Introduction to international finance and International economy

INTERNATIONAL
FINANCE (IF)
Aparrajitha Ariyadasa
( B.Sc (J’pura), B.Sc. (OUSL), Post. Grad. Dip. In IP Law(wales), LLM (Colombo)
Lecturer in University of Plymouth (UK), Lymkokwin (Malaysia), SLIIT, ICBT
Attorney-at-Law, Senior Partner ATD Legal Associates (www.atdlegalassociates.com),
atdlegalassociates@gmail.com
4/18/2019APARRAJITHA ARIYADASA 1

International economics
 International trade
 International finance

International economics
 International economics is a field of
study that assesses the implications of
international trade, international
investment, and international borrowing
and lending.
 There are two broad subfields within the
discipline: international trade and
international finance.

What is international finance?
 International finance (also referred to
as international monetary economics
or international macroeconomics) is
the branch of financial economics
broadly concerned with monetary and
macroeconomic interrelations between
two or more countries.

Objectives of international finance
 International finance applies macroeconomic models to help
understand the international economy. Its focus is on the
interrelationships among aggregate economic variables such as
GDP, unemployment rates, inflation rates, trade balances,
exchange rates, interest rates, and so on. This field expands
basic macroeconomics to include international exchanges. Its
focus is on the significance of trade imbalances, the
determinants of exchange rates, and the aggregate effects of
government monetary and fiscal policies. The pros and cons of
fixed versus floating exchange rate systems are among the
important issues addressed

Elements of international finance
 International trade and investment flows have grown
dramatically and consistently during the past half
century.
 • International trade is a field in economics that
applies microeconomic models to help understand the
international economy.
 • International finance focuses on the
interrelationships among aggregate economic
variables such as GDP, unemployment, inflation,
trade balances, exchange rates, and so on.

Introduction to International Finance
 Finance is an international context
 Why do we need to study international Finance
 We are living in a highly globalized and integrated world
economy
 Continued liberalization of international trade further
internationalizes the consumer pattern
 Globalized production: MNC Source Inputs and locate
production any where in the world
 Integrated Financial Markets: Internationally diversified
investment, internationally tradable financial securities

International finance---
 International finance studies the flow of
capital across international financial
markets, and the effects of these movements
on exchange rates.
 International monetary economics and inte
rnational macroeconomics study flows of
money across countries and the resulting
effects on their economies as a whole.

Wolf Gang says
 "International Macroeconomics" deals with the global
aspects of business cycles and macroeconomic policy.
Globalization is proceeding quickly, implying that
economies are becoming more and more
interconnected. Shocks within one country can easily
be transmitted to other countries. Excess savings in
one country can lead to bubbles in other countries.
The bursting of a bubble in one country can lead to a
recession in a number of other countries.

 The global interconnectedness of
economies is not restricted to the
private sector but also includes the
effects of macroeconomic policies.
 Loose monetary policy in a developed
country can lead to a surge of capital
into emerging economies, and fiscal
stimulus (or austerity) in one country is
likely to affect its trading partners.

International monetary economics
 Monetary economics is the branch
of economics that studies the different
competing theories of money. ... It
examines the effects of
monetary systems, including regulation
of money and associated financial
institutions and international aspects.

What makes International Finance
special?
 Three major dimensions make
international finance different purely
from the domestic finance
 Foreign exchange and political risks
 Market imperfections
 Expanded opportunity sets

What makes International Finance special?
Foreign exchange and the political risks
 Unexpected fluctuations of the exchange rate may adversely
affect the MNCS as well as the individuals who are engaged in
cross boarder transactions
 Exchange rates uncertainty may effect all the major economic
fluctuations Including consumptions production and
investments
 Sovereign country can change the rules eg:
 Tax rules
 Expropriation of the assets
 In some countries there is a lack of tradition of the rule of tax

Market Imperfections
 Market imperfections represent various frictions and
impediments preventing markets from the
functioning perfectly
 Such frictions/Impediments/barriers include
 Legal restrictions
 Excessive transportation and the transaction costs
 Information asymmetry
 Discriminatory taxation

Market Imperfections
 Often MNC are motivated to locate the
production overseas due to such market
imperfections.
 Imperfection in the international finance
market often restricted extent to which
investors can diversify their portfolios.

Expanded opportunity to set
 If firms venture into the arena of global markets, they
can benefit from an expanded opportunity set by:
 Locating production in any country/ region to the
world to maximize the performance.
 Raising funds in any capital market where the cost of
capital is the lowest
 Deploying assets on a global basis to gain from
greater economies of scale.

 International Finance is different from the
domestic finance and to be benefited from it
 Maximize the benefits from the global
opportunity to set
 Control exchange rate and the political risks
 Manage various market imperfections

Important macroeconomic indicators
 GDP
 GDP per capita
 unemployment rates
 inflation rates
 national budget balances
 and national debts.

GDP
 Gross domestic product (GDP) is a
monetary measure of the market value
of all the final goods and services
produced in a period of time, often
annually.

GDP PER CAPITA
 gross domestic product (at purchasing power
parity) per capita, i.e., the purchasing power
parity (PPP) value of all final goods and
services produced within a country in a given year,
divided by the average (or mid-year) population for
the same year.
 As of 2017, the average GDP per capita (PPP) of all of
the countries of the world is US$17,300.For rankings
regarding wealth

GDP PER CAPITA –LIST OF COUNTRIES

GDP PER CAPITA IN SRI LANKA
 With an economy worth $93.45 billion $298.310 billion PPP and a per capita
GDP of about $4,310, $13,480 PPP as of 2018 Sri Lanka has mostly had strong
growth rates in recent years. Wikipedia
 GDP growth: 4.5% (2016) 3.3% (2017) 3.9% (2018e) 4.0% (2019f)
 GDP per capita rank: 109th (nominal, 2017) 90th (PPP, 2017)
 GDP rank: 63rd (nominal, 2018) 59th (PPP, 2018)
 GDP by sector: agriculture: 7.8% industry: 30.5% services: 61.7% (2017 est.)
 Exports: $15 billion (2018 est.)
 Current account: -$2.31 billion (2017 est.)
 Gross external debt: $51.72 billion (79.1% of GDP) (31 December 2017est.)

WHICH COUNTRY HAS THE HIGHEST GDP
PER CAPITA?
Rank Country/economy
GDP per capita (Nominal) ($)
2018
World 11,727
1 Luxembourg 120,061
2 Switzerland 86,835
DP(Nominal)percapitaRanking2018

 countries like Brazil, Russia, India, and China are watched so closely today
that they have acquired their own acronym: the BRIC countries.
 countries like Indonesia, Kenya, Ghana, and Burundi are among the poorest
nations of the world
 African countries- data are less difficult to obtain

UN EMPLOYMENT RATE
 unemployment rate measures the
percentage of the working population in
a country who would like to be working
but are currently unemployed. The
lower the rate, the healthier the
economy and vice versa

Un employment rate in Sri Lanka

Inflation rate
 The inflation rate measures the annual rate of increase of the consumer price
index (CPI).
 The CPI is a ratio that measures how much a set of goods costs this period
relative to the cost of the same set of goods in some initial year.
 Thus if the CPI registers 107, it would cost $107 to buy the goods today, while
it would have cost just $100 to purchase the same goods in the initial period.
 This represents a 7 percent increase in average prices over the period, and if
that period were a year, it would correspond to the annual inflation rate. In
general, a relatively moderate inflation rate (about 0–4 percent) is deemed
acceptable;
 however, if inflation is too high it usually contributes to a less effective
functioning of an economy. Also, if inflation is negative, it is called deflation,
and that can also contribute to an economic slowdown.

Inflation rate in Sri Lanka 2019

GOVERNMENT BUDGET BALANCES
 Government Budget Balances around the World is Another factor that is often
considered in assessing the health of an economy is the state of the country’s
government budget.
 Governments collect tax revenue from individuals and businesses and use that
money to finance the purchase of government provided goods and services.
Some of the spending is on public goods such as national defense, health care,
and police and fire protection.
 The government also transfers money from those better able to pay to others
who are disadvantaged, such as welfare recipients or the elderly under social
insurance programs.

A budget deficit
 Generally, if government were to collect more in tax revenue than it
spent on programs and transfers, then it would be running a
government budget surplus and there would be little cause for
concern.
 However, many governments oftentimes tend to spend and transfer
more than they collect in tax revenue.
 In this case, they run a government budget deficit that needs to be
paid for or financed in some manner. There are two ways to cover a
budget deficit.
 First, the government can issue Treasury bills and bonds and thus
borrow money from the private market;
 second, the government can sometimes print additional money. If
borrowing occurs, the funds become unavailable to finance private
investment or consumption, and thus the situation represents a
substitution of public spending for private spending

NATIONAL DEBT
 When governments borrow, they will issue Treasury bonds with varying maturities. Thus some
will be paid back in one of two years, but others perhaps not for thirty years. In the
meantime, the total outstanding balance of IOUs (i.e., I owe you) that the government must
pay back in the future is called the national debt .
 This debt is owed to whoever has purchased the Treasury bonds; for many countries, a
substantial amount is purchased by domestic citizens, meaning that the country borrows from
itself and thus must pay back its own citizens in the future.
 The national debt is often confused with a nation’s international indebtedness to the rest of
the world, which is known as its international investment position Excessive borrowing by a
government can cause economic difficulties. Sometimes private lenders worry that the
government may become insolvent (i.e., unable to repay its debts) in the future.
 In this case, creditors may demand a higher interest rate to compensate for the higher
perceived risk. To prevent that risk, governments sometimes revert to the printing of money
to reduce borrowing needs. However, excessive money expansion is invariably inflationary
and can cause long-term damage to the economy.

Budget balance on investors
 present budget balances for a selected set of countries. Each is shown as a
percentage of GDP, which gives a more accurate portrayal of the relative size.
Although there is no absolute number above which a budget deficit or a
national debt is unsustainable, budget deficits greater than 5 percent per
year, those that are persistent over a long period, or a national debt greater
than 50 percent of GDP tends to raise concerns among investors.

Budget Balance and National Debt
(Percentage of GDP), 2009
Country/
Region
European
Union
United
States
China Japan India Sri lanka
Table 1.3
National
Debt (%)
- 37.5 15.6 72.1 56.4
Budget
Balance
(%)
-6.5 -11.9 -3.4 -7.7 -8.0

summery
 GDP and GDP per capita are two of the most widely tracked indicators of both
the size of national economies and an economy’s capacity to provide for its
citizens. • In general, we consider an economy more successful if its GDP per
capita is high, unemployment rate is low (3–5 percent), inflation rate is low
and nonnegative (0–6 percent), government budget deficit is low (less than 5
percent of GDP) or in surplus, and its national debt is low (less than 25
percent). •

 The United States, as the largest national
economy in the world, is a good reference
point for comparing macroeconomic data. ◦
The U.S. GDP in 2008 stood at just over $14
trillion while per capita GDP stood at
$47,000. U.S. GDP made up just over 20
percent of world GDP in 2008. ◦ The U.S.
unemployment rate was unusually high at 10
percent in November 2009 while its inflation
rate was very low at 1.8 percent. ◦

 The U.S. government budget deficit was at an
unusually high level of 11.9 percent of GDP in
2009 while its international indebtedness
made it a debtor nation in the amount of 37
percent of its GDP. • Several noteworthy
statistics are presented in this section: ◦
Average world GDP per person stands at
around $10,000 per person. ◦ The GDP in the
U.S. and most developed countries rises as
high as $50,000 per person.

 ◦ The GDP in the poorest countries like
Kenya, Ghana, and Burundi is less than
$2,000 per person per year. ◦ U.S.
unemployment has risen to a very high
level of 10 percent; however, in Spain it
sits over 19 percent, while in South
Africa it is over 24 percent. ◦ Inflation is
relatively low in most countries but
stands at over 9 percent in Russia and
over 11 percent in India. In several
countries like Japan and Estonia,
deflation is occurring.

Exchange Rate Regimes
 Because countries use different national currencies, international trade and
investment requires an exchange of currency. To buy something in another country,
one must first exchange one’s national currency for another. Governments must
decide not only how to issue its currency but how international transactions will
be conducted. For example, under a traditional gold standard, a country sets a
price for gold (say $20 per ounce) and then issues currency such that the amount
in circulation is equivalent to the value of gold held in reserve. In this way, money
is “backed” by gold because individuals are allowed to convert currency to gold on
demand.
 Today’s currencies are not backed by gold; instead most countries have a central
bank that issues an amount of currency that will be adequate to maintain a
vibrant growing economy with low inflation and low unemployment. A central
bank’s ability to achieve these goals is often limited, especially in turbulent
economic times, and this makes monetary policy contentious in most countries.
 One of the decisions a country must make with respect to its currency is whether
to fix its exchange value and try to maintain it for an extended period, or whether
to allow its value to float or fluctuate according to market conditions. Throughout

Exchange rates -fixed
 history, fixed exchange rates have been the norm,
especially because of the long period that
countries maintained a gold standard (with
currency fixed to gold) and because of the fixed
exchange rate system (called the Bretton Woods
system) after World War II. However, since 1973,
when the Bretton Woods system collapsed,
countries have pursued a variety of different
exchange rate mechanisms.

Floating Exchange Rate and IMF
 The International Monetary Fund (IMF), created to monitor
and assist countries with international payments
problems, maintains a list of country currency regimes.
The list displays a wide variety of systems currently being
used. The continuing existence of so much variety
demonstrates that the key question, “Which is the most
suitable currency system?” remains largely unanswered.
Different countries have chosen differently. Later, this
course will explain what is necessary to maintain a fixed
exchange rate or floating exchange rate system and what
are some of the pros and cons of each regime. For now,
though, it is useful to recognize the varieties of regimes
around the world.

Exchange Rate Regimes
 Country/Region Regime Euro Area Single currency within: floating externally
 United States -Float
 China -Crawling peg
 Japan - Float
 India Managed -float
 Russia -Fixed to composite
 Brazil- Float
 South Korea -Float
 Indonesia -Managed float
 Spain Euro zone; fixed in the European Union; float externally
 South Africa- Float
 Estonia -Currency board
Source: International Monetary Fund, De Facto Classification of Exchange Rate
Regimes and Monetary Policy Framework, 2008.

 shows the selected set of countries followed by a currency regime. Notice
that many currencies—including the U.S. dollar, the Japanese yen, the
Brazilian real, the South Korean won, and the South African rand—are
independently floating, meaning that their exchange values are determined in
the private market on the basis of supply and demand. Because supply and
demand for currencies fluctuate over time, so do the exchange values, which
is why the system is called floating.

 Note that India and Indonesia are classified as “managed floating.” This
means that the countries’ central banks will sometimes allow the currency to
float freely, but at other times will nudge the exchange rate in one direction
or another.
 China is listed and maintaining a crawling peg, which means that the currency
is essentially fixed except that the Chinese central bank is allowing its
currency to appreciate slowly with respect to the U.S. dollar. In other words,
the fixed rate itself is gradually but unpredictably adjusted.

 Estonia is listed as having a currency board. This is a
method of maintaining a fixed exchange rate by
essentially eliminating the central bank in favor of a
currency board that is mandated by law to follow
procedures that will automatically keep its currency fixed
in value.
 Russia is listed as fixing to a composite currency. This
means that instead of fixing to one other currency, such as
the U.S. dollar or the euro, Russia fixes to a basket of
currencies, also called a composite currency. The most
common currency basket to fix to is the Special Drawing
Rights (SDR), a composite currency issued by the IMF used
for central bank transactions.

EU
 Finally, sixteen countries in the European Union are
currently members of the euro area. Within this area, the
countries have retired their own national currencies in favor
of using a single currency, the euro. When all countries
circulate the same currency, it is the ultimate in fixity,
meaning they have fixed exchange rates among
themselves because there is no need to exchange.
However, with respect to other external currencies, like the
U.S. dollar or the Japanese yen, the euro is allowed to float
freely.

Globalization of the world Economy
 Key Trends and development including
 Emergence of the Global Financial Markets
 Europe Sovereign debt crisis in 2010,
 Trade Linearization and Economic Integration
 Privatizations
 Global Financial Crisis 2008 and 2009

Globalization of the World economy
Emergence of the Globalized Financial Markets
 De-regulation of the financial markets
 Advances in Technology
 Have greatly reduced the information and transaction costs which led
to
 Finance Innovations Such as
 Currency features and options
 Multi Currency Bonds
 Cross border stock listings
 International Mutual Funds

Globalization of the World economy
Emergence of the Global Currency
 The advent of the euro 1999 represent a momentous
event in the history of world financial system.
 More than 300 million European are using the
common currency
 Many new member of the EU would like to adopt
Euro
 The transaction domain of the euro may become
larger than the USD in near future.

Globalization of the world economy
Emergence of the euro as a global economy
 The advent of the euro in 1999represents a momentous event in
the history of world financial system
 more than 300 million Europeans are using the common
currency
 Many new members of the EU would like to adopt the euro
 The transactions domain of the euro may become larger than
the USD in near future.

Europe Sovereign Debt Crisis of 2010
 All EU member states are automatically members of
both the Economic and Monetary union (EMU) and
the stability growth pact(SGP)
 SGP is an agreement among the member states of the
European union to facilitate and maintain the
stability of the EMU
 The SGP requires each Member state to implement
the fiscal policy aiming for the country to stay within
the limits of the government deficit(3% of GDP)

Europe Sovereign -debt crisis of 2010
 In December 2009, the New Greek Government reveal
that the actual budget deficit was12.7 percent
compared to the previously forecasted 3.7 percent
based on the falsified national account data.
 Therefore , Greece actually was in a serious violation
of SGP.
 This situation was a result of excessive borrowing
and spending with wages and prices rising faster
than the productivity.

 Greece could not use the traditional means of
depreciating national currency as the country had
adopted the euro.
 Investors became worried about sovereign default.
 They started to sell Greek Government Bonds
 The panic spread to the other weak European
countries, especially Ireland Portugal and Spain.

 In 2010 credit ratings agencies downgraded the
government bonds of the affected countries.
 Borrowing and refinancing became more costly
 Although the debt crisis in Greece accounted for only
about 2.5% of Eurozone GDP, it quickly escalated to a
Europe-wide debt crisis.

 On May 9, 2010 EU countries led by France and
Germany jointly with the IMF put together a massive
Euro 750 billion package to ball out Greece and other
weak countries.
 The agreement on the bail out plan was slow and
thus became expensive due to
 Europe Lack of Political Union.
 Fragmented decision making structure.

Trade Liberalization and economic integration
 Over the past 50 years International trade
increased about twice as fast as worlds GDP.
 There has been a change in attitudes of
many of the worlds government who have
abounded mercantile views and embraced
the as the surest route to the prosperity for
their citizenry

 The General Agreement on Tariffs and
trade(GATT) is multilateral agreement among
member countries that has reduced many
barriers to Trade.
 The world Trade Organization (WTO) has the
power to enforce the rules of international
Trade.

 The European Union (EU)was established to foster
economic integration among the countries of western
Europe.
 The North American Free Trade Agreement (NAFTA)
calls phasing out impediments of Trade between
Canada, Mexico and United states over a 15 year
period beginning in 1994.

 The selling of state -run enterprises to
investors is also known as “denationalization”
 Privatization is often seen as socialist
economies in transition to market economies.
 By most estimates , this increase the
efficiency of the enterprise
 It is also often spurs a tremendous increase
in cross border investment.

Globalisation of world Economy
Global Financial crisis 2008-2009
 The “Great Recession “ was the most serious
synchronised economic downturn since the
Great Depression of 1930.
 Factors Included
 Households and Financial institutions
borrowed too much and too much risk
 This risks was repackaged with
securitizations.

Multinational Corporations
 A multinational corporation(MNC) Is a firm that has
been incorporated in one country and has
production on sales operation in other countries.
 There are about 60000 MNC s in the world
 Many MNC obtain raw materials from one nation ,
financial capital from another produce goods in
labour and capital equipment in third country and
sell their output in various other national markets.

Introduction to international finance and International economy

Introduction to international finance and International economy

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