Principles of international Finance

TITLE: PRINCIPLES OF INTERNATIONAL FINANCE

PART I

1.0 INTRODUCTION TO INTERNATIONAL FINANCIAL MANAGEMENT

What is International Financial Management?

This is concerned with financial management in an international setting.

Financial management in general terms is mainly concerned with how to optimally make various corporate financial decisions, such as those pertaining to:-

- Investment;
- Capital structures;
- Dividend policy; and
- Working capital management.

All the above decisions are with the view to achieving a set of given corporate objectives.

We need international financial management because we are now turning in a highly globalize and integrated world. 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 globalize. To a large extent, this has happened as a result of multinational corporations (MNCs) …. Efforts to source inputs and locate production anywhere in the world where costs are lower and profits are higher.

Recently, financial markets have also become highly integrated. This development allows investors to diversify their portfolios internationally. In the words of a wall street journal article, “Over the past decade, its investors have framed buckets of money into overseas markets, in the form of mutual funds. At the same time, Japanese investors are investing heavily in U.S and other foreign financial markets an effort to recycle enormous trade surpluses.

In addition, many major corporations of the world, such as IBM, Sony, etc, have the shares cross-listed on foreign stock exchange, thereby rendering their shares internationally tradable and gaining access to foreign capital as well.

Undoubtedly, we are now living in a world where all the major economic functions. Consumption, production and investment are highly globalised. It is thus essential for financial managers to fully understand vital international dimensions of financial management.

Dimensions about International Finance

This deals with: “How is international finance different from domestic finance”.

There are three major dimensions set for international finance a part from domestic finance. They are:-

1. Foreign exchange and political risk.
2. Market imperfection.
3. Expanded opportunity set.

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 movement of people, goods and capital across their borders.

1. Foreign Exchange and Political Risk

When firms and individuals are engaged in cross border 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 fluctuate continuously in an unpredictable manner. This has been the case since the early 1970s when fixed exchange rates were abandoned, exchange rate utility has exploded since 1973 and will have a persuasive influence in all major economic functions, that is, consumption, production and investment.

On the other hand, one of the major risks that face firms and individuals an international setting is “political risk”; and this 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.

For example, in 1992, the Enron Development Corporation, a subsidiary of a Huston-based energy-based company, signed a contract to build India’s longest power plant. After Euron had spent nearly $300 million, the project was cancelled in 1995 by nationalist politicians in the Maharashtra State, who argued India did not need the power plant. This episode illustrates the difficulty of enforcing contracts with foreign committees.

2. Market Imperfections

Although the world economy is much more integrated today than was the case 20 years ago, a variety of barriers still hamper free movement 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. Market imperfections, which of present various functions and impediments preventing markets from functioning perfectly, play an important role in motivating MNCs to locate production overseas. For example, Honda, a Japanese automobile company, decided to establish production facilities in Ohio, Munich to circumvent trade barriers i.e. MNCs are always referred to be a gift of market imperfections.

Imperfections in the world financial market tend to restrict the extent to which investors can diversify their portfolio. For example, Nestle Company, a Swiss MNC, used to issue two different classes of common stock, bearer shares and registered shares and foreigners were allowed to hold only bearer shares. Bearer shares used to trade for about twice the price of registered shares, which were exclusively presented for Swiss residents. This kind of price disparity is a uniquely international phenomenon that is attributable to market imperfections.

3. Expanded Opportunity Set

When firms venture into the arena of global markets, they can benefit from “an Expanded Opportunity Set”. 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 lowest. In addition, firms can gain from greater economies of scale when their tangible and intangible assets are deployed on a global basis.

Individual investors can also benefit greatly if they invest internationally rather than domestically. If you diversify internationally, the resulting international portfolio may have a lower risk or higher return (or both) than a purely domestic portfolio.

This can happen mainly because stock returns tend to carry 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.

Goals for International Financial Management

International Financial Management is designed to provide today’s financial managers with an understanding of the fundamental concepts and tools necessary to be effective global managers. International financial management is geared to the realization of the goal of “shareholder wealth maximization”, which means that the firm makes all business decisions and investment with an eye towards making the owners of the firm – the shareholders better off financially, or more wealthy, than they were before.

GLOBALISATION OF THE WORLD ECONOMY: RECENT TRENDS

(i) Key Trends of the World Economy

The emergence of globalised financial markets. The 1990s saw the rapid integration of international capital and financial markets. The impetus for globalized financial markets initially came from the government of major countries that began to deregulate the foreign exchange and capital markets.

For example, in 1980, Japan deregulated its foreign exchange market; 1986, the Big Bang occurred when the London Stock Exchange eliminated brokerage commissions, etc.

Deregulated financial markets and heightened competition in financial services provided a national environment for financial innovation that resulted in the introduction of various instruments; e.g. currency futures and options, multi currency frauds, international mutual funds, country funds and foreign stock index futures and options.

Communications played an active role in integrating the world financial market listing their shares across boarders, and this allow investors to buy and sell foreign shares as if they were domestic shares, facilitating international investments.

Lastly, advances in computer and telecommunication technology contributed to the emergence of global financial markets. These technological advancements, especially internet based information technologies gave the 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 cost of international transactions. As a result of these technological developments and the liberalization of financial markets, cross boarder financial transactions have exploded in recent years.

(ii) Advent of the Euro

This has caused a massive change in the history of the financial world system. The common monetary policy for the euro zone is now formulated by the European Central Bank (ECB) that is located in Frankfurt.

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 in becoming another global currency rivaling the US dollar for dominance in international trade and finance. The creation of the euro area will eventually but inevitably lead to competition with the dollar area both from the stand point of excellence in monetary policy, and in the enlistment of other currencies. Thus the world faces a prospect of bifrolen international monetary system.

Since its inception, the euro has already brought about revolutionary changes in European finance. For example, by redenominating corporate and government bonds and stocks from 12 different currencies into the common currency, the euro has predicated the emergence of contaminated capital markets in Europe that are comparable to the US market in depth and liquidity. Countries from all over the world can benefit as they can raise capital more easily on favourable terms in Europe.

In addition, the recent surge in Europe M&A activities, cross boarder alliances among financial exchanges, and lessening dependence on banking sector for capital raining are all manifestation of the profound efforts of the euro.

(iii) Trade liberalization and Economic Litigation

International trade, which has been the traditional link between national economies continued to expand. Currently, international trade is becoming further liberalized at both the regional and the global levels.

At the global level, the GATT, which is a multilateral agreement among member countries has played a key role in dismantling barriers to international trade. GATT since its formation has been successful in gradually eliminating and reducing tariffs, subsidies, quotas and other barriers to trade.

On the regional level, formal arrangement among countries have been instituted to promote integration. All these have helped to ease the movement of goods and services across the globe and among countries.

(iv) Privatization

Through this, a country divest itself of the ownership and operation of a business venture by turning it over to the free market system. The major benefit is that the sale of state owned businesses brings to the national treasury local currency foreign reserves. The sale proceeds are often used to pay down sovereign debts that has weighed heavily on the economy.

Multinational Corporations

In addition to international trade, foreign direct investment by MNCs is a major predominating force in globalization of the world economy.

A MNC is a business firm incorporated in one country that has a production and sales operations in several countries. It involves a firm obtaining raw materials from one national market and financial capital from another, producing goods with labour and capital equipment in a third country and selling the finished product in yet other national markets.

MNCs obtain financing from major money centres 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.

MNCs may gain from their global preserve in a variety of ways:

(a) MNCs can benefit from the economy of scale by:

- Spreading R & D expenditures and advertising costs over their global sales.
- Pooling global purchasing power over suppliers.
- Utilizing their technological and managerial know how globally with minimum additional costs, etc.

(b) MNC can use their global preserve to take advantage of under prices, labour 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.

2.0 INTERNATIONAL MONETARY SYSTEM

Introduction

This defines the overall financial environment in which multinational corporations operate. 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, mechanizations, and policies regarding exchange rates, international payments, and the flow of capital.

Evolution of the International Monetary System

The international monetary system went through several distinct stages of evolution as follows:

1. Bimetallism, Begue 1875.
2. Classical Gold Standard: 1875-1914.
3. Inter war period 1915-1944.
4. BreHon Woods System: 1945-1972.
5. Flexible exchange rate regime: since 1973.

1. Bimetallism: Before 1875

Prior to the 1870s, many countries had “bimetallism”, that is, a double standard in that free coverage was maintained for both gold and silver. For example, in Great Britain, bimetallism was maintained until 1816 when Parliament passed a law maintaining free coverage of sliver.

While in the USA, bimetallism was adopted by the Coverage Act of 1792 and remained a legal standard until 1873, when congress dropped the silver dollar from the list of coins to be invited.

However, the international monetary system before 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 gold or silver contents. For example, Ground 1870, the exchange rate between the British pound, which was fully on a gold standard, and the French firm, which was officially in a bimetallic standard, was determined by the gold content of the two currencies.

On the other hand, the exchange rate between the pound and the mark was determined by their exchange rates against the franc.

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 what is termed as “Gresham’s Law”, according to which “bad” (abundant) money drives out “good” (scarce) money.

2. Classical Gold Standard: 1875-1914

Gold has been widely praised as a store for health and a means of exchange. Christopher Columbus once said “Gold constitutes treasure and he who preserves it has all he needs in this world”.

The first full fledged “gold standard”, however, was not established until 1801 in Great Britain, when notes from the Bank of England were made fully redeemable for gold.

France was effectively on the gold standard beginning in the 1850s and finally adopted the standard in 1878; while the USA adopted the gold standard in 1879, Russia and Japan in 1897.

However, the majority of countries got off gold in 1914 when world war I broke out. Among the classical gold, standard system, London became the centre of international financial system, reflecting Britain’s advanced economy and its pre-eminent position in international trade.

In international gold standard can be said to exist when, in most major countries:

(i) gold alone is assured of unrestricted coinage;
(ii) there is two way convertibility between gold and national currencies at a stable ratio; and
(iii) gold may be freely exported or imported. In order to support unrestricted convertibility into gold, bank notes need to be backed by a gold reserve of a minimum stated ratio. In addition, the domestic money stock shall rise and full as gold flows in and out of the country.

Under the gold standard, the exchange rate between two currencies were 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 would 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.

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 was automatically converted by cross border flows of gold. Likewise, international imbalances of payment was also converted automatically. This adjustment mechanism is referred to as the “price-spew-flow mechanism”. Gold standard is still viewed to-date as an ultimate hedge against price inflation. Gold has a national scarcity and no one can increase its quantity at will. Likewise gold is used as the sole international means of payment, then the countries’ balance of payments will be regulated automatically via the movements of gold.

The Gold Standard, however, has few short comings:-

(i) 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 fare deflationary pressures.

(ii) 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. And there were the reasons for the collapse of the system.

3. The Inter war Period: 1915-1944

World war I ended the classical gold standard in August 1914, as major countries such as major countries such as Great Britain, France, Germany and Russia suspended redemption of bank notes in gold and imposed embargoes on gold exports.

After the war, many countries suffered buffer inflation. Freed from war time pegging, exchange rates among currencies were fluctuating in the early 1920s. During this period, countries widely used “predatory” depreciations of their currencies are 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 restrict the gold standard; and the USA spearheaded this effort. With only mild inflation, the USA was able to lift restrictions on gold exports and return to a gold standard in 1919. In Britain, the Chancellor of the Exchequer, played a key role in restricting the gold stand in 1925. Other countries in Europe also restored the gold standard by 1928.

During this period, most major countries gave priority to the “sterilization of gold” by hatching inflows and outflows of gold respectively with reductions and increases in domestic money and credit. For example, the Federal Reserve of the USA, kept some gold outside the credit base by circulating it as gold certificates. The Bank of England also kept the amount of available domestic credit stable by neutralizing the efforts of gold flows. In short, 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.

The Great Depression and the accompanying financial crisis also contributed to the collapse of the gold standard. During this period, many banks, especially in Austria, Germany, and the USA, suffered sharp declines in their portfolio values, touching off ruins on the banks. Against this backdrop, Britain experienced a massive outflow of gold, which resulted from chronic balance of payment diffracts and lack of confidence in the pound sterling; their gold reserves continued to fall to the point where it was impossible to maintain the gold system. In the end the British Government suspended gold payment and let the funds float. Other countries also followed suit to abandon the gold standard.

In summary, the inter war period was characterized by economic nationalism, half hearted attempts and failures to restore the gold standard, economic and political instabilities, bank failures and panicky flights of capital across boarders.

4. Brettons Woods System: 1945-1972

In July 1994, representatives of 44 nations gathered at BreHon Wooods, New Hansphire, to discuss and design the postwar international monetary system.

These representatives crafted and signed the Articles of Agreement of the International Monetary Fund (IMF) that constituted the core of the BreHon Woods System.

This agreement was then ratified to launch the IMF in 1945; that embodied an explicit set of rules about the conduct of international monetary policies and responsible for enforcing them.

Delegates also created a sister institution, the International Bank for Reconstruction and Development (IBRD), commonly known as the World Bank, that was chiefly responsible for financing individual development projects.

In designing the BreHon Woods system, representatives were coached with how to prevent the reassurance of economic nationalism with destructive “beggar-thy-neighbor” policies and how to adhere the lack of then rules of the game plaguing the inter war years.

The delegates desired exchange rate stability without restoring an international gold standard. They proposed a currency pool to which member countries would make contributions and from which they might borrow to fide themselves over during short-term balance of payment deficits.

Under this system, each country established a “far value” in relation to the US dollar, which was pegged to gold at $35 per ounce. Each country was responsible for maintaining its exchange rate within -1 or +1 percent of the adopted per value by buying or selling foreign exchange as necessary.

However, a member country with a “fundamental disequilibrium” may be allowed to make a change in the per value of its currency. Under this system, the US dollar was the only currency that was fully convertible to gold; other currencies were not directly convertible to gold.

Countries held US dollar, as well as gold, for use as an international means of payment. Because of this arrangements, the BreHon Woods system was described as dollar-based “gold exchange standard”. A country on the gold-exchange standard holds most of its reserves in the form of currency of a country that is really on the gold standard.

Advantages of the system are that:-

(i) It economizes on gold because countries can use not only gold but also foreign exchange as international means of payment; that always offsets the deflationary effects of limited addition to the world’s monetary gold stock;
(ii) Individual countries can earn interest on their foreign exchange holdings, whereas gold holdings yield no returns;
(iii) Countries can save transaction costs associated with transporting gold across countries under the gold exchange system.

However, in the 1970s, this system also collapsed creating a phenomenon known as the “Triffin Paradox”. This means that under the gold exchange system, the reserve-currency country should run balance of payments deficits to supply reserves but if such deficits are large and persistent, they can lead to a crisis of confidence in the reserve currency itself.

The IMF then created an artificial international reserve called the SAR in 1970. The SAR which is a basket currency comprising major individual currencies, was allotted to the embers of the IMF, who could then use it for transactions among themselves or with the IMF. In addition to gold and foreign exchanges, countries could use the SAR to make international payments.

(e) The Flexible Exchange Rate Regime: 1973 to Present

This followed the demise of the BreHon Woods system, and the key elements are as follows:

(i) Flexible exchange rates were declared acceptable to the IMF members, and central banks were allowed to intervene in the exchange markets to iron out unwarranted volatilities;
(ii) Gold was officially abandoned (i.e. demonetized) as an international reserve asset. Half of the IMF’s gold holdings were returned to the members and the other half were sold with the proceeds to be used to help poor nations;
(iii) Non-oil exporting countries and less developed countries were given greater access to IMF funds.

The IMF cautioned to provide assistance to countries facing balance-of-payments and exchange rate difficulties; on the condition that these countries follow the IMF macro economic policy presentation. This conditionality, which often involves deflationary macro economic policies and the elimination of various subsidy programs provided resentment among the people of developing countries receiving the IMFs balance-of-payments loans.

As can be expected, exchange rates have become substantially more volatile than they were under the BreHon Woods System. The value of the dollar has been on as of its peak. In lieu of this, as the dollar continued its decline, the governments of the major industrial counties began to worry that the dollar may fall too far.

To address the problem of exchange rate volatility and other related issues, the G.7 economic summit meeting was convened in Paris in 1987. The meeting produced the “Louvre Accord; according to which:

- G.7 countries would cooperate to achieve greater exchange rate stability;
- The G.7 countries agreed to move closely consult and coordinate their macro economic policies.

The Louvre Accord marked the inception of the ‘managed flat system’ under which the G.7 countries would jointly intervene in the exchange market to correct over or undervaluation of currencies. Since this accord, exchange rates became relatively more stable for a while.

(f) The current Exchange Rate Arrangement

Although the most traded currencies of the world such as the dollar, yen, pound are the euro may be fluctuating against each other, a significant number of the world’s currencies are pegged to single currencies, particularly the US dollar and the euro, or baskets of currencies such as the SAR.

The IMF currently classifies exchange rate arrangements into eight special regimes.

(i) Exchange arrangements with no separate legal tender

The currency of another country circulates as the sole legal tender or the country belongs to monetary or currency union in which the same legal tender is shared by the members of the union e.g. the Euro Zone.

(ii) Currency board arrangements

A monetary regime based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions in the issuing authority to ensure the fulfillment of its obligations. For example, Hongkong fixed to the US Dollar.

(iii) Other conventional fixed peg management

The country pegs its currency(formally or defacto) at a fixed rate to a major currency or a basket of currencies where the exchange rate fluctuates within a narrow margin of less than 1%, plus or minus, a round a central rate. For example, China, Malaysia and Saudi Arabia.

(iv) Pegged exchange rates within horizontal banks

The value of the currency is maintained within the margins of fluctuations around a formal or defacto fixed peg that are wider than at least 1%, plus or minus, around a central rate. For example, Denmark, Egypt and Hungary.

(v) Crawling peg

The currency is adjusted periodically in small amounts at a fixed, pre-announced rate or in response to changes in selective quantitative indicators e.g. Bolivia and Costa Rica.

(vi) Exchange rates within Crawling banks

The currency is maintained within certain fluctuation margins around a central rate that is adjusted periodically at a fixed pre-annoused rate or in response to changes in selective quantitative indicators. For example, Israel, Romania and Venezuela.

(vii) Managed floating with no preannounced path for the exchange rate

The monetary authority influences the movement of the exchange rate through active intervention in the foreign exchange market without specifying or pre-committing to a preannounced path for the exchange rate. For example, Algeria, Singapore and Thailand.

(viii) Independent floating

The exchange rate is market determined with any foreign exchange intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate than at establishing a level for it. For example, Australia, Brazil, Canada, Korea, Mexico, the UK, Japan, Switzerland, and the USA.

THE EUROPEAN MONETARY SYSTEMS

According to the Savithsanian Agreement, which was signed in December, 1971, the band of exchange rate movement was expanded from the original plus or minus 1% to plus or minus 2.25%.

BALANCE OF PAYMENTS

This provides detailed information concerning the demand and supply of a country’s currency. For example, if the USA imports more than it exports, then this means that the supply of dollars is likely to exceed the demand in the foreign exchange market, ceteris baribus.

One would infer that the US dollar would be under pressure to depreciate against other currencies. On the other hand, if the USA exports more than it exports, then the dollar would be likely to appreciate.

Secondly, a country’s balance of payments data may signal its potential as a business partner for the rest of the world. If a country is grappling with a major balance of payment difficulties, it may be able to expand imports from outside world. Instead, the country may be tempted to impose resources to restrict imports and discourage capital outflows in order to improve the balance of payments situation.

On the other hand, a country experiencing a significant balance of payment surplus would be more likely to expand imports, offering marketing opportunities for foreign enterprises, and less likely to impose foreign exchange restrictions.

Thirdly, balance of payments data can be used to evaluate the performance of the country in international economic competition. For example, if a country is experiencing trade deficit year after year. This trade data may then signal that the country’s domestic industries lack international competitiveness.

Balance of Payments Accounting

The balance of payments can be formally defined as “the statistical record of a country’s international transactions over a certain period of time presented in the form of double entry book-keeping”. For example, if international transactions include imports and exports of goods and services and cross-boarder investments in businesses, bank accounts, bonds, stocks and real estates. Since the balance of payment is recorded over a certain period of time i.e. a quarter or a year, it has the same time dimension as national income accounting.

Generally speaking, any transaction that results in a receipt from foreigners will be recorded as a credit, with a positive sign, in the country’s balance of payments, whereas any transaction that gives rise to a payment to foreigners will be recorded as a debit with a negative sign. Credit entries in the Government balance of payments results from foreign sales of the Government goods and services, goodwill, financial claims, and real assets.

Debit entries on the other hand, arise from Government purchases of foreign goods and services, goodwill, financial claims, and real assets.

Further, credit entries gives rise to the demand for the country’s currency, whereas debit entries gives rise to the supply of the country’s currencies. Note that the demand (supply) for the country’s currency is associated with the supply (demands) of foreign exchange.

Since the balance of payments is presented as a system of double entry bookkeeping, every credit in the account is balanced by matching debt and vice versa.

Example I: Suppose that Boeing Corporation exported a Boeing 747 aircraft to Japan Airlines for $50 million, and that Japan Airlines pays from its dollar account kept with Chase Mashattan 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 US bank’s liabilities.

Example II: Suppose 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 (+).

As shown by the preceding examples, every credit in the balance of payments is matched by a debit somewhere to conform to the principle of double-entry bookkeeping.

Not only international trade, that is, exports and imports, but also cross boarder investments are recorded in the balance of payments.

Example III: Suppose that Ford acquires Jaguar a British car manufacturer, for $750 million and that Jaguar deposits the money in Barclays Bank in London, which in turn uses the sum to purchase US treasury notes. In this case, the payment of $750 million by Ford will be recorded as a debit (-), whereas Barclay’s purchase of the US treasury notes will be recorded as a credit (+).

The above samples, therefore, can be summarized as follows:

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Balance of Payments Accounts

Since the balance of payments records all types of international transactions, a country consummates over a certain period of time, it contains a wide variety of accounts. However, a country’s international transactions can be grouped into the following three main types:-

(i) The current account.
(ii) The capital account.
(iii) The official reserve account.

(i) The Current Account

This includes the export and imports of goods and services. It is defined as exports minus imports plus unilateral transfer that is (1) + (2) + (3) in the exhibit below, was negative -$444.69 billion. The US thus had a balance of payments deficit on the current account in 2000. The current account deficit implies that the USA used more output than it produced. Since a country must finance its current account deficit either by borrowing from foreigners or drawing down on its previously accumulative foreign wealth, a current account deficit represents a reduction in the country’s net foreign wealth.

On the other hand, a country with a current account surplus acquires 104 from foreigners, there by increasing its net foreign wealth.

The current account is divided into four categories:-

- Merchandise trade.
- Services.
- Factor income.
- Unilateral transfers.

A summary of the US Balance of Payments for 2000 (in $ billion)

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The current account balance, especially trade balance, tends to be sensitive to exchange rate charges when a country’s currency depreciates against the currencies of major trading partners, the country’s exports and to rise and imports fall, improving the trade balance.

The effect of currency depreciation on a country’s trade balance can be more complicated than the case described above. Indeed, following a depreciation, the trade balance may at first deteriorate for a while. Eventually, however, the trade balance will tend to improve over time. This particular reaction pattern of the trade balance to a depreciation is referred to as J – Curve effect.

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A depreciation will begin to improve the trade balance immediately if imports and exports are responsive to the exchange rate changes. On the other hand, if imports and exports are inelastic, the trade balance will worsen following a depreciation. Following a depreciation of the domestic currency and the resultant rise in import prices, domestic residents may still continue to purchase imports because it is difficult to change their consumption habits in a short period of time. Even if domestic residents are willing to switch to less expensive domestic substitutes for foreign imports, it may take time for domestic producers to supply import substitutes. Likewise, foreigners demand for domestic products, which become less expensive with a depreciation of the domestic currency, can be inelastic essentially for the same reasons. In the long run, however, both imports and exports tend to be responsive to exchange rate changes, exerting positive influences in the trade balance.

(ii) The Capital Account

The capital account balance measures the effectiveness between the Government’s sales of assets to foreigners and the Government’s purchase of foreign assets.

Government sales or exports of assets are recorded as credits, as they result in capital inflow. On the other hand, the country’s purchases (imports) of foreign assets are recorded as debits, as they lead to capital outflow.

Unlike trades in goods and services, trade in financial assets affect future payments and receipt of factor income.

As the previous exhibit shows, the US had a capital account surplus of $444.26 billion in 2000, implying that the capital inflow to the USA far extended capital outflow.

Clearly, the current account deficit was almost entirely offset by the capital account surplus. A country’s current account deficit must be paid for either by borrowing from foreigners or selling off post foreign investments.

In the absence of the government’s reserve transactions, the current account balance must equal to the capital account balance but with the opposite sign. When nothing is excluded, a country’s balance of payments must balance.

The capital account can be divided into three categories:

- Direct investment;
- Portfolio investments; and
- Other investments.

Direct investment occurs when the investor acquires a measure of control of the foreign business. In the US balance of payments, acquisition of 10% or more of the voting shares of a business is considered giving a measure of control to the investor.

Portfolio investments mostly represents sale and purchases of foreign financial assets such as stock and bonds that do not involve a transfer of control international portfolio investments have booked due to the relaxation of capital controls and regulations in many countries, and partly due to investors’ desires to diversify risks globally. Portfolio investments comprises equity securities and debt securities that include corporate shares, bonds and notes respectively, and money market instruments and financial derivatives like options.

Other investments include transactions in currency bank deposits, trade credits, etc. these investments are quite sensitive to both changes in relative interest rates between countries and the anticipated change in exchange rate.

(iii) Statistical Discrepancy

Imperfections arising out of recording, where certain invisible services are likely not going to be captured and always escape detention, e.g. cross boarder financial transactions conducted electronically as well as consulting.

(iv) Official Reserve Account

When a country must make payment to foreigners because of a balance of payments deposit, the central bank of the country should either run down its official reserve assets, such as gold, foreign exchanges and SARs, or borrow a new from foreign central banks.

On the other hand, if a country has a balance of payments surplus its central bank will either retire some of its foreign debts or acquire additional reserve assets from foreigners.

The official reserve account includes transactions undertaken by authorities to finance the overall balance and intervene in foreign exchange markets.

International reserve assets comprise:-

- Gold.
- Foreign exchange.
- Special drawing rights (SARs).
- Reserve positions in the IMF.

The Balance of Payments Identity

When the balance of payments accounts are recorded correctly, the combined balance of the current account, the capital account, and the reserve account must be zero, that is,

BCA + BKA + BRA = 0

Where ; BCA = balance on the current account.

BKA = balance on the capital account.

BRA = balance on the reserve account.

Hence, the balance on the reserve account, BRA represent the change in the official reserves. BOP indicates that a country can run a balance of payments surplus or deficits by increasing or decreasing its official reserves. Under the fixed exchange rate regime, countries maintain official reserves that allow them to have a balance of payments disequilibrium, that is, BCA + BKA is non zero, without adjusting the exchange rate. Under this exchange rate playing, the combined balance on the current and capital accounts will be equal in size, but opposite in sign, to the change in the official reserves.

BCA + BKA = -BRA

For example, if a country runs a deficit on the overall balance that is, BCA + BKA is negative, the Central Bank of the country can supply foreign exchange out of its reserve holdings. But if the deficit persists, the central bank will eventually run out of its reserve, and the country may be forced to devalue its currency.

Under the pure flexible exchange rate regime, the Central Bank will not intervene in the foreign exchange market. In fact, Central Banks do not need to maintain official reserves than this regime, the overall balance this must necessarily balance, that is, BCA = -BKA. In other words, a current account surplus or deficit or surplus and vice-versa.

In a duty float, the exchange rate system under which the central bank discreetly buy and sale foreign exchange.

Functions and Structure of the Forex Market

The structure of the foreign exchange market is an outgrowth of one of the primary functions of commercial banker to assist clients in the conduct of international commerce. For example, a corporate client desiring to import merchandize from abroad would need a source for foreign exchange if the import was invoiced and received in the importer’s home currency. Assisting in foreign exchange transactions of this type is one of the services that commercial banks provide for their clients, and one of the services that bank customers expect from their bank.

The spot and forward foreign exchange market is an “over-the-counter (OTC) market”; that is, trading does not take place in a central place of the market where buyers and sellers congregate; Rather, the foreign exchange market is a world wide linkage of bank currency traders, non dealers, and FX bookers who assist in trades connected to one another via a network of telephones telex machines, computer terminals, and automated dealing systems.

The communications systems of the foreign exchange market is highly modern, including industry, governments, the military and national security and intelligence operations.

Twenty-for-how-a-day among trading follows the sum around the globe. And three major market segments are Australia, Europe and North America. Most trading norms operate over a 9 to 12 hour working days although some banks have experimented with operating three eight-hour shift in order to trade around the clock.

The FX Market Participants

The market for foreign exchange can be viewed as a two tier market. One tier is the “wholesale” or “retail or client market”. FX market participants can be categorized into five groups:-

- International banks;
- Bank customers;
- Non-bank dealers; and
- Central banks.

International banks provide the core of the FX market and actively “make a market” in foreign exchange, that is, they stand willing to buy or sell foreign currency for their own account. These international banks service their retail clients, the bank customers, in conducting foreign commerce or making international investments in financial assets that require foreign exchange. Bank customers include, MNCs, money managers, and private speculators.

Non-bank dealers are large non-bank financial institutions such as investment banks, while size and frequency of trades make it cost effective to establish their own dealing norms to trade directly in the interbank market for their foreign exchange needs.

Part of the interbank trading among international banks involve adjusting the inventory positions they hold in various foreign currencies. However, most interbank trades are speculative or arbitrage transactions, where market participants attempt to correctly judge the future direction of price movement in one currency versus another or attempt to profit from temporary price discrepancies in currencies between competing dealers.

Market psychology is a key ingredient in currency today and a dealer can often infer another’s trading intention from the currency position being accumulated.

FX brokers match dealer orders to buy and sell currencies for a fee, but do not take a position themselves. Brokers have knowledge of the quotes of many dealers in the market. Consequently, interbank traders will use a broker primarily to disseminate as quickly as possible a currency quote to many other dealers. However, in recent years, since the introduction and increased usage of electronic dealing systems, the use of brokers has declined because the computerized systems duplicate many of the same services at much lower fees.

Central banks of particular countries always intervene in the foreign exchange market in an attempt to influence the price of its currency against that of major trading partner, or a security that it “fixes” or “pegs” its currency against. Intervention is the process of using foreign currency reserves to buy one’s own curry in order to decrease its supply and thus increase its value in the foreign exchange market, or alternatively, selling one’s own currency for foreign currency in order to increase its supply and lower its price. However, intervention that successfully increases the value of one’s currency against a trading partner may reduce exports and increase imports, thus alleviating persistent trade deficits of the trading partner likewise central bank intervention in currency markets lose bank reserves attempting to accomplish their goals.

Correspondent Banking Relationships

The interbank market is a network of correspondent banking relationships, with large commercial banks maintaining demand deposit accounts with one another called correspondent banking accounts. The correspondents bank accounts network allows for the efficient functioning of the foreign exchange market.

The Society for World wide Interbank Financial Telecommunications (SWIFT) allows international commercial banks to communicate instructions to one another. SWIFT is a private non-profit message transfer system, headquarters in Brussels, with intercontinental switching centres in the Netherlands and Virginia.

The Clearing House Ltd (ECHO), the first global clearing house for settling interbank FOREX transactions, allows multilateral netting system that on each settlement date netted a client’s payments and receipts in each currency, regardless of whether they are due to or from multiple counter parties. Multilateral netting eliminates the risk and inefficiency of individual settlement.

The Spot Market

This involves almost the immediate purchase or sale of foreign exchange. Typically cash settlement is made two business days (excluding holidays of either the buyer or the seller) after the transactions of trades between the US dollar and non-North American currency for example.

(a) Spot Rate Quotations

Spot rate currency quotations can be stated in direct or indirect terms. Direct quotations is the price of one unit of the foreign currency priced in US dollars. Indirect quotations is the price of the US dollar in the foreign currency.

It is common practice among currency trades world wide to both price and trade currencies against the US dollar.

Most currencies in the interbank market are quoted in “European terms”, i.e. the US dollar is priced in terms of the foreign currency (an indirect quote from the US, perspective). By convention, it is standard practice to price certain currencies in terms of the US dollar or in what is referred to as “American terms”. (a direct quote from the US perspective).

In general, S(j/k) refers to the price of one unit of currency K in terms of currency j. it should thus be intuitive that the American and European term quotes are reciprocals of one another; i.e.

S($/£) = 1/S(£/$)

1.5272 = 1/.6548

and

S(£/$) = 1/S($/£)

.6548 = 1/1.5272

(b) The Bid-Ash Spread

Interbank FX traders buy currency for inventory at the “bid price” and sell from the inventory at the higher “offer” or “ask price”.

The recognition of the bid-ask spread implies:

S($/£a) = 1/$(£/$b)

(c) Spot FX Trading

Most currencies quotations are carried out to four decimal places in both American and European terms. However, for some currencies e.g. the Japanese yen, Slovalcian Koruna, South Korean wou), quotations in European terms are carried out only to two or three decimal places, but in American terms the quotations may be carried out to as many as eight decimals.

The establishment of the bid-ask spread always facilitate acquiring or disposing of inventions. For example, a trader believing the pound will soon appreciate substantially against the dollar will desire to acquire a larger inventory of British pounds. The retail bid-ask spread is wider than the interbank spread; i.e. lower bid and higher ask prices apply to the smaller sums traded at the retail level. This is necessary to cover the fixed costs of a transaction that exists regardless of which tier the trade is made in.

Interbank trading rooms are typically organized with individual traders dealing in a particular currency. The dealing rooms of large banks are set up with traders dealing against the US dollars in all the major currencies: the Japanese yen, euro, Canadian dollar, Swiss Franc and British pound plus the local currency if it is not one of the majors.

Individual banks may also specialize by making a market in regional currencies or in the currencies of less developed countries, again all versus the US dollar. Additionally, banks will normally have a cross rate desk where trades between two currencies not involving the US dollar are handled. In smaller European Banks accustomed to more regional tradings, dealers will frequently quote and trade versus the euro.

(d) Cross-Exchange Rate Quotations

Cross-exchange rate is an exchange rate between a currency pair where neither currency as the US dollar. The cross-exchange rate can be calculated from the US dollar exchange rates for the two currencies, using either European or American term quotation. For example, є/£ cross rate can be calculated from American term quotations as follows:-

S(ŧ/£) = S($/£)/S($/ŧ)

(e) Triangular Arbitrage

Certain banks specialize in making direct market between non-dollar currencies, pricing at a narrower bid-ask spread than the cross rate spread. If their direct quotes are not consistent with cross-exchange rates, a triangular arbitrage profit is possible. Triangular arbitrage is the process of trading out of the US dollar into a second currency then trading it for a third currency, which is in turn traded for US dollars.

The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange rate between the two is not in alignment with the cross-exchange rate.

The Forward Market

This involves contracting today for the future purchase or sale of foreign exchange. The forward price may be the same as the spot price, but usually it is higher (at a premium or lower (at a discount) then spot price. Forward exchange rates are quoted on most major currencies for a variety of maturities. Bank quotes for maturities of 1, 3, 6, 9 & 12 months are readily available. Maturities extending beyond one yen are being more frequent and for good bank customers a maturity extending out to 5, and even as long as 10 years is possible.

(a) Forward Rate Quotations

Forward quotes are either direct or indirect, one being the reciprocal of the other. For example, European term forward quotations are the reciprocals of the American term quotes. One can buy (take a long position) or sell (take a short position) foreign exchange forward. Bank customers can contract with their international bank to buy or sell a specific sum of FX for delivering on a certain date. Likewise, interbank traders can establish a long or short position by dealing with a trader from a competing bank.

Forward contracts can also be used for speculative purpose. If one uses the forward contract, he has “locked in” the forward price for forward purchase or sale of foreign exchange.

(b) Forward Cross Exchange Rates

These quotations are calculated in an analogous manner to spot cross rates. In general terms,

FN(j/k) = FN($/k)/FN($/j)

or

FN(j/k) = FN(j/$)/FN(k/$)

and

FN(k/j) = FN($/j)/FN($/k)

or

FN(k/j) = FN(k/$)/FN(j/$)

(c) Swap Transactions

Forward traders can be classified as outright or swap transactions. In conducting their trading, bank dealers do take speculative position in the currencies they trade but more often traders offset the currency exposure inherent in the trade.

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