Topic 6 The Global Financial Environment

The Scope of International Finance

On the street and in shops, we find cars and different models of vehicles from Japan, clothing from Hong Kong, whiskey from Scotland, wine from France and the list continues. Every one of these commodities has reached us from some other land and has involved international investment and movement of money along the channels of payments network. That is the subject of International Finance.

Events in distant land (changes in price of oil, gold, election results, outbreak of wars, peace treaties) have effects which instantly reverberate around the globe. The consequences of events (in the stock markets and interest rates of one country) immediately show up around the world, the result of integrated and interdependent financial environment.

The links between money and capital markets have become so close (no individual parts) 

Historical Overview

Three recent changes have had a profound effect on the international financial environment:

• The end of the Cold War, the emergence of growing markets among the developing countries of East Asia and Latin America,
• The rapid industrialization and economic growth of countries in several parts of the world (4 Asian Tigers –Hong Kong, Singapore, South Korea, Taiwan)
• Increased Globalization – Nations economies are becoming more financially integrated.

Benefits of Studying International Finance

First - Helps financial managers and international managers decide how international events will affect a firm and which steps can be taken to exploit positive development and insulate the firm from the harm ones.

Second - Helps managers to anticipate events and to make profitable decisions before events occur. Changes in exchange rates, interest rates, inflation rates, national income as well as changes in political environment.

Maurice D. Levi (1990) Amidst the events that affect any firm, managers must anticipate changes in exchange rates, interest rates, inflation rates, and national incomes, as well as the prospects for change in political environments. These events are intricately linked, and are crucial that the links understood in order for managers to make profitable decisions while at the same time trying to avoid the harmful effects of the changes taking place. In general the world moved to a;

• Government intervention in the market
• Buying or selling their own currency, if they wanted to lower or raise it value in terms of other currencies.
• International Trade
• International Investments

Growing Importance of International Finance

It is important to recognize that the international flows of goods and capital that are behind the subject of international finance are important for our well-being. Let us look at the evidences in the international movement of goods and capital across international boundaries.

Example: LNG Project in PNG saw capital movement into the country and our gas product exported.

People and nationals have been trading with each other since beginning of civilization. Since record keeping came into existence, records of trade between countries and people have shown a significant growth in trading between nations which are growing faster than domestic trade. (You can access some of these data from reputable organization such as the World Bank and IMF). 

The Rewards of International Trade - International trade bring about:

• increase prosperity
• Competition allows for efficiency in production
• Quality of Goods and Services
• Alternative products choices
• Comparative advantages 

Risks of International Trade - There are added risks that businesses have to take into considerations:

 

• Uncertainty on future exchange rates
• Unexpected change in exchange rates
• Country risks (War, revolutions political & social risks)
• Currency restrictions
• Impositions of tariffs, quotas etc.

Increased Globalization of Financial and Real-Asset Markets

Besides the importance of international trade versus domestic trade, there has been a growing importance of foreign versus domestic investments in the money market, the bond market, the stock market, real estate markets as well as markets for operating businesses.

 

Rewards of Globalization of Investment and International Flows of Capital

• Improvement in the global allocation of capital formation.
• Enhanced ability to diversify investment portfolios.
• Increase possibilities of diversification of investments due to economic factors vary from countries to countries.

Costs of Globalization of Investment

Exchange-rate risk – Unanticipated changes in exchange rates cause uncertainty in investors’ home currency values of assets and liabilities

Country Risk – are risks that as a results of civil unrest, wars, revolutions or any other social events may results in a firm not being paid for its export. Country risks may also include uncertainty about possible imposition or change of import tariffs or quotas, possible change in subsidization of local producers and impositions of other non-tariffs barriers.

The Balance of Payments and Exchange Rates Determinations

Commodities on the world market are priced and just like any commodity, the price of a country’s currency depends on the supply of and demand for that currency, at least when the exchange rates are determined in a free, unregulated market.

Factors behind the Supply and Demand for a Currency

Appreciation of a Currency – Any factor increasing the demand for the currency, will increase the foreign exchange value of the currency.

Depreciation of a currency – Any factor increasing the supply of the currency will reduce the foreign exchange value of the currency.

One factor of particular importance for explaining the changes in exchange rates in the long-run is inflation.

Balance of Payment Accounts

With demand and supply of any currency, there is considerable interest to maintain records of the factors behind the supply and demand of a country’s currency and this is maintained in the Balance of Payments accounts.

Why maintain records? – One of the reasons why records are maintained and published is to report on the country’s international performance in trading with other nations. 

International Manifestations of the Law of One Price.

When you look at the topic of International Manifestations of the so-called law of one price there are two relationships to the nature of and limitation of this subject;

First of these relationship occurs in the commodity markets, where the law of price states that, when measured in a common currency, freely traded commodities should cost the same everywhere. The extension of this relationship is the principles of purchasing-power parity (PPP).

The second relationship occurs in the money markets, where the of one price states that, when measured in a common currency, interest yields and borrowing costs should be the same everywhere. The relationship is known as the interest parity principles.

The Law of One Price - The connection between exchange rates and commodity prices is known as the law of one price.

Opportunity for profit will catch the eyes of an entrepreneur somewhere in the world – the chance to buy an item in one place and sell it in another place for profit.

Commodity Arbitragers – People who buy in one market and sell in another markets are known as commodity arbitragers.

Cash Management and Market Efficiency

For most corporations, both the inflow and the outflow of funds are frequently uncertain. It is therefore important for companies to maintain a certain degree of liquidity (working cash).

• Coins and currency
• Bank deposits
• Overdraft facilities
• Marketable securities

Objectives for an effective cash flow management in an international environment are both:-

• to allocate short-term investments
• cash-balance holdings between currencies & countries to maximize overall corporate returns.
• To borrow in different money markets to achieve minimum costs.

Issues different from those encountered in the money markets and with direct investment are:-

• Investing in Stock and Bonds
• Raising of Capital via the issue of stock and Bonds.

The Global Financial Environment – Conflict of Interest

External conflicts relate to profit-motivated decisions which involve the

• Transfer of funds
• Production
• Exports
• Imports
• Employment from one country to another.

For instance, an MNC’s wish for foreign exchange remittances frequently conflicts with a local government’s restrictions on these remittances. 

The Global Financial Environment - Current Trends

The effects of the global financial crisis on developing countries:-

Will differ by region

By the ability of individual countries to offset adverse effects on domestic banking sectors and the broader financial market.

sizable widening of spreads and are increasingly being shut out of international bond markets.

A pullback in syndicated bank lending is emerging  (as commercial banks and other financial institutions in the high-income countries shore up balance sheets by limiting new lending or by calling in existing lines of credit).

• Public equity offerings from key emerging markets have dried up.
• Decrease in capital inflows to developing economies.
• Uncertainty leads to decline in global investment .
• Downward pressure on growth.
• Lower capital inflows.
• High Cost in Food and fuel prices.
• Increasing deficits are narrowing development.
• Slowdown in growth impact on industrial production. 

When discussing global finance there are many factors involved:

Political issues – laws and regulations that has an impact of financial transaction across borders.

Economic issues – international trade involve international financial transactions Exchange rates, financial markets, investments, loan etc..

Regulatory risks - are differences in legal systems, overlapping jurisdictions, and restrictive business practices against foreign companies.

Students are encouraged to read other text books on the subject of international finance to enhance knowledge .

 

Source: International Finance, International Edition; Maurice D. Levi, Second Edition