Unit 2

Examples of how international trade affects an MNC's Value

1. A U.S. exporter facing a weakening dollar may find cash inflows increasing in the future. 2. A U.S. importer will be hurt (greater cash outflows) if the dollar depreciates in the future 3. A U.S. exporter to Indonesia will likely benefit if inflation in Indonesia is higher than in the U.S. 4. U.S. importers of steel from China would likely benefit from a reduction in U.S. tariffs imposed on steel imports from China.

Current Account covers 3 main areas

1. Balance of Trade 2. Factor Income 3. Unilateral Transfer Payments

2 identities that every BOP statement has to satisfy

1. Balance on Current Account + Balance on Capital Account + Statistical discrepancy = Overall Balance of payments 2. Official Reserve Account = Overall Balance of payments

7 events that increased international trade

1. Berlin Wall comes down 2. Single European Act 3. NAFTA 4. GATT 5. Inception of the Euro 6. Extension of the European Union 7. Other trade agreements

How is China able to run both a current account surplus and a capital account surplus?

1. China exports more than it imports and has a surplus of dollars. 2. China businesses take those dollars to their local banks and exchange them for RMB (Chinese currency) 3. PBOC buys up dollars from local banks by giving the local banks either RMB, RMB-denominated bonds or RMB-denominated deposits. Local banks essentially surrender their dollars. 4. PBOC holds dollar deposits and buys the U.S. debt in the form of U.S. Treasury bonds, Treasury notes, and Treasury bills. 5. Dollars are reinjected back into the U.S. to be spent again.

Most influential factors which affect a country's international trade flows

1. Cost of labor 2. Inflation 3. National income 4. Government policies with respect to international trade a) Tariff b) Quota c) Subsidies for exporters d) Environmental restrictions e) Labor laws 5. Exchange rates

For the U.S. balance of payments

1. Credit entries generate a demand for dollars (supply of foreign currency_ 2. Debit entries generate a supply of dollars (demand for foreign currency)

2 main components of balance of payments accounting

1. Current Accounts 2. Capital Account

3 components of Capital Account

1. Direct foreign investment 2. Portfolio investment 3. Other capital investment

Trade Friction

1. Environmental Restrictions 2. Labor laws 3. Government subsidies for exporters

Various international trade policy issues relevant to Trade Friction

1. Environmental restrictions 2. Labor laws 3. Government subsidies for exporters

2 subcomponents of Growth in International Trade

1. Events that increased international trade 2. Trade friction

Reasons why a weaker home currency may not correct a balance of trade deficit

1. Foreign sellers may lower their prices (counter price) in order to remain competitive and retain market share 2. Dollar may not weaken relative to all currencies. If the dollar weakens relative to the Euro, but not with respect to the RMB, our trade deficit with Europe may improve but will likely worsen relative to China. 3. Many existing international trade arrangements may be prearranged and not able to be immediately adjusted. 4. Intracompany trade usually continues even when the importer's currency weakens. 5. Dollar may be weakening because of high U.S. inflation.

International Capital Flows: Factors affecting Direct Foreign Investment

1. Government restrictions 2. Privatization 3. Potential economic growth (fast growing economies attract direct foreign investment) 4. Tax rates 5. Anticipated exchange rate movements (countries whose local currency is expected to strengthen attract direct foreign investment)

Factors affecting other investment

1. Interest rates 2. Stability of the U.S. economy as well as stock and bond markets

Agencies that facilitate international trade and capital flows

1. International Monetary Fund 2. World Bank 3. World Trade Organization 4. Bank for International Settlements 5. Organization for Economic Cooperation and Development

Demand for certain traded goods may be

1. Price-elastic 2. Price-inelastic

Effects of outsourcing

1. Reduces costs of products and increases international trade. 2. Can reduce jobs in the U.S.

2 lesser components of balance of payments accounting

1. Statistical discrepancy 2. The official reserve account

Subsidies for exporters

1. Tax breaks 2. Low interest loans 3. Providing land to build factories

Factors affecting International Portfolio Investment

1. Tax rates on dividends and interest 2. Interest rates 3. Anticipated exchange rate movements

If the overall balance of payments is negative

1. The U.S. made a net payment to the rest of the world 2. The official reserve account is positive and will show a credit 3. Fed may have sold official reserve assets such as gold, foreign exchange, and SDRs 4. Fed may have borrowed anew from foreign central banks 5. Fed is receiving funds which will be recorded under credits

4 reasons why the balance of payments is worth studying

1. The balance of payments provides information concerning the supply of and demand for a country's currency. (If U.S. imports are greater than U.S. exports, there is an excess supply of dollars and the dollar may depreciate) 2. A country's balance of payments data may signal its potential as a business partner for the rest of the world. (Countries with trade surpluses may have the money to expand imports; countries with trade deficits may not have the means necessary to further expand imports) 3. Balance of payments data can be used to evaluate the performance of a country in international economic competition. (Persistent U.S. trade deficits suggest the U.S. domestic industries lack international competitiveness) 4. Helps evaluate how dependent a country's economy is on its ability to export goods. (The bigger is the export portion of the overall pie, the more sensitive a country's economic growth, GDP, and employment are to factors that affect trade - such as exchange rates.

Everything else equal, the weaker is the value of a currency

1. the more competitive are that country's exports 2. all currencies cannot be weakened simultaneously

How international trade affects an MNC's Value

A MNC's value is directly affected by its cash flows. Any factor that may affect the amount of sales or the cost of its inputs can affect the MNC's value.

Balance of payments

A statistical (accounting) record of a specific country's transactions with the rest of the world over a certain period of time. Presented in the form of double-entry bookkeeping.

Unilateral transfer payments

Aid, grants, gifts, etc. from one country to others

Government policies with respect to international trade

Almost all countries seek to boost their export markets. Doing so increases employment, increases income and stimulates economic growth.

For a country like the U.S.,

Balance on Current Account + Balance on Capital Account = 0 Balance on Current Account - Balance on Capital Account

Interest rates

First level thinking says high interest rates attract foreign investment. Second level thinking asks why the interest rates might be high. Second level thinking knows interest rates may be high because inflation is high. Second level thinking knows high inflation erodes the value of a currency over time.

National income

If a country's income level rises by more than other countries (due to a tax cut or simply higher wages), its current account balance will likely fall. Intuition: consumers have more money to spend and a portion of that extra spending will be to purchase foreign goods.

The official reserve account

Includes transactions undertaken by the central bank (the Federal Reserve in the U.S) to finance the overall balance and intervene in foreign exchange markets

__________ is the single biggest enemy of any currency

Inflation

Direct foreign investment

Investment in fixed assets. Examples: Building factories, acquiring whole companies, purchasing real estate (land, homes, office buildings)

Outsourcing

Process of sub-contracting to a third party in another country to provide supplies, labor, or services that were previously produced internally.

How does the U.S. finance its large current account deficit?

The U.S. current account deficit is completely offset by capital account surpluses. Foreigners with the monies from their trade surpluses buy: 1. U.S. businesses (manufacturing and banking) or real estate: direct foreign investment 2. Stocks or bonds: portfolio investment 3. Place the funds in banks: other investment

J-curve effect

The short-run tendency for a country's balance of trade to deteriorate (decline) even while its currency is deteriorating (weakening).

Exchange rates

The stronger is the value of a country's currency, the more expensive goods exported by that country become to foreign buyers. Demand falls and the country's current account falls. The stronger is the value of a country's currency, goods imported by that country become less expensive to domestic consumers. Demand rises and the country's current account falls.

A current account surplus or deficit must be matched by

a capital account deficit or surplus, and vice versa

A current account surplus or deficit must be matched by

a capital account deficit or surplus, and vice versa.

According to the J-curve theory

a country's trade deficit worsens just after its currency depreciates because price effects will dominate the effect on volume of imports in the short-run.

J-curve theory predicts

a currency devaluation will initially worsen a country's trade deficit but in the long run will improve a nation's trade deficit.

If there were no statistical discrepancy

all transactions would be recorded correctly and the balance of payments identities would be manipulated to show: Balance on Current Account + Balance on Capital Account + Balance on Official Reserve Account = 0

Credits on the balance of payments

associated with cash inflows (exports) and have a positive sign

Debits of the balance of payments

associated with outflows (imports, dividends paid to foreigners) and have a negative sign

If the Fed tries to weaken the dollar, it does so by

buying official reserve assets; dollars are being sold/supplied in order to buy gold or foreign currencies Official Reserve account is negative; overall balance of payments is positive

Credit entries

create a demand for dollars (supply of foreign money)

Debit entries

create a supply of dollars (demand for foreign money)

Inelastic

demand is relatively insensitive to price changes

Elastic

demand is very sensitive to price changes

In free-floating exchange rate regimes

exchange rates should change in such a way that balance of trade deficits will correct themselves over time

Cost of labor

firms in countries where labor costs are relatively low have an advantage when competing globally, especially in labor intensive industries.

Examples of official reserve assets

gold, foreign exchange, foreign currency baskets knows as Special Drawing rights (SDRs)

Tariff

government imposed tax on imported goods

Inflation

if goods become more expensive in the U.S. relative to our trading partners (because of higher relative inflation), one might logically expect U.S. exports to decline and U.S. imports to rise. The U.S. current account should decline (bigger account deficits for the U.S.)

Official Reserve Account

includes transactions initiated by the central bank (Federal Reserve Bank in the U.S.) to accommodate the overall balance and/or intervene in foreign exchange markets.

Other capital investment

investment in currency, bank deposits, money market securities, etc.

Portfolio investment

investment in stocks and bonds that do not transfer control

Quota

maximum limit on imported goods

Statistical discrepancy

omitted or mis-recorded transactions

Statistical discrepancy

represents omitted or misrecorded transactions

If a foreign country's central bank tried to strengthen its home currency, is does so by

selling official reserve assets The bank sells its gold or foreign currency in exchange for its home currency; the home currency is being bought/demanded as payment for the official reserve assets Official Reserve account is positive; overall balance of payments is negative

A weaker currency, everything else equal,

should boost exports and make imports more expensive

Current account

summarizes the flow of funds due to purchases of goods/merchandise or services or the payment of income on financial assets (top of the BOP statement)

Capital account

summarizes the flow of funds resulting from the sale of assets (bottom of the BOP statement)

Trade balance

term that usually pertains to exports and imports of only merchandise/goods

If the overall balance of payments is positive

the Official Reserve account is negative

In countries like the U.S., which maintain a pure flexible exchange rate regime,

the central bank does not intervene much or often in the foreign exchange market.

Balance of trade

the difference between a country's exports of goods and services and its imports of goods and services

Factor income

the difference between the receipts of interest and dividends on foreign investments by U.S. investors and the payment of interest and dividends on U.S. investments to foreigners.

The balance of payments can be formally defined as

the statistical record of a country's transactions over a certain period of time, presented in the form of double-entry accounting

If the U.S. dollar gets stronger

we import more and are not able to export as much