Balance of Payments and Exchange Rates: A Comprehensive Analysis

Posted on Aug 20, 2024 in Economy

Module 6: The Balance of Payments (Chapter 10)

Deficit in Current Account Balance

The main components of the Current Account (CA) are the merchandise balance, service balance, income balance, and unilateral transfers balance. The deficit in the CA balance was primarily due to the merchandise balance (-US$820.8 billion). The unilateral transfer balance was also in deficit, albeit at a lower level (-US$119.7 billion).

Let’s break down the calculation:

  • CA balance = 673.2
  • Net Capital and Financial Account (CFA) = 546.6 – 2.7 = 543.9
  • Statistical Discrepancy (SD) = CA – Net CFA = 673.2 – 543.9 = 129.3 (CA – FAT – CAT)

When the United States buys more goods and services than it sells, its Current Account falls into a deficit. To finance this difference, the US must borrow or sell more capital assets than it buys. This leads to the US receiving payments from foreigners, similar to exporting goods and services. Consequently, the US Capital Account experiences a surplus. Therefore, when a country’s Current Account enters a deficit, its Capital Account can enter a surplus.

Goods and Services

The trade deficit narrowed to $139.3 billion in Q2-2012 from $148.4 billion in Q1-2012.

Why Economists Expect the Current Account Deficit to Widen Again

The CA deficit in the US is expected to deteriorate due to a slowdown in overseas demand. Problems in Europe and a slowing Chinese economy are affecting their demand for US exports. According to a Bloomberg article from September 2012, the trade gap widened to $42 billion in July 2012.

Investment Income

The gap between US income on overseas assets and foreign earnings on US assets improved to $55.5 billion in Q2-2012, compared to $47.4 billion in Q1-2012.

Why There is a Surplus on Income Payments

U.S. investments overseas (inflow of returns to the US) generally yield more than the Treasury securities that foreign investors prefer to buy (outflow of returns from the US to foreign investors). This difference maintains the income surplus for the US.

Government Transfers

Payments by the US government abroad exceeded official inflows from overseas.

Impact of Government Spending on India’s Economy

Scenario 1: Government Does Not Reduce Spending

If the government could not reduce its spending, its credit rating would be slashed, making it harder and more expensive for India to borrow. This could lead to:

  • Selling of the rupee
  • Outflow of funds from India
  • Depreciation of the rupee

While a cheaper rupee can technically lead to improvements in the CA deficit, it should not come at the expense of a lower credit rating.

Scenario 2: Government Reduces Spending

If the government could reduce its spending, the nation’s savings would increase, according to the loanable funds model. This would lead to:

  • A rightward shift in the savings schedule (SS)
  • A fall in interest rates
  • Depreciation of the rupee
  • Improvement in the CA deficit

Between the two scenarios, the second one carries less risk, and India would resolve both twin deficits in the long run. As stated, “The government has already increased diesel prices by Rs 5 a liter, higher than the Rs 4 a liter increase we had recommended. Similarly, it has capped the sale of subsidized cylinders to six a year, whereas we had suggested an increase of Rs 50 per cylinder. Both these decisions show that the government is willing to take steps for fiscal consolidation.”

Impact of Printing Money

What will happen to the rupee if the government continues to print money to fund its spending? Why would the rupee overshoot? What does it mean for a currency “to overshoot”? What is the value of the rupee now?

If the government continues to print money, the rupee would depreciate immediately in the foreign exchange market due to an increased supply of rupees exceeding demand. However, prices in the goods and services market would not change as quickly due to lagged reactions from buyers and sellers.

Overshooting refers to short-term fluctuations in the exchange rate, where it deviates significantly from its new long-run equilibrium value. This fluctuation compensates for the rigidity in the prices of goods and services.

The foreign exchange market initially overreacts to a monetary change, reaching a new short-run equilibrium. Over time, goods prices adjust, allowing the foreign exchange market to correct its overreaction and the economy to reach a new long-run equilibrium.

Sustainability of India’s Current Account Deficit

Why is India’s CA deficit situation not sustainable? How would a decrease in government spending help improve the CA deficit?

According to the loanable funds model, reducing the budget deficit would improve the CA situation. Improvements in the budget deficit would encourage capital inflows, financing the current account deficit.

Impact of Interest Rate Differentials on Exchange Rates

Let’s assume interest rates in the UK are relatively higher than in the US, making UK assets more attractive.

  • UK investors would find investing in the US less attractive, leading to a decrease in the supply of pounds sterling (£) as they sell fewer pounds to buy US Treasury securities. The supply schedule of pounds (S0) shifts to S1.
  • US investors would find investing in the UK more attractive, leading to an increase in the demand for pounds as they buy more pounds to purchase UK Treasury bills. The demand schedule of pounds (D0) shifts to D1.
  • The combined effect of these shifts would cause the US dollar to depreciate against the pound, for example, from $1.50/£ to $1.60/£.

Do Interest Rate Differentials Always Drive Exchange Rate Movements?

a) Explain whether the relation between interest rate differential and exchange rate movements holds true, in practice, between the periods 1974 – 2006.

While the relationship between interest rate differentials and exchange rate movements generally holds true, other factors can influence exchange rates, and the relationship may not always be consistent in the short term. For example:

  • b) An increase in the U.S. real interest rate increases the expected return on dollar assets, such as Treasury bills and certificates of deposit. This increase encourages flows of foreign investment into the United States, thus causing the dollar’s exchange value to appreciate.
  • c) Conversely, a decrease in the U.S. real interest rate reduces the expected profitability on dollar assets, which promotes a depreciation of the dollar’s exchange value.
  • d) In 1995, while US interest rates remained unchanged, the dollar appreciated, in large part, due to the booming stock market in the late 1990’s that attracted foreign investment inflows and pushed up the dollar.

Hong Kong Dollar and the US Dollar Peg

In June 2012, the exchange rate between the Hong Kong dollar (HK$) and the US dollar was hovering at HK$7.77. By October 2012, the exchange rate had strengthened to HK$7.75.

Reasons for the Strengthening of the Hong Kong Dollar

Why did the currency strengthen between the periods June – Oct 2012? How did the central bank respond?
  • The U.S. Federal Reserve’s latest round of stimulus measures and the European Central Bank’s recent pledge to buy sovereign bonds in mid-2012 restored global investor confidence. This led to increased capital inflows into Hong Kong, pushing up the value of the Hong Kong dollar. Note: We represent the purchase of HK$ by money managers as a rightward shift in the demand (DD) schedule.
  • The Hong Kong Monetary Authority (HKMA) intervenes in the foreign exchange market to maintain the Hong Kong dollar’s peg to the US dollar within a band of HK$7.75 to HK$7.85. On October 20, 2012, when the Hong Kong dollar hit the upper limit of HK$7.75, the HKMA intervened by selling HK$4.67 billion (US$602.6 million) to prevent further appreciation. Note: We represent the selling of HK$ by the HKMA as a rightward shift in the supply (SS) schedule.

Impact of the Peg on Hong Kong’s Monetary Policy

The peg bolts Hong Kong’s monetary policy to that of the U.S. This currency link means that Hong Kong’s interest-rate policy is dictated by the Federal Reserve. If the HKMA tried to pursue an expansionary policy by bringing its interest rates lower than US interest rates, this will fail.

Transmission Mechanism

If the HKMA attempts to decrease interest rates by increasing the money supply, capital would flow out of Hong Kong to seek higher returns in the US. This would lead to a depreciation of the Hong Kong dollar against the US dollar. However, due to the fixed exchange rate and the narrow trading band, the HKMA is obligated to intervene by buying Hong Kong dollars in the foreign exchange market. This intervention would decrease the money supply, pushing interest rates back up to their original level.

In other words, the effects of the HKMA’s expansionary monetary policy on domestic interest rates would be negated by its foreign exchange intervention. This currency link means that Hong Kong’s interest-rate policy is dictated by the Federal Reserve’s monetary policy.

Impact of the Peg on Hong Kong’s Property Prices

“The peg bolts Hong Kong’s monetary policy to that of the U.S., meaning the city has had ultralow interest rates recently, spurring rising property prices because money is cheap to borrow for real-estate purchases.”

Can the HKMA Control Property Prices?

Can HKMA curb the rise in property price by raising interest rates? What alternative policies can the government pursue to curb the rise in property prices?

The HKMA cannot curb rising property prices by raising interest rates because its interest-rate policy is tied to the US Federal Reserve’s monetary policy. Property prices in Hong Kong have surged significantly due to low interest rates and strong foreign demand. Here are some alternative policies the government could pursue:

  • Impose a tax on property purchases made by foreigners (e.g., 15%).
  • Raise special transaction taxes on properties sold within a short period (e.g., 20% on properties sold within three years of purchase).
  • Lower maximum loan-to-value (LTV) ratios for residential mortgages.

Alternative Exchange Rate Options for Hong Kong

Question 5: What exchange rate options do the HKMA have, aside from the current system of pegging to the US$? Should the country switch to:
  • pegging to the Yuan?
  • pegging to a basket of currencies?
  • a complete float, instead?

Advantages and Disadvantages of Each Option

Pegging to the US Dollar

Advantages:

  • Stability in exchange rates, which is beneficial for businesses engaged in international trade.
  • Historical precedent and established credibility.

Disadvantages:

  • Limited monetary policy independence.
  • Exposure to fluctuations in the US economy.
Pegging to the Yuan

Advantages:

  • Closer alignment with China’s economy, which is Hong Kong’s largest trading partner.

Disadvantages:

  • The yuan is not fully convertible, and China’s capital account is not fully liberalized.
  • Uncertainty regarding the future path of the yuan’s exchange rate.
Pegging to a Basket of Currencies

Advantages:

  • Diversification of exchange rate risk.

Disadvantages:

  • Complexity in managing the peg.
  • Potential for conflicts of interest among the currencies in the basket.
Complete Float

Advantages:

  • Full monetary policy independence.
  • Exchange rate flexibility to adjust to economic shocks.

Disadvantages:

  • Volatility in exchange rates, which can be disruptive for businesses and investors.
  • Potential for speculative attacks on the currency.

China’s Exchange Rate Policy and the Impossible Trinity

Why did China maintain capital controls prior to 2005?

Prior to the 2005 period, China wanted a fixed exchange rate and an independent monetary policy. However, it had to give up free mobility of capital flows. Why?

Prior to 2005, China maintained capital controls to pursue a fixed exchange rate and an independent monetary policy. This policy combination is part of the Impossible Trinity, which states that a country cannot simultaneously have all three of the following: a fixed exchange rate, free capital flows, and an independent monetary policy.

By restricting capital flows, China could set domestic interest rates differently from the rest of the world without putting pressure on its exchange rate. If interest rates were lower in China than in other countries, capital would flow out in search of higher returns, depreciating the yuan. However, capital controls allowed China to maintain its fixed exchange rate despite these interest rate differentials.

China’s Exchange Rate Policy in 2012 and 2015

In 2012, explain why China had to relax its capital control to make it easier for foreign investors to put money into China’s stock market and other financial investments. In 2015, explain why China sold its holdings of US$ treasury securities? What is China’s exchange rate policy in 2012 / in 2015? Explain how the recent development affect China’s position in the Impossible Trinity triangle in 2012 / in 2015?.

In 2012, China faced capital outflows, a slumping real estate market, and a weakening stock market. To counter these pressures, the central bank relaxed capital controls, allowing more foreign investment to stabilize these sectors.

In 2015, China sold US dollar treasury securities to counter capital flight and stabilize the yuan, which was depreciating due to concerns about the Chinese economy. This move aimed to increase demand for the yuan by selling US dollar assets.

China’s exchange rate policy has gradually shifted from a fixed exchange rate regime to a managed float, allowing for more flexibility in the yuan’s value while still intervening in the market to influence its exchange rate. This shift reflects China’s changing position within the Impossible Trinity. By gradually loosening capital controls and adopting a more flexible exchange rate, China is moving away from a fixed exchange rate regime toward a combination of independent monetary policy and freer capital flows.

Scenarios of Policy Agreement and Policy Conflicts

Scenario A: Recession and Current Account Deficit

In a recession with a current account deficit, an expansionary monetary policy (E/MP) is a policy agreement. Lowering interest rates stimulates domestic demand, boosting economic growth and reducing the current account deficit by making exports more competitive and imports more expensive.

Scenario B: Economic Boom, Inflation, and Current Account Deficit

In an economic boom with inflation and a current account deficit, a contractionary monetary policy (C/MP) presents a policy conflict. Raising interest rates curbs inflation but worsens the current account deficit by making exports less competitive and imports cheaper.

Conversely, an E/MP in this scenario also presents a policy conflict. It improves the current account deficit but worsens inflation.

Policy Mix

The policy mix refers to the combination of monetary and fiscal policies used to achieve economic objectives. An ideal policy mix maximizes growth, minimizes unemployment, stabilizes inflation, and maintains internal and external balance.

Relations Among Nations

Economic relations among nations can range from conflict to integration. Policy cooperation involves officials from different nations meeting to assess global economic conditions. Policy coordination involves formal agreements among nations to implement specific policies.

Policy Coordination Examples

  • Plaza Agreement (1985): G-5 nations (US, Japan, Germany, Great Britain, France) agreed to coordinated interventions to depreciate the overvalued US dollar.
  • Louvre Accord (1987): G-5 nations agreed to stabilize the US dollar, which had depreciated significantly after the Plaza Agreement.

Balance of Payments (BOP)

The BOP is a record of economic transactions between residents of one country and the rest of the world. It includes transactions involving goods, services, and assets. The BOP is based on a double-entry bookkeeping system, where every transaction is recorded as both a credit (receipt of payment) and a debit (payment made). The BOP comprises the Current Account, Capital and Financial Account, and Statistical Discrepancy.

Current Account (CA)

The CA records transactions related to goods, services, income flows, and unilateral transfers. It includes:

  • Merchandise trade (exports and imports of goods)
  • Services trade (exports and imports of services)
  • Income receipts and payments (net earnings on investments)
  • Unilateral transfers (one-way transfers of assets, such as gifts and remittances)

Capital and Financial Account (CFA)

The CFA records transactions related to the purchase and sale of assets, including:

  • Capital transfers (e.g., debt forgiveness)
  • Acquisitions and disposals of non-financial assets (e.g., natural resources, patents)
  • Direct investment (acquiring a controlling interest in a foreign business)
  • Portfolio investment (purchases of securities, such as stocks and bonds)
  • Other investments (e.g., bank loans, currency deposits)
  • Reserve assets (foreign assets held by central banks)

Statistical Discrepancy

The Statistical Discrepancy accounts for errors and omissions in recording BOP transactions. It ensures that the BOP balances to zero.

Current Account Deficit and Capital Inflows

A CA deficit implies that a country imports more than it exports, leading to borrowing from abroad or selling assets to finance the difference. This results in capital inflows, making the country a net borrower.

Twin Deficits

The Twin Deficits refer to the simultaneous occurrence of a budget deficit (government spending exceeding revenue) and a current account deficit. An increase in the budget deficit, assuming fixed savings, can lead to a decrease in investment or net exports, causing a trade deficit.

Balance of International Indebtedness

The Balance of International Indebtedness is a snapshot of a country’s external assets and liabilities at a specific point in time. It shows whether a country is a net creditor (assets exceeding liabilities) or a net debtor (liabilities exceeding assets).

Foreign Exchange Market

The foreign exchange market is where currencies are traded. It’s the largest and most liquid financial market globally. Exchange rates are determined by the forces of supply and demand.

Types of Foreign Exchange Transactions

  • Spot transactions: Immediate exchange of currencies at the current market rate.
  • Forward transactions: Contracts to exchange currencies at a specified future date and rate.
  • Currency swaps: Simultaneous purchase and sale of a currency for another, with an agreement to reverse the transaction at a future date.

Exchange Rate Determination

Exchange rates are influenced by various factors, including:

  • Market fundamentals: Economic variables such as productivity, inflation, interest rates, consumer preferences, and government policies.
  • Market expectations: Beliefs about future economic conditions and exchange rate movements.

Nominal and Real Exchange Rates

  • Nominal exchange rate: The price of one currency in terms of another.
  • Real exchange rate: The nominal exchange rate adjusted for differences in price levels between countries.

Law of One Price and Purchasing Power Parity (PPP)

The Law of One Price states that identical goods should have the same price in different markets when expressed in a common currency. PPP extends this concept to a basket of goods, suggesting that exchange rates adjust to equalize the purchasing power of different currencies.

Asset Market Approach (AMA)

The AMA focuses on the role of asset prices in exchange rate determination. It suggests that exchange rates are influenced by:

  • Relative interest rates between countries.
  • Expected changes in exchange rates.
  • Other factors, such as investor risk aversion and safe-haven flows.

Exchange Rate Overshooting

Overshooting occurs when the short-term response of an exchange rate to a change in fundamentals is larger than its long-term response. This can happen due to price stickiness in goods and services markets.

Exchange Rate Forecasting

Forecasting exchange rates is challenging, especially in the short term. Techniques include judgmental forecasts, econometric models, and technical analysis.

Exchange Rate Practices

  • Floating exchange rate: Determined by market forces.
  • Fixed exchange rate: Pegged to a specific value, such as another currency or gold.
  • Managed float: A hybrid system where the exchange rate is generally market-determined but subject to central bank intervention.

Impossible Trinity

The Impossible Trinity states that a country cannot simultaneously have a fixed exchange rate, free capital flows, and an independent monetary policy. It must choose two out of the three.

Fixed Exchange Rate System

Under a fixed exchange rate system, the government sets a specific value for its currency against another currency or a basket of currencies. It maintains this peg through central bank intervention in the foreign exchange market.

Devaluation and Revaluation

  • Devaluation: A deliberate downward adjustment of a currency’s par value under a fixed exchange rate system.
  • Revaluation: A deliberate upward adjustment of a currency’s par value under a fixed exchange rate system.

Floating Exchange Rate System

Under a floating exchange rate system, the currency’s value is determined by market forces without government intervention.

Managed Floating Rates

A managed float is a hybrid system where the exchange rate is generally market-determined but subject to central bank intervention to smooth out volatility or influence its value.

Crawling Peg

A crawling peg is a system where the exchange rate is fixed but adjusted periodically in small increments to manage balance of payments disequilibria.

Currency Crises

A currency crisis occurs when a country’s currency experiences significant selling pressure, leading to a sharp depreciation. This can be caused by factors such as unsustainable current account deficits, loss of investor confidence, or speculative attacks.

Increasing the Credibility of Fixed Exchange Rates

Mechanisms to enhance the credibility of fixed exchange rates include:

  • Currency boards: Issue domestic currency fully backed by foreign reserves, limiting the central bank’s ability to create money.
  • Dollarization: Adopting another country’s currency as the official currency.

Global Economic Crisis of 2007-2009

The global financial crisis, triggered by the bursting of the US housing bubble, highlighted the interconnectedness of the global economy and the importance of international policy coordination.

Quantitative Easing (QE)

QE is an unconventional monetary policy tool used by central banks to stimulate economies when interest rates are near zero. It involves injecting liquidity into the financial system by purchasing assets, such as government bonds, from commercial banks and other institutions.

Economic Objectives of Nations

Key economic objectives of nations include:

  • Internal balance (full employment and price stability)
  • External balance (sustainable current account)
  • Overall balance (internal and external balance)
  • Long-term economic growth
  • Equitable income distribution

Policy Instruments

Policy tools to achieve economic objectives include:

  • Expenditure-changing policies: Fiscal policy (government spending and taxes) and monetary policy (money supply and interest rates).
  • Expenditure-switching policies: Exchange rate adjustments and trade policies.
  • Direct controls: Government restrictions on specific transactions, such as capital controls or import quotas.

Aggregate Demand and Aggregate Supply

Aggregate demand (AD) represents the total demand for goods and services in an economy. Aggregate supply (AS) represents the total supply of goods and services. The interaction of AD and AS determines the equilibrium price level and real GDP.

Policy Agreement and Policy Conflict

  • Policy agreement: When a single policy promotes both internal and external balance.
  • Policy conflict: When a single policy promotes one objective (e.g., internal balance) at the expense of another (e.g., external balance).

Policy Mix

The policy mix refers to the combination of fiscal and monetary policies used to achieve economic objectives. A well-coordinated policy mix can help achieve multiple objectives simultaneously.