BSA CORE 6

INTERNATIONAL BUSINESS AND TRADE

MODULE 4
(Monday)

MONETARY SYSTEM IN INTERNATIONAL ARENA

Learning Objectives
1. Explain a country’s balance of payments accounts.
2. Understand how balance of payments deficits are financed.
Balance of Payments
 The balance of payments is a summary statement of all transactions that take
place between a country and the rest of the world during a given period of time
(usually a year).
o One of the main uses of the balance of payments accounts is to provide
information regarding the demand and supply of foreign exchange.
o For a given time period (a year), the balance of payments summarizes a
country’s transactions that require payments to other countries and
transactions that require payments from other countries.

 The balance of payments uses a double-entry system of bookkeeping.

o Transactions are recorded as debits and credits.
 From the standpoint of the home country, a debit (-) transaction is a
flow for which the home country must pay and requires the supply
of the home currency.
 Examples of debit transactions are:
 Imports of goods and services
 Transfers to foreign residents (also known as remittances)
 Acquisition of long-term assets or reduction of a long-term
liability (i.e., stocks, bonds, real capital)
 Acquisition of a short-term asset or reduction of a short-term
liability (i.e., bank deposits, cash or short-term bonds such
as treasury bills)

 From the standpoint of the home country, a credit (+) transaction is

a flow for which the home country is paid and increases the
demand for the home currency by foreign residents.
 Examples of credit transactions are:
 Exports of goods and services
Source: Katsioloudes, Marios & Hadjidakis, Spyros. 2007. International Business: A Global Perspective.
Elsevier Inc.
  Transfers from foreign residents
 Sale of a long-term asset or increase of a long-term liability
 Sale of a short-term asset or increase of a short-term
liability.

 Credit includes all transactions that give rise to foreign exchange inflows
o Exports of goods and services are placed on the credit side.

 Debit includes all transactions causing foreign exchange outflows.

o Imports of goods and services are placed on the debit side.

 “Transfers” entry on the credit side refers to unilateral transactions or transfers

(i.e., it does not require a corresponding payment abroad) and mainly includes
remittances from home residents working abroad and aid from abroad.
o “Transfers” entry on the debit side includes remittances paid to home or
foreign residents (such as remittances to home students studying abroad)
and aid abroad.

Current and Capital Accounts

 One of the most important categories of the balance of payments is the current
account.
o The current account records all transactions involving goods and services.
o It includes goods, services (tourism, banking, insurance, brokerage
services, transport), transfers, receipts of interest, profit and dividends
earned by investments abroad, and, equivalently, payments of interest,
profit, and dividends to investments by foreign residents in the home
country.

 The capital account records all transactions involving short-term and long-term
assets.
o Transactions in assets, termed the capital account of the balance of
payments, consist of the purchase and sale of physical assets like land
and buildings together with borrowing and lending. Included in the capital
account are items like trade credit (i.e., the settlement of debts at a future
date), ending by banks, and the purchase and sale of securities like
company stock, corporate bonds, government long-term bonds, and short-
term bonds such as Treasury bills.
o The purchase of home country assets by foreign residents is known as
inward investment or capital inflow, since funds flow into the home
country, while the purchase of foreign assets by home country residents is
termed outward investment or capital outflow.
Source: Katsioloudes, Marios & Hadjidakis, Spyros. 2007. International Business: A Global Perspective.
Elsevier Inc.
  Transactions in physical assets are known as direct investment while borrowing,
lending, and transactions in securities are termed indirect or portfolio investment.

 A current account deficit means that the home country’s current payments
abroad for goods, services, and transfers are greater than the corresponding
receipts.
o The home country must either resort to foreign lending or reduce its claims
from abroad or draw from its foreign exchange reserves in order to finance
the current account deficit.

 In case of a current account surplus the process is reversed.

o Current receipts are greater than current payments and the home country
can either lend abroad or increase its foreign claims or increase its foreign
exchange reserves.
Balance of Payments Disequilibrium
 Autonomous transactions are independent of the balance of payments in the
sense that they are affected by factors outside the balance of payments
statement.
o These include exports, imports, transfers, public transactions, and net
capital movements. Imports and exports are the result of cost differences
among countries (i.e., international competitiveness).

 Transfers and public transactions are based on military, political, or humanitarian

considerations (i.e., military aid or humanitarian aid following natural disasters).
o Capital movements are dependent on expectations about returns on
foreign investments (i.e., interest rate and exchange rate considerations).

 Transactions occurring in order to compensate for differences between payments

and receipts arising from a country’s autonomous transactions are called
accommodating (offsetting) transactions.
o In effect, they are balancing transactions, which finance payments
imbalances associated with autonomous transactions.
The Foreign Exchange Market
 Foreign exchange market is where different national currencies are bought and
sold.

 The exchange rate is the price of one nation’s currency in terms of another’s.
o Exchange rate is a relative price, that is it can be expressed in either
direction

Source: Katsioloudes, Marios & Hadjidakis, Spyros. 2007. International Business: A Global Perspective.
Elsevier Inc.
 If the euro rises against the US dollar, the US dollar falls against
the euro.
 One way is to express the foreign currency in terms of the domestic
currency.
o In other words, we ask how much foreign currency exchanges for one unit
of the domestic currency.

 If the exchange rate of the domestic currency falls (rises), it means that its
value also falls (rises), that is it depreciates (appreciates).
 Therefore, we can say that the value of the domestic currency has
fallen (risen) or the exchange rate (of the domestic currency) has
fallen (risen).

 An exchange rate is quoted with a trading margin or spread.

o For example, the dollar may be quoted as $1 = euro 1.0186 to1.0196.
o This is known as the bid—ask spread.
 Bid is the rate at which market traders buy the home currency
 Ask rate is the price at which market traders sell the home
currency.
 The difference between the two represents trading costs and
profits.
 A small spread indicates the absence of relative risk (i.e., the
exchange rate is not expected to fluctuate) while the
opposite holds true in the case of a large spread.
Exchange Rates in the Business Context
 To understand the importance of the foreign exchange rate of a currency, it
would be useful to consider the role of the dollar exchange rate in the business
environment.
o Example: American firm exports hand tools to Europe
 If the exchange rate rose, the price of the hand tool in the United
States would still be the same.
 However, this implies that the sale price of the hand tool in Europe
rises and the American firm suffers a loss in sales.
 If, on the other hand, the exchange rate falls, the American firm can
reduce the price of the hand tool.
 This means that the American firm acquires a competitive
advantage and its sales in Europe increase.
 As a general rule, a lower exchange rate for the dollar increases American
exports.

Source: Katsioloudes, Marios & Hadjidakis, Spyros. 2007. International Business: A Global Perspective.
Elsevier Inc.
  Spot exchange rate is exchange rate at which transactions are settled
immediately (within two working days).
o The spot exchange rate we have dealt with so far is also known as the
nominal exchange rate.

 The nominal exchange rate can be either a bilateral exchange rate (i.e., the
exchange rate between two countries) or an effective exchange rate.

 The effective exchange rate as a measure takes into account the fact that the
dollar (or any currency) does not fluctuate evenly against all currencies.
o For example, the dollar may rise against the euro but fall against the yen
and pound sterling.

 Forward exchange rate refers to the rate on a contract to exchange currencies in

30, 60, 90, or 180 days.

 A rise in the real exchange rate indicates a real appreciation, that is a loss in
competitiveness as more foreign currencies will now be exchanged for each $1
worth of American goods outside the United States.
o This is because the price level in the United States was higher than that
abroad and the loss in competitiveness was much higher than the dollar’s
nominal appreciation against its major trading partners.

 A fall in the real effective exchange rate indicates a real depreciation, that is a
gain in competitiveness as less foreign currency units can now be exchanged for
each $1 worth of American goods in international markets.
o For example, the dollar’s nominal effective exchange rate depreciated by
7.34 percent between 2001 and 2002 and, at the same time, the dollar’s
real effective rate fell by 7.14 percent during the same period.
o This indicates that a possible loss in competitiveness through higher
domestic inflation has been, more or less, offset by a depreciation in the
dollar’s effective exchange rate.
Exchange Rate Determination
 The forces influencing the demand and supply of the dollar (or any other
currency) include relative national incomes, relative national price levels, interest
rates, and expectations about the future value of a currency.
 A change in some or all of these factors can cause the demand curve and/or the
supply curve of a currency to shift.

Source: Katsioloudes, Marios & Hadjidakis, Spyros. 2007. International Business: A Global Perspective.
Elsevier Inc.