Thorvaldur Gylfason Joint Vienna Institute/ Institute for Capacity Development

1. Balance of payments and Exchange rate regimes ThorvaldurGylfason Joint Vienna Institute/Institute for Capacity Development Distance Learning Course on Financial Programming and Policies Vienna, Austria November 26–December 7, 2012

2. Outline in six parts • Balance of payments accounts • Balance of payments analysis • Exchange rates • Exchange rate policy • Exchange rate regimes • To float or not to float • 6. How many monies do we need?

3. 1 Balance of payments accounts Accounting system for macroeconomic analysis in four parts • Balance of payments • National income accounts • Fiscal accounts • Monetary accounts Now look at balance of payments accounts per se, looked before at linkages in a separate lecture

4. Balance of payments conventions: Accounting principles Transactions in two major categories • Real transactions • Goods, services, and income • Current account of the BOP • Involve flows • Financial transactions • Reflect changes in foreign assets and liabilities • Capital and financial account of the BOP • Involve changes in stocks Flows involve changes in underlying stocks: X – Z + F = DR X = exports, Z = imports, F = capital account, R = reserves, F = DDF with DF = net foreign debt

5. External transactions Real transactions Financial transactions Examples

6. Recording External transactions The term “capital account” is Old language (BPM4) Shorthand for new language (BPM5) Balance of payments • BOP = Xg + Xs + Fx – Zg – Zs – Fz • = X – Z + F • = current account + capital account • Here • X = Xg + XsExports of good and services • Z = Zg + Zs Imports of good and services • F = Fx – Fz Net exports of capital = Net capital inflow = DDF Also called capital and financial account

7. Recording External transactions Balance of payments • BOP = Xg + Xs+ Fx – Zg – Zs – Fz • = X – Z + F • = current account + capital account • Here • X = Xg + XsExports of good and services • Z = Zg + Zs Imports of good and services • F = Fx – Fz Net exports of capital = Net capital inflow

8. Recording External transactions Balance of payments • BOP = Xg + Xs + Fx – Zg–Zs – Fz • = X – Z + F • = current account + capital account • Here • X = Xg + XsExports of good and services • Z = Zg + Zs Imports of good and services • F = Fx – Fz Net exports of capital = Net capital inflow

9. Recording External transactions Balance of payments • BOP = Xg + Xs + Fx – Zg – Zs–Fz • = X – Z + F • = current account + capital account • Here • X = Xg + XsExports of good and services • Z = Zg + Zs Imports of good and services • F = Fx – FzNet exports of capital = Net capital inflow

10. From trade Balance to current account • Trade balance • TB = Xg + Xnfs – Zg – Znfs Xnfs = Xs – Xfs = exports of nonfactor services Znfs = Zs – Zfs= imports of nonfactor services • Balance of goods and services • GSB = TB + Yf Yf = Xfs – Zfs = net factor income • Current account balance • CAB = GSB + TR = TB + Yf + TR • TR = net unrequited transfers from abroad Intermediate concept GSB

11. Importance of net factor income Yf > 0 in Pakistan Yf < 0 in Argentina Net factor income from labor • Compensation of domestic guest workers abroad (e.g., Pakistanis in the Gulf)minus that of foreign workers at home Net factor income from capital • Interest receipts from domestic assets held abroad minus interest payments on foreign loans (e.g., Argentina) • Includes also profits and dividends Transfers are unrequited transactions • Public or private, disbursed in cash or in kind (e.g., foreign aid)

12. Capital and financial account Two parts • Capital account (esp., capital transfers) • Financial account • Direct investment Involves influence of foreign owners • Portfolio investment Includes long-term foreign borrowing Does not involve influence of foreign owners • Other investment Includes short-term borrowing • Errors and omissions Statistical discrepancy Is the world’s BOP = 0?!

13. national income accounts Y = C + I + G + X – Z • = E + X – Z • where E = C + I +G CAB = X – Z = Y – E • Ignore Yf and TR for simplicity S = I + G – T + X – Z CAB = S – I + T – G CAD = Z – X = E – Y = I – S + G – T Private sector deficit Public sector deficit

14. Links between bop national accounts Y = C + I + G + X – Z GDP = C + I + G + TB GNP = C + I + G + CAB GNP – GDP = CAB – TB = Yf (if TR = 0) GNP = GDP + Yf • GNP > GDP in Pakistan • GNP < GDP in Argentina GNDI = GNP + TR = GDP + Yf + TR

15. Links between bop national accounts

16. Links between bop national accounts

17. Links between bop national accounts

18. 2 • Balance of payments analysis Payments for imports of goods, services, and capital Imports Real exchange rate Equilibrium Earnings from exports of goods, services, and capital Exports Foreign exchange Real exchange rate = eP/P*

19. Balance of payments equilibrium • Equilibrium between demand and supply in foreign exchange market establishes • Equilibrium real exchange rate • Equilibrium in the balance of payments • BOP = X + Fx – Z – Fz • = X – Z + F • = current account + capital account • = 0

20. overvaluation R moves when e is fixed R Deficit Imports Overvaluation Real exchange rate Exports Foreign exchange

21. Overvaluation, again Overvaluation works like a price ceiling Supply (exports) Price of foreign exchange Overvaluation Demand (imports) Deficit Foreign exchange

22. Current account balance • Crucial indicator used to assess the external position of a country • The current account balance is equal to the change in net foreign assets with respect to the rest of the world • Includes change in net foreign assets of • Non-banking sector • Banking sector (including monetary authorities) • CAB  – F + R because X – Z + F = R

23. Current account balance • CAB  – F + R because X – Z + F = R • Hence, current account deficit can be financed by • Attracting foreign direct investment • Accumulating net foreign liabilities • I.e., borrowing abroad • Running down the net foreign assets of the monetary authorities

24. Current account balance • When does a current account deficit become a source of concern? • When it is a lasting (structural) deficit rather than a temporary (cyclical) deficit • When it is financed by short-term external borrowing or by a protracted reduction in net foreign assets • When foreign exchange reserves are low in terms of months of imports or in terms of the Giudotti-Greenspan Rule • Other factors • Capacity to meet financial obligations • Availability of external financing

25. Current account balance • When does a current account deficit become a source of concern? • When continued current account deficits, reflecting the behavior of the government and the private sector, require drastic adjustment of economic policies in order to avoid a crisis, e.g., • Collapse of exchange rate • Default on external debt payments

26. Current account balance • A country is solvent if the present value of future current account surpluses is at least equal to its current external debt • The concept is simple, but putting it into practice is complicated • If the projections of future surpluses are sufficiently large, any current account deficit could be consistent with the notion of solvency

27. Overall balance • Another crucial indicator used to assess the external position of a country • A deficit in the overall balance means a decrease in the net foreign assets of the monetary authority except whenexceptional financingbecomes available • Foreign reserves are traditionally held by the monetary authorities in order to finance payments imbalances and to defend the currency

28. Overall balance • Exceptional financing can be needed in an emergency where reserves have fallen to perilously low levels • Three main types • Rescheduling of external debt obligations • Scheduled payments postponed in agreement with creditors • Debt forgiveness • Voluntary cancellation by creditors • Payments arrears on external debt service • Scheduled payments postponed without agreement with creditors

29. Overall balance • Indicators of an appropriate level of foreign reserves • Ratio of reserves to monthly imports of goods and services of more than 3 • Guidotti-Greenspan Rule • Other considerations • Capital mobility • Exchange rate regime • Composition of external liabilities • Access to foreign borrowing • Seasonal nature of imports and exports

30. 3 exchange rates Increase in Q means real appreciation e refers to foreign currency content of domestic currency Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

31. real vs. nominal exchange rates Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

32. Three thought experiments 1.Suppose e falls Then more rubles per dollar, so X rises, Z falls 2.Suppose P falls Then X rises, Z falls 3.Suppose P* rises Then X rises, Z falls Capture all three by supposing Q falls Then X rises, Z falls

33. 4 Exchange rate policy Payments for imports of goods, services, and capital Imports Real exchange rate Equilibrium Earnings from exports of goods, services, and capital Exports Foreign exchange

34. Exchange rate policy and welfare • Equilibrium between demand and supply in foreign exchange market establishes • Equilibrium real exchange rate • Equilibrium in balance of payments • BOP = X + Fx – Z – Fz • = X – Z + F • = current account + capital account = 0 X – Z = current account F = capital and financial account

35. Exchange rate policy and welfare R moves when e is fixed R Deficit Imports Overvaluation Real exchange rate Exports Foreign exchange

36. Exchange rate policy and welfare Overvaluation works like a price ceiling Supply (exports) Price of foreign exchange Overvaluation Deficit Demand (imports) Foreign exchange

37. Application 1: Dutch disease • Appreciation of currency in real terms, either through inflation or nominal appreciation, leads to a loss of export competitiveness • In 1960s, Netherlands discovered natural resources (gas deposits) • Currency appreciated • Exports of manufactures and services suffered, but not for long • Not unlike natural resource discoveries, aid inflows could trigger the Dutch disease in receiving countries See my “Dutch Disease” in New Palgrave Dictionary of Economics Online

38. Dutch disease: How oil exports crowd out nonoil exports Oil discovery leads to appreciation, and reduces nonoil exports Imports C B Real exchange rate A Exports with oil Exports without oil Composition of exports matters Foreign exchange

39. Dutch disease: How foreign aid can crowd out exports Trade vs. aid Foreign aid leads to appreciation, and reduces exports (e.g., Zambia) Imports C B Real exchange rate A Exports with aid Exports without aid Foreign exchange

40. Application 2: overvaluation • Governments may try to keep the national currency overvalued • To keep foreign exchange cheap • To have power to ration scarce foreign exchange • To make GNP look larger than it is • Other examples of price ceilings • Negative real interest rates • Rent controls in cities

41. Inflation and overvaluation • Inflation can result in an overvaluation of the national currency • Remember: Q = eP/P* • Suppose e adjusts to P with a lag • Then Q is directly proportional to inflation • Numerical example

42. Inflation and overvaluation Real exchange rate Suppose inflation is 10 percent per year 110 Average 105 100 Time

43. Inflation and overvaluation Hence, increased inflation lifts the real exchange rate as long as the nominal exchange rate adjusts with a lag Real exchange rate Suppose inflation rises to 20 percent per year 120 110 Average 100 Time

44. 5 Exchange rate regimes • The real exchange rate always floats • Through nominal exchange rate adjustment or price change • Even so, it matters how countries set their nominal exchange rates because floating takes time • There is a wide spectrum of options, from absolutely fixed to completely flexible exchange rates

45. Exchange rate regimes • There is a range of options • Monetary union or dollarization • Means giving up your national currency or sharing it with others (e.g., EMU, CFA, EAC) • Currency board • Legal commitment to exchange domestic for foreign currency at a fixed rate • Fixed exchange rate (peg) • Crawling peg • Managed floating • Pure floating

46. Exchange rate regimes FIXED FLEXIBLE  Currency union or dollarization  Currency board  Peg Fixed Horizontal bands  Crawling peg Without bands With bands  Floating Managed Independent

47. Basically fixed Dollarization • Use another country’s currency as sole legal tender Currency union • Share same currency with other union members Currency board • Legally commit to exchange domestic currency for specified foreign currency at fixed rate Conventional (fixed) peg • Single currency peg • Currency basket peg

48. intermediate Flexible peg • Fixed but readily adjusted Crawling peg • Complete • Compensate for past inflation • Allow for future inflation • Partial • Aimed at reducing inflation, but real appreciation results because of the lagged adjustment Fixed but adjustable

49. Basically floating Managed floating • Management by sterilized intervention • I.e., by buying and selling foreign exchange • Management by interest rate policy, i.e., monetary policy • E.g., by using high interest rates to attract capital inflows and thus lift the exchange rate of the currency Pure floating

50. Impossible trinity Free to choose only two of three options; must sacrifice one of the three FREE CAPITAL MOVEMENTS 2 Monetary Union (EU) 1 3 FIXED EXCHANGE RATE MONETARY INDEPENDENCE