Balance of Payments: Understanding International Economic Transactions
Module 6: The Balance of Payments (Chapter 10)
A deficit in the current account (CA) balance is 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).
We take the CA balance = 673.2.
We deduct the net capital and financial account (CFA) to get: SD = 673.2 less (546.6 – 2.7) = 129.3, (CA- FAT-CAT)
When the United States buys more goods and services than it sells, its current account becomes a deficit. The US must finance the difference by borrowing, or by selling more capital assets than it buys. This leads to the US receiving payments from foreigners. It is likened to the export of goods and services. The US capital account becomes a surplus. So when a country’s current account becomes a deficit, its capital account can become a surplus.
i. Goods and services: The trade deficit narrowed to $139.3 billion in Q2-2012 from $148.4 billion in Q1-2012.
• Explain why economists say that the CA deficit is expected to widen, again.
The CA deficit in the US is expected to deteriorate due to a slowdown in overseas demand as problems in Europe and a slowing China affect their demand for US exports. The trade data is available monthly, and according to the Bloomberg article dated September 2012, the trade gap widened in July 2012 to $42 billion.
ii. Investment income: The gap between US income on overseas assets and foreign earnings on US assets has improved to $55.5 billion in Q2-2012, compared to $47.4 billion in Q1-2012. Explain 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 return from the US to foreign investors). This maintains the income surplus for the US.
iii. Government transfers: Payments by the US government abroad exceeded official inflows from overseas.
If the government could not reduce its spending, its credit rating would be slashed, making it harder and more expensive for India to borrow.
• A fall in rating may also lead to the selling of rupees, and an outflow of funds from India causing the rupee to depreciate.
• While a cheaper rupee can technically lead to improvements in the CA deficit, that itself should not be at the expense of a lower credit rating.
If the government could reduce its spending, using the savings loanable funds model, the nation’s savings will increase.
• The SS schedule would shift to the right.
• Interest rates will fall, the rupee will depreciate, and the CA deficit will improve.
Between both scenarios, the second one has less risk tied to it, and India in the long run resolves both twin deficits. “The government has already increased diesel prices by Rs 5 a litre, higher than the Rs 4 a litre 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.”
a) 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?
The rupee would depreciate immediately in the foreign exchange market when there is more rupee supplied than demanded. In the goods and services market, however, prices do not change as quickly / or are rigid, because of lagged reactions from buyers and sellers in the goods and services market.
The term overshoot refers to fluctuations in the short run, the exchange rate overshooting its new equilibrium long-run value (weaker in value than it should be under normal conditions). The fluctuation in the short-run price of the rupee currency against, say, the US dollar (i.e. the exchange rate) is to compensate for the rigidity in the prices of goods in India.
The foreign exchange market will initially overreact to a monetary change, achieving a new short-run equilibrium. Over time, goods prices will eventually respond, allowing the foreign exchange market to dissipate its overreaction, and the economy to reach the new long-run equilibrium in all markets.
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, a budget deficit would improve the CA situation. Also, improvements in the budget deficit would encourage inflows of funds into the capital account, and hence finance the current account deficit.
Say interest rates in the UK are relatively higher than in the US, making UK assets relatively more attractive.
• UK investors will find investing in the US less attractive, so they will sell less £ to buy US treasury. The supply schedule of £, S0 shifts to S1.
• US investors will find investing in the UK more attractive, so they buy more £ to buy UK treasury bills. The demand schedule of £, D0 shifts to D1.
• The combined effect of the 2 shifts is to cause the $ to depreciate from $1.50/ £ to $1.60/ £.
a) Explain whether the relation between interest rate differential and exchange rate movements hold true, in practice, between the periods 1974 – 2006.
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 remain 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.
In June 2012, the exchange rate was hovering at HK$7.77.
In October 2012, the exchange rate hits $7.75.
Why did the currency strengthen between the periods June – Oct 2012? How did the central bank respond?
Answer:
• The U.S. Federal Reserve’s latest round of stimulus measures and the European Central Bank’s recent pledge to buy sovereign bonds in mid-2012 has restored global investor confidence.
o And so money managers bought a wide range of assets around the world, including in Hong Kong. The capital inflows from abroad pushed up the value of the Hong Kong dollar.
o Note: We represent the purchase of HK$ by money managers as a rightward shift in the DD schedule.
• The HKMA undertakes to buy or sell the local unit whenever it touches either side of the band that ranges from HK$7.75 to HK$7.85.
o So on 20 October 2012, when the dollar hit $7.75 the upper limit, HKMA intervened to prevent the HK$ from appreciating. In this case, HKMA sold 4.67 billion Hong Kong dollars (US$602.6 million) in the foreign-exchange market.
o Note: We represent the selling of HK$ by the HKMA as a rightward shift in the SS schedule.
The article said that 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. Explain the transmission mechanism.
By increasing the supply of money in the money market, HKMA will attempt to decrease interest rates. The difference in interest rates (compared to US interest rates) will lead to capital flowing out of HK. The HK$ will depreciate against the US$. And because HK has a fixed exchange rate with a narrow trading band, the central bank is obliged to intervene in the forex market when the exchange rate crosses the band. HKMA will buy HK$ in the foreign exchange market. The action by the HMKA will lead to more / less money supply in the money market. Interest rates will increase, back to its original level before the central bank intervenes.
In other words, the effects of the HMKA expansionary monetary policy on the domestic interest rates are negated by the HKMA foreign exchange intervention. This currency link means that Hong Kong’s interest-rate policy is dictated by the Federal Reserve monetary policy.
“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 HKMA curb the rise in property prices by raising interest rates?
• What alternative policies can the government pursue to curb the rise in property prices?
HKMA cannot curb the rise in property prices by raising interest rates. Property prices in Hong Kong have surged 73% (56% inflation-adjusted) over the three years (2009 – 2011), propelled by very low interest rates and strong foreign demand.
• In 2009, house prices rose 28.5% (26.6%).
• In 2010, house prices rose 21% (17.6%).
• In 2011, house prices rose 11.1% (5.1%).
As we saw in Question 3, it is not possible for HKMA to pursue a monetary policy independent from the US. HKMA cannot increase its domestic interest rates if US interest rates stay unchanged. Hong Kong’s interest-rate policy is dictated by the Federal Reserve monetary policy.
Here are some alternative policies: To curb speculation, the government imposed another round of property measures at the end of 2012:
• In October 26, 2012, the government introduced a 15% tax on property purchases made by foreigners.
• The government also raised special transaction taxes to as much as 20% on properties sold within three years of purchase.
• Maximum loan-to-value (LTV) ratios were lowered by the HKMA’s latest residential mortgage tightening (June 2011).
Question 5: What exchange rate options do the HKMA have, aside from the current system of pegging to the US$? Should the country switch to
• pegging to the Yuan?
• pegging to a basket of currencies or
• a complete float, instead?
Advantage of pegging to the US$
– Stability. Goods were made in Hong Kong and distributed offshore, and typically priced in US dollars. Factory owners’ costs were primarily in Hong Kong dollars because they paid wages and other production costs in the local currency. The peg eliminated currency risk in their dealings.
– History: Hong Kong linked its exchange rate to the US$ on Oct. 17, 1983, when negotiations between China and the U.K. over the city’s 1997 return to Chinese rule spurred capital outflows. The currency has been kept at around HK$7.8 per U.S. dollar since then.
Advantage of linking to the Yuan
– Hong Kong is increasingly tied to the cycles of the mainland’s economy. The Hong Kong dollar’s peg to the US dollar has resulted in increased costs for Hong Kong manufacturers with production on the mainland, because their costs are in yuan and their prices are in US dollars.
– The Hong Kong dollar has weakened against the yuan by about 26 per cent over the past 10 years.
Problem of linking to the Yuan:
– China ended its currency peg to the dollar in 2005 after keeping the exchange rate stable for a decade. The yuan now trades in a managed range against a basket of major currencies. Until 2014, the yuan has appreciated 35 percent against the greenback since the end of its peg in July 2005.
– Therefore, a strong Hong Kong dollar would be “quite a negative factor” for the city’s exporters as that would make their goods more expensive, Chan said. If the city’s currency were pegged to the yuan, exports and overall competitiveness would substantially weaken.
– The anchor currency is not fully convertible and the capital account in China is not fully liberalized.
Prior to the 2005 period, China wanted a fixed exchange rate and an independent monetary policy. However, it has to give up free mobility of capital flows. Why?
Answer:
• If interest rates are lower in China, funds will / will not flow into China. This is because prior to 2005 China has / does not have capital controls.
• As a result of capital mobility / immobility, the exchange rate will appreciate / depreciate / will not be affected. The Central bank does / does not need to intervene in the foreign exchange market.
In conclusion, by restricting capital flows, China is able to conduct independent monetary policy, where its domestic interest rates can be different from the rest of the world.
China, until 2005, is able to conduct independent monetary policy and tied its exchange rate to the US$. The trade-off is that China sacrifices free capital flows.
• By controlling the funds that move in and out of the country, it limits the
• resulting changes in the money supply and
• corresponding pressures on the exchange rate.
• That is, by restricting capital flows, China is able to conduct independent monetary policy, where its domestic interest rates can be different from the rest of the world.
Answer:
a) 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?
Funds have been flowing out, putting pressure on real estate prices and the stock market. So by doubling the cap on foreign investment to about $60 billion (from $30 billion), the central bank is hoping to stabilize the stock market and real estate sector.
In addition, the weakness in the renminbi is making oil imports expensive.
“to counter a rising flight of capital from the country, a worsening slump in real estate prices, a weak stock market and at least a temporary trade deficit caused by a steep bill for oil imports”
b) What is China’s exchange rate policy in 2012 / in 2015?
The weakness in the renminbi in 2012 was triggered by investors’ fears that the Chinese property market would collapse after China attempted to slow the rise in property prices.
The weaker renminbi made the US upset that China is using a weak currency to boost its export to the US, causing the US to face a widening trade deficit with China. Thus in 2012, China was pressured by the US to strengthen the renminbi against the US$; hence relaxing the restrictions on capital inflow will enable investors to purchase the renminbi, and hence the renminbi will strengthen.
“Democrats and Republicans alike have been calling for a stronger Chinese currency as a way to limit China’s large bilateral trade surplus with the United States”.
The weakness in the renminbi is also seen as a sign of a loss in confidence in the Chinese economy. Hence the government is keen for the currency to be seen strengthening.
“The weakness was initially attributed to weakening performance of the Chinese economy, but investors increasingly see it as a sign of capital flight as well”
The case in 2015 of China selling US$ treasury securities is triggered by the outflow of capital, as investors feared that there would be further devaluation of the renminbi in August 2015 after PBOC surprised the market with a 3-day devaluation. There were concerns if the yield in US Treasury securities would rise (pushing US QE over the brink). See the graph below that the yield did rise… but it fell thereafter.
c) Explain how the recent development affects China’s position in the Impossible Trinity triangle in 2012 / in 2015?.
• Up until 2005, the renminbi currency was fixed to the US$, China was at the bottom part of the triangle, prior to 2005. See the diagram below.
• Now, the Chinese central bank manages its currency against a trade-weighted basket of currencies where the TWI moves within a trading band. The central bank has allowed the band to widen and the renminbi to appreciate, hence slowly moving away from a fixed exchange rate.
The government is also allowing a more open capital account. According to another article “China Signals Speedier Moves to Loosen Capital Controls”, (optional read)
“An open capital account—allowing investment to move across borders—and a more freely traded currency would mark a significant change. A tightly controlled exchange rate has been a key feature of China’s reform era-development. The controls have been seen as a way to keep exports competitive and shield the country from waves of currency speculation”.
China has moved from the bottom part of the triangle, to the left portion. Loosening controls would help stem a slowdown in China’s growth by encouraging more efficient use of capital and speeding a transition away from dependence on exports and toward stronger domestic demand. But the move also brings risk, as a swing to hefty capital outflows could undermine the stability of an overstretched financial sector.
Exercise C: Scenarios of policy agreement and policy conflicts to achieve internal and external balance
Scenario A
Say the economy is in recession, and it has a current account deficit. It has a floating exchange rate regime.
An expansionary monetary policy (MP) means interest rates r, will fall.
– The cost of borrowing is lower, hence making it cheaper for consumers and firms to consume goods & services and invest in factories (economy expands).
– The rate of return for holding the country’s currency is also lower, hence making it less attractive for fund managers to hold the currency. The currency will depreciate which makes the country’s exports more competitive and imports more expensive (current account deficit improves).
Summary: When there is a recession with a current account deficit, an expansionary MP is seen as a policy agreement – a single economic policy promotes overall balance (internal and external).
Scenario B
The economy is booming, there is inflation, and a deficit in the current account. The country has a floating exchange rate regime.
Say the economy pursues a contractionary MP. This means interest rates will rise.
• The cost of borrowing is higher, hence making it more expensive for consumers and firms to consume goods & services and invest in factories (economy contracts and prices fall, inflation rate declines).
• The rate of return for holding the country’s currency is also higher, hence making it more attractive for fund managers to hold the currency. The currency will appreciate which makes the country’s exports less competitive and imports less expensive (current account deficit worsens).
Summary: When there is an economic boom with inflation and a CA deficit, a contractionary MP is seen as a policy conflict/agreement: MP will slow down the economy and inflation, but worsen the CA deficit (internal balance restored but not external balance).
(Optional) The nation may pursue a combination of contractionary monetary policy and contractionary fiscal policy to achieve both objectives at the same time. TRUE/FALSE
The BOP is a record of the economic transactions between residents of one country and the rest of the world. International transactions involve an exchange of goods, services, or assets between residents of one country and those of another. Residents are businesses, individuals, and government agencies that make the country in question their legal domicile.
A credit transaction (+) is a receipt of a payment from foreigners. Includes merchandise exports, transportation and travel receipts, income received from investments abroad, gifts received from foreign residents, aid received from foreign governments, local investments by overseas residents.
A debit transaction (-) is a payment to foreigners. Includes merchandise imports, transportation and travel expenditures, income paid on the investments of foreigners, gifts to foreign residents, aid given by the local government, overseas investments by local residents.
Because the BOP statement utilizes a double-entry booking system, the overall/total BOP must numerically balance. It is not necessary or the subaccounts of the statement to balance. A surplus means that the subaccount is positive. A deficit means that the balance on a subaccount is negative.
In theory, the current account should balance with the capital and financial accounts. The sum of the BOP statements should be zero. In reality, the accounts do not exactly offset each other due to rounding off errors or items not truly captured. Statistical discrepancies are introduced to ensure BOP is zero.
A country with a persistent CA deficit is effectively exchanging capital assets for goods and services. Large trade deficits mean that the country is borrowing from abroad. This appears as an inflow of foreign capital.
Current Account (CA)
The current account refers to the monetary value of international flows associated with transactions in goods, services, income flows, and unilateral transfers.
Merchandise trade includes all of the goods that a country’s exports or imports, agricultural products, machinery, autos, petroleum, electronics, textiles, etc.
Services trade includes exports (imports) of foreign tourists (locals) spending money in local (foreign) countries. It also includes legal services, construction services, technical services.
Income receipts and payments consist of net earnings on local investments abroad (earnings on the country abroad less payments on foreign assets in the country).
Unilateral transfers include transfers of goods and services (gifts in kind) or financial assets (money gifts) between the country and the rest of the world. Private transfer payments refer to gifts made by individuals and non-government organizations institutions to foreigners (includes remittances from immigrants living in the country to relatives back home).
Capital and Financial Account (CFA)
The capital and financial account refers to all international purchases or sales of assets and includes both private sector and official (central bank) transactions.
Assets include titles to real estates, corporate stocks and bonds, government securities, and ordinary commercial bank deposits.
A credit (+) refers to capital and financial inflows. It means that the home country receiving payments from a foreign country for assets sold to foreigners. It is likened to the export of goods and services.
A debit (-) refers to capital and financial outflows. It leads to foreigners receiving payments from the home country for foreign assets bought. It is likened to imports of goods and services.
Capital transactions consist of capital transfers (mainly debt forgiveness and migrants’ goods and financial assets accompanying them as they leave or enter the country) and acquisitions and disposals of certain non-financial assets (includes sales and purchases of rights to natural resources, patents, copyrights, trademarks, franchises, and leases).
Private sector financial transactions consist of direct investment in a business enterprise in another country (residents of one country acquire a controlling interest, eg. Stock ownership of 10% or more), securities (private sector purchases of short and long-term debt securities, eg. Treasury bills, Treasury notes, Treasury bonds, and securities of private enterprises), bank claims (loans, overseas deposits, claims on affiliated banks abroad) and bank liabilities (demand deposits, passbook savings deposits, certificates of deposits, liabilities to affiliated banks abroad).
Official settlements transactions refer to the movements of financial assets among official holders (eg. US Federal Reserve and UK Bank of England).
Official reserve assets (US government assets abroad) provide international liquidity to finance short-term trade deficits (This is useful for developing countries that do not have readily convertible currency or access to international capital markets) and weather periodic currency crises (for countries with fixed exchange rates, ORA are useful for foreign exchange intervention). They comprise stock of gold reserves held by the U.S. Government, special drawing rights (A new reserve asset, defined as the basket of currencies which includes the U.S. dollar, Japanese yen, UK pound, and the euro, and can be transferred among nations in settlement of balance-of-payments deficits or stabilization of exchange rates, reserve position that the U.S. maintains in the International Monetary Fund and convertible currencies such as Japanese yen, readily acceptable as payment for international transactions.
Liabilities to foreign official agencies (foreign official assets in the US) CA deficit and capital outflow (COP deficit) – > decrease in official reserves/ inflow, then increase.
Statistical Discrepancy – or known as errors and omissions, as some information is collected and some estimated, in the BOP statement, statistical discrepancies are treated as part of the CFA as short-term financial transactions are generally the most frequent source of error.
CA Deficit and CFA Surplus- CA deficit offset/financed by new financial inflows in CFA, CA deficit means an excess of imports over exports, which is financed through borrowing from other nations or liquidating foreign assets. As a result, the home nation experiences foreign capital inflows and the home nation becomes a net demander of funds from abroad.
Impact of capital flows on CA. Fall in savings (say due to excess government spending / decline in private sector savings) pushes up interest rates (interpret as higher returns on investment) which causes an inflow of foreign funds seeking higher investment returns. The strengthening of the currency causes exports to be less competitive and causing the CA to go into deficit.
The diagram above depicts Savings-Investment loanable funds. The fall in savings from the budget deficit is illustrated by a shift in the SS schedule. Domestic interest rates rise, attracting more foreign money. The exchange rate appreciates and becomes costlier in the foreign exchange market. Exports become more expensive to foreigners, resulting in a CA deficit.
Twin Deficit
Y = C + I + G + NX -> (Y-C-T) + (T-G) = I + NX
Assume an economy already at potential output, meaning that Y is fixed. In this case, if the deficit increases and savings remain the same, then this last equation implies that either investment (I) must fall, or net exports (NX) must fall, causing a trade deficit. Hence, the twin deficits.
Balance of International Indebtedness
– Captures a fixed stock of assets and liabilities against the rest of the world, at a single point in time (as opposed to BOP which is a flow concept, over a period of time). It is a record of the International Investment Position of the US at a particular time. It indicates the accumulated value of US-owned assets abroad, as opposed to foreign-owned assets in the US.
A net creditor if its accumulated value of local-owned assets abroad > the value of foreign-owned assets in the US. A net debtor if its value of foreign-owned assets in the country > the accumulated value of US-owned assets abroad.
Local-owned assets abroad are divided into official reserve assets, government assets, and private assets. These assets include gold, foreign currencies, foreign securities, reserve position in the International Monetary Fund, local credits and other long-term assets, direct foreign investment and claims reported by banks.
Foreign-owned assets are divided into foreign official assets and other foreign assets in the U.S. These assets include government, agency, and corporate securities; direct investment; local currency; and U.S. liabilities reported by banks.
Foreign Exchange Market
The FX market refers to the organizational setting within which individuals, businesses, governments, and banks buy and sell foreign currencies and other debt instruments.
The FX market is the largest and most liquid market in the world. The market is dominated by four currencies (U.S. dollar, euro, Japanese yen, British pound). Not all currencies are traded in the market.
A typical foreign-exchange market functions at 3 levels: 1) In transactions between commercial banks and their commercial customers, who are the ultimate demanders and suppliers of foreign exchange 2) In the domestic interbank market conducted through brokers 3) In active trading in foreign exchange with banks overseas.
Types of Foreign Exchange Transactions
1) Spot transaction: This is where you can make an outright purchase or sale of a currency now, as in “on the spot”. It is the simplest way to meet your foreign currency requirements, but it also carries the greatest risk of exchange rate fluctuations as there is no certainty of the rate until the transaction is made (entering the contract and final settlement of currency).
2) Forward transaction: It is about receiving or paying an amount of foreign currency on a specific date in the future at a fixed exchange rate (that cannot be affected by any changes in the market exchange rates). It protects you against unfavorable movements in the exchange rate, but it will not allow gains to be made should the exchange rate move in your favor. A forward exchange contract’s maturity date can be a few months or even a few years in the future.
3) Currency swap is the conversion of one currency to another currency at one point in time, with an agreement to reconvert it back to the original currency at a specified time in the future. The rates of both exchanges are agreed to in advance.
Exchange Rate of Determination
The exchange rate in a free market is determined by both supply and demand conditions.
Here we consider 2 nations (US and UK), and the currency traded is GBPUSD (or USD per £).
The DD for currency £ is a derived DD; driven by DD by US residents and business to import UK’s goods and services, make investments in the UK and make transfer payments to residents in the UK (On a US balance of payments, the purchase corresponds to the DEBIT items).
The SUPPLY for currency £ is derived supply; generated by the desire of UK residents and business to import US goods and services, lend funds and make investments in the US, repay debts owned to US lenders, and extend transfer payments to US residents. (Note: On a US balance of payments, the purchase corresponds to the CREDIT items).
Equilibrium exchange rate is determined by the market forces of supply and demand (Point of intersection of foreign exchange).
An appreciation (depreciation) of the dollar refers to an decrease (increase) in the dollar price of foreign currency.
The supply for £ is upward sloping. Why? As $ depreciates against the £, US goods and services become cheaper to UK residents. Demand for US goods increases and quantity supply for £ increases (movement up the SS curve).
The demand for £ is downward sloping. Why? As $ depreciates against the £, UK goods and services become more expensive to US residents. Demand for UK goods declines and quantity demand for £ decreases (movement UP the DD curve).
Increase (decrease) in the demand for £ shift the DD schedule rightward(leftward.) $ will depreciate(appreciate) against £.
Increase (decrease) in the supply of £ shift the SS schedule rightward (leftward). $ will appreciate (depreciate) against £.
Nominal and Real Exchange Rates
The exchange rate index is a weighted average between the domestic currency and the nation’s most important trading partners.
The weights are given by the relative importance of the nation’s trade with each of these trade partners.
The index is also known as the effective exchange rate; or the trade-weighted dollar.
The USD trade-weighted index is a gauge of the dollar’s value relative to the dollar’s value relative to other major currencies such as the Euro, Yen, Sterling, Canadian dollar, Swedish crown, and Swiss franc.
Nominal exchange-rate index NERI
NERI of the US dollar is an average value of the dollar (it has not been adjusted for changes in price levels), in the US and its trading partners.
If the NERI is increasing, it indicates the dollar’s appreciation relative to the currencies of the other nations in the index; that is a loss of competitiveness for the US. If the NERI is decreasing, it indicates the dollar’s depreciation relative to the other currencies in the index; that is an improvement in US international competitiveness.
The NERI is based on nominal exchange rates that do not reflect changes in price levels in trading partners.
Real exchange-rate index RERI
RERI of the US dollar embodies the changes in prices in the countries in the calculation. RERI is the nominal exchange rate adjusted for relative price levels.
Real Exchange Rate = Nominal Exchange Rate X (Foreign country’s price level/Home country’s price level), where the NERI and RERI are measured in units of domestic currency per unit of foreign currency.
The index is constructed such that an appreciation of the dollar corresponds to a higher index.
A rise in the RERI will tend to reduce the international competitiveness of the country’s firms. A fall in the RERI will tend to increase the international competitiveness of the country’s firms.
Basics of Exchange Rate Determination
Factors that cause the supply and demand schedules of currencies to change can be attributed to Market fundamentals (Due to changes in economic variables such as productivity, inflation rates, real interest rates, consumer preferences, and government trade policy) and Market expectations (such as news about future market fundamentals, or traders’ opinions about future exchange rates).
Time Frame
In the short term (a few weeks or even days), foreign exchange transactions are dominated by transfers of assets (bank accounts, government securities), that respond due to differences in real interest rates and shifting expectations of future exchange rates_.
In the interim (several months), exchange rates are governed by cyclical factors such as fluctuations in economic activity.
Over the long term (one, two or even five years), foreign exchange transactions are dominated by flows of goods, services, and investment capital, which respond to forces such as inflation rates, investment profitability, consumer tastes, productivity, and government trade policy.
Long Term Exchange Rate Determination
Countries with relatively high inflation rates tend to have depreciating currencies. Countries with relatively low inflation rates tend to have appreciating currencies. LOW REAL INTEREST RATES IN THE US TEND TO DECREASE DEMAND FOR DOLLARS, CAUSING DOLLAR TO DEPRECIATE.
Law of One Price
The identical goods should be sold everywhere at the same price when converted to a common currency assuming that it is costless to ship the goods between nations, there are no barriers to trade and markets are competitive.
Purchasing Power Parity (PPP) – Big Mac Index (lighthearted guide to whether currencies are at their “correct” level
PPP theory states that the exchange rates adjust to make goods and services cost the same everywhere.
If the rate of inflation is much higher in one country, its money has lost purchasing power over domestic goods. The goods would become more expensive, and demand for the goods would decrease, leading to decrease in demand for the currency. The currency depreciates. The depreciation of the currency will RESTORE PARITY with prices of goods abroad. Thus, export and import of goods and services (i.e. the trade flows) constitute the mechanism that makes a currency depreciate or appreciate.
The PPP Theory prediction is that changes in relative national price levels determine changes in exchange rates, over the long term. The predictive power of the PPP theory has negligible predictive power.
Foreign-exchange value of a currency tends to appreciate or depreciate, at a rate equal to the difference between foreign and domestic inflation
Asset Market Approach (AMA)
According to the Asset Market Approach, fund managers consider two main factors when deciding between domestic and foreign investments i) Relative levels of interest rates ii) Expected changes in the exchange rate itself over the term of the investment. Other factors (diversification, safe haven and investment flows)
Relative Levels of Interest Rates
The level of the nominal (money) interest rate is a first approximation of the rate of return on assets that can be earned in a particular country. The differences in the level of nominal interest rates between economies is likely to affect international investment flows as investors seek the highest rate of return
If interest rates in U.S. > interest rates abroad, there will be an increase in the demand for dollars (the dollar appreciates in value). If interest rates in U.S.
Expected Change in Exchange Rates
In addition to differences in interest rates that, investors consider how expected changes in the exchange rate will also affect their returns.
That is, even a high interest rate would not be attractive if one expects the currency in which the asset is denominated to depreciate at a similar, or greater rate
Indeed, future expectations of an appreciation of the dollar can be self-fulfilling for today’s value of the dollar
Other Factors
There are other factors affecting investment flows among economies such as the size of the stock of assets denominated in a particular currency in investor portfolios and significant safe haven effect behind some investment flows.
Exchange Rate Overshooting
Exchange rate is said to overshoot when its short-term response (depreciation or appreciation) to change in market fundamentals is greater than its long-term response. Exchange rates need to appreciate or depreciate more in the short run to compensate for other prices that are slower to adjust.
Exchange Rate Forecasting
Forecasting exchange rates is very tricky, especially in the short term. Necessary for exporters, importers, investors, bankers, and foreign-exchange dealers and consulting firms
Judgmental forecast by subjective or common sense models requires wide array of political and economic data and interpretation of these data in terms of the timing, direction, and magnitude of exchange-rate changes. Projections based on a thorough examination of individual nations of their economic indicators; Political, Technical factors and Psychological factors
Exchange Rate Practices
Determined by market forces (floating exchange-rate system); i.e. the currency to float independently (market determines a currency’s value without government intervention, float in unison with a group of other currencies, crawls according to a predetermined formula such as relative inflation rates (soft peg)
Fixed against some standard of value (hard pegged exchange-rate system). Govt does not allow the exchange rate to fluctuate due to SS and DD for the currency. The currency is anchored to a single currency or a basket of currencies or gold.
Some countries managed to do both: countries in the euro bloc have a hard peg (a currency union) with other members of the bloc, but the euro itself floats against third currencies.
Members of the IMF have been free to follow 1) Exchange rates should not be manipulated to prevent effective balance-of-payments adjustments or to gain unfair competitive advantage over other members. 2) Members should act to counter short-term disorderly conditions in exchange markets. 3) When members intervene in exchange markets, they should take into account the interests of other members
The fear of floating is particularly prevalent among emerging market and developing countries for which sharp appreciations / depreciations of the exchange rate may be particularly harmful. When the value of the currency declines, authorities worry about both imported inflation and balance sheet effects of an exchange rate depreciation on borrowers that have borrowed in foreign currency and suddenly find that debt more expensive to service. On the other hand, when a currency’s value rises, there is a loss of export competitiveness.
Indonesia:Bank Indonesia set the value of the rupiah against a basket of currencies, and intervened in the market around that central rate. The central rate was depreciated gradually according to the differential between domestic and foreign inflation, so as to stabilize the real exchange rate. The managed floating exchange regime was replaced by a free- floating exchange rate arrangement
Malaysia:The exchange rate value of the currency was determined by the market, though the Bank acknowledged intervening to smooth fluctuations that it considered excessive. Malaysia fixed its exchange rate at RM 3.8 per U.S. dollar, representing an appreciation of about 10% relative to the ringgit’s previous level. Malaysia implemented comprehensive capital controls. The central bank lowered interest rates without fears of speculation to weaken the ringgit.
Impossible Trinity (also known as the Trilemma)
It is a Trilemma in that it is impossible for a nation to have all three of the objectives at the same time. 1) A fixed exchange rate (fear of floating). 2) Free capital movement (absence of capital controls / caps on volume of transactions / taxes). 3) An independent monetary policy (CB able to control money supply without interference). Can only adopt 2.
What happens if a nation tries to pursue all three goals at once?
Say Country A has a fixed exchange rate policy, has no capital control and it decides to adopt an expansionary monetary policy to try to stimulate its domestic economy. 1. As monetary supply increases, domestic interest rates FALL in Country A. Assuming there is no change in the rest of the world’s ROW interest rates, interest rates will be lower in Country A. 2) Forex traders will sell the local currency to invest in higher yielding foreign currency. With no capital control, market players will do this en masse – this tends to cause the price of Country A’s currency to drop due to the sudden extra supply. 3) Because Country A has a fixed exchange rate, the central bank must defend its currency by selling its reserves to buy its currency back. 4) This decreases the supply of money causing interest rates to RISE. 5) Central bank continues with its monetary easing, … (repeat) interest rates in Country A will remain lower than rest of the world; and forex traders will continue to sell localcurrency; and central bank will continue to intervene to prevent the currency from weakening. When eventually the government’s foreign exchange reserves are exhausted, the currency will devalue. This breaks one of the three goals (fixed exchange rate) and also enriching market players at the expense of the government that tried to break the impossible trinity. The example illustrates why is it impossible for a nation to uphold all three goals at once
The
effects of MP and Forex
Central Bank Balance Sheet
- Central bank’s expansionary monetary policy in the money market, through buying say$1mn Treasury government bonds from a primary dealer (a bank) is captured in the CB balance sheet as an increase in ASSET – expansion of Net Domestic Asset (NDA) – and an increase in LIABILITY – expansion of reserve money (increments the bank’s reserve account at the Fed Reserve) by $1mn
- Central bank foreign exchange intervention, through buying of local currency (sales of foreign reserves) is captured in its balance sheet as an fall in Net Foreign Asset (NFA) and an decrease in reserve money
Example: United States of America
According to the impossible trinity, US wants free capital flows and an independent monetary policy; what it has to give up is the stability of a fixed exchange rate system
An independent MP means that if US wants to Combat excessive growth: It can increase its target interest rates (relative to rest of the world). With rus > rrow, there will be a stronger demand for US$, causing the US$ to appreciate.
Stimulate growth: It can lower its target interest rates (relative to rest of the world). With rus row, there will be a lesser demand for US$, causing the US$ to depreciate. By NOT having a fixed exchange rate, US can enjoy both an independent monetary policy and free capital flows. This is so in practice. Positive results of the currency peg for US is the large investments in US debt, keeping US interest rates low, hence increasing the size of the economy and lower inflation rate in the US.
Example: Hong Kong
Hong Kong fixes the value of its currency to the US$ using a Currency Board Arrangement and it allows free capital flows. The trade off is that HK sacrifices the ability to use monetary policy to influence domestic interest rates.
Unlike US, Hong Kong cannot decrease its interest rates to stimulate a weak economy. If HK attempts to lower its interest rates, capital would flow out of HK to seek higher returns.
US lowers interest rates that leads to inflow of USD to Hong Kong (which rate is higher than US). HKD strengthens. HKMA intervenes to keep exchange rate at pegged value (buy USD/sell HKD). Money supply increase, pushing interest rates down. Hong Kong interest rates fall, therefore following US interst rates.
Hong Kong sacrifices an independent monetary policy, in order to have a fixed exchange rate with capital mobility in and out of the country. This is so in practice.
Example: China
China, until 2005, is able to conduct independent monetary policy and tied its exchange rate to the US$. The trade off is that China sacrifices free capital flows.
•By controlling the funds that move in and out of the country, it limits the
•resulting changes in the money supply and
•corresponding pressures on the exchange rate
•That is, by restricting capital flows, China is able to conduct independent monetary policy, where its domestic interest rates can be different from the rest of the world.
Fixed Exchange Rate System
Fixed exchange rates tend to be used primarily by small, developing nations whose currencies are anchored to a key currency, such as the US$ (e.g. HK$)
A currency is considered a “key currency” when it is widely traded on world money markets, demonstrated relatively stable values over time and widely accepted as a means of international settlement.
Anchoring to a single currency (e.g. US$): This works well for developing nations whose trade and financial relations are mainly with a single industrial-country partner
Anchoring to the special drawing right (SDR): This is about using a basket of four currencies established by the IMF (US dollar, euro, British pound, and Japanese yen)
Anchoring to a basket of currencies: This is when developing nations with more than one major trading partner, anchors to a currency basket. There is a mix of prescribed quantities of foreign currencies in proportion to the amount of trade done
Under a fixed exchange rate system, the government assigns the currency a par value, in terms of gold or other key currencies. By comparing the par value of 2 currencies, we can determine the official exchange rate.
Exchange Stabilization Fund is set up by government to defend the official exchange rate, through purchases and sales of foreign currencies.
Fundamental Disequilibrium
The costs of defending an existing official rate may be high in the case a “fundamental disequilibrium”
By that we mean in the long term, the official exchange rate and the market exchange rate may move apart, reflecting changes in fundamental economic conditions (eg income levels, tastes and preferences, technological factors).
Devaluation/Revaluation
The purpose of currency devaluation is to cause the home currency’s exchange value to depreciate, counteracting a payments deficit
The purpose of currency revaluation is to cause the home currency’s exchange value to appreciate, counteracting a payments surplus
The terms devaluation and revaluation refer to a legal redefinition of a currency’s par value under a system of fixed exchange rates
Depreciation/Appreciation
The term depreciation and appreciation refer to the actual impact on the market exchange rate caused by a redefinition of a par value, or to changes in an exchange rate, stemming from changes in the supply of or demand for foreign exchange
Floating Exchange Rate
Free floating (flexible) exchange rates mean that currency prices are established daily in the foreign-exchange market, without restrictions imposed by government policy
There is an equilibrium exchange rate, that equates the demand for and supply of the home currency
Changes in the exchange rate will ideally correct a payments imbalance, by bringing about shifts in imports and exports of goods, services, and short-term capital movements
The exchange rate depends on relative productivity levels, interest rates, inflation rates.
Managed Floating Rates
Under managed float (vs free float), a nation can alter the degree to which it intervenes in the foreign-exchange market.
Leaning against the wind is a term to capture central bank intervention to reduce short-term fluctuations in exchange rates without attempting to adhere to any particular rate over the long term
Nations choose target exchange rates, to reflect long-term economic forces that underlie exchange-rate movements (eg inflation differentials, levels of foreign exchange reserves, imbalances in international payments accounts)
Managed floating exchange rates attempt to combine market determined exchange rates (allows market forces to determine exchange rates in the long term)with forex market intervention (used to stabilize exchange rates in the short term) to take advantage of best features of floating exchange rates and fixed exchange rates.
A “dirty float” occurs when a nation used central bank intervention in the foreign exchange market to promote a depreciation of its currency’s exchange value, thus gaining a competitive advantage compared to its trading partners.
Monetary Policy (to stabilize the exchange rate)
Foreign exchange intervention (buying and selling of foreign currencies in the foreign exchange market)
Monetary policy in the money market 1) To offset currency appreciation: Expansionary monetary policy is required to increase the money supply and lower interest rates, leading to less demand for US$ 2) To offset currency depreciation: Contractionary monetary policy is required to decrease the money supply and raise interest rates, leading to more demand for US$
The Crawling Peg (Compromise between fixed and floating rates)
The crawling-peg system combines the flexibility of floating rates with the stability associated with fixed rates
A nation makes small, frequent changes in the par value of its currency, to correct balance-of-payments disequilibrium. Deficit and surplus nations both keep adjusting until the desired exchange rate level is attained. The peg thus crawls from one par value to another. The process of exchange-rate adjustment is continuous for all practical purposes
Currency Crises
A currency crisis, also called speculative attack is a situation in which a weak currency experiences heavy selling pressure
The indications of selling pressure are Sizable losses in the foreign reserves held by a country’s central bank, depreciating exchange rates in the forward market, where buyers and sellers promise to exchange currency at some future date rather than immediately, Widespread flight out of domestic currency into foreign currency
And into goods that people think will retain value
Ways to end the crisis (it ends when the selling pressure stops) 1) Devalue the currency, that is establish a new exchange rate at sufficiently depreciated level. 2) Adopt a floating exchange rate, so currency will find its own level which is almost always depreciated compared to the previous pegged value) Sometimes, the crises “ends in crashes”. Ways to end the crisis (without a crash) 3) Impose restrictions on the ability of people to buy and sell foreign currency 4) Obtain a loan (through IMF) to bolster the foreign reserves of the monetary authority.5) Restore confidence in existing exchange rate, by announcing appropriate an credible ways in monetary policy
Increasing the Credibility of Fixed Exchange Rates
There ways to convince speculators that the fix exchange rate is credible and unchangeable: currency board and
Dollarization. They are explicitly intended to maintain fixed exchange rate, and thus prevent currency crisis
Currency Board
A currency board is a monetary authority that issues notes and coins, convertible into a foreign anchor currency (largely US$ or the UK £) at a fixed exchange rate.
There is a commitment to exchange domestic currency for foreign anchor currency at the fix rate. This means that the currency board MUST HAVE SUFFICIENT foreign exchange to honor this commitment
For each unit of domestic currency issued, it requires a fix amount of forex or gold to be deposited
By imposing a discipline on the process of money creation, this results in greater stability on domestic prices which, in turn, stabilizes the value of the domestic currency
Dollarization
Dollarization occurs when residents of a foreign country say Ecuador use the U.S. dollar alongside or instead of the domestic currency
Full dollarization means elimination of the domestic currency and its complete replacement with the U.S. dollar
To replace its currency, the country would sell all its foreign reserves (mostly US treasury securities) to buy dollars and exchange all outstanding local currency for dollar notes
The benefits of dollarization are Credibility and policy discipline, Avoid the capital outflows that often precede or accompany an embattled currency situation, Decrease in transaction costs due to common currency, Lower rate of inflation that is tied to inflation rate of the issuing country, Greater openness and BOP crises are minimized
Global Economic Crisis of 2007 to 2009
The global economic crisis began as a bursting of the US housing market bubble, and an increase in foreclosures ballooned into a global financial and economic crisis
The US is a major center of the financial world: A main guarantor of the international financial system. A provider of dollars widely used as a currency reserves, as well as, an international medium of exchange. A contributor of financial capital that funds investment activities around the world
The global crisis played out at two levels 1) Among the industrialized nations of the world (with losses from subprime mortgage debt, excessive leveraging of investments, and inadequate capital backing financial institutions. 2) Among emerging market and other economies, which are innocent bystanders to the crisis – weak economies
The US crisis spreads to industrial countries, emerging market and developing economies. As these economies deteriorated, investors pulled capital from countries thus plunging values of stocks, domestic currencies. Slumping exports and commodity prices pushed economies into recession or slow economic growth
Measures include 1) Injecting capital (through loans or stock purchases, to prevent bankruptcy of financial institutions).2) Increasing deposit insurance limits, to limit withdrawals from banks.3) Purchasing toxic debt of financial institutions on the verge of failure, so that they would start lending again.4) Coordinating interest-rate reductions by central banks, to inject liquidity into the economy.5) Enacting simulative fiscal policies to bolster sagging aggregate demand
In response to the subprime crisis, the Fed has engaged in several rounds of quantitative easing, The idea was that reducing the bond purchases gradually – that is, tapering them off – would make clear that the central bank would continue to offer support for the economy, just a lower levels.
Quantitative Easing
Usually, central banks try to raise the amount of lending and activity in the economy indirectly, by cutting interest rates. Lower interest rates encourage people to spend, not save. But when interest rates can go no lower, a central bank’s only option is to pump money into the economy directly, an unconventional monetary policy – i.e. quantitative easing (QE).
A central bank implements quantitative easing by buying financial assets from either commercial banks or other financial businesses such as insurance companies, in order to inject a pre-determined quantity of money into the economy. This is distinguished from the more usual policy of buying or selling government bonds to keep market interest rates at a specified target value. The institutions selling those bonds will then have “new” money in their accounts, which then boosts the money supply
Economic Objectives of Nations
The objectives of macroeconomic policy are the following Internal balance, External balance, Overall balance, Long term economic growth and Reasonably equitable distribution of national income
Internal balance: is about achieving economic stability at full employment – a fully employed economy, with no inflation. External balance: in about achieving neither deficits nor surpluses in its current account
Policy Instruments
To attain external and internal balance, policy makers can pursue the following three policies (i) Expenditure-changing, (ii) Expenditure-switching, and (iii) direct controls
Expenditure-changing policies: The policies alter the level of total spending (increasing or decreasing aggregate demand) for goods and services, including those produced domestically and imported. They include fiscal policy (which refers to changes in government spending and taxes) and monetary policy (which refers to changes in the money supply and interest rates by a nation’s central bank)
Expenditure-switching policies: The policies modify the direction of demand, shifting it between domestic output and imports. Under fixed exchange rates, a nation with trade deficit could devalue its currency, to increase the international competitiveness of its firms, thus diverting spending from foreign-produced goods to domestically-produced goods. Under managed floating exchange-rate and to increase its competitiveness, the nation could depreciate its currency by purchasing other currencies with its currency
Direct controls: – It consists of government restrictions on the market economy, to control particular items in the current account. For example, direct controls such as tariffs are levied on imports in an attempt to switch domestic spending away from foreign-produced goods to domestically-produced goods. To restrain capital outflows or to stimulate capital inflows. The effects of DIRECT CONTROLS is similar to EXPENDITURE SWITCHING (because it affects between DOMESTIC OUTPUTS and IMPORTS)
Policy agreement arises when a single economic policy promotes overall balance (internal and external). Policy conflict arises when a single economic policy does not promote overall balance (internal and external)
Aggregate Demand and Aggregate Supply
The AD curve shows the level of real output (real GDP) purchased at alternative price levels during a given year. AD consists of spending by domestic consumers, by businesses, by government, and by foreign buyers (net exports). As the price level falls the quantity of real output demanded increases. Shifts in aggregate demand curve are caused by changes in the determinants of AD (eg consumption, investment, government purchases, or net exports)
The AS curve shows the relation between the level of prices and amount of real output that will be produced by the economy during a given year. It is upward sloping because per-unit production costs and prices increase as real output increases. The economy is in equilibrium when AD = AS. Shifts in the aggregate supply curve are caused by changes in the price of resources, technology, business expectations. The economy is in equilibrium when AD equals to AS.
Scenario
Assuming the economy is in recession, and it has a current account deficit. It has a floating exchange rate regime
An expansionary MP means interest rates r, will fall. The cost of borrowing is lower, hence making it cheaper for consumers and firms to consume goods & services and invest in factories (economy expands)
The rate of return for holding the country’s currency is also lower, hence making it less attractive for fund managers to hold the currency. The currency will depreciate which makes the country’s exports more competitive and imports more expensive (current account deficit improves). When there is recession and CA deficit, an E/MP is in policy agreement – a single economic policy promotes overall balance (internal and external)
Assuming the economy is booming, it has inflation and current account deficit. It has a floating exchange rate regime. Say the economy pursues a contractionary MP. This means interest rates will rise. The cost of borrowing is higher, hence making it more expensive for consumers and firms to consume goods & services and invest in factories (economy contracts and prices fall, inflation rate declines). The rate of return for holding the country’s currency is also higher, hence making it more attractive for fund managers to hold the currency. The currency will appreciate which makes the country’s exports less competitive and imports less expensive (CA deficit worsens)
When there is inflation with CA deficit, a C/MP is in a policy conflict: Monetary Policy will slow down economy but worsen CA deficit (internal balance restored but not external balance).
Assuming the economy is booming, it has inflation and current account deficit. It has a floating exchange rate regime. Say the economy pursues an expansionary MP. This means interest rates will fall.The cost of borrowing is lower, hence making it less expensive for consumers and firms to consume goods & services and invest in factories (economy expands and prices rise, inflation rate worsens). The rate of return for holding the country’s currency is is lower, hence making it less attractive for fund managers to hold the currency. The currency will depreciate which makes the country’s exports more competitive and imports more expensive (CA deficit improves)
When there is inflation with CA deficit, an E/MP is in a policy conflict: E/MP will improve the CA deficit but worsen inflation rate (external balance restored but not internal balance)
Policy Mix
The policy mix is the combination of the monetary policy and the fiscal policy of a country.
These two channels influence growth and employment, and are generally determined by the central bank and the government, respectively. Ideally, the policy mix should aim at maximizing growth and minimizing unemployment, keeping inflation stable, with internal and external balance
Relations Among Nations
Economic relations among nations can be visualized along a spectrum (conflict and Integration).
At the spectrum’s midpoint lies policy independence.
Policy cooperation: “Officials from different nations “meet to evaluate world economic conditions”
Policy coordination: “formal agreement among nations to initiate particular policies”
Policy Coordination
The Plaza Agreement was signed in 1985 by G-5 (US, Japan, Germany, Great Britain, and France). The US$ was perceived to be overvalued. The twin US deficits (trade and federal budget) were too large. Each country made specific pledges on macroeconomic policy, and agreed to initiate coordinated sales of the dollar. By 1986, dollar had dramatically depreciated
Louvre Accord was signed in 1987 by the G-5. The new concern was an uncontrolled dollar plunge. So there was another round of intervention policies to buy the dollar curb the pace of the dollar’s depreciation, accompanied by other macroeconomic adjustments