Financial Forces of International Business

Submitted by:Rai, Manju KumariShrestha, RuchiThapa Magar, DipeshNepal, Rhishikesh

Submitted to:Mr. Lhakpa Gelu SherpaFacilitator of IB

Contents of Financial Forces of International Business

1. Financial forces and its impact on international business arena2. Foreign Exchange3. Changes of demand and supply of foreign exchange4. Free floating systems, managed float system and fixed system5. Taxation and tariffs6. How tariff is affecting international trade?7. Inflation and deflation8. The impact of inflation on international business9. Balance of payment10. What is indebtness?11. Conclusion

1. Financial forces and its impact on international business arena

Generally speaking, tariffs, inflation, and taxes influence international business. Currency exchanges

increase and decrease international business equally depending upon the condition of the economy.

Considering tariffs: if company XYZ exports motorcycles from its facility in Japan to the United States

and the US imposes tariffs on them as a direct result of congressional lobbying from domestic

manufacturers, then the company's payments resulting from sales would decrease. This makes profitable

business a difficult prospect because the consumer is generally not willing to pay a higher price for the

imported motorcycle. As a result, company XYZ must make up the difference by increasing its market

share or cut production costs in some manner.

Considering taxes: a firm selling a product has a cost to produce the product and sells it for a profit. Most

governments impose taxes on businesses which effectively decreases the payments realized by the firm

resulting from the sale and subsequent profit of its products. For international businesses, this is

especially important as foreign governments will likely levy taxes on sales in their country as will the

firm's domestic government when profits are brought home (double taxation in some cases).

Moreover, inflation will affect businesses because a currency's value now is usually not the same as its

future value. Suppose a firm invests in a foreign project and expects to realize cash flows of $100,000 per

month beginning in two years. This level of cash flows is sufficient for now, but inflation can erode the

value of the currency such that the value of $100,000 in two years may be only worth the same as

$50,000 today (a dollar in two years will only buy what $0.50 will buy today). Firms must plan carefully

relative to inflationary forces when planning for fixed levels of cash flows resulting from projects in the

future.

Furthermore, currency exchanges can either increase or decrease payment balances. When a firm's

domestic currency is strong, exchanging profits made in a foreign country will have the effect of

decreasing payment balances when they are brought home and vice versa. For example, a firm completes

a project in Germany and is paid 1,000,000 Euros for doing so. However, the firm's domestic currency

(the US dollar) is strong and is worth 2 Euros. As such, the exchange of the currency when the profits are

brought home will yield a $500,000 profit domestically. Contrastingly, if the dollar is weak and 1 Euro is

worth $2, the project will yield the company $2,000,000 in profit after the exchange of funds. Because

exchange rates change daily, profits realized from a lengthy foreign project can be eroded unexpectedly.

The company can leave the profits overseas until markets improve, but many countries (including the US)

are beginning to tax companies for doing so in an effort to have them bring money home sooner.

Finally, the impact of indebtness of a nation also impacts international business. The level of debt the country gears from domestic market as well as external debt defines the environment for enhancing

international business. For example, if US do not start cutting its 14 trillion dollars of national debt it will be submerged into inflation, recession, and huge deficit of balance of payments ultimately hindering the environment for prosperity of business in the nation.

2. Foreign Exchange

Foreign exchange, or Forex, is the conversion of one country's currency into that of another. In a free economy, a country's currency is valued according to factors of supply and demand. In other words, a currency's value can be pegged to another country's currency, such as the U.S. dollar, or even to a basket of currencies. A country's currency value also may be fixed by the country's government. However, most countries float their currencies freely against those of other countries, which keep them in constant fluctuation. 

The value of any particular currency is determined by market forces based on trade, investment, tourism, and geo-political risk. Every time a tourist visits a country, for example, he or she must pay for goods and services using the currency of the host country. Therefore, a tourist must exchange the currency of his or her home country for the local currency. Currency exchange of this kind is one of the demand factors for a particular currency. Another important factor of demand occurs when a foreign company seeks to do business with a company in a specific country. Usually, the foreign company will have to pay the local company in their local currency. At other times, it may be desirable for an investor from one country to invest in another, and that investment would have to be made in the local currency as well. All of these requirements produce a need for foreign exchange and are the reasons why foreign exchange markets are huge.

Foreign exchange is handled globally between banks and all transactions fall under the auspice of the Bank of International Settlements. The value of a nation’s currency, under a floating exchange rate, is determined by the interaction of supply and demand. We will work through some charts and an example to show how these forces work, from a theoretical point of view.

3. Changes in Demand and Supply of foreign exchange

Factors affecting Demand and Supply of Exchange rate

• Imports and Exportsa rise in import will increase the supply of one’s currency consequence, is depreciation of the currency. Vice versa for exports.

• Money supply of the currencydecrease in money supply of the currency will reduce its supply in the market and shift the supply curve to left giving a rise to the price of the currency.

• Increase in foreign cash inflow an increase in foreign inflow of cash will increase the demand for the currency appreciating the price.

In figure, an increase in the US demand for the pound (rightward shift of the demand curve) causes a rise in the exchange rate, an appreciation in the pound, and depreciation in the dollar. Conversely, a fall in demand would shift the demand curve left and lead to a falling pound and rising dollar. On the supply side, an increase in the supply of pounds to the US market (supply curve shifts right) is illustrated in Figure, where a new intersection for supply and demand occurs at a lower exchange rate and an appreciated dollar. A decrease in the supply of pounds shifts the curve leftward, causing the exchange rate to rise and the dollar to depreciate. …………………………………………………………………….

When the forces between supply and demand change, the market moves in ways to clear itself through a change in price.

In international finance markets, if many investors are selling a particular currency, they are making it more readily available and increasing its supply. If there is not an equal amount of buyers, or demand, for that currency, its price will go down in order to strike a new balance between supply and demand.

The direction in which the value of a currency is heading can cause cash to flow into or out of that currency. A currency that is appreciating can cause money to flow into its country’s assets as investors and Forex traders want to benefit from buying or taking “long” positions on the currency as the currency’s price rises.

4. Exchange rate systems and international business.

a. Free-Floating Systems

In a free-floating exchange rate system, governments and central banks do not participate in the market of foreign exchange. The relationship between governments and central banks on the one hand and currency markets on the other is much the same as the typical relationship between these institutions and stock markets. Governments may regulate stock markets to prevent fraud, but stock values themselves are left to float in the market. The U.S. government, for example, does not intervene in the stock market to influence stock prices.

The concept of a completely free-floating exchange rate system is a theoretical one. In practice, all governments or central banks intervene in currency markets in an effort to influence exchange rates. Some countries, such as the United States, intervene to only a small degree, so that the notion of a free-floating exchange rate system comes close to what actually exists in the United States.

A free-floating system has the advantage of being self-regulating. There is no need for government intervention if the exchange rate is left to the market. Market forces also restrain large swings in demand or supply. Suppose, for example, that a dramatic shift in world preferences led to a sharply increased demand for goods and services produced in Canada. This would increase the demand for Canadian dollars, raise Canada’s exchange rate, and make Canadian goods and services more expensive for foreigners to buy. Some of the impact of the swing in foreign demand would thus be absorbed in a rising exchange rate. In effect, a free-floating exchange rate acts as a buffer to insulate an economy from the impact of international events.

The primary difficulty with free-floating exchange rates lies in their unpredictability. Contracts between buyers and sellers in different countries must not only reckon with possible changes in prices and other factors during the lives of those contracts, they must also consider the possibility of exchange rate changes. An agreement by a U.S. distributor to purchase a certain quantity of Canadian lumber each year, for example, will be affected by the possibility that the exchange rate between the Canadian dollar and the U.S. dollar will change while the contract is in effect. Fluctuating exchange rates make international transactions riskier and thus increase the cost of doing business with other countries.

b. Managed Float Systems

Governments and central banks often seek to increase or decrease their exchange rates by buying or selling their own currencies. Exchange rates are still free to float, but governments try to influence their values. Government or central bank participation in a floating exchange rate system is called a  managed float.

Countries that have a floating exchange rate system intervene from time to time in the currency market in an effort to raise or lower the price of their own currency. Typically, the purpose of such intervention is to prevent sudden large swings in the value of a nation’s currency. Such intervention is likely to have only a small impact, if any, on exchange rates. Roughly $1.5 trillion worth of currencies changes hands every day in the world market; it is difficult for any one agency—even an agency the size of the U.S. government or the Fed—to force significant changes in exchange rates.

Still, governments or central banks can sometimes influence their exchange rates. Suppose the price of a country’s currency is rising very rapidly. The country’s government or central bank might seek to hold off further increases in order to prevent a major reduction in net exports. An announcement that a further increase in its exchange rate is unacceptable, followed by sales of that country’s currency by the central bank in order to bring its exchange rate down, can sometimes convince other participants in the currency market that the exchange rate will not raise further. That change in expectations could reduce demand for and increase supply of the currency, thus achieving the goal of holding the exchange rate down.

c. Maintaining a Fixed Exchange Rate through Intervention…………………………………………………

Initially, the equilibrium price of the British pound equals $4, the fixed rate between the pound and the dollar. Now suppose an increased supply of British pounds lowers the equilibrium price of the pound to $3. The Bank of England could purchase pounds by selling dollars in order to shift the demand curve for pounds to D2. Alternatively, the Fed could shift the demand curve to D2 by buying pounds.

Fixed exchange rate systems offer the advantage of predictable currency values—when they are working. But for fixed exchange rates to work, the countries participating in them must maintain domestic economic conditions that will keep equilibrium currency values close to the fixed rates. Sovereign nations must be willing to coordinate their monetary and fiscal policies. Achieving that kind of coordination among independent countries can be a difficult task.

5. Taxation and tariffs

Another area of great financial importance is taxation. When determining where to pursue business overseas, taxes can be very cost prohibitive, even when other financial, social and political forces are to their advantage. Skillfully negotiating a lower tax burden can be the difference in having the ability to offer a lower product price than ones competitor or not and should therefore be carefully considered.

Tariff and Tax in International Trade

A tariff or customs duty is a tax levied upon goods as they cross national boundaries, usually by the government of the importing country. The words tariff, duty, and customs are generally used interchangeably.

Tariffs may be levied either to raise revenue or to protect domestic industries, but a tariff designed primarily to raise revenue may exercise a strong protective influence and a tariff levied primarily for protection may yield revenue. Gottfried Haberler in his Theory of International Trade suggested that the best objective distinction between revenue duties and protective duties (disregarding the motives of the legislators) is to be found in their discriminatory effects as between domestic and foreign producers.

Tariffs may be further classified into three groups—transit duties, export duties, and import duties.

Transit Duties

This type of duty is levied on commodities that originate in one country, cross another, and are consigned to a third. As the name implies, transit duties are levied by the country through which the goods pass. Such duties are no longer important instruments of commercial policy, but, during the mercantilist period (17th and 18th centuries) and even up to the middle of the 19th century in some countries, they played a role in directing trade and controlling certain of its routes.

Export Duties

Export duties are no longer used to a great extent, except to tax certain mineral and agricultural products. Several resource-rich countries depend upon export duties for much of their revenue. Export duties were common in the past, however, and were significant elements of mercantilist trade policies. Their main function was to safeguard domestic supplies rather than to raise revenue. At the beginning of the 20th century only a few countries levied export duties: for example, Spain still levied them on coke and textile

waste; Bolivia and Malaya on tin; Italy on objects of art; and Romania on hides and forest products. The neo-mercantilist revival in the 1920s and 1930s brought about a limited reappearance of export duties. In the United States, export duties were prohibited by the Constitution, mainly because of pressure from the South, which wanted no restriction on its freedom to export agricultural products.

Export duties may act as a form of protection to domestic industries. As examples, Norwegian and Swedish duties on exports of forest products were levied chiefly to encourage milling, woodworking, and paper manufacturing at home. Similarly, duties on the export from India of unbanned hides after World War I were levied to stimulate the Indian tanning industry. In a number of cases, however, duties levied on exports from colonies were designed to protect the industries of the mother country and not those of the colony.

Import Duties

Import duties are the most important and most common types of custom duties. As noted above, they may be levied either for revenue or protection or both, but tariffs are not a satisfactory means of raising revenue, because they encourage uneconomic domestic production of the dutied item. Even if imports constitute the bulk of the available revenue base, it is better to tax all consumption, rather than only consumption of imports, in order to avoid uneconomical protection.

Import duties are no longer an important source of revenues in developed countries. In the United States, for example, revenues from import duties in 1808 amounted to twice the total of government expenditures, while in 1837 they were less than one-third of such expenditures. Until near the end of the 19th century the customs receipts of the U.S. government made up about half of all its receipts. This share had fallen to about 6 percent of all receipts before the outbreak of World War II and it has since further decreased.

A tariff may be either specific, ad valorem, or compound (i.e., a combination of both). A specific duty is a levy of a given amount of money per unit of the import, such as $1.00 per yard or per pound. An ad valorem duty, on the other hand, is calculated as a percentage of the value of the import. Ad valorem rates furnish a constant degree of protection at all levels of price (if prices change at the same rate at home and abroad), while the real burden of specific rates varies inversely with changes in the prices of the imports. A specific duty, however, penalizes more severely the lower grades of an imported commodity. This difficulty can be partly avoided by an elaborate and detailed classification of imports on the basis of the stage of finishing, but such a procedure makes for extremely long and complicated tariff schedules. Specific duties are easier to administer than ad valorem rates, for the latter often raise difficult administrative issues with respect to the valuation of imported articles.

How tariff is affecting international trade?

It makes foreign products more expensive, which means that consumers have to pay more, which is bad.

It also means the inefficient firms in the protected industry get a free ride. That is very bad for the economy. It means people will earn less in the country over all, and pay more for foreign goods. It means less people will have jobs. It means inflation will be higher.

Tariffs are implied by the government because;

To protect fledgling domestic industries from foreign competition. To protect aging and inefficient domestic industries from foreign competition.

To protect domestic producers from dumping by foreign companies or governments. Dumping occurs when a foreign company charges a price in the domestic market which is "too low". In most instances "too low" is generally understood to be a price which is lower in a foreign market than the price in the domestic market. In other instances "too low" means a price which is below cost, so the producer is losing money.

Who Benefits?.....................................................................................................................................The benefits of tariffs are uneven. Because a tariff is a tax, the government will see increased revenue as imports enter the domestic market. Domestic industries also benefit from a reduction in competition, since import prices are artificially inflated. Unfortunately for consumers - both individual consumers and businesses - higher import prices mean higher prices for goods. If the price of steel is inflated due to tariffs, individual consumers pay more for products using steel, and businesses pay more for steel that they use to make goods. In short, tariffs and trade barriers tend to be pro-producer and anti-consumer.

The effect of tariffs and trade barriers on businesses, consumers and the government shifts over time. In the short run, higher prices for goods can reduce consumption by individual consumers and by businesses. During this time period, businesses will profit and the government will see an increase in revenue from duties. In the long term, businesses may see a decline in efficiency due to a lack of competition, and may also see a reduction in profits due to the emergence of substitutes for their products. For the government, the long-term effect of subsidies is an increase in the demand for public services, since increased prices, especially in foodstuffs, leaves less disposable income. (For related reading, check out In Praise Of Trade Deficits.)

How Do Tariffs Affect Prices?...................................................................................................Tariffs increase the prices of imported goods. Because of this, domestic producers are not forced to reduce their prices from increased competition, and domestic consumers are left paying higher prices as a result. Tariffs also reduce efficiencies by allowing companies that would not exist in a more competitive market to remain open……………………………………………………………………………………

Figure 1 illustrates the effects of world trade without the presence of a tariff. In the graph, DS means domestic supply and DD means domestic demand. The price of goods at home is found at price P, while the world price is found at P*. At a lower price, domestic consumers will consume Qw worth of goods, but because the home country can only produce up to Qd, it must import Qw-Qd worth of goods.

Figure 1. Price without the influence of a tariff

When a tariff or other price-increasing policy is put in place, the effect is to increase prices and limit the volume of imports. In Figure 2, price increases from the non-tariff P* to P'. Because price has increased, more domestic companies are willing to produce the good, so Qd moves right. This also shifts Qw left. The overall effect is a reduction in imports, increased domestic production and higher consumer prices

Figure 2. Price under the effects of a tariff

6. Inflation and deflationThe spending power of one dollar is the goods that can be bought with that dollar. The spending power of money can change overtime. If one dollar buys fewer goods this year than it did last year, then the value of money has been caused by inflation. Inflation can be defined as an increase in the average price level of goods and services.If one dollar buys more goods this year than did last year, then the value of money has increased. This must have been caused by deflation. Deflation can be defined as a fall in the average price level of goods and services. The retail price index RPI is used to measure average price changes. An index number can be used to record average changes in a large number of items.

Causes of inflation

1. Demand-pull. This means buyers want to buy more than sellers can actually produce; so sellers start to put prices up.

2. Cost-push. This means business costs start to rise (eg oil prices rise, or wages start to rise) and sellers need to put prices up to compensate.

3. Monetarist view. This means the government allows too much money to be created. If the supply of money rises, then the price falls just as if the supply of potatoes rises, then the price falls. The price of money here is how many goods and services it will buy. If the price of money falls, then it will buy fewer goods and services i.e. prices of goods and services rise and the value of money falls. This is inflation.

The impact of inflation on international business

Cost increases can be passed on to consumers more easily if there is a general increase in prices.

The real value of debts owed by companies will fall. This means that, because the value of money is falling, when a debt is repaid it is repaid with money of less value than the original loan. Thus, highly geared companies see a fall in the real value of their liabilities.

Rising prices are also likely to affect assets held by firms, so the value of fixed assets, such as land and building, could rise. This will increase the value of business and, when reflected on the balance sheet, make the company more financially secure.

Since stocks are bought in advance and then sold later, there is an increased margin from the effect of inflation.

Therefore, during inflation that are not excessive, business could decide to raise their own prices, borrow more to invest and ensure that increased asset value appear on their balance sheet. However, high rates of inflation say 10% and above can be damaging for the business

Staff will become much more concerned about the real value of their incomes. Higher wage demands are likely and there could be an increase in industrial disputes.

Consumers are likely to become much more price sensitive and look for bargains rather than big names.

Rapid inflation will often lead to higher rates of interest. These higher rates could make it very difficult for highly geared companies to find the cash to make interest payments, despite the fact that the real value of the debts is declining.

Cash flow problems may occur for all businesses as they struggle to find more money to pay the higher costs of materials and other costs.

If inflation is higher in one country than in other countries then business will lose its competiveness in overseas market

Business that sells goods on credit will be reluctant to offer extended credit periods the repayments by creditors will be with money that is losing value rapidly.

Consumers may stockpile some items or transfer thei disposable income t commodities that are more likely to hold or increase value.

Business may be forced to cut back spending, cut profit margins to limit their price rises, reduce borrowing to levels at which the interest payments are manageable hindering stimulation of investment, and layoff workers.

INFLATION AND INTERNATIONAL TRADE

International trade and trade policy are difficult enough to understand when price levels remain relatively constant. But when rapid or chronic inflation are added, most of us find that whatever grip we have on economic principles begins to slip away. This is because general price inflation reflects changes in the level and distribution of real income within countries and across national boundaries. Inflation also tends to change currency exchange rates and international balance of payments accounts. This paper examines briefly some of the major ways in which inflation can influence trade among nations. Inflation is a sustained increase in the general price level of a national economy measured either at the retail or wholesale level. The annual rate of change in this price level, commonly expressed in index numbers, is the inflation rate.

Constant Inflation RatesFirst imagine a curious world in which all trading nations display rapid but equal inflation rates. No changes occur anywhere in relative prices-all conceivable price and cost ratios stay constant over time. Since currency exchange rates are really price relatives, no exchange rates would change in response to this inflation. Thus, no price induced changes in imports, exports, interest rates, capital flows, or balance of payments would occur. Such a world would be uninteresting from our point of view unless this constant international inflation rate was accompanied by unequal rates of change in real income. These could emerge because of differential rates of growth in real output across international borders. Unequal changes in real income could induce changes in commodity trade and foreign exchange through demand shifts, but these would not be inflation phenomena as such. Now consider the more relevant case involving differential inflation rates occurring from one trading nation to another.

Differential Inflation and Fixed Exchange RatesFor whatever underlying reasons, imagine that at least two major trading nations display substantially different internal inflation rates affecting prices of both traded and non-traded goods. If the Rate ofExchange of one nation's currency for that of the other is fixed; relative prices across the border would be changing at a rate equal to the difference between the two inflation rates. For example, if theU.S. inflation rate is 10 percent and the West German rate is 7 percent, then relative prices for U.S. goods would be rising by 3 percent per year in terms of German currency. Similarly, relative prices for German goods in U.S. currency would be falling at 3 percent per year. With fixed exchange rates, the exports of the rapidly-inflating nation would tend to dwindle, and their imports would tend to rise.

In our example, this adjustment would dampen inflation in the United States and heighten it in Germany if large balance of payments surpluses and deficits are not allowed to accumulate and if trade is responsive to price change. This theoretically-tight, international linkage of economic activity and price levels is a major advantage seen by supporters of the gold standard and other types of fixed exchange rates. They favor the automatic external discipline on economic activity and inflation which such schemes provide. With fixed currency exchange rates, inflation is clearly an export commodity. How easily and rapidly inflation can move from nation to nation under fixed exchange rates depends upon the importance of trade in total economic activity and the degree to which exports and imports respond to international price differences. The more important trade is and the more responsive demand and supply are to price changes, the more readily inflation will surge from one country to another.

Flexible exchange rate

The next step in this line of reasoning is to consider the trade impacts of flexible exchange rate adjustments occurring in response to inflation. Fully-adjusting currency exchange markets would completely neutralize the changes in relative prices implied by differential inflation rates. Hence, the purchasing power parity doctrine with flexible exchange rates teaches that we should expect no systematic international trade changes to flow from differential inflation rates themselves.However, if a time lag exists in the rate at which exchange values adjust in response to differential inflation, then the nation with the more rapid inflation will find its exports slipping and its imports rising. Because the value of its currency will not be falling fast enough to maintain equal commodity price relatives. So the net impact that price inflation itself has on international trade hinges upon where actual currency exchange markets fit between the polar extremes of fixity and full flexibility.The Current Situation For the last 10-15 years, the world's trading nations have been edging away from fixed rates toward more flexible, market-determined exchange rates. Governments still intervene heavily in money markets to influence currency values, and currencies of some nations are still welded together in fixed-value blocks.

7. Balance Of Payment: Another financial environmental force

The balance of payment is a statistical record of a country’s transactions with the rest of the world. Payments made to other countries are tracked as debit(-), while payments from other countries are tracked as credits(+). The BOP is considered as a double-entry accounting statement in which total credit and debits are always equal.

CurrentAccountThe balance of the current account tells us if a country has a deficit or a surplus. If there is a deficit, does that mean the economy is weak? Does a surplus automatically mean that the economy is strong? Not

necessarily. But to understand the significance of this part of the BOP, we should start by looking at the components of the current account: goods, services, and income and current transfers.

1. Goods - These are movable and physical in nature, and in order for a transaction to be recorded under "goods", a change of ownership from/to a resident (of the local country) to/from a non-resident (in a foreign country) has to take place. Movable goods include general merchandise, goods used for processing other goods, and non-monetary gold. An export is marked as a credit (money coming in) and an import is noted as a debit (money going out).

2. Services - These transactions result from an intangible action such as transportation, business services, tourism, royalties or licensing. If money is being paid for a service it is recorded like an import (a debit), and if money is received it is recorded like an export (credit).

3. Income - Income is money going in (credit) or out (debit) of a country from salaries, portfolio investments (in the form of dividends, for example), direct investments or any other type of investment. Together, goods, services and income provide an economy with fuel to function. This means that items under these categories are actual resources that are transferred to and from a country for economic production.

4. Current Transfers - Current transfers are unilateral transfers with nothing received in return. These include workers' remittances, donations, aids and grants, official assistance and pensions. Due to their nature, current transfers are not considered real resources that affect economic production.

Why a Current account is considered harmful to the economy

1. If a current account deficit is financed through borrowing it is said to be more unsustainable.

2. Borrowing is unsustainable in the long term and countries will be burdened with high interest payments. E.g. Russia was unable to pay its foreign debt back in 1998. Other developing countries have experience similar repayment problems Brazil, African c (3rd World debt)

3. Foreigners have an increasing claim on UK assets, which they could desire to be returned at any time. E.g. a severe financial crisis in Japan may cause them to repatriate their investments

4. Export sector may be better at creating jobs

5. A Balance of Payments deficit may cause a loss of confidence

 

However a current account deficit is not necessarily harmful

1. Current Account deficit could occur during a period of inward investment (surplus on financial account)

E.g. US ran a current account deficit for a long time as it borrowed to invest in its economy. This enabled higher growth and so it was able to pay its debts back and countries had confidence in lending the US money

2. Japanese investment has been good for UK economy not only did the economy benefit from increased investment but the Japanese firms also helped bring new working practices in which increased labor productivity.

3. With a floating exchange rate a large current account deficit should cause a devaluation which will help reduce the level of the deficit

It depend on the size of the budget deficit as a % of GDP, for example the US trade deficit has nearly reached 5% of GDP (02/03) at this level it is concerning economists

The Capital and Financial Accounts ....................................................................................................Along with transactions pertaining to non-financial and non-produced assets, the capital account relates to dealings including debt forgiveness, the transfer of goods and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets, the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, patents, copyrights, royalties and uninsured damage to fixed assets. Detailed in the financial account are government-owned assets ((i.e., special drawing rights at the International Monetary Fund (IMF) or foreign reserves)), private sector assets held in other countries, local assets held by foreigners (government and private), foreign direct investment, global monetary flows related to investment in business, real estate, bonds and stocks. 

Capital that is transferred out of a country for the purpose of investing is recorded as a debit in either of these two accounts. This is because money is leaving the economy. But because it is an investment, there is an implied return. This return - whether a capital gain from portfolio investment (a debit under the financial account) or a return made from direct investment (a debit under the capital account) - is recorded as a credit in the current account (this is where income investment is recorded in the BOP). The opposite is true when a country receives capital: paying a return on a said investment would be noted as a debit in the current account. 

8. What is indebtness?

Indebtness is the state of a nation being in debt. The national debt of nation can be raised from domestic market as well as external debt. at many instances the country issues various securities like treasury stock like that of Nepal, which is at 9%, bonds etc. this is sold to domestic people and entities which is known as domestic borrowing. Likewise, this security is also sold to other nations and international entities for raising finance for the country. Many countries also acquire direct loans from other nations like Nepal getting loan from US. Moreover the nation is indebt from loans acquired from big international institutions like World Bank or IMF- international monetary fund.

Excesses in debt accumulation have been blamed for exacerbating economic problems. For example, prior to the beginning of the Great Depression debt/GDP ratio was very high. Economic agents were heavily indebted. This excess of debt, equivalent to excessive expectations on future returns, accompanied asset bubbles on the stock markets. When expectations corrected, deflation and a credit crunch followed. Deflation effectively made debt more expensive and, as Fisher explained, this reinforced deflation again, because, in order to reduce their debt level, economic agents reduced their consumption and investment. The reduction in demand reduced business activity and caused further unemployment. In a more direct sense, more bankruptcies also occurred due both to increased debt cost caused by deflation and the reduced demand.

External Debts:

External debt (or foreign debt) is that part of the total debt in a country that is owed to creditors outside the country. The debtors can be the government, corporations or private households. The debt includes money owed to private commercial banks, other governments, or international financial institutions such as the International Monetary Fund (IMF) and World Bank. The debts to the developing countries have been recognized as one of the major obstacles of sustainable human and economic development.

In some of the small countries debts have been properly utilized like in Bhutan and Lesotho debts are used in mega hydro electricity generation projects and therefore the per capita debt are very high. But for many developing countries debt have become obstacles for reason like:

1. Mismanagement2. Mis-utilization3. Rampant corruption and embezzlement by the elite4. Customers siphoning-off by project contractor, international agencies and institutions in

the form of overhead, interests, over valuation and other costs.

The following are the internal and external reasons for the indebtedness of poor developing and least developed countries:

1. Mounting world inflationary pressure due to increase in the price of the fuels, commodities and food stuffs.

2. Rising values of easily convertible currencies of developed countries due to their steady economic growth.

3. Low domestic production or income growth rate in developing and poor nations.4. Chronic and inherited political and socioeconomic constraints and shortcomings.

Conclusion

To sum up this report's analysis can be shown in a cycle:

In the above figure all the financial forces implication on the business and economy is shown. First the cycle starts from the national debt, the country acquires debt when it is unable to support its expenditures and revenue cannot sustain its expenses. If a country rises too much of national debt at such instances it becomes unable to support its obligation, even paying the interest on loan starts becoming troublesome. in such crisis the nation applies the short term measure and simply print more money and supply to banks so as to honor the debt.

Moreover, if there is something of more amounts its value goes down. This is inflation. More money supply simply reduces the value of the currency and makes goods expensive. the nations market will get damped because now the domestic industry experiences the rise in factor cost because of inflation and imports from countries having competitive advantage in terms of cost will take up the domestic market share like goods from China, India, Taiwan etc. the country's goods also loses its competitiveness internationally as there is rise of the price of its goods.

At such instance of losing of competitiveness, the industry that wants to thrive relocates abroad where they can find cheap factor of production. The country continues to import to satisfy its domestic consumption. The domestic industries are losing their competitiveness and have started to close down. The export is in decline. Foreign companies do not want to operate in the nation because of inflation and prospect of recession and instability. Thus, this gives rise to inflation, poor balance of payment, unemployment in the nation because of shutting of businesses consequensing recession.

Furthermore, when the country experiences recession it is in much more pressure to increase its government expenditure. More amount of money is to be spent in welfare payments and the nation will be in huge pressure to pay its debt. This is the instance experienced by Greece. Now the nation will be compelled to acquire more loans from other nations and entities from which it has not loaned before. This will in turn increase the national debt. Thus, if the governments do not intervene and check the situation then this effect will be trickling and the cycle continues.

national debt

recession

worsening of BOP and

unemployment

losing business competitiveness

start of rapid money supply and inflation