The Foreign Exchange Market and the Balance of Payments Accounts (Grade 12 NSC Matric Economics): Revision Notes

Foreign Exchange Markets and Establishment of Foreign Exchange Rates

What is a foreign exchange rate?

A foreign exchange rate represents the price of one country's currency expressed in terms of another country's currency. Think of it as the "cost" of buying foreign money with your domestic money. For example, if $1 = R10.00, this means you need 10 South African rand to purchase 1 US dollar.

In South Africa, currency trading happens through the interbank foreign exchange market. Unlike the Johannesburg Stock Exchange which has a physical building, this market exists electronically worldwide. Banks, businesses, and traders conduct transactions through computers, emails, fax, letters, and phone calls, making it a truly global electronic marketplace.

Understanding foreign exchange markets

A foreign exchange market is essentially a marketplace where people buy and sell different currencies. The major trading centres are located in financial capitals like London, New York, and Tokyo, where massive amounts of currency change hands daily.

These markets operate continuously because when one major financial centre closes, another opens in a different time zone, creating a 24-hour global trading environment.

How supply and demand determine exchange rates

Just like any other market, foreign exchange rates are determined by the interaction between supply and demand forces. When more people want to buy a particular currency (high demand), its price goes up. When fewer people want it (low demand), its price falls.

The graph above shows how supply and demand curves intersect to establish an equilibrium exchange rate. At point P (the equilibrium), the quantity of dollars demanded equals the quantity supplied. However, markets don't always stay in perfect balance:

• Excess supply occurs when the exchange rate is above equilibrium - more people want to sell dollars than buy them
• Excess demand happens when the rate is below equilibrium - more people want to buy dollars than can get them

Factors that influence currency demand and supply

Understanding what drives people to buy or sell foreign currency helps explain exchange rate movements.

Demand factors for foreign exchange

The main factors that create demand for foreign currency include:

Factor	Explanation
Importing goods	When SA businesses buy products from overseas, they need foreign currency to pay suppliers
Payment for foreign services	Paying for services like shipping, insurance, or consulting from foreign companies
Buying shares in another country	SA investors purchasing foreign company shares need that country's currency
Tourists spending money overseas	SA tourists need foreign currency for their trips abroad
Repayment of debt borrowed from foreign countries	Government or businesses repaying loans to foreign lenders

Supply factors of foreign exchange

The main factors that create supply of foreign currency include:

Factor	Explanation
Exporting goods	When SA sells products abroad, foreign buyers pay in their currency, which gets converted to rand
Providing services to foreign countries	SA companies earning foreign currency by offering services internationally
Receiving dividends on shares invested in foreign countries	Returns on SA investments in foreign companies
Inflow of foreign capital	Foreign investors bringing money into SA to invest in local businesses
Expenditure of money by foreign tourists	Foreign visitors spending their currency in SA
Raising new loans in foreign countries	SA borrowing money from overseas lenders

Currency appreciation and depreciation

Currency values constantly change due to market forces. There are two main types of currency movements:

Appreciation occurs when a currency's value increases due to natural market forces. For example, if the rand strengthens from 1 dollar = R10 to 1 dollar = R9, the rand has appreciated because you now need fewer rand to buy one dollar.

Depreciation happens when a currency's value decreases due to market forces. If the rand weakens from 1 dollar = R9 to 1 dollar = R10, the rand has depreciated because you now need more rand to buy the same dollar.

Revaluation and devaluation

These terms apply when governments deliberately change their currency's value, typically under fixed exchange rate systems:

• Revaluation: Government deliberately increases the currency's value
• Devaluation: Government deliberately decreases the currency's value

These actions result from central bank intervention rather than natural market forces.

Government intervention in currency markets

Sometimes governments feel their currency is incorrectly valued by the market. They can intervene in two main ways:

Direct intervention

The central bank directly buys or sells foreign currency:

• When the currency is overvalued (too strong), the bank sells foreign exchange to weaken it
• When the currency is undervalued (too weak), the bank buys foreign exchange to strengthen it

Indirect intervention

The most common tool is interest rate changes:

• Overvalued currency: Increase interest rates to attract foreign investment, creating demand for the local currency
• Undervalued currency: Decrease interest rates to encourage capital outflow, reducing demand for the local currency

Exchange rate systems

Countries can choose different approaches to managing their currency values:

Free floating exchange rates

The currency value is determined purely by market forces - supply and demand for the currency with no government interference.

Managed exchange rates

Governments allow market forces to operate but intervene occasionally to prevent extreme fluctuations, keeping the currency within certain acceptable limits.

Fixed exchange rates

The government sets and maintains a specific exchange rate, often backed by gold reserves. South Africa used this system until 1932 when it abandoned the gold standard.

Terms of trade

The terms of trade measure how a country's export prices compare to its import prices, calculated using this formula:

$\text{Terms of Trade} = \frac{\text{Index of export prices}}{\text{Index of import prices}} \times 100$

Year	2008	2009	2010	2011	2012	2013
Index	105.3	113.7	122.0	124.7	123.0	121.4
% Change	0.0	8.0	7.3	2.2	-1.7	-1.6

Interpreting the data:

• Improvement: When the index increases, export prices are rising faster than import prices (good for the economy)
• Deterioration: When the index decreases, import prices are rising faster than export prices (challenging for the economy)

An improvement can result from:

• Export prices increasing
• Import prices decreasing

A deterioration can result from:

• Export prices decreasing
• Import prices increasing

Free trade versus protection

Free trade allows producers and consumers to buy goods and services from anywhere in the world without government interference. This promotes competition and efficiency.

Protection involves government policies that limit trade between countries, such as import restrictions, to protect domestic industries from foreign competition.

South Africa's foreign trade patterns

South Africa maintains a relatively open economy with foreign trade representing approximately 30% of GDP. This makes the economy quite sensitive to changes in international trade conditions.

Trade composition by sector

Sector	Agriculture	Manufacturing	Mining
Exports	4.02%	50.29%	45.69%
Imports	1.54%	82.53%	15.92%

The data reveals that:

• Manufacturing dominates both exports (50.29%) and imports (82.53%)
• Mining represents a significant portion of exports (45.69%) but smaller share of imports (15.92%)
• Agriculture plays a minor role in both trade flows

Regional trade relationships

Region	Africa	Europe	NAFTA	Asia	Other
Imports %	7.9	33.9	8.5	44.2	6.5
Exports %	14.7	27.4	9.7	45.3	2.9
Total R billion	130.8	352.7	104.6	448.4	113.7

Key insights:

• Asia is SA's largest trading partner (44.2% of imports, 45.3% of exports)
• Europe remains significant (33.9% of imports, 27.4% of exports)
• Trade is fairly balanced between developed (Europe, NAFTA) and developing (Asia, Africa) regions