Balance of Payments



Lecture Notes – 5 November 2012Course Part III – outline8 lectures – before the next mid-term6 lectures – after the next mid-termBefore the next mid-termInternational Financial System - 2 lecturesEquity Markets – 2 lecturesBanking Industry - Commercial Banks – 2 lecturesInvestment Banks – 2 lecturesLecture Notes – 5 November 2012Overview Chapter 16We are going to discuss international capital flows. This will tie together the foreign exchange market and the role of central banks. To begin we need to think about the effect of the exchange rate on various factors. We did this analysis the other way around for a supply/demand perspective but it still holds. If a currency strengthens then you should see:Imports increase. Foreign goods cost less because your currency buys more foreign goods than previously.Exports fall. Your goods cost more in foreign currency than they did previously. Thus they are less attractive than they were previously.Let’s consider the effect of this on inflation. Foreign goods cost less which is positive for inflation. Second there is downward pressure on prices of locally produced goods so that companies can compete in foreign markets.Thus a strong currency should be good for inflation.Equally you can turn this argument around and see that a weak currency can increase inflation. Thus if a central bank is concerned about inflation - which most are – then the central bank will be concerned about the level of its currency. A central bank may intervene in the foreign exchange market in a couple of different ways. These are called sterilized and unsterilized foreign exchange interventions.Definition – an unsterilized foreign exchange intervention describes when the central bank buys/sells foreign assets in exchange for US currency. Let’s look at some T-accountsLet’s have a starting T-Account for the FedAssetsLiabilitiesT-Bills$1bnReserves$1bnT-Bonds$1bnCurrency in Circulation$1bnAt this point the monetary base is $2bn.Let’s say the Fed decides to buy $1bn of German Bunds. They can create $1bn in US currency to make the purchase, exchange the dollars for euros and buy the assets. The new T-account will look like:AssetsLiabilitiesT-Bills$1bnReserves$1bnT-Bonds$1bnCurrency in Circulation$2bnBunds$1bnThe new monetary base will be $3bn. They could also “pay” for the assets through reserves. Thus the Currency in circulation could remain the same but the reserves change. Irrespective of how they do this this will cause the monetary base to increase. This is called an unsterilized foreign exchange intervention.There are several effects of an unsterilized interventionThe Fed is selling USD and buying EUR. This should weaken the USD.The Fed is increasing the monetary base and through this the money supply. This should weaken the USD due to an increased money supply.As this is an open market intervention it has increased the supply of reserves. This should push down the Fed funds rate, which influences other short term rates which should be negative for the dollar.The problem with an unsterilized foreign exchange intervention is that it is both targeting changes in the exchange rate as well as affecting domestic monetary policy. The agreed upon solution is to make a sterilized foreign exchange intervention. The Fed will remove the impact on the monetary base by selling US assets. For example they could sell 1bn of T-bills. After selling the T-bills their T-account will look like:AssetsLiabilitiesT-Bills$0Reserves$1bnT-Bonds$1bnCurrency in Circulation$1bnBunds$1bnThe Monetary Base will be $2bn just as it was before the intervention.This sort of intervention is a little more complicated to figure out what might happen. In fact it is a much more complicated situation and the desired effects do not always happen.Let’s start by thinking about major currencies only – say EUR, GBP, JPY and USD. Think about the supply of money relative to the supply of assets. In each of these currencies the supply of assets is huge relative to the monetary base:the NY stock exchange is worth something like 14tr. Worldwide bond markets is worth 82tr outstandingThe monetary base is roughly 2.5tr USD.Let’s define the “portfolio balance channel.” This is the way in which an intervention could change the relative supply of domestic vs foreign assets. Namely by buying EUR assets and selling USD assets this will change the mix of assets available for investors. In order to have an effect in a major currency one would need to have a massive intervention.The way in which a sterilized intervention might move the exchange rate is through the signaling channel. This is the central bank communicating to the markets its policy intentions. It might carry out sterilized interventions and communicate to the market that it views the currency as too strong. If the central bank is credible then this can have the effect of weakening the currency. These interventions are not guaranteed to work. It is difficult for a central bank to work completely against market fundamentals. For example in 1987 there was an agreement to have coordinated intervention across central banks to strengthen the USD vs the Deutschemark. This failed in part that because Germany increased interest rates significantly and weaker trade figures in the US caused a sharp deterioration in the USD.Balance of PaymentsThe balance of payments is a bookkeeping system for recording all receipts and payments that have a direct bearing on the movement of funds between a nation (private and government) and foreign countries.The current account – These are international transactions that involve currently produced goods and services. The current account includes data on:Imports and exports of goods – (the trade balance -$378bn in 2009)Imports and exports of services – financial, legal, medical etc (132bn in 2009)Income on financial assets (+121bn in 2009)Transfers between countries. Foreign aid, remittances, international gifts etc (-125bn in 2009)Thus the current account showed a deficit of -250bn in 2009.The Capital Account – This includes:Foreign direct investment – for example the purchase or development of a Toyota plant in the USInvestment in business, real estate, stocks and bonds (these are often put in what is called the Financial Account)Other financial transactions – for example, cross border bank accounts.The outstanding item are government assetsGovernment assets including foreign reserves, goldThe sum of the current account and the capital account is the official reserve transaction balance (net change in government international reserves).In 2009 the capital account was $140m. Thus 140m more capital flowed into the United States then flowed out.This means that the official reserve transactions balance was -250bn+140m = -$249.86 Let’s think about a few examples to get our heads around these numbers.First – What happens if I import $1m of BMWs from Europe to the United States. The $1m of goods is part of the current account (the first part called the trade balance). As everything must balance it must be the case that this 1m shows up in the capital account – the European company that sells me the cars might put the funds in a US bank account (the cross border bank account) or it must show up in the shows up somehow in the official reserve transaction balance.I need a bit more work here.There are really two ways of thinking about a current account deficit. In one case if it is financed by the capital account then a country is foregoing capital assets for goods and services. If a current account deficit is borrowing money to fund its current account deficit then it would appear as an inflow of foreign capital in the balance of payments.Looking at the data in 2009 it would appear that we are borrowing money to fund the current account deficit.Exchange Rate MechanismsThere are two primary regimes for exchange rates currently:Fixed exchange rate regimes – the value of a currency is pegged relative to the value of another currency or basket of currenciesFloating exchange rate regimes – the value of a currency is allowed to float relative to the value of other currencies.Fixed Exchange Rate RegimeThe first thing to think about in an fixed exchange rate regime is that there must be an anchor currency. For example the HKD is effectively a fixed exchange rate regime vs the US dollar. Let’s first look at supply/demand for the HK Dollar.Bring up slideLet’s look at a situation where demand for HK assets increase. A typical example might be that interest rates in HK increase. Note this would be a situation where one would expect there to be buying pressure on the HK dollar. For example, if I knew that HK was going to maintain a peg against the US dollar and interest rates in the US were 1% and interest rates in HK were 5% then I would be happy to take my US dollars and invest in a HK bank account @5% and then change my HK dollars back into US dollars. This would increase demand for HK assets and thus the currency would be under-valued. The central bank in HK would then be forced to sell HKD in an unsterilized way in order to counteract the demand. If you think about what an unsterilized intervention would do to interest rates is to push them down. If the central bank sold enough HKD then the effect would be to reduce interest rates to match US interest rates. Clearly going from 5% to 1% is quite a large distance.If a country’s currency is undervalued then in order to maintain a peg against another currency then the central bank must keep selling HKD and buying foreign currency – thus gaining international reserves.This works in both directions. Basically a country that pegs its currency to a larger country loses control of its monetary policy. If a larger country pursues a contractionary monetary policy this would lead to lower inflation expectations in the larger country and thus cause an appreciation of the larger country’s currency relative to the smaller country’s. The smaller country would thus find its currency overvalued and will have to sell the anchor currency and buy its own currency.If the smaller country ran out of foreign reserves to sell then it would have a problem. The Exchange Rate MechanismIn DATE the countries of Europe entered into the exchange rate mechanism as a precursor to the introduction of the euro. Every currency was allowed to fluctuate in a narrow band against each other. After German reunification in October 1990 the Bundesbank with concern about inflation which had been below 3% before 1990 and had gone up to near 5% in 1992. They raised interest rates significantly (CAN I FIND A GRAPH OF GERMAN INFLATION AND GERMAN INTEREST RATES AS WELL AS BRITISH POUND INFLATION AND INTEREST RATES). BRING UP SLIDE.So we have our supply and demand out of line. In order to maintain the exchange rate at the agreed level either the UK would have had to pursue a contractionary monetary policy along with the German policy or would have needed Germany to pursue a looser policy.The catch was that the Bundesbank had the primary goal of fighting inflation and the British who were facing their worst recession since world war II were unwilling to pursue a contractionary policy to prop up the pound. In the end the Bank of England intervened and raised their lending rate from 10% to 15%.On Black Wednesday September 16, 1992 the British accepted defeat and pulled the pound out of the ERM and allowed the pound to depreciate by 10%.If we go back to the balance of payments we see that foreign exchange crises involve significant changes in the central bank’s holding of international reserves.How did China accumulate over $2tr of international reserves.Bretton WoodsAfter World War II the victors set up the Bretton Woods system. In this system the dollars was convertible into gold at $35 dollars an ounce. The Exchange Rate MechanismPart 1 – An overviewPart 2 – The exchange rate mechanism collapse in 1992 – this is probably straightforward to go through….Part 3 – Looking at Balance of Payment issues US and Southern Europe perspectivesPart 4 – Capital Controls and why there is interest in themChapter 13 - The Stock MarketGeneral Overview – mechanics of buying/selling stocks – maybe a bit about the order book. Do I want to mention electronic trading etc? Valuing stocks – different techniquesChapter 17 – Banking and the management of Financial InstitutionsA couple of clasesChapter 19 – Banking Industry if we can make it…Commercial Banks – Investment Banks - ................
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