INTERNATIONAL FINANCE

MODULE 1

MEANING OF INTERNATIONAL FINANCE

 It is the branch of financial economics broadly concerned with monetary and macro-economic inter
relations between 2 or more countries.
 It examines the dynamics of the global financial system, international monetary systems, balance
of payments, exchange rates, foreign direct investment.

ROLE OF FINANCE MANAGER IN A GLOBAL CONTEXT

• To be up to date with significant changes in the economy and analyze its implications for the
company or organization. For instance change in exchange ratio, credit conditions (interest
rates), change in industrial tax

• To analyze and understand interrelationships between various environmental variables. For

instance what happens if a particular sector is opened up to private investment. What if a major
debtor country defaults payment, the effect of funding prospects in international capital markets.

• To be capable of adapting the finance function to major changes in firms position.For instance a
major financial restructuring of competitor may demand action to be taken by us or he should be
capable to explore funding strategies in times of need.

• He should be capable to overcome past failures and mistakes to minimize adverse impact on the
company or organization. For instance finance obtained under a floating rate against fixed finance
and interest rates rising rapidly.

• To find out effective solutions to take advantage of opportunities offered by markets.

ADVANTAGES OF INTERNATIONAL TRADE

• The exploitation of a country's comparative advantage, which means that trade encourages a
country to specialise in producing only those goods and services which it can produce more
effectively and efficiently, and at the lowest opportunity cost.

• Producing a narrow range of goods and services for the domestic and export market means that a
country can produce in at higher volumes, which provides further cost benefits in terms of
economies of scale.

• Trade increases competition and lowers world prices, which provides benefits to consumers by
raising the purchasing power of their own income, and leads a rise in consumer surplus.

• Trade also breaks down domestic monopolies, which face competition from more efficient foreign
firms.

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 • The quality of goods and services is likely to increases as competition encourages innovation, design
and the application of new technologies. Trade will also encourage the transfer of technology
between countries.

• Trade is also likely to increase employment, given that employment is closely related to production.
Trade means that more will be employed in the export sector and, through the multiplier process,
more jobs will be created across the whole economy.

DISADVANTAGES OF INTERNATIONAL TRADE

• Trade can lead to over-specialisation, with workers at risk of losing their jobs should world demand
fall or when goods for domestic consumption can be produced more cheaply abroad. Jobs lost
through such changes cause severe structural unemployment.

• Certain industries do not get a chance to grow because they face competition from more
established foreign firms, such as new infant industries which may find it difficult to establish
themselves.

• Local producers, who may supply a unique product tailored to meet the needs of the domestic
market, may suffer because cheaper imports may destroy their market. Over time, the diversity of
output in an economy may diminish as local producers leave the market.

WHY DO COUNTRIES TRADE ?

• Countries trade with each other when, on their own, they do not have the resources, or capacity to
satisfy their own needs and wants.By developing and exploiting their domestic scarce resources,
countries can produce a surplus, and trade this for the resources they need.For instance Japan has
no oil reserves. It is the worlds 4th largest consumer of oil and hence needs to import it.

• 2 fundamental principles involved here are:

I. Division of labour

II. Specialization

Division of labour: A division of labour means breaking down production into small,
interconnected tasks, and then allocating these tasks to different workers based on their suitability
to undertake the task efficiently. When applied internationally, a division of labour means that
countries produce just a small range of goods or services, and may contribute only a small part to
finished products sold in global markets. For example, a bar of chocolate is likely to contain many
ingredients from numerous countries, with each country contributing, perhaps, just one ingredient
to the final product.

Specialization: It results from division of labour. Given that each worker, or each producer, is given
a specialist role, they are likely to become efficient contributors to the overall process of
production, and to the finished product. Hence, specialization can generate further benefits in
terms of efficiency and productivity. When countries specialise they are likely to become more
efficient over time. This is partly because a country's producers will become larger and exploit

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 economies of scale. Faced by large global markets, firms may be encouraged to adopt mass
production, and apply new technology. This can provide a country with a price and non-price
advantage over less specialised countries, making it increasingly competitive and improving its
chances of exporting in the future.

GLOBAL FIRMS

• The global firm refers to a firm that, by operating in more than one country, gains R&D, production,
marketing, and financial advantages in its costs and reputation that are not available to purely
domestic competitors.
• The global firm sees the world as one market.
• It has a foothold in multiple countries but the offerings and processes are consistent in each
country.

MULTINATIONAL FIRMS

• A corporation enterprise that manages production or delivers services in more than one country.
• MNC as a corporation that has its management headquarters in one country, known as the home
country, and operates in several other countries, known as as host countries. For instance IBM ,
Microsoft, Nokia, Pepsico etc

A multinational has more autonomy in each individual country, whereas a global model is still
beholden to its central operating model.

THE INTERNATIONAL MONETARY SYSTEM (IMS)

• It is an important constituent of the global financial system.

• They are sets of internationally agreed rules, conventions and supporting institutions that facilitate
international trade, cross border investment and generally the reallocation of capital between
nation states.

• They provide means of payment acceptable between buyers and sellers of different nationality,
including deferred payment

EXCHANGE RATE REGIMES (ERR)

• An exchange rate between two currencies is the rate at which one currency will be exchanged for
another.

• It is also regarded as the value of one country’s currency in terms of another currency

• The exchange-rate regime is the way a country manages its currency in relation to other currencies
and the foreign exchange market.

• ERR refers to the mechanism, procedures and institutional framework for determining exchange
rates at a point in time and changes in them over time, including factors which induce the changes.

EVOLUTION OF IMS

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 • THE GOLD STANDARD (1816-1914)

• INTERWAR PERIOD (1918-1939)

• THE BRETTON WOODS SYSTEM (1944-1972)

• PRESENT IMS

THE GOLD STANDARD

• The oldest system in operation till the beginning of First World War.

• Gold specie standard : The actual currency in circulation consisted of gold coins with a fixed gold
content.

• Gold bullion Standard : The currency in circulation consists of paper notes and the authorities are
ready to convert on demand unlimited amounts of paper currency into gold and vice versa at a
fixed conversion ratio

• Gold Exchange Standard : The authorities are ready to convert, at a fixed rate, paper currency
issued by them into paper currency of another country which is operating a gold specie or gold
bullion standard.

• Thus the exchange rate between any pair of currencies will be determined by their respective
hedge rates against gold.

• There are huge costs of storing and transporting gold.

• 22nd June 1816, Great Britain declared the gold currency as official national currency . On 1st May
1821 the convertibility of Pound Sterling into gold was legally guaranteed.

• Other countries pegged their currencies to the British Pound, which made it a reserve currency.
This happened while the British more and more dominated international finance and trade
relations.

• At the end of the 19th century, the Pound was used for two thirds of world trade and most foreign
exchange reserves were held in this currency.

• With the “Gold Standard Act” of 1900, gold became an official instrument of payment.

• From the 1870s to the outbreak of World War I in 1914, the world benefited from a well integrated
financial order, sometimes known as the First age of Globalization. Money unions were operating
which effectively allowed members to accept each other's currency as legal tender.

• In the absence of shared membership of a union, transactions were facilitated by widespread

participation in the gold standard, by both independent nations and their colonies

GOLD STANDARD RULES

• Each country defined the value of its currency in terms of gold.

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 • Exchange rate between any two currencies was calculated as X currency per ounce of gold/ Y
currency per ounce of gold.

• These exchange rates were set by arbitrage depending on the transportation costs of gold.

• Central banks were restricted in not being able to issue more currency than gold reserves.

ADVANTAGES AND DISADVANTAGES OF GOLD STANDARD

• Price Stability: By tying the money supply to the supply of gold, central banks are unable to expand
the money supply.

• Facilitates BOP adjustment automatically: The basic idea was that a country that ran a current
account deficit needed to export money (gold) to the countries that run a surplus. The surplus of
gold reduced the deficit country’s money supply and increased the surplus country’s money supply.

• The growth of output and the growth of gold supplies needed to be closely linked. For example, if
the supply of gold increased faster than the supply of goods did there would be inflationary
pressure. Conversely, if output increased faster than supplies of gold did there would be
deflationary pressure.

• Volatility in the supply of gold could cause adverse shocks to the economy, rapid changes in the
supply of gold would cause rapid changes in the supply of money and cause wild fluctuations in
prices that could prove quite disruptive

• Countries with respectable monetary policy makers could not use monetary policy to fight domestic
issues like unemployment.

INTER WAR PERIOD

• The years between the world wars have been described as a period of de-globalization, as both
international trade and capital flows shrank compared to the period before World War I. During
World War I countries had abandoned the gold standard, except for the United States.

• The onset of the World Wars saw the end of the gold standard as countries, other than the U.S.,
stopped making their currencies convertible and started printing money to pay for war related
expenses.

• After the war, with high rates of inflation and a large stock of outstanding money, a return to the
old gold standard was only possible through a deep recession inducing monetary contraction as
practiced by the British after World War I.

• The focus shifted from external cooperation to internal reconstruction and events like the Great
Depression further illustrated the breakdown of the international monetary system, bringing such
bad policy moves such as a deep monetary contraction in the face of a recession.

THE BRETTON WOODS SYSTEM

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 • Bretton woods is the name of the town in the state of New Hampshire, USA where delegations
from over 40 countries met in 1944 to discuss on proposals for a post war IMS.

• Two international institutions, the International Monetary Fund (IMF) and the World Bank were
created;

• The US government under took to convert the US dollar freely into gold at a fixed parity rate of $35
per ounce.

• The plan involved nations agreeing to a system of fixed but adjustable exchange rates where the
currencies were pegged against the dollar, with the dollar itself convertible into gold. Other
member countries of the IMF agreed to fix the parities of their currencies vis-a vis the dollar with
variation within 1% on either side of the central parity being permissible. If the exchange rate hits
either of the limits, monetary authorities of the countries were required to buy or sell dollars
against their domestic currency to any extent required to keep the exchange rate within limits.

• Under the Bretton woods system, the US dollar became international money.

• Other countries accumulated and held dollar balances with which they could settle their
international payments while the US could simply trade by paying with its own money.

• Thus the US dollar became the international money.

• The system came under pressure and ultimately broke down when this confidence was shaken due
to various political and some economic factors starting in mid 1960s.

• On Aug 15, 1971, the US govt abandoned its commitment to convert dollars into gold at the fixed
price of $35 per ounce and the major currencies went on a float. With the emergence of a parallel
market for gold where the price soared above the official US mandated price, led to speculators
running down the US gold reserves. France, continued building up hoards of gold at the expense of
the US. Eventually these pressures caused President Nixon to end all convertibility into gold on 15
August 1971.

• By early 1973 the world moved to a system of floating rates

INTERNATIONAL MONETARY FUND

• It was formed with a goal to -Stabilize exchange rates and assist the reconstruction of the worlds
international payment system.

• The IMF is an international organization that was conceived on July 22, 1944 originally with 45
members and came into existence on December 27, 1945 when 29 countries signed the agreement.

• Countries contributed to a pool which could be borrowed from, on a temporary basis, by countries
with payment imbalances.

• The organization's stated objectives are:

to promote international economic cooperation

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 international trade

employment,

exchange rate stability

including by making resources available to member countries to meet balance of payments needs.

• In 1947, France was the first country to borrow from the IMF
• The size of the quota of a country is decided by the GNP – Gross National Product.
• 25% of the quota is in terms of foreign currency , gold , SDR’s.
• 75% of the balance quota is in own currency.
• The quota of a particular country is revised from time to time which also decides the voting power
of the particular country.
• Whenever a country is in need the IMF provides funds in return for certain conditions to be fulfilled
by the borrowing nation such as:
• Reduction in budget deficits of recipient government
• Moderating growth in money supply
• Elimination of subsidies
• Realistic pricing of public sector outputs
• Devaluation of exchange rate

WORLD BANK

• The World Bank is an international financial institution that provides loans and grants to the
governments of poorer countries for the purpose of pursuing capital projects.
• It comprises two institutions: the International Bank for Reconstruction and Development, and the
International Development Association.

OBJECTIVES OF WORLD BANK

• To provide long term capital to members countries for economic reconstruction and development.
• ii. To induce long term capital investment for assuring BOP equilibrium and balanced development
of international trade

• To promote capital investment in members countries by following ways

a. To provide guarantee on private loans or capital investment

b. If capital is not available even after providing guarantee, then IBRD provides loans for
productive activities on considerate conditions.

• To ensure the implementation of development projects so as to bring about a smooth transference

from a war time to peace economy.

BALANCE OF TRADE

• The difference in the monetary value of total exports and imports is called its balance of trade.

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 • Balance of trade refers to the difference in net value of exports and net value of imports of a
country in relation to its business with other countries

• Balance of trade is a part of the broader balance of payment that also takes into account unilateral
transfers and investments.

BALANCE OF PAYMENTS

• It is an accounting record of all monetary transactions between a country and the rest of the world.

• These transactions include payments for the country's exports and imports of goods, services,
financial capital, and financial transfers.

• The BoP accounts summarize international transactions for a specific period, usually a year, and are
prepared in a single currency, typically the domestic currency for the country concerned.

• Sources of funds for a nation, such as exports or the receipts of loans and investments, are
recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign
countries, are recorded as negative or deficit items.

• When all components of the BOP accounts are included they must sum to zero with no overall
surplus or deficit.

• For example, if a country is importing more than it exports, its trade balance will be in deficit, but
the shortfall will have to be counterbalanced in other ways – such as by funds earned from its
foreign investments, by running down central bank reserves or by receiving loans from other
countries.

COMPONENTS OF BALANCE OF PAYMENTS

1. THE CURRENT A/C

It contains

• Imports and exports of goods and services

• Unilateral transfer of goods and services like gifts, donations, subsidies

received or given

2. THE CAPITAL A/C.

• It contains changes in foreign financial assets and liabilities.

3. THE RESERVE A/C.

• It contains details of reserve assets.

• IMF, SDR and Reserve and Monetary Gold are collectively called the Reserve account

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 • It means assets used by monetary authorities of the country to settle the deficit/surplus in other
a/c.

• The reserve account records the activity of the nation's central bank

1. SOURCES OF FUNDS

• Exports
• Receipt of loans
• Investments by others

2. USES OF FUNDS

• Imports
• Loan given
• Investment in foreign countries

If the credit (+) is more than the debit (-) there is a surplus or else a deficit.

IMPORTANCE OF BALANCE OF PAYMENTS

• It is an important source of information on economic and financial situation of a country.

• If it reflects more deficit then stiff measures will be taken to reduce imports and encourage
measures to increase exports. There will be restrictions on repatriation of dividends, interest etc.

• It provides foresight regarding type of exchange rates to prevail. If there is a consistent deficit of
BOP it will have an unfavorable effect on exchange rate.

LIMITATIONS OF OF BALANCE OF PAYMENTS

• BOP statement is established in terms of transactions & not settlements (which may be far distinct
in time from date of delivery) due to advances given/ delay in payments.

• BOP is expressed in national currency. Many times operations are done in other currencies/. So
exchange gain/ losses arises which is ignored. Japan prepares BOP in Yen & US $.

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ASSIGNMENTS/ DISCUSSIONS

1. TERMS
 Liberalization
 Globalization
 Glocalisation
 Dollarization
 Brain Drain
 Dematerialization
 Rematerialization
 MNC
 TNC
 Syndicated loan
 RTGS
 NEFT
 Trade Deficit
 Fiscal Deficit
 Deficit Financing
 Balance of Trade
 Balance of Payments
 Dirty Float
 Managed Float
 Rupee Debt Service

2. Trading Blocs
3. SDR’s
4. Top 15 currencies vis a vis Rupee
5. Pattern of International Trade
6. Major Imports/Exports of India
7. Money transfer modes

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