Macroeconomic linkages between countries are expressed through their respective current and capital accounts.
The current account reflects net exports of goods and services, net investment income flows, and unilateral transfers.
The capital account, which for the purposes of this discussion also includes what is known as the financial account, reflects net investment flows for Foreign Direct Investment (FDI)—purchase and sale of productive assets across borders—and Portfolio Investment (PI) flows involving transactions in financial assets.
A useful relationship for understanding how the current account influences economic activity is the following formula:
net exports = net private saving + government surplus
National income accounting also implies the following important relationship among net exports (X – M), saving (S), investment (I), and the government surplus (T – G):
(X – M) = (S – I) + (T – G)
Interest Rate and Exchange Rate Linkages
One of the linkages of greatest concern to investors involves interest rates and exchange rates. The two are inextricably linked. This fact is perhaps most evident in the proposition that a country cannot simultaneously
- allow unrestricted capital flows;
- maintain a fixed exchange rate; and
- pursue an independent monetary policy.
The essence of this proposition is that if the central bank attempts to push interest rates down (up), capital will flow out (in), putting downward (upward) pressure on the exchange rate, forcing the bank to buy (sell) its own currency, and thereby reversing the expansionary (contractionary) policy. Carrying this argument to its logical conclusion suggests that, with perfect capital mobility and a fixed exchange rate, “the” interest rate must be the same in countries whose currencies are pegged to each other.
If a currency is linked to another without full credibility, then bond yields in the weaker currency are nearly always higher.
When the exchange rate is allowed to float, the link between interest rates and exchange rates is primarily expectational. To equalize risk-adjusted expected returns across markets, interest rates must generally be higher (lower) in a currency that is expected to depreciate (appreciate). Ironically, this dynamic can lead to seemingly perverse situations in which the exchange rate “overshoots” in one direction to generate the expectation of movement in the opposite direction.
In the absence of pegging, the relationship of interest rate differentials and currency movement can reflect several factors:
- If a currency is substantially overvalued and expected to decline, bond interest rates are likely to be higher to compensate foreign investors for the expected decline in the currency value.
- Relative bond yields, both nominal and real, increase with strong economic activity and increasing demand for funds.
- Savings and investment decisions as well as capital productivity drive the level of real rates. Although real rates may differ across countries, there is a tendency for them to move up and down together given that global savings and investing are linked through the current account.