Global Finance Module 1 PDF

BEHAVIORAL FINANCE (FIMA 40043) MODULE 1: FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT LEARNING OBJECTIVES 1. Identify forces influencing global finance and global financial stability and their role in global busi...

BEHAVIORAL FINANCE (FIMA 40043) MODULE 1: FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT LEARNING OBJECTIVES 1. Identify forces influencing global finance and global financial stability and their role in global business strategies 2. Recognize the essence of financial system and banking and globalization process 3. Describe the foundations of international financial management International Financial Management International Financial Management is a well-known term in today’s world and it is also known as international finance. It means financial management in an international business environment. It is different because of the different currency of different countries, dissimilar political situations, imperfect markets, diversified opportunity sets. International Monetary System The international monetary system can be defined as the institutional framework within which international payments are made, movements of capital are accommodated, and exchange rates among currencies are determined. It is a complex whole of agreements, rules, institutions, mechanisms, and policies regarding exchange rates, international payments, and the flow of capital. The international monetary system has evolved over time and will continue to do so in the future as the fundamental business and political conditions underlying the world economy continue to shift. In this topic, we will review the history of the international monetary system and contemplate its future prospects. In addition, we will compare and contrast the alternative exchange rate systems, that is, fixed versus flexible exchange rates. For astute financial management, it is important to understand the dynamic nature of international monetary environments. Evolution of International Monetary System The international monetary system went through several distinct stages of evolution. These stages are summarized as follows: Bimetallism: Before 1875 Prior to the 1870s, many countries had bimetallism, that is, a double standard in that free coinage was maintained for both gold and silver. The international monetary system before the 1870s can be characterized as “bimetallism” in the sense that both gold and silver were used as international means of payment and that the exchange rates among currencies were determined by either their gold or silver contents One might say that the international monetary system was less than fully systematic up until the 1870s. Countries that were on the bimetallic standard often experienced the well-known phenomenon referred to as Gresham’s law. Gresham’s Law in economics is a monetary principle stating that when there are two forms of commodity money in circulation, which are accepted by law as legal tender and the same face values, the more valuable one – ‘good money’ – will be hoarded and will disappear from circulation, while the less valuable one – ‘bad money’ – will be passed on (used for transactions). Classical Gold Standard 1875 – 1914 The first full-fledged gold standard, however, was not established until 1821 in Great Britain, when notes from the Bank of England were made fully redeemable for gold. As previously mentioned, France was effectively on the gold standard beginning in the 1850s and formally adopted the standard in 1878. The newly emergent German empire, which was to receive a sizable war indemnity from France, converted to the gold standard in 1875, discontinuing free coinage of silver. The United States adopted the gold standard in 1879, Russia and Japan in 1897. One can say roughly that the international gold standard existed as a historical reality during the period 1875–1914. The majority of countries got off gold in 1914 when World War I broke out. The classical gold standard as an international monetary system thus lasted for about 40 years. An international gold standard can be said to exist when, in most major countries, (i) gold alone is assured of unrestricted coinage, (ii) there is two-way convertibility between gold and national currencies at a stable ratio, and (iii) gold may be freely exported or imported Under the gold standard, the exchange rate between any two currencies will be determined by their gold content. Under the gold standard, misalignment of the exchange rate will be automatically corrected by cross-border flows of gold. Under the gold standard, international imbalances of payment will also be corrected automatically. Price-Specie-Flow Mechanism - The price-specie flow mechanism is a model developed by David Hume to explain how trade imbalances can be  automatically adjusted under the gold standard. In its original form, the model assumes that only gold coins are circulated and the role of central bank is negligible. Interwar Period: 1915 – 1944 World War I ended the classical gold standard in August 1914, as major countries such as Great Britain, France, Germany, and Russia suspended redemption of banknotes in gold and imposed embargoes on gold exports. After the war, many countries, especially Germany, Austria, Hungary, Poland, and Russia, suffered hyperinflation. Freed from wartime pegging, exchange rates among currencies were fluctuating in the early 1920s. During this period, countries widely used “predatory” depreciations of their currencies as a means of gaining advantages in the world export market. As major countries began to recover from the war and stabilize their economies, they attempted to restore the gold standard. The United States, which replaced Great Britain as the dominant financial power, spearheaded efforts to restore the gold standard. With only mild inflation, the United States was able to lift restrictions on gold exports and return to a gold standard in 1919. In Great Britain, Winston Churchill, the chancellor of the Exchequer, played a key role in restoring the gold standard in 1925. Besides Great Britain, such countries as Switzerland, France, and the Scandinavian countries restored the gold standard by 1928. Bretton Woods System: 1945–1972 In July 1944, representatives of 44 nations gathered at Bretton Woods, New Hampshire, to discuss and design the post-war international monetary system. After lengthy discussions and bargains, representatives succeeded in drafting and signing the Articles of Agreement of the International Monetary Fund (IMF), which constitutes the core of the Bretton Woods system. The agreement was subsequently ratified by the majority of countries to launch the  IMF in 1945. The IMF embodied an explicit set of rules about the conduct of international monetary policies and was responsible for enforcing these rules. Delegates also created a sister institution, the International Bank for Reconstruction and Development (IBRD), better known as the World Bank, that was chiefly responsible for financing individual development projects. In designing the Bretton Woods system, representatives were concerned with how to prevent the recurrence of economic nationalism with destructive “beggar-thy- neighbor” policies and how to address the lack of clear rules of the game plaguing the interwar years. The British delegates led by John Maynard Keynes proposedan international clearing union that would create an international reserve asset called “bancor.” Under the Bretton Woods system, each country established a par value in relation to the U.S. dollar, which was pegged to gold at $35 per ounce. The Flexible Exchange Rate Regime: 1973– Present The flexible exchange rate regime that followed the demise of the Bretton Woods system was ratified after the fact in January 1976 when the IMF members met in Jamaica and agreed to a new set of rules for the international monetary system. The key elements of the Jamaica Agreement include: o Flexible exchange rates were declared acceptable to the IMF members, and central banks were allowed to intervene in the exchange markets to iron out unwarranted volatilities. o Gold was officially abandoned (i.e., demonetized) as an international reserve asset. Half of the IMF’s gold holdings were returned to the members and the other half were sold, with the proceeds to be used to help poor nations. Non-oil-exporting countries and less-developed countries were given greater access to IMF funds The Current Exchange Rate Arrangements The classification system is based on IMF member countries’ actual, de facto arrangements, as identified by IMF staff, which can be different from the officially announced, de jure arrangements. The system classifies exchange rate arrangements primarily based on the degree to which the exchange rate is determined by the market rather than by official government action, with market-determined rates generally being moreflexible. As can be seen the IMF currently classifies exchange rate arrangements into 10 separate regimes No separate legal tender: The currency of another country circulates as the sole legal tender. Adopting such an arrangement implies complete surrender of the monetary authorities’ control over the domestic monetary policy. Examples include Ecuador, El Salvador, and Panama. Currency board: A currency board arrangement is a monetary arrangement based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation. This implies that domestic currency is usually fully backed by foreign assets, eliminating traditional central bank functions such as monetary control and lender of last resort, and leaving little room for discretionary monetary policy. Examples include Hong Kong, Bulgaria, and Brunei. Conventional peg: For this category the country formally (de jure) pegs its currency at a fixed rate to another currency or a basket of currencies, where the basket is formed, for example, from the currencies of major trading or financial partners and weights reflect the geographic distribution of trade, services, or capital flows. The anchor currency or basket weights are public or notified to the IMF. The country authorities stand ready to maintain the fixed parity through direct intervention (i.e., via sale or purchase of foreign exchange in the market) or indirect intervention (e.g., via exchange-rate-related use of interest rate policy, imposition of foreign exchange regulations, exercise of moral suasion that constrains foreign exchange activity, or intervention by other public institutions).. Stabilized arrangement: Classification as a stabilized arrangement entails a spot market exchange rate that remains within a margin of 2 percent for 6 months or more (with the exception of a specified number of outliers or step adjustments) and is not floating. The required margin of stability can be met either with respect to a single currency or a basket of currencies, where the anchor currency or the basket is ascertained or confirmed using statistical techniques. Examples are Cambodia, Angola, and Lebanon. Crawling peg: Classification as a crawling peg involves the confirmation of the country authorities’ de jure exchange rate arrangement. The currency is adjusted in small amounts at a fixed rate or in response to changes in selected quantitative indicators, such as past inflation differentials vis-à-vis major trading partners or differentials between the inflation target and expected inflation in major trading partners. Examples are Bolivia and Nicaragua. Crawl-like arrangement: The exchange rate must remain within a narrow margin of 2 percent relative to a statistically identified trend for six months or more (with the exception of a specified number of outliers), and the exchange rate arrangement cannot be considered as floating. Usually, a minimum rate of change greater than allowed under a stabilized (peg-like) arrangement is required. Ethiopia, China, and Croatia are examples. Pegged exchange rate within horizontal bands: The value of the currency is maintained within certain margins of fluctuation of at least positive-negative 1 percent around a fixed central rate, or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent. Tonga is the only example. Other managed arrangement: This category is a residual, and is used when the exchange rate arrangement does not meet the criteria for any of the other categories. Arrangements characterized by frequent shifts in policies may fall into this category. Examples are Costa Rica, Switzerland, and Russia. Floating: A floating exchange rate is largely market determined, without an ascertainable or predictable path for the rate. In particular, an exchange rate that satisfies the statistical criteria for a stabilized or a crawl-like arrangement will be classified as such unless it is clear that the stability of the exchange rate is not the result of official actions. Foreign exchange market intervention may be either direct or indirect, and serves to moderate the rate of change and prevent undue fluctuations in the exchange rate, but policies targeting a specific level of the exchange rate are incompatible with floating. Examples include Brazil, Korea, Turkey, and India. Free floating: A floating exchange rate can be classified as free floating if intervention occurs only exceptionally and aims to address disorderly market conditions and if the authorities have provided information or data confirming that intervention has been limited to at most three instances in the previous six months, each lasting no more than three business days. Examples are Canada, Mexico, Japan, Israel, U.K., United States, and euro zone. Balance of Payments The Balance of Payments is a statement that contains the transactions made by residents of a particular country with the rest of the world over a specific time period. It is also known as the balance of international payments and is often abbreviated as BOP. It summarizes all payments and receipts by firms, individuals, and the government. The transactions can be both factor payments and transfer payments. Components of Balance of Payments The BOP comprises two accounts: Current and Capital. Current Account The four major components of the Current account are as followsVisible trade – This is the net of export and imports of goods (visible items). The balance of this visible trade is known as the trade balance. There is a trade deficit when imports are higher than exports and a trade surplus when exports are higher than imports. 1. Invisible trade – This is the net of exports and imports of services (invisible items). Transactions mainly consist of shipping, IT, banking, and insurance services. 2. Unilateral transfers to and from abroad – These refer to payments that are not factor payments – for example, gifts or donations sent to the resident of a country by a non-resident relative. 3. Income receipts and payments – These include factor payments and receipts. These are generally rent on property, interest on capital, and profits on investments. Capital Account The capital account is used to finance the deficit in the current account or absorb the surplus in the current account. The three major components of the capital account: 1. Loans to and borrowings from abroad – These consist of all loans and borrowings given to or received from abroad. It includes both private sector loans, as well as public sector loans. 2. Investments to/from abroad – These are investments made by nonresidents in shares in the home country or investment in real estate in any other country. 3. Changes in foreign exchange reserves – Foreign exchange reserves are maintained by the central bank to control the exchange rate and ultimately  balance the BOP. 4. A Current account deficit is financed by a surplus in the Capital account and vice versa. This can be done by borrowing more money from abroad or lending more money to non-residents. Significance of Balance of Payments The balance of payments data is important to a lot of users. Investment managers, government policymakers, the central bank, businessmen, etc., all use the BOP data to make important decisions. The BOP data is affected by vital macroeconomic variables such as exchange rate, price levels, interest rates, employment, and GDP. Monetary and fiscal policies are formed in a way to achieve very specific objectives, which generally exert a significant impact on the balance of payments. Policies can be formed with the objectives to induce or curb foreign inflows or outflows. Businesses use BOP to analyze the market potential of a country, especially in the short term. A country with a large trade deficit is not as likely to import as much as a country with a trade surplus. If there is a large trade deficit, the government may adopt a policy of trade restrictions, such as quotas or tariffs. Corporate Governance Corporate governance is something altogether different from the daily operational management activities enacted by a company’s executives. It is a system of direction and control that dictates how a board of directors governs and oversees a company. International Perspective: Corporate Governance (CG) concerns the system by which companies are directed and controlled. It is about having companies, owners and regulators become more accountable, efficient and transparent, which in turn builds trust and confidence. Well-governed companies carry lower financial and non-financial risks and generate higher shareholder returns. They also have better access to external finance and reduce systemic risks due to corporate crises and financial scandals. Reliable financial reporting, timely disclosures, better boards and accountable management also facilitate development of stronger capital markets. They improve a country’s ability to mobilize, allocate and monitor investments and help foster jobs and economic growth. Better supervision and monitoring can detect corporate inefficiencies and minimize vulnerability to financial crises. Key Principle of Corporate Governance – Shareholder Primacy Perhaps one of the most important principles of corporate governance is the recognition of shareholders. The recognition is two-fold. First, there is the basic recognition of the importance of shareholders to any company – people who buy the company’s stock fund its operations. Equity is one of the major sources of funding for businesses. Second, from the basic recognition of shareholder importance follows the principle of responsibility to shareholders. The policy of allowing shareholders to elect a board of directors is critical. The board’s “prime directive” is to be always seeking the best interests of shareholders. The board of directors hires and oversees the executives who comprise the team that manages the day-to-day operations of a company. This means that shareholders, effectively, have a direct say in how a company is run. Transparency Shareholder interest is a major part of corporate governance. Shareholders may reach out to the members of the community who don’t necessarily hold an interest in the company but who can nonetheless benefit from its goods or services. Reaching out to the members of the community encourages lines of communication that promote company transparency. It means that all members  of the community – those who are directly or indirectly affected by the company – and members of the press get a clear sense of the company’s goals, tactics, and how it is doing in general. Transparency means that anyone, whether inside or outside the company, can choose to review and verify the company’s actions. This fosters trust and is likely to encourage more individuals to patronize the company and possibly become shareholders as well. Security An increasingly important aspect of corporate governance is security. Shareholders and customers/clients need to feel confident that their personal information is not being leaked or accessed by unauthorized users. It’s equally important to ensure that the company’s proprietary processes and trade secrets are secure. A data breach is not justvery expensive. It also weakens public trust in the company, which can have a drastically negative effect on its stock price. Losing investor trust means losing access to capital that is necessary for corporate growth. Consequences of Poor Corporate Governance One of the biggest purposes of corporate governance is to set up a system of rules, policies, and practices for a company – in other words, to account for accountability. Each major piece of the “government” – the shareholders, the board of directors, the executive management team, and the company’s employees – is responsible to the others, therefore keeping them all accountable. Part of this accountability is the fact that the board regularly reports financial information to the shareholders, which reflects the corporate governance principle of transparency. Poor corporate governance is best best explained with an example, and there is no better example than Enron Corp. Many of the executives used shady tactics and covert accounting methods to cover up the fact that they were essentially stealing from the company. Erroneous figures were passed along to the board of directors, who failed to report the information to shareholders. With responsible accounting methods gone out the window, shareholders were unaware that the company’s debts and liabilities totalled much more than the company could ever repay. The executives were eventually charged with a number of felonies, and the company went bankrupt. It killed employee pensions and hurt shareholders immeasurably Corporate Governance in the Financial Sector Governance issues in financial institutions are similar but differ in important ways from those in non-financial companies: Financial institutions are charged with upholding the public's trust and protecting depositors. Balance sheets are opaquer, leading to less transparency and greater ability to conceal problems. Good governance requires boards and senior management to fulfill their fiduciary responsibilities by effectively communicating strategic business direction and risk appetite while assuring transparent and effective organization, risk assessment and mitigation, and sufficient capital support. Good governance complements traditional supervision of financial institutions, protects the interests of depositors and other investors in commercial banks, builds and maintains public confidence in the financial sector, and ultimately contributes to its integrity and credibility. Financial institutions are uniquely vulnerable to liquidity shocks which can result in institutional, and potentially, financial instability. Sound governance supports prudential supervision and regulation, enhancing the role and the effectiveness of the financial institution supervisor. Many developing countries are embarking on wide-ranging corporate governance reforms of their state-owned banks in order to improve their efficiency and transparency. Development banks are now playing a more  prominent role in the economy of emerging markets. Development banks play a central role in financial inclusion, SME development and, housing, agriculture and infrastructure finance. Solid corporate governance allows these institutions to fulfill their mandates more effectively. Corporate Governance in Capital Markets Corporate governance continues to be a key component of capital market development. Good CG reduces emerging market vulnerability to financial crises, reduces transaction costs and cost of capital, and leads to capital market development. Capital markets in turn are a major driver of transparency. In addition to private companies, many SOEs are also listing on the capital markets to access alternative sources of capital and enhance transparency. Good CG also encourages investor confidence and outside investment. As pension funds invest increasingly in equity markets, retirement savings are more secure when invested in well-governed companies. Enhancing the governance and capacity of securities markets and financial sector regulators using a corporate governance lens is becoming an important part of the agenda.