MF0006 – International Financial Management -Set-2

Q.1 (a) Explain the responsibilities of IMF. (b) Describe two types of exchange rates. [10 Marks] Ans ( a ): International Monetary Fund (IMF) is the central institution of the international monetary system. It encourages internationalization of businesses through surveillance, and financial and technical assistance. The purpose of surveillance is to prevent or manage financial crises. Its financing facility attempts to reduce the impact of export instability on economies. Responsibilities of IMF :The responsibilities of IMF are: · To promote international monetary co-operation: prevent or manage financial crises. · To facilitate expansion and balanced growth of international trade. · To promote exchange-rate stability. · To assist in establishing multilateral system of payments. · To lend to member countries experiencing balance of payments difficulties. The IMF gets its resources from the quota countries’ pay when they join the IMF and from periodic increases in this quota. The quotas determine a country’s voting power and the amount of financing it can receive from the IMF. Ans.( b ): There are two major exchange rate systems, and they have an important impact on macroeconomic policy. One basic system occurs when exchange rates move purely under the influence of market supply and demand. This system, known s flexible exchange rates, is one where governments neither announce an exchange rate nor take steps to enforce one. That is, in a flexible exchange rate system, the relative prices of currencies are determined in the marketplace through the buying and selling of households and businesses. The United States, Canada, and Japan currently operate flexible exchange rate systems. The other major system is fixed exchange rates, where governments specify the rate at which their currency will be converted into other currencies. Historically the most important fixed exchange rate system was the gold standard, which was used off and on from 1717 until 1933. Today many small countries operate fixed exchange rate systems, and most European countries have had their own system of fixed exchange rates since 1979.

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MF0006 – International Financial Management -Set-2

Q.2 Illustrate Political Exposure in Foreign Exchange Market? [10 Marks] Ans: Foreign exchange exposure is the possibility that a company will gain or lose because of changes in the exchange rates. For example, if an Indian company imports goods from Germany and pays for them in euros, then it is exposed to foreign exchange risk because if the value of the foreign currency rises (i.e., the euro appreciates), the Indian company has to pay more domestic currency (rupees) to get the required amount of foreign currency (euros). Changes in exchange rates can affect not only companies that are directly engaged in international business but also those companies that sell only in the domestic market. Even a purely domestic firm, using only domestic parts (no imports), selling only in the domestic market (no exports), all accounts receivables and accounts payables in local currency, etc., will be affected by changes in exchange rates. Consider an Indian watch manufacturer which sources its raw materials from India and sells its watches only in the Indian markets. As the company’s products compete against imported watches, it is also affected by foreign exchange exposure. If the rupee appreciates against the foreign currencies, the imported watches would become cheaper in India (in rupee terms) and the watch manufacturer’s sales would be hit. There are three types of foreign exchange exposures. Namely Translation exposure, Economic Exposure (also called operating exposure, competitive exposure, or revenue exposure) , Interest rate risk exposure Political Exposure. Political Exposure: Political risk stems from political actions taken by political actors that affect business. The political actors may be the members of the government, political parties, public interest groups that are trying to affect the political process, supra-governmental entities (e.g. WTO, NAFTA) or other corporations that might act in a political way. Political action has a direct bearing when political actors change laws, regulations, etc. or take other actions that directly affect business. An example of such direct effect is the nationalization of business. The indirect effect of political action occurs when the political actors change the economic environment, the attitudes of the population, or some other factor that then indirectly affects specific businesses. An example of such indirect effect is when the local business lobbies the government against the entry of foreign companies. Country risk and political risk are sometimes used interchangeably. Country risk comprises all the socio-political and economic factors which determine the degree and level of risk associated with undertaking business transactions in a particular country; the likelihood that changes in the business environment will occur that reduce the profitability of doing business in a country.
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Examples of political risk:

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MF0006 – International Financial Management -Set-2

1) Nationalization: Nationalization is the appropriation of private assets by a national government. 2) Creeping Expropriation: Creeping expropriation occurs when the government changes the rules and makes profit impossible. An example: The host government may require that the company sell its products only to the local enterprises and that export opportunities are not pursued. This limits the profit potential of the company. 3) Contract Repudiation: Here, the terms of operating arrangements are changed or renegotiated once their operations are in place and have proved successful. Thus additional taxes may be imposed. Companies with large fixed investments are vulnerable due to the “hostage” effect. They cannot credibly threaten to withdraw. Companies with stable technologies are vulnerable because locals could take over the operation without need for continuing foreign technology transfer. 4) Political Pressure in a Democratic System: Spread of democracy increases popular criticism of foreign investors. Opposition parties may use attacks on foreign investors as nationalistic position to gain voter support (but pro-business opposition can also provide protection against government arbitrary policies, such as tariff increases). There is evidence to prove that business grows faster under democracies even though many believe that suppressive authoritarian regimes are more favourable to business. 5) Threats from Local Business: Local business interests use political connections to secure favourable treatment over foreign companies or resist market liberalization. Many local business people become wealthy during the period of protected markets and do not want to eliminate protectionist policies. As a result of lobbying by local business, governments may require foreign investors to have local partners or make laws that keep foreigners entirely away from some “critical” sectors or enact licensing procedures that delay investment. When liberalization occurs, local business still tries to create adverse political conditions. They try to prevent foreign companies from winning government contracts, or try to slow licensing and other approvals for foreign companies to decrease their relative efficiency. The multinational’s interest in political risk lies in forecasting that risk so that it can be avoided or managed. Assessment of political risk is the projection of possible losses that result from governmental and societal sources. The goal of political risk assessment is to provide projections that will guide the multinational in decision-making about investment, corporate strategy, and specific business tactics. Investors cannot always choose projects or countries where the risk is low and it is not possible to insure against all risks. There are steps that the investor can take to reduce risk in a given project. The prudent investor takes advantage of available information and relationships to manage political risks in the same way in which he manages economic or financial risks.
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MF0006 – International Financial Management -Set-2

Basic Strategies to Actively Manage Political Risk: Low Involvement Strategy High Involvement Strategy Work through a coalition of firms. Develop a network with No independent action. economic, political and social groups. Reduce asset exposure and Focus on all policy levels focus on national-level policy. (national, local, etc.). Targets regulatory framework of Targets political environment in business. general.

Q.3 Explain Trade deficits and Trade surplus in regard to Balance of Payments. [10 Marks] Ans:The balance of payments (or BOP) of a country is a record of international transactions between residents of one country and the rest of the world over a specified period, usually a year. Thus, India’s balance of payments accounts record transactions between Indian residents and the rest of the world. International transactions include exchanges of goods, services or assets. The term “residents” means businesses, individuals and government agencies and includes citizens temporarily living abroad but excludes local subsidiaries of foreign corporations. The balance of payments is a sources-and-uses-of-funds statement. Transactions such as exports of goods and services that earn foreign exchange are recorded as credit, plus, or cash inflows (sources). Transactions such as imports of goods and services that expend foreign exchange are recorded as debit, minus, or cash outflows (uses). The Balance of Payments for a country is the sum of the Current Account, the Capital Account and the change in Official Reserves. Trade Deficits: The trade balance is the difference between a country’s output and its domestic demand-the difference between what goods and services a country produces and how many goods and services it buys from abroad. A trade deficit occurs when, during a certain period, a nation imports more goods and services than it exports. Ttrade surplus occurs when a nation exports more goods and services than it imports. According to the BOP identity (Current Account + Capital Account =Change in Official Reserve Account), any trade deficit must be offset by surpluses on other accounts. Since the official reserves are limited, a surplus on the Official Reserve Account (which means selling of the foreign exchange reserves by the central bank) can at best be a
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MF0006 – International Financial Management -Set-2

temporary measure. Thus the trade deficit must be "financed" by foreign income or transfers, or by a capital account surplus. A capital account surplus consists of capital purchases (stocks, bonds etc.) by foreign nationals. A capital account surplus (an increase in net foreign investment) may result in an increase in the net outflow of income (dividend, interest) to foreign nationals on these investments in the future. Thus, such payments to foreigners could have intergenerational effects: they shift consumption over time, and future generations have to pay for the consumption by the present generation. However, a trade deficit can also lead to higher consumption in the future, if, for example, it is used to finance profitable domestic investment, which generates returns in excess of what is paid to the foreign nationals on their investments in the country. Such a situation may arise if a country experiences a gain in productivity as a result of these investments. A trade surplus implies an increase in the net international investment of the residents of the country and the shifting of consumption to future rather than current generations. Even trade surpluses can be undesirable for a country. An example where a trade surplus was not beneficial for the country is Japan in the 1990s. The positive trade balance that Japan had was partly due to the protectionist measures that were adopted by the Japanese government. These measures caused the price of goods in Japan to be much higher than what they would have been, had imports been freely allowed. The foreign currency that the Japanese companies earned overseas were kept abroad and not converted into yen in order to keep the value of the yen low and maintain the competitiveness of Japanese exports. However, a weak yen also prevented Japanese consumers from importing goods from abroad and benefiting from the trade surplus. The foreign exchange earned abroad as a result of the trade surplus was partly squandered by spending it on real estate purchases in the United States that often proved unprofitable.

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