Page 14 - FINAL CFA II SLIDES JUNE 2019 DAY 4

LOS 11.j: Explain how flows in the balance of payment
accounts affect currency exchange rates. READING 11: CURRENCY EXCHANGE RATES: UNDERSTANDING EQUILIBRIUM VALUE

BALANCE OF PAYMENTS MODULE 11.3: EXCHANGE RATE DETERMINANTS, CARRY TRADE, AND
CENTRAL BANK INFLUENCE

INFLUENCE OF BOP ON EXCHANGE RATES

Current Account Deficits (CAD) lead to depreciation of domestic currency via 3 mechanisms:

Flow supply/demand: increases the supply of domestic currency in the markets (exporters
convert their revenues into their own local currency). This may restore the deficit to a
balance—depending on:
• The initial deficit: The larger, the larger the depreciation needed;
• The influence of exchange rates on domestic import & export prices: the cost of imports
increases (not all can be passed to consumers, though)
• Price elasticity of demand of the traded goods (if imports are relatively price inelastic,
the quantity imported will not change).

Portfolio balance mechanism: CAS usually lead to Capital Account Deficits (CADs),
which typically take the form of investments in countries with CADs. Due to these
capital flows, investor countries find their portfolios’ composition being dominated by
few investee currencies. When investor countries decide to rebalance their investment
portfolios, it could significantly depreciate investee country currencies.
Debt sustainability mechanism. A country running a current account deficit may be
When a country experiences a current account deficit, it must running a capital account surplus by borrowing from abroad. When the level of debt
generate a surplus in its capital account (or see its currency gets too high relative to GDP, investors may question the sustainability of this level of
depreciate). debt, leading to a rapid depreciation of the borrower’s currency.

Capital flows tend to be the dominant factor influencing exchange rates in the short term, as they are larger and change more rapidly!

Capital inflows (to capture differences real rates of return), lead domestic currency appreciation. These help to overcome a shortage of
domestic savings to fund investments and economic growth. Excess of this for emerging markets though causes problems:
1) Excessive real currency appreciation;
2) Financial asset and/or real estate bubbles;
3) Increases in external debt by businesses or government;
4) Excessive consumption in the domestic market fueled by credit;
5) Emerging market governments often counteract this by imposing capital controls or by direct
intervention in the foreign exchange markets.