Thorvaldur Gylfason
Joint Vienna Institute/
Institute for Capacity Development
Distance Learning Course on
Financial Programming and Policies
Vienna, Austria
NOVEMBER 26–DECEMBER 7, 2012
1. Balance of payments accounts
2. Balance of payments analysis
3. Exchange rates
4. Exchange rate policy
5. Exchange rate regimes
 To float or not to float
6. How many monies do we need?
Accounting system for macroeconomic
analysis in four parts
1.
2.
3.
4.
Balance of payments
National income accounts
Fiscal accounts
Monetary accounts
Now look at balance of payments
accounts per se, looked before at
linkages in a separate lecture
Transactions in two major categories
1. Real transactions
Goods, services, and income


Current account of the BOP

Involve flows
X = exports, Z = imports,
2. Financial transactions
F = capital account, R = reserves,
F = DDF with DF = net foreign debt
Reflect changes in foreign assets and
liabilities


Capital and financial account of the BOP

Involve changes in stocks
Goods
Exports
Imports
g
X
Z
g
Services Capital
s
X
Z
s
Real
transactions
F
x
z
F
Financial
transactions
Balance of payments
 BOP = Xg + Xs + Fx – Zg – Zs – Fz

=X–Z+F
= current account + capital account
 Here
 X = Xg + Xs Exports of good and services
 Z = Zg + Zs Imports of good and services
 F = Fx – Fz Net exports of capital =
Net capital inflow = DDF

Balance of payments
 BOP = Xg + Xs + Fx – Zg – Zs – Fz

=X–Z+F
= current account + capital account
 Here
 X = Xg + Xs Exports of good and services
 Z = Zg + Zs Imports of good and services
 F = Fx – Fz Net exports of capital =
Net capital inflow

Balance of payments
 BOP = Xg + Xs + Fx – Zg – Zs – Fz

=X–Z+F
= current account + capital account
 Here
 X = Xg + Xs Exports of good and services
 Z = Zg + Zs Imports of good and services
 F = Fx – Fz Net exports of capital =
Net capital inflow

Balance of payments
 BOP = Xg + Xs + Fx – Zg – Zs – Fz

=X–Z+F
= current account + capital account
 Here
 X = Xg + Xs Exports of good and services
 Z = Zg + Zs Imports of good and services
 F = Fx – Fz Net exports of capital =
Net capital inflow

Trade balance
 TB = Xg + Xnfs – Zg – Znfs
Xnfs = Xs – Xfs = exports of nonfactor services
Znfs = Zs – Zfs = imports of nonfactor services
Balance of goods and services
 GSB = TB + Yf
Yf = Xfs – Zfs = net factor income
Current account balance
 CAB = GSB + TR = TB + Yf + TR

GSB
TR = net unrequited transfers from abroad
Net factor income from labor
 Compensation
of domestic guest workers
abroad (e.g., Pakistanis in the Gulf)
minus that of foreign workers at home
Net factor income from capital
 Interest
receipts from domestic assets
held abroad minus interest payments on
foreign loans (e.g., Argentina)
 Includes also profits and dividends
Transfers are unrequited transactions
 Public
or private, disbursed in cash or in
kind (e.g., foreign aid)
Two parts
1. Capital account (esp., capital transfers)
2. Financial account
1. Direct investment
Involves influence of foreign owners
2. Portfolio investment
Includes long-term foreign borrowing
Does not involve influence of foreign owners
3. Other investment
Includes short-term borrowing
4. Errors and omissions
Statistical discrepancy
Y=C+I+G+X–Z
=
E+X–Z
 where
E = C + I +G
CAB = X – Z = Y – E
 Ignore
Yf and TR for simplicity
S=I+G–T+X–Z
CAB = S – I + T – G
CAD = Z – X = E – Y = I – S + G – T
Y=C+I+G+X–Z
GDP = C + I + G + TB
GNP = C + I + G + CAB
GNP – GDP = CAB – TB = Yf (if TR = 0)
GNP = GDP + Yf
 GNP > GDP in Pakistan
 GNP < GDP in Argentina
GNDI = GNP + TR = GDP + Yf + TR
Y
X-Z
Definition
GDP
Trade
balance
Goods and
nonfactor
services
Y
X-Z
GDP
Trade
balance
GNP
Definition
Goods and
nonfactor
services
Current
Goods and
account excl. services
transfers
Y
X-Z
Definition
GDP
Trade
balance
Goods and
nonfactor
services
GNP
Current
account excl.
transfers
Current
account incl.
transfers
Goods and
services
GNDI
Goods and
services plus
transfers
Real exchange rate
Imports
Exports
Foreign exchange
Equilibrium between demand and supply in
foreign exchange market establishes
Equilibrium real exchange rate
Equilibrium in the balance of payments
BOP = X + Fx – Z – Fz
=X–Z+F
= current account + capital account
=0
Real exchange rate
R
Deficit
Imports
Overvaluation
Exports
Foreign exchange
Price of foreign exchange
Supply (exports)
Overvaluation
Deficit
Demand (imports)
Foreign exchange
Crucial
indicator used to assess the
external position of a country
The current account balance is equal
to the change in net foreign assets
with respect to the rest of the world
 Includes
change in net foreign assets of
Non-banking sector
 Banking sector (including monetary
authorities)

 CAB
 – F + DR because X – Z + F = DR
 – F + DR because X – Z + F = DR
 Hence, current account deficit can
be financed by
 CAB
 Attracting
foreign direct investment
 Accumulating net foreign liabilities

I.e., borrowing abroad
 Running
down the net foreign assets of
the monetary authorities
 When
does a current account deficit
become a source of concern?
When it is a lasting (structural) deficit
rather than a temporary (cyclical) deficit
 When it is financed by short-term external
borrowing or by a protracted reduction in
net foreign assets
 When foreign exchange reserves are low in
terms of months of imports or in terms of
the Giudotti-Greenspan Rule

 Other
factors
Capacity to meet financial obligations
 Availability of external financing

When
does a current account deficit
become a source of concern?
 When
continued current account
deficits, reflecting the behavior of the
government and the private sector,
require drastic adjustment of economic
policies in order to avoid a crisis, e.g.,
Collapse of exchange rate
 Default on external debt payments

A
country is solvent if the present
value of future current account
surpluses is at least equal to its
current external debt
 The concept is simple, but putting
it into practice is complicated

If the projections of future surpluses
are sufficiently large, any current
account deficit could be consistent
with the notion of solvency
 Another
crucial indicator used to
assess the external position of a
country
A
deficit in the overall balance means
a decrease in the net foreign assets of
the monetary authority except when
exceptional financing becomes
available
 Foreign
reserves are traditionally
held by the monetary authorities in
order to finance payments
imbalances and to defend the
currency
 Exceptional
financing can be needed
in an emergency where reserves have
fallen to perilously low levels
 Three main types

Rescheduling of external debt obligations


Debt forgiveness


Scheduled payments postponed in agreement
with creditors
Voluntary cancellation by creditors
Payments arrears on external debt service

Scheduled payments postponed without
agreement with creditors
Indicators
of an appropriate level
of foreign reserves
 Ratio
of reserves to monthly imports of
goods and services of more than 3
 Guidotti-Greenspan Rule
Other considerations
 Capital mobility
 Exchange rate regime
 Composition of external liabilities
 Access to foreign borrowing
 Seasonal nature of imports and exports
eP
Q
P*
Increase in Q
means real
appreciation
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
eP
Q
P*
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
1. Suppose e falls
eP
Q
P*
Then more rubles per dollar,
so X rises, Z falls
2. Suppose P falls
Then X rises, Z falls
3. Suppose P* rises
Then X rises, Z falls
Capture all three by supposing Q falls
Then X rises, Z falls
Real exchange rate
Imports
Exports
Foreign exchange
Equilibrium between demand and
supply in foreign exchange
market establishes
Equilibrium real exchange rate
Equilibrium in balance of payments
BOP = X + Fx – Z – Fz
=X–Z+F
= current account + capital account = 0
Real exchange rate
R
Deficit
Imports
Overvaluation
Exports
Foreign exchange
Price of foreign exchange
Overvaluation works
like a price ceiling
Supply (exports)
Overvaluation
Deficit
Demand (imports)
Foreign exchange
 Appreciation
of currency in real terms,
either through inflation or nominal
appreciation, leads to a loss of export
competitiveness
 In 1960s, Netherlands discovered natural
resources (gas deposits)


Currency appreciated
Exports of manufactures and services suffered,
but not for long
 Not
unlike natural resource discoveries, aid
inflows could trigger the Dutch disease in
receiving countries
Real exchange rate
C
B
A
Imports
Exports with oil
Exports without oil
Foreign exchange
Real exchange rate
C
B
A
Imports
Exports with aid
Exports without aid
Foreign exchange
Governments may try to keep the
national currency overvalued
To keep foreign exchange cheap
To have power to ration scarce
foreign exchange
To make GNP look larger than it is
Other examples of price ceilings
Negative real interest rates
Rent controls in cities
Inflation can result in an
overvaluation of the national
currency
Remember: Q = eP/P*
Suppose e adjusts to P with a lag
Then Q is directly proportional to
inflation
Numerical example
Real exchange rate
Suppose inflation is
10 percent per year
110
105
100
Average
Time
Real exchange rate
Suppose inflation rises
to 20 percent per year
120
110
Average
100
Time
The real exchange rate always floats
Through nominal exchange rate
adjustment or price change
Even so, it matters how countries set
their nominal exchange rates
because floating takes time
There is a wide spectrum of options,
from absolutely fixed to
completely flexible exchange rates
There is a range of options
Monetary union or dollarization
Means giving up your national currency or
sharing it with others (e.g., EMU, CFA, EAC)
Currency board
Legal commitment to exchange domestic
for foreign currency at a fixed rate
Fixed exchange rate (peg)
Crawling peg
Managed floating
Pure floating
 Currency union or dollarization
 Currency board
 Peg
FIXED
Fixed
Horizontal bands
 Crawling peg
Without bands
With bands
 Floating
FLEXIBLE
Managed
Independent
Dollarization

Use another country’s currency as sole legal tender
Currency union

Share same currency with other union members
Currency board

Legally commit to exchange domestic
currency for specified foreign currency at fixed
rate
Conventional (fixed) peg


Single currency peg
Currency basket peg
Flexible peg
Fixed but readily adjusted
Crawling peg
Complete
Compensate for past inflation
Allow for future inflation
Partial
Aimed at reducing inflation, but real appreciation
results because of the lagged adjustment
Fixed but adjustable
Managed floating
 Management

by sterilized intervention
I.e., by buying and selling foreign
exchange
 Management
by interest rate policy,
i.e., monetary policy

E.g., by using high interest rates to
attract capital inflows and thus lift the
exchange rate of the currency
Pure floating
FREE CAPITAL
MOVEMENTS
Monetary
Union (EU)
FIXED
EXCHANGE
RATE
MONETARY
INDEPENDENCE
FREE CAPITAL
MOVEMENTS
FIXED
EXCHANGE
RATE
Capital controls
(China)
MONETARY
INDEPENDENCE
FREE CAPITAL
MOVEMENTS
Flexible
exchange
rate (US, UK, Japan)
FIXED
EXCHANGE
RATE
MONETARY
INDEPENDENCE
FREE CAPITAL
MOVEMENTS
Flexible
exchange
rate (US, UK, Japan)
Monetary
Union (EU)
FIXED
EXCHANGE
RATE
Capital controls
(China)
MONETARY
INDEPENDENCE
 If
capital controls are ruled out in view of
the proven benefits of free trade in goods,
services, labor, and also capital (four
freedoms), …
 … then long-run choice boils down to one
between monetary independence (i.e.,
flexible exchange rates) vs. fixed rates

Cannot have both!
 Either
type of regime has advantages as well
as disadvantages
 Let’s quickly review main benefits and costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Stability of trade
and investment
Low inflation
Costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Efficiency
BOP equilibrium
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Efficiency
Instability of
BOP equilibrium trade and
investment
Inflation
 In
view of benefits and costs, no single
exchange rate regime is right for all
countries at all times
 The regime of choice depends on time and
circumstance
 If inefficiency and slow growth due to currency
overvaluation are the main problem, floating
rates can help
 If high inflation is the main problem, fixed
exchange rates can help, at the risk of renewed
overvaluation
 Ones both problems are under control, time may
be ripe for monetary union
What countries actually do (Number of countries, April 2008)
(22)
(84)
(12)
(44)
(40)
(76)
(10)
(66)
(3)
(5)
(2)
96
Source: Annual Report on Exchange Arrangements and Exchange Restrictions database.
No national currency
Currency board
Conventional fixed rates
Intermediate pegs
Managed floating
Pure floating
6%
7%
36%
5%
24%
22%
100%
54%
46%
There is a gradual tendency towards floating, from 10% of LDCs
in 1975 to almost 50% today, followed by increased interest
in fixed rates through economic and monetary unions
In
view of the success of the EU and
the euro, economic and monetary
unions appeal to many other
countries with increasing force
Consider four categories
 Existing
monetary unions
 De facto monetary unions
 Planned monetary unions
 Previous – failed! – monetary unions
 CFA

franc
14 African countries
 CFP

3 Pacific island states
 East

franc
Caribbean dollar
8 Caribbean island states

Picture of Sir W. Arthur Lewis, the great Nobel-prize
winning development economist, adorns the $100 note
 Euro,

more recent
16 EU countries plus 6 or 7 others

Thus far, clearly, a major success in view of old
conflicts among European nation states, cultural
variety, many different languages, etc.

Australian dollar


Indian rupee


South Africa plus Lesotho, Namibia, Swaziland – and
now Zimbabwe
Swiss franc


New Zealand plus 4 Pacific island states
South African rand


India plus Bhutan
New Zealand dollar


Australia plus 3 Pacific island states
Switzerland plus Liechtenstein
US dollar

US plus Ecuador, El Salvador, Panama, and 6 others
 East

Burundi, Kenya, Rwanda, Tanzania, and Uganda
 Eco

African shilling (2009)
(2009)
Gambia, Ghana, Guinea, Nigeria, and Sierra
Leone (plus, perhaps, Liberia)
 Khaleeji

Bahrain, Kuwait, Qatar, Saudi-Arabia, and United
Arab Emirates
 Other,

(2010)
more distant plans
Caribbean, Southern Africa, South Asia, South
America, Eastern and Southern Africa, Africa

Danish krone 1886-1939
Denmark and Iceland 1886-1939: 1 IKR = 1 DKR
 2009: 2,500 IKR = 1 DKR (due to inflation in Iceland)


Scandinavian monetary union 1873-1914


East African shilling 1921-69


Mauritius and Seychelles 1870-1914
Southern African rand


Kenya, Tanzania, Uganda, and 3 others
Mauritius rupee


Denmark, Norway, and Sweden
South Africa and Botswana 1966-76
Many others
These slides will be posted on my
website: www.hi.is/~gylfason
 Centripetal
tendency to join monetary
unions, thus reducing number of currencies

To benefit from stable exchange rates at the
expense of monetary independence
 Centrifugal
tendency to leave monetary
unions, thus increasing number of currencies

To benefit from monetary independence often,
but not always, at the expense of exchange rate
stability
 With
globalization, centripetal tendencies
appear stronger than centrifugal ones