Foreign trade, foreign exchange and balance of payments

•

UNITED NATIONS

AFRICAN INSTITUTE FOR ECONOMIC

• DEVELOPMENT AND PLANNING D A K A R

IDEP ² 2nd Semes ter ² 1964-6_5

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. Kindleberger, International Economies, Part I

&

VI I. Foreign Exchange and the Market for Foreign Exchange

Foreign exchange consista of gold, foreign .. cur;r:encies and credit balances, foreign securities (bills, promissory notes and other credit instrUEants) foreign assets (titles to property, stocks and shares).

All these instruments· derivë from, and finance.the transactions between countries over and above direct exchange of goods and services. The institut ions vrhich handle and arrange transactions in these instruments constitute the foreign exchange market, and consist of central banks, commercial banks, acceptance houses,loan and investment companies, the stock exchanges, the treasury departments of governments, etc.

The differences bet-vreen the values of exporta and imports of goods and services betvreen countries take the form of, and are financed with, foreign exchange.

• Il •

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I:OEP/ET/VII/342 3::::-dLecture Page 2

IL .!gRregatior; of individual supply and demand curve~-for dornestiè commodities in order to ob:bain the ma::-kct supply an.o demand curves for each such commodity~

:OEMAN:O

s " :· u·

:P-:P

L -1 -

--- ---..-.- · -·

VaJ.ue of Units of Good or Servj_ce Bought

No.of Units of

\ Good or Service

1 · Bought by Buyer

.Cost: ;of;

_., ·· 'Oo-6ii- 6r ,

:Service!

1.: . .. :.·. -1

No.of Units of

·aood or Service Sold by Producer/

Sèller

:Value of Units :of Good or :service Sold bj•

jProducer/Sellor ny Euyer

1 !

Tb.e total external demand for i ts exports of gpods anrl se:rvices constitutes the t.otal s_upply of a <?ountry's foreign, e:x:change,. and its ovm ,ii!lJ?Orts of goods and services i ts total demand for forej.gn e·xchange.

C.J·.

~4-p;x;. chvergence he·cween .i ts total supply and demand for foreign

e:z:change _{. : .} during .a given period at a given .rate of exchange has to

'·. .,

be corrected by an adjustement of its supply and demand in the next p~~iod. by credits to cover the difference or by. a change

:: •. :···: . . .... ___ 3. ': .. . :

in the rate of exchange •

. -

... 1 .. .

•

IV.

IDEP/ET/VII/342 3rd Lecture Page 3

A Hypothetical Case and Diagram of Supply and Demand for Foreign Exchange by Country A and the methods for eliminating the imbalance of Supply and Demand

SUPPLY AND DEMAND FOR FOREIGN EXCHANGE: EQUILIBRIUM IN THE FOREIGN EXCHANGE MARKET

A FS Amount of

Country A's Supply of Foreign Exch.

at current Ià.te of Exch.

($ million)

(1)= (2)x(5)

92. 96 91.80 91. 16 89.76 89 . 00 87.36 86.69 86 , 48 J

84 .48 l 82. 32 80. 00

~ l

77.52 7 4. 88 72.08 67.58 64.38 61 .02 55.68 49.98 43.92 37.50 30.72 26.40 18.90

8.34

2.86

1.

47

1 !No.of Units 1

of Country A's Exports demanded by the Rest of the World at

eurre nt Aver.-Price :€niilli.on unitf

(2)

112 108 106 102

100

96 93 92

ⁱ

- <

881 84

80 76 72

68

62 58 54

48

42 36 30

24

20 14

6 2 1

Current Current Fr /Doll. Average Exch.Ra.te Priee of

(No.of Frs Exports per $ 1) ' or Imp.

. (i~ Frs.)

(3) (4)

6.00

5.90 5.8o 5-70 5.60 5-50 5-40

s. ³⁰ J

5· 20 t

5.10

5.00

s.oo

5.00 5.00 5.00 5.00 5.00 5.ood

!

5.oQJ

4· 90 ⁱ 1

4· 80 ¹ 4·

70

^{1 ,} 4.60

5.001.

s.oo

5.00 5.00

s.oo

5.00 5.00

s.oo

4.50 4-40 4.30

4.20

4.10

4.00

3.90 3.80

3.70

3.60 3.50 3.40

5.00 5.00 5.00

1

5.00 5.00

5.00

s.oo

1 5.00

l

i

5.00 5.00

i

5.

⁰⁰

1

No. of Unitsi F

Average A D

Priee of odf Impdordts Amount of . eman e

Exports orb C t Country A's . y oun ry D d f Imports 1n A from the eman or Dollars at Rest of th: Foreign Exch.

current at current

Fr /Dollar World ·at Rate of Exch.

Exch.Rate curr.Aver. ($ million)

Prie~_

(5)

0.83 0.85

0.86

0.88 0.89

o.

91

0.93 0.94)

0.96{

0.98

q.

⁰⁰⁾

.02 1. 04

1.

06

1. 09 1. 11 1.13 1.

16

1.

19

1. 22 1.

25

1.

28

1.

32

1.

35 1.39

1. 43 1. 47

(6) 66

70 72 76 78 82 86

88 (

92 t

96

100

104

108

110

116 120

124 130 134 140

146 152 160 166

174 182 190

(7)= (5)x (6) 54·78 59.50 61.92 66.88 69.42 74.62 79.98 82. 72 f

~-88.

32

'

l 94.08 100.00 106.80

112.32

116.60 126.44

133.20

140.12 150.80 159·46

ne. 8o 182.50 194·56

211. 20

224.10 241.86 260.26 279.30

Note~ Current official Rate of Exohange: Fr 5.00 = $ 1

'

. . • 1

0

! ••

Countl'Y A ¹ s Sup~1y a~1d Ilemand f':or Forei.!In .cJx~h~nge/ Off! e et Demande de Devise~ Etrangères du Pays A

:1

.

^:

:~-i '· ~ ;

... ,·;

28

. A ¹ è:

i ;'

t ')"':

80 85.5 B

- · .112 100

140 168

Eq,uilibrium Ra.te of Exch.== 5.25f;;.s/$ 1 Equilib:dum Level of Foreign Exah. =

$85. 5 mi;Llion A ver. Priee of Exports ( 5 Frs). in . Dollars at the Equilibrium Rate of Exchange $ 0.95

Taux de Change-d'-équilibre,;,5.25Frs/$

Niveau d'équilibre des besoins en devises= $ 85.j million

Prix.rrioyen des exportq.t:ions (5 Frs)

en dol·la~s au taux d ,·équilibre de change = $ 0.95

224

Foreign Lxchange/ Levises Etrangères $ million

..

IDEP/ET/VII/342 3r:i Lecture Page

5

Actiçm to elimina te .the Deficit in th~ Balance .. Qf Payrnë.nt.s .. oL .Country A

-'

î. Increasè in the Supply of Foreign Exchange~ i.e. increase in

·. the volume of' exports at thé existihg world p;ices. This vmuld involve the use of more effièient' production niethods to reduce costs-so that more exports coi_üd be profi tably sold. :Diagr.s,mma-·

tically 9 this pro duces a rightward shift in the AF S curve.

2. Reduction in the Demand for Foreign Exchange9^i.e.~ a reduction in the volume of imports at existing ~vorl.d priees. This may invol ve cu:bting out lu:xru.ry or "inessential" · imports 9 v;rhere

· inessential imports may be interpreted as comrÏwdi ti es for vrhj_ch domestic production could be substituted (impo;t substitution).

Diagrammatically₇ this produces a leftward shift in the A ]) curve. F

· }. Bath increase supply of₉ an~ reduce demand for₉ foreign exchange.

If it is possible to increase the supply ~ore than _. the demand _{. .}

so _

much the better, as ethe deficit- could 'th-en-be 'convertffi:t--·fnto a surplus. However₉ merely eliminating the surplus "'rould d.o

just as well~ for a surplus or a deficit is not necessarily good 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 whiéh is possible --~6~_' 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:qg ra.~~:.~!. ~-~change. ^{··- ·---~ . ; > ··--.. ' ~} ... .

_ 4. Raise the rate of exchange to the point of intersection of the

F F ·-· · · · . - .

A D and A S curves to reduce the deficit to zero. rrlüs will b·a achieved at' the·· point ]) where the rate of exchange is Frs

5.

25==~S

and_ the. demand and supply of foreign exchange are in equilibrium

at $

85.5

million

5.

Export gold,_?..r.:r:apg_e_ for loans, sell dorilestic and extermil __ s.ec\Jiitios for foreign èxchange and reduce external reserves.

.. ·.-::· IDEP/ET/VII/342 3rd Lecture Page 6

-.:.~ ..

Ill).Jllicat.ionE? a-~---w~~l- ~s poss~:ble rrepercussj,on:s. of· the se m.èasure:S~~--

.--;..~ ~·. - -. · ... ---·-:; .... ---^-~ ... •. ··-···

.. -·

•;'_

Increasing_ :the supply of.foreign.exchange -r equires that the

e l·~~ti~i

^ty

~f

^{demand for e}:l(ports must be :;>--1 at

· e:icisti~g world pric~s.

2. · Reducing the demand for foreign exchange implies that

. . . . .

elastici ty of d emand for imports sl10"t;l.ld be

;>

1

... .-·' ' ; ' \' . ·'

·· 3·. Rai sing the rat~ of exch~nge may provake sim·i ia:r: :.action on the part of diher countries in arder to restore their

-.'.

com:r:eti tive PO.Si tion .at the for!ller rate o.f exchange. Or overseas suppli~rsl'l!aY .raise e.xpoi:t. priees accordingly in arder to obtain the same amount of foreign exchange and purchasing po1-rer as be fore .in the deficit country. E:ither type of action would make the deficit cliffi_{. .. ------} cu.l t

.~-·-·

to eliminate.

V. Acti·on 'to Correct a Deficit or a Surp_lus in the Bal çmce of . Payments

Rate of.Exchange Rat e of Exchange

.

^\

•

/ ^:

^{, ;'\' '-. D}

<- • . <;::

'-'F Foreign Exchange

~i

'; .. } ..

~ .

Foreign Exch.

:---...!.__ _ _ ..._ _________ ·'

Deficit

.... ^:

To correct a Deficit

1~ Increase experts· (may require export subsidies

2) Reduce imports (may require increase in import tarif'fs)

Surplus

To correct a Surplus

1) Reduce experts (may· require export tariffs§ also~ export reduytion may not be good for developing countries if this me·ans a. redu:ct io:n: ·in capital expert s by industJ,>.ial countries)

2') Increase .imports (may require re.~uc~ion in import tariffs)

•

• ...

•

3) Export gold.₉ or nake payments from the proceeds of sale of external as sets and secUl'j_ties and wi th- dral·rals from external resel'ves, or from sale of domestic assets to: foreigû creditors (e.g.reduction

in the -~ri~os ol real astate and

vacation spo·s~, 2.s :m encouragement to foreigners to invest, promote tou:r:.srr.? 9·cc. )

4) Arrarrge -for roceipt of loans and credits (lo~v;s---:c,el'ili) and raise the rate o•f intèrest in OJ.'der to attract --sho~:.--~verrG credit and re'TGi'se thereby the prensurè on -the excha;'lge s.

5) Rai_~ thé ra te of e:xchange

(depreciation or devaluation) if the deficit persists. (To be uaed only as a last resort, especially in vie:-T of possib~e competitive reaction from other countries)~

6) Arrange for receipt of credit outl:>ide the rlormal cha::mels of trade and ~he foreign exchange

mar~œt 9 through "bilateral bart er è.eals₇ p:rovicled this does not prGjudice the market prospects of

· maj9_r ___ c.:,);::ports (T.b.is has the

·---c.dvafrta.ge of makii-lg needed ir1ports availablo and permits experts {l"ithout t.!J.G V01Ul1le of t:::-ade

Ll.iminishing. I t relieves further adverse pressure on the exchanges but does ·nothing to correct the é'.efici t. )

VL Glues on Action to be Avoided

Questions: In the case of a country 1·ri th a Deficit

(i) 1-That 1-rould happen if experts faileè_ to increase or were reduced₉ or export priees or export tariffs ';.rere raised₉ or the domestic priees of export-type goods vlere raised?

3)

IDEP/ET/VII/342 3rd Lecture Pago

7

Import gold₉ acquire foreign assets or securities at home and abroad

4) Arrange for granting long-tarrn external loans and credits, make long-tarrn investment abroad; increase short-term investment abroad by lowering the domestic rate of interest (i.e.,if deficit or debtor countries have not

already raiê!ed theirs)

5) Lower the rate of exchange

(appreciation or revaluation) if the surplus persists. (To be used only as a last resort. May not induce competitive reaction by other countries).

6) Arrange for grant of credit outside the normal charillels of trade and the foreign exohange market, through bilateral barter deals with debtors.

(This has the advantage of making needed experts available to. o:t!ler countriës.without dim:l..nishing_:!;he volume of" trade. It r-educes further stimulus to a favourable exchange rate but does nothing to reduce the surplus).

1 Ques-tions: In the case of a country with a Surplus

( i) ~lhat ··,rould happen if exports 1-rere increa.sed₉ export subsidies imposed or export ta:r.iffs lowered9

or the domestic priees of experts

\•rero lowered?

(ii) What would happen if imports failed to c6ntract o~ were

increased~ or import tariffs lowered?

(lii) What would happen if foreign assets were increasingly p:u:r:!chased?

(iv) What would happen if long- tarrn credit 1·ms not available or monetary weapons were

(v)

(vi)

· inef'fectivc or did not exist, or a mortey ~~rket did not exist tO e~courage the inflow of shot-t-terrrî investmen_t; or if the rate of 'interest was reduced. 'in order to encourage doinesi{ic irivestment?

What would happen if the rate of exc.hange was lowered?

1 . • • •

What wo'LŒd happen. if bila,teral barter deals were arrange_d in a principal primary export with a falling world priee in exchange for imports of capital èquipment~ and the pm'yhaser of the primary expqrt later disposed of it on the '1-rorld market?

IDEP/ET/VII/342 3rd Lecture Page

8

•

(ii) What would happen if imports were reduced or import tariffs raised? ·

(iii)What would ha~pen if foreign .assets were increasingly disposed

of? · · ·

(iv) What would happen if foreign capital inflow was encouraged to finance further expansion of the domBstic economy,or the rate of intèrest was' raisErl to encourage an

inflo~ of short~t~rm cap~tal or to reduce the rate of domestic .

investment in the economy?

(v) What would happen if the rate of exchange was raised?

(vi) What would happen if bilateral

· barter deals in export commodi ties

were arranged ~nd the purcnaser later sold a huge volume of these commodities on the world market?

•

•

VII. Risks of Contrary Action. by Other Countries which· ~may .null.if..y, the efforts of a·Country to Correct a Disequilibrium in. its Balance of Payments

In,the ca~e of a Country with a Defi.ci t.

(i) If an incre~se ih exports is subsidized other couutries may raise import tariffs or encourage matching subsidies

(ii)If a reduction in imports was e:ocouraged other countrie.s may reduce th~ir imports from the deficit country by raising

im~ort tariffs.

(i)

In the case of a Country with a Surplus

If a reduction in exports was introduced other countries may find it hard to sell if they cannot obtain particularly needed exports from the surplus country.

(ii) If an increase in imports vras encouraged producers of domestic s_ubsti tu tes m_ight clamour for and obtain increased tariff protection

•

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• IDEP/ET/VtH/342

3rd Lecture Page 9

(iii) If the rate of interest was raised to attr~ct short-term capital other countries may also raise the~r -~atea, if an

(iii) If the rate of interest was lowered ta discourage. sl:).qrt tenn investment tther countrims may lower their rates at the same time or may not find long-term attempt 1'Té1S made to raise long-

tarrn loans othel' cciuntries may ref:use to grant such loans

loans attractive if the rate of

. interest req_uired on loans 1.,ras

... tao high.

(iv) If the r&te of exchange wa.s raised ot~er countries may raise. theirs competiti~ely

or raise import tariffs.

(iv) If the rate of exchnnge was lowered other countries may lo1-i"er theirs mrrespondingly or raise export priees· through tariffs.

(v)

,.

'

Tf bilateral barter·deals were arranged in a primary export purchasers may dispose of it

in~the world market and lower its priee

(v) If bilateral barter deals were arranged pu.r.chasers 'may dj_spose of the commodities in third countries and encourage a further flow of experts

VIII. Implications of Diseq_uilibrium in the Balance of Payments for a De~elopjng Country7 especially one with a Deficit (a developing country with a continuing balance of payments surplus is an economie freak and is not likely to be achieving much development).

:Many C:.eveloping cotmtl·ies get into balance of payments deficits which Jeopa:cdize ·che execution of their development plans.

If they try to inorease their official rate of exchange this may not correct the deficit the first time i f i t is no-e raisedsufficiently.

But tf:te~ they, cannat rai se . it again for a long time as this might

:-~ !

shake confidence in their currency. Renee changüag the exchange rate is a measure of last resort and not an.instrument for day-ta-day use. If they e.re mainly expor-•;ers of raw materia.ls · 1fi th limi tècl demand elasticity and fluctuating prices₁ an attempt ta inorsa~a

experts IIBrely makes p;a,tters worse and prot:.r-ac tsthe de:f.ici t, unless they can . re duce the ir costs sufficientl;y •

If they de:pend to a large extent on capital and ether

imports to execute their development programmes they me.y find it hard to reduce imports, but they may still find it possible to out out

~. -··· ^. IDEP/ET/VII/342 3rd Lecture Page 10

in.essential imports ~ especially luxuries and c,ommodi ti es for which domestic production could be conveniently substituted.

They may then have to fall back on reduction of overseas as sets~ securit.ies and reserves to pay off the deficit - which re duces their long-term dè~elopment prospects. If they try to raise loans 'io support their falling currenëies or prosecute their investment

·programmés they face dii'ficulties in acquiring long-tarrn credit on _{. . . . .}

.

^.

the world market~ lenders may lack confidence in them and refuse to

lend~ debt servicing costs may impose further burdens on them. They may also lack proper or effective monetary toola ~ or a cap~tal ~arket

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 tho IMF riwre ready to support a falling pound than Ghana would find these same countries and institutions ready to support the Ghanaian pound. Thus the IMF would be more ready to senâ an

investigating mission to Ghana or Brazil than it would to Great Britain France or any other Western country.

Developing counbries with balance of payments deficits would therefora 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 within the economy₁ such as inflation which attracts imports at a given official rate of exchange. Renee? before adopting the corrective measures for a deficit developing (as well as other)

countries should first examine the internal structure of their economies. Otherwise corrective· mea~sures applied only to reduction of the deficit may fail. A wa,.7e-cost-price inflation~ a handicapped export sector facing bottleP oék.s·in obtaining labour or resources may first have to

~.

•

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IDEP/Er/VII/342 3rd Lecture Page 11

be dealt with through monetary and physical controls before corrective measures applicable to reducing the deficit may have a chance to work.

An example of the way in which inflation can prevent the effectiveness of remedial mèasures to reduce a deficit is the tendency it sometimes has of making the domestic market more attractive than world markets and thereby of promoting the diversion of experts to the domestic markets instead of abroad. This was the prob1ern''faoed by Great :Bri tain after the Second World War under the "cheap money" policy of the Labour Government. In .consequence the deficit in that COQ~try's balance of payments

at the time ooulcl not easily be reduced. Cars₁ whisky and woollen goods which should have been exported to reduce the deficit were divertecl to the domestic market.

Sorne developing countries in the throes of a balance of payments defici.t and lacking effective means of correcting this or unable to arrange credit through ncrmal channels ₁ resort

to bilateral barter deals in order to obtain the equj_pment required for their development programmes. These arrangements lie outside the scope of normal transactions and the market for foreign exahange. Ho\,rever₁ they do nothing to reduce the deficit and may actually worsen it unless~

(a) in the case of primary commodities, none of these are sold in third countries at reduced priees - other>üse the worldprice and export earnings may decline and make the developing country unable to increase export of the commodities involved;

(b) a check is made on the internationl priees of the goods as vrelL The danger here is that the deficit country

IDEP/ET/VII/342 3rd Lecture Page 12

may oe offered a priee for its exports apparently much above the wo.rld.price and.in return sold imported~goods

at an even much higher priee above what they would normally fetch on the world market. Thus, in addition to tb.e existing deficit a concealed "barter deficit"

is imposed which merely compo.unds the difficulties of the.country.

-r:J;he.lesson here for developing countriea is that they_should pay c~oser attention to the internal structure of their. e6onomies and ensure that ~onetàr~

•

fiscal and other con~rols are first used to put their

econ~!Jl;ies ontb,e right path ,bE;fore they can hope to cope

successfully -vri th diseq_uilibrium in the ir balance of payments.