Balance of Payments & Foreign Exchange

FOREIGN EXCHANGE Floating Exchange Rate System

Fixed Exchange Rate System

The Managed Float System

Purchasing Power Parity Theory of Exchange Rate Determination

Guess the CurrencyAustralian $ Canadian $EuroSing $US $Thai Baht

Why use Foreign Exchange?People in different countries speak different languages, doing business in other countries require different monies ($, , , ) as well.

Need to convert from one type of currency to another whenever business crosses international borders.

The currency of another country needed to carry out such international transactions - Foreign Exchange.

Rate at which one currency can be exchanged for another

Determined by DD & SS of S$ in FOREX MarketEXCHANGE RATE

FOREIGN EXCHANGE DD for S$ depends on foreign DD for our goods, services or assets

SS of S$ depends on our DD for foreign goods, services and assets

Foreigners BuyingJapanese to buy Singapores goods, services or assets - have to pay in S$.

need to exchange their currency for the required amount of S$ - increases the demand for S$.

Demand for S$ depends on foreign Demand for the local goods, services or assets

Singapore BuyingSingaporeans to buy Japanese goods, services or asset - exchange S$ for Yen

local car dealer to import Japanese cars- - exchange S$ for the required quantity of to pay

Since we supply S$ in exchange for foreign currency, the supply of S$ is dependant on our demand for foreign currency - depends on demand for foreign goods, services and assets.

Review Question (P 3)Suppose a large car importer in the UK wants to import 3,000 cars from Japan costing 15 billion Yen. What will it do?

REVIEW QUESTION (p.3)

Car importer will shop around banks for best exchange rateBest exchange rate = most Yen/poundThe banks in turn obtain their Yen from Japanese who buy British goods

FLOATING EXCHANGE RATE SYSTEM-LOATING EXCHANGE RATE

Demand for S$Qty of S$Yen/S$Demand for S$100110Q1Q2

Supply of SGDQty SGDYen/ S$100110Q1Q2Supply of S$

FLOATING EXCHANGE RATE SYSTEMFigure 1: DD and SS of S$

DD and SS intersectionER is S$1 = 100 Yen. 100 Yen is required to purchase 1 S$Price of 1 S$ is 100 Yen Value S$ in terms of another foreign currency

Initially D and S intersect => S$1 = 100 YenFigure 2a: Changes in Demand for S$DD for the S$ increase from D to D1At S$ = 100 Yen shortage resultsS$ appreciates. Fall in qty DDed of Spores exports and assets Fall in the qty DDed of S$ Rise in qty DDed for Jap imports and assets Increase in qty SSed of S$ New equilibriumD1 intersects with SS$1 = 120 Yen Shortage of S$ eliminated

Initially D and S intersect => S$1 = 100 YenFigure 2b: Changes in Supply for S$SS for the S$ increase from S to S1At S$ = 100 Yen, surplus resultsS$ depreciatesRise in qty DDed of Spores exports and assets Rise in the qty DDed of S$ Fall in qty DDed for Jap imports and assets Decrease in qty SSed of S$ New equilibriumS1 intersects with DS$1 = 80 Yen Surplus of S$ eliminated

Factors Affecting the DD and SS of a Currency

Foreign DD for the countrys gds, services & assets Similar to factors affecting DD in microDD for a countrys $

Changes in taste and preference of foreigners.

Change in quality of exports

Different inflation rates

Disposable income of foreigners

Import restrictions by foreigners DD for a countrys G+S (trade)

Interest rates: deposits and bonds

Business costs or incentives. SS side reasons e.g. educated & skilled workforce DD side reasons e.g. rising incomes because of strong economic growth. DD for the asset market (Foreign investments)

SS of a countrys $ depends on: Local DD for foreign goods services and assets

Changes in taste and preference of locals Changes in quality of imports Different inflation rates Disposable income levels of localsImport restrictions by locals SS of $ depends on:

Interest rates of foreign assets

Business costs or incentives overseas. e.g. business outlookChange in SS of local currency due to foreign asset market

Appreciation or Depreciation?Depends on the DIRECTION & MAGNITUDE of the shifts in the DD &SS curves of a currency.E.g. If dd S$ ss S$ S$ Depreciates against Yen

REVIEW QUESTION (p.8)Q1

Donations / Humanitarian AidForex speculation. Currency traders buy & sell foreign exchange in an attempt to profit by changes in exch. rates

REVIEW QUESTION (p.8)Q2Fall in DD for S$ and/or increase in SS of S$:

Increases in domestic prices vs. foreign prs.Increases in domestic Y vs. foreign YReductions in domestic i/r vs. foreign i/rWorsening I prospects at home vs. abroad

Freely floating ER: Volatile - fluctuate daily as market conditions changeCountry prefer to fix ER: Eliminate fluctuations Facilitate international trade and investmentsE.g. China RMB &Malaysia RM peg to the US $ previouslyCentral bank intervention needed to fix ER. CENTRAL BANK MUST MAINTAIN SUFFICIENT FOREIGN RESERVES TO DEFEND THE FIXED RATE

Fixed Exchange Rate System

Figure 3: Maintaining an Undervalued Exchange Rate DD for the HK$ increase from D to D1ER fixed at E Shortage of QQ1 of HK$CB of HK need to SS this shortage Sell HK$ for US$ in the FOREX market. Foreign reserves of US$ increase.

HK$ undervaluedHK$ below the free market value To increase value => revalue

Can undervalued currency be maintained? Yes in theoryNo limit to accumulation of foreign reserves In reality, protectionist threats from export markets facing BOP deficit Lower potential SOL as imports are expensive

REVIEW QUESTION (p.10)Chinas X cheaperUSs M more expensiveChinas (X-M) increases leading to a higher trade surplus & foreign reservesRetaliation or threat by US?Keeping Chinas e/r undervalued will lead to an increase in Chinas domestic money SS InflationRef ST 23/4/11 Call for China to curb forex reserves

Figure 4: Maintaining an Overvalued Exchange RateDD for HK$ decrease from D to D ER fixed at ESurplus of QQ Prevent the HK$ from depreciatingCB buy HK$ with foreign reserves. CB will lose foreign reserves.

HK$ overvalued: ER above free market value Lower value => devalue its currency downwards

Not possible have overvalued currency indefinitely: Need to run down on foreign reserves When reserves run out currency forced to devalue

REVIEW QUESTION (p.11)Speculators sold Baht leading to depreciationBank of Thailand defended by selling its foreign currency to buy BahtFixed exchange rate had to be abandoned once foreign reserves ran low

The Managed Float System ER is allowed to fluctuate within an undisclosed band If value of $ is within that band, Central Bank will not intervene

If ER reaches the upper limit/lower limit: Central Bank will sell off or to buy back S$If DD for S$ increase from D to D: Central Bank sell off S$ (in exchange for Yen) Meet the shortage of Q1Q2 Prevent the exchange rate from rising above E1

REVIEW QUESTION (p.12)MAS intervenes to sell S$ for Yen so as to at least meet the shortage of Q1Q2 of S$ & prevent e/r from rising above E1

Enjoy flexibility in exchange rates Avoid sudden massive detrimental fluctuations Large rise in $ value cause exports to be uncompetitive Large fall in $ value cause severe imported inflation Why countries adopt a manage float system?

Managed float regime

S$ pegged against a basket of currencies - major trading partners and competitors

Weights depend on extent of trade dependence

Composition of basket is periodically changed as our trade patterns changeThe Singapore Exchange Rate System

Exchange rate Regimes / SystemsFixed ER SystemFreely FloatingER SystemManaged FloatSystem

ER determined by the forces of demand & supply

No government intervention

ER is pegged / fixed at a given rate against (usually) the US$Government intervention

ER is allowed to fluctuate within a certain band

Periodic Government intervention

Purchasing Power Parity Theory of Exchange Rate Determination

Assumption of unrestricted trade & fully flexible ERsPredicts that ER in LR reflects different price level between countries.ER adjust in LR to equalize purchasing power between currenciesPurchasing Power Parity Theory

Foreign exchange price of the S$ (measured in Yen /S$) = Price level in Japan Price level in Singapore

Basket of goods costs 10000 Yen in Japan & S$50 in Spore1 Singapore dollar worth 200 yen. PPP predicted LR ER is S$1 = 200 Yen If the same basket increase to 12500 Yen in Japan But price in Spore still = S$50 in Singapore, Predicted ER is 250 Yen = S$1. Adjustment mechanism of PPP theory Prices in Japan rise but Spore prices unchangedSingapore goods relatively cheaperJapanese import more from Spore Increase DD for S$S$ appreciate. Appreciation continues until prices are equalized in both countries Example:

In general,Higher inflation rate causes depreciation Fall in the internal value leads to fall in the external value

1.Many goods are not traded internationally

BUT: Higher prices of non-traded products will raise cost of living Higher wages and hence higher price of traded products results Criticisms of PPP theory

2.Distortions by taxes, subsides, transport costs

BUT: Taxes, subsidies, transportation on overall cost are usually quite smallCriticisms of PPP theory

3.International capital movementsBUT: Fluctuations ST In LR, financial markets adjust to true economic performance of the country Hence ER depends on price and output levels in the real sector in LR Criticisms of PPP theory

Statement of international transactions over a year. Records the international inflows and outflows of S$Balance of Payments

Debit item (denoted with negative sign)Purchase foreign goods, services or assets - Exchange S$ for foreign currency - S$ flows outOutflow of S$

Credit item (denoted with positive sign)Foreigners purchase our goods, services and assets Pay us in S$ Inflow of S$ Inflow of S$

BOP made up of:

Current account Capital account Balancing itemTotal currency flowOfficial financing account

Visible Balance Exports and imports of goods

Invisible BalanceExports and imports of services, Property (asset) income paid to and received from abroad Unilateral transfers paid to and received from abroad

Current Account

ST K flows-sales & purchase of liquid assetsLT K flowsPortfolio InvestmentsDirect InvestmentsCapital Account

Balancing ItemErrors and omissions or statistical discrepancies - occur as information needed for the accounts are from millions of reports

Total Currency Flow = Current Account + Capital Account + Balancing Item

TCF shows whether there is a net inflow or outflow

Under managed float system:TCF = 0BOP in equilibrium - no pressure on the currency to appreciate or depreciate since the total demand for the currency (represented by inflow) is equal to the supply (represented by outflow).

TCF = 0 BOP equilibrium.TCF > 0 BOP surplus (+)Due to undervalued currency Qd S$ > Qs of S$MAS sells S$ & increase foreign reserves.TCF < 0 BOP deficit ( - )Due to overvalued currency Qs of S$ > Qd of S$MAS buys S$ & decreases foreign reserves

In reality, all countries manage their ER

Central banks try to prevent their ER from sudden and severe fluctuationForex transactions by Central Bank recorded under OFAOfficial Financing Account

-ve OFA means MAS losing S$ but gaining foreign reserves+ve OFA means MAS gaining S$ but losing foreign reserves

BOP surplus (+) due to Spore exports.Excess DD for S$ => shortage of S$To prevent appreciation of S$,MAS sells S$ to for foreign exchangeAccumulation of foreign reserves-ve OFARelationship between TCF & OFA

Table 1 Balance of Payments Singapore 2010

S$ millionA Current Account Balance67,430.8 Goods Balance63,596.3 Exports of Goods487,972.1 Imports of Goods424,375.8 Services Balance21,606.1 Income Balance-11,221.2 Net Current Transfers -6,550.4B Capital and Financial Account Balance-9,458.0 Net Capital Account -454.5 Net Financial Account*-9,003.5 Direct Investment25,768.4 Portfolio Investment-29,815.6 Other Investment-4,956.3C Net Errors and Omissions -492.3D Overall Balance (A+B+C)57,480.5E Official Reserves (Net)-57,480.5

Drawing on Official Reserves (positive sign)Addition to Official Reserves (negative sign )

Always balanceWhen all the individual accounts (Current, Capital and Official Financing) are summed up together with the balancing item, the total sum must be equal to zero since any discrepancy is accounted for by the balancing item.

Current Account+Capital Account+Balancing Item+Official Financing Account=Zero(A)(B)(C) (E) (Refer to table 1)

BOP Adjustments in a Floating Exchange Rate System

Any BOP disequilibrium is only temporary

ER adjusts to bring BOP back to equilibrium stateFloating Exchange Rates

Qty of S$Yen Per S$SS$

EoDS$

E1SS$1Q1Q2Rise in DD for Japanese MIncrease in SS of S$ to SS$1Temporary BOP deficit of Q1Q2S$ depreciate DeficitQ3

As S$ depreciate Singapores products and assets become cheaper Increase inflows into CA & KAForeign products and assets more expensive Reduced outflows from our CA and KA

Increased inflows and reduced outflows BOP deficit will decrease. Depreciation stop when ER reaches E1. Qty DDed = Qty SSed (at Q3) BOP reach new equilibrium.

Marshall-Lerner ConditionAS long as the sum of the price elasticity of demand coefficients for exports & imports is greater than one, then a fall in the exchange rate will improve the BOP & a rise will worsen it.

Persistent BOP surplus is sustainableCentral bank merely accumulates foreign reservesPersistent BOP deficit may not be sustainableMay be forced to devalueFixed Exchange Rate

Q2

Increase in DD for Japanese MSupply of S$ increase to SS$1Surplus of S$ = Q1Q2 (BOP deficit)To fix ER at E, MAS purchases the excess S$ Deficit

BOP deficit implyER is overvaluedMAS can maintain ER if it has sufficient foreign reservesIf run out reserves it mustBorrow from IMF or from other countryOR forced to devalue S$

In LR BOP deficit may clear by itselfMAS buys back the S$ => Ms will fallContractionary effect on economyReal income and price levels fallDD for foreign products and assets fallForeign DD for Singapores products and assets riseBOP deficit eventually clears

Balance of Payment Problems

I.Prices of gds & services at home & abroadII.Incomes of consumers at home & abroadIII.The foreign exchange rates e.g. S$ appreciates XMIV.Taste :Consumers preferences for foreign & domestic gds and services due to quality or other reasons. E.g. preference for holiday destinations.V.Other factors like transportation costs or government policies (e.g. tariffs)Causes Current Account disequilibrium

Capital Account disequilibrium ( short-term & long-term capital flows)

(a)Real interest rates paid on foreign and domestic assets(b)Perceived risks of holding foreign assets(c)Business expectations (d)Other factors e.g. govt. policies

A fall in equilibrium national incomeHigher living standardIncreased liabilities to foreigners or decreased ownership of domestic assets

Current Account Deficit

A rise in YeDepression of domestic living standardsc) Inflation (X-M)AEdd-pull inflation (near full employment)c)Retaliation e.g. US vs Japan US vs ChinaCurrent Account Surplus

Capital Account DeficitLess employment opportunities for the domestic economy

Capital Account Surplusexcessive expansion of aggregate demand or macroeconomic overheating - Inflationary pressure - appreciation of currency - widen current account deficitsS-t capital inflows increases financial volatilityHowever, FDI increases output and employment if economy is below full employment.

Overall BOP DeficitDrawing down on reserves

Interdependence through trade

Interdependence through financial marketsImpact of Globalisation

BOP Application QuestionsCurrent Account Trade balance(less exports due to higher prices export earnings depend on price elasticity of dd; more imports for cheaper alternatives) inflow outflowBOP deficit demand supply

Component of BOP AffectedChanges toInflow / OutflowEffect on BOP (i.e. deficit or surplus )Impact on DD/and SS of Domestic CurrencyAn increase in the domestic inflation rate

BOP Application QuestionsCapital AccountDD-pull inflation: If mild inflation, may boost FDICost-push inflation:Foreign investment (long term capital inflow) may fall as cost of production risesShort term capital may be affected due to speculation inflow inflowoutflowBOP deficitMild inflation: demandCost-push inflation: supply demand

Component of BOP AffectedChanges toInflow / OutflowEffect on BOP (i.e. deficit or surplus )Impact on DD/and SS of Domestic CurrencyAn increase in the domestic inflation rate

BOP Application QuestionsCurrent Account Trade balance(more exports due to improved cost competitiveness export earnings depend on price elasticity of dd; less imports)inflow Likely outflowBOP surplus demand likely supply

Component of BOP AffectedChanges toInflow / OutflowEffect on BOP (i.e. deficit or surplus )Impact on DD/and SS of Domestic CurrencyA fall in unit labour cost

BOP Application QuestionsCapital Account More foreign investment (FDI) due to better cost competitiveness,less investment overseas

inflow outflowBOP surplus demand supply

Component of BOP AffectedChanges toInflow / OutflowEffect on BOP (i.e. deficit or surplus )Impact on DD/and SS of Domestic CurrencyA fall in unit labour cost

BOP Application QuestionsCurrent AccountX may fall if production is disrupted.Capital AccountShort term capital flight and long term capital investment falls due to poorer business climate

inflow outflow inflowBOP deficit demand supply demand

Component of BOP AffectedChanges toInflow / OutflowEffect on BOP (i.e. deficit or surplus )Impact on DD/and SS of Domestic CurrencyPolitical instability in the home country

Explain how China keeps the yuan undervalued. (8)Undervalued currency-ER fixed below free market rateExplain how intervention is done. -C/A surplus that China runs with various countries esp. US dd for yuan -To stop yuan fr. appreciating, China central bank intervenes by selling yuan. This ss prevents yuan fr appreciating & keeps yuan value fixed. This means China gains foreign reserves & the yuan is fixed at a level below the equilm ER

Figure 3: Maintaining an Undervalued Exchange Rate DD for the yuan increase from D to D1ER fixed at E Shortage of QQ1 of YuanCB of China need to SS this shortage Sell Yuan for US$ in the FOREX market. Foreign reserves of US$ increase.

APPENDIXAPPENDIX

FLOATING VERSUS FIXED EXCHANGE RATE SYSTEMS : AN ASSESSMENT

Uncertainty in International trade and Investment unsure of levels in bus. dealings deter LT contracts / investments vol. of trade

Problems with floating exchange rate

Speculation undesirable for firms recourse made to forward market

Lack of discipline on the domestic economyFloating sys BOP in eq. To N AD may excessively inflationProblems with floating exchange rate

Need for adequate foreign reserves

Makes monetary policy ineffective

SpeculationEsp. for ctries with persistent BOP deficits trying to maintain overvalued currencyProblems with fixed exchange rate

Automatic correction of BOP disequilibria

No need to hold foreign reservesAdvantages of floating exchange rate system

Protects the economy against external shocks to a certain extentEg: UK on floating sys. & rest of world in recession UK Xs dep. of UK Xs cheaper ADHence impact of world recession on UK Domestic policy is not constrained by BOPAdvantages of floating exchange rate system

Certainty in international trade and investment

Imposes discipline on government macroeconomic policiesAdvantages of fixed exchange rate system

*purchase the currency of the exporting country Equally exporting firms generally expect to be paid in their own currency.S$ strengthens Pr of Spore X rise. J buys less and qty dd of S$ by J falls. Pr of X=S$10 ER1=1000yen ER2 = 1100 yen*S$ strengthens J gds cheaper in S$ We buy more J gds buy yen with S$ -rise in Qs of S$ **