International Finance

Transcription

1 Terminology International Finance Chris Edmond NYU Stern Spring 2008 Trade balance balance on merchandise trade ( goods ) balance on goods and services ( net exports ) Current account balance current account = net exports + net foreign income net foreign income includes * capital income * labor income * taxes and transfers current account measures change in net foreign assets 1 3 Today Current account, 2007 International capital flows balance of payments accounting trade in goods and services vs. trade in assets are large deficits sustainable? Exchange rates nominal vs. real purchasing power parity (PPP) covered and uncovered interest parity (CIP and UIP) currency carry trade fixed vs. floating exchange rate regimes Category amount (billions) Net exports of goods 815 Net exports of services 107 Net labor income 74 Net capital income 6 Net taxes and transfers 104 Current account

2 Notation Trade in services Current account measures change in net foreign assets exports of services B t+1 B t = rb t + X t M t where B t = net foreign assets (think bonds ) rb t = net foreign income X t M t = net exports imports of services net 5 7 Trade in goods Income receipts and payments imports of goods exports of goods income receipts income payments net net 6 8

3 Current account Financing the deficit net income net services How is a current account deficit financed? net goods net transfers etc current account by selling assets to foreigners Trade in assets direct investment (controlling interest) portfolio investment * purchases of government securities * purchases of corporate equity or securities * bank and non-bank loans 9 11 Summary Capital and financial account Capital account includes As a, the US runs large goods deficit modest services surplus modest net capital and labor income surplus Implies trade deficit current account deficit net direct investment net portfolio investment net government transactions (gold, international reserves, etc) Current and capital accounts balance current account + capital & financial account = 0 (up to a statistical discrepancy) Suggests an alternative perspective current account deficit domestic investment > savings perhaps deficit domestic investment opportunities are good relative to rest of world 10 12

4 Capital and financial account, 2007 Direct investment flows Category amount (billions) Net direct investment 131 Net securities 118 Net loans 295 Net government 375 foreign direct investment in US Capital and financial account 657 Current account 744 Statistical discrepancy 87 net US direct investment abroad Balance of payments $800 billion goods, services, etc Purchases of securities foreign purchases of US securities Rest of world United States net equity, securities, etc +$800 billion balance of payments = current account + capital & financial account = 0 US purchases of securities abroad 14 16

5 Purchases of government assets Net foreign assets foreign purchases of US government Current/capital account measure international capital flows Add up current/capital accounts over time to get asset position assets = US claims on foreign countries liabilities = foreign claims on US net foreign assets = assets liabilities US purchases of government abroad Balance of payments US claims abroad (assets) capital & financial account surplus direct investment loans corporate equity current account deficit corporate bonds govt 18 20

6 Foreign claims on US (liabilities) Is the US in trouble? direct investment govt Two perspectives corporate equity pessimistic: current account deficit because low savings, debt burden will grow, consumption will have to fall in future optimistic: capital account surplus because US good place to invest, large flow of savings from low-growth countries ( global savings glut ) loans corporate bonds Net foreign assets Is the US in trouble? foreign claims on US (liabilities) Sustainability analysis, same as with fiscal policy Net foreign assets/output ratio follows US claims abroad (assets) net foreign assets b t+1 b t = r g 1+g b t g (x t m t ) where x m is net exports/output ratio Steady state b = 1 (x m) r g 22 24

7 Is the US in trouble? Exchange rates Steady state net foreign assets/gdp ratio b = 1 (x m) r g Example: US net foreign assets/gdp is If r =0.05 and g =0.02, what trade surplus is needed to sustain this indefinitely? Answer x m = (r g)b = ( )0.35 = Nominal vs. real exchange rates Purchasing power parity (PPP) Covered and uncovered interest parity (CIP and UIP) Currency carry trade Fixed vs. floating exchange rate regimes A surplus of more than 1% of GDP. But currently, deficit of 5% of GDP. Something has to give. What? What have we learned so far? Nominal exchange rates Balance of payments accounting current account = net exports + net foreign income current account + capital & financial account = 0 (deficit financed by selling assets) net foreign assets = sum of past current accounts Two perspectives on current account deficit pessimistic: US isn t saving enough, so has to sell assets optimistic: foreign countries are growing too slow, US is a great place to invest Relative price of two currencies Level or change affect most international business transactions profits in euros = how many dollars? ( level ) return on euro bonds = what return on dollar bonds? ( change ) Very volatile, ought to hedge? 26 28

8 Terminology/notation Dollar/euro nominal exchange rate Bilateral spot exchange rate, e US dollars per euro By convention: local currency price of foreign currency Example: if 1.23 dollars buy 1.00 euro, e =1.23 Counterintuitive: e dollar depreciates (takes more dollars to buy one euro) Dollar/yen nominal exchange rate Real exchange rate US dollars per 100 yen Real exchange rate adjusts for price level differences real exchange rate e P P where e = nominal exchange rate, e.g., dollars per yen P = foreign price level, e.g., Japanese CPI in yen P = domestic price level, e.g., US CPI in dollars Real exchange rate measures relative price of a basket of goods domestic basket is expensive if P > ep foreign basket is expensive if P < ep 30 32

9 Basic idea Law of one price goods should sell for same price everywhere once exchange rate taken into account Goods market arbitrage: for traded commodities i =1, 2,..., n p i = ep i if not, buy low sell high Purchasing power parity ( PPP ) PPP hypothesis is P = ep real exchange rate =1 Often people say domestic currency is overvalued P > ep Empirical tests look at weaker implication log(p )= log(e)+ log(p )=0 or log(e) =π π If so, exchange rate depreciates when domestic inflation is greater than foreign inflation Purchasing power parity ( PPP ) PPP evidence PPP hypothesis is year-on-year rate of change P = ep law of one price for whole consumption baskets Implicit assumptions Japanese inflation US inflation all goods and services traded consumers in both countries have same tastes Other issues tariffs, transportation costs monopoly power, price discrimination inflation differential 34 36

10 PPP evidence Summary year-on-year rate of change Countries with low inflation change in US dollars per yen PPP fails badly, especially at short horizons inflation differentials smooth but exchange rates volatile Countries with high inflation PPP works much better depreciation reflects relatively high domestic inflation PPP works better for high inflation countries Exchange rates and interest rates 2/,3/45+6/!## 1# # >4?(+5)'4-0)??/,/45)+(-+4D-&'()*+,EB-0/.,/3)+5)'4!7819!!77#9!!7719! "###9! "##19! - "%###!%### "## $# "#! &'()*+,-./,-0'((+, Country/region 3-month interest rates (%) Argentina Australia 7.81 Brazil China 4.49 Euro area 4.83 India 7.21 Japan 0.75 Russia Turkey United States 1.97 :;3<+46/-=+5/-0/.,/3)+5)'4 :;3<+46/-=+5/-A('6-B3+(/-!-,)6<5C >4?(@-0)??/,/45)+( 38 40

11 Notation Exchange rates and interest rates i = interest rate on domestic currency i = interest rate on foreign currency e = spot nominal exchange rate f = one-period forward nominal exchange rate How are these related? Two concepts covered interest parity (CIP) uncovered interest parity (UIP) 41 Uncovered interest parity (UIP) Suppose we didn t cover ourselves forward Convert back to dollars at spot rate. Risky return in dollars (1 + i t ) e t+1 e t Expectations hypothesis f t = E t {e t+1 } Combine with covered interest parity or (1 + i t ) = (1 + i t ) f t e t = (1 + i t ) E t{e t+1 } e t 1+i t 1+i t { } et+1 = E t e t Zero expected excess return. 43 Buy and hold dollars Covered interest parity (CIP) invest one dollar in dollar asset, gives 1+i dollars Or, sell euros forward one dollar is 1/e euros at spot rate invest 1/e euros in euro asset, gives (1 + i )/e euros sell (1 + i )/e euros forward at f, gives (1 + i )f/e dollars Two riskless transactions. Arbitrage should give or (1 + i) = (1 + i ) f e 1+i 1+i = f ( ) f e i i log e Works well! 42 Uncovered interest parity (UIP) Interest differentials and expected exchange rate changes { } 1+i t et+1 1+i = E t t e t Implies high interest countries have exchange rates that depreciate doesn t work, at least not for developed countries high interest countries have appreciating currencies suggests a big arbitrage opportunity why? 44

12 UIP fails in the data Currency carry trade high interest countries have appreciating currencies Carry trade exploits this. How? borrow in low interest funding currency (JPY) invest in high interest currency (AUD, NZD) profit if exchange rate does not move too much against bigger profit if exchange rate appreciates (as it does, on average) Up by the stairs, down in the elevator premium for crash risk? Reinforcement? Failure of UIP a consequence of carry trade? Exchange rate regimes Flexible ( floating ) exchange rate market conditions determine exchange rate all the exchange rates we ve looked at so far were floating clean versus dirty floats Fixed ( pegged ) exchange rate government sets price how? must be willing to buy/sell lots of foreign currency at set price collapse if run out of reserves also affected by currency controls Costs and benefits? What do you think? what effect does selling yen and buying NZD have on exchange rate? Forecasting exchange rates China s fixed exchange rate Difficult if not impossible US dollars per yuan PPP works only for high inflation countries UIP works hardly at all CIP works, but has no forecasting content difficult to beat a random walk (a 50/50 up/down bet has almost as much predictive power) Would not matter if exchange rates were not volatile. But they are! Better hedge any exchange rate risk 46 48

13 China s fixed exchange rate What problems might this cause? Does a low yuan help Chinese exports? Can a low yuan be sustained? 49 What have we learned today? International capital flows current account + capital & financial account = 0 (deficit financed by selling assets) net foreign assets = sum of past current accounts two perspectives: US not saving enough vs. great place to invest Exchange rates volatile difficult to forecast. Really! 50