Chapter 1: Foundation of International Finance PDF

CHAPTER 1. FOUNDATION OF INTERNATIONAL FINANCE Learning Outcomes At the end of the chapter, you should be able to: 1. Identify the forces influencing global finance and global financial stability and their role in glo...

CHAPTER 1. FOUNDATION OF INTERNATIONAL FINANCE Learning Outcomes At the end of the chapter, you should be able to: 1. Identify the forces influencing global finance and global financial stability and their role in global business strategies. 2. Describe the foundations of international financial system. INTRODUCTION International finance encompasses the financial interactions and transactions that occur across national borders, involving various financial instruments, institutions, and markets. It plays a crucial role in facilitating trade, investment, and economic growth on a global scale. The nature of international finance is characterized by its complexity, as it integrates diverse elements such as exchange rates, capital flows, and multinational corporate finance. The foundation of the international financial system is built on a network of global financial markets, institutions, and agreements that facilitate the exchange of capital and currencies across borders. This system enables countries, businesses, and investors to access funding, manage risks, and participate in global trade. the international financial system aims to foster economic cooperation, stability, and growth in a rapidly interconnected world. Nature and Definition of International Finance International finance involves a system of financial markets and institutions that govern capital flows, impacting both local and global economies(Mladenovski, 2023). International finance refers to the management of monetary relations and financial transactions that cross international borders, including foreign direct investment and cross-border banking activities(Dumps, 2022) International Finance is the branch of financial economics broadly concerned with monetary and macroeconomic interrelations between two or more countries. International Finance examines the dynamics of the global financial system, international monetary systems, balance of payments, exchange rates, foreign direct investment, and how these relate to international trade. The social and economic development of any country greatly depends on an efficient financial system. It is responsible for financing vital programs and projects that promote and accelerate social and economic development. The rich countries like the United States, Japan, France, Great Britain and other Western European Countries are in a much better position to implement their plans of development because they have sufficient funds. Their financial systems Global Finance with E-banking For Classroom Use Only Wtitten by: Michelle M. Pacpaco are not only well- developed but also very efficient in their operations. On the other hand, the poor countries cannot even finance many of their basic development programs, such as irrigation, roads and bridges, communication facilities, and other development projects. The reason is, of course, the lack of funds. Thus, the last option is to borrow funds from the rich countries and international financial institutions like the World Bank, International Monetary Fund, and the Asian Development Bank. Relevance of Finance for Development A well developed financial system is the lifeblood of the economy. Large scale production and a high degree of specialization can only function with the framework of an effective financial system. Such system facilitates the payment of goods and services which are used in consumption or production. Under this situation, businesses can obtain the funds it needs to purchase capital goods like machinery, buildings and equipment. In the same manner, the national government and other government agencies can implement their various programs and projects if there are efficient ways of making payments and of borrowing money. In the case of the private sector, the goods to be produced and sold are determined by the price system. Goods that give more profits to the businessmen are given top priority in production and marketing. Ultimately, only the most efficient producers/sellers remain in business. And the financial system plays a decisive role in creating an economic environment conducive for both producers and consumers. International Business Finance International business finance refers to the management of financial resources in a global context, focusing on the complexities and risks associated with operating across different countries and currencies. It encompasses a range of activities, including capital allocation, risk management, and financial decision- making for multinational corporations (MNCs). Companies with foreign operations are called global organizations, international corporations or multinationals. These firms consider financial factors, which may not directly affect local companies, such as foreign exchange rates, differing interest rates from one country to another, complex accounting methods for foreign operations, foreign government intervention, and foreign tax rates. Similar with domestic firms, principles of business finance also apply to foreign operations. They also seek to invest in projects that create more value for the shareholders than they cost and to arrange financing that raises cash at the lowest possible cost. In other words, the net present value principle holds both for foreign and domestic operations, although it can be more complicated to apply time value of money to foreign investments. One significant complication of international business is foreign exchange. The foreign exchange markets provide important information and opportunities for an international corporation when it undertakes capital budgeting and financing decisions. These financial variables including international exchange rates, interest rates, and inflation rates, are closely related. Global Finance with E-banking For Classroom Use Only Wtitten by: Michelle M. Pacpaco International Financial System Global Financial System (International Financial System) is a worldwide framework of legal agreements, institutions, and both formal and informal economic actors that together facilitate international flows of financial capital for purposes of investment and trade financing. (Wikipedia.org) The global financial system is a complex network that facilitates the flow of capital, goods, and services across borders, governed by various institutions and regulations. It encompasses a range of actors, including multinational corporations (MNCs), financial markets, and international organizations like the IMF. This system has evolved significantly, particularly from the Bretton Woods era to the current floating exchange rate regime, impacting international trade and economic stability. (Journal, 2024) Evolution of International Financial System Gold Standard - is a monetary system in which the standard economic unit of account is based on a fixed quantity of gold. (wikepedia.org) The gold standard defines a unit of account based on a specific mass of gold, with prices and accounts maintained in this standard("How a Gold Standard Works", 2023). Types:  Gold specie standard - the monetary unit is associated with the value of circulating gold coins or the monetary unit has the value of a certain circulating gold coin, but other coins may be made of less valuable metal. The gold specie standard operates by pegging national currencies to a defined mass of gold, ensuring that banknotes can be exchanged for gold at a predetermined rate(Knafo, 2017).  Gold exchange standard-usually does not involve the circulation of gold coins. The main feature of the gold exchange standard is that the government guarantees a fixed exchange rate to the currency of another country that uses a gold standard (specie or bullion), regardless of what type of notes or coins are used as a means of exchange. This creates a de facto gold standard, where the value of the means of exchange has a fixed external value in terms of gold that is independent of the inherent value of the means of exchange itself. The gold exchange standard is a monetary system that allows countries to hold reserves in gold or foreign currencies convertible into gold, facilitating international trade and currency stability. This system emerged after the classical gold standard and was intended to stabilize exchange rates while providing flexibility in monetary policy. (Vasudevan, 2024).  Gold bullion standard is a system in which gold coins do not circulate, but the authorities agree to sell gold bullion on demand at a fixed price in exchange for currency. Global Finance with E-banking For Classroom Use Only Wtitten by: Michelle M. Pacpaco  As of 2024 no country used a gold standard as the basis of its monetary system, although some hold substantial gold reserves. Bretton Woods System is the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states. This system facilitated international cooperation and the establishment of key institutions like the International Monetary Fund (IMF) and the World Bank, which were designed to promote economic stability and development(Meissner, 2024) (Eynalizade, 2023) (Pittaluga & Seghezza, 2021). It is the international monetary system that creates or established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD) now known today as the World Bank. Functions of Financial Institutions Creation of money. This is done by the banking system. Through deposits of individuals in banks, more money s loaned out to borrowers. This process of savings and lending creates a multiple expansion of money. Transferring money. This is being performed by financial institutions under the financial system most especially by the universal and commercial banks through checking account or demand deposits. Accumulation of savings. Many different types of financial institutions performs perform this function. They encourage people through various promotions to save their money in banks. People place their money in banks not only for interest earnings but also for safekeeping. Lending and investing money.This is a basic function of financial institutions wherein the savings of individuals that have been placed in financial institutions are being utilized by borrowers like businessmen, farmers, fishermen and consumers. Some financial institutions invest all part of the savings of individuals in shares of ownership in a business. Marketing of claims to wealth. Savings may be invested directly or placed with financial institutions that invest them. For example, a company decides to sell shares of ownership to the people. This can be done directly, that is without agents or financial intermediaries. Certain types of financial institutions like investment banks or investment houses have been developed to sell shares of ownership. Facilitating the lending and investing process. Several types of financial institutions act as facilitating agencies in the process of lending and of selling securities. For example, if shares of stocks are to be sold to the people, there should be a ready market for the resale of stocks in case investors do not want to hold them anymore. Stock exchanges, like the Philippine Stock Exchange. International Financial Institutions The country is considered part of the Global South, indicating it is a developing or low-income nation. A fundamental characteristic of its economy is a Global Finance with E-banking For Classroom Use Only Wtitten by: Michelle M. Pacpaco shortage of financial resources. The Philippine economy is a developing economy, particularly an agricultural economy. It does not have enough funds for its various programs/projects of development. Being a developing country, it has to lay the social and economic foundations of the economy like education, health, irrigation, transportation, communication, and electrification among other things. Just like most- if not all – poor countries, the Philippines greatly depends on the international financial institutions to finance its major development programs. Among the international financial institutions are the World Bank, International Monetary Fund and the Asian Development Bank. These three institutions are the biggest lenders to the poor and developing countries. Nevertheless, it is not easy to borrow development funds from the aforementioned institutions. There are many policies and conditions which are imposed on borrowing countries. For instance, the Philippines’ monetary and fiscal policies came from the WB-IMF recommendations. Failure to comply with said recommendations means disapproval of our WB-IMF loans. In the case of our IMF standby credit, its approval or release has been delayed for a long time, because the government has not been able to meet at once all the conditions of the IMF. Among other things, such conditions included: 1. the devaluation of the peso, 2. the increase of taxes 3. fiscal discipline 4. reduction of liquidity in the economy, and 5. the removal of price controls and subsidies. International Monetary System International Monetary System is a system reflecting the development needs of people living in different economic conditions, social systems and cultural environment. The International Monetary System (IMS) is a framework that governs monetary relations among countries, facilitating currency exchange, international payments, and capital movements. It has evolved significantly, transitioning from the Bretton Woods system to the current floating exchange rate regime. This evolution has implications for global trade and multinational corporations (MNCs), particularly during financial crises, which can lead to increased exchange rate volatility and reduced trade volumes(Journal, 2024). Objectives of a New International Monetary System A new international Monetary System must serve the following fundamental objectives: 1. It must be capable of a. achieving monetary stability b. restoring acceptable levels of employment and sustainable growth; and c. checking the present strong inflationary tendencies in the world economy. 2. It must be supportive of a global development, especially for the Third World countries where most of the world`s poor live. Global Finance with E-banking For Classroom Use Only Wtitten by: Michelle M. Pacpaco  Money is anything that is generally accepted in payment for goods and services or in the repayment of debts. Money is a multifaceted concept that serves as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment. It is fundamentally a social relationship between creditors and debtors, shaped by historical, economic, and cultural contexts. This understanding broadens the scope of economic analysis, allowing for the identification of various forms of money beyond traditional definitions(Chowdhury, 2024) (Galvin & Galvin, 2020). Money supply refers to all BSP notes and coins in circulation, thus the quantity of money. The money supply refers to the total amount of monetary assets available in an economy at a specific time, encompassing various forms of currency and deposits. It is a critical indicator of economic health, influencing inflation, interest rates, and overall economic growth. (Bujung et al., 2024)(Anggarini, 2016). Monetary Policy refers to the measures or actions taken by the Bangko Sentral ng Pilipinas to help keep inflation low and stable. It is the management of money supply and interest rates. Monetary policy is a crucial economic tool employed by central banks to regulate a nation's economy by controlling the money supply, interest rates, and exchange rates. Its primary objective is to achieve macroeconomic stability, which includes managing inflation and fostering economic growth. The implementation of monetary policy can vary significantly across different economic systems, such as conventional and sharia-based systems, reflecting the unique challenges and goals of each context(Aziz, 2023)(Raihan et al., 2023). The BSP conducts monetary policy using an approach called Inflation Targeting. Monetary policy actions of the BSP are aimed at influencing the timing, cost and availability of money and credit, as well as other financial factors, for the main objective of stabilizing the price level. Types of Monetary Policy  Expansionary Monetary Policy is a monetary policy setting that intends to increase the level of liquidity/money supply in the economy and which could also result in a relatively higher inflation path for the economy. Examples are the lowering of policy interest rates and the reduction in reserve requirements. Expansionary monetary policy tends to encourage economic activity as more funds are made available for lending by banks. This, in turn, increases aggregate demand which could eventually fuel inflation pressures in the domestic economy.  Contractionary Monetary Policy is a monetary policy setting that intends to decrease the level of liquidity/money supply in the economy and which could also result in a relatively lower inflation path for the economy. Global Finance with E-banking For Classroom Use Only Wtitten by: Michelle M. Pacpaco  Examples of this are increases in policy interest rates and reserve requirements. Contractionary monetary policy tends to limit economic activity as less funds are made available for lending by banks. This, in turn, lowers aggregate demand which could eventually temper inflation pressures in the domestic economy. International Considerations Affecting the conduct of Monetary Policy  Direct Effects of the Foreign Exchange Market on the Money Supply When central banks intervene in the forex market, they acquire or sell off international reserves, and their monetary base is affected. Likewise, it gives up some control of its money supply. International Reserve – central bank holdings of assets denominated in foreign currencies. International reserves consist of liquid assets that provide purchasing power internationally, primarily held by monetary authorities(Gandolfo, 2016). They include foreign currencies, gold, and special drawing rights (SDRs), with a shift towards diversified assets in response to global economic changes(Бунич & Шарма, 2021). Monetary Base – the sum of the central bank`s monetary liabilities (currency in circulation) and Treasury Office`s monetary liabilities (treasury currency in circulation, primarily coins.) The monetary base, often referred to as central bank money, comprises currency in circulation and bank reserves held at the central bank. It serves as a critical tool for monetary policy, influencing economic stability and inflation rates. The monetary base can be manipulated through the purchase and sale of assets, such as foreign exchange and government securities, which directly affects its size and, consequently, the broader money supply(Weber, 2019)(Negro & Sims, 2015). The lower price of imports and higher price of exports as a result of an appreciation in its currency will hurt domestic producers and increase unemployment.  Balance of Payments Considerations The Balance of Payments (BOP) is a comprehensive accounting framework that records a country's economic transactions with the rest of the world over a specific period. It encompasses trade in goods and services, financial transactions, and transfers, providing insights into a nation's economic health and international economic relations. The BOP is divided into several accounts, including the current account, capital account, and financial account, each reflecting different types of transactions. ("The Balance of Payments", 2023)(Nepal et al., 2024). Countries with balance-of-payments deficits do not want to see their currency lose value, because it makes foreign goods more expensive for domestic consumers and can stimulate inflation. To keep the value of the domestic currency high, deficit countries have often bought their own currency in the foreign exchange Global Finance with E-banking For Classroom Use Only Wtitten by: Michelle M. Pacpaco market and it is necessarily gives up international reserves. To keep from running out of these reserves, under the Bretton Woods system it had to implement contractionary monetary policy to strengthen its currency. Conditions in the Balance of Payments Surplus Balance of Payments – a situation where foreign exchange receipts (incomes) are greater than the payments (expenses). In here, there is an excessive inflow of foreign exchange. Deficit Balance of Payments – a situation where the country’s collective disbursements are greater than that of its collective receipts. Here, there is an excessive outflow of foreign exchange. Equilibrium – is a condition wherein a country’s total collective receipts are equal to that of its total collective disbursements. Because the United States is a major reserve currency country, it can run large balance-of-payments deficits without losing huge amounts of international reserves. This does not mean, however, that the Federal Reserve is never influenced by developments in the U.S. balance of payments.  Exchange Rate Considerations Unlike balance of payments considerations, exchange rate considerations now play a greater role in the conduct of monetary policy. If a central bank does not want to see its currency fall in value, it may pursue a more contractionary monetary policy of reducing the money supply to raise the domestic interest rate, thereby strengthening its currency. Similarly, if a country experiences an appreciation in its currency, its domestic industry may from an increased in foreign competition and may pressure the central bank to pursue a higher rate of money growth so as to lower the exchange rate. Global Finance with E-banking For Classroom Use Only Wtitten by: Michelle M. Pacpaco