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International Flow of Funds

2

Chapter

South-Western/Thomson Learning 2003

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Chapter Objectives

To explain the key components of thebalance of payments; and

To explain how the international flow offunds is influenced by economic factors

and other factors.

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Balance of Payments

The balance of paymentsis ameasurement of all transactions between

domestic and foreign residents over a

specified period of time.

Each transaction is recorded as both acredit and a debit, i.e. double-entry

bookkeeping. The transactions are presented in three

groups a current account, a capital

account, and a financial account.

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The current accountsummarizes the flow offunds between one specified country and all

other countries due to the purchases of

goods or services, the provision of income

on financial assets, or unilateral current

transfers (e.g. government grants and

pensions, private remittances). A current account deficitsuggests a greater

outflow of funds from the specified country

for its currenttransactions.

Balance of Payments

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The current account is commonly used toassess the balance of trade, which is simply

the difference between merchandise exports

and merchandise imports.

Balance of Payments

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The new capital account(as defined in the1993 System of National Accountsand the

fifth edition of IMFs Balance of PaymentsManual) is adopted by the U.S. in 1999.

It includes unilateral current transfers thatare really shifts in assets, not current

income. E.g. debt forgiveness, transfers

by immigrants, the sale or purchase of

rights to natural resources or patents.

Balance of Payments

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The financial account(which was calledthe capital account previously)

summarizes the flow of funds resultingfrom the sale of assets between one

specified country and all other countries.

Assets include official reserves, othergovernment assets, direct foreign

investments, investments in securities,

etc.

Balance of Payments

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Different countries rely on trade todifferent extents.

The trade volume of European countries istypically between 30 40% of their

respective GDP, while the trade volume of

U.S. and Japan is typically between 10

20% of their respective GDP.

Nevertheless, the volume of trade hasgrown over time for most countries.

International Trade Flows

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In 1975, the U.S. exported $107.1 billionsin goods, and imported $98.2 billions.

Since then, international trade has grown,with U.S. exports and imports of goods

valued at $773.3 and $1,222.8 billions

respectively for the year of 2000.

Since 1976, the value of U.S. imports hasexceeded the value of U.S. exports,

causing a balance of trade deficit.

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Recent Changes in North American Trade In 1998, a 1989 free trade pact between

U.S. and Canada was fully phased in. Passed in 1993, the North American Free

Trade Agreement (NAFTA) removes

numerous trade restrictions among

Canada, Mexico, and the U.S.

In 2001, trade negotiations were initiated

for a free trade area of the Americas. 34

countries are involved.


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Recent Changes in European Trade The Single European Act of 1987 was

implemented to remove explicit and implicittrade barriers among European countries.

Consumers in Eastern Europe now have

more freedom to purchase imported goods.

The single currency system implemented

in 1999 eliminated the need to convert

currencies among participating countries.


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Trade Agreements Around the World In 1993, a General Agreement on Tariffs

and Trade (GATT) accord calling for lowertariffs was made among 117 countries.

Other trade agreements include:

- Association of Southeast Asian Nations- European Community- Central American Common Market- North American Free Trade Agreement


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Friction Surrounding Trade Agreements Trade agreements are sometimes broken

when one country is harmed by anothercountrys actions.

Dumpingrefers 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.


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Factors Affecting

International Trade Flows Inflation

A relative increase in a countrys inflation

rate will decrease its current account, asimports increase and exports decrease.

National IncomeA relative increase in a countrys incomelevel will decrease its current account, as

imports increase.

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Government Restrictions A government may reduce its countrys

imports by imposing tariffs on importedgoods, or by enforcing a quota. Note that

other countries may retaliate by imposing

their own trade restrictions.

Sometimes though, trade restrictions may

be imposed on certain products for health

and safety reasons.

Factors Affecting


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Exchange Rates If a countrys currency begins to rise in

value, its current account balance willdecrease as imports increase and exports

decrease.

Note that the factors are interactive, suchthat their simultaneous influence on the

balance of trade is a complex one.

Factors Affecting


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Correcting

A Balance of Trade Deficit By reconsidering the factors that affect

the balance of trade, some common

correction methods can be developed. For example, a floating exchange rate

system may correct a trade imbalance

automatically since the trade imbalance

will affect the demand and supply of the

currencies involved.

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However, a weak home currency may notnecessarily improve a trade deficit.

Foreign companies may lower their pricesto maintain their competitiveness.

Some other currencies may weaken too.

Many trade transactions are prearranged

and cannot be adjusted immediately. This

is known as the J-curve effect.

The impact of exchange rate movements

on intracompany tradeis limited.

Correcting

A Balance of Trade Deficit

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Capital flows usually represent portfolioinvestment or direct foreign investment.

The DFI positions inside and outside theU.S. have risen substantially over time,

indicating increasing globalization.

In particular, both DFI positions increasedduring periods of strong economicgrowth.

International Capital Flows

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Factors Affecting DFI

Changes in Restrictions New opportunities may arise from the

removal of government barriers. Privatization

DFI has also been stimulated by the selling

of government operations.

Potential Economic Growth Countries with higher potential economic

growth are more likely to attract DFI.

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Tax Rates Countries that impose relatively low tax

rates on corporate earnings are more likelyto attract DFI.

Exchange Rates Firms will typically prefer to invest their

funds in a country when that countrys

currency is expected to strengthen.


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Factors AffectingInternational Portfolio Investment

Tax Rates on Interest or Dividends Investors will normally prefer countries

where the tax rates are relatively low. Interest Rates

Money tends to flow to countries with high

interest rates.

Exchange Rates Foreign investors may be attracted if the

local currency is expected to strengthen.

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International Monetary Fund (IMF)

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.

Agencies that Facilitate

International Flows

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In particular, its compensatory financingfacilityattempts to reduce the impact of

export instability on country economies. The IMF uses a quotasystem, and its unit

of account is the SDR (special drawing

right).


International FlowsInternational Monetary Fund (IMF)

Its operations involve surveillance, and

financial and technical assistance.

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The weights assigned to the currencies in

the SDR basket are as follows:

Currency 2001 Revision 1996 Revision

U.S. dollar 45 39Euro 29

Deutsche mark 21French franc 11

Japanese yen 15 18Pound sterling 11 11

International Monetary Fund (IMF)


International Flows

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World Bank Group

Established in 1944, the Group assists

development with the primary focus ofhelping the poorest people and the

poorest countries.

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


International Flows

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IBRD: International Bank for Reconstruction

and Development

Better known as the World Bank, the IBRDprovides loans and development

assistance to middle-income countries

and creditworthy poorer countries.

In particular, its structural adjustmentloansare intended to enhance a countrys

long-term economic growth.


International Flows

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It may spread its funds by entering intocofinancing agreementswith official aidagencies, export credit agencies, as well

as commercial banks.


International FlowsIBRD: International Bank for Reconstruction

and Development

The IBRD is not a profit-maximizingorganization. Nevertheless, it has earned a

net income every year since 1948.

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IDA: International Development Association

IDA was set up in 1960 as an agency that

lends to the very poor developing nationson highly concessional terms.

IDA lends only to those countries that lack

the financial ability to borrow from IBRD. IBRD and IDA are run on the same lines,

sharing the same staff, headquarters and

project evaluation standards.


International Flows

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IFC: International Finance Corporation

The IFC was set up in 1956 to promote

sustainable private sector investment indeveloping countries, by

financing private sector projects;

helping to mobilize financing in the

international financial markets; and

providing advice and technical assistance

to businesses and governments.


International Flows

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MIGA: Multilateral Investment Guarantee

Agency

The MIGA was created in 1988 to promoteFDI in emerging economies, by

offering political risk insurance to investors

and lenders; and

helping developing countries attract and

retain private investment.


International Flows

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ICSID: International Centre for Settlement of

Investment Disputes

The ICSID was created in 1966 to facilitatethe settlement of investment disputes

between governments and foreign

investors, thereby helping to promote

increased flows of international

investment.


International Flows

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World Trade Organization (WTO)

Created in 1995, the WTO is the successor

to the General Agreement on Tariffs andTrade (GATT).

It deals with the global rules of trade

between nations to ensure that trade flowssmoothly, predictably and freely.

At the heart of the WTO's multilateraltrading systemare its trade agreements.


International Flows

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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; and

cooperating with other international groups.


International FlowsWorld Trade Organization (WTO)

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Bank for International Settlements (BIS)

Set up in 1930, the BIS is an international

organization that fosters cooperationamong central banks and other agencies

in pursuit of monetary and financial

stability.

It is the central banks central bank andlender of last resort.


International Flows

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The BIS functions as:

a forum for international monetary andfinancial cooperation;

a bank for central banks;

a center for monetary and economicresearch; and

an agent or trustee in connection with

international financial operations.

Agencies that FacilitateInternational Flows


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Regional Development Agencies

Agencies with more regional objectives

relating to economic development include the Inter-American Development Bank;

the Asian Development Bank;

the African Development Bank; and

the European Bank for Reconstruction and

Development.

Agencies that FacilitateInternational Flows

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Impact of International Trade on an MNCs Value

n

tt

m

j

tjtj

k1=

1

,,

1

ERECFE=Value

E (CFj,t) = expected cash flows in currencyjto be receivedby the U.S. parent at the end of period t

E (ERj,t) = expected exchange rate at which currencyjcanbe converted to dollars at the end of period t

k = weighted average cost of capital of the parent

Exchange Rate Movements

Inflation in Foreign CountriesNational Income in Foreign Countries

Trade Agreements

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Balance of Payments Current, Capital, and Financial Accounts

International Trade Flows Recent Changes in North American and

European Trade

Trade Agreements Around the World

Chapter Review

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Chapter Review

Factors Affecting International TradeFlows

Inflation National Income

Government Restrictions

Exchange Rates

Interaction of Factors

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Chapter Review

Correcting a Balance of Trade Deficit Why a Weak Home Currency is Not A

Perfect Solution International Capital Flows


Factors Affecting International Portfolio

Investment

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Chapter Review

Agencies that Facilitate InternationalFlows

International Monetary Fund (IMF) World Bank Group

World Trade Organization (WTO)


Regional Development Agencies

How International Trade Affects an MNCsValue

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