1. Balance of payments and exchange rate issues
Session 7
Macroeconomics and the International Context
MSc Economic Policy Studies
Alan Matthews

2. Balance of payments

3. Lecture objectives
Describe and understand the balance of payments accounts
Do international payments imbalances matter?
Addressing international payments imbalances
Reading: McAleese Chapter 20

4. CSO Student Corner on balance of payments
The balance of payments is a set of accounts showing all economic transactions between residents of the home country and the rest of the world in any one year
The current account in the balance of payments records all visible and invisible trade
The capital account covers mainly capital transfers (EU grants and migrants’ net worth)
The financial account in the balance of payments is a record of a country’s transactions in foreign financial assets and financial liabilities (often distinguishing between long-term and short-term flows)
CSO Student Corner on balance of payments

5. Balance of payments statement
Current account
Goods trade (merchandise trade)
Services
Trading and investment income
Current unilateral transfers
Balance on current account
Capital account
Financial account
Balance on financial account
Foreign direct investment
Portfolio capital
Other investment
Change in official reserves
Net errors and omissions
2011, €bn 37 -2
-31 -1 1 -0 6 11 27
-33 -7
Irish data. Source: CSO Balance of international payments release, Dec 2012

6. Some definitions
Merchandise trade similar to balance of trade account (see Trade lecture) but valued at f.o.b prices for both exports and imports
Invisibles refers to balance of services trade, investment income and current transfers (net current receipts from EU and Irish Aid expenditure)
Capital account transfers refer mainly to capital receipts under EU structural funds
Financial account includes long-term capital flows (FDI and portfolio investment) and other flows which are mainly short-term loans and transactions in financial derivatives
Reserve assets are non-euro denominated liquid assets and gold owned by the Central Bank

7. Further definitions
Sometimes distinction is made between autonomous and accommodating transactions in the balance of payments
Former are seen as ‘active’ transactions, responding to real changes in competitiveness conditions, while latter are ‘passive’
Example: consider reactions to an increased demand for imports
Line is drawn under the basic balance, but increasingly less distinct as capital markets become more liquid

8. Irish balance of payments trends
Year
Merch-andise
Invisibles
Balance on current account
Services
Trading & invest-ment income
Current transfers
Total Invisible
2002
35,442
-13,779
-23,664
707
-36,736
-1,295
2003
32,604
-11,091
-21,947
432
-32,606 -2
2004
31,423
-10,203
-22,481
393
-32,291
-867
2005
28,218
-9,303
-24,870
265
-33,908
-5,690
2006
25,031
-6,797
-24,033
-506
-31,336
-6,304
2007
19,811
-1,121
-27,825
-990
-29,936
-10,124
2008
23,811
-7,670
-25,155
-1,154
-33,979
-10,169
2009
32,469
-6,900
-27,907
-1,424
-36,231
-3,763
2010
35,751
-6,639
-25,918
-1,412
-33,969
1,782
2011
36,588
-1,810
-31,834
-1,159
-34,803
1,785

9. Borrowers and lenders, debtors and creditors
The balance of payments is a flow concept
It shows whether a country is a net borrower or a net lender in any year
A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it.
A creditor nation is a country that has invested more in the rest of the world than other countries have invested in it.
The difference between being a borrower/lender nation and being a creditor/debtor nation is the difference between stocks and flows of financial capital.
Does it matter if a country is a debtor nation? Depends on how the borrowing has been used.
The stock of foreign investment determines whether a country is a debtor or a creditor
Developing countries

10. International Investment Position
The international investment position (IIP) is a point in time statement of the value and composition of the balance sheet stock of an economy's foreign financial assets (i.e. the economy's financial claims on the rest of the world) and its foreign financial liabilities (or obligations to the rest of the world).
The change in the IIP between beginning and end of period is equal by definition to the current account balance over that period plus valuation changes reflecting changes in exchange rates and asset prices
Note reconciliation is also difficult due to large BOP balancing item ‘net errors and omissions’

11. Ireland’s IIP
Source: CSO Quarterly International Investment Position, Dec 2010

12. Source: Lane, Dynamics of Ireland’s net external position, SSISI, 2011

13. Source: Lane, Dynamics of Ireland’s net external position, SSISI, 2011

14. Understanding the balance of payments current account
First, some national income accounting
Recall total income Y is defined from expenditure side as
Y = C + I + G + X – M
Y can also be defined as
Y = C + S + T
In equilibrium, these two definitions are identical
(I - S) + (G – T) = (M – X)
Balance of payments deficit = excess investment over savings plus government budget deficit

15. Interpreting a current account deficit
Two views
A deficit is a sign that a country is spending more than it earns, a weakness which must be corrected by either/both reducing expenditure or switching expenditure from imports in favour of exports
A deficit is a sign of strength because it means the country is sufficiently profitable to attract continued flows of foreign capital (focus on the basic balance)

16. The importance of sustainability
“A country is said to have a balance of payments problem when the current account deficit and the accumulated international investment position have reached a level where continuance of the deficit is no longer judged sustainable” – McAleese
Issues
Time dimension
Size of deficit in relation to GDP and debt position
Method of financing of deficit
Related to use of deficit (investment or consumption?)
Growth position
Sustainability a matter of market confidence

17. Correlation between cost of CDS and current account
Source: EA = Euro Area

18. Why an unsustainable current account deficit matters
Adds to cost of foreign borrowing
Greater exposure to the volatility of international capital markets with potential for lack of confidence scenario (Asian crisis 1997)
May induce excessivly large exchange rate depreciation
Asset ownership moves into foreign hands
Within the euro zone a country’s balance of payments should matter no longer, but it remains an important symptom of underlying problems

19. Interpreting a current account deficit
McAleese ‘tale of three deficits’
US deficit
Developing countries’ debt
Deficits in Euroland

20. Sustainability of the US current account deficit
How sustainable is the deficit?
Will it keep downward pressure on the US dollar?
US deficit was running at around 6% of US GDP
US dollar has depreciated by 40% relative to the euro between Jan 2002 and Jan 2004

21. The US deficit is sustainable
“Some argue our large trade deficit (or current account deficit) is responsible for the fall in the dollar's value. They have it backward. It is the flow of foreign investment dollars (the capital account) into the U.S. economy that drives the trade deficit. The U.S. economy's higher return on capital than Europe or Japan for the last 20 years caused private foreign investors to buy U.S. stocks and bonds and other assets. In addition, foreign governments, particularly of China, Japan and other Asian states, have steadily increased their purchases of U.S. dollars as reserve backing for their own currencies.”
- Cato Institute economist Richard Rahn, Jan 2004
Note similarity to Box 20.1 in MacAleese

22. The US deficit is not sustainable
High productivity growth and booming stock markets in the 1990s drove a wedge between private investment and savings
US household savings now fallen to 1% of GDP
US fiscal policy now hugely expansionary
Foreigners will lose their appetite to hold US assets, causing interest rates to rise and restricting demand

23. Prospects for a soft US landing
US economy insulated from the worst effects of an international financial crisis
Because of its size
The fact that most of its obligations are denominated in its own currency
International role of the dollar underpins demand for it
Damage may be felt as much by other countries as by the US

24. Correcting a balance of payments imbalance
Automatic adjustment mechanisms
Start with adverse shock to exports
-> fall in demand for imports used as inputs to production
-> fall in aggregate demand leads to fall in imports
-> monetary factors such as fall in real balances
-> supply side adjustments through changes in relative prices of traded/nontraded goods

25. Correcting a balance of payments imbalance
Recall (I - S) + (G – T) = (M – X), problem is to reduce excessive (M-X)
Expenditure reduction policies
Increase S
Reduce I
Reduce G – T through restrictive fiscal policies
Expenditure switching policies
Commercial policy (tariffs, etc)
Improved cost competitiveness
Exchange rate changes

27. Relationship between global imbalances and the financial crisis
What role did global imbalances play in the crisis?
One view – excess savings drove down real interest rates, led to underpricing of risk
Other view – poor financial regulation was the cause
Suominen 2010

28. Capital flowing ‘uphill’
Driving by savings ‘glut’ in surplus countries
Source: King 2011

29. Challenges for the G20
How to address global imbalances when OECD countries are undertaking significant fiscal contraction?
Excess of global savings
Export-led growth model of China, Germany, Japan
Currency appreciation by surplus countries?
Alternatives?

30. Exchange rates

31. Motivations
Ireland has a high share of trade outside the eurozone in which exchange rates play a crucial role in determining competitiveness
Exchange rates are highly volatile
The level of exchange rates can cause problems for business
What determines the level and volatility of exchange rates?
Reading: McAleese Chapter 21

32. US dollar/euro exchange rate
Euro depreciates
Euro appreciates
Source: ECB Statistical data warehouse

33. Sterling/euro exchange rate
Euro depreciates
Euro appreciates
Source: ECB Statistical data warehouse

34. The forex market Note its size!
According to BIS, average daily turnover April 2010 was €3.98 trillion (see Wikipedia entry)
Made up of a series of interrelated markets
Spot market
Forward market
Futures market
Derivative markets
Swaps and options
Determines the relative values of different currencies

35. The exchange rate
The price of foreign currency (dollar, sterling, yen) in terms of domestic currency (euro)
(viz. The price of apples – how much do you have to pay in domestic currency)
Suppose it costs US citizen $1.99 to buy 1 GBP in 1991 and twelve years later it costs only $1.58 – dollar has appreciated
From UK perspective, I USD cost 50p in 1991 and 63p in 2003 – sterling has depreciated

36. Impact of exchange rate on firms
Advantages of a strong currency
Makes imported raw materials cheaper
Helps to control inflation
Leads to lower interest rates
Makes foreign assets cheaper
Disadvantages of a strong currency
Exporters lose price competitiveness
Adverse impact on competitiveness may be moderated if leads to lower wage demands

37. Effective exchange rates
Bilateral exchange rates do not move together, so we need some method to summarise the overall strength or weakness of a country’s currency
The nominal effective exchange rate (EER) is defined as the exchange rate of the domestic currency vis-à-vis other currencies weighted by their share in world trade
Which currencies
What weights?
Significance of the base year
Now called the Harmonised Competitiveness Indicator (HCI)

38. Source: The Economist
March

39. Real Effective Exchange Rate
Real effective exchange rate (REER) also takes account of price level changes between countries
adjusts the nominal EER by the ratio of foreign to domestic inflation
Used to assess change in competitive position of a country relative to its competitors
Example
Suppose currency of country A has depreciated over one year by 10% against currency of country B
Suppose inflation rate in A is 7% and inflation rate in B is 2%
Then real depreciation (change in REER) is 10% - (7% - 2%) = 5%
Improvement in competitive position is 5%, not the 10% suggested by the EER
Now called the real HCI

40. Source: NCC, Ireland’s Competitiveness Scorecard 2012

41. Exchange rate determination
The exchange rate between two currencies is the price of one currency in terms of the other
Express the exchange rate as the number of US dollars (price) per euro
To determine the exchange rate we examine both the demand for and the supply of euros

42. The demand for euro A derived demand Americans want euro $/€
in order to pay for European goods and services (exports)
In order to pay for European assets including government bonds, equities and property
$/€ 2
Depreciation 1
0.5
Euro

43. The supply for euro A derived supply Europeans want dollars $/€
in order to pay for American goods and services (imports)
In order to buy American assets including government bonds, equities and property 2
Depreciation 1
0.5
Euro

44. Exchange rate equilibrium
$/€ S D

45. Factors which shift the demand or supply curves
Interest rate differentials
Shifts in demands for assets
Inflation differentials
If EU goods become more expensive
Growth differentials
Stronger growth usually associated with stronger currency
Speculation
Expectations about future exchange rates
Affected by above factors as well as stance of economic policy (budget deficits, balance of payments deficits, political outlook as well as market psychological factors)

46. Reaching a new equilibrium
Suppose euro interest rates rise
Will increase demand for euro from US investors
Will decrease supply of euro as EU investors also shift from US to EU assets
Euro appreciates
$/€ D2 S2 D1 S1

47. Exchange rate equilibrium
How can we tell if a currency is over-valued or under-valued?
Is a currency likely to appreciate or depreciate in the near future?
Answers provided by
Purchasing Power Parity theory
Balance of payments approach
Asset market or portfolio theories

48. Purchasing power parity
PPP model holds that, in the long run, exchange rates adjust to equalise the relative purchasing power of currencies
Draws inspiration from Law of One Price
Arbitrage will ensure price levels converge
Absolute PPP
The exchange rate will be such as to make the general level of prices the same in every country
Exchange rates between currencies are in equilibrium when their purchasing power is the same in each of two countries
Unrealistic assumptions
Difficulties with non-traded goods

49. Purchasing power parity
Relative PPP
Changes in the exchange rate are determined by the difference between relative inflation rates in different countries
Over the long run we would expect exchange rates to adjust to maintain purchasing power parity
In other words, exchange rates should adjust to offset differences in the rates of inflation, maintaining a constant real exchange rate
Do exchange rates adjust to maintain purchasing power parity?
Yes, in the long run, but very slowly for reasons that are still unclear (see Rogoff JEL 1996)

50. Purchasing power parity
How is PPP calculated?
The Economist ‘Big Mac’ index
People consume very different goods and services across countries
Standard estimates produced every six months by OECD/Eurostat (OECD PPP database)
OECD estimates in next chart compare the PPP of a currency with its actual exchange rate compared to US dollar. Green bars (top of chart) indicate currency is overvalued and thus expected to depreciate against he US dollar in the long run, and vice versa.

51. OECD PPP estimates (relative to Euro)
Source: University of British Columbia Pacific FX Service

52. PPP uses
Clearly there are significant discrepancies between PPP and actual exchange rates
But can PPP be used to predict exchange rate changes?
Poor empirical performance
Real exchange rates not only determined by relative inflation differentials
Real exchange rates can and do change significantly over time, because of such things as major shifts in productivity growth, advances in technology, shifts in factor supplies, changes in market structure, and commodity shocks
Note objection: Rapid productivity growth -> higher inflation -> currency appreciation (Balassa-Samuelson effect)
But important long-run benchmark

53. Balance of payments approach
BoP approach focuses on relationship between trade/current account balance, modified to taken into account long-term capital flows, and the exchange rate
BoP approach also allows ER to be influenced by real factors (economic fundamentals)
Country with a persistent deficit is likely to devalue, country with persistent surplus likely to revalue
Different to, but consistent with, PPP theory
PPP -> If country A has higher inflation rate than B, will run into a deficit and be forced to devalue

54. Examples of economic fundamentals
These are factors which can shift the supply and demand curves for a currency (see above)
Changes in the growth rate
Balance of payments (influencing expectations)
Equity and bond market performance
Size of budget deficits and public debt
Governance and political stability

55. Asset market (portfolio) explanations
PPP and BoP approaches focus on role of ER in balancing flows of foreign exchange
Modern approach emphasises role of ER in balancing the supply and demand of domestic and foreign assets
Exchange rates adjust to reflect differences in the rate of return on assets (bills and bonds) in different currencies
It is differences in the expected total return which is relevant. This comprises the interest rate on foreign assets plus the capital gain (loss) from a appreciation (depreciation) of the foreign currency

56. Asset market explanations
Expected exchange rate changes (and hence the expected capital gains or losses from investing abroad) influence decisions
Because expectations are influenced by ‘news’, and news is unpredictable, so are short run fluctuations

57. Interest rate parity
What determines international capital portfolio movements?
Difference between interest rates at home and abroad
Expectations about future exchange rates
Interest rate parity describes the relationship between forward exchange rates, spot exchange rates and interest rates between two countries
Rates of return on comparable assets should be equal around the world, implying that exchange rates adjust so that difference between interest rates is zero.
It relies on the market’s tendency to correct itself through arbitrage
Two versions
Uncovered parity
Covered parity

58. Uncovered interest rate (UIP) parity
If US risk-free interest rate is 4% and euro rate is 2%, why do fund managers not switch into dollar assets?
Domestic interest rate less foreign interest rate = expected change in exchange rate (Uncovered interest rate parity)
Assumes
Perfect capital mobility
Equal risk on home and foreign bonds
If interest rate differential is greater than the expected change in spot rates, potential for arbitrage

59. Covered interest rate (CIP) parity
Borrow money in one currency (low interest rate), use to buy bonds in second currency (higher rate), and protect (cover) against exchange rate movements by buying the first currency forward
Interest rate differences should equal the forward premium (covered interest rate parity)
Forward exchange rate is a proxy for exchange rate expectations. UIP builds on CIP by assuming that market forces ensure the forward exchange rate is equal to the expected future spot exchange rate
However, forward exchange rate is not a good (although unbiased) predictor of the spot rate
Underlines that exchange rates are affected by shocks which are inherently unpredictable

60. Empirical performance of interest rate parity
Does (uncovered) interest rate parity hold?
Hard to measure, since requires information on expectations and on relative risk of bonds
Cause or effect?
if it holds, does it mean that interest rate differentials determine exchange rate changes, or vice versa?

61. One effort to measure desired equilibrium exchange rates
Cline and Williamson, 2012, Peterson Institute

62. Summary
Exchange rate movements are an important determinant of competitiveness
Although we can understand the factors which move exchange rates, their movement is very hard to predict
Modern theory emphasises how the importance of the balance of trade in goods and services (the real economy) in influencing exchange rates is overwhelmed by international capital movements, whose movement is very hard to predict
Firms can adapt strategies to insulate partially against exchange rate movements, but they are partial and costly
International coordination of exchange rates?

63. Euroland issues
Source: EEAG report 2012

64. Source: EEAG report 2012

65. Source: EEAG report 2012

66. Restoring Ireland’s competitiveness
Within the EU, commercial policy and exchange rate changes are ruled out
Expenditure reduction policies (i.e. fiscal tightening) can lead to severe economic contraction and rise in unemployment
Reduction in nominal wages required to mimic a real devaluation – internal devaluation - , but how to achieve?