2. 1 20.Exchange Rate and the Balance of Payment

3. 2 Chapter 20 : main menu 20.1Exchange rates Theory in Life 20.1 Progress Checkpoint 1 20.2 The effects of exchange rate movement on trade 20.3 The linked exchange rate system 20.4Balance of Payments account Theory in Life 20.2 Concept Explorer 20.1 Concept Explorer 20.2 Theory in Life 20.3 Progress Checkpoint 2

4. 3 Theory in Life 20.1 How the linked exchange rate is maintained (This part is not required by the HKCEE. It can be skipped without loss of continuity). Under the currency board system, it is interest rates rather than the exchange rate of HK dollar which adjusts to inflows or outflows of funds.

5. 4 Upward pressure on the HK dollar exchange rate Currency board sells HK dollars Interest rates decrease Monetary base expands Market participants buy HK dollars Capital inflow Currency board buys HK dollars Downward pressure on the HK dollar exchange rate Monetary base contracts Interest rates increase Capital outflow Market participants sell HK dollars The exchange rate between HK dollar and US dollar is stabilized Fig. 20.1 The automatic mechanism to maintain the linked exchange rate. Theory in Life 20.1

6. 5 Reminder : The exchange rate can also be stabilized through an ‘arbitrage and competition’ mechanism among the note-issuing banks. Therefore, the expansion (contraction) in the monetary base leads to a decrease (an increase) in interest rates for Hong Kong dollar. This creates the monetary conditions that counteract the original capital flow automatically. Hence the exchange rate between HK dollar and US dollar can remain stable.

7. 6 Progress Checkpoint 1 Q20.1 Given the following exchange ratio between British pound and Swiss Franc (SFr): £ 5 = € 7 (a) What is the exchange rate of £ 1 in terms of € ? (b) What is the exchange rate of € 1 in terms of £ ? (a) The exchange rate of £ 1 is € 1.4. (b) The exchange rate of € 1 is £ 0.7143.

8. 7 Progress Checkpoint 1 Q20.2 The following shows the exchange ratios of the currencies of Country A ($A) and B($B) on two dates : 1 st August 20021 st August 2003 $A 3 = $B 1$A 2= $B 1 How did (a) the exchange value of $A change relative to $B? (b) the exchange value of $B change relative to $A? (a) the exchange value of $A increased relative to $B, i.e. $A has appreciated against $B. (b) the exchange value of $B decreased relative to $A, i.e. $B has depreciated against $A.

9. 8 Progress Checkpoint 1 Q20.3 Given the following exchange rates between Japanese Yen ( ¥ ) and Hong Kong dollars (HK$) : 1 st July 20011 st July 2002 ¥1,000 = HK$65¥1,000 = HK$70 How does EACH of the following change in the above period? (a) the exchange value of HK$ relative to ¥ ? (b) the exchange value of ¥ relative to HK$? (c) the price and volume of goods exported from Hong Kong to Japan? (d) the prices and volume of goods imported from Japan into Hong Kong? (e) the total expenditure (in HK$) on imports from Japan to Hong Kong?

10. 9 Progress Checkpoint 1 (a) the exchange value of HK$ relative to ¥ falls, i.e. HK$ depreciates against ¥ (b) the exchange value of ¥ relative to HK$ rises, i.e. ¥ appreciates against HK$ (c) the price of goods exported from Hong Kong to Japan falls; the volume of exports from Hong Kong to Japan rises (d) the prices of goods imported from Japan into Hong Kong rises; the volume of imports from Japan into Hong Kong falls (e) there is uncertain change in the total expenditure (in HK$) on imports from Japan to Hong Kong. If HK ’ s demand for Japanese imports is elastic, the total expenditure will fall. If it is inelastic, the total expenditure will rise.

11. 10 Theory in Life 20.2 Finding the balance of trade The following table shows the composition of Hong Kong ’ s Gross Domestic Product (GDP) in 1990 and 2000: Ratio to total GDP GDP components19902000 Private consumption expenditure68%75% Government consumption expenditure10%18% Gross domestic fixed capital formation20%17% Changes in stocks10%-3% Exports of goods50%132% Imports of goods75%113% Exports of services46%92% Imports of services29%118% Source : Hong Kong Census and Statistics Department

12. 11 Was there a trade deficit or surplus in 1990 ? in 2000? Suggest a reason for these. In 1990, since the exports and imports of goods are 50% and 75% of the 1990 GDP, the value of exports is less than that of imports of goods. Hence there was a trade deficit. In 2000, since the exports and imports of goods are 132% and 113% of the 2000 GDP, the value of exports is greater than that of imports of goods. Hence there was a trade surplus. One reason for the change is the expansion of the trade in China. If China exports more goods to the western countries through Hong Kong, Hong Kong’s re-exports of goods will increase. This may lead to a trade surplus in 2000. Theory in Life 20.2

13. 12 Concept Explorer 20.1 Determining the balance of trade The following graph shows an economy’s growth rates of exports and imports of goods from 1980 to 2001. Fig. 20.2The growth rates of exports and imports of goods.

14. 13 Between 1992 and 1997, the growth rate of exports of goods is greater than that of imports of goods. Under what condition can we say that there was a trade deficit? The growth rates of exports and imports of goods are different from the values of exports and imports of goods. If the initial values of imports of goods is significantly greater than that of exports, and such difference is not offset by a larger growth rate of the exports of goods, then in the period 1992 and 1997, it is possible to have a trade deficit. Concept Explorer 20.1

15. 14 Concept Explorer 20.2 The sub-classification of the capital and financial account The following shows how different economic transactions are recorded in the capital and financial account. As the HKCEE does not require students to learn such account in details, this section can be skipped without loss of continuity.

16. 15 Concept Explorer 20.2 Capital Account a.Capital transfers This includes the transfer of ownership of a fixed asset or forgiveness of a liability  ( 債務減免 ). Examples: 1. A businessman in HK donates some machines to an agricultural organization in the Philippines. [debit] 2. An Australian company forgives a loan owed by a HK company. [credit]

17. 16 Concept Explorer 20.2 b. Non-produced and non-financial assets This includes the transactions of tangible assets ( 有形資產 ) that are not actually produced (e.g. land) and of intangible assets ( 無形資產 ) (e.g. patents, copyrights, trademarks and franchises). Examples : 1. A US company buys a piece of land in HK. [credit] 2. A HK garment firm buys the patent of a fashion design from a Paris firm. [debit] 3. A HK film production company sells the copyright of a movie to a US firm. [credit] 4. A HK manufacturing firm buys a trademark from a toy company in Japan. [debit] 5. A HK telecommunication firm buys a franchise from a French company for providing 3G mobile phone service in Europe. [debit]

18. 17 Concept Explorer 20.2 Financial Account c. Direct or Real Investment  This includes external investment in which an investor of an economy acquires a lasting interest of an enterprise located in another economy. External investment in real estate is also a form of direct investment. Examples : 1. A HK resident buys an apartment in Malaysia. [debit] 2. A US bank invests buys a tower in HK. [credit] 3. A HK resident buys 10% of the shares of a publicly listed company in the Mainland of China. [debit]

19. 18 Theory in Life 20.3 How different economic transactions are recorded in the balance of payments How is each of the following economic transactions recorded in the balance of payments of Hong Kong?

20. 19 Theory in Life 20.3 Economic transactionsIn which account is it recorded?Is it a credit or a debit entry? (a) A Hong Kong resident receives dividend from the shares issued by a company in Mainland China. External factor income flow in the current account credit (b) A Hong Kong music production company buys the copyright of a song from a Japanese music firm. Capital and financial accountdebit (c) A Hong Kong advertising firm borrows a loan from a company in Singapore. Capital and financial accountcredit (d) A US technology firm sets up a branch in Hong Kong.Capital and financial accountcredit (e) A Japanese tourist travels by tram in Hong Kong.Invisible trade in the current accountcredit (f) A Hong Kong resident purchases some warrants of a bank in London. Capital and financial accountdebit (g) A Hong Kong resident donates some money to the victims of an earthquake in Iran. Current transfers in the current accountdebit Table 20.3 How different economic transactions are recorded in the balance of payments.

21. 20 (h) A British investor purchases 0.0001% of the shares of the Mass Transit Railway Corporation Ltd. Capital and financial accountdebit (i) A Hong Kong resident purchases a notebook computer from Japan. Visible trade in the current accountdebit (j) A Hong Kong firm forgives a loan owed by an Indian firm. Capital and financial accountcredit Economic transactionsIn which account is it recorded?Is it a credit or a debit entry? Table 20.3 How different economic transactions are recorded in the balance of payments. Theory in Life 20.3 Reminder : If an economic transaction is not recorded in the current account as visible trade, invisible trade, external factor income flow or current transfers, then it is recorded in the capital and financial account.

22. 21 Progress Checkpoint 2 Q20.4 State how EACH of the following item will be recorded in the current account of the balance of payment of Country X: (a) The government of Country X donates of a sum of money to Country A (b) A resident of Country X receives wages from working in a company in Country X for 3 months (c) A firm in Country X sells some manufactured goods to Country C. (d) A securities company of Country D provides stock trading services to a tourist from Country X (a) A debit entry under current transfers (b) A credit entry under external factor income flows (c) A credit entry under visible trade (d) A debit entry under invisible trade

23. 22 Progress Checkpoint 2 Q20.5 Given the following data about the balance of payment components of HK: HK$ million Domestic exports of goods650 Re-exports of goods230 Imports of goods420 Exports of services1,520 Imports of services1,840 External factor income inflow2,450 External factor income outflow2,170 Current transfer inflow320 Current transfer outflow770

24. 23 Progress Checkpoint 2 (a) Calculate the value of exports of goods. (b) Calculate the value of retained imports. (c) Calculate the balance of trade and state whether it is in surplus or deficit. (d) Calculate the balance of invisible and state whether it is in surplus or deficit. (e) Calculate the value of net external factor income inflow. (f) Calculate the current account balance and state whether it is in surplus or deficit.

25. 24 Progress Checkpoint 2 (a) Exports of goods = Domestic exports + re-exports = HK$(650 + 230)m = HK$880 m. (b) Retained imports = Imports of goods – re-exports of goods = HK$(420 – 230) m = HK$190 m. (c) Balance of trade = Exports of goods – imports of goods = HK$(880 – 420)m = HK$460m (surplus).

26. 25 Progress Checkpoint 2 (d) Balance of invisible trade = Exports of services – imports of services = HK$(1,520 – 1,140)m = -HK$ 320m (deficit). (e) Net external factor income inflow = External factor income inflow – external factor income outflow = HK$(2,450 – 2,170)m = HK$280m (surplus). (f) Current account balance = all credit entries – all debit entries = HK$[(650 + 230 + 1,520 + 2,450 + 320) – (420 + 1,840 + 2,170 + 770)]m = - HK$30m (deficit).

27. 26 Q20.6A current account deficit implies that balance of trade, balance of invisible trade, net external factor income inflow and net current transfers are all in deficits. Do you agree? No. A current account deficit only implies that the sum of all credit entries in the account is less than the sum of all debit entries. It is possible that some sub-items (e.g. balance of trade, net current transfers, etc) are in surplus. But it will be impossible for all sub-items to be in surplus. Progress Checkpoint 2

28. 27 Q20.7 For each of the following, name the account within Country A’s balance of payments will be affected, and state whether it will be recorded as a credit or debit entry. (a) A resident of Country A watches a concert in Country X. (b) A firm in Country A donates some medical equipment to a hospital in Country X. (c) A resident of Country A receives a remittance from a relative in Country X. (d) A resident of Country X receives interest from his deposits in a bank in Country A. (e) A resident of Country X purchases some bonds issued by the government of Country A. (f) A resident of Country X purchases an MP3 player produced by a firm in Country A. (a) A debit entry in the current account (invisible trade) (b) A debit entry in the capital and financial account (c) A credit entry in the current account (current transfers) (d) A debit entry in the current account (external factor income flows) (e) A credit entry in the capital and financial account (f) A credit entry in the current account (visible trade) Progress Checkpoint 2

29. 28 Q20.8 (a) “ A balance of payment may be in surplus. ” (b) “ A balance of payment account must always balance." Is EACH of the above statements true or false ? (a)True. A balance of payment will be in surplus if the sum of all credit entries in the current, capital and financial accounts is greater than that of all debit entries. The official reserve assets will rise, which will be recorded as a debit entry in the balance of payment. (b)True. Because the net change in reserve asset just offsets the overall balance of payment, a balance of payment account which includes the net change in reserve asset must balance on the credit and the debit sides. Progress Checkpoint 2

30. 29 Q20.9 Is it possible for an economy to have a trade surplus and a balance of payments deficit in the same year? Yes. It occurs when the economy ’ s other items in the current, capital and financial (non-reserve) accounts altogether have a deficit, and such deficit is greater than the balance of trade surplus. Progress Checkpoint 2

31. 30 End of Chapter 20