Exchange Rates and the Balance of Payments (HSC SSCE Economics): Revision Notes
Exchange Rates and the Balance of Payments
Introduction
The exchange rate and the balance of payments share a dynamic, two-way relationship. Changes in the balance of payments can drive movements in the exchange rate, while exchange rate fluctuations themselves create effects that flow back to influence the balance of payments. Understanding this relationship is essential for analysing Australia's external economic position.
This bidirectional relationship means that:
- Balance of payments changes can cause exchange rate movements
- Exchange rate movements can then feed back to affect the balance of payments
- The relationship creates a complex cycle of cause and effect in the foreign exchange market
Fixed exchange rate systems
Under a fixed exchange rate system, the government or central bank commits to maintaining the currency at a predetermined value. This requires intervention in the foreign exchange market whenever market forces push the exchange rate away from the official fixed level.
Risks of fixed exchange rate systems
Fixed exchange rate regimes carry significant vulnerabilities that can undermine economic stability and policy effectiveness.
Critical Risk: Depletion of Foreign Reserves
If downward pressure on the currency persists, the RBA may exhaust its foreign reserves while continuously buying Australian dollars. This could trigger a complete collapse in currency trading, leaving the central bank unable to defend the fixed rate.
Official revaluation or devaluation: When the market value drifts too far from the fixed rate, governments may be forced to officially adjust the exchange rate. A devaluation occurs when the official exchange rate is lowered, while a revaluation occurs when it is increased.
Limited monetary policy flexibility: Maintaining a fixed exchange rate constrains the central bank's ability to use interest rate policy for domestic economic management.
The managed flexible peg
Australia operated a managed flexible peg system from November 1976 to December 1983. This represented a middle ground between fully fixed and floating exchange rates.
Under this system:
- The Reserve Bank set a new exchange rate each morning at 9:00 am
- This rate applied throughout the trading day
- The peg could be adjusted daily, providing greater flexibility than a permanently fixed rate
However, the system still allowed the official rate to diverge from true market values. Many economists argued that Australia's exchange rate became overvalued during the early 1980s under this system.
How the balance of payments influences the exchange rate
Under a floating exchange rate system, the quantity of Australian dollars supplied must equal the quantity demanded at every moment. This fundamental equilibrium relationship means:
The Balance of Payments Identity
Any outflow on the current account (supply of A$) must be matched by an inflow on the capital and financial account (demand for A$). If disequilibrium emerges, exchange rate movements automatically restore balance.
Current account changes and the exchange rate
The mechanism through which current account changes affect the exchange rate operates through supply and demand for Australian dollars in foreign exchange markets.
Worked Example: How Import Increases Affect the Exchange Rate
Consider what happens when imports increase while exports remain constant:
Step 1: The current account deteriorates as import spending rises
Step 2: Importers sell more Australian dollars to purchase foreign currency
Step 3: This increases the supply of A$ in foreign exchange markets
Step 4: The Australian dollar depreciates
Step 5: The depreciation makes Australian assets cheaper in foreign currency terms
Step 6: A given level of capital inflow can now purchase more Australian dollars
Step 7: The capital and financial account surplus increases in A$ terms to match the larger current account deficit
Result: The exchange rate adjusts until balance is restored between the current account deficit and capital account surplus.
The opposite occurs with current account improvements. An improvement in the current account typically leads to:
- Appreciation of the Australian dollar
- A decrease in the capital and financial account surplus
The role of market perceptions
Financial market sentiment plays a crucial role in determining how balance of payments changes affect the exchange rate. Market psychology can amplify or counteract the fundamental economic forces at work.
Market Confidence Matters
Unsustainable deficits: If markets believe a current account deficit is unsustainable, investors may reduce purchases of Australian assets. This diminished capital inflow causes the dollar to depreciate further.
Confidence despite deficits: Conversely, the dollar may appreciate even when the current account deficit is large, provided markets have confidence in Australia's economic prospects. For example, in mid-2008, the Australian dollar rose above US$0.95 despite a large current account deficit, because investors expected improvement through high commodity prices.
Example - COVID-19 period: After 2019, Australia's current account moved into surplus for the first time in almost half a century. However, the exchange rate depreciated due to other factors, demonstrating that balance of payments changes are not always the dominant influence on exchange rate movements.
Recent experience suggests that financial market reactions to economic indicators have become the most significant driver of exchange rate movements. These reactions can be unpredictable, creating greater instability in foreign exchange markets as sentiment shifts rapidly.
How exchange rate changes influence the balance of payments
Exchange rate movements create ripple effects throughout the economy, particularly affecting the balance of payments. Both appreciations and depreciations generate positive and negative consequences that must be carefully weighed.
Effects of an appreciation
An appreciation occurs when the Australian dollar rises in value against other currencies.
Negative effects of appreciation:
Export competitiveness: Australian exports become more expensive in foreign markets, making them harder to sell. This reduces export revenue and worsens the current account deficit over the medium term.
Import competition: Imports become cheaper, encouraging higher import spending and further deteriorating the current account. Domestic producers of import-competing goods face increased pressure as foreign alternatives become relatively cheaper.
Growth and Investment Impacts
Economic growth: The combination of lower export revenue and higher import spending tends to reduce overall economic growth.
Capital inflows: Foreign investors face higher costs when investing in Australia (in their own currency terms), potentially reducing financial inflows. However, if investors expect further appreciation, capital inflows may continue.
Net primary income: The Australian dollar value of foreign income earned on Australian investments abroad decreases, worsening the net primary income component of the current account.
Valuation effects on assets: Foreign assets owned by Australians decline in Australian dollar terms.
Positive effects of appreciation:
Consumer purchasing power: Australian consumers can purchase more overseas-produced goods with the same amount of Australian dollars, representing increased real purchasing power.
Debt servicing costs: The cost of servicing foreign debt denominated in foreign currencies falls. Australians can buy more foreign currency with their dollars, reducing outflows on the net primary income component and helping to reduce the current account deficit in future periods.
Valuation and Investment Benefits
Valuation effects on debt: Foreign debt borrowed in foreign currencies decreases in Australian dollar terms.
Asset purchases: Australian investors looking to buy overseas assets pay lower prices in Australian dollar terms.
Inflation: Import prices fall, reducing inflationary pressures. This may lessen pressure on the Reserve Bank to raise interest rates to maintain its inflation target.
Effects of a depreciation
A depreciation occurs when the Australian dollar falls in value against other currencies.
Negative effects of depreciation:
Consumer purchasing power: Australians can buy fewer overseas-produced goods with the same quantity of Australian dollars, representing reduced real purchasing power.
Debt servicing costs: Servicing foreign debt becomes more expensive as Australia must use more domestic currency to buy the foreign currency needed for interest payments. This increases income outflows on the net primary income component and enlarges the current account deficit.
Valuation effects on debt: Foreign debt denominated in foreign currencies increases in Australian dollar terms.
Additional Costs of Depreciation
Asset purchases: Overseas assets become more expensive for Australian investors in dollar terms.
Inflation: Import prices rise, creating inflationary pressures. This may force the Reserve Bank to raise interest rates to defend its inflation target.
Positive effects of depreciation:
Export competitiveness: Australian exports become cheaper in foreign markets, making them easier to sell. This typically increases export revenue and improves the current account deficit over the medium term. Following the end of the commodities boom, a weaker Australian dollar helped the economy adjust by improving the international competitiveness of non-mining sectors.
Import substitution: More expensive imports discourage import spending, potentially improving the current account. Domestic production of goods that compete with imports should increase as these locally-made alternatives become relatively cheaper.
Growth and Investment Benefits
Economic growth: Lower import spending combined with higher export revenue tends to boost economic growth. However, this benefit may not materialise if Australia cannot replace imports with domestically-produced alternatives.
Net primary income: Australian dollar earnings from foreign investments increase, improving the net primary income component of the current account.
Valuation effects on assets: Foreign assets owned by Australians increase in Australian dollar value.
Capital inflows: Foreign investors find it cheaper to invest in Australia (in their own currency terms), generally encouraging greater financial inflows. However, if investors expect further depreciation, capital inflows may dry up.
The valuation effect
Valuation effect: An appreciation or depreciation causes an immediate change in the Australian dollar value of foreign debt borrowed in foreign currencies and foreign assets held by Australians.
Currency composition matters
The impact of exchange rate movements on Australia's net foreign liability position depends critically on the currencies in which assets and liabilities are denominated.
Surprising Finding: Depreciation May Reduce Net Foreign Liabilities
A 2023 Reserve Bank analysis reached a surprising conclusion: a depreciation of the Australian dollar may actually reduce rather than increase Australia's net foreign liabilities. This occurs because:
- Australia's liabilities are largely denominated in Australian dollars
- Australia's assets are largely denominated in foreign currencies
When the Australian dollar depreciates:
- Foreign currency-denominated assets rise in Australian dollar value
- Australian dollar-denominated liabilities remain unchanged in Australian dollar terms
The analysis concluded that "the Australian economy overall is well protected from vulnerabilities associated with a depreciation of the exchange rate, despite its net foreign liability position."
The preferred exchange rate level
Given that both appreciations and depreciations create advantages and disadvantages, should policymakers favour a higher or lower exchange rate?
Most economists prefer an exchange rate that reflects genuine supply and demand forces. These "true" forces arise from:
- Exchanges of goods and services between Australia and other countries
- Financial flows related to investment and lending
However, exchange rates should ideally exclude distortions caused by speculation. Speculators who buy or sell Australian dollars based on expectations of future movements can distort the exchange rate significantly.
The speculation problem
Speculation creates several problems that can destabilize foreign exchange markets and distort economic outcomes.
The Dangers of Excessive Speculation
Amplified volatility: Speculators exaggerate both upward and downward movements, increasing exchange rate volatility
Distorted values: Speculative flows push the exchange rate away from the level justified by fundamental economic factors
"Hot money" vulnerability: Australia's relatively small economy combined with large external imbalances makes it reliant on substantial financial inflows. This has traditionally made the Australian dollar a "hot money" currency, more vulnerable to speculative flows than many other advanced economies.
Excessive speculation and volatile currencies have become major concerns in the globalisation era. Many countries experience large, disruptive swings in their currencies due to speculative activity.
Key Points to Remember:
- Under floating exchange rates, the current account and capital and financial account must balance through automatic exchange rate adjustments
- Improvements in the current account typically cause appreciation, while deteriorations cause depreciation
- Market perceptions and confidence matter as much as actual balance of payments figures in determining exchange rate movements
- An appreciation makes exports more expensive and imports cheaper, with mixed effects on the economy
- A depreciation makes exports cheaper and imports more expensive, again with mixed consequences
- The valuation effect causes immediate changes in the Australian dollar value of foreign-denominated debts and assets when the exchange rate moves
- Australia's unique liability structure means depreciation may actually reduce net foreign liabilities
- Economists generally prefer exchange rates determined by genuine economic fundamentals rather than speculation