1. Globalization and the Multinational Firm
Financial management is mainly concerned with how to optimally make various corporate
financial decisions, such as those pertaining to investment, financing, dividend policy, and
working capital management, with a view to achieving a set of given corporate objectives. In
many countries maximising shareholder wealth is considered the most important corporate
objective.
The reason we need to study international financial management is because we now live in a
highly globalized and integrated world economy.
What’s special about International Finance?
Three major dimensions set international finance apart from domestic finance;
1. Foreign exchange and political risks
• Depreciation of a foreign currency may price your products out of that market
• Hungarian house owners defaulting on their € mortgages as the Forint falls
• A sovereign country can change the “rules of the game”
2. Market imperfections
• Several barriers still hamper free movements of people, goods, services, and
capital across national boundaries, which may motivate MNCs to locate
production elsewhere
i. Legal restrictions
ii. Excessive transaction and transportation costs
iii. Information asymmetry
iv. Discriminatory taxing
3. Expanded opportunity set
• Production locations
• Economies of scale
• Funding and investment options
Globalization of the World Economy: Major Trends and Developments
1. Emergence of globalized financial markets
• 1980s and 90s saw a rapid integration of international capital and financial
markets following governments deregulating their foreign exchange and
capital markets
• London Stock Exchange eliminated fixed brokerage commissions in 1986, as
well as eliminating the separating of the order-taking function from the
market-making function. The latter made it possible for foreign commercial
banks to be eligible for membership on the LSE
• Heightened competition introduced various instruments
o Futures and options
o International mutual funds
o Exchange-traded funds (ETFs)
• Corporations started to list their shares across borders
• Advancements in computer and telecommunications technology (internet)
2. Emergence of the Euro as a global currency
• Opened up continent wide capital markets
3. Europe’s sovereign debt crisis of 2010
• Following Greece, panic spread to other weak European countries, affecting
bond prices
, 4. Continued trade liberalization and economic integration
• From 1950 to 2011, international trade increased nearly three times as fast as
world GDP
• Theory of comparative advantage; it is mutually beneficial for countries if they
specialize in the production of those goods they can produce most efficiently
and trade those goods among them: Liberalization of international trade will
enhance the welfare of the world’s citizens
• Global trade agreements (GATT and the WTO)
• Regional arrangements (EU and NAFTA)
5. Large-scale privatization of state-owned enterprises
• Through privatization a country divests itself of the ownership and operation
of a business venture by turning it over to the free market system
6. The global financial crisis of 2008-2009
Multinational corporations
In addition to international trade, foreign direct investment by MNCs is a major force driving
the globalization of the world economy.
A multinational corporation (MNC) is a business firm incorporated in one country that has
operations (production and sales) in a variety of countries. They receive funds from different
currencies, forcing the treasurer’s office to establish international banking relationships, place
short-term funds in several currency denominations, and effectively manage foreign exchange
risk.
MNCs may gain from their global presence in a variety of ways;
1. Can benefit from economies of scale by
a. Spreading R&D expenditures and advertising costs over their global sales
b. Pooling global purchasing power over suppliers
c. Utilizing their technological and managerial know-how globally with
minimum additional costs
2. Can use their global presence to take advantage of under-priced labour services in
developing countries, and gain access to special R&D capabilities in advanced
countries
3. Offshore outsourcing
, 2. International Monetary System
The international monetary system can be defined as the institutional framework within which
international payments are made, movements of capital are accommodated, and exchange
rates among currencies are determined. It is a complex whole of agreements, rules,
institutions, mechanisms, and policies regarding exchange rates, international payments, and
the flow of capital.
Evolution of the international monetary system
The international monetary system went through several distinct stages of evolution.
1. Bimetallism: Before 1875
• Bimetallism; a double standard in that free coinage was maintained for both
gold and silver, which were also used for international payments
2. Classical gold standard: 1875-1914
• Majority of countries were on the gold standard by this time. An international
gold standard can be said to exist when, in most major countries;
i. Gold alone is assured of unrestricted coinage
ii. There is two-way convertibility
iii. Gold may be freely exported and imported
• Under the gold standard, the exchange rate between any two currencies will be
determined by their gold content. Misalignment of the exchange rates will be
automatically corrected by cross-border flows of gold
i. If you wish to buy 1,000 francs using pounds, you can either do so by
directly buying from the exchange market, or (if it is cheaper), buy gold
with pounds, ship that to France, and sell the gold to a French bank
• Imbalances of payment will also be corrected automatically
i. If Great Britain exported more to France that vice versa, more gold
would go in Great Britain, appreciating its currency and reducing
exports/increasing imports (price-specie-flow mechanism)
3. Interwar period: 1915-1944
• Many countries suspended redemption of banknotes in gold and imposed
embargoes on gold exports. Some experienced hyperinflation
• After the war, many countries tried to restore the gold standard, but it failed as
many countries followed a policy of sterilization of gold by matching inflows
and outflows of gold with reductions and increases in domestic money and
credit
4. Bretton Woods system: 1945-1972
• International Monetary Fund (IMF) was launched 1945, which embodied an
explicit set of rules about the conduct of international monetary policies and
was responsible for enforcing these rules
• Under the Bretton Woods system, each country established a par value against
the U.S. dollar, which was pegged to gold at $35 per ounce. Each country was
responsible for maintaining its exchange rate within 1% of the adopted par
value by buying or selling foreign exchanges as necessary
• Triffin paradox: To satisfy the growing need for reserves, the U.S. had to run
balance-of-payments deficits continuously, thereby supplying the dollar to the
rest of the world. Eventually this would impair the public confidence in the
dollar, triggering a run on the dollar
, 5. Flexible exchange rate regime: Since 1973
• After the demise of the Bretton Woods system, the IMF members met in
Jamaica. The key elements of the Jamaica Agreement include:
i. Flexible exchange rates were declared acceptable to the IMF member,
and central banks were allowed to intervene in the exchange markets to
iron out unwarranted volatilities
ii. Gold was officially abandoned as an international reserve asset. Half of
the IMF’s gold holdings were returned to the members and the other
half were sold, with the proceeds to be used to help poor nations
iii. Non-oil-exporting countries and less-developed countries were given
greater access to IMF funds
• As the U.S. trade deficit increased, the so-called G5 countries (France, Japan,
Germany, the U.K. and the U.S.) met at the Plaza Hotel in New York and
reached what became known as the Plaza Agreement, in which they agreed it
would be beneficial for the dollar to depreciate to solve the U.S. trade deficit
problem
• As the dollar continued to fall, the G-7 economic summit meeting produced
the Louvre Accord, according to which;
i. The G-7 countries would cooperate to achieve greater exchange rate
stability
ii. The G-7 countries agreed to more closely consult and coordinate their
macroeconomic policies
The current exchange rate arrangements
Although the most actively traded currencies of the world may be fluctuating against each
other, a significant number of the world’s currencies are pegged to single currencies,
particularly the dollar and the euro, or baskets of currencies such as the SDR.
Exchange rate arrangements as classified by the IMF are;
- No separate legal tender
o The currency of another country circulates as the sole legal tender
o Ecuador, El Salvador, Panama
- Currency board
o A currency board arrangement is a monetary arrangement based on an explicit
legislative commitment to exchange domestic currency for a specified foreign
currency at a fixed exchange rate, combined with restrictions on the issuing
authority to ensure the fulfilment of its legal obligation, implying that domestic
currency is fully backed by foreign assets, eliminating traditional central bank
functions such as monetary control and lender of last resort, and leaving little
room for discretionary monetary policy
o Hong Kong, Bulgaria, Brunei
- Conventional peg
o The country formally pegs its currency at a fixed rate to another currency or a
basket of currencies. The country authorities stand ready to maintain the fixed
parity through direct or indirect intervention
o Jordan, Saudi Arabia, Morocco
- Stabilized arrangement
o A spot market exchange rate that remains within a margin of 2% for 6 months
or more and is not floating. Can be met either with respect to a single currency
or a basket
, o Cambodia, Angola, Lebanon
- Crawling peg
o The currency is adjusted in small amounts at a fixed rate or in response to
changes in selected quantitative indicators, such as inflation differentials vis-à-
vis major trading partners
o Bolivia, Nicaragua
- Crawl-like arrangement
o The exchange rate must remain within a narrow margin of 2 percent relative to
a statistically identified trend for six months or more, and the exchange rate
arrangement cannot be considered as floating. Usually, a minimum rate of
change greater than allowed under a stabilized arrangement is required
o Ethiopia, China, Croatia
- Pegged exchange rate within horizontal bands
o The value of the currency is maintained within certain margins of fluctuation
of at least 1% around a fixed central rate, or the margin between the maximum
and minimum value of the exchange rate exceeds 2%
o Tonga
- Other managed arrangement
o Do not meet the criteria for any of the other categories
o Costa Rica, Switzerland, Russia
- Floating
o Largely market determined, without a predictable path. Foreign exchange
market intervention may be either direct or indirect, and serves to moderate the
rate of change and prevent undue fluctuations in the exchange rate, but policies
targeting a specific level of the exchange rate are incompatible with floating
o Brazil, Korea, Turkey, India
- Free floating
o Intervention occurs only exceptionally and aims to address disorderly market
conditions and if the authorities have provided information or data confirming
that intervention has been limited to at most three instances in the previous six
months, each lasting no more than three business days
o Canada, Mexico, Japan, Israel, U.K., U.S., euro zone
European monetary system
A brief history of the Euro
The euro should be viewed as a product of historical evolution toward an ever deepening
integration of Europe, which began in earnest with the formation of the European Economic
Community in 1958. In 1979 the European Monetary System (EMS) was created to establish
a European zone of monetary stability. In 1991, the Maastricht European Council reached an
agreement on a European Union, calling for the launch of a single European currency by
1999, launching the European Monetary Union (EMU).
On January 1, 2002, euro notes and coins were introduced while national bills and coins were
being gradually withdrawn.
Monetary policy for the euro zone countries is conducted by the European Central Bank
(ECB) headquartered in Frankfurt, Germany, whose primary objective is to maintain price
stability.
The national central banks of the euro zone countries, together with the ECB, form the
Eurosystem, whose tasks are;
1. To define and implement the common monetary policy of the Union
2. To conduct foreign exchange operations
, 3. To hold and manage the official foreign reserves of the euro member states
What are the benefits of monetary union?
- Reduced transaction costs and the elimination of exchange rate uncertainty
o Reducing hedging costs for companies
o Increased price transparency for consumers
o Promotion of cross-border investment and trade
- Enhanced efficiency and competitiveness of the European economy
- Increased depth and liquidity of capital market
- Political cooperation and peace
Costs of monetary union
- Loss of national monetary and exchange rate policy independence
o A country is more prone to asymmetric shocks the less diversified and more
trade-dependent its economy is
The Mexican peso crisis
On December 20, 1994, the Mexican government under a new president announced its
decision to devalue the peso against the dollar by 14%, touching off a stampede to sell pesos
as well as Mexican stocks and bonds. By early January 1995 the peso had fallen as much as
40%, forcing the Mexican government to float the peso. As concerned international investors
reduced their holdings of emerging market securities the crisis rapidly spilled over to other
Latin American and Asian financial markets.
The Clinton administration together with the IMF put together a $53 billion package to bail
out Mexico, stabilizing financial markets.
As the world’s financial markets are becoming more integrated, this type of contagious
financial crisis is likely to occur more often. Two lessons emerge:
1. It is essential to have a multinational safety net in place to safeguard the world
financial system from the peso-type crisis
a. No single country can handle a potentially global crisis alone
b. Slow political processes cannot cope with rapidly changing market conditions
2. Mexico excessively depended on foreign portfolio capital to finance its economic
development. In hindsight, the country should have saved more domestically and
depended more on long-term rather than short-term foreign capital investments
The Asian currency crisis
On July 2, 1997, the Thai baht, which had been largely fixed to the U.S. dollar, was suddenly
devalued. The crisis quickly spread to other Asian countries, and then to Russia and Latin
America, and was the third and largest major currency crisis of the 1990s. Following the
massive depreciations of local currencies, financial institutions and corporations with foreign-
currency debts were driven to extreme financial distress and many were forced to default, also
leading to a long recession in East Asia.
Lessons from the Asian currency crisis
- Liberalization of financial markets when combined with a weak, underdeveloped
domestic financial system tends to create an environment susceptible to currency and
financial crises. Thus, countries should first strengthen their domestic financial system
and then liberalize their financial markets
o The government should strengthen its system of financial-sector regulation and
supervision
, o Banks should be encouraged to base their lending decisions solely on
economic merits rather than political considerations
o Firms, institutions, and the government should provide the public with reliable
financial data in a timely fashion
- Foreign direct investments should be encouraged to be long-term
- Incompatible trinity; A country can only have two of the following three conditions;
o Fixed exchange rate
o Free international flows of capital
o An independent monetary policy
The Argentine peso crisis
From 1991 onward, the Argentine peso was linked to the U.S. dollar at parity, which
increased foreign investments and stabilized inflation. However, as the dollar grew stronger
the peso appreciated against most currencies, hurting exports and causing an economic
downturn, leading to the abandonment of the peso-dollar parity in 2002. This change caused
severe economic and political distress in the country, increasing the unemployment rate above
20% and inflation reaching a monthly rate of about 20%.
At least three factors are related to the collapse of the currency board system and ensuing
economic crisis:
1. The lack of fiscal discipline
2. Labour market inflexibility
3. Contagion from the financial crises in Russia and Brazil
Fixed versus flexible exchange rate regimes
Key arguments for flexible exchange rates are (1) easier external adjustments and (2) national
policy autonomy. Suppose a country is experiencing a balance-of-payments deficit (excess
supply of the country currency at the prevailing exchange rate). Under a flexible exchange
rate regime, the external value of the country’s currency will simply depreciate to the level at
which there is no excess supply anymore. The government does not have to intervene, thus it
can use its monetary and fiscal policies to pursue whatever goals it chooses. Meanwhile,
under a fixed regime, the government may have to take contractionary (expansionary) policies
to correct the balance-of-payments deficit (surplus), meaning it cannot use the same policy
tools to pursue other economic objectives.
The graph shows the steps
described with an example of
a trade (or balance of
payment) deficit experienced
by the U.S.
Flexible: Dollar depreciates
Fixed: U.S. Federal Reserve
may initially draw on foreign
exchange reserves to satisfy
excess demand for British
pounds, but may have to resort
to contractionary fiscal and
monetary policies to shift the
demand curve to the left.
, 5. The Market for Foreign Exchange
Broadly defined, the foreign exchange (FX) market encompasses the conversion of
purchasing power from one currency into another, bank deposits of foreign currency, the
extension of credit denominated in a foreign currency, foreign trade financing, trading in
foreign currency options and futures contracts, and currency swaps.
Function and structure of the FX market
The spot and forward foreign exchange markets are over-the-counter (OTC) markets; that is,
trading does not take place in a central marketplace where buyers and sellers congregate. The
foreign exchange market is a worldwide linkage of bank currency traders, nonbank dealers,
and FX brokers, who assist in trades, connected to one another via a network of telephones,
computer terminals, and automated dealing systems.
Three major market segments: Australasia, Europe, and North America. Most active trading
takes place when the trading hours of the Australasia centres and the European centres
overlap and when the hours of the European and North American centres overlap.
FX market participants
The market for foreign exchange can be seen as a two-tier market. One tier is the wholesale or
interbank market and the other tier is the retail or client market. Market participants can be
categorized into five groups: international banks, bank customers (MNCs, private
speculators), nonbank dealers (investment banks, pension funds), FX brokers, and central
banks.
Correspondent banking relationships
The interbank market is a network of correspondent banking relationships, with large
commercial banks maintaining demand deposit accounts with one another, called
correspondent banking accounts. This means that if a payment is made to a firm in another
country, that the bank for example subtracts a dollar amount from one account and adds a
euro amount to another at the prevailing exchange rate.
The spot market
The spot market involves the immediate purchase or sale of foreign exchange.
Spot rate quotations
Spot rate currency quotations can be stated in direct or indirect terms;
- Direct: the price of one unit of foreign currency in the currency of your choice
- Indirect: the price of one unit of your currency in the foreign currency
It is common among currency traders to both price and trade currencies against the U.S.
dollar. Most currencies in the interbank market are quoted in European terms; the U.S. dollar
is priced in terms of the foreign currency (Foreign/$). American terms; the foreign currency is
priced in terms of the dollar ($/foreign).
In this textbook the following notation for spot rate quotations is used. S(j/k) will refer to the
price of one unit of currency k in terms of currency j. Thus, the American term quote for the
British pound is S($/£) = 1.5405. The corresponding European term is S(£/$) = .6491.
Thus, the American and European term quotes are reciprocals of one another:
1
𝑆($/£) =
S(£/$)
