International Flow of

Funds

Chapter 2
 Balance of Payments (BOP)
• BOP is a measure of international money flows for a
particular country.

• It is a measure of all transactions between domestic

and foreign residents over a specific period of time.

• It is a summary statement of a country for a specific

time period showing all the transactions of the
country’s households, business firms and
Government with all of its trading partners around
the world.
 Recording of transactions in BOP
• The transactions in BOP of a country are
recorded in double entry system, i.e. for each
debit entry, there will be a corresponding
credit entry.
• Thus, the total debits and total credits for a
country’s BOP will be identical in aggregate.
• But for any sub sets of BOP statement, there
may be deficit or surplus position.
 Recording of transactions in BOP Contd.

• Transactions that reflect inflow of funds

generate positive numbers or credit balance in
the country’s BOP statement, while
transactions that reflect outflow of funds
generate negative numbers or debit balance
for the country’s BOP statement.
 Components of BOP Statement
BOP statement can be broken down broadly into two
components:

 Current Account: The current account represents a summary

of flow of funds between one specified country and all other
countries due to purchase of goods or services, or the
provision of income from financial assets.

 Capital Account: The capital account represents a summary of

flow of funds resulting from the sale of financial assets
between one specified country and all other countries over a
specific period of time.
 Components of Current Account
• Balance of Trade: It is simply the difference between
merchandize export and merchandize import. Here merchandize
represents tangible products only. A deficit in balance of trade
reflects a greater value of imported goods than exported goods
and vice versa.

• Service export and import: It is the difference between export

and import of services like insurance, consulting service, legal
service etc.
 Components of Current Account
• Factor income: It represents income in the form of interest and
dividend payments received by investors on foreign investments
in financial assets.
Factor income =
Interests and dividends received by BD investors who invested in
foreign capital markets - Interests and dividends paid to the
foreign investors who invested in BD capital market

• Transfer payments: It represents aids, grants and gifts from one

country to another.
Factor income and transfer payments together are said as
International income transactions
 Components of Capital Account
 Portfolio Investment: The purchase of long term stocks and
bonds of foreign company to obtain a return on funds invested.
Here the investor can’t exercise any control on the operation of
the foreign company.
 Foreign Direct Investment (FDI): The purchase of sufficient
stock in a foreign firm to obtain significant management control
over the foreign firm’s operation. It can also be the investment
in fixed assets in foreign countries that can be used to conduct
business in that country.
 Other Capital Investments: It represents transactions involving
short term financial assets such as money market securities
between countries.
 Factors affecting international trade flows
• Impact of inflation: If a country’s inflation rate increases relative to the
countries with which it trades, its current account would decrease, other things
being equal. The consumers and corporations in that country is most likely to
purchase more goods overseas due to lower price. Hence, import of that
country would increase. At the same time, the country’s export will be less
attractive due to higher price and hence export would decrease and there will
be a deficit in current account.

• Impact of national income: If a country’s income level increases by a higher

percentage than those of other countries, its current account is expected to
decrease, other things being equal. As the real income level increases, so does
the level of consumption because of the constant MPC and MPS. A percentage
of that increase in consumption will most likely reflect an increased demand in
foreign goods and an increase in import, resulting in deficit in current account.
 Factors affecting international trade flows Contd.

• Impact of Government restrictions: A country’s government can prevent

or discourage imports from other countries by imposing some trade
barriers. Such restrictions like tariff, quota and other non-tariff barriers
can disrupt trade flows.
• Impact of exchange rate: The value of most currencies can fluctuate over time in terms of other currencies
due to some market and government forces. If a country’s currency value begins to rise against other
currencies, its current account balance should decrease, other things being equal. As the currency
strengthens, goods exported by that country will become more expensive to other importing countries.
So, the demand for such goods will decrease.
• 1$= Tk.85
• 1$ = Tk. 83
US $ has depreciated and BDT has appreciated. Here value of BDT has increased. Because of rise in value of
BDT, the value of export earning will decrease although the volume of export remains same. So the
exporters will be less interested to increase the volume of export and so will be a decrease in export
earning. There will be reduction in inflow of foreign currency.
On the other hand, when value of BDT rises, the importers will be more interested to increase the volume of
import because the amount required to be paid in the domestic currency will decrease although the
import value remains same. As a result, there will be increase in import volume and import payment as
well. So there will be increase in outflow of foreign currency from the country. In conclusion , if the
currency value of a country rises against other country, the current account will have deficit balance or
current account will decrease.
If the value of currency falls, current account would increase or a surplus balance will be created.
If BDT depreciates and US $ appreciates, the current account of BD will have
surplus balance.
 Strategy for correcting a balance of trade deficit

Trade deficit is created when Export is less than import.

•Any kind of policy that will increase foreign demand for the
country’s goods and services will improve the country’s balance of
trade position.
•Foreign demand for domestic goods and services may increase if the
export price is attractive.
•A country can make the export price cheaper from the foreign
perspective by 1) keeping the rate of inflation low and 2) a
reduced/depreciated currency value.
•A floating exchange rate system can be introduced to correct the
balance of trade deficit.
Why a weak home currency is not a perfect solution to correct
a balance of trade deficit

• Counter pricing by competitors

• Impact of other weak currencies
• Pre-arranged international transactions
• Inter-company trade

Reasons for which a weak/depreciated home currency may not

be able to correct balance of trade deficit.
 BD=10 and US =6%

Due to high inflation in BD, the goods and services in BD are priced high in comparison to the goods and services
in US. So the BD consumers will be more interested to purchase goods and services from USA due to lower price.
As a result there will be increased import from USA to BD and there will be increased outflow of funds.
On the other hand, due to higher inflation in BD, the price of raw materials and other necessary inputs for
production will also increase. Do the cost of production for BD goods and services will also increase making the
price level high for the consumers. This will make the BD goods and services less attractive in the export market.
So there will be decreased export from BD and there will be decrease in export earning and there will be decrease
in inflow of funds.
The ultimate impact is the deficit balance in balance of trade and service export and import.

If there is increase in national income of a country, per capita income will also increase, that means the individual
income level is increasing. With the increase in income, level of consumption will also increase because MPC and
MPS are considered to be constant for short tern period. So there will be increase in demand for goods and
services. A certain portion of this demand for goods and services will be the demand for foreign goods and
services. As a result there will be increased import to the country and there will be outflow of funds making deficit
balance in current account.
Factors affecting Direct Foreign Investment
(DFI)
• Change in restrictions (Govt. restrictions and rules
and regulations)
• Privatization
• Potential economic growth
• Tax rates
• Exchange rates: Firms typically prefer the countries for
DFI where the local currency is strengthening against their
own.
When the local currency gets strong, i.e. the local
currency is expected to appreciate and the domestic
currency is expected to depreciate, The foreign investor
will get added benefit at the time of repatriating the
profit earned from the FDI. So the foreign investor will
be more interested to have FDI in that country.
 Factors affecting International Portfolio
Investment
• Tax rates on Interest and Dividends
• Interest rates
• Exchange rates: If a country’s home currency is expected
to strengthen, foreign investors will be willing to invest in the
country’s security to benefit from the currency movement.
 Agencies that facilitates international
fund flows
• International Monetary Fund (IMF)
• World Bank
• World Trade Organization (WTO)
• International Financial Corporation (IFC)
• International Development Association (IDA)
• Bank for International Settlement (BIS)