Dr Zain Yusufzai International Finance Chapter # 7 (page 179-211).

Introduction
International finance: an area of study concerned
with the balance of payments (BOP) and the
international monetary system.

Balance of Payments
Balance of payments (BOP): The record of all
values of all transactions; between a country’s
residents and the rest of the world.

Measuring a country’s economic activity is by

looking at its balance of payments. There are a wide
variety of account that determine the BOP, but for
purposes of analysis they can be grouped into
three broad categories
1. current account items,
2. capital account items,
3. And reserves.
Every transaction is recorded in terms of a both a
debit and a credit.
Import of a good or service, an increase in assets,
or a reduction in liabilities. Credits record the
export of a good or service, a decrease in assets, or
an increase in liabilities.

Broad BOP categories

International Monetary Fund (IMF): An agency that
seeks to maintain balance – of – payments stability
in the international financial system

Current account
The current account consists of
 Merchandise trade,
 services, and
 Unrequited transfers.
Merchandise trade is typically the first part of the
current. It receives more attention than any of the
other accounts because this is where the imports
and exports of goods are reported, and these are
often the largest single component of all
international transactions. In this account, sales of
goods to foreigners {exports} are reported as
credits because they are a source of funds or a
claim against the purchasing country conversely,

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purchases of goods from overseas {imports} are

recorded as debits because

merchandise trade a balance – of – payments

account that reports imports of goods from foreign
sources and exports of goods to foreign destinations
Services
The services category includes many payments
such as freight and insurance on international
 tourist travel
 profits and income from overseas investment
personal expenditures by government,
civilians, and military personnel overseas
 and payments for management, fees, royalties,
film rental, and construction services
 Purchases of these services are recorded as
debit, while sales of these services are similar
to exports and are recorded as credits.

Unrequited transfers, a balance – of – payments

account that reports transaction which do not
involve repayment or performance of any service

Capital account
Direct investment involves managerial participation
in a foreign enterprise along with some degree of
control.

Capital account items: a balance-of payments

account that involves transactions, which involve
claims in ownership

Reserves
Resaves are used for bringing BOP accounts into
balance. There are four major types of reserves
available to monetary authorities in meeting BOP
deficits {D1 though D4 in table 7.1}.

US balance of payments
US play such a dominant role in the world
economy, it is important to examine the US system.
Table 7.2 presents US international transactions for
two recent yeast.
The table shows that
 US is exports are strong in areas such as
capital goods, industrial supplies and

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materials, consumer goods, and auto vehicles,

and parts.
 On the other hand, the US is importing a great
deal of capital goods, consumer goods, and
industrial supplies and materials.
It is important to realize that when a country suffers
a persistent balance of trade deficit, the nation will
also suffer from a depreciating currency and will
find it difficult to borrow in the international capital
market. There are only two choices available. One is
to borrow from the international monetary fund
{IMF} and be willing to accept the restrictions that
the IMF puts on the country,
Introduce austerity and force the country onto the
right economic track.
Other approach is for the country to change its
fiscal policy {tariffs and taxes}, resort to exchange
and trade controls, or devalue its currency.

International monetary system

Overall monetary system includes a wide variety of
institutions, financial instruments, rules, and
procedures within which foreign exchange markets
function. The objective of this system is to create
an international environment that is conducive to
the flow of goods, services, and capital among
motions. Strives to create a stable foreign
exchange market,

International monetary system: the multinonational

arrangement among the central banks that belong
to the international monetary fund

International monetary fund

The overall goals of the IMF were to:
1. Facilitate the balanced growth of
international trade.
2. Promote exchange stability and orderly
exchange arrangements and discourage
competitive currency depreciation.
3. seek the elimination of exchange restriction
that hinder the growth of world trade
4. Make financial resources available to
members, on a temporary basis and with
adequate sate safeguards, to permit them to
correct payment imbalances without

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resorting to measures destructive to national

and international prosperity.
Special drawing right (SDR):
The IMF created the special drawing right {SDR} as
a unit of value to replace the dollar as a reserve
asset, and today a number of countries peg their
currency to the SDR. When first created the SDR
was linked to gold, but since 1974 its value has
been based on the daily market exchange rates of a
basket of currencies consisting of the US dollar,
British pound, French franc, German mark and
Japanese yen
1976 IMF amendment that resulted in a managed
float system,
International bank for reconstruction and
development (see world bank.)

World Bank: a multigovernment-owned bank

created to promote development projects with low-
interest loans

The managed float system

The main elements of the agreement included;
{A} floating rates were accepted and IMF members
were allowed to enter the foreign exchange market
to deal with any unwarranted speculative
fluctuations;
{B} gold was abandoned as a reserve asset;
{C} the amount of contributions made by IMF
member countries was increased; and
{D} less developed countries were given greater
access to these funds.
Exchange rates have- two major parts:
First, it is argued that a floating exchange rate gives
countries autonomy over their own monetary
policy.
On the other hand, with a floating exchange rate, if
another argument for floating rates is that they
would automatically bring about trade balance the
devaluation of its currency in the international
return to the fixed exchange rate system that
emerged from the Breton woods agreement.

The European monetary system

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Committed itself to establishing a single currency, a

commitment that dated back to the initial objective
was to attain convergence between the inflation
rates and interest rates convergence criteria:
 Inflation must be no more than 1.5 percentage
points above the average of the three lowest
inflation rates in Europe;
 long-term interest rates must be no more 2
percentage points higher than the average of
the lowest;
 the exchange rate must have stayed than of
three EU’s exchanger rate mechanism for two
years without realignment ;and
 The accumulated stock of public debts must
not exceed 60 per can of gross domestic
product. The
When the EMS was created in 1979 it was given
three objectives;
1. to create a zone of monetary stability
2. to control inflation through the use of
monetary discipline
3. to coordinate exchange rate
(Ecu) as a unit of account for the European
monetary union {EMU}
January 1, 2002, consumers in 12 of the EU member
states started using Euro as domestic currencies.
The other three countries-Britain, Denmark, and
Sweden may join the euro in the next few years.

European monetary system (EMS): a system

created by some major members of the EU which
fixes their currency values in relation to each other
(within a band) and floats them together against the
rest of the world

The IMF and the World Bank today

Last couple of decades the role of the IMF has
declined. Floating exchange rates have resulted in a
diminished demand for short-term loans, and no
major industrialized country has borrowed money
from the IMF for over 20 years.
Britain and the US have financed their deficits by
borrowing private money rather than relying on IMF
funds. As a debt was rescheduled, new loans were
made, and an IMF-dictated series of
macroeconomic policies were accepted by the

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Mexican government including tight control over

the growth of the money supply and major cuts in
government spending.
The Brady plan rested on the belief that debt
reduction was a necessary part of the solution and
the IMF and world have to assume roles in
financing it

Economic cooperation
No matter what steps are taken to alter the
international monetary system, without cooperation
among the major economic powers, nothing
substantive will happen. In particular, there will
have to be greater coordination in the conduct of
national policies by the industrialized nations.

Foreign exchange
For purposes of international business, there are
three important areas of foreign exchange that
warrant consideration;
{1} foreign exchange market in the US,
{2} participants in foreign exchange markets, and
{3} determination of exchange rates.

Foreign exchange:
Any financial Instrument that carries out payment
from one currency to another

Exchange rate:
The amount of one currency that can be obtained
for another currency

Foreign exchange markets in the US

There are three major ways of conducting foreign
exchange in major countries such as the US;
1. between banks,
2. through a broker
3. and through forward transactions.
The inter-bank market for foreign exchange
involves transactions between banks.
The brokers’ market cozies of a small group of
foreign exchange brokerage companies that make
markets in foreign currencies. These brokers do not
take currency positions. They simply match up
buyers and charge a commission for their services.

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Three types of exchange rate; that are important to

those dealing in foreign exchange; spot, forward,
and cross.
The forward foreign exchange market is particularly
important to MNs because it lets a customer “lock
in” an exchange rate and thus protect against the
risk of an unfavorable change in the currency that
is needed. Very important to firms doing business
overseas and dealing in foreign currency.

1. Spot rate: the rate quoted for current foreign

currency transactions
2. Forward rate: the rate quoted for the delivery
of foreign currency at a predetermined future
date such as 90 days from now
3. Cross rate: an exchange rate computed from
two other rate s, such as the relationship
between Swiss francs and German marks

Participants in foreign exchange markets

There are five major groups that are active
participants in foreign exchange markets traders/
brokers, speculators, hedgers, arbitrageurs, and
governments.

Foreign exchange brokers: individuals who work in

brokerage firms where they often deal in both spot
rate and forward rate transactions

Foreign exchange traders: individuals who buy and

sell foreign currency for their employer

Speculator: in foreign exchange markets an open

position

Foreign exchange hedgers: individuals who limit

potential losses by locking in guaranteed foreign
exchange positions

Foreign exchange arbitrageurs: individuals who

simultaneously buy and sell currency in two or
more foreign markets and profit from the exchange
rate differences

Governments

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Although the currencies of most developed

countries are allowed to float on the open market,
governments will sometimes intervene as buyers or
sellers in order to crest or maintain a particular
price. For example, many countries of the world
hold US dollars, so it would not be in their best
interests to see the dollar drop sharply. Such a
development would reduce the value of their
holdings as will as increase the ability of the US to
export to them {since imports would now be
cheaper given the increased value of their foreign
currencies}. So government would intervene to buy
dollars in the marketplace in order to shore up the
value of he US currency.

Determination of exchange rates

Rates are determined by the activities of the five
groups discussed in the previous section.

Purchasing power parity (PPP)

Purchasing power parity (PPP): theory an
international finance theory that holds that the
exchange rate between two currencies will be
determined by the relative purchasing power of
hose currencies

Interest rates
There are three key elements in the fisher effect:
1. the nominal rate of interest, which is the
interest rate is being charged to a borrower,
called the “money” rate of interest to
distinguish it from the “real” rate;
2. the rate of inflation in the country; and
3. The real interest rate, which is the difference
between the nominal rate and the inflation
rate.

Fisher effect:
An international finance theory, which describes
the relationship
Between inflation and interest rates and holds that,
as inflation raises, so will the nominal interest rate

Nominal rate of interest:

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the interest rate charged to a borrower, it is called

the,”money”rate of interest to distinguish it from
the” real” rate

Real interest rate:

The difference between the nominal interest rate
and the rate of inflation

International fisher effect (IFE):

An international finance theory, which holds that
the interest rate differential between two countries
is a future, changes in the spot exchange rate

Other considerations”
Other factor also helps to determine exchange
rates. One is confidence in the currency.
Other factors that influence exchange rates are
called “technical factors” these consist of such
things as the release of national economic
statistics, seasonal demands for a currency
weakening of a currency followed by a prolonged
weakness, and the slight wakening of a currency
following a sharp run-up in the exchange rate.
Although technical factors do not generally result in
large exchange rate changes, they do account for
some of the movement.

Strategic management and international finance

One of the primary areas of strategic
considerations is strategies for dealing with
currency exchange rate risk. Another is the
financing of international operations.

Strategies for managing currency exchange rate

risk
One step is to negotiate a lower price with the
Taiwan supplier and thus share the effects of the
devaluation. A second is to pass along the price
increase as possible and absorb the rest. A third,
and complementary, approach is to take steps to
minimize exchange risk. The three most common
ways of doing this are exchange risk avoidance,
exchange risk adaptation, and currency
diversification.

Exchange risk:

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The probability that a company will be unable to

adjust prices and costs to offset changes in the
exchange rate

Exchange risk avoidance:

The elimination of exchange risk by doing
business locally

Exchange risk adaptation:

The use of hedging to provide protection against
exchange rate fluctuations

Currency diversification the spreading of financial

or more currencies

Financing of operations: Another important area

that warrants considerations: foreign capital
markets. Not all financing is done in the home
country. Quite often company will seek capital on
an international basis and borrow or lend money
where the rates are most attractive

Borrowing and lending

Anglo gold: going global, raising capital

Eurocurrencies
Any currency banked outside its country of origin

Eurodollars:
Dollars danced outside the US

London inter bank offered rate (LIBOR)

The interest rate banks charge one another on
Eurocurrency loans

Foreign bond:
A bond sold outside the borrower’s country

Eurobond:
A financial instrument that is typically underwritten
by a syndicate of banks from different countries
and is sold in countries other than the one in which
its currency is denominated

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