International Finance FINA 5331 Lecture 3: Foreign Currency Markets Continued: Introduction to Balance of Payments Aaron Smallwood Ph.D.

Review: Triangular Arbitrage ¥ € $ Budapest: S(¥/€) = Madrid S($/€)= Tokyo S($/¥)= Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

Review: Triangular Arbitrage Sell $10,000,000 for ¥ at S($/ ¥ ) ask = ¥ receive ¥992,063, Sell our ¥992,063, for € at S(¥/ €) = ¥ receive €7,798, Sell € 7,798, for $ at S($/€) = receive $10,112, profit per round trip = $ 10, $10,000,000 = $112,918.41

Balance of Payments Accounting The Balance of Payments is the statistical record of a country’s international transactions over a certain period of time presented in the form of double-entry bookkeeping. credit “positive” entries debit “negative entries”

The balance of payments accounts are those that record all transactions between the residents of a country and residents of all foreign nations. They are composed of the following: –The Current Account –The Capital Account –The Financial Account –The Official Reserves Account –Statistical Discrepancy Balance of Payments Accounts

The Current Account Includes all imports and exports of goods and services (invisible trade). Includes unilateral transfers of foreign aid. If the debits exceed the credits, then a country is running a trade deficit. If the credits exceed the debits, then a country is running a trade surplus. It is thought that the CA responds to changes in income and the exchange rate.

The Current Account Consists of the following: –Merchandise trade –Services –Unilateral transfers –Investment income

The Current Account A credit on the current account results in foreign reserves flowing in (fixed exchange rate) or an increase in the demand for domestic currency in the FOREX market (flexible exchange rate). A debit on the current account results in foreign reserves flowing out of the domestic economy (fixed exchange rate) or an increase in the supply of domestic currency in the FOREX market (flexible exchange rate).

The Current Account When a domestic company sells goods or services to a foreign resident, there will be a credit recorded on the current account. When a domestic resident buys goods or services from a foreign firm, there will be a debit recorded on the current account. When a foreign asset pays interest to a domestic resident, or a domestic resident earns income in the foreign economy, there will be a credit recorded on the current account. When a domestic asset pays interest to a foreign resident, or a foreign resident earns income in the domestic economy, there will be a debit recorded on the current account.

J-curve Effect

What conditions are necessary for J-curve effect? ε IM is the import demand elasticity = %Δimports divided by %ΔS t. When ε IM is greater than one (in absolute value), a domestic depreciation will lead to a fall in the dollar value of imports. Import demand is said to be elastic. When ε IM is equal to one (in absolute value), a domestic depreciation will not change the dollar value of imports. When ε IM is less than one (in absolute value), a domestic depreciation will lead to a rise in the dollar value of imports. Import demand is inelastic. The J-curve can only occur when import demand elasticities are inelastic.

Algebra of Import Demand Elasticities

The Financial Account The financial account measures the difference between U.S. sales of assets to foreigners and U.S. purchases of foreign assets. The financial account is composed of Foreign Direct Investment (FDI), portfolio investments and other investments.

The Financial Account A credit on the financial account results in foreign reserves flowing in (fixed exchange rate) or an increase in the demand for domestic currency in the FOREX market (flexible exchange rate). A debit on the financial account results in foreign reserves flowing out of the domestic economy (fixed exchange rate) or an increase in the supply of domestic currency in the FOREX market (flexible exchange rate).

The Financial Account When a domestic entity (firm or individual) sells an asset to a foreign resident, there will be a credit recorded on the financial account. When a domestic resident buys an asset from a foreign entity, there will be a debit recorded on the financial account. Note – income earned on these assets is recorded on the current account, not the financial account.

Balance of payments Financial account –Includes portfolio investment: Sales of purchases of financial assets –Foreign direct investment: Implies investment where ownership is made by a foreign party –Other investment: Transactions in currency, bank deposits, and so on. Positive entries (credits) increase liabilities or decrease assets

The Balance of Payments Identity BCA + BFA + BRA = 0 where BCA = balance on current account BFA = balance on financial account BRA = balance on the reserves account Note: When a country experiences a currency crisis, we typically see BRA>0 (and HUGE) Under a pure flexible exchange rate regime, BCA + BFA = 0 Because BRA = 0

Balance of Payments Trends Since 1982 the U.S. has experienced continuous deficits on the current account and continuous surpluses on the financial account. During the same period, China has experienced the opposite.

China BOP

Japan BOP

USA BOP

Balances on the Current (BCA) and Financial (BKA) Accounts of United Kingdom

Official reserves In the US official reserve assets include gold, foreign currency, and special drawing rights (issued by the IMF). The official settlements balance is BCA+BFA When BCA+BFA≠0, the central bank must acquire or deplete holdings of official reserves.

Examples Example 3.1: Boeing (US) exports a 747 to Japan Airlines for $50 million. Japan Airlines pays from its dollar account at Chase. Example 3.3: Ford acquires Jaguar, a British car manufacturer for $750 million paid from deposits at Barclay’s. Example: In an intervention move, the Federal Reserve sells RMB10,000,000 in the open market. The RMB are used by a trader to purchase manufactured goods from China.

Balance of Payments and National Income Accounting GNP = Y = C + I + G + X – M Y = C + S + T X – M = (S- I) + (T- G) If a developing economy experiences large trade deficits (X-M <0), the remedies are: 1.Savings must increase, S↑ 2.Investment must fall, I↓ 3.Government spending must fall, G↓ 4.Taxes must rise, T↑

International Monetary Arrangements International Monetary Arrangements in Theory and Practice –The International Gold Standard, –Bretton Woods Agreement, –Smithsonian Agreement –The Floating-Rate Dollar Standard, Jamaica Agreement 1976 –The Plaza-Louvre Intervention Accords (1985 and 1987) and the Floating-Rate Dollar Standard,