International Finance
Chris EdmondNYU Stern
Spring 2007
1
Agenda
• International capital flows
– balance of payments accounting– trade in goods and services vs. trade in assets– are large deficits sustainable?
• Exchange rates
– nominal vs. real– purchasing power parity (PPP)– covered and uncovered interest parity (CIP and UIP)– forecasting– fixed vs. floating exchange rate regimes
2
Terminology
• Trade balance
– balance on merchandise trade (‘goods’)– balance on goods and services (‘net exports’)
• Current account balance
– current account = net exports + net foreign income– net foreign income includes
! capital income! labor income! taxes and transfers
– current account measures change in net foreign assets
3
US current account balance
CATEGORY AMOUNT (BILLIONS)
Net exports of goods -781.6
Net exports of services 58.0
Net labor income -5.8
Net capital income 1.6
Net taxes and transfers -82.9
Current account -810.8
Source: Bureau of Economic Analysis, 2006
4
Notation
• Current account measures change in net foreign assets
Bt+1 "Bt = rBt + Xt "Mt
where
Bt = net foreign assets (think ‘bonds’)rBt = net foreign income
Xt "Mt = net exports
5
US current account balance
CATEGORY AMOUNT (BILLIONS)
Net exports of goods -781.6
Net exports of services 58.0
Net labor income -5.8
Net capital income 1.6
Net taxes and transfers -82.9
Current account -810.8
Xt ! Mt
rBt
Bt+1 ! Bt
Source: Bureau of Economic Analysis, 2006
6
Trade in goods
-0.1
-0.05
0
0.05
0.1
0.15
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
exports of goods
imports of goods
net
share of GDP
Source: Bureau of Economic Analysis, 2006
7
Trade in services
-0.005
0
0.005
0.01
0.015
0.02
0.025
0.03
0.035
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
share of GDP
net
exports of services
imports of services
Source: Bureau of Economic Analysis, 2006
8
Income receipts and payments
0
0.005
0.01
0.015
0.02
0.025
0.03
0.035
0.04
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
share of GDP
net
income receipts
income payments
Source: Bureau of Economic Analysis, 2006
9
Current account
-0.070
-0.060
-0.050
-0.040
-0.030
-0.020
-0.010
0.000
0.010
0.020
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
share of GDPnet services
net goods
net income
current account
net taxes etc
Source: Bureau of Economic Analysis, 2006
10
Summary
• As a share of GDP, the US runs
– an increasingly large goods deficit– a modest services surplus– essentially balances net capital and labor income flows
• Implies
– trade deficit # current account deficit
11
Financing the deficit
• How is a current account deficit financed?
– by selling assets to foreigners
• Trade in assets
– ‘direct’ investment (controlling interest)– ‘portfolio’ investment
! purchases of government securities! purchases of corporate equity or securities! bank and non-bank loans
12
Capital and financial account
• Capital account includes
– net direct investment– net portfolio investment– net government transactions (gold, international reserves, etc)
• Current and capital accounts balance
current account + capital & financial account = 0
(up to a statistical discrepancy)
• Suggests an alternative perspective
– current account deficit $ domestic investment > savings– perhaps deficit $ domestic investment opportunities are good relative to rest of
world
13
Capital and financial account
CATEGORY AMOUNT (BILLIONS)
Net direct investment 107.1
Net securities 334.0
Net loans -35.8
Net government 395.6
Capital & financial account 801.0
Current account -810.8
Statistical discrepancy -9.8
Source: Bureau of Economic Analysis, 2006
14
Balance of payments
goods, services, etc
equity, securities, etc
United StatesRest of world
+$800 billion
!$800 billion
balance of payments = current account + capital & financial account = 0
15
Direct investment flows
-0.030
-0.020
-0.010
0.000
0.010
0.020
0.030
0.040
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
share of GDP
net
foreign direct investment in US
US direct investment abroad
Source: Bureau of Economic Analysis, 2006
16
Purchases of securities
-0.030
-0.020
-0.010
0.000
0.010
0.020
0.030
0.040
0.050
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
share of GDP
net
US purchases securities abroad
Foreign purchases US securities
Source: Bureau of Economic Analysis, 2006
17
Changes in loans
-0.050
-0.040
-0.030
-0.020
-0.010
0.000
0.010
0.020
0.030
0.040
0.050
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
share of GDP
net
Foreign loans to US
US loans abroad
Source: Bureau of Economic Analysis, 2006
18
Purchases of government assets
-0.015
-0.010
-0.005
0.000
0.005
0.010
0.015
0.020
0.025
0.030
0.035
0.040
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
share of GDP
US govt abroad
net
foreign govt in US
Source: Bureau of Economic Analysis, 2006
19
Capital and financial account
-0.020
-0.010
0.000
0.010
0.020
0.030
0.040
0.050
0.060
0.070
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
share of GDP
net govt
capital & financial account
net directnet securities
net loans
Source: Bureau of Economic Analysis, 2006
20
Balance of payments
-0.080
-0.060
-0.040
-0.020
0.000
0.020
0.040
0.060
0.080
1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
share of GDP
current account deficit
capital & financial account surplus
Source: Bureau of Economic Analysis, 2006
21
Net foreign assets
• Current/capital account measure international capital flows
• Add up current/capital accounts over time to get asset position
assets = US claims on foreign countriesliabilities = foreign claims on US
net foreign assets = assets " liabilities
22
US claims abroad (assets)
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
share of GDP
direct investment
bonds
corporate equity
govt
loans
Source: Bureau of Economic Analysis, 2006
23
Foreign claims on US (liabilities)
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
share of GDP
direct investment
corporate equity
corporate bonds
loans
govt
Source: Bureau of Economic Analysis, 2006
24
Net foreign assets
-0.40
-0.20
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
net foreign assets
US claims abroad(assets)
share of GDPforeign claims on US
(liabilities)
Source: Bureau of Economic Analysis, 2006
25
Is the US in trouble?
• Two perspectives
– pessimistic: current account deficit because low savings, debt burden will grow,consumption will have to fall in future
– optimistic: capital account surplus because US is good place to invest, large flowof savings from low-growth countries (‘global savings glut’)
– is the glass half-empty or half-full?
26
Is the US in trouble?
• Sustainability analysis, same as with fiscal policy
• Net foreign assets/output ratio follows
bt+1 " bt =r " g
1 + gbt +
11 + g
(xt "mt)
(where x"m is net exports/output ratio)
• Steady state
b = " 1r " g
(x"m)
27
Is the US in trouble?
• Steady state net foreign assets/GDP ratio
b = " 1r " g
(x"m)
• Example: US net foreign assets/GDP is "0.25. If r = 0.05 and g = 0.02, what tradesurplus is needed to sustain this indefinitely? Answer:
x"m = "(r " g)b= (0.05" 0.02)0.25= 0.0075
A surplus of less than 1% of GDP. But currently, deficit of 6.5% of GDP. Somethinghas to give.
28
What have we learned so far?
• Balance of payments accounting
– current account = net exports + net foreign income– current account + capital & financial account = 0
(deficit financed by selling assets)– net foreign assets = sum of past current accounts
• Two perspectives on current account deficit
– pessimistic: US isn’t saving enough, so has to sell assets– optimistic: foreign countries are growing too slow, US is a
great place to invest
29
Agenda
• Exchange rates
– nominal vs. real– purchasing power parity (PPP)– covered and uncovered interest parity (CIP and UIP)– forecasting– fixed vs. floating exchange rate regimes
30
Nominal exchange rates
• Relative price of two currencies
• Level or change a!ect most international business transactions
– profits in euros = how many dollars? (‘level’)– return on euro bonds = what return on dollar bonds? (‘change’)
• Volatile, would like to forecast
31
Nominal exchange rates
• Terminology/notation
– spot exchange rate, e
– by convention: local currency price of foreign currency– example: if 1.23 dollars buy 1.00 euro, e = 1.23– counterintuitive: % e $ dollar depreciates (takes more dollars to buy one euro)
32
Dollar/yen nominal exchange rate
0.2
0.4
0.6
0.8
1.0
1.2
1971 1974 1976 1978 1981 1983 1986 1988 1991 1993 1996 1998 2001 2003 2006
US dollars per 100 yen
Source: Board of Governors, 2006
33
Dollar/yen nominal exchange rate
0.2
0.4
0.6
0.8
1.0
1.2
1971 1974 1976 1978 1981 1983 1986 1988 1991 1993 1996 1998 2001 2003 2006
depreciation of the dollar
US dollars per 100 yen
Source: Board of Governors, 2006
34
Dollar/yen nominal exchange rate
0.2
0.4
0.6
0.8
1.0
1.2
1971 1974 1976 1978 1981 1983 1986 1988 1991 1993 1996 1998 2001 2003 2006
depreciation of the dollar
appreciation
US dollars per 100 yen
Source: Board of Governors, 2006
35
Dollar/euro nominal exchange rate
0.8
0.9
1.0
1.1
1.2
1.3
1.4
1999 2000 2001 2002 2003 2004 2005 2006
US dollars per euro
Source: Board of Governors, 2006
36
Real exchange rate
• Real exchange rate adjusts for price level di!erences
real exchange rate & eP !
P
where
e = nominal exchange rate, e.g., dollars per yenP ! = foreign price level, e.g., Japanese CPI in yenP = domestic price level, e.g., US CPI in dollars
• Real exchange rate measures the relative price of a basket of goods
– domestic basket is expensive if P > eP !
– foreign basket is expensive if P < eP !
• Measurement issues?
37
‘Law of one price’
• Basic idea
– goods should sell for price everywhere once exchange rate taken into account
• Goods market arbitrage: for traded commodities i = 1, 2, ..., n arbitrage gives
pi = ep!i
– if not, buy low sell high
38
Purchasing power parity (‘PPP’)
• PPP hypothesis is
P = eP !
(‘law of one price’ for whole consumption baskets)
• Implicit assumptions
– all goods and services traded– consumers in both countries have same tastes
(same expenditure shares on each commodity)
• Other issues
– tari!s, transportation costs– monopoly power, price discrimination
(prevents pi = ep!i for at least some i)
39
Purchasing power parity (‘PPP’)
• PPP hypothesis is
P = eP ! ' real exchange rate = 1
• Often people say
‘domestic currency is overvalued’ ' P > eP !
• Empirical tests look at weaker implication
" log(P ) = " log(e) + " log(P !) = 0
or
" log(e) = ! " !!
If so, exchange rate depreciates when domestic inflation is greater than foreign inflation
40
PPP evidence
-0.250
-0.125
0.000
0.125
0.250
0.375
1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
year on year rate of change
US inflation
Japan inflation
inflation di!erential
Source: Board of Governors and Bank of Japan, 2006
41
PPP evidence
-0.250
-0.125
0.000
0.125
0.250
0.375
1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005
year on year rate of change
change in US dollars per yen
Source: Board of Governors and Bank of Japan, 2006
42
PPP evidence
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004
nominal exchange rate, e
real exchange rate, eP
!
P
US dollars per 100 yen
(arbitrary base-year units)
Source: Board of Governors and Bank of Japan, 2006
43
PPP works better for high inflation countries
!
"#
$#
"##
!%###
"%###
&'()*+,-./,-0'((+,
#
1#
!##
2/,3/45+6/
!7819! !77#9! !7719! "###9! "##19!-
:;3<+46/-=+5/-0/.,/3)+5)'4 >4?(@-0)??/,/45)+(
:;3<+46/-=+5/-A('6-B3+(/-!-,)6<5C
>4?(+5)'4-0)??/,/45)+(-+4D-&'()*+,EB-0/.,/3)+5)'4
Source: Board of Governors, 2005
44
Summary
• Countries with low inflation
– PPP fails badly, especially at short horizons– inflation di!erentials smooth but exchange rates volatile
• Countries with high inflation
– PPP works much better– depreciation reflects relatively high domestic inflation
45
Exchange rates and interest rates
Country/region Money market rate (%)
Argentina 9.63
Brazil 16.54
China 2.40
Euro zone 2.80
Japan 0.02
Mexico 7.27
United States 4.77
Why are the interest rates di!erent? Where would you invest?
46
Exchange rates and interest rates
• Notation
i = interest rate on domestic currencyi! = interest rate on foreign currencye = spot nominal exchange ratef = one-period forward nominal exchange rate
• How are these related?
• Two concepts
– covered interest parity (CIP)– uncovered interest parity (UIP)
47
Covered interest parity (‘CIP’)
• Buy and hold dollars
– invest one dollar in dollar asset, gives 1 + i dollars
• Or, sell euros forward
– one dollar is 1/e euros at spot rate– invest 1/e euros in euro asset, gives (1 + i!)/e euros– sell (1 + i!)/e euros forward at f , gives (1 + i!)f/e dollars
• Two riskless transactions. Arbitrage should give
(1 + i) = (1 + i!)f
eor
1 + i
1 + i!=
f
e' i" i! # log
!f
e
"
Works well!
48
Uncovered interest parity (‘UIP’)
• Suppose we didn’t cover ourselves forward
• Convert back to dollars at spot rate. Risky return in dollars
(1 + i!t )et+1
et
• Expectations hypothesis
ft = Et{et+1}
• Combine with covered interest parity
(1 + it) = (1 + i!t )ft
et= (1 + i!t )
Et{et+1}et
or1 + it1 + i!t
= Et
#et+1
et
$
Zero expected excess return.
49
Uncovered interest parity (‘UIP’)
• Interest di!erentials and expected exchange rate changes
1 + it1 + i!t
= Et
#et+1
et
$
• Implies high interest countries have exchange rates that depreciate
– doesn’t work, at least not for developed countries– high interest countries have appreciating currencies– suggests a big arbitrage opportunity– why?
50
Forecasting exchange rates
• Di#cult if not impossible
– PPP works only for high inflation countries– UIP works hardly at all– CIP works, but has no forecasting content– di#cult to beat a ‘random walk’
(a 50/50 up/down bet has almost as much predictive power)
• Would not matter if exchange rates were not volatile. But they are!
• Better hedge any exchange rate risk
51
Exchange rate regimes
• Flexible (‘floating’) exchange rate
– market conditions determine exchange rate– all the exchange rates we’ve looked at so far were floating– ‘clean’ versus ‘dirty’ floats
• Fixed (‘pegged’) exchange rate
– government sets price – how?– must be willing to buy/sell nearly unlimited foreign currency at that price– collapse if run out of reserves– also a!ected by currency controls
• Costs and benefits? What do you think?
52
China’s fixed exchange rate
0.1
0.2
0.3
0.4
0.5
0.6
0.7
1981 1984 1987 1990 1993 1996 1999 2002 2005
US dollars per yuan
Source: Board of Governors, 2006
53
China’s fixed exchange rate
• What problems might this cause?
• Does a low yuan help Chinese exports?
• Can a low yuan be sustained?
54
What have we learned today?
• International capital flows
– current account + capital & financial account = 0(deficit financed by selling assets)
– net foreign assets = sum of past current accounts– two perspectives: US not saving enough vs. great place to invest
• Exchange rates
– volatile– di#cult to forecast. Really!
55
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