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20. Exchange Rate and the Balance of Payment

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Chapter 20 : main menu

20.1 Exchange rates

Theory in Life 20.1Progress Checkpoint 1

20.2The effects of exchange rate movement on trade

20.3The linked exchange rate system

20.4Balance of Payments account

Theory in Life 20.2Concept Explorer 20.1Concept Explorer 20.2Theory in Life 20.3Progress Checkpoint 2

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Theory in Life 20.1 How the linked exchange rate is maintained(This part is not required by the HKCEE. It can be skipped without loss of continuity).Under the currency board system, it is interest rates rather than the exchange rate of HK dollar which adjusts to inflows or outflowsof funds.

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Upward pressure on

the HK dollar

exchange rate

Currency board sells HK dollars

Interestrates

decrease

Monetarybase

expands

Market participants

buy HK dollars

Capitalinflow

Currency board buys HK dollars

Downward pressure on

the HK dollar

exchange rate

Monetarybase

contracts

Interestrates

increase

Capitaloutflow

Market participants

sell HK dollars

The exchange rate betweenHK dollar and US dollar is stabilized

Fig. 20.1 The automatic mechanism to maintain the linked exchange rate.

Theory in Life 20.1

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Theory in Life 20.1 Reminder :The exchange rate can also be stabilized through an ‘arbitrage and competition’ mechanism among the note-issuing banks. Therefore, the expansion (contraction) in the monetary base leads to a decrease (an increase) in interest rates for Hong Kong dollar. This creates the monetary conditions that counteract the original capital flow automatically. Hence the exchange rate between HK dollar and US dollar can remain stable.

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Progress Checkpoint 1 Q20.1 Given the following exchange ratio between British pound and Swiss Franc (SFr): £5 = €7  (a) What is the exchange rate of £1 in terms of €? (b) What is the exchange rate of €1 in terms of £?  (a) The exchange rate of £1 is €1.4. (b) The exchange rate of €1 is £0.7143.

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Progress Checkpoint 1 Q20.2 The following shows the exchange ratios of the currencies of Country A ($A) and B($B) on two dates :

1st August 2002 1st August 2003

$A 3 = $B 1 $A 2= $B 1

How did(a) the exchange value of $A change relative to $B?(b) the exchange value of $B change relative to $A?

(a) the exchange value of $A increased relative to $B, i.e. $A has appreciated against $B.(b) the exchange value of $B decreased relative to $A, i.e. $B has depreciated against $A.

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Progress Checkpoint 1 Q20.3 Given the following exchange rates between Japanese Yen (¥) and Hong Kong dollars (HK$) :

1st July 2001 1st July 2002

¥1,000 = HK$65 ¥1,000 = HK$70

How does EACH of the following change in the above period?

(a) the exchange value of HK$ relative to ¥?(b) the exchange value of ¥ relative to HK$?(c) the price and volume of goods exported from Hong Kong to Japan?(d) the prices and volume of goods imported from Japan into Hong Kong?(e) the total expenditure (in HK$) on imports from Japan to Hong Kong?

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Progress Checkpoint 1 (a) the exchange value of HK$ relative to ¥ falls, i.e. HK$ depreciates against ¥(b) the exchange value of ¥ relative to HK$ rises, i.e. ¥ appreciates against HK$(c) the price of goods exported from Hong Kong to Japan falls; the volume of exports from Hong Kong to Japan rises(d) the prices of goods imported from Japan into Hong Kong rises; the volume of imports from Japan into Hong Kong falls(e) there is uncertain change in the total expenditure (in HK$) on imports from Japan to Hong Kong. If HK’s demand for Japanese imports is elastic, the total expenditure will fall. If it is inelastic, the total expenditure will rise.

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Theory in Life 20.2 Finding the balance of tradeThe following table shows the composition of Hong Kong’s Gross Domestic Product (GDP) in 1990 and 2000:

Ratio to total GDP

GDP components 1990 2000

Private consumption expenditure 68% 75%

Government consumption expenditure 10% 18%

Gross domestic fixed capital formation 20% 17%

Changes in stocks 10% -3%

Exports of goods 50% 132%

Imports of goods 75% 113%

Exports of services 46% 92%

Imports of services 29% 118%

Source : Hong Kong Census and Statistics Department

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Was there a trade deficit or surplus in 1990 ? in 2000? Suggest a reason for these. In 1990, since the exports and imports of goods are 50% and 75% of the 1990 GDP, the value of exports is less than that of imports of goods. Hence there was a trade deficit. In 2000, since the exports and imports of goods are 132% and 113% of the 2000 GDP, the value of exports is greater than that of imports of goods. Hence there was a trade surplus. One reason for the change is the expansion of the trade in China. If China exports more goods to the western countries through Hong Kong, Hong Kong’s re-exports of goods will increase. This may lead to a trade surplus in 2000.

Theory in Life 20.2

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Concept Explorer 20.1Determining the balance of tradeThe following graph shows an economy’s growth rates of exports and imports of goods from 1980 to 2001.

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002Year

Growth rate (%)

Growth rate of exports of goods

Growth rate of imports of goods

Fig. 20.2 The growth rates of exports and imports of goods.

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Between 1992 and 1997, the growth rate of exports of goods is greater than that of imports of goods. Under what condition can we say that there was a trade deficit? The growth rates of exports and imports of goods are different from the values of exports and imports of goods. If the initial values of imports of goods is significantly greater than that of exports, and such difference is not offset by a larger growth rate of the exports of goods, then in the period 1992 and 1997, it is possible to have a trade deficit.

Concept Explorer 20.1

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Concept Explorer 20.2The sub-classification of the capital and financial account The following shows how different economic transactions are recorded in the capital and financial account. As the HKCEE does not require students to learn such account in details, this section can be skipped without loss of continuity.

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Concept Explorer 20.2Capital Accounta. Capital transfers

This includes the transfer of ownership of a fixed asset or forgiveness of a liability ( 債務減免 ). 

Examples:1. A businessman in HK donates some machines to an agricultural organization in the Philippines. [debit]2. An Australian company forgives a loan owed by a HK company. [credit]

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Concept Explorer 20.2b. Non-produced and non-financial assets

This includes the transactions of tangible assets ( 有形資產 ) that are not actually produced (e.g. land) and of intangible assets ( 無形資產 ) (e.g. patents, copyrights, trademarks and franchises).

 Examples :1. A US company buys a piece of land in HK. [credit]2. A HK garment firm buys the patent of a fashion design from a Paris firm. [debit]3. A HK film production company sells the copyright of a movie to a US firm. [credit]4. A HK manufacturing firm buys a trademark from a toy company in Japan. [debit]5. A HK telecommunication firm buys a franchise from a French company for providin

g 3G mobile phone service in Europe. [debit]

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Concept Explorer 20.2

Financial Accountc. Direct or Real Investment

This includes external investment in which an investor of an economy acquires a lasting interest of an enterprise located in another economy. External investment in real estate is also a form of direct investment.

 Examples :1. A HK resident buys an apartment in Malaysia. [debit]2. A US bank invests buys a tower in HK. [credit]3. A HK resident buys 10% of the shares of a publicly listed company in the

Mainland of China. [debit]

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Theory in Life 20.3How different economic transactions are recorded in the balance of payments How is each of the following economic transactions recorded in the balance of payments of Hong Kong?

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Theory in Life 20.3Economic transactions In which account is it recorded? Is it a credit or a

debit entry?

(a) A Hong Kong resident receives dividend from the shares issued by a company in Mainland China.

External factor income flow in the current account

credit

(b) A Hong Kong music production company buys the copyright of a song from a Japanese music firm.

Capital and financial account debit

(c) A Hong Kong advertising firm borrows a loan from a company in Singapore.

Capital and financial account credit

(d) A US technology firm sets up a branch in Hong Kong. Capital and financial account credit

(e) A Japanese tourist travels by tram in Hong Kong. Invisible trade in the current account credit

(f) A Hong Kong resident purchases some warrants of a bank in London.

Capital and financial account debit

(g) A Hong Kong resident donates some money to the victims of an earthquake in Iran.

Current transfers in the current account debit

Table 20.3 How different economic transactions are recorded in the balance of payments.

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(h) A British investor purchases 0.0001% of the shares of the Mass Transit Railway Corporation Ltd. Capital and financial account debit

(i) A Hong Kong resident purchases a notebook computer from Japan.

Visible trade in the current account debit

(j) A Hong Kong firm forgives a loan owed by an Indian firm.

Capital and financial account credit

Economic transactions In which account is it recorded? Is it a credit or a debit entry?

Table 20.3 How different economic transactions are recorded in the balance of payments.

Theory in Life 20.3

Reminder :If an economic transaction is not recorded in the current account as visible trade, invisible trade, external factor income flow or current transfers, then it is recorded in the capital and financial account.

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Progress Checkpoint 2Q20.4 State how EACH of the following item will be recorded in the current account of the balance of payment of Country X:  (a) The government of Country X donates of a sum of money to Country A (b) A resident of Country X receives wages from working in a company in Country X for 3 months (c) A firm in Country X sells some manufactured goods to Country C. (d) A securities company of Country D provides stock trading services to a tourist from Country X  (a) A debit entry under current transfers (b) A credit entry under external factor income flows (c) A credit entry under visible trade (d) A debit entry under invisible trade

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Progress Checkpoint 2Q20.5 Given the following data about the balance of payment components of HK:

HK$ million

Domestic exports of goods 650

Re-exports of goods 230

Imports of goods 420

Exports of services 1,520

Imports of services 1,840

External factor income inflow 2,450

External factor income outflow 2,170

Current transfer inflow 320

Current transfer outflow 770

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Progress Checkpoint 2(a) Calculate the value of exports of goods.(b) Calculate the value of retained imports.(c) Calculate the balance of trade and state whether it is in surplus or deficit.(d) Calculate the balance of invisible and state whether it is in surplus or deficit.(e) Calculate the value of net external factor income inflow.(f) Calculate the current account balance and state whether it is in surplus or deficit.

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Progress Checkpoint 2(a) Exports of goods = Domestic exports + re-exports

= HK$(650 + 230)m = HK$880 m.

(b) Retained imports = Imports of goods – re-exports of goods = HK$(420 – 230) m = HK$190 m.

(c) Balance of trade = Exports of goods – imports of goods = HK$(880 – 420)m = HK$460m (surplus).

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Progress Checkpoint 2(d) Balance of invisible trade = Exports of services – imports of services

= HK$(1,520 – 1,140)m = -HK$ 320m (deficit).

(e) Net external factor income inflow = External factor income inflow – external factor income outflow = HK$(2,450 – 2,170)m = HK$280m (surplus).

(f) Current account balance = all credit entries – all debit entries

= HK$[(650 + 230 + 1,520 + 2,450 + 320) – (420 + 1,840 + 2,170 + 770)]m= - HK$30m (deficit).

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Q20.6 A current account deficit implies that balance of trade, balance of invisible trade, net external factor income inflow and net current transfers are all in deficits. Do you agree?

 No. A current account deficit only implies that the sum of all credit entries in the account is less than the sum of all debit entries. It is possible that some sub-items (e.g. balance of trade, net current transfers, etc) are in surplus. But it will be impossible for all sub-items to be in surplus.

Progress Checkpoint 2

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Q20.7 For each of the following, name the account within Country A’s balance of payments will be affected, and state whether it will be recorded as a credit or debit entry.

(a) A resident of Country A watches a concert in Country X.(b) A firm in Country A donates some medical equipment to a hospital in Country X.(c) A resident of Country A receives a remittance from a relative in Country X.(d) A resident of Country X receives interest from his deposits in a bank in Country A.(e) A resident of Country X purchases some bonds issued by the government of Country A.(f) A resident of Country X purchases an MP3 player produced by a firm in Country A.

 (a) A debit entry in the current account (invisible trade)(b) A debit entry in the capital and financial account(c) A credit entry in the current account (current transfers)(d) A debit entry in the current account (external factor income flows)(e) A credit entry in the capital and financial account(f) A credit entry in the current account (visible trade)

Progress Checkpoint 2

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Q20.8 (a) “A balance of payment may be in surplus.”

(b) “A balance of payment account must always balance."

Is EACH of the above statements true or false ?

(a) True. A balance of payment will be in surplus if the sum of all credit entries in the current, capital and financial accounts is greater than that of all debit entries. The official reserve assets will rise, which will be recorded as a debit entry in the balance of payment.

 

(b) True. Because the net change in reserve asset just offsets the overall balance of payment, a balance of payment account which includes the net change in reserve asset must balance on the credit and the debit sides.

Progress Checkpoint 2

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Q20.9 Is it possible for an economy to have a trade surplus and a balance of payments deficit in the same year?

 Yes. It occurs when the economy’s other items in the current, capital and financial (non-reserve) accounts altogether have a deficit, and such deficit is greater than the balance of trade surplus.

Progress Checkpoint 2

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End of Chapter 20