Chapter

2
International Flow of Funds & Balance
of payments

ballal
 International flow of funds

• Results in balance of payments

• is influenced by economic factors and
other factors.
• Is important in projecting cash flows of an
MNC
 Balance of Payments
• The balance of payments is a measurement of
all transactions between domestic and foreign
residents over a specified period of time.
• Each transaction is recorded as both a credit
and a debit, i.e. double-entry bookkeeping.
• The transactions are presented in three groups
– current account
– capital account
– Includes financial account
 Balance of Payments-
Current Account
• The current account summarizes the flow of
funds between one specified country and all
other countries due to
– the purchase/sales of goods or services,
– Factor income-the provision of income/expense on
financial assets like interest on loans
– unilateral current transfers (e.g. government grants
and pensions, private remittances).
• A current account deficit suggests a greater
outflow of funds from the specified country for
its current transactions.
 Balance of Payments-
Balance of trade
• The current account is commonly used to
assess the balance of trade, which is simply
the difference between
– merchandise exports and merchandise imports.
• If imports are more there is Trade Deficit .e.g
US has trade deficit
 Growth of International Trade
Flows(Current a/c)
• the volume of trade has grown over time for
most countries.
• Reasons for growth of International Trade
Flows are many like
• Removal of Berlin Wall 1989
• NAFTA in 1993
• Single European Act of 1987
• EURO introduction 1999-2002
• GATT/WTO talks
• Other trade agreements
 Economic Factors Affecting
International Trade Flows
1. Inflation
– A relative increase in a country’s inflation rate will
decrease its current account, as imports increase
and exports decrease.
2. National Income
– A relative increase in a country’s income level will
decrease its current account, as imports increase.
 Economic Factors Affecting
International Trade Flows
3. Government Restrictions
– A government may reduce its country’s imports
• by imposing tariffs on imported goods, or
• by enforcing a quota.
– Note that other countries may retaliate by
imposing their own trade restrictions.
– Sometimes though, trade restrictions may be
imposed on certain products for health and safety
reasons.
– Such restrictions increase Current Account deficit
 Economic Factors Affecting
International Trade Flows
4. Exchange Rates
– If a country’s currency begins to rise in value, its current
account balance will decrease as imports increase (e.g less
dollar required) and exports decrease(dollar is costly for
importers of other countries)
• Note that the factors are interactive, such that their
simultaneous influence on the balance of trade is a complex
one.
• Trade deficit can be reduced by government intervention like
floating rates, lowering inflation, devaluation etc
• It may not be still reduced due to competitors strategies,
weakening other currencies, pre arranged transactions
 Effects of factors on Current Account

Increasing Factor Effect on Import Effect on Export

Inflation Increase Decrease

National Income Increase Decrease

Govt Restrictions on Decrease NA

import
Home currency value Increase Decrease
Imported goods cheaper Other countries find it
costlier to import
Foreign currency value Decrease Increase
More HC is required More HC you get

Pre arrranged Reverse of above Reverse of above

transactions
 MCQ
1. 2001
The primary component of the current account is the:
– a. balance of trade.
– c. balance of capital market flows.
– b. balance of money market flows.
– d. unilateral transfers.
2.2012
A General Agreement on Tariffs and Trade (GATT) accord in 1993 called for:
• a. increased trade restrictions outside of North America.
• b. lower trade restrictions around the world.
• c. uniform environmental standards around the world.
• d. uniform worker health laws.
 MCQ
3. 2040
Factor income represents income received by investors on foreign investments in
financial assets (securities). Factor income is part of which component of the
balance of payments?
• a. capital account
b. current account
c. balance of trade
d. none of the above
4. 2072
Which of the following would likely have the least direct influence on a country's
current account?
– a. inflation.
– b. national income.
– c. exchange rates.
– d. tariffs.
– e. a tax on income earned from foreign stocks.
 MCQ
5.2095
______________ is (are) income received by
investors on foreign investments in financial
assets (securities).
• a. Portfolio income
• c. Unilateral transfers
• b. Direct foreign income
• d. Factor income
 MCQ
6.2117
Which of the following are factors that affect
international trade flows?
• a. government restrictions
b. exchange rates
c. inflation
d. all of the above
 MCQ
7. A tariff is a maximum limit on imports.
• a. true.
• b. false.

8. An increase in the current account deficit will place _______ pressure on the
home currency value, other things equal.
– a. upward
– b. downward
– c. no
– d. upward or downward (depending on the size of the deficit)
 MCQ
9. A weakening of the U.S. dollar with respect to the
British pound would likely reduce the U.S. exports to
Britain and increase U.S. imports from Britain.
• a. true.
• b. false.
• (If USD weakens more USD are required for
importing from Britain hence import from Britain is
reduced while British importers require less USD to
buy from US hence US Exports to UK will increase)
Answer False
• CAPITAL ACCOUNT TRANSACTIONS
 Balance of Payments
-capital account
• Capital account include
– Current transfers that are capital in nature
– Capital flows
• unilateral current transfers that are really
– shifts in assets, not current income. E.g. debt relief
– transfers by immigrants
– the sale or purchase of rights to natural resources
or patents.
 International Capital Flows
• Capital flows usually represent
1. portfolio investment(no transfer of control)
2. direct foreign investment.
3. Other financial accounts e.g money market
4. Errors and omissions reserves
• The DFI positions have risen substantially over time, indicating increasing
globalization.
• In particular, both DFI(FROM AND TO) positions increased during periods
of strong economic growth.
• Factors effecting DFI and Portfolio investment are govt restrictions and
policy , interest rates , tax rates, exchange rates, economic growth(more
of this will be dealt during presentation by groups)
 Agencies that Facilitate
International Flows
• International Monetary Fund (IMF)
• CCF, SDR
• World Bank Group
– IBRD, IDA, IFC, MIGA
• World Trade Organization (WTO)
• Bank for International Settlements (BIS)
• Regional Development Agencies
– the Inter-American Development Bank;
– the Asian Development Bank;
– the African Development Bank; and
– the European Bank for Reconstruction and Development.
 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
 MCQ
1. Which of the following factors will lead to an
inflow of direct foreign investment (DFI) into a
country?
• a. high tax rates in the country where the
investment flows
b. privatization in the country where the
investment flows
c. an expectation that the currency in the country
where the investment flows will depreciate
d. all of the above
e. none of the above
 MCQ
2.Which of the following factors will lead to an
inflow of portfolio investment into a country,
everything else held constant?
• a. an expectation of a weaker currency in the
country where the investment flows
b. higher tax rates in the country where the
investment flows
c. higher interest rates in the country where the
investment flows
d. none of the above
e. both a and c
 MCQ
3. ______________ is a component of the
capital account and represents the investment
in fixed assets in foreign countries that can be
used to conduct business operations.
• a. Portfolio investment
b. Direct foreign investment (DFI)
c. Other capital investment
d. Transfer payments
 MCQ
4.The capital account is primarily composed of
merchandise exports and imports and service
exports and imports.
• a. True
b. False
5. Tariffs are taxes imposed on imported goods.
• a. True
b. False
6. In the long run, a weak rupee is expected to
cause a higher balance of trade from the Indian
perspective.
• .a True
b. False