in t e r nati ona l finance - nyu stern school of...

International Finance

Chris EdmondNYU Stern

Spring 2007

1

Agenda

• International capital flows

– balance of payments accounting– trade in goods and services vs. trade in assets– are large deficits sustainable?

• Exchange rates

– nominal vs. real– purchasing power parity (PPP)– covered and uncovered interest parity (CIP and UIP)– forecasting– fixed vs. floating exchange rate regimes

2

Terminology

• Trade balance

– balance on merchandise trade (‘goods’)– balance on goods and services (‘net exports’)

• Current account balance

– current account = net exports + net foreign income– net foreign income includes

! capital income! labor income! taxes and transfers

– current account measures change in net foreign assets

3

US current account balance

CATEGORY AMOUNT (BILLIONS)

Net exports of goods -781.6

Net exports of services 58.0

Net labor income -5.8

Net capital income 1.6

Net taxes and transfers -82.9

Current account -810.8

Source: Bureau of Economic Analysis, 2006

4

Notation

• Current account measures change in net foreign assets

Bt+1 "Bt = rBt + Xt "Mt

where

Bt = net foreign assets (think ‘bonds’)rBt = net foreign income

Xt "Mt = net exports

5

US current account balance


Net exports of goods -781.6

Net exports of services 58.0

Net labor income -5.8

Net capital income 1.6

Net taxes and transfers -82.9


Xt ! Mt

rBt

Bt+1 ! Bt


6

Trade in goods

-0.1

-0.05

0

0.05

0.1

0.15

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

exports of goods

imports of goods

net

share of GDP


7

Trade in services

-0.005

0

0.005

0.01

0.015

0.02

0.025

0.03

0.035

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

share of GDP

net

exports of services

imports of services


8

Income receipts and payments

0

0.005

0.01

0.015

0.02

0.025

0.03

0.035

0.04

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

share of GDP

net

income receipts

income payments


9

Current account

-0.070

-0.060

-0.050

-0.040

-0.030

-0.020

-0.010

0.000

0.010

0.020

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

share of GDPnet services

net goods

net income

current account

net taxes etc


10

Summary

• As a share of GDP, the US runs

– an increasingly large goods deficit– a modest services surplus– essentially balances net capital and labor income flows

• Implies

– trade deficit # current account deficit

11

Financing the deficit

• How is a current account deficit financed?

– by selling assets to foreigners

• Trade in assets

– ‘direct’ investment (controlling interest)– ‘portfolio’ investment

! purchases of government securities! purchases of corporate equity or securities! bank and non-bank loans

12

Capital and financial account

• Capital account includes

– net direct investment– net portfolio investment– net government transactions (gold, international reserves, etc)

• Current and capital accounts balance

current account + capital & financial account = 0

(up to a statistical discrepancy)

• Suggests an alternative perspective

– current account deficit $ domestic investment > savings– perhaps deficit $ domestic investment opportunities are good relative to rest of

world

13



Net direct investment 107.1

Net securities 334.0

Net loans -35.8

Net government 395.6

Capital & financial account 801.0


Statistical discrepancy -9.8


14

Balance of payments

goods, services, etc

equity, securities, etc

United StatesRest of world

+$800 billion

!$800 billion

balance of payments = current account + capital & financial account = 0

15

Direct investment flows

-0.030

-0.020

-0.010

0.000

0.010

0.020

0.030

0.040

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

share of GDP

net

foreign direct investment in US

US direct investment abroad


16

Purchases of securities

-0.030

-0.020

-0.010

0.000

0.010

0.020

0.030

0.040

0.050

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

share of GDP

net

US purchases securities abroad

Foreign purchases US securities


17

Changes in loans

-0.050

-0.040

-0.030

-0.020

-0.010

0.000

0.010

0.020

0.030

0.040

0.050

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

share of GDP

net

Foreign loans to US

US loans abroad


18

Purchases of government assets

-0.015

-0.010

-0.005

0.000

0.005

0.010

0.015

0.020

0.025

0.030

0.035

0.040

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

share of GDP

US govt abroad

net

foreign govt in US


19


-0.020

-0.010

0.000

0.010

0.020

0.030

0.040

0.050

0.060

0.070

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

share of GDP

net govt

capital & financial account

net directnet securities

net loans


20

Balance of payments

-0.080

-0.060

-0.040

-0.020

0.000

0.020

0.040

0.060

0.080

1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

share of GDP

current account deficit

capital & financial account surplus


21

Net foreign assets

• Current/capital account measure international capital flows

• Add up current/capital accounts over time to get asset position

assets = US claims on foreign countriesliabilities = foreign claims on US

net foreign assets = assets " liabilities

22

US claims abroad (assets)

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

share of GDP

direct investment

bonds

corporate equity

govt

loans


23

Foreign claims on US (liabilities)

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

share of GDP

direct investment

corporate equity

corporate bonds

loans

govt


24

Net foreign assets

-0.40

-0.20

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

net foreign assets

US claims abroad(assets)

share of GDPforeign claims on US

(liabilities)


25

Is the US in trouble?

• Two perspectives

– pessimistic: current account deficit because low savings, debt burden will grow,consumption will have to fall in future

– optimistic: capital account surplus because US is good place to invest, large flowof savings from low-growth countries (‘global savings glut’)

– is the glass half-empty or half-full?

26


• Sustainability analysis, same as with fiscal policy

• Net foreign assets/output ratio follows

bt+1 " bt =r " g

1 + gbt +

11 + g

(xt "mt)

(where x"m is net exports/output ratio)

• Steady state

b = " 1r " g

(x"m)

27


• Steady state net foreign assets/GDP ratio

b = " 1r " g

(x"m)

• Example: US net foreign assets/GDP is "0.25. If r = 0.05 and g = 0.02, what tradesurplus is needed to sustain this indefinitely? Answer:

x"m = "(r " g)b= (0.05" 0.02)0.25= 0.0075

A surplus of less than 1% of GDP. But currently, deficit of 6.5% of GDP. Somethinghas to give.

28

What have we learned so far?

• Balance of payments accounting

– current account = net exports + net foreign income– current account + capital & financial account = 0

(deficit financed by selling assets)– net foreign assets = sum of past current accounts

• Two perspectives on current account deficit

– pessimistic: US isn’t saving enough, so has to sell assets– optimistic: foreign countries are growing too slow, US is a

great place to invest

29

Agenda

• Exchange rates

– nominal vs. real– purchasing power parity (PPP)– covered and uncovered interest parity (CIP and UIP)– forecasting– fixed vs. floating exchange rate regimes

30

Nominal exchange rates

• Relative price of two currencies

• Level or change a!ect most international business transactions

– profits in euros = how many dollars? (‘level’)– return on euro bonds = what return on dollar bonds? (‘change’)

• Volatile, would like to forecast

31

Nominal exchange rates

• Terminology/notation

– spot exchange rate, e

– by convention: local currency price of foreign currency– example: if 1.23 dollars buy 1.00 euro, e = 1.23– counterintuitive: % e $ dollar depreciates (takes more dollars to buy one euro)

32

Dollar/yen nominal exchange rate

0.2

0.4

0.6

0.8

1.0

1.2

1971 1974 1976 1978 1981 1983 1986 1988 1991 1993 1996 1998 2001 2003 2006

US dollars per 100 yen

Source: Board of Governors, 2006

33


0.2

0.4

0.6

0.8

1.0

1.2

1971 1974 1976 1978 1981 1983 1986 1988 1991 1993 1996 1998 2001 2003 2006

depreciation of the dollar



34


0.2

0.4

0.6

0.8

1.0

1.2

1971 1974 1976 1978 1981 1983 1986 1988 1991 1993 1996 1998 2001 2003 2006

depreciation of the dollar

appreciation



35

Dollar/euro nominal exchange rate

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1999 2000 2001 2002 2003 2004 2005 2006

US dollars per euro


36

Real exchange rate

• Real exchange rate adjusts for price level di!erences

real exchange rate & eP !

P

where

e = nominal exchange rate, e.g., dollars per yenP ! = foreign price level, e.g., Japanese CPI in yenP = domestic price level, e.g., US CPI in dollars

• Real exchange rate measures the relative price of a basket of goods

– domestic basket is expensive if P > eP !

– foreign basket is expensive if P < eP !

• Measurement issues?

37

‘Law of one price’

• Basic idea

– goods should sell for price everywhere once exchange rate taken into account

• Goods market arbitrage: for traded commodities i = 1, 2, ..., n arbitrage gives

pi = ep!i

– if not, buy low sell high

38

Purchasing power parity (‘PPP’)

• PPP hypothesis is

P = eP !

(‘law of one price’ for whole consumption baskets)

• Implicit assumptions

– all goods and services traded– consumers in both countries have same tastes

(same expenditure shares on each commodity)

• Other issues

– tari!s, transportation costs– monopoly power, price discrimination

(prevents pi = ep!i for at least some i)

39

Purchasing power parity (‘PPP’)

• PPP hypothesis is

P = eP ! ' real exchange rate = 1

• Often people say

‘domestic currency is overvalued’ ' P > eP !

• Empirical tests look at weaker implication

" log(P ) = " log(e) + " log(P !) = 0

or

" log(e) = ! " !!

If so, exchange rate depreciates when domestic inflation is greater than foreign inflation

40

PPP evidence

-0.250

-0.125

0.000

0.125

0.250

0.375

1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

year on year rate of change

US inflation

Japan inflation

inflation di!erential

Source: Board of Governors and Bank of Japan, 2006

41

PPP evidence

-0.250

-0.125

0.000

0.125

0.250

0.375

1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

year on year rate of change

change in US dollars per yen


42

PPP evidence

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004

nominal exchange rate, e

real exchange rate, eP

!

P


(arbitrary base-year units)


43

PPP works better for high inflation countries

!

"#

$#

"##

!%###

"%###

&'()*+,-./,-0'((+,

#

1#

!##

2/,3/45+6/

!7819! !77#9! !7719! "###9! "##19!-

:;3<+46/-=+5/-0/.,/3)+5)'4 >4?(@-0)??/,/45)+(

:;3<+46/-=+5/-A('6-B3+(/-!-,)6<5C

>4?(+5)'4-0)??/,/45)+(-+4D-&'()*+,EB-0/.,/3)+5)'4


44

Summary

• Countries with low inflation

– PPP fails badly, especially at short horizons– inflation di!erentials smooth but exchange rates volatile

• Countries with high inflation

– PPP works much better– depreciation reflects relatively high domestic inflation

45

Exchange rates and interest rates

Country/region Money market rate (%)

Argentina 9.63

Brazil 16.54

China 2.40

Euro zone 2.80

Japan 0.02

Mexico 7.27

United States 4.77

Why are the interest rates di!erent? Where would you invest?

46

Exchange rates and interest rates

• Notation

i = interest rate on domestic currencyi! = interest rate on foreign currencye = spot nominal exchange ratef = one-period forward nominal exchange rate

• How are these related?

• Two concepts

– covered interest parity (CIP)– uncovered interest parity (UIP)

47

Covered interest parity (‘CIP’)

• Buy and hold dollars

– invest one dollar in dollar asset, gives 1 + i dollars

• Or, sell euros forward

– one dollar is 1/e euros at spot rate– invest 1/e euros in euro asset, gives (1 + i!)/e euros– sell (1 + i!)/e euros forward at f , gives (1 + i!)f/e dollars

• Two riskless transactions. Arbitrage should give

(1 + i) = (1 + i!)f

eor

1 + i

1 + i!=

f

e' i" i! # log

!f

e

"

Works well!

48

Uncovered interest parity (‘UIP’)

• Suppose we didn’t cover ourselves forward

• Convert back to dollars at spot rate. Risky return in dollars

(1 + i!t )et+1

et

• Expectations hypothesis

ft = Et{et+1}

• Combine with covered interest parity

(1 + it) = (1 + i!t )ft

et= (1 + i!t )

Et{et+1}et

or1 + it1 + i!t

= Et

#et+1

et

$

Zero expected excess return.

49

Uncovered interest parity (‘UIP’)

• Interest di!erentials and expected exchange rate changes

1 + it1 + i!t

= Et

#et+1

et

$

• Implies high interest countries have exchange rates that depreciate

– doesn’t work, at least not for developed countries– high interest countries have appreciating currencies– suggests a big arbitrage opportunity– why?

50

Forecasting exchange rates

• Di#cult if not impossible

– PPP works only for high inflation countries– UIP works hardly at all– CIP works, but has no forecasting content– di#cult to beat a ‘random walk’

(a 50/50 up/down bet has almost as much predictive power)

• Would not matter if exchange rates were not volatile. But they are!

• Better hedge any exchange rate risk

51

Exchange rate regimes

• Flexible (‘floating’) exchange rate

– market conditions determine exchange rate– all the exchange rates we’ve looked at so far were floating– ‘clean’ versus ‘dirty’ floats

• Fixed (‘pegged’) exchange rate

– government sets price – how?– must be willing to buy/sell nearly unlimited foreign currency at that price– collapse if run out of reserves– also a!ected by currency controls

• Costs and benefits? What do you think?

52

China’s fixed exchange rate

0.1

0.2

0.3

0.4

0.5

0.6

0.7

1981 1984 1987 1990 1993 1996 1999 2002 2005

US dollars per yuan


53

China’s fixed exchange rate

• What problems might this cause?

• Does a low yuan help Chinese exports?

• Can a low yuan be sustained?

54

What have we learned today?

• International capital flows

– current account + capital & financial account = 0(deficit financed by selling assets)

– net foreign assets = sum of past current accounts– two perspectives: US not saving enough vs. great place to invest

• Exchange rates

– volatile– di#cult to forecast. Really!

55

in t e r nati ona l finance - nyu stern school of...

Documents