INTERNATIONAL FINANCIAL SYSTEM

PRESENTATION

Scope of International Finance• Knowledge of I F is crusial to MNCs in two

important ways1. To decide how international events will affect

firm and steps to be taken 2. It helps to recognise how the firm will be

affected by movement in exchange rates, interest rates, inflation rates, assets value

• These events will have its impact on the stock markets and interest rates of another country- money and capital markets.

Objectives of MNCs

• - wealth maximisation• - they have to understand the environments in which

they function. It consists of:1. The international financial system-IMS,INT. Banks and

other MNCs participate in international money and capital markets.

2. Foreign exchange market3. Host countries environment4. Challenges and opportunities-multiplicity of currency,

multiplicity and complexity of the taxation system 5. Foreign exchange and political risks

Distinguish features of international finance

1. Foreign exchange risk2. Political risk3. Expanded opportunity sets4. Market imperfections

Inflows from Foreign investments1. FDI2. Foreign portfolio investments (foreign financial

assets for a purpose other than control)

Methods of International Business1. International Trade2. Licensing3. Franchising 4. Joint ventures5. Management contracts (M&A)6. Establishing new foreign subsidiaries

INTERNATIONAL MONETARY SYSTEM• IMS refers to the body of rules and conventions which have

been developed largely on the basis of traditional mechanisms and practices for conducting international financial transactions and deal with imbalance in international payments.

• International financial transactions necessarily involve transfer of funds between parties across the national frontier, conversion of various national currencies into one another, acquisition and disposal of financial assets and lending and borrowing operations between nationals of different countries.

• IMS is necessarily concerned with determination of exchange rates between different national currencies, the role of capital markets of different countries and provision of international liquidity.

INTERNATIONAL MONETARY SYSTEM

• EVOLUTION1. The Gold Standard (1876-1913)2. The Inter-war Years (1914-1944)3. The Bretton Woods System (1945-1973)4. Flexible Exchange Rate Regime since 1973.

The Gold Standard (1876-1913)

• Fundamental principle was each country should set a par value for its currency in terms of gold and then try to maintain this value.

• -establish the rate at which its currency could be converted to the weight of gold, it is determined by their gold content.

• Features of gold standard are1. Government of each country defines its national

monetary unit in terms of gold.2. Free import and export of gold3. Two way convertibility between gold and

national currencies at a stable ratio.

• Price-Specie-Flow Mechanism• The mechanism was intended to restore equilibrium automatically. When a

country’s currency inflated too fast, the currency lost competitiveness in the world market. The deteriorating trade balance due to imports being greater than exports led to a decline in the confidence of the currency. As the exchange rate approached the gold export point, gold was withdrawn from and shipped abroad to pay for imports.

• Decline of the Gold standard• Reasons 1. Problem involved the price-specie-flow mechanism – Rules of the game

must be followed like a) currency must be valued in terms of gold. B) flow of gold between countries cannot be restricted. C) issuance of notes in some fixed relationship to a coutnry’s gold holdings.

2. Gold is a scarce commodity, gold volume could not grow fast enough to allow adequate amounts of money to be created (printed) to finance the growth of would trade.

3. Unrealistic expectation that countries would subordinate their national economies to the dictates of gold as well as to external and monetary conditions.

The Inter-war Years (1914-1944)

• Widespread fluctuation in currencies in terms of gold during world war I and in the early 1920’s.

• The role of Great Britain as the world’s major creditor nation also came to an end . The US began to assume the role of the leading creditor nation.

• All countries began to recover from the war and stabilise their economies, they made several attempts to return to the gold standard. US-1919, UK-1923, swis, france and scandinavian countries-1928

• Problems1. the pound’s overvaluation was not the only major problem of

the restored gold standard. Other problems were2. failure of the US to act responsibly,3. Undervaluation of the French franc and a general decrease in

the willingness and ability of nations to rely on the gold standard adjustment mechanism.

Bretton Woods System (1945-1973)

• The general agreement that restoring the gold standard was out of question, that governments needed access to credits in convertible currencies if they were to stabilise exchange rates and that governments should make major adjustments in exchange rates only after consultation with other countries. British wanted a reduced role of gold, more exchange rate flexibility than had existed with the gold standard, a large pool of lendable resources at the disposal of the proposed international monetary organisation and acceptance of the principle that the burden of correcting payment disequilibria should be shared by both, surplus countries and deficit countries.

• The main points of the Bretton Woods system are:1. The new institution, the IMF would be established in Washington DC.2. The US dollar (and defacto, the British pound) would be designated as

reserve currencies, and other nations would maintain.3. Each Fund member would establish a par value for its currency and

maintain the exchange rate for its currency within one percent of par value.

4. A Fund member could change its par value with Fund approval and only if the country’s balance of payments was in “fundamental disequilibrium.”

5. After a post-war transition period, currencies were to become convertible.6. The Fund would get gold and currencies to lend through ‘subscription’

Breakdown of the Bretton Woods System• Fixed exchange rates were maintained by official intervention in the foreign exchange

markets from 1947 to 1971. The international trade between the countries have expanded especially those of developed countries and demanded convertibility.

• The stability of exchange rates removed a great deal of uncertainty from international trade and business transactions thus helping the countries to grow.

• The system is suffered from a number of inherent structural problems. They are:1. There was much imbalance in the roles and responsibilities of the surplus and deficits

nations. The deficit imbalance countries had to undergo tight and stringent economic policy measures if they wanted to take help form the IMF.

2. The rigid approach adopted by the IMF to the balance of payments disequilibria situation.

- low conditionality for short term funds - high long term funds3. Built in Instability (countries were reluctant to devalue their currencies)4. The Triffins Dilemma. When all countries demand dollar the demand for reserve for

dollar increased the supply of dollars have reduced.5. Lack of international Liquidity6. Crisis of confidence and collapse

The Flexible Exchange Rate Regime, 1973 - present

• Alternative exchange rate Systems1.Crawling PEG(sliding or gliding

parity)2.WIDE BAND3.FLEXIBLE(FLOATING) SYSTEM

Smithsonian Agreement

• When US dollar fell in value against a number of major currencies, several countries imposed some trade and exchange controls causes a major concern. This has brought fear that such protective measures might become sufficiently widespread to limit international commerce.

• In order to solve the problems, the world’s leading trading countries, called the “Group of Ten,” produced the Smithsonian Agreement in 1971. the Agreement established a new set of parity rates. These parity rates were called central rates because they lacked the approval of the IMF.

• In order to maintain market exchange rates relatively close to the central rates without constant govt. intervention, currencies were permitted to fluctuate over a wider band than in the past. (currency allowed to fluctuate 2.25% from the central rates without govt. intervention, it could fluctuate by as much as 9% against any currency except dollar)

Crawling PEG (sliding or gliding parity)

• A cross between a fixed rate system & a fully flexible system

• Because of the infrequent adjustment of the IMFs par value system necessitated a large devaluation at a large rate, the crawling PEG rate was developed

• This system helps to adjust the rate slowly by small amount at any point in time on a continuous basis to correct for any over valuation and under valuation (0.5% a month or 6% per annum)

WIDE BAND

• the purpose of the wide band in to compensate for the rigidity of the fixed-rate system (which allow small margins of fluctuation on either side of parity) by allowing the currency value to fluctuate, say 5% on each side of the par.

Factors influence the value of currency1. Merchandise Trade deficit2. Oil import prices & volumes3. Economic growth4. Confidence in the govt’s ability to manage the

economy5. Govt. intervention in the foreign exchange market6. Relatively high real interest rates7. Foreign investments8. Strong stock market9. Demand for currency by MNCs10. Large budget deficit

Fixed Exchange Rate

• Merits1. Exchange Rate Stability2. Promotes capital movements of private firms in to a country3. Prevents capital outflows4. Prevents speculation in foreign exchange market5. Serves as an anchor against inflation6. Promotes economic integration of the world.7. Promotes growth of internal money and capital markets

Demerits1. The countries with BOP deficits were losing gold and other foreign

assets2. The countries with BOP surplus were getting more foreign

currencies and assets such as US dollars, pounds and gold. The increase in this lead to inflationary situation.

Flexible Exchange System

• Merits1. Problems of undervaluation and overvaluation are avoided.2. Promotes growth of multilateral trade3. Flexible exchange rates does not necessarily show large

fluctuations.4. It ensures individual freedom5. It frees government from problems of BOPDemerits1. Flexible exchange rates create a situation of instability and

uncertainty.2. Dampening effect on foreign trade3. Widespread speculation with a destabilising effect4. Provides an inflationary bias to an economy. (BOP deficit

leads to devaluation of currency)