ž  Purchases or sales of real and financial assets across international borders
ž  A country with greater investment opportunities than savings can fill the savings gap by borrowing from abroad.
ž  International capital flows allow countries to run trade imbalances.
ž  International financial markets allocate savings to productive capital in different countries.
ž  International financial markets are subject to the laws of at least two countries.
ž  Capital flows usually represent portfolio investment or direct foreign investment.
ž  The DFI positions inside and outside have risen substantially over time, indicating increasing globalization.
ž  In particular, both DFI positions increased during periods of strong economic growth.
ž  Capital Inflows
ž  Purchases of domestic assets by foreign households and firms
ž  Capital Outflows
ž  Purchases of foreign assets by domestic households and firms
ž  Net Capital Inflows
ž  Capital inflows minus capital outflows
ž  DFI can improve profitability and enhance shareholder wealth, either by boosting revenues or reducing costs.
Revenue-Related Motives
ž  Attract new sources of demand, especially when the potential for growth in the home country is limited.
ž  Exploit monopolistic advantages, especially for firms that possess resources or skills not available to competing firms.
ž  React to trade restrictions.
Cost-Related Motives
ž  Fully benefit from economies of scale, especially for firms that utilize machinery.
ž  Use cheaper foreign factors of production.
ž  Use foreign raw materials, especially if the MNC plans to sell the finished product back to the consumers in that country.
ž  Use foreign technology.
ž  React to exchange rate movements, such as when the foreign currency appears to be undervalued. DFI can also help reduce the MNC’s exposure to exchange rate fluctuations.
ž  Diversify sales/production internationally.
ž  The optimal method for a firm to penetrate a foreign market is partially dependent on the characteristics of the market.
ž  For example, if the consumers are used to buying domestic products, then licensing arrangements or joint ventures may be more appropriate.
ž  Before investing in a foreign country, the potential benefits must be weighed against the costs and risks.
ž  As conditions change over time, some countries may become more attractive targets for DFI, while other countries become less attractive.
ž  The key to international diversification is to select foreign projects whose performance levels are not highly correlated over time.
ž  An MNC may not be insulated from a global crisis, since many countries will be adversely affected.
ž  However, as can be seen from the 1997-98 Asian crisis, an MNC that had diversified among the Asian countries might have fared better than if it had focused on one country. Even better would be diversification among the continents.
ž  As more projects are added to a portfolio, the portfolio variance should decrease on average, up to a certain point.
ž  However, the degree of risk reduction is greater for a global portfolio than for a domestic portfolio, due to the lower correlations among the returns of projects implemented in different economies.
ž  An MNC with projects positioned around the world is concerned about the risk and return characteristics of its projects.
ž  Project portfolios along the efficient frontier exhibit minimum risk for a given expected return.
ž  Of these efficient portfolios, an MNC may choose one that corresponds to its willingness to accept risk.
ž  The frontiers of efficient project portfolios of some MNCs are more desirable than the frontiers of other MNCs.
ž  Some periodic decisions are necessary.
¡  Should further expansion take place?
¡  Should the earnings be remitted to the parent, or used by the subsidiary?
ž  For the government, the ideal DFI solves problems such as unemployment and lack of technology without taking business away from the local firms.
ž  The government may provide incentives to encourage the forms of DFI that it desires, and impose preventive barriers or conditions on the forms of DFI that it does not want.
ž  Common incentives offered by the host government include tax breaks, discounted rent for land and buildings, low-interest loans, subsidized energy, and reduced environmental restrictions.
ž  Common barriers imposed by the host government include the power to block a merger/acquisition, foreign majority ownership restrictions, excessive procedure and documentation requirements (red tape), and operational conditions.
ž  Changes in Restrictions
¡  New opportunities may arise from the removal of government barriers.
ž  Privatization
¡  DFI has also been stimulated by the selling of government operations.
ž  Potential Economic Growth
¡  Countries with higher potential economic growth are more likely to attract DFI.
ž  Tax Rates
¡  Countries that impose relatively low tax rates on corporate earnings are more likely to attract DFI.
ž  Exchange Rates
¡  Firms will typically prefer to invest their funds in a country when that country’s currency is expected to strengthen.
ž  Tax Rates on Interest or Dividends
¡  Investors will normally prefer countries where the tax rates are relatively low.
ž  Interest Rates
¡  Money tends to flow to countries with high interest rates.
ž  Exchange Rates
¡  Foreign investors may be attracted if the local currency is expected to strengthen.
ž  Real interest rate
¡  High domestic real interest rates will cause net capital inflows.
¡  Low domestic real interest rates will cause net capital outflows.
ž  Risk
¡  For a given real interest rate, an increase in riskiness in domestic assets will reduce net capital inflows and vice versa
¡  The pool of saving available for domestic investment includes national savings and the funds from savers abroad.
¡  A country that attracts foreign capital will have lower real interest and higher investment.
¡  Countries with a stable political environment and well defined property rights will attract more foreign capital.
ž  Trade Balance (or net exports)
¡  The value of a country’s exports less the value of its imports in a particular period (quarter or year)
ž  Trade Surplus
¡  When exports exceed imports, the difference between the value of a country’s exports and the value of its imports in a given period
ž  Trade Deficit
When imports exceed exports, the difference between the value of a country’s imports and the value of its exports in a given period
ž  Inflation
¡  A relative increase in a country’s inflation rate will decrease its current account, as imports increase and exports decrease.
ž  National Income
¡  A relative increase in a country’s income level will decrease its current account, as imports increase.
ž  Government Restrictions
¡  A government may reduce its country’s imports by imposing tariffs on imported goods, or by enforcing a quota. Note that other countries may retaliate by imposing their own trade restrictions.
¡  Sometimes though, trade restrictions may  be imposed on certain products for health and safety reasons.
ž  Exchange Rates
¡  If a country’s currency begins to rise in value, its current account balance will decrease as imports increase and exports decrease.
ž  Note that the factors are interactive, such that their simultaneous influence on the balance of trade is a complex one.
ž  A low rate of national saving is the primary cause of trade deficits.
ž  Low national saving implies high consumer and government spending
ž  High rates of spending will:
¡  Increase imports.
¡  Decrease exports.
ž  Low national saving will also increase capital inflows.
¡  High spending creates investment opportunities
¡  Shortage of domestic saving will occur
¡  Real interest rates will rise
¡  Capital inflows will occur
ž  By reconsidering the factors that affect the balance of trade, some common correction methods can be developed.
ž  For example, a floating exchange rate system may correct a trade imbalance automatically since the trade imbalance will affect the demand and supply of the currencies involved.
ž  However, a weak home currency may not necessarily improve a trade deficit.
ž  Foreign companies may lower their prices to maintain their competitiveness.
ž  Some other currencies may weaken too.
ž  Many trade transactions are prearranged and cannot be adjusted immediately.
ž  The impact of exchange rate movements on intracompany trade is limited.
¡  World Trade Organization was established on
January 1, 1995.  The WTO is the umbrella organization governing the international trading system.
¡  In 1993, a General Agreement on Tariffs and Trade (GATT) accord calling for lower tariffs was made among 117 countries.
¡  Other trade agreements include:
¡  Association of Southeast Asian Nations
¡  European Union
¡  Central American Common Market
¡  North American Free Trade Agreement
¡  South Asian Free Trade Agreement
¡  Trade agreements are sometimes broken when one country is harmed by another country’s actions.
¡  Dumping is a critical issue which refers to the exporting of products by one country to other countries at prices below cost.
¡  Another situation that can break a trade agreement is copyright piracy.

Acknowledge to Dr. Babar Zaheer Butt on sharing his prestigious presentation to this blog.