International Financial Management

11th Edition
by Jeff Madura

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 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.

Let’s check its history (slide 4 to 7)

3 Lectured by Chheang Huy

 Balance of Payments (History)

 Each transaction is recorded as both a credit

and a debit, i.e. double-entry bookkeeping.
 The transactions are presented in three
groups – a current account, a capital account,
and a financial account.

4 Lectured by Chheang Huy

 Balance of Payments

 The current account summarizes the flow of

funds between one specified country and all
other countries due to the purchases of goods or
services, the provision of income on financial
assets, or unilateral current transfers (e.g.
government grants and pensions, private
remittances).
 A current account deficit suggests a greater
outflow of funds from the specified country for its
current transactions.
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 Balance of Payments

 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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 Balance of Payments

 The new capital account (as defined in the 1993

System of National Accounts and the fifth edition
of IMF’s Balance of Payments Manual) is adopted
by the U.S. in 1999.
 It includes unilateral current transfers that are
really shifts in assets, not current income. E.g.
debt forgiveness, transfers by immigrants, the sale
or purchase of rights to natural resources or
patents.

7 Lectured by Chheang Huy

 Balance of Payments (Now)

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.
b. 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.

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 a. 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 $)

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 b. Capital and Financial Accounts

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
Measurement errors can occur when attempting to
measure the value of funds transferred into or out of a
country.
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 International Trade Flows

1. Distribution of U.S. Exports and Imports:

Canada, China, Mexico, and Japan are the key
exporters to the United States.
2. U.S. Balance-of-Trade Trend: value has
grown substantially over time.
3. Impact of Huge Balance-of-Trade Deficit:
could lead to higher U.S. unemployment but
increases competition leading to more efficient
production.

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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 on specified imported goods over a 10-year
period across 117 countries in 1993.
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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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 Trade Policies

1. Using the exchange rate as a policy

2. Outsourcing
3. Managerial decisions about outsourcing
4. Using trade policies for security reasons
5. Using trade policies for political reasons

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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:
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1.Lectured
Outsourcing may reduce jobs in the United States.
by Chheang Huy
 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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 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 (p.39)

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 (p.40)

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
26 countries that are not subject to the same restrictions.
Lectured by Chheang Huy
 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 (p.40)

 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 (p.41)

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 Direct Foreign Investing (DFI) (p.44)

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 (p.47)
International Monetary Fund (IMF)

1. Major Objectives of the IMF

i. promote cooperation among countries on
international monetary issues,
ii. promote stability in exchange rates
iii. provide temporary funds to member countries
attempting to correct imbalances of international
payments
iv. promote free mobility of capital funds across
countries
v. 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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 Agencies that Facilitate International Flows
World Bank (International Bank for Reconstruction and Development)

ORIGINS (Official name) International Bank for

Reconstruction and Development
Founded to help reconstruct European Countries after
WW II
http://www.worldbank.org
1. Major Objective- Make loans to countries to enhance
economic development.
2. Structural Adjustment Loans (SALs) are intended to
enhance a country’s long-term economic growth.
3. Funds are distributed through co-financing
agreements:
 Official aid agencies
38  Export
Lectured credit Huy
by Chheang agencies
 Agencies that Facilitate International Flows
World Trade Organization (WTO)

1. Major Objective - Provide a forum for multilateral trade

negotiations and to settle trade disputes related to the
General Agreement on Tariffs and Trade (GATT)
accord in 1993, There are 117 countries.
2. Member countries are given voting rights that are used
to make judgments about trade disputes and other
issues.

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  Recent Changes in North American Trade
 In 1998, a 1989 free trade pact between U.S.
and Canada was fully phased in.
 Passed in 1993, the North American Free
Trade Agreement (NAFTA) removes
numerous trade restrictions among Canada,
Mexico, and the U.S.
 In 2001, trade negotiations were initiated for a
free trade area of the Americas. 34 countries are
involved.

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  Recent Changes in European Trade
 The Single European Act of 1987 was
implemented to remove explicit and implicit
trade barriers among European countries.
 Consumers in Eastern Europe now have more
freedom to purchase imported goods.
 The single currency system implemented in
1999 eliminated the need to convert currencies
among participating countries.

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 Agencies that Facilitate International Flows
International Financial Corporation (IFC)

1. Major Objective - promote private enterprise

within countries.
2. Provides loans to corporations and purchases
stock
3. It traditionally has obtained financing from the
World Bank but can borrow in the international
financial markets.

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 Agencies that Facilitate International Flows
International Development Association (IDA)

1. Major Objectives - extends loans at low interest

rates to poor nations that cannot qualify for
loans from the World Bank.

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

1. Major Objectives - facilitate cooperation among

countries with regard to international
transactions.
2. Provides assistance to countries experiencing a
financial crisis.
3. 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.
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 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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