W2 - Reserves as a tool Flashcards
What does the basic national accounts identity tell us?
The total disposable income of domestic residents is equal to the uses for this income
What does a positive current account balance suggest about income?
When the current account balance is positive income is greater than expenditures in a country
To change the current account balance, what must a country do?
To change the current account a country must evaluate it’s saving and investment make-up
What is a larger currency account surplus associated with?
A depreciated currency
What could large currency account surpluses be interpreted as being?
The high CA surpluses (and over depreciated currency) could be interpreted as being the result of high savings (combine private and public savings)
How can the current account surplus be reduced?
It would be necessary to change the incentives for investment and savings for te economy to save less or invest more. The current account balance will then be lower and the exchange rate will appreaciate
What does the double-entry system always say?
A credit in one account always corresponds to a debit in another. Therefore the balance of payments should equal 0
Why would a country like China want to accumulate a large amount of foreign reserves?
These inflows would have changed the ER but the government wanted to keep a fixed ER because of the inflow of investment from this hence why they started to accumulate foreign reserves to stabilise the ER to maintain financial inflows).
What does the financial account measure?
The change in net indebtedness of a country
What happens to the current account if the financial account increases?
If the financial account increases, so your indebtedness increases, you must be running down your current account.
Always think in terms of CA+FA+KA=0
What is the financial capital account (FKA)?
The sum of the capital and financial balances excluding reserve assets
What must happen to an economy if a current account deficit is not financed by enough investment (capital inflow)?
There must be a reduction in reserve assets when a current account deficit is not financed by investment (capital inflows) a corresponding surplus in the capital and financial accounts, that is, if there is insufficient external financing
What must happen if CA<FKA?
Meaning that if CA<FKA, (usually they have opposite signs) it means that CA+FKA<0 meaning that reserves must decrease
If a country was maintaining a fixed exchange rate as in Argentina in 2001 and capital inflow was insufficient to cover the current account deficit, what would the government be able to do?
- Sell reserve assets or
- Allow the ER to depreciate
Cannot achieve both
Why do countries not want to depreciate their exchange rates?
Signalling to foreign investors, nobody wants to invest in your currency if it’s depreciating causing capital flight. In a country such as Argentina with a low level of exports (and hence wouldn’t benefit a huge amount from a currency devaluation in terms of export growth), it is very important to maintain a stable exchange rate at this point in time.
When is the balance of payments said to be in equilibrium?
When its composition can be sustained without intervention and without sudden shocks to the economy
What do the conditions of balance of payments equilibrium depend upon?
The condition of equilibrium can vary depending on domestic economic conditions and international economic conditions
In what scenarios can currency account deficits financed by foreign indebtedness be sustainable and even desirable?
- If the rate of return for investment in the country is high
- The productive capability of the country increases allowing a future increase in savings without reducing consumption generating the surplus in currency account necessary to pay it’s foreign debt
What does the term sudden stop mean?
It describes abrupt reversals to the inflow of capital. If capital inflows suddenly stop and revert to outflows, this can have massive impacts
What are some examples of sudden-stops?
- The Asian Financial Crisis
- The Euro Crisis
What happened as a result of the sudden stop in the Asian financial crisis?
The ASEAN5 were running a current account deficit from large capital inflows from investors. Then investors lost confidence in the ASEAN5’s ability to maintain fixed ER with USD, pulled money forcing the ASEAN-5 to run CA surpluses and therefore crush imports to allow for a trade surplus
What is the issue for short-term capital flows?
If the maturity date is very short, foreign investors can take their money out quickly without restrictions, because of this, you want foreign investment to be long term in nature so that it is less volatile
What were the growing weaknesses in the ASEAN5 that lead to the current account sudden stop?
- Slow productivity growth
- Investment increasingly in non-traded sector
- Fixed exchange rates to USD without substantial reserves
- Large short-term capital flows with relatively few restrictions
What are the implications of a sudden stop?
BoP must balance so imports are crushed:
- Large currency depreciation
- Contraction in investment
- Fall in consumption
- Widespread economic dislocation
What was the issue in the Euro crisis?
Underlying issues with investment from low productivity growth, low economic growth, large budget deficits, Uncompetitiveness as wage growth outstripped productivity, Investment in non-traded sectors
All exacerbated by GFC
Why was running a current account surplus hard for the periphery Euro countries?
These countries were unable to sustain a current account surplus because first they have a lot of wage growth and high wages make high prices making your economy uncompetitive in the international trade market not generating lots of exports so the only way out was through inflows of capital from the ECB providing unlimited financing to these countries to pull them out of this.
What factors make sudden stops more likely?
- Free cross-border movement of capital
- Reliance on short-term funding
- Reliance on foreign-currency debt
- Reliance on credit inflows rather than equity or direct investment
- Small tradable sectors
- Rigid economies
- Rising global risk
- Unstable ER regimes
What is the NIIP?
The Net International Investment Position
What is the Net International Investment Position?
The difference between the amount of foreign assets held by domestic residents and the amount of domestic assets held by foreigners. If this is positive, your income exceeds your expenditure
Let Bt be the NIIP at the beginning of period t, what does it mean if Bt>0?
It means the country is a net lender
If you Bt+1 is smaller than your Bt what type of current account are you running?
If B_t> B_(t+1) you are running a current account deficit
What is the transversality condition?
Essentially that a country will choose an optimal level of debt to maximise wellbeing
Why do we discount the present value of debt by the interest rate?
Because this is what your debt is paying, you could in theory invest this alternatively
What is the present value of the debt or credit of a country assumed to be?
0
What does a positive value of the limit B_s+1/(1+i*)^s-t imply?
A strictly positive value means that the country’s credit grows indefinitely at a rate greater than interest rates. Therefore the country could increase welfare by consuming more and accumulating less credit
What does a negative value of the limit B_s+1/(1+i*)^s-t imply?
It means that debt forever growing at a rate greater than interest rates. But to have explosive debt, another country needs to have explosive credit which isn’t possible
What is the amount of debt equal to?
The amount of debt is equal to the present value of future trade balances
What does an indebted country need to do at some point?
Generate surplus
When are current account deficits sustainable?
When future trade surpluses can be generated, without abrupt shocks, to limit the foreign debt generated by the current account deficits
What is the key takeaway?
The Key takeaway is this: B_t<0 menas that TB_s>0 at some point in the future a country must generate a level of trade surplus to sustain this long-term debt. No country can persistently run current account deficits.
What conditions are necessary for debt to be sustainable?
- The counterpart of a current account deficit should be an increase in the level of investment in the country and not an increase in consumption
- Investment should be effective in increasing production capabilities, so that a higher level of investment would truly increase the rate of growth for a country
- The inflow of capital should be stable during the investment period
What does the sustainability of the composition of current and financial account balances depend on?
- International credit market conditions
- International investors perception of a country’s ability to pay
- The composition of foreign financing
- What foreign financing is used for
