International

Finance
International Financial Management by Jeff Madura 13th edition
Chapter 2 : INTERNATIONAL FLOW OF FUNDS

Instructor: Mehnaz Khan

2-1 Balance of Payments

The transactions arising from international business cause money flows from one country to
another.
The balance of payments is a summary of transactions between domestic and foreign
residents for a specific country over a specified period of time. It represents an accounting of
a country’s international transactions for a period, usually a quarter or a year. It accounts for
transactions by businesses, individuals, and the government.

A balance-of-payments statement is composed of :

1. the current account, (for (1) merchandise (goods) and services, (2) primary income, and
(3) secondary income.)
2. the financial account((1) direct foreign investment, (2) portfolio investment, and (3) other
capital investment)
3. the capital account, (financial assets transferred across country borders by people who
move to a different country, or due to sales of patents and trademarks. )
2-1a Current Account
The current account measures the flow of funds between one country and all
other countries due to purchases of goods and services or to income
generated by assets.

• The current account balance measures a country’s savings surplus or deficit

and indicates the financing needs of a country.
• Countries that incur a current account deficit will witness a downward
pressure on their currency to depreciate. (WHY?)

The main components of the current account are payments between two
countries for
(1) merchandise (goods) and services,
(2) primary income, and
(3) secondary income.
1. Payments for Goods and Services (such as smartphones and clothing, that are
transported between countries. Service exports and imports represent tourism and other
services (such as legal, insurance, and consulting services
• The difference between total exports and imports is referred to as the BALANCE OF TRADE.

2. Primary Income Payments

• composed of income earned by MNCs on their DFI (investment in fixed assets in foreign
countries that can be used to conduct business operations), and
• income earned by investors on portfolio investment (investments in foreign securities).
Thus, primary income received by the United States reflects an inflow of funds into the
United States. Primary income paid by the United States to foreign companies or investors
reflects an outflow of funds from the United States.
• Net primary income represents the difference between the primary income receipts and
the primary income payments.

3. Secondary Income (also sometimes referred to as transfer payments), which represents

aid, grants, and gifts from one country to another. Net secondary income represents the
difference between the secondary income receipts and the secondary income payments.
• Every transaction
generating a U.S. cash
inflow (exports and
income receipts by the
United States)
represents a credit to
the current account,
and every transaction
generating a U.S. cash
outflow (imports and
income payments
from the United
States) represents a
debit to the current
account
2-1b Financial Account
The financial account measures the flow of funds between countries that are due to :

(1) direct foreign investment,

(2) portfolio investment, and
(3) other capital investment

• Direct investments are those in which management control is exerted, defined under
U.S. rules as ownership of at least 10% of the equity.

• Government borrowing and lending are included in the balance on financial account.

• The financial account also includes changes in reserve assets, which are holdings of gold
and foreign currencies by official monetary institutions, as well as transactions involving
financial derivatives.
Direct Foreign Investment :

• The financial account keeps track of a country’s payments for new DFI
over a given period (such as a specific quarter or year).

• Payments representing DFI in the United States (such as the acquisition of

a U.S. firm by a non-U.S. firm) are recorded as a positive number in the U.S.
financial account, because funds are flowing into the United States.

• Conversely, payments representing a U.S.-based MNC’s DFI in another

country are recorded as a negative number because funds are being sent
from the United States to another country. Examples of DFI by the United
States include an MNC’s payments to complete its acquisition of a foreign
company, to construct a new manufacturing plant in a foreign country, or
to expand an existing plant in a foreign country
• Portfolio Investment :

• The financial account also keeps track of a country’s payments for new
portfolio investment (investment in financial assets such as stocks or bonds)
over a given period (such as a specific quarter or year). Thus a purchase of
Heineken International (Netherlands) stock by a U.S. investor is classified as
portfolio investment because it represents a purchase of foreign financial
assets without changing control of the company.

• This transaction is recorded as a negative number for the U.S. financial

account (a debit), as it reflects a payment from the United States to another
country. If a U.S. firm purchased all of Heineken’s stock in an acquisition, this
transaction would result in a transfer of control and therefore would be
classified as DFI instead of portfolio investment.
2-1c Capital Account
The capital account measures the flow of funds between one country and all
other countries due to financial assets transferred across country borders by
people who move to a different country, or due to sales of patents and
trademarks.

• The sale of patent rights by a U.S. firm to a Canadian firm is recorded as a positive amount (a
credit) to the U.S. capital account because funds are being received by the United States.

• A U.S. firm’s purchase of patent rights from a Canadian firm is recorded as a negative amount
(a debit) to the U.S. capital account because funds are being sent from the United States

• The financial account items represent very large cash flows between countries, whereas
the capital account items are relatively minor (in terms of dollar amounts) when compared
with the financial account items. Thus the financial account is given much more attention
than the capital account when attempting to understand how a country’s investment
behavior has affected its flow of funds with other countries during a particular period
Understanding the Balance of Payments

Unlike the current account, which theoretically is expected to run at a

surplus or deficit, the BOP should be zero. Thus, the current account on
one side and the capital and financial account on the other should
balance each other out.

For example, if a Greenland national buys a jacket from a Canadian

company, then Greenland gains a jacket while Canada gains the
equivalent amount of currency. To reach zero, a balancing item is added
to the ledger to reflect the value exchange. According to the IMF's Balance
of Payments Manual, the balance of payment formula, or identity, is
summarized as:
Current Account + Financial Account + Capital Account + Balancing
Item = 0
2-2 Growth in International Trade

2-2a Events That Increased Trade Volume

• Fall of the Berlin Wall

• Single European Act
• NAFTA
• GATT (General Agreement on Tariffs and Trade (GATT) accord.)
• The European Union
• Inception of the Euro )In 2002, 11 countries that were members of the EU
adopted the euro as a new currency in place of their local currency)
Impact of Outsourcing on Trade

• The term outsourcing refers to the process of subcontracting to a third party.

• Under this definition, outsourcing increases international trade activity

because it means that MNCs now purchase products or services from another
country. For example, technical support for computer systems used in the
United States is commonly outsourced to India or other countries.

Concept of reshoring: Reshoring is the process of returning the

production and manufacturing of goods back to the company's
original country. Reshoring is also known as onshoring, inshoring,
or backshoring.
Trade Volume between the United States and Other Countries
The dollar value of U.S. exports to various countries during 2015 is shown in Exhibit 2.3, where amounts are
rounded to the nearest billion. For example, exports to Canada were valued at $251 billion
The proportion of total U.S.
exports to various countries is
shown in the upper portion of
Exhibit 2.4. About 19 percent of
all U.S. exports are to Canada
and 16 percent are to Mexico.
The proportion of total U.S.
imports from various countries is
shown in the lower part of
Exhibit 2.4. Canada, China,
Mexico, and Japan are the key
exporters to the United States;
together, they account for more
than half of the value of all U.S.
imports
PAKISTAN’S EXPORT S (2021)
Factors Affecting International Trade Flows

Because international trade can significantly affect a country’s

economy, it is important to identify and monitor the factors that
influence it.

The most influential factors are:

■ cost of labor,
■ inflation,
■ national income,
■ credit conditions,
■ government policies, and
■ exchange rates.
Factors Affecting International Trade Flows

■ cost of labor,: Firms in countries where labor costs are low typically have
an advantage when competing globally, especially in labor-intensive
industries.

■ inflation :If a country’s inflation rate increases relative to the countries

with which it trades, this could cause its exports to decrease (if foreign
customers shift to cheaper alternatives in other countries) and its imports to
increase (if the local individuals and firms shift to cheaper alternatives).
Consequently, an increase in the country’s inflation may cause its current
account to decrease

■ national income: As the real income level (adjusted for inflation) rises, so
Factors Affecting International Trade Flows

■ Credit conditions:
• Credit conditions tend to tighten when economic conditions weaken because
corporations are less able to repay debt. In that case, banks are less willing to provide
financing to MNCs, which can reduce corporate spending and further weaken the
economy.
• As MNCs reduce their spending, they also reduce their demand for imported supplies.
The result is a decline in international trade flows.
• An unfavorable credit environment also may reduce international trade by making it
difficult for some MNCs to obtain the funds needed for purchasing imports.
• Many MNCs that purchase imports rely on LETTERS OF CREDIT, which are issued by
commercial banks on behalf of the importers and consist of a promise to make payment
upon delivery of the imports.
• If banks fear that an MNC will be unable to repay its debt because of weak economic
conditions then they might refuse to provide credit, and such an MNC will be unable to
purchase imports without that credit
Factors Affecting International Trade Flows

■ Exchange Rates:

If a country’s currency begins to rise in value against other currencies then

its current account balance should decrease, other things being equal.

As the currency strengthens, goods exported by that country will become

more expensive to the importing countries and thus the demand for such
goods will decrease
Factors Affecting International Trade Flows

■Government policies: These policies affect the legislating country’s unemployment level,
income level, and economic growth. Each country’s government wants to increase its
exports because more exports lead to more production and income, and may also create
jobs. Moreover, a country’s government generally prefers that its citizens and firms purchase
products and services locally (rather import them) because doing so creates local jobs.

• Restrictions on Imports (TARIFFS and QUOTAS)

• Subsidies for Exporters (The exporting of products that were produced with the
help of government subsidies is commonly referred to as DUMPING. A
government may offer subsidies to its domestic firms so that they can produce
products at a lower cost than their global competitors)
• Restrictions on Piracy (eg. Pirated movies and books reduce income of copyright
owners)
• Environmental Restrictions( increase production costs putting local forms at a
disadvantage compared with firms (in other countries) that are not subject to the
same restrictions)
• Labor Laws: Firms based in countries with more restrictive laws will incur
higher expenses for labor, other factors being equal. For this reason, their
firms may be at a disadvantage when competing against firms based in other
countries

• Business Laws: (Some countries have more restrictive laws on bribery than
others. Firms based in these countries may not be able to compete globally in
some situations)

• Tax Breaks : (The government in some countries may allow tax breaks to firms
that operate in specific industries)
• Country Trade Requirements: (obtaining licenses)

• Government Ownership or Subsidies: (Some governments maintain

ownership in firms that are major exporters. The Chinese government has
granted billions of dollars of subsidies over the years to its auto
manufacturers and auto parts suppliers. The U.S. government bailed out
General Motors in 2009 by investing billions of dollars to purchase a large
amount of its stock)

• Country Security Laws : (Some U.S. politicians have argued that

international trade and foreign ownership should be restricted when U.S.
security is threatened eg. Military equipment etc)

• Policies to Punish Country Governments : eg. Iran

Correcting A Balance of Trade Deficit

The difference between total exports and imports is referred to as the

BALANCE OF TRADE.

• By reconsidering the factors that affect the balance of trade, some common
correction methods can be developed.

• 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.

Trade deficit ---imports > exports

Imports high … pay in usd…. Selling rs.. Buying usd… supply of Rs in
international exchange markets. Rs. surplus .. Rs. Devalued
Currency devalues/weak …. Exports increase
How Exchange Rates May Correct a Balance-of-Trade Deficit

A balance-of-trade deficit suggests that:

spending on foreign products > receiving from exports to foreign countries.

This exchange of its currency (to buy foreign goods) in greater volume than the foreign
demand for its currency could place downward pressure on the value of that currency. Once
the country’s home currency’s value declines in response to these forces, the result should be
more foreign demand for its products

Why Exchange Rates May Not Correct a Balance-of-Trade Deficit ?

A floating exchange rate will not correct any international trade imbalances when there are
other forces that offset the effects of international trade flows on the exchange rate.
Eg. United States normally experiences a large balance-of-trade deficit, international trade
flows should place downward pressure on the dollar’s value, but more financial flows into the
United States (e.g., to purchase securities) than there are financial outflows. These forces
offset the downward pressure on the dollar’s value caused by the trade imbalance.
Limitations of a Weak–Home Currency Solution
Even if a country’s home currency weakens, there are several reasons why its
balance-of-trade deficit will not necessarily be corrected.

1. When a country’s currency weakens, its prices become more attractive to foreign
customers; hence many foreign companies lower their prices to remain
competitive.
2. A country’s currency need not weaken against all currencies at the same time.
Therefore, a country that has a balance-of-trade deficit with many countries is
unlikely to reduce all deficits simultaneously.
3. Many international trade transactions are prearranged and cannot be
immediately adjusted. Thus exporters and importers are committed to following
through on the international transactions that they agreed to complete.
4. A weak currency is less likely to improve the country’s balance of trade to the
extent that its international trade involves importers and exporters under the
same ownership. Many firms purchase products that are produced by their
subsidiaries in what is known as intracompany trade.
J-curve effect
• The lag time between
weakness in the dollar and
increased non-U.S. demand
for U.S. products has been
estimated to be 18 months
or even longer.
• The U.S. balance-of-trade
deficit could deteriorate
even further in the short
run when the dollar is weak
because U.S. importers then
need more dollars to pay
for the imports they have
contracted to purchase.
Factors Affecting DFI

• Restrictions

• Privatization

• Economic Growth

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

• Exchange Rates:Firms typically prefer to invest in countries where the

local currency is expected to strengthen against their own
Factors Affecting International Portfolio Investment

• Tax Rates on Interest or Dividends: Investors normally prefer countries

where the tax rates are relatively low.

• Interest Rates : • “Hot Money” tends to flow to countries with high

interest rates

• Exchange Rates:Inflow of foreign investment increases when the

domestic currency is expected to strengthen.
Agencies That Facilitate International Flows:

International Monetary Fund

World Bank

World Trade Organization

International Finance Corporation

International Development Association

The Organisation for Economic Co-operation and Development (OECD)

Regional Development Agencies eg. Asian development bank