Lectures 33-39: BOP & Exchange Rate Systems

Lectures 33-39: BOP & Exchange Rate Systems
Components of BOP Exchange rate and its determination

Fall 2007 NU-FAST Zahid Siddique
BOP Accounts Balance of Payment is record of a country’s international transactions—sum of current and capital accounts BOP = CA + KA Current Account is record of a country’s international trade in currently produced goods and services. Include: X – M = NX, called trade or merchandise balance Net investment income = Investment income earned on foreign assets by home residents - Investment income paid to foreigners on home assets earnings include interest payments, dividends or royalties on bonds, stocks, patents or assets also include Net Factor Payment (NFP) Unilateral Transfers include payments that do not involve purchase of goods, services or assets CA = X – M + Net income from abroad + Unilateral Transfer Fall NU-FAST Zahid Siddique

BOP Accounts Capital Account is record of a country’s international trade in existing assets, whether real or financial If assets are traded among private individuals, then it appears on private capital account Includes Capital inflow: occurs when a resident of country sells an asset to someone in another country Capital outflow: occurs when a resident of country purchases an asset from abroad both in shape of FDI and PFI KA = Value of capital inflow – Value of capital outflow Fall NU-FAST Zahid Siddique

BOP Accounts Official Reserve Transactions (ORT) or Official Settlement Balance is conducted by central bank When buyer/seller of assets is central bank, transaction appears on ORT account Includes assets (other than domestic money or securities) that can be used in making international payments e.g. gold, government securities of other economies, foreign bank deposits or IMF created assets Fall NU-FAST Zahid Siddique

Schematic representation of BOP
Accounts and Sub-accounts Cumulative Balance Current Account (CA) Merchandise Services (Transportation, Tourism, Business & professional services) Merchandise / Trade balance = Exports – Imports 2) Net investment income BO goods & income = (X – M) + Investment income received on foreign assets by home residents - Investment income paid to foreigners on domestic assets 3) Unilateral transfer Government grants Private remittances CA Balance = X – M + Net income from abroad + Unilateral Transfers Fall NU-FAST Zahid Siddique

Schematic representation of BOP
Accounts and Sub-accounts Cumulative Balance Capital Account (KA) Direct investment Portfolio investment Long & short term KA Balance = Value of capital inflow – Value of capital outflow Over all BOP = CA + KA Official reserve transaction Changes in foreign CB’s holding of domestic assets Changes in home CB’s holding of foreign assets Gold, foreign exchange reserves , IMF credits Fall NU-FAST Zahid Siddique

How to record transactions?
The rule can be defined in two equivalent ways transaction involving flow of funds into a country is a credit item and entered with plus sign, and transaction that involves flow of funds out of a country is a debit item and entered with minus sign Alternatively, whatever leaves country is recorded as credit item and whatever enters is recorded as debit item Exports Credit item with plus sign Imports Debit item with minus sign Sell of domestic assets Credit item Purchase of foreign assets Debit item (b/c claim to asset enters country) Purchase of assets by home CB Debit item Fall NU-FAST Zahid Siddique

Relationship among three: The Balance
Identity, not equation By definition CA + KA + ORT ≡ 0 This is due to Double Entry Book-keeping Every complete economic transaction is recorded twice, once as debit and once credit b/c each transaction involves something leaving the country in exchange for something entering (except for unilateral transfers) Thus, every swap of goods/services has offsetting effects on the sum of CA, KA and ORT Since it is an accounting identity, it has not much importance! The important statistics are (i) CA balance and (ii) BOP balance The two statistics show whether a country is spending beyond its means, and whether there is net supply of, or demand for, its currency Consider an example Fall NU-FAST Zahid Siddique

Let BOP = 0 initially, and a Pakistani exports of worth $100 Pakistan is now running CA (and hence BOP) surplus The person can use this $100 in following ways may import from US of worth $100 an export credit entry in CA will be offset by another import debit entry in CA and BOP surplus will vanish Current Account Exports + $100 Imports - $100 CA Balance Capital Account No transaction KA Balance BOP Fall NU-FAST Zahid Siddique

may buy US assets of $100 may be in the form of US currency account This involves capital outflow which implies KA deficit equal to CA surplus (KA = - CA), BOP = 0 and ORT = 0 This can be recorded as Current Account Exports + $100 Imports CA Balance Capital Account Capital outflow - $100 KA Balance BOP Fall NU-FAST Zahid Siddique

If country is running CA surplus and private residents are not acquiring foreign assets—i.e. may decide to convert dollars with rupee through some bank bank may loan it to an individual for US imports or purchase of assets, then same as above happens or central bank must be acquiring foreign assets so country will have surplus on CA, and KA = 0 while ORT = - BOP Current Account Exports + $100 CA Balance surplus both on CA and BOP Capital Account KA Balance BOP + $100 CB’s holding of foreign assets - $100 BOP = -ORT Fall NU-FAST Zahid Siddique

Thus, BOP shows net supply of foreign currency (or net demand for domestic currency) after the private sector has made all its desired CA and KA transactions If BOP > 0, ORT must be negative which means CB is adding to its foreign exchange reserves (or is supplying domestic currency that private agents demand in foreign market) If BOP < 0, ORT must be positive, means CB is selling foreign exchange reserves (or buying domestic currency that private agents want to sell in foreign market) This shows that ORT = - BOP, i.e., ORT is negative of the sum of items on BOP account Therefore, ORT is termed as accommodating entry in BOP accounts (b/c it always adjusts to keep BOP = 0) while the other (CA and KA) accounts are said to be autonomous Fall NU-FAST Zahid Siddique

The issue of deficit CA deficit may be expressed as difference between value of exports and imports of goods and services To see this, begin from national income identity With slight rearrangements It says that if output > domestic spending, NX > 0 (i.e., we have trade surplus), and if output < domestic spending, NX < 0 (i.e, we have trade deficit) CA deficit then means a country is importing more than it is exporting—ignoring other small fractions in this total imports subtracted to find expenditures only on domestic goods Fall NU-FAST Zahid Siddique

The issue of deficit Another way to express deficit is the difference between national savings and investment Rearranging national income identity as LHS is national saving, SN To see this, note that SN = Sprivate + Spublic, where summing up we have LHS so we have means trade surplus if (S – I) > 0, and deficit if (S – I) < 0 Deficit now reflects low level of national savings relative to investment or a high rate of investment—or both Fall NU-FAST Zahid Siddique

The issue of deficit CA deficit matters b/c amount flowing to foreigners is used to buy assets in domestic country—i.e. CA deficit is financed by selling domestic assets stream of incomes on assets is paid to foreigners thus limiting resources available for investment If foreigners are not buying our assets, country faces depreciation on its currency (to be discussed later) Deficit is highly unjustified if it is in shape of ‘for consumption goods’ (as is case for Pakistan) due to insolvency issues Bearable if borrowing are used to finance investment that has a higher marginal product than interest rate problematic if private financing not available in future consumption, investment, and government expenditures must be curtailed to repay in short order its past borrowings Fall NU-FAST Zahid Siddique

Exchange rate History of modern financial system evolution later, if possible Nominal Exchange rate is relative price of two currencies Can be expressed in two ways measures how many units of domestic currency I can get in exchange for one unit of foreign currency measures how many units of foreign currency can be purchased by one unit of domestic currency US authors prefer first while Europeans prefer second definition change in definition changes direction of movement of ER Fall NU-FAST Zahid Siddique

Exchange rate Real Exchange rate is relative price of two countries goods; i.e. how many units of foreign good can I get in exchange of one unit of domestic good, also called terms of trade Consider an example a burger costs Rs240 in Pakistan and $2 in US to compare where it is cheaper, covert its price into a common currency if 1$ = Rs60, then USB costs Rs 120 which means that USB costs one-half of a PakB; i.e. two USB can be exchanged with one of PakB algebraically, now in same currency unit Cancel out i.e. 1 USB = 0.5PakB same as above Fall NU-FAST Zahid Siddique

Exchange rate Putting formally, If real exchange rate is high, foreign goods are cheaper while domestic ones are expensive, and vice versa However, with $/Rs definition of ER, formula becomes Don’t get confused if you find different versions in different books Tip: refer to the definition of exchange rate for solution Fall NU-FAST Zahid Siddique

Purchasing Power Parity (PPP)
Relation b/w nominal and real ER can be derived simply Assume all countries producing one and same good None will exchange both goods but on one-to-one bases; i.e. idea that similar domestic and foreign goods should have same price in terms of same currency is called PPP—purchasing power of two currencies should be same across countries an application of the law of one price at international level due to the process of arbitrage Above expression implies that says that enom should equal ratio of foreign to domestic price Fall NU-FAST Zahid Siddique

If USB = $2 and PakB = Rs240, then Data shows PPP does not hold—neither in short nor long run Many reasons account for it Countries don’t produce similar goods Not all types of goods in a basket are freely traded Transaction costs and barriers against trade matter To see the general relationship b/w enom and ereal, apply percentage change on ereal expression using log-rule or for PPP to hold, 1$ = Rs120 Difference b/w foreign and domestic inflation Fall NU-FAST Zahid Siddique

so we have says that enom is affected by inflation in two countries. It depreciates if real exchange rate decreases; or rate of domestic inflation is higher than foreign If ereal is constant over time, then E.g. with USB = $2, PakB = Rs240 and if πf = 0 while πd = 10% after one year, still USB = $2 but PakB = Rs264 PPP predicts that enom should change to Similar result also holds for interest rate parity %Δenom is exactly 10% Fall NU-FAST Zahid Siddique

Digression on terminologies
Flexible exchange rate is one determined by the supply and demand conditions of a currency in the foreign exchange market (the market for international currencies) Fixed exchange rate is one determined by government at official level and is changed only by government actions Managed-floating exchange rate is one in which exchange rate responds to market conditions while central bank also intervenes to prevent undesirable movements in exchange rate Depreciation is a reduction in the value of a currency by market forces under flexible exchange rate system increases in exchange rate means domestic currency depreciates and foreign currency appreciates (when exchange rate is defined as ‘units of domestic currency / foreign currency’) Fall NU-FAST Zahid Siddique

Digression on terminologies
Appreciation is increase in the value of a currency due to market forces under flexible exchange rate system decreases in exchange rate implies that domestic currency appreciates and foreign currency depreciates Devaluation is the reduction in the value of a currency by official government action under fixed exchange rate system Revaluation is the increase in the value of a currency by official by official government action under fixed exchange rate system If exchange rate is instead defined as ‘units of foreign currency / one unit of domestic currency’, the above definitions are reversed; that is depreciation would be called appreciation and so on Fall NU-FAST Zahid Siddique

Determination of floating exchange rate
It is determined by demand for and supply of a currency The demand for, say $, arises when, say, Pakistani purchase US goods or assets Demand for a currency is negatively related to exchange rate So b/c as exchange rate (Rs/$) increases, price of US goods in terms of Rs rises E.g. Suppose a USCam = $1 and enom = Rs 10/$. The camera costs Rs 10 to Pakistanis If enom rises to Rs20/$, same camera costs Rs 20 Pakistanis decrease imports demand from US, hence for its currency—hence negative relation established enom D$ Dollars Fall NU-FAST Zahid Siddique

Supply of currency is positively related to exchange rate So b/c as exchange rate increases, Pakistani exports become less expensive to US residents in terms of dollars E.g. Suppose a PakFootball = Rs10 and enom = Rs 10/$. Then foot-ball would cost 1$ to US residents If, however, enom increases to Rs 20/$, the same foot-ball will cost $0.5 now US order more export of foot-ball from Pakistan (hence more dollars supplied) enom S$ ER is determined by the interaction of demand for and supply of foreign exchange Market exchange rate is e* and $* dollars are traded in the international market e* D$ $* Dollars Fall NU-FAST Zahid Siddique

Factors that affect exchange rate are given below An Increase in Causes ER to Because In Graph Domestic output (income), Yd Fall Higher Yd raises demand for imports and increases supply of domestic currency S$-curve shifts outward Foreign output (income), Yf Rise Higher Yf raises demand for domestic exports and increases demand for domestic currency D$-curve shifts outward Domestic real interest rate, r Rise Higher real r makes domestic assets attractive and increases demand for domestic currency D$-curve shifts outward Foreign real interest rate, rfor Fall Higher rfor makes foreign assets more attractive and increases supply of domestic currency S$-curve shifts outward Fall NU-FAST Zahid Siddique

Exchange rate and CA Factors that affect NX (or TB) are given below An Increase in Causes NX to Because Domestic output (income), Yd Fall Higher Yd raises demand for imports hence decreases NX Foreign output (income), Yf Rise Higher Yf raises demand for our exports hence increases NX Domestic real interest rate, r Fall Higher r appreciates exchange rate; domestic exports become expensive and imports from abroad become cheaper. Hence NX decrease Foreign real interest rate, rfor Rise Higher rfor depreciates exchange rate; domestic exports become cheaper while foreign imports expensive. Hence NX increase Fall NU-FAST Zahid Siddique

Determination of fixed exchange rate
In a fixed ER system, government announces an official ER at which all trading take place This official ER may be above or below market (or fundamental value of) exchange rate This diagram shows that the official exchange rate is above the equilibrium one In this case, the domestic currency ($) is overvalued. To keep ER at levels other than market ER, government becomes demander and supplier of its currency in foreign exchange market Here, supply of domestic currency (point b) in exceeds its private demand (point a) hence excess supply (ab) enom S$ eF a b e* D$ $* Dollars Fall NU-FAST Zahid Siddique

Determination of fixed exchange rate
Government can purchase excess currency in the amount ab against foreign reserve assets (e.g. gold, foreign bank deposits, assets created by IMF etc) However, central bank can’t do it for long b/c it has limited supply of foreign reserve assets The process is even more difficult in case of speculative man—one who buys currencies for arbitrage In case of undervalued fixed ER, country gains reserves at the cost of its trading partner (who is having overvalued currency) It puts political pressure on the country to bring exchange rate at equilibrium rate enom S$ eF a b e* D$ $* Dollars Fall NU-FAST Zahid Siddique

Lectures 33-39: BOP & Exchange Rate Systems

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