Global Finance With E-Banking PDF - 2023-2024 Midterm Reviewer

GLOBAL FINANCE WITH E- BANKING Atty. Caroline L. Terrado Summer, A.Y. 2023-2024  GLOBAL FINANCE GLOBAL FINANCE It is the intricate framework that binds together international financial institutions, economies, and regulatory systems, orchestrating their interactions. Its essential function...

GLOBAL FINANCE WITH E- BANKING Atty. Caroline L. Terrado Summer, A.Y. 2023-2024  GLOBAL FINANCE GLOBAL FINANCE It is the intricate framework that binds together international financial institutions, economies, and regulatory systems, orchestrating their interactions. Its essential functions include facilitating international trade and investment, managing financial risks, and establishing mechanisms for resource collaboration. A complex field rooted in various economic theories. It explores the intricate network of economic interactions, exchanges, and worldwide financial movements. It covers exchange rates, trading, financial regulations, and investments, analyzing investment patterns, production, consumption, and trade dynamics shaping the global economy. These activities are influenced by factors such as international trade, foreign direct investment (FDI), exchange rates, global financial markets, technological advancements, economic conditions, geopolitical events, and regulatory frameworks. (WallStreetMojo) GLOBAL FINANCE 1. International Financial Institutions institutions that provide financial support and professional advice for developing countries' economic and social development activities and promote international economic cooperation and stability. International Monetary Fund (IMF) Five multilateral development banks (MDBs) World Bank Group African Development Bank Asian Development Bank Inter-American Development Bank European Bank for Reconstruction and Development. 2. Economies 3. Regulatory Systems Source: Global Finance (wallstreetmojo.com) What are the benefits of global finance? Global finance offers numerous benefits, including facilitating international trade and investments, fostering economic growth, and providing opportunities for diversification. It enables efficient allocation of resources on a global scale, promoting stability and prosperity. Moreover, global finance contributes to developing interconnected financial markets, improving access to capital, innovation, and overall economic well-being. Why study global finance? Studying global finance is essential for comprehending the complex interactions within the international financial system. It equips individuals with insights into the mechanisms of cross-border trade, currency exchange, and global investments. Also, understanding global finance is crucial for navigating the interconnected nature of economies and fostering informed decision-making. FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT INTERNATIONAL FINANCIAL MANAGEMENT It means financial management in an international business environment. It is different because of the different currencies of different countries, dissimilar political situations, imperfect markets, and diversified opportunity sets. Encompasses a number of critical areas, including the management of global cash flows, foreign exchange risk management, capital expenditure analysis, and international financing. In carrying out these financial activities, multinational enterprises (MNEs) can use three approaches or solutions: polycentric, ethnocentric, or geocentric. (Rugman & Collinson) International Monetary System 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. Evolution of International Monetary System 1875 1915–1944 1973 Bimetallism (before 1875) Interwar Period Flexible Exchange Rate (since 1973) Classical Gold Standard Bretton Woods System 1875–1914 1945–1972 Bimetallism A double standard in that free coinage was maintained for both gold and silver. 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. Countries that were on the bimetallic standard often experienced the well-known phenomenon referred to as Gresham’s law. Gresham’s Law in Economics 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). Classic Gold Standard German Empire (1875) - The newly emergent empire, which was to Great Britain (1821) - The first full- receive a sizable war indemnity fledged gold standard, when the from France, converted to the gold Bank of England notes were made standard in 1875, discontinuing free Japan fully redeemable for gold. coinage of silver. 1850s 1879 1821 1875 1897 France (1878) - was effectively on the gold standard beginning in the United States 1850s and formally adopted the standard in 1878. Classical Gold Standard 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. The exchange rate between any two currencies will be determined by their gold content. Misalignment of the exchange rate will be automatically corrected by cross-border flows of gold. International imbalances of payment will also be corrected automatically. Price-Specie-Flow Mechanism by David Hume Explains 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 the central bank is negligible. Hume theorized that a country with a trade surplus accumulates gold and silver (specie), which increases its money supply, raises price levels (causing inflation) and makes domestic goods expensive compared to foreign ones, leading the surplus to correct itself over time. When a country has a trade surplus, it accumulates specie, leading to increased money supply that causes inflation. The resulting inflation makes the country’s goods more expensive, leading to fewer exports and more imports, thus correcting the initial trade imbalance. Interwar Period 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. Interwar Period 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. The international gold standard of the late 1920s, however, was not much more than a facade. Most major countries gave priority to the stabilization of domestic economies and systematically followed a policy of sterilization of gold by matching inflows and outflows of gold respectively with reductions and increases in domestic money and credit. Even the facade of the restored gold standard crumbled down in the wake of the Great Depression and the accompanying financial crises. Following the stock market crash and the onset of the Great Depression in 1929, many banks, especially in Austria, Germany, and the United States, suffered sharp declines in their portfolio values, touching off runs on the banks. Interwar Period (Summary) The interwar period was characterized by economic nationalism, half- hearted attempts and failures to restore the gold standard, economic and political instabilities, bank failures, and panicky flights of capital across borders. No coherent international monetary system prevailed during this period, which had profoundly detrimental effects on international trade and investment. During this period, the U.S. dollar emerged as the dominant world currency, gradually replacing the British pound. Bretton Woods System The agreement was subsequently ratified by Representatives of 44 nations gathered at the majority of countries to launch the IMF in Bretton Woods, New Hampshire, to discuss 1945. The IMF embodied an explicit set of and design the post-war international rules about the conduct of international monetary system. After lengthy discussions monetary policies and was responsible for and bargains, representatives succeeded in enforcing these rules. Delegates also created drafting and signing the Articles of Agreement a sister institution, the International Bank for of the International Monetary Fund (IMF), Reconstruction and Development (IBRD), which constitutes the core of the Bretton better known as the World Bank, that was Woods system. (July 1944) chiefly responsible for financing individual development projects. (1945) Bretton Woods System 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 proposed an 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. Under the gold-exchange system, the reserve-currency country should run balance-of- payments deficits to supply reserves, but if such deficits are large and persistent, they can lead to a crisis of confidence in the reserve currency itself, causing the downfall of the system. This dilemma, known as the Triffin paradox, was indeed responsible for the eventual collapse of the dollar-based gold exchange system in the early 1970s. Bretton Woods System The United States began to experience trade deficits with the rest of the world in the late 1950s, and the problem persisted into the 1960s. By the early 1960s the total value of the U.S. gold stock, when valued at $35 per ounce, fell short of foreign dollar holdings. This naturally created concern about the viability of the dollar-based system. Against this backdrop, President Charles de Gaulle prodded the Bank of France to buy gold from the U.S. Treasury, unloading its dollar holdings. Efforts to remedy the problem centered on (i) a series of dollar defense measures taken by the U.S. government and (ii) the creation of a new reserve asset, special drawing rights (SDRs), by the IMF. In 1963, President John Kennedy imposed the Interest Equalization Tax (IET) on U.S. purchases of foreign securities to stem the dollar outflow. Bretton Woods System The efforts to support the dollar-based gold-exchange standard, however, turned out to be ineffective in the face of expansionary monetary policy and rising inflation in the United States, which were related to the financing of the Vietnam War and the Great Society program. In the early 1970s, it became clear that the dollar was over-valued, especially relative to the mark and the yen. As a result, the German and Japanese central banks had to make massive interventions in the foreign exchange market to maintain their par values. Given the United States' unwillingness to control its monetary expansion, repeated central bank interventions could not solve the underlying disparities. Bretton Woods System August 1971 - President Richard Nixon suspended the dollar's convertibility into gold and imposed a 10% import surcharge. Under the strain, the foundation of the Bretton Woods system began to crack. December 1971 - In an attempt to save the Bretton Woods system, 10 major countries, known as the Group of Ten, met at the Smithsonian Institution in Washington, D.C. They reached the Smithsonian Agreement, according to which (i) the price of gold was raised to $38 per ounce, (ii) each of the other countries revalued its currency against the U.S. dollar by up to 10%, and (iii) the band within which the exchange rates were allowed to move was expanded from 1% to 2.25% in either direction. (December 1971) February 1973 - the dollar came under heavy selling pressure, again prompting central banks around the world to buy dollars. March 1973 - European and Japanese currencies were allowed to float, completing the decline and fall of the Bretton Woods system. Since then, the exchange rates among major currencies such as the dollar, the mark (later succeeded by the euro), the pound, and the yen have fluctuated against each other. The Flexible Exchange Rate Regime 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: 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. 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 Flexible Exchange Rate Regime The IMF continued to provide assistance to countries facing balance-of-payments and exchange rate difficulties. The IMF, however, extended assistance and loans to the member countries on the condition that those countries follow the IMF’s macroeconomic policy prescriptions. This “conditionality,” which often involves deflationary macroeconomic policies and elimination of various subsidy programs, provoked resentment among the people of developing countries receiving the IMF’s balance-of-payments loans. In September 1985, the so-called G-5 countries (France, Japan, Germany, the U.K., and the United States) met at the Plaza Hotel in New York and reached what became known as the Plaza Accord. They agreed that it would be desirable for the dollar to depreciate against most major currencies to solve the U.S. trade deficit problem and expressed their willingness to intervene in the exchange market to realize this objective. The slide of the dollar that had begun in February was further precipitated by the Plaza Accord. The Flexible Exchange Rate Regime As the dollar continued its decline, the governments of the major industrial countries began to worry that the dollar may fall too far. To address the problem of exchange rate volatility and other related issues, the G-7 economic summit meeting was convened in Paris in 1987. The meeting produced the Louvre Accord, according to which: The G-7 countries would cooperate to achieve greater exchange rate stability. The G-7 countries agreed to more closely consult and coordinate their macroeconomic policies. The Louvre Accord marked the inception of the managed-float system, under which the G-7 countries would jointly intervene in the exchange market to correct currency over- or undervaluation. 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 more flexible. 10 Separate Regimes Classifying Exchange Rate Arrangements No separate legal tender Currency Board Conventional Peg Stabilized Arrangement Crawling peg Crawl-like arrangement Pegged exchange rate within horizontal bands Other managed arrangement Floating Free floating 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: Ecuador, El Salvador, and Panama. Currency board 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: 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). There is no commitment to irrevocably keep the parity, but the formal arrangement must be confirmed empirically: the exchange rate may fluctuate within narrow margins of less than positive-negative 1 percent around a central rate—or the maximum and minimum value of the spot market exchange rate must remain within a narrow margin of 2 percent for at least six months. Examples: Jordan, Saudi Arabia, and Morocco. 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: 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: Bolivia and Nicaragua. Crawl-like arrangement The exchange rate must remain within a narrow margin of 2% 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. Examples: Ethiopia, China, and Croatia Pegged exchange rate within horizontal bands The value of the currency is maintained within certain margins of fluctuation of at least positive-negative 1% around a fixed central rate, or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent. Example: Tonga 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: 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: 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: Canada, Mexico, Japan, Israel, U.K., United States, and euro zone. Balance of Payments (BOP) 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. 2 Components of BOP Current Capital 4 Major Visible Trade—This is the net of exports and imports of goods (visible items). The balance of this visible trade is known as the Components trade balance. There is a trade deficit when imports are higher than exports and a trade surplus when exports are higher than of Current imports. Account Invisible Trade – The net of exports and imports of services (invisible items). Transactions mainly consist of shipping, IT, banking, and insurance services. Unilateral transfers to and from abroad—These refer to payments that are not factor payments, such as gifts or donations sent to a country's resident by a non-resident relative. Income receipts and payments—These include factor payments and receipts. They are generally rent on property, interest on capital, and profits on investments. Capital Account Used to finance the deficit in the current account or absorb the surplus in the current account. 3 Major Components of Capital Account 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. 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. Changes in foreign exchange reserves – Foreign exchange reserves are maintained by the central bank to control the exchange rate and ultimately balance the BOP. Note: 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. Importance of BOP 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 A system of direction and control that dictates how a board of directors governs and oversees a company. Corporate governance concerns the system by which companies are directed and controlled. It is about making companies, owners, and regulators more accountable, efficient, and transparent. This transparency and accountability build 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 the 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, further reassuring the audience of the benefits of corporate governance. Key Principle of Corporate Governance Shareholder Primacy 1. There is the basic recognition of the importance of shareholders to any company – people who buy the company’s stock fund its operations. Equity, as one of the major sources of funding for businesses, plays a crucial role in the company's financial structure, a fact that every business professional should be well-informed about. 2. 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 always seek the best interests of shareholders. The board hires and oversees the executives who comprise the team that manages a company's day-to-day operations. This means that shareholders effectively have a direct say in how a company is run. Key Principle of Corporate Governance Transparency 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 community members 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. Key Principle of Corporate Governance 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 just very 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. Everyone in a company, from entry-level staffers to members of the board, needs to be well-versed in corporate security procedures such as passwords and authentication methods. Consequences of Poor Corporate Governance Example: Enron Corp Enron became one of the largest energy companies in the world and was heralded for its innovative business practices and rapid growth. However, it is best known for its catastrophic collapse in 2001, which was precipitated by widespread corporate fraud and accounting scandals. 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. When good corporate governance is abandoned, a company runs the risk of collapse, and shareholders stand to suffer substantially. Corporate Governance in the Financial Sector Financial institutions are charged with upholding the public's trust and protecting depositors. However, balance sheets are becoming more opaque, leading to less transparency and a 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. Corporate Governance in the Financial Sector 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 the Capital Markets 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. International Financial Institutions (IFI) A financial institution that has been established (or chartered) by more than one country and hence is subject to international law. Its owners or shareholders are generally national governments, although other international institutions and other organizations occasionally figure as shareholders. The most prominent IFIs are creations of multiple nations, although some bilateral financial institutions (created by two countries) exist and are technically IFIs. Types of IFI Multilateral Development Banks Bretton Woods Institutions Regional Development Banks Bilateral Development Banks and Agencies Other Regional Financial Institutions Multilateral Development Banks (MDB) An institution, created by a group of countries, that provides financing and professional advice to enhance development. An MDB has many members, including developed donor countries and developing borrower countries. MDBs finance projects through long-term loans at market rates, very-long-term loans below market rates (also known as credits), and grants. There are also several "sub-regional" multilateral development banks. Their membership typically includes only borrowing nations. The banks lend to their members, borrowing from the international capital markets. Because there is effectively shared responsibility for repayment, the banks can often borrow more cheaply than could any one-member nation. There are also several multilateral financial institutions (MFIs). MFIs are similar to MDBs but they are sometimes separated since they have more limited memberships and often focus on financing certain types of projects. Bretton Woods Institutions The best-known IFIs were established after World War II to assist in the reconstruction of Europe and provide mechanisms for international cooperation in managing the global financial system. They include the World Bank, the IMF, and the International Finance Corporation. Today the largest IFI in the world is the European Investment Bank which lent 61 billion euros to global projects in 2011. Regional Development Banks It consists of several regional institutions with functions similar to the World Bank group's activities but with a particular focus on a specific region. Shareholders usually consist of the regional countries plus the major donor countries. The best-known of these regional banks cover regions that roughly correspond to United Nations regional groupings, including the Inter-American Development Bank, the Asian Development Bank; the African Development Bank; the Central American Bank for Economic Integration; and the European Bank for Reconstruction and Development. The Islamic Development Bank (IsDB) is among the leading multilateral development banks. IsDB is the only multilateral development bank after the World Bank that is global in terms of its membership. Its 56 member countries are spread over Asia, Africa, Europe, and Latin America. Bilateral Development Banks and Agencies A financial institution set up by one individual country to finance development projects in a developing country and its emerging market, hence the term bilateral, as opposed to multilateral. Other Regional Financial Institutions Financial institutions of neighboring countries established themselves internationally to pursue and finance activities in areas of mutual interest; most of them are central banks, followed by development and investment banks. International Bond Markets A market for bonds that are traded beyond national boundaries. They pull together investors from different countries. International bonds – The bonds which are traded in international bond markets. Normally, though not always, these bonds are issued in the issuer’s domestic currency. It depends on where the subscription is expected. In such a situation, the issuer may issue bonds denominated in US Dollars or Euros. Also, international bonds, like most other types of bonds, attract interest payments at regular intervals, and the investor gets the principal amount back upon maturity of the bond. Classifications of International Bond Markets Foreign Bonds — The issuer is from one country but issues the bonds in an other country. The issuer issues these bonds in the local currency of the country where he is issuing bonds. Euro Bond - a foreign entity issues a bond in the domestic market. The issuer issues a bond in a currency that is not the domestic currency of that country. So, a Eurobond in US currency can be issued in any country other than the US. Global Bonds - bonds are issued in multiple countries at a go and often in multiple currencies. Usually, large multinational corporations’ issue global bonds. International Equity Markets The markets in which shares are issued and traded, either through exchanges or over-the-counter markets. Also known as the stock market, it is one of the most vital areas of a market economy because it gives companies access to capital and investors a slice of ownership in a company with the potential to realize gains based on its future performance. International equity markets are an important platform for global finance. They not only ensure the participation of a wide variety of participants but also offer global economies to prosper. International Bond Markets Advantages Disadvantages Diversification Increased risk Increased exposure Exchange rate volatility Higher returns Lack of liquidity Hedging International Equity Markets The markets in which shares are issued and traded, either through exchanges or over-the-counter markets. Also known as the stock market, it is one of the most vital areas of a market economy because it gives companies access to capital and investors a slice of ownership in a company with the potential to realize gains based on its future performance. They not only ensure the participation of a wide variety of participants but also offer global economies to prosper. Secondary Equity Markets Provide marketability and share valuation. Investors or traders who purchase shares from the issuing company in the primary market may not desire to own them forever. Permits the shareholders to reduce the ownership of unwanted shares and lets the purchasers to buy the stock. Two Kinds of Orders Market order − traded at the best price available in the market, which is the market price. Limit order − held in a limit order book until the desired price is obtained. Structures of Secondary Market Dealer market - the broker takes the trade through the dealer. Public traders do not directly trade with one another in a dealer market. The over-the-counter (OTC) market is a dealer market. Agency market - the broker gets client’s orders via an agent. Crowd Trading A form of non-continuous trade. In crowd trading, in a trading ring, an agent periodically announces the issue. The traders then announce their bid and ask prices, and look for counterparts to a trade. Unlike a call market which has a common price for all trades, several trades may occur at different prices. Reasons for Global Integration of Capital Markets Investors understood the good effects of international trade. The prominent capital markets got more liberalized through the elimination of fixed trading commissions. Internet, information, and communication technology facilitated efficient and fair trading in international stocks. The MNCs understood the advantages of sourcing new capital internationally. Cross-listing Having the shares listed on one or more foreign exchanges. In particular, MNCs do this generally, but non-MNCs also cross-list. A firm may decide to cross- list its shares for the following reasons − Cross-listing provides a way to expand the investor’s base, thus potentially increasing its demand in a new market. Cross-listing offers recognition of the company in a new capital market, thus allowing the firm to source new equity or debt capital from local investors. Cross-listing attracts more investors. Investors who trade on their own stock exchange can diversify their portfolios internationally. Cross-listing may be seen as a signal to investors that improved corporate governance is imminent. Cross-listing diminishes the probability of a hostile takeover of the firm via the broader investor base formed for the firm’s shares. Yankee Stock Offerings The issuance of securities by foreign companies in the United States, specifically in U.S. dollars. In the 1990s, many international companies, including Latin Americans, listed their stocks on U.S. exchanges to prime the market for future Yankee stock offerings, that is, the direct sale of new equity capital to U.S. public investors. One reason is the pressure for privatization of companies. Another reason is the rapid growth in the economies. The third reason is the expected large demand for new capital after the NAFTA has been approved. American Depository Receipts (ADR) A receipt that has a number of foreign shares remaining on deposit with the U.S. depository’s custodian in the issuer’s home market. The bank is a transfer agent for ADRs traded in the United States exchanges or in the OTC market. Investment Advantages of ADRs ADRs are denominated in dollars, trade on a US stock exchange, and can be purchased through the investor’s regular broker. This is easier than purchasing and trading in US stocks by entering the US exchanges. Dividends received on the shares are issued in dollars by the custodian and paid to the ADR investor, and a currency conversion is not required. ADR trades clear in three business days as do U.S. equities, whereas settlement of underlying stocks vary in other countries. ADR price quotes are in U.S. dollars. ADRs are registered securities that offer protection of ownership rights. Most other underlying stocks are bearer securities. An ADR can be sold by trading the ADR to another investor in the US stock market, and shares can also be sold in the local stock market. ADRs frequently represent a set of underlying shares , which allows them to trade in a price range meant for US investors. ADR owners can provide instructions to the depository bank to vote the rights. Two Types of ADRs Sponsored - created by a bank after a request of the foreign company. The sponsoring bank offers many services, including investment information and the translation of the annual report. Sponsored ADRs are listed on the US stock markets. New ADR issues must be sponsored. Unsponsored - generally created on request of US investment banking firms without any direct participation of the foreign issuing firm. Global Registered Shares (GRS) a share that are traded globally, unlike the ADRs that are receipts of the bank deposits of home-market shares and are traded on foreign markets. The GRS are fully transferrable — GRS purchased on one exchange can be sold on another. They usually trade in both US dollars and euros. Factors Affecting International Equity Returns Macroeconomic Factors Solnik (1984) examined the effect of exchange rate fluctuations, interest rate differences, the domestic interest rate, and changes in domestic inflation expectations. He found that international monetary variables had only weak influence on equity returns. Asprem (1989) stated that fluctuations in industrial production, employment, imports, interest rates, and an inflation measure affect a small portion of the equity returns. Exchange Rates Adler and Simon (1986) tested the foreign equity and bond index returns sample to exchange rate changes. They found that exchange rate changes generally had a variability of foreign bond indexes than foreign equity indexes. However, some foreign equity markets were more vulnerable to exchange rate changes than the foreign bond markets. Industrial Structure Roll (1992) concluded that the industrial structure of a country was important in explaining a significant part of the correlation structure of international equity index returns. In contrast, Eun and Resnick (1984) found that the correlation structure of international security returns could be better estimated by recognized country factors rather than industry factors. Heston and Rouwenhorst (1994) stated, "industrial structure explains very little of the cross-sectional difference in country returns volatility, and that the low correlation between country indices is almost completely due to country- specific sources of variation.” Interest Rate Swaps A financial derivative contract in which two parties agree to exchange their interest rate cash flows. The interest rate swap generally involves exchanges between predetermined notional amounts with fixed and floating rates. For example, assume bank ABC owns a $10 million investment, which pays the London Interbank Offered Rate (LIBOR) plus 3% every month. Therefore, this is considered a floating payment because as the LIBOR fluctuates, so does the cash flow. Currency Swaps a foreign exchange agreement between two parties to exchange cash flow streams in one currency to another. While currency swaps involve two currencies, interest rate swaps only deal with one currency. For example, assume bank XYZ operates in the United States and deals only with U.S. dollars, while bank QRS operates in Russia and deals only with rubles. Suppose bank QRS has investments in the United States worth $5 million. Assume the two banks agree to enter into a currency swap. Bank XYZ agrees to pay bank DEF the LIBOR plus 1% per month on the notional amount of $5 million. Bank QRS agrees to pay bank ABC a fixed 5% monthly rate on the notional amount of 253,697,500 Russian rubles, assuming $1 is equal to 50.74 rubles. By agreeing to a swap, both firms were able to secure low-cost loans and hedge against interest rate fluctuations. Currency swaps also exist in variations, including fixed vs. floating and floating vs. floating. In sum, parties can hedge against volatility in forex rates, secure improved lending rates, and receive foreign capital. International Foreign Investments or Foreign Portfolio Investment Involves an investor purchasing foreign financial assets. Foreign securities transactions generally occur at an organized formal securities exchange or through an over-the-counter market transaction. Foreign portfolio investing is popular among several different types of investors. Common transactors of foreign portfolio investment include: Individuals Companies Foreign governments Benefits of Foreign Portfolio Investment Portfolio Diversification International Credit Access to markets with different risk-return characteristics Increases the liquidity of domestic capital markets Promotes the development of equity markets Risks of Foreign Portfolio Investment Volatile asset pricing - Across international financial markets, some are riskier than others. For example, consider the Deutscher Aktienindex (DAX). The DAX is a stock market index of 30 major German companies trading on the Frankfurt Stock Exchange. The DAX is historically more volatile than the S&P 500 Index. Jurisdictional risk - Jurisdictional risk can result from investing in a foreign country. For example, if a foreign country that you were invested in drastically changes its laws, it could result in a material impact on the investment’s returns. Moreover, many countries struggle with financial crime, such as money laundering. Investing in countries where money laundering is prevalent increases the jurisdictional risk faced by the investor. Financial Assets for Foreign Portfolio Investments Equities Bonds Derivative Instruments Policies for Foreign Portfolio Investment Foreign portfolio investment is inherently volatile, and rigorously regulated financial markets are needed to manage the risk effectively. Furthermore, the financial system must be capable of identifying and mitigating risks for prudent and efficient allocation of foreign or domestic capital flows. Economic growth and development are enabled by successful financial intermediation and the efficient allocation of credit. Financial systems can maintain their health by identifying and managing business risks. Moreover, the financial system must also withstand economic shocks. Foreign Exchange (Forex or FX) The conversion of one currency into another at a specific rate is known as the foreign exchange rate. The conversion rates for almost all currencies are constantly floating as they are driven by the market forces of supply and demand. The most traded currencies in the world are the United States dollar, Euro, Japanese yen, British pound, and Australian dollar. The US dollar remains the key currency, accounting for over 87% of total daily value traded. Factors that Affect Forex Rates Economic Government’s economic policies; Trade balances; Inflation; and Economic growth outlook Political Political instability Political conflicts Psychological Conditions of Forex market participants Forex Market A decentralized and over-the-counter market where all currency exchange trades occur. It is the largest (in terms of trading volume) and the most liquid market in the world. On average, the daily volume of transactions on the forex market totals $5.1 trillion, according to the Bank of International Settlements’ Triennial Central Bank Survey (2016). The forex market major trading centers are located in major financial hubs around the world, including New York, London, Frankfurt, Tokyo, Hong Kong, and Sydney. Due to this reason, foreign exchange transactions are executed 24 hours, five days a week (except weekends). Despite the decentralized nature of forex markets, the exchange rates offered in the market are the same among its participants, as arbitrage opportunities can arise otherwise. Interest Rate Parity (IRP) A theory regarding the relationship between the spot exchange rate and the expected spot rate or forward exchange rate of two currencies, based on interest rates. The theory holds that the forward exchange rate should be equal to the spot currency exchange rate times the interest rate of the home country, divided by the interest rate of the foreign country. As with many other theories, the equation can be rearranged to solve for any single component of the equation to draw different inferences. If IRP holds true, then you should not be able to create a profit simply by borrowing money, exchanging it into a foreign currency, and exchanging it back to your home currency at a later date. Interpreting the IRP Theory According to the IRP relationship, the amount that you have exchanged at the spot rate, invested in the foreign interest rate and then exchanged at the future date should be equal to simply investing in the home currency interest rate for the same period of time. The idea behind the IRP theory is that if currencies are in equilibrium, then you should not be able to profit from just exchanging money. Uncovered Interest Rate Parity vs Covered Interest Rate Parity Uncovered Interest Rate Parity Covered Interest Rate Parity Refers to the state in which no- Refers to the state in which no-arbitrage arbitrage is satisfied without the use of is satisfied with the use of a forward a forward contract. contract. In the uncovered IRP, the expected In the covered IRP, investors would be exchange rate adjusts so that the IRP indifferent as to whether to invest in holds. This concept is a part of the their home country's interest rate or the expected spot exchange rate foreign country's interest rate since the determination. forward exchange rate holds the currencies in equilibrium. This concept is part of the forward exchange rate determination. Purchasing Power Parity (PPP) When the law of one price is applied internationally to a standard commodity basket, we obtain the theory of purchasing power parity (PPP). This theory states that the exchange rate between currencies of two countries should be equal to the ratio of the countries' price levels. The concept of Purchasing Power Parity (PPP) is a tool used to make multilateral comparisons between the national incomes and living standards of different countries. Purchasing power is measured by the price of a specified basket of goods and services. Thus, parity between two countries implies that a unit of currency in one country will buy the same basket of goods and services in the other, taking into consideration price levels in both countries. A PPP ratio measures deviation from the condition of parity between two countries and represents the total number of the baskets of goods and services that a single unit of a country’s currency can buy. Constructing Purchasing Power Parity The general method of constructing a PPP ratio is to take a comparable basket of goods and services consumed by the average citizen in both countries and take a weighted average of the prices in both countries (the weights representing the share of expenditure on each item in total expenditure). The ratio of the prices will be the PPP rate of exchange. Indexes such as the Big Mac Index and KFC Index use the prices of a Big Mac burger and a bucket of 12-15 pieces of chicken, respectively, to compare living standards between countries. These are moderately standardized products that include input costs from a wide range of sectors in the local economy, which makes them suitable for comparison. Reliability of PPP The underlying expenditure and price levels that represent consumption patterns may not be reported correctly. It is difficult to construct identical baskets of goods and services while comparing dissimilar countries, as people show different tastes and preferences, and the quality of the items varies. The prices of traded goods are rarely seen to be equal, as there are trade restrictions and other barriers to trade that result in deviation from PPP. Transaction Exposure Management Transaction exposure is the risk incurred due to the fluctuations in exchange rates before the contract is settled. The foreign exchange rate that changes in cross-currency transactions can adversely affect the involved parties. Once a cross-currency contract has been framed, and a specific amount of money and quantity of goods is fixed, exchange rate fluctuations can change the value of the contract. However, a company that has agreed to a contract but not yet settled it, faces the transaction exposure risk. The greater the time between agreement and settlement of contracts, the higher is the risk involved with exchange rate fluctuations. When transaction exposure exists, the firm faces three major tasks: Identify its degree of transaction exposure. Decide whether to hedge this exposure. Choose a hedging technique if it decides to hedge part or all of the exposure. To identify net transaction exposure, a centralized group consolidates all subsidiary reports to compute the expected net positions in each foreign currency for the entire MNC. Financial Techniques for Managing Transaction Exposure Forward Contracts - If a firm is required to pay a specific amount of foreign currency in the future, it can enter into a contract that fixes the price for the foreign currency for a future date. This eliminates the chances of suffering due to currency fluctuations Future Contracts - similar to ‘forward contracts. However, futures contracts have standardized and limited maturity dates, initial collateral and contract sizes. Money Market Hedge - the forward price is equal to current spot price multiplied by the ratio of the currency’s riskless returns. This also creates the finance for the foreign currency transaction. Options - involve an upfront fee and do not oblige the owner to trade currencies at a specified price, time period and quantity. After gaining an insight into the financial techniques, we will have a look at the operation techniques for managing transaction exposure. Operational Techniques for Managing Transaction Exposure Risk Shifting - The firm can completely avoid transaction exposure by not involving itself in foreign exchange at all. All the transactions can be conducted in the home currency. However, this is not possible for all types of businesses. Currency Risk Sharing - The two parties involved in the deal can have the understanding to share the transaction risk. Leading and Lagging - involve manipulating currency cash flows in accordance with the fluctuations. Paying off liabilities when the currency is appreciating is known as leading. While collecting receivables when the currency is at a low value in called lagging. Reinvoicing Centers - A single third-party subsidiary used to conduct all intra- company trades. The reinvoicing centers carry out transactions in domestic currency, thereby bearing the losses from the transaction exposures. Economic Exposure Management - also known as operating exposure refers to an effect caused on a company’s cash flows due to unexpected currency rate fluctuations. Economic exposures are long-term in nature and have a substantial impact on a company’s market value. Determining Economic Exposure Economic exposure is higher for firms having both, product prices and input costs sensitive to currency fluctuations. It is lower when costs and prices are not sensitive to currency fluctuations. Economic exposure is higher for firms which do not adjust its markets product mix, and source of inputs in accordance with currency fluctuations. Flexibility in adapting to currency rate fluctuations indicates lesser economic exposure Managing Economic Exposure Operational Strategies Diversifying production facilities and markets for products Sourcing flexibility Diversifying financing Currency risk mitigation strategies Matching currency flows Currency risk-sharing agreements Back-to-back loans Currency swaps International Monetary Fund (IMF) The IMF was conceived in July 1944 at the United Nations Bretton Woods Conference in New Hampshire, United States. The 44 countries in attendance sought to build a framework for international economic cooperation and avoid repeating the competitive currency devaluations that contributed to the Great Depression of the 1930s. Primary mission: to ensure the stability of the international monetary system—the system of exchange rates and international payments that enables countries and their citizens to transact with each other. International Monetary Fund (IMF) The IMF monitors member country policies as well as national, regional, and global economic and financial developments through a formal system known as surveillance. The IMF provides advice to member countries and promotes policies designed to foster economic stability, reduce vulnerability to economic and financial crises, and raise living standards. It also provides periodic assessments of global prospects in its World Economic Outlook, of financial markets in its Global Financial Stability Report, of public finance developments in its Fiscal Monitor, and of external positions of the largest economies in its External Sector Report, in addition to a series of regional economic outlooks. International Monetary Fund (IMF) The IMF's core responsibility is providing loans to member countries experiencing actual or potential balance-of-payments problems. Individual country adjustment programs are designed in close cooperation with the IMF and supported by IMF financing. Ongoing financial support is dependent on the effective implementation of these adjustments. In response to the global economic crisis, in April 2009 , the IMF strengthened its lending capacity and approved a major overhaul of its financial support mechanisms, with additional reforms adopted in subsequent years. These changes enhanced the IMF’s crisis-prevention toolkit, bolstering its ability to mitigate contagion during systemic crises and allowing it to better tailor instruments to meet the needs of individual member countries. International Monetary Fund (IMF) The IMF’s capacity development efforts focus on: Public Finances Monetary and Financial Policies Macroeconomic Frameworks and Tools Legal Frameworks Statistics The IMF's capacity development work also helps countries tackle their developmental priorities by focusing on: Fostering inclusion and reducing inequality Gender Equality Climate Action Special Drawing Rights (SDRs) The IMF issues an international reserve asset known as Special Drawing Rights, or SDRs, that can supplement the official reserves of member countries participating in the SDR Department (currently all members of the IMF). A general allocation of SDRs must be consistent with the objective of meeting the long-term global need for reserve assets and requires Board of Governors approval by an 85 percent majority of the total voting power. Once agreed, the allocation is distributed to member countries in proportion to their quota shares at the Fund. Total global allocations are currently about SDR 204.2 billion (some $293 billion). IMF members can voluntarily exchange SDRs for currencies among themselves. WORLD BANK An international organization dedicated to providing financing, advice, and research to developing nations to aid their economic advancement. The bank predominantly acts as an organization that attempts to fight poverty by offering developmental assistance to middle- and low-income countries. Currently, the World Bank has two stated goals that it aims to achieve by 2030. The first is to end extreme poverty by decreasing the number of people living on less than $1.90 a day to below 3% of the world population. The second is to increase overall prosperity by increasing income growth in the bottom 40% of every country in the world. The World Bank and International Monetary Fund (IMF)—founded simultaneously under the Bretton Woods Agreement—both seek to serve international governments. The World Bank has expanded to become known as the World Bank Group with five cooperative organizations, sometimes known as the World Banks. WORLD BANK While poverty has declined rapidly over the past three decades, humanity continues to face urgent and complex challenges. More than 1 billion people still live-in deep poverty, a state of affairs that is morally unacceptable given the resources and technology we have available today. At the same time, rising inequality and social exclusion seems to accompany rising prosperity in many countries. Under these circumstances, the World Bank's overarching mission of a world free of poverty is as relevant today as it has ever been. So, the Bank has established ambitious, but achievable goals to galvanize international and national efforts to end extreme poverty globally within a generation and to promote "shared prosperity," a sustainable increase in the well-being of the poorer segments of society. This second goal reflects the fact that all countries aspire to a better living standard for all of their citizens, not only for the already-privileged. To end extreme poverty, the Bank's goal is to decrease the percentage of people living with less than $1.90 a day to no more than 3 percent by 2030. To promote shared prosperity, the goal is to promote income growth of the bottom 40 percent of the population in each country. WORLD BANK The World Bank is like a cooperative, made up of 189 member countries. These member countries, or shareholders, are represented by a Board of Governors, who are the ultimate policymakers at the World Bank. Generally, the governors are member countries’ ministers of finance or ministers of development. They meet once a year at the Annual Meetings of the Boards of Governors of the World Bank Group and the International Monetary Fund. The governors delegate specific duties to 25 Executive Directors, who work on-site at the Bank. The five largest shareholders appoint an executive director, while other member countries are represented by elected executive directors. The World Bank Group President chairs meetings of the Boards of Directors and is responsible for overall management of the Bank. The President is selected by the Board of Executive Directors for a five-year, renewable term. The Executive Directors make up the Boards of Directors of the World Bank. They normally meet at least twice a week to oversee the Bank's business, including approval of loans and guarantees, new policies, the administrative budget, country assistance strategies and borrowing and financial decisions. The World Bank operates day-to-day under the leadership and direction of the president, management and senior staff, and the vice presidents in charge of Global Practices, Cross-Cutting Solutions Areas, regions, and functions. WORLD BANK Example of what the World Bank does: Human Capital Project National Immunization Support Project Learning for the Future Project World Trade Organization the only global international organization dealing with the rules of trade between nations. At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in their parliaments. The goal is to ensure that trade flows as smoothly, predictably and freely as possible. The overall objective of the WTO is to help its members use trade as a means to raise living standards, create jobs and improve people’s lives. The WTO operates the global system of trade rules and helps developing countries build their trade capacity. It also provides a forum for its members to negotiate trade agreements and to resolve the trade problems they face with each other. World Trade Organization (Main Activities) negotiating the reduction or elimination of obstacles to trade (import tariffs, other barriers to trade) and agreeing on rules governing the conduct of international trade (e.g. antidumping, subsidies, product standards, etc.) administering and monitoring the application of the WTO's agreed rules for trade in goods, trade in services, and trade-related intellectual property rights monitoring and reviewing the trade policies of our members, as well as ensuring transparency of regional and bilateral trade agreements settling disputes among our members regarding the interpretation and application of the agreements building the capacity of developing country government officials in international trade matters assisting the process of accession of some 30 countries who are not yet members of the organization conducting economic research and collecting and disseminating trade data in support of the WTO's other main activities explaining to and educating the public about the WTO, its mission and its activities. OVERSEEING WTO AGREEMENTS At its heart are the WTO agreements, negotiated and signed by the bulk of the world’s trading nations. Essentially contracts, these documents provide the rules for international commerce and bind governments to keep their trade policies within agreed limits. Their goal is to help producers of goods and services, exporters and importers conduct their business, with a view to raising standards of living, while allowing governments to meet social and environmental objectives. Maintaining Open Trade The system’s overriding purpose is to help trade flow as freely as possible – provided there are no undesirable side effects – because this stimulates economic growth and employment and supports the integration of developing countries into the international trading system. Its rules have to be transparent and predictable, to ensure that individuals, companies and governments know what the trade rules are around the world, and to assure them that there will be no sudden changes of policy. Settling Disputes Trade relations often involve conflicting interests. Agreements, including those painstakingly negotiated in the WTO, often need interpreting. The most harmonious way to settle these differences is through a neutral procedure based on an agreed legal foundation. That is the purpose behind the dispute settlement process written into the WTO agreements. The WTO is run by its member governments. All major decisions are made by the membership as a whole, either by ministers (who usually meet at least once every two years) or by their ambassadors or delegates (who meet regularly in Geneva). While the WTO is driven by its member states, it could not function without its Secretariat to coordinate the activities. The Secretariat employs over 600 staff, and its experts — lawyers, economists, statisticians and communications experts — assist WTO members on a daily basis to ensure, among other things, that negotiations progress smoothly, and that the rules of international trade are correctly applied and enforced. Trade negotiations The WTO agreements cover goods, services and intellectual property. They spell out the principles of liberalization, and the permitted exceptions. They include individual countries’ commitments to lower customs tariffs and other trade barriers, and to open and keep open services markets. They set procedures for settling disputes. These agreements are not static; they are renegotiated from time to time and new agreements can be added to the package. Many are now being negotiated under the Doha Development Agenda, launched by WTO trade ministers in Doha, Qatar, in November 2001. Implementation and monitoring WTO agreements require governments to make their trade policies transparent by notifying the WTO about laws in force and measures adopted. Various WTO councils and committees seek to ensure that these requirements are being followed and that WTO agreements are being properly implemented. All WTO members must undergo periodic scrutiny of their trade policies and practices, each review containing reports by the country concerned and the WTO Secretariat. Dispute Settlement The WTO’s procedure for resolving trade quarrels under the Dispute Settlement Understanding is vital for enforcing the rules and therefore for ensuring that trade flows smoothly. Countries bring disputes to the WTO if they think their rights under the agreements are being infringed. Judgements by specially appointed independent experts are based on interpretations of the agreements and individual countries’ commitments. Building Trade Capacity WTO agreements contain special provision for developing countries, including longer time periods to implement agreements and commitments, measures to increase their trading opportunities, and support to help them build their trade capacity, to handle disputes and to implement technical standards. The WTO organizes hundreds of technical cooperation missions to developing countries annually. It also holds numerous courses each year in Geneva for government officials. Aid for Trade aims to help developing countries develop the skills and infrastructure needed to expand their trade. Outreach The WTO maintains regular dialogue with non-governmental organizations, parliamentarians, other international organizations, the media and the general public on various aspects of the WTO and the ongoing Doha negotiations, with the aim of enhancing cooperation and increasing awareness of WTO activities. INTERNATIONAL INVESTMENT One of the investment strategies in which an investor diversifies his portfolio by purchasing various financial Instruments like shares, mutual funds, etc. or investing to acquire ownership or collaboration in different companies across the globe in order to maximize the return and to reduce their exposure to various investment risks. International Investment provides an opportunity for investors to capitalize on the good performance of the foreign economy if their domestic economy’s performance is relatively bad. These investments are mostly driven by the macroeconomy of the country and most investor focus on the emerging economy Types of International Investment Foreign Direct Investment (FDI) - an investment when the investor invests in a business situated on foreign land in order to acquire ownership or collaboration. Through FDI , investors establish a lasting interest in the business entity that implies the existence of a long-term relationship of the investor with the enterprises with a significant degree of influence on the management of the business. Foreign Portfolio Investment (FPI) - an investment made in a foreign economy by an investor with no motive to gain any role in the management of any organization. Foreign Portfolio Investors purchase securities traded in another country, which is highly liquid and can easily get buyers when required. Such securities include instruments like stocks and bonds. FPI can be short-term in nature in cases when the investor wants a quick return due to a change in the exchange rate, interest rate, etc. Otherwise, the foreign portfolio investment is done with plans of holding onto the asset for the long-term, and such investments are driven by the growth rate of the economy, Macroeconomic stability, Interest rates, etc. FDI Transactions Greenfield Projects: When FDI is used to start an enterprise in a foreign country from scratch and don’t acquire an existing company to enter the market. Greenfield project also includes the construction of new plants, offices, etc. Joint Ventures: When FDI is used to enter in venture with the foreign corporations in order to expand their business in a foreign country. Brownfield Investment: It is another type of FDI transaction in which investment is used to merge or acquire an enterprise on foreign land. Joint Ventures and Brownfield investments are mostly used to enter the foreign market. Factors Affecting International Investment (in case of FDI) Ease of Doing Business of the country, like rules and regulations related to entry in the market and to support operations of the new greenfield business. Political and Social conditions of the economy. Policies on the functioning & structure of markets (esp. competition & merger and acquisition [M&A] Policies. Policies related to ease the business, such as investment promotion, incentives, improvements in amenities and other measures to reduce the cost of business. Privatization Policy. Trade policy (barriers-tariff & non-tariff) and coherence of FDI and trade policies. Factors Affecting International Investment (in case of FPI) National economic growth rates. Exchange Rate stability. General macroeconomic stability. Levels of foreign exchange reserves. Interest rates. Taxes on Capital gains Regulation of the stock and bond markets Quality of domestic accounting and disclosure systems Dispute settlement systems of the economy and degree of protection of investor’s rights. International Investment NFI = Net Outflow of Investment – Net Inflow of Calculation Investment Net Foreign Investment (NFI) - referred to as net capital outflow from the economy. It is the difference between net investment is done by people in the overseas economy and net investment done by overseas people in the domestic economy. NFI includes Outflow and Inflow of both Foreign Direct Investment and Foreign Portfolio Investment. It is also one of the important parameters to analyze the Financial Condition of the economy. A negative NFI states that the nation is a debtor nation and vice versa. Advantages of International Investment International Investment Foreign Investment can creates new job Parent enterprises would also stimulate the country’s opportunities, this leads to an provide investment to get economy and also boost the increase in the purchasing additional expertise, local industries. power of people and increase technology, and products. their standard of living. As an Investor International Investment is an opportunity Reduction in cost of to expand his business, Tax Incentives production. diversify his portfolio, to get entry into the new market. Disadvantages International Investment makes things tough for local of International companies by creating huge Investment competition. The risk of Political change will always be a concern for investors as it can lead to expropriation. Unstable Economic conditions can make your investment economically non-viable. Factors That Influence a Company’s Decision to Invest Natural resources: Is the Logistics: Is it cheaper to Cost: Is it cheaper to Market: Has the company company interested in produce locally if the produce in the local identified a significant obtaining access to local transportation costs are market than elsewhere? local market? resources or significant? commodities? Ease: Is it relatively Know-how: Does the Customers and Policy: Are there local straightforward to invest company want access to competitors: Does the incentives (cash and and/or set up operations local technology or company’s clients or noncash) for investing in in the country, or is there business process competitors operate in one country versus another country in which knowledge? the country? another? setup might be easier? Exit: Can the company Culture: Is the workforce Expatriation of funds: Can Impact: How will this easily and orderly exit or labor pool already the company easily take investment impact the from a local investment, or skilled for the company’s profits out of the country, company’s revenue and are local laws and needs or will extensive or are there local profitability? regulations cumbersome training be required? restrictions? and expensive? Two Forms of FDI Horizontal FDI occurs when a company is trying to open up a new market—a retailer, for example, that builds a store in a new country to sell to the local market. Vertical FDI is when a company invests internationally to provide input into its core operations—usually in its home country. A firm may invest in production facilities in another country. When a firm brings the goods or components back to its home country (i.e., acting as a supplier), this is referred to as backward vertical FDI. When a firm sells the goods into the local or regional market (i.e., acting as a distributor), this is termed forward vertical FDI. The largest global companies often engage in both backward and forward vertical FDI depending on their industry. How Governments Discourage or Restrict FDI In most instances, governments seek to limit or control foreign direct investment to protect local industries and key resources (oil, minerals, etc.), preserve the national and local79 culture, protect segments of their domestic population, maintain political and economic independence, and manage or control economic growth. Ownership restrictions. Host governments can specify ownership restrictions if they want to keep the control of local markets or industries in their citizens’ hands. Some countries, such as Malaysia, go even further and encourage that ownership be maintained by a person of Malay origin, known locally as bumiputra. Although the country’s Foreign Investment Committee guidelines are being relaxed, most foreign businesses understand that having a bumiputra partner will improve their chances of obtaining favorable contracts in Malaysia. Tax rates and sanctions. A company’s home government usually imposes these restrictions in an effort to persuade companies to invest in the domestic market rather than a foreign one. How Governments Encourage FDI Financial incentives: Host countries offer businesses a combination of tax incentives and loans to invest. Home -country governments may also offer a combination of insurance, loans, and tax breaks in an effort to promote their companies’ overseas investments. The opening case on China in Africa illustrated these types of incentives. Infrastructure: Host governments improve or enhance local infrastructure—in energy, transportation, and communications—to encourage specific industries to invest. This also serves to improve the local conditions for domestic firms. Administrative processes and regulatory environment: Host-country governments streamline the process of establishing offices or production in their countries. These countries appear more attractive to foreign firms by reducing bureaucracy and regulatory environments. Invest in education: Countries seek to improve their workforce through education and job training. An educated and skilled workforce is an important investment criterion for many global businesses. Political, economic, and legal stability: Host-country governments seek to reassure businesses that the local operating conditions are stable, transparent (i.e., policies are clearly stated and in the public domain), and unlikely to change. Encouraging Foreign Investment Governments seek to encourage FDI for a variety of reasons. However, the process can occasionally cross the lines of ethics and legality. In November 2010, seven global companies paid the US Justice Department “a combined $236 million in fines to settle allegations that they or their contractors bribed foreign officials to smooth the way for importing equipment and materials into several countries.” The companies included Shell and contractors Transocean, Noble, Pride International, Global Santa Fe, Tidewater, and Panalpina World Transport. The bribes were paid to officials in oil-rich countries—Nigeria, Brazil, Azerbaijan, Russia, Turkmenistan, Kazakhstan, and Angola. In the United States, global firms—including ones headquartered elsewhere but trading on any of the US stock exchanges—are prohibited from paying or even offering to pay bribes to foreign government officials or employees of state-owned businesses with the intent of currying business favors. While the law and the business ethics are clear, in many cases, the penalty fines remain much less onerous than losing critical long-term business revenues.