MA-SEM-IV-Economics-Project-Engligh-Version-munotes

Page 1

1 1
FOREIGN EXCHANGE RATE
Unit Structure
1.0 Objectives
1.1 Introduction
1.2 Concept of Rate of Exchange
1.3 Determination of Rate of Exchange
1.4 Fixed and Flexible Exchange Rate
1.4.1 Fixed Exchange Rate
1.4.2 Flexible Exchange Rate
1.5 Nominal Real and Effective Exchange Rate
1.5.1 Nominal Exchange Rates
1.5.2 Real Exchange Rates
1.6 Purchasing Power Parity and Interest Parity
1.6.1 Purchasing Power Parity Theory
1.6.2 Interest Rate Parity (IRP)
1.7 Questions
1.0 OBJECTIVES  To understa nd the concept of Rate of Exchange.
 To understand the Determination of Rate of Exchange.
 To understand the Types of Rate of Exchange.
1.1 INTRODUCTION There were two ways to think about foreign exchange. In one meaning,
foreign exchange is used to exchange one currency for another or to
purchase and sell foreign currencies. On the other hand, two nations'
obligations are settled by using foreign exchange (Refer) for all
transactions. Therefore, the term "foreign exchange" refers to
1) all organisations th at offer foreign debt facilities,
2) all procedures and systems for making international payments, and
3) the process of exchanging one country's currency for another
country's currency.
Therefore, in foreign exchange, that technique is employed as a to ol and
weapon to settle both national and international debt. munotes.in

Page 2

2 International Finance
2 The term "dowry rate" also refers to the exchange rate itself. The exchange
rate is the price at which one unit of a country's currency is exchanged for
another. When settling currency transacti ons between two countries, the
foreign exchange rate assumes significance. Clearing and accepting
checks, paying off domestic debts, and exchanging one currency for
another are all parts of the foreign exchange process.
1.2 CONCEPT OF RATE OF EXCHANGE The price of one currency represented in terms of another currency is
known as the foreign exchange rate. The relationship between the
currencies of two countries is represented by the exchange rate. The cost
of one unit of foreign money in terms of domestic currency is known as
the exchange rate. Think about the dollar -to-rupee exchange rate. How
many rupees are purchased for one dollar? Here is how the rupee and
dollar exchange rates look when seen from India. Since one US dollar is
equal to 44.35 rupees, A merica must pay 0.0266 dollars to obtain one
rupee.
1.3 DETERMINATION OF RATE OF EXCHANGE Equilibrium Rate of Exchange:
Similar to how supply and demand determine a commodity's price, a free
market's supply and demand for foreign currency determines the e xchange
rate. Foreign exchange supply and demand are balanced at the equilibrium
exchange rate. Nurks contends that the equilibrium rate of exchange funds
the overall transactional balance at any given moment. (According to
Rangner Nurkse, the equilibrium rate of exchange is that condition that
maintains the balance of payments in equilibrium for a predetermined
length of time.)
When the supply or demand of a currency fluctuates, the exchange rate
also changes. As a result, there is constant fluctuation in the exchange rate
in the foreign exchange market. As a result, the foreign exchange account
will alter.
Let's use a diagram to better understand how the exchange rate is
calculated. The demand and supply curves for foreign exchange are
denoted by the lette rs D and C. At point 'E' in the graphic, where the
intersection of each other's demand and supply curves is held, trade is in
equilibrium. The terms "VR" and "VN" in equilibrium rate signify that
demand and supply are in balance. If the exchange rate incre ases to "VR,"
supply will increase to "R2 S2" and demand will increase to "R2 D2."
People won't swap their money, which will cause the exchange rate to rise.
Demand will rise to R1 D1 when it falls to VR1, and supply will fall to R1
S1. Since the exchange rate will be greater, an equilibrium in the exchange
will result. munotes.in

Page 3

3 Foreign Exchange Rate

Figure 1.1: Equilibrium of Exchange Rate
This leads to the conclusion that as the exchange rate remains constant, the
supply of foreign exchange increases as the demand for it rises. A
country's exchange rate will rise if its supply of foreign currency rises
while demand stays the same.
1.4 FIXED AND FLEXIBLE EXCHANGE RATE Foreign exchange rates are either fixed or variabl e. Both have advantages
and disadvantages .
1.4.1 Fixed Exchange Rate :
A fixed exchange rate is a system put in place by a government or central
bank that links the official rate at which the national currency is
exchanged with the currency of another nation or the price of gold. The
goal of a fixed exchange rate system is to keep a currency's value within a
specific range.
In a fixed exchange rate system, all foreign exchange transactions are
settled at the exchange rate location within the country's fiscal authority.
In order to address supply and demand gaps in the fiscal authority's role as
an intermediary in the foreign exchange market and stabilise the exchange
rate, the central bank holds currency reserves. When foreign cash is
exchanged in accordance with the exchange rate established by the
government under law, that rate is called fixed exchange rate.
A. Case for Fixed Exchange Rate:
1. Base of Common Currency : Different nations' fixed exchange rates
are based on a single currency. because the value of common money
is fixed. As a result, trade grows and production and e conomic growth
accelerate. As a result, commerce attracts foreign trade and quotes or
forecasts of commodity prices are made through trade. Johnson claims
that having a constant exchange rate promotes global integration. munotes.in

Page 4

4 International Finance
4 2. Encouragement of Discipline : A fixe d exchange rate promotes
financial restraint. Implementing fiscal and fiscal policy with attention
allows us to influence the flow in the desired direction. It is notably
helpful in reducing the economy's inflationary trend.
3. Currency does not fluctuate : There is no prospect of currency
appreciation or depreciation under a fixed exchange rate regime. As a
result, the national currency grows rapidly and the economy is stable.
4. Capital and Inflow Attraction : Long -term capital inflows are
maintained by a steady exchange rate. The economy benefits. A fixed
exchange rate is risk - and uncertainty -free.
5. Control of Speculation Activity : A fixed exchange rate eliminates
the motivation for speculation. The financial system of the nation
discourages speculation. There is therefore no room for speculation.
6. Beneficial to small countries : A fixed exchange rate regime, in
Johnson's opinion, is particularly advantageous to small nations.
Because countries' exchange rates fluctuate as a result of inflation and
depreciation
7. Liab ility or Burden : Foreign liabilities are created when items are
imported and exported at fixed exchange rates. Money is made by
spending.
8. Development of Money and Capital Markets : Money and capital
markets grow as a result of stable exchange rates. Money c omes into
the nation.
9. Building multiple trades : There is no uncertainty because of the
steady exchange rate. This leads to the country's diversified
development.
10. International Financial Cooperation : An exchange rate system with
fixed exchange rates encoura ges global financial cooperation. It
makes work flow more easily. As a result, the IMF, IBRD, Euro
market, etc., develop effectively.
11. Stability of developing country : A steady currency rate is preferred
by developing nations. Economic growth is envisioned for steady
exchange. For the country's capital to enter smoothly from abroad, a
stable exchange rate is crucial.
12. Importance in the Growth of Domestic Relations : Within a nation,
possibilities and incentives are produced by a stable exchange rate. As
a resu lt, family dynamics immediately improve.
Simply put, a fixed exchange rate serves to ensure domestic economic
stability by stabilising commerce between two nations. International trade
is encouraged by a stable exchange rate because it fosters a sense of
security and assurance. Particularly Japan and England are heavily reliant
on international trade. They assert that such a setting must exist. The munotes.in

Page 5

5 Foreign Exchange Rate foreign trade of these nations is likely to suffer from an unpredictable
exchange rate, creating barriers to e conomic development. The "Louvre
Agreement" was made by the United States and other Western nations like
Germany, Japan, France, and England to fix currency exchange rates in
their commerce.
A stable exchange rate enables traders to accurately predict the cost of
imports as well as the revenue they will realise from exports. A stable
currency rate also fosters an atmosphere that is conducive to long -term
international investment. The result is a healthy expansion of global trade.
Speculative transactions ar e prevented by a set exchange rate. As a result,
the dreaded capital flight is halted. In currency areas like the sterling,
dollar, and euro zones, fixed exchange rates are suited for international
trade. International trade has a significant role in the e conomic growth of
developing nations. They themselves must expand their export business.
In this situation, a stable exchange rate's atmosphere of stability and
confidence is advantageous for them.
B. Case against Fixed Exchange Rate :
The following argume nts are advanced against fixed exchange rate.
1) Abandonment of Objectives : As a result of a fixed exchange rate the
average price level in the economy e.g. Important goals of transaction
stability and full employment are sacrificed. Domestic price hike
policy is adopted to maintain equilibrium. Hence social expenditure in
the country increases to a great extent and financial independence is
affected.
2) Unexpected Disruption : The fixed exchange rate regime changes the
current account balance as a result of unexpected disruptions in the
domestic economy.
3) Heavy burden on foreign exchange reserves : Due to the fixed
exchange rate system, the country's foreign exchange is kept in large
reserves. Therefore, the country automatically has to face that
problem due to shortage of foreign exchange. Therefore, the foreign
exchange reserves have to bear a heavy burden.
4) Failure of real price effect relationship : Fixed exchange rate system
does not show the real picture of cost price in different countries'
curre ncies. The flows of both countries operate under different
economic policies.
5) Instability and Uncertainty : Due to fixed exchange rate uncertainty
and instability cause the volume of international trade to decrease and
investment to a minimum level.
6) Mode of Complexity : Fixed exchange rate adds complexity. Because
the qualities of a highly skilled person are utilized at the time it was
used. But that results in uncertainty. This is a mistake of this method
and it is implemented. munotes.in

Page 6

6 International Finance
6 7) Not always possibl e: It is not possible to maintain a stable exchange
rate for a long time. Because in the long run balance of trade problems
and international commodity prices change. Therefore, the country
has to change the international exchange rate.
8) Balance of Trad e Imbalance : Fixed exchange rate system does not
help to solve the problem of balance of trade imbalance. This is a
temporary solution. There is no permanent solution.
9) Increasing dependence on international issues : Due to fixed
exchange rate regime, th e country is heavily dependent on
international organizations for aid and loans.
10) Problem of International Liabilities : The purpose of fixed exchange
rate is to maintain large reserves of foreign exchange to maintain
balance of trade. Hence the demand for international currency
liabilities increases. More demand increases supply. These problems
arise. It is therefore argued that a country should maintain a flexible
exchange rate.
1.4.2 Flexible Exchange Rates:
Exchange rates that are variable, flexible, or floating are decided by the
market's equilibrium between supply and demand for foreign currency.
Government action in setting the exchange rate, either directly or
indirectly, is nonexistent. The country's trade balance is automatically in
equilibrium if exchange rates are set by supply and demand on the market.
Without any government action, the balance of global trade can approach
equilibrium thanks to a floating exchange rate. It follows that it is a
"floating exchange rate" when the balance between supply and demand for
foreign currency on the market determines the exchange rate without the
involvement of the government.
A. Case for and against Flexible Exchange Rate :
The case for or arguments in favor of Flexible/Floating exchange rate are
as follow s.
1) Simple operation : The mechanism of operation in floating exchange
system is very simple. The exchange rate is freely and automatically
driven by supply and demand in the foreign exchange market. It
reduces the rarity or power of the country.
2) Smo oth Adjustment : The trade balance is adjusted smoothly and
effectively. There is no stress on the balance of trade. Also stress is
accepted in a difficult state of balance.
3) Automatic correction of imbalances : Due to the variable exchange
rate system, i mbalances in the balance of trade are automatically and
effectively corrected. So there is no need for gold flow or capital
flows in or out of the country. munotes.in

Page 7

7 Foreign Exchange Rate 4) No need for foreign exchange reserves : A fluctuating exchange rate
automatically settles at the equilibrium level. No need for foreign
exchange service. The currency depreciates in relation to foreign
exchange to cover the country's balance of trade deficit. Hence,
currency surplus is accepted and the balance of trade automatically
comes to the equil ibrium level.
5) Domestic economic policies are self -sufficient : Government aims at
modern welfare. For this, full employment growth is required along
with stabilizing the growth rate. That goal is achieved through a
flexible exchange rate. Here the objec tive of fixed exchange rate is
also fulfilled.
6) Removal of international liability problem : Flexible exchange rate
creates the problem of foreign exchange imperfection. This creates
speculation in the supply of foreign exchange. The need for private
liability was satisfied. It therefore changes or reduces the problem of
international liability.
7) Less borrowing and borrowing of funds in the short run : As the
foreign exchange rate fluctuates freely, there is no need for borrowing
and borrowing in the sh ort run to deal with the current account
imbalance problem.
8) Economically Stable Exchange Rate : Due to fluctuating exchange
rate there is no need to hold foreign exchange reserves. Hence, a fixed
exchange rate is comparable in economic terms.
9) Effect s of Fiscal Policy : A changing exchange rate regime increases
the effectiveness of fiscal policy. Therefore, there is a possibility of
increasing the export of the country. Hence the interest rate decreases.
Exports stimulate production of goods and capita l outflows. Thus
domestic prices rise, Increases income and employment. When the
problem of inflation arises in the country. Then the interest rate
increases. This method is effective for fiscal policy.
10) Establishment of International Trade : The natural level is
automatically compromised and corrected or maintained according to
the changing exchange rate regime. It is not risky to overvalue or
undervalue a country's currency.
11) Protection to International Development : A country is protected
internation ally against economic fluctuations due to fluctuating
exchange rates. It is more effective. It occurs due to exchange
compromise.
12) Comparative Advantages : Exchange rate is always in equilibrium. A
country enjoys comparative advantages in respect of cer tain goods to
determine the price for taxation.
In other words, without any government interference, a flexible exchange
rate balances the balance of world commerce. In the post -World War II munotes.in

Page 8

8 International Finance
8 era, a stable exchange rate not only boosts international trade, but a
variable exchange rate can also accurately forecast changes in trade. Long -
term international investment depends on many other factors and cannot
be supported by a stable exchange rate alone. Examples include the
accessibility of raw materials, inves tment potential, return on investment,
political stability, and the pursuit of both economic and political goals.
The increase in commerce between nations in the "Sterling Area," "Dollar
Area," and "Euro Area" may not be due solely to exchange rate stabili ty;
there may be a variety of other factors at play.
There can be no guarantee that speculative transactions won't take place in
international trade, even in the case of stable exchange rates.
Each nation experiences economic growth at a different rate. Ad ditionally,
the potential profit in each industry varies. Thus, a fixed exchange rate
may not accurately reflect the two currencies' natural relationship. On the
other hand, stability can be manufactured. International trade became
incredibly unpredictable as long as European countries had their
currencies tied to the US dollar, necessitating the establishment of new
exchange rates. Since 1990, exchange rates have fluctuated as a result of
liberal economic policies.
B. Case against to Flexible / floating ex change rate :
The following arguments are made against floating exchange rate.
1) False appreciation of instruments : Fluctuating exchange rate does
not give proper guidance to the stakeholders in the foreign exchange
market about the equilibrium exchange rate. Therefore, the decision to
share with the resources of the country becomes wrong.
2) Government Intervention : The government does not directly
intervene in the foreign exchange market due to fluctuating exchange
rate transactions. If the exchange r ate appreciates, the government
implements monetary and fiscal policy. E.g. When domestic saving is
high, net investment in the foreign country takes place. The indirect
effects of the government will not be useful as the exchange rate
reduces capital outf lows. Another consequence is that the government
does not understand the exchange rate so the exchange rate is fixed or
manipulated. As a result, chaos would ensue if each country did not
attempt to create a favorable exchange rate with the other. It will
result in wholesale and exchange rate wars.
3) Exchange rate liability and uncertainty : Fluctuating exchange rate
creates exchange rate liability in a developed country and has
economic impact on international trade and capital movement.
4) Nature of Inf lation : Inflation occurs due to changing exchange rate.
Depreciation of exchange increases import prices. As a result the cost
increases. munotes.in

Page 9

9 Foreign Exchange Rate 5) Increase in speculation : Fluctuating exchange rate leads to increase
in speculation. Exchange rate changes due to supply and demand.
Business activity fluctuates unexpectedly. Therefore, the size of the
foreign exchange rate decreases.
6) Scarcity in the global market : In this system, all the functions of
money are performed by a single currency. It is divided into w orld
market goods and capital. So global tools don't take its share. Thus
this method is not sustainable for long.
7) Unfavorable to developing countries : Developing countries face
persistent balance of trade deficits. Importing machinery, tool
materials, raw materials, etc. leads to economic development of the
country. But exports are limited. Demand for primary products is
elastic in international markets. As a result, their currency depreciates
due to fluctuating exchange rates. It also slows down the t rade and
development process of developing countries.
1.5 NOMINAL, RE AL AND EFFECTIVE EXCHANGE RATE 1.5.1 Nominal Exchange Rates:
The nominal exchange rate refers to the price at which a person can
exchange one country's currency for another country's. Th is means it
calculates how much of currency A or currency B can be purchased in
exchange for the other. Starting from that point, depending on the base
currency we select, all exchange rates can be expressed in one of two
ways. Accordingly, we can either c alculate how much of currency A we
receive in return for currency B or how much of currency A we receive.
Let's imagine you visit a bank to convert $100 to EUR as an example. In
other words, at this time, 1 USD is worth 0.88 EUR thanks to the bank's
offer. Therefore, you may trade 100 USD for 88 EUR (i.e., 100 x 0.88). Of
course, if you prefer, you can always convert your EUR 88 back to USD.
In that situation, the bank will give you 1.14 USD for each EUR. Because
EUR is used as the base currency rather than USD, the exchange rate
seems different. However, the situation is essentially the same (if we
ignore the rounding error). So, with this exchange rate, you can get your
initial USD 100 back, in exchange for EUR 88 (i.e., 88 x 1.14).
1.5.2 Real Exchange Rat es:
The real exchange rate refers to the price at which a person can exchange
products and services from one nation for those from another. In other
words, it specifies the quantity of a foreign good or service that can be
exchanged for a single unit of a domestic good or service. Because the
prices of the relevant goods and services must constantly be changed to
the same currency before they can be compared, the actual exchange rate
and nominal exchange rate are closely tied. In order to determine the real
exchange rate, we can apply the following formula: munotes.in

Page 10

10 International Finance
10 Real Exchange Rate = (Nominal Exchange Rate x Domestic Price) /
Foreign Price
A case in point. Let's say you're looking for a great destination for your
upcoming vacation. You discover two hotels online, one in Hawaii and the
other in Ibiza, Spain (USA). Ibiza's accommodation rates are quoted at
EUR 65 per night. In contrast, a hotel night in Hawaii costs USD 150. As
we learned from the aforementioned example, the nominal exchange rate
between the US dolla r and the euro is 0.88. The real exchange rate
between the two hotel rooms, calculated by plugging this into the
calculation above (i.e., 0.88 x 150 / 65), is 2.03 nights in Ibiza for every
night spent in Hawaii. In other words, you could spend more than t wice as
many nights in Ibiza than in Hawaii for the same amount of money.
Determination of Real Exchange Rate :
The changes in the real exchange rates are caused by many factors.
Amongst them demand and supply are the two major factors through
which real ex change rates are determined.
Demand :
A Change in export demand for the concerned country, say India when the
world demand for the Indian goods has increase, its demand curve of
shifts to the right as represented in the following figure –

Figure 1.2
Due to the current exchange rate, when there is a demand for Indian
goods, the relative price of Indian goods must increase relative to the
foreign price in order to restore equilibrium. Therefore, with the given
supply curve S, when demand for Indian goods i ncreases, the demand
curve shifts from D to D1, and the original equilibrium exchange rate
changes from R to R1. munotes.in

Page 11

11 Foreign Exchange Rate As a result, it suggests that the real exchange rate of the nation has
declined. Since the purchasing power of the rupee has increased in relat ion
to international commodities, this suggests that the nominal exchange rate,
or external value, of the Indian rupee has increased in real terms.
Supply :
The availability of Indian exportables may alter as a result of
technological and managerial advance ments. If Indian export production
tends to increase, there may be a supply -demand imbalance. In other
words, the price of Indian goods must decrease in order to restore
equilibrium when the growth in international demand for Indian
exportables is smaller than the increase in the output supply of
exportables. The real exchange rate will be fixed starting at R and
increasing to R1 and beyond, as depicted in the following figure.

Figure 1.3
When a country's productivity grows, which is reflected in a rise i n output
and the supply of exportable goods, the real exchange rate tends to
appreciate.
The country's balance of payments benefits when the real exchange rate
increases or appreciates.
Thus, real exchange rate appreciation acts as a mechanism for adjustin g
the balance of payments in order to address the current account deficit.
The weighted average of the bilateral real exchange rates (RERS) between
the concerned country and each of its trading partners yields the real
effective exchange rate (REER). Accor ding to the respective trade shares
of each trading partner, weights are assigned. munotes.in

Page 12

12 International Finance
12 Suppose, a country has four major trading partners nations: A, B, C, and
D. Then, the real effective exchange rate (REER) of a given country (x) is
measured as:
REER X [(RER A . S)+(RER B . SB)+ RER C . SC)+(RER D . SD)]/4
Here, a, b, c and d are referred to the respective country and its trading
share (5). RE implies the concern country's real exchange in relation to A's
currency. Likewise RER B refers to real exchange rate again st B currency
and so on.
The formula can be extended in general for 'n' partners nations to a
country, thus:
REER x = ∑ ERER n / N
Where, ∑ is sum of, N= number of partner countries, n = 1, 2, 3,...n.
1.6 PURCHASING POWER PARITY (PPP) AND INTEREST RATE PARITY (IRP) A) Purchasing Power Parity Theory :
This idea was created by Gustav Cassel following World War I. The
irreversible paper currency system was established during World War I,
replacing the gold currency system. The purchasing power parity theory of
exchange rate determination was put forth by Swedish economist Gustav
Kassel in order to explain how to exchange di fferent paper currencies of
two different countries and how to calculate the exchange rate since the
majority of the world's nations have adopted the paper currency system.
Thus, purchasing power parity theory explains how the exchange rate of a
paper curr ency that cannot be converted is calculated.
After World War I, Cassel elaborated in his theory.
The base rate is the base rate, and while the gold standard is Mint Par, the
real rate of exchange varies below and above that rate. Similar to this, the
non-convertible paper approach relies heavily on the purchasing power
parity (PPP) rate. Only the base rate's direction is changed by the actual
rate. The true power parity rate is the baseline from which the actual rate
cannot deviate too much. Many individual s in other nations prefer a
certain currency because it has the purchase power of the commodities
produced in that nation. The fundamental tenet of buying power parity
theory is this. When domestic money is used to purchase foreign currency,
foreign purcha sing power is obtained in exchange for domestic purchasing
power. In other words, the exchange rate of a currency is determined by
the relative purchasing power of two different currencies; similarly, the
purchasing power of two different currencies is exc hanged when two
countries exchange their currencies. As a result, the equilibrium exchange
rate develops when two currencies with equal purchasing power are
traded. To put it another way, the exchange rate is considered to be in
equilibrium when the purcha se power of two different currencies is equal. munotes.in

Page 13

13 Foreign Exchange Rate The ratio of the purchasing power of two non -convertible paper currencies
serves as the exchange rate.
The proportion of pure gold in the two nations' currencies set the exchange
rate during the gold standard. However, it is impossible to calculate the
conversion rate of this method while utilising non -convertible paper
money. Therefore, the currency's purchasing power is taken into account.
You can purchase products and services from other countries using
purchasing power. However, one must pay local money to obtain foreign
currency. Therefore, a base rate must be established to ensure that both
currencies have equal purchasing power.
Such an exchange can't be far from the real rate. For instance, the
exchange rate would be 1 dollar = 46 rupees if one spent 46 rupees in
India to purchase the same amount of products and services as could be
purchased with US dollars.
The real rate may be higher or lower than this base rate. The following
approach was suggested by Cassell for calculating the purchasing power
parity rate. Exchange Rate = Foreign Price Index + Domestic Currency
Price of Currency in Base Year
Suppose the exchange rate between England and America is 1 pound =
4.86 dollars. The price index in 1964 is 10 0. If the price index rises to 300
in England and 200 in America in 1973, the exchange rate will be as
follows - 1 pound = 4.86x200 = 3.24 dollars 300
Thus, the ratio of their purchasing power determines the equilibrium
exchange rate between two noncon vertible currencies. This rate is
temporary. Therefore, it varies depending on the circumstances and in the
opposite direction from the typical level of prices between the two
countries. The value of the currency increases when the actual rate
exceeds the purchasing power parity rate. In other words, if the real rate
falls below the purchasing power parity rate, the price of the currency
declines and the currency is considered to be undervalued.
1.6.2 Interest Rate Parity (IRP) :
According to the Interest Ra te Parity (IRP) theory, the difference between
the interest rates of two nations always remains equal to that determined
by using both spot and forward exchange rates. Interest, spot exchange,
and foreign exchange rates are all connected by interest rate p arity. The
theory also emphasises the idea that the size of a currency's forward
premium or discount is equal to the spread between that country's spot and
forward interest rates. In Forex markets, it is essential. This hypothesis is
explained using the fo llowing two categories:
munotes.in

Page 14

14 International Finance
14 1. Covered interest rate parity :
The covered interest rate parity situation means there is no opportunity for
arbitrage using forward contracts, which often exists between countries
with different interest rates.
Formula for Cover ed Interest Rate Parity

where:
id- Interest rate in the domestic currency
if- Interest rate in the foreign currency
S- Current spot exchange rate
F- Forward foreign exchange rate
2. Uncovered Interest Rate Parity (UIP):
Uncovered interest rate parity (UIP) theory states that the difference in
interest rates between two countries will equal the relative change in
currency foreign exchange rates over the same period.
Formula for Uncovered Interest Rate Parity

where:
F0- Forward rate
S0- Spot rate
ic- Interest rate in country
cib- Interest rate in country b
The link between domestic and international interest rates as well as
currency exchange rates is governed by the uncovered interest rate parity
(UIP) equation, which is a fundamental equation i n economics.
Covered interest parity includes using forward contracts to cover the
exchange rate, which is how it differs from uncovered interest parity.
Uncovered interest rate parity, on the other hand, uses simply the
anticipated spot rate and forecasts rates without hedging against exposure
to foreign exchange risk. When the predicted spot rate and the forward munotes.in

Page 15

15 Foreign Exchange Rate rate are same, there is no distinction between covered and uncovered
interest rate parity.
Implications of IRP Theory :
Arbitrage may not be possi ble if the Interest Rate Parity theory is true.
This means that regardless of whether investors use domestic currency or
foreign currency, the Rate of Interest (ROI) will always be the same as if
the investor had used local currency as their initial invest ment.
1. Foreign currency must trade at a forward discount when the domestic
interest rate is lower than the foreign interest rate. This applies to
preventing currency arbitrage in foreign exchange.
2. Domestic investors have the possibility to profit fr om arbitrage when
a foreign currency lacks a forward discount or when the forward
discount is insufficient to offset the interest rate advantage. Therefore,
foreign investment can occasionally be advantageous to domestic
investors.
3. The foreign currency must trade at a forward premium when domestic
rates are higher than international interest rates. This is yet another
measure to counteract local country arbitrage prevention.
4. Foreign investors will have the chance to profit from an arbitrage
opportunity when the foreign currency does not have a forward
premium or when the premium is too small to offset the domestic
country advantage. Therefore, by making investments in the dome stic
market, foreign investors can profit.
1.7 QUESTIONS Q1. Define the Rate of Exchange. Explain Determination of Rate of
Exchange.
Q2. Discuss the Case for and against Fixed Exchange Rate.
Q3. Discuss the Case for and against Flexible Exchange Rate.
Q4. Elaborate the Nominal, Real and Effective Exchange Rate.
Q5. Explain the Purchasing Power Parity.
Q6. Explain the Interest Parity Theory.

*****
munotes.in

Page 16

16 2
FOREIGN EXCHANGE MARKETS
Unit Structure
2.0 Objectives
2.1 Introduction to Foreign Exchange Market
2.2 Types of Foreign Exchange Market
2.3 Foreign Exchange Risk and Exposure
2.3.1 Exposure, Risk and Parity Relationship
2.3.2 Types of Exposures
2.3.3 Hedging, Risk and Exposure
2.4 Summary
2.5 Questions
2.0 OBJECTIVES  To understand the Foreign Exchange Markets.
 To understand the Foreign Exchange Risk and Exposure.
 To understand the Types of Exposure.
 To understand the Hedging Risk and Exposure.
2.1 INTRODUCTION TO FOREIGN EXCHANGE MARKET The marketplace where participants can buy, sell, trade, and speculate on
currencies is known as the foreign exchange market. Investment
management businesses, banks, central banks, hedge funds, commercial
compani es, investors, and retail forex brokers make up the foreign
exchange markets.
In currency exchange transactions, the rights to income and property can
be exchanged for cash by changing one currency into another. This
approach is used to study several eleme nts.
1) Researching the national currency and the currencies of other nations,
2) Exchange appreciation factors,
3) Exchange and equilibrium value at exchange locations.
The transformation of different currencies into financial instruments.
currency tr anslation of prevailing instruments on credit. such as bank
letters of credit, telegraphic transfers, traveler's checks, draughts, faxes,
dowry, and so forth. Banks instantly exchange local money and foreign
currency using tools in the bank account. Physic al exchange of currency is
not possible. It is exchanged and recorded officially in the relevant nation. munotes.in

Page 17

17 Foreign Exchange Markets Exchange services are offered by banks. Between buyers and sellers, or
between importers and exporters, the intermediate role is crucial. The
market wh ere buying and selling of foreign currency takes place is known
as the foreign exchange market.
A foreign exchange market is a digital marketplace where banks,
merchants, people, organisations, governments, etc. buy and sell foreign
currency. The main buye rs in this market for foreign exchange include
traders, brokers, banks, and central banks. Brokers and intermediaries in
the exchange market make money by purchasing and offering foreign
currencies. The financial hub of the currency market is the foreign
exchange market.
2.2 TYPES OF FOREIGN EXCHANGE MARKETS The purpose of foreign exchange is to deal in the market which is
classified into spot market and futures market.
1) Spot Market:
Transactions in foreign currency are completed there ("On the Spot")
within 24 hours. Spot rate refers to the exchange rate set for quick
purchases and sales of foreign currency. The present rate is different for
both the selling rate and the buying rate. The current rate takes into
account cable rate, transfer rate, and mail rat e. The amount is credited to
the buyer's deposit account at the spot rate when the buyer of foreign
currency deposits the foreign currency's purchase price in the bank in local
currency.
2) Forward Market:
In the forward market, two parties are involved. The se parties can be two
businesses, two people, or two government nodal agencies. In this kind of
market, parties have made a commitment to transact at a specified price
and quantity at a later period. For instance, a case of iceberg lettuce would
cost $50 o n January 1. The farmer and the restaurant agree to provide 100
cases of iceberg lettuce at a forward pricing of $55 per case on July 1. The
contract will remain at $55 per case on July 1st, regardless of whether the
cost per case has climbed to $65 per ca se or lowered to $45 per case.
3) Future Market:
The futures market, where contracts are bought and sold at the going rate.
A market is referred to as a "futures market" when lots of traders use it to
buy or sell futures. In the futures market, interest rate s are crucial. The
currency futures rate is lower when a nation pays more interest on
collateral. The exchange rate is greater or stays higher if the purchase's
future time frame is longer. The future rate is defined as "the rate at which
the future is to be purchased and sold at the rate decided in the present."
munotes.in

Page 18

18 International Finance
18 4) Option Market:
An option is a contract that permits (but does not mandate) an investor to
purchase or sell an underlying item, such as a share, ETF, or even an
index, at a predetermined price over a predetermined time period. In this
kind of market, "options" are bought and sold. Options are one of the most
significant innovations in modern finance. An option contract grants the
holder the right, but not the responsibility, to buy or sell, as oppos ed to a
futures contract, which commits one party to deliver and another to pay
for a certain good at a specific future date. Options are appealing to
hedgers because they offer protection against value loss without
sacrificing the possibility of gains. Th ere are other types of options as
well. In 1973 the Chicago Board of Trade established the Chicago Board
Options Exchange to trade options on stocks. The Philadelphia Stock
Exchange has a thriving business in currency options. The options market
owes a goo d deal of its success to the development of the Black -Scholes
option pricing model. Developed by economists Fischer Black, ROBERT C.
MERTON , and MYRON SCHOLES , it was first published in 1973. The model
considers factors including the current price of the stock or currency, its
volatility, the price at which the option allows the buyer to buy the stock
or currency i n the future, interest rates, and time to calculate what the
option is worth.
Options are derivative instruments that allow a foreign exchange market
operator to buy or sell a foreign currency at a predetermined rate ( strike
price ) on or before a specific date (maturity date). A call option allows
traders to buy the underlying asset, whereas a put option allows them to
sell it. Exercising the option means purchasing or selling the underlying
asset through the option. In the options market, exercising the option is not
an obligation for traders
5) Swap/Currency Market:
Swap market is one where transactions for simultaneous lendi ng and
borrowing of two different currencies are done between investors. It is a
contract between two or more parties for exchanging cash flows on the
basis of a predetermined notional principal amount.
In the swap market, there two types of swap transact ions done that are
currency swap and interest swap.
1. Currency swap is an exchange of fixed currency rates of one country
with a floating currency rate of another country.
2. Interest swap means the exchange of floating interest rate with a fixed
rate of interest.

munotes.in

Page 19

19 Foreign Exchange Markets 2.3 FOREIGN EXCHANGE RISK AND EXPOSURE 2.3.1 Exposure, Risk and Parity Relationship:
When a corporation conducts financial transactions in another country's
currency, it is said to be exposed to foreign exchange risk. All currencies
may go through periods of extreme volatility, and if appropriate methods
are not in place to rectify cash flows from unexpected currency swings,
this can negatively affect profit margins.
A potential gain or loss due to a change in the exchange rate is known as
foreign exchange risk. Uncovered liabilities in foreign currencies are
referred to as "shorts" and uncovered claims as "longs."
The risk of unfavourable changes in the settlement value of transactions
put into a currency other than the base currency or dom estic currency is
known as foreign exchange risk. Exchange rate risk, foreign exchange
risk, or currency risk are all terms used to describe this risk, which results
from fluctuations in base currency rates or denominated currency rates. It
is the threat o f financial harm brought on by changes in exchange rates.
Here, changes in currency exchange rates will have an impact on a
business's financial performance or state. For exporters, importers, and
companies conducting business on the global market, exchang e risk is a
significant risk.
When the value of a company's future cash flows depends on the value of
a foreign currency or currencies, the company is said to have foreign
exchange exposure. A British company's cash stream is subject to
currency fluctuatio ns if it sells products to a US company. Additionally,
the US -based company's cash outflow exposes it to currency risk. The
exposure will be met with scepticism in both countries because the
currency rate is prone to shift or fluctuate. In this instance, w e saw that a
company engaged directly in foreign currency dealing is subject to foreign
exchange risk. A company without such a direct connection might
occasionally be determined to be exposed to foreign exchange risk. For
instance, if a company manufactur ing tiny electronics in Sri Lanka
competes with products imported from China, the cost advantage enjoyed
by importers over that Sri Lankan company will diminish as the value of
the Chinese Yuan against the Sri Lankan rupee rises. The example shows
that a c ompany without direct access to foreign exchange will also be
impacted.
2.3.2 Types of Exposures:
As mentioned above exposure refers to the degree to which a company is
affected by exchange rate changes. Multinational companies face unique
risks that do no t hamper domestic firms as much. These risks are related to
foreign exchange risk and political risk.
There are three types of Exposures :
I) Transaction Exposure munotes.in

Page 20

20 International Finance
20 II) Translation exposure
III) Operating exposure
I) Transaction Exposure:
Business organisations frequently conducted transactions in foreign
currencies. When conducting commerce or transactions, they run the
danger of exposure. Transaction exposure is the risk of experiencing
exchange gains or losses on already -completed transactions with a foreign
currency as the denominator.
Gains or losses associated with the payment of financial commitments
with terms expressed in a foreign currency are measured by transaction
exposure. Companies exposed to transactions may see actual exchange
profits or losses. Additionally, it combines prospective and retroactive
transactions. They are of a transient nature.
In short, transaction exposure measures gains are losses that arise from the
settlement of financial obligations whose terms are stated in foreign
currency.
Transaction exposures arises from :
A) Purchasing or selling goods and services on credit whose prices are
stated in foreign currencies
B) Boring and lending funds when repayment is to be made in a foreign
currency
C) Being a party to under formed forward foreign e xchange contract.
D) Acquiring assets or liabilities denominated in foreign currencies
Forward contracts and options can be used to lower transaction risks.
For instance: Consider a scenario where an Indian company exports
products to the USA and is charged i n US dollars. The US dollar weakens
over the two months it has to wait before receiving payments. In rupee
terms, this will result in lower earnings. The export revenues will increase
in terms of rupees if the value of the US dollar increases. In both
instances, the cash flow changes. While there is a loss in one scenario,
there is a gain in the other.
II) Translation Exposure:
Additionally called accounting risk. The risk of a corporation conducting
domestic business at its headquarters but in a different coun try, with its
financial performance reported in that country's currency, is referred to as
translation risk or exposure. When a corporation has a sizable amount of
its assets, liabilities, or equity held in foreign currencies, the risk of
translation is hi gher. munotes.in

Page 21

21 Foreign Exchange Markets Translation exposure occurs when financial statements from foreign
affiliates are converted into the reporting currency of the parent company.
in order to enable the parent to prepare consolidated financial accounts.
For instance: Let's say an Americ an MNC with a subsidiary in the UK
makes £10 million a year. These earnings are converted into US dollars at
the year's weighted average exchange rate when combined with other
subsidiary earnings.
III) Operating Exposure:
Also known as economic risk or f orecast risk is risk that affects the market
value of a company from the unavoidable risk to exchange rate
fluctuations many times companies face such type of risk when changes
occurred in the macroeconomic conditions and regional instability and
also gove rnment regulations.
It measures the change in the value of the firm that results from changes in
future operating cash flows caused by an unexpected change in exchange
rates.
2.3.3 Hedging, Risk and Exposure:
The process of managing exchange rate exposure is known as hedging.
Hedging tactics aid in reducing earnings fluctuations brought on by
exchange rate movements, and it is also important to reduce transactional
economic, translational, and accounting exposures. This is accomplished
by managing the curre ncy rate by utilising different hedging strategies.
This helps to reduce the expense of managing foreign exchange risk and to
prevent volatility and surprises.
Periods of extreme volatility are possible for all currencies, and they can
have a negative impa ct on profit margins. If adequate measures to
safeguard cash flows from unexpected currency fluctuations are not in
place, exchange rate risk can typically be handled through efficient
hedging operations.
Hedging strategies and Techniques to manage risk an d exposure :
There are various tools and techniques of risk management tools to help
business for limiting and reducing their foreign exchange risks. We will
explain here some important tools and techniques which are fundamental
in nature -
I) Spot Transfer :
The danger of exchange rate swings will be reduced by spot transfers of
foreign currency.
Spot transfers involve two parties agreeing to buy one currency and sell
another at a predetermined time within the following two working days, or
the "spot date." This rate is also known as the "here and now" rate. This is
the most fundamental risk management technique utilised in currency
trading. munotes.in

Page 22

22 International Finance
22 1) The currency bought and sold is the most crucial factor that is agreed
upon in every foreign exchange transfer, includ ing spot transfers.
2) The sum of money to be exchanged
3) The transfer maturity date.
4) The exchange rate at which the transaction will take place.
II) Forward Market Hedge :
Currency forward market transactions involve currency exchanges that
happen a fter spot transactions, at a future date that is defined. These
transactions are referred to as forward transactions.
It is a contract between two parties that requires one of the parties to
provide the stated quantity of foreign currency at a future date in exchange
for the other party paying the other party the agreed -upon amount in
domestic currency. The market for forward transactions is referred to as
the Forward Market, and the exchange rate that applies to the forward
contract is known as the forward exchange rate.
Exporters and importers greatly benefit from foreign exchange facilities
because they can use them to enter into a suitable foreign exchange
contract to offset the risk associated with exchange rate variations.
III) Limit Orders :
Another po pular option for managing market risk is limit order, where
businesses can set a target rate with the help of consulting agencies can
monitor the market and notify if great hit that target to make transfer.This
helps the businesses to select rate that work s for them to avoid the risk of
unpredictable market fluctuations.
IV) Hedging Through Currency Options :
People we have to exchange currency at some time in the future use
currency options hedges to protect themselves against swings in currency
values.
A derivative known as an option enables the holder to enter the underlying
market at a given price. The ability to buy or sell a currency at a preset
exchange rate is thus provided by currency options. Options on currencies
expire after a predetermined time . Internationally, currency options hedges
are frequently employed. As an illustration, an American importer might
consent to purchase some electronics from a Japanese producer in the
future. The Japanese Yen will be used for the transaction. In this case, the
American importer develops the hedge by buying Yen currency options.
The importer is now safeguarded in the event that the Yen appreciates
against the dollar.

munotes.in

Page 23

23 Foreign Exchange Markets V) Money Market Hedge :
Small enterprises and retail investors can easily manage their curr ency risk
by using the money market. Without using futures markets, it is one way
to hedge against currency volatility.
When a suitable amount of money is borrowed or deposited now to fix
payments and receipts in domestic currencies, a money market hedge i s
constructed to protect against exposure to foreign currency risk.
The domestic corporation can use a money market hedge to fix the value
of its partner's currency before a planned transaction. By doing this, future
transaction costs are made certain, and the domestic company is
guaranteed to pay the price it desires.
For instance, an American corporation must pay its suppliers in euros
rather than dollars because it has to buy supplies from a German company
in six months. The corporation might utilise the money market to lock in
the value of the Euro relative to the dollar at the present rate, ensuring that
even if the currency falls against the Euro in six months, the US company
will be aware of the exact dollar amount of the transaction cost and can
plan appropriately.
VI) Leads and Lags :
Leads and lags describe the purposeful postponement of payments due in
foreign currency in order to benefit from an anticipated change in
exchange rates.
Businesses may purposefully or unintentionally postpone making
payments to a foreign business in the hope that the currency rate will
change in their favour. The organisation may choose to pay sooner or later
than Scheduled when a payment to a foreign entity is involved.
Additionally, there is danger associated with lead ing and lagging because,
when it comes to timing strategies, currency rates can change abruptly.
VII) Currency Risk Sharing :
Two parties agree to share the risks associated with exchange rate swings.
Under currency sharing, the transaction's basic price is modified if
exchange rates fluctuate above a certain neutral level.
The extent of currency sharing will rely on the two parties' willingness to
participate into such a risk -sharing arrangement and their relative
bargaining positions.
VIII) Currency Swaps :
Swaps are merely tools that allow the conversion of two cash flow sources
into separate currencies. In the currency market, a swap is defined as the
simultaneous selling of spot currency for the purchase of the same
currency in the future or the simultane ous purchase of spot currency for munotes.in

Page 24

24 International Finance
24 the sale of the same currency in the future. The forward is placed in the
new spot. Technically speaking, transactions in which the same currency
is simultaneously sold or bought for spot delivery and then simultaneously
bought or sold for forward delivery are referred to as swaps or double
deals since the spot currency is swapped against the forward. Commercial
banks that engage in forward exchange trading may use swap operations
to change the position of their funds.
2.4 SUMMARY The market where currency rates are decided upon is the foreign exchange
market. Exchange rates are the means through which different national
currencies are linked together on the international market to provide
information about the value of one currency relative to another.
For internal stability, ongoing exchange rate changes are unacceptable. It
will interfere with the efficient operation of global trade and have an
impact on home economic activity. The crucial aspect of managing
foreign exchan ge involves many different considerations.
In the global economy, risk and exposure management is a crucial
problem. To deal with reflections that appear in exchange rates and cause
losses or gains in the currency market, a variety of methods and
technique s are used. The management of such risks inherent in the foreign
currency market requires the use of various hedging methods to address
the risk associated with accounting exposure, transaction exposure, and
operating exposures.
2.5 QUESTIONS Q1. Define t he Foreign Exchange Markets. Explain the types of Foreign
Exchange Market.
Q2. Briefly discuss the types of Exposure.
Q3. Explain the various tools and technics for Hedging Risk and
Exposure.



***** munotes.in

Page 25

25 3
BALANCE OF PAYMENTS - I
Unit Structure
3.0 Objectives
3.1 Introduction
3.2 Balance of Payments
3.2.1 Current Account
3.2.2 Capital Account
3.2.3 Official Reserve Transactions
3.3 Relationship between Balance of Payments and National Income
Accounts
3.4 Summary
3.5 Questions
3.0 Objectives The main objectives behind the study of this unit are:
 To know about in detail about balance of Payments and its accounts.
 To study the relationship between balance of Payments and National
Income.
3.1 INT RODUCTION A method called "double -entry book keeping" is used to make a country's
balance of payments account. The same amount is recorded on both the
credit side and the debit side of each international transaction. Every deal
has two sides, so that's how it works. Say a country sends out goods worth
Rs. 100 crore.
This item will go on the credit side (+) of the merchandise account, since
it gives a country the right to get money from foreigners. But at the same
time, this amount is treated as a short -term capital debit ( -) because it
shows a short -term outflow of capital from the exporting country.
A typical business's balance sheet has entries with credits on the right and
entries with debits on the left. But when figuring out the balance of
payments, cre dits go on the left and debits go on the right.
3.2 BALANCE OF PAYMENTS The balance of payment is a list of all the economic and monetary
transactions between all the units of a country and the rest of the world in
a given accounting year. It is designed t o work with the double -entry
system. munotes.in

Page 26

26 International Finance
26 Definition:
According to Kindle Berger, "The balance of payments of a country is a
systematic record of all economic transactions between the residents of the
reporting country and residents of foreign countries during a given period
of time".
3.2.1 Current Account:
The current account is a list of what goods, services, and transfer
payments were bought and sold. Both exporting and importing goods are
part of commodity trade. There are both transactions that make money f or
the factor and those that don't.
Transfer payments are money that the people of a country get for free,
without having to give anything in return. They come from gifts, grants,
and money sent back home. They could come from the government or
from people who live in other countries.

3.2.2 Capital Account:
The capital account keeps track of all the assets that are owned outside the
country. Any thing that can be used to hold money is called an asset.
Examples include stocks, bonds, government debt, money , etc. When
money is used to buy assets, it comes out of the capital account. If an
Indian buys a UK car company, this is recorded as a "debit" on the capital
account undertakings (as foreign exchange is going out of India).
On the other hand, a credit is made on the capital account when assets are
sold, like when a Japanese customer buys a share of an Indian company.
Foreign direct investments (FDIs), foreign institutional investments (FIIs),
aid, and loans from outside the country are all examples of thes e. munotes.in

Page 27

27 Balance of Payments - I

3.2.3 Official Reserve Transactions:
Official reserve transactions, or ORTs, are things that a country's
monetary authority does to change the country's official reserves. Buying
and selling currency on the exchange market in exchange for other asset s
and foreign currencies. When a country has a deficit, it sells foreign
currencies on the exchange market and buys them when it has a surplus. A
balance of payments surplus or deficit is when the official reserve goes up
or down.
The balance of payments d epends on official reserve transactions
because:
1. Helps fix the deficit or surplus in the balance of payments.
2. Buying your own currency is a credit on the balance of payments,
while selling it is a debit.
Official Reserve Transactions are things tha t the country's monetary
authority does to change the country's official reserves. On the exchange
market for other assets and foreign currencies, people buy and sell
currency. When the economy has a deficit, these foreign currencies are
sold on the exchan ge market, and when the economy has a surplus, they
are bought there. Official reserve transactions are very important because
they help keep the balance of payments for the whole country in check.
So, these transactions are counted as items for housing in the BOP.
The gold reserves, special drawing rights, and foreign currency that can be
sold make up a country's official reserve. The official reserve goes up or
down depending on whether there is a surplus or deficit in the balance of
payments. There are three parts or categories to the Balance of Payments.
These are the Capital Account, the Current Account, and the Financial
Account. When a country's overall balance of payments (BOP) is in the
black, its foreign exchange reserves grow. When there is a def icit, money
is taken out of the reserves by selling foreign currencies on the exchange
market. When a country has more money than it needs, it buys foreign
currency.
This is part of the international accounting for the balance of payments. It
shows the cen tral banks' current account and capital account. The current munotes.in

Page 28

28 International Finance
28 account shows a country's imports and exports of goods, services,
revenues, transfers, and whether or not it is a net creditor or debtor. The
capital account keeps track of how much money is inve sted abroad and at
home, how much money the government borrows, and how much money
the private sector borrows. When there is a deficit or surplus in the balance
of payments, the ledger is brought back into balance by sending or
bringing in reserve assets. This is shown in the official account for
settlement.
3.3 RELATIONSHIP BETWEEN BALANCE OF PAYMENTS AND NATIONAL INCOME ACCOUNTS The National Income and Product Accounts and the Balance of Payments
Accounts are two different sets of accounts that use differ ent rules of
accounting. As their names suggest, the BPAs are mostly about
transactions that happen outside of the country, while the NIPAs are a
broader set of accounts that cover both domestic and international
transactions. Most of the foreign transacti ons listed in BPAs are also listed
in NIPAs. Some things have different names in the two accounts so that it
is clear which set of accounts (and therefore which set of accounting rules)
they belong to. There are small differences in how accounting is done, but
the numbers in the BPAs and NIPAs are very close. In the examples that
follow, we'll get information about both domestic and international
transactions from the NIPAs. But for some foreign transactions, we'll use
their BPA names instead of their NIPA names because these names are
more common.
The Balance of Payments Accounts:
In the BPAs, transactions that result in payments to foreign countries are
called debits, and transactions that result in payments from foreign
countries are called credits. A deb it is written with a minus sign, and a
credit is written with a plus sign. The main categories of debits are imports
of goods and services, payments (profits, interest, and rents) on foreign
investments in the U.S., gifts to foreigners, purchases of assets abroad by
people living in the U.S., and increases in the U.S. government's
international assets. Credits come from what is being paid for the least.
(Gifts are different. When you subtract the gifts you gave to foreigners
from the gifts you got from fore igners, you get a debit entry for the net
gifts you gave to foreigners. There is no credit entry to match.) Table 1
shows a group of BPAs that were made up. The current account is the first
four rows. The table shows that there is no official intervention, which will
be explained in more detail later. These rows show payments that are
being made right now for goods and services, so they are also in the
NIPAs. Rows 6 and 7 are the capital account. These rows show how much
money was paid when assets were trad ed. Since these aren't immediate
payments for goods and services, they don't show up directly in the
NIPAs. In the first row of the table, the imports and exports of goods are
shown. The total of the debit and credit entries in this row is the
merchandise trade balance. If this number is more than zero, it means that munotes.in

Page 29

29 Balance of Payments - I exports are more than imports. This is called a surplus in the goods trade
balance. Both the current account and the capital account have other rows
with balances that are the same. A positive balance means that there is a
surplus, which means that a country is getting more money from
foreigners than it is giving to foreigners. The weights are
Table 3.1
Hypothetical Balance of Payments Accounts
(No Official Intervention) Debits Credits Col. 1 + Col. 2 Running Total of Col 3 (1) (2) (3) (4) Current Account 1 Merchandise Imports -300 Merchandise
Exports 200 Merchandise Trade Balance -100 Merchandise Trade Balance -100 2 Service Imports -60 Service
Exports 50 Balance on Services -10 Balance on Goods and Services (Trade Balance) -110 3 Payments on Foreign Investment in U.S. -70 Receipts on
U.S.
investment
Abroad 90 Balance on investment income (Net Factor income from Abroad) 20 Balance on goods, Services and Income -90 4 Unilateral Transfers -15 -15 Current Account -105 Capital Account 5 Change in private U.S assets abroad -20 Change in Private Foreign assets in U.S. 125 Private Capital Account 105 Official Settlements BOP 0 6 Change in U.S. official Assets 0 Change in Foreign official assets in U.S. 0 Official Capital Account Balance 0 Balance of Payments 0
When you add up the numbers on different lines, the totals get bigger and
bigger. For example, the total of all the debits and credits on lines 1
through 4 is the current account bal ance. According to the rules of double -
entry bookkeeping, every debit must be matched by a credit. So, the total
of all the debit and credit entries in all the rows of the table must equal
zero. This is called the "balance of payments." To have a zero bala nce of
payments, both the current account balance and the capital account
balance must be the same size but have the opposite sign. For example, a
$100 billion current account deficit means a $100 billion capital account
surplus. A current account deficit means that the United States is buying
more domestic goods and services than it is selling. A capital account
surplus means that the US sells more assets to other countries than it buys
from them. These assets could be in the US or in another country. If t he
United States buys more goods and services than it sells, it will have to
sell more assets than it buys to pay for those goods and services. A capital munotes.in

Page 30

30 International Finance
30 account surplus is another name for a net capital inflow. For the goods and
services that are being ma de right now to be paid for, there needs to be a
net inflow of capital. The capital account deficit is also called the net
foreign investment. The U.S. has a capital account deficit when it buys
more assets from other countries than it sells to them. This means that
other countries are giving the U.S. more net assets. Since the balance of
payments must be zero, the amount of net foreign investment must be
equal to the amount of the current account. In fact, the term "current
account" is only used in the BPA s, while the term "net foreign investment"
is used in the NIPAs. Except for small differences in how accounting is
done, these two things are the same.
BPAs, Exchange Rates and Official Intervention:
Let's say that people in one country always want to be p aid in their own
currency and don't have any foreign money. For example, when a U.S.
merchant buys German appliances, she must pay the German exporter
with Deutsche marks that she bought on the foreign exchange market. In
the same way, a German business th at wants to buy goods from the US
must buy dollars. If the US has a trade balance deficit with Germany, it
means that Americans want more Deutsche marks than Germans do. This
means that the United States has more money than Germany. When there
are more dol lars than marks, or when there are more dollars than marks,
the mark is usually more valuable than the dollar.
The U.S. government can support the dollar on the foreign exchange
market instead of letting its value fall. If the U.S. government has a lot of
Deutsche marks, it can sell them for dollars to make the demand and
supply of marks equal on the foreign exchange market. This makes sure
that the mark doesn't get stronger against the dollar. The U.S.
government's Deutsche marks are part of the government 's official assets.
If the government sold these marks, there would be a positive entry in
Table 1, Row 7, Column 1. The entry is good because when the United
States sells this asset, it gets money. Foreign currencies, gold, reserves at
the International M onetary Fund (IMF), and special drawing rights
(SDRs), a type of international reserve "currency" issued by the IMF, are
all part of the U.S. official reserve assets. These assets can help the dollar's
value in other countries. For example, if the U.S. gov ernment doesn't have
any Deutsche marks, it can use SDRs to buy them from the German
government and then sell them on the foreign exchange market to help
support the dollar. Because of this chain of events, the value of all official
U.S. assets also goes d own.
If the U.S. government doesn't get involved in the foreign exchange
market, the German government can step in to keep the Deutsche mark
from getting stronger. To do this, it can change dollars into marks. This
deal increases the German government's as sets in the U.S., so a positive
entry is made in Table 1, Row 7, Column 2. In reality, the German
government would probably use these dollars to buy U.S. government
debt, which makes up a big part of foreign official assets in the U.S. munotes.in

Page 31

31 Balance of Payments - I All of the numbers i n the last row of Table 1 are 0. This means that neither
the U.S. government nor the governments of other countries can change
the foreign exchange market. If the U.S. government and other
governments stay out of the foreign exchange market completely, the
exchange rate between the dollar and other currencies will change so that
the amount of each currency sold matches the amount that is bought. We
call this kind of deal a system with exchange rates that change over time.
Table 3.2 shows a set of imaginary balance of payments accounts that are
similar to those in Table 1, except that the government is now involved in
the foreign exchange market. (Is the US government trying to make the
dollar worth more or less? Are other governments trying to make the
dolla r worth more or less? If the government gets involved, the exchange
rate might stay the same. We call this kind of deal a system of fixed
exchange rates.
When exchange rates were fixed, the official settlements balance of
payments was the total positive ba lance up to row 6. Notice in Table 3.2
that the difference between the official settlements balance of payments
surplus and the official capital account deficit is exactly zero (row 7,
column 3). (row 6, column 4). This must be the case if the overall bala nce
of payments is to be 0. The official settlements balance of payments was a
way to figure out how much the government was involved in the foreign
exchange markets. The balance of payments of a country was in the black
when this number went up. (Remember that the overall balance of
payments must always equal zero by definition.) If a country's official
settlements balance of payments shows a surplus, does government
intervention in the exchange markets make the home currency worth more
or less?
All of the numbers in Row 7 are 0 when exchange rates change. (Look at
Table 3.1 again). This means that for official settlements, the balance of
payments is the same as zero. When fixed exchange rates were no longer
used, the government stopped putting out the offi cial settlements balance
of payments. Even though exchange rates are no longer set in stone,
governments still sometimes change how they move. So, the rates don't
just go up and down. Even though the official balance of payments for
settlements is no longe r reported, it can still be worked out from other
numbers that are. So, people still talk about surpluses or deficits in the
balance of payments (official settlements). As in a system with fixed
interest rates, these surpluses and deficits show how and whe re the
government is stepping into the foreign exchange markets.
Table 3 .3 shows the BPAs for the US in 1997. "Errors and omissions" is
the name of one more thing. This line shows that there is a difference
between the capital account and the current accou nt. The information the
government gets about the exchange of assets is used to measure the
capital account. The current account is made up of information sent to the
government about exports, imports, etc. If all transactions were reported in
full and cor rectly, the current account would be the same as the capital
account. Due to mistakes and omissions in reporting, the measured munotes.in

Page 32

32 International Finance
32 balance of the capital account does not exactly match the measured
balance of the current account. The errors and omissions entry is a small
amount that is left over after the two accounts have been balanced. Both
the current account and the capital account made a lot of mistakes and
missed things in some recent years.
Table 3.2
Hypothetical Balance of Payments Accounts
(Official In tervention) Debits Credits Col. 1 + Col. 2 Running Total of Col 3 (1) (2) (3) (4) Current Account 1 Merchandise Imports -300 Merchandise Exports 200 Merchandise Trade Balance -100 Merchandise Trade Balance -100 2 Service Imports -60 Service Exports 50 Balance on Services -10 Balance on Goods and Services (Trade Balance) -110 3 Payments on Foreign Investment in U.S. -70 Receipts on U.S. investment Abroad 90 Balance on investment income (Net Factor income from Abroad) 20 Balance on goods, Services and Income -90 4 Unilateral Transfers -15 -15 Current Account -105 Capital Account 5 Change in private U.S assets abroad -20 Change in Private Foreign assets in U.S. 140 Private Capital Account 120 Official Settlements BOP 15 6 Change in U.S. official Assets -10 Change in Foreign official assets in U.S. -5 Official Capital Account Balance -15 Balance of Payments 0
Table 3.3
Balance of Payments Accounts, 1997
(Billions of Dollars) Debits Credits Col. 1 + Col. 2 Running Total of Col 3 (1) (2) (3) (4) Current Account 1 Merchandise Imports -877 Merchandise Exports 679 Merchandise Trade Balance -198 Merchandise Trade Balance -198 2 Service Imports -171 Service Exports 258 Balance on Services 87 Balance on Goods and Services (Trade Balance) -110 munotes.in

Page 33

33 Balance of Payments - I 3 Payments on Foreign Investment in U.S. -247 Receipts on U.S. investment Abroad 242 Balance on investment income (Net Factor income from Abroad) -5 Balance on goods, Services and Income -116 4 Unilateral Transfers -40 -40 Current Account -155 5 Errors and Omissions -100 -255 Capital Account 6 Change in private U.S assets abroad -478 Change in Private Foreign assets in U.S. 717 Private Capital Account (Net Capital inflow) 239 Official Settlements BOP 15 7 Change in U.S. official Assets -1 Change in
Foreign
official
assets in
U.S. 16 Official Capital Account Balance 15 Balance of Payments 0
National Income and Product Accounts:
The circular flow diagram shows that the economy's output and income
are the same. So, we can measure total output by measur ing total
production or by measuring the total income of all factors of production.
When you add up all the things that are made, you get an idea of the
national product. When you add up all the income from all sources, you
get an idea of the national inco me.
People often separate the national product into different groups, which
they can do in two ways. Industry is one way to divide up the national
product. The type of spending, or what the product is used for, is another,
more common way to classify natio nal product. In a closed economy, the
national product can be used for consumption (C), investment (I), and
government purchases of goods and services (G). The well -known
national product identity is made in this way.
Y = C + I + G, (1)
where "national product" is often shortened to "Y." This identity says that
the total amount spent on goods for consumption, investment, and
government purchases must equal the total amount of goods and services
made by the economy.
To let the rest of the world into the e conomy, this identity needs to be
changed, and some new ideas need to be brought in. In an open economy,
some of the goods and services made in the country can be sold abroad, so
exports need to be added to the right side of the equation (1). Also, some
of the money spent on domestic consumption might be spent on goods
made outside of the country instead of those made there. The same is true
for investments made at home and purchases made by the government. So,
imports need to stop. This means that the nati onal product identity in an
open economy is: munotes.in

Page 34

34 International Finance
34 Y = C + I + G + NX (2)
Where NX stands NET Exports
Gross Domestic Product, Gross National Product, and Net National
Product are the main ways to talk about the national product. Each of these
explains what Y is in a different way. (Each one also has real and made -up
versions.)
Nominal Gross Domestic Product (GDP) is the current output of final
goods and services produced during a given time period by domestic
factors of production and valued at current market prices.
People who live in other countries own some factors of production that are
in the United States. The money they make from these factors is their
income. Some examples are the income from foreign -owned real estate
and factories in the U.S. and the i ncome from the work of foreign
residents who live in the U.S. and make money there. In the same way,
people from the U.S. can make money abroad by providing services of
capital or labour. Net Factor Income from Abroad is the difference
between the foreign income of U.S. residents and the foreign income of
U.S. residents (NFIA). Most of this money comes from the return on
capital, and only a small amount comes from work. For simplicity's sake,
we'll assume that all net factor income from overseas is a return to capital.
Nominal Gross National Product (GNP) is the current output of final
goods and services made during a certain time period by domestically
owned factors of production and valued at current market prices. What do
GNP and GDP have in common?
GNP = GDP + NFIA (3)
3.4 SUMMARY The balance of payment is a list of all the economic and monetary
transactions between all the units of a country and the rest of the world in
a given accounting year. The current account is a list of what goods,
services, a nd transfer payments were bought and sold. Both exporting and
importing goods are part of commodity trade. The capital account keeps
track of all the assets that are owned outside the country. Official reserve
transactions, or ORTs, are things that a count ry's monetary authority does
to change the country's official reserves. The National Income and Product
Accounts and the Balance of Payments Accounts are two different sets of
accounts that use different rules of accounting. People often separate the
natio nal product into different groups, which they can do in two ways.
Industry is one way to divide up the national product. Gross Domestic
Product, Gross National Product, and Net National Product are the main
ways to talk about the national product.
munotes.in

Page 35

35 Balance of Payments - I 3.5 QUE STIONS 1. Explain the concept of Balance of Payments.
2. Elaborate in detail the Current Account, Capital Account and Official
Reserve Transactions.
3. Outline the relationship between Balance of Payments and National
Income Accounts.

*****

munotes.in

Page 36

36 4
BALANCE OF PAYMENTS - II
Unit Structure
4.0 Objectives
4.1 Introduction
4.2 Approaches to Balance of Payments Adjustment
4.2.1 Elasticity Approaches
4.2.2 Monetary Approaches
4.2.3 Absorption Approaches
4.3 Portfolio -Balance Approaches
4.4 Summary
4.5 Questions
4.0 OBJECTIVES  To Study the various approaches of Balance of Payments
Adjustments.
 To know about Portfolio balance approach.
4.1 INTRODUCTION A method called "double -entry book keeping" is used to make a country's
balance of payments account. The same amount is recorded on both the
credit side and the debit side of each international transaction. Every deal
has two sides, so that's how it works. Say a country sends out goods worth
Rs. 100 crore.
This item will go on the credit side (+) of the merchandise account, since
it gives a country the right to get money from foreigners. But at the same
time, this amount is treated as a short -term capital debit ( -) because it
shows a short -term outflow of capital from the exporting country.
A typical busi ness's balance sheet has entries with credits on the right and
entries with debits on the left. But when figuring out the balance of
payments, credits go on the left and debits go on the right.
4.2 APPROACHES TO BALANCE OF PAYMENTS ADJUSTMENT 4.2.1 Elastic ity Approaches: Marshall -Lerner Condition:
The elasticity approach to BOP is linked to the Marshall -Lerner condition.
These two economists came up with this rule on their own. It looks at the
situations in which changes in exchange rates make a country's c urrency munotes.in

Page 37

37 Balance of Payments - II worth less and bring BOP back into balance. This method is about how a
currency's value going down affects prices.
Assumptions:
a. There is no change in the amount of exports.
b. Prices are set in the country's own currency.
c. The level of inc ome in the country that is devaluing is fixed.
d. There are a lot of imports. arc elasticities are the price elasticity of
demand for exports and imports.
f. Price Elasticities are about absolute values
g. There is no difference between the trade bala nce and the current
account balance.
Based on these ideas, when a country devalues its currency, the prices of
its imports in its own country go up and the prices of its exports in other
countries go down. So, when a country devalues its currency, it incre ases
exports and decreases imports. This makes the BOP deficit go down.
But how well it works will depend on how sensitive the country's demand
for imports and demand for exports are to changes in prices. The
Marshall -Lerner condition says that a country's balance of payments will
get better if the sum of the price elasticities of demand for exports and
imports is more than one. It looks like this:
ex + e m > 1
Where e x is the elasticity of the demand for exports and E m is the elasticity
of the demand for i mports. On the other hand, if the sum of the price
elasticities of demand for exports and imports in absolute terms is less
than one, e x + e m > 1, then devaluation will make the BOP worse (increase
the deficit). If the sum of these elasticities in absolute terms is one, e x + e m
= 1, devaluation has no effect on the BOP, which stays the same.
The following is the process through which the marshall -lerner condition
operates in removing BOP deficit of a devaluing country
When the value of a foreign currency go es down, export prices in the
home country go down. When prices are low, more goods are shipped
abroad. How much they go up depends on how flexible export demand is.
It also depends on the goods that are exported and how the market is
doing.
If the country is the only one that exports raw materials or goods that go
bad quickly, the demand for those exports won't change much. If it exports
machinery, tools, and industrial products in competition with other
countries, the elasticity of demand for its goods wi ll be high, and
devaluation will work to fix a deficit. munotes.in

Page 38

38 International Finance
38 Devaluation also makes imports more expensive in the country where they
are bought, so fewer goods will be brought in. How much the amount of
imports goes down depends on how elastic the demand for im ports is. In
turn, the demand elasticity of imports is affected by the types of goods that
the devaluing country brings in.
If it buys consumer goods, raw materials, and things that help industries
work, it will have a low elasticity of demand for imports. When the import
elasticity of demand for products is high, devaluing a currency can help
fix a deficit in the balance of payments.
So, devaluation will only help a country's balance of payments when the
sum of the elasticity of demand for exports and the elasticity of demand
for imports is more than one.
The J -Curve Effect :
The Marshall -Lerner condition is met in most developed countries, as
shown by facts from the real world. But economists agree that both
demand and supply will be more flexible in the lo ng run than in the short
run.
Consumers and businesses will need some time to get used to how
devaluation affects prices at home and the demand for exports and
imports. Both exports and imports have lower price elasticity of demand in
the short run, so the y don't meet the Marshall -Lerner condition.
So, to start, devaluation hurts the BOP in the short run but helps it in the
long run. This curve in time looks like a J. This is what economists call the
"J-curve effect" of devaluation. This is shown in Fig. 3, where time is on
the left and the difference between the deficit and the surplus is on the
right. Let's say devaluation takes place at time T.
At first, the curve J has a big loop that shows the BOP deficit goes up after
D. It doesn't start to go up and t he deficit starts to get smaller until time
T1. At time T2, BOP is in the black. From T2 to J, the surplus starts to
grow. If the Marshall -Lerner condition is not met, the J -curve will flatten
out from T2 to F over time if it is not met.

Figure 4.1: J -Curve munotes.in

Page 39

39 Balance of Payments - II But if the country's exchange rate is flexible, its currency losing value will
make bop worse. Because of devaluation, there is too much currency on
the foreign exchange market, which could keep the currency from getting
stronger. So, the foreign excha nge market becomes unstable, and in the
long run, the exchange rate may be higher than it should be.
Criticisms:
The Marshall -Lerner method for calculating elasticity based on conditions
has the following problems:
1. Misleading :
The Marshallian idea of el asticity is not the right way to solve the BOP
deficit with the elasticity approach. This is because it only applies to small
changes along a demand or supply curve and problems that happen when
these curves shift. Also, it assumes that the buying power of money stays
the same, which has nothing to do with the value of the country's currency
going down.
2. Partial Elasticities:
Alexander has criticised the elasticity approach because it uses partial
elasticities, which don't take into account anything but the relative prices
and amounts of exports and imports. This only works for trades with one
commodity, not trades with more than one. It means that we can't make
this plan work.
3. Supplies not perfectly Elastic
There aren't enough goods Exports and impor ts are perfectly elastic,
according to the Marshall -Lerner condition. But this is not likely to
happen because the country may not be able to increase the supply of its
exports when they become cheaper because the value of its currency has
gone down.
4. Pa rtial Equilibrium Analysis:
The elasticity method assumes that prices and incomes in the country that
is devaluing will stay the same. It also assumes that there is no limit to
how much more can be put into making things to sell abroad. This analysis
is a partial equilibrium analysis because it is based on these assumptions.
So, it doesn't take into account how changing the price of one product
affects incomes and, as a result, the demand for goods. This is a big
problem with the elasticity approach, since devaluation always has a big
effect on the whole economy.
5. Inflationary:
When a currency loses its value, it can cause prices to rise. Even if it
works to improve the balance of payments, it is likely to raise wages in
industries that compete with impor ts and exports. But the higher incomes
will have a direct effect on the bop by making more people want to buy munotes.in

Page 40

40 International Finance
40 imports. Indirectly, they will affect the bop by increasing overall demand,
which will cause prices to go up in the country.
6. Ignores Income Dis tribution:
The elasticity approach doesn't look at how devaluation affects how
income is shared. When the value of a currency drops, resources have to
be moved around. It takes resources from industries that don't export or
import goods and gives them to industries that do. This will probably
make the incomes of those in the second sector go up and those in the first
sector go down.
7. Applicable in the Long Run:
In the long run, it works. For the J -curve effect of devaluation, the
Marshall -Lerner conditi on works in the long run, but not in the short run.
This is because it takes time for consumers and businesses to adjust when
the value of the local currency goes down.
8. Ignores Capital Flows:
Either the current account or the balance of trade can use t his method. But
most of a country's BOP deficit comes from money leaving the country. It
doesn't take into account bop on capital account. The goal of devaluation
as a solution is to cut down on imports and the flow of money out of the
country while increa sing exports and the flow of money into the country.
Conclusion:
There has been a lot of talk about the Marshall -Lerner condition for
improvements in the balance of payments. Economists tried to figure out
how much demand could change in a country. Some ec onomists thought
that demand wasn't very flexible, while others thought it was.
So, the first group said that devaluation wasn't a good way to fix the
balance of payments, while the second group said that it was a good way
to do so. But it's hard to make a broad statement because each country's
foreign trade is different in terms of how much it is and how it is set up.
4.2.2 Monetary Approaches to Balance of Payment Adjustment:
The work of R. Mundell and H. Johnson on the monetary approach to the
balance of payments is well known. Some of the other people who have
written for it are R. Dornbusch, M. Mussa, D. Kemp, and J. Frankel. The
approach is based on the idea that the BOP disequilibrium is really a
problem with money. It looks at how much money is neede d and how
much is available to try to explain BOP deficits or surpluses.
Assumptions:
The main ideas behind this way of doing things are:
(i) After transport costs are taken into account, the same product in
different countries costs the same amount. munotes.in

Page 41

41 Balance of Payments - II (ii) Things outside of a country set the level of output in that country.
(iii) Every country is making the most of what it has.
(iv) A single price assumption means that in a system with fixed
exchange rates, there is no way to stop the flow of money.
(v) The rate of interest affects the demand for money in the opposite
way that income does.
(vi) The amount of money is decided by the high -powered money and
the money multiplier.
(vii) The demand for nominal money balances hasn't changed.
Based on the abov e assumptions, the monetary approach says that the
difference between the supply of money and the demand for money is
equal to the balance of payments deficit. People buy goods and securities
from other countries with the extra money they have.
In a system where exchange rates are fixed, the central bank can get rid of
the extra money by selling foreign exchange reserves and buying domestic
currency. The balance of payments gets back to normal when there is no
longer too much money on the market.
On the oth er hand, a country will have a surplus in its balance of payments
if it has more money than it needs. People try to get the local currency by
selling goods and securities to people from other countries. The central
bank will buy domestic securities and ext ra foreign currency to make up
for the lack of domestic currency. With these steps, the BOP surplus will
be gone and the BOP will be back in balance.
The following relationships show how money is used to look at BOP:
The supply of money (M s) is made up of the domestic part of the country's
monetary base (H) and the international or foreign part of the country's
monetary base (I) (F).
Ms = H + F
The demand for money (MD) is a stable, direct function of income, and
the rate of interest is an inverse function of MD. When the supply of
money and the demand for money are equal, the monetary equilibrium is
reached.
MS = M D
H + F = M D
F = M D - H
Based on this relationship, it is clear that when there is a BOP surplus, the
difference between how much money people wa nt and how much money
is available in the country is made up by a flow of reserves from abroad or munotes.in

Page 42

42 International Finance
42 the international monetary base. On the other hand, if there is a BOP
deficit, which means that there is more money in circulation than is
needed, the problem can be fixed by sending money out of the country.
The monetary approach also explains how, in a flexible exchange system,
BOP disequilibria are immediately fixed by automatic changes in the
exchange rate, without any money or reserves moving between count ries.
When there is more money in circulation than there is demand for it,
which causes a deficit in the BOP, the value of the country's currency
automatically goes down. Prices go up at home, and more people want
money because of it.
Because of this, the extra money is spent and the BOP deficit is fixed.
On the other hand, if there is a surplus in the BOP because there is more
demand for money than supply, the country's currency will automatically
go up. It causes prices to go down in the country. So, the BOP surplus and
the demand for too much money cancel each other out.
How money is handled in the BOP situation affects policy in important
ways. It means that policies like devaluation can only work in the short
term if the monetary authority doesn't incre ase the supply of money to
meet the rise in demand for money caused by devaluation or other
adjustment policies.
Criticism of the Monetary Approach:
The following are the criticism of the Monetary approach to BOP
Adjustment:
i) Stability of Money Demand F unctions:
The money demand function is assumed to be stable. This might be a good
idea in the long run. But most economists agree that money demand is an
unstable function in the short term.
ii) Assumption of Full Employment:
In this method, everyone is assumed to have a job. In the real world, this
idea is not true.
iii) Invalidity of Single Price:
The monetary approach to BOP adjustment is based on the idea that the
same products should have the same price. Even this thought is wrong.
When productive f actors are moved to sectors that make goods that aren't
traded, the high demand for goods that aren't traded can make the supply
of goods that are traded go down. That could lead to more imports. So, the
rule that all goods should have the same price has b een broken.
iv) Ignoring other factors that affect money demand:
In this method, the demand function for money is only linked to income
and interest rate. In fact, the money demand function is linked to a number munotes.in

Page 43

43 Balance of Payments - II of other variables that have to do with bo th the economy at home and trade
and exchange with other countries.
v) Possibility of Currency Sterilization:
Critics haven't agreed that it's true that currency can't be changed into
something else in a system with fixed exchange rates. They have talked
about situations in which money might not be useful. They think that the
currency flow can be stopped if the private sector is willing to change how
its wealth portfolio is made up in terms of how important bonds and
money balances are.
Currency flow can a lso be stopped if the government is willing to have
bigger budget deficits whenever the country has a BOP deficit.
vi) Market Imperfections:
Flaws in the market break the rule that identical products should have the
same price. There are differences in pri ces between countries that trade
with each other because the markets aren't perfect and because both
domestic and international trade are limited or regulated by the
government.
vii) Ignoring money lags:
The best way to deal with long -term changes in the balance of payments is
with money. Most of the time, this method doesn't take into account the
long time it takes for the final BOP adjustment to be made after the
problem of BOP deficit is recognised.
viii) Ignoring Other Economic Strategies:
In this met hod, the main focus is on how credit flows change over time.
Balance of Payments (BOP) equilibrium can also be reached by switching
between different kinds of spending. This can be done through changes in
the government budget and domestic flows of goods a nd money.
Even though it has problems, D. Hume's traditional price -specie flow
theory is worse than the monetary approach. In that theory, there was a lot
of focus on how the flow of gold changed the BOP and how that changed
prices, international trade, an d payments. The modern monetary approach,
on the other hand, says that BOP deficits or surpluses can be fixed by
changing the domestic and international monetary base and looking at how
those changes affect production, income, and spending.
4.2.3 Absorptio n Approaches:
The absorption approach to the balance of payments looks at the world as
a whole and is based on Keynesian national income relationships. It is also
called the Keynesian approach because of this. It talks about how
devaluation affects prices differently than it does income. The elasticity
approach is also talked about. munotes.in

Page 44

44 International Finance
44 The theory says that if a country's balance of payments has a deficit, it
means that people are "absorbing" more than they are making. The
country's income is less than what it costs to live and invest at home. If
there is a surplus on the balance of payments, it means that the country is
getting less money. The country's income is less than what it spends on
spending and investing. In this case, the BOP is the difference between a
country's income and how much it spends on its own economy.
This idea came from Sydney Alexander. Here's how to put the analysis
into words:
Y = C + Id + G + X -M … (1)
where Y is the country's income, C is what it spends on consumption, I is
its total domestic investment, G is what it spends on its own government,
X is what it exports, and M is what it imports.
The total absorption (A) is equal to the sum of (C + Id + G), and the
balance of payments (B) is equal to (X – M). So, the first equation
becom es
Y = A + B
or
B = Y -A.. (2)
This means that the BOP on current account is the difference between the
country's national income (Y) and how much it spends (A). BOP can be
improved by either making more money at home or using less of it.
Alexander says that the best way to do this is through devaluation, because
it works in both directions. First, a devalued currency makes the country
more money because it increases exports and decreases imports.
The extra money will bring in even more money because of the "multiplier
effect." This will cause more money to be spent in the country. So, the
difference between the total increase in income and the increase in
absorption caused by the increase in income is the net effect of the
increase in national income on the balance of payments.
It looks like this:
DB = DY -DA. (3)
The total absorption (DA) in a devaluation depends on how likely the last
person to absorb is. People say this is a. Devaluation also has a direct
effect on absorption through the change in in come, which is written as D.
So, DA is a DY + DD... (4)
If we plug equation (4) into equation (3),
we get DB = DY -aDY -DD or DB = (1 -a) DY -DD. (5) munotes.in

Page 45

45 Balance of Payments - II The equation shows that there are three reasons why BOP is affected by
devaluation. They are the marginal propensity to absorb (a), the change in
income (DY), and the change in direct absorption (iii) (DD). Since the
marginal tendency to absorb is an, the marginal tendency to save or hoard
is (1 -a). In turn, the number of unemployed or idle resources and the
number of fully used resources in the devaluing country affect these
factors.
Effects of Devaluation on BOP:
1. MP to Absorb:
To absorb the MP, it takes less than one (a1), and if the country has
resources that aren't being used, devaluing the currency wil l make exports
go up and imports go down. The balance of payments (BOP) will improve
because output and income will go up. If, on the other hand, is more than
1, then BOP will be hurt by devaluation.
It means that people are spending more money on things t hey want and
investing more money. In other words, they spend more than the country
makes. In this case, devaluing the currency won't make exports go up or
imports go down, and the BOP situation will get worse.
If there is full employment and is greater th an 1, the government will have
to cut spending and devalue the currency so that the economy's resources
can be redistributed to increase exports and decrease imports. Things will
get better in BOP in the end.
2. Income Effects:
Now let's look at how deval uation affects income. If a country has
resources that aren't being used, devaluing its currency will help it sell
more things abroad and buy fewer things from other countries. When
exporting and importing industries grow, income goes up. Through the
"mult iplier effect," the extra money that goes into the economy will bring
in even more money.
Because of this, things will get better in BOP. If the economy has used up
all of its resources, the BOP can't be fixed by devaluing the currency
because the national income can't go up. Instead, prices might go up,
which would decrease exports and increase imports. This would make the
BOP situation worse.
3. Terms of Trade Effect:
Changes in the terms of trade also have an effect on the national income
because of deva luation. When the exchange rate goes down, the terms of
trade get worse, and the national income goes down. In general,
devaluation makes the terms of trade worse because the country that
devalues has to sell more goods to buy the same amount of goods as
before. So, the trade balance gets worse and the national income drops. munotes.in

Page 46

46 International Finance
46 If prices stay the same in the currency of the buyer (the other country), the
terms of trade get better because exports go up and imports go down.
When a country's currency loses value, the country that buys imports from
that country pays more for its increased exports than it makes from its own
imports. So, the country's trade balance improves and its national income
goes up.
4. Direct Absorption:
There are a number of ways in which de valuation affects direct absorption.
If the country that is devaluing has resources that are not being used,
exports will go up and imports will go down. This is called an
expansionary process. Both income and use will go up because of this.
BOP will get w orse if the rise in income is more than the rise in
absorption. In general, when a country has a lot of idle resources,
devaluation has little effect on direct absorption.
If the economy has full employment and a BOP deficit, lowering the value
of the curr ency won't raise the national income. So cutting down on direct
absorption can help improve BOP. Devaluation can cause domestic
consumption to drop on its own because of the real cash balance effect, the
money illusion, and the redistribution of income.
5. Real Cash Balance Effect:
When the value of a country's currency goes down, prices go up in that
country. If the amount of money stays the same, the cash people have will
be worth less. People start putting away more money so they can get more.
This can only be done if they spend less or get less money. This is what
happens to the real cash balance when a currency loses value.
When people's real cash balances go down, they sell their assets because
the value of their assets has gone down. This causes the prices of assets to
fall and interest rates to rise. Since the amount of money stays the same,
this means that people will invest and spend less. Because of this, less
absorption will happen. When the value of a currency goes down, this is
what happens to the real cash balance.
6. Money Illusion Effect:
Money illusion also makes it less likely that direct absorption will happen.
Prices go up when the value of a currency goes down. People think that
their real incomes have gone down when prices go up, even though their
money incomes have gone up. They think they have more money than
they really do, which makes them cut back on spending on things they
want or need.
7. Redistribution of Income:
Direct absorption falls automatically if devaluation redistribut es income in
favour of people with a high marginal propensity to save and against
people with a high marginal propensity to spend. If workers are more munotes.in

Page 47

47 Balance of Payments - II likely to buy things on a whim than people who make money, absorption
will go down.
Also, when the value of money goes down, people with lower incomes
make more money, so they move into the income tax bracket. When they
have to pay income tax, they spend less than people with higher incomes
who are already paying it. In the first case, this means that the bod y can't
take in as much.
When the value of a currency goes down, there is also a redistribution of
income among the industries that make things. When prices go up more
than production costs, businesses make more money than when production
costs go up more than prices. So, devaluation will cause money to move
from the second and third sectors to the first.
Devaluation will also change how sectors that make and sell traded goods
and sectors that don't will share their income. The prices of goods that are
traded go up more than the prices of goods that aren't traded. Because of
this, producers and traders make more money, and workers who make
goods that are traded get paid more than those who make goods that aren't
traded.
8. Expenditure :
Reducing Policies: Dir ect absorption is also lower when the government
uses policies that reduce spending and cause deflation. They will make
sure that the BOP deficit is cut by devaluation. But people will lose their
jobs because of them.
Its Criticisms:
The following things have been said against the BOP deficit absorption
method:
1. Doesn't Take into Account the Effects on Prices: This method
doesn't take into account the very important effects of devaluation on
prices.
2. Hard to calculate: From an analytical point of vie w, it seems to be
better than the elasticity approach, but it can't be used to figure out
how likely people are to spend, save, or invest.
3. Doesn't think about how it will affect other countries : The
absorption approach is weak because it depends too mu ch on policies
that are meant to change how much a country absorbs. It doesn't look
at how a drop in the value of a country's currency affects how well it
can take in people from other countries.
4. Doesn't Work in a System with a Fixed Exchange Rate: The
absorption method of fixing the BOP deficit doesn't work in a system
with a fixed exchange rate. People spend less on things they want to
buy when prices go up because their money is worth less. If the
amount of money stays the same and the interest rate goes up, both munotes.in

Page 48

48 International Finance
48 output and absorption will go down. So, devaluation won't change the
BOP deficit very much.
5. Pay more attention to spending: With this method, the level of
domestic consumption is more important than how prices compare to
one another. Just because domestic consumption is cut to lower
absorption doesn't mean that the extra resources will be used to fix the
BOP deficit.
4.3 PORTFOLIO -BALANCE APPROACHES The main problem with the Keynesian approach to the demand for money
is that it says people should hold all of their liquid assets in either money
or bonds at any given time, not a little bit of each. This is not true in the
real world.
Tobin's model of liquidity preference solves this problem by showing that
if the return on bonds is uncertain, which means that bonds are risky, then
an investor who is worried about both risk and return is likely to do best
by holding both bonds and money.
In portfolio theories like the one put forward by Tobin, the role of money
as a store of value is emphasised . These ideas say that people keep money
as one of their assets. This is because other assets, like bonds, which are
less liquid than money, have a different mix of risk and return than money.
To be more specific, money gives a safe (nominal) return, while stocks
and bonds can go up or down in value. So, Tobin has said that people's
best portfolio should include money.
Portfolio theories say that the demand for money depends on the risk and
return of holding money, as well as the different things that peopl e can
hold instead of money. Also, the amount of real wealth a person has
should affect how much of their portfolio should be money and how much
should be other assets.
For instance, the money demand function can be written as:
(M/P) d = f(r s, rb, πe, W)
where rs = the expected real return on stock, rb = the expected real return
on bonds, πe = the expected inflation rate and W= real wealth. An increase
in rs or rb reduces money demand, because other assets become more
attractive. An increase in ne also reduces money demand, because money
becomes less attractive. An increase in W raises money demand, because
higher wealth means a larger portfolio.
Speculative Demand for Money as behaviour toward Risk:
Tobin didn't think about how transactions affec t how much money people
want to buy. Instead, he only thought about how important it was to have
money as a way to store wealth. With the wealth constraint (W = M + B),
where W is the person's total fixed wealth, M is money, and B is a bond, munotes.in

Page 49

49 Balance of Payments - II the focus is o n how a person's portfolio is split between holding money
and holding bonds.
Keynes thought that interest rates would always go back to a normal level,
but Tobin's theory says that this is not true. We can assume that there will
be no expected capital gain based on what Tobin says. This is because
each individual investor thinks it is just as likely to make money or lose
money on their investments.
The best way to figure out how much bonds will earn is to look at the
market interest rate at the time (r). Bu t this is exactly what people expect
to get back from bonds. Since interest rates don't usually stay the same, the
actual return also includes any capital gain or loss.
So, bonds should pay interest, but they are a risky way to make money.
Even in the shor t term, the market rate of interest changes, so they don't
know what their actual return will be.
On the other hand, money is a safe asset because it doesn't give you
anything back. Money is a safe asset because it doesn't go up or down in
value. Tobin thi nks that a person will keep some of their money in cash to
make their portfolio less risky as a whole.
If an investor only bought bonds, they would get the highest returns, but
they would also take on the most risk. If you don't like taking risks, you
migh t give up some return for less risk. Tobin says that people don't want
to take risks, so they want money as an asset.
The way Tobin's theory works is shown in Figure. On the vertical axis of
the top quadrant, we measure the expected return of the portfolio , and on
the horizontal axis, we measure how risky the portfolio is. The expected
return on the portfolio is the interest that can be made on bonds.

Figure 4.2 munotes.in

Page 50

50 International Finance
50 This will depend on the interest rate and how many bonds are in the
portfolio. The total risk a person faces depends on two things: I how
uncertain bond prices are, which means how uncertain people are about
how the market rate of interest will change in the future, and (ii) how
much of their portfolio is in bonds.
Write down R for the expected total return and a t for the total risk of the
portfolio. If a person keeps all of his wealth (W) in cash and none in bonds
(W = M + 0), R and t will both be zero, as shown by the origin (point 0).
W = M + B, R and a will both go up as M goes down and B goes up if the
number of bonds goes up.
The opportunity line C is made up of a series of points that show how a
single investor can raise R by making t bigg er. Moving along C from left
to right shows that an investor can only get more bonds by getting less
money.
In the lower part, the different ways that R and t can be combined based
on how the portfolio is divided are shown. The number of bonds held is
show n on the vertical axis. As the investor moves down the vertical axis,
the number of bonds (B) held in W goes up, up to a maximum of W.
The difference between W and B is the amount of money that people want
(M). In the bottom part of the picture, the line O B shows how a and B are
connected. As the amount of B in W goes up, so does the value of t. This
means that as the number of bonds in the portfolio goes up, so does the
total risk of the portfolio.
Preference of the Investor: Risk Aversion
How a portfolio should be split up depends on what the investor wants.
Here, we assume the investor doesn't like taking risks. He wants a high
return on his portfolio while avoiding risk. If he thinks his expected return
will go up, he will take on more risk. Let's say th at the investor's utility
function is U = f(R, t)...(9), where utility (U) goes up when R goes up and
down when T goes up. The investor's three indifference curves for U 1, U2,
and U 3 levels of utility are shown. Each indifference curve shows the
trade -off between risk and return, or when an investor is willing to take on
more risk in exchange for a higher expected return.
Every point on this kind of indifference curve has the same fixed level of
utility.
Any change from U 1 to U 2 and from U 2 to U 3 means a hi gher level of
utility, which means higher levels of R and the same or lower levels of t.
Investors don't like taking risks, so the indifference curves go up. He won't
take on more risk unless it will make him more money. Also, as the
investor moves to the right, the curves get steeper, showing that they are
less willing to take risks. munotes.in

Page 51

51 Balance of Payments - II If we assume this, then the more risk a person has already taken, the
bigger the increase in expected return will have to be for the investor to
take on more risk. We can now figure out how a portfolio should be split
up for an investor who doesn't like taking risks.
Optimal Portfolio Allocation:
A person who doesn't like to take risks will move along line C until he
gets to the point where he can reach the highest indifference curve. At that
point, he chooses the portfolio he had planned to choose, which means he
got the most out of his money. It's obvious why. At the tangency point E,
where R = R* and t = *t, the terms under which the investor can increase
the expected return on the portfolio by taking more risk are the same as the
terms under which he or she is willing to make the trade -off. The slope of
the indifference curve shows this.
From the bottom, we can see that we can get this risk -reward combination
by holding B* wo rth of bonds and the rest of our wealth (W - B* = M*) in
the form of money.
So, the investor's demand for money shows his or her "behaviour toward
risk," which is the result of trying to lower risk below what it would be if
W = B and M = 0. Point F in the upper part of Figure shows that a
portfolio of only bonds would have a risk of t and an expected return of R.
This portfolio isn't as good as having B* bonds and M* money.
The reason is that as an investor moves to the right of point E along line
0C, the e xtra return expected from the portfolio by holding more bonds
(and less money) is not enough to make up for the extra risk (the slope of
the line 0C is less than that of the indifference curve U2). The indifference
curve goes down to U1 when the investor m oves to point F.
Interest Rate Changes and the Speculative Demand for Money:
The amount of money held as an asset, according to Tobin's theory,
depends on how high the interest rate is. Figure shows how the interest
rate is related to how much money asset s want. If the interest rate goes
from r 0 to r 1 and then to r 2, it will be easier to take on more risk and
increase the expected return on the portfolio.
So the line 0C has a steeper slope. In a counter clockwise direction, it goes
from C(r 0) to C(r 1) and then to C. (r 2). munotes.in

Page 52

52 International Finance
52

Figure 4.3
The investor then moves from E to F and then to G, where he or she takes
on more risk and hopes to make more money. It's important to remember
that each point is a part of making a portfolio as good as it can be. In this
case, the number of risky bonds he owns goes up (from B 0 to B 1 and then
to B 2), but the amount of money he has goes down (from M 0 to M 1, then
M2).
In short, the expected return on a portfolio will go up even more as the
interest rate goes up and the risk goes up. Risk goes up when the number
of bonds in the portfolio goes up.
Comments:
Like Keynes's theory, Tobin's says that the interest rate moves in the
opposite direction of the speculative demand for money. This is because
when the interest rate goes up, so does the payoff for taking on more risk.
When the interest rate goes up, an investor wants to put more of his money
into bonds, which are riskier than m oney, and less into money, which is
safer.
The portfolio theories can be made easier to understand by using the
money demand function (M/P)d = f(Y, I). First, it replaces wealth W with
real income Y. Second, it only includes the nominal interest rate as a
return variable, which is the sum of the real return on bonds and expected
inflation (I = rb + e). The portfolio theories say that the expected return on
other assets should also be a part of the demand function for money.
Is studying how much money people want a good way to use portfolio
theories? The answer depends on how much money is involved. If we look munotes.in

Page 53

53 Balance of Payments - II at any narrow money (M 1), we should think of it as a dominated asset,
which means that there are always better ways to store value than it. So,
Mankiw says, "People shouldn't hold money in their portfolios, and
portfolio theories can't explain why people want these dominated forms of
money."
Also, portfolio theories are more likely to work as theories of money
demand if we have a general idea of what mon ey is. Even though the
portfolio approach to money demand might not work for M 1 demand, it
can explain M 2 and M 3 demand in a clear way.
Tax Rates and Portfolio Choice:
When an investment pays off, most of the money goes to the government
in the form of ta xes. Different assets are taxed in different ways, so it's
clear that taxes are an important part of picking a portfolio. After all, smart
investors care more about how much they make after taxes than how much
they make before taxes.
Government bonds are a good example of this. With the same level of risk
and liquidity, these bonds don't pay as much as corporate bonds
(debentures). Still, people buy government bonds because they usually
don't have to pay taxes on their income or capital gains. The investor' s
income goes up because he saves more on taxes when the tax rate is high.
Investors with higher incomes want these tax -free bonds more, which
drives up their price and lowers the return they get on them. We expect the
return to go down until the after -tax return for people with high incomes is
only a little bit higher than what they would get from an ordinary taxable
bond with the same risk.
Loss Offset and the Return on Risk:
No financial investment gives a guaranteed rate of return, and buying
equity sh ares is a risk. There is no safe way to make money. In other
words, making an investment is like taking a risk, and investors should
only be interested in the risk if the value of likely gains is higher than the
value of likely losses.
Since an investor's marginal utility of money income goes down, a fair
bet, in which the odds of winning or losing are the same, may not always
be a good idea. People will be less likely to invest if taxing investment
income makes the odds worse by lowering the expected retur n. But this
kind of tax might not always improve the odds. If the investor wins, his
money will make less money for him.
But if he can get a loss offset, his loss will be less if he loses. Both are just
as likely to happen if there is a proportional tax. C hances of making
money and chances of losing money will both go down by the same
amount. Depending on the situation, an investor may take more risks or
less risks because of the tax. munotes.in

Page 54

54 International Finance
54 In the figure, where the rate of return is on the vertical axis and the r isk is
on the horizontal axis, there is a chance that people will take more risks.
Let's say, for the sake of simplicity, that the investor has to choose
between holding cash, which is completely safe, and one other option, like
a corporate bond, which has some risk.
The opportunity line 0A shows how he can mix cash and bonds to get
different levels of risk and return. If he keeps all of his money in cash, he
won't take any risks and won't get anything back. If all of his money is in
bonds, he will go from point A to point B, where the risk is 0C and the
return is 0D.
Before taxes, the investor is at point E1, where his opportunity line 0A is
just touching the highest possible indifference curve U2. The value of his
risk is 0F, and the value of his return is 0G. Here, the indifference curve is
used to show how people are becoming less willing to take risks.

Figure 4.4
If the investor wants to keep the sa me amount of money, the rate of return
has to go up as the risk goes up. This is because the implicit assumption is
that as income goes up, the income schedule becomes less and less useful.
Now, there is a 50% tax, and we'll assume that the full loss offse t is
allowed. If the investor doesn't change the way his portfolio is made up, he
will have half as much risk and half as much return as he did before. This
is like what portfolio mix H would give him before taxes.
Since he could have done better by going from point H to the tangency
point before the tax, he will now choose to go from point E 1 to point K.
Gross risk and return have both doubled at K, but net risk and return are
still the same as they were at U 2, before taxes. He still takes risks in his
personal life, that's for sure. But people are taking more risks, which is bad munotes.in

Page 55

55 Balance of Payments - II for the economy as a whole. Because now the government is helping them.
It's now willing to take half the return and half the risk. Only if loss offset
is allowed could this happen .
Without loss offset, the tax would move the opportunity line from 0A to
0A', and the new equilibrium would be at a tangency point E 2, with risk
taking going down to 0L.
When certain things are true, a tax with a loss offset will encourage people
to take more risks. You don't have to choose between cash, which is
thought to be risk -free, and one risky asset. Because of inflation, it is risky
to hold cash, and there are other assets that are also risky.
Then, the result will depend on how the preferences or indifference curves
of the investor are set up. People could end up taking more risks or less
risks depending on what happens. You can't easily guess what will
happen.
4.4 SUMMARY The balance of payment is a list of all the economic and monetary
transacti ons between all the units of a country and the rest of the world in
a given accounting year. The elasticity approach to BOP is linked to the
Marshall -Lerner condition. The work of R. Mundell and H. Johnson on the
monetary approach to the balance of payment s is well known. Some of the
other people who have written for it are R. Dornbusch, M. Mussa, D.
Kemp, and J. Frankel. The absorption approach to the balance of payments
looks at the world as a whole and is based on Keynesian national income
relationships. In portfolio theories like the one put forward by Tobin, the
role of money as a store of value is emphasised.
4.5 QUESTIONS 1. Elaborate the elasticity approaches to Balance of Payments
Adjustment.
2. Outline the monetary approaches to Balance of Paymen ts Adjustment.
3. Explain the absorption approaches to Balance of Payments
Adjustment.
4. Describe the Portfolio -Balance Approaches.

*****
munotes.in

Page 56

56 5
INTERNATIONAL INVESTMENT AND
FINANCING - I
Unit Structure
5.0 Objectives
5.1 Introduction
5.2 Cash Management: Investment and Borrowing Criterion with
Transaction Costs
5.2.1 Concept of Cash Management:
5.2.2 Objectives of Cash Management
5.2.3 Problems in Cash Management
5.2.4 Investment Criterion with Transaction Costs
5.2.5 Borrowing Criterion with Transaction Costs
5.3 International Dimensions of Cash Management
5.3.1 Advantages of Centralized Cash Management
5.3.2 Disadvantages of Cent ralized Cash Management
5.4 Portifolio Investment: International Capital Asset Pricing
5.4.1 Introduction
5.4.2 The Benefits of International Portfolio Investment
5.4.3 International Capital Asset Pricing
5.4.4 The International Capital Asset Pricing Mode l, ICAPM
5.5 Settlement of International Portfolio Investment
5.6 Summary
5.7 Questions
5.8 References
5.0 OBJECTIVES  To know the Cash management and investment and borrowing
criterion with transaction costs.
 To know about the dimensions of cash mana gement.
 To know about International Capital Asset pricing and International
Portfolio investment.
5.1 INTRODUCTION If we have a look at any individual factor which is mainly responsible for
the amazing rapid globalization of the world economy then we can s ay
that beyond doubt that it is international investment in its various forms.
This can be shown by the following example, the global flow of foreign
direct investment FDI, which involves overseas managerial control by way munotes.in

Page 57

57 International Investment and Financing - I of ownership, rose from $180 bill ion in 1991 to an approximate figure of
$1.5 trillion in 2000, showing an eight -fold increase over a decade.
This chapter deals with short -term investments, here we discuss the norms
for making short -term covered investments when there is a transaction
cost in the foreign exchange markets. As short -term investments
represents a vital aspect of cash management, this chapter focuses on
short -term borrowing decisions and various other aspects of working
capital management with reference to multinational compan ies.
This chapter also throws light on the portfolio investment, it takes into
consideration international features of stock and bond investment
decisions, focussing closely on the benefits of international portfolio
diversification. It highlights the imp ortance of international diversification
over domestic diversification, despite the risk factor relating to exchange
rates prevailing in international portfolio investment. A unit is included on
the international capital asset pricing model which is used t o compare the
consequences of internationally segmented versus integrated capital
markets. Chapter ends with a discussion of bond investments, again with a
focus on diversification issues.
5.2 CASH MANAGEMENT: INVESTMENT AND BORROWING CRITERION WITH TRANSA CTION
COSTS 5.2.1 Concept of Cash Management :
Both the inflows and outflows of funds are generally unpredictable,
especially for large multinational companies with sales and production
activities throughout the world. It is therefore imperative for compani es to
maintain liquidity. The amount of liquidity and the form it should take is
covered under the topic of working -cash (or working -capital)
management. Liquidity can take a number of forms, including bank
deposits, coin and currency, overdraft facilities , and short -term readily
marketable securities. These involve different degrees of opportunity cost
in terms of earnings options abandoned available on less liquid
investments. However, there are such highly liquid short -term securities in
cultured money m arkets that practically no funds have to remain
completely idle. In some locations there are investments with maturities
that extend no further than ‘‘overnight,’’ and there are overdraft facilities
which allow firms to hold minimal cash balances. This mak es part of the
cash management problem comparable to the problem of where to borrow
and invest.
5.2.2 Objectives of Cash Management :
The objectives of operative working -capital management in a global
environment are: munotes.in

Page 58

58 International Finance
58 1. To distribute short -term investments an d cash -balance holdings
between currencies and countries to maximize overall corporate
returns.
2. To borrow from different money markets in order to achieve the
minimum cost.
However, maintenance of required liquidity level and minimization of
risks is cruci al while meeting these objectives.
5.2.3 Problems in Cash Management:
The main issue of having large number of currency and country
alternatives for investing and borrowing, which is the extra dimension of
international finance, is also faced by companies which deal only in
resident markets. For instance, if a company that manufactures and does
marketing or sells only in the United States of America will still have a
motivation to earn the highest yield, or borrow at the lowest cost, even if
that means ente ring into foreign money markets.
There are extra complications faced by companies that have a
multinational location of manufacture and sales. These comprise of the
queries of local versus head -office management of working capital, and
how to curtail fore ign exchange transaction costs, political risks, and
taxes.
Cash management by considering whether a company should invest or
borrow in domestic versus foreign currency, where any foreign exchange
exposure and risk is hedged by using forward exchange cont racts.
After debating on the investment and borrowing standards we turn to
whether a company with receipts and payments in different nations and
currencies should manage working capital locally or centrally. We shall
see that there are a number of merits to centralization of cash
management, and only a few drawbacks.
5.2.4 Investment Criterion with Transaction Costs:
An investment in pound -denominated securities by a holder of US dollars
requires first a purchase of spot pounds. The pounds must be bought a t the
pound offer or ask rate, S($/ask£), so that $1 will buy
£

This initial investment will grow in n years at the investment return of rI £
£
(1+rI
£) n munotes.in

Page 59

59 International Investment and Financing - I This can be sold forward at the buying or bid rate on pounds, F n($/bid£),
giving a US investor, after n years,
$
(1+rI
£) n
The amount received from $1 invested instead in US dollar -denominated
securities for n years at an annual rate rI
$ is $(1+ rI
$) n. Therefore, the rule
for US dollars holder is to invest in poun d securities when
(1+rI
£) n > (1+rI
$) n……. (1)
and to invest in dollar securities when the reverse inequality holds.
If we had ignored foreign exchange transaction costs, then instead of the
condition (1) we would have written the criterion f or investing in pound
securities as
(1+rI
£) n > (1+rI
$) n……. (2)
In comparing the conditions (1) and (2) we can see that because
transaction costs ensure that F n ($/bid£) < F n ($/£) and S($/ask£)>S($/£),
where F n($/£) and S($/£) are the middl e exchange rates (i.e. the rates half
way between the bid and ask rates), the condition for advantageous hedged
investment in pound securities by a dollar -holding investor is made less
likely by the presence of transaction costs on foreign exchange. That i s,
the left -hand side of (1), which includes transaction costs, is smaller than
the left -hand side of (2), which excludes transaction costs. However,
because both interest rates are investment rates, transaction costs on
securities represented by a borrowi ng–lending spread have no bearing on
the decision, and do not discourage foreign versus domestic -currency
investment. For example, suppose we have S($/bid£) S($/ask£) F1/2($/bid£) F1/2($/ask£) rI$ rI£ 1.5800 1.5850 1.5600 1.5670 7% 10%
where rI
$ and rI
£ are respectively the dollar and pound interest rates on 6 -
month securities, expressed on a full year, or per annum, basis. Then,
earnings from the dollar investment at the end of the 6 months on each
dollar originally invested are
$ (1 + rI
$) n = (1.07) ½ = $ 1.03441
If the investor does not bother to calculate the receipts from the pound
security using the correct side of the spot and forward quotations, but
instead uses the midpoint values half way between ‘‘bids’’ and ‘‘asks,’’ munotes.in

Page 60

60 International Finance
60 that is, S ($/£) = 1.582 5 and F 1/2($/£) =1.5635, then receipts from the
hedged pound security are
$
(1+rI
£)1/2 = $
(1.10)1/2 = $1.03622
This amount surpasses the $1.03441 from the dollar denominated security,
making the pound security the preferr ed choice. However, if the correct
exchange rates are used, highlighting the fact that hedged investment in
pound -denominated securities require buying pounds spot at the ask price
and selling pounds forward at the bid price, then the earnings from the
pound security are calculated as
$
(1+rI
£)1/2 = $
(1.10)1/2 = $1.03227
The dollar -denominated security with receipts of $1.03441/$ invested is
seen to be better than the pound -denominated security for a dollar -holding
investo r. That is, the right choice is the dollar security, a choice that would
not be made without using the exchange rates which shows the transaction
costs of buying and selling pounds. The example confirms that inclusion
of transaction costs on foreign exchan ge tends to favour the choice of
domestic -currency investments.
5.2.5 Borrowing Criterion with Transaction Costs :
When a borrower contemplates using a swap to raise US dollars by
borrowing pounds, the borrowed pounds must be sold at the pound selling
rate, S($/bid£). For each dollar ($1) the dollar borrower wants he or she
must therefore borrow
£

The repayment on this number of borrowed pounds after n years at rB
£ per
annum is
£
(1+ rB
£) n
This number of pounds can be bought forw ard at the buying rate for
pounds, F n($/ask£), so that the number of dollars paid in n years for
borrowing $1 today is
$
(1+ rB
£) n munotes.in

Page 61

61 International Investment and Financing - I Alternatively, if $1 is borrowed for n years in US dollars at rB
$ per annum,
the repayment in n years is
$(1+ rB
$) n
The borrowing standard that allows for foreign exchange transaction costs
is that a borrower should obtain dollars by borrowing hedged British
pounds (i.e. via a swap) whenever
(1+ rB
£) n < (1+ rB
$) n ……. (3)
Because F n($/ask£) > F n ($/£) and S($/bid£) < S ($/£), the condition (3) is
more unlikely than the condition without transaction costs on foreign
exchange, which is simply
(1+ rB
£) n < (1+ rB
$) n……. (4)
where S ($/£) and Fn ($/£) are mid -points between ‘‘bid’’ and ‘ ‘risk’’
exchange rates.
For example, suppose a borrower who needs US dollars for 6 months
faces the following : S($/bid£) S($/ask£) F1/2($/bid£) F1/2($/ask£) rB$ rB£ 1.5800 1.5850 1.5500 1.5570 8% 12%
where rB
$ and rB
£ are respectively the per annum 6 -month borrowing rates
in dollars and pounds. The dollar repayment after 6 months from dollar
borrowing is
$(1 + rB
$)1/2 = $ (1.08)1/2 = $ 1.03923
If the borrower did not bother to calculate the cost of a ‘‘swap out’’ of
pounds using the correct bid or ask exchange rates but instead used mid -
point rates, the repayment per dollar borrowed would be computed from
the left -hand side of equation (4) as
$
(1+ rB
£) n = $
(1.12)1/2 = $1.03891
The borrower’s choice would be the poun d-denominated loan because it
needs a smaller repayment. However, if the borrower selected the proper
bid and ask rates as in the left -hand side of equation (3), the repayment on
the swap would be munotes.in

Page 62

62 International Finance
62 $
(1+ rB
£) n = $
(1.12)1/2 = $1.04289
This is larger than the repayment from borrowing dollars. We find that the
impetus to endeavour into foreign -currency denominated borrowing is
reduced by the consideration of foreign exchange transaction costs, just as
is the incentive to invest in foreign currency.
Unlike the situation with investment, where borrowing –lending spreads
are immaterial, in the case of borrowing, foreign -currency borrowing may
be made more difficult by borrowing –lending spreads. This is because
when foreign funds are ra ised overseas, lenders may charge foreign
debtors more than they charge domestic debtors because they consider
loans to foreigners to be riskier. For example, the mark -up over the prime
interest rate for dollars facing a US borrower in the United States mi ght be
smaller than the mark -up over prime for the same US borrower when
raising pounds in Britain. This may be due to greater trouble in
aggregation on loans to foreigners, or to the difficulty of transferring
credible information on creditworthiness of b orrowers between countries.
However, if the pounds can be raised in form of capital or borrowed in the
United States, there should be no difference between dollar –pound
investment spreads and borrowing spreads.
Companies invest and borrow cash because some times they have net cash
inflows and at other times, they have net cash outflows. While the
investing and borrowing measures that we have given provide a way of
choosing between alternatives, they do not provide direction on some of
the complexities of mul tinational cash management. For example, how
should a company respond when one subsidiary company has excess
amounts of a currency, while another subsidiary company which operates
independently needs to borrow the same currency? Should a company
hedge all its foreign -currency investments and/or borrowing when it deals
in large number of different foreign currencies and thereby enjoys some
natural diversification? Good cash management in these and other
conditions requires some centralization of financial ma nagement and
perhaps also centralize holding of the funds themselves. As we shall see
later, concentration has several merits but also some demerit when the
holdings of funds, as well as management decisions concerning the funds,
are centralized.
5.3 INTER NATIONAL DIMENSIONS OF CASH MANAGEMENT 5.3.1 Advantages of centralized cash management :
1. Netting :
Many multinational companies have their offices across the globe, and
each office has its own debtors and creditors, they also have their other
sources of c ash inflows and outflows, which are denominated in a number munotes.in

Page 63

63 International Investment and Financing - I of different currencies. However, if the offices are allowed to manage their
own working capital, it may so happen, say for example that one office is
hedging a long pound position while at the sa me time another office is
hedging as short pound position of the same maturity. Netting helps in
avoiding this situation as it calculates the overall position in each
currency. However, to do this calculation, a proper co -ordination of the
cash management is a must.
Reduced transaction cost is the main benefit enjoyed by the companies
deploy centralized cash management in order to manage their net cash
inflows and outflows. The amount of savings is reflected by the fact that
how different offices deal in th e same currency and have an opposite
position in these currencies. The benefit of netting also depends on the
length of the time frame over which it is feasible to engage in netting,
which ultimately depends on the ability to practice leading and lagging.
Leading and lagging involve the movement of cash inflows and outflows
forward and backward in time so as to permit netting and achieve other
goals? For example, if Raymond has to pay £1 million for wool on
December 31 and has received an order for £1 mill ion of blazer from
Britain, it might try to organize payment for about the same date and
thereby avoid exposure. Now if the bill for the wool is cleared before its
due date that is December 31 and the receivable amount is carried forward
then this is calle d leading of the export. If the payment for the wool would
have been before December 31 and is overdue, then this is called lagging
of the export. On similar lines, it is also possible to lead and lag payments
which are made for imports.
When dealing in t he nearby areas the scope of netting via leading and
lagging are limited by the likings of the other party. However, when
transactions are between offices of the same multinational corporation, the
opportunity for leading and lagging (for the purpose of ne tting and
achieving other benefits such as deferring taxes by delaying receipts) is
considerable. Recognizing this, governments generally, regulate the credit
period and quickening of settlement by putting limits on leading and
lagging. The regulations dif fer greatly from country to country, and are
subject to change, often with very little warning. If cash managers are to
employ leading and lagging successfully and not find themselves in
trouble with tax authorities, they must keep current with what is all owed.
2. Currency diversification :
When cash management is unified it is possible not only to net inflows
and outflows in each separate currency, but also to reflect whether the
company’s foreign exchange risk is adequately reduced via natural
diversificat ion that the company need not hedge all the individual
positions.
The variation of exchange -rate risk results from the fact that exchange
rates do not all move in congruence. Consequently, a portfolio of inflows
and outflows in different currencies will ha ve a smaller variance of value
than the sum of variances of the values of the individual currencies. We munotes.in

Page 64

64 International Finance
64 can explain the nature of the divergence benefit by considering a
straightforward example.
Suppose that in its foreign operations, Reliance buys its clo th in Britain
and sells its finished garments in both Britain and Germany in the
following amounts: Germany (€) Britain (£) Denim purchase Jeans sales 0 1,500,000 2,000,000 1,000,000
The payments for British denim are made at the time of sales of jeans .
(Alternatively, we could think of the revenue from the export of jeans as
receipts from foreign investments, and the payment for imports of cloth as
repayment of a debt.)
One route open to Reliance is to sell forward the €1.5 million it is to
receive and , after netting its pound position, buy forward £1 million.
Reliance would then be hedged against changes in both exchange rates
versus the dollar. An alternative, however, is to consider how the British
pound and the euro move vis -a`-vis the dollar and he nce between
themselves. Let us suppose for the purpose of revealing the possibilities,
that when the euro appreciates vis -a`-vis the dollar, generally the pound
does so as well. In other words, let us assume that the euro and pound are
highly positively co rrelated. Such a correlation will occur if the source of
exchange -rate movements stems from economic developments in the
United States. For example, good news concerning the US currency such
as a reduced current account deficit would likely increase the va lue of the
dollar against both the euro and the pound.
With net pound payables of £1 million, euro receivables of €1.5 million,
and spot exchange rates of, for example, S ($/€) = 1.2 and S($/£) = 1.8, the
payables and receivables cancel out: the payable to Britain is £1 million x
$1.8/£ = $1.8 million at the c urrent rate, and the receivable from Germany
is €1.5 million x $1.2/€ = $1.8 million. The risk is that exchange rates can
change before payments are made and receipts are received. However, if
the pound and the euro move together and the US dollar depreci ates
against both of the currencies by, for example, 10 percent to S($/€) = 1.32
and S($/£) = 1.98, then payments to Britain will be £1 million x $1.98/£ =
$1,980,000, and receipts from Germany will be €1.5 million x $1.32/€ =
$1,980,000, which is still the same. The amount that is lost through extra
dollar payments to Britain will be offset by extra dollar revenue from
Germany. We find in this case that Aviva is quite naturally unexposed if it
can be sure that the currencies will always move together vis -a`-vis the
dollar.
In our example, we have, of course, selected very special circumstances
and values for convenience. In general, however, there is safety in large
numbers. If there are debtors in many different currencies, then when
some may go up in va lue terms, while the others may come down. There munotes.in

Page 65

65 International Investment and Financing - I will be some cancelling of gains and losses. Similarly, if there are many
payables, they can also neutralize. Moreover, as in our example,
receivables and payables can offset each other if currency values mo ve
together. There are many possibilities that are not obvious, but it should be
remembered that although some cancelling of gains and losses might
occur, some risk will remain. A firm should use forward contracts or some
other form of hedging if it wishes to avoid all foreign exchange risk and
exposure. However, a firm with a large variety of small volumes of
payables and receivables (i.e. small volumes in many different currencies)
might consider that all the transaction costs involved in the alternative
forms of hedging are not worthwhile in view of the natural hedging from
diversification. The determination of whether the diversification has
sufficiently reduced the risk can only be made properly when cash
management is centralized.
3. Pooling :
The conce pt of pooling is witnessed when cash is held as well as managed
in a central location. The main advantage of pooling is that higher returns
can be enjoyed due to economies of scale in returns offered on investment
vehicles such as bank deposits. At the sam e time, cash needs can be met
wherever they occur out of the centralized pool without having to keep
precautionary balances in each country. Delays and uncertainties in
movement of funds to where they are needed require that some balances
be maintained eve rywhere, but with pooling, a given probability of having
sufficient cash to meet liquidity needs can be achieved with smaller cash
holdings than if holdings are decentralized. The reason pooling works is
that cash surpluses and shortages in different locat ions do not move in a
perfectly similar fashion. As a result, the discrepancy of total cash flows is
smaller than the sum of the discrepancies of flows for individual countries.
For example, when there are large cash -balance outflows in Britain, it is
does not imply that there will also be unusually large outflows in
Australia, Japan, Sweden, Kuwait, and so on. If a firm is to have adequate
amounts in each country, it must maintain a large cash reserve in each.
However, if the total cash needs are shared i n, for example, the United
States, then when the need in Britain is unusually high, it can be met from
the central pool because there will not normally be remarkably high drains
in other countries at the same time.
4. Security availability and efficiency o f collections :
All of the merits of centralized cash management that we have mentioned
so far, which are all particular characteristics of economies of scale, would
increase wherever centralization occurs. However, if the centralization
happens in a major international financial centre like London or New
York, there are additional benefits in terms of a broader range of securities
that are available and an ability to function in an effective financial
system.
It is useful for a firm to designate as many pay ments and incomes as its
counter parties will allow in units of a main currency and to have bills munotes.in

Page 66

66 International Finance
66 payable in a financial centre. Contracts for payment due to the firm should
specify not only the payment date and the currency in which payment is to
be made, but it should also specify the details of branch or office at which
the payment is due. In order to ensure timely payments, penalties for late
payments can be imposed. To accelerate the speed of payment collection
post-office box numbers can be used where ver they are available.
Similarly, if a firm bank with a large -scale multinational bank, it can
usually arrange for head -office accounts to be quickly credited using an
electronic funds transfer system, even if payment is done at a foreign
branch of the ba nk.
5.3.2 Disadvantages of centralized cash management:
Practically, it is virtually impossible to hold all cash in a major
international financial centre. This is because there may be unforeseen
delays in moving funds from the financial centre to other co untries.
Important payments like payment to a foreign government for taxes or to a
local supplier of a crucial input, excess cash balances should be held
where they are needed, even if this means sacrificing opportunity in terms
of higher interest earnings available elsewhere. When the cash needs in
local currencies are known well in advance, beforehand arrangements can
be made for receiving the needed currency, but large allowances for
potential delay should be made. When one is used to dealing in USA,
Europe, and other developed areas, it is too easy to believe that banking is
effective across the globe, but the delays that can be faced in banks in
some nations can be exceptionally long, uncertain, and expensive.
In principle it is possible to centralize t he management of working capital
even if some funds do have to be held locally. However, comprehensive
centralization of management is tough because local representation is
often essential for dealing with local clients and banks. Even if a
international b ank is used for accepting revenues and making payments,
problems can arise that can only be dealt with on the spot. Therefore, the
question a firm must answer is the degree of centralization of cash
management and of cash holding that is appropriate, and i n particular,
which activities and currencies should be decentralized.
Check Progress :
1. What are the objectives of international cash management?
------------------------------------------------------------------------------------------
---------------- --------------------------------------------------------------------------
------------------------------------------------------------------------------------------
2. What is meant by ‘‘netting?’’
--------------------------------------------------------- ---------------------------------
------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
munotes.in

Page 67

67 International Investment and Financing - I 3. What is meant by ‘‘leading’’ and ‘‘l agging?’’
------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
------------------------------------------------------------------ ------------------------
4. What do you understand by ‘‘pooling’’?
------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
-------- ----------------------------------------------------------------------------------
5. How does liquidity preference affect international cash management
decisions?
------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
5.4 PORTIFOLIO INVESTMENT: INTERNATIONAL CAPITAL ASSET PRICING 5.4.1 Introdu ction :
The world as a whole has benefitted from global investment via a better
allocation of financial resources, and a smoother capital or consumptive
stream from lending and borrowing. Individual investors gain in these
same ways from engaging in global investment and thereby achieving a
more efficient portfolio. Stated in the local language of finance, diversified
global investment offers investors higher expected returns and/or reduced
risks vis -a`-vis exclusively domestic investment. This chapter empha ses
on the sources and sizes of these gains from venturing abroad for portfolio
investment, which is investment in equities and bonds where the investor’s
holding is too small to provide any effective control.
5.4.2 The Benefits of International Portfolio Investment :
Spreading risk: correlations between national asset markets :
Because of risk aversion, investors demand higher expected return for
taking on investments with greater risk. It is a well -established proposal in
portfolio theory that whenever ther e is imperfect correlation between
different assets’ returns, risk is reduced by maintaining only a part of
wealth in any individual asset. More generally, by choosing an investment
portfolio according to anticipated returns, variances of returns, and
correlations between returns, an investor can achieve minimum risk for a
given expected investment portfolio return, or maximum expected return
for a given risk. Furthermore, all things being equal, the lower are the
correlations between returns on different a ssets, the greater are the benefits
of portfolio diversification.
Within an economy there is some degree of individuality of asset returns,
and this provides some diversification openings for investors who do not munotes.in

Page 68

68 International Finance
68 venture abroad. However, there is a tendenc y for the various segments of
an economy to feel mutually the impact of overall domestic activity, and
for asset returns to respond jointly to projections for domestic activity, and
risks about these prospects. This restricts the independence of individual
security returns, and therefore also restricts the gains to be made from
diversification within only one nation.
Because of different industrial structures in different countries, and
because different economies do not trace out exactly the same business
cycles, there are reasons for smaller correlations of expected returns
between investments in different nations than between investments within
any one nation. This means that international investments offer
diversification benefits that cannot be enjoyed by investing only in the
domestic nation and means, for example, that a US investor might include
British stocks in a portfolio even if they offer inferior expected returns
than US stocks, the benefit of lowering the risk might more than
compensate for inf erior expected returns.
5.4.3 International Capital Asset Pricing :
The central international financial concern relating to the pricing of assets,
and hence their expected rates of return, is whether they are determined in
an integrated, global capital mark et or in local, segmented markets. If
assets are valued in an internationally combined capital market, expected
yields on assets will be in accordance with the risks of the assets when
they are held in an effective, globally diversified portfolio, such as the
world -market portfolio. This means that while in such a situation it is
better to diversify globally than not to, the expected yields on assets will
just compensate for their systematic risk when this is measured with
respect to the globally differenti ated world portfolio. That is, with globally
integrated capital markets the expected returns on foreign stocks will be
appropriate for the risk of these stocks in a globally diversified portfolio.
There will be no ‘‘free lunches’’ from global stocks due to higher
expected returns for their risk. On the other hand, if assets are valued in
segmented or domestic capital markets, their returns will be in accordance
with the systematic risk of their domestic market. This means that if an
investor happens to have an ability to avoid whatever it is that causes
markets to be segmented, this investor will be able to enjoy special
benefits from global diversification. It is consequently significant for us to
consider whether assets are priced in globally integrated or in segmented
capital markets. However, before doing this it is useful to appraise the
theory of asset pricing in a national context, because if we do not
understand the issues in the simpler national context, we cannot
understand the global dimensions of asset pricing.
5.4.4 The international capital asset pricing model, ICAPM :
If assets are valued in globally unified capital markets, expected yields are
given by
rj* = rf + βw (r*
w - rf) …………. ……… (1) munotes.in

Page 69

69 International Investment and Financing - I Where,
βw = Cov (r j, rw) / Var (r w) …………. (2)
and where r* w = ‘‘world market’’ expected return. However, it is not easy
in practice to apply the international CAPM, or ICAPM, because this
need, being able to define a world ri sk-free interest rate, making
assumptions about likings of investors from different nations who face
different real earnings according to the basket of goods they purchase, and
dealing with other problems.
If the international CAPM as summarized in equatio ns (1) and (2) is valid,
then investors do not receive abnormal returns from investing in foreign
assets; returns appropriately compensate for the systematic risk of assets in
a globally diversified portfolio. On the other hand, if assets are priced in
segmented capital markets, then if an investor or firm could overcome the
cause of the market segmentation, perhaps by getting around capital flow
regulations, such an investor could enjoy abnormal returns. (Later we shall
explain that US multinational corpor ations appear to be in this situation,
investing where ordinary US investors cannot.)
5.5 SETTLEMENT OF INTERNATIONAL PORTFOLIO INVESTMENT When an investor buys a stock or bond in a foreign market the settlement
and exchange of assets occurs in more than one regulatory atmosphere.
The procedure of such multi -nation exchange and settlement is handled by
global custodians. Services like holding of securities and making
payments are provided by the custodians. For additional fees, they also
provide services l ike handling foreign exchange dealings, handling of
proxies, collection of dividends, giving relevant corporate information to
the asset owners and making arrangement for reclaiming of withholding
taxes. While some countries such as the US and Canada have so integrated
their settlement procedures that the border does not represent much of a
blockade, in situations where language and regulatory differences exist
settlement can be complex or complicated. For example, changes or
fluctuations in exchange rates as well as asset prices make the timing of
transactions related to settlement tremendously important. All in all, by
overcoming the complexities custodians help in integrating the markets.
However, they have clearly not yet made markets a unified whole, or we
would not observe so much evidence supporting market separation.
5.6 SUMMARY 1. If different countries’ economic performances are not perfectly
synchronized, or if there are other differences between nations such as
in the types of industries they have, t here are benefits from
international diversification of portfolios beyond those from
diversification within a single country. Therefore, investments in
foreign nations might be made even if they offered inferior expected munotes.in

Page 70

70 International Finance
70 returns than some domestic investme nts; the diversification benefits
might more than compensate for lower expected returns.
2. It has been proved beyond that large gains can be earned through
international diversification of the portfolio due to considerable
independence between different nati ons and stock returns. Globally
diversified portfolio does indeed prove to have lower volatility than
portfolios of domestic stocks of the same size.
3. There is very low or no co -relation between the stocks of the
companies in the same industry but in different nations. This points
out to the fact that there is a low correlation but the stock market
indexes which is mainly due to distinctive economic cond itions and
not because indexes of different nations’ markets have different
industrial compositions.
4. If assets are valued in globally unified capital markets, their returns
are appropriate for their risk when combined with the world -market
portfolio. Then, by not diversifying globally, an investor is taking
more risk than is necessary for a given expected return, or lower
expected return than is necessary for a given risk.
5. Global custodians play a major role in handling of the exchange and
settlement of for eign securities. In this way they play a major role in
integrating the capital markets globally.
5.7 QUESTIONS 1. Define Cash Management and Investment Criterion with Transaction
Costs.
2. Explain Borrowing Criterion with Transaction Costs.
3. Explain International dimensions of cash management.
4. How can ‘‘pooling’’ provide benefits for international cash
management?
5. How does liquidity preference affect international cash management
decisions?
6. What types of investments are included in ‘‘international portfolio
invest ment?’’
7. Write note on international capital asset pricing model to an
explanation of the pricing of securities.
8. What does a global custodian do?
5.8 REFERENCES  Book “International Finance” written by Maurice D. Levi
***** munotes.in

Page 71

71 6
INTERNATIONAL INVESTMENT AND
FINANCING - II
Unit Structure
6.0 Objectives
6.1 Introduction
6.2 Capital Budgeting for Foreign Investment
6.2.1 Selecting Projects
6.2.2 Cash Flows: Home versus Foreign Prospective
6.2.3 Discount Rates: Corporative versu s Shareholder perspectives
6.3 Growth and Concerns about Multinationals
6.3.1 Introduction
6.3.2 Reasons for the Growth of MNCs
6.3.3 Problems and Benefits from the Growth of MNCs
6.4 International Financing
6.4.1 Equity Financing
6.4.2 Bond Financing
6.4.3 Bank Financing
6.5 Summary
6.6 Questions
6.7 Reference
6.0 OBJECTIVES  To know the Capital Budgeting for Foreign Investment.
 To know the Growth of Multinationals
 To know about the International Financing
6.1 INTRODUCTION This Chapter considers a c apital -budgeting framework that management
can employ when deciding whether or not to make FDIs. We shall see that
a number of difficulties are faced in assessing foreign investments that are
not present when assessing domestic investments. These extra dif ficulties
include the existence of exchange -rate and country risks, the need to
consider taxes abroad as well as at home, the issue of which country’s cost
of capital to use as a discount rate, the problem posed by restrictions on
repatriating income, and the frequent need to account for subsidized
financing. The ways of dealing with these challenges are explained by an
extensive example. munotes.in

Page 72

72 International Finance
72 Chapter includes an appendix in which various topics in taxation are
covered, some of which are relevant for the capital -budgeting procedure
used for evaluating foreign direct investments. The appendix offers a
general overview of taxation in the international context, covering such
topics as value -added tax – which is assuming increasing international
importance – tax-reducing organizational structures, and withholding tax.
It is through foreign direct investment that some companies have grown
into the huge multi -national corporations (MNCs) whose names have
entered every major language – Sony, IBM, Shell, Ford, Nestle,
Mitsubishi, Citibank, and so on. Chapter studies various reasons for the
growth in relative importance of MNCs, as well as the reasons for
international business associations that have resulted in transnational
alliances. The chapter also takes into account s ome special difficulties
faced by multinational corporations and international alliances, including
the need to set transfer prices of goods and services moving between
divisions and the need to measure and study country risk. The problems in
obtaining and using transfer prices are described, as are some methods of
measuring national risk. A clarity is given regarding the differences
between national risk and two narrower concepts, political risk and
sovereign risk. The ways of reducing or removing country risk are
described. Chapter concludes with an account of the challenges and
benefits that have accompanied the growth of multinational corporations
and international alliances. This involves a discussion of the power of
these huge organizations to irritate the economic policies of host
governments, and of the transfer of technology and jobs that results from
foreign direct investment. The final chapter deals with project financing.
The problems addressed include the nation of equity issue, foreign bonds
versus Eurobonds, government lending, bank loans and matters that relate
to financial structure. Overall, we shall see that there are important matters
which are unique to the international arena, whether the issue concerns the
uses or the sources of funds. W e shall also see that considerable progress
has been made in understanding many of the more challenging
multinational matters.
6.2 CAPITAL BUDGETING FOR FOREIGN INVESTMENT 6.2.1 Selecting Projects :
The massive multinational corporations (MNCs), whose names are
household words around the globe and which have power that is the envy
and fear of many governments, grew large by making foreign direct
investment (FDI). A standard used for making these investments will be
shown in this chapter as we develop the pri nciple of capital budgeting that
can be used in assessing foreign projects.
A typical foreign direct investment is the building of a plant to
manufacture a company’s products for sale in overseas markets. The
choice of building a plant is one of several al ternative ways of selling the
company’s products in a foreign country. Other options include exporting munotes.in

Page 73

73 International Investment and Financing - II from domestic facilities, licensing a producer in the foreign market to
manufacture the good, and producing the good in a facility outside the
intended m arket which the firm already operates.
Project assessments, generally referred to as capital budgeting. However,
in the international arena, capital budgeting involves multifaceted
problems that are not shared in a domestic context. These include, for
exam ple, the amount of debt versus equity used in the company financing,
the dependence of cash flows on capital structure, because of cheap loans
from foreign governments. This brings about a difference in the cost of
capital to the corporation as compared to the opportunity cost of capital of
shareholders, where the latter is the correct discount rate. There are also
exchange -rate risks, national risks, multiple tiers system of taxation, and
sometimes restrictions on sending income back to home country. We wi ll
show the conditions under which some of the more complicated problems
in the evaluation of overseas direct investments can be reduced to
controllable size.
There are numerous approaches to capital budgeting for traditional
domestic investments, includin g net present value (NPV), adjusted present
value (APV), internal rate of return, and payback period. We shall use the
APV technique, which has been characterized as a ‘‘divide and conquer’’
approach because it tackles each difficulty as it occurs. The adj usted
present value approach involves accounting separately for the
complexities found in foreign investments as a result of such factors as
subsidized loans and restrictions on repatriating income. Before we show
how the difficulties can be handled, we sh all enumerate the difficulties
themselves. Our clarifications will show why the APV approach has been
proposed for the assessment of overseas projects, rather than the
traditional NPV approach which is generally the preferred choice in
evaluating domestic projects.
Difficulties in Evaluating Foreign Projects :
Introductory finance textbooks tend to advise the use of the NPV
technique for capital budgeting decisions. The NPV is defined as follows

Where,
K0 = project cost
CF*
t = expected before -tax cash flo w in year t
t = tax rate
= weighted average cost of capital munotes.in

Page 74

74 International Finance
74 T = life of the project
The weighted average cost of capital,
is in turn defined as follows :
=

+
r (1+t)
Where,
= equilibrium cost of equity reflecting only the systematic risk
r = before -tax cost of debt
E = total market value of equity
D = total market value of debt
t = tax rate
We see that the cost of equity and the cost of debt is weighted by the
relative importance of equity and debt as sources of capital, and that an
additional adjustment is made to the cost of debt i.e., interest which is due
to the fact that interest payments are generally a deductible expense when
determining corporate taxes. The adjustment of (1 -t) gives the effective
cost of debt after the fraction t of interest payments has been saved from
taxes. While not generally acknowledged, this NPV approach has enjoyed
a prominent place in finance textbooks.
There are two thoughts of reasons why it is difficult to apply the
traditional NPV technique to overseas projects and why an alternative
framework such as the adjusted -present -value technique is preferred by
many managers. The first thought of reasons involves the problems which
cause cash flows the numerators in the NPV calculation to be seen from
two different perspectives that of the investor’s home country and that of
the country in which the project is placed. The right perspective is that of
the investor’s home nation, which w e assume to be the same for all
company shareholders.
The second category of reasons involves the degree of risk of foreign
projects and the appropriate discount rate the denominator of the NPV
calculation. We shall begin by looking at why cash flows diffe r between
the investor’s perspective and the perspective of the foreign country in
which the project is located.
6.2.2 Cash Flows: Home versus Foreign Prospective :
Blocked funds :
If funds that have been blocked or otherwise restricted can be utilized in a
foreign investment, the effective project cost to the investor may be below
the local project construction cost. From the investor’s perspective there is
a profit from activated funds equal to the difference between the face
value of those funds liberated by pursuing the project, and the present
value of the funds if the next best thing is done with them. This profit munotes.in

Page 75

75 International Investment and Financing - II should be deducted from the capital cost of the project to find the effective
cost from the investor’s perspective. For example, if the next b est thing
that can be done is to leave blocked funds idle abroad, the full value of the
activated funds should be deducted from the project cost. Alternatively, if
half of the blocked funds can be returned to the investor after the investor
pays taxes, or if the blocked funds earn half of a fair market interest rate,
then 50% of the value of the blocked funds should be subtracted from the
capital cost of the project.
Effects on sales of other divisions :
From the perspective of the foreign manager of an over seas project, the
total cash flows generated by the investment would appear to be relevant.
However, factories are frequently built in countries in which sales have
previously taken place with goods produced in other facilities owned and
operated by the sa me parent company. When the MNC exports to the
country of the new project from the home country or some other pre -
existing facility, only the increment in the MNC’s corporate income due to
the investment is relevant. This means deducting from the new proje ct’s
cash flow, the income lost from other projects due to the new project. It
should be noted that it may not be necessary to deduct all losses of cash
flows from other facilities because sales in the foreign market will
sometimes decline or be lost in th e absence of the new project, and this is
why the investment is being made. For example, the foreign investment
may be to pre -empt another company entering the foreign market. What
we must do is net out whatever income would have otherwise been earned
by the MNC without the new project.
Remittance restrictions :
When there are limitations on the sending back home of newly generated
income earned on a foreign project the amount that can be remitted to the
parent investor’s country only those cash flows that a re remittable to the
parent company are important from the MNC’s viewpoint. This is true
irrespective of the fact whether or not the income is actually remitted.
When remittances are legally limited by the foreign government,
sometimes the restrictions can be circumvented to an extent by using
charges for parent company overhead and so on. If we include only the
income which is remittable via legal and open channels, we will obtain a
conservative estimate of the project’s value. If this is positive, there i s no
need for any more addition. If it is negative, we can add income that is
remittable via illegal transfers, for example. The ability to perform this
two-step procedure is a major advantage of the APV approach. As we
shall see, a two -step process can al so be applied to taxes.
Different levels of taxation :
International taxation is an extremely complicated topic that is best treated
separately,
as it is in Appendix A. However, for the purpose of assessing foreign
direct investment, what matters is the tot al taxes paid, and not which munotes.in

Page 76

76 International Finance
76 government collects them, the form of taxes collected, the expenditures
allowed against taxes, and so on. The important point is that for a US -
based multinational, when the US corporate tax rate is above the foreign
rate, the e ffective tax rate will be the US rate if full credit is given for
foreign taxes paid. For example, if the foreign project is located in
Singapore and the local tax rate for foreign -based corporations is 22
percent while the US corporate tax rate is 40 perc ent, then after the credit
for foreign taxes paid is applied, only 18 percent will be payable in the
United States. If, however, the project is located in Japan and faces a tax
rate of 42 percent, full credit will not be available, and the effective tax
rate will be 42 percent. This means that when we deal with foreign
projects from the investor’s point of view, we should use a tax rate, t,
which is the higher of the home -country and foreign rates.
Taking t as the higher of the tax rates at home and abroad is a conservative
approach. In reality, taxes are often reduced to a level below t through the
judicious choice of transfer prices, through royalty payments, and so on.
These methods can be used to move income from high -tax nations to low -
tax nations and t hereby reduce overall corporate taxes. In addition, the
payment of taxes can be deferred by leaving remittable income abroad,
and so if cash flows are measured as all remittable income whether or not
remitted, some modification is required since the actual amount of taxes
paid will be less than the cash -flow term indicates. The modification can
be made to the cost of capital or included as an extra term in an APV
calculation.
6.2.3 Discount Rates: Corporative versus Shareholder perspectives :
While governmen ts occasionally offer special financial terms and other
kinds of aid for certain domestic projects, it is very common for foreign
investors to receive some sort of assistance. This may come in the form of
reduced -cost land, lower interest rates on debt, an d so on. Reduced -cost
land can be reflected in project costs, but cheaper financing is more
problematic in the NPV approach. However, with the APV method we can
add an additional term to the calculation to reflect the value of the debt
subsidy. As we shall see, the benefit of the APV approach is due to the
fact that cheaper loans are available to the corporation but not to the
shareholders of the corporation. Cheaper financing also makes the
appropriate cost of capital for foreign investment projects differ from that
for domestic projects, which is what happens in segmented capital
markets.
6.3 GROWTH AND CONCERNS ABOUT MULTINATIONALS 6.3.1 Introduction :
Regardless of where you live, chances are you have come across the
names of numerous multinational corpor ations (MNCs) such as those
listed in Table 1. These huge organizations, which measure sales by the
tens of billions of dollars and employment by the tens or even hundreds of munotes.in

Page 77

77 International Investment and Financing - II thousands, have assessed expected cash flows and risks and decided that
foreign d irect investment (FDI) is useful. But what makes likely cash
flows and risks what they are? Furthermore, can anything be done to
influence them? For example, can transfer prices of goods and services
moving within an MNC be used to decrease taxes or otherw ise increase
net cash flows from a given scheme? Can financial structure the
combination between debt and equity for financing actions be used to
reduce political risk? Definitely, can an MNC correctly calculate the cash
flows and political risks of foreig n investments? Furthermore, do the
matters relating to MNCs apply also to members of multinational alliances
firms in different nations working in cooperation or are transnational
alliances a means of avoiding problems faced by MNCs? These questions,
which are vital to the emergence and management of MNCs and
multinational alliances, are addressed in this chapter. Besides this, we look
at the difficulties and advantages that have accompanied the growth of
multinational and transnational forms of corporate o rganization.
Table 6.1
The 50 largest non -financial MNCs, ranked by total assets, 2022 Rank Corporation Home Country Industry Total assets (billion $) Total sales (billion $) Total Employment 1. Volkswagen Germany Consumer
Durables 638.26 295.73 672,789 2. Saudi Arabian Oil Company (Saudi Aramco) Saudi Arabia Oil & Gas Operations 576.07 400.38 68,493 3. Toyota Motor Japan Consumer Durables 552.46 281.75 366,283 4. AT&T Unites States Telecommunications 551.62 163.03 203,000 5. Amazon United States Retail and Wholesale 420.55 469.82 1,608,000 6. SoftBank Japan Telecommunications 418.94 96.86 58,786 7. Royal Dutch/Shell United Kingdom Petroleum 404.38 261.76 82,000 8. Petro China China Oil & Gas Operations 392.6 380.31 476,223 9. Apple United States Semiconductor, Electronics, Electrical Engineering, Technology Hardware & Equipment 381.19 378.7 154,000 10. Verizon Communications United States Telecommunications Services, Cable Supplier 366.6 134.35 105,376 11. Gazprom Russia Oil & Gas Operations 360.47 117.3 477,600 12. Alphabet United States IT Software & Services 359.27 257.49 156,500 munotes.in

Page 78

78 International Finance
78 13. Samsung South Korea Semiconductors, Electronics, Electrical Engineering, Technology Hardware & Equipment 358.88 244.16 113,485 14. Deutsche Telekom Germany Telecommunications Services 340.56 128.59 216,528 15. Microsoft United States Services IT, Internet, Software & Services 340.39 184.9 182,268 16. Exxon Mobil United States Oil & Gas Operations 338.92 280.51 63,000 17. Mercedes-Benz Germany Consumer Durables 295.48 178.94 172,425 18. Group
Total France Oil & Gas Operations 293.46 185.12 101,309 19. Sinopec China Oil & Gas Operations 292.05 384.82 385,691 20. BP United
Kingdom Oil & Gas Operations 287.27 158.01 65,900 21. China Mobile
Hong
Kong Telecommunication Services 283.37 131.49 449,934 22. BMW Gr oup Germany Automotive (Automotive and Suppliers) 277.28 131.48 118,909 23. Alibaba
Group China Retailing 276.25 129.76 251,462 24. Comcast United States Media & Advertising 275.9 116.39 132,300 25. Sony Japan Semiconductors, Electronics, Electrical Engineering, Technology Hardware & Equipment 260.48 89.9 109,700 26. Ford Motor Canada Automotive (Automotive and Suppliers) 257.04 136.34 26,000 27. Tencent Holdings China IT Software & Services 252.99 86.86 112,771 28. Walmart United States Retailing 244.86 572.75 2,300,000 29. General Motors United States Automotive 244.72 127 88,400 30. CVS Health United States Retailing 240.5 291.98 300,000 31. Chevron United States Construction, Oil & Gas Operations, Mining and Chemicals 239.53 156.29 42,595 32. Nippon Telegraph & Tel Japan Telecommunications Services 204.46 110.39 324,667 33. Stellantis Company Netherlands Automotive (Automotive and Suppliers) 195.33 176.61 189,512 34. Reliance Industries India Oil & Gas Operations 192.59 86.85 236,334 munotes.in

Page 79

79 International Investment and Financing - II 35. Johnson & Johnson United States Drugs &
Biotechnology 182.02 94.88 144,300 36. Pfizer United States Drugs & Biotechnology 181.48 81.49 29,000 37. Petrobras Brazil Oil & Gas Operations 174.68 83.89 45,532 38. Intel United States Semiconductors, Electronics, Electrical Engineering, Technology Hardware & Equipment 168.41 79.02 121,100 39. Meta Platforms United States IT, Internet, Software & Services 165.99 117.93 71,970 40. Siemens Germany Professional
Service 164.22 76.46 8,000 41. Nestlé Switzerland Food, Soft
Beverages,
Alcohol &
Tobacco 152.71 95.25 276,000 42. Equinor Norway Oil & Gas
Operations 147.12 88.37 21,126 43. AbbVie United States Drugs &
Biotechnology 146.53 56.2 50,000 44. LVMH Moët Hennessy Louis Vuitton France Clothing,
Shoes, Sports
Equipment 142.5 75.9 34,930 45. Taiwan Semiconductor Taiwan Semiconductors 139.35 61.47 56,831 46. Novartis Switzerland Drugs & Biotechnology 135.88 51.63 104,323 47. Procter & Gamble United States Packaged Goods 120.22 79.62 26,000 48. BHP Group Australia Materials 105.72 65.55 80,000 49. Roche Holding Switzerland Drugs & Biotechnology 101.32 68.69 100,920 50. The Home Depot Canada Retail and Wholesale 71.88 151.16 30,000 Source: The Global 2000: Forbes report 2022, Ranks are calculated by
assets by author
6.3.2 Reasons for the Growth of MNCs :
1. Avai lability of raw materials:
If there are factories which are manufacturing a good quality of denim
cloth and at a cheaper rate then why should not a company like Aviva
Corporation purchase the denim material from abroad, and bring it to the
United States do the jeans manufacturing and export it once again?
Clearly, if the ability exists to manufacture the jeans in the foreign market,
the firm can eliminate two -way shipping costs for denim in one direction
and jeans in the other by directly investing in a man ufacturing plant
abroad.1
Many companies, especially in mining sector, have little options but to
locate at the site where raw materials is readily available. If copper or iron munotes.in

Page 80

80 International Finance
80 ore is being smelted, it often does not make sense to ship the ore when a
smel ter can be erected near the mine site. The product of the smelter the
copper or iron bars which weigh less than the original ore can be
transported out to the market. However, even in this rather straightforward
situation we still have to ask why it would be an overseas firm rather than
a native firm that owned the smelter.
With a native firm there would be no foreign direct investment. Thus, to
explain foreign direct investment, we must explain why a multinational
corporate organization can do things bette r or cheaper than local firms. As
we shall see in the following paragraphs, there are many advantages
enjoyed by MNCs versus local, single country companies.
Note:
A model of overseas direct investment that considers transportation costs as well as issues involving stages of
production and economies of scale has been developed by Jimmy Weinblatt and Robert E. Lipsey, ‘‘A Model of
Firms’ Decisions to Export or Produce Abroad,’’ National Bureau of Economic Research, Working Paper 511,
July 1980.
2. Integrati ng operations :
The benefit of ownership of the various stages of the supply chain is based
on the lower stock levels that are required when there is good
communication of data between the different stages of production, stock
arrival can then move closer t o just -in-time levels. The benefit of common
ownership to achieve this is perhaps less significant than it used to be
because of electronic data exchange that can link separately owned
companies when the flow of information between stages of the supply
chain is jointly helpful.
3. Non-transferable knowledge :
Nowadays, selling their knowledge in the form of patent rights and to
license a foreign producer is quite possible for any firm. This is turn
removes the burden from the firm to make a foreign direct in vestment.
Many a times a firm which has production process or product, if it does
the foreign production itself then it can make huge profits. This is mainly
because of the fact that many a times, there are certain kinds or types of
knowledge which cannot be sold or purchased but are acquired through
years of experience. For example, Aviva can sell its patterns and designs
to a foreign firm, it can also license the use of its name, but it cannot sell
its production and marketing experience to a foreign firm . This is the main
reason why the firms want to do their own foreign production.
4. Protecting reputations :
Products develop good or bad repute, and these are carried across
international borders. For example, people everywhere know the names of
certain br ands of fast food, jeans commercial banks and soft drinks. It
would not serve the good repute of a multinational company to have a
foreign licensee do a careless job providing the good or service. Whether
we are talking about restaurant chains where people could become sick, munotes.in

Page 81

81 International Investment and Financing - II accounting firms which might use unlawful or ethically questionable
practices, or pharmaceutical companies that can make mistakes, it is
important for multinationals to maintain high and similar standards across
the globe to protect the ir reputations. A bad experience in one location can
easily spill over to sales and profits in other locations as well. This is the
nature of negative external factors which are internalized if foreign
production is kept within the company rather than bein g licensed out to a
separate corporate entity. We find that there is good reason for foreign
direct investment rather than alternative ways of expanding into foreign
markets such as granting foreign licences.
5. Exploiting reputations :
Foreign Direct Inves tment may occur to utilize rather than guard a
reputation. This inspiration is probably of particular significance in
Foreign Direct Investment by banks, and it happens in the form of opening
branches and establishing or buying subsidiaries. One of the rea sons why
banking has become an industry with huge multinationals is that an
international repute can attract deposits; many associate the size of a bank
with its safety. For example, a name like Coca Cola, KFC, or Standard
Chartered Bank in a small, less d eveloped nation is likely to attract
deposits away from local banks. Repute is also important in accounting, as
Exhibit table 1. explains. This is why many large industrial nations such as
the United States Of America and Great Britain have argued in globa l
trade negotiations for a liberalization of restrictions on services, including
accounting and banking. It is also the reason why the majority of less -
developed nations have confronted this liberalization.
6. Protecting secrecy :
Direct investment may be c hosen to the granting of a license for a foreign
company to manufacture a product if secrecy is significant. This point has
been raised by Erich Spitteler, who argues that a firm can be inspired to
choose direct investment over licensing by a feeling that, while a licensee
may take safety measures to protect patent rights, it may be less careful
than the original owner of the patent.
7. The product life -cycle hypothesis :
To sustain the growth of earnings, the company must undertake foreign
ventures where ma rkets are not as well infiltrated and where there is
perhaps less competition. This makes direct investment the natural
significance of being in business for a long enough time and having
exhausted options of expansion at home. There is an unavoidability i n this
view that has concerned those who believe that American firms are further
along in their life -cycle development than the firms of other countries and
are therefore dominant in foreign expansion. However, even when US
firms do expand into foreign mar kets, their activities are often scrutinized
by the host governments. Moreover, the spread of US multinationals has
been matched by the inroads of foreign firms into the United States.
Particularly noticeable have been auto and auto -parts producers such as
Toyota, Honda, Nissan, and Michelin. Foreign firms have an even longer munotes.in

Page 82

82 International Finance
82 history as leaders in the US food and drug industry (Nestle, Hoffmann -La
Roche); in oil and gas (Shell, British Petroleum as BP and so on); in real -
estate development, banking, and ins urance; and in other areas.
8. Capital availability :
Robert Aliber has suggested that access to capital markets can be a reason
why firms themselves move abroad.5 The smaller one -nation licensee does
not have the same contact to cheaper funds as the larger firm, and so larger
firms are able to operate within overseas markets with a lower discount
rate. However, Edward Graham and Paul Krugman have challenged this
argument on two grounds. First, even if large multinational firms have a
lower cost of capital t han small, native firms, the form of foreign
investment does not have to be direct investment. Rather, it can be an
indirect investment and take the form of portfolio investment. Second, the
majority of Foreign Direct Investment has been two -way, with, for
example, US companies investing in Japan while Japanese companies
invest in the United States. This pattern is not a consequence of the
differential -cost-of-capital argument which implies one -way investment
flows.
9. Strategic FDI :
Companies enter oversea s markets to preserve market share when this is
being endangered by the potential entry of local firms or multinationals
from other nations. This strategic motivation for FDI has always existed,
but it may have contributed to the multi -nationalization of b usiness as a
result of improved access to capital markets. This is different from the
argument regarding the differential cost of capital, given previously. In the
case of increased strategic Foreign Direct Investment, it is globalization of
financial mark ets that has reduced entry barriers due to large fixed costs.
Admission to the necessary capital means a wider set of corporations with
an ability to expand into any given market. This increases the motivation
to move and enjoy any potential first -mover ad vantage.
10. Organizational factors
Richard Cyert and James March emphasize reasons given by organization
theory, a theme that is extended to FDI by E. Eugene Carter.6 The
organization theory view of Foreign Direct Investment emphasizes broad
management ob jectives in terms of the way management attempts to shift
risk by operating in many markets, sales growth, etc. which is against the
outdated view to focus on maximization of profits.
11. Avoiding tariffs and quotas :
Another reason for producing abroad ins tead of producing at home and
shipping the product concerns the import tariffs that might have to be
paid.7 If import duties are in place, a firm might manufacture inside the
foreign market in order to evade them. We must not forget, however, that
tariffs guard the company engaged in production in the foreign market,
whether it be a foreign company or a local firm. Tariffs cannot, therefore, munotes.in

Page 83

83 International Investment and Financing - II clarify why overseas companies move abroad rather than use the licensing
route, and yet the movement of companies is the core of direct investment.
Nor, along comparable lines, can tax write -offs, subsidized or even free
land offerings, and so on, explain direct investment, since overseas
companies are not usually helped more than domestic ones. We must trust
our other l isted reasons for direct investment and the superseding desire to
make a larger profit, even if that means moving abroad rather than
expanding into alternative domestic endeavours. There have been cases
where the danger of burden of tariffs, or numerical r estrictions on imports
in the form of quotas, have provoked direct investment overseas. For
example, a number of foreign automobile and truck manufacturers
established plants, or considered establishing plants, in the United States
to avoid restrictions on selling foreign -made cars. The limits were
intended to protect jobs in the US industry. Nissan Motors constructed a
plant in Tennessee, and Honda erected a plant in Ohio. For a period of
time Volkswagen manufactured automobiles and light trucks in the Uni ted
States and Canada. Other companies included Renault and Daimler -Benz
which made direct investment in United States and Canada.
12. Avoiding regulations :
The multi -nationalization in the banking sector, Foreign Direct Investment
has been made by banks t o evade guidelines. This has also been a
incentive for foreign investment by manufacturing companies. For
example, a case might be made that some companies have moved to
escape values set by the US Environmental Protection Agency, the
Occupational Safety a nd Health Administration, and other agencies. Some
foreign nations with lower ecological and safety standards offer a haven to
firms using dirty or hazardous processes. The items manufactured, such as
chemicals and prescription drugs, may even be offered f or sale back in the
parent companies’ home nations.
13. Production flexibility :
An indicator of departures from purchasing power parity (PPP) is that
there are periods when manufacture costs in one nation are predominantly
low because of a real decline of its currency. Multinational companies
may be able to relocate
manufacturing to exploit the prospects that real depreciations offer. This
requires, obviously, that trade unions or governments do not make the
shifting of manufacturing too difficult. Small ma nufactured goods such as
televisions and computer components offer themselves to such shuffling
of production, whereas automobile production, with its worldwide unions
and exclusive setup costs, does not.
14. Symbiotic relationships :
Some firms follow clie nts who make FDIs. For example, large American
accounting firms which have knowledge of holding companies’ special
needs and practices have opened offices in countries where their clients
have opened subsidiary companies. These US accounting firms have an munotes.in

Page 84

84 International Finance
84 advantage over local firms because of their knowledge of the parent and
because the client may prefer to engage only one company in order to
reduce the number of people with access to sensitive data; The same factor
may apply to securities, consulting, and legal companies, which often
follow their home country clients’ direct investments by opening offices in
the same overseas sites. Similarly, it has been shown that manufacturing
companies may be drawn to locations where other manufacturing
companies from the same nation are situated. The advantage of being in
the same area is that they can work together and benefit from their
knowledge of each other. The advantages from being in the same area as
other companies are called agglomeration economies.
15. Indir ect diversification :
We should not leave our discussion of factors contributing to the growth
of multinational companies without mentioning the potential for the
multinational companies to indirectly provide portfolio diversification for
shareholders. This service will, obviously, be valued only if shareholders
are incapable to diverge themselves. This needs the existence of
segmented capital markets that only the multinational companies can
overcome. All the reasons of growth of multinational companies,
including that relating to divergence, depend on market limitations.
6.3.3 Problems and Benefits from the Growth of MNCs:
As we have mentioned, much of the worry about multinational companies
stems from their size, which can be huge. Indeed, the profits of s ome of
the larger companies can exceed the operating budgets of the governments
in smaller nations. It is the power that such scale can give that has led to
the greatest worry. Can the multinational companies push around their
host governments to the advan tage of the shareholders and the
disadvantage of the citizens of the nation of operation? This has led
several nations and even the United Nations to investigate the impact of
multinational companies. The issues considered include the following.
1. Bluntin g local economic policy :
It can be tough to manage economies in which multinationals have wide -
ranging investments, such as the economies of Canada and Australia.
Since multinational companies often have ready access to outside sources
of finance, they can blunt local monetary policy. When the host
government wishes to constraint economic activity, multinationals may
nevertheless expand through foreign borrowing. Similarly, efforts at
economic expansion may be unfulfilled if multinational companies
transfer funds overseas in search of yield advantages elsewhere. You do
not have to be a multinational to upset plans for economic expansion
unified financial markets will always produce this effect but multinational
companies are likely to participate in any oppo rtunities to gain profits.
Additionally, as we have seen, multinational companies can also shift
profits to reduce their total tax liability; they can try to manipulate transfer
prices to move profits to countries with lower tax rates. This can make the
multinational companies a slippery animal for the tax collector, even munotes.in

Page 85

85 International Investment and Financing - II though, on the other side of the ledger, by buying local goods they
contribute to tax revenue.
2. Destabilizing exchange rates :
It has been contended that multinational companies can make foreign
exchange markets unstable. For example, it has been demanded that when
the US dollar is moving quickly against the world’s major currencies, the
Canadian dollar swings even further. In particular, it has been contended
that a falling value of the U S dollar against, for example, the euro or
sterling, has been related with an average larger decline of the Canadian
dollar against these currencies. Although the existence of this phenomenon
has not been officially confirmed, multinational companies have been
responsible for such an effect. It has been claimed that when US parent
companies are expecting an increase in the price of the euro, sterling, and
so on, they buy these foreign currencies and instruct their Canadian
subsidiary companies to do the sam e. With a thinner market in the
Dominion currency, the effect of this activity could be larger movement in
the Canadian dollar than the US dollar.
3. Defying foreign policy objectives :
Apprehension has been expressed, especially within the United States of
America, that US -based multinational companies can challenge foreign
policy objectives of the US government through their foreign branches and
subsidiaries. For example, a US multinational companies might break a
barrier and avoid permissions by operating through overseas subsidiary
companies. This has caused even greater fear within some host nations.
Why should corporations operating within their boundaries have to follow
orders of the American government or any other foreign government?
Multinational co mpanies present a possibility for conflict between national
governments. There is even possibility for conflict within
international/multinational trade unions. For example, in 1980 and 1981
Chrysler Corporation was given loan guarantees to help it continu e in
business. The US government asserted on wage and salary rollbacks as a
condition. Chrysler workers in Canada did not like the instruction from the
US Congress to accept a reduced wage.
4. Creating and exploiting monopoly power :
It is quite common to l isten to the view that because multinational
companies are so large, they have lessened the rivalry. However, the truth
may be the contradictory. In some industries such as computers,
automobiles, shipbuilding and steel where a single country might support
one or only a few companies in the industry, competition is increased by
the presence of foreign multinational companies. That is, the multinational
companies themselves compete in global markets, and without them
monopoly powers in some sectors might be even stronger. Charges have
been levelled, most remarkably with regard to the oil industry, that
multinationals can use monopoly power to hold back output to effect price
increases for their products. Because the multinational companies have
such wide oper ations, much of the data on which the governments must munotes.in

Page 86

86 International Finance
86 rely are often data collected and reported by the multinational companies
themselves. There is no assurance that the data remain accurate, and there
is no simple way to implement controls and punish cu lprits. This became
one of the foremost political matters of the new millennium.
5. Keeping top jobs at home :
Multinational companies tend to focus and specialize their ‘‘good’’ and
‘‘bad’’ activities within certain sites. This can mean doing Research &
Development within the home nation. Highly skilled university and
technical -school graduates who find their employment and promotion
prospects reduced would prefer locally owned and managed enterprises in
their nation to foreign multinational companies. This has been a debated
problem in nations that consider themselves ‘‘branch plant’’ economies.
Canadian and Australian scientists and engineers have been predominantly
frank. While multinational companies have enhanced projections for some
better -paid employe es in their home nations, it has been reasoned that they
have ‘‘exported’’ lower -wage jobs, especially in production sector. The
evidence does not appear to support this claim. FDI is frequently
motivated by strategic considerations, and it can help inves ting firms
retain markets threatened by new entrants. In such a way jobs at home
those providing partly treated inputs and R&D are protected. Also, on the
positive side, multinational companies have relocated technology and
capital to less -developed countr ies (LDCs), and in this way helped
quicken their economic development. US and Japanese based
multinational companies have been particularly active building
manufacturing facilities in less developed countries. For example, US
multinational companies impact in Latin America has been particularly
strong. The Japanese MNCs’ impact has also risen, particularly in Asian
LDCs.
6. Homogenization of culture :
There is little or no doubt that multinational companies spread a public
culture. Chain hamburger openings b ecome the same on Main Street in
Iowa and on the Champs -Elysees in Paris. Soft drink bottles with a
conversant shape can wash up on any beach with no way of telling from
which nation they came. Hotel rooms are similar everywhere. The same
company names and merchandise names appear in every major Western
language. Even architecture shows a common inspiration – the
‘‘international style.’’ Many have criticized this development,
complaining that it is robbing the world of a good deal of its diversity and
local interest. Yet the local people demand the products of the
multinational companies. This is all part of the never -ending love -hate
relationship between concerned people everywhere and the multinational
companies.

munotes.in

Page 87

87 International Investment and Financing - II Check Progress :
1. What do you understa nd by capital budgeting in international
prospective.
------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
---------------------- --------------------------------------------------------------------
2. How we can select project in international capital budgeting.
------------------------------------------------------------------------------------------
------------------------------ ------------------------------------------------------------
------------------------------------------------------------------------------------------

3. Write a note on Growth of multinational corporations.
-------------------------------------------- ----------------------------------------------
------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
4. What are the reasons of gr owth of multinational corporations.
------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
---------------------------------------- --------------------------------------------------
5. What is the benefits of host country for establishing multinational
corporations.
------------------------------------------------------------------------------------------
--------- ---------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
6.4 INTERNATIONAL FINANCING The amalgamation and associated globalization of capita l markets has
opened up a huge arrangement of new sources and forms of financing.
Today’s corporate treasurers of large multinational companies as well as
domestic companies can often access overseas capital markets as easily as
they can access the domesti c capital market. This chapter considers these
broadened prospects by explaining the central international financial
issues involved in each of the major methods of raising financial capital,
some of which are unique to the international sphere. We conside r the
international aspects of raising capital via stocks, bonds, parallel loans
between corporations, credit swaps between banks and corporations, and
loans from host governments and development banks.
6.4.1 Equity Financing :
The prime international finan cial question concerning equity financing is
in which country stocks should be issued. A second question relates to munotes.in

Page 88

88 International Finance
88 the legal vehicle that should be used for raising equity capital ; should
this be done by the parent firm or by a subsidiary company, and if by a
subsidiary company, where should it be registered?
a. The country in which shares should be issued :
Obviously, stocks should be issued in the nation in which the best price
can be received, net of issuing costs. If for the time being, we assume the
costs of issue to be the identical everywhere, the nation in which the best
price can be received for the shares is the nation in which the cost of
equity in terms of the required expected rate of return for investors is the
cheapest. There is no concern abo ut risk from the equity issuer’s
perspective, other than to the extent that through equity buyer’s concern
for systematic risk, the riskiness of shares issued affects the required
expected rate of return and hence the price received for the shares; the
required expected rate of return of shareholders is, of course, the expected
rate of return paid by the firm. It should be clear that if international
capital markets are integrated, the expected cost of equity financing will
be the same in every country.
If capital markets are divided, the expected returns on the same security
could be different in diverse markets. A firm might then be able to receive
more for its stocks in some markets than others. Obviously, when a
company’s stocks are listed concurrently i n different nations, the share
price measured in a common currency will have to be the same
everywhere up to the transaction costs of arbitrage. Otherwise, the shares
will be bought in the inexpensive market and sold in the costlier market
until the price difference has been eradicated. However, the cause of the
capital -market division may prevent arbitrage. Additionally, a company
may not be considering concurrent issue in different nations, but rather, a
single nation in which to float an issue.
b. The ve hicle of share issue :
A company that has decided to issue shares overseas must decide whether
to issue such shares directly, or to do so indirectly via a subsidiary
company situated abroad. There is frequently a motive to use a specially
established financ ing subsidiary to avoid the need to withhold tax on
payments made to foreigners. For example, many US companies
established subsidiary companies in the Netherlands Antilles and other tax
havens to evade having to withhold 30 percent of dividend or interest
income paid to foreigners. The US financing subsidiaries took advantage
of a ruling of the US Internal Revenue Service that if 80 percent or more
of a corporation’s income is earned abroad, then dividends and interest
paid by the company are considered fo reign and not subject to the need to
withhold. To the degree that foreign creditors or shareholders of American
companies are incapable of receiving full credit for taxes withheld, they
may be willing to pay more for securities issued by American subsidiar y
companies than for the securities of the parent company in the United
States of America.
munotes.in

Page 89

89 International Investment and Financing - II 6.4.2 Bond Financing:
Identical two questions arise with bond financing as with equity financing,
namely, (1) the nation of issue and (2) the vehicle of issue. The
conclusions regarding these matters with bonds are also very much like to
those we have defined above in connection to equities. In particular,
organizations tend to issue in markets with comparatively full disclosure
rules and strong investor safety becau se these are the markets which
appeal to investors. Corporations also choose markets with comparatively
low issue costs of debt, just as they do when issuing equity. However, an
extra global issue does stand up with bond financing, namely the currency
of issue.
The currency of issue is not the same as the nation of issue, although the
two may coincide. For example, if an American company sells a pound
denominated bond in Great Britain, the currency of issue is that of the
nation of issue. However, if an Ame rican company sells a US -dollar -
denominated bond in Great Britain, the currency of issue is not that of the
nation of issue. In the first case of these situations the bond is called a
foreign bond; in the second case it is called a Eurobond. Let us provide a
more general explanation of foreign bonds and Eurobonds.
Foreign bonds versus Eurobonds :
A foreign bond is a bond sold in a foreign nation in the currency of the
nation of issue. The borrower is foreigner to the nation of issue, hence the
name. For exam ple, a Canadian company or a Canadian provincial
government might sell a bond in New York designated in US dollars. In
the same way, a Brazilian firm might sell a euro -denominated bond in
Germany. These are examples of foreign bonds, also stated to as "Yan kee
bonds". A Eurobond, on the other hand, is a bond that is designated in a
currency that is not that of the nation in which it is issued. For example, a
US-dollar -denominated bond sold outside of the United States in Europe
or elsewhere is a Eurobond, a Eurodollar bond. In the same way, a
sterling -designated bond sold outside of the United Kingdom is a
Eurobond, a Euro -sterling bond.
Foreign bonds are generally guaranteed and sold by brokers who are
situated in the nation in which the bonds are issued. Eu robonds, on the
other hand, are sold by international syndicates of brokers because they
are generally sold simultaneously in a number of countries. The syndicates
will normally have a lead manager which underwrites the largest
proportion of the issue, and a number of smaller members, although some
syndicates have co -lead managers. The lead managers include Merrill
Lynch, Goldman Sachs, Union Bank of Switzerland
(UBS), Morgan Stanley, Deutsche Bank, JP Morgan, and others.
Eurobond issues tend to be very lar ge, and their existence is an indication
in itself that capital markets are segmented. This is because if there was no
capital market segmentation, big bond issues could take place in a single
market with foreign bond buyers purchasing what they want in th at
market. The need to sell parts in different countries’ markets suggests that munotes.in

Page 90

90 International Finance
90 in any individual market there is a downward -sloping demand curve for
any particular issue.
The vehicle of bond issue :
Whether the bond that is issued is a Eurobond, foreign bo nd, or domestic
bond, and whether it is designated in a solitary currency or in numerous
currencies, a decision must be made either to issue the bond directly as an
obligation of the parent company, or to issue it indirectly through a
financing subsidiary company or some other subsidiary company. Firms
issue bonds via a foreign subsidiary if they do not want the bonds to be a
responsibility of the parent company. This has the additional benefit of
dropping country risk if some of the subsidiary company’s bo nds are held
locally. However, because the parent is almost always viewed as less risky
than subsidiary companies, the reduction in the parent’s obligation and
also in nation risk must be traded off against the fact that the interest rates
that must be pai d are usually higher when having a subsidiary company
issue bond.
6.4.3 Bank Financing :
It is quite common for funding to be done by governments or development
banks. Because government and development -bank funding are usually at
favourable terms, many cor porations consider these official sources of
capital before considering the issue of stock, the sale of bonds, borrowings
from commercial banks, or parallel loans from other financial
corporations.
Host governments of overseas investments offer funding whe n they
believe projects will generate jobs, earn foreign exchange money, or
provide training for their workforce. There are abundant examples of loans
being provided to multinational companies by the governments of, for
example, Spain, Canada Australia and Great Britain, to induce industrial
firms to make investments in their nations. Sometimes the state or
provincial governments also offer funding, perhaps even challenging with
each other within a country to have plants built in their jurisdiction.
Several American states have provided cheap funding and other
concessions to attract Japanese and other foreign firms to establish
operations. Canadian provincial and Australian state governments have
also used special funding arrangements to induce investors.
Even though the governments of poorer nations or less developed
countries do not generally have the resources to offer cheap funding to
investors, there are a number of development banks which specialize in
providing funds for investment in infrastructure, f or irrigation, and for
similar projects. While this funding is usually provided to the host
government instead of to companies involved in the building of the
projects, the companies are indirectly being funded by the development
bank loans to the host gov ernments.
A foremost provider of financial aid is the International Bank for
Reconstruction and Development (IBRD), normally known as the World munotes.in

Page 91

91 International Investment and Financing - II Bank. The World Bank, which was established in 1944, is not a bank in
the sense that it does not accept deposits or provides payment on behalf of
all the nations across the globe. In fact, it is a lending institution that
borrows from the governments of the developed nations by selling them
its bonds, and then uses the proceeds for development in underdeveloped
(or developing) nations. World Bank or IBRD loans have a maturity
period of up to 20 years depending upon the terms and conditions of the
loan being provided. Interest rates are determined by the (relatively low)
cost of funds to the bank.
Many developing nati ons do not meet the requirements for World Bank
loans, so in 1960 an allied organization, the International Development
Agency (IDA) , was established to help even poorer nations. Credits, as the
advances are called, have terms of up to 50 years and carry n o interest
burden. A second partner of the World Bank is the International Finance
Corporation (IFC) . The IFC provides advances for private investments
and takes equity positions along with private -sector partners.
6.5 SUMMARY 1. We must be reliable in foreig n-project assessments. We can use
domestic or foreign currency as long as we use the matching discount
rates, and we can use real values of cash flows if we use nominal cash
flows or real interest rates if we use nominal interest rates.
2. Discount rates sho uld show only the systematic risk of the item being
discounted. Doing business overseas can help reduce overall company
risk when earnings are more independent between nations than
between activities within a particular nation, and this can mean lower
discount rates for overseas projects.
3. Multi -National Companies have grown by making Foreign Direct
Investments.
4. Among the reasons why Multi National Companies have made direct
investments are to gain access to raw materials, to integrate operations
for increas ed efficiency, to avoid regulations, to protect industrial
mysteries and copyrights, to expand when domestic prospects are
over, evade tariffs and quotas, to increase manufacture flexibility and
thereby profit from variations in real exchange rates, to pre vent others
entering a market, to follow client Multi National Companies, and to
increase diversification.
5. Multi -National Companies face two dimensional problems to a
greater degree than other firms, namely measuring transfer prices and
nation risks.
6. If capital markets are globally combined, the cost of capital should be
the same wherever the capital is raised.
7. If capital markets are divided, it pays to raise equity in the nation in
which the company can sell its shares for the highest price. It may munotes.in

Page 92

92 International Finance
92 also pa y to consider selling equity instantaneously in several nations;
such shares are called Euro equities.
8. A foreign bond is a bond sold in an overseas country and in the
currency of that foreign country. A Eurobond is a bond in a currency
other than that of t he nation in which it is sold.
9. Companies issuing bond should take into consideration costs and
sizes of bond issues when determining the country of issue.
10. Credit swaps are made between banks and firms. They are also a way
of avoiding foreign exchange contr ols.
11. The relations between banks and companies in Germany, Japan and
some other countries may explain the high debt/equity ratios in these
nations. However, it does appear in overall from the within -country
distinctions in financial structure that industry - and firm -specific
impacts on monetary structure are more significant than country
effects.
6.6 QUESTIONS 1. How to select project in Capital Budgeting for foreign investment?
2. Write difficulties in evaluating foreign projects?
3. Write a note on Home versus For eign cash flows.
4. Write a note on Discount rate.
5. Explain reasons of growth of MNCs.
6. Explain problems and benefits from growth of MNCs.
7. Write a note on Equity Financing.
8. Write a note on Bond Financing.
9. Write a note on Bank Financing
6.7 REFERENCE  Book “International Finance” written by Maurice D. Levi


*****
munotes.in

Page 93

93 7
INTERNATIONAL FINANCIAL
INSTITUTIONS - I
Unit Structure
7.0 Objectives
7.1 Introduction
7.2 Gold Standard System (1880 - 1914)
7.2.1 Features of Gold Standard
7.2.2 History of gold standard
7.2.3 Working of the gold standard
7.2.4 External bal ance under the gold standard
7.2.5 Automatic Mechanism (The price -specie -flow mechanism)
7.2.5 Advantages of the gold standard
7.2.6 Disadvantages of the gold standard
7.3 Gold Exchange Standard (1947 -1971)
7.3.1 Features of the Gold Exchange Standard System
7.3.2 History and Working of Gold Exchange Standard
7.3.3 Advantages of Gold Exchange Standard
7.3.4 Disadvantages of Gold Exchange Standard
7.4 International Monetary Fund (IMF)
7.4.1 Formation
7.4.2 Objectives of IMF
7.4.3 Functions of IMF
7.4.4 Governance Structure of IMF
7.4.5 IMF Quotas
7.4.6 International Reserves
7.5 Special Drawing Rights
7.5.1 Working of SDR system
7.5.2 SDR Value
7.5.3 Advantages of SDR Scheme
7.5.4 Disadvantages of SDR Scheme
7.6 Summery
7.7 Questions
7.0 OBJECTIVES  To analyze the gold standard system
 To know the working of gold exchange system
 To understand the working of special drawing rights munotes.in

Page 94

94 International Finance
94 7.1 INTRODUCTION For smooth functioning of international financial relations between
various countries as w ell as international institutions, efficient
international monetary system is required. The expansion of global trade
and economy depends upon this system. The present chapter take reviews
of some of the important concepts related to this international mon etary
system.
During the period from the beginning of the nineteenth century to the
World War II, the international monetary system was based on gold. Most
of the industrialised nations and their trading partners were operating
under a fixed exchange rate system called gold standard. Under this
system each country had to define its currency in terms of gold. Exchange
rate between two different currencies was decided upon the basis of the
equivalency of the gold purchasing value of these currencies. This sy stem
had gone through different phases. Based upon the history, this system can
be classified as Gold Standard System and Gold Exchange Standard
System.
7.2 GOLD STANDARD SYSTEM (1880 - 1914) Gold standard (or also called full -fledged gold standard) was a
monetary system, well prevailing before World War I, in which the
standard measure of the value of the currency was a fixed quantity
of gold or was kept at the value of a fixed quantity of gold. The currency
was freely convertible at home or overseas into a fixed amount of gold per
unit of currency.
7.2.1 Features of Gold Standard:
The following were the basic features this system :
a) The monetary unit was used to define in terms of gold.
b) Coins made of gold were held as standard unlimited legal tender.
c) Paper m oney or token money were also in circulation but freely
convertible into gold.
d) There was no limit and no cost for making of gold coins.
e) Melting of gold was free and unlimited.
f) The central bank had to buy and sell gold without limit to maintain
the internal as well as external value of currency and for this purpose
it had to hold gold reserves.
g) There were no restrictions on import and export of gold.
h) As countries used to tie their currencies to gold under a gold standard,
official international reserves were of the form of gold. munotes.in

Page 95

95 International Financial Institutions - I 7.2.2 History of gold standard:
The period of gold standard is considered from 1880 to 1914. The system
was first put into operation by United Kingdom in 1819 when the British
Parliament revoked long -standing restrictions on the expo rt of gold coins
and bullion from Britain. During the 1870s Germany, France, and
the United States adopted the gold standard with many other countries
following suit. The system remained successful until the World War I.
In order to maintain this system, the participating country had to allow
export and import gold without any restriction. But as the World War I
broke; the shipment of gold became impossible and cooperation among
the central banks of the countries was shattered. Therefore, the world had
to leave the gold standard system.
7.2.3 Working of the gold standard:
Under the gold standard system, the central bank of a country had to
maintain the gold reserve for two reasons, i. e. to control the money supply
in the economy and to maintain the excha nge rate of the currency. As the
issuance of each note in the circulation was backed by gold, the money
supply was automatically controlled due to scarcity of gold.
In order to maintain the exchange rate stable with the money units of
different gold stand ard countries, the country had to freely allow the
export and import of gold. The central bank also had to intervene to keep
the exchange rate stable. For that purpose, the central bank had to be ready
with gold reserves.
7.2.4 External balance under the gold standard:
Under the gold standard, a central bank had to fix the exchange rate
between its currency and gold. To keep this gold price, the central bank
had to maintain an adequate stock of gold reserves. Therefore, the policy
makers were regarding external balance not in terms of a current account
target, but as a situation in which the country neither importing excess
gold from abroad nor exporting excess gold to foreign countries at too
rapid a rate. It means the central bank had to avoid sharp fl uctuations in
the balance of payments as international reserves took the form of gold
during this period. The surplus or deficit in the balance of payments had to
be financed by gold shipments between central banks of the countries
involved.
7.2.5 Automa tic Mechanism (The price -specie -flow mechanism):
The gold standard system had powerful automatic mechanism which led to
the simultaneous accomplishment of balance of payments equilibrium by
all countries. This mechanism can be understood with the followin g
hypothetical example. munotes.in

Page 96

96 International Finance
96 Suppose there are two countries India and Britain. India is having deficit
balance of payments and Britain is with surplus balance payments. Both
countries are not in equilibrium with balance of payments. The
disequilibrium between these two countries will automatically get
corrected through the mechanism price -specie -flow mechanism as follows.
1. Gold Movement:
Gold will flow out (Exported) of India with deficit balance of payments
and will flow in (Imported) to Britain with surplu s balance of payments.
2. Changes in Money Supply:
As the gold is responsible to create money in the economy, the outflow of
gold will lead to a reduction in the supply of money in India.
Alternatively, the inflow of gold will result in the increase of mon ey
supply in Britain.
3. Changes in Prices and Economic Activity:
In India, reduction in money supply will lead to a fall in the prices and the
profit margins. This will lead to reduction in investment, income, output
and employment in the country. On the other hand, in Britain, increase in
money supply will increase prices and profit margins and consequently
investment, income, output and employment.
4. Changes in Imports and Exports:
Reduction in prices in India will encourage foreigners’ demand for its
products. Also, the situation will force the country to curtail its import.
Thus, exports will exceed imports. Simultaneously, price rise in country
Britain will lead to an increase in import.
5. Equilibrium in the Balance of Payments:
Increase in export and reduction in import will create conditions of
favourable balance of payments for India. On the other hand, reduction in
export and increase in import will lead to an adverse balance of payments
in Britain. Consequently, gold will start flowing from Bri tain to India and
this will finally remove disequilibrium in the balance of payments in both
the countries.
The automatic mechanism explained above can be summarised with the
following flow chart for your quick revision.



munotes.in

Page 97

97 International Financial Institutions - I The price -specie -flow mechanism Disequilibrium in balance of payments (Deficit or Surplus) movements of gold (Import or Export of gold) changes in money supply (will increase or will decrease) changes in prices and incomes (will increase or will decrease) changes in exports and imports (Export or Import of goods) equilibrium in the balance of payments.
7.2.5 Advantages of the gold standard :
The gold standard system had following advantages.
a) International Medium of Exchange:
Gold is universally demanded commodity. Therefore, it serves the
function of the medium of exchange. Exchange rates of the currencie s of
various countries could be easily determined as their par values are
expressed in terms of gold. Gold also can be served as a measure of value
for all goods and services, which made a ready comparison of the values
of goods in different countries.
b) No requirement of government intervention:
Under gold standard, the monetary system functions automatically.
Therefore, the government need not to interfere in the system. As the
relationship between gold and quantity of money is strong, changes in
gold reserves automatically leaded to corresponding changes in the money
supply. Thus, the imbalance in the balance of payment of the country or
inflation or deflation situations were used to get corrected automatically.
c) Stability of Exchange Rate:
The great adva ntage of gold standard was, it provided stability of
exchange rates among the countries those were following to it. Gold
standard ensured the slight movement of exchange rate up to specie or
gold point. This exchange rate stability facilitated the internat ional trade
and capital movements during the era.
d) Public Confidence:
Gold standard promoted public confidence in money because people
always have trust in gold because of its intrinsic value. This system had no munotes.in

Page 98

98 International Finance
98 danger of over-issue currency as total volume of currency in the country
was directly related to the volume of gold.
e) Simple to understand:
The system was very simple to understand for common people. It didn’t
have complications like other monetary systems.
Therefore, the gold standard was very useful monetary system in many
ways.
7.2.6 Disadvantages of the gold standard:
The gold standard system had following disadvantages.
a) Monetary policy subjected to international pressure:
The country following the Gold Standard System had to design its
mone tary policy by keeping the view of international situations. In such
conditions the country was being deprived from adopting the particular
monetary policy appropriate to her internal requirements.
b) Rigidity in monetary system:
Under the gold standard, the monetary system has less flexibility, because
in this system, money supply depends upon the gold reserves. The
increment in gold reserves is always not an easy task. Therefore, money
supply is not elastic enough to meet the changing requirements of the
country.
c) Expensive and Extravagant:
Gold standard is a very expensive monetary standard as the coins consists
of expensive metal. It is also a wasteful standard because there is a great
depreciation of the precious metal when gold coins are handled by publi c.
d) Fails during crisis:
The gold standard functions well during normal or peaceful time, but
during the periods of war or economic crisis, it always fails. During
irregular time like war, the people possessing gold try to hoard it. During
the first world war, the gold standard system was suspended as it became
difficult to transport the gold across the border.
e) Deflationary:
According to Mrs. Joan Robinson, gold standard usually suffers from an
inherent bias towards deflation. Under this standard, the gold losing
country have to contract money supply in proportion to the fall in gold
reserves.
But the gold gaining country, on the other hand, may avoid to increase
money supply in proportion to the increase in gold reserves. Therefore, the munotes.in

Page 99

99 International Financial Institutions - I gold standard, which inevitably produces deflation in the gold losing
country, may not create inflation in gold receiving country.
f) Economic Dependency:
Under gold standard, normally the economic problems of one country are
transferred to the other countries and therefore it becomes difficult for an
individual country to follow independent economic policy.
g) Not suitable for Developing Countries:
Gold standard is mainly not suitable to the developing economies as they
have adopted a policy of planned economic development with an objective
to attain self-sufficiency.
7.3 GOLD EXCHANGE STANDARD (1947 -1971) Gold Exchange Standard is a monetary system under which the
currency of a nation can be converted into bills of exchange drawn on a
particular country whose currency is convertibl e into gold at a stable rate
of exchange. A country on the gold -exchange standard is therefore able to
keep its currency at parity with gold without maintaining a huge gold
reserve.
The major difference between Gold Standard System and Gold Exchange
Stand ard System is that under the Gold Standard System all the
participating countries had to keep their own gold reserves to defend the
external value of their currencies but on the contrary, under the Gold
Exchange Standard System one or some of the countries will keep the gold
reserves to defend their currencies and all the other participating country
will just have to maintain the price of their currency in terms of the value
of the gold backing countries currencies. They do not require to keep huge
gold res erve.
7.3.1 Features of the Gold Exchange Standard System:
a) The national currency is made of coins with less intrinsic value and
paper money. Gold coins are out of circulation.
b) The national currency is not convertible into gold but is convertible at
the fixed rate into the currency of the other country which is based on
the gold standard.
c) There is no straight association between the volume of domestic
currency and the gold reserves of the country.
d) The nation’s monetary base is made of foreign exchange and foreign
bills along with gold.
e) The government controls the gold market in the economy. Import and
export of gold is under the strict regulation. munotes.in

Page 100

100 International Finance
100 f) Foreign payments are made either in gold or in currency of a country
based on gold.
7.3.2 History and Working of Gold Exchange Standard:
In July 1944 representatives of 44 countries met at out in Bretton Woods,
New Hampshire at the United Nations Monetary and Financial Conference
to decide what international monetary system to establish after World War
II. Becau se earlier gold stand system faltered between the two world wars
and finally collapsed during World War II. The agreement between the
participating country at this conference was called as Bretton Woods
Agreement.
Under this system, gold was used as the b asis for the United States’ dollar.
The United States was to preserve the price of gold at $35 per ounce of
gold. The United States also had to be ready to exchange on demand the
dollar for gold at that price without any limitation. The currencies of oth er
countries were linked to the U.S dollar value. These other countries were
to fix the price of their currencies in terms of dollars and intervene in
foreign exchange market to keep the exchange rate from moving by more
than 1 percent above or below the p ar value. Within the allowed band of
fluctuation, the exchange rate was determined by demand and supply
forces.
This system, however, came to an end in the early 1970s when the U. S.
President Richard M. Nixon announced that the U.S would
not exchange gold for U.S currency.
7.3.3 Advantages of Gold Exchange Standard:
Following were the advantages of Gold Exchange Standard :
a) Cost -effective System:
Gold exchange standard was cheaper and economical as it avoids the
wastage of gold because of non -circulation of gold coins and the
government need not to keep gold reserves for converting domestic
currency into gold.
b) Autonomy for Internal Monetary System:
As the domestic currency is not backed by gold reserves in this system, the
monetary authority can easily, ad just the money supply to meet the needs
of internal trade and industry.
c) Exchange Stability:
Under gold exchange standard, it is government’s responsibility to
maintain the stability of exchange rate. Exchange stability is needed for
the advancement of fore ign trade.

munotes.in

Page 101

101 International Financial Institutions - I d) Advantages of Gold Standard:
All the advantages of the gold standard are available under this standard
without putting precious gold coins in circulation.
e) Suitable for Poor Countries:
This standard was particularly suited to the less developed countries with
gold scarcity.
7.3.4 Disadvantages of Gold Exchange Standard:
The gold exchange standard has the following weaknesses:
a) Complex System:
This system was complex in its working.
b) Problem of Public Confidence:
Under this system, domestic curre ncy was not directly linked with gold
and the currency is not convertible into gold. So, it not easily attracting the
public confidence.
c) Not Automatic:
This system was not working automatically. The government intervention
was badly needed on regular basis . The government had to manage the
external value of its currency.
d) Prone to Inflation:
Under this system, money supply could be increased easily but it was very
difficult to reduce money supply. Therefore, the system was prone to
inflation.
e) External Uncert ainty:
Under this system the domestic currency of a country was connected with
the currency of a country having gold standard. The instability of the
foreign currency was automatically making the monetary system of the
related country insecure and unstable .
7.4 INTERNATIONAL MONETARY FUND (IMF) The gold exchange standard system was the outcome of the Bretton
Woods Conference. The system created at Bretton Woods called for the
establishment of International Monetary Fund for the purpose of
1) Supervision: If nations followed a set of agreed upon rules of
conduct in international trade and finance. and
2) Borrowing facilities: Providing borrowing facilities for nations in
temporary balance of payments problem. munotes.in

Page 102

102 International Finance
102 7.4.1 Formation:
The Bretton Woods Conference (United Nations Monetary and Financial
Conference) held in 1944, was attended by 730 delegates of 44 countries.
The Bretton Woods Conference had three main outcomes: (1) Articles of
Agreement to create the IMF, (2) Articles of Agreement to create
the IBRD (World B ank), (3) Other recommendations for international
economic cooperation.
The IMF agreement among them was very much important from the point
of the operations to be undertaken in establishing new monetary system
after the World War II. Its major features w ere:
 An adjustably pegged foreign exchange rate: Exchange rates were to
be pegged to gold. Governments were only supposed to adjust the
exchange rate of their currencies to correct only fundamental
disequilibrium.
 Member countries were allowed to make the ir
currencies convertible for current account transactions.
 If established exchange rates might not be favourable to a
country's balance of payments position, governments can revise them
by up to 10% from the initially agreed level (par value) without
objection by the IMF.
 All member countries had to subscribe to the IMF's capital.
Membership in the IBRD was allowed to only IMF members. Voting
in both organizations was allocated according to formulas giving
greater weight to countries contributing more ca pital (quotas).
The IMF came into official existence on 27 December 1945 with 29
member countries. At present it is headquartered in Washington, D.C.,
consisting of 190 member countries.
7.4.2 Objectives of IMF:
The objectives of the International Monetar y Fund are stated in Article 1
of the IMF Agreements are as follows:
1) To promote international monetary cooperation through consultation
and collaboration on international monetary problems
2) To promote and maintain high levels of employment, real income a nd
the development of the productive resources of all member countries
through facilitating the expansion of stable growth of international
trade.
3) To promote exchange stability avoiding competitive exchange
depreciation.
4) To assist in the formation of a m ultilateral system of payments and in
the elimination of foreign exchange restrictions obstructing the
growth of world trade. munotes.in

Page 103

103 International Financial Institutions - I 5) To provide member countries the opportunity to correct disturbances
in their balance of payments without resorting to measures de structive
of national or international prosperity
6) To shorten the duration and lessen the degree of disequilibrium in the
international balances of payments of member countries.
7.4.3 Functions of IMF :
Following are the important functions of IMF :
1) The F und works as a short -term credit institution for member
countries.
2) It provides a machinery for the orderly adjustment of exchange rates.
3) It is a pool of the currencies of all the member countries, from which
a borrower nation can borrow the currency of other nations.
4) It is a lending institution in foreign exchange. It grants loans for
financing current transactions only and not capital transactions.
5) It also provides a machinery for altering sometimes the par value of
the currency of a member country .
6) It also provides a machinery for international consultations on various
issues related to trade and balance of payments.
7.4.4 Governance Structure of IMF :
The IMF's governance structure have advanced with changes in the global
economy, by allowing th e institution to retain a central role within the
international financial architecture.
IMF is an autonomous organisation affiliated to the U.N.O. Its main office
is in Washington and at present the it has 190 members.
1) Board of Governors:
The Board of Go vernors is the highest decision -making body of the IMF.
It consists of one governor and one alternate governor appointed by each
member country. The Board of Governors exercises its power in such
important matters as to approve quota increases, special dra wing right
(SDR) allocations, the admittance of new members, compulsory
withdrawal of members, and amendments to the Articles of
Agreement and By-Laws. The Board of Governors have the power to
appoint executive directors and is also the ultimate mediator o n issues
related to the interpretation of the IMF's Articles of Agreement.
The Board of Governors meets normally once in a year.
2) Ministerial Committees
The IMF Board of Governors is advised by two ministerial committees,
the International Monetary and Fi nancial Committee (IMFC) and
the Development Committee. munotes.in

Page 104

104 International Finance
104 The IMFC has 24 members, selected from 190 governors. Its structure
mirrors that of the Executive Board and its 24 constituencies. As such, the
IMFC represents all the member countries of the Fund.
The IMFC meets twice a year, mostly during the Spring and Annual
Meetings. The Committee discusses matters related to mutual concern
affecting the global economy and also advises the IMF on the direction of
work.
The Development Committee is a joint committe e to advise the Boards of
Governors of the IMF and the World Bank on issues related to economic
development in emerging and developing countries. The committee is
having 24 members. It represents the full membership of the IMF and the
World Bank and mainly serves as a forum for building intergovernmental
harmony on critical development matters.
3) The Executive Board :
The IMF’s 24 -member Executive Board is for look after the daily business
of the IMF. It exercises the powers delegated to it by the Board of
Governors, as well as those powers given to it by the Articles of
Agreement. Since January, 2016, all the Executive Directors, are elected
by the member countries.
The Board normally makes decisions based on mutual agreement, but
sometimes formal votes are t aken. A member’s quota determines its
voting power in executive board.
IMF's present governance structure can be understood by diagram bellow.


Source: https://www.imf.org/external/about/govstruct.htm
munotes.in

Page 105

105 International Financial Institutions - I 7.4.5 IMF Quotas:
The IMF is a quota -based institution. Each member country contributes to
the capital of IMF through quotas. Therefore, quotas are the building
blocks of th e IMF’s financial and governance structure. An individual
member country’s quota broadly indicates its relative position in the world
economy. Quotas are finally denominated in Special Drawing Rights
(SDRs), the IMF’s unit of account.
The IMF's Board of G overnors conducts general reviews of quotas at
regular intervals. Any changes in quotas must be approved by 85 percent
majority of the total voting power, and a member’s own quota is not
changed without its consent.
7.4.6 International Reserves:
Accordi ng to Sixth Edition of the IMF's Balance of Payments and
International Investment Position Manual a country’s international
reserves refer to external assets readily available to and controlled by
monetary authorities for meeting balance of payments financ ing needs, for
interference in exchange markets to affect the currency exchange rate, and
for other related purposes such as maintaining confidence in the currency
and the economy, and serving as a basis for foreign borrowing. Reserve
assets comprise monet ary gold, special drawing rights (SDRs), reserve
position in the IMF, and other reserve assets.
7.5 SPECIAL DRAWING RIGHTS International monetary system after World War II may be characterised as
the currency reserve system, in which the U.S. dollar had b een serving as
reserve asset. But, due to some overriding reasons like the week position
of U.S. dollar, speculation in gold, anarchy in Euro -dollar market etc., this
system was facing acute difficulties in international liquidity. To resolve
these proble ms a reform in the existing international monetary system was
inevitable. Many proposals and plans were being suggested to evolve
some alternative system to get rid of the difficulties faced by the current
system. In due course, a proposal aimed at limiti ng the future role of dollar
and sterling and broadening the functions of the IMF had been put
forward. It is called the scheme of Special Drawing Rights (SDRs)
commonly apprehended as Paper Gold.
IMF's annual meeting at Rio de Janeiro in September 1967 ap proved the
SDR system principally. Though, the SDRs system came into practice
only since January 1970. Under this scheme, the IMF is empowered to
grant member countries Special Drawing Rights (SDRs), on a specified
basis, subject to approval. SDRs were re garded as the international
reserve, allocated annually by the collective decision of participating
members in the IMF. Possession of SDRs entitles a country to obtain a
defined equivalent of currency from other participating countries, and
enable it to di scharge certain obligations towards the General Account of
the IMF. The creation SDRs is thus intended to increase the resources munotes.in

Page 106

106 International Finance
106 available to IMF members to overcome their temporary foreign exchange
difficulties without putting any additional strain on the IMF resources.
SDRs are thus a method of supplementing the existing reserve assets in
international liquidity.
7.5.1 Working of SDR system:
The features of the Special Drawing Rights Scheme are as follows:
1) The idea of SDRs is drawn from the popular K eynes plan of the
creation of ICU and Bancor currency.
2) SDRs are allocated by the IMF to member countries and cannot be
held or used by private parties.
3) The allocation of SDRs is to be made on the basis of the quotas of
IMF of the individual member countr ies.
4) SDRs have been created under a Special Drawing Account (SDA)
with the IMF. The resources of the new account, SDA, are created by
an agreement amongst members as to the percentage of the existing
quotas with the IMF to be formed into SDRs.
5) With the i ntroduction of SDR scheme, thus, the accounts of the IMF
are divided into: (i) the General Account and (i) the Special Drawing
Account.
6) The General Account deals with the ordinary transactions of the IMF
relating to subscriptions towards quotas, drawings , repurchases,
payment of charges etc. and the SDA deals with the SDR transactions.
7) The value of the SDRs is fixed in gold. As per the scheme, the unit
value of SDRs is expressed in terms of gold equal to 0,88671 gram of
fine gold or one U.S. dollar prio r to August 15, 1971.
8) The scheme provides for regularly creating SDRs in the IMF account
which the member countries would accept as reserves and could use
for the settlement of international payments.
9) The SDRs themselves are not actual money. SDRs are just like
coupons which can be exchanged for currencies required by the
holder of SDRs, for making international payments.
10) Under the this scheme, the central banks of the member countries will
hold SDRs as their reserves along with gold and key currencies .
11) The SDRs allocated to the members are transferable assets under the
designation issued by the IMF subject to certain limits of holding.
Consequently, it is mandatory on the part of the participating
countries to accept drawing rights from other member c ountry in
exchange for an equal amount of convertible currency. Again, this
cannot exceed twice a country's allocation. munotes.in

Page 107

107 International Financial Institutions - I 12) Under the scheme, the use of SDRs would obviously imply a
reduction in the reserves of the using country, while the other
participatin g countries which are receiving drawing rights in
international settlements would accumulate their SDR holdings.
13) It was also proposed that a modest rate of interest will be payable on
SDR holdings.
14) The scheme offers that the decumulation and accumulation of SDRs
would be taking place within the Special Drawing Account itself.
Over a five -year period, a country shall not use more than 70 per cent
of its average net cumulative allocation.
7.5.2 SDR Value:
At present the value of the SDR is determined by t he basket created by
IMF. Currently this basket contains five major currencies, those are,
Chinese yuan, Euro, Japanese yen, U.K. pound, U.S. dollar. The value of
the SDR is calculated on the basis of daily market exchange rates of these
currencies. The S DR currency value is calculated daily (except on IMF
holidays or whenever the IMF is closed for business) and the valuation
basket is reviewed and adjusted every five years.
7.5.3 Advantages of SDR Scheme:
Following are the merits of SDR system introduced :
1) Simplicity and flexibility:
The SDRs are a system of reserve assets which are appropriate for
consider into the countries reserves. SDR also a form of international
credit creation. Moreover, the scheme is based on pure fiduciary reserve
creation, increases its flexibility.
2) Liquidity as per requirement:
The scheme may help the IMF to increase the volume of world liquidity as
per requirements. The IMF need not to depend upo n the weak supply of
monetary gold' or increasing the obligations of the reserve currency
countries. The scheme consequently seeks to create unconditional liquidity
in international reserves.
3) Suitable for member countries:
The drawing against SDRs would be unconditional as no change needed in
the domestic economic policies to restore balance payments equilibrium
by the country using SDRs.
4) Easy to implement:
The implementation of the SDR system avoids any sort of change in the
existing reserves of the m embers. It doesn’t need transfer of the quotas to
the new Special Drawing Account (SDA) because the resources of the munotes.in

Page 108

108 International Finance
108 new account SDA are to be created by an agreement amongst the members
as to the percentage of their existing quotas formed into SDRs.
7.5.4 Disadvantages of SDR Scheme:
The SDR system is crit icised on the following grounds:
1) Probability of distrust: The scheme is purely fiduciary in nature.
Therefore, there is possibility of distrust in the new reserve assets
(SDRs).
2) Problem of persistent payment deficits: SDR scheme is convenient
and flexible reserve instrument of short -term international liquidity
but it cannot be used to finance persistent payment deficits. In such
condition the use will lead to a universal inflation problem.
3) The schem e to support the dollar: According to some critics, the
whole scheme of SDRs appears to be a rescue operation for the dollar.
It is a collective effort to rehabilitate the dollar through international
action, because the value of the SDR is prescribed to be equal to the
current official gold value of the dollar.
4) Disadvantageous to the poor nations: The scheme is much in favour
of USA. but highly disadvantages especially to the poor nations.
According to critics the scheme would have beneficial to the poor
nations if the value of SDR is kept in parity with the market value of
the U.S. dollar not in parity with the artificially over -valued dollar.
7.6 SUMMERY For smooth functioning of international financial relations between
various countries as well as in ternational institutions, efficient
international monetary system is required. The 20th century witnessed
highly fluctuating era in connection with eco -political events. The shifting
of gold standard system to gold exchange standard system by international
community was the impact of these political events. Finally, the world
abandoned the gold exchange system also. The study of these systems
gives good acquaintance to understand the eco -political events of this 20th
century.
7.7 QUESTIONS a) What is Gold St andard? Discuss the working of Gold Standard
system?
b) What is Gold Exchange Standard? Differentiate between Gold
Standard and Gold Exchange Standard.
c) How the IMF have helped in solving the exchange liquidity problem
during the last quarter of the 20th centu ry? Explain.
***** munotes.in

Page 109

109 8
INTERNATIONAL FINANCIAL
INSTITUTIONS - II
Unit Structure
8.0 Objectives
8.1 Introduction
8.2 Theory of Optimum Currency Area
8.2.1 Optimum Currency Area (OCA) Concept:
8.2.2 Criteria for a successful OCA
8.2.3 Application of the theory
8.2.4 Criti cism
8.3 International Policy Coordination
8.3.1 Need of the policy coordination
8.4 A Currency Board
8.4.1 Working of the Currency Board
8.4.2 Advantages of a Currency Board
8.4.3 Disadvantages of a Currency Board
8.5 International Financial and Cur rency Crisis
8.5.1 Financial Crisis
8.5.2 Types of Financial Crisis
8.5.3 Some Examples of Financial Crisis
8.6 Currency Crisis
8.6.1 Causes of a Currency Crisis:
8.7 International Debt
8.7.1 Types of International Debt
8.7.2 India's External Debt: Creditor -Wise
8.8 Measures of Indebtedness
8.9 International Debt Crisis
8.9.1 Sovereign Debt Crises in the 1980s
8.9.2 European Sovereign Debt Crisis of 2008
8.10 Summery
8.11 Questions
8.0 OBJECTIVES  To know the theory of Optimum Currency Area
 To understand the concept of currency board
 To analyse the concept of financial crises munotes.in

Page 110

110 International Finance
110 8.1 INTRODUCTION The Euro, intended single currency for European Union virtually came
into existence on 1 January, 1999. Actual notes and coins came into
circulation i n 2002. Single Currency for more than one nation concept was
coming into reality with the existence of Euro. But far before that, the
economists had started the discussion regarding single currency. In the
present chapter we will discuss the theoretical ba ckground of the single
currency concept and also, we will discuss the concepts related to financial
crisis.
8.2 THEORY OF OPTIMUM CURRENCY AREA The theory of the optimum currency area was pioneered in the 1960s by
Canadian economist Robert Mundell. He pu t forward his theory in the
paper published in The American Economic Review, of September 1961.
Although the credit of this theory goes to Mundell as the designer of the
idea, but the theorist like A. P. Lerner, Kenen (1969) and McKinnon
(1963) were also t he contributor and further developers of this idea.
The original theory describes the optimal characteristics for the merger of
currencies by keeping the fixed exchange rate between the currencies of
the members or the creation of a new currency. The theor y is used often to
argue whether a particular region is ready to become a currency union or
not. A Currency Union is considered as one of the final stages in the
theory of economic integration.
8.2.1 Optimum Currency Area (OCA) Concept:
An optimum curre ncy area (OCA) or optimal currency region (OCR) is
considered as the final stage of economic integration where an entire
geographical region shares a single currency to maximize economic
efficiency of the region. According the theory the specific geograph ical
area not bounded by national borders may be better off using the
same currency instead of each country within that geographic region using
its own currency. An optimal currency area is often larger than a country.
8.2.2 Criteria for a successful OCA :
For a successful optimum currency area, the region needs to fulfil
following criteria.
a) Labour mobility:
A geographical area needs to have integrated labour market so that
workers will move freely throughout the area. This will also help to
minimise the unemployment problem in any single zone. Free labour
mobility indicates three things. One is physical ability to travel freely for
that, rules related to visas, workers' rights, etc. need to be reformed.
Second is lack of cultural barriers to free movement . Cultural barriers such
as different languages etc will create obstacles to free migration. Third is munotes.in

Page 111

111 International Financial Institutions - II requirements related to certain institutional arrangements. Such as the
ability to have pensions transferred throughout the region etc.
b) Openness of the economies:
There should be capital mobility across the region. Capital mobility will
help to eliminate the imbalance of balance of payments as well as
imbalance in the distribution of capital and interest rates.
c) Price and wage flexibility:
Price and w ages flexibility across the region will help to clears the money
and goods markets in the economy. The market forces of supply and
demand will automatically distribute money and goods to the area needed.
In practice perfect wage flexibility is hard to find . Therefore, this idea
does not work perfectly.
d) A risk sharing arrangement:
In order to eradicate the problems of the particular region’s sufferings
there should be risk sharing arrangement like common fiscal policy. In
such policy, suffered area can be helped through taxation policy and
public expenditure.
e) A joint central bank:
Participant countries may have alike business cycles. When one member
country involves in a boom or recession, other countries in the union are
most likely to follow. The commo n central bank will be able to promote
growth in downturns and to contain inflation in booms. If a particular
country in a union has individual business cycles, then optimal monetary
policy may diverge and union participants may be made worse off under a
joint central bank.
8.2.3 Application of the theory:
There are two examples largely discussed in relation to this theory. Those
are:
European Union :
OCA theory has been normally applied to the Eurozone and European
Union as both has attained the highest le vel of economic integration. But
many have criticised the idea as the EU did not actually meet the criteria
for an OCA at the time the euro was accepted. EU has lesser labour
mobility due to language and cultural differences. Fiscal federalism is also
not attained in EU.
United States :
United States is considered as good example of OCA as she has integrated
labour market and consolidated fiscal policy. But Michael Kouparitsas
found the USA not fit into an optimal currency area. He considered the
United Sta tes as divided into the eight regions. By using a statistical munotes.in

Page 112

112 International Finance
112 model, he found that two out of eight regions of the country do not satisfy
Mundell's criteria to form a single Optimal Currency Area.
8.2.4 Criticism:
The idea of monetary solidarity without fiscal unity is largely criticized
by Keynesian and Post-Keynesian economists. They argue that fiscal
incentive in the form of deficit spending is the most powerful method of
fighting unemployment during a liquidity trap. Such policy may not help if
member states in a monetary union are not allowed to run sufficient
deficits in their fiscal policies.
According to some of the critiques of the theory some of the OCA criteria
are not given and fixed, but rather they are economic outcomes determined
by the cre ation of the currency union itself.
8.3 INT ERNATIONAL POLICY COORDINATION International Policy Coordination is much discussed but rarely seen topic
in the history of mankind. When there is a calamity, to avoid the spill
overs effects national cooperate eac h other on various levels but during the
peace time coordination is rarely seen. The world had failure on economic
as well as political ground many times due to lack of cooperation and
coordination. The Gold Standard System as well as Gold Exchange
Stand ard System failed due to absence of coordination among the
participating countries.
According to Benes J. etc all (2013) the term international policy
coordination describes a situation where, due to well -designed incentives
or penalties, a group of count ries manages to move away from individual
Nash policies to a set of policies that internalizes some cross -border
externalities, and that is therefore Pareto superior.
8.3.1 Need of the policy coordination:
It is impossible to have a single policy on a glo bal level. The economic
policies are concerned with the problem and prospectus of a region or
people living in a particular geographical area. Those are designed to
address the local problems. But on the contrary on global level the
problems need to tackle level collectively. As the countries have joined
their hands to encourage the global trade, the vulnerability towards the
economic as well as physical problems have increased drastically. To
tackle this the cooperation on global level is badly needed. Thi s outcome
based global cooperation only can be through the coordination of the
policies among nations.
8.4 A CURRENCY BOARD A currency board is a type of exchange rate system based on the full
convertibility of a local currency into an internally accepte d currency of
another nation. This system uses a fixed exchange rate regime and 100 munotes.in

Page 113

113 International Financial Institutions - II percent coverage of the monetary supply supported up with foreign
currency reserves. It is an extreme form of a pegged exchange rate.
8.4.1 Working of the Currency Board:
When a country is on a currency board, the administration of the exchange
rate and money supply are given to a monetary authority designated for it.
That board have to decide about the value of a nation’s currency. Mostly,
this authority has to back each unit of domestic currency in circulation
with foreign currency. With this 100% reserve obligation, a currency
board functions like a strong form of the gold standard. The currency
board is set free to the unlimited exchange of the domestic currency with
foreign currency. Nation’s central bank can print money as per the
requirements, but a currency board have to back extra units of currency
with extra foreign currency. A Currency Board have to keep the reserve of
foreign currencies upon which it can earn in terest. Therefore, domestic
interest rates typically imitator of the prevailing rates in the foreign
currency.
Some of small countries are using Currency Board System. Hong Kong
has effectively used a currency board to back up her money with the U.S.
dollar since the early 1980s. Bulgaria, Estonia, Latvia and Lithuania all
used currency boards to speedily break strong inflation.
8.4.2 Advantages of a Currency Board
Currency board regimes are admired for :
 rule-based nature.
 stable exchange rates,
 promote trade and investment.
 restricts government actions.
 irresponsible governments cannot simply print money to pay down
deficits.
 keeping inflation under control.
8.4.3 Disadvantages of a Currency Board :
Currency boards have some disadvantages as :
 imports m uch of the foreign country's monetary policy.
 can create serious issues during business cycle.
 can cause even more damage during crisis.
 banking crisis can get worse fast because currency boards is unable to
act as a lender of last resort. munotes.in

Page 114

114 International Finance
114 8.5 INTERNATI ONAL FINANCIAL AND CURRENCY CRISIS 8.5.1 Financial Crisis:
A financial crisis can be defined as a situation where one or more
significant financial assets – such as stocks, real estate, etc – suddenly and
unexpectedly drops a considerable amount of their value.
According to Eichengreen and Portes (1987) financial crisis a situation
creating a disturbance to financial markets, associated typically with
falling asset prices and insolvency amongst debtors and intermediaries,
which ramifies through the financ ial system, disrupting the market’s
capacity to allocate capital.
According to Schularick and Taylor (2012) financial crisis is a condition
where bank runs sharp increase in default rates accompanied by large
losses of capital that result in public interve ntion, bankruptcy or forced
merger of financial institutions.
From the above definitions it is clear that financial crisis is an adverse
economic phenomenon where a financial system falls in to serious trouble.
8.5.2 Types of Financial Crisis:
As per th e source of the crisis the financial crisis can be of following
types :
 Currency crisis: Where currency of a country loses its nominal
value. The exchange rate with another currencies goes down and
down.
 Balance of Payments (BoP) crisis: Where Balance of Pa yment
Account have fundamental long run deficit.
 External debt crisis: Where country is unable to repay her external
debt and declare herself bankrupt
 Sovereign debt crisis: Sovereign debt refers to the amount of money
borrowed by a country’s central gove rnment. This is the situation
when the government is unable to repay even the interest on this
sovereign debt.
 Banking crisis: It is the situation where the banking system of a
country have miserably lost the value of its capital assets.
 Corporate debt c risis: When the majority corporate institutions of the
country are lost in debt traps
 Household debt crisis: When the majority common households of
the country are not in position to repay their debts.
 Oil crisis: When the oil supply of the world drastica lly declines and
affects the trade and commerce of the world. munotes.in

Page 115

115 International Financial Institutions - II  Real estate crisis: When the real estate sector of the country
continuously loses its assets value on large scale.
8.5.3 Some Examples of Financial Crisis:
Financial Crisis are very common. We will find so many incidences in the
history inclined towards financial crises. Some of them are as follows :
Tulip Mania (1637):
It was a period during the Dutch Golden Age when contract prices for
some tubers of the fashionable tulip reached unusually v ery high. The
prices started rising in 1634 and then melodramatically collapsed during
February 1637. It is normally considered to have been the first
recorded speculative bubble in history.
Credit Crisis of 1772:
It was originated in London and spread ov er Europe within a short period
of time. After a period of speedily expanding credit, this crisis started in
March/April of 1772 in London. Alexander Fordyce, an eminent Scottish
banker, centrally involved in the bank run on Neale, lost a huge sum
shorting shares of the East India Company and fled to France to avoid
repayment. Panic led to a run -on many English banks that left large banks
either bankrupt or stopping payments to depositors.
Stock Crash of 1929 :
This was also called as great wall street cra sh, started on Oct. 24, 1929,
saw share prices downfall after a period of wild speculation and borrowing
to buy shares. This was a starting point of the Great Depression, which
was felt worldwide for more than ten years. Its impacts lasted far longer.
A dr astic oversupply of commodity crops triggered this crash, which
finally led to a steep decline in prices. A wide range of regulations and
market -managing tools were introduced as a result of the crash.
1973 OPEC Oil Crisis:
Organisation for Petroleum Expo rting Countries members started an oil
production cut in October 1973 targeting countries that supported Israel in
the Yom Kippur War. By the end of this restraint, the prices of oil plunged
four times at international level. As all the modern economies we re
depending on oil, the higher prices and uncertainty led to the stock market
crash of 1973 –74.
Asian Crisis of 1997 –1998:
This crisis started in July 1997 with the collapse of the Thai currency. Due
to constant currency devaluations, led to stock marke t fluctuations and
asset price decline. The crisis spread to much of East Asia, also hitting
Japan, as well as a huge rise in debt -to-GDP ratios of most of the east
Asian countries.
munotes.in

Page 116

116 International Finance
116 Global Financial Crisis2007 -2008:
It is supposed that this financial c risis was the worst economic disaster
since 1929. It started in USA with a subprime mortgage lending crisis in
2007 and expanded into a global banking crisis with the collapse of
investment bank Lehman Brothers in September 2008. The whole world
shaken fro m this crisis.
8.6 CURRENCY CRISIS A currency crisis is a type of financial crisis. It is a situation in which the
central bank of a country loses trust on a very serious ground that whether
it has sufficient foreign exchange reserves to maintain the coun try's fixed
exchange rate. The crisis is often followed by a large -scale speculative
attack in the foreign exchange market of a country.
A currency crisis normally involves the following steps….
 central banks inability to maintain sufficient reserves
 To maintain fixed exchange rate becomes difficult
 Speculative attacks in foreign exchange market of the economy
 sudden and drastic devaluation in a nation's currency
 Markets become more volatile
 faith in the nation's economy is lost
 Devaluation of the curre ncy becomes inevitable
A currency crisis normally results from long -lasting balance of
payments deficits, and therefore also called a balance of payments crisis.
Often such a crisis ends in a devaluation of the currency of the country.
8.6.1 Causes of a Currency Crisis:
Many internal as well as external factors are responsible for a currency
crisis in a country. Some of them may be as follows.
a) Inflation:
Inflation always remains th e biggest threat to the internal value of the
currency. Normally, central bank is assigned to maintain price stability in
the economy. But there are so many factors contributing to start to creep
the inflation higher. Inflation in the economy devaluates th e internal value
of the currency resulting in decreasing export and increase in import. Such
inflationary situation leads to deficit in the balance of payments of the
country.
b) Debt:
Heavy external debt can put pressure upon the foreign exchange reserve
while repaying it. Such situation also may hamper the credit ratings of the munotes.in

Page 117

117 International Financial Institutions - II economy at international level. This will turn in lowering the external
value of the currency .
c) Political Issues:
The issues like political instability in the country may hamper th e image of
the government and finally of the country at international level. This can
lead to lowering the external value of the domestic currency.
d) Loss of confidence in the central bank:
Adverse monetary policy of the central bank can create panic the fo reign
exchange market. Investors trust upon the central bank may decline in
such situation. The foreign investors may start to withdraw their
investments which will drain out the valuable foreign exchange from the
country. This situation may lead to contin uous devaluation of the domestic
currency.
e) Poor performance of the economy:
Poor performance of the economy may lead to loss of confidence by
investors. Foreign investors may start leaving. This will create flight of
investments.
8.7 INTERNATIONAL DEBT The term international debt is also referred as foreign debt or external
debt. External debt is the loans raised through foreign lenders. There
foreign lenders can be foreign commercial banks, foreign governments,
and international financial institutions.
The total liabilities of a country which normally include debt securities,
such as bonds, notes and money market instruments, as well as loans,
deposits, currency, trade credits and advances due to non -residents, is
called as foreign debt. The debt may be issued with different maturity
outlines by the general government, banks, and other sectors.
Foreign debt is raised and also repaid in internationally accepted
currencies.
8.7.1 Types of International Debt:
International debt is classified on following various ground.
a) Long - and Short -Term Debt :
This classification is based on the time period of maturity of the debt
raised at international level.
The debt with an original maturity of more than one year is called as long -
term debt. Short term debt can be defined as debt which is to repaid on -
demand or with maturity of one year or even less.
munotes.in

Page 118

118 International Finance
118 b) Multilateral and Bilateral Debt :
This classification is based on the sources of debt.
When the debt is raised from multilateral institutions like the International
Development Association (IDA), International Bank for Reconstruction
and Development (IBRD), Asian Development Bank (ADB), BRIKS
Bank etc is considered as multilateral creditors.
When the debt is raised by the government of a country from the
government of another country (one -to-one loan arrangement), such debt
is called as bilateral debt. And the creditor in such procedure are bilateral
creditors. India’s bilateral creditors are Japan, United States, France,
Germany etc.
c) Sovereign and Non -Sovereign debt :
Sovereign debt is also referred to as government debt, national debt,
public debt, or country debt. It is the debt which is raised by government
of a country. It The sovereign foreign debt of a country consists of all its
debt liabilities to foreign credito rs. Theoretically, the sovereign debt of a
country is a liability of the government rather than a direct liability of the
citizens of that country.
Non-Sovereign debt is the rest of the components of external debt i.e.,
Trade/Export Credits, External Comm ercial Borrowings etc. Non -
Sovereign debt is the primary responsibility of the individual borrower,
may be an individual, a company or an institution.
d) Gross foreign debt and Net foreign debt :
The gross foreign debt of an economy is the total outstanding a mount of
its actual current liabilities that require payment of principal amount
and/or interest to non -residents at some point in the future.
The net foreign debt is obtained by subtracting the gross foreign debt
assets from the liabilities. The gross fo reign debt assets here mean the
lending by residents of the country to non -residents and official reserve
assets held by the central bank.
8.7.2 India's External Debt: Creditor -Wise:
In the following table India’s external debt (Creditor -Wise) is given. The
table will help to understand the India’s current external debt position as
well as the components of the external debt for a country. Absolute Variation Percentage Variation Item Mar 2020 Mar 2021 Mar 2022 Mar-22 over Mar-21 Mar 22 over Mar 21 I. Multilateral 59.9 69.7 72.8 3.0 4.4 munotes.in

Page 119

119 International Financial Institutions - II II. Bilateral 28.1 30.9 32.3 1.3 4.3 III. International Monetary Fund 5.4 5.6 22.9 17.2 305.7 IV. Trade Creditors 7.0 6.3 3.4 -2.9 -46.3 V. Commercial 219.5 217.1 227.8 10.7 4.9 VI. Non-resident Depositors (above one-year maturity) 130.6 141.9 139.0 -2.9 -2.0 VII. Rupee Debt 1.0 1.0 1.0 0.0 -1.5 VIII. Short-term Creditors 106.9 101.1 121.7 20.6 20.4 a) Trade related creditors 101.4 97.3 117.4 20.1 20.7 GROSS EXTERNAL DEBT POSITION (I to VIII) 558.4 573.7 620.7 47.1 8.2 A. Total Long-term Debt 451.6 472.6 499.1 26.5 5.6 B. Short-term Debt 106.9 101.1 121.7 20.6 20.4
Source : INDIA’S EXTERNAL DEBT A STATUS REPORT 2021 -22,
GOI Report
https://www.dea.gov.in/sites/default/files/India%27s%20External%20Deb
t%20 -%20A%20Status%20Report%202021 -22.pdf
8.8 MEASURES OF INDEBTEDNESS Indebtedness for a country is the state of being in debt, or owing money to
someone else. As far external debt is concerned the indebtedness is a
situation where a country is liable to repay the amount to her creditor, it
may a country or any international institution or a company or a person.
Followin g are the measurements used to measure the indebtedness of a
country :
a) External Debt to GDP Ratio:
The ratio of the external debt stock to GDP is derived by scaling the total
outstanding debt stock (in rupees) at the end of the financial year by the
GDP ( in rupees at current market prices) during the financial year.
b) Debt Service Ratio:
Debt service ratio is measured by the proportion of total debt service
payments (i.e. principal repayment plus interest payment) to current
receipts (minus official transf ers) of Balance of Payments (BoP). It
designates the claim that servicing of external debt makes on current munotes.in

Page 120

120 International Finance
120 receipts and is, so, a measure of strain on BoP due to servicing of debt
service commitments.
c) Ratio of Foreign Exchange Reserves to Total Debt:
It is the proportion of foreign exchange reserve in the hands of central
bank to the total external debt of a country. It is considered to know
whether the foreign reserve funds are adequate to meet the international
payment obligations or not.
d) Ratio of Tot al External Debt to GDP:
The debt -to-GDP ratio is usually used in economics to gauge a country’s
ability to repay its debt. Simply it is the ratio of a country’s total debt to
its gross domestic product (GDP) of a particular year. Expressed as a
percenta ge, the debt -to-GDP ratio compares a country’s public debt to its
annual economic output.
e) Ratio of Concessional Debt to Total Debt:
Usually, a loan is defined as ‘concessional’ when it is entitled to a grant
element of 25 per cent or more. In India, loans from multilateral sources
(the International Development Association (IDA), International Fund for
Agricultural Development (IFAD)) and bilateral sources (including rupee
debt that is serviced through exports) is categorized as ‘concessional’,
based on th eir terms of long maturity and less -than-market rate of interest
charged on them. This ratio is considered to know the burden of the
external debt in near future.
f) Ratio of Short -term Debt to Foreign Exchange Reserves:
Immediate liability of the country t o repay short term debt for which
foreign exchange is needed. To judge the current foreign debt position of
the country Ratio of Short -term Debt to Foreign Exchange Reserves is
calculated. The ratio lower than one, indicates country’s is capable enough
to repay her current liabilities.
g) Ratio of Shor term Debt to Total Debt:
This ratio gives the percentage of current external liabilities of the country.
8.9 INTERNATIONAL DEBT CRISIS Debt crisis is a situation where a country finds it difficult to pay ba ck its
government debt. Normally a country enters into a debt crisis when
the revenue of the government is less than its expenditure for a persistent
period.
Normally taxation is the important way to finance the public expenditures
for any government. If tax revenue becomes inadequate, the government
can fill up the differences by issuing its treasury bills in the open market.
The investment institutions as well as general public purchase such bills as
an investment instrument. munotes.in

Page 121

121 International Financial Institutions - II When the government has a g ood record of repaying debt or has a very
little debt, it doesn’t face any difficulty in raising new loans from the
market. But if the government is burdened with heavy debt and become
helpless to repay her debt, the trust of the investors is lost. Such
government face difficulties in raising new loans. This debt trap for the
country is called as debt crisis. When the debt crisis is related to only the
government of the country not to the individuals or institutions, such debt
crisis is called as sovereign debt crisis.
There are many examples of debt crisis for the various countries. Two of
the famous debt crises examples from the history are discussed below.
8.9.1 Sovereign Debt Crises in the 1980s:
This crisis the first major external financial crisis since the Great
Depression of 1929, that directly affected emerging market countries and
also endangered the international economic and financial system.
During the decade of 1980s, the Latin America and other developing
regions become highly indebted. The problem started in August 1982 as
Mexico declared incapability to service its foreign debt. Soon thereafter,
Brazil and Argentina were also dropped in the same situation. By spring
1983, about 25 developing countries were unable to make regularly
schedule d payments and started negotiation for rescheduling with creditor
banks. These countries accounted for 66% of the total debt owed to private
banks by those developing countries that do not produce oil.
This crisis involved long -term commercial bank debt wh ich was
accumulated in the public sector. The governments of developing
countries were unable to repay the debt and started requesting for help, so
financial rescue operations became necessary.
Anatomy of the crisis was as follows :
 Initially during 1960s there were growth and investment opportunities
in these countries, because economies started to open and to rise in
the second half of the 1960s.
 In 1973 -74s oil shock, skyrocketed the current -account deficit of the
borrowing nations, accelerated bank lo ans to these countries.
 During the oil shock of 1973s, the higher oil prices escalated the
problem of inflation and unemployment for the world
 world recession followed the oil shock where many developing
countries began to incur large balance -of-payments deficits during the
early 1980s, because the worldwide recession of 1979 -82 compelled
industrial countries to reduce their imports from developing countries.
 capital flight, prompted by political and economic uncertainty, caused
the debt crisis. The Worl d Bank estimated the capital flight, from
Latin American debtor countries to industrial countries, as exceeded
$70 billion between 1979 and 1982. munotes.in

Page 122

122 International Finance
122 8.9.2 European Sovereign Debt Crisis of 2008 :
During the European sovereign debt crisis several European coun tries
experienced the collapse of financial institutions and high government
debt. The crisis began in 2008 when the banking system of Iceland got
collapsed. Initially in 2009, this spread to Portugal, Italy, Ireland, Greece,
and Spain. It led to a loss of trust in European businesses and economies.
The crisis was finally controlled by the financial guarantees of European
countries as these were under horror of the collapse of the euro and
financial contamination, and also by the help of International Mo netary
Fund (IMF).
The structure of this debt crisis was as follows :
 During 2007 to 2008 the financial crisis originated in US spread to
Europe and then to whole world.
 The Great Recession followed during 2008 to 2012, the real estate
market crisis and pr operty bubbles in several countries.
 By the end of 2009, the exterior Eurozone member states of Greece,
Spain, Ireland, Portugal, and Cyprus expressed their inability to repay
or refinance their government debt.
 In 2009, Greece revealed the underreportin g of its budget deficit by its
previous government, signifying a violation of EU policy. It
prompted the fear of euro collapse via political and financial
infection.
 17 Eurozone countries voted to create the EFSF in 2010, specifically
to address and assi st with the crisis.
 The debt crisis peaked between 2010 and 2012.
 Increasing fear of excessive sovereign debt, creditors demanded
higher interest rates from Eurozone states. Due to high debt and high
deficit levels, it became difficult to these countries to finance their
budget deficits when they were facing with low economic growth.
 international credit rating agencies downgraded the sovereign debt of
some of these countries, including Greece, Portugal, and Ireland to
junk status. This again led to worse ning investor fears.
8.10 SUMMERY An optimum currency area (OCA) or optimal currency region (OCR) is
considered as the final stage of economic integration where an entire
geographical region shares a single currency to maximize economic
efficiency of the r egion. For a successful optimum currency area, the
region needs to fulfil some of the criteria. High level policy coordination munotes.in

Page 123

123 International Financial Institutions - II at international is needed. This single currency area is also highly
vulnerable for the financial irregularities as each member nation is open to
import it from others. European Union Sovereign Debt Crisis is a good
example of this.
8.11 QUESTIONS a) Discuss the theory of Optimum Currency Area.
b) What is international debt? Explain the types of international debts.
c) What do you mean by financial crisis? Discuss the concept of
currency crisis with example.

*****

munotes.in