Exchange Rates and Balance of Payments

Exchange rates:
 Price at which currencies are exchanged
 Indirect: how much foreign for one unit local ($/R1)
 Direct: how much local for one foreign unit (R/$1)
 Direct: fall/strengthening in direct exchange rate = rand appreciates; rise/weakening =
rand depreciation
 Indirect: vice versa

Demand in the foreign exchange market:

 Determinants: exchange rate; world demand for SA exports; interest rates vs. other
countries; expected future exchange rate
 Law of demand: higher the exchange rate, smaller the demanded quantity
 Exports effect: weaker/lower rate makes prices lower and more rand is demanded to
purchase goods
 Expected profit effect - the weaker the rand is today, more potential profit is available in
future and rand demand increases

Supply in the forex market:

 Determinants: exchange rate; SA imports demand; interest rate vs. other countries;
expected future exchange rate
 Law of supply: stronger the exchange rate, greater the amount of Rands supplied
 Imports effect: stronger exchange rate means foreign goods are cheaper & South
Africans supply more Rands to the market
 Expected profit effect - rand strong  less potential future profit more Rands sold
Changes in the demand for Rands:
 World demand for SA exports increases
 Interest rate differential increases
 Expected future exchange rate increases

Changes in supply of the Rand:

 Demand for imports increases
 Interest rate differential decreases
 Expected future exchange rate weakens

Exchange rate expectation drivers:

 Interest rate parity: prime int. in USA is 3% vs. SA 8%; rand is always expected to
depreciate against dollar
 Purchasing power parity: how much can money buy us; if PPP holds, goods cost the
same globally; rand depreciates to even out price changes by PPP
Nominal vs. Real Exchange Rates:
 Nominal: price of one currency in terms of another
 Real: local price relative to foreign
 RER = real exchange rate; E = nominal exchange rate; PSA = SA prices; PF = Foreign prices
 RER = E(PSA/PF)
 Effective exchange rate: weighted average exchange rate for major trading partners

Flexible exchange rates:

 Determined by demand & supply
 No direct central bank interventions in forex markets
 Indirectly influenced by central bank: SARB increases int. rates, other countries R
remains unchanged; demand for ZAR increases; supply of ZAR decreases; exchange rate
strengthens (appreciates)
 Change in int. rates not usual to influence forex markets
 Countries with flexible: EU; USA; RSA; UK
 Advantages: automatic correction; no international liquidity & reserves problems;
insulation from external economic shock; governments free to choose domestic policy
 Disadvantages: speculation; uncertainty for traders/investors; lack of domestic discipline

Fixed exchange rates:

 Determined by govt. or central bank: active CB intervention; CB promises to keep
nominal at a specified level
 Active intervention required to achieve fixed exchange rate: requires lots of foreign
reserves
 If SARB wanted to fix the rand they would need to buy ZAR & sell forex
 No limit on ZAR quantity SARB can sell
 Limit on quantity SARB can buy (foreign currency holdings)
 Advantages: certainty; minimal speculation; auto correction of monetary errors;
prevents irresponsible macroeconomics policies
 Disadvantages: balance of payments deficits can lead to recession; competitive
deflations lead toward world depression; problems of international liquidity; may make
monetary policy ineffective

Crawling peg:
 Path determined by govt. or CB: active CB intervention; like fixed except target value
changes
 Usually adjusts for inflation differential between domestic & pegged to not lose
competitiveness
Balance of payments:
 Always adds to zero: sum current, capital transfer, financial (incl. reserve assets) &
unrecorded transaction accounts
 Current account: exports(+); imports(-); receive aid(+);income from abroad(+); income
going abroad(-)
Influenced by competitiveness, domestic & foreign income
 Capital transfer account: net receipts(+)
 Financial account: foreigners buying shares(+); domestic investor buys foreign shares(-)
Influenced by relative interest rates which affect international capital flows
Net direct investment; net portfolio investment; net financial derivatives; net other
assets; reserve assets [increase(-); decrease(+)]

Financing international trade:

 Net borrower: country that borrows more than it lends
 Net lender: country that lends more than borrows
 Debtor nation: a country that historically has borrowed more than it has lent
 Creditor nation: a country that historically has lent more than it has borrowed
 Difference between being borrower/lender & creditor/debtor is the difference between
stocks and financial capital flows