ME PPsection c group 2T.pptx

8/9/2019 ME PPsection c group 2T.pptx

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What is BOP??

It is where countries record their monetarytransactions with the rest of the worldTransactions: Credit or Debit

Three different categorieso Current Accounto Ca ital Accounto !inancial Account


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Com onents of Current Account

"oods#er$icesIncome

Current Transfers

CAB ! " M # NY # NCT


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Does it matter how long a country runs a current account deficit?

De ends ono %&tent of its foreign liabilitieso

Whether borrowing will be financing in$estment that has ahigher marginal roduct than the interest rate the country hasto ay on its foreign liabilities


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Causes of Current Account Deficit

CAD is caused by the following:Trade Deficit both merchandise and ser$icesDeficit in the -et Income

Deficit in Direct Transfers

Countries with current account deficits generally s end more. but are consideredcredit worthy/ The businesses in these countries0 can0t borrow from their ownresidents. because they ha$en0t sa$ed enough in their local ban*s/ They would

refer to s end than sa$e their income/ Businesses in a country li*e this can0te& and unless they borrow from foreigners/ That0s where the credit1worthinesscomes into the icture/Basically. the lender country also e& orts a lot of goods and ossibly e$en someser$ices to the borrower/ Therefore. the lender country can manufacture moregoods and gi$e 2obs to more of its eo le by lending to the s endthrift country/

Both countries benefit/


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!actors affecting Trade Deficit

6/ D' %,' %, C '.%.%5','66 A decline in the e& orting manufacturing sector. because it has struggled tocom ete with de$elo ing countries in the far east has led to a ersistent deficit inthe balance of trade/

H%-*' %,8 +.% ,

This ma*es e& orts less com etiti$e and im orts more com etiti$e/ ,owe$er thisfactor may be offset by a decline in the $alue of currency/

R' '66% , %, .*' ,. %'6If a country0s main trading artners e& erience negati$e economic growth thenthey will buy less of our e& orts. worsening the current account/

4 H%-* MPM:In the )7 there is high 8arginal ro ensity to im orts m m because they do notha$e a com arati$e ad$antage in the roduction of manufactured goods/Therefore if there is fast economic growth there tends to be a significant increasein the (uantity of im orts


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!actors affecting -et Income

The second com onent is usually a deficit in the net income/ Ifthe income aid out by a country0s indi$iduals. businesses andgo$ernment to their foreign counter arts is more than theyrecei$e. it contributes to a deficit/

# ecifically. these are ayments of interest and di$idends toforeigners who own assets in the country. and wages aid toforeigners who wor* in the country/On the fli side. the o osite will cut the deficit:

i/ Income earned on foreign assets owned by a country0sresidents and businesses/ This is usually recei ts. such asinterest and di$idends. earned on in$estments/

ii/ Income earned by a country0s residents who wor* o$erseas/


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!actors affecting Direct Transfers

The third com onent of the deficit is direct transfers. whichincludes go$ernment grants to foreigners/ It also includes anymoney sent bac* to their home countries by foreigners/Direct transfers refer to money transferred withoute&changing any goods or ser$ices/ !or e&am le: An Indian wor*er. who wor*s abroad and sending money 9remittanceto his family in India/

# ecifically. deficit is increased by these direct transfers: Wages sent bac* to a foreigner0s home country/"o$ernment grants made to foreigners/Direct in$estments made abroad by a country0s residents/

Ban* loans to foreigners/


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!actors behind CAD of India

O$er the years. it0s seen the trade deficit has been widening on bac* of higherim orts and slower growth of e& orts/; Till first half of 5 /@> bn and=56 /553bn res ecti$ely resulting in trade deficit of =


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O$erall im ort and oil and gold in absolute terms

!rom the chart. it0sseen oil and goldim ort has been

continuously rising/; Till first half of 5


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O% +, G % .6 +6 ' ',.+-' 8 . .+ % .6 %, .*',.

ear Oil "old55


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Indian %conomy olicy13 615


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Indian %conomy olicy13 615


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Does such a large CAD im ly that thecountry0s aggregate demand

9consum tion lus in$estment hugelye&ceeded its aggregate domestic out ut or

income?


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E!CESS DEMAND OR SUPPLY SHOCKS;

'esearch at the Indira "andhi Institute of De$elo ment'esearch shows the Indian CAD is countercyclical/ That is.it rises when out ut falls and not when demand rises/ This ise&actly what ha ened last year as well/

In this. India H or the #outh Asian region H is unusual/ In allother emerging mar*ets. the CAD tends to be ro1cyclical.lin*ed to o$erconsum tion in good times

A countercyclical CAD in India0s case suggests dominance ofe&ternal su ly shoc*s rather than e&cess demand factors/


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E!CESS DEMAND OR SUPPLY SHOCKS;

!or e&am le. if oil shoc*s raise costs. and as a result growth falls. theCAD would rise along with falling growth/ It can also be due to e& ort1led growth: As e& orts rise. they raise income and reduce the CAD/ Onthe other hand. a sudden colla se of e& ort mar*ets. due to a globalshoc*. reduces income and increases the CAD/

In line with this analysis. 5/5 ercent of "DP. saw both a shar rise in oil rices and fall in growth/ Asagainst this. the CAD was only 3/6 er cent in 5


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WHAT ARE THE IMPLICATIONS O$ A LARGECURRENT ACCOUNT GAP;

This is why a current account deficit in e&cess of5/@E of "DP is seen as worrisome in case of India/In the last fiscal. des ite getting higher ca ital flows.the country is li*ely to ha$e an o$erall BOP deficit because of much higher current account deficit/

CADOutflow of

foreigne&change

!ore& reser$ee&hausted9if ca ital

flows cannotma*e u

deficit

Currencyde reciates

Cannot meetinternationalCommitment

or fund itscurrent

hases


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Is CAD good or bad?

If the deficit reflects an e&cess of im orts o$er e& orts. it may beindicati$e of com etiti$eness roblems. but because the currentaccount deficit also im lies an e&cess of in$estment o$er sa$ings. itcould e(ually be ointing to a highly roducti$e. growing economy/

If the deficit reflects low sa$ings rather than high in$estment. itcould be caused by rec*less fiscal olicy or a consum tion binge/Or it could reflect erfectly sensible inter1tem oral trade. erha s because of a tem orary shoc* or shifting demogra hics/ Without *nowing which of these is at lay. it ma*es little sense to

tal* of a deficit being goodJ or badJ: deficits reflect underlyingeconomic trends. which may be desirable or undesirable for acountry at a articular oint in time/


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7eynesian model

%& ansionary !iscal Policy " 1K 1K C 1K 8 1K deterioration of CAD

%& ansionary 8onetary olicy

r 1K I 1K without go$t inter$ention ca ital account and current account


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Inter1Tem oral 8odel

+onger1term $ariations in current account balancescan also be e& lained by the inter1tem oral model/ A small o en economy. which is initially ca ital 9and

income oor. ro$ided it has access to internationalca ital mar*ets. will run current account deficits fora sustained eriod of time in order to build its ca italstoc* while maintaining its long1run rate of

consum tion/


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Is it safe to be Inter1tem orally sol$ent?

Inter1tem orally sol$ent means: current liabilities will be co$ered by future re$enues/But e$en if the country is inter1tem orally sol$ent its current account deficit may

become unsustainable if it is unable to secure the necessary financing/ While some countries 9such as Australia and -ew Lealand ha$e been able tomaintain current account deficits a$eraging about >M to @ ercent of "DP for se$eraldecades. others 9such as 8e&ico in 3 @ and Thailand in 3 e& erienced sharre$ersals of their current account deficits after ri$ate financing withdrew in themidst of financial crises/#uch re$ersals can be highly disru ti$e because ri$ate consum tion. in$estment.and go$ernment e& enditure must be curtailed abru tly when foreign financing is nolonger a$ailable and. indeed. a country is forced to run large sur luses to re ay inshort order its ast borrowings/This suggests thatNregardless of why the country has a current account deficit 9ande$en if the deficit reflects desirable underlying trends Ncaution is re(uired inrunning large and ersistent deficits. lest the country e& erience an abru t and

ainful re$ersal of financing/


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Why I# )# Current Account Deficit #o large ?

Large U.S. Current Account Deficit is considered to be mainreason for world macroeconomic imbalance in 1980s

United States acquires a significant portion of the or!dssa"ings# so other countries must ad$ust to the scarcity of capital

%mba!ance of domestic sa"ings and domestic in"estment.

&h' (

)e!dsteins *'pothesis + ,o"t. -o!ic' -rob!em%n"estment *'pothesis-roducti"it' *'pothesis


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!eldstein0s ,y othesis : "o$ernment olicy roblem

Large U.S. ,o"ernment udget deficits attractedforeign in"estment to the united states# thus causingcurrent account to mo"e into further deficit.

%f U.S. go"ernment do not reduce the budget deficit# iti!! continue to absorb !arge portion of the rest ofor!ds sa"ings

Since# capita! account determines current account# po!icies that do not address capita! mo"ements i!! nota!ter the current account deficit.


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In$estment ,y othesis : -o Policy Problem

As the countr' accumu!ates debt to finance the currentdeficit# it accumu!ates capita! and therefore theadditiona! producti"e capacit' to pa' off the debt

/fforts to shrin deficit i!! destro' beneficia!in"estment boom

*ence# ,o"ernment shou!d ta e no action to reduceCAD

ut this appears to be dangerous since U.S. ma' face!o er standard of !i"ing in future as it pa's off the debtaccumu!ated for toda's consumption


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Producti$ity ,y othesis

Current account balance reflects falling roducti$ity in )/#/com ared to its trading artners/)/#/ must ado t olicies to su ort e& ort and im ro$e

roducti$ity/

,ence reducing CAD may re(uire drastic changes in AmericansocietyBut this $iew does not address the source of sa$ings1in$estmentimbalance

As per the "arious ector Auto regressions# app!ied using h'pothesistests it is found that Federal Budget Deficit is at the centre of the!arge U.S. Current Account Deficit


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Im act of large current account deficit: )#

3/There could be roblems financing the deficit in the long term/ If you ha$e adeficit of o$er E of "DP then it is a roblem if you rely on Ca ital flows/ Asignificant art of the CAD of )# is finance by Chinese in$estors buying )#securities. at relati$ely low interest rates/

5/ 8ost countries would not be able to borrow such large amounts at low interestrates/ The )# currently can because the )# is seen as the World0s reser$ecurrency/ ,owe$er if attitudes to the )# economy change and in$estors lose theirconfidence in the )# economy. they will sto buying )# debt/This will cause 5 roblems:

)# interest rates will need to rise to attract enough eo le to buy the debt/

If ca ital flows can0t be attracted then the dollar will continue to de$aluefurther/ This could cause inflationary ressures. interest rates may need to riseto stabilise the dollar/

Basically to correct the deficit would be a ainful e& erience for the )# economyand result in a slowdown or ossibly recession


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Im act of large current account deficit: )#

6/ In the )# the current account deficit is to a large e&tentcaused by e&cess s ending in the economy/ A large currentaccount deficit is often a sign of an unbalanced economy/ Itcould be a sign of structural wea*ness and an uncom etiti$emanufacturing sector/

>/ A deficit on the current account increases foreign liabilities/This means that in the future the economy will need to attractca ital flows 2ust to ay off the in$estment income as well asthe deficit on goods and ser$ices/


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IC%+A-D

Iceland is an e&am le of a country with a large current deficit whichlater im loded/In the years leading u to 5


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%)'OLO-%

In the %uroGone. currentaccount deficits are a biggercause for concern becausecountries ha$e a

ermanently fi&ed e&changerate 9common currency /Therefore they can t de$alueto restore com etiti$eness/

Therefore countries mayha$e to ursue internalde$aluation 9deflation torestore com etiti$eness/


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'educing the current accountdeficit


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3/ De reciation of currency

De reciation 1K 8 1K 9Assum tion: demand is rice elastic

Problems:+ead to im orted inflation 1K reduce country0scom etiti$eness/ #o. im ro$ement in CAD might betem orary Ways to de reciate%&change mar*et inter$ention: buying and selling currencyon world e&change mar*ets to mani ulate the e&changerate/%m irical e$idence suggests that steriliGed inter$ention isgenerally inca able of altering e&change rates


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!iscal olicy $s 8onetary olicy

Permanent effects of monetary olicy on the CAD may be (uite small in a system where e&change ratesfluctuate/ !iscal olicy is well suited for influencing thee&ternal balance/Ideally monetary olicy would be used to regulatedomestic economic conditions such as out ut andinflation while fiscal olicy would hel control e&ternal

conditions such as trade deficit/


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5/ Deflation

T or r 1K DD 1K 8 Also ressure on manufacturers to reduce cost 1Kmore com etiti$e e& orts 1K

But with lower DD growth will fall causing higherunem loyment/"o$t unli*ely to want to ris* higher unem loyment 2ust to reduce CAD


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6/ Protectionism

Increased tariffs 1K 8 1K im ro$ement in CADDangers

o +ead to retaliation so e& orts will decreaseo Domestic industries may become uncom etiti$e because there

is no incenti$e


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>/ #u ly side olicies

"o$ernment attem ts to increase roducti$ity andshift aggregate su ly to the rightIm ro$es the com etiti$eness of the economy and

ma*e e& orts more attracti$e 1K im ro$ement inCADOther benefitso +ower inflation 9#hifting A# lowers the rice le$elo

+ower unem loymento Im ro$ed economic growth

may ta*e considerable time to ha$e effect


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>/ #u ly side olicies 9cont//

8ost su ly side olicies aim to enable the free mar*et to wor*more efficiently by reducing go$t interference/ #ome of them are:

Pri$atiGation 9more efficient in running business as they ha$e arofit moti$e to reduce cost and de$elo better ser$ices

Deregulation 9increases com etition which lead to lower ricesand better (uality of goods'educing income ta& 9increases the incenti$es for eo le to wor* harder leading to more out ut/ -ot true if income effectoutweighs substitution effect'educing the ower of trade unions 9increase efficiency andreduce unem loyment


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