International Balances and the Exchange Rate

I've read a few things recently on the complex relationships between interest rates, exchange rates and trade balances.

I like to approach this by starting with the stock variables.  We can imagine a simple global balance sheet matrix like that set out below.  This looks at the position of Country X, which uses Currency X (and we'll assume for simplicity that only Country X uses Currency X).  The assets in other currencies are converted into Currency X at prevailing spot rates, so that we can do some adding up.

So at a particular point in time, investors of Country X hold total assets of 100, which they need to allocate.  Being based in Country X, there will be some preference for investing in currency X assets.  However, those investors will probably also wish to hold some level of other assets to diversify their portfolio.  The balance will depend to some extent on potential returns in different currencies, with the return being a function of nominal interest rates in the respective currencies and potential exchange rate movements.

	Currency X Assets	Other Currency Assets	Total
Country X Investors	80	20	100
Rest of World Investors	50	850	900
Total	130	870	1,000

Likewise, investors in the rest of the world will also want to diversify their investments, so they will want to include some Currency X assets in their portfolio.  Again they will take potential returns into account.  There will be many other factors, of course, effecting what assets investors choose to hold.  But, all other things being equal, the better the prospects for returns in a currency, the more of it investors will want to hold.

Just as Country X investors have a preference for investing in their own currency, so will investors in the rest of the world.  So, the greater the share of total investments held by Country X investors, the greater the overall demand for Currency X assets.

This is what determines exchange rates in the very short term.  At any point in time, the amount of assets in each currency is given, as is the assets of each investor class.  Taking interest rates as given, the exchange rate must find a level where investors want to hold the assets that are available in each currency.

Generally, if there are more Currency X assets than investors wish to hold, then Currency X needs to become cheaper and it will depreciate until it finds the right level.  However, since the right level depends on potential future movements of the currency, which in turn depends on what the exchange rate will be in the future, this can be hard to pin down.  I will come back to this.

So far we have said nothing about trade flows.  In fact, current account items do not matter in themselves.  There is no need for the current account to balance in either the short or the long term.  The relevance of trade flows and investment income is that, over time, they change the balance of assets.

So, if country X is running a persistent current account deficit, then there will be corresponding changes in our matrix.  This could be reflected in a growth of Currency X assets, as Country X finances its spending with borrowing[1], or it might be reflected in a reduction in the total assets of Country X investors (or some combination of the two).

The impact depends on what is going on with investors and assets in the rest of the world.  In combination, these changes may result in the ratios of values within the matrix remaining relatively stable.  However, they could lead to significant changes.  For example, Country X's persistent deficits might lead to Currency X assets becoming a greater and greater proportion of the whole.  In that event we might expect to see some consequences for interest rates and/or exchange rates.

We can see what is happening with interest rates, but we are left with the question of what drives expectations of exchange rate movements.  If today's exchange rate falls, we might hazard a guess that it is more likely to return gains in the future, but it all depends on where the exchange rate needs to be going into the distant future.  We seem to need some kind of target exchange rate to which the actual exchange rate will move over time.

In some models, this target exchange rate role is filled by a measure of purchasing power parity.  The framework I'm using here suggests a slightly different approach.  What it requires is that the exchange rate moves towards a level that allows the values in the matrix to remain in balance.  In a growth scenario, this would mean all the values ultimately growing at the same rate.  Any exchange rate that fails to meet this criterion will lead to an unsustainable position of ever diverging values.

We can write down models that reflect this.  By making certain assumptions about behaviours, we can trace out exchange rate paths that tend towards these steady state positions, while fulfilling relative return requirements along the way.  But it should be noted that there are many factors coming into play in these models, not least how fiscal and monetary policy are expected to develop into the future.  However clearly the equilibrium exchange rate might be defined under perfect foresight, the reality of exchange rate determination is probably closer to blind guesswork.

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[1] I have assumed here that Country X borrowers only borrow in Currency X, but in reality they might borrow in different currencies.  The same issues apply, but this explanation is much simpler if we ignore that.  On the whole, it is much less common for an entity to borrow (other than on a matched basis) outside its functional currency than it is to invest.