Macro Review BOP Exchange Rates Jeffrey H Nilsen

Macro Review: BOP, Exchange Rates Jeffrey H. Nilsen http: //thedailyshow. cc. com/videos/zjr 96 n/julian-castro

Balance of Payments Accounting (part of N. I. P. A. ) assume BNB buys & sells $ to ensure Lev won’t change (exchange rate “peg”) Count transaction as: CREDIT: in-flow of funds, + DEBIT: out-flow of funds, - Sell good to foreigners => credit (CA) Sell asset to foreigners => credit (private KFA) Sell ORA to foreigners => credit (public KFA, i. e. OSB)

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

CAUS as percentage of GDP

Table 5. 1 US BOP Accounts 2008 ($ Billions) - 553. 5

1998 -01 1998 -05 1998 -09 1999 -01 1999 -05 1999 -09 2000 -01 2000 -05 2000 -09 2001 -01 2001 -05 2001 -09 2002 -01 2002 -05 2002 -09 2003 -01 2003 -05 2003 -09 2004 -01 2004 -05 2004 -09 2005 -01 2005 -05 2005 -09 2006 -01 2006 -05 2006 -09 2007 -01 2007 -05 2007 -09 2008 -01 2008 -05 2008 -09 2009 -01 2009 -05 2009 -09 2010 -01 2010 -05 2010 -09 2011 -01 2011 -05 2011 -09 2012 -01 2012 -05 2012 -09 2013 -01 2013 -05 2013 -09 2014 -01 Current Account of Bulgaria (to 2014 Jan) 1000 500 0 Series 1 1998 -01 -57. 9 -500 -1000 -1500

Capital & Financial Account (KFA) KFA accounts for trade in existing real & financial assets, including ORA (official reserve assets) If sell domestic house, inflow => KFA credit If buy Boeing shares, outflow => KFA debit KFA Surplus if BG sells more assets to foreigners than they do to BG

Official Settlements Balance OSB = 0 if no intervention o OSB accounts for official purchase/sales of ORA ($, €, Yen, Renimbi, gold, special drawing rights) n Officials: BOK, Fed, ECB o NO intervention => BNB, Fed don’t buy/sell ORA n (the reason to intervene is to try to influence the exchange rate)

The OSB non-zero if Intervention BNB buys/sells ORA to influence euro per lev exchange rate If tends to appreciate : e. g. CA, private KFA > 0 (Germans want many Leva; BNB buys euro (ORA), selling leva (outflows) OSB DEBIT offsets CA + (private KFA credit) so finally CA + KFA = 0

US KFA . . Sell good to foreigners => credit (CA) Sell asset to foreigners => credit (KFA) Sell ORA to foreigners => credit (KFA) Fed buys ORA OSB, 2 parts (on net positive) SNB buys $ Swiss buy US houses KFA surplus CA deficit When the SNB buys $ from a Swiss person or bank : Private Swiss had bought US asset (US sold asset [Bo. PUS inflow]) So transfer to official account OSB (OSBUS inflow) 11

Emerging Market Volatility in early 2014 http: //video. ft. com/3111207196001/ Emerging-market-sell-off-spreadsacross-Asia/Markets

Media Attention on Possible Argentine Currency Crisis In 2014, many investors withdrew funds from emerging markets since expected higher US r; (have pesos want $ assets). Private outflows. To prevent peso from depreciating, Bank of Argentina sells $ for investors’ pesos BUT : continuing private KFA deficit may deplete BOA’s $ ORA (FX reserves) All nations are concerned with exchange rate, but those with pegs are more prone to problems; often Have CA, KFA deficits How much depreciation should central bank allow? ?

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

Review Exchange Rates Plan o Nominal vs. real o PPP: absolute vs. relative o Determination of “fundamental exchange rate” where FX amount supplied = amount demanded o Peg en : over-valued vs. under-valued

Exchange Rates o Nominal: How much foreign currency you receive for 1 unit of home currency, e. g. 0. 50 € per 1 lev o Real (e. R): how many German goods you get for 1 BG good If mavrud costs 12 leva & same wine costs 5 euro in Germany, e. R = 1. 2 (German wine per bottle mavrud) Real exchange rate > 1: Consumers choose 1 Bulgarian vs. > 1 identical German goods

Nominal depreciation: e. N falls (get fewer € for 1 lev) e. R rises (real appreciation) => Get more German wine for each case mavrud (so more difficult to sell mavrud in D)

Purchasing Power Parity (long run influence) o ABSOLUTE PURCHASING POWER PARITY (PPP) => assuming free trade, identical goods: goods trade 1 -for-1 only => => (same price in $ ) n If doesn’t hold, pressure to return to PPP: o PBG or e. R falls due to unsold BG goods o or PDE rises due to high demand for German goods

Express absolute PPP as: PFor / P Pounds per $ (US domestic, UK foreign)

Relative PPP Instead ? o Absolute PPP does NOT hold because: n 1. services (especially) not subject to int’l competition; n 2. trade barriers don’t allow international P to equalize o Relative PPP: instead of er = 1, assume er constant over time o Relative PPP => e. N will appreciate to extent euro π > BG π

Nations with higher inflation (vs. $) experience greater depreciation Lane (1999) What determines the nominal exchange rate, some cross sectional evidence. CJE

Finding Eqbm e. N FX Market o Leva. S: BG public supplies leva to get euro $ to buy Airbus Jets & VW shares High e. N: BG want lots of euro since German Goods are cheap Low e. N: BG wants few euro since German goods high cost o Leva. D: Germans demand Leva to buy Mavrud & real estate Low e. N: Germans want many Leva since Mavrud cheap

FX Market Shifts Lev Supply (Lev appreciates) Quality of BG goods improves Lev demand Foreign interest Rate rise ? ?

Floating en & Policy o Float: en set by S & D IN ABSENCE OF central bank intervention o (zero OSB)

“Fixed” Exchange Rate Regime (e. g. Bulgaria) o Pure peg: the BNB commits to buy/sell € to maintain 0. 5 € per lev rate o Often not pure; even in float, national bank may intervene if believe currency overvalued (tough for exporters) e. g. Switzerland http: //video. ft. com/1145014411001/Swissie-pegdestabilising/Editors-Choice (Switzerland generally allows its Swiss Franc to float)

Important Issue in Pegs o Compare peg value to value that e would have without intervention (at fundamental value, where SFX = DFX ) o Undervalued peg may be strategy to increase exports o Overvalued peg may bring currency crisis Recall: policy changes in exchange rate are “revaluation” & “devalu

Undervalued Peg o e. PEG < efundamental o Low e. PEG => n American public buys many cheap Chinese goods, assets => Chinese CA, KFA both surplus n BUT EDYUAN: To maintain peg, PBo. C must sell yuan & buy $ (ORA) OSB debit Central Bank $ ↑ Y ↑ Result: PBo. C holds 2 trillion $

Overvalued Peg (Bulgaria pre-financial crisis) o e. PEG > e. FUND: CA, KFA deficit o Policy choices: n 1. Devalue to get to e. FUND n 2. e. g. tax IM to cut Lev. S (raising e. FUND) n 3. Soak up ESLEV: sell $, buy lev (must abandon peg if no more $ !!) Germans: Mavrud too costly Central Bank $ ↓ lev ↓ Cheap VW, D. assets

Speculative Attack o Germans fear lev assets lose value if BNB devalues At 0. 5 €/lev, share of Bulgartabak at 100 lev worth 50 € in Germany If BNB devalues to 0. 25€/lev => value drops to 25 € o Sell lev assets => lev. S shifts out o Fear makes ESLEV worse, BNB needs more $ to maintain overvalued peg => peg less sustainable

Compare Peg to Float o Peg cuts volatility and costs to trade. Disciplines M policy (limits BNB ability for discretionary M policy => lower π) o But float allows M policy to stabilize Y