Chapter 7. The financial relationships with the Rest of the World

João Cadete de Matos
(Banco de Portugal),
Daniele Fano
(Fondazione AIB)
Filipa Lima
(Banco de Portugal)

The accounts for the “Rest of the World”, which record the transactions and positions of residents of a country with non-residents, are key to understanding many domestic and international economic developments. According to economic literature, the balance of current and capital transactions with the Rest of the World is linked with the growth and international competitiveness of an economy, through the impact of issues such as productivity, costs of production factors, product/market diversification, tariff regimes, development of the financial system, as well as other factors such as the ageing of population, the propensity to save and the trade openness of the country. This chapter discusses the interpretation of persistent imbalances, and its relationship with the international investment position or the indebtedness of a country, including the composition of such foreign exposures. Standard criteria and thresholds to test external debt sustainability are also discussed.

  

1. A general overview

References to the position of an economy in its economic relationships with other countries are frequently discussed, and often make the headlines. Prominent examples are: “Is the US current account sustainable? If not, how costly is adjustment likely to be?” (Edwards, 2005); and “German current account surplus to hit record, world’s largest in 2016 (Wagner et al., 2017)”.

The accounts for the Rest of the World record all transactions and positions between residents and non-residents. This overview of the relationship of one country with the Rest of the World is often referred to as the balance of (external) payments statistics. Within both overviews, the current account balance of a country shows the international balance of its exports and imports of goods and services, and the balance of income transactions (wages and salaries, interest, dividends, taxes, etc.) with the Rest of the World. With respect to the latter, a distinction can be made between primary income and secondary income. Primary income is accrued due to being directly involved in the production process (e.g. the payment of wages and salaries to someone working in one country but living in another country, and vice versa) or due to the ownership of assets (interest, dividends, etc.). Secondary incomes refer to receipts and payments made without receiving something (directly) in return. Examples of the latter are remittances, taxes, social contributions, social benefits, etc. An example of the balance of payments, part of which concerns the current account, is presented in Table 7.1. In addition to the current account, the balance of payments also includes capital and financial transactions.

The current account balance receives (rightly so) great attention from economic analysts. The current account balance is a key indicator that is monitored on a regular basis, giving insight into the economic performance of a country vis-a-vis the Rest of the World. As such, it is also an indicator of the economic constraints and opportunities of a country. Less attention is usually given to how a current account surplus or deficit (positive or negative external saving) is financed. The latter is monitored by analysing the financial accounts and balance sheets. This chapter aims to show that understanding the way a current account surplus or deficit is financed is indeed useful and important.

Table 7.1. Overview of the accounts for the Rest of the World

Credits

Debits

Balance

Current accounts

 Goods and services account

  Goods

462

392

  Services

78

107

Goods and services (total)

540

499

41

Primary income account

  Compensation of employees

6

2

  Interest

13

21

  Distributed income of corporations

17

17

  Reinvested earnings

14

0

Primary income (total)

50

40

10

 Goods, services and primary income

590

539

51

Secondary income account

  Current taxes on income, wealth, etc.

1

0

  Net non-life insurance premiums

2

11

  Non-life insurance claims

12

3

  Current international transfers

1

31

  Miscellaneous current transfers

1

10

Secondary income (total)

17

55

-38

Current account balance

13

Capital account

  Acquisition or disposals of non-produced assets

0

0

  Capital transfers

1

4

Capital account balance

-3

Net lending (+) or net borrowing (-)

10

Financial account (by functional category)

  Direct investment

8

11

  Portfolio investment

18

14

  Financial derivatives (other than reserves) and ESOs

3

0

  Other investment

20

22

  Reserve assets

8

Total changes in assets or liabilities

57

47

Net lending (+) or net borrowing (-)

10

Net errors and omissions

0

Source: European Commission et al. (2008), System of National Accounts, https://unstats.un.org/unsd/nationalaccount/docs/SNA2008.pdf.

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As discussed in detail in Indicator 3 below, large and persistent current account deficits, for example deficits caused by having imports which are structurally higher than exports, lead to an increase in foreign debt exposure. To pay for the excess imports, the domestic country will have to borrow money from other counties. Continuous increases in the level of liabilities may eventually make the international investment position1 of a country less sustainable, with inevitable economic, political and social consequences (the concept of the international investment position is discussed in more detail later in this chapter). A deficit is not, however, necessarily a negative feature, as will be further discussed in this chapter and in Chapter 10. Some developing countries or some more mature economies may be able to sustain persistent minor current account deficits, as long as the quality of their financing is such that it does not generate instability (see e.g. IMF [2004]). For example, the United States can run persistent deficits because the US Dollar (USD) is generally accepted as the international currency for a significant share of international transactions. As a consequence, non-US residents have quite substantial holdings of USD, which ultimately is a liability of the US Federal Reserve, without any threat to financial stability.

Conversely, current account surpluses are not necessarily benign. Mercantilism was preoccupied with generating surpluses with the Rest of the World, but was rightly criticised as far back as the 18th century for being globally inconsistent. All countries cannot generate surpluses simultaneously. Moreover, if the objective of a surplus is associated with protectionist policies, it may hamper growth. On the other hand, surpluses may contribute to stability by creating a healthy balance sheet position for a country. With that said, abnormally high and persistent surpluses are generally considered a factor of instability. For instance, in EU countries, a current account surplus above 6% will trigger a so-called Macroeconomic Imbalances Procedure,2 the European Union’s surveillance mechanism that aims to identify potential risks, and to prevent and correct harmful macroeconomic imbalances. Excessive surpluses may not only represent a threat to global growth and stability, but they may end up encouraging financial flows towards dubious real and financial investments. They may also lead to international discussions on the fairness of international trade, as a consequence of which partner countries running a persistent deficit may consider protectionist measures to reverse the situation.

Figure 7.1 below shows the current account balance for selected EU countries. It is interesting to see how, following the 2007-09 economic and financial crisis, some imbalances have been narrowing while others have been increasing. Germany’s surplus has been increasing steadily, the opposite has happened to the United Kingdom, and Italy and Spain have switched from a deficit to a surplus.

Figure 7.1. Current account for selected EU countries, 2005-16
Percentage of GDP
picture

Source: Eurostat (2017), Balance of Payments Statistics and International Investment Positions (database), http://ec.europa.eu/eurostat/web/balance-of-payments/data/database.

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The sections that follow will show how the analysis of the “flip side” of the current account figures, as represented by the financial accounts and balance sheets, may prove to be very useful in uncovering the implications of the excess or lack of national saving implied by current account surpluses or deficits.

2. The balance of payments and its relationship with national accounts

The complete set of transactions with the Rest of the World in the 2008 SNA matches exactly the set of transactions captured in the balance of payments statistics, as defined by the BPM6, although there are some differences in terminology and breakdowns. Box 7.2 explains the similarities and differences, as well as statistical discrepancies, with further references to both the 2008 SNA and BPM6. This section aims to help the reader understand the relationship between two key indicators: the current account balance, which is usually directly derived from the balance of payments, and net lending/net borrowing, which is in essence the balance of the current and capital accounts and is derived from the Rest of the World financial accounts. Therefore, we start with introducing the capital account.

Introducing the capital account

As shown in Table 7.1, the current account balance is not exactly equal to the balance of international lending or borrowing. To arrive at the net lending/net borrowing figure, capital transactions must be taken into consideration as well. In the context of transactions between residents and non-residents, capital transactions consist of purchases/sales of non-produced non-financial assets and capital transfers. These transactions are usually relatively minor, and therefore it is generally acceptable, with all the necessary caveats, to use the broadly available current account balance as a handy proxy of net lending/net borrowing.

One may wonder why the capital account for the Rest of the World only records the transactions in non-produced non-financial assets, and then only part of them. First of all, purchases of newly produced non-financial assets from non-residents, or sales of such assets to non-residents, are recorded as part of imports and exports of goods and services. Furthermore, in the case a non-resident buys a non-financial asset that remains in the country, e.g. a dwelling or a non-residential building, the non-resident is automatically considered as a resident unit for the ownership of the relevant assets, including the related transactions. The purchase is recorded as a financial investment into a “notional unit” when it concerns, for example, a second house, or into an enterprise that uses the assets in the production of goods and services. As a consequence, the transactions in non-financial assets in the Rest of the World accounts are limited to sales and purchases of leases, licenses, etc. The payment for a football player offers a concrete example.

It is useful to consider the sequence of accounts, as presented in Table 7.1, which is drawn from the 2008 SNA. As mentioned previously, the table clarifies how net lending/net borrowing can be derived from the combination of the current account and the capital account. Box 7.1 shows the same logic, but this time in the form of traditional macroeconomic notations. In this theoretical example, the item “Errors and omissions” at the bottom of Table 7.1, which can be calculated as the difference between net lending/net borrowing from the current and capital accounts and the same balancing item from the financial account, is assumed to be equal to zero. It means that the two sets of accounts match perfectly. However, in practice, this usually is not the case; the “Going further” section at the end of this chapter further discusses the “errors and omissions” item.

Box 7.1. Saving, investments and the pivotal role of net lending/net borrowing

It is useful to go through the sequence of accounts, not only by analysing Table 7.1, but also by taking the relevant identities of the national accounts framework as a starting point. In doing so, the first important balancing item in the accounts for the Rest of the World is the external balance on goods and services, also known as the (foreign) trade balance, which shows the difference between the value of exports and the value of imports. The second balancing item of interest is the current account balance, which equals the foreign trade balance plus net receipts of (primary and secondary) income from the Rest of the World.

Foreign trade balance = X – M

Current acount balance = X – M + W

Where:

X = Exports

M = Imports

W = Balance of primary and secondary income transactions with the Rest of the World

The current account surplus or deficit also reflects whether a country’s investments in non-financial assets are matched with its saving, or, in general terms, if a country’s aggregate (internal and external) final demand exceeds domestic production.

(1) Y = C + I + (X –M)

(2) Y + W – C = S = I + (X – M) + W

(3) S – I = (X – M) + W = Current account balance

Where:

Y = Gross Domestic Product (GDP)

S = Saving

C = Consumption

I = Investment

X – M = External demand

C + I = Internal (or domestic) demand

In order to understand the link between the current account balance and financial transactions, one will have to introduce the capital account, as shown in Table 7.1, to arrive at net lending/net borrowing:

(4) Current account balance + R = (X-M) + W + R = S – I + R

R = Balance of capital transactions with the Rest of the World

As a macroeconomic equilibrium, the balance of equation 4 needs to be financed by external net lending/net borrowing. This financing of the balance of transactions on the current and capital accounts is reflected in the financial account:

(5) S – I + R = (X – M) + W + R = Net lending/net borrowing = NAFA – NIL + net errors and omissions

Where:

NAFA = net acquisition of financial assets

NIL = net incurrence of liabilities

National accounts versus balance of payments

A comparison between Table 7.1 above and Table 7.2 below illustrates how the national accounts and the balance of payments contain the same concepts. They are, however, presented in a slightly different way. Moreover, the terminology differs somewhat. The case of Japan presented in Table 7.2 is interesting in itself. It confirms that the current account is indeed a good proxy of net lending/net borrowing (which, again, represents the combined current and capital accounts). It also highlights the importance of “errors and omissions.

Table 7.2. Japanese balance of payments standard presentation (simplified), 2016
Millions of USD

2016

Current account

187 264.8

Goods and services

40 328.5

Primary income

166 549.6

Secondary income

-19 613.3

Capital account

-6 579.7

Gross disposals of non-produced, non-financial assets, credit

386.7

Gross acquisitions of non-produced, non-financial assets, debit

4 922.4

Capital transfers, credit

108.5

Capital transfers, debit

2 152.6

Current and capital accounts

180 685.1

Financial account

265 378.6

Direct investment

134 749.1

Portfolio investment

274 517.6

Financial derivatives (other than reserves) and employee stock options

-15 815.8

Other investment

-122 741.0

Reserve assets

-5 331.3

Monetary gold

Special drawing rights

583.2

Reserve position in the IMF

2 890.9

Other reserve assets

-8 805.3

Net errors and omissions

84 693.5

Source: IMF (2017), Balance of Payments Statistics (database), www.imf.org/external/datamapper/datasets/BOP.

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The international investment position

In the end, financial transactions between residents and non-residents, together with revaluations and some other changes in the volume of assets, have an impact on the position towards the Rest of the World, as recorded on the balance sheets. This so-called “international investment position” represents the stocks of external financial assets minus the stocks of external liabilities, and should not be confused with financial transactions.

Transactions in goods and services as well as income and capital transactions are recorded in the current and capital accounts and normally result in a concomitant entry in the financial account. For example, an export of goods will result in an increase in currency holdings, an increase in bank deposits or an increase in trade credits. A transaction may also involve two financial accounts entries, when it concerns a purchase or disposal of a financial asset between a resident and a non-resident. For instance, a foreign government bond may be exchanged for currency and deposits. In other cases, the transaction may involve the creation of a new financial asset and corresponding liability.

As noted, the ownership of stocks of foreign financial assets and liabilities by residents, and the ownership of domestic financial assets and liabilities by non-residents are represented in the international investment position (IIP). The IIP is a key indicator in many financial stability reports. By analysing the IIP together with the current account, one can make a macroeconomic assessment of a country’s financial situation, and combine this analysis with other macroeconomic analyses. A strong IIP will help to smooth current account imbalances, whereas a weak IIP, in general, may trigger the need for more drastic structural adjustments. Table 7.3 shows Japan’s IIP. It is clear that Japan has a very strong international position, which, coupled with a current account surplus shown above, gives a positive signal for the country.

Table 7.3. Japanese IIP summary presentation, Q4 2016

Q4 2016

Millions of USD

% of GDP

Assets

8 586 458.5

174

 Direct investment

1 413 767.1

 29

  Equity and investment fund shares

1 289 032.5

 26

  Debt instruments

124 734.6

  3

 Portfolio investment

3 875 436.6

 78

  Equity and investment fund shares

1 417 739.7

 29

  Debt instruments

2 457 696.9

 50

 Financial derivatives (other than reserves) and employee stock options

371 113.0

  8

 Other investment

1 705 719.2

 35

  Other equity

71 164.4

  1

  Debt instruments

1 634 554.8

 33

 Reserve assets

1 220 414.0

 25

Liabilities

5 519 203.4

112

 Direct Investment

240 907.5

  5

  Equity and investment fund shares

198 604.5

  4

  Debt instruments

42 311.6

  1

 Portfolio investment

2 729 691.8

 55

  Equity and investment fund shares

1 508 587.3

 31

  Debt instruments

1 221 104.5

 25

 Financial derivatives (other than reserves) and employee stock options

388 407.5

  8

 Other investment

2 160 188.0

 44

  Other equity

7 525.7

  0

  Debt instruments

2 152 662.3

 44

Net International Investment Position

3 067 255.1

 62

Source: IMF (2017), Balance of Payments Statistics (database), www.imf.org/external/datamapper/datasets/BOP.

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As can be seen in Table 7.3, the Japanese economy has a positive external position with the Rest of the World. More concretely, at the end of 2016, the Japanese net IIP was 62% of GDP. In other words, the financial assets held abroad were higher than the financial assets held by non-residents (liabilities from the Japanese position), and the net amount of assets less liabilities towards the Rest of the World was the equivalent of more than half of the total income generated in Japan in 2016.

Box 7.2. IMF Balance of Payments and International Investment Position Statistics versus National Accounts’ Rest of the World accounts

As explained previously, the 2008 SNA governs the presentation of the Rest of the World in national accounts and the BPM6 sets standards for the presentation of the balance of payments statistics.

One would expect that both overviews are consistent with each other. However, there are some differences in terminology and breakdowns between the 2008 SNA and BPM6, but these are generally quite minor. The main differences can be observed in the financial accounts (and balance sheets). While in the 2008 SNA, the traditional financial instruments are distinguished (see Chapter 1), the balance of payments statistics usually apply the breakdown of financial transactions and positions by functional category: direct investment, portfolio investment, financial derivatives (other than reserves) and employee stock options, other investment, and reserve assets.

Other differences, and these can be quite substantial in some countries, may be caused by the balancing, within the national accounts, of the numbers from the balance of payment statistics with the statistics on domestic activities. For each transaction between a resident unit and a non-resident unit, as recorded in the balance of payments, there is a counterpart in the domestic economy. When confronting statistics on domestic sectors with the balance of payments statistics, these transactions and positions, which are derived from a variety of data sources, do not match, and to which adjustments will need to be made. Part of these adjustments may be made to the balance of payments. As a consequence, the balance of payments diverges from the Rest of the World accounts in the national accounts. This also affects the original errors and omissions (discussed in detail in the ‘Going further’ section at the end of this chapter), which are labelled “statistical discrepancies” in the 2008 SNA. One of the motivations for adjusting the balance of payments data, rather than the source data for domestic activities may actually be related to the adjustment’s potential to lower the statistical discrepancies.

In 2016, the strength of the Japanese IIP essentially relied on three particular functional categories:

  • direct investment: ownership of foreign enterprises with voting power of more than 10%: these investments usually represent strategic decisions regarding the location of productive activities inside the country or abroad; as such, they often concern long-term investments which are not easily reversed;

  • portfolio investment – ownership of tradeable securities: the Japanese economy held a significant amount of foreign debt securities;

  • reserve assets: Japanese monetary authorities held an equivalent of one quarter of the GDP in assets denominated in foreign currencies.

3. The underlying components of non-financial and financial accounts

The dynamics of current account deficits/surpluses

As explained in Indicator 1, the balance of the current and capital accounts comprises both the balance of foreign trade in goods and services and the balance of other income and capital transactions. Typically, an overall deficit coincides with a foreign trade deficit, i.e. when a country imports more goods and services than it exports. By definition, any deficit/surplus on the current and capital accounts is balanced by transactions in financial assets and liabilities in the financial accounts. This identity reflects the double entry bookkeeping system, which also underlies the system of national accounts and the balance of payments system. Any current or capital transaction has to have a matching counterpart in a financial transaction.

Another identity, representing the equivalence of total payments and total receipts for each transaction, is shown in equation 4, in Box 7.1, where the current and capital accounts are expressed as the difference between national saving and investment plus the balance of the external capital account. This equation is basically an alternative presentation of the equivalence of total supply and total use of goods and services, as expressed in equation 1. Unlike closed economies, where investment must always equal saving, open economies may finance a shortage of domestic saving by incurring foreign debt or having non-residents invest, for example, in the equity of domestic corporations. In this perspective, for a given period, a current and capital accounts deficit may be viewed as the domestic country having insufficient national saving to finance the desired level of domestic investment.

Figure 7.2 shows the balance of current and capital accounts for the total of a number of “stressed” EU countries: Greece, Ireland, Italy, Portugal and Spain. From 2005 to 2011, these countries had a negative foreign trade balance. From 2013 to 2016, these countries managed, through an internal adjustment process, to turn this deficit into a positive international trade balance. These movements in the performance of exports and imports were also the main drivers of the total balance of the current and capital accounts, or the external net borrowing/net lending figure. Looking at Figure 7.2 in combination with Figure 7.3, which shows the developments in saving and (non-financial) investments, one can easily observe the above discussed macroeconomic identities. Figure 7.3 shows that during the years when the current and capital accounts were negative, domestic investments were larger than domestic saving in the selected EU countries.

Figure 7.2. Balance of payments for selected stressed EU countries,* 2005-16
Percentage of GDP
picture

1. Greece, Ireland, Italy, Portugal and Spain

Source: Eurostat (2017), Balance of Payments Statistics (database), http://ec.europa.eu/eurostat/web/balance-of-payments/data/database; Eurostat (2017), National Accounts Statistics (database), http://ec.europa.eu/eurostat/web/national-accounts/data/database.

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Figure 7.3. Savings and investment for selected stressed EU countries,* 2005-15/16
Percentage of GDP
picture

1. Greece, Ireland, Italy, Portugal and Spain.

Source: Eurostat (2017), Balance of Payments Statistics (database), http://ec.europa.eu/eurostat/web/balance-of-payments/data/database; Eurostat (2017), National Accounts Statistics (database), http://ec.europa.eu/eurostat/web/national-accounts/data/database and World Bank (2017), Gross Domestic Savings (database), http://data.worldbank.org/indicator/NY.GDS.TOTL.ZS.

 http://dx.doi.org/10.1787/888933588858

As previously mentioned, large and persistent current account deficits may cause external sustainability problems. However they are not, per se, necessarily a negative indicator in any economy, and need to be considered along with other macroeconomic indicators such as the growth rates of GDP and investments, as well as export and import fluctuations.3

There is also a link between GDP growth and the balance of the current and capital accounts. More specifically, the additional income generated through a growing level of GDP may lead to more demand for goods and services. Some of these goods and services may need to be imported, thus affecting the external goods and services account negatively, ceteris paribus. Figure 7.4 illustrates this negative relation between GDP and the current account balance, for the years between 2005 and 2016, for the total of selected stressed EU countries. However, it is also worth mentioning that other factors may also have an impact on the relation between domestic output and the current account balance, thus challenging the negative relationship between GDP and current account balance. For example, the growth of GDP may actually be caused by improved competitiveness, as a consequence of which exports of domestically produced goods and services have increased.

Figure 7.4. Current and capital accounts and GDP growth for selected stressed EU countries,* 2005-16
Billions of EUR (left-hand scale) and GDP annual growth rate (right-hand scale)
picture

1. Greece, Ireland, Italy, Portugal and Spain.

Source: Eurostat (2017), Balance of Payments Statistics (database), http://ec.europa.eu/eurostat/web/balance-of-payments/data/database; Eurostat (2017), National Accounts Statistics (database), http://ec.europa.eu/eurostat/web/national-accounts/data/database.

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Current and capital accounts versus financial flows

Figure 7.5 shows, for each year, and for the total of selected stressed EU countries, two different bars: the first shows the main drivers of the balance of the current and capital account (i.e. decomposed into net trade in goods and services, net primary income, and net capital account); and the second shows how the “real” economy is externally financed (foreign direct investment, portfolio investment, other investment and reserve assets).

Figure 7.5. Current and capital accounts and financial accounts for selected stressed EU countries,* 2005-16
Billions of EUR
picture

1. Greece, Ireland, Italy, Portugal and Spain.

Source: Adapted from Eurostat (2017), Balance of Payments Statistics and International Investment Positions (database), http://ec.europa.eu/eurostat/web/balance-of-payments/data/database.

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As described above, the selected stressed EU countries have experienced an adjustment process between 2005 and 2016, during which they managed to reverse the negative balance of the current and capital accounts into a positive balance. On the “real side” of the economy, in selected countries, the foreign trade in goods and services was clearly the main driver of the evolution of the current and capital accounts. In the 2005-16 time period, income paid by residents to non-residents was always larger than the income received by residents from non-residents.

Deficits on the current and capital accounts need to be financed, whereas surpluses can be used to invest abroad. As noted before, leaving apart statistical discrepancies, the balance of the current and capital accounts is, by definition, equal to the balance of the financial transactions with the Rest of the World. Residents may provide loans to non-residents, and vice versa. They may also purchase foreign debt securities or invest in the equity of non-resident companies, by purchasing shares of a foreign corporation (portfolio investment). An alternative way of investing abroad is to establish a subsidiary enterprise, which is referred to as (foreign) direct investment. Using data from the financial accounts, as also demonstrated in Figure 7.5 above, one can see that in the case of the stressed EU countries, external deficits between 2005 and 2009 were mainly financed through portfolio investments by non-residents, while other investments were generally the main counterpart of the current and capital account balances from 2010 onwards.

The income generated by all these investments, in the form of interest, dividends and reinvested earnings (on foreign direct investment), is an important component of the current and capital accounts. This income is influenced by the stocks of external debt and equity accumulated in the past. In this respect, reinvested earnings are a special category. In the case of foreign direct investment (FDI), the distributed profits of foreign subsidiaries are recorded as investment income. Additionally, the non-distributed profits are considered as payment/receipt of property income, which is subsequently recorded as re-investment in the subsidiary in the financial accounts.

Current and capital accounts sustainability and foreign exposures

Large and persistent current and capital account deficits may constitute a cause for economic concern, particularly when sustainability issues are being raised, questioning the economic prospects of a country. Regardless of the origins, when a country runs current and capital account deficits on a structural basis, it is building up liabilities vis-a-vis the Rest of the World that eventually need to be repaid. Therefore, the country should be able to generate, in the future, sufficient current and capital account surpluses to repay what it has borrowed to finance the current and capital account deficits. In that sense, the extent of the foreign liabilities of a given economy, and their respective servicing costs, may be important aspects to consider when analysing the vulnerabilities of an economy. Whatever the reason behind a current and capital account deficit, high and persistent current account deficits should call for further policy considerations.

When analysing foreign exposures, understanding the composition of the financing is important, as short-term financing is more easily reversed than long-term financing. Similarly, equity financing tends to be more stable than debt-based financing. Particularly, FDI, which is often related to the long-lasting establishment of an enterprise in a country, tends to represent long term investment, whereas other inflows are generally easier to reverse (as in the case of Japan in Table 7.3). Although it may be difficult to state with certainty which components of financing are short- or long-term, some general assumptions can be made. For instance, a current and capital account deficit that is mainly financed by extensive FDI is generally more sustainable than financing through short-term portfolio investments, which may be easily liquidated if the market conditions or expectations change. Moreover, FDI tends to finance long-term investment projects that increase the capital stock of the country and generate revenues required to repay foreign debt in the future. On the other hand, financial sustainability may be seriously threatened if the financing of the external deficit leads to significant losses in official foreign exchange reserves.

Foreign debt exposures

The macroeconomic impact of an increasing foreign or external indebtedness in the case of persistent deficits in the current and capital accounts depends on how the country is using the foreign financing. It also depends on how much a country has borrowed from abroad in the past. External debt requires the payments of principal and/or interest in the future. As such, the liability represents a claim on the resources of the resident’s economy. These liabilities may include debt securities, such as bonds, notes and money market instruments, as well as loans, deposits, currency, trade credits and advances owed to non-residents. The debt could be issued with different maturity profiles by different institutional sectors (mainly general government, the non-financial and the financial corporations’ sectors). Although not always available, other additional details, such as the geographical breakdown of creditors and debtors and the residual maturity, can be useful to supplement this analysis.

There are a number of valuable methodologies and indicators to measure a key macroeconomic concept like external debt. Overall, they allow for a multi-dimensional approach, making use of several balance of payments items, with their main advantage the possibility to provide a comprehensive measure of external debt consistent across the range of debt instruments, institutional sectors and valuation methods used. Comparisons can be made by focusing on alternatives like gross external debt versus net external debt, external debt vis-a-vis the overall international investment position (IIP), and external debt at nominal value versus external debt at market value. Figure 7.6 illustrates the gross external debt position of the Portuguese general government between Q4 2009 and Q4 2016. Overall, it can be seen that the Portuguese government increased its exposure to the Rest of the World. In the period under analysis, Portuguese gross external debt increased by 33%. The maturity analysis enables the user to understand that this was due to longer term contracts, since short-term debt decreased by 57%.

Figure 7.6. Portuguese general government gross external debt position by original maturity, 2009-16
Millions of EUR
picture

Source: Banco de Portugal (2017): Balance of payments Statistics (database), www.bportugal.pt/EstatisticasWeb/(S(d2kqsvm5bxjx3bag2hq5lo55))/DEFAULT.ASPX?Lang=en-GB.

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Gross external debt, at any given time, is the outstanding amount of liabilities of the residents of an economy towards residents of other countries. These debt liabilities, which exclude equity investments of non-residents in the domestic economy, only capture one side of an economy’s external exposure to international debt markets. Net external debt, which can be obtained by subtracting debt liabilities of non-residents towards residents from gross external debt, captures both sides of external exposure. As such, it can provide additional insights into the sustainability of external debt. The recent massive increase in the use of certain types of financial contracts, such as repurchase agreements, securities lending, collateralised loans and securitisation issues, has driven up gross external debt figures. This is because these instruments simultaneously create new debt positions in both assets and liabilities. As a consequence, net external debt has become more relevant as an indicator of foreign debt exposures.

The analysis of solvency risks related to external debt, which is usually based on net interest payments to the Rest of the World, is inferred from the net external debt concept. In this context, large imbalances in net external debt and large net interest payments generally constitute a credible early warning signal of rising risks concerning the ability of the economy to successfully meet its external financial obligations, particularly in periods of economic distress or in the aftermath of external shocks. Figure 7.7 shows the gap between gross and net external debt for a number of EU countries. From this figure, two clear conclusions can be drawn: i) the level of net external debt is, by definition, lower than that of the gross debt; and ii) some countries become creditors when the net concept is used to measure external debt. The latter relates to, for example, Belgium and Germany.

Figure 7.7. Gross and net external debt for selected EU countries, 31 December 2016
Percentage of GDP
picture

Source: ECB (2017), Balance of Payments and Other External Statistics: Gross External Debt (database), http://sdw.ecb.europa.eu/browse.do?node=9691635; Eurostat (2017): Net External Debt (database), http://appsso.eurostat.ec.europa.eu/nui/show.do? dataset=tipsii20&lang=en.

 http://dx.doi.org/10.1787/888933588934

Total international investment position (IIP)

Beyond external debt indicators, other kinds of measures, such as the IIP, can significantly contribute to the analysis of a country’s economic performance. The IIP relates to the overall net external financial position of a country. As discussed previously, it measures the sum of all external financial assets (residents’ investments in the Rest of the World) minus all external liabilities (non-residents’ investments in a country). It thus includes, in addition to the net external debt, the net external position in equity (including FDI), financial derivatives, and other components such as official reserves.

Although the analysis of balance of payments statistics has an important role to play in understanding the sustainability and vulnerability of an economy, IIP data are useful for other purposes as well. According to BPM6, IIP data can be used for:

  1. monitoring rates of return of external financial investment;

  2. analysing solvency issues, where “assets are insufficient to cover liabilities”; and

  3. analysing dependency problems, for example, when the majority of a country’s exports are being sold to just one or two countries.

Within the EU context, the IIP is one of the indicators included in the scoreboard of the Macroeconomic Imbalances Procedure, a surveillance mechanism that aims to identify potential risks, and to prevent and correct harmful macroeconomic imbalances in the European Union (as already mentioned above). Figure 7.8 shows the total IIP and the net external debt position in 2016 for fifteen EU countries. Only Denmark, Germany and Belgium have both external net debt (defined here as assets minus liabilities of residents towards the Rest of the World) and a positive IIP. In this sense, their foreign assets are larger than their liabilities owed towards non-residents. On the other hand, countries like Greece and Portugal have a negative net stock below minus 100% of GDP. In practice, that means that, in 2016, both countries owe to non-residents the equivalent of more than one year of value added generated through production (GDP). From Figure 7.8 it is also possible to derive, by the size of the gap between the two bars, the external position of non-debt related instruments. Looking at the difference between the two bars in Figure 7.8, one can observe both positive and negative positions of non-debt related instruments. Denmark and Germany, for example, have substantial non-debt international positions, whilst Eastern European countries typically have negative positions, showing that considerable equity-type investments have been made in these countries.

Figure 7.8. Net external debt* and IIP for selected EU countries, 31 December 2016
Percentage of GDP
picture

1. To ease comparison in this figure, net external debt is represented in negative terms.

Source: Eurostat (2017): Net External Debt (database), http://appsso.eurostat.ec.europa.eu/nui/show.do?dataset=tipsii20& lang=en; ECB (2017): Balance of Payments and International Investment Position (database), http://sdw.ecb.europa.eu/browse.do? node=9688874.

 http://dx.doi.org/10.1787/888933588953

Specific cases of foreign direct investment

Residence is a key concept, not only when it comes to defining domestic activities, but also when it concerns the definition of external investment positions. In this respect, some issues can arise regarding the inclusion, or exclusion, of some entities to which the application of the concept of residence is not straightforward. Examples include enterprises located in free trade territories or offshore zones, or “Special Purpose Entities” (SPEs). According to the international standards for compiling balance of payments and national accounts, enterprises located in offshore zones should be registered in the economies in which the zones are located, even though such enterprises may belong to non-resident multinational groups. The financial transactions and positions between the enterprise located offshore and the non-resident multinational group to which it belongs constitute a foreign direct investment relationship. Similarly, SPEs are always treated as separate institutional units, if they are resident in another country than that of their owners. A brass plate company, a typical example of an SPE, which has been set up by a non-resident unit to collect worldwide royalties for tax avoidance reasons, is thus also recorded as a foreign direct investment relationship.

As a consequence of the above treatment, the debt issued and registered on the balance sheets of entities legally incorporated or domiciled in an offshore centre is classified as external debt of the economy in which the offshore centre is located. The same is true for SPEs. Any subsequent lending of funds to a non-resident of the economy where the SPE or the offshore is located, e.g. to a parent or subsidiary corporation, is classified as an external asset of the offshore entity. However, as these units do not have substantial economic activities in the country of residence, relevant countries are strongly encouraged by users to separately identify the external positions of these entities, especially when they are significant. Figure 7.9 shows the impact SPEs can have on the interpretation of data on FDI positions for a number of OECD countries. In the Netherlands, for example, the positions of SPEs amount to more than 80% of total FDI. In Hungary, they account for more than 50%. Other countries with substantial positions of SPEs, not presented in Figure 7.9, are Ireland and Luxembourg.

Figure 7.9. FDI liabilities in OECD selected countries by type of entity, 2015-16
Percentage of total liabilities
picture

Source: OECD (2017), OECD Statistics on Measuring Globalisation (database), https://stats.oecd.org/Index.aspx?DataSetCode= FDI_POS_AGGR.

 http://dx.doi.org/10.1787/888933588972

External debt at nominal value and external debt at market value

International standards encourage the valuation of gross external debt positions at both nominal value and market value. The nominal value of a debt instrument is a measure of value from the viewpoint of the debtor. It reflects the amount that the debtor owes, at any moment in time, to the creditor. This value is typically established with reference to the terms of a contract between the creditor and the debtor. The market value is determined by the prevailing market price, which provides a measure of the opportunity cost to both the creditor and the debtor. As an example of this difference in valuation, consider a country having trouble in settling external imbalances. The measurement of external debt at market value can decrease due to a cut in the government bonds’ price, as caused by the perception of an augmented sovereign risk and inherent increase of the risk premium. The latter effect is not observable when analysing the external debt at nominal value.

In addition to transactions in debt instruments, external debt positions can also be affected by non-transaction effects, such as price and exchange rate fluctuations. Figure 7.10 compares, for a number of countries, the change in gross external debt at market value between the end of 2015 and the end of 2016 and the corresponding transactions that occurred during 2016. For some countries, transactions actually show a pattern that is quite different from the change in the position from one year to another. In Estonia and Belgium, the sign is even reversed, meaning that despite of disposals/acquisitions of relevant liabilities the total position at market value has increased/decreased.

Figure 7.10. Gross external debt change for selected EU countries, 2016
Percentage of GDP
picture

Source: ECB (2017), Balance of Payments and Other External Statistics (database), http://sdw.ecb.europa.eu/browse.do? node=9691635; and Eurostat (2017), National Accounts Statistics (database), http://ec.europa.eu/eurostat/web/national-accounts/data/database.

 http://dx.doi.org/10.1787/888933588801

In the case of external debt, the non-transaction flows are mainly linked to earnings/losses caused by exchange rate fluctuations of national domestic currency vis-a-vis other foreign currency in which underlying liabilities are denominated and, in the case of tradeable securities, changes in the price of the relevant liabilities. Other adjustments may include bankruptcies, write-offs and relocations of enterprises (including SPEs) from one country to another.

Maturity mismatch between financial assets and liabilities

Finally, one more important tool in analysing a country’s risks and vulnerabilities relates to so-called “balance sheet mismatches”. These mismatches can include a mismatch between the maturities of financial assets and the maturities of liabilities, or a mismatch in the currency composition of assets and liabilities. In respect to maturity mismatches, if a country has short-term financial assets and long-term liabilities, the external debt can be considered as more sustainable than if the country had long-term financial assets and short-term liabilities. This maturity mismatch can be analysed by focusing on either original maturity or remaining maturity.

The original maturity, which is typically referenced, enables a user to understand the maturity of the loans initially agreed for the down payment of the loan (also known as the amortisation agenda), as stipulated by the contract. On the other hand, the remaining maturity provides information on the time left for the debt instrument to be completely paid down to the lender. While the original maturity enables analysts to make inferences about the investors’ preferences, the residual maturity gives a clearer picture about the time profile of the future responsibilities. Users are increasingly asking for data with maturity breakdowns for both original and remaining maturity for all debt instruments.

Some concluding remarks on sustainability of foreign exposures

In this chapter we have introduced the current and capital accounts and the IIP of a country. We also tried to show that balance of payments figures always need to be put in context. Some economies, be they emerging or already developed, may benefit for a number of years from flows in FDI that may be considered “good liabilities” in that they help develop productivity and competitiveness. The important question is whether the continuation of certain trends is sustainable. Answering this question requires studying the various items of both the balance of payments and the IIP one by one. For example, the balance of goods and services may be rapidly corrected by economic policy measures or financial crises. One key factor is the relationship of debt-creating flows and the sustainability of stocks of debt. Even initially “benign” FDI can turn into a negative, if a financial crisis spurs a wave of international divestments from a country. Moreover, the sustainability of the external debt burden is important to analyse, using external statistics. One should always project different scenarios where the stock of debt can grow exponentially, stabilise or decrease.

The standard criteria to assess the sustainability of an IIP are quite similar to the ones used in the case of domestic public or private debt:

  • In an open economy, the discounted value of future (positive) trade balances should be at least equal to the external investment position of the country at a certain point in time. If a country is initially running trade deficits and has a negative external position, i.e. its liabilities towards the Rest of the World are higher than its foreign assets, it needs to run trade surpluses over time to remain solvent.

  • Alternative measures, that may be less constraining from a policy point of view, are external debt to exports, debt service to GDP, and debt service to exports.

  • Market prices of the value of the external debt of a country may provide another measure of the market perception of the likelihood that a country may not pay in time and in full its external liabilities.

Chapter 10 further analyses the issue of sustainability. Once a problem in relation to the sustainability of a country’s external position is assessed, a series of redress policies may need to be put in place, in order to prevent negative external investment positions from “snowballing” (Roubini and Setser, 2004). Such measures may take place on the financial side, for example through rescheduling debt; on the policy side, by improving competitiveness, either through exchange rate adjustments or by a set of macroeconomic measures imposing domestic “austerity”; or through a combination of such measures. On the opposite side, a persistence of current account surpluses for an extended period may also represent an imbalance affecting stability, as explained previously. As Ben Bernanke has noted: “… the gold standard of the 1920s was brought down by the failure of surplus countries to participate equally in the adjustment process” (2015).. Policies aimed at increasing domestic demand through investments in infrastructure, raising wages or tax incentives for private domestic investment may be used in such circumstances.

Key points

  • The current account balance is a key indicator of a country’s position with the Rest of the World. This indicator is usually also a good proxy of net lending/net borrowing, which represents the combination of the current and capital accounts.

  • From a pure accounting perspective, the balance of the current and capital account, net lending/net borrowing, is by definition equal to the balance of the financial account. However, in practice there usually are statistical discrepancies or “errors and omissions”. When the balancing item of the current and capital account is positive/negative, this means that the Rest of the World is being financed by/is financing the domestic economy.

  • The international investment position (IIP) expresses the stocks of financial assets and liabilities of a country vis-a-vis non-resident economies. It results from the accumulation of financial transactions (net purchases of financial assets and net incurrence of liabilities) and other flows (for instance, price changes and exchange rate changes).

  • Current account surpluses or deficits need careful interpretation and should never be taken as a “positive” or “negative” in isolation. Key economic and financial factors, such as the rate of growth or the nature and quality of financial flows should be added to the analysis, along with a more thorough analysis of the IIP.

  • It is, however, true that persistent deficits may create a situation of disequilibrium and “snowballing” into crises. The level and risk of disequilibria can be assessed and monitored through external statistics, the use of which may help signal risks in a timely manner so as to implement redress policies and avoid crises.

Going further

Net errors and omissions

Net errors and omissions result from the difference between the net lending/net borrowing figure in the financial account and the same balancing item resulting from the current and capital accounts. In the words of the IMF: “… when a resident unit carries out a transaction with a non-resident unit, national compilers are unable to verify independently the counterpart entries in the Rest of the World. As a result, although in principle the balance of payments is balanced, in practice, there may be an imbalance due to shortcomings in source data and compilation … This imbalance, a usual feature of published balance of payments data, is labelled net errors and omissions. The balance of payments manuals have traditionally discussed this item, to emphasise that it should be published explicitly, rather than included indistinguishably in other items and that it should be used to indicate possible sources of mismeasurement”.

Balance of payments statistics cover an enormous number of transactions and need to cope with the growing and challenging phenomenon of globalisation. As a result of this inherent complexity, the two recording sides (on the one hand, the “financial” side – the financial account – and, on the other hand, the “real” side – the current and capital accounts) hardly ever match in practice. Imperfect measurements of the balance of the various payments can arise from:

  1. Time lags between the recording of payments and the recording of the concomitant receipts (moment of transaction versus moment of payment), and vice versa. These unknown discrepancies mainly arise from differences between when a transaction is entered into the relative accounts of the different parties involved in the transaction and/or incomplete source data, and should not be associated with known trade credits and other accounts receivable/payable;

  2. Errors in recorded volumes, stemming from documentation errors and/or from estimation-based records;

  3. Incomplete or incoherent coverage of transactions.

The sign (over time) and magnitude of net errors and omissions often has a direct relationship with the quality of balance of payments statistics. Small errors and omissions can also “hide” more significant omissions. The latter is the case when, for instance, there are significant omissions on both sides of the accounts, which cancel each other out and result in an artificially low value for net errors and omissions. Still, significant values of net errors and omissions can tell us something about the imperfections of the compilation procedures and the need for improvements. The dynamics of net errors and omissions may also point economic policy makers to the fact that a part of economic flows which are more difficult to cover (for example, hidden and/or illegal transactions) are missing. This could then lead to changes in the legal framework or to concrete measures to avoid various forms of tax evasion.

Although there is no international consensus on the quantitative limits of net errors and omissions, it is always useful to monitor them and check whether the magnitude is within reasonable and sound thresholds. In fact, over time, one would expect that the accumulated amount of net errors and omissions is more or less balanced, meaning that positive and negative amounts of net errors and omissions cancel each other out. In the case of Portugal, an interval between +/- 3% of the current account turnover is taken as a reference point; see Figure 7.11. It goes without saying that having a positive or negative amount of errors and omissions over longer periods of time may point to a serious quality issue of a more structural nature.

Figure 7.11. Balance of payments’ internal consistency indicator for Portugal, 2006-16
Millions of EUR
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Source: Banco de Portugal (2017): Balance of Payments Statistics (database), www.bportugal.pt/EstatisticasWeb/(S(d2kqsvm5 bxjx3bag2hq5lo55))/DEFAULT.ASPX?Lang=en-GB.

 http://dx.doi.org/10.1787/888933588820

Overall, net errors and omissions are an unavoidable part of the balance of payments compilation procedure, targeted to offset overstatements or understatements of the entries on the two sides of the accounts. Nevertheless, the uncertainty created by net errors and omissions can affect the use and interpretation of the balance of payments itself and the economic and financial statistics that are based on the balance of payments, including the international investment position (IIP). Therefore, despite the difficulties, it is essential to monitor the size and evolution of net errors and omissions over time, in addition to identifying their underlying causes.

References

Banco de Portugal (2017), Balance of Payments Statistics, Banco de Portugal, Lisbon, www.bportugal.pt/EstatisticasWeb/(S(d2kqsvm5bxjx3bag2hq5lo55))/DEFAULT.ASPX? Lang=en-GB.

Bernanke, B. (2015), “Germany’s trade surplus is a problem”, Brookings Institue blog, www.brookings.edu/blog/ben-bernanke/2015/04/03/germanys-trade-surplus-is-a-problem/.

Edwards, S. (2005), “Is the US current account sustainable? If not, how costly is adjustment likely to be?”, Brookings Papers on Economic Activity, No. 1/2005, Brookings Instiute, Washington, DC, www.brookings.edu/bpea-articles/is-the-u-s-current-account-deficit-sustainable-if-not-how-costly-is-adjustment-likely-to-be/.

ECB (2017), Balance of Payments and Other External Statistics, European Central Bank, Frankfurt, http://sdw.ecb.europa.eu/browse.do?node=9691635.

Eurostat (2017), Balance of Payments Statistics and International Investment Positions, Eurostat, Luxembourg, http://ec.europa.eu/eurostat/web/balance-of-payments/data/database.

Eurostat (2017), National Accounts Statistics (database), Eurostat, Luxembourg, http://ec.europa.eu/eurostat/web/national-accounts/data/database.

Eurostat (2017), Net External Debt, Eurostat, Luxembourg, http://appsso.eurostat.ec. europa.eu/nui/show.do?dataset=tipsii20&lang=en.

IMF (2017), Balance of Payments Statistics, International Monetary Fund, Washington, DC, www.imf.org/external/datamapper/datasets/BOP.

IMF (2004), Assessing Sustainability, International Monetary Fund, Washington, DC, www.imf.org/external/np/pdr/sus/2002/eng/052802.pdf.

OECD (2017), OECD Statistics on Measuring Globalisation, OECD Publishing, Paris, https://stats.oecd.org/Index.aspx?DataSetCode=FDI_POS_AGGR.

Roubini, N. and B. Setser (2004), The US as Net Debtor: The Sustainability of the US External Imbalances, NYU Stern School of Business, New York City.

Wagner, R. et al. (2017), “German current account surplus to hit record, world’s largest in 2016”, Reuters, 30 January, www.reuters.com/article/us-germany-economy-trade-idUSKBN15E0W4.

World Bank (2017), Gross Domestic Savings, World Bank, Washington, DC, http://data. worldbank.org/indicator/NY.GDS.TOTL.ZS.

Notes

← 1. The international investment position, according to the definition of BPM6 is equivalent to the balance sheet positions in the 2008 SNA.

← 2. The European Union’s Macroeconomic Imbalances Procedure scoreboard comprises fourteen indicators: current account balance, net international investment position, exports market share, nominal unit labor cost, real effective exchange rates, private sector debt, private sector credit flow, house price index, general government sector debt, unemployment rate, total financial sector liabilities, activity rate, long-term unemployment rate and youth unemployment rate.

← 3. For a wider discussion on the implications of current account deficits, reference is made to “Judging whether deficits are bad” in: Ghosh, Atish and Ramakrishnan, “Current Account Deficits: Is there a Problem?”, International Monetary Fund (2012).