Impact of exchange rates on the NPI and KAFA Flashcards
Impact of the exchange rate on the NPI theory
The exchange rate can have direct implications for the NPI component of the CA through valuation effects.
An appreciation of the $A will decrease returns on foreign equity and lower the servicing costs of Australia’s net foreign liabilities through the valuation effect, with 60% of foreign loans denoted in foreign currency terms,
Contrastingly, a depreciation should increase the servicing costs of Australia’s net foreign liabilities and increase the returns on foreign investment.
Impact of the exchange rate on the KAFA theory
An appreciation of the $A should make Australian investments more expensive and less attractive for foreign investors as they become relatively more expensive in foreign currency terms.
This, theoretically, should lead to a decrease in the surplus on the KAFA as financial inflows are recorded as a credit.
Impact of the exchange rate on the NPI examples
The recent depreciation of the $A from 0.80 to 0.70 USD from January 2017 to January 2019 coincided with the improvement in the NPI from -60 billion deficit to a 13 billion deficit from 2017-18 to 2018-19, increasing the returns on foreign equity relative to the servicing costs of foreign liabilities.
However, the contribution of valuation effects to this improvement were relatively insignificant, mitigated by currency hedging, with 60% of foreign debt hedged and 20% of foreign equity hedged to mitigate external risks.
The improvement is largely due to changing composition of Australia’s foreign equity and foreign debt, as “government debt has lower servicing costs than public debt and now comprises a larger share of the stock of liabilities in Australia” as noted by Deputy RBA Governor Guy Debelle.
Simulatenously, returns on foreign equity associated with Superannuation have risen.
Impact of an appreciation on the BOGS
An appreciation should lead to a deterioration of the BOGS in the short term through decreasing the international competitiveness of Australian exporters.
The appreciation of the $A from 0.67 USD in 2008 to 1.10 USD in 2011, and maintaining parity wit hte USD form 2011-13 negatively affected non mining export sectors, including tourism, education and financial services.
This is because their services became relatively more expensive than foreing alternatives in overseas markets.
This contributed to the deterioration of the BOGS from a $13 billion surplus to a $3 billion deficit from 2010-11 to 2011-12.
However, this BOGS deterioration was insignificant in impacting the CAD, which only rose by 0.2% of GDP during the same period.
This is because the worsening BOGS coincided with the NPI improvement as the servicing costs of Australia’s foreign liabilities in the mining sector fell due to lower returns on mining investments.
Exchange Rate theory paragraph
The exchange rate is defined as the value of the Australian dollar in terms of the value of other foreign currencies.
An appreciation is the increase in the value of the $A relative to the value of other foreign currencies, whilst a depreciation is the decrease in the value of the $A relative to the value of other foreign currencies.
An appreciation of the $A may occur through a decrease in supply. as
Under a floating exchange rate, the surplus on the KAFA is equal to the deficit on the CA such that :
CA - KAFA = 0.
Furthermore, the Current Account has two main sub-=
accounts, the Net Primary Income Account (NPI) and the Balance of Goods and Services, whilst the Net Secondary Income Account is insignificant. The KAFA has two sub-accounts, the Capital and Financial Accounts, although the capital account is insignificant.
Impact of the exchange rates on the KAFA - example + counter
Example:
However, the appreciation of the $A from 2009-11, peaking at 1.10 USD, had insignificant impacts on the KAFA, which recorded larger surpluses despite the appreciating dollar.
This is because the appreciation was underpinned by large investment into the Australian mining sector during the commodities boom.
