Chapter

2
International Flow of Funds
 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 the international capital
flows are influenced by country
characteristics.

C2 - 2
Many MNCs are heavily engaged in international business,
such as exporting, importing, or direct foreign investment (DFI)
in foreign countries. The transactions arising from international
business cause money flows from one country to another. The
balance of payments is a measure of international money flows.

Financial managers of MNCs monitor the balance of payments

so that they can determine how the flow of international
transactions is changing over time. The balance of payments
can indicate the volume of transactions between specific
countries and may even signal potential shifts in specific
exchange rates. Thus it can have a major influence on the long-
term planning and management by MNCs.

C2 - 3
 Balance of Payments
• The balance of payments is a measurement of all
transactions between domestic and foreign
residents over a specified period of time.

• The BOP is composed of the three groups – a

current account, a capital account, and a
financial account.

C2 - 4
 Balance of Payments-
1. Current Account

• The current account measures the flow of funds between

one country and all other countries due to purchases of
goods and services or to income generated by assets.
• The main components of the current account are
payments between two countries for
(1) merchandise (goods) and services, (2) primary
income, and (3) secondary income.
• A current account deficit suggests a greater outflow
of funds from the specified country for its current
transactions.

C2 - 5
a) Payments for Goods and Services
• Merchandise/Service exports and imports represent
products, such as smartphones, clothing, tourism
that are transported between countries.
• The difference between total exports and imports is
referred to as the balance of trade.
• A deficit in the BD balance of trade means that the
value of merchandise and services exported by the
BD is less than the value of merchandise and
services that it imports.

C2 - 6
 b) Primary Income Payments
• Primary income (sometimes referred to as factor income),
which is mostly composed of i) income earned by MNCs on
their DFI (investment in fixed assets in foreign
countries that can be used to conduct business operations),
and also ii) income earned by investors on portfolio
investment (investments in foreign securities).
• Thus, primary income received by the Bangladesh reflects an
inflow of funds into the Bangladesh. Primary income paid by
the Bangladesh to foreign companies or investors reflects an
outflow of funds from the Bangladesh.
• Net primary income represents the difference between the
primary income receipts and the primary income payments.

C2 - 7
 c) Secondary Income
• The third main component of the current account is
secondary income (sometimes referred to as transfer
payments), which represents aid, grants, and gifts
from one country to another.
• Net secondary income represents the difference
between the secondary income receipts and the
secondary income payments.

C2 - 8
 Balance of Payments—
2. Financial Account

• The financial account measures the flow of funds

between countries that are due to
i) Direct foreign investment,
ii) Portfolio investment, and
iii) Other capital investment.

C2 - 9
2-i) Direct Foreign Investment

• The financial account keeps track of a country’s payments for

new DFI over a given period (such as a specific quarter or
year).
• Payments representing DFI in the United States (such as the
acquisition of a U.S. firm by a non-U.S. firm) are recorded as
a positive number in the U.S. financial account, because
funds are flowing into the United States. Conversely,
payments representing a U.S.-based MNC’s DFI in another
country are recorded as a negative number because funds
are being sent from the United States to another country.

C2 - 10
 2-ii) Portfolio Investment

• The financial account also keeps track of a country’s

payments for new portfolio investment (investment in financial
assets such as stocks or bonds) over a given period (such as
a specific quarter or year).
• A purchase of Heineken International (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.
• This transaction is recorded as a negative number for the
U.S. financial account (a debit), as it reflects a payment from
the United States to another country.

C2 - 11
 2-iii) 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, DFI 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.

C2 - 12
 Balance of Payments—
3. Capital Account
• The capital account measures the flow of funds between one
country and all other countries due to financial assets
transferred across country borders by people who move to a
different country, or due to sales of patents and trademarks.
• The sale of patent rights by a U.S. firm to a Canadian firm is
recorded as a positive amount (a credit) to the U.S. capital
account because funds are being received by the United
States as a result of the transaction.
• Conversely, a U.S. firm’s purchase of patent rights from a
Canadian firm is recorded as a negative amount (a debit) to
the U.S. capital account because funds are being sent from
the United States to another country.
C2 - 13
 Capital Account
• In general, the financial account items represent very large
cash flows between countries, whereas the capital account
items are relatively minor (in terms of dollar amounts) when
compared with the financial account items.

• Thus the financial account is given much more attention

than the capital account when attempting to understand
how a country’s investment behavior has affected its flow of
funds with other countries during a particular period.

C2 - 14
Summary of BOP of Bangladesh

https://www.bb.org.bd/econdata/bop.php

C2 - 15
 Relationship between the Accounts
• If a country has a negative current account balance,
then it should have a positive financial and capital
account balance (and vice versa).
• This implies that if it sends more money out of
the country than it receives from other countries due
to international trade and income payments, it
receives more money from other countries than it
spends on foreign investments.

C2 - 16
 Events that increased Trade Volume
Fall of NAFTA in The EU in
Berlin Wall 1993 2004
in 1989

Single GATT in Inception of

European 1993 the Euro
Act 1987
(1992)

C2 - 17
 Factors Affecting
International Trade Flows
• Cost of Labor
• Inflation
• National Income
• Credit conditions
• Government policies and
• Exchange rates

C2 - 18
 Factors Affecting
International Trade Flows
• Cost of Labor: The cost of labor varies substantially among
countries.
• Many of China’s workers earn of less than $300 per month,
so it is not surprising that China’s firms commonly make
products that require manual labor—at a much lower cost
than most countries in Europe and North America.
• Firms in countries where labor costs are low typically have an
advantage when competing globally, especially in labor-
intensive industries.

C2 - 19
 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.

C2 - 20
 Factors Affecting
International Trade Flows
• Credit conditions: Credit conditions tend to tighten
when economic conditions weaken because corporations
are less able to repay debt. In that case, banks are less
willing to provide financing to MNCs, which can reduce
corporate spending and further weaken the economy.
• An unfavorable credit environment also may reduce
international trade by making it difficult for some MNCs to
obtain the funds needed for purchasing imports.

C2 - 21
 Factors Affecting
International Trade Flows
• Government Policies
Government policies can have a major influence on which firms
within an industry attain the most market share worldwide.
These policies affect the legislating country’s unemployment
level, income level, and economic growth.
Each country’s government wants to increase its exports
because more exports lead to more production and income, and
may also create jobs. Moreover, a country’s government
generally prefers that its citizens and firms purchase products
and services locally (rather import them) because doing so
creates local jobs.
There are several types of policies often used to improve the
balance of trade and thereby to create jobs within a country.
C2 - 22
 Government Policies
• There are several types of policies often used to
improve the balance of trade and thereby to create
jobs within a country.
a) Restrictions on Imports (Tariffs, Quota, Embargo etc)
b) Subsidies for Exporters (Dumping and Anti-Dumping)
c) Restrictions on Piracy
d) Environmental restrictions
e) Labor Laws and Business laws
f) Tax breaks
g) Country Trade Requirements
h) Government ownership/subsidies

C2 - 23
 Example
Assume that a large number of agriculture firms in the United States have lost
business recently because local consumers have begun buying vegetables
imported from the country of Vegambia at much lower prices. Having laid off
many employees as a result, these firms decide to lobby their political
representatives. The agriculture firms argue that:
■ Vegetables from Vegambia are unfairly priced because Vegambia’s
government gives tax breaks to the firms that grow the vegetables,
■ There is speculation that the vegetables imported from Vegambia have caused
illness among some consumers, and
■ Vegambia allows its children to work at an earlier age than the age allowed in
the United States.
In response to this lobbying, the U.S. government decides to impose restrictions
on imports. Vegambia’s vegetable exports to the United States consequently
decline, and its unemployment rate rises.
Vegambia’s government decides that it can correct its unemployment rate by
improving its balance of-trade deficit. Some of its firms specialize in
manufacturing toys, but sales have been weak recently because many local
citizens purchase toys imported from the United States.
C2 - 24
 Example
The government of Vegambia determines that:
■ the U.S. toy manufacturers have an unfair advantage because they pay
low taxes (as a proportion of their income) to the U.S. government,
■ the toys produced in the United States present a health risk to local
children because reportedly a few children have hurt themselves while
playing with these toys, and
■ the U.S. government has failed to intervene in some foreign countries
to prevent the production of illegal drugs that flow into Vegambia, so
Vegambia should reduce U.S. imports as a form of protest.

Therefore, the government of Vegambia prohibits the importing of toys

from the United States.

C2 - 25
 Exchange Rates
Each country’s currency is valued in terms of other currencies
through the use of exchange rates. Currencies can then be
exchanged to facilitate international transactions.
The values of most currencies fluctuate over time because of
market and government forces. If a country’s currency begins to
rise in value against other currencies then its current account
balance should decrease, other things being equal.
As the currency strengthens, goods exported by that country will
become more expensive to the importing countries and thus the
demand for such goods will decrease.

C2 - 26
 Example
Accel Co. produces a standard tennis racket in the Netherlands and sells it online
to consumers in the United States. This racket competes with a tennis racket
produced by Malibu Co. in the United States, which is of similar quality and is
priced at about $140. Accel has set the price of its tennis racket at 100 euros.
Assuming that the euro’s exchange rate (during the sales month in question) was
$1.60, then the price of Accel’s racket to U.S. consumers is $160 (i.e., 100 euros
$1.60 per euro).
Because U.S. consumers could buy a Malibu racket for only $140, Accel only
sold about 1,000 rackets to U.S. consumers in that month.
Since then, however, the euro’s value has weakened; this month, the euro’s
exchange rate is only $1.20. U.S. consumers can now purchase the Accel tennis
racket for $120 (100 euros $1.20 per euro), which is less than that charged for
the U.S. Malibu racket. In this month, Accel sold 5,000 rackets. The U.S.
demand for this tennis racket is price-elastic (sensitive to price changes) because
there are substitute products available: the increase in demand for Accel rackets
led to reduced demand for tennis rackets produced by Malibu Co.

C2 - 27
 Example
Malibu Co. produces tennis rackets in the United States and sells some
of them to European countries. Its standard racket is priced at $140, and
it competes with the Accel racket in both the U.S. and the eurozone
market. When the euro was valued at $1.60, eurozone consumers paid
about 87 euros for Malibu’s racket (computed as $140/$1.60 = 87.50
euros). Because this price to eurozone consumers was lower than the
Accel racket price of 100 euros per racket, Malibu sold 7,000 rackets in
the eurozone at that time.
When the euro’s value fell to $1.20, however, eurozone consumers had
to pay about 117 euros for Malibu’s standard tennis racket (i.e.,
$140/$1.20), which is more than the 100 euros for an Accel racket.
Hence Malibu sold only 2,000 rackets to eurozone consumers in this
month. As those consumers reduced their demand for Malibu rackets,
they increased their demand for tennis rackets produced by Accel.

C2 - 28
 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.

C2 - 29
 Correcting
A Balance of Trade Deficit
• However, a weak home currency may not
necessarily improve a trade deficit.
¤ Foreign companies may lower their prices
to maintain their competitiveness.
¤ Some other currencies may weaken too.
¤ Many trade transactions are prearranged
and cannot be adjusted immediately. This
is known as the J-curve effect.
¤ The impact of exchange rate movements
on intracompany trade is limited.
C2 - 30
 J-Curve Effect
U.S. Trade Balance

0 Time

J Curve

C2 - 31
 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.
C2 - 32
 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.

C2 - 33
 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.
C2 - 34
 Agencies that Facilitate
International Flows
International Monetary Fund (IMF)
World Bank
WTO
International Finance Corporation (IFC)
International Development Assistance (IDA)
Bank for International Settlements (BIS)
OECD(Org, for Economic Cooperation and Development)
Other Development Agencies
ADB
C2 - 35
 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.
C2 - 36
 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 IMF uses a quota system, and its unit
of account is the SDR (special drawing
right).
C2 - 37
 Agencies that Facilitate
International Flows
International Monetary Fund (IMF)
• The weights assigned to the currencies in
the SDR basket are as follows:
Currency 2001 Revision 1996 Revision
U.S. dollar 45 39
Euro 29
Deutsche mark 21
French franc 11
Japanese yen 15 18
Pound sterling 11 11
C2 - 38
 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.

C2 - 39
 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.
C2 - 40
 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.
C2 - 41
 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.
C2 - 42
 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.
C2 - 43
 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.

C2 - 44
 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.

C2 - 45
 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.
C2 - 46
 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.
C2 - 47
 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.”

C2 - 48
 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.
C2 - 49
 Agencies that Facilitate
International Flows
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.

C2 - 50
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

 
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
k = weighted average cost of capital of the parent
C2 - 51
 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

C2 - 52
 Chapter Review

• Factors Affecting International Trade

Flows
¤ Inflation
¤ National Income
¤ Government Restrictions
¤ Exchange Rates
¤ Interaction of Factors

C2 - 53
 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
C2 - 54
 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

• How International Trade Affects an MNC’s

Value
C2 - 55
 Assignment

International Monetary Fund (IMF) Background,

World Bank Establishment Date,
WTO Objectives, Major
International Finance Corporation (IFC) Functions, Members,
International Development Assistance (IDA) Success and
OECD(Org, for Economic Cooperation and Failures/Criticisms.
Development)
SAARC

C2 - 56
 Review Questions
a) Is a negative current account harmful to a country?
Discuss.
b) When South Korea’s export growth stalled, some
South Korean firms suggested that South Korea’s
primary export problem was the weakness in the
Japanese yen. How would you interpret this
statement?
c) Assume that the dollar is presently weak and is
expected to strengthen over time. How will these
expectations affect the tendency of U.S. investors
to invest in foreign securities?

C2 - 57
• Assignment—
a) Explain J curve affect in terms of
improving trade deficit of a country.
b) Analyse the trend of Balance of payment
of Bangladesh over the last 10 years.

C2 - 58