Foreign Trade Dersi 8. Ünite Özet

The Balance of Payments of a Country

The balance of payments is an accounting system informing the international transactions of a country. It depends on the fundamental principle of the “double-entry bookkeeping”, and so does the balance of payments accounting. In the balance of payments accounting, the value of incoming flows to and the value of outgoing flows from the country are recorded. Credit items in the balance of payments accounting denote a payment by a foreigner into the country while debit items denote a payment by the country to a foreigner.

Balance of Payments Accounts

Current Account: This account involves all credit and debit items arising from export and import transactions of all goods and services, income receipt, and payment transactions in the country. If we add up all items related to goods and services export and import, we obtain the trade balance which is an important component of current account. Income flows are basically payments made to foreign financial asset holders. These payments include interest and dividend earnings obtained by holding foreign assets together with the wage payments to the foreign workers and the other payments to the foreign business owners in the country. Net value of goods, services and income flows is called as current account balance.

Capital Account: This account fundamentally consists of unilateral transfers occurred in the country with the rest of the world. Since unilateral transfers express unrequited payments among nations, in this account, generally donations a country makes and receives are recorded.

Financial Account: The net value of financial assets and similar claims that a country bought and sold (except the official international reserve changes) with the rest of the world states the private finance account balance in the balance of payments. The values recorded in the financial account are the principal values of the financial assets bought and sold; revenues obtained or paid to the holders of these types of assets are recorded in the capital account. Direct investments (or its widely used name, Foreign Direct Investments – FDI) are the financial flows that stem from ownership transferring of a foreign company or lending to a foreign company that is widely controlled by the investor. Indirect investments are the financial flows arising from securities (in a large scale, equities and bonds), loans or bank deposits. An indirect foreign investment consisting of purchasing or selling of an equity or a bond is known as the international portfolio investment.

Reserve Assets: As long as the credit usage from the International Monetary Fund (IMF) is zero, international reserve assets consists mainly of the changes in official reserves of the country. Official international reserve assets are the quasi money assets which are held by government and are accepted in international payments. The difference between non-official and official international financial assets is not the same as the difference between private and government concepts in general meanings.

Economic Implications of the Current Account Balance

Current account balance carries some major implications in macroeconomic terms. The first implication comes from the requirement that balance of payments of a nation must be zero at the end. All the items except those involved in current account are financial flows. Thus, the current account balance must be equal to the net foreign investments in that country. Provided that the country has a current account deficit (that is, if the foreign liabilities of the country are growing faster than the foreign assets), net foreign investments are negative. In other words, the country is a net debtor from the rest of the world. However, net foreign investments are positive provided that the country has a current account surplus (that is, if the foreign assets of the country are growing faster than the foreign liabilities). This means that the country is a net lender (or creditor) to the rest of the world.

Capital Movements Among Nations

International trade and movement of productive resources (like labor, capital and technology) among countries are the substitutes of each other. A capital abundant country exports the capital-intensive products or capital itself to other countries. A country that produces goods and services under the conditions of capital scarcity imports capital-intensive goods and services or obtains the capital she needs from other countries. The international capital movements or flows are defined as movements or flows of financial resources from one country to others to eliminate the disequilibrium in the balance of payments or to improve the country’s production possibilities. Capital movements are generally carried out to finance balance of payments deficit or to create a net increase in the production capacity of the country. In the latter case you can think of the capital movements as a production factor. In this case it is clear that production activities in the home country will be negatively affected if there is an insufficient foreign capital inflow.

Types of International Capital Movements

Domestic and Foreign Capital Movements: Funds used for investments made by a country’s own citizens in a foreign country are called as domestic capital while the funds used for foreign investments in a country are foreign capital. In the first case, there is a capital outflow from country to abroad while there is an inflow of capital from abroad to the country in the latter case. In the balance of payments, the capital inflow to the country is a credit (+) item while the capital outflow from the country is a debit (-) item. The difference between credit and debit items stemming from capital movements represents the net foreign investments and may be positive or negative.

Government and Private Capital Movements: Government capital movements refer to capital movements arising from lending and borrowing transactions among governments. Transactions like lending to foreigners or borrowing from foreigners by private individuals and institutions in a country create private international capital movements.

Long and Short Term Capital Movements: Short term capital movements are capital flows based on debt instruments with a maturity less than one year. Frequently this type of capital flows is realized by using currency, demand deposits and treasury bills. However, long term capital flows depend on debt instruments with a maturity more than one year. In other words, buying and selling transactions of bonds and other long term securities internationally create long term capital flows among countries. Long term capital movements may also be realized by the loans of international financial institutions. Long term capital flows are generally divided into two groups as direct investments and portfolio investments. Short term capital flows generally do not come to a country to utilize its economic development potential; they generally move into a country to benefit the high return possibilities in financial assets and to obtain extra profit by using interest rate-foreign exchange rate arbitrage. Therefore, it is possible to say that this type of capital flows is largely speculative.

In economics, speculation means buying or selling of an economic value to obtain extra income depending on the price changes in time. From this definition, speculators help to smooth the price fluctuations by purchasing in low price and selling in high price and help to fluctuate the price around its normal value. If this is the case, speculation is a useful activity (stabilizing speculation) for the market and the whole economy. Speculators who realize the existence of a price increase in the market may intend to obtain excessive profit by engaging regular buying to create further increase in the price and selling when the targeted price is achieved. In this case, activities of speculators cause instability in the market (destabilizing speculation). Recently this type of speculation activities is called as speculative attack in international economics.

Speculative attack is the speculation activities in which speculators who realize the existence of a price increase in the market may intend to obtain excessive profit by engaging regular buying to create further increase in the price and selling when the targeted price is achieved.

The Importance of Foreign Direct Investments

• In case of an economic turbulence in the receiving country, it is not easy for foreign direct investments to leave the country compared to portfolio investments.
• Receiving country gets the possibility of investing over her domestic savings to sustain economic growthwithout increasing indebtedness.
• Foreign direct investments create new business lines in the receiving country.
• High technologies with direct investments promote the research and development activities in the receiving country so that she becomes a technology producing country instead of importing one.
• Advanced production technology improves the quality of labor force overtime and this will help to increase wage and to reduce other production costs.
• Foreign direct investments cause some important changes in the market structure of the receiving country through evolving competition culture. This helps to increase new types of products, to reduce product prices and, in the end, to increase consumer welfare overtime.

Effects of Direct Investments

Effects on the balance of payments: Direct investments create their effects on the balance of payments with two different channels: Financial flow and trade flow. First of all, since foreign direct investments are inflow of funds from another country, they represent capital incoming to the home country. This creates a positive effect on the balance of payments. However, when the income obtained from the direct investments is transferred to the origin country of this investment, there will be a negative effect on the balance of payments. These types of effects are called as financial flow effects on the balance of payments. According to trade flow effect, direct investments increase the capacity of export while they reduce the need for importing some goods and services in the receiving country. These two effects together create a contraction in the foreign trade deficit or an expansion in the foreign trade surplus.

Effects on capital accumulation: One of the most important characteristics of the developing countries is that they cannot achieve the sufficient fixed capital investments to support economic growth. Foreign direct investments increase the capital level for those investments and reduce barriers for development like the low level of national savings and the scarcity of foreign exchange in developing countries. On the other hand, by using the new technologies in the production process, increasing the abilities for management and marketing and improving the productivity of production factors, foreign direct investments contribute to improve human quality in the production. As you can see, direct investments affect capital accumulation in developing countries on both grounds: fixed capital and human capital.

Effects on economic growth: Direct investments positively affect the production capacity and, therefore, gross domestic product and economic growth. Studies present empirical evidence for which the degree of the growth depends on the degree of openness to international trade, human capital accumulation, regulations related to competition, and trade regime in the investigated developing country.

Effects on employment: Foreign direct investments are one of the factors that help to decrease high unemployment rate in developing countries. However, this effect of direct investments depends on whether they take over an existing production facility or establish a new one. The latter type of foreign direct investments is also known as greenfield investments. It is the greenfield investments that create additional employment opportunities in the investment receiving country. The other type of foreign investments can indirectly contribute to increase employment level in the investment receiving country.

Distinctions between Direct and Portfolio Investments

When you consider the definitions of foreign direct and portfolio investments, there is a conceptual difference that could be explained as foreign investor does not want to be effective on the management of and to be in a long term relationship with the company whose securities are bought. However, the conceptual difference cannot be used in practice since it is not possible to determine investor’s intention when she/he buys a company’s securities. In practice, a foreign portfolio investment is distinguished from a foreign direct investment by considering the “10 percent threshold rule”. For instance, if a foreign investor holds securities that represent at least a 10 percent of a company, this foreign investment is not accepted as portfolio investment, but direct investment. Although there are some different threshold levels used, 10 percent level is suggested by some international organizations like the IMF and OECD and used by many countries throughout the world. In addition to above main difference, we can list other minor differences as follow:

• Foreign direct investments include the investor’s interest with the company for long lasting years while foreign portfolio investments do not continue so long.
• Foreign direct investments represent an investment made to company’s all assets like machinery park, equipment, building and technology while foreign portfolio investments are indirect investments made by buying company’s securities.
• Foreign portfolio investments incur higher risks depending on financial turbulences lived especially in developing countries.
• Foreign portfolio investments can be easily liquidated since they are more vulnerable to financial, economic and political problems that could arise in investment receiving countries.
• The outflow possibility of the foreign portfolio investments is always higher than that of the foreign direct investments.

Capital Movements and Financial Crises

Definition of Financial Crises

Although they have a variety of features, financial crises are often experienced as a banking crisis, a foreign exchange crisis, a debt crisis or a combination of these three.

A banking crisis arises when the banking sector in a country is unable to fulfill its lending function and confronts with the risk of insolvency. A bank, like any other business, goes to insolvency when it becomes impossible to meet its liabilities with its assets or, in other words, its net value becomes negative. For example, the recession of 2008 in the USA is partly a result of banking crisis which started in 2007 including banking firms and other financial institutions like insurance companies. Banking sector in an economy carries out the primary function by transferring funds from savers who want to spend less than their income to debtors who want to spend more than their income. This process of fund transfer is called as financial intermediation. Without involving technical details, financial intermediaries (like banks) collect funds from households and lend these funds to investing firms. If the borrowing firm goes to bankrupt, the creditor bank cannot fulfill its obligations to households (like paying interest and paying back the deposited amount) who deposit their saving in that bank and, consequently, the bank goes out of business or bankrupts. In this case, together with the increasing systemic risk of the entire system, there will be a contraction in the financial system. This process is known as the financial disintermediation effect and it causes very serious negative effects on the economy as a whole. When a bank (or any other financial institution) goes bankrupt, households who bought financial instruments of this bank (like deposits, bonds) lose all or a part of their savings. To prevent the loss in savings and to protect savers’ interests, many countries implement deposit insurance system in which other financial liabilities of the bank (like issued bonds and sold shares) are not included. The loss occurring in the savings induces households to cut their consumption expenditures and, therefore, creates a recessionary effect on the economy.

A foreign exchange (or a foreign exchange rate) crisis occurs when there is an unexpected and sudden collapse of domestic currency unit (high level of depreciation in the flexible exchange rate regime or high level of devaluation in the fixed exchange rate regime). This type of financial crisis is possible in each of the exchange rate regimes whether it is fixed or fully flexible or in the middle of these two ends. If the exchange rate regime in the country is a version of fixed exchange rate regime, the foreign exchange crisis produces a loss in the country’s foreign exchange reserves. When this loss in the reserves reaches a critical amount (in other words, the loss is big enough), domestic currency faces a sudden devaluation and loses its value. The objective of devaluation is to protect the level of international reserves or to ensure the accumulation in reserves again since devaluation eliminates the attractiveness of foreign currency for those who want to convert domestic currency to the foreign one. If the exchange rate regime in the country is a version of flexible exchange rate regime, the foreign exchange crisis produces a very rapid and uncontrollable depreciation in the local currency unit. None of the exchange regimes is entirely safe against the crises but current researches show that countries who implement fixed exchange rate regime are more vulnerable against foreign exchange crises. Like banking crises, foreign exchange crises also result in a deep recession in the economy.

A debt crisis occurs when the debtor cannot fulfill his/her obligations (interest and principal payment) on time and a need shows up to restructure the debt. A complete deletion of debt is a rare occasion but it is not impossible. Most of the debt crises result in restructuring which involves a reduction in interest rate, an extension of the term, a partly deletion of the debt or a combination of these measures. Debtors can belong to private or public entities domestically or internationally. If you think individually, you will lose your payment ability and your expected cash flows will be damaged when your friend does not pay the amount he/she borrowed on the time promised. It is also true when you consider the entire economy. Therefore, restructuring can cause a reduction in the payment ability of lenders since the value of their assets decreases. If these types of losses spread to whole economy, a debt crisis is present. Of course, there may be some other transferring channels of a debt crisis to economy via interest rate, expectations, other asset prices and so on.

Volatility of Foreign Capital Flows: Vulnerability and Contagion

The vulnerability of a country may arise from two different sources: (1) Inconsistent and unsustainable monetary and fiscal policies followed by the government and (2) volatility of foreign capital flows that the country receives.