International Finance IF1 - Globalization (SKEMA Business School) PDF

SK SKEMA Business School Topic 1 – Globalization and the Multinational Firm Overview Why study International Finance? What’s special about International Finance? Goals for international financial management. Globalization of the world economy. Multinational corpor...

SK SKEMA Business School Topic 1 – Globalization and the Multinational Firm Overview Why study International Finance? What’s special about International Finance? Goals for international financial management. Globalization of the world economy. Multinational corporations. Why Study International Finance?  The world economy is highly globalized and integrated in. the markets for goods and services. the financial markets.  Today, all the major economic functions are globalized: Consumption. Production. Investment. What’s Special about International Finance?  Four major dimensions set international finance apart from domestic finance: 1. Foreign exchange risk. 2. Political risks. 3. Market imperfections. 4. Expanded opportunity set.  These are largely because sovereign nations have the right to issue currencies, formulate their own economic policies, impose taxes, and regulate movements of people, goods, and capital across their borders. Foreign Exchange Risk Foreign exchange risk stems from uncertain future exchange rates. For example, profits made in a foreign currency may disappear once converted into the domestic currency due to unanticipated exchange rate movements. Exchange rates among major currencies (for example, U.S. dollar, Japanese yen, British pound, and euro) fluctuate continuously in an unpredictable manner. Exchange rate uncertainty influences all major economic functions, including consumption, production, and investment.  *Remark: Fixed exchange rates were abandoned in the early 1970s.  Foreign Exchange Risk Example  Suppose $1 = ¥100 today, and you invest $1,000 to buy 50 shares of Toyota at ¥2,000 per share (initial investment: ¥100,000).  One year later, the share price has increased by ten percent, and your investment is worth ¥110,000.  If the yen has depreciated to $1 = ¥120 by that time, how much is your investment worth in dollar terms? Initial investment in dollars: $1,000. Initial investment in yen: $1,000 × (¥100/$) = ¥100,000. Maturity value in yen: ¥110,000 (after 10% increase). Maturity value in dollars: ¥110,000 / (¥120/$) = $916.67.  You lost money due to yen depreciation even though Toyota’s share price went up.  Monthly Percentage Change in Japanese Yen—U.S. Dollar Exchange Rate  Source: Bank for International Settlements, US dollar exchange rates. Political Risk Political risk arises from the fact that a sovereign country can change the “rules of the game” and the affected parties may not have effective recourse.  Multinational corporations and international investors are exposed to political risks when they operate in certain foreign countries or hold foreign assets.  Political risks range from unexpected changes in tax rules to outright expropriation of assets held by foreigners.  Especially relevant in those countries without a tradition of the rule of law, where the rights of shareholders and investors may not be protected. Market Imperfections Market imperfections are frictions and impediments hampering free movements of people, goods, services, and capital across national boundaries and preventing markets from functioning perfectly: Legal restrictions. Transaction and transportation costs. Information asymmetry. Discriminatory taxation. World markets are highly imperfect. Motivates MNCs to locate production overseas. Restricts the extent to which investors can diversify their portfolios. Example of Market Imperfections: Nestlé  Nestlé used to issue two different classes of common stock, bearer shares and registered shares. Foreigners were only allowed to hold bearer shares. Swiss residents could buy registered shares.  The bearer shares were more expensive than registered shares.  On November 18, 19 88, Nestlé lifted restrictions imposed on foreigners, allowing them to hold registered shares as well as bearer shares. Price spread between the two share types narrowed drastically.  Daily Prices of Nestlé’s Bearer and Registered Shares  Source: Loderer, Claudio, and Andreas Jacobs. 19 95. “The Nestlé Crash.” Journal of Financial Economics, 37, no. 3: pp. 315–39, Elsevier Science S.A. Expanded Opportunity Set  Firms and investors may benefit from an expanded opportunity set when they venture into global markets. Firms can locate production anywhere in the world to maximize their performance, gain from greater economies of scale, and raise funds in any market to lower cost of capital. Investors can benefit from diversifying internationally due to lower risk or higher return (or both) of international portfolios compared to domestic portfolios.  “It just doesn’t make sense to play in only one corner of the sandbox.” Goals for International Financial Management (1)  Global financial managers focus on how to maximize the benefits from the global opportunity set, while controlling political and exchange rate risks and managing various market imperfections.  Fundamental goal of sound financial management is shareholder wealth maximization, which means the firm makes all business decisions and investments with an eye toward making the owners of the firm (that is, shareholders) better off financially.  Generally accepted as the ultimate goal in countries like the U.S., U.K., Australia, and Canada, but not as widely embraced in other parts of the world. Goals for International Financial Management (2)  Continental Europe (for example, France and Germany):  Shareholders are viewed as one among many “stakeholders” of the firm, others being employees, suppliers, customers, and banks etc.  Japan:  Managers have typically sought to maximize the value and growth of the keiretsu—a family of firms to which individual firms belong. Corporate Governance o Managers may pursue their own private interests at the expense of shareholders when they are not closely monitored. o This “agency problem” is a major weakness of the public corporation. o Corporate governance is the financial and legal framework for regulating the relationship between a firm’s management and its shareholders. o Corporate governance problems can be especially rife where the legal protection of shareholders is weak or nonexistent. Globalization of the World Economy: Major Trends and Developments 1. Emergence of Globalized Financial Markets. 2. Multinational Corporations 3. Privatization 4. Trade Liberalization and Economic Integration 5. Global Financial Crisis of 2008 to 2009 Emergence of Globalized Financial Markets Forces that contributed to the emergence of globalized financial markets:  Deregulation of financial markets.  Financial innovations such as: Currency futures and options. Multi-currency bonds. Cross-border stock listings. International mutual funds.  Advances in technology.  Multinational Corporations  A multinational corporation (MNC) is a firm that is incorporated in one country and has production and sales operations in other countries.  MNCs benefit from economy of scale in many ways: Spreading R and D expenditures and advertising costs over their global sales. Pooling global purchasing power over suppliers. Utilizing their technological and managerial know-how globally with minimum additional costs. Accessing underpriced labor and special R and D capabilities in certain countries.  Privatization  Privatization is the act of a country divesting itself of ownership and operation of business ventures by turning them over to the free market system.  May be described as a denationalization process.  Selling state-owned businesses brings in hard-currency foreign reserves to the national treasury.  Often seen as a cure for bureaucratic inefficiency and waste.  Some economists estimate privatization improves efficiency and reduces operating costs by as much as 20%.  Case: Chinese Privatization  State-owned enterprises (SOEs) have been listed on organized stock exchanges, making them eligible for private ownership.  China launched two stock exchanges, the Shanghai Stock Exchange and the Shenzhen Stock Exchange, in the early 1990s As of 2021, approximately 4,400 companies are listed on China’s stock exchanges. “A-shares” are primarily reserved for Chinese citizens, while foreigners may invest in “B-shares” or “H-shares.”  Chinese government still retains the majority stakes in most public firms Trade Liberalization and Economic Integration  The principal argument for international trade is based on the theory of comparative advantage. It is mutually beneficial for countries if they specialize in producing the goods they can produce most efficiently and trade those goods among them. It is about relative advantage, not absolute advantage. International trade is an “increasing-sum game,” not a “zero- sum” game, and will enhance the welfare of the world’s citizens.  Long-Term Openness in Perspective: Exports/GDP (%) County 1870 1913 1929 1950 1973 2020 United States 2.5 3.7 3.6 3.0 5.0 10.1 Canada 12.0 12.2 15.8 13.0 19.9 29.4 Australia 7.4 12.8 11.2 9.1 11.2 24.0 United 12.0 17.7 13.3 11.4 14.0 28.1 Kingdom Germany 9.5 15.6 12.8 6.2 23.8 43.4 France 4.9 8.2 8.6 7.7 15.4 27.9 Spain 3.8 8.1 5.0 1.6 5.0 30.6 Japan 0.2 2.4 3.5 2.3 7.9 15.5 Korea, Rep. 0.0 1.0 4.5 1.0 8.2 36.4 Thailand 2.1 6.7 6.6 7.0 4.5 51.5 Argentina 9.4 6.8 6.1 2.4 2.1 16.6 Brazil 11.8 9.5 7.1 4.0 2.6 16.9 Mexico 3.7 10.8 14.8 3.5 2.2 40.2 World 5.0 8.7 9.0 7.0 11.2 26.5 Trade Liberalization and Economic Integration (1)  At the global level: General Agreement on Tariffs and Trade (GATT) is a multilateral agreement among member countries that has reduced many barriers to trade. It was founded in 1947. The World Trade Organization (WTO) replaced the GATT. It has more power to enforce the rules of international trade. China joined the WTO in 2001. WTO’s latest round of talks, the Doha Round, has stalled mainly over a divide between the developed and the Trade Liberalization and Economic Integration (2)  At the regional level: The European Union (EU) includes 27 member states that have eliminated barriers to the free flow of goods, capital, and people. North American Free Trade Agreement (NAFTA) called for phasing out impediments to trade between Canada, Mexico, and the United States over a 15-year period beginning in 1994.  In November 2018, the three countries signed a new accord, the U.S.-Mexico-Canada-Agreement (USCMA). Global Financial Crisis of 2008 to 2009  The subprime mortgage crisis in the U.S. led to a severe credit crunch, which then escalated to a global financial crisis.  Factors that drove the financial crisis: Households and financial institutions borrowed too much and took too much risk. Crisis was amplified and transmitted globally by securitization. Securitization allows loan originators to avoid bearing the default risk, which leads to a compromised lending standard and increasing moral hazard. “Invisible hands” of free markets apparently failed to self- regulate excesses, contributing to the banking crisis. U.S. Unemployment Rate and Dow Jones Industrial Average (DJIA)  Source: Bloomberg. Optional Reading  “International Financial Management”, By Cheol Eun, Bruce Resnick and Tuugi Chuluun, 10th Edition, 2024  Chapter 1