Macroeconomics 1. Lecture 3. Balance of payments and exchange rates
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1 Macroeconomics 1 Lecture 3. Balance of payments and exchange rates
2 How to get $1 billion in a day? 1990: THE UK joins European Exchange Rate Mechanism. Deutche Mark (DEM) became reference point for Pound Sterling (GBP). The British pound was quoted at 2.95 DM. ERM required for Pound to be kept in +/- 6% band. This meant that if the pound falls to a level of DM, an intervention of the Bank of England will be necessary.
3 How to get $1 billion in a day? The UK economy was then in a different phase of the business cycle than Germany. In Germany, inflation was rising so the German Central Bank (Deutsche Bundesbank) raised interest rates to 8.75%. The Bank of England was thus forced to raise his rate as well to keep the GBP/DEM exchange rate at the level required by ERM, although the economy was in a phase of a significant slowdown - WHY?
4 First you have to prepare the ground From mid-1992 George Soros' Quantum Fund was borowing British pounds, and then, in September, Soros started to give numerous - as some later claimed "sponsored" - interviews claiming that the pound is overvalued. He was suggesting that we should expect devaluation of pound. Then Quantum began to exchange pounds to other currencies. Pound violently "went south" - as a it is said in stock analysts slang.
5 16 September 1992: Black Wednesday The Bank of England threw its foreign exchange reserves to defend the Pound's exchange rate: it was selling DEM and buying GBP. On September , in the morning, Bank of England raised its interest rate by 2 percentage points (from 10% to 12%). In the afternoon it announced another increase up to 15%, but at 7PM in the evening announced capitulation - Pound was devalued from DEM 2.78 to DEM 2.2 and fell out of the ERM. Soros bought cheaper Pounds to repay loans incurred in Pounds and was left with few billion in other currencies that he had bought using overvalued Pound. In USD he earned over a billion!
6 George Soros born on 12 August 1930 in Budpest American financier of Hungarian-Jewish origin, one of the most famous currency speculators, but also a philanthropist, founder of the Open Society Institute and numerous foundations, including the Stefan Batory Foundation, a student of Karl Popper.
7 FOREX the biggest financial market in the world
8 Agenda for today Balance of payments Definition Accounting principles Structure of the balance of payments Example: Polish balance of payments Exchange rate Exchange rate system Foreign exchange market Balance of payments and exchange rate market
9 Why foreign exchange market? What are the economic links among nations? International trade in goods and services allows nations to raise their standards of living by specializing in areas of comparative advantage in production, exporting goods and services in which they are relatively efficient and importing those in which they are relatively inefficient. In a modern economy, trade takes place using different currencies. The foreign exchange market plays an important role for it is the lubricant that facilitates exchange among nations in commodities, services, and financial assets.
10 Foreign households Foreign firms Macroeconomic equilibrium in an open and closed economy Goods market Households Production factors market Firms Saving (financial) market If both countries use different currencies a need for currency exchange market
11 Balance of payments The balance of payments (BOP) is a statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world. More precisely: between residents and non-residents 11
12 Putting trasactions into records The balance of payments records each transaction as either a plus (credit) or a minus (debit). The general rule in BOP accounting is specified as follows: Credit (+): A flow for which the country is paid: inflow of funds. E.g.: Exports of goods, services to foreigners, income generated from investing abroad, sales of assets to foreign investors Debit (-): A flow for which the country pays: outflow of funds. E.g.: Imports of goods, travel expenses in foreign countries, income paid to foreign investors, purchases of foreign assets
13 Putting trasactions into records That is, if a transaction earns or generates foreign currency for the nation, it is called a credit (is recorded as a plus item). If a transaction involves spending foreign currency, it is a debit (is recorded as a negative item). All credit items in the BOP have to be accounted for by the debit items. So the sum of all the plus numbers in the BOP has to be equal to the sum of the entire debit numbers in absolute values. That is: Total credits + Total debits = 0
14 Similarities between balance of payments and individual s personal account Credit Debit Salary 800 Housing 300 Interest earnings Other income 100 Food Travel 200 Other 200 Savings 100 TOTAL 1000 TOTAL 1000 Note that your saving is included on the debit side because it accounts for what you have done with the money you have earned.
15 Let s change the situation slightly Credit Debit Salary 800 Housing 500 Interest earnings Other income 100 Food Travel 200 Other 200 Savings 0 TOTAL 1000 TOTAL 1100 Is this possible your total income is $1000 but your total spending is $1100?
16 Let s change the situation slightly Credit Debit Salary 800 Housing 500 Interest earnings Other income 100 Food Travel 200 Borrowing 100 Other 200 Savings 0 TOTAL 1100 TOTAL 1100 This is possible if you can borrow. But the above balance of personal payments is not consistent: it does not show where the extra money ($100) comes from. So we need to include the borrowing in the above balance.
17 Let us now go back to the initial situation, but change it to one like the following Credit Debit Salary 800 Housing 300 Interest earnings Other income 100 Food Travel 200 Other 100 Savings 100 TOTAL 1000 TOTAL 900 In the above situation, your total debits are $100 short of the credits. Have you ever been in a situation in which your numbers simply do not add up to account for a specified total? You spent the money but simply cannot recall the transaction. Something is missing but you cannot figure out what. What you need to do now is to create an item called errors or omissions, or statistical discrepancy to make up the difference
18 Let us now go back to the initial situation, but change it to one like the following Credit Debit Salary 800 Housing 300 Interest earnings Other income 100 Food Travel 200 Other 100 Savings 100 Net errors and omissions 100 TOTAL 1000 TOTAL 1000 To repeat, the key idea here is that all the credits (positive numbers) and the debits (negative numbers) in the balance of payments have to sum up to zero. Different accounts within the BOP may have positive or negative balances, but the entire BOP has to sum up to zero.
19 Gernal structure of the balance of payments The balance of payments is divided into two major accounts: the current account and the financial account. The current account includes all items of income and outlay imports and exports of goods and services, investment income, and transfer payments. The financial account records all international purchases or sales of financial assets.
20 The IMF analytic presentation of balance of payments current account 1. Current account Goods (imports and exports f.o.b. - a shipping term under which the price quoted applies only at inland shipping point) Services (communications, construction, insurance and financial services, royalties and license fees etc.) Factors of production income Remuneration of labor Investment income from capital other income Unilateral transfers (both private and public) 20
21 Structure of balance of payments capital account 2. The capital account - capital transfers consist of those involving transfers of ownership of fixed assets; transfers of funds linked to, or conditional upon, acquisition or disposal of fixed assets; or cancellation, without any counterparts being received in return, of liabilities by creditors; or the acquisition / disposal of capital assets of non-financial type (patents, licenses, property rights, trademarks); or land for construction of the embassies. Although conceptually important, capital account transactions are believed to be generally small for most of economies. 21
22 Structure of balance of payments financial account 3. Financial account balance Direct investment - Direct investment reflects lasting interest of a resident entity in one economy (direct investor) in an entity resident in another economy (direct investment enterprise). Normally direct investment represents controlling ownership of the enterprises that receives the investment (in practice: purchase at least 10% of the shares in the capital of companies) Portfolio investment - it covers transactions in equity securities and debt securities; the latter are subsectored into bonds and notes, money market instruments, and financial derivatives (such as options) when the derivatives generate financial claims and liabilities. Other investments - It covers short- and long-term trade credits; loans; currency and deposits; and other accounts receivable and payable. 22
23 Financial account: revisited Direct investment Equity capital Reinvested earnings Other capital Portfolio investment Equity securities Debt securities Money market instruments Other investment Trade credits Loans Currency and deposits Other assets and liabilities Financial derivatives
24 Same ado about caputal and financial account What is now called the financial account used to be referred to as the capital account. A newly defined capital account by the IMF consists of capital transfers and the acquisition and disposal of nonproduced nonfinancial assets. This new terminology is helpful because it emphasizes that the financial account involves flows of financial assets and liabilities rather than aircraft and factories. The newly defined capital account is extremely small and can be omitted for analysis for most countries. Because of the transition in the usage of terminologies, a lot of people still use the traditional definition of the capital account, or use the terms financial account and capital account interchangeably.
25 Structure of balance of payments 4. Statistical discrepancy (net errors and omissions) Data from a transaction may come from different sources that differ in coverage, accuracy, and timing. The balance of payments accounts therefore seldom balance in practice. The statistical discrepancy is the account added to or subtracted from the financial account to make it balance with the current account and capital 5. Reserves and Related Items foreign assets held by central banks to cushion against instability in international markets. 25
26 Structure of balance of payments financial account - Reserves and Related Items The transactions included in this account are mainly the central bank s purchase and sales of foreign exchange in the foreign exchange market. These actions are called foreign exchange market intervention. A country s international reserves, or external reserves (versus domestic assets the central bank holds), are controlled by the country s central bank. The components of the international reserves are the following: Monetary gold Special drawing rights (SDRs) Reserve position in the IMF Foreign exchange assets (consisting of currency and deposits and securities), and Other claims
27 Identyfying the accounts The IMF Analytic Presentation A. Current Account B. Capital Account C. Financial Account D. Net Errors and Omissions E. Reserves and Related Items The Two-Account Structure Current Account (A) Financial Account (B+C+D+E) We separate the current account from the rest in the balance of payments because the current account measures income flows for a country while the rest represents the corresponding financial flows. So the two account balances add up to zero.
28 Basic balanace of payments identity Basic balanace of payments identity: CA + KA + FA + SD + RES = 0 where: CA current account KA capital account FA financial account SD statistical discrepancy RES change of reserves Balance of payments accounts always add up to zero! 28
29 Identyfying the accounts The five accounts within the balance of payments are often divided alternatively as the overall balance and the official reserves balance: The Overall Balance or the Official Settlement Balance A. Current Account B. Capital Account C. Financial Account D. Net Errors and Omissions The Official Reserves Balance E. Reserves and Related Items
30 Balance of payment deficit or balance of payment surplus explained! Since this balance offsets the official reserves balance, it is also called the official settlement balance (OSB). The overall balance or the official settlement balance measures all the private sector s international transactions. It represents the trade and investment flows that reflect the economy s performance with respect to the external balance and drive the exchange rate in the foreign exchange market. The overall balance or the official settlement balance is so important that people often refer to it as the balance of payments. That is why you see expressions such as balance of payment deficit or balance of payment surplus being used in the business media or even by academics and policy makers.
31 Poland: Balance of Payments, 2012 EUR mn 2012 A. Current Account Balance on Goods Goods: exports f.o.b Goods: imports f.o.b Balance on Services Services: Credit Services: Debit Balance on Income Income: Credit Income: Debit Balance on Current Transfers Current transfers: Credit Current transfers: Debit B. Capital Account Capital account: Credit Capital account: Debit 511 C. Financial Account Direct investment abroad -607 Direct investment in Poland Portfolio investment assets -335 Equity securities -442 Debt securities 107 Portfolio investment liabilities Equity securities Debt securities Other investment assets Monetary authorities 0 Central and local government -243 MFI (excluding Central Bank) -180 Other sectors Other investment liabilities Monetary authorities 276 Central and local government MFI (excluding Central Bank) Other sectors Financial derivatives D. Net errors and omissions Overall Balance E. Official Reserve Assets
32 Polish current account balance Relacja rachunku Polish current bieżącego bilansu account płatniczego do produktu to GDP krajowego ratio (%) brutto (%)
33 Inflow of foreign capital to Poland, mln PLN Napływ Inflow of inwestycji foreign direct bezpośrednich investment to do Poland Polski Napływ inwestycji porfelowych do Polski Inflow of foreign portfolio investment to Poland
34 US Balance of Payments Accounts
35 Polish international investment position IIP/GDP Assets/GDP Debits/GDP 35
36 Current account balance across the world The blue colour marks countries with a surplus on the current account ( balance of trade), and the colour red - the countries with a deficit on this account (year 2005). Because the deficit on the current account usually means a surplus of a capital account and financial, we may conclude that "blue" countries are lending their savings to red countries. Red countries spend more than they produce. 36
37 Official foreign reserves, 2009
38 Current account balance and financial crisis 38
39 Foreign exchange market
40 40 Foreign exchange market The foreign exchange market is the market where currencies of some countries are exchanged for currencies of other countries Currency - the term used interchangeably with the concept of money, especially in the context of international trade Foreign currency includes foreign coins, banknotes, deposits in foreign banks and other foreign liquid, short-term financial instruments
41 41 Exchange rate The exchange rate is the price of one currency expressed in another currency Each exchange rate can be expressed in two ways: direct quotation - showing the price of foreign currencies in the domestic currency indirect quotation - stating how much domestic currency in foreign currencies One way of quotation is reciprocal of the other one. In Poland, most often we use a direct quotation, however in the UK or US indirect quotation is popular. We will denote it E 3.08 PLN/USD: the rate (price) of the US dollar expressed in PLN Often we use the following provision: USD/PLN 3.08
42 Exchange rate system The exchange rate system (the exchange rate regime) is intended by the monetary authorities scope of exchange rate volatility The authorities can decide that a rate should not have vary at all or should freely only depend on the market situation (the demand and supply), or choose a variant between the extremes.
43 Exchange rate systems Degree of exchange rate volatility Currency board Fixed exchange rate Crawling exchange rate Exchange rate band Floating exchange rate Fixed and irreversible exchange rate Fixed exchange rate with possibility to change it Central bank sets a central exchange rate but it also defines a path of change for the rate (e.g. devaluation path) Central bank sets a central exchange rate but the market rate may vary around it in a certain band Exchange rate set by market mechanism
44 44 Changes of the exchange rate Currency appreciation: growth of its value Currency depreciation : fall of its value Both terms are used in a floating exchange rate system Example: if a month ago 1 $ was equal to 2,8 PLN, but today is equal to 3,1 PLN, we say that during this period $ appreciated and PLN depreciated Two similar terms, only used in a fixed exchange rate system are: revaluation and devaluation Example: if central bank sets a PLN exchange rate as 2 PLN for $, but year later changes the rate to 3 PLN for $, we will say that PLN was devaluated by the central bank
45 45 Where the exchange rate come from? Exchange rate is a price Price is set on the market
46 Exchange rate is determined on the currency market 46 Exchange rate E 1 M s Supply of foreign currency: willingness to sell foreign currency (e.g. euro) depending on its price expressed in other currency (e.g. PLN) E 0 M d1 M d2 Demand for foreign currency: willingness to buy foreign currency (e.g. euro) depending on its price expressed in other currency (e.g. PLN) M 1 M 2 Foreign currencies
47 47 Exchange rate system Exchange rate system Floating (exchange rate is determined by market forces) Fixed (exchange rate that is determined by monetary authorities (e.g. central bank); usually it is a band within which an exchange rate is floating) M S0 e 1 e 0 M S0 e centr M s1 Central bank intervention M D1 M D1 M D0 M S0 M * M * 1 M * M * 1
48 Foreign exchange market: BIS statistics
49 FOREX 24-hours a day
50 Role of exchange rate in macroeconomic equilibrium Macroeconomic equilibrium in an open economy: Goods market Factors of production market (labour) Savings market (financial market) Foreign exchange market Interdependences between markets Next week: money market
51 End of lecture 3. Thank you and see you next week!
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