Lecture 1Lecture 1International FinanceInternational Finance

ECON 243 – Summer I, 2005ECON 243 – Summer I, 2005Prof. Steve CunninghamProf. Steve Cunningham

The New World EconomyThe New World Economy The world economy has become The world economy has become

increasingly interconnected:increasingly interconnected: GlobalizationGlobalization: markets exceed : markets exceed

national boundaries; increased national boundaries; increased mobility of workers, products, and mobility of workers, products, and information. information.

IntegrationIntegration: people of different : people of different countries choose to function jointly in countries choose to function jointly in governance, economic interests, governance, economic interests, currency, etc.currency, etc.

DevelopmentsDevelopments The possibility of such a global economy The possibility of such a global economy

has been brought about by: has been brought about by: Collapse of communism Collapse of communism Lower transportation costs Lower transportation costs Advances in telecommunications (internet, etc.) Advances in telecommunications (internet, etc.)

related technological innovations related technological innovations Economic need Economic need These have led to reductions in trade barriersThese have led to reductions in trade barriers

General barriersGeneral barriers Integration and free trade zones—Europe, North Integration and free trade zones—Europe, North

America, etc.America, etc. The relaxation of bank and capital market regulationsThe relaxation of bank and capital market regulations

Top 20 Globalized NationsTop 20 Globalized NationsRankRank NationNation Rank Rank NationNation11 IrelandIreland 1111 United StatesUnited States22 SwitzerlandSwitzerland 1212 FranceFrance33 SwedenSweden 1313 NorwayNorway44 SingaporeSingapore 1414 PortugalPortugal55 NetherlandsNetherlands 1515 Czech RepublicCzech Republic66 DenmarkDenmark 1616 New ZealandNew Zealand77 CanadaCanada 1717 GermanyGermany88 AustriaAustria 1818 MalaysiaMalaysia99 United KingdomUnited Kingdom 1919 IsraelIsrael1010 FinlandFinland 2020 SpainSpain

Source: Foreign Policy

SectorsSectors Economists typically separate the Economists typically separate the

production and sale of goods and production and sale of goods and services from the exchanges of services from the exchanges of financial assets.financial assets. Real SectorReal Sector: production and sale of goods : production and sale of goods

and services.and services. Financial SectorFinancial Sector: transactions in global, : transactions in global,

foreign, or domestic financial assets.foreign, or domestic financial assets. Measurement is difficult because Measurement is difficult because

trade may include services (invisibles) trade may include services (invisibles) and electronic commerce.and electronic commerce.

Balance of PaymentsBalance of Payments A record of international transactions A record of international transactions

between residents of one country and between residents of one country and the rest of the worldthe rest of the world

International transactions include International transactions include exchanges of goods, services or assetsexchanges of goods, services or assets

““ResidentsResidents” means businesses, ” means businesses, individuals and government agencies, individuals and government agencies, including citizens temporarily living including citizens temporarily living abroad but excluding local subsidiaries abroad but excluding local subsidiaries of foreign corporationsof foreign corporations

Double-entry Accounting in Double-entry Accounting in the BOPthe BOP

All transactions are either debit or All transactions are either debit or credit transactionscredit transactions

Credit transactionsCredit transactions result in receipt of result in receipt of payment from foreignerspayment from foreigners Merchandise exports (valued f.o.b.)Merchandise exports (valued f.o.b.) Transportation and travel receiptsTransportation and travel receipts Income received from investments abroadIncome received from investments abroad Gifts received from foreign residentsGifts received from foreign residents Aid received from foreign governmentsAid received from foreign governments

Double-entry AccountingDouble-entry Accounting (Cont’d)(Cont’d)

Debit transactionsDebit transactions involve to payments to involve to payments to foreignersforeigners Merchandise importsMerchandise imports Transportation and travel expendituresTransportation and travel expenditures Income paid on investments of foreignersIncome paid on investments of foreigners Gifts to foreign residentsGifts to foreign residents Aid given by home governmentAid given by home government Overseas investments by home country residentsOverseas investments by home country residents

Each credit transaction has a balancing debit Each credit transaction has a balancing debit transaction, and vice versa, so the transaction, and vice versa, so the overalloverall balance of payments is always in balance.balance of payments is always in balance.

Accounts Overview (Level Accounts Overview (Level 1)1)

Current AccountCurrent Account (all real transfers) (all real transfers) Merchandise tradeMerchandise trade Service tradeService trade TransfersTransfers

Capital and Financial AccountCapital and Financial Account (transfers (transfers of ownership and financial assets and of ownership and financial assets and liabilities)liabilities) Changes in private assetsChanges in private assets Changes in holdings of official international Changes in holdings of official international

reservesreserves Statistical DiscrepancyStatistical Discrepancy

Current AccountCurrent Account The The current accountcurrent account is that balance of is that balance of

payments account in which all short-payments account in which all short-term flows of payments are listed: term flows of payments are listed: Goods and services balance Goods and services balance (exports – imports)(exports – imports)

Merchandise trade balance Merchandise trade balance (exports – imports)(exports – imports) Services balance Services balance (exports – imports)(exports – imports)

Net Investment incomeNet Investment income Unilateral transfersUnilateral transfers

Private transfer paymentsPrivate transfer payments Governmental transfersGovernmental transfers

What are Services?What are Services? Travel and tourismTravel and tourism Trade transportationTrade transportation InsuranceInsurance EducationEducation Financial, technical, and marketing Financial, technical, and marketing

servicesservices TelecommunicationTelecommunication Use of property rights (royalties)Use of property rights (royalties) Other professional and consulting servicesOther professional and consulting services

What is Investment What is Investment Income?Income?

Payment to holders of foreign Payment to holders of foreign financial assets, including:financial assets, including: Interest on bonds and loansInterest on bonds and loans Dividends and other claims on profits Dividends and other claims on profits

by owners of foreign businessesby owners of foreign businesses Payments made to temporary Payments made to temporary

(nonresident) workers(nonresident) workers

Unilateral TransfersUnilateral Transfers Official government grants in aid to Official government grants in aid to

foreign governmentsforeign governments Charitable giving (e.g., famine relief)Charitable giving (e.g., famine relief) Migrant workers transfers to families Migrant workers transfers to families

in their home countriesin their home countries

Capital AccountCapital Account The The capital and financial accountcapital and financial account is that is that

balance of payments account in which all balance of payments account in which all cross-border transactions involving cross-border transactions involving financial assets are listed. This includes financial assets are listed. This includes transactions between foreign and domestic transactions between foreign and domestic residents, and foreign and domestic residents, and foreign and domestic governments.governments. All purchases or sales of assets, including:All purchases or sales of assets, including:

Direct investmentDirect investment Securities (debt)Securities (debt) Bank claims and liabilitiesBank claims and liabilities Official reserves transactionsOfficial reserves transactions When U.S. citizens buy foreign securities or when When U.S. citizens buy foreign securities or when

foreigners buy U.S. securities, they are listed here as foreigners buy U.S. securities, they are listed here as outflows and inflows, respectively.outflows and inflows, respectively.

Foreign Direct Investment Foreign Direct Investment (FDI)(FDI)

Any flow of lending to, or purchases of ownership Any flow of lending to, or purchases of ownership in, a foreign enterprise that is largely owned by in, a foreign enterprise that is largely owned by residents of the investing country.residents of the investing country. Securities (stocks and bonds)Securities (stocks and bonds) LoansLoans Bank depositsBank deposits Minority ownership positionsMinority ownership positions

FDIFDI is the purchase of assets to establish financial is the purchase of assets to establish financial control of a foreign entity. Generally control of a foreign entity. Generally ownership of ownership of 10% or more10% or more of a company’s outstanding stock is of a company’s outstanding stock is considered FDI.considered FDI.

Portfolio investmentPortfolio investment involves little management involves little management control or interest, and is solely for financial gain.control or interest, and is solely for financial gain.

Official Reserve AssetsOfficial Reserve Assets Early on in this century, this was primarily Early on in this century, this was primarily

goldgold Now primarily financial assets denominated Now primarily financial assets denominated

in a foreign currency that is widely in a foreign currency that is widely accepted in international transactions:accepted in international transactions: Euro assets (heavily used by U.S.)Euro assets (heavily used by U.S.) Yen assets (heavily used by U.S.)Yen assets (heavily used by U.S.) U.S. dollar assets (key currency worldwide)U.S. dollar assets (key currency worldwide) Reserve positions in IMFReserve positions in IMF SDRs (created by IMF)SDRs (created by IMF)

Official Reserves Official Reserves TransactionsTransactions

Governments can influence exchange rates Governments can influence exchange rates by buying and selling by buying and selling official reservesofficial reserves. .

The buying and selling of official reserves is The buying and selling of official reserves is recorded in the recorded in the “official“official transactions”transactions” account.account. Also referred to as “Also referred to as “changes in holdings of official changes in holdings of official

international reserves” or “official settlements international reserves” or “official settlements balance”balance”. .

It is the part of the balance of payments It is the part of the balance of payments accounts that records the amount of its own accounts that records the amount of its own currency or foreign currencies that a nation currency or foreign currencies that a nation buys or sells.buys or sells.

Statistical Discrepancy?Statistical Discrepancy? It is the net result of errors and omissions It is the net result of errors and omissions

on both the credit and debit sides.on both the credit and debit sides. Where do these errors come from?Where do these errors come from?

Under-reporting merchandise importsUnder-reporting merchandise imports Under-reporting investment incomesUnder-reporting investment incomes Under-reporting capital exportsUnder-reporting capital exports Basically, people succeed in hiding their Basically, people succeed in hiding their

imports, foreign investment incomes, capital imports, foreign investment incomes, capital flight from their governments for tax and flight from their governments for tax and other purposes.other purposes.

Account Overview (Level Account Overview (Level 2)2)

Current AccountMerchandise trade

exportsimportsTrade Balance

Servicesmilitary trans. (net)other services, netService Balance

Balance on goods & servicesInvestment income, net

Unilateral transfersUS government grantsUS govt pensions, and other transfersPrivate remittances and other transfersAll transfers, net

Balance on current account

Capital AccountChanges in US assets abroad, net

other US govt assetsUS private assetsAll changes, net

Changes in foreign assets in the US, net foreign private assetsAll changes, net

Changes in holdings of official international reserves, net

Statistical discrepancy

Balance on capital account

Current AccountCurrent Account The difference between the import and The difference between the import and

export of goods is sometimes called export of goods is sometimes called the the balance of merchandise tradebalance of merchandise trade.. Although the popular press often uses this Although the popular press often uses this

measure, the merchandise trade balance measure, the merchandise trade balance is not a good summary because services is not a good summary because services are an important component of trade.are an important component of trade.

The The balance on goods and servicesbalance on goods and services includes trade in services. This includes trade in services. This includes includes visiblevisible and and invisible tradeinvisible trade ..

Current Account, 1970-Current Account, 1970-20022002

-600

-500

-400

-300

-200

-100

0

100

200

1970 1975 1980 1985 1990 1995 2000

Current Account

Goods

Services

Current Account Surplus and Current Account Surplus and DeficitDeficit

A A current account surpluscurrent account surplus means means exports of goods and services, exports of goods and services, investment income and transfers investment income and transfers exceed imports and outflows.exceed imports and outflows.

A A current account deficitcurrent account deficit means means imports of goods and services, and imports of goods and services, and outflows are greater than exports outflows are greater than exports and inflows; must be financed by and inflows; must be financed by borrowing (capital account inflows).borrowing (capital account inflows).

Linkage to NIPA and Linkage to NIPA and the Domestic Economythe Domestic Economy

Current Account (Current Account (CA) CA) surplus equals net surplus equals net foreign investment (foreign investment (IIff

). ). CA = ICA = If f .. If If IIf f > 0, the country has net foreign > 0, the country has net foreign

investment, so the country must be investing investment, so the country must be investing part of its saving abroad, and part of its saving abroad, and S S = = IIdd + + IIff . .

That means That means IIff = = S S – – IIdd . . Recall that Recall that YY = = CC + + IIdd ++ G G + (+ (X X – – MM).). Also, Also, CACA = = XX – – M.M. Domestic Expenditures Domestic Expenditures EE = = CC + + IIdd ++ G G, and , and

Y Y – – EE = = X X – – M M = = CACA CC + + IIdd ++ G G is sometimes referred to as is sometimes referred to as

absorptionabsorption..

Meaning of Overall Meaning of Overall BalanceBalance

The current account and the capital The current account and the capital account measure the private and non-U.S. account measure the private and non-U.S. government supply of and demand for government supply of and demand for dollars. dollars.

Official Settlements BalanceOfficial Settlements Balance:: BB = = CA CA + + KAKA

Because the balance of payments must Because the balance of payments must sum to zero, any imbalance in the official sum to zero, any imbalance in the official settlements balance must be financed settlements balance must be financed (paid for) by official reserves flows:(paid for) by official reserves flows: BB + + OROR = 0 = 0

BOP Surplus and DeficitBOP Surplus and Deficit The The Official Settlements Balance (Official Settlements Balance (B B )) is is

sometimes referred to as the net sum of the sometimes referred to as the net sum of the items items above the lineabove the line or or autonomous autonomous transactionstransactions, and, and

The The Official Reserves TransactionsOfficial Reserves Transactions ((OR OR )) are are referred to as the sum of the items referred to as the sum of the items below below the line, the line, also calledalso called nonautonomousnonautonomous or or accommodating transactionsaccommodating transactions.. When When BB = 0, there is said to be a = 0, there is said to be a BOP BOP

equilibrium, equilibrium, and if and if BB 0, a 0, a BOP disequilibriumBOP disequilibrium.. When When BB > 0, there is said to be a > 0, there is said to be a BOP surplusBOP surplus.. When When BB < 0, there is said to be a < 0, there is said to be a BOP deficitBOP deficit..

BOP Surplus and Deficit BOP Surplus and Deficit (Continued)(Continued)

In terms of the supply and demand In terms of the supply and demand of a nation’s currency, there is:of a nation’s currency, there is: A A balance of payments surplusbalance of payments surplus if quantity if quantity

demanded for a currency exceeds quantity demanded for a currency exceeds quantity supplied, putting supplied, putting upwardupward pressure on the pressure on the value of the nation’s currency.value of the nation’s currency.

A A balance of paymentsbalance of payments deficitdeficit if quantity if quantity supplied of a currency exceeds quantity supplied of a currency exceeds quantity demanded, putting demanded, putting downwarddownward pressure on pressure on the value of the nation’s currency.the value of the nation’s currency.

Official Transactions Official Transactions AccountAccount

Most of the Official Reserves flows are Most of the Official Reserves flows are official interventions by the country’s official interventions by the country’s monetary authorities in the foreign monetary authorities in the foreign exchange markets.exchange markets.

When a government buys its own currency When a government buys its own currency to hold up the currency’s price, we say that to hold up the currency’s price, we say that the government has the government has supported its currencysupported its currency.. It is holding the exchange rate higher than that rate It is holding the exchange rate higher than that rate

otherwise would have been.otherwise would have been. When it sells its currency, it is attempting to When it sells its currency, it is attempting to

depress the value of its currency.depress the value of its currency. It is forcing the exchange rate to be lower than that rate It is forcing the exchange rate to be lower than that rate

would otherwise have been.would otherwise have been.

Official Transactions Official Transactions AccountAccount

Because they are an accounting Because they are an accounting identity, the current, capital, and identity, the current, capital, and official transactions accounts must official transactions accounts must sum to zero—sum to zero—in total, the balance in total, the balance of payments balancesof payments balances..

The supply of currency, including The supply of currency, including government’s, must equal the government’s, must equal the demand for currency, including demand for currency, including government’s.government’s.

1999 Balance of Payments 1999 Balance of Payments AccountsAccounts

1999 Balance of Payments 1999 Balance of Payments AccountsAccounts

Line (Credits +; debits -)/1/ 2000 2001 2002/p/Current account

1 Exports of goods and services and income receipts 1,417,236 1,281,793 1,216,5042 Exports of goods and services 1,064,239 998,022 971,8643 Goods, balance of payments basis/2/ 771,994 718,762 682,5864 Services/3/ 292,245 279,260 289,278

12 Income receipts 352,997 283,771 244,64013 Income receipts on U.S.-owned assets abroad 350,656 281,389 242,17714 Direct investment receipts 149,677 125,996 128,06815 Other private receipts 197,133 151,832 110,76616 U.S. Government receipts 3,846 3,561 3,34317 Compensation of employees 2,341 2,382 2,46318 Imports of goods and services and income payments (1,774,135) (1,625,701) (1,663,908)19 Imports of goods and services (1,442,920) (1,356,312) (1,407,406)20 Goods, balance of payments basis/2/ (1,224,417) (1,145,927) (1,166,939)21 Services/3/ (218,503) (210,385) (240,467)29 Income payments (331,215) (269,389) (256,502)30 Income payments on foreign-owned assets in the United States(323,005) (260,850) (247,601)31 Direct investment payments (60,815) (23,401) (50,121)32 Other private payments (179,217) (156,784) (124,542)33 U.S. Government payments (82,973) (80,665) (72,938)34 Compensation of employees (8,210) (8,539) (8,901)35 Unilateral current transfers, net (53,442) (49,463) (56,023)36 U.S. Government grants/4/ (16,821) (11,628) (16,914)37 U.S. Government pensions and other transfers (4,705) (5,798) (5,131)38 Private remittances and other transfers/6/ (31,916) (32,037) (33,978)

BEA International Transactions DataMay 19, 2003, U.S. International Transactions (Millions)

Capital and financial accountCapital account

39 Capital account transactions, net 837 826 708Financial account

40 U.S.-owned assets abroad, net (increase/financial outflow (-)) (606,489) (370,962) (156,169)41 U.S. official reserve assets, net (290) (4,911) (3,681)46 U.S. Government assets, other than official reserve assets, net (941) (486) 37947 U.S. credits and other long-term assets (5,182) (4,431) (5,213)48 Repayments on U.S. credits and other long-term assets/8/ 4,265 3,873 5,69649 U.S. foreign currency holdings and U.S. short-term assets, net (24) 72 (104)50 U.S. private assets, net (605,258) (365,565) (152,867)55 Foreign-owned assets in the United States, net (increase/financial inflow (+))1,015,986 752,806 630,36456 Foreign official assets in the United States, net 37,640 5,224 96,63057 U.S. Government securities 30,676 31,665 74,01358 U.S. Treasury securities/9/ (10,233) 10,745 43,65659 Other/10/ 40,909 20,920 30,35760 Other U.S. Government liabilities/11/ (1,909) (1,882) 15861 U.S. liabilities reported by U.S. banks, not included elsewhere 5,746 (30,278) 18,83162 Other foreign official assets/12/ 3,127 5,719 3,62863 Other foreign assets in the United States, net 978,346 747,582 533,73464 Direct investment 307,747 130,796 30,11465 U.S. Treasury securities (76,965) (7,670) 53,15566 U.S. securities other than U.S. Treasury securities 455,213 407,653 284,61167 U.S. currency 1,129 23,783 21,51368 U.S. liabilities to unaffiliated foreigners reported by U.S. nonbanking concerns174,251 82,353 49,73669 U.S. liabilities reported by U.S. banks, not included elsewhere 116,971 110,667 94,60570 Statistical discrepancy (sum of above items with sign reversed) 7 10,701 28,524

70a Of which: Seasonal adjustment discrepancy ..... ..... .....

Line (Credits +; debits -)/1/ 2000 2001 2002/p/71 Balance on goods (lines 3 and 20) (452,423) (427,165) (484,353)72 Balance on services (lines 4 and 21) 73,742 68,875 48,81173 Balance on goods and services (lines 2 and 19) (378,681) (358,290) (435,542)74 Balance on income (lines 12 and 29) 21,782 14,382 (11,862)75 Unilateral current transfers, net (line 35) (53,442) (49,463) (56,023)76 Balance on current account (lines 1, 18, and 35 or lines 73, 74, and 75)/13/(410,341) (393,371) (503,427)

Memoranda

Int’l Investment PositionInt’l Investment Position In order to buy U.S. assets foreigners In order to buy U.S. assets foreigners

need dollars, so net capital inflows need dollars, so net capital inflows represent a demand for dollars.represent a demand for dollars. The demand for dollars comes from the The demand for dollars comes from the

demand to buy goods and services and demand to buy goods and services and the demand to buy (capital) assets. the demand to buy (capital) assets.

In the 1980s, the inflow of capital In the 1980s, the inflow of capital into the U.S. greatly exceeded the into the U.S. greatly exceeded the outflow of capital from the U.S., and outflow of capital from the U.S., and this trend has continued into the late this trend has continued into the late 1990s. (1990s. (KAKA > 0, > 0, CACA < 0) < 0)

Int’l Investment Position Int’l Investment Position (continued)(continued)

International Investment Position (IIP)International Investment Position (IIP) is another related balance sheet. It is is another related balance sheet. It is a statement of the a statement of the stocksstocks of a of a nation’s international assets and nation’s international assets and foreign liabilities at a point in time, foreign liabilities at a point in time, usually the end of a year. usually the end of a year.

Any capital flows (related to a current Any capital flows (related to a current account imbalance) creates a change account imbalance) creates a change in the in the IIPIIP..

Int’l Investment Position Int’l Investment Position (continued)(continued)

We say that a nation is a We say that a nation is a lender or a lender or a borrowerborrower depending on whether its depending on whether its current account is in surplus or deficit current account is in surplus or deficit during a time period.during a time period.

We say that a nation is a We say that a nation is a creditor or creditor or debtordebtor depending on whether its net depending on whether its net stock of foreign assets is positive or stock of foreign assets is positive or negative.negative.

The first refers to flows over time, the The first refers to flows over time, the second to stocks at a point in time.second to stocks at a point in time.

Int’l Investment Position Int’l Investment Position (continued)(continued)

Prior to WWI, the U.S. was a net debtor.Prior to WWI, the U.S. was a net debtor. From WWI through 1983, the U.S. was a From WWI through 1983, the U.S. was a

net creditor (the world’s leading creditor).net creditor (the world’s leading creditor). Since 1983, the U.S. has run large current Since 1983, the U.S. has run large current

account deficits, requiring int’l borrowing. account deficits, requiring int’l borrowing. By 1989, the U.S. was a net debtor, and By 1989, the U.S. was a net debtor, and

continues to be so until the present.continues to be so until the present.