International finance system unit-1


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International finance system unit-1

  2. 2. 24/02/2012 CONTENTSIntroduction to financial managementAn overview of international economy in IndiaInternational financial environmentMultinational CorporationsTheories of International business,International Business Methods,International Monitory systemInternational risk exposure 2
  3. 3. FINANCIAL MANAGEMENT Financial Management represents the bridge between the firms real assets and financial assets (Financing) (Capital budgeting) Financial Loans Management Equity Real assets shares
  4. 4. Objectives of F MPrimary - Profit maximization - Maximize the wealth of the owners (share holders)Others - Ensure financial stability Functions of F MPlanning - Ascertain and determine the source of financing the needsOrganization - Procurement and allocation of funds.Control - Monitoring of funds through financial discipline.
  5. 5. PRIMARY ROLE OF F M Mobilization Deployment Control end Risk-return of funds of funds Use of funds Trade-off From where ? Fixed assets Ascertaining facts Investment & figures through (Risk-return) At what cost ? Current assets Reports Financing In what time ? Investments Cash flow (debt-equity) Repayment of debts
  6. 6. OTHER ROLES-Treasury Foreign Financial Maintainingoperations exchange structuring share priceShort term funds Currency fluctuation Debt- equity Dividend policyManagement Hedging Arbitrage Bonus policySpeculative gains byanticipating interest Forward Contract . Pricing of new issue Healthy level ofrate movements share price.
  7. 7. FINANCIAL FUNCTIONS Anticipation Acquire the Utilization Increase MaximizeOf funds needed funds needed Of the funds profitability Firms valueFor financing the Long term Most profitable Reducing the costs Proper planningassets / projects manner. Short Term Efficient allocation Effective monitoring Domestic International At least cost
  8. 8. 24/02/2012 OVERVIEW TO I F M India is not a land of billion problems , but a land of billion opportunities Mukesh Ambani I F M has assumed significance after liberalization More & more FDI’s, FII’s & F F I’s are in Indian market F F I’s hold over 20% of market capitalization Many Indian corporates are listed in foreign stock exchanges. Indian exports are growing at a rate of 12%/ annum with 50% of manufacturing items being exported. 8
  9. 9. 24/02/2012 OVERVIEW TO I F M Total forex trade has crossed 450 billion US $ & forex assets are over US $ 300 billions India is a creditor country among IMF members. Many Indian companies have acquired big ones abroad (Indian MNC) FDI & NRI continue to grow even in the recession years though there may be a negative situation at times. Many international companies look to India for their market. The GDP continue to grow over 7 % 9
  10. 10. 24/02/2012 OVERVIEW TO I F M With such a scenario and the future though tense is bright too , it is essential for the Finance managers to have fairly good knowledge on international financial management. The company’s operations today are global & the finance man has to be well aware of the various intricacies on export/ import/ forex front. The mutual interactions between foreign sector of various countries lead us to International financial system . The institutions operating in the international financial system are closely connected with the foreign sectors of various economies. 10
  11. 11. INTERDEPENDENCE Equity Investment Granting Technical J V in third Participation In bonds Loans/ credits Consultancy countries In Indian & debentures on Govn,t Transfer of companies to Govn,t basis, Technology Party to Party basis In view of global importance to the operations in international trade & funds flow, the importance of international financial management has assumed vital role.,
  12. 12. 24/02/2012 IFM TO TODAY MANAGERSManagers should have a good knowledge of both domestic &international markets in globalized world.Operations of domestic & international markets are different & hencethe factors influencing them should be studied separately.Survival of the fittest is the watch word. A right exposure ininternational & domestic finance for managers are preferred.The activities of MNC with international forces today needs managerswith good command over international operations.No manager can be blind on the international economic & financialoperations today. 12
  13. 13. 24/02/2012 INTERNATIONAL ENVIRONMENT International environment Economic Political Social Demographic Natural Technological & & & factors environment & other Financial Government Cultural factors factors policies factorsRecession Stability Public interest Size, age, gender Climatic condition QualityDepression Legal system Taste of the Transport StandardsBoom Efficiency Consumption Population Power EfficiencyInflation executive/ Beliefs Language, caste Standards SkillsGDP Legislative Religion of livingExchange rate /judiciaryCurrency fluctuation CorruptionCommodity price Fiscal policy Other policies standards 13
  14. 14. 24/02/2012 M N C’SA MNC is an enterprise which has its managerial H Q located in one country& operations in number of countries.They expand either by setting up branches abroad , JV, subsidiaries etc.Expansion takes place through vertical / horizontal / conglomerate route. MNC trade & production has been increasing over the last decades They control 1/3 rd of world production is controlled by MNC’s. The total sales of MNC will be 25% of world sales Bulk pvt investments are from MNC’s Induction of latest technology & exploitation of natural resources are by MNC’s. Globalization led to the growth of MNC”s 14
  15. 15. 24/02/2012 M N C- OBJECTIVES Economies of scale, expansion of operations globally Diversification of product range to reduce risk Cost minimization & profit maximization International collaboration Secure inputs & intermediaries from different countries at low cost , assemble them in their own country & sell them back globally 15
  16. 16. 24/02/2012 M N C- FEATURESThey have different state of mind. They think global, plan global, act global.The plant size, operations, activities, place are global.The MNC’s F M differs from D FM in many ways. Seeking capital at low cost markets on international basis Investment proposals are decided on global basis. Integrate their world wide operations Flexible in planning , adaptability to the environment, quickness in decisions , innovative , vision, selecting best talent , profitable , efficient MIS, well developed R & D etc 16
  17. 17. 24/02/2012 M N C’S - DC’SLarger investments in R & D Less investments in R & DControl on cheaper capital Not much excess reservesRating is higher Struggle to get good ratingCapital intensive Not Capital intensiveInternational diversification Domestic diversificationAmbitious & expansionist Less ambitiousSound F M Not efficient F M 17
  18. 18. INTERNATIONAL TRADE THEORIESClassical theory Modern theory Some recent theories (General Equilibrium theory )Barter V/s money trade Karvis theory Heckscher Ohlin theoremAbsolute advantage theory Technology & trade theoryComparative advantage theoryReciprocal demand theory
  19. 19. 24/02/2012 CLASSICAL THEORIES Barter trade V/S Money trade Trade between commodities without any exchange of money.. This was prevalent between any two countries. After advent of IMF , multilateral trade is encouraged . Still some countries practice barter trade on a limited basis Classical trade theory- Absolute Advantage ( A A) Value of product in a country is determined by its labour contents. As labour cannot move internationally , this was used as absolute advantage by some countries as per Adam Smith. Production of one man in one week product In USA In India wheat 8 kgs (A A) 2 kgs Cloth 2 yards 6 yards ( A A)Exchange rate between wheat & cloth in India is 1;3 whereas it is 4;1 in USAIf wheat of USA is exchanged for cloth of India, the ratio will be between 1: 3 & 4:119
  20. 20. 24/02/2012 CLASSICAL THEORIESComparative advantage theoryDeveloped by David RicardoThe country would export that commodity in which it had a greaterComparative advantage & import a commodity in which it had a greaterComparative disadvantage.Example- If no trade takes place , India will have only 2 kgs of wheat & 6 yds of cloth. With trade taking place, it can produce 12 yds of cloth, export 6 yds & retain balance for its use. It can also get 3 kgs of wheat even at domestic exchange ratio in US.(Assumption- Only labour is taken into consideration, no trade &tariffs, unrestricted flow of trade, cost of transport & insurance ignored ) 20
  21. 21. 24/02/2012 CLASSICAL THEORIESReciprocal Demand theoryPropounded by J S Mill Law of comparative costs determines the supply of goods in foreign trade as per David Recardo. Law of reciprocal demand sets the price at which the trade will take place. i.e , it is the law of supply & demand that will determine the price. ( It is the US demand for Indian cloth & Indian demand for US wheat) The offer & bids in the international trades are represented by offer curves. These curves can be regarded as demand curves representing various amounts of cloth which USA would demand in exchange for a unit of wheat & units of wheat which India would demand for exchange of one unit of cloth. 21
  22. 22. Modern theory of international tradeClassical theory explains trade based on the cost difference which in turnIs dependent on the labour or other factor efficiencies.The modern theory also called general equilibrium theory is based on demand& supply principles.It shows that there is hardly any difference between internal & internationaltheories. 22
  23. 23. Modern theory of international tradeModern economists were of the view that there is no need for a separate theoryin view of the following1. Factor mobility among countries is restricted as in case of regions within a country .2. Difference in currencies among nations do not stand in any way of trade as there is arrangement for exchange of currencies in forex market.3. Transport cost is there both for international & domestic trade.4. Comparative cost difference is there both for domestic & international trade.5. The other differences such as habits, customs, trade restrictions are not insurmountable. 23
  24. 24. 24/02/2012 INTERNATIONAL BUSINESS THEORIESHeckscher- Ohlin theoremAccording to this theory , a country with capital abundance will export capitalgoods & those countries with labour abundance will export labour intensivegoods.Ex- USA can export capital intensive goods in exchange for labour intensivegoods by India.(PK/ PL) A < ( PK/ PL)P= price factor , K= capital, L = labour, A & B are two countries.For trade to take place between two countries , there should be difference infactor efficiencies and for each commodity .What is said for factor of production can also be true for goods as they are theinputs in productive activities 24
  25. 25. RECENT THEORIESKarvis theory Technology & Trade theoryAlso called availability theory Technology difference may lead to trade advantages.Those countries which have exportablesurplus will export to other countries. Introduction of new technology may lead to trade in that goods & from thatConsumers preference for the goods of a country.particular country also holds good. The country which introduces new technology first will increase its exports Emerging models of international theories as per economists are Ricaro goods, Herkscher – Ohlin goods & Technology goods
  27. 27. GlobalizationGlobalization / deregulation / liberalization has made business morecompetitive & challenging.Indian companies have become MNC’s & foreign MNC’s have entered India .Business methods adopted by various companies have also undergone changes.Globalization had brought remarkable effect on following areas.1. corporate strategy & corporate Governance.2. Corporate goals & objectives3. Corporate financial strengths & weakness4. Input market, output market both in direction & content. 27
  28. 28. International Business environment.Financial markets opened up & are dynamic & volatile in globalized set upIT & telecommunication media has made world a global village.Competition is severe & those who are weak/ late will not survive.Natural forces will act, interest rates moves freely & exchange rates are dynamic.Those who are agile & alert can survive.Those management who have skilled power/ financial strong / optimize shareholders value by adopting to changes can be global MNC’s.Corporate management have to adapt to new situation .They have to change strategies & undergo a deep transformationto meet the challenges 28
  29. 29. Global factorsCapital flow will be from less efficient / less profitable ventures / marketsto more efficient & profitable markets.Capital can now be sourced from cheaper markets internationally.Human skills & technology will also see mobility.Free exports & imports can reduce the costs due to comparative advantagesBoth short term & long term finances can be available both from Domestic& international markets.Availability of capital when required can reduces locking of funds athigh cost borrowings.JV, M & A, Disinvestments , putting weight in profitable directionswill be the order of the day. 29
  30. 30. Global factors- (Contd)Multicurrency loans, flexi rate loans, ECB,s , guarantees , bridge loans will beavailable in global markets.Changes in legal frame work has brought in International court of justice.Borrower & Lender have to abide by a legal system which is acceptable toboth.International chamber of commerce & International court of justice are theagencies on legal issues.The documents & agreements between parties may specify the law of theirchoice which should govern their contract.Government will take up with international court of justiceIndividuals & corporate bodies can approach the International chamber ofCommerce for adjudication.Production sharing will be the most important form of economicintegration Peter Drucker 30
  31. 31. Global sourcingOne of the main characteristics of MNC is global sourcing for inputs & financialresources.Japan/ USA increasingly depend on outside source depending on lowest globalcost alternatives.Toyota of Japan outsource 60 to 70% of their requirements & General Motorsof US to the extent of 30-40% .Reasons for global sourcing are1. Price/ cost/ quality2. Advanced technology3. Prompt , co-operative delivery & consistent attitude.4. Agreement with subsidiaries/ counter trade requirement.5. Reduction of use of capital/ labour.The issues in global sourcing are1. Reduction in flexibility of own planning2. There might be some hidden cost3. Possibilities of changes in currency exchange rate. 31
  32. 32. 24/02/2012 GLOBAL ORGANIZATIONAL STRUCTURE organization under globalization is a dynamic phenomenon. It involves integration of organization theory, organization functions, organization design, organization performance etc. Organization, components, activities are influenced by environment which is influenced through human behaviour. This involves human adaptation & behavioral adaptation of the organization. Each organization has evolved on the basis of culture, tradition & precedents. Organization design for globalization involves various factors 32
  33. 33. 24/02/2012 ORGANIZATIONAL – DESIGN FOR GLOBALIZATION Steps for globalization1. Size & type 2. Structure , 3. Human 4. Human of business strategies & behaviour Resources systems & culture Development Training Adaptation Professionalism Mind setForeign Government Foreign Global Business Law Attitudetechnology Policies & finance Practices of procedures Foreign Banks of host/ home & markets 33 countries
  35. 35. International Monitory –Pre war periodGold standard was followed by various countries prior to first world war -1914.The exchange rate between two countries was determined on the basis of therates at which two countries could convert their currencies for one ounce of gold.Ex- If one ounce of gold was $ 400 in Us & sterling Pounds 200 in G B,then the $ - pound convertible rate was $ 2 / pound.Countries continued on Gold standards due to its inherent advantages.( Price stability of gold)This was abandoned with the advent of W W 1 and modified version of Gold standardCalled gold exchange standards came into force.In this system, some countries committed converting their currencies into the currenciesof other countries on gold standards rather than gold.II W W effectively stopped all international economic activities. 35
  36. 36. International Monitory system- Bretton Woods systemSecond world war has led to international monitory disorder , Exchange restrictions,undesirable trade practices.Need for international monitory co-operation & understanding was greatly felt afterthe war.Britton Woods conference resulted in establishment of IMF & ( IBRD ) world bank.44 member countries met at Britton woods , New Hampshire , USA & signedan agreement for establishing a new monetary system .Later more countries joined & almost all countries (184) are now members . 36
  37. 37. Objectives of International Monitory Fund ( IMF)1. To promote international co-operation through consultation & mutual collaboration2. To promote exchange stability & maintain orderly exchange arrangements.3. Avoid competitive exchange depreciation4 To help members of temporary balance of payment difficulties & to tide over them without resort to exchange restrictions.5. To promote growth of multilateralism in trade payments & expand world trade6. To help achieve balance of payments equilibrium , shorten the duration of disequilibrium & promote orderly international relations. 37
  38. 38. Importance of IMFIn all matter of exchange rate changes, , imposition of restrictions on currentaccount , use of discriminatory practices, members are obliged to consult IMFIf the members fail to consult IMF, they would be ineligible to have recourseto financial resources.The consultations include the following1. Supply of economic & financial data to the fund by the member countries2. The staff of the fund can call various types of data from a member country on ad hoc basis.3. The staff team visits member countries once an year for a first hand study on economic & financial conditions in the member country.4. Formal & informal consultations are held with member countries when they approach for standby arrangement or credit withdrawal. 38
  39. 39. Sources of funds for IMF- The Quotas Every member country in the IMF has been allotted a quota , The formula was worked out based on the following1. 2 % of the national income2. 5 % of the gold & $ balances3. 10% of the average annual exports4. 10% of the maximum variation of annual exports5. The sum of the above , increased by the % ratios of average annual exports to national income of the member. Each member’s quota was fixed as their initial contribution to the fund. The total quotas as on 1944 of 44 countries was $ 8800 million & by 1994 the number of countries were 178 & quota was SDR- 144,620 million 39
  40. 40. Special drawing rights ( S D R )Historically Gold was taken by the US $ & U K sterling pound in inter war &post war period.This was replaced by Special drawing rights ( S D R ) after seventies.SDR is now the standard unit account whose value will be fixed in terms ofbasket of currencies.SDR is a source of augmenting international liquidity.This is an asset specially intended to replace Gold and is called paper gold.The value of SDR is fixed on daily basis as weighted average of a basket of16 currencies of countries with more than 1 % of world trade .Since 1981, the value of SDR is based on the weighted average of 5 majorcurrencies namely US $, DM, UK pound sterling, French Frank & Yen,Since 2005 , it is UK pound sterling, US $, Euro & Japanese Yen. 40
  41. 41. Other sources of fund for IMF IMF holds substantial quantum of gold reserves which was received as Quota from its members . Only 25% of the gold was converted into SDR’s. In 1975 , IMF sold 1/6 th of gold reserves in auction which realised US $ 5.7 billions Under general agreement to borrow, IMF could borrow from its participating members ( G-10 countries), which will be repaid with interest in 5 years period. IMF can also acquire any currency in exchange for its gold reserves. The repayment made by member countries is also a source for further lending. 41
  42. 42. 24/02/2012 I M F- BOARD There are 22 directors on Board. 6 of them are appointed by those governments who hold largest quotas. The rest are appointed by other countries The M D / Chairman is appointed for 5 years period. The board meets once an year to take major policy decisions. Its members are mostly finance ministers / central bank governors of member countries All member countries are represented on this board. 42
  43. 43. 24/02/2012 I M F- LENDING OPERATIONS Provides temporary assistance for balance of payment purposes. A member can draw up to 25% of its quota (Gold tranche) in gold automatically. Further 100% of its quota can be borrowed in 4 stages with strict restrictions. If that country has 10% credit position as its quota as borrowings by other countries ( super gold tranche) , it can draw up to 35 % of its quota. IMF lends under various schemes 43
  44. 44. 24/02/2012 I M F- SCHEMESStandby Compensating Buffer stock ExtendedArrangement Finance Facility Financing Facility 19741952 1963 Facility 1969country can Borrow Financial assistance Financial assistance Borrow on medium at first Indication To countries facing For purchase of Term basis toWithout getting the Temporary shortfall Approved primary OvercomeLoan approval Products to avoid Balance of paymentto save time Price shocks Problem due to Structural imbalance 44
  45. 45. 24/02/2012 POST BRITTON WOODS SYSTEM (CURRENT SYSTEM) Britton woods system was abandoned & most of the countries shifted to floating exchange system from 1976. Under this system, countries were given flexibility to choose the exchange system they wanted to follow in managing their exchange rates. The countries can float / peg their currencies with basket of currencies / SDR. Pegging with gold was abandoned. Members no longer required to deposit their quota in gold. IMF reduced the role of gold and SDR became reserve asset. IMF became more powerful & was given the responsibility of supervising the monitory system. 45
  46. 46. 24/02/2012 POST BRITTON WOODS SYSTEM (CURRENT SYSTEM) As of 1995, of 155 members in the fund, the following were the exchange rate mechanism followed by various countries Currencies pegged to No of countries US$ 27 French frank 14 SDR 6 Currency basket 34 Independent float 27 Joint Float 5 Other currencies 42 46
  47. 47. 24/02/2012 POST BRITTON WOODS SYSTEM (CONT’D) PRINCIPLES OF EXCHANGE RATE MANAGEMENT A member country neither should manipulate the exchange rates in such a way to prevent a correction in BOP position. Countries should use the exchange rate to gain competitive advantage in international market. Member country shall intervene in the exchange market If necessary to counter disorderly conditions While intervening in exchange markets, , a member country should keep the interest of other countries in mind. Members are free to choose their exchange rate arrangements except to maintain value in terms of SDR They should co-operate with fund in orderly exchange arrangements. 47
  48. 48. 24/02/2012 IMPORTANCE OF RESERVES Just as one needs domestic cash requirements for transactions, countries need reserves to meet payments in international transactions. The adequacy of reserves is also important ( reserves to imports, rate of growth of world trade to rate of growth of reserves & magnitude of balance of payments deficit) Under floating rate system, a larger need for reserves is a must to meet the BoP. Increasing BOP by non oil producing countries require more reserves to meet the deficit. Many poor countries have their exchange rates pegged to a currency or basket of currency for which central bank intervention is needed in the market 48
  49. 49. 24/02/2012 INDIAS - RESERVES  Indians currency exchange rate is linked to basket of currencies.  India’s reserves position is comfortable and is now almost equal to one year’s imports .  The reserve’s position comprises of Gold, Foreign exchange assets, & SDR’s. The reserve levels over the last 50 years (Rs in crs) are as follows. March 71 March 81 Jan 94 Dec 99 June 02 June09Gold 182 226 12,665 12,790 16,272 46,914Forex 438 4,822 61,440 1,39,134 2,67,333 12,16,345assetsSDR 112 497 233 18 47 2Total 732 5,545 74,338 1,51,942 2,83,652 12,63,261 49
  50. 50. 24/02/2012 UNIT-1CONCLUDED 50