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International Finance summaryLecture 1: Introduction to International Finance
Why international finance?
Why finance?
o Finance is of critical importance to any business
Comparing profitability of investment opportunities
Choosing ways of financing operations
Deciding on dividend policy and working capital management
Why international finance?
o For management in international context standard/domestic finance is not sufficient
Key aspects of international finance
Opportunity: Broader set of business opportunities
o Key reason for managers to pursue business internationally
Examples:
Access to a larger pool of resources
More efficient production abroad
Higher economies of scale
Raising capital at a lower cost
Challenge: Foreign exchange risk
o Most currencies have a flexible exchange rate regime of which the value fluctuates
freely
o These changes are difficult to predict large source of risk for a business
Examples:
Brexit and pound value
Rising value of CHF in 2010
2007-8 financial crisis and PLN (Polish currency) and HUF
(Hungarian currency) drop
Challenge: Political risk
o Sovereign countries decide on the rules of doing business which has major
consequences for firms
o This risk is especially large when there is a weak rule of law and political instability
in a specific country.
o Examples:
Sudden changes in taxes
Policies that limit certain investments
Laws that allow expropriation of foreign investors
o Recent case: Keystone Pipeline
Project run by Canadian firm TC Energy
Heavily criticized for environmental impact
Delayed by Obama, permitted by Trump, now permit revoked by Biden
Challenge: Market imperfections
o Frictions limit free flow of people, goods, services and capital.
Examples:
Legal restrictions
Transaction costs
Transportation costs
Discriminatory taxes
, Information asymmetries: local people might know better than
foreigners. Domestic people hold them into power. Politicians care
about them and may want to protect labour and restrict immigration.
o Recent problem: exploding cost of transportation from Asia to Europe
Free trade: historical views
Prior to the 19th century there was Mercantilism
o Trade was viewed as a zero-sum game: the net change in wealth is always equal to 0.
So when one party wins, another one loses.
o For maximum gains: you had to minimize imports and maximize exports
o Motivation for colonial conquest to obtain important resources
In the 19th century there were 2 influential economists: Smith and Ricardo
o They argued that trade is beneficial to both countries involved
o Smith: due to absolute advantage
Italy produces wine more efficiently then Belgium
o Ricardo: due to comparative advantage
Comparative advantage is an economy's ability to produce a particular good
or service at a lower opportunity cost than its trading partners.
Italy produces wine more efficiently than beer
Belgium produces beer more efficiently than wine
So Italy might be more expensive in both beer and wine production, but wine
is relatively cheap (specialize in the least worst thing).
Consensus among economists in the 20th century: trade benefits everyone
Global trade liberalization
General Agreement on Tariffs and Trade (GATT)
o Multilateral agreement to reduce barriers to trade (tariffs, quotas, subsidies, etc.)
o Achieved reductions in barriers and helped stimulate trade agreements
o Founded in 1947, in 1995 it was replaced by the World Trade organization
World Trade Organization (WTO)
o Multinational organization that regulates international trade
o Provides framework for trade negotiations
o Enables dispute resolution by independent judges
o Progress stalled, big obstacle: agricultural subsidies in developed nations
Regional trade liberalization
European Union
o No barriers to the flow of goods, capital and people
North American Free Trade Agreement/ US-Mexico-Canada Agreement:
o Phasing out of trade barriers (NAFTA)
o Adding regulations for environment, labour, intellectual property rights (USMCA)
Trans-Pacific Partnership:
o Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru,
Singapore and Vietnam
o Lower tariffs and facilitate trade
African Continental Free Trade Agreement:
o 49 African countries
o Stimulate intra-African trade and investment, lower barriers to migration
There is a reversal in trade today, especially because of the period that Trump was in power. The
trend of exports rising is not going up anymore.
The dark side of free trade
, Economists in the 20th century focused almost exclusively on the aggregate benefits of trade.
But free trade does not benefit everyone in society.
o Low educated people are often suffering as these jobs are taken by immigrants that
can move freely because of more free trade or because these sectors do not survive
the higher competition because of free trade.
o In general, when imports go up, unemployment goes up as well
o In 1999-2009, China joined the WTO (2001)
o House prices in Bulgaria went up to levels in Western European countries. As the
income tax in Bulgaria is only 10%, there is no intend to compensate the losers.
For gains to be felt by everyone, they need to be redistributed (e.g., taxes, education)
Without that, globalization can exacerbate inequality
Political consequences
Distributional effects of free trade may lead to shifts in political preferences:
o In UK areas that experience higher inflow of Eastern European immigrants, they
tended to vote for UKIP (The UK Independence Party is a Eurosceptic, right-wing
populist political party in the United Kingdom) and were more likely to support
Brexit.
o Import shocks from China can be linked to a shift to the right in media-viewing habits
and political beliefs, greater polarization, etc. and more authoritarian values.
Authoritarianism is a political system characterized by the rejection of
political plurality, the use of strong central power to preserve the political
status quo, and reductions in the rule of law, separation of powers, and
democratic voting.
COVID and trade
For most countries, exports were not that affected because of COVID. COVID was not really a big
shock for international trade.
International monetary system
Institutional framework within which:
o International payments are made
o Movements of capital are accommodated
o Exchange rates among currencies are determined
Evolution of international monetary system
It went through several stages of evolution:
o Bimetallism: before 1875
Both gold and silver are used as international means of payment
, Some countries used both gold and silver, others used just one of the two
Exchange rate determined by content of one of the metals in the respective
coins
o Classical gold standard: 1875-1914
International payments using gold
Local currency: gold or a currency convertible to gold at a stable rate, in
latter case need gold reserved to back the currency
Exchange rate between currencies determined by each currencies rate to gold
Benefits: holds inflation in check, no trade deficits or surpluses
Costs: may limit growth and lead to deflation, is not credible
Arbitrage:
1 pound is worth 10 ounces of gold, 1 dollar is worth 15 ounces of
gold
The exchange rate should be 10/15 = 0.67 dollars for 1 pound
What if the prevailing exchange rate is 0.5?
We can buy pounds with dollars more cheaply then with gold.
o To get 100 pounds with gold it costs 100*10 = 1000 ounces
of gold
o To get 100 pounds with dollars it costs 50 dollars = 750
ounces of gold
We want to buy pounds with dollars, want to sell pounds for gold.
None wants to sell at current exchange rate exchange rate
increases to 0.67.
Trade imbalances are self correcting: high net imports outflow of
gold value of currency increases price level drops more
exports as local products are cheaper lower net imports
o Interwar period: 1915-1944
War let go of gold standard to produce more money to finance the war
Afterwards attempts to reinstate the gold standard but there was no
commitment so it didn’t work.
o Bretton Woods system: 1945-1972
In 1944, 44 nations set up International Monetary Fund (and World Bank)
Rules of conduct in international monetary policy and enforcement of rules
Goal: exchange rate stability without gold standard
How did it work?
Countries peg (=fix) the currency to dollar, which in turn is pegged to
gold
If large difference of real value of currency from the peg, country
may change peg
All countries kept reserves of gold as well as dollars or other
currencies.
Benefits:
Easier to transport/ transact than gold, can earn interest on bonds!
Stability of inflation + large reserves conducive to growth
Problems:
Growing need for reserves due to economic growth US cannot
hold enough gold for all the dollars that are abroad intervention
needed in 1960 SDR was created
Special Drawing Rights = artificial currency composed of a basket of
real currencies.
Ultimately collapsed due to the dollar devaluation (US financing Vietnam
War)
o Flexible exchange rate regime: since 1973
After 1976:
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