INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

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INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

  1. 1. INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT Lecture 3 Balance of Payments and Exchange Rates
  2. 2. A Country’s Balance of Payments <ul><li>An accounting record of the money value of international transactions between one nation and the rest of the world over a specific period of time. </li></ul><ul><li>The record shows the sum of transactions of individuals, businesses, and government agencies located in one nation, against those of all other nations. </li></ul>
  3. 3. Two Important Balance of Payments Measures <ul><li>Current Account: </li></ul><ul><ul><li>Trade in goods and services, investment income earned abroad, and unilateral transfers. </li></ul></ul><ul><ul><li>An important sub category of the current account is the trade balance (exports of goods and services minus imports of goods and services) </li></ul></ul><ul><li>Capital and Financial Account: </li></ul><ul><ul><li>Cross border investments in real estate, foreign direct investment, portfolio investment and bank related fund flows (e.g., bank loans). </li></ul></ul>
  4. 4. BOP Surplus and Deficit Transactions <ul><li>Individual balance of payments (BOP) transactions can be viewed as either a surplus or deficit transaction. </li></ul><ul><li>Basic rule to use in determining whether the transaction is a surplus or deficit BOP transaction is to: </li></ul><ul><ul><li>Follow the flow of money: </li></ul></ul><ul><ul><li>If as a result of the transaction money flows into a country , it is surplus transaction. </li></ul></ul><ul><ul><li>If as a result of the transaction, money flows out of a country , the transaction it is a deficit transaction. </li></ul></ul>
  5. 5. Examples of Surplus and Deficit BOP Transactions <ul><li>United States importing cars from Japan: </li></ul><ul><ul><li>US: Deficit </li></ul></ul><ul><ul><li>Japan: Surplus </li></ul></ul><ul><li>United Kingdom hedge funds investing in US Government securities: </li></ul><ul><ul><li>US: Surplus </li></ul></ul><ul><ul><li>UK: Deficit </li></ul></ul><ul><li>Chinese companies investing in plant and equipment (FDI) in the United States: </li></ul><ul><ul><li>US: Surplus </li></ul></ul><ul><ul><li>China: Deficit </li></ul></ul><ul><li>See Appendix 1 for further detail. </li></ul>
  6. 6. US Balance of Payments, 2006 (Billions of Dollars); Net Figures <ul><li>Current Account Balance: -$856.7 </li></ul><ul><ul><li>Goods and Services: -$765.3 (89.3%) </li></ul></ul><ul><ul><li>Investment Income: -$ 7.3 </li></ul></ul><ul><ul><li>Transfers (workers abroad) -$ 84.1 </li></ul></ul><ul><li>Capital Account Balance: -$ 3.9 </li></ul><ul><li>Financial Account Balance: +$719.1 </li></ul><ul><ul><li>US Owned Assets Abroad: -$1,045.8 </li></ul></ul><ul><ul><ul><li>Stocks -$128.5 </li></ul></ul></ul><ul><ul><ul><li>Bonds -$149.2 </li></ul></ul></ul><ul><ul><ul><li>FDI -$248.9 </li></ul></ul></ul><ul><ul><li>Foreign Owned US Assets: +$1,764.9 </li></ul></ul><ul><ul><ul><li>Stocks +$114.0 </li></ul></ul></ul><ul><ul><ul><li>Corporate Bonds +$406.3 </li></ul></ul></ul><ul><ul><ul><li>FDI +$183.6 </li></ul></ul></ul>
  7. 7. Use of BOP Data by Global Businesses <ul><li>Multinational businesses use BOP measures to assess types of business opportunities by country. </li></ul><ul><ul><li>What is a country buying, i.e., their imports (suggests a potential export market or FDI opportunity). </li></ul></ul><ul><li>Forecasters use BOP measures as an indicator of the potential pressure on a country’s exchange rate. </li></ul><ul><ul><li>Surplus BOP countries are generally associated with strong currencies. </li></ul></ul><ul><ul><li>Deficit BOP countries are generally associated with weak currencies. </li></ul></ul><ul><ul><li>In this regard, BOP measures are one possible indication of the potential risk for a global firm associated with their currency exposures. </li></ul></ul>
  8. 8. Balance of Payments and Exchange Rates <ul><li>The key question for currency markets is how does the relationship between BOP and exchanges rates proceed. </li></ul><ul><li>There are two possible channels: </li></ul><ul><ul><li>1. Changes in the exchange rates will affect, with some lag, balance of payments components. </li></ul></ul><ul><ul><ul><li>For example, a country’s ability to export, or willingness to import, will be affected by changes in the exchange rate. </li></ul></ul></ul><ul><ul><ul><ul><li>See slide on next page. </li></ul></ul></ul></ul><ul><ul><li>2. Changes in a country’s balance of payments position will put pressure on a country exchange rate. </li></ul></ul><ul><ul><ul><li>This was noted in the previous slide and this relationship will be developed through the remainder of this lecture. </li></ul></ul></ul>
  9. 9. Relationship of Exchange Rate to Trade Deficit
  10. 10. Current and Capital/Financial Account and the Exchange Rate <ul><li>We can think of the current account as a summary of a country’s trade position and the capital/financial account a summary of a country’s international capital flows . </li></ul><ul><li>If the two are roughly equal in size (but opposite in sign) then we can note that a country’s capital/financial transactions are financing that country’s current account transactions. </li></ul><ul><li>If this is the case, then there should be no resulting BOP pressures on that country’s exchange rate. </li></ul>
  11. 11. Current and Capital/Financial Account and the Exchange Rate <ul><li>If the current account and capital/financial account are not in rough balance, then we might expect BOP pressures on that country’s exchange rate. </li></ul><ul><ul><li>The typical relationship of these two accounts for the United States since the early 1980s is for the two accounts to roughly cancel each other out. </li></ul></ul><ul><ul><li>Specifically, a surplus in the US capital/financial account has generally financed the deficit in the US current account. </li></ul></ul><ul><ul><ul><li>See slide next page. </li></ul></ul></ul><ul><ul><li>We also see the same pattern for the UK </li></ul></ul>
  12. 12. Current (BCA) and Capital /Financial (BKA) Accounts of the US
  13. 13. Current (BCA) and Capital /Financial (BKA) Accounts of the UK
  14. 14. Current Account and Capital/Financial Accounts not in Balance <ul><li>Whenever these two accounts do not offset one another, BOP exchange rate pressures are likely to exist. </li></ul><ul><ul><li>If both accounts are in surplus, the currency should come under strengthening pressures. </li></ul></ul><ul><ul><ul><li>Japan in 2003 </li></ul></ul></ul><ul><ul><ul><li>China since 2000 </li></ul></ul></ul><ul><ul><li>If both accounts are in deficit, the currency should come under weakening pressures. </li></ul></ul><ul><ul><ul><li>Thailand 1997 </li></ul></ul></ul>
  15. 15. Current (BCA) and Capital/Financial (BKA) Accounts of Japan
  16. 16. Japanese Yen 2003
  17. 17. Balances on the Current (BCA) and Capital (BKA) Accounts of China
  18. 18. Chinese Yuan 2002-2007
  19. 19. Current and Capital /Financial Account Balances for Thailand, 1991-1998
  20. 20. Response of Exchange Rate to 1997 Thailand Current and Capital Account Imbalance.
  21. 21. US Dollar in 2006 <ul><li>Go back to slide 6 and look at the data for the US current account and capital/financial account in 2006. </li></ul><ul><li>What do you see? Are the two roughly in balance and if not, what BOP pressures would you have expected on the US dollar that year? </li></ul><ul><li>Go to one of our foreign exchange web site to see what happened to the dollar in 2006. </li></ul><ul><ul><li>Look at the EUR/USD or GBP/USD rates. </li></ul></ul>
  22. 22. Issue for US and US Dollar: Increasing Current Account Deficits
  23. 23. Who’s Financing the Current Account Deficit?
  24. 24. Sources of Balance of Payments Data <ul><li>The Economist Magazine </li></ul><ul><ul><li>Trade Balance, Current Account Balance and BOP Forecasts for Selected Countries. </li></ul></ul><ul><ul><ul><li>Note: Go to Economic and Financial Indicator Section </li></ul></ul></ul><ul><li>United States Balance of Payments Data: </li></ul><ul><ul><li>http:// bea.gov/International/Index.htm </li></ul></ul><ul><ul><li>http:// bea.gov/bea/di/home/bop.htm </li></ul></ul><ul><ul><li>http:// bea.gov / </li></ul></ul><ul><ul><ul><li>Note: Link to International </li></ul></ul></ul><ul><li>OECD Member Country Balance of Payments Data </li></ul><ul><ul><li>http://www.oecd.org/LongAbstract/0%2C2546%2Cen_2649_33715_2487499_119656_1_1_1%2C00.html </li></ul></ul><ul><li>IMF Balance of Payments Data </li></ul><ul><ul><li>http:// www.imf.org/external/np/sta/bop/bop.htm </li></ul></ul>
  25. 25. Appendix 1: Real and Financial Balance of Payments Transactions
  26. 26. Real and Financial BOP Transactions <ul><li>Cross Border transactions in Real Assets; i.e., purchase or sale of : </li></ul><ul><ul><li>Goods: </li></ul></ul><ul><ul><ul><li>Cars, computers, clothing, agricultural products, industrial products… </li></ul></ul></ul><ul><ul><li>Services: </li></ul></ul><ul><ul><ul><li>Banking, consulting, air travel, student exchange programs, foreign workers. </li></ul></ul></ul><ul><ul><li>Enterprises: </li></ul></ul><ul><ul><ul><li>Cross border acquisitions of companies in other countries. </li></ul></ul></ul><ul><ul><ul><li>Joint ventures with foreign partners. </li></ul></ul></ul><ul><li>Cross Border transactions in Financial Assets; i.e. purchase or sale of: </li></ul><ul><ul><li>Equity </li></ul></ul><ul><ul><ul><li>Common Stock </li></ul></ul></ul><ul><ul><li>Long term Debt </li></ul></ul><ul><ul><ul><li>Bonds </li></ul></ul></ul><ul><ul><ul><ul><li>Private and Government. </li></ul></ul></ul></ul><ul><ul><li>Short term Assets </li></ul></ul><ul><ul><ul><li>Deposits in overseas banks </li></ul></ul></ul><ul><ul><ul><li>Money market instruments </li></ul></ul></ul>
  27. 27. Example of BOP Real Asset Transaction <ul><li>Assume: Japan Airlines purchases aircraft from Boeing (United States manufacturer) </li></ul><ul><ul><li>From U.S. BOP standpoint the transaction is the sale of real assets. </li></ul></ul><ul><ul><ul><li>As a result of Boeing’s aircraft exports, money flows to U.S. </li></ul></ul></ul><ul><ul><ul><ul><li>Thus, this is a surplus BOP transaction. </li></ul></ul></ul></ul><ul><ul><li>From Japan’s BOP standpoint the transaction is the purchase of real assets. </li></ul></ul><ul><ul><ul><li>As a result of Japan Airlines, money flows out of Japan. </li></ul></ul></ul><ul><ul><ul><ul><li>Thus, this is a deficit BOP transaction. </li></ul></ul></ul></ul>
  28. 28. Example of BOP Real Asset Transaction <ul><li>British company acquires a U.S. company . </li></ul><ul><ul><li>From U.S. BOP standpoint the transaction is the sale of a real asset. </li></ul></ul><ul><ul><ul><li>As a result of the sale of the U.S. company, money flows to U.S. (to shareholders) </li></ul></ul></ul><ul><ul><ul><ul><li>Thus, this is a surplus BOP transaction. </li></ul></ul></ul></ul><ul><ul><li>From U.K.’s BOP standpoint the transaction is the purchase of a real asset. </li></ul></ul><ul><ul><ul><li>As a result of the UK’s purchase of the U.S. company, money flows out of the U.K.. </li></ul></ul></ul><ul><ul><ul><ul><li>Thus, this is a deficit BOP transaction. </li></ul></ul></ul></ul><ul><ul><ul><li>Note: this is an example of foreign direct investment (DFI). </li></ul></ul></ul>
  29. 29. Example of BOP Financial Asset Transaction <ul><li>An American mutual fund buys stock listed on the Mexican stock market. </li></ul><ul><ul><li>From U.S. BOP standpoint the transaction is the purchase of financial assets. </li></ul></ul><ul><ul><ul><li>As a result of the purchase of stock, money flows out of the U.S. </li></ul></ul></ul><ul><ul><ul><ul><li>Thus, this is a deficit BOP transaction. </li></ul></ul></ul></ul><ul><ul><li>From Mexico’s BOP standpoint the transaction is the sale of financial assets. </li></ul></ul><ul><ul><ul><li>As a result of Mexico’s sale of stock, money flows into Mexico. </li></ul></ul></ul><ul><ul><ul><ul><li>Thus, this is a surplus BOP transaction. </li></ul></ul></ul></ul><ul><ul><ul><li>Note: this is an example of portfolio investment. </li></ul></ul></ul>

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