INTERNATIONAL FINANCE

IMQF course in International Finance

Caves, Frankel and Jones (2007) World Trade and Payments, 10e, Pearson
 Introduction
International finance macroeconomic side of international economics (international
macroeconomics)
Examination of behaviour of monetary variables quantity of money and various prices measured in
currency units (wage rates, price levels, foreign exchange (FX) rates, etc.)

Strong internationalization (globalization) of the economies in the last 50 years boosts

importance of foreign sector
Shift to market-based exchange rate regime (1973), oil prices volatility, integration of developing countries in
global economy, EMU, currency crises
New developments in macroeconomic theory: rational expectations in financial markets, credible
commitment in monetary policy, intertemporal optimization of saving behavior, etc.

By inserting foreing sector into analysis, important assumptions get altered

Rigid (or sticky) prices and wages; free movement of capital; market-determined exchange rates, etc.
 Outline of the Course
Topics:
Balance of payments accounts (Chapter 15)
FX market and trade elasticities (Chapter 16)
National income and trade balance (Chapter 17)
Spending and the exchange rate in the Keynesian model (Chapter 18)
Money supply, price level and the balance of payments (Chapter 19)
Developing countreis and other small open economics with nontraded goods (Chapter 20)
Mundell-Fleming model with partial international capital mobility (Chapter 22)
Fiscal and monetary policy under modern financial market conditions (Chapter 23)
Crises in emerging markets (Chapter 24.1 and 24.2)
Supply and inflation (Chapter 26.1)
Expectations, money and determination of FX rate (Chapter 27.1 and 27.2)
 Lectures, Literature and Examination
Lectures
Normally Tuesday and Thursday starting at 18h
Attendance is mandatory (up to 1 absence is accepted)

Readings
Caves, R., Frankel, J., and R. Jones, (2007) World Trade and Payments: an Introduction, 10th edition,
Pearson International Edition

Examination and grading

Written exam 100 points
Classroom presentation up to 10 points
Clasroom discussion up to 5 points
Homework?
 The Balance of Payments Accounts

IMQF course in International Finance

Caves, Frankel and Jones (2007) World Trade and Payments, 10e, Pearson
 Outline of the Chapter
Balance of Payments Accounts
Topics:
Breakdown of accounts
Recording individual transactions
Double-entry bookkeeping
Balances
Statistical errors
 Structure of the Economy
Economy consists of four interconnected sectors:
Real sector (production of goods and non-financial services)
Financial sector (provision of financial services to other sectors)
Government sector (provision of goods and services to individuals and companies)
Foreign sector (exports and imports of goods and services, cross-border flows of capital)
 The Balance of Payments
- Breakdown of Accounts
The Balance of Payments (BoP) accounts definition
Statistical record of all economic transactions taking place between its residents and the rest
of the world

Three types of accounts within BoP:

Current account (CA): record of trade in goods and services and other current transactions
(no trade in assets)
Private capital account (KA): record of assets traded among private entities
Official reserve transactions account (ORT): record of trade in assets when at least on one
side monetary authority (central bank) is involved
 Breakdown of Accounts
- Current Account
Current Account (CA) components:
Merchandise balance: account of trade in goods
Services balance: transportation, tourism and business and professional services
Investment income: interest, dividends, etc.
payment for the capital working abroad (capital itself is recorded under KA)
Unilateral transfers: government grants (foreign aid) and private remittances
They appear under CA, not under KA, because they do not create any obligations in the future
 Breakdown of Accounts
- Private Capital Account
Private Capital Account, i.e. Capital Account (KA) components:
Foreign direct investments (FDI)
When resident of one country acquire control over a business enterprise in another country (e.g.
acquisition of more than 10% of shares within 1 year timeline)otherwise, it is recorded under portfolio
investments
Greenfield vs brownfield
Long-term portfolio investments:
International transactions in financial assets with maturity greater than 1 year (securities, bank loans, etc.)
Short-term capital flows
International transactions in financial assets with maturity of less than 1 year (treasury bills, commercial
papers, certificates of deposits, etc.)
 Breakdown of Accounts
- Official Reserve Transactions
Official Reserve Transactions (ORT) components:
Changes in foreign central banks holdings of domestic assets
Changes in the domestic central banks holdings of foreign assets (gold, IMF credits and SDR,
FX reserves)
 Breakdown of Accounts
Accounts Cumulative balance
CURRENT ACCOUNT (CA)
Merchandise Merchandise balance
Services
- transportation
- tourism
- business and professional services Balance of goods and services
Investment income Balance of goods, services and income
Unilateral transfers
- government grants
- private remittances Current account balance

PRIVATE CAPITAL ACCOUNT (KA)

Direct investment
Portfolio investment
- long term Basic balance
- short term overall Balance of Payment

OFFICIAL RESERVE TRANSACTIONS (ORT)

Change in foreing CB holding of domestic assets
Change in domestic CB holding of foreign assets
- gold
- IMF credit and SDRs
- FX reserves
 Recording Individual Transactions
Key principle: whatever enters the country is recorded as debit (e.g. import), and
whatever leaves the country is recorded as credit (e.g. export)
How do we record in Serbia IT services, provided by Serbian IT company to the US-based electric power
company?

Gifts and other transfers recorded under unilateral transfers

Remittances paid by Serbian migrants living in Austria to their relatives in Serbia: debit in Austria, credit in
Serbia

KA and ORT: acquisition of foreign assets debit (import of assets from abroad)
and vice versa
Direct investment made by Serbian company in B&H (debit in Serbia)
Investment of Scottish bank in Serbias T-bills (credit in Serbia)
When the National Bank of Serbia buys Euro, as a reserve asset (debit in Serbia)
 Double-entry Bookkeeping
Every transaction booked twice - debit and credit, because otherwise the BoP would
imply that someone is giving up something for nothing
Is there such case?

Paying for imports (e.g. import of gas in Serbia from Russia)

Debit: balance of goods, in Serbia
Credit: short-term capital account, in Serbia (regardless if payment is in cash, bank cheque, or loan)

Paying for asset purchases (e.g. German company buys a hotel in Serbia)
Debit: banking flows in Serbia
Credit: direct investment
 The Balances
Net flows usually matters more than gross flows

Positive balance: when credit outweights debit

e.g. positive trade balance the country exports more than it imports -- Merchantilistic semantic

Negative balance: when debit outweights credit

The adding-up constraint:

CA KA ORT 0
CA KA BP

If country is running CA deficit and its ORT=0, than KA = -CA

If KA=0, than ORT=-CA

 The Balances
BP reveals whether the country is spending beyond its means and whether there is net
supply of foreign currency or net demand for domestic currency
If BP is positive, the ORT is negative, i.e. the central bank is adding on its FX reserves
If BP is negative, the ORT is positive, i.e. the central bank is selling FX reserves

Negative Balance of trade in goods and services (deficit) can be financed either by:
investment income and transfers
borrowings and investments (KA) or
reserve loss (ORT)

Negative CA balance (deficit) can be financed either by investments/borrowings (KA) or by

reserve loss (ORT)
CA is autonomous, while KA and ORT are accomodating

Negative BoP (deficit) can be financed by reserve loss (ORT)

BP is autonomous, while ORT is accomodating
 The Balances
Balance of goods and services is the point of connection between the international
payment statistics and national income accounts

Balance of goods and services (X-M) is part of GDP

GDP C I G ( X M )
Balance of goods, services and income
Net exports of goods and services + net investment income

Current account balance

Net exports of goods and services + net investment income + net transfers

BoP National accounts

Balance of goods and services Gross domestic product

Balance of goods, services and income Gross national product

Current account balance Total national income

 Accommodating Transactions?
Traditional view: autonomous transactions (above the line) cause change in
accommodating transaction
CA and KA alter the ORT

Modern view: as the exchange rate is floating (e.g. managed floating FX regime), can the
change in ORT affect the CA?
If a country is running short on reserves, will it reduce its import?
If a country is running large KA surplus, will it be more prone to import?
Case of Yugoslavia in early 1980s
 Statistical Errors
Statistics does not observe directly debit and credit side of the transaction
some transactions are valued incorrectly or one side of transaction is ommitted

Therefore, if debit does not equal credit, the difference between the sum of debit and the
sum of credit is called statistical discrepancy or errors and ommissions
e.g. unmeasured net inflow of money (capital flights going informally)
What should be the World total sum of the current account balances?
EU: CA Statistics
 Problem 1 (pp. 288)

Transaction Debit Credit Effect on Effect on

CA BoP
US imports BMW from Germany; pays
by check
US tourists spend Swiss francs in
Geneva
US investor buys 2-year Canadian
treasury note; pays by check
China buys nuclear reactor from US;
pays in gold (no CB involved)
Dutch holding company buys
controlling interest in an Americal firm;
pays in dollars