BUSFIN 4250: Ch 2 International Flow of Funds

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Balance of Payments BOP

• Def: a summary of transactions between domestic and foreign residents for a specific country over a specified period of time.

• Def: is a summary statement that

  records the exchange of goods, services, and assets between

  businesses, individuals, and the government of one country with the

  rest of the world during a particular period

• It represents an accounting of a country’s international transactions for that period, usually a quarter or a year.

• This summary includes transactions by businesses, individuals, and the government.

• Comprised of the current account, the capital account, and the financial account.

Current Account

• Def: broad measure of a country’s international trade in goods and services.

• Def: records the flow of funds between domestic

  and foreign residents from trade in goods, services, and income

  from investments

• The main components are payments between two countries for (1) merchandise (goods) and services (aka balance of trade), (2) primary income, and (3) secondary income.

*Payments for Goods and Services (balance of trade):

This component records exports and imports of goods (ex cars, soybeans) and services (ex tourism)

Within this, the trade balance is an important sub-account

*Trade Balance

• Trade Balance = Exports – Imports

  • If exports > imports → Trade Surplus

  • If exports < imports → Trade Deficit

If exports > imports →

• Trade Surplus

If exports < imports →

• Trade Deficit

*Primary Income Payments

• This refers to income earned by U.S. multinational corporations (MNCs)

from their investments in other countries, and by U.S. investors from

their portfolio investments, such as dividends and interest income.

• It also includes income earned by foreign MNCs and foreign investors from

their investments in the United States

*The U.S. current account has indeed been in

• deficit since 1992.

• This persistent deficit is primarily due to the U.S. trade balance, where

imports of goods and services consistently exceed exports. For

instance, in 2023, the current account deficit was approximately $905.4

billion

*A current account deficit is a sign that

a country is borrowing more from other countries than it is lending to them.

*US Trade Deficit In Order

China, Mexico, and Vietnam

*US Trade Surplus In Order

Netherlands, Hong Kong, Australia

Merchandise exports and imports comprise

tangible products, such as smartphones and clothing, that are transported between countries.

Service exports and imports encompass

tourism and other services (such as legal, insurance, and consulting services) provided for customers based in other countries.

Balance of Trade

• Def: difference between the value of merchandise exports and merchandise imports.

• Ex. A deficit in the U.S. balance of trade means that the value of merchandise and services exported by the United States is less than the value of merchandise and services that it imports.

Primary Income Payments / Factor Income

• Def: income earned by multinational corporations on their direct foreign investment (investment in fixed assets in foreign countries that can be used to conduct business operations) as well as income earned by investors on their portfolio investments (investments in foreign securities).

Secondary Income / Transfer Payments

• Def.: aid, grants, and gifts from one country to another.

Financial Account

• Def: a measurement of the flow of funds between countries that are due to direct foreign investment, portfolio investment, and other capital investment.

Direct Foreign Investment DFI

• Payments representing direct foreign investment in the United States (such as the acquisition of a U.S. firm by a non-U.S. firm) are recorded as a positive number in the U.S. financial account because funds are flowing into the United States.

• Conversely, payments representing a U.S.-based MNC’s direct foreign investment in another country are recorded as a negative number because funds are being sent from the United States to another country.

• Ex: payments to complete the acquisition of a foreign company, to construct a new manufacturing plant in a foreign country, or to expand an existing plant in a foreign country.

*DFIs made by foreign firms in the U.S. are recorded as a

credit (capital inflow) in the U.S. financial account because funds are

flowing into the U.S.

*Conversely, DFIs made by U.S. firms in other countries are

recorded as a

debit (capital outflow) in the U.S. financial account

because funds are sent from the U.S. to another country.

Portfolio Investment

• investment in financial assets such as stocks or bonds

• Def: refers to transactions involving long-term financial

  assets, such as stocks and bonds, between countries that do not result in a

  transfer of control—that is, the investor does not gain control over the

  enterprise.

*Portfolio investments by foreign residents in the U.S. result in an

inflow of funds (credit entry) in the U.S. financial account

*Portfolio investments by U.S. residents in other countries result in

capital outflows (debit entry) in the U.S. financial account

Other Capital Investment

• represents transactions involving short-term financial assets (such as money market securities) between countries.

• Examples include, foreign loans and bank deposits.

  
  

Capital Account

• Def: a summary of the flow of funds between one specified country and all other countries due to purchases of goods and services or to the cash flows generated by income-producing financial assets.

Outsourcing

• Def: the process of subcontracting to a third party.

  • subcontracting to a third party in another country to provide supplies or services that were previously produced internally.

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• Because international trade can significantly affect a country’s economy, it is important to identify and monitor the factors that influence it. The following factors are the most influential:

• A nation’s characteristics influence the volume of its international

  trade and hence its balance of payments.

• Cost of labor

• Inflation

• National income

• Credit conditions

• Government policies

• Exchange rates

Influential PT 1

• Cost of labor

• Inflation

• National income

Influential PT 2

• Credit conditions

• Government policies

• Exchange rates

Cost of Labor

• The cost of labor varies substantially among countries.

• Firms in countries where labor costs are low typically have an advantage when competing globally, especially in labor-intensive industries. '

• Countries with an abundance of labor (such as China, India,

  and Vietnam) have a comparative advantage in producing

  labor-intensive goods, such as textiles.

  • As a result, they export these goods to other nations. So,

  lower labor costs can boost exports and improve the trade

  balance

Inflation

• If a country’s inflation rate increases relative to the countries with which it trades, this could cause its exports to decrease (if foreign customers shift to cheaper alternatives in other countries) and its imports to increase (if local individuals and firms shift to cheaper alternatives).

• Consequently, an increase in the country’s inflation may cause its current account to decrease.

*Inflation

• Countries with higher inflation than their trading partners will

experience a decrease in exports and an increase in

imports, resulting in a trade deficit.

• Similarly, countries with a lower rate of inflation than their

trading partners will experience a trade surplus.

National Income

• If a country’s income level (national income) increases by a higher percentage than those of other countries, then its current account should decrease, other things being equal.

• As the real income level (adjusted for inflation) rises, so does consumption of goods. A percentage of that increase in consumption will most likely reflect an increased demand for foreign goods.

• The trade balance tends to decrease when a nation’s real

  income increases relative to that of its trading partners

*As real income (real GDP) rises,

consumers demand

more goods and services, including imports. This increase in

imports leads to a deterioration in the trade balance

*Conversely, the trade balance tends to improve when a nation’s

real GDP

declines relative to the real income of its trading

partners, as import demand decreases

Credit Conditions

• When credit conditions become more restrictive, banks are less willing to provide financing to MNCs. MNCs, in turn, may reduce their corporate spending, which further weakens the economy, and they may also reduce their demand for imported supplies.

Government Policies

• On a practical level, governments implement many policies that affect their respective balance-of-trade positions, as explained here.

• Government Policies can impact trade flows through:

  • Restrictions on imports – Tariffs and quotas

  • Subsidies for exporters

  • Environmental restrictions

  • Labor laws – Child labor and overtime pay laws

  • Exchange-rate policie

*Government Policies can impact trade flows through: PT 1

• Restrictions on imports – Tariffs and quotas

• Subsidies for exporters

• Environmental restrictions

• Government Policies can impact trade flows through: PT 2

• Labor laws – Child labor and overtime pay laws

• Exchange-rate policies

*Restrictions on Imports:

Tariffs and quotas on imported goods reduce the volume of imports,

which can lead to an improvement in the trade balance, assuming

the trading partners do not retaliate. If they do, the net effect on

trade balance can not be known in advance

*Subsidies for Exporters:

• Government subsidies can enable exporters to offer lower prices in

international markets, thereby increasing exports.

• A subsidy is government assistance provided to exporters. They take the

form of (1) direct payments to exporters, (2) loans at low or zero interest

rates, or (3) tax breaks.

• All forms of subsidies and trade barriers are prohibited by the WTO

*The practice of exporting goods at prices below the domestic market

price—or even below the cost of production—is known as

dumping. The

aim of dumping may be to increase exports or to eliminate foreign

competition.

* Environmental Restrictions:

• Environmental regulations can increase production costs, putting

domestic firms at a competitive disadvantage.

• Countries with less stringent environmental standards may gain a

comparative advantage in some industries.

*Loose Regulations

• Example: Mexico's relatively loose environmental regulations have

encouraged multinational corporations (MNCs) to relocate production

there, increasing trade with the U.S.

• Other countries with relatively lax environmental regulations include

China and Turkey

* Labor Laws

Child labor is inexpensive. Strict labor laws increase production costs,

putting domestic firms at a competitive disadvantage.

*Countries Child Labor

• In the U.S., child labor is illegal, and firms must pay 50% more for

overtime, increasing production costs.

• In countries such as Indonesia, weaker child labor laws have encouraged

some multinational corporations (MNCs) to relocate production.

• Example: Nike has faced accusations of using child labor in Indonesia

and other countries since the 1970s.

Exchange Rates PT 1

• Each country’s currency is valued in terms of other currencies through the use of exchange rates.

• Once the necessary exchange rate is established, currencies can then be exchanged to facilitate international transactions.

Exchange Rates PT 2

• The values of most currencies fluctuate over time because of market and government forces.

• As the value of a country’s currency changes, the prices of its exported goods will change for the importing countries, as will the demand for those goods.

*Exchange Rates:

• The exchange rate is the price of one currency in terms of another. For example,

£1 = $2, where £ represents the British pound.

• Governments can influence exchange rates through policy, which in turn affects

international trade.

• Some governments keep their currencies undervalued (cheap) to increase

exports and reduce imports, creating a trade surplus

*Exchange Rates Ex

Suppose the U.S. imports T-shirts priced at £10 and the exchange rate is £1 =

$2. The dollar cost is $20. If the U.S. dollar weakens (so it takes more dollars to

buy one pound), the dollar cost of the T-shirt increases, resulting in fewer

imports

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Direct Foreign Investment DFI PT 1

• One of the most important types of capital flows.

• Firms commonly pursue _ so that they can reach additional consumers or utilize low-cost labor.

• Notably, MNCs based in the United States engage in _ more than MNCs from any other country.

DFI PT 2

• Europe as a whole attracts more than 60 percent of all DFI by U.S.-based MNCs.

• The countries that are most heavily involved in pursuing such outside investments also attract considerable DFI. In particular, the United States attracts about one-fourth of all DFI, which is more than any other country. Much of the DFI in the United States comes from the United Kingdom, Japan, the Netherlands, Canada, and France.

Factors Affecting Direct Foreign Investment

• Changes in Restrictions

• Privatization

• Potential Economic Growth

• Tax Rates

• Exchange Rates

*Changes in DFI Restrictions

o Lowering barriers to foreign investment encourages multinational

corporations (MNCs) to increase direct foreign investment (DFI).

o During the 1990s, many developing countries liberalized their

economies to attract foreign capital, create jobs, and promote economic

growth by opening their markets to foreign investors

Potential for Economic Growth

o MNCs are more likely to increase their DFI in countries with strong

economic growth prospects, as these environments offer greater

potential for higher profits

Tax Rates

o Countries that offer relatively low tax rates on corporate

earnings are more likely to attract DFI.

o Low taxes mean MNCs can keep a larger portion of their profits

Exchange Rates

o MNCs prefer to pursue direct foreign investment (DFI) in

countries where the local currency is currently weak but

expected to strengthen (appreciate) in the future.

o As the local currency appreciates over time, the MNCs’ earnings

can be converted into more units of the home currency (such as

the U.S. dollar), increasing their returns

Capital flows resulting from DFI change whenever

conditions in a country change the desire of MNCs to conduct business operations there.

Changes in Restrictions

• Many countries lowered their restrictions on DFI during the 1990s, which resulted in more DFI in those countries.

• Many U.S.-based MNCs (including Colgate-Palmolive, Starbucks, and Walmart) have aggressively pursued DFI in less developed countries such as Argentina, Chile, China, Hungary, India, and Mexico.

• New opportunities in these countries have arisen since government barriers were removed.

Privatization

• Def: the selling of some of their operations to corporations and other investors.

• This policy allows for expansion of international business because foreign firms can acquire operations sold by national governments.

The primary reason that the market value of a firm may increase in response to privatization is

the anticipated improvement in managerial efficiency.

• Managers in a privately owned firm can focus on the goal of maximizing shareholder wealth; in contrast, a state-owned business must consider the economic and social ramifications of any decision.

• Also, managers of a privately owned enterprise are more motivated to ensure profitability because their careers may depend on it. The trend toward privatization will undoubtedly create a more competitive global marketplace.

Potential Economic Growth

• Countries that have greater potential for economic growth are more likely to attract DFI because firms recognize the possibility of capitalizing on that growth by establishing more business there.

Tax Rates

Countries that impose relatively low tax rates on corporate earnings are more likely to attract DFI. When assessing the feasibility of DFI, firms estimate the after-tax cash flows that they expect to earn.

Exchange Rates

• Firms typically prefer to pursue DFI in countries where the local currency is expected to strengthen against their own.

• Under these conditions, they can invest funds to establish their operations in a country at a time when that country’s currency is relatively cheap (weak).

Factors Affecting International Portfolio Investment

• The amount of funds invested by individual or institutional investors in a specific country is influenced by the following factors.

• Tax Rates on Interest and Dividends

• Interest Rates

• Exchange Rates

Tax Rates on Interest or Dividends

• Investors generally prefer to invest in a country where the taxes on interest or dividend income from investments are relatively low.

• Investors assess their potential after-tax earnings from investments in foreign securities.

• Investors prefer to invest in countries where taxes on interest income or

  dividends are relatively low

Interest Rates

• Money tends to flow to countries with high interest rates, as long as the local currencies are not expected to weaken.

• Capital tends to flow to countries with higher interest rates, as they offer

  better returns on investment

Exchange Rates

• If a country’s home currency is expected to strengthen, then foreign investors may be willing to invest in that country’s securities so that they can benefit from the currency movement.

• Conversely, if a country’s home currency is expected to weaken, then foreign investors may prefer to purchase securities in other countries.

Expected Change in the Domestic Currency Exchange Rate

o If the U.S. dollar is expected to depreciate against the euro over time, U.S.

investors may shift their funds to the EU to purchase European securities.

When these investments mature, both principal and interest can be converted

into more dollars, resulting in higher returns when repatriated

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Agencies That Facilitate International Flows PT 1

• A variety of agencies have been established to facilitate international trade and financial transactions. These agencies often represent a group of nations. Each of the more important agencies is described next.

• International Monetary Fund IMF

• International Bank for Reconstruction and Development IBRD

• World Trade Organization WTO

• International Finance Corporation IFC

Agencies That Facilitate International Flows PT 2

• International Development Association IDA

• Bank for International Settlements BIS

• OECD

• Regional Development Agencies

International Monetary Fund (IMF)

• agency that attempts to increase international trade by promoting cooperation among countries on international monetary issues.

• Established after World War II, the International Monetary Fund (IMF) was

  created to stabilize the foreign exchange market and provide short-term

  financial assistance to countries facing balance of payments (BoP) deficits.

  Another key motivation behind its creation was to discourage the competitive

  currency devaluations and manipulations that were widespread during the

  1930s.

The General Agreement on Tariffs and Trade (GATT)

was established in 1947 to

promote free international trade.

• It was replaced by the World Trade Organization (WTO) on January 1, 1995

• The World Bank Group

• is one of the world’s largest sources of funding and knowledgesharing for developing countries. It is made up of five institutions.

  • The most important of these five institutions is the International Bank for Reconstruction

  and Development (IBRD), commonly known as the World Bank. The World Bank

  provides financing for development projects and offers policy advice to countries with

  the aim of reducing poverty and promoting sustainable economic development.

  
  

International Bank for Reconstruction and Development (IBRD)

bank established in 1944 to enhance economic development by providing loans to countries; the World Bank.

World Trade Organization (WTO)

organization established to provide a forum for multilateral trade negotiations and to settle trade disputes related to the GATT accord.

International Finance Corporation IFC

organization composed of a number of member nations that attempt to increase economic development through the private sector, rather than through the government sector.

International Development Association (IDA)

organization that offers loans at low interest rates to poor nations that cannot qualify for loans from the World Bank, in an effort to enhance economic development in those countries.

Bank for International Settlements (BIS)

• institution that facilitates cooperation among countries involved in international transactions and provides assistance to countries experiencing international payment problems.

• It is an international financial institution owned by 61 central banks.

  • Its goal is to foster international monetary and financial cooperation

  among central banks.

  • It serves as the lender of last resort for all central banks.

  • The BIS was originally established to facilitate payments that

  Germany was required to make (WWI reparations) for damages it

  inflicted on Allied nations during the war

The Organisation for Economic Co-operation and Development (OECD)

• facilitates governance in governments and corporations of countries with market economics.

• It has thirty-eight member countries as well as relationships with numerous other countries.

• The _ promotes international country relationships that lead to globalization.

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Factors that Contributed to Rapid Growth in Trade Since the

End of WWII

• General Agreement on Tariffs and Trade (GATT) of 1947

• European Union in 1993

• North American Free Trade Agreement (NAFTA) of 1994

• Inception of the Euro in 2002

  
  

General Agreement on Tariffs and Trade (GATT) of 1947

• established in 1947 to promote free international trade. Its primary goal was to

reduce or eliminate trade barriers, such as tariffs and quotas, which

had increased significantly during the interwar period (1918–1939).

• Since GATT dealt only with trade in goods, it was replaced by the

World Trade Organization (WTO) on January 1, 1995, which covers

trade in goods, services, and intellectual property.

Inception of the European Union (EU) in 1993:

o Created free trade among member countries.

o The EU now has 27 member nations.

o The EU accounts about 15.5% of global trade (2024 data).

North American Free Trade Agreement (NAFTA) of 1994

o Free trade agreement among the U.S., Canada, and Mexico.

o Replaced by the United States–Mexico–Canada Agreement (USMCA) in

2020

Inception of the Euro in 2002

o Reduced exchange rate risk, making trade within the eurozone easier.

o Today, 20 of the EU's 27 members use the euro.