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International
Flow of Funds
Chapter 2
Chapter Objectives
1. Explain the key components of the balance of payments,
2. Explain the growth in international trade activity over time,
3. Explain how international trade flows are influenced by economic factors and
other factors,
4. Explain how international capital flows are influenced by country
characteristics,
5. Introduce the agencies that facilitate the international flow of funds.

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

Components of the Balance of Payments Statement:

a. Current Account: summary of flow of funds due to purchases of goods or
services or the provision of income on financial assets.
b. 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
of time.
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Current Account
1. Payments for merchandise and services
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.
2. Factor income payments
Represents income (interest and dividend payments) received by investors on
foreign investments in financial assets (securities).
3. Transfer payments
Represent aid, grants, and gifts from one country to another.
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Exhibit 2.1 Examples of Current Account Transactions

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Capital and Financial Accounts
1. Direct foreign investment
Investments in fixed assets in foreign countries

2. Portfolio investment
Transactions involving long term financial assets (such as stocks and bonds) between countries that do not
affect the transfer of control.

3. Other capital investment

Transactions involving short-term financial assets (such as money market securities) between countries.

4. Errors and omissions

Measurement errors can occur when attempting to measure the value of funds transferred into or out of a
country.

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Impact of Outsourcing on Trade
1. Definition of Outsourcing: The process of subcontracting to a third party in
another country to provide supplies or services that were previously produced
internally.
2. Impact of outsourcing:
1. Increased international trade activity because MNCs now purchase products
or services from another country.
2. Lower cost of operations and job creation in countries with low wages.
3. Criticism of outsourcing:
1. Outsourcing may reduce jobs in home country.
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Managerial Decisions About Outsourcing

1. Managers of an MNC may argue that they create jobs for local workers.
2. Shareholders may suggest that the managers are not maximizing the MNC’s
value as a result of their commitment to creating jobs for home country.
3. Managers should consider the potential savings that could occur as a result of
outsourcing.
4. Managers must also consider the possible bad publicity or bad morale that could
occur among the local workers.

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Factors Affecting International Trade Flows

1. Cost of Labor: Firms in countries where labor costs are low commonly have an
advantage when competing globally, especially in labor intensive industries
2. Inflation: Current account decreases if inflation increases relative to trade
partners.
3. National Income: Current account decreases if national income increases relative
to other countries.

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Factors Affecting International Trade Flows (cont.)
4. Government Policies: can increase imports through:
a. Restrictions on imports
b. Subsidies for exporters
c. Lack of Restriction on piracy
d. Environmental restrictions
e. Labor laws
f. Tax breaks
g. Country security laws

5. Exchange Rates: current account decreases if currency appreciates relative to other

currencies.
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Impact of Government Policies

1. Restrictions on Imports: Taxes (tariffs) on imported goods increase prices and

limit consumption. Quotas limit the volume of imports.
2. Subsidies for Exporters: Government subsidies help firms produce at a lower
cost than their global competitors.
3. Restrictions on Piracy: A government can affect international trade flows by its
lack of restrictions on piracy.
4. 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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Impact of Government Policies (cont.)
5. Labor Laws: countries with more restrictive laws will incur higher expenses for
labor, other factors being equal.
6. Business Laws: Firms in countries with more restrictive bribery laws may not be
able to compete globally in some situations.
7. Tax Breaks: Though not necessarily a subsidy, but still a form of government
financial support that might benefit many firms that export products.
8. Country Security Laws: Governments may impose certain restrictions when
national security is a concern, which can affect on trade.

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Impact of Exchange Rates
• 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 Direct Foreign Investing
(DFI)
1. Changes in Restrictions
 New opportunities have arisen from the removal of government
barriers.
2. Privatization
 DFI is stimulated by new business opportunities associated with
privatization.
 Managers of privately-owned businesses are motivated to ensure
profitability, further stimulating DFI.

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Factors Affecting Direct Foreign Investing
(DFI) (Cont.)
4. Potential Economic Growth
 Countries with greater potential for economic growth are more likely
to attract DFI.
5. Tax Rates
 Countries that impose relatively low tax rates on corporate earnings
are more likely to attract DFI.
6. Exchange Rates
 Firms typically prefer to pursue DFI in countries where the local
currency is expected to strengthen against their own.
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Factors Affecting International Portfolio
Investment
1. Tax Rate on Interest or Dividends
Investors normally prefer to invest in a country where taxes are
relatively low.
2. Interest Rates
Money tends to flow to countries with high interest rates, as long as
the local currencies are not expected to weaken.
3. Exchange Rates
Investors are attracted to a currency that is expected to strengthen.

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Impact of International Capital Flows
1. A country relies heavily on foreign investment in:
 Manufacturing plants, offices, and other buildings.
 Debt securities issued by domestic firms.
 Government Treasury debt securities.
2. Foreign investors are especially attracted to foreign financial
markets when the interest rate in their home country is
substantially lower than that in other countries.

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

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 China Trade 2017 in $US Billion
(Synergized from the Data of World Bank)
Rank Country/Region Total Trade Exports Imports Trade Balance
China Totals 4,107.1 2,263.3 1,843.7 419.6
1 United States 583.3 429.7 153.9 275.8
2 Hong Kong 575.2 304.2 271.0 33.2
3 European Union 573.1 375.1 197.9 177.1
4 Japan 303.0 137.2 165.8 28.6
5 South Korea 280.2 102.7 177.5 74.8
6 Taiwan 199.9 43.9 155.9 112.0
7 Australia 136.4 41.4 95.0 53.6
8 Vietnam 121.9 71.6 50.3 21.3
9 Malaysia 96.1 41.7 54.4 12.7
10 Brazil 87.0 28.9 58,8 29.9
20+ New Zealand 26.1 14.8 11.2 3.6

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How does it work?
• US and EU corporations set up in China because of relatively low labor costs,
excellent infrastructure that China has developed in recent years and a well-
educated workforce.
• They do not produce for the Chinese economy but for the US, European and
global economy. They produce and export out of China by choice.
• $250 iphone from China has just $8.46 China value-add. A 25% tariff by the US is
a much higher tariff from the Chinese perspective.

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Who pays the tariffs
• The importer pays the tariff but will normally pass on the
cost to the US about consumer.
• To date the US has raised about $21 Billion from the China
tariffs but has spent $28 Billion in farmer support for those
affected by China cutting back on US agricultural imports.

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The U.S. argued that China is a currency manipulator

• A currency manipulator must be a net lender to the rest of the world (account
surplus), a net exporter relative to the U.S. (trade surplus) and determined that
the country levers its currency “for gaining unfair competitive advantage in
international trade.”
• In the most recent case, the U.S. argued that China actively devalued its currency
to make it more expensive for U.S. exporters to sell goods and services to Chinese
buyers. The action is the latest in an escalating trade war between the two
nations.
• But not all currency devaluation is currency manipulation, and the difference
comes down to how active a government pushes movements in the value of its
currency.

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How to manipulate your currency
• By the U.S. Treasury’s definition, currency devaluation becomes currency manipulation when it is
actively done by a government for the purposes of gaining a trade advantage.
• When a foreign currency depreciates against the U.S. dollar, American exports become more
expensive for foreigners to buy. Similarly, the foreign goods become cheaper for Americans to
buy, thus exacerbating the trade deficit if the foreign country already exports more goods to the
U.S. than it imports.
• Countries can manipulate their currencies by actively managing their reserves of foreign
currencies to support their home currency at a desired level.
• Recall that foreign exchange rates are determined by supply and demand. A country can build up
a reserve of U.S. dollars so that if it wanted to weaken its currency, it could sell its own currency
and buy U.S. dollars. The resulting demand for foreign currency would devalue the home
country’s currency.

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Currency depreciation
• In general, foreign exchange rates are determined by the supply and demand of
currencies across countries.
• Holding all else equal, if demand for U.S. dollars increases across the world,
purchases of more U.S. dollar-denominated assets would drive the value of the
dollar higher against other currencies (appreciation). Conversely, if demand for
U.S. dollars decreases across the world, outflows from U.S. dollar-denominated
assets would decrease the value of the dollar against other currencies
(depreciation).
• Interest rates are an example of one factor that can change a currency’s value.

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Currency depreciation (Cont.)
• For an investor looking to deposit money and earn interest, a country with higher
interest rates would be a more attractive place to park money compared to a
country with lower interest rates. As a result, a country with higher interest rates
will face higher demand for its domestic currency, strengthening that currency
against others.
• Even if interest rates are higher in one country, investors may prefer to park
money in another country because of expectations for stronger growth. Investors
may also steer money away from countries with high interest rates if those
countries also suffer from unstable levels of inflation.

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