Monetary Review - 2nd Quarter 2003

Erik Haller Pedersen, Economics

Introduction and conclusion

For many years, the deficit on the current account of the balance of payments was the "Achilles heel" of the Danish economy. It determined much of the economic policy strategy pursued. In 1990, the balance of payments showed a surplus for the first time in almost 30 years, cf. Chart 1. Since then, the surplus has been maintained, with the exception of one single year. In recent years, the surplus has been robust at around 2-3 per cent of GDP, despite the international economic slowdown and stronger growth in Denmark than in many of its trading partner countries. This article describes the background to this development and discusses whether, in view of the free capital flows, the current-account balance should be considered at all by economic policymakers.

Balance of payments and external debt	Chart 1

Note: External debt from Statistics Denmark (1960-75) and Danmarks Nationalbank (1991-2002). Calculated figures for the period 1976-90, see more details in the Appendix to the reference in footnote 1, p. 34.

It is concluded that the reversal of the current account of the balance of payments from a deficit to a surplus can be attributed to the resolution of the chronic savings problem of former times. This was mainly resolved through changes to the taxation system, and first and foremost the reduction of the taxable value of interest deductions. Another contributing factor is sound public finances.

The more specific factors leading to recent years' sound surpluses are that Denmark has become a net exporter of energy, that exports of marine transport have increased significantly in terms of both volumes and prices, and that manufactured exports have gained market shares. In addition, net interest payments to abroad have been falling. Denmark's competitiveness currently seems healthy, but in the longer term a higher wage-increase rate in Denmark than in competitor countries will be a source of concern.

The current-account balance should continue to play a central role in determining Denmark's economic policy. The fact that in many cases free capital flows have made a deficit easy to finance does not make the deficit itself unproblematic.

Compilation and interpretation of the balance of payments

As described in Box 1, there are certain problems associated with the practical compilation of the balance of payments. This article is based on Statistics Denmark's compilation of the current account.

What does the balance of payments measure?

Box 1

In principle, the balance of payments registers all economic transactions between residents and non-residents. Residents are all business enterprises domiciled in Denmark, including subsidiaries and branches of foreign business enterprises, while Danish business enterprises' foreign units are non-residents. Individuals are residents if they are resident in Denmark for more than one year. A balance of payments thus registers the volume of transactions between geographically delineated areas, in our case Denmark.

The balance of payments can be divided into the current account and the capital account, and the change in the foreign-exchange reserve. The balance of payments is compiled according to the double-entry bookkeeping principle, whereby the total balance of payments is always zero. What is somewhat inaccurately termed a deficit or surplus on the balance of payments is normally understood as a current-account deficit or surplus.

Table 1 shows some key items of the balance of payments. The current-account surplus can either be lent to non-residents (capital exports) or placed in the foreign-exchange reserve. As "errors and omissions" shows, there are considerable statistical problems associated with correct compilation of the balance of payments for an individual year. Viewed over a number of years, "errors and omissions" is considerably smaller, however, as it fluctuates around zero.

The compilation problems are also reflected in the typically rather considerable ongoing revisions of the published balance-of-payments data. One reason is that Statistics Denmark publishes the balance-of-payments statistics for the first time before all reported data have been processed. The users require the statistics as quickly as possible.

More generally, there will be a tendency to underestimate revenue, including exports, and overestimate expenditure, including imports. This is e.g. shown by the fact that the sum of current-account balances for all countries in the world taken as one shows a considerable deficit, where it should be zero. In Denmark and other European countries this is offset by the VAT system which gives an economic incentive to report correct export data, since such data is a prerequisite for reimbursements of VAT to the business enterprises. There is no such incentive on the import side.

There are at least four approaches to the current-account balance. The balance reflects the difference between the value of exports and imports, and net transfers and interest payments to abroad, cf. Table 1. This is the conventional interpretation. The balance can also be considered to be a result of domestic revenue exceeding or falling short of domestic demand. A third interpretation is to consider the balance as the difference between domestic savings and investment. The fourth and last interpretation reflects that the balance always equals net capital imports. The capital account shows how a current-account deficit has been financed, or how a surplus has been invested. The four interpretations of the current-account balance are closely interrelated, as described in further detail in the Appendix. Savings and investments represent the most constructive approach to understanding the reversal of the current-account balance from a sustained deficit to a sound surplus.

Denmark's balance of payments		Table 1
Net payments in kr. billion	2001	2002
Current account
Goods and services (X-M)	86	81
Transfers¹ (T)	-20	-20
Interest payments² (i*A)	-25	-22
Current account of the balance of payments (CABP)	41	39
Total capital exports	13	-6
Of which
Direct investments	15	-9
Portfolio investments	35	-3
Unrecorded payments, loans, etc.	-11	-14
Errors and omissions	-26	20
Change in the foreign-exchange reserve	27	45
Total balance of payments	0	0
Note: CABP = Capital export + change in the foreign-exchange reserve. Due to rounding the sum of the items is not exactly zero. The letters in parenthesis refer to the equations in the Appendix. Sources: Statistics Denmark and Danmarks Nationalbank. ¹E.g. development aid, block grants for the Faroe Islands and Greenland, environmental subsidies, EU-related payments, etc. ²The item contains all types of interest on the net external debt, i.e. interest, dividend, withheld profits on foreign investments, etc.

Savings and investments

The current account of the balance of payments can be interpreted as the difference between Danish savings, in both the private and public sectors, and investments. In the event of a current-account deficit investments exceed total domestic savings, so that Denmark resorts to foreign savings. On the other hand, the build-up of external debt will give foreign savers a part interest in future Danish output.

The background to the robust current-account surplus during the sustained upswing in the 1990s was the significant consolidation in the private sector from the mid-1980s until 1993. During this period the private sector's net savings improved from a deficit of 8 per cent of GDP to a surplus of 6 per cent of GDP, cf. Chart 2. At the same time, the government deficit was generally kept at a reasonable level. Throughout the 1990s, the private savings surplus declined again, but without leading to protracted current-account deficits, e.g. because the government surplus was maintained. In a historical perspective, a current-account surplus maintained during a sustained upswing was a unique phenomenon^[1].

Savings balances by sector	Chart 2

Note: The current account of the balance of payments = government balance + net acquisition of assets by private sector.

An improvement in the balance of payments can result from decreasing investments, which will jeopardise future economic growth, or from increasing savings, or a combination of the two. As shown in Chart 3, the present current-account surplus is mainly attributable to higher savings. From the mid-1980s until 1993, the investment ratio did decline considerably, but this has since been redressed. However, the investment ratio is still significantly below the level in the 1960s when e.g. housing investments were higher, while Denmark's transformation from an agricultural to an industrial country accelerated.

Savings and investment ratios	Chart 3

In general terms, the current-account deficit in the 1960s could be attributed to a high level of investment, while the deficit from the mid-1970s and 1980s was the result of low domestic savings. Today, this savings problem seems to have been solved. Among several possible reasons the most important is the stimulating effect on savings of the significant reduction of the taxable value of interest deductions achieved in stages via the tax reforms in 1985, 1993 and 1998. Together with the more appropriate taxation of pension savings this has made it less advantageous to increase one's indebtedness. High tax deductions for interest payments typically make savings less attractive to the private individual than to society overall, since an individual private borrower can transfer some of the costs of borrowing to the rest of society^[2]. This problem is aggravated by a high price-increase rate, since all nominal interest expenditure is tax-deductible, including the part which solely compensates for inflation. At sufficiently high price-increase rates, the real interest rate after tax becomes negative, whereby indebtedness becomes profitable. This was typically the case for private borrowers in the 1970s and the first part of the 1980s. The current historically low level of interest rates again entails a low real interest rate after tax for private savers and investors, although in the short term this does not jeopardise the current-account surplus.

The accumulation of labour-market pensions is another important element that strengthens total savings in the build-up phase in cases where the savers in these schemes would otherwise have no savings of significance.

On the investment side, the taxation and depreciation rules and the direct investment subsidies have been reduced in terms of both number and value, thereby reducing investment in projects that are only profitable to private individuals and not to society. The current Danish taxation system is more neutral than before as regards savings and investment decisions, and thereby vis-à-vis the balance of payments. The low inflation rate has a similar effect. All in all, a sensible and forward-oriented economic policy has contributed significantly to the present surplus on the current account of the balance of payments.

Exports and imports, interest payments and transfers

Chart 4 shows the development in the main items of the current account of the balance of payments since 1960. The balance of goods and services was negative throughout the 1960s and 1970s, but was in surplus from around 1980, and has been by and large positive ever since. Over the last 20 years, the value of Denmark's exports has thus as a general rule exceeded the value of its imports.

Key items of the current account of the balance of payments	Chart 4

Exports are determined by growth in the export markets, competitiveness and the degree of domestic capacity utilisation. In historical terms, exports have grown more strongly than the overall economy as a consequence of the increasing international division of labour.

German reunification boosted Danish exports in around 1990, without improving price competitiveness. The timing was right, since at that time the Danish economy was at a cyclical low, and had abundant capacity to produce for the export markets. This led to a temporary increase in Danish industry's market share. In recent years industry has won back market shares, cf. Box 2.

Danish industry's market share	Box 2
Danish industry's¹ market share increased after German reunification, cf. Chart 5, but resumed its declining trend during the 1990s. In the last few years, industry has again gained market shares, e.g. because Danish exports are less sensitive to cyclical fluctuations than the exports of many other countries. This can be attributed to the large content of non-cyclical goods such as pharmaceutical products, and the small element of investment goods such as machinery. As a consequence, Denmark typically gains market shares during cyclical downturns, and loses market shares in cyclical upturns. In the longer term, the market shares of Danish industry have decreased as newly industrialised countries have begun to gain ground in the world market. Other factors are that Danish exports are becoming more and more diversified across countries, and that the calculation of market shares is based on only selected export markets. The relation between manufactured exports in Denmark and the EU is shown in order to adjust for these effects. This shows that Danish exports have not performed more poorly than the exports of EU member states over the period. Losing market shares is not a problem for as long as there are no imbalances in the economy such as unemployment and unsustainable current-account deficits. Viewed over a longer period, virtually all industrialised countries have lost market shares. In view of the surplus on the balance of goods and services Danish industry does not appear to face any acute competitiveness problem. This is due to such factors as positive development in productivity.
Market share of danish industry	Chart 5

Note: The market share is the volume of Danish manufactured exports to 13 major markets as a ratio of these countries' total imports of industrial goods, all calculated in current prices. ¹See also the more detailed analysis in Heino Bohn Nielsen, Market Shares of Manufactured Exports and Competitiveness, Danmarks Nationalbank, Monetary Review, 2nd Quarter 1999.

The increasing production of oil and gas from the North Sea has led to a significant underlying improvement in the balance of goods and services. While in the build-up phase fixed investments make a negative contribution to the current-account balance, the contribution becomes positive when production from the oil or gas field starts. Net energy exports entailed expenditure of around 3 per cent of GDP in the 1980s and became positive in 1998. In 2002, net energy exports showed a surplus of 2 per cent of GDP. Especially in recent years there has been a significant improvement after start-up of production in several new fields. At the same time, the oil price has been high, but volatile. However, a factor also to be considered is the foreign ownership of a significant part of Dansk Undergrunds Consortium (DUC), the operator in the North Sea. A surplus on oil extraction will thus also entail dividend payments to abroad, and will thus have a negative impact on the interest item of the balance of payments.

Agricultural exports in constant prices have increased strongly, but the prices have been stagnating for the last 20 years. Even though Denmark's net exports of agricultural products still accounted for around 3 per cent of GDP in 2002, the surplus decreased over the period.

External trade in services shows a surplus. In the first instance this can be attributed to large exports of sea freight. The value of sea-freight exports increased strongly in 2000 and 2001 due to such factors as significant freight-rate increases. Sea-freight exports have increased in volume terms, especially in recent years, as the merchant fleet has expanded. Today, shipping is one of Denmark's largest export sectors.

Imports are closely related to growth in domestic demand, although in this area too the internationalisation of the global economy has over time led to an increase in imports to Denmark as a ratio of domestic demand, cf. Chart 6 that shows the standardised import ratio. In the second half of the 1990s there was no significant growth in the import ratio, even though domestic demand expanded. Danish producers thus gained market shares on the domestic market. The 4th quarter of 2002 saw another steep increase in the import ratio. This may be a random fluctuation.

Standardised import ratio	Chart 6

Note: Imports to Denmark as a ratio of total domestic demand excluding structural effects.

Interest payments and transfers
The sustained current-account deficits throughout the 1980s notwithstanding the surplus on the balance of goods and services were first and foremost the result of strong increases in interest expenditure due to rising international interest rates for the external debt accumulated in the preceding period. Net interest on Denmark's external debt increased throughout the 1980s to approximately 4 per cent of GDP. In the following decade the Danish economy entered a virtuous circle with a current-account surplus, and thereby a reduction of the debt, concurrently with falling interest rates. This eased the interest burden on the debt, which in itself contributed to the surplus, etc. In 2002, net interest expenditure still accounted for more than 1.5 per cent of GDP.

It is noteworthy that the net interest payments are the result of ever-increasing gross payment flows as a consequence of ever-increasing gross balances. Denmark's external assets thus increased from almost 90 per cent of GDP in 1993 to 165 per cent of GDP in 2002, while external liabilities showed a similar increase. This has weakened the correlation between the current-account balance in an individual year and the external debt, since the debt may be subject to substantial value adjustments due to fluctuations in market prices and/or exchange rates^[3]. Capital gains and losses are not included in the current account of the balance of payments, but have a direct impact on the debt. In recent years the net debt has increased, despite considerable current-account surpluses. However, when the international trade cycle is reversed, and if interest rates and stock prices^[4] begin to rise again, with a sustained current-account surplus at the present level, it is realistic to assume that Denmark's net external debt will slip beyond zero within a relatively short time. Even in this situation there will initially still be net interest payments to abroad, since external liabilities are subject to higher interest rates than external assets.

Unilateral transfers from Denmark, called "transfers" in this article, have increased steadily since the 1960s when Denmark was a net recipient, and now account for approximately 1.5 per cent of GDP. Transfers comprise development aid, block grants to the Faroe Islands and Greenland, environmental subsidies, etc. as well as EU-related payments.

All in all, the sound current-account surplus can be attributed to increasing oil and gas production in the North Sea, increased revenue from marine transport, a positive development in manufactured exports and decreasing interest payments to abroad. Considered on the basis of the macroeconomic balances there are no indications of an acute competitiveness problem for the Danish economy. Employment is still high, there are sound surpluses on public finances and the current account of the balance of payments, and Denmark's inflation rate is at the euro-area level. In the longer term, however, a continued higher rate of wage increase in Denmark than in competing countries may become problematic.

Relative demand and competitiveness

Competitiveness is of vital importance to the course of exports. Chart 7 shows a close relation between relative hourly wages and market shares throughout the 1970s and up to the mid-1980s. The strong positive fluctuation in exports in the last half of the 1970s can be attributed to improved competitiveness as a result of krone devaluations, which together with idle capacity pushed up exports, despite receding external demand.

Competitiveness and market share	Chart 7

Note: Market shares are calculated in current prices.

The correlation between relative wages and market share diminishes considerably from the mid-1980s. At that time the fixed-exchange-rate policy began to gain credibility. On the other hand, the correlation between exports and relative domestic demand^[5] has become tighter.

The capacity necessary for increased exports was created by the do-mestic recession in the wake of the October 1987 package of economic measures, and the tax reform that took effect in 1987. Together with sound external demand this increased the current-account surplus, cf. Chart 8. The boom from 1993 to 1998 saw a reversal with a falling current-account balance, leading to a deficit in 1998. In recent years, growth in domestic demand has been in line with growth abroad, but the current-account balance has nevertheless improved. It seems that the pattern of the correlation between the balance of payments and demand has generally shifted in recent years to a higher balance of payments for a given relationship between external and domestic demand, cf. Chart 8. This reflects an increase in earnings from energy and marine transport that has not immediately led to higher consumption and investment. If this is sustained, it will have the same effect as improved competitiveness, since the level of domestic demand at a given current-account surplus can be higher.

Relative demand and balance of the current account of the balance of payments	Chart 8

Note: Relative demand is calculated as domestic demand in the OECD countries weighted together using the weights of the effective krone-rate index as a ratio of domestic Danish demand.

The shift from competitiveness to relative domestic demand as the main determinant of the development in the current account can be considered to be a result of the fixed-exchange-rate policy. This policy stabilises the environment for competitiveness over time, since the exchange rate remains the same vis-à-vis a large number of Denmark's trading partners. However, competitiveness still plays a role in the medium term due to variations in wage development. It is still essential to prevent Danish wage increases from deviating excessively from wage-increase rates in competitor countries. The effect of a higher wage-increase rate in Denmark will emerge only slowly, but is difficult to rectify once it has materialised. As its credibility has increased, the fixed-exchange-rate policy, viewed in isolation, has improved competitiveness by reducing the risk premium associated with locating production in Denmark.

The current-account balance and net capital imports

A final approach to explaining the current-account balance is based on the fact that a deficit or surplus is by definition offset by the balance of the capital account in net terms, including the change in the foreign-exchange reserve. The view held in parts of the economic literature is that the current-account balance is not first and foremost the result of real savings and investment decisions or trade flows. On the contrary, it is the result of investors' portfolio considerations. Furthermore, shifts in expectations are the actual determinant of fluctuations in the capital account, and thereby in the current account. This view shifts the focus from the current account to the capital account. With a fixed-exchange-rate policy as in Denmark's case a net change in the capital account will initially be reflected in the foreign-exchange reserve, and eventually in the short-term and long-term interest rates. This may affect the current account.

Each of the four approaches to understanding the current-account balance may be appropriate in explanatory or analytical terms, depending on the focus, but basically the four approaches describe the same reality, cf. the Appendix. Assume, for example, that the economy is subject to a shock from reduced sales opportunities in the export markets. This leads to a decrease in exports and thereby ceteris paribus to a deterioration of the current account (equation 3*). Domestic output declines as a result of lower exports, which, given unchanged domestic demand, again offsets the deterioration in the current account (equation 4*). At the same time domestic savings decrease, since declining output entails lower incomes (equation 5*). In view of the lower net savings there are less funds to be placed in foreign assets or in the foreign-exchange reserve (equation 6*). The four approaches are thus not alternatives, but supplement each other, and illustrate that changes in the current-account balance are typically the result of several factors.

Is a current-account deficit necessarily a problem?

There is a close correlation between the savings and investment ratios in Denmark, as appears from Chart 3. This is also the case in many other countries. This is natural in a world subject to restrictions on capital flows, as it is then necessary to finance a large proportion of investments via domestic savings. It is more surprising that the co-variation remains high in the period of liberalised capital flows. In this scenario, investments will in principle be driven by the need to maximise returns across countries, while savings are determined by the savers' wish to redistribute consumption over time and protect consumption from short-lived income fluctuations. Investment and savings decisions are thus independent, at least in the short and medium term. In the longer term, the intertemporal budget constraint, cf. below, will ensure a correlation between savings and investments.

The close correlation between savings and investments in the short and medium term may be a result of the fact that it is regarded as politically unacceptable for a country to have a sustained current-account deficit, thereby building up external debt. This has been the prevailing view in Denmark where transforming the current-account deficit into a surplus, so as to begin to repay the external debt, was an independent economic-policy objective for many years. Other countries, typically producers of raw materials, such as Australia, have taken a different approach and held sustained deficits for decades, although this has by no means been beyond discussion.

The view of the balance of payments has varied over time. In the period after World War II up to the 1970s the focus was on exports, imports and relative wages, i.e. competitiveness. The latter was a central issue, since sound competitiveness could enable a country to improve its balance of payments, while ensuring low unemployment. The current-account deficit was a source of concern, since – given restrictions on capital flows and undeveloped international financial markets – it could be difficult to finance, whereby the foreign-exchange reserve might be drained.

In step with the liberalisation of capital flows and deepening international financial markets views of the current account changed, with more focus on the intertemporal aspect, i.e. focus on savings and investment. According to this "new" view of the current account, a deficit is not necessarily a problem for as long as it can be attributed to indebtedness in the private sector and merely reflects a wish to redistribute consumption over time, while placing investments in assets with the highest risk-adjusted return. According to this view, the problem only arises if the current-account deficit is attributable to the public sector's indebtedness or is a result of distortions to the incentive structure for private decision-makers, such as interest taxation. Economic policy should thus be aimed at removing such distortions and ensuring fiscal balance, rather than focusing on the current-account balance^[6]. It is difficult to disagree with this. There is little doubt that a surplus or balance on the government budgets and absence of distortions in savings and investment incentives reduce the probability of permanent, unsustainable current-account deficits.

Although in most cases there is easy access to finance a current-account deficit in a situation with free capital flows, sustained deficits may be problematic. First and foremost, free capital flows are not only an advantage, since they may have a destabilising effect in certain periods, as experience shows. This is not an argument in favour of restricting capital flows, but in favour of pursuing a sound economic policy. The current-account balance is an important element in a sound economic policy together with the government budget balance, the unemployment rate, inflation, etc. This applies particularly to a small, open economy that pursues a fixed-exchange-rate policy, and which may be vulnerable to sudden shifts in expectations and revaluation of risks on the financial markets.

A current-account deficit entails the accumulation of debt. A stable debt-to-GDP ratio is a sufficient prerequisite for a country to remain solvent. In a growing economy this is possible even in the event of sustained deficits on the balance of goods and services plus transfers in net terms, for as long as economic growth exceeds interest payments on the external debt, cf. formula 10 in the Appendix. On the other hand, if interest payments on the external debt exceed the rate of economic growth, a current-account surplus is needed to stabilise the debt ratio in the long term.

Until the mid-1970s, the nominal rate of growth in the economy exceeded the bond yield, which can be taken an indicator of marginal borrowing costs^[7], but the pattern reversed from the second half of the 1970s, cf. Chart 9. This required an ever-increasing current-account surplus, excluding interest expenditure^[8] in order to stabilise the debt ratio. This illustrates that a country with a large external debt is vulnerable to shifts in interest-rate levels and economic growth rates.

Borrowing rate and growth in nominal GDP	Chart 9

Indebtedness means that a proportion of the future output must be relinquished to non-resident savers. A case in point is Ireland whose present GDP per capita is on a par with Denmark's, while GNP per capita is considerably lower than Denmark's because a proportion of Ireland's output has to be surrendered to non-residents. This strategy may be appropriate in newly-industrialised countries or in the transition economies of Eastern Europe, but for a mature economy like Denmark's the inability to finance investments from own savings is a danger signal. This applies even in the event of great variations over time in the proportion of the population participating in the labour market, i.e. who are net savers. If these development trends are global, it is not possible for all countries to seize non-residents' savings in periods when the number of senior citizens is high and the number of people in the labour market is low. The current-account balance is thus in principle neutral vis-à-vis global demographic changes. On the other hand, declining global savings will lead to rising real interest rates.

The borrowing costs as such will depend on the size of the external debt, as reflected by the credit standing. The latter plays a particularly important role in financing the external debt via bonds and direct borrowing, and a less important role in financing via direct investments. The composition of debt financing can thus determine a country's sensitivity to shifts in expectations on the financial markets. By tradition, direct investments have played only a minor role in the financing of Denmark's external debt.

The view that if public finances are in equilibrium the current-account deficit is a private matter about which the economic policymakers should not be concerned only holds true under a large number of simplified assumptions. In contrast, based on models that explicitly include the prosperity of future generations, and in which it is not possible to borrow unlimited amounts at a fixed interest rate, the conclusion is typically that large, sustained current-account deficits will present a welfare problem in a society like Denmark's^[9].

For a number of years Denmark has shown a current-account surplus, so that focus has moved away from the current account. Nevertheless, the balance of payments is still an important indicator since rapid deterioration may indicate that the economy has almost reached its capacity limit, or that new distortions have arisen.

In conclusion, there is every reason to be concerned about the current-account balance in economic-policy planning if the country has a large, sustained current-account deficit. This applies particularly to Denmark's situation where the fixed-exchange-rate policy is a cornerstone of economic strategy. This argument will lapse should Denmark opt for participation in the Economic and Monetary Union, but nevertheless it will probably be appropriate to avoid sustained external indebtedness, since ceteris paribus this makes the economy more vulnerable, and also means that an increasing proportion of the year's output must be relinquished to non-resident savers.

Appendix

The gross domestic product can be written as:

1) Y = C + G + I + X – M

where

Y       =GDP, i.e. value added generated in the country within a given period.
C       =private consumption.
G       =government consumption.
I        =total investments.
S       =savings.
X       =exports.
M      =imports.

The following additional variables are applied:

T       =transfers to abroad, e.g. development aid or EU payments.
i        =the international borrowing rate.
i*A    =interest payments on the external debt (A), including share    dividend.

CABP=the current account of the balance of payments. This element also indicates the change in the external debt disregarding value adjustments.

Addition of transfers (T) and interest payments to abroad (i*A) on both sides of the equal sign gives:

2) Y + T + i*A = C + G + I + CABP

where

3*) CABP = X – M + i*A +T

According to this equation, CABP shows a deficit if the value of imports exceeds the value of exports, adjusted for interest payments to abroad and transfers. In Denmark's case i*A and T are negative, cf. Table 1. This means that besides the value of imports the value of exports must also cover these expenses to achieve a CABP in balance.

Equation 2) can also be written as:

4*) CABP = (Y + T + i*A) – (C+ G + I)

According to this equation CABP shows a deficit if total domestic demand (C + G + I) exceeds the country's output (Y) adjusted for the proportion thereof that is transferred to non-residents (T + i*A).

Equation 4*) can also be written as:

5*) CABP = (Y + T + i*A – C – G) – I = S – I

The quantity (Y + T + i*A) is the gross national income. Deduction of government and private consumption, C and G, gives domestic savings. CABP can thus be interpreted as the difference between a country's savings and investments. Should investments exceed savings, CABP will show a deficit. This corresponds to financing investments via external savings. The opposite is an increase in the external debt, i.e. non-resident savers acquire a claim on future domestic output.

The fourth and final interpretation of CABP is that a deficit will always correspond to net capital imports, including the change in the foreign-exchange reserve, while a surplus will correspond to net capital exports, since the balance of payments must always balance.

6*) CABP = net capital exports

The equations 3*, 4*, 5* and 6* are expressions of the four perceptions of CABP.

If Danish external assets are called A, the following applies:

7) CABP = A_t+1 - A_t disregarding value adjustments and with time, t, in subscript.

If 7) is inserted in 3*), the following is given:

8) X_t – M_t + T_t + (1 + i_t)*A_t = A_t+1

Divisions by GDP (Y) give:

9) X_t/Y_t – M_t/Y_t + T_t/Y_t + (1 + i_t)*A_t/Y_t = Y_t+1/Y_t*A_t+1/Y_t+1

If growth in nominal GDP is called g, the following is given in long-term equilibrium:

10) X/Y – M/Y + T/Y = (g – i)*A/Y

This equation is the intertemporal budget constraint that can be used to assess whether a given deficit on the net balance of goods and services and transfers is sustainable in the long term. This is the case if economic growth (g) exceeds the borrowing rate (i) on the external debt. For a given spread (g - i), a maximum long-term debt fraction (A/Y) can be calculated for a given deficit (X/Y - M/Y + T/Y)^[10]. On the other hand, if i exceeds g, stabilisation of the debt fraction in the long term requires a surplus.

[1] For a more detailed discussion, see Jørgen H. Gelting, (1972), The Balance of Payments 1872-1972 (in Danish), Nationaløkonomisk Tidsskrift, Volume 110, Issue 5-6.

[2] However, it is important to emphasise that taxation of asset income in Denmark is still subject to considerable asymmetry. See Kristian Kjeldsen and Erik Haller Pedersen, Taxation of Asset Income and the Financial Markets, Danmarks Nationalbank, Monetary Review, 1st Quarter 2002.

[3] Cf. the more detailed analysis in Tom Nordin Christensen and Jens Hald, Denmark's External Debt 1960-99, Danmarks Nationalbank, Monetary Review, 3rd Quarter 2000.

[4] Rising interest rates and stock prices both lead to capital gains on the external debt at given exchange rates. The value of abroad's holdings of Danish bonds is higher than the value of Danish residents' holdings of foreign bonds, i.e. decreasing bond prices generate capital gains on the net debt. The reverse applies to stocks, since Danish residents' holdings of foreign stocks exceed non-residents' holdings of Danish stocks, so that increasing stock prices yield a capital gain for Denmark, and thereby reduce Denmark's external debt.

[5] Relative demand is defined as domestic demand abroad weighted together using the krone‑rate weights relative to Danish domestic demand.

[6] This argument is described in: Peter Birch Sørensen (1999), The Current-Account Target – a Commentary, (in Danish) Nationaløkonomisk Tidsskrift, Issue No. 137.

[7] The relevant issue is not the historical rate of interest for external borrowing, but the rate of interest for new borrowing. Most of Denmark's external debt has traditionally been financed by selling (government) bonds to non-residents.

[8] The current account of the balance of payments excluding interest payments corresponds to the primary balance when the sustainability of the government-budget balance is being considered.

[9] This view is discussed in further detail in Lars Haagen Petersen (1999), Welfare Effects of a Current-Account Deficit in a Small, Open Economy (in Danish) and Claus Vastrup (1999), Does the Current Account Represent a Problem? (in Danish). Both published in L. Langhoff-Roos (ed.), Socialøkonomisk Debat Gennem 25 År, Jurist- og Økonomforbundets Forlag.

[10] This is discussed in further detail in M. Obstfeld and K. Rogoff, The Intertemporal Approach To The Current Account, Handbook of International Economics (1997), Vol. 3, eds. G. M. Grossman and K. Rogoff.

The Balance of Payments – from Sustained Deficit to Sound Surplus