AJA4604.02 International Flow of Funds

1. AJA4604.02International Flow of Funds Definition: The Balance of Payment (BOP) is a systematic record of all economic transactions between the residents of the reporting country and the rest of the world during a given period of time, usually one year. • Aninternational economic transactioninvolves the transfer of title or rendering of services from residents of one country to residents of another country.

2. The BOP is based on the rule of double-entry book keeping in which every credit entry brings about an equal and offsetting debit entry so that debits equal credits and the sum of all transactions equals zero. • A “credit” transaction leads to receipt of payments from foreign entities. • A “debit” transaction leads to payment being made to foreign entities. • Further, credit entries give rise to the demand for dollars, while debit entries give rise to the supply of dollars. • Alternatively, “sources” and “uses” of funds method of accounting can be used whereby: • sources = credits = pluses uses = debits = minuses

3. The BOP account identifies transactions along functional lines. One useful classification is as follows: (a)Current Account: Merchandise, services, investment income, and unilateral transfers. (b) Capital Account: Long-term capital & short- term capital. (c) Official Reserve Account: Covers purchases and sales of international reserve assets such as US dollars, Euro, Yen, and other convertible currencies, gold, and Special Drawing Rights (SDRs).

4. The Current Account • Records trade in goods and services, investment incomes (factor incomes) and the exchange of gifts and grants among countries. • Trade in goods or merchandize trade, comprises exports and imports. • A country exports when it sells goods to foreigners (a source of funds) and imports when it buys goods from foreigners (a use of funds). • The difference between merchandize exports and • imports is called the “Trade Balance”

5. Services: Include such “invisible” items as military expenditures,travel and transportation, consulting/service fees and, insurance/reinsurance premiums, shipping, banking, educational or instructional services, financial or accounting and other consulting services. • Investment Incomes (Factor Incomes): Consists of payments and receipt of interests, dividends, and other income on foreign investments previously made.

6. Unilateral Transfers: Gifts, grants, both from the private sector and the government, reparations.. • Private: Personal gifts, philanthropic activities, shipments by relief organizations. • Government: Money, goods, and services to other countries. To preserve the double-entry bookkeeping rule, unilateral transfers are regarded as buying goodwill from the recipients. • The difference on the services account is called the “difference on the invisibles”

7. The Capital Account Includes loans, investments, and other transfer of financial assets and creation of liabilities. • Long-term Capital: Maturities 1 year or more, e.g., Foreign Direct Investment (FDI), Portfolio Investments, and Loans. • Private flows are usually in the form of FDI and portfolio investments. • Official flows are usually loans, financial support in economic development projects overseas, and subscription to various regional development banks.

8. Portfolio Investment: Purchase of Stocks, bonds, and other financial assets. The asset owner does notcontrol the foreign firms. • Foreign Direct Investment: Takes place when real assets, e.g., land, factories, equipment are acquired in a foreign country. Also includes acquisition of stocks if control can be exercised by buyer. • Short-term Capital: Claims with maturity of < 1 year, e.g., demand deposits, short-term loans, and short-term securities.

9. Short-term capital may be: • An Accommodating adjustment induced by merchandise trade, service trade, unilateral transfers, and investments (to finance other items in BOP). • An Autonomous adjustment attributable to interest rate differences among nations and expected changes in exchange rates (based on purely economic considerations).

10. Account Balances • The Trade Balance Records the balance on merchandise trade. • The Balance on Current Account Indicates the balance on current spending. It tells whether we are spending more abroad than foreigners are spending in our country (ignoring investment flows and accommodating flows). The most important types of transactions included are imports and exports of goods and services, net transfer payments and the payment and receipt of interests, dividends, and other investment incomes.

11. The Basic Balance • Is the sum of the balance on current account and the long-term investment account. • It indicates the extent to which autonomous long- • term investments are affecting the balance of • payments. • When a country is a net recipient of long-term investment funds, the basic balance should be more positive than the current account balance. • Thus, long-term investment (net) may alleviate or • aggravate the pressure on the domestic currency.

12. The Performance Balance • Provides a summary of all autonomous flows plus some accommodating transactions. It is computed by adding short-term capital account to the basic balance. It therefore provides insights into the extent to which short-term investment flows are affecting the pressure on domestic currency. • A negative performance balance means that additional accommodating transaction will be needed to meet payment requirements. • A country's ability to execute accommodating transaction is limited to the availability of reserves. • In the absence of reserves, governments may resort to restrictive measures on current or capital account activities.

13. Accommodating transactions have two characteristics: (a) They are undertaken by a government. (b) Their purpose is to finance deficit/surplus in the BOP. However, not all international transactions conducted by the government are accommodating. Foreign aid is given for political or humanitarian purposes, not to finance BOP surplus or deficit, hence it is not accommodating.

14. The Net Liquidity Balance • Includes the basic balance plus short-term private non-liquid capital balance, the allocation of SDR and errors and omissions. • Errors and Omissions • Theoretically, double entry bookkeeping should cause total credits to equal total debts when all accounts are taken together. • However, because of recording errors and omissions • this equality does not always hold. • A special entry to make a nation's BOP "balance" • is called the statistical discrepancy.

15. The Official Reserves Account The official reserve account rounds off the balance of payments. It shows the means of international payment that the monetary authorities of a country have acquired or lost during the particular period. • These include gold, convertible currencies, and SDR. • Movement of official reserves may be interpreted to as an indicator of direct intervention in the foreign exchange market by the central bank. • When monetary authorities support the home currency, they do so by selling reserves and buying the home currency (this reduces official reserves). • Conversely, by buying convertible currencies and selling the home currency they reduce the value of the home currency (this increases official reserves)

16. In Summary • Balance of Merchandise Trade = exports of merchandise goods minus imports of goods. Reflects international competitiveness of a country’s manufacturing sector or natural resources • Balance on Goods and Services = exports of goods and services minus imports of goods and services. Reflects international competitiveness of manufacturing and service sectors.

17. Current Account Balance = current account exports minus current account imports. Reflects international competitiveness of a country’s manufacturing and service sectors as well as its generosity and income generated by past international investments. • Official Settlement Balance = changes in a country’s official reserves. Represents the extent of official intervention in the foreign exchange market over the period covered.

18. Factors Affecting BOP Components Economic Factors • Inflation Rates (relative inflation rates): A higher domestic inflation relative to a nation’s trading partners, ceteris paribus, will result in current account deficit.With higher domestic inflation, foreign goods become more attractive, (imports á) or domestic goods become more expensive and foreign demand for them drops (exports â) • Interest Rates: An increase in domestic interest (real) rates compared with ROW attracts funds from foreign investors, so that, ceteris paribus, increase in domestic rates leads to improvements in the capital account balance.

19. Income Level: A relatively higher domestic income level leads to increased domestic consumption with most of the additional consumption coming from higher imports. This will tend to increase current account deficits. • Domestic Currency Value: The higher(stronger) the domestic currency value in terms of foreign currencies, ceteris paribus, the worse the current account balance. • With a strong currency, domestic exports become more expensive to the importing countries and as a consequence, the demand for such goods will decrease. On the other hand, an appreciating domestic currency makes foreign goods more attractive to domestic residents who will increase their demand for such goods. • A decrease in exports and an increase in imports have a negative effect on domestic current account balance.

20. The J-curve Effect: Refers to a particular reaction pattern of trade balance to a currency depreciation. • Following a currency depreciation, the trade balance may at first deteriorate for a while. • Eventually the trade balance may improve over time. • The J-curve shows the initial depreciation and the eventual improvement in the trade balance. • A depreciation will begin to improve the trade balance if imports and exports are responsive to exchange rate changes. • If imports and exports are inelastic, the trade balance will worsen following a depreciation.

21. Government Restrictions • Tariff: Tax on imported goods. • Quota: Quantitative limit on amount of a particular product imported.If a government imposes restrictions, BOP, especially the current account should improve provided no retaliatory measures are taken by trading partners or ROW.

22. Tax on Foreign Income: May reduce the amount of foreign investment undertaken by domestic residents. • Restrictions on International Capital Flows: • Dual exchange rates (multiple exchange rates) e.g., - Different rate for government payments - Different rate for importers, etc. These restrictions will tend to reduce domestic currency outflows. • Government Monetary and Fiscal Policies: • May affect economic variables such as inflation and interest rates which in turn influence BOP components.

23. Impact of BOP on the Economy: A current account deficit may be associated with higher domestic inflation and often results in higher unemployment. • Capital Account Deficit: May beassociated with higher domestic interest rates which discourage domestic borrowing for investment and result in a slowdown of economic expansion. Higher domestic real interest rates, however, attract capital inflows.

24. Correcting BOP Problems Current Account/Capital Account Deficit: Any policy which improves foreign demand for domestic goods and services or for investment securities, e.g., more attractive export prices resulting from low inflation or depreciating domestic currency.Under a floating exchange rate regime, any international trade imbalance should be correctedautomatically by changes in exchange rates.

25. A Trade Deficit in the Domestic Economy:Implies that a nation is selling off its currency (supplying its currency) to buy foreign goods more than foreign demand for its currency to buy its goods. A depreciation of domestic currency should stimulate foreign demand for domestic goods and help to correct the deficit(Ceteris Paribus). (See Marshall-Lerner conditions).Restrictions on Imports:If domestic imports can be restricted while domestic exports can be increased, the trade balance should improve.

26. Questions: 1. Why are managers and investors interested in the BOP of countries? • Helps forecast a country’s market potential, especially in the short-run. A country experiencing a serious BOP deficit is not likely to import as much as if it were running a surplus. • The BOP is an important indicator of pressure on a country’s foreign exchange rate, unstable currency results in exchange gains or losses! • Continuing deficit in a country’s BOP may signal future controls on outgoing capital movements, such as payment of dividends, fees, interest on foreign investment.

27. Continuing surpluses in a country’s BOP may indicate that country’s strong international position, and therefore a potentially good location for an operating subsidiary, or portfolio investment. • Beware of resulting currency appreciation and loss of competitive advantage. • BOP deficits or surpluses can influence trade policies and currency values.

28. Question 2. Is a (persistent) current account deficit or surplus good or bad ? Why ? Why not ? Discuss the long-term consequences for a nation that runs a (persistent) current account deficit(surplus). • If the Current Account deficit (and the resulting capital account surplus) finances productive domestic investments, then the nation is better off - the returns from these added investments will help to service the foreign debts with income left to improve living standards. • If the capital account surplus finances current consumption, it merely increases a nation’s well-being today at the expense of future well-being.

29. Handout #1: A Typical BOP Example • Handout #2: Sample Problem Set 1. • Available in my website • Protectionism: Pros and Cons. • Maintain employment/reduce unemployment • Increase business size • For retaliation/bargaining • To protect home market • Keep “dollars” (domestic currency) at home • Promote capital accumulation • Maintain standard of living/real wages • Conserve natural resources • Protect infant industries • National security concerns

30. US Trade Balances with ROW since 1987 Go to: http://www.census.gov/foreign-trade/balance/c0015.html