Daniels and VanHoose International Monetary and Financial ...

International Finance International Finance IntroductionIntroduction

Fred Thompson 2

Today’s Objectives

• Understand the syllabus and how it works• Understand my goals for this course

(teaching and learning objectives)• Understand my philosophy of teaching• Understand the focus of the course• Understand FOREX transactions and the

role of arbitrage.

Fred Thompson 3

Learning Objectives and Philosophy

• I want you to learn how to DO things– Perform codified practices such as calculating

cross-exchange rates, currency and intertemporal arbitrage, currency hedging

– Understand when and why to perform them, as well as how

• Watch, Do, Teach

Fred Thompson 4

Our Focus

• We will focus on the institutions and markets that “connect” nations’ economies, especially financial sector linkages.

• More specifically, we will concentrate on FOREIGN DIRECT INVESTMENT.

Fred Thompson 5

Real and Financial Sectors

• Real Sector: Production and sale of goods and services; acquisition and divestiture of capital assets.

• Financial Sector: Transactions in financial assets: currency, bank deposits, bonds, stocks, futures and options, etc.

Fred Thompson 6

International Economic Integration

International economic integration refers to the extent and strength of real- sector and financial-sector linkages among national economies. Real-sector linkages occur through the international transactions in goods and services while the financial-sector linkages occur through international transactions in financial assets.

Fred Thompson 7

The Rise of Multinational Firms

• Changes our definition of comparative Advantage– Relative value-added -- product development, design, logistics,

assembly, marketing -- depends less on national differences and more on firm-specific competencies and investments, although these latter reflect national differences in factor endowments

– The range of a nation’s exports is equivalent to the range of its exports

• Comparative Advantage in a world of multinationals– Most cross-border trade involves intermediate products, much of it

takes place within the boundaries of a single firm (a single Barbie doll is made in 12 countries)

Fred Thompson 8

Evolution of the Multinational Corporation (FDI)

• Raw materials seekers.• Market seekers.• Cost minimizers/product enhancers

– Coase -- firms exist where they reduce transactions (search, bargaining, monitoring and enforcement costs) and logistics costs, otherwise transactions would take place through markets. They internalize externalities, economies of scale and scope (which give rise to non-exhaustibility), thru creation of effective governance institutions, that would obtain in a world without organizations.

– Some of these potential economies can be obtained by locating operations where factor costs are lower.

• Flexibility, adaptability, & speed of response

Fred Thompson 9

International Financial Management: Why?

• Financing & investment decisions that maximize value added by firm

• Asset deployment & utilization to increase PV future cash flows– You must create value first before you can

distribute it

• True of Corp. Finance in general, so why study IFM? What makes it different?

Fred Thompson 10

International Financial Management: Why?

• Borders, different currenciescurrencies• BUT, if financial markets were completely

integrated, different currencies wouldn’t matter. (Of course, if there were no real exchanges, you wouldn’t need financial markets.) IN NEITHER CASE WOULD WE BOTHER TO STUDY IFM!

• IFM deserves a special course only because integration has gone far enough to give it meaning, but not far enough to make it just like domestic finance.

Fred Thompson 11

Functions of Financial Management:Acquisition & Investment of Funds

Differences relevant to international financial management

• Exchange risks, taxes, multiple money markets (often w/limited access to credit, some w/currency controls), political risks

• Access to segmented money markets, shift profits to lower taxes, reduce risk thru international diversification of markets & production sites

Constants relevant to international financial management

• Arbitrage (APT)• Market efficiency

– Herd behavior• CAPM

– Systematic (undiversifiable) risk

– Unsystematic (diversifiable) risk

• Total risk• You cannot create value with

smoke and mirrors

Fred Thompson 12

FOREX

Multinational PolicymakingMultinational Policymaking

The International Financial Architecture

Fred Thompson 14

International Financial Architecture

• The international financial architecture is comprised of the institutions, governmental and non-government organizations, and the policies that govern activity in the international monetary and financial markets.

• Since the collapse of the Bretton Woods system that most important aspect of the international financial system is the growth of capital flows among nations.

Fred Thompson 15

Capital Market Liberalization

• Advocates of liberalized capital flows argue that unhindered capital flows allow savings to flow to their most productive use, resulting in the development of real resources and higher productivity.

• Financial market imperfections may result in capital misallocations and financial instability.

Fred Thompson 16

Financial Instability and Financial Crisis

• Financial instability occurs when the financial sector is unable to allocate funds to their most productive use.

• A financial crisis is a situation where a nation’s financial system is no longer able to function. A financial crisis typically involves– a banking crisis,

– a currency crisis, and

– a foreign debt crisis.

Fred Thompson 17

Capital Flows and Financial Crisis

• International capital flows consists of short-term (primarily portfolio) capital flows, and long-term (primarily foreign direct investment) flows.

• An excessive reliance on portfolio capital can be destabilizing and may contribute to financial crises.

Fred Thompson 18

Multilateral Policymaking

• The two organizations at the center of efforts to stem international financial crises are:

• The International Monetary Fund: a multinational organization the promotes international monetary policy cooperation, exchange arrangements, and economic growth.

• The World Bank: A sister institution that specializes in making loans to developing nations to promote development and growth.

Fred Thompson 19

Can these Organizations Predict a Crisis?

• To predict a crisis, policymakers must have an idea of their cause. Potential sources of financial crisis are:– An inconsistency between the exchange rate

and economic fundamentals.– Speculative attacks.– Structural moral hazards.

Balance-of-Payments Balance-of-Payments Accounts and Net Accounts and Net Financial FlowsFinancial Flows

Fred Thompson 21

Financial InflowFinancial Inflow

• Balance of Payments is a flow account, which consists of the current account Balance of Payments is a flow account, which consists of the current account and the capital and financial account and the capital and financial account

• A flow of capital, real and/or financial, into a country, takes the form of A flow of capital, real and/or financial, into a country, takes the form of increased purchases of domestic assets by foreigners and/or reduced holdings increased purchases of domestic assets by foreigners and/or reduced holdings of foreign assets by domestic residents. Inflows are recorded as of foreign assets by domestic residents. Inflows are recorded as positivepositive, or a , or a creditcredit, in the capital and financial account., in the capital and financial account.

• Each country also has an international balance sheet, which is a stock account Each country also has an international balance sheet, which is a stock account which shows assets and liabilities abroad and foreign assets and liabilities at which shows assets and liabilities abroad and foreign assets and liabilities at home -- Called the international investment positions accounts in the home -- Called the international investment positions accounts in the U.S. (the accumulated stocks of U.S.-owned assets abroad and of foreign-U.S. (the accumulated stocks of U.S.-owned assets abroad and of foreign-owned assets in the United States) .owned assets in the United States) .

• The net change in the international investment positions accounts from the The net change in the international investment positions accounts from the beginning of one year to the end of the next is the net capital/financial flow for beginning of one year to the end of the next is the net capital/financial flow for the yearthe year

Fred Thompson 22

Exchange and Net FlowsExchange and Net Flows

• Exchange of Real Assets – exchange of goods and Exchange of Real Assets – exchange of goods and services for other goods and services or for financial services for other goods and services or for financial claims (will give rise to a net change in financial claims if claims (will give rise to a net change in financial claims if x≠m)x≠m)

• Exchange of Financial Assets – Exchange of financial Exchange of Financial Assets – Exchange of financial claims for other financial claims (net financial claims are claims for other financial claims (net financial claims are unchanged)unchanged)

• Hence, m-x = net capital flow, also = I-SHence, m-x = net capital flow, also = I-S

[ignoring reporting errors and official settlements][ignoring reporting errors and official settlements]

Fred Thompson 23

Balance of Payments Statistics for theBalance of Payments Statistics for theUnited States, 1966United States, 1966

(Amounts in millions of dollars)(Amounts in millions of dollars)

Sources of Foreign Exchange• Exports of Goods and Services $43,142

Balance on goods, services, remittances, and pensions +$4065

• Foreign Capital Flow, net $2,532

Balance of all of the above -$1357

• Change in U.S. Reserve Assets $568• Change in Liquid Liabilities of Foreign

Accounts $789.

Uses of Foreign Exchange• Imports of Goods and Services $38,063• Remittances and Pensions $1,015

• U.S. Government grants, net $3,444• U.S. private Capital Flow, net $4,298• Errors and Omissions $210

Source: Federal Reserve Bulletin, April 1969, pp A70-71

The Balance of Payments The Balance of Payments Accounting SystemAccounting System

International Bookkeeping

Fred Thompson 25

International Transactions Accounts (Balance of Payments) A quarterly statistical summary of

transactions between U.S. and foreign residents organized into three major categories:– The current account– The capital account– The financial account

Fred Thompson 26

Balance of Payments

• System of accounts which is a subset of the National Income and Production Accounts– A double-entry bookkeeping system.– Debit Entries: Transactions that generate a

payment outflow (e.g., import).– Credit Entries: Transactions that generate a

payment inflow (e.g., export).

Fred Thompson 27

Balance of Payments

• The current account includes exports and imports of goods, services, income, and current transfers.– Goods– Services– Income Receipts and Payments– Unilateral Transfers

Fred Thompson 28

Balance of Payments

• Goods: Exports and imports of tangible items.

• Services: Exports and imports of services, for example:– Typical business services such as banking and

financial services, insurance, and consulting.– Tourism

Fred Thompson 29

Balance of Payments

• Income Receipts: Includes items such as– Investment income on US-owned assets abroad.– Receipts of income on US direct investment

abroad.– Government income receipts

Fred Thompson 30

Balance of Payments

• Income Payments: Includes items such as– Investment income on foreign-owned assets in

the United States.– Payments of income on foreign direct

investment in the United States– US Government income payments

Fred Thompson 31

Balance of Payments

• Unilateral Transfers: Includes items such as:– Government grants abroad– Private remittances– Private grants abroad

Fred Thompson 32

Balance of Payments (2000)Exports Millions 1,414,925

Goods 773,304 Services 296,227 Income Receipts 345,394

Imports -1,797,061 Goods -1,222,772 Services -215,239 Income Payments -359,050Unilateral Transfers -53,241Current Account Balance -435,377

Fred Thompson 33

Balance of PaymentsThe Financial Sector

• In June 1999, US capital account definitions were modified to bring them more in line with definitions recommended by the International Monetary Fund.

• Now there are two accounts: – The capital account includes capital transfers, such as debt

forgiveness. – The financial account includes transactions for official assets, for

U.S. Government assets other than official reserve assets, for direct investment, for portfolio investment, and for other investment.

Fred Thompson 34

Balance of PaymentsThe Financial Sector

• The new Capital Account includes items that were previously included in unilateral transfers, such as:– Debt forgiveness– Migrants’ transfers (as they leave the country).

• The new capital account is small for the US (< 0.1 percent of capital flows), but expected to grow.

Fred Thompson 35

Balance of PaymentsThe Financial Sector

• The Financial Account– Records international transactions in the

financial sector– Includes portfolio and foreign direct investment– Includes changes in banks’ and brokers’ cash

deposits that arise from international transactions.

Fred Thompson 36

Balance of PaymentsThe Financial Sector

• US-Owned Assets Abroad: Increase or decrease in US ownership of foreign financial assets.

• Foreign-Owned Assets in the US: Increase or decrease in foreign ownership of domestic assets.

• Reserve Assets: Primarily the assets of central banks.

Fred Thompson 37

Balance of PaymentsThe Financial Sector

• Portfolio Investment: Individual or business purchase of stocks, bond, or other financial assets or deposits. (An income strategy)

• Foreign Direct Investment: Purchase of financial assets that results in a 10 percent or greater ownership share. (A financial control strategy)

Fred Thompson 38

Capital and Financial Account (2000)

Capital Account, Net 680 Financial Account US-Owned Assets Abroad

-553,349

US Official Reserve Assets -290

US Government Assets -715

US Private Assets -552,344

Foreign-Owned Assets 952,430 Foreign Official Assets 35,909 Other Foreign Assets 916,521

Net Financial Flows 399,761

Fred Thompson 39

The Balance of PaymentsThe Statistical Discrepancy

Balance on Current Account -435,377

Capital Account, net 680

Net Financial Flows 399,081

Statistical Discrepancy 35,616

International Allocation of International Allocation of CapitalCapital

Fred Thompson 41

Feldstein - Horioka

• Savings and Investment Relation

• Based on a closed economy income condition:

y = c + i + g.

• Rearrange as:

y - c - g = i.

Fred Thompson 42

Feldstein - Horioka

• Rearranged as:

y - c - g = i.

• Note that y - c - g equals savings, s. Then:

s = i.

• In a closed economy, domestic investment is equal to domestic saving by definition, but is also correlated in practice, i.e., correlation coefficient is necessarily close to 1 in value.

Fred Thompson 43

International Flow of Goods, Services, & Capital

• Domestic Savings and Investment & NFFNational Income (GNY) = Consumption (C) +

Savings (S)National Spending (GNE) = Consumption (C) +

Investment (I)GNY - GNE = S - IGNY - GNE = Exports (x) - Imports (m)S - I = x - mNet Foreign Investment = x - m

Fred Thompson 44

Government Budget Deficits and NFF

GNE = Household spending + Private I + Government spending

= GNY - Private S - Taxes + Private I + Government spending

GNE - GNY = Private (I - S) + GovDeficit/Surplus

NFF = Private savings surplus - GovDeficit

US Balance of PaymentsUS Balance of Payments

Fred Thompson 46

U.S. TRADE AND CURRENT ACCOUNT BALANCESEXPRESSED AS A PERCENTAGE OF GDP

-6%

-4%

-2%

0%

2%

4%

46 50 54 58 62 66 70 74 78 82 86 90 94 98 2

C/A

TB

Fred Thompson

Basic PremiseBasic Premise

A current account deficit A current account deficit mustmust be financed by be financed by capital inflows, or it cannot be incurred in the capital inflows, or it cannot be incurred in the first placefirst place

Fred Thompson

Over 1982-2003, U.S. current Over 1982-2003, U.S. current account deficits have averaged account deficits have averaged

$183 billion per year.$183 billion per year.$4 $4 trilliontrillion worth of assets have worth of assets have

been transferred to foreign been transferred to foreign ownership.ownership.

FACTFACT

Fred Thompson 49

Trade and Scale Variables ITrade and Scale Variables I

QuickTime™ and aTIFF (Uncompressed) decompressor

are needed to see this picture.

Fred Thompson 50

Scale Variables I

U.S. monthly GDP: $1 trillionU.S. monthly GDP: $1 trillion

• Monthly goods and services exports: $130 Monthly goods and services exports: $130 billion = 13% billion = 13%

• Monthly goods and services imports: $185 Monthly goods and services imports: $185 billion = 18.5% billion = 18.5%

• Balancing item: net capital flow: $55 billion Balancing item: net capital flow: $55 billion = 5.5% = 5.5%

Fred Thompson 51

Scale Variables II

U.S. GDP per worker: $84,000 per U.S. GDP per worker: $84,000 per yearyear

• Exports of $10,900 per year Exports of $10,900 per year • Imports of $15,500 per yearImports of $15,500 per year

Fred Thompson

Foreign claims on U.S. assets Foreign claims on U.S. assets now exceed U.S. claims on now exceed U.S. claims on foreign assets by about $2.7 foreign assets by about $2.7

trillion.trillion.–Storing up purchasing power for the future Storing up purchasing power for the future

–Private political risk insurance Private political risk insurance –Public political risk insurancePublic political risk insurance

ResultResult::

Fred Thompson

International InvestmentsInternational Investments(market value, end-2003)(market value, end-2003)

U.S. foreign investments:U.S. foreign investments: $7.9 trn $7.9 trn

Foreign investments in U.S.:Foreign investments in U.S.: $10.5 trn$10.5 trn

Net:Net: -$2.7 trn -$2.7 trn

Much of this capital inflow has been Much of this capital inflow has been portfolio portfolio investment.investment.

Some has been Some has been direct investmentdirect investment..

Fred Thompson

Foreign Direct InvestmentForeign Direct Investment(market value, end-2003)(market value, end-2003)

U.S. DI abroad:U.S. DI abroad: $2.7 trillion$2.7 trillion

Foreign DI in U.S.:Foreign DI in U.S.: $2.4 trillion$2.4 trillion

Net:Net: $0.3 trillion $0.3 trillion

Fred Thompson 55

Direct Investment PositionsDirect Investment PositionsAt current market value, $ trillionAt current market value, $ trillion

0.0

0.5

1.0

1.5

2.0

2.5

3.0

84 86 88 90 92 94 96 98 00 02

U.S. Direct Investment Abroad

Foreign Direct Investment in U.S.

Fred Thompson 56

US foreign direct investment, 2001

U.K.

18%

Europe

34%Canada

10%

L.America

12%

Caribbean

8%

Japan

5%

Asia,Pacific

11% Other

2%

Fred Thompson 57

Foreign direct investment in US, 2001

UK16%

other Europe

56%

Canada8%

Caribbean3%

Japan12%

Other5%