Basics of International Financial Management

Module 1: Session 2 :
Balance of Payment and International
Trade Flows 1
Session Overview
A. Balance of Payments
B. International Trade Flows
C. International Trade Issues
D. Factors Affecting International Trade
Flows
E. Correcting a Balance of Trade Deficit
F. Agencies That Facilitate International
Flows

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Session 2 Objectives

1. Explain the key components of the balance of payment

2. Explain how international trade flows are influenced by

economic factors and other factors

C. Explain how balance of trade deficit can be corrected

3
Balance of Payments (BOP)

 Definition : The balance of payments account is the systematic record of all

economic transactions between a country with the rest of the world. The
BOP records the movements of goods, services and capital between the
country and Rest of the World

 Definition 2: BOP represents an accounting of a country’s international

transactions for a specific period of time a quarter or a year. It accounts for
transactions by businesses, individuals and the government

The BOP is composed of the following four segments:

1. The Current Account

2. The Capital Account
3. The Official Reserves Account
4. Statistical Discrepancy

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 Current Account and Capital Account:

1.Current Account (Balance of Trade)

a) Payments for merchandise and services

b) Factor income payments
c) Transfer payments

2. Capital Account

a) Foreign Direct Investment (FDI)

b) Portfolio investment (Foreign Institutional Investment
c) Other Investments

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The Official Reserves Account and Statistical Discrepancy

3. Statistical Discrepancy (Official Settlement Balance or BOP

> There’s going to be some omissions (illegal transfers or smuggled goods)

and misrecorded transactions—so we use a “plug” figure to get things to
balance. Our Example shows a discrepancy of $51.9 billion in 2004.

4. The Official Reserves Account

> The reserve account represents the transactions (changes in official

reserve) undertaken by the Governments to finance the overall balance
and intervene in the foreign exchange market

> Official reserves assets include gold, foreign currencies, SDRs, reserve
positions in the IMF

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The Balance of Payments Identity

BCA + BKA + BRA = 0

where
BCA = balance on current account
BKA = balance on capital account
BRA = balance on the reserves account

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 U.S. Balance of Payments Data
  Credits Debits
Current Account    
1 Exports $1,516.2  
2 Imports   ($2,109.1)
3 Unilateral Transfers $16.4 ($89.4)
  Balance on Current Account ($665.9)
Capital Account    
4 Direct Investment $115.5 ($248.5)
5 Portfolio Investment $794.4 ($90.8)
6 Other Investments $524.3 ($483.7)
  Balance on Capital Account $611.2  
7 Statistical Discrepancies 51.9 
  Overall Balance $2.8  
Official Reserve Account $2.8

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 U.S. Balance of Payments Data
  Credits Debits
Current Account     In 2004, the 
1 Exports $1,516.2  
U.S. imported 
2 Imports   ($2,109.1)
3 Unilateral Transfers $16.4 ($89.4)
more than it 
  Balance on Current Account ($665.9) exported, thus 
Capital Account     running a 
4 Direct Investment $115.5 ($248.5)
5 Portfolio Investment $794.4 ($90.8) current account 
6 Other Investments
Balance on Capital Account
$524.3 ($483.7) deficit of 
  $611.2  
7 Statistical Discrepancies 51.9  $665.9 billion.
  Overall Balance $2.8  
Official Reserve Account $2.8

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U.S. Balance of Payments Data
  Credits Debits
Current Account    
1 Exports $1,516.2   During the same 
2 Imports   ($2,109.1) year, the U.S. 
3 Unilateral Transfers $16.4 ($89.4) attracted net 
  Balance on Current Account ($665.9)
Capital Account    
investment of 
4 Direct Investment $115.5 ($248.5) $611.2 billion—
5
6
Portfolio Investment
Other Investments
$794.4
$524.3
($90.8)
($483.7)
clearly the rest 
  Balance on Capital Account $611.2   of the world 
7 Statistical Discrepancies
Overall Balance
51.9 
found the U.S. 
  $2.8  
Official Reserve Account $2.8 to be a good 
place to invest.

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 U.S. Balance of Payments Data
  Credits Debits
Current Account    
1 Exports $1,516.2   Under a pure flexible 
2 Imports   ($2,109.1) exchange rate regime, these 
3 Unilateral Transfers $16.4 ($89.4) numbers would balance 
  Balance on Current Account ($665.9) each other out.
Capital Account    
4 Direct Investment $115.5 ($248.5)
5 Portfolio Investment $794.4 ($90.8)
6 Other Investments $524.3 ($483.7)
  Balance on Capital Account $611.2   In the real world, there 
7 Statistical Discrepancies 51.9  is a statistical 
  Overall Balance $2.8  
Official Reserve Account $2.8 discrepancy. 

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 U.S. Balance of Payments Data
  Credits Debits
Current Account     Including official 
1 Exports $1,516.2  
reserve, the balance 
2 Imports   ($2,109.1)
3 Unilateral Transfers $16.4 ($89.4)
of payments identity 
  Balance on Current Account ($665.9) should hold:
Capital Account    
4 Direct Investment $115.5 ($248.5) BOP Identity :
5 Portfolio Investment $794.4 ($90.8) BCA + BKA + BRA =  0
6 Other Investments $524.3 ($483.7)
  Balance on Capital Account $611.2  
7 Statistical Discrepancies 51.9 
  Overall Balance - $2.8  
Official Reserve Account $2.8

($665.9) + $611.2 + $51.9 = ($2.8)

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Balance of Payments and the Exchange
Rate

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 Balance of Payments and the Exchange
Rate

As U.S. citizens import and invest in other financial markets, they supply dollars 
to the FOREX market.
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 Balance of Payments and the Exchange
Rate

As U.S. citizens export and receives foreign investments, others demand dollars at 
the FOREX market.

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 Adjustments by way of Changes in
Official Reserve

As the U.S. government sells dollars to buy reserve, the supply of dollars increases.

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Exchange Rate Determination under
Flexible Exchange Rate Regimes

 Suppose the exchange rate is $1.40/£ today.

 In the next slide, we see that demand for British pounds

far exceed supply at this exchange rate.

 The U.S. experiences trade deficits.

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Exchange Rate and Balance of Trade
Deficit

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Exchange Rate Determination under
Flexible Exchange Rate Regimes

 Under a flexible exchange rate regime, the dollar will

simply depreciate to $1.60/£, the price at which supply
equals demand and the trade deficit disappears.

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Exchange Rate and Balance of Trade
Equilibrium

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2006 Distribution of U.S. Exports and Imports

Insert Exhibit 2.4 from page 28

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International Trade Issues

Events that Increased International Trade

a. Removal of the Berlin Wall

b. Single European Act
c. NAFTA
d. Inception of the Euro
e. European Union Expansion

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 Euro Area
16 Member Countries of the European Union out of total members of
27 countries use the euro as their currency presently in 2009

* Belgium * Luxembourg
* Germany * Malta
* Ireland * TheNetherlands
* Greece * Austria
* Portugal
* Spain
* Slovenia
* France
* Slovakia
* Italy
* Finland
* Cyprus

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Factors Affecting International Trade
Flows

Four Key Factors Affecting International Portfolio

Investment

a. Inflation
b. National Income
c. Government Policies
d. Exchange Rates

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Correcting a Balance of Trade Deficit

Why a Weak Home Currency is Not a

Perfect Solution

a. Counterpricing by Competitors
b. Impact of Other Weak Currencies
c. Prearranged International Transactions: J-curve
Effect

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J-Curve Effect

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Agencies that Facilitate International
Flows

1. International Monetary Funds

2. World Bank

3. World Trade Organization

4. International Financial Corporation

5. Bank for International Settlements

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