Winter 2017

BBA Semester 6

BBA603: Role of International Financial Institutions

Q1. What do you mean by International Finance? What are the various emerging
trends in global trade?

International finance is the branch of economics that broadly studies monetary and
macroeconomic relationship between nations. It studies capital flows among nation,
exchange rate fluctuations, balance of trade, tax policies effects, and other related issues.
The importance of international finance has increased in the last two decades owing to the
technological development and the deregulation of the financial markets and products. With
growing internationalization and globalization of economic activity across the nations of the
world, complex networks of financial relationships have emerged. International finance plays
a very important role in linking world trade and foreign investment.

Benefits of international finance

Some of the benefits of international finance are mentioned below:

• Integrates world economies and facilitates easy flow of capital across countries
worldwide
• Moderates domestic regulations through global financial institutions
• Leads to healthy competition and hence, more effective banking
• Promotes domestic growth and investment through capital import
• Leads to effective capital allocation by providing information on vital areas of
investment
• Gives countries access to capital markets across the world and, thus, enables a
country to lend in good times and borrow in bad times

Emerging Trends in Global Trade

The past few decades have seen important shifts that have reshaped the global trade
landscape. As a share of global output, trade is now at almost three times the level in the
early 1950s, in large part driven by the integration of rapidly growing Emerging Market
Economies (EMEs). The share of developed countries in world merchandise trade in value
terms declined from 69 per cent to 55 per cent between 1995 and 2010, while that of
developing countries increased from 29 per cent to 41 per cent. The expansion in trade is
mostly accounted for by growth in non-commodity exports, especially of high-technology
products such as computers and electronics. It is also characterized by growing regional
concentration and an ongoing shift of technology content toward EMEs. These
developments in global trade have important implications for trade patterns, in particular in
response to relative price changes.
1. Trade interconnectedness: Not only has the number of systemically important trading
nations increased over time, their trade links have also multiplied. A chief contributor is the
growing role of global supply chains in overall trade, facilitated by lower tariffs and
technology-led declines in transportation and communication costs.

2. Emerging market economies as major players: In the early 1970s, trade was largely
confined to a handful of advanced economies, notably the United States, Germany, and
Japan, which together accounted for more than a third of the global trade. By 1990, the
global trading landscape had become more diversified to include several EMEs, especially in
east Asia. By 2010, China became the second largest trading partner after the United
States, overtaking Germany and Japan.

3. The structure of trade has been characterized by a rising share of higher

technology goods: The role of global supply chains for trade in high technology goods has
increased over time, especially in China. The increase is particularly pronounced for China—
imported content of Chinese high-technology exports increased by close to 30 percentage
points from the mid-1990s to the mid-2000s.

Q2. What are the various factors that influence the exchange rates?

There are many other factors which influence the exchange rates, such as:

• Balance of Payment (BOP): The BOP position of a country is a clear indicator of the
demand and supply of foreign currency. If a country has a BOP surplus i.e. more
supply of foreign currency, then foreign currency will be cheaper than the domestic
currency i.e. domestic currency will appreciate and vice versa.

• Strength of the economy: The demand and supply of foreign currency also depends
on the relative strength of the country. An economy with a faster growth rate as
indicated by various parameters such as Gross Domestic Product, and Gross
National Product, drop in unemployment level, growth in industrial production and
capacity utilization, etc. may lead to a better performance on balance of trade.
However, it is also possible that in the short run, increasing economic activity may
lead to higher imports as compared to exports.

• Interest rate differential: A higher rate of interest in a particular country may lead to a
demand of the currency of that country and greater supply of the foreign currency as
speculative capital is attracted provided there are no controls.

• Inflation rate differential: When two countries have different inflation rates, the
currency of the country whose inflation rate is higher will depreciate vis-à-vis the
other country. This will lead to a change in exchange rate.
 • Fiscal policy: If an expansionary policy is followed by the government by lowering the
interest rates, which in turn may fuel economic growth, it may lead to increase in
exports. On the contrary, if the expansionary policy is followed by resorting to higher
budget deficit and monetizing this deficit, this may result in high inflation in the
economy and can be detrimental for the growth in export.

• Monetary policy: The monetary policy of any country is an important tool to control
money supply in a economy, keep a check on inflation, ensure price stability and
growth of the economy. It also gives an indication of the interest rates in the
economy. Too much of money supply leads to inflation. In such as case, the central
bank raises the interest rates, sells government securities and may raise reserve
requirements. It is, therefore, clear that the monetary policy influences inflation,
interest rates, employment etc. and thereby affects the exchange rates.

• Speculation: Speculators influence exchange rates by buying and selling a particular

currency in the expectation of making profits and as a result may strengthen or
weaken any currency in the short run. This is known as the ‘bandwagon affect’.

• Government interventions: Sometimes the government of a country intervenes in the

foreign exchange market by imposing restrictions on currency movements,
restrictions on currency dealings and by their monetary and taxation policies. All this
influences the exchange rate of the country.

• Central bank interventions: The central bank of a country can influence the exchange
rate of the country by selling and buying foreign currency in the foreign exchange
market. For example, RBI buys dollars whenever the rupee starts appreciating
beyond a particular level and sells dollars whenever the rupee starts depreciating
beyond a desired level. This is called ‘open market operations’ of the central bank. A
highly appreciating rupee is favorable to importers and unfavorable to exporters and
vice versa. However, it is important to understand that for these operations, the
central bank of the country should have huge reserves of dollar.

Q3. What do you mean by Letter of Credit (LC)? What are the various types of Letter
of Credit?

Letter of Credit

Letter of Credit (LC) is one of the methods of making trade payment while dealing with
unknown exporters or importers. LC is one of the most secured modes of payment for
international traders, especially when the foreign buyer’s reliable credit information is not
there. The exporter has to be content with the creditworthiness of the importer’s bank.
Through this method, the specific performance of both the parties i.e. exporters and
importers is ensured. Also, the exporter is protected since payment is only made once the
goods are delivered or shipped as promised.
 Figure: The Process of Issuing Letter of Credit

The main parties involved in a letter of credit transaction are the applicant, the beneficiary,
the issuing bank, the confirming bank, and the nominated bank. The importer sends an
application to his bank i.e. the issuing bank to open a letter of credit in favour of the
beneficiary i.e. the exporter through another bank called the correspondent bank. Therefore,
a Letter of Credit is a commitment by a bank to honour the payment to the exporter on behalf
of the importer, subject to the fulfillment of the terms and conditions mentioned in the LC. For
rendering this service the bank is paid a fee by the buyer or importer.

The different types of Letter of Credit:

(i) Commercial Letters of Credit: Commercial letters of credit are used as a primary
payment tool in international trade. Majority of commercial letters of credit are issued subject
to the latest version of UCP (Uniform Customs and Practice for Documentary Credits). The
ICC publishes UCP, which are the set of rules that governs the commercial letters of credit
procedures.

(ii) Standby letters of Credit: Commercial letters of credit are a means of payment to be
utilized when the principal perform its duties. In standby letters of credit, a payment is made
to the beneficiary when there is a breach of the principal’s obligation.
(iii) Back-to-back letter of credit: Back-to-back documentary credit is used in situations
where a transferable documentary credit cannot or is not allowed to be used for some
reason. Upon the intermediary’s request the bank issues a back-to-back documentary credit
in favour of the supplier. The documentary credit, opened by intermediary’s bank, is based
on documentary credit (so-called initial documentary credit) previously opened in favour of
the intermediary. Legally, these are two independent documentary credits; therefore,
contrary to the transferable documentary credit, the bank may require the intermediary to
provide additional security for the issuing of a back-to-back documentary credit (as the initial
documentary credit is not a 100 per cent security for a bank). At the same time the use of
back to-back documentary credit allows the intermediary to avoid direct contacts between
the buyer and the seller.

(iv) Revolving letter of credit: A revolving documentary credit is suitable for making
payments for regular deliveries made over a longer period of time. The buyer asks his bank
to issue a letter of credit with a so called ‘revolving clause’ that allows the seller to present
documents to the bank after a certain period of time defined in the documentary credit,
submitting then under the same documentary credit without the buyer having to make any
amendments.

(v) Revocable Letters of Credit: Revocable letters of credit give issuer the amendment or
cancellation right of the credit any time without prior notice to the beneficiary. Since
revocable letters of credit do not provide any protection to the beneficiary, they are not used
frequently. In addition, UCP 600 has no reference to revocable letters of credit. All credits
issued subject to UCP 600 are irrevocable unless otherwise agreed between the parties.

Q4. Write short notes on International Bank for Reconstruction and Development
(IBRD) and International Finance Corporation (IFC).

International Bank for Reconstruction and Development

The International Bank for Reconstruction and Development (IBRD) is an international

financial development institution and is the first of the five-member institutions which make
up the World Bank Group. IBRD has been constituted for the purpose of giving loans to
middle-income developing nations of the world and is considered to be the hard lending arm
of the World Bank. Initially, IBRD was set up for financing the reconstruction of the European
countries which were destroyed by World War II, but later on its aid was extended all over
the world for eradicating poverty and advancing economic development. The areas of focus
for IBRD are healthcare, education, domestic policy, energy investments, infrastructure,
access to food and potable water, environmental awareness and improved sanitation.
Although IBRD is governed by its member states, it has its own staff and executive
leadership to carry on its day-to-day business operations.

Governance and membership

IBRD is governed by a Board of Governors consisting of one governor (either treasury
secretary or finance minister) per member country. Membership to IBRD is only given to
those countries who are members of International Monetary Fund. At present there are 188
member countries of IBRD which contribute capital, vote on policy matters and give approval
for all its activities. Each member state is a shareholder of IBRD of which the USA is the
largest, followed by Japan, Germany, France and United Kingdom. Together the high
income countries have a shareholding of 65.92 per cent. This percentage of ownership is
based on the size of the economy and the amount of capital contributed to support the
borrowing activity of the bank from the international capital markets. The US alone has the
veto power on any structural changes of the bank.

Funding

Some of the key points about IBRD funding are as follows:

• The IBRD funds are generated by contributions from members and also from bonds
issued in the international capital markets.
• The IBRD has the privilege of AAA rating since 1959 which enables it to borrow
capital at favorable rates.
• The instruments used by IBRD for raising funds in the international capital markets
are structured notes with tailor made yields and currencies, discount notes
denominated in dollars and euro dollars, benchmark and global benchmark bonds,
and bonds denominated in soft currencies.

Services

The highlights of the services offered by IBRD are as follows:

• The IBRD provides financial and information services and also strategic coordination
to its member countries.
• It finances the sovereign governments or projects supported by the sovereign
governments of the middle income developing nations.
• The IBRD‘s debt portfolio of more than $100 billion and financial derivative
transactions of $20 billion are managed by the World Bank’s treasury.
• The bank offers loans also in local currencies.
• The loans offered by IBRD are flexible in nature and are with maturity of up to 30
years and the repayment schedules are customized as per the requirements of the
country.

International Finance Corporation

International Finance Corporation (IFC), a development finance institution, is a member of

the World Bank Group and offers advisory, investment and asset management services to
developing countries with the aim of poverty reduction and economic development in
developing nations. It makes investments, strictly, in for profit and commercial projects and
also provides companies of developing countries access to competitive markets and
supports job creation. Its goals are also to facilitate investment in climate health, public
health and education, increase access to finance for microfinance institutions and advance
infrastructure. IFC is owned and governed by its member countries, although it has its own
executive leadership and staff. It is assessed by individual evaluator every year.

History

The Bretton Woods Conference in 1944 resulted in the formation of World Bank and the
International Monetary Fund. The World Bank became operational in 1946 and at that time
only consisted of the International Bank of Reconstruction and Development (IBRD) which
made loans to the governments of the developing countries. It was only in 1947 that Robert
Garner, a senior executive of the World Bank, expressed his views that there was an urgent
need to establish another institution which would focus on the private business and
investments in developing countries. This would also play an important role in contributing
towards international development. He gave the proposal in 1950 for the establishment of
IFC and it was also encouraged by the US. In 1956, President Eugene Black of World Bank
further emphasized that the International Finance Corporation would only invest in private
businesses but will not take part in their management. Finally in 1956, IFC was operational
with a staff of 12 members and a capital of $100 million under the leadership of Garner.

Membership

Membership to IFC is only given to those countries who are members of the World Bank and
within that IBRD. At present there are 184 member countries of IFC which are also
shareholders of IFC and have right to vote on important policy matters and also all its
investment activities. The US is the IFCs largest share holder with a share capital of 24 per
cent followed by Japan with 6 per cent and France, Germany and the UK with 5 per cent.
IFC’s share capital is around $2.4 billion as of 30 June of which seven largest members of
OECD control 51 per cent.

Response to financial crisis of 2008

IFC helped developing countries deal with the after effects of the financial crisis of 2008 by
providing their SME with $16.2 billion line of credit and also a selective capital increase of
$200 million which increased the representation of developing countries to a total share of
39.48 per cent.

Q5. Write a short note on Asian Development Bank (ADB). What are the various
criticisms that are made for the ADB?

Asian Development Bank (ADB)

The Asian Development Bank (ADB) was originally a brain child of some influential
Japanese in 1962, since they felt that the World Bank was not able to successfully serve the
interest in Asia. This was also supported by the Japanese government and finally it was
established in 1966. The Asian Development Bank has its headquarters in Mandaluyong
City, Philippines. Japan being the major shareholder, held a very influential position in the
banks administration and policy framework.

ADB loans were mainly to countries like Thailand, Philippines, Malaysia, South Korea and
Indonesia, with whom Japan had major trading ties. Thus, with the establishment of ADB,
Japans’ economic interest was served to a large extent. The first ADB President was
Japan’s Takeshi Watanabe who held office from 1966-1972.

Organization structure

The highest policy making body of ADB is the Board of Governors which comprises one
representative from each member state. The Board of Governors elect among themselves a
twelve member Board of Directors and their deputy. Eight of these twelve members Board of
Directors are from regional members and the other four are from non-regional members. The
Board of Directors elects the president for a five-year term and may also be re-elected.
Since Japan has been a major shareholder of the bank, the bank president, till date, has
been Japanese.

Lending

The Asian Development Bank offers hard loans on commercial terms from its Ordinary
Capital Resources (OCR) and offers soft loans on concessional terms from its special fund
resources. In 2011 the bank’s capital base was $165 billion. This is due to the 200 per cent
increased contributions by the member countries in response to a call by the G-20 countries
in 2009 to increase the resources of the multilateral development banks in order to support
the growth of the developing countries after the global financial crisis. For the ordinary
capital resource, members subscribe capital which includes both the paid in and the callable
element. The Asian Development Bank borrows from the international capital markets by
using its capital as a guarantee.

Criticism

Some of the criticisms that are made for the ADB are:

• The two major donors, the United States and Japan have been exerting major
influence in all the lending, staffing and policy decision of ADB since its inception.
• There have been many cases of the bank being insensitive to local poor and
marginalized communities when major projects are undertaken. Many a times their
have been cases of human rights violation.
• The United Nations Environmental Programme has criticized ADB for showing
growth at the cost of more than 70 per cent of its rural population who are dependent
on the natural resources for their income and livelihood.
• ADBs large scale projects have been causing a lot of environmental and social
damage as the environment safeguard policies are not followed and implemented by
 the Banks officials in most cases and are only stated in paper. Example: Thailand’s
Mae Moh coal-fire power station has been much in controversy for this reason.
• There has been much criticism on the role of the bank in the food crisis. The civil
society has accused the bank for the pressure it has created on the governments
taking loans from the bank, to deregulate and privatize agriculture. Example: Rice
supply shortage in Southeast Asia.
• There has been criticism for the bank by the Vietnam War veterans for funding
projects in Laos underwritten by taxes as United States has 15 per cent stake in the
bank.

Q6. Write a short note on China’s Yuan Revolution and Sovereign Wealth Funds
(SWF)?

China’s Yuan Revolution

Time and again, remarks and statements from top officials of Central Bank of China have
indicated that the yuan or Renminbi, the official currency of China, has started to show its
potential and would soon be included in the reserve currencies across different countries
such as Europe, North America and the Middle East. Great efforts are being made by
Chinese officials to have yuan play a greater role in the international trade and investment. A
global yuan competing with dollar can be beneficial in bringing down the foreign exchange
costs for the Chinese companies and at the same time upgrading China’s status in the
international monetary system.

The growth of yuan has been exponential in cross-border trade settlements with around 10
per cent of China’s total trade being made up of yuan-denominated trade transactions.
Investors, including the foreign exchange central banks, are concerned about the long-term
strength of the dollar and weakening euro and are, therefore, trying to take corrective actions
by thinking of diversifying their currency reserves to include the Yuan.

Some of them have entered into currency swap agreements with the People’s Bank of
China, while others are thinking of buying Yuan-denominated assets sold in Hong Kong.

Despite these promising indicators, Yuan has still to go a long way before it can become the
reserve currency. Besides, the international use of yuan requires China’s financial sector to
be revamped through steps such as liberalizing the interest rates and exchange rates and
also remove restrictions on the capital flows. Global investors would only invest in yuan
when they are free to buy and sell yuan-denominated assets. However, some analysts are of
the view that yuan’s internationalization can lead to the financial sector reforms in China,
whereas others feel both the financial sector reforms and internationalization of yuan can go
together. Still, there are others who feel that reforms should precede the internationalization.

Sovereign Wealth Funds

The term Sovereign Wealth Funds (SWF) was coined in 2005 by Andrew Rozanov in his
article ’Who holds the wealth of the nation?’ published in the Central Banking Journal. The
previous edition of the journal had talked about a shift from traditional foreign reserve
management to sovereign wealth management. In other words, sovereign wealth funds are
assets (stocks, bonds, property, precious metals, foreign direct investment and even hedge
funds or private equity) held by governments of certain countries in other countries’
currencies. The SWFs invest all around the world. This happens when a particular country
has accumulated foreign exchange reserves much more than its current requirement as a
result of continued current account surplus. Its creation also happens when a country has no
international debt. These funds have existed since 1950s, but over a period their total size
has increased worldwide from $500 million in 1990 to $2-3 trillion in 2007. At present, these
gigantic funds are estimated to hold reserves more than $5 trillion, which is considered to be
huge as compared to the GDP of US, which is $14 trillion, traded securities’ global value
(more than $165 trillion), and total value of traded securities denominated in US dollars
(more than $50 trillion). When compared to the size of emerging countries, the size of these
SWFs is really huge.

Countries which are major exporters of oil and gas, such as Norway, Russia, Canada,
Alaska, Trinidad and Tobago, own more than half of these assets. About one-third is owned
by Asian and Pacific countries such as China, Australia and Singapore.