International Finance

� INTRODUCTION

Import and export are important activities for an open economy. Besides these, there are other international transactions that are equally important to the economy such as purchase of bonds, shares and other foreign financial assets. Most international transactions involve the payment flow between countries. For this purpose, the mechanism to determine the value of foreign currency is required. The value of currency is very important to determine exports, imports and a countryÊs foreign investment. For instance, the value of the Ringgit compared with American Dollar, Japanese Yen and Euro are important for MalaysiaÊs international transactions. This topic is divided into two parts. The first part focuses on the foreign exchange rate. This covers the process of determining the foreign exchange rate and the factors that influence it. The second part explains how each international transaction influences the payment flow between countries. The classification of this transaction will also be explained. The second part specifically discusses balance of payments accounts, issues and concepts related to it. Let us continue the lessons!

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� International Finance

LEARNING OUTCOMES

By the end of this topic, you should be able to:

1. Explain the meaning of foreign exchange rate and how this is determined;

2. Assess factors that influence the foreign exchange rate;

3. Evaluate the use of balance of payments and its components; and

4. Discuss strategies to reduce a balance of payment deficits.

TOPIC 9 INTERNATIONAL FINANCE � 201

FOREIGN EXCHANGE RATE

Almost all countries have their own currency. In order to carry out international trade with different currencies, one currency has to be exchanged with another currency. So what does foreign exchange rate refer to?

For example, Proton company agrees to sell a Wira car for RM30,000 to a dealer in America. If the foreign exchange rate between the American Dollar and Ringgit is RM2.50 to US$1, then the dealer in America has to pay US$12,000 to purchase a Proton Wira car. Since trade is carried out with countries using different currencies, foreign exchange rate plays a vital role in influencing international trade. If the foreign exchange rate increases from RM2.50 to RM2.60 for US$1, then the value of the Dollar has increased compared to the Ringgit. In other words, the value of the Ringgit has depreciated. This is because with US$1, the holder can now get more Ringgit. Instead, if the foreign exchange rate drops from RM2.50 to RM2.40 for US$1, then the value of the Dollar has depreciated compared to the Ringgit. In other words, the value of the Ringgit has increased compared to the the Dollar because one Dollar can now be purchased with just RM2.40. In this topic, the foreign exchange rate is stated in Ringgit for every unit of Dollar, such as RM2.50 for US$1. Actually, the foreign exchange rate can also be stated in Dollar for every Ringgit such as US$0.40 for every Ringgit. This means that US$0.40 can be exchanged for RM1. This figure is obtained by dividing US$1 with RM2.50, which equals US$0.40.

Foreign exchange rate refers to the rate at which one currency may be converted into another.

9.1

ACTIVITY 9.1

In your opinion, how important is the foreign exchange rate to a government that sponsors its studentsÊ costs of education overseas?

� TOPIC 9 INTERNATIONAL FINANCE

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HOW IS THE FOREIGN EXCHANGE RATE DETERMINED?

The foreign exchange rate is determined in the currency market. In order to understand the determination of the foreign exchange rate, the demand and supply models. Figure 9.1 shows the demand and supply for the Dollar compared with Ringgit.

Figure 9.1: Determinant of foreign exchange rate

The vertical axis represents the foreign exchange rate that is stated in Ringgit for every Dollar. The supply curve shows the quantity of Dollar supplied to be converted into Ringgit. Americans have to get Ringgit in order to purchase goods from Malaysia. Similarly, if firms from the United States want to make investments in Malaysia or to make transfer payments to residents in Malaysia they will supply the US dollar to get Malaysian Ringgit. Demand curve shows the quantity of Dollar that is demanded to exchange with Ringgit. If an individual or firm from Malaysia wants to buy a product made in America, they will have to get Dollars and exchange it to Ringgit. Similarly, if firms from Malaysia want to make investments in the United States or to make transfer payments to residents in the United States, they will demand US Dollars and exchange with the Malaysian Ringgit. The equilibrium value is RM2.50 for US$1. If the exchange rate increases to RM3.00 for US$1, then the value of Dollar has appreciated compared with Ringgit because every US$1 can get RM3.00. In reverse, if the exchange rate drops to RM2.00 for US$1, then the value of Ringgit has increased compared to the Dollar.

9.2


CHANGES IN DEMAND OR SUPPLY

Changes in demand or supply will cause changes in the equilibrium foreign exchange rate. Figure 9.2 shows an increased demand for the Dollar.

Figure 9.2: Increase in demand for the Dollar

Notice that original demand curve D moved to the right, to DÊ. This increases the equilibrium foreign exchange rate from RM2.50/US$1 to RM2.75/US$1 (now US$1 equals to RM2.75). An increase in demand pushes up the value of the Dollar because more Ringgit can be obtained with US$1. In other words, value of the Ringgit depreciated compared to the Dollar. Let us look at another figure which is Figure 9.3.

9.3

EXERCISE 9.1

1. Provide the definition of foreign exchange rate.

2. How does the market mechanism determine the foreign exchange rate?


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Figure 9.3: Increase in supply of the Dollar

Figure 9.3 shows the effect of an increase in supply of the Dollar compared to the Ringgit. This increase causes the original supply curve S to move to SÊ and achieve a new equilibrium rate at RM2.25/ US$1. At this level, US$1 can only be exchanged with RM2.25. At this rate, it is a little more compared with the rate of RM2.50/US$1. In other words, the value of the Dollar has depreciated compared to the Ringgit or the value of the Ringgit has gone up compared to the Dollar.

FACTORS THAT INFLUENCE THE FOREIGN EXCHANGE RATE

Equilibrium foreign exchange rate will change if demand or supply changes. There are four factors that can influence demand and supply of any currency. Do you know what are they? Let us refer to Figure 9.4 to identify the four factors that influence the foreign exchange rate.

9.4

ACTIVITY 9.2

Imagine that you are a money changer in Kuala Lumpur. Discuss how the international trade activities in Malaysia could influence your business.


Figure 9.4: Four factors that influence foreign exchange rate

The explanation for each factor is as follows:

9.4.1 Price of Traded Goods

The price of traded goods is the main determining factor for demand and supply. If local goods can be sold cheaper than goods from other countries, it will increase exports and eventually, cause a hike in the demand for local currency. This means the value of local currency will increase compared with other currencies. On the other hand, if the price of imported goods is cheaper, it will encourage demand for foreign currency with an increase in imports. This will cause the value of foreign currency to go up and the value of local currency to drop.

9.4.2 Inflation Level

There are two reasons why the value of currency can drop. Firstly, a high inflation level will make local products more expensive compared to imported goods. The difference in price will encourage consumers to purchase imported goods, which will directly increase the value and demand for foreign currency. Secondly, inflation not only affects the price of goods sold domestically, but also the price of goods exported. Exported goods will become more expensive and this will cause a decline in the demand for local currency. Eventually, the value of local currency will deteriorate.


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9.4.3 Interest Rate

Among the important factors that influence the movement of capital is the interest rate. What does it reflect?

High interest rates show profitable investment returns and this increases capital inflow. An increase in capital inflow will cause an increase in demand for local currency and this will eventually increase the value of local currency compared with foreign currency. On the other hand, low interest rates compared with that of other countries will encourage capital outflow. This will reduce demand and subsequently, the value of the local currency. Demand for foreign currency will increase because investors will invest in countries that offer a higher interest rate.

9.4.4 Income of the People in a Country

The average income of the people in a country influences their expenditure pattern. Those who have high incomes prefer to import goods from overseas because they have a higher purchasing power. This will increase the demand for foreign currency. On the other hand, low incomes encourage people to buy only locally produced goods.

The iinterest rate reflects the rate of returns on the investment made.

EXERCISE 9.2

Discuss FOUR factors that influence foreign exchange rates.

ACTIVITY 9.3

Visit the website of Ministry of Domestic Trade, Co-Operatives and Consumerism at http://www.kpdnkk.gov.my There are many interesting articles for you to read which provide additional information on consumerism in Malaysia.


BALANCE OF PAYMENTS

Have you ever heard about balance of payment? What does it stand for?

What about a country's balance of payments? A countryÊs balance of payments refers to balance of financial records showing the total inflow of money into the country and the total money outflow paid to other countries. The financial records can be either classified as credit or debit depending on the type of international transactions that are carried out.

The credit transactions will be marked ppositive (+) in the balance of payments account. Credit transactions include exported goods and services, receipt of transfer payment/gifts, and any capital inflow. The debit transaction will be marked nnegative (-) in the balance of payments account. Among the debit transactions are import of goods and services, giving of gifts to other countries and capital outflow. Figure 9.5 shows the categories of balance of payments.

Figure 9.5: Categories of balance of payments

The bbalance of payments is a systematic record of a nation's total payments to foreign countries, including the payment for imports and the outflow of capital and gold, along with the total receipts from abroad, including the payment for exports and the inflow of capital and gold.

9.5

Credit transactions record the receipt of money from other countries. Whereas, ddebit transactions record payments made to other countries.


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9.5.1 Current Account

The current account records all transactions on exports and imports of goods and services plus net international transfers (public or private gifts or donations). The current account is divided into three smaller accounts, namely the ttrade account, services account and the transfer of payments account. This is shown in Figure 9.6.

Figure 9.6: Three types of current accounts

Table 9.1 gives the description of the three types of accounts in the current account.

Table 9.1: Types of Current Accounts

Types of Current Accounts

Description

Trade Account The trade account records the total exports and imports for the production of agriculture, industrial, mining and various other traded goods.

The difference between export value and import value is known as the bbalance of trade. A positive balance of trade is known as a ttrade surplus and occurs when exports exceed imports; a negative balance of trade is known as a ttrade deficit or informally, as a trade gap.

Services Account The services account records the total exports and imports for services that include payments for transportation, insurance, tourist expenditure and investment income.

The difference between the export value and import value of services is called the bbalance of services. A positive balance is known as a services surplus and occurs when exports exceed imports; a negative balance is known as a services deficit which means imports exceed exports.

Transfer of Payments Account

The ttransfer of payments account records all transfer payments made or received by the government and the private sector.

Transfer payments include giving (receiving) assistance and gifts to (from) other countries. Transfer payments do not get any payment in return, whether in cash or kind. For example, the humanitarian channel given by Malaysia to Afghanistan is a transfer of payment.


These three transactions when placed together form ccurrent balance, as given in the formula below.

9.5.2 Capital Account

What does capital account record? The capital account records the net result of public and private international investments flowing in and out of a country. Investment and loans from overseas are recorded as credits in a countryÊs capital account. Investment and loans given to other countries are recorded as debits. As shown in Figure 9.7, the capital account is divided into two smaller accounts, namely, llong-term capital account and sshort-term capital account.

Figure 9.7: Types of capital accounts

(a) LLong-term Capital Account

A long-term capital account covers all forms of capital inflow and outflow in a country which has the maturity date of more than a year. It includes official long-term capital and private long-term capital. Let us refer to Table 9.2 for explanations.

Trade account + services account + transfer of payments account

= CCURRENT BALANCE


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Table 9.2: Types of Long-term Capital Accounts

Types of Capital Accounts Explanation

Official Long-term Capital

The movement of official long-term capital are the loans and payments between governments of one country and another or international financial bodies. For example, the loans taken by the Malaysian government from Japan and the World Bank.

Private Long-term Capital

The movement of private long-term capital can be divided into two types, namely, ddirect investment and pportfolio investment. Direct investment means investing in asset ownership such as building new firms in other countries together with ownership control.

Portfolio investment is the purchase of shares and bonds but the government guarantee letter does not include ownership control.

When current balance meets long-term capital account, they form basic balance as shown here:

(b) SShort-term Capital Account

The short-term capital account covers all types of capital inflow and outflow in a country with a maturity date of less than a year. The short-term capital account includes official and private short-term capital. Let us refer to Table 9.3 for the explanation of these two types of short-term capital accounts.

Table 9.3: Types of Short-term Capital Account

Types of Capital Account Explanation

Official Short-term Capital

The movement of official short-term capital is the payment of interest rate on loans taken from other countries or international financial institutions. For example, payment of interest by the Malaysian government on loans taken from the World Bank.

Private Short-term Capital

The movement of private short-term capital includes bank loans, trade credits and such for a short period. For instance, the short-term investments made by foreign investors in the country to get profits in the short-run.

Current balance + Long-term capital account = BBASIC BALANCE


(c) MMistakes and Omissions Mistakes and omissions are movements of short-term capital that cannot be

determined or classified as either official or private. Besides this, it is also the capital flow which cannot be traced or recorded.

9.5.3 Official Settlement Account

What does this type of account record? Official settlement account records the net change of foreign currency reserve and gold reserve in a country. This change is due to an imbalance in the balance of payments. When there is an excess balance of payments, foreign currency and gold will increase. In addition, if there is a deficit balance of payments, the foreign currency and gold reserves will decrease as well. This clearly shows that surplus or deficit balance of payments will be balanced by changes in the official settlement account. When the basic balance (current balance + long-term capital account) is added to short-term capital account and the official settlement account, the total obtained is called the bbalance of payment, or simply:

CURRENT BALANCE + CAPITAL ACCOUNT + OFFICIAL SETTLEMENT ACCOUNT = BALANCE OF PAYMENT


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SELF-CHECK 9.1

Are these statements True or False? Mark � in the appropriate column. You can check your answers based on the topics you have studied. No. Statement True False

1. A capital account records all transactions related to the export and import of goods and services plus net international transfers (public or private gifts or donations).

2. The current account records the flow of public and private capital/international investments flowing in and out of a country.

3. The current account is classified into three smaller accounts, namely trade account, services account and transfer of payments account.

4. All forms of capital inflow and outflow in a country which have a maturity date of more than a year are known as short-term capital account.

5. All forms of capital inflow and outflow in a country which have a maturity date of less than a year are known as long-term capital account.

6. The current balance added to the long-term capital account is known as the balance.

7. The trade account added to the net capital services account is known as the current balance.

8. Three types of long-term capital account are official long-term capital, private long-term capital and government long-term capital.

9. There are two types of short-term capital account, namely, official short-term capital and private short-term capital.


STRATEGIES TO REDUCE A BALANCE OF PAYMENTS DEFICIT

There are a few strategies that can be used by the government to reduce deficits in the balance of payments. Do you know what they are? They are exchange rate devaluation, demand management and supply side policy.

9.6.1 Exchange Rate Devaluation

If one country devalues its exchange rate, foreigners will buy more of the countryÊs exports and less of their own products. At the same time, domestic producers buy fewer imports and more domestically produced goods. This will eventually help to improve the balance of payments. However, the extent to which exchange rates affect exports and imports will also depend upon the elasticity of demand for the products.

9.6.2 Demand Management

This is an expenditure reducing policy where fewer imports will be demanded as aggregate demand falls. This can be done by using either fiscal or monetary policies. Fiscal policy can be done through higher direct taxes and this causes disposable income to fall and reduces demand for imports. Besides that, lower government spending also will reduce demand for imports. Monetary policy through higher interest rates which will reduce aggregate demand in several ways such as discouraging borrowing by households and firms; business investment may also fall, as the cost of borrowing funds will increase. Planned investment may prove to be unprofitable and consequently aggregate demand falls. These policies will reduce the demand for imports by households and firms.

9.6

ACTIVITY 9.4

Let us find articles on balance of payments and the accounts that you have studied in this topic at the Department of Statistics, Malaysia's website (www.statistics.gov.my). Get the important key words from the articles.


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9.6.3 Supply Side Policy

This policy will lead to increased exports and reduced imports as the quality of one countryÊs product improves whilst it decreases in cost. Supply side policies include technological progress and the impact of innovation; changes in factor productivity of both labour and capital; changes in unit wage costs and changes in size and quality of capital stock through investment.

� Foreign exchange rate refers to the rate at which one currency may be converted into another.

� The foreign exchange determinant process is based on the power of supply and demand.

� Factors such as prices of goods, inflation levels, interest rates, and peopleÊs income influence the foreign exchange rate.

� The balance of payments is a systematic record of a nation's total payments to foreign countries, including the price of imports and the outflow of capital and gold, along with the total receipts from abroad, including the price of exports and the inflow of capital and gold.

� Three main components of a balance of payment account are the current account, the capital account and the official settlement account.

� There are a number of policy options available to reduce a balance of payments deficit. This can be done through the exchange rate devaluation, or demand management policy either through fiscal or monetary policies that will reduce demand for imports. It can also be done through supply side policies that will lead to an increase in exports and a decrease in imports.


Balance of payment

Capital account

Credit transaction

Current account

Determinants

Foreign exchange rate

Interest rate

Trade account

Documents

International Finance