International Financial ManagementPROF. PARVEEN SULTANA

Unit-1 International Financial Management Overview, Nature & scope of IFM, factors leading to fast strides in international financial functions, MNC-the key participant in International financial functions, International business &its modes, IFM and domestic financial management. International flow of funds: - Balance of payments - structure of BOP, equilibrium, Disequilibrium and Adjustment

Introduction The main objective of international financial management is to maximise shareholder wealth.

• Adam Smith wrote in his famous title, “Wealth of Nations” that if a foreign country can supply us with a commodity Cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own in which we have some advantage

International business &its modes

Determinants of entry mode:

A firm adopts various modes for its entry into business transaction across borders, which mode a firm should adopt depends at least upon four factors. The are

1. Subservience of corporate objectives.

2. Corporate capability

3. Host country environment.

4. Perceived risk(firm would prefer to expand internationally only if the benefits surpass the anticipated risks)

TYPES OF ENTRY MODE

TRADE MODES CONTRACTUAL ENTRY MODE

EXPORTS:1. DIRECT EXPORTS2. INDIRECT EXPORTS

COUNTER TRADE:1. COMMERCIAL

COUNTER TRADE2. INDUSTRAIAL

COUNTER TRADE

Exports Exports deals with the physical movement of goods and services from one place to another through a custom port, following the rules of both the country of origin and the destination country.

Depending upon the involvement of exporter, exports are two types:

Direct export:- Direct exporters export their goods and services in their own names and buyer directly remits proceeds in a proper manner i.e. remittances is made through the banking channels in the currency quoted in the invoice and through a proper channels i.e. the goods are legally exported through a customs port.

Indirect export:- it supply goods to direct exporters. A lack of expertise, international contacts and manpower causes them to depend on direct exporters.

Ex:- farmers rarely export grains artisans cannot develop international contacts to clinch business deal. So the products are exported to other countries but not in their name. export management companies, trading companies and trade facilitators.

Exports: classification of exporters

Depending on the size of business

Depending on their legal status

Depending on the destination of their exports

Depending on the frequency of the exports

Depending on the product line exported

• Small exporters• Large exporters

• Proprietary • Partnership• Private ltd• Public ltd

• Single destination exports• Multi destination exports such as multi

product, strategic, dimensional , operations

• Occasional exporters• Dynamic exporters

Single line productsMultiple line products

Counter trade Counter trade came into existence in the absence of foreign exchange reserves in a country. Some times the country is nor willing to pay even though it has foreign Exchange reserves such an unwillingness will lead to the non- repatriation of payment . The ultimate solution is to enter in counter trade practices . Counter trade is classified into 3 types,

1. Pure barter (commercial counter trade). It means product to product exchange.

2. Buy back (industrial counter trade) it means to buy end product form the host partner.’

3. Counter purchase. Exchange of goods in various counter until foreign exchange is found.

Counter trade – Pure Barter

Ex: Russia supplied news print and crude oil to India for decades and in turn India supplied tea, garments, medicines and tobacco products to Russia at a comparatively low price, so both the countries enjoyed advantage.

Counter trade: Buy back agreements

It is a form of industrial counter trade . A buy back is an arrangement by which the home country representative sets up a project in the host country, which has sufficient foreign exchange reserves to fully pay the supplier for the project . Normally the counter period is for long term varying form 10 to 20 years.

The project amount is paid partially in foreign exchange and the remaining amount is paid in kind. Usually the home country purchases the end product of the same project at a comparatively low price. This can be sold in the home country or could be diverted to a third country in order to maximum the profit margin.

ex: BHEL sets up projects in other countries. It gets partial payments in foreign exchange and for the balance amount it takes back tankers from the host country and market them in any other country as well a sell in India at higher prices.

Counter trade: purchase agreement

This is a method where in company A from country A supplies product X to country B .

Country B which has a surplus of product Y compensates by supplying it to company A which finds a market for product Y in the country C.

Country C sells the product Z to country D which has sufficient foreign exchange to pay for it.

Country D can then pay country C and finally country A collects payment routed through companies B & C.

Thus purchasing takes place against supply until a country with foreign exchange reserves is found for transactions.

Many MNC use this system to make large amount of money at every stage of the process.

Counter trade: Develop for import arrange Develop for import arrangements are also a type of buy back arrangements where the exporters of plant and machinery participate in the capital of importing firm & takes the share in the profit . The role of exporter is much more than in general buy back agreements.

Counter trade: Frame work agreement

Frame work agreements are the long term protocol or bilateral clearing agreement normally concluded between Govt. trade is balanced after along period of time as mentioned in the agreement.

If the trade is not equal in value the debtor sells the agreed upon commodity in the international market and the creditor is paid off.

Ex: Mexico sold Cocoa to the USA to pay off its excess import from Malaysia

Merits of counter trade Bilateral or counter trade has various advantages:

1. A good option for meeting import requirements

2. Helps stabilize the export earnings because it predetermines the size of export and import.

3. Helps stabilize the term of trade

4. Due above two it encourages stability in the development process.

5. helps in trade diversification.

6. It augments the flow of technology to the flow of technology to the developing countries.

7. It is long term in nature so provides other facility also.

Demerits of counter trade1. It is against multilateral trade.

2. Can no control distortion completely.

3. Difficult to sell products are some times traded.

4. Balancing of trade poses serious problems.

CONTRACTUAL ENTRY MODE

International Finance vs. Domestic Finance

The term ‘International Finance’ has not come from Mars. It is similar to the domestic finance in many of the aspects. If we talk on a macro level, the most important difference between international finance and domestic finance is of foreign currency or to be more precise the exchange rates.

In domestic financial management we aim at minimizing the cost of capital while raising funds and try optimizing the returns from investments to create wealth for share holders. We do not do any different in international fiancé. So the objective of financial mgmt. remains same for both domestic and international fiancé i.e. wealth maximization of share holders . Still the analytics of international fiancé is different from domestic finance.

Following are the major differences

1. Exposure to foreign exchange

2. Macro business environment

3. Legal & tax environment

4. Different group of stake holders

5. Foreign exchange derivatives

6. Different standards of reporting

7. Capital management

Exposure to foreign exchange Exchange to foreign exchange: the most significant difference is of foreign currency exposure, currency exposure impacts almost all the areas of an international business / starting from your purchase from suppliers, selling from customers, investing in plant& machinery, fund raising etc. Wherever you need money , currency exposure will come into play and as we know it well that there is no business transaction without money.

Macro business environment Macro business environment: an international business is exposure to altogether a different economic and political environment. All trade policies are different in different countries. Financial manager has to critically analyse the policies to make out the feasibility and profitability of their business propositions. One country may have business friendly policies and other may not

Legal & tax environment The other important aspect to look at is the legal and tax front of a country. Tax impacts directly to your product costs or net profits i.e. the bottom line for which the where story is written. International finance manger will look at the taxation structure to find out whether the business which is feasible in his home country is workable in the foreign country or not.

Different group of stake holders It is not only the money which along matters, there are other thing which carry greater importance viz. the group of suppliers, customers, lenders, shareholders etc. why theses group of people matter? .

It because they carry altogether a different culture , a different set of values and most importantly the language also may able different. When you are dealing with those stake holders , you have no clue about their likes and dislikes . A business is driven by these stakeholders and keeping them happy is all you need.

Foreign exchange derivatives Since it is inevitable to expose to the risk of foreign exchange in a multinational business. Knowledge of forwards, futures options and swaps is invariably required. A financial manger has to be strong enough to calculate the cost impact of hedging the risk with the help of different derivatives instruments while taking any financial decisions.

Different standards of reporting: If the business has presence in say US & India , the books of accounts need to be maintained in US GAAP & IGAAP.

It is not surprising to know that the booking of assets has a different treatment in one country compared to other. Managing the reporting another big different . The financial manger or his team needs to be familiar with accounting standards of different countries.

Capital management In an MNC, the financial managers have ample options of raising the capital . More number of options creates more challenges with respect to selection of right source of capital to ensure the lowest possible cost of capital.

INTERNATIONAL FLOW OF FUNDS

Balance of payments The balance of payments is a measurement of all transactions between domestic and foreign residents over a specified period of time.

Each transaction is recorded as both a credit and a debit, i.e. double-entry bookkeeping.

The transactions are presented in three groups –1. current account, 2. capital account, 3. financial account.

Current account The current account summarizes the flow of funds between one specified country and all other countries due to the purchases of goods or services, the provision of income on financial assets, or unilateral current transfers (e.g. government grants and pensions, private remittances).

A current account deficit suggests a greater outflow of funds from the specified country for its current transactions.

The current account is commonly used to assess the balance of trade, which is simply the difference between merchandise exports and merchandise imports.

Current account1. Payments for merchandise and services

Merchandise exports and imports represent tangible products that are transported between countries. Service exports and imports represent tourism and other services. The difference between total exports and imports is referred to as the balance of trade.

2. Factor income paymentsRepresents income (interest and dividend payments) received by investors on foreign investments in financial assets (securities).

3. Transfer paymentsRepresent aid, grants, and gifts from one country to another.

Capital account The new capital account (as defined in the 1993 System of National Accounts and the fifth edition of IMF’s Balance of Payments Manual) is adopted by the U.S. in 1999.

It includes unilateral current transfers that are really shifts in assets, not current income. E.g. debt forgiveness, transfers by immigrants, the sale or purchase of rights to natural resources or patents

Financial account The financial account (which was called the capital account previously) summarizes the flow of funds resulting from the sale of assets between one specified country and all other countries.

Assets include official reserves, other government assets, direct foreign investments, investments in securities, etc.

Capital and financial account1. Direct foreign investment

Investments in fixed assets in foreign countries2. Portfolio investment

Transactions involving long term financial assets (such as stocks and bonds) between countries that do not affect the transfer of control.

3. Other capital investmentTransactions involving short-term financial assets (such as money market securities) between countries.

4. Errors and omissionsMeasurement errors can occur when attempting to measure the value of funds transferred into or out of a country.

International flow of fund Different countries rely on trade to different extents.

The trade volume of European countries is typically between 30 – 40% of their respective GDP, while the trade volume of U.S. and Japan is typically between 10 – 20% of their respective GDP.

Nevertheless, the volume of trade has grown over time for most countries.

In 1975, the U.S. exported $107.1 billions in goods, and imported $98.2 billions. Since then, international trade has grown, with U.S. exports and imports of goods valued at $773.3 and $1,222.8 billions respectively for the year of 2000.

Since 1976, the value of U.S. imports has exceeded the value of U.S. exports, causing a balance of trade deficit

INDIA’S FOREIGN TRADE (SERVICES): JUNE, 2014(As per the RBI Press Release dated 14th August, 2014)

A. EXPORTS (Receipts)

Exports during June, 2014 were valued at US $ 12972 Million (Rs. 77482.66

Crore).

B. IMPORTS (Payments)

Imports during June, 2014 were valued at US $ 7194 Million (Rs. 42970.27

Crore).

C. TRADE BALANCE

The trade balance in Services (i.e. net exports of Services) for June, 2014 was

estimated at US $ 5778 Million.

Event that Changes in Trade volumes

◦ In 1998, a 1989 free trade pact between U.S. and Canada was fully phased in.◦ Passed in 1993, the North American Free Trade Agreement (NAFTA) removes numerous

trade restrictions among Canada, Mexico, and the U.S.◦ In 2001, trade negotiations were initiated for a free trade area of the Americas. 34

countries are involved.◦ The Single European Act of 1987 was implemented to remove explicit and implicit trade

barriers among European countries.◦ Consumers in Eastern Europe now have more freedom to purchase imported goods.◦ The single currency system implemented in 1999 eliminated the need to convert

currencies among participating countries

Events that increased the trade volume

1. Removal of the Berlin Wall: Led to reductions in trade barriers in Eastern Europe.

2. Single European Act of 1987: Improved access to supplies from firms in other European countries.

3. North American Free Trade Agreement (NAFTA): Allowed U.S. firms to penetrate product and labor markets that previously had not been accessible.

4. General Agreement on Tariffs and Trade (GATT): Called for the reduction or elimination of trade restrictions on specified imported goods over a 10-year period across 117 countries.

Events that increased the trade volume

5. Inception of the Euro: Reduced costs and risks associated with converting one currency to another.

6. Expansion of the European Union: reduced restrictions on trade with Western Europe.

7. Other Trade Agreements: The United States has established trade agreements with many other countries.

Trade Agreements Around the World

◦ In 1993, a General Agreement on Tariffs and Trade (GATT) accord calling for lower tariffs was made among 117 countries.

Other trade agreements include:◦ Association of Southeast Asian Nations◦ European Community◦ Central American Common Market◦ North American Free Trade Agreement

Friction Surrounding Trade Agreements

◦ Trade agreements are sometimes broken when one country is harmed by another country’s actions.

◦ Dumping refers to the exporting of products by one country to other countries at prices below cost.

◦ Another situation that can break a trade agreement is copyright piracy.

Impact on outsourcing on trade1. Definition of Outsourcing: The process of subcontracting to a third

party in another country to provide supplies or services that were previously produced internally.

2. Impact of outsourcing: 1. Increased international trade activity because MNCs now purchase products

or services from another country.

2. Lower cost of operations and job creation in countries with low wages.

3. Criticism of outsourcing: 1. Outsourcing may reduce jobs in the United States.

Managerial decision on outsourcing

1. Managers of a U.S.–based MNC may argue that they create jobs for U.S. workers.

2. Shareholders may suggest that the managers are not maximizing the MNC’s value as a result of their commitment to creating U.S. jobs.

3. Managers should consider the potential savings that could occur as a result of outsourcing.

4. Managers must also consider the possible bad publicity or bad morale that could occur among the U.S. workers.

Trade volumes among the countries

1. The annual international trade volume of the United States is between 10 and 20 percent of its annual GDP.

2. Trade volume between the United States and Other Countries:1. About 20 percent of all U.S. exports are to Canada, while 13 percent

are to Mexico.

2. Canada, China, Mexico, and Japan are the key exporters to the United States. Together, they are responsible for more than half of the value of all U.S. imports.

Factors Affecting International Trade Flows

Inflation◦ A relative increase in a country’s inflation rate will decrease its current account, as imports

increase and exports decrease.

National Income◦ A relative increase in a country’s income level will decrease its current account, as imports

increase.

Government Restrictions◦ A government may reduce its country’s imports by imposing tariffs on imported goods, or

by enforcing a quota. Note that other countries may retaliate by imposing their own trade restrictions.

◦ Sometimes though, trade restrictions may be imposed on certain products for health and safety reasons.

Factors affecting the international trade

Exchange Rates◦ If a country’s currency begins to rise in value, its current account balance will

decrease as imports increase and exports decrease.Cost of Labor: Firms in countries where labor costs are low commonly have an advantage when competing globally, especially in labor intensive industries

Note that the factors are interactive, such that their simultaneous influence on the balance of trade is a complex one.

Correcting A Balance of Trade Deficit

However, a weak home currency may not necessarily improve a trade deficit.◦ Foreign companies may lower their prices to maintain their

competitiveness.◦ Some other currencies may weaken too.◦ Many trade transactions are prearranged and cannot be adjusted

immediately. This is known as the J-curve effect.◦ The impact of exchange rate movements on intra-company trade is

limited.

J- Effect

International capital flow Capital flows usually represent portfolio investment or direct foreign investment.

The DFI positions inside and outside the U.S. have risen substantially over time, indicating increasing globalization.

In particular, both DFI positions increased during periods of strong economic growth

Factors Affecting Direct Foreign Investment

Changes in Restrictions◦ New opportunities may arise from the removal of government barriers.

Privatization◦ DFI has also been stimulated by the selling of government operations.

Potential Economic Growth◦ Countries with higher potential economic growth are more likely to attract DFI

Tax Rates◦ Countries that impose relatively low tax rates on corporate earnings are more likely to attract DFI.

Exchange Rates◦ Firms will typically prefer to invest their funds in a country when that country’s currency is expected to

strengthen.

Factors Affecting International Portfolio Investment

Tax Rates on Interest or Dividends◦ Investors will normally prefer countries where the tax rates are relatively low.

Interest Rates◦ Money tends to flow to countries with high interest rates.

Exchange Rates◦ Foreign investors may be attracted if the local currency is expected to

strengthen

Impact on Govt. policies1. Restrictions on Imports: Taxes (tariffs) on imported goods increase prices and

limit consumption. Quotas limit the volume of imports.

2. Subsidies for Exporters: Government subsidies help firms produce at a lower cost than their global competitors.

3. Restrictions on Piracy: A government can affect international trade flows by its lack of restrictions on piracy.

4. Environmental Restrictions: Environmental restrictions impose higher costs on local firms, placing them at a global disadvantage compared to firms in other countries that are not subject to the same restrictions.

Impact on Govt. policies5. Labor Laws: countries with more restrictive laws will incur higher expenses

for labor, other factors being equal.

6. Business Laws: Firms in countries with more restrictive bribery laws may not be able to compete globally in some situations.

7. Tax Breaks: Though not necessarily a subsidy, but still a form of government financial support that might benefit many firms that export products.

8. Country Security Laws: Governments may impose certain restrictions when national security is a concern, which can affect on trade

Impact of Balance of trade How exchange rates may correct a balance of trade deficit:

When a home currency is exchanged for a foreign currency to buy foreign goods, then the home currency faces downward pressure, leading to increased foreign demand for the country’s products.

Why exchange rates may not correct a balance of trade deficit:Exchange rates will not automatically correct any international trade balances when other forces are at work.

Limitation of weak home currency solution

1. Competition: foreign companies may lower their prices to remain competitive.

2. Impact of other currencies: a country that has balance of trade deficit with many countries is not likely to solve all deficits simultaneously.

3. Prearranged international trade transactions: international transactions cannot be adjusted immediately. The lag is estimated to be 18 months or longer, leading to a J-curve effect.

4. Intra-company trade: Many firms purchase products that are produced by their subsidiaries. These transactions are not necessarily affected by currency fluctuations.

Agencies that Facilitate International Flows

International Monetary Fund (IMF)

The IMF is an organization of 183 member countries. Established in 1946, it aims◦ to promote international monetary cooperation and exchange stability; ◦ to foster economic growth and high levels of employment; and◦ to provide temporary financial assistance to help ease imbalances of

payments.◦ Its operations involve surveillance, and financial and technical assistance. ◦ In particular, its compensatory financing facility attempts to reduce the impact

of export instability on country economies. ◦ The IMF uses a quota system, and its unit of account is the SDR (special drawing

right).

The weights assigned to the currencies in the SDR basket are as follows:IMF

Currency 2001 Revision 1996 Revision

U.S. dollar 45 39

Euro 29

Deutsche mark 21

French franc 11

Japanese yen 15 18

Pound sterling 11 11

World Bank Group

World Bank Group Established in 1944, the Group assists development with the primary focus of helping the poorest people and the poorest countries.

It has 183 member countries, and is composed of five organizations - IBRD, IDA, IFC, MIGA and ICSID

IBRD: International Bank for Reconstruction and Development

Better known as the World Bank, the IBRD provides loans and development assistance to middle-income countries and creditworthy poorer countries.

In particular, its structural adjustment loans are intended to enhance a country’s long-term economic growth.

The IBRD is not a profit-maximizing organization. Nevertheless, it has earned a net income every year since 1948.

It may spread its funds by entering into co-financing agreements with official aid agencies, export credit agencies, as well as commercial banks

IDA: International Development Association

IDA was set up in 1960 as an agency that lends to the very poor developing nations on highly concessional terms.

IDA lends only to those countries that lack the financial ability to borrow from IBRD.

IBRD and IDA are run on the same lines, sharing the same staff, headquarters and project evaluation standards.

IFC: International Finance Corporation

The IFC was set up in 1956 to promote sustainable private sector investment in developing countries, by◦financing private sector projects;◦helping to mobilize financing in the international financial markets; and

◦providing advice and technical assistance to businesses and governments.

M IGA: Multilateral Investment Guarantee Agency

The MIGA was created in 1988 to promote FDI in emerging economies, by ◦ offering political risk insurance to investors and lenders; and ◦ helping developing countries attract and retain private investment.

ICSID: International Centre for Settlement of Investment Disputes

The ICSID was created in 1966 to facilitate the settlement of investment disputes between governments and foreign investors, thereby helping to promote increased flows of international investment.

World Trade Organization (WTO)

Created in 1995, the WTO is the successor to the General Agreement on Tariffs and Trade (GATT).

It deals with the global rules of trade between nations to ensure that trade flows smoothly, predictably and freely.

At the heart of the WTO's multilateral trading system are its trade agreements.

Its functions include:◦ administering WTO trade agreements;◦ serving as a forum for trade negotiations;◦ handling trade disputes;◦ monitoring national trading policies;◦ providing technical assistance and training for developing countries; and◦ cooperating with other international groups

Bank for International Settlements (BIS)

Set up in 1930, the BIS is an international organization that fosters cooperation among central banks and other agencies in pursuit of monetary and financial stability.

It is the “central banks’ central bank” and “lender of last resort.

The BIS functions as:◦ a forum for international monetary and financial cooperation;◦ a bank for central banks;◦ a center for monetary and economic research; and◦ an agent or trustee in connection with international financial operations

Regional Development Agencies

Agencies with more regional objectives relating to economic development include◦ the Inter-American Development Bank;◦ the Asian Development Bank;◦ the African Development Bank; and◦ the European Bank for Reconstruction and Development.

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