Country Risk Analysis The Balance of Payments II Capital Account February 2008

1
Country Risk Analysis The Balance of Payments
IICapital AccountFebruary 2008

• Professor M.H. Bouchet

2

• Balance of payments
• Accounting framework and statistical record of
  all the economic and financial flows that take
  place over a specified time period between
  residents of the reporting country and the rest
  of the world
• The time period itself is arbitrary but it is
  common practice to supply balance of payments
  data on a monthly, quarterly and yearly basis
  (IMF)
• Flows refer to income and expenditure or changes
  in levels of outstanding assets and liabilities.
• The accumulation of flows leads to asset or debt
  stocks.

3

• Double bookkeeping Summary statement that
  records as a credit () any transaction resulting
  in a receipt from the rest of the world and as a
  debit (-) any transaction resulting in a payment
• These transactions lead to changes in supply and
  demand for foreign exchange, hence an impact on
  exchange rates, reserve assets and on foreign
  exchange markets

4

• Risk assessment is rooted in balance of payments
  analysis!
• Trade flows and competitiveness
• Structural or short-term deficits?
• Exchange rate variations
• External financing flows
• Capital flight
• Debt crisis!

5
(No Transcript)
6
The US CAD dilemma

• 2006 Trade deficit US760 billion (6 of GDP)
• CAD -6,6 of GDP
• - US 870 billion
• Need to shrink the deficit by boosting exports
  and reducing import growth with a weaker
• BUT need to finance the deficit by attracting
  US2,4 billion/day foreign capital inflows with
  stronger !
• Capital sources surplus countries Germany
  China Japan Korea
• Need to maintain positive real interest rates to
  enhance the dollar attractiveness and
  competitiveness
• Engine of world growth

7
The US CAD dilemma revisited (1)

• Large US CAD, though
• The US net liabilities have risen less than the
  cumulative CAD
• Decline in US net liabilities/GDP
• Minimal debt servicing burden
• NYFed staff report n271 12/2006

8
The US CAD dilemma revisited (2)

• A dollar depreciation alone will NOT curb the US
  deficit, because
• Use of the dollar in international trade
  transactions (all US exports and imports are
  invoiced in , hence insensitivity to exchange
  rate changes) Asia
• Market share concern of foreign exporters, hence
  desire to remain competitive in the large US
  market)
• High marketing and distribution costs of US
  imports might insulate the final consumption
  price of imported goods
• However, foreign demand for US goods will
  increase

Fed RB NY, June 2007
9

• Capital account
• Reflects changes in countrys ownership of assets
• Reflects international market access
• Financing flows lead to changes in external debt
  stock, and to future debt servicing payment
  outflows
• Financing sources debt, equity/FDI,
  international borrowing in the capital markets
  (Eurobonds, Eurocredits, official financing, ODA,
  short-term flows)

10
Capital account

• The financial analyst must focus not only on the
  volume of financing to match the financing
  requirements of the current account deficit, but
  also the nature of financing sources
  (private/public) and the sustainability of the
  financing (short term/long term, volatility,
  floating/fixed rates, repayment conditions)

11
The capital account
From less liquid items to more liquid items!

• Capital account
• (-) Direct investment (non debt creating
  flows)
• (-) Portfolio investment (NDCF)
• (-) Other long-term capital (private
  official)
• (-) Other short-term capital (private
  official)
• (-) Net errors and omissions
• (-) Counterpart items
• (-) Change in reserves
• Capital account balance
• Exceptional Financing

12
The Capital/Financial Account

• The Capital Account of the balance of payments
  measures all international economic transactions
  of financial assets. It is divided into two
  major components
• The Capital Account
• The Financial Account
• The Capital Account is minor (in magnitude),
  while the Financial Account is significant.

Source Eiteman/Pearson
13
The Financial Account

• Financial assets can be classified in a number of
  different ways including the length of the life
  of the asset (maturity) and the nature and source
  of the ownership (public or private).
• The Financial Account, however, uses a third
  method. This focuses on the degree of investor
  control over the assets or operations.

14

• The Financial Account consists of three
  components
• Direct Investment in which the investor exerts
  some explicit degree of control over the assets
• Portfolio Investment in which the investor has
  no control over the assets nor any participation
  in the management
• Other Investment consists of various short-term
  and long-term trade credits, cross-border loans,
  currency deposits, bank deposits and other
  capital flows related to cross-border trade

15
Developing countries that have relied less on
foreign capital have grown faster! (IMF/03-2007)
16
Sources of external financing

• Official bilateral multilateral
• Paris Club (government to government credits)
• Export credit agencies
• IFIs
• RDBs

• Private
• FDI
• Portfolio Investment
• International bank loans
• Working capital lines
• ST Trade credits
• Bonds

17
Where do capital flows go?
18
Balance on current account
In US billion
Source IIF, IMF-WEO 2006
19
Major net Exporters of Capital
Source IMF 2007
20
Major net Importers of Capital
Source IMF 2007
21
Net external capital sources for EMCs
US billion
IIF/IMF
22
Net Private Capital Flows to EMCs (Equity, FDI,
Portfolio, Banks non-banks)
Billion of US
Source IIF/IMF
23
Net FDI and portfolio capital flows to EMCs
US billion
Source IMF/IIF
24

• 1. Direct investment and portfolio investment
• The difference between direct investment and
  portfolio investment resolves around whether or
  not the investor intends to take an active role
  in the management of the enterprise whose assets
  are being acquired.
• When the investors purpose is to have an
  effective voice in the management of the foreign
  enterprise, it is considered as a direct
  investment. Examples
• Bonds, debentures and the like are portfolio
  investments in so far as they confer no
  management or voting rights on their owners (ST
  and relatively volatile investment)
• Foreign branches, wholly owned subsidiaries and
  joint ventures are clearly direct investments
  (depending on percentage!)

25
FDI Flows worldwide 2006 in of total volume
France 81 billion (7,1 of total)
Source CNUCED/2006 Total 1230 billion IDE
In 81 billion, et IDE Out 115 billion (OCDE
et BDF)
26
Total FDI inflows in US trillion
Post-2003 bounceback has been driven by OECD
markets. FDI flows to EMCs will remain buoyant
in 2007-10, averaging over US400bn per year, but
growth rates will be modest as privatisation
tails off and the global economy slows.
27
GLOBAL FDI FLOWS 2006-07
EMCs
EMCs (19)
ASIA (64)
OECD (81)
LATIN AMERICA (29)
GLOBAL ECONOMY
PERU (4)
CHILE (10)
CHINA (80)
MEXICO (32)
ASIA
LATIN AMERICA
Source IIF, OECD
28
IIF/FMI
29
30 most attractive Emerging markets for FDI

1. India
2. Russia
3. Vietnam
4. Ukraine
5. China
6. Chile
7. Latvia
8. Slovenia
9. Croacia
10. Turkey
11. Tunisia
12. Thailand
13. Korea
14. Malaysia
15. Macedonia
16. UAE
17. Arabia Saudita
18. Slovakia
19. México

S Economic Political risk Market potential AT
Kearney GRDI 2006
30
Most attractive emerging markets in 2006
Lows Risk
High Risk
31
World Economic ForumGlobal Competitiveness
Ranking
Switzerland 1
Finland 2
Sweden 3
Denmark 4
Singapore 5
United States 6
Japan 7
Germany 8
Netherlands 9
United Kingdom 10
Hong Kong SAR 11
Norway 12
Taiwan, China 13
Island 14
Israel 15
Canada 16
Austria 17
France 18
32
China FDI Flows
In billions of US
Source OECD
33
FDI Flows in Vietnam
In millions of US
Source IMF
34
Overview of FDI in Vietnam

• Opening of the Vietnamese economy to FDI in 1987,
  fast growth of the 1990s, rapid increase in FDI
  inflows 1988-1996, drop in the 1997-98 Asian
  crisis, rise since 2004

35
Main sources of FDI in Vietnam

• WHO?
• Japan
• Singapore
• South Korea
• Netherlands
• Taiwan
• Hongkong
• France
• Thailand
• USA

• WHERE?
• Sectors
• Industry
• Oil
• Mining
• Tourism

36
FDI in Vietnam by Sector
37
TOP 10 INVESTOR NATIONS IN VIETNAM
38
Contribution of FDI to Vietnams Economy

• FDI companies contribute 13.3 to GDP, 23 to
  export, 25 to state budget revenues.
• On other hand the FDI attracted into Vietnam is
  by regional standards quite modest ( about 2 of
  FDI into China)
• Employment 750,000 workers

39
France FDI Flows In Out
Ratio OUT/IN 1,8
Source FMI OCDE 2007
40
Cumulative negative net FDI flows 1997-2006
In billions of US
France - 391 billion (15 GDP)
Source FMI/2007
41
Outsourcing and job losses in Europe
Source European Fondation for the improvement of
living and working conditions/2006
42
Outsourcing and sectoral job losses in Europe
Source European Restructuring Monitor/2006
43
Offshoring and job losses in Europe
44
Distribution of FDI benefits for the capital
exporting countries
0,74/1
1. Cost reduction and better price
competitiveness 2. Export income and dividend
remittences 3. Growing jobs in new high value
added activities
0,86/1
1,15/1
Source McKinsey Report 08/2005
45
FDIs Benefits and challenges
Benefits Challenges
Additional resources available for  productive investment Risk sharing with the rest of the world (equity) Greater external market discipline on macroeconomic policy Greater exploitation of comparative economic advantages Enhanced access to technology, information, ideas and management skills Broader access to export markets through foreign partners Training and  broader exposure of national staff Greater liquidity to meet domestic financing needs Broadening and deepening of national capital markets Improvement of financial sector skills Currency appreciation Reduced  scope for independent macroeconomic policy actions Greater exposure to external shocks Demands for protection in local markets Lesser control of foreign owned domestic industry Disruption of national capital markets, asset inflation Risk of rising volatility in financial and exchange markets
46

• 2. Other capital is a residual category that
  groups all the capital transactions that have not
  been included in direct investment, portfolio
  investment end reserves.
• Two categories
• Long-term capital
• Short-term capital
• Non-negotiable instruments gt 1 year or more such
  as London Club bank loans and mortgages,
  syndicated credits, euroloans...
• Financial assets lt 1 year, such as currency,
  deposits and bills, interbank credit lines, trade
  credits (Source BIS)

47
Gross private capital flows to LACs
48

• 3. Change in reserves
• Reserves include
• Hard currency assets Monetary gold (gold held
  by the authorities as a financial asset)
• Special drawing rights (SDRs) reserves created
  by IMF as book-keeping entries and credited to
  the accounts of IMF member countries according to
  quotas
• Reserve position in the Fund (members quota
  other claims on the Fund)

49

• Foreign Exchange Reserves
• The largest component of total international
  liquidity. It includes monetary authorities
  claims on non-residents in the form of bank
  deposits, treasury bills, short-term and
  long-term government securities, and other claims
  usable in the event of balance of payments need,
  including non-marketable claims from
  inter-central bank and intergovernmental
  arrangements, without regard as to whether the
  claim is denominated in the currency of the
  debtors or the creditors.
• A sign in the BOP means a financing flow in the
  capital account, i.e., a decrease in the stock of
  reserves!

50
Chinas rising official reserve assets
US billion
Source IMF 2006/IIF
51

• 4. Counterpart items offsetting amounts
• Counterparts items are analogous to unrequited
  transfers in the current account.
• They arise because of the double entry system in
  balance of payments accounting and refer to
  adjustments in reserves owing to monetization of
  gold, allocation or cancellation of SDRs and
  revaluation of the various components of total
  reserves.
• These BOP items do not stem from international
  transactions.

52

• 5. Net errors and omissions
• Statistical difficulties involved in gathering
  balance of payments data (and capital flight!).
• Other sources of EOs
• leads and lags in trade flows, underinvoicing of
  exports and overinvoicing of imports, undeclared
  short-term capital movements

53
Net errors and omissions ?

• An examination of the size and direction of
  NEOs may shed some light on the accuracy of BoP
  estimates. The adoption of the double entry
  accounting system means that the net sum of all
  credit and debit entries should equal zero.
• In practice, any discrepancies are recorded in
  NEOs, reflecting the net effect of differences
  in coverage, timing and valuation. An amount gt 5
  of the gross sum of merchandise exports and
  imports is a source of concern!

54
In millions of US Source IIF
55
Russia Net Errors Omissions in US billion
Source IMF-IFS/IIF
56
Peru and Capital flight
57
6. Exceptional Financing

• IMF Drawings
• World Banks HIPC Initiative
• London Club debt reduction and restructuring
  workouts
• Paris Club debt relief
• Debt swap transactions

58
Table of Uses and Sources
59
Risk Management and BOP Analysis
Export of goods f.o.b. - Imports of goods
f.o.b. Trade balance /-
Exports/Imports of non-financial services
/- Investment income/expenditures
(credit/debit) (-) Private/Official
unrequited transfers Current account
balance /- FDI /- Portfolio capital Flows
LT Capital Inflows - Debt Servicing
Payments /- ST Capital Flows Reserve Variation
60
External Finance AnalysisThe dual face of
Country Risk

• Liquidity Risk
• Debt Service Ratio
• (PI/X)
• Interest Ratio (I/X)
• Current account/GDP
• Reserve/Import ratio
• Elasticity of exports
• Growth rate of exports/ Average external interest
  rate

• Solvency Risk
• Debt/Export ratio
• Debt/GDP ratio
• Debt/Reserves
• ST Debt/Reserves

61
Liquidity and Solvency Thresholds

• Stock variable
• Solvency Debt/GDP lt 100
• Debt/Exports lt 150
• Reserves/months of Imports gt 6 months
• Flow variable
• Liquidity Debt Service ratio lt 33 of X
  Interest/X ratio lt 25

62
US Payments statistics the basic balance

• Basic balance balance on current account and
  long-term capital
• It puts below the line changes in reserves and
  all short-term capital movements (including
  errors omissions). It stresses the importance
  of demand management policies affecting net
  international transactions in goods and services

63
US International Investment Position

• Foreign-owned assets in the US 9079
• Foreign official assets 1133
• FDI 2007
• US Treasury securities 504
• Corporate bonds 1690
• Corporate stocks 1170
• US currency 297
• US bank liabilities 1407

• US-owned assets abroad 6473
• US government assets 244 (official reserves)
• US private assets 6229
• FDI 2302
• Foreign securities 1847
• Non-bank claims 891
• US Bank claims 1455

64
Net US external investment position in US billion
65
Net US external investment position in US billion

• FRB of NY Current issues in economics and
  finance, December 2005, N12
• End-2004 - 2500 billion, or 22 of GDP, but the
  US earned US36 billion more on its foreign
  assets than it paid out to service its foreign
  liabilities!
• Despite the surge in net liabilities, investment
  income has remained positive, largely because US
  MNCs earn a higher rate of return than do foreign
  firms operating in the US. The continuing buildup
  in liabilities, however, will push the US income
  balance negative, hence boosting the CAD!

66
The History of the U.S. Balance of Payments
Stage I The U.S. is a young debtor nation
(1770-1870) -Current account deficit due to the
need to import most goods and inability to
produce many goods for export. -Capital account
surplus due to a great deal of foreign investment
in the U.S. in the areas of roads, farming,
cattle ranches, railroads, and canals. Stage II
The U.S. is a mature debtor nation (1870-1920) -
Current account deficit due to large investment
income being paid back to foreign investors based
on the investment of stage I. Merchandise account
in surplus -- exports gt imports. Stage III The
U.S. is a young creditor nation (1920-1945) -Huge
surplus in the current account due to large
volume of postwar (WWI) exports. -Capital account
in deficit due to a great deal of U.S. investment
in Europe for postwar reconstruction.
Source http//www.digitaleconomist.com/bop_4020.h
tml
67
Stage IV The U.S. is a mature creditor nation
(1945-1980) -Merchandise deficit -- exports lt
imports but an investment income surplus with a
slight net surplus overall. -Capital account is
in deficit largely due to postwar (WW II)
reconstruction in Europe and Japan. Stage V
(1980- ) -Large (and growing) deficit in the
merchandise accounts (Trade Deficit) and slight
surplus in the investment income accounts. -Large
surplus in the capital account partially to
finance the above merchandise deficit (foreign
individuals and banks lending money to
individuals in the U.S.) Additionally, since the
U.S. has had a low inflation rate since 1982 and
consistent economic growth , the U.S. has been a
good place to invest relative to the rest of the
world. However the current inflow of capital
investment could eventually lead to large
investment income payments in the near future.
The investment income surplus may soon be eroded
thus worsening the current account deficit.