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• International business transactions occur in many different forms over the course of a year
• The measurement of all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP)
• BOP data is important for government policymakers and MNEs as it is a gauge of a nations competitiveness or health (domestic and/or foreign)
• For a MNE both home and host country BOP data is important as:
– An indication of pressure on a country’s foreign exchange rate
– A signal of the imposition or removal of controls in various sorts of payments (dividends, interest, license fees, royalties and other cash disbursements)
– A forecast of a country’s market potential (especially in the short run)
• Each of the following represents an international economic transaction that is counted in and captured in the US BOP:– A US subsidiary of a foreign MNE acts as a
distributor for the MNEs products in the US market– A US based firm, manages the construction of a
major water treatment facility in a foreign country– The US subsidiary of a foreign firm pays profits
(dividends) back to a parent in its home (foreign) country
– The US government finances the purchase of military equipment for a foreign military ally
• The BOP is often misunderstood as many people infer from its name that it is a balance sheet, whereas in fact it is a cash flow statement
• By recording all international transactions over a period of time such as a year, it tracks the continuing flows of purchases and payments between a country and all other countries
• It does not add up the value of all assets and liabilities of a country on a specific date (as an individual firm’s balance sheet would do)
• Two types of business transactions dominate the balance of payments:– Exchange of Real Assets
– Exchange of Financial Assets
• Although assets can be identified as belonging to distinct groups, it is easier to think of all assets simply as goods that can be bought or sold (a clock versus a bond)
• The Current Account includes all international economic transactions with income or payment flows occurring within one year, the current period. It consists of the following four subcategories:– Goods trade and import of goods
– Services trade
– Income
– Current transfers
• The Current Account is typically dominated by the first component which is known as the Balance of Trade (BOT) even though it excludes service trade
• The deficits in the BOT of the past decade have been an area of considerable concern for the United States, in both the public and private sectors: WHY? What is potential impact of large CA deficits?
• The goods trade deficit saw the decline of heavy traditional industries in the U.S. (steel, automobiles, automotive parts, textiles)
• The Capital Account of the balance of payments measures all international economic transactions of financial assets. It is divided into two major components:– The Capital Account
– The Financial Account
• The Capital Account is minor (in magnitude), while the Financial Account is significant
• Financial assets can be classified in a number of different ways including the length of the life of the asset (maturity) and the nature of the ownership (public or private)
• The Financial Account, however, uses a third method. This focuses on the degree of investor control over the assets or operations
• The Financial Account consists of three components;– Direct Investment – in which the investor exerts
some explicit degree of control over the assets
– Portfolio Investment – in which the investor has no control over the assets
– Other Investment – consists of various short-term and long-term trade credits, cross-border loans, currency deposits, bank deposits and other A/R and A/P related to cross-border trade
• This is the net balance of capital that flows in and out of the U.S. but does not reach the 10% threshold of direct investment.
• The purchase of debt securities across borders is classified as portfolio investment because debt securities by definition do not provide the buyer with ownership or control.
• Portfolio investment is motivated by a search for returns rather than to control or manage the investment.
• The Net Errors and Omissions account ensures that the BOP actually balances.
• The Official Reserves Account is the total reserves held by official monetary authorities within the country.
• These reserves are normally composed of the major currencies used in international trade and financial transactions (hard currencies).
• The significance of official reserves depends generally on whether the country is operating under a fixed exchange rate regime or a floating exchange rate system.
• A surplus in the BOP implies that the demand for the country’s currency exceeded the supply and that the government should allow the currency value to increase – in value – or intervene and accumulate additional foreign currency reserves in the Official Reserves Account.
• A deficit in the BOP implies an excess supply of the country’s currency on world markets, and the government should then either devalue the currency or expend its official reserves to support its value.
Where:X = exports of goods and servicesM = imports of goods and servicesCI = capital inflowsCO = capital outflowsFI = financial inflowsFO = financial outflowsFXB = official monetary reserves
• Apart from the use of interest rates to intervene in the foreign exchange market, the overall level of a country’s interest rates compared to other countries does have and impact on the financial account of the BOP
• Relatively low real interest rates should normally stimulate an outflow of capital seeking higher rates elsewhere
• However, in the case of the U.S., the opposite has occurred due to perceived growth opportunities and political stability – allowing it to finance its large fiscal deficit
• However, it is beginning to appear that the favorable inflow on the financial account is diminishing while the current account balance is worsening – making the U.S. a bigger debtor nation vis-à-vis the rest of the world
• A country’s import and export of goods and services is affected by changes in exchange rates
• The transmission mechanism is in principle quite simple: changes in exchange rates change relative process of imports and exports, and changing prices in turn result in changes in quantities demanded through the price elasticity of demand
• Theoretically, this is straightforward, in reality global business is more complex
• The degree to which capital moves freely across borders is critically important to a country’s balance of payments
• The financial account surplus has probably been one of the major reasons that the U.S. dollar has been able to maintain its value over the past 20 years
• The authors argue that the post-1860 era can be subdivided into four distinct periods with regard to capital mobility.– 1860-1914 – continuously increasing capital mobility as the
gold standard was adopted and international trade relations were expanded
– 1914-1945 – global economic destruction, isolationist economic policies, negative effect on capital movement between countries
– 1945-1971 – Bretton Woods era say a great expansion of international trade
• Although no single definition of capital flight exists, it has been characterized as occurring when capital transfers by residents conflict with political objectives.
• Many heavily indebted countries have suffered capital flight, compounding their debt service problems.
• Capital can be moved via international transfers, with physical currency, collectables or precious metals, money laundering or false invoicing of international trade transactions.
• Where in the current account would the imported telecommunications equipment be listed? Would this location correspond to the increase in magnitude and timing of the financial account?
• Why do you think that net direct investment declined from $573 million in 1998 to $112 million in 2000?
• Why do you think that TelSim defaulted on its payments for equipment imports from Nokia and Motorola?