Balance of payments and exchange rates: a discussion of the links

Summary:

– A previous article showed why a current account deficit in the balance of payments puts pressure on a country’s currency to depreciate.

– A counterargument could be that the resulting financial surplus creates pressure for the appreciation of that country’s currency

– This article shows that this is not the case and that this counterargument is not valid.

– The confusion behind this argument is analyzed

– The article also shows that an increase in capital flows to a country does not automatically translate into a financial account surplus, while at the same time putting upward pressure on the appreciation of a country’s currency.

NB: The author would like to thank V.L. and J.A. of BSi Economics for their useful feedback on this article.

The argument (put forward by some in relation to a previous article) is as follows: a current account deficit necessarily requires one of the other items in the balance of payments to be in surplus, as the balance of payments is by definition balanced. In this case, one naturally thinks of a surplus in the financial account. The intuition is as follows: if citizens spend more on the rest of the world (through imports, for example) than they earn from the rest of the world (through exports, for example), then they must necessarily be borrowing from the rest of the world: you cannot spend more than you have without borrowing. The net balance of borrowing from the rest of the world appears in the financial account of the balance of payments, and will therefore be in surplus in this case. However, when a country has more capital inflows (allowing us to borrow from the rest of the world) than capital outflows, it would seem that the currency appreciates. Thus, a financial account surplus would offset the depreciation caused by a current account deficit. This reasoning seems logical, but it actually contains a conceptual error, which is to think that capital inflows in themselves create a surplus in the financial account of the balance of payments.

How a current account deficit translates into a financial account surplus

Let’s start at the beginning, i.e., by looking at how a current account deficit translates into a surplus in the financial account of the balance of payments, using the example of the US balance of payments.

Let’s take a simple and general example of an American company that imports €90 (say $100) worth of European products. The entry in the US balance of payments will be as follows:

Purchase of euros [1] (« sale » of dollars and purchase of euros)

Purchase of the product (import and « sale » of euros in exchange):

Ultimately, the current account is in deficit and the financial account is in surplus. If we consider not just one individual but all the residents of a country, we can see that the direct counterpart to a current account deficit is naturally a financial account surplus [2]. Furthermore, the purchase of euros in this case will contribute to upward pressure on the euro and depreciation of the dollar, as explained in our previous post.

Why an influx of capital does not automatically translate into a surplus in the financial account

Let’s take the example of capital flows in the simple form of European citizens investing in US debt securities [3], and continue to focus on the US balance of payments. Before acquiring dollar-denominated securities, non-residents (in this case, Europeans) must first acquire dollars in exchange for euros [4]. The entry associated with this transaction is as follows: in the « other investments » sub-account of the financial account, the « Bank deposits » liability item will be debited to reflect the increase in euro holdings (there is an « import » of euros), and the « Bank deposits » asset item will be credited to reflect the increase in dollar holdings. – Bank deposits » item will be debited to reflect the increase in euro holdings (there is an « import » of euros), and the « Assets – Bank deposits » item will be credited to reflect the acquisition of dollars by non-residents (as if the Americans had exported their currency and imported foreign currency):

Step 1: Purchases of euros (« sale » of dollars and purchase of euros)

The financial account will therefore remain unchanged after this first step.Furthermore, since Europeans will have demanded more dollars in exchange for euros, this will create upward pressure on the dollar.

Once the dollars have been acquired, it will be possible to purchase US securities, and these purchases will give rise to the following entry: the « Assets – Bank deposits » account will be debited (sale of dollars) and the « Debt securities » account (in the well-known « Portfolio investments » category) will be credited.

Step 2: Purchase of the security (export of an « IOU » (debt security) and « sale » of dollars in exchange):

Ultimately, capital flows will create a surplus in the « Portfolio investments » sub-account and a deficit in the « Other investments » sub-account: the financial account of the balance of payments will remain unchanged [5]. This example clearly shows that « basic » capital flows, although they will put pressure on the exchange rate (since dollars are in greater demand in our example here), will not result in a surplus in the financial account.

Conclusion:

We can therefore clearly see that:

– a current account deficit does put pressure on the exchange rate to depreciate [6].

– the mechanism is not automatically counterbalanced by any other effect that would automatically follow.

This article also clearly shows that the current account is not the only factor exerting pressure on the exchange rate. Significant financial flows into a country will often not be directly visible in the form of a financial account surplus, but will potentially have a significant impact on the exchange rate (since they imply, by definition, stronger demand for foreign currency). Sub-account indicators of the financial account can help predict pressure on the exchange rate, which is why some economists focus on such items or on gross flows (Blanchard et al. (2015)) to assess short-term exchange rate developments.

Interesting documents for further reading:

Blanchard, Adler, and Carvalho Filho (2015) Can Foreign Exchange Intervention Stem Exchange Rate Pressures from Global Capital Flow Shocks?

IMF, Balance of Payments Manual (page 108) https://www.imf.org/external/pubs/ft/bopman/bopman.pdf