Monthly Archives: August 2012

Balance of Payments Theories

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National Income Accounting

A country’s current account measures the value of its trade in goods, services, investment income (not buy/sell of financial assets), and unilateral transfers.  The current account indicates whether a country is a net borrower or lender to the rest of the world.  The current account must be matched by a financial account, which measures foreign investment in domestic financial assets, of opposite sign.  The national income accounting identity is

Y = C + I + G + X

where Y is GDP, C is consumption spending, I is investment, G is government spending, and X is the current account.  This identity can be rearranged to show many things, including the fact that when savings is greater than investment there is a current account surplus, where savings includes both the private and government sectors.  In other words, X = S – I.  A negative X means that a country must borrow from the world to finance its imports.  The current account deficit will fall when domestic spending, private or government, falls relative to domestic income.

In the absence of decreased government spending, the exchange rate and interest rate markets will cause a reduction in the current account.  As the current account is financed by selling domestic securities to the world, the domestic currency is pressured downward, causing interest rates to rise, making domestic securities even more attractive.  But the higher interest rates, and hence greater borrowing costs, cause a decrease in domestic spending.  Domestic income increases due to the weaker currency leading to greater exports.  The reduced domestic spending and higher income cause a reduction in the current account deficit.

The Elasticities Approach to the Balance of Trade

The change in the quantity demanded of foreign goods due to a change in the exchange rate of the two currencies is measured by the elasticity of demand, or the percent change in demand due to percent change in price.  Elastic means the absolute value of the ratio is greater than one.  Similarly, the change in amount supplied due to changes in price is measured by the elasticity of supply.

A currency devaluation should normally cause an increase in the balance of trade, but this is not always so if there are low short run elasticities.  This causes what is called the J Curve in the balance of trade, where the balance actually decreases after currency devaluation before beginning to improve.  This could be due to the currency contract period, when contracts enacted before the devaluation must be fulfilled.  Inelastic demand for imports would also cause a J Curve.  The change in domestic and foreign prices is measured by the pass through effect.  The difference in profit margins between countries, and the greater pricing flexibility among higher profit margin countries, lessens the effect of a devaluation.

The Absorption Approach to the Balance of Trade

Here, the balance of trade is defined as an economy’s production less its “absorption”, or total domestic spending.  Absorption has to decrease in an economy with full resource utilization for the current account balance to increase, which would allow domestic prices to fall and exports to rise.  A devaluation here will produce domestic inflation as foreigners bid up the price of domestic goods.  A currency devaluation could improve output and GDP, and increase the current account, while absorption remained unchanged in an economy not employing all its resources.

The Monetary Approach to the Balance of Payments

The Elasticities and Absorption Approaches have the limitation that they do not consider the financial account and instead focus on the trade in goods and services, which worked well in a world of limited capital mobility.  MABOP emphasizes monetary disequilibrium in explaining balance of payments disequilibria, where monetary disequilibrium is the difference between the fiat currency supplied and the currency demanded.  Excess money demand will lead to increased exports.  This analysis assumes fixed exchange rates and high capital mobility.

The exports are paid for with foreign currency, which the commercial bank will exchange for dollars with the Federal Reserve.  These dollars are created by the Fed and lead to an increase in the supply of base money and hence domestic credit.  The demand for money can be written as

L = kPY

with L the demand for money, k a constant, P the domestic price level, and Y is real income.  The demand to hold money increases with P or Y.  MABOP assumes a stable demand for money.  MABOP states that the percentage change in the balance of payments minus the percentage change in the exchange rate equals the inflation rate of the foreign currency plus the percentage growth of real income (Y) minus the percentage change in domestic credit (due to the increase or decrease in base money). This can be written as

R’ – E’ = P'(foreign) + Y’ – D’

The Monetary Approach assumes fixed exchange rates, so E’ = 0.  With a fixed exchange rate, like a gold standard system, an increase of domestic credit by the central bank, assuming prices, income, and money demand are constant, will cause a decrease in foreign reserves.  An increase in domestic credit leads to a weaker BOP as spending goes up to decrease excess cash reserves, and vice versa.

BOP problems are monetary phenomena in this world, and countries could not run perpetual deficits since they could not inflate a gold backed currency.  Instead, the deficit running country would eventually run out of reserves.  Domestic prices would become cheap and foreigners would buy domestic goods, and the exports would bring in currency until the system reached equilibrium again.

A domestic credit adjustment by the central bank would be used to equilibrate the BOP.  Barring this, an increase in domestic income, which would strengthen the currency, would improve the BOP with domestic credit unchanged.

Regardless of the forces acting on the BOP, Gresham’s Law is always at work under fixed exchange rates and a currency managed by a central bank.  People will always seek to unload overvalued currency and buy undervalued currency.

According to the MABOP analysis of currency crises, budget deficits contribute to inflation since it is known they will eventually be monetized.  Devaluations of a currency do not keep pace with inflation, leading to overvalued exchange rates.  Exports fall while imports rise, leading to a trade deficit and capital flight.  Governments must borrow to finance the balance of payments deficit, which leads to high interest payments.  Each step of the cycle makes the next step worse and the cycle is perpetuated until the government capitulates.

It can be seen that in an international commodity money system, such as the gold standard, governments would not have to worry about the supply of money, or conversely they would not be able to manipulate the supply of money.  In this case each individual’s money holdings is based on his marginal utility of money and flows between countries are no more important than flows between cities or individuals.  Under fiat systems too the analysis must begin with the individual’s demand for money (methodological individualism versus aggregate analysis) to avoid the problems associated with the abstraction of the country.

Mexican Fiscal and Monetary History

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Mexico maintained a fixed exchange rate of 12.50 pesos to the dollar until 1976.  To accomplish this, the Banco de Mexico actively intervened in the currency market to keep the peso at the desired exchange rate.  The central bank would use its foreign currency reserves, usually dollars, to buy pesos.  This decreases the supply of pesos on the market and increases the supply of dollars, making pesos more valuable relative to the dollar.  A main reason for this is to maintain the purchasing power of the peso in order to keep imports affordable.
On the other hand, if the peso is perceived to be overvalued, the bank will sell pesos in exchange for dollars, driving the value of the peso down.  Mexican exports will be more attractive with a weaker peso.
Despite continued economic growth in Mexico in the 1970s, budget deficits and inflation were rising, and deficits were financed through foreign debt.  A precursor of problems to come, the peso was devalued by 56% in 1976 and taken off its fixed exchange rate in favor of a managed floating rate.  In the managed floating rate system, the peso would be allowed to move within a band which would be enforced with central bank intervention.
The Mexican government, expecting increasing oil revenues from high world prices, increased borrowing in dollars.  However, oil prices plummeted in the early 1980s, greatly reducing revenues and dollar inflows.  Declining international economic conditions decreased demand for Mexico’s primary exports.  Foreign capital, made nervous by the growing debt, began to leave Mexico, putting downward pressure on the now overvalued peso.  These dollars had been used to service the growing Mexican debt, and in their absence the government announced in 1982 that it could not service its debt on billions of dollars of loans.
Neoclassical economists developed the Monetary Approach to the Balance of Payments (MABOP) theory to explain the cycle indebted Latin American countries found themselves in during the 1970s and 1980s.  According to MABOP, budget deficits contribute to inflation since it is known they will eventually be monetized.  Devaluations of a currency do not keep pace with inflation, leading to overvalued exchange rates.  Exports fall while imports rise, leading to a trade deficit and capital flight.  Governments must borrow to finance the balance of payments deficit, which leads to high interest payments.  Each step of the cycle makes the next step worse and the cycle is perpetuated until the government must capitulate and devalue the currency.
Miguel de la Madrid came into office in 1982, inheriting an economy in crisis and in serious need of reform after years of government intervention.  The first order of business was to tackle the near 100% inflation rate.  The government was able to slow inflation to around 65% by 1985 through spending cuts and tighter monetary policy, but at the cost of a 13% decrease in GDP over the same period.  Another top priority was government debt reduction, which resulted in net transfers through debt payments to foreign creditors of 6% of GDP between 1982 and 1985.
Despite publicly claiming to control inflation, the government was incentivized to inflate the money supply through the existence of an “inflation tax”, which is the wealth transfer from holders of cash to the spender of newly created money, in this case the government.  Money creation was such that this course of action equated to up to 8% of GDP between 1983 and 1985.  By 1986, inflation had returned to its 1982 level of near 100%.
The Mexican government was still heavily involved in the economy, controlling the banking sector and limiting foreigners’ ability to invest in Mexican businesses.  Government debt and controls had smothered the economy, causing a drop in per capita income in the 1980s almost as large as that seen in the Depression.  Clearly, a freeing of the economy through free market policies was in order.
In 1987 and 1988, the Mexican government signed two agreements with the business, labor, and agriculture sectors popularly called the Pacto, which through its various incarnations has attempted to curb expansionary monetary and fiscal policies, control prices and wages, renegotiate debt, deregulate markets, and privatize state-owned businesses.
The Mexican public sector owned 1,155 businesses in 1982, and by 1994 940 of those were divested.  The tax system was simplified, rates were decreased, tax collection and tax revenue increased, and government spending and fiscal deficits fell.  The government also implemented financial and trade liberalization.  The elimination of bank reserve requirements and mandatory financing of public sector businesses removed a heavy burden from private finance and allowed capital to flow to more productive areas in the economy.  Banks were privatized, capital controls were lifted, and foreign capital was allowed greater access to Mexican investment.  Trade liberalization came in the form of reduced import licensing and tariffs, and was codified with the passage of the North American Free Trade Agreement (NAFTA) in 1993 (Gould, 1995).
Mexico’s economic liberalization programs and successful foreign debt renegotiation in 1990 attracted capital inflows, which were made more attractive by the low interest rates seen at the time in the U.S.  The financial sector’s unburdening resulted in rapid credit expansion, made possible by a large reduction in public debt and a rise in the Mexican stock market and real estate prices.  Expectations of economic growth and an abundance of foreign and domestic capital led to decreased lending standards which, when faced with an economic slowdown in 1993, resulted in a rapidly increasing number of non-performing loans on the books of Mexican banks.
Local Mexican commercial banks increased credit to the private sector by an average of 25% per year from 1988 to 1994.  During this same period, credit card debt rose 31% per year and mortgage loans rose 47% per year (Gil-Diaz, 1998).  This local credit expansion combined with large foreign capital inflows led to rising aggregate demand within Mexico and a strengthening peso which could only lead to a current account deficit.  Unfortunately, the Pacto contained within it a commitment to keep the exchange rate within a narrow band that was not in harmony with the current heated economic conditions.
With foreign money spurning low U.S. interest rates in favor of higher Mexican rates, largely in the form of short term capital, money flowed into Mexican markets.  The Banco de Mexico acquired an increasing supply of dollar reserves and was able to provide the needed pesos to the market.
Predictably in an environment inundated with foreign capital and easy credit, leveraged investment began to flow to less productive projects chasing returns, increasing the fragility of the economy and leaving it vulnerable to changing international investment conditions, which occurred when U.S. interest rates rose, decreasing the demand for peso denominated investments and exposing the multitude of bad loans on the books of Mexican banks (Kaplan, 1998).  As investors began to demand dollars in exchange for pesos at the managed exchange rate, Mexico’s foreign reserves began to shrink to the point that peso devaluation became necessary.  The peso/dollar exchange rate went first from 3 to 3.5 pesos to the dollar, with the managed currency band still in effect.  This move did not end speculative pressure on the peso, and the government increased the peso’s band.  With pressure mounting, the government was forced to capitulate totally on December 22, 1994 by removing the peso’s managed float and allowing the currency to move freely against the dollar.  This effectively devalued the peso from four pesos to the dollar to 7.2 pesos to the dollar in one week’s time.  The U.S. government began buying pesos in an attempt to stop a collapse, and then put forth $50 billion in loan guarantees to Mexico, which were accepted and repaid ahead of schedule by 1997.