· Level of domestic income: An increase in the level of domestic income increases the demand for all goods and services, including imports. This again results in an increased supply of the domestic currency.
· International prices: The international demand and supply positions determine the international price of a commodity. A higher international price would get translated into a higher domestic price. If the demand for imported goods is inelastic, this would result in a higher domestic currency value of imports, increasing the supply of the domestic currency. In case of the demand being elastic, the effect on the supply of the domestic currency would depend on the effect on the domestic currency value of imports.
· Inflation rate: A domestic inflation rate that is higher than the inflation rate of other economies would result in imported goods and services becoming relatively cheaper than domestically produced goods and services. This would increase the demand for the former, and hence, the supply of the domestic currency.
· Trade barriers: Trade barriers have the same effect on imports as on exports – higher the barriers, lower the imports, and hence, lower the supply of the domestic currency.
Importance of BoP Statistics
As said earlier, an attempt at forecasting exchange rates can be made if the factors affecting the demand and supply of a currency are known. In the last few sections, the different components of the BoP account and the factors affecting them (and eventually the exchange rate of a currency) were listed. A careful study of these factors and of the underlying economic factors the world over can prove quite helpful for predicting at least the direction of the movement in exchange rates, if not the magnitude.
A movement in the reserves position of a country can also provide some indications as to the possible movement of the exchange rate of its currency. A continuous depletion of reserves may indicate either of the following two circumstances:
a. A repeated overall BoP deficit. As outflow exceeds inflow, there would be an excess supply of the domestic currency in the forex markets, thus putting a downward pressure on its exchange rates with other currencies.
b. There may already be a pressure on the exchange rate due to the above mentioned reason, because of which the official reserves may be used to defend the domestic currency. This would be done by selling the reserves in exchange for the local currency to increase the total demand for the latter, in order to prevent the exchange rate from sliding down.
Both the scenarios predict an eventual depreciation of the domestic currency. Similarly, a continuous accretion to the reserves would be an indication of impending appreciation.
Limitations of Balance of Payments
Though BoP statistics are very helpful in predicting movements in the exchange rates, they are more useful for estimating general trends rather than the specific levels at which the exchange rates would stabilize. Besides, care has to be taken while interpreting BoP data. All the different balances (current account balance, capital account balance, overall balance) should be considered, along with the actual and expected trends in these balances and the expected developments in the international scene. The BoP data for one country can only give an idea as to whether that country’s currency is likely to increase or decline in value. It would not help in predicting the currency’s movement with respect to a particular currency. That movement can be estimated only if the BoP data for both the countries are studied together.
EXCHANGE RATE MECHANISM
The exchange rate is formally defined as the value of one currency in terms of another. There are different ways in which the exchange rates can be determined. Exchange rates may be fixed, floating, or with limited flexibility. Different systems have different methods of correcting the disequilibria between international payments and receipts, one of the basic functions of these mechanisms.
Fixed Exchange Rate System
As the name suggests, under a fixed (or pegged) exchange rate system the value of a currency in terms of another is fixed. Governments or the central banks of the respective countries determine these rates. The fixed exchange rates result from countries pegging their currencies to either some common commodity or to some particular currency. There is generally some provision for correction of these fixed rates in case of a fundamental disequilibrium. Examples of this system are the gold standard and the Bretton Woods system. The particular variations of the fixed rate system are
· Currency board system
· Target zone arrangement
· Monetary Union.
Currency Board System
Under a currency board system, a country fixes the rate of its domestic currency in terms of a foreign currency, and its exchange rate in terms of other currencies depends on the exchange rates between the other currencies and the currency to which the domestic currency is pegged. Due to the pegging, the monetary policies and economic variables of the country of the reference currency are reflected in the domestic economy. If the fundamentals of the domestic economy show a wide disparity from that of the reference country’s, there is a pressure on the exchange rate to change accordingly. This may result in a run on the currency, thus forcing the authorities to either change, or altogether abandon the peg. To prevent such an event, the monetary policies are kept in line with that of the reference country by the central monetary authority, called the currency board.It commits to convert its domestic currency on demand into the foreign anchor currency to an unlimited extent, at the fixed exchange rate. The currency board maintains reserves of the anchor currency up to 100% or more of the domestic currency in circulation. These reserves are generally held in the form of low-risk, interest-bearing assets denominated in the anchor currency. An internationally accepted, relatively stable currency is generally selected as the anchor currency.
The currency board does not have any discretionary powers over the monetary policy. The interest rates are automatically set by the market mechanism. If demand for the anchor currency rises and people start converting more and more of the domestic currency for the anchor currency, the reserves with the currency board get depleted. As the currency in circulation has to be backed by the anchor currency reserves, the depletion of reserves results in a contraction of the domestic currency’s supply. This, in turn, will result in an increase in the domestic interest rates. A high domestic interest rate increases the demand for the domestic currency as more and more people become interested in investing in the economy. This increases the supply of the anchor currency and eliminates the pressure on the domestic currency. The opposite will happen in case of an increase in the supply of the anchor currency. The interest rates, thus, act as the force, which brings back the forex markets to equilibrium.
Unlike a central bank, a currency board does not even have the power to print unlimited amounts of money. Due to the requirement of the domestic currency being backed by reserves of anchor currency, the board can print only as much currency as can be backed by its existing reserves. This prevents the board from lending to either the government, or the domestic banks. As government’s deficits are not automatically monetized, it has to finance its operations by either raising taxes, or by borrowing in the market. The market determined interest rates keep the government borrowing, and hence, spending under check; and thus forces fiscal discipline. At the same time, as neither of the sources of funds (taxes and borrowings) increases the money supply, there is no inflationary pressure on the economy due to government spending.
Since the board does not lend to even the domestic banks, it cannot act as the lender of last resort. On one hand, this ensures more prudent policies on the part of banks. On the other hand, it would result in even sound banks going under at the time of a financial panic.
The biggest advantage of a currency board system is that it offers stable exchange rates, which act as an incentive for international trade and investment. The discipline enforced on the government and the financial system also helps in improving the macroeconomic fundamentals in the long run.
Among the drawbacks, the foremost is the loss of control over interest rates. The equilibrium in the forex markets is established at the point where the domestic interest rates in the economy are in accordance with the underlying economic fundamentals of the domestic and the anchor currency economy and the fixed exchange rate. A high inflation in the domestic markets can result in low or even negative real interest rate. This may cause an asset price bubble as money is borrowed at low interest rates and put in financial and real assets. The excess demand for these assets makes their prices go up to unrealistically high levels. When the interest rates start rising due to any endogenous or exogenous reason, these prices come crashing down due to the high selling pressure and thus cause a financial panic. Another effect of the inability of the board to set interest rates is that an important tool for controlling the level of economic activity becomes inoperative. Interest rates cannot be used to control the inflation level in the economy and hence the level of economic activity. The economy may thus become exposed to phases of painful contraction and inflation. Further, this system, in order to operate efficiently, needs wages to be flexible. In case of the domestic economy facing a higher degree of
inflation than the anchor currency country, or in case of an exogenous shock like a fall in the export prices, a movement in the exchange rates is not possible in this system. Thus, the adjustment has to come via domestic wages. If these prove to be sticky, the domestic currency could become overvalued, and the domestic goods uncompetitive in the international markets.