Balance of Payments (BOP) and Exchange Rates

You are Here: Home > International Finance > Balance of Payments (BOP) and Exchange Rates The International Monetary Fund (IMF) defines the BOP as a statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world. BOP data measures economic transactions include exports and imports of goods and services, income flows, capital flows, and gifts and similar one-sided transfer payments. The net of all these transactions is matched by a change in the countrys international monetary reserves. The significance of a deficit or surplus in the BOP has changed since the advent of floating exchange rates. Traditionally, BOP measures were used as evidence of pressure on a countrys foreign exchange rate. This pressure led to governmental transactions that were compensatory in nature, forced on the government by its need to settle the deficit or face a devaluation. Exchange Rate Impacts: The relationship between the BOP and exchange rates can be illustrated by use of a simplified equation that summarizes BOP data: BOP = (X-M) + (CI-CO) + (FI-FO) +FXB Where: X is exports of goods and services, M is imports of goods and services, (X-M) is known as Current Account Balance CI is capital outflows, CO is capital outflows, (CI-CO) is known as Capital Account Balance FI is financial inflows, FO is financial outflows, (FI-FO) is known as Financial Account Balance FXB is official monetary reserves such as foreign exchange and gold The effect of an imbalance in the BOP of a country works somewhat differently depending on whether that country has fixed exchange rates, floating exchange rates, or a managed exchange rate system. a) Fixed Exchange Rate Countries. Under a fixed exchange rate system, the government bears the responsibility to ensure a BOP near zero. If the sum of the current and capital accounts does not approximate zero, the government is expected to intervene in the foreign exchange market by buying or selling official foreign exchange reserves. If the sum of the first two accounts is greater than zero, a surplus demand for the domestic currency exists in the world. To preserve the fixed exchange rate, the governments must then intervence in the foreign exchange market and sell domestic currency for foreign currencies or gold so as to bring the BOP back near zero. It the sum of the current and capital accounts is negative, an exchange supply of the domestic currency exists in world markets. Then the government must intervene by buying the domestic currency with its reserves of foreign currencies and gold. It is

obviously important for a government to maintain significant foreign exchange reserve balances to allow it to intervene effectively. If the country runs out of foreign exchange reserves, it will be unable to buy back its domestic currency and will be forced to devalue. For fixed exchange rate countries, then, business managers use balance-of-payments statistics to help forecast devaluation or revaluation of the official exchange rate. Normally a change in fixed exchange rates is technically called devaluation or revaluation, while a change in floating exchange rates is called either depreciation or appreciation. b) Floating Exchange Rate Countries. Under a floating exchange rate system, the government of a county has no responsibility to peg the foreign exchange rate. The fact that the current and capital account balances do not sum to zero will automatically (in theory) alter the exchange rate in the direction necessary to obtain a BOP near zero. For example, a country running a sizable current account deficit with the capital and financial accounts balance of zero will have a net BOP deficit. An excess supply of the domestic currency will appear on world markets. As is the case with all goods in excess supply, the market will rid itself of the imbalance by lowering the price. Thus, the domestic currency will fall in value, and the BOP will move back toward zero. Exchange rate markets do not always follow this theory, particularly in the short-to-intermediate term. c) Managed Floats. Although still relying on market conditions for day-to-day exchange rate determination, countries operating with managed floats often find it necessary to take actions to maintain their desired exchange rate values. They therefore seek to alter the markets valuation of a specific exchange rate by influencing the motivations of market activity, rather than through direct intervention in the foreign exchange markets. The primary action taken by such governments is to change relative interest rates, thus influencing the economic fundamentals of exchange rate determination. A change in domestic interest rates is an attempt to alter capital account balance, especially the short-term portfolio component of these capital flows, in order to restore an imbalance caused by the deficit in current account. The power of interest rate changes on international capital and exchange rate movements can be substantial. A country with a managed float that wishes to defend its currency may choose to raise domestic interest rates to attract additional capital from abroad. This will alter market forces and create additional market demand for domestic currency. In this process, the government signals exchange market participants that it intends to take measures to preserve the currencys value within certain ranges. The process also raises the cost of local borrowing for businesses, however, and so the policy is seldom without domestic critics. For managed-float countries, business managers use BOP trends to help forecast changes in the government policies on domestic interest rates.

Balance of Payments

1. Flexible Exchange Rates When the exchange rates are not stabilized by government authorities, the FE market closely resembles the theoretical model of perfect competition. There is a large number of buyers and sellers who act as price takers. Accordingly, the exchange rates are determined by demand and supply in the foreign exchange (FE) market. the demand for foreign exchange originates in the debit items in the BP. The amounts of FE demanded are inversely related to its price. Demand Debit transactions involve payments by domestic residents to foreign residents. Imports of merchandise foreign transportation services purchases of American residents traveling abroad foreign investment by home residents. the supply of FE derives from the credit items in the BP. Credit transactions involve receipts by domestic residents from foreign residents Supply exports of merchandise purchases of foreign travelers in the US investment in the US by foreign residents There is a direct relationship with price. pure float (clean float): No intervention by monetary authorities dirty (managed) float: occasional monetary intervention designed to smooth out fluctuations 2. Fixed Exchange Rates Government officials strive to keep the exchange rates stable even if the rates they choose deviate from the current equilibrium rates. They announce the "par value" and a "band" of exchange rates. The

par value

exchange rates are allowed to vary within the band.

For example, if Bank of England announces that the par value of = $2.00 and supports British pound at 2% below the par or supports $ at 2% above the par, they have to get rid of the excess supply or demand at these prices using their international reserve assets. During the Bretton Woods era, a country's international reserve assets included gold and other foreign currencies. (See for instance, Japan's international reserves (copy)). Since 1973, they included SDRs and foreign currencies.

While gold can be held by the private sector as well as public institutions, gold is no longer used as a means to settle international payments. In countries where gold is held as a reserve asset, its market value is listed, but gold cannot be directly used to settle payments between central banks. (i) US buys , this increases reserve in US (For example, because of its low dollar peg of RMB, China is buying dollars, about $200 billion a year. China accumulated about $1.4 trillion as of November 2007. China is considering selling dollars As $ , the value of China's reserve asset declines. ) (ii) UK buys (sell $), this decreases $ reserve in UK.

(i) US sells ( reserve falls in the US) (ii) UK sells ($ reserve increases in UK). China sells RMB and $ reserve increase in China.

2. Systems of Exchange Monetary authorities differ greatly in their approach to maintaining the value of their currency in the FE market. Some central banks intervene on a daily basis. With most banks, intervention is intermittent. Others make no attempt to influence the price of their currencies.

Fixed Rates

the government announces an exchange rate, called the parity rate and defends it.

Hard peg: Permanently fixed rate (the government has no plan to change it): Currency Boards, Dollarization Adjustable peg: Rates are periodically adjusted (Bretton woods) Soft peg High frequency pegging: day-to-day dollar pegging or week-to-week pegging Low frequency pegging: month-to-month pegging or quarter-to-quarter pegging

Exchange control: rates may be maintained through rationing of foreign exchange How? wide band: rates are fixed, but a considerable amount of fluctuation is allowed around the parity rate. crawling peg: at any point in time, a country is committed to maintain its pegged exchange rate within a margin of X percent. The level is equal to its moving average of the exchange rates over a preceding period of Y

weeks.

where ZY = mean of Z over Y weeks. Mexico's arrangement during the early 1990s provides a good example of a crawling peg. Mexico pegged the peso to the US dollar. However, the inflation rates of the two countries diverged considerably, which necessitated a gradual depreciation of the peso. In this case, it is better to adopt a crawling peg than to devalue the peso drastically once in a while. Example Similarly, Nicaragua pegged the value of its currency to the US dollar. US inflation averaged about 2 to 3 %, but inflation in Nicaragua remained between 10 to 20% a year. Because of this large difference in inflation rates, there would be a tendency for the crdoba to depreciate against the US dollar. Thus, Nicaragua adopted a crawling peg. (Daniels and van Hoose, 2002) While it is efficient to peg one's currency to a stable currency, relying on a single currency might be risky. For this reason, a nation might peg its currency to a basket of foreign currencies. A basket of currencies is likely to be less variable than a single currency. Currency Baskets If all other currencies were included in the basket, the resulting peg would be most stable. However, managing such a peg can be quite cumbersome. Moreover, not all currencies are equally important, and weights should be assigned to each currency in accordance with the economic power of the nations included in the basket. For this reason, the currency baskets often include a small number of major currencies. For instance, the Czech Republic pegged its currency koruna to a basket of currencies including 0.0125 USD and 0.0329 DM, equivalent to 1 koruna (Kc 1). Some countries do not have a central bank that conduct monetary policies. Instead they have a currency board, an independent monetary agency, that links the growth of its money supply to the foreign exchange holdings; it issues domestic money in exchange for foreign currency at a

Currency Boards

fixed exchange rate. Currency Boards do not engage in discretionary monetary policy. Many small countries have currency boards: Estonia, Hong Kong, Lithuania, and Argentina. Recently, Lithuania abadoned its currency board because in 1997 a rise in the value of USD resulted in an appreciation of lit against the currencies of its major trading partners and a huge trade deficit. Some countries use the currencies of another nation as their legal tender. Other nations may also abandon their domestic currencies. This practice is called dollarization, i.e., the use of any other currency (dollar or not) as the legal tender. Some European countries now consider euroization, namely to use euro as a legal tender in their countries unilaterally without consulting European Union. The new member states are expected to use euro as legal tender sooner or later. There is as yet no movement to use euro as legal tender in other European countries.

Dollarization

Euroization

3. Balance of Payments

Organizing BP accounts

The majority of countries publish payments accounts. The items can be grouped into three categories.

Merchandise Balance = merchandise exports - merchandise imports Services = transportation, insurance, travel, investment services (interest income, dividends, profits), royalties and other services Current Account Unilateral transfers = gifts to foreigners private transfers = expenditures for missionary, charitable and educational organizations + personal remittances (of immigrants to their families and relatives) government transfers = tax receipts from nonresidents, nonmilitary grants, but the largest is government aid toward developing countries (net military

transactions) records the net changes in the country's international financial assets and liabilities Capital inflow occurs when residents' financial liabilities increase, e.g. selling bonds to foreigners Capital outflow occurs when residents' financial claims on foreigners increase (or liabilities decrease) Capital Account Direct Investment = long term capital outflow. This includes only foreign branches + subsidiaries effectively controlled. (US residents control 50% or more of the voting stock) Portfolio Investment = long term capital outflow that do not give effective control over investments. covers all international financial transactions with maturity exceeding one year. Short term capital flows = transactions of international assets with maturity of one year or less. short term borrowing from foreign banks/short term deposits in foreign banks. Most volatile component/ errors & Omissions records the transactions of the central bank (Federal Reserve system, Treasury, exchange stabilization agency) when it buys/sells foreign currencies. The central bank has only one intent for these transactions: delay a change in the exchange rate.

Official Reserve Account

4. Concepts of BP surplus/deficit Surplus and deficit are economic concepts that are used to measure disequilibrium in the balance of payments. One would place some items "above the line" which are regarded as autonomous, and other items "below the line" which are viewed as accommodating the surplus or deficit by the government sector. Autonomous activities by the private sector generally cause a gap in the

balance of payments. Accommodating activities are by the monetary authorities intended to fill the gap. This balance measures only exports and imports of merchandise by putting them above the line, i.e., treating them as autonomous decisions. Available monthly, and hence popular. Xg - Mg US Balance of Merchandise Trade Goods & Service Balance X - M.

Merchandise Balance

It is more difficult to keep track of service transactions. This measure covers all transactions that are current,

Current Account Balance

X-M-T If surplus, it represents the amount of international lending and corresponds to net foreign investment. Large current account deficits do not necessarily imply there is a problem in the economy. The basic balance is the sum of the current account balance and the net movement of long term capital (direct and portfolio investments). X - M - T - LTC LTC = long term capital outflow

Basic Balance

Basic Balance is intended to measure structural changes in a country's balance of payments insensitive to short run changes in economic variables such as interest rates, exchange rates, expectations. responsive only to long term changes in productivity, international competitiveness. This concept is close to the theoretical concept of fundamental equilibrium.

Liquidity

This balance measures the liquidity position of the US,

Balance

X - M - T - LTC - STCUS. STCUS = short term US capital outflow In case of trouble, STCUS cannot be mobilized, but STCforeign can be quickly retrieved from the US. Appropriate measure in a crisis, but not in a steady state. This balance puts the transactions of monetary authorities below the line, and all others above the line. X - M - T - LTC - STCprivate. If the monetary authorities engage in no transactions to manipulate exchange rates, the official reserve transactions are zero by definition. This balance measures the extent of actions by monetary authorities to delay a change in exchange rates.

Official Reserve Transactions Balance

intended to measure the exchange market pressure on the country's currency useful when the monetary authorities are in charge of maintaining a stable exchange rate If ORTB (was a deficit) = -$10B, then the monetary authorities were compelled to intervene in the FE market for the same amount to prevent a depreciation of the country's currency by (i) depleting FE reserve by $10 B, (ii) obtaining FE by exporting $10 B of gold, or (iii) borrowing FE from foreign central banks.

5. BP Accounting under Flexible Exchange Rate Since 1978 the US decided not to intervene in the FE market, except in emergency. However, several countries have intervened in the FE markets occasionally, when a currency appreciated or depreciated too much relative to other currencies (e.g., Plaza accord in 1985). Accordingly, BP accounts are prepared in a different way. In a country with a clean float, no reserve transactions occur, so the official reserve transactions account is zero by definition. If there are no reserve movements, then the current account and capital account must total zero. If there is a shock in the payments system, the adjustment is made through exchange rates, i.e., a change in the foreign price of a domestic currency. If clean floats were in operation, then payments

US BP accounts

accounts would include only current and capital accounts. However, the US and many industrial countries maintain dirty or managed floats. Since 1977 in the US, BP accounts have been published in a different format which reflects the nonintervention policy of the Federal Reserve Bank. (No reserve transactions) Exports of goods, services, and income Merchandise export service export income receipts on US assets abroad Current Account Imports of goods, services, and income merchandise import service import income payments on foreign assets in US Unilateral transfers US Assets Abroad US official reserve asset (gold, SDR, reserve position in the IMF) US government assets US private assets Foreign Assets in the US Foreign official assets in the US other foreign assets Statistical discrepancy No reserve account transactions

Capital Account

Introduction - Balance of Payments (BOP) Theory

BOP is yet another important theory of exchange rate determination. It is also known as General Equilibrium Theory. According to this theory, when there is free market situation, the exchange rates are determined by the market forces i.e. demand for and supply of the foreign exchange. This theory is based on simple market mechanism in which the price of any commodity is determined. Under this theory the external values cf domestic currency depends on the demand for and the supply of the currency. The Nation's overall Balance of Payments (BOP) can either be in surplus or in deficits. When the nation's BOP is in deficits, the exchange rate depreciates, and when BOP is in surplus, there will be healthy foreign exchange reserves, leading to the appreciation of the home currency. Under deficits in the BOP, residents of a country in question demands foreign currency, excessively leading to excess demand for foreign currency in terms of home currency. However, under surplus BOP situation there is an excess demand for home currency from foreigners than the actual supply of home currency. Due to this price of home currency in terms of concerned foreign currency rises, i.e. exchange rate improves or appreciates. Thus according to this theory the exchange rate is basically determined by the demand for and the supply of foreign currency in concerned nations. The BOP theory of exchange rate determination is more satisfaction is more satisfactory than the PPP theory of exchange rate determination. It is because BOP theory recognizes the significance of all items in the BOP rather than few items selected under the PPP theory. The BOP theory is like the general equilibrium theory, under which market farces determines the value of the commodity. According to this theory the BOP disequilibrium can be corrected by adjusting the exchange rate in either direction i.e. devaluation or revaluation. However, this theory has a drawback like it ignores the impact of exchange rate on the BOP.