Slides 1: The Balance of Payments and Global

Imbalances
Ke Pang
Wilfrid Laurier University

Based on materials from Schmitt-Grohe and Uribe Chapter 1-2

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The Balance of Payments (BOP)

The Balance of Payments records a countrys international
transactions in goods, services, and assets.
I

Current Account records trade transactions and income from abroad.

F

Trade Balance

Income Balance

Net Unilateral Transfers

Financial Account (sometimes called Capital Account) records net

changes in international ownership of assets.

Fundamental balance of payment identity

Balance of Payment = Current Account + Financial Account = 0

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Current Account (CA)

The Current Account is the sum of the Trade Balance, the Income
Balance, and Net Unilateral Transfers.
I

Current Account = Tade Balance + Net Income from Abroad (i.e.,

Income Balance + Net Unilateral Transfers).

Trade Balance measures the difference between exports in goods and

services and imports of goods and services.
Trade Balance = Merchandize Trade Balance + Service Balance.

Income Balance measures the difference between incomes received

from the rest of the world and incomes paid to the rest of the world.
Income Balance = Net Investment Income + Net International
Payments to Employees.

Net Unilateral Transfers measures the difference between gifts

received from the rest of the world and gifts given to the rest of the
world.
Net Unilateral Transfers = Private Remittances + Government
Transfers.

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Current Account: Examples (from the perspective of the

U.S.)
Trade Balance
I

Merchandize: Imports of Nokia phones from Finland (-) / Export of

ipads to Germany (+)

Service: Drinks in a Paris bar (-) / British tourists watching Broadway

shows (+)

Income Balance
I

Investment Income: General Mills subsidiary in Mexico makes profits

and rebates them to the U.S. (+) / Dividends for Japanese
shareholders of U.S. stocks (-)

Compensation to employees: earnings of U.S. professionals temporarily

residing in foreign countries (+) / earnings of foreign temporary
workers in the U.S. (-)

Net Unilateral Transfers

I

Mexican citizens residing in the U.S. send money to relatives in Mexico

(-) / Foreign aid to U.S. for Katrina relief (+)

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Financial Account (FA)

The Financial Account records the difference between sales of assets

to foreigners and purchases of assets from foreigners.
Financial Account = Change in foreign ownership of domestic assets Change in domestic ownership of foreign assets.
I

Examples: purchasing a residence abroad (-) / purchase of U.S. stocks

by foreigners (+)

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Fundamental Balance of Payment Identity

Every movement in the current account must be reflected in a

balancing movement in the countrys financial account.
I

Examples: a U.S. retailer imports $1,000 of Japanese TVs; U.S.

current account goes down by $1,000; at the same time, the Japanese
TV producer purchases a financial asset (U.S. dollars) worth $1,000;
hence, the U.S. finanical account increases by $1,000.

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Table 1.1
The U.S. Balance-of-Payments Accounts in 2012
Billions Percentage
Item
of dollars
of GDP
CURRENT ACCOUNT BALANCE
-475.0
-3.0
Trade Balance
-539.5
-3.4
Merchandise Trade Balance
-735.3
-4.7
Services Balance
195.8
1.2
Income Balance
198.6
1.3
Net Investment Income
206.2
1.3
Net International
Payments to Employees
-7.6
-0.0
Net Unilateral Transfers
-134.1
-0.9
Private Remittances
-77.6
-0.5
U.S. Government Transfers
-56.5
-0.4
Source: Bureau of Economic Analysis, U.S. Department of Commerce,
http://www.bea.gov.
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Observations of Table 1.1

In 2012, the U.S. runs a large current account deficit.
Most of the current account deficit is accounted for by a large trade
deficit.
The U.S. mostly imports low-tech manufactured goods (e.g., textiles
and electronics) and exports human capital intensive services (e.g.,
higher education, R&D, health care, and professional consulting).
Net investment income is positive which means that investments of
U.S. residents in foreign assets paid more in interest, dividends, and
profits than the investments of foreign residents in U.S. assets.
Net international payments to employees is quite small.
Net unilateral transfers are negative which means that the U.S. gives
more gifts to the rest of the world (mostly transfers of U.S.
immigrants to foreign residents and government aids) than it received.
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Figure 1.1
The U.S. Trade Balance and Current Account As
Percentages Of GDP: 1960-2012
2
TB /GDP
t

CA /GDP
t

Percent of GDP

6
1960

1965

1970

1975

1980

1985
Year

1990

1995

2000

2005

2010

Source: http://www.bea.gov
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Observations of Figure 1.1

Trade balance is the main driver of the current account.

I

This applies to most countries except in cases where debt forgiveness

and direct transfers are large.

Large deteriorations in U.S. current accounts and trade balances over

time.

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Figure 1.2
Trade Balances and Current Account Balances Across Countries
in 2005
15

10

Data

Source:

World

Development

China

100 CA/GDP

Indicators. Note: TB denotes the trade

Arg

balance in goods and services and CA

Philippines
0

denotes the current account balance.

Mex

There are 102 countries included in the

Ire
5

USA

sample.

Countries with trade balances

or current accounts in excess of 15

10

percent of GDP are not shown.

o

45
15
15

10

0
100 TB/GDP

10

15

14
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Observations of Figure 1.2

Trade balances and current accounts comove closely across countries.

Countries with positive (negative) trade balances tend to be countries
with positive (negative) current accounts as well. However, any sign
combination is possible.
Most countries trade balance and current account are of the same
sign and of roughly the same magnitude, which suggests that trade
balance is the main determinant of the current account.

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Table 1.2

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Observations of Table 1.2

Recall CA = TB + Income Balance + Net Unilateral Transfers.
Argentina: TB/GDP > CA/GDP > 0; Argentinas
net investment income < 0 (i.e., net debtor).
China: CA/GDP > TB/GDP > 0; Chinas
net investment income > 0 (i.e., net creditor).
Mexico: TB/GDP < CA/GDP < 0; Mexicos private remittance > 0.
U.S.: CA/GDP < TB/GDP < 0; U.S.s
net income from abroad < 0.
Philippines: TB/GDP < 0 < CA/GDP because of large personal
remittances received from overseas Filipino workers.
Ireland: CA/GDP < 0 < TB/GDP; Irelands
net investment income < 0 (i.e., net debtor).
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Net International Investment Position (NIIP)

Net International Investment Position (NIIP) records the difference

between a countrys foreign assets and its foreign liabilities. In other
words, NIIP refers to a countrys net foreign wealth.
NIIP = U.S. owned foreign assets - foreign owned U.S. assets.
Note that NIIP is a stock while CA is a flow.

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The U.S. Net International Investment Position (NIIP):

1976-2012
500

500

Billions of dollars

1000

1500

2000

2500

3000

3500

4000

1980

1985

1990

1995
Year

2000

2005

2010

25
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The U.S. Net International Investment Position (NIIP) as

a Share of GDP: 1976-2012
15

10

Percent of GDP

10

15

20

25

1980

1985

1990

1995
Year

2000

2005

2010

26
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The U.S. Net International Investment Position (NIIP)

The U.S. was a net creditor of the rest of the world until the late
1980s.
The U.S. has been a net debtor since the late 1980s.
The U.S. NIIP has been falling both in levels and as a fraction of
GDP.
The U.S. became the largest external debtor in the world in the 1990s.

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Determinants of NIIP

NIIP = CA + valuation changes

Valuation changes refer to changes in the market value of a countrys
foreign asset and liability positions (e.g., due to changes in exchange
rates or asset prices, etc.)
We know that the U.S. current account has been in deficit since the
early 1980s. These current account deficits should have resulted in a
large deterioration of the NIIP.
Are the valuation changes positive or negative in the U.S.? How big
are they?

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Figure 1.4
The U.S. CA and Changes in the NIIP: 1977-2012
8
2009
6
1979

4
2007

2005

1993

1999

100
N IIP
GDP

1978

1980

1990 1977
1994
1982
1996
1981
1983
19872012 1998
1991
1989
1995 1992
1988
1986
1985
2010

2003
2004
2006

2002

1984

1997

2001
6

2000

10

12
7

2011

2008

3
CA
GDP

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U.S. Valuation Changes

For the U.S. mostly valuation gains since 1976:
Valuation Changes as Share of GDP
10

Percent of GDP

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Figure 1.5
The U.S. NIIP and the Hypothetical NIIP with No Valuation Changes Since 1976
1000
0
1000

NIIP

2000

Billions of dollars

3000

Cumulative CA balances since 1976

4000
5000
6000
7000
8000
9000
10000

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Observations of Figure 1.4 and Figure 1.5

Since 1976 the U.S. had mostly positive valuation changes.
Large valuation changes are a recent phenomenon (i.e., after 2000).
The U.S. external debt would be much larger today if it had not
benefited from these large positive valuation changes.
Sources of the positive valuation changes between 2002-2007:
I

depreciation of the U.S. dollar because most of U.S. owned foreign

assets are denominated in foreign currecies, while foreign owned U.S.
assets are mostly denominated in the U.S. dollar;

foreign asset markets outperform the U.S. asset market.

Abrupt change in 2008 due to losses in foreign equity markets.

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The Negative-NIIP-Positive-NII Paradox

Even though the U.S. is the largest external debtor in the world, it
receives positive net investment income (NII) from the rest of the
world.
Between 1976 and 2012, U.S. NII has always been positive, whereas
NIIP has been negative since 1986.
How can this paradoxical situation happen? There are two potential
explanations:
I

dark matter;

return differentials.

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Figure 1.6

300

3000

200

2000

100

1000

100

1000

200

2000

300

3000

400

1980

1985

1990

1995
Year

2000

2005

2010

US NIIP, $bn

US Net Investment Income, $bn

Positive Net Investment Income And

Negative NIIP: A Paradox?

4000

Data Source: Bureau of Economic Analysis.

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Dark Matter
The Dark Matter hypothesis, proposed by Hausmann and
Sturzenegger (2005), suggests that in reality the U.S. NIIP is positive,
but the Bureau of Economic Analysis (BEA) fails to account for all of
it.
I

e.g., U.S. foreign direct investment contains intangible human capital,

such as enterpreneurial capital and brand capital whose values are not
correctly reflected in the official Balance of Payment.

Assuming this theory is valid, how much dark matter is there in the
U.S. NIIP? Lets make a simple calculation.
I

TNIP = truenet international investment position.

NIIP = observed net international investment position, -$4 trillions in

2012.

NII = net investment income, $0.2 trillion in 2012.

r = rate of return on the NIIP, assume r = 5% per year.

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Dark Matter (contd...)

Dark matter is the difference between the true and the observed
NIIPs.
Dark Matter = TNIIP - NIIP.
NII is the income from the TNIIP.
NII = r TNIIP
0.2 = 0.05 TNIIP TNIIP = $4 trillions.
Dark Matter = 4-(-4)=$8 trillions! A number seems to be too big to
go unnoticed by the BEA.

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Return Differentials
An alternative explanation is that there is no dark matter, but the
U.S. earns a higher return on its foreign asset holdings than foreigners
earn on their U.S. asset holdings.
In fact, the gross international asset position of the U.S. is mostly
composed of risky high-return assets, such as foreign stocks, whereas
its gross international liability position is composed of safer low-return
assets, such as U.S. T-bills.
Let A denote the U.S. international asset position and L its
international liability position.
NIIP = A - L.
Let r A be the return on A and r L the return on L.
NII = r A A - r L L.
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Return Differentials (contd...)

How large the interest rate differential on assets and liabilities

(r A r L ) have to be to explain the paradox?
In 2012, A = $21 trillions, L = $25 trillions, and NII = $0.2 trillion.
Moreover, we use the average real rate of return on U.S. T-biils as a
proxy for r L , r L = 2%.
Now lets solve for the value of r A that solves the paradox.
0.2 = r A 21 - 0.02 25 r A = 3.3%.
An annual 1.3% interest rate differential seems to be quite reasonable.

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Return Differentials (contd...)

Why is such a small interest rate differential sufficient to explain the

negative-NIIP-positive-NII paradox?
Gross asset and liability positions have exploded in the past 30 years.
They have roughly doubled every decade.
Therefore a small return differential can lead to a positive NII even
though the NIIP is negative.

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Figure 1.7
Gross Positions Have Exploded over the past 20 Years

U.S.-Owned Assets Abroad (A) and Foreign-Owned Assets in the U.S. (L)
180
U.S.owned assets abroad
Foreignowned assets in the United States
160

140

Percent of U.S. GDP

120

100

80

60

40

20

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U.S. Current Account and China

A large fraction of the U.S. current account deficit is accounted for by
its trade with China.
A large part of the U.S. trade deficit is accounted for by Chinese
imports.
I

In 2008, U.S. trade balance with China is -$268 billions.

In 1985, it was only -$6 millions!

The fraction of the U.S. current account deficit explained by deficits

with China has increased steadily since the 1980s, reaching around
70% in recent years.
In this sense, a main driver of the U.S. current account imbalances is
the rise of the Chinese economy.
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Figure 1.8
The Bilateral Current Account Deficit of the United States
With China
70

65

60

55

Percent

50

45

40

35

30

25

20
1998

2000

2002

2004
Year

2006

2008

2010

Source: http://www.bea.gov. Note: The U.S. current account deficit with

China is expressed as a fraction of the total U.S. current account deficit.
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Who Lends and Who Borrows Around the World?

It must be the case that CAUS + CAROW = 0.

So who is running current account surpluses and who is running
current account deficits?

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Figure 1.10

Cumulative Current Account Balances Around the World: 19802012, billions of U.S. dollars.

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Observations of Figure 1.10

The country with the biggest cumulative current account deficit is the
U.S..
The countries which have been financing these deficits are China,
Japan, Germany, and oil exporting countries (e.g., Russia, Saudi
Arabia, Algeria, Libya, Norway, Sweden, and Venezuela).
Is the U.S. current account deficit sustainable?

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Four Expressions for Current Account

In the absence of valuation changes, the current account measures
, where B represents the
the change in the NIIP: CAt = Bt Bt1
t
countrys NIIP at the end of period t.
In the absence of net international compensation to employees and
net unilateral transfers, the current account is equal to the sum of the
.
trade balance and NII: CAt = TBt + rBt1
We can also show that the current account is equal to the difference
between
I

saving and investment: CAt = St It ;

income and domestic absorption: CAt = Yt Dt ;

see below for detailed derivations.

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Four Expressions for Current Account (contd...)

TBt = Xt IMt , where Xt and IMt denote exports and imports in
period t, respectively.
Qt + IMt = Ct + It + Gt + Xt , where Qt , Ct , Gt , and It are GDP (i.e.,
the amount of goods and services produced domestically), private
consumption, government consumption, and domestic investment in
period t, respectively.

We can show that CAt = rBt1

+ Qt Ct It Gt . Note that

rBt1
+ Qt represents national income (GNP, Yt ). Hence, we have

CAt = Yt Ct It Gt
National savings equal the difference between national income and
the sum of private and government consumption, therefore,
CAt = St It
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Four Expressions for Current Account (contd...)

Finally, let Dt denote a countrys domestic absorption in period t,

Dt = Ct + It + Gt .
We can show that CAt = Yt Dt using the second last equation on
the previous page.
Note that these four expressions represent accounting identities that
must be satisfied at all times in any economy. They do not provide
explanations of the determinants of the current account. To do so,
we need a model, which is what we will focus on next.

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