Chapter 2

International Flow of Funds

Prepared By
Prof. Dr. Mohammad Bayezid Ali
MBA (Evening) Program
Department of Finance
Jagannath University, Dhaka
 Chapter Objectives
➢Balance of Payment (BOP): Basic Concept
➢Key Components of the Balance of Payments
➢Events That Increased International Trade
➢Trade Friction
➢Factors Affecting International Trade Flows
➢International Capital Flows: Direct Foreign Investment (DFI)
➢Factors Affecting DFI
➢Factors Affecting International Portfolio Investment
➢Impact of International Capital Flows
➢Agencies that Facilitates international Flows
 Balance of Payment: Basic Concept
The Balance of Payment (BOP) is a summery of transactions
between domestic and foreign residents for a specific country
over a specific 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 of businesses,
individuals, and the government.
In brief, BOP is a statement that summarizes an economy’s
transactions with the rest of the world for a specified time
period. Transactions that reflect inflows of funds generate
positive numbers (credits) for the country’s balance, while
transactions that reflect outflows of funds generate negative
numbers (debits) for the country’s balance.
Key Components of the Balance of Payments
Balance-of-Payment (BOP) statement can be broken
down into three components.
A. The Current Account
B. The Capital Account
C. The Financial Account
 The Current Account on BOP
Current account refers to an account which records all the
transactions relating to export and import of goods and
services and unilateral transfer during a given period of
time. Current account contains the receipts and payments
relating to all the transactions of visible items, invisible
items and unilateral transfers. It represents a summery of
the flow of funds between one specified country and all
other countries due to purchase of goods and services or
the provision of income on financial assets.
 Components of Current Account on BOP
1. Exports and import of goods or merchandise (Tangible items like
computer or cars etc.) and services (intangible items like tourism, legal,
insurance or consulting services etc.). The difference between total
exports and imports is referred to as balance of trade (BOT). A deficit in
the balance of trade means that the value of merchandise and services
exported is less than the value of merchandise and services imported.
2. Investment or Factor incomes which represents income (interest and
dividend payments) received by investors on foreign investments in
financial assets (securities). Thus factor income received by a country
reflects an inflow of funds and factor income paid by a country reflects
an outflow of funds.
3. Transfer payments which represents aid, grants, and gifts from one
country to another.
 Summary of U.S. International Transactions
(For the Year of 2000 in Millions of Dollars)
Specimen of Current Account
Exports of goods and services and income receipts 1418568
Goods, balance of payments basis 772210
Services 293492
Income receipts 352866
Imports of goods and services and income receipts -1809099
Goods, balance of payments basis -1224417
Services -217024
Income payments -367658
Unilateral current transfers, net -54136
Balance on current account -444667
 The Capital Account on BOP
The capital account consists of capital transfers and the
acquisition and disposal of real and intangible assets, such
as real estate or patents. Capital account of BOP records all
those transactions, between the residents of a country and
the rest of the world, which cause a change in the assets or
liabilities of the residents of the country or its government.
Capital Account is used to:
(i) Finance deficit in current account; or
(ii) Absorb surplus of current account.
Capital account is concerned with financial transfers. So, it
does not have direct effect on income, output and
employment of the country.
 Components of Capital Accounts
1. Borrowings and lending to and from abroad: It
includes:
A. All transactions relating to borrowings from abroad by
private sector, government, etc. Receipts of such loans
and repayment of loans by foreigners are recorded as
positive or credit item.
B. All transactions of lending to abroad by private sector
and government. Lending abroad and repayment of
loans to abroad is recorded as negative or debit item.
 Components of Capital Accounts
2. Investments to and from abroad: It includes:
A. Investments by rest of the world in shares of local
companies, real estate in local area, etc. Such
investments from abroad are recorded on the positive
(credit) item as they bring in foreign exchange.
B. Investments by local residents in shares of foreign
companies, real estate abroad, etc. Such investments to
abroad be recorded on the negative (debit) item as they
lead to outflow of foreign exchange.
 Components of Capital Accounts
3. Change in Foreign Exchange Reserves:
The foreign exchange reserves are the financial assets
of the government held in the central bank. A change in
reserves serves as the financing item in country’s BOP.
So, any withdrawal from the reserves is recorded on
the negative (debit) side and any addition to these
reserves is recorded on the positive (credit) side. It
must be noted that ‘change in reserves’ is recorded in
the BOP account and not ‘reserves’.
 The Financial Account on BOP
The key components of the financial accounts are
payments for
✓Foreign direct investment (FDI)
✓Portfolio investment
✓Other capital investment
 Foreign Direct Investment (FDI)
Foreign Direct Investment (FDI) represents the
investment in fixed assets in foreign countries that can
be used to conduct business operations. Examples of
FDI include a firm’s acquisition of a foreign company,
its construction of a new manufacturing plant, or its
expansion of an existing plant in a foreign country.
 Portfolio Investment
Portfolio Investment represents transaction involving
long-term financial assets (such as stocks and bonds)
between countries that do not affect the transfer of
control. Thus the purchase an Indian Stock by
Bangladeshi investor is classified as portfolio
investment because it represents a purchase of foreign
financial assets without changing assets’ control of the
company.
 Other Capital Investment
Another component of the financial account consists of
other capital investment, which represents transaction
involving short-term financial assets (such as money
market securities) between countries.

In general, foreign direct investment measures the

expansion of firm’s foreign operation, whereas portfolio
investment and other capital investment measure the
net flow of funds due to financial assets transactions
between individual or institutional investors.
 Events That Increased International Trade
The following events reduced trade restrictions and
increased international trade.
1. Removal of Berlin Wall: In 1989, the Berlin Wall
separating East Germany from West Germany was torn
down. This was symbolic of new relations between
these two country and was followed by reunification of
the two countries. It engaged free enterprise in all
Eastern European countries and the privatization of
business that were owned by the government. It also
led to major reductions in trade barriers in Eastern
Europe.
 Events That Increased International Trade
2. Single European Act: In the late 1980s, industrialized
countries in Europe agreed to make regulations more
uniform and to remove many taxes on goods traded
between these countries. This agreement, supported by
the Single European Act of 1987, was followed by a
series of negotiations among the countries to achieve
uniform policies by 1992. The act allows firms in a given
European country greater access to supplies from firms
in other European countries.
 Events That Increased International Trade
3. NAFTA: As a result of North American Free Trade
Association (NAFTA) of 1993, trade barriers between United
States and Mexico were eliminated. Some U.S. firms
attempted to capitalize on this by exporting goods that has
previously been restricted by barriers to Mexico.
4. GATT: Within a month after the NAFTA accord, the
momentum for free trade continued with a GATT (General
Agreement on Tariffs and Trade). This accord was the
conclusion of trade negotiations from the so-called Uruguay
Round that had begun 7 years earlier. It called for the
reduction or elimination of trade restrictions on specified
imported goods over a 10-year period across 117 countries.
 Events That Increased International Trade
5. Inception of the Euro: In 1999, several European
countries adopted the euro as their currency for business
transactions between these countries. The euro was
phased in as a currency for other transactions during 2001
and completely replaced the currencies of the
participating countries on January 1, 2002. As a result
participating countries no longer face the costs and risks
associated with converting one currency to another.
6. Expansion of the European Union:
7. Other Trade Agreement:
 Trade Friction
In one sense, international trade have reduced tariffs
and quotas of the participating countries over time,
most countries still impose some type of trade
restrictions on particular products or on all products of
specified countries. Friction arises whenever we
consider free trade is beneficial for any country, but we
enact policies that goes against free trade
arrangement among participating counties.
 Arguments in Favor of Free Trade
✓Free trade encourages more intense competition among
firms in producing goods and services, and thus enables
consumers to obtain highest quality products at a lowest
price.
✓Free trade should cause a shift in production to those
countries where it can be done most efficiently. It lead
to have high level of production and export; and also
expands job opportunities.
Arguments Against Free Trade- Infant Industry Theory

The infant industry argument is an economic rationale

for trade protectionism. The core of the argument is
that promising industries in developing economy often
do not have the economies of scale that their older
competitors from other countries may have, and thus
need to be protected until they can attain similar
economies of scale. The argument was first fully
articulated by Alexander Hamilton in 1790.
Arguments Against Free Trade- Infant Industry Theory
Infant-industry theorists argue that industries in
developing sectors of the economy need to be protected to
keep international competitors from damaging or
destroying the domestic infant industry. In response to
these arguments, governments may enact import duties,
tariffs, quotas and exchange rate controls to prevent
international competitors from matching or beating the
prices of an infant industry, thereby giving the infant
industry time to develop and stabilize. This theory holds
that once the emerging industry is stable enough to
compete internationally, any protective measures
introduced, such as tariffs, are intended to be removed. In
practice, this is not always the case because the various
protections that were imposed may be difficult to remove.
 Factors Affecting International Trade Flows
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
influence the international trade flows:
1. Impact of Inflation: If a country’s inflation rate increases
relative to the countries with which it trades, its current
account will be expected to decrease, other things
being equal. Consumers and corporations in that
country will most likely purchase more goods overseas
(due to high local inflation), while the country’s exports
to the other countries will decline.
 Factors Affecting International Trade Flows
2. Impact of National Income: If a country’s income level
(national income) increases by a higher percentage than
those of other countries, its current account is expected
to 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.
 Factors Affecting International Trade Flows
3. Impact of the Credit Crisis on Trade: In the case of credit
crisis, the amount of spending, including spending for
imported products, declined. MNCs cut back on their
plans to boost exports as they lowered their estimates
for economic growth in their foreign markets. As they
reduced their expansion plans, they also reduced their
demand for imported supplies. Thus, international trade
flows were reduced in response to the credit crisis.
 Factors Affecting International Trade Flows
4. Impact of Government Policies: A country’s government can
have a major effect on its balance of trade by its policies on
subsidizing exporters, restrictions on imports, or lack of
enforcement on piracy.
✓Subsidies for exporter: Government subsidies to local
producers enhances production at a lower cost which also
increases the demand for export at a lower cost.
✓Restriction on import: Import restrictions like tariffs or quota
discourages imports from other countries. By imposing such
restrictions , the government disrupts trade flows.
✓Lack of restriction on piracy: In some cases, a government
can affect international trade flows by its lack of restrictions
on piracy.
 Factors Affecting International Trade Flows
5. Impact of Exchange Rates: Exchange rate determine the
rate at which one country’s currency can be exchanged
for other currency. This exchange rates fluctuates over
time because of market and government forces. If a
country’s currency begins to rise in value against other
currencies, its current account balance should decrease,
other things being equal. As the currency strengthens,
goods exported by that country will become more
expensive to the importing countries. As a consequence,
the demand for such goods will decrease.
 Correcting a Balance-of-Trade Deficit
Balance-of-trade deficit arise whenever the total value
of import is greater than the total value of export in any
country. This deficit balance-of-trade enables local
consumers to benefit from high quality imported
products, but it also implies less reliance on domestic
production. Thus a larger balance-of-trade deficit may
cause a transfer of jobs to some foreign countries. As a
result, a country’s government may attempt to correct a
balance-of-trade deficit.
 Correcting a Balance-of-Trade Deficit
The large balance-of-trade deficit can be corrected by
making the export prices more attractive to foreign
consumer. This can be done when the government
controls the inflation rate at a low level or when its
currency’s value is reduced.

How a floating exchange rate could correct any

international trade imbalances?
Limitations of a Weak Home Currency Solutions

However, a weak home currency may not necessarily

improve a trade deficit.
– Foreign companies may lower their prices to maintain
their competitiveness.
– Some other currencies may weaken too.
 The Effect of J-Curve
In economies, the 'J curve' refers to the trend of a country’s trade balance
following a devaluation or depreciation of local currency under a certain
set of assumptions. A devalued currency means imports are more
expensive, and the volume of imports and exports change little
immediately following devaluation of the currency. The volume of
imports and exports may remain largely unchanged due in part to pre-
existing trade contracts that have to be continued. In the short run,
demand for the more expensive imports remain price inelastic. Over the
longer term a depreciation in the exchange rate can have the desired
effect of improving the current account balance. Domestic consumers
might switch their expenditure to domestic products and away from
expensive imported goods and services, assuming equivalent domestic
alternatives exist. Equally, many foreign consumers may switch to
purchasing the products being exported into their country, which are
now cheaper in the foreign currency, instead of their own domestically
produced goods and services.
The Effect of J-Curve
 International Capital Flows
One of the most important type of capital flows is
foreign direct investment (FDI). Firms commonly
attempt to engage in direct foreign investment so that
they can reach additional consumers or can rely on low-
cost labor.
 Factors Affecting FDI
• Changes in Restrictions
– New opportunities may arise from the removal of
government barriers.
• Privatization
– FDI has also been stimulated by the selling of government
operations to corporations and investors. Privatization
also results increase of the market value of the privatized
firm due to anticipated improvement in managerial
efficiency..
• Potential Economic Growth
– Countries with higher potential economic growth are
more likely to attract DFI.
 Factors Affecting DFI
• 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.
 Factors Affecting
International Portfolio Investment
• 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.
• Exchange Rates
– Foreign investors may be attracted if the local currency is
expected to strengthen.
 Role and Activities of Agencies that
Facilitate International Flows: Assignment
1. International Monetary Fund (IMF)
2. World bank (WB)
3. World Trade Organization (WTO)
4. International Financial Corporation (IFC)
5. International development Association (IDA)
6. Bank of International Settlement (BIS)
7. The Organization of Economic Cooperation and
development (OECD)
8. Regional Development Agencies.
End of Chapter 2