Economics Essay - Impact of the Exchange Rate on the Balance of Payments Flashcards
Define the BOP
The Balance of Payments is a record of all reversible and non reversible transactions between Australian residents and overseas residents over a given period of time.
Introduction: Argument
The Australian economy operates under a floating exchange rate where the $A is determined by the intersection of the supply and demand curves in the FOREX market.
The appreciation of the Australian dollar has corresponded to increasing BOGS deficits in the long term.
Contrastingly, the recent depreciation of the $A from 0.80 USD in January 2017 to 0.70 USD in January 2019 has contributed to the improvement in the BOGS and recent CAS.
The exchange rate also has implications on the NPI and KAFA through valuation effects, although these impacts have been mitigated through currency hedging and relatively insignificant.
Exchange Rate Theory + BOP theory
Define - the exchange rate is defined as the value of one currency in terms of the value of another currency
The exchange rate is determined by the intersection of the supply and demand curves for $A in the FOREX markets.
An appreciation is the increase in the value of the $A relative to the value of other currencies
Draw diagram - label
As seen in the diagram, the appreciation of the $A from 0.75 to 0.80 USD can occur through a decrease in supply from SS to S1S1 however, an increase in demand for $A will similarly cause an appreciation.
The balance of payments has two primary accounts, the Capital and Financial Account (KAFA) and the Current Account (CA).
Under a floating exchange rate, market equilibrium iccurs where the demand for $A is equal to the supply of the $A, such that the deficit on the Current Account is equal to the surplus on the Capital and Financial Account
CA - KAFA = 0
Appreciation - BOGS thesis + theory
An appreciation of the Australian dollar is associated with the deterioration of the bOGS through decreasing the international competitiveness of Australian exporters.
Depreciation - J Curve Effect thesis
A depreciation of the $A can have varying short and long term implications on Australia’s trade balance, and therefore the BOP.
Exchange rate on the NPI thesis
Exchange rates have implications for the NPI component of the CA in the short term.
Exchange rate on the NPI theory
An appreciation of the $A will decrease the value of Australia’s net foreign liabilities denoted in foreign currency terms, approximately 60% of Australia’s foreign debt, and decrease the surplus on the KAFA.
However, it will also decrease the servicing costs of Australia’s net foreign liabilities, recorded as debts on the NPI.
Similarly, a depreciation should lead to an increase in the servicing costs of Australia’s net foreign liabilities and an increase in the returns on foreign equity owned by Australians.
Exchange rate on the NPI examples and counter
The recent depreciation of the $A has contributed to the improvement in the NPI component of the CA from a -60 bn deficit in 2017-18 a $13 bn dollar deficit in 2018-19 through increasing the returns on investment relative to the interest repayments on foreign debt.
As supported by Deputy RBA Governor Guy Debelle, this is because “government debt has lower servicing costs than private debt and now comprises a larger share of the stock of liabilities in Australia”
However, it must be noted that valuation effects have been relatively insignificant as a cause of the change in the equity and debt yields, whilst falling interest rates on financial assets been more significant in reducing the servicing costs of net foreign liabilities.
The hedging of foreign currency has also decreased the impact of valuation effects on the NPI, with 60% of foreing debt hedged and 20% of foreign equity hedged to mitigate external risks.
Exchange rate on the NPI - counter
However, these impacts are mitigated by currency hedging, with approximately 60% of Australia’s net foreign debt and 20% of Australia’s net foreign equity hedged.
Appreciation - BOGS - example
The appreciation of the $A from 2008-11 from 0.67 - 1.10 USD due to high export demand negatively affected other Australian export industries, including tourism, education and financial services, creating a two speed economy.
Appreciation - BOGS - further explanation + example
This is because Australian exports became relatively more expensive in foreign currency terms, making them less attractive than foreign G + S.
This is evidenced in the shift from a 13.7 bn surplus in 2010-11 to a -3.7 bn deficit in 2011-12.
Appreciation - BOGS - However
However this BOGS deficit was ultimately insignificant in affecting Australia’s CAD, which only increased by 0.2% of GDP between 2011-12 and 2012-13.
This is because of the decreasing NPI deficit associated with reduced returns on investment in the Australian mining sector, 75% foreign owned, decreasing the total profits distributed to overseas foreign investors.
Impact of valuation effects on the KAFA
theory
Fluctuations in the value of the Australian dollar have implications for the KAFA component of the BOP.
An appreciation of the AUD may lead to lower levels of capital inflow into
-Australia as domestic assets, including shares and other financial derivatives, become
more expensive and less attractive relative to foreign assets.
-Through decreasing the level of portfolio and investment inflows relative to outflows,
this would contribute to a surplus in the KAFA.
Impact of valuation effects on the KAFA
examples
However, the appreciation of the Australian dollar during the from 2009-2011 was underpinned by significant increases in the profitability and growth of Australia’s mining and resources sector during the commodity boom of 2009-13.
- As such, KAFA inflows continued to rise despite an appreciating $A.
