INTERNATIONAL FINANCE

Tang My Sang

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 CHAPTER 5.
INTERNATIONAL FLOW OF FUNDS

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 LEARNING OUTCOMES

A. Explain the key components of the balance of

payment
B. Explain how international trade flows are influenced
by economic factors and other factors
C. Explain how international capital flows are
influenced by country characteristics
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 BALANCE OF PAYMENTS (BP)

Summary of transactions between domestic and

foreign residents for a specific country over a specified
period of time.

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 BALANCE OF PAYMENTS (BP)

Structure of BP:
- Current account
- Capital and Financial account
- Errors and Omissions
- Official Financing Balance
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 Entry Balance of
Content Cash inflow (+) Cash outflow(-) payment account
CA Current account CA = (TB + SE + IC + TR) -70
TB Balance of merchandise -50
Merchandise Export 150
Merchandise Import -200
SE Balance of services -40
Service export 120
Service import -160
IC Factor income 10
Inflow of funds 20
Outflows of funds -10
TR Transfers 10
Inflow 30
Outflow -20
K Capital and Financial Accounts K = (KL+ KS + KTR) 60
KL Long capital 90
Inflow 140
Outflow -50
KS Short capital -35
Inflow 20
Outflow -55
KTR Tranfer Payment 5 5

OM Errors and Omissions -10 -10

OB Overall Balance OB = CA + K + OM -20
OFB Official Financing Balance OFB = -OB 6 20
∆R Reserve change 15 15
LIMF and other central bank loans 5 5
#Other funds 0 0
BALANCE OF PAYMENTS (BP)
Content Year of 2014
A Current account  8.896
Merchandise Export and Import 11.913
Service Export and Import (3.530)
Factor income (9.095)
2 main
Transfers 9.608
components
B Capital Accounts (712)
C Financial Accounts (1.150)
Direct foreign investment 8.050
Indirect foreign investment 93
Other investment (2.317)
D Errors and Omissions (6.342)7
E Overall Balance 8.380
F Official Financing Balance (8.380)
 CURRENT ACCOUNT (CA)

Represents a summary of the flow of funds between

one specified country and all other countries due to
purchases of goods or services, or the provision of
income on financial assets

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 CURRENT ACCOUNT (CA)
International Trade Transaction USD cash flow Entry on VN Balance
position of Payments Account

Mr A purchases stereos USD cash outflow Debit

produced in Indonesia that it
will sell in its VN. retail stores.

Individuals in the Viet Nam USD cash outflow Debit

purchase CDs over the Internet
from a firm based in China.

The Mexican government pays USD cash inflow Credit

a V.N. consulting firm for
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consulting services provided by
the firm
 CURRENT ACCOUNT (CA)

Current Account

Payments for Payments for Factor income Transfer

merchandise services payments payments
TB SE Ic Tr

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 PAYMENTS FOR MERCHANDISE

Distribution of U.S. Exports and Imports. This is a visible

balance
 Exports result in an inflow of funds => Credit (+) on BP
 Imports result in an outflow of funds => Debit (-) on BP
 When Exports be lower Imports => Balance of Trade
deficit
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 FACTORS AFFECTING PAYMENTS
FOR MERCHANDISE
1.Exchange Rates:
When exchange rates increase, value of foreign
currency exports decrease, exports has grown over
a) Value of home currency exports increase
X = P.Qx
(P is a constant, E↑ => Qx ↑ => X ↑)
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 FACTORS AFFECTING PAYMENTS
FOR MERCHANDISE
1.Exchange Rates:
b) Value of foreign currency exports increase or
decrease
X* =
(P is a constant, E↑ => Qx ↑ => X*↑↓)
If increase rate of Qx > increase rate of E => X*
increase :
>1
=> Value of foreign currency exports is elastic with
exchange rates 13
 FACTORS AFFECTING PAYMENTS FOR
MERCHANDISE
 If increase rate of Qx < increase rate of E => X*
decrease:
<1
Þ Value of foreign currency exports is not elastic with
exchange rates
 If increase rate of Qx = increase rate of E => X* no
change:
=1
Þ Value of foreign currency exports is elastic equal to
exchange rates
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FACTORS AFFECTING PAYMENTS FOR
MERCHANDISE
2. Inflation:
Payments for Merchandise decreases if inflation
increases relative to trade partners
a) Value of home currency exports increase or decrease
X = P.Qx (P increase, Qx decrease => X ↑↓)
b) Value of foreign currency exports increase or
decrease
X* = (E is a constant => P↑ => Qx↓ => X*↑↓)
=> Affecting of inflation on value of home currency
exports is not clear

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FACTORS AFFECTING PAYMENTS FOR
MERCHANDISE

3.National Income: Payments for Merchandise decreases

if national income increases relative to other countries
4. Government Policies
Subsidies for exporters
Restrictions on imports
Lack of restriction on piracy

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 CURRENT ACCOUNT (CA)

Current Account

Payments for Payments for Factor income Transfer

merchandise services payments payments
TB SE Ic Tr

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 PAYMENTS FOR SERVICES (SE)

Service exports and imports represent tourism and other

services, such as legal, insurance, and consulting services,
provided for customers based in other countries

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 INCOME PAYMENTS (IC)

Compensation • Wages, salaries

of employees • Other benefit

Investment • Direct investment income

income • Indirect investment income

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 TRANSFER PAYMENTS (TR)
 Represent aid, grants, and gifts from one country to
another

 Paymentof services, income and transfers are invisible

payments

Current account = visible payments + invisible payments

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CAPITAL AND FINANCIAL ACCOUNTS
The capital account includes the value of
financial assets transferred across
country borders by people who move to
a different country.

It also includes the value of non

produced nonfinancial assets that are
transferred across country borders, such
as patents and trademarks
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 CAPITAL AND FINANCIAL ACCOUNTS
Statistical purpose:

Capital account Financial account

Capital transfers Direct investment

Acquisition or Indirect investment

disposal of non-
Other investment
produced
nonfinancial assets 22
 DIRECT INVESTMENT
Foreign direct investment is the category of international
investment that reflects the objective of a resident entity
in one economy obtaining a lasting interest in an
enterprise resident in another economy

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MOTIVES FOR DIRECT FOREIGN
INVESTMENT

Revenue Related Motives:

• Attract new sources of demand
• Enter profitable markets
• Exploit monopolistic advantages
• React to trade restrictions
• Diversity Internationally

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MOTIVES FOR DIRECT FOREIGN
INVESTMENT

Cost Related Motives

• Fully benefit from economies of scale
• Use foreign factors of production
• Use foreign raw materials
• Use foreign technology
• React to exchange rate movements

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MOTIVES FOR DIRECT FOREIGN
INVESTMENT

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 CAPITAL AND FINANCIAL ACCOUNTS
Economic statistical purpose

Long
term • FDI, IFI,..
investm
ent
Short • Credit, deposit
term • Foreign currency trade, valuation note trade
investm
ent

Tranfers • Represent aid, grants, and gifts

payment 27
FACTORS AFFECTING CAPITAL AND
FINANCIAL ACCOUNTS

Population

Financial
Account

Foreign
Capital
Exchange
Control 28
Fluctuation
 BASIC BALANCE
To analyze liquidity risk of the economy, (Basic
Balance – BB) concept is used
BB = CA + KL
 CA deficit => Economy is a debtor
 CA surplus => Economy is a creditor

When is the economy in

liquidity risk?

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 BASIC BALANCE
 Economy is a debtor (assume OM = 0)
CA = -10, KL = 15, KS = -5
ÞBB = CA + KL = (-10) + 15 = 5 > 0
Þ the economy is not in liquidity risk
 Economy is a creditor (assume OM = 0)
CA = 10, KL = -15, KS = +5
ÞBB = CA + KL = (10) + (-15) = -5 < 0
Þ the economy is in liquidity risk
Þ So:
BB> 0, the economy is not in liquidity risk
BB< 0, the economy is in liquidity risk 30
 ERRORS AND OMISSIONS (OM)

OB + OFB = 0
OB = -OFB
CA + K + OM = -OFB
OM = -(CA + K + OFB)

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 OFFICIAL FINANCING BALANCE (OFB)

OFB = ∆R + L + #
R: change in country reserve
L: IMF and other central bank credits
#: change in other country reserves (used home
currency in their reserves)
Foreign currency reserve increase: debit (-).
Decrease: credit (+) 32
 FOREIGN EXCHANGE RESERVE

Measure entire official reserves volume of a

country's central bank in holding US dollars, yen,
euro , pound, gold and special drawing rights
(SDR)

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CASE STUDY

BLADE, INC.CASE
(p.54)

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DOUBLE ENTRY RULE OF BALANCE
OF PAYMENTS

Liabilities Assets
Saving: 100 millions Cash: 100 millions

where it from ? Where is it going?

Inflow Outflow
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 DOUBLE ENTRY RULE OF BALANCE OF
PAYMENTS
Basic transaction Derivative transaction

(-) Merchandise import

(-) Services import
outflow
credit debit (-) Income outflow
Inflow (-) Transfer outflow
(+) (-)
(-) asset increase
(-) Liabilities decrease
(-) Errors and omissions

(+) Merchandise export

(+) Services export
debit inflow credit (+) Income inflow
Outflow (+) Transfer inflow
(-) (+)
(+) asset decrease
(+) Liabilities increase 36
(+) Errors and omissions
 DOUBLE ENTRY RULE OF BALANCE OF
PAYMENTS

Example 1:
Viet Nam import 100 million USD value of merchandise
from EU, and export 50 million USD value of
merchandise to EU, sell 50 million USD instalment value
of merchandise.
 DOUBLE ENTRY RULE OF BALANCE OF
PAYMENTS
BOP Viet Nam  BOP EU 
CA   CA  
 Import - 100  Export +100
merchandise merchandise (to
(from EU) VN)
 Export + 50  Import -50
merchandise (to merchandise (from
EU) VN)
 Export  Import -50
merchandise + 50 merchandise
(instalment) (instalment)
 DOUBLE ENTRY RULE OF BALANCE OF
PAYMENTS

Example 2:
Viet Nam import 100 million USD value of merchandise
from EU by issue 50 million USD value of foreign bonds
and was 50 million USD aid
 DOUBLE ENTRY RULE OF BALANCE OF
PAYMENTS
BOP Viet Nam  BOP EU 
CA   CA  
 Import - 100  Export +100
merchandise merchandise (to
(from EU) VN)
 Aid (from EU) + 50  Aid (to VN) -50
K K
 Liabilities + 50 Asset increase -50
increase (issue (buy foreign bonds)
foreign bonds)
SURPLUS AND DEFICIT

The 1st method

Surplus or deficit of each main
component

The 2nd method

Accumulated surplus or deficit
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 SURPLUS AND DEFICIT
Content Inflow Outflow Component Accumulate
(+) (-)

Merchandise export +150      

Merchandise import   -200    
Payments for merchandise     -50 -50
Services export +120      
Services import   -160    
Payments for Services     -40 -90
Inflow +20      
Outflow   -10    
Income payments     +10 -80
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………… ………… ………… …………. …………
…
 SURPLUS AND DEFICIT
(X-M+SE+IC+Tr)+(KL+KS)+(∆R+L+#)=0
- X: export value
- M: import value
- SE: net service value
- IC: net income value
- Tr: net transfers value
- KL: long – term capital
- KS: short – term capital
- ∆R: change in reserves
- L: IMF or other central banking loans
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 SURPLUS AND DEFICIT

Surplus or
deficit
Payments for
Surplus or Merchandise
deficit Surplus or
Overall Balance deficit
Current
Surplus or deficit account
Basic Balance

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SURPLUS AND DEFICIT - BALANCE OF TRADE

TB=(X-M)=-(SE+IC+Tr+KL+KS+∆R) (1)

 (X-M)>0: surplus
 (X-M)<0: deficit

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SURPLUS AND DEFICIT – CURRENT ACCOUNT

CA=(X-M+SE+IC+Tr) = -(KL+KS+∆R)

 (X-M+SE+IC+Tr)>0: CA surplus
 (X-M+SE+IC+Tr)<0: CA deficit
 (X-M+SE+IC+Tr)=0: CA balance
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 SURPLUS AND DEFICIT – CURRENT ACCOUNT

CA=0 => X-M+SE+IC+Tr =0

 In long - term: ∆R=0
(1) → KL+KS = 0 ↔ KL = -KS
 Case 1: KL<0 and KS>0
→ National payment capacity threatened → pressure to
increase interest rates and currency prices
 Case 2: KL>0 and KS<0
→ the macroeconomic environment more stable → 47

exchange rate and interest rate is stable

 SURPLUS AND DEFICIT – CURRENT ACCOUNT

CA=0 => X-M+SE+IC+Tr =0

 In short term: KL=0

(1) → KS+∆R=0 ↔ KS=-∆R
 Case1: ∆R>0 and KS<0
→ Still can survive the pressure decrease the home
currency to raise interest rates
 Case 2: ∆R<0 and KS>0
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 SURPLUS AND DEFICIT – OVERALL
BALANCE

BB=CA+KL=-(KS+∆R)

When CA<0 but (CA+KL)>0

→ country is not in liquidity risk
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 SURPLUS AND DEFICIT – OVERALL
BALANCE
OB=X-M+SE+IC+Tr+KL+KS
OB = -OFB
 If surplus (+), it implied the amount of money one
country can be used to increase the foreign
exchange reserves
 If deficit (-), it implied the amount of money one
country have to pay to decrease the foreign
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exchange reserves
EXTERNAL AND INTERNAL DEFICIT

NATIONAL PRODUCTION = NATIONAL DEMAND

Y=C+I+G+X–M
Y=C+S+T
→C+I+G+X–M=C+S+T
Þ X – M = (S – I) – (G – T)
So
Balance of trade = Net private saving – Budget deficit

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CORRECTING A BALANCE-OF-TRADE DEFICIT

Large
deficit

Transfer of
jobs

Try to
correct 52
WHY A WEAK HOME CURRENCY IS
NOT A PERFECT SOLUTION

Impact
Counter of Other
pricing by Weak
Competitors
Prearranged International Transactions
Currencies

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Trade Balance J-CURVE EFFECT

J - Curve

Time 54
 AGENCIES THAT FACILITATE
INTERNATIONAL FLOWS

• International Monetary Fund (IMF)

• World Bank
• World Trade Organization (WTO)
• International Financial Corporation (IFC)
• International Development Association (IDA)
• Bank for International Settlements (BIS)
• Organization for Economic Cooperation and
Development (OECD)
• Regional development agencies 55
 CASE STUDY

Read and answer questions of case study about

VDEC corporation, page 103 – exercise book

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