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International Financial Management

International Financial Management (International Finance)

• means financial management in an international business environment

• different due to different currency in each countries with dissimilar political situations, imperfect markets, & diversified opportunity sets

International Monetary System (IMS)

• institutional framework within which international payments are made, movements of capital are accommodated, & exchange rates among currencies are determined

• complex whole of agreements, rules, institutions, mechanisms, & policies regarding exchange rates, international payments, & the flow of capital

• evolved over time & will continue to do so in the future as the fundamental business & political conditions underlying the world economy continue to shift

Evolution of International Monetary System

• Bimetallism (before 1875)

• Classical Gold Standard (1875-1914)

• Interwar Period (1915-1944)

• Bretton Woods System (1945-1972)

• Flexible Exchange Rate Regime (1973-Present)

Bimetallism

• before 1875

• double standard in that free coinage was maintained for both gold and silver

• IMS before 1870s can be characterized as “bimetallism” in the sense that both gold & silver were used as IMP & that the exchange rates among currencies were determined by either their gold or silver contents

• countries with bimetallic standard experienced the Gresham’s Law

Gresham’s Law

• monetary principle stating that when there are 2 forms of commodity money in circulation, which are accepted by law as legal tender & the same face values

• more valuable one – ‘good money’ – will be hoarded & will disappear from circulation

• less valuable one ‘bad money’ – will be passed on (used for transactions)

Classical Gold Standard

• 1875-1914

• international gold standard can be said to exist when, in most major countries

  • gold is assured of unrestricted coinage

  • 2-way convertibility between gold & national currencies at a stable ratio

  • gold may be freely exported or imported

• exchange rate between any two currencies will be determined by their gold content

• first full-fledged gold standard was not established until 1821 in Great Britain when notes from the BOE were made fully redeemable for gold

• France was effectively on the gold standard beginning in the 1850s and formally adopted the standard in 1878

• newly emergent German empire, which was to receive a sizable war indemnity from France, converted to the gold standard in 1875, discontinuing free coinage of silver

• US adopted the gold standard in 1879, Russia and Japan in 1897

Interwar Period

• 1915-1944

• characterized by economic nationalism, half-hearted attempts & failure to restore the gold standard, economic & political instabilities, bank failures, & panicky flights of capital across borders

• no coherent IMS prevailed during this period, with profoundly detrimental effects on international trade & investment

• U.S. dollar emerged as the dominant world currency, gradually replacing the British pound for the role

Bretton Woods System

• 1945-1972

• July 1944: representatives of 44 nations gathered at Bretton Woods, New Hampshire, to discuss and design the post-war IMS

• representatives succeeded in drafting and signing the Articles of Agreement of the IMF, which constitutes the core of the Bretton Woods system

• agreement was subsequently ratified by the majority of countries to launch the IMF in 1945

• IMF embodied an explicit set of rules about the conduct of international monetary policies and was responsible for enforcing these rules

• Delegates also created a sister institution, the International Bank for Reconstruction and Development (IBRD), the World Bank, that was chiefly responsible for financing individual development projects

• each country established a par value in relation to the U.S. dollar, which was pegged to gold at $35 per ounce

Triffin Paradox

• under the gold-exchange system, the reserve-currency country should run BOP 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 the downfall of the system

• responsible for the eventual collapse of the dollar-based gold exchange system in the early 1970s

Flexible Exchange Rate Regime

• 1973-present

• followed the demise of the Bretton Woods system

• ratified after the fact in January 1976 when the IMF members met in Jamaica and agreed to a new set of rules for the IMS

• continued to provide assistance to countries facing BOP and exchange rate difficulties

• extended assistance and loans to the member countries on the condition that those countries follow the IMF’s macroeconomic policy prescriptions

• September 1985: G-5 countries (France, Japan, Germany, UK, US) met at the Plaza Hotel in New York and reached what became known as the Plaza Accord

• agreed that it would be desirable for the dollar to depreciate against most major currencies to solve the U.S. trade deficit problem and expressed their willingness to intervene in the exchange market to realize this objective. The slide of the dollar that had begun in February was further precipitated by the Plaza Accord

• Louvre Accord marked the inception of the managed-float system under which the G-7 countries would jointly intervene in the exchange market to correct over- or undervaluation of currencies

Conditionality

involves deflationary macroeconomic policies and elimination of various subsidy programs, provoked resentment among the people of developing countries receiving the IMF’s BOP loans

Jamaica Agreement

1. Flexible exchange rates were declared acceptable to the IMF members, & central banks were allowed to intervene in the exchange markets to iron out unwarranted volatilities

2. Gold was officially abandoned as an international reserve asset. Half of the IMF’s gold holdings were returned to the members and the other half were sold, with the proceeds to be used to help poor nations

3. Non-oil-exporting countries and less-developed countries were given greater access to IMF funds

Current Exchange Rate Agreements (CERA)

• classification system is based on IMF member countries’ actual, de facto arrangements, as identified by IMF staff, which can be different from the officially announced arrangements

• system classifies exchange rate arrangements primarily based on the degree to which the exchange rate is determined by the market rather than by official government action, with market-determined rates generally being more flexible

• IMF currently classifies exchange rate arrangements into 10 separate regimes

First Regime of CERA

No separate legal tender

• currency of another country circulates as the sole legal tender

• adopting such an arrangement implies complete surrender of the monetary authorities’ control over the domestic monetary policy

• Ecuador, El Salvador, & Panama

Second Regime of CERA

Currency Board

• currency board arrangement is a monetary arrangement based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation

• implies that domestic currency is usually fully backed by foreign assets, eliminating traditional central bank functions such as monetary control and lender of last resort, and leaving little room for discretionary monetary policy

• Hong Kong, Bulgaria, & Brunei

Third Regime of CERA

Conventional peg

• country formally (de jure) pegs its currency at a fixed rate to another currency or a basket of currencies, where the basket is formed, for example, from the currencies of major trading or financial partners & weights reflect the geographic distribution of trade, services, or capital flows

• anchor currency or basket weights are public or notified to the IMF

• country authorities stand ready to maintain the fixed parity through direct intervention (i.e., via sale or purchase of foreign exchange in the market) or indirect intervention (e.g., via exchange-rate-related use of interest rate policy, imposition of foreign exchange regulations, exercise of moral suasion that constrains foreign exchange activity, or intervention by other public institutions)

• no commitment to irrevocably keep the parity, but the formal arrangement must be confirmed empirically: the exchange rate may fluctuate within narrow margins of less than positive-negative 1 percent around a central rate—or the maximum & minimum value of the spot market exchange rate must remain within a narrow margin of 2 percent for at least 6 months

• Jordan, Saudi Arabia, and Morocco

Fourth Regime of CERA

Stabilized arrangement

• entails a spot market exchange rate that remains within a margin of 2 percent for 6 months or more (with the exception of a specified number of outliers or step adjustments) and is not floating

• Required margin of stability can be met either with respect to a single currency or a basket of currencies, where the anchor currency or the basket is ascertained or confirmed using statistical techniques

• Cambodia, Angola, & Lebanon

Fifth Regime of CERA

Crawling peg

• involves the confirmation of the country authorities’ de jure exchange rate arrangement

• currency is adjusted in small amounts at a fixed rate or in response to changes in selected quantitative indicators, such as past inflation differentials vis-à-vis major trading partners or differentials between the inflation target and expected inflation in major trading partners

• Bolivia & Nicaragua

Sixth Regime of CERA

Crawl-like arrangement

• exchange rate must remain within a narrow margin of 2 percent relative to a statistically identified trend for 6 months or more (with the exception of a specified number of outliers), and the exchange rate arrangement cannot be considered as floating

• minimum rate of change greater than allowed under a stabilized (peg-like) arrangement is required

• Ethiopia, China, & Croatia

Seventh Regime of CERA

Pegged exchange rate within horizontal bands

• value of the currency is maintained within certain margins of fluctuation of at least positive-negative 1 percent around a fixed central rate, or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent.

• Tonga

Eighth Regime of CERA

Other managed arrangement

• residual

• used when the exchange rate arrangement does not meet the criteria for any of the other categories

• Arrangements characterized by frequent shifts in policies may fall into this category

• Costa Rica, Switzerland, and Russia.

Ninth Regime of CERA

Floating

• floating exchange rate is largely market determined, without an ascertainable or predictable path for the rate

• exchange rate that satisfies the statistical criteria for a stabilized or a crawl-like arrangement will be classified as such unless it is clear that the stability of the exchange rate is not the result of official actions

• Foreign exchange market intervention may be either direct or indirect and serves to moderate the rate of change and prevent undue fluctuations in the exchange rate, but policies targeting a specific level of the exchange rate are incompatible with floating

• Brazil, Korea, Turkey, & India

Tenth Regime of CERA

Free floating

• floating exchange rate can be classified as free floating if intervention occurs only exceptionally and aims to address disorderly market conditions and if the authorities have provided information or data confirming that intervention has been limited to at most three instances in the previous 6 months, each lasting no more than 3 business days

• Canada, Mexico, Japan, Israel, U.K., United States, and euro zone.

Balance of Payments (Balance of International Payments or BOP)

• statement that contains the transactions made by residents of a particular country with the rest of the world over a specific time period

• summarizes all payments and receipts by firms, individuals, and the government

• transactions can be both factor payments and transfer payments

• 2 accounts: Current and Capital

Current Account

1. Visible trade

2. Invisible Trade

3. Unilateral transfers to and from abroad

4. Income receipts and payments

Visible Trade

• net of export and imports of goods (visible items).

• balance of this visible trade is known as the trade balance

• trade deficit when imports are higher than exports

• trade surplus when exports are higher than imports

Invisible Trade

• net of exports and imports of services (invisible items)

• transactions mainly consist of shipping, IT, banking, and insurance services

Unilateral transfers to and from abroad

refer to payments that are not factor payments – for example, gifts or donations sent to the resident of a country by a non-resident relative

Income receipts and payments

• include factor payments and receipts

• generally rent on property, interest on capital, and profits on investments

Capital Account

• used to finance the deficit in the current account or absorb the surplus in the current account

  • Loans to and borrowings from abroad

  • Investments to/from abroad

  • Changes in foreign exchange reserves

Loans to and borrowings from abroad

consist of all loans and borrowings given to or received from abroad. It includes both private sector loans, as well as public sector loans.

Investments to/from abroad

investments made by nonresidents in shares in the home country or investment in real estate in any other country

Changes in foreign exchange reserves

• Foreign exchange reserves are maintained by the central bank to control the exchange rate and ultimately balance the BOP

• Current account deficit is financed by a surplus in the Capital account and vice versa

• can be done by borrowing more money from abroad or lending more money to non-residents

Significance of BOP

• BOP data is important to a lot of users

  • Investment managers, government policymakers, the central bank, businessmen, etc., all use the BOP data to make important decisions. The BOP data is affected by vital macroeconomic variables such as exchange rate, price levels, interest rates, employment, and GDP

• Monetary and fiscal policies are formed in a way to achieve very specific objectives, which generally exert a significant impact on the BOP. Policies can be formed with the objectives to induce or curb foreign inflows or outflows

• Businesses use BOP to analyze the market potential of a country, especially in the short term. A country with a large trade deficit is not as likely to import as much as a country with a trade surplus. If there is a large trade deficit, the government may adopt a policy of trade restrictions, such as quotas or tariffs.

Corporate Governance (CG)

• something altogether different from the daily operational management activities enacted by a company’s executives

• system of direction & control that dictates how a board of directors governs & oversees a company

• International Perspective: concerns the system by which companies are directed and controlled

  • about having companies, owners & regulators become more accountable, efficient & transparent, which in turn builds trust & confidence

• Well-governed companies carry lower financial and non-financial risks & generate higher shareholder returns

• have better access to external finance & reduce systemic risks due to corporate crises & financial scandals

• Reliable financial reporting, timely disclosures, better boards & accountable management also facilitate development of stronger capital markets

• improve a country’s ability to mobilize, allocate & monitor investments & help foster jobs and economic growth

• better supervision & monitoring can detect corporate inefficiencies & minimize vulnerability to financial crises

Key Principle of Corporate Governance

Shareholder Primacy

• recognition of shareholders

• recognition is two-fold

  • first, basic recognition of the importance of shareholders to any company – people who buy the company’s stock fund its operations. Equity is one of the major sources of funding for businesses

  • second, from the basic recognition of shareholder importance follows the principle of responsibility to shareholders

• policy of allowing shareholders to elect a board of directors is critical. The board’s “prime directive” is to be always seeking the best interests of shareholders. The BOD hires & oversees the executives who comprise the team that manages the day-to-day operations of a company. This means that shareholders, effectively, have a direct say in how a company is run

Transparency

• shareholder interest is a major part of corporate governance

• shareholders may reach out to the members of the community who don’t necessarily hold an interest in the company but who can nonetheless benefit from its goods or services

• reaching out to the members of the community encourages lines of communication that promote company transparency

• means that all members of the community – those who are directly or indirectly affected by the company – & members of the press get a clear sense of the company’s goals, tactics, & how it is doing in general

• means that anyone, whether inside or outside the company, can choose to review & verify the company’s actions

• fosters trust & is likely to encourage more individuals to patronize the company & possibly become shareholders as well

Security

• increasingly important aspect of corporate governance

• shareholders & customers/clients need to feel confident that their personal information is not being leaked or accessed by unauthorized users

• it’s equally important to ensure that the company’s proprietary processes & trade secrets are secure

• data breach is not just very expensive, it also weakens public trust in the company, which can have a drastically negative effect on its stock price

• losing investor trust means losing access to capital that is necessary for corporate growth

Consequences of Poor Corporate Governance

• biggest purposes of corporate governance is to set up a system of rules, policies, and practices for a company – in other words, to account for accountability

  • each major piece of the “government” – the shareholders, the BOD, the executive management team, & the company’s employees – is responsible to the others, therefore keeping them all accountable

  • part of this accountability is the fact that the board regularly reports financial information to the shareholders, which reflects the corporate governance principle of transparency

  • when good corporate governance is abandoned, a company runs the risk of collapse, and shareholders stand to suffer substantially.

Poor Corporate Governance

In Enron Corp., many of the executives used shady tactics & covert accounting methods to cover up the fact that they were essentially stealing from the company. Erroneous figures were passed along to the BOD, who failed to report the information to shareholder with responsible accounting methods gone out the window, shareholders were unaware that the company’s debts & liabilities totaled much more than the company could ever repay. The executives were eventually charged with a number of felonies, and the company went bankrupt. It killed employee pensions and hurt shareholders immeasurably.

Corporate Governance in the Financial Sector

• Governance issues in financial institutions are similar but differ in important ways from those in non-financial companies

• Financial institutions are charged with upholding the public's trust & protecting depositors

• Balance sheets are opaquer, leading to less transparency & greater ability to conceal problems

• Good governance requires boards & senior management to fulfill their fiduciary responsibilities by effectively communicating strategic business direction & risk appetite while assuring transparent & effective organization, risk assessment & mitigation, & sufficient capital support

• Good governance complements traditional supervision of financial institutions, protects the interests of depositors & other investors in commercial banks, builds & maintains public confidence in the financial sector, & ultimately contributes to its integrity & credibility

• Financial institutions are uniquely vulnerable to liquidity shocks which can result in institutional, & potentially, financial instability

• Sound governance supports prudential supervision & regulation, enhancing the role and the effectiveness of the financial institution supervisor

• Many developing countries are embarking on wide-ranging corporate governance reforms of their state-owned banks in order to improve their efficiency and transparency

• Development banks are now playing a more prominent role in the economy of emerging markets

• Development banks play a central role in financial inclusion, SME development &, housing, agriculture & infrastructure finance

• Solid corporate governance allows these institutions to fulfill their mandates more effectively

Corporate Governance in Capital Markets

• Corporate governance continues to be a key component of capital market development

• Good CG reduces emerging market vulnerability to financial crises, reduces transaction costs & cost of capital, and leads to capital market development

• Capital markets in turn are a major driver of transparency

• In addition to private companies, many SOEs are also listing on the capital markets to access alternative sources of capital & enhance transparency

• Good CG also encourages investor confidence & outside investment

• As pension funds invest increasingly in equity markets, retirement savings are more secure when invested in well-governed companies

• Enhancing the governance and capacity of securities markets and financial sector regulators using a corporate governance lens is becoming an important part of the agenda