balance of payment.pptx

INTERNATIONALFINANCIAL

MANAGEMENT

EUN / RESNICK

Third Edition

Chapter Objective:

This chapter serves to introduce the student to the balance of payments. How it is constructed and how balance of payments data may be interpreted.

3Chapter Three

The Balance of Payments

CHAPTER THREE OUTLINE

• Balance of Payments Accounting• Balance of Payments Accounts

• The Current Account• The Capital Account• Statistical Discrepancy• Official Reserves Account

• The Balance of Payments Identity

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.

N.B. when we say “a country’s balance of payments” we are referring to the transactions of its citizens and government.

BALANCE OF PAYMENTS ACCOUNTS

• 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 Official Reserves Account• Statistical Discrepancy

THE CURRENT ACCOUNT

• Includes all imports and exports of goods and services.• 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.

THE CAPITAL ACCOUNT

• The capital account measures the difference between U.S. sales of assets to foreigners and U.S. purchases of foreign assets.• The U.S. enjoys about a $444,000,000,000 capital

account surplus—absent of U.S. borrowing from foreigners, this “finances” our trade deficit.• The capital account is composed of Foreign Direct

Investment (FDI), portfolio investments and other investments.

STATISTICAL DISCREPANCY

• There’s going to be some omissions and misrecorded transactions—so we use a “plug” figure to get things to balance.• Exhibit 3.1 shows a discrepancy of $0.73 billion in

2000.

THE OFFICIAL RESERVES ACCOUNT

• Official reserves assets include gold, foreign currencies, SDRs, reserve positions in the IMF.• Official reserve transactions refer to central

banks’ purchases or sales of official reserve assets such as gold, U.S. T-bills, and main foreign currencies.• Balance of official reserve transactions =Changes

in U.S. official reserve assets held abroad + Changes in foreign official reserve assets held in U.S. = -OSB

THE BALANCE OF PAYMENTS IDENTITY

BCA + BKA + BRA = 0whereBCA = balance on current accountBKA = balance on capital accountBRA = balance on the reserves account

U.S. BALANCE OF PAYMENTS DATA

Credits DebitsCurrent Account

1 Exports $1,418.64

2 Imports ($1,809.18)

3 Unilateral Transfers $10.24 ($64.39) Balance on Current Account ($444.69

)Capital Account 4 Direct Investment $287.6

8($152.44

)5 Portfolio Investment $474.39

($124.94)6 Other Investments $262.6

4($303.27

) Balance on Capital Account

$444.26

7 Statistical

Discrepancies

Overall Balance $0.30 Official Reserve Account ($0.30)

0.73


In 2000, the U.S. imported more than it exported, thus running a current account deficit of $444.69 billion.


1 Exports $1,418.64

2 Imports ($1,809.18)



8($152.44



4($303.27


$444.26

7 Statistical

Discrepancies


0.73


During the same year, the U.S. attracted net investment of $444.26 billion—clearly the rest of the world found the U.S. to be a good place to invest.


1 Exports $1,418.64

2 Imports ($1,809.18)



8($152.44



4($303.27


$444.26

7 Statistical

Discrepancies


0.73


Under a pure flexible exchange rate regime, these numbers would balance each other out.


1 Exports $1,418.64

2 Imports ($1,809.18)



8($152.44



4($303.27


$444.26

7 Statistical

Discrepancies


0.73


In the real world, there is a statistical discrepancy.


1 Exports $1,418.64

2 Imports ($1,809.18)



8($152.44



4($303.27


$444.26

7 Statistical

Discrepancies


0.73


Including that, the balance of payments identity should hold:

BCA + BKA = – BRA

($444.69) + $444.26 + $0.73 = $0.30= –($0.30)


1 Exports $1,418.64

2 Imports ($1,809.18)



8($152.44



4($303.27


$444.26

7 Statistical

Discrepancies


0.73

BALANCE OF PAYMENTS AND THE EXCHANGE RATE

Q

P

Exchange rate $ Credits Debits

Current Account 1 Exports $1,418.

64

2 Imports ($1,809.18)



8($152.44



4($303.27


$444.26

7 Statistical

Discrepancies


0.73

S

D


Q

P

As U.S. citizens import, they are supply dollars to the FOREX market.


1 Exports $1,418.64

2 Imports ($1,809.18)



8($152.44



4($303.27


$444.26

7 Statistical

Discrepancies


0.73

Exchange rate $

S

D


Q

P

As U.S. citizens export, others demand dollars at the FOREX market.


1 Exports $1,418.64

2 Imports ($1,809.18)



8($152.44



4($303.27


$444.26

7 Statistical

Discrepancies


0.73

Exchange rate $

S

D


Q

P S

D

As the U.S. government sells dollars, the supply of dollars increases.

S1


1 Exports $1,418.64

2 Imports ($1,809.18)



8($152.44



4($303.27


$444.26

7 Statistical

Discrepancies


0.73

Exchange rate $

BALANCE OF PAYMENTS TRENDS

• Since 1982 the U.S. has experienced continuous deficits on the current account and continuous surpluses on the capital account.• During the same period, Japan has experienced

the opposite.

EXCHANGE RATES

• The rate at which one currency can be exchanged for another e.g.• £1 = $1.90• £1 = €1.50• Important in trade

EXCHANGE RATES

• Converting currencies:• To convert £ into (e.g.) $• Multiply the sterling amount by the $ rate• To convert $ into £ - divide by the $ rate:

e.g.• To convert £5.70 to $ at a rate of £1 = $1.90,

multiply 5.70 x 1.90 = $10.83• To convert $3.45 to £ at the same rate, divide

3.45 by 1.90 = £1.82

EXCHANGE RATES

• Appreciation of the exchange rate:• A rise in the value of £ in relation to other

currencies – each £ buys more of the other currency e.g.• £1 = $1.85 £1 = $1.91• UK exports appear to be more expensive

( Xp)• Imports to the UK appear to be cheaper (

Mp)

EXCHANGE RATES

• Depreciation of the Exchange Rate• A fall in the value of the £ in relation to

other currencies - each £ buys less of the foreign currency e.g. • £1 = € 1.50 £1 = € 1.45• UK exports appear to be cheaper

( Xp)• Imports to the UK appear more expensive

( Mp)

EXCHANGE RATES

• A depreciation in exchange rate should lead to a rise in D for exports, a fall in demand for imports – the balance of payments should ‘improve’• An appreciation of the exchange rate should

lead to a fall in demand for exports and a rise in demand for imports – the balance of payments should get ‘worse’ BUT

EXCHANGE RATES

• The volumes and the actual amount of income and expenditure will depend on the relative price elasticity of demand for imports and exports.

EXCHANGE RATES

$ per £

Quantity onForEx Markets

D£

S£

1.85

Q1

Assume an initial exchange rate of £1 = $1.85. There are rumours that the UK is going to increase interest rates

Investing in the UK would now be more attractive and demand for £ would rise

D£1

Q2

Shortage

1.90

Q3

The rise in demand creates a shortage in the relationship between demand for £ and supply – the price (exchange rate) would rise

EXCHANGE RATES

• Floating Exchange Rates:• Price determined only by demand and supply

of the currency – no government intervention• Fixed Exchange Rates:• The value of a currency fixed in relation to an

anchor currency – not allowed to fluctuate• Dirty Floating or Managed Exchange Rate:

– rate influenced by government via central bank around a preferred rate

EXCHANGE RATES

• Purchasing Power Parity (PPP)

• The relationship between the exchange rate and the price level in different countries.• The price of £ in the foreign currency = Foreign Country

price level/UK price level

EXCHANGE RATES

• The exchange rate would be a proper reflection of the purchasing power in each country if the relative values bought the same amount of goods in each country.

• E.g. If the price of a pint of Stella in the UK was £3.00 and in Europe €4.50, the exchange rate between the two countries should be £1 = €1.50

• If any lower than this value, the £ would be undervalued and if any higher, the £ would be overvalued.

Determinants of Exchange Rates

DETERMINANTS OF EXCHANGE RATES

• OverviewBefore we look at these forces, we should sketch out how exchange rate movements affect a nation's trading relationships with other nations. A higher currency makes a country's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country's exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange rate would increase it.

1. DIFFERENTIALS IN INFLATION:

• As a rule of thumb, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.

2. DIFFERENTIALS IN INTEREST RATES:

• Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates.

3. CURRENT-ACCOUNT DEFICITS:

• The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

4. PUBLIC DEBT:

• Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.

• In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate.

5. TERMS OF TRADE:

• A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners.

6. POLITICAL STABILITY AND ECONOMIC PERFORMANCE:

• Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.

7. SPECULATION:

• Simply a believe in the path the currency, shall cause speculators to adjust their trades in light of this believe. e.g. if currency speculators believe that an economy is overheating and soon there shall be a devaluation, then they will get out of the currency causing there to be more supply than demand on the forex for that currency, hence it depreciates.

END OF CHAPTER

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