Chapter

IV Flow of Funds

Author(s):
Marcello Caiola
Published Date:
August 1995
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The analysis of the financial developments of a country and the preparation of a financial program are greatly facilitated by the use of a “flow of funds” table. Besides showing the interrelation between the different sectors of the economy, such a presentation ensures consistency of the available data, thus assuring that the data base used to analyze or project financial variables is reliable. It should, however, be recognized that for several countries, preparation of a flow of funds is seriously hampered by limited information and the uncertain quality of data.3

A flow of funds table, whether it is used to review past developments or to project financial transactions, aims at presenting the flows of financial resources among the sectors of the national economy and between a country and the external sector. It is important to remember that the economic sectors receiving an income are not necessarily those that spend it. In other words, income and expenditure are not necessarily identical in the individual economic sectors.

In preparing a flow of funds table, there are two guiding issues: the purpose of the exercise, and the relevant sectors of the economy under analysis. As a result of financial transactions, every sector of the economy generates either an overall surplus (if its income is higher than its expenditures) or an overall deficit. Flow of funds analysis then would be aimed at identifying whether an individual sector had an overall surplus or a deficit, determining the origins and causes of these surpluses or deficits, and calculating how the surplus was utilized or the deficit financed. Deficits would be financed either internally—by the surplus of other sectors—or externally.

What was said about individual sectors applies also to the country as a whole, except that the overall surplus or deficit of a country would provide financing to, or be financed by, the rest of the world. This overall surplus or deficit may be called a “resource gap,” because it represents the resources that were missing to finance expenditures (in the case of a deficit) or the resources in excess after financing expenditures (in the case of a surplus). Basically, the resource gap is the difference between savings and investment. Even better, it is that portion of investment that could not be financed by internal savings, or the excess internal savings after financing investment.

The purpose of analyzing the financial developments of a country is to identify inductively the sectors that either required or generated financing, the flows of the financial surpluses and deficits, and the origins of these surpluses and deficits. In preparing a program, the purpose of the exercise is to identify the resource gap (surplus or deficit) that would be acceptable and the sector that would be expected to provide or require financing. This identification of past and potential problem areas facilitates the decision-making process in the country.

To be useful, a flow of funds analysis has to cover a certain number of years, thus becoming a dynamic rather than a static presentation. For example, if a country has an increase in its resource gap over a given period, the question is whether the widening of the gap was due to a drop in savings or an increase in investment, or a combination of the two. Also, it would be useful to know whether the resource gap was financed by genuine external resources or by use of net international reserves (including accumulation of arrears). Within the economy, the domestic sectors that face difficulties should be identified, because the policy action would have to be directed toward solving the problems of those sectors. By identifying the relationships between the different sectors (including the external sector), the policymaker can select the best possible course of action and recognize the implications of policies on the various sectors.

On this basis, a flow of funds presentation to facilitate analysis could be as follows:

  • Income

  • Consumption

  • Savings (income minus consumption)

  • Investment

  • Resource gap: surplus/deficit (savings minus investment)

  • Internal financing (zero at national level)

  • External financing

Income and consumption could be replaced by current receipts and expenditures, depending on the quality of the national accounts and/or whether a reconciliation with the national accounts is sought.

Next, the sectors must be identified. A flow of funds table should show separately the external sector and the operations of the financial system. The external sector should be shown, because a key aspect of the exercise is to quantify the resources obtained from, or supplied to, the rest of the world as a result of domestic transactions—in other words, the resources that the country can obtain from abroad to complement domestic resources. Moreover, data should identify the kind of capital movements involved—direct investment, borrowing, and/or lending—as well as whether external savings were supplemented by use of the country’s net international reserves.

The function of the financial system is of critical importance in a country. As mentioned before, income and expenditure are not necessarily identical at the level of an individual economic sector. Financial transactions represent the flows between the sectors that save and those that spend. The financial system plays the intermediary role of attracting and redistributing financial savings, thus making the economy more efficient. The financial system, as the only sector that can extend credit over and above what the community has saved or wishes to save, is also the sector in which inflationary pressures of domestic origin are generated.

The presentation of other sectors would depend on the circumstances of the country and on the availability of data. By and large, the nonfinancial public sector and the private sector should be shown separately. The former could be further divided to show separately the operations of the central government, the rest of the general government, and the state enterprises, if the transactions of those individual subsectors were important enough to warrant individual treatment. If the central government accounts for most of the public sector transactions, little would be gained by desegregating the public sector. In contrast, if state enterprises play an important role in the economy in terms of savings (positive or negative), investment, and financing requirements, the analysis would be enhanced by showing their operations separately. Similarly, the private sector could be expanded into household and enterprises, provided that reliable information is available on their transactions.

To summarize, all financial transactions of an economy would be classified or attributed to certain basic categories that, broadly speaking, would cover the nonfinancial public sector, the private sector, the financial sector, and the external sector. No other sector exists, and all flows among the selected sectors must add up to zero. In analyzing a country’s activities, it is very important that nothing be left out if a full picture is to be gained; to ensure data are comprehensive, all transactions must be attributed to a basic category and to only one category. Since all transactions must be attributed to individual sectors, one of these sectors should also include all errors, omissions, and statistical discrepancies. The private sector usually serves as this residual, because in developing countries there are seldom independent, reliable estimates on private sector operations. The coverage of a category may change from country to country, depending on the circumstances, but once a country’s categories are defined, their coverage must be maintained for the sake of consistency. Thus, the nonfinancial public sector in the case of the United States may cover only the federal government, whereas in another country it may include the rest of the general government and the state enterprises.

All transactions in a country are either operations within a category, or operations between two categories. Operations within a category nullify each other and will add up to zero at the category level. What remains are operations between the category. For instance, if the nonfinancial public sector were consolidated into an individual category, transfers between the central government and the rest of the public sector would represent operations within a category, and at the public sector level they would be equal to zero. On the other hand, central bank credit to the government represents a transaction between two categories: the financial sector and the public sector. Naturally, all internal financing transactions among the categories will also add up to zero when viewing the economy as a whole. In other words, credits from the financial system to the public sector must be equal to the credit received by the public sector from the financial system. Appendix II presents a simplified version of a flow of funds table aimed at presenting the interrelations of the accounts of the different sectors.

As mentioned before, there may be transfers among domestic sectors, and in this respect the banking system is very important; it is basically the only sector that may obtain resources from one sector (for example, the private sector) and transfer them to another sector (for example, the public sector). What is not financed domestically—transfers among the public, private, and financial sectors—is the gap that is financed from abroad.

The categories also facilitate analysis of what is going on in the economy, such as which sector financed, or could finance, a certain deficit. Indeed, a policy decision affecting one category may have an impact on other categories. At the same time, each category reacts to different incentives or disincentives.

Bearing this in mind, let us look at the different components of the matrix in Appendix Table II-1:

  • Domestic savings are a function of internal policies (broadly defined) and of decisions made in both the public and the private sectors. Domestic savings depend on the income of the sectors as well as on the desire or possibility to consume. Therefore, domestic savings are both a function and a reflection of wage policy, pricing policy, supply of goods, exchange rate, interest rate, etc. It should be noted here that if wages are increased and domestic prices of certain exportable goods are kept low, there may be a shift from exports to local consumption.

  • Investment depends on domestic policies and decisions, as well as on the availability of internal resources (savings and borrowings from other domestic sectors) and external resources. The potential investor looks at the expected rate of return, direct taxation, other tax laws (for instance, rate of depreciation), market feasibility, know-how, etc. Government decisions to invest may depend also on political and social considerations, regardless of the financing available.

  • A resource gap at the national level is equal to foreign financing; at a sectoral level, it is equal to the financing from other domestic sectors plus external financing. Therefore, it depends partly on internal policy decisions, such as credit distribution and interest rate structure.

  • Internal financing depends on internal decisions of the government and of the private sector (credit distribution, interest rates, accrual of financial savings, legal reserves, open market operations, and floating debt). The private sector’s reaction to certain government decisions may differ considerably from the government’s expectations. Since internal financing is zero on the national level, a program cannot envisage that all sectors would be borrowing domestically.

  • External financing depends on internal decisions (how much to borrow or whether to invest private financial savings abroad) and on external decisions. Foreign financing may be supplemented by use of net international reserves and/or accumulation of arrears.

If a sector spends more than its resources, this excess should be compensated by other sectors. Thus, if the public sector has negative savings and, nevertheless, would like to carry out a certain investment plan, it will have to borrow either from the other domestic sectors or from abroad.

The following is a numerical example of the above. Suppose that the projected financial flows of a country were as follows:

  • Investment plans are scaled down to 350, which is the amount that can be financed by the projected savings (200) and external capital inflows (150).

  • External financing is increased either by drawing down the net international reserves (provided that the monetary authorities have such reserves) or by increasing the foreign borrowing, which would depend also on the willingness of foreign lenders; in addition, the impact of future debt service would have to be taken into account. Also, measures would have to be taken to improve the creditworthiness of the country.

  • Savings are increased either by raising the available income through measures aimed at fostering economic activity in general or by reducing consumption.

  • A combination of all of the above could be used.

Income2,000
Consumption1,800
Savings200
Investment
External financing150
Capital movements150
Changes in net international reserves (increase −)

If the government’s plans call for an investment of 550, the following alternatives are possible:4

At the sectoral level, the analysis would be similar, except that the sector could also be financed domestically, in which case the impact on the other sectors of this additional borrowing would have to be taken into account. For instance, if the fiscal deficit is considered to be too large, and a decision is taken to reduce it, what will be the impact of this decision? The objective would be achieved through higher revenue, lower expenditures, or a combination of the two, but these actions would have an impact (to be determined) on other sectors of the economy. If the fiscal deficit cannot be reduced, it would require additional financing, which would also have an impact on the rest of the economy.

After the fact, the surplus or deficit of each sector must be compensated for. There is no alternative. In the planning stage, the equality between a sectoral deficit and its financing is a condition of equilibrium. In other words, the planned surplus or deficit must be equal to the planned financing. Therefore, each column must add up to zero, and, similarly, the internal financing at a national level must be equal to zero.

The main sources of information on financial transactions are financial statements. Since these statements are geared to meet the needs of a vast number of institutions, the form they take can differ from institution to institution. Flow of funds accounting, therefore, must first concern itself with establishing a framework within which financial data can be reconciled to facilitate macro-economic analysis. This reconciliation takes place on two levels: by translating financial data into a unique classification framework and by deriving a consistent set of data so that the transactions between any two units are represented by identical values in the accounts of each unit.

The completeness of the flow of funds table depends on the amount and quality of information at the disposal of the compiler. Appendix II presents flow of funds tables for a country (El Salvador) for which a fair degree of detailed information is available. However, in many developing countries, limited data are available. Nevertheless, flow of funds tables can still be prepared. Appendix II also gives two examples (referred to as Simulations A and B) of flow of funds tables derived from very limited information.

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