Chapter 2 International Flow of Funds
Why should a manager know the significance of a foreign countrys balance of payments? 1. 2. 3. BOP deficits often precede reduced imports by a country BOP is an important indicator of trends in exchange rates Excessive BOP deficits lead countries to place controls on imports, dividend and interest payments, etc. Balance of Payments The balance of payments is a measurement of all transactions between domestic and foreign residents over a specified period of time. The recording of transactions is done by double-entry bookkeeping. Deficit Expenditures abroad by residents of a nation exceed what the residents earn or otherwise receive in payments from abroad Balance of Payments Accounts Current Acct Bal (X M + NP+UT) + Capital Acct Bal + (CI CO) + Reserve Balance + FXB = Bal of Payments = BOP Measuring the Balance of Payments
X = Exports of goods and services M = Imports of goods and services NP = Net flow of interest and dividend payments UT = Unilateral transfers (Government and private gifts and grants) CI = Capital Inflows CO = Capital Outflows FXB = Foreign Exchange Balance of the Country In general: BOP < 0 => weak economy BOP > 0 => strong economy Current Account Balance: Reflects the Balance of Goods and Services and Net flow of interest and dividend payments.
A deficit in Balance of Trade exists when merchandise imports are greater than exports. Balance of Goods and Services is the Balance of Trade plus Net Payments of dividends and interest plus net payments for services provided. Capital Account Balance: Reflects the flow of investment funds across borders. CI CO > 0 => greater investment by foreigners in a country than by its residents in foreign countries
Counter exampleJapanese corporations buying U.S. companies and properties in the early 1980s: U.S. economy not too strong, but the Capital Account Balance was strong What was going on?
FACTORS AFFECTING the CURRENT ACCOUNT
Inflation High inflation (relative to trade partners) tends to decrease a countrys current account Inflation causes: 1. the cost of production to increase, thus the prices of exports increase (holding the exchange rate constant) => 2. the cost of foreign goods to become relatively cheaper => National Income If National Income increases relative to trading partners => Why? Government Restrictions Tariffs and quotas can reduce imports Cost? Exchange Rates For stronger currency, if the exported goods are Price Elastic then the current account balance will decrease Price Elastic: Example: Taking a Dollar perspective U.S. made computer monitor price (at R1 = $1) stronger $ (at R1.50 = $1)
The U.S. is interested in Brazil being able to maintain its currency value! Price Elasticity Example:
Interaction of factors Well discuss this later
Why a Weak Currency is Not a Perfect Solution!! A weak currency does not guarantee that a country will be able to export its way out of a slow economy 1980s late 1990s examples:
1)
As dollar weakened against the yen, the Japanese automakers reduced the Yen price of their cars As the dollar weakened against European currencies, but was stable versus the Korean won and Singapore dollar, instead of producing in US, the sourcing of inputs only shifted from Europe to Asia.
2)
Finally, 3) Prices often set in advance
FACTORS AFFECTING the CAPITAL ACCOUNT 1)
XR (U.S. example: weak $ meant cheap for foreigners to buy)
Expectations: If foreigners expect the dollar to then appreciate, it is a good opportunity Korean example (mid-1990s): Korean banks offered high interest rates to help boost the XR. U.S. investor can get: 2) Interest Rates (see Germany example)
German Reunification, Interest Rates, and Capital Flows
Capital Flows (see Capital Account) In an effort to finance the addition of East Germany to the West German economy, the Bundesbank (the Central Bank of Germany) chose to increase interest rates to attract additional funds. How does this process work? (1) By raising the interest that is paid on deposits in German banks, Germany attracts additional capital * Foreign investors are motivated to convert holdings of their own currency for Deutschemarks (they buy DM) in order to get the higher returns on these safe deposits. The immediate impact on the BOP is an increase in the Capital Account, and an increase in the BOP. (2) Funds flow from the U.S. to Germany, placing upward pressure on interest rates in the U.S. Why do US rates rise?
Diagram to find Quantity of Funds! What is the expected impact on exchange rates in this scenario? Back to (1) The demand for DM increases (see *): But we often see high interest rates in countries with weakening currencies!!?! Why? Capital Flight (what is it?, how do governments deal with it?) Investors are taking their money out of the country (converting the weakening domestic currency for a stronger currency) causing the value of the domestic currency to decline (net supply is increasing) The government then institutes high interest rates to attempt to stop the outflow of funds, following the same logic as in the DM case.