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EC3343 International Finance

Lecture 2
Current Account & its sustainability

1
Review of Lecture 1
National Income Identities:
• 𝑌 = 𝐶 +𝐼 +𝐺 +𝐸𝑋 −𝐼𝑀 +𝑁𝐹𝐼 +𝑁𝑈𝑇 = 𝐶 +𝐼 +𝐺 +𝐶𝐴

Domestic International Current Account (CA)


transactions transactions

• 𝑪𝑨 = 𝑻𝑩 + 𝑵𝑭𝑰 + 𝑵𝑼𝑻
• 𝑪𝑨 = 𝑺 − 𝑰 = 𝑺𝑷 + 𝑺𝒈 − 𝑰 = 𝑺𝑷 + 𝑻 − 𝑮 − 𝑰
Fiscal
National Income Identity: Balance
• 𝑩𝑶𝑷 = 𝑪𝑨 + 𝑭𝑨 + 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑨𝒄𝒄𝒐𝒖𝒏𝒕

Assumed zero in this course for simplicity


• 𝑪𝑨 = −𝑭𝑨 2
Learning Objectives

• Know the theory of the Current Account (CA) sustainability


• Derived the optimal CA, from household utility maximization
• Describe the pros and cons of running a CA deficit

3
Part 1

A model for current account sustainability

• Two-period model setup

• Perpetual Trade Deficit and current account deficit

• Ponzi game and sovereign default

4
Current Account Deficit
• Can the US run a perpetual trade deficit or current account
deficit?

5
Two-period Model: Net Foreign Wealth
• Consider an open economy that lasts for two periods. Assume
that all residents are identical, and they can only save in
internationally-traded bonds
• Let 𝑩𝒕 be net foreign wealth in period 𝑡.
• Net foreign wealth is the value of overseas assets owned
by a nation, minus the value of domestic assets owned by
foreigners, adjusted for changes in valuation and exchange
rates.
• 𝑩𝒕 > 𝟎: the country has positive foreign wealth (i.e. the
country is a net lender)
• 𝑩𝒕 < 𝟎: the country has negative foreign wealth (i.e. the
country is a net borrower)
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Two-period Model: Net Foreign Wealth

• Consider an open economy that lasts for two periods.


Assume that all residents are identical, and they can only
save in internationally-traded bonds

• Let 𝑩𝒕 be net foreign wealth in period 𝑡.


• Net foreign wealth is the value of overseas assets
owned by a nation, minus the value of domestic assets
owned by foreigners, adjusted for changes in valuation
and exchange rates.

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Active Learning 1
Two-period Model: Net Foreign Wealth
• 𝑩𝒕 > 𝟎: the country has

positive / negative net foreign wealth

(i.e. the country is a net lender / borrower )

• 𝑩𝒕 < 𝟎: the country has

positive / negative net foreign wealth

(i.e. the country is a lender / borrower)

8
Two-period Model: Net Factor Income

• Net foreign wealth carries over from period 𝒕 − 𝟏 to 𝒕:

period 𝒕 period 𝒕 + 𝟏

𝑩𝒕−𝟏 𝑩𝒕 𝑩𝒕+𝟏

• Suppose net foreign wealth (i.e. internationally-traded bond


holding) generates stable net factor income (i.e. interest) at
rate 𝑟:

𝑵𝑭𝑰𝒕 = 𝒓𝑩𝒕−𝟏

9
Two-period Model: Current Account Balance
• Let 𝑻𝑩𝒕 denotes the trade balance in period 𝑡, and 𝑪𝑨𝒕 the
current account balance in period 𝑡.

• Ignoring NUT (i.e. assume NUT=0), by definition, Current


account is defined as the change of net foreign wealth:
𝑪𝑨𝒕 = 𝑩𝒕 − 𝑩𝒕−𝟏

• Current account is categorized into trade balance and the net


factor income:
𝑪𝑨𝒕 = 𝑻𝑩𝒕 + 𝑵𝑭𝑰𝒕 = 𝑻𝑩𝒕 + 𝒓𝑩𝒕−𝟏

• Combine:
𝑩𝒕 = 𝑩𝒕−𝟏 + 𝑪𝑨𝒕 = 𝟏 + 𝒓 𝑩𝒕−𝟏 + 𝑻𝑩𝒕

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Two-period Model: No-Ponzi-Game Condition
• For period 1:
𝑩𝟏 = 𝟏 + 𝒓 𝑩𝟎 + 𝑻𝑩𝟏

• For period 2:
𝑩𝟐 = 𝟏 + 𝒓 𝑩𝟏 + 𝑻𝑩𝟐

• Combine both equations by substituting out 𝑩𝟏 :

𝑩𝟐 𝑻𝑩𝟐
𝟏 + 𝒓 𝑩𝟎 = − 𝑻𝑩𝟏 −
𝟏+𝒓 𝟏+𝒓
• Since the economy lasts only two periods, 𝑩𝟐 = 𝟎.

• This is known as the no-Ponzi-game (NPG) condition.


𝑻𝑩𝟐
𝟏 + 𝒓 𝑩𝟎 = −𝑻𝑩𝟏 −
𝟏+𝒓 11
Active Learning 2: Perpetual Trade Deficit?

• From the No-Ponzi-game condition:


𝑻𝑩𝟐
𝟏 + 𝒓 𝑩𝟎 = −𝑻𝑩𝟏 −
𝟏+𝒓
• Can we have perpetual trade deficit? i.e. both 𝑻𝑩𝟏 and 𝑻𝑩𝟐
are negative?
a. If 𝑩𝟎 < 𝟎 and 𝑻𝑩𝟏 < 𝟎, then 𝑻𝑩𝟐
must be positive / must be negative / can be either.
b. If 𝑩𝟎 > 𝟎 and 𝑻𝑩𝟏 < 𝟎, then 𝑻𝑩𝟐
must be positive / must be negative / can be either.

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Perpetual CA Deficit?

• Substitute 𝑻𝑩 by 𝑪𝑨, using 𝑪𝑨𝒕 = 𝑻𝑩𝒕 + 𝑵𝑭𝑰𝒕 = 𝑻𝑩𝒕 + 𝒓𝑩𝒕−𝟏

𝑪𝑨𝟐 − 𝒓𝑩𝟏
𝟏 + 𝒓 𝑩𝟎 = −(𝑪𝑨𝟏 − 𝒓𝑩𝟎 ) −
𝟏+𝒓
𝑪𝑨𝟐 − 𝒓𝑩𝟏
𝑩𝟎 = −𝑪𝑨𝟏 −
𝟏+𝒓
𝑪𝑨𝟏 = 𝑩𝟏 − 𝑩𝟎

𝑪𝑨𝟐 − 𝒓(𝑪𝑨𝟏 + 𝑩𝟎 )
𝑩𝟎 = − 𝑪𝑨𝟏 −
𝟏+𝒓
• Rearranging:
𝑩𝟎 = −𝑪𝑨𝟏 − 𝑪𝑨𝟐
13
Active Learning 3: Perpetual CA Deficit?
• From the No-Ponzi-game condition:

𝑩𝟎 = −𝑪𝑨𝟏 − 𝑪𝑨𝟐

• Can we have perpetual current account deficit? i.e. both 𝑪𝑨𝟏


and 𝑪𝑨𝟐 are negative?
a. If 𝑩𝟎 < 𝟎 and 𝑪𝑨𝟏 < 𝟎, then 𝑪𝑨𝟐
must be positive / must be negative / can be either.
b. If 𝑩𝟎 > 𝟎 and 𝑪𝑨𝟏 < 𝟎, then 𝑪𝑨𝟐
must be positive / must be negative / can be either.
14
Ponzi Game
• The game is named after Charles Ponzi, who used this
technique in the US during 1920s.

• A Ponzi game is a fraudulent investment operation in which,


(1) the operator pays returns to its previous investors with the
capital raised from new investors, (2) rather than from
legitimate business.

• The Ponzi game is still played (e.g. the Swiss Cash scam in
2006).

• The No-Ponzi-Game condition (𝑩𝟐 = 𝟎) means there is an


end of life and borrowers must pay off all his debt in the end.

15
Ponzi Game

16
Madoff and His Ponzi game

• Bernard Madoff, a former stockbroker and financier in New


York, was charged of operating a Ponzi game at his asset
management company in 2008.

• Madoff’s game began in the mid-1980s. It eventually led to


an estimated loss of $64 billion for investors.

• Madoff was sentenced to 150 years in prison.

17
Can a Country Play Ponzi-game?

• Countries do not die off, unlike humans. Moreover, there


exists no international law enforcement for debt repayment.

• 𝑩𝑻 = 𝟎 is not a binding constraint.

• A country can run a perpetual current account deficit, as


long as other countries are willing to lend to it.

• If a country fails to meet its external debt obligation, it may


choose to default (sovereign default), and it happens!

18
Case Study: 1982 Mexican Sovereign Default
• In 1982, Mexico defaulted on its external debt obligations,
marking the beginning of the Developing Country Debt Crisis,
mainly among Latin American countries.
• External borrowing dried up; incomes dropped; growth
stagnated; unemployment rose.
• Reputation was seriously damaged, making future borrowing even
more difficult.
• Rising oil prices in the 1970s forced poorer countries to borrow
heavily. Meanwhile, OPEC deposited and "recycled" the capital as
loans.

• International Monetary Fund (IMF) came to rescue. In return,


IMF forced reforms and austerity measures.
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Sovereign Default

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Part 2

A model for current account optimality

• Two-period model setup

• Budget constraint

• Utility maximization

• Determination of optimal CA balance

• Effects of economic shocks on optimal CA balance


21
Model Setting
We extend the two-period model from part 1:
• By adding utility optimization into the problem

Consider a representative household born with endowments


and live for two periods.
The household consumes, and save / borrow in international
market:
• 𝑸𝒕 : endowment in period t
• 𝑪𝒕 : consumption in period t
• 𝑩𝒕 : net wealth at the end of period t
• 𝒓𝒕 : interest rate in period t 22
Lifetime Budget Constraint
Household’s budget constraints are

𝑪𝟏 + 𝑩𝟏 = 𝟏 + 𝒓𝟎 𝑩𝟎 + 𝑸𝟏

𝑪𝟐 + 𝑩𝟐 = 𝟏 + 𝒓𝟏 𝑩𝟏 + 𝑸𝟐

Assume 𝑩𝟐 = 𝟎. The lifetime budget constraint is

𝑪𝟐 𝑸𝟐
No-Ponzi-game
𝑪𝟏 + = 𝟏 + 𝒓𝟎 𝑩𝟎 + 𝑸𝟏 +
𝟏 + 𝒓𝟏 𝟏 + 𝒓𝟏

Household’s permanent income 23


Lifetime Budget Constraint
𝑨 is the endowment point.
The figure below is drawn, by assuming that 𝑩𝟎 = 𝟎.
𝑪𝟐
LBC of a representative household:
𝑪𝟐 𝑸𝟐
𝑪𝟏 + = 𝟏 + 𝒓𝟎 𝑩𝟎 + 𝑸𝟏 +
𝟏 + 𝒓𝟏 𝟏 + 𝒓𝟏

𝑸𝟐 𝑨

𝑪𝟏
𝑸𝟏
24
Utility Function
Household’s preference is described by utility function
𝑼 𝑪𝟏 , 𝑪𝟐 , which gives convex indifferent curve:

𝑪𝟐
Outward shift means higher utility level.

𝑪𝟏
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Utility Optimization Problem

Households maximize utility w.r.t. lifetime budget constraint:

𝑴𝒂𝒙𝑪𝟏 ,𝑪𝟐 𝑼(𝑪𝟏 , 𝑪𝟐 )

Such that
𝑪𝟐 𝑸𝟐
𝑪𝟏 + = 𝟏 + 𝒓𝟎 𝑩𝟎 + 𝑸𝟏 +
𝟏 + 𝒓𝟏 𝟏 + 𝒓𝟏
Note 𝑩𝟎 , 𝒓𝟎 , 𝒓𝟏 , 𝑸𝟏 , 𝑸𝟐 are exogenously given.

• In general, we do not assume 𝑩𝟎 = 𝟎. However, the


graph drawn in this example assume that 𝑩𝟎 = 𝟎.

26
Household’s Optimization Problem
At point 𝑩, marginal rate of substitution

𝑪𝟐 𝝏𝑼(𝑪𝟏 , 𝑪𝟐 )
𝑴𝑼𝑪𝟏 𝝏𝑪𝟏
𝑴𝑹𝑺 = = = 𝟏 + 𝒓𝟏
𝑴𝑼𝑪𝟐 𝝏𝑼(𝑪𝟏 , 𝑪𝟐 )
𝝏𝑪𝟐
Implicitly, 𝑩𝟎 = 𝟎.
𝑸𝟐
𝑨 𝑩
𝑪𝟐

𝑪𝟏
𝑸𝟏 𝑪𝟏
27
Country’s Optimization Problem

Assume all households are identical. A country’s optimization


problem is the same as a household’s problem.

Let 𝑩𝒕 be a country’s net foreign asset position. Borrowing or


lending are in terms of internationally-traded bonds.

Assume 𝑩𝟐 = 𝟎 (No-Ponzi-game condition).

Assume the country is a small open economy and takes the


world interest rate as given: 𝒓𝟎 = 𝒓𝟏 = 𝒓.

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Country’s Optimization Problem

𝑴𝒂𝒙𝑪𝟏 ,𝑪𝟐 𝑼(𝑪𝟏 , 𝑪𝟐 )

𝑪𝟐 such that
𝑪𝟐 𝑸𝟐
𝑪𝟏 + = 𝟏 + 𝒓 𝑩𝟎 + 𝑸𝟏 +
𝟏+𝒓 𝟏+𝒓
Optimization:
𝑴𝑼𝑪𝟏
𝑴𝑹𝑺 = =𝟏+𝒓
𝑸𝟐 𝑴𝑼𝑪𝟐
𝑨 𝑩
𝑪𝟐

𝑪𝟏
𝑸𝟏 𝑪𝟏
29
Trade Balance
Recall the definitions:
𝑪𝑨𝟏 = 𝑻𝑩𝟏 + 𝒓𝑩𝟎
𝑪𝑨𝟏 = 𝑩𝟏 − 𝑩𝟎

Thus,
𝑻𝑩𝟏 = (𝑩𝟏 − 𝑩𝟎 ) − 𝒓𝑩𝟎 = 𝑸𝟏 − 𝑪𝟏
budget constraint for period 1:
𝑪𝟏 + 𝑩𝟏 = 𝟏 + 𝒓𝟎 𝑩𝟎 + 𝑸𝟏

Similarly,
𝑻𝑩𝟐 = (𝑩𝟐 − 𝑩𝟏 ) − 𝒓𝑩𝟏 = 𝑸𝟐 − 𝑪𝟐
budget constraint for period 2:
𝑪𝟐 + 𝑩𝟐 = 𝟏 + 𝒓𝟏 𝑩𝟏 + 𝑸𝟐

30
Current Account Balance

In 1st period,
𝑪𝑨𝟏 = 𝑻𝑩𝟏 + 𝒓𝑩𝟎 = 𝑸𝟏 − 𝑪𝟏 + 𝒓𝑩𝟎

In 2nd period,
𝑪𝑨𝟐 = 𝑻𝑩𝟐 + 𝒓𝑩𝟏 = 𝑸𝟐 − 𝑪𝟐 + 𝒓𝑩𝟏

Since 𝑪𝑨𝟐 = 𝑩𝟐 − 𝑩𝟏 = −𝑩𝟏 ,

we have 𝑪𝑨𝟐 = 𝑸𝟐 − 𝑪𝟐 − 𝒓𝑪𝑨𝟐 .

Thus
𝑸𝟐 − 𝑪𝟐
𝑪𝑨𝟐 =
𝟏+𝒓
31
Example
Consider an economy with logarithmic preferences:

𝑴𝒂𝒙𝑪𝟏 ,𝑪𝟐 𝒍𝒐𝒈 𝑪𝟏 + 𝒍𝒐𝒈 𝑪𝟐

𝑪𝟐 𝑸𝟐
𝑠𝑢𝑐ℎ 𝑡ℎ𝑎𝑡 𝑪𝟏 + = 𝟏 + 𝒓 𝑩𝟎 + 𝑸𝟏 +
𝟏+𝒓 𝟏+𝒓

where 𝑩𝟎 , 𝒓, 𝑸𝟏 , 𝑸𝟐 are exogenously given.


Optimization condition is:

𝑴𝑼𝑪𝟏 𝑪𝟐
𝑴𝑹𝑺 = = =𝟏+𝒓
𝑴𝑼𝑪𝟐 𝑪𝟏
32
Example
Plug into budget constraint:

𝑪𝟐 𝑸𝟐
𝑪𝟏 + = 𝟐𝑪𝟏 = 𝟏 + 𝒓 𝑩𝟎 + 𝑸𝟏 +
𝟏+𝒓 𝟏+𝒓
Solve it:

𝟏 𝑸𝟐
𝑪𝟏 = 𝟏 + 𝒓 𝑩𝟎 + 𝑸𝟏 +
𝟐 𝟏+𝒓

𝟏 𝑸𝟐
𝑻𝑩𝟏 = 𝑸𝟏 − 𝑪𝟏 = 𝑸𝟏 − 𝟏 + 𝒓 𝑩𝟎 −
𝟐 𝟏+𝒓

𝟏 𝑸𝟐
𝑪𝑨𝟏 = 𝑻𝑩𝟏 + 𝒓𝑩𝟎 = 𝒓𝑩𝟎 + 𝑸𝟏 − 𝟏 + 𝒓 𝑩𝟎 −
𝟐 𝟏+𝒓 33
The Impact of Shocks on CA

Consider the following two types of economic shocks, how


would each affect the CA of a small open economy?

1. A one-period shock in endowment/production, e.g. 𝑸𝟏

• Natural disaster that disrupts production

2. A shock in world interest rate 𝒓

• US started Quantitative Easing (QE) and lowered dollar


interest rate

34
Shock in Endowment or Production 𝑸𝟏 ↓
𝑪𝟐
𝑨: original endowment point

𝑨’: endowment point after the shock

𝑨′ 𝑨
𝑸′𝟐 = 𝑸𝟐

𝑪𝟏
𝑸′𝟏 𝑸𝟏
35
Shock in Endowment or Production 𝑸𝟏 ↓
𝑩: original consumption point
𝑪𝟐
𝑩′ : consumption point after the
shock

𝑪𝑨𝟏 ↓ and 𝑪𝑨𝟐 ↑ as household


𝑨′ 𝑨 smooth consumption across
𝑸′𝟐 = 𝑸𝟐
𝑪𝟐 𝑩 periods
𝑪′𝟐 𝑩′

𝑪𝟏
𝑸′𝟏 𝑪′𝟏 𝑸𝟏 𝑪𝟏
36
Shock in World Interest Rate 𝒓 ↑

• What happens if the world interest rate, 𝒓, increases?

• Substitution effect: household increases saving in the first


period.

• Income effect: household increases consumption if it is a


saver, and reduces consumption if it is a borrower.

• We assume the substitution effect dominates.

37
Shock in World Interest Rate 𝒓 ↑
𝑪𝟐
𝒓: original world interest rate

𝒓′: new world interest rate


Slope −(𝒓′ + 𝟏)

𝑨 Slope −(𝒓 + 𝟏)
𝑸𝟐

𝑸𝟏 𝑪𝟏

38
Shock in World Interest Rate 𝒓 ↑
𝑪𝑨𝟏 ↑ and 𝑪𝑨𝟐 ↓ to smooth
𝑪𝟐 consumption across periods;
𝑪𝑨𝟏 ↑ and 𝑪𝑨𝟐 ↓ for both CA-deficit
and CA-surplus countries, because
we assume that substitution effect
dominates in the household
preferences.
𝑸𝟐
𝑨
𝑪′𝟐 𝑩′ 𝑩
𝑪𝟐

𝑸𝟏 𝑪′𝟏 𝑪𝟏 𝑪𝟏

39
Shock in World Interest Rate 𝒓 ↑

• If we assume substitution effect dominates,


𝒓 ↑ → 𝑪𝟏 ↓ and 𝑩𝟏 ↑ → 𝑪𝑨𝟏 ↑
• Conversely,
𝒓 ↓ → 𝑪𝟏 ↑ and 𝑩𝟏 ↓ → 𝑪𝑨𝟏 ↓
• Then, what is the implication of US Quantitative Easing (QE)
for small open economies?
• Small open economies will reduce their CA balance

40
Is current CA deficit good or bad?

• A cyclical CA deficit can be good, as it allows intertemporal


consumption smoothing
• E.g. when natural disasters happen.

• A structural CA deficit is bad as it may be a signal of:


• Lack of export competitiveness
• Lack of domestic saving, and hence, high dependency on
external financing (particularly short-term debt financing)
• Over-investment such as asset bubble

41
CA Deficit and Economic Crisis
• Large and persistent CA deficit often precedes economic
crisis.

Mexico ran a large CA deficit before the Tequila crisis in Dec 1994,
when sudden capital outflow made the peso depreciated roughly
50% against the dollar in one month.
42
CA Deficit and Economic Crisis

The Asian financial crisis started from Thailand in July 1997.


43
CA Deficit and Economic Crisis

The persistent CA deficit in the US prior to the Global financial crisis in 2008.

44
CA Deficit and Economic Crisis

The debt crisis began in 2008 with the collapse of Iceland's banking system. It spread
to other European countries such as Portugal, Italy, Ireland, Greece, and Spain in 2009.
45
CA Deficit and Economic Crisis

• It seems that countries with persistent and large CA deficits


are more easily falling into economic crisis. Why?
• Investment funded by foreign money
• mounting external debt
• rising concerns over burst of asset bubble and borrower’s
ability to repay
• change in investor’s sentiment
• sudden capital outflows and “bank run”
• economic crisis
• Economists often consider a large and persistent CA deficit
as a warning sign/indicator.
46
Measures to Reduce CA Deficit

• Promote exports and reduce imports:


• Make America Great Again (U.S.)
• Cutting subsidy in imported oil (Indonesia)
• Tightening restrictions in gold imports (India)
• Promote domestic (private and public) saving:
• Fiscal consolidation after crisis (U.S. and Greece)
• Imposing restrictions on capital flows (Brazil and Korea)

47
Summary

• Two-period model for current account (CA) determination


• Two-period model setup
• CA sustainability and No-Ponzi-game condition
• Determination of optimal CA balance
• Pros and cons of CA deficit

48