Chapter 4:

The International Flow of Funds and Exchange Rates

Introduction

World economic and financial markets have become increasingly integrated due to steadily expanding international trade over
the past 100 years. In this regard, consumers, businesses, and governments must convert from one currency to another at
market exchange rates to make payments for internationally traded goods, services, and financial instruments.

Major changes in the world monetary system have had an impact on foreign exchange (also called forex) markets over the
years. The gold standard for benchmarking or pegging currencies was replaced in 1973 by a flexible exchange rate system with
freely floating currency values determined by market supply and demand.

Currency values can change for many reasons. One factor is different price levels in different countries for the same goods and
services. Price imbalances could be due to mispricing or due to differential inflation across countries. Another factor is varying
interest rates across countries. According to parity theories discussed later in this chapter, price levels and debt costs should be
the same in different countries after considering exchange rates. If not, exchange rates should change to make prices more
uniform across countries. Additionally, the economic prospects of countries can affect their currency values.

The Balance of International Payments

Balance of payments (BOP) refers to a statement of account that summarizes all transactions between the residents of one
country and the rest of the world for a given period of time, usually one year.
A country’s balance of payments is an objective standard that shows how well the country’s economy and government policies
are performing. Since BOP is based on a system of credits and debits, the balance of payments must always balance. BOP is
generally split into two major components with major business implications: (1) the current account, and (2) the financial
account.
Analyzing BOP statistics is based upon “flow of funds.” In flow of funds analysis, money moving into a country is a credit (plus
sign), while money leaving the same country is a debit (negative sign).

The Current Account

Current account of the BOP is largely driven by activities of consumers and business. It consists of four subaccounts: (a) trade
(or goods) balance, (b) services balance, (c) income balance, and (d) net transfers.

A. Trade Balance

The trade balance is the net of merchandise exports (1 sign as incoming dollars when merchandise, such as a Dell computer, is
exported) and merchandise imports (2 sign as dollars leave the country to pay for imports, such as Toyota brand cars). When a
country imports more than it exports, it has a merchandise trade deficit. The trade balance provides an indication of how
competitive an economy is via its primary trade partners.

B. Services Balance  the net of exports of services and imports of services.

(Shipping, airlines, consulting, insurance, banking, tourism, software development, etc.) is the net of exports of services (1 sign
when they are sold overseas) and imports of services (– sign when they purchased from overseas)

As in the case of the trade balance, a surplus in the services balance will indicate that a country is competitive in its service
industry. The “Balance of services” account shows that the United States is primarily a service economy, with intangible services
provided for customers in other countries comprising more of its exports.

C. Income Balance  the net of investment income from abroad and investment payments to foreigners

The third subaccount in the current account of BOP is income balance, which is the net of investment income from abroad (1
sign reflects earnings from overseas investment) and investment income paid to foreigners (2 sign indicates payments are sent
overseas).

D. Balance of Transfers the net of transfer payments going overseas and inflows from abroad

Balance of transfers is the net of transfer payments between countries based on outflows (2 sign means that a payment is going
abroad as foreign aid, retirement benefits, etc.) and inflows (1 sign reflects repayment of foreign aid loans, etc.)

E. Current Account Balance

The sum of these four subaccounts equals the current account balance, which is more important than the trade balance
discussed earlier in the chapter. Whether the current account balance is positive (surplus) or negative (deficit) is important
because it provides a measure of the financing needs of a particular country. A country with a current account surplus is called a
capital surplus country. For example, China, France, Japan, Singapore, and Switzerland have consistently had current account
surpluses over recent years. These countries maintain surplus funds, which they invest abroad. The United States, in contrast,
has had large current account deficits each year, which implies that it will need to attract capital from abroad in order to finance
current account deficits.
The Financial Account

Financial account describes the second half of a country’s balance of payments.

Foreign countries (investors) will be less willing to continue investing in current account deficit countries for extended periods of
time because of the perceived risk of nonpayment of debt. In this case investors will require a risk premium that increases
interest rates of the borrowing country.

Financial account  consists of domestic-country owned assets abroad, foreign owned assets in the domestic country, and
net financial derivatives.

Risk premium  the added return required by investors for risk associated with a security or asset.

Foreign Direct Investment

Foreign direct investment (FDI)  encompasses purchases of fixed assets (such as factories and equipment) abroad used
in the manufacture and sales of goods and services

The flow of FDI is dictated by opportunities to earn profit overseas. FDI decisions have important implications to consumers,
businesses, government, and society. Consumers gain through greater choice of products (or services) at competitive prices,
businesses face increased competition as well as profit opportunities, governments reap additional tax revenues, and society
benefits through increased employment opportunities and corporate social responsibility.

Security Investments

Security investments also have a significant impact on the BOP’s financial account. Financial capital flows between countries in
search of higher rates of return on foreign stocks and bonds. Often, individuals and firms hold foreign financial assets in order
to diversify their investments beyond domestic stocks and bonds only. During the technology boom years of the mid to late
1990s, massive inflows of funds for investment in U.S. stocks occurred as foreign investors tried to take advantage of the
perceived profit opportunities. These security investment inflows and outflows of funds affect a country’s BOP.

Statistical Discrepancy

Lastly, there is a statistical discrepancy line item in BOP statistics. While the financial account balance is intended to offset the
imbalance in the current account, the offset is not complete. The statistical discrepancy line reconciles any remaining
imbalance to ensure that all debit and credit entries in the BOP statement sum to zero. This line captures statistical
inconsistencies in the recording of the credit and debit entries as well as illegal trade.

World Trade and the Balance of Payments

According to this exhibit, Asian countries’ exports are growing the fastest with China normally expanding its exports at a rate of
about 11 percent per year. India is second in export expansion at around 10.5 percent growth per year. The United States has
continued to have relatively slower import growth of 0.5 percent than its export growth of 4.5 percent from 2005 to 2013. This
helps to explain its declining current account balance from 2006 to 2013. Nonetheless, the United States has typically been a
net importer of goods and services in the past, which explains its recent, large, current account deficit. Europe is a net exporter
with exports and imports growing at an average of 2.0 and 1.0 percent, respectively.

Some countries, such as Norway, are net importers, but most European Union countries are net exporters. These world trade
patterns help to explain the U.S. BOP accounts, especially which countries are lending funds to the United States to finance its
growing current account deficit.

Over the past 65 years, the growth of international trade has been driven by world economic growth, as well as the elimination
of barriers to trade such as tariffs, nontariff import and export quotas, and other restrictions.

However, the World Trade Organization (WTO) observed that in 2009, world trade declined by 12.2 percent, the largest decline
since World War II. In addition, global exports dipped 20 percent from their peak in 2008 to the lowest in 2009.

The global economic and financial crises in 2008 and 2009 were primarily responsible for this sharp downturn in world trade
activities. As economic recovery began, the WTO expected that world trade would rebound and grow by 9.5 percent in 2010.
Forecasters anticipated that economic development in China, India, and other emerging market countries would dramatically
boost world trade and thereby affect countries’ BOP accounts in the years ahead.

The Foreign Exchange Market

There are almost 200 countries in the world, most of which are engaged in international trade, and about 150 different
currencies that are used to make international payments for goods and services.

The exchange of currencies takes place in foreign exchange markets (often referred to as forex), which consists of a network of
international banks (who work with exporters and importers) and currency traders (who buy, sell, and speculate in currencies).

Over $1.5 trillion dollars’ worth of currencies are traded daily. The three largest foreign exchange markets are in London, New
York, and Tokyo followed by Hong Kong, Singapore, and Bahrain.
London is the largest foreign exchange market; it largely serves Europe and Africa and handles over 30 percent of the world’s
daily transactions. New York City handles about 20 percent of transactions and meets the needs of the Western Hemisphere.
Tokyo services about 8 percent of the transactions for Asia, and Tokyo competes with Hong Kong and Singapore. Bahrain
primarily covers the Middle East.

The foreign exchange market is a 24-hour market with international financial institutions connected by means of sophisticated
telecommunications systems that enable instant, real-time exchange rate quotations.

The function of the foreign exchange market is to facilitate international trade (in goods and services) and investment (FDI,
security investment, and short-term money market flows). Hence, there is a close relationship between the balance of
payments and foreign exchange markets.

The Exchange Rate

An exchange rate is nothing more than a price at which one currency can be converted to another currency.

In a free-market-oriented foreign exchange market, major currency values are determined by the demand for and supply of
currencies; this is called the independent floating exchange rate system.

The values of some currencies (e.g., Indonesian rupiah, Thai baht, Russian ruble, Indian rupee, and Singapore dollar) are
determined by the managed floating exchange rate system. In this system, the currency’s value depends partly upon
demand and supply in the foreign exchange market and partly on active government intervention in the foreign exchange
market (by means of central bank purchases and sales of its own currencies to manage currencies).

Some countries conduct the bulk of their international transactions with a few major trade partners and for this reason link their
currencies to those of the major trade partners (e.g., Chinese yuan, Malaysian ringgit, and Saudi Arabian riyal). This system,
called the fixed exchange rate system, is one in which the country pegs its currency (formally or informally) at a fixed rate
to a major currency or basket of currencies, and the exchange rate fluctuates within a narrow margin around a central rate.

Components of the Foreign Exchange Market

The forex market consists of spot, forward, and futures markets.

The spot market trades currencies on a real-time basis for immediate delivery. For example, a British firm may need dollars to
pay for U.S. imports. It can work with banks in London to exchange pounds for dollars to make this payment. Large banks
normally carry an inventory of frequently used currencies in international transactions and can make electronic payment
transfers.

The difference between bid and ask prices for a currency, or bid-ask spread, represents the transaction fee earned by the
bank.

Direct quotes give the prices of a foreign currency in dollars (or the number of dollars per one unit of foreign currency).
Indirect quotes are the reciprocal of the direct quote, or the prices of a dollar in foreign currency terms

As an example, the spot rate for the euro may be quoted at 1.40 EUR/USD, which is a direct quote indicating that €1 5 $1.40
(i.e., one-euro costs 1.40 dollars). The indirect quote would be 1/1.40 5 0.71 USD/EUR, or $1 5 €0.71 (i.e., one-dollar costs
0.71 euros). Assume that the spot rate increased from 1.40 EUR/USD a few weeks ago to 1.45 EUR/ USD today. This change
means that each euro can now buy more dollars than it could a few weeks ago. That is, the euro appreciated in value against
the dollar or, conversely, the dollar depreciated in value against the euro.

The forward market enables purchases and sales of currencies in the future with prices (known as the forward rate)
established at a previous time. The forward market is an informal over-the-counter (OTC) market run by banking institutions.

forward rate  the price at an earlier time of a currency in terms of another currency established for future delivery in the
forward market.

The difference between forward and spot exchange rates reflects expectations by investors about future exchange rate
movements.

Discount  in the forward market, the selling of a currency at a spot rate that is less than the forward rate

Premium in the forward market, the selling of a currency at a spot rate that is more than the forward rate.

Again, firms use the forward market to lock in future exchange rates and ensure against uncertain future currency movements.
This insurance reduces their future exchange rate risk and, therefore, is considered a hedge that lowers risk. Because it is likely
that the actual future spot rate will not exactly equal the earlier forward rate, a hedge is not precise.

Hedge insurance that reduces future risk.

International Monetary Systems

Over time, various international monetary systems have developed to facilitate international trade. In this regard, governments
around the world have worked together to promote stable exchange rates and world trade.

Money and Inflation

Many governments have used money to meet political goals of stimulating economic growth and providing employment for
citizens. Printing more money could increase economic activity. With more money on hand, people can purchase more goods
and services, and the economy can benefit, at least for a while. This political use of money is not without its pitfalls, however;
excess supplies of money could cause inflation.

That is, when the supply of money exceeds the demand for goods and services, the prices of goods and services can rise.

The Bretton Woods System

In 1944, the Bretton Woods Agreement established a global currency system based on a gold standard with the U.S. dollar
pegged at a fixed rate of exchange to gold in an effort to control inflation. And the currencies of 43 other countries fixed to the
dollar.

Gold Standards  monetary system that pegs currency values to the market value of gold.

The International Monetary Fund (IMF) was established under the Bretton Woods Agreement to help ensure the stability
of the international monetary and financial system.

Over time, the U.S. dollar became overvalued, with negative consequences to its export competitiveness in world markets. This
problem forced the United States to stop buying and selling gold for the settlement of international transactions on August 15,
1971. Subsequently, major nations met to consider abandoning the Bretton Woods Agreement, including pegging the dollar to
gold.

Under the resulting Smithsonian Agreement on December 17–18, 1971, the United States devalued the dollar against other
countries’ currencies, thereby beginning the breakdown of the 1944 Bretton Woods Agreement.

On April 24, 1972, the European Monetary System established a managed float exchange rate system with a range of 2.25
percent around central rates for six currencies, known as the “snake-in-the-tunnel,” an exchange rate precursor to the euro.

On August 15, 1974 the United States closed the gold window and relinquished the dollar-gold exchange standard.

Then, in January 1976, IMF members adopted the Jamaica Agreement, which ushered in a reformed international monetary
order. Some of the key principles in the Jamaica Agreement were: (1) members could adopt their own exchange systems; (2) a
system of global fixed exchange rates (as under Bretton Woods) would only be implemented if approved by a vote of 85 percent
of membership; (3) gold would no longer be a common denominator of the monetary system; and (4) the special drawing
right (SDR) created by the IMF was recommended as the primary reserve asset of the international monetary system.

Due to the breakdown of the Bretton Woods world monetary system in 1971, some developing countries have experienced
periodic episodes of volatile currency values, high inflation, and economic stagnation. To promote stability in the international
monetary system, the IMF in cooperation with the World Bank work to assist member countries with exchange rate, liquidity,
economic development, and structural issues.

Jamaica Agreement  the 1976 international monetary order that allowed countries to adopt different exchange rate
systems including floating their currencies in world markets.

special drawing right (SDR)  a basket of currencies consisting of dollars, euros, pounds, and yen created by the
International Monetary Fund (IMF) for use as a benchmark to value the currencies of different countries.

The Flexible Exchange Rate System

After 1971, a flexible exchange rate system began to emerge with market forces of supply and demand determining the prices
of different currencies. Currency values can be affected by a variety of forces, including current account balance, economic
conditions, inflation and interest rates, and other factors. At times, central banks intervene in the forex market by buying or
selling currency to prevent its value from going too high or low.

A clean float currency has minimal government intervention and, with few exceptions, is market determined. A dirty float
currency has varying degrees of government intervention to maintain a range of acceptable values against other currencies.
Hence, currencies that freely float in forex markets on a daily basis may be subject to a managed float at times.

Some emerging market countries practice managed float due to potential problems with liabilities denominated in foreign
currencies and assets denominated in local currency.

Of course, some countries do not float their currencies for these reasons. For example, some countries practice dollarization,
which means to use the dollar or some other foreign currency together with, or instead of, a domestic currency.

Dollarization can be unofficially adopted by citizens in a country or officially approved by a country as legal tender in
transactions.
The European Euro

The European community established the European Exchange Rate Mechanism (ERM) in 1979. Under the ERM, a weighted
basket of European currencies known as the ECU (European Currency Unit) was defined based on a managed-float system with
fixed exchange rates varying within 2.25 percent margins. The EMU introduced the euro as a new currency to replace the
currencies of the member countries in the Eurozone, which has since grown to 17 members.

In 2002, euro coins and notes were distributed. The euro was an immediate success; it quickly became the second most
important currency in the world, ahead of the Japanese yen. For countries using the euro, problems of currency fluctuations,
inflation, and related economic downturns were substantially reduced. For individual European consumers and businesses, the
euro put an end to the expensive and time-consuming need to convert one currency to another as goods and services are
purchased or as business is conducted between countries.

It is expected that the Eurozone will continue to expand in the future as a way to eliminate exchange rate risks associated with
uncertain currency movements, improve macroeconomic stability, and contribute to price parity across countries competing in
world trade. Interestingly, some countries in Africa, South America, and Southeast Asia are discussing the possibility of creating
regional currencies similar to the euro.

Hard and Soft Currencies

Together, the dollar, euro, and yen account for around 60 percent of the world economy. The dollar, euro, and yen describe
three currency areas of the world that lend monetary stability to each respective regional economy. These hard currencies are
used by emerging market countries to peg the values of the soft currencies.

Hard currencies  leading world currencies of developed industrialized countries, including the U.S. dollar, European euro,
Japanese yen, and British pound sterling.

Soft currencies  emerging market countries’ currencies that are less stable in value than hard currencies and are sometimes
pegged to hard currency values.

However, it should be recognized that, even though each hard currency is fairly stable within its own region of the world, its
value can considerably fluctuate against its counterparts around the world. Thus, exchange rate risk remains a major factor in
international trade and finance even among large industrial countries.

According to the law of one price, identical goods should sell for the same price in different countries according to the local
currencies.

Arbitrage  buying goods in a lower priced market and selling them in a higher priced market to make profits.

Purchasing Power Parity

The law of one price is the underlying principle of the purchasing power parity (PPP) theory. By comparing the prices of
identical goods in different countries, assuming efficient markets that arbitrage away price differences, the real or PPP exchange
rate can be computed. Given that these imperfections are not large and markets are fairly efficient, a basket of goods should
have approximately the same prices across different countries. If the prices of goods change in one country but not in other
countries, the exchange rate of the country’s local currency should likewise change with foreign currencies to maintain PPP.

purchasing power parity (PPP)  theory stating that a basket of goods should have approximately the same prices across
different countries.

The Big Mac Index  calculation using the cost of a McDonald’s restaurant sandwich to assess the relative values of
currencies.

While it would not be practical to purchase Big Macs in undervalued currency countries and sell them in overvalued currency
countries to earn arbitrage profits, it is possible to buy and sell the basket of ingredients required to make a Big Mac.
Consequently, if price differentials like these existed in traded goods markets, short-run differences should be reversed over
time.

Problems with PPP

PPP posits that exchange rate changes are explained by relative prices across countries. However, empirical tests of PPP have
found mixed results. While PPP appears to hold in the long run for periods exceeding five years, it may not hold in shorter
periods. For countries with large price disparities due to inflation or other reasons, PPP is predictive of exchange rate
movements. But for other countries with little difference in inflation rates, PPP is less reliable.

Interest Rate Parity  theory stating that interest rates on bonds in different countries should be the same, as investors
would buy and sell these bonds to make arbitrage profits until this condition holds.

Covered interest rate parity  principle implying that forward exchange rates and spot exchange rates set interest rates on
bonds in different countries equal to one another.

Uncovered interest rate parity  principle implying that expected future spot exchange rates and spot exchange rates set
interest rates on bonds in different countries equal to one another.