4.20 - Financial Account & Exchange Rate
Influence of financial account surpluses
A surplus in the financial account occurs when capital inflows into a country exceed outflows. This situation typically leads to an appreciation of the country's currency, assuming other factors remain constant. The diagram below works this through for the Australian dollar, at a time when investors believe Australia's strong non-inflationary growth will continue. It plots the price of AUD in US dollars against the quantity of AUD traded per period, with S1 for AUD coming from investment outflows out of Australia, and the market starts at the exchange rate e1.
Mechanism behind currency appreciation from financial surpluses
- Increased demand for the currency - Strong economic performance attracts foreign investors, who need the local currency to buy assets like shares, bonds, or to make direct investments. Demand for Australian dollars therefore shifts right, from D1 for AUD to D2 for AUD.
- Excess demand at original rates - At the original exchange rate e1, the quantity of AUD demanded (point b on D2 for AUD) exceeds the quantity supplied (point a), so there is excess demand for the currency equal to ab. That excess demand is Australia's financial account surplus showing up in the foreign exchange market.
- Resulting appreciation - Excess demand bids the currency up, and the market clears again at f, where D2 for AUD crosses S1 for AUD. The exchange rate has appreciated from e1 to e2, making the Australian dollar more expensive relative to the US dollar.
- General principle - When private capital inflows surpass outflows, the currency tends to appreciate, all else being equal.
Interaction of current and financial accounts
The current account and financial account are interconnected components of the balance of payments, and their combined effects determine exchange rate movements. A deficit or surplus in one can be offset by the other, influencing whether a currency appreciates or depreciates.
Effects of current account deficits and surpluses
| Current account position | Pressure on the currency in isolation | Why | What can offset it | Outcome if the offset is large enough |
|---|---|---|---|---|
| Deficit | Downward, so the currency tends to depreciate | Imports exceed exports, so the supply of the domestic currency in foreign markets rises | A financial account surplus, where capital inflows add to demand for the currency | Depreciation is prevented, and the currency can even appreciate |
| Surplus | Upward, so the currency tends to appreciate | Exports create more demand for the domestic currency than imports create supply | Residents, the government, or the central bank buying foreign assets, which adds to the supply of the currency | Appreciation is avoided and the flows balance |
So the direction a currency moves in depends on the two accounts together. A position in one account only settles the outcome when the other account is not pulling the other way.
Short-term dominance of financial flows
Financial account movements often have a stronger immediate effect on exchange rates compared to the current account, due to the rapid nature of capital flows in response to economic conditions or investor sentiment.
Historical examples of exchange rate movements
Real-world cases illustrate how the balance between current and financial accounts can lead to unexpected exchange rate outcomes, highlighting the importance of capital flows.
| Country and period | Current account position | Financial account influence | Exchange rate outcome |
|---|---|---|---|
| USA (1994-2002) | Growing trade deficit | Attracted substantial foreign capital inflows through investments in stocks and bonds | US dollar appreciated despite the deficit |
| China (various periods) | Large current account surpluses | Government purchased vast amounts of US Treasury bonds, increasing demand for US dollars | Yuan prevented from appreciating against the US dollar |
Overall factors determining exchange rate changes
Exchange rates are ultimately shaped by the net effect of flows in both the current and financial accounts.
Key principles in exchange rate determination
- Net balance of flows - If combined inflows (from exports and capital investments) exceed outflows (from imports and capital outflows), the currency appreciates; the reverse leads to depreciation.
- Role of interventions - Governments or central banks can influence outcomes by adjusting financial flows, such as through asset purchases, to manage currency values.
- Ceteris paribus assumption - These effects hold assuming no changes in other variables like interest rates or inflation, which can also impact exchange rates.