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Title: Balance of payments and exchange rate issues


1
Balance of payments and exchange rate issues
  • Session 7
  • Macroeconomics and the International Context
  • MSc Economic Policy Studies
  • Alan Matthews

2
Balance of payments
3
Lecture objectives
  • Describe and understand the balance of payments
    accounts
  • Do international payments imbalances matter?
  • Addressing international payments imbalances
  • Reading McAleese Chapter 20

4
Balance of payments
  • The balance of payments is a set of accounts
    showing all economic transactions between
    residents of the home country and the rest of the
    world in any one year
  • The current account in the balance of payments
    records all visible and invisible trade
  • The capital account covers mainly capital
    transfers (EU grants and migrants net worth)
  • The financial account in the balance of payments
    is a record of a countrys transactions in
    foreign financial assets and financial
    liabilities (often distinguishing between
    long-term and short-term flows)

CSO Student Corner on balance of payments
5
Balance of payments statement
  • Current account
  • Goods trade (merchandise trade)
  • Services
  • Trading and investment income
  • Current unilateral transfers
  • Balance on current account
  • Capital account
  • Financial account
  • Balance on financial account
  • Foreign direct investment
  • Portfolio capital
  • Other investment
  • Change in official reserves
  • Net errors and omissions
  • 2011, bn
  • 37
  • -2
  • -31
  • -1
  • 1
  • -0
  • 6
  • 11
  • 27
  • -33
  • 0
  • -7

Irish data. Source CSO Balance of
international payments release, Dec 2012
6
Some definitions
  • Merchandise trade similar to balance of trade
    account (see Trade lecture) but valued at f.o.b
    prices for both exports and imports
  • Invisibles refers to balance of services trade,
    investment income and current transfers (net
    current receipts from EU and Irish Aid
    expenditure)
  • Capital account transfers refer mainly to capital
    receipts under EU structural funds
  • Financial account includes long-term capital
    flows (FDI and portfolio investment) and other
    flows which are mainly short-term loans and
    transactions in financial derivatives
  • Reserve assets are non-euro denominated liquid
    assets and gold owned by the Central Bank

7
Further definitions
  • Sometimes distinction is made between autonomous
    and accommodating transactions in the balance of
    payments
  • Former are seen as active transactions,
    responding to real changes in competitiveness
    conditions, while latter are passive
  • Example consider reactions to an increased
    demand for imports
  • Line is drawn under the basic balance, but
    increasingly less distinct as capital markets
    become more liquid

8
Irish balance of payments trends
Year Merch-andise Invisibles Invisibles Invisibles Invisibles Balance on current account
Year Merch-andise Services Trading invest-ment income Current transfers Total Invisible Balance on current account
2002 35,442 -13,779 -23,664 707 -36,736 -1,295
2003 32,604 -11,091 -21,947 432 -32,606 -2
2004 31,423 -10,203 -22,481 393 -32,291 -867
2005 28,218 -9,303 -24,870 265 -33,908 -5,690
2006 25,031 -6,797 -24,033 -506 -31,336 -6,304
2007 19,811 -1,121 -27,825 -990 -29,936 -10,124
2008 23,811 -7,670 -25,155 -1,154 -33,979 -10,169
2009 32,469 -6,900 -27,907 -1,424 -36,231 -3,763
2010 35,751 -6,639 -25,918 -1,412 -33,969 1,782
2011 36,588 -1,810 -31,834 -1,159 -34,803 1,785
9
Borrowers and lenders, debtors and creditors
  • The balance of payments is a flow concept
  • It shows whether a country is a net borrower or a
    net lender in any year
  • A debtor nation is a country that during its
    entire history has borrowed more from the rest of
    the world than it has lent to it.
  • A creditor nation is a country that has invested
    more in the rest of the world than other
    countries have invested in it.
  • The difference between being a borrower/lender
    nation and being a creditor/debtor nation is the
    difference between stocks and flows of financial
    capital.
  • Does it matter if a country is a debtor nation?
    Depends on how the borrowing has been used.

10
International Investment Position
  • The international investment position (IIP) is a
    point in time statement of the value and
    composition of the balance sheet stock of an
    economy's foreign financial assets (i.e. the
    economy's financial claims on the rest of the
    world) and its foreign financial liabilities (or
    obligations to the rest of the world).
  • The change in the IIP between beginning and end
    of period is equal by definition to the current
    account balance over that period plus valuation
    changes reflecting changes in exchange rates and
    asset prices
  • Note reconciliation is also difficult due to
    large BOP balancing item net errors and
    omissions

11
Irelands IIP
Source CSO Quarterly International Investment
Position, Dec 2010
12
Source Lane, Dynamics of Irelands net external
position, SSISI, 2011
13
Source Lane, Dynamics of Irelands net external
position, SSISI, 2011
14
Understanding the balance of payments current
account
  • First, some national income accounting
  • Recall total income Y is defined from
    expenditure side as
  • Y C I G X M
  • Y can also be defined as
  • Y C S T
  • In equilibrium, these two definitions are
    identical
  • (I - S) (G T) (M X)
  • Balance of payments deficit excess investment
    over savings plus government budget deficit

15
Interpreting a current account deficit
  • Two views
  • A deficit is a sign that a country is spending
    more than it earns, a weakness which must be
    corrected by either/both reducing expenditure or
    switching expenditure from imports in favour of
    exports
  • A deficit is a sign of strength because it means
    the country is sufficiently profitable to attract
    continued flows of foreign capital (focus on the
    basic balance)

16
The importance of sustainability
  • A country is said to have a balance of payments
    problem when the current account deficit and the
    accumulated international investment position
    have reached a level where continuance of the
    deficit is no longer judged sustainable
    McAleese
  • Issues
  • Time dimension
  • Size of deficit in relation to GDP and debt
    position
  • Method of financing of deficit
  • Related to use of deficit (investment or
    consumption?)
  • Growth position
  • Sustainability a matter of market confidence

17
Correlation between cost of CDS and current
account
Source http//www.voxeu.org/index.php?qnode/282
0 EA Euro Area
18
Why an unsustainable current account deficit
matters
  • Adds to cost of foreign borrowing
  • Greater exposure to the volatility of
    international capital markets with potential for
    lack of confidence scenario (Asian crisis 1997)
  • May induce excessivly large exchange rate
    depreciation
  • Asset ownership moves into foreign hands
  • Within the euro zone a countrys balance of
    payments should matter no longer, but it remains
    an important symptom of underlying problems

19
Interpreting a current account deficit
  • McAleese tale of three deficits
  • US deficit
  • Developing countries debt
  • Deficits in Euroland

20
Sustainability of the US current account deficit
  • How sustainable is the deficit?
  • Will it keep downward pressure on the US dollar?
  • US deficit was running at around 6 of US GDP
  • US dollar has depreciated by 40 relative to the
    euro between Jan 2002 and Jan 2004

21
The US deficit is sustainable
  • Some argue our large trade deficit (or
    current account deficit) is responsible for the
    fall in the dollar's value. They have it
    backward. It is the flow of foreign investment
    dollars (the capital account) into the U.S.
    economy that drives the trade deficit. The U.S.
    economy's higher return on capital than Europe or
    Japan for the last 20 years caused private
    foreign investors to buy U.S. stocks and bonds
    and other assets. In addition, foreign
    governments, particularly of China, Japan and
    other Asian states, have steadily increased their
    purchases of U.S. dollars as reserve backing for
    their own currencies.
  • - Cato Institute economist Richard Rahn, Jan
    2004
  • Note similarity to Box 20.1 in MacAleese

22
The US deficit is not sustainable
  • High productivity growth and booming stock
    markets in the 1990s drove a wedge between
    private investment and savings
  • US household savings now fallen to 1 of GDP
  • US fiscal policy now hugely expansionary
  • Foreigners will lose their appetite to hold US
    assets, causing interest rates to rise and
    restricting demand

23
Prospects for a soft US landing
  • US economy insulated from the worst effects of an
    international financial crisis
  • Because of its size
  • The fact that most of its obligations are
    denominated in its own currency
  • International role of the dollar underpins demand
    for it
  • Damage may be felt as much by other countries as
    by the US

24
Correcting a balance of payments imbalance
  • Automatic adjustment mechanisms
  • Start with adverse shock to exports
  • -gt fall in demand for imports used as inputs to
    production
  • -gt fall in aggregate demand leads to fall in
    imports
  • -gt monetary factors such as fall in real balances
  • -gt supply side adjustments through changes in
    relative prices of traded/nontraded goods

25
Correcting a balance of payments imbalance
  • Recall (I - S) (G T) (M X), problem is to
    reduce excessive (M-X)
  • Expenditure reduction policies
  • Increase S
  • Reduce I
  • Reduce G T through restrictive fiscal policies
  • Expenditure switching policies
  • Commercial policy (tariffs, etc)
  • Improved cost competitiveness
  • Exchange rate changes

26
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27
Relationship between global imbalances and the
financial crisis
  • What role did global imbalances play in the
    crisis?
  • One view excess savings drove down real
    interest rates, led to underpricing of risk
  • Other view poor financial regulation was the
    cause
  • Suominen 2010

28
  • Capital flowing uphill
  • Driving by savings glut in surplus countries

Source King 2011
29
Challenges for the G20
  • How to address global imbalances when OECD
    countries are undertaking significant fiscal
    contraction?
  • Excess of global savings
  • Export-led growth model of China, Germany, Japan
  • Currency appreciation by surplus countries?
  • Alternatives?

30
Exchange rates
31
Motivations
  • Ireland has a high share of trade outside the
    eurozone in which exchange rates play a crucial
    role in determining competitiveness
  • Exchange rates are highly volatile
  • The level of exchange rates can cause problems
    for business
  • What determines the level and volatility of
    exchange rates?
  • Reading McAleese Chapter 21

32
US dollar/euro exchange rate
Euro depreciates
Euro appreciates
Source ECB Statistical data warehouse
33
Sterling/euro exchange rate
Euro depreciates
Euro appreciates
Source ECB Statistical data warehouse
34
The forex market
  • Note its size!
  • According to BIS, average daily turnover April
    2010 was 3.98 trillion (see Wikipedia entry)
  • Made up of a series of interrelated markets
  • Spot market
  • Forward market
  • Futures market
  • Derivative markets
  • Swaps and options
  • Determines the relative values of different
    currencies

35
The exchange rate
  • The price of foreign currency (dollar, sterling,
    yen) in terms of domestic currency (euro)
  • (viz. The price of apples how much do you have
    to pay in domestic currency)
  • Suppose it costs US citizen 1.99 to buy 1 GBP
    in 1991 and twelve years later it costs only
    1.58 dollar has appreciated
  • From UK perspective, I USD cost 50p in 1991 and
    63p in 2003 sterling has depreciated

36
Impact of exchange rate on firms
  • Advantages of a strong currency
  • Makes imported raw materials cheaper
  • Helps to control inflation
  • Leads to lower interest rates
  • Makes foreign assets cheaper
  • Disadvantages of a strong currency
  • Exporters lose price competitiveness
  • Adverse impact on competitiveness may be
    moderated if leads to lower wage demands

37
Effective exchange rates
  • Bilateral exchange rates do not move together,
    so we need some method to summarise the overall
    strength or weakness of a countrys currency
  • The nominal effective exchange rate (EER) is
    defined as the exchange rate of the domestic
    currency vis-à-vis other currencies weighted by
    their share in world trade
  • Which currencies
  • What weights?
  • Significance of the base year
  • Now called the Harmonised Competitiveness
    Indicator (HCI)

38
Source The Economist March 24 2012
39
Real Effective Exchange Rate
  • Real effective exchange rate (REER) also takes
    account of price level changes between countries
  • adjusts the nominal EER by the ratio of foreign
    to domestic inflation
  • Used to assess change in competitive position of
    a country relative to its competitors
  • Example
  • Suppose currency of country A has depreciated
    over one year by 10 against currency of country
    B
  • Suppose inflation rate in A is 7 and inflation
    rate in B is 2
  • Then real depreciation (change in REER) is 10 -
    (7 - 2) 5
  • Improvement in competitive position is 5, not
    the 10 suggested by the EER
  • Now called the real HCI

40
Source NCC, Irelands Competitiveness Scorecard
2012
41
Exchange rate determination
  • The exchange rate between two currencies is the
    price of one currency in terms of the other
  • Express the exchange rate as the number of US
    dollars (price) per euro
  • To determine the exchange rate we examine both
    the demand for and the supply of euros

42
The demand for euro
  • A derived demand
  • Americans want euro
  • in order to pay for European goods and services
    (exports)
  • In order to pay for European assets including
    government bonds, equities and property

/
2
Depreciation
1
0.5
Euro
43
The supply for euro
/
  • A derived supply
  • Europeans want dollars
  • in order to pay for American goods and services
    (imports)
  • In order to buy American assets including
    government bonds, equities and property

2
Depreciation
1
0.5
Euro
44
Exchange rate equilibrium
/
S
D
45
Factors which shift the demand or supply curves
  • Interest rate differentials
  • Shifts in demands for assets
  • Inflation differentials
  • If EU goods become more expensive
  • Growth differentials
  • Stronger growth usually associated with stronger
    currency
  • Speculation
  • Expectations about future exchange rates
  • Affected by above factors as well as stance of
    economic policy (budget deficits, balance of
    payments deficits, political outlook as well as
    market psychological factors)

46
Reaching a new equilibrium
  • Suppose euro interest rates rise
  • Will increase demand for euro from US investors
  • Will decrease supply of euro as EU investors also
    shift from US to EU assets
  • Euro appreciates
  • /

D2
S2
D1
S1
47
Exchange rate equilibrium
  • How can we tell if a currency is over-valued or
    under-valued?
  • Is a currency likely to appreciate or depreciate
    in the near future?
  • Answers provided by
  • Purchasing Power Parity theory
  • Balance of payments approach
  • Asset market or portfolio theories

48
Purchasing power parity
  • PPP model holds that, in the long run, exchange
    rates adjust to equalise the relative purchasing
    power of currencies
  • Draws inspiration from Law of One Price
  • Arbitrage will ensure price levels converge
  • Absolute PPP
  • The exchange rate will be such as to make the
    general level of prices the same in every country
  • Exchange rates between currencies are in
    equilibrium when their purchasing power is the
    same in each of two countries
  • Unrealistic assumptions
  • Difficulties with non-traded goods

49
Purchasing power parity
  • Relative PPP
  • Changes in the exchange rate are determined by
    the difference between relative inflation rates
    in different countries
  • Over the long run we would expect exchange rates
    to adjust to maintain purchasing power parity
  • In other words, exchange rates should adjust to
    offset differences in the rates of inflation,
    maintaining a constant real exchange rate
  • Do exchange rates adjust to maintain purchasing
    power parity?
  • Yes, in the long run, but very slowly for reasons
    that are still unclear (see Rogoff JEL 1996)

50
Purchasing power parity
  • How is PPP calculated?
  • The Economist Big Mac index
  • People consume very different goods and services
    across countries
  • Standard estimates produced every six months by
    OECD/Eurostat (OECD PPP database)
  • OECD estimates in next chart compare the PPP of a
    currency with its actual exchange rate compared
    to US dollar. Green bars (top of chart) indicate
    currency is overvalued and thus expected to
    depreciate against he US dollar in the long run,
    and vice versa.

51
OECD PPP estimates(relative to Euro)
Source University of British Columbia Pacific FX
Service
52
PPP uses
  • Clearly there are significant discrepancies
    between PPP and actual exchange rates
  • But can PPP be used to predict exchange rate
    changes?
  • Poor empirical performance
  • Real exchange rates not only determined by
    relative inflation differentials
  • Real exchange rates can and do change
    significantly over time, because of such things
    as major shifts in productivity growth, advances
    in technology, shifts in factor supplies, changes
    in market structure, and commodity shocks
  • Note objection Rapid productivity growth -gt
    higher inflation -gt currency appreciation
    (Balassa-Samuelson effect)
  • But important long-run benchmark

53
Balance of payments approach
  • BoP approach focuses on relationship between
    trade/current account balance, modified to taken
    into account long-term capital flows, and the
    exchange rate
  • BoP approach also allows ER to be influenced by
    real factors (economic fundamentals)
  • Country with a persistent deficit is likely to
    devalue, country with persistent surplus likely
    to revalue
  • Different to, but consistent with, PPP theory
  • PPP -gt If country A has higher inflation rate
    than B, will run into a deficit and be forced to
    devalue

54
Examples of economic fundamentals
  • These are factors which can shift the supply and
    demand curves for a currency (see above)
  • Changes in the growth rate
  • Balance of payments (influencing expectations)
  • Equity and bond market performance
  • Size of budget deficits and public debt
  • Governance and political stability

55
Asset market (portfolio) explanations
  • PPP and BoP approaches focus on role of ER in
    balancing flows of foreign exchange
  • Modern approach emphasises role of ER in
    balancing the supply and demand of domestic and
    foreign assets
  • Exchange rates adjust to reflect differences in
    the rate of return on assets (bills and bonds) in
    different currencies
  • It is differences in the expected total return
    which is relevant. This comprises the interest
    rate on foreign assets plus the capital gain
    (loss) from a appreciation (depreciation) of the
    foreign currency

56
Asset market explanations
  • Expected exchange rate changes (and hence the
    expected capital gains or losses from investing
    abroad) influence decisions
  • Because expectations are influenced by news,
    and news is unpredictable, so are short run
    fluctuations

57
Interest rate parity
  • What determines international capital portfolio
    movements?
  • Difference between interest rates at home and
    abroad
  • Expectations about future exchange rates
  • Interest rate parity describes the relationship
    between forward exchange rates, spot exchange
    rates and interest rates between two countries
  • Rates of return on comparable assets should be
    equal around the world, implying that exchange
    rates adjust so that difference between interest
    rates is zero.
  • It relies on the markets tendency to correct
    itself through arbitrage
  • Two versions
  • Uncovered parity
  • Covered parity

58
Uncovered interest rate (UIP) parity
  • If US risk-free interest rate is 4 and euro rate
    is 2, why do fund managers not switch into
    dollar assets?
  • Domestic interest rate less foreign interest rate
    expected change in exchange rate (Uncovered
    interest rate parity)
  • Assumes
  • Perfect capital mobility
  • Equal risk on home and foreign bonds
  • If interest rate differential is greater than the
    expected change in spot rates, potential for
    arbitrage

59
Covered interest rate (CIP) parity
  • Borrow money in one currency (low interest rate),
    use to buy bonds in second currency (higher
    rate), and protect (cover) against exchange rate
    movements by buying the first currency forward
  • Interest rate differences should equal the
    forward premium (covered interest rate parity)
  • Forward exchange rate is a proxy for exchange
    rate expectations. UIP builds on CIP by assuming
    that market forces ensure the forward exchange
    rate is equal to the expected future spot
    exchange rate
  • However, forward exchange rate is not a good
    (although unbiased) predictor of the spot rate
  • Underlines that exchange rates are affected by
    shocks which are inherently unpredictable

60
Empirical performance of interest rate parity
  • Does (uncovered) interest rate parity hold?
  • Hard to measure, since requires information on
    expectations and on relative risk of bonds
  • Cause or effect?
  • if it holds, does it mean that interest rate
    differentials determine exchange rate changes, or
    vice versa?

61
One effort to measure desired equilibrium
exchange rates
Cline and Williamson, 2012, Peterson Institute
62
Summary
  • Exchange rate movements are an important
    determinant of competitiveness
  • Although we can understand the factors which move
    exchange rates, their movement is very hard to
    predict
  • Modern theory emphasises how the importance of
    the balance of trade in goods and services (the
    real economy) in influencing exchange rates is
    overwhelmed by international capital movements,
    whose movement is very hard to predict
  • Firms can adapt strategies to insulate partially
    against exchange rate movements, but they are
    partial and costly
  • International coordination of exchange rates?

63
Euroland issues
Source EEAG report 2012
64
Source EEAG report 2012
65
Source EEAG report 2012
66
Restoring Irelands competitiveness
  • Within the EU, commercial policy and exchange
    rate changes are ruled out
  • Expenditure reduction policies (i.e. fiscal
    tightening) can lead to severe economic
    contraction and rise in unemployment
  • Reduction in nominal wages required to mimic a
    real devaluation internal devaluation - , but
    how to achieve?
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