Balance of payments and exchange rate issues

Session 7

Macroeconomics and the International Context

MSc Economic Policy Studies

Alan Matthews

Balance of payments

Lecture objectives

• Describe and understand the balance of payments accounts

• Do international payments imbalances matter?• Addressing international payments imbalances

• Reading: McAleese Chapter 20

Balance of payments

• The balance of payments is a set of accounts showing all economic transactions between residents of the home country and the rest of the world in any one year

• The current account in the balance of payments records all visible and invisible trade

• The capital account covers mainly capital transfers (EU grants and migrants’ net worth)

• The financial account in the balance of payments is a record of a country’s transactions in foreign financial assets and financial liabilities (often distinguishing between long-term and short-term flows)

CSO Student Corner on balance of payments

Balance of payments statement

Current accountGoods trade (merchandise trade)ServicesTrading and investment incomeCurrent unilateral transfersBalance on current account

Capital accountFinancial account

Balance on financial accountForeign direct investmentPortfolio capitalOther investmentChange in official reservesNet errors and omissions

2011, €bn37-2

-31-11

-0

61127

-330

-7

Irish data. Source: CSO Balance of international payments release, Dec 2012

Some definitions

• Merchandise trade similar to balance of trade account (see Trade lecture) but valued at f.o.b prices for both exports and imports

• Invisibles refers to balance of services trade, investment income and current transfers (net current receipts from EU and Irish Aid expenditure)

• Capital account transfers refer mainly to capital receipts under EU structural funds

• Financial account includes long-term capital flows (FDI and portfolio investment) and other flows which are mainly short-term loans and transactions in financial derivatives

• Reserve assets are non-euro denominated liquid assets and gold owned by the Central Bank

Further definitions

• Sometimes distinction is made between autonomous and accommodating transactions in the balance of payments

• Former are seen as ‘active’ transactions, responding to real changes in competitiveness conditions, while latter are ‘passive’

• Example: consider reactions to an increased demand for imports

• Line is drawn under the basic balance, but increasingly less distinct as capital markets become more liquid

Irish balance of payments trendsYear Merch-

andiseInvisibles Balance

on current account

Services Trading & invest-

ment income

Current transfers

Total Invisible

2002 35,442 -13,779 -23,664 707 -36,736 -1,295

2003 32,604 -11,091 -21,947 432 -32,606 -2

2004 31,423 -10,203 -22,481 393 -32,291 -867

2005 28,218 -9,303 -24,870 265 -33,908 -5,690

2006 25,031 -6,797 -24,033 -506 -31,336 -6,304

2007 19,811 -1,121 -27,825 -990 -29,936 -10,124

2008 23,811 -7,670 -25,155 -1,154 -33,979 -10,169

2009 32,469 -6,900 -27,907 -1,424 -36,231 -3,763

2010 35,751 -6,639 -25,918 -1,412 -33,969 1,782

2011 36,588 -1,810 -31,834 -1,159 -34,803 1,785

Borrowers and lenders, debtors and creditors

The balance of payments is a flow concept

It shows whether a country is a net borrower or a net lender in any year

A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it.

A creditor nation is a country that has invested more in the rest of the world than other countries have invested in it.

The difference between being a borrower/lender nation and being a creditor/debtor nation is the difference between stocks and flows of financial capital.

Does it matter if a country is a debtor nation? Depends on how the borrowing has been used.

International Investment Position

• The international investment position (IIP) is a point in time statement of the value and composition of the balance sheet stock of an economy's foreign financial assets (i.e. the economy's financial claims on the rest of the world) and its foreign financial liabilities (or obligations to the rest of the world).

• The change in the IIP between beginning and end of period is equal by definition to the current account balance over that period plus valuation changes reflecting changes in exchange rates and asset prices

• Note reconciliation is also difficult due to large BOP balancing item ‘net errors and omissions’

Source: CSO Quarterly International Investment Position, Dec 2010

Ireland’s IIP

Source: Lane, Dynamics of Ireland’s net external position, SSISI, 2011

Source: Lane, Dynamics of Ireland’s net external position, SSISI, 2011

Understanding the balance of payments current account

• First, some national income accounting• Recall total income Y is defined from

expenditure side asY = C + I + G + X – M

• Y can also be defined asY = C + S + T

• In equilibrium, these two definitions are identical(I - S) + (G – T) = (M – X)

Balance of payments deficit = excess investment over savings plus government

budget deficit

Interpreting a current account deficit

• Two views– A deficit is a sign that a country is spending

more than it earns, a weakness which must be corrected by either/both reducing expenditure or switching expenditure from imports in favour of exports

– A deficit is a sign of strength because it means the country is sufficiently profitable to attract continued flows of foreign capital (focus on the basic balance)

The importance of sustainability

• “A country is said to have a balance of payments problem when the current account deficit and the accumulated international investment position have reached a level where continuance of the deficit is no longer judged sustainable” – McAleese

• Issues– Time dimension– Size of deficit in relation to GDP and debt position– Method of financing of deficit– Related to use of deficit (investment or consumption?)– Growth position

• Sustainability a matter of market confidence

Source: http://www.voxeu.org/index.php?q=node/2820 EA = Euro Area

Correlation between cost of CDS and current account

Why an unsustainable current account deficit matters

– Adds to cost of foreign borrowing– Greater exposure to the volatility of international

capital markets with potential for lack of confidence scenario (Asian crisis 1997)

– May induce excessivly large exchange rate depreciation

– Asset ownership moves into foreign hands– Within the euro zone a country’s balance of

payments should matter no longer, but it remains an important symptom of underlying problems

Interpreting a current account deficit

• McAleese ‘tale of three deficits’– US deficit– Developing countries’ debt– Deficits in Euroland

Sustainability of the US current account deficit

• How sustainable is the deficit?

• Will it keep downward pressure on the US dollar?

• US deficit was running at around 6% of US GDP

• US dollar has depreciated by 40% relative to the euro between Jan 2002 and Jan 2004

The US deficit is sustainable

“Some argue our large trade deficit (or current account deficit) is responsible for the fall in the dollar's value. They have it backward. It is the flow of foreign investment dollars (the capital account) into the U.S. economy that drives the trade deficit. The U.S. economy's higher return on capital than Europe or Japan for the last 20 years caused private foreign investors to buy U.S. stocks and bonds and other assets. In addition, foreign governments, particularly of China, Japan and other Asian states, have steadily increased their purchases of U.S. dollars as reserve backing for their own currencies.”- Cato Institute economist Richard Rahn, Jan 2004

Note similarity to Box 20.1 in MacAleese

The US deficit is not sustainable

• High productivity growth and booming stock markets in the 1990s drove a wedge between private investment and savings

• US household savings now fallen to 1% of GDP

• US fiscal policy now hugely expansionary• Foreigners will lose their appetite to hold

US assets, causing interest rates to rise and restricting demand

Prospects for a soft US landing

• US economy insulated from the worst effects of an international financial crisis– Because of its size– The fact that most of its obligations are

denominated in its own currency– International role of the dollar underpins

demand for it– Damage may be felt as much by other

countries as by the US

Correcting a balance of payments imbalance

• Automatic adjustment mechanisms– Start with adverse shock to exports

-> fall in demand for imports used as inputs to production

-> fall in aggregate demand leads to fall in imports

-> monetary factors such as fall in real balances

-> supply side adjustments through changes in relative prices of traded/nontraded goods

Correcting a balance of payments imbalance

• Recall (I - S) + (G – T) = (M – X), problem is to reduce excessive (M-X)

• Expenditure reduction policies– Increase S– Reduce I– Reduce G – T through restrictive fiscal policies

• Expenditure switching policies– Commercial policy (tariffs, etc)– Improved cost competitiveness– Exchange rate changes

Relationship between global imbalances and the financial crisis

• What role did global imbalances play in the crisis?

• One view – excess savings drove down real interest rates, led to underpricing of risk

• Other view – poor financial regulation was the cause

• Suominen 2010

Source: King 2011

• Capital flowing ‘uphill’• Driving by savings ‘glut’ in

surplus countries

Challenges for the G20

• How to address global imbalances when OECD countries are undertaking significant fiscal contraction?– Excess of global savings– Export-led growth model of China, Germany,

Japan– Currency appreciation by surplus countries?– Alternatives?

Exchange rates

Motivations

• Ireland has a high share of trade outside the eurozone in which exchange rates play a crucial role in determining competitiveness

• Exchange rates are highly volatile• The level of exchange rates can cause problems

for business• What determines the level and volatility of

exchange rates?• Reading: McAleese Chapter 21

US dollar/euro exchange rate

Source: ECB Statistical data warehouse

Euro depreciates

Euro appreciates

Sterling/euro exchange rate

Source: ECB Statistical data warehouse

Euro depreciates

Euro appreciates

The forex market

• Note its size!– According to BIS, average daily turnover April 2010 was

€3.98 trillion (see Wikipedia entry)

• Made up of a series of interrelated markets– Spot market

– Forward market

– Futures market

– Derivative markets• Swaps and options

• Determines the relative values of different currencies

The exchange rate

• The price of foreign currency (dollar, sterling, yen) in terms of domestic currency (euro)– (viz. The price of apples – how much do you have to

pay in domestic currency)

• Suppose it costs US citizen $1.99 to buy 1 GBP in 1991 and twelve years later it costs only $1.58 – dollar has appreciated

• From UK perspective, I USD cost 50p in 1991 and 63p in 2003 – sterling has depreciated

Impact of exchange rate on firms

• Advantages of a strong currency– Makes imported raw materials cheaper– Helps to control inflation– Leads to lower interest rates– Makes foreign assets cheaper

• Disadvantages of a strong currency– Exporters lose price competitiveness– Adverse impact on competitiveness may be

moderated if leads to lower wage demands

Effective exchange rates• Bilateral exchange rates do not move together, so we

need some method to summarise the overall strength or weakness of a country’s currency

• The nominal effective exchange rate (EER) is defined as the exchange rate of the domestic currency vis-à-vis other currencies weighted by their share in world trade– Which currencies– What weights?– Significance of the base year– Now called the Harmonised Competitiveness

Indicator (HCI)

Source: The Economist

March 24 2012

Real Effective Exchange Rate

• Real effective exchange rate (REER) also takes account of price level changes between countries– adjusts the nominal EER by the ratio of foreign to domestic

inflation– Used to assess change in competitive position of a country

relative to its competitors• Example

– Suppose currency of country A has depreciated over one year by 10% against currency of country B

– Suppose inflation rate in A is 7% and inflation rate in B is 2%– Then real depreciation (change in REER) is 10% - (7% - 2%) =

5%– Improvement in competitive position is 5%, not the 10%

suggested by the EER• Now called the real HCI

Source: NCC, Ireland’s Competitiveness Scorecard 2012

Exchange rate determination

• The exchange rate between two currencies is the price of one currency in terms of the other

• Express the exchange rate as the number of US dollars (price) per euro

• To determine the exchange rate we examine both the demand for and the supply of euros

The demand for euro

• A derived demand• Americans want euro

– in order to pay for European goods and services (exports)

– In order to pay for European assets including government bonds, equities and property

$/€

Euro

Depreciation

2

1

0.5

The supply for euro

• A derived supply• Europeans want

dollars– in order to pay for

American goods and services (imports)

– In order to buy American assets including government bonds, equities and property

$/€

Euro

Depreciation

2

1

0.5

Exchange rate equilibrium$/€

S

D

Factors which shift the demand or supply curves

• Interest rate differentials– Shifts in demands for assets

• Inflation differentials– If EU goods become more expensive

• Growth differentials– Stronger growth usually associated with stronger currency

• Speculation– Expectations about future exchange rates– Affected by above factors as well as stance of economic policy

(budget deficits, balance of payments deficits, political outlook as well as market psychological factors)

Reaching a new equilibrium

• Suppose euro interest rates rise

• Will increase demand for euro from US investors

• Will decrease supply of euro as EU investors also shift from US to EU assets

• Euro appreciatesD1

D2

S1

S2

$/€

Exchange rate equilibrium

• How can we tell if a currency is over-valued or under-valued?

• Is a currency likely to appreciate or depreciate in the near future?

• Answers provided by– Purchasing Power Parity theory– Balance of payments approach– Asset market or portfolio theories

Purchasing power parity

• PPP model holds that, in the long run, exchange rates adjust to equalise the relative purchasing power of currencies

• Draws inspiration from Law of One Price– Arbitrage will ensure price levels converge

• Absolute PPP– The exchange rate will be such as to make the general level of

prices the same in every country– Exchange rates between currencies are in equilibrium when

their purchasing power is the same in each of two countries– Unrealistic assumptions– Difficulties with non-traded goods

Purchasing power parity

• Relative PPP– Changes in the exchange rate are determined by the

difference between relative inflation rates in different countries

• Over the long run we would expect exchange rates to adjust to maintain purchasing power parity

• In other words, exchange rates should adjust to offset differences in the rates of inflation, maintaining a constant real exchange rate

• Do exchange rates adjust to maintain purchasing power parity?– Yes, in the long run, but very slowly for reasons that

are still unclear (see Rogoff JEL 1996)

Purchasing power parity

• How is PPP calculated?– The Economist ‘Big Mac’ index– People consume very different goods and services

across countries– Standard estimates produced every six months by

OECD/Eurostat (OECD PPP database)– OECD estimates in next chart compare the PPP of a

currency with its actual exchange rate compared to US dollar. Green bars (top of chart) indicate currency is overvalued and thus expected to depreciate against he US dollar in the long run, and vice versa.

OECD PPP estimates(relative to Euro)

Source: University of British Columbia Pacific FX Service

PPP uses• Clearly there are significant discrepancies

between PPP and actual exchange rates• But can PPP be used to predict exchange rate

changes?– Poor empirical performance – Real exchange rates not only determined by relative

inflation differentials– Real exchange rates can and do change significantly over

time, because of such things as major shifts in productivity growth, advances in technology, shifts in factor supplies, changes in market structure, and commodity shocks

– Note objection: Rapid productivity growth -> higher inflation -> currency appreciation (Balassa-Samuelson effect)

– But important long-run benchmark

Balance of payments approach

• BoP approach focuses on relationship between trade/current account balance, modified to taken into account long-term capital flows, and the exchange rate

• BoP approach also allows ER to be influenced by real factors (economic fundamentals)

• Country with a persistent deficit is likely to devalue, country with persistent surplus likely to revalue

• Different to, but consistent with, PPP theory– PPP -> If country A has higher inflation rate than B,

will run into a deficit and be forced to devalue

Examples of economic fundamentals

• These are factors which can shift the supply and demand curves for a currency (see above)– Changes in the growth rate– Balance of payments (influencing

expectations)– Equity and bond market performance– Size of budget deficits and public debt– Governance and political stability

Asset market (portfolio) explanations

• PPP and BoP approaches focus on role of ER in balancing flows of foreign exchange

• Modern approach emphasises role of ER in balancing the supply and demand of domestic and foreign assets

• Exchange rates adjust to reflect differences in the rate of return on assets (bills and bonds) in different currencies

• It is differences in the expected total return which is relevant. This comprises the interest rate on foreign assets plus the capital gain (loss) from a appreciation (depreciation) of the foreign currency

Asset market explanations

• Expected exchange rate changes (and hence the expected capital gains or losses from investing abroad) influence decisions

• Because expectations are influenced by ‘news’, and news is unpredictable, so are short run fluctuations

Interest rate parity

• What determines international capital portfolio movements?– Difference between interest rates at home and abroad– Expectations about future exchange rates

• Interest rate parity describes the relationship between forward exchange rates, spot exchange rates and interest rates between two countries

• Rates of return on comparable assets should be equal around the world, implying that exchange rates adjust so that difference between interest rates is zero.

• It relies on the market’s tendency to correct itself through arbitrage • Two versions

– Uncovered parity– Covered parity

Uncovered interest rate (UIP) parity• If US risk-free interest rate is 4% and euro rate is 2%,

why do fund managers not switch into dollar assets?• Domestic interest rate less foreign interest rate =

expected change in exchange rate (Uncovered interest rate parity)

• Assumes– Perfect capital mobility– Equal risk on home and foreign bonds

• If interest rate differential is greater than the expected change in spot rates, potential for arbitrage

Covered interest rate (CIP) parity

• Borrow money in one currency (low interest rate), use to buy bonds in second currency (higher rate), and protect (cover) against exchange rate movements by buying the first currency forward

• Interest rate differences should equal the forward premium (covered interest rate parity)

• Forward exchange rate is a proxy for exchange rate expectations. UIP builds on CIP by assuming that market forces ensure the forward exchange rate is equal to the expected future spot exchange rate– However, forward exchange rate is not a good (although

unbiased) predictor of the spot rate– Underlines that exchange rates are affected by shocks which

are inherently unpredictable

Empirical performance of interest rate parity

• Does (uncovered) interest rate parity hold?– Hard to measure, since requires information

on expectations and on relative risk of bonds

• Cause or effect?– if it holds, does it mean that interest rate

differentials determine exchange rate changes, or vice versa?

One effort to measure desired equilibrium exchange rates

Cline and Williamson, 2012, Peterson Institute

Summary

• Exchange rate movements are an important determinant of competitiveness

• Although we can understand the factors which move exchange rates, their movement is very hard to predict

• Modern theory emphasises how the importance of the balance of trade in goods and services (the real economy) in influencing exchange rates is overwhelmed by international capital movements, whose movement is very hard to predict

• Firms can adapt strategies to insulate partially against exchange rate movements, but they are partial and costly

• International coordination of exchange rates?

Source: EEAG report 2012

Euroland issues

Source: EEAG report 2012

Source: EEAG report 2012

Restoring Ireland’s competitiveness

• Within the EU, commercial policy and exchange rate changes are ruled out

• Expenditure reduction policies (i.e. fiscal tightening) can lead to severe economic contraction and rise in unemployment

• Reduction in nominal wages required to mimic a real devaluation – internal devaluation - , but how to achieve?