thorvaldur gylfason joint vienna institute/ institute for capacity development
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Thorvaldur GylfasonJoint Vienna Institute/
Institute for Capacity DevelopmentDistance Learning Course on
Financial Programming and PoliciesVienna, Austria
NOVEMBER 26–DECEMBER 7, 2012
BALANCE OF PAYMENTS AND EXCHANGE RATE REGIMES
1. Balance of payments accounts
2. Balance of payments analysis
3. Exchange rates4. Exchange rate policy5. Exchange rate regimes
To float or not to float6. How many monies do we
need?
OUTLINE IN SIX PARTS
Accounting system for macroeconomic analysis in four parts
1. Balance of payments2. National income accounts3. Fiscal accounts4. Monetary accounts
Now look at balance of payments accounts per se, looked before at linkages in a separate lecture
BALANCE OF PAYMENTS ACCOUNTS1
Transactions in two major categories
1. Real transactions Goods, services, and income
Current account of the BOP Involve flows
2. Financial transactions Reflect changes in foreign assets
and liabilities Capital and financial account of the
BOP Involve changes in stocks
BALANCE OF PAYMENTS CONVENTIONS:ACCOUNTING PRINCIPLES
Flows involve changes in underlying stocks: X – Z + F = DRX = exports, Z = imports,
F = capital account, R = reserves, F = DDF with DF = net foreign debt
Goods Services
Capital
Exports Xg Xs Fx
Imports Zg Zs Fz
ExamplesReal transactions
Financial transactions
EXTERNAL TRANSACTIONS
Balance of paymentsBOP = Xg + Xs + Fx – Zg – Zs – Fz
= X – Z + F = current account + capital accountHereX = Xg + Xs Exports of good and servicesZ = Zg + Zs Imports of good and servicesF = Fx – Fz Net exports of capital =
Net capital inflow = DDF
Also called capital and financial account
The term “capital account” is1. Old language (BPM4) 2. Shorthand for new language
(BPM5)
RECORDING EXTERNAL TRANSACTIONS
Balance of paymentsBOP = Xg + Xs + Fx – Zg – Zs – Fz
= X – Z + F = current account + capital accountHereX = Xg + Xs Exports of good and servicesZ = Zg + Zs Imports of good and servicesF = Fx – Fz Net exports of capital =
Net capital inflow
RECORDING EXTERNAL TRANSACTIONS
Balance of paymentsBOP = Xg + Xs + Fx – Zg – Zs – Fz
= X – Z + F = current account + capital accountHereX = Xg + Xs Exports of good and servicesZ = Zg + Zs Imports of good and servicesF = Fx – Fz Net exports of capital =
Net capital inflow
RECORDING EXTERNAL TRANSACTIONS
Balance of paymentsBOP = Xg + Xs + Fx – Zg – Zs – Fz
= X – Z + F = current account + capital accountHereX = Xg + Xs Exports of good and servicesZ = Zg + Zs Imports of good and servicesF = Fx – Fz Net exports of capital =
Net capital inflow
RECORDING EXTERNAL TRANSACTIONS
Trade balanceTB = Xg + Xnfs – Zg – Znfs
Xnfs = Xs – Xfs = exports of nonfactor services
Znfs = Zs – Zfs = imports of nonfactor services
Balance of goods and servicesGSB = TB + Yf
Yf = Xfs – Zfs = net factor incomeCurrent account balance
CAB = GSB + TR = TB + Yf + TR TR = net unrequited transfers from
abroad
Intermediate concept
GSB
FROM TRADE BALANCE TO CURRENT ACCOUNT
Net factor income from laborCompensation of domestic guest workers
abroad (e.g., Pakistanis in the Gulf) minus that of foreign workers at home
Net factor income from capitalInterest receipts from domestic assets
held abroad minus interest payments on foreign loans (e.g., Argentina)
Includes also profits and dividends Transfers are unrequited transactions
Public or private, disbursed in cash or in kind (e.g., foreign aid)
Yf > 0 in PakistanYf < 0 in Argentina
IMPORTANCE OF NET FACTOR INCOME
Two parts1. Capital account (esp., capital
transfers)2. Financial account
1. Direct investmentInvolves influence of foreign owners
2. Portfolio investmentIncludes long-term foreign borrowingDoes not involve influence of foreign owners
3. Other investmentIncludes short-term borrowing
4. Errors and omissionsStatistical discrepancy
Is the world’s BOP = 0?!
CAPITAL AND FINANCIAL ACCOUNT
Y = C + I + G + X – Z= E + X – Zwhere E = C + I +G
CAB = X – Z = Y – E Ignore Yf and TR for simplicity
S = I + G – T + X – Z CAB = S – I + T – GCAD = Z – X = E – Y = I – S + G – T
Private sector deficitPublic
sector deficit
NATIONAL INCOME ACCOUNTS
Y = C + I + G + X – Z GDP = C + I + G + TBGNP = C + I + G + CABGNP – GDP = CAB – TB = Yf (if TR = 0)GNP = GDP + Yf GNP > GDP in Pakistan GNP < GDP in Argentina
GNDI = GNP + TR = GDP + Yf + TR
LINKS BETWEEN BOP NATIONAL ACCOUNTS
Y X - Z Definition
GDP Trade balance
Goods and nonfactor services
LINKS BETWEEN BOP NATIONAL ACCOUNTS
Y X - Z Definition
GDP Trade balance
Goods and nonfactor services
GNP Current account excl. transfers
Goods and services
LINKS BETWEEN BOP NATIONAL ACCOUNTS
Y X - Z Definition
GDP Trade balance
Goods and nonfactor services
GNP Current account excl. transfers
Goods and services
GNDI Current account incl. transfers
Goods and services plus transfers
LINKS BETWEEN BOP NATIONAL ACCOUNTS
Foreign exchange
Rea
l exc
hang
e ra
te Imports
Exports
Earnings from exports of goods, services, and capital
Payments for imports of goods, services, and capital
Equilibrium
Real exchange rate = eP/P*
2 BALANCE OF PAYMENTS ANALYSIS
Equilibrium between demand and supply in foreign exchange market establishesEquilibrium real exchange rateEquilibrium in the balance of paymentsBOP = X + Fx – Z – Fz
= X – Z + F = current account + capital account = 0
BALANCE OF PAYMENTS EQUILIBRIUM
Foreign exchange
Rea
l exc
hang
e ra
te Imports
Exports
Overvaluation
Deficit
R R moves when e is fixed
OVERVALUATION
Foreign exchange
Pric
e of
fore
ign
exch
ange
Supply (exports)
Demand (imports)
Overvaluation
Deficit
Overvaluation works like a price ceiling
OVERVALUATION, AGAIN
Crucial indicator used to assess the external position of a country
The current account balance is equal to the change in net foreign assets with respect to the rest of the worldIncludes change in net foreign
assets of Non-banking sector Banking sector (including monetary
authorities)CAB – F + DR because X – Z + F = DR
CURRENT ACCOUNT BALANCE
CAB – F + DR because X – Z + F = DR
Hence, current account deficit can be financed byAttracting foreign direct investmentAccumulating net foreign liabilities
I.e., borrowing abroad Running down the net foreign assets
of the monetary authorities
CURRENT ACCOUNT BALANCE
When does a current account deficit become a source of concern?When it is a lasting (structural) deficit
rather than a temporary (cyclical) deficit When it is financed by short-term external
borrowing or by a protracted reduction in net foreign assets
When foreign exchange reserves are low in terms of months of imports or in terms of the Giudotti-Greenspan Rule
Other factorsCapacity to meet financial obligationsAvailability of external financing
CURRENT ACCOUNT BALANCE
When does a current account deficit become a source of concern?When continued current account deficits, reflecting the behavior of the government and the private sector, require drastic adjustment of economic policies in order to avoid a crisis, e.g., Collapse of exchange rate Default on external debt payments
CURRENT ACCOUNT BALANCE
A country is solvent if the present value of future current account surpluses is at least equal to its current external debt
The concept is simple, but putting it into practice is complicated If the projections of future
surpluses are sufficiently large, any current account deficit could be consistent with the notion of solvency
CURRENT ACCOUNT BALANCE
Another crucial indicator used to assess the external position of a countryA deficit in the overall balance means a
decrease in the net foreign assets of the monetary authority except when exceptional financing becomes available
Foreign reserves are traditionally held by the monetary authorities in order to finance payments imbalances and to defend the currency
OVERALL BALANCE
Exceptional financing can be needed in an emergency where reserves have fallen to perilously low levels
Three main typesRescheduling of external debt obligations
Scheduled payments postponed in agreement with creditors
Debt forgiveness Voluntary cancellation by creditors
Payments arrears on external debt service Scheduled payments postponed without
agreement with creditors
OVERALL BALANCE
Indicators of an appropriate level of foreign reservesRatio of reserves to monthly
imports of goods and services of more than 3
Guidotti-Greenspan Rule Other considerations
Capital mobilityExchange rate regimeComposition of external liabilitiesAccess to foreign borrowing Seasonal nature of imports and
exports
OVERALL BALANCE
EXCHANGE RATES
*PePQ
Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad
Increase in Q means real appreciation
e refers to foreign currency content of domestic currency
3
Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad
Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged
REAL VS. NOMINAL EXCHANGE RATES
*PePQ
THREE THOUGHT EXPERIMENTS
*PePQ
1. Suppose e fallsThen more rubles per dollar, so X rises, Z falls
2. Suppose P fallsThen X rises, Z falls
3. Suppose P* risesThen X rises, Z falls
Capture all three by supposing Q falls
Then X rises, Z falls
Foreign exchange
Real
exc
hang
e ra
te
Imports
Exports
Earnings from exports of goods,
services, and capital
Payments for imports of goods, services, and capital
Equilibrium
EXCHANGE RATE POLICY4
Equilibrium between demand and supply in foreign exchange market establishesEquilibrium real exchange rateEquilibrium in balance of
paymentsBOP = X + Fx – Z – Fz
= X – Z + F = current account + capital
account = 0
EXCHANGE RATE POLICY AND WELFARE
X – Z = current accountF = capital and financial account
Foreign exchange
Real
exc
hang
e ra
te
Imports
Exports
EXCHANGE RATE POLICY AND WELFARE
OvervaluationDeficit
R R moves when e is fixed
Foreign exchange
Price
of f
orei
gn e
xcha
nge
Supply (exports)
Demand (imports)
EXCHANGE RATE POLICY AND WELFARE
Overvaluation
Deficit
Overvaluation works like a price ceiling
Appreciation of currency in real terms, either through inflation or nominal appreciation, leads to a loss of export competitiveness
In 1960s, Netherlands discovered natural resources (gas deposits)Currency appreciated Exports of manufactures and services
suffered, but not for long Not unlike natural resource discoveries,
aid inflows could trigger the Dutch disease in receiving countriesSee my “Dutch Disease” in New
Palgrave Dictionary of Economics
Online
APPLICATION 1: DUTCH DISEASE
DUTCH DISEASE: HOW OIL EXPORTS CROWD OUT NONOIL EXPORTS
Foreign exchange
Real
exc
hang
e ra
te
Imports
Exports without oilExports with oil
A
C BOil discovery leads to appreciation, and reduces nonoil exports
Composition of exports matters
DUTCH DISEASE: HOW FOREIGN AID CAN CROWD OUT EXPORTS
Foreign exchange
Real
exc
hang
e ra
te
Imports
Exports without aidExports with aid
A
C BForeign aid leads to appreciation, and reduces exports (e.g., Zambia)
Trade vs. aid
APPLICATION 2: OVERVALUATIONGovernments may try to keep
the national currency overvaluedTo keep foreign exchange cheapTo have power to ration scarce
foreign exchangeTo make GNP look larger than it
isOther examples of price ceilings
Negative real interest ratesRent controls in cities
INFLATION AND OVERVALUATIONInflation can result in an
overvaluation of the national currencyRemember: Q = eP/P*
Suppose e adjusts to P with a lag
Then Q is directly proportional to inflation
Numerical example
INFLATION AND OVERVALUATION
Time
Real exchange rate
100
110105 Average
Suppose inflation is 10 percent per year
INFLATION AND OVERVALUATION
Time
100
120
Real exchange rate
110 Average
Hence, increased inflation lifts the real exchange rate as long as the nominal exchange rate adjusts with a lag
Suppose inflation rises to 20 percent per year
EXCHANGE RATE REGIMES
The real exchange rate always floatsThrough nominal exchange rate
adjustment or price changeEven so, it matters how countries
set their nominal exchange rates because floating takes time
There is a wide spectrum of options, from absolutely fixed to completely flexible exchange rates
5
EXCHANGE RATE REGIMESThere is a range of options
Monetary union or dollarizationMeans giving up your national
currency or sharing it with others (e.g., EMU, CFA, EAC)
Currency boardLegal commitment to exchange
domestic for foreign currency at a fixed rate
Fixed exchange rate (peg)Crawling pegManaged floatingPure floating
Currency union or dollarization Currency board Peg
Fixed Horizontal bands
Crawling peg Without bands With bands
Floating Managed Independent
FIXED
FLEXIBLE
EXCHANGE RATE REGIMES
DollarizationUse another country’s currency as sole legal
tenderCurrency union
Share same currency with other union members
Currency boardLegally commit to exchange domestic
currency for specified foreign currency at fixed rate
Conventional (fixed) pegSingle currency pegCurrency basket peg
BASICALLY FIXED
Flexible pegFixed but readily adjusted
Crawling pegComplete
Compensate for past inflationAllow for future inflation
PartialAimed at reducing inflation, but real appreciation results because of the lagged adjustment
Fixed but adjustable
INTERMEDIATE
Managed floatingManagement by sterilized
intervention I.e., by buying and selling foreign
exchangeManagement by interest rate
policy, i.e., monetary policy E.g., by using high interest rates to
attract capital inflows and thus lift the exchange rate of the currency
Pure floating
BASICALLY FLOATING
IMPOSSIBLE TRINITYFREE CAPITAL MOVEMENTS
FIXEDEXCHANGE
RATEMONETARYINDEPENDENCE
MonetaryUnion (EU)
Free to choose only two of three options; must sacrifice one of the
three
1
2
3
IMPOSSIBLE TRINITYFREE CAPITAL MOVEMENTS
FIXEDEXCHANGE
RATEMONETARYINDEPENDENCECapital controls
(China)
Free to choose only two of three options; must sacrifice one of the
three
1
2
3
IMPOSSIBLE TRINITYFREE CAPITAL MOVEMENTS
FIXEDEXCHANGE
RATEMONETARYINDEPENDENCE
Flexible exchange rate (US, UK, Japan)
Free to choose only two of three options; must sacrifice one of the
three
1
2
3
IMPOSSIBLE TRINITYFREE CAPITAL MOVEMENTS
FIXEDEXCHANGE
RATEMONETARYINDEPENDENCE
MonetaryUnion (EU)
Flexible exchange rate (US, UK, Japan)
Capital controls (China)
Free to choose only two of three options; must sacrifice one of the
three
1
2
3
FIX OR FLEX? If capital controls are ruled out in view of
the proven benefits of free trade in goods, services, labor, and also capital (four freedoms), …
… then long-run choice boils down to one between monetary independence (i.e., flexible exchange rates) vs. fixed rates Cannot have both!
Either type of regime has advantages as well as disadvantages
Let’s quickly review main benefits and costs
Benefits Costs
Fixed exchange rates
Floating exchange rates
BENEFITS AND COSTS
Benefits Costs
Fixed exchange rates
Stability of trade and investmentLow inflation
Floating exchange rates
BENEFITS AND COSTS
Benefits Costs
Fixed exchange rates
Stability of trade and investmentLow inflation
InefficiencyBOP deficitsSacrifice of monetary independence
Floating exchange rates
BENEFITS AND COSTS
Benefits Costs
Fixed exchange rates
Stability of trade and investmentLow inflation
InefficiencyBOP deficitsSacrifice of monetary independence
Floating exchange rates
EfficiencyBOP equilibrium
BENEFITS AND COSTS
Benefits Costs
Fixed exchange rates
Stability of trade and investmentLow inflation
InefficiencyBOP deficitsSacrifice of monetary independence
Floating exchange rates
EfficiencyBOP equilibrium
Instability of trade and investmentInflation
BENEFITS AND COSTS
In view of benefits and costs, no single exchange rate regime is right for all countries at all times
The regime of choice depends on time and circumstance If inefficiency and slow growth due to
currency overvaluation are the main problem, floating rates can help
If high inflation is the main problem, fixed exchange rates can help, at the risk of renewed overvaluation
Ones both problems are under control, time may be ripe for monetary union
BENEFITS AND COSTS
What do countries do?
To eliminate high inflation, need fixed exchange rate for a time
96Source: Annual Report on Exchange Arrangements and Exchange Restrictions database.
What countries actually do (Number of countries, April 2008)
(3)
(12)
(22)
(5) (2)(66)
(44) (40)
(76)
(84)
(10)
No national currency 6%Currency board 7%Conventional fixed rates
36%Intermediate pegs 5%Managed floating 24%Pure floating 22% 100%
46%
54%
There is a gradual tendency towards floating, from 10% of LDCs in 1975 to almost 50% today, followed by increased interest in fixed rates through economic and monetary unions
WHAT COUNTRIES ACTUALLY DO (2008, 182 COUNTRIES)
WHY WE HAVE FEWER CURRENCIES THAN COUNTRIES In view of the success of the EU
and the euro, economic and monetary unions appeal to many other countries with increasing force
Consider four categoriesExisting monetary unionsDe facto monetary unionsPlanned monetary unions Previous – failed! – monetary unions
6
EXISTING MONETARY UNIONS CFA franc
14 African countries CFP franc
3 Pacific island states East Caribbean dollar
8 Caribbean island states Picture of Sir W. Arthur Lewis, the great Nobel-prize
winning development economist, adorns the $100 note Euro, more recent
16 EU countries plus 6 or 7 others Thus far, clearly, a major success in view of old
conflicts among European nation states, cultural variety, many different languages, etc.
DE FACTO MONETARY UNIONS Australian dollar
Australia plus 3 Pacific island states Indian rupee
India plus Bhutan New Zealand dollar
New Zealand plus 4 Pacific island states South African rand
South Africa plus Lesotho, Namibia, Swaziland – and now Zimbabwe
Swiss franc Switzerland plus Liechtenstein
US dollar US plus Ecuador, El Salvador, Panama, and 6 others
PLANNED MONETARY UNIONS East African shilling (2009)
Burundi, Kenya, Rwanda, Tanzania, and Uganda
Eco (2009)Gambia, Ghana, Guinea, Nigeria, and Sierra
Leone (plus, perhaps, Liberia) Khaleeji (2010)
Bahrain, Kuwait, Qatar, Saudi-Arabia, and United Arab Emirates
Other, more distant plansCaribbean, Southern Africa, South Asia,
South America, Eastern and Southern Africa, Africa
PREVIOUS MONETARY UNIONS Danish krone 1886-1939
Denmark and Iceland 1886-1939: 1 IKR = 1 DKR 2009: 2,500 IKR = 1 DKR (due to inflation in
Iceland) Scandinavian monetary union 1873-1914
Denmark, Norway, and Sweden East African shilling 1921-69
Kenya, Tanzania, Uganda, and 3 others Mauritius rupee
Mauritius and Seychelles 1870-1914 Southern African rand
South Africa and Botswana 1966-76 Many others
No significant divergence of prices or currency
rates following separation
99.95%
CONFLICTING FORCES Centripetal tendency to join monetary
unions, thus reducing number of currencies To benefit from stable exchange rates at the
expense of monetary independence Centrifugal tendency to leave monetary
unions, thus increasing number of currenciesTo benefit from monetary independence often,
but not always, at the expense of exchange rate stability
With globalization, centripetal tendencies appear stronger than centrifugal onesThe End
These slides will be posted on my website:
www.hi.is/~gylfason
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