International Finance: Balance of Payments and Exchange Rates

Understanding the Balance of Payments

The Balance of Payments (BOP) is a systematic record of all economic exchanges that take place between residents of a country and the rest of the world during a specific period. Its operations are grouped, depending on their nature, into three main sections, often referred to as sub-balances:

Current Account

This account reflects the movements of goods and services between a country and the rest of the world. It comprises:

• Balance of Trade: Records the value of all goods that residents of a country buy from and sell to other countries (exports and imports of merchandise).
• Balance of Services: Records the value of all services provided to residents of other countries and received from them (e.g., tourism, transport, financial services).
• Primary Income Balance: Records income earned from investments abroad and income paid to foreign investors (e.g., wages, interest, dividends).
• Secondary Income Balance (Current Transfers): Records one-way transfers of foreign capital between countries, such as remittances, foreign aid, and grants.

Capital Account

This account primarily records capital transfers, such as debt forgiveness, transfers of assets by migrants, and the acquisition or disposal of non-produced, non-financial assets (e.g., patents, copyrights). It also includes the difference in subsidies entering the country.

Financial Account

This account records international monetary flows related to investment. It includes:

• Direct Investment: Investments made by non-residents in Spain and investments made abroad by Spanish residents (e.g., establishing a new business or acquiring a controlling stake in an existing one).
• Portfolio Investment: Investments in equity and debt securities (e.g., stocks, bonds).
• Other Investment: Loans, currency and deposits, trade credits.
• Reserve Assets: Includes the variation in foreign exchange reserves held by the central bank (e.g., the Bank of Spain).

International Trade and Exchange Rates

International trade necessitates the existence of a currency market where currencies are bought and sold. In this market, exchange rates are determined.

What is an Exchange Rate?

An exchange rate is the price of one currency expressed in terms of another. It represents the equivalence relation between different currencies, indicating the quantity of one country's currency needed to exchange for another country's currency.

Types of Exchange Rate Systems

There are primarily three types of exchange rate systems:

• Flexible Exchange Rates: The value of a currency is determined solely by the free interplay of supply and demand in the market. An increased demand for a currency triggers its appreciation, while an increased supply causes its depreciation.
• Fixed Exchange Rates: A country's monetary authorities undertake to maintain a constant exchange rate for its currency with respect to another currency or a basket of currencies. This system was, for example, established by the EU some years before the physical introduction of the Euro currency.
• Adjustable Peg (Managed Float) Exchange Rates: This system combines aspects of both flexible and fixed rates. While the currency's value is allowed to fluctuate within certain predefined limits, monetary authorities may intervene in the market. If the currency depreciates or appreciates too much, the central bank intervenes by selling its own currency (to prevent excessive appreciation) or buying its own currency (to halt excessive depreciation) in the currency markets.