Lecture 2 - International Flow of Funds

9/8/2017
International Financial Management
Dr. Nguyen Thi Hoang Anh
Lecture 2:
International Flows of Fund
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2 International Flow of Funds

Lecture Objectives
 Explain the key components of the balance of payments,

 Explain the growth in international trade activity over time,
 Explain how international trade flows are influenced by
economic factors and other factors,
 Explain how international capital flows are influenced by
country characteristics,
 Introduce the agencies that facilitate the international flow of
funds.
2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
Balance of Payments
• Definition:
Summary of transactions between domestic and
foreign residents for a specific country over a
specified period of time.
• It represents an accounting of a country’s
international transactions for a period, usually a
quarter or a year.
• It accounts for transactions by businesses,
individuals, and the government
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Balance of Payments
Components of the Balance of Payments

Statement:
a. Current Account: summary of flow of funds due to
purchases of goods or services or the provision of
income on financial assets.
b. Capital Account: summary of flow of funds
resulting from the sale of assets between one
specified country and all other countries over a
specified period of time.
c. Financial Account: refers to special types of
investment, including FDI and portfolio
investment.
Balance of Payments
For all three accounts, transactions that reflect

inflows of funds generate positive numbers (credits)
for the country’s balance whereas transactions that
reflect outflows of funds generate negative numbers
(debits) for its balance.
Current Account
1. Payments for merchandise and services

Merchandise exports and imports represent tangible
products that are transported between countries. Service
exports and imports represent tourism and other services.
The difference between total exports and imports is referred
to as the balance of trade.
2. Factor income payments
Represents income (interest and dividend payments)
received by investors on foreign investments in financial
assets (securities).
3. Transfer payments
Represent aid, grants, and gifts from one country to
another.
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Exhibit 2.1 Examples of Current Account Transactions
Exhibit 2.2 Summary of Current Account in the year

2010 (in billions of $)
Capital Account
 The Capital Account measures financial transactions that don't

affect a country's income, production or savings.
 These transactions are all non-produced, non-financial assets.
 They might produce an investment stream in the future. In that
case, they would be included in the financial account. They
might eventually produce income from goods or services. When
that happens, they would be counted in the current account.
 The capital account items are relatively minor (in terms of
dollar amounts) when compared with the financial account
items
 E.g.:
 a company purchased a foreign trademark
 an oil company bought drilling rights to an overseas location.
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Financial Account
1. Direct foreign investment

Investments in fixed assets in foreign countries
2. Portfolio investment
Transactions involving long term financial assets (such as
stocks and bonds) between countries that do not affect the
transfer of control.
3. Other capital investment
Transactions involving short-term financial assets (such as
money market securities) between countries.
4. Errors and omissions
Measurement errors can occur when attempting to measure the
value of funds transferred into or out of a country.
Growth of International Trade
Events That Increased Trade Volume

1. Removal of the Berlin Wall: Led to reductions in trade
barriers in Eastern Europe.
2. Single European Act of 1987: Improved access to supplies
from firms in other European countries.
3. North American Free Trade Agreement (NAFTA):
Allowed U.S. firms to penetrate product and labor markets that
previously had not been accessible.
4. General Agreement on Tariffs and Trade (GATT):

Called for the reduction or elimination of trade restrictions on
specified imported goods over a 10-year period across 117
11
countries.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
Events That Increased Trade Volume (cont.)
5. Inception of the Euro: Reduced costs and risks

associated with converting one currency to another.
6. Expansion of the European Union: reduced

restrictions on trade with Western Europe.
7. Other Trade Agreements
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Impact of Outsourcing on Trade
1. Definition of Outsourcing: The process of

subcontracting to a third party in another country to
provide supplies or services that were previously
produced internally.
2. Impact of outsourcing:
1. Increased international trade activity because MNCs now
purchase products or services from another country.
2. Lower cost of operations and job creation in countries with
low wages.
3. Criticism of outsourcing:
1. Outsourcing may reduce jobs in the home country.
Managerial Decisions About Outsourcing
1. Managers of a U.S.–based MNC may argue that

they create jobs for U.S. workers.
2. Shareholders may suggest that the managers are not
maximizing the MNC’s value as a result of their
commitment to creating U.S. jobs.
3. Managers should consider the potential savings that
could occur as a result of outsourcing.
4. Managers must also consider the possible bad
publicity or bad morale that could occur among the
U.S. workers.
Trade Volume Among Countries
• Some countries rely more heavily on international trade than

do others.
• The annual international trade volume of the United States is
typically between 10 and 20 percent of its GDP.
• Canada, France, Germany, and other European countries rely
more heavily on trade than does the United States.
• For instance, Canada (> 50 percent of its annual GDP)
European countries (between 30 and 40 percent of their
respective GDPs), Japan (between 10 and 20 percent of its
GDP, much as in the United States)
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Exhibit 2.4 2008 Distribution of U.S. Exports and

Imports
Trend in U.S. Balance of Trade
1. The U.S. balance of trade deficit increased

substantially from 1997 until 2008.
2. In the 2008–2009 period, U.S. economic
conditions weakened and the U.S. demand for
foreign products and services decreased.
3. In recent years, the U.S. annual balance of trade
deficit with China has exceeded $200 billion.
4. Any country’s balance of trade can change
substantially over time.
Exhibit 2.5 U.S. Balance of Trade Over Time

(Quarterly)
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Vietnam Trade Balance
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Factors Affecting International Trade Flows
1. Cost of Labor: Firms in countries where labor costs

are low commonly have an advantage when
competing globally, especially in labor intensive
industries
2. Inflation: Current account decreases if inflation
increases relative to trade partners.
3. National Income: Current account decreases if
national income increases relative to other
countries.
Factors Affecting International Trade Flows (cont.)
4. Government Policies: can increase imports through:

a. Restrictions on imports
b. Subsidies for exporters
c. Lack of restriction on piracy
d. Environmental restrictions
e. Labor laws
f. Tax breaks
g. Country security laws
5. Exchange Rates: current account decreases if

currency appreciates relative to other currencies.
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Impact of Government Policies
1. Restrictions on Imports: Taxes (tariffs) on imported goods

increase prices and limit consumption. Quotas limit the
volume of imports.
2. Subsidies for Exporters: Government subsidies help firms
produce at a lower cost than their global competitors.
3. Restrictions on Piracy: A government can affect
international trade flows by its lack of restrictions on
piracy.
4. Environmental Restrictions: Environmental restrictions
impose higher costs on local firms, placing them at a global
disadvantage compared to firms in other countries that are
not subject to the same restrictions.
Impact of Government Policies (cont.)
5. Labor Laws: countries with more restrictive laws will

incur higher expenses for labor, other factors being
equal.
6. Business Laws: Firms in countries with more restrictive
bribery laws may not be able to compete globally in
some situations.
7. Tax Breaks: Though not necessarily a subsidy, but still a
form of government financial support that might benefit
many firms that export products.
8. Country Security Laws: Governments may impose
certain restrictions when national security is a concern,
which can affect on trade.
Impact of Exchange Rates
 How exchange rates may correct a balance of trade

deficit:
When a home currency is exchanged for a foreign currency
to buy foreign goods, then the home currency faces
downward pressure, leading to increased foreign demand for
the country’s products.
 Why exchange rates may not correct a balance of
trade deficit:
Exchange rates will not automatically correct any
international trade balances when other forces are at work.
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Limitations of a Weak Home Currency Solution
1. Competition: foreign companies may lower their prices to

remain competitive.
2. Impact of other currencies: a country that has balance of
trade deficit with many countries is not likely to solve all
deficits simultaneously.
3. Prearranged international trade transactions: international
transactions cannot be adjusted immediately. The lag is
estimated to be 18 months or longer, leading to a J-curve
effect.
4. Intracompany trade: Many firms purchase products that are
produced by their subsidiaries. These transactions are not
necessarily affected by currency fluctuations.
Exhibit 2.6 J-Curve Effect
Friction Regarding Exchange Rates
1. All governments cannot weaken their home

currencies simultaneously.
2. Actions by one government to weaken its currency
causes another country’s currency to strengthen.
3. Government attempts to influence exchange rates
can lead to international disputes.
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International Capital Flows
1. One of the most important types of capital flows is direct

foreign investment. Firms commonly attempt to engage in
direct foreign investment so that they can reach additional
consumers or utilize low-cost labor.
2. Multinational corporations based in the United States
engage in FDI more than MNCs from any other country.
Europe as a whole attracts more than 50 percent of all FDI
by U.S.-based MNCs.
3. The countries that are most heavily involved in pursuing
FDI also attract considerable FDI. In particular, the United
States attracts about one-sixth of all FDI, which is more
than any other country. Much of the FDI in the United
States comes from the United Kingdom, Japan, the
Netherlands, Germany, and Canada.
Factors Affecting Direct Foreign Investing (FDI)
1. Changes in Restrictions
 New opportunities have arisen from the
removal of government barriers.
2. Privatization
 FDI is stimulated by new business opportunities
associated with privatization.
 Managers of privately owned businesses are
motivated to ensure profitability, further
stimulating FDI.
Factors Affecting Direct Foreign Investing (FDI)

(Cont.)
4. Potential Economic Growth

 Countries with greater potential for economic
growth are more likely to attract FDI.
5. Tax Rates
 Countries that impose relatively low tax rates on
corporate earnings are more likely to attract FDI.
6. Exchange Rates
 Firms typically prefer to pursue FDI in countries
where the local currency is expected to strengthen
against their own.
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Factors Affecting International Portfolio Investment
1. Tax Rate on Interest or Dividends

Investors normally prefer to invest in a country
where taxes are relatively low.
2. Interest Rates
Money tends to flow to countries with high interest
rates, as long as the local currencies are not expected
to weaken.
3. Exchange Rates
Investors are attracted to a currency that is expected
to strengthen.
Impact of International Capital Flows
1. The United States relies heavily on foreign

investment in:
 U.S. manufacturing plants, offices, and other
buildings.
 Debt securities issued by U.S. firms.
 U.S. Treasury debt securities
2. Foreign investors are especially attracted to the U.S.
financial markets when the interest rate in their home
country is substantially lower than that in the United
States.
Exhibit 2.7 Impact of the International Flow of Funds on U.S.

Interest Rates and Business Investment in the United States
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Agencies that Facilitate International Flows

International Monetary Fund (IMF)
1. Major Objectives of the IMF

i. promote cooperation among countries on international
monetary issues,
ii. promote stability in exchange rates
iii. provide temporary funds to member countries attempting
to correct imbalances of international payments
iv. promote free mobility of capital funds across countries
v. promote free trade. It is clear from these objectives that
the IMF’s goals encourage increased internationalization
of business
2. Its compensatory financing facility (CFF) attempts to
reduce the impact of export instability on countries.
3. Financing is measured in special drawing rights (SDRs)

World Bank (International Bank for Reconstruction and Development)
1. Major Objective- Make loans to countries to enhance

economic development.
2. Structural Adjustment Loans (SALs) are intended to
enhance a country’s long-term economic growth.
3. Funds are distributed through cofinancing agreements:
 Official aid agencies
 Export credit agencies
 Commercial banks

World Trade Organization (WTO)
1. Major Objective - Provide a forum for multilateral trade

negotiations and to settle trade disputes related to the GATT
accord.
2. Member countries are given voting rights that are used to
make judgments about trade disputes and other issues.
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International Financial Corporation (IFC)
1. Major Objective - promote private enterprise within

countries.
2. Provides loans to corporations and purchases stock
3. It traditionally has obtained financing from the
World Bank but can borrow in the international
financial markets.

International Development Association (IDA)
1. Major Objectives - extends loans at low interest rates

to poor nations that cannot qualify for loans from the
World Bank.

Bank for International Settlements (BIS)
1. Major Objectives - facilitate cooperation among

countries with regard to international transactions.
2. Provides assistance to countries experiencing a
financial crisis.
3. Sometimes referred to as the “central banks’
central bank” or the “lender of last resort.”
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Organization for Economic Cooperation and Development (OECD)
1. Major Objective - Facilitate governance in

governments and corporations of countries with
market economics.
2. It has 30 member countries and has relationships
with numerous countries.
3. Promotes international country relationships that
lead to globalization.

Regional Development Agencies
1. Inter-American Development Bank: focusing on the

needs of Latin America
2. Asian Development Bank: established to enhance
social and economic development in Asia
3. African Development Bank: focusing on
development in African countries
4. European Bank for Reconstruction and
Development: created in 1990 to help the Eastern
European countries adjust from communism to
capitalism.
SUMMARY
 The key components of the balance of payments are the

current account and the capital account. Current account -
broad measure of the country’s international trade balance.
Capital account - measure of the country’s long-term and
short-term capital investments.
 International trade activity has grown over time. Outsourcing,
subcontracting with a third party in a foreign country for
supplies or services they previously produced themselves, has
increased. Thus increasing international trade activity.
 A country’s international trade flows are affected by inflation,
national income, government restrictions, and exchange rates.
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SUMMARY (Cont.)
 A country’s international capital flows are affected by any

factors that influence direct foreign investment or portfolio
investment. Direct foreign investment tends to occur in those
countries that have no restrictions and much potential for
economic growth. Portfolio investment tends to occur in those
countries where taxes are not excessive, where interest rates
are high, and where the local currencies are not expected to
weaken.
 Several agencies facilitate the international flow of funds by
promoting international trade and finance, providing loans to
enhance global economic development, settling trade disputes
between countries, and promoting global business
relationships between countries.
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Lecture 2 - International Flow of Funds

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Lecture 2 - International Flow of Funds

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9/8/2017

International Financial Management

Dr. Nguyen Thi Hoang Anh

2 International Flow of Funds

 Explain the key components of the balance of payments,

Components of the Balance of Payments

For all three accounts, transactions that reflect

1. Payments for merchandise and services

Exhibit 2.1 Examples of Current Account Transactions

Exhibit 2.2 Summary of Current Account in the year

 The Capital Account measures financial transactions that don't

1. Direct foreign investment

Growth of International Trade

Events That Increased Trade Volume

4. General Agreement on Tariffs and Trade (GATT):

Events That Increased Trade Volume (cont.)

5. Inception of the Euro: Reduced costs and risks

6. Expansion of the European Union: reduced

7. Other Trade Agreements

Impact of Outsourcing on Trade

1. Definition of Outsourcing: The process of

Managerial Decisions About Outsourcing

1. Managers of a U.S.–based MNC may argue that

Trade Volume Among Countries

• Some countries rely more heavily on international trade than

Exhibit 2.4 2008 Distribution of U.S. Exports and

Trend in U.S. Balance of Trade

1. The U.S. balance of trade deficit increased

Exhibit 2.5 U.S. Balance of Trade Over Time

Vietnam Trade Balance

Factors Affecting International Trade Flows

1. Cost of Labor: Firms in countries where labor costs

Factors Affecting International Trade Flows (cont.)

4. Government Policies: can increase imports through:

5. Exchange Rates: current account decreases if

Impact of Government Policies

1. Restrictions on Imports: Taxes (tariffs) on imported goods

Impact of Government Policies (cont.)

5. Labor Laws: countries with more restrictive laws will

Impact of Exchange Rates

 How exchange rates may correct a balance of trade

Limitations of a Weak Home Currency Solution

1. Competition: foreign companies may lower their prices to

Exhibit 2.6 J-Curve Effect

Friction Regarding Exchange Rates

1. All governments cannot weaken their home

International Capital Flows

1. One of the most important types of capital flows is direct

Factors Affecting Direct Foreign Investing (FDI)

Factors Affecting Direct Foreign Investing (FDI)

4. Potential Economic Growth

Factors Affecting International Portfolio Investment

1. Tax Rate on Interest or Dividends

Impact of International Capital Flows

1. The United States relies heavily on foreign

Exhibit 2.7 Impact of the International Flow of Funds on U.S.

Agencies that Facilitate International Flows

1. Major Objectives of the IMF

Agencies that Facilitate International Flows

1. Major Objective- Make loans to countries to enhance

Agencies that Facilitate International Flows

1. Major Objective - Provide a forum for multilateral trade

Agencies that Facilitate International Flows

1. Major Objective - promote private enterprise within