Lecture 1

International Finance
ECON 243 Summer I, 2005
Prof. Steve Cunningham

The New World Economy

The world economy has become

increasingly interconnected:

Globalization: markets exceed

national boundaries; increased
mobility of workers, products, and
information.
Integration: people of different
countries choose to function jointly in
governance, economic interests,
currency, etc.

Developments

The possibility of such a global economy

has been brought about by:

Collapse of communism
Lower transportation costs
Advances in telecommunications (internet, etc.)
related technological innovations
Economic need
These have led to reductions in trade barriers

General barriers
Integration and free trade zonesEurope, North
America, etc.
The relaxation of bank and capital market regulations

Top 20 Globalized Nations

Rank

Nation

Rank

Nation

Ireland

11

United States

Switzerland

12

France

Sweden

13

Norway

Singapore

14

Portugal

Netherlands

15

Czech Republic

Denmark

16

New Zealand

Canada

17

Germany

Austria

18

Malaysia

United Kingdom

19

Israel

10

Finland

20

Spain

Source: Foreign Policy

Sectors

Economists typically separate the

production and sale of goods and
services from the exchanges of
financial assets.

Real Sector: production and sale of goods

and services.
Financial Sector: transactions in global,
foreign, or domestic financial assets.

Measurement is difficult because

trade may include services (invisibles)
and electronic commerce.

Balance of Payments

A record of international transactions

between residents of one country and
the rest of the world
International transactions include
exchanges of goods, services or assets
Residents means businesses,
individuals and government agencies,
including citizens temporarily living
abroad but excluding local subsidiaries
of foreign corporations

Double-entry Accounting in
the BOP

All transactions are either debit or

credit transactions
Credit transactions result in receipt of
payment from foreigners

Merchandise exports (valued f.o.b.)

Transportation and travel receipts
Income received from investments abroad
Gifts received from foreign residents
Aid received from foreign governments

Double-entry Accounting
(Contd)

Debit transactions involve to payments to

foreigners

Merchandise imports
Transportation and travel expenditures
Income paid on investments of foreigners
Gifts to foreign residents
Aid given by home government
Overseas investments by home country residents

Each credit transaction has a balancing debit

transaction, and vice versa, so the overall
balance of payments is always in balance.

Accounts Overview (Level

1)

Current Account (all real transfers)

Merchandise trade
Service trade
Transfers

Capital and Financial Account (transfers

of ownership and financial assets and
liabilities)

Changes in private assets

Changes in holdings of official international
reserves
Statistical Discrepancy

Current Account

The current account is that balance of

payments account in which all shortterm flows of payments are listed:

Goods and services balance (exports imports)

Merchandise trade balance (exports imports)

Services balance (exports imports)

Net Investment income

Unilateral transfers

Private transfer payments

Governmental transfers

What are Services?

Travel and tourism

Trade transportation
Insurance
Education
Financial, technical, and marketing
services
Telecommunication
Use of property rights (royalties)
Other professional and consulting services

What is Investment
Income?

Payment to holders of foreign

financial assets, including:

Interest on bonds and loans

Dividends and other claims on profits
by owners of foreign businesses
Payments made to temporary
(nonresident) workers

Unilateral Transfers

Official government grants in aid to

foreign governments
Charitable giving (e.g., famine relief)
Migrant workers transfers to families
in their home countries

Capital Account

The capital and financial account is that

balance of payments account in which all
cross-border transactions involving financial
assets are listed. This includes transactions
between foreign and domestic residents,
and foreign and domestic governments.

All purchases or sales of assets, including:

Direct investment
Securities (debt)
Bank claims and liabilities
Official reserves transactions
When U.S. citizens buy foreign securities or when
foreigners buy U.S. securities, they are listed here as
outflows and inflows, respectively.

Foreign Direct Investment

(FDI)

Any flow of lending to, or purchases of ownership

in, a foreign enterprise that is largely owned by
residents of the investing country.

Securities (stocks and bonds)

Loans
Bank deposits
Minority ownership positions

FDI is the purchase of assets to establish financial

control of a foreign entity. Generally ownership of
10% or more of a companys outstanding stock is
considered FDI.
Portfolio investment involves little management
control or interest, and is solely for financial gain.

Official Reserve Assets

Early on in this century, this was primarily

gold
Now primarily financial assets denominated
in a foreign currency that is widely
accepted in international transactions:

Euro assets (heavily used by U.S.)

Yen assets (heavily used by U.S.)
U.S. dollar assets (key currency worldwide)
Reserve positions in IMF
SDRs (created by IMF)

Official Reserves
Transactions
Governments can influence exchange rates

by buying and selling official reserves.

The buying and selling of official reserves is
recorded in the official transactions
account.

Also referred to as changes in holdings of official

international reserves or official settlements
balance.

It is the part of the balance of payments

accounts that records the amount of its own
currency or foreign currencies that a nation
buys or sells.

Statistical Discrepancy?

It is the net result of errors and omissions

on both the credit and debit sides.
Where do these errors come from?

Under-reporting merchandise imports

Under-reporting investment incomes
Under-reporting capital exports
Basically, people succeed in hiding their
imports, foreign investment incomes, capital
flight from their governments for tax and
other purposes.

Account Overview (Level

2)
Current Account

Capital Account

Merchandise trade
exports
imports
Trade Balance
Services
military trans. (net)
other services, net
Service Balance
Balance on goods & services
Investment income, net

Changes in US assets abroad, net

other US govt assets
US private assets
All changes, net
Changes in foreign assets in the US,
net foreign private assets
All changes, net

Unilateral transfers
US government grants
US govt pensions, and
other transfers
Private remittances and
other transfers
All transfers, net
Balance on current account

Changes in holdings of official

international reserves, net
Statistical discrepancy
Balance on capital account

Current Account

The difference between the import and

export of goods is sometimes called
the balance of merchandise trade.

Although the popular press often uses this

measure, the merchandise trade balance
is not a good summary because services
are an important component of trade.

The balance on goods and services

includes trade in services. This includes
visible and invisible trade .

Current Account, 19702002

200
100
0
-100
-200
-300
Current Account

-400
-500
-600
1970

Goods
Services

1975

1980

1985

1990

1995

2000

Current Account Surplus and

Deficit

A current account surplus means

exports of goods and services,
investment income and transfers
exceed imports and outflows.
A current account deficit means
imports of goods and services, and
outflows are greater than exports
and inflows; must be financed by
borrowing (capital account inflows).

Linkage to NIPA and

the Domestic Economy

Current Account (CA) surplus equals net

foreign investment (If ). CA = If .

If If > 0, the country has net foreign

investment, so the country must be investing
part of its saving abroad, and S = Id + If .
That means If = S Id .
Recall that Y = C + Id + G + (X M).
Also, CA = X M.
Domestic Expenditures E = C + Id + G, and
Y E = X M = CA
C + Id + G is sometimes referred to as
absorption.

Meaning of Overall
Balance

The current account and the capital

account measure the private and non-U.S.
government supply of and demand for
dollars.
Official Settlements Balance:
B = CA + KA
Because the balance of payments must
sum to zero, any imbalance in the official
settlements balance must be financed
(paid for) by official reserves flows:
B + OR = 0

BOP Surplus and Deficit

The Official Settlements Balance (B ) is

sometimes referred to as the net sum of the
items above the line or autonomous
transactions, and
The Official Reserves Transactions (OR ) are
referred to as the sum of the items below
the line, also called nonautonomous or
accommodating transactions.

When B = 0, there is said to be a BOP

equilibrium, and if B 0, a BOP disequilibrium.
When B > 0, there is said to be a BOP surplus.
When B < 0, there is said to be a BOP deficit.

BOP Surplus and Deficit

(Continued)

In terms of the supply and demand

of a nations currency, there is:

A balance of payments surplus if quantity

demanded for a currency exceeds quantity
supplied, putting upward pressure on the
value of the nations currency.
A balance of payments deficit if quantity
supplied of a currency exceeds quantity
demanded, putting downward pressure on
the value of the nations currency.

Official Transactions
Account

Most of the Official Reserves flows are

official interventions by the countrys
monetary authorities in the foreign
exchange markets.
When a government buys its own currency
to hold up the currencys price, we say that
the government has supported its currency.

It is holding the exchange rate higher than that rate

otherwise would have been.

When it sells its currency, it is attempting to

depress the value of its currency.

It is forcing the exchange rate to be lower than that rate

would otherwise have been.

Official Transactions
Account

Because they are an accounting

identity, the current, capital, and
official transactions accounts must
sum to zeroin total, the balance
of payments balances.
The supply of currency, including
governments, must equal the
demand for currency, including
governments.

1999 Balance of Payments

Accounts

1999 Balance of Payments

Accounts

BEA International Transactions Data

May 19, 2003, U.S. International Transactions (M

Memoranda

Line
71
72
73
74
75
76

(Credits +; debits -)/1/

2000
2001 2002/p/
Balance on goods (lines 3 and 20)
(452,423) (427,165) (484,353)
Balance on services (lines 4 and 21)
73,742
68,875
48,811
Balance on goods and services (lines 2 and 19)
(378,681) (358,290) (435,542)
Balance on income (lines 12 and 29)
21,782
14,382 (11,862)
Unilateral current transfers, net (line 35)
(53,442) (49,463) (56,023)
Balance on current account (lines 1, 18, and 35 or lines 73, 74, and
(410,341)
75)/13/ (393,371) (503,427)

Intl Investment Position

In order to buy U.S. assets foreigners

need dollars, so net capital inflows
represent a demand for dollars.

The demand for dollars comes from the

demand to buy goods and services and
the demand to buy (capital) assets.

In the 1980s, the inflow of capital

into the U.S. greatly exceeded the
outflow of capital from the U.S., and
this trend has continued into the late
1990s. (KA > 0, CA < 0)

Intl Investment Position

(continued)

International Investment Position (IIP)

is another related balance sheet. It is
a statement of the stocks of a
nations international assets and
foreign liabilities at a point in time,
usually the end of a year.
Any capital flows (related to a current
account imbalance) creates a change
in the IIP.

Intl Investment Position

(continued)

We say that a nation is a lender or a

borrower depending on whether its
current account is in surplus or deficit
during a time period.
We say that a nation is a creditor or
debtor depending on whether its net
stock of foreign assets is positive or
negative.
The first refers to flows over time, the
second to stocks at a point in time.

Intl Investment Position

(continued)

Prior to WWI, the U.S. was a net debtor.

From WWI through 1983, the U.S. was a
net creditor (the worlds leading creditor).
Since 1983, the U.S. has run large current
account deficits, requiring intl borrowing.
By 1989, the U.S. was a net debtor, and
continues to be so until the present.