Preface
Our Reason for Writing this Textbook
Both of us have been teaching international financial management to undergraduates and M.B.A. students at Georgia Institute of Technology, Wake Forest University, and at other universities we have visited for two decades. During this time period, we conducted many research studies, published in major finance and statistics journals, concerning the operation of international financial markets. As one might imagine, in doing this we put together an extensive set of teaching materials which we used successfully in the classroom. As the years went by, we individually relied more on our own teaching materials and notes and less on any one of the major existing textbooks in international finance (most of which we tried at some point).
As you may be aware, the scope and content of international finance have been fast evolving due to deregulation of financial markets, product innovations, and technological advancements. As capital markets of the world are becoming more integrated, a solid understanding of international finance has become essential for astute corporate decision making. Reflecting the growing importance of international finance as a discipline, we have seen a sharp increase in the demand for experts in the area in both the corporate and academic worlds.
In writing International Financial Management, Third Edition, our goal was to provide well-organized, comprehensive, and up-to-date coverage of the topics that take advantage of our many years of teaching and research in this area. We hope the text is challenging to students. This does not mean that it lacks readability. The text discussion is written so that a self-contained treatment of each subject is presented in a userfriendly fashion. The text is intended for use at both the advanced undergraduate and M.B.A. levels.
The Underlying Philosophy
International Financial Management, Third Edition, like the first two editions, is written based on two tenets: emphasis on the basics, and emphasis on a managerial perspective.
Emphasis on theBasics
We believe that any subject is better learned if one first is well grounded in the basics. Consequently, we initially devote several chapters to the fundamental concepts of international finance. After these are learned, the remaining material flows easily from them. We always bring the reader back, as the more advanced topics are developed, to their relationship to the fundamentals. By doing this, we believe students will be left with a framework for analysis that will serve them well when they need to apply this material in their careers in the years ahead.
A Managerial Perspective
The text presentation never loses sight that it is teaching students how to make managerial decisions. International Financial Management, Third Edition, is founded in the belief that the fundamental job of the financial manager is to maximize shareholder wealth. This belief permeates the decision-making process we present from cover to cover. To reinforce the managerial perspective, we provide numerous “real-world” stories whenever appropriate.
Changes in the Third Edition
Following are the specific key changes made to update this edition. For all chapters, examples and cases using former European Union national currencies have been revised to reflect the new common euro currency. Also, all chapter exhibits are updated with current data. There is a new chapter on corporate governance around the world.
Chapter 1: Updated review of new trends in the world economy.
Chapter 2: Extensive coverage of the Euro.
Chapter 3: Expanded coverage on the relationship between balance of payments accounting and national income accounting.
Chapter 4: Updated discussion of triangular arbitrage.
Chapter 5: More examples of international parity relationships and exchange rate forecasting.
Chapter 6: New section on the Japanese banking crisis.
Chapter 6: Updated section on bank capital adequacy reflecting the New BasleAccord.
Chapter 8: Anew section on Global Registered Shares.
Chapter 8: Athorough revision of The European Stock Market section.
Chapter 10: Expanded coverage on interest rate and currency swap quotations.
Chapter 11: Updated analysis of risk-return of World Stock Markets. Revised and expanded appendices on international portfolio diversification and hedging exchange rate uncertainty.
Chapter 12: Updated real-world examples of exchange risk management practices.
Chapter 13: More discussion of exchange risk management and firm value.
Chapter 15: Updated coverage of foreign direct investment and cross-border M& As.
Chapter 16: More discussion of the effect of cross-border stock listings.
Chapter 21: New chapter on corporate governance. Comprehensive coverage of international corporate governance issues, with numerous real-world examples.
Pedagogical Features
www.wto.org/
The World Trade Organization website covers news and data about international trade development.
NEW! Annotated Web Resources—New Annotated Web Resources have been added to the margins within each chapter to serve as a quick reference of pertinent chapter-related websites. Each URL listed also includes a short statement on what can be found at that specific site.
INTERNET EXERCISES
NEW! Web Exercises—New Internet Exercises have been added at the end of each chapter to highlight specific topics, and prompt the student to search the Internet for specific data. The student is then able to analyze the data found to solve the exercise.
Chapter Outline—At the beginning of each chapter, a chapter outline andstatement of purpose are presented, which detail the objectives of the chapter.
NEW! CFA Questions—Many chapters also include questions from prior CFA exams. These CFA problems, indicated with the CFA logo, show students the relevancy of what is expected of certified professional analysts.
What’s Special about International Finance?
Foreign Exchange and Political Risks
Market Imperfections
Expanded Opportunity Set
Goals for International Financial Management
Globalization of the World Economy: Recent Trends
Emergence of Globalized Financial Markets
Advent of the Euro
Trade Liberalization and Economic Integration
Privatization
Multinational Corporations
Organization of the Text
Summary
Key Words
Questions
Internet Exercises
MINI CASE: Nike’s Decision
References and Suggested Readings
APPENDIX 1A: Gains from Trade: The Theory of Comparative Advantage
EXAMPLE3.1 For example, suppose that Boeing Corporation exported a Boeing 747 aircraft to Japan Airlines for $50 million, and that Japan Airlines pays from its dollar bank account kept with Chase Manhattan Bank in New York City. Then, the receipt of $50 million by Boeing will be recorded as a credit ( ), which will be matched by a debit ( ) of the same amount representing a reduction of the U.S. bank’s liabilities.
EXAMPLE3.2 Suppose, for another example, that Boeing imports jet engines produced by Rolls-Royce for $30 million, and that Boeing makes payment by transferring the funds to a New York bank account kept by Rolls-Royce. In this case, payment by Boeing will be recorded as a debit ( ), whereas the deposit of the funds by Rolls-Royce will be recorded as a credit ( ).
Examples—These are integrated throughout the text, providing students with immediate application of the text concepts.
Graphs and Numerical Examples—Within each chapter extensive use is made of graphs to provide visual illustration of important concepts, which are followed by numerical examples.
horizontal arrow) and, at the same time, lower the forward premium/discount (as indicated by the vertical arrow). Since the foreign exchange and money markets share the burden of adjustments, the actual path of adjustment to IRPcan be depicted by the dotted arrow. When the initial market condition is located at point B, IRPwill be restored partly by an increase in the forward premium, (F S)/S, and partly by a decrease in the interest rate differential, i$ i£
EXAMPLE5.2 Before we move on, it would be useful to consider another CIA example. Suppose that the market condition is summarized as follows:
Three-month interest rate in the United States: 8.0% per annum.
Three-month interest rate in Germany: 5.0% per annum.
Current spot exchange rate: €1.0114/$.
Three-month forward exchange rate: €1.0101/$.
The New World Order of Finance
Global financial panics erupt every decade or so. But even by historical standards, Mexico’s currency collapse ranks among the scariest. With the crisis stretching into its seventh week, investors were stampeding. Worse yet, the panic was spreading from Buenos Aires to Budapest. Even the dollar was taking an unexpected shellacking. Some were bracing for another 1987 crash—not just in Mexico City, but in New York, London, and Tokyo.
It took forceful action to stop the runaway markets before they dragged the world economy down with them:
$49.8 billion in loans and guarantees for Mexico from the U.S. and its allies. Some bankers say the total could reach $53 billion or more. Certainly, this will go down as the largest socialization of market risk in international history.
This time, it was mutual-, hedge-, and pension-fund gunslingers who provided the capital. Mexico attracted $45 billion in mutual-fund cash in the past three years. And when the peso dived, fund managers bolted. In this global market, all it takes is a phone call to Fidelity to send money hurtling toward Monterey—or zooming back. And world leaders should be able to act with similar speed. Clinton’s $40 billion in loan guarantees for Mexico got nowhere because Congress objected to bailing out Wall Street. Legislators also did not like the U.S. shouldering most of the cost. They were right. Emerging markets will stay volatile, and countries and investors shouldn’t expect a handout every time an economy hits a rough patch. And when a rescue is necessary, it should be global.
International Finance in Practice Boxes—Selected chapters contain International Finance in Practice boxes. These real-world illustrations offer students a practical look at the major concepts presented in the chapter.
EXHIBIT 5.3
SUMMARY
This chapter presents an introduction to the market for foreign exchange. Broadly defined, the foreign exchange market encompasses the conversion of purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated in a foreign currency, foreign trade financing, and trading in foreign currency options and futures contracts. This chapter limits the discussion to the spot and forward market for foreign exchange. The other topics are covered in later chapters.
1.The FX market is the largest and most active financial market in the world. It is open somewhere in the world 24 hours a day, 365 days a year.
2.The FX market is divided into two tiers: the retail or client market and the wholesale or interbank market. The retail market is where international banks service their customers who need foreign exchange to conduct international commerce or trade in international financial assets. The great majority of FX trading takes place in the interbank market among international banks that are adjusting inventory positions or conducting speculative and arbitrage trades.
3.The FX market participants include international banks, bank customers, nonbank FX dealers, FX brokers, and central banks.
4.In the spot market for FX, nearly immediate purchase and sale of currencies takes place. In the chapter, notation for defining a spot rate quotation was developed. Additionally, the concept of a cross-exchange rate was developed. It was determined that nondollar currency transactions must satisfy the bid-ask spread determined from the cross-rate formula or a triangular arbitrage opportunity exists.
5.In the forward market, buyers and sellers can transact today at the forward price for the future purchase and sale of foreign exchange. Notation for forward exchange rate quotations was developed. The use of forward points as a shorthand method for expressing forward quotes from spot rate quotations was presented. Additionally, the concept of a forward premium was developed.
Summary—A short summary concludes each chapter, providing students with a handy overview of key concepts for review.
KEY WORDS bimetallism, 27 Bretton Woods system, 30 currency board, 35 euro, 26 European Currency Unit (ECU), 38 European Monetary System (EMS), 38 European Monetary Union (EMU), 40 Exchange Rate Mechanism (ERM), 40 European System of Central Banks (ESCB), 41 gold-exchange standard, 31 gold standard, 27 Gresham’s law, 27 international monetary system, 26 Jamaica Agreement, 33 Louvre Accord, 34 Maastricht Treaty, 39 managed-float system, 34 optimum currency area, 43 par value, 30 Plaza Accord, 34 price-specie-flow mechanism, 29 Smithsonian Agreement, 32 snake, 38 special drawing rights (SDRs), 31 sterilization of gold, 29 “Tobin tax,” 51 Triffin paradox, 31
Key Words—One of the most interesting aspects of studying international finance is learning new terminology. All key terms are presented in boldfaced type when they are first introduced, and they are defined thoroughly in the chapter. A list of key words is presented at the end of the chapter with convenient page references.
Supplementary Material
Capital Asset Pricing under Cross-Listings10
To
Listings10
Supplementary Material—Some topics are by nature more complex than others. The chapter sections that contain such material are indicated by the section heading“Supplementary Material”’ and are in blue type. These sections may be skipped without loss of continuity, enabling the instructor to easily tailor the reading assignments to the students. End-of-chapter Questions and Problems relating to the Supplementary Material sections of the text are also indicated by blue type
QUESTIONS
9.Use the quotations in Ex of the 801⁄2 September Ja
10.Assume the spot Swiss fr What is the minimum pr price of $0.6800 should month Eurodollar rate is
11.Do problem 10 again ass
12.Use the European option of problem 10 and the p
Questions with Excel Software—An icon indicates which end-of-chapter questions throughout the book are linked to the software program created by the authors. See the next section on Ancillary materials for more information on the software.
REFERENCES & SUGGESTED READINGS
Bank for International Settleme ternational Settlements, M Cheung, Yin-Wong, and Menzie Survey of the US Market.”
Coninx, Raymond G. F. Foreign Irwin, 1986.
Copeland, Laurence S. Exchang Addison-Wesley, 1994.
Dominguez, Kathryn M. “Centr ternational Money and Fin Federal Reserve Bank of New Y Survey: Turnover in the Un
Reference and Suggested Readings—At the end of each chapter a list of selected references and suggested readings is presented, allowing the student to easily locate references that provide additional information about specific topics.
1.Suppose that your firm is operating in a segmented capital market. What actions would you recommend to mitigate the negative effects?
2.Explain why and how a firm’s cost of capital may decrease when the firm’s stock is cross-listed on foreign stock exchanges.
3.Explain the pricing spillover effect.
4.In what sense do firms with nontradable assets get a free ride from firms whose securities are internationally tradable?
5.Define and discuss indirect world systematic risk.
6.Discuss how the cost of capital is determined in segmented versus integrated capital markets.
7.Suppose there exists a nontradable asset with a perfect positive correlation with a portfolio T of tradable assets. How will the nontradable asset be priced?
8.Discuss what factors motivated Novo Industri to seek U.S. listing of its stock. What lessons can be derived from Novo’s experiences?
End-of-Chapter Questions and Problems—A set of end-of-chapter questions and problems is provided for each chapter. This material can be used by students on their own to test their understanding of the material, or as homework exercises assigned by the instructor. Questions and Problems relating to the Supplementary Material sections of the text are indicated by blue type.
MINI CASE
Mexico’s Balance-of-Payments Problem
Recently, Mexico experienced large-scale trade deficits, depletion of foreign reserve holdings, and a major currency devaluation in December 1994, followed by the decision to freely float the peso. These events also brought about a severe recession and higher unemployment in Mexico. Since the devaluation, however, the trade balance has improved.
Investigate the Mexican experiences in detail and write a report on the subject.
In the report, you may:
1.Document the trend in Mexico’s key economic indicators, such as the balance of payments, the exchange rate, and foreign reserve holdings, during the period 1994.1 through 1995.12.
2.Investigate the causes of Mexico’s balance-of-payments difficulties prior to the peso devaluation.
3.Discuss what policy actions might have prevented or mitigated the balance-ofpayments problem and the subsequent collapse of the peso.
4.Derive lessons from the Mexican experience that may be useful for other developing countries.
In your report, you may identify and address any other relevant issues concerning Mexico’s balance-of-payments problem. International Financial Statistics published by IMF provides basic macroeconomic data on Mexico.
Mini Cases—Almost every chapter includes a mini case for student analysis of multiple concepts covered throughout the chapter. These Mini Case problems are “real-world” in nature to show students how the theory and concepts in the textbook relate to the everyday world.
Ancillary Materials
The third edition comes with the following materials:
Instructor’s Resource CD (ISBN 0072825170)—Contains the following assets:
• Instructor’s Manual—Includes detailed suggested answers and solutions to the problems and a software User’s Manual and sample projects, all written by the authors
• Test Bank—Multiple-choice test questions for each chapter, written by the authors and Victor Abraham
• Computerized Test Bank—Includes the questions from the test bank (above) in a program that allows you to easily choose questions to create tests
• PowerPoint Presentation System PowerPoint slides for each chapter to use in classroom lecture settings, created by John Stansfield, University of Missouri
– Columbia
Online Learning Center—www.mhhe.com/er3e
This website contains the supplement assets for instructors and study tools, such as flashcards and quizzes, for students.
The site also includes the International Finance Software that can be used with this book. This Excel software has three main programs:
• Acurrency options pricing program allows students to price put and call options on foreign exchange.
• Ahedging program allows the student to compare forward, money market instruments, futures, and options for hedging exchange risk.
• Aportfolio optimization program based on the Markowitz model allows for examining the benefits of international portfolio diversification.
The three programs can be used to solve certain end-of-chapter problems (marked with an Excel icon) or assignments the instructor devises. AUser’s Manual and sample projects are included in the Instructor’s Manual.
Acknowledgments
We are indebted to the many colleagues who provided insight and guidance throughout the development process. Their careful work enabled us to create a text that is current, accurate, and modern in its approach. Among all who helped in this endeavor:
Christopher W. Anderson University of Kansas
Victor Abraham
The Fashion Institute of Design and Merchandising
Gurdip Bakshi University of Maryland
Arjun Chatrath
University of Portland
Edward Duett
Mississippi State University
Robert Duvic
University of Texas, Austin
Ali Emami
University of Oregon
Hsing Fang
California State University, Los Angeles
Joseph Greco
California State University, Fullerton
Christine Jiang
San Francisco State University
Yong Cheol Kim
Clemson University
PART ONEGLOBALIZATION AND THE MULTINATIONAL FIRM
Suk Hun Lee
Loyola University, Chicago
Harridutt Ramcharran University of Akron
Atul Saxena
Mercer College
Tulin Sener
SUNY, New Paltz
Chris Stivers University of Georgia
Nilufer Usmen
Montclair State University
David Vanderlinden
University of Southern Maine
K. G. Viswanathan
Hofstra University
Wim Westerman
University of Groningen, The Netherlands
Many people assisted in the production of this textbook. At the risk of overlooking some individuals, we would like to acknowledge Arie Adler, Vice President at UBS Warburg, and Robert LeBien, former Senior Vice President and Managing Director of Global Trading at Security Pacific National Bank, for their feedback while we were writing Chapter 4 on foreign exchange trading practices. Dale R. Follmer, Manager of Accounting Operations at Eli Lilly and Company, kindly wrote the International Finance in Practice reading in Chapter 10. Lila Rubio-Quero did an outstanding job proofreading the manuscript. Likewise, Sukru Certinkaya did an excellent job proofreading the instructor’s manual. Kristen Seaver, Milind Shrikhande, Jin-Gil Jeong, Sanjiv Sabherwal, Sandy Lai, and Victor Huang provided useful inputs into the text. Professor Martin Glaum of the Giessen University (Germany) also provided valuable comments.
We also wish to thank the many professionals at McGraw-Hill/Irwin for their time and patience with us. Michele Janicek, sponsoring editor, and Barb Hari, editorial coordinator, have done a marvelous job guiding us through this edition, as has Laura Griffin as project manager.
Last, but not least, we would like to thank our families, Christine, James, and Elizabeth Eun and Donna Resnick, for their tireless love and support without which this book would not have become a reality.
We hope that you enjoy using International Financial Management, Third Edition. In addition, we welcome your comments for improvement. Please let us know either through McGraw-Hill/Irwin, c/o Editorial, or at our e-mail addresses provided below.
Cheol S. Eun cheol.eun@mgt.gatech.edu
Bruce G. Resnick bruce.resnick@mba.wfu.edu
Eun−Resnick: International Financial Management, Third Edition
© The McGraw−Hill Companies, 2004
Currency
EXCHANGE RATES
Monday, August 19, 2002
The New York foreign exchange mid-range rates below apply to trading among banks in amounts of $1 million and more, as quoted at 4 p.m. Eastern time by Reuters and other sources. Retail transactions provide fewer units of foreign currency per dollar.
Currency
U.S. $ EquivalentperU.S. $ CountryMon.Fri.Mon.Fri.
Argentina (Peso) -y.2751.27513.63503.6350
Australia (Dollar).5422.54591.84451.8317
Bahrain (Dinar)2.65252.6525.3770.3770
Brazil (Real).3221.32033.10453.1225
Britain (Pound)1.52721.5387.6548.6499
1-month forward1.52421.5359.6561.6511
3-months forward1.51881.5303.6584.6535
6-months forward1.51041.5218.6621.6571
Canada (Dollar).6356.64071.57341.5607
1-month forward.6350.64021.57481.5621
3-months forward.6337.63891.57801.5653
6-months forward.6315.63671.58361.5707
Chile (Peso).001431.001429698.75699.75
China (Renminbi).1208.12088.27678.2768
Colombia (Peso).0003782.0037892643.952639.05
Czech. Rep. (Koruna)
Commercial rate.03155.0315131.69731.731
Denmark (Krone).1315.13257.60697.5450
Ecuador (U.S. Dollar)1.00001.00001.00001.0000
Hong Kong (Dollar).1282.12827.80007.8000
Hungary (Forint).003962.003996252.41250.28
India (Rupee).02059.0206048.56048.550
Indonesia (Rupiah).0001130.000113488488815
Israel (Shekel).2162.21444.62504.6650
Japan (Yen).008433.008493118.58117.75
1-month forward.008448.008506118.37117.57
3-months forward.008471.008531118.05117.23
6-months forward.008508.008568117.53116.72
Jordan (Dinar)1.41841.4184.7050.7050
Kuwait (Dinar)3.31133.3156.3020.3016
Lebanon (Pound).0006612.00066121512.501512.50
Malaysia (Ringgit) -b.2632.26323.80003.8000
Malta (Lira)2.36132.3747.4235.4211
Mexico (Peso)
Floating rate.1028.10199.72359.8130
New Zealand (Dollar).4667.46842.14272.1349
Norway (Krone).1324.13337.55337.4992
Pakistan (Rupee).01683.0168359.42559.425
Peru (new Sol).2805.28073.56503.5628
Philippines (Peso).01926.0193151.92551.795
Poland (Zloty).2397.23934.17254.1795
Russia (Ruble) -a.03167.0316731.57531.575
Saudi Arabia (Riyal).2666.26663.75053.7505
Currency U.S. $ EquivalentperU.S. $ CountryMon.Fri.Mon.Fri.
Singapore (Dollar).5710.57241.75131.7470
Slovak Rep. (Koruna).02241.0225644.62944.328
South Africa (Rand).0941.094710.631510.5600
South Korea (Won).0008409.00084471189.201183.90
Sweden (Krona).1058.10679.44869.3703
Switzerland (Franc).6653.67141.50301.4895 1-month forward.6660.67201.50161.4881 3-months forward.6670.67301.49931.4858 6-months forward.6684.67441.49611.4828
Taiwan (Dollar).02959.0296833.79033.690
Thailand (Baht).02378.0239342.05541.780
Turkey (Lira).00000061.0000006116400001640000
United Arab (Dirham).2723.27233.67293.6729
Uruguay (Peso) Financial.03738.0373826.75026.750
Venezuela (Bolivar).000726.0007261376.501376.50 SDR 1.32471.3228.7549.7560 Euro .9764.98471.02421.0155
Special Drawing Rights (SDR) are based on exchange rates for the U.S., British, and Japanese currencies. Source: International Monetary Fund. a-Russian Central Bank rate. b-Government rate. y-Floating rate.
MONEYRATES
Monday, August 19, 2002
The key U.S. and foreign annual interest rates below are a guide to general levels but don’t always represent actual transactions.
Prime Rate: 4.75% (effective 12/12/01).
Discount Rate: 1.25% (effective 12/11/01).
Federal Funds: 1.750% high, 1.625% low, 1.625% near closing bid, 1.688% offered. Effective rate: 1.73%. Source: Prebon Yamane (USA) Inc. Federal-funds target rate: 1.750% (effective 12/11/01).
Call Money: 3.50% (effective 12/12/01).
Commercial Paper: Placed directly by General Electric Capital Corp.: 1.72% 30 to 64 days; 1.70% 65 to 270 days.
Euro Commercial Paper: Placed directly by General Electric Capital Corp.: 3.30% 30 days; 3.31% two months; 3.32% three months; 3.34% four months; 3.34% five months; 3.35% six months.
DealerCommercial Paper: High-grade unsecured notes sold through dealers by major corporations: 1.73% 30 days; 1.69% 60 days; 1.68% 90days.
Certificates of Deposit: 1.75% one month; 1.70% three months; 1.70% six months.
Bankers Acceptances: 1.74% 30 days; 1.72% 60 days; 1.71% 90 days; 1.70% 120 days; 1.70% 150 days; 1.70% 180 days. Source: Prebon Yamane (USA) Inc.
Eurodollars: 1.76%–1.74% one month; 1.74%–1.70% two months; 1.73%–1.70% three months; 1.72%–1.68% four months; 1.72%–1.68% five months; 1.74%–1.70% six months. Source: Prebon Yamane (USA)Inc.
London Interbank Offered Rates (Libor): 1.8050% one month; 1.7700% three months; 1.76594% six months; 1.93875% one year. Effective rate for contracts entered into two days from date appearing attop of this column.
Euro Libor: 3.32900% one month; 3.35625% three months; 3.40113% six months; 3.49713% one year. Effective rate for contracts entered into two days from date appearing at top of this column.
Euro Interbank Offered Rates (Euribor): 3.327% one month; 3.360% three months; 3.404% six months; 3.497% one year. Source: Reuters. Foreign Prime Rates: Canada 4.50%, Germany 3.25%, Japan 1.375%, Switzerland 2.625%, Britain 4.00%.
Treasury Bills: Results of the Monday, August 19, 2002, auction of short-term U.S. government bills, sold at a discount from face value in units of $1,000 to $1 million: 1.630% 13 weeks; 1.630% 26 weeks.
Tuesday, August 13, 2002 auction: 1.670% 4 weeks.
Overnight Repurchase Rate: 1.74%. Source: Garban Intercapital.
Freddie Mac: Posted yields on 30-year mortgage commitments. Delivery within 30 days 6.00%, 60 days 6.09%, standard conventional fixed-rate mortgages: 3.375%, 2% rate capped one-year adjustable rate mortgages.
Fannie Mae: Posted yields on 30 year mortgage commitments (priced at par) for delivery within 30 days 6.10%, 60 days 6.19%, standard conventional fixed-rate mortgages; 3.75%, 6/2 rate capped one-year adjustable rate mortgages. Constant Maturity Debt Index: 1.688% three months; 1.683% six months; 1.865% one year.
Merrill Lynch Ready Assets Trust: 1.36%.
ConsumerPrice Index: July, 180.1, up 1.5% from a year ago. Bureau ofLabor Statistics.
CURRENCYFUTURES
Monday, August 19, 2002
Japanese Yen (CME) 12.5 million yen; $ per yen (.00)
Sept.8518.8526.8434.8448 .0069.8685.749571,162
Dec.8510.8510.8473.8484 .0069.8885.75691,925
Est vol 2,731; vol Fri 5,050; open int 73,683, 274.
Canadian Dollar (CME) 100,000 dlrs; $ per Can $
Sept.6403.6415.6345.6355 .0050.6640.617551,278
Dec.6370.6396.6327.6336 .0051.6620.61908,472
Mr03.6370.6370.6318.6317 .0053.6590.61982,051
June.6315.6325.6290.6299 .0055.6565.6197742
Est vol 5,493; vol Fri 4,232; open int 62,946, 315.
British Pound (CME) 62,500 pds; $ per pound
Sept1.53641.54201.52221.5238 .01041.59001.399028,828
Dec1.51761.52181.51301.5150 .01041.57201.4070738
Est vol 1,991; vol Fri 2,449; open int 29,626, 38.
Swiss Franc (CME) 125,000 francs; $ per franc
Sept.6716.6735.6648.6659 .0056.6975.586036,600 Dec.6724.6724.6668.6674 .0056.6986.5875984
Est vol 3,208; vol Fri 5,979; open int 37,663, 391.
Australian Dollar (CME) 100,000 dlrs; $ per A$ Sept.5450.5458.5398.5409 .0030.5752.479020,790 Dec.5304.5396.5365.5366 .0030.5702.4980855
Est vol 708; vol Fri 1,551; open int 22,446, 396.
Mexican Peso (CME) 500,000 new Mex. peso, $ per MP Sept.10145.10243.10135.1023800072.10830.0971014,102 Dec.09995.10060.09995.1006300070.10673.095402,104
Est vol 5,938; vol Fri 9,023; open int 16,650, 565.
Euro FX (CME) - Euro 125,000; $ per Euro Sept.9832.9860.9738.9756 .00691.0185.837594,786 Dec.9795.9818.9700.9716 .00691.0129.83904,713
Est vol 7,504; vol Fri 15,217; open int 100,009, 1,001.
CURRENCYOPTIONS
Tuesday, July 6, 1999
PHILADELPHIAEXCHANGE CallsPuts Vol.LastVol.Last British Pound156.13
31,250 Brit. Pounds-European Style. 158Jul160.23. . . . . . 31,250 Brit. Pounds-cents perunit. 163Jul40.01. . . 0.01 Euro102.46
62,500 Euro-cents perunit. 98Sep. . . 0.01890.35 100Sep. . . . . . 220.67 102Sep. . . 0.0141.38 104Sep. . . . . . 242.47 106Sep20.53. . . 0.01 110Sep30.10. . . 0.01 Japanese Yen 82.64
6,250,000 J. Yen-100ths of a cent perunit. 80 1⁄2 Sep. . . 0.01250.60
6,250,000 J. Yen-EuropeanStyle. 80 1⁄2 Sep. . . 0.01200.53 Swiss Franc63.80 62,500 Swiss Francs-cents perunit. 67Sep100.30. . . . . . 68Sep20.15. . . . . . Call Vol . . .
. .986Open Int
.39,510 Put Vol
.3,569Open Int
.30,445
Category 1
Antigua & Barbuda
Aruba
Belize
Djibouti Dominica
Ecuador
El
Grenada
Hong Kong, PRC
Kiribati
Lebanon
Malaysia
Maldives
Marshall
Micronesia
Oman
Palau
Qatar
Saudi
St. Kitts & Nervis
St.
St.
Syria
Turkmenistan
United
Emirates
Zimbabwe
Category 2
Benin
Bosnia & Herzegovina
Cameron
Congo
Côte d’Ivoire
Equatorial
Estonia
Gabon
Guinea-Bissau
Senegal
Togo
Category 3
Bangladesh Bhutan
Botswana
Burunei
Cape Verde
Fiji Jordan
Kuwait
Latvia
Lesotho
Libyn
Malta
Morocco
Namibia
Nepal
Samoa
Swaziland
Vanuatu
Category 4
Austria
Belgium
Italy
Luxembourg
Netherlands
Portugal Spain
Category
Cyprus
Denmark
Egypt Honduras
Category 6 Algeria
São Tomé & Principe Singapore
Slovak Rep.
Slovenia
Trinidad & Tobago
Tunisia
Ukraine
Uzbekistan
Vietnam
Yugoslavia
Zambia
Category 7 Afghanistan Albania
Armenia
Australia
Brazil
Canada
Chile
Gambia
Haiti
Iceland
Japan
Rep.
New
Papua
South
United
United
Yemen
North Atlantic Ocean
South Atlant
Pacific Ocean South Pacific Ocean
3
Pegged to US Dollar
Pegged to Euro
Pegged to Other Currencies
European Monetary Union (Euro) Managed Floating Independent Floating Category 1
Limited Flexibility
Indian Ocean
tic Ocean
North Pacific Ocean
Foundations of International Financial Management
PART ONE lays the macroeconomic foundation for all the topics to follow. A thorough understanding of this material is essential for understanding the advanced topics covered in the remaining sections.
CHAPTER 1 provides an introduction to International Financial Management. The chapter discusses why it is important to study international finance and distinguishes international finance from domestic finance.
CHAPTER 2 introduces the various types of international monetary systems under which the world economy can function and has functioned at various times. The chapter traces the historical development of the world’s international monetary systems from the early 1800s to the present. Additionally, a detailed discussion of the European Monetary System of the European Union is presented.
CHAPTER 3 presents balance-of-payment concepts and accounting. The chapter shows that even a country must keep its “economic house in order” or else it will experience current account deficits that will undermine the value of its currency.
CHAPTER 4 provides an introduction to the organization and operation of the spot and forward foreign exchange market. This chapter describes institutional arrangements of the foreign exchange market and details of how foreign exchange is quoted and traded worldwide.
CHAPTER 5 presents the fundamental international parity relationships among exchange rates, interest rates, and inflation rates. An understanding of these parity relationships is essential for practicing financial management in a global setting.
CHAPTER OUTLINE
Globalization and the Multinational Firm
What’s Special about International Finance?
Foreign Exchange and Political Risks
Market Imperfections
Expanded Opportunity Set
Goals for International Financial Management
Globalization of the World Economy: Recent Trends
Emergence of Globalized Financial Markets
Advent of the Euro
Trade Liberalization and Economic Integration
Privatization
Multinational Corporations
Organization of the Text
Summary
Key Words
Questions
Internet Exercises
MINI CASE: Nike’s Decision
References and Suggested Readings
APPENDIX 1A: Gains from Trade: The Theory of Comparative Advantage
AS THE TITLE International Financial Management indicates, in this book we are concerned with financial management in an international setting. Financial management is mainly concerned with how to optimally make various corporate financial decisions, such as those pertaining to investment, capital structure, dividend policy, and working capital management, with a view to achieving a set of given corporate objectives. In Anglo-American countries as well as in many advanced countries with well-developed capital markets, maximizing shareholder wealth is generally considered the most important corporate objective.
Why do we need to study “international” financial management? The answer to this question is straightforward: We are now living in a highly globalized and integrated world economy. American consumers, for example, routinely purchase oil imported from Saudi Arabia and Nigeria, TVsets and camcorders from Japan, automobiles from Germany, garments from China, shoes from Indonesia, pasta from Italy, and wine from France. Foreigners, in turn, purchase American-made aircraft, software, movies, jeans, wheat, and other products. Continued liberalization of international trade is certain to further internationalize consumption patterns around the world.
Like consumption, production of goods and services has become highly globalized. To a large extent, this has happened as a result of multinational corporations’(MNCs) relentless efforts to source inputs and locate production anywhere in the world where costs are lower and profits are higher. For example, IBM personal computers sold in the world market might have been assembled in Malaysia with Taiwanese-made monitors, Korean-made keyboards, U.S.made chips, and preinstalled software packages that were jointly developed by U.S. and Indian engineers. It has often become difficult to clearly associate a product with a single country of origin.
Recently, financial markets have also become highly integrated. This development allows investors to diversify their investment portfolios internationally. In the words of a Wall Street Journal article, “Over the past decade, U.S. investors have poured buckets of money into overseas markets, in the form of international mutual funds. In April 1996, the total assets in these funds reached a whopping $148.14 billion, far beyond the measly $2.49 billion reported in 1985.”1 At the same time, Japanese investors are investing heavily in U.S. and other foreign financial markets in efforts to recycle their enormous trade surpluses. In addition, many major corporations of the world, such as IBM, Daimler-Benz (now, DaimlerChrysler), and Sony, have their shares cross-listed on foreign stock exchanges, thereby rendering their shares internationally tradable and gaining access to foreign capital as well. Consequently, Daimler-Benz’s venture, say,
1Sara Calian, “Decision, Decision,” The Wall Street Journal, June 27, 1996, p. R6.
in China can be financed partly by American investors who purchase Daimler-Benz shares traded on the New York Stock Exchange.
Undoubtedly, we are now living in a world where all the major economic functions—consumption, production, and investment—are highly globalized. It is thus essential for financial managers to fully understand vital international dimensions of financial management. This global shift is in marked contrast to a few decades ago, when the authors of this book were learning finance. At that time, most professors customarily (and safely, to some extent) ignored international aspects of finance. This attitude has become untenable since then.
What’s Special about International Finance?
Although we may be convinced of the importance of studying international finance, we still have to ask ourselves, what’s special about international finance? Put another way, how is international finance different from purely domestic finance (if such a thing exists)? Three major dimensions set international finance apart from domestic finance. They are:
1.Foreign exchange and political risks.
2.Market imperfections.
3.Expanded opportunity set.
As we will see, these major dimensions of international finance largely stem from the fact that sovereign nations have the right and power to issue currencies, formulate their own economic policies, impose taxes, and regulate movements of people, goods, and capital across their borders. Before we move on, let us briefly describe each of the key dimensions of international financial management.
Foreign Exchange and Political Risks
Suppose Mexico is a major export market for your company and the Mexican peso depreciates drastically against the U.S. dollar, as it did in December 1994. This means that your company’s products can be priced out of the Mexican market, as the peso price of American imports will rise following the peso’s fall. If such countries as Indonesia, Thailand, and Korea are major export markets, your company would have faced the same difficult situation in the wake of the Asian currency crisis of 1997. The preceding examples suggest that when firms and individuals are engaged in crossborder transactions, they are potentially exposed to foreign exchange risk that they would not normally encounter in purely domestic transactions.
Currently, the exchange rates among such major currencies as the U.S. dollar, Japanese yen, British pound, and euro fluctuate continuously in an unpredictable manner. This has been the case since the early 1970s, when fixed exchange rates were abandoned. As can be seen from Exhibit 1.1, exchange rate volatility has exploded since 1973. Exchange rate uncertainty will have a pervasive influence on all the major economic functions, that is, consumption, production, and investment.
www.cia.gov/cia/ publications/factbook/ Website of The World Factbook published by the CIA provides background information, such as geography, government, and economy, of countries around the world.
Another risk that firms and individuals may encounter in an international setting is political risk. Political risk ranges from unexpected changes in tax rules to outright expropriation of assets held by foreigners. Political risk arises from the fact that a sovereign country can change the “rules of the game” and the affected parties may not have effective recourse. In 1992, for example, the Enron Development Corporation, a subsidiary of a Houston-based energy company, signed a contract to build India’s largest power plant. After Enron had spent nearly $300 million, the project was canceled in 1995 by nationalist politicians in the Maharashtra state who argued India didn’t need the power plant. The Enron episode illustrates the difficulty of enforcing contracts in foreign countries.2
2Since
EXHIBIT 1.1
ONEFOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT
Monthly Percentage Change in Japanese Yen–U.S. Dollar Exchange Rate
196019651970197519801985199019952000 Year
Source: International Monetary Fund, International Financial Statistics, various issues.
3It is noted that bearer and registered shares of Nestlé had the same claims on dividends but differential voting rights. Chapter 16 provides a detailed discussion of the Nestlé case. Market Imperfections
Although the world economy is much more integrated today than was the case 10 or 20 years ago, a variety of barriers still hamper free movements of people, goods, services, and capital across national boundaries. These barriers include legal restrictions, excessive transaction and transportation costs, and discriminatory taxation. The world markets are thus highly imperfect. As we will discuss later in this book, market imperfections, which represent various frictions and impediments preventing markets from functioning perfectly, play an important role in motivating MNCs to locate production overseas. Honda, a Japanese automobile company, for instance, decided to establish production facilities in Ohio, mainly to circumvent trade barriers. One might even say that MNCs are a gift of market imperfections.
Imperfections in the world financial markets tend to restrict the extent to which investors can diversify their portfolios. An interesting example is provided by the Nestlé Corporation, a well-known Swiss MNC. Nestlé used to issue two different classes of common stock, bearer shares and registered shares, and foreigners were allowed to hold only bearer shares. As Exhibit 1.2 shows, bearer shares used to trade for about twice the price of registered shares, which were exclusively reserved for Swiss residents.3 This kind of price disparity is a uniquely international phenomenon that is attributable to market imperfections.
On November 18, 1988, however, Nestlé lifted restrictions imposed on foreigners, allowing them to hold registered as well as bearer shares. After this announcement, the price spread between the two types of Nestlé shares narrowed drastically. As Exhibit 1.2 shows, the price of bearer shares declined sharply, whereas that of registered shares rose sharply. This implies that there was a major transfer of wealth from foreign shareholders to domestic shareholders. Foreigners holding Nestlé bearer shares were exposed to political risk in a country that is widely viewed as a haven from such risk. The Nestlé episode illustrates both the importance of considering market imperfections in international finance and the peril of political risk.
EXHIBIT 1.2
Daily Prices of Nestlé’s Bearer and Registered Shares
Nestlé voting bearer stock price
Expanded Opportunity Set
Nestlé registered stock price
November 18, 1988
Dec. 29, 1988 Jan 4, 1988 Jan 5, 1987
Source: Reprinted from Journal of Financial Economics, Volume 37, Issue 3, Claudio Loderer and Andreas Jacobs, “The Nestlé Crash,” pp. 315–339, 1995, with kind permission from Elsevier Science S.A., P.O. Box 564, 1001 Lausanne, Switzerland. 12001
Dec. 28, 1990 Jan 4, 1990
When firms venture into the arena of global markets, they can benefit from an expanded opportunity set. As previously mentioned, firms can locate production in any country or region of the world to maximize their performance and raise funds in any capital market where the cost of capital is the lowest. In addition, firms can gain from greater economies of scale when their tangible and intangible assets are deployed on a global basis. Areal-world example showing the gains from a global approach to financial management is provided by the following excerpt from The Wall Street Journal (April 9, 1996):
Another factor binding bond markets ever closer is large companies’flexibility to issue bonds around the world at will, thanks to the global swap market. At the vanguard are companies such as General Electric of the U.S. Mark VanderGriend, who runs the financing desk at Banque Paribas, says it took “about 15 minutes” to put together a four billion franc ($791.6 million) deal for GE. By raising the money in francs and swapping into dollars instantly, GE will save five hundredths of a percentage point—or about $400,000 annually on the nine-year deal. “They have such a huge requirement for capital that they are constantly looking for arbitrages,” adds Mr. VanderGriend. “And they don’t care much how they get there.”
Individual investors can also benefit greatly if they invest internationally rather than domestically. Suppose you have a given amount of money to invest in stocks. You may invest the entire amount in U.S. (domestic) stocks. Alternatively, you may allocate the funds across domestic and foreign stocks. If you diversify internationally, the resulting international portfolio may have a lower risk or a higher return (or both) than a purely domestic portfolio. This can happen mainly because stock returns tend to covary much less across countries than within a given country. Once you are aware of overseas investment opportunities and are willing to diversify internationally, you face a much expanded opportunity set and you can benefit from it. It just doesn’t make sense to play in only one corner of the sandbox.
Goals for International Financial Management
The foregoing discussion implies that understanding and managing foreign exchange and political risks and coping with market imperfections have become important parts of the financial manager’s job. International Financial Management is designed to CHAPTER
provide today’s financial managers with an understanding of the fundamental concepts and the tools necessary to be effective global managers. Throughout, the text emphasizes how to deal with exchange risk and market imperfections, using the various instruments and tools that are available, while at the same time maximizing the benefits from an expanded global opportunity set.
Effective financial management, however, is more than the application of the newest business techniques or operating more efficiently. There must be an underlying goal. International Financial Management is written from the perspective that the fundamental goal of sound financial management is shareholder wealth maximization. Shareholderwealth maximization means that the firm makes all business decisions and investments with an eye toward making the owners of the firm—the shareholders— better off financially, or more wealthy, than they were before.
Whereas shareholder wealth maximization is generally accepted as the ultimate goal of financial management in “Anglo-Saxon” countries, such as Australia, Canada, the United Kingdom, and especially the United States, it is not as widely embraced a goal in other parts of the world. In countries like France and Germany, for example, shareholders are generally viewed as one of the “stakeholders” of the firm, others being employees, customers, suppliers, banks, and so forth. European managers tend to consider the promotion of the firm’s stakeholders’overall welfare as the most important corporate goal. In Japan, on the other hand, many companies form a small number of interlocking business groups called keiretsu, such as Mitsubishi, Mitsui, and Sumitomo, which arose from consolidation of family-owned business empires. Japanese managers tend to regard the prosperity and growth of their keiretsu as the critical goal; for instance, they tend to strive to maximize market share, rather than shareholder wealth.
It is pointed out, however, that as capital markets are becoming more liberalized and internationally integrated in recent years, even managers in France, Germany, Japan and other non-Anglo-Saxon countries are beginning to pay serious attention to shareholder wealth maximization. In Germany, for example, companies are now allowed to repurchase stocks, if necessary, for the benefit of shareholders. In accepting an unprecedented $183 billion takeover offer by Vodafone AirTouch, a leading British wireless phone company, Klaus Esser, CEO of Mannesmann of Germany cited shareholder interests: “The shareholders clearly think that this company, Mannesmann, a great company, would be better together with Vodafone AirTouch. . . . The final decision belongs to shareholders.”4
Obviously, the firm could pursue other goals. This does not mean, however, that the goal of shareholder wealth maximization is merely an alternative, or that the firm should enter into a debate as to its appropriate fundamental goal. Quite the contrary. If the firm seeks to maximize shareholder wealth, it will most likely simultaneously be accomplishing other legitimate goals that are perceived as worthwhile. Shareholder wealth maximization is a long-run goal. Afirm cannot stay in business to maximize shareholder wealth if it treats employees poorly, produces shoddy merchandise, wastes raw materials and natural resources, operates inefficiently, or fails to satisfy customers. Only a well-managed business firm that profitably produces what is demanded in an efficient manner can expect to stay in business in the long run and thereby provide employment opportunities.
While managers are hired to run the company for the interests of shareholders, there is no guarantee that they will actually do so. As shown by a series of recent corporate scandals at companies like Enron, WorldCom, and Global Crossing, managers may pursue their own private interests at the expense of shareholders when they are not closely monitored. Extensive corporate malfeasance and accounting manipulations at
these companies eventually drove them into financial distress and bankruptcy, devastating shareholders and employees alike. Lamentably, some senior managers enriched themselves enormously in the process. Clearly, the boards of directors, the ultimate guardians of the interests of shareholders, failed to perform their duties at these companies. In the wake of these corporate calamities that have undermined the credibility of the free market system, the society has painfully learned the importance of corporate governance, that is, the financial and legal framework for regulating the relationship between a company’s management and its shareholders. Needless to say, the corporate governance problem is not confined to the United States. In fact, it can be a much more serious problem in many other parts of the world, especially emerging and transition economies, such as Indonesia, Korea, China, and Russia, where legal protection of shareholders is weak or virtually nonexistent.
Shareholders are the owners of the business; it is their capital that is at risk. It is only equitable that they receive a fair return on their investment. Private capital may not have been forthcoming for the business firm if it had intended to accomplish any other objective. As we will discuss shortly, the massive privatization that is currently taking place in developing and formerly socialist countries, which will eventually enhance the standard of living of these countries’citizens, depends on private investment. It is thus vitally important to strengthen corporate governance so that shareholders receive fair returns on their investments. In what follows, we are going to discuss in detail: (1) the globalization of the world economy, (2) the growing role of MNCs in the world economy, and (3) the organization of the text.
Globalization of the World Economy: Recent Trends
The term “globalization” became a popular buzzword for describing business practices in the last few decades, and it appears as if it will continue to be a key word for describing business management throughout the new century. In this section, we review a few key trends of the world economy: (i) the emergence of globalized financial markets, (ii) advent of the euro (iii) continued trade liberalization and economic integration, and (iv) large-scale privatization of state-owned enterprises.
Emergence of Globalized Financial Markets
The 1980s and 90s saw a rapid integration of international capital and financial markets. The impetus for globalized financial markets initially came from the governments of major countries that had begun to deregulate their foreign exchange and capital markets. For example, in 1980 Japan deregulated its foreign exchange market, and in 1985 the Tokyo Stock Exchange admitted as members a limited number of foreign brokerage firms. Additionally, the London Stock Exchange (LSE) began admitting foreign firms as full members in February 1986.
Perhaps the most celebrated deregulation, however, occurred in London on October 27, 1986, and is known as the “Big Bang.” On that date, as on “May Day” in 1975 in the United States, the London Stock Exchange eliminated fixed brokerage commissions. Additionally, the regulation separating the order-taking function from the marketmaking function was eliminated. In Europe, financial institutions are allowed to perform both investment-banking and commercial-banking functions. Hence, the London affiliates of foreign commercial banks were eligible for membership on the LSE. These changes were designed to give London the most open and competitive capital markets in the world. It has worked, and today the competition in London is especially fierce among the world’s major financial centers. The United States recently repealed the Glass-Steagall Act, which restricted commercial banks from investment banking activities (such as underwriting corporate securities), further promoting competition among financial institutions. Even developing countries such as Chile, Mexico, and Korea began to liberalize by allowing foreigners to directly invest in their financial markets.
10 PART ONEFOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT
www.imf.org/external/ np/exr/ib/
Offers an overview of globalization and ways in which countries may gain from the process.
Advent of the Euro
Deregulated financial markets and heightened competition in financial services provided a natural environment for financial innovations that resulted in the introduction of various instruments. Examples of these innovative instruments include currency futures and options, multicurrency bonds, international mutual funds, country funds, and foreign stock index futures and options. Corporations also played an active role in integrating the world financial markets by listing their shares across borders. Such wellknown non-U.S. companies as Seagram, Sony, Toyota Motor, Fiat, Telefonos de Mexico, KLM, British Petroleum, Glaxo, and Daimler are directly listed and traded on the New York Stock Exchange. At the same time, U.S. firms such as IBM and GM are listed on the Brussels, Frankfurt, London, and Paris stock exchanges. Such crossborder listings of stocks allow investors to buy and sell foreign shares as if they were domestic shares, facilitating international investments.5
Last but not least, advances in computer and telecommunications technology contributed in no small measure to the emergence of global financial markets. These technological advancements, especially Internet-based information technologies, gave investors around the world immediate access to the most recent news and information affecting their investments, sharply reducing information costs. Also, computerized order-processing and settlement procedures have reduced the costs of international transactions. Based on the U.S. Department of Commerce computer price deflator, the relative cost index of computing power declined from a level of 100 in 1960 to 15.6 in 1970, 2.9 in 1980, and only 0.5 in 1999. As a result of these technological developments and the liberalization of financial markets, cross-border financial transactions have exploded in recent years.
The advent of the euro at the start of 1999 represents a momentous event in the history of world financial system that has profound ramifications for the world economy. Currently, more than 300 million Europeans in 12 countries (Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain) are using the common currency on a daily basis. No single currency has circulated so widely in Europe since the days of the Roman Empire. Considering that up to 10 countries, including the Czech Republic, Hungary, and Poland, may join the European Union (EU) by the year 2004, and that many of them would like to adopt the euro relatively soon thereafter, the transaction domain of the euro may become larger than that of the U.S. dollar in the near future.
Once a country adopts the common currency, it obviously cannot have its own monetary policy. The common monetary policy for the euro zone is now formulated by the European Central Bank (ECB) that is located in Frankfurt and partly modeled after the Bundesbank, the German central bank. ECB is legally mandated to achieve price stability for the euro zone. Considering the sheer size of the euro zone in terms of population, economic output, and world trade share and the prospect of monetary stability in Europe, the euro has a strong potential for becoming another global currency rivaling the U.S. dollar for dominance in international trade and finance. Reflecting the significance of the euro’s introduction, Professor Robert Mundell, who is often referred to as the intellectual father of the euro, recently stated: “The creation of the euro area will eventually, but inevitably, lead to competition with the dollar area, both from the standpoint of excellence in monetary policy, and in the enlistment of other currencies.”6 The world thus faces a prospect of bipolar international monetary system.
5Various studies indicate that the liberalization of capital markets tends to lower the cost of capital. See, for example, Peter Henry, “Stock Market Liberalization, Economic Reform, and Emerging Market Equity Prices,” Journal Finance (2000), pp. 529–64.
6Source: Robert Mundell, 2000, “Currency Area, Volatility and Intervention,” Journal of Policy Modeling22 (3), 281–99
Trade Liberalization and Economic Integration
Since its inception in 1999, the euro has already brought about revolutionary changes in European finance. For instance, by redenominating corporate and government bonds and stocks from 12 different currencies into the common currency, the euro has precipitated the emergence of continentwide capital markets in Europe that are comparable to U.S. markets in its depth and liquidity. Companies all over the world can benefit from this development as they can raise capital more easily on favorable terms in Europe. In addition, the recent surge in European M&Aactivities, crossborder alliances among financial exchanges, and lessening dependence on the banking sectors for capital raising are all manifestations of the profound effects of the euro. The International Finance in Practice box, “Why We Believe in the Euro,” presents an upbeat view of the euro expressed by Jürgen Schrempp, CEO of DaimlerChrysler.
Since the end of World War I, the U.S. dollar has played the role of the dominant global currency, displacing the British pound. As a result, foreign exchange rates of currencies are quoted against the dollar and the lion’s share of currency trading involves the dollar on either the buy or sell side. Similarly, international trade in primary commodities, such as petroleum, coffee, wheat, and gold, is conducted using the U.S. dollar as the invoice currency. Reflecting the dominant position of the dollar in the world economy, central banks of the world hold a major portion of their external reserves in dollars. The ascendance of the dollar reflects several key factors such as the dominant size of the U.S. economy, mature and open capital markets, price stability, and the political and military power of the United States. It is noted that the dominant global currency status of the dollar confers upon the United States many special privileges such as the ability to run trade deficits without having to hold much foreign exchange reserves, that is, “deficits without tears,” and conduct a large portion of international transactions in dollars, without bearing exchange risks. However, once economic agents start to use the euro in earnest as an invoice, vehicle, and reserve currency, the dollar may have to share the aforementioned privileges with the euro.7
International trade, which has been the traditional link between national economies, continued to expand. As Exhibit 1.3 shows, the ratio of merchandise exports to GDP for the world has increased from 7.0 percent in 1950 to 19.7 percent in 2001. This implies that, over the same time period, international trade increased nearly three times as fast as world GDP. For some countries, international trade grew much faster; for Germany, the ratio rose from 6.2 percent to 31.1 percent, while for Taiwan it grew from 2.5 percent to 45.2 percent over the same time period. Latin American countries such as Argentina and Brazil have relatively low export-to-GDPratios. This reflects the inward-looking, protectionist economic policies these countries pursued in the past. Even these once-protectionist countries are now increasingly pursuing free-market and open-economy policies because of the gains from international trade.
The principal argument for international trade is based on the theory of comparative advantage, which was advanced by David Ricardo in his seminal book, Principles of Political Economy (1817). According to Ricardo, it is mutually beneficial for countries if they specialize in the production of those goods they can produce most efficiently and trade those goods among them. Suppose England produces textiles most efficiently, whereas France produces wine most efficiently. It then makes sense if England specializes in the production of textiles and France in the production of wine, and the two countries then trade their products. By doing so, the two countries can increase their combined production of textiles and wine, which, in turn, allows both countries
7Arecent study by Eun and Lai, 2002, “The Power Contest in FX Markets: The Euro vs. the Dollar,” indicates that within three years since its inception, the euro has succeeded in establishing its own currency bloc in Europe, comprising the currencies of Croatia, Czech Republic, Hungary, Norway, Slovakia, Slovenia, Sweden, and Switzrerland. The study, however, shows that the U.S. dollar remains as the dominant global currency. In contrast, the Japanese yen does not have its own currency bloc in Asia.
INTERNATIONAL FINANCE IN PRACTICE
Why We Believe in the Euro
By Jürgen Schrempp, CEO of DaimlerChrysler
In our company, we don’t mean to waste even a day in putting the euro to work. On Jan. 1, 1999—day one for the new currency—our company will switch over completely to the euro as the internal and external unit of account. We expect to be one of the first German-based companies—perhaps the first—to make such a complete change. We’ll also encourage our suppliers within Euroland to invoice us in euros from the very beginning. Our Euroland customers, of course, will have the option of paying in either euros or their domestic currency until 2001.
Nearly all major European companies are in favor of the single currency. But having recently agreed on a historic, transatlantic merger with Chrysler Corp. of the United States, we feel especially attuned to the forces of global competition that make the euro so essential. For our new company, DaimlerChrysler AG, and for Germany and Europe as a whole, economic and monetary union will bring substantial and lasting benefits as we take our place in the interdependent world of the 21st century.
Those benefits will take shape—indeed, are already occurring—in several realms at once. First and most fundamental is the political. The single currency will push the countries of Europe into cooperating more and more in seeking solutions to common economic problems. As they do so, they’ll grow increasingly intertwined politically.
At the same time, the euro will unleash powerful market forces certain to transform the way Europeans live and work. The years ahead will bring increased efficiency, greater productivity, higher overall living standards and lower unemployment. For businesses, a common currency will reduce transaction costs—eliminating, among other things, the unnecessary waste of resources involved in dealing with several European currencies. At present, doing business across borders means having to buy and sell foreign currencies—and taking the risk that sudden changes in their relative value could upend an otherwise sound business strategy. The risks can be hedged, of course, but only at a cost that must ultimately be borne by customers.
The market forces unleashed by the euro will be felt not just by corporate managers but also by political leaders. Business executives are already working to rationalize their companies, enhancing productivity and improving labor flexibility. Elected officials, facing competition as they try to attract the investments that create jobs, will eventually lower corporate tax rates and streamline regulation. In so doing, governments will give corporations a boost, like the reduction in the cost of capital that came about as countries tightened their fiscal and monetary policies in preparation for EMU.
These changes are mutually reinforcing. And as they take hold, Euroland companies will grow more confident
United States2.53.73.63.05.07.2
Canada12.012.215.813.019.941.1
(Merchandise Exports/GDP at 1990 Prices, in Percent)
Australia7.412.811.29.111.217.6
United Kingdom12.017.713.311.414.019.0
Germany9.515.612.86.223.831.1
France4.98.28.67.715.424.7
Spain3.88.15.01.65.019.0
Japan0.22.43.52.37.910.7
Korea0.01.04.51.08.236.0
Taiwan0.02.55.22.510.245.2
Thailand2.16.76.67.04.559.4
Argentina9.46.86.12.42.19.9
Brazil11.89.57.14.02.610.3
Mexico3.710.814.83.52.228.7
World5.08.79.07.011.219.7
Source: Various issues of
about committing resources to long-term projects. A lookat the level of corporate mergers in recent years shows that managers have already stepped up their strategic decision making. Europe saw 237 such deals last year, worth $250 billion, of which 25 percent were European cross-border transactions. In 1995, by contrast, there were just 100 deals, worth $168 billion— and only 17 percent were European cross-border transactions.
Euroland will be a strong base for companies striving to compete globally. In 1997 its combined population numbered 290 million, compared with 268 million for the United States and 126 million for Japan. Its combined GDP was $6.3 trillion, versus $7.8 trillion for the United States and $4.2 trillion for Japan. Euroland already trades with the rest of the world as much as the United States does, and the picture will change in favor of Europe as soon as the United Kingdom, and others who have stayed out of the first wave, join the currency union. Such a development—the sooner the better—is something we would very much welcome.
Launching the new euro is one thing; successfully managing the EMU process in the years ahead is quite another. Implementation poses major challenges. Some will be technical; others will have to do with maintaining a unity of purpose among a diverse group of nations, regions, peoples and cultures. I believe, however, that Europe possesses the unshakable political will and financial expertise needed to keep this endeavor on track.
It will help that—as we as DaimlerChrysler well know—some of the payoffs are immediate and obvious.
Currently, one third of our group’s revenues are earned in Deutsche marks, but nearly three quarters of our costs are incurred in that currency. That makes planning harder and running the company more complex. But with the coming of the euro, the disparity between our DM costs and DM revenues will diminish. As of January, 50 percent of our revenues will be in euros, with 80 percent of our costs incurred in the same currency.
How will the euro affect our ability to compete in the United States, our main export market outside the EU?
In a word, positively. Higher productivity and a stable “home” currency will allow us to maintain a competitive pricing structure. Such long-term consistency in our business practices is something our U.S. customers have come to appreciate.
One final point. Thanks to the single market and the pending introduction of a single currency, Europe has matured both politically and economically. As a major transatlantic player, DaimlerChrysler is now in a position to communicate an important message to its business partners in that other great single-currency market, the United States. Working through the World Trade Organization and other groups, the globe has made great progress toward free and fair trade over the years. Now let us together examine opportunities for removing some of the remaining obstacles to trade between Europe and the United States. The beneficiaries will be consumers on both sides of the Atlantic.
Source: Newsweek, Special Issue. Winter 1998, p. 38. Reprinted with permission.
to consume more of both goods. This argument remains valid even if one country can produce both goods more efficiently than the other country.8 Ricardo’s theory has a clear policy implication: Liberalization of international trade will enhance the welfare of the world’s citizens. In other words, international trade is not a “zero-sum” game in which one country benefits at the expense of another country—the view held by the “mercantilists.” Rather, international trade could be an “increasing-sum” game at which all players become winners.
www.wto.org/
The World Trade Organization website covers news and data about international trade development.
Although the theory of comparative advantage is not completely immune to valid criticism, it nevertheless provides a powerful intellectual rationale for promoting free trade among nations. Currently, international trade is becoming further liberalized at both the global and regional levels. At the global level, the General Agreement on Tariffs and Trade (GATT), which is a multilateral agreement among member countries, has played a key role in dismantling barriers to international trade. Since it was founded in 1947, GATThas been successful in gradually eliminating and reducing tariffs, subsidies, quotas, and other barriers to trade. The latest round of talks, the Uruguay Round launched in 1986, aims to (1) reduce the import tariffs worldwide by an average of 38 percent, (2) increase the proportion of duty-free products from 20 percent to 44 percent for industrialized countries, and (3) extend the rules of world trade to cover agriculture, services such as banking and insurance, and intellectual property rights. It also created a permanent World Trade Organization (WTO) to replace GATT. The WTO
8Readers are referred to Appendix 1Afor a detailed discussion of the theory of comparative advantage.
14 PART ONEFOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT
has more power to enforce the rules of international trade. China recently joined WTO. China’s WTO membership will further legitimize the idea of free trade.
www.lib.berkeley.edu/ GSSI/eu.html
The University of California at Berkeley library provides a web guide to resources related to the European Union.
Privatization
On the regional level, formal arrangements among countries have been instituted to promote economic integration. The European Union (EU) is a prime example. The European Union is the direct descendent of the European Community (formerly the European Economic Community), which was established to foster economic integration among the countries of Western Europe. Today the EU includes 15 member states that have eliminated barriers to the free flow of goods, capital, and people. The member states of the EU hope this move will strengthen its economic position relative to the United States and Japan. In January 1999, 11 member countries of EU successfully adopted a single common currency, the euro, which may rival the U.S. dollar as a dominant currency for international trade and investment. The launch of the euro has spurred a rush by European companies into seeking pan-European and global alliances. Merger and acquisition (M&A) deals in Europe totaled $1.2 trillion in 1999, exceeding the figure for U.S. deals for the first time. The EU may expand in the near future to include such formerly socialist countries as Poland, Hungary, and the Czech Republic.
Whereas the economic and monetary union planned by the EU is one of the most advanced forms of economic integration, a free trade area is the most basic. In 1994, Canada, the United States, and Mexico entered into the North American Free Trade Agreement (NAFTA). Canada is the United States’largest trading partner and Mexico is the third-largest. In a free trade area, all impediments to trade, such as tariffs and import quotas, are eliminated among members. The terms of NAFTAcall for phasing out tariffs over a 15-year period. Many observers believe that NAFTAwill foster increased trade among its members, resulting in an increase in the number of jobs and the standard of living in all member countries. It is interesting to note from Exhibit 1.3 that for Mexico, the ratio of export to GDPhas increased dramatically from 2.2 percent in 1973 to 28.7 percent in 2001.
The economic integration and globalization that began in the 1980s picked up speed inthe 1990s via privatization. Through privatization, a country divests itself of the ownership and operation of a business venture by turning it over to the free market system. Privatization did not begin with the fall of the Berlin Wall; nevertheless, its pace has quickly accelerated since the collapse of communism in the Eastern Bloc countries. It is ironic that the very political and economic system that only a short while ago extolled the virtues of state ownership should so dramatically be shifting toward capitalism by shedding state-operated businesses. President Calvin Coolidge once said that the business of America is business. One might now say that business is the business of the world.9
Privatization can be viewed in many ways. In one sense it is a denationalization process. When a national government divests itself of a state-run business, it gives up part of its national identity. Moreover, if the new owners are foreign, the country may simultaneously be importing a cultural influence that did not previously exist. Privatization is frequently viewed as a means to an end. One benefit of privatization for many less-developed countries is that the sale of state-owned businesses brings to the national treasury hard-currency foreign reserves. The sale proceeds are often used to pay down sovereign debt that has weighed heavily on the economy. Additionally, privatization is often seen as a cure for bureaucratic inefficiency and waste; some economists estimate that privatization improves efficiency and reduces operating costs by as much as 20 percent.
9Our discussion in this subsection draws heavily from the article in the special “World Business” section of TheWall Street Journal, October 2, 1995, entitled “Sale of the Century.”
There is no one single way to privatize state-owned operations. The objectives of the country seem to be the prevailing guide. For the Czech Republic, speed was the overriding factor. To accomplish privatization en masse, the Czech government essentially gave away its businesses to the Czech people. For a nominal fee, vouchers were sold that allowed Czech citizens to bid on businesses as they went on the auction block. From 1991 to 1995, more than 1,700 companies were turned over to private hands. Moreover, three-quarters of the Czech citizens became stockholders in these newly privatized firms.
In Russia, there has been an “irreversible” shift to private ownership, according to the World Bank. More than 80 percent of the country’s nonfarm workers are now employed in the private sector. Eleven million apartment units have been privatized, as have half of the country’s 240,000 other business firms. Additionally, via a Czech-style voucher system, 40 million Russians now own stock in over 15,000 medium- to largesize corporations that recently became privatized through mass auctions of stateowned enterprises.
For some countries, privatization has meant globalization. For example, to achieve fiscal stability, New Zealand had to open its once-socialist economy to foreign capital. Australian investors now control its commercial banks, and U.S. firms purchased the national telephone company and timber operations. While workers’rights have changed under foreign ownership and a capitalist economy, New Zealand now ranks high among the most competitive market environments. Fiscal stability has also been realized. In 1994, New Zealand’s economy grew at a rate of 6 percent and inflation was under control. As can be seen from the experiences of New Zealand, privatization has spurred a tremendous increase in cross-border investment. The Bank for International Settlements reports that foreign direct investment has soared to $240 billion in 1994 from an annual level of $100 billion in the early 1990s and only $10 billion a decade earlier.
Multinational Corporations
In addition to international trade, foreign direct investment by MNCs is a major force driving globalization of the world economy. According to a UN report, there are about 60,000 MNCs in the world with over 500,000 foreign affiliates.10 Throughout the 1990s, foreign direct investment by MNCs grew at the annual rate of about 10 percent. In comparison, international trade grew at the rate of 3.5 percent during the same period. MNCs’worldwide sales reached $11 trillion in 1998, compared to about $7 trillion of world exports in the same year.11 As indicated in the International Finance in Practice box on page 17, MNCs are reshaping the structure of the world economy.
www.unctad.org/wir/
This UNCTAD website provides a broad coverage of crossborder investment activities by multinational corporations.
A multinational corporation (MNC) is a business firm incorporated in one country that has production and sales operations in several other countries. The term suggests a firm obtaining raw materials from one national market and financial capital from another, producing goods with labor and capital equipment in a third country, and selling the finished product in yet other national markets. Indeed, some MNCs have operations in dozens of different countries. 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 exchange risk.
Exhibit 1.4 lists the top 40 of the largest 100 MNCs ranked by the size of foreign assets. The list was compiled by the United Nations Conference on Trade and Development (UNCTAD). Many of the firms on the list are well-known MNCs with household
10The source for this information is the United Nations’ World Investment Report 1999. 11The source of this information is World Investment Report 1999, the United Nations.
EXHIBIT 1.4 The World’s Top 40 MNCs Ranked by Foreign Assets, 1999 (Billions of Dollars) AssetsSales Ranking by Foreign
1General ElectricUnited StatesElectronics141.1405.232.7111.6
2ExxonMobil CorporationUnited StatesPetroleum expl./ref./distr.99.4144.5115.5160.9
3Royal Dutch/Shell GroupThe Netherlands/Petroleum expl./ref./distr.68.7113.953.5105.4 United Kingdom
4General MotorsUnited StatesMotor vehicles68.5274.746.5176.6
5Ford Motor CompanyUnited StatesMotor vehicles..273.450.1162.6
6Toyota Motor CorporationJapanMotor vehicles56.3154.960.0119.7
7DaimlerChrysler AGGermanyMotor vehicles55.7175.9122.4151.0
8TotalFina SAFrancePetroleum expl./ref./distr...77.631.639.6
9IBMUnited StatesComputers44.787.550.487.6
10BPUnited KingdomPetroleum expl./ref./distr.39.352.657.783.5
11Nestlé SASwitzerlandFood/beverages33.136.845.946.7
12Volkswagen GroupGermanyMotor vehicles..64.347.870.6
13Nippon Mitsubishi JapanPetroleum expl./ref./distr.31.535.528.433.9 Oil Corporation (Nippon Oil Co. Ltd.)
14Siemens AGGermanyElectronics..76.653.272.2
15Wal-Mart StoresUnited StatesRetailing30.250.019.4137.6
16Repsol-YPF SASpainPetroleum expl./ref./distr.29.642.19.126.3
17Diageo PlcUnited KingdomBeverages28.040.416.419.0
18Mannesmann AGGermanyTelecommunications/..57.711.821.8 engineering
19Suez Lyonnaise des EauxFranceDiversified/utility..71.69.723.5
20BMW AGGermanyMotor vehicles27.139.226.836.7
21ABBSwitzerlandElectrical equipment27.030.623.824.4
22Sony CorporationJapanElectronics..64.243.163.1
23Seagram CompanyCanadaBeverages/media25.635.012.311.8
24UnileverUnited Kingdom/Food/beverages25.328.038.444.0
The Netherlands
25AventisFrancePharmaceuticals/..39.04.719.2 chemicals
26Mitsubishi CorporationJapanDiversified24.678.615.8127.3
27Roche GroupSwitzerlandPharmaceuticals24.527.118.118.4
28Renault SAFranceMotor vehicles..46.423.937.6
29Honda Motor Co Ltd.JapanMotor vehicles24.441.838.751.7
30Telefónica SASpainTelecommunications24.264.19.523.0
31News CorporationAustraliaMedia/publishing23.538.412.914.3
32Motorola IncUnited StatesElectronics23.540.518.333.1
33Philips ElectronicsThe NetherlandsElectronics22.729.831.833.5
34Nissan Motor Co. Ltd.JapanMotor vehicles..59.7..58.1
35British American United KingdomFood/tobacco22.026.216.518.1 Tobacco Plc
36ENI GroupItalyPetroleum expl./ref./distr.20.944.311.429.1
37Chevron CorporationUnited StatesPetroleum expl./ref./distr.20.140.79.735.4
38Johnson & JohnsonUnited States Pharmaceuticals19.829.212.127.5
39Hewlett-PackardUnited StatesElectronics/computers..35.323.442.4
40Elf Aquitaine SAFrancePetroleum expl./ref./distr.18.843.225.735.8
Source: World Investment Report 2001, United Nations.
INTERNATIONAL FINANCE IN PRACTICE
Mulutinationals More Efficient
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 businesses, according to the Organisation for Economic Co-operation and Development.
The Paris-based organisation also says that the proportion of manufacturing under foreign ownership in European Union countries rose substantially during the 1990s, a sign of increasing economic integration.
In a report on the global role of multinationals, the OECD points out that for some countries, the level of production abroad by foreign subsidiaries of national businesses was comparable to total exports from these countries.
The finding underlines the increasing importance in the world economy of large companies with bases scattered across the globe.
Gross output per employee, a measure of productivity, in most OECD nations tends to be greater in multinationals than in locally-owned companies, the report says.
This is partly a factor of the multinationals being bigger and more geared to operating according to worldclass levels of efficiency. But it also reflects their ability to transfer new thinking in production technologies through an international factory network.
Reflecting the greater efficiencies, workers in foreignowned plants tend to earn more money than those in locally-owned ones.
In Turkey, employees of multinationals earn double the wages of their counterparts. The equivalent figure in the UK is 23 per cent and in the US it is 9 per cent.
In the EU in 1998, a quarter of total manufacturing production was controlled by a foreign subsidiary of a
Foreign companies’ share in manufacturing production 1998 or lastest year (%)
Ireland
Hungary
Luxembourg
Canada
Poland*
Netherlands
France
UK**
Czech Rep*
Norway
Sweden
US
Finland*
Italy**
Turkey
Germany
Japan
01020304050607080
Source: OECD, Activities of Foreign Affiliates database
*1999 **1997
bigger company compared to 17 per cent in 1990. The figure has probably increased since then, and is expected to climb further as the impact of the euro tightens the link between member countries’ economies.
Measuring Globalisation: The Role of Multinationals in OECD Economies. For details see www.oecd.org
Source: Peter Marsh, Financial Times, March 20, 2002, p. 6. Reprinted with permission.
names because of their presence in consumer product markets. For example, General Motors, Royal/Dutch Shell, Toyota, Daimler-Benz, IBM, Philip Morris, British Petroleum, Unilever, Nestlé, Sony, and Siemens are names recognized by most people. By country of origin, U.S. MNCs, with 26 out of the total of 100, constitute the largest group. Japan ranks second with 18 MNCs in the top 100, followed by France with 13, Germany with 12, and the U.K. with 8. It is interesting to note that some Swiss firms are extremely multinational. Nestlé, for instance, derived about 98 percent of its sales from overseas markets.
MNCs may gain from their global presence in a variety of ways. First of all, MNCs can benefit from the economy of scale by (1) spreading R&D expenditures and advertising costs over their global sales, (2) pooling global purchasing power over suppliers, (3) utilizing their technological and managerial know-how globally with minimum additional costs, and so forth. Furthermore, MNCs can use their global presence to take advantage of underpriced labor services available in certain developing countries, and gain access to special R&D capabilities residing in advanced foreign countries. MNCs can indeed leverage their global presence to boost their profit margins and create shareholder value.
Organization of the Text
International Financial Management contains 21 chapters divided into four parts. Part One, Foundations of International Financial Management, contains five chapters on the fundamentals of international finance. This section lays the macroeconomic foundation for all the topics to follow. Athorough understanding of this material is essential for understanding the advanced topics covered in the remaining sections.
Chapter 2 introduces the student to the various types of international monetary systems under which the world economy can function and has functioned at various times. Extensive treatment is given to the differences between a fixed and a flexible exchange rate regime. The chapter traces the historical development of the world’s international monetary systems from the early 1800s to the present. Additionally, a detailed discussion of the European Monetary System of the European Union is presented. Chapter 3 presents balance-of-payment concepts and accounting. The chapter is designed to show that even a national government must keep its “economic house in order” or else it will experience current account deficits that will undermine the value of its currency. This chapter also shows how the balance of payments reveals the sources of demand and supply of a country’s currency. It concludes by surveying the balance-of-payments trends in major countries.
Chapter 4 provides an introduction to the organization and operation of the spot and forward foreign exchange market. It describes institutional arrangements of the foreign exchange markets and details of how foreign exchange is quoted and traded worldwide. Chapter 5, in turn, presents some of the fundamental international parity relationships among exchange rates, interest rates, and inflation rates. An understanding of these parity relationships, which are manifestations of market equilibrium, is essential for astute financial management in a global setting. Chapter 5 begins with the derivation of interest rate parity, showing the interrelationship between the interest rates of two countries and the spot and forward exchange rates between the same two countries. Similarly, the theory of purchasing power parity (PPP) is developed, showing the relationship between a change in exchange rate between two countries and the relative values of their inflation rates. The limitations of PPPare clearly detailed. The chapter concludes with a discussion of forecasting exchange rates using parity relationships and other fundamental and technical forecasting techniques.
The chapters in Part One lay the macroeconomic foundation for International Financial Management. Exhibit 1.5 provides a diagram that shows the text layout. The diagram shows that the discussion moves from a study of macroeconomic foundations to a study of the financial environment in which the firm and the financial manager must function. Financial strategy and decision making can be discussed intelligently only after one has an appreciation of the financial environment.
Part Two, World Financial Markets and Institutions, provides a thorough discussion of international financial institutions, financial assets, and marketplaces, and develops the tools necessary to manage exchange rate uncertainty. Chapter 6, International Banking and the Money Market, begins the section. The chapter differentiates between international and domestic bank operations and examines the institutional differences between various types of international banking offices. International banks and their clients make up the Eurocurrency market and form the core of the international money market. The chapter includes a discussion of the features and characteristics of the major international money market instruments: forward rate agreements, Euronotes, Euro-medium-term notes, and Eurocommercial paper. The chapter concludes with an examination of the international debt crisis that severely jeopardized the economic viability of many of the world’s largest banks during the past decade.
Chapter 7 distinguishes between foreign bonds and Eurobonds, which together make up the international bond market. It discusses the advantages to the issuer of sourcing funds from the international bond market as opposed to raising funds domestically. It describes both the underwriting procedure for issuing new Eurobonds and the
EXHIBIT 1.5
Overview of the Organization of International Financial Management Macroeconomic The Financial Management of the EnvironmentEnvironmentMultinational Firm
I.Foundations of International Financial Management
1.Globalization and the Multinational Firm
2.International Monetary System
3.Balance of Payments
4.The Market for Foreign Exchange
5.International Parity Relationships and Forecasting Foreign Exchange Rates
II.World Financial Markets and Institutions
6.International Banking and Money Market
7.International Bond Market
8.International Equity Markets
9.Futures and Options on Foreign Exchange
10.Currency and Interest Rate Swaps
11.International Portfolio Investments
III.Foreign Exchange Exposure and Management
12.Management of Economic Exposure
13.Management of Transaction Exposure
14.Management of Translation Exposure
IV.FinancialManagementoftheMultinationalFirm
15.Foreign Direct Investment and Cross-Border Acquisitions
16.International Capital Structure and the Cost of Capital
17.International Capital Budgeting
18.Multinational Cash Management
19.Exports and Imports
20.International Tax Environment
21.Corporate Governance around the World
procedure for trading existing international bonds in the secondary market. Adiscussion of the major types of international bonds is included in the chapter. The chapter concludes with a discussion of international bond ratings.
Chapter 8 covers international equity markets. There is not a separate international equity market that operates parallel to domestic equity markets. Instead, the equity shares of certain corporations have broad appeal to international investors rather than just investors from the country in which the corporation is incorporated. Chapter 8 documents the size of both developed and developing country equity markets. Various methods of trading equity shares in the secondary markets are discussed. Additionally, the chapter discusses the advantages to the firm of cross-listing equity shares in more than one country.
Chapter 9 provides an extensive treatment of exchange-traded currency futures and options contracts. The chapter covers the institutional details of trading these derivative securities and also develops basic valuation models for pricing them. We believe that derivative securities are best understood if one also understands what drives their value. How to use derivative securities is saved for Chapters 13 and 14, which examine the topics of transaction exposure and translation exposure.
Approximately 30 percent of the bonds issued in the world end up being involved in an interest rate or currency swap. Chapter 10 provides an extensive treatment of both types of swaps. The chapter provides detailed examples and real-life illustrations of swap arrangements that highlight the cash flows between counterparties and that clearly delineate the risks inherent in swap transactions. Swap pricing is also covered.
Chapter 11 covers international portfolio investment. The chapter begins by examining the benefits to the investor from diversifying his or her portfolio internationally rather than just domestically. It shows that the gains from international diversification come from the lower correlations that typically exist among international assets in comparison to those existing among domestic assets. The chapter documents the potential benefits from international diversification that are available to all national investors. An appendix to the chapter shows how the rewards from international diversification can be further enhanced by using derivative contracts to hedge the exchange rate risk in the portfolio.
Part Three, Foreign Exchange Exposure and Management, comprises three chapters, one each devoted to the topics of economic, transaction, and translation exposure management. Chapter 12 covers economic exposure, that is, the extent to which the value of the firm will be affected by unexpected changes in exchange rates. The chapter provides a way to measure economic exposure, discusses its determinants, and presents methods for managing and hedging economic exposure. Several real-life illustrations are provided.
Chapter 13 covers the management of transaction exposure that arises from contractual obligations denominated in a foreign currency. Several methods for hedging this exposure are compared and contrasted: the forward hedge, the futures hedge, the money market hedge, and the options hedge. The chapter also discusses why aMNC should hedge, a debatable subject in the minds of both academics and practitioners.
Chapter 14 covers translation exposure or, as it is sometimes called, accounting exposure. Translation exposure refers to the effect that an unanticipated change in exchange rates will have on the consolidated financial reports of a MNC. The chapter discusses, compares, and contrasts the various methods for translating financial statements denominated in foreign currencies. The chapter includes a discussion of managing translation exposure using funds adjustment and the pros and cons of using balance sheet and derivatives hedges.
Part Four, Financial Management of the Multinational Firm, covers topics on financial management practices for the MNC. The section begins with Chapter 15 on foreign direct investment, which discusses why MNCs make capital expenditures in productive capacity in foreign lands rather than just produce domestically and then export to overseas markets. The chapter also deals with an increasingly popular form of foreign investment, cross-border mergers and acquisitions. The chapter includes a full treatment of the political risk associated with foreign investment.
Chapter 16 deals with the international capital structure and the cost of capital of a MNC. An analytical argument is presented showing that the firm’s cost of equity capital is lower when its shares trade internationally rather than just in the home country. Moreover, the cost of debt can be reduced if debt capital is sourced internationally. The result of international trading of equity and sourcing debt in the international bond market is a lower weighted average cost of capital, which increases the net present value of capital expenditures as well as the value of the firm.
Chapter 17 presents the adjusted present value (APV) framework of Donald Lessard, which is useful for a parent firm in analyzing a capital expenditure in foreign operations. The APVframework is a value additivity model that determines the present value of each relevant cash flow of a capital project by discounting at a rate of discount consistent with the risk inherent in the cash flow. The Lessard model is an insightful method for analyzing capital expenditures.
Chapter 18 covers issues in cash management for the MNC. The chapter begins with an illustration of a cash management system for a MNC. It is shown that if a centralized cash depository is established and if the parent firm and its foreign affiliates employ a multinational netting system, the number of foreign cash flows can be reduced, thus saving the firm money and giving the MNC better control of its cash. It is also shown that managing cash transactions through a centralized depository that administers a precautionary cash balance portfolio reduces the systemwide investment in cash. Additionally, transfer pricing strategies are explored as a means for reducing a MNC’s worldwide tax liability. Further, transfer pricing strategies and other methods are considered as means for removing blocked funds from a host country.
Chapter 19 provides a brief introduction to trade financing and countertrade. Through the use of an example, a typical foreign trade transaction is traced from beginning to end. The example shows the three primary documents used in trade financing: letter of credit, time draft, and bill of lading. The example also shows how a time draft can become a negotiable money market instrument called a banker’s acceptance. The chapter concludes with a discussion of countertrade transactions, which
are reciprocal promises between a buyer and a seller to purchase goods or services from one another.
Chapter 20 examines the international tax environment. The chapter opens with a discussion on the theory of taxation, exploring the issues of tax neutrality and tax equity. Different methods of taxation—income tax, withholding tax, value-added tax— are considered next. Income tax rates in select countries are compared, as are the withholding tax rates that exist through tax treaties between the United States and certain countries. The chapter concludes with a treatment of the organizational structures MNCs can use for reducing tax liabilities.
The text concludes with Chapter 21, which deals with the important issue of corporate governance. Among other things, the chapter explains how separation of ownership and control in modern corporations gives rise to agency problems—conflict of interest between agents (managers) and principals (shareholders)—and how different countries deal with the problem using different corporate governance frameworks. The chapter also discusses the practical issue of how to improve corporate governance practices so that the interests of managers and shareholders can be better aligned.
SUMMARY
This chapter provided an introduction to International Financial Management.
1.It is essential to study “international” financial management because we are now living in a highly globalized and integrated world economy. Owing to the (a) continuous liberalization of international trade and investment, and (b) rapid advances in telecommunications and transportation technologies, the world economy will become even more integrated.
2.Three major dimensions distinguish international finance from domestic finance. They are (a) foreign exchange and political risks, (b) market imperfections, and (c) an expanded opportunity set.
3.Financial managers of MNCs should learn how to manage foreign exchange and political risks using proper tools and instruments, deal with (and take advantage of) market imperfections, and benefit from the expanded investment and financing opportunities. By doing so, financial managers can contribute to shareholder wealth maximization, which is the ultimate goal of international financial management.
4.The theory of comparative advantage states that economic well-being is enhanced if countries produce those goods for which they have comparative advantages and then trade those goods. The theory of comparative advantage provides a powerful rationale for free trade. Currently, international trade is becoming liberalized at both the global and the regional levels. At the global level, WTO plays a key role in promoting free trade. At the regional level, the European Union and NAFTA play a vital role in dismantling trade barriers within regions.
5.Amajor economic trend of the present decade is the rapid pace with which former state-owned businesses are being privatized. With the fall of communism, many Eastern Bloc countries began stripping themselves of inefficient business operations formerly run by the state. Privatization has placed a new demand on international capital markets to finance the purchase of the former state enterprises, and it has also brought about a demand for new managers with international business skills.
6.In modern times, it is not a country per se but rather a controller of capital and know-how that gives the country in which it is domiciled a comparative advantage over another country. These controllers of capital and know-how are multinational corporations (MNCs). Today, it is not uncommon for a MNC to produce merchandise in one country on capital equipment financed by funds raised in a number of different currencies through issuing securities to investors in many countries and then selling the finished product to customers in yet other countries.
PART ONEFOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT
KEY WORDS
corporate governance, 9
European Central Bank, 10
European Union (EU), 14 expanded opportunity set, 7
foreign exchange risk, 5 General Agreement on Tariffs and Trade (GATT), 13
QUESTIONS
globalized and integrated world economy, 4 market imperfections, 6 multinational corporation (MNC), 15 North American Free Trade Agreement (NAFTA), 14 political risk, 5 privatization, 14
shareholder wealth maximization, 8 theory of comparative advantage, 11 transaction domain 10 World Trade Organization (WTO), 13
1.Why is it important to study international financial management?
2.How is international financial management different from domestic financial management?
3.Discuss the three major trends that have prevailed in international business during the last two decades.
4.How is a country’s economic well-being enhanced through free international trade in goods and services?
5.What considerations might limit the extent to which the theory of comparative advantage is realistic?
6.What are multinational corporations (MNCs) and what economic roles do they play?
7.Ross Perot, a former presidential candidate of the Reform Party, which is a third political party in the United States, had strongly objected to the creation of the North American Trade Agreement (NAFTA), which nonetheless was inaugurated in 1994. Perot feared the loss of American jobs to Mexico where it is much cheaper to hire workers. What are the merits and demerits of Perot’s position on NAFTA? Considering the recent economic developments in North America, how would you assess Perot’s position on NAFTA?
8.In 1995, a working group of French chief executive officers was set up by the Confederation of French Industry (CNPF) and the French Association of Private Companies (AFEP) to study the French corporate governance structure. The group reported the following, among other things: “The board of directors should not simply aim at maximizing share values as in the U.K. and the U.S. Rather, its goal should be to serve the company, whose interests should be clearly distinguished from those of its shareholders, employees, creditors, suppliers and clients but still equated with their general common interest, which is to safeguard the prosperity and continuity of the company.” Evaluate the above recommendation of the working group.12
9.Emphasizing the importance of voluntary compliance, as opposed to enforcement, in the aftermath of such corporate scandals as those involving Enron and WorldCom, U.S. President George W. Bush stated that while tougher laws might help, “ultimately, the ethics of American business depends on the conscience of America’s business leaders.” Describe your view on this statement.
10.Suppose you are interested in investing in shares of Nokia Corporation of Finland, which is a world leader in wireless communication. But before you make investment decision, you would like to learn about the company. Visit the website of
12This question draws on the article by François Degeorge, “French Boardrooms Wake Up Slowly to the Need for Reform,” in the Complete MBACompanion in Global Business, Financial Times, 1999, pp. 156–60.
REFERENCES & SUGGESTED READINGS
CNN Financial Network (www.cnnfn.com) and collect information about Nokia, including the recent stock price history and analysts’views of the company. Discuss what you learn about the company. Also discuss how the instantaneous access to information via Internet would affect the nature and workings of financial markets.
1.Visit the corporate websites of Nestlé, one of the most multinational companies in the world, and study the scope of geographical diversification of its sales and revenues. Also, gather and evaluate the company’s financial information from the related websites. You may use such Internet search engines as Netscape, Microsoft Internet Explorer, and Yahoo.
Nike’s Decision
Nike, a U.S.-based company with a globally recognized brand name, manufactures athletic shoes in such Asian developing countries as China, Indonesia, and Vietnam using subcontractors, and sells the products in the U.S. and foreign markets. The company has no production facilities in the United States. In each of those Asian countries where Nike has production facilities, the rates of unemployment and underemployment are quite high. The wage rate is very low in those countries by U.S. standards; the hourly wage rate in the manufacturing sector is less than one dollar in each of those countries, compared with about $18 in the United States. In addition, workers in those countries often operate in poor and unhealthy environments and their rights are not well protected. Understandably, Asian host countries are eager to attract foreign investments like Nike’s to develop their economies and raise the living standards of their citizens. Recently, however, Nike came under worldwide criticism for its practice of hiring workers for such a low pay—“next to nothing” in the words of critics—and condoning poor working conditions in host countries.
Evaluate and discuss various ethical as well as economic ramifications of Nike’s decision to invest in those Asian countries.
Basic Finance References
Bodie, Zvi, Alex Kane, and Alan J. Marcus. Investments, 5th ed. New York: Irwin/McGraw-Hill, 2001.
Ross, Stephen A., Randolph W. Westerfield, and Jeffrey F. Jaffee. Corporate Finance, 6th ed. New York: Irwin/McGraw-Hill, 2002.
International Accounting References
Al Hashim, Dhia D., and Jeffrey S. Arpan. International Dimensions of Accounting, 3rd ed. Boston: PWS-Kent, 1992.
Meuller, Gerhard G., Helen Gernon, and Gary Meek. Accounting: An International Perspective, 5thed. Burr Ridge, Ill.: Richard D. Irwin, 2000.
International Economics References
Baker, Stephen A. An Introduction to International Economics. San Diego: Harcourt Brace Jovanovich, 1990.
Husted, Steven, and Michael Melvin. International Economics, 5th ed. Reading, Mass.: AddisonWesley, 2000.
Krugman, Paul R., and Maurice Obstfeld. International Economics: Theory and Policy, 6th ed. Reading, Mass.: Addison-Wesley, 2002.
Rivera-Batiz, Francisco L., and Luis Rivera-Batiz. International Finance and Open Economy Macroeconomics, 2nd ed. Upper Saddle River, N.J.: Prentice Hall, 1994.
Appendix 1A Gains from Trade: The Theory of ComparativeAdvantage
The theory of comparative advantage was originally advanced by the 19th-century economist David Ricardo as an explanation for why nations trade with one another. The theory claims that economic well-being is enhanced if each country’s citizens produce that which they have a 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, buildings, labor, technology, and capital) are relatively immobile. Consider the example described in Exhibit A.1 as a vehicle for explaining the theory.
Exhibit A.1 assumes two countries, Aand B, which each produce only food and textiles, but they do not trade with one another. Country Aand B each have 60,000,000 units of input. Each country presently allocates 40,000,000 units to the production of food and 20,000,000 units to the production of textiles. Examination of the exhibit shows that Country Acan produce five pounds of food with one unit of production or three yards of textiles. Country B has an absolute advantage over Country Ain the production of both food and textiles. Country B can produce 15 pounds of food or four yards of textiles with one unit of production. When all units of production are employed, Country Acan produce 200,000,000 pounds of food and 60,000,000 yards of textiles. Country B can produce 600,000,000 pounds of food and 80,000,000 yards of textiles. Total output is 800,000,000 pounds of food and 140,000,000 yards of textiles. Without trade, each nation’s citizens can consume only what they produce.
While it is clear from the examination of Exhibit A.1 that Country B has an absolute advantage in the production of food and textiles, it is not so clear that Country A(B) has a relative advantage over Country B (A) in producing textiles (food). Note that in using units of production, Country Acan “trade off” one unit of production needed to produce five pounds of food for three yards of textiles. Thus, a yard of textiles has an opportunity cost of 5/3 1.67 pounds of food, or a pound of food has an opportunity cost of 3/5 .60 yards of textiles. Analogously, Country B has an opportunity cost of 15/4 3.75 pounds of food per yard of textiles, or 4/15 .27 yards of textiles per pound of food. When viewed in terms of opportunity costs it is clear that Country Ais relatively more efficient in producing textiles and Country B is relatively more efficient in producing food. That is, Country A’s (B’s) opportunity cost for producing textiles (food) is less than Country B’s (A’s). A relative efficiency that shows up via a lower opportunity cost is referred to as a comparative advantage.
Exhibit A.2 shows that when there are no restrictions or impediments to free trade, such as import quotas, import tariffs, or costly transportation, the economic well-being of the citizens of both countries is enhanced through trade. Exhibit A.2 shows that Country Ahas shifted 20,000,000 units from the production of food to the production of textiles where it has a comparative advantage and that Country B has shifted 10,000,000 units from the production of textiles to the production of food where it has a comparative advantage. Total output is now 850,000,000 pounds of food and 160,000,000 yards of textiles. Suppose that Country Aand Country B agree on a price of 2.50 pounds of food for one yard of textiles, and that Country Asells Country B 50,000,000 yards of textiles for 125,000,000 pounds of food. With free trade, Exhibit A.2 makes it clear that the citizens of each country have increased their consumption of food by 25,000,000 pounds and textiles by 10,000,000 yards.
EXHIBIT A.1
Input/Output without Trade
EXHIBIT A.2
Input/Output with Free Trade
I.Units of input (000,000)
II.Output per unit of input (lbs. or yards)
III.Total output (lbs. or yards) (000,000) Food200600800
IV.Consumption (lbs. or yards) (000,000) Food200600800
I.Units of input (000,000)
II.Output per unit of input (lbs. or yards) Food515
III.Total output (lbs. or yards) (000,000)
IV.Consumption (lbs. or yards) (000,000) Food225625850
PROBLEMS
1.Country C can produce seven pounds of food or four yards of textiles per unit of input. Compute the opportunity cost of producing food instead of textiles. Similarly, compute the opportunity cost of producing textiles instead of food.
2.Consider the no-trade input/output situation presented in the following table for countries X and Y. Assuming that free trade is allowed, develop a scenario that will benefit the citizens of both countries.
Input/Output without Trade Country
I.Units of input (000,000) Food7060 Textiles4030
II.Output per unit of input (lbs. or yards) Food175
III.Total output (lbs. or yards) (000,000)
Food1,1903001,490 Textiles20060260
IV.Consumption (lbs. or yards) (000,000)
Food1,1903001,490 Textiles20060260
CHAPTER 2
Evolution of the International MonetarySystem
Bimetallism: Before 1875
International Monetary System
Classical Gold Standard: 1875–1914
Interwar Period: 1915–1944
Bretton Woods System: 1945–1972
The Flexible Exchange Rate Regime:
1973–Present
The Current Exchange Rate Arrangements
European Monetary System
The Euro and the European Monetary Union
A Brief History of the Euro
What Are the Benefits of Monetary Union?
Costs of Monetary Union
Prospects of the Euro: Some Critical Questions
The Mexican Peso Crisis
The Asian Currency Crisis
Origins of the Asian Currency Crisis
Lessons from the Asian Currency Crisis
Fixed versus Flexible Exchange Rate Regimes
Summary
Key Words
Questions
Internet Exercises
MINI CASE: Will the U.K. Join the Euro Club?
References and Suggested Readings
THIS CHAPTER EXAMINES the international monetary system, which defines the overall financial environment in which multinational corporations operate. As mentioned in Chapter 1, the exchange rates among major currencies, such as the U.S. dollar, British pound, Swiss franc, and Japanese yen, have been fluctuating since the fixed exchange rate regime was abandoned in 1973. Consequently, corporations nowadays are operating in an environment in which exchange rate changes may adversely affect their competitive positions in the marketplace. This situation, in turn, makes it necessary for many firms to carefully measure and manage their exchange risk exposure. As we will discuss shortly, however, many European countries have adopted a common currency called the euro, rendering intra-European trade and investment much less susceptible to exchange risk. The complex international monetary arrangements imply that for adroit financial decision making, it is essential for managers to understand, in detail, the arrangements and workings of the 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. The international monetary system has evolved over time and will continue to do so in the future as the fundamental business and political conditions underlying the world economy continue to shift. In this chapter, we will review the history of the international monetary system and contemplate its future prospects. In addition, we will compare and contrast the alternative exchange rate systems, that is, fixed versus flexible exchange rates.
Evolution of the International Monetary System
The international monetary system went through several distinct stages of evolution. These stages are summarized as follows:
1.Bimetallism: Before 1875.
2.Classical gold standard: 1875–1914.
3.Interwar period: 1915–1944.
4.Bretton Woods system: 1945–1972.
5.Flexible exchange rate regime: Since 1973.
We now examine each of the five stages in some detail.
Bimetallism: Before 1875
Prior to the 1870s, many countries had bimetallism, that is, a double standard in that free coinage was maintained for both gold and silver. In Great Britain, for example, bimetallism was maintained until 1816 (after the conclusion of the Napoleonic Wars) when Parliament passed a law maintaining free coinage of gold only, abolishing the free coinage of silver. In the United States, bimetallism was adopted by the Coinage Act of 1792 and remained a legal standard until 1873, when Congress dropped the silver dollar from the list of coins to be minted. France, on the other hand, introduced and maintained its bimetallism from the French Revolution to 1878. Some other countries such as China, India, Germany, and Holland were on the silver standard.
The international monetary system before the 1870s can be characterized as “bimetallism” in the sense that both gold and silver were used as international means of payment and that the exchange rates among currencies were determined by either their gold or silver contents.1 Around 1870, for example, the exchange rate between the British pound, which was fully on a gold standard, and the French franc, which was officially on a bimetallic standard, was determined by the gold content of the two currencies. On the other hand, the exchange rate between the franc and the German mark, which was on a silver standard, was determined by the silver content of the currencies. The exchange rate between the pound and the mark was determined by their exchange rates against the franc. It is also worth noting that, due to various wars and political upheavals, some major countries such as the United States, Russia, and Austria-Hungary had irredeemable currencies at one time or another during the period 1848–79. One might say that the international monetary system was less than fully systematic up until the 1870s.
Countries that were on the bimetallic standard often experienced the well-known phenomenon referred to as Gresham’s law. Since the exchange ratio between the two metals was fixed officially, only the abundant metal was used as money, driving more scarce metal out of circulation. This is Gresham’s law, according to which “bad” (abundant) money drives out “good” (scarce) money. For example, when gold from newly discovered mines in California and Australia poured into the market in the 1850s, the value of gold became depressed, causing overvaluation of gold under the French official ratio, which equated a gold franc to a silver franc 151⁄2 times as heavy. As a result, the franc effectively became a gold currency.
Classical Gold Standard: 1875–1914
Mankind’s fondness for gold as a storage of wealth and means of exchange dates back to antiquity and was shared widely by diverse civilizations. Christopher Columbus once said, “Gold constitutes treasure, and he who possesses it has all he needs in this world.” The first full-fledged gold standard, however, was not established until 1821 in Great Britain, when notes from the Bank of England were made fully redeemable for gold. As previously mentioned, France was effectively on the gold standard beginning in the 1850s and formally adopted the standard in 1878. The newly emergent German empire, which was to receive a sizable war indemnity from France, converted to the gold standard in 1875, discontinuing free coinage of silver. The United States adopted the gold standard in 1879, Russia and Japan in 1897.
One can say roughly that the international gold standard existed as a historical reality during the period 1875–1914. The majority of countries got off gold in 1914 when
1This does not imply that each individual country was on a bimetallic standard. In fact, many countries were on either a gold standard or a silver standard by 1870.
PART ONEFOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT
World War I broke out. The classical gold standard as an international monetary system thus lasted for about 40 years. During this period, London became the center of the international financial system, reflecting Britain’s advanced economy and its preeminent position in international trade.
An international gold standard can be said to exist when, in most major countries, (1) gold alone is assured of unrestricted coinage, (2) there is two-way convertibility between gold and national currencies at a stable ratio, and (3) gold may be freely exported or imported. In order to support unrestricted convertibility into gold, banknotes need to be backed by a gold reserve of a minimum stated ratio. In addition, the domestic money stock should rise and fall as gold flows in and out of the country. The above conditions were roughly met between 1875 and 1914.
Under the gold standard, the exchange rate between any two currencies will be determined by their gold content. For example, suppose that the pound is pegged to gold at six pounds per ounce, whereas one ounce of gold is worth 12 francs. The exchange rate between the pound and the franc should then be two francs per pound. To the extent that the pound and the franc remain pegged to gold at given prices, the exchange rate between the two currencies will remain stable. There were indeed no significant changes in exchange rates among the currencies of such major countries as Great Britain, France, Germany, and the United States during the entire period. For example, the dollar–sterling exchange rate remained within a narrow range of $4.84 and $4.90 per pound. Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment.
Under the gold standard, misalignment of the exchange rate will be automatically corrected by cross-border flows of gold. In the above example, suppose that one pound is trading for 1.80 francs at the moment. Since the pound is undervalued in the exchange market, people will buy pounds with francs, but not francs with pounds. For people who need francs, it would be cheaper first to buy gold from the Bank of England and ship it to France and sell it for francs. For example, suppose that you need to buy 1,000 francs using pounds. If you buy 1,000 francs in the exchange market, it will cost you £555.56 at the exchange rate of Fr1.80/£. Alternatively, you can buy 83.33 1,000/12 ounces of gold from the Bank of England for £500:
£500 (1,000/12) 6
Then you could ship it to France and sell it to the Bank of France for 1,000 francs. This way, you can save about £55.56.2 Since people only want to buy, not sell, pounds at the exchange rate of Fr1.80/£, the pound will eventually appreciate to its fair value, namely, Fr2.0/£.
Under the gold standard, international imbalances of payment will also be corrected automatically. Consider a situation where Great Britain exported more to France than the former imported from the latter. This kind of trade imbalance will not persist under the gold standard. Net export from Great Britain to France will be accompanied by a net flow of gold in the opposite direction. This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Great Britain. (Recall that under the gold standard, the domestic money stock is supposed to rise or fall as the country experiences an inflow or outflow of gold.) The resultant change in the relative price level, in turn, will slow exports from Great Britain and encourage exports from France. As a result, the initial net export from Great Britain will eventually disappear.
2In this example, we ignored shipping costs. But as long as the shipping costs do not exceed £55.56, it is still advantageous to buy francs via “gold export” than via the foreign exchange market.
This adjustment mechanism is referred to as the price-specie-flow mechanism, which is attributed to David Hume, a Scottish philosopher.3
Despite its demise a long time ago, the gold standard still has ardent supporters in academic, business, and political circles, which view it as an ultimate hedge against price inflation. Gold has a natural scarcity and no one can increase its quantity at will. Therefore, if gold serves as the sole base for domestic money creation, the money supply cannot get out of control and cause inflation. In addition, if gold is used as the sole international means of payment, then countries’balance of payments will be regulated automatically via the movements of gold.4
The gold standard, however, has a few key shortcomings. First of all, the supply of newly minted gold is so restricted that the growth of world trade and investment can be seriously hampered for the lack of sufficient monetary reserves. The world economy can face deflationary pressures. Second, whenever the government finds it politically necessary to pursue national objectives that are inconsistent with maintaining the gold standard, it can abandon the gold standard. In other words, the international gold standard per se has no mechanism to compel each major country to abide by the rules of the game.5 For such reasons, it is not very likely that the classical gold standard will be restored in the foreseeable future.
Interwar Period: 1915–1944
World War I ended the classical gold standard in August 1914, as major countries such as Great Britain, France, Germany, and Russia suspended redemption of banknotes in gold and imposed embargoes on gold exports. After the war, many countries, especially Germany, Austria, Hungary, Poland, and Russia, suffered hyperinflation. The German experience provides a classic example of hyperinflation: By the end of 1923, the wholesale price index in Germany was more than 1 trillion times as high as the prewar level. Freed from wartime pegging, exchange rates among currencies were fluctuating in the early 1920s. During this period, countries widely used “predatory” depreciations of their currencies as a means of gaining advantages in the world export market.
As major countries began to recover from the war and stabilize their economies, they attempted to restore the gold standard. The United States, which replaced Great Britain as the dominant financial power, spearheaded efforts to restore the gold standard. With only mild inflation, the United States was able to lift restrictions on gold exports and return to a gold standard in 1919. In Great Britain, Winston Churchill, the chancellor of the Exchequer, played a key role in restoring the gold standard in 1925. Besides Great Britain, such countries as Switzerland, France, and the Scandinavian countries restored the gold standard by 1928.
The international gold standard of the late 1920s, however, was not much more than a façade. Most major countries gave priority to the stabilization of domestic economies and systematically followed a policy of sterilization of gold by matching inflows and outflows of gold respectively with reductions and increases in domestic money and credit. The Federal Reserve of the United States, for example, kept some gold outside the credit base by circulating it as gold certificates. The Bank of England also followed the policy of keeping the amount of available domestic credit stable by neutralizing the
3The price-specie-flow mechanism will work only if governments are willing to abide by the rules of the game by letting the money stock rise and fall as gold flows in and out. Once the government demonetizes (neutralizes) gold, the mechanism will break down. In addition, the effectiveness of the mechanism depends on the price elasticity of the demand for imports.
4The balance of payments will be discussed in detail in Chapter 3.
5This point need not be viewed as a weakness of the gold standard per se, but it casts doubt on the long-term feasibility of the gold standard.
effects of gold flows. In a word, countries lacked the political will to abide by the “rules of the game,” and so the automatic adjustment mechanism of the gold standard was unable to work.
Even the façade of the restored gold standard was destroyed in the wake of the Great Depression and the accompanying financial crises. Following the stock market crash and the onset of the Great Depression in 1929, many banks, especially in Austria, Germany, and the United States, suffered sharp declines in their portfolio values, touching off runs on the banks. Against this backdrop, Britain experienced a massive outflow of gold, which resulted from chronic balance-of-payment deficits and lack of confidence in the pound sterling. Despite coordinated international efforts to rescue the pound, British gold reserves continued to fall to the point where it was impossible to maintain the gold standard. In September 1931, the British government suspended gold payments and let the pound float. As Great Britain got off gold, countries such as Canada, Sweden, Austria, and Japan followed suit by the end of 1931. The United States got off gold in April 1933 after experiencing a spate of bank failures and outflows of gold. Lastly, France abandoned the gold standard in 1936 because of the flight from the franc, which, in turn, reflected the economic and political instability following the inception of the socialist Popular Front government led by Leon Blum. Paper standards came into being when the gold standard was abandoned.
In sum, the interwar period was characterized by economic nationalism, halfhearted attempts and failure to restore the gold standard, economic and political instabilities, bank failures, and panicky flights of capital across borders. No coherent international monetary system prevailed during this period, with profoundly detrimental effects on international trade and investment.
Bretton Woods System: 1945–1972
In July 1944, representatives of 44 nations gathered at Bretton Woods, New Hampshire, to discuss and design the postwar international monetary system. After lengthy discussions and bargains, representatives succeeded in drafting and signing the Articles of Agreement of the International Monetary Fund (IMF), which constitutes the core of the Bretton Woods system. The agreement was subsequently ratified by the majority of countries to launch the IMF in 1945. The IMF embodied an explicit set of rules about the conduct of international monetary policies and was responsible for enforcing these rules. Delegates also created a sister institution, the International Bank for Reconstruction and Development (IBRD), better known as the World Bank, that was chiefly responsible for financing individual development projects.
In designing the Bretton Woods system, representatives were concerned with how to prevent the recurrence of economic nationalism with destructive “beggar-thy-neighbor” policies and how to address the lack of clear rules of the game plaguing the interwar years. The British delegates led by John Maynard Keynes proposed an international clearing union that would create an international reserve asset called “bancor.” Countries would accept payments in bancor to settle international transactions, without limit. They would also be allowed to acquire bancor by using overdraft facilities with the clearing union. On the other hand, the American delegates, headed by Harry Dexter White, proposed a currency pool to which member countries would make contributions and from which they might borrow to tide themselves over during short-term balance-of-payments deficits. Both delegates desired exchange rate stability without restoring an international gold standard. The American proposal was largely incorporated into the Articles of the Agreement of the IMF.
Under the Bretton Woods system, each country established a parvalue in relation to the U.S. dollar, which was pegged to gold at $35 per ounce. This point is illustrated in Exhibit 2.1. Each country was responsible for maintaining its exchange rate within 1 percent of the adopted par value by buying or selling foreign exchanges as necessary.