Summary ch. 1 & ch. 2 - Chapter 1: Globalization and the Multinational firm What’s Special about - Studeersnel (2024)

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Chapter 1: Globalization and the Multinational firm

What’s Special about International Finance?Three major dimensions set international finance apart from domestic finance, they are: 1. Foreign exchange rate and political risk; 2. Market imperfections; 3. Expanded opportunity set.

Foreign Exchange and Political RisksWhen firms and individuals are engaged in cross-border transactions, they are potentiallyexposed to foreign exchange risk that they would not normally encounter in purely domestictransactions.

Political risk: ranges from unexpected changes in tax rules to outright expropriation of assetsheld by foreigners. Political risk arises because a sovereign country can change the “rules ofthe game” and the affected parties may not have effective recourse.

Market ImperfectionsMarket imperfections represent various frictions and impediments preventing markets fromfunctioning perfectly. They play an important role in motivating MNCs to locate productionoverseas. Imperfections in the world financial markets tend to restrict the extent to whichinvestors can diversify their portfolios.

Expanded opportunity setWhen firms venture into the arena of global markets, they can benefit from an expandedopportunity set. I.: firms can locate production in any country or region of the world tomaximize their performance and raise funds in any capital market where the cost of capitalis the lowest. Also, firms can gain from greater economies of scale.

Individual investors can also benefit greatly if they invest internationally rather thandomestically ( stock returns tend to covary less across countries than within a givencountry).

Goals for International Financial ManagementInternational Financial Management is designed to provide today’s financial managers withan understanding of the fundamental concepts and the tools necessary to be effective globalmanagers. Throughout, the text emphasizes how to deal with exchange risk and marketimperfections, using the various instruments and tools that are available, while at the sametime maximizing the benefits from an expanded global opportunity set. Goal: shareholderwealth maximization.

Shareholder wealth maximization means that the firm makes all business decisions andinvestment with an eye toward making the owners of the firm – the shareholders – betteroff financially, or more wealthy, than they were before. If the firms seeks to maximizeshareholder wealth, it will most likely simultaneously be accomplishing other legitimategoals that are perceived as worthwhile.

Corporate governance: the financial and legal framework for regulating the relationshipbetween a company’s management and its shareholders.

Globalization of the World Economy: Major Trends and Developments

Emergence of Globalized Financial MarketsThe impetus for globalized financial markets initially came from the governments of majorcountries that had begun to deregulate their foreign exchange and capital markets.Deregulated financial markets and heightened competition in financial services provided anatural environment for financial innovations that resulted in the introduction of variousinstruments  currency futures and options, multicurrency bonds, international mutualfunds etc. Corporations also played a role by listing their shares across borders: allowsinvestors to buy and sell foreign shares as if they were domestic shares, facilitatinginternational investments. Furthermore, advances in computer and telecommunicationstechnologies contributed in no small measure to the emergence of global financial markets.

Emergence of the Euro as a Global CurrencyOnce a country adopts the common currency, it obviously cannot have its own monetarypolicy. The common monetary policy for the euro zone is now formulated by the ECB. ECB islegally mandated to achieve price stability for the euro zone.

Europe’s Sovereign Debt Crisis of 2010The euro’s emergence as a global currency, however, was dealt a serious setback in themidst of Europe’s sovereign debt crisis. The crisis started in December 2019, when the newGreek government revealed that its budget deficit for the year would be much greater thanforecasted. But, with the adoption of the euro, Greece no longer can use the traditionalmeans of restoring competitiveness, i., depreciation of the national currency. The panicspread to other weak countries. The spectre of chaotic sovereign defaults led to a sharp fallof the euro’s exchange value in currency markets.

Europe’s sovereign-debt crisis revealed a profound weakness of the euro as the commoncurrency: Euro-zone countries have achieved monetary integration by adopting the euro, butwithout fiscal integration. A lack of fiscal discipline in a euro-zone country can alwaysbecome a Europe-wide crisis, threatening the value and credibility of the common currency.

Trade Liberalization and Economic IntegrationThe principal argument for international trade is based on the theory of comparativeadvantage: it is mutually beneficial for countries if they specialize in the production of thosegoods they can produce most efficiently and trade those goods among them (David Ricardo).Ricardo’s theory has a clear policy implication: “liberalization of international trade willenhance the welfare of the world’s citizens”.  international trade could be an “increasing-sum” game at which all players become winners.

Currently, international trade is becoming further liberalized at both the global and regionallevels. Examples:

2. 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. (outsourcing)

Chapter 2: International Monetary SystemThe international monetary system can be defined as: the institutional framework withinwhich international payments are made, movements of capital are accommodated, andexchange rates among currencies are determined.

Evolution of the International Monetary SystemStages:

Bimetallism: Before 1875Double standard in that free coinage was maintained for both gold and silver. “bimetallism”,because both gold and silver were used as international means of payment and that theexchange rates among currencies were determined by either their gold or silver contents.Gresham’s law: ‘bad’ (abundant) money drives out ‘good’ (scarce) money.

Classical Gold Standard: 1875-An 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,(iii) gold may be freely exported or imported.In order to support unrestricted convertibility into gold, bank-notes need to be backed by agold reserve of a minimum stated ratio. In addition, the domestic money stock should riseand fall as gold flows in and out of the country.

Highly stable exchange rates under the classical gold standard provided an environment thatwas conductive to international trade and investment. Under the gold standard,misalignment of the exchange rate will be automatically corrected by cross-border flows ofgold. Also, international imbalances of payment will also be corrected automatically. Price-specie-flow mechanism: Adjustment mechanism.

Gold has a natural scarcity and no one can increase its quantity at will. Therefore, if goldserves as the sole base for domestic money creation, the money supply cannot get out ofcontrol and cause inflation. In addition, if gold is used as the sole international means ofpayment, then countries’ balance of payments will be regulated automatically via themovement of gold.  no country may have a persistent trade deficit or surplus.

Shortcomings: - 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. - 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; no mechanism to compel each major country to abide by the rules of the game.

Interwar Period: 1915-Countries widely used ‘predatory’ depreciations of their currencies as a means of gainingadvantages in the world export market. As major countries began to recover from the warand stabilize their economies, they attempted to restore the gold standard. Theinternational 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 andsystematically followed a policy of sterilization of gold by matching inflows and outflows ofgold respectively with reductions and increases in domestic money and credit.  did notabide the rules  automatic adjustment mechanism of the gold standard was unable towork.

Even the façade of the restored gold standard crumbled down in the wake of the GreatDepression. Paper standards came into being when the gold standard was abandoned.

No coherent international monetary system prevailed during this period, with profoundlydetrimental effect on international trade and investment. During this period, the U. dollaremerged as the dominant world currency, gradually replacing the British pound for the role.

Bretton Woods System: 1945-Core: International Monetary Fund (IMF). The IMF embodied an explicit set of rules aboutthe conduct of international monetary policies and was responsible for enforcing these rules.Delegates also created a sister institution: the World Bank (IBRD: International Bank forReconstruction and Development), which was responsible for financing individualdevelopment projects.

Under the Bretton, each country established a par value in relation to the U. dollar. Eachcountry was responsible for maintaining its exchange rate within +- 1 percent of the adoptedpar value by buying or selling foreign exchanges as necessary. Only the US dollar wasconvertible to gold: gold-exchange standard. A country on the gold-exchange standard holdsmost of its reserves in the form of currency of a country that is really on the gold standard.

Advantages: - System economizes on gold because countries can use not only gold but also foreign exchanges as an international means of payment. Foreign exchange reserves offset the deflationary effects of limited addition to the world’s monetary gold stock. - Individual countries can earn interest on their foreign exchange holdings, whereas gold holdings yield no returns. - Countries can save transaction costs associated with transporting gold across countries under the gold-exchange system.

Triffin Paradox: To satisfy the growing need for reserves, the US had to run balance-of-payments deficits, it would eventually impair the public confidence in the dollar, triggering arun on the dollar. Under the gold-exchange system, the reserve-currency country should runbalance-of-payment 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, causing a downfall in thesystem.  was indeed responsible for the eventual collapse of the dollar-based gold-exchange system in the early 1970s.

6. Crawl-like arrangement: the exchange rate must remain within a narrow margin of 2 percent relative to a statistically identified trend for six months or more, and the exchange rate arrangement cannot be considered as floating.
7. Pegged exchange rate within horizontal bands: the value of the currency is maintained within certain margins of fluctuation of at least +-1 percent around a fixed central rate, or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent.
8. Other managed arrangement: residual: is used when the exchange rate arrangement does not meet the criteria for any of the other categories.
9. Floating: largely market determined, without an ascertainable or predictable path for the rate.
10. Free floating: a floating exchange rate can be classified as free floating if interventionoccurs only exceptionally and aims to address disorderly market conditions and if theauthorities have provided information or date confirming that intervention has beenlimited to at most three instances in the previous six months, each lasting no morethan three business days.

European Monetary SystemChief objectives EMS: 1. To establish a “zone of monetary stability” in Europe; 2. To coordinate exchange rate policies vis-à-vis the non-EMS currencies; 3. To pave the way for the eventual European monetary union.The two main instruments of the EMS are: - The European Currency Unit (ECU): a “basket” currency constructed as a weighted average of the currencies of member countries of the European Union (EU). The weights are based on each currency’s relative GNP and share in intra-EU trade. - The Exchange Rate Mechanism (ERM) refers to the procedure by which EMS member countries collectively manage their exchange rates. The ERM is based on a “parity grid” system, which is a system of par values among ERM currencies.Maastricht Treaty: according to the treaty, the EMS would irrevocably fix exchange ratesamong the member currencies by January 1, 1999, and subsequently introduce a commonEuropean currency, replacing individual national currencies.

To pave the way for the European Monetary Union (EMU), the member countries of theEuropean Monetary System agreed to closely coordinate their fiscal, monetary, andexchange rate policies and achieve convergence of their economies. Specifically eachmember country shall strive to: (i) keep the ratio of government budget deficits to GDPbelow 3 percent, (ii) keep gross public debts below 60 percent of GDP, (iii) achieve a highdegree of price stability, and (iv) maintain its currency within the prescribed exchange rateranges of the ERM.

The Euro and the European Monetary Union

A Brief History of the EuroThe euro should be viewed as a product of historical evolution toward an ever deepeningintegration of Europe.

Monetary policy for the euro zone countries is now conducted by the European Central Bank(ECB).