Interna9onal

 Macroeconomics  
Master  in  Interna9onal  Economic  Policy  

Current  account  imbalances    

and  exchange  rates  

Ludovic  Subran  
Lectures  3-­‐4    ludovic.subran@sciencespo.fr  
MoEvaEon  

–  Global  imbalances  and  the  US  current  account  

deficit  
–  Is  there  an  “exorbitant  privilege”  of  the  dollar?  
–  Global  imbalances  and  the  financial  crisis  
–  External  adjustment  in  the  Eurozone  
Current  account  imbalances  and  exchange  rates  

1.  Open  economy  accounEng:  balance  of  payments  

2.  The  BOP  theory  of  exchange  rates  
3.  Global  Imbalances:  current  account  and  net  foreign  
assets  
4.  Adjustment  of  global  imbalances  
Current  account  imbalances  and  exchange  rates  

1.  Open  economy  accounEng:  balance  of  payments  

2.  The  BOP  theory  of  exchange  rates  
3.  Global  Imbalances:  current  account  and  net  foreign  
assets  
4.  Adjustment  of  global  imbalances  
Open  economy  naEonal  income  idenEEes    

Na9onal  Accoun9ng    
Y=  C  +  I  +  G  +  EX  -­‐  IM  
•  Y:  GDP  
•  C:  ConsumpEon  
•  I:  Investment  
•  G:  public  spending  
•  EX:  Exports  of  goods  and  services  
•  IM:  Imports  
•  Current  account  (someEmes  net  exports):  CA=  EX-­‐IM    
A  Remark:  GDP  and  GNI  

•  GDP  (Gross  DomesEc  Product):  value  of  all  final  goods  and  
services  produced  within  naEonal  borders  (on  a  given  period)  
•  GNI  (Gross  naEonal  Income):  value  of  all  final  goods  and  
services  produced  by  naEonal  factors  of  producEon  (on  a  
given  period)  
•  GNP  =  GDP  +  net  receipts  of  factor  income  from  the  ROW;  
(income  domesEc  residents  earn  on  wealth  held  in  ROW  –  
payments  domesEc  residents  make  to  foreigners  who  own  
wealth  located  in  domesEc  economy)  
•  Usually  small  difference  (except  few  well  idenEfied  countries  
like  Ireland)  
•  Here,  we  focus  on  GDP  (in  K&O,  GNP)  because  Europe  does  
(US  more  recent)  
 From GDP To GNI

Add transfers from overseas

-  remitted profits from UK firms foreign operations
-  interest payments and dividends received from overseas
investments
-  remittances from UK residents based overseas
-  grants received from foreign governments

Deduct transfers from overseas

-  remitted profits from foreign firms UK operations
-  interest payments and dividends received from foreign investments in the UK
-  remittances from overseas residents based in the UK
-  grants paid by UK government
 Difference between GDP and GNI (as % of GDP) 2007

Source: OECD Main Economic Indicators and Quarterly National Accounts, International Monetary Fund, 2009.
 NaEonal  AccounEng  for  US  and  France  2009  
Y(GDP)=  C+I+G+EX-­‐IM  
France    in  billions  €                        US  in  billions  $  (%  of  GDP)  
Y:1  909  (1950  en  2008)                    Y:  14  119  (14  441  in  2008)  
C:  1113  (58,3%)                        C:  10  001  (70.8%)  
I:  298  (15,6%)                                                  I:    1589  (11.2%)  
G:  534  (28,0%)                                                G:  2915  (20,6%)  
EX:  440  (23,0%)                    EX:  1578  (11.1%)  
IM:  477  (25,0%)                      IM:  1964  (13.9%)  
EX-­‐IM=  -­‐  37  (-­‐2%)                                            EX-­‐IM=  -­‐386  (-­‐2,7%;  -­‐4.9%  in  2008)  

China:  C  (36%);  I  (41%);  G  (14%);  EX  (40%);  IM  (32%)  

The  Fundamental  Balance  of  Payments  IdenEty  

NaEonal  Revenue  =  NaEonal  Output  

NaEonal  output  (Y)  is:  
       Y  ≡  I  +  C  +  G  +  [EX  –  IM]    
with  EX  –  IMP  =  CA  =  Current  Account  Balance  
The  use  of  naEonal  revenues  :  Y  ≡  C  +  SP  +  T  
Then:  (I  –  SP)  +  (G  –  T)  +  (EX  –  IMP)  ≡  0  
Introducing  Public  Savings  (Fiscal  Surplus):  SG=T-­‐G  
 CA  ≡  SP  +  SG-­‐  I  ≡  S-­‐I  
The  Fundamental  Balance  of  Payments  IdenEty  

CA  ≡  SP  +  SG-­‐  I  ≡  S-­‐I  

• AccounEng   idenEty   (no   behaviour,   no   explanaEon,   no   theory  

here)  
• A   country   whose   savings   exceed   naEonal   investment   tends   to  
run   a   current   account   surplus   :   the   country   is   lending   to   the   rest  
of  the  world  
• A  current  account  deficit  can  reflect:  
 -­‐  Small  saving  rate  (high  consumpEon)  (US  from  2000)  
 -­‐  High  investment  (US    1995-­‐2000)  
   -­‐  Budget  deficit  (US  since  2001)  
(SP  –  I)  and  (SG)  in  the  US  
A  bit  more  of  accounEng…  

Balance  of  Payments  (BOP)  

-­‐  Registers  all  transacEons  with  foreign  economic  agents  
-­‐  3  main  sorts  of  transacEons:  
 -­‐  exports  and  imports  of  goods  and  services  
current  account  (CA)  
 -­‐  sale  and  purchase  of  financial  assets    
financial  account  (FA)  
 -­‐  certain  transfers  of  wealth  (small)  
capital  account  (KA)  
The  Balance  of  Payments  

The  Balance  of  Payments  (BOP)    

=  Current  Account  +  Financial  Account+  Capital  Account  

The  Balance  of  Payments  has  to  balance:    

BOP  =  0  
(abstracEng  from  errors  and  omissions)  
Why  does  the  balance  of  payments  have  to  balance?  

• EssenEally  an  accounEng  trick  -­‐  every  credit  needs  to  be  matched  by  a  
debit:  double  entry  book  keeping  principle!  
• The  current  account  shows  overall  situaEon  in  transacEons  of  goods  
and  services.  The  capital  and  financial  account  shows  how  this  is  
financed.  
• Consider  the  case  of  the  U.K  running  a  current  account  deficit,  in  
other  words  the  U.K  cannot  pay  its  import  bill  from  exports  alone.    
• One  soluEon  is  for  the  U.K  to  sell  any  overseas  assets  and  use  the  
money  to  pay  the  import  bill.  Another  opEon  would  be  to  sell  some  
U.K  assets  (say  Canary  Wharf)  which  would  count  as  Inward  Direct  
Investment.  This  would  create  a  financial  account  surplus  equal  to  the  
current  account  deficit.  
The  Current  Account  

•  Trade Balance = Exports of Goods and Services - Imports

of Goods and Services = (X-M)

•  Current Account =Balance on Goods and Services + Net

Foreign Workers Remittances + Net International Aid+ Net
Royalties + Net Investment Income = (X-M+NFI)
The  Financial  &  Capital  Accounts  

•  Financial account (FA): records flow of financial

assets. These are Foreign Direct Investment, Net
Portfolio Flows and Net Other (mainly bank loans and
trade credits)
•  Capital account (KA): records flow of non-financial
assets between countries – debt forgiveness,
purchase of royalty rights
•  However because of measurement error also a
category called “errors and omissions”
 US  Balance  of  Payments  ($bn  2010)  

Capital  Account   -­‐0.1  

Current   -­‐471   Financial  Account   254  
Account  

Balance  of   -­‐646   Net  FDI   -­‐115  

Trade  

Balance  of   146   Net  Porwolio   225  

Services  

Net  inv.   165   Net  Other  (incl.   144  

income   derivaEves)  

Net  Transfers   -­‐136   Errors  and   217  

Omissions  
China Balance of Payments
($bn H1 2009)

Balance  of  Trade   118   Net  FDI,  Private  and   32  

Official  Assets  
Balance  of  Services   -­‐19   Reserves   -­‐186  

NFI   31   StaEsEcal  Discrepancies   25  

Current  Account   130   Financial  Account   -­‐129  

Capital  Account   -­‐1  
Total  Balance  (CA+FA+KA)                                                                                                                                0  
Current  account  imbalances  and  exchange  rates  

1.  Open  economy  accounEng:  balance  of  payments  

2.  The  BOP  theory  of  exchange  rates  
3.  Global  Imbalances:  current  account  and  net  foreign  
assets  
4.  Adjustment  of  global  imbalances  
BOP  theory  of  exchange  rates  

•  Develop  a  simple  framework  to  examine  how  the  

current  account  and  exchange  rate  of  a  country  is  
affected  by  various  macroeconomic  events…  

•   …  to  explain  some  of  the  medium  term  deviaEons  

from  PPP  documented  in  the  previous  lecture  
The  role  of  exchange  rate  

• But  while  the  NaEonal  Accounts  show  that:  

CA  =  S-­‐I  
How  does  this  happen?  
• VariaEons  in  the  real  exchange  rate  ensure  that  
current  account  equals  net  savings.  
• A  theory  of  the  current  account  is  a  theory  of  net  
savings.  
The  Current  Account  

Focus  on  flexible  exchange  rates  

Two  country  model:  Europe-­‐US.  

CA€  =  CA(q,  Y€d,  Y$d)    

 q  =  E  P$/P€  :  real  exchange  rate;  relaEve  price  of  US  

goods  with  respect  to  European  goods    

 q      :  real  depreciaEon  of  euro    

The  Current  Account  

CA€  =  EX€    -­‐  IM€  in  euros  =  Net  exports  in  euros  

 Suppose  E  ↑  (or  equivalently  q  ↑  ):    

 How  do  exports  (foreign  demand  for  European  goods)  and  imports  
(European  demand  for  foreign  goods)  react  ?  
 Depends  on  two  main  factors:  
1)  In  which  currency  exporters  fix  their  prices?  
 How  much  ‘pass-­‐through’  of  exchange  rates  to  consumer  prices?  
2)  How  large  is  the  elasEcity  of  subsEtuEon  between  domesEc  and  
foreign  goods?  
The  Current  Account  

•  How  much  do  consumers  subsEtute  from  US  to  European  goods?  

•  Depends   on   Pass-­‐through:   if   exports   are   fixed   in   Local   (Producer)  

Currency:  small  (large)  effects    

•  Depends   on   the   elasEcity   of   subsEtuEon:   if   goods   are   highly  

(poorly)  subsEtutable:  large  (small)  effect  

•  May   explain   that   €   appreciaEon   affects   less   German   exports   than  

French   exports:   German   exporters   (machinery)   are   in   sectors   and  
produce  (high  quality)  goods  less  price  sensiEve  (lower  elasEcity  of  
subsEtuEon)  

•  Aggregate  elasEcity  of  exports  to  real  exchange  rate  movements  is  
low:  a  bit  more  than  1  for  OECD  countries  a•er  one  year  
The  Current  Account  

•  If  q  ↑  →  volume  of  imports↓,  exports↑:  subsEtuEon  

•  But  if  slow  response  of  volumes  (empirically  6  months-­‐1  year):  
value  of  imports    ↑    
•  volume   versus   value   effect.   In   short   term,   the   value   effect   can  
dominate  
•  Net  effect  on  the  CA  of  q      ?  
•  J   curve   and   the   Marshall-­‐Lerner   condiEon   such   that   a  
depreciaEon   generates   an   improvement   in   CA:   the   sum   of  
import  and  export  elasEciEes  to  exchange  rate  >  1  
 The  J-­‐Curve  

volume effect
dominates
value effect

Immediate
effect of real J-curve: value
depreciation
effect dominates
on the CA
volume effect
The  Current  Account  

We  assume  from  now  on:  

 €  nominal  or  real  depreciaEon  (E  ↑  or  q  ↑)  

generates  an  ↑  in  demand  via  an  ↑  in  net  exports  :  

CA€  (q)=  (EX€    -­‐  IM€)    

+
The  Current  Account  

High  real  exchange  rate  means  

European  goods  cheaper  so  Europe  
export  more  and  import  less  -­‐  net  
exports  increases  with  q  

0   CA=Net Exports
BOP  Theory  of  Exchange  Rates  

q S-­‐I  

CA=Net Exports
Real Exchange Rate determined by equality of net savings with net exports
BOP  Theory  of  Exchange  Rates  

•  A  depreciaEon  of  real  exchange  rate  means  domesEc  goods  

are  more  compeEEve  on  internaEonal  markets.  

•   Real  exchange  rate  adjusts  to  ensure  net  exports  equals  net  
savings.    

•    If   net   savings   >   net   exports,   then   real   exchange   rate  

depreciates   which   decreases   imports   and   boosts   exports.  
Eventually  net  exports  equal  net  savings.  
Increase  in  fiscal  deficits  (fall  in  public  savings)  

q S-­‐I  

CA=Net Exports

AppreciaEon  of  the  currency  and  deterioraEon  of  the  current  account    
Reagan  and  Bush  I  Deficits  

Source : Bureau of Economic Analysis

Drop  in  investment  

q S-­‐I  

CA=Net Exports

DepreciaEon  of  the  currency  and  improvement  of  the  current  account    
ArgenEna  2001-­‐2002  Financial  Crisis  
Increase  in  demand  for  European  goods  

q S-­‐I  

CA=Net Exports
Current  account  imbalances  and  exchange  rates  

1.  Open  economy  accounEng:  balance  of  payments  

2.  The  BOP  theory  of  exchange  rates  
3.  Global  Imbalances:  current  account  and  net  foreign  
assets  
4.  Adjustment  of  global  imbalances  
Global  Imbalances  

•  Previous  model  useful  to  interpret  how  real  exchange  

rate   adjust   to   macroeconomic   shocks.   But   very  
«  staEc  ».  
•  What  happens  when  a  country  runs  current  account  
deficits  for  years  (the  US)?  Should  the  country  adjust  
and   reduce   its   deficit?   How   does   it   happen?   What  
are  the  consequences  for  the  exchange  rates?  
•  Should   we   worry   about   the   persistent   current  
account   deficit   of   some   countries   (in   parEcular   the  
US)?  
Blanchard and Milesi Ferretti, 2009
 Saving and Investment Trends (in percent of domestic GDP)

Source Blanchard and Milesi Ferretti, 2009

 Saving and Investment Trends (in percent of domestic GDP)

EUR deficit: Greece, Ireland, Italy, Portugal, Spain, UK, Bulgaria, Czech Republic, Estonia,
Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, Turkey, Ukraine
EUR surplus: Austria, Belgium, Denmark, Finland, Germany, Luxembourg, Neth,
Sweden,Switzerland.
 Saving and Investment Trends (in percent of domestic GDP)

Blanchard and Milesi Ferretti, 2009

«  Good  »  and  «  bad  »  imbalances  
No  obvious  normaEve  judgment  on  sign  (if  not  size)  of  CA  
«  Good  »  imbalances  »:    
 S  >  I  :  ageing  countries  (anEcipaEon  of  later  dissaving);  low  expected  growth  
in  the  future    
 I  >  S  :    high  returns  to  investment:  finance  part  of  I  through  foreign  saving  
(example:  poor  countries  catching-­‐up  in  terms  of  producEvity)  

«  Bad  »  imbalances  »:    

1)  Domes9c  Distor9ons  
-­‐  «  Too  »  high  private  saving  :  lack  of  social  insurance,  financial  repression    
-­‐  «  Too  »  low  private  saving  (US):  asset  bubbles  (real  estate)  
-­‐  Too  much  public  borrowing  (dissaving)  
2)  Systemic  Distor9ons  
-­‐  A•er  Asian  crisis  (1997-­‐98),  emerging  markets  ran  large  CA  surpluses  and  
accumulated  large  FOREX  reserves.  Partly  insurance  (precauEonary  saving)  
against  speculaEve  a†acks  (IMF  did  not  help  much).  Individually  raEonal  but  
globally  may  lead  to  global  imbalances  
The  Chinese  Savings  Puzzle?  
China:    
•  Fast  growing  country.  Very  high  producEvity  growth.    
•  As  expected,  very  large  investment  rates.    
•  But  savings  growing  at  an  even  faster  pace  and  China  runs  
current  account  surpluses.  

Why?  
•  DomesEc  financial  distorEons:  financial  markets  not  very  
developed  (borrowing  constraints).  
•  PrecauEonary  moEve  (lack  of  social  insurance…)  
•  Demographics  («  one  child  »  policy  ;  market  for  marriage)  

SEll  very  difficult  to  jusEfy  such  a  high  saving  rate.  

The  Chinese  Savings  Puzzle?  

Savings,  Investment  and  Current  Account  in  China  

Current  accounts  and  net  foreign  assets  
 AccumulaEng  CA  deficits  leads  to  a  negaEve  NFA  (net  foreign  
assets)  posiEon  with  the  ROW  (also  called  Net  internaEonal  
investment  posiEon  (NIIP))  
 AccounEng  (forget  capital  gains  and  losses,  valuaEon  effects):  
 If  a  country  in  year  t  has  a  CA  deficit,  its  net  external  posiEon  (or  
NFA)  Bt  deteriorates:    
CAt  =  NFAt  -­‐  NFAt-­‐1    (Flow)    

 Net  external  posiEon  (NFA)  in  t  is  NFA  in  t-­‐1  +  CA  value  
   NFAt  =  NFAt-­‐1  +  CAt                  Stock  (wealth)    
 NFAt  <  0  if  debtor  country:  value  of  the  foreign  assets  it  holds  <  
value  of  domesEc  assets  held  by  foreigners  
 Net foreign assets (in percent of world GDP)

US as largest debtor country

Source: IMF
Debtor and creditor countries before the crisis (% of GDP)
 NFA in % of GDP; 2007 (selected countries)

Source: Lane Milesi Ferreti, 2009

Link  between  global  imbalances  and  the  financial  crisis    
(see  Obsfeld  and  Rogoff,  2010)  

•  Global  imbalances  unsustainable  (CA  deficit  in  US  in  

part.)  :  low  saving  rate  of  US  consumers  (close  to  zero  
before  crisis)  and  high  saving  rate  in  China  (relaEve  to  
inv.)  
•  Two  other  connected  trends  also  unsustainable  before  
the  crisis  
–  real  estate  values  (bubble)  rising  in  the  US,  UK,  
Spain…(all  countries  with  CA<0)  
–  extraordinary  high  levels  of  leverage  (consumers  in  
the  US  and  UK;  financial  enEEes  in  many  countries)  
Countries  running  CA  deficit  have  larger  real  estate  bubbles  

Source:  O&R  (2010)  

Change  in  current  account  and  real  estate  prices  over  
2000-­‐2006  for  selected  countries  
What  is  the  nature  of  the  connecEon  between  global  
imbalances  and  the  financial  crisis?  Causal?    
 High  savings  in  Emerging  Asia  and  US  monetary  policy  
   ⇒  ↓global  real  interest  rates    
   ⇒  fall  in  interest  rates  encourage  investors/consumers  to  borrow  and  build  
leveraged  posiEons  
    ⇒   US   easy   foreign   borrowing:   indirectly   made   it   easier   for   consumers   to  
borrow  and  for  banks  to  finance  this  borrowing  
   ⇒  Housing  prices  raising  globally.  SpeculaEve  bubble.  
  Note   that   easy   borrowing   was   reinforced   by   the   (unsustainable)   real   estate  
bubble.    
 Another  interpretaEon  is  that  real  estate  bubble  (and  lax  regulaEon)  made  
consumer  borrowing  and  the  consumpEon  boom  possible  which  drove  the  
CA  deficit.  

  “The   global   imbalances   of   the   2000s   both   reflected   and   magnified   the  
ulEmate  causal  factors  behind  the  recent  financial  crisis.”  O&R  (2010)  
 ValuaEon  effects  on  external  posiEons  

•  CA  deficits  only  one  factor  of  the  evoluEon  of  the  NFA  
posiEon  
•  ValuaEon  effects  have  become  very  large  due  to  
financial  globalizaEon  and  the  increase  in  gross  posiEons  
(assets  and  liabiliEes)  
•  NFAt  -­‐  NFAt-­‐1  =  CAt  +  Capital  gains  (or  losses)  on  external  
assets/liabiliEes    
•  Changes  in  exchange  rate  and/or  movements  in  equity  
markets  affect  value  of  both  foreign  assets  held  by  
domesEc  agents  (assets)  and  domesEc  assets  held  by  
foreign  agents  (liabiliEes)  
•  Capital  gains  on  NFA  are  extremely  volaEle.  
Bureau of Economic Analysis 2008
ValuaEon  effects:  Annual  real  returns  (%)  on  foreign  assets  &  liabiliEes  

Source: Gourinchas-Rey (2005)

ValuaEon  effects  and  the  US  deficits  

•  Growing  divergence  between  accumulaEon  of  CA  deficits  and  

NFA  (or  NIIP,  net  internaEonal  investment  posiEon)  posiEon  in  
US  
•  Period  2002-­‐2006:  with  CA  deficits  (>5%  of  GDP)  the  US  NFA  
posiEon  (measures  the  difference  between  the  value  of  foreign  
assets  held  by  US  agents  and  US  assets  held  by  foreigners)  
barely  changed:  cumulaEve  of  CA  deficits  around  $3.4  trillion  ⇒  
should  have  raised  US  net  external  liabiliEes  to  some  $5.5  
trillion  (40%  of  GDP).  The  NFA  deterioraEon  was  only  $400  
billion.  As  a  raEo  of  GDP  it  actually  improved.  
•  Where  did  those  other  $3  trillion  of  US  net  borrowing  go?  
NFA,  %  of  US  GDP  

The US becomes a net debtor

Net International Investment Position of the US, 1983–2008

Bureau of Economic Analysis 2008

How  can  that  be?  

•  Foreign  assets  held  by  Americans  (mostly  

denominated  in  foreign  currency)  increased  in  value  
much  more  than  foreign-­‐held  assets  in  the  US  
(mostly  denominated  in  $):  why?  
•  $  depreciaEon  2002-­‐2007  
•  foreign  stocks  did  be†er  than  US  stocks  
•  In  2008  (financial  crisis):  dollar  appreciaEon  and  
foreign  equity  markets  fared  even  worse  than  US  
equity  markets  
 The  US  Net  foreign  asset  posiEons  in  2004  

Currency  denominaEon  of  US  assets  and  liabiliEes  

 A  numerical  example  and  the  role  of  the  $  

•  NIIP  or  NFA  of  US  in  2002  ≈  20%  of  GDP  
•  Foreign  assets  held  in  the  US  ≈  125%  GDP    
•  US  held  by  foreigners  ≈  145%  GDP  
•  Around  65%  of  foreign  assets  held  by  US  are  in  foreign  
currency  (euro,  yen…)  
•  Around  95%  of  US  assets  held  by  foreigners  are  in  $  
•  $  depreciates  by  10%  (other  currencies  appreciate  by  
10%)  
•  Foreign  assets  (in  foreign  currency)  gain:  (0.1)(0.65)
(1.25)  =  8,1%  of  US  GDP  
•  US  assets  (in  foreign  currency)  held  by  foreigners  gain  :  
(0.1)(.05)(1.45)  =  0.7%  of  US  GDP    
•  In  net:  the  net  value  of  US  debt  to  ROW  decreases  by  
7.4%  of  US  GDP  (a  transfer  of  more  than  $  1000  billions  
to  U.S!)  
•  If  (big  if)  repeated:  can  suggest  that  due  to  dollar  role  
(US  debt  in  dollar)  foreigners  get  a  weak  return  on  
American  assets:  «  exorbitant  privilege    »  
Current  account  imbalances  and  exchange  rates  

1.  Open  economy  accounEng:  balance  of  payments  

2.  The  BOP  theory  of  exchange  rates  
3.  Global  Imbalances:  current  account  and  net  foreign  
assets  
4.  Adjustment  of  global  imbalances  
 Adjustment  of  global  imbalances  

•  Two  adjustment  mechanisms  to  close  the  deficit:    

–  Trade  channel  :  depreciaEon  helps  exports  and  
decreases  imports  (J-­‐curve)    
–  Financial  channel  (valuaEon  effects):    
•  In  the  US:  a  depreciaEon  facilitates  the  adjustment  because  
debts  are  in  $  and  assets  are  in  foreign  currency    
•  In  emerging  markets:  a  currency  depreciaEon  (against  the  
$)  makes  the  adjustment  more  difficult  because  external  
debts  are  in  $  :  the  «  original  sin  »  
 Adjustment  of  global  imbalances  

•  ImplicaEons  for  the  dollar    

–  Closing  the  current  account  deficit  and  reducing  net  external  
debt  implies  a  depreciaEon  of  the  dollar  in  the  future  
•  Boosts  net  exports  
•  PosiEve  valuaEon  effects  for  the  US  
–  Adjustment  started  in  the  2000’s:  real  depreciaEon  of  the  
dollar  of  20%  over  2000-­‐2007  
–  EsEmates  in  the  literature  before  last  recession  suggested  at  
least  30%  more  to  go  (Obsweld  and  Rogoff  2007).  
–  Yet  global  imbalances  did  not  vanish  and  financial  crisis  seems  
to  have  slow  downed  the  adjustment.  Why?  
 Adjustment  of  global  imbalances  

•  The  Trade  Adjustment  

–  Effect  of  the  real  exchange  rate  on  the  trade  balance  (NX)  
∆NX/GDP  =  β  ∆RER  
EsEmate  of  β:  depends  on  the  subsEtutability  between  US  and  foreign    
goods  (as  well  as  the  share  of  non  tradables).  Macro  esEmates  β  between    
0.05  and  0.1.  An  improvement  of  1%  of  the  trade  balance  requires  a    
depreciaEon  of  10  to  20%.  Let’s  use  the  value  of  15%.  
•  The  Financial  Adjustment  
–  A  15%  depreciaEon  will  reduce  net  US  debt  by  about  10%  of  US  GDP  due  to  
posiEve  valuaEon  effects.  Assuming  a  reasonable  rate  of  return  on  assets  of  
4%,  reduces  interest  payments  by  0.4%  of  GDP.    

From Blanchard, Giavazzi and Sa, 2005

 Adjustment  of  global  imbalances  

•  Adding   the   trade   balance   and   the   valuaEon   effects   together   means  
that  a  depreciaEon  of  15%  improves  the  CA  by  around  1.4%.  
•  Then  a  reducEon  of  5%  of  the  current  account  deficit  means  a  dollar  
depreciaEon   of   around   50%.   Without   valuaEon   effects,   the  
depreciaEon  required  would  have  been  much  larger,  up  to  75%.  
•  Note   that   this   does   not   tells   at   what   rate   the   depreciaEon   would  
occur:  won’t  happen  overnight  but  the  more  we  wait  the  larger  is  the  
net  US  debt  posiEon  and  the  larger  must  be  the  depreciaEon  
•  If  “exorbitant  privilege”  (see  below),  smaller  adjustment  needed.  

From Blanchard, Giavazzi and Sa, 2005

Adjustment  of  global  imbalances:  
ImplicaEons  for  exchange  rate  forecasts  
•  Difficult  exercice  at  short  horizons:    
 Meese  and  Rogoff  (1991):  Fundamentals  do  not  predict  
be†er  than  a  random-­‐walk  
•  But  net  foreign  asset  posiEon  can  be  used  as  a  predictor  of  
future  exchange  rate  movements:  financial  and  trade  
adjustment  of  large  negaEve  NFA  in  the  case  of  the  US  
requires  a  future  depreciaEon  of  the  USD.  
•  Gourinchas  and  Rey  (2007)  find  that  this  works  well  for  the  
USD.    
 NFA  also  help  forecasEng  net  external  returns  on  foreign  
assets  (financial  adjustment)  
Source: Gourinchas-Rey (2007)
Source: Gourinchas-Rey (2007)
How  large  is  the  «exorbitant  privilege»?  

Gourinchas  and  Rey  (2005):  From  world  banker  to  world  venture    
capitalist:  US  external  adjustment  and  the  “exorbitant  privilege”’  
Total  return  on  US  assets  held  by  foreigners  (the  US  debt)    <  
Return  on  foreign  assets  held  by  foreigners  (parEcularly  true  
since  1971,  end  of  Bre†on  Woods)  
–  US  borrow  at  3.6%  and  lend  or  invest  at  5.7%:  important  
differenEal    
–  2.1%!  =  (large)  exorbitant  privilege  ;  both  a  composiEon  effect  
(assets  are  riskier  and  less  liquid  than  liabiliEes)    and  a  return  
effect  (excess  return  within  class  of  assets).  Even  larger  (3.3%)  
in  post  Bre†on-­‐Woods  1973-­‐2004.  
-­‐ Returns  are  not  equated  even  within  classes  (no  arbitrage)  
-­‐   could  be  that  assets  and  liabiliEes  of  US  of  different  maturiEes  
-­‐   role  of  dollar  as  reserve  currency  +  liquidity  of  US  financial  markets(?):  foreigners  are  
willing  to  hold  underperforming  US  assets  because  more  liquid  (exorbitant  privilege)  
-­‐   composiEon  effect:  assets  are  in  risky/high  return  (equity/fDI),  liabiliEes  are  in  low  
returns  bonds:  plays  a  less  important  role  (but  more  important  through  Eme)  
 Exorbitant  privilege  and  duty  

•  Consequence   of   exorbitant   privilege:   US   external  

constraint  relaxed    
 →  CA  deficits  without  worsening  of  external  posiEon  
•  Gourinchas,  Rey  and  Govillot  (2010):    
 financial  crisis  →    dramaEc  worsening  of  US  NFA  (19%  
of   GDP)   :   dramaEc   valuaEon   adjustment   (price   of   US  
holdings  abroad  contracted  more  than  foreign  holdings  
in  US):  exorbitant  duty  during  disasters  (insurance)  
•  Find  large  exorbitant  privilege  in  normal  Emes    
 (New  esEmates:  3.47%  excess  returns  of  external  assets  
over  liabiliEes  for  1973-­‐2009)  
Exorbitant  privilege  

Source:  Gourinchas  et  al.  (2010)  

Exorbitant  duty  

Source:  Gourinchas  et  al.  (2010)  

 Adjustment  of  ‘euro’  imbalances  
•  Eurozone  as  a  whole  roughly  on  balance  externally.    
•  But  hide  a  very  large  heterogeneity  across  countries:  large  
creditors  (Germany,  Finland,  Netherlands)  and  large  debtors  
(Greece,  Portugal,  Spain,  Ireland)  
•  In  peripheral  countries  similar  pa†erns  than  in  the  US  in  the  
2000s:  consumpEon  and  credit  boom,  housing  prices  boom.  
•  Easy  foreign  borrowing  from  the  peripheral  countries  has  
magnified  the  consequences  of  the  financial  crisis  in  these  
countries  (financial  fragility)  
 Euro  area  heterogeneity  
Average  current  account  balances  %  of  GDP  (2002-­‐2007)  
 Adjustment  of  ‘euro’  imbalances  

•  Two  adjustment  mechanisms  

–  Trade  channel    
–  Financial  channel  (valuaEon  effects)    
•  Requires  a  real  depreciaEon  of  the  currency  for  deficit  countries  
•  Financial  channel  shut  down  with  the  euro  zone  unless  default  
•  Real  depreciaEon  difficult  in  a  monetary  union:  ‘compeEEve  
disinflaEon’  needed.  Very  costly  (e.g  France  in  the  90s)  
•  ParEcularly  difficult  for  countries  without  a  large  traded  sector.  
•  Nominal  depreciaEon  of  the  euro  with  other  currencies  might  
help  (not  for  intra-­‐European  trade  though).  
•  Real  appreciaEon  in  Germany?  
Brief  Summary  

•  A  depreciaEon  of  the  exchange  rate  worsens  the  trade  balance  in  the  short-­‐run  
but  improves  it  in  the  medium-­‐run  (J-­‐curve).  
•  In   the   medium   term,   real   exchange   rate   adjusts   such   that   the   BOP   is   in  
equilibrium.  
•  Over   the   last   15   years,   large   global   imbalances   have   emerged,   with   the   US  
running   large   current   account   deficits   financed   by   borrowing   to   some  
industrialized   countries   (Japan   and   Germany)   and   oil   producers   but   more  
surprisingly   to   some   fast   growing   emerging   markets   (China…).     These   global  
imbalances  have  magnified  the  factors  behind  the  recent  financial  crisis.  
•  Adjustment   of   US   current   account   imbalances   requires   a   $   real   depreciaEon,  
which   sEmulates   net   exports   (trade   adjustment)   and   reduces   the   value   of   net  
external  debt  for  the  US  (capital  gains  on  NFA=  financial  adjustment).  
•  The   US   earn   higher   returns   on   their   external   assets   than   what   they   pay   on   their  
external   liabiliEes   (‘exorbitant   privilege’).   This   relaxes   their   external   constraint  
and  reduces  the  necessary  adjustment.  
•  In   period   of   financial   crisis,   the   US   tend   to   transfer   large   amount   of   wealth   to  
the  rest  of  the  world  (‘exorbitant  duty’),  effecEvely  acEng  as  a  world  insurer.