Understanding Trade and Capital Flows: Part 1

Understanding the Balance of Payments

To understand international trade and finance, we must begin with the Balance of Payments (BoP). The BoP is a comprehensive account of a country’s economic transactions with the rest of the world. It tracks all the money flowing into and out of a nation, ensuring the economic flows balance each other out.

In simple terms, any money that flows out of a country needs to flow back in some form. If this doesn’t happen, the country will have no money, and the economic engine will stop.

For this reason, the BoP must always balance to zero. Here’s the basic formula we’ll be working with:

Balance of Payments = Current Account + Capital Account

The Current Account

The current account records the flow of goods and services into and out of a country, as well as income flows (like wages or investment returns) and current transfers (such as remittances or foreign aid). The largest component of the current account is the trade balance, so for simplicity, we’ll refer to it as the trade balance in this example.

Here’s how the trade balance works:

• Trade Surplus: When a nation exports more than it imports, it has a trade surplus.
• Trade Deficit: When a country imports more than it exports, it has a trade deficit.

By focusing on the trade balance, we simplify the understanding of money flowing in and out of a country, making it easier for those new to the topic.

The Capital Account

The capital account (which we will combine with the financial account for simplicity) tracks the movement of money into and out of a country due to investments, loans, and the purchase of assets. This includes foreign investment, loans, and changes in foreign reserves held by the central bank.

Here’s a breakdown of how monetary flows affect the capital account:

If a country is running a trade deficit, the money flowing abroad must flow back into the country through foreign investment (e.g., purchasing real estate or stocks) or loans (e.g., purchasing government debt). Foreign reserves or FX reserves can also be used to return capital. FX reserves are assets held by a country’s central bank in foreign currencies. When a country reduces its foreign reserves, foreign currency flows out, and domestic currency flows in.

Example: The US has a trade deficit with China. China sends goods and services to the US, and the US sends dollars to China. China returns those dollars to to the US through the purchase of US Treasuries. This increases China’s foreign reserves and balances its trade surplus with the US by running a capital account deficit.

If China begins selling its US Treasuries and therefore reduces its foreign reserves, the US trade deficit will need to decrease. This can be a bit tricky to understand, but we need to consider that every transaction has a corresponding currency flow.

When China sells US Treasuries, it receives dollars and exchanges them for Chinese yuan. This strengthens the yuan relative to the dollar, making Chinese goods and services more expensive for those wanting to purchase them in dollars.

In other words, whenever one currency is sold to buy another, the currency being sold loses value relative to the one being purchased.

To visualize this better, imagine a scenario where everyone wants to buy the latest iPhone. As people sell their dollars to buy iPhones, the value of the dollar drops relative to the iPhone, making the iPhone more expensive. Now, substitute “iPhone” with whatever you want, and the principle remains the same.

In short, all economic transactions must balance. The capital account will always offset any trade surplus or deficit.

Balance of Payments Example: Greece and Germany (Pre-Eurozone)

Before the creation of the Eurozone, Greece and Germany had their own currencies: the Greek Drachma and the German Deutsche Mark. In this example, assume that Germany is running a trade surplus with Greece, meaning Germany is selling more products to Greece than it is buying from them.

When Greece purchases German goods, it needs to exchange Greek Drachmas for German Deutsche Marks. As Greece imports more goods from Germany, the demand for Deutsche Marks increases, while the demand for Drachmas decreases. This leads to the Drachma depreciating and the Deutsche Mark appreciating. As a result, German goods become more expensive for Greek buyers, and Greece reduces its purchases from Germany.

In other words, when Germany runs a trade surplus with Greece, the Deutsche Mark appreciates, making German products more expensive for Greek consumers. Meanwhile, the Greek Drachma depreciates, making Greek products more affordable to Germans. Over time, this adjustment process can help correct the trade imbalance.

Currency depreciation and appreciation also influence interest rates. For example, when the Greek Drachma depreciates, investors demand higher yields on Greek bonds. This is because they are being paid in a weaker currency and require a higher rate of return to compensate for the loss in value of the currency.

An interesting case is the United States and its ongoing trade deficit. Based on traditional economic theory, we might expect this to result in a weak currency for the US. However, the opposite is true. The US Dollar, as the world’s reserve currency, enjoys strong global demand. This unique situation is typical only for countries whose currency holds reserve status. To understand this dynamic further, you can explore the Triffin Paradox.

Quick Comments Regarding Central Banks and Interest Rates

It’s important to debunk a common myth: while governments and central banks can influence interest rates through fiscal and monetary policy, the rates are ultimately determined by the market. A government can set a bond’s coupon rate (interest rate), but whether investors buy the bonds at that rate depends on the market’s demand. If there are no buyers at the set rate, the government must hold another auction, offering the bonds at a higher yield until investors are willing to purchase them. Bonds that have already been issued can be traded on the secondary market, where investors carefully track these prices to predict future interest rate movements.

The rate at which the government can finance its debt sets the lending floor within the economy. For example, if the government can sell bonds at 3%, borrowers within that country will likely pay 3% plus a risk premium when they borrow money in that currency.

Bond trading can be counterintuitive: when bonds are sold, their face value decreases, but the coupon payments remain the same. This results in a higher real rate of return for buyers. Conversely, when bonds are bought, their face value increases, lowering the real rate of return. Therefore, when bond yields rise in the secondary market, it means bonds are being sold, and when bond yields fall, it means they are being bought.

Balance of Payments Example: Greece and Germany (Pre-Eurozone) Continued

Now, let's relate this to the above example. If interest rates in Greece rise due to market demand (caused by a weaker Drachma), it will attract foreign capital from investors coming in the form of investment and loans. This influx of foreign capital would lead to a surplus in the capital account, helping balance the Balance of Payments despite a persistent trade deficit.

As investors rush to buy the Drachma to take advantage of the higher returns, the increased demand for the currency will drive its appreciation. By allowing interest rates to rise, Greece could offset its trade deficit by attracting foreign capital, thereby generating the capital account surplus needed to balance the Balance of Payments.

On the other hand, if foreign investors show little interest in Greece, the country could reduce (sell) its foreign reserves to help balance the BoP.

If Greece does not have an issue with being an import-driven economy, it will need to maintain a sustained capital account surplus (similar to the US today). However, this would lead to foreign investors owning an increasing share of Greek assets and increasing levels debt (and increasing interest rates). It’s important to remember that any money leaving Greece must eventually flow back into the country.

Balance of Payments Example: Greece and Germany (Eurozone)

Before the Eurozone was created, Germany had a highly industrialized and competitive economy, while Greece faced slow growth and higher debt levels. The formation of the Eurozone required both Greece and Germany to abandon their respective currencies—the Drachma and the Deutsche Mark—in favor of the newly introduced Euro.

Instead of each country managing its own monetary policy through individual central banks (like in the example above), the newly established European Central Bank (ECB) would take on this responsibility. The ECB’s role includes:

• Price stability: Maintaining low inflation across all Eurozone countries.
• Fiscal prudence: Ensuring fiscal responsibility among member states with autonomous fiscal policies.
• Interest rates: Keeping interest rates within a set range to prevent significant disparities in borrowing costs between member states.

The central question is: under this new system of monetary unity, can Greece’s underdeveloped economy be brought up to the level of Germany’s highly developed economy?

Short answer: No.

Full answer:

Germany’s economy thrives because of high labor efficiency and strong export markets, which lead to a trade surplus. These export markets drive demand for Euros, which strengthens the currency.

Labor productivity, the amount of output produced per unit of time worked, plays a key role. When productivity rises, workers produce more goods and services per hour, which leads to:

• Higher wages: Due to increased productivity.
• Lower costs for businesses: As more output is generated per unit of labor.
• Economic growth: As companies can produce more with fewer inputs.

In advanced economies like Germany, labor productivity is driven by:

• Technological advancements and automation
• Better education and skills
• Efficient infrastructure and management practices
• High investment in capital goods (machinery, equipment, technology)

The problem with the Eurozone, however, is that trade imbalances (surpluses and deficits) cannot be easily corrected through interest rates or currency adjustments. Germany’s economy creates a strong Euro, while Greece, lacking the same high labor efficiency, struggles with the strong currency. Greek goods become more expensive for foreign buyers, which undermines its export market.

In the pre-Eurozone setup, Germany would have a stronger currency, and Greece would have a weaker one. However, within the same currency zone, the Euro is artificially too strong for Greece and too weak for Germany. This discrepancy results from the differences in labor efficiency, which impacts the demand for each country’s exports.

Although Greece and Germany have different interest rates, the ECB works to keep the difference between them narrow. If German bonds are issued at 3% while Greek bonds are offered at 10-12%, the inflation rate for the Euro would be affected. To prevent this, the ECB or trade-surplus countries (like Germany) must intervene and buy Greek debt to maintain of interest rates within a close range. This intervention keeps Greek debt artificially low, allowing Greece to borrow at a lower rate than it would be able to if it were not in the Eurozone.

For Greece, this presents a clear incentive: borrow as much as possible at artificially low rates and invest that money in higher-productivity countries like Germany. This has led to countries like Greece running trade deficits with countries like Germany, financed by foreign purchasing (investment) of Greek assets and the increasing amounts of debt loaned to Greece.

Now that we’ve examined how trade imbalances work within the Eurozone, Part 2 will explore how Greece could reshape its economy if it regained control over its monetary policy.