Introduction To International Finance: CCCH9007 China in The Global Economy

CCCH9007 China in the Global Economy
Introduction to International Finance
Jing Li
Faculty of Business and Economics

University of Hong Kong
October 20, 2021

Overview
Balance of Payment
Exchange Rate
Macro Policies and International Finance
Overview
Balance of Payment
Exchange Rate
Jing Li October 20, 2021 1/42

Overview
Balance of Payment
Exchange Rate
Balance of Payment

Overview
Balance of Payment
Exchange Rate
Balance of Payment
For every flow of goods, there is a corresponding and

opposite flow of money or financial clams.
The balance of payments is a yearly summary of all the
economic transactions between residents of one
country(consumers, businesses, and government) and
residents of the rest of the world.
Inflows of foreign currency are counted as a positive entry;
Outflows of foreign currency are counted as negative entry
International balance of payments is represented by the
expression:
Current Account + Capital Account + Balancing Items=0

Overview
Balance of Payment
Exchange Rate
Balance of Payment
Current Account
Current Account + Capital Account + Balancing Items =0
The sum of three items:

1 The balance of trade, export-import
(+) CN exports a lot of tractors
(−) CN imports grapes from Chile
2 Net income due to ownership of foreign assets
(+) CN owns a med factory in JAP and gets dividends from JAP
(−) JAP invest a beer factory in CN and collect dividend from CN
3 Net transfer payment
(+) CN receives foreign aid/donation from other countries
(−) CN sends foreign aid to other countries

Overview
Balance of Payment
Exchange Rate
Balance of Payment
Capital Account
Current Account + Capital Account + Balancing Items =0
Capital account measures changes in foreign ownership

of domestic assets, including financial assets like stocks
and bonds as well as physical assets.
Composed by the following categories:
1 By private
Foreign direct investment–Foreigners construct new
business plant in CN
Portfolio investment–Foreigners buy CN stock
Others–Foreigners deposit money in a bank in Peking
2 By government
Net change in the official foreign reserve
Overview
Balance of Payment
Exchange Rate
Balance of Payment
How the Pieces Fit Together?

– A case of Walmart’s toy purchase (Home country: USA)

Overview
Balance of Payment
Exchange Rate
Balance of Payment
Two Sides, One Coin (USA)
Source: Bureau of Economic Analysis, Cowen and Tabarrok (2015)

Overview
Balance of Payment
Exchange Rate
Balance of Payment
Two Sides, One Coin (China)
Source: https://econreviews.org/

Overview
Balance of Payment
Exchange Rate
Balance of Payment
Two Sides, One Coin (China)

Overview
Balance of Payment
Exchange Rate
Balance of Payment
Declining Balance of Current Account in China
Source: The Economist

Overview
Balance of Payment
Exchange Rate
Exchange Rate

Overview
Balance of Payment
Exchange Rate
Exchange Rate
Exchange rate (nominal) is the price of one currency in

terms of another currency
Foreign Currency
Nominal Exchange Rate (NER) = Domestic Currency
It is important to understand how this ratio is expressed:

NER↑ represents an appreciation of domestic currency.
The ”denominator” country is usually stated second, i.e.
the ”dollar-euro” exchange rate means dollar/euro.

Overview
Balance of Payment
Exchange Rate
Exchange Rate
Dollar-Euro Exchange Rate, Daily, 1999-2019

Overview
Balance of Payment
Exchange Rate
Exchange Rate
RMB-Dollar Exchange Rate, Daily, 1999-2019

Overview
Balance of Payment
Exchange Rate
Exchange Rate
How NER is Determined?

Overview
Balance of Payment
Exchange Rate
Exchange Rate
What Factors Affect the Demand and Supply of A Currency?

Demand:
Increase in the demand for a country’s exports tends to increase
the value of its currency, vice versa
The more desirable a country for foreign investment (higher
interest rate), the higher the value of that country’s currency,
vice versa
An increase in the willingness to hold a currency as reserve
boosts the value of that currency on international markets, vice
versa
Supply:
Increase the supply of a currency (print more money) causes
the currency to lose value, which is depreciated.
Tight monetary policy (decrease or slow increase) in the supply
will lead to appreciation.
Overview
Balance of Payment
Exchange Rate
Exchange Rate
Another Question:
Why sometimes the market exchange rate is said to be
undervalued/overvalued?
Relative to what?

Overview
Balance of Payment
Exchange Rate
Exchange Rate
Theorem of Purchasing Power Parity (PPP)
The PPP theorem says that the real purchasing power of a

money should be the same, whether it is spent at home or
converted into another currency and spent abroad
It is the application of the law of one price, the principle that
if trade were free, then the identical goods should sell for
about the same price through out the world

Overview
Balance of Payment
Exchange Rate
Exchange Rate
PPP Theorem

Overview
Balance of Payment
Exchange Rate
Exchange Rate
PPP Theorem
2L Coca Cola:
Price in Japan: 217YEN
Price in US: 1.74USD
Implied Exchange Rate (PPP):
217YEN
1.74USD = 124.71YEN/1USD
Official exchange rate (NER):

104.65YEN/1USD

Overview
Balance of Payment
Exchange Rate
Exchange Rate
PPP Theorem
2L Coca Cola:
Price in Japan: 217YEN
Price in US: 1.74USD How PPP is different from NER?
PPP−NER 124.71−104.65
Implied Exchange Rate (PPP): NER = 104.65 =19.17%
217YEN
1.74USD = 124.71YEN/1USD ⇓
Official exchange rate (NER): Japanese Yen is overvalued by
104.65YEN/1USD 19.17%

Overview
Balance of Payment
Exchange Rate
Exchange Rate
Real Exchange Rate (RER)

RER is the rate at which you can exchange the goods and
services of one country for the goods and services of another.
It reflects the relative price of goods of two countries in the
same currency, showing how much a domestic item is worth
compared to a similar foreign item
Different with NER (simply the exchange ratio between home
currency and foreign currency)
Calculated as: the nominal exchange rate times the relative
price of a market basket of goods in the two countries.
Price of domestic goods
RER = NER ∗ Price of foreign goods

Overview
Balance of Payment
Exchange Rate
Exchange Rate
Implications from RER

Comparing the price of a domestic item with a same foreign item
using the same currency is to compute the real exchange rate (RER):
Price of domestic goods
RER = NER ∗ Price of foreign goods
If RER < 1, the domestic item is cheaper

If RER > 1, the domestic item is more expensive

Overview
Balance of Payment
Exchange Rate
Exchange Rate
Big Mac Index

- another way to understand PPP...
How it works?
Recall: PPP implies that exchange
rate is determined by the value of
goods that currencies can buy
Different in local price of Big Mac
can suggest the implied exchange
rate
Using this implied exchange rate
from Big Mac’s price, we can
evaluate whether a currency is over-
or under-valued

Overview
Balance of Payment
Exchange Rate
Exchange Rate
Big Mac Index: RMB vs USD

A Big Mac cost:
Price in China: 21.50 RMB
Price in USA: 5.67 USD
Implied exchange rate under the PPP theorem: 3.79 RMB/USD
Exchange rate in the market: 6.88 RMB/USD
⇓
Chinese yuan is undervalued!

Overview
Balance of Payment
Exchange Rate
Exchange Rate
Big Mac Index: Most currencies are undervalued

against the US dollar

Overview
Balance of Payment
Exchange Rate
Exchange Rate
Big Mac Index: RMB is undervalued for a long time

Overview
Balance of Payment
Exchange Rate
Exchange Rate
PPP Theorem is Only Approximately Ture

Because:
Transportation cost
Tariffs and quotas
Some goods can not be shipped at all
Imperfect competition

Overview
Balance of Payment
Exchange Rate
Exchange Rate
Exchange Rate Regime

Two Major Systems:
Floating Exchange Rate: or flexible exchange rate,
where exchange rates are determined by market forces
Fixed Exchange Rate: where governments specify the
exact rate (fixed) at which home currency will be
converted into other currencies

Overview
Balance of Payment
Exchange Rate
Exchange Rate
EX Regime: More Varieties in Between

Overview
Balance of Payment
Exchange Rate
Exchange Rate
Exchange Rate Regime in China

Overview
Balance of Payment
Exchange Rate

Overview
Balance of Payment
Exchange Rate
Case 1: Maintain fixed exchange rate

in China

Overview
Balance of Payment
Exchange Rate
Macro Policies and Exchange Rate
China maintains fixed exchange rate until mid of 2005

Accumulate enormous surplus in current account due to
the growth of export
In order to keep the export-led growth, China has to
maintain the below-market exchange rate to make export
goods competitive in the international market

Overview
Balance of Payment
Exchange Rate
Chinese Government Exchange-rate Intervention:
Government directly buying

dollars and selling yuan
Monetary policy: lowering
interest rates to induce the
private sector to increase
supply of yuan in the foreign
exchange market.

Overview
Balance of Payment
Exchange Rate
Case 2: Plaza Accord

Overview
Balance of Payment
Exchange Rate
Plaza Accord
The Plaza Accord is a 1985 agreement among the G-5
nations-France, Germany, the United States, the United
Kingdom, and Japan-to intervening in the currency market by
depreciating the U.S. dollar relative to the Japanese yen and
the German Deutsche mark.

Overview
Balance of Payment
Exchange Rate
Increasing oil price drives interest rate to grow in US

Overview
Balance of Payment
Exchange Rate
High interest rate–Large appreciation–Huge trade deficit

Overview
Balance of Payment
Exchange Rate

Overview
Balance of Payment
Exchange Rate

Overview
Balance of Payment
Exchange Rate
Thank You!

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CCCH9007 China in the Global Economy

Introduction to International Finance

Faculty of Business and Economics

October 20, 2021

Jing Li October 20, 2021 1/42

Jing Li October 20, 2021 2/42

For every flow of goods, there is a corresponding and

Jing Li October 20, 2021 3/42

The sum of three items:

Jing Li October 20, 2021 4/42

Capital account measures changes in foreign ownership

How the Pieces Fit Together?

Jing Li October 20, 2021 6/42

Two Sides, One Coin (USA)

Source: Bureau of Economic Analysis, Cowen and Tabarrok (2015)

Jing Li October 20, 2021 7/42

Two Sides, One Coin (China)

Jing Li October 20, 2021 8/42

Two Sides, One Coin (China)

Jing Li October 20, 2021 9/42

Declining Balance of Current Account in China

Source: The Economist

Jing Li October 20, 2021 10/42

Jing Li October 20, 2021 11/42

Exchange rate (nominal) is the price of one currency in

It is important to understand how this ratio is expressed:

Jing Li October 20, 2021 12/42

Dollar-Euro Exchange Rate, Daily, 1999-2019

Jing Li October 20, 2021 13/42

RMB-Dollar Exchange Rate, Daily, 1999-2019

Jing Li October 20, 2021 14/42

How NER is Determined?

Jing Li October 20, 2021 15/42

What Factors Affect the Demand and Supply of A Currency?

Jing Li October 20, 2021 17/42

Theorem of Purchasing Power Parity (PPP)

The PPP theorem says that the real purchasing power of a

Jing Li October 20, 2021 18/42

Jing Li October 20, 2021 19/42

Official exchange rate (NER):

Jing Li October 20, 2021 20/42

Jing Li October 20, 2021 21/42

Real Exchange Rate (RER)

Jing Li October 20, 2021 22/42

Implications from RER

If RER < 1, the domestic item is cheaper

Jing Li October 20, 2021 23/42

Big Mac Index

Jing Li October 20, 2021 24/42

Big Mac Index: RMB vs USD

Jing Li October 20, 2021 25/42

Big Mac Index: Most currencies are undervalued

Jing Li October 20, 2021 26/42

Big Mac Index: RMB is undervalued for a long time

Jing Li October 20, 2021 27/42

PPP Theorem is Only Approximately Ture

Jing Li October 20, 2021 28/42

Exchange Rate Regime

Jing Li October 20, 2021 29/42

EX Regime: More Varieties in Between

Jing Li October 20, 2021 30/42

Exchange Rate Regime in China