International Finance Introduction

Fred Thompson2 Today’s Objectives Understand the syllabus and how it works Understand my goals for this course (teaching and learning objectives) Understand my philosophy of teaching Understand the focus of the course Understand FOREX transactions and the role of arbitrage.

Fred Thompson3 Learning Objectives and Philosophy I want you to learn how to DO things –Perform codified practices such as calculating cross-exchange rates, currency and intertemporal arbitrage, currency hedging –Understand when and why to perform them, as well as how Watch, Do, Teach

Fred Thompson4 Our Focus We will focus on the institutions and markets that “connect” nations’ economies, especially financial sector linkages. More specifically, we will concentrate on FOREIGN DIRECT INVESTMENT.

Fred Thompson5 Real and Financial Sectors Real Sector: Production and sale of goods and services; acquisition and divestiture of capital assets. Financial Sector: Transactions in financial assets: currency, bank deposits, bonds, stocks, futures and options, etc.

Fred Thompson6 International Economic Integration International economic integration refers to the extent and strength of real- sector and financial-sector linkages among national economies. Real-sector linkages occur through the international transactions in goods and services while the financial-sector linkages occur through international transactions in financial assets.

Fred Thompson7 The Rise of Multinational Firms Changes our definition of comparative Advantage –Relative value-added -- product development, design, logistics, assembly, marketing -- depends less on national differences and more on firm-specific competencies and investments, although these latter reflect national differences in factor endowments –The range of a nation’s exports is equivalent to the range of its exports Comparative Advantage in a world of multinationals –Most cross-border trade involves intermediate products, much of it takes place within the boundaries of a single firm (a single Barbie doll is made in 12 countries)

Fred Thompson8 Evolution of the Multinational Corporation (FDI) Raw materials seekers. Market seekers. Cost minimizers/product enhancers –Coase -- firms exist where they reduce transactions (search, bargaining, monitoring and enforcement costs) and logistics costs, otherwise transactions would take place through markets. They internalize externalities, economies of scale and scope (which give rise to non-exhaustibility), thru creation of effective governance institutions, that would obtain in a world without organizations. –Some of these potential economies can be obtained by locating operations where factor costs are lower. Flexibility, adaptability, & speed of response

Fred Thompson9 International Financial Management: Why? Financing & investment decisions that maximize value added by firm Asset deployment & utilization to increase PV future cash flows –You must create value first before you can distribute it True of Corp. Finance in general, so why study IFM? What makes it different?

Fred Thompson10 International Financial Management: Why? currenciesBorders, different currencies BUT, if financial markets were completely integrated, different currencies wouldn’t matter. (Of course, if there were no real exchanges, you wouldn’t need financial markets.) IN NEITHER CASE WOULD WE BOTHER TO STUDY IFM! IFM deserves a special course only because integration has gone far enough to give it meaning, but not far enough to make it just like domestic finance.

Fred Thompson11 Functions of Financial Management: Acquisition & Investment of Funds Differences relevant to international financial management Exchange risks, taxes, multiple money markets (often w/limited access to credit, some w/currency controls), political risks Access to segmented money markets, shift profits to lower taxes, reduce risk thru international diversification of markets & production sites Constants relevant to international financial management Arbitrage (APT) Market efficiency –Herd behavior CAPM –Systematic (undiversifiable) risk –Unsystematic (diversifiable) risk Total risk You cannot create value with smoke and mirrors

Fred Thompson12 FOREX

Multinational Policymaking The International Financial Architecture

Fred Thompson14 International Financial Architecture The international financial architecture is comprised of the institutions, governmental and non-government organizations, and the policies that govern activity in the international monetary and financial markets. Since the collapse of the Bretton Woods system that most important aspect of the international financial system is the growth of capital flows among nations.

Fred Thompson15 Capital Market Liberalization Advocates of liberalized capital flows argue that unhindered capital flows allow savings to flow to their most productive use, resulting in the development of real resources and higher productivity. Financial market imperfections may result in capital misallocations and financial instability.

Fred Thompson16 Financial Instability and Financial Crisis Financial instability occurs when the financial sector is unable to allocate funds to their most productive use. A financial crisis is a situation where a nation’s financial system is no longer able to function. A financial crisis typically involves –a banking crisis, –a currency crisis, and –a foreign debt crisis.

Fred Thompson17 Capital Flows and Financial Crisis International capital flows consists of short- term (primarily portfolio) capital flows, and long-term (primarily foreign direct investment) flows. An excessive reliance on portfolio capital can be destabilizing and may contribute to financial crises.

Fred Thompson18 Multilateral Policymaking The two organizations at the center of efforts to stem international financial crises are: The International Monetary Fund: a multinational organization the promotes international monetary policy cooperation, exchange arrangements, and economic growth. The World Bank: A sister institution that specializes in making loans to developing nations to promote development and growth.

Fred Thompson19 Can these Organizations Predict a Crisis? To predict a crisis, policymakers must have an idea of their cause. Potential sources of financial crisis are: –An inconsistency between the exchange rate and economic fundamentals. –Speculative attacks. –Structural moral hazards.

Balance-of-Payments Accounts and Net Financial Flows

Fred Thompson21 Financial Inflow Balance of Payments is a flow account, which consists of the current account and the capital and financial accountBalance of Payments is a flow account, which consists of the current account and the capital and financial account A flow of capital, real and/or financial, into a country, takes the form of increased purchases of domestic assets by foreigners and/or reduced holdings of foreign assets by domestic residents. Inflows are recorded as positive, or a credit, in the capital and financial account.A flow of capital, real and/or financial, into a country, takes the form of increased purchases of domestic assets by foreigners and/or reduced holdings of foreign assets by domestic residents. Inflows are recorded as positive, or a credit, in the capital and financial account. Each country also has an international balance sheet, which is a stock account which shows assets and liabilities abroad and foreign assets and liabilities at home -- Called the international investment positions accounts in the U.S. (the accumulated stocks of U.S.-owned assets abroad and of foreign- owned assets in the United States).Each country also has an international balance sheet, which is a stock account which shows assets and liabilities abroad and foreign assets and liabilities at home -- Called the international investment positions accounts in the U.S. (the accumulated stocks of U.S.-owned assets abroad and of foreign- owned assets in the United States). The net change in the international investment positions accounts from the beginning of one year to the end of the next is the net capital/financial flow for the yearThe net change in the international investment positions accounts from the beginning of one year to the end of the next is the net capital/financial flow for the year

Fred Thompson22 Exchange and Net Flows Exchange of Real Assets – exchange of goods and services for other goods and services or for financial claims (will give rise to a net change in financial claims if x≠m)Exchange of Real Assets – exchange of goods and services for other goods and services or for financial claims (will give rise to a net change in financial claims if x≠m) Exchange of Financial Assets – Exchange of financial claims for other financial claims (net financial claims are unchanged)Exchange of Financial Assets – Exchange of financial claims for other financial claims (net financial claims are unchanged) Hence, m-x = net capital flow, also = I-SHence, m-x = net capital flow, also = I-S [ignoring reporting errors and official settlements] [ignoring reporting errors and official settlements]

Fred Thompson23 Balance of Payments Statistics for the United States, 1966 (Amounts in millions of dollars) Sources of Foreign Exchange Exports of Goods and Services $43,142 Balance on goods, services, remittances, and pensions +$4065 Foreign Capital Flow, net $2,532 Balance of all of the above -$1357 Change in U.S. Reserve Assets $568 Change in Liquid Liabilities of Foreign Accounts $789. Uses of Foreign Exchange Imports of Goods and Services $38,063 Remittances and Pensions $1,015 U.S. Government grants, net $3,444 U.S. private Capital Flow, net $4,298 Errors and Omissions $210 Source: Federal Reserve Bulletin, April 1969, pp A70-71

The Balance of Payments Accounting System International Bookkeeping

Fred Thompson25 International Transactions Accounts (Balance of Payments) A quarterly statistical summary of transactions between U.S. and foreign residents organized into three major categories: –The current account –The capital account –The financial account

Fred Thompson26 Balance of Payments System of accounts which is a subset of the National Income and Production Accounts –A double-entry bookkeeping system. –Debit Entries: Transactions that generate a payment outflow (e.g., import). –Credit Entries: Transactions that generate a payment inflow (e.g., export).

Fred Thompson27 Balance of Payments The current account includes exports and imports of goods, services, income, and current transfers. –Goods –Services –Income Receipts and Payments –Unilateral Transfers

Fred Thompson28 Balance of Payments Goods: Exports and imports of tangible items. Services: Exports and imports of services, for example: –Typical business services such as banking and financial services, insurance, and consulting. –Tourism

Fred Thompson29 Balance of Payments Income Receipts: Includes items such as –Investment income on US-owned assets abroad. –Receipts of income on US direct investment abroad. –Government income receipts

Fred Thompson30 Balance of Payments Income Payments: Includes items such as –Investment income on foreign-owned assets in the United States. –Payments of income on foreign direct investment in the United States –US Government income payments

Fred Thompson31 Balance of Payments Unilateral Transfers: Includes items such as: –Government grants abroad –Private remittances –Private grants abroad

Fred Thompson32 Balance of Payments (2000)

Fred Thompson33 Balance of Payments The Financial Sector In June 1999, US capital account definitions were modified to bring them more in line with definitions recommended by the International Monetary Fund. Now there are two accounts: –The capital account includes capital transfers, such as debt forgiveness. –The financial account includes transactions for official assets, for U.S. Government assets other than official reserve assets, for direct investment, for portfolio investment, and for other investment.

Fred Thompson34 Balance of Payments The Financial Sector The new Capital Account includes items that were previously included in unilateral transfers, such as: –Debt forgiveness –Migrants’ transfers (as they leave the country). The new capital account is small for the US (< 0.1 percent of capital flows), but expected to grow.

Fred Thompson35 Balance of Payments The Financial Sector The Financial Account –Records international transactions in the financial sector –Includes portfolio and foreign direct investment –Includes changes in banks’ and brokers’ cash deposits that arise from international transactions.

Fred Thompson36 Balance of Payments The Financial Sector US-Owned Assets Abroad: Increase or decrease in US ownership of foreign financial assets. Foreign-Owned Assets in the US: Increase or decrease in foreign ownership of domestic assets. Reserve Assets: Primarily the assets of central banks.

Fred Thompson37 Balance of Payments The Financial Sector Portfolio Investment: Individual or business purchase of stocks, bond, or other financial assets or deposits. (An income strategy) Foreign Direct Investment: Purchase of financial assets that results in a 10 percent or greater ownership share. (A financial control strategy)

Fred Thompson38 Capital and Financial Account (2000)

Fred Thompson39 The Balance of Payments The Statistical Discrepancy

International Allocation of Capital

Fred Thompson41 Feldstein - Horioka Savings and Investment Relation Based on a closed economy income condition: y = c + i + g. Rearrange as: y - c - g = i.

Fred Thompson42 Feldstein - Horioka Rearranged as: y - c - g = i. Note that y - c - g equals savings, s. Then: s = i. In a closed economy, domestic investment is equal to domestic saving by definition, but is also correlated in practice, i.e., correlation coefficient is necessarily close to 1 in value.

Fred Thompson43 International Flow of Goods, Services, & Capital Domestic Savings and Investment & NFF National Income (GNY) = Consumption (C) + Savings (S)GNY National Spending (GNE) = Consumption (C) + Investment (I) GNY - GNE = S - I GNY - GNE = Exports (x) - Imports (m) S - I = x - m Net Foreign Investment = x - m

Fred Thompson44 Government Budget Deficits and NFF GNE = Household spending + Private I + Government spending = GNY - Private S - Taxes + Private I + Government spending GNE - GNY = Private (I - S) + GovDeficit/Surplus NFF = Private savings surplus - GovDeficit

US Balance of Payments

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Basic Premise Basic Premise A current account deficit must be financed by capital inflows, or it cannot be incurred in the first place

Over , U.S. current account deficits have averaged $183 billion per year. $4 trillion worth of assets have been transferred to foreign ownership. FACT

Fred Thompson49 Trade and Scale Variables I

Fred Thompson50 Scale Variables I U.S. monthly GDP: $1 trillion Monthly goods and services exports: $130 billion = 13%Monthly goods and services exports: $130 billion = 13% Monthly goods and services imports: $185 billion = 18.5%Monthly goods and services imports: $185 billion = 18.5% Balancing item: net capital flow: $55 billion = 5.5%Balancing item: net capital flow: $55 billion = 5.5%

Fred Thompson51 Scale Variables II U.S. GDP per worker: $84,000 per year Exports of $10,900 per yearExports of $10,900 per year Imports of $15,500 per yearImports of $15,500 per year

Foreign claims on U.S. assets now exceed U.S. claims on foreign assets by about $2.7 trillion. –Storing up purchasing power for the future –Private political risk insurance –Public political risk insurance Result:

International Investments (market value, end-2003) U.S. foreign investments: $7.9 trn U.S. foreign investments: $7.9 trn Foreign investments in U.S.: $10.5 trn Foreign investments in U.S.: $10.5 trn Net: -$2.7 trn Net: -$2.7 trn Much of this capital inflow has been portfolio investment. Some has been direct investment.

Foreign Direct Investment (market value, end-2003) U.S. DI abroad:$2.7 trillion U.S. DI abroad:$2.7 trillion Foreign DI in U.S.:$2.4 trillion Foreign DI in U.S.:$2.4 trillion Net: $0.3 trillion Net: $0.3 trillion

Fred Thompson55 Direct Investment Positions At current market value, $ trillion U.S. Direct Investment Abroad Foreign Direct Investment in U.S.

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