BALANCE OF TRADE

1
BALANCE OF TRADE

• The balance of trade measures visible goods (i.e.
  of a physical merchandise nature) in trade on
  current account
• Exports result in an inflow of money and are
  treated as a credit item
• imports result in an outflow and are treated as
  a debit item
• Balance of Trade
• visible exports - visible imports
• At present Ireland enjoys a substantial balance
  of trade surplus
• This is mainly due to the activities of
  multinational companies in Ireland who export in
  great amounts abroad (using transfer pricing)

2
BALANCE OF PAYMENTS

• The balance of payments includes invisible items
  in trade
• Factor flows relate to money which is earned in
  one country yet repatriated to another
• - in Ireland multinational companies make large
  profits which are
• repatriated overseas (mainly US) leading
  to a negative flow repatriation back
• home from Irish companies abroad would
  lead to a positive flow
• - repayment of interest on foreign debt would
  also lead to a negative flow
• - in past emigrants remittances were received in
  large amounts from
• Irish workers abroad
• Services e.g. tourism, financial services,
  software development now increasingly are traded
  internationally.
• Overall, services is now greater in value than
  merchandise trade with Ireland ranked 9th in the
  world for exports of services
• - There are very large invisible exports in
  software (with Ireland ranked no. 1
• internationally in this category
• - however equally there are large invisible
  imports with respect to consultancy
• services and royalty payments by
  multinational companies

3
BALANCE OF PAYMENTS (con)

• Invisible payments also arise due to
  international transfers of funds
• Ireland is a member of the EU and contributes to
  and receives money from the EU budget
• - in past Ireland received much more from budget
  than it contributed
• - however because of substantial income growth
  during the Celtic
• Tiger years we are contributing more and
  receiving less
• Overall there is a massive deficit on invisible
  trade in Ireland
• This largely wipes out the surplus on the trading
  balance so that we now have just a small surplus
  on the balance of payments
• Balance of Payments (on current account)
• (visible invisible exports) (visible
  invisible imports)

4
BASIC BALANCE

• Trade also takes place in capital items
• Long term capital transactions involve activities
  such as investment by foreign companies in
  Ireland and Government foreign borrowing (for
  capital purposes)
• Short terms capital transactions reflect
  financial activity of stock markets
• Capital transactions by their nature tend to be
  very volatile
• When net capital transactions are added to
  current we get the overall balance of payments)
  referred to as the Basic Balance
• In the past corrective action had to be taken by
  governments when a large basic balance existed
• - now because of membership of the Eurozone the
  overall balance for
• this bigger region is more important

5
DEFINITION OF EXCHANGE RATES

• An exchange rate measures the value of one
  currency in terms of another
• As with goods and services, the values of a
  currency against another is determined by demand
  and supply
• When goods are exported from Ireland payment must
  be made in our currency (i.e. the euro)
• When goods are imported into Ireland - say from
  the UK - payment must be made in the UKs
  currency (i.e. sterling)
• When the euro rises - say against sterling or the
  dollar - it becomes more expensive to sell goods
  in the UK and the US (but cheaper to import from
  these countries)
• When the euro falls against these currencies it
  becomes cheaper to sell abroad but more expensive
  to import

6
EXCHANGE RATES (con)

• Factors determining exchange rates - demand for
  exports and imports - inflationary pressures -
  changes in interest rates - speculation -
  political factors    
• Intervention on Foreign Markets - using reserves
  - borrowing abroad - raising interest rates -
  deflationary policy - supply-side policies -
  controls on imports

7
Determination of the rate of exchange
S by UK
price of
D by USA
Q of
8
EXCHANGE RATES

• Fixed  
• - absolutely fixed - adjustable pegs -
  crawling pegs      
• Floating  
• - pure - managed      
• Basket of Currencies  
• - composite mix of currencies - examples  

9
FIXED RATES

• Advantages  
• - creates more certain environment for trade
• - reduces speculation
• Disadvantages  
• - creates strains in terms of managing Balance
  of Payments
• - not in keeping with market approach - can
  lead to instability and damaging devaluations
  (and
• revaluations)

10
External Reserves

• European Central Banks reserve assets, December
  2000
• 
  billions
• Foreign exchange 234.1 59.5
• SDR 4.3 1.1
• Reserve position at IMF 20.8 5.3
• Gold 117.8 29.9
• Other claims 16.4 4.2
• Total
  393.4 100.0
• Source European Central Bank, Monthly Bulletin,
  November 2001, Table 8.7.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
11
Fixed versus Floating Exchange Rates

• Advantages of free-floating rates
• automatic correction
• no problem of international liquidity
• insulation from external events
• less constraint on domestic macro policy
• Disadvantages of free-floating rates
• possibly unstable exchange rates
• speculation
• uncertainty for business
• but use of forward markets
• lack of discipline on economy

12
Fixed Exchange Rate Systems

• Gold Standard (1870 1914)
• Currencies fixed to gold.
• Bretton Woods (1945-71)
• fixed to gold (35/1 ounce). All other
  currencies fixed to .
• Establishment of IMF and World Bank.
• Snake System ( 1973-78)
• European currencies held inside a band of /-
  1.125 around a central rate.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
13
Gold Standard (1870-1914)

• Currencies fixed to gold.
• Automatic adjustment mechanism which removes BP
  surpluses or deficits.
• BP (-) ? currency outflow ? ?Ms ? ?P ?
  improvement in competitiveness ? removal BP (-)
• Note incorporation of Quantity Theory.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
14
Exchange Rates and Balance of Payments

• Exchange rates and the balance of payments
  government intervention
• reducing short-term fluctuations
• using reserves
• borrowing from abroad
• changes in interest rates
• maintaining a fixed rate of exchange over the
  longer term
• deflation / reflation
• supply-side policies
• import controls

15
FEATURES OF ECONOMIC UNION

• Single market for persons, goods, services and
  capital
• High level of co-ordination of economic policy
• - esp. central control of fiscal policy
• Greater role for competition policies
• Structural Funds
• - transfer of funds to weaker countries

16
FEATURES OF MONETARY UNION

• Total and irreversible convertibility of
  currencies
• Complete liberalisation of capital movements
• Full integration of banking and other financial
  markets
• Elimination of margins of fluctuation and
  irrevocable locking of exchange rates (implying a
  single currency)    

17
ADVANTAGES OF EMU

• Symbolic of overall union
• Would reduce transaction costs for business
• Would eliminate uncertainty due to exchange rate
  adjustments facilitating trade
• Individual countries do not have to hold reserves
  as all are pooled
• Would encourage more co-ordination of economic
  policies
• Beneficial effects on efficiency
• Currency would become international reserve asset
  
• Help to reduce interest rates
• Help to reduce inflation
• Could facilitate overall growth and employment in
  Community    

18
Why Join EMU? Economic Benefits

• 1. Completing the internal market.
• A. Single currency increases price transparency.
  
• Should lead to a convergence of prices in
  Eurozone.
• Indirect taxes still a serious problem.
• B. Elimination of exchange rate transaction
  costs. Savings of about 0.5 of GDP.
• Downside is a fall in earnings in financial
  sector.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
19
Continued

• 2. Reduction in exchange rate uncertainty.
• Should stimulate trade and investment.
• But little evidence to support this view. Trade
  between USA and Japan has grown dramatically even
  though the exchange rate is flexible.
• Also 60-70 per cent of Irish trade is outside the
  Eurozone. Still very exposed to swings in the
  dollar and sterling exchange rates.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
20
Continued

• 3. Scale economies.
• Firms spread plants around Europe to hedge
  against currency movements. Now build plants to
  reap economies of scale.
• Lead to regional specialisation and an efficiency
  gain.
• However, peripheral regions could suffer a
  decline as firms shift to the centre.
• Could be a cost as far as Ireland is concerned.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
21
Continued

• 4. Low inflation.
• Inflation is determined by the ECB. Given the
  single currency, this inflation rate should be
  transmitted (on average) to the rest of the
  Eurozone.
• In effect, Irish inflation has diverged
  considerably from EU rate.
• Argued that this is better than an anti-inflation
  policy based on internal rules (doing it for
  ourselves).
• Note that Ireland had achieved a low inflation
  rate prior to EMU entry.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
22
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
23
Continued

• 5. Low interest rates.
• Given the single currency, there can be only one
  interest rate in the Eurozone.
• The current rate represents a significant fall
  for high interest rate countries like Ireland,
  Spain, Portugal and Italy.
• In 2002, real interest rates were negative in
  several Eurozone countries.
• Represents a transfer of resources from savers to
  borrowers.
• Also major implications for macroeconomy.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
24
? Leddin and Walsh Macroeconomy of the Eurozone,
2003
25
POSSIBLE DISADVANTAGES

• Considerable loss in national sovereignty
• Effects might not be equally spread throughout
  Community
• Possible difficulties in dealing with crisis
  situations
• No guarantees in relation to stability of
  currency in relation to other world currencies
• Special problems for Ireland (in relation to UK
  and US currencies)
•  

26
Costs Associated with EMU Membership

• 1. Transition costs.
• A. 1 1.269738 or 1 0.787564. Euro prices
  are 27 higher.
• Introduced on the basis of new currency same
  price.
• Does not appear to be the case. Survey by the
  Consumer Association of Ireland found that the
  euro resulted in price rises in a whole range of
  products and services.
• B. Cost to banks is around 130 m .
• C. Cost of adopting new international payments
  system.
• D. Cost of withdrawing domestic notes and coins.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
27
Continued

• 2. Problem of adjustment within a monetary union.
• Economy can suffer asymmetric shocks.
• For example, swings in sterling and dollar
  exchange rate, foot and mouth disease, downturn
  in US economy, September 11th.
• In EMU, countries no longer have control over the
  money supply, interest rates or the exchange
  rate.
• Also fiscal policy is constrained by the
  Stability Pact.
• Represents a considerable loss of economic
  independence.
• A country may find itself in recession and be
  unable to do anything about it.
• Raises key issues regarding present EU response
  to deepening recession?

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
28
Continued

• EMU results in a loss of economic independence.
• No longer has a country control over money
  supply, interest rates or the exchange rate.
  Fiscal policy is constrained by the Growth and
  Stability Pact.
• Means the burden of adjustment switches from
  monetary and fiscal policies to the wage
  adjustment effect and an international
  competitiveness effect.
• But the labour market is much less flexible than
  the money market (and good reasons to believe
  that it has proven ineffective with respect to
  adjustment in Ireland).
• Result is that the economy may be slow to adjust.
• Booms and recession may last longer giving rise
  to the possibility of abrupt or hard landings.

? Leddin and Walsh Macroeconomy of the Eurozone,
2003
29
EMU AND IRELAND (Con)

• Economic Benefits  
• - completing internal market
• - price transparency
• - reduced transactions costs
• - reduction in exchange rate uncertainty
• - scale economies  
• Economic Costs  
• - transition costs
• - difficulty in adjusting to shocks
• - loss of fiscal autonomy
• - loss of economic independence
• - loss of unemployment/inflation trade-off

30
EMU (PRESENT PROBLEMS)

• During early years of Euro currency, banks from
  all countries had access to a huge largely
  unregulated market for both loaning and borrowing
  funds
• In some countries, such as Ireland huge bank
  debts arose as result of property crash however
  this problem was not confined to Ireland with the
  bulk of these loans relating to lending by other
  EU banks (esp. UK, Germany and France)
• Official policy of the ECB - fearing a huge
  possible bank problem in many countries
  initially was that all bank loans (to senior
  bondholders) should be fully honoured and was
  enforced in Ireland. This policy was totally
  unfair however from a social perspective as it
  placed all the burden of adjustment on
  shareholders and (innocent) taxpayers while not
  penalising the rash lending policies of the EU
  banks which significantly contributed to this
  problem
• Huge burden of adjustment now being felt by
  peripheral economies (such as Greece, Ireland and
  Portugal) then Spain and Italy and more recently
  Cyprus as the stronger economies such as France
  and Germany seek to protect national interests.
• Lack of sufficient political integration is
  endangering the future of the Euro which now
  requires radical interventions to stem market
  fears

31
EMU (PRESENT PROBLEMS con.)

• Possible responses would include
• - a dramatic increase in size of European
  Satbility Mechanism (ESM) that has European
  Finance and Stability Facility (EFSF) and
  European finacial stabilisation Mechanism (EFSM)
  to meet possible costs of bailing out larger
  economies such as Spain and Italy. (This however
  is likely to be resisted strongly by Germany
  which would be expected to be main contributor).
• - a reversal of traditional ECB policy towards
  quantitative easing (as has happened in US). This
  would enable the ECB to effectively create
  additional money which then could be used to buy
  bonds (at lower interest rates than market) from
  countries that are finding it presently expensive
  to borrow. However this would also be likely to
  sharply increase inflation (though this would
  have the virtue of reducing the real cost for
  countries like Ireland of redeeming debt). Though
  some relaxation has taken place under Mario
  Draghi, once again this proposal is likely to be
  resisted strongly by Germany and will only be
  considered in the context of substantial
  tightening of fiscal controls agreed to when
  signing the new fiscal Treaty (the fiscal
  compact).
• - the issuance of a common Euro bond (backed by
  all Eurozone countries) for at least a
  significant proportion of a countrys borrowing
  needs. However this would mean higher rates of
  interest for countries such as Germany (who once
  again are opposed to this idea).
• - The imposition of austerity through a
  significant increase in intervention by the EU in
  each members domestic fiscal policy and banking
  policy controlling all key targets and decisions.
  Though favoured by Germany this would lead to a
  considerable loss of national sovereignty (and be
  resisted by member governments). Also it would
  significantly increase danger of recession
  throughout Europe.

32
EMU (PRESENT PROBLEMS con.)

• - the large scale default of commitments to
  senior bondholders at both a private banking and
  - possibly - sovereign level. Many observers
  believe that Ireland will eventually be forced
  down this route. However the possible
  implications both political and economic are hard
  to forecast
• Acceptance that the Eurozone is not working in
  its present form preparing the way for its
  possible breakup.
• One favoured scenario would see the stronger
  economies (inc, Germany, France, Austria,
  Holland, Finland, Luxembourg form a hard Euro
  would other economies possibly including Ireland
  former a softer Euro (that would initially
  undergo considerable devaluation against the hard
  currency).
• Another scenario would have strong countries
  like Germany leaving to once again restore their
  national currency with other countries continuing
  in a more flexible Eurozone. Another possibility
  is that the weaker peripheral economies would
  leave reverting to national currencies that would
  eventually try and track the Euro. What Ireland
  would take in this scenario is very difficult to
  say as there are problems with all possible
  options

33
PRESENT PROBLEMS (and Ireland)

• Ireland is still in a bail-out programme
  involving the troika (the EU Commission, the ECB
  and the IMF) which it hopes to exist later this
  year. This entails brining the Government deficit
  down to accepted levels of 3 GDP by 2015. At
  present deficit is still close to 9
• Crucial to this is success achieved through
  obtaining debt relief through renegotiation of a
  promissory note for Anglo Irish debt currently
  costing over 3 bl. each year and also
  renegotiation payment terms for troika money lent
  to Ireland. Compensation for the 30 bl.
  Taxpayers, money put into the pillar banks for
  recapitalisation looks more difficult to achieve.
• New European Stability Mechanism (ESM) has been
  created to help EU countries in financial
  difficulty. However it is highly unlikely that
  this will be used retrospectively to help with
  Irish banking issues
• Though Irish exports have performed very strongly
  in recent years a return of economic growth is
  likely to be greatly hampered through a deepening
  of recession within the EU with the German
  economy now expected to grow by just 0.4 next
  year.