UNITED NATIONS
AFRICAN INSTITUTE FOR ECONOMIC DEVELOPMENT ~fD PLANNING
DAKAR
IDEP2 2nd Semester, 1964-65
FOREIGN TRADE
IDEP/ET/VII/342 D. Carney
3rd Lecture
FOREIGN EXCHANGE AND BALANCE OF PAYMENTS
Background References:
Raymond Barre, Economie PolitiQue, Tome II, Quatrième Partie, Titre I à Titre III (p. 786)
C.P. Kindleberger9 International Economies, Part I
&
VII. Foreign Exchange and the Market for Foreign Exchange
Foreign exchange consists of gold, foreign. currencies and credit balances, foreign securities (bills, promissory notes and other credit instrUEants) foreign assets (titles to property, stocks and share s ) •
All these instruments derive from, and finance the transactions between countries over and above direct exchange of goods and services. The institutions which handle and arrange transactions in these instruments constitute the foreign exchange market, and consist of central banks, commercial banks, acceptance houses,loan and investment companies9 the stock exchanges, the treasury departments of governments9 etc.
The differences between the valuesof exports and.imports of goods and services between countries take the form of, and are financed with9 foreign exchange.
. . . 1 ...
IDEP/ET/VII/342 3rd Lecture Page 2
II. Aggregatio~ of individual supply and demand curves for domestic commoàities in order to obtain the market supply and demand curves for each such cornmodity:
Value of Units of Good or Service Bought
by Buyer
DEMAND No.of Units of Good or Service Bought by Buyer
.Oost of;
:aood or;
~ervicej
1 1
1 i
SUPPLY
No.of Units of Good or Service Sold by Producer/
Seller
1Value of Uni ts iof Good or
!Service Sold L--y
!Producer/SelJor
III. Supply and Demand for Foreign Exchange at given rate~ of exchange
The total external demand for its exports of goods and services constitutes the total supply of a country's foreign exchange, and i~R
own irnports of goods and services its total dernand for foreign exchange. Any divergence between its total eupply and dernand for foreign
exchange during a given period at a given rate of exchange has to be corrected by an adjusternent of its supply and demand in the next_period, by credits to cover the difference or by a change in the rate of exchange.
. . . 1 . ..
•
:A FS Amount
I DEP/ET/VII/3 42 ):rd :GecturG
?age 3
IV
.A Hypoth e tical Case a nd Di agfaiD of
Supp~·and
D~Ed!or
?o~·9igEExchange by Country A and the
method~ fo~~~limin~~i~the i
mbalancGof Supply a nd Demand
of
S
UPPLY AND
DEMAND FOR FOREIGN EXCHANGE_ü9,UIL I B_B_:LUM
I~'l'Hfl FOREIGN EXCHAlWE î _ If!.BI.<]I
1
1
No. of U ni ts
1 1 1-- - ---- .. .
~ ..... ,
of Country
1A _
To. or Unital
ver
age _;,_,_ . ..1p ; - - --J f of I
mporte
1 . ~·. ,
1_.. ,.. t'A' s Exports Curren t Cur:rent r _c e o d _
_, d "----'1 ··----· ..; ..Country A' s _
.eoa:1J.e .
.dem ande d by Fr
1D oll. Ave r
age ~xpor~so r
JCountry
A· sI
t .by
Cou~cryD d f Suppl y of
th e R es t of Exch . R at e Prj_ ce of mpo r s
m A .f' tl e:nano::
Fo
re i gn Exch. D
11 t .. rom · 1e
Fore i gn
E::ch.the W orld at (N'o
. ofFrs Experts
0ar s a R
est of tffi
at curr ent curren t at
cul~ren-Gfute
of Ez cb
.cur
rent
·per $î) or I mp
.Fr /Dollar Uor l d at R
ate of
Exc.h.A ver.
-P.r ic e (in Frs .)
Ex ch. Rate cur:r-
. l1ver .
($Hi l lion)
($million)
~~:i.J..li.on unit~ p_:r.J.ce
.. --
( 1 ) :: (2 )x ( 5 ) (2) (3) ( 4 ) (5) {6) ( 7
)=, (5)x (6)
92
.96 112 6
.00 s.oo 0
.83 66 54 .
789
Î.80
1085- 90 5. 00 0 . 85 70 59 .
:~o91 . 16 " 106 s.8o 5. 00 0 . 86 72
61.
9289 .76 102 5- 70 s.oo 0.88 76 66.88
89 . 00 100 5· 60 s
.oo 0
.89
1
78
69.
42R7 .36 96 5-50 s .oo o . 9 1 82
'(L;.ô286 . 69 93 5
-40 s . oo 0. 93
1
86 79. 9
8~_:_48 ~
-92
< i5. 30 I s. 00
~o
---< . 94i - as < r 82.7 2
"88~3-2
84
. 48 l 88! s. 20
t5· OOt
0.96i92
L82.3 2 84 s. 10 s . oo 0 . 98 96
94.0880 . 00 80
rs. oç)_J s
.oo !T:-ool 100 1CO
,OO
77.52 76 4
· 90 1s.oo ' l'-:-02 -· 104
106.eo
74 . 88 72 4 . 80 i s . oo 1. 04 108 '11
2.3272 . 08 68 4-70
1s . oo
Î.06 1'10 'i1
6.6067.58 62 4 . 60 s . oo 1. 09
116126 .
4464.38 58 4- 50 s . oo
1.11 120 133. 20
61 . 02 54 4 - 40 s.oo
î.13 124 1
L10. 1?.55.68 48 4.30 s.oo
Î.16
130 150.8049
.98 42 4 . 20 s . oo
1. 19131 159 •
;1r643.92 36 4 . î O s.
co
1.22 140 nr:.
so
37 - 50 30 i 4. 00
1s . oo
1.25
1~.6 ;82.50
30.72 24 3. 90
1s . oo
1.28 152 1 94 - 56
26 .40 20
3.80
1
s.oo
1.32 160 21 1. 20
18. 90
143.70
1s . oo 1. 35 166 224 .
108. 34 6 3.60
1 1s . oo
1.39 174 24
i. 862. 86 2 3- 50
1
s . oo
1.43 182 260
.261.
47
13.40
1
s
.oo 1. 47
\
190
27
9. 30
1
Note~
Curr ent of f icial Ra t e of Exohange : Fr 5.00
$ •J .
f
/ ' '
- 7 1 (
1
1
1 11
0
Country A1s Supply and Demanà. for Forei&f_ J;.;xchf'Lngt:J Offre et Demande de Devises Etrangères du Pa:ys A
Fra.n-os-
A i
c
B_...__
5 6 --·
28
f ')
11280 85.5 100
140 168
Equilibrium Rate of Exch.= 5.25frs/$ 1 Equilibrium Level of Foreign Exah. =
$85.5 million Aver.Price of Exports (5 Frs).in
Dollars at the Equilibrium Rate of Exchange = $ 0.95
---
--- --- --------~-- --______ A F DTaux de Change d'équilïbre=5.25Frs/$
Niveau d'équilibre des besoins en devises= $ 85.5 million
Prix moyen des exportations (5 Frs) en dollars au taux d'équilibre de change = $ 0.95
224 ·- 2 )2- --- ---·-280 Foreign Lxchange/ Levises Etrangères $ million
•
IDEP/ET/VII/342 2:rd.. Lecture Page 5
Action to elimina te the Deficit in the :Balance of Payments of Countr;y_J-:.
i . Increase in the Supply of Foreign Exchange 9 i.e. increase in the volume of experts at the existing world priees. This 1wuld involve the use of more efficient production methods to reduce costs so that more experts could be profitably sold. Diagramm&- tically9 this produces a rightward shift in the AFS curve.
2. Reduction in the Demand for Foreign Exchange 9i.e. 9 a reduc-cion in -Ghe volume of imports at existing 1vorl.d priees. This may involve cu±ting out hurury or "inessential'' imports 9 ,-;rhere inessential imports may be interpreted as commodities for which domestic production could be substi tuted ( import substi tutio:..1).
li1
Diagrammatically, this produces a leftward shift in the A-D curve"
3. Both increase supply of, an~ reduce demand for9 foreign exchange.
If it is possible to increase the supply more than the ~emand
so much the better 9 as the ûeficit could then be converted into a surplus. Rowever, merely eliminating the surplus would do
just as well 9 for a surplus or a deficit is not necessarily goocl or bad in itself since all countries cannot have a surplus in their balance of payments and sorne countries must have deficits if others have surpluses. The ideal situation which is possible for all countries simultaneously is one of zero balance of
payments. Diagrammatically, a zero balance of p~y.ments implies
F F
an intersection of the A D and A S curves at the prevaili~g
rate of exchange.
4.
Raise the rate of exchange to the point of intersection of the AFD and AFS curves to reduce the defici·è -i;o zero. '.;:'his vïill be achieved at the point D where the rate of exchange is Frs 5.25=$ l and the demand and supply of foreign exchange are in equilibrium at $ 85.5 million5.
Export gold,arrange for loans9 sell domestic and axternol secu~itiesfor foreign exchange and reduce external reserves.
IDEP/ET/VII/3~~2 3rd Lecture Page 6
ImElications as well as Eossible repercussions of these measures 1. Increasing the supply of foreign exchange requires that
the elasticity of demand for exports must be /-l ::tt existing world priees.
2. Reducing the demand for foreign exchange implies that elastici ty of demand for imports should be
:>
13.
Raising the rate of exchange may provoke Rimilar action on the part of d;her countries in order· to restore thei.::c competitive position at the former rate of e~change.Or overseas suppliersmay raise export priees accordin5ly in order to obtain the same amount of foreign exchanse and purchasing po1·rer as be fore in the deficit count:ry. Eithe1:' type of action would make the deficit diff:i.cult to elim:i.nate.
V. Action to Correct a Deficit or a Surplus in the Bala~ce of Payments Rate of Exchange
1
l
/
Rate of Exchange
/ s
/ ~-
" "' /
. ."'
/• .''<'
1
!
Foreign Exchangey<,[>
1 ' ; ! ·. 1= Foreign E1:ch .
L--.---~---
Deficit To correct a Deficit
ÎJ
Increase exports (may require export subsidies2) Reduce imports (may require inc:rease in import tariffs)
Surplus
'I'o correct a Sv.r_ph~-
1) Reduce exports (may rey_uj.::::-.:;
export tariffsg al_o9 9Yp~rt
reduction may not be good for developing countries if thic means a reduction in capi. üü exports by indus·~riaJ. cou:::.tl·:i.e:..; >
2) Increase imports (may :r ~lire reduction in import tariffs)
s
3) Export gold, or make payments from the proceeds of sale of external assets and securities and witû- dra'trals from external reserves,
4)
or from sale of domestic assets to foreign creditors (e.g.reduction in the priees of real estat3 and vacation spots as an encouragement to foreigners to invest , promote tourism, etc.)
Arrange for rcceipt of loans and credits (long-term) and raise the rate of interest in or der to at tract shor:b-term credit and reverse thereby the :9ressure on the exchanges.
5) Raise the rate of exchange
(depreciation or devaluation) if the deficit persists. (To be uaed only as a last resort, especially in vievr of possihle competitive reaction from other countries).
6) Arrange for receipt of credit outside the normal channels of trade and the foreign exchange market, through bilateral barter deals, provided this does not prejudice the market prospects of major exports (This has the
advantage of making needed irnports available and permits exports without the volume of trade
diminishing. It relieves further adverse pressure on the exchanges but does nothing to correct the deficit.)
VI. Glues on Action to be Avoided Questions: In the case of a country vri th a Deficit
( i) I-lliat would happen if exports fc:.iled to increase or were reduced, or export priees or export tariffs were raised, or the domestic priees of export-type goods were raised?
IDEP/ET)VII/342 3rd Lecture Page
7
3) Import gold, acquire fo::':'e:i.gn.
assets or securities at home and abroad
4) Arrange for granting long-term external loans and credits, make long-term investment abroad; j_ncrease short-term investment a.broad by lowering the domestic rate of interest (i.e.,if deficit or ~ebtor countries have not
already ra1eed theirs) 5)
6)
J,ouer the rate of exchange
r;~p:y;eciation or revaluation) -:..f the surplus persiste. (To be used only as a last re sort, J{a:y uot ind.uca cumpet :i.ti7G reaction bJ other countries).
.A..rrange for- grant of cred:i.t outsitla the norma:'.. channels of ·c:::-ad..e anCl.
the foreign exchange ma:::-ket ; throug:1.
bilateral barter deals ~itû dobtors.
(This has the advan~;age of mal.cin.c;- needed exports availabla to other countries without diminishing t~o
volume of trade. It reduces further stj_mulus to o9. frwourable exchange rate but does noth:'..ng ·~o
reduce the surplus).
Questions: In the case of a country x:;_t_ a Surplus
(i) What would happen if exports were increased5 export subsidies imposed or export tariffs lowered9
or the domestic pricGs of expor~s
were lowered?
(ii) What would happen if imports failed to contract or were increased, or import tariffs lowered?
(ïi) What would happen if foreign assets were increasingly pr.I!chased?
(iv) What would happen if long- tarrn credit was not available or monetary weapons were ineffective or did not exist7 or a mor.ey market did not exist to encourage the inflow of short-term investment; or if the rate of interest was reduced in arder to encourage domestic investment?
(v) What vrould happen if the rate of exchange was lowered?
(vi) What would happen if bilateral barter deals 1-rere arranged in a principal primary export with a falling world priee in exchange for imports of capital equipment, and the pnrchaser of the primary export later disposed of it on the world market?
IDEP/ET/VII/342 3rd Lecture Page 8
(ii) What would happen if imports were reduced or impor·t tariifs raised?
(iii )What would happen if foreigfl.
assets were increasingly disposed of?
(iv) vlliat would happen if foreign capital inflow was encouraged to finance further expansion of tho domestic economy,or the rate of interest was raisedto encourage an inflow of short-tarrn capital or t0 reduce the rate of domestic
investment in the economy?
(v) 1·fnat v~ould happen if the rate of exshange was rEd.sed?
(vi) I-lhat -vmuld. hapl}Bn if biJ.ateral barter deals in expor commoditie2
~ere arranged an~ the purchaser later sold a huge volwne of the:Je commodities on the wor~d market?
VII. Risks of Contrary Action by Other Countries Hhich· ~may .null-i~he effo:;:-~~
of a Country to Correct a Disequilibrium in. its Balance of Payment~
In the case of a Country with a Deficit.
(i) If an increase in experts is subsidized other countries may raise import tariffs or encourage matching subsidies
(ii)If a reduction in imports was encouraged other countries may reduce th:!iir imports from the deficit country by raising imfort tariffs.
In the case of a Country with a Surplus
( i) If a reduction in experts >ms introduced other countries may
find it hard to sell if they cann~t
obtain particularly noeded expo~tc
from the surplus country.
(ii) If an increase in imports :·ras encouraged producers of domestic substitutes might clameur for and obtain increased tariff pTotection
•
IDEP j:E,'T /Vlf..I/ 342 3rd Lecture Page
9
(iii) If the rate of interest was raised to attract short-term capital other countries may also raise tbeir r~tes; if an
(iii) If the rate of interest was lowered to discourage short -r;er~a
investment ~ther countri:Js mr.y lower their rates at the same time or may not fi.nè. lor.g-to:-..·rr:
loans attractive if the rate o~
interest req_uired on 2-.oans -va.;
too high.
attempt vras made to raise long- term loans other countries may refuse to grant such loans
(iv) If the rate of exchange was raised other countries may raise theirs competitively or raise import tariffs.
(iv) If the rate of exch:=1n.ge .vras lowered other countries may lovrer theirs mrresponclingly or raise export priees thr::n~~)l
tariffs.
(v) If bilateral barter deals were arranged in a primary export purchasers may dispose of it in ;the >vorld market and lo1ver its priee
(v) If bilater~l barter deals w r~
arranged pu:r..c_ .. aserc ffi2,y d.~ c;po~5E'
of the commo~ities in third countries an~ encourage a iu?~la_
:flow of exports
VIII. Implications of Diseq_uilibrium in the Balance of Payments fo.L' e Developing Country1 especially one with a Deficit (a developing country vri th a continuing balance of payments surplus is e.n economie f:i.·eak and j s not likely to be achieving much development).
Many developing countries get into balance of pasTients deficits which Jeopardize the execution of their development plans. If they try to increase their official rate of excbange this may not correct the deficit the first time if it is not raisedsufficiently.
:But then they cannat raise it again for a lor..g time as this might shake confidence in their currency, Hence changing the exchange rate is a measure of last resort and not an instrument for day-to-day use. If they are mai11ly exporters of -cavr matc:r·iala 1-1~ tl1 :.~.~=--t3è demand elasticity and fluctuating priees, an attempt to ~noraaa0
exportsœrely makea ~atters worse and protractstha deficit, unless they can reduce their costs sufficiently,
If they depend to a large extent on CF.?i ta 1_ and othe:c-
imports to execute the ir developmer..t programmes t11eJ ma'- fi:1è.. i t h2.:rd.
to reduce imports, but they may still find it possible to cuè ou~
j
:;::DEP/ET/VII/342 3 rd. Le ct ure Page 10
inessential imports, especially luxuries and commodities for which domestic production could be conveniently substituted.
f t
They may then have to fall back on reduction of overseas assets, securities and reserves to pay off the deficit - lvhich redè-lces their long-tarrn development prospects. If they try to raise loans to support their falling currencies or prosecute their investment programmes they face difficulties in acquiring long-term credit on the world market g lenders may lack confidence in them and refuse to lend, debt servicing costs may impose further burdens on ther;J. ~]le~,
may also lack proper or effective monetary tools. or a capital market with which to attract short-term capital and reduce the pressure on their rates of exchange.
There are ideological and other considerations in addition: Great Britain may find other Atlantic community countries or even the IMF more ready to support a falling pound than Ghaï.1B would find these same countr:i.es and institutions read;y to Bupport the Ghanaian pound. Thus the Tii'IF would be more ready to send an
investigating mission to Ghana or Brazil than i t would to Great Bri ta.in France or any other Western country.
Developing coun:bries with balance of payments deficits would therefore have to try several measures in combination, using an official change in the rate of exchange as a weapon of last resort.
However , balance of payments difficulties may arise from structural problems wi thin the economy, such as inflation 1.,rhich at tracts imports at a given official rate of exchange. Hence, before adopting the corrective measures for a deficit developing (as well as oth2r)
countries should first examine the inter:aal Rtructure of their economiGs. Otherwise corrective measures applied only to reduction of the deficit may fail. A wa;;o:-e-cost-price inflation9 a héi.ndicapped export sector facing bottler ccks in obtaining labour or resour0es ma;;r :first have to
•
te
IDEP
j 'Ifr
/VE/342 3rd Lecture Page 11à.eal t 1-ri th through monetary and physical contro2.s befo:-..~e
corrective measures applicable to reducing the deficit muy have a chance ·l;o 'irork,.
An example of the wa;/ in which inflation ca.n prevent the effe~tivoness of re~edial measures to reduce a defic:.t i.s the tendency it sometimes has of making the domes·Gic markGt more attractive than worl d markets and th0reby of promoting the diverAion bf exporta to the ~ocastic markets instead of abroaà. This was the problem·facod by Great Britai~ after the S~cond Vorld War under thE' 11cheap money" policy of tl:J.e Labou:;:- Uover.nme:!.'l.t. E l
·consequence the deficiJc in that country' s balance of paymen·cs at the time could. lto-~ easj_ly "Je ro~uced .
. goods wbich shouJ.d h?.·vr:; 1)0811 expo:,:-te3. to reduce the è.0ficit vm:r·o diverted to the dcmosti0 market.
Sm1e deveJ o:')ing countrics in the th:-o0s of a t.alanc:e of payments dcfi~it aud lacking effective means o~ corrP~tin3 thiD or 1mable tu arrange credi·~ through ncrméù chan:1els , resort
to bilateral barter deals in arder to obtain the equipment requirsd for tl ... oi:::' clevelcpmont programmes. These arranGo:nencs ~.ü; ol.J.t::::'..C:e the scope cf nor~al transactions and the market for foreign ex~harge.
Hor.mver~ thoy do ::",othing to reduco the deficit and :nay ac·~u'lï.J.;:,r
(a) in the case of primary commodities7 none of thess are sold in third countries at reduced priees - otherwise tl:J.e •wr-ldprice and expor·0 earnings mg_y decline and make the dovelopir!g country unable Go increase export of the commodities involved?
(b) a check is made on the internationl priees of ~he ~oocc as vrell. The danger here :i.s ti:ta-t the deficit so"L:Ir~:•f
IDEP/ET/VII/342 3rd Lecture
Page 12
' /
may oe offered a priee for its exports apparently much above the world priee and in return sold imported goods at an even much higher priee above what they 1wuld
normn~_ly fetch on the world market. Thus1 in addition to the existing deficit a concealed ~barter deficit"
is imposed 1-Thich merely compounds tp.e difficul ties of the country.
The lesson here for developing oountrioa is that they should pay closer attention to the internal structure of their economies and ensure that monetar~
fiscal and other controls are first used to put their economies anthe right path 1before they cau hope J:o cope
suocessfully 1-Ti th disequilibrium in the ir balance of paymeLtG,
