7-International Finance(International Business)

Dr Zain Yusufzai

International Finance

Chapter # 7 (page 179-211).

Introduction International finance: an area of study concerned with the balance of payments (BOP) and the international monetary system. Balance of Payments Balance of payments (BOP): The record of all values of all transactions; between a country’s residents and the rest of the world. Measuring a country’s economic activity is by looking at its balance of payments. There are a wide variety of account that determine the BOP, but for purposes of analysis they can be grouped into three broad categories 1. current account items, 2. capital account items, 3. And reserves. Every transaction is recorded in terms of a both a debit and a credit. Import of a good or service, an increase in assets, or a reduction in liabilities. Credits record the export of a good or service, a decrease in assets, or an increase in liabilities. Broad BOP categories International Monetary Fund (IMF): An agency that seeks to maintain balance – of – payments stability in the international financial system Current account The current account consists of  Merchandise trade,  services, and  Unrequited transfers. Merchandise trade is typically the first part of the current. It receives more attention than any of the other accounts because this is where the imports and exports of goods are reported, and these are often the largest single component of all international transactions. In this account, sales of goods to foreigners {exports} are reported as credits because they are a source of funds or a claim against the purchasing country conversely,

International business Alan M. Rugman, Richard M. Hodgetts

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Dr Zain Yusufzai

International Finance

Chapter # 7 (page 179-211).

purchases of goods from overseas {imports} are recorded as debits because merchandise trade a balance – of – payments account that reports imports of goods from foreign sources and exports of goods to foreign destinations Services The services category includes many payments such as freight and insurance on international  tourist travel  profits and income from overseas investment personal expenditures by government, civilians, and military personnel overseas  and payments for management, fees, royalties, film rental, and construction services  Purchases of these services are recorded as debit, while sales of these services are similar to exports and are recorded as credits. Unrequited transfers, a balance – of – payments account that reports transaction which do not involve repayment or performance of any service Capital account Direct investment involves managerial participation in a foreign enterprise along with some degree of control. Capital account items: a balance-of payments account that involves transactions, which involve claims in ownership Reserves Resaves are used for bringing BOP accounts into balance. There are four major types of reserves available to monetary authorities in meeting BOP deficits {D1 though D4 in table 7.1}. US balance of payments US play such a dominant role in the world economy, it is important to examine the US system. Table 7.2 presents US international transactions for two recent yeast. The table shows that  US is exports are strong in areas such as capital goods, industrial supplies and International business Alan M. Rugman, Richard M. Hodgetts

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Dr Zain Yusufzai

International Finance

Chapter # 7 (page 179-211).

materials, consumer goods, and auto vehicles, and parts.  On the other hand, the US is importing a great deal of capital goods, consumer goods, and industrial supplies and materials. It is important to realize that when a country suffers a persistent balance of trade deficit, the nation will also suffer from a depreciating currency and will find it difficult to borrow in the international capital market. There are only two choices available. One is to borrow from the international monetary fund {IMF} and be willing to accept the restrictions that the IMF puts on the country, Introduce austerity and force the country onto the right economic track. Other approach is for the country to change its fiscal policy {tariffs and taxes}, resort to exchange and trade controls, or devalue its currency. International monetary system Overall monetary system includes a wide variety of institutions, financial instruments, rules, and procedures within which foreign exchange markets function. The objective of this system is to create an international environment that is conducive to the flow of goods, services, and capital among motions. Strives to create a stable foreign exchange market, International monetary system: the multinonational arrangement among the central banks that belong to the international monetary fund International monetary fund The overall goals of the IMF were to: 1. Facilitate the balanced growth of international trade. 2. Promote exchange stability and orderly exchange arrangements and discourage competitive currency depreciation. 3. seek the elimination of exchange restriction that hinder the growth of world trade 4. Make financial resources available to members, on a temporary basis and with adequate sate safeguards, to permit them to correct payment imbalances without International business Alan M. Rugman, Richard M. Hodgetts

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Dr Zain Yusufzai

International Finance

Chapter # 7 (page 179-211).

resorting to measures destructive to national and international prosperity. Special drawing right (SDR): The IMF created the special drawing right {SDR} as a unit of value to replace the dollar as a reserve asset, and today a number of countries peg their currency to the SDR. When first created the SDR was linked to gold, but since 1974 its value has been based on the daily market exchange rates of a basket of currencies consisting of the US dollar, British pound, French franc, German mark and Japanese yen 1976 IMF amendment that resulted in a managed float system, International bank for reconstruction and development (see world bank.) World Bank: a multigovernment-owned bank created to promote development projects with lowinterest loans The managed float system The main elements of the agreement included; {A} floating rates were accepted and IMF members were allowed to enter the foreign exchange market to deal with any unwarranted speculative fluctuations; {B} gold was abandoned as a reserve asset; {C} the amount of contributions made by IMF member countries was increased; and {D} less developed countries were given greater access to these funds. Exchange rates have- two major parts: First, it is argued that a floating exchange rate gives countries autonomy over their own monetary policy. On the other hand, with a floating exchange rate, if another argument for floating rates is that they would automatically bring about trade balance the devaluation of its currency in the international return to the fixed exchange rate system that emerged from the Breton woods agreement. The European monetary system

International business Alan M. Rugman, Richard M. Hodgetts

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Dr Zain Yusufzai

International Finance

Chapter # 7 (page 179-211).

Committed itself to establishing a single currency, a commitment that dated back to the initial objective was to attain convergence between the inflation rates and interest rates convergence criteria:  Inflation must be no more than 1.5 percentage points above the average of the three lowest inflation rates in Europe;  long-term interest rates must be no more 2 percentage points higher than the average of the lowest;  the exchange rate must have stayed than of three EU’s exchanger rate mechanism for two years without realignment ;and  The accumulated stock of public debts must not exceed 60 per can of gross domestic product. The When the EMS was created in 1979 it was given three objectives; 1. to create a zone of monetary stability 2. to control inflation through the use of monetary discipline 3. to coordinate exchange rate (Ecu) as a unit of account for the European monetary union {EMU} January 1, 2002, consumers in 12 of the EU member states started using Euro as domestic currencies. The other three countries-Britain, Denmark, and Sweden may join the euro in the next few years. European monetary system (EMS): a system created by some major members of the EU which fixes their currency values in relation to each other (within a band) and floats them together against the rest of the world The IMF and the World Bank today Last couple of decades the role of the IMF has declined. Floating exchange rates have resulted in a diminished demand for short-term loans, and no major industrialized country has borrowed money from the IMF for over 20 years. Britain and the US have financed their deficits by borrowing private money rather than relying on IMF funds. As a debt was rescheduled, new loans were made, and an IMF-dictated series of macroeconomic policies were accepted by the International business Alan M. Rugman, Richard M. Hodgetts

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Dr Zain Yusufzai

International Finance

Chapter # 7 (page 179-211).

Mexican government including tight control over the growth of the money supply and major cuts in government spending. The Brady plan rested on the belief that debt reduction was a necessary part of the solution and the IMF and world have to assume roles in financing it Economic cooperation No matter what steps are taken to alter the international monetary system, without cooperation among the major economic powers, nothing substantive will happen. In particular, there will have to be greater coordination in the conduct of national policies by the industrialized nations. Foreign exchange For purposes of international business, there are three important areas of foreign exchange that warrant consideration; {1} foreign exchange market in the US, {2} participants in foreign exchange markets, and {3} determination of exchange rates. Foreign exchange: Any financial Instrument that carries out payment from one currency to another Exchange rate: The amount of one currency that can be obtained for another currency

Foreign exchange markets in the US There are three major ways of conducting foreign exchange in major countries such as the US; 1. between banks, 2. through a broker 3. and through forward transactions. The inter-bank market for foreign exchange involves transactions between banks. The brokers’ market cozies of a small group of foreign exchange brokerage companies that make markets in foreign currencies. These brokers do not take currency positions. They simply match up buyers and charge a commission for their services. International business Alan M. Rugman, Richard M. Hodgetts

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Dr Zain Yusufzai

International Finance

Chapter # 7 (page 179-211).

Three types of exchange rate; that are important to those dealing in foreign exchange; spot, forward, and cross. The forward foreign exchange market is particularly important to MNs because it lets a customer “lock in” an exchange rate and thus protect against the risk of an unfavorable change in the currency that is needed. Very important to firms doing business overseas and dealing in foreign currency. 1. Spot rate: the rate quoted for current foreign currency transactions 2. Forward rate: the rate quoted for the delivery of foreign currency at a predetermined future date such as 90 days from now 3. Cross rate: an exchange rate computed from two other rate s, such as the relationship between Swiss francs and German marks Participants in foreign exchange markets There are five major groups that are active participants in foreign exchange markets traders/ brokers, speculators, hedgers, arbitrageurs, and governments. Foreign exchange brokers: individuals who work in brokerage firms where they often deal in both spot rate and forward rate transactions Foreign exchange traders: individuals who buy and sell foreign currency for their employer Speculator: in foreign exchange markets an open position Foreign exchange hedgers: individuals who limit potential losses by locking in guaranteed foreign exchange positions Foreign exchange arbitrageurs: individuals who simultaneously buy and sell currency in two or more foreign markets and profit from the exchange rate differences Governments

International business Alan M. Rugman, Richard M. Hodgetts

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Dr Zain Yusufzai

International Finance

Chapter # 7 (page 179-211).

Although the currencies of most developed countries are allowed to float on the open market, governments will sometimes intervene as buyers or sellers in order to crest or maintain a particular price. For example, many countries of the world hold US dollars, so it would not be in their best interests to see the dollar drop sharply. Such a development would reduce the value of their holdings as will as increase the ability of the US to export to them {since imports would now be cheaper given the increased value of their foreign currencies}. So government would intervene to buy dollars in the marketplace in order to shore up the value of he US currency. Determination of exchange rates Rates are determined by the activities of the five groups discussed in the previous section. Purchasing power parity (PPP) Purchasing power parity (PPP): theory an international finance theory that holds that the exchange rate between two currencies will be determined by the relative purchasing power of hose currencies Interest rates There are three key elements in the fisher effect: 1. the nominal rate of interest, which is the interest rate is being charged to a borrower, called the “money” rate of interest to distinguish it from the “real” rate; 2. the rate of inflation in the country; and 3. The real interest rate, which is the difference between the nominal rate and the inflation rate. Fisher effect: An international finance theory, which describes the relationship Between inflation and interest rates and holds that, as inflation raises, so will the nominal interest rate

Nominal rate of interest:

International business Alan M. Rugman, Richard M. Hodgetts

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Dr Zain Yusufzai

International Finance

Chapter # 7 (page 179-211).

the interest rate charged to a borrower, it is called the,”money”rate of interest to distinguish it from the” real” rate

Real interest rate: The difference between the nominal interest rate and the rate of inflation

International fisher effect (IFE): An international finance theory, which holds that the interest rate differential between two countries is a future, changes in the spot exchange rate Other considerations” Other factor also helps to determine exchange rates. One is confidence in the currency. Other factors that influence exchange rates are called “technical factors” these consist of such things as the release of national economic statistics, seasonal demands for a currency weakening of a currency followed by a prolonged weakness, and the slight wakening of a currency following a sharp run-up in the exchange rate. Although technical factors do not generally result in large exchange rate changes, they do account for some of the movement. Strategic management and international finance One of the primary areas of strategic considerations is strategies for dealing with currency exchange rate risk. Another is the financing of international operations. Strategies for managing currency exchange rate risk One step is to negotiate a lower price with the Taiwan supplier and thus share the effects of the devaluation. A second is to pass along the price increase as possible and absorb the rest. A third, and complementary, approach is to take steps to minimize exchange risk. The three most common ways of doing this are exchange risk avoidance, exchange risk adaptation, and currency diversification. Exchange risk: International business Alan M. Rugman, Richard M. Hodgetts

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Dr Zain Yusufzai

International Finance

Chapter # 7 (page 179-211).

The probability that a company will be unable to adjust prices and costs to offset changes in the exchange rate Exchange risk avoidance: The elimination of exchange risk by doing business locally Exchange risk adaptation: The use of hedging to provide protection against exchange rate fluctuations Currency diversification the spreading of financial or more currencies Financing of operations: Another important area that warrants considerations: foreign capital markets. Not all financing is done in the home country. Quite often company will seek capital on an international basis and borrow or lend money where the rates are most attractive Borrowing and lending Anglo gold: going global, raising capital Eurocurrencies Any currency banked outside its country of origin Eurodollars: Dollars danced outside the US London inter bank offered rate (LIBOR) The interest rate banks charge one another on Eurocurrency loans Foreign bond: A bond sold outside the borrower’s country Eurobond: A financial instrument that is typically underwritten by a syndicate of banks from different countries and is sold in countries other than the one in which its currency is denominated

International business Alan M. Rugman, Richard M. Hodgetts

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Dr Zain Yusufzai

International Finance

International business Alan M. Rugman, Richard M. Hodgetts

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Chapter # 7 (page 179-211).