Impact of exchange rate on BOP

A change in a country’s balance of payments can cause fluctuations in the exchange rate between its currency and foreign currencies. The reverse is also true when a fluctuation in relative currency strength can alter balance of payments.

Balance of Payments and Exchange Rates

A balance of payment is a statement of all transactions made between entities in one country and the rest of the world over a specific time frame, such as a quarter or a year. Two dynamics are in play which links a country’s balance of payment and changes in the value of its currency: the market for all financial transactions on the international market (balance of payments) and the supply and demand for a specific currency (exchange rate).

Exchange Rate Impacts:

The relationship between the BOP and exchange rates can be illustrated by use of a simplified equation that summarizes BOP data:

BOP = (X-M) + (CI-CO) + (FI-FO) +FXB

• Where: X is exports of goods and services,
• M is imports of goods and services,
• (X-M) is known as Current Account Balance
• CI is capital outflows,
• CO is capital outflows,
• (CI-CO) is known as Capital Account Balance
• FI is financial inflows,
• FO is financial outflows,
• (FI-FO) is known as Financial Account Balance
• FXB is official monetary reserves such as foreign exchange and gold

The effect of an imbalance in the BOP of a country works somewhat differently depending on whether that country has fixed exchange rates, floating exchange rates, or a managed exchange rate system.

a) Fixed Exchange Rate Countries. Under a fixed exchange rate system, the government bears the responsibility to ensure a BOP near zero. If the sum of the current and capital accounts does not approximate zero, the government is expected to intervence in the foreign exchange market by buying or selling official foreign exchange reserves. If the sum of the first two accounts is greater than zero, a surplus demand for the domestic currency exists in the world. To preserve the fixed exchange rate, the government must then intervence in the foreign exchange market and sell domestic currency for foreign currencies or gold so as to bring the BOP back near zero. It the sum of the current and capital accounts is negative, an exchange supply of the domestic currency exists in world markets. Then the government must intervene by buying the domestic currency with its reserves of foreign currencies and gold. It is obviously important for a government to maintain significant foreign exchange reserve balances to allow it to intervene effectively. If the country runs out of foreign exchange reserves, it will be unable to buy back its domestic currency and will be forced to devalue. For fixed exchange rate countries, then, business managers use balance-of-payments statistics to help forecast devaluation or revaluation of the official exchange rate. Normally a change in fixed exchange rates is technically called devaluation or revaluation, while a change in floating exchange rates is called either depreciation or appreciation.

b) Managed Floats. Although still relying on market conditions for day-to-day exchange rate determination, countries operating with managed floats often find it necessary to take actions to maintain their desired exchange rate values. They therefore seek to alter the market‘s valuation of a specific exchange rate by influencing the motivations of market activity, rather than through direct intervention in the foreign exchange markets. The primary action taken by such governments is to change relative interest rates, thus influencing the economic fundamentals of exchange rate determination. A change in domestic interest rates is an attempt to alter capital account balance, especially the short-term portfolio component of these capital flows, in order to restore an imbalance caused by the deficit in current account. The power of interest rate changes on international capital and exchange rate movements can be substantial. A country with a managed float that wishes to defend its currency may choose to raise domestic interest rates to attract additional capital from abroad. This will alter market forces and create additional market demand for domestic currency. In this process, the government signals exchange market participants that it intends to take measures to preserve the currency‘s value within certain ranges. The process also raises the cost of local borrowing for businesses, however, and so the policy is seldom without domestic critics. For managed-float countries, business managers use BOP trends to help forecast changes in the government policies on domestic interest rates.

c) Floating Exchange Rate Countries. Under a floating exchange rate system, the government of a county has no responsibility to peg the foreign exchange rate. The fact that the current and capital account balances do not sum to zero will automatically (in theory) alter the exchange rate in the direction necessary to obtain a BOP near zero. For example, a country running a sizable current account deficit with the capital and financial accounts balance of zero will have a net BOP deficit. An excess supply of the domestic currency will appear on world markets. As is the case with all goods in excess supply, the market will rid itself of the imbalance by lowering the price. Thus, the domestic currency will fall in value, and the BOP will move back toward zero. Exchange rate markets do not always follow this theory, particularly in the short-to-intermediate term.