International finance

The BOP summarizes international flows of goods, services, and changes in asset ownership between a country and the rest of the world over a specific time.

The BOP is typically recorded monthly, quarterly, or yearly.

1. Current Account: Goods/services, primary income, secondary income.

2. Capital Account: Real estate, patents, and similar asset transactions.

3. Financial Account: Purchases/sales of foreign financial assets like bonds and equity.

It is a central bank-managed account used to maintain liquidity using gold, foreign currency, and IMF SDRs.

Gold, foreign currencies, and Special Drawing Rights (SDRs) from the IMF.

Each transaction has two entries:

• Credit (+): Inflows, such as exports.

• Debit (-): Outflows, such as imports.

Exporting goods to a foreign country results in a credit because it brings foreign currency into the country

A credit signifies foreign currency inflows, such as from foreign purchases of local goods.

A debit signifies foreign currency outflows, such as domestic purchases of foreign goods.

MNCs heavily influence money flows between countries through trade, investments, and financial activities.

To assess changes in international trade patterns and potential exchange rate impacts.

The Current Account tracks:

1. Merchandise and services.

2. Primary income (e.g., dividends, interest).

3. Secondary income (e.g., foreign aid, grants)

It is the difference between a country's total exports and total imports.

A trade deficit occurs when imports exceed exports.

The Capital Account tracks the transfer of financial assets such as real estate, patents, trademarks, and goodwill.

The Financial Account covers investments like direct foreign investment (DFI), portfolio investments, and other capital flows.

DFI refers to payments made to acquire substantial control over foreign businesses or operations, such as building production plants or acquiring stakes in companies.

DFI involves significant control over operations, while portfolio investment typically includes smaller stakes with no management control.

Portfolio investments involve purchasing foreign stocks, bonds, or other securities without obtaining control over the entity.

Portfolio investments are traded in financial markets and can be quickly bought or sold, unlike long-term DFIs.

Examples include short-term loans, trade credits, and currency swaps between countries.

They create short-term financial obligations and increase cross-border capital mobility.

Official reserves are central bank holdings of foreign currencies, gold, and SDRs used to stabilize exchange rates.

They intervene by buying or selling reserves in the forex market to maintain desired currency values.

Economic growth increases demand for imports from other nations, boosting international trade.

1. Economic growth.

2. Labor costs.

3. Inflation rates.

4. National income levels.

5. Government policies.

6. Exchange rate fluctuations.

Countries with lower labor costs attract manufacturing operations, improving their trade balance.

Rising labor costs reduce competitiveness, shifting manufacturing to lower-cost countries.

High inflation raises export prices, reducing global competitiveness, and increases demand for cheaper imports.

Low inflation keeps export prices competitive, boosting international demand for a country’s goods.

Higher income increases demand for imports, which can worsen the trade balance.

Lower income reduces import demand, potentially improving the trade balance.

Governments use tariffs, quotas, subsidies, and restrictions to control imports and exports.

Subsidies lower production costs, making exports more competitive globally.

1. A weaker currency boosts exports by making them cheaper.

2. A stronger currency reduces exports and increases imports due to higher prices.

It improves the trade balance by increasing demand for cheaper exports.

Countries with lower costs of capital attract more foreign investment, while higher interest rates deter investment.

Exchange rate volatility increases uncertainty, discouraging trade and foreign investment.

Tariffs increase the cost of imports, protecting domestic industries but risking retaliation from trading partners.

Quotas set quantitative limits on imports, reducing foreign competition but potentially causing inefficiencies.

Subsidies reduce production costs for domestic industries, boosting exports but potentially distorting fair competition.

Stable governments attract foreign investment and improve trade balances, while instability increases capital flight and reduces investor confidence.

1. DFI: Long-term investment in foreign operations with control (e.g., factories).

2. Portfolio Investment: Short-term, liquid investments like stocks or bonds without control.

The WTO oversees trade agreements, resolves disputes, and promotes fair global competition.

The IMF provides financial assistance and promotes exchange rate stability.

They eliminate trade barriers among member nations, increasing intra-regional trade.

Trade deficits lead to currency depreciation, increasing the cost of imports.

Surpluses strengthen the domestic currency, improving purchasing power for imports and foreign investments.

Capital inflows strengthen the financial account by financing deficits in the current account.

Capital outflows occur due to foreign investments or repayment of foreign debt.

Spot and forward markets allow businesses to manage exchange rate risks and stabilize costs.

Currency hedging protects businesses from exchange rate fluctuations, reducing financial uncertainty.

A system where governments maintain currency value at a specific level relative to another currency or a basket of currencies.

A system where exchange rates are determined by supply and demand in the market.

1. Provides exchange rate stability.

2. Reduces uncertainty in international trade and investments.

1. Leads to exchange rate volatility.

2. Increases uncertainty for businesses and investors.

They use foreign reserves or monetary policies like adjusting interest rates to stabilize currency values.

To stabilize exchange rates, control inflation, and support economic growth.

Loss of investor confidence due to factors like speculative attacks, high inflation, or debt defaults, leading to rapid depreciation.

1. Capital flight.

2. Increased cost of imports.

3. Economic instability.

To finance trade deficits, fund infrastructure projects, or stabilize their economies.

Trade surplus nations lend to deficit nations, creating interconnected economies reliant on stable financial flows.

Higher ratings attract foreign investment, while downgrades increase borrowing costs and reduce investor confidence.

They assess sovereign creditworthiness, impacting a country’s ability to attract foreign capital.

1. Increases efficiency.

2. Fosters competition.

3. Expands global markets.

1. Job losses in uncompetitive sectors.

2. Dependence on foreign markets.

By enabling faster communication, improving logistics, and reducing transaction costs.

They facilitate efficient cross-border transactions and lower costs for businesses.

To stabilize exchange rates during crises and enhance investor confidence.

They reduce financial risks and provide liquidity during economic shocks.

They reduce trade barriers, foster economic cooperation, and increase trade efficiency across member countries.

NAFTA (now USMCA), the European Union (EU), and ASEAN.

They increase exports by reducing trade barriers and removing tariffs, lowering costs for cross-border businesses.

They may cause job losses in sectors that cannot compete internationally

Persistent trade surpluses in some countries (e.g., China) and trade deficits in others (e.g., the U.S.) that lead to economic and policy challenges.

By adjusting trade policies, improving competitiveness, and managing exchange rates.

By adjusting interest rates, buying or selling foreign currencies, and managing reserves.

To regulate the flow of foreign investment and reduce volatility in the foreign exchange market.

It reduces production costs and boosts efficiency by allocating tasks to countries with comparative advantages.

It can lead to job losses in domestic industries and over-reliance on foreign suppliers.

FDIs promote economic growth, create jobs, and improve infrastructure.

Dependence on foreign capital and loss of local control over industries.

The spot market facilitates immediate transactions for currency exchanges.

Forward contracts lock in exchange rates for future transactions, protecting businesses from volatility.

Deficits lead to borrowing or currency depreciation to finance the gap.

Surpluses strengthen the domestic currency but may create dependency on export revenues.

A system where a country fixes its currency value to another currency, such as the U.S. dollar, for stability.

It requires large reserves and is vulnerable to speculative attacks.

Political instability, economic sanctions, and natural disasters.

By diversifying trading partners and maintaining adequate foreign reserves.

Free trade zones, customs unions, and economic unions reduce trade barriers and increase interdependence among nations.

It increases trade efficiency but may create regional dependencies.

They shield domestic industries but may reduce efficiency, provoke retaliation, and increase consumer costs.

Tariffs, quotas, and subsidies.

It has enhanced logistics, manufacturing, and communications, reducing costs and improving efficiency.

They facilitate cross-border transactions and reduce costs for businesses.

The current exchange rate for immediate delivery of currencies.

The agreed-upon rate for exchanging currencies at a future date.

Speculative trading can destabilize exchange rates, especially in smaller economies, leading to volatility.

By intervening in currency markets or using monetary policy tools to stabilize rates.

Persistent deficits drain liquidity and foreign reserves, requiring policy adjustments like devaluation or fiscal reforms.

Currency devaluation, improving competitiveness, and reducing fiscal deficits.

It funds infrastructure, healthcare, and education in developing nations but may create dependency if mismanaged.

n the secondary income account of the Current Account.

Policies like carbon taxes and green technology subsidies aim to reduce environmental impacts while promoting sustainable growth.

They ensure long-term economic growth while protecting natural resources.

Their rapid growth creates new opportunities for exports and investments.

Infrastructure gaps, political risks, and complex regulations.

They increase volatility, creating risks for emerging and smaller economies.

They provide consistent funding for development but require robust governance and policies.