International Currencies Made EZ #8

by | Dec 20, 2004 | Archives

Few economic events can have as much impact on your life as the falling U.S. dollar. I am learning this right now while on a trip to London. If one converts what things cost here in dollars…well its just better not to.

While I am away, the Gary Scott messages each day contain a review from the course International currencies Made EZ. This information can help you understand why and how currency parities move. Here is a section from Chapter Eight. This report is dated but do not let the dates and numbers get in the way. The fundamentals remain the same.

More Long Term Factors of Currency Movement

Last lesson we viewed the first three long term factors that affect the value of currencies. These factors were a nation's production and consumption, government debt and the nature of government debt.

The next long term factors are below.

* Long-Term Factor #4: Trade Balance (Surplus Deficit). When two countries trade with each other, it's unlikely that the sum of the imports and exports between them will add to zero. Most often, one country sells more to the other country than it buys. Thus, there are always surpluses and deficits in a country's balance of payments.

A country has a surplus in its balance of payments when it sells more than it buys. Put another way, a country has a surplus when it exports more than it imports, or when it produces more than it consumes.

A surplus in balance of payments results in a positive flow of cash into the country from its sales and/or investment income out of the country. A country has a deficit in its balance of payments when it buys more from outside the country than it sells outside the country. A deficit in balance of payments results in an outflow of cash from the country because of its excess purchases and expenditures abroad.

The relative value of two currencies depends primarily on the balance of payments between the countries. The following list shows the potential credits that can accrue to a country's balance of payments. Note that each of these items pertains to all private individuals, private organizations (businesses and others) and public organizations (the government and its branches).

1. All receipts of foreign money.

2. Earnings from investments in foreign countries.

3. Sales of goods or services (exports).

4. Gifts or foreign aid from foreign countries.

5. Sales of stocks or bonds.

The following list shows the potential debits that can be applied against a country's balance of payments. Again, each item pertains to all private individuals, private organizations, and public organizations.

1. All payments to foreign countries.

2. Investments within foreign countries.

3. Purchases of goods or services (imports).

4. Gifts or aid to foreign countries. \

5. Purchases of stocks or bonds (private and public).

Current Account

A term often used in connection with balance of payments is “current account” or “current balance.” This is a measure of all sales or purchases of merchandise and services, flows of income to and from a country's foreign investments, etc. The term “current account” is often confused with the term “balance of payments, The current account can be called the balance of trade because it reflects the difference (positive or negative) between exports and imports. Those who use the two terms balance of payment and balance of trade (current account) as one are wrong. There is a difference between the current account and the balance of payments as is explained below.

We can understand the concepts of current account (balance of trade) and balance of payments and the difference between the two by looking at the international financial position of nations in simple accounting terms. A simple double entry system of accounting is used in which each nation uses debits (for goods and services each nation buys from abroad) and credits (for goods and services each nations sells abroad).

Since double entry bookkeeping requires that debits and credits must always balance, the import of a good or service on one side must be matched by the outflow of money to pay for it on the other side.

A nation's imports cannot exceed exports in the long term because the nation will run out of money to pay for the foreign goods purchased.

To help understand this better I have put a hypothetical balance of payments below:

                                   Debit        Credit      Balance 

(Imports) (Exports)

Goods & Services -175 +110 -65

Investment Income - 35 + 45 +10

Current Account Balance -210 +155 -55

Capital Account - 12 + 62 +50

Reserve Account 0 + 5 + 5

Balance of Payments -222 +222 0

The first balance above of the goods and services and investment income is the Current Account Balance (often called the Balance of Trade which can be confused with the Balance of Payments, the second balance above).

The difference between the Current Account (Balance of Trade) and the Balance of Payments is the nation's stock or capital. The Current Account is a measure of current flow and the Balance of Payments is a measure of total equity (or capital).

The Balance of Payments is all the accumulated assets of the nation, either financial or real. A positive Current Account adds to this balance. A negative Current Account reduces this balance.

A nation's Reserves are the measure of the net additions or reductions from the nation's assets. Nations accumulate reserves if they sell more abroad then they buy or they accumulate them in gold if they mine gold, or they accumulate reserves in credits if they are given reserve credits from the International Monetary Fund which serves as the central bank to the world.

The Current Account (Balance of Trade) can be stated in any time length desired. Usually it is stated in annual terms, such as “The United States last year had a Balance of Payments deficit of $70 billion with Japan.” But it can be stated in weekly, monthly, quarterly — or any other terms, including two-year, five-year, or decade-long terms.

Exchange Rates and Balance of Payments

What is the mechanism that causes a change in the exchange rate when there is a surplus or deficit in the balance of payments between two countries? Let's use trade between Japan and the U.S. as an example to answer this question.

First, remember that U.S. companies, headquartered and operating in the U.S., need to be paid in dollars for their products and services, because they need dollars to pay their bills, workers' salaries, etc. For the same reason, Japanese companies need to be paid in yen. A Japanese company, headquartered and operating in Japan, cannot use dollars to pay salaries and bills. It can only pay salaries and bills in yen.

Therefore, when a U.S. company or private citizen buys something produced in Japan, at some point dollars must be converted into yen. Similarly, when a Japanese company or private individual buys something produced in the U.S., at some point yen must be converted into dollars.

Therefore, whenever a country buys something from another country, its own currency must be converted, or exchanged, into the other country's currency.

Since the U.S. is currently buying more from Japan that Japan is buying from the U.S., more dollars are being exchanged into yen than yen into dollars. Every time a transaction is made, any place in the world, in which some individual or some organization in the U.S. buys something manufactured in Japan, dollars are exchanged to yen.

In each of these transactions, a currency trader places an order on the world's foreign exchange markets, asking for the price of exchanging dollars for yen. When this happens over and over, demand for yen becomes greater, and demand for the dollar becomes less. As a result, the price of the yen rises, and the price of the dollar falls.

Important Point to Remember: (This point is absolutely crucial to the understanding of foreign exchange.) Whenever goods or services are purchased from a country, that country's currency must be bid for and bought on the world's foreign exchange markets to pay for the goods or services. This is also the case for foreign investments, for financial transfers of a multinational company to one of its divisions within a foreign country and for foreign aid given to a country. In each of these activities, currency of the country must be purchased, because any money used or distributed within that country has to be in the currency of that country.

When a U.S. company buys auto parts from Japan, dollars are exchanged into yen, which increases the demand for yen and raises the price of the yen on the international exchange market. Correspondingly, the value of the dollar falls because dollars are let loose in the international market. A balance of payments deficit or surplus between two countries affects the relative demand (and hence price) of the two currencies.

But two countries never trade in a vacuum. The world of international trade and finance involves all countries. Japan trades with and invests in hundreds of different countries, as does the U.S. Therefore, the value of the yen on international foreign exchange markets is the sum total of all the trade surpluses and deficits Japan has. The same is true of the U.S. Every moment of the day, seven days a week, a foreign exchange broker is converting U.S. dollars into some foreign currency.

Take a three way view as an example. Imagine that the U.S. has a trade deficit with Japan (as is the case) and that the U.S. has a trade surplus with Mexico (as has been the case). If Mexico has a trade surplus with Japan that equals the trade deficit the U.S. has with Japan, then the trade between all three nations balances out. In this example there is no overall deficit.”

Until next message, good investing!