Module 1.

International Finance and Balance of Payments

Chapters 1 and 3

Massey University | massey.ac.nz | 0800 MASSEY

Outline
⚫ The globalization of world economy
⚫ Multinational corporations
⚫ What’s special about “international” finance
⚫ Balance of payments accounting
⚫ The balance of payments identity
⚫ Balance of payments trends in major countries
 Why Study International Finance?
It is important to study international finance since we
are living in a globalized and integrated world
economy.
⚫ The theory of comparative advantage states that
economic well-being is enhanced if countries
produce goods and services for which they have a
comparative advantage and trade for other goods.
⚫ Trade liberalization and economic integration
- The General Agreement on Tariffs and Trade (GATT,
1947), later replaced by the World Trade Organization.
 The Globalization of World Economy
Over the past 50 years, international trade increased
about twice as fast as world GDP.
⚫ Emergence of globalized financial markets
⚫ Deregulation of financial markets.
⚫ Financial innovations – currency derivatives,
cross-border stock listings, ...
⚫ Advances in technology - information and
transaction costs are greatly reduced.
Globalization of the World Economy (cont.)
⚫ Privatization
⚫ Increased enterprise efficiencies
⚫ Allowing foreign ownership, leading to an
increase in cross-border investments.

⚫ Emergence of the euro as a global currency - a

common currency for 19 of the 27 EU member
states.
 Multinational Corporation
A multinational corporation (MNC) is a company that
has been incorporated in one country and has
production and sales operations in other countries.

⚫ Going international for expanded opportunity set.

- Greater economies of scale.
- Cheaper raw material
- Lower cost of labor
- Access to other national markets.
- Lower cost of financial capital
 Examples of MNCs
A global company operating in 50 countries.
Manufacture in the U.S., Mexico, Italy, Thailand and China.

A global dairy nutrition company.

Operates in more than 100 countries around the world.

A leading manufacturer of products for use in

respiratory care and acute care.
Products are sold in over 120 countries worldwide.
Financial Management of MNCs: Characteristics
⚫ Market imperfections motivate MNCs.
- Legal restrictions on movement of goods, people
and money
- Transactions and shipping costs

- Differential taxation systems.

⚫ Political risk: regulatory changes (e.g. change of tax

rules or outright expropriation of assets) may hurt
your foreign operation.
⚫ Foreign exchange risk: foreign currency profits may
be hurt by exchange rate fluctuation.
Political risk: Example

Nestlé used to have two different classes of common stock:

⚫ Swiss citizens could buy registered shares.
⚫ Foreigners were only allowed to buy bearer shares
⚫ Bearer shares were more expensive due to high
demand.

On Nov. 18, 1988, Nestlé lifted restrictions imposed on

foreigners, allowing them to hold registered shares.
 Price chart: Nestlé’s Bearer and Registered Shares

Price spread narrowed – transfer of wealth from foreign

shareholders to Swiss shareholders.
Foreign Exchange Risk: Example
Suppose Anna bought 10 shares of Toyota at ¥10,000 per
share when NZ$1 = ¥75.
One year later, her investment is worth ¥110,000 when
NZ$1 = ¥85. How well did Anna do in NZ$ terms?
Example (cont.)
One year later, Anna’s investment is worth ¥110,000.
➢ She’s made a 10% profit in JPY terms on equity market.
 Global Financial Crises
Recent global financial crises due to
- Excessive borrowing and risk taking.
- Failure of government regulation.

⚫ The Global Financial Crisis of 2008 – 09

⚫ The Eurozone Debt Crisis
 The Global Financial Crisis of 2008 - 09

⚫ Households and financial institutions borrowed too

much and took too much risk.
⚫ This risk was repackaged with securitization, and
defaults on subprime mortgages in the U.S. came to
threaten the solvency of a teacher’s retirement plans
in Norway.
➢ The most serious, synchronized economic downturn
since the Great Depression of the 1930s.
 U.S. Unemployment Rate and DJIA Index

During the course of the crisis, the G-20 emerged as the premier forum for
discussing international economic issues and coordinating financial regulations and
macroeconomic policies.
The Eurozone Debt Crisis
⚫ Dec 2009: the new Greek government revealed its
budget deficit would be 12.7% of GDP, not the
3.7% forecast.
⚫ April 2010: deficit revised to 13.6%.
⚫ Investors sold off Greek govt. bonds - downgraded
to junk bonds.
⚫ The crisis became a Europe-wide debt crisis.
⚫ May 2010: bailout package to rescue Greece.
 The Greek Drama

⚫ Greece paid no premium above the German rate until late fall 2009.
⚫ The Greek interest rate rose until the bailout package on May 9.
 The Balance of Payments
Doing business internationally leads to cross-border
transaction of money, which has an impact on a
country’s wealth.

Balance of Payments (BOP) is the statistical record of

a country’s transactions with the rest of the world over
a certain period of time.
✓ reflects the change in a country’s foreign worth of wealth.
✓ reflects the supply and demand for a country’s currency.
 Balance of Payments Accounting
BOP is presented in the form of double-entry
bookkeeping.

Suppose a NZ company imports $100,000 worth of

bicycles from China.
⚫ A $100,000 debit will be recorded by the NZ
importer
⚫ The Chinese exporter will record a $100,000 credit.
➢ This will lead to a rise in the supply of NZ$ and the
demand for RMB.
 Balance of Payment Accounts
⚫ Current Account: export and import of goods & services.
⚫ Capital Account: capital transfers and the cross-border
acquisition and disposal of nonproduced nonfinancial
assets.
⚫ Financial Account excluding official reserves:
purchases and sales of financial assets.
⚫ Official Reserves Account: transactions of international
reserve assets (gold, foreign currencies, and SDRs with the
IMF).
⚫ Statistical Discrepancy: a “plug” figure that reflects
omissions and misrecorded transactions to get the account
balanced.
 The Current Account
Divided into four finer categories:
⚫ Goods trade represents exports and imports of tangible
goods (e.g., oil, wheat, clothes, automobiles, etc.)
⚫ Services include payments and receipts for legal,
consulting, financial, and engineering services; royalties
for patents and intellectual properties; shipping fees; and
tourist expenditures.
⚫ Primary income consists largely of payments and receipts
of interest, dividends, and other income on foreign
investments that were previously made.
⚫ Secondary income involves “unrequited” payments.
 The Financial Account
Measures the difference between a country’s sales of assets
to foreigners and its purchases of foreign assets.
Can be divided into three categories:
⚫ Foreign direct investment (FDI) occurs when the
investor acquires a measure of control of the foreign
business.
⚫ Portfolio investment mostly represents sales and
purchases of foreign financial assets, such as stocks and
bonds, that do not involve a transfer of control.
⚫ Other investment includes transactions in currency,
bank deposits, trade credits, etc.
 U.S. Balance of Payments Data 2018
(Figures in $ billion)
Credits Debits
Current Account
[1] Exports 2,500.7
[1.1] Goods 1,672.3
[1.2] Services 828.4
[2] Imports −3,122.9 Import > export,
[2.1] Goods −2,563.7 thus running a
[2.2] Services −559.2 current account
[3] Primary income 1,060.4 −816.1 deficit.
[4] Secondary income 140.6 −251.2
Balance on current account −488.5
[[1] + [2] + [3] + [4]]
Capital Account 9.4 0
Capital account
Balance on capital account 9.4
surplus.
 U.S. Balance of Payments Data 2018 ($b)

Credits Debits
Financial Account
[5] Direct investment 267.1 50.6
[6] Portfolio investment 340.3 −210.4
[6.1] Equity securities 147.2 −97.2
Attracted net
[6.2] Debt securities 172.8 −113.2
investment in
[6.3] Derivatives, net 20.3
financial assets
[7] Other investment 213.8 −136.9
Balance on financial account 524.5 -this largely
[[5] + [6] + [7]] “finances” the
[8] Statistical discrepancies −40.5 trade deficit.
Overall balance 4.9
Official Reserve Account −4.9
 U.S. Balance of Payments Data 2018 ($b)
Credits Debits
Financial Account
[5] Direct investment 267.1 50.6
[6] Portfolio investment 340.3 −210.4 Statistical
[6.1] Equity securities 147.2 −97.2 discrepancy is a
[6.2] Debt securities 172.8 −113.2 “plug” figure,
[6.3] Derivatives, net 20.3 the BOP identity
[7] Other investment 213.8 −136.9 should hold:
Balance on financial account 524.5 BCA + BKA
[[5] + [6] + [7]]
[8] Statistical discrepancies −40.5 = – BRA
Overall balance 4.9
Official Reserve Account −4.9
-$488.5b + $9.4b + $524.5b + plug = 4.9
Solve for plug = -$40.5b
 The Overall Balance
Overall balance is the cumulative balance of payments
including the current account, capital account, financial
account, and the statistical discrepancies.
▪ It reflects a country’s international payment gap.
▪ It is indicative of a pressure on the value of a country’s
currency.
▪ Must be accommodated with the government’s official
reserve - a country can run a balance-of-payments
surplus or deficit by increasing or decreasing its official
reserves.
 The Balance of Payments Identity

BCA + BKA + BFA + BRA = 0

where
BCA = balance on current account
BKA = balance on capital account
B F A = balance on financial account
BRA = balance on the reserves account

⚫ Under the fixed exchange rate regime, countries

maintain official reserves that allow them to have BOP
disequilibrium: BCA + BKA +BFA = -BRA.
BOP and the Exchange Rate

⚫ As U.S. citizens import or

Exchange rate $
purchase assets abroad,
they supply USD to the P S
FOREX market.

P0
⚫ As U.S. citizens export or
sell assets to foreigners,
D
foreign buyers demand
USD from the FOREX Q
market.
 BOP and the Exchange Rate

⚫ An overall surplus causes the Exchange rate $

demand for dollars to increase,
P
therefore, P1 > P0. S1

P1
D1
P0

D
Q
 BOP and the Exchange Rate

Exchange rate $
⚫ As the U.S. government P S
buys reserve assets using S1
dollars, it provides supply
P1
of dollars, P2 < P1.
P2

D
Q
 J-Curve Effect of Currency Depreciation

▪ Short-term deterioration
Change in the Trade Balance

of the trade balance.

▪ Improvement over the
long term.
Time

The shape of trade balance curve depends on the elasticity of

imports/exports - if imported goods are not produced
domestically and demands are price inelastic, trade balance
will get worse.
 Balance of Payments Trends
⚫ New Zealand, the U.S. and the U.K. tend to realize
current account deficits.
⚫ China, Japan, and Germany tend to realize current
account surpluses.
➢ Some countries generally use up more outputs than they
produce, while the opposite holds for other countries.

Data source:
https://www.rbnz.govt.nz/
statistics/m7
Homework:
⚫ Chapter 1: 1, 2, 3, 4, 6.
⚫ Chapter 3: Questions: 1-4, 9, 10, 11. Problem 1.
⚫ Download the data for “Balance of Payments and
International Investment Position” from RBNZ’s website:
https://www.rbnz.govt.nz/statistics/m7. Study the data to
develop a good understanding of NZ’s historical record
of BOP accounts, the causes and implications of an
imbalance in current or capital accounts.

Next week:
The international monetary system (chapter 2)