Lecture 1

International Finance
ECON 243 Summer I, 2005
Prof. Steve Cunningham
 The New World Economy
The world economy has become
increasingly interconnected:
Globalization: markets exceed national
boundaries; increased mobility of workers,
products, and information.
Integration: people of different countries
choose to function jointly in governance,
economic interests, currency, etc.
 Developments
The possibility of such a global economy has been
brought about by:
Collapse of communism
Lower transportation costs
Advances in telecommunications (internet, etc.) related
technological innovations
Economic need
These have led to reductions in trade barriers
General barriers
Integration and free trade zonesEurope, North America, etc.
The relaxation of bank and capital market regulations
 Top 20 Globalized Nations
Rank Nation Rank Nation
1 Ireland 11 United States
2 Switzerland 12 France
3 Sweden 13 Norway
4 Singapore 14 Portugal
5 Netherlands 15 Czech Republic
6 Denmark 16 New Zealand
7 Canada 17 Germany
8 Austria 18 Malaysia
9 United Kingdom 19 Israel
10 Finland 20 Spain
Source: Foreign Policy
 Sectors
Economists typically separate the production
and sale of goods and services from the
exchanges of financial assets.
Real Sector: production and sale of goods and
services.
Financial Sector: transactions in global, foreign, or
domestic financial assets.
Measurement is difficult because trade may
include services (invisibles) and electronic
commerce.
 Balance of Payments
A record of international transactions
between residents of one country and the
rest of the world
International transactions include
exchanges of goods, services or assets
Residents means businesses, individuals
and government agencies, including citizens
temporarily living abroad but excluding
local subsidiaries of foreign corporations
 Double-entry Accounting in the BOP
All transactions are either debit or credit
transactions
Credit transactions result in receipt of
payment from foreigners
Merchandise exports (valued f.o.b.)
Transportation and travel receipts
Income received from investments abroad
Gifts received from foreign residents
Aid received from foreign governments
 Double-entry Accounting (Contd)
Debit transactions involve to payments to foreigners
Merchandise imports
Transportation and travel expenditures
Income paid on investments of foreigners
Gifts to foreign residents
Aid given by home government
Overseas investments by home country residents
Each credit transaction has a balancing debit
transaction, and vice versa, so the overall balance of
payments is always in balance.
 Accounts Overview (Level 1)
Current Account (all real transfers)
Merchandise trade
Service trade
Transfers
Capital and Financial Account (transfers of
ownership and financial assets and liabilities)
Changes in private assets
Changes in holdings of official international reserves
Statistical Discrepancy
 Current Account
The current account is that balance of
payments account in which all short-term
flows of payments are listed:
Goods and services balance (exports imports)
Merchandise trade balance (exports imports)
Services balance (exports imports)
Net Investment income
Unilateral transfers
Private transfer payments
Governmental transfers
 What are Services?
Travel and tourism
Trade transportation
Insurance
Education
Financial, technical, and marketing services
Telecommunication
Use of property rights (royalties)
Other professional and consulting services
 What is Investment Income?
Payment to holders of foreign financial
assets, including:
Interest on bonds and loans
Dividends and other claims on profits by
owners of foreign businesses
Payments made to temporary (nonresident)
workers
 Unilateral Transfers
Official government grants in aid to foreign
governments
Charitable giving (e.g., famine relief)
Migrant workers transfers to families in their
home countries
 Capital Account
The capital and financial account is that balance
of payments account in which all cross-border
transactions involving financial assets are listed.
This includes transactions between foreign and
domestic residents, and foreign and domestic
governments.
All purchases or sales of assets, including:
Direct investment
Securities (debt)
Bank claims and liabilities
Official reserves transactions
When U.S. citizens buy foreign securities or when foreigners buy
U.S. securities, they are listed here as outflows and inflows,
respectively.
 Foreign Direct Investment (FDI)
Any flow of lending to, or purchases of ownership in, a
foreign enterprise that is largely owned by residents of the
investing country.
Securities (stocks and bonds)
Loans
Bank deposits
Minority ownership positions
FDI is the purchase of assets to establish financial control of a
foreign entity. Generally ownership of 10% or more of a
companys outstanding stock is considered FDI.
Portfolio investment involves little management control or
interest, and is solely for financial gain.
 Official Reserve Assets
Early on in this century, this was primarily gold
Now primarily financial assets denominated in
a foreign currency that is widely accepted in
international transactions:
Euro assets (heavily used by U.S.)
Yen assets (heavily used by U.S.)
U.S. dollar assets (key currency worldwide)
Reserve positions in IMF
SDRs (created by IMF)
 Official Reserves Transactions
Governments can influence exchange rates by
buying and selling official reserves.
The buying and selling of official reserves is recorded
in the official transactions account.
Also referred to as changes in holdings of official
international reserves or official settlements balance.
It is the part of the balance of payments accounts
that records the amount of its own currency or
foreign currencies that a nation buys or sells.
 Statistical Discrepancy?
It is the net result of errors and omissions on
both the credit and debit sides.
Where do these errors come from?
Under-reporting merchandise imports
Under-reporting investment incomes
Under-reporting capital exports
Basically, people succeed in hiding their imports,
foreign investment incomes, capital flight from
their governments for tax and other purposes.
 Account Overview (Level 2)
Current Account Capital Account
Merchandise trade Changes in US assets abroad, net
exports other US govt assets
imports US private assets
Trade Balance All changes, net
Services Changes in foreign assets in the US,
military trans. (net)
other services, net net foreign private assets
Service Balance All changes, net
Balance on goods & services
Investment income, net
Unilateral transfers
Changes in holdings of official
US government grants international reserves, net
US govt pensions, and
other transfers
Private remittances and
Statistical discrepancy
other transfers
All transfers, net Balance on capital account
Balance on current account
 Current Account
The difference between the import and
export of goods is sometimes called the
balance of merchandise trade.
Although the popular press often uses this
measure, the merchandise trade balance is not
a good summary because services are an
important component of trade.
The balance on goods and services includes
trade in services. This includes visible and
invisible trade .
 Current Account, 1970-2002
200

100

-100

-200

-300
Current Account
-400
Goods
-500 Services

-600
1970 1975 1980 1985 1990 1995 2000
 Current Account Surplus and Deficit
A current account surplus means exports
of goods and services, investment income
and transfers exceed imports and
outflows.
A current account deficit means imports
of goods and services, and outflows are
greater than exports and inflows; must be
financed by borrowing (capital account
inflows).
 Linkage to NIPA and
the Domestic Economy
Current Account (CA) surplus equals net
foreign investment (If ). CA = If .
If If > 0, the country has net foreign investment,
so the country must be investing part of its
saving abroad, and S = Id + If .
That means If = S Id .
Recall that Y = C + Id + G + (X M).
Also, CA = X M.
Domestic Expenditures E = C + Id + G, and
Y E = X M = CA
C + Id + G is sometimes referred to as absorption.
 Meaning of Overall Balance
The current account and the capital account
measure the private and non-U.S. government
supply of and demand for dollars.
Official Settlements Balance:
B = CA + KA
Because the balance of payments must sum to
zero, any imbalance in the official settlements
balance must be financed (paid for) by official
reserves flows:
B + OR = 0
 BOP Surplus and Deficit
The Official Settlements Balance (B ) is sometimes
referred to as the net sum of the items above the
line or autonomous transactions, and
The Official Reserves Transactions (OR ) are
referred to as the sum of the items below the line,
also called nonautonomous or accommodating
transactions.
When B = 0, there is said to be a BOP equilibrium, and
if B 0, a BOP disequilibrium.
When B > 0, there is said to be a BOP surplus.
When B < 0, there is said to be a BOP deficit.
 BOP Surplus and Deficit (Continued)
In terms of the supply and demand of
a nations currency, there is:
A balance of payments surplus if quantity
demanded for a currency exceeds quantity
supplied, putting upward pressure on the value
of the nations currency.
A balance of payments deficit if quantity
supplied of a currency exceeds quantity
demanded, putting downward pressure on the
value of the nations currency.
 Official Transactions Account
Most of the Official Reserves flows are official
interventions by the countrys monetary authorities
in the foreign exchange markets.
When a government buys its own currency to hold
up the currencys price, we say that the
government has supported its currency.
It is holding the exchange rate higher than that rate otherwise
would have been.
When it sells its currency, it is attempting to depress
the value of its currency.
It is forcing the exchange rate to be lower than that rate would
otherwise have been.
 Official Transactions Account
Because they are an accounting identity,
the current, capital, and official transactions
accounts must sum to zeroin total, the
balance of payments balances.
The supply of currency, including
governments, must equal the demand for
currency, including governments.
 1999 Balance of Payments Accounts

1. Current Account
2. Merchandise
3. Exports +683
4. Imports -1,030
5. Balance of trade -347
6. Services
7. Exports +277
8. Imports -197
9. Balance of services +80
10. Balance of goods and services -256
 1999 Balance of Payments Accounts

11. Net invesment income -25

12. Net transfers -47
13. Invest. trans. balance -72
14. Balance on current account -339
15. Capital account
16. Capital inflows +751
17. Capital outflows -373
18. Balance on capital account +378
19. Current and capital balance -39
20. Statistical discrepancy -36
21. Official transaction account +3
22. Totals 0
 BEA International Transactions Data
May 19, 2003, U.S. International Transactions (Millions)
Line (Credits +; debits -)/1/ 2000 2001 2002/p/
Current account
1 Exports of goods and services and income receipts 1,417,236 1,281,793 1,216,504
2 Exports of goods and services 1,064,239 998,022 971,864
3 Goods, balance of payments basis/2/ 771,994 718,762 682,586
4 Services/3/ 292,245 279,260 289,278
12 Income receipts 352,997 283,771 244,640
13 Income receipts on U.S.-owned assets abroad 350,656 281,389 242,177
14 Direct investment receipts 149,677 125,996 128,068
15 Other private receipts 197,133 151,832 110,766
16 U.S. Government receipts 3,846 3,561 3,343
17 Compensation of employees 2,341 2,382 2,463
18 Imports of goods and services and income payments (1,774,135) (1,625,701) (1,663,908)
19 Imports of goods and services (1,442,920) (1,356,312) (1,407,406)
20 Goods, balance of payments basis/2/ (1,224,417) (1,145,927) (1,166,939)
21 Services/3/ (218,503) (210,385) (240,467)
29 Income payments (331,215) (269,389) (256,502)
30 Income payments on foreign-owned assets in the United States
(323,005) (260,850) (247,601)
31 Direct investment payments (60,815) (23,401) (50,121)
32 Other private payments (179,217) (156,784) (124,542)
33 U.S. Government payments (82,973) (80,665) (72,938)
34 Compensation of employees (8,210) (8,539) (8,901)
35 Unilateral current transfers, net (53,442) (49,463) (56,023)
36 U.S. Government grants/4/ (16,821) (11,628) (16,914)
37 U.S. Government pensions and other transfers (4,705) (5,798) (5,131)
38 Private remittances and other transfers/6/ (31,916) (32,037) (33,978)
 Capital and financial account
Capital account
39 Capital account transactions, net 837 826 708
Financial account
40 U.S.-owned assets abroad, net (increase/financial outflow (-)) (606,489) (370,962) (156,169)
41 U.S. official reserve assets, net (290) (4,911) (3,681)
46 U.S. Government assets, other than official reserve assets, net (941) (486) 379
47 U.S. credits and other long-term assets (5,182) (4,431) (5,213)
48 Repayments on U.S. credits and other long-term assets/8/ 4,265 3,873 5,696
49 U.S. foreign currency holdings and U.S. short-term assets, net (24) 72 (104)
50 U.S. private assets, net (605,258) (365,565) (152,867)
55 Foreign-owned assets in the United States, net (increase/financial 1,015,986
inflow (+))752,806 630,364
56 Foreign official assets in the United States, net 37,640 5,224 96,630
57 U.S. Government securities 30,676 31,665 74,013
58 U.S. Treasury securities/9/ (10,233) 10,745 43,656
59 Other/10/ 40,909 20,920 30,357
60 Other U.S. Government liabilities/11/ (1,909) (1,882) 158
61 U.S. liabilities reported by U.S. banks, not included elsewhere 5,746 (30,278) 18,831
62 Other foreign official assets/12/ 3,127 5,719 3,628
63 Other foreign assets in the United States, net 978,346 747,582 533,734
64 Direct investment 307,747 130,796 30,114
65 U.S. Treasury securities (76,965) (7,670) 53,155
66 U.S. securities other than U.S. Treasury securities 455,213 407,653 284,611
67 U.S. currency 1,129 23,783 21,513
68 U.S. liabilities to unaffiliated foreigners reported by U.S. nonbanking
174,251concerns 82,353 49,736
69 U.S. liabilities reported by U.S. banks, not included elsewhere 116,971 110,667 94,605
70 Statistical discrepancy (sum of above items with sign reversed) 7 10,701 28,524
70a Of which: Seasonal adjustment discrepancy ..... ..... .....
 Memoranda

Line (Credits +; debits -)/1/ 2000 2001 2002/p/

71 Balance on goods (lines 3 and 20) (452,423) (427,165) (484,353)
72 Balance on services (lines 4 and 21) 73,742 68,875 48,811
73 Balance on goods and services (lines 2 and 19) (378,681) (358,290) (435,542)
74 Balance on income (lines 12 and 29) 21,782 14,382 (11,862)
75 Unilateral current transfers, net (line 35) (53,442) (49,463) (56,023)
76 Balance on current account (lines 1, 18, and 35 or lines 73, 74, and
(410,341)
75)/13/ (393,371) (503,427)
 Intl Investment Position
In order to buy U.S. assets foreigners need
dollars, so net capital inflows represent a
demand for dollars.
The demand for dollars comes from the
demand to buy goods and services and the
demand to buy (capital) assets.
In the 1980s, the inflow of capital into the
U.S. greatly exceeded the outflow of capital
from the U.S., and this trend has continued
into the late 1990s. (KA > 0, CA < 0)
 Intl Investment Position (continued)
International Investment Position (IIP) is
another related balance sheet. It is a
statement of the stocks of a nations
international assets and foreign liabilities at a
point in time, usually the end of a year.
Any capital flows (related to a current
account imbalance) creates a change in the
IIP.
 Intl Investment Position (continued)
We say that a nation is a lender or a
borrower depending on whether its current
account is in surplus or deficit during a time
period.
We say that a nation is a creditor or debtor
depending on whether its net stock of
foreign assets is positive or negative.
The first refers to flows over time, the second
to stocks at a point in time.
 Intl Investment Position (continued)

Prior to WWI, the U.S. was a net debtor.

From WWI through 1983, the U.S. was a net
creditor (the worlds leading creditor).
Since 1983, the U.S. has run large current
account deficits, requiring intl borrowing.
By 1989, the U.S. was a net debtor, and
continues to be so until the present.