FIN3IFM : International Financial Management Tutorial 02: Solutions Semester 1, 2021 Subject Coordinator Dr Muhammad Al Mamun International Financial Management Tutorial Solutions First 10 minutes: Please provide a summary of the week lecture materials Balance of Payments • • • Current Account Financial Account Capital Account Growth in International Trade • • • • Events That Increased Trade Volume Major trends in global trade Impact of Outsourcing on Trade Trade Volume Among Countries Factors Affecting International Trade Flows • • • • • • • Cost of Labor Inflation National Income Credit Conditions Government Policies Exchange Rates Interaction of Factors International Capital Flows • • • Factors Affecting Direct Foreign Investment Factors Affecting International Portfolio Investment Impact of International Capital Flows Agencies that Facilitate International Flows • • • International Monetary Fund World Bank World Trade Organizations • • • • • International Finance Corporation International Development Association Bank for International Settlements OECD Regional Development Agencies Question 2: Determine the type of relevant account and the nature of the treatment to record the following transactions Answer: Transactions Facebook paid 2.5 billion US dollars to Australian Media companies US government renegotiated the NAFTA deal that results in 1.2 million additional jobs for US workers Beximco Pharma from South Asia invested in US$20 million in US treasury bonds Federal reserve remitted US$2.5 billion to various Chinese firms as interest payment Indian students studying in universities in the USA paid the admission fees Apple invests $2.5 billion in foreign subsidiaries United States receives aid from UAE to fight the COVID pandemic Types of Accounts U.S Cash Flow Position Current Account Not a transaction Cash outflow Entry on U.S Balance-OfPayments Account Debit N/A N/A Financial Account Cash inflow Credit Current Account Cash outflow Debit Current Account Cash inflow Credit Financial Account Current Account Cash outflow Debit Cash inflow Credit Question 3: Describe some salient features of international trade observed over the last 5-6 decades Answer: Since the early 1900s, the has been significant growth in global trade Using 1913 as the base year, by 2014 global trade has grown 40 folds This growth in international trade demonstrates some interesting facts a Trade has contributed to economic growth The world economy has experienced sustained positive economic growth for the last few centuries, and over the same period, this process of economic growth has been accompanied by even faster growth in global trade The correlation between global trade and economic growth, particularly over the last five decades is highly positive At the macro level, trade has delivered unprecedented access to goods and services, with a revolution in the availability of goods for low-income households Take the cost of purchasing a television set, for example: between 1980 and 2014, the price of a roughly comparable TV set fell by 73%, in part as the result of ambitious trade liberalization efforts – and the smart television sets we buy today are vastly better than those available in the 1980s b Significant growth of trade between non-rich (non-OECD) to non-rich and non-rich to rich (OECD) countries Up until World War II, the majority of trade transactions involved exchanges between this small group of rich countries But this has been changing quickly over the last couple of decades As of 2014, trade between non-rich countries is just as important as trade between rich countries c Bilateral trade is becoming increasingly common In the majority of cases, there is a bilateral trade relationship today Most countries that export goods to a country, also import goods from the same country While bilateral trade comprised 13% of global trade in the 1950s, today that number stands at approximately 58% of global trade In contrast, trade with non-trading partners has declined significantly In the 1950s 80% of global trade took place between non-trading partners, today only 25% of the trade takes place between non-trading partners d The majority of preferential trade agreements (PATs) are between emerging economies A preferential trade agreement is a trade pact that reduces tariffs between the participating countries for certain products There is an increasingly important role of trade between developing countries (South-South trade), vis-a-vis trade between developed and developing countries (North-South trade) In the late 1970s, North-South agreements accounted for more than half of all agreements – in 2010, they accounted for about one quarter Today, the majority of preferential trade agreements are between developing economies e The financial system has promoted the growth of international trade Conducting international trade requires both financial and non-financial institutions to support transactions Some of these institutions are fairly obvious (e.g., law enforcement); but some are less obvious For example, the evidence shows that producers in exporting countries often need credit to engage in trade Manova (2013)1, documents that a positive correlation between levels in private credit (exporters’ private credit as a share of GDP) and exports (average bilateral exports across destinations and sectors) Financially developed economies – those with more dynamic private credit markets – typically outperform exporters with less evolved financial institutions f A large part of economic gain for OECD economics comes from trade A large part of the economic gains from trade is received by OECD economies For example, around 90% of large-scale corporations from OECD economies have international engagement This has been facilitated by regulations set by IMF, World Bank, and WTO For example, since 1945 US GDP has grown by 96-fold and a Manova, Kalina “Credit constraints, heterogeneous firms, and international trade.” The Review of Economic Studies 80.2 (2013): 711-744 significant part of that has been contributed by international trade Question 4: ‘Growth in international trade confirms the theory of comparative advantage’ - Evaluate? Answer: In theory, comparative advantage predicts that a country with a relative abundance of certain factors of production will export goods that rely heavily upon those factors A country typically has a comparative advantage in those goods that use more intensively its abundant resources The growth in international trade over the last six decades, confirms the theory of comparative advantage For example, using Japanese experience, Bernhofen, and Brown (2004)2, provide evidence that Japan’s dramatic nineteenth-century move from a state of near-complete isolation to wide trade openness with electronic products has provided Japan significant comparative advantage over other economics Similarly, in the case of the USA and Saudi Arabia, while Saudi Arabia becomes a significant exporter of crude oil, the USA slowly divest its fund from traditional energy sectors, and over time the USA has moved towards technologically advanced high-end products such as digital technology, social media companies, arms manufacturing, education service, etc Question 5: Why weakening the local currency is not always a solution to correct the balance of payment deficit? Traditionally, weakening the home currency has been viewed as a solution to correcting the balance of payment deficit The USA has significantly used this tool during Bretton Wood Era China has been using it over the last three decades The economic intuition is straightforward As a country experience balance of payment deficit, a weakening home currency can make the local product more competitive internationally and make import more expensive Collectively, this will result in correcting the balance of the payment deficit However, few factors limit its effectiveness • Competition: Foreign companies may lower their prices to remain competitive • Impact of other currencies: A country that has the balance of payment deficit with many countries is not likely to solve all deficits simultaneously • Poor prescription: In some cases, if the local economy is not robust enough due to a lack of exportable quality goods abroad, a weakening local currency can increase import cost and will bring little benefit to add to the export volume In the early 2000s, many emerging economies were prescribed such a solution by IMF, however, it has yielded very poor outcomes • J-curve effect: International transactions cannot be adjusted immediately The nominal trade deficit initially grows after a devaluation, as prices of exports rise before quantities can adjust Then, as quantities adjust, there is an increase in imports as exports remain static, and the trade deficit shrinks or reverses into a surplus forming a “J” shape Bernhofen, D., & Brown, J (2004) A Direct Test of the Theory of Comparative Advantage: The Case of Japan Journal of Political Economy, 112(1), 48-67 However, for firms that rely on imported raw materials, such immediate shock may hurt their long-term survival Question 6: China - U.S Balance of Trade There is an ongoing debate between the U.S and China regarding whether the Chinese yuan's value should be revalued upward The cost of labor in China is substantially lower than that in the U.S a Would the U.S balance of trade deficit in China be eliminated if the yuan was revalued upward by 20%? By 40%? By 80%? b If the yuan was revalued to the extent that it substantially reduced the U.S demand for Chinese products, would this shift the U.S demand toward the U.S or toward other countries where wage rates are relatively low? In other words, would the correction of the U.S balance of trade deficit have a major impact on U.S productivity and jobs? Answer: a This is an open question without a perfect answer Yet, it should at least make students realize that a small increase in the value of the yuan is not going to make Chinese products more expensive than U.S products in laborintensive industries, given that Chinese wages may be less than one-tenth of U.S wages in these industries b To the extent that there are decent substitute products in other low-wage countries, it seems likely that U.S consumers would just shift their demand toward the products in these countries If so, a correction in the U.S balance of trade deficit with China would shift jobs to other low-wage countries rather than to the U.S Question 7: (Self-preparation) Use the CSV file ‘US-India Trade balance’ to view how to trade balance has behaved over the last three decades between the US and India Given your knowledge about factors affecting trade flows, research and identify factors that contributed to such outcome Main points to discuss: • Liberalization of the financial sector in the 1990s • WTO membership in 1996 • Liberalization of trades in service sectors • Strategic partnership relation • Creating of a trade policy forum in 2005 Additional self-preparation for Final Exam: Q 11, Q 12 ... deal that results in 1 .2 million additional jobs for US workers Beximco Pharma from South Asia invested in US $20 million in US treasury bonds Federal reserve remitted US $2. 5 billion to various... forming a “J” shape Bernhofen, D., & Brown, J (20 04) A Direct Test of the Theory of Comparative Advantage: The Case of Japan Journal of Political Economy, 1 12( 1), 48-67 However, for firms that rely...International Financial Management Tutorial Solutions First 10 minutes: Please provide a summary of the week lecture materials Balance of Payments • • • Current Account