Chapter 1

Scope of International Finance

Financial management of a company is a complex process, involving its own methods and procedures. It is
made even more complex because of the globalization taking place, which is making the world’s financial and
commodity markets more and more integrated. The integration is both across countries as well as markets. Not
only the markets, but even the companies are becoming international in their operations and approach. This
changing scenario makes it imperative for a student of finance to study international finance.

When a firm operates only in the domestic market, both for procuring inputs as well as selling its output, it
needs to deal only in the domestic currency. As companies try to increase their international presence, either by
undertaking international trade or by establishing operations in foreign countries, they start dealing with people
and firms in various nations. Since different countries have different domestic currencies, the question arises as
to which currency should the trade be settled in. The settlement currency may either be the domestic currency
of one of the parties to the trade, or may be an internationally accepted currency. This gives rise to the problem
of dealing with a number of currencies. The mechanism by which the exchange rate between these currencies
(i.e., the value of one currency in terms of another) is determined, along with the level and the variability of the
exchange rates can have a profound effect on the sales, costs and profits of a firm. Globalization of the financial
markets also results in increased opportunities and risks on account of the possibility of overseas borrowing
and investments by the firm. Again, the exchange rates have a great impact on the various financial decisions
and their movements can alter the profitability of these decisions.

In this increasingly globalize scenario, companies need to be globally competitive in order to survive.
Knowledge and understanding of different countries’ economies and their markets is a must for establishing
oneself as a global player. Studying international finance helps a finance manager to understand the
complexities of the various economies. It can help him understand as to how the various events taking place
the world over are going to affect the operations of his firm. It also helps him to identify and exploit
opportunities, while preventing the harmful effects of international events. A thorough understanding of
international finance will also assist the finance manager in anticipating international events and analyzing their
possible effects on his firm. He would thus get a chance to maximize profits from opportunities and minimize
losses from events which are likely to affect his firm’s operations adversely.

Companies having international operations are not the only ones, which need to be aware of the complexities of
international finance. Even companies operating domestically need to understand the issues involved. Though
they may be operating domestically, some of their inputs (raw materials, machinery, technological know-how,
capital, etc.) may be imported from other countries, thus exposing them to the risks involved in dealing with
foreign currencies. Even if they do not source anything from outside their own country, they may have foreign
companies competing with them in the domestic market. In order to understand their competitors’ strengths and
weaknesses, awareness and understanding of international events again gains importance.

What about the companies operating only in the domestic markets, using only domestically available inputs and
neither having, nor expecting to have any foreign competitors in the foreseeable future? Do they need to
understand international finance? The answer is in the affirmative. Globalization and deregulation have resulted
in the various markets becoming interlinked. Any event occurring in, say Japan, is likely to affect not only the
Japanese stock markets, but also the stock markets and money markets the world over. For e.g., the forex and
money markets in India have become totally interlinked now. As market players try to profit from the arbitrage
opportunities arising in these markets, the events affecting one market also end up affecting the other market
indirectly. Thus, in case of occurrence of an event which has a direct effect on the forex markets only, the
above mentioned domestic firm would also feel its indirect effects through the money markets. The same holds
good for international events, thus, the need for studying international finance.

Trends in International Trade and Cross Border Financial Flows

Globalization essentially involves the various markets getting integrated across geographical boundaries.
Integration of financial markets involves the freedom and opportunity to raise funds from and to invest anywhere
in the world, through any type of instrument. Though the degree of freedom differs from country to country, the
trend is towards having a reducing control over these markets. As a result of this freedom, anything affecting
the financial markets in one part of the world automatically and quickly affects the rest of the world also. This is
what we may call the Transmission Effect. Higher the integration, greater is the transmission effect.

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Financial markets were not always as integrated as they are today. A number of factors are behind this change.
The most important reason is the remarkable development of technology for transfer of money and information,
making the same possible at an extremely fast speed and at considerably reduced cost. This has made
possible the co-ordination of activities in various centers, even across national boundaries. Another significant
development was the sudden increase in the inflation levels of various industrial countries which resulted in the
price of various financial assets changing widely in response to the changes in the domestic inflation rates and
the interest rates in different countries. These developments led to some others, which contributed all the more
to the process of globalization. They are:

• The development of new financial instruments: For example, instruments of the euro-dollar market, interest rate
swap, currency swap, futures contracts, forward contracts, options, etc.

• Liberalization of regulations governing the financial markets: Though the extent and direction of
liberalization has been different in different countries, based on the domestic compulsions and the local
perspective, it has been substantial enough to make operations in foreign markets a lucrative affair.

• Increased cross penetration of foreign ownership: This has helped in the countries developing an
international perspective while deciding on various factors influencing the process of globalization.

The function of the financial system is to efficiently transfer resources from the surplus units to the deficit units.
Greater integration of the financial markets helps in performing this function in a better manner. Just like natural
resources are distributed unequally among various countries, some countries are capital-rich, while others are
capital-poor. Capital-rich countries generally enjoy a lower return on capital than the capital-poor countries. Let
us imagine the scenario where there is no capital flows between these two sets of countries. In the absence of
adequate capital, the capital-poor countries will have to either forego or postpone some of the high-yielding
investments. On the other hand, capital-rich countries will be investing in some of the low-yielding investments
due to lack of better opportunities. When capital flows are allowed to take place, investors from the capital-rich
countries would invest in the high-yielding projects available in the capital-poor countries. This would benefit
both the countries. The residents of the capital-rich country will benefit by earning a higher return on their
investments, and the cash-poor country will benefit by earning profits on the project, which they would
otherwise have had to forego. Integration of financial markets thus results in a more efficient allocation of capital
and a better working financial system.

India in the Global Economy

India is the seventh largest and second most populous country in the world. A new spirit of economic freedom is
now stirring in the country, bringing sweeping changes in its wake. A series of ambitious economic reforms
aimed at deregulating the country and stimulating foreign investment has moved India firmly into the front ranks
of the rapidly growing Asia Pacific region and unleashed the latent strengths of a complex and rapidly changing
nation.

India's process of economic reform is firmly rooted in a political consensus that spans her diverse political
parties. India's democracy is a known and stable factor, which has taken deep roots over nearly half a century.
Importantly, India has no fundamental conflict between its political and economic systems. Its political
institutions have fostered an open society with strong collective and individual rights and an environment
supportive of free economic enterprise.

India's time tested institutions offer foreign investors a transparent environment that guarantees the security of
their long-term investments. These include a free and vibrant press, a judiciary, which can and does overrule
the government, a sophisticated legal and accounting system and a user-friendly intellectual infrastructure.
India's dynamic and highly competitive private sector has long been the backbone of its economic activity. It
accounts for over 75% of its Gross Domestic Product and offers considerable scope for joint ventures and
collaborations.

Today, India is one of the most exciting emerging markets in the world. Skilled managerial and technical
manpower that match the best available in the world and a middle class whose size exceeds the population of
the USA or the European Union, provide India with a distinct cutting edge in global competition.

According to the report of Goldman Sachs, India would be the 3rd most important economic power in next 50
years after America and China. Its projection is that GDP of America would be 45 trillion dollars, China’s 35
trillion dollars and India’s 28 trillion dollars, whereas Japan’s will be about 7 trillion dollars. It was further
estimated that by 2020 the US would be short of 17 million working age people, China 10 million, Japan 9
million, and Russia 6 million, whereas India will have a surplus of 47 million.

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The world is getting closer. Now it is a connected universe. So India should have a clear vision of its effective
participation in the global economy. It should identify the areas where it can compete successfully and the
areas where it should protect its industries from global invasion. It should be sensitive towards continuous
changes.

India’s ability to benefit from globalization and being a leader in making things happen in global economy, will
make all the difference whether India become economically developed by 2020 or become a victim of
globalization.

Recent Developments in Global Financial Markets

The foremost among recent changes in world financial markets has been their accelerating integration and
globalisation. This development, which has been fostered by the liberalisation of markets, rapid technological
progress and major advances in telecommunications, has created new investment and financing opportunities
for businesses and people around the world. Easier access to global financial markets for individuals and
corporations will lead to a more efficient allocation of capital, which, in turn, will promote economic growth and
prosperity.

Apart from this ongoing integration and globalisation, world financial markets have also recently experienced
increased securitisation. In part, this development has been spurred by the surge in mergers and acquisitions
and leveraged buy-outs that has taken place in markets of late, not least in the euro area. One aspect of this
securitisation process has been the increase in corporate bond issuance, which has also coincided with a
diminishing supply of government bonds in many countries, particularly in the United States.

Other interesting developments in world financial markets include the continued broadening and expansion of
derivatives markets. The broadening of these markets has largely come about because rapid advances in
technology, financial engineering, and risk management have helped to enhance both the supply of and the
demand for more complex and sophisticated derivatives products. The increased use of derivatives to adjust
exposure to risk in financial markets has also contributed to the rise in the notional amounts of outstanding
derivatives contracts seen in recent years, in particular in over-the-counter (OTC) derivatives markets with
interest rates and equities as underlying securities. While the leveraged nature of derivative instruments poses
risks to individual investors. Derivatives also provide scope for a more efficient allocation of risks in the
economy, which is beneficial for the functioning of financial markets, and hence enhances the conditions for
economic growth.

The introduction of the common currency euro has acted as a catalyst for promoting integration of financial
markets in Europe, and provides an opportunity to create a Europe-wide securities market. The result will be
more efficiently functioning markets which, in turn, will mean a reduced cost of capital and improved investment
opportunities for businesses and individuals. This process will also enhance the depth and liquidity of financial
markets, which in turn will promote stability.

The European Central Bank contributes to this stability by pursuing a credible and transparent monetary policy.
In fact, a consistent monetary policy that is committed to price stability is the best contribution that the ECB can
make to the smooth functioning and integration of European financial markets. Such a policy will be beneficial,
as it will minimise the adverse effects of inflation and high inflation uncertainty, thereby creating conditions for
steady and sound economic growth in the medium term. A stability-oriented monetary policy thus contributes to
the smooth functioning of financial markets and to economic prosperity as a whole.

Challenges of International Financial Management

Managers of international firms have to understand the environment in which they function if they are to achieve
their objective in maximizing the value of their firms, or the rate of return from foreign operations. The
environment consists of:

1. The international financial system, which consists of two segments: the official part represented by the
accepted code of behavior by governments comprising the international monetary system, and the private
part, which consists of international banks and other multinational financial institutions that participate in
the international money and capital markets.

2. The foreign exchange market, which consists of multinational banks, foreign exchange dealers, and
organized exchanges where currency futures are regularly traded.

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3. The foreign country's environment, consisting of such aspects as the political and socioeconomic systems,
and people's cultural values and aspirations. Understanding of the host country's environment is crucial
for successful operation and essential for the assessment of the political risk.

The multinational financial manager has to realize that the presence of his firm in a number of countries and the
diversity of its operations present challenges as well as opportunities. The challenges are the unique risks and
variables the manager has to contend with which his or her domestic counterpart does not have to worry about.
One of these challenges, for example, is the multiplicity and complexity of the taxation systems, which impact
the MNC's operations and profitability. But this same challenge presents the manager with opportunities to
reduce the firm's overall tax burden, through transfer of funds from high- to low-tax affiliates and by using tax
havens.

The financing function is another such challenge, due to the multiplicity of sources of funds or avenues of
investment available to the financial manager. The manager has to worry about the foreign exchange and
political risks in positioning funds and in mobilizing cash resources. This diversity of financial sources enables
the MNC at the same time to reduce its cost of capital and maximize the return on its excess cash resources,
compared to firms that raise and invest funds in one capital market.

In a real sense MNCs are particularly situated to make the geographic, currency, and institutional diversity work
for them. This diversity, if properly managed, helps to reduce fluctuations in their earnings and cash flows,
which would translate into higher stock market values for their shares. This observation is especially valid for
the well-diversified MNCs.

This is not to suggest that the job of the manager of an MNC is easier, or less demanding, than if he or she
were to operate within the confines of one country. The challenges and the risks are greater, but so are the
rewards accruing to intelligent, flexible, and forward-looking management. The key to such a management is to
make the diversity and complexity of the environment work for the benefit of the firm and to lessen the adverse
impact of conflicts on its progress.

Gains from International Trade and Investment

The major gain of international trade is that it has brought about increased prosperity by allowing nations to
specialize in producing those goods and services at which they are relatively efficient. The relative efficiency of
a country in producing a particular product can be described in terms of the amounts of other, alternative
products that could be produced by the same inputs. When considered this way, relative efficiencies are
described as the comparative advantages. All nations can do simultaneously gain from exploiting their
comparative advantages, as well as from the large-scale production and broader choice of products that are
made possible by the international trade.

Suppose that Japan is relatively more efficient in producing steel than food and the United States is relatively
more efficient in producing food than steel. So we can expect food to be cheap relative to steel in United States,
and steel to be cheap relative to food in Japan. This suggests that by exporting foods to Japan, the United
States can receive a relatively large amount of steel in return. Similarly, by exporting steel to United States,
Japan can receive a relatively large amount of food. Therefore, via exchange of products through trade, both
countries can be better off. This gain is pure exchange gain and would be enjoyed even without specialization
of production. Here we implicitly assumed constant returns to scale, that is, the number of people required to
produce the food and steel are same. However, if there is increasing returns to scale, it will take fewer people to
produce a given quantity of output for which the country has a comparative advantage. In this case economies
of scale is the further gain from international trade. Another gain from trade comes in the form of an increased
product variety. In addition, international trade can make a brooder range of inputs and technology available
and thereby increase economic growth.

Among the gains of international investment has been improvement in the global allocation of capital and an
enhanced ability to diversify investment portfolios. The gain from the better allocation of capital arises from the
fact that international investment reduces the extent to which investment opportunities with high returns in some
countries are forgone for want of available capital, while low-return investment opportunities in other countries
with abundant capital receive funding. The flow of capital between countries moves rates of return in different
locations closer together, thereby offering investors overall better returns. There is an additional gain from
increased international capital flows enjoyed via an enhanced ability to smooth consumption over time by
lending and borrowing.

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TRADING BLOCKS

The post-second World War period has seen a growing interest in integrating national economies at regional
levels. The efforts to form regional groupings, trade blocks and treaties have often floundered due to political
differences and unforeseen economic hurdles. The motivation arises out of the realization of the limitations
imposed by national frontiers and the expected benefits of a wider market, consisting of several national
economies.

Regional trade agreements represent an attempt by a group of countries to increase the flow of trade and
investment by reducing direct and indirect trade barriers between them, as well as implement similar trade
policies vis-à-vis outsiders. Multinational trade blocks are a major global trend. Most of these blocks are formed
by geographically close countries, and revolve around a small group of larger economies. This is further
testament to the importance of closeness and proximity in establishing network structures. Proximity in this
case refers to both geographic as well as economic and social similarities among countries. Such trade and
economic conglomerations give the group a bigger role in the world economy, and insures that smaller member
countries are not marginalized. In a recent study of future high growth areas, it was shown that world trade and
regional trade conglomerations such as NAFTA, ASIAN, and the EU will fuel economic growth.

The common trading policies and preferential treatment for member countries created by a trade agreement
have the double effect of promoting intra regional trade, while, at the same time, putting outsiders at a
disadvantage. This has two major implications for investors. First, due to the liability of being an outsider, many
companies decide to set up shop inside a trade area in order to benefit from the intra regional preferential
arrangements. Second, in most cases, countries do not stop at homogenizing their trade policies, but rather
move towards greater trade and economic integration. This is further evident in the continuously increasing
degree of integration between the economies of Western Europe. Such trends create greater market similarities
as laws and business practices are standardized within the region. Market similarities have been identified in
the literature as an important determinant in foreign market selection decisions. In addition, costs associated
with international commerce can be reduced when doing business in similar markets as harmonization of trade
practices reduces the need for adopting different trade approaches for different markets.

The rapid growth of regional trading relationships in Europe, Asia, and Latin America has raised policy concerns
about their impact on excluded countries and on the global trading system. Some observers worry that the
multilateral system may be fracturing into discriminatory regional blocs. Others are hopeful that regional
agreements will go beyond what was achieved in the Uruguay Round and instead become building blocks for
further global liberalization and WTO rules in new areas. Jeffrey Frankel shows through extensive empirical
analysis that the new breed of preferential trade arrangements is indeed concentrating trade regionally. He then
assesses whether regional blocs are "natural" or "supernatural"—that is, whether they enhance or reduce global
welfare. He concludes that a move to complete liberalization within blocs, with no reduction in barriers between
blocs, would push the trading system into the super natural zone of an excessive degree of regionalization.
More balanced patterns of liberalization, however, give favorable outcomes. He considers regionalism at two
levels: both the formal trading arrangements that are already in effect, and the broader continent-sized
groupings that are under discussion (the Americas, Europe, and the Asia Pacific). Frankel's study also
assesses the political and economic dimensions of regionalization and its implications for world economic
prospects and public policy. In conclusion, Frankel proposes several policy prescriptions for pursuing partial
regional liberalization among blocs as a stepping-stone toward global free trade.

Conditions for Success of Trading Blocks

One of the questions that are raised these days is whether the World Trade Organization, the European-
Mediterranean agreements, and the Arab common markets are complementary or substitute arrangements.
This question is not only interesting, but also relevant and provocative: It is interesting because the answer is
not obvious. For instance, many hold the view that countries may lock themselves into regional trade
agreements and might not necessarily feel the pressure to open up their markets beyond those agreements. It
is relevant — and not merely academic — as all countries in the Middle East and North Africa region are
dealing with it or will have to deal with it in the immediate future. In fact, these countries have been liberalizing
their trade regimes, simultaneously negotiating with the EU and, for some time, trying to integrate into an Arab
common market. And it is provocative because, in trying to answer it, many people might end up supporting the
Euro-Med agreements rather than an Arab common market, which would make others unhappy.

The question of whether trade agreements are compliments or substitutes to the WTO depends in part on
whether they are building or stumbling blocks toward full liberalization. It also depends on whether these
agreements are favorable to countries’ development. In this connection, three conditions seem to make these
agreements beneficial.
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First, these agreements work when countries have both the economic and political incentives to conclude them.
Here the main issue is that even when the economic incentives are present, political realities might offset them,
and vice versa. For example, for some time, countries in the Arab region have been trying to create a common
market. Although the political incentives are probably there, perhaps the economic incentives are not strong
enough to push countries in that direction. As a result, there is no Arab common market. At the same time, over
the last two years, Morocco and Tunisia have signed trade agreements with the EU, Egypt is about to sign one,
and other Arab countries are negotiating similar deals.

Why are these countries signing trade agreements with the EU? The reason is that the economic incentives are
present and, at the same time, there are no political considerations constraining them. In other words, it is hard
to find convincing arguments for these countries not to sign trade agreements with the EU. Moreover, the
proximity between Europe and the Middle East and the lack of competition between their respective production
structures act as positive factors towards trade cooperation — the latter element being absent among Arab
countries, where the production structures are very similar.

Second, trade agreements are successful when complementary domestic reforms are simultaneously
undertaken. For instance, if a country such as Egypt signs a trade agreement with EU, as tariff barriers are
removed, its domestic industry will face increasing competition from European producers. Although the country
might at first have a comparative advantage in terms of labor costs, the transaction costs of domestic
production may eventually prove to be too high — even as European inputs become cheaper — to the point
where Egyptian exporters would not be able to penetrate European markets. For that reason, for Egypt or any
other country to take full advantage of a trade agreement with the EU, it will need to reduce these transaction
costs — which include shipping and communications, processing and even bribes. In addition, investments will
converge in those areas where production costs are cheap and export markets are large. Therefore, to the
extent that transaction costs are high and that domestic reforms are not undertaken to reduce them, investors
will tend to look elsewhere. In sum, domestic reforms are an essential condition for the success of trade
agreements.

Third, some trade agreements that do not appear advantageous in the short term may be beneficial in the long
term. This relates to the fact that "vertical integration" — or trade agreements between countries in the region
and the EU — and "horizontal integration" — or trade agreements among countries in the region — can be
reconciled in time. On the basis of the existing economic and political incentives, it may appear that it is in the
interest of a country such as Egypt to open up its economy first to a large trading partner such as the EU than
to other countries in the region. After all, Egypt’s exports to and imports from the EU represent some 50 percent
and 40 to 50 percent of the total, respectively.

In contrast, the country’s trade within the region accounts for less than 10 percent of its total trade. Therefore,
based on strict reveled preferences, it does not appear that integration within the region is nearly as attractive
as integration with the EU now. Moreover, as Egypt, Morocco and Tunisia move towards greater economic
integration with the EU, investors from the EU and possibly all three countries will choose to locate where they
can serve a larger market — that is, the EU, which will in turn reduce even further the appeal of horizontal
integration. However, at a later stage, to the extent that these countries become more open and attractive for
investors, it will be beneficial for them to integrate horizontally, as that would create a larger market, which
would further attract investors to the region. In other words, while horizontal integration may not appear
attractive in the short term on economic grounds, the likelihood is that, in the long term, it will become
beneficial, mostly as a result of the economic effects of vertical integration with the EU.

Forms of Trading Blocks

There are four different forms of trading blocks:

Free Trade Area

If the members of a preferential trade arrangement go so far as to eliminate all tariffs and quantitative import
restrictions among themselves (100 percent preferences), then they form a free trade area (FTA). Typically,
they retain varying levels of tariffs and other barriers against the products of nonmembers. Uncompetitive
industries in the more highly protected member countries may have sufficient clout to prevent their shields from
being lowered to the same levels as in the less-protected member countries.

Customs Union

The next level of integration occurs when the members of an FTA go beyond removing trade barriers among
themselves and set a common level of trade barriers vis-à-vis outsiders. This at a minimum entails a common
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external tariff. A full customs union would also harmonize quantitative restrictions, export subsidies, and other
trade distortions. Indeed, it would set all trade policy for its members as a unified whole. It would, for example,
engage in any future trade negotiations with other countries with a single voice.

Common Market

Beyond the free exchange of goods and services among members, a common market entails the free
movement of factors of production: labor and capital. The dividing line is admittedly sometimes blurred between
the free exchange of services and the free movement of factors: labor includes services such as construction or
consulting, and capital includes banking and other financial services. The free movement of capital applies to
portfolio capital as well as to foreign direct investment (FDI), which is the purchase and sale across national
boundaries of real estate, plant, and equipment. This is deep integration in that it impacts some laws and
institutions that could have been preserved as domestic prerogatives even with a high level of trade integration.

Economic Union

Going beyond the free movement of goods, services, and factors, economic union involves harmonizing
national economic policies, including typically taxes and a common currency. There is a unified central bank
and a common currency. The fiscal as well as monetary policies are well co-coordinated, some of them being
decided by the central bank. The decision of the European Community to change its name to the European
Union in 1994 represented a determination to proceed to this higher stage of integration. The countries forming
an economic union have to give up a lot of economic and social freedom in favor of the central decision-making
authority.