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14 The balance of payments and

exchange rates

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© John Tribe

Learning outcomes

• By studying this section students will be able to:– understand the arguments for free trade, the

role of the WTO and GATS– understand the balance of payments accounts– analyse the contribution of the sector to net

export earnings– describe and explain comparative data for

balance of payments accounts

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Learning outcomes

• By studying this section students will be able to:– understand the significance of exchange rates

to recreation, leisure and tourism organizations

– distinguish between spot and forward rates of exchange

– analyse exchange rate movements– understand government and EC policy in

trade and international payments

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Leisure and Trade

• Tourists arriving at Koh Phi Phi, Thailand bringing foreign currency to spend

• Changi Airport Singapore. Foreign currency earnings from transit tourists

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Free trade

• Ricardo argued that specialisation and trade would lead to an increase in total output compared to a position of no specialisation and trade, based upon greater efficiency of production.– it will benefit countries to specialise in producing

those goods and services which it is the very best at producing (where it has a ‘comparative advantage’ over other countries)

– specialisation also leads to economies of scale and acquired expertise

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WTO and GATS

• The WTO (World Trade Organisation) is the international agency that promotes free trade and its GATS (General Agreement on Trade in Services) is the treaty that seeks to operationalise this aim. Free trade liberalisation under GATS is based on three specific pillars:– 1. Market access: Foreign owned companies have free access

to domestic markets– 2. Most Favoured Nation Status: Concessions granted to any

one country must also be made available on a non-discriminatory basis to all other signatories of the agreement.

– 3. National treatment: Foreign investors must be treated on an equal basis with domestic investors, domestic investors must not receive any favourable treatment that could be conceived as protectionist.

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Limits to trade benefits• extra costs involved in currency conversion and risk.• transport costs can add to production costs.• extra costs are involved in adapting goods and services

for local markets.• many countries seek to protect their home markets by

protectionist policies.• most countries wish to maintain some balance of

production in key strategic goods and services so as not to expose themselves to over-dependence on foreign countries.

• although overall there are significant gains to be made from trade, which particular countries benefit most will depend on the terms of trade.

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Trading blocs

• The European Union (EU)

• North American Free Trade Agreement (NAFTA)

• The Asia-Pacific Economic Cooperation forum (APEC)

• The Cairns group

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The terms of trade

• measures the relative prices of what a country exports in relation to the prices of its imports. It is expressed by the formula:

the average price of exports ÷ the average price of imports

• A persistent argument put forward by developing countries is that they face unfavourable terms of trade in comparison with developed countries.

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The balance of payments

• The balance of payments is an account which shows a country’s financial transactions with the rest of the world.

• It records inflows and outflows of currency.• the balance of payments has three main

components– a current – a capital – and a financial account.

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UK Balance of Payments

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The current account

• The current account records payments for trade in goods and services and is thus divided into two parts: visible and invisible trade.– Visibles = exports and imports in goods– Invisibles = the trade in services or intangibles

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Leisure Balance of Payments

• Tourism is an important foreign currency earner for many countries

• What impact has Arsenal striker Henry had on the UK Balance of Payments?– Initial transfer fee– Export sales of club

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Contribution of tourism to Australian Balance of Payments

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Tourism vs other exports: Australia

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US Balance of tourism trade

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The capital and financial account• Investment

– Direct investment is the direct purchase of firms or land or buildings abroad. Portfolio investment is the purchase of securities or shares abroad. Such activity leads to an outflow of funds, but a potential future inflow of profits or dividends under invisibles in the current account.

• Lending and borrowing– This records international loans.

• Official reserves activity– Government use of official reserves of foreign

currencies is recorded here.

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The Hilton, Sharm, Egypt

• What impact does this hotel have on Egypt’s Balance of payments?– Initial Investment– Bills of foreign

tourists– Imports of goods

and services– Repatriation of

profits

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Tourism Leakages

• An Italian made Coffee making machine unloaded for a new café in Kho Phi Phi, Thailand.

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Government policy

• An acute long-term current account deficit will require government intervention. This may take the form of:– devaluation or

currency depreciation– deflation (see graph)– protectionism

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Exchange rates

• Significance of exchange rates:– How does a rise in a

country’s exchange rate affect leisure and tourism?

• Makes imports cheaper (e.g. clothes, equipment)

• Makes exports dearer (e.g. discourages inbound tourists)

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Currency movements and prices

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Determination of floating exchange rates

• A floating exchange rate is one which is determined in the market without government intervention.

• Here the exchange rate is determined, like most prices, by the forces of demand and supply.

• Using the Australian $ to stand for all foreign currencies, we can identify the main determinants of the demand for and supply of sterling as follows:

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Demand for sterling (supply of $Aus)

• What factors cause demand for £ sterling?– demand for UK visible exports– demand for UK invisible exports– demand for funds for direct and portfolio

investment in the UK– demand for funds for overseas deposits in

sterling bank accounts– speculation– government intervention

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Supply of sterling (demand for $Aus)

• What factors cause £ sterling to be supplied for $ Australian?– demand for Australian visible exports– demand for Australian invisible exports– demand for funds for direct and portfolio investment in

Australia– demand for funds for deposits in Australian bank

accounts– speculation– government intervention

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S £

D1 £D2 £

£1 = 2.8 $Aus

£1 = 2.4 $Aus

Price of £

Q0

The Exchange Rate

A fall in the demand for £ will cause the exchange rate to fall

What factors might cause this?

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Exchange Rates

• A fixed exchange rate system is where the price of one currency is fixed in terms of another currency.

• Spot and Forward Markets– The spot market is the immediate market in foreign

currency and represents the current market rate. Payment is made today and the transaction takes place today at today’s rate.

– The forward market exists to satisfy demand for a guaranteed future exchange rate. Payment is made today but the transaction is made in the future (e.g. 3 months) at a rate agreed today.

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Exchange rate and government policy

• Governments may attempt to influence the exchange rate.

• Policy instruments to affect the exchange rate consist of – interest rates and – direct buying and selling of currency by the Central

Bank.

• Raising interest rates will generally increase the demand for a currency as savings are moved from overseas banks to domestic banks to benefit from higher interest rates.

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High or Low Rate?

• The government faces a dilemma in its exchange rate policy as in many other policy areas. – a lower exchange rate makes export prices

competitive and discourages imports– a higher exchange rate, by cutting import

prices, helps to combat inflation.

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Review of key terms• Terms of trade = ?

relative prices of imports and exports• Balance of payments = ?

record of one country’s financial transactions with the rest of the world.

• Exchange rate = ?price of one currency in terms of another.

• Current account = ?value of trade in goods and services.

• Visible trade = ?trade in goods.

• Invisible trade = ?trade in services.

• Devaluation or currency depreciation = ?– movement to a lower exchange rate.

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Review of key terms• Deflationary policy = ?

government policy to reduce economic activity.• Protectionism = ?

policy to control imports• GATS =?

– General Agreement on Tariffs and Trade (tariff-reducing treaty).• Floating exchange rate = ?

one which is determined in the market without government intervention.

• Fixed exchange rate = ?constant rate of exchange maintained by market intervention.

• Spot market = ?the immediate market in foreign currency.

• Forward market = ?futures market for currency.

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14 The balance of payments and

exchange rates

The End