International Capital Flows

Transcription

1 International Capital Flows Capital ows across countries are typically classi ed in terms of maturity (short-term versus long-term) and whether the investment represent some form of control over the target investment (portfolio versus direct). Short-term Capital Flows: Short-term debt instruments (e.g., U.S. Treasury bill) have o ered relatively high real rates of return at low levels of risk for investor worldwide. Short-term capital tends to follow interest rates. Long-term Capital Flows: Long-term capital is typically attracted to economic and business environments expected to provide signi cant long-run stability and economic growth, and plays a signi cant role in the Balance of Payments (BoP) structure of many nations 1

2 Portfolio Investment: A portfolio investment is a transaction in which securities are held purely as a nancial investment. Portfolio investment is made by investors are not particularly interested in involvement in the management of a company. Direct Investment: Foreign Direct Investment (FDI) is a transaction in which the investor has a controlling share or participates in the management of the rm. FDI implies a controlling stake in a business, and often connotes ownership of physical assets such as a equipment, buildings and real estate, FDI is more di cult to pull out or sell o compared to the portfolio investment. 2

3 Balance of Payment (BOP) Account The balance of payments account summarizes a country s transactions with the rest of the world Two types of transactions. 1. Transactions that involves goods and services! current account 2. Transactions that involves assets! capital (or nancial) account Receipt from foreigners: credit (+) Payment to foreigners: debit (-) 3

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5 The Current Account Trade Balance: Export-Imports Investment Income: The ow of earnings from the di erent forms of direct and portfolio investments made in prior periods For instance when a U.S. corporation builds a plant in Canada, the productive services the plant generates are viewed as a service export from the United States to Canada Note: Investments are recorded in the capital account but income ows from investments are recorded in the current account. This also includes the money sent by individuals working abroad, known as remittances, to their families back home Net transfers received: Foreign aids given and received 5

6 The Capital (Financial) Account An asset is any one of the forms in which wealth can be held, such as money, stocks, factories, or government securities The nancial account measures the di erence between sales of assets to foreigners and purchases of assets located abroad Example 1: When America exports blue jeans to the Turkey, the transaction enters the U.S. balance of payments accounts as a credit on the current account, but as a debit to nancial accounts. It is debit since Turkey sell their asset (money) to the United States If the US (may be its central bank) agrees on keeping Turkish currency it means the US covering Turkey s current account de cit 6

7 Otherwise Turkey will need capital in ows to cover current account de cit arise from importing the blue jeans (it can obtain this capital in ow by foreign investment, by using the international reserves of the central bank, or by selling government securities at the expense of o ering higher interest) Hence, a country with a CA de cit increases its foreign debts In fact, even if the US agrees on keeping Turkish currency, they can use it any time to buy goods and services from Turkey. Hence, this money can be seen as part of foreign debt as well Example 2: A U.S. citizen buys a $95 share of stock of British Petroleum (BP). BP deposits the $95 in its own U.S. bank account This time the U.S. trades an asset for a more liquid assets. It enters the U.S. nancial account both with a negative and positive signs 7

8 The nancial account, also known as net capital ow, is positive if foreign holdings of U.S. assets are greater than U.S. holdings of foreign assets, in which case there is a nancial account surplus Putting in another way, a surplus in the nancial account means money is owing into the country The Fundamental Balance of Payments Identity: Every international transaction automatically enters the balance of payments twice, once as a credit and once as a debit, resulting in a fundamental identity: Current account + nancial account(+statistical discrepancy)=0 If the change in o cial (central bank) reserves is not included in the nancial account, then the same equation can also be written as Current account + nancial account+ change in o cial reserves=0 8

9 O cial international reserves are the foreign assets held by central banks. A country with a negative balance of payments may signal that it is running down its international reserve assets or incurring debts to foreign monetary authorities. 9

10 Table shows that the U.S. o cial reserve assets that is, international reserves held by the Federal Reserve rose by $52.3 billion. Foreign central banks purchased $450.0 billion to add to their reserves, indicating central bank nancial ows You can think of this net central bank nancial ow as measuring the degree to which monetary authorities in the United States and abroad joined with other lenders to cover the U.S. current account de cit The level of net central bank nancial ows is called the o cial settlements balance or (in less formal usage) the balance of payments. This balance is the sum of the current account and nancial account balances, less the nonreserve portion of the nancial account balance, and it indicates the payments gap that o cial reserve transactions need to cover 10

11 Ödemeler Dengesi, Türkiye Örne¼gi 11

12 Tabloya göre Ocak-May s 2010 döneminde cari aç ¼g m z 16.8 milyar dolar, nans ve sermaye hesab fazlam z 23.2 milyar dolar Aradaki fark 7.4 milyar dolar. Ama 0.8 lik bir net hata ve noksan oldu¼gu için Genel Denge (Balance of Payments) 7.2 milyar dolar. Yani merkez bankas rezevleri bu miktarda artm ş Bu terimin Rezer Varl klar nda (-) olmas n n sebebi biz Amerika n n paras n tutarak Amerika n n bize paras n satm ş oluyor. Onlar n d ş ticaret aç ¼g n nanse ediyoruz 12

13 Daha Detayl Bir örnek 13

14 In principle If a country has a oating exchange rate its central bank does not intervene the exchange rate market. Then the change in o cial reserves (balance of payments) is zero 0 But since countries usually follow a managed exchange rate regime, they interfere with the market Market intervention is highest with a xed exchange rate regime 14

15 A question? Suppose change in o cial reserves is zero, and government does not sell debt to foreigners. How do we know that the balance of payments identity comes into an equilibrium with a oating exchange rate regime? The answer is that a BoP de cit increases the demand for foreign currency and appreciates it, which stimulates exports and lowers imports (i.e. decrease the demand for the foreign currency and improves the CA) 15

16 THE COMPLETE OPEN ECONOMY IS-LM MODEL IS Curve: Y = C + I(r ) + G + NX(e) Suppose that the investment depends on the nominal interest rate instead of the real rate. (Use the sher equation: i = r + e and that prices are xed in the short run) 16

17 A depreciation of the real exchange rate will raise exports. This will cause the IS curve to shift outwards. In fact, NX = NX(Y ; Y ; ), and higher income in foreign countries will increase their demand from us and will also shift the IS curve out 17

18 LM Curve As in the closed economy case, in open economies central banks can and do change the money supply by open market operation (buy or sell government bonds on the open market) or by changing the interest rates In the open economies, central bank also change the money supply also by exchanging domestic and foreign currency 18

19 In the following gure the central bank takes in foreign currency and hands out domestic currency in exchange for it the money supply increases 19

20 The Balance of Payments (BP) Curve In the open economy equilibrium not only will goods and money markets balances have to hold but the Balance of Payments Accounts must balance as well. For a oating exchange rate regime, the central banks do not intervene the market and the change in o cial reserves is zero. Hence, the fundamental BoP identity reduces to The nancial account is 0 = CA(Y ; Y ; ) + F A(i; i ; ee e ) e positively related to domestic interest rates (i) (because higher domestic interest rates will result in a capital in ow) negatively related to foreign interest rates 20

21 and negatively related to the expected depreciation of the domestic currency (since this will increase the return from investing abroad) We would expect the BP curve to have a positive slope - higher Y will lead to higher demand for imports and a CA de cit, which in turn requires a higher i to generate a counterbalancing FA surplus 21

22 But according to Uncovered Interest Rate Parity condition i = i + ee e there is only one domestic interest rate possible the given the world interest rate Hence, if BP curve is upward sloping this means UIRP does not hold, which further means there are restrictions on the ows of money in and out of an economy (limited mobility of capital.) What if there is perfect capital mobility? UIRP condition holds? Then UIRP condition must hold and we obtain horizontal BP curve e 22

23 Balance of Payments curve with perfect capital mobility If domestic interest rate rises there would be capital in ow into the country, the exchange rate appreciates (the expected depreciation increases), the BP curve moves up Notice that the notation is di erent now. exchange rate means a decline in e The appreciation of the 23

24 The Equilibrium We can consider an open economy as a closed economy where UIRP condition holds 24

25 A-) A Small Open Economy Under Floating Exchange Rates Fiscal Policy: Increase in Government Purchases This will shift out the IS curve and result in an increase in the domestic interest rate 25

26 This increase in interest rates will result in a BOP surplus since i > i + (e E e)=e; and bring about an in ow of money into the country, which will lead to an immediate appreciation of the domestic currency The nominal appreciation leads to a real exchange rate appreciation. This will reduce NX and shift the IS curve back lowering interest rates. An appreciation of the currency today, e #, will increase the expected depreciation of the domestic currency (e E e)=e ". This will move the BP curve up and raise the domestic interest rates Due to the raise in the interest rates we will move along the LM curve and the equilibrium will not come back to its initial point (Y 0 ) but to Y 2 26

27 To sum up, increase in government purchases increases the demand in an open economy, which rises the interest rates. But the standard e ect of expansionary in a closed economy (a raise in interest rate and 27

28 an increase in output) will be o set by an increase in the exchange rate appreciation, but not fully Also previously we have seen that increase in government purchases increases decreases the amount of net exports, which deteriorates the current account Now we also observe that the increase in the interest rates improves the nancial account. The Fundamental Balance of Payments Identity is still at work The dynamics seen above are the similar those of a large open economy 28

29 Monetary Policy: Increase in the Money Supply This will shift out the LM curve and result in a decrease of the domestic interest rate. 29

30 This decrease in interest rates (or directly lowering the interest rates in an in ation targeting regime) will result in a BOP de cit since i < i + (e E e)=e, and bring about an out ow of money from the country, which will lead to an immediate depreciation of the domestic currency The nominal depreciation leads to a real exchange rate depreciation. This will increase NX and shift the IS curve out raising interest rates from i 1 The decline in the interest rates moves down the BP curve. This is consistent with the currency market since a depreciation of the currency today, e ", will lower the expected depreciation of the domestic currency (e E e)=e # 30

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32 Previously we have seen that increase in money supply reduces the real exchange rate and increases the amount of net exports, which improves the current account Now we also observe that the reduction in the interest rates deteriorates the nancial account. The Fundamental Balance of Payments Identity is still at work 32

33 B-) A Small Open Economy Under Fixed Exchange Rates With the oating exchange rate system, the changes in the changes in the exchange and interest rates had to satisfy the UIRP condition i = i + ee e With the xed exchange rate system it must be that e E = e, which requires i = i. Therefore, the results regarding the e ects of scal and monetary policies that are outlined in our previous lecture notes (in the Mankiw s Book) continue to hold For a xed exchange rate regime, the fundamental BoP identity is 0 = CA(Y ; Y ; ) + F A(i; i ; ee e ) + (Official Reserves) e e 33

34 Fiscal Policy: Increase in Government Purchases Suppose that the government stimulates domestic spending by increasing government purchases or by cutting taxes 34

35 When the domestic interest rate increases above the foreign interest rate UIRP is violated since i 1 > i. Domestic returns are higher so there is an in ow of money into the country. In the xed exchange rate regime the central bank intervenes the market and hands out domestic currency in exchange for foreign currency, which increases the domestic money supply and shifts the LM curve out Thus, under a xed exchange rate, a scal expansion raises aggregate income but leaves interest rates and exchange rates una ected Net exports (and the current account) are una ected. But the rise in the interest rate brings capital in ow to the country ( nancial account improves), which increases the foreign reserves of the central bank. The Fundamental Balance of Payments Identity is still at work 35

36 Monetary Policy: Increase in the Money Supply 36

37 If CBs tries to increase the money supply, it puts downward pressure on the exchange rate and on the domestic interest rate When the domestic interest rate decreases below the foreign interest rate UIRP is violated since i 1 < i there is an out ow of money from the country (increase in demand for foreign currency); the central bank hands out foreign currency reserves in exchange for domestic currency. This reduces the domestic money supply and shifts the LM curve back. The results for the xed exchange rate regime are better understood when we discuss about impossible trinity In addition, the decline in the interest rates brings capital out ow from the country and decreases the foreign reserves of the central bank. The Fundamental Balance of Payments Identity is still at work 37

38 THE IMPOSSIBLE TRINITY When Mundell 1st presented the open economy IS-LM model back in the 1960 s most of the world operated with restrictions of capital movement Relaxing the assumption of perfect capital mobility changes the conclusions we have reached thus far regarding the e ectiveness of xed and exible exchange rates. Imperfect capital mobility: As you would remember we would expect the BP curve to have a positive slope - higher Y will lead to higher demand for imports and a CA de cit, which in turn requires a higher i to generate a counterbalancing FA surplus 38

39 The upward sloping BP curve shifts up/down for the same reasons that the horizontal BP curve did Mundell used his model to formulate an important theorem known as the "Impossible Trinity" 39

40 The Impossible Trinity is a set of three desirable objectives that a country may want to attain yet is unable to. The three objectives are described by the diagram below 40

41 Due to the UIRP condition (which needs to be satis ed when there is perfect capital mobility) i = i + ee e e A country can only achieve two of these objectives With perfect capital mobility and a stable exchange rate, a country has to give up monetary policy autonomy A country that wants to have perfect capital mobility and monetary policy autonomy has to let its exchange rate oat. A country that wants to have a stable exchange rate and conduct an independent monetary policy will have to restrict the mobility of capital. 41

42 Some examples 42

43 U.S with a strong monetary policy maker and a general belief in the freedom of money to move around the world have chosen to sacri ce a stable exchange rate and allow the dollar to oat Countries like Argentina (in the 1990s) and Hong Kong which share the general trend towards relaxing the mobility of capital but, which have had unfortunate experiences with irresponsible monetary policy making, at some point chose to give up monetary policy autonomy and adapt a stable exchange rate system and perfect capital mobility Finally countries like China and Malaysia have chosen to have a xed exchange rate and have monetary policy autonomy. However, they have only been able to do so by imposing restrictions on the movement of money to and from the country. 43

44 We can also understand the impossible trinity by taking a closer look at the UIRP equation i = i + ee e e The UIRP was derived under the assumption of perfect capital mobility. The freedom to set i (monetary autonomy) means that (e E e)=e 6= 0 (i.e. you have to give up stable exchange rates) Similarly, suppose we decide to have a xed exchange rate, i.e. set (e E e)=e = 0 Then it follows from UIRP that i = i (if we have perfect capital mobility, we have no autonomous monetary policy) Suppose we set i to whatever value we want. Then we give up on perfect capital mobility (no = sign in the UIRP equation) 44

45 Some Other Topics for the Mundell Fleming Model (1) The Role of Expectations for the Exchange Rate Using the uncovered interest rate parity condition i t = i t + Ee tl=;t+1 E tl=;t E tl=;t Suppose the future exchange rate is expected to depreciate (E e tl=;t+1 "). But central bank does not change the interest rates Then the investors do not prefer local currency for their investments. The demand for foreign currency increases and the domestic currency depreciates today The result: Expectations of the exchange rate are partially self-ful lling (i.e. if people believe so, it occurs so) 45

46 (2) Interest Rate Di erentials We have assumed that the interest rate in our small open economy is determined by the world interest rate But in some less developed countries, it is plausible to fear that a revolution or other political upheaval might lead to a default on loan repayments, called the country risk. Borrowers in such countries often have to pay higher interest rates (r + ) to compensate lenders for this risk Y = C(Y T ) + I(r + ) + G + NX(e) (IS) M=P = L(r + ; Y ) (LM) Now suppose that risk premium rises 46

47 Then rst, the IS curve shifts to the left, because the higher interest rate reduces investment. Second, the LM curve shifts to the right, because the higher interest rate reduces the demand for money, and this allows a higher level of income for any given money supply 47

48 These two shifts cause income to rise and the currency to depreciate So just as expected depreciation (a kind of country risk) depreciates the currency today, so does the increase in risk premium 48

49 This is intuitive as an increase in country risk or an expected depreciation makes holding the country s currency less attractive. Be careful that due to the uncovered interest rate parity condition, when interest rate at home rises (or when money supply falls), we would expect the LM curve shift to the right and the currency to appreciate. But in the analysis it depreciates. This is because central bank does not play with the money supply to change the interest rates. In some way, the increase in the interest rate due to the risk premium works as if the real interest rate that the country o ers declines 49

50 Why increase in risk premium may not rise income in practice? The residents of the country might respond to the same event by increasing their demand for money because money is often the safest asset available. This tend to shift the LM curve toward the left, which mitigates the fall in the exchange rate but also tends to depress income The depreciation might boost the price of imports enough to increase the price level (which would reduce the real money supply) 50

51 (3) Should Exchange Rates Be Floating or Fixed? Pros and Cons of Di erent Exchange-Rate Systems Fixed rates provide greater certainty for exporters and importers. This also helps the government maintain low in ation, which in the long run should keep interest rates down and stimulate increased trade and investment. A system of oating exchange rates leaves monetary policy-makers free to pursue other goals, such as stabilizing employment or prices Yet, after the world (many of the industrialized nations) abandoned the Bretton Woods system of xed exchange rate around 1970, the amount of world trade has continued to rise. In fact, there are many other policy rules than committing to a xed 51

52 exchange rate to discipline a nation s monetary authority. During periods of oating exchange rates, countries often use formal or informal targets for the exchange rate when deciding whether to expand or contract the money supply. Hence, we rarely observe exchange rates that are completely xed or completely oating. Instead, under both systems, stability of the exchange rate is usually one among many of the central bank s objective 52

53 Speculative Attacks, Currency Boards, and Dollarization. If you decide to x your currency, you now have to stand ready to buy and sell foreign currency for a domestic currency Problem: You might run out of foreign currency. In this case, the central bank has no choice but to abandon the xed exchange rate and let the domestic currency depreciate This fact raises the possibility of a speculative attack suppose that a rumor spreads that the central bank is going to abandon the exchange-rate peg. People would respond by rushing to the central bank to convert domestic currency into dollars before the domestic currency loses value. This rush would drain the central bank s reserves and could force the central bank to abandon the peg. In this case, the rumor would prove self-ful lling. 53

54 Currency board: the central bank holds enough foreign currency to back each unit of the domestic currency. (No matter how many domestic currency turned up at the central bank to be exchanged, the central bank would never run out of foreign currency.) It is a very strict form of xed exchange rate regime with explicit legislative commitments. Once a central bank has adopted a currency board, it might consider the natural next step: it can abandon the domestic currencny altogether and let its country use the U.S. dollar. Such a plan is called dollarization. It happens on its own in high-in ation economies, where foreign currencies o er a more reliable store of value than the domestic currency The only loss from dollarization. is the small seigniorage revenue,which accrues to the U.S. government. 54

55 (4) From Short Run to Long Run: Changes in the Price Level To examine price adjustment in an open economy, we now distinguish between the nominal (e) and real () exchange rates, where = ep=p Suppose the economy is initially at point K (perhaps because of a previous fall in the money supply) 55

56 At K, the short run equilibrium, demand for goods and services is too low to keep the economy producing at its natural rate Over time, low demand causes the price level to fall (P #) The real exchange rate ( = ep=p ) depreciates, so net exports rise. Eventually, the economy reaches point C, the long- run equilibrium 56

57 A Remark: If there is one essential topic about open economy macroeconomics that we did not cover during this course, it is in ation targeting in an open economy by using an interest rate rule, which is actually current standard practice of many central banks, including ours Although our analysis includes elements from this topic, it is beyond the scope of our course which intends to cover basic macroeconomic theory in a traditional way but for those of you that are interested, I would recommend you one of the very few resources that can teach you in ation rate targeting without heavy use of mathematical technique while addressing an enormous variety of practical questions: See publications of Wendy Carlin and David Soskice. Fatih Ozatay also spares a chapter on this matter in his book 57