## Chapter 19 Selected Issues in Balance of Payments and Integrated International Investment Position Analysis ## Source details **Canonical URL:** [Chapter 19 Selected Issues in Balance of Payments and Integrated International Investment Position Analysis](https://www.imf.org/-/media/files/data/statistics/bmp7/draft-chapters/bpm7-ch19.pdf) ## Other formats - [Markdown version](/-/media/files/data/statistics/bmp7/draft-chapters/bpm7-ch19.pdf.md) - [Structured JSON version](/-/media/files/data/statistics/bmp7/draft-chapters/bpm7-ch19.pdf.json) --- ### A. Introduction - The chapter introduces use of balance of payments (BOP) and integrated international investment position (IIP) data in economic analysis and emphasizes factors influencing international external transactions and positions and the extent to which such factors are sustainable. - Analysis assumes, by and large, that international and domestic transactions are not constrained by formal or informal administrative controls, market participants are free to respond to price signals and macroeconomic policies, and the economy does not affect global interest rates. - BOP financing and adjustment are treated in illustrative, introductory terms; highly mobile financial and balance sheet effects are noted as beyond the chapter’s scope. ### B. General framework — accounting identities and interpretations - Core accounting identities and definitions: - Supply = Output + M = Use = C + G + I + X + IC - M = imports of goods and services - C = household consumption - G = government consumption - I = gross capital formation - X = exports of goods and services - IC = intermediate consumption - GDP (expenditure approach): GDP = C + G + I + X – M - Gross national disposable income (GNDY): GNDY = C + G + I + X – M + BPEI + BSTI - BPEI = balance on primary earned income - BSTI = balance on secondary transfer income (net current transfers) - Current account balance: CAB = X – M + BPEI + BSTI - Alternative representation: CAB = GNDY – C – G – I - Gross saving: S = GNDY – C – G - Saving–investment identity: S = I + CAB → S – I = CAB - Key analytical implications: - CAB equals the saving–investment gap (S – I). - An increase in investment relative to saving has the same short-run accounting impact on the current account as an equivalent decline in saving. - Identities do not imply behavioral causation; induced responses (consumption, capital formation) must be incorporated for policy analysis. - Public versus private decomposition: - S – I = Sp + Sg – Ip – Ig - CAB = (Sp – Ip) + (Sg – Ig) - Persistent government dissaving not offset by private saving implies a current account deficit and may call for fiscal tightening. - BOP double-entry and financing identities: - Sum of current, capital, and financial transactions equals zero in principle (practical discrepancies from errors/omissions). - Identity: NLB = CAB + KAB = NFAB - NLB = net lending/net borrowing - KAB = capital account balance - NFAB = net financial account balance/entries - Alternative: CAB = NKF FKB + BRT - BRT = net balance on reserve asset transactions - A surplus on current and capital accounts corresponds to an increase in net claims on the rest of the world; a deficit must be financed by liquidating foreign assets or increasing liabilities. ### C. Nexus between the current account and the IIP - Accounting linkage: - ∆IIP = NFAB + VAL + OCV (1314) - NFAB = net financial account balance/entries - VAL = net revaluation - OCV = net other changes in volume - ∆IIP = CAB + KAB + VAL + OCV (1415) - Interpretations and implications: - Change in net IIP equals CAB + KAB plus revaluations and other changes in volume, each positive or negative. - Net IIP developments typically hinge on the current account because CAB usually has highest volume and is less volatile than valuation and other changes. - Revaluations and other changes can dominate for economies with large external positions and high exposure to foreign markets and currencies. - Sustainability and policy: - If net IIP is out of line with fundamentals, a persistent increase in CAB can help restore sustainability; policy measures should target the corresponding current account imbalance as an intermediate target. - An unsustainable CAB and substantially negative net IIP may be addressed by currency depreciation to encourage exports and reduce real imports, improving CAB and net IIP over time, subject to revaluation effects and currency composition of balance sheets. - Revaluation effects: depreciation changes values of foreign-currency-denominated assets/liabilities; net revaluation positive if foreign-currency assets exceed liabilities, and vice versa. - Feedbacks from IIP to CAB: - Investment income in the current account depends on the size and structure of the IIP stock; revaluations and other changes likewise depend on composition. - Decomposition: ∆IIP = (CAB – II + KAB) + (II + VAL) + OCV (1516) - II = investment income balance - Practical accounting: - Errors and omissions (statistical discrepancy) must enter accumulation equations in practice; equation (1415) becomes ∆IIP = CAB + KAB + VAL + OCV + EOSD when including EOSD. ### Nexus between the current account and the IIP; rates of return - Definitions and structure: - "External primary balance" = CAB + KAB – II (first term; encompasses capital account balance and current account less investment income). - Net total return on net external position = income rate of return + revaluation rate of return. - Income rate of return = investment income divided by corresponding average asset or liability position in the IIP. - Revaluation rate of return = revaluations divided by corresponding average asset or liability position. - Analytical role: - The nexus is pivotal for external sustainability assessment and for calculating rates of return on IIP positions (paragraphs [19.XX35] and [19.XX]). ### Three-dimensional accounting for changes in net IIP (generation, instrument, sector) - Three dimensions: - First (generation/source): nexus between CAB and integrated IIP, decomposition per identity (15). - Second (functional/instrument): allocation across functional categories (e.g., portfolio investment, direct investment). - Third (sector): allocation to domestic sectors involved (e.g., central bank, general government, nonfinancial corporations). - Figure 19.1 example values (Units): - Investment income: 33 - Portfolio investment: 75 - Deposit-taking corporations, except the central bank: 57 - Current account (excluding investment income) and capital account: 113 - Other investment: 30 - Other financial corporations: 136 - Revaluations: -25 - Reserve assets: 39 - General government: -30 - Other changes in volume: -21 - Direct investment: -21 - Central bank: -25 - Financial derivatives: -23 - Nonfinancial corporations: -20 - Households and NPISHs: -18 - External primary balance / Net total return: illustrative axis from -100 to 200 (Units) - Illustration interpretations: - Generation account documents that approx. 45 billion units originate from the current account balance, whereas valuation effects and other changes have a negative impact. - Instruments account: portfolio investment gains ~30 billion units. - Sector account: deterioration for general government and nonfinancial corporations, households and NPISHs; strong increase for other financial corporations. ### Alternative presentations of BOP data - Standard presentation: groups economic processes consistent with SNA; balancing items include current account balance and net lending/net borrowing. - "Analytic" presentation: distinguishes reserves and related items from other transactions; shows reserves, IMF credit and loans, and exceptional financing below the line; designed to focus on reserve management. - Table 19.1 headings (selected lines shown): - Current account n.i.e.; Goods; Services; Primary Earned income; Secondary Transfer income n.i.e.; Balance on current account n.i.e. - Capital account n.i.e.; Balance on capital account n.i.e. - Financial account n.i.e.; Direct investment n.i.e.; Portfolio investment; Financial derivatives and ESOs n.i.e.; Other investment n.i.e.; Balance on financial account n.i.e. - Balance on current, capital, and financial accounts n.i.e. - Reserves and related items: Reserve assets; IMF credit and loans; Exceptional financing; Total reserves and related items. - Sectoral analysis: groups financial account items by resident recipient (central bank; deposit-taking corporations except central bank; general government); requires sectoral splits and supports sustainability/vulnerability analysis. - Monetary presentation: links BOP to monetary and financial statistics; key equations: - (1417) NFA + DDC – DM + OTR = 0 - NFA = net transactions in foreign assets and liabilities of deposit-taking corporations - DC = domestic credit - M = broad money (liabilities) - OTR = other (net) transactions vis-à-vis residents - D = transactions derived from corresponding positions - (1518) NFA + ETN = 0 - ETN = nonfinancial balance of payments transactions and transactions in foreign assets and liabilities by sectors other than deposit-taking corporations - (1619) DM = –ETN + DDC + OTR - Partner analysis: data by partner economy useful for trade negotiations, vulnerability identification, contagion analysis, and data-quality checks; assets shown by debtor residence, liabilities by creditor residence; debtor-creditor and transactor bases each serve analytical purposes. ### Financing a current account deficit: mechanisms, servicing, and policies - Initial framework: assume S = I so CAB and net financial/reserve balances zero. - Autonomous increase in investment (e.g., productivity rise) not matched by saving leads to higher interest rates (if not controlled) and a CAB deficit financed by net financial inflow. - Determinants of spontaneous financing: - Functional, sectoral, partner, and currency breakdowns matter for assessing determinants and policy responses. - Direct investment often provides stable, long-term links and technology/management. - Foreign financing sources: direct investment, foreign bank loans, bonds in international markets. - Domestic financing (bank loans, equity/bonds) can raise domestic interest rates and attract foreign funds depending on perceptions. - Servicing implications when net foreign asset position declines: - Change in net investment income flow is central: ability to service depends on whether investment is productive enough to pay required returns and enhance debt-servicing capacity. - Productive investment makes external financing more likely to be sustained. - Risks when saving declines but investment unchanged: - Causes: increased government spending without revenue, higher private consumption. - Domestic interest rates tend to rise; investors may refuse to provide sustained inflows if deterioration reflects unsustainable policies. - In the absence of spontaneous financial inflow (19.29): - Necessary actions: attract private funds, use reserve assets for BOP financing, and implement BOP adjustment measures. - Reserve use limited by stock and borrowing capacity; reserves useful to smooth temporary shocks but cannot indefinitely substitute for adjustment. ### Financial mobility, expectations, and volatility; composition of financial account - High financial mobility means financing willingness hinges on expectations about future domestic and international developments; expectation shifts can trigger rapid rebalancing and volatility (paragraphs 19.32–19.34). - Composition matters: - NKF FKB transactions (direct investment, portfolio investment, financial derivatives, other investment) have differing implications for volatility and future returns; instrument and maturity detail are crucial (paragraph 19.34). - A CAB deficit financed by increased liabilities and/or reduction in claims reduces net foreign assets and net investment income, potentially worsening CAB unless arrested by policy or adjustments (paragraph 19.35). - Determinants of flows: interest rates, profitability, expected exchange rate changes, tax considerations (paragraphs 19.36–19.37). - Cash flow vs accrual: BOP uses accruals, but payment crises are driven by cash flows; when timing differences matter, cash-flow analysis is useful (paragraph 19.38). ### Adjustment measures for unsustainable current account deficits and policy roles - If private and official financing cannot sustain a CAB deficit, abrupt adjustment, reserve depletion, or a BOP crisis may occur (paragraph 19.39). - Adjustment tools include exchange rate changes, fiscal measures, and monetary policy (paragraph 19.40). - Rewriting identity: S – I = CAB = BTG + BTS + BEPI + BTSI = NKF FKB + BRT (17); magnitude of needed adjustment depends on CAB components (paragraph 19.41). - Importance of amortization schedules and near-term large amortizations for preemptive measures (paragraph 19.42). - Exchange rate depreciation: - Can restore competitiveness and shift demand to exports/import substitutes but may raise domestic prices and erode competitiveness gains. - Generally should be supplemented by restrictive monetary and fiscal policies to facilitate resource shifts and avoid eroding competitiveness gains (paragraphs 19.43–19.44). - Fiscal policy: - Can reduce S – I but should avoid harming supply potential (e.g., cutting infrastructure) or creating disincentives; preferable actions include eliminating subsidies and trimming government activity better done privately (paragraph 19.45). - Monetary policy: - Should keep interest rates generally positive in real terms to incentivize saving and stabilize investment conditions; aim to align domestic expenditure with productive capacity and financing (paragraph 19.46). - Reserve interactions with monetary conditions: - Reserve declines reduce monetary base and tighten monetary stance, raising rates and dampening demand; authorities can offset reserve losses (e.g., open-market purchases), which may prevent rate rises and prolong a BOP deficit (paragraph 19.47). ### Implications and policy issues of current account surpluses - Surplus implies increase in net claims on nonresidents (NKF FKB), increase in official reserve assets (BRT), or both (paragraph 19.48). - Policy distortions that bias toward surplus (paragraph 19.50): - tariffs and quotas; restrictions on payments abroad; export subsidies; exchange market intervention biasing currency downward; measures limiting foreign acquisition of domestic assets. - Distortions tend to produce offsetting movements in other components absent changes in underlying saving and investment (paragraph 19.51); recommended action is removal of distortionary measures. - Even market-driven surpluses can cause problems: - Resource curse: resource discovery/terms-of-trade improvements raise CAB and appreciate currency, contracting other tradable sectors; intervention and reserve accumulation can insulate short-run effects (paragraphs 19.49–19.52a). - Creditor-nation vulnerabilities: accumulated net external assets expose creditors to losses when debtors suffer stress, including debt write-offs (paragraphs 19.52–19.52a). - Monetary management concerns from surpluses: - Reserve accumulation increases monetary aggregates and can cause credit expansion, overheating, inflationary pressures, and financial-sector vulnerabilities; sterilization is costly (paragraphs 19.53–19.55). - Policy tools to reduce surplus (paragraph 19.56): - Expenditure-expanding policies (expansionary fiscal/monetary) — risk of credit booms and inflation. - Expenditure-switching (currency appreciation) — may require gradual appreciation for smooth adjustment. ### Balance sheet approach: framework, mismatches, and vulnerability analysis - Rationale: - Financial integration permits foreign borrowing for investment but private flows are volatile; financial structure (composition/size of liabilities and assets) is a key vulnerability source (paragraphs 19.57–19.61). - Net IIP at period end reflects flows, valuation changes, and other adjustments; consolidated country balance sheet = domestic nonfinancial assets + net IIP. - Five critical balance sheet mismatches (paragraphs 19.62–19.63): - (a) Maturity mismatches: short-term liabilities due vs liquid assets. - (b) Currency mismatches: unhedged FX exposures. - (c) Financial structure problems: excessive debt vs equity financing. - (d) Solvency problems: assets insufficient to cover nonequity liabilities, including contingent liabilities. - (e) Dependency problems: concentration by partner economy, contagion risk. - Additional analysis needs: - Currency composition and residual maturity of debt; hedging strategies; differentiation between nominal derivative exposures and hedged net positions. ### IIP composition, transmission channels, crisis propagation, and timing - Composition effects: - If assets are largely foreign-currency denominated and liabilities domestic-currency denominated, depreciation produces positive wealth effects and typically expands production via net exports; converse for other compositions (paragraphs 19.64–19.66). - Domestic debt mismatches can propagate to external BOP crises via banking system vulnerabilities and deposit runs. - Crisis dynamics: - Initial shocks can reveal latent balance sheet weaknesses; inability to finance flows from reserves can force disorderly adjustments and large relative price changes. - Timing is hard to predict because inflows can sustain exchange rates until confidence shocks trigger rapid escalations. ### Liquidity, interest rate, currency, and credit risk; valuation paradox - Liquidity and remaining maturity: - Breakdown by original maturity and collection of remaining maturity information are encouraged to show financing due within the year; duration is a complementary measure of interest-rate sensitivity. - Currency risk: - Currency mismatches are frequent sources of macro risk; detailed currency breakdown of debt liabilities is crucial. - Collection efforts (G-20 Data Gaps Initiative) request assets/liabilities broken down by sector and original maturitycurrency and foreign currency derivatives notional amounts to adjust for hedging. - Notional derivatives are a rough proxy; underlying contract purpose (hedge vs speculation) is generally unavailable. - Credit risk: - IIP statistics by counterpart area/sector help assess country and counterparty risk; cross-classifications by instrument, counterpart economy, and sector enhance credit-risk assessment. - Guarantees and credit derivatives alter portfolio risk; for guarantees, underlying notional debt values are relevant. - Valuation paradox: - Mark-to-market reporting can make net IIP appear to improve when bond prices fall (liabilities fall in value) even as solvency deteriorates because payment obligations remain unchanged. - Example (Box 19.1): - Country Economy A: - End of period t-1: Assets 25025 Liabilities 100 Net IIP 150-75 - End of period t: Assets 25025 Liabilities 50 Net IIP 200-25 - Bond price t-1 = 100; bond price t = 50 - Country Economy B: - End of period t-1: Assets 25025 Liabilities 100 Net IIP 150-75 - End of period t: Assets 25025 Liabilities 110 Net IIP 140-85 - Bond price t-1 = 100; bond price t = 110 - Paradox more pronounced in currency unions and when market pricing diverges from payment obligations. ### Calculating and using rates of return; FISIM and pure interest - Suggested integrated presentation (Table 19.2) links IIP, investment income, and rates of return including: - Beginning-of-period position; accumulation accounts (transactions; other changes in volume); end-of-period position; income rate of return; revaluation rate of return; total rate of return. - Definitions: - Income rate of return = investment income / corresponding average asset or liability position. - Revaluation rate of return = revaluations / corresponding average asset or liability position. - Total rate of return = income rate of return + revaluation rate of return. - Treatment of FISIM and pure interest (19.81): - Estimation of pure interest on loans and deposits (after deduction of implicit financial services on loans and deposits) alters rates of return on loans and deposits relative to rates estimated from actual interest. - BPM7 recommends estimating rates of return using both pure interest and actual interest to provide a more complete analytical picture. - The term "implicit financial services on loans and deposits" will replace "FISIM" in BPM7. - Financial derivatives: - Do not pay interest income; capital-gains revaluations are difficult to relate to original principal, so rates of return for derivatives are omitted from Table 19.2X; revaluation rates on derivatives are a topic for additional research. - Income rate of return differentials and macro implications: - Differential = rate of return on assets minus rate of return on liabilities. - A positive differential mitigates the impact of net foreign asset changes on net investment income; a negative differential exacerbates it. - Income/revaluation rates influence sustainability analysis and expected real after-tax total rates of return (BPM6 paragraph [19.36] referenced). *Chapter 19, Selected Issues in Balance of Payments and Integrated International Investment Position Analysis (International Monetary Fund).* ### Chapter 19 Selected Issues in Balance of Payments and Integrated International Investment Position Analysis ### Chapter 19 Selected Issues in Balance of Payments and Integrated International Investment Position Analysis ### A. Introduction - The chapter provides an introduction to the use of balance of payments (BOP) and integrated international investment position (IIP) data in economic analysis. - Emphasis is placed on factors influencing international external transactions and positions and the extent to which such factors are sustainable. - The discussion assumes, by and large, that international and domestic transactions are not constrained by formal or informal administrative controls and that market participants are free to respond to price signals and macroeconomic policies; it also assumes the economy does not affect global interest rates. - The chapter treats BOP financing and adjustment in illustrative, introductory terms and notes more complex cases with volatile and highly mobile financial and balance sheet effects are beyond the chapter’s scope. ### B. General Framework — Accounting Identities and Interpretations - The chapter stresses that the SNA relationships among economic accounts are expressed as accounting identities and that no causation should be inferred from identities alone. - Core identities and definitions presented: - Supply = Output + M = Use = C + G + I + X + IC - M = imports of goods and services - C = household consumption - G = government consumption - I = gross capital formation - X = exports of goods and services - IC = intermediate consumption - GDP (expenditure approach): GDP = C + G + I + X – M - Gross national disposable income (GNDY): GNDY = C + G + I + X – M + BPEI + BSTI - BPEI = balance on primary earned income - BSTI = balance on secondary transfer income (net current transfers) - Current account balance: CAB = X – M + BPEI + BSTI - Alternative representation: CAB = GNDY – C – G – I - Gross saving: S = GNDY – C – G - Saving–investment identity: S = I + CAB → S – I = CAB - Key analytical implications drawn from the identities: - The current account balance equals the saving–investment gap (S – I). - An increase in investment relative to saving has the same short-run accounting impact on the current account as an equivalent decline in saving relative to investment. - Identities do not describe behavioral responses; analysis must incorporate induced responses in consumption and capital formation when incomes or policies change. - Public versus private sector decomposition: - S – I = Sp + Sg – Ip – Ig - CAB = (Sp – Ip) + (Sg – Ig) - A negative government saving–investment gap (dissaving) not offset by private sector net saving implies a current account deficit; persistent government spending in excess of revenues may suggest fiscal tightening. - Behavioral interactions matter: e.g., tax increases affect disposable income, private saving, and private investment in differing ways; interest rate changes affect consumption, investment, exchange rates, exports, imports, and debt service depending on currency composition. - BOP double-entry principle and financing: - Sum of all international transactions—current, capital, and financial—is in principle equal to zero (practical discrepancies arise from errors or omissions). - Identity: NLB = CAB + KAB = NFAB - NLB = net lending/net borrowing - KAB = capital account balance - NFAB = net financial account balance/entries - Alternative expression relating CAB, financial account balances, and reserve asset transactions: - CAB = NKF FKB + BRT - (Text defines NKF FKB and BRT in context; BRT = net balance on reserve asset transactions) - A surplus on current and capital accounts corresponds to an increase in net claims on the rest of the world; a deficit must be financed by liquidating foreign assets or increasing liabilities to nonresidents. ### C. Nexus Between the Current Account and Integrated International Investment Position - Link between changes in net IIP and transaction/revaluation/other effects: - ∆IIP = NFAB + VAL + OCV (1314) - NFAB = net financial account balance/entries - VAL = net revaluation - OCV = net other changes in volume - Substituting identity (12) yields: - ∆IIP = CAB + KAB + VAL + OCV (1415) - Interpretation: - The change in net IIP equals the current account and capital account balances plus revaluation effects and other changes in volume, each of which may be positive or negative. - The size of an economy’s net IIP is not an independent investment decision to prefer financial assets abroad; development in net IIP typically hinges on the economy’s current account balance because the current account usually has the highest volume and is less volatile than valuation and other changes in volume. - Periods may occur when revaluations and other changes dominate current account contributions—particularly for economies with large external asset and liability positions and high exposure to foreign financial markets and currencies. - Sustainability and policy implications: - If an IIP is deemed not to be sustainable out of balance with economic fundamentals, a persistent increase in the current account balance could bring it back on a sustainable path; hence, policy measures must aim at the corresponding current account imbalance as an intermediate target. - A country facing an unsustainable current account deficit and substantially negative net IIP might respond with a depreciation of the domestic currency to encourage exports and reduce real imports, thereby increasing the current account balance and, over time, improving the net IIP—subject to revaluation effects and balance sheet currency composition. - Revaluation effects after an exchange rate depreciation: foreign-currency-denominated assets and liabilities change value; if foreign-currency-denominated assets exceed foreign-currency-denominated liabilities, net IIP registers a positive revaluation change, and vice versa. - Feedback from IIP to the current account: - Investment income (part of the current account) depends on the size and structure of the existing IIP stock; revaluations and other changes also depend on the volume and composition of external assets and liabilities. - Equation distinguishing IIP changes dependent on the current IIP stock and those independent of it: - ∆IIP = (CAB – II + KAB) + (II + VAL) + OCV (1516) - II = investment income balance - Practical accounting note: - To balance the accumulation account in practice, errors and omissions (statistical discrepancy of the BOP) must enter equation (12) and consequently equation (1415) as an additional term; equation (1415) would change into ∆IIP = CAB + KAB + VAL + OCV + EOSD. *Chapter 19, Selected Issues in Balance of Payments and Integrated International Investment Position Analysis (International Monetary Fund).* ### Chapter 19 Selected Issues in Balance of Payments and Integrated International Investment Position Analysis ### Chapter 19 Selected Issues in Balance of Payments and Integrated International Investment Position Analysis ### Nexus between the current account and the IIP; rates of return - The first term may be labelled "external primary balance," encompassing the capital account balance and the current account balance less investment income. - The second term represents the net total return on an economy’s net external position. - The total rate of return = income rate of return + revaluation rate of return. - Income rate of return = ratio of investment income to the corresponding average asset or liability position in the IIP. - Revaluation rate of return = ratio of revaluations (holding gains and losses) to the corresponding average asset or liability position. - The nexus between the current account and the IIP is pivotal for assessing external sustainability and for calculating rates of return on IIP positions (paragraphs [19.XX35] and [19.XX]). ### Three-dimensional accounting system for changes in the net IIP - The change in the net IIP in a given period can be visualized in a three-dimensional accounting system; each dimension captures a specific aspect: - First dimension (source/generation account): shows the nexus between the current account and the integrated IIP and breaks down sources of the change in the net IIP by the components from identity (16). - Second dimension (functional/instrument account): shows how the change in the net IIP is reflected in the various functional categories. - Third dimension (sector account): allocates the change to the domestic sectors involved. - The first pillar (generation account) breaks down the total net IIP change into components according to (15); the instruments and sector accounts reuse data from the standard IIP presentation to illustrate allocation. - Example statements from the chapter: - "The net IIP ... has increased in any given period ... by 40 billion units." - "Note: In this example, the change in the net IIP is 100 as illustrated for all three accounts." - Figure 19.1 example values (Units): - Investment income: 33 - Portfolio investment: 75 - Deposit-taking corporations, except the central bank: 57 - Current account (excluding investment income) and capital account: 113 - Other investment: 30 - Other financial corporations: 136 - Revaluations: -25 - Reserve assets: 39 - General government: -30 - Other changes in volume: -21 - Direct investment: -21 - Central bank: -25 - Financial derivatives: -23 - Nonfinancial corporations: -20 - Households and NPISHs: -18 - External primary balance / Net total return: illustrative axis from -100 to 200 (Units) - Illustration interpretation from the chapter: - The generation account documents that approx. 45 billion units originate from the current account balance, whereas valuation effects and other changes have a negative impact. - The instruments account identifies portfolio investment as the functional category that gains most with an increase of approx. 30 billion units. - The sector account shows deterioration in external positions for general government and non-financial corporations, households and NPISHs, while other financial corporations record a strong increase in net IIP. ### Alternative presentations of balance of payments data - Purpose: reorganize items to highlight different aspects of BOP financing and its effect on the economy. - Main presentations described: 1. Standard presentation - Groups economic processes consistent with the SNA and other macroeconomic statistics. - Two major lines for balances: - (a) between current account credits/revenues and debits/expenditures/accumulation entries — balancing item: current account balance. - (b) between financial and nonfinancial entries — balancing item: net lending/net borrowing. - Other balancing items are shown in Table [2.1] and Chapters 7–13 14. 2. "Analytic" presentation - Reorganizes the standard presentation to distinguish (a) reserves and closely related items and (b) other transactions. - Designed to focus on management of reserves and related items; the term "analytic" does not imply suitability for all analytical purposes. - Draws the line between ways monetary authorities finance transactions (below the line) and other items (above the line). - Shows reserves, IMF credit and loans, and exceptional financing (accumulation of arrears, debt forgiveness, intergovernmental grants, debt restructuring) used to finance other "autonomous" international transactions. - Arrears related to exceptional financing are recorded below the line as transactions in the analytical presentation with the corresponding entry in the relevant instrument. - Table 19.1 headings (selected lines shown in the chapter): - Current account n.i.e.; Goods; Services; Primary Earned income; Secondary Transfer income n.i.e.; Balance on current account n.i.e. - Capital account n.i.e.; Balance on capital account n.i.e. - Financial account n.i.e.; Direct investment n.i.e.; Portfolio investment; Financial derivatives and ESOs n.i.e.; Other investment n.i.e.; Balance on financial account n.i.e. - Balance on current, capital, and financial accounts n.i.e. - Reserves and related items: Reserve assets; IMF credit and loans; Exceptional financing; Total reserves and related items. 3. Sectoral analysis - Groups financial account items by type of resident recipient of external financing (e.g., central bank; deposit-taking corporations except the central bank; general government). - Requires sectoral splits for most financial account items. - Facilitates analysis of net foreign lending or borrowing of each domestic sector to identify sustainability and vulnerability issues. - Developed in conjunction with balance sheets (paragraphs [19.57–19.66]) and external debt statistics guidance. 4. Monetary presentation - Explicitly shows link between the balance of payments and monetary and financial statistics (paragraph [2.8]). - Identifies transactions of deposit-taking corporations (plus money market funds where relevant) equal to foreign assets and liabilities of the same entities as recorded in monetary and financial statistics. - Highlights effects of international transactions on monetary developments. - Equations presented: - (1417) NFA + DDC – DM + OTR = 0 - where NFA = net transactions in foreign assets and liabilities of the deposit-taking corporations - DC = domestic credit - M = broad money (liabilities) - OTR = other (net) transactions vis-à-vis residents - D = transactions derived from corresponding positions (i.e., excluding any changes due to revaluation or other changes in volume) - (1518) NFA + ETN = 0 - where ETN = nonfinancial balance of payments transactions and transactions in foreign assets and liabilities by sectors other than deposit-taking corporations - (1619) DM = –ETN + DDC + OTR - Emphasizes links between balance of payments and monetary statistics and the effect of international transactions on domestic liquidity. 5. Partner analysis - Data by partner economy assist in trade negotiations, identifying vulnerability from reliance on another economy, and forecasting/analysing contagion effects. - Useful for monitoring data quality via comparison of bilateral data as reported by partner economies. - For IIP by partner: - Assets shown according to residence of the debtor (issuers of nondebt instruments). - Liabilities shown according to residence of the creditor (holders of nondebt instruments). - For BOP transactions by partner, data on both a debtor-creditor and a transactor basis may be of interest: - Debtor-creditor basis facilitates analysis of whose securities are being purchased and sold. - Transactor basis facilitates analysis of where residents engage in financial asset transactions with nonresidents and the growth of international financial centers. ### Financing a current account deficit: mechanisms and policy considerations - Framework: use identity (12) and assume initially S = I (current account balance and net capital/financial account balances, including reserve asset transactions, are zero). - Effects of an autonomous increase in investment (from a rise in productivity of capital): - If additional investment is not matched by a corresponding rise in saving, interest rates tend to rise (if monetary authorities do not control rates). - Excess of investment over saving will be reflected in a current account deficit, which may be financed by a net financial inflow. - Determinants of spontaneous financing of a current account deficit: - Functional category breakdowns (and further splits by domestic sector, partner economy, currency) are crucial to assess determinants and appropriate policy measures for sustainable financing. - Direct investment is often characterized by stable, long-lasting economic links and provision of technology and management. - Foreign financing sources include direct investment, loans from foreign banks, and bonds issued in international financial markets; financing may be used for imported goods/services for investment projects and domestic inputs. - Domestic financing of investment via bank loans or equity/bond issues may not create a direct link between increased domestic expenditures and foreign financing but can raise domestic interest rates and attract foreign funds depending on investor perceptions. - Servicing implications when financial inflow reduces the net foreign asset position: - The reduction will change the net investment income flow of the economy. - Key analytical issue: whether the economy can service the change in its net foreign investment position without undertaking significant policy modifications or causing undesirable interest rate or exchange rate changes. - Servicing without major changes is more likely if the investment contributes substantially to productivity: - Investment must be sufficiently profitable to pay the rate of return that attracted financing. - Additional investment must enhance debt-servicing capacity of the economy. - If funds from abroad are invested productively, external financing for a current account deficit is likely to be sustained and indicates efficient allocation of resources. - Risks when saving declines while investment is unchanged: - Example causes: increase in government spending not matched by revenue, or rise in private consumption not offset by higher government saving. - Domestic interest rates tend to rise, but the shift to a current account deficit is not accompanied by productivity gains. - There may not be sustained spontaneous inflows if investors view the deterioration as reflecting inappropriate or unsustainable policies. - Decline in saving could reflect an enlarged public sector deficit not associated with increased investment or higher private spending from expansionary monetary policy; investors may be unwilling to increase net claims on the economy under such conditions. *Source: Chapter 19 Selected Issues in Balance of Payments and Integrated International Investment Position Analysis* ### 19.29 In the absence of a spontaneous financial inflow, some combination of the following will be ### bpm7-ch19 - 19.29 In the absence of a spontaneous financial inflow, some combination of the following will be necessary: policy actions to attract private funds, the use of reserve assets for balance of paymentsBOP financing, and the implementation of balance of paymentsBOP adjustment measures. ### Financing options and constraints - If the current account shifts into deficit, financing must take place either by drawing down the economy’s reserve assets or by increasing incentives for attracting private funds (see identity (12)). - Attracting private funds can be achieved by enhancing the domestic economic environment for long-term investment and adopting monetary and fiscal policies that support stable conditions and encourage direct and other investment. - Raising domestic interest rates can induce inflows and provide short-term BOP financing but may be unreliable for sustained financing because changes in foreign monetary conditions can make domestic investment unattractive. - Use of reserve assets is limited by the economy’s existing stock of reserve assets and the resources it can borrow to supplement them; therefore recourse to reserves can only finance deficits within those limits. ### Role and appropriate use of reserve assets - Reserve assets can perform a useful buffer function by financing temporary or reversible gaps between domestic expenditure and income (paragraph 19.30). - Appropriate uses include smoothing temporary shocks (e.g., poor harvests, seasonal swings) so that consumption and investment need not immediately adjust to temporary output shocks. - Financing temporary shocks through reserve assets does not obviate the need for adjustment if the decline in the current account persists; reserves can make the adjustment path smoother and more gradual but cannot substitute for required adjustment indefinitely. ### Limits of private financing and risks from low reserves - Private sector willingness to invest may be directly influenced by ongoing changes in reserve assets; if reserves are low relative to the current account deficit and expected to be exhausted within investors’ horizons, the probability of exchange rate depreciation or policy changes that reduce expected returns increases significantly (paragraph 19.31). - Under such circumstances, private inflows financing a current account deficit could quickly switch to net outflows, potentially requiring reserves to finance both an excess of investment over saving and a net increase in liabilities to nonresidents—producing loss of confidence, exacerbated outflows, and rapid reserve exhaustion. ### Financial mobility, expectations, and volatility - In a world of high financial mobility, external and domestic private sector willingness to provide financing is influenced by expectations about future economic, political, and other developments domestically and internationally (paragraph 19.32). - Changes in expectations can trigger rapid rebalancing of balance sheets and high volatility in financial flows with significant current account and macroeconomic implications. ### Composition of financial account and dynamic links with the current account - Financial account transactions (NKF FKB in identity (13))—including direct investment, portfolio investment, financial derivatives, and other investment—have different implications for volatility, future returns, and capital formation; instrument and maturity detail matter for assessing future effects (paragraph 19.34). - Financial flows change foreign claims and liabilities and generate investment income that appears in the current account; differences in returns on assets and liabilities can create dynamic feedbacks from deficits to future current account balances (paragraph 19.35). - A current account deficit financed by increased liabilities to nonresidents and/or reduction in claims on nonresidents reduces net foreign assets and net investment income, potentially worsening the deficit unless policies or adjustments (e.g., exchange rates) arrest the deterioration. ### Analysis and determinants of financial flows - Determinants of financial flows relate mainly to factors affecting rate of return and risk on foreign and domestic assets: interest rates, profitability of investments, expected exchange rate changes, and tax considerations (paragraph 19.36). - Expected real after-tax rates of return on stocks of foreign assets and claims held by nonresidents embody these factors; residents and nonresidents face different legal and tax considerations but are similarly affected by external economic conditions, which are exogenous to an individual economy (paragraphs 19.36–19.37). ### Cash flow considerations versus accrual accounting - BOP statistics use the accrual principle to reflect underlying resource flows, but payments crises are typically driven by cash flows; when timing differences between payments and resource flows are significant (e.g., accrual of interest, reinvested earnings, nonperforming loans), it may be useful to consider cash flow dimensions (paragraph 19.38). ### Adjustment measures for an unsustainable current account deficit - If private and official financing cannot sustain a current account deficit, adjustment will occur via changes in market willingness to finance, reserve depletion, or both, potentially abruptly and painfully up to a BOP crisis (paragraph 19.39). - Adjustment measures to achieve a viable external payments position can include exchange rate changes, fiscal measures, and monetary policy (paragraph 19.40). - Rewriting identity (9): S – I = CAB = BTG + BTS + BEPI + BTSI = NKF FKB + BRT (17); the magnitude of necessary adjustment depends on the nature of current account components (paragraph 19.41). - Consideration of the amortization schedule and near-term large amortization payments is important; if expected inflows cannot cover falling due payments, preemptive adjustment measures may be necessary to avoid a more severe BOP crisis (paragraph 19.42). ### Exchange rate, fiscal, and monetary policy roles in adjustment - Exchange rate depreciation can be an adjustment measure, especially under fixed or managed regimes, to restore competitiveness and shift demand toward exports and import substitutes, but it may raise domestic prices and partially or fully erode competitiveness gains (paragraph 19.43). - Exchange rate depreciation should generally be supplemented by restrictive monetary and fiscal policies (expenditure-reducing measures) to facilitate the resource shift signaled by relative price changes and to avoid eroding competitiveness gains—especially if no excess capacity exists (paragraph 19.43–19.44). - Fiscal policy can reduce the saving–investment gap but must be designed to avoid long-run harm to supply potential (e.g., cuts in infrastructure investment) or creating disincentives to saving and investment via adverse tax measures; preferable fiscal actions include eliminating subsidies and trimming government activity better performed by the private sector (paragraph 19.45). - Monetary policy should ensure interest rates are generally positive in real terms to incentivize saving and stabilize conditions for investment; monetary and fiscal policies aim to align domestic expenditure with productive capacity and available domestic and foreign financing (paragraph 19.46). - Reserve asset transactions interact with domestic monetary conditions: reserve declines can reduce the monetary base and tighten monetary stance, raising interest rates and dampening demand; however, authorities can offset reserve losses by increasing the domestic component of the base (e.g., open-market purchases), which prevents interest rate rises and can prolong a BOP deficit (paragraph 19.47). ### Implications of current account surpluses - A current account surplus implies an increase in net claims on nonresidents (NKF FKB) or an increase in official reserve assets (BRT), or both (paragraph 19.48). - Surpluses may raise issues for domestic monetary management, vulnerabilities, and speed of adjustment toward more balanced external accounts; a change in net foreign assets may also reflect reduction in liabilities to nonresidents rather than an increase in gross claims, which can be desirable if prior liability buildup had imposed severe debt burdens (paragraph 19.48). *Chapter 19, Selected Issues in Balance of Payments and Integrated International Investment Position Analysis (IMF).* ### Chapter 19 Selected Issues in Balance of Payments and Integrated International Investment Position Analysis ### Chapter 19 Selected Issues in Balance of Payments and Integrated International Investment Position Analysis ### Current account surpluses: causes, distortions, and economic costs - Paragraphs 19.49–19.51: An increase in gross private claims on nonresidents with no recent current account deficits reflects an excess of aggregate saving over domestic investment; if the government fiscal balance is in deficit, private saving may exceed domestic investment. Allocation of saving to foreign assets can reflect higher marginal rates of return abroad and can be efficient if driven by market forces rather than government policies. - Paragraph 19.50: Government policies that can bias an economy toward a current account surplus include: - tariffs and quotas that limit imports; - restrictions on payments abroad; - export subsidies and government procurement favoring domestic producers; - exchange market intervention that biases the currency downward; - measures limiting foreign acquisition of domestic assets that bias the financial account toward net outflow. - Paragraph 19.51: Policy actions aimed at specific BOP components tend to lead to offsetting movements in other components absent changes in underlying saving and investment determinants. If large persistent surpluses arise from distortionary measures, the recommended policy action is reduction and eventual removal of those distortions. If a surplus persists after removing distortions, demonstration that private or government saving is excessively high or domestic investment too low is required to identify the surplus as a problem. - Paragraph 19.52–19.52a: Even market-driven current account surpluses can cause economic difficulties: - Resource curse scenario: natural resource discovery or terms-of-trade improvement can raise the current account and appreciate the currency, contracting other tradable sectors; exchange market intervention and reserve accumulation can insulate the real economy from short-run disturbance. - Creditor-nation vulnerabilities: accumulation of net external assets via sustained surpluses can expose creditors to losses when debtors experience external stress—losses can come from adverse exchange rate movements, lower asset and bond prices, and debt write-offs; debt write-offs are particularly important because such losses will not be recovered. - Paragraphs 19.53–19.55: Domestic macroeconomic and monetary management difficulties from surpluses include: - Reserve asset accumulation increases monetary aggregates and can trigger credit expansion, potentially causing overheating, inflationary pressures, or financial-sector vulnerabilities. - Sterilization can mitigate monetary effects but at significant cost because domestic securities used for sterilization often carry higher interest than reserves yield; future currency appreciation can reduce the monetary authority’s net worth. - Excessive reserve assets are those exceeding, by a wide margin, amounts required to finance possible future short-run deficits; in such cases resources may be more efficiently used for domestic consumption or capital formation rather than exporting financing demand abroad. Footnote 16: economies that are large exporters of nonrenewable resources may have limited domestic investment opportunities, so buildup of foreign assets can be wealth diversification; reserve accumulation can be warranted if resource-curse effects are transitory. - Paragraph 19.56: Policy tools to reduce a surplus include: - expenditure-expanding policies (expansionary fiscal and monetary policy) — risk: fueling credit boom, inflationary pressures, heightened credit vulnerabilities; - expenditure-switching policies (currency appreciation) — can moderate credit expansion and limit new base money creation by reducing intervention; gradual appreciation may be needed for smooth external account adjustment. ### The balance sheet approach: framework and rationale - Paragraphs 19.57–19.61: Key elements: - Financial integration has allowed foreign borrowing to finance higher investment but private flows are volatile and sensitive to market conditions and shocks. - The financial structure (composition and size of liabilities and assets) is a key source of vulnerability to crises. - The balance sheet approach focuses on stock variables in sectoral balance sheets (general government, financial sector, nonfinancial corporations) and requires harmonized classifications with monetary, financial, and government finance statistics. - Net IIP at period end reflects financial flows, valuation changes, and other adjustments affecting total claims on nonresidents and total liabilities to nonresidents. - Consolidated country balance sheet = stock of domestic nonfinancial assets + net IIP, but inspection inside sectors is often equally important. ### Balance sheet mismatches and vulnerability analysis - Paragraph 19.62–19.63: Five types of balance sheet mismatches critical for assessing the ability to service debt under shocks: - (a) Maturity mismatches: gap between short-term liabilities due and liquid assets, exposure to creditor rollover refusal and interest rate increases. - (b) Currency mismatches: unhedged foreign exchange exposures cause holding losses when exchange rates change. - (c) Financial structure problems: heavy reliance on debt rather than equity financing reduces resilience to revenue shocks. - (d) Solvency problems: assets (including present value of future revenue streams) insufficient to cover nonequity liabilities, including contingent liabilities. Footnote 17: interpretation of loan asset values is enhanced by fair values and nonperforming loan information. - (e) Dependency problems: concentration of IIP or BOP by partner economy can indicate overreliance on another economy and contagion risk. - Additional analysis considerations: - Currency composition and residual maturity of debt liabilities should be analyzed. - Hedging strategies matter: currency or interest rate hedging can reduce apparent exposure; unhedged derivatives positions imply greater vulnerability than nominal values suggest. - Maturity mismatches, currency mismatches, and poor financial structure can contribute to solvency risk, which can also arise from overborrowing or investment in low-yielding assets. ### IIP composition, transmission channels, and crisis propagation - Paragraphs 19.64–19.66: How IIP composition affects macroeconomic outcomes and crisis transmission: - If assets are largely foreign-currency denominated and liabilities domestic-currency denominated, a depreciation (appreciation) produces positive (negative) wealth effects; depreciation (appreciation) typically expands (contracts) production via net exports and contracts (expands) domestic consumption. - When assets are in domestic currency and liabilities in foreign currency, wealth effects reinforce consumption responses to exchange rate changes. - Domestic debts creating internal balance sheet mismatches can propagate to external BOP crises via the banking system: concerns about government debt servicing can destabilize banks holding that debt and trigger deposit runs; exchange rate changes with unhedged corporate FX exposure can undermine banks that lent to that sector. - Crisis dynamics: an initial shock can trigger portfolio adjustments and reveal latent balance sheet weaknesses; shocks can precipitate large, disorderly adjustments if flows cannot be financed from reserves, forcing relative price adjustments between foreign and domestic assets. - Timing of crises is hard to predict because weaknesses can persist while capital inflows support exchange rates; but confidence shocks can rapidly escalate into broader dislocations. *Source: Chapter 19, Selected Issues in Balance of Payments and Integrated International Investment Position Analysis, International Monetary Fund* ### 19.67 Balance of paymentsThe BOP was developed as a statistical tool to measure countries’ econ- ### 19.67 Balance of payments ### Overview - The Balance of Payments (BOP) was developed as a statistical tool to measure countries’ external imbalances by providing a detailed overview of the economic transactions of residents vis-à-vis the rest-of-the-world. - The fifth edition of the Balance of Payments Manual (BPM5) added the international investment position (IIP), allowing broader forward-looking vulnerability analysis. - BPM6 developed the IIP further, making it a more analytical tool by providing an integrated view of flows and stocks/positions. - BPM7 builds on these developments and focuses on the link between transaction flows and positions and the analytical power of revaluations and other changes in volume. - The following considerations complement Section H on the balance sheet approach and discuss developing the IIP and the revaluation account to increase analytical value for risk analysis. ### Liquidity and interest rate risk - Liquidity is a dimension used in international macroeconomic statistical standards to cluster financial instruments/assets (e.g., distinction between listed and unlisted equity; breakdown of deposits between overnight short-term and long-term other deposits). - Breakdown by original maturity for debt instruments provides an additional liquidity dimension but does not fully capture financing needs by maturity; collection of residual/remaining maturity information is needed to show a more comprehensive picture (e.g., financing due within the year). - A classification by remaining maturity is encouraged in current macroeconomic statistical standards for debt liabilities and a request for short-term remaining maturity of debt liabilities by sector is included in Table [A9-IV] of BPM6. - Duration is a complementary approach to liquidity risk: - Duration is defined as the weighted average term to maturity of a financial instrument and measures sensitivity of instrument value to changes in interest rates. - For fixed-rate instruments, each cash flow time period is weighted by the present value of that cash flow as a proportion of the present value of total cash flows; duration equals remaining maturity only for zero coupon instruments. - The longer the duration of a portfolio, the greater the gains (or losses) for any given change in interest rates. - If the duration of assets and liabilities differs, investors can be exposed to gains (or losses) as interest rates change, even if maturities are matched. ### Currency risk - Currency mismatches—differences in currency composition of financial assets and liabilities vis-à-vis the rest-of-the-world—are a frequent source of macroeconomic risk, particularly for emerging market and developing economies. - Large positions in foreign-currency-denominated debt may pose substantial risks if foreign currency inflows diminish while fixed debt payment schedules come due; this can exacerbate currency pressures. - Detailed information on the currency breakdown of debt liabilities is crucial for macroeconomic policy analysis and for creditor risk assessment. - Details on the currency composition of financial portfolios support macroprudential analysis and identification of risks from over-exposure to idiosyncratic currency shocks. - Institutional frameworks and data initiatives: - The IMF Financial Soundness Indicators (FSI) include currency-related indicators for deposit-taking corporations, e.g., foreign-currency-denominated loans and liabilities to total loans and total liabilities. - The ESRB risk dashboard reports on currency risk by percentage of total loans denominated in foreign currency. - In the second phase of the G-20 Data Gaps Initiative, the IMF, FSB, and BIS have sponsored collection of the data defined in Table [A9-I] of BPM6, requesting assets and liabilities broken down by sector and original maturitycurrency and information on foreign currency derivatives (notional amounts) to adjust for hedged exposures. - Notional amounts of derivatives are a rough proxy because the underlying purpose (hedging or speculation) of derivative contracts is generally not available. - Limitations and analytical use: - The IIP broken down by currency plus information on foreign currency derivatives provides a good picture of structural currency exposures but does not suffice for a comprehensive immediate assessment of the impact of foreign currency movements to the net IIP. - Analysis should include price revaluations of foreign currency derivatives and net impact of exchange-rate-driven revaluations for other instruments. - Net currency-driven revaluations are generally negative for economies with a net liability position in foreign currency and relative inflationary processes contributing to domestic currency depreciation. - For other economies, the impact depends on whether the economy has a net asset or liability position in foreign currency and on domestic currency stability. ### Credit risk - Credit risk is defined as the risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation; it arises from dimensions including liquidity and currency considerations. - IIP statistics by counterpart area or geographical detail can provide useful information to assess counterparty (country) risk, which includes factors such as political and social stability, rule of law, and corruption; this country risk dimension is often well covered in national BOP/IIP statistics. - Counterpart sector breakdowns are gaining importance (IMF Coordinated Portfolio Investment Survey (CPIS) sponsorship); currently counterpart-sector information is generally available only for portfolio investment and, in some jurisdictions, for direct investment (SPEs versus non-SPEs) and other investment. - Cross-classification of IIP data by instrument, counterpart economy, and counterpart country and sector is a powerful tool to assess portfolio or credit risk. - Additional considerations for comprehensive credit risk assessment: - Existence of credit derivatives (e.g., credit default swaps) or guarantees can change portfolio risk levels; for derivatives, information on notional amounts broken down by counterpart area and sector would be necessary. - For guarantees, the relevant information for credit risk analysis is the underlying (notional) value of the debt being guaranteed rather than the market value of the guarantees. - Rating information would have strong analytical value; a breakdown of portfolio investment by rating grade would better qualify portfolio creditworthiness but is generally missing in IIP statistics. - Sectoral presentation: - Grouping financial account and IIP items by resident recipient type (e.g., central bank, deposit-taking corporations except central bank, general government) requires sectoral splits for most financial account and IIP items. ### Valuation paradox in the international investment position - Revaluation effects should be interpreted cautiously when used as measures of an economy’s or sector’s gains and losses; IIP stocks/financial positions are reported at market values where possible, so recorded values do not necessarily reflect realized gains or losses. - The IIP captures only the external part of a sector’s financial balance sheet; losses recorded externally may be offset by gains on domestic positions. - Hedging operations that transfer open positions to other domestic or foreign sectors are not always taken into account. - Valuation paradox: - Marking bonds to market can lead to a situation where a country’s net IIP appears to improve even though the country is on the verge of insolvency, because falling bond prices reduce recorded liabilities while payment obligations remain unchanged. - The paradox can be more pronounced within a currency union, which may restrict exchange rate adjustments; conversely, expectation of bailouts within a currency union can dampen bond price responses. - The mechanism applies to other bond liabilities as well and works in the opposite direction when rising bond prices (e.g., due to a rating upgrade) increase recorded liabilities and lower net IIP despite unchanged payment obligations. - Box 19.1: Numerical Example (ceteris paribus analyses; asset values constant) - Example 1: Country Economy A faces mounting solvency problems - Country Economy A’s IIP - Assets Liabilities Net IIP - End of period t-1 25025 100 150-75 - End of period t 25025 50 200-25 - Bond price at the end of period t-1=100 - Bond price at the end of period t=50 - Example 2: Country Economy B’s rating is upgraded, driving interest rates down and bond prices up - CountryEconomy B’s IIP - Assets Liabilities Net IIP - End of period t-1 25025 100 150-75 - End of period t 25025 110 140-85 - Bond price at the end of period t-1=100 - Bond price at the end of period t=110 ### Calculating and using rates of return - Rates of return are important for understanding capital allocation between economies, differences in sustainability of current account deficits, and behavior over time of the current account, the financial account, and the IIP. - Current-account investment income transactions, financial-account transactions, and other changes in volume of financial assets and liabilities are interrelated with important consequences for national economies. - Rates of return influence investment and income and thus economic outcomes. - Suggested integrated presentation (Table 19.2) links the integrated IIP, investment income, and rates of return and includes: - Beginning-of-period position, accumulation accounts (transactions in financial assets and liabilities; other changes in volume), end-of-period position, income rate of return, revaluation rate of return, total rate of return. - Detailed instrument breakdowns for assets and liabilities (excluding financial derivatives) and memoranda items (e.g., other investment assets and interest income before deduction of implicit financial services on loans and deposits FISIM). - Definitions: - Income rate of return = ratio of investment income to the corresponding average asset or liability position in the IIP. - Revaluation rate of return = ratio of revaluations to the corresponding average asset or liability position; revaluations are holding gains and losses arising from changes in financial instrument prices, including exchange rates. - Total rate of return = income rate of return + revaluation rate of return. - Rates of return can be computed for assets (excluding financial derivatives) and liabilities (excluding financial derivatives). *Chapter 19 Selected Issues in Balance of Payments and Integrated International Investment Position Analysis, BPM7* ### 19.81 The estimation of pure interest on loans and deposits, i.e., after deduction of implicit financial ser- ### bpm7-ch19 - 19.81 The estimation of pure interest on loans and deposits, i.e., after deduction of implicit financial services on loans and deposits ### Estimation of pure interest and FISIM - BPM7 notes that the estimation of pure interest on loans and deposits, i.e., after deduction of implicit financial services on loans and deposits, when financial intermediation services indirectly measured (FISIM) are excluded from investment income will cause rates of return on loans and deposits to differ from rates of return estimated from actual interest. - BPM7 recommends estimating rates of return using both pure interest and actual interest (interest before deduction of implicit financial services on loans and deposits FISIM) to provide a more complete picture for analysis. - The term "implicit financial services on loans and deposits" will replace "FISIM" in BPM7 as decided by BOPCOM and the AEG. ### Systematic estimation of rates of return across the IIP - The systematic estimation of rates of return across the IIP can shed light on how the characteristics of investment across functional categories can differ. - Functional categories reflect differences in economic motivations and patterns of behavior exhibited by investors in these categories. - Instruments such as equity and debt that are included in portfolio investment and direct investment can have different rates of return when compared across functional categories. - The different treatment of retained earnings for portfolio investment equity and direct investment equity does not affect the total rate of return, but it will impact the mix between the income rate of return and the revaluation rate of return. ### Treatment of financial derivatives and revaluation considerations - Financial derivatives do not pay interest income and the capital gains revaluations are difficult to relate to an original principal/e investment; therefore, rates of return on financial derivatives would not be reliable if computed using the framework suggested for other asset types and are omitted from Table 19.2X. - Revaluation rates of return on financial derivatives are identified as a potential topic for additional research. - BPM7 emphasizes attention to both income and revaluation rates of return; whereas BPM6 focused primarily on income rates of return, BPM7 highlights the importance of revaluation rates for many analyses. - Examples where revaluation rates matter: - Valuation paradox guidance relies heavily on the effect of revaluations on positions that are marked to market in the IIP (proposed new paragraphs [19.XX14–19.17 and 19.XX]). - Direct investment positions marked to market in the IIP (using various market capitalization methods) potentially generate much larger revaluations than positions recorded at own funds book value (or current cost). ### Income rate of return differentials and macroeconomic implications - Rate of return differentials can be computed by subtracting the rate of return on liabilities from the corresponding rate of return on assets. - The income rate of return differential is relevant to a possibly destabilizing feedback loop between the current account and the financial account as described in BPM6, paragraph [19.35]. - Mechanism described: - A current account deficit must be financed by a decrease in net foreign assets. - The decrease in net foreign assets can affect net investment income, potentially increasing the current account deficit. - The impact depends on the income rate of return differential: - A positive differential will reduce the impact on net investment income. - A neutral differential of zero means the change in net investment income will be proportional to the change in net foreign assets. - A negative differential will increase the impact on net investment income. - Thus, the income rate of return differential can moderate or exacerbate this potential source of instability. ### Rates of return in sustainability analysis - Rates of return and their impact on financial flows are important in a comprehensive analysis of the sustainability of a current account deficit as described in BPM6, paragraph [19.36]. - Income and revaluation rates of return, along with factors such as tax rates and expected future changes in prices, play a role in determining the expected real after-tax total rates of return on foreign assets and liabilities. --- _Source: https://www.imf.org/-/media/files/data/statistics/bmp7/draft-chapters/bpm7-ch19.pdf_