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International Flow of Funds
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Chapter Objectives
Explain the key components of the balance ofpayments,
Explain the growth in international trade activity overtime,
Explain how international trade flows are influencedby economic factorsand other factors,
Explain how international capital flows are influencedby country characteristics,
Introduce the agenciesthat facilitate the internationalflow 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.
It represents an accounting of a countrysinternational
transactions for a period of one year or a quarter.
It accounts for transactions by businesses, individuals,
and the government.
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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 foreigncountries, are recorded as debit.
Alternatively, sources and uses of funds method of
accounting can be used whereby:sources = credits = pluses
uses = debits = minuses
Balance of Payments
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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
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The current account summarizes the flow of fundsbetween 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 offunds from the specified country for its current
transactions
Key components of the current account include:
i. Balance of trade(exports and imports of merchandiseand service)
ii. Factor income(interest & dividends)
iii.Transfer payments(aids, gifts, & grants).
Current Account
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Current Account
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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.
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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-termfinancial assets
other capital investment:transactions of short-
term financial assets
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Financial account
The financial account records an economys transaction in
external financial assets and liabilities.Financial Account* = Change in the ownership of domesticassets-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 meansmoney is flowing into the country, but unlike a surplus inthe current account, the inbound flows will effectively beborrowings or sales or transfer of assets rather than earnings.
* Capital Account
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Balance Of Payment
If a country has a negative current account balance, itshould 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 inthe 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.
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BOP of Pakistan
Items Jul-Sep Oct-Dec Jan-Mar Apr-Jun
Current Account balance -1,367 -1,032 -639 -1,620 -4,658 214
Trade balance (Goods) -4,241 -3,776 -3,820 -3,928 -15,765 -10,516
Exports 6,149 5,923 6,262 6,362 24,696 25,356
Imports 10,390 9,699 10,082 10,290 40,461 35,872
Services (net) -746 -619 -732 -1,095 -3,192 -1,940
Income (net) -650 -922 -690 -983 -3,245 -3,017
Current transfers (net) 4,270 4,285 4,603 4,386 17,544 15,687
Capital Account (net) 31 59 54 39 183 161
Financial Account(net) 602 -326 145 859 1,280 2,101
Errors and Omissions (net) -25 266 -419 98 -80 16
Overall balance -759 -1,033 -859 -624 -3,275 2,492
Rese rve and Related Item 759 1,033 859 624 3,275 -2,492
Table 1: Balance of Payments - Summary (Million US dollar)
FY12
FY12 FY11
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Trading Partners of Pakistan
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Foreign Trade (Pakistan)
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Factors Affecting International Trade Flows Inflation
A relative increase in a countrys inflation rate willdecrease its current account, as imports increaseand 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 byimposing tariffs on imported goods, or by
enforcing a quota. Note that other countries mayretaliate by imposing their own trade restrictions.
Sometimes though, trade restrictions may beimposed on certain products for health and safetyreasons.
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Factors Affecting International Trade Flows
Some governments offer subsidies to theirdomestic firms, so that those firms can produceproducts at a lower cost than their globalcompetitors.
Exchange Rates If a countrys currency begins to rise in value, its
current account balance will decrease as importsincrease and exports decrease.
Note that the factors are interactive, such that theirsimultaneous influence on the balance of trade is acomplex one.
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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 andmany other countries. Consequently, the demand for
Asian products increased and sometimes replaced the
demand for products of other countries.
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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 reducesthe 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.
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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 additionalconsumers or can rely on low-cost labor and other
resources.
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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 haverecently engaged in privatization, or the selling of
some of their operations to corporations and other
investors.
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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 PortfolioInvestment
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Exchange Rates-If a countrys home currency is
expected to strengthen, foreign investors may be
willing to invest in the countryssecurities 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.
Factors Affecting International PortfolioInvestment
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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.
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Should Pakistan Rely to Much on ForeignFunds
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 governmentand 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 tocompensate for the risk (a risk premium).
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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 internationalmonetary issues
b) Stability in exchange rates
c) Provide temporary funds to member countries
attempting to correct imbalances of internationalpayments
d) Promote free mobility of capital funds across
countries and free trade
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2. World Bank
The International Bank for Reconstruction andDevelopment (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
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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.
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International Financial Corporation
International Financial Corporation (IFC) was
established in 1965 to promote private enterprise
within countries.
IFC works to promote economic developmentthrough 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.
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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
bankscentral bankor the lenderof 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.
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Organization for Economic Cooperationand 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.
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Regional Development Agencies
Inter-American Development Bank
Asian Development Bank
African Development Bank
European Bank for Reconstruction and Development
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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 ameasure of the countrys long-term and short-term
capital investments, including direct foreign
investment and investment in securities (portfolio
investment).
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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 astrong local currency tend to result in a strong
demand for imports and a current account deficit.
Summary
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A countrysinternational 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 norestrictions 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 localcurrencies are not expected to weaken.
Summary