All right my beloved one. Welcome back. What now, what do I have to say? Let's see. I have seen many things. But which system, this subset it still missing in our discussion about macroeconomics. Which system shows all trade and financial transactions of a country with the rest of the world. The system is named balance of payments. It's absolutely crucial for you to understand. More important, they memorize what balance of payment stands for is to present and help you to analyze the performance of accounts in the SIP accounts of the balance of payments. Let's start by saying the balance of payments is composed by two different accounts. One, current account. We have export, import trade balance, we'll see later on of goods and service and for income from abroad and capital and financial account, purchase and sale of assets. Obviously, if you sum up current account plus capital and financial account should be equal to zero. All countries if they sum up, should be zero, but there's not going to be zero. So that's why we have also errors and omissions because sometimes there are some transaction that has not been a recorded errors and ambitious, but let's focus on current and capital account. Lets us scrutinize each part of those accounts as they tend to be, as we said, crucial instruments to evaluate whether a country is on the verge to experience occurrence attack, a speculative attack, or as we said, a currency crisis. Let's start with the first account. There's what we call current account, which is composed by trade balance. You remember what trade balance is, exports minus imports. If exports is higher than imports we are in a trade surplus. If export is lower than import you are not trade deficit. Remember, what does affect my trade balance? Exchange rate, domestic income and foreign income. Do not forget that. Then we have the second sub-account refers for sub-account trade balance. The second one, balance of service. What do I have in my balance of service? Service, ferrites, insurance, but most important interests on external debt. If a country get external debt for some particular reason, the interests they have to pay will be on this balance of service and also remittance of profit and dividends. Because every country, we have companies, either multinational or domestic. Sometimes they have profits and this profits, they may remit to their headquarters or not. That's why we call all this profit remittance. We'll be allocating a balance of service and the third sub-account, unilateral transfer. Why do you call unilateral transfer? Because we don't have the counterpart. For example, donation. Let's say our NGO will donate money and nothing will leave. How do this happen for us at exports? We have a double-counting. Why? Because something will leave your country, a money you enter your country, but unilateral transfer, you have just one way. For example, expatriates, they send money from the country they work to your country. This will end as a unilateral transfer. If you sum up trade balance, balance of service, and unilateral transfer. You have current account things to be careful when analyzed the current account, for example, check if the trade balance is deteriorating and if the counter is buying consumer goods rather than capital goods, remember that we discuss trade surplus. Eventually, it might be a bad sign because your economy is going down. Your export is not growing, but your imports are going down because you are in a session. Again, if you are in a trade deficit, it's good or bad. It depends. For example, if you are in a trade deficit, check, if it's a consumer goods because consumer good does not improve your export competitiveness. So check how your trade balance is composed. Consumer goods, imports, exports, commodity this is absolutely important. Also, if you check not just the trade balance, because we have discussed but in a balance of service. What do I think it's absolutely important? Check the interests on external debt. See if it's increasing. If the interest on external debt is increasing year after year, it might be because of two reasons. One, too much external debt or external lenders are require a higher interest rates to lend to your country. Because your country is experiencing a higher counter risk. If your country is riskier, external lenders will charge higher interest rates to lend to you. So is a very important sign to see if you're on the verge to experience a currency crisis. We move to capital account, the financial account, which is composed by loans and facility, for example, Euro bonds, IMF, IFC,104-A, ADR whatever it is and don't forget investments. An investment is split by two categories. One, foreign direct investment and portfolio investment. I will discuss each one. For example, what do you have to keep in mind and check, check if loans and facilities will be used for economic segments that somehow will trigger higher export competitiveness? Why? Because your country will have to pay for this external debt. It's better to use these external funds wisely to increase export competitiveness in order to generate international funds, to pay and assist the external debt raised by your country. It makes perfect sense. You get loan, you have to pay loan. If you have to pay loan, hopefully, you use this external loan to generate more international reserve to pay for your external debt. Otherwise, for example, real estate, sometimes there are some countries in Asia like Thailand, Malaysia, Indonesia, Korea, during the '97, '98, the most part of international loans were through real estate. Is it bad? Is it good? Real estate investment use international funds. It's not that bad, but it's not that good. What do you mean? It will not improve the export competitiveness if you use all these funds, just to buy, or to build apartments or buildings. We have to check exactly, go, make a deep-dive on those. Check, also if your investment that your country is receiving is predominately foreign direct investment, FDI. Why? Because this is the kind of investment is more perineal. It will leave your country, and it will not leave your country suddenly. Is like for example, Mercedes or everything is not just if a country decide to increase interest rate, that kind of money will not experience what we call a sudden stop. But, hold on, this is not Red Cross money. This money will leave your country one day. How? Don't forget, your country sooner will have to remit profit and dividends that will affect your country balance of service later on. Remember the balance of service and the balance of service I have interest on external debt and remittance of profit and dividends. In the capital account, you have foreign direct investment, good. But this is not Red Cross. Two, three, four or five years later on, that money that enter your country will leave as profit and dividends so will effect negatively your balance of service. It's good, but check it, which segment as well. Also, this is more important. Check if portfolio investment, that's what we call hot money is the main source of a current account financing. This is very dangerous. Why? Because this is a huge red flag as a portfolio investment representing investment on stock market and bonds. Any bad news could lead investors to leave the country in less than 72 hours, leaving your current account absolutely exposed and your currency eventually ready to experience a massive kermes of depreciation. Portfolio investment, it's good, it's not bad. But this is considered to be hot money. They can leave like this. If your current account is hugely financed just by portfolio, you are in a danger, you're in a great risk because this money could leave and that could trigger a currency crisis. At the end, what we might have, we know at the beginning with that current account plus capital and financial account plus errors and omission should be zero. Not so, why not? It depends. How come it depends? It depends on the exchange rate regime. For example, let's forget for a moment, errors and omissions. Current account plus capital and financial account should be equal to zero when you have an a flexible exchange rate regime. The Central Bank will not intervene in exchange rate market, but how the Central Bank can intervene in exchange rate market? Remember that we said, in the Central Bank, they have their asset side, international reserves. They use international reserves to influence the exchange rate. But if it's flexible, the Central Bank will not intervene whatsoever. In that case, current account plus capital account, the financial account is equal to zero. All the way around, if you have a known flexible exchange rate regime, how come non-flexible? It could be dirt floating. What's Dutch floating? The central bank intervenes in the exchange rate market sometimes, or could fix it? The central bank fix it the exchange rate and does not allow to change at all. In that case, current account plus capital or financial account is equal to change in international reserves. I know you didn't understand. Eventually you did not understand. Let me make an example. Let's suppose you have Mary and John. Mary owns a company within my country, but today is maturing $100 million external debt. My country, let suppose Brazil, domestic currency, reais. She needs to buy US dollar to pay her external debt. That's Mary, John. John, there's a bunch of $35 trillion together. Does John exists? Not really, but he is represented by a bunch of banks. Let's suppose these banks does not exist. Mary would just call John to buy US dollar. "Hi Mary." "Hi John." "Would you be willing to sell me," Let suppose the exchange rate is one-to-one, "One reais?" Brazilian reais is equal to one US dollar one thing. Do you know that Mary, if she needs to buy, for example, $100 million dollars, she wants the exchange rate to appreciate to 0.8. Then she will need to pay R$80 million and get $100 million all the way around. John. John wants my exchange rate to depreciate. For example, John wants my exchange rate to be like 1.5 because he would give $100 million to her, but he will get R$150 million. They negotiate, and let's suppose I'm the central bank, "Hi John." "Hi Mary. "How much would you sell me?" "Well the exchange rate is one-to-one." "One-to-one, I'm not going to sell it to you." "What about one to 1.21?" "No 1.2 I'm not going to sell it to you." "1.3? " "Not 1.3. " "1.5? " "Okay 1.5, I'll give it to you." $100 million entered the country and $100 million will leave the country to pay external debt. There is no Intervention of the Central Bank. That's why current account plus capital account should be equal to zero. The exchange rate is the gauge to make this equation equal to zero. Let's suppose now we are leaving a dirty floating exchange rate regime, and I'm the Central Bank. Mary and John. "Hi Mary." "Hi John." "$100 million." "One-to-one?"1.2?" "No." "1.3?" As a Central Bank, I might say, stop it. "I will give you Mary, John, go home. I will give you marry $100 million and you give to me R$130 million. I intervene in exchange rate market in order to not allow the exchange rate to depreciate more than 1.3. I just tried to keep the exchange rate from one to 1.3. That's enough. That's why to defend the currency, what do I need to have? International reserves? Can you see that things are getting together? I have to check on my current account, if it's negative is a problem. If my capital account is hugely financed by portfolio investment, well, it's not a bad. What's the exchange rate regime? Well my exchange rate regime is fix-it. The central bank, you have to keep a huge eye on that. I don't have international reserves. If I don't have international reserves as a central bank, do you understand that John is not going to sell dollars to Mary at 1.3? It will sell to Mary, let's say at 1.9. Why? Because I'm not here to defend, to protect the currency. That's what we call currency crisis. Check the current account, check the capital account, and how much you have in terms of international reserves and which exchange rate regime you have. We will discuss about currency crises in the next sob. That's explanation we have now. Hopefully, you understand. If you don't get back a little bit, just to understand why international reserves make part of a non flexible exchange rate regime. The next team, next part, next lesson, we will discuss and get a deep dive, speculative attack, currency crisis, corporate crisis, and banking crisis. Stay with us.
