1.1 Module 79: Capital Flows and the Balance of Payments

The Balance of Payments Accounts

In 2012, people living in the United States sold about $3.5 trillion worth of stuff to people living in other countries and bought about $3.5 trillion worth of stuff in return. What kind of stuff? All kinds. Residents of the United States (including employees of firms operating in the United States) sold airplanes, bonds, wheat, and many other items to residents of other countries. Residents of the United States bought cars, stocks, oil, and many other items from residents of other countries.

How can we keep track of these transactions? Earlier we learned that economists keep track of the domestic economy using the national income and product accounts. Economists keep track of international transactions using a different but related set of numbers, the balance of payments accounts.

Understanding the Balance of Payments

A country’s balance of payments accounts are a summary of the country’s transactions with other countries.

To understand the basic idea behind the balance of payments accounts, let’s consider a small-scale example: not a country, but a family farm. Let’s say that we know the following about how last year went financially for the Costas, who own a small artichoke farm in California:

• They made $100,000 by selling artichokes.
• They spent $70,000 on running the farm, including purchases of new farm machinery, and another $40,000 buying food, paying utility bills for their home, replacing their worn-out car, and so on.
• They received $500 in interest on their bank account but paid $10,000 in interest on their mortgage.
• They took out a new $25,000 loan to help pay for farm improvements but didn’t use all the money immediately. So they put the extra in the bank.

How could we summarize the Costas’ year? One way would be with a table like Table 79-1, which shows sources of cash coming in and money going out, characterized under a few broad headings.

The first row of Table 79-1 shows sales and purchases of goods and services: sales of artichokes; purchases of groceries, heating oil, that new car, and so on. The second row shows interest payments: the interest the Costas received from their bank account and the interest they paid on their mortgage. The third row shows cash coming in from new borrowing versus money deposited in the bank.

In each row we show the net inflow of cash from that type of transaction. So the net in the first row is −$10,000 because the Costas spent $10,000 more than they earned. The net in the second row is −$9,500, the difference between the interest the Costas received on their bank account and the interest they paid on the mortgage. The net in the third row is $19,500: the Costas brought in $25,000 with their new loan but put only $5,500 of that sum in the bank.

The last row shows the sum of cash coming in from all sources and the sum of all cash used. These sums are equal, by definition: every dollar has a source, and every dollar received gets used somewhere. (What if the Costas hid money under the mattress? Then that would be counted as another “use” of cash.)

A country’s balance of payments accounts summarize its transactions with the world using a table similar to the one we just used to summarize the Costas’ financial year.

Table 79-2 on the next page shows a simplified version of the U.S. balance of payments accounts for 2012. Where the Costa family’s accounts show sources and uses of cash, the U.S. balance of payments accounts show payments from foreigners—in effect, sources of cash for the United States as a whole—and payments to foreigners.

Row 1 of Table 79-2 shows payments that arise from sales and purchases of goods and services. For example, the value of U.S. wheat exports and the fees foreigners pay to U.S. consulting companies appear in the second column; the value of U.S. oil imports and the fees American companies pay to Indian call centers—the people who often answer your 1-800 calls—appear in the third column.

Row 2 shows factor income—payments for the use of factors of production owned by residents of other countries. Mostly this means investment income: interest paid on loans from overseas, the profits of foreign-owned corporations, and so on. For example, the profits earned by Disneyland Paris, which is owned by the U.S.-based Walt Disney Company, appear in the second column; the profits earned by the U.S. operations of Japanese auto companies appear in the third column. Factor income also includes labor income. For example, the wages of an American engineer who works temporarily on a construction site in Dubai are counted in the second column.

Row 3 shows international transfers—funds sent by residents of one country to residents of another. The main element here is the remittances that immigrants, such as the millions of Mexican-born workers employed in the United States, send to their families in their country of origin. Notice that Table 79-2 shows only the net value of transfers. That’s because the U.S. government provides only an estimate of the net, not a breakdown between payments to foreigners and payments from foreigners.

The next two rows of Table 79-2 show payments resulting from sales and purchases of assets, broken down by who is doing the buying and selling. Row 4 shows transactions that involve governments or government agencies, mainly central banks. As we’ll learn later, in 2012 most of the U.S. sales in this category involved the accumulation of foreign exchange reserves by the central banks of China and oil-exporting countries. Row 5 shows private sales and purchases of assets. For example, the 2012 purchase of the American-owned AMC Cinema chain, by the Chinese company Dalian Wanda, showed up in the “Payments from foreigners” column of row 5; purchases of European stocks by U.S. investors show up as positive values in the “Payments to foreigners” column.

In laying out Table 79-2, we have separated rows 1, 2, and 3 into one group and rows 4 and 5 into another. This reflects a fundamental difference in how these two groups of transactions affect the future.

When a U.S. resident sells a good, such as wheat, to a foreigner, that’s the end of the transaction. But a financial asset, such as a bond, is different. Remember, a bond is a promise to pay interest and principal in the future. So when a U.S. resident sells a bond to a foreigner, that sale creates a liability: the U.S. resident will have to pay interest and repay principal in the future. The balance of payments accounts distinguish between transactions that don’t create liabilities and those that do.

Transactions that don’t create liabilities are considered part of the balance of payments on the current account, often referred to simply as the current account: the balance of payments on goods and services plus factor income and net international transfer payments. The balance of row 1 of Table 79-2, −$534 billion, corresponds to the most important part of the current account: the balance of payments on goods and services, the difference between the value of exports and the value of imports during a given period.

If you read news reports on the economy, you may well see references to another measure, the merchandise trade balance, sometimes referred to as the trade balance for short. This is the difference between a country’s exports and imports of goods alone—not including services. Economists sometimes focus on the merchandise trade balance, even though it’s an incomplete measure, because data on international trade in services aren’t as accurate as data on trade in physical goods, and they are also slower to arrive.

The current account, as we’ve just learned, consists of international transactions that don’t create liabilities. Transactions that involve the sale or purchase of assets, and therefore do create future liabilities, are considered part of the balance of payments on the financial account, or the financial account for short. (Until a few years ago, economists often referred to the financial account as the capital account. We’ll use the modern term, but you may run across the older term.)

So how does it all add up? The first two unnumbered rows of Table 79-2 show the bottom lines: the overall U.S. current account and financial account for 2012. As you can see, in 2012, the United States ran a current account deficit: the amount it paid to foreigners for goods, services, factors, and transfers was greater than the amount it received. Simultaneously, it ran a financial account surplus: the value of the assets it sold to foreigners was greater than the value of the assets it bought from foreigners.

In the official data, the U.S. current account deficit and financial account surplus almost, but not quite, offset each other: the financial account surplus was $7 billion larger than the current account deficit. But that’s just a statistical error, reflecting the imperfection of official data. (And a $7 billion error when you’re measuring inflows and outflows of $3.5 trillion isn’t bad!) In fact, it’s a basic rule of balance of payments accounting that the current account and the financial account must sum to zero:

or

Why must Equation 79-1 be true? We already saw the fundamental explanation in Table 79-1, which showed the accounts of the Costa family: in total, the sources of cash must equal the uses of cash. The same applies to balance of payments accounts. Figure 79-1, a variant on the circular-flow diagram we have found useful in discussing domestic macroeconomics, may help you visualize how this adding up works. Instead of showing the flow of money within a national economy, Figure 79-1 shows the flow of money between national economies.

Money flows into the United States from the rest of the world as payment for U.S. exports of goods and services, as payment for the use of U.S.-owned factors of production, and as transfer payments. These flows (indicated by the lower yellow arrow) are the positive components of the U.S. current account. Money also flows into the United States from foreigners who purchase U.S. assets (as shown by the lower green arrow)—the positive component of the U.S. financial account.

At the same time, money flows from the United States to the rest of the world as payment for U.S. imports of goods and services, as payment for the use of foreign-owned factors of production, and as transfer payments. These flows, indicated by the upper yellow arrow, are the negative components of the U.S. current account. Money also flows from the United States to purchase foreign assets, as shown by the upper green arrow—the negative component of the U.S. financial account. As in all circular-flow diagrams, the flow into a box and the flow out of a box are equal. This means that the sum of the yellow and green arrows going into the United States is equal to the sum of the yellow and green arrows going out of the United States. That is,

• (43-2) Positive entries on the current account (lower yellow arrow) + Positive entries on the financial account (lower green arrow) = Negative entries on the current account (upper yellow arrow) + Negative entries on the financial account (upper green arrow)

Equation 43-2 can be rearranged as follows:

• (43-3) Positive entries on the current account − Negative entries on the current account + Positive entries on the financial account − Negative entries on the financial account = 0

Equation 43-3 is equivalent to Equation 79-1: the current account plus the financial account—both equal to positive entries minus negative entries—is equal to zero.

But what determines the current account and the financial account?

Modeling the Financial Account

A country’s financial account measures its net sales of assets, such as currencies, securities, and factories, to foreigners. Those assets are exchanged for a type of capital called financial capital, which is funds from savings that are available for investment spending. We can thus think of the financial account as a measure of capital inflows in the form of foreign savings that become available to finance domestic investment spending.

What determines these capital inflows?

Part of our explanation will have to wait for a little while because some international capital flows are created by governments and central banks, which sometimes act very differently from private investors. But we can gain insight into the motivations for capital flows that are the result of private decisions by using the loanable funds model we developed previously. In using this model, we make two important simplifications:

1. We simplify the reality of international capital flows by assuming that all flows are in the form of loans. In reality, capital flows take many forms, including purchases of shares of stock in foreign companies and foreign real estate as well as foreign direct investment, in which companies build factories or acquire other productive assets abroad.
2. We also ignore the effects of expected changes in exchange rates, the relative values of different national currencies. We’ll analyze the determination of exchange rates later.

Figure 79-2 recaps the loanable funds model for a closed economy. Equilibrium corresponds to point E, at an interest rate of 4%, at which the supply of loanable funds, S, intersects the demand for loanable funds curve, D. But if international capital flows are possible, this diagram changes and E may no longer be the equilibrium. We can analyze the causes and effects of international capital flows using Figure 79-3, which places the loanable funds market diagrams for two countries side by side.

Figure 79-3 illustrates a world consisting of only two countries, the United States and Britain. Panel (a) shows the loanable funds market in the United States, where the equilibrium in the absence of international capital flows is at point E_US with an interest rate of 6%. Panel (b) shows the loanable funds market in Britain, where the equilibrium in the absence of international capital flows is at point E_B with an interest rate of 2%.

Will the actual interest rate in the United States remain at 6% and that in Britain at 2%? Not if it is easy for British residents to make loans to Americans. In that case, British lenders, attracted by high American interest rates, will send some of their loanable funds to the United States. This capital inflow will increase the quantity of loanable funds supplied to American borrowers, pushing the U.S. interest rate down. At the same time, it will reduce the quantity of loanable funds supplied to British borrowers, pushing the British interest rate up. So international capital flows will narrow the gap between U.S. and British interest rates.

Let’s further suppose that British lenders regard a loan to an American as being just as good as a loan to one of their own compatriots, and American borrowers regard a debt to a British lender as no more costly than a debt to an American lender. In that case, the flow of funds from Britain to the United States will continue until the gap between their interest rates is eliminated. In other words, international capital flows will equalize the interest rates in the two countries.

Figure 79-4 shows an international equilibrium in the loanable funds markets where the equilibrium interest rate is 4% in both the United States and Britain. At this interest rate, the quantity of loanable funds demanded by American borrowers exceeds the quantity of loanable funds supplied by American lenders. This gap is filled by “imported” funds—a capital inflow from Britain.

At the same time, the quantity of loanable funds supplied by British lenders is greater than the quantity of loanable funds demanded by British borrowers. This excess is “exported” in the form of a capital outflow to the United States. And the two markets are in equilibrium at a common interest rate of 4%. At that interest rate, the total quantity of loans demanded by borrowers across the two markets is equal to the total quantity of loans supplied by lenders across the two markets.

In short, international flows of capital are like international flows of goods and services. Capital moves from places where it would be cheap in the absence of international capital flows to places where it would be expensive in the absence of such flows.

Underlying Determinants of International Capital Flows

The open-economy version of the loanable funds model helps us understand international capital flows in terms of the supply and demand for funds. But what underlies differences across countries in the supply and demand for funds? Why, in the absence of international capital flows, would interest rates differ internationally, creating an incentive for international capital flows?

International differences in the demand for funds reflect underlying differences in investment opportunities. In particular, a country with a rapidly growing economy, other things equal, tends to offer more investment opportunities than a country with a slowly growing economy. So a rapidly growing economy typically—though not always—has a higher demand for capital and offers higher returns to investors than a slowly growing economy in the absence of capital flows. As a result, capital tends to flow from slowly growing to rapidly growing economies.

The classic example is the flow of capital from Britain to the United States, among other countries, between 1870 and 1914. During that era, the U.S. economy was growing rapidly as the population increased and spread westward and as the nation industrialized. This created a demand for investment spending on railroads, factories, and so on. Meanwhile, Britain had a much more slowly growing population, was already industrialized, and already had a railroad network covering the country. This left Britain with savings to spare, much of which were lent to the United States and other New World economies.

International differences in the supply of funds reflect differences in savings across countries. These may be the result of differences in private savings rates, which vary widely among countries. For example, in 2012, private savings were 22% of Japan’s GDP but only 17% of U.S. GDP. They may also reflect differences in savings by governments. In particular, government budget deficits, which reduce overall national savings, can lead to capital inflows.

Two-way Capital Flows

The loanable funds model helps us understand the direction of net capital flows—the excess of inflows into a country over outflows, or vice versa. As we saw in Table 79-2, however, gross flows take place in both directions: for example, the United States both sells assets to foreigners and buys assets from foreigners. Why does capital move in both directions?

The answer to this question is that in the real world, as opposed to the simple model we’ve just constructed, there are other motives for international capital flows besides seeking a higher rate of interest.

Individual investors often seek to diversify against risk by buying stocks in a number of countries. Stocks in Europe may do well when stocks in the United States do badly, or vice versa, so investors in Europe try to reduce their risk by buying some U.S. stocks, even as investors in the United States try to reduce their risk by buying some European stocks. The result is capital flows in both directions.

Meanwhile, corporations often engage in international investment as part of their business strategy—for example, auto companies may find that they can compete better in a national market if they assemble some of their cars locally. Such business investments can also lead to two-way capital flows, as, say, European carmakers build plants in the United States even as U.S. computer companies open facilities in Europe.

Finally, some countries, including the United States, are international banking centers: people from all over the world put money in U.S. financial institutions, which then invest many of those funds overseas.

The result of these two-way flows is that modern economies are typically both debtors (countries that owe money to the rest of the world) and creditors (countries to which the rest of the world owes money). Due to years of both capital inflows and outflows, at the end of 2012, the United States had accumulated foreign assets worth $20.8 trillion and foreigners had accumulated assets in the United States worth $25.2 trillion.

Module 79 Review

Check Your Understanding

Draw two side-by-side graphs of the loanable funds market in the United States and in China to show how a higher interest rate in the United States will lead to capital flows between the two countries. On your graphs, label the starting and ending interest rates and the size of the capital inflows and outflows.