International Flow of Funds CHAPTER 2 International Flow of Funds ©2000 South-Western College Publishing 1

Chapter Objectives To explain the key components of the balance of payments; and To explain how the international flow of funds is influenced by economic factors and other factors.

Balance of Payments The balance of payments is a measurement of all transactions between domestic and foreign residents over a specified period of time. The recording of transactions is done by double-entry bookkeeping. The balance-of-payments statement can be broken down into various components, the chief ones being the current account and the capital account.

Balance of Payments The current account represents a summary of the flow of funds between one specified country and all other countries due to the purchases of goods or services, or the provision of income on financial assets, over a specified period of time. The current account is commonly used to assess the balance of trade, which is the difference between merchandise exports and merchandise imports.

Balance of Payments The capital account represents a summary of the flow of funds resulting from the sale of assets between one specified country and all other countries over a specified period of time. Assets include direct foreign investments, portfolio investments, as well as other capital investments.

Leading exporters and importers - 2000 (www.wto.org)

International Trade Flows Friction Surrounding Trade Agreements 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.

Factors Affecting International Trade Flows Inflation A relative increase in a country’s inflation rate will decrease its current account. National Income A relative increase in a country’s income level will decrease its current account.

Factors Affecting International Trade Flows Government Restrictions An increase in the tariffs on imported goods will increase the country’s current account. A government can also reduce its country’s imports by enforcing a quota. Exchange Rates If a country’s currency begins to rise in value, its current account balance will decrease. Note that the factors are interactive, such that their simultaneous influence is complex.

Correcting a Balance of Trade Deficit By reconsidering the factors that affect the balance of trade, some common correction methods can be developed. However, a weak home currency may not necessarily improve a trade deficit due to: revised pricing policy by foreign competition, weakening of some other currencies, trade prearrangements (J curve effect), and intracompany trade.

International Capital Flows Capital flows usually represent direct foreign investment or portfolio investment. The DFI positions in the U.S. and outside the U.S. have risen substantially over time, indicating increasing globalization. DFI by U.S. firms are mainly targeted at the United Kingdom and Canada, while much of the DFI in the U.S. comes from the United Kingdom, Japan, the Netherlands, Germany, and Canada.

DFI Flows

Inflows by region

FDI Sources - 2000

Factors Affecting DFI Changes in Restrictions New opportunities may arise from the removal of government barriers. Privatization DFI has also been stimulated by the movement toward free enterprise. Potential Economic Growth Countries that have more potential economic growth are more likely to attract DFI.

Factors Affecting DFI Tax Rates Countries that impose relatively low tax rates on corporate earnings are more likely to attract DFI. Exchange Rates Firms will typically prefer DFI in countries where the local currency strengthens against their own.

Factors Affecting International Portfolio Investment Tax Rates on Interest or Dividends Investors assess their potential after-tax earnings from investments in foreign securities. Interest Rates Money tends to flow to countries with high interest rates. Exchange Rates If a country’s home currency is expected to strengthen, foreign investors may be attracted.

Agencies that Facilitate International Flows International Monetary Fund (IMF) IMF goals encourage increased internationalization of business. Its compensatory financing facility attempts to reduce the impact of export instability on country economies. Financing by the IMF is measured in special drawing rights.

Agencies that Facilitate International Flows World Bank The primary objective of the profit-oriented bank is to make loans to countries in order to enhance economic development. The World Bank may spread its funds by entering into cofinancing agreements. A recently established agency offers various forms of political risk insurance.

Agencies that Facilitate International Flows World Trade Organization This was established to provide a forum for multilateral trade negotiations and to settle trade disputes related to the GATT accord. International Financial Corporation (IFC) The IFC promotes private enterprise within countries through loans and stock purchases. International Development Association (IDA) The “World Bank” for less prosperous nations.

Agencies that Facilitate International Flows Bank for International Settlements (BIS) The BIS facilitates international transactions among countries. It is the “central banks’ central bank” and the “lender of last resort.” Regional Development Agencies These agencies, such as the Inter-American Development Bank and the Asian Development Bank, have regional objectives relating to economic development.

Impact of International Trade on an MNC’s Value Trade Agreements Inflation in Foreign Countries Exchange Rate Movements National Income in Foreign Countries E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = the weighted average cost of capital of the U.S. parent

Chapter Review Balance of Payments Current Account ¤ Capital Account International Trade Flows World trade flows Trade Agreements Around the World Friction Surrounding Trade Agreements

Chapter Review Factors Affecting International Trade Flows Inflation ¤ Government Restrictions National Income ¤ Exchange Rates Correcting a Balance of Trade Deficit Why a Weak Home Currency is Not a Perfect Solution International Capital Flows Distribution of DFI by U.S. Firms and in the U.S. Factors Affecting DFI Factors Affecting International Portfolio Investment

Chapter Review Agencies that Facilitate International Flows International Monetary Fund World Bank World Trade Organization International Financial Corporation International Development Association Bank for International Settlements Regional Development Agencies How International Trade Affects an MNC’s Value