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IFM-KGIM
An Introduction: International Financial Management Dr. Daviender Narang (ProfessorKGIM) 1
CHAPTER OVERVIEW: I. The Rise of the Multinational Corporation II. The Internationalization of Business and Finance III. Multinational Financial Management: Theory and Practice
International Financial
2
Multinational Corporation (MNC)
Foreign Exchange Markets
Exporting & Importing Product Markets International Financial
Dividend Remittance & Financing
Subsidiaries
Investing & Financing International Financial Markets
PART 1 THE RISE OF THE MULTINATIONAL CORPORATION
I. The MNC: Definition A company with production and distribution facilities in more than one country.
International Financial
4
THE RISE OF THE MULTINATIONAL CORPORATION A. Forces Changing Global Markets
Massive deregulation Collapse of communism Privatizations of stateowned industries Revolution in information technology Wave of M&A Emergence of free market policies Rise of Big Emerging Markets (BEMs)
International Financial
5
THE RISE OF THE MULTINATIONAL CORPORATION B. Prime Transmitter of Competitive Forces in the Global Economy:
The MNC emphases group performance such as Global coordinated allocation of resources Market – entry strategy Ownership of foreign operations Production, marketing and financial activities
International Financial
6
THE RISE OF THE MULTINATIONAL CORPORATION
C. EVOLUTION OF THE MNC Reasons to Go Global: 1. More raw materials 2. New markets 3. Minimize costs of production
International Financial
7
THE RISE OF THE MULTINATIONAL CORPORATION
RAW MATERIAL SEEKERS
Exploit markets in other countries Historically first to appear Modernday counterparts British Petroleum Exxon
International Financial
8
THE RISE OF THE MULTINATIONAL CORPORATION
MARKET SEEKERS
Produce and sell in foreign markets Heavy foreign direct investors Representative firms: IBM MacDonald’s Nestle Levi Strauss
International Financial
9
THE RISE OF THE MULTINATIONAL CORPORATION
COST MINIMIZERS
Seek lowercost production abroad Motive: to remain cost competitive Texas Instruments Intel Seagate Technology
International Financial
10
THE RISE OF THE MULTINATIONAL CORPORATION
D. THE MNC: A BEHAVIORAL VIEW 1. State of mind: committed to producing, undertaking investment and marketing, and financing globally. International Financial
11
THE RISE OF THE MULTINATIONAL CORPORATION
E. THE GLOBAL MANAGER 1. Understands political and economic differences; 2. Searches for most cost effective suppliers; 3. Evaluates changes on value of the firm. International Financial
12
Part II The Internationalization of Business and Finance
I. Globalization A. Political and Labor Union Concerns B. Consequences of Global Competition Acceleration of the global economy
International Financial
13
PART III. MULTINATIONAL FINANCIAL MANAGEMENT: THEORY AND PRACTICE I. THE MULTINATIONAL FINANCIAL SYSTEM
A. Main Objective of MNC: Maximize shareholder wealth B. Other Objectives Reflect Ability to Link: via affiliate transfer mechanisms
International Financial
14
THEORY AND PRACTICE C. Mode of Transfer: Reflects freedom to select a variety of financial channels. D. Timing Flexibility: Most MNC have some flexibility in timing of fund flows. International Financial
15
THEORY AND PRACTICE E. Value The ability to avoid national taxes has led to controversy.
International Financial
16
Goal of the MNC The commonly accepted goal of an MNC is to maximize shareholder wealth. We will focus on MNCs that are worked Globally and that wholly own their foreign subsidiaries.
International Financial
Constraints Interfering with the MNC’s Goal As MNC managers attempt to maximize their firm’s value, they may be confronted with various constraints. Environmental constraints. Regulatory constraints. Ethical constraints.
International Financial
18
THEORY AND PRACTICE II. FUNCTIONS OF FINANCIAL MANAGEMENT A. Two Basic Functions: 1. Financing 2. Investing International Financial
19
THEORY AND PRACTICE B. Additional Factors Facing the MNC Executive 1. Political risk 2. Economic risk
International Financial
20
THEORY AND PRACTICE III. THEORETICAL FOUNDATIONS A. Useful Concepts from Financial Economics: 1. Arbitrage 2. Market Efficiency 3. Capital Asset Pricing International Financial
21
THEORY AND PRACTICE B. Importance of Total Risk 1. Adverse Impact lower sales and higher costs 2. Justifies hedging activities of MNC 3. Diversification reduces risk International Financial
22
THEORY AND PRACTICE IV. THE GLOBAL FINANCIAL MARKET PLACE A. Interlinkage by Computers B. Market Acts as A Global Referendum Process: Currencies may rise or fall International Financial
23
International Economics
International Financial
24
Introduction The study of international economics has never been as important as it is now.
At the beginning of the 21st century, nations are more closely linked through trade in goods and services, through flows of money, and through investment in each others’ economies than ever before. Figure 11 shows that international trade for the United States has roughly tripled in importance compared with the U.S. economy as a whole.
International Financial
25
Figure 1-1: Exports and Imports as a Percentage of U.S. National Income
International Financial
26
What is International Economics About? International economics deals with economic interactions that occur between independent nations.
The role of governments in regulating international trade and investment is substantial. Analytically, international markets allow governments to discriminate against a subgroup of companies. Governments also control the supply of currency.
There are several issues that recur throughout the study of international economics. International Financial
27
Financial Crises
The Financial crises can be broadly classified as currency (balance of payments) crises and banking crises. Spillover effects in other countries Crises in one country, rapidly transmitted to others countries. Mexican Crises (199495) East Asian Crises (199798) Russian Crises (1998)
International Financial
28
Financial Crises
Currency Crises A run on official foreign exchange reserves (Exerting downward pressure) Due to deterioration in economic fundamentals Overheating and generation of selffulfilling expectations of the economy Banking Crises Fundamental weakness of several commercial banks Currency and bank crises tend to be associated with each other and often take place together.
International Financial
29
Financial Flows to Developing Countries Bond Finance
Domestic or Foreign currency
Bank Finance:
Syndicated loans, LIBOR
Foreign Direct Investment Official flows
Grants, Aids, Loans from IMF, World Bank
International Financial
30
Evolution of Trade Theory The Age of Mercantilism Classical Trade Theory Factor Proportions Trade Theory International Investment and Product Cycle Theory The New Trade Theory: Strategic Trade The Theory of International Investment International Financial
31
Mercantilism Mixed exchange through trade with accumulation of wealth The way for a nation to become rich and powerful was to export more than its imported Conducted under authority of government Demise of mercantilism inevitable Country’s wealth depended upon its holdings of treasure England (15001750) – wanted to force colonies to buy goods Contribution – “favorable” balance of trade exports exceed imports. Does this exist? U.S. has “unfavorable” balance in textile and apparel
International Financial
32
The Theory of Absolute Advantage Adam Smith (1776) Father of Free Trade One country is said to have an absolute advantage over another in the production of a particular good if it can produce that good using smaller quantities of resources than can the other country (i.e. efficiency) If a country has an absolute advantage in all areas, that country does not need to trade International Financial
33
Ricardo’s theory of Comparative Advantage Country will export that product in which it has a comparative labor productivity
International Financial
34
The Theory of Comparative Advantage
The notion that although a country may produce both products more cheaply than another country, it is relatively better at producing one product than the other Deals with relative differences in productivity of labor among nations Applies even if one country is at an absolute disadvantage relative to another country in the production of every good Both countries gain from trade even if one of them is more efficient than the other in producing everything
International Financial
35
Classical Trade Theory Contributions Adam Smith—Division of Labor
Industrial societies increase output using same laborhours as preindustrial society
David Ricardo—Comparative Advantage
Countries with no obvious reason for trade can specialize in production, and trade for products they do not produce
Gains From Trade
A nation can achieve consumption levels beyond what it could produce by itself
International Financial
36
Factor Proportions Trade Theory Developed by Eli Heckscher
Expanded by Bertil Ohlin
International Financial
37
Factor Proportions Trade Theory Considers Two Factors of Production
Labor
Capital International Financial
38
Factor Proportions Trade Theory A country that is relatively labor abundant (capital abundant) should specialize in the production and export of that product which is relatively labor intensive (capital intensive).
International Financial
39
H-O Theory Capital abundant countries (ex. US) will export capital intensive products (ex. nonwovens) Labor abundant countries (ex. China) will export labor intensive products (ex. Apparel)
International Financial
40
Porter’s Model of competitive Advantage Why does a nation become the home base for successful international competitors in an industry? Why are firms based in a particular nation able to create and sustain competitive advantage against the world’s best competitors in a particular field? International Financial
41
Porter’s Model of competitive Advantage
International Financial
42
Economic Integration Economic integration is an agreement among nations to decrease or eliminate trade barriers and classified as: Preferential trade arrangement Free trade area Custom Union Common market or an Economic union
International Financial
43
Tariff and Non Tariff Barriers to Trade Tariff are most commonly used as a fool for trade restraint. A tariff is a custom duty as a tax imposed on imports or exports. Protective tariff Revenue tariff
Nontariff measures Quotas
International Financial
44
IFM-KGIM
The International Monetary System
45
A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM I. THE USE OF GOLD A. Desirable properties B. In short run: High production costs limit changes. C. In long run: Commodity money insures stability.
International Financial
46
A BRIEF HISTORY II.The Classical Gold Standard (18211914) A.
Major global currencies on gold standard. 1. Nations fix the exchange rate in terms of a specific amount of gold.
International Financial
47
A BRIEF HISTORY 2.
Maintenance involved the buying and selling of gold at that price.
3.
Disturbances in Price Levels: Would be offset by the price specie*flow mechanism. * specie = gold coins International Financial
48
A BRIEF HISTORY
a. Pricespecieflow mechanism adjustments were automatic: 1.) When a balance of payments surplus led to a gold inflow; 2.)
Gold inflow led to higher prices which reduced surplus;
3.)
Gold outflow led to lower prices and increased surplus.
International Financial
49
A BRIEF HISTORY III. The Gold Exchange Standard (19251931) A.
Only U.S. and Britain allowed to hold gold reserves.
B.
Others could hold both gold, dollars or pound reserves.
International Financial
50
A BRIEF HISTORY C. D.
Currencies devalued in 1931 led to trade wars. Bretton Woods Conference called in order to avoid future protectionist and destructive economic policies
International Financial
51
A BRIEF HISTORY V.The Bretton Woods System (19461971) 1.
U.S.$ was key currency; valued at $1 1/35 oz. of gold.
2.
All currencies linked to that price in a fixed rate system.
International Financial
52
A BRIEF HISTORY 3.
Exchange rates allowed to fluctuate by 1% above or below initially set rates. B. Collapse, 1971 1. Causes: a. U.S. high inflation rate b.
International Financial
U.S.$ depreciated sharply.
53
A BRIEF HISTORY V.PostBretton Woods System (1971Present) A.
Smithsonian Agreement, 1971: US$ devalued to 1/38 oz. of gold. By 1973: World on a freely floating exchange rate system.
International Financial
54
A BRIEF HISTORY B. OPEC and the Oil Crisis (1973774) 1. OPEC raised oil prices four fold; 2.
Exchange rate turmoil resulted;
3.
Caused OPEC nations to earn large surplus BOP.
International Financial
55
A BRIEF HISTORY 4. Surpluses recycled to debtor nations which set up debt crisis of 1980’s. C. Dollar Crisis (197778) 1. U.S. BOP difficulties 2. Result of inconsistent monetary policy in U.S. International Financial
56
A BRIEF HISTORY 3. D.
Dollar value falls as confidence shrinks.
The Rising Dollar (198085) 1. U.S. inflation subsides as the Fed raises interest rates 2.
Rising rates attracts global capital to U.S.
International Financial
57
A BRIEF HISTORY 3. E.
Result: Dollar value rises. The Sinking Dollar:(198587) 1. Dollar revaluated slowly downward; 2. Plaza Agreement (1985) G5 agree to depress US$ further.
International Financial
58
A BRIEF HISTORY 3.
Louvre Agreement (1987) G7 agree to support the falling US$. F. Recent History (1988Present) 1. 1988 US$ stabilized 2. Post1991 Confidence resulted in stronger dollar 3. 19931995 Dollar value falls
International Financial
59
THE EUROPEAN MONETARY SYSTEM I. INTRODUCTION A. The European Monetary System (EMS) 1. A targetzone method (1979) 2. Close macroeconomic policy coordination required. International Financial
60
THE EUROPEAN MONETARY SYSTEM B. EMS Objective: to provide exchange rate stability to all members by holding exchange rates within specified limits. International Financial
61
THE EUROPEAN MONETARY SYSTEM C. European Currency Unit (ECU) a “cocktail” of European currencies with specified weights as the unit of account.
International Financial
62
THE EUROPEAN MONETARY SYSTEM 1. Exchange rate mechanism (ERM) each member determines mutually agreed upon central cross rate for its currency.
International Financial
63
THE EUROPEAN MONETARY SYSTEM 2.
Member Pledge: to keep within 15% margin above or below the central rate.
International Financial
64
THE EUROPEAN MONETARY SYSTEM D.
EMS ups and downs 1. Foreign exchange interventions: failed due to lack of support by coordinated monetary policies.
International Financial
65
THE EUROPEAN MONETARY SYSTEM 2. Currency Crisis of Sept. 1992 a. System broke down b. Britain and Italy forced towithdraw from EMS.
International Financial
66
THE EUROPEAN MONETARY SYSTEM G. Failure of the EMS: members allowed political priorities to dominate exchange rate policies.
International Financial
67
THE EUROPEAN MONETARY SYSTEM H. Maastricht Treaty 1. Called for Monetary Union by 1999 (moved to 2002) 2. Established a single currency: the euro International Financial
68
THE EUROPEAN MONETARY SYSTEM 3.
Calls for creation of a single central EU bank
4.
Adopts tough fiscal standards
International Financial
69
THE EUROPEAN MONETARY SYSTEM I. Costs / Benefits of A Single Currency A. Benefits 1. Reduces cost of doing business 2. Reduces exchange rate risk
International Financial
70
THE EUROPEAN MONETARY SYSTEM B.
Costs 1. Lack of national monetary flexibility.
International Financial
71
ALTERNATIVE EXCHANGE RATE SYSTEMS
I.
FIVE MARKET MECHANISMS A. Freely Floating (“Clean Float”) 1. Market forces of supply and demand determine rates.
International Financial
72
ALTERNATIVE EXCHANGE RATE SYSTEMS 2. Forces influenced by a.
price levels
b. c.
interest rates economic growth
3. Rates fluctuate randomly over time. International Financial
73
ALTERNATIVE EXCHANGE RATE SYSTEMS B.
Managed Float (“Dirty Float”) 1. Market forces set rates unless excess volatility occurs. 2.
Then, central bank determines rate.
International Financial
74
ALTERNATIVE EXCHANGE RATE SYSTEMS C.
TargetZone Arrangement 1.
Rate Determination a.
Market forces constrained to upper and lower range of rates.
b.
Members to the arrangement adjust their national economic policies to maintain target.
International Financial
75
ALTERNATIVE EXCHANGE RATE SYSTEMS D.
Fixed Rate System 1. Rate determination a.
Government maintains target rates.
b.
If rates threatened, central banks buy/sell currency. Monetary policies coordinated.
c. International Financial
76
ALTERNATIVE EXCHANGE RATE SYSTEMS E.
Current System 1.
A hybrid system a. Major currencies:use freely floating method b.
International Financial
Other currencies move in and out of various fixedrate systems.
77
International Financial Flows
International Financial
78
CHAPTER OVERVIEW I. BALANCEOFPAYMENT CATEGORIES II. THE INTERNATIONAL FLOW OF GOODS, SERVICES,AND CAPITAL III. COPING WITH CURRENT ACCOUNT DEFICITS International Financial
79
PART I. BALANCE-OF-PAYMENT CATEGORIES A.
THE BALANCE OF PAYMENTS (BOP) 1. PURPOSE: Measures all financial and economic transactions over a specified period of time.
International Financial
80
BALANCE-OF-PAYMENT CATEGORIES 2. Doubleentry bookkeeping a. Currency inflows = credits earn foreign exchange b. Currency outflows = debits expend foreign exchange
International Financial
81
BALANCE-OF-PAYMENT CATEGORIES 3.
4.
Three Major Accounts: a. Current b. Capital c. Official Reserves Current Account records net flow of goods, services, and unilateral transfers.
International Financial
82
BALANCE-OF-PAYMENT CATEGORIES 5. Capital Account a. Function: records public and private investment and lending. b. Inflows = credits c. Outflows = debits
International Financial
83
BALANCE-OF-PAYMENT CATEGORIES 5. Capital Account (con’t) d. Transactions classified as 1.) portfolio 2.) direct 3.) short term
International Financial
84
BALANCE-OF-PAYMENT CATEGORIES 6. Official Reserves Account a. Function: 1.) measures changes in international reserves owned by central banks. 2.) reflects surplus/deficit of a.) current account b.) capital account International Financial
85
BALANCE-OF-PAYMENT CATEGORIES 6. Official Reserves Account (con’t) b. Reserves consist of 1.) gold 2.) convertible securities
International Financial
86
BALANCE-OF-PAYMENT CATEGORIES 7. Net Effects: a. Sum of all transactions must be zero: 1.) current account 2.) capital account 3.) official reserves International Financial
87
BALANCE-OF-PAYMENT CATEGORIES 8. The Balanceofpayment measures a. Some Definitions: 1.) Basic Balance a.) consists of current account and long term capital flows. International Financial
88
BALANCE-OF-PAYMENT CATEGORIES 1.) Basic Balance (con’t) b.) emphasizes long term trends.
International Financial
89
BALANCE-OF-PAYMENT CATEGORIES 1.) Basic Balance (con’t) c.) excludes shortterm capital flows that heavily depend on temporary factors.
International Financial
90
BALANCE-OF-PAYMENT CATEGORIES 2.) Net Liquidity Balance: measures the change in private domestic borrowing or lending require to keep payments equal without adjusting official reserves. International Financial
91
BALANCE-OF-PAYMENT CATEGORIES 3.)
Official Reserve Transactions Balance
measures adjustments needed by official reserves.
International Financial
92
PART II. THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL II. LINKS FROM INTERNATIONAL TO DOMESTIC FLOWS A. Global Linkages set of basic macroeconomic identities which link: domestic spending and production to current and capital accounts
International Financial
93
THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL B.
Domestic Savings and Investment and the Capital Account 1. National Income Accounting a. National Income (NI) is either spent (C) or saved (S) NI = C + S (5.1)
International Financial
94
THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL b. National spending (NS) is divided into personal spending (C) and investment (I) NS = C + I
International Financial
(5.2)
95
THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL c. Subtracting (4.2) (4.1) NI NS = S I
(5.3)
If NI >NS, S > I which implies that surplus capital spent overseas. International Financial
96
THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL d. In a freelyfloating system, excess saving = the capital account balance e. Implications: 1.
International Financial
A nation which produces more than it spends will save more than it invests domestically with a net capital outflow producing a capital account deficit. 97
THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL 2.
A nation which spends more than it produces has a net capital inflow producing a capital account surplus.
3.
A healthy economy will tend to run a current account deficit.
International Financial
98
THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL C. THE LINK BETWEEN THE CURRENT AND CAPITAL ACCOUNTS 1. Beginning identity NI NS = X M (5.4) where X = exports M = imports XM=current account balance (CA) International Financial
99
THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL 2.
Combining (5.3) + (5.4) S I = X M (5.5) 3. If S I = Net Foreign Investment (NFI) NFI = X M (5.6)
International Financial
100
THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL 4. Implications: a. If CA is in surplus, the nation must be a net exporter of capital. b. If CA is a deficit, the nation is a major capital importer. c. When NS > NI, the excess must be acquired through foreign trade. International Financial
101
THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL d. Solutions for Improving CA deficits: 1.) Raise national income (output) relative to domestic investment (I). 2.) Increase (S) relative to domestic investment (I).
International Financial
102
THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL D. GOVERNMENT BUDGETS AND CURRENT ACCOUNT DEFICITS 1. CURRENT ACCOUNT BALANCE CA = Saving Surplus Gov’t budget deficit International Financial
103
THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL 2. CA Deficit means the nation is not saving enough to finance (I) and the deficit. 3. CA Surplus means the nation is saving more than needed to finance its (I) and deficit. International Financial
104
PART III. COPING WITH THE CURRENT ACCOUNT DEFICIT
I.
POSSIBLE SOLUTIONS UNLIKELY TO WORK: A.
Currency Depreciation
B.
Protectionism
International Financial
105
COPING WITH THE CURRENT ACCOUNT DEFICIT
II.CURRENCY DEPRECIATION A. U.S. Experience: Does not improve the trade deficit.
International Financial
106
COPING WITH THE CURRENT ACCOUNT DEFICIT B. Depreciations are ineffective because 1. It takes time to affect trade. 2.
JCurve Effect states that a decline in currency value will initially worsen the deficit before improvement. International Financial
107
THE J - CURVE Net change in trade balance
Currency depreciation
Trade balance improves
TIME
0
Trade balance initially deteriorates International Financial
108
COPING WITH THE CURRENT ACCOUNT DEFICIT
III.
PROTECTIONISM A. Trade Barriers used: 1. Tariffs 2. Quotas B. Results: Most likely will reduce both X and M.
International Financial
109
COPING WITH THE CURRENT ACCOUNT DEFICIT
C. FOREIGN OWNERSHIP one protectionist solution would place limits on or eliminate foreign ownership leading to capital inflows.
International Financial
110
COPING WITH THE CURRENT ACCOUNT DEFICIT
D.
STIMULATE NATIONAL SAVING change the tax regulations and rates.
International Financial
111
COPING WITH THE CURRENT ACCOUNT DEFICIT
III.
SUMMARY: CURRENTACCOUNT DEFICITS neither bad nor good inherently 1. Since one country’s exports are another’s imports, it is not possible for all to run a surplus
International Financial
112
COPING WITH THE CURRENT ACCOUNT DEFICIT
2.Deficits may be a solution to the problem of different national propensities to save and invest.
International Financial
113
An Introduction: International Financial Management Dr. Daviender Narang (ProfessorKGIM) 1
CHAPTER OVERVIEW: I. The Rise of the Multinational Corporation II. The Internationalization of Business and Finance III. Multinational Financial Management: Theory and Practice
International Financial
2
Multinational Corporation (MNC)
Foreign Exchange Markets
Exporting & Importing Product Markets International Financial
Dividend Remittance & Financing
Subsidiaries
Investing & Financing International Financial Markets
PART 1 THE RISE OF THE MULTINATIONAL CORPORATION
I. The MNC: Definition A company with production and distribution facilities in more than one country.
International Financial
4
THE RISE OF THE MULTINATIONAL CORPORATION A. Forces Changing Global Markets
Massive deregulation Collapse of communism Privatizations of stateowned industries Revolution in information technology Wave of M&A Emergence of free market policies Rise of Big Emerging Markets (BEMs)
International Financial
5
THE RISE OF THE MULTINATIONAL CORPORATION B. Prime Transmitter of Competitive Forces in the Global Economy:
The MNC emphases group performance such as Global coordinated allocation of resources Market – entry strategy Ownership of foreign operations Production, marketing and financial activities
International Financial
6
THE RISE OF THE MULTINATIONAL CORPORATION
C. EVOLUTION OF THE MNC Reasons to Go Global: 1. More raw materials 2. New markets 3. Minimize costs of production
International Financial
7
THE RISE OF THE MULTINATIONAL CORPORATION
RAW MATERIAL SEEKERS
Exploit markets in other countries Historically first to appear Modernday counterparts British Petroleum Exxon
International Financial
8
THE RISE OF THE MULTINATIONAL CORPORATION
MARKET SEEKERS
Produce and sell in foreign markets Heavy foreign direct investors Representative firms: IBM MacDonald’s Nestle Levi Strauss
International Financial
9
THE RISE OF THE MULTINATIONAL CORPORATION
COST MINIMIZERS
Seek lowercost production abroad Motive: to remain cost competitive Texas Instruments Intel Seagate Technology
International Financial
10
THE RISE OF THE MULTINATIONAL CORPORATION
D. THE MNC: A BEHAVIORAL VIEW 1. State of mind: committed to producing, undertaking investment and marketing, and financing globally. International Financial
11
THE RISE OF THE MULTINATIONAL CORPORATION
E. THE GLOBAL MANAGER 1. Understands political and economic differences; 2. Searches for most cost effective suppliers; 3. Evaluates changes on value of the firm. International Financial
12
Part II The Internationalization of Business and Finance
I. Globalization A. Political and Labor Union Concerns B. Consequences of Global Competition Acceleration of the global economy
International Financial
13
PART III. MULTINATIONAL FINANCIAL MANAGEMENT: THEORY AND PRACTICE I. THE MULTINATIONAL FINANCIAL SYSTEM
A. Main Objective of MNC: Maximize shareholder wealth B. Other Objectives Reflect Ability to Link: via affiliate transfer mechanisms
International Financial
14
THEORY AND PRACTICE C. Mode of Transfer: Reflects freedom to select a variety of financial channels. D. Timing Flexibility: Most MNC have some flexibility in timing of fund flows. International Financial
15
THEORY AND PRACTICE E. Value The ability to avoid national taxes has led to controversy.
International Financial
16
Goal of the MNC The commonly accepted goal of an MNC is to maximize shareholder wealth. We will focus on MNCs that are worked Globally and that wholly own their foreign subsidiaries.
International Financial
Constraints Interfering with the MNC’s Goal As MNC managers attempt to maximize their firm’s value, they may be confronted with various constraints. Environmental constraints. Regulatory constraints. Ethical constraints.
International Financial
18
THEORY AND PRACTICE II. FUNCTIONS OF FINANCIAL MANAGEMENT A. Two Basic Functions: 1. Financing 2. Investing International Financial
19
THEORY AND PRACTICE B. Additional Factors Facing the MNC Executive 1. Political risk 2. Economic risk
International Financial
20
THEORY AND PRACTICE III. THEORETICAL FOUNDATIONS A. Useful Concepts from Financial Economics: 1. Arbitrage 2. Market Efficiency 3. Capital Asset Pricing International Financial
21
THEORY AND PRACTICE B. Importance of Total Risk 1. Adverse Impact lower sales and higher costs 2. Justifies hedging activities of MNC 3. Diversification reduces risk International Financial
22
THEORY AND PRACTICE IV. THE GLOBAL FINANCIAL MARKET PLACE A. Interlinkage by Computers B. Market Acts as A Global Referendum Process: Currencies may rise or fall International Financial
23
International Economics
International Financial
24
Introduction The study of international economics has never been as important as it is now.
At the beginning of the 21st century, nations are more closely linked through trade in goods and services, through flows of money, and through investment in each others’ economies than ever before. Figure 11 shows that international trade for the United States has roughly tripled in importance compared with the U.S. economy as a whole.
International Financial
25
Figure 1-1: Exports and Imports as a Percentage of U.S. National Income
International Financial
26
What is International Economics About? International economics deals with economic interactions that occur between independent nations.
The role of governments in regulating international trade and investment is substantial. Analytically, international markets allow governments to discriminate against a subgroup of companies. Governments also control the supply of currency.
There are several issues that recur throughout the study of international economics. International Financial
27
Financial Crises
The Financial crises can be broadly classified as currency (balance of payments) crises and banking crises. Spillover effects in other countries Crises in one country, rapidly transmitted to others countries. Mexican Crises (199495) East Asian Crises (199798) Russian Crises (1998)
International Financial
28
Financial Crises
Currency Crises A run on official foreign exchange reserves (Exerting downward pressure) Due to deterioration in economic fundamentals Overheating and generation of selffulfilling expectations of the economy Banking Crises Fundamental weakness of several commercial banks Currency and bank crises tend to be associated with each other and often take place together.
International Financial
29
Financial Flows to Developing Countries Bond Finance
Domestic or Foreign currency
Bank Finance:
Syndicated loans, LIBOR
Foreign Direct Investment Official flows
Grants, Aids, Loans from IMF, World Bank
International Financial
30
Evolution of Trade Theory The Age of Mercantilism Classical Trade Theory Factor Proportions Trade Theory International Investment and Product Cycle Theory The New Trade Theory: Strategic Trade The Theory of International Investment International Financial
31
Mercantilism Mixed exchange through trade with accumulation of wealth The way for a nation to become rich and powerful was to export more than its imported Conducted under authority of government Demise of mercantilism inevitable Country’s wealth depended upon its holdings of treasure England (15001750) – wanted to force colonies to buy goods Contribution – “favorable” balance of trade exports exceed imports. Does this exist? U.S. has “unfavorable” balance in textile and apparel
International Financial
32
The Theory of Absolute Advantage Adam Smith (1776) Father of Free Trade One country is said to have an absolute advantage over another in the production of a particular good if it can produce that good using smaller quantities of resources than can the other country (i.e. efficiency) If a country has an absolute advantage in all areas, that country does not need to trade International Financial
33
Ricardo’s theory of Comparative Advantage Country will export that product in which it has a comparative labor productivity
International Financial
34
The Theory of Comparative Advantage
The notion that although a country may produce both products more cheaply than another country, it is relatively better at producing one product than the other Deals with relative differences in productivity of labor among nations Applies even if one country is at an absolute disadvantage relative to another country in the production of every good Both countries gain from trade even if one of them is more efficient than the other in producing everything
International Financial
35
Classical Trade Theory Contributions Adam Smith—Division of Labor
Industrial societies increase output using same laborhours as preindustrial society
David Ricardo—Comparative Advantage
Countries with no obvious reason for trade can specialize in production, and trade for products they do not produce
Gains From Trade
A nation can achieve consumption levels beyond what it could produce by itself
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Factor Proportions Trade Theory Developed by Eli Heckscher
Expanded by Bertil Ohlin
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Factor Proportions Trade Theory Considers Two Factors of Production
Labor
Capital International Financial
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Factor Proportions Trade Theory A country that is relatively labor abundant (capital abundant) should specialize in the production and export of that product which is relatively labor intensive (capital intensive).
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H-O Theory Capital abundant countries (ex. US) will export capital intensive products (ex. nonwovens) Labor abundant countries (ex. China) will export labor intensive products (ex. Apparel)
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Porter’s Model of competitive Advantage Why does a nation become the home base for successful international competitors in an industry? Why are firms based in a particular nation able to create and sustain competitive advantage against the world’s best competitors in a particular field? International Financial
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Porter’s Model of competitive Advantage
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Economic Integration Economic integration is an agreement among nations to decrease or eliminate trade barriers and classified as: Preferential trade arrangement Free trade area Custom Union Common market or an Economic union
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Tariff and Non Tariff Barriers to Trade Tariff are most commonly used as a fool for trade restraint. A tariff is a custom duty as a tax imposed on imports or exports. Protective tariff Revenue tariff
Nontariff measures Quotas
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IFM-KGIM
The International Monetary System
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A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM I. THE USE OF GOLD A. Desirable properties B. In short run: High production costs limit changes. C. In long run: Commodity money insures stability.
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A BRIEF HISTORY II.The Classical Gold Standard (18211914) A.
Major global currencies on gold standard. 1. Nations fix the exchange rate in terms of a specific amount of gold.
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A BRIEF HISTORY 2.
Maintenance involved the buying and selling of gold at that price.
3.
Disturbances in Price Levels: Would be offset by the price specie*flow mechanism. * specie = gold coins International Financial
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A BRIEF HISTORY
a. Pricespecieflow mechanism adjustments were automatic: 1.) When a balance of payments surplus led to a gold inflow; 2.)
Gold inflow led to higher prices which reduced surplus;
3.)
Gold outflow led to lower prices and increased surplus.
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A BRIEF HISTORY III. The Gold Exchange Standard (19251931) A.
Only U.S. and Britain allowed to hold gold reserves.
B.
Others could hold both gold, dollars or pound reserves.
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A BRIEF HISTORY C. D.
Currencies devalued in 1931 led to trade wars. Bretton Woods Conference called in order to avoid future protectionist and destructive economic policies
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A BRIEF HISTORY V.The Bretton Woods System (19461971) 1.
U.S.$ was key currency; valued at $1 1/35 oz. of gold.
2.
All currencies linked to that price in a fixed rate system.
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A BRIEF HISTORY 3.
Exchange rates allowed to fluctuate by 1% above or below initially set rates. B. Collapse, 1971 1. Causes: a. U.S. high inflation rate b.
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U.S.$ depreciated sharply.
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A BRIEF HISTORY V.PostBretton Woods System (1971Present) A.
Smithsonian Agreement, 1971: US$ devalued to 1/38 oz. of gold. By 1973: World on a freely floating exchange rate system.
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A BRIEF HISTORY B. OPEC and the Oil Crisis (1973774) 1. OPEC raised oil prices four fold; 2.
Exchange rate turmoil resulted;
3.
Caused OPEC nations to earn large surplus BOP.
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A BRIEF HISTORY 4. Surpluses recycled to debtor nations which set up debt crisis of 1980’s. C. Dollar Crisis (197778) 1. U.S. BOP difficulties 2. Result of inconsistent monetary policy in U.S. International Financial
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A BRIEF HISTORY 3. D.
Dollar value falls as confidence shrinks.
The Rising Dollar (198085) 1. U.S. inflation subsides as the Fed raises interest rates 2.
Rising rates attracts global capital to U.S.
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A BRIEF HISTORY 3. E.
Result: Dollar value rises. The Sinking Dollar:(198587) 1. Dollar revaluated slowly downward; 2. Plaza Agreement (1985) G5 agree to depress US$ further.
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A BRIEF HISTORY 3.
Louvre Agreement (1987) G7 agree to support the falling US$. F. Recent History (1988Present) 1. 1988 US$ stabilized 2. Post1991 Confidence resulted in stronger dollar 3. 19931995 Dollar value falls
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THE EUROPEAN MONETARY SYSTEM I. INTRODUCTION A. The European Monetary System (EMS) 1. A targetzone method (1979) 2. Close macroeconomic policy coordination required. International Financial
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THE EUROPEAN MONETARY SYSTEM B. EMS Objective: to provide exchange rate stability to all members by holding exchange rates within specified limits. International Financial
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THE EUROPEAN MONETARY SYSTEM C. European Currency Unit (ECU) a “cocktail” of European currencies with specified weights as the unit of account.
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THE EUROPEAN MONETARY SYSTEM 1. Exchange rate mechanism (ERM) each member determines mutually agreed upon central cross rate for its currency.
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THE EUROPEAN MONETARY SYSTEM 2.
Member Pledge: to keep within 15% margin above or below the central rate.
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THE EUROPEAN MONETARY SYSTEM D.
EMS ups and downs 1. Foreign exchange interventions: failed due to lack of support by coordinated monetary policies.
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THE EUROPEAN MONETARY SYSTEM 2. Currency Crisis of Sept. 1992 a. System broke down b. Britain and Italy forced towithdraw from EMS.
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THE EUROPEAN MONETARY SYSTEM G. Failure of the EMS: members allowed political priorities to dominate exchange rate policies.
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THE EUROPEAN MONETARY SYSTEM H. Maastricht Treaty 1. Called for Monetary Union by 1999 (moved to 2002) 2. Established a single currency: the euro International Financial
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THE EUROPEAN MONETARY SYSTEM 3.
Calls for creation of a single central EU bank
4.
Adopts tough fiscal standards
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THE EUROPEAN MONETARY SYSTEM I. Costs / Benefits of A Single Currency A. Benefits 1. Reduces cost of doing business 2. Reduces exchange rate risk
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THE EUROPEAN MONETARY SYSTEM B.
Costs 1. Lack of national monetary flexibility.
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ALTERNATIVE EXCHANGE RATE SYSTEMS
I.
FIVE MARKET MECHANISMS A. Freely Floating (“Clean Float”) 1. Market forces of supply and demand determine rates.
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ALTERNATIVE EXCHANGE RATE SYSTEMS 2. Forces influenced by a.
price levels
b. c.
interest rates economic growth
3. Rates fluctuate randomly over time. International Financial
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ALTERNATIVE EXCHANGE RATE SYSTEMS B.
Managed Float (“Dirty Float”) 1. Market forces set rates unless excess volatility occurs. 2.
Then, central bank determines rate.
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ALTERNATIVE EXCHANGE RATE SYSTEMS C.
TargetZone Arrangement 1.
Rate Determination a.
Market forces constrained to upper and lower range of rates.
b.
Members to the arrangement adjust their national economic policies to maintain target.
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ALTERNATIVE EXCHANGE RATE SYSTEMS D.
Fixed Rate System 1. Rate determination a.
Government maintains target rates.
b.
If rates threatened, central banks buy/sell currency. Monetary policies coordinated.
c. International Financial
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ALTERNATIVE EXCHANGE RATE SYSTEMS E.
Current System 1.
A hybrid system a. Major currencies:use freely floating method b.
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Other currencies move in and out of various fixedrate systems.
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International Financial Flows
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CHAPTER OVERVIEW I. BALANCEOFPAYMENT CATEGORIES II. THE INTERNATIONAL FLOW OF GOODS, SERVICES,AND CAPITAL III. COPING WITH CURRENT ACCOUNT DEFICITS International Financial
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PART I. BALANCE-OF-PAYMENT CATEGORIES A.
THE BALANCE OF PAYMENTS (BOP) 1. PURPOSE: Measures all financial and economic transactions over a specified period of time.
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BALANCE-OF-PAYMENT CATEGORIES 2. Doubleentry bookkeeping a. Currency inflows = credits earn foreign exchange b. Currency outflows = debits expend foreign exchange
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BALANCE-OF-PAYMENT CATEGORIES 3.
4.
Three Major Accounts: a. Current b. Capital c. Official Reserves Current Account records net flow of goods, services, and unilateral transfers.
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BALANCE-OF-PAYMENT CATEGORIES 5. Capital Account a. Function: records public and private investment and lending. b. Inflows = credits c. Outflows = debits
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BALANCE-OF-PAYMENT CATEGORIES 5. Capital Account (con’t) d. Transactions classified as 1.) portfolio 2.) direct 3.) short term
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BALANCE-OF-PAYMENT CATEGORIES 6. Official Reserves Account a. Function: 1.) measures changes in international reserves owned by central banks. 2.) reflects surplus/deficit of a.) current account b.) capital account International Financial
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BALANCE-OF-PAYMENT CATEGORIES 6. Official Reserves Account (con’t) b. Reserves consist of 1.) gold 2.) convertible securities
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BALANCE-OF-PAYMENT CATEGORIES 7. Net Effects: a. Sum of all transactions must be zero: 1.) current account 2.) capital account 3.) official reserves International Financial
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BALANCE-OF-PAYMENT CATEGORIES 8. The Balanceofpayment measures a. Some Definitions: 1.) Basic Balance a.) consists of current account and long term capital flows. International Financial
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BALANCE-OF-PAYMENT CATEGORIES 1.) Basic Balance (con’t) b.) emphasizes long term trends.
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BALANCE-OF-PAYMENT CATEGORIES 1.) Basic Balance (con’t) c.) excludes shortterm capital flows that heavily depend on temporary factors.
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BALANCE-OF-PAYMENT CATEGORIES 2.) Net Liquidity Balance: measures the change in private domestic borrowing or lending require to keep payments equal without adjusting official reserves. International Financial
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BALANCE-OF-PAYMENT CATEGORIES 3.)
Official Reserve Transactions Balance
measures adjustments needed by official reserves.
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PART II. THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL II. LINKS FROM INTERNATIONAL TO DOMESTIC FLOWS A. Global Linkages set of basic macroeconomic identities which link: domestic spending and production to current and capital accounts
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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL B.
Domestic Savings and Investment and the Capital Account 1. National Income Accounting a. National Income (NI) is either spent (C) or saved (S) NI = C + S (5.1)
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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL b. National spending (NS) is divided into personal spending (C) and investment (I) NS = C + I
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(5.2)
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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL c. Subtracting (4.2) (4.1) NI NS = S I
(5.3)
If NI >NS, S > I which implies that surplus capital spent overseas. International Financial
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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL d. In a freelyfloating system, excess saving = the capital account balance e. Implications: 1.
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A nation which produces more than it spends will save more than it invests domestically with a net capital outflow producing a capital account deficit. 97
THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL 2.
A nation which spends more than it produces has a net capital inflow producing a capital account surplus.
3.
A healthy economy will tend to run a current account deficit.
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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL C. THE LINK BETWEEN THE CURRENT AND CAPITAL ACCOUNTS 1. Beginning identity NI NS = X M (5.4) where X = exports M = imports XM=current account balance (CA) International Financial
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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL 2.
Combining (5.3) + (5.4) S I = X M (5.5) 3. If S I = Net Foreign Investment (NFI) NFI = X M (5.6)
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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL 4. Implications: a. If CA is in surplus, the nation must be a net exporter of capital. b. If CA is a deficit, the nation is a major capital importer. c. When NS > NI, the excess must be acquired through foreign trade. International Financial
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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL d. Solutions for Improving CA deficits: 1.) Raise national income (output) relative to domestic investment (I). 2.) Increase (S) relative to domestic investment (I).
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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL D. GOVERNMENT BUDGETS AND CURRENT ACCOUNT DEFICITS 1. CURRENT ACCOUNT BALANCE CA = Saving Surplus Gov’t budget deficit International Financial
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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL 2. CA Deficit means the nation is not saving enough to finance (I) and the deficit. 3. CA Surplus means the nation is saving more than needed to finance its (I) and deficit. International Financial
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PART III. COPING WITH THE CURRENT ACCOUNT DEFICIT
I.
POSSIBLE SOLUTIONS UNLIKELY TO WORK: A.
Currency Depreciation
B.
Protectionism
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COPING WITH THE CURRENT ACCOUNT DEFICIT
II.CURRENCY DEPRECIATION A. U.S. Experience: Does not improve the trade deficit.
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COPING WITH THE CURRENT ACCOUNT DEFICIT B. Depreciations are ineffective because 1. It takes time to affect trade. 2.
JCurve Effect states that a decline in currency value will initially worsen the deficit before improvement. International Financial
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THE J - CURVE Net change in trade balance
Currency depreciation
Trade balance improves
TIME
0
Trade balance initially deteriorates International Financial
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COPING WITH THE CURRENT ACCOUNT DEFICIT
III.
PROTECTIONISM A. Trade Barriers used: 1. Tariffs 2. Quotas B. Results: Most likely will reduce both X and M.
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COPING WITH THE CURRENT ACCOUNT DEFICIT
C. FOREIGN OWNERSHIP one protectionist solution would place limits on or eliminate foreign ownership leading to capital inflows.
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COPING WITH THE CURRENT ACCOUNT DEFICIT
D.
STIMULATE NATIONAL SAVING change the tax regulations and rates.
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COPING WITH THE CURRENT ACCOUNT DEFICIT
III.
SUMMARY: CURRENTACCOUNT DEFICITS neither bad nor good inherently 1. Since one country’s exports are another’s imports, it is not possible for all to run a surplus
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COPING WITH THE CURRENT ACCOUNT DEFICIT
2.Deficits may be a solution to the problem of different national propensities to save and invest.
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