Balance of Payment BOP

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Balance of Payment BOP

• BOP is virtually an accounting identity, as a
  sources and uses of funds.
• Sources of funds are those transactions
  increasing the purchasing power of a nation such
  as export of goods, services and capital.
• Uses of funds are those transactions reducing the
  purchasing power of a country such as import of
  goods, services and capital.
• The Export of goods, services and capital
  generate demand for the currency of the exporting
  country and supply of foreign currency.
• The import of goods, services and capital
  generate supply of currency of the importer and
  demand for foreign currency in order to settle
  transactions.

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Comparative Advantage

• refers to specialization as a key for producing
  goods at a minimum average cost and trading these
  goods for other products in which trading partner
  can produce more efficiently.
• The ratio of productivity over wage (comparative
  advantage) dictates why a country such as U.S.
  with very high wages and high productivity in
  high tech trades with a country such as Mexico
  with low wages (absolute advantage) and low
  productivity.
• Absolute Advantage in wage or productivity alone
  is a necessary but not a sufficient condition for
  producing goods at a minimum average cost.

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COMPONENTS OF BALANCE OF PAYMENTS

• Current Account
• Capital Account
• Official Foreign Exchange Reserve
• Statistical Error and Omissions

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Economics and Current Account

• The factors inducing change in current account
  can be summarized as follows
• -Exchange Rate ? ratio of two prices
• -Income
• -Government
• -Expectations ? Consumer Confidence

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United States BOP
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Current Account and Capital account as a
Percentage of GDP
US current account continued to deteriorate since
1980, The current account as percentage of GDP
dropped to -6 percent in 2006 reaching over 850
billion deficit.
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Exchange Rate Pass-through

• Exchange Rate As the dollar weakens against
  foreign currencies, requiring more dollars to
  acquire foreign currency, the goods and services
  made in the U.S. becomes relatively more
  attractive to foreign buyers.
• The exports in this scenario are expected to
  improve as the domestic goods become cheaper for
  foreigners to acquire and
• Imports are expected to fall as foreign goods and
  services tend to be more expensive, thus creating
  an increase and improvement in the current
  account balance.
• The above simplistic analysis assumes among other
  things that the pass-through from the exchange
  rate to prices of goods and services in the
  exports and imports sector of the economy is
  complete and simultaneous.
• In a complete pass-through a currency
  appreciation/depreciation i.e., say 5 percent
  causes export price/import price to go up/down
  simultaneously by 5 percent.

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Capital Account, Expectation and Interest Rate

• The capital account tends to be interest rate and
  yield sensitive.
• Expectation also plays a major role for making
  foreign direct investment and portfolio
  investment by U.S. individual and institutions
  overseas as well as their foreign counterparts in
  the U.S. markets.
• Investors seeking far better return overseas are
  usually attracted to emerging economies with a
  promise of expected high yield.
• Particularly the short-term capital account is
  highly sensitive to interest rate and the yield
  in the emerging markets stocks and bonds markets.
• The so called hot capital in pursuit of high
  returns moves swiftly from one country to another
  and retreats at the sign of any weakness and
  financial crises creating substantial exposure to
  users and providers of capital

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Exposure Related to Capital Account

• The exposure in the capital account is related to
  the foreign direct investment and portfolio
  investment overseas.
• The return of the original capital as well as
• The capital gain or loss,
• royalties, and
• Interest income are exposed to foreign exchange
  risk as well as interest rate and market risk,
  creating opportunities for a windfall gain as a
  result of favorable exchange rate movements and
  falling interest rates or losses stemming from
  unfavorable exchange rate and rising interest
  rates.

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Example Return
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• Foreign exchange gain (loss) (S t S t-1)/ S
  t-1
• Where S t and S t-1 are the exchange rates
  prevailing at time t and t-1 in direct quote
  (/foreign currency).
• (S t-1 S t )/ S t Foreign exchange gain
  (loss) in indirect quote foreign currency per
  (f/)

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Example

• Korean Won was KW900/ on July 1997, in November
  the exchange rate devalued to KW1100/. Korean
  Won devalued by how much from July to November?
• (900-1100)/1100 -18.2

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Example

• Strong hedge fund invested in a one year Yankee
  bond promising 8 percent interest rate and the
  Euro is currently at 1.10/.. Estimate the
  return realized by the U.S. based hedge fund
  assuming the Euro appreciates to 1.21/ by the
  end of the year.

Foreign exchange gain (loss) (1.21
-1.10)/(1.10)
.10 (1 return ) (1.08)
(1.10) 1.188 Return
.1880
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Risk

• Ignoring the co-variation of the return in
  foreign currency and percentage change in
  dollar value of pound, the rate of return in
  dollars will be simply equal to 13 the sums of
  8 interest and windfall gain due to favorable
  exchange rate movement of 5.
• The risk as measured by the variance of Equation
  2.1 will be
• Volatility in volatility in volatility of
  percentage change in / exchange rate

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Brazil

• The turbulence involving emerging market
  economies in general, and Brazil in particular,
  deeply affected countrys access to international
  capital markets.
• The magnitude of change can been seen in the
  widening spreads for sovereign bonds.
• In June 1997, the Brazil Treasury issued a
  global, thirty-year bond with a 395 basis point
  spread over U.S. Treasury two years later, a
  global, ten-year bond was bearing an 850 basis
  point spread.

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Brazil Current Account/GDP
After the implementation of Real Plan that pegged
the Brazilian Real to US dollar at exchange rate
of 1 to 1 in 1994, Brazil continued to have
current account deficit as Brazilian goods for
export became very expensive. Once Brazil
abandoned the parity and Real devalued by 67
percent, current account as percentage of GDP
turned positive in 2003.
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Before and Aftermath of Real Plan

• Export is very expensive aftermath of Real Plan
  that pegged Real to one US dollar per/Real.
• After severe devaluation current account/GDP
  turns into surplus as Brazilian goods (export)
  become very competitive

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Percentage Change in Brazilian Real
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Argentina Current Account/GDP
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Tale of Argentina Dollarization

• As seen in the previous graph, Argentina
  experiences deficit in current account following
  dollarization that pegged Peso per dollar in
  1994-200.
• Argentina goods became fairly very expensive,
  making export uncompetitive.
• After severe devaluation current account/GDP
  turns positive, as goods made in Argentina
  becomes fairly inexpensive.

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Real Interest Rate Differentials Argentina USA
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Argentina Retail and Wholesale Inflation
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• When the imbalance is financed primarily with
  large capital inflows and short-term credit from
  large foreign banks at times of economic growth,
  the return on investment is usually greater than
  the cost of capital.
• However, as the boom ends and local currency
  devalues and as the cost of servicing foreign
  currency denominated loans skyrocket,
  bankruptcies mount, putting solvency of local
  banks in doubts due to currency and banking
  crises

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Asian Financial Crisis
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Causes of Financial crises S E Asia

• Rigid exchange rate mechanism
• Moral hazard associated with financial
  intermediaries
• Lack of transparency
• Lax regulation
• Capital account liberalization

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The effects

• Widening current account deficit
• Asset price inflation (bubble in equity and real
  estate prices
• Appreciation of real exchange rate
• Rising roll-over risk
• Export slow down
• Mismatch of revenue cost (unhedged exposure to
  currency risk)
• Interest rate risk

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• Roll over risk refers also to the availability
  risk as major international banks refuse to
  extend credit to a borrower at a prevailing
  market interest rate on a maturing debt or demand
  and require good collateral and or substantial
  increase in interest rate.

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