CHAPTER 20: EXCHANGE RATES AND THE BALANCE OF PAYMENTS

OBJECTIVE
To be introduced to the balance of payments (BoPs) and the main accounts in the BoPs. To determine how the market for foreign exchange operates. To examine foreign exchange rate implications on the economy.

Balance of payments BoP

The BoP records transactions in goods, services and assets between a countrys residents and foreign residents during a calendar year. Components of the BoP:
The current account, the capital transfer account (not significant for discussion in this chapter), the financial account, unrecorded transactions.

1. The current account

This is where payments and receipts relating to flows of goods and services, and other flows of income, are recorded. This includes:
The Rand value of exports and imports on merchandise.

Net gold exports (the above merchandise traded and net gold exports = trade balance). Service receipts and payments. Income receipts (earned by South Africans in the rest of world) and income payments (earned by foreigners in South Africa). Current transfers, for example gifts, benefits or donations. Current Account Balance (CAB): the difference between credits and debits of goods, services, income and current transfers.

2. The financial account

These are international transactions in financial assets, including the borrowing and lending of funds (a summary of transactions in assets and liabilities). The financial account has three components:
Direct investment: the purpose of the investor is to gain control, or at least a meaningful say, in the running of an enterprise (any transactions related to such investments are recorded here). Portfolio investment: the investor is only interested in the financial return on the investment (any transactions related to such investments are recorded here). Other investment: all investments that are not recorded in the above two sections, are recorded as other investments, for example, short term loans.

3. Unrecorded transactions

It serves the purpose of ensuring that the balance of payments actually balance. Also, because a double entry accounting system is used to record all transactions in BoP, the net sum of all debit and credit entries should add up to a countrys change in net gold and other foreign reserves. In reality, this account is needed because of errors and omissions that may occur while compiling the BoP.

4. Gold and other foreign reserves

Export of goods and services increases foreign currency, and imports decreases it.
A country earns foreign currency by exporting goods and services, and by receiving transfers as well as inflows on financial account (capital inflows). Also, it has to pay in foreign currency for imported goods and services and it loses currency through transfer and outflows on financial account (capital outflows).

The difference between the receipts and payment of foreign currency makes up the foreign reserves (forex).
If receipts of forex > payments of forex, a country's reserves of forex If receipts of forex < payments of forex, a country's reserves of forex

Total reserves are calculated by adding together the surpluses/deficits of all the years BoP. A portion of South Africas gold production is held by SARB, as part of the countrys foreign reserves, so that if need be, gold reserves can be sold to obtain foreign currency .

Exchange rate policy

The choice of the exchange rate regime for a country will have a significant influence on the impact of monetary and fiscal policies. Three types of exchange rate regimes and their implications for policy:
Flexible exchange rate regime, fixed exchange rate regime, managed-float exchange rate regime.

Flexible exchange rate regime

The value of the currency is determined by the supply and demand for the foreign exchange (market forces). There is no interference by the Reserve Bank.

What is the driving forces behind the supply and demand in the market for forex? SUPPLY:
Supply of forex, for example, US$ into South Africa, is generally twofold. To pay for South African exports of goods and services. Through capital inflows. The supply curve for forex is upward-sloping (Fig 20.1), because as the Rand becomes cheaper against US$, it means South African goods and services become cheaper for foreigners, who will increase their purchases and therefore, increase forex supplied.

 DEMAND:
This stems from the need for South Africans to pay for foreign goods and services. This also stems from the need to repay foreign loans or to invest outside the country. The demand curve for forex (Fig 20.2) is downward-sloping, because as the value of the Rand strengthens against the US$, the quantity demanded will increase, because foreign goods and services, and investment opportunities now all become relatively cheaper. Note: as the Rand loses value against US$, imports become more expensive and less US$ will be demanded in South Africa.

Flexible exchange rate: determination of exchange rate (Fig 20.3)

The equilibrium exchange rate Exchange rate is R2 for every $1. D If the exchange rate was R3/$, there would be excess supply of $: a BoP R3/$ surplus of US$160m exists in South Africa (US$ = R2/$ appreciated, R = depreciated). If the exchange rate was R1/$ R1/$, there would be an excess demand of $: a deficit of US$160m on South African BoP (US$ = depreciated, R = appreciated). 150M 0

230M 310M Quantity supplied and demanded of US$(million)

Fixed exchange rates

In a fixed exchange rate system, national governments agree to sell their currency and buy foreign currency at a fixed exchange rate. The greatest virtue of fixed exchange rates is the reduction of uncertainty about the value of the currency.

Fixed exchange rate: defending of currency (Fig 20.4)

If the exchange rate is R2: $1 (point A), assume an increase in demand for $ (D2). This results in excess demand for $ (A C). In such a case, SARB would supply US$ from its reserve buy purchasing Rands to avoid depreciation of the Rand. Thus, when currency is defended in the wake of an increase in demand for foreign currency, it means forex reserves are depleted /lost. On the other hand, if excess supply under-fixed the exchange rate, SARB would buy excess supply and use it in future to defend depreciation of the Rand.

D2 Exchange rate D
R3/$ R2/$ A B C

R1/$

Q1

Amount of forex required to defend the currency

Fixed exchange rate: what happens when SARB runs out of forex when there is excess demand for it? (Fig 20.5)
Assume the demand for US$ is US$800m, but SARB only has US$500m. What happens? The government is left with no option but to devalue the Rand, for example, from R2/$ to R4/$, in order to eliminate excess demand for US$. The difference between depreciation and devaluation: Depreciation/appreciation occurs when the laws of demand and supply under flexible exchange rates cause currency to increase/decrease. Devaluation/revaluation is the forced change in the currency activated by the government.

Exchange rate D
R4/$ R2/$

500m

650m

800m

Quantity supply and demand of US$ (millions)

A managedfloat exchange rate

Combines features from both fixed and flexible exchange rate systems. The exchange rate is allowed to fluctuate as the market changes, but the Reserve Bank intervenes to smooth out short-term fluctuations. This is the most common system followed by countries.

Managed-float exchange rate: (Fig 20.7)

SARB would supply US$ from its reserve by purchasing Rands in order to defend the Rand, if it believed the depreciation from e1 to e2 to be temporary. Therefore, SARB defends the Rand at e1. If SARB believes depreciation is likely to endure for a long time, there would be no reason to defend currency, as this would be a waste of forex. So, the market is left to forces of demand and supply.

D2 Exchange rate D S
B A C

depreciation

e2

e1

Q1 Q Amount of forex required to defend the currency

SUMMARY
The exchange rate system that a country chooses, will have a significant influence on the impact of monetary and fiscal policies. In a fixed exchange rate system, national governments agree to maintain the convertibility of their currency at a fixed exchange rate. In a flexible exchange rate system, the exchange rate is determined by the interaction of supply and demand, and not SARB or government intervention. In a managed-float exchange rate system, the currency is allowed to fluctuate as markets change, and SARB intervenes to sort out only short-term fluctuations.

DISCUSSION
1. Assuming a flexible exchange rate, discuss the impact of an increase in the price of crude oil on the local forex market.