International Finance Economics and Forex Trade

PCL-I (Finance)

Section 9 and 10

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Topics covered in this secession:
1. Balance of Payment
2. Theory of purchasing Parity
3. Theory of interest rate Parity
4. Relation between nominal interest rates of inflation and future spot exchange
5. Method of forecasting exchange rate.

Balance of payment:
Balance of Payment (BOP) records commercial, financial and economic flows between a given
country and other countries of the world. BOP statement is kept in the form of credits and debits.

The major uses are:

. Imports of goods and services;

. Purchase of foreign financial assets;

. Foreign lendings and so on.

PRESENTATION OF BALANCE OF PAYMENTS

A BOP statement is divided into several intermediate accounts. The three major segments are:

(i) Current account,

(ii) Capital account, and
(iii) Official reserve:

Account Table 2.1 provides details of these accounts as shown in a typical BO] statement. The data
needed to prepare different accounts are collected from various sources. For instance, the data on
imports and exports are gathered from customs!

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Authorities whereas the financing of these transactions appears largely among the data on changes in
foreign assets and liabilities reported by financial.

institutions. That is why there is an additional account in the BOP Statement, 'namely Errors and
Omissions. The succeeding paragraphs contain a brief description of various accounts] shown in the
BOP Statement.

The Current Account is a record of the trade in goods and services among countries. The trade in
goods is composed of exports (selling merchandize td foreigners) and imports (buying merchandize
from abroad). Exports are sources of funds and result in a decrease in real assets. On the other hand,
imports are a use of funds and result in an acquisition of real assets. The trade in services (also called
invisibles) includes interest, dividends tourism/travel expenses and financial charges, etc. Interest
and dividends measures the services that the country's capital renders abroad. Payments coming from
tourists measure the services that the country's shops and hotels provide to foreigners who visit the
country. Financial, insurance and shipping charges measure the services that the country's financial
and shipping sectors render to foreigners. Receipts obtained by servicing foreigners on these counts
constitute, source of funds. On the other hand, when the country's residents receive the services from
foreign-owned assets, utilization of funds, takes place. .

Unilateral transfers consist of remittances by migrants to their kith and kin and gifts, donations and
subsidies received from abroad. Remittances so receive 1 are obviously sources; remittances made in
forms of gifts/donations, etc., b immigrants cause utilization of funds.

The Capital Account is divided into foreign direct investment (FDI), portfolio investment and private
short-term capital flows. FDIs are for relatively longer period of time and portfolio investments have
a maturity of more than one year. When they are made. The short-term capital flows mature in a
period of less, than one year. The distinction between FDI and portfolio investment is made on the
basis of the degree of involvement in the management of the company (and not on the basis of the
extent of ownership) in which investment is made.

Table 2.1 Typical BOP Statement

Goods Accounts
Account Exports (+)

Imports (-)

Balance on Goods Account = A(1)

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Services Account
Receipts as interest are dividends, tourism receipts for travel and filarial charges (+) Payments as
interest and dividends, tourism payments for travel and financial charges (-)

Balance on Services Account = A(ll)

Unilateral Transfers
Gifts, donations, subsidies received from foreigners (+) Gifts, donations, subsidies made to
foreigners (-) Balance on Unilateral Transfers Account = A(llI) Current Account Balance: A(l) +
A(ll) + A(llI)

B. Long-term Capital Account

Foreign Direct Investment FDI.

Direct investment by foreigners (+) Direct investment abroad (-) Balance on Direct Foreign
Investment = B(1)

Portfolio Investment
Foreigner's investment in the securities of the country (+) Investment in securities abroad (-) Balance
on Portfolio Investment = B(ll) Balance on Long-term Capital Account = B(l) + B(ll)

Private Short-term Capital Flows

Foreigners' claim on the country (+) Short-term claim on foreigners (-) Balance on Short-term
Private Capital Account = B(llI) Overall Balance: [A(1) + A(ll) + A(ill) +. [B(1) + B(ll) + B(llI)]

C. Official Reserves Account decrease or increase in foreign exchange reserves.

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BALANCE OF PAYMENTS (BOP) AND EXCHANGE RATE

A deficit or surplus of certain segments in the BOP may also help to explain the level of exchange
rates as disequilibrium indicates the level of demand and supply of foreign currencies. Deficit
increases the demand of foreign exchange. This reduces, all other things being the same, the value of
national currency; on the contrary, surplus increases the value of national currency on the exchange
market

EXCHANGE RATE THEORIES

INTRODUCTION

The objective of this chapter is to explain forward rates theories, concerned with Determination of
exchange rates. The important factors affecting exchange rates are: (i) rate of inflation, (ii) interest
rates, and (iii) balance of payment the subject matter of this chapter is to describe two important
theories partly explain fluctuations in exchange rate:

(1) Purchasing Power Parity (PPP) (2) Interest Rate Parity

THEORY OF PURCHASING POWER PARITY (PPP)

This theory was enunciated by "Gustav Cassel. Purchasing power of a currency is determined by the
amount of goods and services that can be purchased with one unit of that currency. If there is more
than one currency, it is fair all equitable that the exchange rate between these currencies provides the
same purchasing power for each currency. This is referred to as purchasing POW. Parity.

It is ideal if the existing exchange rate is in tune with this cardinal principal of purchasing power
parity. On the contrary, if the existing exchange rates I such that purchasing power parity does not
exist in economic terms, it is f situation of disequilibrium. It is expected that the exchange rate
between the two currencies conforms eventually to purchasing power parity.

Likewise, if the rate of inflation is different in two countries, the floatin1 exchange rate should
accordingly vary to reflect that difference. Let us consider two countries, A and B. The rate of

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inflation in the country A is higher than that in the country B. As a result, imports of the country A
Increase since the prices of foreign goods tend to be lower. Similarly, exports from the country.

Criticism of the PPP Theory

Conceptually, this theory is sound. However, there are a nqruJ2.er of reed) factors that, prevent this
theory from determining exchange rates, in practice Some of the major factors in this regard are: (i)
Government intervention, directly in the exchange markets or indirectly through trade restrictions;
(ii) Speculation in the exchange market; (iii) structural changes in the economies of the countries (iv)
continuation of long-term flows in spite of the disequilibrium between purchasing power parity and
exchange rates. Another criticism levelled against this theory is that the rate of inflation or the
relevant price level indices are. Not weII defined. Questions pertaining to what constitutes an
appropriate sample and weight assigned to each commodity are not satisfactorily answered. For
example, should the sample represent goods, and services, or only those that are traded
internationally?' The theory takes into account only the movement of goods and not capital. In
operational terms, it is concerned only with the current account segment of the balance of payment
and not with the total BOP. , Above all, this theory ignores the fact that a currency may be an
instrument of payment by other countries (e.g. US dollar). In this situation, the exchange rate may
evolve in a manner that has nothing to do with the price levels of the country (i.e. the USA).

The ppp theory can be considered as an ideal theory to determine exchange rates in specific
situations, such as high inflation or monetary disturbances. In such situations, the response of
individuals to changes in value of real and monetary assets can be expected to be strong and the
exchange rate prediction by ppp theory may turn out to be realistic.

THEORY OF INTEREST RATE PARITY

This theory states that premium or discount of one currency against another should reflect the
interest differential between the two currencies. In a perfect market situation and where there is no
restriction on the flow of money, one should be able to gain the same real value on one's monetary
assets irrespective of the country where they are held.

Say, an investor has a sum of DM 1 today. The exchange rate is, say, f' $Co/DM. That is, he can
convert his DM 1 to get $Co if he so desires. Further, say, the net interest per dollar is t$ while per
DM it is tDM. The investor has two choices before him:

(i) He places his money in DM to receive 1 x (1 + tDM) after a period T;

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(ii) He converts his money into US dollar and places it in dollar market to receive Co x (1 + t$) at
the end of the period T.

In order that he be indifferent in placing his money either in DM or in US dollars, the two sums, at
the end of the period T, should be equal.

Co (1 + t$) dollars = 1 (1 + tDM) Deutschmark

or

DMI = $Co [(1 + t$)/(1 + tDM)] So, the rate of exchange after the period T is $CT/DM. So in
general, we can write:

CT = Co x (1+tD)/ (1+tE)

Where:

CT: forward rate;

Co: spot rate;

tD: domestic rate of interest;

tE: interest rate in foreign country.

This equation can be rearranged such that:

CT – Co/ Co = tD- tE/1+tE

If tE is considered very small compared to 1, then

CT'-CO/ Co = tD - tE

Thus, premium or discount should be almost equal to the difference between the rates of interest of
the two currencies.

Criticism of the Theory of Interest Rate Parity

The theory of interest rate parity is a very useful reference for explaining the differential between the
spot and future exchange rate, and international movement of capital. Accepting this theory implies
that international financial markets are perfectly competitive and function freely without any
constraints. However, reality is much more complex. Some of the major factors that inhibit the
theory from being put into practice are as follows:

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Availability of funds that can be used for arbitrage is not infinite. Further, the importance of capital
movements, when they are available, depends on the credit conditions practiced between the
financial places and on the freedom of actions of different operators as per the rules of the country in
vogue.

Exchange controls certainly place obstacles in the way of theory of interest rate parity. The same is
true about the indirect restrictions that can be placed on capital movements in short run.

Interest rate is only one factor affecting the attitude and the behaviour of arbitrageurs. In other words,
capital movements do not depend only on interest rates. Other important factors are concerned with
liquidity and the ease of placement.

Speculation is an equally important element. This becomes very significant during the crisis of
confidence in the future of a currency. The crisis manifests in tenns of abnormally high premium or
discount-much higher than what the interest rate parity can explain.

RELATION BETWEEN NOMINAL INTERFST RATES, RATES OF

INFLATION AND FUTURE SPOT EXCHANGE RATES

Variations of future spot rates should reflect:

. Difference of nominal interest rates;

. Difference of anticipated inflation.

As stated earlier, nominal interest rate difference, tE - tD, should be equal to premium or discount. If
the markets are efficient, the forward rate is an unbiased predictor of future spot exchange rate. For
example, if the nominal interest rate on US dollar is 4 per cent less than that on Indian rupee, this
difference of 4 per cent can be explained by the fact that an anticipated inflation rate is apprehended
to be 4 per cent higher in India than that in the USA. Consequently, this difference is expected to be
reflected in the future spot rate leading to a depreciation of the Indian rupee by 4 per cent.

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METHODS OF FORECASTING EXCHANGE RATES
Forecasting future exchange rates is virtually a necessity for a multinational enterprise, inter-alia, to
develop an international financial policy. In particular, it is useful when the international firn is to
borrow from or invest abroad.

Foreign investment decisions require forecast pertaining to future cash flows, which in turn, will
need input of host country's exchange rate. Above all, exchange rates are decisive in framing hedging
policy.

Forecasting the Exchange Rate in Short-term

Forecasting the exchange rate is one of the most difficult areas of international t finance. The
theories explaining exchange rate variations are not satisfactory to

Forecast how the rates are going to evolve. Under the circumstances, therefore,

Recourse is taken to less than perfect methods. The following three methods are generally employed
for the purpose.

(1) Method of advanced indicators

(2) Use of forward rate as a predictor of the future spot rate

(3) Graphical methods.

Method of Advanced Indicators

Several indicators are used for prediction of exchange rates. One important indicator widely used is
to determine the ratio of country's reserves to its imports.

The reserves consist of gold, foreign currencies and SDRs. The ratio indicates the number of months
(N) imports, covered by the reserves (R) (Eq. 6.4).

N = R/I x 12 (6.4)

Let us assume that annual imports of India cost Rs 80 billion and reserves are Rs 30 billion, the
number of months of imports covered by reserves is:

N = (30/80) x 12 = 4.5 months.

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 The general rule that seems to be followed in this regard is that if amount of reserves is less than the
value of 3 months' imports, the currency is vulnerable and may face devaluation.

Use of Forward Rate as Predictor of Future Spot Rate

Some authors believe in the efficiency of markets and consider that forward rates are likely to be an
unbiased predictor of the future spot rate. If on 1 January of current year, the 6-month forward rate is
Rs 38/US$, the spot rate on 1 July should be Rs 38/US$. In other words, the rate of premium or
discount should be an unbiased predictor of the rate of appreciation or depreciation of a currency.

Graphical Methods
Since long, these methods have been used on exchange markets. The objective of making charts or
graphs is to gain insight into the trend of fluctuations' and forecast the moment when the trend is
likely to reverse. Technical analysts consider that the behaviour of operators remains stable over a
period. They identify certain configurations and then forecast rates.

One type of graph is in the form of a curve. Every day, the closing rate is marked on a vertical scale
while the horizontal scale is for time. Different points are linked to prepare a curve (Fig. 6.2).
Another type of graph can be in the form of bars. Every day or every week or every month, high and
low rates are indicated while closing rates are indicated by a small horizontal bar on the vertical line
joining high and low (Fig. 6.3).

Joining the points of high (also called resistance points), a curve of resistance (Fig. 6.4) is obtained.
On the other hand, by joining low points, a curve of support (Fig. 6.5) is obtained. The two curves
joining high and low points form a tunnel.

If rates become significantly distant from these curves, which indicate a change in: the market
behaviour.

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Forecasting the Exchange Rates in Medium and long term:
There are two important methods used to forecast medium and long-tenn exchange rates:

(1) Economic approach;

(2) Sociological and political approach.

Economic Approach:
This approach takes into consideration fundamental factors, reflecting strengths and weaknesses of
the economy in the long run. A selective list of decisive factors used under this approach is as
follows:

Structure of the balance of payments.

If a country imports more than it exports during a long period, the probability of depreciation of its
currency becomes high.

Examination of reserves in gold or in foreign exchange.

A deficit in BOP results into decrease of reserves. A significant reduction in reserves of a country
increases the probability of depreciation of its currency.

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Comparative examination of interest rates.
Relatively speaking, the higher interest rate (in comparison to other countries) is indicative of likely
depreciation of the currency. If higher rates persist for a long period, the devaluation is virtually
imminent.

Comparative study of inflation rates.

A higher inflation rate than those of major competing countries increases the risk of depreciation of
the currency.

Study of activity and employment level.

Higher level of economic activity and full employment are likely to have a positive bearing on
exchange rates.

Sociological and Political Approach

The analysis based on sociological and political approach is important to supplement the economic
analysis. It has been observed that the attitude of government with respect to the value of its currency
depends on several factors.

The important factors included in-this category is proximity of elections, behaviour of opposition
parties, recommendations of the IMF, etc.

Government, confronted with the risk of depreciation of ' its currency may - initiate anyone or more
of the following remedial measures to overcome the problem.

• Rigorous control of foreign exchange

• Interest rate hike
• Deflationary policy.

However, the negative effect of one or several of these steps should be weighed by the Government
before implementing them.

CONCLUSION

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Exchange markets and exchange rates are influenced by numerous factors such as exports and
imports, investments and disinvestrnents lending and borrowing, psychological factors, anticipation
of increase or decrease in reserves, sociopolitical factors, international payments deficits, and
stability of governments, etc.

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