Chapter 2

International Flow of Funds

International Financial Management

13th Edition – by Jeff Madura
Chapter Objectives
• Explain the key components of the balance of payments.
• Explain the growth in international trade activity over time.
• Explain how international trade flows are influenced by economic and other
factors.
• Explain how international capital flows are influenced by country
characteristics.
• Introduce the agencies that facilitate the international flow of funds.

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Balance of Payments (1 of 6)
Definition:
Summary of transactions between domestic and foreign residents for a specific
country over a specified period of time.
indicator for country health

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Balance of Payments (2 of 6) 2 key components are
current account and
financial acc

Components of the Balance of Payments Statement:

• Current Account: summary of flow of funds due to purchases of goods or
services or the provision of income on financial assets.
• Capital Account: summary of flow of funds resulting from the sale of assets
between one specified country and all other countries over a specified period
non- productivitive
of time. aset=> not the key
debt - forgiveness

• Financial Account: refers to special types of investment, including DFI and

portfolio investment.
reason for error and
omissions

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Balance of Payments (3 of 6)
Current Account
• Payments for Goods and Services
o Merchandise exports and imports represent tangible products that are
transported between countries. Service exports and imports represent tourism
and other services. The difference between total exports and imports is referred
to as the balance of trade.
• Primary Income Payments
o Represents income earned by MNCs on their direct foreign investment as well as
income earned by investors on their portfolio investments.
• Secondary Income
o Represents aid, grants, and gifts from one country to another.

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Balance of Payments (4 of 6)
Current Account (continued)
• Examples of payment entries
o Exhibit 2.1. shows several examples of transactions that would be reflected in the
current account.
• Actual U.S. current account balance
o The U.S. current account balance has been consistently negative since 1992.
Since 2011, the quarterly current account balance for the United States has
typically exceeded $40 billion per month, which is primarily due to the U.S.
balance-of-trade deficit.

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Exhibit 2.1 Examples of Current Account Transactions (1 of 3)

U.S. Cash Flow Entry On U.S. Balance-

International Trade Transaction Position Of-Payments Account
Walmart purchases clothing produced in Indonesia U.S. cash outflow Debit
that it will sell in its U.S. retail stores.
Individuals in the United States purchase leather U.S. cash outflow Debit
goods over the Internet from a firm based in Italy.
The Mexican government pays a U.S. consulting firm U.S. cash inflow Credit
for consulting services provided by the firm.
The Home Depot headquarters in the United States U.S. cash outflow Debit
purchases lumber from Canada that it uses in
assembling kitchen cabinets.
A university bookstore in Ireland purchases textbooks U.S. cash inflow Credit
produced by a U.S. publishing company.

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Exhibit 2.1 Examples of Current Account Transactions (2 of 3)

U.S. Cash Flow Entry On U.S. Balance-

International Primary Income Transaction Position Of-Payments Account
A U.S. investor receives a dividend payment from a U.S. cash inflow Credit
French firm in which she purchased stock.
The U.S. Treasury sends an interest payment to a U.S. cash outflow Debit
German insurance company that purchased U.S.
Treasury bonds one year ago.
Apple's foreign subsidiaries remit earnings to their U.S. cash inflow Credit
U.S. parent.
U.S.-based Mercedes-Benz subsidiaries remit U.S. cash outflow Debit
earnings to their parent (Daimler AG) in Germany.

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Exhibit 2.1 Examples of Current Account Transactions (3 of 3)

U.S. Cash Flow Entry On U.S. Balance-

International Secondary Income Transaction Position Of-Payments Account
The United States provides aid to Costa Rica in U.S. cash inflow Debit
response to a flood in Costa Rica.
Switzerland provides a grant to U.S. scientists to U.S. cash inflow Credit
work on cancer research.

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Balance of Payments (5 of 6)
Financial Account
• Direct foreign investment
o Summarizes the new direct foreign investment over a given period.
• Portfolio investment
o Summarizes the new portfolio investment (investment in financial assets such as
stocks or bonds) over a given period.
• Other capital investment
o Transactions involving short-term financial assets (such as money market
securities) between countries.

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Balance of Payments (6 of 6)
Capital Account
• Summarizes the flow of funds between one country and all other countries
due to financial assets transferred across country borders by people who
move to a different country, or due to sales of patents and trademarks.

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Growth in International Trade (1 of 6)
Events That Increased Trade Volume
• Removal of the Berlin Wall: Led to reductions in trade barriers in Eastern
Europe.
• Single European Act of 1987: Improved access to supplies from firms in
other European countries.
• North American Free Trade Agreement (NAFTA): Allowed U.S. firms to
penetrate product and labor markets that previously had not been
accessible.
• 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.
Wt

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Growth in International Trade (2 of 6)
Events That Increased Trade Volume (continued)
• The European Union: Free movement of products, services, and capital
among member countries.
• Inception of Euro: Avoid exposure to exchange rate risk.
• Other Trade Agreements: The United States has established trade
agreements with many other countries.

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Growth in International Trade (3 of 6)
Impact of Outsourcing on Trade
• Definition of Outsourcing: The process of subcontracting to a third party in
another country to provide supplies or services that were previously
produced internally.
• Impact of outsourcing:
o Increased international trade activity because MNCs now purchase products or
services from another country.
o Lower cost of operations and job creation in countries with low wages.
• Criticism of outsourcing:
o Outsourcing may reduce jobs in the United States.

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Factors Affecting International Trade Flows (1 of 11)
Since international trade can significantly affect a country’s economy, it is
important to identify and monitor the factors that influence it. The following
factors are the most influential:
• Cost of labor
• Inflation
• National income
• Credit conditions
• Government policies
• Exchange rates

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Factors Affecting International Trade Flows (2 of 11)
Cost of Labor:
• The cost of labor varies substantially among countries.
• Firms in countries where labor costs are low commonly have an advantage
when competing globally, especially in labor intensive industries.
Inflation:
• Current account decreases if inflation increases relative to trade partners.

National Income:
• Current account decreases if national income increases relative to other
countries.

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Factors Affecting International Trade Flows (3 of 11)
Credit Conditions:
• When credit conditions become more restrictive, MNCs may reduce their
corporate spending and reduce their demand for imported supplies.

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Factors Affecting International Trade Flows (4 of 11)
Government Policies: can affect international trade flows through:
• Restrictions on imports
• Subsidies for exporters
• Restrictions on piracy
• Environmental restrictions
• Labor laws
• Business laws
• Tax breaks
• Country trade requirements
• Government ownership or subsidies
• Country security laws
• Policies to punish country governments
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Factors Affecting International Trade Flows (5 of 11)
Impact of Government Policies (continued)
• Restrictions on Imports: Taxes (tariffs) on imported goods increase prices
and limit consumption. Quotas limit the volume of imports.
• Subsidies for Exporters: Government subsidies help firms produce at a
lower cost than their global competitors.
• Restrictions on Piracy: A government can affect international trade flows by
its lack of restrictions on piracy.
• 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.

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Factors Affecting International Trade Flows (6 of 11)
Impact of Government Policies (continued)
• Labor Laws: Countries with more restrictive laws will incur higher expenses
for labor, other factors being equal.
• Business Laws: Firms in countries with more restrictive bribery laws may
not be able to compete globally in some situations.
• Tax Breaks: Though not necessarily a subsidy, still a form of government
financial support that might benefit many firms that export products.
• Country Trade Requirements: Requiring various forms or obtaining
licenses before countries can export to the country (Bureaucracy) is a strong
trade barrier.

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Factors Affecting International Trade Flows (7 of 11)
Impact of Government Policies (continued)
• Government Ownership or Subsidies: Some governments maintain
ownership in firms that are major exporters.
• Country Security Laws: Governments may impose certain restrictions
when national security is a concern, which can affect on trade.
• Policies to Punish Country Governments: Many expect countries to
restrict imports from countries that:
o Fail to enforce environmental laws and child labor laws.
o Initiate war against another country.
o Are unwilling to participate in a war.

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Factors Affecting International Trade Flows (8 of 11)
Impact of Government Policies (continued)
• Summary of Government Policies:
o Every government implements some policies.
o No formula ensures a completely fair contest for market share.

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Factors Affecting International Trade Flows (9 of 11)
Exchange Rates: Current account decreases if currency appreciates relative
to other currencies.
• 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.

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Factors Affecting International Trade Flows (10 of 11)
Exchange Rates (continued)
• Limitations of a Weak Home Currency Solution
o Competition: Foreign companies may lower their prices to remain competitive.
o Impact of other currencies: A country that has balance of trade deficit with many
countries is not likely to solve all deficits simultaneously.
o Prearranged international trade transactions: International transactions cannot be
adjusted immediately. The lag is estimated to be 18 months or longer, leading to
a J-curve effect. (Exhibit 2.6)
o Intracompany trade: Many firms purchase products that are produced by their
subsidiaries. These transactions are not necessarily affected by currency
fluctuations.

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Exhibit 2.6 J-Curve Effect

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Factors Affecting International Trade Flows (11 of 11)
Exchange Rates (continued)
• Exchange Rates and International Friction
o All governments cannot weaken their home currencies simultaneously.
o Actions by one government to weaken its currency causes another country’s
currency to strengthen.
o Government attempts to influence exchange rates can lead to international
disputes.

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International Capital Flows (1 of 4)
Factors Affecting Direct Foreign Investment
• Changes in Restrictions
o New opportunities have arisen from the removal of government barriers.
• Privatization
o Privatization policy allows for expansion of international business because foreign
firms can acquire operations sold by national governments.
o The primary reason that the market value of a firm may increase in response to
privatization is the anticipated improvement in managerial efficiency.
o The trend toward privatization will undoubtedly create a more competitive global
marketplace.

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International Capital Flows (2 of 4)
Factors Affecting Direct Foreign Investment (Continued)
• Potential Economic Growth
o Countries with greater potential for economic growth are more likely to attract DFI.
• Tax Rates
o Countries that impose relatively low tax rates on corporate earnings are more likely
to attract DFI.
• Exchange Rates
o Firms typically prefer to pursue DFI in countries where the local currency is
expected to strengthen against their own.

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International Capital Flows (3 of 4)
Factors Affecting International Portfolio Investment
• Tax Rates on Interest or Dividends
o Investors normally prefer to invest in a country where taxes are relatively low.
• Interest Rates
o Money tends to flow to countries with high interest rates, as long as the local
currencies are not expected to weaken.
• Exchange Rates
o Investors are attracted to a currency that is expected to strengthen.

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International Capital Flows (4 of 4)
Impact of International Capital Flows (Exhibit 2.7)
• The United States relies heavily on foreign investment in:
o U.S. manufacturing plants, offices, and other buildings.
o Debt securities issued by U.S. firms.
o U.S. Treasury debt securities.
• 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.
• U.S. reliance on foreign funds: In general, access to international funding
has allowed more growth in the U.S. economy over time but has also made
the U.S. more reliant on foreign investors.

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Exhibit 2.7 Impact of the International Flow of Funds
on U.S. Interest Rates and Business Investment

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Agencies that Facilitate International Flows (1 of 7)
International Monetary Fund
• Major Objectives of the IMF
o promote cooperation among countries on international monetary issues,
o promote stability in exchange rates,
o provide temporary funds to member countries attempting to correct imbalances of
international payments,
o promote free mobility of capital funds across countries,
o promote free trade. It is clear from these objectives that the IMF’s goals
encourage increased internationalization of business.
• Its compensatory financing facility (CFF) attempts to reduce the impact of
export instability on countries.
• Financing is measured in special drawing rights (SDRs)
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Agencies that Facilitate International Flows (2 of 7)
World Bank — (International Bank for Reconstruction and Development)
• Major Objective — Make loans to countries to enhance economic
development.
• Structural Adjustment Loans (SALs) are intended to enhance a country’s
long-term economic growth.
• Funds are distributed through cofinancing agreements:
o Official aid agencies
o Export credit agencies
o Commercial banks

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Agencies that Facilitate International Flows (3 of 7)
World Trade Organization (WTO)
• Major Objective — Provide a forum for multilateral trade negotiations and to
settle trade disputes related to the GATT accord.
• Member countries are given voting rights that are used to make judgments
about trade disputes and other issues.

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Agencies that Facilitate International Flows (4 of 7)
International Finance Corporation (IFC)
• Major Objective — promote private enterprise within countries.
• Provides loans to corporations and purchases stock
• It traditionally has obtained financing from the World Bank but can borrow in
the international financial markets.
International Development Association (IDA)
• Major Objectives — extends loans at low interest rates to poor nations that
cannot qualify for loans from the World Bank.

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Agencies that Facilitate International Flows (5 of 7)
Bank for International Settlements (BIS)
• Major Objectives — facilitate cooperation among countries with regard to
international transactions.
• Provides assistance to countries experiencing a financial crisis.
• Sometimes referred to as the “central banks’ central bank” or the “lender
of last resort.”

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Agencies that Facilitate International Flows (6 of 7)
OECD — Organization for Economic Cooperation and Development
• Major Objective — Facilitate governance in governments and corporations of
countries with market economics.
• It has 30 member countries and has relationships with numerous countries.
• Promotes international country relationships that lead to globalization.

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Agencies that Facilitate International Flows (7 of 7)
Regional Development Agencies
• Inter-American Development Bank: focusing on the needs of Latin America
• Asian Development Bank: established to enhance social and economic
development in Asia
• African Development Bank: focusing on development in African countries
• European Bank for Reconstruction and Development: created in 1990 to help
the Eastern European countries adjust from communism to capitalism.

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Summary (1 of 4)
• The key components of the balance of payments are the current account, the
capital account and the financial account. The current account is a broad
measure of the country’s international trade balance. The capital account
measures the value of financial and nonfinancial assets transferred across
country borders. The financial account consists mainly of payments for direct
foreign investment and investment in securities (portfolio investment).

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Summary (2 of 4)
• International trade activity has grown over time in response to several
government agreements to remove cross-border restrictions. In addition, MNCs
have commonly used outsourcing in recent years, subcontracting with a third
party in a foreign country for supplies or services they previously produced
themselves. Thus, outsourcing is another reason for the increase in
international trade activity.

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Summary (3 of 4)
• A country’s international trade flows are affected by inflation, national income,
government restrictions, and exchange rates. High labor costs, high inflation,
a high national income, low or no restrictions on imports, and a strong local
currency tend to result in a strong demand for imports and a current account
deficit. Although some countries attempt to correct current account deficits by
reducing the value of their currencies, this strategy is not always successful.

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Summary (4 of 4)
• A country’s international capital flows are affected by any factors that
influence direct foreign investment or portfolio investment. DFI 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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