International Flow of Funds

2 Chapter
A2 - 2
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.
• To explain how international capital flows are influenced by
country characteristics.
A2 - 3
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 accounts for transactions by business, individuals,
and the government.

Each transaction is recorded as both a credit and a debit, i.e. double
entry bookkeeping.

A balance of payments statements can be broken down into two
components-
(1) Current account, and
(2) Capital account
A2 - 4
Current Account:
The current account summarizes 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, or
unilateral current transfers (e.g. government grants and pensions,
private remittances).

Components of the Current account are payments for-

(1) Merchandise (goods) and services
(2) Factor Income
(3) Transfer Payments
Balance of Payments, cont..
A2 - 5
Payments for Merchandise and Services:
Payments related to imports and exports of goods and services. The
current account is commonly used to assess the balance of trade,
which is simply the difference between merchandise exports and
merchandise imports.

Factor Income Payments:
Income (interest and dividend payments) receive by investors on
foreign investments in financial assets (securities).

Transfer Payments:
Represents aid, grants, and gifts from one country to another.
Current Account, cont..
A2 - 6
Capital Account:
The capital account summarizes the flow of funds resulting for the
sale of assets between one specified country and all other countries
over a specified period of time.

The capital account includes the value of financial assets transferred
across country borders.

It also includes the value of non-produced non-financial assets that
are transferred across country borders, such as patents and
trademarks.

Capital account items are relatively minor compared to the financial
account items.
Balance of Payments, cont..
A2 - 7
Financial Accounts:
The financial account (which was called the capital account
previously) summarizes the flow of funds resulting from the sale of
assets between one specified country and all other countries.

The key components of the financial account are payments for-

(1) Direct foreign investment
(2) Portfolio investment
(3) Other capital investment

Balance of Payments, cont..
A2 - 8
Direct Foreign Investment:
DFI represents the investments in fixed assets in foreign countries
that can be used to conduct business operation.

Portfolio Investment:
Represents transactions involving long-term financial assets (such as
stocks and bonds) between countries that do not affect the transfer of
control.

Other Capital Investment:
Represents transactions involving short-term financial assets (such as
money market securities) between countries.
Financial Account, cont..
A2 - 9
Factors Affecting International Trade Flows
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:

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.
A2 - 10
Government Restrictions:
A country’s government can have a major effect on its balance of
trade due to its different policies related on international trade, like

Subsidies for Exporters- some government offer subsidiary to their
domestic firms, so that those firms can produce products at a lower
cost than their global competitors.

Restrictions on Imports (tariff and quota)- government can increase
the price of foreign products by imposing tax (tariff), and also can
reduce its country’s imports by enforcing a quota, maximum limit that
can be imported.

Lack of restrictions on Piracy- government can affect international
trade flows by its lack of restrictions on piracy.
Factors Affecting International Trade Flows, cont.
A2 - 11
Exchange Rates:
Each country’s currency is valued in terms of other currencies through
the use of exchange rates, so that currencies can be exchanged to
facilitate international transactions.

If a country’s currency begins to rise in value against others
currencies, its current account balance will decrease as goods exported
by that country will became expensive to the importing countries, as a
consequence, the demand for such goods will decrease.


Note that the factors are interactive, such that their simultaneous
influence on the balance of trade is a complex one.
Factors Affecting International Trade Flows, cont.
A2 - 12
International Capital Flows usually represent-

• Portfolio Investment,

• Direct Foreign Investment (DFI).

Firms commonly attempt to engage in direct foreign investment so
that they can reach additional consumers or can rely on low cost
labor.

International Capital Flows
A2 - 13
Factors Affecting DFI
Capital flows resulting from DFI change whenever conditions in a
country change the desire of the firm to do business. Some common
factors that could affects a country’s appeal for 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.
A2 - 14
Potential Economic Growth:
Countries with higher potential economic growth are more likely to
attract DFI because firms recognize that they may be able to
capitalize on that growth by establishing more business there.

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 against their own.
Factors Affecting DFI, cont.
A2 - 15
Factors Affecting
International Portfolio Investment
International portfolio investment to a specific country is influenced by
the following factors-
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, as long as the
local currencies are not expected to weaken.

Exchange Rates
Foreign investors may be attracted if the local currency is expected to
strengthen.
A2 - 16
International Monetary Fund (IMF):
The IM F is an organization of 183 member countries. Established in
1946, it aims-

1. To promote international monetary cooperation and exchange
stability;
2. To foster economic growth and high levels of employment;
and
3. To provide temporary financial assistance to help ease
imbalances of payments.
4. To promote the free mobility of capital funds across
countries.
5. To promote free trade.
Agencies that Facilitate International Flows
A2 - 17
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.
Agencies that Facilitate International Flows, cont.
A2 - 18
IBRD: International Bank for Reconstruction and Development

IDA: International Development Association

IFC: International Finance Corporation

M IGA: Multilateral Investment Guarantee Agency

ICSID: International Centre for Settlement of Investment Disputes


Agencies that Facilitate International Flows, cont.
A2 - 19
World Trade Organization (WTO)
Created in 1995, the WTO is the successor to the General Agreement
on Tariffs and Trade (GATT).

This organization was established to provide a forum for multilateral
trade negotiations and to settle trade disputes related to the GATT
accord.

It deals with the global rules of trade between nations to ensure that
trade flows smoothly, predictably and freely.
Agencies that Facilitate International Flows, cont.
A2 - 20
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.
World Trade Organization (WTO), Cont..
Agencies that Facilitate International Flows, cont.
A2 - 21
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.”

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.
Agencies that Facilitate International Flows, cont.
A2 - 22
Regional Development Agencies:

Agencies with more regional objectives relating to economic
development include-

¤ The Inter-American Development Bank;

¤ The Asian Development Bank;

¤ The African Development Bank; and

¤ The European Bank for Reconstruction and Development.
Agencies that Facilitate International Flows, cont.
A2 - 23
Impact of International Trade on an MNC’s Value
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Exchange Rate Movements
Inflation in Foreign Countries National Income in Foreign Countries
Trade Agreements

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.

• To explain how international capital flows are influenced by
country characteristics.

A2 - 2

double entry bookkeeping. and (2) Capital account A2 . It accounts for transactions by business. A balance of payments statements can be broken down into two components- (1) Current account.3 .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. individuals. Each transaction is recorded as both a credit and a debit. and the government.e. i.

Components of the Current account are payments for- (1) Merchandise (goods) and services (2) Factor Income (3) Transfer Payments A2 . cont.Balance of Payments.. or unilateral current transfers (e. or the provision of income on financial assets. Current Account: The current account summarizes the flow of funds between one specified country and all other countries due to the purchases of goods or services. government grants and pensions. private remittances).4 .g.

Payments for Merchandise and Services: Payments related to imports and exports of goods and services.. Transfer Payments: Represents aid. which is simply the difference between merchandise exports and merchandise imports.5 . cont. and gifts from one country to another. Factor Income Payments: Income (interest and dividend payments) receive by investors on foreign investments in financial assets (securities). A2 . The current account is commonly used to assess the balance of trade. grants.Current Account.

6 . such as patents and trademarks. Capital Account: The capital account summarizes the flow of funds resulting for the sale of assets between one specified country and all other countries over a specified period of time. cont.Balance of Payments. Capital account items are relatively minor compared to the financial account items.. A2 . It also includes the value of non-produced non-financial assets that are transferred across country borders. The capital account includes the value of financial assets transferred across country borders.

The key components of the financial account are payments for- (1) Direct foreign investment (2) Portfolio investment (3) Other capital investment A2 .Balance of Payments. Financial Accounts: The financial account (which was called the capital account previously) summarizes the flow of funds resulting from the sale of assets between one specified country and all other countries.7 .. cont.

Direct Foreign Investment: DFI represents the investments in fixed assets in foreign countries that can be used to conduct business operation.8 .Financial Account. A2 . cont. Other Capital Investment: Represents transactions involving short-term financial assets (such as money market securities) between countries.. Portfolio Investment: Represents transactions involving long-term financial assets (such as stocks and bonds) between countries that do not affect the transfer of control.

as imports increase and exports decrease. It is important to identify and monitor the factors that influence it. as imports increase. National Income: A relative increase in a country’s income level will decrease its current account.Factors Affecting International Trade Flows International trade can significantly affect a country’s economy. A2 . The most influential factors are: Inflation: A relative increase in a country’s inflation rate will decrease its current account.9 .

cont. maximum limit that can be imported. Government Restrictions: A country’s government can have a major effect on its balance of trade due to its different policies related on international trade.10 .government can increase the price of foreign products by imposing tax (tariff). Restrictions on Imports (tariff and quota). A2 . Lack of restrictions on Piracy. so that those firms can produce products at a lower cost than their global competitors.Factors Affecting International Trade Flows.government can affect international trade flows by its lack of restrictions on piracy.some government offer subsidiary to their domestic firms. like Subsidies for Exporters. and also can reduce its country’s imports by enforcing a quota.

11 . so that currencies can be exchanged to facilitate international transactions.Factors Affecting International Trade Flows. the demand for such goods will decrease. Note that the factors are interactive. its current account balance will decrease as goods exported by that country will became expensive to the importing countries. Exchange Rates: Each country’s currency is valued in terms of other currencies through the use of exchange rates. such that their simultaneous influence on the balance of trade is a complex one. If a country’s currency begins to rise in value against others currencies. cont. A2 . as a consequence.

• Direct Foreign Investment (DFI).12 .International Capital Flows International Capital Flows usually represent- • Portfolio Investment. A2 . Firms commonly attempt to engage in direct foreign investment so that they can reach additional consumers or can rely on low cost labor.

13 .Factors Affecting DFI Capital flows resulting from DFI change whenever conditions in a country change the desire of the firm to do business. A2 . Privatization: DFI has also been stimulated by the selling of government operations. Some common factors that could affects a country’s appeal for DFI- Changes in Restrictions: New opportunities may arise from the removal of government barriers.

Exchange Rates: Firms will typically prefer to invest their funds in a country when that country’s currency is expected to strengthen against their own.Factors Affecting DFI. Potential Economic Growth: Countries with higher potential economic growth are more likely to attract DFI because firms recognize that they may be able to capitalize on that growth by establishing more business there.14 . cont. A2 . Tax Rates: Countries that impose relatively low tax rates on corporate earnings are more likely to attract DFI.

A2 . Exchange Rates Foreign investors may be attracted if the local currency is expected to strengthen.Factors Affecting International Portfolio Investment International portfolio investment to a specific country is influenced by the following factors- 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.15 . as long as the local currencies are not expected to weaken.

4. To foster economic growth and high levels of employment.16 . Established in 1946.Agencies that Facilitate International Flows International Monetary Fund (IMF): The IM F is an organization of 183 member countries. 2. To promote free trade. 3. To promote the free mobility of capital funds across countries. To promote international monetary cooperation and exchange stability. and To provide temporary financial assistance to help ease imbalances of payments. it aims1. A2 . 5.

World Bank Group: Established in 1944. IFC.IBRD. the Group assists development with the primary focus of helping the poorest people and the poorest countries. cont. and is composed of five organizations . IDA.Agencies that Facilitate International Flows. It has 183 member countries. MIGA and ICSID. A2 .17 .

cont. IBRD: International Bank for Reconstruction and Development IDA: International Development Association IFC: International Finance Corporation M IGA: Multilateral Investment Guarantee Agency ICSID: International Centre for Settlement of Investment Disputes A2 .18 .Agencies that Facilitate International Flows.

This organization was established to provide a forum for multilateral trade negotiations and to settle trade disputes related to the GATT accord.Agencies that Facilitate International Flows. It deals with the global rules of trade between nations to ensure that trade flows smoothly. cont. the WTO is the successor to the General Agreement on Tariffs and Trade (GATT). predictably and freely. A2 . World Trade Organization (WTO) Created in 1995.19 .

and Cooperating with other international groups. Cont.Agencies that Facilitate International Flows..20 . Providing technical assistance and training for developing countries. A2 . Its functions include: ¤ ¤ ¤ ¤ ¤ ¤ Administering WTO trade agreements. Monitoring national trading policies. World Trade Organization (WTO). Serving as a forum for trade negotiations. Handling trade disputes. cont.

21 .Agencies that Facilitate International Flows. Bank for International Settlements (BIS): Set up in 1930. It is the “central banks’ central bank” and “lender of last resort.” The BIS functions as: ¤ A forum for international monetary and financial cooperation. ¤ A center for monetary and economic research. A2 . and ¤ An agent or trustee in connection with international financial operations. ¤ A bank for central banks. cont. the BIS is an international organization that fosters cooperation among central banks and other agencies in pursuit of monetary and financial stability.

Regional Development Agencies: Agencies with more regional objectives relating to economic development include¤ ¤ ¤ ¤ The Inter-American Development Bank.Agencies that Facilitate International Flows.22 . A2 . cont. and The European Bank for Reconstruction and Development. The African Development Bank. The Asian Development Bank.

t ) = expected cash flows in currency j to be received by the U. t  E ER j .Impact of International Trade on an MNC’s Value National Income in Foreign Countries Trade Agreements Inflation in Foreign Countries Exchange Rate Movements m  E CFj .23 . parent at the end of period t E (ERj.S.t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent A2 . t  n   j 1  Value =    t 1  k  t =1       E (CFj.

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