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Summary ECS3703- International finance study notes
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- University Of South Africa (Unisa)
ECS3703- International finance study notes
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International Finance, STUDY UNIT 1
Items of the South African Balance of Payments:
Current account
Merchandise exports
Net gold exports
Service receipts
Income receipts
Merchandise imports
Payments for services
Income payments
Current transfers
Balance on current account
Capital transfer account
Financial account
Direct investment
Portfolio investment
Other investment
Balance on financial account
Unrecorded transactions
Change in net gold and other foreign reserves owing to balance of payments transactions
Change in liabilities related to reserves
SDR allocations and valuation adjustments
Net monetisation/demonetisation of gold
Change in gross gold and other foreign reserves
Memo item: change in capital transfer and financial accounts including unrecorded transactions
The balance of payments
What is the balance of payments?
The BOP is an accounting summary of various transactions that have taken place between a country and its
trading partners over a year. The balance of payments is different from a national balance sheet. A national
balance sheet is a statement of a country’s assets and liabilities.
The South African balance of payments
1. The Current Account
Subdivided into, trade account, net service receipts, net income receipts and current transfers.
Trade account-trade in physical goods. Trade balance not shown explicitly. Is calculated by subtracting
merchandise imports from merchandise exports plus net gold exports. (X+NX- I)
Large deficit on SA’s current account due to large merchandise imports. This means that SA
borrows in order to spend. (credit)
Service items – are transport of goods and passengers between countries
Income items are interest, dividends and foreign branch profits.
Current transfers – foreign payments and receipts of government social security payments and taxes,
private transfers of income (gifts, donations).
,2. The Financial Account
Records exchanges of international asset
Subdivided into: direct investment, portfolio investment and other investment
Direct investment foreign investment in South Africa and investments abroad by South Africans.
Portfolio investment is the purchase and sale of financial instruments such as bonds, treasury bills and
equities.
Other investment includes all financial transactions not part of direct or portfolio investment. Main
item is trade credit.
Direct investment is considered more desirable than portfolio investment because it shows stronger
commitment to invest. It is more stable and has lasting positive effects on the domestic economy. Portfolio
investment on the other hand is characterised by speculative “hot money” flows which may prove disruptive
and difficult for monetary authorities to control. Direct investment may also bring with it much needed scarce
skills and technology.
3. Unrecorded transactions
Arises from the use of a double entry accounting system to reconcile the balance of payments.
Serves as a residual that ensures that the balance of payment accounts always balance.
4. The official reserves
Records changes in the official gold and foreign exchange reserves. Changes in gold and foreign exchange
reserves are also referred to as the below the line or 'accommodating' foreign exchange flows.
Transactions not related to changes in official reserves are called autonomous or above the line flows.
Any imbalance in these flows is accommodated by the required change in official reserves.
The Significance of Imbalances in the Balance of Payments
The BOP always balances but it does not mean there can never be any problems. Gold and foreign exchange
reserves are not inexhaustible. Autonomous flows can be accommodated temporarily by below the line flows or
foreign credit. Long before the reserves are exhausted, monetary and fiscal policy will be necessary to prevent
full blown balance of payments crises. The right measures will depend on whether the country concerned has a
fixed or floating exchange system.
Imbalances above the line may be significant even if they don't require any change in official reserves. E.g.
foreign exchange outflows corresponding to a current account deficit may be more or less balanced by inflows
corresponding to a financial account surplus, that is, non residents may be willing to finance the deficits.
However such borrowings must be repaid with interest. This borrowing from foreign lender cannot go on
forever. Lenders may no longer be willing to finance further deficits. This will require tough monetary and
other policies.
Large current account surpluses are not without their own problems. Under flexible exchange rate system large
current account surpluses may lead to a sharp appreciation of the currency thereby reducing foreign demand for
exports and increasing domestic demand for imports in the short run. This may lead to reduced aggregate
demand, production and employment in the short run.
A current account deficit is not necessarily bad and a surplus good. A current account deficit implies that a
country is consuming more than it is producing. Imports add to consumer welfare. Exports represent a sacrifice
in the production of goods and services that are not available for domestic consumption.
Changes in the foreign reserves reflect changes in the domestic money supply. A decrease in the reserves means
that people are exchanging domestic currency for foreign currency and therefore a decrease in the domestic
money supply.
Conversely an increase in the domestic supply implies that people are exchanging foreign currency into
domestic currency and thus increasing the domestic money supply.
, STUDY UNIT 2
Foreign exchange markets and exchange rates
Foreign exchange markets are markets where individuals, firms, and banks buy and sell foreign currencies.
Functions of the foreign exchange markets
Transfer of purchasing power from one currency to another.
Banks with excess supply of foreign exchange sell their excess foreign exchange to other banks with shortage.
If a country’s total demand for foreign exchange exceeds total foreign exchange earnings, the exchange rate
changes to equilibrate total demand and total supply. If adjustment in the exchange rate is not allowed, banks
must borrow from the country’s central bank.
On the other hand, an excess supply of foreign exchange with no adjustment must be exchanged for national
currency at the central bank. This increases the foreign exchange reserves held by the central bank.
The central bank acts as the seller and buyer of last resort when the nation’s foreign exchange earnings and
expenditures are not equal. It either decreases its foreign exchange reserves or adds to them
Credit function
Credit is needed when goods are sold and allows the buyer time to resell the goods and make payment.
The foreign exchange market also provides credit for foreign trade. Like all the traders, international trade also
requires credit. It takes time to move the goods from seller to purchaser and during this period, the transaction
must be financed. When the exporter does not need credit for the manufacture of export goods, credit is
necessary for the transit of goods. When the special credit facilities of the foreign exchange market are used,
the foreign exchange department of a bank or the bill market is used; the foreign exchange department of the
bank or the bill market of one country or the other extends the credit facilities to finance the foreign trade.
Providing facilities for hedging and speculation
The foreign exchange market by providing facilities of buying and selling at spot or forward exchange, enables
the exporters and importers to hedge their exchange risks arising from change in the foreign exchange rate. The
forward market in exchange also enables those banks, which are unlikely to run any considerable exchange
position to cover their commitments.
Foreign exchange rates
The exchange rate is defined as the domestic price of a foreign currency. Under flexible exchange rates the
equilibrium exchange rate is determined by the intersection of the demand and supply curve for the foreign
currency.
Fig 14.1 Equilibrium foreign exchange rates
R Vertical axis measures the dollar price of the
S€ euro. Horizontal axis measures the quantity of
euros. Demand and supply curves intersect at
point E defining a new equilibrium exchange
rate R=$10 at which the demand and supply are
equal at 2 million euros per day. A higher
E exchange rate leads to an increase in supply that
10 exceeds demand. This results in a lower
exchange rate. A lower exchange rate leads to
an increase in demand that exceeds supply. This
will cause the exchange rate to rise up towards
5 the equilibrium level. If the domestic price of
D€ foreign currency rises then, it implies
0 € depreciation. If the domestic price falls then it
implies appreciation.
Various exchange rates
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