Download Lecture 6: Balance of Payments and Exchange Rates

Lecture 6
Balance of Payments Accounting and Exchange Rates
The National Income Accounts
The Gross National Product (GNP) of a country is the value of all the final
goods and services produced by its factors of production and sold on the
market in a given time period.
A country’s GNP equals its National Income which is the income earned in
the same period by its factors of production.
For calculating GNP it does not matter where the country’s factors of
production are located: if a US company builds a plant in Ireland, the
investment income from the plant is a part of US GNP but of Irish GDP.
The Gross Domestic Product (GDP) of a country is the total volume of
output produced within the country’s borders. Consequently:
GNP = GDP + net receipts of factor income from abroad
Note that Ireland’s GNP is considerably less than its GDP.
National Income Identity in an Open Economy
The basic National Income (NI) accounting identity for an open economy is:
C + I +G+ X −M =Y
(1)
CA = X − M is defined as the current account balance: surplus (CA>0) or
deficit (CA<0), and if Y − (C + G ) represents national savings, then:
S − I = X − M = CA
(2)
Equation (2) says that if national savings exceed domestic investment, then
the country’s balance of trade will be in surplus or, equivalently, it will be a net
foreign lender. On the other hand, if national savings are not enough for
domestic investment, then the country’s balance of trade will be in deficit or,
equivalently, it will be a net foreign borrower.
Private versus Public Saving
Private Saving and public saving, denoted SP and SG, respectively, are
defined as:
S P = Y − T − C and S G = T − G ⇒ S P + S G = S
In the light of equation (3), equation (2) can be rewritten as:
S P = CA + I − S G
Equation (4) shows that private saving can take three forms:
1. Lending to foreigners, through balance of trade surplus
2. Lending to domestic investors, through funding investment
3. Lending to government, through purchase of government debt
(3)
(4)
Given a volume of private saving and investment, growing government deficits
will be reflected in growing trade deficits:
CA = S P − I + S G
(5)
National Income Statistics for the USA [Japan] (% of GDP)
Year
CA
SP
I
SG
1981
0.2
19.1
18.2
-1.0
[0.4]
[34.9]
[30.7]
[-3.8]
1983
-1.2
18.7
15.9
-4.1
[1.8]
[33.3]
[28.0]
[-3.6]
1984
-2.6
19.5
18.9
-2.9
[2.8]
[32.5]
[27.7]
[-2.1]
1986
-3.4
16.9
16.8
-3.4
[4.3]
[32.4]
[27.2]
[-0.9]
1991
-0.1
15.6
12.8
-3.0
[1.2]
[30.6]
[32.3]
[2.9]
From 1981-83, CA went from surplus to deficit, in spite of a fall in investment,
due to an increase in the government deficit. This was due to tax cuts under
the Reagan administration.
In 1984, the economy recovered, income and, therefore, tax revenues
increased, and the government deficit fell; but the recovery in investment was
so strong that the CA deficit increased.
In 1986, private saving and investment were of identical magnitudes, and the
government deficit was almost exactly mirrored in the CA deficit.
In 1991, a new recession meant that investment fell and, in spite of a large
government deficit, the CA deficit was small.
A succession of CA deficits transformed the USA’s net foreign wealth from
positive up to 1985, to negative thereafter. Mirroring this, Japan’s net foreign
wealth became positive after 1985 – The Rockefeller Center in New York and
Warner Bros. acquired Japanese owners.
BoP accounting follows the principles of double-entry bookkeeping: every
transaction is entered twice, once as a credit, once as a debit.
Example: US consumer buys a Volkswagen car for $15,000 and pays for this
with a dollar cheque. This transaction of $15,000 is entered as a debit item in
the current account of the US BoP. The German supplier deposits the dollar
cheque in his/her account and receives (say) 15,000 euros for the same. The
$ assets of the European Central Bank increase by $15,000 and this item is
entered as a credit item in the capital account (under Foreign Reserve Assets
held in the USA) of the US BoP (see below)
Balance of Payments Accounting
USA, 1992 $ billion
Current Account
Exports of goods and services:
Merchandise
Other Services
Credits
579.6
416.0
163.6
Debits
Imports, of which:
Merchandise
Other Services
607.7
489.4
118.3
Balance of Trade
28.1
Investment Income
Net Transfers
125.3
8.0
Balance on Current Account
108.9
3.7
In order to cover its CA deficit of $3.7 billion, the USA needed to borrow from
abroad (sell assets to foreigners) worth $3.7 billion. These transactions,
leading to a net capital inflow of $3.7 billion, along with other capital market
transactions, are shown in the capital account.
(Note an asset purchase is entered as a debit item, an asset sale as a credit
item)
Capital Account
US non-reserve assets held abroad
Foreign non-reserve assets held in US
Credits
48.6
Balance on Capital Account
Consolidated Current and Capital
Account
Balance on Current Account
Balance on Capital Account
Statistical Discrepancy
Official Settlements Balance of which:
US Reserve assets held abroad
Foreign Reserve assets held in US
Debits
68.0
19.4
Credits
Debits
3.7
19.4
1.1
24.2
5.8
18.4
Exchange Rates
An exchange rate represents the price of a country’s currency in terms of the
currency of another currency (for example: $1.50/£ or Rs.40/$)
An exchange rate appreciates if a country’s currency gains in value in terms
of other currencies ($1.50/£ to $2.00/£) and it depreciates if a country’s
currency loses in value in terms of other currencies ($1.50/£ to $1.00/£).
When a country’s exchange rate appreciates/depreciates, the prices of its
exports, expressed in foreign currencies rise/fall, and the prices of its imports
expressed in the domestic currency fall/rise.
The (expected) rate of return on an asset is the percentage increase in its
value (expected) over a time period.
The real rate of return is the rate of return less the inflation rate over the
period.
To compare rates of return on assets denominated in different currencies (£
and $), first, define the expected rate of depreciation of £ against $ as:
1
D£$e = ( E£$
− E£$0 ) / E£$0
1
where: E£$
is the exchange rate expected in period 1 and E£$0 is the current
exchange rate1
If r£ and r$ are the current interest rats on 1-year £ and $ deposits, then £1
invested in a $ deposit will after 1 year become:
 1
r  1
£  0 + $0  E£$
 E£$ E£$ 
and so the expected rate of return in £ on a 1-year $ deposit is:
 1
 1
r  1
r  1 E£$0
E1
r$£ =  0 + $0  E£$
− 1 =  0 + $0  E£$
− 0 = D£$e + r$ £$0
E£$
E£$
 E£$ E£$ 
 E£$ E£$ 
= D£$e + r$
1
1
 E£$

E£$
e
+
−
=
+
+
− 1 = D£$e + r$ + r$ D£$e
r
r
D
r
r
$
$
£$
$
$
0
0
E£$
 E£$ 
D£$e + r$
Consequently the difference in the rate of return on a £ asset versus a $deposit (from the point of view of a UK investor) is:
r£ − r$£ = r£ − r$ − D£$e
and the decision will be: invest in a £ ($) asset if UK interest rates exceed US
interest rates by more (less) than the expected rate of depreciation in £.
1
The exchange rate is being expressed as the amount of the domestic currency required to
buy one unit of the foreign currency (£0.60/$)
The foreign exchange market is in equilibrium when deposits on all currencies
offer the same expected rate of return:
r£ − r$£ = r£ − r$ − D£$e = 0 ⇒ r£ − r$ = D£$e
This is the interest rate parity condition. When is condition is satisfied,
there will no excess supply of, or demand for, any currency.
Current £/$ exchange rate (E£$0)
£1.0/$
rate on £ deposits (r£)
£0.75/$
$0.50/$
Expected £ return
on $ assets (r$£)
Rates of return in £ terms
1
Given an expected exchange rate, E£$
and current interest rates, r£ and r$, the
expected £ return on $ assets ( r$£ ) will be low, the lower the current value of
sterling2. In Figure 6.1, the equilibrium exchange rate is £0.75/$ or,
equivalently, $1.33/£.
If UK interest rates rise, £ becomes stronger: the expected rate of
depreciation D£$e is now greater.
If US interest rates rise, the curve showing the expected £ return on $ assets
shifts outwards: £ becomes weaker and the expected rate of depreciation D£$e
is now smaller.
1
If £ is expected to be weaker in the future ( E£$
to rise), then the expected
depreciation rate is higher: the curve showing the expected £ return on $
assets shifts outwards because at every current exchange rate, the £ return
on $ assets, r$£ , is higher.
Forward Exchange Rates
In order to be certain that a dollar investment (at a rate of return r$) will
guarantee a given amount in £ one can buy £ forward at an exchange rate
F£$: this guarantees that when the $ investment matures it will be converted to
2
e
Because, the smaller will the expected depreciation, D£$ .
£ at this exchange rate. The simultaneous purchase of a $ deposit at the
current exchange rate and the sale of the principal and interest at the forward
exchange rate is termed a covered transaction. The rate of return on a
covered $ deposit is:
 F£$1 − E£$0 
 F£$1 − E£$0 
£
1
rˆ$ = r$ + 
 + r$ 
 r$ + P£$
0
0
 E£$ 
 E£$ 
 F1 − E0 
where: P£$1 =  £$ 0 £$  is the 1-year forward premium on $ against £. The
 E£$ 
covered interest rate parity condition is:
r£ = rˆ$£ = r$ + P£$1
Comparing the covered interest rate parity condition with the uncovered
interest rate parity condition:
r£ = r$£ = r$ + D£$e
the two conditions can both be true if and only if the forward exchange rate
1
currently quoted equals the exchange rate expected one year on: F£$1 = E£$
that is, if and only
Example: A UK importer sells US computers for £1,000 and pays his US
supplier $1,500. So his profit depends upon the exchange rate: at $1.50/£ he
just breaks even; at $2.00/£ he makes a profit of £250 per computer and at
exchange rates below $1.50/£ he makes a loss. Suppose the current
exchange rate is $1.60/£ at which he would make a profit of £62.50 per
computer.
In order to ensure these profits (which will only be realised in 30 days time
when the computers arrive and are sold), the UK importer enters into a 30-day
forward exchange deal by which his bank agrees to sell him $ in 30 days time
at $1.60/£.
But, alternatively, the importer could have:
1. Borrowed $ from his bank: say £1 million for 1,000 computers
2. Converted £1 million into $1.5 million at current exchange rate
3. Deposited $1.5 million into a into a 30-day $ asset
4. Used the matured $ asset to pay US supplier $1.5 million
5. Used the revenue from computer sales to pay the bank and kept the
interest earned on the $ deposit as his profits.