The foreign exchange market and balance of payments Economics Grade 12 Notes and Study Guide

The foreign exchange market and balance of payments Economics Grade 12 Notes and Study Guide. The foreign exchange market (currency market) is an exchange market which determines the relative values of different currencies, and enables the conversion of currency to facilitate international trade.

The balance of payments (BoP) accounts record all financial transactions between a country and the rest of the world over a period of a year. They include export and import transactions, financial transfers and financial capital transactions. Read The Foreign Exchange Market and the Balance of Payment Accounts Economics Grade 12 Questions and Answers

THE FOREIGN EXCHANGE MARKET AND THE BALANCE OF PAYMENT ACCOUNTS GRADE 12 NOTES – ECONOMICS STUDY GUIDES

Overview

4.1 Key concepts

These definitions will help you understand the meaning of key Economics concepts that are used in this study guide. Understand these concepts well.

Make mobile notes to learn these terms and definitions. Instructions on how to make mobile notes are on page xiv in the introduction.

4.2 The reasons for international trade

There are many reasons for international trade. Countries may have a surplus of some goods and a shortage of other goods, and they will trade in order to correct these imbalances. For example, South Africa has more minerals than it can use, but less oil than it needs. Certain goods are only produced in specific countries (e.g. French champagne) and the citizens of other countries may desire access to those goods. Droughts can severely damage the production of staple crops in a country resulting in the need to import crops to feed the population.
4.2.1 Demand reasons

• The size of the population impacts demand. If there is an increase in population growth, it causes an increase in demand, as more people’s needs must be satisfied. Local suppliers may not be able to satisfy this demand.
• The population’s income levels effect demand. Changes in income cause a change in the demand for goods and services. An increase in the per capita income of people results in more disposable income that can be spent on local goods and services, some of which may then have to be imported.
• An increase in the wealth of the population leads to greater demand for goods. People have access to loans and can spend more on luxury goods, many of which are produced in other countries.
• Preferences and tastes can play a part in the determining of prices, e.g. customers in Australia have a preference for a specific product which they do not produce and need to import, and it will have a higher value than in other countries.
• The difference in consumption patterns is determined by the level of economic development in the country, e.g. a poorly developed country will have a high demand for basic goods and services but a lower demand for luxury goods.

Learn these five demand reasons for international trade.
Use the following word mnemonic to help you remember the 5 demand reasons:
P = Population → People
I = Income → In
W = Wealth → Witbank
P = Preferences → Prefer
C = Consumption → Coffee
4.2.2 Supply reasons

• Natural resources are not evenly distributed across all countries of the world. They vary from country to country and can only be exploited in places where these resources exist.
• Climatic conditions make it possible for some countries to produce certain goods at a lower price than other countries, e.g. Brazil is the biggest producer of coffee.
• Labour resources differ in quality, quantity and cost between countries. Some countries have highly skilled, well-paid workers with high productivity levels, e.g. Switzerland.
• Technological resources are available in some countries that enable them to produce certain goods and services at a low unit cost, e.g. Japan.
• Specialisation in the production of certain goods and services allows some countries to produce them at a lower cost than others, e.g. Japan produces electronic goods and sells these at a lower price.
• Capital allows developed countries to enjoy an advantage over underdeveloped countries. Due to a lack of capital, some countries cannot produce all the goods they require themselves.

Learn these six supply reasons for international trade.
Use this word mnemonic to help you remember the 6 supply reasons:
R = Resources → Rich
C = Climate → Countries
L = Labour → Like
T = Technology → To
S = Specialisation → Send
C = Capital → Chocolate
4.2.3 The effects of international trade

• Specialisation increases the standard of living, especially when the area of specialisation is in great demand due to a shortage of supply, e.g. Angola has oil so it can specialise in oil products. Mozambique has no oil resources and cannot specialise in these resources.
• Mass production becomes possible if the domestic demand is added to foreign demand, e.g. manufacturing of cell phones.
• Efficiency increases when there is competition. Lower prices means that the same income can buy more goods and services.
• Globalisation is driven by international trade, e.g. trade in IT products and vehicles (cars and trucks).

Learn these four effects of international trade.
Use this word mnemonic to help you remember the 4 effects of international trade:
S = Specialisation → Selling
P = Production → Products
E = Efficiency → Equals
G = Globalisation → Growth

4.3 The balance of payments accounts

4.3.1 Definition
A systematic record of all transactions between one country and other countries, e.g. between South Africa and all other countries in the world.
4.3.2 The value of the balance of payments
Each country keeps a record of all its international transactions with the rest of the world. A country is said to have a BoP surplus when inflows are greater than outflows. An example of a BoP surplus on the current account would be when exports are greater than imports. A BoP deficit occurs when outflows are greater than inflows (imports are greater than exports).
4.3.3 Composition
The current account
The current account is the account in the BoP that records international transactions relating to production, income and expenditure. In calculating the balance on the current account, 5 groups of items are taken into account. They are merchandise (goods), gold, services, income and current transfers.
The capital transfer account
The balance shown reflects the net amount of the capital transfer, either negative or positive. The balance is a net amount and includes firstly transactions and grants relating to the ownership of fixed assets, for example a grant by a foreign NGO for a housing project in South Africa, secondly, debt forgiveness, thirdly, the value of households and personal effects, and financial claims and liabilities of migrants.
The financial account
The financial account shows records of investments by South Africans in other countries and by foreigners in South Africa.
These investments will include:

• Direct investments:
  Foreign direct investment (FDI) refers to investment in real estate (fixed property) and obtaining a meaningful share (10%+) or control of such business.
  E.g. USA Walmart’s takeover of the local chain Massmart was a foreign direct investment of US$2.2 billion.
• Portfolio investments:
  Refers to the buying of financial assets such as shares in companies on the stock exchange of another country. These investments are highly liquid and their flows can be reversed at any time. Portfolio investment money is also known as ‘hot money’.
• Other investments:
  Other investments are a residual category. Transactions that cannot be classified as direct investments, portfolio investments or reserve assets and liabilities are classified as other investments.
  Refers to other financial transactions not covered by FDI. Short term investment that flows in and out of a country, trade credits and short term loans.

The reserve account
The reserve account records changes to the amount of gold and foreign exchange reserves (Dollars, Pounds, Euros) held by the country. These changes are a reflection of the international transactions recorded in all the other accounts on the BoP.
South Africa’s total gold and foreign exchange reserves are a stock item and are not shown in the reserve account. Only the changes to the gold and foreign reserves are shown.
Table 4.1 shows the latest available balance of payments from the Quarterly Bulletin from the South African Reserve Bank. You should be able to make certain assumptions from the data given, for example:

• Determine whether there was a surplus or deficit in one of the accounts.
• Identify possible reasons for funds flowing out of or into the country.

4.4 Foreign exchange markets

A foreign exchange rate is the price of one country’s currency in terms of another. It is expressed (quoted) as the domestic price of one unit of a foreign currency, for example, $1=R10.00.
In South Africa, the forex market is known as the interbank foreign exchange market. It does not have a physical location or corporate form, such as the Johannesburg Stock Exchange (JSE). It is a worldwide practice, transactions are done electronically by computers, in writing by e-mail, fax or letter or by phone.
4.4.1 Definition: Foreign exchange markets
A foreign exchange market is a market engaged in the buying and selling of foreign exchange. The leading markets are in London, New York and Tokyo.
4.4.2 Supply and demand

Figure 4.1: The interaction of demand and supply in establishing the rate of exchange
A demand for dollars exists when, for example, South African importers wish to exchange rands for dollars to pay for goods/services to be imported from the United States of America. On the other hand, the holders of dollars seek to exchange dollars for rands when, for example, the American importer wants to pay for goods/services to be imported from South Africa.There might be an excess supply or excess demand for dollars when the price rises above or falls below the market price of QP (see Figure 4.1).

Table 4.2 Factors that will influence demand and supply of foreign exchange
4.4.3 Appreciation and depreciation
Appreciation of a country’s currency is an increase in the price of the currency in terms of another currency due to market forces. For example when the dollar goes from $1 = R9 to $1 = R10, then the dollar has appreciated.
Depreciation of a currency is a decrease in the price of the currency in terms of another country’s currency due to market forces. For example if the dollar goes from $1 = R9 to $1 = R8, then the dollar has depreciated against the rand.
4.4.4 Revaluation and devaluation
Revaluation of a currency refers to the deliberate increase in the value of the currency in terms of another currency. (As a result of central bank intervention.) This occurs under a fixed exchange system. Devaluation of a currency refers to the deliberate decrease in the value of the currency in terms of another currency. (As a result of central bank intervention).
4.4.5 Intervention in the market
A symbiotic (mutually dependent) relationship exists between the exchange rate of a country and its balance of payments. This relationship invites continuous attention from the central bank. Central banks often intervene when the currency is either overvalued or undervalued.
Overvalued: When a country’s currency is valued too high, for example, the South African rand is R7 rather than R8 for a US dollar. This can lead to continuous deficits on the current account of the balance of payments.
Undervalued: When a country’s currency is not valued high enough, for example, the South African rand is R9 rather than R8 to a US dollar. Such undervaluation can be demonstrated by continuous surpluses on the current account of the balance of payments.
Two methods of intervention are traditionally used:
Direct intervention: The Central bank buys foreign exchange when the currency is overvalued, and sells foreign exchange when the currency is undervalued.
Indirect intervention: The most important instrument used by the central bank for indirect intervention is interest rate changes. When a currency is overvalued an increase in interest rates invites an inflow of investments. A surplus is created on the financial account that balances out the deficit on the current account. When the currency is undervalued interest rates can be decreased to cause an outflow of foreign currency and drain excess liquidity from the economy and release inflation pressure. The surplus on the current account will then decrease.

4.5 Establishment of foreign exchange rates

4.5.1 Exchange rate systems
Every country manages the value of its currency by determining the exchange rate system that will apply to its currency. There are numerous exchange rate systems. Among these are:
Free floating exchange rates
The value of the currency is determined purely by the forces of the market, i.e. demand for rand and supply of rand.
Managed exchange rates
These are exchange rates which are allowed to respond to market forces within certain limits.
Fixed exchange rates
Currencies are devaluated and revaluated. The gold standard backed the value of the currency to a certain amount of gold. South Africa stepped off the gold standard in 1932.
4.5.2 Terms of trade

• The terms of trade compare a country’s export prices with its import prices by means of indexes. The formula is:
  Index of export prices/Index of import prices × 100

  Item	2008	2009	2010	2011	2012	2013
  Index	105,3	113,7	122,0	124,7	123	121.4
  % Change	0,0	8,0	7,3	2,2	–1,7	–1,6

  Table 4.3 South Africa’s terms of trade (excluding gold) (SARB QB)

• South Africa’s terms of trade index increased at high rates in 2009 and 2010. If the numerical value indexes increase, it is said that the terms of trade have improved. If the numerical value decreases, it is said that the terms of trade have deteriorated.
• An improvement in the terms of trade may be the result of the following:
  • An increase in export prices
  • A decrease in import prices
• A deterioration in the terms of trade may be the result of the following:
  • A decrease in export prices
  • An increase in import prices

4.5.3 Free trade and protection

• Free trade – Happens when producers and consumers are free to buy goods and services anywhere in the world without interference from a government.
• Protection – Limits the extent of trade between countries. For example limiting imports.

4.5.4 South Africa’s foreign trade

• South Africa has a relatively open economy. Foreign trade is approximately 30% of the GDP, which means that the economy at large is sensitive to changes in the terms of trade.
• The composition of our exports and imports in Table 4.4 shows that mining and manufacturing will be more sensitive in terms of trade than, for instance agriculture.
  

  Trade	Agriculture	Manufacturing	Mining
  Exports	4,02%	50,29%	45,69%
  Imports	1,54%	82,53%	15,92%

  Table 4.4 Composition of South Africa’s’ foreign trade (2010) (SAIRR SAS)

• Table 4.5 shows that South Africa’s trade is almost equally divided between countries of the East and West or countries from the North and South.
  

  	Africa	Europe	NAFTA	Asia	Other
  Imports %	7,9	33,9	8,5	44,2	6,5
  Exports %	14,7	27,4	9,7	45,3	2,9
  Total R billion	130,8	352,7	104,6	448,4	113,7

  Table 4.5 South Africa’s trade with the world (2010) (SAIRR SAS)

4.6. Corrections of the balance of payments

Balance of payments disequilibria exist when the outflow of foreign currency continuously exceeds or is less than the inflow of foreign currency. You will remember that a deficit on the balance of payments implies that the outflow of foreign currency exceeds the inflow of foreign currency while a surplus exists when the outflow is less than the inflow.
A way to correct balance of payments disequilibrium lies in earning more foreign exchange through more exports and reducing imports.
The following are methods that can be used to correct the deficit or surpluses on the balance of payments.
4.6.1 Lending and Borrowing
Countries with surpluses often lend money to countries with deficits.
Countries with deficits often borrow. This is why some developing countries have so much foreign debt.
In the event of a fundamental disequilibrium, member countries may borrow from the International Monetary Fund (IMF).
Borrowing is nevertheless not a long-term solution for fundamental balance of payments disequilibrium.
4.6.2 Change in exchange rate
Currency depreciation or devaluation makes imports more expensive for domestic consumers and exports cheaper for foreign buyers. For example, when the rand depreciates, South African goods (exports) become cheaper for foreign buyers. Imports become more expensive for South Africans.
4.6.3 Change in demand
The following four instruments are used in various countries to restore the equilibrium:
Long-term policies – Export promotion, such as government incentives, is applied to encourage the production of goods that can be exported. For example, European countries pay subsidies to farmers. Import substitution, for example, government incentives to produce goods domestically rather than to import them. The South African government favours export promotion.
Interest rates – Domestic demand can be changed by changing interest rates. If interest rates are increased spending, including on imports, decreases. Foreign traders will try to take advantage by increasing their investment in the country with the higher interest rate. The opposite happens when interest rates are decreased.
Import control – They include import tariffs, other duties and quotas. The WTO is trying to phase them out for the sake of trade liberalisation.
Exchange control – There are domestic regulations that allow central banks to ration foreign exchange. Earners of foreign exchange are compelled by law to hand it over to the central bank. Those who require foreign exchange have to apply to the central bank.
Activity 1
Study Figure 4.2 concerning international trade and answer the questions that follow.
Figure 4.2 International trade

1. What does graph 1 depict? Supply a reason for your answer. (2)
2. Define the term balance of trade. (3)
3. Does the balance of trade in 2008 indicate a positive or a negative balance? (2)
4. Estimate the balance of trade for 2008. (4)
5. What effect did the closing of textile factories in South Africa have on the balance of trade? (3)
6. Which economic trend in 2009 contributed to the decline in imports and exports? (2)
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Activity 2
Study Table 4.2 which shows the balance of payments extract and answer the questions that follow:

Table 4.2 Balance of payments for 2009–2011

1. Define the concept balance of payments. (2)
2. Calculate the missing figures in A and B. (4)
3. What does ‘net figures’ indicate in the financial account? (2)
4. Give TWO examples of income receipts earned by South African residents. (4)
5. Briefly explain how balance of payments disequilibria can be corrected. (6)
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