PREFACE

The scope and content of international finance have been fast evolving due
to deregulation of financial markets, product innovations and technological
advancements. Reflecting the growing importance of international finance as a
discipline, there is a sharp increase recently in the demand for experts in the area
of both the corporate and academic worlds.

International Finance has been taught in Academy of Finance for nearly

fifteen years in Vietnamese. Recognizing the importance of equipping students
with necessary knowledge in the time of globalization and improving their ability
in using English efficiently in future careers, International Finance is among the
subjects that needed to be taught in English.

International Finance text book aims to provide well-organized,

comprehensive and up-to-date coverage of the topics that take advantage of the
authors’ many years of teaching and researching in this area. The book is written
based on two tenets: the emphasis on fundamental concepts and the emphasis on
empirical knowledge. It initially focuses on studying the principles and
mechanics, the rules and natures of monetary flows among economic entities of
one country and the rest of the world. Then specific processes and valuable
techniques are presented to serve as systematic tools and essential guidance for
analyzing, organizing international financial activities and especially for realizing
and adapting with the global continuous changes.

This book will be of use to all students in economics and business schools
whose degrees are in English or students majoring in economics with upper-
intermediate English level, and also for those who wish to widen understanding
about international finance in English for their study, research or work. For a
better usage, students are required to already have acquaintance from a wide
range of other subjects including Economics, International Economics, Financial
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and Monetary Theory, Corporate Finance Management, Insurance, Capital
Market…

International Finance is composed of eight chapters that are fairy

independent and may be studied in a variety of sequences.

Chapter 1: An overview of international finance - written by Luong Thi Anh

Hoa, MA and Vu Viet Ninh, MA - contains concepts, characteristics, the roles and
components of international finance.

Chapter 2: Exchange rate and the Balance of Payment - written by Tran Thi
Phuong Mai, MA - illustrates the determination method, factors affecting
exchange rate and its regimes as well as the contents and principles in recording
the balance of payments.

Chapter 3: International Financial Market - written by Luong Thi Anh Hoa,

MA and Vu Viet Ninh, MA - studies the establishment and components of
international financial market especially in foreign exchange market.

Chapter 4: International Payment - written by Cao Phuong Thao, MA -

provides definition, features, classifications, methods, instruments and the
mechanism of international payment.

Chapter 5: International investment and multinational corporate finance -

written by Cao Phuong Thao, MA - focuses on concepts, categories of
international investment and then intensively deals with Foreign Direct
Investment (FDI), Foreign Indirect Investment (FII) and multinational corporate
finance.

Chapter 6: Foreign Aid – Grant, Loan and Debt - written by Dang Le Ngoc -
is a deep look at concepts, classification, roles and management of grant, loan and
debt.

Chapter 7: The International Union of Taxation - written by Nguyen Thi

Minh Tam, Associate Prof, PhD - investigates principles and rules on imposing
taxes on international economic relations, regulations on dealing with

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international economic relations, forms of the international union of taxation, and
types and methods to avoid double taxation.
Chapter 8: Major professional activities of several international financial
organizations - written by Nguyen Thi Minh Tam, Associate Prof, PhD - concerns
with the development, roles and specific works of International Monetary Fund,
World Bank and Asian Development Bank.

We are indebted to many colleagues who provided insight and guidance

throughout the development process especially authors of the International
Finance text book in Vietnamese.

Though the authors took considerable time and effort working on all of the
aforementioned issues, the limitation in knowledge and other resources might be
reasons for the book’s drawbacks. The authors look forward to receive comments
and suggestions from researchers, lecturers, readers and students to revise the
book before being published.

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 Chapter 1

AN OVERVIEW OF INTERNATIONAL FINANCE

1.1. CONCEPTS AND CHARACTERISTICS OF INTERNATIONAL FINANCE

1.1.1. The appearing and existing conditions of international finance
International Finance is the movement of monetary flows among economic
entities of one country and the rest of the world.
Throughout the study of history and comparing with what is happening now, it
is shown that the relationship between different countries (international relations) and
the function of international currency are two basic premise conditions that make
International Finance exist. When the productive forces develop to a certain degree,
there are surplus products, which need to be exchanged with each other. The exchange
not only takes place within a country but also carries out among countries. At first,
exchange activities are mainly carried out among neighbors and direct barter, goods
exchange for goods (G – G). Until currency appears and performs the function of
international currency, the action of that exchange is done through monetary, goods –
money – goods (G – M - G), which is divided into two processes: Selling (G -M) and
Buying (M - G). Now, when country A sells goods to country B, goods (G) flow from
A to B, but money (M) then flows back from B to A, given an increase to the
International Financial activities. Similarly, when country A buys C’s goods, then G
will move from C to A, but the flow of money will come from A to C.
In sum, International Finance makes its way into the world relying on two
following basic conditions: the first, international relations of economics, politics,
culture, diplomacy, etc and the second, the function of international currency.
Condition 1: International relations
The world combines of all countries and every country has its own
independence as well as dependence in the development process. In fact, no country in
the world has enough resources to produce all goods and services needed on its own.
Hence, it is necessary for one country to establish relationships with others. Due to the
increasing dependence among countries, it is not surprised when a product is
4
manufactured in one country but designed or processed in another and sold over the
world.
The international relationships stimulate the formation, existence, and
development of international financial activities. Such relationships are established in
many areas: economics, politics, culture, diplomacy, etc...
a. International relations of economics
International economic relations of one country are often represented in forms
of international trade, international investment and international credit, etc…
* International trade
International trade helps to increase the consumption capacity of one country.
Taking part in international trade allows a country to consume more than what it can
produce on its own.
International trade constitutes international finance through the movement of
goods and services from one country to another, which creates the movement of
currency flows in the opposite direction. This opposite movement of currency flows
occurs through the international payment activity that is one of the important parts of
international finance.
* International Investment
This is an activity of investing capitals and assets abroad in order to do
business for making profits.
International investment can be carried out in two forms:
International Indirect Investment (also called “foreign indirect investment”-
FII): is an investment where the foreign investor puts money on buying foreign
securities or lending to foreign borrowers, etc…Its specific characteristic is that the
investor does not participate directly in the process of managing and using invested
capital.
International Direct Investment (also called “foreign direct investment”-FDI)
is a long-term investing activity where the foreign investor invests in all or a part of
capital in order to reserve the right to directly manage the entire or a part of business
activities.  

5
 Its specific characteristic is that the investor directly participates in the process
of managing and using invested capital for the FDI company in accordance with the
capital contribution ratio.
International investment is also an origin of international finance since it is
usually accompanied by movements of capital from one country to another.
* International credit
This is an activity where a foreign lender (creditor) lends money to a borrower
of another country. The initial form of international credit is commercial credit and it
is further developed to banking and institutional credit.
International credit is a part of international finance because international
lending and borrowing activities create the movement of capital flows from one
country to another.
b. International relations of culture
Besides international relations of economics, there are similar relations of
culture, which include relations of education and healthcare, etc…
International social-cultural relations are other origins of international finance
because they help to create international payment activities, such as payment of salary,
scholarship, tuition fees; payment for healthcare treatment services, etc…
c. International cooperation on labor
In fact, this is a labor export activity. Accordingly, workers of one country go to
work in another country. Their incomes under the forms of salaries or wages are
considered as a part of GNP of their home country. Labor export activity leads to
international financial relations in the way that a portion of exported workers’ incomes
is often transferred to their home country.
d. International tourism
International tourism is an activity where tourists from one country travel to
another. These foreign tourists have to spend money on goods and services that they
receive in the country of destination. In fact, the supply of goods and services to
foreign tourists is considered as an export activity of the host country. In other words,
there are cash flows moving from one country to another through international tourism
activity, which is a manifestation of international financial destination spending money
on service countries                                  .

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 e. International relations of politics, military, and diplomacy: These relations
also help to create cash flows transferred in the international scope. As a result, they
become a mentionable reason for the existence and development of international
finance.
Condition 2: the function of international currency
Within a single economy, money fulfills three basic functions—it serves as
medium of exchange, a unit of account, and a store of value. When there are
transactions among economic agents in multiple economies, there comes a need for
currency that has those three functions and can servers internationally.
As a medium of exchange, it is used by private agents both in direct exchange
of currencies and as a vehicle currency in carrying out indirect exchanges between two
other currencies in foreign trade and international capital transactions. It is also used
by official agents as a vehicle for exchange market intervention and for balance of
payments financing.
As a unit of account, it is used to invoice merchandise trade, to denominate
financial transactions, and—by official agents—to define exchange rate parities.
As a store of value, it is used by private agents when they are choosing
financial assets, such as bonds held by nonresidents. Similarly, official agents may
hold both an international currency and financial assets denominated in it as reserve
assets.
There is, however, one fundamental difference between the use of money in a
single economy and the use of an international currency in a multieconomy setting. In
the former context, governments typically declare the currency that is used as legal
tender within their jurisdictions. For example, when receiving tax receipts, the US
government demands to be paid in US dollars and not in, say, Canadian dollars. In the
international setting, however, the choice of currencies responds predominantly to
market forces, whose consequences are ratified more than guided by international
agreements. While the process determining the use of international currencies
responds to market forces, there may be some factors influence the costs of changing
currencies, as is explained later in the textbook.
In conclusion, the appearing and existing of international finance is based on
necessary and compulsory conditions as follows:

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 Necessary conditions: International relations of economics, politics, culture,
diplomacy, etc.
Compulsory conditions: The function of international currency.
1.1.2. Concept and Characteristics of international finance
1.1.2.1. .Concept of international finance
International financial activities take place in the international scope. It is the
movement of capital flows among entities of countries or between these entities and
international organizations. This movement of capital flows is the consequence of
international relations of economics, culture, politics, military, diplomacy and via the
way of establishing and utilizing the monetary funds by each entity to meet different
needs on its international relationships.
1.1.2.2. Characteristics of international finance
As a financial sector, international finance also has common features of other
areas, such as monetary funds and cash flows maneuvering through monetary
relations, etc. In addition, there are following unique features:
1.2.2.2.1. International finance has a broad scope and relates to almost countries in
the world.
This characteristic is quite different from other fields of finance such as
corporate finance or public finance, which is often attached to a certain entity in
national scope. International finance relations take place in an extensive sphere, which
is among countries and with the participant of many entities. It is demonstrated that
international finance relates to two countries at least and is governed by conditions and
environment of own countries. This characteristic leads to a special and peculiar risk
which is known as political risk (also known as "geopolitical risk"). Causes of this
kind of risk include changes in a country's political structures or policies, such as
payments, investments, credits, taxes and tariffs, expropriation of assets or restrictions
in repatriation of profits, etc …
For example, a company may suffer from such loss in the case of expropriation
or tightened foreign exchange repatriation rules, or from increased credit risk if the
government changes policies to make it difficult for the company to pay creditors.
For multinational companies, political risk refers to the risk that a host country
will make political decisions that will prove to have adverse effects on the
multinational's profits and/or goals. Adverse political actions can range from very
8
detrimental, such as widespread destruction due to revolution, to those of a financial
nature, such as the creation of laws that prevent the movement of capital. Overall,
regardless of the type of political risk that a multinational corporation faces,
companies usually will end up losing a lot of money if they are unprepared for these
adverse situations.
With this feature, international finance often faces with a particular type of risk,
known as political risk, which is caused by:
- Changes in legislations, policies and modes of countries about payments,
investments, credits and taxes will cause risks and unexpected damages to money
relations of international finance;
- Changes in viewpoints, state institutions and political systems of countries
will impact on international finance. Specifically:
+ Due to the election, a new political party keeps the power and the
implementation of new guidelines, policies and rules will cause losses or damages to
international finance;
+ Due to the coup and revolution, new forces keep the power, which can lead to
huge changes in state institutions, and even political regimes; and cause disruption as
well as substantial damages to international finance.
Political risks can be evaluated by a set of key factors such as:
+ The host country’s political and government system: Whether the host
country has a political and administrative infrastructure that allows for effective and
streamlined policy decisions. If a country has too many parties and frequent changes in
government, its policies may become inconsistent, creating high level of political
risks. Examination of the ideological orientations and historical track records of
political parties would be a suggestion on the way they would run the economies.
+ Integration into the world system: If a country is politically and economically
isolated and segmented, it would be less willing to follow the international rules of
game and vice verse for a country that is a member of major international
organizations such as the EU, OECD and WTO, reducing political risk.
+ The host country’s ethnic and religious stability: this is because domestic
peace can be strongly vulnerable to ethnic and religious conflicts, causing political risk
for foreign business.

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 + Regional security: Real and potential aggression from neighboring country is
obviously a main attribution to political risk and regional condition may encourage or
make harms to the country’s international transactions.
+ Key economic indicators: Political events are often triggered by economic
situation. For example, persistent trade deficits may induce a host country’s
government to delay or stop interest payment to foreign lenders or erect trade barriers.
Severe inequality in income distribution and deteriorating living standards can cause
major political disturbances.
1.2.2.1.2. International finance relates to lots of different currencies
There are so many different currencies used in international financial activities.
Therefore, currencies must be certainly exchanged with each other. This leads to
another kind of risk which is called exchange rate risk or currency risk.
Exchange rate risk is a form of risk that arises from the change in price of one
currency against another.
Currently, the exchange rate among such major currencies as the US dollar,
Japanese yen, British pound and euro fluctuate continuously in an unpredictable
manner and have a pervasive influence on all the major economic functions:
consumption, production and investment. A company with overseas operations will
find the value of domestic currency of its overseas profits changing along with
exchange rates. Thus, they will face exchange rate risk if their positions are not
hedged.
For example, a U.S. investor has stocks in Canada; the return that he will
realize is affected by both the change in the price of the stocks and the change of the
Canadian dollar against the U.S. dollar. Suppose that he realized a return in the stocks
of 15% but if the Canadian dollar depreciated 15% against the U.S. dollar, he would
realize no gain.
1.2.2.1.3. International finance is affected by the level of market imperfections:
Although the world economy is much more integrated today than was the case
several decades ago, a variety of barriers still hamper free movements of people,
goods, services and capital across national boundaries. These barriers include legal
restrictions, excessive transaction and transportation cost, information asymmetry and
discriminatory taxation. The world markets are thus highly imperfect. Market

10
imperfections prevent the markets from functioning perfectly and become key
motivating forces driving international finance transactions.
In term of trade barriers, international market for goods and services are often
rendered imperfect by acts of governments. Governments may impose tariffs, quotas
and other restrictions on exports and imports of goods and services, hindering the free
flow of these products across countries. Sometimes, governments may impose
complete bans on the international trade of certain products. The objectives of those
regulations are to raise governments’ revenue, protect domestic industries and pursue
other economic policies. Trade barriers may also arise naturally from transportation
costs, especially for goods like mineral ore or cement that are bulky relative to their
economic values, making high transportation cost and low profit margin. Facing
barriers to exporting its products to foreign markets, a firm may decide to move
production to foreign countries as a means of circumventing the trade barriers. Thus
some say that FDI and MNCs are the gift of market imperfections.
In term of labor market, labor service in one country may be underpriced
relative to its productivity because workers are not allowed to move freely across
national boundaries to seek for higher wages. Severe imperfections in the labor
market lead to persistent wage differentials among countries, making labor market to
be the most imperfect among all factor markets. When workers are not mobile because
of immigration barriers there will be the movement of capital to benefit from
underpriced labor services. The recent surge in investment in developing countries can
be attributable, in part, to the low-cost workforces.
1.2. ROLES OF INTERNATIONAL FINANCE
1.2.1. International finance helps to exploit the external resources in
order to finance for the social and economic development of a country
The implementation of international financial activities shall lead to the
movement of financial resources from one country to another. Through international
financial relations, financial resources, technologies and labor resource are reallocated
all over the world
With respect to the countries which receive capital inflows, especially
developing countries, international finance becomes an important agent in inspiring
their potentials and available resources to boost their economic growth.

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1.2.2. International finance impulses the integration of national
economies to the international economy
The expansion of international credit, trade and investment, along with the
participation in the markets of capital, currency and foreign exchange helps many
countries to develop their domestic economies as well as to improve and perfect their
policies, in accordance with requirements of regionally and internationally economic
integration.
In other words, international finance, as a result of international economic
relations, makes contribution to the increase of dependence among countries.
1.2.3. International finance helps to enhance the effectiveness of
utilization of financial resources
In respect of the capital exploration and utilization, countries and businesses
have more opportunities to approach with different kinds of financial resources thanks
to international financial relations. Consequently, they have more opportunities to
select loans that are conformable to their needs and capacities. For example,
Vietnamese government can raise concessional loans by borrowing from foreign
governments and international financial organizations, or raise commercial loans by
borrowing from foreign commercial banks or issuing bonds in the international
financial market.
In respect of capital owners, they have more opportunities to select places,
sectors, and projects to invest their money in thanks to international financial relations.
By that way, they can limit risks and maximize profits taken from their invested
capital.
1.3. CONTENTS (COMPONENTS) OF INTERNATIONAL FINANCE
1.3.1.According to monetary relations, international finance is made up
by:
- International payment relations
International payment is any payments made by one country to another.
International payment is closely related to the foreign exchange market in which
national currencies are bought and sold by those who require them for such payments.
Countries may make payments in settlement of a trade debt, for capital investment, or
for other purposes. International payment transactions may involve governments,

12
exporters, importers, multinational corporations, or persons wishing to send money
abroad to relatives or friends.
- International aid-grants.
International aid-grants are kinds of international indirect investments. There
are three sorts of international aid-grants, which include bilateral, multilateral and non-
governmental organization’s international aid-grants. Receivers of international aid-
grants may involve central governments, local governments, social and economic
entities as well as people and communities, etc. Donors of international aid-grants may
be governments, international organizations or non-governmental organizations, etc.  
- International credit
International credit is another kind of international indirect investment. One
side of the international credit relation – the lender (or creditor) lends his money
abroad for making profit, which is in terms of interest rate. The other side of this
relation – the borrower (or debtor) borrows money from the foreign lender and makes
principal and interest payments in accordance with terms of the credit contract.
Lenders and borrowers in the international credit relation may include social
and economic entities of every country as well as international financial organizations.
- International investment in securities
International investment in securities is also another kind of international
indirect investment. Entities that have financial resources will invest their money in
purchasing securities issued by foreign governments or companies. These investors
gain from dividends and differences between the securities’ buying and selling prices.
They do not participate in the management of their capital-invested objects.
- International direct investment
International direct investment (also known as foreign direct investment - FDI)
is a long-term investing activity where the foreign investor invests all or a part of the
capital to reserve the right to directly manage the entire or a part of business activities.
The FDI investors are always private entities but governments.
1.3.2. According to participants of international finance activities,
international finance is made up by activities of:
- Economic organizations, which take part in international financial activities
under the forms of carrying out international direct and/or indirect investments,
international trade, international payment and international credit, etc.
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 - Commercial banks, which take part in international financial activities by
carrying out operations of international credit, international investment, and other
banking services, such as payments, consultancy and guarantee services, etc.
- Insurance companies, which take part in international financial activities
through operations of international marine insurance, international aviation insurance,
international reinsurance, and international investment, etc.
- Security companies, which take part in international financial activities
through operations of brokerage, security trading, investment and consultation in the
international scope.
- International financial institutions (IMF, ADB, WB…), which take part in
international financial activities through operations of raising capital from member
countries and international financial markets, providing capital to their members,
mainly in terms of lending…  
- Governments, which take part in international financial activities through
operations of providing aid-grants, government credit in the international scope and
collecting tariffs (export and import taxes).
1.4. MAJOR TRENDS OF THE WORLD ECONOMY INFLUENE INTERNATIONAL
FINANCE

1.4.1. The emergence of globalized financial markets

Recent decades observe a rapid integration of international capital and
financial markets. The impetus for globalized financial markets initially came
from the governments of major countries that had begun to deregulate their
foreign exchange and capital markets. For example, in 1980 Japan deregulated its
foreign exchange market, and in 1985 the Tokyo Stock Exchange admitted as
members a limited number of foreign brokerage firms. Additionally, the London
Stock Exchange began admitting foreign firms as full members in 1986. Then
fixed brokerage commission and the regulation separating the order-taking
function from the market-making function were eliminated. In Europe, financial
institutions are allowed to perform both investment banking and commercial
banking functions. These changes were designed to give London the most open
and competitive capital market in the world. In US, when the restriction on
commercial banks from investment banking activities was repealed, competition
among financial institutions was further promoting. Even in developing countries
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such as Chile, Mexico and Korea began to liberalize by allowing foreigners to
directly invest in their financial markets.
Deregulated financial markets and heightened competition in financial
services provided a natural environment for financial innovations that resulted in
the introduction of various instruments. Examples of these innovative
instruments include currency futures and options, multicurrency bonds,
international mutual funds and foreign stock index futures and options.
Corporations also played an important role in integrating the world financial
market by listing their shares across borders. Such well-known non US
companies as Sony, Toyota Motor, Fiat, and British Petroleum are directly listed
and traded on the NYSE. At the same time, US firms such as IBM and GM are listed
on the Brussels, Frankfurt, London, and Paris stock exchanges. Such multi-
financial markets listing allow investors to buy and sell foreign shares as if they
were domestic shares, facilitating international investments.
Furthermore, computer and telecommunications technology advances
significantly contributed to the emergence of global financial markets. These
technological innovations, especially internet-based information technologies,
are considered to be valuable means for investors around the world to
immediately access to the most recent news and information affecting their
investments, sharply reducing information costs. Additionally, computerized
order-processing and settlement procedures have reduced the cost of
international transactions. As a result of these technological developments and
the liberalization of financial markets, international financial transactions have
exploded in recent years.

1.4.2. The emergence of the Euro as a global currency

The appearance of euro at the start of 1999 likes a momentous event in the
history of the world financial system and exists on daily basis that no single
currency has circulated so widely in Europe since the days of the Roman Empire.
Together with the expansion of the European Union, the transactions domain in
euro are becoming larger.
Once adopting the common currency, a country obviously cannot have its
own monetary policy. The common monetary policy for the euro zone is now
formulated by the European Central Bank (ECB). ECB is legally mandated to
15
achieve price stability for the euro zone. Considering the sheer size of the euro
zone in terms of population, economic output, world trade share and the prospect
of monetary stability in Europe, the euro has a strong potential for becoming
another global currency rivaling the US dollar in dominating in international
transactions.
Since its the inception in 1999, the euro has already brought about
revolutionary changes in European finance. In particular, by redenominating
corporate and government bonds and stocks from individual currencies into the
common currency, the euro has created the emergence of continent-wide capital
markets in Europe that are comparable to US markets. Companies all over the
world can benefit from this development as they can raise capital more easily on
favorable terms in Europe. Moreover, the recent European mergers and
acquisitions waves, cross-border alliances among financial exchanges and
lessening dependence on the banking sectors for capital raising are all results of
the profound effects of the euro.
After World War I, the US dollar has played the role of dominant global
currency, displacing the British pound. As a result, foreign exchange rates of
currencies are quoted against the dollar and a large proportion of currency
trading involves the dollar on either the buy or sells side. Similarly, international
trade in primary commodities, such as petroleum, coffee, wheat, and gold, is
conducted using the invoice currency. Reflecting the dominant position of the
dollar in the world economy, central banks of other countries hold a major
portion of their foreign reserve in US dollar. Once economic agents start to use
the euro as invoice, vehicle and reserve currency, the US dollar may have to share
the aforementioned privileges with the euro.

1.4.3. Trade liberalization and economic integration

According to the theory of comparative advantage, it is mutually beneficial
for countries if they specialize in the production of goods that they can produce
most efficiently and then trade those goods among them. By doing so, the volume
of those goods in both production and consumption increase in all countries
involved. Realizing this gain, international trade, which has been the traditional
link between national economies, continued to expand. The theory has a clear

16
implication, that is: liberalization of international trade will enhance the welfare
of the world’s citizens that all players become winners.
Currently, international trade is becoming further liberalization at both the
global and regional levels. At the global level, the General Agreement on Tariffs
and Trade (GATT), which is multilateral agreement among member countries,
has played a key role in dismantling barriers to international trade. Since it was
founded in 1947, GATT has been successful in gradually eliminating and reducing
import tariffs worldwide, increasing the proportion of duty-free products and
extending the rules of world trade to cover agriculture, banking and insurance,
and intellectual property rights. Also, the World Trade Organization (WTO) has
more power to enforce the rules of international trade among members.
On the regional level, formal arrangements among countries have
promoted economic integration. The most striking evidence is the European
Union which was established to foster economics transactions among the
countries of Western Europe to eliminate barriers to the free flow of goods,
capital and labors. With the adoption of the common currency, the euro,
members of EU hope that their economic position relative to the US and Japan
will be strengthened and euro will rival the US dollar as a dominant currency for
international trade and investment.
Additionally, several other regional agreement have adopted such as the
North American Free Trade Agreement (NAFTA) and ASEAN Free Trade Area
(AFTA). In 1994, the United States, Canada and Mexico – the largest and the third-
largest trading partner with the US entered in NAFTA. In a free trade area, all
impediments to trade, such as tariffs and imported quotas, are eliminated among
members. In the mean time, AFTA was formed in 1992, aiming to remove all tariff
and non-tariff barriers among ASEAN countries. It is noted that the ratio of export
to GDP in those countries has increased dramatically and can be attributed to the
agreements.

1.4.4. Privatization wave

The integration and globalization are promoted via privatization. Through
privatization, a country divests itself of the ownership and operation of business
by entering the free market system. Privatization can be viewed in a variety ways.
First and foremost, it is a denationalization process when a government releases
17
from a state-run business. Furthermore, if the new owners are foreign, the
country may simultaneously be importing a cultural influence that did not
previously exist. In many developing countries, privatization can be seen as
solution for national reserve when the sale proceeds are often used to pay down
sovereign debt that has weighed heavily on the national economy. Additionally,
privatization is often considered to be a cure for bureaucratic inefficiency and
waste. There were estimates that privatization increase efficiency and reduce
operating cost.
For some countries, privatization has meant globalization. When open
their economy to private and foreign capital, foreign investors now control their
commercial banks, purchase national companies and the efficiency in operation
lead to higher rank for those countries in the competitive market environment
list. Privatization has played a new demand on international financial markets to
facilitate the purchase of the former state enterprises and brought about a
demand for new managers with international business skills. It is undeniable
that privatization has spurred a tremendous surge in cross-border transactions.

18
 Chapter 2

EXCHANGE RATE AND THE BALANCE OF PAYMENTS

2.1. EXCHANGE RATE

2.1.1. Concept
When studying opened economies that trade with one another, there is a
major difference in transactions between domestic and foreign residents as
compared to those between residents of the same country, namely, different
national currencies. Two currencies are exchanged in a specific rate which is
called an exchange rate.
Exchange rate could be explained in many different ways and is not
understood in a uniform. However, from widely accepted universal points,
nowadays in the mechanism of the market economy, an exchange rate is defined
as: “Exchange rate is the price of one currency in terms of another”. This definition
is absolutely reasonable. For example, a US importer will generally have to pay a
Japanese exporter in Yen, a German exporter will have to buy these currencies
with dollars in what is known as the foreign exchange market. The foreign
exchange market is not a single physical place, rather it is defined as a market
where various national currencies are bought and sold. Hence, in this market,
these currencies could be traded as commodities and have prices. Price which is
now represented by a necessary amount of money to pay for a unit of currency
trading, is called exchange rate.
Exchange rate often relates to two different currencies and each currency
has its own position. The currency which is an unit currency can be considered as
a commodity bought and sold in the foreign exchange market, and the other
which is called term currency has payment mission when trading the unit
currency.
Nowadays, countries in the world use both two exchange rate quotation
methods:

19
 Direct quotation: Exchange rate is the price of one unit of foreign currency
in terms of units of domestic currency.
1 foreign currency = x domestic currency
For example: on 15 April 2013, in Hanoi, 1USD = 20350 VND
Indirect quotation: Exchange rate is the price of one unit of domestic
currency in terms of units of foreign currency. There are 5 currencies quoted
indirectly, which are GBP, AUD, NZD, EUR and SDR
1 domestic currency = x foreign currency
For example: on 14 January 2005, in New York, 1USD = 17110 VND
Until now, there has been no official regulation on the quotation method
applied in a country. Every country has the right to choose initiatively a way of
quotation that is suitable for its context.
In exchange rate between two currencies: A/B = x1 / x2
X1 is bid rate (B) , X2 is ask rate - A (or offer rate – O), in this case, both bid
rate and ask rate are exchange rates of people trading currencies. The slash
between x1 and x2 is used to distinguish between the bid and ask rate.
Nowadays, exchange rate is not only used widely in the foreign exchange
market but also in many economic and social activities, especially in researching,
statistics, analysing, calculating, forecasting…and international economic
activities. In these cases, if exchange rate is considered as price, it is clearly not
suitable, so we could understand that exchange rate is the rate at which one
currency can be exchanged for another.
But why currencies can be traded or exchanged for others and what the
essence of exchange rate is? The problem is that currencies have a common
characteristic: they have their own immanent value or represent for an amount of
value, which means that they are entirely exchanged for an amount of
corresponding value. That is the purchasing power of currencies. Thus, the
essence of exchange rate is the comparison of the purchasing power among
currencies.
In exchange rate between two currencies A/B = x, we can easily point out
that:

20
 - 1 A equal xB in purchasing power or 1 A and xB have the same
purchasing power
- A has higher purchasing power of x times in comparison with the
purchasing power of B
- X expresses the comparison of purchasing power between A and B
In summary, we could fully understand that: Exchange rate is the rate at
which currencies can be exchanged for others, and the essence of it is the
correlation of purchasing power between currencies.
2.1.2. Determination method of exchange rate
There are 3 methods applied to determine exchange rate between two
currencies A and B:
The 1st method: exchange rate determination under the gold standard
of currencies
Exchange rate between The gold standard of currency A
=
currency A and currency B The gold standard of currency B

This method is rather simple, which conducts an accurate exchange rate of

two currencies and was used commonly in old gold standard system many years
ago. However, it is not possible because nowadays, most of currencies do not
have their own gold standards.
The 2nd method: Exchange rate determination under purchasing
power parity (PPP)
In order to determine the exchange rate between two currencies A and B,
in their markets we choose two baskets which consist of n identical goods and
services.

Market price of a basket of goods

Exchange rate between and services in currency A
=
currency A and currency B
Market price of a basket of goods
and services in currency A
or
21
 ∑ Pi A
B/A =
∑ Pi B

PiA(B) represents the market price of a basket of goods and services in

currency A(B)
This method helps to determine a relatively accurate exchange rate
between two currencies. The more goods and services selected for the basket, the
more accurately the exchange rate would be determined (often 25 kinds of goods
and services selected at least). Moreover, it is hardly to eliminate elements added
to the price of goods and services such as tariffs, quotas, taxes, speculation…In
order to get an accurate result, goods in baskets must be numerous and identical
between two currencies. However, it is not easy to get such baskets in reality.
The 3rd method: Exchange rate determination under cross exchange
rate approach.
If we already have exchange rates between two currencies A/C = a and two
currencies B/C = b, we can determine the exchange rate of currencies A/B =
(A/C)/(B/C) = a/b; B/A = (B/C)/(A/C) = b/a
Case 1: The intermediary currency is simultaneously the base in one currency
pair and the term in the other currency pair:
Assuming that we have the exchange rates of the two following currency
pairs: A/C = a/b and C/B = c/d
- To calculate the bid rate of A/B: The bid rate of A/B is the rate at which the
bank buys A from customer in exchange of B (or customer sells A for the bank in
exchange of B)
Firstly, customer sell A for the bank and get a.C per A (1A = a.C). Then,
customer sell the C he gets in exchange of B at the rate: 1C = c.B
Therefore, we have: 1A = a.C = a.c.B or selling 1A, customer gets a.c B,
which is the bid rate of the bank for 1A
- To calculate the ask rate of A/B: The ask rate of A/B is the rate at which
the bank sells A for customer in exchange of B (or customer buys A from the bank
and pay in B).
22
 Customer buy A from the bank and pay b.C per A (1A = b.C). Before that,
customer have to buy C and pay d.B per C (1C = d.B) in order to have C for making
payment. Therefore, we have: 1A = b.C = b.d.B or buying 1A, customer pays b.d B,
which is the ask rate of the bank for 1A
=> The exchange rate of A and B is: A/B = a.c/b.d
Case 2: The intermediary currency is the base one in both currency pairs
Assuming that we have the exchange rates of the two following currency
pairs: C/A = a/b and C/B = c/d
- To calculate the bid rate of A/B: customer sell A for the bank in exchange
of B
Firstly, customer use A to buy C (sell A for C) from the bank and pay b.A
per C (1C = b.A). Then, customer use the C he gets to buy B (sell C for B) at the
rate: 1C = c.B
Therefore, we have: 1C = b.A and 1C = c.B => b.A = c.B or 1A = c/b.B or
selling 1A, customer gets c/b B, which is the bid rate of the bank for 1A
- To calculate the ask rate of A/B: Customer buy A from the bank and pay in
B
Firstly, customer uses B to buy C from the bank at the rate: 1C = d.B. Then,
customer use the C he gets to buy A (sell C for A) at the rate: 1C = a.A
Therefore, we have: 1C = d.B and 1C = a.A => d.B = a.A or 1A = d/a.B or buy
1A, customer pays d/a B, which is the ask rate of the bank for 1A
=> The exchange rate of A and B is: A/B = (c/b)/ (d/a)
Case 3: The intermediary currency is the term one in both currency pairs
Assuming that we have the exchange rates of the two following currency
pairs: A/C = a/b and B/C = c/d
- To calculate the bid rate of A/B: customer sell A for the bank in exchange
of B
Firstly, customer uses A to buy C (sell A for C) from the bank at the rate: 1A
= a.C (or C = 1/a.A). Then, customer use the C he gets to buy B at the rate: 1B = d.C
(or C = 1/d.B)

23
 Therefore, we have: 1/a.A = 1/d.B or 1A = a/d.B (selling 1A, customer gets
a/d B, which is the bid rate of the bank for 1A)
- To calculate the ask rate of A/B: Customer buy A from the bank and pay in
B
Firstly, customer uses B to buy C (sell B for C) from the bank at the rate: 1B
= c.C (or C = 1/c.B). Then, customer use the C he gets to buy A at the rate: 1A = b.C
(or C = 1/b.A)
Therefore, we have: 1/c.B = 1/b.A or 1A = b/c.B (buying 1A, customer pays
b/c B, which is the ask rate of the bank for 1A)
=> The exchange rate of A and B is: A/B = (a/d)/(b/c)
This method is quite simple and feasible in practice, however, its accuracy
could be limited due to intermediate exchange rates. Furthermore, it is
complicated to determine exchange rates by means of bid or ask rate. Now, in
addition to applying traditional methods of determination, we could determine
the cross rate through 3 steps below:
The 1st step: establishing the correlation rate mathematically
The 2nd step: determining the component rate which could be bid or ask
rate in specific situations according to the principle that the bid or ask rate
belongs to people who trade currencies, as opposed to the exchange rate of
clients: the bid or ask rate of term currency.
The 3rd step: calculating the corresponding data
2.1.3. Factors affecting exchange rate
Exchange rate is very sensitive which could be affected by numerous
factors. In general, there are some following major groups of factors:
2.1.3.1. The difference in inflation rate among currencies
The inflation rate has a direct influence to the purchasing power of
currencies. For this reason, in a certain period of time, if two currencies have
differences in inflation rate, assuming other factors are unchangeable, it means
that the correlation of purchasing power between them has changed,
consequently, the exchange rate will change.
The exchange rate of A and B quoted at the beginning of the year ( t=0) is
A/B= E0 , after one year (t=1), if the inflation rate of currency A is a% while B is b
24
% then we can calculate the exchange rate of this currency pair at t=1 is as
follow : A/B= E0 [ ( 1+b)/(1+a) ]
In summary, the currency which has higher inflation rates would
depreciate more than the other and vice versa.
2.1.3.2. The fluctuation in supply and demand of foreign currency in the
foreign exchange market.
In the foreign exchange market of a country, exchange rate is the price of
foreign exchange, mainly foreign currencies traded. In this case, exchange rate is
the price of foreign currencies which are called commodities. The price of any
commodities depends on their supply and demand, consequently, exchange rate
is impacted strongly by an increase or decrease in supply and demand of foreign
currencies in the market. There are some major cases occurred when a specific
foreign currency is considered:
- If the supply of a currency remains unchanged while the demand for it
increases

Graph 2.1. The change of exchange rate if the supply of a currency remains
unchanged while the demand for it increases

E S
(exchange rate)

E1 D1

E0 D
D2

E2
m2 m0 m1 m (Foreign currency)
0

+ If the supply of a currency remains unchanged while the demand for it

increases, D shifts to D1, E1 > E0 , exchange rate goes up

25
 + If the supply of a currency remains unchanged while the demand for it
decrese, D shifts to D2, E2 < E0 , exchange rate goes down.
- If the demand of a currency remains unchanged while the supply for it
increases
+ If the demand of a currency remains unchanged while the supply for it
increases, S shifts to S1 , E3 < E0, exchange rate goes down
+ If the demand of a currency remains unchanged while the supply for in
decreases, S shifts to S2, E4 > E0 , exchange rate goes up

Graph 2.2. The change of exchange rate if the demand of a currency remains
unchanged while the supply for it increases

E
S2 S
(exchange rate)

E4

E0
S1
E3

0
m2 m0 m1 m (Foreign currency)

2.1.3.3. The government’s interference

The government is one of subjective factor that impacts significantly the
increase, decrease or stabilization of exchange rates. The government’s
interference often has following directions:

26
 - The government intervenes to keep the exchange rate stable for a long
time. These interventions are expressed most significantly when the government
implements a fixed exchange rate regime, which means the exchange rate is kept
to be fixed for a long time; consequently, the government will adopt subjective
measures to intervene in the foreign exchange market, such as: fixing the
exchange rate within a narrow band, buying foreign currencies at low prices
when the tendency of exchange rate goes up and vice versa.
- Devaluation: in the fixed exchange rate regime, a devaluation of a
currency refers to a drop in the domestic currency’s value in comparison with
foreign currencies (made by the government). The signal of a devaluation is that
exchange rate is adjusted to increase compared to that the government commits
to maintain. Exchange rate rises, leading to a decrease in the domestic currency’s
value, therefore, it is called devaluation.
2.1.3.4. Public psychology
Generally, in some countries which have high inflation rates within a long
time, the rapid and continuous decline of a domestic currency will cause public’s
psychological lack of trust in the currency; consequently, people tend to reject
holding the domestic currency, they find numerous ways to hold valuable
commodities, gold, silver and foreign currencies…The high demand of holding
foreign currencies, especially, strong foreign currencies, has pushed the demand
of foreign currencies soaring artificially, hence the market falls on scarce of
foreign currencies, dragging on the higher of the exchange rate.
2.1.3.5. The fluctuation in interest rate of currencies
The fluctuation in interest rate of currencies often causes following trends:
- The fluctuation in demand and supply of foreign currencies in the foreign
exchange market. The currency which has a slight increase in interest rate than
others, will has a rise in the demand due to the trend of holding this currency to
receive higher earnings and vice versa. These fluctuations will affect the demand
and supply of currencies, therefore, it leads to exchange rate fluctuations.
- Psychological reactions. Adjusting the interest rate of some currencies
could affect psychologically in the international currency market. For instance,
when the FED (Federal Reserve System – A state bank of America) announced
their interest rate adjustments, some major international trading currencies had
27
positive and negative reactions through the exchange rate of other currencies
with USD, depending on up or down interest rate adjustments. Nevertheless,
these immediate reactions are not only economic aspect but also quite significant
in psychological aspect.
2.1.3.6. The international monetary speculation
There are many people trading currencies who adopt speculative and
manipulative measures to make illicit earnings. Speculation is a phenomenon that
some people trading currencies who buy one certain currency (often a strong
foreign currency) in a short time, keep it without selling, consequently, it causes
artificial scarcity of that currency, from there, the exchange rate increases
meaning that the price of the currency goes up significantly. After waiting until
the price reaches the peak rate, they sell that currency to get the exchange
difference.
The consequence of international monetary speculation is causing shocks
and even exchange rate crisis; and the domestic currency is devaluated sharply.
Generally, the speculation also causes public psychology; and when they have
resonance, that will create financial and monetary crisis for that country with
unexpected consequences. For example, the major reason of Asian financial and
monetary crisis occurred in 02/07/1997 in Thailand was the speculation of an
American billionaire George Soros, a leading expert on international monetary
speculation.
2.1.4. Regimes of exchange rate
2.1.4.1. Concept of exchange rate regime
In general, exchange rate is an objective existing category which associates
with international economic activities among countries. However, the selection
and application for a suitable exchange rate for economic and social benefits of
countries are different and not permanent in all periods. In other words, in each
period with specific economic and social conditions, each country could select a
certain exchange rate regime.
Exchange rate regime is the exchange rate applied by one country and
measures used to ensure that the type of exchange rate is implemented

28
 Through the above concept, we easily recognize that one exchange rate
regime includes two major elements:
+ The kind of exchange rate, which means the form of exchange rate
selected to apply
+Measures used to ensure that the kind of exchange rate is implemented
2.1.4.1. Types of exchange rate regime
a, Based on the number of exchange rate types, exchange rate regime can be
divided into two mains types : the single exchange rate regime and the dual
exchange rate regime
- The single exchange rate regime is a regime that only one type of
exchange rate exists and is used for every monetary transaction (one price
regime)
Thus, the single exchange rate has created justice and equality in monetary
transactions which is applied commonly when the exchange rate is set primarily
on the basic of the market.
- The dual exchange rate regime is a regime that at least two kinds of
exchange rate co-exist in monetary transactions (multiple price regimes)
This exchange rate regime has created the distinction of monetary
transactions of different subjects and in many circumstances, the level of
disparity among types of exchange rate is quite high. Consequently, it creates
inequity, inequality, and even negative impacts on the implementation of
monetary transactions.
In the dual exchange rate regime, the official exchange rate is fixed in a
long time that is not suitable for practice; consequently, the unofficial exchange
rate arises, and in other words it is called implicit exchange rate.
b, Based on the degree of flexibility of exchange rate applied, exchange rate regime
is divided into 2 types: fixed exchange rate regime and flexible exchange rate
regime
- The fixed exchange rate regime is a regime that exchange rate is kept
constantly, and even fixed for a long time.

29
 In general, official exchange rate is regulated, fixed within a narrow band
in a long time by governments, and does not depend on the relation between
demand and supply in the foreign exchange market.
In the fixed exchange rate regime, the Central Bank has to maintain a
specific amount of foreign exchange reserves in order to intervene in the foreign
exchange market with the aim of pegging exchange rate fixedly.
If the official exchange rate set by the Central Bank is lower than the
market exchange rate, it is said that domestic currency is overvalued and foreign
currency is undervalued. When the domestic currency is overvalued, the central
bank must purchase domestic currency to keep the exchange rate fixed, but as a
result it loses international reserves. If the country’s central bank eventually runs
out of international reserves, it can not keep its currency from depreciating, and
then a devaluation must occur, meaning that the par exchange rate is reset at a
lower level.
If the official exchange rate set by the Central Bank is higher than the
market exchange rate, it is said that domestic currency is undervalued and
foreign currency is overvalued. When the domestic currency is undervalued, the
central bank must sell domestic currency to keep the exchange rate fixed, but as a
result, it gains international reserves. If we will see shortly, the central bank
might not want to acquire these international reserves, it might want to reset the
par value of its exchange rate at a higher level (a revaluation).
In conclusion, the advantage of this exchange rate regime is contributing
the monetary stability and macroeconomic stability, creating the condition for
economic and social development. However, if exchange rate is fixed too long,
that is not suitable with reality and easily arising the implicit exchange rate.
Moreover, to intervene in the foreign exchange market, the Central Bank is
required to have available international reserves.
- The flexible exchange rate regime is a regime that exchange rate easily
fluctuates because of market impacts.
In this exchange rate regime, exchange rate is shaped by market elements,
consequently, it often reflects exactly the market situation. However, due to the
flexibility of exchange rate, this easily causes the fluctuation of exchange rate,
“shock” exchange rate, and even financial – monetary crisis.
30
 From advantages and disadvantages of above exchange rate regimes, many
countries select an exchange rate regime which is a combination of both two
exchange rate regimes, called managed floating exchange rate regime.
+ The flexibility: exchange rate is shaped mainly by elements of the market.
+ The management of the state: The intervention of the state due to against
exchange rate shocks by some measures such as: (i) intervene in the foreign
exchange market if necessary; (ii) fix the fluctuation band of exchange rate
2.2. THE BALANCE OF PAYMENTS
The balance of payments is one of the most important economic indicators
for policy-makers in an opened economy. What happening to a country’s balance
of payments often captures news headlines and can become the focus of
attention. A good or bad set of figures can have an influential effect on the
exchange rate and can lead policy-makers to change the content of their
economic policies.
2.2.1. Concept
The balance of payments is a statistical record of all economic transactions
between residents of the reporting country and residents of the rest of the world
during a given time period.
Based on this concept, some following implications have to be made clear:
- Economic transactions: are the reciprocal movement of goods, services,
incomes and other financial assets between organizations and individuals for the
purpose of short or long term material benefits.
Economic transactions include exchange transactions and unilateral
transfer.
+ exchange transactions : are two-way transactions including two parties in
which one party supplies goods, services, labour, capital and assets to the other
party and receives a certain corresponding economic value.
+ Unilateral transfer: is the transaction in which one party supplies a
certain economic value for others but almost has not got back any economic
values.
- Residents and non- residents: The term “residents” comprises individuals,
households, firms and public authorities. An institution known as a resident of a
31
country if it has a head office, business places or homes in the economic territory
of the country as well as carries out production activities and economic
transactions in a long time in that country ( at least 1 year), unless the following
exceptions :
+ Individual: pupils, students, patients, military and diplomatic personnel,
including family’s members going with them, living abroad in embassies,
consulates and army base are considered non-residents of a country no matter
how long they have been living abroad.
+ Organizations: consulates, embassies and army base are always non-
residents of a country in which they are stationed
+ International organizations (WB, IMF, ADB, UN…) are considered non-
residents of a country in which they are stationed
+Multinational corporations are considered residents of more than one
country, subsidiaries of a multinational corporation are treated as being
residents in the country in which they are located even if their shares are actually
owned by domestic residents.
- The reporting period for all statistics in the balance of payments (BOP):
statistics are reported in the BOP in a certain period of time: a month, a quarter, a
year or from the beginning of a year to a point of time in that year.
- Currencies used to record in the BOP: The BOP of a country could be
accounted and recorded by only one currency: domestic or foreign currency
may be used. As recommended by the IMF, USD should be used to record in the
BOP.
2.2.2. Contents of the balance of payments
The balance of payments consists of 5 main items, namely: Current
account, capital and financial account, net errors and omissions, official
settlement balance, reserves and related items.

Table 2.1: Structure of a balance of payments

(based on the aim of economic analysis)

Unit : USD
32
 Receipts/ Payments/
Contents
inflows Outflows
A. Current account (1+2+3+4)
1. Trade balance (1.1. + 1.2.)
1.1. Export (+)
1.2. Import (-)
2. Services (2.1. +2.2.)
2.1. Export(+)
2.2. Import(-)
3. Income (3.1. + 3.2.)
3.1. Receipts
3.2. Payments
4. Unilateral current transfers
B. Capital and financial account
(5+6+7+8)
5. Capital account
- Unilateral capital transfers(+,-)
- Trade of non-financial and non-production
assets (+,-)
6. Direct investments (6.1+6.2)
6.1. Direct investments abroad (-)
6.2. Direct investments within a
nation(+)
7. Portfolio investments (7.1+7.2)
7.1. Portfolio investment assets(+,-)
7.2. Portfolio investment liabilities(+,-)
8. Other investments (8.1 +8.2)
8.1. other investment assets(+,-)
8.2. other investment liabilities(+,-)

33
 C. Net errors and omissions (D-A-B)
D. Overall Balance (D=-E)
E. Official settlement balance (9+10)
9. Reserves (+,-)
10. Exceptional financing (+,-)
- Moratorium and debt forgiveness (+,-)
- Debt overdue change (+,-)

2.2.2.1. Current account

Current account records the value of imports and exports, receipts and
payments for goods and services of a country related to foreign countries.
Current account includes following sub-accounts:
- Trade balance: is sometimes referred to a visible balance because it
represents the discrepancy between receipts from exports and payments from
imports for goods which can be visibly seen crossing frontiers. Receipts for
exports are recorded as a credit in the balance of payments, while payments for
imports are recorded as a debit. When the trade balance is in surplus, this means
that country has earned more from its exports of goods than it has paid for its
import of goods. It is noted that prices of goods are quoted in the FOB term (Free
on board).
- Services (exports and imports of services): show the receipt and payment
from services in transportation, travel, finance, banking, insurance,
communication, construction and other activities between residents and non-
residents. Exports of services resulting in the supply of foreign currency are
credited, imports of services leading to the demand of foreign currency are
debited.
- Income (income credit and income debit): includes two components,
namely: compensations of employees and investment income.
+ compensations of employees such as salary, bonus and other incomes in
cash which non-residents pay to residents and vice versa

34
 + investment incomes are receipts from direct investment profits,
interests from portfolio investments and interests from loans between residents
and non-residents.
Residents’ income from non-residents resulting in a supply of a foreign
currency (demand for domestic currency) is credited and non-residents’ income
leading to a demand for a foreign currency (supply of domestic currency) is
debited.
- Unilateral current transfers are defined as offsetting entries for real
resources or financial items provided, without a quid pro quo, by one economy to
another. They include aids, gifts, grants and other transfers in cash or in kind for
spending on consumption without corresponding quid pro quo, which are
transferred from non-residents to residents, and vice versa. Examples of such
transactions are migrant worker’s remittances to their families back home, the
payment of pensions to foreign residents, and foreign aids. Such receipts and
payments represent a redistribution of income between domestic and foreign
residents. Unilateral payments viewed as a fall in domestic income due to
payments for foreigners are recorded as a debit, while unilateral receipts viewed
as an increase in income due to receipts from foreigners are recorded as a credit.
2.2.2.2. Capital and financial account
Capital and financial account presents all items of economic transactions
between residents and non-residents in terms of capital transfers of direct
investments, portfolio investments, foreign debts and liabilities, foreign borrows
and payments, foreign loans and debt collections, unilateral capital transfers and
other investments to increase or decrease assets and liabilities.
Capital and financial account includes following sub-accounts:
- Long-term capital account: records long-term capital inflows and outflows
of a specific country, which consists of:
+ Direct investment;
+ Indirect investment;
+ Other long-term investments: mainly long-term commercial lending
+ Official development assistance

35
 - Short-term capital account: records short-term capital inflows and
outflows of a specific country
+ Short-term commercial borrowing and lending;
+ Deposit operations;
+ Short-term portfolio investments;
+…
- Unilateral capital transfers: record non-refundable grants and assistance
for investment purposes and debt forgiveness.
- Account of foreign currencies deposited in a commercial banking system:
records foreign currencies deposit account in commercial banks.
2.2.2.3. Overall Balance (OB)
Theoretically, overall balance records economic transactions between
residents and non-residents in a given time period, including goods, services,
long-term investments, short-term investments, non-refundable grants for
investment purposes, and debt forgiveness…
Practically, overall balance is used at the end of a specific period to
calculate the total debt of current account and capital and financial account.
2.2.2.4. Errors and Omissions (OM)
If the statistic process is absolutely accurate, the overall balance and
capital and financial account are equal, which means that:
The overall balance= the current account + the capital and financial account
In fact, due to a lot of statistical problems arising during data collections
and making the balance of payments, errors and omissions often exist,
consequently:
The overall balance = the current account+ the capital and financial account
± errors and omissions
2.2.2.5. Official financing balance (OFB)
In principle, the balance of payments is always in equilibrium, which
means that the sum of all credit and debit items in the balance of payments is
equal, the balance of OFB equals to the balance of OB but in opposite, it means
that:
36
OFB = -OB or OFB + OB = 0
Due to errors and omissions, consequently: OFB = -OB±OM
Official financing balance contains the following items:
- Official foreign exchange reserves
- Foreign exchanges lending from the IMF and other Central Banks
- Changes in reserves of lending from the IMF and other Central Banks in
the currency of a nation making the balance of payments
When the official balance is in surplus, foreign exchange reserves of a
nation would be increased, vice versa, the official balance suffers a deficit, foreign
exchange reserves of a nation would be decreased. In the deficit case, that nation
could use a special draw right in the IMF to lend from other Central Banks due to
payments or arrange special compensations such as debt forgiveness or debt
delaying payments…
2.2.3. Principles in recording the balance of payments
2.2.3.1. Double-entry principle
In accounting, the balance of payments is always in balance. This
materializes because the double-entry accounting system is applied to the
balance of payments. This means that every recorded transaction between
residents and non-residents is represented by two entries with equal absolute
values and opposite signs. In other words, double-entry accounting system
requires every transaction to be recorded with two entries as “Credit” and
“Debit”. More specifically:
- Export goods and services : recorded in credit
- Import goods and services : recorded in debit
- Income receipts : recorded in credit
- Income payments : recorded in debit
- Receipts from unilateral transfers : recorded in credit
- Unilateral current transfer payments : recorded in debit
- Increase in financial liabilities : recorded in credit
- Increase in financial assets : recorded in debit
- Decrease in financial liabilities : recorded in debit
37
 The following examples illustrate in a simple manner of the double-entry
nature of the balance of payment statistics.
Example 1: In return for exported goods, 100 units are deposited by a
nonresident importer to the resident exporter’s account in a domestic bank. This
transaction is recorded as follows:

38
 Credit Debit
Current account
Exports 100
Capital and financial account
Other investments/assets/ currencies and deposits 100

Example 2: A syndicated loan with the amount of 100 units provided by

nonresident banks to a resident bank is recorded as follows:

Credit Debit
Capital and financial account
Other investments/assets/currencies and deposits 100
Other investments/liabilities/loans 100
Non-cash transactions are also recorded in the balance of payments.
Example 3: a resident importer imports 100 units worth of goods, which will
be repaid in a future date after the delivery is realized. The recording of this
transaction is as follows:

During the delivery of the goods:

Credit Debit
Current account
Goods 100
Capital and financial account
Other investments/ Liabilities/ Trade credits 100

39
 And when the payment is realized
Credit Debit
Capital and financial account
Other investments/ Assets/ Currencies and Deposits 100
Other investments/ Liabilities/ Trade credits 100

2.2.3.2. Change of ownership

Within the framework of double-entry accounting principle, credit and
debit entries of all economic transactions are recorded at the time of changing
ownership.
2.2.3.3. Market value
Economic transactions are valued at market prices. Market price may be
defined as the exchange price agreed upon by transactions and the current price
at which an asset or service can be bought and sold.
2.2.4. The surplus and deficit of the balance of payments
As we have seen, the balance of payments always balances since each
credit in the account has a corresponding debit elsewhere. However, while the
overall balance of payments always balances, this does not mean that each
individual account making up the balance of payments is necessarily in balance.
For instance, the current account can be in surplus while the capital account is in
deficit. When talking about a balance of payments deficit or surplus, economists
normally say that a subset of items in the balance of payments is in surplus or
deficit.
In principle, a surplus or deficit in the balance of payments cannot be the
difference between the sum of all credit entries and that of all debit entries
because the balance of payments is accounted in the double-entry system.
Consequently, the difference between the sum of all credit and debit entries is
always zero. The sum of all credit entries (or the sum of all debit entries) only
reflects the balance of payments’ turnover without indicating the status of the
balance of payments to be in a deficit or surplus. Determining a deficit or surplus
in each part of the balance is by the difference between credit and debit entries in
each balance.
40
 In addition, when referring to a balance of payments deficit or surplus,
economists make a distinction between autonomous (above the line) items and
accommodating (below the line) items. Autonomous items are transactions that
take place independently of the balance of payments, whilst accommodating ones
are those transactions which finance any differences between autonomous
receipts and payments. A surplus in the balance of payments is defined as an
excess of autonomous receipts over autonomous payments, while a deficit is an
excess of autonomous payments over autonomous receipts
Autonomous receipts > Autonomous payments = surplus
Autonomous receipts< Autonomous payments = deficit
The issue will then arise in which specific items in the balance of payments
should be classified as autonomous instead of accommodating. Disagreement on
which items qualifying as autonomous items leads to alternative views on what
constitute a balance of payments surplus or deficit. This difficulty over classifying
items as autonomous or accommodating arises because it is not easy to identify
the motive underlying a transaction. For example, there is a short-term capital
inflow in response to a higher domestic interest rate, which should be classified
as an autonomous item. If, however, the item is an inflow to enable the financing
of imports, then it should be classified as an accommodating item. The difficulty
of classifying items as either accommodating or autonomous items leads to
several concepts of the balance of payments disequilibrium.

41
 Chapter 3

INTERNATIONAL FINANCIAL MARKET

3.1. ESTABLISHMENT OF THE INTERNATIONAL FINANCIAL MARKET

The international financial market is the market where currency trading and
capital trading takes place among entities of countries via specific financial
instruments. The existence of the international financial market is derived because of
the following reasons:
- Uneven development among countries
Uneven development among countries leads to an increase in capital demands
as well as ability of supplying capital among countries. In order to make capital
supplies meet capital demands, it is necessary to have the existence of the international
financial market.
- Countries need to strengthen the power of their industrialization
The international financial market has significant advantages in supplying
capital for national industrialization. Historically, the industrialization in the UK and
US… is largely due to direct financial sources from financial markets via the sales of
securities.
- The development of science and technology, especially information
technology
There is no distance between the domestic financial market and the foreign one
which is blurred by the progress of information technology. As the development of
information technology, transaction costs are reduced and different markets that scatter
over the world are merged into a large one. A significant advantage of the
globalization of financial markets is to create such a strong competition among
financial centers and institutions, which will further reduce the cost of raising capital
in financial markets.

42
3.2. COMPONENTS OF THE INTERNATIONAL FINANCIAL MARKET
The international financial market is separated into two segments: The
international monetary market and the international capital market.
The international monetary market is the market where transfers of payment and
short – term capitals are exchanged (short – term capitals are mostly under one-year
term).
The international capital market is the medium and long – term market in which
borrowers and lenders of funds from different countries are brought together to
exchange funds.
In the following section, we just pay particular attention to the international
monetary market only.
3.3. THE INTERNATIONAL MONETARY MARKET
3.3.1. Eurocurrency market
In this section, we pay attention to a market that exerts a great deal of influence
on the international financial system, the Eurocurrency market. Eurocurrency markets
are defined as banking markets which involve short – term borrowing and lending
conducted outside of the legal jurisdiction of the authorities of the currency that is
used. For example, Eurodollar deposits are dollar deposits held in London and Paris.
The Eurocurrency market has two sides to it; the receipt of deposits and the loaning
out of those deposits. By far the most important Eurocurrency is the Eurodollar which
currently accounts for approximately 60 - 65% of all Eurocurrency activity.
The origin of the Eurocurrency market
The origin of the Eurocurrency market can be traced back to 1957. The
Russians, having acquired US dollars through the export of raw materials, developed a
strong anti-communist sentiment that prevailed in the USA. However, due to the “cold
war”, they were reluctant to hold these funds with US banks. Instead of this, they were
held in an account with a French bank in Paris of which the address was Euro – bank.
In 1958, the abolition of the European payment union and the restoration of the
convertibility of European currencies meant that European banks could now hold US
dollars without being forced to convert these dollar holdings with their central banks
into domestic currencies. The major centers for Eurobank activity are London, Paris,
New York, Tokyo and Luxembourg. The main users of Eurocurrency market facilities

43
are Eurobanks themselves, non – Eurobank financial institutions, multinational
corporations, international institutions as well as central and local governments.
The creation of Eurodollar deposits and loans
Eurobanks are basically financial intermediaries whose function is to channel
funds from a non – bank lender to a non – bank borrower. Between the deposit and the
lending, there may be series of interbank transactions. Eurobanks are in effect acting
as financial intermediaries ensuring that surplus funds from one organization are
transferred to others with borrowing requirements. When the organization spends
money, dollars will be ultimately derived from the US banking system, not from
Eurobanks. Only the US banking system creates dollars, Eurobanks create deposits
which are not means of payment. Eurobanks are essentially financial intermediaries.
They accept deposits and then loan out these funds.
3.3.2.The Foreign Exchange Market
When studying open economies that trade with one another, there is a major
difference in the transactions between domestic and foreign residents as compared to
those between residents of the same country; namely, that differing national currencies
are usually involved. A US importer will generally have to pay a Japanese exporter in
Yen and a German exporter in Euro…For this reason the US importer will have to buy
these currencies with dollars in a market known as the foreign exchange market. In
this part, we will take a detailed look at basic issues as well as some popular derivative
instruments applied for trading currencies in this market.
3.3.2.1. Definition of the foreign exchange market
The foreign exchange market (Forex or FX market) is where currency trading
takes place.In other words, the foreign exchange market is anywhere currencies are
bought and sold against others.
The foreign exchange market is a worldwide market which is made up
primarily of commercial banks, foreign exchange brokers and other authorized agents
trading in most of the currencies of the world. These groups are kept in close and
continuous contact with one another and with developments in the market via
telephone, computer terminals, telex and fax. The foreign exchange market that we see
today started evolving during the 1970s when countries gradually switched to floating
exchange rate from exchange rate regime which remained fixed as per the Breton
Woods system until 1971. Nowadays, the FX market is one of the largest and the most

44
liquid financial markets in the world, and includes trading between large banks, central
banks, currency speculators, corporations, governments, and other institutions. The
average daily volume in the global foreign exchange and related markets is
continuously growing.
3.3.2.2 Characteristics of the foreign exchange market
- High trading volume and huge turnover. According to statistics, in 2006, average
daily global turnover in foreign market transactions was at $2.7 trillion and reached
$2.9 trillion in case of including its satellites (futures, options and swaps). This was
about 10 times the daily turnover of all international trades in stock. With an estimated
average daily trading turnover of about $4.5 trillion, the foreign exchange market is by
far the world’s largest market (Bank for International Settlements 2012).

Table 3.1: Foreign exchange market average daily turnover

Global foreign exchange market

UK US Japan Others
turnover ($bn)

April 2010 3,981 36.7 17.9 6.2 39.2

April 2011 4,752 38.2 17.0 5.4 39.4

Oct 2011 4,758 37.1 19.4 5.6 37.9

April 2012 4,541 38.1 17.9 5.4 38.9

Sources: The City UK estimates based on BIS, FXJSC, FXC, SFEMC, CFEC, TFEMC, AFXC data.

- Geographical dispersion. The foreign exchange market is not a visible place

but a global network that is set up anywhere the currency exchange takes place. They
are scattered locations throughout the world, especially, major financial centers such
as London (34.1 percent of transactions), New York (16.6 percent of transactions),
Tokyo (6 percent of transactions), and Singapore (5 percent of transactions). Major
secondary trading centers include Zurich, Frankfurt, Paris, Hong Kong, and Sydney…
- Currencies are traded in pair. In the Forex market, every currency can be
exchanged directly for each other. Thus, currencies are in a pair of money and goods.
However, in fact, strong currencies are often traded much more.

45
 Table 3.2: Ten most traded currencies in the foreign exchange market

ISO 4217 code % daily share

Rank Currency
(symbol) (April 2007)

1  United States dollar USD ($) 86.3%

2  Euro EUR (€) 37.0%

3  Japanese yen JPY (¥) 17.0%

4  British pound sterling GBP (£) 15.0%

5  Swiss franc CHF (Fr) 6.8%

6  Australian dollar AUD ($) 6.7%

7  Canadian dollar CAD ($) 4.2%

8  Swedish krona SEK (kr) 2.8%

9  Hong Kong dollar HKD ($) 2.8%

10  Norwegian krone NOK (kr) 2.2%

Others 19.2%
Source: Bank for International Settlements (BIS)
- Long trading hours. In fact, the market operates 24 hours a day or people
often say that it never sleeps. Due to the geographical dispersion of foreign exchange
trading centers, the foreign exchange market operates uninterruptedly day after day.
Tokyo, London, and New York are all shut for only 3 hours out of every 24. During
these three hours, trading continues in a number of minor centers.  
- The economic, political and social factors have an effect on the foreign
exchange market.
- The participants join in the foreign exchange market by all means of modern
communications. This effectively creates a single market and there can be no
significant difference in exchange rates quoted in different trading centers, which
means there can hardly be opportunities for arbitrage (buying a currency low and
selling it high at nearly the same time).

46
3.3.2.3. Market participants
Any organizations or individuals can participate in the foreign exchange
market. However, major participants in this market are commercial banks, central
banks, retail clients and foreign exchange brokers.
+ Commercial banks. Commercial banks play a central role in the foreign
exchange market. They create the majority of commercial turnover and large amounts
of speculative trading every day. For this reason, commercial bank is said to be the
“market maker.” A large commercial bank may trade billions of dollars daily. Some of
these transactions are undertaken on behalf of customers, but much is conducted by
proprietary desks, trading for the bank's own account.
+ Central banks. Central banks are also major participants in the foreign
exchange market. Central banks intervene in the market from time to time to smooth
exchange rate fluctuations or to maintain target exchange rates. They can use their
foreign exchange reserves to stabilize the market through buying when the exchange
rate is too low, and selling when the rate is too high. However, Central bank
intervention is often indistinguishable from foreign exchange dealings of commercial
banks or other private participants.
+ Retail clients. They are made up of businesses, international investors,
multinational corporations, tourists and individuals who need foreign exchange for
purposes of operating their businesses. Normally, they do not directly purchase or sell
foreign currencies themselves but rather they operate by placing buying/selling orders
with commercial banks.
+ Foreign exchange brokers. Banks often do not exchange currencies directly
with others, but rather they offer to buy or sell currencies via foreign exchange brokers
who specialize in matching net supplier and demander clients, or in other words, bring
buyers and sellers of foreign exchanges together. Operating through such brokers is
advantageous since they collect buying and selling quotations for most currencies from
many banks, the most favorable quotation is obtained quickly and at very low cost.
These brokers receive a small commission on all trades. Each financial centre
normally has just a handful of authorized brokers through which commercial banks
conduct their exchanges. Some brokers tend to specialize in certain currencies, but
they all handle major currencies such as the U.S dollar, euro, pound sterling, Canadian
dollar, Japanese yen, and Swiss franc.

47
3.3.2.4 Transactions of the foreign exchange market
3.3.2.4.1 Spot transaction
a. Definition
Spot transaction is the most basic and popular operation in the foreign exchange
market that allows traders to exchange a specific amount of currency for another at the
prevailing market exchange rate and the transfer takes place immediately or within
two business days since the contract is due.
b. The content of Spot transaction
- The Spot exchange rate. The exchange rates governing such “on the spot”
trades are referred to as spot exchange rates. The spot exchange rate is available at the
dealing moment and is the quotation between two currencies for immediate delivery.
In spot transactions, banks do not normally charge a fee or commission to clients but
rather profit from the spread between bid rates and ask rates. This spread is the
transaction cost for clients.              
Ask rate – bid rate
Transaction cost (%) = ---------------------------------- x 100%
                    Bid rate
The spread between bid and ask rates for a currency is based on the breadth
and depth of the market for that currency as well as on the currency’s volatility. The
spread for widely traded currencies (from 0.1 to 0.5 percent) is often smaller than for
the less heavily traded ones.
- Value date. In spot transactions, buyers and sellers need to determine the point
of time for settlement which is called the “value date.” The value date of spot
transactions is the date on which the money must be paid by parties involved. In fact,
there is normally a two- business day lag between a spot purchase or sale and the value
date is called T + 2. The value date also can be set at the same day (T + 0) with the
contract date or the next business day (T + 1) from the contract date.
- Steps on dealing. Commonly, a spot transaction includes two steps.
Step 1: Making a purchase or a sale and confirming the dealing.
Step 2: Settlement between parties involved
3.3.2.4.2. Forward transaction
a. Definition and characteristics
48
 A foreign exchange forward transaction is the transaction in which parties
agree to exchange a given amount of currencies on the pre-determined date in the
future at an exchange rate fixed on the contract date and quoted in the contract.
Once the importer engages in the forward transaction, he has to comply with all
of the commitments agreed in the forward contract and has no right to break them. The
same requirement is also reserved for his partner. Because counterpart risks may occur
in a forward transaction, the forward contract buyer (the one who buys a right to buy
or sell an amount of currency forward) is often required by the forward contract seller
to deposit an amount of money in proportion to the contract value.
Characteristics of a forward transaction
- Exchange is considered via the forward contract and available in major
currencies, trading turnovers and maturities.
- When parties sign the contract, they must make a deposit with the exchange.
- The forward contract is actually compelling.
- The forward agreements are non - standardized and there is not an active
secondary market in forward contracts
b. Contents of a forward transaction
- Commodity currency. That is the total amount of money given in the contract.
The more the total amount of money is, the huger the turnover of forward contract is.
- Maturity. That is the number of dates on which the contract is available. There
are active forward transactions in major currencies, most commonly for 1 month (30
days), 2 months (60 days), 3 months (90 days), 6 months (180 days), 9 months (270
days)...
- Forward exchange rate
+ Definition.
An exchange rate at which such a forward transaction can be made is known as
the forward exchange rate. The forward exchange rate is the price of currency for
delivery at some time in the future.
+ Forward exchange rate quotations
There are 2 ways to express forward exchange rates: Outright forward exchange
rate quotation and Swap forward exchange quotation. The first one is usually quoted
for commercial customers. However, dealers only quote the forward rate as a discount

49
from, or a premium on, the spot rate in the interbank market. This forward difference
is known as the swap point.
+ Calculating forward exchange rate.
Method 1: Formula for calculating forward exchange rate based on Swap point
as follows:
Forward rate (F) = Spot rate (S) +/- Swap point (W)
If the bid swap point is lower than the ask swap point, add swap point to spot
rate to get forward rate.
If the bid swap point is higher than the ask swap point, subtract swap point
from spot rate to get forward rate.
Method 2: The forward foreign exchange rate (F) can also be calculated basing
on the theory of interest rate parity by the following general formula:

( 1+r T t )
F=S ×
( 1+r C t )
Where:
F = Forward foreign exchange rate
S = Spot foreign exchange rate
rT = Annual interest rate of term currency
rC= Annual interest rate of base commodity currency
t = Maturity of the forward contract, calculated by the number of days on
maturity (n) divided by 360 (n/360).
The forward bid rate and the forward ask rate in details:

( 1+r TD t )
F B=S B ×
( 1+r CL t )

( 1+ r TL t )
F O=SO ×
( 1+r CD t )

Where:
FB = Forward bid rate
SB = Spot bid rate
50
 rTD= Annual deposit interest rate of term currency.
rCL= Annual loan interest rate of commodity currency.
t = Maturity of the forward contract, calculated by the number of days on
maturity (n) divided by 360 (n/360).
FO = Forward ask rate
SO = Spot ask rate.
rTL = Annual loan interest rate of term currency.
rCD= Annual deposit interest rate of commodity currency.
3.3.2.4.3. Foreign exchange swap
a. Definition and characteristics
There are basically two types of swaps: (i) interest rate swap and (ii) currency
swap. In an interest rate swap, the exchange involves payments denominated in the
same currency, while in a currency swap, the exchange involves two different
currencies. Hence, it is an international financial transaction which needs to be
considered carefully.
Definition: A foreign exchange swap is the simultaneous purchase and sale of a
given amount of foreign exchange for two different value dates.
The most common kind of forex swap is spot against forward. It is a transaction
of foreign exchange in which the customer, at the time selling Currency A in exchange
for Currency B, buys the forward Currency A and pays in Currency B in converse
directions. Thus, a forex swap normally includes two transactions at the same time: a
foreign exchange spot transaction and a foreign exchange forward transaction. In other
words, there are often two kinds of contracts signed in a forex swap transaction: spot
contract and forward contract. Another kind of forex swap is forward against forward,
where both transactions are for two different forward dates.
Characteristics
+ The foreign exchange swap contracts are traded in the over – the – counter
market.
+ Forex swaps are transacted between companies taking part in international
business and their banks, and among banks when they desire to convert one currency
into another for a limited period without incurring foreign exchange risk. And the
bank plays an activerole as an intermediary.

51
b. Contents of the foreign exchange swap transaction.
A combination of spot and forward transactions results in the purchase of one
currency for a spot rate and the sale of the same currency for a forward rate or vice
versa. Thus, in a spot against forward forex swap, there are two exchange rates agreed:
the spot exchange rate applied in the spot transaction and the forward exchange rate
applied in the forward transaction. The forward rate calculation is based on the spot
rate and interest rates in the interbank market. The difference between spot and
forward rates is called forward point or swap point (W) and is expressed as the
following:
1+r T t
W =S × ( 1+r C t
−1 )
Where:
W = Swap point
S = Spot exchange rate
rT = Annual interest rate of term currency
rC= Annual interest rate of commodity currency
t = Maturity of the forward contract, calculated by the number of days on
maturity (n) divided by 360 (n/360).
3.3.2.4.4. Options
a. Definition and characteristics
Definition: A foreign exchange option (FX option or currency option) is a
derivative financial instrument that gives the purchaser the right, but not the obligation
to buy or sell a specific quantity of one foreign currency at a predetermined exchange
rate on or before a specified date in the future.
FX options are considered as valuable tools in managing foreign exchange risks
because they bring a much wider range of hedging alternatives and are one of the best
ways for corporations or individuals to hedge against adverse movements in exchange
rates. They are used extensively and make up between 4 - 6 % of the foreign exchange
market’s total turnover.
Characteristics. In a foreign exchange option contract, the currency in which
the option is granted is known as the underlying currency. The currency to be
52
exchanged for the underlying currency is known as the counter currency. An option
contract involves two parties, the writer or the seller who sells the option and the
holder who purchases the option. The holder of an option contract has the right but not
obligation to either buy or sell the underlying currency at a pre-determined exchange
rate in the future. The seller or writer of the option contract has the obligation to be the
counter party in the trade, if decided by the holder of the option. In order to have the
right of exercising or giving up the contract, the contract buyer has to pay the seller a
“premium” or “option price.” Option premiums are what the option contract seller
gets for accepting to bear risks transferred from the buyer. Option premiums are
quoted on option exchanges or markets. The option contract that gives the holder the
right to purchase the underlying currency at a pre-determined price from the other
party of the contact is known as a call option. The option contract that gives the owner
the right to sell the underlying currency at a pre-determined exchange rate to the other
party of the contract is known as a put option.
b. Types of Options
There are two popular methods to classify Options: (i) based on the maturity
date and (ii) the simplicity of complexity of the option contract’s items. But the first
one is used more common. Following that way, Option includes two types. They are
known as American option or European option. An option contract that can be
exercised at any time up until its maturity date is called an American option while an
option that can only be exercised on the expiration date is known as a European
option.
Usual prescribed conditions included in option contracts are:
+ Contract size: The quantity of the currency to buy or sell.
+ The expiration date (maturity date): The last date the option can be exercised.
+ The strike price (exercise price): The exchange rate between two related
currencies at which transaction will occur upon exercise.
+Types of Option: American option or European option.
+ Option premium or price
+ The settlement terms: time, place of settlement, delivery method (whether
two parties must deliver the actual asset on exercise, or may simply tender the
equivalent cash amount).

53
c. Exchange rate and option premium
The price at which the underlying currency can be bought or sold is called the
strike price or exercise price or the exchange rate between two related currencies at
which transaction will occur upon exercise. In reality, strike prices almost are likely
the forward exchange rate (F). If the option contract is such a call option, the forward
exchange ask rate (FO) is used for the strike price. If the option contract is a put option,
the exercise price is the forward exchange bid rate (FB).
The price paid by the holder to the writer for an option is known as the option
premium. An option offers the purchaser limited downside loss as given by the option
premium paid, combined with unlimited upside potential profit. The option premium
is extremely sensitive with lots of factors. There are some crucial factors that influence
the price to be paid for the option.
+ The spot exchange rate: The higher the spot exchange rate is, consequently
the higher the price of a option is.
+ The strike price: The higher the strike price is, the lower the price of a option
is.
+ The time left to expiry: The longer the time left to expiry is, the higher the
option premium is.
+ Interest rate of the underlying currency: In case of other things being equal,
the higher the interest rate of the underlying currency is, the lower the call option
premium is and the higher the put option premium is.
+ Interest rate of the counter currency: In case of other things being equal, as
the interest rate of the counter currency increases, the premium for a call option on the
underlying currency needs to increase and the one for a put option on the underlying
currency needs to decrease.
Foregoing the exchange rate applied when the option contract being exercised
is the strike price (FO or FB). The option holder must pay the premium in turn to
acquire the right to buy or sell the underlying currency in the future than spot. Thus,
we must add or subtract the option premium (f) to or from the exercise price to get the
real one. They are called the real exchange ask rate (F OR) or the real exchange bid rate
(FBR) and f is abbreviated for option premium of buying or selling the underlying
currency.

54
d. Loss/ Profit on Options
Loss / Profit on call options.
The strike price = The forward exchange ask rate (F O).
The real strike price (FOR) = The strike price + Option premium (FO + f).
The expiry spot exchange rate = SOF
States can be happened:
State 1: SOF < FO: The option contract will not be certainly exercised and the
option is said to be out of money. Loss from buying or selling one underlying currency
is the option premium for one:
Loss = f
State 2: FO < SOF< FOR: The contract is exercised and the option is still said to
be out of money. Loss from buying or selling one underlying currency is equal to the
difference between the expiry spot exchange rate and the real exchange ask rate
Loss = SOF - FOR
State 3: SOF = FOR: The contract is exercised and the option is said to be at the
money.
State 4: SOF > FOR: The contract is exercised and the option is said to be in the
money. Profit obtained from buying or selling one underlying currency is calculated
by subtracting the real exchange ask rate from the expiry spot exchange rate.
Profit = SOF - FOR

Graph 3.1: Loss/profit on the call option holder

Loss/profit for
1 underlying currency

In the money

FO FOR
0 SOF

At
55the money
 f
Out of the money

Loss/Profit on put options

The strike price = The forward exchange bid rate (FB).
The real strike price (FBR) = The strike price - Option premium (FB - f).
The expiry spot exchange rate = SBF
States can be happened:
State 1: SBF< FBR: The option contract is certainly exercised and the option is
said to be in the money. The profit from buying or selling one underlying currency is
the difference between the real strike price and the expiry spot exchange rate.
Profit = FBR - SBF
State 2: SBF = FBR: The contract is exercised and the option is said to be at the
money.
State 3: FBR < SBR < FB: The contract is exercised and the option is said to be out
of money. The loss from buying or selling one underlying currency is equal to the
difference between the real exchange bid rate and the expiry spot exchange rate.
Loss = FBR – SBF
State 4: SBF > FB: The contract is exercised and the option is said to be out of
the money. The loss from buying or selling one underlying currency is option
premium.
Loss = f

Graph 3.2: Loss/profit on the put option holder

Loss/profit for
1 underlying currency

In the money

FBR FB
0
SBF
56
 At the money Out of the money
-f

3.3.2.4.5. Futures transaction

a. Definition
A futures transaction is an agreement between two counterparties to buy or sell
a specified amount of a given currency at a predetermined price (futures price) on
a set date in the future. Futures contracts are traded on organized exchanges.
Futures transaction is a derivative instrument used for managing risks.
Basically, it is standardized as a forward transaction on types of currency, contract size
and maturity…
Futures transactions are traded on the exchange. Once the clearing house
confirms the deal, a futures contract is in existence and the contract is guaranteed. This
means that if one of the parties fails to fulfill its obligations, the exchange will assume
the defaulting party’s obligations. Effectively, the exchange will remove counterpart
risks.
Futures transactions take place for two major purposes: they can be used to
remove the exchange-rate risk inherent in cross-border transactions by companies or
sole proprietors or they can be used to speculate and profit from currency exchange-
rate fluctuations by speculators.
b. Content of futures transaction
- Types of currencies which the futures contract quotes. On foreign exchange
markets, futures transactions are only applied for currencies of USD, GBP, EUR,
CAD, CHF, JPY, and AUD.
-The contract size. The contract size is standardized for each kind of currencies:
62.500 GBP; 100,000 CAD; 125,000 CHF; 12,500,000 JPY.  
- The maturity date. The maturity date is the pre-determined date in the future.
The exact dates of acceptable delivery vary considerably and will be specified by the
exchange in contract specifications. Nevertheless, the last trading day is always on the
3rd Wednesday of the delivery month. Similar to the case of a forward contract, the
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futures contract buyers and sellers are obligated to obey all of the agreements made in
futures contracts and have no right to break them. In other words, both parties of a
futures contract must fulfill the contract on the settlement date. To exit the
commitment prior to the settlement date, the holder of a futures contract has to offset
his position by either selling a long position (if he is holding the “buying foreign
exchange” futures contract) or buying back a short position (if he is holding the
“selling foreign exchange” futures contract), which effectively closes out the futures
position and its contract obligations.
-Margin account. Each party of a futures contract makes an initial deposit with
the exchange known as the “initial margin” account at the clearing house. This is
usually from 2 to 10% of the value of the contract and constantly maintained upon the
minimum amount of money (75% of the initial margin account for example).
Once the contract involves a party making a profit position which credits to its
margin account, it can be withdrawn if greater than the initial margin. On the contrary,
if the other party has a loss which is subtracted from its margin account, this party
must settle a margin payment in case of margin account is below the minimum
amount. The deposit is required on a daily basis from the losing party to reflect the
potential loss associated with the contract. The “marking to market” is carried out at
the end of each day on the basis of the settlements price (usually the closing price). In
the rare event that a trader fails to settle a margin payment, the exchange has the right
to close the trader’s position. For a futures, the profit or loss is realized daily and
shown in the margin account on a daily basis. This hence limits the exposure of the
exchange, while for a forward contract, the gain or loss remains unrealized until the
expiry date.

3.4. THE INTERNATIONAL CAPITAL MARKET

3.4.1. Overview of the international capital market
The international capital market is a subsector of the international
financial market which allows participants from different countries to exchange
medium and long-term funds.
3.4.1.1. Classification of international capital market:
Considering object traded on the market, international capital market
consists of the international medium and long-term credit market and the
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international securities market. The international medium and long-term credit
market is the market for international lending and borrowing medium and long-
term funds. The international securities market is the market where bonds and
equity are issued and traded, it has two sub-segments: international bonds
market and international equity market.
Base on the exchange of funds, international capital market composed of
primary market and secondary market. Primary market is the market for the sale
of new securities to initial investors. A new issue of shares increases both the
amount of cash held by the company and the number of shares held by the public.
Secondary market is the market in which previously issued securities are traded
among investors. Secondary transaction is simply a transfer of existing securities’
ownership from investor who decides to raise some cash to investor who wishes
to invest his spare money.
3.4.1.2. Participants of international capital market:
Investment banks are main player on the international capital market.
Investment banks help issuers to sell securities to investors. They advice their
customers on price can be charged for the securities issued, market conditions,
appropriate interest rates, and so forth. Ultimately, investment banks handle the
marketing of security issue to the public.
Brokerage firms are financial intermediaries that help investment
management companies and private individuals to invest in securities, they are
licensed to buy and sell securities for their clients and for their own accounts
through stock exchange or over the counter, in return for a fee or a commission.
Commercial banks are financial institutions that collect deposits and relend
the cash to corporations and individuals. Internationally, they facilitate the
import and export of their clients by arranging for foreign exchange rate
necessary to conduct cross-border transactions and make foreign investments.
Commercial banks also trade foreign exchanged products for their own account.
Investors participate in the international capital market as main customers.
They can be individuals or institutions who invest their money or buy and sell
securities for capital premium.
Centre banks of different countries play an important role in the
international capital market with their activities in open market operations.
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Through buying and selling long-term financial instruments, centre banks have
impact on both supply and demand sides.
3.4.1.3. Market transactions
In the primary market, a borrower desiring to raise funds to the investing
public will contact an investment banker and ask it to serve as lead manager of
an underwriting syndicate that will bring securities to market. The underlying
syndicate is a group of investment banks and commercial banks that specialized
in some phase of a public issuance. The lead manager will usually invite other
banks to form a managing group to help negotiate terms, ascertain market
conditions, and manage the issuance. The managing group, along with other
banks, will serve as underwriters for the issue, that is, they will commit their
own capital to buy the issue at a discount from the issue price. Most of the
underwriters, along with other banks, will be part of a selling group that sells the
securities to the investing public. The various members of the underwriting
syndicate receive a portion of the spread (usually in the range of 2 to 2.5 percent
of the issue size), depending upon the number and type of functions they
perform. The lead manager receives the full spread, and a bank serving as only a
member of the selling group receives a smaller portion.
In the secondary market, transactions are conducted by market makers
and brokers who connected by an array of telecommunications equipment.
Market makers stand ready to buy or sell for their own account by quoting two-
way bid and ask prices. Market makers trade directly with one another, through a
broker, or with retail customers. The bid-ask spread represents their only profit,
no other commission is charged. Brokers accept buy or sell orders from market
makers and then attempt to find a matching party for the other side of the trade;
they also trade for their own account. Brokers charge a small commission for
their services. They do not deal directly with retail clients.
3.4.2. The International bond market
3.4.2.1. Market segments

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 The international bond market encompasses two basic market segments:
foreign bond and Eurobond. The market for foreign bonds and Eurobonds
operate in parallel with the domestic national bond markets, and all of three
markets compete with one another.
3.4.2.1.1. Foreign bonds market
Foreign bonds market is the market for issuing, selling and buying foreign
bonds. A foreign bond issue is one offer by a foreign borrower to the investors in
a national capital market and denominated in that nation’s currency. An example
is a German MNC issuing dollar-denominated bonds to US investor. Foreign
bonds frequently have colorful names that designate the country in which they
are issued. For example, Yankee bonds are dollar-denominated foreign bonds
sold to US investors, Samurai bonds are yen-denominated foreign bonds sold in
Japan, and Bulldogs are pound sterling-denominated foreign bonds sold in the
UK.
Foreign bonds are usually registered bonds which the owner’s name is
assigned to a bond serial number recorded by the issuer. When a registered bond
is sold, a new bond certificate is issued with the new owner’s name, or the new
owner’s name is assigned to the bond serial number.
Foreign bonds must meet the securities regulations of the country in which
they are issued. This mean that publicly traded Yankee bonds must meet the
same regulations as US domestic bonds which relevant information relating to
security issue and issuer must be provided and made available to prospective
investors. The expense of registration process, the time delay it creates in
bringing a new issue to market and the disclosure of information that many
foreign borrowers historically consider private have made it more desirable for
foreign borrowers to raise money in Eurobonds market.
3.4.2.1.2. Eurobonds market
The first Eurobonds were traded in 1963 and were originally issued by
Autostrade, an Italian motorway construction company, in conjunction with SG
Warburg and Co; Autostrade issued $15 million in Eurobonds through the
London banking institution. After a slow start, the Eurobond market has grown to
become a major force in the international securities markets.

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 Eurobonds market is the market for issuing, selling and buying Eurobonds.
A Eurobond issue is one denominated in a particular currency but sold to
investors in national capital markets other than country that issued the
denominating currency. An example is a Dutch borrower issuing dollar-
denominated bonds to investors in the UK or Japan. Eurobonds are known by the
currency in which they are denominated, for example, US dollar Eurobonds, yen
Eurobonds and Swiss franc Eurobonds, or, correspondingly, Eurodollar bonds,
Euroyen bonds and EuroSF bonds.
Eurobonds are usually bearer bonds. With a bearer bond, possession is
evidence of ownership. The issuer does not keep any record indicating who is the
current owner of a bond which make bearer bonds to be very attractive to
investors desiring privacy and anonymity. Consequently, investors will generally
accept a lower yield on bearer bonds than on registered bonds of comparable
terms making them a less costly source of funds for the issuer.
Eurobonds do not have to meet national security regulations require
shorter time in bringing a Eurodollar bond issue to market, together with the
lower interest rate that borrowers pay for Eurobond financing in comparison to
foreign bond financing, are two main reasons why the Eurobond segment of the
international bond market is always larger than the foreign bond market.
A special type of Eurobonds is Global bond which is a very large
international bond offering by a single borrower that is simultaneously sold in
North America, Europe and Asia. Global bond denominated in one country’s
currency and issue by that country’s borrower trade as Eurobonds oversea and
domestic bond in the country’s market. Global offering enlarge the borrower’s
opportunities for financing at reduced costs.
3.4.1.2. Market instruments
Straight fixed-rate bond issues have a designated maturity date at which
the principal of the bond issue is promised to be repaid. During the life of the
bond, fixed coupon payment, which are a percentage of the face value, are paid as
interest to the bond holders. In contrast to many domestic bonds, which make
semiannual coupon payments, coupon interest on international bonds is typically
paid annually. The reason is that annual coupon redemption is more convenient

62
for bondholders and less costly for issuer because the bondholders are scattered
geographically.
Floating-rate notes (FRNs) are typically medium-term bonds with coupon
payments indexed to some reference rate. Common reference rates are either
three-month or six-month LIBOR – London Interbank Offered Rate. Coupon
payments on FRNs are usually quarterly or semiannual and in accordance with
the reference rate. For example, considering a five-year FRN with coupon
referred to six-month dollar LIBOR paying interest semiannually. At the
beginning of every six month period, the next semiannual payment is reset to be:
0,5 x (LIBOR + X%) of the face value where X% is the default risk premium above
LIBOR the issuer must pay based on its creditworthiness. If X% = 0.00125 and
current LIBOR is 6.6%, face value = 1,000$ so the next period’s payment will be
0.5x(0.66 + 0.00125) x 1,000 = $33.625.
Equity-related bonds with two main types: convertible bonds and bonds
with equity warrants. A convertible bond issue allows the investor to exchange
the bond for a predetermined number of equity shares of the issuer. Investors are
usually willing to accept a lower coupon rate of interest than the comparable
straight fixed coupon rate because they find the conversion feature attractive.
Bonds with equity warrants can be viewed as straight fixed-rate bonds with the
addition of a call option or warrant feature. The warrants entitle the bondholder
to purchase a certain number of equity shares in the issuer at a prestated price
over a predetermined period of time.
Zero-coupon bonds are sold at discount from face value and do not pay any
coupon interest over their life. At maturity, the investor receives the full face
value. Alternatively, some zero-coupon bonds originally sell for face value and at
maturity the investor receives an amount in excess of the face value to
compensate the investor for the use of money. Generally, zero-coupon bonds are
attractive to investor who desires to avoid the reinvestment risk of coupon
receipts at a possibly lower interest rate.
Dual-currency bonds are straight fixed-rate bonds issue in one currency,
pay coupon interest in the same currency and repaid the principal at maturity in
another currency. Coupon interest is frequently at a higher rate than comparable
straight fixed-rate bonds. The amount of the dollar principal repayment at
63
maturity is set at the inception, frequently, the amount allow for some
appreciation in the exchange rate of the stronger currency. From the investor’s
perspective, a dual-currency bond includes a long-term forward contract to
reduce exchange rate risk.
Multicurrency bonds are denominated in a currency basket, such as SDRs or
ECUs, instead of a single currency. They are frequently called currency cocktail
bonds. They are typically straight fixed-rate bonds. The multicurrency bond is a
portfolio of currencies: when some currencies are depreciating others may be
appreciating, thus yielding lower variability overall.
3.4.3. The international equity market
3.4.3.1. Market structure
Base on the exchange of funds, the international equity market insists of
the international primary equity market which allows for the sale of new common
stock by corporation to initial investors and the international secondary equity
market where previously issued common stock is resold between investors.
The secondary markets of the world serve two major purposes. They
provide marketability and share valuation. Investors or traders who buy shares
from the issuing firm in the primary market may not want to hold them
indefinitely. The secondary market allows share owners to reduce their holdings
of unwanted shares and purchasers to acquire the stock. Firms would have a
difficult time attracting buyers in the primary market without the marketability
provided through the secondary market. Additionally, competitive trading
between buyers and sellers in the secondary market establishes fair market price
for existing issues.
There are many different designs for secondary markets that allow for
efficient trading of shares between buyers and sellers and it is generally
structured as dealer or an agency market. In a dealer market, the broker takes the
trade through the dealer, who participates in trades as a principal by buying and
selling the security for his own account. Public traders do not trade directly with
one another in a dealer market. In an agency market, the broker takes the client’s
order through the agent, who matches it with another public order. The agent can
be viewed as a broker’s broker. Other names for the agent are official broker and
central broker.
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 Considering the operational characteristic, the international equity
market comprises of centralized market and non- centralized market. Centralized
market is a market that transactions are conducted at a defined stocks exchange
for example the New York Stock Exchange, London Stock Exchange, Tokyo Stock
Exchange… The exchange markets are agency market. Non-centralized market
which is often called over-the-counter (OTC) market is a computer-linked system
that show that bid (buy) and ask (sell) prices of all dealers in a security. OTC
market is a dealer market.
3.4.3.2. Market characteristics
The international equity market has high level of liquidity which allows
investors to be able to buy and sell stocks quickly at close to the current quoted
price. A measure of liquidity for a stock market is the turnover ratio, that is, the
ratio of stock market transactions over a period of time divided by the size, or
market capitalization, of the stock market. Generally, the higher the turnover
ratio, the more liquid the secondary stock market, indicating ease in trading.
The international equity market has higher number of stocks because
investment in foreign equity markets became common practice once investors
realize the benefits of international portfolio diversification. It is clear even from
casual observation that security prices in different countries do not closely move
together. This suggests that investors may be able to achieve a given return on
their investments at a reduced risk when they diversify their investment
internationally rather than domestically because security returns are much less
correlated across countries than within a country. Together with the borrowers’
need of sourcing new capital internationally, the high level of demand leads to
high level of supply side in the international equity market.
The internationalization trend of stock exchanges in different country
which reflects the globalization of financial market can be considered to be an
effective way to attract international financial resources. The impetus for
globalized financial markets initially came from government of major countries
began to deregulate foreign exchange and their capital market. In addition, recent
advances in telecommunication and computer technologies have contributed to
the globalization of investment by facilitating cross-border transactions and
rapid dissemination of information across national borders.
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 As in a given national equity market, the international capital market
performance is measured by an index of the stock traded on the secondary
exchange (or exchanges). There are some global financial institutions that
introduced indexes which present return and price level data for a number of
national stock market indexes. Investing in such indexes is a convenient ways for
investors to hold diversified investment in several different countries. Examples
are Standard & Poor’s indexes, Morgan Stanly Capital International’s indexes,
Dow Jones Company’s indexes…
3.4.3.3. International equities
Cross-listing shares are shares that listed on one or more foreign
exchanges, in addition to the home country stock exchange. With the increased
globalization of world equity markets, the amount of cross-listing has exploded in
recent years and has been used by both MNCs and non-MNCs. Several exchanges
have a large proportion of foreign listings. Cross-listing of a firm’s stocks
obligates the firm to follow the securities regulations of its home country as well
as the regulations of the countries in which it is cross-listed. A firm may
decide to cross-listing for the following reasons:
1. Cross-listing provides means for expanding the investor base for a
firm’s stock, thus potentially increasing its demand and the market
price as well as the share’s liquidity
2. Cross-listing establishes name recognition of the company in a new
capital market, thus paving the way for the firm to source new equity or
debt capital from local investor
3. Cross-listing brings the firms’ name to more investors and consumer
groups that might be their potential consumers of companies’ products
and investors in the companies’ stocks vice verse.
4. Cross-listing into developed equity markets with strict securities
regulations and information disclosure requirements may be seen as a
signal to investors that improved corporate governance is forthcoming.
Yankee stock offerings are the direct sale of new foreign equity capital to
US public investors allowing them to buy and sell a large amount of foreign
stocks. This was a break from the past as before 1990 the sales were only sold to
institutional investors.
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 American Depository Receipts (ADRs) are receipts representing a
number of foreign shares that remain on deposit with the US depository’s
custodian in the issuer’s home market. In reality, though foreign stocks can be
traded directly on a national stock market, most often they are traded in the form
of depository receipts. A special type of ADR is Global Depository Receipts (GDRs)
allows a foreign firm to simultaneously cross-list on several national exchanges.
The bank serves as a transfer agent for ADRs, which are traded on the
listed exchanges or in the OTC market. ADRs holders give instructions to the
depository bank as how to vote the rights associated with the underlying shares.
An ADR investment can be sold by trading the depository receipt to another
investor. In this case, the ADR is delivered for cancellation to the bank depository,
which delivers the underlying shares to the buyer.

Graph 3.3. ADR issuance and cancellation

Standard Issuance Standard Cancellation

ADR Investor ADR Investor

US
Buy ADR Market Sell ADR
US Broker US Broker

Issue Cancel

Depository
Confirmation Instruction

Local
Custodian

Deposit shares Release shares

Local Broker Local Broker Local Broker

Buy shares 67 Sell shares
 The investment advantages in ADRs over trading directly in the underlying
stocks are:
1. ADRs are denominated in dollars, trade on a US stock exchange, and
can be purchased through the investor’s regular broker. By contrast,
trading in the underlying shares would likely to require investor to set
up an account with a broker from the country of issuing company;
make a currency exchange; and arrange shipment of the stock
certificates or the establishment of a custodial account.
2. Dividends received on the underlying shares are collected and
converted to dollars by the custodian and paid to the ADR investor
whereas investment in the underlying assets requires the investor to
do those works themselves.
3. ADR trades clear in three business days as do US equities, whereas
settlement practices for the underlying stock vary in foreign countries.
4. Most ADRs are registered securities that provide for the protection of
ownership rights, whereas most underlying stocks are bearer
securities.
5. ADRs frequently represent a multiple of the underlying shares, rather
than a one-for-one correspondence, to allow the ADR to trade in a price
range customary for US investors.

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 Chapter 4

INTERNATIONAL PAYMENT

4.1. INTERNATIONAL PAYMENT: AN OVERVIEW

4.1.1. Definition and features
Definition:
International payment is a process executing obligations to payment and
entitlements to benefits of money which results in economic and non-economic
activities between organizations, individuals, governments…of different
nationalities or between a nation and an international organization through bank
systems of related partners, especially through commercial banks.
Features:
International payment is characterized by some main features:
International payment is an over the world activity and includes many
international elements. In terms of scope, international payment can be made
between two subjects in different countries or between international
organizations. In general, the beneficiary and payer are not in the same country.
In terms of subjects, international payment can be done between a resident and
non-resident of a country. In terms of currency, it is an international currency
used in international payment, or national payment, which can be accepted by
both parties.
International payment is a risky activity. International payment is a part of
international finance; therefore, international payment faces with risks of
international finance, such as politic risk, exchange rate risk… Otherwise,
technical infrastructure of international payment systems and legal systems also
create differences in payment process between parties.
International payment is an activity applied high technology. The
development of information brought a new face to international payment
services, such as the International Electronic Funds Transfer system – IEFTS or
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the Clearing House Interbank Payment Systems – CHIPS. The appearance of eUCP
1.0 and eUCP 1.1 applying for electronic documents is an example for the trend of
applying high information technology in payment process.
4.1.2. Classifications
There are some types of international payment. Certain methods of
payment are less risky than others. It is up to the buyer and seller to agree on a
method that suits them both.
In terms of purposes of goods and services transaction, there are trade
payment and non-trade payment. Trade payment is a payment involved in
international trade and commercial transactions. In this kind of transactions,
parties buying and selling goods and services are looking for benefits.
In terms of paying directly or indirectly, there are direct payment and
indirect payment. Direct payment is executed directly between buyers and
sellers. In indirect payment, the payment is transferred to the third party.
In terms of point at which goods and services ownership is transferred, there
are advance payment, cash on delivery and deferred payment.
Cash on delivery: It is a system where goods and services and all shipping
documents are sent directly to buyers who pay on delivery or after an agreed
period. The system does not offer any security to the seller/ exporter. The seller
can face risks of non-receipt of payment or goods may be left in a distant port due
to non-payment by the buyer/ importer. A high degree of mutual trust and
confidence must exist between two parties.
Advance payment or Cash in Advance is a pre-payment method in which, an
importer makes a payment for items to be imported in advance prior to the
shipment of goods. The importer must trust that the supplier will ship the
product on time and the goods will be as advertised. Cash-in-Advance method of
payment creates a lot of risk factors for importers. However, this method of
payment is inexpensive as it involves direct importer-exporter contact without a
commercial bank involvement. In international trade, Advance payment is usually
done when:
 The Importer has not been long established.
 The Importer's credit status is doubtful or unsatisfactory.

70
  The country or political risks are very high in the importer’s country.
 The product is in heavy demand and the seller does not have to
accommodate an Importer's financing request in order to sell the
merchandise.
A deferred payment is an arrangement in which total or an amount of
money purchasing goods and services does not have to be repaid until sometime
in the future. Payment for goods or services can then be deferred for a certain
amount of time, depending on the arrangement. In some cases, payment in full
must be made by a certain date, and in other cases, multiple smaller payments
can be made until the full amount has been paid. Depending on the specific
arrangement, interest might be added to the amount due starting immediately or
after a certain amount of time — or no interest might be added at all.
4.1.3. Methods
The issue of payment in international trade is important when one takes
into consideration different currencies and exchange rates. There is also the
matter of security and confidence that the merchant will receive the money.
There are several methods of payment in international trade, such as remittance,
collection, open account and a letter of credit. The exact method depends on the
type of trade, scope of trade, and preferences of the trading party. In this chapter,
we are mainly focusing on two methods: Collection and Letter of credit.
Collection is a method of payment in international trade whereby an
exporter collects or authorizes a bank to collect a payment on his or her behalf.
When the exporter’s bank receives the authorization from the exporter, it will
prepare and send documents for the transaction to the bank of the importer,
requesting for payment and stating how the payment should be made. A part of
documents sent to the importer’s bank includes a draft with the amount owed
printed on top. The importer would be asked to pay the amount on the draft to
the exporter through the importer’s bank.
A letter of credit is a secure form of payment in international trade that
involves the bank of the importer. The importer’s bank assumes the
responsibility for the payment of the goods and also offers protection to the
buyer who will not be obliged to pay for the goods until it has entered his or her
custody.
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4.1.4. Instruments
Methods of payment can be executive by many instruments. Some of them
are cheque, promissory note, bill of exchange…
A cheque (or check) is a document that orders a payment of money from a
bank account. The person writing the cheque, the drawer, usually has a current
account or checking account where their money was previously deposited. The
drawer writes various details including the monetary amount, date, and
a payee on the cheque, and signs it, ordering their bank, known as the drawee, to
pay that person or company the amount of money stated. The buyer could draw a
cheque payable at his own domestic bank, and forward it to the exporter. It may
take some weeks for such a cheque to be cleared through the banking system,
though it is sometimes possible for the exporter to obtain funds against the
cheque by having it purchased by his own bank.
 A promissory note is a negotiable instrument. It is an unconditional
promise in writing made by one person to another, signed by the maker or issuer,
engaging to pay a determinate sum of money to the payee, either at a fixed or
determinable future time, certain in money, to order or to bearer. Bank note is
frequently referred to as a promissory note, a promissory note made by a bank
and payable to bearer on demand. If the promissory note is unconditional and
readily salable, it is called a negotiable instrument.
A bill of exchange or "draft" is a written order by the drawer to
the drawee to pay money to the payee. Bills of exchange are used primarily in
international trade, and are written orders by one person to his bank to pay the
bearer a specific sum on a specific date. Because of the popularity of bill of
exchange, in this part, we are mainly discussing on bill of exchange as a primary
instrument in international payment.
4.1.4.1. Definition of a bill of exchange
“A bill of exchange is an unconditional order in writing, addressed by one
person to another signed by the person giving it, requiring the person to whom it
is addressed to pay, on demand or at a fixed or determinable future time, a sum
certain in money to or to the order of a specified person or to bearer” (Sec 3, the
Bill of exchange Act 1882, England)

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 To ease understanding, the definition is broken down into segments and
each segment is considered individually:
1. “An unconditional order”: The order to pay should not be subject
to the fulfillment of any condition(s). It should simply say “Pay”.
If a condition is set, it is not a bill of exchange, but a conditional
order.
“In writing”: It is not possible to have an oral bill of exchange.
Evidence must be available, in writing, of its existence. What the
bill is actually written on, or written with, is not impossible.
2. “Addressed by one person”
3. “To another person” (the drawee) : A bill of exchange is usually
written by the person selling goods or services (the drawer) and
addressed to the person who is required to pay (the drawee)
4. “Signed by the person giving it”: It is signed by the person who is
owned money (the drawer)
5. “Requiring the person to whom it is addressed to pay”: It is itself-
explanatory (the drawee)
6. “To pay on demand”: The bill would say “at sight” requiring
immediate payment should be made. Or “at fixed or determinable
future time” if the bill is not payable immediately then it may be
payable “at 90days sight” meaning that it is due 90 days from the
date it is seen by the person to whom it is addressed.
7. “A sum certain in money”: The exact amount of money should be
stated.
8. “To or to the order of a specified person (the payee) or to
bearer”: An order bill payable to a specific person can be easily
transferred to another by endorsement. A bearer bill is payable
to the holder of the bill at the date of maturity (payment)
Most bills of exchange are written in specially printed form available from
all good business stationers. Such bills often have “for value received” printed on
them to establish “value consideration”, usually essential if legal action is
proposed under contract law.

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4.1.4.2. Parties to a bill of exchange
There are three main parties to a bill of exchange:
- The Drawer is the person, who gives an order to pay the amount of the bill
of exchange
- The Drawee is the person on whom the bill is drawn, e.g. the person who is
required to pay the amount of the bill of exchange.
- The Payee is the person to whom the amount of the bill of exchange is
payable. The drawer and payee of a trade bill are often the same person.

In addition, there are also some other parties to a bill of exchange:

- The endorser: When a person (the payee) transfers the bill of exchange to
another person the payee writes his signature together with a statement
on the reserve of the bill and is known as the endorser.
- The endorsee: The name of the person to whom the bill of exchange is
transferred. The endorsee’s name is written in the endorsement.
- The acceptor: An acceptor is the person (the drawee), who gives consent to
comply with the order of the drawer to pay by signing across the face of
the bill of exchange.
- The holder: The payee or any person who for a valid reason or legally
comes into actual possession of a bill of exchange.
- The holder for value: A person who obtains actual possession of the bill of
exchange:
(i) When it is complete and regular on its face (e.g. properly
complete with all information required)
(ii) Before it is overdue, e.g. before its maturity date.
(iii) Without notice that it has been previously dishonored
(unpaid)
(iv) In good faith and without notice of defect in the title of the
person from whom obtained
(v) After giving “consideration” for it.
4.1.4.3. Types of bills of exchange
Sight bill of exchange:

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 A sight bill of exchange is one which is payable on sight, demand or
presentation to the drawee. Acceptance of a sight bill is not required because the
bill is payable on demand, i.e. immediately the drawee has seen it
Usance bill of exchange:
A usance bill of exchange is one which is payable sometime in the future,
i.e. after a number of days, months, or years e.g. “90 days at sight”. It needs to be
accepted by the drawee to make him liable to the bill. The drawee accepts the bill
by signing on the face of the bill i.e. the drawee agrees to make payment on
maturity. A usance bill of exchange is also known as a Term or Tenor bill.
Clean bill of exchange:
A clean bill of exchange is one that is not accompanied by shipping
documents. When goods are shipped, documents are sent directly to the importer
so that he can take delivery of the goods and the bill of exchange is handed over
by the seller to his bank for collecting the payment from the importer.
Documentary bill of exchange
A bill of exchange accompanied by shipping documents i.e. invoice, bill of
lading, insurance policy and other documents, is called a documentary bill of
exchange.
Accommodation bill of exchange
A bill to which a person, called an accommodation party, puts his name to
oblige or accommodate another person without receiving any considerations for
so doing. The position of such party is, in fact, that of surety or guarantor. Bill of
this type is called “kites” or “windmills” or “windbills”. “A” may accept a bill for
the accommodation of “B” the drawer, who is in need upon to pay the bill when
due. Banks discourage the use of accommodation bills by customers who may
request finance against such bills.
…….
Documentar => Documentary

Types of bills of exchange

Sight Usance
75
Documentar Documentar
Clean y Clean y
4.1.4.4. Clauses on bills of exchange
D/P (Document agaist payment)– The drawee /seller gives instruction to
the remitting bank to deliver documents relating to the goods against payment of
the bill. The remitting bank instructs the agent bank i.e. collecting bank to follow
the same instructions. These instructions are in the case of a sight bill of
exchange. The buyer makes payment and takes delivery of documents, which
need to be presented to the carrier to deliver goods.
A/S (accepted at sight) – This clause is used in the case of usance bill of
exchange. The seller sells goods on a credit basis. The drawer/seller gives
instructions to the remitting bank to deliver documents relating to the goods
after the bill has been sighted i.e. accepted. This means the buyer agrees with
terms and conditions of the sale contract and undertakes to pay on the maturity
date. The maturity date is calculated after the date of acceptance of the bill of
exchange. The remitting bank instructs the agent bank to follow the same
instructions.
A/D (accepted against document) – This is another clause also used in the
case of usance bill of exchange. The seller sells goods on a credit basis. The
drawer/seller gives instructions to the remitting bank to deliver documents
relating to goods after the bill has been sighted and the maturity date is
calculated, as instructed by the seller, i.e. after the date of the bill of exchange or
the bill of lading. This means the buyer agrees with terms and conditions of the
sale contract and undertakes to pay on the maturity date. The remitting bank
instructs the agent bank to follow the same instructions.
The use of D/P clause on usance documentary bills of exchange is not
allowed under the URC 522.
Acceptance
Acceptance of a bill of exchange

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 Meaning of acceptance: Acceptance is a promise to pay the creditor when
the drawee of a usance or time bill of exchange writes words “accepted” above
their name and signature across a bill.
A bill may be accepted:
(i) Before it has been signed by the drawer, or while otherwise it is
incomplete.
(ii) When it is overdue or after it has been dishonored by a previous refusal
to accept, or by a non-payment.
Importance and requisites of acceptance
(i) An acceptance of a bill is signification by the drawee of his assent to an
order of the drawer.
(ii) An acceptance is invalid unless it complies with following conditions,
namely:
(a) It must be written on the bill and signed by the drawee. The mere
signature of the drawee without additional words is sufficient.
(b)It must not express that the drawee will perform his promise by any
other means than the payment of money
(c) The acceptance must be completed by delivery of the bill or
notification that it has been accepted.
A holder with a “general acceptance” bill may present it to the acceptor,
but, if there is a place of payment mentioned on the bill it must be presented at
that place, otherwise the holder will lose recourse against all other parties to the
bill.
Liability of acceptor
The acceptor of a bill, by accepting it:
(i) Engages that he will pay it according to the tenor of his acceptance,
(ii) It precludes from denying to a holder in due course
(a) The existence of the drawer, the genuineness of his signature,
and his capacity and authority to draw the bill.
(b)In the case of a bill payable to the drawer’s order, the capacity of
the drawer to endorse, but not the genuineness or validity of his
endorsement.

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 (c) In the case of a bill payable to the order of a third person, the
existence of the payee and his capacity to endorse, but not the
genuineness or validity of his endorsement.
Presentation for acceptance
Presentation of a bill of exchange for acceptance is legally necessary:
(i) Where the bill is payable after sight. Presentment for acceptance is
necessary in order to fix the maturity of the instrument.
(ii) Where a bill expressly stipulates that, it must be presented for
acceptance, and
(iii) Where a bill is drawn payable elsewhere than at the residence or place
of business of the drawee. Except for these three cases, it is not
obligatory to present a bill for acceptance. The holder may await the
maturity of the bill and then present it for payment. As a rule, however,
it is presented for acceptance to secure the liability of the drawee. If the
drawee refuses to accept the bill, the holder then has an immediate
right of recourse against the drawer and endorsers, if appropriate
steps are taken.
Types of acceptance
There are two principal types of acceptance of a usance bill of exchange
- General acceptance: It is to confirm the drawee’s liability and agreement to
terms of the bill
- Qualified acceptance: where the drawee, upon accepting bill, varies or
alters its terms, i.e. by partial acceptance of the amount. The holder’s
agreement to any alternation may discharge the liability of any previous
parties to the bill
Types of qualified acceptance:
(i) Qualified as to a certain event: A conditional acceptance, which makes
payment dependent upon the fulfillment of a stated condition, i.e. on
arrival of a ship, or the goods themselves.
(ii) Qualified as to amount; a partial acceptance, an acceptance to pay a part
of the amount for which the bill is drawn, i.e. a bill drawn for $10,000
but the drawee accepts for lesser amount, i.e. $7,000 only.

78
 (iii) Qualified as to tenor; where the usance period on the bill is charged, e.g
extended from 90 to 180 days.
(iv) Qualified as to place of payment; an acceptance to pay at a particular
specified place but unless words “and not elsewhere” or “and there
only” or their equivalent are inserted, the acceptance is a general
acceptance.
Endorsement
Many bills are payable to a specific person “or order”. This means that title to
the bill can be transferred, or “negotiated” by the payee to another person. This is
achieved by endorsement and delivered to the person concerned.
By law, a bill is an order bill when:
- It is expressed to be payable to order, or
- It is payable to the order of a particular person, or
- It is payable to a particular person and does not contain words prohibiting
any transfers.
Endorsement is not required to transfer the title of a bearer bill, as it may be
negotiated by mere delivery to the other person.
Types of endorsement
There are four types of endorsement. Under the Cheques Act 1992, these
endorsements do not apply to cheques in the UK, but may apply to cheques in
other countries.
(i) Blank endorsement: This is where the payee simply signs his name on
the reverse of the bill without stating the name of any particular
endorsees. The cheque becomes payable to the bearer.
(ii) Special endorsement: The payee, on signing his name, specifies the
endorsee. The endorsee can either collect the proceeds of the bill or
sign his own name, i.e. blank endorse the bill, to make it payable to the
bearer. Similarly, a blank endorsement can be converted into a special
endorsement by any holders signing it and stating the name of the
person to whom it is to be payable.
(iii) Restrictive endorsement: A restrictive endorsement, as the name
implies, prevents further endorsement of the bill. The payee specifies

79
 the name of the endorsee and writes “only” at the end, e.g. “pay X bank
limited only”.
(iv) Conditional endorsement: The least important of the four, the payee
states a condition that has to be fulfilled before a negotiation e.g. “pay X
bank limited after the arrival of the goods”. In practice, banks will
ignore any conditional endorsements as they presume the condition
has been satisfactorily fulfilled.
Negotiability of Bill of exchange
An instrument, which is legally considered as “negotiable”, has following
characteristics:
- It is transferable by delivery, or by endorsement and delivery.
- The legal title passes to the person who takes it in good faith, for value, and
without notice of any defects in the title of the transfer.
- The legal holder can sue in his own name.
- Notice of transfer needs not to be given to the party liable on the
instrument.
- The title passes free of all equities or counterclaims between previous
parties of which the transferee has no notice.
When a negotiable instrument e.g. a bill is passed from one person to another,
all prior parties are liable to the final holder if the instrument is dishonored. The
last person in the chain is deemed to be a “holder in due course” if he can prove
that he has fulfilled requirements of Sec 29 of the Bill of exchange Act 1882; i.e:
- He has taken the bill in good faith
- The bill is complete and regular on the face or it
- For value
- Before it is overdue
- Without notice of any defects in the title of the transferor or any prior
dishonors of the bill.
It follows that before giving the value the new holder may look to see who has
previous endorsed the bill and assess his creditworthiness in case the bill should
be dishonored.
Discharge of bill of exchange

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 The bill of exchange Acts states that any liabilities on the bill is discharged:
- When the bill is paid by the acceptor on the due date
- Where the acceptor becomes the holder of the bill at or before maturity
- Where any material alternations have been made to the bill without the
agreement of all parties liable on the bill. If the bill is altered without the
consent, those liable parties prior to the alternation (but not after) will be
discharged.
- Where the holder gives up his right to receive payment, cancelling the bill
itself
- Where the bill becomes statute barred under the Limitation Acts e.g. the
holder usually has only six years to take legal actions in recovery from the
debt.
The majority of bills are properly accepted and subsequently paid on
maturity. However, bills may be dishonored by non-acceptance where the
drawee refuses to accept liability, or dishonored by non-payment when the
acceptor refuses to pay.
4.2. THE MECHANISM OF INTERNATIONAL PAYMENT
4.2.1. Collection mechanism
Business partners who have been cooperating for a long period of time and
enjoy each other’s confidence can benefit from a simplified option for their
settlements - documentary collection.  The transaction is initiated by the
exporter, who delivers the goods to the buyer’s country. At the same time, they
entrust related documents (which may include negotiable bills of lading) to their
bank, for collection of sale proceeds and the delivery of documents to the buyer
according to terms of the sales contract. Collections do not give the exporter the
security of advance payment or the relative peace of mind that comes from open
account transactions with long-term customers in established relationships. They
require both exporter and buyer to exercise great care in agreeing the detail of
the sales contract. 
Depending on the type of document involved, there are two types
of collection: Clean collection and documentary collection.

81
 - Clean collections are collections of financial documents (promissory notes,
cheques, …) without attached commercial documents (invoices, and
shipping and insurance documents).
- Documentary collections are collections of financial documents, which may
have attached commercial documents, or collections of commercial
documents without financial documents.
International payments via documentary and clean collections are
performed in accordance with international banking practice, such as the ICC
Uniform Rules for Collections, as well as Banks’ regulatory documents.

4.2.1.1. Clean collection

The exporter creates a bill of exchange, which is sent without any export
documents to a buyer for collection through the remitting bank to the collecting
bank. There is less security for an exporter since documents are sent directly to
the importer.

Graph 4.1. Clean collection

(3)
Remitting Bank Collecting Bank

(6)

(2) (7) (5) (4)

(0)
Principal/exporter Drawee/importer

(1)

(1)A contract signed, in which, payment method applied is clean collection.

(2)The exporter sends goods and commercial documents to the buyer.
(3)The exporter sends financial documents to his/her bank (Remitting bank).
(4)The remitting bank sends financial documents to the buyer’s bank
(collecting bank).
(5)The collecting bank presents documents to the buyer/drawee.
(6)The buyer pays the money or accepts to pay the money.

82
 (7)Collecting bank pays money or sends accepted bill of exchange to the
remitting bank.
(8)Remitting bank pays money or sends accepted bill of exchange to the
exporter.

4.2.1.2. Documentary Collection

Graph 4.2. Documentary Collection

(3)
Remitting Ban Collecting Bank

(7)

(2) (8) (6) (5) (4)

(0)
Exporter Importer

(1)
(1)A contract signed, in which, payment method applied is documentary
collection.
(2)The exporter sends goods to the buyer.
(3)The exporter sends commercial and financial documents to his/her bank
(Remitting bank).
(4)The remitting bank sends documents to the buyer’s bank (collecting bank).
(5)The collecting bank presents documents to the buyer/drawee.
(6)The buyer pays the money or accepts to pay the money.
(7)The collecting bank sends commercial documents to the buyer after
receiving the payment acceptance of payment from the buyer.
(8)Collecting bank pays money or sends accepted bill of exchange to the
remitting bank.
(9)Remitting bank pays money or sends accepted bill of exchange to the
exporter.

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4.2.2. Letter of credit mechanism
Documentary Letters of credit (or Letter of credit, L/C) is the safest and
probably the fastest method of obtaining payment for goods exported. The
documentary credit achieves a commercially acceptable compromise between
conflicting interests of the buyer and seller by matching time of payment for the
goods with time of their delivery. It does this, however, by making payment
against documents representing the goods rather than against the goods
themselves.
A letter of credit is not only a method of obtaining payment but it also
assures buyers of receiving documents relating to goods through their bank,
provided they ask for the required type of documents.
Definition of Letter of credit: (UCP 600, Article 1&2)
“For purposes of the Article, the expressions “Documentary Credit(s)” and
“Standby Letter(s) of Credit” (hereinafter referred to as “Credit(s)”), mean any
arrangements, however named or described, whereby a bank (the issuing bank)
acting at the request and on instructions of a customer (The applicant) or on its
own behalf,
(i) Is to make a payment to or to the order of a third party (The
beneficiary), or is to accept and pay bills of exchange (Draft(s)) drawn
by the beneficiary. Or:
(ii) Authorizes another bank to effect such payment, or to accept and pay
such bills of exchange (draft(s)). Or:
(iii) Authorizes another bank to negotiate, against stipulated document(s)
provided that terms and conditions of the Credit are complied with.
For purposes of these articles, branches of a bank in different countries are
considered another bank”
An irrevocable documentary credit (especially a confirmed one) is,
therefore, an excellent instrument of payment. Also, if appropriate documents are
called for and provided, reliance can be replaced on the integrity of the seller – it
is an effective means of obtaining delivery of the goods.

84
 It is nevertheless, a precision instrument, and must be properly handled by
all concerned. Thus, both buyer and seller should observe certain rules of
commonsense and understand their responsibilities.
It is an important instrument for the exporter to secure payment.
Parties of a letter of credit and their responsibilities
Applicant’s/Buyer’s responsibilities:
Applicant to a letter of credit is a buyer or importer of goods. The applicant
makes a request in writing to their bank to issue a letter of credit in favor of the
seller/exporter of the goods or beneficiary. Their instructions to the issuing bank
must be clear and precise and free from excessive details. The bank cannot be
expected to guess what is wanted: nor can it check complicated, and often
technical specifications, etc.
The purpose of the credit is to pay for the purchase, not to “police” the
commercial transaction. Its terms and conditions, and the documents called for,
should therefore, be in agreement with the sales contract on which it may be
based.
Any examinations of the goods prior to, or at the time of shipment must be
evidenced by a document. The precise nature and issuer of such documents must
be stated in the credit.
The credit should not call for documents that the seller cannot provide, nor
set out conditions that cannot be met. (This is particularly important with
changes in traditional documentation resulting from trade facilitation
developments and changes in transport technology).
The issuing bank:
The issuing bank is an opening bank of letter of credit on behalf and at the
request of the applicant, the buyer/importer of the goods. Letter of credit is a
legal contract between the seller/beneficiary and issuing bank. It is an
independent undertaking of the issuing bank to pay or accept the bill of exchange
and make payment, on presentation of documents according to terms and
conditions stated on the letter of credit. If documents do not satisfy requirements
of the letter of credit, the issuing bank is not liable to act in any ways i.e. to pay or
accept the bill of exchange and make payment.

85
 Letter of credit may be issued by mail, telex, cable or by SWIFT (Society for
Worldwide Inter-bank Financial Telecommunication) in accordance with
requirements of the applicant and the beneficiary. Using SWIFT system is
becoming more popular these days. Authentication of letter is the responsibility
of the advising bank by verifying authorized signatures on the letter, in case of
mail, test key number in case of telex and cable etc.
The advising bank:
The advising bank is an agent bank of the issuing bank in the country of the
exporter. The advising bank forwards the letter of credit to the beneficiary in
accordance with instructions of the issuing bank. Being an agent of the issuing
bank, it has a list of signatories of the issuing bank. Therefore, it is advising bank’s
responsibility to ensure that the letter of credit is signed by authorized
signatories of the issuing bank before forwarding it to the beneficiary.
If the advising bank forwards the letter without any undertaking in its part,
it must say clearly when advising a letter of credit to the beneficiary, i.e. it (the
advising bank) is under no obligations to make payment or incur any liabilities to
make deferred payment etc.
The seller’s/beneficiary’s responsibilities:
Although considerable time may elapse between the receipt of a credit and
its utilization, the seller should not delay studying it and requesting any
necessary changes, if required.
The seller should satisfy him that terms, conditions and documents called
for are in agreement with the sales contract. (Banks are not concerned with such
contracts. Their examination of documents will take into consideration only
terms of the credit and any amendments to it).
When it is time to present documents, the beneficiary should:
(i) Present required documents exactly as called for by the credit.
Documents must be in accordance with terms and conditions of the
credit and not on their face, which is inconsistent with one another.
(ii) Present documents to the bank as quickly as possible and in any cases
within the validity of the credit and within the period of time after the

86
 date of issuance of the document specified in the credit or as applicable
under Article No.14(c) UCP 600.
(iii) Must remember that non-compliance with terms stipulated in the credit
or irregularities in the document obliges the bank to refuse the
settlement.
A confirming bank:
A confirming bank is the one, which adds its independent guarantee to the
letter of credit. It undertakes the responsibility to make payment/ acceptance of
bills of exchange and pay on maturity or negotiate under the letter of credit in
addition to the issuing bank. A confirming bank is usually the advising bank. If the
issuing bank requests the advising bank to add its confirmation, the advising
bank does so. Once the advising bank adds its confirmation, it is known as a
confirming bank. The confirmation is an independent undertaking between the
confirming bank and the beneficiary.
A Nominated bank:
A nominated bank is the bank authorized by the issuing bank to pay, incur
deferred payment liability, to accept bill of exchange and pay on maturity, or to
negotiate the letter of credit.
A Reimbursing bank:
A reimbursing bank is a bank authorized by the issuing bank to honor the
reimbursement claim made by the negotiation/paying bank in the settlement of
negotiation/payment under a letter of credit. This is the bank with which the
issuing bank has agency/accounting arrangements.
The carrier:
The carrier is the company which takes possession of the cargo with
undertaking to transport and deliver it safely at a place of destination agreed by
the buyer and the seller. The cargo carrier is a shipping company, an airline or
another type of transporters by road i.e. Lorries etc. The cargo carrier supplies a
transport document indicating the receipt of goods and terms of carriage of
goods.
The insurer:

87
 The insurer is an insurance company with a prime responsibility for
insuring the cargo as required under terms and conditions of the letter of credit.
The insurer indemnifies the holder of the insurance document i.e. insurance
policy or insurance certificate against any losses or damages to the cargo.

Graph 4.3. Letter of credit mechanism

(3)
Issuing bank Advising bank
(8)
(9)

(2) (10) (7) (6) (4)

(1)
Importer Beneficiary

(5)

(1)Sale contracts signed between the exporter and importer

(2)L/C contract between the importer and issuing bank
(3)L/C advice sent to the advising bank
(4)L/C confirmation advised to the beneficiary
(5)The exporter hands goods to the importer, normally through carries
(6)The exporter presents documents to the advising bank
(7)After checking or negotiating documents sent, the advising bank makes
payment to the beneficiary
(8)Documents forwarded to the issuing bank with a reimbursement clause
(9)The issuing bank reimburses to the advising bank.
(10) Documents are forwarded to the importer with payment or an
acceptance of payment.
Advantages and disadvantages of a letter of credit
Advantages to the exporter
88
 Assurance of payment: The beneficiary is assured of payment as the
issuing bank is bound to honor documents drawn under the letter of credit
Ready negotiability: The exporter, if he needs money immediately can
secure payment by having documents, drawn under the letter of credit,
discounted (post shipment advance)
Compliance with regulations: The letter of credit is an evidence that the
exchange control regulations, if applicable in the country of the importer, have
been complied with.
Pre-shipment facility: The exporter can secure an advance from his bank
against a letter of credit received for export of goods
Advantages to the importer
Credit facility from the issuing bank: The issuing bank lends its own credit
facility to the importer against a letter of credit, if the importer cannot avail any
credit facilities from the exporter.
Assured delivery of goods: The issuing bank honors documents drawn
under the letter of credit only when all of the terms and conditions of the credit
have been complied with. Therefore, the importer is assured not only of obtaining
the goods, but also, if proper care is taken, obtaining specified goods in time. In
this respect, the buyer and seller should negotiate the date of shipment of the
goods from named ports of shipment and destination.
Disadvantages to the applicant/ importer
Fraudulent documents: The beneficiary wants to sell goods against a
letter of credit and lays down terms and conditions, regarding to payment for the
goods suitable for him. He is going to supply certain documents as an evidence of
shipment of goods and, if bent upon defrauding, he may succeed in obtaining
payment by supplying poor quality goods or falsifying documents.
Expensive: Issuing banks charge fees for issuing a letter of credit and such
fees are not required to be paid in case of an open account system. Charges
recovered by banks under an open account system are much less than under a
letter of credit.
Credit line: A certain amount/portion of the buyer’s/applicant’s credit
line with their bank gets tied up in an outstanding letter of credit. It will not be

89
available for any more pressing credit needs, which may develop in the
applicant’s business operations.
Cash flow: The applicant may have to tie up his cash as collateral security
against the letter of credit, which will cause the deficit in his cash flow.
Delayed Document: It often happens that documents of title to goods do
not reach the importer on time because those are processed by different banks in
different countries.
Delayed Goods: Sometimes the goods are delayed in transit because of
various reasons. If the importer has committed him or herself with another party
to supply those goods on or before a pre-determined date, the delay may cause
damage to his reputation and/or financial loss
Disadvantages to the beneficiary
Discrepancies in documents: If the exporter is not familiar with proper
procedures for processing documents, documents may be presented with
discrepancies and the bank will send those on collection basis.
Difficult terms and conditions of L/C: Terms and conditions relating to
certain documents may not be easy to fulfill or those documents may be difficult
to obtain.
Different languages: A letter of credit may be received in the importing
country’s language and may not be understood by the exporter. It will be costly to
get documents translated.
Competitive terms: Letter of credit payment terms are so restrictive that
sellers may lose sales to competitors who quote less restrictive terms.
Delayed Documents: It often happens that documents of title goods do
not reach the importer on time because documents have been processed by
different banks in different countries.
Delayed Goods: Sometimes the goods are delayed in transit because of
various reasons. If the exporter has committed to supply those goods on or
before a pre-determined date, the delay may cause damage to his reputation
and/or financial loss if a claim is made by the importer./.

CONCLUSION
90
 International payment is an over the world activities and includes many
international elements. International payment is not only an activity applied high
technology, but is an activity applied high technology. In terms of purposes of
goods and services transaction, there are trade payment and non-trade payment.
In terms of paying directly or indirectly, there are direct payment and indirect
payment. In terms of point at which goods and services ownership is transferred,
there are advance payment, cash on delivery and deferred payment. International
payment can be executive by many instruments, in which, bill of exchange is one
of the most useful one.
A bill of exchange – according to Sec 3, the Bill of exchange Act 1882,
England - is an unconditional order in writing, addressed by one person to
another signed by the person giving it, requiring the person to whom it is
addressed to pay, on demand or at a fixed or determinable future time, a sum
certain in money to or to the order of a specified person or to bearer. There are
some main clauses in the use of bill of exchange, including acceptance,
endorsement, negotiability and discharge.
Collection and Letter of credit are the two method of international
payment. Collection is a method of payment in international trade whereby an
exporter collects or authorizes a bank to collect a payment on his or her behalf.
Depending on the type of document involved, there are two types
of collection: Clean collection and documentary collection. International
payments via documentary and clean collections are performed in accordance
with international banking practice, such as the ICC Uniform Rules for
Collections, as well as Banks’ regulatory documents.
A letter of credit is not only a method of obtaining payment but it also
assures buyers of receiving documents relating to goods through their bank,
provided they ask for the required type of documents. Despite some drawbacks
of L/C, it has still a most advantageous international payment method. It is
beneficiary to both exporter, importer

REVIEW
1. What is international payment? What features characterize for
international payment.
91
2. How international payment is classified?
3. Analyze some main points of a bill of exchange.
4. How does acceptance a bill pf exchange differ from endorsement and
negotiability?
5. What is mechanism of documentary collection? How is it advantageous to
exporter and importer?
6. What is mechanism of Letter of credit?
7. How many parties are there in a L/C transaction?
8. Analyze advantages and disadvantages of L/C

92
 CHAPTER 5

INTERNATIONAL INVESTMENT
AND MULTINATIONAL CORPORATE FINANCE

 
International investment has accelerated at a breathtaking pace, and shifts
in the flow of this investment are now reshaping the global economic
landscape. Foreign investors not only bring fresh capital; they also bring jobs,
technology, competitive spirit and ideas to new markets. These foreign affiliates
also point to a deeper level of economic integration among nations. It is
undeniable that investment has played an important role in the modern economy.
Technically, there is a difference between international investment and
foreign investment. However, it is complicated to make a sharp distinction
between these two terms. Therefore, in this chapter, the term “international
investment” can be replaced by “foreign investment”.
5.1. INTERNATIONAL INVESTMENT GENERAL KNOWLEDGE
5.1.1. Concepts and characteristics
In an economic sense, an investment is the purchase of goods that are not
consumed today but are used in the future to create wealth. In finance, an
investment is a monetary asset purchased with the idea that the asset will
provide income in the future or appreciate and be sold at a higher price. The term
“investment” is usually used when referring to a long-term outlook.
In other words, in the finance context, investment can be seen as
the use of money or capital to purchase financial instruments or other assets in
order to gain profitable returns in the form of interest, income, or appreciation of
the value of the instrument.
An investment involves the choice by an individual or an organization
such as a financial institution, after some analysis or thought, to place or lend
money in a medium, instrument or asset, such as property, commodity, stock,
bond, financial derivatives (e.g. futures or options), or foreign assets
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denominated in foreign currency, that has certain levels of risk and provides the
possibility of generating returns over a period of time. When an asset is bought or
a given amount of money is invested in the bank, there is anticipation that some
returns will be received from the investment in the future.
An international investment is an investing strategy in which non-
domestic investors choose to purchase options related to the economic
institutions and the currency related to a specific nation. The idea behind this
approach is to increase the value associated with that national currency in
relation to other currencies around the world. By engaging in this type of activity,
investors can in turn increase the value of other holdings that are also associated
with that nation, sometimes selling those investments at a considerable profit. 
International investment is characterized by some features:
Investment capital flows are transferred from a national economy to
economies of other countries. This is an outstanding feature of international
investment, which distinguishes international investment from national
investment. In international investment, capital is transferred from the economy
of one country to another economy. As a result, this activity contributes directly
to the GDP of the host country. In an open economy, there would be no
constraints on the flow of investment capital. Individuals and firms would be
allowed to move their resources into and out of specific activities, both internally
and across the country’s borders without any restrictions. 
International investment involves at least two different currencies in at least
two countries. Every country today (except Eurozone) has its own currency.
Therefore, international investment requires an exchange from one currency to
another. This is also another main feature of international investment. Using
different currencies in an investment also creates differences in management,
comparing between international and national investment.
Foreign investment is governed by many different laws and regulations of
different countries. The international investments are operated in both invested
country and international financial markets. Therefore, these activities have
always been set under different laws and regulations. Normally, investment law
is composed of three legal sources: International law (especially investment

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treaties), investment contracts between investors and states, and domestic laws
of both investing and invested countries.
Foreign investment always involves risk. Risk includes the possibility of
losing some or all of the original investment. Every investment opportunity
carries some risks. In international investment, the risks seem much greater than
national investment because of the differences in laws, politics, currencies and
customs. Two examples of risks in international investment are: political risk and
exchange rate risk. Political risk, or sometimes referred to as country risk, is the
potential for shifts in a nation’s political climate or changes to trade laws and
regulations that have an adverse effect on the ability of international investors or
corporations to do business with entities within that nation.  Currency or
exchange rate risk is a form of risk that arises from the change in price of one
currency against another. When investing directly in a foreign market, you have
to exchange your domestic currency into a foreign currency at the current
exchange rate in order to purchase the foreign assets. It is the uncertainty of what
the future exchange rate will be that scares many investors. Therefore, the
investors’ returns will be affected by currency volatility.

5.1.2. Categories of international investment

International investment reflects the capital flows that fall into some
principal categories. In terms of how investors manage capital, there are two
types of international investment: Foreign Direct Investment (FDI) and Foreign
Indirect Investment (FII).
Foreign Direct Investment
This category refers to an international investment in which the investors
obtain a lasting interest in an enterprise in another country. Most concretely, it
may take the form of buying or constructing a factory in a foreign country or
adding improvements to such a facility, in the form of property, plant, or
equipment.
In the form of FDI, the investors directly supervise the organization and
executive management, as well as the use of capital. Normally, FDI can be made
among many countries, such as developed with developing countries, developing
with developing countries, developed with developed countries, or even between
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developing with developed countries. FDI can be made by different forms in
which FDI project is quite common. 
Foreign Indirect Investment
This category refers to an international investment, in which investors do
not directly supervise the organization and executive management, as well as the
use of capital. This task is transferred to other subjects or institutions. In this
way, there is a distinction between ownership and management.
Foreign indirect investment is made indirectly by foreign private investors
through international financial markets or by financial intermediary institutions.
These include investments via equity instruments (stocks) or debt (bonds) of a
foreign enterprise which do not necessarily represent a long-term interest.
Indirect investment differs from direct investment in weighing the transfer of
technologies, the direct participation in management and operation.... However,
in many cases, the distinction between direct investment and indirect investment
is very vague.
5.2. FOREIGN DIRECT INVESTMENT (FDI)
5.2.1. Concept
Foreign Direct Investment can be described as investment made by a
foreign entity in the equity of a domestic company (Target Company) with the
intention of participating in the management of the enterprise. Alternatively it
can be described as an investment transaction in which an investor from one
country (home country) seeks to obtain managerial interest in an entity in
another country (host country) for direct controlling and operating physical
assets created through such investments. Foreign direct investment has been
performed very soon. The primary purpose of the investment is seeking for raw
material. Therefore, FDI, in some cases, has been considered as a form of capital
export.
Foreign direct investment refers to long term participation by country A
into country B. It usually involves participation in management, joint-venture,
transfer of technology and expertise.
Foreign direct investment has many forms. Broadly, foreign direct
investment includes "mergers and acquisitions, building new facilities,

96
reinvesting profits earned from overseas operations and intracompany loans". In
a narrow sense, foreign direct investment refers just to building new facilities.
5.2.2. Characteristics
The common feature of FDI that distinguish FDI from other types of
investment is represented in term “control” or “controlling interest”. In forms of
FDI, investors take directly part in managing, performing operation and
investment decision making. It implies that some degree of discretionary decision
making by the investor is present in management policies and strategies. The
investors in this kind of investment would be different subjects in different
countries who join together in investment activities.
Usually, FDI has been done in the field of production, which directly supply
products for society.FDI has been perform in a form of FDI enterprise or FDI
project, operated in production field of host country.
FDI is long-term investment which would last about 10 years. Physical
content of FDI is not only capital or cash, but technique, reputations and brand or
trademark.

5.2.3. Roles of the foreign direct investment

Foreign direct investment (FDI) plays an extraordinary and growing role in
global business, and assists the economic development of both host and recipient
countries.
For host country
FDI assists economic growth and development. Through FDI, a huge amount
of capital has been injected into the economy, directly leading to an increase in
expenses of the whole society, which in turn grows the economy. FDI also has
helped the economies of the host countries to obtain a launching pad from where
they can make further improvements. In addition, it has been observed that
foreign direct investment has been able to improve the infrastructural condition
of a country. The standard of living of the general public of the host country could
be improved as a result of the foreign direct investment made in a country.
FDI introduces world-class technologies and technical expertise to recipient
countries. The money that comes into a country through foreign direct
investment can be utilized to buy or import technology from other countries. This
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is an indirect way in which foreign direct investment plays an important part in
the context of economic development. Foreign direct investment can also be
helpful in assisting the host countries to set up mass educational programs that
help them to educate the disadvantaged sections of the society. Besides, FDI can
provide a source of new processes, products, organizational technologies and
management skills, and as such can provide a strong impetus to economic
development.   
FDI also enhances trade in recipient countries. Foreign Direct Investments
have opened a wide spectrum of opportunities in the trading of goods and
services, both in terms of import and export production. Besides, thanks to FDI,
trade policies and regulations have been improved to take advantages of Foreign
direct investment and to attract foreign investors. As a result, it leads to the
decline in trade barriers.
Inward FDI has the potential for job creation and employment. By
introducing new industries, building new factories and broadening production,
FDI creates job opportunities for people living in the recipient economy, which is
often followed by higher wages and salaries.
  For recipient country
Through the development, it can be observed that FDI benefits not only
host countries but also home countries – where the FDI capital comes from. FDI
brings wealth to the investors, broadens economic scales and minimizes the
trade-off costs… With the purpose of factor-seeking, FDI is a good way for
investors to seek natural resources and cheap labor.  With the purpose of market-
seeking, new markets in recipient countries are always a goal for investors. One
way to access these new potential customers is to set up foreign subsidiaries or
joint ventures where the potential market is large.
However, foreign direct investment has many drawbacks, despite its
overall effectiveness in promoting economic growth and society. FDI focuses on
some fields of the economy, while other areas has no investment; leading to an
unbalanced and unstable situation in the economy. There are concerns that
foreign direct investment may disrupt local industry and economy by attracting
the best workers and creating income disparity. Besides, there are arguments
that once a foreign investment becomes profitable, capital begins to flow out of
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the host country and goes back the investor's country. Additionally, FDI can
create a sudden movement of capital flows that may hurt the economy by capital
shock: a large amount of FDI capital may flow in as quickly as flow out of the
recipient countries.
5.3. FOREIGN INDIRECT INVESTMENT (FII)
5.3.1. Concept
Foreign indirect investment (FII) refers to an international investment in
which the international investors invest via international financial instruments
(international bonds, international stocks...) or international loans through the
international financial market or foreign financial markets.
Investing in international financial instruments and international loans are
two main parts of foreign indirect investment. However, practically, investing in
international financial market plays a significant role in FII. Therefore, in some
cases, there is no clear distinction between foreign indirect investment (FII) and
foreign portfolio investment (FPI).
International stocks include enterprise stocks and bonds, or government
bonds transacted in international and national markets. They are purchased in
Stock Exchange or Over-the-counter markets. Participants in FII can be
individuals or organizations in which investment funds account for a significant
part. 
5.3.2. Characteristics of foreign indirect investment
Foreign indirect investment is characterized by basic features:
The investors do not directly supervise the organization and executive
management, as well as the use of capital. However, in many cases, the distinction
between direct investment and indirect investment is not clear. For example,
when a foreign investor purchases stocks of a host-country enterprise, if the
proportion owned by this investor is below the band (10% under the IMF
standard and 30% under current Vietnamese standards), he is an indirect
investor. However, if the proportion owned by this investor is higher, he can
directly intervene in the company’s operation and management.
Foreign Indirect Investment is purely financial investment in international
financial market. Differing from the foreign direct investment, indirect investors

99
inject capital into a host country without any commitments of transferring visible
assets, technologies or education and management skills.
Using this type of indirect investment approach can be especially helpful
when the investor wishes to allocate at least a portion of his or her portfolio to
international or foreign indirect investment development. Since the investor
assumes no responsibility for directly managing the real estate properties
involved, it is a relatively easy task to identify opportunities associated with
specific geographical locations and work through a third party to invest in those
opportunities. Assuming the investment is sound, the investor can enjoy returns
without devoting any other resources to the venture, making it easier to focus on
other money-making opportunities closer to home.

As with any type of investing, choosing to go with an indirect investment

requires qualifying the potential for that investment in advance. This means
taking the time to assess the history of that opportunity, understand how it is
performing in the current market, and the potential for growth in the future given
what can be reasonably assumed will happen within the marketplace in both the
short and the long term. Doing so makes it possible to understand if the projected
returns are acceptable in comparison to the risk involved, or if the investor
should look for a different opportunity that shows more promise.

5.3.3. International portfolio investment

A foreign portfolio investment (sometimes known simply as a portfolio
investment) is an investing activity that involves the purchase of stocks, bonds,
commodities, or money market instruments that are based in a different country. In
some cases, these types of investments are short-term in nature, allowing the
investor to quickly take advantage of favorable exchange rates to buy and sell the
assets. At other times, the foreign portfolio investment is acquired with plans of
holding onto the asset for an extended period of time.
An international portfolio is designed to give the investor exposure to
growth in emerging and international markets and provide
diversification. International portfolios allow investors to further diversify their
assets by moving away from a domestic-only portfolio. This type of portfolio can
carry increased risk due to potential economic instability stemming from
emerging markets, but can also bring increased stability through investments in
industrialized and more stable markets. Due to the integration of global financial
markets, many companies already have operations in more than one country. 
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 There are several characteristics that tend to define the nature of a foreign
portfolio investment. Typically, the investor has no desire to be actively involved
within the management of the asset. In addition, the investment will not provide
the investor with a controlling interest in the issuing company. While the number
of shares acquired may be significant, the shares will not position the investor so
that he or she has a great deal of control over how the issuer conducts business.
Along with the somewhat hands-off nature of a foreign portfolio investment,
there may also be certain tax requirements that the investor has to both the
nation in which the assets are based and his or her own home country.
Under the right circumstances, a foreign portfolio investment can be an
excellent way to generate a decent amount of return in relatively little time. This
is sometimes managed by paying close attention to current conditions in the
foreign exchange market. If the investor can use the right currency to make the
purchase, then sell that same investment when exchange rates are in his or her
favor, there is the chance to not only earn returns from the upward movement of
the investment itself, but also from the current rate of exchange between the two
currencies involved. While this type of strategy does require careful timing of
both the purchase and the sale, the end result can be well worth the time and
effort.
FDI and FPI have some significant differences. As mentioned before, FDI
refers to international investment in which the investor obtains a lasting interest in an
enterprise in another country. Most concretely, it may take the form of buying or
constructing a factory in a foreign country or adding improvements to such a facility,
in the form of property, plants, or equipment.
FDI is calculated to include all kinds of capital contributions, such as the
purchases of stocks, as well as the reinvestment of earnings by a wholly owned
company incorporated abroad (subsidiary), and the lending of funds to a foreign
subsidiary or branch. The reinvestment of earnings and transfer of assets between a
parent company and its subsidiary often constitutes a significant part of FDI
calculations. FDI is more difficult to pull out or sell off. Consequently, direct investors
may be more committed to managing their international investments, and less likely to
pull out at the first sign of trouble.

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 On the other hand, FPI represents passive holdings of securities such as foreign
stocks, bonds, or other financial assets, none of which entails active management or
control of the securities' issuer by the investor. Unlike FDI, it is very easy to sell off
the securities and pull out the foreign portfolio investment. Hence, FPI can be much
more volatile than FDI. For a country on the rise, FPI can bring about rapid
development, helping an emerging economy move quickly to take advantage of
economic opportunity, creating many new jobs and significant wealth. However, when
a country's economic situation takes a downturn, sometimes just by failing to meet the
expectations of international investors, the large flow of money into a country can turn
into a stampede away from it.
Foreign portfolio investment can be performed in variety of forms. In terms of
stocks, the investors can consider between different types of stocks, such as stock
(ordinary shares, preference shares), bonds (ordinary bonds, transferable bonds…),
derivatives (futures contracts, options contracts…). In terms of investment methods,
the investors can purchase stocks with the help of stock dealers or through investment
funds. In terms of maturity, there are short-term stocks and long-term stock. Short-
term stocks are securities, which its’ maturity is under 1 year (treasury bills, bank
notes…). Long-term stocks are securities which its’ maturity is more than 1 year
(government bonds, enterprise stocks…). The longer the maturity is, the riskier the
securities.
  Rate of return on security investment
The purchase of foreign investors in a country’s stock and bond market is
to speculate and/or invest to achieve higher rate of return in comparison with
local security market. There are two specific reasons for this diversification.
Firstly, there is potential for higher expected return with the same level of risk.
Secondly, it is a chance of lower portfolio risk for the same return.
  In a security market, the amount of revenue that an investment generates
over a given period of time is expressed as the percentage of invested capital.
Return on security investment is determined pretty much the same way with
other investments. However, the details vary. Different investors have different
required rates of return at different levels of risk.
 
International portfolio investment in stock market:

( P1 + DIV ) /( 1+ Et )−P
102 0
Rs = ×100 %
P0
 

In which :
Rs: rate of return of international stock investment
P1: price of share at selling time (measured in currency of
transaction)
P0: buying price of share (measured in currency of transaction)
DIV: dividend (measured in currency of transaction)
Et: exchange rate changes (in per cent) between investment
currency and the transaction currency between the end and the beginning
of investment period
  E1 −E0
Et=
E0
E1: exchange rate changes (in per cent) between investment
currency and the transaction currency at the end of investment period.
E0: exchange rate changes (in per cent) between investment
currency and the transaction currency at the beginning of investment
period

International portfolio investment in bond market:

  ( P1 +INC )/ ( 1+Et )−P 0
  Rb = ×100 %
P0
In which :
Rb: rate of return of bond investment
P1: price of bond at selling time (measured in currency of
transaction)
P0: buying price of bond (measured in currency of transaction)
INC: income for holding bond in an amount of time.
Et: exchange rate changes (in per cent) between investment
currency and the transaction currency  between the end and the beginning
of investment period
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 E1 −E0
Et=
E0
E1: exchange rate changes (in per cent) between investment
currency and the transaction currency at the end of investment period.
E0: exchange rate changes (in per cent) between investment
currency and the transaction currency at the beginning of investment
period

5.3.4. International  commercial credit

International commercial loan (or international commercial credit) is a
part of international credit, in which terms of loans are set up based on
commercial conditions. The purpose of lenders normally is to receive the interest
payment. 
International commercial loans have several characterizing features:
 There is normally a credit agreement between lenders and borrowers,
which is known as an international credit contract.
 This credit is often guaranteed by a third party, which could be the parent
company or Government.
 They are affected by many factors, such as national politic situations or
volatility in exchange rate…
International commercial credit can be given by commercial banks or
financial institutions. Besides, it can also be created by brands of a multinational
company or a transnational company. There are many different kinds of loans. In
terms of maturity, there are medium term and long term loans. In terms of
interest payment, there are discount and deferred payments. In terms of loan
conditions, there are mortgage loans, guaranteed loan…, in which guaranteed
loans are much popular.
An international commercial loan agreement or contract is the document
in which a lender – usually a bank or other financial institution – sets out the
terms and conditions under which it is prepared to make a loan available to a
borrower.  Loan agreements are often referred to by their more technical name,
"facilities agreements" - a loan is a banking "facility" offered by the lender to its
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customer.  Besides some main terms and conditions, an international commercial
loan contract consists of:
 Total loan: The amount of money the borrower receives from the lenders.
It is the basic information for the transaction, set under the agreement
between two parties.
 Maturity: The period of time from the first disbursement until finishing the
last principal repayment under the agreement of a contract. The maturities
of medium and long term facilities are always more than one year.
 Interest: The interest is normally based on the interest rates in the inter-
bank market, such as LIBOR or SIBOR…
 Payment: payment can be advanced or deferred payment. Interest
payment can be discounted right before the loan or paid annually,
quarterly or monthly. The principal can be divided into many different
periods to pay or just paid one time at maturity. The currency used in the
loan is also set up under the agreement.
Effective financing rate
The effective interest rate or effective financing rate is the actual annual
rate at which your financial obligations will grow. It is this rate, and not what may
be printed on your contract, that will determine how much you will actually owe
on your credit or any other kind of debt.
The actual cost of financing will depend on the interest rate charged by the
bank providing the loan and the movement in the borrowed currency’s value
over the life of the loan. The effective financing rate may differ from the quoted
interest rate.
In a facility agreement, the interest rate quoted in the contract is called
nominal interest rate (in). In fact, the effective interest rate or real interest rate
(ir) differs from the nominal interest rate.
In a discounted loan, the real interest rate is defined as followed:
  in
ir=
  1−i n
Assume that, the country that owns lending currency experiences an
inflation rate of if, the real interest rate is:
1+i n 105
ir = −1
1+i f
  

If the lending currency differs from the payment currency, the real interest
rate will be affected and adjusted under the change of exchange rates between
lending and payment currencies.
  ir =(1+i n )(1+ Et )−1
In which,
 
E1 −E0
E  t =
E0

 
5.4. MULTINATIONAL CORPORATE FINANCE

5.4.1. Concept and models of multinational corporation

A multinational corporation (MNC) or multinational enterprise (MNE) is a
corporation that is registered in more than one country or that has operations in
more than one country. It is a large corporation which both produces and sells
goods or services in various countries.  It can also be referred to as
an international corporation.
That corporation has its facilities and other assets in at least one country
other than its home country. Such companies have offices and/or factories in
different countries and usually have a centralized head office where they co-
ordinate global management. Very large multinationals have budgets that exceed
those of many small countries. 
The exact model for an MNC may vary slightly. One common model for the
multinational corporation is the positioning of the executive headquarters in one
nation, while production facilities are located in one or more other countries.
This model often allows the company to take advantage of benefits of
incorporating in a given locality, while also being able to produce goods and
services in areas where the cost of production is lower.
Another structural model for a multinational organization is to base the
parent company in one nation and operate subsidiaries in other countries around

106
the world. With this model, just about all the functions of the parent are based in
the country of origin. The subsidiaries more or less function independently,
outside of a few basic ties to the parent.
A third approach to the setup of an MNC involves the establishment of a
headquarters in one country that oversees a diverse conglomeration that
stretches tomany different countries and industries. With this model, the MNC
includes affiliates, subsidiaries and possibly even some facilities that report
directly to the headquarters.

5.4.2. Reasons for the growth of multinational corporate

The growth of the multinational corporate has been a result of foreign
direct investments which have been taken place in the past. The strategic
overseas investment is especially important in dynamic and changing markets,
such as publishing and fashion clothing, where subsidiaries must keep in line
with local needs and where shipping time is vital. In addition to strategic reasons
for direct investment, numerous other reasons have been put forward, and while
these are not strictly financial.
A number of factors have contributed to the phenomenal growth of MNCs.
Some of the important factors are as follows:
- Availability of raw materials:
In general, MNCs try to achieve efficiency by minimizing their cost and
maximizing economies of scale while reducing duplication. They invest in
different locations to get different advantages from host countries in order to
operate better in their home base. Looking for domestic markets to sell more
goods, seeking raw materials and managerial knowledge or technology and trying
to find countries where factors of production are cheaper are the main
motivations behind global expansion of companies. Multinational companies are
also looking for the perfect mix of these factors. Additionally, labor costs and
attributes of the workforce such as skill and educational levels are also critical.
- Protecting and Exploiting reputations:
Products develop good or bad names, and these carries across
international boundaries. People on over the world can know the names of
certain brands. We can find that there can be valid reasons for direct investment

107
rather than licensing in terms of transferring expertise and ensuring the
maintenance of a good name.
In some cases, foreign direct investment may occur to exploit rather than
protect a reputation. This motivation is probably of particular importance in
foreign direct investment by banks, and it takes the form of opening branches and
establishing or buying subsidiaries.
- The product Line-Cycle hypothesis:
To maintain the growth of profits, the corporation must venture abroad to
where markets are not as well penetrated and where there is perhaps less
competition. This makes direct investment the natural consequence of being in
business for a long enough time and doing well at home.
- Capital availability
Accessing to capital markets can be a reason why firms themselves move
abroad. The smaller one-country licensee does not have the same access to
cheaper funds as the larger firms, and so larger firms are able to operate within
foreign markets with a lower discount rate.
- Strategic FDI:
Companies enter foreign markets to preserve market share when this is
being threatened by the potential entry of indigenous firms or multinationals
from other countries. This strategic motivation for FDI has always existed, but it
may have contributed to the multinationalization of business as a result of
improved access to capital markets. In the case of increased strategic FDI, it is
globalization of financial markets that has reduces entry barriers due to large
fixed costs. Access to the necessary capital means a wider set of companies with
an ability to expand into a given market. This increases the incentive to move and
enjoy any potential first-mover advantage.
- Avoiding tariffs, Quotas and other regulations
Another reason for producing abroad instead of producing at home and
shipping the product concerns the import tariffs that might have to be paid. If
import duties are in place, a firm might produce inside the foreign market in
order to avoid them. We have been seen many cases where the threat of tariffs or

108
quantitative restrictions on imports in the form of quotas have prompted direct
investment overseas.
Avoiding regulations has also been a motivation for foreign investment by
manufacturing firms. There is a case that some firms have moved to escape
standards set by the home countries.
Besides, there are many other reason for the development of MNCs in the
recent centuries, including integrating operations, nontransferable knowledge,
protecting secrecy, organizational factors, production flexibility, symbiotic
relationships, indirect diversification…All of these motivations have been assisted
for the rapid growth of MNCs, and MNCs in turn play an important roles in
sharping the global economy.
5.4.3. Special issues facing multinational corporations: Transfer pricing
While any firm with multiple divisions must price goods and services
transferred between its divisions if it is to be able to judge its profit centers
correctly, there are few if any political or tax implications of transfer pricing in
the domestic context. This situation is very different for the multinational
corporation.
5.4.3.1. The measurement of transfer prices
If correct measures of prices of goods and services moving between
corporate divisions are not available, management will have difficulty making
adjusted present value calculations for new projects, and will even face
difficulties judging past projects and performances of corporate divisions.
The prices managers must determine are those of intermediate products
moving through the value chain of vertically integrated firms. The most obvious
source for these prices is the market. However, market prices do not always exist
for intermediate products. Furthermore, even when there are market prices for
the goods and services transferred between divisions within a firm, using these
prices may result in incorrect decisions.
The theoretically correct transfer price is equal to the marginal cost. This is
because the price paid then correctly reflects the cost of producing another unit.
If a good or service transferred between corporate divisions is available in the
marketplace, where it trades in a “perfectly competitive” market, the market

109
price will equal the marginal cost, and this market price can then be used as the
transfer price. However, goods and services moving between divisions are
frequently available only in monopolistic or monopolistically competitive
markets. In this case, market prices will typically exceed marginal costs. This
means that by setting transfer prices equal to market prices, a buying division
will be paying above marginal cost for inputs. This will induce the use of too few
inputs to achieve the profit-maximizing output from the firm’s perspective. The
firm’s output of its final product will also be less than the profit –maximizing
level.
In addition, with transfer prices equal to market prices, and these being
higher than the firm’s marginal costs of the transferred goods and services, input
combinations will be inappropriately intensive in products bought from outside
the firm. That is, if, instead of setting transfer prices of intermediate products
equal to market prices, the firm sets them equal to its marginal costs of
production, buying divisions would correctly use more of the firm’s own
intermediate products as inputs.
While setting transfer prices equal to marginal costs will maximize the
firm’s overall profits, it will make it difficult to attribute the company’s profit to
the correct divisions; marginal costs are typically lower than market prices, so
divisions supplying intermediate products will show losses. This will make bonus
allocations and expansion budgets difficult to determine properly. One way
round this is to use marginal costs as the transfer prices that are paid, but to
calculate divisional profitability at market prices. This requires, of course, that
market prices of intermediate products are available, and that marginal costs are
known. In reality, neither requirement is likely to be satisfied. 
5.4.3.2. Considerations in transfer pricing
Repatriation of profits by a multinational firm from its overseas operations
can be a politically sensitive problem. It is important that the host governments
do not consider the profit rate too high, or else the multinational is likely to face
accusations of price gouging and lose favor with foreign host governments. In
order to give an appearance of repatriating a lower profit without reducing the
actual profit brought home, the multinational can use transfer prices. It may set
high transfer prices on what is supplied by other divisions or for general
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overheads. Alternatively, the multinational can lower the transfer prices of
products which the foreign division sells to the parent company or to other
divisions. These methods of reducing foreign profits while repatriating income
are particularly advantageous when foreign reinvestment opportunities are
limited. Because host countries know that these practices occur, it is a good idea
to itemize everything.
Transfer pricing to reduce overall corporate taxes can be advantageous.
The multinational has an incentive to shuffle its income to keep profits low in
high-tax countries and relatively high in low-tax countries. Additionally, a
multinational firm is likely to be in a better position to avoid foreign exchange
losses than a firm with only local operations.
Transfer prices can be used to reduce import tariffs and to avoid quotas.
When tariffs on imports are based on values of transactions, the value of goods
moving between divisions can be artificially reduced by keeping down the
transfer prices. This puts a multinational firm at an advantage over domestic
firms. Similarly, when quotas are based on values of trade, the multinational firm
has an advantage over the domestic counterparts; but import authorities
frequently adopt their own “value for duty” on goods entering trade to help
prevent revenues from being lost through the manipulation of transfer prices.
Large variations in profits may be a concern to shareholders. In order to
keep local shareholders happy, fluctuations in local foreign profits can be reduced
via transfer prices. By raising the prices of goods and services supplied by foreign
operations or lowering prices on sales to foreign operations, unusually high
profits can be brought down so that subsequent falls in profits are reduced. Of
course, shareholders are normally assumed to be concerned only with systematic
risk and not with total risk, so the premise that profit volatility is of concern to
shareholders is open to criticism. To the extent that transfer prices apply to
financial transactions such as credits granted between corporation divisions, the
scope for meeting the many strategic objectives, such as reducing host-
government criticism over profits and reducing taxes, are substantially enhanced.
Indeed, when we add discretion over timing of repayment of credits, the MNC
may be at a substantial advantage over non-multinational competitors.

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5.4.3.3. The mechanism of transfer prices
The transfer pricing system works as follows:
Pricing charged by one company in country A to another company in
country B is reflected in profit and loss accounts of both companies, either as
income or expenditure. By resorting the transfer prices, related entries can
reduce the global incidence of tax by transferring higher income to low-tax
countries and/or greater expenditure to those where the tax rate is very high.
Thus the global group as a whole will benefit from the tax savings. Some of the
important areas where transfer pricing has been prevalent are:
 Import of raw materials
 Semi-finish goods for assembling
 Intellectual property – such as know-how and technology areas.
  There can be internal and external reasons for transfer pricing. Internal
reasons includes motivating managers and monitoring performance, e.g. by
putting a cost to imported inputs. External reasons would be taxes and tariffs.
The most important uses of transfer pricing include:
(1) Reducing taxes;
(2) Reducing tariffs; and
(3) Avoiding exchange controls.
Transfer prices may also be used to increase the MNC’s share of profits
from a joint venture and to disguise an affiliate’s true profitability. In effect,
profits are being shifted from a higher to a lower tax jurisdiction. In extreme
cases, an affiliate may be in a loss position because of high start-up cost, heavy
depreciation charges, or substantial investments that are expensed.
Consequently, it has a zero effective tax rate, and profits channeled to that unit
can receive tax-free.
The basic rule of thumb to follow if the objective is to minimize taxes is as
follows: If affiliate A is selling goods to B, where tA and tB are corporate tax rates
of A and B, respectively, then:
1. If  tA >tB , set the transfer price as low as possible,
2. If  tA <tB , set the transfer price as high as possible.

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 In effect, profits are being shifted from a higher to a lower tax jurisdiction.
In the extreme case, an affiliate may be in a loss position because of high start-up
cost, heavy depreciation charges, or substantial investments that are expensed.
Consequently, it has a zero effective tax rate, and profits channeled to that unit
can receive tax-free.
Scenario:
Suppose that affiliate/subsidiary A produces 100,000 circuit board for
$10/piece and sells them to affiliate B at $15/piece. B, in turn, sells these boards
for $22/piece to an unrelated customer. The following table will illustrate the
pre-tax profit for the consolidated company (A+B), regardless of the price at
which the goods are transferred from A to B. A’s corporate tax rate is 30%
whereas that of B is 50% and consolidated after-tax income will differ depending
on the transfer prices applied.
 
Low transfer prices (in thousands)

  A B A+B
Revenue/Sales 1,500 2,200 3,700
Cost of goods sold 1,000 1,500 2,500
Gross profit 500 700 1,200
Other expenses 100 100 200
Income before taxes 400 600 1,000
Taxes (30%/50%) 120 300 420
Net income 280 300 580
 
Under  the low-markup policy, in which affiliate A sets a unit transfer price
of $15, affiliate A pays an amount of $120,000 for corporate tax and B pays
$300,000, for a total tax bill of $420,000 and a consolidated net income of
$580,000.
High transfer prices (in thousands)

  A B A+B
Revenue/Sales 1,800 2,200 4,000
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Cost of goods sold 1,000 1,800 2,800
Gross profit 800 400 1,200
Other expenses 100 100 200
Income before taxes 700 300 1,000
Taxes (30%/50%) 210 150 360
Net income 490 150 640
 
Switching to a high-markup policy (a transfer price of $18), affiliate A’s
corporate tax increases to $210,000 and that of B declines to $150,000, for a
combined tax payment of $360,000 and consolidated net income of $640,000.  
The result of this transfer pricing increase is to lower total taxes paid by
$60,000 and to boost consolidated net income by the same amount.

CONCLUSION
In the finance context, investment can be seen as the use of money or
capital to purchase financial instruments or other assets in order to gain
profitable returns in the form of interest, income, or appreciation of the value of
the instrument. An international investment is an investing strategy in
which non-domestic investors choose to purchase options related to the
economic institutions and the currency related to a specific nation
International investment is characterized by some features, namely
Investment capital flows are transferred from a national economy to economies
of other countries; International investment involves at least two different
currencies in at least two countries; is governed by many different laws and
regulations of different countries; and always involves risk.
There are two types of international investment: Foreign Direct
Investment (FDI) and Foreign Indirect Investment (FII). In forms of FDI, investors
take directly part in managing, performing operation and investment decision
making. It implies that some degree of discretionary decision making by the
investor is present in management policies and strategies. The investors in this
kind of investment would be different subjects in different countries who join
together in investment activities. Foreign indirect investment (FII) refers to an
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international investment in which the international investors invest via
international financial instruments (international bonds, international stocks...)
or international loans through the international financial market or foreign
financial markets.
International commercial loan (or international commercial credit) is a
part of international credit, in which terms of loans are set up based on
commercial conditions. The purpose of lenders normally is to receive the interest
payment. International commercial credit can be given by commercial banks or
financial institutions. Besides, it can also be created by brands of a multinational
company or a transnational company.
With the increasingly growth of MNC, price transfer has been becoming
popu;ar. It is used to reduce taxes, tariffs, and avoide exchange control. Transfer
prices may also be used to increase the MNC’s share of profits from a joint
venture and to disguise an affiliate’s true profitability

REVIEW
1. What is international investment?
2. What are characteristics of international investment?
3. What is FDI? What is FII? Distinghuish FDI and FII
4. What are the roles of foreign direct investment and foreign indirect
investment?
5. How are foreign direct investment differed from international portfolio
investment?
6. What is effective financing rate?
7. What are reasons for the growth of MNCc?
8. What are the purposes of transferring price?
9. What is the mechanism of transferring price?

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 CHAPTER 6

FOREIGN AID - GRANT, LOAN AND DEBT

6.1. OVERVIEW OF FOREIGN AID - GRANT, LOAN AND DEBT

6.1.1. Foreign aid - grant.
Foreign aid–grant is a kind of non-refundable financial assistance provided
by governments, developmental organizations of the United Nations,
international organizations, foreign non-governmental organizations (NGOs)
and foreign economic entities or foreigners. Aid–grant is provided for targets of
national socio-economic development or other humanitarian purposes, such as
emergency relief for overcoming wars or disaster consequences. There are some
criteria to classify international aids, namely:
- By purposes, there are three main types including humanitarian aid,
military aid and ODA aid.
+ Humanitarian aid: is material or logistical assistance provided
for humanitarian humanitarian purposes, typically in response to  humanitarian
crises including natural disasters and man-made disasters. The primary objective
of humanitarian aid is to save lives, alleviate suffering, and maintain human
dignity.
+Military aid: refers to a bilateral aid between two governments. Military
aid is often given in-kind (meaning physical items such as tents, food, weapons).
This aid may be given in the form of credits for foreign militaries to purchase
designated weapons and equipment from the donor country.
+ Grant ODA: is a form of ODA provision which is not refundable to the
donor. This grant is often provided by foreign governments, UN developmental
organizations and international financial institutions in forms of either project
assistance or non-project assistance.
- In terms of performance form, it is divided into in-kind aid and cash aid.

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 + In-kind aid: It refers to an aid in which goods and services are given, for
instance machines, equipment and medicines, etc.
+ Cash aid: It refers to an aid which are launched with a certain amount of
money to realize various aid purposes. This is the most popular aid form.
Moreover, intellectual aids such as assigning experts and advisors to train or
popularize knowledge and experience to the aid recipient are provided.
- In terms of aid subject, it is divided into aid-grants from governments,
inter-governmental international organizations and NGOs.
+ Aid from governments: It refers to an aid which is directly launched by
overseas governments.
+ Aid from Inter-Governmental International Organizations. This aid is
derived from international organizations such as UN, EU.
+ Aid from NGOs: It refers to an aid offered by NGOs such as aids of The
International Red Cross, The International Red Crescent, and The Greenpeace.
Such aids are generally characterized by humanitarian aids.
6.1.2. Foreign loan
6.1.2.1. Concept of foreign loan
Foreign loan refers to a short, medium or long-term loan offered to a
government or an enterprise with legal status (including foreign invested
enterprises), or organizations of a foreign government, territory, organization,
individual or an international financial organization.
6.1.2.2. Classification of foreign loan
- Nature of loan classification:
+ Foreign commercial loan: refers to a loan under market conditions which
are similar to conditions of export credit loan or mobilization on the international
capital market.
+ Foreign concessional loan: refers to a foreign loan, in which
concessionality is achieved by interest rates, maturities, grace periods, loan
guaranties, and other preferences. However, to be eligible to receive such soft
loans, the debtor must accept some conditions applied by the creditor.
- Borrower classification:

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 + Foreign loan provided to public sector. It includes foreign loan to the
government, local authorities of provinces and municipalities, State-owned
enterprises including financial and credit institutions and economic
organizations.
+ Foreign loan provided to private sector. It includes foreign loan to
private enterprises and individuals. Private sector can raise capital by issuing
international bonds or borrowing from foreign commercial banks, etc.
- Creditor classification.
+ Multilateral international loan: refers to a loan of multilateral
international financial institutions such as the WB, IMF, and ADB.
+ Bilateral international loan: refers to a loan of the government of a
nation, a foreign organization or an individual.
- Loan’s maturity classification
+ Short-term loan: is generally a loan with a term of less than one year.
+ Medium and long-term loan: is generally a loan with a term of one year
or more.
6.1.2.3. Advantages and disadvantages of foreign loan
a) Advantages
- To be a critical source of income for a country to ensure the essential
spending demand without causing inflation directly.
- To facilitate a country to further increase investment funds, strengthen
socio-economic development and uphold available potentials in the country.
b) Disadvantages
Foreign loan may cause negative impacts as follows.
- The fact that borrowers have to settle interests for foreign creditors
which leads to a reduction in partial national income.
- Excessive reliance on foreign loan may impose a debt burden on
future generations.
- High foreign loan may lead a country to insolvency. National insolvency
(National bankruptcy) is the failure or refusal of a government  to pay
back its debt which is calculated in gold or in foreign currencies. There

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 will be extremely serious consequences to a nation once it declares
insolvency.
6.1.3. External debt (or Foreign debt)
According to the IMF, gross external debt is the amount, at any given time,
of disbursed and outstanding contractual liabilities of residents of a country to
non-residents to repay principal, with or without interest, or to pay interest, with
or without principal.
In this definition, the IMF defines key elements as follows:
- Outstanding and Actual Current Liabilities: For this purpose, the decisive
consideration is whether a creditor owns a claim on the debtor. Here debt
liabilities include arrears of both principal and interest.
- Principal and Interest: When this cost is paid periodically, as commonly
occurs, it is known as an interest payment. All other payments of economic value
by the debtor to the creditor that reduce the principal amount outstanding are
known as principal payments. However, the definition of external debt does not
distinguish between whether the payments that are required are principal or
interest, or both. Also, the definition does not specify that the timing of future
payments of principal and/or interest need to be known for a liability to be
classified as debt.
- Residence: To be qualified as an external debt, debt liabilities must be
owed by a resident to a nonresident. Residence is determined by where the
debtor and creditor have their centers of economic interests—typically, where
they are ordinarily located—and not by their nationalities.
- Current and Not Contingent: Contingent liabilities are not included in the
definition of external debt. These are defined as arrangements under which one
or more conditions must be fulfilled before a financial transaction takes place.
However, from the viewpoint of understanding vulnerability, there is analytical
interest in the potential impact of contingent liabilities on an economy and on
particular institutional sectors, such as government.
Generally, external debt is classified into four heads: (1) public and
publicly guaranteed debt; (2) private non-guaranteed credits; (3) central bank
deposits; and (4) loans due to the IMF. However, the exact treatment varies from

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country to country. For example, while Egypt maintains this four head
classification, in India it is classified into seven heads: (a) multilateral, (b)
bilateral, (c) IMF loans, (d) Trade Credit, (e) Commercial Borrowings, (f) NRI
Deposits, and (g) Rupee Debt, and (h) NPR Debt.
According to the Law No. 29/2009/QH12 of Vietnam’s National Assembly
on Public Debt Management, “National foreign debts mean the total of foreign
debts of the Government, Government-guaranteed debts and debts borrowed and
paid by enterprises and other organizations themselves under the law of Vietnam”.
6.2. OFFICIAL DEVELOPMENT ASSISTANCE (ODA)
6.2.1. Concept of ODA
ODA is offered to underdeveloped and developing countries by the
Organization for Economic Co-operation and Development (OECD), which was
founded in 1960, to implement socio-economic development programs as a
moral obligation of developed countries.
The full definition of ODA is: “Flows of official financing administered with
the promotion of the economic development and welfare of developing countries
as the main objective, and which are concessional in character with a grant
element of at least 25 percent (using a fixed 10 percent rate of discount). By
convention, ODA flows comprise contributions of donor government agencies, at
all levels, to developing country (“bilateral ODA”) and to multilateral institutions.
ODA receipts comprise disbursements by bilateral donors and multilateral
institutions, (OECD, Glossary of Statistical Terms).
In other words, ODA needs to contain three elements:
- Undertaken by the official sector;
- With promotion of economic development and welfare as the main
objective; and
- At concessional financial terms (if a loan, having a grant element of at
least 25 per cent)
6.2.2. Grant Element of ODA
Grant element is a percentage rate of the face value of an ODA loan,
reflecting the level of concessionality of a loan. During the negotiation of an ODA
loan, it is necessary to consider various options available in order to ensure the
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maximum level of concessionality based on a mix of following input factors:
interest rate, grace period and maturity, etc.

Calculating formula:
1 1
[
GE3 = 1 –
R f /a
r
×]1− [
(1+ r) aG
−
(1+ r)aM ×
r (aM −aG) ]L
A
× 100% +
A−L
A [
× 100% ]
Where:
Rf: Annual preferential loan interest rate
a: Number of repayments per year (under conditions of the creditor)
r: Discount rate of each debt repayment period: r = (1+r1)1/a - 1
r1: Discount rate of whole year (as announced by the OECD or agreed
by the creditor, similar to annual average loan interest of the
market)
G: Grace period
M: Maturity (Repayment period)
L: ODA loan
A: Total investment value of a project /program
Although absolute accuracy is not obtained, such method is relatively easy
and practical for loans with multiple debt repayment periods within a year.
Therefore, it is used to calculate GE of ODA by OECD members, international
financial institutions and many ODA recipients.
6.2.3. Classification of ODA
- Classification by characteristics of assistance: types of ODA shall include
the following:
+ Grant ODA (Non-refundable ODA): is a form of ODA provision which is
not refundable to the donor.
+ Concessional ODA loan: is a form of ODA provision which must refund to
the donor under concessional conditions on interest rates, grace periods and
repayment durations with the non-refundable element accounting for at least

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35% of the value of binding loans or for at least 25% of the value of non-binding
loans. 
+ Mixed ODA loans: are aid - grants and concessional loans provided
simultaneously in an ODA program/project. It has a grant element of no less than
25 percent of the loan value.
- Classification by purposes:
+ Fundamental Assistance: ODA is used to fund major items of socio-
economic infrastructure projects/programs and environmental protection
projects, normally in forms of concessional loans.
+ Technical Assistance: ODA is provided for preparing loan projects,
capacity strengthening, studies for economic and social development,
institutional reform, etc, normally in forms of grants.
- Classification in terms of funding
+ ODA without binding provisions: the recipient is not bound by any
provisions proposed by the donor.
+ ODA with binding provisions: the recipient has to accept some binding
provisions such as: purchasing goods, hiring foreign experts and contractors
according to the designation of the donor or using money only for some given
purposes regulated by the donor, etc.
+ Mixed ODA: of which one part attached with binding provisions and the
other part is free of binding provisions.
- Classification by implementing methods:
+ Project Assistance ODA: ODA is used for a specific project, which may be
a fundamental of technical assistance, grant, or concessional loan.
+ Non-project Assistance ODA: ODA which does not couple with a specific
project. It may be used to assist the balance of payment or paying Government
debt, etc.
+ Program Assistance ODA: ODA which is used for a general objective in a
given period of time. It often associates with many specific projects of a general
program (e.g. hunger eradication and poverty reduction programs of a country
are often implemented with many different projects in many different regions).

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This form of ODA was particularly focused on from 1990s and applied to
countries that have been using ODA capital effectively.
- Classification by donors:
+ Bilateral ODA: ODA which is sponsored by a government for another one.
+ Multilateral ODA: ODA which is co-sponsored by many governments for
another one directly or through international financial organizations.
+ ODA of Non-Governmental Organizations: ODA which is provided by the
International Red Cross, the International Red Crescent Moon, and the Green
Peace Organization, etc.
6.2.4. Roles of ODA loan
6.2.4.1. For donors
ODA provision of mainly developed countries helps them fulfill a series of
important purposes, in which the most outstanding are political, socio-economic
and humanitarian purposes.
a) Political purposes
All nations wish to uphold their prestige, impact and political position in
the international arena in general and in each country in particular; as well as to
prevent or reduce the political impact of other countries. There are many ways to
fulfill such purposes, including ODA aid which is one of the most effective
solutions.
b) Economic purposes
ODA assistance does not aim at direct profit, including ODA loan with
interests. In other words, interest is not the ultimate purpose of donors.
However, thanks to ODA loan, the technical infrastructure , legislative framework
and management capacity of the state mechanism of recipients are improved,
facilitating to promote potentials and strengths to develop economies of such
nations and to create favorable conditions to establish a good market for
investment and consumption of goods and products of donors.
c) Social – humanitarian purposes
Every year, a large amount of non-refundable ODA loan from international
organizations and some developed countries, especially North European
countries, supports social – humanitarian programs such as poverty elimination,
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illiteracy eradication, social epidemic prevention (HIV, H5N1, SARS, etc) and
global climate change prevention, etc. Thanks to that, the natural environment is
increasingly improved and many global dangerous diseases are successfully
repelled.
6.2.4.2. For recipients
Recipients of ODA loan are mainly poor and developing countries. Due to
different subjective and objective reasons, economies and living standards of
such countries are at low levels although such countries may have certain
potentials and strengths. Concretely, ODA helps recipients to:
- Recover emergency difficulties caused by natural disasters or epidemics.
- Provide large amount of capital to develop the technical infrastructure
network for the economy.
- Act as a critical resource to launch social- humanitarian programs such as
poverty elimination, illiteracy eradication and epidemic prevention, etc
- Facilitate to develop and perfect the legislative framework system;
support to improve capacity-building and management qualification of officials.
6.2.5. The process of mobilization, management and use of ODA
Mobilization, management and utilization of ODA are implemented in a
very stringent process in compliance with related laws and regulations of
recipients as well as donors. Apart from some differences due to specific
characteristics in the economic and political system of each country, this process
is nearly similar among ODA recipients. The following part examines and takes
the general mechanism and process of mobilizing, managing and utilizing ODA in
Vietnam as an example for reference.
(1) Lists of priority projects for ODA mobilization: Before the fourth quarter
of each year, ministries, central agencies, People’s Committees of provinces and
centrally managed cities (hereafter jointly called Line Agencies - LAs) submit to
the Ministry of Planning and Investment (MPI) lists of priority projects for ODA
mobilization together with proposed project outlines. The outline should
describe the project’s rationale, its relevance to the master plan, its objectives,
expected outputs, main activities, implementation schedule, and budget estimate
including ODA fund and counterpart fund, proposed internal financial mechanism

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for ODA utilization (state budget grant or on-lending modalities), economic
benefits, social and environmental impacts.
The MPI shall take the lead, in coordination with other appropriate
authorities and government’s agencies, in reviewing lists of priority ODA
projects submitted and consolidating them into one list only for the purpose of
ODA mobilization at the annual Consulting Group (CG) meeting.
(2) ODA mobilization: ODA mobilization is conducted in forums such as CG
meetings, sector assistance coordination meetings, and external relation
activities by ministries, provinces, cities and diplomatic missions;
The MPI is a focal point agency of the government in preparation for CG
meetings that are chaired by the World Bank and the government;
Concerned authorities and agencies shall take the lead in organizing and
preparing for sector assistance coordination meetings, in collaboration with the
co-chairmanship of the MPI;
Local authorities participate directly in mobilizing ODA in consultation
with the MPI to ensure that ODA mobilization is consistent with socio-economic
development strategy, public investment plans of the government and in
consideration of prioritized areas and sectors of provinces as well as the policy
and strength of donors.
(3) Negotiation and Announcement of Framework International Treaties
on ODA: The MPI shall take the lead in coordination with other related authorities
and agencies to prepare a list of ODA projects for respective donors and submit
them to the Prime Minister for consideration and approval, to prepare the
content of framework agreements on ODA and to negotiate with respective
donors such framework agreements (protocols, memorandum of understanding,
diplomatic notes on funding commitments for ODA for each specific fiscal year or
project). If the draft framework agreement on ODA contains provisions which are
different from existing laws and regulations of Vietnam, the MPI shall seek
written comments from related authorities and relevant agencies and submit a
report to the Prime Minister for consideration and decision. Following the
signing of the framework agreement, the MPI informs LAs by submitting a list of
projects which donors agree to finance so that beneficiaries can make necessary
preparations. For ODA projects, which are not in the plan or the framework
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agreements, the MPI shall take the lead in coordination with other related
authorities and relevant agencies in submitting proposals to the government for
consideration and approval of such projects.
(4) Preparation of the ODA Project Document: After the MPI officially
notifies the list of ODA projects and programs, which is approved by the Prime
Minister and financed by donors, the LAs shall establish Project Preparation Units
(PPUs). The PPUs draft a plan for the ODA project and program preparation,
which is submitted to the LAs for approval. The PPUs will be a focal point, in
coordination with local agencies and donors to prepare pre-feasibility study (if
the project belongs to group A), feasibility study for investment projects and
programs, or project documents for technical assistance projects.
(5) Appraisal and Approval of the contents of ODA projects and programs:
The MPI shall take the lead in appraising projects, which are under approving
responsibility of the Prime Minister. The LAs shall authorize their relevant
departments to appraise projects, which are under approving responsibility of
the LAs. The MPI notifies donors of the approval of ODA projects and programs
by the competent authority. Upon the agreement of donors, the MPI notifies the
LAs to prepare to negotiate specific project agreements.
(6) Negotiation, signing and approval of Specific International Treaties on
ODA projects: The LAs shall be authorized to take the lead, in coordination with
relevant agencies, to negotiate grant project agreements. The Ministry of Finance
shall be authorized to take the lead, in coordination with relevant agencies, to
negotiate loan project agreements (except agreements with the WB, IMF and
ADB). The State Bank of Vietnam shall be authorized to take the lead, in
coordination with relevant agencies, in negotiating project agreements with the
WB, IMF and ADB. If necessary or required by donors, the Prime Minister will
assign an appropriate agency on behalf of the Government or request the
President to authorize an appropriate agency on behalf of the State to take the
lead in negotiating project agreements.
For grant ODA projects and programs which are subject to be approved by
the head of LAs, upon receipt of written comments from relevant agencies, the
head of the agency that chairs the negotiation will be authorized by the

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Government to sign project agreements with donors (except the WB, IMF, ADB
with which the SBV shall sign project agreements).
For ODA projects and programs which are subject to be approved by the
Prime Minister, upon receipt of written comments from relevant agencies, the
agency that chairs the negotiation will submit negotiation outcomes to the Prime
Minister for approval and appointment of a Government’s representative to sign
project agreements with donors.
(7) Implementation of ODA projects and programs: this is the step of
realizing specific agreements on ODA projects on specific projects and programs.
It is extremely meaningful to ensure the implementation as well as the
effectiveness of ODA projects. Project owners have to set up ODA project
management units with legal status to implement projects in conformity with
laws and specific agreements on ODA.
(8) Supervision, evaluation, acceptance, payment and handover of ODA
project results.
This is an important step to be regularly and periodically implemented to analyze
and compare obtained results with set targets in the project’s instruments; to
check and inspect the ODA reception, management and utilization; to launch the
acceptance, payment and handover of results and to put the program/project
into operation in practice.
(9) Management of ODA.
- For non-refundable ODA. Although such aid has no repayment obligation,
close management should be applied. In case of cash aid, it should be converted
into domestic currency and credited in the State budget to balance the State
budget. In case of in-kind aid which is allowed to sell, the Government may sell,
take processes and credit to the State budget. In case of in-kind aid which is not
allowed to sell, deliverables must be handed over to the recipient to use, then the
Government shall convert into money and include in the receipt and payment of
the State budget.
- For concessional ODA loan.
+ For loans to be entered to balance the State budget. When the loan is
made, the State budget shall be credited. When due date arrives, the State budget

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may be directly debited to pay (through the State treasury) or transfer to the
national debt payment fund for payment.
+ For loans offered to projects, depending on each case that a proper
management plan may be applied.
Governments often establish independent debt management agencies and
National Debt Fund to actively pay the due debts.
6.3. MANAGEMENT OF FOREIGN LOAN, DEBT AND DEBT CRISIS
6.3.1. Management of foreign loan and debt.
6.3.1.1. Concept of objectives of foreign loan and debt management
The foreign loan and debt management is defined to be a process including
activities concerning preparation, organization and implementation of borrowing
and repayment of subjects to satisfy certain objectives in each period.
The foreign loan and debt management aims at fulfilling two basic objectives,
concretely:
- To satisfy requirements on capital mobilization for economic sectors with
the lowest costs and certain risk levels.
-To ensure effective loan allocation and utilization and out-performance of
loan repayment obligations as committed.
6.3.1.2. Evaluation of a nation’s foreign debt level.
These criteria released by the World Bank are often referred to evaluating
the foreign debt level of each country.
- The 1st criteria: Total foreign debt against GDP
- The 2nd criteria: Total foreign debt against export turnover (goods &
services).
- The 3rd criteria: Foreign debt payment expenses (due annual principal
and interest) against export turnover (goods and services.)
- The 4th criteria: Foreign debt payment expenses against GDP.
- The 5th criteria: Foreign debt payment expenses against export turnover
(goods & services).

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 Table 6.1. Indicators for sustainable level of foreign debt

Criteria Normal Difficult Severe

Percent (%) of total foreign
≤ 30% 30-50% ≥ 50%
debt against GDP
Percent (%) of total foreign
debt against export turnover of ≤ 165% 265-200% ≥ 200%
goods and services
Percent (%) of debt payment
obligations against export ≤ 18% 18-30% ≥ 30%
turnover of goods and services
Percent (%) of debt payment
≤ 2% 2– 4% ≥ 4%
obligations against GDP
Percent (%) of interest
payment obligations against
≤ 12% 12 – 20% ≥ 20%
export turnover of goods and
services
Source: World Bank
6.3.1.3. Contents of foreign loan and debt management
a) Macro-management of foreign loan and debt.
In the macro scope, governments should ensure that both scale and level of
their foreign debt increasing level must be basically maintained in sustainable
level which may be payable in all circumstances meanwhile, risk objectives or
expenses enclosed with loans are successfully maintained.
In order to effectively manage the nation’s foreign debt, following tasks
must be fulfilled by the Government.
- To perfect the legislative system of foreign loan and debt:
+ To focus on preparation of foreign loan and debt management plan and
strategy because such strategy is always regarded as a standard framework to
orient foreign loan and debt activities from time to time.
+ To implement the prudent management policy, ensuring debt ratio
within the safety limit and strengthening foreign debt risk management through
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modeling the risk management, developing the debt safety indicator; To actively
take risk precautions to maintain the debt limit within the safety limit; To
improve financial relations in the international financial market to be able to
minimize risk.
- To enhance the effective management of foreign loan utilization.
+ To ensure capital allocation and foreign loan utilization in accordance
with committed purposes.
+ To raise the high sense of responsibility of capital users.
+ To strengthen the project monitoring and evaluation.
- To regularly evaluate the debt sustainability (evaluating domestic and
international environment development; forecasting on debt mobilization trends;
analyzing and determining risks) to develop new loan strategy and plan. To
regularly analyze the debt list to evaluate risks (evaluating term structure,
interest rate, currency and related risks) to take re-structure measures as
necessary.
- To establish an “accumulative fund” to pay the country’s public debts. The
fund is accumulated from all collections of the Government’s refinancing
programs, fees for Government-guaranteed loans, interests from banking
deposits and other sources. It ensures the payment for the country’s public debt
obligations.
- To actively make due payments for the Governmental debt, contributing
to debt solvency of private sector.
In case the government’s loan cannot be paid on the due date, the
Government may negotiate with creditors or propose to settle in Paris Club to
obtain debt rescheduling, delaying, freezing, refinancing, debt buy-back, debt for
equity swap, debt cancellation and insolvency in case of force majeure. For loans
guaranteed by the Government, if enterprises have difficulties in paying foreign
debts, following solutions may be applied by the Government:
+Paying for debt under the name of guarantor: swapping private debt into
Governmental debt.
+ Using financial measures to support such as preferential loan, temporary
acquisition of shares from such enterprises, etc.

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 Moreover, it is required to focus on communication, propaganda and
regular information provision to the society regarding debt management,
improving the society's supervision efficiency.
b) Micro-management of international loan and debt
Micro-management of international loan and debt is to ensure to timely
and completely satisfy the capital demand with proper costs and the use of loans
effectively; and to make a full due debt payment. Therefore, following contents
must be fulfilled:
- Borrowers of foreign loans must specify the loan volume, loan interest,
functional currency, term and debt payment period accurately to be matched
with the capital absorption capacity, ensuring capital utilization efficiency to
make a full and due debt payment.
- Economic entities shall be responsible for their legal capacity, financial
capacity and capacity to implement the International Loan Agreement.
Such entities must be completely responsible for fulfilling the international
loan and repayment procedures. The foreign debt management must be launched
right from the loan planning, starting from project and loan efficiency appraisal
phase for each loan and project. It is required to manage effectively loan
utilization, to quickly launch payback and to make due payments for loans.
- The foreign loan borrowing and repayment activity must be subject to
the supervision of the State competent agencies of the local country.
The foreign loans of private sector are often put under the direct
management and supervision of the competent agency through following
decisions:
+ Loans with right purposes.
+ Total loan (outstanding debts) within the regulated loan limit.
+ Compliance to regulations on foreign currency management, collateral or
deposit for loans as stipulated by laws.
+ Adherence to the periodic reporting regulation on the international debt
information or as per request of the management agency.

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6.3.2. External debt crisis (Foreign debt crisis)
External debt crisis refers to a fact that countries make external debts but
lose solvency, or in other words, it is a situation where external debts of
countries are not repaid .
6.3.2.1. Causes of external debt crisis
There are many causes of external debt crisis. It may be divided into two
basic cause groups as follows.
a) Subjective causes
- Too high foreign loan. The Government and other entities of such country
have made too many loans against their capital absorption capacity, capacity to
create growth and foreign currencies in the future and their future debt payment
capacity.
- Ineffective use of loans. Borrowers fail to make prudent use of borrowed
resources; such as wasteful government spending, undertaking low economic
priority development projects, and poor implementation of foreign aided
projects. Besides, borrowers fail to develop the effective loan utilization
supervision mechanism, resulting in loss and waste of international loans.
b) Objective causes
Objective causes include global economic shocks and economic policies in
many borrowing countries, resulting in crises .
- Global economic shocks
One of determining causes of debt crises in history is rising oil prices,
reducing income from export of debtors, and sharp increases in foreign loan
interest, making debtors fall into a difficult situation where debt solvency is
hardly available.
- Macro-economic policies in developed countries also create a very
significant impact on external debt crisis in developing countries.
6.3.2.2. Solutions to prevent external debt crisis
 Under the perspective of borrowers
- When borrowing

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 + Borrowers must develop a proper foreign borrowing strategy,
thoroughly considering loan volume and paying attention to safe loan limit to
avoid excessive loans to handle the short-term capital inadequacy without
calculating subsequent debt burdens.
+ Borrowers also need to improve their credit rating (including
government, enterprises, and individuals) to be able to mobilize the foreign loan
with low interest rate in an ease and effective manner.
+ The concerned government must apply mechanism and measures to
manage and supervise foreign loans of borrowers to guarantee the nation's
foreign loan security.
- During loan utilization
+ To ensure the loan is used in right purposes effectively. This target is
very important and essential for each borrower as well as each concerned nation.
+ The borrower must apply an effective monitoring mechanism for foreign
loans from grassroots to government level. The foreign loan and debt
supervision, inspection and reporting mechanism of each entity as well as the
foreign debt management level must be transparent, clear, specifically assigned
and decentralized to avoid misuse, resulting in capital loss.
+ Loan repayment. Together with the preparation of foreign loan strategy,
loan repayment resource must be planned to ensure the solvency when debts are
on due date.
+ Income of the entity is ensured not to be lost; correct and complete
income must be available to improve the foreign loan repayment, especially
foreign currency income. All measures should be worked out to increase the
income for the State budget and foreign loan repayment capacity by Governments
of concerned nations.
+ Application of trade barriers and monetary dumping.
In order to obtain a more favorable trade balance, Governments of
developing countries may apply barriers for importing activities or intervene in
the foreign currency market to undercut the domestic value. The first solution
often causes losses on local production performance and reprisals from
Governments of other countries. Meanwhile the latter may offer a better trade

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balance, but it may make the foreign debt payment “more expensive” whereas
loans are calculated in foreign currencies. Another important thing is that, the
competitive dumping shall face with reactions of other nations, and a series of
side effects may threaten the stability and security of the domestic economy .
 Under the perspective of foreign lenders
Under the light of the lender’s benefits, in order to avoid losses and risks
before a debt crisis, following tasks are required to be launched:
- Thoroughly considering and calculating when loan is determined for each
international loan entity.
The loan must be based on the credit rating of the borrower as well as his
solvency. A periodic supervision and inspection of capital utilization must be
launched to ensure the capital utilization efficiency. For concessional loans, a close
supervision and cooperation of two parties should be strengthened in each lending
and capital disbursement cycle.
- Selling debts of developing countries
In a debt crisis, many commercial banks try to minimize losses caused by
loans offered to entities in developing countries by swapping loans of such
entities to obtain a more diversified mixture (to minimize their losses on events
happened in each developing country).
- Strengthening provision for loan loss
Provision for loan loss is a component of debt items which is considered to
be bank capital. That means, it is not completely related to the provision for
assets in the Balance Sheet as what its name is referred to.
Making provision for loan loss before being writing off is much better if
loss is allowed in case it has sufficient income to realize that. Such method is
better instead of waiting till a bank facing with actual losses (caused by bad
debts) and in this case, the income may be too low to write off.
- Conversing debt to equity
A debt conversion to equity is also referred to as a debt-equity swap. A
debt-equity swap allows a borrower to convert loan amounts into shares of
equity. In other words, a lender, such as a bank or an insurance company,

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becomes a shareholder after a debt to equity conversion process. Accordingly,
debt volume of borrowers in developing countries will be reduced.
6.3.2.3. Foreign debt settlement through Paris Club and London Club
- Paris Club
In a complex context of foreign debt settlement issues, Paris Club was
established in 1956 to negotiate and settle foreign debts with debtors as the
Government. The Club’s official member list is unavailable. Members of the Club
are determined case by case, for example representatives of international
financial institutions involved with creditors. A new Secretary Team was
established in 1974 in the Ministry of Finance of France to cover administrative
procedures. Such Secretary Team consisted of four persons who worked for the
State Treasury of France. When claims were submitted to convene a meeting by
countries, such team would convene and organize negotiation activities.
In order to negotiate debts, creditors, debtors and international
organizations must participate in right from the paramilitary meeting session.
Although official principles are not available, non-official rules and procedures
are also set out such as: Debtors must provide evidences on insolvency;
conditional principles; equality principles; burden sharing principles and
principles on some confidential elements of each creditor towards debtors, etc.
Contents of negotiation process often include: Determination of debts to be
settled; debt payment conditions; and debts to be written off; etc.
- London Club
London Club was established in 1986 as initiated by some British
commercial banks with the purpose of settling commercial debts with creditors
of commercial banks after the debt crisis happened in countries in Latin America.
London Club has no fixed head quarter, Chairman or Standing Secretary Board.
Creditors often elect the Banking Advisory Committee including members of the
largest creditors, acting on behalf of creditors to negotiate with borrowing
countries.
Unlike the Governmental debt settlement through Paris Club, negotiating
with creditors as foreign private banks through London Club is extremely difficult
and complicated, which often lasts for 2-3 years to reach a principle agreement.

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 Although different approaches were applied for foreign debts, thanks to
great efforts of Paris Club and London Club, many nations successfully escaped
insolvency and approached the economic recovery and development./.

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 Chapter 7

THE INTERNATIONAL UNION OF TAXATION

7.1. INTERNATIONAL UNION OF TAX: GENERAL KNOWLEDGE

7.1.1. Concept
Along with the development of international trade, international
investment has appeared and developed rapidly. In international investment,
investors transfer resources and capitals from their countries to other economies
with the aim to maximizing profits. With this operation, the taxation regime of
countries significantly impacts the performance of investments (capital transfer)
and the transfer of incomes as well as profits back to the home country, which in
many cases becomes barriers to investors.
Therefore, in order to smooth the international trade, international
investment, as well as a range of other international economic relations
(international credit, international travel, international labor cooperation ...),
countries should make a deal or an agreement so that impacts on their tax
regimes are reduced, controlled effectively, and even vanished to not create
above barriers. These are activities of the international union of taxation.
Thus, that the international union of taxation is defined as a commitment
of two or more nations to create reasonable tax arrangements on exchanged
products, services, capitals and incomes that ensure economic relations of
countries to be run smoothly, following ordinary principles of the international
economic cooperation.
7.1.2. Principles and rules on imposing taxes on international economic relations
As mentioned above, while tax itself is a national issue, the taxation union
takes place among nations, hence it is international. However, despite its national
characteristic, countries may apply different taxation regimes, typically forming

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two kinds of taxes: direct taxes and indirect taxes with four principles which are
popular all over the world.
Origin Principle – OP: The content of this principle is that commodities
(goods, services, currency flows…) should be taxed on the basis of their place of
production, regardless of where they are consumed. Thus, based on the principle,
the producer of goods and services is the one who has to pay tax to the
government. This is known as tax on production. Applying this principle is quite
convenient for the government as these producing manufacturers often have
fixed locations, which make it easier to control and supervise. The Vietnamese
taxation regime, the resource utility tax and the export tax in Vietnam and other
countries are mostly conducted based on the OP.
Destination Principle – DP: According to this principle, commodities are
taxed in the country of destination (that is, where they are consumed), regardless
of where they are produced. This principle is applied widely in economic markets
as all products, regardless of their “input” or “output” characteristics, are
exchanged and sold in the market. It can be said that almost indirect taxes, such
as value added tax (VAT), special consumption tax, export tax...are in compliance
with the DP.
Residence Principle – RP:The concept of the principle is that tax is levied on
incomes of residents. This principle is mostly applied for income taxes (the
commodity is the income). Normally, residence laws of each country will regulate
whether organizations or individuals are residents or nonresidents (being
considered as “residents” is common with the time of living and doing business
continuously over 12 months, especially, there are some countries which regulate
a shorter time of 6 months). Legal entities and any residents of the area with any
earnings formed in the residence country, will be taxed. Nowadays, in almost
countries, corporate income tax and personal tax virtually follow the RP.
Resource Principle – RSP: According to this principle, commodities which
are incomes, regardless of their origins, will be taxed. Tax regulations applying
this principle will be basically similar to the ones applying the RP.
Each country can fully apply these four principles of taxation. However, to
ensure consistency, only one principle should be applied. Nevertheless, as
countries all apply principles of taxation, taxed objectives which are transferred
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among countries will be levied a double taxation (for example, an exporting
country applies the OP to export products, but when it imports from others, the
DP will be levied...). This will distort prices, create inequity and limit international
trade as well as other international economic relations.
7.2.2. Regulations on dealing with international economic relations
Equality is the most basic principles in international economic relations.
Hence, in order to ensure equality in international relations as well as
international economic relations, there are two kinds of rules, namely national
treatment and international treatment rules.
- Non-discrimination principle: National Treatment – NT
This regulation ensures national territories to have fair treatment and
approach equality as well as non-discrimination between domestic factors and
exotic elements of taxes, charges, fees and rates ... for example, prices of goods
and services sold to domestic citizens and foreign visitors must be the same;
taxes, fees and charges levied on either domestic products or imported goods are
similar.
The non-discrimination principle is not only applied to this organization,
but also applied to many other regional trade agreements as well as bilateral
trade agreements. The non-discrimination principle is reflected in two major
mechanisms, which are known as the Most Favoured Nation (MFN) treatment
and the National treatment (NT)
Most Favoured Nation – MFN. This regulation ensures equality among
nations in international economic relations. A nation with the MFN treatment will
be granted all priorities of taxes, fees, charges and prices no less than privileges
to any other third countries. However, there are several exceptions to this rule
regarding to treatments provided in the regional trade agreement, the general
system of preferential tariff and the general system of preference.
The NT rule states that there must be no discrimination between imported
goods and domestically produced goods in taxes, fees and other treatments. With
regard to tariff, this rule requires that there should be no discrimination in tariff
treatments on goods originating from different countries.

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 General Preferential System – GPS or Generalized System of Preference –
GSP. This is a system of exemption from the MFN principle. When countries apply
the MFN principle, under some special conditions, they may also be entitled the
GPS which brings better preferences in comparison with applying only the MFN.
For instance, all WTO member countries are entitled to the MGN principle,
but if members are developing countries, they will be entitled to the additional
GPS.
7.1.3. Forms of the international union of taxation
Considering the number of partners, there are two types of the international
union of taxation, known as bilateral and multilateral alliances.
Bilateral alliance is an agreement on international union by governments
of two countries. Common form of this alliance is a bilateral agreement signed
between governments of two countries, which is only applied to these two
countries. For example, The US - Vietnam Bilateral Trade Agreement signed in
2000 is considered as a bilateral taxation alliance.
Multilateral alliance is an agreement on international union by
governments of many countries. In this case, commitment is conducted through
multilateral agreements, particularly the agreement of international
organizations. When a nation signs a treaty to join an international organization,
it also commits to abide by the international union of taxation. Some typical
agreements of multilateral alliances are General Agreement of Tariff and Trade -
GATT 1947, WTO 1994, Common Effective Preferential Tariff – CEPT to establish
AFTA in 1992.
Considering the tax, there are two major alliances, namely customs union
and double taxation avoidance union.
Customs Union is an agreement among countries in the union to remove
trade barriers, and reduce or eliminate customs duty on mutual trade. In fact,
although tariffs include export and import taxes, customs union is almost about
import tax.
Double taxation avoidance union is an agreement not to double taxes on
the cash flow, mainly capital incomes moving around countries in the union. The

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avoidance of double taxation is applied to many different types of taxes, mainly to
corporate income and personal income taxes.
7.2. CUSTOM UNION
7.2.1. Tariff
7.2.1.1.Overview of tariff
Tariff is defined as a type of tax imposed on goods or services at the border
when such goods and services are moved in or out of a country.
Tariff is developed not only for the purpose of collecting revenue for the
State budget but also as a means of controlling the movement of goods from
outside to the domestic market. Therefore, tariff has been used by governments
of many countries as an effective method to protect the domestic economy.
In parallel with import activities, there are exporting good and service
activities. Governments impose taxes on the exportation of goods and services.
Therefore, it can be said that tariff consists of export duty and import tariff.
Recently, due to requirements of the international economic integration,
the level of tariff has been gradually reduced or removed. Many countries have
removed export duty or kept it at a very low level.
- Most countries highly focus on the development of exports. Therefore,
there is a need to strengthen the competitiveness level of exported goods.
- Both export and import duties are all imposed on consumption, therefore,
the amount of tax paid is added to the selling price of goods and services charged
to consumers. There are two popular methods of imposing taxes on consumption.
The first one is to impose tax based on origin- principle and the other method is
based on destination- principle. Most countries apply destination principle and
therefore they do not impose duty on export goods.
Therefore, import tariff plays a dominant role over export tariff. As a
result, many people think that tariff is limited to only import duty. However, in
this chapter, we do not take this view, but use reality to discuss about tariff, and
we focus mainly on import tariff. Hence, when discussing about tariff in this
chapter, it is mainly on import tariff.

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7.2.1.2. Types of tariffs
Based on purposes and methods of imposing tariff, it can be classified as
follows:
Based on methods of imposing tariff, it can be divided into:
a. Ad- valorem tariff: An ad valorem tariff rate is expressed as a percentage
of the value of the imported good.
b. Specific tariff: A specific tariff specifies the amount of money a resident
must pay to the government on each physical unit of the imported good
c. Mixed tariff: A mixed tariff is a combination of ad valorem tariff and
specific tariff. For example, an importer has a car, which is subject to a specific tax
of 1000 US dollars per unit and an ad valorem tariff rate of 1% based on the value
of the car.
From collecting revenue for the State budget perspective, there is not much
difference in applying between an ad valorem tariff and a specific tariff. However,
from social- economic senses, there are some important differences between
these two methods of imposing tariff. These differences are summarized as
follows:
- For certain categories of goods, which consist of different types and
prices of goods, applying an ad valorem tariff is more equitable than using a
specific tariff
- The level of protection when an ad valorem tariff is used moves in the
same direction with the movement of price; and they move in opposite directions
when a specific tariff is used. In a period of high inflationary pressure (an
increase in the price level), the burden of a specific tariff decreases and in the
deflation period (a price decrease), the burden of a specific tariff increases.
Therefore, there are complaints from producers that the level of protection is
"eroded" when a specific tariff is used.
- From administrative perspective, applying a specific tariff is simpler. A
specific tariff is independent of the movement of the price of imported goods.
Based on purposes of imposing tariff
Tariff has the following major roles:

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 - Tariff for the purpose of fiscal collection: The major role of tariff is to
create revenue for the state budget. When a tariff is designed for this purpose, it
has characteristics of a consumption tax imposed on imported goods, (goods are
not domestically produced), in which the importation of such goods is not
encouraged due to economic or social reasons, such as spirits, beers, and
cigarettes. People sometimes call it a consumption-tariff or balancing-tariff.
- Protection tariff: This type of tariff is mainly used to protect the domestic
production, which is known as "infant industries". A protection tariff is applied in
the following cases:
* Limiting the importation of goods which exceeds the quota. This is
accomplished by imposing a very high tariff on the amount of goods which
exceeds the quota.
* Discriminating the importation of goods based on means of
transportation by designing different types of tariffs.
- Negotiation tariff: This type of tariff is determined based on the level,
which is needed to protect domestic industries. This is also a means of bargaining
when negotiating trade issues with other countries.
- Penalizing tariff: This type of tariff is applied when there is a need to take
a counter measure to deal with the discrimination of tariff treatments of
importing countries; or when there is a price dumping or a subsidy provided by
the government of exporting countries. Penalizing tariff is often set at a very high
level. Therefore, applying penalizing tariff may lead to "trade disputes" among
countries.
In addition to those mentioned types of tariffs, during the current process
of economic integration, depending on the degree of trade relation among
countries, different types of special preference tariffs are also used by many
countries. These types of tariffs are distinguished by the level of tariff rates.
7.2.1.3. Analyzing impacts of tariffs
Effects of a tariff imposed by the government of a “small open economy”
In international trade theory, we define a “small open economy” as a
trading economy in which export and import activities of any products take a
very small part of the total world trade. As a result, that economy has no effect on

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the international price. When a small economy introduces tariffs, what will be
impacts on that economy? We could consider the impact of tariffs on price levels
and the performance of the economy by the following figure.

Assume that there is a country and goods X produced by that country

account for only a very small share of the total world trade in those goods. S is the
supply curve. D is the domestic demand curve for these goods. If the economy is
closed, the market will be in equilibrium at point E, which is at price P 0 and
output Q0.
Meanwhile, the world price for these goods (CIF price) is P w. This price is
much lower than P0.
At the price Pw, domestic supply is very small. Q sis lower than Q0. On the
other hand, demand for QD is higher than for Q0. In this economy, there is a
shortage of output of (QD - Qs). This is the amount which needs to be imported.
When the economy is fully opened, the amount of shortage goods will be
compensated by imports and the economy will move to the equilibrium point F,
which is at the price Pw and output level QD.
When the Government imposes import duty (t), the price will increase
from Pw toPt = Pw + t. Therefore, the demand will be Q Dt, which is smaller than QD,
but the domestic supply increases to Qst, which is greater than Qs*.
As can been seen from the Figure, impacts of import tariff can be analyzed
as follows:

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 - For the consumer: The level of consumption of goods X will decrease from
QD to QDt. The amount of reduction is QD - QDt. This is the impact on consumption
tariff.
- For the producer: The level of domestic output increases from Q s to Qst due
to the increase in prices of goods X from P w to Pt. When the level of output for
goods X is expanded, more domestic resources will be shifted into the production
of goods X (which is protected by the tariff). This is known as protection impacts
on tariff.
- For trade: Tariff will reduce the amount of imported goods from (Q D - Qs)
to (QDt - Qst). This is called trade impacts on tariff.
When the level of tariff is high enough, making the price of goods X when
importing to the domestic market being sold at price P0, the volume of imports
will equal to zero and this is known as a "prohibited tariff". Applying a prohibited
tariff will bring the economy to the stage of "self production and consumption".
This is equivalent to import prohibition.
- For collecting revenue for the State budget: Tariffs will create revenues for
the State budget. The amount of revenue collection is T = t x (Q Dt - Qst). When a
prohibited tariff is applied, the amount of revenue collection is 0.
- From redistribution aspects: When a tariff is used, a part of the consumer
surplus will transfer to the producer. The additional amount of money that
consumers have to pay is equivalent to the sum of areas: (1), (2), (3) illustrated
in the Figure. The reduction in consumer surplus is the areas (1) + (2) + (3) + (4).
A part of this will lead to an increase in the amount of revenue collection for the
State budget (3) = T; another part will result in an increase in the income of the
producer (1), which is known as additional producer surplus (T s = t x (Qs +
Qst)/2; a part of this (2) is the loss to the society from the production of goods X
instead of the importation of these goods at the world price (this is called
protection expense)
Tbh = t (Qst - Qs)/2; part of 4) is the dead weight loss (loss to the society).
Loss to the society from the imposition of import tariff consists of areas (2) and
(4).
Above analysis illustrates impacts of import tariff imposed on goods which
are protected, in the economy on following aspects:
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 - Tariff makes the relative price of goods subject to such tariff in a small
economy increase.
- Resources of the small economy are shifted to sectors which are
protected by tariffs
- Levels of domestic consumption decrease. The reduction occurs not only
with imported goods but also with the same goods produced domestically.
Therefore, there is an increase in the price of imported goods and locally
produced goods.
- There is an increase in the revenue collection for the state budget.
- Producers produce goods which are subject to tariffs shall enjoy an
increase in the price of goods;
- There is a reduction in the amount of consumer surplus available to
consumers due to the higher amount of money that consumers have to pay for
the goods;
Tariff will increase the volume of goods produced locally as the production
of such goods is protected. Resources shall be concentrated on the production of
goods which are protected, which in turn create employment and serve as the
"supporter" for a number of sectors in the economy which are required to be
protected by the tariff. However, there is also a waste of the society’s resources.
In addition, such tariffs create a "deadweight loss" and opportunities for
smuggling, corruption and bribery.
Effects of a tariff imposed by the government of a “large-open economy.”
A “large open economy” is a trading economy whose export and import
activities of any products play a substantial role in the total world trade in those
goods or a group of goods. As a result, that economy has effects on international
prices. When this economy imposes tariffs on the good Y, impacts of the
imposition of tariffs are illustrated in the following model:
When this large economy imposes import duty (t) on goods Y, the price
will be Pt = Pw - t and therefore, demand will be Q 1, which is smaller than Q 0. The
volume of exports is equal to Q1 x Pt which is less than Q0 x Pw.

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 Impacts of tariffs in this case are illustrated as follows:
- For the domestic consumer, there is no impact on the domestic consumer.
This is because the price of good Y in the market remains unchanged.
- For the domestic producer, there is no added benefit. The price of good Y
in the market does not change.
- For the importer (or the foreign exporter, foreign producer of imported
goods), there is a loss in the value of the surplus. The exporter has to export their
products at lower prices. The amount of goods exported to the large economy
decreases.
- For the foreign trade activity, the tariff reduces imported goods from
quantity Q0 to Q1. This is known as the international trade impact of the tariff.
- For the revenue collection for the state budget of the large economy, the
imposition of tariff has create a revenue of (T = t x Q1)
- As for income redistribution, the decrease in the value of surplus of the
foreign producer includes the area (1) + (2). A part of this will lead to an increase
in the amount of revenue collection (1) = T; and part (2) is a loss to the society
(which is also known as "deadweight loss)
7.2.1.4. Roles of tariff.
Tariff is one of the important tools to create revenues for the state budget in
developing countries

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 Developing countries have considered customs tariff as a very important
source of revenue for the government budget. This is derived from the following
facts:
- Collecting customs tariff has a very low cost in comparison with other
internal revenue sources. Customs tariffs are also relatively transparent.
- The revenue from customs tariff has accounted for a relative large
amount of the total revenue collection. Customs revenue is accounted for around
15% to 20% of total level of revenue collection.
For developed countries, the adoption of customs tariff is not only for
revenue collection but also industrial protection purposes. For example, in the
United State, the percentage of customs revenue in total government revenue is
1.56%. This number of the United Kingdom is 0.01%, for Italia is 0.21%, and for
Germany is 0.2%.
Customs tariff is an important instrument to protect domestic production.
For a long time, economists have believed that trade liberalization, along
with free competition is essential for an economy. However, in fact, it has been
shown that many of the so called "market economies" have maintained different
measures to protect certain domestic industries from the competition of foreign
goods. Rationales to adopt protection policy are as follows:
- In a "market economy", in addition to its merits, there are some market
failures, which cannot be corrected by the market itself. An example is the
inefficiency in the allocation of resources. Therefore, it is important to have the
government intervention through protection policy.
- "Infant" domestic industries should be protected by the Government
against the competition raised by foreign producers in other countries
throughout the world, which has been established for a long period of time. In
order to implement the trade protection policy, governments around the world
utilize the following instruments: quota; import license; foreign exchange control
and tariff.
The utilization of customs tariff for the purpose of domestic protection is
usually carried out by the following two measures:

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 -Reducing the tariff rate imposed on inputs, which are imported from other
countries;
-Increasing the tariff rates imposed on products, which can be produced
locally
This protection shall create advantages for domestic industries. It helps
domestic industries to improve the quality of products and to expand the scope of
business operation and hence, to attract more resources in the society. This also
helps to redistribute resources in the economy.
In comparison with other protection measures, such as quota, import
license, and foreign exchange control, the utilization of non-prohibitive tariff to
protect domestic industries has the following advantages:
- Tariff helps to create revenue for the state budget. This method is also
more transparent in comparison with quota. Quota system creates unfair
privileges for entities, which have access to the quota.
- Consumers have the right to select between imported goods, which are
imposed tariffs and locally produced goods. This will help to eliminate the
monopoly in the provision of goods (which may raise the price of goods in the
market).
Tariff plays an important role in the redistribution of income between
domestic producers and consumers
When tariff is introduced, prices of goods will increase. As a result, the
volume of imports decreases. In order to meet the domestic demand, domestic
producers will increase their production to substitute for imported goods. The
price of domestically produced goods will also increase to the tariff- inclusive
price level of imported goods. The value of consumer surplus decreases. A part of
the reduction in the value of consumer surplus is transferred to the State budget
and another part is moved to the production cost and the income of the producer.
7.2.2. Customs Union
7.2.2.1.Levels of tariff integration
* Preferential trade agreements
In order to facilitate for the movement of goods and investments, liberalize
trade and move towards economic integration, countries around the world need
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to gradually remove trade obstacles through trade policy. Currently, there are at
least five different types of trade policy, ranging from low to higher levels based
on the degree of integration.
* Preferential trade association
Two or more countries voluntarily provide tariff exemptions on goods
imported from each other. This creates a preferential trade association (the tariff
rate imposed on goods imported from countries outside the association remains
unchanged). Commonwealth countries proposed by the United Kingdom in 1932
are examples.
* Free trade area or association of free trade
Similar to the preferential trade association, in addition to the abolishment
of tariff, member countries also agree to remove quantity restrictions on goods
imported from other member countries (tariff rate and quantity restrictions may
still apply for goods imported from countries, which are not members of the free
trade area). Examples of free trade area are NAFTA, AFTA, ACAFTA, AIFTA and so
on.
 Customs union (tariff union)
Customs union is one type of trade preferential arrangements. The basic
idea of tariff union is that two or more countries have reached an agreement on:
removing or reducing tariff imposed on goods produced in one country when
exporting to others; and abolishing all quantitative restrictions. Member
countries also agree to develop a Common external tariff schedule to apply
consistently to goods imported from countries outside the union.
Similar to the free area, the difference is that member countries of the
customs union adopt Common external tariff schedule. This schedule is applied
uniformly to goods imported from countries outside the union.
* Common market
A common market is similar to a customs union. However, in the common
market, there is a free movement of factors of production, including capital and
labor among member countries.
* Economic union.

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 Economic union shares basic characteristics with the common market
model. The difference is that fiscal and monetary policies as well as other
economic and social policies are uniformly applied by member countries.
BENCLUX Union between Belgium, Holland, and Luxemburg in 1860 or EU at
present are examples of the economic union
7.2.2.2. Roles of customs union
Increasing the level of competition among enterprises within the union
When the tariff is abolished or reduced to the lowest level, this will
facilitate the movement of goods among member countries. This will create
competition pressures among producers of similar goods as the supply of the
goods is strengthened. This will change the market structure, remove monopoly
and oligopoly in production of a particular type of goods in the domestic market
as there is a competition from producers in other countries in the union. In order
to be survived and avoid being bankrupt, enterprises have to renovate
technology, improve management practices, reduce production costs and
improve business efficiency. As a result, the level of competitiveness of
enterprises will be strengthened, which then leads to an improvement in the
overall level of competitiveness of the economy.
In order to penetrate and be able to compete with goods produced by
countries in the tariff union and in the international market, enterprises located
in countries outside the union also have to improve their competitiveness. This
will improve the competitiveness level throughout the world.
Creating conditions to increase the level of revenue collection from internal
sources
Following the above part, the tariff union will make goods produced in the
union become cheaper. This will lead to an increase in the domestic consumption
within the union. The increase in the level of consumption then will result in an
increase in the production, expanding business operation to higher levels and
scopes. Business expansion will broaden revenue for the state budget in terms of
corporate income tax and personal income tax. On the other hand, an increase in
consumption level will also lead to an increase in the revenue collection from
indirect taxes. Therefore, although there is a decrease in the price of imported
goods and locally produced goods, the increase in consumption and the
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expansion of business operation lead to an increase in revenue in a sustainable
manner.
7.2.2.3. Tendency of trade emerged in customs union.
Prior to 1950s, there had been a believe that customs union is a very
important step in moving toward trade liberalization, which then help to improve
the efficiency in the allocation of international resources. However, since 1950s,
with the introduction of the Jacob Viner's theory on customs union, it has been
recognized that tariff union may create two contra dictionary trends, which are
trade creation and trade diversion and then the allocation of resource either
efficient or inefficient.
 Trade creation:
Customs union contributes to strengthen production capacity in an
efficient manner. This will is known as trade creation.
For example: Two countries A and B produce the same good X and there
are no trading activities between these two countries. When tariff union is
created and tariff is removed. Goods will move between two countries. Country A
when recognize that the good X in country B is cheaper as B can produce this
good at lower cost and there is no tariff imposed on goods X. The production of
goods X then will transfer to the country B and country A with the e production
capacity in producing goods X will shift to produce other goods, which is more
efficient. This will improve the allocation of the world resources and then lead to
the increase in world welfare.
 Trade diversion.
Custom union only lead to the increase in foreign relation, which is
inefficient between the member countries in the union.
For example: There are three countries. All these three countries produce
goods Y. Country A has the highest demand in consumption of goods Y while cost
of production Y of the country C is lowest. Country A imports goods Y from
country C. When Aan B forms a custom union and tariff on good Y is removed.
Consequently, the cost of goods Y from country B is cheaper than that imported
from country C, as there is no tariff. Therefore, customs union has made the
resource using for the production of goods Y transfer from country C, which

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produce the good Y with lowest cost, to country B (produce good Y at higher
cost). This is a trade diversion and lead to the inefficiency in the allocation of
world resources. In this case, the world wealth fare decreases.
7.2.3.Some customs unions that Vietnam participates in
7.2.3.1 Relations in tariff in the WTO
The General Agreement on Trade and Tariff was signed by the member
states in 1947. This Agreement had been in force since January 1, 1948 by 23
member countries participated in the La Habana Charter to promote trade and
create employment. In its 48 years of existence, GATT had conducted 9 trade
negotiation rounds and scope of GATT has expanded significantly. The coverage
of GATT has expanded to cover: from reducing tariff barriers to the removal of
non-tariff barriers, trade in services, intellectual property rights and trade
dispute resolutions. The average rate of tariff has reduced from 40% in 1948 to
4% in the developed countries and around 15% in the developing countries.
Based on the results from GATT and Uruguay Round, the member countries have
agreed to establish the World Trade Organization to promote international trade
and establish an international trade dispute settlement mechanism., which has
been take effect from January 1, 1995.
The World Trade Organization (WTO) is the only global international
organization dealing with trading rules among nations. The center of its heart are
WTO agreements, which are negotiated and signed by the bulk of the world’s
trading nations and ratified in their parliaments. The goal is to help producers of
goods and services, exporters, and importers conduct their businesses.
Vietnam is the 150th country acceding to this organization. The average
tariff level of developed countries in the WTO reduces to 3.8% and that for
developing countries is 12.2%. The multilateral trade system has been developed
from the concern of tariffs in trading goods, such as trade in services,
investments, intellectual property rights and dispute settlement mechanism
among member countries.
7.2.3.2. Tariff issues in ASEAN
ASEAN Free Trade Area (AFTA) was established in 1992 with an objective
to remove all tariff and non-tariff barriers among ASEAN countries. The main
mechanism in the establishment of the AFTA is the Common Effective
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Preferential Tariff (CEPT), in which member countries have agreed to reduce the
tariff level to 0-5% within 10 years. For the former Asean-6 countries, the
deadline is January 1, 2003, for Vietnam is January 2006 and for Laos, Cambodia,
Myanmar, the deadline for tariff removal is January 1, 2008. In addition, when a
good is brought into the coverage of the CEPT/AFTA and has the tariff rate of less
than 20%, all quantitative restrictions on the importation of such goods need to
be abolished and within 5 years, all other related non-tariff measures also need
to be removed. The reduction in the tariff of member countries is carried out
through four different lists:
- Inclusion List (IL): The Inclusion List includes goods, of which tariff rates
need to be reduced at the time of joining the AFTA.
- Temporary Exclusion List (TEL): This list includes goods of which tariff
rates are not readily to be reduced by member countries at the time of joining the
AFTA. The goods in this List are gradually transferred into the Inclusion list at a
pre-specified ratio every year. For Vietnam, the transfer period is from 1999 to
2003.
- Sensitive Exclusion List (SEL): This list includes agricultural products
which are sensitive to member countries of the ASEAN. The deadline for the tariff
removal on these goods is longer than goods included in the Temporary
Exclusion List. In the period from 2006 to 2013, Vietnam has to transfer all goods
which are in the Sensitive Exclusion List to the Inclusion List and reduce tariff
rates applied to such goods from 0% to 5%.
- General Exclusion List: This list includes goods which are not allowed to
receive a tariff reduction by member countries when participating in the AFTA.
Goods included in this list are things which are dangerous or potentially
dangerous to the society, or which are harmful to the society, health of people,
animals and culture...
7.3 THE INTERNATIONAL UNION FOR THE AVOIDANCE OF DOUBLE TAXATION

7.3.1. Concept of double taxation

One of the principal requirements in ensuring transparency in economy and
equity of taxation is that an income should only be taxed once. In all countries, it
is necessary to have a mechanism for efficiently calculating taxation so that a

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company’s income is taxed only once time in a country. In fact, many countries do
not consider the taxation of income already taxed in other countries; thus, this
income is taxed twice. This action increases the burden on multinational
businesses.
Tax collection in each country is based on two basic privileges, which are
rights of residents in a country and rights of income generated within a country.
These two privileges create four popular taxation principles as mentioned above
and lead to double taxation as tax payers may live in a country but their incomes
are generated in others.
Therefore, double taxation is when two countries (territories) or more
apply a tax with different taxation principles, resulting in a taxable object (income
or property) in a taxation period being taxed by these nations.
For example, a business X with a residence in country A earns some
incomes generated there ; at the same time in country B, it also has business
operations and incomes arising regularly. Country B applies the principle of
"residence", while country A applies the principle of "source of income". Hence,
the income of business X transferred from country B to A is imposed income
taxes in both countries, which means a double taxation.

7.3.2. Types of double taxation

There are some popular types of double taxation as follows:
- Simultaneous residence. This arises when both two different countries
assume that a tax payer is its resident, hence they both impose duties on that
taxpayer on the same earned income.
- Simultaneous source of incomes. Due to different taxation regulations in
different countries, an income can be classified to be derived from many nations
- Competing about sources and residence. This case arises when a resident of
a country earns incomes derived from others, both two countries (source country
and country of residence) will seek to levy a tax on that income.
Double taxation brings negative impacts on economic development among
nations.
- For developed countries

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 + Restrict foreign investments. The double taxation occurs on the portion
of incomes from foreign investments, which results in a lower net profit than
domestic investments. Hence, entrepreneurs do not feel being encouraged to
invest in.
+ Do not encourage transferring new technologies. To own the most
advanced technologies, developed countries must spend a large amount of money
to invest in research and technology development, which requires investments to
expand production to recover capitals quickly. Hence, if a receiving new
technology country has a high income tax rate on technology transferring
activities, the remaining portion of income will not be enough to offset costs or
just achieve negligible profits.
- For developing countries
Contrasting to developed countries, developing countries seek to attract
foreign investors for capitals as well as technologies by offering taxation
incentives, including tax reduction or exemption to reduce the tax burden for
investors, such as tax exemption or reduction for some certain types of incomes ;
widening deductible business expenses to promote exports ; decreasing some
types of earnings in exporting businesses; reducing personal income tax and
adopting accelerated depreciation regime . These methods benefit foreign
investors only when their own countries allow tax exemption for incomes
derived from abroad or accept deductions in payment of taxes to the host
country. Therefore, if double taxation still occurs, developing countries will have
to deal with difficulties in attracting foreign investments, particularly the FDI .
Hence, in order to prevent negative impacts on double taxation, countries
need to eliminate or reduce double taxation by different methods. There is a very
popular solution, which is to jointly sign bilateral or multilateral agreements for
the avoidance of double taxation.

7.3.1.3. Methods to avoid double taxation

- Tax exemption method. According to this measure, countries and territories
do not impose taxes on incomes derived from abroad through tax exemption or
exemption with progression methods, including:

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 + Tax exemption is not to impose taxes on incomes which are already
taxed overseas.
+ Exemption with progression method is not to impose taxes again on
incomes which are already taxed overseas but to add in incomes in order to
determine the progressive tax rate which is applied to incomes earned in the host
country.
- Tax deduction method. According to this measure, the amount of tax paid
overseas will be deducted from the tax payable on incomes being paid within a
country for the part of foreign incomes. Normally, this situation will be seperated
into two directions:
+ Full tax deduction. The government allows taxpayers to receive a full tax
deduction on taxes paid abroad.
+ Determined tax deduction. The government allows taxpayers to receive a
deduction, even if those taxpayers do not have to pay any taxes overseas.
However, taxpayers are required to pay taxes for an income which is higher than
the determined tax deduction.

7.3.4 Conventions for the avoidance of double taxation

Normally, conventions for the avoidance of double taxation are
implemented through the double taxation avoidance agreements. In addition,
depending on the content of agreements among parties, probably within the
protocol or additional parts of agreements, the form of national arrangement for
the avoidance of double taxation is mainly bilateral agreements.

Chapter 8

MAJOR PROFESSIONAL ACTIVITIES OF

SEVERAL INTERNATIONAL FINANCIAL ORGANIZATIONS

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8.1. THE ESTABLISHMENT, CLASSIFICATION AND ROLES OF INTERNATIONAL
FINANCIAL ORGANIZATIONS
8.1.1. The establishment of international financial organizations
In the 1930s, the world witnessed the Great Economic Downturn (1929 -
1933) and the collapse of the multilateral trade and payment system set up from
the XIXth century. Meanwhile, the international payment system experienced a
remarkable reduction in foreign exchange control regulations in many countries.
Capital and international labor flows were blocked. The explosion of the World
War II further contributed to the critical downturn of international transactions
and international trade fell into an extremely dark shadow. However, in this
period, efforts to reduce trade and foreign currency barriers towards a post-war
healthy world economy kept going on.
The re-organization of the international financial order was initiated at the
International Financial Conference of Bretton Woods (New Hampshire, USA) in
7/1944 with the participation of 44 nations. It was decided to establish the
International Monetary Fund – IMF and the International Bank for
Reconstruction and Development - IBRD later known as the Word Bank (WB).
The objective of the IMF is: to establish a multilateral payment system based on
high ability for conversion of foreign currencies globally, to eliminate foreign
exchange management regulations; to maintain exchange rates at a reasonable
level and to avoid competitiveness improvement by anti-dumping, if anti-
dumping is a necessity, it should be conducted following a sequence; to ensure
the independence of each nation in financial and monetary issues.
Together with the IMF, the World Bank (WB) was born with an original
objective of financing the economic restructuring of different countries in the
post-war time. Later on, the WB switched to financing developing and under-
developed countries before having functions of providing development credit for
member nations for specific projects; providing funds for private sector
businesses of member nations and technical assistance....These two institutions,
one after another, started operations after the World War II ended. Up to now,
they are still pillars of the international financial system.

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 The practical situation of the world socio-economic development after the
World War II inspired the establishment of international financial institutions in
the region with the vision of settling regional financial-monetary issues. From
this need, The Inter - American Development Bank – IDB was set up in 1959; the
African Development Bank in (AfDB) in 1964 and the Asian Development Bank
(ADB) in 1966.
In Europe, the establishment of the European common market and after
that the European Economic Community (EEC), the European Community (EC),
the European Union (EU) gave rise to numerous regional financial organizations
such as: the European Investment Bank directing and supporting agricultural
economy in 1962, the European Fund for Regional Development in 1975, the
European Fund for Cooperation of Exchange Rate in 1973, the European
Monetary Cooperation Fund in 1973 later on renamed as the European Central
Bank in 1989.
The establishment of international financial organizations in Arabian
region adds to the variety of the international financial system. They are: the
Kuwait Fund for Economic Development of Arabian Nations in 1961, the Arab-
Seud Development Fund in 1972, the Arabian Monetary Fund in 1979
encompassing 20 Arabian member nations...
During the life time of the Economic Cooperation and Interdependent Bloc
of Socialist Countries (SEV), two regional financial organizations were
established, e.g: the International Bank for Cooperation and Interdependence and
the International Investment Bank.
In the context of globalization and economic integration currently, the
reform of functions and organizational structures of operating international
financial organizations and founding of new ones is a necessity.
8.1.2. Classification of international financial organizations
8.1.2.1. Based on the scope of activities
+ Global international financial organizations: Those include the
International Monetary Fund (IMF), the World Bank, the Bank for International
Payment. They share common features of having their capital contributed by
different countries or mobilized from the world capital market and providing
financial services for various countries.
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 + Regional international financial organizations: Those include: regional
banks and monetary funds, for example: the Asian Development Bank, the
European Central Bank, the African Bank...They share a common activity of
providing prioritized financial services mainly for regional countries.
8.1.2.2. Based on supporting targets:
+International financial organizations supporting the balance of payment:
They mainly provide short-term and medium-term loans to support the payment
balance, including: the IMF, the Arabian Monetary Fund, and theEuropean Central
Bank...
+International Financial Organizations financing medium-term and long-
term investment projects: Provide financial supports for medium-term and long-
term investments of various nations, financial organzations, and
businesses....They include: the World Bank, the Regional Invesment and
Development Bank, the Arabian Development Bank, and the European
Investment Bank.
8.1.3. The role of international financial organizations.
8.1.3.1. Combining monetary policies of member countries to bring stability
to national and international monetary systems.
- International financial organizations, firstly the IMF, must coordinate
with the Central Banks of member countries to have one common currency as a
basis to define a fair and appropriate exchange rate (SDR).
- Maintaining a flexible exchange rate subjected to adjustment, which has
been assessed appropriately with the market economy. This requires the
collaboration of international financial organizations with member countries to
prevent sudden variation of the exchange rate as well as to prevent and eliminate
crisis risks.
- Providing necessary supports for member countries to develop national
economies, achieve the balance of international payment and create a firm
foundation for stabilizing national and international currencies.

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8.1.3.2. Providing supports for member countries to develop their economies,
especially the poorest and most under-developed countries.
+ The most significant support is to provide loans for socio-economic
development of member countries,
+ Providing technical assistance to prepare for and implement socio-
economic development projects and programs,
+ Promoting investments and developments of member countries in both
public and private sectors, local and foreign investments.
What important is to bring consensus between donors and recipients, the
coordination of international financial organizations’ financing policies is to
achieve high socio-economic development effectiveness of member nations.
8.1.3.3. Supporting developing member nations to strengthen economic-
financial management capacity.
+ Supporting developing countries to strengthen the capacity to produce
and implement short-term, medium-term and long-term socio-economic
development plans fitting with realities.
+ Assisting developing countries with improvement of statistics,
accounting and auditing systems for monitoring and managing economies.
+ Assisting developing countries to train and strengthen the capacity of
managers and technical workers in financial and monetary issues.
8.2. THE INTERNATIONAL MONETARY FUND (IMF)
8.2.1. Overview of the International Fund
The International Monetary Fund was conceived at a United Nations
conference convened in Breton Woods, New Hampshire, US in July 1944. The 45
Governments represented at that conference sought to build a framework that
help promote the health of the world economy through the international
monetary cooperation. Headquartered in Washington DC, The IMF is governed by
and accountable to governments of 188 countries that take up its global
membership.
All Governors meet one each year at the IMF – World Bank Annual
Meetings. Twenty-four Governors sit on the International Monetary and Finance
Committee (IMFC) to meet twice each year. The day –to- day work of the IMF is
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conducted at its Washington DC headquarters by its 24 –member Executive
Board; this work is guided by the IMFC and supported by the Imp’s professional
staff. The Managing Director is the Head of IMF staff and Chairman of the
Executive Board, and is assisted by three Deputy Managing Directors.
Goals of the IMF
- Promoting global growth and economic stability
The IMF is generally, responsible for promoting the stability of the
international monetary and financial system – the system of international
payments and exchange rates among national currencies that enables trade and
financial transactions to take place among courtiers. Its three main activities –
surveillance, technical assistance, and lending – are to meet these goals.
- Surveillance comprises multilateral surveillance, under which the IMF
provides periodic assessment of global and regional developments and prospects,
published twice each year in the World Economic Outlook; and bilateral
surveillance which regulates dialogue, and policy advice that the IMF offers to
each of its members.
- Technical assistance and training are offered to help member countries
strengthen their capacity to design and implement effective policies. Technical
assistance is offered several times in areas, including fiscal policy, monetary and
exchange policies, banking and financial system supervision and regulation, and
statistics.
- Financing balance of payment need
Financial assistance is available to give member countries to correct the
balance of payment problems. A policy program support by the IMF is designed
by national authorities in close cooperation with the IMF, and continued financial
support is conditional on effective imp lamentation of this program.
8.2.2. Financial resources of the IMF
The IMF’s resources are provided by its member countries, primarily
through payment quotas, which broadly reflects each country’s economic size.
The total amount of quotas is the most important factor determining the IMF
lending capacity.
- The quota system
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 Subscription. Each member of the IMF is assigned a quota, based broadly on
its relative size in the world economy, which determines its maximum
contribution to the IMF’s financial resources.
Quotas are denominated in Special Drawing Rights (SDRs), the IMF’s unit
of account.
Upon joining the IMF, a country normally pays up to one-quarter of its
quota in the form of widely accepted foreign currencies (such as the U.S dollar,
euro, yen, or pound sterling) or Special Drawing Rights (SDRs). The remaining
three-quarters are paid in the country’s own currency.
- Voting power. The quota largely determines a member’s voting power in
IMF decisions. Each IMF member has 250 basic votes plus one additional vote for
each SDR 100,000 of quota. Accordingly, the United States has 371,743 votes
(16,77 percent of the total) and Palau has 281 votes (0.01%).
- Access to financing: the amount of financing a member can obtain from
the IMF (its access limit) is based on its quota. Currently, under Stand- By and
Extended Arrangements a member can borrow up to 100% of its quota annually
and 300% cumulatively. However, access may be higher in exceptional
circumstances.
The IMF Board of Governors conducts general quota review. Quotas are
reviewed at least every five years. Any changes in quotas must be approved by an
85% majority. There are two main issues addressed in the review: the size of an
overall increase and the distribution of an increase among members.
- Gold holdings
Valuated at current market prices, making the fund the third largest official
holder of gold in the world. However, the IMF’s Articles of Agreement strictly
limit its use. If approved by an 85% majority of voting power of member
countries, the IMF may sell gold or may accept gold as payment by member
countries, but the IMF is prohibited from buying gold or engaging in other gold
transactions.
-IMF Borrowing Arrangements: General Arrangements to Borrow (GAB)
and New Arrangements to Borrow (NAB).

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 While quota subscriptions of member countries are its main source of
financing, the IMF can activate supplementary borrowing arrangements if the
resources might fall short of members’ needs. Through the General Arrangements
to Borrow (GAB) and the New Arrangements to Borrow (NAB), a number of
member countries and institutions stand ready to lend additional funds to the
IMF.
 The GAB enables the IMF to borrow specified amounts of currencies
from 11 industrial countries (or their central banks), under certain
circumstances, at market –related rates of interest.
The GAB, established in 1962, in response to the growing pressures on the
IMF’s resources caused by the emergence of the debt crisis in Latin America in
1982.
Other major amendments to earlier GAB provisions permit the IMF to use
it to finance lending to nonparticipants in the GAB, if the IMF faces a situation
where it has inadequate resources of its own. The GAB carried a rate of interest
below market rates; this rate was raised at the time of the GAB enlargement and
made equal to the SDR interest rate.
 The NAB is a set of credit arrangements between the IMF and 26
members and institutions. The NAB is the facility of first and principal recourse in
the event of a need to provide supplementary resources to the IMF.
8.2.3. The process of IMF lending.
Upon request by a member country, an IMF loan is usually proved under an
“arrangement”, which stipulates specific policies and measures a country has
agreed to implement to resolve its balance of payments problem. The economic
program underlying an arrangement is formulated by countries in consultation
with the IMF, and is presented to the Fund’s Executive Board in the “Letter of
Intent”. Once an arrangement is approved by the Board, the loan is released in
phased installments as the program is implemented.
Over the years, the IMF has developed various loan instruments that are
tailored to address the specific circumstances of its diverse membership. Low –
income countries may borrow at a concessional interest rate through the Poverty
Reduction and Growth Facility (PRGF) and the Exogenous Shocks Facility (ESF).

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Non –concessional loans are provided mainly through Stand – By Arrangements
(SBA), and occasionally using the Extended Fund Facility (EFF), the Supplement
Reserve Facility (SRF), and the Compensatory Financing Facility (CFF). The IMF
also provides emergency assistance to support the recovery from natural
disasters and conflicts, in some cases at concessional interest rates. The IMF
continues to explore possible crisis prevention instruments. Except for the PRGF
and the ESF, all facilities are subject to the IMF’s market – related interest rate,
known as the “rate of charge”, and some carry a surcharge. The rate of charge is
based on the SDR interest rate, which is revised weekly to take account of charges
in short - term interest rate in major international money markets. Large loans
carry a surcharge. The mount that a country can borrow from the fund –its
“access limit” varies depending on the type of loan, but is typically a multiple of
the country of the country’s IMF quota. In exceptional circumstances, some loans
may exceed access limits.
Policy advice, covering the full range of macroeconomic policies and
supporting structural measures, is an essential component of the IMF emergency
assistance. In post- conflict cases, technical assistance is also very important to
implement macroeconomic policy. Areas of focus include rebuilding statistic
capacity and establishing and reorganizing fiscal, monetary, and exchange,
institutions to help restore tax and government expenditure capacity, payment,
credit, and foreign exchange operation.
8.3. THE WORLD BANK
8.3.1. Overview of the World Bank
The World Bank (WB) is a vital source of financial and technical assistance
to developing countries around the world. It’s not a bank in the common sense.
The WB is made up of two unique development institutions owned by 185
member countries – the International Bank for Reconstruction and Development
(IBRD) and the International Development Association (IDA). And the WB’s
affiliates are International Finance Corporation (IFC) and Multilateral Investment
Guarantee Agency (MIGA), and International Centre for Settlement of Investment
Disputes (ICSID).
Each institution plays a different but collaborative role to advance the
vision of an inclusive and sustainable globalization. The IBRD focuses on middle
165
income and creditworthy poor countries, while IDA focuses on the poorest
countries in the world. Together, the WB provides low-interest loans, interest –
free credits and grants to developing countries for a wide array of purposes that
include investments in education, heath, public administration, infrastructure,
financial and private sector development, agriculture, and environmental and
natural resource management.
- The WB is like a cooperative, where its 185 member countries are
shareholders. The shareholders are represented by a Board of Governors, who
are the ultimate policy makers at the WB. Generally, the governors are member
countries’ ministers of finance or ministers of development. They meet once a
year at the Annual Meeting of the Boards of Governors of the WB group and the
IMF.
Because of governors only meet annually, they delegate specific duties to
24 Executive Directors, who work on – site at the Bank. The five largest
shareholders, France, Germany, Japan, the United Kingdom and the United States
appoint an executive director, while other member countries are represented by
19 executive directors.
The President of the WB, chairs meetings of the Board of Directors and is
responsible for overall management of the Bank. By tradition, the Bank president
is a US national , and the President is elected by the Board of Governors for a five
– year, renewable term.
The Executive Directors make up the Boards of Directors of the WB. 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 and borrowing and financial decisions.
The WB operates day –to –day under the leadership and direction of the
president, management and senior staff, and the vice presidents in charge of
regions, sectors, networks and functions.
In addition, the IBRD and the IDA, three other institutions are closely
associated with the WB: the International Finance Corporation (IFC) and the
Multilateral Investment Guarantee Agency (MIGA), and the International Centre
for Settlement of Investment Disputes (ICSID). All five of these institutions
together make up the World Bank Group.
166
 WB’s two closely affiliated entities – the IBRD and the IDA – provide low or
no interest loans (credit) and grants to countries that have unfavorable or no
access to international credit markets. Unlike other financial institutions, the WB
does not operate for profit. The IBRD is market – based, and it uses its high credit
rating to pass the low interest the IBRD pays for money on to its borrowers –
developing countries.
8.3.2. The International Bank for Reconstruction and Development (IBRD)
- Founded in 1944 to help Europe recover from World War II, the IBRD is
one of five institutions that make up the World Bank Group. IBRD works with
middle – income and creditworthy poorer countries to promote sustainable,
equitable and job – creating growth, reduce poverty and address issues of
regional and global importance.
- Structured something like a cooperative, IBRD is owned and operated for
the benefit of its 188 member countries. Delivering flexible, timely and tailored
financial products, knowledge and technical services, and strategic advice helps
its members achieve results. Through the WB Treasury, IBRD clients also have
access to capital on favorable terms in large volumes, with longer maturities, and
in a more sustainable manner than world financial markets typically provide.
The objectives of International Bank for Reconstruction and Development
(IBRD)
- Supports long-term human and social development needs that private
creditors do not finance
- Preserves borrowers’ financial strength by providing support in crisis
periods.
- Uses the leverage of financing to promote key policy and institutional
reforms (such as safety net or anticorruption reforms)
- Creates a favorable investment climate in order to catalyze the provision
of private capital.
- Provides financial support (in the form of grants made available from
the IBRD’s net income) in areas that are critical to the well-being of poor people
in all countries.

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 To increase its middle – income countries, IBRD is working closely with the
IFC, the MIGA, the IMF and other multilateral development banks. In the course of
its work, IBRD is also striving to capitalize on middle - income countries’ own
accumulated knowledge and development experience and collaborates with
foundations, civil society partners and donors in the development community.
The financial resource of International Bank for Reconstruction and
Development (IBRD)
IBRD raises most of its fund on the world’s financial markets. It has become
one of the most established borrowers since issuing its first bond in 1947 to
finance the reconstruction of Europe after World War II. Investors see IBRD
bonds as a safe and profitable place to put their money and their cash finances
projects in middle –income countries.
IBRD became a major player on the international capital markets by
developing modern debt products, opening new markets for debt issuance, and
building up a broad investor base around the world of pension funds, insurance
companies, central banks, and individuals.
IBRD borrows at attractive rates on the capital market with AAA status
that it has had with credit rating agencies since 1959. This has enabled it to
borrow in US dollars, for example, at an overall funding cost that comes close to
that of the U.S Treasury. The IBRD has strong balance sheet, prudent financial
policies and its expected treatment as a preferred creditor when a country has
difficulty in repaying its loans.
IBRD has profited from anticipating shifts in investor preferences and
investing in the risk management and systems to take advantage of those trends.
IBRD’s earns an income every year from the return on its equity and from
the small margin it makes on lending. This pays for IBRD’s operating expenses,
goes into reserves to strengthen the balance sheet and also provides an annual
transfer to the IDA.
The using of the money of IBRD
- Fund generation
IBRD lending to developing countries by selling AAA rated – bonds in the
world’s financial markets. While IBRD earns a small margin on this lending, the

168
greater proportion of its income comes from lending out of its own capital. This
capital consists of reserves built up over the years and money paid in from the
Bank’s member country shareholders. IBRD income also pays for WB operating
expenses and has contributed to IDA and debt relief.
- Loan
BIRD offers two basic types of loans and credits: Investment operations
and development policy operations. Countries use investment operations for
goods, works and services in supporting economic and social development
projects in a broad range of economic and social sectors. Development policy
operations (formerly known as adjustment loans) provide quick – disbursing
financing to support a country’s policy and institutional reforms.
Trust funds and grants
Donor governments and a broad array of private and public institutions
make deposits in Trust funds. These donor resources are leveraged for a broad
range of development initiatives. The initiatives vary significantly in size and
complexity, ranging from multibillion dollar arrangements – such as the Global
Environment Facility ; the Heavy Indebted Poor Countries Initiative; and the
Global Fund to Fight AIDS…
The IBRD also mobilizes external resources for IDA concessionary
financing and grants, as well as funds for non – lending technical assistance and
advisory activities to meet the special needs of developing countries, and co-
financing of projects and programs. Direct grants to civil society organizations
emphasize broad –based stakeholder participation in development, and aim to
strengthen the voice and influence of poor groups in the development process.
Analytic and Advisory Services
The IBRD is to provide analysis, advice and information to its member
countries so they can deliver the lasting economic and social improvements their
people need. The IBRD does this in various ways: through economic research and
data collection on broad issues such as the environment, poverty, trade and
globalization or through country specific, non –lending activities such as
economic and sector work.

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8.3.3. The International Development Association (IDA).
Overview of the International Development Association
The International Development Association (IDA) is the part of the WB that
helps the world’s poorest countries.
Established in 1960, IDA aims to reduce poverty by providing interest –
free credits and grants for programs that boost economic growth, reduce
inequalities and improve people’s living conditions. IDA is one of the largest
sources of assistance for the world’s 78 poorest countries. IDA lends money
(known as credits) on occasional terms so these credits have no interest charges
and repayments are stretched over 35 -40 years, including a 5 to 10 year grace
period. IDA also provides grants to countries at risk of debt distress.
Financial resources of IDA
The IDA is funded largely by contributions from governments of its richer
countries. Additional funds come from BIRD’s income and from borrower’s
repayments of earlier IDA credits.
Donors get together every three years to replenish IDA funds. Donors’
contributions account for 60% of the SDR 27.3 billion ($41.6 billion) in the IDA
15th replenishment, which finances projects over the three –year period ending
June 30, 2011.
IDA lending
IDA credits have maturities of 20, 35 or 40 years with a 10 – year grace
period before repayments of principal begins. IDA funds are allocated to the
borrowing countries in relation to their income levels and record of success in
managing their economies and their ongoing IDA projects. Nearly all credits have
no interest charge, but credits do carry a small service charge, currently 0.75% on
funds paid out. IDA also provides grants, which are allocated at a risk of debt
distress.
8.4. ASIAN DEVELOPMENT BANK (ADB)
8.4.1. Overview of Asian Development Bank
The ADB is an international development finance institution whose
mission is to help its developing member countries reduce poverty and improve
the quality of life of their people.
170
 Headquartered in Manila, and established in 1966, ADB is owned and
financed by its 67 members, of which 48 are from the region and 19 are from
other parts of the globe.
ADB’s main partners are governments, the private sectors, nongovernment
organizations, development agencies, community – based organizations, and
foundations.
The ADB’s goal is eradicating poverty in the region. With over 1.9 billion
people living on less than $2 per day in Asia, the institution has a formidable
challenge. It plays the following functions for countries in the Asia Pacific region:
 Provides loans and equity investments to its developing member
countries (DMCs).
 Provides technical assistance for the planning and execution of
development projects and programs and for advisory services.
 Promotes and facilitates investment of public and private capital for
development.
 Assists in coordinating development policies and plans of its DMCs.
Though well- intentioned, ADB – funded operations have been responsible
for causing widespread environmental and social damage, adversely affecting
some of the regions poorest and most vulnerable communities.
8.4.2. Financial Resources of ADB
- Quota.
- The ADB is a leading AAA borrower in international and domestic capital
markets. The ADB diversifies its funding sources across markets, instruments,
and maturities. The ADB has so far issued bonds in 25 markets.
The ADB offers a variety of debt products to investors including large and
liquid benchmark bonds, plain vanilla bonds, emerging market emergency bonds,
and a broad range of investors – specific structured notes, which are tailored to
investors’ requirements.
Ordinary Capital Resources: these are a pool of funds available for ADB’s
lending operations, replenished by borrowings from the world’s capital markets.
OCR loans are offered at near-market terms to better-off borrowing countries.

171
 Asian Development Fund: Funded by ADB’s donor member countries, ADF
offers loan at very low interest rates and grants to help reduce poverty in ADB’s
poorest borrowing countries.
Technical Assistance: Assists countries in identifying and designing
projects, improving institutions, formulating development strategies, or fostering
regional cooperation. TA can be financed by grants, or – more rarely- loans
through ADB’s central budget or numbers of special funds provided by ADB’s
donor members.
Asian Development Fund (ADF)
Established in 1973, the ADF is the oldest and largest of ADB’s existing
special funds. Resources come mainly from contributions mobilized under
periodic replenishments from ADB’s members and reflows from mainly ADF loan
repayments.
Roles of the ADF in ADB.
The ADF is a multilateral source of concessional assistance dedicated
exclusively to the needs of the region. The ADF is designed to provide loans on
concessional terms and grants to those developing member countries with low
income per capita and limit debt- repayment capacity. Activities supported by the
ADF promote poverty deduction and improvements in the quality of life in poorer
countries of the Asia and Pacific region
ADF financial resources
Thirty-two members of ADB have provided direct contributions to ADF.
The largest contributors are Japan, the United States, Germany, Canada, Australia,
France and the United Kingdom.
ADF lending
Lending terms for ADF loans are as follows: 32 – year maturity, including
an 8-year grace period, 1% interest charge during the grace period and 1.5%
during the amortization period, and equal amortization. However, quick-
disbursing program loans have a shorter maturity of 24 years.
In the case of ADF-financed Emergency Assistance Loans, terms are a 40-
year maturity, including a 10 – year grace period, 1% interest per year, with a

172
repayment of principal at 2% a year for the first 10 years after the grace period
and 4% a year thereafter.
ADF includes a facility with harder lending terms to help cover the
foregone interest income from ADF grants. Loan terms are the same as current
ADF terms, i.e., equal amortization, 8 – year grace period, 32 – year maturity for
project loans and 24 –year maturity for program loans. The interest rate is 150
basis points below the weighted average of the 10-year fixed swap rates of the
special drawing rights component currencies plus the OCR lending spread, or the
applicable ADF interest rate, whichever is higher. The interest rate is reset every
January and applied to all hard-term loans approved during that year. The
interest rate is fixed for the life of the loan. There is no commitment fee
associated with ADF-financed loans.

173
 REFERENCES
In Vietnamese:
1. PGS.TS. Phan Duy Minh, PGS.TS. ĐinhTrọ ngThịnh – Giá o trình Tà i chính
quố c tế - Nhà xuấ t bả n tà i chính, 2012.
2. Bộ tậ p quá n quố c tế về L/C (Cá c vă n bả n có hiệu lự c mớ i nhấ t) – Nhà xuấ t
bả n đạ i họ c kinh tế quố c dâ n, 2007.
3. PGS,TS Đinh Trọ ng Thịnh, TS Nguyễn Thị Minh Tâ m – Giá o trình Quả n trị
vay và nợ quố c tế - Nhà xuấ t bả n tà i chính, 2011.
4. PGS.TS. PhanDuy Minh - Hệ thố ng câ u hỏ i và bà i tậ p Tà i chính Quố c tế, Nhà
xuấ t bả n tà i chính, 2003

In English:
5. Maurice D.Levi - International Finance, McGraw-hill international editions
– Third edition
6. Tarsem Singh Bhogal & Arun Kumar Trivedi - International Trade Finance
- A pragmatic approach, Palgrave –Macmellan publisher, 2008.
7. Jeff Madura -International Financial management,10 th edition, Cengage
Learning EMEA, 2007
8. International Finance, third edition, Keith Philbean.
9. Balance of payment manual, International Monetary Fund
10.Keith Pilbeam (2006), International Finance, third Edition.
11.Prof. Tien, Nguyen Van (2011), International Finance, Statistical publishing
House, Ha Noi.
12.IMF, 1988. External debt: Definition, Statistical Coverage and Methodology.
Washington DC.
13.IMF, 2003. External Debt Statistics: Guide for Compilers and Users –
Appendix III. Washington DC.
14.IMF and WB, 2013.The Joint World Bank–IMF Debt Sustainability
Framework for Low-Income Countries. Washington DC.
15.OECD, 2001. Development Co-operation Report: Efforts and Policies of
Members of the Development Assistance Committee.

174
Websites:
16.www.imf.org (International Monetary Fund)
17.www. Adb.org(Asian Development Bank)
18.www.bis.org (Bank for International Settlements)
19.www.worldbank.org (World Bank)
20.www. Bloomberg.com (Bloomberg)
21.www. finance.yahoo.com
22.www.morganstanley.com
23.www.mof.gov.vn
24.www.mpi.gov.vn

175
 LIST OF TABLES

Table 2.1: Structure of a balance of payments.....................................................................32

Table 3.1: Foreign exchange market average daily turnover................................................43
Table 3.2: Ten most traded currencies in the foreign exchange market...............................44
Table 6.1. Indicators for sustainable level of foreign debt..................................................121

LIST OF GRAPHS

Graph 2.1. The change of exchange rate if the supply of a currency remains unchanged while
the demand for it increases......................................................................................................25

Graph 2.2. The change of exchange rate if the demand of a currency remains unchanged
while the supply for it increases...............................................................................................26

Graph 3.1: Loss/profit on the call option holder......................................................................54

Graph 3.2: Loss/profit on the put option holder......................................................................55

Graph 3.3. ADR issuance and cancellation...............................................................................65

Graph 4.1. Clean collection.......................................................................................................79

Graph 4.2. Documentary Collection.........................................................................................80

Graph 4.3. Letter of credit mechanism.....................................................................................84

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 LIST OF ABBREVIATIONS

ADB Asian Development Bank

ADR American Depository Receipts
AfDB African Development Bank in
AFTA ASEAN Free Trade Area
BOP Balance of Payments
CEPT Common Effective Preferential Tariff
CFF Compensatory Financing Facility
CG) Consulting Group
CHIPS Clearing House Interbank Payment Systems
DP Destination Principle
EC European Community
ECB European Central Bank
EEC European Economic Community
EFF Extended Fund Facility
ESF Exogenous Shocks Facility
EU) European Union
FDI Foreign Direct Investment
FED Federal Reserve System
FII Foreign Indirect Investment
FOB Free on board
FX Foreign Exchange Market
G Good
GAB General Arrangements to Borrow
GATT General Agreement of Tariff and Trade
GPS General Preferential System

177
GSP Generalized System of Preference
IBRD the International Bank for Reconstruction and
Development
IBRD International Bank for Reconstruction and
Development
ICSID International Centre for Settlement of
Investment Disputes
IDA International Development Association
IDB Inter - American Development Bank
IEFTS International Electronic Funds Transfer
system
IFC International Finance Corporation
IL Inclusion List
IMF International Monetary Fund
Las Line Agencies
LIBOR London Interbank Offered Rate
M Money
MFN Most Favoured Nation
MIGA Multilateral Investment Guarantee Agency
MNC Multinational corporation 
MNE or multinational enterprise 
MPI Ministry of Planning and Investment
NAB New Arrangements to Borrow
NAFTA North American Free Trade Agreement
NGO Non-governmental organizations
NT National treatment
NYSE New York Stock Exchange
OB Overall Balance
ODA Official Development Assitstance
OECD Organization for Economic Co-operation and
Development
OFB Official financing balance

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OM Errors and Omissions
OP Origin Principle
OTC Over-the-counter
PRGF Poverty Reduction and Growth Facility
RP Residence Principle
RSP Resource Principle
SBA Stand – By Arrangements
SDR Special Drawing Rights
SEL Sensitive Exclusion List
SRF Supplement Reserve Facility
SWIFT Society for Worldwide Inter-bank Financial
Telecommunication
TEL Temporary Exclusion List
UN United Nations
VAT Value added tax
WB World Bank
WTO World Trade Organization

179
 CONTENT

CHAPTER 1

AN OVERVIEW OF INTERNATIONAL FINANCE

1.1. CONCEPTS AND CHARACTERISTICS OF INTERNATIONAL FINANCE.......4

1.1.1. The appearing and existing conditions of international finance...................4

1.1.2. Concept and Characteristics of international finance....................................8

1.1.2.1. .Concept of international finance....................................................................8

1.1.2.2. Characteristics of international finance..........................................................8

1.2. ROLES OF INTERNATIONAL FINANCE.............................................................11

1.2.1. International finance helps to exploit the external resources in order to

finance for the social and economic development of a country............................11

1.2.2. International finance impulses the integration of national economies to

the international economy...........................................................................................12

1.2.3. International finance helps to enhance the effectiveness of utilization of

financial resources........................................................................................................12

1.3. CONTENTS (COMPONENTS) OF INTERNATIONAL FINANCE.....................12

1.3.1.According to monetary relations, international finance is made up by:.....12

1.3.2. According to participants of international finance activities, international

finance is made up by activities of:............................................................................13

1.4. MAJOR TRENDS OF THE WORLD ECONOMY INFLUENE INTERNATIONAL FINANCE....14

1.4.1. The emergence of globalized financial markets...................................................14

1.4.2. The emergence of the Euro as a global currency..................................................15

1.4.3. Trade liberalization and economic integration.....................................................16

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 1.4.4. Privatization wave.................................................................................................17

CHAPTER 2
EXCHANGE RATE AND THE BALANCE OF PAYMENTS

2.1. EXCHANGE RATE..........................................................................................................19

2.1.1. Concept.................................................................................................................19

2.1.2. Determination method of exchange rate.............................................................21

2.1.3. Factors affecting exchange rate............................................................................24

2.1.3.1. The difference in inflation rate among currencies.......................................24

2.1.3.2. The fluctuation in supply and demand of foreign currency in the foreign
exchange market........................................................................................................24

2.1.3.3. The government’s interference.....................................................................26

2.1.3.4. Public psychology..........................................................................................27

2.1.3.5. The fluctuation in interest rate of currencies..............................................27

2.1.3.6. The international monetary speculation.....................................................27

2.1.4. Regimes of exchange rate.....................................................................................28

2.1.4.1. Concept of exchange rate regime.................................................................28

2.1.4.1. Types of exchange rate regime.....................................................................28

2.2. THE BALANCE OF PAYMENTS......................................................................................30

2.2.1. Concept.................................................................................................................30

2.2.2. Contents of the balance of payments...................................................................31

2.2.2.1. Current account.............................................................................................33

2.2.2.2. Capital and financial account.......................................................................34

2.2.2.3. Overall Balance (OB).....................................................................................35

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 2.2.2.4. Errors and Omissions (OM)...........................................................................35

2.2.2.5. Official financing balance (OFB)...................................................................35

2.2.3. Principles in recording the balance of payments..................................................36

2.2.3.1. Double-entry principle..................................................................................36

2.2.3.2. Change of ownership.....................................................................................38

2.2.3.3. Market value..................................................................................................38

2.2.4. The surplus and deficit of the balance of payments.............................................38

CHAPTER 3

INTERNATIONAL FINANCIAL MARKET

3.1. ESTABLISHMENT OF THE INTERNATIONAL FINANCIAL MARKET............40

3.2. COMPONENTS OF THE INTERNATIONAL FINANCIAL MARKET................41

3.3. THE INTERNATIONAL MONETARY MARKET..................................................41

3.3.1. Eurocurrency market.........................................................................................41

3.3.2.The Foreign Exchange Market.........................................................................42

3.3.2.1. Definition of the foreign exchange market....................................................42

3.3.2.2 Characteristics of the foreign exchange market.............................................43

3.3.2.3. Market participants.......................................................................................45

3.3.2.4 Transactions of the foreign exchange market.................................................46

CHAPTER 4 INTERNATIONAL PAYMENT

4.1. INTERNATIONAL PAYMENT: AN OVERVIEW................................................................67

4.1.1. Definition and features.........................................................................................67

182
 4.1.2. Classifications........................................................................................................68

4.1.3. Methods................................................................................................................69

4.1.4. Instruments...........................................................................................................69

4.1.4.1. Definition of a bill of exchange.....................................................................70

4.1.4.2. Parties to a bill of exchange..........................................................................71

4.1.4.3. Types of bills of exchange..............................................................................72

4.1.4.4. Clauses on bills of exchange..........................................................................73

4.2. THE MECHANISM OF INTERNATIONAL PAYMENT.......................................................78

4.2.1. Collection mechanism...........................................................................................78

4.2.1.1. Clean collection.............................................................................................79

4.2.1.2. Documentary Collection................................................................................80

4.2.2. Letter of credit mechanism...................................................................................80

CHAPTER 5
INTERNATIONAL INVESTMENT
AND MULTINATIONAL CORPORATE FINANCE

5.1. INTERNATIONAL INVESTMENT GENERAL KNOWLEDGE..............................................88

5.1.1. Concepts and characteritics..................................................................................88

5.1.2. Categories of international investment................................................................90

5.2. FOREIGN DIRECT INVESTMENT (FDI)...........................................................................91

5.2.1. Concept.................................................................................................................91

5.2.2. Characteristics.......................................................................................................91

5.2.3. Roles of the foreign direct investment.................................................................92

5.3. FOREIGN INDIRECT INVESTMENT (FII).........................................................................93

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 5.3.1. Concept.................................................................................................................93

5.3.2. Characteristics of foreign indirect investment......................................................94

5.3.3. International portfolio investment.......................................................................94

5.3.4. International commercial credit...........................................................................98

5.4. MULTINATIONAL CORPORATE FINANCE...................................................................100

5.4.1. Concept and models of multinational corporation.............................................100

5.4.2. Reasons for the growth of multinational corporate...........................................101

5.4.3. Special issues facing multinational corporations: Transfer pricing....................103

5.4.3.1. The measurement of transfer prices...........................................................103

5.4.3.2. Considerations in transfer pricing..............................................................104

5.4.3.3. The mechanism of transfer prices...............................................................105

CHAPTER 6 FOREIGN AID - GRANT, LOAN AND DEBT.................................................................108

6.1. OVERVIEW OF FOREIGN AID - GRANT, LOAN AND DEBT...........................................108

6.1.1. Foreign aid - grant...............................................................................................108

6.1.2. Foreign loan.........................................................................................................109

6.1.2.1. Concept of foreign loan...............................................................................109

6.1.2.2. Classification of foreign loan......................................................................109

6.1.2.3. Advantages and disadvantages of foreign loan.........................................110

6.1.3. External debt (or Foreign debt)...........................................................................110

6.2. OFFICIAL DEVELOPMENT ASSISTANCE (ODA)............................................................112

6.2.1. Concept of ODA...................................................................................................112

6.2.2. Grant Element of ODA.........................................................................................112

6.2.3. Classification of ODA...........................................................................................113

6.2.4. Roles of ODA loan................................................................................................115

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 6.2.4.1. For donors....................................................................................................115

6.2.4.2. For recipients...............................................................................................115

6.2.5. The process of mobilization, management and use of ODA..............................116

6.3. MANAGEMENT OF FOREIGN LOAN, DEBT AND DEBT CRISIS.....................................119

6.3.1. Management of foreign loan and debt...............................................................119

6.3.1.1. Concept of objectives of foreign loan and debt management...................119

6.3.1.2. Evaluation of a nation’s foreign debt level................................................120

6.3.1.3. Contents of foreign loan and debt management........................................121

6.3.2. External debt crisis (Foreign debt crisis).............................................................123

6.3.2.1. Causes of external debt crisis......................................................................124

6.3.2.2. Solutions to prevent external debt crisis...................................................124

6.3.2.3. Foreign debt settlement through Paris Club and London Club.................126

CHAPTER 7 THE INTERNATIONAL UNION OF TAXATION...........................................................128

7.1. INTERNATIONAL UNION OF TAX: GENERAL KNOWLEDGE.........................................128

7.1.1. Concept...............................................................................................................128

7.1.2. Principles and rules on imposing taxes on international economic relations....128

7.2.2. Regulations on dealing with international economic relations..........................130

7.1.3. Forms of the international union of taxation.....................................................131

7.2. CUSTOM UNION........................................................................................................131

7.2.1. Tariff....................................................................................................................131

7.2.1.1.Overview of tariff..........................................................................................131

7.2.1.2. Types of tariffs.............................................................................................132

7.2.1.3. Analyzing impacts of tariffs........................................................................134

7.2.1.4. Roles of tariff...............................................................................................138

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 7.2.2. Customs Union....................................................................................................139

7.2.2.2. Roles of customs union................................................................................140

7.2.3.Some customs unions that Vietnam participates in............................................142

7.2.3.1 Relations in tariff in the WTO......................................................................142

7.2.3.2. Tariff issues in ASEAN.................................................................................143

7.3 THE INTERNATIONAL UNION FOR THE AVOIDANCE OF DOUBLE TAXATION..............144

7.3.1. Concept of double taxation................................................................................144

7.3.2. Types of double taxation.....................................................................................145

7.3.1.3. Methods to avoid double taxation...................................................................146

7.3.4 Conventions for the avoidance of double taxation.............................................146

CHAPTER 8 MAJOR PROFESSIONAL ACTIVITIES OF SEVERAL INTERNATIONAL FINANCIAL

ORGANIZATIONS.................................................................................................................................. 147

8.1. THE ESTABLISHMENT, CLASSIFICATION AND ROLES OF INTERNATIONAL FINANCIAL

ORGANIZATIONS.............................................................................................................. 147

8.1.1. The establishment of international financial organizations...............................147

8.1.2. Classification of international financial organizations........................................149

8.1.2.1. Based on the scope of activities..................................................................149

8.1.2.2. Based on supporting targets:......................................................................149

8.1.3. The role of international financial organizations................................................149

8.1.3.1. Combining monetary policies of member countries to bring stability to

national and international monetary systems.......................................................149

8.1.3.2. Providing supports for member countries to develop their economies,

especially the poorest and most under-developed countries.................................150

8.1.3.3. Supporting developing member nations to strengthen economic-financial

management capacity.............................................................................................150

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 8.2. THE INTERNATIONAL MONETARY FUND (IMF)..........................................................150

8.2.1. Overview of the International Fund....................................................................150

8.2.2. Financial resources of the IMF............................................................................151

8.2.3. The process of IMF lending.................................................................................153

8.3. THE WORLD BANK.....................................................................................................154

8.3.1. Overview of the World Bank...............................................................................154

8.3.2. The International Bank for Reconstruction and Development (IBRD)................155

8.3.3. The International Development Association (IDA).............................................158

8.4. ASIAN DEVELOPMENT BANK (ADB)...........................................................................159

8.4.1. Overview of Asian Development Bank................................................................159

8.4.2. Financial Resources of ADB................................................................................160

REFERENCES.......................................................................................................................................... 162

LIST OF TABLES..................................................................................................................................... 164

LIST OF GRAPHS.................................................................................................................................... 164

LIST OF ABBREVIATIONS..................................................................................................................... 165

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 ACADEMY OF FINANCE
Associate Prof, PhD. NGUYEN THI MINH TAM

INTERNATIONAL FINANCE

HA NOI - 2013