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International Financial Management

M.B.S – Final
Chapter – 2
International Flow of Funds
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1) What is balance of payment?

Ans: The balance of payments is a defined as an accounting record of
all transactions made by a country over a certain time period,
comparing the amount of foreign currency taken in to the amount of
domestic currency paid out. The transactions are recorded using
double entry bookkeeping.

2) Discuss the key components of the balance of payments.

Ans: A balance of payment statement can be broken into various
components. Those that receive the most attention are the current
account and the capital 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 on financial assets. The capital account represents a summary
of the flow of funds resulting from the sale of assets between one
specified country and all other countries over a specified period of
time.>………The inner bracket writings should be skipped in exam.

The main components of current account are – Payments for -

1) Merchandise and services
2) Factor income
3) Transfers

The main components of Capital account are – Payments for –

1) Direct foreign investment
2) Portfolio investment
3) Other capital investment

Explanation:
Components: Current Account:
1) Merchandise and services: Merchandise imports and exports
represent tangible products, such as computers and clothing that
are transported between countries. Service import and export
represents tourism and other services such as legal, insurance etc
provided for customers based in other countries. The difference
between total exports and imports is referred to as the balance of
trade.
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2) Factor income: Factor income represents income (interest and

dividend payments) received by investors on foreign investments
in financial assets.
3) Transfers: Transfer payments represent aid, grants, and gifts from
one country to another.

Components: Capital Account

1) Direct Foreign Investment: Direct foreign investment represents
the investment in fixed assets in foreign countries that can be
used to conduct business operations.
2) Portfolio Investment: Portfolio investment represents
transactions involving long – term financial assets between
countries that do not affect the transfer of control.
3) Other Capital investment: Other capital investment represents
transactions involving short term financial assets (e.g. – money
market securities) between countries.

3) Explain How the international flow of funds is influenced by

economic and Non – economic factors?
Ans: International flow of funds are influenced by the following factors
–
1) Inflation
2) National Income
3) Government policies and
4) Exchange Risk
Explanations are provided below –

1) Inflation: If the inflation rate of a country increases relative to

the
Countries with which it trades, its current account would be
expected to decrease, other things being equal. Consumers
and corporations in that country will most likely purchase
more goods overseas (due to high local inflation), While the
country’s exports to other countries will decline.
2) National Income: If a country’s income level (National income)
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 (adjusted for
inflation) rises, so does the consumption of goods. A
percentage of that increase in consumption will most likely
reflect an increased demand for foreign goods.
3) Government policies: The most commonly used Govt.
restrictions is tariff and quotes.
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4) Exchange Risk: Each country’s currency is valued in terms of

other currencies through the use of exchange rates, so that
currencies can be exchanged to facilitate international
transactions. As the currency strengthens, goods exported by
that country will become more expensive to the importing
countries. As a consequence, the demand for such goods will
decrease.

4) What is current account generally composed of?

Ans: The current account deals with international trade in goods and
services and with earnings on investments. The current account is
composed of 4 sub-accounts:
1) Merchandise trade: It consists of all raw materials and
manufactured goods bought, sold, or given away. Until mid-1993, this
was the figure that was used when the balance of trade was reported
in the media. Since then, the merchandise trade account has been
combined with a second sub-account, services, to determine the total
for the balance of trade.
2) Services: It include tourism, transportation, engineering, and
business services, such as law, management consulting, and
accounting. Fees from patents and copyrights on new technology,
software, books, and movies also are recorded in the service category.
Most outsourcing of labor is a debit to the services account.
3) Income receipts: It includes income derived from ownership of
assets, such as dividends on holdings of stock and interest on
securities.
4) Unilateral transfers: It represents one-way transfers of assets, such
as worker remittances from abroad and direct foreign aid. In the case
of aid or gifts, a debit is assigned to the capital account of the donor
nation.

(Basic: The amount of goods and services imported compared to the

amount exported is known as the balance of trade. A trade surplus
exists when exports exceeds imports over a measured period and a
trade deficit exists when imports exceeds exports.)

5) Is a negative account harmful to a country?

Ans: Defintely a negative account is harmful to a country. The reasons

are provided below -
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1. If the current account had to be financed by borrowing or running

down reserves this is unsustainable in the long run. This may
participate depreciation in the currency as the demand for taka will be
less than the supply of taka.

A rapid depreciation can cause problems such as inflation and falling

confidence in the country. A depreciation also reduces living standards
making imported goods more expensive.

2. Low Competitiveness

3. Foreigners have an increasing claim on Domestic Assets: To finance

the deficit the country has mostly relied on attracting foreign
investment, this means foreigners have an increasing claim on
country’s assets. This could leave the country vulnerable if an
economic crisis caused foreign firms to withdraw their investment.
However this is unlikely, despite a recession in Japan, firms have not
withdrawn their investments.

4. Capital Flows may Dry Up

5. Could lead to lower Economic Growth: If the deficit is due to

excessive consumer demand - a recession or slowdown should help to
reduce the problem. Consumers cannot go on spending in excess of
their income for ever. Eventually they have to control their spending
and start saving again to improve their own finances.