EXCHANGE RATES & BALANCE OF PAYMENTSChap. 26

BALANCE OF PAYMENTS

Current Account Balance

• Current Account: NX +NFI + Secondary Income• Primary Income/NFI (Overseas Wage & Investment Income)• Secondary Income (Transfers)

Census and Statistics Department

Credit Debit Balance Credit Debit Balance Net Exports2013# 3,945,256 -4,148,558 -203,302 817,948 -596,581 221,367 18,065

Credit Debit Balance Credit Debit Balance Net Income1,183,568 -1,143,049 40,519 8,088 -28,964 -20,876 19,643

Current Account37,708

HK$ millionPrimary income Secondary income

BoP : Current account HK$ million

YearGoods Services

International Capital Flows

• Capital Outflows: domestic acquisition of foreign assets.• Capital Inflows: foreign acquisition of domestic assetsNet 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

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

Global Imbalances

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World Current Account equals zero!

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)

Capital & Financial Account 2011Increases 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.

Capital & Financial Account (CFA) (Hong Kong) -113,242Capital Account (Hong Kong) -2,021Financial Account (FA) (Hong Kong) -111,220 Financial Non Reserve Assets (Hong Kong) -24,437 Direct Investment (DI) (Hong Kong) 1,868 Assets (AS) (Hong Kong) -746,372 Liabilities (LB) (Hong Kong) 748,240 Portfolio Investment (PI) (Hong Kong) -10,979 Assets (AS) (Hong Kong) -155,818 Liabilities (LB) (Hong Kong) 144,839 Financial Derivatives (FD) (Hong Kong) 20,884 Assets (Hong Kong) 359,707 Liabilities (Hong Kong) -338,823 Other investment (OI) (Hong Kong) -36,210 Assets (Hong Kong) -780,960 Liabilities (Hong Kong) 744,749 Reserve Assets (Hong Kong) -86,783Net Errors and Omissions (Hong Kong) 3,156Overall Balance (Hong Kong) 86,783

Salient Feature of Balance of Payments

Official Account• Accumulation of Foreign Reserves by Official Sector (Finance

Ministry Central Bank• Sometimes referred to as Balance of Payments or Official

Settlements Account

Balance of PaymentsForeign 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

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Supply of US$ Demand for US$

EXCHANGE RATES

What level should it be?

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Foreign Exchange Rate: Bank of Russia: US Dollar

Spot 1 Year Forward50

52

54

56

58

60

62

64

66

Ruble/$ Rate December 30 2014 Forward Premium 1.1656071+i 1.17251+iF 1.006288(1+i)/(1+iF) 1.165173

Two Models• UIRP• Balance of Payments: Supply & Demand

Interest Parity

1(1 ) (1 )F tt t

t

Ei iE

Saving

It is January 1st, 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 iF.

Payoff to strategy #2• Strategy two has three parts.1. Buy foreign exchange at spot rate St to get {D$1000/Et}

F$.. 2. Put {D$1000/Et} F dollars into FC bank account. After 1

year get F$(1+iF)×{D$1000/Et }3. Convert these funds into F$ at exchange rate prevailing at

end of year. 1(1 )

$1000F

t

t

i ED

E

Uncovered Interest Parity

• If , deposit funds then deposit in

F$ account.• If , deposit funds then deposit in

D$ account. • Then in equilibrium

1(1 ) 1F

t

t

i Ei

E

1(1 ) 1F

t

t

i Ei

E

1 (1 ) 1Ft

t

Ei i

E

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

11

t tF F Et t t t

t

E Ei i i g

E

Three Reasons UIRP might not hold1. 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

{ }1

11

t tFt tt

iF Ei

{ }

1 :ttF

Balance of Payments Model

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

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

1 (1 )Ftt

t

E iE

11t

tt

E iE

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.

• Expected Profit Effect - e.g. Expensive US$ magnifies returns on domestic accounts

• Exports Effect – Expensive US$ increases the attractiveness of domestic exports.

11t

tt

E iE

• 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

• Expected Profit Effect - e.g. Cheap US$ magnifies returns on foreign accounts

• Imports Effect – Cheap US$ increases the competitiveness of imports.

1 (1 )Ftt

t

E iE

Supply and Demand in Forex Mkt

E

Demand

Supply

Forex Turnover

BoP > 0

BoP < 0

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.

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

OtherU.S. dollar (66) Composite (15) Other (7) _ (44)

Currency board Hong Kong SAR Brunei Conventional Peg DenmarkStabilized Arrangement Cambodia VietnamCrawling & Crawl-like ChinaOther Managed Singapore Bangladesh, Malaysia MyanmarFloat Mongolia, Pakistan, Sri Lanka, Korea

Indonesia, Thailand, Philippines, IndiaFree Float Australia, New Zealand, J apan

Exchange rate arrangement

Monetary Policy FrameworkExchange rate anchor

Equilibrium with Floating Rates

E

Demand

Supply

E*

E

E

⓪

Forex Turnover

𝐸

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

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

Domestic Monetary Policy Causes D.C. Interest Rates Go Up Relative Demand for US$ Goes Down

ESupply

Demand

E*

Supply'

Demand'

E**

Domestic Currency Appreciates1

2

Excess Supply

Foreign Monetary Policy Causes Foreign Interest Rates Go Up/Relative Demand for US$ Goes Up

E

SupplyDemand

E*

Supply'

Demand '

E**

Domestic Currency Depreciates

2

1

Excess Demand

Monetary PolicyExpectations 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.

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

Expectation of Et+1 Increases

E

SupplyDemand

E*

Supply'

Demand'

E**

Domestic Currency Depreciates1

2

Excess Demand

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

Fixed Exchange Rate: Weak Currency Target

E

Demand

Supply

Forex Turnover

BoP > 0ETGT

Gov’t Buys Excess Supply US$

Foreign Reserves Increase

2005 2006 2007 2008 2009 2010 2011 2012 2013$0.0

$500.0

$1,000.0

$1,500.0

$2,000.0

$2,500.0

$3,000.0

$3,500.0

PRC Balance of Payments (Billions of US $)

Supply (Exports + Financial Inflows) Demand (Imports+Financial Outflows)

2005 2006 2007 2008 2009 2010 2011 2012 2013

Supply (Exports + Financial Inflows) $1,020.4 $1,281.3 $1,662.4 $1,839.6 $1,670.0 $2,333.2 $2,728.0 $2,728.2 $3,230.6Demand (Imports+Financial Outflows) $800.9 $1,008.2 $1,221.2 $1,385.1 $1,236.2 $1,817.8 $2,337.3 $2,553.1 $2,727.7Balance of Payments $250.6 $284.8 $460.7 $479.5 $400.3 $471.7 $387.8 $96.6 $431.4

Source: IMF Balance of Payments Data

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Link

Fixed Exchange Rate: Strong Currency Target

E

Demand

Supply

Forex Turnover

BoP < 0ETGT

Gov’t Buys Excess DCU

Foreign Reserves Decrease

Foreign Currency InterventionSterilized vs. UnsterilizedTwo 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.

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.

MONETARY POLICY UNDER FIXED EXCHANGE RATESHong Kong’s Exchange Rate Regime

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.

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

Hong Kong Interbank Market:HIBOR higher than US interest rate.

SBR

DBR

iHIBOR

Reserve Accounts

iFedFunds

i*

SBR 'Banks convert US$ to Clearing Balances to take advantage of higher interest rates in Hong Kong

1

2

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

Fixed Exchange Rate

1 0 .Ft tt t

t

E Ei i

E

• 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.

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.

1HIBOR FF t tt t

t

E Ei iE

32874 -1033m/yy

yy

33086 -1033m/yy

yy

33298 -1033m/yy

yy

33512 -1033m/yy

yy

33725 -1033m/yy

yy

33939 -1033m/yy

yy

34151 -1033m/yy

yy

34366 -1033m/yy

yy

34578 -1033m/yy

yy

34790 -1033m/yy

yy

35004 -1033m/yy

yy

35217 -1033m/yy

yy

35431 -1033m/yy

yy

35643 -1033m/yy

yy

35855 -1033m/yy

yy

36069 -1033m/yy

yy

36281 -1033m/yy

yy

36495 -1033m/yy

yy

36708 -1033m/yy

yy

36923 -1033m/yy

yy

37135 -1033m/yy

yy

37347 -1033m/yy

yy

37561 -1033m/yy

yy

37773 -1033m/yy

yy

37987 -1033m/yy

yy

38200 -1033m/yy

yy

38412 -1033m/yy

yy

38626 -1033m/yy

yy

38838 -1033m/yy

yy

39052 -1033m/yy

yy

39264 -1033m/yy

yy

39479 -1033m/yy

yy

39692 -1033m/yy

yy

39904 -1033m/yy

yy

40118 -1033m/yy

yy

40330 -1033m/yy

yy

40544 -1033m/yy

yy

40756 -1033m/yy

yy

40969 -1033m/yy

yy

41183 -1033m/yy

yy0.000

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Overnight US$ and HK$ Interest Rates

Interbank Offered Rate: Overnight (Hong Kong) Federal Funds Rate: Month Average (United States)

Iron Triangle of International Finance

Pick 2 items from this menu

Open International Capital Flows

Independent Interest Rate

Stable Exchange Rates

Final Exam• When Friday December 18th, . • 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.

REAL EXCHANGE RATES & TRADE BALANCE

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

Ft

t t HOMEt

PRER EP

Benchmark: PPP• The first theory of exchange rates was Purchasing

Power Parity – Arbitrage should insure the price of goods was equalized across countries

1HOME USt t t tPPP P E P RER

•Is PPP true? Not in short run. Trade arbitrage does not work that fast. How about long run?

Exchange Rates OECDSource: IFS 1975-1995

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.

2000 [YR2000]

2001 [YR2001]

2002 [YR2002]

2003 [YR2003]

2004 [YR2004]

2005 [YR2005]

2006 [YR2006]

2007 [YR2007]

2008 [YR2008]

2009 [YR2009]

2010 [YR2010]

2011 [YR2011]

0

0.5

1

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3.5

Real Exchange Rate

Competitiveness & Current Account

IMF Data Mapper

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.