Financial Forces of InternationalBusinessSubmitted by:Rai, Manju KumariShrestha, RuchiThapa Magar, DipeshNepal, Rhishikesh...
Contents of Financial Forces of International Business  1. Financial forces and its impact on international business arena...
1. Financial forces and its impact on international business arenaGenerally speaking, tariffs, inflation, and taxes influe...
2. Foreign ExchangeForeign exchange, or Forex, is the conversion of one countrys currency into that of another. In a freee...
In figure, an increase in the US demand for the pound (rightward shift of the demand curve) causes a risein the exchange r...
In international finance markets, if many investors are selling a particular currency, they are making itmore readily avai...
b. Managed Float SystemsGovernments and central banks often seek to increase or decrease their exchange rates by buying or...
Initially, the equilibrium price of the British pound equals $4, the fixed rate between the pound and thedollar. Now suppo...
waste; Bolivia and Malaya on tin; Italy on objects of art; and Romania on hides and forest products. Theneo-mercantilist r...
To protect domestic producers from dumping by foreign companies or governments. Dumping occurs    when a foreign company c...
Figure 1. Price without the influence of a tariffWhen a tariff or other price-increasing policy is put in place, the effec...
6. Inflation and deflationThe spending power of one dollar is the goods that can be bought with that dollar. The spending ...
Consumers are likely to become much more price sensitive and look for bargains rather than big names.Rapid inflation will ...
Differential Inflation and Fixed Exchange RatesFor whatever underlying reasons, imagine that at least two major trading na...
necessarily. But to understand the significance of this part of the BOP, we should start by looking at the    components o...
It depend on the size of the budget deficit as a % of GDP, for example the US trade deficit has nearlyreached 5% of GDP (0...
External Debts:External debt (or foreign debt) is that part of the total debt in a country that is owed to creditors outsi...
ConclusionTo sum up this reports analysis can be shown in a cycle:                                                 nationa...
Upcoming SlideShare
Loading in …5



Published on

Published in: Business, Economy & Finance
  • Be the first to comment

  • Be the first to like this

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide


  1. 1. Financial Forces of InternationalBusinessSubmitted by:Rai, Manju KumariShrestha, RuchiThapa Magar, DipeshNepal, RhishikeshSubmitted to:Mr. Lhakpa Gelu SherpaFacilitator of IB
  2. 2. Contents of Financial Forces of International Business 1. Financial forces and its impact on international business arena 2. Foreign Exchange 3. Changes of demand and supply of foreign exchange 4. Free floating systems, managed float system and fixed system 5. Taxation and tariffs 6. How tariff is affecting international trade? 7. Inflation and deflation 8. The impact of inflation on international business 9. Balance of payment 10. What is indebtness? 11. Conclusion
  3. 3. 1. Financial forces and its impact on international business arenaGenerally speaking, tariffs, inflation, and taxes influence international business. Currency exchangesincrease and decrease international business equally depending upon the condition of the economy.Considering tariffs: if company XYZ exports motorcycles from its facility in Japan to the United Statesand the US imposes tariffs on them as a direct result of congressional lobbying from domesticmanufacturers, then the companys payments resulting from sales would decrease. This makes profitablebusiness a difficult prospect because the consumer is generally not willing to pay a higher price for theimported motorcycle. As a result, company XYZ must make up the difference by increasing its marketshare or cut production costs in some manner.Considering taxes: a firm selling a product has a cost to produce the product and sells it for a profit. Mostgovernments impose taxes on businesses which effectively decreases the payments realized by the firmresulting from the sale and subsequent profit of its products. For international businesses, this isespecially important as foreign governments will likely levy taxes on sales in their country as will thefirms domestic government when profits are brought home (double taxation in some cases).Moreover, inflation will affect businesses because a currencys value now is usually not the same as itsfuture value. Suppose a firm invests in a foreign project and expects to realize cash flows of $100,000 permonth beginning in two years. This level of cash flows is sufficient for now, but inflation can erode thevalue of the currency such that the value of $100,000 in two years may be only worth the same as $50,000today (a dollar in two years will only buy what $0.50 will buy today). Firms must plan carefully relativeto inflationary forces when planning for fixed levels of cash flows resulting from projects in the future.Furthermore, currency exchanges can either increase or decrease payment balances. When a firmsdomestic currency is strong, exchanging profits made in a foreign country will have the effect ofdecreasing payment balances when they are brought home and vice versa. For example, a firm completesa project in Germany and is paid 1,000,000 Euros for doing so. However, the firms domestic currency(the US dollar) is strong and is worth 2 Euros. As such, the exchange of the currency when the profits arebrought home will yield a $500,000 profit domestically. Contrastingly, if the dollar is weak and 1 Euro isworth $2, the project will yield the company $2,000,000 in profit after the exchange of funds. Becauseexchange rates change daily, profits realized from a lengthy foreign project can be eroded unexpectedly.The company can leave the profits overseas until markets improve, but many countries (including the US)are beginning to tax companies for doing so in an effort to have them bring money home sooner.Finally, the impact of indebtness of a nation also impacts international business. The level of debt thecountry gears from domestic market as well as external debt defines the environment for enhancinginternational business. For example, if US do not start cutting its 14 trillion dollars of national debt it willbe submerged into inflation, recession, and huge deficit of balance of payments ultimately hindering theenvironment for prosperity of business in the nation.
  4. 4. 2. Foreign ExchangeForeign exchange, or Forex, is the conversion of one countrys currency into that of another. In a freeeconomy, a countrys currency is valued according to factors of supply and demand. In other words, acurrencys value can be pegged to another countrys currency, such as the U.S. dollar, or even to a basketof currencies. A countrys currency value also may be fixed by the countrys government. However, mostcountries float their currencies freely against those of other countries, which keep them in constantfluctuation.The value of any particular currency is determined by market forces based on trade, investment, tourism,and geo-political risk. Every time a tourist visits a country, for example, he or she must pay for goods andservices using the currency of the host country. Therefore, a tourist must exchange the currency of his orher home country for the local currency. Currency exchange of this kind is one of the demand factors fora particular currency. Another important factor of demand occurs when a foreign company seeks to dobusiness with a company in a specific country. Usually, the foreign company will have to pay the localcompany in their local currency. At other times, it may be desirable for an investor from one country toinvest in another, and that investment would have to be made in the local currency as well. All of theserequirements produce a need for foreign exchange and are the reasons why foreign exchange markets arehuge.Foreign exchange is handled globally between banks and all transactions fall under the auspice of theBank of International Settlements.The value of a nation’s currency, under a floating exchange rate, is determined by the interaction ofsupply and demand. We will work through some charts and an example to show how these forces work,from a theoretical point of view.3. Changes in Demand and Supply of foreign exchangeFactors affecting Demand and Supply of Exchange rate • Imports and Exports a rise in import will increase the supply of one’s currency consequence, is depreciation of the currency. Vice versa for exports. • Money supply of the currency decrease in money supply of the currency will reduce its supply in the market and shift the supply curve to left giving a rise to the price of the currency. • Increase in foreign cash inflow an increase in foreign inflow of cash will increase the demand for the currency appreciating the price.
  5. 5. In figure, an increase in the US demand for the pound (rightward shift of the demand curve) causes a risein the exchange rate, an appreciation in the pound, and depreciation in the dollar. Conversely, a fall indemand would shift the demand curve left and lead to a falling pound and rising dollar. On the supplyside, an increase in the supply of pounds to the US market (supply curve shifts right) is illustrated inFigure, where a new intersection for supply and demand occurs at a lower exchange rate and anappreciated dollar. A decrease in the supply of pounds shifts the curve leftward, causing the exchange rateto rise and the dollar to depreciate. …………………………………………………………………….When the forces between supply and demand change, the market moves in ways to clear itself through achange in price.
  6. 6. In international finance markets, if many investors are selling a particular currency, they are making itmore readily available and increasing its supply. If there is not an equal amount of buyers, or demand, forthat currency, its price will go down in order to strike a new balance between supply and demand.The direction in which the value of a currency is heading can cause cash to flow into or out of thatcurrency. A currency that is appreciating can cause money to flow into its country’s assets as investorsand Forex traders want to benefit from buying or taking “long” positions on the currency as thecurrency’s price rises.4. Exchange rate systems and international business. a. Free-Floating SystemsIn a free-floating exchange rate system, governments and central banks do not participate in the market offoreign exchange. The relationship between governments and central banks on the one hand and currencymarkets on the other is much the same as the typical relationship between these institutions and stockmarkets. Governments may regulate stock markets to prevent fraud, but stock values themselves are leftto float in the market. The U.S. government, for example, does not intervene in the stock market toinfluence stock prices.The concept of a completely free-floating exchange rate system is a theoretical one. In practice, allgovernments or central banks intervene in currency markets in an effort to influence exchange rates.Some countries, such as the United States, intervene to only a small degree, so that the notion of a free-floating exchange rate system comes close to what actually exists in the United States.A free-floating system has the advantage of being self-regulating. There is no need for governmentintervention if the exchange rate is left to the market. Market forces also restrain large swings in demandor supply. Suppose, for example, that a dramatic shift in world preferences led to a sharply increaseddemand for goods and services produced in Canada. This would increase the demand for Canadiandollars, raise Canada’s exchange rate, and make Canadian goods and services more expensive forforeigners to buy. Some of the impact of the swing in foreign demand would thus be absorbed in a risingexchange rate. In effect, a free-floating exchange rate acts as a buffer to insulate an economy from theimpact of international events.The primary difficulty with free-floating exchange rates lies in their unpredictability. Contracts betweenbuyers and sellers in different countries must not only reckon with possible changes in prices and otherfactors during the lives of those contracts, they must also consider the possibility of exchange ratechanges. An agreement by a U.S. distributor to purchase a certain quantity of Canadian lumber each year,for example, will be affected by the possibility that the exchange rate between the Canadian dollar and theU.S. dollar will change while the contract is in effect. Fluctuating exchange rates make internationaltransactions riskier and thus increase the cost of doing business with other countries.
  7. 7. b. Managed Float SystemsGovernments and central banks often seek to increase or decrease their exchange rates by buying orselling their own currencies. Exchange rates are still free to float, but governments try to influence theirvalues. Government or central bank participation in a floating exchange rate system is called a managedfloat.Countries that have a floating exchange rate system intervene from time to time in the currency market inan effort to raise or lower the price of their own currency. Typically, the purpose of such intervention is toprevent sudden large swings in the value of a nation’s currency. Such intervention is likely to have only asmall impact, if any, on exchange rates. Roughly $1.5 trillion worth of currencies changes hands everyday in the world market; it is difficult for any one agency—even an agency the size of the U.S.government or the Fed—to force significant changes in exchange rates.Still, governments or central banks can sometimes influence their exchange rates. Suppose the price of acountry’s currency is rising very rapidly. The country’s government or central bank might seek to hold offfurther increases in order to prevent a major reduction in net exports. An announcement that a furtherincrease in its exchange rate is unacceptable, followed by sales of that country’s currency by the centralbank in order to bring its exchange rate down, can sometimes convince other participants in the currencymarket that the exchange rate will not raise further. That change in expectations could reduce demand forand increase supply of the currency, thus achieving the goal of holding the exchange rate down. c. Maintaining a Fixed Exchange Rate through Intervention…………………………………………………
  8. 8. Initially, the equilibrium price of the British pound equals $4, the fixed rate between the pound and thedollar. Now suppose an increased supply of British pounds lowers the equilibrium price of the pound to$3. The Bank of England could purchase pounds by selling dollars in order to shift the demand curve forpounds to D2. Alternatively, the Fed could shift the demand curve to D2 by buying pounds.Fixed exchange rate systems offer the advantage of predictable currency values—when they are working.But for fixed exchange rates to work, the countries participating in them must maintain domesticeconomic conditions that will keep equilibrium currency values close to the fixed rates. Sovereign nationsmust be willing to coordinate their monetary and fiscal policies. Achieving that kind of coordinationamong independent countries can be a difficult task.5. Taxation and tariffsAnother area of great financial importance is taxation. When determining where to pursue businessoverseas, taxes can be very cost prohibitive, even when other financial, social and political forces are totheir advantage. Skillfully negotiating a lower tax burden can be the difference in having the ability tooffer a lower product price than ones competitor or not and should therefore be carefully considered.Tariff and Tax in International TradeA tariff or customs duty is a tax levied upon goods as they cross national boundaries, usually by thegovernment of the importing country. The words tariff, duty, and customs are generally usedinterchangeably.Tariffs may be levied either to raise revenue or to protect domestic industries, but a tariff designedprimarily to raise revenue may exercise a strong protective influence and a tariff levied primarily forprotection may yield revenue. Gottfried Haberler in his Theory of International Trade suggested that thebest objective distinction between revenue duties and protective duties (disregarding the motives of thelegislators) is to be found in their discriminatory effects as between domestic and foreign producers.Tariffs may be further classified into three groups—transit duties, export duties, and import duties.Transit DutiesThis type of duty is levied on commodities that originate in one country, cross another, and are consignedto a third. As the name implies, transit duties are levied by the country through which the goods pass.Such duties are no longer important instruments of commercial policy, but, during the mercantilist period(17th and 18th centuries) and even up to the middle of the 19th century in some countries, they played arole in directing trade and controlling certain of its routes.Export DutiesExport duties are no longer used to a great extent, except to tax certain mineral and agricultural products.Several resource-rich countries depend upon export duties for much of their revenue. Export duties werecommon in the past, however, and were significant elements of mercantilist trade policies. Their mainfunction was to safeguard domestic supplies rather than to raise revenue. At the beginning of the 20thcentury only a few countries levied export duties: for example, Spain still levied them on coke and textile
  9. 9. waste; Bolivia and Malaya on tin; Italy on objects of art; and Romania on hides and forest products. Theneo-mercantilist revival in the 1920s and 1930s brought about a limited reappearance of export duties. Inthe United States, export duties were prohibited by the Constitution, mainly because of pressure from theSouth, which wanted no restriction on its freedom to export agricultural products.Export duties may act as a form of protection to domestic industries. As examples, Norwegian andSwedish duties on exports of forest products were levied chiefly to encourage milling, woodworking, andpaper manufacturing at home. Similarly, duties on the export from India of unbanned hides after WorldWar I were levied to stimulate the Indian tanning industry. In a number of cases, however, duties leviedon exports from colonies were designed to protect the industries of the mother country and not those ofthe colony.Import DutiesImport duties are the most important and most common types of custom duties. As noted above, they maybe levied either for revenue or protection or both, but tariffs are not a satisfactory means of raisingrevenue, because they encourage uneconomic domestic production of the dutied item. Even if importsconstitute the bulk of the available revenue base, it is better to tax all consumption, rather than onlyconsumption of imports, in order to avoid uneconomical protection.Import duties are no longer an important source of revenues in developed countries. In the United States,for example, revenues from import duties in 1808 amounted to twice the total of governmentexpenditures, while in 1837 they were less than one-third of such expenditures. Until near the end of the19th century the customs receipts of the U.S. government made up about half of all its receipts. This sharehad fallen to about 6 percent of all receipts before the outbreak of World War II and it has since furtherdecreased.A tariff may be either specific, ad valorem, or compound (i.e., a combination of both). A specific duty is alevy of a given amount of money per unit of the import, such as $1.00 per yard or per pound. An advalorem duty, on the other hand, is calculated as a percentage of the value of the import. Ad valorem ratesfurnish a constant degree of protection at all levels of price (if prices change at the same rate at home andabroad), while the real burden of specific rates varies inversely with changes in the prices of the imports.A specific duty, however, penalizes more severely the lower grades of an imported commodity. Thisdifficulty can be partly avoided by an elaborate and detailed classification of imports on the basis of thestage of finishing, but such a procedure makes for extremely long and complicated tariff schedules.Specific duties are easier to administer than ad valorem rates, for the latter often raise difficultadministrative issues with respect to the valuation of imported articles.How tariff is affecting international trade?It makes foreign products more expensive, which means that consumers have to pay more, which is bad.It also means the inefficient firms in the protected industry get a free ride. That is very bad for theeconomy. It means people will earn less in the country over all, and pay more for foreign goods. It meansless people will have jobs. It means inflation will be higher.Tariffs are implied by the government because; To protect fledgling domestic industries from foreign competition. To protect aging and inefficient domestic industries from foreign competition.
  10. 10. To protect domestic producers from dumping by foreign companies or governments. Dumping occurs when a foreign company charges a price in the domestic market which is "too low". In most instances "too low" is generally understood to be a price which is lower in a foreign market than the price in the domestic market. In other instances "too low" means a price which is below cost, so the producer is losing money.Who Benefits?.....................................................................................................................................The benefits of tariffs are uneven. Because a tariff is a tax, the government will see increased revenue asimports enter the domestic market. Domestic industries also benefit from a reduction in competition, sinceimport prices are artificially inflated. Unfortunately for consumers - both individual consumers andbusinesses - higher import prices mean higher prices for goods. If the price of steel is inflated due totariffs, individual consumers pay more for products using steel, and businesses pay more for steel thatthey use to make goods. In short, tariffs and trade barriers tend to be pro-producer and anti-consumer.The effect of tariffs and trade barriers on businesses, consumers and the government shifts over time. Inthe short run, higher prices for goods can reduce consumption by individual consumers and by businesses.During this time period, businesses will profit and the government will see an increase in revenuefrom duties. In the long term, businesses may see a decline in efficiency due to a lack of competition, andmay also see a reduction in profits due to the emergence of substitutes for their products. For thegovernment, the long-term effect of subsidies is an increase in the demand for public services, sinceincreased prices, especially in foodstuffs, leaves less disposable income. (For related reading, check out InPraise Of Trade Deficits.)How Do Tariffs Affect Prices?...................................................................................................Tariffs increase the prices of imported goods. Because of this, domestic producers are not forced toreduce their prices from increased competition, and domestic consumers are left paying higher prices as aresult. Tariffs also reduce efficiencies by allowing companies that would not exist in a more competitivemarket to remain open……………………………………………………………………………………Figure 1 illustrates the effects of world trade without the presence of a tariff. In the graph, DS meansdomestic supply and DD means domestic demand. The price of goods at home is found at price P, whilethe world price is found at P*. At a lower price, domestic consumers will consume Qw worth of goods,but because the home country can only produce up to Qd, it must import Qw-Qd worth of goods.
  11. 11. Figure 1. Price without the influence of a tariffWhen a tariff or other price-increasing policy is put in place, the effect is to increase prices and limit thevolume of imports. In Figure 2, price increases from the non-tariff P* to P. Because price has increased,more domestic companies are willing to produce the good, so Qd moves right. This also shifts Qw left.The overall effect is a reduction in imports, increased domestic production and higher consumer prices Figure 2. Price under the effects of a tariff
  12. 12. 6. Inflation and deflationThe spending power of one dollar is the goods that can be bought with that dollar. The spending power ofmoney can change overtime. If one dollar buys fewer goods this year than it did last year, then the valueof money has been caused by inflation. Inflation can be defined as an increase in the average price levelof goods and services.If one dollar buys more goods this year than did last year, then the value of money has increased. Thismust have been caused by deflation. Deflation can be defined as a fall in the average price level of goodsand services. The retail price index RPI is used to measure average price changes. An index number canbe used to record average changes in a large number of items.Causes of inflation1. Demand-pull. This means buyers want to buy more than sellers can actually produce; so sellers start toput prices up.2. Cost-push. This means business costs start to rise (eg oil prices rise, or wages start to rise) and sellersneed to put prices up to compensate.3. Monetarist view. This means the government allows too much money to be created. If the supply ofmoney rises, then the price falls just as if the supply of potatoes rises, then the price falls. The price ofmoney here is how many goods and services it will buy. If the price of money falls, then it will buy fewergoods and services i.e. prices of goods and services rise and the value of money falls. This is inflation.The impact of inflation on international businessCost increases can be passed on to consumers more easily if there is a general increase in prices.The real value of debts owed by companies will fall. This means that, because the value of money isfalling, when a debt is repaid it is repaid with money of less value than the original loan. Thus, highlygeared companies see a fall in the real value of their liabilities.Rising prices are also likely to affect assets held by firms, so the value of fixed assets, such as land andbuilding, could rise. This will increase the value of business and, when reflected on the balance sheet,make the company more financially secure.Since stocks are bought in advance and then sold later, there is an increased margin from the effect ofinflation.Therefore, during inflation that are not excessive, business could decide to raise their own prices, borrowmore to invest and ensure that increased asset value appear on their balance sheet. However, high rates ofinflation say 10% and above can be damaging for the businessStaff will become much more concerned about the real value of their incomes. Higher wage demands arelikely and there could be an increase in industrial disputes.
  13. 13. Consumers are likely to become much more price sensitive and look for bargains rather than big names.Rapid inflation will often lead to higher rates of interest. These higher rates could make it very difficultfor highly geared companies to find the cash to make interest payments, despite the fact that the real valueof the debts is declining.Cash flow problems may occur for all businesses as they struggle to find more money to pay the highercosts of materials and other costs.If inflation is higher in one country than in other countries then business will lose its competiveness inoverseas marketBusiness that sells goods on credit will be reluctant to offer extended credit periods the repayments bycreditors will be with money that is losing value rapidly.Consumers may stockpile some items or transfer thei disposable income t commodities that are morelikely to hold or increase value.Business may be forced to cut back spending, cut profit margins to limit their price rises, reduceborrowing to levels at which the interest payments are manageable hindering stimulation of investment,and layoff workers.INFLATION AND INTERNATIONAL TRADEInternational trade and trade policy are difficult enough to understand when price levels remain relativelyconstant. But when rapid or chronic inflation are added, most of us find that whatever grip we have oneconomic principles begins to slip away. This is because general price inflation reflects changes in thelevel and distribution of real income within countries and across national boundaries. Inflation also tendsto change currency exchange rates and international balance of payments accounts. This paper examinesbriefly some of the major ways in which inflation can influence trade among nations. Inflation is asustained increase in the general price level of a national economy measured either at the retail orwholesale level. The annual rate of change in this price level, commonly expressed in index numbers, isthe inflation rate.Constant Inflation RatesFirst imagine a curious world in which all trading nations display rapid but equal inflation rates. Nochanges occur anywhere in relative prices-all conceivable price and cost ratios stay constant over time.Since currency exchange rates are really price relatives, no exchange rates would change in response tothis inflation. Thus, no price induced changes in imports, exports, interest rates, capital flows, or balanceof payments would occur. Such a world would be uninteresting from our point of view unless thisconstant international inflation rate was accompanied by unequal rates of change in real income. Thesecould emerge because of differential rates of growth in real output across international borders. Unequalchanges in real income could induce changes in commodity trade and foreign exchange through demandshifts, but these would not be inflation phenomena as such. Now consider the more relevant caseinvolving differential inflation rates occurring from one trading nation to another.
  14. 14. Differential Inflation and Fixed Exchange RatesFor whatever underlying reasons, imagine that at least two major trading nations display substantiallydifferent internal inflation rates affecting prices of both traded and non-traded goods. If the Rate ofExchange of one nations currency for that of the other is fixed; relative prices across the border would bechanging at a rate equal to the difference between the two inflation rates. For example, if theU.S. inflation rate is 10 percent and the West German rate is 7 percent, then relative prices for U.S. goodswould be rising by 3 percent per year in terms of German currency. Similarly, relative prices for Germangoods in U.S. currency would be falling at 3 percent per year. With fixed exchange rates, the exports ofthe rapidly-inflating nation would tend to dwindle, and their imports would tend to rise.In our example, this adjustment would dampen inflation in the United States and heighten it in Germanyif large balance of payments surpluses and deficits are not allowed to accumulate and if trade isresponsive to price change. This theoretically-tight, international linkage of economic activity and pricelevels is a major advantage seen by supporters of the gold standard and other types of fixed exchangerates. They favor the automatic external discipline on economic activity and inflation which such schemesprovide. With fixed currency exchange rates, inflation is clearly an export commodity. How easily andrapidly inflation can move from nation to nation under fixed exchange rates depends upon the importanceof trade in total economic activity and the degree to which exports and imports respond to internationalprice differences. The more important trade is and the more responsive demand and supply are to pricechanges, the more readily inflation will surge from one country to another.Flexible exchange rateThe next step in this line of reasoning is to consider the trade impacts of flexible exchange rateadjustments occurring in response to inflation. Fully-adjusting currency exchange markets wouldcompletely neutralize the changes in relative prices implied by differential inflation rates. Hence, thepurchasing power parity doctrine with flexible exchange rates teaches that we should expect nosystematic international trade changes to flow from differential inflation rates themselves.However, if a time lag exists in the rate at which exchange values adjust in response to differentialinflation, then the nation with the more rapid inflation will find its exports slipping and its imports rising.Because the value of its currency will not be falling fast enough to maintain equal commodity pricerelatives. So the net impact that price inflation itself has on international trade hinges upon where actualcurrency exchange markets fit between the polar extremes of fixity and full flexibility.The Current Situation For the last 10-15 years, the worlds trading nations have been edging away fromfixed rates toward more flexible, market-determined exchange rates. Governments still intervene heavilyin money markets to influence currency values, and currencies of some nations are still welded together infixed-value blocks.7.CurrentAccountThe balance of the current account tells us if a country has a deficit or a surplus. If there is a deficit, doesthat mean the economy is weak? Does a surplus automatically mean that the economy is strong? Not
  15. 15. necessarily. But to understand the significance of this part of the BOP, we should start by looking at the components of the current account: goods, services, and income and current transfers. 1. Goods - These are movable and physical in nature, and in order for a transaction to be recorded under "goods", a change of ownership from/to a resident (of the local country) to/from a non- resident (in a foreign country) has to take place. Movable goods include general merchandise, goods used for processing other goods, and non-monetary gold. An export is marked as a credit (money coming in) and an import is noted as a debit (money going out). 2. Services - These transactions result from an intangible action such as transportation, business services, tourism, royalties or licensing. If money is being paid for a service it is recorded like an import (a debit), and if money is received it is recorded like an export (credit). 3. Income - Income is money going in (credit) or out (debit) of a country from salaries, portfolio investments (in the form of dividends, for example), direct investments or any other type of investment. Together, goods, services and income provide an economy with fuel to function. This means that items under these categories are actual resources that are transferred to and from a country for economic production. 4. Current Transfers - Current transfers are unilateral transfers with nothing received in return. These include workers remittances, donations, aids and grants, official assistance and pensions. Due to their nature, current transfers are not considered real resources that affect economic production. Why a Current account is considered harmful to the economy1. If a current account deficit is financed through borrowing it is said to be more unsustainable.2. Borrowing is unsustainable in the long term and countries will be burdened with high interest payments. E.g. Russia was unable to pay its foreign debt back in 1998. Other developing countries have experience similar repayment problems Brazil, African c (3rd World debt)3. Foreigners have an increasing claim on UK assets, which they could desire to be returned at any time. E.g. a severe financial crisis in Japan may cause them to repatriate their investments4. Export sector may be better at creating jobs5. A Balance of Payments deficit may cause a loss of confidence However a current account deficit is not necessarily harmful1. Current Account deficit could occur during a period of inward investment (surplus on financial account) E.g. US ran a current account deficit for a long time as it borrowed to invest in its economy. This enabled higher growth and so it was able to pay its debts back and countries had confidence in lending the US money2. Japanese investment has been good for UK economy not only did the economy benefit from increased investment but the Japanese firms also helped bring new working practices in which increased labor productivity.3. With a floating exchange rate a large current account deficit should cause a devaluation which will help reduce the level of the deficit
  16. 16. It depend on the size of the budget deficit as a % of GDP, for example the US trade deficit has nearlyreached 5% of GDP (02/03) at this level it is concerning economistsThe Capital and Financial Accounts ....................................................................................................Along with transactions pertaining to non-financial and non-produced assets, the capital account relates todealings including debt forgiveness, the transfer of goods and financial assets by migrants leaving orentering a country, the transfer of ownership on fixed assets, the transfer of funds received to the sale oracquisition of fixed assets, gift and inheritance taxes, death levies, patents, copyrights, royalties anduninsured damage to fixed assets.Detailed in the financial account are government-owned assets ((i.e., special drawing rights atthe International Monetary Fund (IMF) or foreign reserves)), private sector assets held in other countries,local assets held by foreigners (government and private), foreign direct investment, global monetary flowsrelated to investment in business, real estate, bonds and stocks.Capital that is transferred out of a country for the purpose of investing is recorded as a debit in either ofthese two accounts. This is because money is leaving the economy. But because it is an investment, thereis an implied return. This return - whether a capital gain from portfolio investment (a debit under thefinancial account) or a return made from direct investment (a debit under the capital account) - is recordedas a credit in the current account (this is where income investment is recorded in the BOP). The oppositeis true when a country receives capital: paying a return on a said investment would be noted as a debit inthe current account.8. What is indebtness?Indebtness is the state of a nation being in debt. The national debt of nation can be raised from domesticmarket as well as external debt. at many instances the country issues various securities like treasury stocklike that of Nepal, which is at 9%, bonds etc. this is sold to domestic people and entities which is knownas domestic borrowing. Likewise, this security is also sold to other nations and international entities forraising finance for the country. Many countries also acquire direct loans from other nations like Nepalgetting loan from US. Moreover the nation is indebt from loans acquired from big internationalinstitutions like World Bank or IMF- international monetary fund.Excesses in debt accumulation have been blamed for exacerbating economic problems. For example,prior to the beginning of the Great Depression debt/GDP ratio was very high. Economic agents wereheavily indebted. This excess of debt, equivalent to excessive expectations on future returns, accompaniedasset bubbles on the stock markets. When expectations corrected, deflation and a creditcrunch followed. Deflation effectively made debt more expensive and, as Fisher explained, this reinforceddeflation again, because, in order to reduce their debt level, economic agents reducedtheir consumption and investment. The reduction in demand reduced business activity and caused furtherunemployment. In a more direct sense, more bankruptcies also occurred due both to increased debt costcaused by deflation and the reduced demand.
  17. 17. External Debts:External debt (or foreign debt) is that part of the total debt in a country that is owed to creditors outsidethe country. The debtors can be the government, corporations or private households. The debt includesmoney owed to private commercial banks, other governments, or international financial institutions suchas the International Monetary Fund (IMF) and World Bank. The debts to the developing countries havebeen recognized as one of the major obstacles of sustainable human and economic development.In some of the small countries debts have been properly utilized like in Bhutan and Lesotho debts areused in mega hydro electricity generation projects and therefore the per capita debt are very high. But formany developing countries debt have become obstacles for reason like: 1. Mismanagement 2. Mis-utilization 3. Rampant corruption and embezzlement by the elite 4. Customers siphoning-off by project contractor, international agencies and institutions in the form of overhead, interests, over valuation and other costs.The following are the internal and external reasons for the indebtedness of poor developing and leastdeveloped countries: 1. Mounting world inflationary pressure due to increase in the price of the fuels, commodities and food stuffs. 2. Rising values of easily convertible currencies of developed countries due to their steady economic growth. 3. Low domestic production or income growth rate in developing and poor nations. 4. Chronic and inherited political and socioeconomic constraints and shortcomings.
  18. 18. ConclusionTo sum up this reports analysis can be shown in a cycle: national debt start of rapid money supply recession and inflation worsening of losing business BOP and competitiveness unemploymentIn the above figure all the financial forces implication on the business and economy is shown. First thecycle starts from the national debt, the country acquires debt when it is unable to support its expendituresand revenue cannot sustain its expenses. If a country rises too much of national debt at such instances itbecomes unable to support its obligation, even paying the interest on loan starts becoming troublesome. insuch crisis the nation applies the short term measure and simply print more money and supply to banks soas to honor the debt.Moreover, if there is something of more amounts its value goes down. This is inflation. More moneysupply simply reduces the value of the currency and makes goods expensive. the nations market will getdamped because now the domestic industry experiences the rise in factor cost because of inflation andimports from countries having competitive advantage in terms of cost will take up the domestic marketshare like goods from China, India, Taiwan etc. the countrys goods also loses its competitivenessinternationally as there is rise of the price of its goods.At such instance of losing of competitiveness, the industry that wants to thrive relocates abroad wherethey can find cheap factor of production. The country continues to import to satisfy its domesticconsumption. The domestic industries are losing their competitiveness and have started to close down.The export is in decline. Foreign companies do not want to operate in the nation because of inflation andprospect of recession and instability. Thus, this gives rise to inflation, poor balance of payment,unemployment in the nation because of shutting of businesses consequensing recession.Furthermore, when the country experiences recession it is in much more pressure to increase itsgovernment expenditure. More amount of money is to be spent in welfare payments and the nation will bein huge pressure to pay its debt. This is the instance experienced by Greece. Now the nation will becompelled to acquire more loans from other nations and entities from which it has not loaned before. Thiswill in turn increase the national debt. Thus, if the governments do not intervene and check the situationthen this effect will be trickling and the cycle continues.