Transcript Lecture 7 Balance of payments and exchange rates

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 account
Goods trade (merchandise trade)
Services
Trading and investment income
Current unilateral transfers
Balance on current account
Capital account
Financial account
Balance on financial account
Foreign direct investment
Portfolio capital
Other investment
Change in official reserves
Net errors and omissions
2011, €bn
37
-2
-31
-1
1
-0
6
11
27
-33
0
-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 trends
Year
Merchandise
Invisibles
Services
Trading
& investment
income
Current
transfers
Total
Invisible
Balance
on
current
account
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’
Ireland’s IIP
Source: CSO Quarterly International Investment Position, Dec 2010
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 as
Y=C+I+G+X–M
• Y can also be defined as
Y=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
Correlation between cost of CDS and
current account
Source: http://www.voxeu.org/index.php?q=node/2820 EA = Euro Area
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
• Capital flowing ‘uphill’
• Driving by savings ‘glut’ in
surplus countries
Source: King 2011
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
Euro
depreciates
Euro
appreciates
Source: ECB Statistical data warehouse
Sterling/euro exchange rate
Euro
depreciates
Euro
appreciates
Source: ECB Statistical data warehouse
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
$/€
2
Depreciation
1
0.5
Euro
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
$/€
2
Depreciation
1
0.5
Euro
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 appreciates
$/€
D2
S2
S1
D1
Exchange rate equilibrium
• How can we tell if a currency is overvalued 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?
Euroland issues
Source: EEAG report 2012
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?