Chapter 11 International Financial Management Chapter 1 Features of international finance Michael Connolly School of Business Administration, University.

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International Financial Management

Chapter 1 Features of international finance

Michael ConnollySchool of Business Administration,

University of Miami

Michael Connolly © 2007

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Introduction

International finance differs from finance in several ways:

Currencies Accounting rules Stake-holders Legal and institutional framework Language Taxation Regulatory framework Political risk Intellectual property rights

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Currencies

Exchange rates Currency conversion

Spot rates – for “immediate” delivery

“On the spot” Or within two business days

Futures and forwards – Futures are standardized contracts

traded on exchanges, while Forwards are over-the-counter

tailored contracts in terms of size, maturity and delivery

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Currencies

Exchange rates American quotations vs. European

quotations

American: USD per unit of foreign currency

Example: $1.7778 per GBP

European: Units of foreign currency per USD

Example: 8.04 yuan (RMB) per USD

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Currencies Exchange rate risk

Transaction exposure

Gains or losses due to unanticipated changes in the exchange rate associated with a foreign currency transaction

Usually dealt with by offsetting contractual hedges

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Currencies Exchange rate risk

Operational exposure

Unanticipated changes in the value of the cash flow from operations in foreign exchange due to unexpected changes in the exchange rate.

Usually dealt with by natural hedges – matching cash flows.

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Currencies Exchange rate risk

Translation exposure Accounting requirement: US Federal Accounting Standards Board (FASB) 52 requires conversion of most line items at the current exchange rate to the USD for reporting of income and financial statements.

Usually dealt with by matching cash flows and accounting hedges.

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Accounting rules

In the United States Generally Accepted Accounting

Practice (GAAP) based on FASB rulings and law, such as the SEC Act of 1934 and the Sarbanes-Oxley Act of 2002

Overseas

Internationally Accepted Standards (IAS) based more on concept than rules and regulations

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Accounting rules Comparison:

Reporting and disclosure requirements are higher in the U.S., England, and continental Europe than abroad: specifically, in emerging markets

American Depositary Receipts (ADRs) are frequently listed on US exchanges in lieu of foreign shares due to disclosure and reporting requirements

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Stakeholders In the US:

Shareholders are of utmost importance: the objective of the firm is to maximize shareholder wealth.

Overseas: Often various stakeholders:

The Government is often a majority, state owned enterprises (SOEs) or a minority shareholder

Management holds less shares than in the US

Workers and unions are often powerful and have many legal rights

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Legal framework Common laws in the US and the UK

Securities and Exchange Commission, 1934 US SEC Act of 1934 and SOX 2002

regulates securities offerings, disclosure and reporting

US Foreign Corrupt Practices Act of 1997 (FCPA 1977) prohibits making payments to foreign officials to obtain contracts, licenses and favors

Civil penalties of up to $100,000 and imprisonment for not more than 5 years, or both

Exception for “grease money” - to expedite or to secure the performance of a routine governmental action by a foreign official, are permitted unless prohibited by local laws

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Legal framework

Napoleonic laws France, Spain, Italy and most Latin

American countries are governed by the Napoleonic Code. Louisiana is partially so

Islamic laws Interest prohibited by the Koran, but

profit sharing permitted

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Legal framework In 1999, the Organization for Economic

Cooperation and Development (OECD) -established A Convention Against Bribery of Foreign Public Officials in International Business which makes it a crime to offer, promise or give a bribe to a foreign public official in order to obtain or retain international business deals

The UN Convention Against Corruption

(UNCAC) was signed by 113 countries since its launching in December 2003

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Language

Language can be either an obstacle or an advantage. Banco Santander Central Hispano of

Madrid - the largest bank in Latin America in terms of assets - owes its comparative advantage over other banks in Latin America to language, Napoleonic Law, and its long history of good banking practices.

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Corporate income taxes Statutory corporate income taxes vary:*

Countries such as Ireland are now tax havens for foreign direct investment and foreign sales corporations, benefiting from a 10% special tax rate, while others, such as Russia have adopted a flat tax of 15% to encourage compliance.

*Source: Price Waterhouse.

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Corporate income tax Corporate income tax collections are a small

percentage of GDP in general. However, the data do not reflect marginal effective tax rates since countries like Ireland with low effective tax rates have greater compliance and attract FDI, thus collecting a high percentage of GDP.

The US, on the other hand, has depreciation and interest expenses as tax shields, so despite a high marginal statutory rate, collections are low as a percentage of GDP, as seen in the OECD countries

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Corporate income taxTaxes on Corporate I ncome in OECD Countries in 2002 as a percentage of GDP

Country Percentage of GDP Country Percentage of GDP

Austria 2.3 Luxembourg 8.6

Australia 5.3 Mexico *

Belgium 3.5 Netherlands 3.5

Canada 3.3 New Zealand 4.2

Czech Republic 4.6 Norway 8.2

Denmark 2.9 Poland 2.0

Finland 4.3 Portugal 3.6

France 2.9 Slovak Republic 2.7

Germany 1.0 Spain 3.2

Greece 3.8 Sweden 2.4

Hungary 2.4 Switzerland 2.7

I celand 1.1 Turkey 2.2

I reland 3.7 United Kingdom 2.9

I taly 3.7 United States 1.8

J apan 3.2 Unweighted average 3.4

Republic of Korea 3.1 Weighted average 2.5

Source: Revenue Statistics of OECD Member Countries , Table 12, Paris, OECD, 2004.

* = data not available.

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Capital gains taxation Capital gains taxes vary and depend on

the length the investment is held. The US reformed it’s rates in 2003, but these expire in 2009, unless re-voted.

• A principal residence in the U.S. has a capital gains exempt amount of US$250,000 (US$500,000 for married persons filing jointly) for gains on the principal residence if owned and occupied by the taxpayer as the principal residence for greater than two years over prior five years.

United States Short term rate Long term rate

(2003-2008) (less than one year) (one year or longer)

> or = 25% regular income tax bracket (25, 33 or 35%) 15%

< 25% regular income tax bracket (10 or 15%) 5%

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Capital gains taxation In the United Kingdom, capital

gains are taxed at top marginal personal rate on savings income.

These are respectively:

10 per cent/20 per cent/40 per cent

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Transfer pricing Transfer pricing involves the price

one branch of a company charges the other for the transfer of intermediate goods It can be used to transfer profits from

a high tax jurisdiction to a low tax jurisdiction

Foreign Sales Corporations (FSC) Under US laws, a FSC may

incorporate in a tax haven to promote exports. If it does not repatriate profits, they go untaxed

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Transfer pricing

Under WTO regulations, a Foreign Sales Corporation violates Article VI Anti-Dumping and Countervailing Duties since U.S. corporations’ export earnings are exempted from corporate taxes, constituting an export subsidy.

Indeed, the European Union won its anti-dumping case against the Foreign Sales Corporation which is being phased out.

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The regulatory framework The U.S. Securities and Exchange Commission

(SEC) regulates major exchanges and securities dealers based on a simple concept: all investors should have access to certain basic facts about an investment prior to buying it

The SEC requires public companies to disclose meaningful information to the public to judge for themselves if a company's securities are a good investment

SEC-governed typical infractions include insider trading, accounting fraud, providing false or misleading information about securities and issuing companies, and backdating of options grants.

The SEC offers the public the EDGAR database of required disclosure documents from public companies

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Political risk Political risk: economic exposure to

unanticipated changes in governmental policy that affect the earnings and value of your affiliate or subsidiary, the most serious being nationalization.

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Political risk

Political risk falls with WTO’s growing membership

The GATT/WTO’S Article III National Treatment on Internal Taxation and Regulation requires equal treatment for both domestic and foreign firms. Despite national treatment requirements, discrimination against foreign firms may still take place

Nationalization with a populist government coming to power

The foreign oil companies in Venezuela are facing implicit nationalization through governmental decrees, as was the case under Alan García in Perú from 1985-90 where they were explicitly nationalized

Possible solutions World Bank Multilateral Investment Guarantee

Association (MIGA) provides insurance against investment risk in emerging markets

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Intellectual property rights Pirated and counterfeit products

are commonplace worldwide Software code, Madonna’s songs,

Microsoft’s latest Windows operating system and its Office Suite, Rolex watches, Lacoste shirts and so on

In some countries, the copying and manufacture of patented pharmaceuticals is perfectly legal

Brazil seems to be the greatest culprit in Latin America.

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Intellectual property rights Possible deterrents?

WTO member countries are to respect international patents, trademarks and brands (TRIPS –Trade related intellectual property rights are to be implemented according to the Uruguay Round 1994)

As a WTO member, China is taking steps to enforce intellectual property rights

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Conclusion International finance has an additional

layer of complication that involves currency risk and conversion, different laws, regulations, languages, and business practices

Today, however, world production and trade are global in nature

Therefore, financing is also global

This leads to less market segmentation, more liquidity, and greater efficiency in world capital markets