1. INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT Lecture 2: Financial Market Globalization

2. Beginning Quote “Globalization is the inexorable integration of markets, transportation systems, and communication systems to a degree never witnessed before -- in a way that is enabling corporations, countries, and individuals to reach around the world farther, faster, deeper, and cheaper than ever before...”  Thomas Friedman, The World is Flat (2005)

3. Viewing Globalization The act of becoming world wide in scope.  Thus, it can be viewed as an increasingly freer flow of Goods, Companies, People, Ideas (technology; R&D), Services (including financial services), Capital ... across national borders.  Refer to Appendix 1 for a discussion of the history of globalization, Appendix 2 for examples of globalization by business functions and Appendix 3 for contemporary issues surrounding globalization.

4. Globalization’s Two Main Trends The globalization process can be divided into two main trends: (1) The globalization of the markets for goods and non-financial services.  Recent trend began after WWII with GATT rounds (1947) and the WTO (1995 on). (2) The globalization of financial markets and financial services.  Recent trend began in the 1980s with developed countries liberalizing their capital markets followed by developing countries in the 1990s.

5. Globalization’s Potential Impacts on Business Firms Impacts on the target markets where companies sell and/or buy.  consumer goods  industrial goods, and  financial services I mpacts on where companies source the factors of production for their enterprises:  capital (where firms finance),  technology,  labor

6. Globalization’s Potential Impacts on Business Firms Impacts on mergers and acquisitions.  Firms can now be the target of or acquirer of foreign firms. Buying other firm’s technology, market share, patents, etc. Expands the “opportunity set” for acquiring firms. Impacts on types and degree of risk associated with an increasingly global enterprise.  Associated with the unique business and financial risks that confront firms in a global environment. Exchange rates, global competition, cultural differences, foreign governments, variations in economic environments.

7. Globalization’s Potential Impacts on Investors Potential Positive Diversification Impacts.  Investors can construct portfolios consisting of a combination of domestic and foreign securities and in a combination of different currencies.  This can have an impact on a Portfolio’s Systematic Risk (“market risk”).  Through international diversification, investors can reduce a portfolio's systematic risk and increase the portfolio's return. Potential Negative Impacts.  Increase portfolio risk associated with exchange rates, country risk, contagion financial market effects.

8. Globalization’s Potential Impacts on Countries Globalization has resulted in countries becoming more “open.”  Exports as a percent of GDP Germany: 6.2% to 31.3% (1950 to 2003) Mexico: 3.5% to 26.3% (1950 to 2003) United States: 4.9% to 9.3% (1960 to 2007)  Imports as a percent of GDP United States: 4.4% to 14.4% (1960 to 2007) Consequences:  Countries become increasingly dependent upon foreign markets for their domestic growth (exports) and supplies (imports).  Coupling effects

9. How Does International Business Differ from Domestic? Global Business Deals with:  Different cultures  Different consumers  Different governments  Different legal system and laws  Different regulatory environments (including regulators)  Different business/management styles  Differences in corporate goals  Differences in corporate governance  Different economies and economic conditions  Different financial markets  Different currencies

10. Dealing with Exchange Rates One of the major differences between global firms and purely domestic firms, is that the former need to deal in different currencies and are therefore subject to the potential for exchange rate risk.  Exchange rate risk results from a firm having exposure in a foreign currency and that foreign currency moves in a manner detrimental to the firm. Refer to Appendix 5 for a complete discussion of the differences between domestic and international finance (including exchange rate risk).

11. Quick History of Exchange Rates After WWII  World turns to the US and agrees on a system of stable exchange rates to renew confidence in the global system.  Bretton Woods System, 1944 After Bretton Woods  World turns to floating exchange rates, 1973

12. Foreign Exchange Risk C ritical questions for global company in this contemporary “floating rate” environment:  How will changes in these foreign currencies affect their consolidated financial performance? Revenues and Costs components.  How volatile are the currencies it is dealing in? Short term moves and longer term trend changes. Managers must be aware of potential impact of exchange rate changes on their companies along with the potential of exchange rate volatility. Managers must also understand the techniques for managing the risk associated with this floating rate environment?  See the following slides for examples of long term trend changes and intermediate term and short term currency movements. See Appendix 5 for more detail.

13. Trend Changes: The Euro Against the Dollar, January 1999 - Present Source: http://fx.sauder.ubc.ca/http://fx.sauder.ubc.ca/

14. Intermediate Moves About the Trend: Euro in 2007

15. Short Term Moves: U.S. Dollar, August 28, 2008 (Surprise Upward Revision of GDP)

16. Short Term Moves: U.S. Dollar, August 29, 2008 (Larger than expected increase in NAPM-Chicago index)

17. Short Term Moves: British Pound: Noon (MST) January 11, 2007 (Surprise interest rate increase)

18. Globalization of Financial Markets Definition of Financial Market Globalization Process: The integration of a country's domestic financial system into the international arena. And, as a result, individual domestic financial markets become so closely integrated with others that, taken as a whole, they can be considered as a single market. Financial market globalization has resulted from  (1) the liberalization of capital flow restrictions worldwide and  (2) advancing technology (in communications).

19. The Globalization of Financial Markets: Summary Financial markets now function in many ways as one integrated market covering the globe. This integration is represented by:  Large trading volumes across borders.  Securities of different nations (corporate and government issues) trading in many major financial market centers.  Financial events in one country affect other countries. Major central bank actions, U.S. stock market. Today, companies look at funding possibilities in financial markets around the world. Today, investors can select from opportunities offered by a vast array of countries.

20. Appendix 1: The History of Globalization The following slides discuss the history of globalization in general and of financial markets in particular

21. Quick History of Globalization About 200 years ago: Free Trade Era  Second British Empire and Industrial Revolution Last half of the 18 th Century.  New (Free Market) Economic Thought of the Time Adam Smith (1776) and David Ricardo (1817)  Both showed how countries would benefit from free trade. WW I (1914-1918) – 1940s: Abandonment of Free Trade  High protectionism especially during Great Depression (1929 – early 1940s)  Hawley-Smoot Tariff Act in U.S. (1930) imposed the highest duties on agricultural products and manufactured goods in U.S. history.

22. Quick History of Globalization  Period Immediately After WWII (1939 – 1945): Slow Return to Globalization Process Formation of GATT in 1948  Goal: To reduced tariffs and expand world trade.  How: Through trade rounds among member countries. Bretton Woods Agreements in 1944  Goal: To restored exchange rate stability.  How: Return to fixed exchange rates to promote world trade. (created the Bretton Woods International Monetary System) International Monetary Fund established in 1944  Goal: To maintain exchange rate stability by assisting countries who’s currencies were under attack.  How: By providing short term funds for intervention.

23. Quick History of Globalization  1970s and 1980s: Acceleration of “goods” trade liberalization among world’s industrial countries and eventually among the developing counties. Accounted for by the continuing impact of GATT, and Impact of negotiated trade agreements and regional trading blocs (e.g., the EU and later NAFTA) on cross border trade.  1994: Establishment of WTO Goal: To replace GATT as the world’s forum for trade negotiations and the settlement of trade disputes. 2006/07 Failure of Doha Round (2001 agricultural subsidies, manufacturing and services trade talks).  What does this mean for the future of goods globalization?

24. Brief History of Financial Market Globalization: Early 20 th Century After the severe financial and economic disruptions of the 1930s, many government policy makers questioned whether free capital flows and liberalized capital markets were desirable. As a result, many countries restricted outward capital transfers either because  (1) they preferred their capital to be invested within their domestic economies or  (2) because they wished to prevent downward pressure on their exchange rates. Countries also put severe restrictions on inward investments, many fearing foreign control of their domestic companies, economies and/or financial markets.

25. Brief History of Financial Market Globalization: Mid 20 th Century During the 1950s and 1960s, each countries’ financial institutions/markets and their regulatory structures evolved in relative isolation from the rest of the world. During those years, most countries, including the United States, imposed restrictions on international capital movements.  1964 U.S. Interest Equalization Tax; a 15% tax imposed on foreign borrowers in the US (lifted in 1974).  1965 Foreign Credit Restraint Program restricted the ability of U.S. banks to extend loans to US and foreign borrowers for foreign purposes (lifted in 1974).

26. Brief History of Financial Market Globalization: Late 20 th Century During the 1980s, capital account liberalization was seen as an essential step on the path to a country’s economic development.  In many ways this was analogous to the earlier reductions in barriers to international trade in goods and services. Refer to Appendix 3 for a comparison of the pace of goods and financial market globalization since 1980. Capital account liberalization meant the reduction in restrictions on cross border capital flows.  Portfolio investment and foreign direct investment.

27. Financial Market Deregulation in the 1980s In the 1980s, the capital markets underwent extensive reforms. The markets became increasingly internationalized, as government deregulations allowed foreign-owned banks to extend their operations in local markets. There was also extensive restructuring of domestic financial market as interest-rate ceilings were abolished and competition between different financial institution intensified. The lead in financial market deregulation occurred in the industrial/developed countries.

28. Deregulations of Financial Markets Among Developed Countries United States: Abolished capital controls in 1974. The removal of the Glass Steagall Act in 1999. U.K.: Lifted currency inconvertibility restrictions in 1979.  U.K. “Big Bang” in 1986 (LSE; stock market deregulations) Japan: “Big Bang’ in 1996-98  Lifting restrictions on capital movements in and out of Japan including restrictions preventing non-banks from conducting foreign exchange business  Japan: Phasing in of universal financial institutions legislation (2005/2006) EU: Lisbon Agreements (2000): goal of opening up financial markets and promoting single market in financial services by 2010.

29. Deregulations of Financial Markets Among Developing Countries Compared with the situation in industrial countries, financial market liberalization occurred at a slower pace in developing countries. After the “Third World Debt Crisis” (in the early 1980s), bank loans to developing countries dried up and a result these countries needed to attract new sources of capital. By the 1990s many developing countries had greatly liberalized their foreign investment regimes, as well as reduced their controls over capital movements.  Individual country stock markets were established or expanded as part of developing country financial sector reforms.  These markets have been used in many developing countries to facilitate privatization by attracting foreign portfolio capital. Process slowed somewhat by the Asia currency crisis in 1997.

30. Appendix 2: Globalization by Business Functions The following are examples of globalization impacts on selling, producing, and financial services on selected U.S. companies

31. Examples of Business Functions Selling (Products) Function  McDonalds Corporation  Starbucks Production (of Products) Function  Nike Corporation Financial Services (commercial banking, investment banking, insurance, asset management) Function  Citigroup

32. Selling Function McDonalds operates in 120 Countries. - 66% of 2004 sales were from international operations. Starbucks in 2005, had 2,691 international retail coffee stores (company owned and licensed stores) operating in 34 countries. - These represented 26% of their stores. - Major markets included Japan, U.K. and Canada - International stores accounted for about 16% of Starbucks 2005 earnings.

33. Production Function Nike: 99% of all its brand apparel is produced outside the United States, in 35 different countries. CountryPercent China38% Indonesia27 Vietnam18 Thailand16 Note: 60% of Nike 2004 revenues from outside U.S.

34. Financial Services Function Citigroup operates in over 100 countries in banking, insurance, and investment services. In 2005, 46% of its revenues from operations resulted from activities outside of the United States. - Mexico is a major foreign market for Citigroup.

35. Summary As a result of globalization, business firms are discovering new opportunities beyond their domestic markets:  New markets for their products.  New sources (including capital) for their inputs. Globalization, however, introduces new and more complex sources of risk.  These need to be managed to survive. Governments are also involved in this globalized world through their policies.  Their involvement can hurt or help companies.

36. Appendix 3: Contemporary Issues Facing the Globalization Process The following are some of the major criticisms of the current globalization process

37. Contemporary Issues Surrounding the Globalization Process Has the globalization process has been uneven for various categories of countries? Claim that rich countries have benefited at the expense of poorer countries. Claim that rich countries continue to protect their “key sectors” (historically agriculture; textiles). Has globalization resulted in greater financial and economic instability? Currency and economic crises of the 1990s – on. Has globalization (countries becoming more connected through trade and financial flows) contributed to this?

38. Contemporary Issues Surrounding the Globalization Process Has globalization resulted in a disruptive level of outsourcing?  A “political” issue in many developed (industrial) countries. United States, Western Europe, Japan  Where are the major country outsourcing sites? Production: China Services: India  Question: Unfair trading or comparative advantage? Suggested follow up reading: The World is Flat, by Thomas Friedman (2005).  Discusses the rise and issues surrounding globalization (and outsourcing).  Concludes: “Economic stability [will not] be a feature” of the 21 st century.

39. Appendix 4: Comparing the Pace of Trade and Financial Globalization The following slide is from a 2004 study which compared the percent of countries identified as opening their economies to trade and to financial flows. It reveals that the pace of financial market globalization has been slower than that of trade globalization.

40. Measuring Trends Globalization Finance & Development Globalization study by Kose, Prasad, and Terrones (December, 2004 in Finance & Development) looked at 85 countries over the last 20+ (1980 – 2003) years. Findings:  Trade (Exports and Imports) liberalization rose from 30% to 85% (of sample)  Financial (Capital Flows) liberalization rose from 20% to 55% (of sample)  Thus, more countries in the sample had engaged in trade liberalization than financial market liberalization.

41. Appendix 5: Why is International Finance Different from Domestic Finance? The following slides illustrate the differences between a purely domestic business and a global (international) firm

42. Why is International Finance Difference from Domestic Finance? Foreign Exchange Risk  Risks associated with doing business in different currencies. Political Risk  Policies of different national governments can affect corporate performance (e.g., exchange rate policies, tax and profit remittance policies, monetary policy). Expanded Opportunities for Financing and Investing  Financing and investment options now expand beyond domestic borders. Cultural Differences  Country differences in “equity” cultures and “corporate” cultures complicate global business. Corporate Governance and Regulation Differences  Country differences in the relationship between managers and investors (owners) as well as differences in regulations.

43. Foreign Exchange Risk Global companies take positions in foreign currencies as a result of their global activities.  Foreign currency denominated assets Resulting from subsidiary sales overseas, export accounts receivable and owned overseas financial assets  Foreign currency denominated liabilities Results from subsidiary liabilities overseas, import accounts payable and overseas financial liabilities

44. Foreign Exchange Risk C ritical questions for global company:  How will changes in these foreign currencies affect their consolidated financial performance? Revenues and Costs components.  How volatile are the currencies it is dealing in? Short term moves and longer term trend changes. Next four slides show how currencies are subject to short term moves and longer term trend changes.  Managers must be aware of this potential volatility and understand the techniques for managing this risk?

45. Short Term Change in Exchange Rate: British Pound, January 11, 2007 The Bank of England surprised markets on Thursday, January 11, 2007, by raising interest rates a quarter percentage point to 5.25 percent, saying the economy had less spare capacity and price pressures were increasing. Only one of the 50 analysts polled by Reuters had predicted the move, which took borrowing costs to their highest level in 5-1/2 years. Most had thought the central bank would wait at least another month to see whether wages were heading up in the new year and for a clearer reading on the consumer sector. The pound rose from $1.935 to over $1.950 within a matter of 15 minutes.  See next slide for chart.  Chart trades the exchange rate on January 11 from 7:00 am until around 1:00 pm. Note the movement around noon at the time of the announcement.

46. Pound Exchange Rate: January 11, 2007

47. Longer term Trend Changes in Exchange Rates Currencies are also subject to changes in longer term trends. These occur as changes in relative economic data occur and are priced into prices. For example the Euro has experienced two major trends since its introduction on January 1, 1999.  Weakening until early 2002  Strengthening since early 2002  Note that there have been shorter term trend reversals during these two major periods (e.g., in 2005).

48. The Euro Against the Dollar Source: http://fx.sauder.ubc.ca/http://fx.sauder.ubc.ca/

49. Currency Volatility: Summary Today, major currencies appear to be potentially volatile, in that they are:  Subject to longer term trend reversals.  Subject to (sudden) short term movements. Why?  Rates are constantly adjusting to new information and  Governments are less (or no longer) involved in managing (i.e., supporting) their currencies.  Market forces, therefore, determine these rates. As a result, exchange rates have become more volatile because market forces now play a dominant role in setting prices and establishing trends.

50. Political Risk Involves the role and activities of a foreign government in affecting the financial performance of a global firm.  Foreign exchange market. Managing rates and government intervention.  Profit repatriation process. Government regulations determine how easy (or difficult) it is to remove profits from foreign operations.  Taxation policies. Governments set withholding taxes on subsidiary dividends paid out of country to parent companies and negotiate tax treaties.  Monetary policies. Government policies will affect the cost of borrowing local capital.  Contract enforcement. Governments establish legislation for the protection of private property and contracts.

51. Global Differences in Monetary Policy: Central Bank Target Rates, August 2006 Rate Difference from U.S. United States 5.25% --- Japan 0.25% -5.00% Switzerland 1.27% -3.98% Euro Zone 3.00% -2.25% Canada 4.25% -1.00% South Korea 4.50% - 0.75% United Kingdom 4.75% +0.50% Australia 6.00% +0.75% Russian Federation 11.50% +6.25% Brazil 14.75% +9.50% Source: http://www.bis.org/cbanks.htmhttp://www.bis.org/cbanks.htm

52. Expanded Financial Opportunities Borrowers  Now have access to financial markets all over the world, including: Individual national markets and offshore markets. Includes short term borrowing options, long term debt options, and equity financing. Investors  Now have access to financial assets all over the world, including Government and corporate debt, and corporate equity. Global borrowing and global investing carries new risks not experienced with domestic activities.  Exchange rate risk.  Information (not understanding these markets) risk.

53. “Corporate Structural” Differences Two distinct and different corporate models exist: Shareholder Wealth Structure (Anglo-American or Anglo-Saxon) Model:  Believes that a firm’s objective should be to maximize shareholder wealth. These countries include the US, Canada, Australia, United Kingdom. Corporate Wealth Structure (Non-Anglo-American) Model:  Believe that a firm’s objective should be to maximize corporate wealth (which includes all stakeholders; e.g., employees, community, banks, owners) These countries include the EU, Japan and Latin American countries. There is some evidence that some corporate wealth model countries are adopting aspects of the shareholder wealth model.  Japan’s changing corporate structure and corporate objective is one example Many Japanese companies are now concern with the “bottom line.” Have hired non-Japanese to “modernize” their companies (e.g., Sony).

54. Shareholder Wealth Structure This model focuses on the importance of shareholders to the corporate structure. Wealth is strictly “financial.”  Within this context, management tools measure impact of their decisions on equity (common stock) values.  Capital budgeting techniques: Net Present Value Internal Rates of Return Aimed at securing returns greater than the firm’s cost of capital and thereby increasing returns to shareholders. Within this model, there is an acceptance of “hostile” takeovers to ensure appropriate financial performance.  Again to the benefit of shareholders.

55. Corporate Wealth Structure Definition of corporate wealth is much broader than the Shareholder Wealth (Anglo-American) viewpoint  Consideration given to the implications of strategic moves affecting all parties such as: human resources, community, state, etc.  Advisory Committees important in Europe (part of corporate structures and involved by law in corporate decisions)  Strict labor laws (e.g., on firing employees) in Europe.  Life time employment concept in Japan in early post war years.  Weakened substantially in Japan in the 1990s.  Less attention in Japan of Anglo Saxon capital budgeting techniques; especially equity cost of capital. Came about because of: Distrust of Anglo-American capitalism especially in Post World War II Europe (thus, a search for the “Third- Way”). Friendly takeovers are the rule (although this is changing as well, in Japan and in Europe).

56. “Equity” Cultural Differences Anglo Saxon countries (U.S., U.K., Canada)  Generally have a well developed equity culture Understanding and acceptance of ownership and, especially, equity capital risk.  Thus, this sector is an important source of funds for corporate financing.  But, perhaps, it also affects corporate goals. Management tends to focus on shareholders. Non-Anglo Saxon Countries (Continental Europe and many Asian countries)  Relatively poorly developed equity culture Thus, risk is not as well understood or tolerated.  Thus there is a reliance on debt and bank financing.  And, corporate goals become more diverse with a wider range of stakeholders.

57. Corporate Governance Defined: “The financial and legal framework for regulating the relationship between managers and owners.”  Very important to shareholders (as owners of firms). Thus, historically important in Anglo-American markets; but less so in other markets.  Also involves the issue of financial market transparency (important information available to all at the same time). This too is very important to shareholders.  Corporate governance has become (relatively) well defined in the United States. Undoubtedly recent abuses have contributed to this:  Waste Management and Sunbeam (1998) and Enron (2001).  Abuses resulted in passage of Sarbanes-Oxley Act (2002)  But there is no similar regulation in foreign countries.  Issue of applying this act to foreign companies in the U.S.