Chapter 18 International Finance

International Finance Business has become increasingly international International business has changed from import/export to operating full-scale businesses in other countries. Multi-national companies (MNCs) have worldwide operations Investing in foreign securities is common Globalization 2

Currency Exchange Companies expect to be paid in their home currency –Buying from a firm in another country requires that country’s currency –A US department store importing British sweaters must exchange dollars for British pounds 3

The Foreign Exchange Market Organized to trade/exchange currencies –Network of brokers/banks based in financial centers around the world Exchange Rate Tables –State the price of one currency in terms of another –Exchange rate tables show two reciprocal rates for each currency, Direct Quote Indirect Quote 4

Exchange Rates

Concept Connection Example 18-1 Exchange Rates An American retail store orders 500 sweaters from Britain costing £35,000, when the exchange rate is $ = 1£. Store’s Cost is – £35,000 x $ = $55,090 Exchange rates affect both: The volume of trade between the two countries The cost of imported products in the US 6

Exchange Rate Risk Exchange rates move constantly Exchange rate risk is the chance of a gain or loss from exchange rate movement that occurs during a transaction 7

Exchange Rate Risk Exchange rate movements affect the profitability of international transactions –British sweaters: Buyer ordered at $1.5740/£ for a cost of $55,090 –If pay at $2.0000/£, order costs $70,000, and buyer makes $14,910 less than expected –If exchange rate moves down store profits This variability in cost/profit is exchange rate risk 8

Spot and Forward Rates Spot Rate –The exchange rate for “immediate” delivery of currency –Spot deliveries are made in two days Forward Rate –The price of currencies to be delivered in future –Major currencies have well-developed forward markets for delivery 1, 3 and 6 months ahead 9

Hedging with Forward Exchange Rates Exchange rate risk can be hedged with forward contracts Lock in exchange rates for anticipated foreign currency needs –Eliminates exchange rate risk –Accomplished by buying the currency at the forward rate for future delivery 10

Terminology of Exchange Rate Movements When a currency becomes more valuable in terms of dollars, it is said to strengthen or rise against the dollar When a currency becomes less valuable in terms of dollars, it is said to weaken or fall against the dollar 11

Supply and Demand—The Source of Exchange Rate Movement Origins of Supply & Demand for Foreign Exchange –Supply & demand stem from trade and the flow of investment money between nations –Americans want a British product –British want an American product Supply and demand curves that determine exchange rates are derived from each country’s demand for the other’s products 12

Foreign Exchange: British Pounds and U.S. Dollars 13

Foreign Exchange: British Pounds and U.S. Dollars 14

Why the Exchange Rates Move Exchange rates move in response to shifts in the supply and demand for currencies in the two countries –Preferences in Consumption –Government Policy –Economic Conditions –Speculation –Direct Government Intervention 15

Governments and the International Monetary System When a nation’s currency strengthens –Imported goods become cheaper –The nation’s exported goods become more expensive in foreign countries 16

Governments and the International Monetary System A strong dollar makes imports cheaper improving our standard of living But it makes US products more expensive in other countries so people buy fewer and we manufacture less for export reducing employment A weak dollar makes US products cheaper in other countries with the reverse result 17

Governments and the International Monetary System Exchange rates impact both employment and the general standard of living – Governments are interested in maintaining a balance and sometimes intervene to keep rates within reasonable limits – Buy and sell their own currencies 18

The International Monetary System Rules by which countries exchange currencies A floating exchange rate system has been in place since the early 1970s –Floating  Free market forces determine rates Between 1945 and the early 1970s a fixed exchange rate system was used –Rates set by international treaty –Each country was required to hold its exchange rate nearly constant relative to the US dollar –Proved unworkable post WWII 19

Convertibility Not all currencies are convertible –Can’t be exchanged for other currencies at market-determined rates –The currencies of China and Russia have historically been inconvertible Inconvertibility is an impediment to international trade 20

The Balance of Trade The net financial flow between two countries from trade –If US imports > exports: A trade deficit exists with that county –If imports < exports: A trade surplus exists A long-term deficit can significantly impair the deficit country’s economy 21

International Capital Markets Investments in foreign countries are common today –Portfolio investments in foreign securities –Direct investments in plant and equipment overseas The US dollar has a unique status –It is the world’s leading currency –Often serves as “international money” –Many international contracts are denominated in U.S. dollars even though none of the contracting parties are American 22

The Eurodollar Market Eurodollars are American dollar deposits in foreign banks The Eurodollar market is created when banks lend deposits to international businesses and foreign governments –Borrowers use Eurodollars To pay for U.S. exports To invest in American stocks and bonds As a medium of exchange Deposits are not just in European banks 23

The International Bond Market International Bond –Sold outside the home country of the borrower Foreign Bond –Issued by a foreign company but denominated in local currency Eurobond –denominated in a currency other than that of the country in which it is sold 24

Eurobonds Most are denominated in U.S. dollars Advantages to foreign buyers –Securities regulations in foreign countries require less disclosure –Issued in bearer form –Most governments don’t withhold income taxes on Eurobond interest 25

Political Risk The chance that a foreign government will expropriate property or that terrorists will destroy it Other value-reducing foreign risk exposure: –Raising taxes –Limiting the amount of profit that can be withdrawn –Requiring the purchase of key inputs from local suppliers –Limiting the prices of products sold within the country –Requiring part ownership by citizens of the host country 26

Transaction and Translation Risks Transaction gains/losses –Arise from exchange rate changes that occur during current international transfers of money –Have real profit, cash flow and tax impact Translation gains/losses –Arise when assets and liabilities held in a foreign country are translated for consolidation on a parent company’s books in its home currency Relevance of Translation Gains and Losses –Translation gains/losses only exist on paper Not “realized” –Shown cumulatively as an adjustment to equity –Not taxable since not realized 27

Free Trade, the Theory of Comparative Advantage, and Protectionism Free Trade –Implies that firms in both countries are free to market or manufacture their products in either country Protectionism –Exists when one or both countries pass laws to limit or prohibit importing goods and foreign business ownership 28

The Theory of Comparative Advantage A two country–two product community will be better off if each nation specializes in what it does best and buys the other product from the other country Comparative Advantage is a powerful argument for free trade in the long run But there is a great deal of economic pain among workers and investors in the short run 29

Globalization A general movement of the world economy toward free trade –Along with an increase in international business –Governments are promoting the process Proponents say increased production due to unrestricted trade leads to a higher standard of living for everyone 30

Anti-Globalization Most agree on the comparative advantage benefit of free trade: More total production …. BUT Not all agree globalization is a good thing –Free trade includes putting factories in poor countries, paying extremely low wages, and making huge profits on the cheap labor Many say this amounts to exploitation of underdeveloped countries Opponents also maintain that it leads to –A widening gap between rich and poor –Excessive corporate power 31

The Migration of Jobs Outsourcing Today outsourcing means moving work overseas –Leads to a loss of jobs at home –Originally limited to low end jobs But outsourcing of knowledge-based jobs began in the 1990’s –Certain low wage nations have some highly educated people e.g., India –Technology is making it possible to transfer knowledge functions electronically 32

Labor Migration and Illegal Immigration Developed countries often lack the people to do low-end jobs –Creates incentives for labor migration from undeveloped countries The problem is serious in US due to the historical ease of entering the country and staying without permission –11.5 million illegal immigrants –Currently a major political problem 33

The Balance of Trade with China and its Inconvertible Currency China has moved towards a free market economy in the last 30 years An undervalued currency makes Chinese products extremely cheap in US –Inconvertible – Exchange rate doesn’t float –40% price advantage over US manufacturers –Trade deficit of more than $280 billion per year –A conservative U.S. government maintains the low prices of Chinese goods benefit Americans –Another major political issue 34

Sovereign Debt Sovereign governments collect taxes and spend on services –If spending exceeds taxes have a deficit and gov’t borrows by selling bonds Deficits accumulate into national debts –Interest also paid out of taxes In a recession tax income falls but services and interest continue –Gov’t depends on continued borrowing. –Investors recognize weakness and stop lending –CRISIS – Government may fail

36 European Sovereign Debt Crisis At least 5 of 17 Eurozone countries are facing financial crises –Could cause governments to fail Started with the post 2008 recession Important Note: Eurozone countries give up an economic control when join the zone. –Can’t print money to pay on national debts. Troubled countries are –Greece, Ireland, Italy, Portugal and Spain

Banks and Contagion When a bond issuer is in financial trouble the value of its existing bonds falls European banks invest in those bonds so their assets shrink when countries are in crisis. –Banks fail if the value of their assets falls too far –Banks holding sovereign debt are all over Europe The failure of a country in crisis can trigger bank failures across Europe –Banks stop lending –Lack of commercial credit deepens the recession Hence we say the crisis is contagious

Actions to Combat the Crisis Stronger Eurozone countries (largely Germany and France), the European Central Bank (ECB), and the IMF have contributed to several bailouts of Greece and other troubled countries. –Demanded cuts in gov’t spending in those countries – Austerity programs – Not popular with populations European Financial Stability Facility was set up to provide emergency lending.

Tensions in the Eurozone People in the healthy economies, are tired of pouring money into failing countries People in crisis countries resent austerity programs forced on them Financial experts say there’s as much as a 75% chance that at least one country will exit the zone.