International Finance vs.

Domestic Finance
Monday, 30 May 2011 21:06 Sanjay Borad Corporate Finance - International Financial Management

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International finance is different from domestic finance in many aspects and first and the most significant of them is foreign currency exposure. There are other aspects such as the different political, cultural, legal, economical, and taxation environment. International financial management involves into a lot of currency derivatives whereas such derivatives are very less used in domestic financial management. 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 shareholders. We do not do any different in international finance. So, the objective of financial management remains same for both domestic and international finance i.e. wealth maximization of shareholders. Still, the analytics of international finance is different from domestic finance. Following are the major differences: Exposure 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 to customers, investing in plant and 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: An international business is exposed to altogether a different economic and political environment. All trade policies are different in different countries. Financial manager has to critically analyze 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 and 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 whole story is written. International finance manager 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 Stakeholders: It is not only the money which along matters, there are other things which carry greater importance viz. the group of suppliers, customers, lenders, shareholders etc. Why these group of people matter? It is because they carry altogether a different culture, a different set of values and most importantly the language also may be different. When you are dealing with those stakeholders, 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 manager has to be

strong enough to calculate the cost impact of hedging the risk with the help of different derivative instruments while taking any financial decisions. Different Standards of Reporting: If the business has presence in say US and India, the books of accounts need to be maintained in US GAAP and 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 task is another big difference. The financial manager 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 challenge with respect to selection of right source of capital to ensure the lowest possible cost of capital. There may be such more points of difference between international and domestic financial management. Mentioned above are list of major differences. We need to consider each of them before taking any decision involving multinational financial environment.

nternational capital flows are the financial side ofINTERNATIONAL

TRADE.1

When someone imports a good or service, the buyer (the importer) gives the seller (the exporter) a monetary payment, just as in domestic transactions. If total exports were equal to total imports, these monetary transactions would balance at net zero: people in the country would receive as much in financial flows as they paid out in financial flows. But generally the trade balance is not zero. The most general description of a countrys balance of trade, covering its trade in goods and services, income receipts, and transfers, is called its current account balance. If the country has a surplus or deficit on its current account, there is an offsetting net financial flow consisting of currency, securities, or other real property ownership claims. This net financial flow is called its capital account balance.
When a countrys imports exceed its exports, it has a current account deficit. Its foreign trading partners who hold net monetary claims can continue to hold their claims as monetary deposits or currency, or they can use the money to buy other financial assets, real property, or equities (stocks) in the trade-deficit country. Net capital flows comprise the sum of these monetary, financial, real property, and equity claims. Capital flows move in the opposite direction to the goods and services trade claims that give rise to them. Thus, a country with a current account deficit necessarily has a capital account surplus. In BALANCE-OF-

PAYMENTS

accounting terms, the current-account balance, which is the total balance

of internationally traded goods and services, is just offset by the capital-account balance, which is the total balance of claims that domestic investors and foreign investors have acquired in newly invested financial, real property, and equity assets in each others countries. While all the above statements are true by definition of the accounting terms, the data on international trade and financial flows are generally riddled with errors, generally because of undercounting. Therefore, the international capital and trade data contain a balancing error term called net errors and omissions. Because the capital account is the mirror image of the current account, one might expect total recorded world tradeexports plus imports summed over all countriesto equal financial flowspayments plus receipts. But in fact, during 19962001, the former was $17.3 trillion, more than three times the latter, at $5.0 trillion.2 There are three explanations for this. First, many financial transactions between international financial institutions are cleared by netting daily offsetting transactions. For example, if on a particular day, U.S. banks have claims on French banks for $10 million and French banks have claims on U.S. banks for $12 million, the transactions will be cleared through their central banks with a recorded net flow of only $2 million from the United States to France even though $22 million of exports was financed. Second, since the 1970s, there have been sustained and unexplained balance-of-payments discrepancies in both trade and financial flows; part of these balance-of-payments anomalies is almost certainly due to unrecorded capital flows. Third, a huge share of export and import trade is intrafirm transactions; that is, flows of goods, material, or semifinished parts (especially automobiles and other nonelectronic machinery) between parent companies and their subsidiaries. Compensation for such trade is accomplished with accounting debits and credits within the firms books and does not require actual financial flows. Although data on such intrafirm transactions are not generally available for all industrial countries, intrafirm trade for the United States in recent years accounts for 3040 percent of exports and 3545 percent of imports.3 The bulk of capital flows are transactions between the richest nations. In 2003, of the more than $6.4 trillion in gross financial transactions, about $5.4 trillion (84 percent) involved the 24 industrial countries and almost $1.0 trillion (15 percent) involved the 162 less-developed countries (LDCs) or economic territories, with the

rest, less than 1 percent, accounted for by international organizations.4 The shares of both industrial nations and the international organizations have been receding from their highs in 1998: 90 percent for industrial nations and 5 percent for the international organizations. In that year the combination of the Russian debt default and ruble devaluation, the south Asia financial crisis, and the lingering uncertainty about financial consequences of the return of Hong Kong to Chinese sovereignty in July 1997 drove the LDC share down to 5 percent of world capital flows.5 In the more tranquil five years following these crises, 19992003, LDC financial transactions involving mainland China and Hong Kong averaged 28 percent of the LDC total, and adding Taiwan, Singapore, and Korea brings the share to 53 percent of the developing-country transactions. Of the remaining forty-seven percentage points of developing-country transactions, Europe (primarily Russia, Turkey, Poland, and the Czech Republic) and the Western Hemisphere (primarily Mexico, Brazil, and Chile) each accounted for about sixteen percentage points, with the Middle East and Africa combining for the remaining sixteen percentage points.
Financing Trade in Goods, Services, and Assets

Figure 1 shows that most financial flows involve industrial countries whose gross flows (credits plus debits) during 19952003 averaged $4.9 trillion per year. Capital flowsinvolving industrial countries comprised about 90 percent of total transactions, with LDCs and international organizations accounting for the remainder. Perhaps more significant, these gross flows were about ten times the net capital flows, reflecting the netting out of the vast majority of financial flows.

Figure 1 World Financial Flows

While much international trade is financed by offsetting trade flows, ultimately net trade balances must be financed by net financial flows. As Figure 2 shows, the United States has had large current-account deficits, primarily due to its deficit on merchandise trade; the non-U.S. industrial countries have had large trade surpluses; and LDCs, in aggregate, shifted from trade deficits to growing trade surpluses at the end of the twentieth century. Net capital and financial flows finance these net trade imbalances, which, while primarily between industrial counties in gross terms, increasingly flowed, on net, from both developing and non-U.S. industrial countries to the United States. Reflecting their shift from trade deficits to trade surpluses at the end of the twentieth century, LDCs became net suppliers of capital in 1999 (Figure 3).

Figure 2 Current Account Balances (CABs)

Figure 3 Capital Account Balances (KABs)

Figures 2 and 3 contain two glaring anomalies. First, Figure 2 shows that the U.S. current account deficit is far larger than the sum of the current account surpluses of the other industrial countries and the LDCs. This implies that the world has been running a current account deficit with itself, something that is logically impossible because the sum of all transactions across all countrieswith exports positive and imports negativemust be zero. That is, an export from China to France is an import by France from China. Because the world is a closed system (no country trades with Mars), if trade data were accurate, the sum of world trade in goods and services (including income and transfers) would be zero. Yet, according to the recorded data, the world ran a current account deficit averaging more than $95 billion annually during 19952003. Combined with estimated errors and omissions, these missing data constitute omitted exports and financial flows well in excess of $100 billion per year.6Second, Figure 3 shows that the sum of capital outflows from the non-U.S. industrial countries and LDCs is far smaller than the reported inflow of capital to the United States. Thus, the world ran a substantial capital surplusagain, a logical impossibility (no borrowing from Mars). Although thereis no agreed-upon explanation for these discrepancies, there are two possible reasons, depending on whether or not U.S. data on earnings from foreign direct INVESTMENT are accurate. First, if the U.S. data are correct, then, because the sum of the U.S. current account deficit in Figure 2 and its capital account surplus in Figure 3 is close to zero, there must be underreported exports to the United States from the non-U.S.

industrial countries and the LDCs, balanced by unreported financial flows from them to the United States. Alternatively, suppose that the U.S. data on foreign direct investment earnings are not accurate, in particular that U.S. net income from its direct investments has been underreported.7 Reporting these earnings at their higher actual level would result in a reduction of the U.S. current account deficit (due to the increased income from renting capital to foreigners) and an equal reduction of the U.S. capital-account surplus.8 The available evidence makes the second explanation more likely than the first.
Composition of Capital and Financial Flows

Trade imbalances are financed by offsetting capital and financial flows, which generate changes in net foreign assets. These payments can be any combination of the following:

capital investments

portfolio investments in either debt or equity securities

direct investment in domestic firms (FDI) including start-ups

changes in international reserves 9

As Table 1 shows, industrial countries financed their current account balances primarily with financial flows other than direct investment or reserve flows. Indeed, while the industrial countries were importing capital in the form of other financial flows, they were at the same time exporting capital as investors in the form of foreign direct investment (outflow of capital indicated by minus sign). The flow of

net direct investment from industrial countries averaged $115 billion during the nine years shown in Table 1 and was directed primarily to developing countries. These capital outflows were an important component of financing investment in the LDCs, where the foreign direct investment inflows averaged $154 billion, positive numbers indicating an inflow. The difference between the industrial country outflow and the developing country inflow was primarily due to foreign direct investment in the United States, which averaged $36 billion; that is, investors in LDCs were making substantial investments in the United States, much of it reflecting capital flight from insecure financial markets in LDCs to the greater security of PROPERTY RIGHTS in industrial countries. Because financial claims may be short term or long term, real or financial, the key to development is to raise long-term investments as a percentage of capital inflows into LDCs.10Foreign direct investmentdistinguished from portfolio investment by the investors substantial ownership share (>10 percent)implies a greater commitment to a long-term interest in the investment project and an active interest in managing the project. While the United States has been, along with developing countries, the major recipient of direct investment inflows, it is also a major supplier of foreign direct investment. As Table 1 shows, flows of net investment from industrial countries to LDCs were substantial and were a major impulse to their growth; however, much of industrial and developing country investment was funneled to the United States. Of these capital flows from LDCs to the United States, a substantial share has been purchases of U.S. government debt taken up by LDCs as reserve assets; LDCs central banks buy and hold a great amount of U.S. debt as international reserves to back their domestic currencies. Purchases of such reserve assets, primarily shortterm U.S. Treasury bills, amounted to more than $1 trillion during 19972003, with $340 billion in 2003 alone. The non-U.S. industrial countriesparticularly France, JAPAN, the Netherlands, Switzerland, and the United Kingdomhave been the primary net investors; these five countries supplied the largest part of direct investment during the period 1995 2003, equivalent to 76 percent of the annual net direct investment of all LDCs over this period.11 The distribution of this net foreign direct investment (inflows) was not uniform across LDCs. Almost half of total net direct investment in developing

countries was invested in three LDCs: China with 26 percent, Brazil with 13 percent, and Mexico with 8 percent. At the other end of the spectrum, the countries of sub-Saharan Africa accounted, in total, for only 5 percent of total direct investment in LDCs.