreign hands– Arguably, within the euro zone a country’s

balance of payments no longer matters, but it remains an important symptom of underlying problems

Interpreting a current account deficit

• McAleese ‘tale of three deficits’– US deficit– Developing countries’ debt– Deficits in Euroland

Sustainability of the US current account deficit

• How sustainable is the deficit?

• Will it keep downward pressure on the US dollar?

• US deficit was running at around 6% of US GDP

• US dollar has depreciated by 40% relative to the euro between Jan 2002 and Jan 2004

The US deficit is sustainable

“Some argue our large trade deficit (or current account deficit) is responsible for the fall in the dollar's value. They have it backward. It is the flow of foreign investment dollars (the capital account) into the U.S. economy that drives the trade deficit. The U.S. economy's higher return on capital than Europe or Japan for the last 20 years caused private foreign investors to buy U.S. stocks and bonds and other assets. In addition, foreign governments, particularly of China, Japan and other Asian states, have steadily increased their purchases of U.S. dollars as reserve backing for their own currencies.”- Cato Institute economist Richard Rahn, Jan 2004

Note similarity to Box 20.1 in MacAleese

The US deficit is not sustainable

• High productivity growth and booming stock markets in the 1990s drove a wedge between private investment and savings

• US household savings now fallen to 1% of GDP

• US fiscal policy now hugely expansionary• Foreigners will lose their appetite to hold

US assets, causing interest rates to rise and restricting demand

Prospects for a soft US landing

• US economy insulated from the worst effects of an international financial crisis– Because of its size– The fact that most of its obligations are

denominated in its own currency– International role of the dollar underpins

demand for it– Damage may be felt as much by other

countries as by the US

Correcting a balance of payments imbalance

• Automatic adjustment mechanisms– Start with adverse shock to exports

-> fall in demand for imports used as inputs to production

-> fall in aggregate demand leads to fall in imports

-> monetary factors such as fall in real balances

-> supply side adjustments through changes in relative prices of traded/nontraded goods

Correcting a balance of payments imbalance

• Recall (I - S) + (G – T) = (M – X), problem is to reduce excessive (M-X)

• Expenditure reduction policies– Increase S– Reduce I– Reduce G – T through restrictive fiscal policies

• Expenditure switching policies– Commercial policy (tariffs, etc)– Improved cost competitiveness– Exchange rate changes

Restoring Ireland’s competitiveness

• Within the EU, commercial policy and exchange rate changes are ruled out

• Expenditure reduction policies (i.e. fiscal tightening) can lead to severe economic contraction and rise in unemployment

• Reduction in nominal wages required to mimic a real devaluation, but how to achieve?

Financial balances

• Derived from flow-of-funds data (CSO institutional accounts)

• Based on the identity that the three balances (private, government and foreign) must sum to zero

• Households are highly indebted and need to deleverage (i.e. run financial surpluses)

• Government is highly indebted and needs to run financial surpluses

• Implies need for substantial current account surplus• At eurozone level, implies strong depreciation in euro to

achieve, i.e. competitive devaluation

Global imbalances

Source: OECD Economic Outlook Nov 2010

Global imbalances

Global imbalances

Source: IMF World Economic Outlook, Oct 2010

Challenges for the G20

• How to address global imbalances when OECD countries are undertaking significant fiscal contraction?– Excess of global savings– Export-led growth model of China, Germany,

Japan– Currency appreciation by surplus countries?– Alternatives?