International Finance PDF

Currency and Financial Crises  Exhibit 9‐1 The Determinants of iii teen Foreign Exchange Rates 2  Exchange Rates in Emerging Markets Analyze the primary causes of exchange rate disequilibrium in emerging market currencies Although th...

Currency and Financial Crises  Exhibit 9‐1 The Determinants of iii teen Foreign Exchange Rates 2  Exchange Rates in Emerging Markets Analyze the primary causes of exchange rate disequilibrium in emerging market currencies Although the three different schools of thought on exchange rate determination (parity conditions, balance of payments, asset approach) make understanding exchange rates appear to be straightforward, that it is rarely the case. The large and liquid capital and currency markets follow many of the principles outlined so far relatively well in the medium to long term. The smaller and less liquid markets, however, frequently demonstrate behaviors that seemingly contradict the theory. – The problem lies not in the theory, but in the relevance of the assumptions underlying the theory.  Currency Regime Choices for Emerging Markets Some experts suggest countries will be forced to extremes when choosing currency regimes—either a hard peg or free‐floating (Exhibit 2.11) Three common features that make emerging market choices difficult: Lochments 1. weak fiscal, financial, and monetary institutions completely 2. tendencies for commerce to allow currency substitution ditched and the denomination of liabilities in dollars for the 3. the emerging market’s vulnerability to sudden stoppages of outside capital flows as markets emerginginflows get big outflows cash recess Pass‐Through, the Impossible Trinity, and Emerging Markets have moved from  h pegged move to favor to floatingen Exhibit 2.11 Currency Regime Choices for 60 Emerging Market Nations attract capital flow and growth risk that can be a Lot of big outflows when confider  is main problem w emerging trying to control Inflation and exchange rates Loss of currency value has two meanings – Internal → inflation – External → exchange rate devaluation/depreciation – Closely related by PPP the pace of XR devaluation closely matches the pace of relative inflation, so that the relative ability of a currency to purchase real goods and services at home or abroad is unchanged long term correspondence they do not match well in the short run since exchange rates are financial prices and adjust quickly to expectations, differently from good prices  is inflation bad Consumers care bcs of decision why merling for companies uncertainty when int unpredictable Inflation uncertainty why emerging markets certain have high inflation mix Investors must guess future inflation and set gov α expectations of interest rates and exchange ratesCB accordingly – a problem when inflation is high and thus unpredictable – uncertainty about prices of goods and services makes it difficult for markets to optimally allocate resources – uncertainty in the market for money and capital makes investors nervous, adds a risk premium to all interest rates and increases investors’ required rate of return above what would normally be Capital is expensive and will depress and distort investment Thus, currency and price stability matter! – Financial markets in high inflation countries become restricted with serious consequences for capital allocation and economic growth  this vs venezuela do extreme inflation can behind in reasoning so Inflationbes result and Fiscal Deficits and quada psombegef.EE In open economies, governments with budget deficits have 3 options to money to fund get – Borrow from bond investors deficit – Draw down foreign reserves lively run ache Neither can continue indefinitely. Reserves disappear and risk 6 premium on debt increases. Thus, only a temporary expedient. Eventually deficit monetization will happen – Monetize the deficit, or sell bonds to the CB that creates an account for the gov’t to be used to pay for purchases. Net effect is expansion of money supply with same quantity of goods, or inflation It clashes with the independence of the CB force CB to print money to pay  def 11 to ah Inflation and Fiscal Deficits Why inflation? High money growth used as a fiscal device – as a way to pay for expenditures when direct taxation is not sufficient Relationship deficit/monetary growth is closer in EMs – In DMs, CBs are independent and have built credibility, thus they can implement monetary policies independent of the governments – In EMs, CBs are usually not independent (obliged to buy gov’t debt) and have little control over monetary policy, thus monetary policy is subordinate to fiscal decisions  What is a Currency crisis? Crises Type Threshold Inflation An annual inflation rate of 20% or higher Currency crash An annual depreciation against the dollar (or anchor currency) of 15% or more Currency debasement: type I A reduction in the metallic content of coins in circulation of 5 % or more Currency debasement: type II A currency reform whereby a new currency replaces a much depreciated currency earlier in circulation make it smaller  An example What makes a currency vulnerable? – Overvalued exchange rate or appreciation of the local currency in real terms – Typically fixed nominal exchange rate, but excessive inflation (relative to the country to which it is pegged) – Rapid money growth, often to finance inefficient public sector – Traditional taxation mechanism underdeveloped, so printing money is one of the few ways to fund public sector deficit Effects of overvalued currency. – Declining exports – High unemployment – Low level of reserves (measured in “months of imports”) Heavy reliance on short‐term borrowing by government and commercial banks Currency crises and credibility problems go hand in hand  Currency regimes and inflation Fixed exchange rates (pegs, crawling pegs, trading bands and currency boards) as inflation controls – In favor: A strong foreign currency as an anchor to overcome domestic currency weakness and against which seek to limit volatility – Against: Loss of monetary policy (more on this later) Makes the country vulnerable to the shocks of the strong‐country currency used as the anchor Tempting target for speculative attacks, when little risk of currency strengthening and possibility of huge gains if the peg breaks  Speculative attacks against the currencies How these collapses occur? – Borrow/short the vulnerable currency even at high local interest rates – Convert the local currency to hard currency → downward pressure on the currency and draining the hard currency reserves – after the collapse, the local currency loan is much cheaper (in hard currency terms) to repay – Sell the currency forward, if/when the peg breaks, buy it spot at a depreciated rate and gain (F0,t‐St)$/LC (see Soros’ strategy) feed to take Short or sell currency this  a ge of currency collapse Central Bank Intervention with Sterilization CB buys HC with $ (i.e. with international reserves) – reserves of $ will decrease – supply of the home currency also decreases While reserves are spent to defend the currency, domestic currency conversion into foreign currency has contractionary effects for domestic money supply Sterilization could be used as offset: the CB buys local currency bills from local banks in quantity equal to foreign reserves drawn down, so the monetary base in unchanged This makes currency stabilization less painful, but it is equivalent to monetization of the deficit and will undermine long‐run credibility and viability of the peg  Capital Flows Capital mobility: the degree to which capital moves freely across borders is critically important to a country’s balance of payments The free flow of capital in and out of an economy can contribute significantly to an economy’s development or can potentially destabilize economic activity The Bretton Woods Agreement was careful to promote free flow of capital for current account transactions (e.g., imports and exports of goods and services) but less so for financial account (previously, capital account) transactions (e.g., foreign direct investment and foreign portfolio investment, or FDI & FPI) – More recently, trend toward liberalizations of the financial account, i.e. free flow of capital toward “full financial integration”  Explanation of crises (1) Overvalued currency – the role of fixed exchange rates peg in the effort to control inflation – tendency of pegged currencies to become overvalued due to continuing inflation – first sign of overvaluation is a deterioration of the current account deficit financed by drawing down reserves link to global imbalances – with freely floating exchange rates, the adjustment might be gradual and manageable  Argentine currency crisis rate exchangeobligation Currency board new 1 1 fixedof CB to batteryit – Fixed exchange rate system supported by hard currency reserves backing frad with – For every unit of domestic currency issued the monetary authority must hold hard currency equal in value to the domestic currency issued by exportin – Rate of growth of money supply limited by the rate at which the country receives net inflows of US dollars from trade and general get surplus – This discipline ensures that an attack can always be defended Restrictive monetary policy – Difficult to come out of recessions Appreciation of the currency in real terms – Importance of Brazil as export competitor and trading partner  Real Exchange Rate bilateral/effective rate (we have seen this earlier) Different from nominal (bilateral/effective) exchange rate We can redefine absolute PPP in terms of the (bilateral) real exchange rate offset eachother – If absolute PPP holds, then e(f/h) is constant in every period – If absolute PPP does not hold, home prices translated into the foreign currency are higher than foreign prices, then e(f/h) , or the value of the real exchange rate will change between periods – If absolute PPP does not hold, home prices translated into the foreign currency are lower than foreign prices, then e(f/h) , or the value of the real exchange rate will change between periods  Pricesgo up 10 Overvaluation exchange rates example go down 10 The Real price of a new leather jacket produced in Brazil is 300 BRL S(USD/BRL) =.33 (3 BRL/$) Thus, the cost of the jacket to US consumer is $100 The Peso price of a new leather jacket produced in Argentina is 100 ARS S(USD/ARS) = 1 (1 ARS/$) Thus, the cost of the jacket to US consumer is $100 Say next period inflation rate in Brazil and Argentina is 10% (no inflation in the US for simplicity)  Overvaluation example The cost of the jacket in the US depends on how the exchange rate is affected by the increase in prices – Based on PPP, we expect the $/ FC nominal exchange rate to drop In Brazil, the new price of the jacket is 330 BRL The new exchange rate is S(USD/BRL) =.303 The US price of the jacket made in Brazil is 100$ – In nominal terms, the $ is stronger, i.e. it will purchase more reals – In real terms, there is no change in the exchange rate since the $ cost of the jacket is the same. The competitiveness of Brazilian goods is not affected so real exchange rate hasn't changed  Overvaluation example And in Argentina? In Argentina, the new price of the jacket is 110 ARS But the exchange rate is fixed! The US price of the jacket made in Argentina is 110$ – In nominal terms, there is no change in the exchange rate – In real terms, the argentine peso has increased since the $ cost of the jacket has changed. The peso needs to depreciate to preserve the same real exchange rate. This affects the competitiveness of Argentine goods. People went to buy so bcs currency overvalued CA excl rate  So problem contraction raising monetary in Exhibit 9.5 The collapse of the base Argentine Peso  Explanation of crises (2) Capital flows, overborrowing and illiquidity – High level of foreign borrowing (a large capital inflow) usually precedes a financial crisis – crisis consists in sudden reversal of such flows worse when capital inflows are short term debt denominated in dollars or external currency – creates risk of liquidity crisis Liquidity dries up and borrowers are under pressure to repay debts falling due rather than refinance them Crises are the consequence of low reserves and high debt at excessively short term that makes economies vulnerable to random fluctuations  Capital Controls and Capital Flight A capital control is any restriction that limits or alters the rate or direction of capital movement into or out of a country – Purposes: – Control inflows to correct BoP surplus, prevent real appreciation, prevent volatile flows, restrict foreign ownership of domestic assets – Control outflows to correct BoP deficit, for financial repression, to protect domestic financial sector Capital flight—the rapid outflow of capital in opposition to or in fear of domestic political and economic conditions and policies—is one of the problems that capital controls are designed to control. – Many heavily indebted countries have suffered significant capital flight. From the Iceland mini case  Explanation of crises (3) Troubled banks and moral hazard – moral hazard occurs when a risk decision is asymmetric: the agent benefits if it is a good decision but does not bear a commensurate price if it is bad – countries with weak institutions opening up to global markets (liberalization) before appropriate reforms – banks and firms take too much risk and have too many losses Borrowing short‐term in foreign currencies often sets up the preconditions of crises This is a problem also for sovereign debt  Its more of Anatomy of an EM financial crisis a Spirilling situation Collapse of currency value them rather Attempt to flee a virginal Attempt to stabilize Massive capital Exchange Rapid rise in outflow rate risk interest rates Interest rate Loss of investor risk confidence Overextension of banks and firms Source: Beim and Calomiris (2001) ImpPEd  Real Exchange Rate SEE Example of a “Crisis Indicator” Price level Real value of the Peso PMEX RER e$/MXP S$/MXP PUS ridership An increase means a “real appreciation” of the peso. – if Mexico has high inflation, the S$/MXP should be falling and PMEX should be rising and offset each other – a rise in the real exchange rate means that the country is losing competitiveness – Likelihood of a crisis is increasing if P s should and equidistant  Example of a “Crisis Indicator” A Calculate the real value of the Mexican peso from pUSA p*MEX s$/Peso pristine 100 100.02 100 200.02 100 400.02 e z 0.8 If the nominal exchange rate is fixed but Mexican prices rise faster the US prices, the Mexican peso is appreciating in real terms year 1.02 year 2.04 year 3.08 (100 200 400 if rebased to 100) The Mexican currency is not depreciating as it should to compensate for higher prices in Mexico – Mexico is becoming more expensive, the currency is overvalued  lole ok role Symptoms and Leading Crisis Indicators more generally Symptoms Crisis Indicator Problems in the financial sector Money multiplier, domestic (Over‐borrowing cycles, bank runs, credit/GDP, Excess M1 balances, monetary policy ) lending‐deposit rate spreads Problems with current account Exports, imports, real exchange rates, trade balance/GDP, fiscal balance/GDP Problems with financial account Foreign reserves, real interest differential, (short‐term) foreign debt, capital flight Problems in the real sector Output, domestic real interest rates, (Domestic growth slowdown ) stock prices, asset price bubbles Foreign growth slowdown US real interest rate, US GDP growth, world oil prices, dollar/yen XR  Cryptocurrencies and EMs Weak currencies fall short of the 3 properties of money – Public money and CBDC – “Private money” and stablecoins they cannot guarantee convertibility at par at all times, making them prone to runs (like an old‐time currency crisis) EMs: – History of financial instability – Unpredictable inflation – Volatile and unpredictable exchange rates – Restrictions and regulatory uncertainty Advantages – Facilitating international payments – Capital controls (also disadvantages) Bitcoin is legal tender in El Salvador Foreign Currency Derivatives Futures and Options  Derivatives Notation S = nominal spot exchange rate (the underlying) – S($/FC) = $ units per unit of FC currency everywhere F = forward exchange rate – F($/FC) = $ units per unit of FC currency everywhere f = futures price – f0,T , fT,T T = maturity k = strike price of an option c = price of a call p = price of a put i = risk free rate (HC, home country currency) i* = risk free rate (FC, foreign country currency)  Learning Objectives Explain how foreign currency futures are quoted, valued, and used for hedging/speculation purposes Explore the buying and writing of foreign currency options in terms of risk and return as a function of exchange rate movements Examine how foreign currency option values change are used for hedging/speculation purposes  Derivative Securities Securities valued in reference to underlying assets, in this context, the exchange rate Purpose – to manage currency risk (hedge) when derivative contract offsets existing cash contract – to speculate on future exchange rate movements when derivative position is independent of any cash position  Currency Futures A futures contract is a tradable obligation to the buyer (seller) to buy (sell) a set amount of foreign exchange at a specified price at some future date. – Payoff dependent of an unknown future price forward only certain people can access forward very limited  Who uses currency futures Hedgers – Companies with foreign currency receivables desiring to lock in a price at which to sell this currency could sell futures. Companies with foreign‐currency payables desiring to lock in a price at which they can buy the currency could purchase currency futures Speculators – if they expect a currency to appreciate, they could buy futures contracts for that currency. Those who expect a currency to depreciate could sell futures contracts for that currency  Futures and Forward contracts With respect to: – Size of the contract – Maturity – Trading location – Margin/collateral – Settlement – Commissions – Trading hours – Counterparties – Liquidity What is the difference? Can you answer?  Why a market for Futures? Provide low‐cost access to payoffs similar to forward contracts. IMM (International Monetary Market) division of the CME first to offer currency future contracts in 1972 Until 1972, speculators or hedgers could take forward positions only through the wholesale OTC market. – They needed to establish lines of credit with commercial banks and also deal in large transaction sizes to benefit from low bid‐ask spreads. Qualified public speculation is encouraged, differently from the forward markets where participants are banks, brokers and multinational companies  Exhibit 7.1 Mexican Peso (CME) (MXN 500,000; $ per MXN) All contracts are for 500,000 Mexican pesos. “Open” means the opening price on the day. “High” means the high price on the day. “Low” indicates the lowest price on the day. “Settle” is the closing price on the day. “Change” indicates the change in the settle price from the previous day’s close. “High” and “Low” to the right of “Change” indicate the highest and lowest prices this specific contract (as defined by its maturity) has experienced over its trading history. “Open Interest” indicates the number of contracts outstanding.  Futures Contract Specifications Maturity – Expiration on the second business day before the third Wednesday of the delivery month Exchange rate quotation – American terms Contract size – specifies the amount of currency traded E.g. CAD 100,000; GBP 62,500; EUR 125,000; JPY 12,500,000 Margin Requirements – initial margin: amount the investor must place in the account when the contract is written – maintenance: amount below which the margin account cannot fall – adjust for gains and losses – losses are allowed to accumulate up to a certain level before the margin call is issued  Open Interest Open interest = # long contracts = # short contracts – think of this as a list of names of those long and those short, the list obviously must be equal Example: Jerry goes long one GBP futures contract Kramer goes short one GBP futures contract at the same time – case A: neither had previously participated in the futures market (or Jerry was already long and Kramer was already short) Open interest increases by 1 – case B: Jerry was previously short while Kramer was already short or non‐participant Open interest remains unchanged – case C: Jerry was previously short while Kramer was previously long Open interest decreases by 1  Marking to Market With a forward contract, we know the foreign currency price Ft,T is paid entirely at time T With a futures contract, information on how much is paid at what time depends on the day‐to‐day movement of the futures price The value of the contract is revalued on a daily basis – This is daily marking to market – Settlement price = day’s closing price – Amount to be paid is the variation margin of daily marking to market cash outflows  Marking to Market Example Ex‐post daily US dollar cash flows in a three‐day contract purchase of foreign currency Day 0 1 2 3 Future price (f) 100 98 96 97 Marking to Market -2 -2 +1 Margin Balance 10 8 6 7 Final payment -97 The cash flows to the seller of the currency futures contract are the reverse of the cash flows to the buyer  Marking to Market Generalizing the marking to market cash flows (+ or -) On day 1 f1,T – f0,T On day 2 f2,T – f1,T On day T fT,T – fT-1,T Total CF fT,T – f0,T And at maturity fT,T = ST Equivalently, the cash flows to the buyer are (fT,T – f0,T) over the life of the futures contract – fT,T at the maturity of the futures contract Thus, the buyer pays f0,T over the entire life of the futures contract – unlike a forward contract, the exact timing of the payments is uncertain  Marking to Market example You bought CAD 100,000 at f0,T = USD 0.7600/CAD – in the last day of trading, fT,T = USD 0.7350/CAD Cumulative marking-to-market cash flows = CAD100,000 x (USD0.7350 – 0.7600/CAD) = - USD2,500 Immediate payment at the contract maturity = CAD100,000 x (USD0.7350/CAD) = -USD73,500 Total payment = -USD(2,500+73,500) = -76,000 or CAD100,000 x (USD0.7600/CAD) = -USD76,000  Other characteristics of futures contracts Low default risk – contract between individual and exchange No counterparty risk – critical if agents do not have the proper credit rating – credibility/commitment established through the use of margin Settlement – futures contracts are typically closed out with an offsetting (reversing) position an agent with a long position in a futures contract is obligated to buy forex at some date in the future the position is reversed by selling a futures contract on the same currency with the same delivery date value of account payable  lose money A when currency unbedged A appreciates Payoffs for a long and a short position at maturity The buyer is said to have a long position, while the seller is said to be short punbedge $ Profit appreciation $ Profit ÉEgf agea + of foreign f0,T Position currency Kedge 7b 0 f0,T f0,T ST $/FC ST $/FC ‐ ‐f0,T buy futures sell futures appreciate currency you lung has depreciated depreciate  Arbitrage between the futures and forward markets Forward ask price for March 20 on CHF is $0.7127 Futures price of the IMM March 20 CFH futures contract is $0.7145 Buy CFH 125,000 in the forward market at $0.7127 Sell 1 futures contract (CHF 125,000) at $0.7145 On March 20, profit = ($0.7145‐ 0.7127)(125,000)=$225 Note that there is no risk here: – arbitrageur takes delivery of the CHF in the forward market and sells them in the futures market – arbitrage will tend to force the forward price up and/or the futures price down  Speculating with futures contracts Very attractive for speculation – High leverage possibility, very high liquidity, low transaction costs, large body of information on the price behavior Often entered without an underlying cash position. Bearish on the currency: sell a futures CHF contract and buy it back at a lower price once expectations are realized Bullish on the currency: buy a futures CHF contract and sell it at a higher price once the currencies have moved in the expected direction – In either case, speculators can close out their position if their expectations do not materialize  Hedging with futures contracts To offset an underlying cash position, expecting that the profits on the future contract will offset those in the cash market. Short hedge: a long position (i.e. a receivable) in the spot market and simultaneously a short position in futures market Long hedge: a short position (i.e. a payable) in the spot market and a long position in futures market  Potential problems in hedging with futures Mismatch – contract size – maturity dates – currency If all uncertainty in the total payoff is eliminated, the hedge is said to be perfect A forward hedge is in fact a perfect hedge – easy to match the size, timing and currency of the underlying exposure No such guarantees in the case of futures because of the mismatch  Currency Options A currency option gives the holder the right but not the obligation to buy (a call option) or to sell (a put option) a designated quantity of foreign currency at a specified price (exchange rate) called the strike price, at or before a designated expiration date – The underlying asset is the foreign currency – An European option can only be exercised at expiration date, differently from an American option  Currency Options We refer to selling an option as “writing an option” the buyer of the option pays a premium for the right to buy (call) or sell (put) a currency the seller of a call (put) option receives a premium and must sell (buy) the currency if the buyer exercises his option  Who uses currency options Option position is a hedge – option + cash position in the underlying or speculation – no cash counterpart to the option position  Exhibit 7.2 Swiss Franc Option Quotations (U.S. cents/SF) Each option = 62,500 Swiss francs. The August, September, and December listings are the option maturities or expiration dates. Contract type: European. Table constructed by textbook authors to illustrate how option quotations are often presented in The Wall Street Journal  Option Contract Specifications on organized exchanges Exchange rate quotation – American terms Maturity – Mid‐month Saturday following the third Friday of the expiration month Consecutive calendar month – Long‐term options European‐style exercise only Fewer contract months (quarterly) Contract size – specifies the amount of currency traded E.g. CAD 50,000, GBP 31,250; EUR 62,500; JPY 6,250,000  Option Contract Specifications on organized exchanges Margin Requirements – long positions in currency options do not require posting a margin 100% of the option premium paid in advance by the long position holder, no commitment during the life of the option. – short positions require posting a margin Default risk is very small – all contracts are guaranteed by the Options Clearing Corporation  Option Contracts Vocabulary Strike price (exercise price) – fixed price, specified in contract, set by the exchange around prevailing spot rate k = strike price ($/FC), S = spot price ($/FC) Generally, HC/FC if traded outside the US European options – exercisable only at expiration American options – exercisable on or before expiration (added feature not worth much)  Moneyness in the money (ITM) = positive value if exercised today for a call, this means S>k for a put, this means S strike price – pT = Max [k‐ST, 0] at expiration, a put option exercised only if ITM → spot rate < strike price At expiration, a European option and an American option (not previously exercised) with same strike price will have same terminal value  Time value Time value: excess of option value over intrinsic value Additional value embedded in option resulting from potential further gains if option moves further into the money. Total option value ( reflected in the premium) = Intrinsic value + time value NOTE: We will only focus on the intrinsic value as we will practice with European style option contracts  unhedged bos paid symmetric payoff fwd has The Foreign Exchange Market  Learning Objectives Explore the structure and functions of the foreign exchange market Detail how of the global currency market has been changing Practice with the forms of currency quotations used by agents of all kinds when conducting foreign exchange transactions, taking account of transaction costs (with bid and ask)  Size of foreign exchange market as of April 2022 source: Triennial Survey, Bank of International Settlement (BIS) https://www.bis.org/publ/qtrpdf/r_qt2212f.htm Daily average turnover of approximately $7.5 trillions – In 1973, the end of the era of fixed exchange rates daily forex transactions were $15 billion – US GDP in 2021 was almost $23.32 trillions – World GDP in 2021 was $96.51 trillions The UK is the largest foreign exchange market based on turnover (43%), followed by the US (17%), Singapore, HK Share of transactions (see graph on next slide) – Largest part in FX spot and FX swaps – CAD is sixth most traded currencies – Emerging market currencies (Mexican peso, Chinese renminbi (4%), Indian rupee)  Size of foreign exchange market as of April 2022 source: Triennial Survey, Bank of International Settlement (BIS) The dollar has an outsized role in financial markets even compared to import or export markets: Dollar dominance is striking in this FX market segment, greater than in any other aspect of dollar use. As a vehicle currency, the US dollar is on one side of 88% of outstanding positions — or $85 trillion. An investor or bank wanting to do an FX swap from, say, Swiss francs into Polish zloty would swap francs for dollars and then dollars for zloty. dolface dom Is chinese ramimbi  Functions of the Foreign Exchange Market A network of banks, foreign exchange brokers and dealers whose function is to bring buyers and sellers of foreign exchange together The foreign exchange market is the mechanism by which participants: – transfer purchasing power between countries; – obtain or provide credit for international trade transactions; and – minimize exposure to the risks of exchange rate changes.  Market participants Commercial banks and Non‐bank foreign exchange dealers – “Market makers”, they stand willing to buy or sell foreign currency, thus maintain an “inventory” position in those currencies Foreign exchange brokers – Facilitate trades between dealers for a fee – do not take positions themselves Central banks and treasuries Firms (such as importers, exporters, MNEs and asset management companies) and individuals conducting commercial or investment transactions Speculators and arbitrageurs  Market Participants: Central Banks and Treasuries Central banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded. They may act to support the value of their own currency because of policies adopted at the national level or because of commitments entered into through membership in joint agreements such as the European Monetary System. The motive is not to earn a profit as such, but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens. As willing loss takers, central banks and treasuries differ in motive from all other market participants.  Transactions in the Foreign Exchange Market A spot transaction is the purchase of foreign exchange with delivery and payment between parties The exchange of a foreign exchange trade today actually involves three different components: – The foreign exchange trade transaction agreement – Electronic communication and notification for payment and settlement – Final settlement of the currency trade, referred to as the value date. – consider the potential for efficiency improvements in cross‐border payments through instant payment and settlement of a digital currency Exhibit 5.4 The Foreign Exchange Market Today  Scope of the Forex market Hedging – used to protect against the exchange rate risk derivative contract offsets existing cash contract Speculation – used to speculate on one’s belief derivative position independent of any cash position Arbitrage – used to obtain riskless profit  Foreign Exchange Rates and Quotations A foreign exchange rate is the price of one currency expressed in terms of another currency. A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate. Quotations may be designated by traditional currency symbols or by the three‐letter ISO codes http://markets.ft.com/ft/markets/currencies.asp  number of CNY 1US if buys less any must mean that it weakens Exhibit 2.9 The Revaluation of the Chinese Yuan and thereto Chinese Renminbi (CNY) to US dollar USD Spot rate the (CNY = 1USD) Cny strengthens beggomager I  Notation S = nominal spot exchange rate S(i/j) = units of currency i per unit of currency j S(CUR2 / CUR1) = Every currency exchange involves two currencies: the price or units of the quote currency (CUR2) in terms of the base or unit currency (CUR1) I ow much of to E.g. 142 JPY/USD or JPY 142/USD or ¥ 142/$ 1 quotebase buy – Consistent with axis labels in charts of textbook (see Renminbi chart) – Base currency always at the denominator. We will not use USD/JPY 142 or CUR1CUR2 as sometimes in the book or by traders, but the interpretation is the same F = forward exchange rate F(i/j) = units of currency i per unit of currency j  Exchange Rates for September 12, 2024 (Bloomberg) footfunit of foreign US $ equiv. Currency per US $ Country Feign currency perspective Britain 1.3087 0.7641 Japan 0.0070 142.52 Euro 1.1044 0.9055 Canada 0.7355 1.3596  Exchange Rate Basics and terminology S(i/j) = units of currency i per unit of currency j – Example : = $/£ dollar‐pound exchange rate = the number of $ per £ = dollar price of sterling = price of sterling in terms of dollar – Depreciation of the pound: price of pound sterling (in terms of dollar) falls S($/£) goes down fewer dollar to buy a pound more pounds to buy a dollar – Remember that S(£/$) = 1/S ($/£) S(£/$) goes up price of the dollar (in terms of sterling) rises appreciation of the dollar – and viceversa Foreign Exchange Rates and Quotations (European/American) foreign per 1 USD European terms is most common, industry standard – the quoting of the quantity of a specific currency per one U.S. dollar. Two major exceptions: the euro and the U.K. pound sterling: both are normally quoted in American terms – the U.S. dollar price of one euro and the U.S. dollar price of one pound sterling. American terms are also utilized in quoting rates for most foreign currency options and futures, as well as in retail markets that deal with tourists. for 1 foreign number ofto USD not linked inquote  Thus, quotations against the $US American terms: $/unit of (non‐US) currency – The US dollar price of a unit of foreign currency – USD 1.3087 for one pound and – USD 1.1044 for one euro European terms: units of (non‐US) currency/$ – The foreign currency price of one US dollar – GBP 0.7641 for one dollar and – JPY 142.52 for one dollar Foreign Exchange Rates and Quotations (Direct/Indirect) Foreign exchange quotes are at times described as either direct or indirect. In this pair of definitions, the home or base country of the currencies being discussed is critical. A direct quote is a home currency price of a unit of foreign currency. CHF in NY or CHleur in An indirect quote is a foreign currency price of a unit of Switzer home currency. CHF in NY The form of the quote depends on what the speaker regards as “home.” Thus, quotations for home currency Direct quotation (home price of foreign currency) ‐ JPY/$ in Tokyo ‐ $/£ in U.S. Indirect quotation (foreign currency price of home currency) ‐ $/JPY in Tokyo ‐ £/$ in U.S. Example. In Tokyo, the direct quote – 142.52 yen = $1, which is the same as the “indirect” – 1 yen = $ 0.0070 What is the direct quote in New York?  The Spot Market with transaction costs midpoint middle point between bid Prices are quoted in pairs ask – BID : price at which bank will buy currency Cust sells – ASK : price at which bank will sell currency cust buys – Bank’s profit = ASK‐BID = “Bid‐Ask Spread” transaction cost, or price of a round trip transaction The exchange rate might be 142.28‐142.76 JPY/USD – 142.28 the rate at which BANK will BUY dollars (customer can SELL dollars) – 142.76 the rate at which BANK will SELL dollars (customer can BUY dollars) hint: the price of dollars (the denominator currency) in terms of yen (the numerator currency) the traded currency is at the denominator, the price at numerator  For the customers – example price of a round trip transaction 142.28‐142.76 JPY/USD means: – receive 142.28 JPY per USD traded when selling dollars (buying yen) – pay 142.76 JPY per USD traded when buying dollars (selling yen) remember: us, the customers, always lose, i.e. pay the higher rate, receive the lower rate Try it yourself ‐ If you started with one million dollars and converted it into yen, then back to dollars, how much would you have after the two conversions?  Exchange rates with transaction costs Example S($/£) BID ‐ S($/£) ASK, the direct quote for the £ in New York, is 1.3061 – 1.3113 (or 1.3061 – 113) Try it yourself ‐ What is the direct quote for the $ in London? ‐what is S(£/$)ask? ‐what is S(£/$)bid? S E bI 0.7656 Have 0 7626  Exchange rates with transaction costs Example Consider S($/£)ASK ‐ bank will sell £ for $S ‐ bank will buy $ for 1/S£ Consider S($/£)BID ‐ bank will buy £ for $S ‐ bank will sell $ for 1/S£ Now, instead of writing S($/£)=1/S(£/$), we write 1 1 S($/£) ASK  S($/£) BID  S(£/$) BID S(£/$) ASK  Exchange rates with transaction costs Example The New York Bank will – sell £ for 1.3113 $/£ direct ask quote in Ny – or equivalently, buy $ for 1/1.3113 = 0.7626 £/$ indirect – This is the direct bid quote for the $ in London bid The New York Bank will buy £ for 1_3061 _ _ $/£ or equivalently, will sell $ for 1_ _1.3061 _ 0.7656 ‐ This is the direct ask quote for the $ in London Thus, the direct quote for the $ in London is 0.7626 ‐ _ _ _£/$ 0.7656  Reserve currencies Heavy lies the crown The USD is involved in nearly 90% of foreign‐exchange transactions; such is the liquidity of the greenback that if you want to swap euros for Swiss francs, it can be cheaper to trade via dollars than to do so directly. The Economist, April 29 2023  most of the K is dollar time Cross Rates Many currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency Use S(i/j), the spot exchange rate between currency i and currency j, with a third currency k S(i/j) = S(i/k). S (k/j) and S(j/i) = 1/ S(i/j) =1/(S(i/k). S (k/j)) SINCE ALL CURRENCIES ARE QUOTED AGAINST THE $, THE $ EXCHANGE RATE CAN BE USED TO COMPUTE A CROSS RATE  in domestic quantity Usd Cross Rates other disqualify September 12, 2024 (Bloomberg) USD EUR JPY GBP CHF CAD AUD HKD USD ‐ 1.1044 0.0070 1.3087 1.1716 0.7355 0.6697 0.1282 EUR 0.9055 ‐ 0.0064 1.1850 1.0609 0.6660 0.6064 0.1160 JPY 142.520 157.400 ‐ 186.51 166.983 104.825 95.446 18.264 GBP 0.7641 0.8439 0.0054 ‐ 0.8953 0.5620 0.5117 0.0979 CHF 0.8535 0.9426 0.0060 1.1170 ‐ 0.6278 0.5716 0.1094 CAD 1.3596 1.5015 0.0095 1.7793 1.5930 ‐ 0.9105 0.1742 AUD 1.4932 1.6491 0.0105 1.9542 1.7495 1.0983 ‐ 0.1914 HKD 7.8033 8.6180 0.0548 10.2122 9.1427 5.7394 5.2259 ‐  Cross Rates Example – no transaction costs S(USD/EUR) = 1.1044 $/EUR S(JPY/USD) = 142.52 JPY/$ what is S(JPY/EUR)? S(JPY/EUR) = S(JPY/$). S($/EUR) S(JPY/EUR) = (142.52). (1.1044) = 157.4 S(USD/EUR) = 1.1044 $/EUR and S(USD/JPY) = 0.0070 $/JPY (actually 0.007016) or S(EUR/USD) = 0.955 and S(JPY/USD) = 142.52 $/JPY what is S(EUR/JPY)? Try it yourself 1.1044 142.52 4 SCE 3 0.0064  Cross Rates September 12, 2024 (Bloomberg) USD EUR JPY GBP CHF CAD AUD HKD USD ‐ 1.1044 0.0070 1.3087 1.1716 0.7355 0.6697 0.1282 EUR 0.9055 ‐ 0.0064 1.1850 1.0609 0.6660 0.6064 0.1160 JPY 142.520 157.400 ‐ 186.51 166.983 104.825 95.446 18.264 GBP 0.7641 0.8439 0.0054 ‐ 0.8953 0.5620 0.5117 0.0979 CHF 0.8535 0.9426 0.0060 1.1170 ‐ 0.6278 0.5716 0.1094 CAD 1.3596 1.5015 0.0095 1.7793 1.5930 ‐ 0.9105 0.1742 AUD 1.4932 1.6491 0.0105 1.9542 1.7495 1.0983 ‐ 0.1914 HKD 7.8033 8.6180 0.0548 10.2122 9.1427 5.7394 5.2259 ‐  Cross Rates September 12, 2024 (Bloomberg) USD EUR JPY GBP CHF CAD AUD HKD USD ‐ 1.1044 0.0070 1.3087 1.1716 0.7355 0.6697 0.1282 EUR 0.9055 ‐ 0.0064 1.1850 1.0609 0.6660 0.6064 0.1160 JPY 142.520 157.400 ‐ 186.51 166.983 104.825 95.446 18.264 GBP 0.7641 0.8439 0.0054 ‐ 0.8953 0.5620 0.5117 0.0979 CHF 0.8535 0.9426 0.0060 1.1170 ‐ 0.6278 0.5716 0.1094 CAD 1.3596 1.5015 0.0095 1.7793 1.5930 ‐ 0.9105 0.1742 AUD 1.4932 1.6491 0.0105 1.9542 1.7495 1.0983 ‐ 0.1914 HKD 7.8033 8.6180 0.0548 10.2122 9.1427 5.7394 5.2259 ‐  Cross Rates Example – with transaction costs price for foreign In the US, the direct spot quote on the SGD is currency $0.6016 ‐ 24 b a SGD The direct spot quote on the DKK is $0.1792 ‐ 98 b a DKK What is the direct spot quote for the DKK in Singapore? ‐what is S(SGD/DKK)BID ? 5 ask ‐what is S(SGD/DKK)ASK ? SCS D Did SGD bid DRK bid 0 1792 024 S SGD DKK bid bid Fenbid ask.se bid 0 1792 4 0 2975 SCSGDIDKKJOSK SFa.sk yask dbid.Fu ask 0.6 16 0 1798 0.2989  Say a person wants to exchange SGD from DKK Alternative #1: DKK SGD ‐sell DKK directly for SGD at S(SGD/DKK)BID Alternative #2: DKK $ SGD ‐sell DKK for $ at S($/DKK)BID use rate J ‐sell $ for SGD at S(SGD/$)BID cross usd  Thus, S(SGD/DKK)BID = S(SGD/$)BID. S($/DKK)BID and therefore, 1 1 1   S(DKK/SGD) ASK S($/SGD) ASK S(DKK/$) ASK S(DKK/SGD) ASK  S($/SGD) ASK  S(DKK/$) ASK DID 0 4  Cross Rates Example – with transaction costs S(SGD/DKK) BID  S(SGD/$) BID  S($/DKK) BID 1   S($/DKK) BID S($/SGD) ASK  1     0.1792   0.6024   0.2974 SGD/DKK Try it yourself ‐ What is what is S(SGD/DKK)ASK , the direct quote for the DKK in Singapore? ask a bid as dat ask 1 0.1798 6 0.2989  Bd Currency Arbitrage Simultaneously buying and selling mispriced currencies and realizing a riskless profit An equilibrium relationship – In equilibrium, you cannot make money without investing capital and without taking risk If currencies are out of equilibrium, it is possible to make profit In equilibrium, actual quotation = calculated rate  Intermarket Currency Arbitrage Example Exchange rate quotes might be inconsistent across different markets CAD/USD Bank of Montreal 1.3250-60 Bank of America 8 1.3270-75 Buy USD from Bank of Montreal at CAD 1.3260/$ Immediately sell USD to Bank of America at CAD 1.3270/$ Pocket a net profit of CAD 0.001 per USD traded – You know there is arbitrage since the two banks’ quotes do not overlap  Intermarket Arbitrage Quoted rates (no bid‐ask) Cross rate calculation based on Citibank and Barclays Bank quotes. / EUR1.1721/GBP. / Which is.001 less than the Dressner Bank quote, and results in triangular arbitrage. Exhibit 5.12 Triangular Arbitrage by a Market Trader  Triangular Arbitrage Ensures consistency between, exchange rates A (between currencies 1 and 2) and B (between currencies 1 and 3), vs. exchange rate C (between currencies 2 and 3) – if it did not hold, one could earn infinite riskless profit. In making these profits, the arbitrageur will push the prices toward their (arbitrage‐free) equilibrium rates – the potential for arbitrage profits results in a market which reacts very quickly to eliminate such profits  Triangular Arbitrage Example Market A: Yen per dollar = 120 JPY/USD Market B: Dollars per pound = 1.50 USD/GBP These two rates automatically imply the third, making the third rate redundant – that’s why it is sufficient to quote all rates against the US dollar only Yen per pound = 180 JPY/GBP calculated from ( _ _ _ JPY/USD)*( _ _ _ USD/GBP) Under these prices, are arbitrage profits possible?  Triangular Arbitrage Example What if instead the cross‐rate for JPY/GBP were quoted as 178 in market C? – Pound is undervalued in market C relative to A and B – How would you earn arbitrage profit? – Is there risk? Let’s calculate!  Triangular Arbitrage with bid‐ask spreads In real life, with bid‐ask spreads, triangular arbitrage is not quite so powerful. Exchange rates A and B no longer determine a single point for exchange rate C. Instead, they determine a range for exchange rate C. If exchange rate C goes out of this range, then the three rates are “inconsistent” and arbitrage profits are possible Arbitrage flows will force the exchange rates to be aligned  Triangular Arbitrage with bid‐ask spreads Example Central (mid) rates still misaligned – A) Yen per dollar = 119 ‐ 121 – B) Dollars per pound = 1.49 ‐ 1.51 – C) Yen per pound = 178 ‐ 179 Can one earn a riskless profit? Let’s calculate! – Attempt to replicate earlier result, here you actually lose yen. – Why? transaction costs – Reversing the direction of a transaction, you still lose, due to transaction costs, not to misalignment  I Gutager get the Lower 1 SC pYS E bid number 1 119 Fiat 0.9905 Since there are transaction costs mean that changing doesn't the transaction the order of will give a gain bid valider logique ask quote slides  Do you have arbitrage profit? Without transaction costs, since each market is symmetric (you get the same price no matter which direction you go), if going in one direction results in a loss, the other will result in a gain. The only stable equilibrium is the single point that results in neither a gain nor a loss With transaction costs, i.e. with bid‐ask spreads, the quotes are not symmetric. If you make money in one direction you will definitely lose money in the opposite direction. If however, you lose money in one direction, you might also lose it in the opposite direction since the loss could be due to transaction costs  Forward Transactions in the Interbank Market An outright forward transaction (usually called just forward) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity. Forward exchange rates are usually quoted for value dates of one, two, three, six, and twelve months. Buying forward and selling forward describe the same transaction (the only difference is the order in which currencies are referenced.)  Exchange Rates September 12, 2024 US $ equiv. Currency per US $ Country spot Euroa 1.1044 0.9055 One-year Forward 1.1177 0.8947 Lower int rate euro appreciating us depreciate int rate  Forward Quotations Outright rate – actual price, quoted to commercial customers (previous slide) Points quotation – as the difference between the forward rate and the spot rate – also called swap rate – quoted by traders In percentage terms – percent‐per‐annum expressed as deviation from the spot rate Forward rates of one year or less maturity are termed cash rates; for longer than one‐year they are called swap rates  Forward Points Quotation For the Canadian dollar, “minus 100” or “discount of 100” For the Swiss Franc, “plus 200” or “premium of 200” american quote Spot or Forward rate Canadian dollars Swiss Francs 90-day forward rate $0.7900 $0.6000 Less spot rate 0.8000 0.5800 90-day forward -100 +200 quote in points 0d at a ata discount premium to a dollar  Forward Points Quotation no transaction costs Example The 180‐day £ forward quote is $1.6255 – The spot rate is $1.6293 – Thus the £ is quoted in the forward market at 1.6255 ‐ 1.6293 = ‐38, or 38 point discount The 180‐day ¥ forward quote is $0.006892 – the spot rate is $0.006748 – Thus the ¥ is quoted in the forward market at a 0.006892 ‐ 0.006728 = 14 point premium NOTE that the meaning of a “point” varies: – for the ¥, a point is $.000001 – for the £, a point is $.0001  currency gives more dollar if forward positive Forward Quotation in Percentage Terms By convention, formula for calculating forward premium or discount using American terms is (n - day) forward rate - spot 360 Premium (discount)    100 spot n 7 – With this quotation, the non‐US currency is at a forward premium to the dollar if the forward rate > spot rate – The non‐US is at a forward discount if the forward rate < spot rate Using European terms, the formula is flip spot rate - (n - day)forwar d 360 Premium (discount)    100 forward n – With this quotation, the non‐US currency is at a forward premium to the dollar if the forward rate < spot rate – The non‐US currency is at a forward discount if the forward rate > spot rate  Quotation with bid‐ask spread add example containing The quotes for the JPY are Ptsubstractor y beco.gg learn substreet from spot Spot 1‐month forward if current up or get forwarf to 142.28/76 83/47 Point quotation as win relative other down the – If bidoffer, subtract from the spot quotation – The yen is selling at a forward premium against the dollar. – The outright forward with bid and ask is…? Calculate! Percentage terms quotation – For this, you need to calculate the midpoint of the quotes for the outright bid and ask, see the following slide  142.28 142.76 outright spot 142.5 forward outwright 5 142 mid point 142.76 142.52 29 mid point 5 141.652142 7141 142.52481 9 100 5.51 admerican premium since 0 interest rate is provided as every annualized So have to adjust with if have to come up Gmo forward to compare with what is provided  Percentage Terms Forward Quotation example Using the spot and forward American quotes for the JPY (mid‐point) of.00702 and.00705 respectively, we have.000705.00702 360 Premium discount 100 5.5%.00702 30 Using European terms (as quotation in previous slide), 142.52 141.87 360 Premium discount 100 5.5% 141.87 30 What does this say about the direction of the JPY? of the $?  Exchange Rate Changes e (later) Percentage change in the exchange rate between two specific points in times, i.e. current and past exchange rate (or 0.65 and 0.69) Direct quotation in NY, home currency price of foreign currency Formula for percent change in the foreign currency S S $0.65/AUD $0.69/AUD %Δ 100 5.79%% S $0.69/AUD That is, the Australian dollar is weaker, it depreciated 5.79% Note: this formula is the one to use to calculate change in foreign currency (non‐US) with American quotes  Exchange Rate Changes (later) If you were given the indirect quotation in NY, foreign currency price of home currency (or 1.45 and 1.54) Formula for percent change in the foreign currency S S AUD1.45/$ AUD1.54/$ %Δ 100 5.79% S AUD1.54/$ also with this method, the Australian dollar decreased in value Note: this formula is the one to use to calculate changes in foreign currency (non‐US) with European quotes  Exchange Rate Changes (later) By definition, with discrete changes, the % appreciation of currency A against currency B is not equal to the % depreciation of currency B against currency A Using the same quote, formula to calculate the percent change in the home currency S S AUD1.54/$ AUD1.45/$ %Δ 100 6.15% S AUD1.45/$ Thus, a change in the exchange rate from 1.45 to 1.54 is equivalent to a AUD depreciation of 5.79% and a USD appreciation of 6.15% – it differs since the base rate from which it is measured differs – difference is larger for bigger changes (depreciation/appreciation)  Useful website for economic and financial data https://tradingeconomics.com/ And country reports from EIU https://country‐eiu‐ com.proxy3.library.mcgill.ca/AllCountries.aspx Global imbalances: the Balance of Payments, the macroeconomy and international linkages 1  Learning Objectives What are global imbalances and why do they matter? How do the primary accounts of the balance of payments reflect fundamental economic and financial activities across borders? How do changes in the balance of payments affect/are affected by key macroeconomic rates like exchange rates and interest rates? How are exchange rate changes related to international trade? How do policy makers and multinationals management use balance of payments’ accounts and accounting in decision‐making? 2 IMF External Sector Report 2024 3  balance sheet p its about recording the Balanceβ of Payments flows related has 3 main accountstress A statistical record of the flows and payments (all transactions) between residents of one country and the rest of the world in a given time period It comprises stuff products – CURRENT ACCOUNT (CA) goodsfinancial – FINANCIAL/CAPITAL ACCOUNT (FA) assets – OFFICIAL RESERVES ACCOUNT (ORA) hasby definition a the Bop if current balance of 0 so  n 08 Japan us example Japan as us current deficit surplus account give them more than what would want to buy dollar Japan US dollar Japan us country Ten selling financial asset or phas Japan warn us surplus deficit Investment financial account currency of country with surplus is likely to appreciate since will all the  you receive Fundamentals of BOP Accounting A BOP statement is a statement of cash flows over an interval of time. – not a balance sheet A credit is an event, such as the export of a good or service, that records foreign exchange earned—an inflow of foreign exchange to the country. A debit records foreign exchange spent, such as payments for imports or purchases of services—an outflow of foreign exchange. All entries are recorded independently, not together as double‐entry bookkeeping 5  Fundamentals of BOP Accounting For our purposes, the BOP involves the measurement of all the reasons why a currency is supplied and demanded Basically, it accounts for – the number of $s going out of the country and – the number of $s coming into the country The BOP must balance – Therefore, it is incorrect to state that the BOP is in disequilibrium – the net errors and omissions account is produced to preserve the balance of the BOP  liked ch Exhibit 3.1 The U.S. Balance of Accounts, more int Summary mm things the sign 2 important the magnitude 7  The Current Account The Current Account includes all international economic transactions with income or payment flows occurring within one year, the current period. It consists of the following four subcategories: – Goods trade and import of goods – Services trade – Income – Current transfers The Current Account is typically dominated by the first component which is known as the Balance of Trade (BOT) even though it excludes service trade – Merchandise trade is the original core of international trade. – The manufacturing of goods was the basis of the industrial revolution and the focus of the theory of comparative advantage in international trade. 8  Financial Account (FA) formerly the Capital Account Exchange of financial assets – degree of control over assets or operations used to classify financial assets It measures net foreign investment – Direct investment, acquired with the goal of controlling the company (FDI) Honda builds a plant in Ohio Japanese investors buy a golf course in US – Portfolio investment (FPI) German residents buy Japanese government bonds  Foreign Portfolio Investment This is the net balance of capital that flows in and out but does not reach the 10% threshold of direct investment – The purchase of debt securities across borders is classified as portfolio investment because debt securities by definition do not provide the buyer with ownership or control. Some financial flows are very mobile: move quickly in response to investor expectations → Capital Flight – Mobility of financial flows brings economic volatility – Upon sudden financial outflows, a country can sink into a financial crisis – The volatility of financial flows has increased concern about the various types of flows – In Exhibit 3, portfolio investment is shown much more volatile 10  Official Reserves Account (Reserves Balance) Total reserves held by official monetary authorities within the country. – These reserves are normally composed of gold and the major currencies used in international trade and financial transactions (hard currencies). ORA measures the change in official reserves – the U.S. government buys $s with ¥ to support the $ against the ¥ – the U.S. government sells $s for pounds to depreciate the $ Its importance? – whether the country is operating under a fixed exchange rate regime or a floating exchange rate system Since each account represents a net supply of or demand for $s CURRENT ACCOUNT BALANCE + FINANCIAL ACCOUNT BALANCE + CHANGE IN OFFICIAL RESERVES = BALANCE OF PAYMENTS = 0  Characteristics of a floating exchange system No government intervention Markets are allowed to work The price of a currency is the market clearing price, i.e. supply = demand – demand for $ is created from exports (X) foreign investment in U.S. (INVF→US) – supply of $ is created from imports (M) U.S. investment in foreign countries (INVUS→F)  Since supply = demand X+ INVF→US = M+ INVUS→F Thus, CURRENT ACCOUNT BALANCE = ‐ (FINANCIAL ACCOUNT BALANCE)  Lapan Turkey Tap Turkey current current surplus deficit price cess attractedprice Say less more attracted se more buy Shrinks deficit surplus  dollar doming Exhibit 3.4 The U.S. rest of world Current and Financial Accounts, doesn't 1992‐2020 mind holding your currency able to sustain fi deficit sustained current account with a persistent should depreciate deficit as the currency bes of 15  c 1 a Intuition If the Current Account has a deficit balance, – imports > exports – supply of “current” $s > demand for “current” $s – net demand for “investment” $s – net investment in U.S. by foreigners – financial account surplus  Intuition If the Current Account has a surplus balance, – imports < exports – supply of “current” $s < demand for “current” $s – net supply for “investment” $s – net investment by U.S. citizens in foreign countries – financial account deficit  The BOP and Exchange Rates Floating Exchange Rate Countries – Under a floating exchange rate system, the government has no responsibility to peg its foreign exchange rate, the exchange rate adjustments are driven by market forces Fixed Exchange Rate Countries – Under a fixed exchange rate system, the government bears the responsibility to ensure that the BOP is near zero Managed Floats – Countries operating with a managed float often find it necessary to take action to maintain their desired exchange rate values 18  Current and Combined Financial/Capital Account Balances Japan, 2000‐2007 (trillion of Japanese yens) Managing the exchange rate over some periods  Characteristics of a fixed exchange system Price of a currency is fixed by the government – It instructs the Central Bank to intervene whenever its currency deviates from the stated values by more than an agreed‐upon percentage To keep it fixed, excess market demand for an undervalued currency is supplied by the government(s) To keep it fixed, excess market supply of an overvalued currency is absorbed by the government(s) thus, it must be maintained by central banks, who are willing to buy and sell at fixed rate – does not require participation from both sides but can be difficult to maintain by one Central Bank  Supply and demand Demand for CNYs (yuan) is created from – exports (X) – foreign investment in China (INVF→CH) – government buying CNYs Supply of CNYs is created from – imports (M) – Chinese investment in foreign countries (INVCH→F) – government selling CNYs  Example Say the CNY is sufficiently undervalued at the fixed rate that, as a result – exports > imports (demand for CNYs > supply of CNYs) Current Account surplus – net foreign investment > 0 (demand for CNYs > supply of CNYs) Financial Account surplus How is the excess demand for CNYs satisfied? – The government(s) must sell CNYs for foreign currency Official Reserves Account deficit an increase in foreign assets is recorded with a negative number (as with a private investment). The Central Bank is adding to its foreign exchange reserves, or supplying the domestic currency see how managing currency DCS CB can sell currenced  Since supply = demand X+ INVF→CH – M – INVCH→F = NET GOVERNMENT SALES Thus, CURRENT ACCOUNT BALANCE + FINANCIAL ACCOUNT BALANCE = CHANGE IN OFFICIAL RESERVES  China’s Twin Surpluses Exhibit 3.5 illustrates China’s highly unusual twin surplus in both the current and financial accounts – these relationships are typically inverse in a truly free floating currency The twin surpluses are balanced by the official reserves – The official reserves will show a deficit – Thus not breaking the rules (language in your textbook…) The reserves allow the Chinese government to manage the value of the Chinese yuan and its impact on Chinese competitiveness in the world economy – A source of political friction 24 render Exhibit 3.5 China’s Twin Surplus, 2006‐2020 25  China’s Balance of Payments, 2007‐2018 consider third account an not gives second half actual of the deficit story 0 so a don't DCS actually break theyto the ru pay capital pull get end investors out of but up richer money china 26  accumulation overtime China’s Foreign Exchange Reserves (USD Million) Printing money outflow of domestic money to purchase dollar  BOP Impact on Key Macroeconomic Rates A country’s balance of payments both impacts and is impacted by the three macroeconomic rates of international finance: – exchange rates – interest rates – inflation rates Capital controls and mobility to be discussed later in the course 28  Exchange rate adjustment BoP impact Under flexible exchange rates → there is a price adjustment in the currency, the central bank does not intervene and no change in official reserves Example – Trade flows channel US (flexible XR) has a current account deficit of USD 100m, the central bank does not intervene → excess supply of USD. Need a financial account surplus to finance this → USD 100m worth of assets (bank deposits) transferred to foreigners. The exchange rate must move to the level at which foreign lenders are willing to finance the current deficit through financial inflows. The price of USD likely to drop in order to convince foreign investors to hold these additional USD. This likely fall in value helps to correct the trade imbalance over time. Alternatively, → currency intervention. The central bank might want to intervene to stop the currency depreciation. Not very common among flexible currencies  Exchange rate adjustment BoP impact Under fixed exchange rates → there is no price adjustment, the central bank must provide the quantity adjustment of the currency to keep the par value fixed Example – Financial flows channel Due to uncertainty in Hong Kong (fixed XR) political situation, investors from Hong Kong are investing in Canada → positive net portfolio investment in Canada → deficit in the financial account of the BOP in Hong Kong → from this outflow, HK monetary authority has to intervene, buying its own currency, selling foreign currency, this decrease in the official reserves is recorded with a positive number in HK’s BOP Instead, under flexible exchange rates, the excess demand for Canadian assets would lead to a depreciation of the HKD/appreciation of the CAD  The BOP and Interest Rates Relatively low real interest rates should normally stimulate an outflow of capital seeking higher rates elsewhere – Important role in managed float regimes The opposite has occurred in the U.S. in the past due to perceived growth opportunities and political stability— allowing it to finance its large fiscal deficit – Who can borrow at most favorable rates around the world? Favorable inflows on the financial account and a current account balance year after year—making the U.S. a bigger debtor nation vis‐à‐vis the rest of the world – Consider the Net International Investment Position (NIIP) 31  The BOP and Inflation rates Imports have the potential to lower a country’s inflation rate. Foreign competition substitutes for domestic competition to maintain a lower rate of inflation than might have been the case without imports. – Global trade with high volume of imports is pro‐competition On the other hand, to the extent that lower‐priced imports substitute for domestic production and employment, gross domestic product will be lower and the balance on the current account will be more negative. Imports also have the potential to increase a country’s inflation rate (see later) 32  Trade Balances and Exchange Rates A country’s import and export of goods and services is affected by changes in exchange rates What is the transmission mechanism? – changes in exchange rates change relative prices of imports and exports, and changing prices in turn result in changes in quantities demanded through the price elasticity of demand Theoretically, this is straightforward; in reality global business is more complex – Three stages in the short/intermediate/long term – It takes time – Importance today of global supply chains 33 Exhibit 3.6 Trade Adjustment to Exchange Rates: The J‐Curve 34 no Output and growth Gross Domestic Product GDP – Market value of all final goods and services produced by a country in a given year Sources of output growth – Increases in labor, increases in capital, increases the efficiency with which they are used Total amount of output that a country produces = its ultimate budget constraint – A country can use more output only if it borrows the difference from foreigners – Concept of output exchange (= global trade) is important, now we can think of the role of money in an international context  Some Important Macroeconomic Relations Notation – Y = National Income or Gross Domestic Product (GDP) – C = Consumption (by private domestic residents) household – I = Investment companies spent spend – G = Government Expenditures gov spend – X = Exports of Goods and Services current account – M = Imports of Goods and Services CA = X‐M = current account g p – S = S + S = National (Gov’t and private) Saving – T = Tax Revenue G‐T = Government deficit  National Income Identity (Open Economy) Y = GDP = C + I + G + X – M Y = C + I + G + CA is money save because there can the for CA = Y – (C + I + G) future forks CA < 0 CA > 0 5 surplus deficit everything that want more is bought by domes  th is p deeed m s less 1 So get from foreigners is produced National Saving like produce more USA and the Current Account then it is consuming National Saving (S) is the portion of national incomedomestically (Y) that is not directed to household consumption (C) or government purchases (G) S = Y – (C + G) – Closed economy: S = I – A closed economy can save only by building up its capital stock (I) can onlythat grow if continues to comes out of savings invest  National Saving and the Current Account National Saving (S) is the portion of national income (Y) that is not directed to household consumption (C) or government purchases (G) – Open economy: S does not have to be equal to I S = I + CA – An open economy can save by – building up domestic capital (I) – “acquiring” foreign wealth (thus a CA surplus) to build up domestic capital can use foreign capital  Investment, National Saving and the Current Account Equivalently, investment is funded out of three basic sources p I = S - CA + Sg If a nation wishes to increase its level of investment, it must – Reduce private consumption (increase Sp) – Reduce government spending (increase Sg) – Increase foreign borrowing (thus, more investment funded by foreigners, likely a CA deficit)  Why do we care? Policymakers and global business BOP data is important for government policymakers and MNEs as it is a gauge of a nation’s competitiveness or health (domestic and/or foreign) For a MNE, both home and host country BOP data is important as: – An indication of pressure on a country’s foreign exchange rate – A signal of the imposition or removal of controls in various sorts of payments (dividends, interest, license fees, royalties and other cash disbursements) – A forecast of a country’s market potential (especially in the short run) 41  Why do we care? Global imbalances The balance of payments helps understand the broader implications and consequences of current account imbalances It gives cues on how nations can avoid crises brought by volatile financial flows and how they can minimize the damage of financial crises if such occur Lessons from global imbalances – The global financial crisis of 2008 – For the COVID economic and health crisis  IMF External Sector Report 2024 July 2024 IMBALANCES RECEDING With tight monetary policy conditions in key advanced economies continuing in 2023, the US dollar remained strong in 2023 and early 2024 by historical standards, while other reserve currency movements have been mixed. Net capital inflows to emerging market and developing economies recovered slightly from the lows experienced in 2022 but remained negative in 2023. Gross inflows and outflows in emerging markets declined, however. Against this background, the global current account balance (defined as the cross‐country sum of absolute values of current account) narrowed significantly in 2023. The narrowing reflected a reversal of large current account surpluses in commodity exporting countries, as commodity prices declined. Continued recovery from the COVID‐19 pandemic and a slowdown in global trade in goods during 2023 also contributed.  IMF External Sector Report IMF’s external sector assessments highlight the importance of efforts in both excess surplus and deficit economies to promote external rebalancing. Economies with weaker‐than‐warranted external positions should focus on policies that boost saving and competitiveness. Economies with stronger‐than‐warranted external positions should prioritize policies aimed at promoting investment and diminishing excess saving to support external rebalancing while also pursuing domestic objectives. Current‐account global imbalances IMF External Sector Report 2024 imbalances surplus defci how large are they relative Lack of to GDP confident foreign Surplus 0 big borrowing us deficit Global current balance is the absolute sum of global surpluses and deficits. 45 Creditor and debtor nations to IMF External Sector Report 2024 nations 46  International position A country which spends more than its income (CA deficit) will: – import more than it exports – invest more than it saves – and /or run a government budget deficit – This overspending must be financed with investment by foreigners, so with flexible exchange rates there will be a financial account surplus to match the current account deficit A country which spends less than its income (CA surplus) will: – export more than it imports – save more than it invests – and /or run a government budget surplus doesn't buy all GDP  Adjustment towards external balance What happens if the country has a current account deficit? – The country must borrow from (or sell domestic securities to) the rest of the world to finance the current account deficit. – As foreigners accumulate domestic securities, the domestic currency value falls which, in turn, raises net exports and consequently output (income) – In addition, domestic interest rates rise which, in turn, lowers consumption and investment spending. – The increase in national output (income) relative to spending will reduce the current account deficit – This is the link between global imbalances and the domestic economy  Coping with Current Account imbalances Is the CA deficit sustainable? Likely lead to a currency depreciation – See adjustment toward external balance – However we need to consider the FA – very attractive investment opportunities at home can explain the persistent strength of the domestic currency Remember the U.S. example of continuous CA deficits through the years: – Total domestic spending (C + I + G) > Total output (Y) U.S. is buying more from foreigners than it sells to them U.S. is running continuous FA surpluses by borrowing abroad  Coping with Current Account imbalances Protectionism ‐ Tariffs, quotas, import restrictions! – increase price of imports – reduce the deficit However, – restrictions decrease demand of foreign currency → increase in domestic currency – domestic goods more expensive abroad → exports decrease – reduction in imports and in exports too! Everyone loses Risk of trade wars! Examples in the real world?  Is a current account deficit always a bad thing? It is caused at times by economic growth – Import will rise faster than export when a country is growing faster than its partners A growing country offers attractive returns on capital – Attract foreign investors who will finance the CA deficit – CA 0 not a good thing  In summary A BOP cannot be in disequilibrium (= 0 by definition) – Supply