Understanding Balance of Payments and Exchange Rates
Balance of Payments: Definition and Components
Many countries maintain economic relations with other countries in the world. These are foreign or international transactions. The balance of payments statistics is a measure of the exchange of goods, services, and financial assets of a country with other countries.
- Income transactions record the exchange provided to countries producing the balance: exports of goods, capital inputs, etc.
- Payment transactions record involving foreign exchange out of the country to develop the balance: imports of goods, investments abroad, etc.
The balance is the difference between income and payments. The balance of payments is structured in two main blocks:
Current Account Balance
Includes three components:
The Balance of Goods and Services
This is the difference between the goods and services sold abroad and those purchased abroad. The balance of services registers only exports and imports of services. If we only consider exports of goods, then we talk of the trade balance. This scale is often considered to measure the competitiveness of a country with the outdoors. The trade balance is positive if a country’s exports are greater than its imports, and negative if the opposite happens.
Net Current Transfers
Show the difference between funds or national remittances that migrants send from abroad to their country and the immigrants established in this country.
The Balance of Income
Shows the difference between the national income a country receives from abroad and what is sent out as dividends by foreign companies.
The Financial Account Balance
After all these transactions, if there is a negative balance of income, there will be a debt. How to finance this? If a private company wants to buy goods and services at a higher level than its income from selling its own products and services, it will necessarily have to resort to financial flows, such as requesting a loan from a bank or issuing shares in the stock market. Financial transactions in a country with the exterior are recorded in the financial balance. It collects the difference between sales and purchases of financial assets abroad. In economic slang, this is known as a negative change in net financial assets. The financial balance is formed by different categories:
Direct Investment
Financial investments made in Spain from abroad, or those made from Spain to other countries, intended to be permanent.
Investment Holdings
Financial investments made in Spain from abroad, or those made from Spain to other countries, with a speculative purpose or limited for a long time.
Central Bank Reserves
The Central Bank maintains reserves that endorse the value of a currency. These reserves can be embodied in other currencies or gold. In the case of some countries, reserves play a major role in ensuring the credibility given to the value of its currency in relation to other countries.
International Capital Flows
The factors that explain capital flows: The first factor in financial operations is the calculation of the yield-risk of an investment. International decisions in these factors can also affect taxes. On many occasions, financial transactions are carried out through companies established in countries or areas with special tax regimes, such as the Bahamas. Another factor that explains international financial operations are corporate calls.
The Financial Crisis
If there is doubt that a country will grow enough to return the capital it has borrowed, an international financial crisis is generated, and foreign capital flows to that country cease. These crises often generate contagious effects to other countries.
The Role of the Exchange Rate
Exchange Rate: The value at which one unit of a country’s currency is exchanged for the currency of another country. In general, each country often takes a specific currency as a reference and expresses the exchange rate as other units of the foreign currency needed to buy a unit of the national currency.
Depreciation and Appreciation of the Exchange Rate
Exchange rate changes are known as appreciation or depreciation. When the dollar value of a country increases with respect to another country, it is said to have appreciated. If it loses value, it is said to have depreciated. The exchange rate, like any other price, varies when there are events that alter the supply and demand for currencies. Changes in the exchange rate will impact the balance of payments. In this case, as the modification is motivated by an acquisition of financial assets abroad, it eventually results in an effect on the income balance, increasing the dividends a Spanish company receives from abroad. Given that it affects the price of foreign exchange, its effect will also be extended to the trade balance. A stronger dollar makes exports cheaper and imports more expensive, thereby increasing exports and reducing imports. In the end, the setting in the exchange rate allows the sum of the current account balance and the financial balance to be zero.
The Real Exchange Rate
Represents the change in the value of currencies corrected for price changes.
Purchasing Power Parity (PPP)
To calculate the consumer price index in each country, the most consumed products are taken into account, and these do not coincide across countries. Contrasting the price indices of two different countries or regions does not necessarily mean comparing the same type of products. A way of solving this problem is to use comparable baskets of goods. That is, assume a standard basket of products that is different in all countries and see the cost for each of them. This measure is known as purchasing power parity or PPP.
Effective Exchange Rates
An index of the exchange rate of different countries with regard to a country.
Exchange Rate Policy: Exchange Rate Regimes
As we have seen, the exchange rate is a fundamental variable for understanding international business due to many factors. Some of these factors depend on people’s expectations and can change quickly. The way in which governments establish control over the exchange rate is known as the exchange system. There are two key exchange regimes: the fixed exchange rate and the flexible or floating exchange rate.
The Fixed Exchange Rate
In countries with a fixed exchange rate regime, authorities fix the value of the currency, taking into account supply and demand. Authorities are also changing that reference. When the dollar value decreases, it is said that there has been a devaluation of the exchange rate. If a government decides to raise the value of its currency against foreign currencies, it is called a revaluation. In a fixed exchange rate system, the authorities of a country agree on the price of its currency, regardless of the supply and demand for the currency. When governments want to set a price for their currency that is different from the market price, they use their reserves to intervene.
Flexible or Floating Exchange Rate
In a flexible exchange rate system, the exchange rate is determined only through market mechanisms. If there is a high demand for a currency, its exchange rate rises, and if there is an excess supply of a currency, its exchange rate falls. Under a flexible exchange rate, movements are known as appreciation or depreciation. When the dollar value rises, it is said to have appreciated, and if its value falls, it is said to have depreciated. When there are very abrupt mismatches in the exchange rate, the government may make interventions to maintain the exchange rate at reasonable levels. In general, the institutions that perform these interventions are usually the Central Banks. The exchange rate is closely related to interest rates, the monitoring and control of which is instructed by the Central Bank.
Intermediate Exchange Rates
Beyond the fixed and flexible exchange rate systems, there are other systems known as intermediate regimes, such as dirty float or currency areas. A good example of an interim regime was the European Monetary System (EMS). This system allowed the currencies of member countries to float freely but within certain bands.