International financial management

1.2.4 Distinguishing Features of International Finance1.3 IFM and Domestic Financial Management 1.3.1 Foreign Direct Investment 1.3.2 Portfolio Investment 1.3.3 Other Non-debt Flows 1.3.

International Financial Management

MBA Second Year (Financial Management)

School of Distance Education

Bharathiar University, Coimbatore - 641 046

Author: Madhu Vij

Copyright © 2008, Bharathiar University

All Rights Reserved

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Page No UNIT I

UNIT II

UNIT III

Lesson 6 Arbitrage and Speculation in Foreign 94

UNIT IV

Lesson 8 Techniques for Covering the Foreign Exchange Risk 161

UNIT V Lesson 9 International Financial Market Instruments 175

CONTENTS

INTERNATIONAL FINANCIAL MANAGEMENT

SYLLABUS UNIT I

IFM- Nature and Scope, IFM and Domestic financial management- Balance of significance- preparation of BOP statement - Link between BOP and the economy

payments-UNIT II

International Monetary System - Gold standard - IMF and World Bank Exchange Ratemechanism - factors influencing exchange rate - Purchasing power parity and InterestRate parity theorems

UNIT III

Foreign Exchange Market - Transactions - Spot, Forward, Futures, Options and Arbitrage and speculation in Foreign exchange market.- Exchange arithmetic, Spread,premium and Discount

Swaps-UNIT IV

Foreign Exchange Exposure - managing transaction, translation and operating Techniques for covering the foreign exchange risk - Internal and external techniques ofrisk

Exposure-UNIT V

International financial market instruments International Equities ADR and GDR Foreign Bond and euro-bond- Short-term and medium term instruments

-UNIT I

1.2.4 Distinguishing Features of International Finance

1.3 IFM and Domestic Financial Management

1.3.1 Foreign Direct Investment

1.3.2 Portfolio Investment

1.3.3 Other Non-debt Flows

1.3.4 Changes in the BOP System of Recording

1.3.5 International Business Methods

1.3.6 Field of International Business

1.3.7 Motivations for International Business

1.0 AIMS AND OBJECTIVES

After studying this lesson, you will be able to:

l Understand the meanings and definitions of International Financial Management

l Have a knowledge of the Nature and Scope of International Financial Management

l Distinguish between the International Financial Management and Domestic FinancialManagement

1.2 NATURE AND SCOPE OF

A Multinational Corporation (MNC) is a company involved in producing and selling goodsand services in more than one country It usually consists of a parent company located inits home country with numerous foreign subsidiaries As business expands, the awareness

of opportunities in foreign markets also increases This, ultimately, evolves into some ofthem becoming MNCs so that they can enjoy the benefits of international businessopportunities

A knowledge of International Finance is crucial for MNCs in two important ways First,

it helps the companies and financial managers to decide how international events willaffect the firm and what steps can be taken to gain from positive developments andinsulate from harmful ones Second, it helps the companies to recognise how the firmwill be affected by movements in exchange rates, interest rates, inflation rates and assetvalues

The consequences of events affecting the stock markets and interest rates of one countryimmediately show up around the world This is due to the integrated and interdependentfinancial environment which exists around the world Also, their have been close linksbetween money and capital markets All this makes it necessary for every MNC andaspiring manager to take a close look at the ever changing and dynamic field ofInternational Finance

1.2.1 Global Links

Globalisation increases the ability of firms to do business across national boundaries.The barriers to crossing those boundaries are coming down gradually What once tookdays now takes hours and what once took hours now takes minutes, or even seconds.All this is opening new opportunities for everyone everywhere; but Globalisation is notreally risk-free

Globalisation is a phenomenon that no development agenda can afford to ignore Nationalgovernments generally face frustrations in dealing with Globalisation and these frustrationsare magnified for small developing countries But such countries stand to gain morefrom international trade and finance than their large counterparts since they face tighterresource and market size constraints

Foreign trade has grown more quickly than the world economy in recent years, a trendthat is likely to continue For developing countries, trade is the primary vehicle for realisingthe benefits of Globalisation Figure 1.1 shows that trade is growing much faster thannational income in developing countries

The past half century has brought unprecedented prosperity and better living standards

to most parts of the world World GNP has risen from $1.3 trillion in 1960 to $29 trillion

in 1997 Between 1987 and 1997, world trade has nearly doubled and the ratio of trade

9 IFM – Nature and Scope

to GDP in purchasing power parity dollars has risen from 20.6 to 29.6 per cent Trade in

services has grown even faster, aided by the revolution in telecommunications and

computers

1.2.2 Objective of the MNCs

An objective is necessary so that all decisions of the organisation contribute towards the

fulfillment of this purpose The usually accepted objective of an MNC is to maximise

shareholders wealth This is the objective which a domestic firm also accepts and tries

to fulfil

Source: World Bank, World Development Indicators, 1999.

Note: Trade is the sum of exports and imports of goods and services.

Figure 1.1: Trade is growing much faster than national income in developing countries

In the context of a MNC, the objective of maximising shareholders’ wealth must be

analysed in a much wider context, with a much wider range of opportunities, taking into

account the worldwide market share This makes the MNCs task much more complex

than that of the domestic firms

If the managers of MNCs are to achieve their objective of maximising the value of their

firms or the rate of return from foreign operations, they have to understand the

environment in which they function The environment consists of:

1 The international financial system consists of two segments: the official part

represented by the accepted code of behaviour by governments comprising the

International Monetary System and the private part which consists of international

banks and other multinational financial institutions that participate in the international

money and capital markets

2 The foreign exchange market consists of international banking, foreign exchange

dealers and 24 hour trading at organised exchanges around the world where

currency future options and derivatives are regularly traded

3 The host country’s environment consists of such aspects as the political and

socio-economic systems and people’s cultural values and aspirations Understanding of

the host country’s environment is crucial for successful operation and assessment

of the political risk

a MNC has to face Another important challenge is the multiplicity and complexity of thetaxation system which has an impact on the MNC’s operations and profitability But themanager can use the taxation tool to reduce the firm’s overall tax burden through transfer

of funds from high to low tax affiliates and by using tax havens

In addition, due to the multiplicity of sources of funds, the finance manager has to worryabout the foreign exchange and political risk in positioning funds and in modifying cashresources The MNC can reduce its cost of capital and, at the same time, maximise thereturn on its excess cash resources by taking advantage of the fact that financial resourceshave been raised from different capital markets

Thus, a well diversified MNC can actually reduce risks and fluctuations in earnings andcash flows by making the diversity in geography and currency work in its favour Asuccessful manager of an MNC will take into account the various challenges of operatinghis firm in a number of countries so that he can make the diversity and complexity of theenvironment work for the total benefit of the firm

1.2.3 Agency Problem

Financial executives in multinational corporations many times have to make decisionsthat conflict with the objective of maximising shareholders wealth It has been observedthat as foreign operations of a firm expand and diversify, managers of these foreignoperations become more concerned with their respective subsidiary and are tempted tomake decisions that maximise the value of their respective subsidiaries These managerstend to operate independently of the MNC parent and view their subsidiary as single,separate units The decisions that these managers take will not necessarily coincide withthe overall objectives of the parent MNC There is less concern, here, for how the entitycan contribute to the overall value of the parent MNC Thus when a conflict of goalsoccurs between the managers and shareholders, it is referred to as the 'Agency Problem'.MNCs use various strategies to prevent this conflict from occurring One simple solutionhere is to reward the financial managers according to their contribution to the MNC as

a whole on a regular basis Still another alternative may be to fire managers who do nottake into account the goal of the parent company or probably give them less compensation/rewards The ultimate aim here is to motivate the financial managers to maximize thevalue of the overall MNC rather than the value of their respective subsidiaries

1.2.4 Distinguishing Features of International Finance

International Finance is a distinct field of study and certain features set it apart fromother fields The important distinguishing features of international finance are discussedbelow:

1 Foreign exchange risk: An understanding of foreign exchange risk is essential

for managers and investors in the modern day environment of unforeseen changes

in foreign exchange rates In a domestic economy this risk is generally ignoredbecause a single national currency serves as the main medium of exchange within

a country When different national currencies are exchanged for each other, there

is a definite risk of volatility in foreign exchange rates The present InternationalMonetary System set up is characterised by a mix of floating and managed exchangerate policies adopted by each nation keeping in view its interests In fact, thisvariability of exchange rates is widely regarded as the most serious internationalfinancial problem facing corporate managers and policy-makers

11 IFM – Nature and Scope

At present, the exchange rates among some major currencies such as the US

dollar, British pound, Japanese yen and the euro fluctuate in a totally unpredictable

manner Exchange rates have fluctuated since the 1970s after the fixed exchange

rates were abandoned Exchange rate variation affect the profitability of firms and

all firms must understand foreign exchange risks in order to anticipate increased

competition from imports or to value increased opportunities for exports

2 Political risk: Another risk that firms may encounter in international finance is

political risk Political risk ranges from the risk of loss (or gain) from unforeseen

government actions or other events of a political character such as acts of terrorism

to outright expropriation of assets held by foreigners MNCs must assess the political

risk not only in countries where it is currently doing business but also where it

expects to establish subsidiaries The extreme form of political risk is when the

sovereign country changes the “rules of the game” and the affected parties have

no alternatives open to them For example, in 1992, Enron Development Corporation,

a subsidiary of a Houston based energy company, signed a contract to build India’s

longest power plant Unfortunately, the project got cancelled in 1995 by the politicians

in Maharashtra who argued that India did not require the power plant The company

had spent nearly $300 million on the project The Enron episode highlights the

problems involved in enforcing contracts in foreign countries Thus, political risk

associated with international operations is generally greater than that associated

with domestic operations and is generally more complicated

3 Expanded opportunity sets: When firms go global, they also tend to benefit from

expanded opportunities which are available now They can raise funds in capital

markets where cost of capital is the lowest In addition, firms can also gain from

greater economies of scale when they operate on a global basis

4 Market imperfections: The final feature of international finance that distinguishes

it from domestic finance is that world markets today are highly imperfect There

are profound differences among nations’ laws, tax systems, business practices and

general cultural environments Imperfections in the world financial markets tend to

restrict the extent to which investors can diversify their portfolio Though there are

risks and costs in coping with these market imperfections, they also offer managers

of international firms abundant opportunities

Thus, the job of the manager of a MNC is both challenging and risky The key to such

management is to make the diversity and complexity of the environment work for the

benefit of the firm

Check Your Progress 1

State whether the following statements are True or False:

1 When firms go global, they also tend to benefit from expanded opportunities

which are available now

2 The features of international financial management that distinguishes it from

domestic finance is that world markets today are highly imperfect

3 Imperfections in the world financial markets tend to restrict the extent to

which the investors can diversify their portfolio

4 The job of the manager of an MNC is neither challenging nor risky

International

Financial Management

1.3 IFM AND DOMESTIC FINANCIAL MANAGEMENT

The volume of international business has exploded in recent years Globalisation is thenew buzzword in industry circles today and is making economies to be more open andadaptable to foreign investment The inflow of foreign investment is very important forthe economic development of a country The inflows from foreign investment can bedivided into two categories:

1 Foreign Direct Investments (FDI) are investments made for the purpose of activelycontrolling property assets or companies located in host countries

2 Foreign Portfolio Investments are purchases of foreign financial assets for a purposeother than control

FDI is one of the most important sources of capital market and links the host economywith the global markets and fosters economic growth The potential of FDI is determined

by seven factors – access to resource, low production costs, access to export markets,cultural-cum-geographic proximity, competitor presence and a host of governmentincentives

The economic benefits of FDI are many from a global perspective FDI is an importantmeans of promoting and encouraging capital to flow where it is most valuable, FDIfacilitates the production of goods and services in locations that have a comparativeadvantage for such production

FDI is also imperative to economic development of a country It generates increasedemployment opportunities and also enhances labour productivity which in turn leads tohigher wage rates, lower inflation rates and an improved overall productivity In fact,attracting foreign capital is one way a national government can improve the living standards

of its people

In addition, FDI also brings with it new technology and management techniques thatpave the way to judiciously utilise the resource and improve the efficiency of the nationaleconomy It also helps in raising the level of competition in the national economy to thebenefit of consumers, providing new or improved quality products at lower prices therebyincreasing productivity Table 1.1 gives the details of the share of top investing countries

in FDI inflows

Table 1.1: Main investing countries

Rank Country Actual Inflows of FDI (US$ million) April

13 IFM – Nature and Scope

Source: Reserve Bank of India

1.3.1 Foreign Direct Investment

In the schema of classification of capital flows based on duration, FDI has been the most

attractive type of capital flows for emerging market economies because of its lasting

nature and also because it is considered a vehicle for transformation of the domestic

production process through bridging the technological gap Concerted efforts towards

attracting FDI through an emphasis on policies of promoting non-debt creating capital

inflows during the reform period did not yield results on the expected lines initially

With reform in policies, better infrastructure and a more vibrant financial sector, FDI

inflows into India accelerated in 2006-07 On a gross basis, FDI inflows into India, after

rising to a level of US$ 6.2 billion in 2001-02, fell to US$ 4.5 billion in 2003-04 After a

recovery, the proportion has risen to reach US$ 23.0 billion in 2006-07 The trend continued

in the current financial year with gross FDI flows at US$ 11.2 billion in the first six

months FDI inflows continued to be preponderantly of the equity variety, broad-based

and spread across a range of economic activities like financial services, manufacturing,

banking services, information technology services and construction

FDI grew appreciably on both gross and net basis While on a gross basis, the growth in

2006-07 was 150.2 per cent, on a net basis it was 179.5 per cent Even as FDI into India

(credit side) grew substantially, a simultaneous pick up in outward investment moderated

the overall net inflows Outward investment by India shot up from levels less than US$

2.4 billion in the period 2003-04 to 2004-05 to reach US$ 14.4 billion in 2006-07 Thus,

overall net FDI in 2006-07 was at US$ 8.5 billion The trend continued in the current

year also with FDI inflows in the period April-September 2007 being moderated by

outward investment of US$ 7.3 billion to yield net flows of US$ 3.9 billion The proportion

of payments to receipts under FDI into India was 0.7 per cent and 0.4 per cent in

2005-06 and 202005-06-07, respectively This indicates the lasting and stable nature of FDI flows in

India

1.3.2 Portfolio Investment

With greater openness in the emerging market economies and developing countries,

portfolio investment flows became net outflows in four out of the last six years ending

2006 According to the WEO, private net portfolio flows to these economies, after being

overall outflows in the period 2001-03, recorded modest levels of positive inflows of US$

21.1 billion and US$ 23.3 billion in 2004 and 2005, respectively The year 2006 witnessed

a great reversal with a massive net outflow of US$ 111.9 billion The reversal in emerging

Asia was the highest with an outflow of US$ 120.8 billion in 2006 There was no such

outflow from India in 2006, though the level of portfolio inflows was lower than in 2005

With heightened volatility in Asian and global financial markets in 2006-07, net portfolio

inflows into India amounted to US$ 7.1 billion for 2006-07 Portfolio net flows after

August-In the schema of classification based on duration, portfolio investment flows fall undershort-term variety The proportion of net portfolio outflows to total portfolio flows underthis head indicates the nature of such flows In the seven-year period from 2000-01, theproportion of net flows to total gross flows (inflows plus outflows) were below 13 percent, with the exception of 2003-04 when it was higher at 25.2 per cent In 2006-07, theproportion was abysmally low at 3.3 per cent (Table 1.3).

Table 1.3: Portfolio net flows as a proportion of total portfolio flows

In US$ million Year

Credit Debit Net Total

(2+3)

In per cent Proportion (4/5)

Source: RBI

An analysis of the monthly data on net FII inflows released by the Securities and ExchangeBoard of India (SEBI) also indicates similar volatility For instance, the standard deviation(a statistical measure of dispersion indicating how widely the values of the data set arespread; a larger standard deviation means greater dispersion) of the net inflows underFII was very high (US$ 2,423.4 million) in the 12 months ending December 2007 Thesame measure for 24 months ending December 2007 yielded a somewhat lower (US$1,882.8 million) dispersion In terms of another statistical measure, namely coefficient ofvariation (indicates the variation in a set of values around its average; a coefficientabove 1 indicates higher variation), the SEBI data yields results of 1.69 and 1.79 for the

12 and 24 months period ending December 2007 Notwithstanding the fact that portfolioinvestment flows have been volatile, there has not been any significant net outflow forthe year as a whole in the post-reform period, except in 1998-99

1.3.3 Other Non-debt Flows

In the BoP system of accounts of the RBI, the head "Other Capital" covers mainly theleads and lags in export receipts (the difference between the custom data and the bankingchannel data), funds held abroad, and the residual item of other capital transactions notincluded elsewhere such as flows arising from cross-border financial derivative andcommodity hedging transactions, migrant transfers, and sale of intangible assets such aspatents, copyrights, trademarks, etc In 2006-07, Other Capital (net) including bankingcapital amounted to US$ 8.8 billion Payments transaction like short-term credits, whichearlier were not captured explicitly elsewhere, were accounted under this residual headimplicitly In its Press Release dated December 29, 2007, reporting BoP developments

15 IFM – Nature and Scope

for the second quarter, the RBI had, among other things, indicated some accounting

changes in this head

As per the RBI's revised data on Other Capital, leads and lags in export payments,

which was negative in 2005-06 and less than a billion US dollars in 2006-07, shot up in

April-September 2007 and reached US$ 3.7 billion In 2007-08, advance received for

effecting FDI (pending with authorized dealers) amounted to US$ 2 billion With other

residual capital of the order of US$ 2.1 billion, total net flows under Other Capital head

was of the order of US$ 6 billion

1.3.4 Changes in the BOP System of Recording

The RBI, in conformity with the best international practices and as per the provisions of

Balance of Payments Manual 5 (BPM5) of the IMF, made certain changes in the system

of recording BoP flows In the earlier system of recording of international transactions

between residents and non-residents, trade credits or credits for financing imports by

Indian residents extended by foreign suppliers up to 180 days were not covered explicitly

and were subsumed under the head 'Other Capital' or errors and omissions However,

such credit beyond 180 days was recorded and reported Usually very short-term credit

less than 180 days get rolled over within a year and as such they are recorded on a net

basis only However, using the internationally accepted methodology as recommended in

BPM5, the RBI started recording these transactions for both BoP and external debt

purposes While in the case of BoP there was no change in the overall balance as other

capital and errors and omissions were lower to the extent that short-term credits were

higher, total stock of outstanding external debt went up (details in the subsequent section

on external debt)

Transactions by non-resident Indians (NRIs) in the Non-Resident Ordinary (NRO) account

were earlier included under 'Other Capital' in the capital account The RBI has put in

place a reporting system and record these data separately As such, transactions under

the NRO account have now been included under NRI deposits Besides, the RBI, taking

cognizance of the importance of the services in invisibles account and the possibility of

some overlap between business services and software services of the ITES variety, had

reviewed the data reported by authorized dealers and revised the business services data

and started providing greater details of the non-software services The methodology of

the revision was detailed in its Press Release dated December 31, 2007

Economic Survey 2007-08: Acceleration in FDI inflows news Dated 28 February

2008 The Economic Survey 2007-08 has said that foreign direct investment (FDI) inflows

into India accelerated in 2006-07, due to reforms in policies, better infrastructure, and a

more vibrant financial sector

On a gross basis, FDI inflows into India after rising to a level of $6.2 billion in 2001-02

have risen to $23.0 billion in 2006-07 The trend continued in the current financial year,

with gross FDI inflows at $11.2 billion in the first six months FDI inflows continued to be

preponderant of the equity variety, broad-based and spread across a range of economic

activities like financial services, manufacturing, banking services, information technology

services and construction

FDI grew by 179.5 per cent on a net basis during 2006-07, while the growth was 150.2

per cent on gross basis Even as FDI into India grew substantially, a simultaneous upswing

in outward investment moderated the over all net inflows

Outward investment by India shot up from levels less than $2.4 billion in the period

2003-04 to 202003-04-05, to reach $14.4 billion in 2006-07 Thus, over all net FDI in 2006-07 was at

$8.5 billion

April-1.3.5 International Business Methods

The rapid growth of international business in the last two decades has been a challengefor the managers Managers of multinational enterprises have to establish their presence

in foreign locations by entering into some form of contract with an independent enterprise,

by creating or acquiring a local enterprise, or by various hybrid combinations There arevarious forms of organisation, but keeping in view the generally accepted format, fivemethods by which firms conduct international business activity can be identified.These are Licensing, Franchising, Joint Ventures, Management Contracts and EstablishingNew Foreign Subsidiaries

l Licensing: A firm in one country licenses the use of some or all of its intellectual

property (patents, trademarks, copyrights, brand names) to a firm of some othercountry in exchange for fees or some royalty payment Licensing enables a firm touse its technology in foreign markets without a substantial investment in foreigncountries

l Franchising: A firm in one country authorising a firm in another country to utilise

its brand names, logos etc in return for royalty payment

l Joint Ventures: A corporate entity or partnership that is jointly owned and operated

by two or more firms is known as a joint venture Joint ventures allow two firms toapply their respective comparative advantage in a given project

l Establishing New Foreign Subsidiaries: A firm can also penetrate foreign markets

by establishing new operations in foreign countries to produce and sell their products.The advantage here is that the working and operation of the firm can be tailoredexactly to the firms needs However, a large amount of investment is required inthis method

l Management Contracts: A firm in one country agrees to operate facilities or

provide other management services to a firm in another country for an agreedupon fee

The above mentioned methods which help multinational enterprises establish their presence

in foreign locations must attempt to answer two basic questions

l Will the expected benefits to be derived from any of these arrangement exceed itscosts?

l If yes, which arrangement will provide the largest net benefit?

The most frequently used method to compare the net benefits from any given arrangement

is to compare a stream of future costs with a stream of future benefits by discountingthem to their present value The adjustment associated with the risk and uncertainty ofthe projection should also be taken into account here

In practice, however, the corporate analyst will realise the problems associated withcalculating some costs and benefits due to some hard to quantify factors that may affectthe decision The relative merits of the different arrangements depends on the answer totwo questions

l What is the size of the difference when one arrangement outweighs another insome element of cost or benefit?

17 IFM – Nature and Scope

l If one arrangement is ranked high in one area and low in another, can some common

measure be applied so that a final decision can be reached by the manager?

The challenge for multinational managers is to find that form of international business

activity that is most consistent with his or her strategy For example, licensing arrangements

generally involve less political risk than ownership arrangements Also the stability

associated with expected income flows is generally higher for licensing arrangements as

they are fixed in amount or are a function of production volumes However, in terms of

flexibility, the licensing agreement generally imposes a heavier cost on the foreign licensor

than do most ownership arrangements For instance, the foreign licensor may be

irrevocably tied during the life of the license to use the licensee as its instrumentality for

serving some given market In some cases of licensing there is often a risk that the

licensee will breach some of the provisions of the agreement, such as provisions that

impose geographical limitation on sales that require quality control or that require the

licensee to purchase intermediate products from the licensor

Firms having long overseas experience are generally found to prefer wholly owned

subsidiaries than joint ventures and any kind of subsidiary over a license This is so

because firms with overseas experience have ready access to the information skills and

capital needed to launch a foreign subsidiary Also, in cases where control is a important

and significant factor in decision-making, a wholly owned subsidiary may be preferred

Hence, from the viewpoint of the multinational firm, the optimum ownership arrangement

may vary over time and also from one foreign affiliate to the other In some cases, the

choice is likely to be determined by the kind of resources already available with the firm

and the kind of strategy the firm is pursuing

Check Your Progress 2

State whether the following statements are True or False:

1 When a firm in one country authorises a firm in another country to utilise its

brand names, logo etc in return for royalty payment, then it is called

franchising

2 A corporate entity or partnership that is jointly owned and operated by two or

more firms is known as a joint venture

3 Joint ventures do not allow two firms to apply their respective comparative

advantage in a given project

4 The most frequently used method to compare the net benefits from any given

arrangement is to compare a stream of future costs with a stream of future

benefits by discounting them to their present value

5 The environment conditions do not affect the means of carrying out business

functions such as finance, marketing, production, etc

1.3.6 Field of International Business

Several developments have encouraged Globalisation of world trade through international

business Global integration of goods and services improves the overall efficiency of

resources and also tends to increase competition forcing firms to be more efficient

Another significant reason for Globalisation of business is the increasing standardisation

of products and services across countries This helps firms to sell their products across

countries To pursue any of its international objectives, a company must establish

international operations that may be different from those used domestically Another

Source: International Business Environments and Operations by John D Daniels and Lee H Radebaugh, Sixth

Edition, p 8, Adison Wesley Publishing Company.

Figure 1.2: Operations and Influences of International Business

1.3.7 Motivations for International Business

There are three primary motivations for firms to pursue international business – to expandsales, to acquire resources and to diversify sources of sales and supplies So the growthpotential becomes much greater for companies that seek out foreign markets

Figure 1.3 illustrates the cost-benefit evaluation for purely domestic firms versus MNCs.

The marginal return on projects for both the MNC and purely domestic firm are shownwith the help of horizontal steps Each horizontal step represents a specific project Thehorizontal steps differ in length since project sizes differ It is also assumed that theseprojects are independent of each other and their expected returns have been adjustedfor the risk factor The marginal return on projects for the MNC is above that of thepurely domestic firm because of the expanded opportunity set of projects available to theMNC

The marginal cost of capital curves for the MNC and purely domestic firm are alsoshown in the diagram The cost of capital shows an increasing trend with asset size forboth the MNC and domestic firm This is based on the assumption that as the firmgrows, the creditors and shareholders demand a higher return for the increased risk theyare now exposed to Once again the MNC is assumed to have an advantage in obtainingfunds at a lower cost than the purely domestic firms This is due to the larger opportunitiesand resources available to it

As shown in the figure, the firm continues to accept projects as long as the marginal cost

of financing the projects is greater than the marginal returns on projects A purely domesticfirm accepts projects up to point A while the MNC continues to accept projects up topoint B The MNC accepts projects up to a higher level due to the cost advantages andopportunities in foreign countries In both the cases, the firm accept projects as long asthe expected benefits from additional projects exceeds the marginal cost of the projects.This comparison helps us to understand why firms expand internationally However, the

l Speed of product changes

l Optimum production size

l Number of customers

l Amount bought by each customer

l Homogeneity of customers

l Local versus international competitors

l Cost of moving products

l Unique capabilities of competitors

19 IFM – Nature and Scope

analysis may change in cases where no feasible foreign opportunities for firms are

available or when foreign projects are riskier than domestic firms resulting in a higher

cost of capital

Figure 1.3: Asset Level of Firm

1.4 LET US SUM UP

Knowledge of international finance is very crucial for MNCs as it helps the companies

and financial managers to decide how international events will affect the firm and the

steps companies can take to be insulated from adverse movements in exchange rates,

interest rates and inflation rates Also an understanding of international finance has become

important as the world has entered an era of unprecedented global economic activity

with worldwide production and distribution

The distinguishing features in international finance which need special focus are – foreign

exchange risk, political risk, expanded opportunity sets and market imperfections The

important aspect here is that MNCs that compete in the global market place must not

only be managed in such a way that they can withstand the effects of crisis in foreign

countries, but must also have the flexibility to capitalise on these crisis

There are five methods by which firms conduct international business activity – licensing,

franchising, joint ventures, management contracts and establishing new foreign subsidiaries

The challenge for multinational managers is to find that form of international business

activity that is most consistent with his or her strategy

The agency problem reflects a conflict of interest between decision making managers

and the owners of the MNC Agency costs occur in an effort to ensure that managers

act in the best interests of the owners Generally, the agency costs are normally larger

for MNCs than for purely domestic firms

1.5 LESSON END ACTIVITY

FDI is an important avenue through which investment takes place Analyse the FDI

trends of Indian firms What conclusions can you draw with respect to the FDI movement

during the last 5 years

Purely domestic

MNC

Purely domestic firm

Appropriate size for purely domestic firm

Appropriate size for MNC

International

Financial Management

1.6 KEYWORDS

Multinational Corporation (MNC): It is a company involved in producing and selling

goods and services in more than one country

International financial system: It consists of two segments: the official part represented

by the accepted code of behaviour by governments comprising the International MonetarySystem and the private part which consists of international banks and other multinationalfinancial institutions that participate in the international money and capital markets

Foreign exchange market: It consists of international banking, foreign exchange dealers

and 24 hour trading at organised exchanges around the world where currency futureoptions and derivatives are regularly traded

Host country’s environment: It consists of such aspects as the political and

socio-economic systems and people’s cultural values and aspirations Understanding of thehost country’s environment is crucial for successful operation and assessment of thepolitical risk

Political risk: Another risk that firms may encounter in international finance is political

risk

Expanded opportunity sets: When firms go global, they also tend to benefit from

expanded opportunities which are available now

Market imperfections: The final feature of international finance that distinguishes it

from domestic finance is that world markets today are highly imperfect

Foreign Direct Investments (FDI): These are investments made for the purpose of

actively controlling property assets or companies located in host countries

Foreign Portfolio Investments: These are purchases of foreign financial assets for a

purpose other than control

Licensing: A firm in one country licenses the use of some or all of its intellectual property

(patents, trademarks, copyrights, brand names) to a firm of some other country in exchangefor fees or some royalty payment

Franchising: A firm in one country authorising a firm in another country to utilise its

brand names, logos etc in return for royalty payment

Establishing New Foreign Subsidiaries: A firm can also penetrate foreign markets by

establishing new operations in foreign countries to produce and sell their products

Management Contracts: A firm in one country agrees to operate facilities or provide

other management services to a firm in another country for an agreed upon fee

1.7 QUESTIONS FOR DISCUSSION

1 What factors cause some firms to become more internationalised than others?

2 Describe the constraints that interfere with the MNC’s objective

3 Briefly describe the motivations for International Business

4 “Because of its broad global environment, a number of disciplines (geography,history, political science, etc.) are useful to help explain the conduct of InternationalBusiness.” Elucidate with examples

5 “The conflict between the MNCs and their environment is real and frequently veryintense.” Discuss

21 IFM – Nature and Scope

6 Briefly discuss the distinguishing features of international finance

7 Explain the possible reasons for growth in international business

Check Your Progress: Model Answers

Madhu Vij, International Financial Management, Excel Books, New Delhi, IInd Edition, 2003.

V Sharan, International Financial Management, 4th Edition, Prentice Hall of India.

Alan C Shapiro, International Financial Management, PHI.

Levi, International Finance, McGraw Hill International Series.

Adrian Buckly, Multinational Finance, PHI.

2.3 Preparation of BOP Statement2.3.1 Current Account2.3.2 Capital Account2.3.3 Official Reserve Account2.3.4 Debit and Credit Entries2.4 Let us Sum up

2.5 Lesson End Activity2.6 Keywords

2.7 Questions for Discussion2.8 Suggested Readings

2.0 AIMS AND OBJECTIVES

After studying this lesson, you will be able to:

l Understand the balance of payments and its significance

l Make preparation of BOP Statement

l Understand link between the BOP and the economy

2.1 INTRODUCTION

A country’s balance of payments affects the value of its currency, its ability to obtaincurrencies of other countries and its policy towards foreign investment The presentlesson first gives an overview of the BOP and then goes on to discuss the variousaccounting rules regarding the recording of all types of international transactions that acountry consummates over a certain period of time The lesson then discusses the threesections in which the BOP statement can be divided – the current account, the capitalaccount and the official reserve account The discussion here is useful for an MNCsince the MNC can be affected by changes in a country’s current account and capitalaccount positions over a period of time Various solved problems are discussed which

23 Balance of Payments

help the students to clearly understand the technique of recording the transactions in a

BOP statement and also help them to prepare a BOP statement An appendix to this

lesson gives the BOP position of India in the 1990s

The Balance of Payments (BOP) is an accounting system that records the economic

transactions between the residents and government of a particular country and the

residents and governments of the rest of the world during a certain period of time,

usually a year Economic transactions include exports and imports of goods and services,

capital inflows and outflows, gifts and other transfer payments and changes in a country’s

international reserves For the governments, the BOP provides valuable information for

the conduct of economic policy For firms and individuals, it provides clues about

expectations relating to such matters as the volume of different types of trade and capital

flows, the movement of exchange rates and the probable course of economic policy

2.2 SIGNIFICANCE OF BOP

In particular, a country’s own balance of payments is important to investors, multinational

companies, business managers, consumers and government officials because it affects

the value of its currency, its policy towards foreign investments and also influences

important macroeconomic variables like gross national product, interest rates, price levels,

employment scenario and exchange rate The monetary and fiscal policy of a country

also takes into account the BOP position of a country

International managers may be interested in a foreign country’s balance of payments for

predicting the country’s overall ability regarding exports, imports, the payment of foreign

debts and dividend remittances A country experiencing a severe balance of payments

deficit is not likely to import as much as it would in a surplus position Persistent and

continuing deficits in a country’s BOP may signal future problems over payments of

dividends and interest fees or other cash disbursements to foreign firms or investors

Also, the balance of payments is an important indicator of the likely pressure on a country’s

foreign exchange rate and the resultant foreign exchange gains or losses which firms

trading with that country are likely to face

The balance of payments of a country summarises all the transactions that have taken

place between its residents and foreigners in a given period, usually a year The word

transactions refers to exports and imports of goods and services; lending and borrowing

of funds; remittances; and government aid and military expenditures The term residents

includes all individuals and business enterprises, including financial institutions, that are

permanently residing within a country’s borders, as well as government agencies at all

levels In other words, the balance of payments reflects the totality of a country’s economic

relations with the rest of the world: its trade in goods, its exchange of services, its purchase

and sale of financial assets; and such important governmental transactions as foreign

aid, military expenditures abroad and the payment of reparation Certain forces determine

the volume of these transactions, how they are brought into balance, what problems

arise when they fail to balance and what policies are available to deal with those problems

2.2.1 Balance of Payments Accounting

Like other accounting statements, the BOP conforms to the principle of double entry

bookkeeping This means that every international transaction should produce debit and

credit entries of equal magnitude It is important to mention here that BOP is neither an

income statement nor a balance sheet It is a source and uses of funds statement that

reflects changes in assets, liabilities and net worth during a specified period of time

Decreases in assets and increases in liabilities or net worth represent credits or sources

of funds Increases in assets and decreases in liabilities or net worth represent debits or

uses of funds In the context of international transactions, sources of funds include exports

However, if expenditure abroad by residents of one nation exceeds what the residents ofthat nation can earn or otherwise receive from abroad, that nation is supposed to have a

“deficit” in its balance of payments If a nation receives from abroad more than it spends,then the nation incurs a “surplus” BOP accounts show the size of any surplus or deficitwhich a nation can have and also indicate the manner in which a deficit was financed orthe proceeds of a surplus invested

2.2.2 Debits and Credits

Since the balance of payments statement is based on the principle of double entrybookkeeping, every credit in the account is balanced by a matching debit and vice versa.The following section now explains, with examples, the BOP accounting principlesregarding debits and credits These principles are logically consistent, though they may

be a little confusing sometimes

A country earns foreign exchange on some transactions and expends foreign exchange

on others when it deals with the rest of the world Credit transactions are those that earnforeign exchange and are recorded in the balance of payments with a plus (+) sign.Selling either real or financial assets or services to nonresidents is a credit transaction.For example, the export of Indian made goods earns foreign exchange for us and is,hence, a credit transaction Borrowing abroad also brings in foreign exchange and isrecorded as a credit An increase in accounts payable due to foreigners by Indianresidents has the same BOP effect as more formal borrowing in the world’s capitalmarket The sale to a foreign resident of a service, such as an airline trip on Air India or

‘hotel booking’ in an Indian hotel, also earns foreign exchange and is a credit transaction.Transactions that expend or use up foreign exchange are recorded as debits and areentered with a minus (-) sign The best example here is of import of goods and servicesfrom foreign countries When Indian residents buy machinery from US or perfumesfrom France, foreign exchange is spent and the import is recorded as a debit Similarly,when Indian residents purchase foreign services, foreign exchange is used and the entry

a Exports of goods or services

b Unilateral transfers (gifts) received from foreigners

c Capital inflows

2 Debit Transactions (-) are those that involve the payment of foreign exchange i.e.,transactions that expend foreign exchange The following are some of the importantdebit transactions:

a Import of goods and services

b Unilateral transfers (or gifts) made to foreigners

c Capital outflows

25 Balance of Payments

Let us now analyse the two terms – capital inflows and capital outflows – in a little more

detail

1 Capital Inflows can take either of the two forms:

a An increase in foreign assets of the nation

b A reduction in the nation’s assets abroad

For Example,

l A US resident purchases an Indian stock When a US resident acquires a

stock in an Indian company, foreign assets in India go up This is a capital

inflow to India because it involves the receipt of a payment from a foreigner

l When an Indian resident sells a foreign stock, Indian assets abroad decrease

This transaction is a capital inflow to India because it involves receipt of a

payment from a foreigner

2 Capital Outflows can also take any of the following forms:

a An increase in the nation’s assets abroad

b A reduction in the foreign assets of the nation

Both the above transactions involve a payment to foreigners and are capital outflows

For Example,

l Purchase of a UK treasury bill by an Indian resident The transaction results in an

increase in the Indian assets abroad and is a debit transaction since it involves a

payment to foreigners

l Sale by a US firm of an Indian subsidiary The transaction reduces foreign assets

in India and is entered as a debit transaction

Check Your Progress 1

State whether the following statements are True or False:

1 A country earns foreign exchange on some transactions and expands foreign

exchange on others when it deals with the rest of the world

2 The balance of payments statements records all types of international

transactions that a country consummates over a period of time

3 Credit transactions are those that earn foreign exchange and are recorded in

the balance of payments with a plus sign

4 Transactions that expand or use up foreign exchange are recorded as debits

and are entered with a minus sign

2.3 PREPARATION OF BOP STATEMENT

The balance of payment statement records all types of international transactions that a

country consummates over a certain period of time

It is divided into three sections:

I Current Account

II Capital Account

III Official Reserve Account

a The balance of merchandise trade refers to the balance between exports and imports

of tangible goods such as automobiles, computers, machinery and so on A favourablebalance of merchandise trade (surplus) occurs when exports are greater in valuethan imports An unfavourable balance of merchandise trade (deficit) occurs whenimports exceed exports Merchandise exports and imports are the largest singlecomponent of total international payments for most countries

b Services represent the second category of the current account Services includeinterest payments, shipping and insurance fees, tourism, dividends and militaryexpenditures These trades in services are sometimes called invisible trade

c Unilateral transfers are gifts and grants by both private parties and governments.Private gifts and grants include personal gifts of all kinds and also relief organisationshipments For example, money sent by immigration workers to their families intheir native country represents private transfer Government transfers include money,goods and services sent as aid to other countries For example, if the United Statesgovernment provides relief to a developing country as part of its drought-reliefprogramme, this would represent a unilateral government transfer

Unlike other accounts in the BOP, unilateral transfers have only one-directional flowwithout offsetting flows For double entry bookkeeping, unilateral transfers are regarded

as an act of buying goodwill from the recipient

A country’s current account deficit must be paid for either by borrowing from foreigners

or by selling off past foreign investment In the absence of the government reservetransaction, a current account surplus equals a capital account deficit and a currentaccount deficit equals a capital account surplus That is, the current account balancemust be equal to the capital account balance but with the opposite sign

The capital account can be divided into three categories: direct investment, portfolioinvestment and other capital flows

a Direct investment occurs when the investor acquires equity such as purchases ofstocks, the acquisition of entire firms, or the establishment of new subsidiaries.Foreign Direct Investment (FDI) generally takes place when firms tend to takeadvantage of various market imperfections Firms also undertake foreign directinvestments when the expected returns from foreign investment exceed the cost

27 Balance of Payments

of capital, allowing for foreign exchange and political risks The expected returns

from foreign profits can be higher than those from domestic projects due to lower

material and labour costs, subsidised financing, investment tax allowances, exclusive

access to local markets, etc For example, many US firms are engaged in direct

investment in foreign countries Coca-Cola has built bottling facilities all over the

world

b Portfolio investments represent sales and purchases of foreign financial assets

such as stocks and bonds that do not involve a transfer of management control A

desire for return, safety and liquidity in investments is the same for international

and domestic portfolio investors International portfolio investments have specifically

boomed in recent years due to investors’ desire to diversify risk globally Investors

generally feel that they can reduce risk more effectively if they diversify their

portfolio holdings internationally rather than purely domestically In addition, investors

may also benefit from higher expected returns from some foreign markets

c Capital flows represent the third category of capital account and represent claims

with a maturity of less than one year Such claims include bank deposits,

short-term loans, short-short-term securities, money market investments and so forth These

investments are quite sensitive to both changes in relative interest rates between

countries and the anticipated change in the exchange rate For example, if the

interest rates rise in India, with other variables remaining constant, India will

experience capital inflows as investors would like to deposit or invest in India to

take advantage of the higher interest rate But if the higher interest rate is

accompanied by an expected depreciation of the Indian rupee, capital inflows to

India may not materialise

Short-term capital flows are of two types: non-liquid term capital and liquid

short-term capital Non-liquid short-short-term capital flows include bank loans and other short-short-term

funds that are very difficult to liquidate quickly without loss Liquid short-term capital

flows represent claims such as demand deposits and short-term securities that are easy

to liquidate with minimum or no loss

Short-term capital accounts change for two specific reasons: compensating adjustments

and autonomous adjustments Compensating adjustments or accommodating adjustments

are short-term capital movements induced by changes due to merchandise trade, services,

unilateral transfers and investments These compensating accounts change so as to

finance other items in the balance of payments Autonomous adjustments are short-term

capital movements due to differences in interest rates and also expected changes in

foreign exchange rate among nations Autonomous changes take place for purely

economic reasons

2.3.3 Official Reserve Account

Official reserves are government owned assets The official reserve account represents

only purchases and sales by the central bank of the country (e.g., the Reserve Bank of

India) The changes in official reserves are necessary to account for the deficit or surplus

in the balance of payments For example, if a country has a BOP deficit, the central bank

will have to either run down its official reserve assets such as gold, foreign exchange

and SDRs or borrow fresh from foreign central banks However, if a country has a BOP

surplus, its central bank will either acquire additional reserve assets from foreigners or

retire some of its foreign debts

Official Reserve Account

9 Foreign official reserve assets 36.40Balance of reserve transactions 41.74

Source: IMF, International Financial Statistics, May 1995.

2.3.4 Debit and Credit Entries

The Balance of Payment of a country is classified into three well-defined categories –the Current Account, the Capital Account and the Official Reserve Account

The Current account measures the net balance resulting from merchandise trade, service

trade, investment income and unilateral transfers and reflects the country’s currentcompetitiveness in international markets The rules for recording a transaction as debitand credit in the current account are:

Debit (Outflow) Credit (Inflow)

29 Balance of Payments

The Capital account in the BOP records the capital transactions – purchases and sales

of assets between residents of one country and those of other countries Capital account

transactions can be divided into two categories Foreign direct investment and portfolio

investment Portfolio investments are of two types – short-term and long-term

Short-term portfolio investments are financial instruments with maturities of one year

or less e.g., time deposits, certificate of deposit held by residents of a country in foreign

banks or by foreigners in domestic banks, commercial paper etc

Long-term portfolio investments are stocks, bonds and other financial instruments issued

by private and public organisations that have maturities greater than one year and are

held for purposes other than control The rules for doubly entry recording here are as

Making a payment to a foreigner

Selling a domestic short-term asset to a foreigner

Selling a short-term foreign asset acquired previously

Portfolio

(long-term)

Buying a long-term foreign asset (not for purpose of control)

Buying back a long-term domestic asset from its foreign owner (not for purpose of control)

Selling a domestic long-term asset to a foreigner (not for purpose of control) Selling a long-term foreign asset acquired previously (not for purposes of control)

Foreign direct investment Buying a foreign asset for

purpose of control Buying back from its foreign owner a domestic asset previously acquired for purposes of control

Selling a long-term foreign asset acquired previously (not for purposes of control) Selling a foreign asset previously acquired for purposes of control

Illustration 1

The following transactions can help us to understand the effect that they have on the

balance of payments:

i Merchandise Trade: An Indian company sells Rs 4,00,000 worth of machinery to

a US company The US company pays for the machinery in 30 days In this

transaction, merchandise exports are credited because they provide India with an

increase in its claims on foreigners At the same time, the Indian exporter should

increase its short-term investment abroad, i.e., an increase in its account receivable

This short-term investment represents a use of funds or a debit entry

Liquid short-term capital (debit) Rs 4,00,000

ii Services: Services represent non-merchandise transactions such as tourist

expenditures Consider an Indian woman who visits her husband in UK She cashes

Rs 3,00,000 worth of her Indian traveller’s cheques at a UK hotel Before she

returns to India, she spends Rs 3,00,000 in UK In this case, India received travel

services from UK in the amount of Rs 3,00,000 In return for these tourist services,

UK banks now have Rs 3,00,000 worth of rupees The services provided by UK

are clearly a use of funds The resulting increases in deposits of UK banks in

residents or gifts by the domestic government to foreign governments Assumethat the US Red Cross sends $10,000 worth of flood relief goods to India The term

“transfer” reflects the nature of the transaction: the United States receives nothing

in return Because the US sends its goods to India, this transaction reduces the realassets of the United States Thus, these transfers should be debited The sale orunilateral transfer of products by the United States represents exports and theseexports are credited The flood relief shipments appear in the US balance of payments

as followsTransfer payments $10,000 (debit)

iv Long-term Capital: This account shows inflow and outflow of capital commitments

whose maturity is longer than one year It covers investments in financial assetswithout significant control of the real assets The account also covers investments

in real assets or financial assets with significant control of real assets Assume that

a Japanese purchases yen 60,000 worth of UK bonds and pays for it with a chequedrawn on an account The Japanese now owns a UK bond, while UK ownsJapanese yen deposits Since the acquisition of the UK bond increases Japan’sportfolio of bank investments in foreign countries, the portfolio investments must

be debited At the same time, the yen balance owned by UK, represents an increase

in Japanese liabilities to foreigners Hence, Japan’s short-term capital should becredited This transaction will appear in Japan’s balance of payments as followsPortfolio investments yen 60,000 (debit)

Liquid short-term capital yen 60,000 (credit)

v Non-liquid Short-term Capital: Non-liquid short-term liabilities are flows of funds

that are not normally resold Bank loans represent non-liquid short-term liabilities.Suppose that a US bank lends $30,000 to a Canadian firm Since this loan reduces

US purchasing power, the US non-liquid short-term liabilities must be debited Atthe same time, the bank creates or increases a deposit balance for the foreign firmthrough its loan Because this loan increases US short-term liabilities to foreigners,the liquid short-term liabilities should be credited In the US balance of payments,this transaction will appear as follows

Non-liquid short-term capital $30,000 (debit)Liquid short-term capital $30,000 (credit)

Illustration 2

i An Indian firm exports Rs 80,000 worth of goods to be paid in three months

Debit CreditShort-term capital outflow Rs 80,000

31 Balance of Payments

ii An Indian resident visits UK and spends Rs 1,00,000 on hotel and meals and so on

Debit CreditTravel services Rs 1,00,000

Short-term capital inflow Rs 1,00,000

Travel services are debited for Rs 1,00,000 because the transaction here is similar

to an Indian import The payment itself is then entered as a short-term credit because

it represents an increase in foreign assets in India

iii An Indian resident purchases foreign stock for Rs 50,000 and pays for it by increasing

the foreign bank balances in India

Debit CreditLong-term capital outflow Rs 50,000

Short-term capital inflow Rs 50,000

Purchase of foreign stock increases Indian assets abroad and thus long-term capital

outflow is debited Short-term capital inflow is credited because the increase in

foreign bank balance in India represents an increase in foreign assets in India

iv A foreign investor purchases Rs 70,000 worth of Indian treasury bills and pays by

drawing down his bank balance in India by an equal amount

Debit CreditShort-term capital outflow Rs 70,000

Short-term capital inflow Rs 70,000

Short-term capital outflow is debited because it represents a reduction in foreign

bank balances in India while short-term capital inflow is credited since it represents

a purchase of Indian treasury bills by a foreigner

v US government gives a US bank balance of $10,000 to the government of a

developing nation as part of the US aid programme

Debit CreditUnilateral transfers $10,000

Short-term capital inflow $10,000

Unilateral transfers are debited since extending aid involves a US payment to foreigners

Short-term capital inflow is credited because it represents an increase in foreign claims

of foreign assets in the US

Illustration 3

Record the following transactions and prepare the balance of payments statement:

a A US firm exports $1,000 worth of goods to be paid in six months

b A US resident visits London and spends $400 on hotel, meals and so on

c US government gives a US bank balance of $200 to the government of a developing

nation as part of the US aid programme

d A US resident purchases foreign stock for $800 and pays for it by increasing the

foreign bank balances in the US

e A foreign investor purchases $600 of United States treasury bills and pays by

drawing down his bank balances in the United States by an equal amount

b Travel services purchased from foreigners 400

(The reduction in foreign bank balances in

Short-term capital inflow(The purchase of US treasury bills by a foreigner)

If we assume that these five transactions are all the international transactions of UnitedStates during the year, the US balance of payments is as follows

Debit (-) Credit (+) (in $) (in $)

Illustration 4

Comprehensive Exercises on Balance of Payments Accounting

Given below is a series of transactions between country A and country B (the rest of theworld) Assume the point of view of country A and that A’s currency is dollars ($) Dothe following:

1 Indicate the accounts to be debited and credited in each transaction

2 Enter these transactions in the appropriate “T accounts”

3 Prepare the balance of payments for country A Assume that all the short-termcapital movements are of a compensating nature

Transactions

1 a A exports goods to B for $1,000 B’s importers sign a bill of exchange for

the goods they imported from A

b A’s exporters discount the bill of exchange with their bank which, in turn,keeps the bill until maturity (Assume 10% discount)

c On the bill’s maturity, A’s bank receives payment for the bill in B’s currency(as it was originally drawn) A’s bank deposits B’s currency in B’s bank.The interest accrued on the bill is $50

33 Balance of Payments

2 A imports goods from B for $800 and A’s importers pay B’s exporters for the $800

with a loan in B’s currency which they get from A’s bank

3 A resident of country A, Mr X goes on vacation to country B He spends all the

money he had with him, $5,000, for services received while on his vacation in

country B

4 Mr X is lucky, however, because on the last day of his vacation he finds in the

street a purse with $100 in B’s currency He brings the money home and declares

his finding to custom authorities

5 Another resident of A who has migrated from B to A few years ago decides to

send $100 to his family His father uses this money to buy a bond from another

citizen of A

6 A businessman of A, Mr Y decides to build a subsidiary plant in B Therefore, he

ships to B all necessary materials for this purpose, which cost $50,000

7 Mr Y very soon finds out that he needs another $20,000 for the completion of the

plant Thus, he issues bonds on the parent company for this amount and sells them

to the citizens of B

8 Mr Y makes $10,000 profit during the first year of operation which Mr Y uses to

enlarge his business in B A’s citizens are very impressed by the successful operation

of Mr Y’s plant in B Therefore, A’s citizens buy from B’s citizens half of the bonds

issued by Mr Y

9 A resident of B, Mr Z, migrates to A His only property is $1,000 in B’s currency,

which he carries with him to A and his house in B which he rents to a friend for

$100 a month The house is worth $8,000 No rent payment, however, has been

received

10 Mr Z decides to sell his house to his friend for $8,000 The payment is arranged as

follows: $4,000 in cash and $4,000 in five years Mr Z deposits this money with his

old bank in B (Everything here is in terms of B’s currency)

11 Mr Z, however, thinks he should give back to the church of his village $1,000

Therefore, $1,000 is transferred from Mr Z’s account in B’s bank to the account of

the church

12 B is a producer of gold During the period of time for which the balance of payments

is completed, B produces $1 million worth of gold Half of this is consumed at

home However, 20% is sold to A’s central bank and 10% is exported to A for

industrial use For the amount of gold exported to A, B accepts a deposit with the

central bank of country A

13 A citizen of A, Mr M, who migrated there from B a long time ago, finds out that he

has inherited the property of his uncle The property consists of a farm worth

$2,000 and a deposit of $1,000 in B’s bank

14 Mr M keeps the money with B’s bank but he buys a designers dress of $200 which

he sends to his sister in B as a gift The dress is purchased in A with A’s currency

15 Finally, Mr M sells the farm for $2,000 He uses the proceeds and his deposit in B’s

bank to buy bonds issued by B’s government

16 Mr M makes a gift to his brother in B This gift consists of a watch which costs

$500 and a cheque for $100 The watch is purchased in country A with A’s currency

International

Financial Management

Solution

1 a As country A has exported goods worth $1000, we have to credit exports by

$1000 Short-term claims on foreigners is debited by $1000 simultaneously Theentries are

Debit CreditShort-term claim on foreigners $1,000

b As this is an agreement between the exporter and his own local bank, there is

no effect on the balance of payments

c This transaction represents the substitution of one short-term claim (Bill ofExchange) by another (an account in B’s bank) Therefore, both the debitand the credit entry are on the same account Also, the amount of interestaccrued is credited to the interest account The entries are

Debit CreditShort-term claims on foreigners (Bill of Exchange) $1000Short-term claim on foreigners (Account in B’s bank) $1000

Short-term claim on foreigners (interest) $50

2 Now country A has imported goods worth $800 This is paid with a loan in B’scurrency Thus, accounting entry will be debit of imports account and creditingshort-term claims

Debit CreditShort-term claims on foreigner’s (B’s) currency $800

3 A’s currency is a liability for A Thus, when a resident X spends this currency in B,there is an increase in liabilities (short-term) This is in exchange for services receivedfrom foreigners Thus the entries are:

Debit CreditShort-term liabilities (A’s currency) $5000Services received from foreigners $5000

4 Mr X finds a purse with $100 in B’s currency Thus, this represents an increase inshort-term claims on foreigners and can be treated as a gift from foreigners Theentries therefore, are

Debit CreditShort-term claims on foreigners (B’s currency) $100

5 The $100 represents a gift to foreigners This money is used to buy a bond from acitizen of A The entries are

Debit Credit

Long-term liabilities to foreigners (bill or bond) $100

35 Balance of Payments

6 Mr Y of country A is making a subsidiary plant in country B with an investment of

$50,000 worth of goods which he ships to B This is equivalent to an export of

goods worth US $50,000 and the balancing entry is an increase in long-term claims

The entries therefore, are

Debit CreditLong-term claims on foreigners $50,000

7 Another $20,000 is needed for completion of the plant Bonds on the parent company

are issued on company B’s citizens This represents an increase of long-term liabilities

of country A balanced by an increase in short-term claims (due to citizens of B

buying the bonds) As this amount raised is invested in the plant in country B, this

represents an increase in direct investment in foreign countries balanced by a

decrease in short-term claims The entries are

Debit CreditLong-term liabilities to foreigners (bonds issued) $20,000

Short-term claims from foreigners (B’s currency

Direct investment in foreign countries $20,000

Short-term claims on foreigners (B’s currency) $20,000

8 Mr Y makes a profit of $10,000 which he uses to enlarge his business in B This

represents a direct investment in country B The balancing entry will be profits for

foreigners

As citizens of A buy $10,000 worth of bonds from B’s citizens, this represents

decrease in long-term liabilities (bonds) countered by increase in short-term liabilities

(assuming A’s currency is used) The entries are

Debit CreditDirect investment in foreign countries $10,000

Long-term liabilities (bonds) $10,000

Short-term liabilities (A’s currency) $10,000

9 When Mr Z migrates from B to A, the currency that he brings ($100) becomes a

short-term claim on foreigners This is balanced by an equivalent credit entry on

gifts from foreigners

Also, the house represents a long-term claim on foreigners This is also balanced

by a credit entry on gifts from foreigners The entries are

Debit CreditShort-term claim on foreigners (B’s currency) $1000

Long-term claim on foreigners (fixed asset) $8000

Debit CreditLong-term claim on foreigners (fixed asset) $8000Short-term claim on foreigners (account in B’s bank) $4000

Long-term claim on foreigners (promise) $4000

11 This represents a gift to foreigners The entries are

Debit Credit

Short-term claim on foreigners (account in B) $1000

12 B produces gold worth $1 million Out of this, country A asks for $300,000 worth ofgold ($200,000 to A’s central bank and $100,000 for industrial use) This represents

an increase in official gold reserves of A (a debit entry) balanced by short-termliability increase The entries are

Debit Credit

Short-term liabilities to foreigners $300,000

13 This again represents gift from foreigners The entries are

Debit Credit

Short-term claim on foreigners (money in B’s bank) $1000Long-term claim on foreigners (fixed assets) $2000

14 As there is no record of this gift to his sister, this will not be recorded in the BOPstatement

15 This represents the conversion of one long-term claim into another The entries are

Debit CreditLong-term claim on foreigners (fixed asset) $2000Long-term claim on foreigners (bonds) $2000

16 Again the gift of the watch goes unrecorded However, the gift by cheque figures

in the BOP statement The entries are

37 Balance of Payments

Account in B’s bank $1000 of Exchange

Sale of Fixed Asset $4000

Gift to foreigners $100Balance c/d $315,100

Gift from foreigners $2,000

Purchase of bonds $2,000 Sale of Fixed asset $2,000

Balance c/d $56,000

39 Balance of Payments

Balance of Payments Statement

Long-term capital flows

Direct investments abroad -$30,000

Balance on long-term capital $75,900

Short-term capital flows

Short-term claims -$5350

Short-term liabilities $315,100

Balance on short-term capital $309,750

Official Reserves account

Balance on official reserves -$200,000

Check Your Progress 2

State whether the following statements are True or False:

1 A country’s balance of payments does not affect the value of its currency

2 Balance of payments is an accounting system that records the economic

transactions between the residents and government of a particular country

and the residents and governments of the rest of the world

Contd

2.4 LET US SUM UP

The balance of payments is a double entry accounting system that records the economictransactions between the residents and government of a particular country and theresidents and governments of the rest of the world during a certain period of time,usually a year The key components of the balance of payments are the current accountand the capital account The current account represents a broad measure of the country’sinternational trade balance The capital account is a measure of the country’s long-termand short-term capital investments, including direct foreign investment and portfolioinvestment

The BOP conforms to the principle of double entry bookkeeping Every internationaltransaction is recorded as a debt and credit entry of equal magnitude The BOP is asources and uses of funds statement that reflects changes in assets, liabilities and networth during a specified period of time

A country’s international capital flows are affected by factors that influence direct foreigninvestment or portfolio investments FDI generally takes place when firms tend to takeadvantage of various market imperfections Portfolio investments represents sales andpurchase of foreign financial assets that do not involve a transfer of management control

2.5 LESSON END ACTIVITY

Analyze the impact that the Global Slowdown has had on India’s BOP in the last fewyears Has it been favourable?

2.6 KEYWORDS

Balance of Payments (BOP): It is an accounting system that records the economic

transactions between the residents and government of a particular country and theresidents and governments of the rest of the world during a certain period of time,usually a year

Debits and Credits: Since the balance of payments statement is based on the principle

of double entry bookkeeping, every credit in the account is balanced by a matching debitand vice versa

Portfolio investments: These represent sales and purchases of foreign financial assets

such as stocks and bonds that do not involve a transfer of management control

Capital flows: These represent the third category of capital account and represent

claims with a maturity of less than one year

Current account: This measures the net balance resulting from merchandise trade,

service trade, investment income and unilateral transfers and reflects the country’s currentcompetitiveness in international markets

41 Balance of Payments

Short-term portfolio investments: These are financial instruments with maturities of

one year or less e.g., time deposits, certificate of deposit held by residents of a country

in foreign banks or by foreigners in domestic banks, commercial paper etc

Long-term portfolio investments: These are stocks, bonds and other financial instruments

issued by private and public organisations that have maturities greater than one year and

are held for purposes other than control

2.7 QUESTIONS FOR DISCUSSION

1 What are the implications and uses of the balance of payments statement?

2 What is meant by the balance of payments? In what way is the balance of payments

a summary statement? In what way is the time element involved in measuring a

nation’s balance of payment?

3 What is a credit transaction and a debit transaction? Which are the broad categories

of international transactions classified as credits and as debits?

4 Why is it useful to examine a country’s balance of payments data? How does it

differ from balance of trade?

5 What does the balance of payments of a country demonstrate? How can you use

the balance of payments in determining what will happen to the value of a currency?

Check Your Progress: Model Answers

Madhu Vij, International Financial Management, Excel Books, New Delhi, IInd Edition, 2003.

V Sharan, International Financial Management, 4th Edition, Prentice Hall of India.

Alan C Shapiro, International Financial Management, PHI.

Levi, International Finance, McGraw Hill International Series.

Adrian Buckly, Multinational Finance, PHI.