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FIN 329 International Business Finance Multinational Financial Management: opportunities and challenges    

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A multinational enterprise (MNE): has operating subsidiaries, branches or affiliates located in foreign countries. The ownership of some MNEs is so dispersed internationally that they are known as transnational corporations. ‘Enterprise’ – to include organizational forms that are not limited to corporations; however, we will use MNC (multinational “Corporation”) and MNE interchangeably. While multinational business finance emphasizes MNEs, purely domestic firms also often have significant international activities: o Import & export of products, components and services o Licensing of foreign firms to conduct their foreign business o Exposure to foreign competition in the domestic market o Indirect exposure to international risks through relationships with customers and suppliers The prices of purely domestically produced roses are affected by the prices of Tulips produced by the Netherlands. Examples of multinationals: o Manchester United is listed on NYSE, although it is based in the UK they decided to raise their money in the US o Toyota North America – manufacturing: Alabama, Indiana, Kentucky, Mississippi, Texas, West Virginia o Volvo (Swedish brand) – owned by Geely Automobile from China o Chrysler is a subsidiary of Fiat from Italy); Fiat is now FCA (Fiat Chrysler Automobiles); FCA as a holding co operates two main subsidiaries: 1) FCA Italy 2) FCA US (or ‘Chrysler’). o Jaguar and Land Rover (based in the UK) are owned by Tata Motors from India o Lamborghini (Audi) is owned and operated by Volkswagen from Germany o The majority of iphones (APPLE, which is supposed to be american) are produced in Zhengzhou, China (operated by Foxconn from Taiwan)

Theory of Comparative Advantage – David Ricardo    

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Country A has ‘Absolute Advantages’ in producing both product X and product Y, as compared to country B (i.e. A is more efficient than B in both). However, let’s say B has a ‘Comparative (relative) Advantage’ in producing Y -> B has lower opportunity costs Then both A and B can “GAIN” from trades in which A produces X, B produces Y, and then they TRADE. Example o Bill Gates and a secretary: Bill is better (more efficient) at 1) making software and 2) doing office paperwork than a secretary; o but both will be better off if Bill focuses on making software and hire the secretary & have him do office paperwork  efficiency gap is larger in 1) than in 2): the secretary has ‘comparative (relative) advantage’ in 2); Bill has ‘comparative advantage’ in 1). counter-intuitive yet brilliant theory (early 19c)  explains division of labor, specialization, and (international) trade  ‘gains from trade’* growth in global trading: countries specialize at production of goods for which they have a comparative advantage

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Ricardo: “Trade binds together, by one common tie of interest and intercourse, the universal society of nations throughout the civilized world,” Most economists still agree that globalization fosters political stability and cooperation The traditional comparative advantage model gets complicated: o By trade barriers, government interference, sovereignty, etc. o By uncertainty and information costs, the role of differentiated products in imperfectly competitive markets. Comparative advantage is still a relevant theory in the 21st century: ((good example)) the extent of global outsourcing that is reaching out to every corner of the globe

Brexit and other Effects of Protectionism     

Immediate effect was a drop in both the pound and the euro but an increase in the value of the dollar and yen -> „flight to safety“ by people that become increasingly ancious and try to find safe harbors Effect of increasing protectionist sentiment, nationalism, anti-establishment and immigration (similarily as the US and several european elections) One reason is the shrinking middle class (the median US household income didn’t change in the recent decades, however costs went up) Costs of globalization were underestimated The structure of the economy changed such that a lot of jobs got lost (automization and robotization)

The International Monetary System 

History of the Monetary System o The Gold Standard (1876-1913)  Gold was used since the time of the pharaos  During the free-trade period in the nineteenth century, many countries set a par value for its currency in terms of gold an tried to adhere the so-called “rules of the game” (classical gold standard)  Each country set the rate at which its currency unit (paper/coin) could be converted to a given weight of gold  Fixed exchange rates between currencies  Very important for each country to maintain reserves of gold sufficient to back the currency’s value  trade is made easier as there is no uncertainty about the future exchange rate  Implicitly limited the rate at which any individual country could expand its money supply (limited to the rate local authorities could acquire gold)  Trade dominated capital flows  Increased world trade with limited capital flows o The Interwar Years and WW II (1914-1944)  war prevented fold from flowing freely -> interrupting supply/demand of gold  currency value fluctuated over a fairly wide range in terms of gold and each other -> overall currency volatitily increased  Flexible exchange rates depending on supply and demand for a currency existed throughout WW I an the 20’s but didn’t work out in an equilibrating manner as shortselling of weak currencies by international speculators worsened their value without taking into account the real economic factors  Re-adoption of the gold standard in the 30’s

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 Protectionism and nationalism  Increased trade barriers and barriers in capital flows o Bretton Woods and the International Monetary Fund (1994)  Meeting to create a new monetary system after WW II  IMF (aids countries with balance of payments and exchange rate problems) and World Bank (helped fund post-war reconstruction and supports general economic development) were created  Under original provisions, countries fixed value of their currencies in terms of gold but weren’t required to exchange their currencies for gold, only dollar remained convertible into gold -> each country set its exchange rate vis-à-vis the dollar  Dollar was pegged to gold, the other currencies were pegged to the dollar  “gold exchange standard”  Creation of a special drawing right (SDR): international reserve asset, nowadays a weighted sum of dollar, euro, yen and pound o Fixed Exchange Rates (1945-1973)  Gold exchange standard system broke due to differential rates of inflation, diverging national monetary and fiscal policies and various unexpected external shocks  US had persistent trade deficits -> capital outflow of dollar -> was required to finance these deficits -> resulted in lack of confidence in the ability of the US to meet its commitments in gold  due to the Vietnam War, the US had to raise a large amount of money in the 60’s  printed money ( FED bought a lot of treasury bonds)  inflation of dollar -> price of gold went up  countries often plugged the peg to the dollar in order to devalue their currencies  from 1973 on, Nixon declared the end of the gold exchange standard and most countries relieved the peg of their currencies on the dollar  Expanded open economies  Capital flows begin to dominate trade o The Floating Era (1973-1997)  Capital flows dominate trade  Industrial economies increasingly open, emerging nations open slowly o The Emerging Era (1997-Present)  Global monetary system has already begun embracing a number of major emerging market currencies  Selected emerging nations open capital markets  Capital flows drive economic development Eurocurrencies: o domestic currencies of one country on deposit in a second country o eurodollar: dollars deposited (e.g. in Germany) o benefits:  not regulated (not within the control of the US government)  very liquid  large, major source of capital o started with pound traded in thailand (“europound”) o LIBOR (London Interbank Offered Rate) is the reference rate of interest in the eurocurrency market -> most widely accepted interest rate used in standardized quotations, loan agreements,… The Classification of Currencies by the IMF o Since Asian Crisis, IMF rates a currency based on an ex post analysis and not submissions by governments

classification due to:  independent floating  crawling pegs  exchange rates within crawling pegs  managed floating with no pre-announced path  pegged exchange rates within horizontal bands  other conventional fixed peg arrangements  exchange arrangements with no separate legal tender (do not have their own currency -> e.g. Eurozone)  currency board arrangement o Categories of currencies (determined by whether the exchange rate is determined by markets or official action)  Hard Pegs: countries have given up their own sovereignty over monetary policy (have adopted other countries’ currencies), extreme currency regime peg such as Currency Boards or Dollarization  Soft Pegs: have fixed exchange rates but authorities maintain a set but variable band about some other currency  Floating Arrangements: currencies are mostly market-driven (may be occasional government intervention)  Residual: everything not fitting in the other categories, countries that often change their policy Fixed exchange rates o Provide stability in international prices for the conduct of trade -> aid the growth pf international trade and lessen risks for all businesses o Inherently anti-inflationary, require the country to follow restrictive monetary and fiscal policies, can be a burden for a country (inflation -> devaluation pressure on the currency -> government has to buy back its own currency to retain the fixed rate and sell dollars (or buy the own currency with the currency fixed to -> money supply goes down -> inflation goes down) o Require that countries maintain large cash balances of foreign currencies to stabilize the exchange rate o Must be changed administratively -> usually too late, with too much publicity and at too large one-time cost to the nation’s economic health o rates may be inconsistent with economic fundamentals o choice between fixed and flexible exchange rates depend on inflation, unemployment, interest rate levels, trade balances and economic growth The Impossible Trinity of a Perfect Currency o Must inherit all of the following factors:  Exchange rate stability: investors can be certain of foreign exchange value of each currency in present + near future -> managed/pegged exchange rate  Full financial integration: complete freedom of monetary flows -> easy to move funds from one country to another in response to perceived economic opportunities and risks  Monetary independence: national monetary policies, print money whenever they want o Forces of economics don’t allow to simultaneously achieve all three goals o

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The Euro o Aim was to eliminate currency risks associated with cross-border trade o First step was to integrate the countries’ monetary and fiscal policies (“convergence”) o Convergence criteria:  Less than 1.5% above nominal inflation of average of three EU members with lowest rate  Less than 2% above longterm inflation rate of average of three EU members with lowest rate  Budget deficits less than 3% of GDP  Government debt less than 60% of GDP o Launch in 1999 o Benefits:  Less transaction costs  Currency risks related to exchange rate uncertainty are reduced  Increased price transparency and price-based competition Emerging Markets and Regime Choices o Currency Boards  Exists when a country’s central bank commits to back its monetary base (=money supply) entirely with foreign reserves at all times  Unit of domestic currency can only be introduced with a unit of a foreign exchange reserves being obtained  Implemented in Argentina: pegs the peso to the dollar on a one-to-one basis, made the monetary policy of Argentina dependent on the ability to acquire dollars through trade/investment  no possibility of seignorage, cannot print money/control money supply -> no central bank o Dollarization  Use of U.S. Dollars as official currency  Benefits: removal of currency volatility (against the dollar), greater economic integration with other dollar-based markets  Disadvantages: loss of sovereignty over monetary policy, loss of power of seigniorage (ability to profit from printing its own money), central bank doesn’t serve as first lender o Bi-polar choice = choice between rigidly fixed or floating currency o Any currency regime is made difficult by the following factors:

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Weak fiscal, financial and monetary institutions Tendencies for commerce to allow currency substitution and the denomination of liabilities in dollars  Emerging markets’ vulnerability to sudden stoppages of outside capital flows Globalizing the Chinese Renminbi o Renminbi = RMB, has been carefully controlled o CNH and CNY are other Chinese currencies o RMB since 2015 considered a reserve curreny o China tried to keep the RMB down by selling RMB and buying dollar -> build up large foreign exchange reserves o Market is divided into two parts: the China Onshore Market and the Hong Kong Offshore Market  Restricted exchange of currency in and out of the onshore market  CNH is traded offshore/in Hongkong  export/import activities are less sensitive to movements in currency value vis-à-vis the dollar  Onshore Market (CNY): traded through the Foreign Exchange Trade System (CFETS) -> PBOC (People’s Bank of China) sets a daily parity rate against the dollar (fixing), continues to be deregulated. CNY is not a convertible currency that can be traded internationally  offshore market (CNH): Hong Kong based market, created in the attempt to make an effort toward currency globalization o Yuan’s rise lead to more expensive import (import is high in China), due to former low-value currency policy that didn’t reflect economic reality o at the beginning of 2017, the foreign exchange reserves of China were at a pretty low level as PBOC is commited to use their reserves to buy up yuan and used capital control to prop up the currency and prevent people from sending their money offshore -> efforts to stabilize the yuan were the main reason for the drop, other reason: strengthening of the dollar aigainst other currencies -> value of non-dollar-denominated assets dent in dollar terms  POBC is trying to gradually deflate the Yuan that has been overvalued for years  POBC’s efforts to keep the Yuan up has only led to more people believing in a further devaluation of the Yuan -> want to export their capital -> more pressure on the Yuan (“vicious cycle”)  Yuan’s fall has been triggered by the rising dollar and capital outflows  will be difficult to maintain the stability of the Yuan as Trump has signaled harder approach to China -> could raise interest rate in U.S. -> attract investors and lure money out of emerging markets as China  some Chinese economists now urge the POBC to stop market intervention and let the Yuan find its market value  despite the drop, the yuan is still considered overvalued  China still has enough foreign exchange currencies to meet its foreign debt but the M2 ratio (currency reserves to M2 – the broad money supply with savings deposits and money-market funds and cash) is not that high anymore (measure is used by the IMF to measure the sufficiency of a countries’ exchange reserves) o Yuan rose again in late 2017  complicates Chinas strategy to slow down growth  more than recouped the former decline  rise is due to softening dollar and POBC’s efforts  more individuals have holding in the Yuan -> have trust in the currency  POBC’s efforts have not only prevented capital outflows but also not attracted foreign investors to buy Chinese stocks and bonds

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Chinese individuals and companies want to diversify and also invest abroad  lack of fundamental drivers to keep the currency up: industrial overcapacity, high debt, out-of-balance housing market  domestic demand in goods is low -> China relies on export which is made more expensive by the rising Yuan  trade with other countries has already dropped  POBC added a “countercyclical factor” in May -> since then the Yuan rose again The Triffin Dilemma o Theoretical concern about being an international reserve currency o Potential conflict that may arise between domestic monetary and currency policy objectives and external/international policy o Domestic policy may require a trade on balance surplus while being an international reserve currency may require running an account deficit (capital export) -> country needs to be internationally indebted

Major trade off’s o Non-cooperation vs cooperation between countries: whether to consult and act in unison with other countries or operating independently as a member of a system o Policy rules vs discretionary policy: whether a country’s government has strict intervention requirements (rules) or if it may choose whether/when and to what degree to intervene in the foreign exchange markets (discretion)

The Balance of Payments    

balance of payments = measurement of all international economic transactions taking place between residents of a country and foreign residents rather a cashflow statement than a balance sheet exchange of real assets (exchange of goods and services for other goods or money) and exchange of financial assets (exchange of financial claims for other financial claims or money) are dominant recorded business transactions why it is important o indicator of pressure on a country’s foreign exchange rate -> of the potential for a firm trading with/investing in that country to experience foreign exchange gains or losses

changes may signal the imposition/removal of controls over payment of dividends and interest, license fees,… o helps to forecast a country’s market potential o affects various government policies Terminology: o BOP credit = event that records foreign exchange earned (export of a good/service), decrease in asset or increase in liability, SOURCE, (+) o BOP debit = records foreign exchange spent (payments for imports), increase in asset or decrease in liability, USE, (-) The Accounts of the Balance of Payments o sub-accounts: current account, capital account and financial account, official reserves account, net errors and omissions account  current account: includes all international economic transactions with income/payment flows occuring within the period, subcategories:  goods trade: export and import of goods, preference is for balance/surplus on goods trade, balance of trade refers to the balance of import and export of goods only  services trade: export and import of services (travel services, financial services, construction services, consulting)  income: income associated with investments made in previous periods, wages and salaries paid to nonresident workers  current transfers: transfer payments made by migrant/guest workers back to their home countries, financial settlements associated with the change in ownership of real resources/financial items  financial account  four components: direct investment, portfolio investment, net derivatives and other asset investment  uses degree of control over the assets/operations to classify financial assets  direct investment = investment that has a long-term life/maturity in which the investor exerts some explicit degree of control over the assets (10% or more stocks) o e.g. purchase of a foreign company by a US company o when capital flows out of the US it enters the balance of payments as a negative cash flow o if a foreign firm purchases a firm in the US, it is considered as capital inflow and enters the balance of payments positively o concerns in foreign direct investment:  restrictions in ownership rights of foreign assets by non-residents  profits from the US enterprise...