THE BALANCE OF PAYMENTS.
The balance of payments is the record of a country's international transactions. There is a
simple rule:
Any transaction that requires a purchase of domestic currency is a credit
(positive) item in that country's balance of payments, any transaction that
requires a sale of domestic currency is a debit (negative) item.
Since a purchase of domestic currency can only be completed if someone agrees to a sale,
the sum of all credit items (purchases of domestic currency) must equal the sum of all debit
items (sales). Then the demand for domestic currency always equals the supply of domestic
currency, and the foreign exchange market always clears. This is why the conditions that
equilibrate the balance of payments also equilibrate the foreign exchange market at the
same time.
Consider the stylized world with only two countries, Great Britain and Sweden. Someone in the
UK wants to import from Sweden and has to pay in kronors for it.
(Source: Case et al., 1999, p. 637)
There are, as we can see, three possibilities to pay for the imports:
1. There can be other, balancing transactions in the current account. But exactly offsetting
transactions will rarely occur.
2. Sweden does not insist on payment right now, accepts the promise of payment some time
in the future. Some British institution has to go into debt (e.g. through bonds) towards some
Swedish institution or individual, which offers the amount of kronors that is needed. The British
current account reports a deficit, the capital account records a surplus of equal size.
3. Also the British central bank can provide the kronors in need. This means a reduction in
foreign assets held by the British central bank. The current account is still in deficit, but the
private capital account is balanced.
A real-world balance of payments is shown in the next figure. The merchandise trade
balance is traditionally positive in Germany, the service balance is negative because of the
huge amounts spent by Germans travelling abroad.
(Source: Case et al., 1999, p. 639)
Lines 7 and 8 show investment income received from abroad and paid to other countries,
respectively. The final category records private and government transfer payments to and
from other countries. Examples here are German contributions to the EU budget and to the
United Nations, foreign aid, and gifts from Turkish families living in Germany to relatives in
Turkey. The sum of all these net payments equals – 19,7. This is the current account. Although
traditionally positive, the German current account turned negative upon unification.
The first two lines in the capital account should show the increase in German assets held by
foreigners, and the increase in foreign assets held by residents of Germany. Given is only the
difference between the two: 21 billion DM. This is the net decrease in Germany's foreign asset
holdings, the balance on capital account. The official reserves account shows that the
Bundesbank's holdings of foreign assets increased by 1,6 billion.
The overall sum of all entries in the balance of payments must be zero.
If the exchange rate is fixed, it cannot move to balance the foreign exchange market (or the
balance of payments). Instead, the central bank must intervene in the foreign exchange
market to satisfy any excess demand for domestic currency or purchase any excess supply.
The extent of these interventions is indicated by the official reserves account balance.
Under fixed exchange rates the official reserves account is usually not zero. It is a
measure of central bank intervention in the foreign exchange market. Under
flexible exchange rates the capital account balance is the perfect mirror image
of the current account balance. The two balances add up to zero.
In an arrangement of fixed exchange rates like the EMS the actual exchange rates were
allowed to fluctuate around a central parity within so-called 'bands' or 'target zones'.
Interventions of the central bank to stabilize the exchange rate had to take place at the
upper and lower bounds of the target zones, but inframarginal interventions (which take
place way inside the band) were possible as well.
Up to now we have described the capital account and central bank intervention in the
foreign exchange market if they were only necessary to make current account imbalances
possible. In reality, the capital account has a life of its own. Capital flows across borders
(unless capital controls exist). In the absence of central bank intervention, the capital
account shows whether wealth has been shifted from domestic into foreign assets or vice
versa.
To simplify, suppose there is only one domestic and one foreign interest-bearing asset which
are perfect substitutes. Then all that investors are interested in is which asset yields the highest
rate of return. For domestic assets the rate of return is simply the interest rate. For foreign
assets this is only true if the exchange rate does not change. When deciding whether to buy
domestic or foreign bonds we have to make a forecast of the expected exchange rate.
Suppose the exchange rate is not expected to change. There is only one condition that
prevents wealth from moving all the way into either direction (into the country with the higher
interest rate – in the absence of different transaction costs and risk), the state where interest
rates are equal. Then investors are perfectly fine with the current composition of their portfolio
(they would be just as happy with any other split between foreign and domestic assets since
the expected returns in both countries are the same). Return equality with different interest
rates is given by the (uncovered) interest parity condition.
To sum up, the capital account can only be in equilibrium if domestic and foreign returns are
equal. If domestic returns are higher, everybody wants to shift wealth into domestic assets. To
be able to buy them one must first acquire domestic currency. Since no domestic currency is
offered, because no one wants to move wealth out of domestic assets, there is an excess
demand for domestic currency that drives down the exchange rate (appreciation of the
domestic currency). If rates of return at home are lower than abroad, capital moves out of
the country. Everybody wants to get rid of domestic currency, which drives the exchange
rate up (depreciation of the domestic currency).
Now that we understand each of the two non-official balance of payments accounts in
isolation, we can merge them for a complete picture. Under flexible exchange rates, the
balance of payments always balances, and, therefore, the foreign exchange market always
clears.
Note that the capital account and therefore international financial investors dominate the
foreign exchange market because only approx. 5 % of one year's transactions in the foreign
exchange market suffice to accomodate global trade.
If returns (interest rates if we expect no change in the exchange rate) differ, the limited
volume of trade cannot serve to equalize the balance of payments which gets out of
equilibrium because of huge capital in- or outflows result in huge capital account surpluses or
deficits. In this case the domestic interest rate must equal the foreign one.
Exports and imports depend on the exchange rate, which determines how expensive goods
produced at home are relative to goods produced abroad. The exchange rate is
determined in the foreign exchange market, where currencies are bought and sold both for
the purpose of trading goods and of shifting wealth across borders.
Source:
CASE, K. E., FAIR, R. C., GÄRTNER, M. and K. HEATHER, Economics, Prentice Hall Europe, 1999.