International Finance Pr. Ariane Chapelle ariane.chapelle@ulb.ac.be site : http//solvay.ulb.ac.be/cours/chapelle

1. International Finance Pr. Ariane Chapelle ariane.chapelle@ulb.ac.be site : http//solvay.ulb.ac.be/cours/chapelle

2. Contents of the Course • Introduction : The International Financial Environment • Part 1 : Fundamentals of International Finance • Exchange rate determination • Balance of payments approaches • Parity conditions : purchasing power parity & interest parity • Asset market approaches • Monetary integration in the European Union • The case for a greater fixity in exchange rates • Optimal single currency zone • The IMF and the provision of finance • A critique of the IMF approach • International debt crises : a few examples

3. Contents of the Course • Part 2 : International Corporate Finance • Foreign Exchange Exposure • Transaction exposure • Operating exposure + decision case • Financing the Global Firm : • Sourcing equity globally • Financial structure and international debt • Foreign Investment Decision : • FDI theory and strategy • Multinational capital budgeting • Adjusting for risk + decision case • Managing Multinational Operations : • International tax management • Repositioning funds • Working capital management + decision case

4. Contents of the Course • Reference textbooks • Moffet, M., Stonehill, A. and Eiteman, D., Fundamentals of Multinational Finance, Addison Wesley, 2003. • + Web site: www.aw.com/moffett • OR : Eiteman, D., Stonehill, A. and M. Moffet, Multinational Business Finance, 9th edition Addison Wesley, 2001. • + Web site: www.awl.com/eiteman • and : Gibson, H. , International Finance, Longman, 1996.

5. The international financial system • Introduction • Different forms of exchange rates organisation : • fixed • floating • managed • monetary unions • Questions of • adjustment of balance of paiements • liquidity provision in the system • international money deficition and usage

6. Full Capital Controls Impossible Trinity Monetary Independence Exchange rate stability Pure float Monetary Union Full Financial Integration The international financial system • Impossible Trinity : • Exchange rate stability • Full financial integration (free capital flows) • Monetary independence • Is there a best system? • What design of institutions?

7. The international financial system • International money • Caracteristics : International money should be : • defined • convertible • inspire confidence • store of value • Summary issues & concerns of financial markets : • Adjustments of BOP • Provision of liquidity • -> 4 different systems address these 2 issues.

8. Adjustment issue : the BOP • Balance of payments (BOP) - reminder: • Balance of paiements : sum of all the transactions between the residents of a country and the rest of the world • BOP = current account balance + capital account + financial account + changes in reserves • BOP = (X - M) + (CI - CO) + (FI - FO) + FXB • Current account = exports - imports of goods and services • Capital account = capital inflows - capital outflows = capital transferts related to purchase and sale of fixed assets • Financial account = financial inflows - financial outflows = net foreign direct investments + net portfolio investments • Sum of 3 first terms = Basic balance • FXB : changes in official monetarry reserves (gold, foreign currencies, IMF position)

9. Adjustment issue : the BOP • Balance of payments (BOP) - reminder: • In equilibrium : BOP = 0 • Deficit country : BOP < 0 • Surplus country : BOP > 0 • Deficit country (current account deficit) • X - M < 0 : too many imports compared to exports • Money supply > money demand (in domestic currency) • Too large amount of domestic currency : deflationary pressures

10. Adjustment issue : the BOP • Possible policies for a deficit country : • let the FX rate depreciate and restore competitiveness, leading to a rise in X and a reduction in M (if FX rates are floating) • reduce the stock of money by direct intervention : buy domestic currencies against foreign currencies held in monetary reserves (if FX rates are fixed) • reduce the stock of money and sterilise : sell govt bonds against domestic currency to maintain the FX rate (if FX rates are fixed) • increase interest rates to attract capital inflows (financing the deficit) and to reduce demand for imports (monetary view)

11. Adjustment issue : the BOP • Surplus country (current account surplus) • X - M > 0 : too many exports compared to imports • Money demand > money supply (in domestic currency) • Lack of domestic currency : inflationary pressures • Possible policies for a surplus country : • let the FX rate appreciate and decrease competitiveness, leading to a reduction in X, and an increase of M • increase the supply of money by direct intervention : sell domestic currencies and buy foreign currencies, growing the monetary reserves, to avoid FX appreciation

12. Adjustment issue : the BOP • Possible policies for a surplus country : • increase the supply of money and sterilise to avoid a price rise : exhange M1 and M3 : buy government bonds against domestic currencies • lower interest rates to discourage capital inflows (increase outflows) and to reduce financial surplus

13. Adjustment issue : the BOP • Adjustment issue - reminder • The deficit is not dependant of the exchange rate (in theory) • In practice, however : • prices and wages are sticky • some regional shocks can create asymmetric disequilibrium • large players like government and financial insitutions influence equilibrium • surplus and deficit countries experience asymetric pressures for adjustments • Problem of adjustments : central concern of government • -> need for design of institutions

14. The international financial system • International Financial systems - 4 types : • Automatic mechanisms • Pure floating rates : between the two World Wars • Pure fixed exchange rates : gold period • (N-1) Systems • N countries linked to gold : a large country, its currency = international money • N-1 countries linked to N = fixed exchange rate regime : Bretton Woods • Policy coordination & Multilateral mechanisms : SME • Monetary union : EU

15. Automatic Mechanisms • Automatic mechanisms: • 2 mechanisms can be defined as fully automatic : • freely floating exchange rate system • fully fixed commodity standard • Freely floating : no BOP problem : any disequilibirum leads to automatic adjustment of exchange rates. • Automatic market mechanism of the demand / supply market for foreign exhange. • Demand curve for foreign exchange (D) derives from the desire of domestic residents to purchase foreign goods, services and assets. • D is negativley related to exchange rate (S).

16. Domestic price of foreign exchange Supply of foreign exchange S0 Depreciation S1 Demand for foreign exchange Q of foreign exchange Automatic Mechanisms • S = FX rate = P/P* = amount of domestic currency per one unit of foreign currency. Ex. €/$ = S for Europeans. • A depreciation of the domestic currency = a rise in S. • Ex. S0= 1, S1 = 0.9. • S1 : excess of demand= deficit of BOP (too many imports). A depreciation makes foreign goods more expensive, and D decreases to equilibirum.

17. Automatic Mechanisms • Automatic mechanisms: • Full floating rates : • liquidity in the system is unnecessary provided adjustment occurs immediatly • international money is not explicitly specified; a few currencies will be widely used as international means of payment. • Fully fixed commodity standards • Main characteristics : fiduciary money is backed by a particular commodity (ex. Gold) • The ratio of fiduciary money to the reserves of the commodity is fixed, and the monetary authorities garantee free convertibility. The various ratios per country determine the exchange rate.

18. Automatic Mechanisms • Fully fixed commodity standards • All countries set a fixed price between their national currency and the commodity • All currencies are tied together -> exchange rates are fixed. • The international money is the commodity. • BOP disequilibira are eliminated by transfering the commodity from the deficit country to the surplus country, leading to : • a contraction of the money supply in deficit country • an expansion of the money supply in the surplus country • leading to symmetrical adjustments • However, if the surplus country « sterilise » (do not expand the money supply to prevent inflation), the system becomes asymmetrical.

19. Automatic Mechanisms • Automatic mechanisms - in practice: • Fully fixed commodity standards : the Gold Standard : 1870 - 1914 + short period in the 1920 ’s • Pre-World War I : « classical gold standard » • Inter-War period : « managed gold standard » • Not worked as in theory : currencies more considered as international money; manipulation of interest rates by central banks, sterilisation policies ; positive correlation of prices and wages accross countries, whereas the opposite was expected. • The gold standard did not bring the price stability expected. • Gold discoveries played a role in explaining price movements. • Adjustment in bank credit (1/3 of the money) helped smooth monetary growth.

20. Automatic Mechanisms • Automatic mechanisms - in practice: • Full floating rates : the inter-war period • absences of co-operation and agreement on how the international monetary system should be organised • desastrous consequences for the economies of individual countries • played a role in the depth and length of the 30 ’s crisis • 3 rounds of vane tentatives to bring monetary coordination • number of competitive depreciations between US and UK.

21. The international financial system • Second type : (N-1) System • N countries • Nth country is linked to a commodity standard, convertible at a fixed price. • All other currencies fixed to the Nth country • (N-1) exchange rates, fixed. Arbitrage occurs by buying and reselling the commodity if the FX rate moves. • How adjustment occurs? • No automatic adjustment, no connection between money and the commodity. • In principle, unadjusted countries should increase or decrease their money supply to get back to equilibrium. • Governements should undertake policies to secure adjustments.

22. (N-1) System • How adjustment occurs? • A deficit country (too many imports - too low foreign currency) : should undertake a deflationary policy. Problem : prices and wages are sticky. • A surplus country (too many exports - too high domestic currency) : should reflate. Problem : less pressure for adjustment. Tempted to build up their reserve of foreign currencies and sterilise the impact by selling domestic bonds. • System that tends to create asymmetry. • No fixed ratio clearly defined between money supply and the commodity. • No clear definition of the process deflation or reflation, leaving great room for discretion.

23. (N-1) System • Nth country • Is in a special position, that creates and 2nd asymmetry. • Does not intervene in the foreign exchange markets. The (N-1) countries maintain their chosen FX rate. • The BOP of the N countries should balance, so the Nth country should accept whatever aggregate BOP the N-1 countries have. • The Nth country plays a key role in the provision of international money and liquidity : its currency is the international mean of exchange.

24. (N-1) System • Nth country • It should be a large country, in order to be able to absorb the balance of the desequilibrium of the N-1 other countries. • It should have a fairly closed economy to be more isolated from the international shocks and to maintain the system stability. • The Nth currency should be acceptable as international money : central Banks should be confident in its value : • A confidence crisis would lead to a collapse of the system; • Acceptability of value eased by inflation control inthe Nth country; • Heart of the system, should remain economically strong.

25. (N-1) System - in practice • (N-1) System - in practice • Bretton Woods (1944 - 1971) • US as the most powerful nation after the War, keen to ensure access to foreign markets for its goods. • Europe and Japan physically devastated, seeking access to international credit. • Huge recycling problem of funds collected in the US, to rebuild Europe and Japan. • Bretton Woods agreement (July 1944) negociated between US and Europe (essentially UK). • UK representative : John Maynard Keynes. • US representative : Harry Dexter White.

26. (N-1) System - in practice • Bretton Woods (1944 - 1971) • Agreement on the need for greater fixity of exchange rates. • Disagreements over : • the question of financial flows • the problem of recycling • White proposal : • creation of a fund to help maintain BOP and encourage international trade. • Aim : eliminate control on trade flows and restrictions on foreign exchange transactions.

27. (N-1) System - in practice • Keynes ’ proposal : • Creation of a recycling mechanism to allow deficit countries to finance their development without the need to resort to trade restrictions. • Concerned about the risk of surplus countries to exert a deflationary pressure on the world economy. • Proposed to create a international Clearing Union which would receive funds from surplus countries, and would lend them to deficit countries. • Recycling would be automatic and deflation avoided. • Final agreement was much closer to White ’s proposal.

28. (N-1) System - in practice • Bretton Woods : (N-1) system where the US is the Nth country. Relies on five main principles : • 1. FX rate could fluctuate by max. 1%, and be reajusted only in case of « fundamental disequilibrium » • 2. Pool of currencies contributed by members countries to help deficit countries funding their temporary disequilibrium, in a regime of fixed exchange rates. • Institution set up to administer the pool : the International Monetary Fund (IMF). Quota of members represent drawing rights, only for short periods of time. Too small in practice. • 3. The trading system should be open. Principle of free trade. Desire to dismantle protectionism and restore convertibility, at least for trade reasons.

29. (N-1) System - in practice • Bretton Woods - five main principles : • Set up of the GATT (General Agreement on Trade and Tariffs) to organise the dismantling of tariffs. • Set up of IBRD (International Bank for Reconstruction and Development) to promote investment and development in the poorest countries. • 4. Disequilibria of BOP was supposed to be the responsability of both the deficit and the surplus countries, in a system tending to produce asymmetry. • Pressure on surplus countries by the scarce currency clause (Keynes idea). The IMF declares a currency scarce, restricting access to it, making more difficult for other countries to purchase exports from the surplus country.

30. (N-1) System - in practice • Bretton Woods - five main principles : • 5. Design and set-up of institutions to support the exchange rate organisation : IMF, IBRD, GATT. • Bretton Woods - two periods • 1945 - 1959 : reconstruction • Setup of the Marshall Paln : US gave $4-$5 billions a year to European countries between 1948 - 1951. • Set-up of the European Paiement Union (EPU) to organise trade witihin Europe and gradually restore convertibility.

31. (N-1) System - in practice • 1959 - 1971 : Bretton-Woods into action • End of the EPU and convertibility restored. • Achievements : stability of exchanges rates, availability of foreign exchange for current transactions, rapid growth of trade, marcoeconomic stability. • Problems gradually occurred in the adjustement proces : speed of adjustment insufficient, and asymmetrical. • Adjustment via deflation or reflation, but countries reluctant to adjust, in particular for reflation (surplus countries), sterilising to contain inflationnary pressures. • Prices stickiness downward, but flexibility upwards. • In the 1960 ’s : increasing deficit in the US, UK and France. Surplus in Switzerland and Germany. • Growing loss of confidence in the $, likely to be devalued.

32. The international financial system • Third type : Policy co-ordination • This category : all the attempts to co-ordinate policy and manage exchange rates. • In a « managed international monetary system » : choice of exchange rate regimes. • This choice has important implications both on the adjustment process and on the degree of policy co-ordination required.

33. Policy co-ordination • 2 sources of BOP disequilibria : • Exogenous shocks : if they are asymmetric (ex. Rise in oil prices : deficit for importing, surplus for exporting countries) -> large BOP disquelibria to adjust. • Incompatible policies pursued by individual countries. • Example: a number of countries pursuing a deflationary policy to reduce inflation, will end up running a surplus, and create deficit of trade balance in countries trying to expand their economy. Country B M rises, i drops, Rise de D and M - > Deficit Country A P drops, S rises X rise -> Surplus Goods

34. Policy co-ordination • In theory : • The more flexible the exchange rate, the more easily countries can adjust to asymmetric shocks and the greater is the opportunity for countries to pursue their own policies. Automatic adjustments through floating rates. • However, need for policy co-ordination since adjustements are imperfect. Need for international liquidity to help smooth the process and finance the disequelibria.

35. Policy co-ordination - in practice • Managed float 1971 - present • Smithsonian agreement : 1971 - 1973 : after Bretton Woods, attempt to peg European currencies to the dollar, with +/- 2.25% movements. • After 1973 : managed float for major currencies : $, Yen, Sterling. • Co-operative arrangements under the European Monetary System. • However, still highly volatile exchange rates over this period, both nominal and real. • Floating exchange rates did not appear to solve the adjustment issue, with persistent large surplus of Japan and Germany, and large deficits of the US.

36. The international financial system • Fourth type : Monetary union • Individual currencies eliminated : common currency adopted. • The union currency is the international money. • BOP disequilibria no longer exist (in their usual form) : BOP problems become regional problems. • See lecture n°3.