Chapter 2

International Flow of Funds

Balance of Payments

a summary of transactions
between domestic and
foreign residents for a
specific country over a
specified period of time
(usually a quarter or a year).

inflows of funds
generate credits ( )
for the countrys
balance
outflows of funds
generate debits ( ).

Current Account

The current account

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

Key components of the current

account include
balance of trade
(exports and imports of
merchandise and service)
factor income (interest &
dividends)
transfer payments (aids, gifts, &
grants).

The U.S. Current Account in 2003

Exhibit 2.2 (in billions of $)
(1) U.S. exports of goods
+(2) U.S. exports of services
+(3) U.S. income receipts

+ $712
+
292
+
275

=(4) Total U.S. exports & income receipts

=$1,279

(5) U.S. imports of goods

+(6) U.S. imports of services
+(7) U.S. income payments

$1,263

246

259

=(8) Total U.S. imports & income payments =$1,768

(9) Net transfers by the U.S.
(10)Current account balance = (4) (8) (9)

$68

$557

Capital Account
The capital account
summarizes the flow of funds
resulting from the sale of
assets between one specified
country and all other
countries.

The key components of the

capital account are
direct foreign investment:
investment in fixed assets in foreign
countries (firm expansion)
portfolio investment: transactions of
long-term financial assets
other capital investment:
transactions of short-term financial
assets

International Trade
Flows

Some countries are more

dependent on trade than others.
The trade volume of a European
country is typically between 30 ~
40% of its GDP
The trade volume of U.S. and Japan
is typically between 10 ~ 20% of
its GDP.

U.S.
Balance
of Trade
Over Time

10

Trade Agreements
Many agreements have been
made to reduce trade restrictions:
1988 U.S. and Canada free trade
pact
North American Free Trade
Agreement (NAFTA)
General Agreement on Tariffs and
Trade (GATT)
Single European Act and the
European Union
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Trade Disagreements
Even without tariffs and quotas,
the strategies that can give
local firms an edge in exporting:
environmental restrictions
labor laws
bribes to large customers
government subsidies (dumping)
tax breaks for specific industries

12

Trade Disagreements
Other trade-related issues
include:
exchange rate manipulations
the outsourcing of services
the use of trade policies for
political reasons
disagreements within the
European Union
13

Factors Affecting
International Trade
Flows
Impact of Inflation
Other things being equal, a
relative increase in a countrys
inflation rate will decrease its
current account, as imports
increase and exports decrease.

14

Impact of National Income

A relative increase in a countrys
income level will decrease its
current account, as imports
increase.

15

Impact of Government
Restrictions
A government may reduce its
countrys imports by imposing a
tariff on imported goods, or by
enforcing a quota.
Some trade restrictions may be
imposed on certain products for
health and safety reasons (
).

16

Impact of Exchange Rates

If a countrys currency begins to
rise in value, its current account
balance will decrease as imports
increase and exports decrease.
Example (p44):
A tennis racket = $100 = C$125
C$1=$0.8
If C$1=0.7
Then the tennis racket =C$143
17

 The factors interact, such that

their simultaneous influence on

the balance of trade is
complex.

18

Correcting
A Balance of Trade
Deficit
If trade deficit exists severely, we
need to increase foreign demand
for our goods and services.
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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Why a Weak Home Currency Is

Not a Perfect Solution
Counterpricing by competitors
Impact of other weak currencies
Prearranged international transactions
The lag time between a weaker U.S.$ and
increased foreign demand has been
estimated to be 18 months or longer.

Stability of intracompany trade

Many firms purchase products that are

produced by their subsidiaries. (more
than 50% of international trades)

20

U.S. Trade Balance

The J-Curve Effect

0

Time

J Curve

Deterioration due to
dollar depreciation

Change in purchasing
power caused by
weaker dollar

21

International Capital
Flows
Factors Affecting DFI
Changes in Restrictions
New opportunities may arise
from the removal of government
barriers. (emerging markets)

Privatization
DFI has also been stimulated by
the selling of government
operations. (emerging markets)
22

Factors Affecting DFI

Potential Economic Growth
Countries that have higher potential
for economic growth are more
attractive. (emerging markets)

Tax Rates
Countries that impose relatively low
tax rates on corporate earnings are
more likely to attract DFI.

23

Factors Affecting DFI

Exchange Rates
Firms typically prefer to invest
in countries where the local
currency is expected to
strengthen against their own.

24

Factors Affecting
International 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.
Borrow from the countries with low
interest rates

25

Exchange Rates
Foreign investors may be
attracted if the local
currency is expected to
strengthen.

26

Agencies that Facilitate

International Flows
(self-study)
International Monetary Fund
(IMF)
A result of Bretton Woods
conference in 1944.
184 member countries
Compensatory financing facility
(CFF)
Special drawing rights (SDRs)
27

World Bank
This International Bank for
Reconstruction and Development makes
loans to countries to enhance their
economic development.
In particular, its Structural Adjustment
Loans (SALs) are intended to enhance a
countrys long-term economic growth.
Funds are spread through cofinancing
agreements with official aid agencies,
export credit agencies, and commercial
banks.
28

Multilateral Investment
Guarantee Agency
Established by the World Bank,
the MIGA helps develop
international trade and
investment by offering various
forms of political risk insurance.

29

World Trade Organization

The WTO was established to
provide a forum for multilateral
trade negotiations and to settle
trade disputes related to the
GATT accord.

30

International Financial
Corporation
The IFC promotes private
enterprise within countries
through loan provisions and
stock purchases.

31

International Development
Association
The IDA extends loans at low interest
rates to poor nations that cannot
qualify for loans from the World Bank.

Bank for International Settlements

The BIS is the central banks central
bank and lender of last resort.

32

Regional development
agencies
Inter-American Development
Bank
Asian Development Bank
African Development Bank
European Bank for Reconstruction
and Development.
33

Dilemma
The helps from those
organizations aim to promote
the global financial stability.
However, some nations may
rely too much on them, so it
may lead to low quality
decision production.
34