International Finance & Forex Management 1

PAN African e-Network Project
MFC
International Finance & Forex Management
Semester - 3
Session – 1
Mr. Navneet Saxena

Objective
• In this session we will learn about:
– Module I: International Financial
Environment
– Finance function in global business scenario,
– International Monetary System,
– International Financial Markets and
Instruments,
– Balance of Payments,
– Recent Developments.
Finance function in global business
scenario
• Historically, the finance functions in large
U.S. and European firms have focused on
cost control, operating budgets, and
internal auditing.
• But as corporations go global, a world of
finance opens up within them, presenting
new opportunities and challenges for
CFOs.
scenario
• Rather than simply make aggregate capital-
structure and dividend decisions, for example,
they also have to wrestle with the capital structure
and profit repatriation policies of their companies’
subsidiaries.
• Capital budgeting decisions and valuation must
reflect not only divisional differences but also the
complications introduced by currency, tax, and
country risks.
• Incentive systems need to measure and reward
managers operating in various economic and
financial settings.
scenario
• The Globally Competent Finance Function
• As companies globalize, they face new
financial challenges.
• The first set of questions summarizes the
work of the traditional finance function with
respect to external providers of capital.
• Because a global firm is itself a capital
market, the finance function must consider a
second set of questions, which addresses the
internal capital market, in addition to the first.
scenario
• Traditional questions for the local finance
function:
• How should we finance ourselves?
• How should we return cash to shareholders?
• How should we analyze investment
opportunities?
• How should we communicate information to
shareholders and lenders?
• How should our ownership structure influence
operations?
scenario
• New questions for the global finance function:
• How should we finance our subsidiaries?
• How should we get money out of our
subsidiaries?
• How should we analyze the same investment
opportunities in different countries?
• How should we communicate financial
information inside the firm?
• How should we decide what to own and with
whom?
scenario
• The existence of what amounts to internal markets
for capital gives global corporations a powerful
mechanism for arbitrage across national financial
markets.
• But in managing their internal markets to create a
competitive advantage, finance executives must
delicately balance the financial opportunities they
offer with the strategic opportunities and
challenges presented by operating in multiple
institutional environments, each of which has it
own legal regime and political risks.
scenario
• There is also a critical managerial
component:
• What looks like savvy financial management
can ruin individual and organizational
motivation.
• Some of the financial opportunities available
to global firms are affected by institutional
and managerial forces in three critical
functions: financing, risk management, and
capital budgeting.
scenario
• Financing in the Internal Capital Market
• Institutional differences across a company’s
operations allow plenty of scope for creating
value through wise financing decisions.
• Because interest is typically deductible, a
CFO can significantly reduce a group’s
overall tax bill by borrowing disproportionately
in countries with high tax rates and lending
the excess cash to operations in countries
with lower rates.
scenario
• CFOs can also exploit tax differences by
carefully timing and sizing the flows of profits
from subsidiaries to the parent.
• However, tax is not the only relevant variable:
• Disparities in creditors’ rights around the
world result in differences in borrowing costs.
• As a consequence, many global firms borrow
in certain foreign jurisdictions or at home and
then lend to their subsidiaries.
scenario
• Multinational firms can also exploit their
internal capital markets in order to gain a
competitive advantage in countries when
financing for local firms becomes very
expensive.
• When the Far East experienced a currency
crisis in the 1990s, for example, and
companies in the region were struggling to
raise capital, a number of U.S. and European
multinationals decided to increase financing
to their local subsidiaries.
scenario
• This move allowed them to win both market share
and political capital with local governments, who
interpreted the increased financing as a gesture of
solidarity.
• But the global CFO needs to be aware of the
downside of getting strategic about financing in
these ways.
• Saddling the managers of subsidiaries with debt
can cloud their profit performance, affecting how
they are perceived within the larger organization
and thereby limiting their professional
opportunities.
scenario
• Similar considerations should temper
companies’ policies about the repatriation of
profits.
• For U.S. companies, tax incentives dictate
lumpy and irregular profit transfers to the
parent.
• But many firms choose to maintain smooth
flows of profits from subsidiaries to the parent
because the requirement to disgorge cash
makes it harder for managers to inflate their
performance through fancy accounting.
scenario
• Finally, letting managers rely too much on
easy financing from home saps their
autonomy and spirit of enterprise, which is
why many firms require subsidiaries to
borrow locally, often at disadvantageous
rates.
• Managing Risk Globally
• The existence of an internal capital market
also broadens a firm’s risk-management
options.
scenario
• For example, instead of managing all
currency exposures through the financial
market, global firms can offset natural
currency exposures through their worldwide
operations.
• Let’s say a European subsidiary purchases
local components and sells a finished product
to the Japanese market.
• Such operations create a long position in the
yen or a short position in the euro.
scenario
• That is, those operations will become
stronger if the yen appreciates and weaker
if the euro appreciates.
• This exposure could be managed, in part,
by offsetting exposures elsewhere in the
group or by having the parent borrow in
yen so that movements in the yen asset
would be cancelled by movements in the
yen liability.
scenario
• Given this potential for minimizing risk, it might
seem perverse that many multinationals let local
subsidiaries and regions manage their risks
separately. General Motors is a case in point.
• Even though its treasury function is widely
regarded as one of the strongest pools of talent
within the company—and one of the best
corporate treasury functions worldwide—GM’s
hedging policy requires each geographic region to
hedge its exposures independently, thereby
vitiating the benefits of a strong, centralized
treasury.
scenario
• Why duplicate so many hedging decisions?
• Because forcing a business’s hedging
decisions to correspond to its geographic
footprint gives GM more-accurate
measurements of the performance of the
individual business unit and of the managers
running it.
• In a related vein, companies often limit—in
arbitrary and puzzling ways—their
considerable expertise in managing currency
exposures.
scenario
• Many firms require finance managers to
follow “passive” policies, which they apply in
a rote manner.
• For example, GM actively measures various
exposures but then requires 50% of them to
be hedged with a prescribed ratio of futures
and options.
• Firms adhere to these passive strategies
because they limit the degree to which
financial managers can undertake positions
for accounting or speculative reasons.
International Monetary System
• The rules and procedures for exchanging national

currencies are collectively known as the
international monetary system.
• This system doesn't have a physical presence, like
the Federal Reserve System, nor is it as codified
as the Social Security system.
• Instead, it consists of interlocking rules and
procedures and is subject to the foreign exchange
market, and therefore to the judgments of currency
traders about a currency.
• Yet there are rules and procedures—

exchange rate policies—which public
finance officials of various nations have
developed and from time to time modify.
• There are also physical institutions that
oversee the international monetary
system, the most important of these being
the International Monetary Fund.
• Exchange Rate Policies

• In July 1944, representatives from 45 nations
met in Bretton Woods, New Hampshire to
discuss the recovery of Europe from World
War II and to resolve international trade and
monetary issues.
• The resulting Bretton Woods Agreement
established the International Bank for
Reconstruction and Development (the World
Bank) to provide long-term loans to assist
Europe's recovery.
• It also established the International Monetary Fund

(IMF) to manage the international monetary
system of fixed exchange rates, which was also
developed at the conference.
• The new monetary system established more
stable exchange rates than those of the 1930s, a
decade characterized by restrictive trade policies.
• Under the Bretton Woods Agreement, IMF
member nations agreed to a system of exchange
rates that pegged the value of the dollar to the
price of gold and pegged other currencies to the
dollar.
• This system remained in place until 1972.

• In 1972, the Bretton Woods system of
pegged exchange rates broke down forever
and was replaced by the system of managed
floating exchange rates that we have today.
• The Bretton Woods system broke down
because the dynamics of supply, demand,
and prices in a nation affect the true value of
its currency, regardless of fixed rate schemes
or pegging policies.
• When those dynamics are not reflected in the

foreign exchange value of the currency, the
currency becomes overvalued or
undervalued in terms of other currencies.
• Its price—fixed or otherwise—becomes too
high or too low, given the economic
fundamentals of the nation and the dynamics
of supply, demand, and prices.
• When this occurs, the flows of international
trade and payments are distorted.
• In the 1960s, rising costs in the United States

made U.S. exports uncompetitive.
• At the same time, western Europe and Japan
emerged from the wreckage of World War II to
become productive economies that could compete
with the United States.
• As a result, the U.S. dollar became overvalued
under the fixed exchange rate system.
• This caused a drain on the U.S. gold supply,
because foreigners preferred to hold gold rather
than overvalued dollars.
• By 1970, U.S. gold reserves decreased to

about $10 billion, a drop of more than 50
percent from the peak of $24 billion in 1949.
• In 1971, the U.S. decided to let the dollar
float against other currencies so it could find
its proper value and imbalances in trade and
international funds flows could be corrected.
• This indeed occurred and evolved into the
managed float system of today.
• A nation manages the value of its currency

by buying or selling it on the foreign
exchange market.
• If a nation's central bank buys its currency,
the supply of that currency decreases and
the supply of other currencies increases
relative to it.
• This increases the value of its currency.
• On the other hand, if a nation's central

bank sells its currency, the supply of that
currency on the market increases, and the
supply of other currencies decreases
relative to it.
• This decreases the value of its currency.
• The International Monetary Fund plays a
key role in operations that help a nation
manage the value of its currency.
• The International Monetary Fund

• The International Monetary Fund
(www.imf.org) is like a central bank for the
world's central banks.
• It is headquartered in Washington, D.C., has
184 member nations, and cooperates closely
with the World Bank, which we discuss in The
Global Market and Developing Nations.
• The IMF has a board of governors consisting
of one representative from each member
nation.
• The board of governors elects a 20-member

executive board to conduct regular
operations.
• The goals of the IMF are to promote world
trade, stable exchange rates, and orderly
correction of balance of payments problems.
• One important part of this is preventing
situations in which a nation devalues its
currency purely to promote its exports.
• That kind of devaluation is often considered

unfairly competitive if underlying issues, such
as poor fiscal and monetary policies, are not
addressed by the nation.
• Member nations maintain funds in the form of
currency reserve units called Special Drawing
Rights (SDRs) on deposit with the IMF.
• This is a bit like the federal funds that U.S.
commercial banks keep on deposit with the
Federal Reserve.
• From 1974 to 1980, the value of SDRs was based

on the currencies of 16 leading trading nations.
Since 1980, it has been based on the currencies
of the five largest exporting nations.
• From 1990 to 2000, these were the United States,
Japan, Great Britain, Germany, and France.
• The value of SDRs is reassigned every five years.
• SDRs are held in the accounts of IMF nations in
proportion to their contribution to the fund.
• The United States is the largest contributor,
accounting for about 25 percent of the fund.
• Participating nations agree to accept SDRs in

exchange for reserve currencies—that is,
foreign exchange currencies—in settling
international accounts.
• All IMF accounting is done in SDRs, and
commercial banks accept SDR-denominated
deposits.
• By using SDRs as the unit of value, the IMF
simplifies its own and its member nations'
payment and accounting procedures.
• In addition to maintaining the system of SDRs

and promoting international liquidity, the IMF
monitors worldwide economic developments,
and provides policy advice, loans, and
technical assistance in situations like the
following:
• After the collapse of the Soviet Union, the
IMF helped Russia, the Baltic states, and
other former Soviet countries set up treasury
systems to assist them in moving from
planned to market-based economies.
• During the Asian financial crisis of 1997 and

1998, the IMF helped Korea to bolster its
reserves.
• The IMF pledged $21 billion to help Korea
reform its economy, restructure its financial
and corporate sectors, and recover from
recession.
• In 2000, the IMF Executive Board urged the
Japanese government to stimulate growth by
keeping interest rates low, encouraging bank
restructuring, and promoting deregulation.
• In October 2000, the IMF approved a $52 million

loan for Kenya to help it deal with severe drought.
• This was part of a three-year $193 million loan
under an IMF lending program for low-income
nations.
• Most economists judge the current international
monetary system a success.
• It permits market forces and national economic
performance to determine the value of foreign
currencies, yet enables nations to maintain orderly
foreign exchange markets by cooperating through
the IMF.
• The EU and the Euro

• The biggest news on the foreign currency
front over the past few years is the adoption
of the euro by the European Union (EU).
• Twelve member states of the EU use the
euro instead of their old local currencies:
Austria, Belgium, Finland, France, Germany,
Greece, Ireland, Italy, Luxembourg,
Netherlands, Portugal, and Spain.
• Nations that adopt the euro participate in a single

EU monetary policy and are subject to fiscal
guidelines requiring them to keep deficits to a
certain level and to balance their federal budgets
by 2006.
• Although it will reconsider the matter again, Britain
has refused to adopt the euro and has stuck with
the pound sterling.
• This reflects England's traditional sense of
“apartness” from continental Europe and its
reluctance to give up sovereignty over its
economic policies.
International Financial Markets
The International Financial Market is the

place where financial wealth is traded
between individuals (and between
countries).
It can be seen as a wide set of rules and
institutions where assets are traded
between agents in surplus and agents in
deficit and where institutions lay down the
rules.
The financial market comprises the markets

strictu sensu (stock market, bond market,
currency market, derivatives market, commodity
market and money market), the institutions
which work in them with different aims and
functions, as well as direct/indirect policies
orientated to making the market the place (not
necessarily a physical place and not necessarily
ruled but regulated) where the exchange
between surplus and deficit units is carried out
as efficiently as possible.
With regard to policies, consideration must be

given to those connected with monetary, fiscal
and more structural policies, as well as those
directly connected with the governance of the
market itself.
Governance in the financial market can be
defined as a set of rules useful in
interconnecting the agents who operate within it
and the institutions.
These rules define the market.
Governance rules in a financial market can be

defined at both a microeconomic and
macroeconomic level.
Microeconomic rules deal not only with
individuals (single money savers, professional
agents, and companies) but also with the
market itself and its microstructure.
Macroeconomic governance rules deal with the
market as a whole, but they are also strictly
connected with policies regulating the market.
At a macroeconomic level, governance is

important for the financial market in order to
define every single rule of the trading process:
from those which regulate the stock exchange
or the Over The Counter (OTC) trades to those
which define who can join the market.
Moreover, great importance is given to the
market microstructure, where microstructure is
understood as the set of rules that makes and
defines the asset exchange price.
This is a main point in allowing the market

to function properly. The
liquidity/thickness/depth of the market
depends on the price formation rules
according to which the asset is traded off. At
a microeconomic level, the steps to trade
assets on the financial market are: listing,
trading, and post-trading. The latter
comprises clearing, settlement, and custody.
From the market insiders’ point of view,

each of these steps needs to be defined in
order to conclude the exchange at a time
and price previously defined. Each step has
its own rules that allow those who operate in
the financial market to establish their own
strategy with respect to their specific
expectations. The traded asset returns are
linked to the definition of these rules.
Each market has its own rules that deal with

the microstructure. Different markets have
different liquidity and this depends on the micro-
rules that they themselves have established.
These rules are relevant both for (official)
exchange trading and for the OTC trading.
Another class of microeconomic governance
rules are those which state, for instance, who
can operate in the market and how.
Microeconomic rules also concern the

manner in which the institutions themselves
operate in the market .
Macroeconomic rules of the financial market
have a different task and are linked to the
broad-spectrum policies of the market.
These can indicate the required market
institution, the market structure and
furthermore its aims and its own monetary
and fiscal policies.
All these characteristics make the market

unique with respect to the economy in which
it works. One of the features of this
uniqueness is market transparency. This
characteristic is defined on the basis of
(governance) rules, institutions, agents, and
polices connected to it. The more people
know how to complete the trading asset
process, the more a market is transparent.
In this manner, expectations become

heterogeneous for individuals/agents and, at
the same time, they reflect the information at
hand, which is then elaborated depending on
the different sell/buy strategies.
This leads to the definition of expectations.
Defining the role of expectations in a financial
market has a two-fold purpose. The first is
defined at a macroeconomic level.
Expectations are defined with respect to

the policies and rules to be adopted in the
market.
This leads to defining the sell/buy
strategies on the basis of the role that, for
instance, inflation will have in the
subsequent period t+1 given the
policies/rules defined in t.
This kind of expectation may vary

depending on the discretion that exists in
defining the rules, not only at a
macroeconomic level but also at a
microeconomic one. The second objective
is microeconomic. Agents formulate their
expectations to predict asset price
variations in order to determine the asset
returns.
This point leads back to the liquidity

concept previously introduced. The
different level of liquidity in the trading
process determines a different formulation
of expectations. In the same way, the
diverse discretion utilised in setting
macro-economic rules determines a
different formulation of the expected
inflation.
Macroeconomic rules, as previously defined,

are connected to different monetary and
fiscal policies. The financial market is
subjected to policies that depend mostly on
the regulating institutions. At the same time,
institutions are responsible for defining rules
and for enforcing the application of these
rules in the market. The institutions
determine the rules that in turn define their
field of action.
Individuals who operate in one market have to

follow these rules but, at the same time, their
decision is based on the rules that a given
market has set itself. Transparency, liquidity,
and expectations help individuals to choose the
market in order to maximise their own utility.
The financial market examined in this manner is
an extremely complex system in which rules,
individuals and institutions interact.
This complexity increases even more in time

and space (in the case of international financial
markets). In time, financial markets cover an
increasingly important role in the financial
saving mediation of agents at an international
as well as at a national level. In space, agents
have instruments at their disposal that have
become increasingly more complicated and
specific.
These instruments are utilised through the

markets of reference (stock market, bond
market, currency market, derivatives
market, commodities market, money
market) that are a fundamental part of the
financial market. Each market has its own
characteristics that in turn define the
contexts in which agents operate on the
basis of the risk associated to them.
International capital flows surged after the

oil shock of 1973–74, which spurred
financial intermediation on a global scale.
Surpluses in the oil-exporting countries
and corresponding deficits among oil
importers led to a recycling of
“petrodollars” in the growing Euromarkets.
Many developing countries gained new access

to international capital markets, where they
financed mounting external imbalances. Most of
this intermediation occurred in the form of bank
lending, and large banks in the industrial
countries accepted huge exposures to
developing country debt. The debt crisis of the
1980s led to a significant slowdown in capital
flows to emerging markets.
International Financial Instruments
• Classification of financial instruments and

identification of their nature is one of the
most important phases for compilation and
presentation of monetary statistics.
• Like other classifications used in monetary
statistics, it is also advisable here to follow
international standards that would help to
make statistics comparable across
countries’ and ensure its unity.
• In carrying out classification, there will be a need

to consider features of a country’s banking and
financial system paying a due regard to their
development prospects.
• Financial instruments are financial contracts of
different nature made between institutional units.
• These comprise the full range of financial claims
and liabilities between institutional units,
including contingent liabilities like guarantees,
commitments, etc.
• Financial asset is defined as any contract

from which a financial claim may derive for
one party and a financial liability or
participation in equity for another.
• Financial instrument can exist only
between two institutional units.
• Where financial instruments are

compounded, i.e. represent a set of
several instruments, for compilation of
statistics there will be a need to distinguish
them into separate instruments so that
each of them includes only a single pair of
institutional units.
• Financial assets are contracts that do not

contain contingency, i.e., irrespective of
any conditions, generate financial claims
having demonstrable value over which
ownership rights are enforced, individually
or collectively, and from which economic
benefits can be derived by using or
holding them.
• The concept of financial instrument is wider

than the concept of financial asset as defined
in the System of National Accounts, 1993.
• Thus, financial instruments are classified into
financial assets and other financial
instruments.
• Classification of financial assets is based on
their two principal characteristics, liquidity
and legal characteristics.
• Monetary Gold and SDRs

• Monetary gold and SDRs, issued by the
IMF, are the only financial assets for which
there are no corresponding financial
liabilities.
• Monetary gold - Monetary gold consists
only of standard bullions of gold held by
the central bank or government as part of
official reserves.
• Monetary gold, therefore, can be a financial

asset only for the central bank or
government.
• Transactions with monetary gold are
operations on purchase and sale of gold by
authorities implementing monetary policy.
• These transactions are carried out between
the central banks only or between the central
banks and international financial
organizations.
• For commercial banks, standard bullions

of gold are not treated as monetary gold.
• Gold denominated deposits are treated as
financial assets and classified as “gold”.
• Assets denominated in gold, which are not
treated as part of official reserves, are
classified as nonfinancial assets.
• Gold and gold denominated deposits held

by nonfinancial units and financial
corporations (other than the central bank)
are treated as nonmonetary gold.
• Operations on gold carried out by other
sectors of economy are treated as
operations on acquisition of values and
disposal, and it is treated as nonfinancial
asset.
• SDRs –
• SDRs are international reserve assets
created by the IMF and allocated to
member countries to supplement existing
official reserves.
• SDRs are not treated as the IMF’s liability.
• SDRs are held only by the IMF member
countries and by a limited number of
international financial organizations.
• SDR holdings are held exclusively by official

authorities, which are normally the central
banks.
• Transactions in SDRs between the IMF
members or between the IMF and its members
are treated as financial transactions.
• SDR holdings represent unconditional rights to
holders to obtain foreign exchange or other
reserve assets from other IMF members.
• Currency and Deposits

• Currency and deposits are the most liquid
financial assets consisting of notes and
coins in circulation, all types of deposits in
national currency and foreign currency.
• Currency - Currency represents notes and
coins in circulation, which are of fixed
nominal values and have no dates of
repayment.
• Issued notes and coins are considered

liabilities of the central bank.
• Generally, currency is used for making
payments.
• For statistical purposes, it is always
necessary to distinguish between notes
and coins issued by resident and non-
resident central banks, i. e. separate
national currency from foreign currency.
• If national currency is the country’s (the central

bank’s) liability, foreign currency is other
countries’ liability.
• All sectors of economy and nonresidents can
hold as an asset, but only monetary authorities
or central banks are authorized to issue it.
• In many countries, only national currency is
included in monetary aggregates, as only the
national currency can be used directly for (local)
transactions between residents.
• In some countries, however, foreign

currency circulates along with national
currency, and hence it is important in the
view of monetary policy to consider foreign
currency in circulation.
• Some countries issue gold and other
precious metal-made coins, which
theoretically can be used as a means of
payment.
• Normally, such coins are held for

numismatic value.
• If not in active circulation, such coins
should be classified as nonfinancial
assets.
• Deposits - Deposits include all claims on
the central bank and other depository
corporations, represented as bank
deposits.
• In some cases, other financial

corporations may also accept deposits.
• Deposits of depository corporations can
fall into two categories: transferable
deposits and other deposits
(nontransferable deposits).
• Normally, separate sub-categories are
used for deposits denominated in national
currency and for those in foreign currency.
• Transferable deposits - Transferable

deposits are deposits (in national and
foreign currency) that are i) subject to
payment on demand at par and without
penalty or restriction, ii) directly usable for
making payments by payment orders,
checks, cards or other payment facilities,
or otherwise usable as a means of
payment or circulation.
• Transferable deposits comprise

transferable deposits with resident and
nonresident financial corporations.
• This category comprises also deposits that
allow direct cash withdrawals but not direct
transfers to third parties.
• All sectors of economy and nonresidents
(the rest of the world) can open and
operate transferable deposit accounts.
Balance of Payments
• Maintaining a balance of payments with the rest

of the world is a macro-
• economic objective. In simple terms, if the
balance of payments balances,
• then the combined receipts from selling goods
and services abroad, and
• from the return on investments abroad, equals
the combined expenditure on
• imports of goods and services, and investment
income going abroad.
Balance of Payments
• As an official record, the balance of

payments is broken down into two basic
accounts - the current account, and the
capital and financial account.
• The current account
• The current account is made up of the
following payments:
• Trade in goods
Balance of Payments
• These items include the import and export

of finished goods, such as cars, and
computers; semi-finished goods, such as
parts and components for assembly, and
commodities, such as oil, tea and coffee.
• Trade in services
• Trade services include financial services,
tourism, and consultancy.
• Income from investment and employment
Balance of Payments
• Investment income refers to any income

made from investing abroad, and includes
profits, such as those from business
activities of subsidiaries located abroad;
interest received from UK financial
investments and loans abroad, and
dividends from owning shares in overseas
firms.
Balance of Payments
• Payments to individuals who are residents of a

country, and are employed in another, are also
included in the current account. Investment and
employment income are also known as 'primary
income'.
• Transfers
• The final section of the current account includes
transfer payments (transfers) arising from gifts
between residents of different countries,
donations to charities abroad, and overseas aid.
Balance of Payments
• Transfers are also known as 'secondary'

income.
• Any deficit on the Current Account will be
balanced by actions on the Financial and
Capital Accounts.
• The Capital and Financial Account
• The Capital and Financial Account records
the flows of capital and finance between
the UK and the rest of the world.
Balance of Payments
• Types of flow include:

• Real foreign direct investment (FDI), such
as a UK firm establishing a manufacturing
facility in China.
• Direct investment refers to investment in
an enterprise where the owners or
shareholders have some element of
control of the business.
Balance of Payments
• Portfolio investment, such as a UK investor

buying shares in an existing business abroad.
• With portfolio investment, the investor has no
control over the enterprise.
• Financial derivatives are any financial
instrument whose underlying value is based
on another asset, such as a foreign currency,
interest rates, commodities or indices.
Balance of Payments
• Reserve assets are foreign financial

assets that are controlled by monetary
authorities - namely the Bank of England.
• These assets are used to finance deficits
and deal with imbalances.
• Reserve assets include gold, Special
Drawing Rights, and foreign exchange
held by the Bank of England.
Balance of Payments
• This process is often called official financing.

• Net errors and omissions
• In theory, the Capital and Financial Account
balance should be equal and ‘opposite’ to the
Current Account balance so that the overall
Account balances, but in practice this is only
achieved by the use of a balancing item
called net errors and omissions.
Balance of Payments
• This device compensates for various

errors and omissions in the balance of
payments data, and which brings the final
balance of payments account to zero.
• Financing deficits and surpluses
• The financing of a deficit is achieved by:
• Selling gold or holdings of foreign
exchange, such as US dollars, yen or
euros, or:
Balance of Payments
• Borrowing from other Central Banks or the

International Monetary Fund (IMF).
• A surplus will be disposed of by:
• Buying gold or currencies.
• Paying off debts.
• Is a current account deficit a problem?
• A deficit can be a problem if:
• It is persistent.
Balance of Payments
• It forms a large share of GDP.

• There are no compensating inflows of
investment income or inward capital
account flows.
• The Central Bank has low reserves.
• The economy has a poor record of
repaying debt.
Balance of Payments
• Economic growth and trade

• In the UK, there is a strong connection
between a growing economy and trade
deficits. Soon after the economy went into
recession in 1990, the trade deficit began to
fall quickly. However, as the economy came
out of recession and into a period of strong
growth from 1993, the trade deficit began to
rise quickly, and continued to rise through the
next 15 years.
Balance of Payments
• It is likely that the recession that started in

late 2008 will cause the deficit to fall back,
as indeed the above table indicates.
• Causes of a current account deficit
• There are several possible causes of a
persistent current account deficit, including
the following:
Balance of Payments
• Excessive growth
• If the economy grows too quickly, and rises
above its own trend rate, which in the UK is
around 2.5%, then domestic output (AS) may
not be able to cope with domestic aggregate
demand.
• High export prices - High export prices will occur
if a country's inflation is higher than that of its
competitors, or if its currency is over-valued
which will reduce its price competitiveness.
Balance of Payments
• Non-price factors
• Non-price factors can discourage exports,
such as poorly designed products, poor
marketing or a worsening reputation for
reliability.
• Poor productivity
• An economy might not be producing
enough from its scarce factors of
production.
Balance of Payments
• Labour productivity, which is defined as

output per worker, plays an important role
in a country’s competitiveness and trade
performance, and the UK has suffered
from poor productivity.
• The productivity gap is the gap between
the UK’s relatively poor productivity
performance and that of the UK’s leading
competitors.
Balance of Payments
• Low levels of investment in real capital

• This could be caused by excessive long-term
interest rates, or low levels of research and
development.
• Low levels of investment in human capital
• This involves a lack of investment in
education and training, which reduce skill
levels relative to competitor countries and
force countries to produce low value exports.
Balance of Payments
• The full employment of labour has been a

key economic objective ever since the
mass unemployment experienced in the
1930s. Clearly, it is not possible to give a
simple numerical definition of full
employment, other than to say the
unemployment rate should be as low as is
achievable, and the employment rate as
high as is achievable.
Recap
• In this session we learnt about:
– Module I: International Financial
Environment
– Finance function in global business scenario,
– International Monetary System,
– International Financial Markets and
Instruments,
– Balance of Payments,
– Recent Developments.
Please forward your query
To: nsaxena1@amity.edu

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PAN African e-Network Project

Mr. Navneet Saxena

• The rules and procedures for exchanging national

• Yet there are rules and procedures—

• Exchange Rate Policies

• It also established the International Monetary Fund

• This system remained in place until 1972.

• When those dynamics are not reflected in the

• In the 1960s, rising costs in the United States

• By 1970, U.S. gold reserves decreased to

• A nation manages the value of its currency

• On the other hand, if a nation's central

• The International Monetary Fund

• The board of governors elects a 20-member

• That kind of devaluation is often considered

• From 1974 to 1980, the value of SDRs was based

• Participating nations agree to accept SDRs in

• In addition to maintaining the system of SDRs

• During the Asian financial crisis of 1997 and

• In October 2000, the IMF approved a $52 million

• The EU and the Euro

• Nations that adopt the euro participate in a single

The International Financial Market is the

The financial market comprises the markets

With regard to policies, consideration must be

Governance rules in a financial market can be

At a macroeconomic level, governance is

This is a main point in allowing the market

From the market insiders’ point of view,

Each market has its own rules that deal with

Microeconomic rules also concern the

All these characteristics make the market

In this manner, expectations become

Expectations are defined with respect to

This kind of expectation may vary

This point leads back to the liquidity

Macroeconomic rules, as previously defined,

Individuals who operate in one market have to

This complexity increases even more in time

These instruments are utilised through the

International capital flows surged after the

Many developing countries gained new access

• Classification of financial instruments and

• In carrying out classification, there will be a need

• Financial asset is defined as any contract

• Where financial instruments are

• Financial assets are contracts that do not

• The concept of financial instrument is wider

• Monetary Gold and SDRs

• Monetary gold, therefore, can be a financial

• For commercial banks, standard bullions

• Gold and gold denominated deposits held

• SDR holdings are held exclusively by official

• Currency and Deposits

• Issued notes and coins are considered

• If national currency is the country’s (the central

• In some countries, however, foreign

• Normally, such coins are held for

• In some cases, other financial

• Transferable deposits - Transferable

• Transferable deposits comprise

• Maintaining a balance of payments with the rest

• As an official record, the balance of

International Finance & Forex Management 1

International Finance & Forex Management 1