Ch. 2 International Flow of Funds. Balance of Payments. Current Account
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1 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. 1
2 Sample Current Account Transactions Exports, Imports & Trade Balance Service Exports & Imports 2
3 Travel (for all purposes including education) 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. 3
4 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. 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 11 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. 4
5 J-Curve Effect Capital Account The new capital account is adopted by the U.S. in 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. 5
6 Financial Account Financial Account Distribution of Global FDI 6
7 Factors Affecting FDI Changes in Restrictions Privatization Potential Economic Growth Tax Rates Exchange Rates 19 Factors Affecting International Portfolio Investment Tax rates on Interest or Dividends Interest Rates Exchange Rates 20 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 I G X M = consumption spending = capital investment spending = government spending = exports of goods and services = imports of goods and services X M = Current account balance 7
8 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 International Monetary Fund 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. World Bank Group 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. 8
9 World Trade Organization 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 Impact of Int l Trade on an MNC s Value National Income in Foreign Countries Inflation in Foreign Countries Trade Agreements Exchange Rate Movements Value = [ ( ) ( )] m E CF n j, t E ER j, t j= 1 t t= 1 ( 1 + k ) E (CF j,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ER j,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 9
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