Macro Review:BOP, Exchange Rates

Jeffrey H. Nilsen

http://thedailyshow.cc.com/videos/zjr96n/julian-castro

Count transaction as:

CREDIT: in-flow of funds, +DEBIT: out-flow of funds, -

assume BNB buys & sells $ to ensure Lev won’t change (exchange rate “peg”)

Sell good to foreigners => credit (CA)Sell asset to foreigners => credit (private KFA)Sell ORA to foreigners => credit (public KFA, i.e. OSB)

Balance of PaymentsAccounting (part of N.I.P.A.)

Accounts for trade in currently produced goods & services, includes Net Exports Net Factor Payments Net unilateral transfers

Current Account

CAUS as percentage of GDP

Table 5.1 US BOP Accounts 2008 ($ Billions)

- 553.5

Current Account of Bulgaria (to 2014 Jan)

KFA accounts for trade in existing real & financial assets, including ORA (official reserve assets)

Capital & Financial Account (KFA)

If sell domestic house, inflow => KFA credit

If buy Boeing shares, outflow => KFA debit

KFA Surplus if BG sells more assets to foreigners than they do to BG

KR house

KFABG ROW

Boeing shares

Sell

Leva

Buy

Leva

Outflow (Debit)

Inflow (Credit)

OSB accounts for official purchase/sales of ORA ($, €, Yen, Renimbi, gold, special drawing rights) Officials: BOK, Fed, ECB

NO intervention => BNB, Fed don’t buy/sell ORA (the reason to intervene is to try to

influence the exchange rate)

Official Settlements BalanceOSB = 0 if no intervention

The OSB non-zero if Intervention

BNB buys/sells ORA to influence euro per lev exchange rate

If tends to appreciate : e.g. CA, private KFA > 0 (Germans want many Leva; BNB buys euro (ORA), selling leva (outflows)

OSB DEBIT offsets CA + (private KFA credit) so finallyCA + KFA = 0

FX

OSB|BG ROW

Sell €

Buy

Leva

(Debit)

(Credit)

Leva

€

11

US KFA

When the SNB buys $ from a Swiss person or bank :Private Swiss had bought US asset (US sold asset [BoPUS inflow])So transfer to official account OSB (OSBUS inflow)

OSB, 2 parts(on net positive)

CA deficit

KFA surplus

.

.

.

.

Sell good to foreigners => credit (CA)Sell asset to foreigners => credit (KFA)Sell ORA to foreigners => credit (KFA)

Fed buys ORA

Swiss buy US houses

SNB buys $

http://video.ft.com/3111207196001/Emerging-market-sell-off-spreads-across-Asia/Markets

Emerging Market Volatility in early 2014

Media Attention on Possible Argentine Currency Crisis

All nations are concerned with exchange rate, but those with pegsare more prone to problems; often Have CA, KFA deficits

How much depreciation should central bank allow??

To prevent peso from depreciating, Bank of Argentina sells $ for investors’ pesos

BUT : continuing private KFA deficit may deplete BOA’s $ ORA(FX reserves)

In 2014, many investors withdrew fundsfrom emerging markets since expected higher US r; (have pesos want $ assets). Private outflows.

Reason for recent depreciation doesSeems UNrelated to CA (in surplus for a decade)

Nominal vs. real PPP: absolute vs. relative Determination of “fundamental

exchange rate” where FX amount supplied = amount demanded

Peg en : over-valued vs. under-valued

Review Exchange RatesPlan

Exchange Rates Nominal: How much foreign currency you

receive for 1 unit of home currency, e.g. 0.50 € per 1 lev

Real (eR): how many German goods you get for 1 BG good

lev

euroeN 1

50.0

For

NR P

Pee

goodGermaneuro

goodBGlev

leveuro

eR*

2.15

)12()50.0(

Re

Real exchange rate > 1: Consumers choose 1 Bulgarian vs. > 1 identical German goods

If mavrud costs 12 leva & same wine costs 5

euro in Germany, eR = 1.2 (German wine per

bottle mavrud)

Nominal depreciation: eN falls (get fewer € for 1 lev)

eR  rises (real appreciation) => Get more German wine for each case mavrud (so more difficult to sell mavrud in D)

ABSOLUTE PURCHASING POWER PARITY (PPP) => assuming free trade, identical goods: goods trade 1-for-1 only =>=> (same price in $ )

If doesn’t hold, pressure to return to PPP: PBG or eR falls due to unsold BG goods or PDE rises due to high demand for German goods

Purchasing Power Parity(long run influence)

1Re

eurolevaleveuro 512*)/(50.0 ForN PPe

For

NR P

Pee

(US domestic, UK foreign)Pounds per $

PFor / P

Express absolute PPP as:P

Pe ForN

Absolute PPP does NOT hold because: 1. services (especially) not subject to int’l

competition; 2. trade barriers don’t allow international P to

equalize

Relative PPP: instead of er = 1, assume er constant over time

Relative PPP => eN will appreciate to extent euro π > BG π

Relative PPP Instead ?

ForN

N

e

e

For

NR P

Pee

Lane (1999) What determines the nominal exchange rate, some cross sectional evidence. CJE

Nations with higher inflation (vs. $)experience greater depreciation

LevaS: BG public supplies leva to get euro $ to buy Airbus Jets & VW shares

LevaD: Germans demand Leva to buy Mavrud & real estate

Finding Eqbm eN

FX Market

Low eN: BG wants few euro since German goods high cost

High eN: BG want lots of euro since GermanGoods are cheap

Low eN: Germans want many Leva since Mavrud cheap

FX Market Shifts

(Lev appreciates)

Lev demand

Lev Supply

Quality of BG goods improves

Foreign interestRate rise ??

Floating en & Policy

Float: en set by S & D IN ABSENCE OF central bank intervention

(zero OSB)

Pure peg: the BNB commits to buy/sell € to maintain 0.5 € per lev rate

Often not pure; even in float, national bank may intervene if believe currency overvalued (tough for exporters) e.g. Switzerland

“Fixed” Exchange Rate Regime (e.g. Bulgaria)

http://video.ft.com/1145014411001/Swissie-peg-destabilising/Editors-Choice (Switzerland generally allows its Swiss Franc to float)

Compare peg value to value that e would have without intervention (at fundamental value, where SFX = DFX )

Undervalued peg may be strategy to increase exports

Overvalued peg may bring currency crisis

Important Issue in Pegs

Recall: policy changes in exchange rate are “revaluation” & “devaluation”

ePEG < efundamental   Low ePEG =>

American public buys many cheap Chinese goods, assets => Chinese CA, KFA both surplus

BUT EDYUAN: To maintain peg, PBoC must sell yuan & buy $ (ORA) OSB debit

Undervalued Peg

Central Bank $ ↑ Y ↑ Result: PBoC holds 2 trillion $

ePEG > eFUND: CA, KFA deficit

Policy choices: 1. Devalue to get to

eFUND

2. e.g. tax IM to cut LevS (raising eFUND)

3. Soak up ESLEV: sell $, buy lev (must abandon peg if no more $ !!)

Overvalued Peg(Bulgaria pre-financial crisis)

Central Bank $ ↓ lev ↓

Cheap VW, D. assets

Germans:Mavrud too costly

Germans fear lev assets lose value if BNB devalues

Sell lev assets => levS shifts out

Fear makes ESLEV worse, BNB needs more $ to maintain overvalued peg => peg less sustainable

Speculative Attack

At 0.5 €/lev, share of Bulgartabak at 100 levworth 50 € in GermanyIf BNB devalues to 0.25€/lev => value drops to 25 €

Peg cuts volatility and costs to trade. Disciplines M policy (limits BNB ability for discretionary M policy => lower π)

But float allows M policy to stabilize Y

Compare Peg to Float