Chapter 2 - International Flows of Fund

International Corporate Finance
11th Edition
by Jeff Madura
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Chapter Objectives
3. Economic factors
1. Balance of 2. International influencing
payments trade international trade
flows
5. Agencies 4. Factors
facilitate influencing
international flows international capital
of funds flows (Ch.6)
What is Balance of Payments (BOP)?
BOP is a summary/record of international

economic transactions between domestic and
foreign residents for a specific country over a
specified period of time.
Importance of BOP
Why BOP is important?
Who need BOP?
When BOP is issued?
Which transactions will be reported on the BOP
of the U.S?
1. An American company purchases coffee and rice from

Vietnam and Thailand $100,000 million.
2. A subsidiary of Toyota located in New York pays tax for
the U.S government.
3. The Canadian agency pays $1 million for construction
services provided by the U.S firms.
4. IBM headquarters in the U.S purchase computer chips
from Singapore that are used in assembling lines 5 million
USD.
6. Foreign students pay tuition fees for American
universities: 50 million USD.
7. The US citizens travel to Asia and spend total of 10
million USD
Which transactions will be reported on the BOP of the
U.S?
6. The U.S company sells machinery to European

market 30 million USD.
7. The U.S investors received interest payment from
investment in Japan $50 million.
9. The U.S teachers was paid 1 million thanks to
providing English courses for overseas students.
10. The U.S pays $ 30 million each year for disabled
children in Vietnam war.
11. The U.S firms sell manufacturing equipment to
developing countries $20 million.
12. An American student pays tuition fee to his
university in Los Angeles.
Which transactions will be reported on the BOP
of the U.S?
13. The U.S forgives debt for poor nations: $50 million.
14. The Vietnamese people living in the US send money back
to their relatives on Tet holiday: $20 million.
15. The Asian countries pay for the U.S firms to buy new
technology patents: $60 million.
17. The U.S investors pays $100 million to invest in their
subsidiaries in Vietnam.
18. Japanese investor buys corporate stocks of $200 million.
19. HP deposits $10 million in bank account in London.
20. US firm borrows $50 million from Swiss banks in six
months.
Accounting treatment
Credit (Cash inflows) Debit (Cash outflows)

(+) (-)
• Exports • Imports
• Investment and interest • Dividends and interest
earnings. paid
• Transfer receipts from to foreign residents.
foreign residents. • Transfer payments
• Investments and loans abroad.
from foreign residents • Investments and loans
• ….. to foreigners.
• …..
Balance of Payments
Components of the Balance of Payments Statement:

1. Current Account
2. Capital Account
3. Financial Account.
4. Errors and Omissions
5. Reserves and other related items.
Balance of Payment - Current Account
Components of the Balance of Payments Statement:
Current Account: a summary of flow of

funds due to purchases of goods or services
or the provision of income on financial
assets.
Component of the Current Account
1. Goods Trade or Balance of Trade - export/import of

goods.
2. Services Trade – export/import of services
(financial, construction, and tourism).
3. Income: represents income (interest and dividend
payments made in previous periods) received by
investors on foreign investments in financial assets
(securities) + wages & salaries paid to non-resident
workers.
4. Transfer payments: Represent aid, grants, and gifts
from one country to another. (unilateral or one-way).
Current Account Example
1. Goods Trade Balance

Debit (-): Sun Microsystems buys LCDs from Hong Kong.
Credit (+) : Singapore Airlines buys Boeing jet.
2. Services Trade Balance.

Debit (-): American rents an apartment in Singapore.
Credit (+): TUI -Germany places an ad in the NYT.
3. Income payments
Debit (-) : Honda US pays dividend to Honda Japan.
Credit (+): Bank Austria pays salary to rep in NY office.
4. Unilateral Current Transactions

Debit: Peace Corps pays US volunteer teachers in Bosnia.
Credit:Total Finapays tuition of employee for Stern MBA.
Balance of Payment – Capital Account
 Capital Account consists of capital transfers and the

acquisition or disposal of non-produced, non-financial
assets.
- Capital transfers: include the transfer of title to fixed
assets, the transfer of funds linked to the sale and
acquisition of fixed assets, debt forgiveness by creditors,
and migrants’ transfer of good and financial assets as
they leave or enter the country.
- Non-produced, non-financial assets: sale or purchase of
non-produced assets (such as the rights to natural
resources) and the sale or purchase of intangible assets
(such as patents, copyrights, trademarks, and leases).
Capital Account Example
1. Acquisition or disposal of non-produced.

Debit (-): The U.S government buys a big land in HCMC to build up
their consular.
Credit (+) : International Labor Organization buys a land to build up
their building in Los Angeles.
2. Acquisition or disposal of non-financial assets

Debit (-): American company buys a license to serve their production.
Credit (+): TUI -Germany sells a franchise to a U.S company.
Balance of Payment - 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.
Direct investments
 Net balance of capital which is dispensed from and into US for

the purpose of exerting control over assets.
- E.g: +U.S company acquires foreign company stake(-)
+ Foreign company acquires US company stake (+)
+ Foreign direct investment (FDI): 10% of voting shares
acquired.
Portfolio investments
 Net balance of capital which flows in/out of US but does not

reach 10% ownership.
- No voting or control rights over the assets.
- Purchase/sale of equity securities.
- Purchase/sale of debt securities
+ E.g. T-bill purchases by foreigners (net portfolio
investment).
+ E.g. US$ debt issues by foreign companies/
governments
- Risk/Return motivated
- Far more volatile than FDI
Other investments
Short & long-term trade credits, cross-border

loans, currency & bank deposits, & other
accounts receivable and payable in cross-border
trade
For example
1. Direct Investment
Debit (-): Ford builds factory in Australia.
Credit (+): Ford sells its factory in UK.
2. Portfolio Investment
Debit (-): US investor buys BASF stock at Frankfurt
Stock Exchange
Credit (+): Korean government buys US T-bills to hold as
foreign reserves.
3. Other investment
Debit (-): HP deposits $10m in a bank account in London.
Credit(+): HP generates accounts receivable in Canada.
Errors and Omissions
 This is a plug item designed to keep the balance of payments

accounts in balance.
 Measurement errors can occur when attempting to measure the
value of funds transferred into or out of a country.
Reserve and Related Items
 Official reserve assets: gold, convertible foreign currencies,

deposits, and securities.
 Use of IMF credits and loans.
 Exceptional financing
Balance of Payment
The Balance of Payment identity.
 Flows of goods and services: current account
 Flows of financial assets (net foreign investment) = capital account +

financial account + net errors and omissions + reserves and related
items.
 Flows of goods and services + net foreign investment = 0 or
 Current account + capital account + financial account + net errors

and omissions + reserves and related items = 0
CuA + CaA +FiA + NEO + RR = 0
Surplus/Deficit.
 Country Deficit or Surplus
- A country incurs a “surplus” if credit transactions exceed

debit transactions, or if it earns more abroad than it
spends.
- A country incurs a “deficit” if debit transactions exceed

credit transactions, or if it spends more abroad than it
earns.
Surplus/Deficit
 Balance of payments is used to:
- Predict pressures on foreign exchange rate
- Anticipate government policy actions
- Assess a country’s credit and political risks
- Evaluate a country’s economic health.
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 countries.
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: The United States has

established trade agreements with many other countries.
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 United States.
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
1. The annual international trade volume of the United

States is between 10 and 20 percent of its annual
GDP.
2. Trade volume between the United States and Other
Countries:
1. About 20 percent of all U.S. exports are to Canada,
while 13 percent are to Mexico.
2. Canada, China, Mexico, and Japan are the key
exporters to the United States. Together, they are
responsible for more than half of the value of all U.S.
imports.
Exhibit 2.3 Distributions of U.S. Exports Across
Countries (in billions of $)
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)
Factors Affecting International Trade Flows
3. National
income
4.Government
2. Inflation
policies
1. Cost of INTERNATIONAL 5. Exchange

TRADE
labor rate
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:
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.
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.
Exhibit 2.6 J-Curve Effect
Discuss solutions to trade deficit
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.
Factors Affecting Direct Foreign Investing (DFI)
1. Changes in Restrictions
 New opportunities have arisen from the
removal of government barriers.
2. Privatization
 DFI is stimulated by new business opportunities
associated with privatization.
 Managers of privately owned businesses are
motivated to ensure profitability, further
stimulating DFI.
Factors Affecting Direct Foreign Investing (DFI)
(Cont.)
4. Potential Economic Growth

 Countries with greater potential for economic
growth are more likely to attract DFI.
5. Tax Rates
 Countries that impose relatively low tax rates on
corporate earnings are more likely to attract DFI.
6. Exchange Rates
 Firms typically prefer to pursue DFI in countries
where the local currency is expected to strengthen
against their own.
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
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.
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.”
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, the capital account and financial account.
Current account - broad measure of the country’s
international trade balance. Capital and financial 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.
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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International Corporate Finance

BOP is a summary/record of international

Why BOP is important?

Who need BOP?

When BOP is issued?

1. An American company purchases coffee and rice from

6. The U.S company sells machinery to European

Credit (Cash inflows) Debit (Cash outflows)

Components of the Balance of Payments Statement:

Components of the Balance of Payments Statement:

Current Account: a summary of flow of

1. Goods Trade or Balance of Trade - export/import of

1. Goods Trade Balance

2. Services Trade Balance.

4. Unilateral Current Transactions

 Capital Account consists of capital transfers and the

1. Acquisition or disposal of non-produced.

2. Acquisition or disposal of non-financial assets

1. Direct foreign investment

 Net balance of capital which is dispensed from and into US for

 Net balance of capital which flows in/out of US but does not

Short & long-term trade credits, cross-border

 This is a plug item designed to keep the balance of payments

 Official reserve assets: gold, convertible foreign currencies,

 Flows of goods and services: current account

 Flows of financial assets (net foreign investment) = capital account +

 Flows of goods and services + net foreign investment = 0 or

 Current account + capital account + financial account + net errors

CuA + CaA +FiA + NEO + RR = 0

 Country Deficit or Surplus

- A country incurs a “surplus” if credit transactions exceed

- A country incurs a “deficit” if debit transactions exceed

 Balance of payments is used to:

- Predict pressures on foreign exchange rate

- Anticipate government policy actions

- Assess a country’s credit and political risks

- Evaluate a country’s economic health.

1. Removal of the Berlin Wall: Led to reductions in trade

2. Single European Act of 1987: Improved access to

3. North American Free Trade Agreement

4. General Agreement on Tariffs and Trade

5. Inception of the Euro: Reduced costs and risks

6. Expansion of the European Union: reduced

7. Other Trade Agreements: The United States has

1. Definition of Outsourcing: The process of

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

1. The annual international trade volume of the United

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

1. Cost of INTERNATIONAL 5. Exchange

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

5. Exchange Rates: current account decreases if

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

5. Labor Laws: countries with more restrictive laws will

 How exchange rates may correct a balance of trade

1. All governments cannot weaken their home

4. Potential Economic Growth

1. Tax Rate on Interest or Dividends

1. The United States relies heavily on foreign