International flow of funds

Balance of payment:
It is an account of all the trade transaction that takes place
between the domestic residents of a country and the foreign
residents of another country over a specified period of time. The
balance of payment account can be divided into two components
the current account and capital account.
The current account represents all the transfer of funds between
one country and the other country which results from the
purchase of goods and services. Its main components are the
payments for
1. Merchandise
2. Factor income
3. Transfer
Payments for merchandise and services:
The current account takes into consideration the import and
export of all the tangible good that are traded between the
countries, also the transfer of services between the countries. If a
country exports goods to the other country and earn revenue on
these exports then it should have a positive impact on its current
account as there is an inflow of funds to the country. Similarly
when a country imports certain goods for example the
components use in car manufacturing from another country as
there is an outflow of funds from the country so therefore it has a
negative impact on its current account. The difference between
total exports and imports is referred to as the balance of trade.
Factor income payments:
It represents the gain of an investor of a country by the securities
such as the stocks and bonds issued by the other country.The
interest and the dividends received by the investors of a country
represents an inflow of capital and it should increase its current
account and when a country pay a return on its securities it

should represent a outflow of capital and it decreases its current

account.
Transfer payments:
The third component of current account is the transfer of
payments through the aid and grants received by one country
from the residents of other country.
Capital and financial accounts:
The financial account represents the value of financial assets
transferred across the country border. It also includes the value of
nonproduced non financial assets such as the patients and
trademarks. The sale of patent by an American firm to a Canadian
firm represents an inflow for the US balance of payment.
The key components of capital account are
1. DFI
2. Portfolio investment
3. Other capital investment
Direct foreign investment:
Direct foreign investment represents the investment of a country
in the fixed assets in the other country. It includes the
establishment of subsidiary of an existing firm in other country or
to build a manufacturing plant in other country.
Portfolio investment:
Portfolio investment represents the investment in the long-term
financial assets such as stocks and bonds of the foreign country
by the other country which do not involve the transfer of control.
Other capital investments:
A third component of capital account is the investment in the
short-term securities such as the money market securities
between the countries. The DFI in general measures the
expansion of the firm foreign operations while the Portfolio and
other investments measures the net transfer of funds in the
financial assets.

International trade flow:

Countries in the world are more dependent on the trade with the
rest of the worlds. The trade volume of the Canadian exports and
imports per year is valued at more than 50 percent of its gross
domestic product(GDP). The trade volume of America and japan is
between 10 and 20 percent of their GDP.
US BALANCE OF TRADE TREND:
The balance of trade of US depends on its exports and its imports.
During the last few years the US balance of trade runs in a deficit
because of the large imports from the china and japan while the
amount of their exports to these countries is very less as
compared to the amount of imports. In 2006 the value of US
exports to china is $55 billion as compared to its imports of $256
billion that caused a balance of trade deficit of $200 billion.
The US should be concerned about the balance of trade deficit
because if the production goes out of US it should create serious
unemployment which could create other financial problems in US.
International trade has created jobs in foreign countries, which
replaces the jobs in US. International trade has caused a shift in
the production to countries that can produce the product
efficiently
International trade issues:
The following events reduce trade restrictions and increased
international trade.
REMOVAL OF BERLIN WALL:
The berlin wall which has separated East Germany from the West
Germany was removed in 1989 which result in the flow of trade
between the western European countries and the East Germany.
Many European firms have established their subsidries in the East
Germany in order to get advantage of the cheap labor and to

penetrate the market. This has removed the trade barriers

between the countries and the pace of international trade has
increased as a result of this.
NAFTA:
In 1993 an agreement was signed between the countries of north
America which is called the north American free trade area which
eliminated all the trade barriers between the US,mexico and
Canada. As a result of the NAFTA all the taxes and the tariff
between these countries are removed and they have created a
free trade zone for their trade. This agreement should give the US
firms an easy access to the cheap labored of Mexico therefore
many US MNC have established their subsidries in mexico to
produce the same product at a low price and to easily reach the
Mexican market.
Inception of the Euro:
The adoption of Euro as a common currency of the European
countries in 1999 and now Euro is use as a currency for the
transaction between these countries. As a result of the
introduction of euro the problem faced by many firms and their
subsidries for the conversion of currencies has been eliminated
this increases the trade among these countries.
Factors Affecting international trade flows:
The influential factors affecting the international trade are
1.
2.
3.
4.

Inflation
National income
Government policies
Exchange rates

Impact of inflation:
The high inflation rate of a country affect its current account
because its exports decreases due to the high cost of production

and the local consumers of that country will prefer to use the
international product as compared to the local product due to the
increased inflation in the country.
National income:
As the national income of the country increases as compared to
the other countries its current account will decreased as the real
income rises, therefore the consumption increases and this will
make an increased demand for the consumption of foreign goods.
Impact of government policies:
The international trade up to a large extent depends on the trade
policies of the governments and it can affect it in many ways.
Subsidies for Exporter:
The governments in some countries protected their domestic
firms from the increased global competition from their foreign
competitors therefore they have given subsidies to the local firms
which are exporting to other countries to produce at a low cost
then their competitors. They have always put some restrictions on
imports like tariff and quotas.
Restrictions on imports:
The government in order to restrict the imports they should
impose a tax on the consumption of foreign goods commonly
referred to as tariff this will make the prices of the local goods
cheaper as compared to the foreign goods and throughthese
measures they should protect their local firm from foreign
competition. Sometimes they imposed quotas on imports that is
to maintain a limit on these imports.
Impact of exchange rates:
If there is an increase in the value of a country currency then its
current account deficit increases because a high value of local

currency compared to that of the other currency will make the

exports more expensive for the foreign consumers. Similarly a
decrease in the value of local currency will reduce its current
account deficit as it make the exports cheaper for foreign
consumers.
International capital flows:
The most important type of capital flow is the direct foreign
investment and the portfolio investment. The direct foreign
investment provide an opportunity to take advantage of the low
cost of production and to explore new market for its goods and
services. In 2006 the direct foreign investment by foreign firms
was about $1.2 trillion.
Factors affecting DFI:
Changes in Restrictions:
In the last decade many countries have reduced trade restrictions
on DFI as a result of which many firms in the developed nation
such the general electric have expand their operations to the
developing countries like mexico and india as the DFI in these
countries have created new jobs for the local population and have
removed many trade barriers.
Privatization:
Some countries have made an attempt to sell some of their
corporations to the investors and other corporations because it
allows for greatorinternation business because the foreign firm
has acquire its operations. There is an increase in the value of
these firms which are privatized because there is an anticiped
improvement in the managerial efficiency. Managers in the
privately owned enterprises are more focused on the goal of
maximizing shareholder wealth.
Potential economic growth:

Firms always like to do DFI in the countries which have more

growth in its market to purchase its products.
Tax rates:
Those countries which have a very low tax on the corporate
earnings are more feseable to attract more direct foreign
investment because the firms should consider its after tax cash
flows.
Exchange rate:
Firms while making a decision about a direct foreign investment
should consider the exchange rate and prefer the DFI in those
countries which have a strong currency as compare to firm local
currency because it should give more earnings in their local
currency after converting its foreign income.
Factors affecting international portfolio investment:
The following are the factors which affect the portfolio
investment.
1. Tax rate on interest or dividends.
2. Interest rate.
3. Exchange Rates.