Determination of Exchange Rates & Balance of Payments

Reading: Chapters 3 & 5 (not pg148-161)

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Lecture Objectives

Determination of Exchange Rates Currency Forecasting Introduction to Balance of Payments Balance of Payments Accounting BOP & Exchange Rates

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Exchange rate determination is complex.The following exhibit provides an overview of the

many determinants of exchange rates.This road map is first organized by the three major

schools of thought (parity conditions, balance of payments approach, asset market approach), and secondly by the individual drivers within those approaches.

These are not competing theories but rather complementary theories.

Determination of Exchange Rates

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Determination of Exchange Rates

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The theory of purchasing power parity is the most widely accepted theory of all exchange rate determination theories:– PPP is the oldest and most widely followed of the

exchange rate theories.

– Most exchange rate determination theories have PPP elements embedded within their frameworks.

– PPP calculations and forecasts are however plagued with structural differences across countries and significant data challenges in estimation.

Parity Conditions Approach

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The balance of payments approach is the second most utilized theoretical approach in exchange rate determination:– The basic approach argues that the equilibrium exchange

rate is found when currency flows match up current and financial account activities.

– This framework has wide appeal as BOP transaction data is readily available and widely reported.

– Critics may argue that this theory does not take into account stocks of money or financial assets.

Balance of Payments Approach

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The asset market approach argues that exchange rates are determined by the supply and demand for a wide variety of financial assets:– Shifts in the supply and demand for financial

assets alter exchange rates.– Changes in monetary and fiscal policy alter

expected returns and perceived relative risks of financial assets, which in turn alter exchange rates.

Asset Market Approach

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The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers (among others):

– Relative real interest rates

– Prospects for economic growth

– Capital market liquidity

– A country’s economic and social infrastructure

– Political safety

– Corporate governance practices

– Contagion (spread of a crisis within a region)

– Speculation

Asset Market Approach

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Equilibrium Exchange Rate

Qty

$1.50

S

$/€D

Equilibrium

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What Changes the Equilibrium Rate?

Inflation rates: Higher domestic inflation means less demand for local goods

(decreased supply of foreign currency) and more demand for foreign goods (increased demand for foreign currency).

Interest rates: Higher domestic (real) interest rates attract investment funds

causing a decrease in demand for foreign currency and an increase in supply of foreign currency.

Economic growth: Stronger economic growth attracts investment funds causing

a decrease in demand for foreign currency and an increase in supply of foreign currency.

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What Changes the Equilibrium Rate?

Political & economic risk: Higher political or economic risk in the domestic country

results in increased demand and reduced supply of foreign currency.

Changes in future expectations: Any improvement in future expectations regarding the

domestic currency or economy will decrease the demand for foreign currency and increase the supply of foreign currency.

Government intervention: Maintain weak currency to improve export competitiveness.

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Numerous foreign exchange forecasting services exist, many of which are provided by banks and independent consultants.

Some multinational firms have their own in-house forecasting capabilities.

Predictions can be based on elaborate econometric models, technical analysis of charts and trends, intuition, and a certain measure of gall.

Forecasting in Practice

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Technical analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future.

The single most important element of technical analysis is that future exchange rates are based on the current exchange rate.

Exchange rate movements can be subdivided into three periods:

– Day-to-day

– Short-term (several days to several months)

– Long-term

Forecasting in Practice

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The longer the time horizon of the forecast, the more inaccurate the forecast is likely to be.

Whereas forecasting for the long run must depend on the economic fundamentals of exchange rate determination, many of the forecast needs of the firm are short to medium term in their time horizon and can be addressed with less theoretical approaches.

Forecasting in Practice

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Forecasting in Practice

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Currency Forecasting Project

For each currency you can do the following: RPPP and IFE (long-term influences) Technical analysis (past trends) Asset market approach (ongoing relationships and changes?) Balance of payments approach Unbiased forward rate

Then you conclude with your overall prediction based on all of these methods and allocate funds to your trading strategy.

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Balance of Payments

The BOP is a statistical record of the flow of all of the payments between the residents of a country and the rest of the world in a given year.

Transactions are recorded on the basis of double entry bookkeeping – by definition it has to balance. Every “source” must have a “use”.

The two main components are: Current Account Capital/Financial Account

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Balance of Payments

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Current Account (CA)

This is record of a country’s trade in goods and services in the current period.

CA = Exports (X) – Imports (M)

It is divided into 4 sub-categories: Goods trade Services trade Income Current transfers

The sum of the four sub-categories = CA balance

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Capital Account (KA)

This includes all short- and long-term transactions pertaining to financial assets.

KA = Capital Inflow (cr) – Capital outflow (dr)

The two main components: Capital account. Financial account (direct, portfolio, other).

KA balance = Sum of capital account and financial account.

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Official Reserves

Records the purchase or sale of official reserve assets by the central bank. These assets include

Commercial paper, Treasury bills and bonds Foreign currency Money deposited with the IMF

This account shows the change in foreign exchange reserves held by the central bank.

Since the BOP must balance

CA + KA + RFX = 0

CA + KA = – RFX

The Balance of Payments Identity

For floating rate regime countries, such as the U.S., official reserves are relatively unimportant.

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Statistical Discrepancy (E&O)

The identity CA + KA = – RFX assumes that all transactions are measured accurately.

Inaccurate recording of transactions (errors & omissions), results in the above equality not holding. For BOP to balance,

CA + KA + E&O = – RFX

Assuming changes in official reserves, errors are approximately zero:

Current Account = (–) Capital Account

This will hold approximately for floating rate countries

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CA ≈ -KA

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A surplus in the BOP implies that the demand for the country’s currency exceeded the supply and that the government should allow the currency value to increase – in value – or intervene and accumulate additional foreign currency reserves in the Official Reserves Account.

A deficit in the BOP implies an excess supply of the country’s currency on world markets, and the government should then either devalue the currency or expend its official reserves to support its value.

BOP in Total

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Accounting Principles

1. Any transaction resulting in a payment to foreigners is entered in the BOP accounts as a debit and is given a negative sign.

2. Any transaction resulting in a receipt from foreigners is entered as a credit and given a positive sign.

3. Current Account records transactions involving exports and imports of goods and services

4. Capital Account records transactions involving the purchase and sale of assets.

5. Double-Entry book keeping: Every international transaction automatically enters twice, once as a credit and once as a debit.

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Examples of Transactions

Credit Transactions (+ve): Provision of goods and services to non-residents Income receivable from non-residents A decrease in foreign financial assets An increase in foreign financial liabilities

Debit Transactions (-ve): Purchase of goods & services from non-residents Income payable to non-residents An increase in foreign financial assets A decrease in foreign financial liabilities

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Examples of Transactions

An Australian company exports goods worth US$1 million to the United States: Export of goods is credit for the current account. Increase in foreign asset (US$1 million) is debit for capital account.

Australian company then coverts US$ into A$ and buys government bonds back in Australia: Decrease in foreign asset is credit for the capital account. Increase in government liability is debit for official reserves

account.

Australian individual imports a sports car from Europe: Increase in foreign liabilities is credit for the capital account. Import of goods is debit for current account.

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A nation’s balance of payments interacts with nearly all of its key macroeconomic variables.

Interacts means that the BOP affects and is affected by such key macroeconomic factors as:– Gross Domestic Product (GDP)– Exchange rate– Interest rates– Inflation rates

BOP & Macroeconomic Variables

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A country’s BOP can have a significant impact on the level of its exchange rate and vice versa.

The relationship between the BOP and exchange rates can be illustrated by use of a simplified equation that summarizes the BOP (see next slide).

BOP & Exchange Rates

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(X – M) + (CI – CO) + (FI – FO) + FXB = BOP

Where:X = exports of goods and servicesM = imports of goods and servicesCI = capital inflowsCO = capital outflowsFI = financial inflowsFO = financial outflowsFXB = official monetary reserves

Current Account Balance

Capital Account Balance

Financial Account Balance

BOP & Exchange Rates

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Fixed Exchange Rate Countries– Under a fixed exchange rate system, the

government bears the responsibility to ensure that the BOP is near zero.

Floating Exchange Rate Countries– Under a floating exchange rate system,

surpluses/deficits influence exchange rate.

BOP & Exchange Rates

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A country’s import and export of goods and services is affected by changes in exchange rates.

The transmission mechanism is in principle quite simple: changes in exchange rates change relative prices of imports and exports, and changing prices in turn result in changes in quantities demanded through the price elasticity of demand.

Theoretically, this is straightforward, in reality global business is more complex.

Trade Balances & Exchange Rates

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Trade Balances & Exchange Rates