Balance of Payments and Exchange Rate: 25-1 © 2010 Aristo Educational Press LTD

Chapter 25
Balance of Payments and Exchange Rate
2010 Aristo Educational Press Ltd.
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Chapter 25
Describe the major components of a balance of payments account. Explain why the balance of payments account must be balanced. Explain the role of exchange rate in international transactions. State the meaning of exchange rate.
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Explain the meaning of appreciation and depreciation, revaluation and devaluation. Describe the effects of a change in the exchange rate on import and export prices. Describe the relationship between the linked exchange rate system and the note-issuing mechanism in Hong Kong.
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Content
25.1 Brief Introduction to the Balance of Payments Account 25.2 Exchange Rate
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25.1 Brief Introduction to the Balance of Payments Account
The balance of payments (BOP) account is a statistical statement that systematically summarises, for a specific time period, the economic transactions of an economy with the rest of the world.
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The BOP account records the transactions between local residents and foreign residents over a specified period. Each transaction is recorded in accordance with the principles of the double-entry bookkeeping system. The amount involved is entered on each of the two sides (i.e. debit and credit) of the balance of payments account.
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All payments and liabilities to nonresidents are recorded on the debit side. All payments and obligations received from non-residents are recorded on the credit side. In Hong Kong, economic transactions with the Mainland are treated as external transactions.
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The sum of all credit entries is equal to the sum of all debit entries in a complete balance of payments account. The balance of payments account must always be balanced. The balance of payments account consists of the current account and the capital and financial account.
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25.1.1 The Current Account
The current account mainly measures the flow of real resources, including export and import of goods and services, income receivable and payable abroad, and current transfers to and from abroad.
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These external transactions are recorded in four different components: goods, services, income and current transfers. Transactions that involve a receipt (inflow) from other countries are recorded as credit (+) entries; transactions that involve a payment (outflow) are recorded as debit () entries.
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1. Goods
It is also known as visible trade or merchandise trade. It records the values of imports and exports of physical commodities.
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We receive foreign exchange when we export goods. The value of exports received is recorded on the credit (+) side of the account. E.g. the value of a watch we export to the United States is recorded on the credit (+) side.
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The value of imports paid is recorded on the debit () side as we pay foreign exchange for the imports. E.g. the value of a digital camera imported from Japan is recorded on the debit () side.
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The following table shows Hong Kongs visible trade in 2007. Hong Kongs visible trade deficit was HK$153,672 million in 2007.
Debit () (HK$ million) Total exports of goods Total imports of goods Balance of trade 2,852,522
Credit (+) (HK$ million) 2,698,850
Balance (HK$ million)
-153,672
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Balance of visible trade is the difference between the value of total exports of goods and the total imports of goods.
Value of total exports < Value of total imports The balance of trade is negative (i.e. a visible trade deficit). Value of total exports > Value of total imports The balance of trade is positive (i.e. a visible trade surplus).
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Balance of visible trade = Value of total exports Value of total imports = (Value of domestic exports + Value of re-exports) Value of total imports
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Total exports = Domestic exports + Reexports
Domestic exports refer to the exported goods that are produced in the country. Re-exports refer to the goods that are imported to a country and then exported to other countries.
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2. Services
It is also known as invisible trade. It records the value of imports and exports of services. Exports of services include services provided by local residents to nonresidents. The value is recorded on the credit (+) side of the account.
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Imports of services include services provided by non-residents to local residents. The value is recorded on the debit () side. Examples of imports and exports of services: insurance, travel and transportation
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Balance of invisible trade is the difference between the value of total exports and imports of services.
Value of exports of services > Value of imports of services Invisible trade surplus Value of exports of services < Value of imports of services Invisible trade deficit
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Balance of invisible trade = Value of exports of services Value of imports of services The following table shows Hong Kongs invisible trade in 2007.
Debit () (HK$ million)
Credit (+) (HK$ million)
Balance (HK$ million)
Total exports of services

Total imports of services Balance of invisible trade
660,728
332,240 328,488
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Economics Tools 25.1
VISIBLE AND INVISIBLE TRADE ACCOUNT
Suppose you are given the following information.

($ billion) Domestic exports of goods 200
Re-exports of goods
Imports of goods Exports of services Imports of services
500
400 600 300
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Balance of visible trade = Domestic exports of goods + Re-exports of goods Imports of goods = $(200 + 500 $400) billion = $300 billion A visible trade surplus of $300 billion
Re-exports of goods
500
400 600 300
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Balance of invisible trade = Exports of services Imports of services = $(600 300) billion = $300 billion A invisible trade surplus of $300 billion
Re-exports of goods
500
400 600 300
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3. Income
It is also known as the external factor income flow. It records the income receivable and income payable.
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Income receivable consists of income earned by local residents from abroad for providing factors of production. E.g. dividends earned by a Hong Kong resident from holding shares of an overseas company are regarded as income receivable from abroad recorded on the credit (+) side of the account
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Income payable is the income paid abroad by local residents for the factors of production provided by non-residents. E.g. the wage paid by a Hong Kong company to a French employee for 3 months work is regarded as income payable abroad recorded on the debit () side of the account
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The difference between the value of income receivable and income payable abroad is known as the net factor income from abroad. Net factor income from abroad = Income receivable abroad Income payable abroad
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4. Current transfers
Current transfers are transactions of real and financial resources between local residents and non-residents. These transactions are unilateral in nature.
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The resources are likely to be consumed immediately or shortly after they are received. The provider does not receive anything of equivalent economic value in return. E.g. the remittance sent by foreign workers to their home countries
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The difference between the current transfers from abroad and the current transfers paid abroad is known as net current transfers. Net current transfers = Current transfers from abroad Current transfers paid abroad
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CURRENT ACCOUNT BALANCE

Net factor income from abroad = Income receivable Income payable = $(350 400) billion = -$50 billion Income outflow
($ billion)
Domestic exports of goods Re-exports of goods Imports of goods Exports of services Imports of services Income receivable Income payable Current transfers received from aboard 200 500 400 600 300 350 400 100
Current transfers paid aboard
110
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Net current transfers = Current transfers from abroad Current transfers paid abroad = $(100 110) billion = -$10 billion
($ billion)

110
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Current account balance = Balance of visible trade + Balance of invisible trade + Net factor income from abroad + Net current transfer = $300 billion + $300 billion + (-$50 billion) + (-$10 billion) = $540 billion A surplus of $540 billion in the current account
($ billion)
110
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25.1.2 The Capital and Financial Account
The capital and financial account records international transactions that involve assets. It consists of a capital account and a financial account.
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1. Capital account
It records external transactions in capital transfers and external transactions in assets. Land, patents, copyrights and franchises are recorded in the capital account.
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2. Financial account
It records transactions of financial assets and liabilities between local residents and non-residents. It records most transactions involving the flow of assets into or out of a country and changes in official reserves.
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CAPITAL ACCOUNT
Suppose you are given the following information.

($ billion)
Capital transfers received from non-residents Capital transfers paid to non-residents Disposal of non-produced, non-financial assets to non-residents Acquisition of non-produced, non-financial assets from nonresidents
450 400 250 100

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Capital account balance = $(450 400 + 250 100) billion = $200 billion
($ billion) 450 400 250 100
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Capital transfers received from non-residents Capital transfers paid to non-residents Disposal of non-produced, non-financial assets to non-residents Acquisition of non-produced, non-financial assets from nonresidents
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25.1.3 Meaning of Balance of Payments Surplus (Deficit)
A balance of payments surplus: Total receipts > Total payments in international transactions reserve assets
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A balance of payments deficit: Total receipts < Total payments in international transactions reserve assets
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CALCULATION OF BALANCE OF PAYMENTS
Suppose you are given the information in the next slide.
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Economic Tools 25.4

Credit ($ billion) Domestic exports of goods Re-exports of goods 200 500 Debit ($ billion)
Imports of goods
Exports of services Imports of services Income receivable Income payable Current transfers received from non-residents Current transfers paid to non-residents Capital transfers received from non-residents Capital transfers paid to non-residents Disposal of non-produced, non-financial assets to non-residents 250 450 100 350 600
400
300
400
110
400
Acquisition of non-produced, non-financial assets from non-residents

All inward investment All outward investment Total
100 750 1,250 3,200 2,960

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Steps to calculate the balance of payments:
1. Add all the amounts on the credit side (excluding changes in reserve assets) = $3,200 billion 2. Add all the amounts on the debit side (excluding changes in reserve assets) = $2,960 billion 3. Balance of payments = $240 billion The amount of reserve assets will increase by $240 billion.
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The increase in reserve assets will be recorded on the debit side. In this way, the balance of payments account is balanced.
Credit ($ billion) Increase in reserve assets Total 3,200 Debit ($ billion) 240 3,200
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Note that balance of payments is different from balance of payments account.

Balance of payments can be in balance, surplus or deficit. Balance of payments account is always balanced in principle.
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25.2 Exchange Rate
25.2.1 Meaning of Exchange Rate
Foreign exchange is the currency of another country. The foreign exchange market is the market in which one currency is exchanged for another. An exchange rate is the price of one unit of a currency in terms of another currency.
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25.2 Exchange Rate
The table below shows some examples of exchange rates (on 28/11/2007).
HKD (HK dollar) USD (US dollar) GBP (British pound) JPY (Japanese Yen) EUR (Euro)
HKD 1 =
USD 1 = GBP 1 = JPY 1 =
1
7.787 16.046 0.07118
0.1284
1 2.061 0.00914
0.0623
0.4853 1 0.00444
14.0497
109.405 225.443 1
0.0871
0.6786 1.398 0.0062
EUR 1 =
11.475
1.474
0.715
161.219
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25.2 Exchange Rate
There are two main types of exchange rate systems, namely the floating exchange rate system and the fixed exchange rate system.
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25.2 Exchange Rate
1. Floating exchange rate system
It refers to the system where the exchange rate of a currency is determined by the demand and supply of that currency in the foreign exchange market. Under this system, a rise (fall) in the value of one currency in terms of another currency is called currency appreciation (depreciation).
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25.2 Exchange Rate
2. Fixed exchange rate (pegged exchange rate) system
It refers to the system where government or central bank of a country fixes the exchange rate of its currency against other currencies or the price of gold. When a government increases (decreases) the value of her domestic currency against another currency, this is known as currency revaluation (devaluation).
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25.2 Exchange Rate
Suppose the exchange rate of the Japanese Yen against the Hong Kong dollar changes from 100:HK$6.5 to 100:HK$6.7. The Japanese Yen has appreciated against the Hong Kong dollar as the same 100 can be exchanged for more Hong Kong dollars.
1st January 20X7 1st February 20X7 100 : HK$6.5 100 : HK$6.7
1st March 20X7

100 : HK$6.6
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25.2 Exchange Rate

The appreciation of the Japanese Yen against the Hong Kong dollar is the same as the depreciation of the Hong Kong dollar against the Japanese Yen. The Hong Kong dollar has depreciated against the Japanese Yen as the same amount of Hong Kong dollars are exchanged for less Japanese Yen.
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25.2 Exchange Rate

Suppose the exchange rate of the Japanese Yen against the Hong Kong dollar falls from 100:HK$6.7 to 100:HK$6.6. The Japanese Yen has depreciated against the Hong Kong dollar as the same 100 can be exchanged for less Hong Kong dollars.
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25.2 Exchange Rate

After calculation, we know that 100:HK$6.5 is the same as HK$1:15.38. When the price of 100 rises from HK$6.5 to HK$6.7, the price of HK$1 falls from 15.38 to 14.93.
100 : HK$6.5 = 100/6.5 : HK$6.5/6.5 = 15.38 : HK$1 100 : HK$6.7 = 100/6.7 : HK$6.7/6.7 = 14.93 : HK$1
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1st January 20X7 1st February 20X7

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25.2 Exchange Rate
25.2.2 Effects of a Change in the Exchange Rate on Import Price and Export Price
1. Import price
Suppose Jenny is a Hong Kong resident and she is going to buy a digital camera in Japan for 50,000.
Exchange rate 100 : HK$6.5 100 : HK$6.7 100 : HK$6.6 Price in JPY : Price in HKD 50,000 : HK$3,250 50,000 : HK$3,350 50,000 : HK$3,300
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Date 1st January Year 1 1st February Year 1 1st March Year 1
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25.2 Exchange Rate

We assume that the price of the camera in Yen remains 50,000 over the period. From the table, Jenny has to pay HK$100 more in February than in January because of the appreciation of Yen. If Jenny buys it in March, she can pay HK$50 less than the price in February.
Exchange rate 100 : HK$6.5 100 : HK$6.7 100 : HK$6.6 Price in JPY : Price in HKD 50,000 : HK$3,250 50,000 : HK$3,350 50,000 : HK$3,300
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Date 1st January Year 1 1st February Year 1 1st March Year 1
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25.2 Exchange Rate
We can see that,
an appreciation of foreign currency (or a depreciation of domestic currency) will lead to a rise in the import price in terms of domestic currency. an appreciation of domestic currency (or a depreciation of foreign currency) will lead to a fall in the import price in terms of domestic currency.
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25.2 Exchange Rate
2. Export price
Suppose Ayumi is a Japanese tourist on holiday in Hong Kong and she is going to buy a dress in Hong Kong for HK$500. If Ayumi buys the dress in January, she needs to pay 7692.31 for it.
Exchange rate 100 : HK$6.5 Price in JPY : Price in HKD 7,692.31 : HK$500
Date 1st January Year 1
1st February Year 1

1st March Year 1
100 : HK$6.7
100 : HK$6.6
7,462.69 : HK$500
7,575.76 : HK$500
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25.2 Exchange Rate
If Ayumi buys it in February, she only needs to pay 7,462.69 (229.62 less), due to the appreciation of the Japanese Yen. If she buys it in March, it will cost her 7,575.76 (113.07 more than the February price), due to the depreciation of the Japanese Yen.
Exchange rate 100 : HK$6.5 Price in JPY : Price in HKD 7,692.31 : HK$500
Date 1st January Year 1
1st February Year 1

1st March Year 1
100 : HK$6.7
100 : HK$6.6
7,462.69 : HK$500
7,575.76 : HK$500
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25.2 Exchange Rate
We can see that,

an appreciation of foreign currency (or a depreciation of domestic currency) will lead to a fall in the export price in terms of foreign currency. an appreciation of domestic currency (or a depreciation of foreign currency) will lead to a rise in the export price in terms of foreign currency.
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EFFECTS OF A CHANGE IN THE EXCHANGE RATE ON EXPORT REVENUE AND IMPORT EXPENDITURE
1. Effects on export price, volume and revenue
Suppose the price of a Hong Kong watch exported to Europe is fixed at HK$880. The initial exchange rate of the euro against the Hong Kong dollar is 1:HK$10. Export price of a watch = 88
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The Hong Kong dollar then depreciates and the exchange rate becomes 1:HK$11. The export price of a watch drops to 80.
Unit price ()
88 80
Q1
Q2
Quantity (units)
Market for Hong Kong watches
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By the law of demand, the quantity demanded of Hong Kong watches in Europe increases from Q1 to Q2. Export volume
Unit price ()
88 80
Q1
Q2
Quantity (units)
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The change in export revenue depends on the price elasticity of demand for the watches.
Unit price ()
88 80
Q1
Q2
Quantity (units)
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2. Effects on import price, volume and expenditure
Suppose the price of a litre of New Zealand milk imported to Hong Kong is fixed at 1.5 New Zealand dollars (NZ$1.5). The initial exchange rate of the New Zealand dollar against the Hong Kong dollar is NZ$1:HK$6. Import price of a litre of milk = HK$9
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The Hong Kong dollar then depreciates and the exchange rate of the New Zealand dollar against the Hong Kong dollar becomes NZ$1:HK$7. Import price of a litre of milk rises to HK$10.5.
Unit price (HK$)
10.5 9
D 0 Q2 Q1 Quantity (units)
Market for New Zealand milk
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The quantity demanded of New Zealand milk decreases from Q1 to Q2. Import volume Import expenditure in terms of New Zealand dollars
Unit price (HK$)
10.5 9
D 0 Q2 Q1 Quantity (units)
Market for New Zealand milk
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25.2 Exchange Rate
25.2.3 Brief Introduction to the Linked Exchange Rate System in Hong Kong
Hong Kong adopted the linked exchange rate system on 17th October, 1983. The exchange rate of the Hong Kong dollar against the US dollar is therefore relatively stable. Hong Kongs linked exchange rate system is a Currency Board System.
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25.2 Exchange Rate

The HKMA authorised note-issuing banks to issue banknotes. These banks can only issue Hong Kong dollars if it has an equivalent amount of US dollars to buy the Certificate of Indebtedness (CI) from the Exchange Fund. The HKMA guarantees to exchange US dollars (Hong Kong dollars) for Hong Kong dollars (US dollars) at HK$7.80 per US dollar, which ensures that Hong Kongs entire monetary base is backed by US dollars.
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25.2 Exchange Rate
Under the linked exchange rate system, the exchange rate of the Hong Kong dollar against other currencies is still determined by demand and supply in the foreign exchange market. Nevertheless, when the US dollar depreciates against other currencies, the Hong Kong dollar also depreciates against other currencies. The fluctuations of the exchange rates of the US dollar and the Hong Kong dollar are in phase.
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25.2 Exchange Rate

Period 1863 1935 December 1935 June 1972 Exchange rate system Silver Standard Pegged to Sterling Reference rate Silver dollars as legal tender 1 = HK$16 (December 1935 November 1967) 1 = HK$14.55 (November 1967 June 1972)
July 1972 November 1974
Pegged to the US dollar at a fixed rate
US$1 = HK$5.65 (July 1972 February 1973) US$1 = HK$5.085 (February 1973 November 1974)
November 1974 October 1983
Free floating
Exchange rates on selected dates: US$1 = HK$4.965 (25th November, 1974) US$1 = HK$9.6 (24th September, 1983) US$1 = HK$7.80
Since 17th October, 1983
Linked exchange rate system
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End of Chapter 25
Answers for revision exercise
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Balance of Payments and Exchange Rate: 25-1 © 2010 Aristo Educational Press LTD

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Chapter 25

Balance of Payments and Exchange Rate

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

25.1.1 The Current Account

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

Credit (+) (HK$ million) 2,698,850

Balance (HK$ million)

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

Total exports = Domestic exports + Reexports

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

2010 Aristo Educational Press Ltd. 25-19

Balance of Payments and Exchange Rate

25.1 Brief Introduction to the Balance of Payments Account

2010 Aristo Educational Press Ltd.

Balance of Payments and Exchange Rate