NPTEL International Finance Vinod Gupta School of Management , IIT.Kharagpur.

Module: 2 International Financial Environment

Developed by: Dr. A.K.Misra Assistant Professor, Finance Vinod Gupta School of Management Indian Institute of Technology Kharagpur, India Email: arunmisra@vgsom.iitkgp.ernet.in

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NPTEL International Finance Vinod Gupta School of Management , IIT.Kharagpur.

Lesson: 2 International Financial Environment

Learning Objectives:
In this session, international trade is discussed in details. In Session-1 the historical development of international trade is outlined. The transition from GATT regime to functional aspect of WTO is discussed also discussed in the session-1

Highlights & Motivation:

In this session, the following details about international trade and international financial environment are discussed. International Financial Transactions Balance of Payments: Meaning & Structure The session would help readers to understand the historical development of international trade and international financial environment and also articulate the structure of Balance of Payments.

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2.1 International Financial Transactions

Prior to First World War, growth in world trade was quite smooth. Gold based monetary standard provided stability to world trade. However, the collapse of gold standard, great depression of 1930s and subsequent events created a high tariff international trade regime which affected the world trade. With the establishment of IMF and GATT world trade started gaining the lost pace again. The General Agreement on Tariffs and Trade (GATT), was established after World War II in the wake of other new multilateral institutions dedicated to international economic cooperation. Seven rounds of negotiations occurred under the GATT for reducing tariffs, anti-dumping and nontariff trade barriers. The eighth GATT round known as the Uruguay Round was the biggest negotiating mandate on trade ever agreed. The talks were going to extend the trading system into several new areas, notably trade in services and intellectual property, and to reform trade in the sensitive sectors of agriculture and textiles. The Final Act concluding the Uruguay Round and officially establishing the WTO regime was signed during the April 1994. The agreements fall into a structure with six main parts:

The Agreement Establishing the WTO Goods and investment the Multilateral Agreements on Trade in Goods including the GATT 1994 and the Trade Related Investment Measures Services the General Agreement on Trade in Services Intellectual property the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) Dispute settlement (DSU) Reviews of governments' trade policies (TPRM)

The WTO agreements deal with agriculture, textiles and clothing, banking, telecommunications, government purchases, industrial standards and product safety, food sanitation regulations, intellectual property, and much more. The fundamental principle of post-WTO international trade is the foundation of the multilateral trading system. The economic case for an open trading system based on multilaterally agreed rules is simple enough and rests largely on commercial common sense. But it is also supported by evidence. Tariffs on industrial products have fallen steeply and now average less than 5% in industrial countries and 25% in developing countries. During the first 25 years after the war, world economic growth averaged about 5% per year, a high rate that was partly the result of lower trade barriers.

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During the last four decades of the world economic liberalization, the World trade has not been smooth. At the same time, it is not confined to developed/industrialized countries. World economic activities were affected by international liquidity crisis, credit crunch, high crude oil prices, galloping inflation, severe drought and other natural calamities. World trade is generally affected the international business cycles. The characteristic of international business cycle has been changed a lot since 1980s. Prior of 1980s, 70% of the world output was confined to advanced economies and hence the international business cycles were affected by the performance of these economies At present, the share of the advanced economies in World output came down to 55% on purchasing power parity basis. Hence, international business cycles are no longer control by these advanced economies; rather it is the emerging market economies which are playing the leading roles in the world output and trade. In 2007, as the slowdown in economic activity in the USA and other advanced economies began, the hope was that emerging and developing economies, with their domestic economic size and strength, would help in keeping the international business cycles upward. As per the WTO forecast, the collapse in global demand brought on by the biggest economic downturn in decades will drive exports down by about 9% in volume terms in 2009, the biggest such contraction since the Second World War. Economic contraction has led to steep export declines which already posted in the early months of 2009 by major economies makes for an unusually bleak 2009 trade assessment, as per the annual assessment of global trade by the WTO. Signs of the sharp deterioration in trade were evident in the latter part of 2008 as demand sagged and production slowed. Although world trade grew by 2% in volume terms for the whole of 2008 it tapered off in the last six months and was well down on the 6% volume increase posted in 2007. The global economy is in a severe recession inflicted by a massive financial crisis and an acute loss of confidence. Wide-ranging and often unorthodox policy responses have made some progress in stabilizing financial markets but have not yet restored confidence nor arrested negative feedback between weakening activity and intense financial strains. While the rate of contraction is expected to moderate from the second quarter onward, global activity is projected to decline by 1.3 percent in 2009 as a whole before rising modestly during the course of 2010. This turnaround depends on financial authorities acting decisively to restore financial stability and fiscal and monetary policies in the worlds major economies providing sustained strong support for aggregate demand.

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NPTEL International Finance Vinod Gupta School of Management , IIT.Kharagpur.

2.2 Balance of Payments: Meaning & Structure

The Balance of Payments (BOP) of a country is a systematic record of all its economic transactions with the outside world in a given year. It is merely a way of listing receipts and payments in international transaction for a country. The Balance of payments accounts of a country are constructed on the principle of double-entry book-keeping. Each transaction is entered on the credit and debit side of the balance sheet. Payment is received from a foreign country is credit transaction and payment to a foreign country is a debit transaction. The collection of all exports, imports and financial transactions in a BOP account are grouped into three main categories. 1. Current Account: Import and export of goods and services and unilateral transfer of goods and services including transfer of money for family living expenses. 2. Capital Account: Transactions related to changes in foreign assets and liabilities. This includes short-term and long-term borrowings, private and government investments and international capital flows. 3. Reserves Account: It also relates to international assets and liabilities for such transactions which the countrys monetary authorities uses to settle the deficits and surpluses that arise on the other two categories of accounts. The structure of BOP account is provided hereunder: A. Current Account
a. Merchandise

Debits

Credits

Net

b. Invisibles i. Services 1. Travel 2. Transportation 3. Insurance 4. Government 5. Miscellaneous ii. Transfer 1. Official 2. Private iii.Income 1. Investment Income 2. Compensation to Employees

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NPTEL International Finance Vinod Gupta School of Management , IIT.Kharagpur.

Total Current Account (a+b)

B. Capital Account Debits Credits Net

1. Foreign Investment a. In India i. Direct ii. Portfolio b. Abroad 2. Loans a. External Assistance i. By India ii. To India b. Commercial Borrowings(Long and Medium) i. By India ii. To India c. Short-Term Borrowings i. To India 3. Banking Capital a. Commercial Banks i. Assets ii. Liabilities iii Non-resident Deposits b. Others 4. Rupee Debt Service 5. Other Capital Total Capital Account (1to 5) In accounting sense balance of payments always balances since all international transactions are recorded as per double entry book-keeping methods. However, various subsets of BOP account can have deficit and/or surplus which have economic interpretations. To say that the BOP always balances is to interpret that a net credit balance in one of these accounts must have a counterpart net debit balance in one of the other accounts or in a combination of the two other accounts.

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References
Sachs, J.D, Warner, A, Aslund, A & Fischer, S, Economic Reform and the Process of Global Integration Brookings Papers on Economic Activity, Vo.1995, No.1, 25th Anniversary Issue. 1995, pp.1-118. Foreign Trade of India 1947-2007: Trends, Policies and Prospects, Vibha Mathur, New Century Publication, 2006. http://en.wikipedia.org/wiki/World_Trade_Organization http://www.blackwellpublishing.com/content/BPL_Images/Content_store/Sa mple_chapter/9780631229513/001.pdf

Model Questions
1. Discuss the importance of various components of Balance of Payments. 2. Balance of Payments always balances. Explain with example. 3. Discuss the importance of GATT and its transition to WTO

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NPTEL International Finance Vinod Gupta School of Management , IIT.Kharagpur.

World Merchandise Exports: Region-wise (Billion dollars and percentage)

1948 1953 1963 1973 1983 1993 2003 2006

World World North America United States Canada Mexico South and Central America Brazil Argentina Europe Germany a France United Kingdom Italy Commonwealth of Independent States (CIS) b Africa South Africa c Middle East Asia China Japan India Australia and New Zealand Six East Asian traders Memorandum item: EU d USSR, former GATT/WTO Members e

59 100 28.1 21.7 5.5 0.9 11.3 2.0 2.8 35.1 1.4 3.4 11.3 1.8 7.3 2.0 2.0 14.0 0.9 0.4 2.2 3.7 3.4 2.2 60.4

84 100 24.8 18.8 5.2 0.7 9.7 1.8 1.3 39.4 5.3 4.8 9.0 1.8 6.5 1.6 2.7 13.4 1.2 1.5 1.3 3.2 3.0 3.5 68.7

157 100 19.9 14.9 4.3 0.6 6.4 0.9 0.9 47.8 9.3 5.2 7.8 3.2 5.7 1.5 3.2 12.5 1.3 3.5 1.0 2.4 2.4 27.5 4.6 72.8

Value 579 1838 Share 100 100 17.3 16.8 12.3 11.2 4.6 4.2 0.4 1.4 4.3 4.4 1.1 1.2 0.6 0.4 50.9 43.5 11.6 9.2 6.3 5.2 5.1 5.0 3.8 4.0 4.8 1.0 4.1 14.9 1.0 6.4 0.5 2.1 3.4 38.6 3.7 81.8 4.5 1.0 6.8 19.1 1.2 8.0 0.5 1.4 5.8 30.4 5.0 76.5

3675 100 18.0 12.6 4.0 1.4 3.0 1.0 0.4 45.4 10.3 6.0 4.9 4.6 1.5 2.5 0.7 3.5 26.1 2.5 9.9 0.6 1.5 9.7 36.1 89.5

7371 100 15.8 9.8 3.7 2.2 3.0 1.0 0.4 45.9 10.2 5.3 4.1 4.1 2.6 2.4 0.5 4.1 26.2 5.9 6.4 0.8 1.2 9.6 42.4 94.3

11783 100 14.2 8.8 3.3 2.1 3.6 1.2 0.4 42.1 9.4 4.2 3.8 3.5 3.6 3.1 0.5 5.5 27.8 8.2 5.5 1.0 1.2 9.6 38.5 93.9

a Figures refer to the Fed. Rep. of Germany from 1948 through 1983. b Figures are significantly affected by i) changes in the country composition of the region and major adjustment in trade conversion factors between 1983 and 1993; and ii) including the mutual trade flows of the Baltic States and the CIS between 1993 and 2003. c Beginning with 1998, figures refer to South Africa only and no longer to the Southern African Customs Union. d Figures refer to the EEC(6) in 1963, EC(9) in 1973, EC(10) in 1983, EU(12) in 1993, and EU(25) in 2003 and 2006. e Membership as of the year stated. Note: Between 1973 and 1983 and between 1993 and 2003 export shares were significantly influenced by oil price developments.
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NPTEL International Finance Vinod Gupta School of Management , IIT.Kharagpur.

World Merchandise Imports: Region-wise (Billion dollars and percentage)

1948 1953 1963 1973 1983 1993 2003 2006

Value World World North America United States Canada Mexico South and Central America Brazil Argentina Europe Germany a United Kingdom France Italy Commonwealth of Independent States (CIS) b Africa South Africa c Middle East Asia China Japan India Australia and New Zealand Six East Asian traders Memorandum item: EU d USSR, former GATT/WTO Members e 62 100 18.5 13.0 4.4 1.0 10.4 1.8 2.5 45.3 2.2 13.4 5.5 2.5 8.1 2.5 1.8 13.9 0.6 1.1 2.3 2.9 3.5 1.9 52.9 85 100 20.5 13.9 5.5 0.9 8.3 1.6 0.9 43.7 4.5 11.0 4.9 2.8 7.0 1.5 2.1 15.1 1.6 2.8 1.4 2.3 3.7 3.3 66.0 164 100 16.1 11.4 3.9 0.8 6.0 0.9 0.6 52.0 8.0 8.5 5.3 4.6 5.2 1.1 2.3 14.1 0.9 4.1 1.5 2.2 3.1 29.0 4.3 74.2 595 1882 Share 100 100 17.2 18.5 12.3 14.3 4.2 3.4 0.6 0.7 4.4 3.8 1.2 0.9 0.4 0.2 53.3 44.2 9.2 8.1 6.5 5.3 6.3 5.6 4.7 4.2 3.9 4.6 0.9 0.8 2.7 6.2 14.9 18.5 0.9 1.1 6.5 6.7 0.5 0.7 1.6 1.4 3.7 6.1 39.2 3.5 89.1 31.3 4.3 83.9 3770 100 21.5 16.0 3.7 1.8 3.3 0.7 0.4 44.8 9.1 5.6 5.8 3.9 1.2 2.6 0.5 3.4 23.3 2.8 6.4 0.6 1.5 9.9 34.3 88.7 7650 100 22.6 17.0 3.2 2.3 2.5 0.7 0.2 45.3 7.9 5.2 5.2 3.9 1.7 2.1 0.5 2.7 23.1 5.4 5.0 0.9 1.4 8.2 41.6 96.1 1211 3 100 21.0 15.8 3.0 2.2 3.0 0.8 0.3 43.1 7.5 5.1 4.4 3.6 2.3 2.4 0.6 3.1 25.0 6.5 4.8 1.4 1.4 8.6 39.2 95.8

a Figures refer to the Fed. Rep. of Germany from 1948 through 1983. b Figures are significantly affected by i) changes in the country composition of the region and major adjustment in trade conversion factors between 1983 and 1993 and ii) including the mutual trade flows of the Baltic States and the CIS between 1993 and 2003. c Beginning with 1998, figures refer to South Africa only and no longer to the Southern African Customs Union. d Figures refer to the EEC(6) in 1963, EC(9) in 1973, EC(10) in 1983, EU(12) in 1993, EU(25) in 2003 and 2006. e Membership as of the year stated. Note: Between 1973 and 1983 and between 1993 and 2003 import shares were significantly influenced by oil price developments.

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NPTEL International Finance Vinod Gupta School of Management , IIT.Kharagpur.

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