Chapter 2: The Global Flow of Funds

INTRODUCTION AND SUMMARY

A nation's international transactions are captured in their balance of payments (130P). Essentially an
accounting balance sheet, the BOP is divided into two ledgers. The current account measures trade in
goods and services, while the capital account documents trade in financial assets. A country's accounts
must balance, meaning that any deficit in the current account must be offset by a surplus in the capital
account. Thus by definition, a country with a current account deficit consumes more than it produces and
must borrow savings from abroad.

Economic theory provides little guidance on the optimal level of the current account. The
macroeconomic impact of a current account imbalance depends on how a nation uses the imported capital
as well as how much it has borrowed from abroad in the past. As with any borrower, a nation's ability to
service its future foreign debts without drawing down future consumption turns on whether it uses the
capital to finance current consumption or investment.

Persistent current account deficits generally lead to a rise in a country's net external indebtedness and a
growing risk premium on its debt. In addition, if foreign capital inflows do not balance the current
account, then changes in interest rates, exchange rates, and other economic variables usually result.
Empirically, we observe a positive relationship between a nation's accumulated current account deficit
and the real long-term interest rates that a government pays on its debt. In addition, countries that run
chronically large current account deficits tend to suffer currency depreciation over time.

The short-term relationship between a nation's current account balance and its currency is difficult to
predict because it depends on a broad set of factors. An appreciating currency dampens foreign demand
for a nation's goods and services while making foreign goods cheaper so it usually raises the country's
merchandise trade balance. Furthermore, if a country is running a large current account deficit, then the
adjustment of the deficit toward balance typically requires that the real value of that country's currency
fall relative to the currency of its major trading partners to improve the country's trade balance. However,
whether a country's current account balance will respond to an adjustment in the currency value depends
on other factors such as the state of the economy and the desirability of a country's assets in international
markets.

This chapter is organised around three major topics: First, we define the BOP and describe the standard
national income identities as they relate to the 130P. A case study of the US-Japan bilateral trade balance
is used to illustrate these concepts. Second, we explain the macroeconomic implications of the 130P,
principally as it relates to inflation and interest rates. New Zealand's current account problems in the
mid-1980s demonstrates how extreme saving - investment imbalances can damage an economy. Lastly,
we describe both the short-term and long-term influences of the BOP on exchange rates. Recent trends in
the US current account illustrate the structural impact of different sources of current account deficits.

DEFINING THE BALANCE OF PAYMENTS

Fundamental supply and demand for currency is derived from international trade in goods and services,
foreign direct investment, or capital flows. The balance of payments is the broadest bookkeeping
legend of a country's commercial transactions with the rest of the world. The two portions of the BOP are
the current account, comprised of all cross-border goods and services trade; and the capital account, in
which international asset transactions are measured. It is important to understand a country's balance
sheet because entries in the BOP usually involve a foreign currency transaction.

The current account is the sum of a country's merchandise trade balance, service balance, and unilateral
transfers within a period of time. The merchandise trade balance is the difference between the value of
what a country exports and what it imports. The service balance is composed of interest payments,
dividends, freight and insurance, and tourism. The unilateral transfers balance aggregates such items as
governmental aid and the repatriation of foreign earnings.

Cross-border financial transactions for a given period are measured in a country's capital account. These
transactions can be associated with either international trade or simple portfolio shifts in the form of
government or private bonds, equities, or bank deposits.
A country's balance of payments accounts must balance. The capital account exactly offsets the current
account which means that a current account surplus exactly equals a capital account deficit and
vice-versa. Thus, the net change in the ownership of foreign assets is represented by the current account.
A current account deficit resulting from a trade deficit must be offset by an equal amount of foreign
borrowing or investment or by running down the central bank's foreign exchange reserves. Nations with
large reserves of foreign assets can sustain modest current account deficits without a major
macroeconomic adjustment. Nations that must chronically borrow abroad to finance their current account
deficit remain at the mercy of foreign creditors to finance the debt.

BALANCE OF PAYMENT IDENTITIES

Another way to regard the current account balance follows the identity of national income accounts.
Recall that in equilibrium an open economy's total output (Y) equals consumption (C), plus investment
(.1), plus government spending (G), plus net exports (X - IM). Symbolically, this statement can be
represented by:

Y = C + 1 + G + (X - IM).

It is also a basic identity that total output (i.e., GDP) can either be consumed (C), saved (S), or taxed by
the government (T):

Y = C + S + T.

These two expressions for Y are necessarily equivalent in equilibrium. Netting out consumption from
both sides and rearranging terms involving the government on the left-hand side and the private sector on
the right reveals:

G - T = (S - 1) - (X - IM).

In other words, the government balance, (G - T), equals the economy's private saving balance, (S - I),
minus the trade balance, (X -.IM). Since any imbalance in the current account must be balanced by an
equal and opposite amount in the capital account, we can replace the current account balance term, (X
-IM), in the previous expression with net capital flows:

G - T = (S - I) + net capitalflows.

The elements of a country's balance of payments can be expressed in terms of its savings and investment
balance:

current account = (S - I) - (G - T) = capital account

This equation is the basic current account identity: the current account balance is equal to private
after-tax savings minus private investment spending minus government savings. Intuitively, if the supply
of after-tax savings falls short of a nation's private investment demand and government deficit, then the
economy will run a current account deficit.

The national income identity means that one or more of three things must happen to reduce or eliminate a
current account deficit. First, with static investment and the public deficit,, private savings must rise.
Second, holding savings and the government deficit constant, the propensity of private firms to invest
must fall. Or third, for a given quantity of private savings and investment, the government's budget
deficit (i.e., the government's lack of propensity to save) must decline.

CASE STUDY: THE US-JAPAN BILATERAL BALANCE

To illustrate these concepts, we examine the bilateral relationship between the US and Japan. The US is
currently running a large annual current account deficit, largely as a result of a private savings imbalance
(overall US government accounts are closing in on balance). In contrast, Japan has a substantial surplus
of domestic savings that finances an oversized public sector deficit. These imbalances are reflected in a
sizable and politically sensitive bilateral trade imbalance between the two nations. In an integrated world
financial system, Japanese investors must recycle their large trade surpluses by
 either direct or indirect lending to the US.

There are several possible policies that could

close this trade imbalance. First, the US could
persuade the Japanese to open their markets
more to international competition so that the
US could export more to Japan. This structural
solution is a longer-term response to the
situation. Second, changes in macroeconomic
policy could narrow the bilateral US-Japan
trade balance. If the Japanese officials
employed a loose monetary policy and a more
expansionary fiscal policy, then domestic
demand would rise and their trade surplus
would drop. Conversely, the US could reduce
its government budget deficit and perhaps even
run surpluses to reduce its trade 4eficit. In fact,
officials in both countries have adopted policies
along these lines.

MACROECONOMIC IMPLICATIONS OF
THE BOP

The macroeconomic ramifications of a nation's

international transactions depend crucially on
two factors: why a nation runs its current
account balance and how much it has borrowed
in the past. A current account deficit or surplus
can be either a positive or negative
development for an economy, depending on the source of the imbalance. However, over the long term,
nations that run chronic current account deficits have higher inflation rates and pay higher real interest
rates than nations that do not. At the conclusion of this section, we present a case study of New Zealand's
external account problems in the mid 1980s. The example illustrates that if foreign capital inflows do not
offset burgeoning, unchecked current account deficits, then changes in interest rates, exchange rates, and
other economic variables will occur.

A country's current account position can be either beneficial or detrimental to an economy. Just as
households cannot borrow indefinitely to maintain their current consumption in excess of income and
firms cannot use debt to cover their operating losses forever, nations cannot use foreign savings to
finance current consumption without end. However, if foreign capital is advanced to purchase investment
equipment that will produce a long-lasting stream of returns that can service future foreign claims on its
output, then running a current account deficit may be reasonable and beneficial for an economy.

A current account deficit stemming from an inflow in capital to finance an economy's physical or
tangible investment spending is generally not problematic. Indeed, countries in the early stage of
development usually run current account deficits to finance their expansion. For example, South Korea
ran a current account deficit averaging 5% of GDP in the 1970s, a move designed to finance its rapid
growth. In the past decade, Korean real GDP growth has averaged 9.5 % and the nation has run a current
account surplus averaging 1% using the productive investments it made in the 1970s.

Conversely, a large current account surplus may stem from insufficient domestic investment
opportunities that leaves excess capital to be exported abroad. This capital outflow could negatively
affect domestic growth. Japan has consistently run a current account surplus averaging 2.4% of GDP in
the past decade. Domestic investment of close to 30% of GDP in the past five years was 60% higher than
either US or European Union investment. These investments did little to benefit the Japanese economy,
however, because growth in this period consistently lagged both the US and Europe.

Current account deficits that result from excess consumption (i.e., inadequate domestic savings) are
usually detrimental to an economy. In the early 1980s, the US experienced a dramatic widening of its
current account deficit due to a sharp rise in the government budget deficit, i.e., public dissavings,
together with a decline in the private savings rate. Private investment remained basically constant. This
set of events suggests that imported foreign capital was being used to finance consumption rather than
investment. Government expenditures channeled into consumption make it difficult for succeeding
generations to repay the loans because there is no income stream generated.

Large public sector budget deficits are not the only source of unhealthy, consumption-led current account
deficits. The case of Mexico illustrates how a country can run into trouble with a large current account
deficit, even if it does not result from poor public finances. Mexico's current account deficit in 1994 was
close to 8% of GDP while its official budget deficit was under 1%. The experience in Mexico
demonstrates that private borrowers such as banks that incur too much debt can be quickly shut off from
international capital if foreign investors believe that a country is not credit worthy. It is still too early to
know whether the structural reforms put in place following the 1994 devaluation of the Mexican peso
will lead to long-run, more sustainable growth.

In addition to the source of the current account imbalance, the degree of past borrowing is also critical in
determining its macroeconomic impact. A country running a modest deficit such as Germany after many
years as an international creditor might not be adversely affected, even if the deficit is being used to
finance current consumption. In short, persistent current account deficits generally boost a nation's net
external debt causing a rise in both the credit and inflation risk premia on those assets and higher
borrowing costs.

The rapid growth of external debt can harm a nation's economic performance because it is inflationary.
Countries who are running current account deficits are essentially over-consuming relative to domestic
output, a basic inflationary condition. Nations-that borrow foreign capital also have significant incentive
to inflate their way out of their debt. This situation can feed upon itself because countries with poor
current account and inflation experiences are often
forced to cheapen their currencies (a classic inflationary exercise) to attract the foreign capital needed to
roll-over their external debt.
 This observation is well supported by historical
record. We find a -80% correlation between the
average current ac6ount to GDP and the annual
inflation rate in a cross-section of nations between
1970 and 1995. Switzerland, the Netherlands,
Japan, Belgium, and Germany have been net
exporters of capital in the past 25 years and these
countries have also had some of the lowest annual
average inflation rates.

Empirically, we also observe that countries that

have had large current account deficits pay higher
real interest rates (i.e., net of expected inflation)
on average in world financial markets. Japan
provides an example of the advantages of running
external surpluses. Because there is considerable
excess savings in the Japanese economy,
risk-adjusted rates of return have been driven
down on domestic assets in Japan. As a result,
Japanese government bond yields are among the
lowest in the world.

Risk premia on debtor countries' assets tend to

rise when they most need foreign capital, i.e.,
during periods when financial liquidity is being
constrained by major central banks. For example,
when the US Federal Reserve began raising short
rates in 1994, countries with higher outstanding
external deficits suffered disproportionately
relative to those without such records. Australia,
which had been running current account deficits
of over 4% of GDP, witnessed a 360-basis-point
increase in its government bond yields in 1994.

Because government fiscal savings or, more

frequently, dissavings is a large component of
their country's savings-investment balance, we
observe a strong relationship between an
economy's government budget deficit relative to
output and the government's real borrowing costs.
Until very recently Canadian, Italian, UK, and
Swedish government budget balances were
considerably above those recorded in other major
developed countries. As a result, government
bond yields in these countries have generally been
significantly above average. The converse is also
true. Nations that do not accumulate large public debts pay lower average real interest rates. For example,
Switzerland has an average net public debt figure substantially below average so Swiss real long-term
interest rates have been significantly below US rates.

CASE STUDY. NEW ZEALAND'S 1980S CURRENT ACCOUNT NIGHTMARE

New Zealand's experiences in the early 1980s provides an example of what can happen to a nation that
accumulates extreme savings-investment imbalances. It ran annual current account deficits averaging
6.2% of GDP. Government consumption was a principle source of the imbalance. New Zealand's general
government fiscal deficit peaked in 1982 at 6.6% of GDP. New Zealand was on the verge of default on
its public external debt. Policy makers were overwhelmed by an uncontrollable domestic inflation and
high long-term interest rates. The NZ$ depreciated by over 50% in five short years. International bankers
refused to provide New Zealand with any more credit in 1984, so the economy ground to a halt in the
second half of the decade.

In response to this crisis, New Zealand's political leaders took dramatic steps to reform their nation's
economic policies. To correct the current account imbalance, government finances were tightly
disciplined, for instance, reducing subsidies to farmers, cutting social welfare benefits, and deregulating
the labour market. The economy opened up to international competition to build a globally competitive
export sector. Officials made the central bank independent and gave monetary policy makers a strict
inflation target so that the nation could build credibility in international financial markets.

Today, slightly more than a decade later, the results have been impressive. The government of New
Zealand has run fiscal surpluses for the past four years and it is committed to the goal of paying off its
foreign debt. New Zealand has managed to run a modest trade surplus of US$2.8 billion in the past three
years. Economic growth has averaged 3.9% since 1992, double the rate at which the economy grew in
1980s. Unemployment has fallen 4.5% from its peak in 1992 to just 6.1% today. Annual underlying
inflation has averaged only 2.0% within this period. Economic reforms associated with the financial
collapse significantly improved New Zealand's long-run economic performance and raised its citizens
standard of living.
CYCLICAL BOP INFLUENCES ON EXCHANGE RATES

Over short periods, exchange rates both influence and are influenced by the current account balance in a
complex, non-linear fashion. Since a nation's balance of payments must balance, equilibrium must be
simultaneous in two markets: the goods market (i.e., the current account) and the financial market (i.e.-,
the capital account). Disturbances in one market may have important implications for how the other
market will clear. Once again, the reason for and duration of a nation9s current account imbalance has
important implications for its short-run effect if only on the exchange rate.

First, we examine a shock in the goods market. The standard economic view holds that a country's
currency depreciates when its trade deficit widens. Take the case in which there is a positive shock to
domestic demand. Imports usually expand faster than exports and the trade deficit grows. To achieve
equilibrium in the capital account, domestic interest rates usually need to rise and the currency
depreciates to attract counter-balancing inflows of foreign capital.

The financial market's response to a demand shock depends on the anticipated reaction of policy makers.
Countries with strong, independent, and credible central banks usually witness currency appreciation in
response to a positive demand shock as investors anticipate the move to a restrictive monetary policy
stance. For instance, the DM appreciated in
the wake of the unification boom even though
the current account fell into deficit. Investors
correctly predicted that the Bundesbank would
offset easier fiscal policy with a tighter
monetary stance.

A country's borrowing history is important in

this process. If a country has a large external
surplus, such as Japan, then a cyclical or
transitory deterioration of the trade balance
may have little consequence for the currency.
In other cases, a shock to domestic demand
that leads investors to expect higher interest
rates will significantly raise the risk premium
for inflation on the nation's debt assets. For
instance, Italy's large stock of existing
government debt means that higher expected
short-term interest rates worsen the country's
fiscal balance and they are also typically
associated with a weaker currency.

Another link between a nation's external

accounts and its currency works through the
capital account.
Suppose that a nation's superior investment
opportunities attract an inflow of foreign
capital. Disequilibrium within the capital
account will induce an appreciation of the
nation's currency. In the goods market,
domestic products become more expensive
relative to foreign substitutes. In equilibrium,
the country experiences a larger trade deficit to
offset the higher capital inflows. Thus, the domestic currency may appreciate even though the trade
deficit widens.

In the early 1980s, the US began running sizable trade and current account deficits because of a sizable
fiscal expansion. Indeed, since the consumption share of GDP was rising (as opposed to the investment
share), America was borrowing from abroad to finance a presumably "unhealthy" consumption binge.
Meanwhile, foreign investors saw the US as a relatively attractive place to invest their extra capital given
that the US was drawing down its savings and offered superior risk-adjusted returns. Indeed, returns on
US$ assets rose to levels that induced foreigners to accumulate US$ assets at a rate in excess of the rising
current account deficit. This portfolio shift caused the trade-weighted US$ to appreciate by over 65%
between 1980 and 1985.

Finally, adjustment lags between real and financial markets can complicate the analysis. Sometimes the
causality may run from the exchange rate to the current account balance. Empirically, we observe that
trade flows respond to exchange rate movements with a lag of four to eight quarters. Within this
adjustment period, current account surpluses may fall in the wake of a significant appreciation of the
exchange rate rather than vice-versa. In Canada's case for example, the C$ tends to impact the current
account because Canada and the US have a close and open trading arrangement that is almost
immediately affected by changes in the exchange rate.

The empirical evidence linking the level of a nation's contemporary current account balance to the
performance of its currency is mixed. We examined the contemporaneous correlation between annual
changes in 13 nations' current account balances (as a percentage of GDP) and their trade-weighted
exchange rate between 197 9 and 1996. If countries with current account surpluses have appreciating
currencies, then we should observe a positive correlation between these series.

In fact, we observe that in four cases - the US, Italy, Finland, and Spain, the correlation is moderately
negative. Five other cases exhibit a correlation less than 20% - Germany, the UK, Canada, Australia, and
Sweden. The case with the strongest correlation

Correlation Between Annual Current

Account Balance and the Trade-Weighted
Exchange Rate: 1979-1996
Country Correlation
Switzerland 77.7
France 73.9
Japan 59.8
New Zealand 45.3
Canada 17.7
Sweden 8.1
Germany 7.5
UK 7.3
Australia 4.0
USA -26.5
Italy -27.2
Spain -30.0
Finland -34.9

— Switzerland at 77.7% — is statistically uninteresting because both the current account surplus and the
currency rise without variation throughout the entire sample period. Given the multiplicity of channels
through which current account balances and currencies interact, these weak correlation results are not
surprising.

STRUCTURAL BOP INFLUENCES ON CURRENCY VALUATION

The linkage between a nation's long-run savings-investment balance and their currency's value is more
pronounced. When a nation has run a large current account deficit over a long period of time, financing
the outstanding international obligations may be more important to setting the value of the currency than
short-run developments in the trade accounts.

Persistent current account deficits are generally negative for a nation's currency. Chronically large
external deficits mean that the world accumulates claims on the country's future output. Inevitably, the
country becomes a debtor. As foreign
obligations mount, risk adverse creditors
require higher expected returns to take the
debtor country's obligations into their portfolio.
This relationship could work through both
greater inflation expectations and a higher credit
premium. Foreign investors must be
compensated for this risk in the form of higher
interest rates and a weaker currency, all else

being equal. In short, these high relative

expected returns become necessary to balance
the current and capital accounts.

In contrast to the short-term statistical analysis

above, we observe a strong positive structural
relationship between long-term current account
trends and movements in a nation's currency.
We examined the accumulated current account
balances and trade-weighted exchange rates in a
cross-section of countries between 1991 and
1995. We find a solid 64% correlation between
the average current account balance and the
average percentage change in the trade-weighted
exchange rate.

In summary, it is difficult to establish a causal

short-term relationship between current account
balances and currency values because so many
elements of the economy may change in
tandem. Over longer horizons, a strong external
position generally translates into a structurally
strong currency.

CASE STUDY: TRENDS IN THE US

CURRENT ACCOUNT

From a structural perspective, the growing US

current account deficit has been a principle
concern to investors because it could potentially weaken the US$. The US current account deficit is
forecast to be roughly US$187 billion in 1997, up from US$165 billion in 1996. On a relative basis, the
US deficit is 2.3% of GDP, a figure that is the highest within the G7, but small compared to some of the
imbalances observed in other major advanced economies. On an absolute basis, the US must currently
attract all of the excess savings in the G7 to finance its current account imbalance.

Fifteen years of large current account deficits have pushed the US from being a net international creditor
to being the world's largest net international debtor. The US net external debt is over US$ 1.1 trillion, or
close to 14% of GDP. At the present rate of accumulation, the US net external debt/GDP ratio should rise
above 20% within the next three years.

Naturally, given the huge absolute size of this imbalance, it is reasonable to expect that the risk premium
on US assets should rise. Rapidly accumulating current account deficits and the need for external capital
would ordinarily weigh down the US$. Based on the discussion above, the two questions that arise are:
(1) why is the current account deficit so large and (2) can we expect these trends to continue?

One can easily contrast US current account deficits in the past six years from those amassed in the 1980s.
The majority of the US current account deficit during the Reagan era was attributable to a substantial rise
in the US government budget deficit. Effectively, government dissavings increased while investment was
constant and US private savings drifted slightly lower.

In the past five years, however, US government

budget deficits have consistently fallen as the
budget deficit to GDP ratio has dropped. At the
same time, the private savings rate has declined
to roughly offset the improvement made by less
government dissavings. With net national
savings essentially unchanged, the larger US
current account deficit accumulated in recent
years has largely resulted from an increase in the
propensity to invest. Private investment as a
percentage of GDP rose almost 25 % to 15.6%
of GDP since 1991. This trend accounts for a
significant fraction of the increase in the current
account imbalance in the past several years. In
short, recent US current account deficits have
been an investment-led phenomenon that ought to enable the US to better finance the foreign claims on
its future output.

Looking forward, the outlook for the US current account seems relatively benign. Historically, increases
in the rate of investment spending are unlikely to be sustained, prompting ever greater
investment-savings imbalances. In addition, strong economic growth and new-found fiscal discipline has
reduced the government budget deficit to just 0.6% of GDP, a 27 year low. US political leaders have
adopted a balanced budget package that will continually reduce the government's draw on national
savings in coming years. Assuming that already low private savings rate will be maintained, trends in
investment and government budgets should result in a lower US current account deficit as a percentage of
GNP in coming years.

In conclusion, our analysis suggests that US net external debt as a percentage of GDP should soon settle
at a sustainable level. In this case, foreign investors are unlikely to demand a significantly higher risk
premium on US assets to rollover the outstanding stock of US obligations. Over the long-run, ongoing
US savings and investment trends may indeed be a favourable structural development for the US$.
John Simpson