International Flow of Funds

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 factors and other factors, Explain how international capital flows are influenced by country characteristics, Introduce the agencies that facilitate the international flow of funds.

Balance of Payments
Definition: Summary of transactions between domestic and foreign residents for a specific country over a specified period of time.

It represents an accounting of a countrys international transactions for a period of one year or a quarter.
It accounts for transactions by businesses, individuals, and the government.

Balance of Payments
Each transaction is recorded as both a credit and a debit, i.e. double-entry bookkeeping. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as credit. Uses of funds, such as for imports or to invest in foreign countries, are recorded as debit. Alternatively, sources and uses of funds method of accounting can be used whereby: sources = credits = pluses uses = debits = minuses

Components of Balance of Payment

The balance of payments statement can be broken down and are presented in three groups: A current account A capital account A financial account

Current Account
The current account summarizes the flow of funds between one specified country and all other countries due to purchases of goods or services, or the provision of income on financial assets. A current account deficit suggests a greater outflow of funds from the specified country for its current transactions Key components of the current account include: i. Balance of trade (exports and imports of merchandise and service) ii. Factor income (interest & dividends) iii.Transfer payments (aids, gifts, & grants).

Current Account

Capital Account

The capital account summarizes the flow of funds resulting from the sale of assets between one specified country and all other countries.

It also includes the value of non-produced nonfinancial assets that are transferred across country borders, such as patents and trademarks.

Capital Account
The key components of the capital account are: direct foreign investment: investment in fixed assets in foreign countries (firm expansion) portfolio investment: transactions of long-term financial assets other capital investment: transactions of shortterm financial assets

Financial account
The financial account records an economys transaction in external financial assets and liabilities. Financial Account* = Change in the ownership of domestic assets-change in the ownership of foreign assets. Financial Account* = Foreign Direct Investment + Foreign Portfolio Investment +Other Investments +Reserve Account A surplus in the capital account and Financial Account means money is flowing into the country, but unlike a surplus in the current account, the inbound flows will effectively be borrowings or sales or transfer of assets rather than earnings. * Capital Account

Balance Of Payment If a country has a negative current account balance, it should have a positive capital and financial account balance. In fact, the negative balance on the current account should be offset by a positive balance on the capital, may be in the form of borrowing or foreign investment. However, there is not normally a perfect offsetting effect because measurement errors can occur when attempting to measure the value of funds transferred into or out of a country. For this reason, the balance-of-payments account includes a category of errors and omissions.

BOP of Pakistan
Table 1: Balance of Payme nts - Summary FY12 Ite ms C urre nt Account balance T rade balance (Goods) Exports Imports Services (net) Income (net) Current transfers (net) C apital Account (ne t) Financial Account(ne t) Errors and Omissions (net) Overall balance Re se rve and Re late d Ite m Jul-Sep -1,367 -4,241 6,149 10,390 -746 -650 4,270 31 602 -25 -759 759 Oct-Dec -1,032 -3,776 5,923 9,699 -619 -922 4,285 59 -326 266 -1,033 1,033 Jan-Mar -639 -3,820 6,262 10,082 -732 -690 4,603 54 145 -419 -859 859 Apr-Jun -1,620 -3,928 6,362 10,290 -1,095 -983 4,386 39 859 98 -624 624 FY12 -4,658 -15,765 24,696 40,461 -3,192 -3,245 17,544 183 1,280 -80 -3,275 3,275 FY11 214 -10,516 25,356 35,872 -1,940 -3,017 15,687 161 2,101 16 2,492 -2,492 (Million US dollar)

Trading Partners of Pakistan

Foreign Trade (Pakistan)

Factors Affecting International Trade Flows

Inflation A relative increase in a countrys inflation rate will decrease its current account, as imports increase and exports decrease. National Income A relative increase in a countrys income level will decrease its current account, as imports increase. Government Restrictions A government may reduce its countrys imports by imposing tariffs on imported goods, or by enforcing a quota. Note that other countries may retaliate by imposing their own trade restrictions. Sometimes though, trade restrictions may be imposed on certain products for health and safety reasons.

Factors Affecting International Trade Flows

Some governments offer subsidies to their domestic firms, so that those firms can produce products at a lower cost than their global competitors.

Exchange Rates If a countrys currency begins to rise in value, its current account balance will decrease as imports increase and exports decrease.

Note that the factors are interactive, such that their simultaneous influence on the balance of trade is a complex one.

Impact of Exchange Rates During the 19971998 Asian crisis, the exchange rates of Asian currencies declined substantially against the dollar, which caused the prices of Asian products to decline from the perspective of the United States and many other countries. Consequently, the demand for Asian products increased and sometimes replaced the demand for products of other countries.

Interaction of Factors
The factors that affect the balance of trade interact, their simultaneous influence on the balance of trade is complex. For example, as a high Pakistan inflation rate reduces the current account, it places downward pressure on the value of Rupees. Since a weaker Rupee can improve the current account, it may partially offset the impact of inflation on the current account.

International Capital Flows

1. Foreign Direct Investment 2. Foreign Portfolio Investment One of the most important types of capital flows is direct foreign investment. Firms commonly attempt to engage in direct foreign investment so that they can reach additional consumers or can rely on low-cost labor and other resources.

Factors Affecting DFI Changes in Restrictions - During the 1990s, many countries lowered their restrictions on DFI, thereby opening the way to more DFI in those countries. Privatization - Several national governments have recently engaged in privatization, or the selling of some of their operations to corporations and other investors.

Factors Affecting DFI Potential Economic Growth - Countries that have greater potential for economic growth are more likely to attract. Tax Rates - Countries that impose relatively low tax rates on corporate earnings are more likely to attract DFI. 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 Tax Rates on Interest or Dividends - Investors normally prefer to invest in a country where the taxes on interest or dividend income from investments are relatively low. Interest Rates - Portfolio investment can also be affected by interest rates. Money tends to flow to countries with high interest rates, as long as the local currencies are not expected to weaken.

Factors Affecting International Portfolio Investment Exchange Rates-If a countrys home currency is expected to strengthen, foreign investors may be willing to invest in the countrys securities to benefit from the currency movement. Conversely, if a countrys home currency is expected to weaken, foreign investors may decide to purchase securities in other countries.

Impact of International Capital Flows

Foreign investors are especially attracted to a countrys financial markets when the interest rate in their home country is substantially lower than that in the foreign country. Japans annual interest rate is closer to 1% while Pakistans interest rate is closer to 12 % because of low saving rate. So Pakistan is attractive country as compared to Japan, if other things remain constant.

Should Pakistan Rely to Much on Foreign Funds Pakistan is relying on foreign funds and access to the foreign funds has allowed more growth in Pakistan. Pakistan should be able to rely on substantial foreign funding in the future as long as Pakistani government and firms are still perceived to be creditworthy. If that trust is ever weakened, Pakistan government and firms would only be able to obtain foreign funding if they paid a higher interest rate to compensate for the risk (a risk premium).

Agencies That Facilitate International Flows

1. International Monetary Fund Established as a result of United Nations Monetary & Financial Conference in 1944 to promote: a) Cooperation among countries on international monetary issues b) Stability in exchange rates c) Provide temporary funds to member countries attempting to correct imbalances of international payments d) Promote free mobility of capital funds across countries and free trade

2. World Bank The International Bank for Reconstruction and Development (IBRD), also referred to as the World Bank, was established in 1944. Its primary objective is to make loans to countries to enhance economic development. It has a profit-oriented philosophy. Therefore, its loans are not subsidized but are extended at market rates to governments

World Trade Organization

This organization was established in 1993 to 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.

International Financial Corporation

International Financial Corporation (IFC) was established in 1965 to promote private enterprise within countries. IFC works to promote economic development through the private rather than the government sector. It not only provides loans to corporations but also purchases stock, thereby becoming part owner in some cases rather than just a creditor.

Bank for International Settlements

BIS attempts to facilitate cooperation among countries with regard to international transactions. The BIS is sometimes referred to as the central banks central bank or the lender of last resort. It played an important role in supporting some of the less developed countries during the international debt crisis in the early and mid-1980s.

Organization for Economic Cooperation and Development The Organization for Economic Cooperation and Development (OECD) facilitates governance in governments and corporations of countries with market economics. The OECD promotes international country relationships that lead to globalization.

Regional Development Agencies

Inter-American Development Bank Asian Development Bank African Development Bank European Bank for Reconstruction and Development

Summary The key components of the balance of payments are the current account and the capital account. The current account is a broad measure of the countrys international trade balance. The capital account is a measure of the countrys long-term and short-term capital investments, including direct foreign investment and investment in securities (portfolio investment).

Summary Countrys international trade flows are affected by inflation, national income, government restrictions, and exchange rates. 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.

Summary A countrys 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.