1. The International Finance Environment PDF

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Taught by Rong Huang...

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1. The International Finance Environment Who is interested in International Finance?  Multinationals  Domestic firms (exporters, importers, competing with foreign firms)  Commercial and investment banks  International investment managers / analysts Globalization and the Multinational Firm Four questions will be being answered: 1. What’s Special about “International Finance”? As a multinational company, you will face two main risks: foreign exchange risk and political risk. You also need to take into account market imperfections and on the other side there is an expanded opportunity set. Foreign Exchange Risk:  The risk that foreign exchange currency profits may evaporate in dollar terms due to unanticipated unfavourable exchange rate movements  Suppose that $1 = ¥100 and you buy 10 shares of Toyota at ¥10,000 per share  One year later, the investment is worth 10% more in yen: ¥110,000  But, if the yen has depreciated to $1 = ¥120, your investment has actually lost money in dollar terms. Political Risk:  Sovereign governments have the right to regulate the movement of goods, capital and people across their borders  These laws can sometimes change in unexpected ways  For example, a multinational company operating in multiple countries can be affected by changes that the government makes Market Imperfections:  Legal restrictions on the movement of goods, people and money  Transaction costs  Shipping costs  Tax arbitrage Expanded Opportunity Set  It doesn’t make sense to play in only one corner of the sandbox  Multinational companies operating in different countries is a way of diversification of your risk  True for corporations as well as individual investors where they invest in stocks in different countries to minimise risk  Remember that they will face an exchange rate or political risk that may affect their investment.

Multinational Corporations  A firm that has incorporated on one country and has production and sales operations in other countries

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Many MNCs obtain raw materials from one nation, financial capital from another, produce goods with labour and capital equipment in a third country and sell their output in various other national markets o These can be said to be the main reasons why a firm can become multinational; they are market seekers, they are raw material seekers, they are production efficiency seekers o By operating in different countries, they can gain access to the knowledge (technology, managerial expertise) of this specific country and can then transfer this knowledge to their origin country o They are also political safety seekers – this means they will operate in countries where the political risk is almost 0

International Monetary System Look at Mexico peso crisis Asian currency crisis Argentine peso crisis on my own in textbook Evolution of the International Monetary System: Bimetallism: Before 1875  A “double standard” in the sense that both gold and silver were used as money  Some countries were on the gold standard, some were on the silver standard, some on both  Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents Classical Gold Standard: 1875 – 1914  In most major countries: o Gold alone was assured of unrestricted coinage (only gold) o There was two-way convertibility between gold and national currencies at a stable ratio o Gold could be freely exported and imported  The exchange rate between two country’s currencies would be determined by their relative gold contents o i.e. gold was the benchmark to determine the exchange rate between the country’s national currencies  There are shortcomings: o The supply of newly minted gold is so restricted that the growth of world trade and investment was hindered because of the lack of sufficient monetary reserves o Even if the world returned to a gold standard, any national government could abandon the standard therefore, it wouldn’t make sense to have it Interwar Period: 1915 – 1944  Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market  Attempts were made to restore the gold standard by some countries, but participants lacked the political will to “follow the rules of the game”  The result for international trade and investment was profoundly detrimental

Bretton Woods System: 1945 – 1972  Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire  The purpose was to design a post war international monetary system  The goal was exchange rate stability without the gold standard  The result was the creation of the IMF and the World Bank  Under the Bretton Woods system, the US Dollar was pegged to gold at $35 per ounce and the other currencies were pegged to the US dollar  Each country was responsible for maintaining its exchange rate withing ±1% of the adopted par value by buying or selling foreign reserves as necessary  The Bretton Woods system was a dollar-based gold exchange standard The Flexible Exchange Rate Regime: 1973 – Present (focus more on this)  Flexible exchange rates were declared acceptable to the IMF members o Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities  Gold was abandoned as an international reserve asset  Non-oil-exporting countries and less-developed countries were given greater access to IMF funds Current Exchange Rate Arrangements  Free Float o The largest number of countries, about 48, allow market forces to determine their currency’s value  Managed Float o About 25 countries combine government intervention with market forces to set exchange rates  Pegged to another currency o Such as the US dollar or euro (e.g. French franc or German mark)  No national currency o Some countries do not bother printing their own currency o E.g. Ecuador, Panama and El Salvador have dollarized. Montenegro and San Marino use the euro

$ / £ Exchange Rate 

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The flat period is before the free flow exchange rate was introduced in 1971 After 1971, the graph shows that the exchange rate between £ and $ fluctuated and is volatile You can see the movement of the exchange after the financial crisis in

2007 – the value of the dollar against the pound fell.

The Asian Crisis of 1997: A Chronology of Events  Capital flows into Thailand as a result of rapid economic growth and cheap borrowing rates in international markets  Excessive expansion leads to excessive indebtedness  Current account deficit turns into overall balance of payments deficit  Markets raise questions about the economy’s ability to repay debt. Baht is under pressure  Thai government’s intervention was unsuccessful. On July 2 nd 1997, the baht is allowed to float and it fell by 17% against the US$  Within days, a number of neighbouring Asian nations came under speculative attack Argentina In Crisis  Economic reforms started in 1991  A Currency Board was established  Hyperinflation is brought down from over 3000%  The Economy grows by 7% p.a. in real terms during 1991 – 1994  There is a loss of competitiveness after the Asian, Russian and Brazilian crises and the fall of the $ against the Yen and the Euro  The economy is in recession from 1998 with unemployment at 20%  Argentina defaults on its debt ($155bn) in December 2001  The currency is devalued in January 2002 and the peso floats in February 2002 European Union  The ultimate fixed exchange rate system: 1 currency (euro) for all participating countries o Germany, France, Italy, Belgium, Netherlands, Luxembourg, Austria, Finland, Ireland, Portugal and Spain o UK, Denmark and Sweden declined to join in 1999 but joined later. o Greece did not initially qualify

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Began Jan 1st 1999, where all currencies were permanently fixed against the Euro By 2002, all national currencies were replaced by the Euro New members of the EU who join will gradually join the Euro-bloc...