1. Lecture 7 August 23th2010

2. Balance of Payment

3. Balance-of-Payments Balance of payments accounts are a way of keeping track of all economic transactions between the home country and the rest of the world over a specific time period (usually one year).

4. Recent Growth of Trade and Capital Movements The value of trade in goods and services has increased from $582 billion in 1973 to $15.8 trillion in 2008. International transactions of the monetary sort have also grown very rapidly over the last few decades.

5. Credit and Debits in Balance-of-Payments Accounting Credit items reflect transactions that give rise to payments flowing into the home country. e.g., exports, foreign investment inflows, interest payments on earlier investments Debit items reflect transactions that give rise to payments flowing out of the home country. e.g., imports, foreign investment outflows, interest payments to foreigners

6. Credit and Debits in Balance-of-Payments Accounting The IMF groups items into four categories Category I: Current account, Category II: Direct investment and other long-term financial flows, Category III: Short-term nonofficial financial flows, and Category IV: Changes in reserve assets of official monetary authorities (central banks).

7. Credit and Debits in Balance-of-Payments Accounting Category I: Current account Credit items include exports of goods and services, interest and dividends from investments abroad, wages earned abroad, and gifts from abroad. Debit items include imports of goods and services, interest and dividends paid to investors abroad, wages paid to foreigners, and gifts sent abroad.

8. Credit and Debits in Balance-of-Payments Accounting Category II: Direct investment and other long-term financial flows Credit entries: anything that causes a net increase in the holdings of assets in the home country by the foreign country. Debit entries: anything that causes a net increase in the holdings of assets in a foreign country by the home country.

9. Credit and Debits in Balance-of-Payments Accounting Category III: Short-term nonofficial financial flows These are mainly private flows, with maturities under one year. Credit items: any increase in foreign holdings of such assets in the home country. Debit items: any increase in home country holdings of such assets in the foreign country.

10. Credit and Debits in Balance-of-Payments Accounting Category IV: Changes in reserve assets of official monetary authorities (central banks) Credit items: whenever the foreign country central bank acquires home country assets (such as bank accounts). Debit items: whenever the home country central bank acquires foreign country assets.

11. Sample Entries in the Balance-of-Payments Accounts In general, balance-of-payments accounting relies on double-entry bookkeeping. This means that any transaction must be added as a credit and a debit. This implies that the sum of all credits must equal the sum of all debits, and the total BOP is always in balance.

12. Example

13. Sample Entries in the Balance-of-Payments Accounts #1: Exporters in the U.S. send $6,000 of goods to Canada, receiving a short-term bank deposit of $6,000 from Canada. Credit: Category I: Export of goods +$6,000 Debit: Category III: Increase in short-term private assets abroad -$6,000

14. Sample Entries in the Balance-of-Payments Accounts #2: Consumers in the U.S. buy $10,000 of goods from Canada, paying with a short-term bank deposit of $10,000. Debit: Category I: Imports of goods -$10,000 Credit: Category III: Increase in foreign short-term assets in the U.S. +$10,000

15. Sample Entries in the Balance-of-Payments Accounts #3: U.S. residents send $5,000 to Mexico as gifts. Credit: Category I: Exports of +$5,000 Debit: Category I: unilateral transfer of -$5,000

16. Sample Entries in the Balance-of-Payments Accounts #4: An American firm provides $2,000 of shipping services to a Canadian company, which pays by transferring money into its U.S. account. Credit: Category I: export of services +$2,000 Debit: Category III: Decrease in short-term private assets in the U.S.: -$2,000

17. Sample Entries in the Balance-of-Payments Accounts #5: A Canadian company sends $8,000 in dividends to bank accounts of American stockholders. Credit: Category I: investment receipts from abroad +$8,000 Debit: Category III: Decrease in short-term private assets in the U.S.: -$8,000

18. Sample Entries in the Balance-of-Payments Accounts #6: An American buys a long-term bond from a Mexican company for $2,000; transfers payment from her U.S. bank account. Debit: Category II: increase in long-term asset abroad -$2,000 Credit: Category III: Increase in short-term private assets in the U.S.: +$2,000

19. Sample Entries in the Balance-of-Payments Accounts #7: Canadian banks wish to reduce holdings of dollars in U.S. banks by selling $800 to the Federal Reserve. Debit: Category III: Decrease in short-term private assets in the U.S.: -$800 Credit: Category IV: Increase in foreign short-term official assets in the U.S.: +$800

20. Assembling a BOP Summary Statement

21. BOP Summary

22. BOP Summary (cont’d)

23. Statistical Discrepancy The current account balance may not exactly equal the financial account balance due to incomplete or imperfect data, illegal activities, and mismatches on the timing of data collection. To account for these, a category called “statistical discrepancy” is included in the BOP.

24. U.S. International Transactions, 2007 (billions of $)

25. U.S. International Transactions, 2007 (billions of $)

26. International Investment Position of the U.S. The BOP accounts are flow concepts– they represent changes over a time period. The international investment position is a stock concept – it involves totals up to the present. If foreign assets outweigh foreign liabilities, a country is a net creditor; otherwise it is a net debtor.

27. Int’l Investment Position of the U.S. (end of 2007) – billions of $

28. Int’l Investment Position of the U.S. (end of 2007) – billions of $

29. International Investment Position of the U.S. The U.S. is a net international debtor. No other country in the world is as indebted. Disadvantages We must transfer future goods and income abroad. Foreign ownership may threaten U.S. sovereignty. Still, productive investments should allow repayment.

30. Foreign Exchange

31. The Foreign Exchange Rate and the Market for Foreign Exchange Foreign exchange rate: the price of one currency in terms of another. e.g., US$/€ or €/US$ The foreign exchange rate is determined by the interaction of demand for and supply of foreign exchange. The foreign exchange market is the worldwide network of markets and institutions that exchange currencies.

32. The Market for Foreign Exchange: Demand Foreign exchange is demanded by those wishing to buy goods and services from or send gifts or payments to another country. wishing to purchase financial assets in another country. wishing to profit from exchange rate changes (speculation). wishing to minimize risk from exchange rate changes (hedging).

33. The Market for Foreign Exchange: Supply Foreign exchange is supplied by those selling goods and services to or receiving gifts or payments from another country. in other countries who wish to purchase financial assets in the home country. wishing to profit from exchange rate changes (speculation). wishing to minimize risk from exchange rate changes (hedging).

34. The Market for Foreign Exchange S€ $/€ Initially, Qeqeuros are traded, and the equilibrium price is eeq. eeq D€ Qeq Euros (€)

35. The Market for Foreign Exchange S€ $/€ An increase in U.S. demand for euros causes an appreciation of the euro. e'eq eeq D'€ D€ Qeq Q'eq Euros (€)

36. The Market for Foreign Exchange S€ S'€ $/€ An increase in the supply of euros causes a depreciation of the euro. eeq e'eq D€ Qeq Q'eq Euros (€)

37. The Market for Foreign Exchange: Supply The total supply and demand for foreign exchange includes two components. One is related to current account transaction. The other is related to financial flows, including speculation and hedging.

38. The Market for Foreign Exchange SG&S $/€ STotal The total equilibrium exchange rate will only be the same as the one for Good & Service (G&S) if the current account is exactly in balance. eeq DG&S DTotal Qeq Euros (€)

39. The Spot Market The spot market is the daily or current market for foreign exchange. The main participants are large commercial banks trading with each other in the interbank market. There are many foreign exchange markets, but they all tend to generate the same exchange rate regardless of location. This is the result of arbitrage.

40. Arbitrage Arbitrage occurs when individuals see an opportunity to buy something at a low price in one market, then sell it for a higher price in a second market. This causes prices in all markets to move towards each other. Arbitrage causes currency prices to be similar across markets, and makes cross rates between currencies consistent.

41. Different Measures of the Spot Rate How can we measure a country’s overall exchange rate (not just a bilateral rate)? Nominal effective exchange rate (NEER) Real exchange rate (RER) Real effective exchange rate (REER) Purchasing power parity (absolute and relative)

42. Different Measures of the Spot Rate: NEER The NEER is an index that measures the change over time in the nominal value of a country’s currency. The nominal effective exchange rate weights the exchange rates of each of a country’s trading partners by the volume of trade with each. NEER is a weighted average of a currency’s exchange rate against a bundle of other currencies.

43. Different Measures of the Spot Rate: NEER However, prices in the two countries may not be constant. Suppose the dollar appreciates against the euro by 10%, but at the same time U.S. prices rose by more than European prices. The decline in U.S. competitiveness is more than 10%. RER=e€/$(price indexUS/price indexEur).

44. Different Measures of the Spot Rate: NEER The REER is an index that measures the change over time in the real value of a country’s currency. The real effective exchange rate weights the real exchange rates of each of a country’s trading partners by the volume of trade with each. REER is a weighted average of a currency’s real exchange rate against a bundle of other currencies.

45. Absolute Purchasing Power Parity In principle, a commodity should have the same price worldwide when measured in a common currency, due to arbitrage. PPPabs = price levelUS/price levelEur If cotton costs $0.5 per pound in the U.S., and €0.35 per pound in Europe, the exchange rate should be $1.43/€. However, transportation costs and other differences means absolute PPP doesn’t generally occur.

46. Relative Purchasing Power Parity Relative PPP takes into account differences in price indexes PPPrel$/€ = (e $/€) (PIUS/PIEur). Relative PPP relates the change in the exchange rate to changes in the two countries’ price levels.

47. The Forward Market Most exchanges of currencies takes place two business days after the contract has been completed. In general, forward exchange rates can be for any period of time into the future. Suppose a U.S. company agrees to buy 5 trucks from a French company at a price of €50,000 each, with delivery in 6 months, the equivalent of $70,000 at today’s spot exchange rate of $1.4/€.

48. The Forward Market What if the euro appreciates to $1.6/€? Now the price in dollars has risen to $80,000. There are ways to hedge against this potential risk. The buyer and seller can agree to make the sale at today’s forward exchange rate. The buyer can purchase a foreign currency option This gives the buyer the right to a specific exchange rate at a specific time in the future.

49. Foreign Exchange and Financial Market

50. The Link Between the Foreign Exchange and the Financial Markets The decision to invest internationally depends on the expected rate of return on the international asset relative to domestic alternatives. Specifically, investors consider The domestic interest rate or expected rate of return. The foreign interest rate or expected rate of return. Any expected changes in exchange rates.

51. The Link Between the Foreign Exchange and the Financial Markets An investor would be indifferent between a $1 domestic or foreign investment if her expected return is the same after accounting for expected changes in the spot rate. Let iNY = 90-day interest rate in New York. Let iParis = 90-day interest rate in Paris. Let E(e) = the expected spot rate in 90 days.

52. The Link Between the Foreign Exchange and the Financial Markets An investor would be indifferent if $1(1+iNY) =[($1)/(e)]x(1+iParis)[E(e)] or (1+iNY)/(1+iParis)=E(e)/e This can be approximated as (iNY – iParis) ≈ xa where xa is the expected appreciation of the foreign currency.

53. The Link Between the Foreign Exchange and the Financial Markets This is called uncovered interest parity (UIP). If (iNY – iParis) > xa, investments in the U.S. will be more attractive to investors and investment funds would flow into the U.S. If (iNY – iParis) < xa, investments in France will be more attractive to investors and investment funds would flow into France.

54. The Link Between the Foreign Exchange and the Financial Markets Naturally, individuals don’t have perfect foresight. Since expectations can be wrong, there may be an additional premium required to undertake the risk: (iNY – iParis) ≈ xa – RP If the risk premium is 1%, the gap between the interest rates must be higher for investors to be indifferent.

55. The Link Between the Foreign Exchange and the Financial Markets So far, we’ve assumed any exchange rate risk is borne by the investor. In fact, the risk can be hedged in the forward market. The relationship between the spot and forward rates is usually stated as p = [efwd/e] – 1 where efwd is the forward exchange rate p is the premium (or discount).

56. The Link Between the Foreign Exchange and the Financial Markets If the forward market exchange rate is $1.72/€ and the spot market rate is $1.70/€, p = [1.72/1.70] – 1 = 1.2%. That is, there is a 1.2% premium on the foreign currency.

57. The Link Between the Foreign Exchange and the Financial Markets An investor would be approximately indifferent if (iNY – iParis) ≈ p where p is the percentage premium. We can also include transactions costs: (iNY – iParis) ≈ p ± transactions costs This is called covered interest parity (CIP).

58. Simultaneous Adjustments of the Foreign Exchange and Financial Mkts What happens if (iNY – iParis) > p ± transactions costs? Investment funds should move from Paris to New York, decreasing the supply of loan-able funds in Paris. This should put upward pressure on interest rates in Paris.

59. International Financial and Exchange Rate Adjustments S'€ iParis S€ Paris money market i'P iP D€ €

60. International Financial and Exchange Rate Adjustments The conversion of euros into dollars in the spot market increases the supply of euros, thereby putting downward pressure on the euro spot rate (that is, causing the dollar to appreciate).

61. International Financial and Exchange Rate Adjustments S€ e$/€ S'€ e0 Spot market e' D€ €

62. International Financial and Exchange Rate Adjustments Investors wish to cover themselves against exchange rate changes will now purchase euros in the forward market. This will put upward pressure on the euro forward rate.

63. International Financial and Exchange Rate Adjustments St€ e$/€fwd Forward market efwd' efwd Dt'€ Dt€ €

64. International Financial and Exchange Rate Adjustments When the new funds move to New York, supply of loanable funds increases there. This will put downward pressure on iNY.

65. International Financial and Exchange Rate Adjustments S$ iNY S‘$ iNY N.Y. money market iNY' D$ $

66. International Financial and Exchange Rate Adjustments All of these adjustments work toward reducing the initial inequality. Eventually, (iNY – iParis) = p ± transactions costs.

67. International Bank Lending Banks’ balance sheets commonly have loans and deposits that are international in origin. As of 2008, gross international bank lending was $37.5 trillion!

68. International Bank Lending Gross international bank lending can be divided into three components: domestic bank loans in domestic currency to foreigners, domestic bank loans in foreign currency to foreigners, and domestic bank loans in foreign currency to domestic residents. The first is called “traditional foreign bank lending.” The second and third represent the eurocurrency market.

69. The Eurodollar Market Eurodollar deposits arise when a U.S. exporter wishes to sell goods to a foreigner, is paid in dollars, and wishes to leave the dollars in an account in a foreign bank. The Eurodollar market began to be important in the 1950s, as the USSR chose to put dollar-denominated deposits in British (rather than American) banks. Other factors, such as the oil shocks in the 1970s, increased Eurodollar holdings.

70. The Significance of Eurodollar Markets The rise of Eurodollar markets has significantly increased the international mobility of financial capital. This means that interest rates have been increasingly linked across countries, and have moved toward each other. One drawback is that financial problems quickly spread worldwide, such as happened in 2008.

71. The International Bond Market (Debt Securities) Government and corporations can borrow money by issuing bonds. Bonds have a face value – this is the amount that will be paid to the lender when the bond matures. Foreign bond markets and eurobond markets together comprise the international bond market. The stock of this sort of debt was $23.9 trillion as of 2008.

72. Significance of the International Bond Market As with the Eurodollar markets, the increasing importance of international bond markets has increased the international mobility of financial capital, and countries’ interest rates have moved toward each other. This increased interdependence also helps spread financial problems.

73. International Stock Markets Ownership in companies (common stock) is another asset that is traded internationally. Exact figures on the volume of international stock transactions are difficult to obtain, but most believe these have increased. This may create a tendency for movements of stock prices across countries to become more similar to each other.

74. Significance of the Rise of International Stock Markets The increasing importance of international stock markets has facilitated the flow of financial capital to its most productive use. This increased interdependence can also allow financial problems to spread quickly, as was demonstrated in 2008.

75. Basic International Financial Linkages: Review Investors will be indifferent between domestic and foreign investment when (ihome – iforeign) ≈ p = xa – RP, where p is the forward exchange rate premium.

76. Basic International Financial Linkages: An Example How does the Eurodollar market change our understanding of financial linkages? Suppose

77. Basic International Financial Linkages If covered interest arbitrage parity holds, after dividing the annual interest rate difference by 4 to approximate a 3-month rate we get (ihome – iforeign) ≈ p (0.07 -0.08)/4 ≈ (1.687 – 1.691)/1.691 -0.0025 ≈ -0.0025.

78. Basic International Financial Linkages What happens if the Federal Reserve raises U.S. interest rates by ½ of a percentage point? Now, the eurodollar deposit rate will rise to 6% and the eurodollar lending rate will rise to 7%. We’d also expect the forward rate to rise (the dollar depreciates) and the spot rate to fall (the dollar appreciates)

79. International Financial and Exchange Rate Adjustments S'$ i S$ NY money market i' i D€ $

80. International Financial and Exchange Rate Adjustments The higher interest rate in New York increases demand for eurodollars. This will put upward pressure on the eurodollar rate.

81. International Financial and Exchange Rate Adjustments S$ i London money market (eurodollars) i' i0 D$ D‘$ $

82. International Financial and Exchange Rate Adjustments The higher U.S. interest rate leads to an increased supply of pounds on the spot market This additional supply is hedged in the forward market.

83. S£ e$/£ S'£ Spot market e$/£ e'$/£ D£ £ International Financial and Exchange Rate Adjustments

84. St€ e$/£ Forward market e'$/£ e$/£ D'£ D£ € International Financial and Exchange Rate Adjustments

85. International Financial and Exchange Rate Adjustments Further adjustments might occur in the U.K.’s money market and the eurosterling market that would lead to higher interest rates there, but the Bank of England may intervene to prevent this.

86. Hedging Eurodollar Interest Rate Risk New instruments, called derivatives, have emerged to hedge interest rate risk. Derivatives are financial contracts whose value is derived from an underlying asset such as stocks, bonds, commodities, etc.

87. Commonly Used Derivatives Maturity mismatching Future rate agreements Eurodollar interest rate swaps Eurodollar cross-currency interest rate swaps Eurodollar interest rate futures Eurodollar interest rate options Options on swaps Equity financial derivatives

88. The Current Global Derivatives Market Futures have been traded on metals and agricultural commodities for more than a century, so the idea of derivatives isn’t new. However, in the past 25 years there has been an explosion in the use of global derivatives. Annual growth rates have been in the range of 20%-30%.

89. Values of Selected Global Derivatives, 1987-2008

90. The Current Global Derivatives Market Why have derivatives become so important? Participants in the international financial markets have discovered that derivatives can increase their returns and/or lower their risk. Derivatives allow for an unbundling of exposure to foreign exchange risk, interest rate risk, and price risk.

91. The Current Global Derivatives Market However, as the global financial crisis of 2007-08 has shown, derivatives cannot eliminate risk.