Chapter 2

International Flow of Funds

 Chapter Objectives

• To explain the key components of the balance of payments;

and
• To explain how the international flow of funds is influenced
by economic factors and other factors.
• To explain how international capital flows are influenced by
country characteristics.

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 Balance of Payments
The balance of payments is a summary of transactions between
domestic and foreign residents for a specific country over a specified
period of time. It accounts for transactions by business, individuals,
and the government.

Each transaction is recorded as both a credit and a debit, i.e. double

entry bookkeeping.

A balance of payments statements can be broken down into two

components-
(1) Current account, and
(2) Capital account
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 Balance of Payments, cont..
Current Account:
The current account summarizes the flow of funds between one
specified country and all other countries due to the purchases of
goods or services, or the provision of income on financial assets, or
unilateral current transfers (e.g. government grants and pensions,
private remittances).

Components of the Current account are payments for-

(1) Merchandise (goods) and services

(2) Factor Income
(3) Transfer Payments
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 Current Account, cont..
Payments for Merchandise and Services:
Payments related to imports and exports of goods and services. The
current account is commonly used to assess the balance of trade,
which is simply the difference between merchandise exports and
merchandise imports.

Factor Income Payments:

Income (interest and dividend payments) receive by investors on
foreign investments in financial assets (securities).

Transfer Payments:
Represents aid, grants, and gifts from one country to another.
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 Balance of Payments, cont..
Capital Account:
The capital account summarizes the flow of funds resulting for the
sale of assets between one specified country and all other countries
over a specified period of time.

The capital account includes the value of financial assets transferred

across country borders.

It also includes the value of non-produced non-financial assets that

are transferred across country borders, such as patents and
trademarks.

Capital account items are relatively minor compared to the financial

account items.
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 Balance of Payments, cont..
Financial Accounts:
The financial account (which was called the capital account
previously) summarizes the flow of funds resulting from the sale of
assets between one specified country and all other countries.

The key components of the financial account are payments for-

(1) Direct foreign investment

(2) Portfolio investment
(3) Other capital investment

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 Financial Account, cont..
Direct Foreign Investment:
DFI represents the investments in fixed assets in foreign countries
that can be used to conduct business operation.

Portfolio Investment:
Represents transactions involving long-term financial assets (such as
stocks and bonds) between countries that do not affect the transfer of
control.

Other Capital Investment:

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

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Factors Affecting International Trade Flows
International trade can significantly affect a country’s economy. It is
important to identify and monitor the factors that influence it. The
most influential factors are:

Inflation:
A relative increase in a country’s inflation rate will decrease its
current account, as imports increase and exports decrease.

National Income:
A relative increase in a country’s income level will decrease its
current account, as imports increase.

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Factors Affecting International Trade Flows, cont.
Government Restrictions:
A country’s government can have a major effect on its balance of
trade due to its different policies related on international trade, like
Subsidies for Exporters- some government offer subsidiary to their
domestic firms, so that those firms can produce products at a lower
cost than their global competitors.
Restrictions on Imports (tariff and quota)- government can increase
the price of foreign products by imposing tax (tariff), and also can
reduce its country’s imports by enforcing a quota, maximum limit that
can be imported.
Lack of restrictions on Piracy- government can affect international
trade flows by its lack of restrictions on piracy.
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Factors Affecting International Trade Flows, cont.
Exchange Rates:
Each country’s currency is valued in terms of other currencies through
the use of exchange rates, so that currencies can be exchanged to
facilitate international transactions.

If a country’s currency begins to rise in value against others

currencies, its current account balance will decrease as goods exported
by that country will became expensive to the importing countries, as a
consequence, the demand for such goods will decrease.

Note that the factors are interactive, such that their simultaneous
influence on the balance of trade is a complex one.

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 International Capital Flows
International Capital Flows usually represent-

• Portfolio Investment,
• Direct Foreign Investment (DFI).

Firms commonly attempt to engage in direct foreign investment so

that they can reach additional consumers or can rely on low cost
labor.

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 Factors Affecting DFI
Capital flows resulting from DFI change whenever conditions in a
country change the desire of the firm to do business. Some common
factors that could affects a country’s appeal for DFI-

Changes in Restrictions:
New opportunities may arise from the removal of government
barriers.

Privatization:
DFI has also been stimulated by the selling of government
operations.

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 Factors Affecting DFI, cont.
Potential Economic Growth:
Countries with higher potential economic growth are more likely to
attract DFI because firms recognize that they may be able to
capitalize 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.

Exchange Rates:
Firms will typically prefer to invest their funds in a country when
that country’s currency is expected to strengthen against their own.

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 Factors Affecting
International Portfolio Investment
International portfolio investment to a specific country is influenced by
the following factors-
Tax Rates on Interest or Dividends
Investors will normally prefer countries where the tax rates 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.

Exchange Rates
Foreign investors may be attracted if the local currency is expected to
strengthen.
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 Agencies that Facilitate International Flows
International Monetary Fund (IMF):
The IM F is an organization of 183 member countries. Established in
1946, it aims-
1. To promote international monetary cooperation and exchange
stability;
2. To foster economic growth and high levels of employment;
and
3. To provide temporary financial assistance to help ease
imbalances of payments.
4. To promote the free mobility of capital funds across
countries.
5. To promote free trade.

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Agencies that Facilitate International Flows, cont.

World Bank Group:

Established in 1944, the Group assists development with the
primary focus of helping the poorest people and the poorest
countries.

It has 183 member countries, and is composed of five organizations

- IBRD, IDA, IFC, MIGA and ICSID.

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Agencies that Facilitate International Flows, cont.

IBRD: International Bank for Reconstruction and Development

IDA: International Development Association

IFC: International Finance Corporation

M IGA: Multilateral Investment Guarantee Agency

ICSID: International Centre for Settlement of Investment Disputes

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Agencies that Facilitate International Flows, cont.

World Trade Organization (WTO)

Created in 1995, the WTO is the successor to the General Agreement
on Tariffs and Trade (GATT).

This organization was established to provide a forum for multilateral

trade negotiations and to settle trade disputes related to the GATT
accord.

It deals with the global rules of trade between nations to ensure that
trade flows smoothly, predictably and freely.

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Agencies that Facilitate International Flows, cont.

World Trade Organization (WTO), Cont..

Its functions include:

¤ Administering WTO trade agreements;
¤ Serving as a forum for trade negotiations;
¤ Handling trade disputes;
¤ Monitoring national trading policies;
¤ Providing technical assistance and training for
developing countries; and
¤ Cooperating with other international groups.

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Agencies that Facilitate International Flows, cont.
Bank for International Settlements (BIS):
Set up in 1930, the BIS is an international organization that fosters
cooperation among central banks and other agencies in pursuit of
monetary and financial stability.

It is the “central banks’ central bank” and “lender of last resort.”

The BIS functions as:

¤ A forum for international monetary and financial cooperation;
¤ A bank for central banks;
¤ A center for monetary and economic research; and
¤ An agent or trustee in connection with international financial
operations.
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Agencies that Facilitate International Flows, cont.

Regional Development Agencies:

Agencies with more regional objectives relating to economic

development include-
¤ The Inter-American Development Bank;

¤ The Asian Development Bank;

¤ The African Development Bank; and

¤ The European Bank for Reconstruction and Development.

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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

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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
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