Module 1-Foundations of International Financial Management PDF

Module 1: Foundations of International Financial Management INTERNATIONAL FINANCIAL MANAGEMENT A well-known term in today's world. Also known as international finance. It means financial management in an international business environment. It deals with han...

Module 1: Foundations of International Financial Management INTERNATIONAL FINANCIAL MANAGEMENT A well-known term in today's world. Also known as international finance. It means financial management in an international business environment. It deals with handling various financial aspects that arise because businesses engage with multiple currencies and work in varied political and economic environments. ○ Because countries use different currency, dissimilar political situations, imperfect markets, diversified opportunity sets. The international financial activities help the organizations to connect with international dealings with overseas business partners-customers, suppliers, lenders etc. It is also used by government organizations and non-profit institutions. INTERNATIONAL MONETARY SYSTEM The institutional framework within which international payments are made, movements of capital are accommodated, and exchange rates among currencies are determined. ○ The structure and set of rules that govern how payments between countries are made, how capital moves across borders, and how exchange rates between currencies are determined. Refers to the system and rules that govern the use and exchange of money around the world and between countries. ○ Each country has its own currency as money and the international monetary system governs the rules for valuing and exchanging these currencies. It is a complex whole of agreements, rules, institutions, mechanisms, and policies regarding exchange rates, international payments, and the flow of capital. ○ A system of agreements and policies that ensure countries can trade and invest with each other smoothly. Consists of four elements: ○ Exchange arrangements and exchange rates ○ Payments and transfers relating to current international transactions ○ International capital movements ○ International reserves EVOLUTION OF INTERNATIONAL MONETARY SYSTEM First Semester Page 1 1. Bimetallism (Before 1875) Also known as the bimetallic standard. Prior to 1870s. A monetary standard in which the value of the monetary unit is defined as equivalent to certain quantities of two metals, typically gold and silver, creating a fixed rate of exchange between them. Refers to a monetary system where countries used both gold and silver as a basis for their currencies. In this system, both metals were accepted for coinage. ○ Meaning coins could be made from either gold or silver. This system allowed both gold or silver to serve as a medium of exchange for international payments. The exchange rates between different countries’ currencies at the time were determined by how much gold or silver was in the coins. ○ For example, if one country's currency had a higher amount of gold compared to another country’s silver-based currency, the exchange rate would reflect that difference. However, this system was not fully organized. Gresham's Law ○ A monetary principle in economics. ○ A principle in economics that describes what happens when two types of money, both recognized as legal currency and circulate at the same time. ○ When two forms of money are available (such as gold coins and silver coins), they are treated as if they have the same value in transactions. ○ People will naturally prefer to hold on to the more valuable form of money (good money) and use the less valuable one (bad money) for everyday transactions. ○ Example: If a gold coin and silver coin are both legally worth the same amount but the gold coin is actually worth more because of its higher gold content, people would keep the gold coin and spend the silver coin. Over time, the gold coins (good money) would be hoarded or saved and fewer of them would be used in the economy. Meanwhile, the silver coins (bad money) would be spent in transaction - becoming the mean form of money in circulation. ○ This behavior leads to the "bad money" driving the "good money" out of circulation. ○ Less valuable money is used more often, while the more valuable money is stored or hidden away. 2. Classical Gold Standard (1875 - 1914) First full-fledged gold standard. A monetary system where a country’s currency or paper money has a value directly First Semester Page 2  A monetary system where a country’s currency or paper money has a value directly linked to gold. With this system, countries agreed to convert paper money into a fixed amount of gold. An international monetary system where the value of country's currency was directly linked to a specific amount of gold. Fully established in 1821 when Great Britain made the Bank of England's notes fully redeemable for gold. Over the next several decades, other countries also adopted the gold standard - including France, Germany, United States, Russia, and Japan. ○ France → become effective on the gold standard by the 1850s and officially adopted it in 1878. ○ Germany → after receiving a large war indemnity from France, the country switched to the gold standard in 1875. ○ United States → adopted the gold standard in 1879. ○ Russia → adopted the gold standard in 1897. ○ Japan → adopted the gold standard in 1897. Between 1875 and 1914, most of the world's major economies used the gold standard. The outbreak of World War I in 1914 disrupted this system and most countries moved off the gold standard at that time. The classical gold standard lasted for about 40 years. Under this system, the international gold standard worked when countries followed a few key rules: ○ Gold alone is assured of unrestricted coinage. → It could be freely minted into coins by the government. ○ There is two-way convertibility between gold and national currencies at a stable ratio. → People could exchange national currencies for gold and vice versa at a stable rate. ○ Gold may be freely exported or imported. → Countries could transfer gold across borders without restrictions. The exchange rates between two countries' currencies were determined by their gold content. ○ Example: if one country’s currency had twice the gold content of another’s, it would be worth twice as much. Had a built-in mechanism to correct any misalignment of exchange rates or imbalances in trade. ○ If a country imported more than it exported, gold would flow out of that country to settle the trade imbalance. International imbalances of payment will also be corrected automatically. Price-Specie-Flow Mechanism ○ A model developed by economist David Hume. ○ 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. ○ In this model, trade imbalances would correct themselves as gold (or specie) flowed between countries, affecting prices and the flow of goods without much need for central bank intervention. 3. Interwar Period (1915 - 1944) First Semester Page 3 3. Interwar Period (1915 - 1944) World War I (1914–1918) ended the classical gold standard. ○ The system collapsed not because of an internal dilemma but because of an external violence. ○ As soon as the fighting began in Europe, private trade and financial transactions were suspended. ○ Gold exports were banned. ○ Countries like Great Britain, France, Germany, and Russia stopped allowing the exchange of banknotes for gold and placed restrictions on gold exports in August 1914. ○ This marked the collapse of the gold standard. ○ After the war, several countries experienced severe economic problems. → As international linkage disappeared, each country started to issue bonds and print money to finance the war effort. → They began to have different inflation rates. ○ Hyperinflation occurred in places like Germany, Austria, Hungary, Poland, and Russia, causing the value of their currencies to plummet. ○ All financial trade were suspended. Predatory Depreciation ○ With the end of wartime controls, exchange rates among currencies became unstable in the early 1920s. ○ Many countries deliberately depreciated their currencies (lowered their value) to make their goods cheaper in the global market. ○ Used as a strategy to boost exports. As countries recovered from the war, they sought to restore the gold standard to stabilize their economies and bring back order to international trade. ○ The United States emerged as the world’s leading financial power after the war, replacing Great Britain. With relatively low inflation, the U.S. lifted its restrictions on gold exports and returned to the gold standard in 1919. ○ In Great Britain, Winston Churchill, who was then the Chancellor of the Exchequer (finance minister), led efforts to restore the gold standard. This was successfully done in 1925. ○ Other countries, such as Switzerland, France, and the Scandinavian countries, followed suit and restored the gold standard by 1928. 4. Bretton Woods System (1945 - 1972) July 1944 ○ Representatives from 44 nations met in Bretton Woods, New Hampshire, to create a new international monetary system for the post-war period. ○ This meeting was aimed at preventing the economic instability seen between World War I and World War II. After extensive discussions, the representatives drafted and signed the Articles of Agreement for the International Monetary Fund (IMF). ○ This agreement formed the foundation of the Bretton Woods system. In 1945 ○ The agreement was ratified by most participating nations, officially launching the IMF. ○ The IMF's main purpose was to create a clear set of rules for international monetary policies and to enforce these rules. In addition to the IMF, the delegates created a sister institution. ○ the International Bank for Reconstruction and Development (IBRD), commonly known as the World Bank, was also created. First Semester Page 4  commonly known as the World Bank, was also created. ○ Its primary responsibility was to provide financial assistance for rebuilding economies and funding development projects. The design of the Bretton Woods system was influenced by concerns over the economic nationalism of the interwar period. Countries had used "beggar-thy-neighbor" policies, which involved devaluing currencies to boost exports at the expense of other nations. The lack of clear rules during this period had led to global instability, so the Bretton Woods system aimed to prevent this from happening again. John Maynard Keynes ○ Lead the British delegation. ○ He proposed an innovative idea: the creation of an international reserve asset called "bancor" through an international clearing union. ○ Although this proposal was not adopted, it reflected concerns about creating a stable global monetary system. Under the Bretton Woods system: ○ Gold was the basis for the U.S. dollar and other currencies were pegged to the U.S. dollar’s value. ○ Tied to gold at a fixed rate of $35 per ounce. ○ This pegging system helped maintain exchange rate stability while allowing for some flexibility in currency adjustments. In 1971 ○ The U.S. gold supply was no longer adequate to cover the number of dollars in circulation. ○ President Richard M. Nixon devalued the U.S. dollar relative to gold. He declared a temporary suspension of the dollar's convertibility into gold. In 1973 ○ Bretton Woods system had collapsed. ○ Countries were then free to choose any exchange arrangement for their currency, except pegging its value to the price of gold. ○ They could, for example, link its value to another country's currency, or a basket of currencies, or simply let it float freely and allow market forces to determine its value relative to other countries' currencies. 5. The Flexible Exchange Rate Regime (1973 - Present) After the collapse of the Bretton Woods system, a new international monetary system emerged, known as the flexible exchange rate regime. A monetary system that allows the exchange rate to be determined by supply and demand. Can be defined as exchange rates determined by global supply and demand of currency. In January 1976: ○ The Jamaica Agreement was reached when members of the International Monetary Fund (IMF) met in Jamaica to a new set of rules for the international monetary system. ○ This agreement formalized the shift to flexible exchange rates and established new rules for the international monetary system. Key Elements of the Jamaica Agreement: ○ Flexible exchange rates were officially recognized and declared acceptable. This meant that currencies could now fluctuate based on market conditions, without being tied to gold or pegged to the U.S. dollar. Central banks were allowed to intervene in currency markets if exchange rates First Semester Page 5  ○ Central banks were allowed to intervene in currency markets if exchange rates became too volatile, to prevent large, destabilizing fluctuations. ○ Gold was demonetized, meaning it was no longer considered an international reserve asset. ○ The IMF’s gold holdings were split: half was returned to member countries, and the other half was sold. The proceeds from these gold sales were used to assist poor nations. ○ Non-oil-exporting countries and less-developed countries gained greater access to IMF funds, giving them more financial resources to stabilize their economies and promote development. The flexible exchange rate regime continues to this day, allowing countries to adopt exchange rate policies that best fit their economic needs, while the IMF plays a role in monitoring and managing international financial stability. THE CURRENT EXCHANGE RATE ARRANGEMENTS Classification System: ○ Based on actual (de facto) exchange rate arrangements used by IMF member countries. ○ Differences can exist between actual practices and officially announced (de jure) arrangements. ○ Classification focuses on the degree to which exchange rates are determined by market forces versus government actions. ○ Market-determined rates are generally more flexible. The IMF currently classifies exchange rate arrangements into 10 separate regimes: 1. No Separate Legal Tender → Another country's currency is used as the sole legal tender. → The domestic government loses control over its monetary policy. → Ang currency ng isang bansa ay ginagamit ang currency ng ibang bansa. → Examples: Ecuador, El Salvador, and Panama are using the U.S. dollar currency. 2. Currency Board → Legally committed to exchange domestic currency for a specified foreign currency at a fixed rate. → The domestic currency is backed by foreign assets, limiting the ability of the central bank to control money supply. → Little room for discretionary monetary policy. → Countries who have reference currency. → Examples: Hong Kong, Bulgaria, and Brunei use this system. 3. Conventional Peg → Currency is formally pegged to another currency or a basket of currencies. → The authorities actively maintain this fixed rate through interventions in the foreign exchange market or by manipulating interest rates. → This arrangement reflects a commitment to keeping the exchange rate stable. 4. Stabilized Arrangement → The exchange rate remains within a tight margin (2%) for at least six months, but it is not allowed to float freely. → This arrangement reflects a commitment to stability without the flexibility of a fully floating exchange rate. → Examples: Cambodia and Angola. 5. Crawling Peg Involves the confirmation of the country authorities’ de jure exchange rate First Semester Page 6  → Involves the confirmation of the country authorities’ de jure exchange rate arrangement. → The exchange rate is adjusted gradually based on certain economic indicators, like inflation rates compared to trading partners. → This approach allows for a controlled response to economic changes. → Examples: Bolivia and Nicaragua. 6. Crawl-like Arrangement → The exchange rate must stay within a narrow margin of a statistically determined trend. → Exchange rate must remain within 2% of a statistically identified trend for six months or more. → This arrangement requires more frequent adjustments than a stabilized peg. → The exchange rate arrangement cannot be considered as floating. → Examples: Ethiopia, China, and Croatia 7. Pegged Exchange Rate within Horizontal Bands → The currency is allowed to fluctuate within a specified range (±1% around a fixed rate). → Margin exceeds 2% between maximum and minimum value. → Example: Tonga is the only example. 8. Other Managed Arrangement → 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. 9. Floating → The market largely determines the exchange rate without an ascertainable or predictable path. → While interventions can occur to stabilize the rate, they are not meant to maintain a specific level. → Examples: Brazil, Korea, Turkey, and India. 10. Free Floating → A floating exchange rate can be classified as free floating: a. If intervention occurs only exceptionally and aims to address disorderly market conditions. b. 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 A comprehensive statement recording all transactions made by residents of a specific country with the rest of the world over a designated time period. Also referred to 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 Captures all economic transactions, detailing how much money flows into and out of a country. It is crucial for assessing a nation’s economic performance and its interactions with other First Semester Page 7  It is crucial for assessing a nation’s economic performance and its interactions with other countries. Components of Balance of Payments: 1. Current Account → Records a country's transactions with the rest of the world related to trade, services, transfers, and income. → It consists of four major components: i. Visible Trade – This refers to the net balance of exports and imports of tangible goods - known as visible items. – If exports exceed imports, the trade balance is a surplus. – If imports exceed exports, there is a deficit. ii. Invisible Trade – This encompasses the net balance of exports and imports of services, referred to as invisible items or intangible goods. – Services may include shipping, banking, IT, insurance, and tourism. iii. Unilateral Transfers – These refer to payments that are not factor payments. – They include gifts, donations, and remittances sent to residents from non-residents. iv. Income Receipts and Payments – These include factor payments and receipts. – These are generally rent on property, interest on capital, and profits on investments. 2. Capital Account → Reflects financial transactions that help finance the current account's deficit or absorb its surplus. → It consists of three primary components: i. 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. – Example: If a government borrows $100 million from a foreign bank, this transaction is recorded as an inflow in the capital account. ii. Investments to/from Abroad – This involves investments made by non-residents in the domestic economy, as well as domestic investments in foreign markets, such as purchasing shares or real estate. – Example: If a foreign company invests $10 million in a local startup, this amount represents an inflow in the capital account. iii. Changes in Foreign Exchange Reserves – Foreign exchange reserves are maintained by the central bank to control the exchange rate and ultimately balance the BOP. – Example: If a central bank sells foreign currency reserves to stabilize the national currency, this transaction will be reflected in the capital account. Relationship Between the Current and Capital Accounts: ○ The Current Account and Capital Account are interconnected. ○ A deficit in the current account needs to be financed by a surplus in the capital account and vice versa. → Current Account Deficit: If a country is importing more goods and services than it is exporting, it may need to borrow from other countries or attract First Semester Page 8  than it is exporting, it may need to borrow from other countries or attract foreign investments to cover this deficit. → Capital Account Surplus: If there is a surplus in the capital account due to significant foreign investment, it can help balance the current account deficit by providing the necessary funds. Significance of Balance of Payments: ○ Important to a lot of users. ○ An important tool for various stakeholders, including investment managers, government policymakers, central banks, and businesses to make important decisions. ○ This comprehensive financial statement provides insights into a country's economic transactions with the rest of the world and helps inform critical decisions across multiple sectors. ○ The BOP data is affected by vital macroeconomic variables such as exchange rate, price levels, interest rates, employment, and GDP. ○ 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 (CG) 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. 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. International Perspective on Corporate Governance: ○ Corporate governance involves how companies are directed and controlled to ensure accountability and transparency. ○ 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 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 Principles of Corporate Governance: 1. Shareholder Primacy → One of the most important principles of corporate governance is the recognition of shareholders. → The recognition is two-fold: a. 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. b. 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. First Semester Page 9  → 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. → Shareholders have a direct say in how a company is run. 2. Transparency → Shareholder interest is a major part of corporate governance. → Transparency involves open communication between a company and its stakeholders. → Anyone, whether inside or outside the company, can choose to review and verify the company’s actions. → This means shareholders, the community, and the press can access relevant information about the company’s operations and performance. → This fosters trust and is likely to encourage more individuals to patronize the company and possibly become shareholders as well. 3. Security → Shareholders and customers/clients need to feel confident that their personal information is not being leaked or accessed by unauthorized users. → Ensuring the security of personal information and proprietary company data is increasingly vital in corporate governance. → Protecting against data breaches helps maintain customer trust and safeguard corporate assets. → 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. Consequences of Poor Corporate Governance ○ Effective corporate governance establishes a framework of accountability where shareholders, the board of directors, and executives hold each other responsible for their actions. ○ The collapse of Enron serves as a stark example of poor corporate governance. Executives engaged in deceptive accounting practices, hiding the company’s true financial condition from the board and shareholders, ultimately leading to bankruptcy. ○ The fallout affected not only shareholders but also employees and retirees, who lost their pensions and investments. Corporate Governance in the Financial Sector ○ 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 have a unique responsibility to uphold public trust and protect First Semester Page 10  ○ Financial institutions have a unique responsibility to uphold public trust and protect depositors. Good governance practices ensure transparency and accountability within these institutions. ○ Sound governance practices help financial institutions manage liquidity risks, thereby reducing the chances of institutional failures that could lead to broader economic crises. ○ Many developing nations are implementing corporate governance reforms in state- owned banks to enhance transparency and efficiency, supporting overall economic development. Corporate Governance in Capital Markets ○ Corporate governance continues to be a key component of capital market development. ○ Capital markets in turn are a major driver of transparency. ○ Financial institutions are uniquely vulnerable to liquidity shocks which can result in institutional, and potentially, financial instability. ○ Good corporate governance is essential for the development of capital markets, reducing transaction costs and enhancing investor confidence. ○ Investors are more likely to invest in companies with transparent governance structures, knowing their interests are protected. First Semester Page 11