Title: Balance of payments and exchange rate issues
1Balance of payments and exchange rate issues
- Session 7
- Macroeconomics and the International Context
- MSc Economic Policy Studies
- Alan Matthews
2Balance of payments
3Lecture objectives
- Describe and understand the balance of payments
accounts - Do international payments imbalances matter?
- Addressing international payments imbalances
- Reading McAleese Chapter 20
4Balance 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
5Balance 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
6Some 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
7Further 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
8Irish 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
9Borrowers 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.
10International 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
11Irelands IIP
Source CSO Quarterly International Investment
Position, Dec 2010
12Source Lane, Dynamics of Irelands net external
position, SSISI, 2011
13Source Lane, Dynamics of Irelands net external
position, SSISI, 2011
14Understanding 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
15Interpreting 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)
16The 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
17Correlation between cost of CDS and current
account
Source http//www.voxeu.org/index.php?qnode/282
0 EA Euro Area
18Why 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
19Interpreting a current account deficit
- McAleese tale of three deficits
- US deficit
- Developing countries debt
- Deficits in Euroland
20Sustainability 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
21The 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
22The 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
23Prospects 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
24Correcting 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
25Correcting 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(No Transcript)
27Relationship 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
29Challenges 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?
30Exchange rates
31Motivations
- 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
32US dollar/euro exchange rate
Euro depreciates
Euro appreciates
Source ECB Statistical data warehouse
33Sterling/euro exchange rate
Euro depreciates
Euro appreciates
Source ECB Statistical data warehouse
34The 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
35The 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
36Impact 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
37Effective 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)
38Source The Economist March 24 2012
39Real 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
40Source NCC, Irelands Competitiveness Scorecard
2012
41Exchange 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
42The 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
43The 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
44Exchange rate equilibrium
/
S
D
45Factors 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)
46Reaching 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
47Exchange 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
48Purchasing 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
49Purchasing 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)
50Purchasing 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.
51OECD PPP estimates(relative to Euro)
Source University of British Columbia Pacific FX
Service
52PPP 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
53Balance 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
54Examples 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
55Asset 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
56Asset 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
57Interest 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
58Uncovered 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
59Covered 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
60Empirical 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?
61One effort to measure desired equilibrium
exchange rates
Cline and Williamson, 2012, Peterson Institute
62Summary
- 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?
63Euroland issues
Source EEAG report 2012
64Source EEAG report 2012
65Source EEAG report 2012
66Restoring 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?