Balance of Payments (BOP) and Exchange RatesYou are Here:

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The International Monetary Fund (IMF) defines the BOP as a statistical statement that systematically

summarizes, for a specific time period, the economic transactions of an economy with the rest of the

world. BOP data measures economic transactions include exports and imports of goods and services,

income flows, capital flows, and gifts and similar ―one-sided transfer payments. The net of all these

transactions is matched by a change in the country‘s international monetary reserves.

The significance of a deficit or surplus in the BOP has changed since the advent of floating exchange

rates. Traditionally, BOP measures were used as evidence of pressure on a country‘s foreign exchange

rate. This pressure led to governmental transactions that were compensatory in nature, forced on the

government by its need to settle the deficit or face a devaluation.

Exchange Rate Impacts:

The relationship between the BOP and exchange rates can be illustrated by use of a simplified equation

that summarizes BOP data:

BOP = (X-M) + (CI-CO) + (FI-FO) +FXB

Where: X is exports of goods and services,

M is imports of goods and services,

(X-M) is known as Current Account Balance

CI is capital outflows,

CO is capital outflows,

(CI-CO) is known as Capital Account Balance

FI is financial inflows,

FO is financial outflows,

(FI-FO) is known as Financial Account Balance

FXB is official monetary reserves such as foreign exchange and gold

The effect of an imbalance in the BOP of a country works somewhat differently depending on whether

that country has fixed exchange rates, floating exchange rates, or a managed exchange rate system.

a) Fixed Exchange Rate Countries. Under a fixed exchange rate system, the government bears the

responsibility to ensure a BOP near zero. If the sum of the current and capital accounts does not

approximate zero, the government is expected to intervene in the foreign exchange market by buying or

selling official foreign exchange reserves. If the sum of the first two accounts is greater than zero, a

surplus demand for the domestic currency exists in the world. To preserve the fixed exchange rate, the

governments must then intervence in the foreign exchange market and sell domestic currency for foreign

currencies or gold so as to bring the BOP back near zero. It the sum of the current and capital accounts is

negative, an exchange supply of the domestic currency exists in world markets. Then the government

must intervene by buying the domestic currency with its reserves of foreign currencies and gold. It is

obviously important for a government to maintain significant foreign exchange reserve balances to allow it

to intervene effectively. If the country runs out of foreign exchange reserves, it will be unable to buy back

its domestic currency and will be forced to devalue. For fixed exchange rate countries, then, business

managers use balance-of-payments statistics to help forecast devaluation or revaluation of the official

exchange rate. Normally a change in fixed exchange rates is technically called ―devaluation‖ or

―revaluation, while a change in floating exchange rates is called either ―depreciation or ―appreciation.

b) Floating Exchange Rate Countries. Under a floating exchange rate system, the government of a

county has no responsibility to peg the foreign exchange rate. The fact that the current and capital

account balances do not sum to zero will automatically (in theory) alter the exchange rate in the direction

necessary to obtain a BOP near zero. For example, a country running a sizable current account deficit

with the capital and financial accounts balance of zero will have a net BOP deficit. An excess supply of

the domestic currency will appear on world markets. As is the case with all goods in excess supply, the

market will rid itself of the imbalance by lowering the price. Thus, the domestic currency will fall in value,

and the BOP will move back toward zero. Exchange rate markets do not always follow this theory,

particularly in the short-to-intermediate term.

c) Managed Floats. Although still relying on market conditions for day-to-day exchange rate

determination, countries operating with managed floats often find it necessary to take actions to maintain

their desired exchange rate values. They therefore seek to alter the market‘s valuation of a specific

exchange rate by influencing the motivations of market activity, rather than through direct intervention in

the foreign exchange markets. The primary action taken by such governments is to change relative

interest rates, thus influencing the economic fundamentals of exchange rate determination. A change in

domestic interest rates is an attempt to alter capital account balance, especially the short-term portfolio

component of these capital flows, in order to restore an imbalance caused by the deficit in current

account. The power of interest rate changes on international capital and exchange rate movements can

be substantial. A country with a managed float that wishes to defend its currency may choose to raise

domestic interest rates to attract additional capital from abroad. This will alter market forces and create

additional market demand for domestic currency. In this process, the government signals exchange

market participants that it intends to take measures to preserve the currency‘s value within certain ranges.

The process also raises the cost of local borrowing for businesses, however, and so the policy is seldom

without domestic critics. For managed-float countries, business managers use BOP trends to help

forecast changes in the government policies on domestic interest rates.

Balance of Payments

1. Flexible Exchange Rates

 

When the exchange rates are not stabilized by government authorities, the FE market closely resembles the theoretical model of perfect competition. There is a large number of buyers and sellers who act as price takers.

Accordingly, the exchange rates are determined by demand and supply in the foreign exchange (FE) market.

Demand

the demand for foreign exchange originates in the debit items in the BP.

The amounts of FE demanded are inversely related to its price.

Debit transactions involve payments by domestic residents to foreign residents.

Imports of merchandiseforeign transportation servicespurchases of American residents traveling abroadforeign investment by home residents.

Supply

the supply of FE derives from the credit items in the BP.

Credit transactions involve receipts by domestic residents from foreign residents

exports of merchandisepurchases of foreign travelers in the USinvestment in the US by foreign residents

There is a direct relationship with price.

 

pure float (clean float): No intervention by monetary authorities

dirty (managed) float: occasional monetary intervention designed to smooth out fluctuations

 

2. Fixed Exchange Rates

par value Government officials strive to keep the exchange rates stable even if the rates they choose deviate from the current equilibrium rates. They announce the "par 

value" and a "band" of exchange rates. The exchange rates are allowed to vary within the band.

For example, if Bank of England announces that the par value of £ = $2.00 and supports British pound at 2% below the par or supports $ at 2% above the par, they have to get rid of the excess supply or demand at these prices using their international reserve assets.

During the Bretton Woods era, a country's international reserve assets included gold and other foreign currencies. (See for instance, Japan's international reserves (copy)). Since 1973, they included SDRs and foreign currencies.

 

While gold can be held by the private sector as well as public institutions, gold is no longer used as a means to settle international payments. In countries where gold is held as a reserve asset, its market value is listed, but gold cannot be directly used to settle payments between central banks.

 

(i) US buys £, this ⇒ increases £ reserve in US

(For example, because of its low dollar peg of RMB, China is buying dollars, about $200 billion a year. China accumulated about $1.4 trillion as of November 2007. China is considering selling dollars ⇒ As $ ↓, the value of China's reserve asset declines. )

(ii) UK buys £ (sell $), this ⇒ decreases $ reserve in UK.

 

(i) US sells £ (£ reserve falls in the US)

(ii) UK sells £ ($ reserve increases in UK). China sells RMB and $ reserve increase in China.

 

 

2. Systems of Exchange

 

Monetary authorities differ greatly in their approach to maintaining the value of their currency in the FE market. Some central banks intervene on a daily basis. With most banks, intervention is intermittent. Others make no attempt to influence the price of their currencies.

Fixed Ratesthe government announces an exchange rate, called the parity rate and defends it.

 

Hard peg: Permanently fixed rate (the government has no plan to change it): Currency Boards, Dollarization

Adjustable peg: Rates are periodically adjusted (Bretton woods)

Soft peg

High frequency pegging: day-to-day dollar pegging or week-to-week pegging

Low frequency pegging: month-to-month pegging or quarter-to-quarter pegging

How? Exchange control: rates may be maintained through rationing of foreign exchange

wide band: rates are fixed, but a considerable amount of fluctuation is allowed around the parity rate.

crawling peg: at any point in time, a country is committed to maintain its pegged exchange rate within a margin of X percent. The level is equal to its moving average of the exchange rates over a preceding

period of Y weeks.

where ZY = mean of Z over Y weeks.

Example

Mexico's arrangement during the early 1990s provides a good example of a crawling peg. Mexico pegged the peso to the US dollar. However, the inflation rates of the two countries diverged considerably, which necessitated a gradual depreciation of the peso. In this case, it is better to adopt a crawling peg than to devalue the peso drastically once in a while.

Similarly, Nicaragua pegged the value of its currency to the US dollar. US inflation averaged about 2 to 3 %, but inflation in Nicaragua remained between 10 to 20% a year. Because of this large difference in inflation rates, there would be a tendency for the córdoba to depreciate against the US dollar. Thus, Nicaragua adopted a crawling peg. (Daniels and van Hoose, 2002)

Currency Baskets

While it is efficient to peg one's currency to a stable currency, relying on a single currency might be risky. For this reason, a nation might peg its currency to a basket of foreign currencies. A basket of currencies is likely to be less variable than a single currency.

If all other currencies were included in the basket, the resulting peg would be most stable. However, managing such a peg can be quite cumbersome. Moreover, not all currencies are equally important, and weights should be assigned to each currency in accordance with the economic power of the nations included in the basket. For this reason, the currency baskets often include a small number of major currencies. For instance, the Czech Republic pegged its currency koruna to a basket of currencies including 0.0125 USD and 0.0329 DM, equivalent to 1 koruna (Kc 1).

Currency  Some countries do not have a central bank that conduct monetary 

Boards

policies. Instead they have a currency board, an independent monetary agency, that links the growth of its money supply to the foreign exchange holdings; it issues domestic money in exchange for foreign currency at a fixed exchange rate.

Currency Boards do not engage in discretionary monetary policy. Many small countries have currency boards: Estonia, Hong Kong, Lithuania, and Argentina.

Recently, Lithuania abadoned its currency board because in 1997 a rise in the value of USD resulted in an appreciation of lit against the currencies of its major trading partners and a huge trade deficit.

DollarizationSome countries use the currencies of another nation as their legal tender. Other nations may also abandon their domestic currencies. This practice is called dollarization, i.e., the use of any other currency (dollar or not) as the legal tender.

Euroization

Some European countries now consider euroization, namely to use euro as a legal tender in their countries unilaterally without consulting European Union. The new member states are expected to use euro as legal tender sooner or later. There is as yet no movement to use euro as legal tender in other European countries.

3. Balance of Payments 

 

Organizing BP accounts

The majority of countries publish payments accounts. The items can be grouped into three categories.

Current Account

Merchandise Balance = merchandise exports - merchandise imports

Services = transportation, insurance, travel, investment services (interest income, dividends, profits), royalties and other services

Unilateral transfers = gifts to foreignersprivate transfers = expenditures for missionary, charitable and educational organizations + personal remittances (of immigrants to their families and

relatives)

government transfers = tax receipts from nonresidents, nonmilitary grants, but the largest is government aid toward developing countries (net military transactions)

Capital Account

records the net changes in the country's international financial assets and liabilities

Capital inflow occurs when residents' financial liabilities increase, e.g. selling bonds to foreigners

Capital outflow occurs when residents' financial claims on foreigners increase (or liabilities decrease)

Direct Investment = long term capital outflow. This includes only foreign branches + subsidiaries effectively controlled. (US residents control 50% or more of the voting stock)

Portfolio Investment = long term capital outflow that do not give effective control over investments. covers all international financial transactions with maturity exceeding one year.

Short term capital flows = transactions of international assets with maturity of one year or less. short term borrowing from foreign banks/short term deposits in foreign banks. Most volatile component/ errors & Omissions

Official Reserve Account

records the transactions of the central bank (Federal Reserve system, Treasury, exchange stabilization agency) when it buys/sells foreign currencies.

The central bank has only one intent for these transactions: delay a change in the exchange rate.

   

 

4. Concepts of BP surplus/deficit

  Surplus and deficit are economic concepts that are used to measure

disequilibrium in the balance of payments. One would place some items "above the line" which are regarded as autonomous, and other items "below the line" which are viewed as accommodating the surplus or deficit by the government sector.

Autonomous activities by the private sector generally cause a gap in the balance of payments. Accommodating activities are by the monetary authorities intended to fill the gap.

Merchandise Balance

This balance measures only exports and imports of merchandise by putting them above the line, i.e., treating them as autonomous decisions. Available monthly, and hence popular.

Xg - Mg

US Balance of Merchandise Trade

Goods & Service Balance

X - M.

It is more difficult to keep track of service transactions.

Current Account Balance

This measure covers all transactions that are current,

X - M - T

If surplus, it represents the amount of international lending and corresponds to net foreign investment. Large current account deficits do not necessarily imply there is a problem in the economy.

Basic Balance

The basic balance is the sum of the current account balance and the net movement of long term capital (direct and portfolio investments).

X - M - T - LTC

LTC = long term capital outflow

Basic Balance is intended to measure structural changes in a country's balance of payments

insensitive to short run changes in economic variables such as interest rates, exchange rates, expectations.

responsive only to long term changes in productivity, international competitiveness. This concept is close to the theoretical concept of fundamental equilibrium.

Liquidity Balance

This balance measures the liquidity position of the US,

X - M - T - LTC - STCUS.

STCUS = short term US capital outflow

In case of trouble, STCUS cannot be mobilized, but STCforeign can be quickly retrieved from the US. Appropriate measure in a crisis, but not in a steady state.

Official Reserve Transactions Balance

This balance puts the transactions of monetary authorities below the line, and all others above the line. X - M - T - LTC - STCprivate. If the monetary authorities engage in no transactions to manipulate exchange rates, the official reserve transactions are zero by definition. This balance measures the extent of actions by monetary authorities to delay a change in exchange rates.

intended to measure the exchange market pressure on the country's currency

useful when the monetary authorities are in charge of maintaining a stable exchange rate

If ORTB (was a deficit) = -$10B, then the monetary authorities were compelled to intervene in the FE market for the same amount to prevent a depreciation of the country's currency by

(i) depleting FE reserve by $10 B, (ii) obtaining FE by exporting $10 B of gold, or (iii) borrowing FE from foreign central banks.

 

5. BP Accounting under Flexible Exchange Rate

US BP accounts Since 1978 the US decided not to intervene in the FE market, except in emergency. However, several countries have intervened in the FE markets occasionally, when a currency appreciated or depreciated too much relative to other currencies (e.g., Plaza accord in 1985). Accordingly, BP accounts are prepared in a different way. In a country with a clean float, no reserve

transactions occur, so the official reserve transactions account is zero by definition.

If there are no reserve movements, then the current account and capital account must total zero.

If there is a shock in the payments system, the adjustment is made through exchange rates, i.e., a change in the foreign price of a domestic currency. If clean floats were in operation, then payments accounts would include only current and capital accounts.

However, the US and many industrial countries maintain dirty or managed floats.

Since 1977 in the US, BP accounts have been published in a different format which reflects the nonintervention policy of the Federal Reserve Bank. (No reserve transactions)

Current Account

Exports of goods, services, and income

Merchandise export

service export

income receipts on US assets abroad

Imports of goods, services, and income

merchandise import

service import

income payments on foreign assets in US

Unilateral transfers

Capital Account US Assets Abroad US official reserve asset (gold, SDR, reserve position in the IMF) US government assets US private assets

Foreign Assets in the US

Foreign official assets in the US other foreign assetsStatistical discrepancy

  No reserve account transactions

 Introduction - Balance of Payments (BOP) Theory

BOP is yet another important theory of exchange rate determination. It is also known as General Equilibrium Theory.According to this theory, when there is free market situation, the exchange rates are determined by the market forces i.e. demand for and supply of the foreign exchange. This theory is based on simple market mechanism in which the price of any commodity is determined.

Under this theory the external values cf domestic currency depends on the demand for and the supply of the currency. The Nation's overall Balance of Payments (BOP) can either be in surplus or in deficits. When the nation's BOP is in deficits, the exchange rate depreciates, and when BOP is in surplus, there will be healthy foreign exchange reserves, leading to the appreciation of the home currency. Under deficits in the BOP, residents of a country in question demands foreign currency, excessively leading to excess demand for foreign currency in terms of home currency. However, under surplus BOP situation there is an excess demand for home currency from foreigners than the actual supply of home currency. Due to this price of home currency in terms of concerned foreign currency rises, i.e. exchange rate improves or appreciates. Thus according to this theory the exchange rate is basically determined by the demand for and the supply of foreign currency in concerned nations.

The BOP theory of exchange rate determination is more satisfaction is more satisfactory than the PPP theory of exchange rate determination. It is because BOP theory recognizes the significance of all items in the BOP rather than few items selected under the PPP theory. The BOP theory is like the general equilibrium theory, under which market farces determines the value of the commodity.

According to this theory the BOP disequilibrium can be corrected by adjusting the exchange rate in either direction i.e. devaluation or revaluation. However, this theory has a drawback like it ignores the impact of exchange rate on the BOP.