thorvaldur gylfason joint vienna institute/ institute for capacity development

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

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


Y X - Z Definition

GDP Trade balance


GNP Current account excl. transfers

Goods and services


Y X - Z Definition

GDP Trade balance


GNP Current account excl. transfers

Goods and services

GNDI Current account incl. transfers

Goods and services plus transfers


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


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


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


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


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


OvervaluationDeficit

R R moves when e is fixed

Foreign exchange

Price

of f

orei

gn e

xcha

nge

Supply (exports)

Demand (imports)


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

http://www3.hi.is/~gylfason/Dutch%20Disease%20Palgravex.pdf

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


FIXEDEXCHANGE

RATEMONETARYINDEPENDENCECapital controls

(China)


three

1

2

3


FIXEDEXCHANGE


Flexible exchange rate (US, UK, Japan)


three

1

2

3


FIXEDEXCHANGE


MonetaryUnion (EU)

Flexible exchange rate (US, UK, Japan)

Capital controls (China)


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


Stability of trade and investmentLow inflation


BENEFITS AND COSTS

Benefits Costs



InefficiencyBOP deficitsSacrifice of monetary independence


BENEFITS AND COSTS

Benefits Costs





EfficiencyBOP equilibrium

BENEFITS AND COSTS

Benefits Costs





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

thorvaldur gylfason joint vienna institute/ institute for capacity development

Documents

economic transactions

records transactions

oneway transactions

avoirs ou une augmentation

accounting principlescredit

accounting sense

financial liabilities

xfs zfs