Balance of payments and exchange rate issues

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. 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. 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 0 -7 Balance of payments statement 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

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.

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: http://www.voxeu.org/index.php?q=node/2820 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 24 2012

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. 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 The demand for euro $/€ 2 Depreciation 1 0.5 Euro

43. 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 The supply for euro $/€ 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.