Tag Archives: international investment position

Z.1, Q3-2011

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The Federal Reserve released the Flow of Funds Accounts of the United States today.

The Flow of Funds Accounts provides one of the best snapshot of an economy. In an article appropriately titled ‘No one saw this coming’ – or did they? (see the full paper here), Dirk Bezemer correctly recognizes that the Economics profession’s ignorance of Flow of Funds had a big role to play in its inability to see a crisis coming. Bezemer says

We economists – and the policymakers who rely on us – ignore balance sheets and the flow of funds at our peril.

Of course, as Bezemer points out, there were exceptions. Post Keynesians were always aware of the flow of funds because monetary economy is a natural starting point in their theory. Wynne Godley and Marc Lavoie wrote a book (my favourite!) Monetary Economics: An Integrated Approach To Credit, Money, Income, Production and Wealth, Palgrave Macmillan, 2007, to unify Post Keynesian theory and the flow of funds approach, perhaps improving the presentation of the latter using something called the “transactions flow matrix”.

In my opinion, nobody even came close to Wynne Godley in not only predicting the crisis but the warning about the difficulties in resolving it.

One notable highlight of today’s Z.1 release was that

Household net worth—the difference between the value of assets and liabilities—was $57.4 trillion at the end of the third quarter, about $2.4 trillion less than at the end of the previous quarter.

A lot of readers will know about sectoral balances. How do we get that from Z.1? Table F.8 gives “Net Lending” of each sector of the economy. The difference in a sector’s income and expenditure is it’s “Net Lending”.

(click to expand, and click again to expand)

Before the crisis, the private sector had its income lower than expenditure and was financing the difference by borrowing from the other sectors. As the crisis hit, private sector expenditure retrenched – so you can see how the private sector has become a net lender from being a net borrower before the crisis. Because of this, the government’s borrowing increased from (line 49) $408.1bn in 2007 to $1,471.7bn in Q3 2011 (annualized). It was also due to a relaxation of fiscal policy during the crisis, in order to stimulate demand. The expenditure of the United States as a whole is higher than its income, and the difference is the current account deficit. This is financed by net borrowing from foreigners (line 42) – which was $446.7bn in Q3 2011 (annualized). This deficit was $715.9bn in 2007, bleeding demand at a massive scale from the US economy.

There are two more tables I see closely. The first is the net income payments from the rest of the world, which surprisingly remains positive, leading to a lot of literature about “dark matter”. (More on that some other time). This, according to the Z.1 is the “net receipts from foreigners of interest, corporate profits, and employee compensation”.

 The Levy Institute has been tracking this since 1994. Here’s a latest graph (from their March 2011 analysis)

There are discrepancies between BEA and Fed data. The other table which I rush to check, whenever the flow of funds data is released is the United States’ net indebtedness to the rest of the world – L.107:

which at the end of Q3 was $3,616bn, or 24% of GDP.

There’s a new table – L.108, Financial Business – which actually appeared first time in the previous release (Q2). This sector had $64,299bn in assets and $60,457bn of liabilities at the end of Q3!

Of course, I look at all the tables at some time or the other. Highly recommended.

S&P Again

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Yesterday S&P put 15 of the EA17 governments on CreditWatch negative (comments and links here). It later came out with Credit FAQ: Factors Behind Our Placement Of Eurozone Governments On CreditWatch which gives the rationale for the action. According to the S&P

For countries in net external liability positions, including the eurozone’s peripheral economies, we see growing risks to the funding of their external requirements. In our view, financial institutions located in countries in net external asset positions (such as Germany) also face pressure where the quality of those assets is deteriorating.

So it seems to understand that the problem of the Euro Area is severe internal imbalances leading to high net external debt.

S&P also wrote an article titled Why Trade Imbalances For Creditors As Well As Debtors In The Eurozone Are Weighing On Growth, a few days back. Available through S&P’s Twitter update

click to view the tweet on Twitter

A wisecrack:

More fundamentally, large imbalances between the 17 member economies remain; after many years of high current account deficits in net debtor eurozone countries, these economies have built up substantial levels of net external debt. Such high levels of external leverage will weigh on economic growth prospects–in both net debtor and net creditor eurozone countries–over the next several years. How imbalances between them are unwound, and under what conditions, could determine the success or failure of policymakers in addressing the European debt crisis.

Australia

More on net indebtedness. Australia’s ABS released its Balance of Payments and International Investment Position, September 2011. It has this chart on Australia’s Net International Investment Position (with sign reversed in their convention):

So around 60% of GDP. Highly indebted nation!

Australia’s debt is both in domestic and foreign currencies and banks have hedged most of the foreign currency exposure hedged using foreign exchange derivatives. Australia’s government has almost zero liabilities in foreign currency.

Some people claim that as long as the debt to foreigners is in domestic currency, it doesn’t matter for some kind of “intuitive” reasons. My view is that while it is true that it is advantageous to incur liabilities to foreigners in domestic currency, my reasons are entirely different. A liability in domestic currency prevents revaluation losses if the exchange rate depreciates. A net indebtedness to foreigners is still a burden.  A point rarely understood.

Nice Charts From The Bank Of England

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The Bank of England released the semiannual Financial Stability Report, December 2011 today. Complete book here. These reports have a lot of information, in addition to being well-written, well-formatted and colourful.

The following graph shows how international banks’ funding from US Money Market Mutual Funds changed during the year.

It also plots the Net International Investment Position (the negative of a nation’s debt) – which I have plotted many times in this blog (see here and here for example) and linked to other sources who have plotted it recently and is the reason for my writing this post!

It also has a chart on global imbalances with a focus on EA imbalances

Nice report. Go read.

Update: FT Alphaville’s post BoE charts, UK banks’ gloom also discusses some (different) charts from the report.

Update2: One most post from Alphaville on this.

Update 3: Another one from Alphaville today on Central Counterparties.

The Eurosystem: Part 3

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In the previous post in this series The Eurosystem: Part 2, I discussed cross-border flows within the Euro Area. With exceptions, most of these flows are current balance of payments and balance of payments financing flows. Of course there are other flows with the world outside the EA17 and these flows flow via the correspondent banking arrangements banks have put in place and not the topic of discussion in this series.

The cross-border flows are important for the Euro Area since as a whole, the Euro Area’s balance of payments is almost in balance.

Source 

Source

So the Euro Area current account was in a deficit of €11.7bn in 2011Q3 and a net indebtedness of €1.35tn to the rest of the world at the end of Q3, or 14.5% of GDP. So most of external imbalances of the EA17 nations are within the Euro Area.

Back to TARGET2 flows: there was a debate among some economists on various matters related to these flows. Some even went on to suggest that these flow affect credit in Germany because the nation was financing the current account of the other nations. From an exogenous money viewpoint, this reduces banks’ ability to provide loans to their customers! (which is incorrect because money is not exogenous). The replies tried to disprove it by using the argument that attempted to prove that the NCBs were not financing the current account. Sorry no links.

This is a small post and my point is to show that since  TARGET2 is designed to automatically change the balance sheets of the NCBs, the debate whether the NCBs finance the flows or not is a bit counterproductive. Of course having said this, I wish to highlight the fact that the item “Claims within the Eurosystem” (in either assets or liabilities) is definitely recorded in the balance of payments and the international investment position as can be seen below for the case of Spain.

(Click to enlarge, Source)

(click to enlarge, Source)

Of course, the “Claims Within the Eurosystem” is just one item in the financial account and the international investment position, so not the whole of the current account deficit is financed this way. One minor advantage is that this part of the gross indebtedness of a whole deficit nation is at the ECB’s main refinancing rate, which is much lower than the effective interest rate deficit EA nations are paying on their gross liabilities to foreigners. This is not worthy of further attention, though.

How long can these flows continue? As long as the banks have sufficient collateral to provide to their home NCB. When banks run out of collateral (eligible for borrowing from the Eurosystem), emergency measures have to be taken and a future post in this series will discuss the Emergency Loan Assistance Program (ELA) used by NCBs.

[I welcome your comments. I have a “Zero Comments Policy” as opposed to a “No Comments Policy”. I like being notified of a comment.]

UK’s Assets Held In The Euro Area

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The UK Office of National Statistics released the 2011 editions of the “Blue Book” and the “Pink Book” recently.

The UK Gross Domestic Product was £1,394 billion in 2009 and £1,458 billion in 2010.

In the last 20-40 years, external assets (and liabilities) have grown to a huge multiples of GDP. Hyman Minsky worried about gross assets and liabilities in addition to net assets/liabilities and showed the importance of “gross”. At the end of 2010, according to the Pink Book, total value of assets held abroad by UK residents was equivalent of £9,961 billion while liabilities to foreigners was £10,159 billion, leaving the United Kingdom with a net asset position of minus £197 billion.

With talks of a Eurocalypse not so unthinkable these days, countries’ exposure to the Euro Area is the natural question to ask. Since London is a financial center and the United Kingdom is close to the Euro Area, it is likely to have more exposure to the Euro Area than other nations. The Pink Book 2011 edition gives the geographic breakdown of assets and liabilities only till 2009, unfortunately. Anyway the statistics below

by type:

(click to enlarge)

and in more detail on countries but consolidated across all resident sectors:

(click to enlarge)

Needless to say, huge!

The column for “Derivatives” shows assets valued less than £1,000 billion but here too there may be hidden exposures, since there can be a lot of netting, even though Derivatives appear in both Assets and Liabilities.

If there are problems in the Euro Area, assets held by residents will be impaired (such as due to defaults) and this is already happening at a lesser scale compared to the “unthinkable”. A depreciation of the Euro to the Pound Sterling will also cause revaluation losses for UK residents. On the other hand, to maintain credit ratings, it will be difficult for the UK to default on its liabilities, increasing UK’s net indebtedness to the rest of the world by a huge amount. It is really difficult to forecast how severe the crisis can be, but these numbers suggest it can be devastating to the extreme.

There are second order effects. For example, UK residents hold assets in the United States and if these assets fall in market value due to a crisis situation, there could be a further deterioration in the gross value of UK Assets held abroad.

With EFSF bonds not appealing to investors even in a flight to quality environment, and European politicians’ plans losing credibility, and the ECB’s Securities Markets Programme losing its effect, the only way forward is for the ECB to put explicit ceilings on government bond yields. The reason it is hesitant in doing it is because it creates a moral hazard problem. (See Mervyn King’s Got A Point).

Of course, there seems to be no alternative (except rumours of a €600 billion bailout for Italy!), so challenging times ahead for the ECB.

Update: Wolfgang Münchau of FT thinks the Eurozone has only a few days! Link

An Internal Balance Of Payments Crisis

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Economists are increasingly recognizing the Euro Area problems as a balance-of-payments crisis, in addition to realizing that the Euro Area national governments cannot finance their deficits by making a draft at the Eurosystem in extreme emergency.

The Economist has an article today Beware of falling masonry with the graph on the net asset position which I posted on several occasions in this blog.

With a few exceptions, the benchmark cost of credit in each euro-zone country is related to the balance of its international debts. Germany, which is owed more than it owes, still has low bond yields; Greece, which is heavily in debt to foreigners, has a high cost of borrowing (see chart 2). Portugal, Greece and (to a lesser extent) Spain still have big current-account deficits, and so are still adding to their already high foreign liabilities. Refinancing these is becoming harder and putting strain on local banks and credit availability.

The higher the cost of funding becomes, the more money flows out to foreigners to service these debts. This is why the issue of national solvency goes beyond what governments owe. The euro zone is showing the symptoms of an internal balance-of-payments crisis, with self-fulfilling runs on countries, because at bottom that is the nature of its troubles. And such crises put extraordinary pressure on exchange-rate pegs, no matter how permanent policymakers claim them to be.

The magazine also had another nice article recently: Is this really the end?. Here is a collection of covers from the magazine in recent times on the Euro.

An NIIP Prism

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Alastair Marsh at FT Alphaville discusses the Euro Area problems looked through the prism of net international investment position (NIIP), quoting Goldman Sachs economist Lasse Holboell Nielsen:

When considering the causes of the ongoing Euro area debt crisis, it is natural to focus on public debt and deficits as the primary sources of market tensions. However, as the Irish experience demonstrates, private-sector debt can rapidly migrate onto public-sector balance sheets in the event of a financial crisis. It may therefore be more meaningful to look at the aggregate indebtedness of an economy, consolidating the public- and private- sector positions, in assessing a country’s vulnerability to sovereign yield tensions. [Italics not in original]

Nielsen is apparently trying to model government bond yields using NIIP data for some of the EA17 nations.

This blog had discussed this earlier in the post Eurozone Indebtedness. I re-did the graph and is below

A nation which is running a current account deficit and is highly indebted (proxied by the NIIP-GDP ratio) has to borrow from the international banking system, money markets and capital markets and refinance the debt and faces the risk of a run on its liabilities if the debt gets out of hand. The chart above gives an insight on why some EA17 nations face more troubles than others.

Chart: Eurozone Indebtedness

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The Euro Zone is under a crisis. Is there a chart which shows what the underlying factor is which makes the difference ? Below:


You can see that the external situation is clearly the one which makes the difference as opposed to the public debt. It’s true that Belgium’s bond market is under pressure – creditors may not like high public debt but I think the graph is still useful.

Chart: U.S. Indebtedness

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The Net International Investment Position is measure of how indebted a nation is. Why is that so ? Combine all the balance sheets of the sectors of a nation. Debts between residents cancel out and one is left with assets held abroad and liabilities to non-residents. One can replace “residents” with “citizens” and define a slightly different system of accounts and hence there is more than one way of doing it. The difference between assets and liabilities is called the net international investment position or net asset position. Below you see how this has changed over the years for the United States and how it has moved from positive to negative number territory over the years.

There are many discussions we can have one this – never ending ones! This could range from sustainability of this to whether this is problematic since most of the liabilities to foreigners is in US Dollars. Also, there are many stories on the movement of this graph with puzzles such as the dark matter problem. Each is worthy of being analyzed in detail, but for now my viewpoint:

The fact that liabilities to foreigners is in US Dollars is advantageous to the United States not because of the usual reasons given but because the liabilities do not suffer from revaluation losses if the dollar depreciates. But only advantageous at best. Not more.

Enough stories over many future blogs.

bfn.