<4.6 BALANCE OF PAYMENTS>

--IB GUIDE--

--BOP: DEFINITION--

Everyday SGD is demanded and supplied, most typically to buy a good or service (Imports or exports) or a financial asset such as a bond or stock. These purchases are all recorded in the ledger called the BALANCE OF PAYMENTS (BOP) which is defined as a RECORD/LEDGER of all economic transactions between the residents of one country and the rest of the world over a specific period, typically a year.
Depending on the breakdown of these expenditures within the ledger we end up with a deficit in one side of the ledger matched by a surplus in the other side.
To see how this works let’s look at the components of the ledger.

--DEBITS--

DEBITS refer to OUTFLOWS of SGD from the ledger and are given a NEGATIVE sign.
For example if an import is purchased it must involve a payment to a Foreign producer, thus there is an outflow of SGD.
In order to obtain the FOREX to purchase the import, the Singaporean will need to exchange SGD for the FOREX on the foreign exchange market, hence we can say that an OUTFLOW creates a SUPPLY OF SGD and a DEMAND FOR FOREX.
The questions that arise for later are, why was the SGD accepted in the first place? What will it be used for?

--CREDITS--

CREDITS refer to INFLOWS of SGD into the ledger and are given a POSITIVE sign.
For example if a Singapore export is purchased it must involve a payment to a Singaporean producer, thus there is an inflow of SGD.
In order to obtain the SGD to purchase the export, the foreigner will need to exchange their currency for the SGD on the foreign exchange market, hence we can say that an INFLOW creates a DEMAND FOR SGD and a SUPPLY OF FOREX.
The question for later is what happened to the USD that was accepted in exchange for the SGD? Why did the SGD-holders make the exchange? What will it be used for?

--BALANCED | SURPLUS | DEFICIT--

--If CREDITS = DEBITS = BALANCED--

--IF CREDITS > DEBITS = SURPLUS--

--IF CREDITS < DEBITS = DEFICIT--

--THE STRUCTURE OF THE BOP--

CURRENT ACCOUNT (CA)

As defined by IB...

IN

OUT

1. EXPORT OF GOODS

Refers to all SALES OF GOODS to other countries, for which PAYMENT IS RECEIVED IN SGD.
PAYMENTS RECEIVED are 'INFLOWS' and therefore called 'CREDITS'.
These create a DEMAND FOR SGD and a SUPPLY of FOREX.

+40

-

2. IMPORT OF GOODS

Refers to all PURCHASES OF GOODS from other countries, for which PAYMENT IS MADE IN FOREX.
PAYMENTS MADE are 'OUTFLOWS' and therefore called 'DEBITS'.
These create a SUPPLY OF SGD and a DEMAND for FOREX.

-

-65

BALANCE OF TRADE IN GOODS

EXPORT OF GOODS LESS IMPORTS OF GOODS
In this example the balance of trade in goods is NEGATIVE, meaning it has a TRADE IN GOODS DEFICIT.

-25

3. EXPORT OF SERVICES

Refers to all SALES OF SERVICES to other countries, for which PAYMENT IS RECEIVED IN SGD.
PAYMENTS RECEIVED are 'INFLOWS' and therefore called 'CREDITS'.
These create a DEMAND FOR SGD and a SUPPLY of FOREX.

+25

-

4. IMPORT OF SERVICES

Refers to all PURCHASES OF SERVICES from other countries, for which PAYMENT IS MADE IN FOREX.
PAYMENTS RECEIVED are 'INFLOWS' and therefore called 'DEBITS'.
These create a SUPPLY OF SGD and a DEMAND for FOREX.

-

-15

BALANCE OF TRADE IN SERVICES

EXPORT OF SERVICES LESS IMPORTS OF SERVICES
In this example the balance of trade in services is POSITIVE, meaning it has a TRADE IN SERVICES SURPLUS.

+10

BALANCE OF TRADE IN GOODS + SERVICES (AKA 'TRADE BALANCE')

BALANCE OF TRADE IN GOODS LESS BALANCE OF TRADE IN SERVICES
In this example the balance of trade is NEGATIVE, meaning it has a TRADE DEFICIT.

-15

5. NET INCOME

Refers to INFLOWS OF SGD from...
INTEREST from OVERSEAS SAVINGS/STOCKS
RENT from OVERSEAS PROPERTIES
PROFITS from OVERSEAS BUSINESSES

LESS

OUTFLOWS OF SGD...
INTEREST earned by FOREIGN OWNERS of DOMESTIC SAVINGS/STOCKS
RENT earned by FOREIGN OWNERS of DOMESTIC PROPERTIES
PROFITS earned by FOREIGN OWNERS of DOMESTIC BUSINESSES

-

-6

6. NET CURRENT TRANSFERS

CURRENT TRANSFERS refer to inflows and outflows of currency in the form of GIFTS, REMITTANCES, FOREIGN AID, and PENSIONS.
These types of flows are ONE-WAY IN NATURE, and NOTHING IS RECEIVED.
These transfers are usually for the purpose of buying CONSUMER GOODS, eg, FOOD AID

+1

-

TOTAL CA INFLOWS & OUTFLOWS

+66

-86

BALANCE ON CURRENT ACCOUNT

The BALANCE ON THE CURRENT ACCOUNT (or THE CA BALANCE) is the TOTAL INFLOWS (CREDITS) in SGD, LESS the TOTAL OUTFLOWS (DEBITS) in SGD.
In this example, there is a CA DEFICIT OF $20Bn:
- - Meaning the DEBITS > the CREDITS
  - which implies the SUPPLY of SGD ($86bn) is GREATER THAN the DEMAND for SGD ($66bn) in other words, EXCESS SUPPLY OF SGD as illustrated below.

-20

CAPITAL ACCOUNT (KA)

IN

OUT

7. NET CAPITAL TRANSFERS

CAPITAL TRANSFERS are similar to the CURRENT TRANSFERS in the CA account, in that they involve a one-way transaction, however, these transfers are USUALLY INTENDED for the PURCHASE/CONSTRUCTION of FIXED ASSETS such as AID TO FINANCE PHYSICAL CAPITAL
DEBT FORGIVENESS

+0.7

-

8. NET TRANSACTIONS/NON-FINANCIAL

These transactions refer to the PURCHASES of NON-PRODUCED, NON-FINANCIAL ASSETS, such as NON-PRODUCED NATURAL LAND RESOURCES such as FISHING & FORESTRY RIGHTS.

+0.3

-

BALANCE ON CAPITAL ACCOUNT

+1.0

FINANCIAL ACCOUNT (FA)

IN

OUT

9. NET FDI

FOREIGN DIRECT INVESTMENT (FDI) includes INVESTMENTS IN PRODUCTIVE FACILITIES, consisting of PHYSICAL CAPITAL, such as BUILDINGS, and FACTORIES bought by MNCs.

+23

-

10. NET PORTFOLIO INVESTMENT

PORTFOLIO INVESTMENTS refer to the PURCHASES of FINANCIAL CAPITAL such as STOCKS, BONDS, FDI, and OVERSEAS PROPERTIES.
The return from these investments are those recorded in the 'NET INCOME' section of the CA ACCOUNT (INTEREST, PROFITS, and RENTS)

-

-4

11. RESERVE ASSETS

RESERVE ASSETS refer to the FOREX RESERVES that the CB holds, which they use to INFLUENCE THE VALUE OF THE CURRENCY.
When FACING DOWNWARD PRESSURE ON THE EX-RATE the CB SELLS FOREX and BUYS SGD, thus INCREASING the DEMAND for SGD (Forcing it to APPRECIATE) which creates an INFLOW of SGD.
When FACING UPWARD PRESSURE ON THE EX-RATE the CB BUYS FOREX and SELLS SGD, thus INCREASING the SUPPLY of SGD (Forcing it to DEPPRECIATE) which creates an OUTFLOW of SGD.
If the net reserve assets entry is POSITIVE then it implies that MORE SGD was bought than sold by the Gov't while FOREX was sold hence we can say the gov't FOREX RESERVES DECREASED
In our example Singapore CB has BOUGHT SGD by SELLING FOREX, creating an inflow (CREDIT) of $1bn SGD.
BUT WHY???? STAY TUNED

+1

-

12. OFFICIAL BORROWING

OFFICIAL BORROWING refers to the GOVERNMENTS BORROWING (LENDING) FROM (TO) ABROAD.

-

-1

BALANCE ON FINANCIAL ACCOUNT

+19

TOTAL KAFA INFLOWS & OUTFLOWS

+25

-5

BALANCE ON KA + FA ACCOUNT

The BALANCE ON THE CAPITAL ACCOUNT is the TOTAL INFLOWS (CREDITS) in SGD, LESS the TOTAL OUTFLOWS (DEBITS) in SGD.
In this example, the economy has KA SURPLUS OF $20Bn:
- - meaning the CREDITS > DEBITS
  - which implies the SUPPLY of SGD ($5bn) is LESS THAN the DEMAND for SGD ($25bn). In other words EXCESS DEMAND FOR SGD as illustrated below.

+20

TOTAL INFLOW & OUTFLOWS

+91

-91

BALANCE OF PAYMENTS 0

ERRORS & OMISSIONS

In the real world, NOT ALL TRANSACTIONS ARE RECORDED, some of the outflow therefore if the accounts don't balance a BALANCING ITEM must be used.

--WHY IT MUST BALANCE--

Regardless of the type and quantity of goods, services, or assets being traded, the following will always be true at any exchange rate.

"At the point where currency demand equals currency supply, it is always the case that the sum of credits is equal to the sum of debits. Therefore, deficits must match surpluses." Tragakes

Let's look at the worked example below:

We can see above that at exchange rate 'Ex1', the equilibrium quantity of SGD transacted is $SGD91m, meaning $SGD91m is demanded in exchange for USD to buy items from Singapore, whilst $SGD91m is supplied in exchange for USD to buy items from the US.
The composition of what this $SGD91m buys, be it goods, services, bonds, shares etc, can change but what can't change is the following:

...The sum of all credits = The sum of all debits

...The sum of all outflows of SGD = The sum of all inflows of SGD

...-ve Deficits on the CA = +ve Surpluses on the KAFA

...+ve Surpluses on the CA = -ve Deficits on the KAFA

What we can conclude from the scenario above is that both the CURRENT ACCOUNT and the CAPITAL/FINANCIAL ACCOUNTS are INTERDEPENDANT in the following way:

CA DEFICIT = KA+FA SURPLUS

CA SURPLUS = KA+FA DEFICIT

--TASK--

The exchange rate is 'Ex1', and £1000 is demanded and supplied on the FOREX market

- - - The £1000 that is supplied is exchanged into USD to purchase a computer for £500, some Pokémon cards for £100, some shares in Apple inc. worth £250, as well as a US gov't bond for £150.
    - The GBP 1000 that is demanded (swapped for the USD equivalent at Ex1 as above) is exchanged into SGD to purchase a football shirt for £100, a Harry Potter Scarf for £200, some shares in Manchester United inc. for £300, as well as give a donation of £400.

CREATE A MINI BOP LIKE THE ONE BELOW for these transactions
Then explain how it illustrates the following:
- - - ...The sum of all credits = The sum of all debits
    - ...The sum of all outflows of £ = The sum of all inflows of £
    - ...-ve Deficits on the CA = +ve Surpluses on the KAFA
    - ...+ve Surpluses on the CA = -ve Deficits on the KAFA

--BOP + EXCHANGE RATES--

--WHAT IS THE RELATIONSHIP?--

Lets use the scenario presented above showing a CA DEFICIT of $20bn and a KAFA SURPLUS of $20bn:
The CA DEFICIT implies that Singaporeans are supplying more SGD to buy items on the ROW's CA, than the ROW are demanding SGD for items on the Singaporean CA, hence there is EXCESS SUPPLY of SGD on the CA. This is illustrated in Fig 1 below.
On the other hand, the KAFA SURPLUS implies that the ROW are demanding more SGD to buy items on Singapore's KAFA, than Singaporeans are demanding for items on the ROW's KAFA, hence there is EXCESS DEMAND for SGD on the KAFA. This is illustrated in Fig 2 below.

In this scenario the 'EXCESS SUPPLY = EXCESS DEMAND', and therefore market forces will make NO CHANGES to the exchange rate.
However if the 'EXCESS SUPPLY > EXCESS DEMAND', then there will be a SURPLUS and market forces will put DOWNWARD pressure on the exchange rate (DEPRECIATION) and...
...if the 'EXCESS SUPPLY < EXCESS DEMAND', then there will be a SHORTAGE and market forces will put UPWARD pressure on the exchange rate (APPRECIATION).

--EXCHANGE RATE REMAINS STABLE WHEN THERE IS A BALANCED BOP--

CA DEFICIT = KAFA SURPLUS

In this scenario the EXCESS SUPPLY of 20bn SGD on the CA is matched by the
A CA DEFICIT implies a greater outflow of SGD to buy items on the ROW's CA than the inflow of SGD to buy items on Singapore's CA thus their is an EXCESS SUPPLY of 20bn SGD on the CA.
A KAFA SURPLUS implies a greater inflow of SGD to buy items on the Singapore's KAFA than the outflow of SGD to buy items on the ROW's KAFA thus their is an EXCESS DEMAND for 20bn SGD on the KAFA.
As

CA SURPLUS = KAFA DEFICIT

--EXCHANGE RATE FACES DOWNWARD PRESSURE WHEN THERE IS A BOP DEFICIT--

CA DEFICIT > KAFA SURPLUS

CA SURPLUS < KAFA DEFICIT

--EXCHANGE RATE FACES UPWARD PRESSURE WHEN THERE IS A BOP SURPLUS--

CA DEFICIT < KAFA SURPLUS

CA SURPLUS > KAFA DEFICIT

--USING FOREX TO MAINTAIN FIXED RATE--

--CORRECTING DOWNWARD PRESSURE WHEN THERE IS A BOP DEFICIT--

CA DEFICIT > KAFA SURPLUS

--CORRECTING UPWARD PRESSURE WHEN WHEN THERE IS A BOP SURPLUS--

CA SURPLUS > KAFA DEFICIT

--CONSEQUENCES OF PERSISTENT CA DEFICIT (HL)--

--INTRODUCTION--

A persistent CA deficit poses many issues for the economy, especially if it wishes to keep its exchange rate relatively stable:
- - Firstly, as shown they will need to continually finance the excess supply of the currency which poses issues
    - - If it is financed through sale of assets
        If it is financed through selling FOREX
        If it is financed through borrowing
        If it is financed through raised interest rates

--IN A FIXED SYSTEM--

--CONSTANT NEED TO FINANCE--

As shown above, A CURRENT ACCOUNT DEFICIT creates an EXCESS SUPPLY of the domestic currency, and this needs to be financed in its entirety by a corresponding EXCESS DEMAND FOR THE CURRENCY on THE KAFA for the exchange rate to remain stable.
If the government wishes to keep the exchange rate stable they have to either INCREASE THE DEMAND FOR SGD and/or DECREASE THE SUPPLY OF SGD which we will look at a little later in 'CORRECTING A CA DEFICIT'. However needless to say if they are unable to do this then the exchange rate will LIKELY DEPRECIATE.

--FOREIGN OWNERSHIP OF DOM. ASSETS--

If the CA DEFICIT is FINANCED THROUGH THE SALE OF DOMESTIC ASSETS such as STOCKS, SHARES, and PROPERTY, then in affect OWNERSHIP is being traded which could eventually lead to a country's LOSS OF CONTROL over its ASSETS, and possibly a LOSS OF SOVEREIGNTY.
Furthermore, foreign ownership may lead to greater outflows of income as well as reduced employment opportunities, if foreign talent is preferred.

--DEBT REPAYMENTS DIVERT FUNDS--

Clearly, if the country is determined to maintain its rate but can not attract enough finance and/or it doesn't have enough FOREX reserves, it may resort to BORROWING THE FOREX, and the MORE BORROWING the MORE POTENTIAL FOR DEFAULT.
Furthermore, the GREATER THE INTEREST RATE BURDEN and LOSS OF BUDGET REVENUE that could have been used for MERIT GOODs, in addition as debts are repaid in FOREX this will mean less is available to spend on the IMPORT OF ESSENTIAL CAPITAL GOODS.

--RISKIER CREDIT RATING--

Countries with PERSISTANT CA DEFICITS that are FINANCED BY LARGE AMOUNTS OF BORROWING make them MORE AT RISK OF DEFAULT, hence they are given a 'RISKY CREDIT RATING', which means they will be CHARGED A HIGHER INTEREST RATE if they require MORE BORROWED FUNDS.

--CONTRACTIONARY MONETARY POLICY--

A further method to attract finance is to RAISE INTEREST RATES to ATTRACT SAVINGS in SGD, which has the effect of increasing the demand for SGD, however this will have a CONTRACTIONARY IMPACT on the economy (AD falls) and may therefore be in CONFLICT WITH OTHER ECONOMIC OBJECTIVES.

--IN A FLOATING SYSTEM--

--IMPORTED INFLATION--

In a floating system the downward pressure would simply result in the currency DEPRECIATING and once the currency depreciates, it will make EXPORTS CHEAPER and IMPORTS MORE EXPENSIVE which can result in IMPORTED INFLATION.

--PAINFUL DEMAND-MANAGEMENT--

One method (Discussed below) to limit the supply of a currency and hence downward pressure is to use CONTRACTONARY FISCAL AND MONETARY POLICIES so that CONSUMERS HAVE LESS DISPOSABLE INCOMES to SPEND ON IMPORTS.

--ECONOMIC GROWTH REDUCED--

As mentioned above, HIGHER DEBT REPAYMENTS IN FOREX implies LESS money is available for investments and growth.

--POSITIVE EFFECTS--

--BORROWING CAN LEAD TO ECONOMIC GROWTH--

As long as the borrowed funds are used to FINANCE IMPORTS OF CAPITAL GOODS and OTHER INPUTS NEEDED FOR PRODUCTION.
PRODUCTION is GEARED TOWARDS EXPORT INDUSTRIES.

--CORRECTING CA DEFICIT--

--RATIONALE--

As we know a CA DEFICIT occurs due to EXCESS CA PURCHASES OF ITEMS ON THE ROW'S CA OVER PURCHASES BY THE ROW OF ITEMS ON OUT CA which also implies EXCESS SUPPLY of SGD on the CA.
As such in order to correct the negative effects associated with a persistent CA deficit (as listed above) policies are aimed at REDUCING THE ABILITY/WILLINGNESS OF PEOPLE TO SUPPLY SGD for the purposes of buying imports OR by INCREASING the DEMAND for SGD

--1) EXPENDITURE REDUCING POLICIES--

EXPENDITURE REDUCING POLICIES aim to LOWER the amount of money people have to spend on imports through the use of CONTRACTIONARY FISCAL & MONETARY POLICIES however the results can be mixed:
- IMPROVES CA DEFICIT?

(+) LOWERS DISPOSABLE INCOME => LOWER DEMAND FOR IMPORTS

(+) LOWERS APL OF EXPORTS => HIGHER DEMAND FOR EXPORTS

WORSENS CA DEFICIT?

(-) HIGHER ROI => APPRECIATION => LOWER DEMAND FOR EXPORTS

(-) HIGHER ROI => APPRECIATION => HIGHER DEMAND FOR IMPORTS

(-) LOWERS AD => RECESSION

--2) EXPENDITURE SWITCHING POLICIES--

EXPENDITURE SWITCHING POLICIES aim to SWITCH CONSUMPTION AWAY FROM IMPORTED GOODS, TOWARDS DOMESTICALLY PRODUCED GOODS. These include:
- - - PROTECTIONISM: Making IMPORTS MORE EXPENSIVE through TARIFFS etc, makes IMPORTS less COMPETITIVE so more domestically produced goods are demanded instead. However, as we know, there are many negative impacts on stakeholders of such policies including the THREAT OF RETALIATION.
    - DEVALUATION (IN FIXED SYSTEM): A cheaper exchange rate will make IMPORTS MORE EXPENSIVE, so more domestically produced goods are demanded instead however again, this carries many negative impacts such as a RISE IN THE PRICE OF IMPORTS, which if highly INELASTIC IN DEMAND will LEAD TO GREATER IMPORT EXPENDITURE.
    - NOTE that in a FLOATING EXCHANGE RATE SYSTEM, this will happen AUTOMATICALLY, however, as to whether this will result in a reduced CA deficit depends on whether the Marshall Lerner Condition is met (SEE BELOW)

--3) SUPPLY-SIDE COMPETITION POLICIES--

MARKET-BASED S-SIDE POLICIES aim to REDUCE THE COSTS OF PRODUCTION OF FIRMS, will result in LOWER EXPORT PRICES and GREATER COMPETITIVENESS, therefore LEADING TO MORE EXPORTS, and a LOWER DEFICIT.
INTERVENTIONIST-BASED S-SIDE POLICIES aim to ENCOURAGE INDUSTRIES THAT EXPORT through SUBSIDIES and GRANTS.

--MARSHALL-LERNER--

-Q. WILL A DEPRECIATION ALWAYS REDUCE A DEFICIT?-

--WHAT HAPPENS TO EXPORT REVENUE?--

When the SGD DEPRECIATES we can be 100% assured that EXPORT REVENUES in SGD will INCREASE, why?
- - - - Because THE PRICE OF THE GOODS IN TERMS OF THE OTHER CURRENCIES WILL FALL, leading foreigners to increase the quantity they demand which CAUSES A RIGHTWARD SHIFT IN THE DEMAND CURVE FOR EXPORTS, hence EXPORT REVENUE IN SGD WILL 100% RISE.
        Obviously THE MORE ELASTIC the FOREIGNER'S PED for OUR EXPORTS, THE LARGER THE INCREASE IN Qd and the BIGGER the RIGHTWARD SHIFT and EXPORT REVENUE EARNED.

--WHAT HAPPENS TO IMPORT EXPENDITURE?--

When the SGD depreciates IMPORT PRICES INCREASE.
Therefore the impact on IMPORT EXPENDITURE IN SGD depends on the PED FOR IMPORTS.
If it is INELASTIC then IMPORT EXPENDITURE RISES.
If it is ELASTIC then IMPORT EXPENDITURE FALLS.

--DOES THE TRADE BALANCE IMPROVE OR NOT?--

Thankfully, there is a CONDITION that if met, means the CA DEFICIT IS IMPROVING thanks to a DEPRECIATION, it is referred to as the MARSHALL-LERNER CONDITION:

IF THE SUM OF PEDm + PEDX > ONE, then IMPROVES
IF THE SUM OF PEDm + PEDX < ONE, then WORSENS
IF THE SUM OF PEDm + PEDX = ONE, then UNCHANGED

--J-CURVE--

--DEFINITION--

You may remember one of the main determinants of PED was 'TIME', in that THE LONGER THE TIME PERIOD THE MORE ELASTIC DEMAND GROWS. If we apply this to the situation of a DEPRECIATION and its IMPACT ON THE TRADE ACCOUNT OVERTIME, we can derive the 'J-CURVE'.
If we assume the nation is initially at a trade balance of zero when X=M, then following a depreciation,

--TASK--

Following the depreciation, it is observed that the current account balance worsens initially, but improves after a certain period of time. Explain why this might be expected to happen. (4)

A DEPRECIATION makes the domestic currency MORE EXPENSIVE/CHEAPER therefore the PRICE OF EXPORTS (X) in terms of other currencies RISES/FALLS, while the PRICE OF IMPORTS (M) in terms of domestic currencies RISES/FALLS. As to whether this results in an IMPROVEMENT/WORSENING of the current account (CA) depends on the price elasticities of demand for exports and imports. In the SHORT RUN, elasticities tend to be ELASTIC/INELASTIC

--CA SURPLUS: CONSEQUENCES--

--LOW DOMESTIC CONSUMPTION--

CA SURPLUSES imply that domestic production is being exported, hence CONSUMPTION takes place WITHIN the PPC, which likely means LOWER STANDARDS OF LIVING for the POPULATION.

--INSUFFICIENT DOMESTIC INVESTMENT--

The CA SURPLUS only occurs due to the desire of domestic investors to INVEST OVERSEAS, which could imply that THERE ARE FEW GOOD DOMESTIC INVESTENT OPPORTUNITIES which will IMPACT DOMESTC GROWTH PROSPECTS.
However this may lead to an inflow in the current account through PRIMARY INCOME in the long run.

--RETALIATION--

The CA SURPLUS, means a CA DEFICIT for others who, if the situation persists, may RETALIATE and use EXPENDITURE SWITCHING POLICIES, in particular PROTECTIONIST MEASURES.

--RELATED TO APPRECIATION--

--POSSIBLE APPRECIATION--

As mentioned the CA SURPLUS creates EXCESS DEMAND for the SGD and must be countered exactly by a KAFA DEFICIT, with EXCESS SUPPLY of SGD. If this is not the case then there will be UPWARD PRESSURE on the exchange and it will APPRECIATE.
This will make EXPORTS MORE EXPENSIVE and IMPORTS RELATIVELY CHEAPER potentially LOWERING NET EXPORTS,, AD, and ECONOMC GROWTH.

--LOWER INFLATIONARY PRESSURE--

Following on from above, an appreciation will reduce AD via lower NX, which should LOWER THE LEVEL OF DEMAND-PULL INFLATION, as well as LOWER THE LEVEL OF IMPORTED ('COST-PUSH INFLATION')

--EMPLOYMENT--

A HIGHER EXCHANGE RATE may INCREASE UNEMPLOYMENT IN EXPORT INDUSTRIES that are now UNCOMPETITIVE, however UNEMPLOYMENT MAY FALL in INDUSTRIES that BECOME MORE COMPETITIVE due to CHEAPER IMPORTED RAW MATERIALS.

--REDUCED EXPORT COMPETITIVENESS--

As just mentioned THE HIGHER EXTERNAL PRICE of the CURRENCY, will MAKE EXPORTS LESS COMPETITIVE.

--FIXED vs FLOATING--

--FIXED--

--FLOATING--

--CERTAINTY--

When the exchange rate is FIXED, then there is HIGH CERTAINTY, with regard to THE VALUE OF THE CURRENCY IN THE FUTURE, as such producers, consumers, and governments who plan to trade internationally can plan ahead hence FIXED RATES HELP ENCOURAGE TRADE.

--UNCERTAINTY--

When the exchange rate is FLOATING, then there is HIGH UNCERTAINTY, with regard to THE VALUE OF THE CURRENCY IN THE FUTURE, as such producers, consumers, and governments who plan to trade internationally can't plan ahead hence FIXED RATES HELP DISCOURAGE TRADE.

--LARGE FOREX--

When the exchange rate is FIXED, and the CA is in DEFICIT , there may be DOWNWARD PRESSURE on the rate, if they are unable to finance it through the sale of items on the KAFA hence the Government will need to SELL some of its FOREX RESERVES, in order to BUY SGD to BOOST DEMAND, however, if the downward pressure is PERSISTENT, then the CB MAY RUN OUT OF FOREX, and have to DEVALUE.

--NO FOREX--

When the exchange rate is FLOATING, then the RATE is left to MARKET FORCES, so THERE IS NO NEED TO HOLD FOREX RESERVES.

--INTERVENTION--

When the exchange rate is FIXED, the government must somehow manage SHOCKS that put pressure on the rate.
For example, when dealing with a CA DEFICIT, that cannot be financed by the KAFA, what can they do to boost demand and/or reduce supply?
- SELL FOREX RESERVES?
- BORROW FOREX?
- Use CONTRACTIONARY POLICES?
- Use PROTECTIONIST POLICIES?
- Use CURRENCY CONTROLS?

--SELF-CORRECTING--

When the exchange rate is FLOATING, all EXTERNAL SHOCKS are MANGED AUTOMATICALLY
For example, a CA DEFICIT that results in a DEPRECIATION should help CLOSE the CA DEFICIT.

--INFLATION--

When the exchange rate is FIXED, and YOUR INFLATION RATE is HIGHER THAN your TRADING PARTNER, then your X-RATE CAN'T JUST FALL and SELF CORRECT.
Hence these countries MUST FOLLOW CONTRACTIONARY FISCAL and MONETARY POLICIES,

--COUNTERINFLATION--

If the economy has a HIGHER INFLATION RATE THAN ITS TRADING PARTNER there will be an increase in the supply of the currency in order to buy the CHEAPER IMPORTS, which will DEPRECIATE THE CURRENCY, which will LOWER THE PRICE OF EXPORTS...
Note that IMPORT PRICES will RISE, which could lead to COST-PUSH INFLATION.

--INFLEXIBLE POLICY--

When the exchange rate is FIXED, and

--FLIEXIBLE POLICY--

--NO SPECULATION--

When the exchange rate is FIXED, and

--SPECULATION--

--CA DEFICIT FINANCED BY BORROWING--

--INTRO--

So far we have seen that a government facing a CA DEFICIT, with a desire to maintain its exchange rate will attempt to buy its own currency by selling its forex, however as stated above this can not go on indefinitely as such another method that is often utilised is to simply borrow it

Let's look at this through an analogy of a university economics student, who studies via D/L from Singapore at a school in the US. He has a part-time job but this does not cover his study expenses so he takes loans and uses his credit cards to pay for the excess.

This could be problematic if the following occurs:

Due to his lack of collateral, as well as strong demand for loanable funds he may have to agree to pay a higher rate of interest, which will inevitably leave him with less disposable income and thus reduce his spending activity, meaning less income for his local pub (Recession alert!!)
Furthermore, this high level of indebtedness obviously increases his risk of credit default and if this was to occur, he would be blacklisted and have a very poor credit history and would find it extremely difficult to secure any more loans requiring him to seriously curtail his lifestyle and reduce his consumption activities. (Lower standard of living)
If blacklisted his only hope would be to turn to 'Loan sharks' and accept an even higher rate of interest, though he may lose his kneecaps, or worse. (High indebtedness)
His interest repayment commitment means he can no longer afford his gym-membership and vitamins so his wellbeing starts to suffer.
In addition, his constant supply of SGD currency to pay for his US studies lowers the value of the SGD meaning he will have to pay more and more SGD to exchange for his study expenses which are in USD.
Moreover, this increase in the price of imports from the US, (One of Singapore's largest trading partners) means that the general price level in Singapore starts to rise, and the purchasing power of his money is getting less and less, so he needs to work longer hours to afford the same amount of USD.
If this situation continues and he is not generating enough income from his job, he may well have to defer or even leave his course in order to lower his consumption activities below that of his part-time job's income so he can repay his debts, seriously lowering his living standards and this could take years to accomplish, all the while he is not studying and his potential for higher earnings will be lost. (No economic growth)

However, these problems need not necessarily arise:

If the interest rate on the loan is modest and the amount not too extravagant, then the student is likely to have a much easier time paying it back.
Also and most crucially, if his debt is used to increase his level of human capital enabling him to secure a high-paying job then he will easily be able to repay his loan hassle-free.
Furthermore, his new career allows him to sell his services internationally, and as result, he receives his income in various currencies which he uses to purchase goods in those countries. (Balanced CA)

--PROS OF BORROWING--

So far we have seen that a government facing a CA DEFICIT, with a desire to maintain its exchange rate will attempt to buy its own currency by selling its forex, however as stated above this can not go on indefinitely as such another method that is often utilised is to simply borrow it

This could be problematic if the following occurs:

Due to his lack of collateral, as well as strong demand for loanable funds he may have to agree to pay a higher rate of interest, which will inevitably leave him with less disposable income and thus reduce his spending activity, meaning less income for his local pub (Recession alert!!)
Furthermore, this high level of indebtedness obviously increases his risk of credit default and if this was to occur, he would be blacklisted and have a very poor credit history and would find it extremely difficult to secure any more loans requiring him to seriously curtail his lifestyle and reduce his consumption activities. (Lower standard of living)
If blacklisted his only hope would be to turn to 'Loan sharks' and accept an even higher rate of interest, though he may lose his kneecaps, or worse. (High indebtedness)
His interest repayment commitment means he can no longer afford his gym-membership and vitamins so his wellbeing starts to suffer.
In addition, his constant supply of SGD currency to pay for his US studies lowers the value of the SGD meaning he will have to pay more and more SGD to exchange for his study expenses which are in USD.
Moreover, this increase in the price of imports from the US, (One of Singapore's largest trading partners) means that the general price level in Singapore starts to rise, and the purchasing power of his money is getting less and less, so he needs to work longer hours to afford the same amount of USD.
If this situation continues and he is not generating enough income from his job, he may well have to defer or even leave his course in order to lower his consumption activities below that of his part-time job's income so he can repay his debts, seriously lowering his living standards and this could take years to accomplish, all the while he is not studying and his potential for higher earnings will be lost. (No economic growth)

However, these problems need not necessarily arise:

If the interest rate on the loan is modest and the amount not too extravagant, then the student is likely to have a much easier time paying it back.
Also and most crucially, if his debt is used to increase his level of human capital enabling him to secure a high-paying job then he will easily be able to repay his loan hassle-free.
Furthermore, his new career allows him to sell his services internationally, and as result, he receives his income in various currencies which he uses to purchase goods in those countries. (Balanced CA)

--CONS OF BORROWING--

LOW COLLATERAL may mean they have to agree to pay a higher rate of interest, which will inevitably leave him with less disposable income and thus reduce his spending activity, meaning less income for his local pub (Recession alert!!)

Furthermore, this high level of indebtedness obviously increases his risk of credit default and if this was to occur, he would be blacklisted and have a very poor credit history and would find it extremely difficult to secure any more loans requiring him to seriously curtail his lifestyle and reduce his consumption activities. (Lower standard of living)
If blacklisted his only hope would be to turn to 'Loan sharks' and accept an even higher rate of interest, though he may lose his kneecaps, or worse. (High indebtedness)
His interest repayment commitment means he can no longer afford his gym-membership and vitamins so his wellbeing starts to suffer.
In addition, his constant supply of SGD currency to pay for his US studies lowers the value of the SGD meaning he will have to pay more and more SGD to exchange for his study expenses which are in USD.
Moreover, this increase in the price of imports from the US, (One of Singapore's largest trading partners) means that the general price level in Singapore starts to rise, and the purchasing power of his money is getting less and less, so he needs to work longer hours to afford the same amount of USD.
If this situation continues and he is not generating enough income from his job, he may well have to defer or even leave his course in order to lower his consumption activities below that of his part-time job's income so he can repay his debts, seriously lowering his living standards and this could take years to accomplish, all the while he is not studying and his potential for higher earnings will be lost. (No economic growth)

However, these problems need not necessarily arise:

If the interest rate on the loan is modest and the amount not too extravagant, then the student is likely to have a much easier time paying it back.
Also and most crucially, if his debt is used to increase his level of human capital enabling him to secure a high-paying job then he will easily be able to repay his loan hassle-free.
Furthermore, his new career allows him to sell his services internationally, and as result, he receives his income in various currencies which he uses to purchase goods in those countries. (Balanced CA)

--CA DEFICIT FINANCED BY SALE OF ASSETS--

--CONS--

--WHEN FINANCED BY SALE OF DOMESTIC ASSETS--

Carrying on our analogies, imagine that you are a business in Singapore that needs

This is very similar to borrowing, especially if the assets are instruments such as bonds, which are essentially loans anyway. in the case of

• Higher interest rates to attract foreign

financial investments, leading to recession.

Long-term current account deficits may lead to a need

for higher interest rates to induce foreign financial

investors to make financial investments in the

domestic economy, thus creating recessionary effects.

• High indebtedness. As in the case of borrowing,

continued sales of domestic assets result in the

accumulation of high levels of ‘debt’ (meaning

foreign ownership of domestic assets), which it may

be difficult to regain (i.e. to have ownership come

back to the domestic economy).

• Depreciating exchange rate. For the same

reasons as with borrowing, a persistent current

account deficit puts a downward pressure on the

exchange rate.

• Poor international credit ratings and a loss

of confidence in the currency and economy.

The ability of a country to go on indefinitely

financing its current account deficit by selling off

its assets depends very much on the confidence that

foreign investors have in the domestic economy

and currency. If there is a belief that the currency

may depreciate substantially, or that the economy

will not perform well in the future, they may be

unwilling to continue to invest in the country, or

they may even try to sell their assets in the country,

in which case the country will be unable to finance

its current account deficit. This is likely to result in

a significant and rapid depreciation of the domestic

currency.

• Painful demand management policies. As in

the case of borrowing, it may become necessary to

pursue contractionary and other policies in an effort

to reduce the size of these (see below).

• Lower standard of living in the future.

Countries that sell off their assets do not have

to pay back loans; however, they are selling off a

portion of their domestic property. In this case,

they will have to consume less than the amount

they produce in the future if they want to regain

possession of their domestic assets.

Here, too, these problems need not necessarily arise,

if the country achieves economic growth that allows

it to secure increases in per capita output and income

large enough to allow increasing consumption

levels together with a current account surplus and a

fi nancial account defi cit (involving the purchase from

foreigners of domestic assets).

...CA SURPLUS--

While a current account surplus may seem like a positive economic indicator, it can also pose certain problems and challenges for an economy. Here are some of the reasons why a current account surplus can be a possible problem:

EXCHANGE RATE APPRECIATION: A persistent current account surplus can lead to an appreciation of the country's currency. When a nation exports more than it imports, there is a higher demand for its currency in the foreign exchange market. This increased demand drives up the value of the currency, making exports more expensive and imports cheaper. As a result, domestic industries that rely on exports may suffer, which can lead to job losses and reduced economic growth.

REDUCED DOMESTIC DEMAND: A current account surplus often implies that a country is saving more than it is investing. This can result in reduced domestic consumption and investment, which may lead to slower economic growth and lower domestic employment levels.

DEPENDENCE ON EXTERNAL DEMAND: A surplus may indicate that a country's economy is overly dependent on external demand, relying on other countries to buy its goods and services. This makes the country vulnerable to economic downturns in its trading partners, as reduced demand from abroad can negatively impact its own economic growth.

Loss of Competitiveness: If a country consistently runs a current account surplus, it might not have the same incentives to innovate and improve its productivity as a country with a more balanced trade position. This can lead to a loss of competitiveness in the long run, as industries may become complacent and less efficient.

Capital Inflows: To maintain a current account surplus, a country might attract foreign capital inflows, such as foreign direct investment or portfolio investment. While these capital inflows can be beneficial, they can also lead to financial instability if they suddenly reverse, causing capital flight and exchange rate volatility.

Political and Trade Tensions: A persistent current account surplus can create tensions with trading partners, as they may accuse the surplus country of engaging in unfair trade practices or currency manipulation to maintain the surplus. This can result in trade disputes and protectionist measures, potentially harming international relations and trade agreements.

Economic Imbalances: A current account surplus can mask domestic economic imbalances, such as income inequality, resource misallocation, or structural inefficiencies. These issues may remain unaddressed as long as the surplus is maintained, potentially causing long-term problems for the economy.

It's important to note that the impact of a current account surplus depends on the specific circumstances of the country and the global economic environment. While a surplus can create challenges, it may also be a sign of a strong export-oriented economy. Government policies and measures should be carefully designed to address the potential problems associated with a surplus while maintaining economic stability and growth.

...CA DEFICIT--

A current account deficit, like a surplus, can also present a range of problems and challenges for an economy. Here are some reasons why a current account deficit can be a possible problem:

CURRENCY DEPRECIATION: A persistent current account deficit can lead to a depreciation of the country's currency. When a nation imports more than it exports, it needs to purchase foreign currency to pay for those imports. This increased demand for foreign currency can lead to a decrease in the value of the domestic currency. While this can make exports cheaper and potentially boost export industries, it can also result in higher costs for imported goods and services, contributing to inflation.
Inflationary Pressure: A current account deficit can put upward pressure on domestic prices, as the cost of imported goods and raw materials rises due to the weaker domestic currency. This can lead to inflation, which erodes the purchasing power of consumers and reduces their standard of living.
External Debt Accumulation: Running a current account deficit typically means that a country is borrowing from the rest of the world to finance its consumption and investment. This can lead to an accumulation of external debt, which may become unsustainable if the deficit persists at high levels. Servicing this debt can put a strain on government finances and the economy.
Reduced Economic Stability: A chronic current account deficit can make an economy vulnerable to external shocks, as it relies on foreign capital inflows to sustain its consumption and investment. If global economic conditions change or foreign investors lose confidence, it can lead to a sudden outflow of capital, financial instability, and economic crises.
Structural Issues: A current account deficit may reflect structural issues within the economy, such as a lack of competitiveness, low savings rates, or excessive reliance on imported goods and services. These issues can hinder long-term economic growth and sustainability.
Trade and Political Tensions: A persistent current account deficit can lead to tensions with trading partners, who may accuse the deficit country of engaging in unfair trade practices or currency manipulation to maintain the deficit. Trade imbalances can result in trade disputes and protectionist measures, affecting international relations and trade agreements.
Loss of Economic Autonomy: A significant current account deficit can limit a country's economic autonomy and sovereignty, as it becomes increasingly dependent on foreign capital and financing. This can reduce the ability to pursue independent economic policies.

It's worth noting that not all current account deficits are problematic, especially if they are driven by temporary factors or reflect a healthy level of investment and economic growth. However, addressing the potential problems associated with a current account deficit often involves a combination of policies aimed at improving competitiveness, promoting exports, controlling inflation, and managing external debt to ensure economic stability and sustainability.

--LOW DOMESTIC CONSUMPTION--

--PERSISTENT CA DEFICIT--

--MCQ DOWNLOAD--

--EXCESS SUPPLY on CA = EXCESS DEMAND on KAFA--

This set of diagrams represents the scenario that we see above, in which the EXCESS SUPPLY of SGD (20bn) on the CA, was EQUAL TO the EXCESS DEMAND for SGD (20bn) on the KAFA. In this case there is no shortages or surpluses at the initial exchange rate, therefore it REMAINS STABLE.

--CAN THE BOP BE UNBALANCED?--

Now that we know the link between the BOP and exchange rates we can explain how an UNBALANCED BOP can occur.
As we know the authorities often wish to keep the exchange rate fixed and do so by either SELLING FOREX to BOOST the DEMAND for SGD to COUNTER DOWNWARD PRESSURE, or BUYING FOREX to BOOST the SUPPLY of SGD to COUNTER UPWARD PRESSURE. This transaction is entered into the KAFA as 'CHANGES IN RESERVES', and as this effectively keeps the rate at a different level to its natural rate, it is the reason why the BOP can be IMBALANCED.
In our original example, we can see that if we remove the government intervention in the form of the 1bn credit ('Item 11') on the FA, the excess supply on the current account of $20bn, is not matched by the excess demand on the KAFA which is now only $19bn, which would give a BOP deficit of -$1bn and result in a depreciation of the exchange rate.
However, the government has intervened to purchase 1bn SGD, using its FOREX to ensure the rate stays fixed, and prevent market forces from lowering the rate, thus the BOP remains in deficit (Unbalanced)

--EXCESS DEMAND on CA < EXCESS SUPPLY on KAFA--

In this scenaro, we can see that despi

--EXCESS DEMAND on CA > EXCESS SUPPLY on KAFA--

--EXCESS DEMAND on CA < EXCESS SUPPLY on KAFA--

If a CA SURPLUS exists it means that there is greater demand for items on the SIng. CA, by the US than there is demand for items on the US CA from Singapore, hence THE DEMAND FOR SGD IS GREATER THAN THE SUPPLY OF SGD which will CREATE A SHORTAGE OF SGD on the CA
IF THIS SHORTAGE IS COUNTERED BY A GREATER AMOUNT OF EXCESS SUPPLY of the SGD on the KAFA, like in the example below, WE HAVE EXCESS SUPPLY in the FOREX MARKET which will make THE EXCHANGE RATE DEPRECIATE. Yes even with a CA SURPLUS it is still possibel to have downward pressure on th exchange rate.
In the example below we can see that the excess demand of $20bn on the CA is countered by $21bn of excess supply on the KAFA, thus the exchange rate depreciates to Er2.

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