The sky’s the limit: The economics of inflation and hyperinflation

5 Foreign debt and the current account

gross domestic product (GDP)

A measure of the market value of the output of final goods and services in the economy in a given period. Output of intermediate goods that are inputs to final production is excluded to prevent double counting.

On 19 December 2022, the Ghanaian government announced the suspension of its payments on external debt. The debt they owed to foreign countries and banks had risen from USD32.6 billion in 2019 to USD42.7 billion in 2022, or about 55% of gross domestic product (GDP). That year, inflation had jumped to 31.3%, up from just 10% the year before. The country was no longer able to make the debt payments it owed, and a restructuring—a negotiated alteration in the terms of the debt to make it affordable for the country—was required.

Foreign debt is a major concern for most countries. When it becomes unsustainable it can lead to sovereign debt crises, which are among the costliest events that can occur in an economy. And inflation is a key part of the story, as we show in this section.

Foreign debt is defined as debt that is denominated in a foreign currency. Usually it is also owed to foreigners and we will assume that this is the case, although sometimes part of it is owed to domestic residents. Both the government and domestic firms can owe foreign debt, and here we will focus on foreign debt owed by the government. (During economic crises, governments often end up taking responsibility for the debts of the private sector anyway.) The fact that the government has to repay debt to foreigners and in a currency that is not its own has important implications.

Macroeconomic policy affects foreign debt via the current account, which is defined as a country’s net income flows with respect to the rest of the world, including both the government and the private sector. The current account is usually driven by imports and exports, which in most cases comprise the largest income flows in and out of the country. But for highly indebted countries, debt payments can become very important.

The key concern is that when the current account is negative—for example, if the country is importing more than it is exporting, or it has high payments on foreign debt—then it will need to be borrowing from other countries in order to cover the difference. Like any economic actor, if a country’s income flows are less than its expenditure flows then it is in deficit and its stock of debt rises. In the case of a country, the borrowing is from other countries, meaning its foreign debt will rise.

If the economy is growing then rising foreign debt is not necessarily a problem—debt is a normal part of a capitalist economy. But economic crises due to excessively high foreign debt have been frequent and enormously costly for many low- and middle-income countries.

The current account

current account (CA)

The sum of all payments made to a country minus all payments made by the country. See also: current account deficit, current account surplus.

The current account (CA) tracks the income flows in and out of a country, including those due to both its government and its private sector. For any country other than the US, we can think of it as flows of dollars. Like any economic actor, those income flows determine the amount of debt that a country has. Here we show that the CA has three different interpretations that help us to understand the background to debt-driven inflationary crises.

The current account as net income flows

We start by considering the income flows in and out of the country. First consider the income that the home country receives from the rest of the world. It comprises:

A. Exports
B. Payments to home’s investments in foreign assets (for example, if a domestic firm invests abroad and receives income from that investment)
C. Unrequited transfers from other countries: mainly aid and remittances. (Unrequited here means not in exchange for any good or service.)

The reverse of each of these components (denoted with a \(´\) symbol) comprises home’s payments to, or expenditures on, the rest of the world:

A´. Imports
B´. Payments to foreigners that own domestic assets
C´. Unrequited transfers sent from home to other countries.

For each of the three categories we can take the net amounts \(A-A´\), \(B-B´\), \(C-C´\), which are home’s income minus home’s expenditure or outgoings. (B and C are not expenditures on goods or services, but they are outgoings or payments to another economic actor.) \(A-A´\) is net exports (NX). We will use the abbreviation NINV for net investment income \((B-B´)\) and the abbreviation NUT for net unrequited transfers \((C-C´)\).

The current account is therefore defined as

\[\text{CA} = \text{NX} + \text{NINV} + \text{NUT}\]

We incorporate this first definition into the national accounts as follows. Start with GDP of the home country, where the value of domestic product equals the components of domestic aggregate demand:

\[\text{GDP} = C + I + G + \text{NX}\]

To learn more about the components of GDP, read Section 3.3 of The Economy 2.0: Macroeconomics.

GDP is the value of everything produced in the home country (to simplify, assume inventory investment is included in \(I\)).

gross national income (GNI)

A measure of the total amount of income earned by residents in a country, irrespective of where the income was produced (within the country or abroad). It is different from gross domestic product, which measures the production within a country, irrespective of who owns the income that the production generates.

But now we are interested in all income received by the country, including income from abroad that is not associated with domestic production, and taking out income from domestic production that belongs to foreigners. So we need to add NINV and NUT, which gives us gross national income (GNI):

\[\begin{align*} \text{GNI}&=C+I+G+\text{NX}+\text{NINV}+\text{NUT} \\ &=C+I+G+ \text{CA} \end{align*}\]

This equation shows that GNI can be bigger or smaller than GDP depending on whether \(\text{NINV}+\text{NUT}\) is positive or negative.

We will now show that there are two further ways to interpret the CA that help us understand its role in the economy.

The current account as the change in net foreign assets

flow

A quantity measured per unit of time, such as weekly income, or annual carbon emissions. See also: stock.

stock

A quantity measured at a point in time, such as a firm’s stock of capital goods, or the amount of carbon dioxide in the atmosphere. Its units do not depend on time. See also: flow.

net foreign assets (NFA)

The difference between a country’s foreign financial assets and its foreign financial liabilities at a given point in time, i.e. what residents or the government own abroad (e.g., foreign bonds, equity, real estate, reserves) minus what foreigners own in the country (e.g., domestic bonds held by foreigners, FDI, external debt). Also known as: net international investment position (NIIP).

net foreign debt (NFD)

Net foreign debt (NFD) is equal to minus net foreign assets. When foreign liabilities are greater than foreign assets, NFD is positive.

Where the CA is a net flow of income, the corresponding stock is net foreign assets (NFA), known in official documents as the net international investment position. NFA adds up all the foreign assets of everyone in the economy, both public sector and private sector, and subtracts all of their liabilities to foreigners, including debt and any other investments that foreigners have made in the home economy. Thus these assets can include shares and direct investments abroad, and the liabilities include foreign ownership of domestic shares and foreign direct investment in the home country.

We can simplify, however, by assuming that all such assets are just bonds: that the home country’s foreign assets are foreign bonds that domestic actors have bought, and the home country’s liabilities are domestic bonds that foreigners have bought. On this assumption, if NFA is positive it means that the home country is a net creditor to the rest of the world: the world owes home more than home owes the world. And if NFA is negative, it means that the home country is a net debtor to the rest of the world: home owes the world more than the world owes home. So we also define net foreign debt (NFD) as minus NFA, so that NFD is positive when the home country is a net debtor. This is the case for many countries, and it has important implications for their economies, as we will discuss in Sections 6 and 7.

A positive CA means that the home country earns more dollars from the rest of the world than it spends, so it increases its stock of foreign assets. A negative CA means home spends more on assets from the rest of the world than it earns, so its stock of foreign assets declines. (We will ignore any changes in NFA due to changing valuations of assets, for example a rise in the price of foreign shares owned.) That is:

• A current account surplus implies that net foreign assets are rising (or net foreign debts are declining).
• A current account deficit implies that net foreign assets are falling (or net foreign debts are rising).

This means that

\[\text{CA}_t = \Delta \text{NFA}_t = \text{NFA}_t - \text{NFA}_{t - 1}\]

So our second interpretation of the current account is that it is also equal to the home country’s change in net foreign assets.

Before moving on, we can now elaborate on the NINV component in the current account equation. To simplify, assume that all international investment pays the same interest rate \(r^*\). Then net investment income is just this interest rate times net foreign assets:

\[\text{NINV}_t = r^*\text{NFA}_t\]

This is positive if the country is a net creditor to the rest of the world and negative if it is a net debtor. Below we will focus on countries that are net debtors (\(\text{NFD}>0\)), and for these countries,

\[\text{NINV}_t = r^*\text{NFD}_t < 0\]

Countries that are net debtors make net debt payments to other countries (their creditors). So our first definition of the current account can be rewritten to show that in this case NINV is negative and represents interest on foreign debt:

\[\text{CA} = \text{NX} - r^*\text{NFD} + \text{NUT}\]

The current account as national saving minus investment

We now show that there is also a third representation. First note that private saving, \(S^P\), is equal to national income minus consumption, \(C\), minus taxes, \(T\):

\[S^{P} = \text{GNI} - C - T\]

This equation assumes that all output is produced by the private sector. If there are public enterprises that make a profit, then that profit can be included in \(T\), since it also comprises income to the government.

Substitute this expression in the GNI equation to get

\[\begin{align*} S^P &= C+I+G+ \text{CA}-C-T \\ &= \text{CA}+I+G-T \end{align*}\]

government budget surplus

When the government budget balance is positive. See also: government budget balance, government budget deficit.

Public or government saving is \(S^G = T - G\), also known as the fiscal surplus (government budget surplus), so we use this equivalence to rearrange the equation in terms of total national saving, \(S\):

\[\begin{align*} S &=S^P+S^G \\ &= \text{CA}+I+G-T+T-G \\ &=\text{CA}+I \end{align*}\]

Thus

\[\text{CA}_t = S_t - I_t\]

So the current account in any particular year is equal to national saving minus domestic investment.

What is the intuition behind this?

• We know from the circular flow that spending must equal production, so money not spent on consumption must be spent on something else.
• In an economy that does not trade with other economies, this implies that national saving equals investment: for the economy to save, it must spend on capital via investment.
• In an economy that does trade with other economies, if saving is not equal to investment then the difference can go abroad:
  • Excess saving, \(S > I\), can be spent on foreign assets.
  • Excess investment, \(I > S\), can be funded by foreign debt.

Thus excess income which is not spent on goods and services will be spent on foreign financial assets, and excess spending will be financed by taking out foreign debt.

So we now have three representations of the CA:

1. Net foreign income:

\[\text{CA}_t = \text{NX}_t - r^*\text{NFD}_t + \text{NUT}_t\]

2. Change in net foreign assets:

\[\text{CA}_t = \Delta\text{NFA}_t\]

3. National saving minus investment:

\[\text{CA}_t = S_t - I_t\]

Using the current account to understand debt-driven inflation

These different interpretations help us to understand the background to many episodes of high inflation. Consider a country starting with a current account in balance that now wants to increase its expenditures. Perhaps it wants to increase investment without increasing savings, or it might increase the fiscal deficit, reducing national saving. Or it might want to sustain expenditure in the face of a decline in output, requiring a reduction in saving. In Ghana’s case, the government ran a fiscal deficit of 17% of GDP during the COVID-19 pandemic. Either way, the country moves into a position where \(S < I\), so from equation 3 (national saving minus investment), this means \(\text{CA} < 0\).

From equation 2 (CA as the change in net foreign assets), we can deduce that the country must borrow from abroad to achieve this. Thus \(\Delta\text{NFA}_t < 0\), meaning that either net foreign assets fall or net foreign debt (NFD) rises.

And equation 1 (CA as net foreign income) explains how this rise in debt occurs: typically the country is importing more goods to either consume or invest as capital, so NX becomes more negative.

This might be good policy if the borrowing is used to finance investments that have a higher return than the interest payments on the debt. The problem arises when this is not the case. For instance, as we will discuss further in Section 7, international interest rates were low in the 1970s, and many low- and middle-income countries used this opportunity to increase either domestic consumption (reducing saving, \(S\)) or increase investment, \(I\). So their NFD rose. But in 1979 international interest rates, \(r^*\), rose, which led to a jump in interest payments. The rise in \(r^*\) then worsened the CA (equation 1), leading to further increases in NFD (equation 2), further increases in debt payments (equation 1 again), and so on in a cycle of rising debt that rapidly became unpayable.

How does unsustainable debt lead to inflation? There are two mechanisms. First, it pushes up demand for dollars as the government scrambles to make its dollar debt payments. When a government owes dollar-denominated debt, but earns revenue in local currency, it needs to buy dollars to repay its debt. In a fixed exchange rate regime this rapidly uses up foreign exchange reserves, leading to devaluation. In a floating regime, it immediately implies depreciation as the government attempts to purchase more dollars using its domestic currency. This sparks a devaluation–inflation or depreciation–inflation spiral.

Second, the fiscal deficit worsens as the government’s debt payments rise. But at the same time, it becomes more difficult to finance the deficit with borrowing, because investors know that the country already has too much debt, and they fear default. This pushes governments to finance the deficit by printing money. We will discuss in Section 6 why this can quickly lead to rising inflation.

Foreign creditors have a claim over domestic output just as domestic economic actors do. And the conflict between them and the government is particularly challenging because the government has much less sway over them than it has over its own workers, firms, taxpayers, and recipients of public spending.

Internal balance and external balance

A country that has built up a large amount of foreign debt needs to find a way to fulfil its dollar debt payments. This means it may need to reduce its current account deficit. From equation 1 above, the obvious way to do this is to increase net exports. And the obvious way to increase net exports is to increase competitiveness by devaluing a fixed exchange rate, or by encouraging a floating exchange rate to depreciate by reducing the interest rate.

In this situation the country aims to raise the nominal exchange rate (\(e\)) in order to raise the real exchange rate (\(c\)). But this doesn’t just increase export earnings via NX. As discussed in Section 4, it also pushes up domestic prices, \(P\), undoing (some of) the real depreciation, pulling the real exchange rate, \(c\), back down again. This reverses the increase in competitiveness just achieved and can lead to the devaluation–inflation or depreciation–inflation spiral.

In this way, using a depreciation to increase the current account and pay off foreign debt can be self-defeating, because it leads to rising inflation. So how can a country get around this problem?

Based on our model of the macroeconomy, the way to avoid it is not to use monetary policy alone but also to use fiscal policy. In particular, the government can offset the cut in the interest rate with a tighter fiscal policy, by raising taxes or cutting spending. The fall in interest rates causes a depreciation while raising AD, and the fiscal tightening brings AD back down. In this way the government can try to keep AD stable at \(U^*\) to prevent the second-round effects of the rise in \(c\), breaking the inflationary spiral, while still achieving the real depreciation that improves the CA.

This is an example of a principle known as the Tinbergen rule, named after the Nobel Prize–winning economist Jan Tinbergen: that if you have \(n\) policy targets then you need at least \(n\) policy tools, or instruments. Here, if we want to sustain internal balance (moderate inflation and unemployment) at the same time as external balance (a sustainable current account deficit and foreign debt) then we can’t do it with just one instrument: we need at least two, and here we use both monetary policy and fiscal policy.

While this should work in theory, we should remember that fiscal policy faces many constraints in practice. Particularly for low- and middle-income countries with relatively weak government capacity, raising taxes in response to macroeconomic shocks may be very difficult: it might lead to more tax avoidance rather than more tax revenues. Given that, fiscal tightening may depend on cutting expenditure, which may mean cutting public education or health services, or public pensions, or public investment. Such cuts can both increase poverty in the short run and reduce growth in the long run. This helps to explain why low- and middle-income countries tend to have higher inflation and are more likely to suffer from a depreciation–inflation spiral: their policymaking is more constrained and their policy trade-offs involve much greater costs.