We study international finance since there are many nations and they do trade with one another.

If there were no national economies that did trade with one another, then we would not have this
field. So if there is no international trade we may not need to educate ourselves in International
Finance either. But the reality is; countries do trade with each other, and because countries (not
all, but many) use their own currencies to complete the transactions; we have to wonder about
how these goods are paid for and what determines the prices that currencies trade at. Moreover,
we have to also consider the fact that countries do borrow and lend from each other. In other
words, they trade intertemporally consumption today for consumption in the future. Because
of international borrowing and lending economic opportunities are expanded and households
have better options to smooth their incomes. These are good things. But just as the existence of
banks make bank panics possible; the existence of an international financial system makes
international financial crises possible. This is where all the interesting action of the course comes
from. In order to understand such crises we need to understand the nature of the international
financial system.
BENEFITS OF FREE TRADE
1. Allocation efficiency is obtained because MNCs devote more of their resources to producing
those products with a comparative advantage.
2. Increased competition stimulates efficiency and growth.
3. Production efficiency is obtained because foreign trade stimulates the flow of new ideas and
information across borders.
4. Expanded menu of goods with higher quality and lower price.
PROTECTIONISM
.
1. Forms of protectionism are tariffs, quotas, red tape and other trade barriers.
2. Reasons for protectionism include national security, unfair competition, infant industry
argument, domestic employment, and diversification.
ECONOMIC INTEGRATION
1. World Trade Organization (WTO) replaced GATT on January 1, 1995.
a) Most favored nation clause: if a country grants a tariff reduction to one country, it must grant
the same concession to all other WTO countries.
b) To join the WTO, countries must adhere to the most favored nation clause.
2. Trading blocs: Types of economic cooperation:
a) Free trade area: no internal tariffs.
b) Customs union: no internal tariffs and common external tariffs.
c) Common market: customs-union features + free flow of production factors.
d) Economic union: common-market features with harmonization of economic policy.
e) Political union: economic-union features with political harmony.
3. Regional economic agreements:
a) North American Free Trade Agreement of the US, Canada, and Mexico on January 1, 1994.
b) European Union of 15 countries began its operations with a single Central European Bank on
January 1, 1999. The EU accepted 10 new members on Mary 1, 2004.

c) Asian integration efforts consist of the Association of South East Asian Nations (ASEAN), the
Asian Pacific Economic Cooperation (APEC), and informal yen-trading bloc.
d) SAARC member states of Bangladesh, India, Pakistan, Sri-Lanka, Nepal, Maldives,
Afghanistan, and Bhutan has formed SAFTA.
One thing to keep in mind that multinational companies are more exposed to the changing events
in international finance but there are few principles which is applied to them for conducting
business outside their borders.
THE SEVEN PRINCIPLES OF INTERNATIONAL FINANCE FOR MNCs
1. Risk return trade off: We know maximization of profit is the ultimate goal of a firm but
what does maximization of profit mean? In simple term it means making as much profit as
possible. Well there is a risk portion attached to this. Generally, the higher the risk of a
project the higher the expected return. Otherwise, no one will pursue that project. So, if
someone has offered you a very lucrative return from an investment like investing in the
Share market and assuring you in three months time your money will be double, you should
immediately suspect that the investment is very risky and it could go the other way as well.
2. Market imperfections: When sellers of goods and services have complete freedom of entry
and exit without any restriction we call that perfect competition in which mobility of goods
and services creates equality in costs and returns. So it is not possible for a firm to make an
abnormal profit. But unfortunately, many barriers like tariffs, quota, license, transport cost
and asymmetric information causes market imperfections.
3. The portfolio effect: When MNCs add different assets in their portfolio not only investing in
different industries of a country but also across the globe, it does diversify their risk and by
decreasing risk it adds valuable quality in their portfolio management. Unfortunately, we
didnt yet attract much of portfolio investment in our capital market.
4. Comparative advantage: Trade between two countries is not an ICC world cup Cricket final
where one nation will dance while the other will shed tears. It could be a win-win situation.
Modern trade is based on comparative advantage not on absolute advantage. Comparative
advantage is where a nation can produce the same amount of output by using less factors of
production or less production cost. For example, Americans and Bangladeshis; physically
Americans have an absolute advantage over Bangladeshi workers but Bangladeshis have a
comparative advantage over Americans in producing a T- shirt. For example, if An American
can produce 10 shirts a day compare to a Bangladeshi producing just one shirt a day but a
Bangladeshi has a comparative advantage given he is earning only a dollar for that shirt but
the American is earning $50 dollar for that 10 shirts. So the same shirt labor cost in U.S. will
be $5 whereas it will be only $1 in Bangladesh. Thats why we see our cheap shirts have
flooded the western shopping malls.
5. The internationalization advantage: When a firm goes global it is not only exporting in a
foreign country but also building factories, offices internationally as well. This
internationalization reduces fixed cost and helps diversify risk exposure along with market
saturation. For example, Japanese automaker Honda has a plant in almost all western
countries. So having a factory in Michigan, USA has helped Toyota minimizing its foreign
currency exposure and also reduce costs on research and development.
6. Economies of scale: By expanding production line the average fixed cost goes down and
thus the lower unit cost. Why do you think Chinese products are so cheap? It is not only the
Chinese cheap labor but the sheer volume of production that makes the average fixed cost

very low and thus the average cost of a product becomes low. So they can sale the product at
lower price.
7. Valuation: The valuation principle states that the value of an asset is the present value of its
expected earnings. Every firm will try to increase its expected earning and thus add value to
the existence company. Normally, MNCs value more than a domestic firm not only a
multinational company makes higher profit but also can structure their capital at lower cost
compare to a domestic firm.

Definition: The balance of payments in Bangladesh is defined in "Annual Balance of Payments"

as a statistical statement for a given period showing: (a) transactions in goods, services, and
income between the Bangladesh economy and the rest of the world; (b) changes in the economy's
monetary gold, Special Drawing Rights (SDRs), and claims on and liabilities to the rest of the
world; and (c) transfers and counterpart entries that are needed to balance, in the accounting
sense, any entry for the foregoing transactions and changes that are not mutually offsetting.
Balance of payments data are compiled and disseminated on a monthly, quarterly, and annual
basis by the Bangladesh Bank (BB) in accordance with the principles and methodology
recommended in the fifth edition of the IMF "Balance of Payments Manual" (BPM5). So,
Balance of Payments is a record of official estimates of all transactions between a country with
the rest of the world during a given year. It shows the sum total of all external transactions
arising from export and import of goods and services and transfers, such as remittances and
capital inflows and outflows (transactions on capital account).
STRUCTURE OF BALANCE OF PAYMENTS
The IMF classifies balance of payments transactions into five major groups:
A: Current Account
B: Capital Account
C: Financial Account
D: Net Errors and Omissions
E: Reserves and Related Items
A.

Current Account consists of:

Goods (exports and imports).
Services (earning and expenditures for invisible trade item).
Income (on investments).
Current Transfers like workers remittance.

B. Capital Account consists of:

Capital transfers (transfer of title, fixed assets, etc.)
Acquisition or disposal of non-produced, non-financial assets, sale or purchase of nonproduced assets (rights to natural resources, patents, copyrights, trademarks, and leases).
C. Financial Account consists of:
Foreign direct investments (FDIs).
Foreign portfolio investments.

Other investments.

D. Net Errors and Omissions:

This is a plug item designed to keep the balance-of-payments accounts in balance.
E.

Reserves and Related Items: Group E, Consists of:

Official reserve assets
Use of IMF credits and loans
Exceptional financing

Since Balance of Payments will always balance that means all five major groups will sum up to
zero.
Current account + capital account + financial account + net errors and omissions +
reserves and related items = 0 or equation wise;
CuA + CaA + FiA + NEO + RR = 0.
BOP of Bangladesh (2010-2011)
Balance of payments of Bangladesh over the past two fiscal years is given below:
Balance of payments [Annual Data]

(In million US$)

Items
1

2009-10 2010-11 % Changes

July-June July-June 3 over 2
2

Trade balance

-5155

-7328

Export f.o.b.(including EPZ)

16233

23008

41.74

Of which : Readymade garments(RMG)

12497

17914

43.35

Import f.o.b (including EPZ)

-21388

-30336

41.84

Services

-1233

-2398

Receipts

2478

2570

3.71

Payments

-3711

-4968

33.87

Income

-1484

-1354

Receipts

52

119

Payments

-1536

-1473

Of which : Official interest payments

-215

-220

Current transfers

11596

12075

Official transfers

127

127

Private transfers

11469

11948

4.18

Of which : Workers' remittances

10987

11650

6.03

3724

995

Current Account Balance

Capital account

512

600

Capital transfers

512

600

Financial account

-651

-1584

Foreign direct investment (net)

913

768

Portfolio investment (net)

-117

-28

Other investment

-1447

-2324

MLT loans (excludes suppliers credit)

1589

1051

MLT amortization payments

-687

-739

Other long term loans (net)

-151

-101

Other short term loans (net)

62

531

Trade credit (net)

-1043

-1895

DMBs and NBDCs

-315

-160

Assets

-410

-902

Assets

-452

-1011

Liabilities

95

292

Errors and omissions

-720

-646

Overall Balance

2865

-635

Reserve Assets

-2865

635

Assets*

-3616

481

Liabilities

751

154

Bangladesh Bank

-2865

635

11087

10538

Memorandum Items :
Gross reserves (before valuation
adjustments)

Valuation Adjustment During the Period** -337

374

Gross reserves (after valuation adjustments) 10750

10912

In months of imports of goods and services 5.1

3.7

ODs to ADs and Reserve held at OBUs

-123456789 -269

Source: Statistics Department Bangladesh Bank.

* Estimated for the current year
Policies to improve the Balance of Payments
How to Reduce a Trade Deficit: There are ways for a country to reduce her trade deficit. It may
take some short term measures to mid and long term policies to improve the BOP. For example,
Deflate the Economy

A tight monetary and fiscal policy will reduce inflation and income. This leads to increased
exports and reduced imports, which, in turn, improve the trade balance. In action, this means the
country should control government budget deficits, reduce the growth of the money supply, and
institute price and wage controls.
Devalue the Domestic Currency
A devalued currency against the currencies of major trading partners will reduce a trade deficit.
This is because currency devaluation will make imported goods more expensive and exported
goods less expensive. But this will not work if:
1. There is no strong foreign demand for discounted priced exports.
2. If domestic companies do not have the spare capacity to produce more exports.
3. If other competing countries also devalue their currency.
4. If domestic residents buy imports, even at higher prices.
5. If middlemen do not pass the price changes to customers.
Establish Public Control
There are two types of public controls: foreign exchange controls and trade controls.
1. Under foreign exchange controls, a country forces its exporters and other recipients to sell
their foreign exchange to the government. This foreign exchange is then allocated to various
domestic users.
a. This restricts the countrys imports to a certain amount of foreign exchange earned by the
countrys exports.
b. This lowers the amount of imports.
2. Under trade controls, exports and imports are manipulated through tariffs, quotas, and
subsidies.
a. These measures can be used to lower the level of imports.
b. On the other hand, these measures may also lead to increased inflation, eroded purchasing
power, and a lower standard of living and also invite a trade war with other trading partners.
J-Curve
The J-curve is an economics term that describes the relationship between the trade balance and
currency devaluation. The J-curve shows that a countrys currency depreciation causes its trade
balance to deteriorate for a short time, followed by a flattening out period, and then ending with
a significant improvement in the long run. The typical time lag is 18 months, and empirical study
finds the J-curve effect in about 40% of cases.
The J-curve depicts the lag between the currency depreciation of a country and the improvement
in its trade balance. According to J-curve, when a countrys currency depreciates trade balance
worsens at first because the cost of previously ordered imports rises, while the home currency
price of previously ordered exports remains the same but gradually trade balance starts to
improve as lower cost of exports stimulate foreign demand while the demand for imports
declines due to higher prices of foreign made goods. For example, our currency in the beginning
of 2011 was around 70 BDT per USD what has depreciated to around 78 in the month of
November of 2011. So for us we have to pay the higher prices for the imported goods like what
we bought for $1 now importers will pay 78 TK instead 70 whereas the exporter will earn $1. So,
a higher import bill but unchanged export earnings will worsen the trade balance but as time

progress foreigners will find our 70 TK product not $1 anymore but only around $0.875 so they
are getting around 12.5% discount and thus a sharp rise in export order whereas our citizens will
find the same foreign products which was only 70 TK now it is 78 TK which will force some of
them to substitute foreign made goods to home made goods and thus a lower demand for foreign
imports. In the long run, we will see the trade balance improves gradually but we must keep in
mind whether only our currency has depreciated or our competitors did the same thing as well.
For example, if Pakistani Rupee depreciates 20% against USD at the same time then J- Curve
wont be applicable for us to that situation since 20% discounted Pakistani products would be
preferred by foreigners more than 12.5% discount on Bangladeshi products.
Change in Trade balance

J-curve
Trade balance
eventually improves
Currency devaluation

Time
Trade balance initially deteriorates

-Diagram 9.1
Marshall Lerner condition
Marshall Lerner condition is the minimum necessary condition in order for a country to devalue
her currency to improve her balance of payments. It is the sum of price elasticity of exports and
price elasticity of imports which must be greater than one to have a net positive effect on BOP.
The bigger the sums of these two are, the bigger the improvement of the balance of payments
account. For example, if Bangladesh wants to lower the value of Taka we must calculate the sum
of price elasticity of exports and imports and then if it comes more than one only then it could be
justified since balance of payments will improve. A devaluation of taka means a reduction in the
price of exports, quantity demanded for these will increase and at the same time, price of imports
will rise and their quantity demanded will diminish. The net effect on the trade balance will
depend on if goods exported are elastic to price means more sensitive to price changes to demand
increases for example, a 10% discounted products has increased a 20% rise in demand then total
export will rise. Similarly, if goods imported are elastic to price translates that a 10% rise in
foreign imports have caused 20% drop in demand of foreign made goods then in both cases it
will help improve the trade balance. If they are not price elastic then a 10% cut in prices will
cause only say 5% rise in quantity demanded and takas devaluation wont be a wise decision in
that situation. Besides most of the products that we purchase from international market like
petrol, soya beans, wheat, cotton etc. are price inelastic which means even the price of these

commodities rises we have no other alternative but to import since we are totally dependent on
imports. So a rise in prices of these commodities wont cut the demand as much and so a stronger
currency could well help us to get it cheaper. But for a country like China who has a trade
surplus a weaker currency give them a competitive edge in the global trade which makes their
products even more cheaper and thus raise their trade surplus further.
Balance of Trade:
The difference between the value of goods and services exported out of a country and the value
of goods and services imported into the country. The balance of trade is the official term for net
exports that makes up the balance of payments. The balance of trade can be a surplus which
translates export amount is bigger than import amount and is considered favourable whereas an
unfavourable trade balance is trade deficit where export amount is less than import bills. The
official balance of trade is separated into the balance of merchandise trade for tangible goods and
the balance of services.
Balance of trade = Dollar price of exports X Quantity of Exports Dollar price of Imports X
Quantity of Imports
Financing the Current Account Deficit:
A country running a current account deficit automatically implies running a capital account and
financial account surplus. The larger the current account deficit, the larger the capital and
financial account surplus. So a country like USA who has got a huge current account deficit
automatically translates they must run almost the same size capital and financial account surplus.
Otherwise, it wont be possible for them to finance the trade. Now if still after that a country is in
deficit balance then they have to use their foreign reserve or sale of foreign assets to finance the
deficit. For a third world country like Bangladesh when it runs current account deficit most of
the time it seeks IMFs help to stabilize the balance of payments. Bangladesh Bank has recently
secured almost $1 billion dollar IMF soft loan to negate any immediate impact on our balance of
payments. The other thing a country can do is to use her foreign currency reserve as we have
done it over the last few quarters and thats why our foreign reserve has dwindled from over $11
billion to now below $10 billion (Jan 2012). Another way is to attract more FDI and portfolio
investments which will help stabilize the balance of payments along with inspiring Bangladeshi
expatriates to send more money to Bangladesh. One of the last resorts is to find a friendly
country that may be willing to lend us soft loan.