MODULE- 1

An Overview Of International Finance

To identify the main goal of the multinational
company (MNC) and conflicts with the goal.
To describe the key theories that justify the
international business
To explain the common methods used to conduct
international business
Doing of trade and making money through the
exchange of foreign currency
Conti…
Finance in an international context…
Why do we need to study international finance?
We are living in a highly globalized and integrated
world economy
Continued liberalization of international trade further
internationalizes the consumption pattern
Globalized production: MNCs source inputs and locate
productions anywhere in the world
Integrated financial markets: internationally diversified
investment, internationally tradable financial securities
Conti…
International Finance: is defined as the set of relations for
the creation and using of funds (assets), needed for the
foreign economic activity of international companies and
countries.
Assets: is the financial aspect considered not just as
money, but money as the capital, i.e. the value that brings
added profit (value)
Capital: is the movement, the constant change of forms in
the cycle that passes through three stages:
the monetary,
the productive,
the commodity.
What makes International Finance special?
Three major dimensions make international finance
different from purely domestic finance:
Foreign exchange & political risks
Market imperfections
Expanded opportunity sets
Foreign exchange and Political risk
Unexpected fluctuations of the exchange rates may
adversely affect the MNCs as well as individuals who
are engaged in cross border transactions
Exchange rate uncertainty may affect all the major
economic functions including consumption,
production, and investment.
Sovereign country can change the rules, e.g.,
Tax rules
Expropriation of assets
In some countries, there is a lack of tradition of the
rule of law.
Conti….
Foreign exchange risk
E.g., an unexpected devaluation adversely affects your
export market…
Political risk
E.g., an unexpected overturn of the government that puts
a risk to existing negotiated contracts…
Market imperfections
 Market imperfections represent various frictions and
impediments preventing markets from functioning perfectly.
 Such frictions/ impediments/ barriers include
 Legal restrictions
 Excessive transportation and transaction costs
 Information asymmetry
 Discriminatory taxation
 Often, MNCs are motivated to locate production overseas
due to such market imperfections
 Imperfection in the international financial market often
restrict the extent to which investors can diversify their
portfolios.
Expanded Opportunity Set
If firms venture into the arena of global markets, they
can benefit from an expanded opportunity set by:
locating production in any country/region of the world
to maximize performance
raising fund in any capital market where the cost
capital is the lowest.
deploying assets on a global basis to gain from greater
economies of scale.
Nature if International Finance
IF is concerned with the financial decisions taken in
international business.
IF is an extension of corporate finance at international
level.
IF set the standard for international tax planning and
international accounting.
IF includes management of exchange rate risk.
SCOPE OF INTERNATIONAL
FINANCIALMANAGEMENT
International Institutions
Balance of Payments
International Financial Markets
FOREX Markets
International financial services
International Taxation & Accounting
Globalization of the World Economy: Major Trends and
Developments

Key trends and developments include:

Emergence of Globalized Financial Markets
Emergence of the Euro as a Global Currency
Europe’s Sovereign Debt Crisis of 2010
Trade Liberalization and Economic Integration
Privatization
Global Financial Crisis of 2008-2009
Emergence of Globalized Financial Market

In 1980s & 90s a rapid integration of international

capital and financial market was seen.
In 1980 Japan deregulated its foreign exchange
market.
In 1985 Tokyo Stock Exchange admitted as members a
limited number of foreign brokerage firms.
In Feb 1986 London Stock Exchange (LSE) began
admitting foreign firms as full members.
On October 27, 1986 LSE eliminated fixed brokerage
commission & therefore it is celebrated as “Big Bang”.
Emergence of the euro as a global currency
The advent of the euro in 1999 represents a
momentous event in the history of world financial
system
More than 300 million Europeans are using the
common currency
Many new members of the EU would like to adopt the
euro
The transaction domain of the euro may become larger
than the USD in near future
Europe’s sovereign-debt crisis of 2010

 All EU member states are automatically members of both the

Economic and Monetary Union (EMU) and the Stability and Growth
Pact (SGP)
 SGP is an agreement, among the member states of the European
Union, to facilitate and maintain the stability of the EMU.
 The SGP requires each Member State to implement a fiscal policy
aiming for the country to stay within the limits on government deficit
(3% of GDP)
 In December 2009, the new Greek government revealed that the
actual budget deficit was 12.7 percent compared to the previously
forecasted 3.7 percent based on falsified national account data
 Therefore, Greece actually was in a serious violation of the SGP.
 This situation was a result of excessive borrowing and spending, with
wages and prices rising faster than productivity
Greece could not use the traditional means of depreciating
national currency as the country had adopted the euro.
Investors became worried about sovereign default. They
started to sell off Greek government bonds
The panic spread to other weak European countries,
especially Ireland, Portugal, and Spain
In 2010, credit rating agencies downgraded the
government bonds of the affected countries
Borrowing and refinancing became more costly
Although the debt crisis in Greece accounted for only
about 2.5% of Eurozone GDP, it quickly escalated to a
Europe-wide debt crisis
Trade liberalization and economic integration

Over the past 50 years, international trade increased about

twice as fast as world GDP.
There has been a change in the attitudes of many of the
world’s governments, who have abandoned mercantilist
views and embraced free trade as the surest route to
prosperity for their citizenry.
The General Agreement on Tariffs and Trade (GATT) is a
multilateral agreement among member countries that has
reduced many barriers to trade.
The World Trade Organization (WTO) has the power to
enforce the rules of international trade.
The European Union (EU) was established to foster
economic integration among the countries of Western
Europe.
The North American Free Trade Agreement (NAFTA)
calls for phasing out impediments to trade between
Canada, Mexico, and the United States over a 15-year
period beginning in 1994.
Privatization
The selling of state-run enterprises to investors is also
known as “denationalization.”
Privatization is often seen as socialist economies in
transition to market economies.
By most estimates, this increases the efficiency of the
enterprise.
It also often spurs a tremendous increase in cross-
border investment.
Global financial crisis of 2008—2009

The “Great Recession” was the most serious,

synchronized economic downturn since the Great
Depression of the 1930s.
Factors included:
Households and financial institutions borrowed too much
and took too much risk.
This risk was repackaged with securitization.
Multinational Corporations

A multinational corporation (MNC) is a firm that has

been incorporated in one country and has production
and sales operations in other countries.
There are about 60,000 MNCs in the world.
Many MNCs obtain raw materials from one nation,
financial capital from another, produce goods with
labor and capital equipment in a third country, and sell
their output in various other national markets.
International Trade grew at annual rate of 3.5% during
the same period after 1991.
MNCs obtain financing from major money centers
around the world in many different currencies to
finance their operations.
Global operations force the treasurer’s office to
establish international banking relationships, place
short term funds in several currency denominations,
and effectively manage foreign risk.
Foreign owned manufacturing companies in the
world’s most highly developed countries are generally
more productive and pay their workers more than
comparable locally owned business according to
Organization for Economic Co-operation &
Development (OECD).
Theory of Comparative Advantage
The theory of Comparative Advantage was originally
advanced by the 19th Century economist “David
Ricardo”.
The theory claims that economic well-being is
enhanced if each country’s citizens produce that which
they have comparative advantage in producing relative
to the citizens of other countries, and then trade
products.
Underlying the theory are the assumptions of free trade
between nations and that the factors of production
(land, labour, capital & technology) are relatively
immobile.
ASSUMPTIONS
 1) 2 x 2 x 1 model
 Two country-two commodity-one factor model
 2) Labour is the only productive factor
 3) Cost of production is measured in terms of wage
 4) Labour is perfectly mobile only within the nation
 5) Labour is homogenous
 6) Free trade / Unrestricted trade between nations
 7) Constant returns to scale for producing both commodities
in both nations
 8) All factors are fully employed in all nations in both nations
 9) Perfect competition in both nations: No
firm/consumer/Government is able to influence prices
 On the basis of these assumptions, trade between 2 nations
happens on the basis of comparative cost advantage
Conti…
 As per the above table, England needs 120 labour hours in
order to produce 1 unit of wine. Portugal takes only 80
labour hours for the same. Here Portugal has the absolute
advantage while England has absolute disadvantage.
 Similarly, England requires 100 labour hours to produce 1
unit of cloth while that is just 90 in Portugal. Here also
Portugal has the absolute cost advantage and England has
absolute cost disadvantage.
 Then only Portugal can export if absolute advantage theory
is followed. But when comparative advantage theory is in
operation, both nations (Portugal and England) will get a
chance to specialize and export. We need to measure
comparative cost ratios of two nations in terms of two
commodities. (See next table and explanation).
Different cost ratios of Portugal and England on wine
and cloth are shown in the above table. For Portugal,
cost ratio of wine is lower (0.66) than cloth (0.9). So
Portugal can specialize and export wine instead of
cloth. England has got the lower cost ratio for cloth
(1.11) than wine (1.50). Although England’s cost ratios
for both wine and cloth are greater than Portugal’s cost
ratios,
Portugal can do better if they employ their entire labour
force for wine. It is better for them to let England to
specialize in cloth. Here according to Comparative
advantage theory, trade is governed by comparative
differences in cost rather than absolute differences in
cost.
According to Ricardian theory of comparative
advantage, better for Portugal to specialize in wine and
England in cloth
For Portugal: cost ratio of wine is lower than cloth.
Portugal has comparative advantage for wine than
cloth. So Portugal can produce and export wine
For England: cost ratio of cloth is lower than wine.
England has comparative advantage for cloth than
wine. So England can produce and export
LIMITATIONS OF COMPARATIVE
ADVANTAGE THEORY
1 ) Too simplified model: It is not easy to apply this
theory for the current multination trade situation.
2) The theory neglected the role of capital .
3) The theory neglected other costs of production; like
price of capital, maintenance cost, advertisement costs.
4) Labour is mobile across the boarder: The theory
neglected this possibility.
• Eg: Keralites travel to gulf countries for seeking
employment.
5) Labour is not homogeneous in all countries
• Productivity of labours may differ
Conti…
6) The theory did not consider trade barriers like
import duty, export duty etc.
7) The theory neglected the possibility of
increasing/decreasing returns to scale
8) The theory did not consider the possibility of
unemployment of factors.
9) Perfect competition cannot be practical. Imperfect
market is quite common. But the theory neglected this
possibility.
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.
STAGES IN INTERNATIONAL
MONETARY SYSTEM

1. Bimetallism: Before 1875

2. Classical Gold Standard: 1875-1914
3. Interwar Period: 1915-1944
4. Bretton Woods System: 1945-1972
5. The Flexible Exchange Rate Regime: 1973-
Present
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 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.
Gresham’s Law implied that it would be the least
valuable metal that would tend to circulate.
Gresham’s Law
 Gresham's law is an economic principle that states:
 "if coins containing metal of different value have the same
value as legal tender, the coins composed of the cheaper
metal will be used for payment, while those made of more
expensive metal will be hoarded or exported and thus tend
to disappear from circulation.”
 It is commonly stated as: "“Bad” (abundant) money
drives out “Good” (scarce) money”.
 The law was named in 1860 by Henry Dunning Macleod,
after Sir Thomas Gresham (1519–1579), who was an
English financier during the Tudor dynasty. However, there
are numerous predecessors.
Image of first United States gold coin -
the 1795

Gold Eagle
Classical Gold Standard (1875-1914)

During this period in most major countries:

Gold alone was assured of unrestricted coinage
There was two-way convertibility between gold and
national currencies at a stable ratio.
Gold could be freely exported or imported.
The exchange rate between two country’s currencies
would be determined by their relative gold contents.
Rules of the GOLD system
Each country defined the value of its currency in terms
of gold.
Exchange rate between any two currencies was
calculated as X currency per ounce of gold/ Y currency
per ounce of gold.
These exchange rates were set by arbitrage depending
on the transportation costs of gold.
Central banks are restricted in not being able to issue
more currency than gold reserves.
Classical Gold Standard : Exchange rate
determination
For example, if the dollar is pegged to gold at U.S.
$30 = 1 ounce of gold, and the British pound is pegged
to gold at £6 = 1 ounce of gold, it must be the case that
the exchange rate is determined by the relative gold
contents.
$30 = £6
$5 = £1
Classical Gold Standard:
 Highly stable exchange rates under the classical gold
standard provided an environment that was favorable to
international trade and investment
 Misalignment of exchange rates and international imbalances
of payment were automatically corrected by the price-specie-
flow mechanism.
 Suppose Great Britain exported more to France than France
imported from Great Britain.
 Net export of goods from Great Britain to France will be
accompanied by a net flow of gold from France to Great Britain.
 This flow of gold will lead to a lower price level in France and,
at the same time, a higher price level in Britain.
 The resultant change in relative price levels will slow exports
from Great Britain and encourage exports from France.
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, but
participants lacked the political will to “follow the
rules of the game”
The world economy characterized by tremendous
instability and eventually economic breakdown, what
is known as the Great Depression (1930 – 39)
International Economic Disintegration:
Many countries suffered during the Great
Depression.
Major economic harm was done by restrictions
on international trade and payments.
These beggar-thy-neighbor policies provoked
foreign retaliation and led to the disintegration of
the world economy.
All countries’ situations could have been
bettered through international cooperation
Bretton Woods agreement
Bretton Woods System: 1945- 1972
Named for a 1944 meeting of 44 nations at Bretton
Woods, New Hampshire.
The purpose was to design a postwar 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
1. IMF: maintain order in monetary system
2. World Bank: promote general economic
development
The Demise of the Bretton Woods System
In the early post-war period, the U.S. government had to
provide dollar reserves to all countries who wanted to
intervene in their currency markets.
The increasing supply of dollars worldwide, made
available through programs like the Marshall Plan, meant
that the credibility of the gold backing of the dollar was in
question.
U.S. dollars held abroad grew rapidly and this represented
a claim on U.S. gold stocks and cast some doubt on the
U.S.’s ability to convert dollars into gold upon request.
Domestic U.S. policies, such as the growing expenditure
associated with Vietnam resulted in more printing of
dollars to finance expenditure and forced foreign
governments to run up holdings of dollar reserves.
The world moved from a gold standard to a dollar standard
from Bretton Woods to the Smithsonian Agreement.
Growing increase in the amount of dollars printed further
eroded faith in the system and the dollars role as a reserve
currency.
By 1973, the world had moved to search for a new
financial system: one that no longer relied on a worldwide
system of pegged exchange rates.
An agreement reached by a group of 10 countries (G10) in
1971 that effectively ended the fixed exchange rate system
established under the Bretton Woods Agreement.
The Smithsonian Agreement reestablished an international
system of fixed exchange rates without the backing of
silver or gold, and allowed for the devaluation of the U.S.
dollar. This agreement was the first time in which currency
exchange rates were negotiated.
The Flexible Exchange Rate Regime:
1973- Present
Flexible exchange rates were declared
acceptable to the IMF members.
Central banks were allowed to intervene in
the exchange rate markets to iron out
unwarranted volatilities.
Gold was abandoned as an international
reserve asset.
The currencies are no longer backed by gold.
 In September 1985, the so called G-5 countries (France, Japan,
Germany, U.K. & U.S.) met at the Plaza Hotel in New York and
reached what became known as the “Plaza Record”. They agreed
that it would be desirable for the dollar to depreciate for the dollar
to depreciate against most major currencies to solve the U.S. trade
deficit problem.
 In 1986 in Paris, to address the problem of exchange rate volatility
and other related issues, the G-7 economic summit meeting was
convened. The meeting produced the “Louvre Accord”, according
to which:
 The G-7 countries would cooperate to achieve greater exchange rate
stability.
 The G-7 countries agreed to more closely consult and coordinate their
macro-economic policies.
 The Louvre Accord marked the inception of the managed-float
system under which G-7 countries would jointly intervene in the
exchange market to correct over-or undervaluation of currencies.
Current Exchange Rate Arrangements
Free Float
The largest number of countries, about 48, allow market
forces to determine their currency’s value.
Managed Float
About 25 countries combine government intervention
with market forces to set exchange rates.
Pegged to another currency
Such as the U.S. dollar or euro etc..
No national currency
Some countries do not bother printing their own, they
just use the U.S. dollar. For example, Ecuador, Panama,
and have dollarized.
Balance of Payments
According to Kindle Berger, "The balance of payments
of a country is a systematic record of all economic
transactions between the residents of the reporting
country and residents of foreign countries during a given
period of time".
It is a double entry system of record of all economic
transactions between the residents of the country and the
rest of the world carried out in a specific period of time
when we say “a country’s balance of payments” we are
referring to the transactions of its citizens and
government.
Balance Of Payment : Definition
The balance of payments of a country is a
systematic record of all economic transactions
between the residents of a country and the rest
of the world. It presents a classified record of
all receipts on account of goods exported,
services rendered and capital received by
residents and payments made by them on
account of goods imported and services
received from the capital transferred to non-
residents or foreigners.
- Reserve Bank of India
A country has to deal with other countries
in respect of the following
1. Visible items:
which include all types of physical goods
exported and imported.
2. Invisible items:
which include all those services whose export
and import are not visible. e.g. transport
services, medical services etc.
3. Capital transfers:
which are concerned with capital receipts and
capital payment
Features
It is a systematic record of all economic transactions
between one country and the rest of the world.
It includes all transactions, visible as well as invisible.
It relates to a period of time. Generally, it is an annual
statement.
It adopts a double-entry book-keeping system.
It has two sides: credit side and debit side.
Receipts are recorded on the credit side and payments
on the debit side.
Importance of Balance Of Payments
1. BOP records all the transactions that create demand
for and supply of a currency.
2. Judge economic and financial status of a country in
the short-term
3. BOP may confirm trend in economy’s international
trade and exchange rate of the currency. This may also
indicate change or reversal in the trend.
4. This may indicate policy shift of the monetary
authority (RBI) of the country.
5. BOP may confirm trend in economy’s international
trade and exchange rate of the currency. This may also
indicate change or reversal in the trend.
The General Rule in BOP Accounting

a. If a transaction earns foreign currency

for the nation, it is a credit and is
recorded as a plus item.
b. If a transaction involves spending of
foreign currency it is a debit and is
recorded as a negative item.
The various components of a BOP
1. Current Account
2. Capital Account
3. Reserve Account
4. Errors & Omissions
Current Account Balance
BOP on current account is a statement of actual
receipts and payments in short period.
It includes the value of export and imports of both
visible and invisible goods. There can be either surplus
or deficit in current account.
The current account includes:- export & import of
services, interests, profits, dividends and unilateral
receipts/payments from/to abroad.
BOP on current account refers to the inclusion of three
balances of namely – Merchandise balance, Services
balance and Unilateral Transfer balance
Types of Balances
Trade Balance
Merchandise: exports - imports of goods
Services: exports - imports of services
Income Balance
Net investment income: net income receipts from
assets
Net international compensation to employees:
net compensation of Employees
Net Unilateral Transfers
Gifts from foreign countries minus gifts to
foreign countries
Capital Account Balance
The capital account records all international transactions
that involve a resident of the country concerned changing
either his assets with or his liabilities to a resident of
another country. Transactions in the capital account
reflect a change in a stock – either assets or liabilities.
It is difference between the receipts and payments on
account of capital account. It refers to all financial
transactions.
The capital account involves inflows and outflows
relating to investments, short term borrowings/lending,
and medium term to long term borrowing/lending.
Conti…
There can be surplus or deficit in capital
account.
It includes: - private foreign loan flow, movement
in banking capital, official capital transactions,
reserves, gold movement etc.
These are classifies into two categories
Direct foreign investments
Portfolio investments
Other capital
The Reserve Account
Three accounts: IMF, SDR, & Reserve and
Monetary Gold are collectively called as The
Reserve Account.
The IMF account contains purchases (credits) and
repurchase (debits) from International Monetary
Fund.
Special Drawing Rights (SDRs) are a reserve
asset created by IMF and allocated from time to
time to member countries. It can be used to settle
international payments between monetary
authorities of two different countries.
Errors & Omissions
The entries under this head relate
mainly to leads and lags in reporting of
transactions
It is of a balancing entry and is needed
to offset the overstated or understated
components.
Disequilibrium In The Balance Of
Payments
A disequilibrium in the balance of payment means
its condition of Surplus Or deficit
A Surplus in the BOP occurs when Total Receipts
exceeds Total Payments.
Thus, BOP= CREDIT>DEBIT
A Deficit in the BOP occurs when Total Payments
exceeds Total Receipts.
Thus, BOP= CREDIT<DEBIT
Causes of Disequilibrium In The BOP
Cyclical fluctuations
Short fall in the exports
Economic Development
Rapid increase in population
Structural Changes
Natural Calamites
International Capital Movements
Measures To Correct Disequilibrium in
the BOP
1. Monetary Measures :-
a) Monetary Policy
 The monetary policy is concerned with money supply and
credit in the economy. The Central Bank may expand or
contract the money supply in the economy through
appropriate measures which will affect the prices.
b) Fiscal Policy
 Fiscal policy is government's policy on income and
expenditure. Government incurs development and non -
development expenditure,. It gets income through taxation
and non - tax sources. Depending upon the situation
governments expenditure may be increased or decreased.
Conti…
c) Exchange Rate Depreciation
By reducing the value of the domestic currency,
government can correct the disequilibrium in the BOP in
the economy. Exchange rate depreciation reduces the
value of home currency in relation to foreign currency.
As a result, import becomes costlier and export become
cheaper. It also leads to inflationary trends in the country,
d) Devaluation
devaluation is lowering the exchange value of the
official currency. When a country devalues its currency,
exports becomes cheaper and imports become expensive
which causes a reduction in the BOP deficit.
Conti…
e) Deflation
 Deflation is the reduction in the quantity of money to
reduce prices and incomes. In the domestic market, when
the currency is deflated, there is a decrease in the income of
the people. This puts curb on consumption and government
can increase exports and earn more foreign exchange.
f) Exchange Control
 All exporters are directed by the monetary authority to
surrender their foreign exchange earnings, and the total
available foreign exchange is rationed among the licensed
importers. The license-holder can import any good but
amount if fixed by monetary authority.
Conti….
II. Non- Monetary measures :-
a) Export Promotion
To control export promotions the country may adopt
measures to stimulate exports like:
 export duties may be reduced to boost exports
 cash assistance, subsidies can be given to exporters to increase
exports
 goods meant for exports can be exempted from all types of taxes.

b) Import Substitutes

Steps may be taken to encourage the production of
import substitutes. This will save foreign exchange in the
short run by replacing the use of imports by these import
substitutes.
Conti…
 c) Import Control
 Import may be kept in check through the adoption of a wide
variety of measures like quotas and tariffs. Under the quota
system, the government fixes the maximum quantity of goods
and services that can be imported during a particular time period.
 1. Quotas – Under the quota system, the government may fix and
permit the maximum quantity or value of a commodity to be
imported during a given period. By restricting imports through
the quota system, the deficit is reduced and the balance of
payments position is improved.
 2. Tariffs – Tariffs are duties (taxes) imposed on imports. When
tariffs are imposed, the prices of imports would increase to the
extent of tariff. The increased prices will reduced the demand for
imported goods and at the same time induce domestic producers
to produce more of import substitutes
Some Terminologies