Module II

International flow of funds and International Monetary system:-

International Flow of Funds: Balance of Payments (BoP), Fundamentals of BoP, Accounting

components of BOP, Factors affecting International Trade and capital flows, Agencies that
facilitate International flows. BOP, Equilibrium & Disequilibrium. Trade deficits. Capital
account convertability.( problems on BOP)
International Monetary System: Evolution, Gold Standard, Bretton Woods system, the flexible
exchange rate regime, the current exchange rate arrangements, the Economic and Monetary
Union (EMU).

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International Flow of Funds

International business is facilitated by markets that allow for the flow of funds between
countries. The transactions arising from international business cause money flows from one
country to another. The balance of payments is a measure of international money flows and is
discussed in this chapter.
Financial managers of MNCs monitor the balance of payments so that they can determine
how the flow of international transactions is changing over time. The balance of payments can
indicate the volume of transactions between specific countries and may even signal potential
shifts in specific exchange rates.

BALANCE OF PAYMENTS
The balance of payments is a summary of transactions between domestic and foreign residents
for a specific country over a specified period of time. It represents an accounting of a country’s
international transactions for a period, usually a quarter or a year. It accounts for transactions by
businesses, individuals, and the government.

Fundamentals of BOP

 The balance of payments must balance

Subaccounts may be imbalanced
 Three main elements to the process of measuring international economic activity include:
 Identifying what is and is not an international economic transaction
 Understanding how the flow of goods, services, assets, and money creates debits and
credits to the overall BOP
 Understanding the bookkeeping procedures for BOP accounting
 Defining International Transactions
 Identifying many international transactions is ordinarily not difficult
 However, some international transactions are not obvious
 The BOP as a Flow Statement
 The BOP is often believed to be a balance sheet rather than a cash flow
statement
 There are two types of business transactions that dominate the BOP:
 Real assets
  Financial assets

 BOP Accounting: Double-Entry Bookkeeping

 BOP employs an accounting technique called double-entry bookkeeping
 In this age-old method every transaction produces a debit and a credit of the same
amount
 A debit is created whenever:
 An asset is increased
 A liability is decreased
 An expense is increased

 A credit is created whenever:

 An asset is decreased
 A liability is increased
 An expense is decreased
 BOP Accounting: Double-Entry Bookkeeping
 The measurement of all international transactions in and out of a country over a year
is a difficult task
 Mistakes, errors, and statistical discrepancies will and do occur
 Current and capital account entries are recorded independent of one another, not
together as this accounting method would prescribe
 The following table shows the elements of BOP.

BALANCE OF PAYMENTS ACCOUNT

Receipts (Credits)
Payments (Debits)
1.    Export of goods. Imports of goods.
Trade Account Balance

2.       Export of services. Import of services.

3.       Interest, profit and dividends Interest, profit and dividends paid.
received.
4.    Unilateral receipts.

Current Account Balance (1 to 4)

5.    Foreign investments. Unilateral payments.
Investments abroad.
6.    Short term borrowings.
Short term lending.
7.    Medium and long term borrowing.

Capital Account Balance (5 to 7)

Medium and long term lending.
8.    Errors and omissions. Errors and omissions.
9.    Change in reserves. (+) Change in reserve (-)
 Total Reciepts = Total Payments

Accounting components of BOP

I. Current Account
The main components of the current account are payments for (1) merchandise (goods)
and services, (2) factor income, and (3) transfers.
(1)Payments for Merchandise and Services. Merchandise exports and imports
represent tangible products, such as computers and clothing, that are transported between
countries. Service exports and imports represent tourism and other services, such as legal,
insurance, and consulting services, provided for customers based in other countries. Service
exports by the United States result in an inflow of funds to the United States, while service
imports by the United States result in an outflow of funds.
The difference between total exports and imports is referred to as the balance of trade. A deficit
in the balance of trade means that the value of merchandise and services exported by the United
States is less than the value of merchandise and services imported by the United States2)Factor
Income Payments. A second component of the current account is factor income, which
represents income (interest and dividend payments) received by investors on foreign investments
in financial assets (securities). Thus, factor income received by U.S. investors reflects an inflow
of funds into the United States. Factor income paid by the United States reflects an outflow of
funds from the United States.

(3)Transfer Payments. A third component of the current account is transfer payments, which
represent aid, grants, and gifts from one country to another.

Examples of Payment Entries. Exhibit 2.1 shows several examples of transactions that would be
reflected in the current account. Notice in the exhibit that every transaction that generates a U.S.
cash inflow (exports and income receipts by the United States) represents a credit to the current
account, while every transaction that generates a U.S. cash outflow (imports and income
payments by the United States) represents a debit to the current account. Therefore, a large
current account deficit indicates that the United States is sending more cash abroad to buy goods
and services or to pay income than it is receiving for those same reasons.

Actual Current Account Balance. The U.S. current account balance in the year 2007 is
summarized in Exhibit 2.2. Notice that the exports of merchandise were valued at $1,148 billion,
while imports of merchandise by the United States were valued at $1,967 billion. Total U.S.
exports of merchandise and services and income receipts amounted to $2,463 billion, while total
U.S. imports and income payments amounted to $3,082 billion. The bottom of the exhibit shows
that net transfers (which include grants and gifts provided to other countries) were –$112 billion.
The negative number for net transfers represents a cash outflow from the United States. Overall,
the current account balance was –$731 billion, which is primarily attributed to the excess in U.S.
payments sent for imports beyond the payments received from exports.

Exhibit 2.2 shows that the current account balance (line 10) can be derived as the difference
between total U.S. exports and income receipts (line 4) and the total U.S. imports and income
payments (line 8), with an adjustment for net transfer payments (line 9). This is logical, since the
total U.S. exports and income receipts represent U.S. cash inflows while the total U.S. imports
and income payments and the net transfers represent U.S. cash outflows. The negative current
account balance means that the United States spent more on trade, income, and transfer payments
than it received.

II. Capital and Financial Accounts

The capital account category has been changed to separate it from the financial account, which is
described next. The capital account includes the value of financial assets transferred across
country borders by people who move to a different country. It also includes the value of non
produced nonfinancial assets that are transferred across country borders, such as patents and
trademarks. The sale of patent rights by a U.S. firm to a Canadian firm reflects a credit to the
U.S. balance-of-payments account, while a U.S. purchase of patent rights from a Canadian firm
reflects a debit to the U.S. balance-of-payments account. The capital account items are relatively
minor compared to the financial account items.
The key components of the financial account are payments for
(1) direct foreign investment,
(2) portfolio investment, and
(3) other capital investment.

1.Direct Foreign Investment. Direct foreign investment represents the investment in fixed assets
in foreign countries that can be used to conduct business operations. Examples of direct foreign
investment include a firm’s acquisition of a foreign company, its construction of a new
manufacturing plant, or its expansion of an existing plant in a foreign country.

2.Portfolio Investment. Portfolio investment represents transactions involving long-term

financial assets (such as stocks and bonds) between countries that do not affect the transfer of
control. Thus, a purchase of Heineken (Netherlands) stock by a U.S. investor is classified as
portfolio investment because it represents a purchase of foreign financial assets without changing
control of the company. If a U.S. firm purchased all of Heineken’s stock in an acquisition, this
transaction would result in a transfer of control and therefore would be classified as direct
foreign investment instead of portfolio investment.

3.Other Capital Investment. A third component of the financial account consists of other capital
investment, which represents transactions involving short-term financial assets (such as money
market securities) between countries. In general, direct foreign investment measures the
expansion of firms’ foreign operations, whereas portfolio investment and other capital
investment measure the net flow of funds due to financial asset transactions between individual
or institutional investors.

Errors and Omissions and Reserves. If a country has a negative current account balance, it
should have a positive capital and financial account balance. This implies that while it sends
more money out of the country than it receives from other countries for trade and factor income,
it receives more money from other countries than it spends for capital and financial account
components, such as investments. In fact, the negative balance on the current account should be
offset by a positive balance on the capital and financial account. However, there is not normally
a perfect offsetting effect because measurement errors can occur when attempting to measure the
value of funds transferred into or out of a country. For this reason, the balance-of-payments
account includes a category of errors and omissions.

INTERNATIONAL TRADE FLOWS

Canada, France, Germany, and other European countries rely more heavily on trade than
the United States does. Canada’s trade volume of exports and imports per year is valued
at more than 50 percent of its annual gross domestic product (GDP). The trade volume
of European countries is typically between 30 and 40 percent of their respective GDPs.
The trade volume of the United States and Japan is typically between 10 and 20 percent
of their respective GDPs. Nevertheless, for all countries, the volume of trade has grown
over time. As of 2008, exports represented about 15 percent of U.S. GDP.

FACTORS AFFECTING INTERNATIONAL TRADE FLOWS

Because international trade can significantly affect a country’s economy, it is important
to identify and monitor the factors that influence it. The most influential factors are:
• Inflation
• National income
• Government policies
• Exchange rates

1) Impact of Inflation
If a country’s inflation rate increases relative to the countries with which it trades, its current
account will 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) Impact of 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 consumption of goods. A percentage of that
increase in consumption will most likely reflect an increased demand for foreign goods.

Impact of the Credit Crisis on Trade. The credit crisis weakened the economies (and national
incomes) of many different countries. Consequently, the amount of spending, including spending
for imported products, declined. MNCs cut back on their plans to boost exports as they lowered
their estimates for economic growth in their foreign markets. As they reduced their expansion
plans, they also reduced their demand for imported supplies. Thus, international trade flows were
reduced in response to the credit crisis.
A related reason for the decline in international trade is that some MNCs could not obtain
financing. International trade is commonly facilitated by letters of credit, which are issued by
commercial banks on behalf of importers promising to make payment upon delivery. Exporters
tend to trust that commercial banks would follow through on their obligation even if they did not
trust the importers. However, because many banks experienced financial problems during the
credit crisis, exporters were less willing to accept letters of credit.
 3. Impact of Government Policies
A country’s government can have a major effect on its balance of trade by its policies on
subsidizing exporters, restrictions on imports, or lack of enforcement on piracy.

Subsidies for Exporters. Some governments offer subsidies to their domestic firms so that those
firms can produce products at a lower cost than their global competitors. Thus, the demand for
the exports produced by those firms is higher as a result of subsidies.

Restrictions on Imports. A country’s government can also prevent or discourage imports from
other countries. By imposing such restrictions, the government disrupts trade flows. Among the
most commonly used trade restrictions are tariffs and quotas.
If a country’s government imposes a tax on imported goods (often referred to as a tariff),
the prices of foreign goods to consumers are effectively increased. Tariffs imposed by the U.S.
government are on average lower than those imposed by other governments.
Some industries, however, are more highly protected by tariffs than others. American
apparel products and farm products have historically received more protection against foreign
competition through high tariffs on related imports.
In addition to tariffs, a government can reduce its country’s imports by enforcing a quota,
or a maximum limit that can be imported. Quotas have been commonly applied to a variety of
goods imported by the United States and other countries.

4. Impact of Exchange Rates

Each country’s currency is valued in terms of other currencies through the use of exchange rates.
Currencies can then be exchanged to facilitate international transactions. The values of most
currencies fluctuate over time because of market and government forces . If a country’s currency
begins to rise in value 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 the importing countries. As a consequence, the demand for such goods will
decrease.

Interaction of Factors
While exchange rate movements can have a significant impact on prices paid for U.S. exports or
imports, the effects can be offset by other factors. For example, as a high U.S. inflation rate
reduces the current account, it places downward pressure on the value of the dollar (as discussed
in detail in Chapter 4). Because a weaker dollar can improve the current account, it may partially
offset the impact of inflation on the current account.

EQUILIBRIUM AND DISEQUILIBRIUM IN BOP :-

Balance of payments is the difference between the receipts from and payments to
foreigners by residents of a country. In accounting sense balance of payments, must always
balance. Debits must be equal to credits. So, there will be equilibrium in balance of payments.
Symbolically, B = R - P
Where : - B = Balance of Payments
 R = Receipts from Foreigners
P = Payments made to Foreigners
When B = Zero, there is said to be equilibrium in balance of payments.

When B is positive there is favourable balance of payments; When &. B is negative

there is unfavourable or adverse balance of payments.' When there is a surplus or a deficit in
balance of payments there is said : to be disequilibrium in balance of payments. Thus
disequilibrium refers to imbalance in balance of payments.

   TYPES OF DISEQUILIBRIUM IN BOP

The following are the main types of disequilibrium in the balance of payments:-
1.        Structural Diseguilibrium :-
Structural disequilibrium is caused by structural changes in the economy affecting
demand and supply relations in commodity and factor markets. Some of the structural
disequilibrium are as follows :-
.    A shift in demand due to changes in tastes, fashions, income etc. would
decrease or increase the demand for imported goods thereby causing a
disequilibrium in BOP.
b.    If foreign demand for a country's products declines due to new and cheaper substitutes
abroad, then the country's exports will decline causing a deficit.
c.    Changes in the rate of international capital movements may also cause structural
disequilibrium.
d.    If supply is affected due to crop failure, shortage of raw-materials, strikes, political
instability etc., then there would be deficit in BOP.
e.    A war or natural calamities also result in structural changes which may affect not only goods
but also factors of production causing disequilibrium in BOP.
f.     Institutional changes that take place within and outside the country may result in BOP
disequilibrium. For Eg. if a trading block imposes additional import duties on products imported
in member countries of the block, then the exports of exporting country would be restricted or
reduced. This may worsen the BOP position of exporting country.

2.        Cyclical Disequilibrium :-

Economic activities are subject to business cycles, which normally have four phases
Boom or Prosperity, Recession, Depression and Recovery. During boom period, imports may
increase considerably due to increase in demand for imported goods. During recession and
depression, imports may be reduced due to fall in demand on account of reduced income. During
recession exports may increase due to fall in prices. During boom period, a country may face
deficit in BOP on account of increased imports.
Cyclical disequilibrium in BOP may occur because
 a.  Trade cycles follow different paths and patterns in different countries.
b.  Income elasticities of demand for imports in different countries are not identical.
c.  Price elasticities of demand for imports differ in different countries.

3.        Short - Run Disequilibrium :-

This disequilibrium occurs for a short period of one or two years. Such BOP
disequilibrium is temporary in nature. Short - run disequilibrium arises due to unexpected
contingencies like failure of rains or favourable monsoons, strikes, industrial peace or unrest etc.
Imports may increase exports or exports may increase imports in a year due to these reasons and
causes a temporary disequilibrium exists.
International borrowing or lending for a short - period would cause short - run
disequilibrium in balance of payments of a country. Short term disequilibrium can be corrected
through short - term borrowings. If short - run disequilibrium occurs repeatedly it may pave way
for long - run disequilibrium.
4.        Long - Run I Secular Disequilibrium :-
Long run or fundamental disequilibrium refers to a persistent deficit or a surplus in the
balance of payments of a country. It is also known as secular disequilibrium. The causes of long
- term disequilibrium are
a.  Continuous increase in demand for imports due to increasing population.
b.  Constant price changes - mostly inflation which affects exports on continuous basis.
c.  Decline in demand for exports due to technological improvements in importing countries, and
as such the importing countries depend less on imports.
The long run disequilibrium can be corrected by making constant efforts to increase
exports and to reduce imports.
5.        Monetary Diseguilibrium
Monetary disequilibrium takes place on account of inflation or deflation. Due to
inflation, prices of products in domestic market rises, which makes exports expensive. Such a
situation may affect BOP equilibrium. Inflation also results in increase in money income with
people, which in turn may increase demand for imported goods. As a result imports may turn
BOP position in disequilibrium.
6.        Exchange Rate Fluctuations :-
A high degree of fluctuation in exchange rate may affect the BOP position. For Eg. if
Indian Rupee gets appreciated against dollar, then Indian exporters will receive lower amounts of
foreign exchange, whereas, there will be more outflow of foreign exchange on account of higher
imports. Such a situation will adversely affect BOP position. But, if domestic currency
depreciates against foreign currency, then the BOP position may have positive impact.
CAUSES OF DISEQUILIBRIUM IN BOP
Any disequilibrium in the balance of payment is the result of imbalance between
receipts and payments for imports and exports. Normally, the term disequilibrium is interpreted
from a negative angle and therefore, it implies deficit in BOP.
The disequilibrium in BOP is caused due to various factors. Some of them are

I. Import - Related Causes

The rise in imports has been the most important factor responsible for large BOP
deficits. The causes of rapid expansion of imports are :-
 Population Growth
Population Growth may increase the demand for imported goods such as food items and non
food items, to meet their growing needs. Thus, increase in imports may lead to BOP
disequilibrium.
 Development Programme
Increase in development programmes by developing countries may require import
of capital goods, raw materials and technology. As development is a continuous process, imports
of these items continue for a long time landing the developing countries in BOP deficit.
 Imports Of Essential Items
Countries which do not have enough supply of essential items like Crude oil or
Capital equipments are required to import them. Again due to natural calamities government may
resort to heavy imports, which adversely affect the BOP position.
 Reduction Of Import Duties
When import duties are reduced, imports becomes cheaper as such imports
increases. This increases the deficit in BOP position.
 Inflation
Inflation in domestic markets may increase the demand for imported goods,
provided the imported goods are available at lower prices than in domestic markets.
 Demonstration Effect
An increase in income coupled with awareness of higher living standard of
foreigners, induce people at home to imitate the foreigners. Thus, when people become victims
of demonstration effect, their propensity to import increases.

II. Export Related Causes :-

Even though export earnings have increased but they have not been sufficient enough to
meet the rising imports. Exports may reduce without a corresponding decline in imports.
Following are the causes for decrease in exports
1.             Increase In Population :-
 Goods which were earlier exported may be consumed by rising population. This
reduces the export earnings of the country leading to BOP disequilibrium.
2.             Inflation :-
When there is inflation in domestic market, prices of export goods increases. This
reduces the demand of export goods which in turn results in trade deficit.
3.             Appreciation Of Currency :-
Appreciation of domestic currency against foreign currencies results in lower foreign
exchange to exporters. This demotivates the exporters.
4.             Discovery Of Substitutes :-
With technological development new substitutes have come up. Like plastic for rubber,
synthetic fibre for cotton etc. This may reduce the demand for raw material requirement.
5.             Technological Development :-
Technological Development in importing countries may reduce their imports. This can be
possible when they start manufacturing goods which they were exporting earlier. This will have
an adverse effect on exporting countries.
6.             Protectionist Trade Policy :-
Protectionist trade policy of importing country would encourage domestic producers by
giving them incentives, whereas, the imports would be discouraged by imposing high duties.
This will affect exports.

III. Other Causes :-

1.             Flight of Capital

Due to speculative reasons, countries may lose foreign exchange or gold stocks. Investors
may also withdraw their investments, which in turn puts pressure on foreign exchange reserves.
2.             Globalization
Globalization and the rules of WTO have brought a liberal and open environment in
global trade. It has positive as well as negative effects on imports, exports and investments. Poor
countries are unable to cope up with this new environment. Ultimately they become loser and
their BOP is adversely affected.
3.             Cyclical Transmission
International trade is also affected by Business cycles. Recession or depression in one or
more developed countries may affect the rest of the world. The negative effects of trade cycle
(low income, low demand, etc.) are transmitted from one country to another. For eg. The current
financial crisis in U.S.A. is affecting the rest of the world.
4.             Structural Adjustments
Many countries in recent years are undergoing structural changes. Their economies are
being liberalised. As a result, investment, income and other variables are changing resulting in
changes in exports and imports.
5.             Political factors
The existence of political instability may result in disrupting the productive apparatus of
the country causing a decline in exports and increase in imports. Likewise, payment of war
 expenses may also serious affect disequilibrium in the country’s BOP. Thus political factors may
also produce serious disequilibrium in the country’s BOPs.

MEASURES TO CORRECT DISEQUILIBRIUM IN BOP :-

Any disequilibrium (deficit or surplus) in balance of payments is bad for normal internal
economic operations and international economic relations. A deficit is more harmful for a
country’s economic growth, thus it must be corrected sooner than later. The measures to correct
disequilibrium can be broadly divided into four groups

MEASURES
1.Monetary Policy
2. Fiscal Policy
3.Exchange Rate Policy
4.Non-monetary Policy

1)        Monetary Policy :-

The monetary policy is concerned with money supply and credit in the economy. The
Central Bank may expand or contract the money supply in the economy through appropriate
measures which will affect the prices.
A.            Inflation :-
If in the country there is inflation, the Central Bank through its monetary policy will make
an attempt to reduce inflation. The Central Bank will adopt tight monetary policy. Money supply
will be controlled by increase in Bank Rate, Cash Reserve Ratio, Statutory Ratio etc.
The monetary policy measures may reduce money supply, and encourage people to save
more, which would reduce inflation. If inflation is reduced, the prices of domestic market will
decrease and also that of export goods. In foreign markets there will be more demand for export
goods, which would correct BOP disequilibrium.
B.            Deflation :-
During deflation the Central Bank of the country may adopt easy monetary
policy. It will try to increase money supply and credit in the economy, which would increase
investment. More investment leads to more production. Surplus can be exported, which in turn
may improve BOP position.

2)        Fiscal Policy

Fiscal policy is government's policy on income and expenditure. Government
incurs development and non - development expenditure,. It gets income through taxation and non
- tax sources. Depending upon the situation governments expenditure may be increased or
decreased.
a)         Inflation
During inflation the government may adopt easy fiscal policy. The tax rates for
corporate sector may be reduced, which would encourage more production and distribution
 including exports. Increased exports will bring more foreign exchange there by making the BOP
position favourable.
b)         Deflation
During deflation the government would adopt restrictive fiscal policy.It may
impose additional taxes on consumers or may introduce tax saving schemes. This may reduce the
consumption of citizens, which in turn may enable more export surplus.
To restrict imports the government may also impose additional tariffs or customs duties
which may improve the BOP position.
3)        Exchange Rate Policy
Foreign exchange rate in the market may directly or indirectly be influenced by the
Government.
a)       Devaluation
When foreign exchange problem is faced by the country, the government tries to reduce
imports and .increase exports. This is done through devaluation of domestic currency. Under
devaluation, the- government makes a deliberate effort to reduce the value of home country. If
devaluation is carried out, then the exports will become cheaper and imports costlier. This is turn
will help to reduce imports and increase exports.

b)       Depreciation
Depreciation like devaluation lowers the value of domestic currency or increases the
value of foreign currency. Depreciation of a country's currency takes place in free or competitive
foreign exchange market due to market forces. Depreciation and devaluation have the same
effect on exchange rate. If there is high demand for foreign currency than its supply, it will
appreciate and vice versa. However, in several countries the system of managed flexibility is
followed. If there is more demand for foreign exchange, the central bank will release the foreign
currency in the market from its reserves so as to reduce the appreciation of foreign currency. If
there is less demand for foreign exchange, it will purchase the foreign currency from market so
as to reduce the depreciation of foreign country and appreciation of domestic currency.
Due to devaluation and depreciation of domestic currency, the exports become cheaper
and imports become expensive. This helps to increase exports.

4) Non-Monetary / General Measures :

A deficit country along with monetary measures may adopt the following non-monetary
measures too, which will either restrict imports or promote exports.
1)             Tariffs :-
Tariffs refer to duties on imports to restrict imports. Tariff is a fiscal device which may
be used to correct an adverse balance of payments. The imposition of import duties will raise the
prices of imports. This will lead to a reduction in demand for imports thereby improving the
balance of payments position.
2)             Quotas :-
 Under Quota System, the government may fix and permit the maximum quantity or value
of a commodity to be imported during a given period. By restricting imports through quota
system, the deficit is reduced and the balance of payments position is improved.
3)             Export Promotion :-
The government may introduce a number of export promotion measures to encourage
exporters to export more so as to earn valuable foreign exchange, which in turn would improve
BOP Situation. Some of the incentives are Subsidies, Tax Concessions, Grants, Octroi refund,
Excise exemption, Duty Drawback, Marketing facilities etc.
4)             Import Substitution
Governments, especially, that of the developing countries may encourage import
substitution so as to restrict imports and save valuable foreign exchange. The government may
encourage domestic producers to produce goods which were earlier imported. The domestic
producers may be given several incentives such as Tax holiday, Cash Subsidy, Assistance in
Research & Development, Providing technical assistance, Providing Scarce inputs etc.

  CONCLUSION :-
From the above measures it is clear that more exports with import substitution based on
economic strength of the country are the real effective solutions to correct the disequilibrium in
the balance of payments.