1. EXCHANGE RATES & BALANCE OF PAYMENTS Chap. 26

2. BALANCE OF PAYMENTS

3. Current Account Balance Current Account: NX +NFI + Secondary Income Primary Income/NFI (Overseas Wage & Investment Income) Secondary Income (Transfers) Census and Statistics Department

4. International Capital Flows Capital Outflows: domestic acquisition of foreign assets. Capital Inflows: foreign acquisition of domestic assets Net Capital Outflows = Capital Outflows – Capital Inflows Money is an asset. Most international financial transaction are swaps of one asset for another and have zero net effect on capital flows. Only net trade of foreign assets for goods or services creates opportunity for net capital flows. Current Account = Net Capital Outflows Net Capital Outflows both private sector and public sector. Examine each more carefully

5. Savings & Current Account Gross National Savings: GNS GNS =Income – Consumption (PCE + GCE) Income = GNP + Secondary GDP = Consumption + Gross Capital Formation + Net Exports (Exports – Imports) GNS – GCF = NX + NFI + Secondary = Current Account

6. Global Imbalances Link World Current Account equals zero!

7. Capital & Financial Account Capital & Financial Account measures the allocation of (non- official( net inflows. Capital Account: Transfer of Real Assets Financial Account: Transfer of Financial Assets Non-reserve Assets Direct Investment: (Taking Controlling Stakes in Foreign Entities) Portfolio Investment: (Stocks, Bonds) Financial Derivatives (Futures, Swaps) Other (Mostly Bank Loans and Deposits)

8. Capital & Financial Account 2011 Increases in financial assets, and decreases in liabilities should be shown as debits. Decreases in financial assets, and increases in liabilities should be shown as credits. Salient Feature of Balance of Payments

9. Official Account Accumulation of Foreign Reserves by Official Sector (Finance Ministry Central Bank Sometimes referred to as Balance of Payments or Official Settlements Account

10. Balance of Payments Foreign Currency Received (Credit) Foreign Currency Paid (Debit) Exports (+) Income Receipts (+) {Non official} Capital Inflows (+) Imports (-) Income Payments (-) {Non reserve} Capital Outflows (-) BoP = Current Account + Capital & Financial Account Balance of Payments = Credits – Debits Link Supply of US$Demand for US$

11. EXCHANGE RATES

12. What level should it be? Link

14. Two Models UIRP Balance of Payments: Supply & Demand

15. Interest Parity

16. Saving It is January 1 st, and you have D$1000 to save for 1 year. You can put it into: 1. a domestic currency bank account at an interest rate i. 2. a foreign currency bank account at interest rate i F.

17. Payoff to strategy #2 Strategy two has three parts. 1. Buy foreign exchange at spot rate S t to get {D$1000/E t } F$.. 2. Put {D$1000/E t } F dollars into FC bank account. After 1 year get F$(1+i F )×{D$1000/E t } 3. Convert these funds into F$ at exchange rate prevailing at end of year.

18. Uncovered Interest Parity If, deposit funds then deposit in F$ account. If, deposit funds then deposit in D$ account. Then in equilibrium

19. Interest Rate Parity The only reason people would be willing to hold a US$ account when US interest rates were lower than domestic interest rates would be if they can achieve an expected gain from an increase in the value of US$ during the time that they were holding the account. Approximately

20. Three Reasons UIRP might not hold 1. Future exchange rates are risky, uncovered interest parity does not account for risk. A. Interest Parity Works for Forward Prices Forward Price for currency delivered at t+1 2. Domestic and foreign currency not perfect substitutes. People like to hold currency for liquidity reasons. 3. Currency controls

21. Balance of Payments Model

22. Exchange Rates as price of US$ Unlike textbook, we will describe a model of domestic country’s forex market in which US$ is vehicle currency BIS Triennial Survey of Foreign Exchange Turnover

23. From Interest Parity People trade currencies to engage in foreign trade and international investment. Expected (Investment) Profit: Of Domestic Investors in Foreign Economy Of Foreign Investors in Domestic Economy

24. Consider the spot foreign exchange market. Supply of US$: People who want to acquire DCU to buy domestic goods or assets. Substitution Effects When US$ becomes expensive, domestic goods or assets get cheap and foreign investors are attracted to domestic currency. Expensive Expected Profit Effect - e.g. Expensive US$ magnifies returns on domestic accounts Expensive Exports Effect – Expensive US$ increases the attractiveness of domestic exports.

25. Demand for US$: Domestic people who want to acquire US$ for foreign purchases or overseas investment. Substitution Effects: When US$ get cheap, US$ goods or assets get cheap and demand for US$ rises Cheap Expected Profit Effect - e.g. Cheap US$ magnifies returns on foreign accounts Cheap Imports Effect – Cheap US$ increases the competitiveness of imports.

26. Supply and Demand in Forex Mkt E Demand Supply Forex Turnover BoP > 0 BoP < 0

27. Equilibrium in the Forex Market Gap between supply and demand of US$ is the Balance of Payments. Two types of Forex Markets Floating: Forces of supply and demand equilibrate markets. Fixed: Gov’t/Central Bank buys excess foreign currency in market.

28. De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks Currency board - explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed rate. Conventional Peg - formally (de jure) pegs its currency at a fixed rate to another currency or a basket of currencies. Stabilized Arrangement - spot exchange rate remains w/in a margin of 2% for six months or more. Crawling - rate remains w/in a narrow margin of 2% relative to a trend Float - largely market determined, w/o ascertainable/predictable path Free Float – intervention occurs only exceptionally

29. Equilibrium with Floating Rates E Demand Supply E* E E ⓪ Forex Turnover

30. Increase in Desired Capital Inflows by Foreign Investors/ Desired Purchases of Domestic Goods E Supply Demand E* Supply ' E** Domestic Currency Appreciates ⓪ ① Forex Turnover

31. Increase in Desired Capital Outflows by Domestic Investors/ Desired Purchases of Foreign Goods E Supply Demand E* Demand ' E** Domestic Currency Depreciates ⓪ ① Forex Turnover

32. Domestic Monetary Policy Causes D.C. Interest Rates Go Up Relative Demand for US$ Goes Down E Supply Demand E* Supply' Demand' E** Domestic Currency Appreciates 1 2 Excess Supply

33. Foreign Monetary Policy Causes Foreign Interest Rates Go Up/Relative Demand for US$ Goes Up E Supply Demand E* Supply' Demand ' E** Domestic Currency Depreciates 2 1 Excess Demand

34. Monetary Policy Expectations and Exchange Rates Future exchange rates affect the expected profitability of holding bank accounts in a country’s currency. Current level of the exchange rate guided by the future path of interest rates.

35. Exchange Rates are Volatile! – Japan and USA have same monetary policy

36. Expectation of E t+1 Increases E Supply Demand E* Supply' Demand' E** Domestic Currency Depreciates 1 2 Excess Demand

37. China Forex Market: Excess Supply of US Trade Surplus: Chinese exporters bringing cash home can sell foreign currency at policy rate to SAFE. Capital & Currency Controls: Non-trivial to move money into China and even harder to move it out. Govt policies to encourage FDI inflows and discourage portfolio outflows. Exchange Rate Policy: Crawling Peg

38. Fixed Exchange Rate: Weak Currency Target E Demand Supply Forex Turnover BoP > 0 E TGT Gov’t Buys Excess Supply US$ Foreign Reserves Increase

39. Source: IMF Balance of Payments Data

40. Link

41. Fixed Exchange Rate: Strong Currency Target E Demand Supply Forex Turnover BoP < 0 E TGT Gov’t Buys Excess DCU Foreign Reserves Decrease

43. Foreign Currency Intervention Sterilized vs. Unsterilized Two ways of financing interventions Foreign currency purchase: Central bank purchases foreign currency Unsterilized: Create additional domestic currency liquidity Sterilized: Borrow domestic currency from banks, govt, selling bonds. Foreign currency sale Central bank sells foreign currency Unsterilized: Withdraw domestic currency liquidity Sterilized: Repay domestic currency loans.

44. Balance of Payments Crisis Basic asymmetry between weak and strong currency target. Weak target: Govt has infinite amount of domestic currency and can always maintain. Strong target: Govt has finite amount of foreign currency and may face a balance of payments crisis. BoP crisis: Gov’t must borrow funds from abroad or allow a weakening of the currency.

45. MONETARY POLICY UNDER FIXED EXCHANGE RATES Hong Kong’s Exchange Rate Regime

46. Clearing Accounts Reserves May 2005 Under the strong-side Convertibility Undertaking, the HKMA undertakes to buy US dollars from licensed banks at 7.75. Under the weak-side Convertibility Undertaking, the HKMA undertakes to sell US dollars at 7.85.

47. US Monetary Policy Causes US Interest Rates Go Down, Strengthening Pressure on HK$ E Supply Demand E=7.8 Supply' Demand' Appreciation Pressure on HK$ 1 Excess Supply

48. Hong Kong Interbank Market: HIBOR higher than US interest rate. S BR D BR i HIBOR Reserve Accounts i FedFunds i*i* S BR ' Banks convert US$ to Clearing Balances to take advantage of higher interest rates in Hong Kong 1 2

49. Convertibility Undertaking Stabilizes Forex Demand and Supply Curves Automatically E Supply ' ' Demand ' ' E=7.8 Supply' Demand' Hong Kong Interest Rate Falls 1 Excess Supply

50. Fixed Exchange Rate If the central bank undertakes to keep the exchange rate fixed and that is a credible undertaking, then If the relative values of currency are fixed, then funds will flow out of the domestic currency if domestic interest rates are too low and flow into domestic currency if interest rates are too high.

51. Loss of Credibility A fixed exchange rate will lose credibility if people come to believe that the central bank will: devalue the currency, (ie. raise S in the future) revalue the currency (ie. reduce S in the future) If market expects an exchange rate change, commercial banks will adjust comparison rate for the expectations of devaluation.

53. Iron Triangle of International Finance Pick 2 items from this menu Open International Capital Flows Independent Interest Rate Stable Exchange Rates

54. Final Exam When Friday December 18 th,. Where LSK: 2001 L2: 2003. What: In class material, through here How: The format of the exam will be similar to the midterm or the practice exams with a combination of multiple choice, short answer, calculation, and graphing questions. Students should bring a calculator, writing instruments and an A4 sheet of paper with handwritten notes (must be handwritten, no Xerox or printout) on both sides.

55. REAL EXCHANGE RATES & TRADE BALANCE

56. Real Exchange Rate: Measure of Competitiveness We can measure the competitive pricing of home goods. Numerator: # of domestic currency units needed to by the # of foreign currency units needed to buy 1 foreign good. Denominator: # of domestic currency units needed to buy 1 domestic good

57. Benchmark: PPP The first theory of exchange rates was Purchasing Power Parity – Arbitrage should insure the price of goods was equalized across countries Is PPP true? Not in short run. Trade arbitrage does not work that fast. How about long run?

58. Exchange Rates OECD Source: IFS 1975-1995

59. Real Exchange Rate & Competitiveness When RER is weak (i.e. when currency is undervalued), domestic exports are competitive on global markets while foreign imports may be less attractive.

60. Competitiveness & Current Account IMF Data Mapper

61. Learning Outcomes Students should be able to: Use interest differentials to calculate expected depreciation rate under UIRP. Use the Supply-Demand model of the forex model to explain the effect of international trade conditions on the exchange rate. Calculate the real exchange rate with the exchange rate and PPP.