From Econ CFAI P. 580: “…consider a country in which capital flows are restricted, as is often the case with developing nations. A trade deficit would lead to a reduction in the country’s reserves and, ultimately, to a depreciation of the home currency.” Please let me know what I am missing: -If a country had a trade deficit that had to be financed with the official reserve account, the country would sell its official reserves (foreign currency) on the foreign exchange market. -This would reduce the official reserves and bring an inflow of domestic currency to cover the trade deficit. Since this action is taking domestic currency OUT of the foreign exchange market, wouldn’t this cause the home currency to appreciate? If someone can point out what I’m missing here I would appreciate it. Thanks.
… but then again, a deficit cannot be financed by reserves indefinitely, so the depreciation would probably be a long term effect to restore equilibrium. Any appreciation from the purchase of domestic currency would be short-term and probably insignificant… I am guessing that is it.
I think you are on the right track here… In order for the trade to ultimately balance out, the foreign country will have to begin to receive more goods for the amount of FC they spend. The domestic country cannot continue to accrue the trade deficit through debt, so eventually it begins to reverse through the devaluation of the DC. This is not really an easy topic to grasp.
I think reserve account has minimum effect of all three (current, financial, reserve) in term of amount in all ccountries. app/dep is mainly decided by current and financial account. if a country have huge deficit doesn’t cause the depr as long as it can attract the inflow of financial account. but sure enough USA $ is down. one of many reason are deficit and inflow of financial account is …
The text really doesn’t provide a good explanation of why this is. The only reason I can think of is a situation akin to an individual taking on too much debt… eventually, their currency i.e. their credit and credibility to repay are diminished. The only real difference is that a sovereign nation is able to print money to satisfy debt holders while you and I cannot… hence inflationary pressures come in and thereby reduce the value of the home currency.
It seems to me that as foreigners become less willing to finance or purchase US assets, the cost of foreign capital increasing results in the decline in the . As the ability to attract foreign capital weakens, a decline in the makes foreign investment more attractive. As the $ declines, the trade deficit should push in the other direction.
I agree with itfaster - currency app/dep is affected mostly by current and financial accounts. Trade deficit leads to foreign countries holding your currency, and if they don’t want to invest in your assets, they will sell your currency in open market, causing it to depreciate.
I think we’re looking long term here as you correctly stated McLeod81. The fact that they are a developing country probably indicates limited avaiable reserves for financing the deficit as they most likely do not have a history of surplus. Furthermore, flow of capital is restricted which will limit demand for currency with which to invest thus increasing the strain on the official reserves.
Black Swan Wrote: ------------------------------------------------------- > I think we’re looking long term here as you > correctly stated McLeod81. The fact that they are > a developing country probably indicates limited > avaiable reserves for financing the deficit as > they most likely do not have a history of surplus. > Furthermore, flow of capital is restricted which > will limit demand for currency with which to > invest thus increasing the strain on the official > reserves. This is the correct way of looking at it. Since capital investment flows are restricted in this developing country, the short-term burden is on the official reserves account. My opinion is that the domestic currency may initially appreciate (short-term due to this country selling foreign currency reserves). Then once the reserve account runs out, the domestic currency will have to depreciate since there will be no other way to finance the CA deficit.
I agree with the direction itfaster and gz2nyc are headed. In my mind, it is a demand and supply situation. Importers are selling more DC than exporters are buying. Normally that would be covered with foreign investors/financiers funding the shortfall by transfering money into the developing country - buying DC. Demand and supply would be equal and the currency is stable. If foreign financiers are restricted from investing money into the economy (buying DC) then there will be an oversupply that the official reserves must cover (buying the DC on the open market by selling FC). Because a developing nation has a limited ability to do so, there soon develops an over supply situation - and a subsequent fall in price/depreciation due to the normal demand/supply relationship.
DblA, I was assuming what you said, but added the impacts of the details regarding A) they are a developing country and B) they have restricted capital flow. Without A they could have official reserves with which to meet the demand regarding the capital account and without B demand for dollars with which to invest could create offsetting currency appreciation.
Agreed.
Gz2nyc has the idea. If any country is running at a trade deficit that mean they’re importing more than exporting (United States is an example). They have to pay for the good being imported by selling their currency and buying the currency of the exporting country to pay for the items. That drives domestic currency down relative to others.
How is that each new viewer fails to recognize that my post was an elaboration / extension of the others and not a disagreement. jesus
schuurmer Wrote: ------------------------------------------------------- > Gz2nyc has the idea. > > If any country is running at a trade deficit that > mean they’re importing more than exporting (United > States is an example). They have to pay for the > good being imported by selling their currency and > buying the currency of the exporting country to > pay for the items. That drives domestic currency > down relative to others. If the country is covering the deficit with their official reserves (reserves of foreign currency) that would mean that they are selling foreign currency and receiving their own currency. That was the point of my original question. On a short term basis this would lead to domestic currency appreciation. Long term, the reserves would run out and this would force the domestic currency to depreciate.
In my view the treasury wouldn’t be inclined to purchase more DC than they had to so foreign reserves would initially only serve to maintain the currency value rather than necessarily cause it to appreciate.