Balance of Payment (BOP) and Foreign Exchange Rates

• At the end of this topic, students are able to:– Explain the concept of BOP and exchange rates– Apply the concept of BOP and exchange rate in

economic issues.

• Sub-topics covered:– BOP, its structure, implications and improvement of

BOP deficits.– Foreign exchange rates, FER equilibrium and

effects of FER on the economy/BOP.

Introduction• Interdependence of the present economies.

• Economic events in one country or region may have significant repercussions on the economies of other nations.

• Examples, financial crisis in Thailand in 1997, spread rapidly to other countries – Southeast Asia and East Asian countries; subprime mortgage crisis in the U.S. in 2008 felt by other regions, including E.U.

• BOP shows the “health” of a country’s economy in relation to another country or countries.

BALANCE OF PAYMENT (BOP)

• BOP is the record of a country’s financial transactions in goods, services and assets with the rest of the world as well as the record of a country’s supply (sources) and demand (use) of foreign exchange (foreign currencies) (Case et al. 2012, p.720).

• It records a country’s international financial transactions in 2 broad accounts, i.e. (1) the current account; and (2) the financial account and capital account in a given period of time.

Structure of BOP

….. Structure of BOP 1) Current Account=

a. Trade Account (X-M of Goods) +

b. Services Account (X-M of services) +

c. Income (from investment – plants, real estate, securities)

d. Transfer Payments (gifts, foreign aid by government, NGO, individuals etc.

2) Financial Account = Differences between sales of assets to foreigners and purchases of assets held abroad; e.g. Malaysian government assets abroad, Malaysian private assets (real estate direct investment, securities etc)

3) Capital Account = Capital transfers that result in a change in the stock of assets: mostly capital transfers (e.g. debt forgiveness); other minor items non-financial non-produced (eg. copyrights etc).

HOMEWORK: Get the last 3-year Malaysian BOPs and analyse them.

BOP Deficits

• Current Account, Capital Account and BOP can be surplus or deficits.

• Implications of deficits/negative BOP: – Deterioration of foreign reserve– Increase in foreign debt to finance imports.– Depreciation in foreign exchange rate.– ↓ economic growth and ↑ unemployment rate.

How to improve BOP Deficits

• Use gold and foreign currencies reserves• Discourage imports:

– tariff, quota, embargo– Foreign currency control– Increase interest rate

• Promote exports• Campaign to use/ buy local prooduct• Devaluation: reducing the value of local currency

against foreign currencies. E.g.: USD1 = RM3.80 to USD1 = RM4.00. This ↑ exports and ↓ imports.

FOREIGN EXCHANGE RATES (FER)

• What is FER

• DD & SS for foreign exchange

• Shifts in SS and DD for foreign exchange

• Flexible versus Fixed exchange rates

• FER= the price of one currency in terms of another nation’s currency. For example: USD1 = RM4.00 or RM1 = USD0.25

The exchange rate for any nation’s currency is determined by international forces of demand and supply.

DD & SS for dollars (USD):Dollars (USD) are demanded by foreigners who seek to purchase (import) US goods, services, and assets.Dollars are supplied by US residents who need foreign currencies to buy (import) foreign goods, services, and assets.

(We will focus on the market in which US dollars are traded for ringgit)

The demand for dollars (supply of RM) - from Malaysians•Firms, households, or governments import US goods into Malaysia.

• Malaysian citizens traveling in US.

•Holders of ringgit who want to buy US stocks, bonds or other financial instruments

• Malaysian companies that want to invest in US•Speculators who anticipate a rise in the value of dollar relative to ringgit.

The supply of dollars (demand for RM) - by Americans•US firms, households, or governments import Malaysian goods into US.

•US citizens traveling in Malaysia,

•Holders of dollars who want to buy Malaysian stocks, bonds or other financial instruments.

•US companies that want to invest in Malaysia.

•Speculators who anticipate a rise the value of ringgit relative to dollar

Demand for Foreign Currency (USD)

• DD for USD arises when Malaysians import G&S from or invest in US.

• E.g. Malaysian traders import goods from the US worth USD100,000. If USD1=RM3.00, this trader will demand USD100,000 and supply RM300,000.

• If USD ↑ in value to USD1=RM3.50, US imports are more expensive, i.e. RM350,000. It leads to ↓ in imports from US, ↓Dd for USD.

DD for USD – from Malaysian traders

RM/USD

RM3.50

RM3.00

D

D

Quantity of dollarsQ1 Q2

Demand for dollars

Supply of Foreign Currency (USD)• SS of USD exists when the US residents import

G&S from or invest in Malaysia. • If Americans import RM300,000 worth of goods

from Malaysia, they supply USD100,00 (if USD1=RM3.00) to finance the import.

• If, exchange rate change to USD1=RM3.50, they supply < USD100,000. Malaysian goods are cheaper, ↑M from Malaysia, SS USD↑

SS of dollars (USD) – from Americans

S

S

RM/USD

RM3.50

RM3.00

Quantity of dollarsQ1 Q2

Supply of dollars

The Market Equilibrium Value of the DollarSupply of dollars

Demand for dollars

Quantity of USD

RM/USD

RM3.00

Q1

Market equilibrium value of the exchange rate = the exchange rate that equate the quantities of the currency supplied and demanded in foreign exchange market.An excess dd for dollars will cause the dollar to appreciate against ringgit.An excess ss of dollars will lead to a depreciating dollar.

Appreciation of a currency = the rise in value of one currency relative to another.Depreciation of a currency = the fall in value of one currency relative to another.

Excess SS of USD

Excess DD for USD

FACTORS AFFECTING EXCHANGE RATE

(shift in dd and ss curve).

Factors influencing the demand for dollars:1.An increase in the taste for US goods by foreign customers.

2.An increase in real GDP abroad, thus more demand for imports from US.

3.An increase in the real interest rate on US assets, which would make US assets more attractive to foreign savers. To acquire US assets, foreign citizens would demand more dollars.

4.Inflation: if inflation occurs in Malaysia, it will make the price tag on US goods relatively lower for Malaysian importers.

S

D2D1

RM3.00

RM3.50

The demand for dollars will increase, thus shift the demand curve to the right. This causes the price of dollar to rise (USD will appreciate), or RM will depreciate.

RM/USD

Quantity of dollars

Factors influencing the supply of dollars: 1.An increase in the taste for Malaysian products. US importers will increase their supply of dollars.

2.An increase in US real GDP, thus more demand for imports from abroad.

3.Inflation occurs in US, it will make the price tag on foreign products relatively lower for US importers.

4.An increase in the real interest rate on Malaysian asset. This means more Malaysian asset Americans will choose to hold. To purchase additional Malaysian assets, US households and firms will supply more dollars.

S1S2

D

RM/USD

RM4.00

RM3.80

Quantity of dollarsQ1 Q2

The supply of dollars will increase, thus shift the supply curve to the right. This causes the price of dollar to fall.

Flexible versus Fixed Exchange Rates:For the most part, we have been discussing a system of flexible (floating) exchange rates.

Flexible exchange rate = rate determined by the forces of dd & ss without government intervention. The rate varies according to the dd & ss of the currency in the forex market.

Fixed exchange rate = rate of exchange between currencies pegged and maintained by the central bank’s on going purchases and sales of currencies.

Floating FER

• Floating FER is an exchange rate determined by the market forces.

• Eo = Initial equilibrium• When Dd for US goods (M↑),

Dd for USD↑ (Do to D1), USD ↑ and RM↓. Vice Versa.

• This floating FER regime creates:- economic instability- currency speculation- High risks for exporters and

importers in the long run.

Do

S

D1

RM/USD

RM3.00

RM3.50

Q of USD

Qo Q10

Eo

E1

Effects of Floating FER on BOP

• Eo = Initial equilibrium. • When Malaysian ↑M from

US, Dd for USD↑ (Do to D1); US BOP surplus by EoE1; USD↑; US exports more expensive; Dd for US goods drops from E1 to E2.

• In contrast, RM↓ and Malaysia goods cheaper; US ↑M for Malaysia goods, ↑Ss of USD from Eo to E2. New Eq.= E2

• Thus, Malaysia and US BOPs are always in equilibrium between Eo and E2.

Do

D1

SRM/USD

0 Qo Q1

Eo E1RM3.00

RM3.50E2

Q of USD

Fixed FER

• An exchange rate determined by the government through buying/selling of currencies.

• Initial FER equilibrium at E. • If the Malaysian Government sees this

rate is not suitable, new rate can be as follows:1. RM less valued = RM < market

value = RM depreciation. - To encourage exports and discourage imports – RM depreciation makes Malaysian products relatively cheaper than foreign goods.

2. RM over valued = RM > market value = RM appreciation.

- To discourage speculation on RM (buying and selling RM for profit).

RM/USD

Quantity of dollar

RM3.00RM2.50

RM3.50 RM less valued

RM over valued

D

S

0 Q1

USD1=RM3.50 or RM1=USD0.286

USD1=RM3.00 or RM1=USD0.333

USD1=RM2.50 or RM1=USD0.400

E

Effects of Fixed FER on BOP

• Fixed FER would not achieve equilibrium BOP.

• At USD1=RM3.50: Ss of USD>Dd for USD (X>M for Malaysia). To fix this rate, the Government uses RM reserve to buy USD. To achieve, equilibrium, USD should ↓.

• In contrast, to remain at USD1=RM2.50, the Government sell USD reserve to finance the BOP deficit (imports).

S

D

RM/USD

RM3.00

RM3.50

RM2.50

Q of USD

BOP surplus

BOP deficit

RM undervalued

RM overvalued

0

(X>M)

(M>X)