The Balance of Payments and Exchange Rates
I. Trade and Capital Flows
Each country in the world keeps an account of the transactions its citizens
have with the rest of the world. This account is called the balance of payments and its
basic function is to record the sale of goods, services, and assets between the home
country and foreign countries. The balance of payments is important because it
summarizes the condition of trade and foreign investment which the country has
experienced. Furthermore, changes in the balance of payments can affect exchange rates,
and thus employment, inflation, and economic growth. Usually, the balance of payments
is published quarterly, with an annual summary given at the end of the year. The
International Monetary Fund (IMF) provides guidelines on how the balance of payments
should be calculated, and Taiwan follows this IMF format when it publishes it data.
The balance of payments is composed of three major accounts: (1) the current
account, (2) the capital account, and (3) the official settlements (or reserve) account.
Because the balance of payments uses the method of double entry business accounting,
all three accounts must sum to zero. The current account is composed of all international
transactions in goods, services, payment of income on assets, and unilateral transfers.
The bulk of the current account is devoted to recording exports and imports. Services are
largely payments for transportation and insurance involved in international trade. When
interest and dividends are paid to individuals internationally, these are also recorded in
the current account. By contrast, the capital account records all changes in the ownership
of assets between the home country and the rest of the world. For example, the sale of
corporate stock to foreigners represents a capital inflow, because money is flowing into
the home country, while a financial asset (i.e., the stock is flowing out). The official
settlements balance is largely composed of changes in the government's holding of
foreign assets.
If we limit our consideration to exports and imports in the current account,
we can focus on the trade balance. This is merely total exports minus total imports, and
is sometimes referred to as the merchandise balance of trade. A trade surplus means that
the value of exports during the period exceeded the value of imports during the period.
Usually a trade surplus will result in a current account surplus, since trade in goods is the
dominant part of the current account. The trade surplus is a closely watched statistic, and
can influence economic and foreign policy. Naturally, Taiwan runs trade surpluses with
some countries and trade deficits with others, but it has had an overall trade surplus every
year since 1980.
II. Determining Exchange Rates
Trade between countries means that not only goods and assets are traded, but also
different types of money must exchange as well. For example, an import from Japan may
be paid for using Japanese yen or US dollars. This implies that at some point in the
transaction, NT dollars must exchange for either Japanese yen or US dollars. Such
transactions take place on the foreign exchange market. Here the supply of and demand
for foreign money interact. The largest foreign exchange market in Taiwan, as with most
other countries, is the market for the US dollar. Those supplying US dollars are generally
firms and banks which have received US dollars in payment for an international
transaction -- for example, a Taiwan exporter. Those demanding US dollars are
individuals, firms, and banks who currently have NT dollars and wish to obtain US
money for purposes of international transactions -- for example a Taiwan importer. The
exchange rate is simply the price of the foreign money (US dollars) in terms of the
domestic currency (NT dollars).
Now suppose that Taiwan exports many goods and imports very few. The result
will be a flood of US dollars seeking to exchange for NT dollars, and such a dramatic
increase in the supply of foreign exchange will drive down the price of the US dollar.
Conversely, if Taiwanese suddenly felt a strong inclination to invest in the US and buy
American corporate stock, the demand for the US dollar would rise, and the foreign
exchange rate would increase sharply. In short, the foreign exchange rate is simply the
price of the US dollar, and is determined by the demand for and supply of the US dollar.
It is now easy to see how the balance of payments and the exchange rate are
related. Suppose that both the current account and capital account show a surplus. This
means that exports exceed imports and there is a net capital inflow. Taiwanese are
basically selling goods and assets to foreigners in excess of what they are buying from
foreigners. As a result, the surplus generates a large inflow of US dollars seeking to
exchange for NT dollars. If the government does not attempt to buy up these dollars, then
the price of the US dollar will fall and this will reduce the balance of payments surplus.
In this example, we assumed that both the current account and the capital account were in
positive surplus. Actually, all we need is for the sum of these two accounts to be in
surplus -- so one may be positive and the other negative.
Often the government can keep the exchange rate stable by entering the foreign
exchange market to buy or sell US dollars whenever there is a market disequilibrium.
This is how the government gains and loses its foreign exchange reserves. Whenever the
government buys and sells foreign exchange, the transaction will appear in the third
account mentioned above in Section I -- namely, the official settlements account. If the
government took a passive attitude towards the foreign exchange market, then the official
settlements account would be small, and the exchange rate would be determined entirely
by the balance on current and capital accounts.
III. What Determines the Balance of Payments?
Since the exchange rate is largely determined by the balance of payments, it is
natural to ask what factors affect the balance of payments. To answer this question, we
must look again at the structure of the accounts. Exports and imports dominate the
current account, and therefore anything which tends to affect trade in goods will affect the
current account. For example, if domestic prices tend to rise faster than foreign prices,
then exports will begin to fall and imports will begin to rise. Similarly, if income at home
is rising faster than abroad, then imports will tend to increase faster than exports. Both
income and prices have important effects on the balance of payments through their
influence on the current account.
The major variable which affects the capital account is the interest rate. If the
interest rate at home is significantly lower than the interest rate abroad, then people will
seek to purchase foreign assets and the capital account will be negative ( a negative
capital inflow is a positive capital outflow). On the other hand, if the domestic interest
rate rises, then foreigners will seek to buy domestic assets and there will be a surplus on
the capital account (i.e., a positive net capital outflow).
Finally, we have seen that the government can also influence the balance of
payments by buying and selling foreign exchange whenever there is disequilibrium in the
foreign exchange market. Some economists have argued that this is another form of
protectionism. If a government wanted to promote its exports and retard the growth of
imports, it could simply buy foreign exchange and support the price of the foreign money.
At other times we hear of the US government and the Bank of Japan working together to
prop up the value of the US dollar. The idea is the same as we have discussed before.
Essentially, the governments of both countries are working together to buy dollars with
Japanese yen in order to keep the US dollar at a reasonable level. The monetary
authorities are always concerned that a free market in the dollar may result in a disastrous
"free fall" in the value of the dollar, as one can see from the experiences of the late1980's.
Discussion Questions:
#1.
#2.
#3.
#4.
#5.
What is the function of the balance of payments?
What are the three accounts included in the balance of payments?
What items are included in the current account?
What items are included in the capital account?
Give some examples of current account transactions and give some examples of
capital account transactions.
#6. What is a foreign exchange rate?
#7. How is the exchange rate related to the balance of payments?
#8. What factors influence the current account and what factors influence the capital
account?