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Ch. 2 International Flow of Funds

Topics

� Balance of Payments

� International Trade Flows

� International Capital Flows

� Agencies that Facilitate International Flows

Balance of Payments

� Definition: Measurement of all transactions between domestic and foreign residents over a specified period of

time.

1. Current Account

2. Capital Account

3. Finance Account

Current Account

� Definition: Summary of the flow of funds between one specified country and all other countries due to the purchases of goods or services, the provision of income on financial assets.

1. Merchandise Export and Imports / Balance of Trade

2. Service Exports and Imports

3. Factor Income: Interests and dividends received by investors on foreign investments in financial assets.

4. Transfer Payments: International aid, grants and gifts.

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Sample Current Account Transactions

Exports, Imports & Trade Balance

Source: BEA.gov

Service Exports & Imports

Source: BEA.gov

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Travel (for all purposes including

education)

Source: BEA.gov

Source: BEA.gov

Balance on Goods and Services

(Quarterly)

Factors Affecting Int’l Trade Flows

1. Inflation: A relative increase in a country’s inflation rate will decrease its current account, as imports increase and exports decrease.

2. National Income: A relative increase in a country’s income level will decrease its current account, as imports increase.

3. Government Policies

� Subsidies for exporters

� Restrictions on imports

� Lack of restriction on piracy

4. Exchange Rates: If a country’s currency begins to rise in value, its current account balance will decrease as imports increase and exports decrease.

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Trade Frictions

� Friction Surrounding Trade Agreements

� Trade agreements are sometimes broken when one country is harmed by another country’s actions.

� Dumping refers to the exporting of products by one country to other countries at prices below cost.

� Another situation that can break a trade agreement is copyright piracy.

� Other causes for friction include environmental restrictions, labor laws, bribes, government subsidies and tax breaks.

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Trade Policies

� Using the exchange rate as a policy

� Outsourcing

� Managerial decisions about outsourcing

� Using trade policies for security reasons

� Using trade policies for political reasons

Correcting a Balance of Trade Deficit

� Why a Weak Home Currency is not a Perfect Solution to Trade Deficit:

� Competition: foreign companies may lower their prices to

remain competitive.

� Impact of other currencies: a country that has balance of

trade deficit with many countries is not likely to solve all deficits simultaneously.

� Prearranged international trade transactions: international

transactions cannot be adjusted immediately. The lag is

estimated to be 18 months or longer, leading to a J-curve effect. (Exhibit 2.6)

� Intracompany trade: Many firms purchase products that are produced by their subsidiaries. These transactions are not

necessarily affected by currency fluctuations.

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J-Curve Effect

Capital Account

� The new capital account is adopted by the U.S. in 1999.

� It includes unilateral current transfers that are really shifts in assets, not current income.

� Debt forgiveness

� Transfers by immigrants

� Sale or purchase of rights to natural resources or patents

Financial Account

� Previously called as the capital account.

� Definition: Summary of the flow of funds resulting form the sale of assets between one specified country and all other countries over a specified period of time.

� Assets include official reserves, other government assets, direct foreign investments, investments in securities, etc.

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Financial Account

Source: BEA.gov

Financial Account

Source: BEA.gov

Distribution of Global FDI

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Factors Affecting FDI

� Changes in Restrictions

� Privatization

� Potential Economic Growth

� Tax Rates

� Exchange Rates

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Factors Affecting International Portfolio

Investment

� Tax rates on Interest or Dividends

� Interest Rates

� Exchange Rates

Balance of Payments Interaction with Key Macroeconomic Variables

� In a static (accounting) sense, a nation’s GDP can be represented by the following equation:

GDP = C + I + G + X – M

C = consumption spending

I = capital investment spending

G = government spending

X = exports of goods and services

M = imports of goods and services

X – M = Current account

balance

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Agencies Facilitating Int’l Flows

� International Monetary Fund (IMF)

� World Bank

� World Trade Organization (WTO)

� International Financial Corporation (IFC)

� International Development Association (IDA)

� Bank for International Settlements (BIS)

� Organization for Economic Cooperation and Development (OECD)

� Regional Development Agencies

� The IMF is an organization of 183 member countries. Established in 1946, it aims

� to promote international monetary cooperation and exchange

stability;

� to foster economic growth and high levels of employment;

and

� to provide temporary financial assistance to help ease imbalances of payments.

International Monetary Fund

� Established in 1944, the Group assists development with the primary focus of helping the poorest people and the poorest countries.

� It has 183 member countries, and is composed of five organizations - IBRD, IDA, IFC, MIGA and ICSID.

� International Bank for Reconstruction and Development (IBRD) � Better known as the World Bank, the IBRD provides loans and

development assistance to middle-income countries and creditworthy poorer countries.

� In particular, its structural adjustment loans are intended to enhance a country’s long-term economic growth.

World Bank Group

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� Created in 1995, the WTO is the successor to the General Agreement on Tariffs and Trade (GATT).

� It deals with the global rules of trade between nations to ensure that trade flows smoothly, predictably and freely.

� At the heart of the WTO's multilateral trading system are its trade agreements.

� Its functions include:� administering WTO trade agreements

� serving as a forum for trade negotiations

� handling trade disputes

� monitoring national trading policies

� providing technical assistance and training for developing countries

� cooperating with other international groups

World Trade Organization

( ) ( )[ ]

( )∑

∑

+

×=

n

1tt

m

1jtjtj

k1=

, , ER ECF E

= Value

E (CFj,t ) =expected cash flows in currency j to be received by the U.S. parent at the end of period t

E (ERj,t ) =expected exchange rate at which currency j can be converted to dollars at the end of period t

k =weighted average cost of capital of the parent

Exchange Rate MovementsExchange Rate Movements

Inflation in Foreign CountriesInflation in Foreign CountriesNational Income in Foreign CountriesNational Income in Foreign Countries

Trade AgreementsTrade Agreements

Impact of Int’l Trade on an MNC’s Value