International Financial Management

by Jeff Madura

1
 2 International Flow of Funds
Chapter Objectives

 Explain the key components of the balance of payments,

 Explain the growth in international trade activity over time,
 Explain how international trade flows are influenced by
economic factors and other factors,
 Explain how international capital flows are influenced by
country characteristics,
 Introduce the agencies that facilitate the international flow
of funds.

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 Balance of Payments

Definition:
Summary of transactions between domestic and
foreign residents for a specific country over a
specified period of time.

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 Balance of Payments

Components of the Balance of Payments Statement:

a. Current Account: summary of flow of funds due to
purchases of goods or services or the provision of income
on financial assets.
A current account deficit suggests a greater outflow of funds
from the specified country for its current transactions.
The current account is commonly used to assess the balance of
trade, which is simply the difference between merchandise
exports and merchandise imports.

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 Current Account

1. Payments for merchandise and services

Merchandise exports and imports represent tangible
products that are transported between countries. Service
exports and imports represent tourism and other services.
The difference between total exports and imports is referred
to as the balance of trade.
2. Factor income payments
Represents income (interest and dividend payments)
received by investors on foreign investments in financial
assets (securities).
3. Transfer payments
Represent aid, grants, and gifts from one country to another.

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 Exhibit 2.1 Examples of Current Account Transactions

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 Exhibit 2.2 Summary of Current Account in the year
2010 (in billions of $)

http://www.tradingeconomics.com/pakistan/current-account

http://www.tradingeconomics.com/pakistan/net-capital-account-bo
p-us-dollar-wb-data.html
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 Capital and Financial Accounts

Capital Account: summary of flow of funds resulting from the sale

of assets between one specified country and all other countries
over a specified period of time.
Financial Account:
1. Direct foreign investment
Investments in fixed assets in foreign countries
2. Portfolio investment
Transactions involving long term financial assets (such as
stocks and bonds) between countries that do not affect the
transfer of control.
3. Other capital investment
Transactions involving short-term financial assets (such as
money market securities) between countries.
4. Errors and omissions
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Measurement errors can occur when attempting to measure the
 Balance of Payments – Pakistan

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 Growth in International Trade

1. Events That Increased Trade Volume

2. Impact of Outsourcing

3. Trade Volume among Countries

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 Events That Increased Trade Volume

1. Removal of the Berlin Wall: Led to reductions in trade

barriers in Eastern Europe.

2. Single European Act of 1987: Improved access to

supplies from firms in other European countries.

3. North American Free Trade Agreement

(NAFTA): Allowed U.S. firms to penetrate product and
labor markets that previously had not been accessible.

4. General Agreement on Tariffs and Trade

(GATT): Called for the reduction or elimination of trade
restrictions in 1993 on specified imported goods over a 10-year
period across 117 countries.
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 Events That Increased Trade Volume (cont.)

5. Inception of the Euro: Reduced costs and risks

associated with converting one currency to another.

6. Expansion of the European Union: reduced

restrictions on trade with Western Europe.

7. Other Trade Agreements: The United States has

established trade agreements with many other countries.

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 Impact of Outsourcing on Trade

1. Definition of Outsourcing: The process of

subcontracting to a third party in another country to
provide supplies or services that were previously
produced internally.
2. Impact of outsourcing:
1. Increased international trade activity because MNCs now
purchase products or services from another country.
2. Lower cost of operations and job creation in countries with
low wages.
3. Criticism of outsourcing:
1. Outsourcing may reduce jobs in the United States.
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 Managerial Decisions About Outsourcing

1. Managers of a U.S.–based MNC may argue that

they create jobs for U.S. workers.
2. Shareholders may suggest that the managers are not
maximizing the MNC’s value as a result of their
commitment to creating U.S. jobs.
3. Managers should consider the potential savings that
could occur as a result of outsourcing.
4. Managers must also consider the possible bad
publicity or bad morale that could occur among the
U.S. workers.
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 Trade Volume Among Countries

1. The annual international trade volume of the United

States is between 10 and 20 percent of its annual
GDP.
2. Trade volume between the United States and Other
Countries:
1. About 20 percent of all U.S. exports are to Canada,
while 13 percent are to Mexico.
2. Canada, China, Mexico, and Japan are the key
exporters to the United States. Together, they are
responsible for more than half of the value of all U.S.
imports.
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 Exhibit 2.3 Distributions of U.S. Exports Across
Countries (in billions of $)

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 Exhibit 2.4 2008 Distribution of U.S. Exports and
Imports

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17
 Distributions of Pakistan Exports Across Countries

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 Distributions of Pakistan Exports Across Countries

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 Trend in U.S. Balance of Trade

1. The U.S. balance of trade deficit increased

substantially from 1997 until 2008.
2. In the 2008–2009 period, U.S. economic
conditions weakened and the U.S. demand for
foreign products and services decreased.
3. In recent years, the U.S. annual balance of trade
deficit with China has exceeded $200 billion.
4. Any country’s balance of trade can change
substantially over time.

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 Exhibit 2.5 U.S. Balance of Trade Over Time
(Quarterly)

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 Factors Affecting International Trade Flows

1. Cost of Labor: Firms in countries where labor costs

are low commonly have an advantage when
competing globally, especially in labor intensive
industries
2. Inflation: Current account decreases if inflation
increases relative to trade partners.
3. National Income: Current account decreases if
national income increases relative to other
countries.

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 Factors Affecting International Trade Flows (cont.)

4. Government Policies: can increase imports through:

a. Restrictions on imports
b. Subsidies for exporters
c. Lack of Restriction on piracy
d. Environmental restrictions
e. Labor laws
f. Tax breaks
g. Country security laws

5. Exchange Rates: current account decreases if

currency appreciates relative to other currencies.

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 Impact of Government Policies

1. Restrictions on Imports: Taxes (tariffs) on imported goods

increase prices and limit consumption. Quotas limit the
volume of imports.
2. Subsidies for Exporters: Government subsidies help firms
produce at a lower cost than their global competitors.
3. Restrictions on Piracy: A government can affect
international trade flows by its lack of restrictions on
piracy.
4. Environmental Restrictions: Environmental restrictions
impose higher costs on local firms, placing them at a global
disadvantage compared to firms in other countries that are
not subject to the same restrictions.
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 Impact of Government Policies (cont.)

5. Labor Laws: countries with more restrictive laws will

incur higher expenses for labor, other factors being
equal.
6. Business Laws: Firms in countries with more restrictive
bribery laws may not be able to compete globally in
some situations.
7. Tax Breaks: Though not necessarily a subsidy, but still a
form of government financial support that might benefit
many firms that export products.
8. Country Security Laws: Governments may impose
certain restrictions when national security is a concern,
which can affect on trade.
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 Impact of Exchange Rates

 How exchange rates may correct a balance of trade

deficit:
When a home currency is exchanged for a foreign currency
to buy foreign goods, then the home currency faces
downward pressure, leading to increased foreign demand for
the country’s products.
 Why exchange rates may not correct a balance of
trade deficit:
Exchange rates will not automatically correct any
international trade balances when other forces are at work.

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 Limitations of a Weak Home Currency Solution

1. Competition: foreign companies may lower their prices to

remain competitive.
2. Impact of other currencies: a country that has balance of
trade deficit with many countries is not likely to solve all
deficits simultaneously.
3. 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.
4. Intracompany trade: Many firms purchase products that are
produced by their subsidiaries. These transactions are not
necessarily affected by currency fluctuations.

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 Exhibit 2.6 J-Curve Effect

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 Friction Regarding Exchange Rates

1. All governments cannot weaken their home

currencies simultaneously.
2. Actions by one government to weaken its currency
causes another country’s currency to strengthen.
3. Government attempts to influence exchange rates
can lead to international disputes.

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 Factors Affecting International Capital Flows

1. Factors Affecting DFI

2. Factors Affecting Portfolio Investment

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 Factors Affecting Direct Foreign Investing (DFI)

1. Changes in Restrictions
 New opportunities have arisen from the
removal of government barriers.
2. Privatization
 DFI is stimulated by new business opportunities
associated with privatization.
 Managers of privately owned businesses are
motivated to ensure profitability, further
stimulating DFI.

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 Factors Affecting Direct Foreign Investing (DFI)
(Cont.)

4. Potential Economic Growth

 Countries with greater potential for economic
growth are more likely to attract DFI.
5. Tax Rates
 Countries that impose relatively low tax rates on
corporate earnings are more likely to attract DFI.
6. Exchange Rates
 Firms typically prefer to pursue DFI in countries
where the local currency is expected to strengthen
against their own.

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 Factors Affecting International Portfolio Investment

1. Tax Rate on Interest or Dividends

Investors normally prefer to invest in a country where taxes
are relatively low.
2. Interest Rates
Money tends to flow to countries with high interest rates, as
long as the local currencies are not expected to weaken.
3. Exchange Rates
Investors are attracted to a currency that is expected to
strengthen.

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 Impact of International Capital Flows

1. The United States relies heavily on foreign

investment in:
 U.S. manufacturing plants, offices, and other
buildings.
 Debt securities issued by U.S. firms.
 U.S. Treasury debt securities
2. Foreign investors are especially attracted to the U.S.
financial markets when the interest rate in their home
country is substantially lower than that in the United
States.

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 Exhibit 2.7 Impact of the International Flow of Funds on U.S.
Interest Rates and Business Investment in the United States

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 Agencies that Facilitate International Flows
International Monetary Fund (IMF)

1. Major Objectives of the IMF

i. Established in 1946 – 183 members
ii. promote cooperation among countries on international
monetary issues,
iii. promote stability in exchange rates
iv. provide temporary funds to member countries attempting
to correct imbalances of international payments
v. promote free mobility of capital funds across countries
vi. promote free trade. It is clear from these objectives that
the IMF’s goals encourage increased internationalization
of business
2. Its compensatory financing facility (CFF) attempts to
reduce the impact of export instability on countries.
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3. Financing is measured in special drawing rights (SDRs)
 Agencies that Facilitate International Flows
International Monetary Fund (IMF)
• The value of the SDR was initially defined as equivalent to 0.888671
grams of fine gold—which, at the time, was also equivalent to 1 US$
• After the collapse of the Bretton Woods system in 1973, the SDR was
redefined as a basket of currencies.
• The basket composition is reviewed every five years by the Executive
Board -- 2015
• The weights (%) assigned to the currencies in the SDR basket are as
follows:

Currency 2001 2016

U.S. dollar 45 41.73
Euro 29 30.93
Japanese yen 15 8.33
Pound sterling 11 8.09
China Renminbi* 10.92
37 *was included from 01 Oct 2016
 Agencies that Facilitate International Flows
World Bank Group

1. Established in 1944 – 183 members

2. Major Objective- Make loans to countries to enhance
economic development.
3. Structural Adjustment Loans (SALs) are intended to
enhance a country’s long-term economic growth.
4. Funds are distributed through co-financing agreements:
 Official aid agencies
 Export credit agencies
 Commercial banks
5. Five organizations - IBRD, IDA, IFC, MIGA and ICSID

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 Agencies that Facilitate International Flows
World Bank Group

1. IBRD: International Bank for Reconstruction and Development

• 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.
• The IBRD is not a profit-maximizing organization.
Nevertheless, it has earned a net income every year since 1948.
• It may spread its funds by entering into co-financing
agreements with official aid agencies, export credit agencies,
as well as commercial banks.

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 Agencies that Facilitate International Flows
World Bank Group

2. IDA: International Development Association

• IDA was set up in 1960 as an agency that lends to the very poor
developing nations on highly concessional terms 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.
3. IFC: International Finance Corporation
• The IFC was set up in 1956 to promote sustainable private
sector investment in developing 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.
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 Agencies that Facilitate International Flows
World Bank Group

4. MIGA: Multilateral Investment Guarantee Agency

• The MIGA was created in 1988 to promote FDI in emerging
economies, by
• offering political risk insurance to investors and lenders; and
• helping developing countries attract and retain private
investment.
5. ICSID: International Centre for Settlement of Investment
Disputes
• The ICSID was created in 1966 to facilitate the settlement of
investment disputes between governments and foreign
investors, thereby helping to promote increased flows of
international investment.

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Online Application
 Agencies that Facilitate International Flows
World Trade Organization (WTO)

1. Created in 1995, the WTO is the successor to the General

Agreement on Tariffs and Trade (GATT).
2. It deals with the global rules of trade between nations to
ensure that trade flows smoothly, predictably and freely.
3. At the heart of the WTO's multilateral trading system are its
trade agreements.
4. Major Objective - Provide a forum for multilateral trade
negotiations and to settle trade disputes related to the GATT
accord.
5. Member countries are given voting rights that are used to
make judgments about trade disputes and other issues.

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 Agencies that Facilitate International Flows
World Trade Organization (WTO)

• 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.

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 Agencies that Facilitate International Flows
Bank for International Settlements (BIS)

1. Established in 1930
2. Major Objectives - facilitate cooperation among
countries with regard to international transactions in
pursuit of monetary and financial stability.
3. Provides assistance to countries experiencing a
financial crisis.
4. Sometimes referred to as the “central banks’
central bank” or the “lender of last resort.”

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 Agencies that Facilitate International Flows
Organization for Economic Cooperation and Development (OECD)

1. Major Objective - Facilitate governance in

governments and corporations of countries with
market economics.
2. It has 30 member countries and has relationships
with numerous countries.
3. Promotes international country relationships that
lead to globalization.

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 Agencies that Facilitate International Flows
Regional Development Agencies

1. Inter-American Development Bank: focusing on the

needs of Latin America
2. Asian Development Bank: established to enhance
social and economic development in Asia
3. African Development Bank: focusing on
development in African countries
4. European Bank for Reconstruction and
Development: created in 1990 to help the Eastern
European countries adjust from communism to
capitalism.
47 5. Islamic Development Bank
Impact of International Trade on an MNC’s Value

National Income in Foreign Countries Inflation in Foreign Countries

Trade Agreements Exchange Rate Movements

m 
n 

E  CFj , t   E ER j , t   
 j 1 
Value =   
t =1  1  k  t

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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
 SUMMARY

 The key components of the balance of payments are the

current account and the capital account. Current account -
broad measure of the country’s international trade balance.
Capital account - measure of the country’s long-term and
short-term capital investments.
 International trade activity has grown over time.
Outsourcing, subcontracting with a third party in a foreign
country for supplies or services they previously produced
themselves, has increased. Thus increasing international trade
activity.
 A country’s international trade flows are affected by inflation,
national income, government restrictions, and exchange rates.

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 SUMMARY (Cont.)

 A country’s international capital flows are affected by any

factors that influence direct foreign investment or portfolio
investment. Direct foreign investment tends to occur in those
countries that have no restrictions and much potential for
economic growth. Portfolio investment tends to occur in those
countries where taxes are not excessive, where interest rates
are high, and where the local currencies are not expected to
weaken.
 Several agencies facilitate the international flow of funds by
promoting international trade and finance, providing loans to
enhance global economic development, settling trade disputes
between countries, and promoting global business
relationships between countries.
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