Balance of Payment (BOP) and Foreign Exchange Rates At the end of this topic, students are able to: Explain the concept of BOP and exchange rates Apply the concept of BOP and exchange rate in economic issues. Sub-topics covered: BOP, its structure, implications and improvement of BOP deficits. Foreign exchange rates, FER equilibrium and effects of FER on the economy/BOP.

Introduction Interdependence of the present economies. Economic events in one country or region may have significant repercussions on the economies of other nations. Examples, financial crisis in Thailand in 1997, spread rapidly to other countries – Southeast Asia and East Asian countries; subprime mortgage crisis in the U.S. in 2008 felt by other regions, including E.U. BOP shows the “health” of a country’s economy in relation to another country or countries.

BALANCE OF PAYMENT (BOP) BOP is the record of a country’s financial transactions in goods, services and assets with the rest of the world as well as the record of a country’s supply (sources) and demand (use) of foreign exchange (foreign currencies) (Case et al. 2012, p.720). It records a country’s international financial transactions in 2 broad accounts, i.e. (1) the current account; and (2) the financial account and capital account in a given period of time.

Structure of BOP

….. Structure of BOP Current Account= a. Trade Account (X-M of Goods) + b. Services Account (X-M of services) + c. Income (from investment – plants, real estate, securities) d. Transfer Payments (gifts, foreign aid by government, NGO, individuals etc. 2) Financial Account = Differences between sales of assets to foreigners and purchases of assets held abroad; e.g. Malaysian government assets abroad, Malaysian private assets (real estate direct investment, securities etc) 3) Capital Account = Capital transfers that result in a change in the stock of assets: mostly capital transfers (e.g. debt forgiveness); other minor items non-financial non-produced (eg. copyrights etc). HOMEWORK: Get the last 3-year Malaysian BOPs and analyse them.

BOP Deficits Current Account, Capital Account and BOP can be surplus or deficits. Implications of deficits/negative BOP: Deterioration of foreign reserve Increase in foreign debt to finance imports. Depreciation in foreign exchange rate. ↓ economic growth and ↑ unemployment rate.

How to improve BOP Deficits Use gold and foreign currencies reserves Discourage imports: tariff, quota, embargo Foreign currency control Increase interest rate Promote exports Campaign to use/ buy local prooduct Devaluation: reducing the value of local currency against foreign currencies. E.g.: USD1 = RM3.80 to USD1 = RM4.00. This ↑ exports and ↓ imports.

Foreign Exchange Rates (FER) What is FER DD & SS for foreign exchange Shifts in SS and DD for foreign exchange Flexible versus Fixed exchange rates

FER= the price of one currency in terms of another nation’s currency FER= the price of one currency in terms of another nation’s currency. For example: USD1 = RM4.00 or RM1 = USD0.25 The exchange rate for any nation’s currency is determined by international forces of demand and supply. DD & SS for dollars (USD): Dollars (USD) are demanded by foreigners who seek to purchase (import) US goods, services, and assets. Dollars are supplied by US residents who need foreign currencies to buy (import) foreign goods, services, and assets. (We will focus on the market in which US dollars are traded for ringgit)

The demand for dollars (supply of RM) - from Malaysians Firms, households, or governments import US goods into Malaysia. Malaysian citizens traveling in US. Holders of ringgit who want to buy US stocks, bonds or other financial instruments Malaysian companies that want to invest in US Speculators who anticipate a rise in the value of dollar relative to ringgit. The supply of dollars (demand for RM) - by Americans US firms, households, or governments import Malaysian goods into US. US citizens traveling in Malaysia, Holders of dollars who want to buy Malaysian stocks, bonds or other financial instruments. US companies that want to invest in Malaysia. Speculators who anticipate a rise the value of ringgit relative to dollar

Demand for Foreign Currency (USD) DD for USD arises when Malaysians import G&S from or invest in US. E.g. Malaysian traders import goods from the US worth USD100,000. If USD1=RM3.00, this trader will demand USD100,000 and supply RM300,000. If USD ↑ in value to USD1=RM3.50, US imports are more expensive, i.e. RM350,000. It leads to ↓ in imports from US, ↓Dd for USD.

DD for USD – from Malaysian traders RM/USD D RM3.50 RM3.00 Demand for dollars D Q1 Q2 Quantity of dollars

Supply of Foreign Currency (USD) SS of USD exists when the US residents import G&S from or invest in Malaysia. If Americans import RM300,000 worth of goods from Malaysia, they supply USD100,00 (if USD1=RM3.00) to finance the import. If, exchange rate change to USD1=RM3.50, they supply < USD100,000. Malaysian goods are cheaper, ↑M from Malaysia, SS USD↑

SS of dollars (USD) – from Americans RM/USD S Supply of dollars RM3.50 RM3.00 S Q1 Q2 Quantity of dollars

The Market Equilibrium Value of the Dollar RM/USD Supply of dollars Excess SS of USD RM3.00 Excess DD for USD Demand for dollars Q1 Quantity of USD Market equilibrium value of the exchange rate = the exchange rate that equate the quantities of the currency supplied and demanded in foreign exchange market. An excess dd for dollars will cause the dollar to appreciate against ringgit. An excess ss of dollars will lead to a depreciating dollar. Appreciation of a currency = the rise in value of one currency relative to another. Depreciation of a currency = the fall in value of one currency relative to another.

Factors affecting exchange rate (shift in dd and ss curve). Factors influencing the demand for dollars: An increase in the taste for US goods by foreign customers. An increase in real GDP abroad, thus more demand for imports from US. An increase in the real interest rate on US assets, which would make US assets more attractive to foreign savers. To acquire US assets, foreign citizens would demand more dollars. Inflation: if inflation occurs in Malaysia, it will make the price tag on US goods relatively lower for Malaysian importers. RM/USD S The demand for dollars will increase, thus shift the demand curve to the right. This causes the price of dollar to rise (USD will appreciate), or RM will depreciate. RM3.50 RM3.00 D2 D1 Quantity of dollars

Factors influencing the supply of dollars: An increase in the taste for Malaysian products. US importers will increase their supply of dollars. An increase in US real GDP, thus more demand for imports from abroad. Inflation occurs in US, it will make the price tag on foreign products relatively lower for US importers. An increase in the real interest rate on Malaysian asset. This means more Malaysian asset Americans will choose to hold. To purchase additional Malaysian assets, US households and firms will supply more dollars. RM/USD S1 S2 The supply of dollars will increase, thus shift the supply curve to the right. This causes the price of dollar to fall. RM4.00 RM3.80 D Q1 Q2 Quantity of dollars

Flexible versus Fixed Exchange Rates: For the most part, we have been discussing a system of flexible (floating) exchange rates. Flexible exchange rate = rate determined by the forces of dd & ss without government intervention. The rate varies according to the dd & ss of the currency in the forex market. Fixed exchange rate = rate of exchange between currencies pegged and maintained by the central bank’s on going purchases and sales of currencies.

Floating FER Floating FER is an exchange rate determined by the market forces. Eo = Initial equilibrium When Dd for US goods (M↑), Dd for USD↑ (Do to D1), USD ↑ and RM↓. Vice Versa. This floating FER regime creates: - economic instability - currency speculation - High risks for exporters and importers in the long run. RM/USD S E1 RM3.50 Eo RM3.00 D1 Do Qo Q1 Q of USD

Effects of Floating FER on BOP Eo = Initial equilibrium. When Malaysian ↑M from US, Dd for USD↑ (Do to D1); US BOP surplus by EoE1; USD↑; US exports more expensive; Dd for US goods drops from E1 to E2. In contrast, RM↓ and Malaysia goods cheaper; US ↑M for Malaysia goods, ↑Ss of USD from Eo to E2. New Eq.= E2 Thus, Malaysia and US BOPs are always in equilibrium between Eo and E2. RM/USD S E2 RM3.50 Eo E1 RM3.00 D1 Do 0 Qo Q1 Q of USD

Fixed FER An exchange rate determined by the government through buying/selling of currencies. Initial FER equilibrium at E. If the Malaysian Government sees this rate is not suitable, new rate can be as follows: 1. RM less valued = RM < market value = RM depreciation. - To encourage exports and discourage imports – RM depreciation makes Malaysian products relatively cheaper than foreign goods. 2. RM over valued = RM > market value = RM appreciation. - To discourage speculation on RM (buying and selling RM for profit). RM/USD S RM less valued RM3.50 E RM3.00 RM2.50 RM over valued D Q1 Quantity of dollar USD1=RM3.50 or RM1=USD0.286 USD1=RM3.00 or RM1=USD0.333 USD1=RM2.50 or RM1=USD0.400

Effects of Fixed FER on BOP Fixed FER would not achieve equilibrium BOP. At USD1=RM3.50: Ss of USD>Dd for USD (X>M for Malaysia). To fix this rate, the Government uses RM reserve to buy USD. To achieve, equilibrium, USD should ↓. In contrast, to remain at USD1=RM2.50, the Government sell USD reserve to finance the BOP deficit (imports). RM/USD (X>M) S BOP surplus RM3.50 RM undervalued RM3.00 RM overvalued RM2.50 BOP deficit (M>X) D Q of USD