MGE 11'1

1

• Session 11 Open Economies (I) Trade and Balance
  of Payments
• Goal Understanding role of international
  capital flows.
• Small Open Economies Fixed Interest Rate
• Balance of Payments Current and Capital Accounts
• Foreign Direct Investment
• Globalization

Loïc Sadoulet Macroeconomics in a Global
Economy P3 Jan-Feb. 2004
2
Closed Economies




NX 0
, and no international capital flows.



In equilibrium, the interest rate adjusts to have
I S
.


S
2

Real interest rate

S

1


r
2



r
1


I

Investment
/ Saving

3
Imports/Exports as of GDP
Total World Exports (2002) 8 trillion World
GDP32 trillion
4
Open Economies(with perfect capital mobility)

• Y C I G ( X IM )
• can be rewritten as
• ( Y C G ) I ( X IM )
• Use of savings S I X IM

5
Small open economies

The interest rate is equal to the world interest
rate, and taken as fixed



(country is too small to influence world interest
rates).


Real interest rate

S



World interest rate


r



I

Investment

/ Saving

I
S



Use of savings identity
NX
6
What happens when S lt I ?
S lt I gt need capital from abroad! Investment
Gap
S
Real interest rate
World interest rate
r
NX lt 0
I
Investment
/ Saving
I
S
7
S I Net Capital Outflow

• Net capital outflow net investment abroad (net
  purchases of foreign assets)
• Why?
• If S gt I excess supply of funds to the domestic
  loanable funds market(which would put downwards
  pressure on interest rate)
• Alternative go abroad and earn r (perfect
  capital mobility)
• This drives the domestic interest rate back to r

8
S I Net Capital Outflow
Real interest rate
S
S
r
World interest rate
I
Investment/ Saving
I
S
9
Why should Net Capital Outflows be related to
Net Exports?

• S I X IM
• Example
• EU company imports US product for 70
• EU net exports fall by 70
• S I gt X (IM 70)
• US company now has extra 70

10
What to do with the extra 70 ?

• Possibility 1 Buy 70 worth of EU products
• S I gt X (IM 70)
• S I (X 70) (IM 70)

balanced trade
11
What to do with the extra 70 ?

• Possibility 2 Invest 70 in EU assets (buy a
  corporate bond, for example)
• S I gt X (IM 70)
• S (I 70) X (IM 70) if leads to new
  investment
• or
• (S 70) I X (IM 70) if replaces
  domestic savings

Trade deficit and capital inflows
12
What to do with the extra 70 ?

• Possibility 3 Go to US bank and exchange 70
  for US dollars
• Bank then sells the 70 to another customer
• who buys EU products
• S I (X 70) (IM 70)
• or assets
• S (I 70) X (IM 70) if leads to new
  investment
• or
• (S 70) I X (IM 70) if replaces
  domestic savings

13
So in all cases we have
S I X IM
or

• (I S ) (X IM ) 0

current account
capital account (net capital inflows into the
country)
14
BALANCE OF PAYMENTS

-
-
(
X
IM
)
S
I


Exports of Goods and Services
Capital Outflow (Purchase of For. Assets)



Imports of Goods and Services
Capital Inflow (Sales of Dom Assets)
-
-



Trade Balance


Net Ca
pital Outflows




Net Investment Income Net Royalties


Net Purchases of Foreign Reserves



(currencies, gold, gvt. Securities)

Net unilateral transfers (Aid, )


Balance of Payments




Errors and Omissions



Current Account Balance


-

Capital
Account Balance




CA

KA

0


15
Balance of Payments China 2001 Millions of USD

-
-
(
X
IM
)
S
I


Net capital outflows 2,525
Exports of Goods and Services



- Net FDI inflows 37,357
Imports of Goods and Services
-



Trade Balance 28,084


Net Ca
pital Outflows




Net Investment Income Net Royalties


Net Purchases of Foreign Reserves 47,500



(currencies, gold, gvt. Securities)

Net unilateral transfers (Aid, )


Balance of Payments




4,732
Errors and Omissions



Current Account Balance 17,401


-

Capital
Account Balance 12,668




CA

KA

0


16
BALANCE OF PAYMENTS

-
-
(
X
IM
)
S
I


Exports of Goods and Services
Capital Outflow (Purchase of For. Assets)



Imports of Goods and Services
Capital Inflow (Sales of Dom Assets)
-
-



Trade Balance


Net Ca
pital Outflows




Extra foreign currency
Use it to buy foreign assets
Net Investment Income Net Royalties


Net Purchases of Foreign Reserves



(currencies, gold, gvt. Securities)

Net unilateral transfers (Aid, )


Balance of Payments




Errors and Omissions



Current Account Balance


-

Capital
Account Balance




CA

KA

0


17
BALANCE OF PAYMENTS

-
-
(
X
IM
)
S
I


Exports of Goods and Services
Capital Outflow (Purchase of For. Assets)



Imports of Goods and Services
Capital Inflow (Sales of Dom Assets)
-
-



Trade Balance


Net Ca
pital Outflows




Extra foreign currency
Net Investment Income Net Royalties


Net Purchases of Foreign Reserves



(currencies, gold, gvt. Securities)

Net unilateral transfers (Aid, )


Balance of Payments




Or buy foreign reserves
Errors and Omissions



Current Account Balance


-

Capital
Account Balance




CA

KA

0


18
Confusing terminology
19
Confusing terminology BOP deficit

-
-
(
X
IM
)
S
I


Exports of Goods and Services
Capital Outflow (Purchase of For. Assets)



Imports of Goods and Services
Capital Inflow (Sales of Dom Assets)
-
-



Trade Balance


Net Ca
pital Outflows




Trade Deficit
Net Investment Income Net Royalties


Net Purchases of Foreign Reserves



(currencies, gold, gvt. Securities)

Net unilateral transfers (Aid, )


Balance of Payments




Balance of payment deficit
Errors and Omissions



Current Account Balance


-

Capital
Account Balance




CA

KA

0


20
CA KA 0

• Is that bad?
• Foreigners are buying domestic assets
• Future resources need to go to foreign countries
• Difference between deficits for growth and for
  consumption/property-price bubble (Mexico,
  Thailand) Figures to fret about
• Trade deficit and foreign branches ex IBM

21
Foreign Direct Investment (FDI)

• Trade deficit ? Net inflows of foreign capital
• Acquisition of financial assets
• Direct participation (equity based) in Investment
  FDI
• FDI equity capital, reinvested earnings,
  intra-company loans

Real interest rate


S
1





r


I (total domestic FDI)


NX lt 0


Investment
/ Saving

S
I

ID (by domestic


agents)


22
FDI across the world
23
Distribution of FDI
Source UNCTAD website http//stats.unctad.org
24
Foreign Capital Inflows
25
Foreign Direct Investment
26
Globalization
27
Presentations China and the WTO
28
Globalization three main problems

• (1) Reduced barriers to trade and investment
  increase the difference between
• The people who can cross borders (either
  directly, or indirectly through outsourcing)
• (Owners of capital, skilled labor)
• And the people who cannot.
• (Unskilled labor, middle managers)
• High elasticity of demand for their services
  (easily substitutable)
• Consequence they lose bargaining power (and are
  more exposed to shocks)

29
Globalization problem 1

• Losers are those who cannot move
• Typically, redistribution of income worth 5 for
  every 1 gained from trade! Rodrick, 1996
• However,
• Since gains from trade are important, trade
  should have concentrated on the scarce factor
  (i.e. unskilled labor)
• and yet, imports from LDCs are only about 2 of
  OECD GDP.

30
Globalization problem 2

• (2) Competing against different norms
• Child labor
• Low wages
• Note
• WTO rules forbid discrimination among commodities
  or countries on the basis of mode of production
  (except prison work, article XXe)
• Political motivation calls for ban on child
  labor come from upper middle-class districts, not
  lower class (i.e. low skilled labor) Krueger,
  1996
• Fair trade, Leveling the playing field
  (Are the losses worth it?)(Light bulb vs.
  candle makers, Child labor)

31
Globalization problem 3

• (3) The losers need protection and yet that
  makes us uncompetitive.
• Problem how to finance this protection?
• Mobility of employers creates a negative
  externality on tax revenues (Tobin tax on
  physical capital to share revenue among nations?)
• Alternative making workers more mobile
  (education, trade adjustment assistance,
  retraining) financing would come from less
  unemployment

32
Summary Session 11

• Open economy international trade ( NX ? 0 )
• Current account Trade balance net inflows of
  income
• Capital Account Net capital inflows Net sale
  of foreign reserves
• Small open economy with free capital flow
• Interest rate world interest rate (up to risk
  premium)
• Any upward/downward pressure on interest rates
  leads to capital flows
• Globalization
• Trade hurts less mobile factors
• Issue how to protect these factors or increase
  their mobility

33
Want more?

• International Business and Government Policies
  elective
• Relationship between economic forces, policies,
  and strategic management
• Topics
• International trade
• Dumping
• Foreign Direct Investment
• Privatization, deregulation, mergers
• Who? Vanessa Strauss-Kahn
• Where? P4 in Singapore, P5 in Fontainebleau