INTERNATIONAL

FINANCE
Jeff Madura
10th Edition
Chapter 2
International Flow of Funds

1 Prepared By: NASIR ABBAS (Lecturer)

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 Chapter Objectives:
To explain the key components of the
balance of payments,
To explain how the international trade
flows are influenced by economic factors
and other factors,
Explain how international capital flows
are influenced by country
characteristics.

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 Balance of Payments:
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.
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 Balance of Payments:
A balance-of-payments statement can be
broken down into various components.
Those that receive the most attention are
the current account and the capital
account.
The current account represents a
summary of 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.
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 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.
 It compares the new foreign investments made by a
country with the foreign investments within a
country over a particular time period. Transactions
that reflect inflows of funds generate positive
numbers (credits) for the country’s balance, while
transactions that reflect outflows of funds generate
negative numbers (debits) for the country’s balance.

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 Current Account:
The main components of the current
account are payments for
(1) merchandise (goods) and services,
(2) factor income, and
(3) transfers.

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 (1) Payments for Merchandise
and Services.:
Merchandise exports and imports represent tangible
products, such as computers and clothing, that are
transported between countries. Service exports and
imports represent tourism and other services, such as
legal, insurance, and consulting services, provided for
customers based in other countries.
The difference between total exports and imports is
referred to as the balance of trade.

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 (2) Factor Income Payments.
A second component of the current
account is factor income, which
represents income (interest and
dividend payments) received by
(3) Transfer
investors Payments.
on foreign investments in
• financial assets (securities).
A third component of the current
account is transfer
payments, which represent aid, grants,
and gifts from one country to another.

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 Summary of U.S. International
Transactions:(For the Year of 2006 in Millions of
Dollars)
Current Account
Exports of goods and services and income receipts
1418568
Goods, balance of payments basis 772210
Services 293492
Income receipts 352866
Imports of goods and services and income receipts
-1809099
Goods, balance of payments basis -1224417
Services -217024
Income payments -367658
Unilateral current transfers, net
-54136
Balance on current account
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-444667
 Capital and Financial Accounts:
The key components of the financial
account are payments for
(1) Direct foreign investment,
(2) Portfolio investment, and
(3) Other capital investment.

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 (1) Direct Foreign Investment.
Direct foreign investment represents the
investment in fixed assets in foreign
countries that can be used to conduct
business operations.
Examples of direct foreign investment
include a firm’s acquisition of a foreign
company, its construction of a new
manufacturing plant, or
its expansion of an existing plant in a
foreign country.
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 (2) Portfolio Investment.
 Portfolio investment represents transactions
involving long-term financial assets (such as stocks
and bonds) between countries that do not affect the
transfer of control.
 Thus, a purchase of Heineken (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. 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 direct
foreign investment instead of portfolio investment.

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 (3) Other Capital Investment.
 A third component of the financial account
consists of other capital investment, which
represents transactions involving short term
financial assets (such as money market
securities) between countries.
 In general, direct foreign investment measures
the expansion of firms’ foreign operations,
whereas portfolio investment and other capital
investment measure the net flow of funds due
to financial asset transactions between
individual or institutional investors.

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 Factors Affecting
International Trade Flows
Inflation
National Income
Government Restrictions
Exchange Rates

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

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 Factors Affecting
International Trade Flows
Government Restrictions
A government may reduce its country’s
imports by imposing tariffs on imported
goods, 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.

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 Factors Affecting
International Trade Flows
Exchange Rates
If a country’s currency begins to rise in value,
its current account balance will decrease as
imports increase and exports decrease.
Note that the factors are interactive, such
that their simultaneous influence on the
balance of trade is a complex one.

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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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 International Capital Flows
Capital flows usually represent portfolio
investment or direct foreign investment.
The DFI positions inside and outside the
U.S. have risen substantially over time,
indicating increasing globalization.
In particular, both DFI positions increased
during periods of strong economic growth.

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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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 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 to invest their
funds in a country when that country’s
currency is expected to strengthen.

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

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 Agencies that Facilitate International
Flows
International Monetary Fund (IMF)
The IM F 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.

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 Agencies that Facilitate International
Flows
International Monetary Fund (IMF)
• Its operations involve surveillance, and
financial and technical assistance.
 In particular, its compensatory financing facility
attempts to reduce the impact of export
instability on country economies.
 The IM F uses a quota system, and its unit of
account is the SDR (special drawing right).

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 Agencies that Facilitate International
Flows
World Bank Group
Established in 1944, the Group assists
development with the primary focus of
helping the poorest people and the poorest
countries.
It has 183 member countries, and is
composed of five organizations - IBRD, IDA,
IFC, MIGA and ICSID.

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 Agencies that Facilitate International
Flows
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.

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 Agencies that Facilitate International
Flows
IBRD: International Bank for Reconstruction
and Development
• 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
cofinancing agreements with official aid
agencies, export credit agencies, as well as
commercial banks.

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 Agencies that Facilitate International
Flows
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.
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.

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 Agencies that Facilitate International
Flows
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
M IGA: 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.

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 Agencies that Facilitate International
Flows
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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 Agencies that Facilitate International
Flows
To learn more about the World Bank Group
and its organizations, visit:
http://www.worldbank.org
http://www.worldbank.org/ibrd
http://www.worldbank.org/ida
http://www.ifc.org
http://www.miga.org
http://www.worldbank.org/icsid

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 Agencies that Facilitate International
Flows
World Trade Organization (WTO)
Created in 1995, the WTO is the successor
to the General Agreement on Tariffs and
Trade (GATT).
It deals with the global rules of trade
between nations to ensure that trade flows
smoothly, predictably and freely.
At the heart of the WTO's multilateral
trading system are its trade agreements.

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 Agencies that Facilitate International
Flows
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)
Set up in 1930, the BIS is an international
organization that fosters cooperation
among central banks and other agencies in
pursuit of monetary and financial stability.
It is the “central banks’ central bank” and
“lender of last resort.”

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 Agencies that Facilitate International
Flows
Bank for International Settlements (BIS)
The BIS functions as:
a forum for international monetary and
financial cooperation;
a bank for central banks;
a center for monetary and economic
research; and
an agent or trustee in connection with
international financial operations.

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 Agencies that Facilitate International
Flows
Bank for International Settlements (BIS)
To learn more about the WTO and the BIS,
visit:
http://www.wto.org
http://www.bis.org

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 Chapter Review
Balance of Payments
Current, Capital, and Financial Accounts
International Trade Flows
Distribution of U.S. Exports and Imports
U.S. Balance of Trade Trend
Recent Changes in North American and
European Trade
Trade Agreements Around the World

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 Chapter Review
Factors Affecting International Trade Flows
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
Distribution of DFI by U.S. Firms
Distribution of DFI in the U.S.
Factors Affecting DFI
Factors Affecting International Portfolio
Investment

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 Chapter Review
Agencies that Facilitate International Flows
International Monetary Fund (IMF)
World Bank Group
World Trade Organization (WTO)
Bank for International Settlements (BIS)
Regional Development Agencies

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