EXCHANGE RATES &
BALANCE OF PAYMENTS
Chap. 26
BALANCE OF PAYMENTS
Current Account
Balance
Census and Statistics Department
• Current Account: NX +NFI + Secondary Income
• Primary Income/NFI (Overseas Wage & Investment Income)
• Secondary Income (Transfers)
BoP : Current account
Year
2013#
Credit
3,945,256
HK$ million
Goods
Debit
-4,148,558
Primary income
Credit
Debit
1,183,568 -1,143,049
Balance
-203,302
Balance
40,519
Credit
817,948
Services
Debit
-596,581
Balance
221,367
HK$ million
Secondary income
Credit
Debit
Balance
8,088
-28,964
-20,876
Net Exports
18,065
Net Income
19,643
Current Account
37,708
International Capital Flows
• Capital Outflows: domestic acquisition of foreign assets.
• Capital Inflows: foreign acquisition of domestic assets
Net 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
World Current Account equals zero!
Global
Imbalances
Link
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
2011
Increases 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.
Salient Feature of Balance of Payments
Capital & Financial Account (CFA) (Hong Kong)
Capital Account (Hong Kong)
Financial Account (FA) (Hong Kong)
Financial Non Reserve Assets (Hong Kong)
Direct Investment (DI) (Hong Kong)
-113,242
-2,021
-111,220
-24,437
1,868
Assets (AS) (Hong Kong)
Liabilities (LB) (Hong Kong)
Portfolio Investment (PI) (Hong Kong)
Assets (AS) (Hong Kong)
Liabilities (LB) (Hong Kong)
Financial Derivatives (FD) (Hong Kong)
Assets (Hong Kong)
Liabilities (Hong Kong)
Other investment (OI) (Hong Kong)
Assets (Hong Kong)
Liabilities (Hong Kong)
Reserve Assets (Hong Kong)
Net Errors and Omissions (Hong Kong)
Overall Balance (Hong Kong)
-746,372
748,240
-10,979
-155,818
144,839
20,884
359,707
-338,823
-36,210
-780,960
744,749
-86,783
3,156
86,783
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 Payments
Foreign Currency Received (Credit)
Supply of US$
Exports (+)
Income Receipts (+)
{Non official} Capital Inflows (+)
Foreign Currency Paid (Debit)
Demand for US$
Imports (-)
Income Payments (-)
{Non reserve} Capital Outflows (-)
Balance of Payments = Credits – Debits
Link
BoP = Current Account + Capital & Financial Account
EXCHANGE RATES
What level should it be?
Foreign Exchange Rate: Bank of Russia: US Dollar
80
70
60
50
40
30
20
10
0
Link
Ruble/$ Rate December 30 2014
66
64
62
60
58
56
54
52
50
Spot
1 Year Forward
Forward Premium
1+i
1+iF
(1+i)/(1+iF)
1.165607
1.1725
1.006288
1.165173
Two Models
• UIRP
• Balance of Payments: Supply & Demand
Interest Parity
(1  i ) 
F
t
Et 1
Et
 (1  it )
Saving
It is January 1st, and you have D$1000 to
save for 1 year. You can put it into:
a domestic currency bank account at an
interest rate i.
2. a foreign currency bank account at interest
rate iF.
1.
Payoff to strategy #2
•
Strategy two has three parts.
1.
Buy foreign exchange at spot rate St to get {D$1000/Et}
F$..
Put {D$1000/Et} F dollars into FC bank account. After 1
year get F$(1+iF)×{D$1000/Et }
Convert these funds into F$ at exchange rate prevailing at
end of year.
F
2.
3.
(1  i )  Et 1
 D$1000
Et
Uncovered Interest Parity
(1  i F )  Et 1
 1  i , deposit funds then deposit in
• If
Et
F$ account.
F
(1

i
)  Et 1
• If
Et
 1 i
, deposit funds then deposit in
D$ account.
• Then in equilibrium
Et 1
F
 (1  i )  1  i
Et
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
it  i
F
t
Et 1  Et  F

E

i g
Et
t
t 1
Three Reasons UIRP might not hold
Future exchange rates are risky, uncovered interest
parity does not account for risk.
1.
Interest Parity Works for Forward Prices
A.
Ft{t1}  Et 
{t }
t 1
1  it
1  itF
F
:
2.
Domestic and foreign currency not perfect substitutes.
People like to hold currency for liquidity reasons.
Currency controls
3.
Forward Price for currency delivered at t+1
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
Et 1
Et
 (1  itF )
• Of Foreign Investors in Domestic Economy
Et
Et 1
1  it
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
Et
Et 1
1  it
• Exports Effect – Expensive US$ increases the attractiveness
of domestic exports.
• 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
Et 1
Et
 (1  itF )
• Imports Effect – Cheap US$ increases the
competitiveness of imports.
Supply and Demand in Forex Mkt
E
Supply
BoP > 0
BoP < 0
Demand
Forex Turnover
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
Exchange rate
arrangement
Monetary Policy Framework
Exchange rate anchor
Other
U.S. dollar (66) Composite (15) Other (7)
Currency board
Hong Kong SAR
Brunei
Conventional Peg
Denmark
Stabilized Arrangement Cambodia
Vietnam
Crawling & Crawl-like
Other Managed
Float
Free Float
_
(44)
China
Singapore
Bangladesh, Malaysia Myanmar
Mongolia, Pakistan, Sri Lanka, Korea
Indonesia, Thailand, Philippines, India
Australia, New Zealand, Japan
• 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
Equilibrium with Floating Rates
E
Supply
E
𝐸
⓪
E*
E
Demand
Forex Turnover
Increase in Desired Capital Inflows by Foreign Investors/
Desired Purchases of Domestic Goods
E
Supply
Supply'
⓪
E*
E**
①
Domestic Currency
Appreciates
Demand
Forex Turnover
Increase in Desired Capital Outflows by Domestic Investors/
Desired Purchases of Foreign Goods
E
E**
①
E*
Domestic Currency
Depreciates
⓪
Supply
Demand
Demand '
Forex Turnover
Domestic Monetary Policy Causes D.C. Interest Rates Go Up Relative
Demand for US$ Goes Down
E
Supply
Supply'
Domestic Currency
Appreciates
1
E*
Excess Supply
E**
2
Demand
Demand'
Foreign Monetary Policy Causes
Foreign Interest Rates Go Up/Relative Demand for US$ Goes
Up
E
2
E**
Domestic Currency
Depreciates
1
E*
Excess Demand
Supply'
Supply
Demand '
Demand
Monetary Policy
Expectations 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
2
E**
Domestic Currency
Depreciates
1
E*
Excess Demand
Supply'
Supply
Demand'
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
ETGT
Gov’t Buys Excess Supply US$
BoP > 0
Supply
Foreign Reserves Increase
Demand
Forex Turnover
PRC Balance of Payments (Billions of US $)
$3,500.0
$3,000.0
$2,500.0
$2,000.0
$1,500.0
$1,000.0
$500.0
$0.0
2005
2006
2007
2008
2009
Supply (Exports + Financial Inflows)
2005
Supply (Exports + Financial Inflows)
Demand (Imports+Financial Outflows)
Balance of Payments
$1,020.4
$800.9
$250.6
2006
2010
2011
2012
2013
Demand (Imports+Financial Outflows)
2007
2008
2009
2010
2011
2012
2013
$1,281.3 $1,662.4 $1,839.6 $1,670.0 $2,333.2 $2,728.0 $2,728.2 $3,230.6
$1,008.2 $1,221.2 $1,385.1 $1,236.2 $1,817.8 $2,337.3 $2,553.1 $2,727.7
$284.8
$460.7
$479.5
$400.3
$471.7
$387.8
$96.6
$431.4
Source: IMF Balance of Payments Data
Link
Link
Fixed Exchange Rate: Strong Currency Target
E
Supply
Foreign Reserves Decrease
ETGT
BoP < 0
Gov’t Buys Excess DCU
Demand
Forex Turnover
Foreign Currency Intervention
Sterilized vs. Unsterilized
Two ways of financing interventions
• Foreign currency purchase:
• Central bank purchases foreign currency
• Unsterilized: Create additional domestic currency liquidity
• Sterilized: Borrow domestic currency from banks, govt, selling
bonds.
• Foreign currency sale
• Central bank sells foreign currency
• Unsterilized: Withdraw domestic currency liquidity
• Sterilized: Repay domestic currency loans.
Balance of Payments Crisis
• Basic asymmetry between
weak and strong currency
target.
• Weak target: Govt has
infinite amount of
domestic currency and can
always maintain.
• Strong target: Govt has
finite amount of foreign
currency and may face a
balance of payments crisis.
• BoP crisis: Gov’t must
borrow funds from abroad
or allow a weakening of
the currency.
MONETARY POLICY UNDER
FIXED EXCHANGE RATES
Hong Kong’s Exchange Rate Regime
Clearing Accounts Reserves
• May 2005 Under the strong-side Convertibility
Undertaking, the HKMA undertakes to buy US dollars
from licensed banks at 7.75. Under the weak-side
Convertibility Undertaking, the HKMA undertakes to
sell US dollars at 7.85.
US Monetary Policy Causes US Interest Rates Go Down,
Strengthening Pressure on HK$
E
Supply
Supply'
1
E=7.8
Excess Supply
Appreciation Pressure on
HK$
Demand
Demand'
Hong Kong Interbank Market:
HIBOR higher than US interest rate.
iHIBOR
SBR '
SBR
Banks convert US$
to Clearing Balances
to take advantage of
higher interest rates
in Hong Kong
i*
iFedFunds
1
2
DBR
Reserve Accounts
Convertibility Undertaking Stabilizes Forex Demand
and Supply Curves Automatically
E
Supply ' '
Supply'
1
Hong Kong Interest Rate
Falls
E=7.8
Excess Supply
Demand ' '
Demand'
Fixed Exchange Rate
• If the central bank undertakes to keep the exchange rate fixed
and that is a credible undertaking, then
Et 1  Et
 0  it  itF .
Et
• 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.
HIBOR
t
i
i
FF
t
Et 1  Et

Et
Overnight US$ and HK$ Interest Rates
20.000
18.000
16.000
14.000
12.000
10.000
8.000
6.000
4.000
2.000
0.000
Interbank Offered Rate: Overnight (Hong Kong)
Federal Funds Rate: Month Average (United States)
Iron Triangle of International Finance
Open International
Capital Flows
Independent
Interest Rate
Pick 2 items from this menu
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.
RERt  Et 
Pt
Pt
F
HOME
• 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
Benchmark: PPP
• The first theory of exchange rates was Purchasing
Power Parity – Arbitrage should insure the price of
goods was equalized across countries
PPP  Pt HOME  Et  PtUS  RERt  1
•Is PPP true? Not in short run. Trade arbitrage does
not work that fast. How about long run?
Exchange Rates OECD
Source: 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.
Real Exchange Rate
3.5
3
2.5
2
1.5
1
0.5
0
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.