Global Business Economics. Mark Crosby SEMBA International Economics

Global Business Economics Mark Crosby SEMBA International Economics

The balance of payments and exchange rates Understand the structure of a country s balance of payments. Understand the difference between public debt and international debt. Analyse the dangers associated with Australia s high international debt level. Introduction to exchange rates.

International Accounts

International Accounts The National Accounts present output data for a country. International Accounts present data that relate to transactions between countries. The Balance of Payments includes data on transactions between countries over a given period.

Balance of Payments and International Investment Position

Current Account Australia s current account deficit in 2013-14 was $48.1 billion. The goods and services (trade) balance was in deficit of $6.85 billion. The primary income deficit was $38.98 billion.

Current Account Australia has a trade surplus, and a current account deficit. Why? Past deficits lead to large incomes payments overseas (interest and dividends). The US also has a current account deficit, but in their case it is because of a large trade deficit.

Japan s surplus

and asset position

Causes of a Current Account Deficit Australia Very large incomes deficit due to past current account deficits, and therefore a large international liability position. Trade deficits Why does the US have a large trade deficit? Low national savings, excess of demand over production implies a trade deficit.

Capital and Financial Account The capital and financial account shows financial flows that fund the current account deficit.

Capital and Financial Account (Foreign) Direct investment flows are defined as longer term flows. Portfolio flows are shorter term flows (eg share purchases by a mutual fund). Other investments include bank deposits.

Australia s large income payments arise from its large international liability position.

International liabilities The US liability position is about 30 percent of GDP, compared with roughly 55 percent in the case of Australia. However, the US liability position is steadily increasing.

Liabilities as percent of global GDP

Is Australia s high debt level a problem? Many countries have gotten into difficulty with high levels of international debt Examples include Latin America in the 1980s, the Asian crisis in 1997, and Greece and elsewhere currently. How is Australia different? The Latin American and current crisis involved public (government) international debt. Australia s debt is privately owed. Asian crisis countries had high levels of short-term, unhedged international debts. Is there a shock(s) that could unhinge Australia? The GFC came close difficulties with banks raising international finance, widening spreads etc.

Summary: Balance of Payments What you need to know. The difference between a current account deficit and international debt. The difference between public debt and international debt. Basic mechanics of fixed exchange rate determination.

Exchange rates Exchange rate regimes. Basics of flexible exchange rate determination.

For Discussion In Class Discussion Question: How does Singapore manage its exchange rate (Syndicates 1 and 2)? How does Hong Kong manage its exchange rate (Syndicates 3 and 4)? How does China manage its exchange rate (remaining syndicates)?

Different exchange rates For most countries the USD, the Euro, and the TWI (or NEER) will be the most relevant exchange rate.

Exchange rates since 1990

Exchange Rate Determination What determines the exchange rate? How do fixed vs. flexible exchange rates work? How do exchange rates affect trade and the current account? Let s look at the AUD/$US rate, and think about what determines this rate, and why it is so volatile

Flexible Exchange Rates Market forces determine the exchange rate foreign currency is brought into the country through exports and capital inflow foreigners supply foreign currency in return for domestic currency so they can purchase local exports and also local capital (bonds, shares, companies).

The A$ market The $A market price of $A S D D, S for $A

The $A market price of $A S D (exports, foreign buyers of Aus assets) D, S for $A

The $A market price of $A S (importers, Aus buyers of foreign assets) D (exports, foreign buyers of Aus assets) D, S for $A

The $A market price of $A S (importers, Aus buyers of foreign assets) US78c D (exports, foreign buyers of Aus assets) D, S for $A

An increase in demand for $A leads to an appreciation price of $A S (importers, Aus buyers of foreign assets) US78c D (exports, foreign buyers of Aus assets) D, S for $A

What underlies the supply and demand curves? Trade (exports and imports) depend on competitiveness relative inflation rates (relative purchasing power parity) interest rates productivity strength of the domestic versus the international economy.

Purchasing Power Parity (PPP) Idea related to story that goods should sell for the same price in all countries. The law of one price (LOOP) says that the real exchange rate should equal one all goods should cost the same in all countries. The real exchange rate is defined as ep*/p e is the price of foreign exchange (A$1.12/$US), and P* is the foreign price level, so ep* is the local currency price of foreign goods.

LOOP and PPP You can think of P* and P as either prices of individual goods or aggregate price levels. i.e. if LOOP applied to all goods then the costs of our CPI basket ought to be (almost) the same as for the US CPI basket (this is known as absolute PPP). In practice LOOP and absolute PPP do not hold e.g. the Big Mac Index, the fact that poor countries have low prices.

Big Mac Index

The Exchange Rate in the LR Absolute PPP does not hold In the short run, PPP may not hold because Market baskets differ across nations There are barriers to the movement of goods between nations (i.e. transportation costs and tariffs) Many goods are non-tradable (i.e. land) Relative PPP, whereby the real exchange rate is constant works better.

Relative PPP (long run) Relative PPP implies a constant real exchange rate, meaning that the rate of depreciation of the exchange rate is equal to the difference between domestic and foreign inflation...holds in the long run... Average % per year, 1955-1996 π* - π us E/E Argentina 67.9 64.3 Brazil 81.4 79.7 Chile 31.4 35.5 Colombia 12.4 14.6 Indonesia 7.0 7.1 Peru 48.3 45.7 Singapore (1970-1997) -1.6 2.7

Relative inflation and exchange rate movements (short run)...doesn t work! 20 15 10 5 0-5 -10-15 -20 1975 1976 Figure 1a: Purchasing Power Parity in Australia? correlation = 0.25 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Aus inf - US inf %$A depreciation

Interest rates and the exchange rate If interest rates are raised, capital flows in, pushing the exchange rate up... but it is also possible that high interest rates may be predicting a depreciation... why? high expected inflation forces countries to offer high interest rates the market expects the currency to depreciate. In short, there is no simple relationship between interest rates and the exchange rate.

What causes exchange rate volatility? Exchange rates are volatile because capital account flows are volatile in particular portfolio flows are speculative, follow fads, herds. Demand and Supply curves move around a great deal because of these volatile flows. e.g. the past two decades have seen 3 factors affecting the AUD/$US exchange rate.

USD per AUD 1.1 1.0 0.9 0.8 0.7 0.6 What s going on? 0.5 Why so low? 0.4 Mar-2001 Mar-2003 Mar-2005 Mar-2007 Mar-2009 Mar-2011 Mar-2013

1990s Fad #1: The US sharemarket Portfolio flows and Stock Values, United States 250 200 200 NYSE Index (left Scale) 150 150 100 100 Portfolios flows into the US 50 50 0 0 Mar-90 Mar-91 Mar-92 Mar-93 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03-50

1990s Fad #2: The new economy. US is new economy provides support for fad #1. Commodity exporters, such as Australian and Canadian economies are old economy this view leads to very strong appreciation of the $US against the $C, $A, $NZ until 2002. Problem with the old economy story is that US productivity growth is not higher than in old (or other) economies.

1990s Fad #3: The Strong $ policy Since 1995 US Treasury Secretaries have repeated the mantra that the US government is for a strong dollar. This was NEVER a policy no more than rhetoric. Still in 2006, G.W. Bush reaffirmed the official strong US dollar policy...

The late 1990s The combined effect of a strong US sharemarket, the IT revolution and the strong $ policy was a very strong demand for US assets. This demand for US assets continued through to 2002. Since 2002 this has all gone into reverse.

Declining portfolio flows into the US after 2001 Demand for US assets started to weaken with the decline in demand for portfolio assets in 2002/03 This caused the USD to begin to weaken from this time.

Since 2002 Demand would have fallen further, except that Asian central banks have been very strong buyers of $US and US government bonds

Since 2002 The US budget deficit grew very quickly after 2001. Relatedly, the US trade deficit has remained at very high levels the financing of the current account deficit means that the US requires capital inflow each month. if capital inflow is insufficient, the $US falls to bring the market to equilibrium.

Why so volatile in 2008/09? GFC sees investors move to safe havens. Return to normality and growth in China sees return to risk, return to commodities, return of carry traders.

Where to for currencies from here? The real issue is sentiment. Is the US a safe haven? Will QE lead to inflation in future? Will China crash? Etc, etc

Forecast for the $A in the short run

Forecast for the $A in the short run the best forecast in the short term is the random walk! This is true of all of the major flexible exchange rates (Yen, Euro, USD, Pound, AUD, NZD, Swiss Franc, etc). But remember

Forecast for the $A in the short run

Unpredictability consistent with very large volumes of trade in OECD currencies

And in the long run? The exchange rate is a random walk in the short run, but does have a fundamental or equilibrium long run value. Rogoff and Obstfeld have argued that the USD is still very overvalued, based on large trade deficits. The RBA have recently argued thet the AUD is overvalued. Some central banks have intervened to weaken their currency.

Fixed Exchange Rates The central bank buys and sells domestic currency at a fixed price in terms of foreign currency If the price is fixed below the equilibrium level the central bank must exchange foreign currency for local currency to meet the excess demand, and vice versa A devaluation (revaluation) takes place when the value of the currency in terms of foreign exchange is officially reduced (increased)

Fixed Exchange Rates The RMB market price of RMB S Price until July 2005 12.07c Build up of foreign reserves D D, S for RMB

Fixed Exchange Rates The RMB market Price until July 2005 price of RMB 15c 12.07c Build up of foreign reserves S D Today the exchange rate is about 15c/RMB. But demand for RMB has increased since 2005, so even with the stronger RMB forex reserves continue to grow. D, S for RMB

The Asian Crisis Common features of the Asian crisis economies: increasing CAD/GDP ratio pegged exchange rates Increasing CAD/GDP ratio during the 1990s appeared justifiable since high GDP growth could ensure future repayment of foreign liabilities small budget deficits were not crowding out net exports

Pegged Exchange Rates Economies operated under exchange rates pegged against the US dollar Financial sector deregulation led to large capital inflows these inflows increased dramatically in the early 1990s.

Pegged Exchange Rates Asian crisis countries encountered problems because of insufficient regulatory controls which created poor quality loans rapid growth in short-term unhedged foreign currency debt

The Crisis: 1997 From 1995, the US dollar appreciated against many other currencies The international competitiveness of East Asian economies declined Their CADs worsened In 1997, the CA and exchange rate pressures led to the floating of the currencies in the Asian crisis nations leading to rapid currency depreciation

The Crisis: 1997

The Crisis: 1997 Since most foreign debt was in unhedged foreign currency, firms could not repay their foreign loans Foreign lenders became unwilling to commit further loans High levels of short-term debt meant large capital outflows in 1997 98 The capital outflow led to further currency devaluation

Recovery from the Crisis IMF programs attempted to stabilise these economies, with mixed early success. The IMF forced foreign lenders to roll over existing debt for at least one year The governments were permitted to run large budget deficits Korea and Thailand stabilised, but not so in Indonesia. Malaysia reintroduced capital controls and a fixed exchange rate in 1998.

Recovery from the Crisis Real GDP Growth Rates 1997 1998 1999 2000 2001 2002 Indonesia 4.7-13.2 0.2 4.7 3.4 3.7 Korea 3.3-5.2 13.8 5.2 3.1 6.3 Malaysia 7.3-7.4 6.1 8.3 0.3 4.1 Thailand -1.5-10.8 4.2 4.3 2.1 5.4

Questions raised by the crisis What is the most appropriate exchange rate regime? How can flexible exchange rates be made less volatile? Do hedge funds need to be regulated?

Hedge fund attacks the AUD USD per AUD: 1997 and 1998 0.80 0.78 0.76 0.74 0.72 0.70 0.68 0.66 0.64 0.62 0.60 0.58 0.56 31-Jan-1997 20-Jun-1997 07-Nov-1997 27-Mar-1998 14-Aug-1998 01-Jan-1999

Hedge Fund attacks the HK double play Complicated position (see next slide), but aim was to drive up interest rates and drive down the Hang Seng or push HK off the currency board. Between 14 and 28 August 1998 the HKMA purchased HK$118.1 billion in stocks 7.3% of the value of the 33 HSI stocks. In 1998 the HKMA commenced disposal of their shares through a tracker fund, at very large profits.

(Goodhart and Dai, 2003)

Intervention Hedge fund attacks HKMA intervention

Summary What makes exchange rates appreciate or depreciate? Why are exchange rates volatile? How does a fixed exchange rate work. EXAM QUESTION: In January this year the Swiss central bank unpegged the Swiss Franc to Euro exchange rate. Why would they do this, and what might be the economic impacts of this action? Why did the exchange rate move as a result of the unpegging?