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International Financial Management

Seventh Edition

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The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor

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International Financial Management

Seventh Edition

Cheol S. Eun Georgia Institute of Technology

Bruce G. Resnick Wake Forest University

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INTERNATIONAL FINANCIAL MANAGEMENT, SEVENTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121.

publication may be reproduced or distributed in any form or by any means, or stored

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ISBN 978-0-07-786160-5

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Library of Congress Cataloging-in-Publication Data

Eun, Cheol S.

International financial management / Cheol S. Eun, Georgia Institute of Technology,

Bruce G. Resnick, Wake Forest University.—Seventh Edition.

pages cm

Includes index.

ISBN 978-0-07-786160-5 (alk. paper)

1. International finance. 2. International business enterprises—Finance.

3. Foreign exchange. 4. Financial institutions, International. I. Title.

HG3881.E655 2014

658.15’99—dc23 2013041099

The Internet addresses listed in the text were accurate at the time of publication. The

inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill

Education, and McGraw-Hill Education does not guarantee the accuracy

of the information presented at these sites.

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To Elizabeth C.S.E.

To Donna B.G.R.

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Cheol S. Eun, Georgia Institute of Technology

Cheol S. Eun (Ph.D., NYU, 1981) is the Thomas R.

Williams Chair and Professor of Finance at the Scheller

College of Business, the College of Management,

Georgia Institute of Technology. Before joining Georgia

Tech, he taught at the University of Minnesota and the

University of Maryland. He also taught at the Wharton

School of the University of Pennsylvania, Korea

Advanced Institute of Science and Technology (KAIST),

Singapore Management University, and the Esslingen

University of Technology (Germany) as a visiting pro-

fessor. He has published extensively on international

finance issues in such major journals as the Journal of Finance, JFQA, Journal of Banking and Finance, Jour- nal of International Money and Finance, Management Science, and Oxford Economic Papers . Also, he has

served on the editorial boards of the Journal of Banking and Finance, Journal of Financial Research, Journal of International Business Studies, and European Financial Management . His research is widely quoted and refer-

enced in various scholarly articles and textbooks in the

United States as well as abroad.

Dr. Eun is the founding chair of the Fortis/Georgia Tech Conference on International Finance. The key

objectives of the conference are to promote research on

international finance and provide a forum for interactions

among academics, practitioners, and regulators who are

interested in vital current issues of international finance.

Dr. Eun has taught a variety of courses at the under-

graduate, graduate, and executive levels, and was the

winner of the Krowe Teaching Excellence Award at the

University of Maryland. He also has served as a con-

sultant to many national and international organizations,

including the World Bank, Apex Capital, and the Korean

Development Institute, advising on issues relating to

capital market liberalization, global capital raising, inter-

national investment, and exchange risk management. In

addition, he has been a frequent speaker at academic and

professional meetings held throughout the world.

Bruce G. Resnick, Wake Forest University

Bruce G. Resnick is the Joseph M. Bryan Jr. Professor

of Banking and Finance at the Wake Forest University

School of Business in Winston-Salem, North Carolina.

He has a D.B.A. (1979) in finance from Indiana Uni-

versity. Additionally, he has an M.B.A. from the Uni-

versity of Colorado and a B.B.A. from the University

of Wisconsin at Oshkosh. Prior to coming to Wake For-

est, he taught at Indiana University for ten years, the

University of Minnesota for five years, and California

State University for two years. He has also taught as

a visiting professor at Bond University, Gold Coast,

Queensland, Australia, and at the Helsinki School of

Economics and Business Administration in Finland.

Additionally, he served as the Indiana University resi-

dent director at the Center for European Studies at the

Maastricht University, the Netherlands. He also served

as an external examiner to the Business Administration

Department of Singapore Polytechnic and as the faculty

advisor on Wake Forest University study trips to Japan,

China, and Hong Kong.

Dr. Resnick teaches M.B.A. courses at Wake Forest

University. He specializes in the areas of investments,

portfolio management, and international financial man-

agement. Dr. Resnick’s research interests include mar-

ket efficiency studies of options and financial futures

markets and empirical tests of asset pricing models. A

major interest has been the optimal design of interna-

tionally diversified portfolios constructed to control for

parameter uncertainty and exchange rate risk. In recent

years, he has focused on information transmission in the

world money markets and yield spread comparisons of

domestic and international bonds. His research articles

have been published in most of the major academic

journals in finance. His research is widely referenced by

other researchers and textbook authors. He is an associ-

ate editor for the Emerging Markets Review, Journal of Economics and Business, and the Journal of Multina- tional Financial Management .

About the Authors

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vii

Preface

Our Reason for Writing this Textbook Both of us have been teaching international financial management to undergraduates

and M.B.A. students at Georgia Institute of Technology, Wake Forest University, and

at other universities we have visited for three decades. During this time period, we

conducted many research studies, published in major finance and statistics journals,

concerning the operation of international financial markets. As one might imagine, in

doing this we put together an extensive set of teaching materials that we used success-

fully in the classroom. As the years went by, we individually relied more on our own

teaching materials and notes and less on any one of the major existing textbooks in

international finance (most of which we tried at some point).

As you may be aware, the scope and content of international finance have been fast evolv-

ing due to deregulation of financial markets, product innovations, and technological advance-

ments. As capital markets of the world are becoming more integrated, a solid understanding

of international finance has become essential for astute corporate decision making. Reflecting

the growing importance of international finance as a discipline, we have seen a sharp increase

in the demand for experts in the area in both the corporate and academic worlds.

In writing International Financial Management, Seventh Edition, our goal was to

provide well-organized, comprehensive, and up-to-date coverage of the topics that take

advantage of our many years of teaching and research in this area. We hope the text is

challenging to students. This does not mean that it lacks readability. The text discussion

is written so that a self-contained treatment of each subject is presented in a user-friendly

fashion. The text is intended for use at both the advanced undergraduate and M.B.A. levels.

The Underlying Philosophy International Financial Management, Seventh Edition, like the first six editions, is written

based on two tenets: emphasis on the basics and emphasis on a managerial perspective.

We believe that any subject is better learned if one first is well grounded in the basics.

Consequently, we initially devote several chapters to the fundamental concepts of

international finance. After these are learned, the remaining material flows easily from

them. We always bring the reader back, as the more advanced topics are developed, to

their relationship to the fundamentals. By doing this, we believe students will be left

with a framework for analysis that will serve them well when they need to apply this

material in their careers in the years ahead.

We believe this approach has produced a successfuI textbook: International Finan- cial Management is used in many of the best business schools in the world. Various

editions of the text have been translated into Spanish and two dialects of Chinese.

There is a global edition. In addition, local co-authors have assisted in preparing a

Canadian, Malaysian, and Indian adaptations.

Emphasis on the Basics

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viii P R E F A C E

Seventh Edition Organization International Financial Management, Seventh Edition, has been completely updated.

All data tables and statistics are the most current available when the text went to press.

Additionally, the chapters incorporate several new International Finance in Practice

boxes that contain real-world illustrations of chapter topics and concepts. In the mar-

gins below, we highlight specific changes in the Seventh edition.

Part ONE Foundations of International Financial Management 2

Part THREE Foreign Exchange Exposure and Management 196

Part TWO The Foreign Exchange Market, Exchange Rate Determination, and Currency Derivatives 110

Globalization and the Multinational Firm 4

International Monetary System 29

Balance of Payments 64

Corporate Governance around the World 83

The Market for Foreign Exchange 112

International Parity Relationships and Forecasting Foreign Exchange Rates 139

Futures and Options on Foreign Exchange 172

Management of Transaction Exposure 198

Management of Economic Exposure 231

Management of Translation Exposure 252

Conceptual and managerial analysis of economic exposure to currency risk.

Systematic coverage of foreign currency transaction exposure management and a new case application.

This part describes the various types of foreign exchange risk and discusses methods available for risk management.

This part lays the macroeconomic foundation for all the topics to follow.

Updated coverage of monetary developments, including the euro zone crisis.

Updated balance-of-payments statistics.

Review of corporate governance systems in different countries, the Dodd-Frank Act, and managerial implications.

This part describes the market for foreign exchange and introduces currency derivatives that can be used to manage foreign exchange exposure.

Integrated coverage of key parity conditions and currency carry trade.

Recent economic developments such as the global financial crisis and sovereign debt crisis of Europe.

Fully updated market data and examples. New section on non-deliverable forward contracts.

Fully updated market data and examples.

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P R E F A C E ix

A Managerial Perspective The text presentation never loses sight of the fact that it is teaching students how to

make managerial decisions. International Financial Management, Seventh Edition, is

founded in the belief that the fundamental job of the financial manager is to maximize

shareholder wealth. This belief permeates the decision-making process we present

from cover to cover. To reinforce the managerial perspective, we provide numerous

“real-world” stories whenever appropriate.

Part FOUR World Financial Markets and Institutions 270

Part FIVE Financial Management of the Multinational Firm 410

International Banking and Money Market 272

International Bond Market 310

International Equity Markets 330

Interest Rate and Currency Swaps 354

International Portfolio Investment 372

Foreign Direct Investment and Cross-Border Acquisitions 412

International Capital Structure and the Cost of Capital 439

International Capital Budgeting 465

Multinational Cash Management 484

International Trade Finance 495

International Tax Environment and Transfer Pricing 506

This part provides a thorough discussion of international financial institutions, assets, and marketplaces.

This part covers topics on financial management practices for the multinational firm.

Updated trends in cross-border investment and M&A deals. Updated political risk scores for countries.

New analysis of home bias and the cost of capital around the world.

Updated discussion of multilateral netting systems available for commercial use.

Fully updated market data and statistics. Updated discussion on Basel 2.5 and III capital adequacy standards. Updated discussion on the causes and consequences of the global financial crisis. New Finance in Practice box on the Libor scandal. New section on BBA Libor.

Fully updated market data and examples. Updated empirical coverage of the features, characteristics, and regulations governing dollar denominated foreign bonds, Eurobonds, and global bonds.

Fully updated market data and statistics. Updated discussion of market consolidations and mergers.

Fully updated market data and statistics.

Updated statistical analysis of international markets and diversification with small-cap stocks.

Fully updated comparative national income tax rate table with updated examples. New Finance in Practice box reading on transfer pricing.

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Pedagogical Features Chapter Outline—At the beginning of each chapter, a chapter outline is presented to provide a roadmap of concepts to be learned in that chapter.

Exhibits—Within each chapter, extensive use is made of graphs and tables to illustrate important concepts.

Examples—These are integrated throughout the text, providing students with immediate application of the text concepts.

The Value of the U.S. Dollar since 1960 a EXHIBIT 2.3

a The value of the U.S. dollar represents the nominal exchange rate index (2005 5 100) with weights derived from trade among 21 industrialized countries.

Source: International Financial Statistics.

180

160

Collapse of

Bretton Woods

Jamaica

Agreement

Reagan

Era

Louvre

Accord

Plaza

Agreement

Technology

Boom

Global

Financial

Crisis

140

120

100

N om

in al

E ff

ec ti

ve E

xc ha

ng e

R at

60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

EXAMPLE 11.1: Rollover Pricing of a Eurocredit

Teltrex International can borrow $3,000,000 at LIBOR plus a lending margin of .75 percent per annum on a three-month rollover basis from Barclays in London. Suppose that three-month LIBOR is currently 517⁄32 percent. Further suppose that over the second three-month interval LIBOR falls to 51⁄8 percent. How much will Teltrex pay in interest to Barclays over the six-month period for the Eurodollar loan?

Solution: $3,000,000 3 (.0553125 1 .0075)/4 1 $3,000,000 3 (.05125 1 .0075)/4 5 $47,109.38 1 $44,062.50

5 $91,171.88

C H

A P

T E

R O

U T

L IN

Balance-of-Payments Accounting Balance-of-Payments Accounts

The Current Account

The Capital Account

Statistical Discrepancy

Official Reserve Account

The Balance-of-Payments Identity Balance-of-Payments Trends in Major Countries Summary Key Words Questions Problems Internet Exercises MINI CASE: Mexico’s Balance-of-Payments

Problem

References and Suggested Readings APPENDIX 3A: The Relationship Between

Balance of Payments and National Income Accounting

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International Finance in Practice Boxes —Selected chapters contain International Finance in Practice boxes. These real-world illustrations offer students a practical look at the major concepts presented in the chapter.

Annotated Web Resources —Web links located in the margins within each chapter serve as a quick reference of pertinent chapter-related websites. Each URL listed also includes a short statement on what can be found at that site.

In More Depth —Some topics are by nature more complex than others. The chapter sections that contain such material are indicated by the section heading “In More Depth”’ and are in blue type. These sections may be skipped without loss of continuity, enabling the instructor to easily tailor the reading assignments to the students. End-of-chapter Questions and Problems relating to the In More Depth sections of the text are also indicated by blue type.

The FX market is growing at record levels, according to figures released by the CME Group, the largest regulated foreign exchange market in the world.

Last month the CME Group reported average daily notional volume at a record level of $121 billion, up 82 percent compared to a year earlier.

With a number of indicators at play, like the news of Greece's credit concerns and the continued appetite for high-yielding currencies like the Australian dollar and the Canadian dollar, the CME saw record volumes and notional values in the euro and Australian and Canadian dollars. Euro FX futures and options saw total average daily volume of 362,000 contracts with total notional ADV of slightly over $62 billion.

Australian dollar futures and options climbed to nearly 119,000 contracts in average daily volume with almost $11 billion in total notional ADV, and Canadian

dollar futures and options surpassed 88,000 contracts in ADV and $8 billion in total notional ADV.

With foreign currency futures going from strength to strength, the CME Group recently published a white paper outlining the benefits of FX futures.

“These contracts provide an ideal tool to manage currency or FX risks in an uncertain world,” it said. “Product innovation, liquidity, and financial surety are the three pillars upon which the CME Group has built its world-class derivatives market. The CME Group provides products based on a wide range of frequently transacted currencies, liquidity offered on the state-of-the-art CME Globex electronic trading platform, and financial sureties afforded by its centralized clearing system.”

Source: Global Investor, March 2010.

FX Market Volumes Surge INTERNATIONAL FINANCE IN PRACTICE

www.theice.com

This is the website of the Intercontinental Exchange (ICE). Several FX futures contracts are traded on their electronic trading platform.

www.numa.com/ref/ exchange.htm

This is the website of The Numa Directory. It provides the website address of most of the stock and derivative exchanges in the world.

In More Depth

European Option-Pricing Formula In the last section, we examined a simple one-step version of binomial option-pricing

model. Instead, we could have assumed the stock price followed a multiplicative binomial

process by subdividing the option period into many subperiods. In this case, S T and C T could be many different values. When the number of subperiods into which the option

period is subdivided goes to infinity, the European call and put pricing formulas presented

in this section are obtained. Exact European call and put pricing formulas are: 5

Ce 5 Ste 2riTN(d

1 ) 2 Ee2r$TN(d

2 ) (7.12)

and

Pe 5 Ee2r$TN(2d2) 2 Ste 2riTN(2d

1 ) (7.13)

The interest rates r i and r $ are assumed to be annualized and constant over the term-to-

maturity T of the option contract, which is expressed as a fraction of a year.

Invoking IRP, where with continuous compounding F T 5 S t e (r $ – r i )T , C e and P e in

Equations 7.12 and 7.13 can be, respectively, restated as:

Ce 5 [FT N(d 1 ) 2 EN(d

2 )]e2r$T (7.14)

and

Pe 5 [EN(2d 2 ) 2 FT N(2d

1 )]e2r$T (7.15)

where

d 1 5

ln (FT /E) 1 .5s2T ________________

s √ __

and

d 2 5 d

1 2 s √

__ T

N ( d ) denotes the cumulative area under the standard normal density function from

2` to d 1 (or d

2 ). The variable s is the annualized volatility of the change in exchange

rate ln ( S t11 / S t ). Equations 7.14 and 7.15 indicate that C e and P e are functions of only

five variables: F T , E, r $, T , and s. It can be shown that both C e and P e increase when

s becomes larger.

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Summary —A short summary concludes each chapter, providing students with a handy overview of key concepts. The main points of the chapter are summarized and numbered for easy reference and study.

Key Words —One of the most interesting aspects of studying international finance is learning new terminology. All key terms are presented in boldfaced type when they are first introduced, and they are defined thoroughly in the chapter. A list of key words is presented at the end of the chapter with convenient page references.

Questions with Excel Software —An icon in the margin indicates that the end-of-chapter question is linked to an Excel software program created by the authors. See the Ancillary Materials section for more information on the software.

Questions and Problems —Each chapter contains a set of Questions and Problems. This material can be used by students on their own to test their understanding of the material, or as homework exercises assigned by the instructor. Questions and Problems relating to the In More Depth sections of the text are indicated by blue type.

End-of-Chapter Features SUMMARY This chapter presents an introduction to the market for foreign exchange. Broadly

defined, the foreign exchange market encompasses the conversion of purchasing power

from one currency into another, bank deposits of foreign currency, the extension of credit

denominated in a foreign currency, foreign trade financing, and trading in foreign cur-

rency options and futures contracts. This chapter limits the discussion to the spot and

forward markets for foreign exchange. The other topics are covered in later chapters.

1. The FX market is the largest and most active financial market in the world. It is

open somewhere in the world 24 hours a day, 365 days a year. In 2013, average

daily trading in spot and forward foreign exchange was $4.95 trillion.

2. The FX market is divided into two tiers: the retail or client market and the whole-

sale or interbank market. The retail market is where international banks service

their customers who need foreign exchange to conduct international commerce or

trade in international financial assets. The great majority of FX trading takes place

in the interbank market among international banks that are adjusting inventory

positions or conducting speculative and arbitrage trades.

3. The FX market participants include international banks, bank customers, nonbank

FX dealers, FX brokers, and central banks.

4. In the spot market for FX, nearly immediate purchase and sale of currencies take

place. In the chapter, notation for defining a spot rate quotation was developed.

Additionally, the concept of a cross-exchange rate was developed. It was deter-

mined that nondollar currency transactions must satisfy the bid-ask spread deter-

mined from the cross-rate formula or a triangular arbitrage opportunity exists.

5. In the forward market, buyers and sellers can transact today at the forward price for

the future purchase and sale of foreign exchange. Notation for forward exchange

rate quotations was developed. The use of forward points as a shorthand method

for expressing forward quotes from spot rate quotations was presented. Addition-

ally, the concept of a forward premium was developed.

6. Exchange-traded currency funds were discussed as a means for both institutional

and retail traders to easily take positions in nine key currencies.

contingent exposure, 208

cross-hedging, 208

economic exposure, 198

exposure netting, 211

forward market

hedge, 200

hedging through invoice

currency, 210

lead/lag strategy, 211

money market hedge, 203

options market

hedge, 203

reinvoice center, 211

transaction

exposure, 198

translation

exposure, 198

KEY WORDS

1. How would you define transaction exposure ? How is it different from economic

exposure?

2. Discuss and compare hedging transaction exposure using the forward contract

versus money market instruments. When do alternative hedging approaches pro-

duce the same result?

3. Discuss and compare the costs of hedging by forward contracts and options

contracts.

QUESTIONS

The spreadsheet TRNSEXP.xls may be used in solving parts of problems 2, 3, 4, and 6.

1. Cray Research sold a supercomputer to the Max Planck Institute in Germany on

credit and invoiced €10 million payable in six months. Currently, the six-month

forward exchange rate is $1.10/€ and the foreign exchange adviser for Cray

Research predicts that the spot rate is likely to be $1.05/€ in six months.

a. What is the expected gain/loss from a forward hedge?

b. If you were the financial manager of Cray Research, would you recommend

hedging this euro receivable? Why or why not?

PROBLEMS

xii

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References and Suggested Readings —At the end of each chapter a list of selected references and suggested readings is presented, allowing the student to easily locate references that provide additional information about topics discussed in that chapter.

Mini Cases —Almost every chapter includes a mini case for student analysis of multiple concepts covered throughout the chapter. These Mini Case problems are “real-world” in nature to show students how the theory and concepts in the textbook relate to the everyday world.

Case Applications —Case Applications are incorporated within selected chapters throughout the text in order to enhance specific topics and help students apply theories and concepts to “real-world” situations.

CFA Questions —Many chapters include problems from CFA Program Curriculum study materials. These CFA problems, indicated with the CFA logo, show students the relevancy of what is expected of certified professional analysts.

Internet Exercises —Found at the end of each chapter, these highlight specific topics, and they prompt the student to search the Internet for specific data. The student is then asked to analyze the data found to solve the exercise.

INTERNET EXERCISES

WWW

Aggarwal, R., and A. Demaskey. “Cross-Hedging Currency Risks in Asian Emerging Markets Using

Derivatives in Major Currencies.” Journal of Portfolio Management, Spring (1997), pp. 88−95.

Allayannis, George, and James Weston. “The Use of Foreign Currency Derivatives and Firm Market

Value.” Review of Financial Studies 14 (2001), pp. 243−76.

Aubey, R., and R. Cramer. “Use of International Currency Cocktails in the Reduction of Exchange

Rate Risk.” Journal of Economics and Business, Winter (1977), pp. 128−34.

Beidelman, Carl, John Hillary, and James Greenleaf. “Alternatives in Hedging Long-Date Contractual

Foreign Exchange Exposure.” Sloan Management Review, Summer (1983), pp. 45−54.

Benet, B. “Commodity Futures Cross-Hedging of Foreign Exchange Exposure.” Journal of Futures Markets, Fall (1990), pp. 287−306.

Dufey, Gunter, and S. Srinivasulu. “The Case for Corporate Management of Foreign Exchange Risk.”

Financial Management, Winter (1983), pp. 54−62.

E-Masry, Ahmed. “Derivatives Use and Risk Management Practices by UK Nonfinancial

Companies.” Managerial Finance 32 (2006), pp. 137−159.

Folks, William. “Decision Analysis for Exchange Risk Management.” Financial Management, Winter (1972), pp. 101−12.

Giddy, Ian. “The Foreign Exchange Option as a Hedging Tool.” Midland Corporate Finance Journal, Fall (1983), pp. 32−42.

Jesswein, Kurt, Chuck C. Y. Kwok, and William Folks, Jr. “Corporate Use of Innovative Foreign

Exchange Risk Management Products.” Columbia Journal of World Business, Fall (1995),

pp. 70−82.

REFERENCES & SUGGESTED READINGS

MINI CASE Airbus’ Dollar Exposure

Airbus sold an A400 aircraft to Delta Airlines, a U.S. company, and billed $30 million payable in six months. Airbus is concerned about the euro proceeds from interna- tional sales and would like to control exchange risk. The current spot exchange rate is $1.05/€ and the six-month forward exchange rate is $1.10/€. Airbus can buy a six-month put option on U.S. dollars with a strike price of €0.95/$ for a premium of €0.02 per U.S. dollar. Currently, six-month interest rate is 2.5 percent in the euro zone and 3.0 percent in the United States.

1. Compute the guaranteed euro proceeds from the American sale if Airbus decides to hedge using a forward contract.

2. If Airbus decides to hedge using money market instruments, what action does Airbus need to take? What would be the guaranteed euro proceeds from the American sale in this case?

3. If Airbus decides to hedge using put options on U.S. dollars, what would be the “expected” euro proceeds from the American sale? Assume that Airbus regards the current forward exchange rate as an unbiased predictor of the future spot exchange rate.

4. At what future spot exchange do you think Airbus will be indifferent between the option and money market hedge?

CASE APPLICATION

Richard May’s Options

It is Tuesday afternoon, February 14, 2012. Richard May, Assistant Treasurer at American Digital Graphics (ADG), sits in his office on the thirty-fourth floor of the building that dominates Rockefeller Plaza’s west perimeter. It’s Valentine’s Day, and Richard and his wife have dinner reservations with another couple at Balthazar at 7:30. I must get this hedging memo done, thinks May, and get out of here. Foreign exchange options? I had better get the story straight before someone in the Finance Committee starts asking questions. Let’s see, there are two ways in which I can envi- sion us using options now. One is to hedge a dividend due on September 15th from ADG Germany. The other is to hedge our upcoming payment to Matsumerda for their spring RAM chip statement. With the yen at 78 and increasing I’m glad we haven’t covered the payment so far, but now I’m getting nervous and I would like to protect my posterior. An option to buy yen on June 10 might be just the thing.

xiii

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xiv P R E F A C E

Ancillary Materials To assist in course preparation, the following ancillaries are offered on the Online

Learning Center—www.mhhe.com/er7e:

• Solutions Manual —Includes detailed suggested answers and solutions to the

end-of-chapter questions and problems, written by the authors.

• Lecture Outlines—Chapter outlines, learning objectives, and teaching notes

for each chapter.

• Test Bank —True/false and multiple-choice test questions for each chapter

prepared by John Stansfield, University of Missouri. Available as Word

documents and in computerized EZ Test format.

• PowerPoint Presentations —PowerPoint slides for each chapter to use in

classroom lecture settings, created by John Stansfield.

The site also includes the International Finance Software that can be used with this

book. This Excel software has four main programs:

• A currency options pricing program allows students to price put and call

options on foreign exchange.

• A hedging program allows the student to compare forward, money market

instruments, futures, and options for hedging exchange risk.

• A currency swap program allows students to calculate the cash flows and

notional values associated with swapping fixed-rate debt from one currency

into another.

• A portfolio optimization program based on the Markowitz model allows for

examining the benefits of international portfolio diversification.

The four programs can be used to solve certain end-of-chapter problems (marked with

an Excel icon) or assignments the instructor devises. A User’s Manual and sample

projects are included on the website.

Acknowledgments

We are indebted to the many colleagues who provided insight and guidance throughout

the development process. Their careful work enabled us to create a text that is current,

accurate, and modern in its approach. Among all who helped in this endeavor for the

seventh edition:

Richard Ajayi Jaemin Kim

University of Central Florida San Diego State University

Lawrence A. Beer Yong-Cheol Kim

Arizona State University University of Wisconsin, Milwaukee

Nishant Dass Yen-Sheng Lee

Georgia Institute of Technology Bellevue University

John Hund Charmen Loh

Rice Univèrsity Rider University

Irina Khindanova Atsuyuki Naka

University of Denver University of New Orleans

Gew-rae Kim Richard L. Patterson

University of Bridgeport Indiana University, Bloomington

eun61604_fm_i-xxiii.indd xiveun61604_fm_i-xxiii.indd xiv 1/3/14 11:29 AM1/3/14 11:29 AM

P R E F A C E xv

Adrian Shopp H. Douglas Witte

Metropolitan State University of Denver Missouri State University

John Wald

University of Texas at San Antonio

Many people assisted in the production of this textbook. At the risk of overlooking

some individuals, we would like to acknowledge Brian Conzachi for the outstanding

job he did proofreading the entire manuscript and Chee Ng for his excellent work

proofreading selected chapters. Additionally, we thank Yusri Zaro for his hard work

checking the accuracy of the solutions manual. Rohan-Rao Ganduri, Kristen Seaver,

Milind Shrikhande, Jin-Gil Jeong, Sanjiv Sabherwal, Sandy Lai, Jinsoo Lee, Hyung

Suk Choi, Teng Zhang, and Victor Huang provided useful inputs into the text. Professor

Martin Glaum of the Giessen University (Germany) also provided valuable comments.

We also wish to thank the many professionals at McGraw-Hill/Irwin for their time

and patience with us. Charles Synovec, executive brand manager, and Noelle Bathurst

and Sarah Otterness, development editors have done a marvelous job guiding us

through this edition, as has Judi David, as content project manager.

Last, but not least, we would like to thank our families, Christine, James, and

Elizabeth Eun and Donna Resnick, for their tireless love and support, without which

this book would not have become a reality.

We hope that you enjoy using International Financial Management, Seventh

Edition. In addition, we welcome your comments for improvement. Please let us know

either through McGraw-Hill/Irwin, c/o Editorial, or at our e-mail addresses provided

below.

Cheol S. Eun [email protected]

Bruce G. Resnick [email protected]

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PART ONE Foundations of International Financial Management

1 Globalization and the Multinational Firm, 4 2 International Monetary System, 27 3 Balance of Payments, 62 4 Corporate Governance Around the World, 82

PART TWO The Foreign Exchange Market, Exchange Rate Determination, and Currency Derivatives

5 The Market for Foreign Exchange, 112 6 International Parity Relationships and Forecasting Foreign

Exchange Rates, 140 7 Futures and Options on Foreign Exchange, 173

PART THREE Foreign Exchange Exposure and Management

8 Management of Transaction Exposure, 198 9 Management of Economic Exposure, 225 10 Management of Translation Exposure, 245

PART FOUR World Financial Markets and Institutions

11 International Banking and Money Market, 264 12 International Bond Market, 304 13 International Equity Markets, 324 14 Interest Rate and Currency Swaps, 348 15 International Portfolio Investment, 366

PART FIVE Financial Management of the Multinational Firm

16 Foreign Direct Investment and Cross-Border Acquisitions, 404 17 International Capital Structure and the Cost of Capital, 431 18 International Capital Budgeting, 457 19 Multinational Cash Management, 476 20 International Trade Finance, 487 21 International Tax Environment and Transfer Pricing, 498

Glossary, 520 Index, 527

Contents in Brief

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Contents

PART ONE Foundations of International Financial Management

CHAPTER 1

Globalization and the Multinational Firm, 4

What’s Special about International Finance?, 5

Foreign Exchange and Political Risks, 5

Market Imperfections, 6

Expanded Opportunity Set, 7

Goals for International Financial Management, 8

Globalization of the World Economy: Major Trends and Developments, 10

Emergence of Globalized Financial Markets, 10

Emergence of the Euro as a Global Currency, 11

Europe’s Sovereign Debt Crisis of 2010, 12

Trade Liberalization and Economic Integration, 13

Privatization, 15

Global Financial Crisis of 2008–2009, 16

Multinational Corporations, 18

INTERNATIONAL FINANCE IN PRACTICE: Multinationals More Efficient, 19

Summary, 21

M I N I CA S E : Nike and Sweatshop Labor, 23

A P P E N D I X 1A: Gain from Trade: The Theory of Comparative Advantage, 25

CHAPTER 2

International Monetary System, 27

Evolution of the International Monetary System, 27

Bimetallism: Before 1875, 28

Classical Gold Standard: 1875–1914, 28

Interwar Period: 1915–1944, 30

Bretton Woods System: 1945–1972, 31

The Flexible Exchange Rate Regime: 1973–Present, 34

The Current Exchange Rate Arrangements, 36

European Monetary System, 40

The Euro and the European Monetary Union, 43

A Brief History of the Euro, 43

What Are the Benefits of Monetary Union?, 44

Costs of Monetary Union, 46

Prospects of the Euro: Some Critical Questions, 47

INTERNATIONAL FINANCE IN PRACTICE: Mundell Wins Nobel Prize in Economics, 48

The Mexican Peso Crisis, 48

The Asian Currency Crisis, 51

Origins of the Asian Currency Crisis, 52

Lessons from the Asian Currency Crisis, 53

The Argentine Peso Crisis, 55

Fixed versus Flexible Exchange Rate Regimes, 56

Summary, 58

M I N I CA S E : Will the United Kingdom Join the Euro Club?, 60

CHAPTER 3

Balance of Payments, 62 Balance-of-Payments Accounting, 62

Balance-of-Payments Accounts, 64

The Current Account, 64

The Capital Account, 66

Statistical Discrepancy, 68

Official Reserve Account, 69

The Balance-of-Payments Identity, 72

Balance-of-Payments Trends in Major Countries, 72

INTERNATIONAL FINANCE IN PRACTICE: The Dollar and the Deficit, 74

xvii

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xviii C O N T E N T S

Summary, 77

M I N I CA S E : Mexico’s Balance-of-Payments Problem, 80

A P P E N D I X 3A: The Relationship Between Balance of Payments and National Income Accounting, 81

Governance of the Public Corporation: Key Issues, 83

The Agency Problem, 84

Remedies for the Agency Problem, 86

Board of Directors, 86

Incentive Contracts, 87

Concentrated Ownership, 87

INTERNATIONAL FINANCE IN PRACTICE: When Boards Are All in the Family, 88

Accounting Transparency, 89

Debt, 90

Overseas Stock Listings, 90

Market for Corporate Control, 91

Law and Corporate Governance, 92

Consequences of Law, 95

Ownership and Control Pattern, 95

Private Benefits of Control, 99

Capital Markets and Valuation, 99

Corporate Governance Reform, 100

Objectives of Reform, 100

Political Dynamics, 101

The Sarbanes-Oxley Act, 101

The Cadbury Code of Best Practice, 102

The Dodd-Frank Act, 103

Summary, 104

MINI CASE: Parmalat: Europe’s Enron, 106

CHAPTER 4

Corporate Governance Around the World, 82

Function and Structure of the FX Market, 113

INTERNATIONAL FINANCE IN PRACTICE: The Mouse Takes Over the Floor, 114

FX Market Participants, 114

Correspondent Banking Relationships, 116

The Spot Market, 117

Spot Rate Quotations, 117

INTERNATIONAL FINANCE IN PRACTICE: Where Money Talks Very Loudly, 118

Cross-Exchange Rate Quotations, 122

Alternative Expressions for the Cross-Exchange Rate, 123

The Bid-Ask Spread, 123

Spot FX Trading, 124

The Cross-Rate Trading Desk, 125

Triangular Arbitrage, 127

Spot Foreign Exchange Market Microstructure, 127

The Forward Market, 129

Forward Rate Quotations, 129

Long and Short Forward Positions, 130

Non-Deliverable Forward Contracts, 130

Forward Cross-Exchange Rates, 130

Forward Premium, 132

Swap Transactions, 132

Exchange-Traded Currency Funds, 134

Summary, 135

MINI CASE: Shrewsbury Herbal Products, Ltd., 138

CHAPTER 5

The Market for Foreign Exchange, 112

PART TWO The Foreign Exchange Market, Exchange Rate Determination, and Currency Derivatives

CHAPTER 6

International Parity Relationships and

Forecasting Foreign Exchange Rates, 140

Interest Rate Parity, 140

Covered Interest Arbitrage, 142

Interest Rate Parity and Exchange Rate Determination, 145

Currency Carry Trade, 146

Reasons for Deviations from Interest Rate Parity, 147

Purchasing Power Parity, 149

PPP Deviations and the Real Exchange Rate, 151

Evidence on Purchasing Power Parity, 151

INTERNATIONAL FINANCE IN PRACTICE: McCurrencies, 152

Fisher Effects, 156

Forecasting Exchange Rates, 158

Efficient Market Approach, 159

Fundamental Approach, 160

Technical Approach, 161

Performance of the Forecasters, 162

Summary, 166

M I N I CA S E : Turkish Lira and Purchasing Power Parity, 170

A P P E N D I X 6A: Purchasing Power Parity and Exchange Rate Determination, 172

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C O N T E N T S xix

Futures Contracts: Some Preliminaries, 174

Currency Futures Markets, 176

INTERNATIONAL FINANCE IN PRACTICE: FX Market Volumes Surge, 177

Basic Currency Futures Relationships, 178

Options Contracts: Some Preliminaries, 181

Currency Options Markets, 181

Currency Futures Options, 182

Basic Option-Pricing Relationships at Expiration, 182

American Option-Pricing Relationships, 185

European Option-Pricing Relationships, 187

Binomial Option-Pricing Model, 189

European Option-Pricing Formula, 191

Empirical Tests of Currency Options, 192

Summary, 193

M I N I CA S E : The Options Speculator, 195

CHAPTER 7

Futures and Options on Foreign Exchange, 173

How to Measure Economic Exposure, 227

Operating Exposure: Definition, 230

Illustration of Operating Exposure, 231

Determinants of Operating Exposure, 233

Managing Operating Exposure, 236

Selecting Low-Cost Production Sites, 236

Flexible Sourcing Policy, 236

Diversification of the Market, 237

R&D Efforts and Product Differentiation, 237

Financial Hedging, 237

INTERNATIONAL FINANCE IN PRACTICE: Porsche Powers Profit with Currency Plays, 238

CA S E A P P L I CAT I O N: Exchange Risk Management at Merck, 238

Summary, 241

M I N I CA S E : Economic Exposure of Albion Computers PLC, 243

CHAPTER 9

Management of Economic Exposure, 225

Translation Methods, 245

Current/Noncurrent Method, 245

Monetary/Nonmonetary Method, 246

Temporal Method, 246

Current Rate Method, 246

Financial Accounting Standards Board Statement 8, 247

Financial Accounting Standards Board Statement 52, 247

The Mechanics of the FASB 52 Translation Process, 250

Highly Inflationary Economies, 251

International Accounting Standards, 251

CA S E A P P L I CAT I O N: Consolidation of Accounts according to FASB 52: The Centralia Corporation, 251

Management of Translation Exposure, 255

Translation Exposure versus Transaction Exposure, 255

Hedging Translation Exposure, 256

Balance Sheet Hedge, 256

Derivatives Hedge, 257

Translation Exposure versus Operating Exposure, 258

CHAPTER 10

Management of Translation

Exposure, 245

Three Types of Exposure, 198

Forward Market Hedge, 200

Money Market Hedge, 202

Options Market Hedge, 203

Hedging Foreign Currency Payables, 205

Forward Contracts, 206

Money Market Instruments, 206

Currency Options Contracts, 207

Cross-Hedging Minor Currency Exposure, 208

Hedging Contingent Exposure, 208

Hedging Recurrent Exposure with Swap Contracts, 209

Hedging through Invoice Currency, 210

Hedging via Lead and Lag, 210

Exposure Netting, 211

Should the Firm Hedge?, 211

What Risk Management Products Do Firms Use?, 213

Summary, 214

M I N I CA S E : Airbus’ Dollar Exposure, 218

CA S E A P P L I CAT I O N: Richard May’s Options, 218

CHAPTER 8

Management of Transaction Exposure, 198

PART THREE Foreign Exchange Exposure and Management

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xx C O N T E N T S

Empirical Analysis of the Change from FASB 8 to FASB 52, 258

Summary, 258

M I N I CA S E : Sundance Sporting Goods, Inc., 260

PART FOUR World Financial Markets and Institutions

CHAPTER 11

International Banking and Money Market, 264

International Banking Services, 264

The World’s Largest Banks, 265

Reasons for International Banking, 266

Types of International Banking Offices, 266

Correspondent Bank, 267

Representative Offices, 267

Foreign Branches, 267

Subsidiary and Affiliate Banks, 268

Edge Act Banks, 268

Offshore Banking Centers, 268

International Banking Facilities, 269

Capital Adequacy Standards, 269

International Money Market, 272

Eurocurrency Market, 272

BBA LIBOR, 274

Eurocredits, 274

INTERNATIONAL FINANCE IN PRACTICE: The Rotten Heart of Finance, 276

Forward Rate Agreements, 276

Euronotes, 279

Eurocommercial Paper, 279

Eurodollar Interest Rate Futures Contracts, 279

International Debt Crisis, 281

History, 282

Debt-for-Equity Swaps, 283

The Solution: Brady Bonds, 284

The Asian Crisis, 285

Global Financial Crisis, 285

The Credit Crunch, 285

Impact of the Financial Crisis, 289

Economic Stimulus, 292

The Aftermath, 293

Summary, 294

M I N I CA S E : Detroit Motors’ Latin American Expansion, 299

A P P E N D I X 11A: Eurocurrency Creation, 301

CHAPTER 12

International Bond Market, 304

The World’s Bond Markets: A Statistical Perspective, 304

Foreign Bonds and Eurobonds, 304

Bearer Bonds and Registered Bonds, 305

National Security Regulations, 306

Withholding Taxes, 306

Security Regulations that Ease Bond Issuance, 306

Global Bonds, 307

Types of Instruments, 307

INTERNATIONAL FINANCE IN PRACTICE: SOX and Bonds, 308

Straight Fixed-Rate Issues, 308

Euro-Medium-Term Notes, 308

Floating-Rate Notes, 309

Equity-Related Bonds, 309

Dual-Currency Bonds, 309

Currency Distribution, Nationality, and Type of Issuer, 310

International Bond Market Credit Ratings, 311

INTERNATIONAL FINANCE IN PRACTICE: Heineken Refreshes Euromarket with Spectacular Unrated Bonds, 312

Eurobond Market Structure and Practices, 313

Primary Market, 313

Secondary Market, 318

Clearing Procedures, 318

International Bond Market Indexes, 319

Summary, 321

M I N I CA S E : Sara Lee Corporation’s Eurobonds, 323

CHAPTER 13

International Equity Markets, 324

A Statistical Perspective, 324

Market Capitalization of Developed Countries, 324

Market Capitalization of Developing Countries, 325

Measures of Liquidity, 326

Measures of Market Concentration, 328

Market Structure, Trading Practices, and Costs, 329

Market Consolidations and Mergers, 331

Trading in International Equities, 332

Cross-Listing of Shares, 332

Yankee Stock Offerings, 334

American Depository Receipts, 334

Global Registered Shares, 338

Empirical Findings on Cross-Listing and ADRs, 338

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C O N T E N T S xxi

International Equity Market Benchmarks, 340

iShares MSCI, 341

INTERNATIONAL FINANCE IN PRACTICE: Foreign Interest In South Africa Takes Off, 342

Factors Affecting International Equity Returns, 342

Macroeconomic Factors, 343

Exchange Rates, 343

Industrial Structure, 343

Summary, 344

M I N I CA S E : San Pico’s New Stock Exchange, 346

CHAPTER 14

Interest Rate and Currency Swaps 348

Types of Swaps, 348

INTERNATIONAL FINANCE IN PRACTICE: The World Bank’s First Currency Swap, 349

Size of the Swap Market, 349

The Swap Bank, 350

Swap Market Quotations, 350

Interest Rate Swaps, 350

Basic Interest Rate Swap, 350

Pricing the Basic Interest Rate Swap, 353

Currency Swaps, 353

Basic Currency Swap, 353

Equivalency of Currency Swap Debt Service Obligations, 355

Pricing the Basic Currency Swap, 356

A Basic Currency Swap Reconsidered, 357

Variations of Basic Interest Rate and Currency Swaps, 358

Risks of Interest Rate and Currency Swaps, 358

INTERNATIONAL FINANCE IN PRACTICE: Fallout from Greece’s Swap, 359

Is the Swap Market Efficient?, 360

Summary, 361

M I N I CA S E : The Centralia Corporation’s Currency Swap, 365

CHAPTER 15

International Portfolio Investment, 366

International Correlation Structure and Risk Diversification, 367

Optimal International Portfolio Selection, 369

Effects of Changes in the Exchange Rate, 376

International Bond Investment, 378

International Mutual Funds: A Performance Evaluation, 379

International Diversification through Country Funds, 381

International Diversification with ADRs, 384

International Diversification with Exchange- Traded Funds (ETFs), 385

International Diversification with Hedge Funds, 386

Why Home Bias in Portfolio Holdings?, 387

International Diversification with Small-Cap Stocks, 388

Summary, 390

M I N I CA S E : Solving for the Optimal International Portfolio, 396

A P P E N D I X 15A: International Investment with Exchange Risk Hedging, 398

A P P E N D I X 15B: Solving for the Optimal Portfolio, 400

PART FIVE Financial Management of the Multinational Firm

CHAPTER 16

Foreign Direct Investment and Cross-Border Acquisitions, 404

Global Trends in FDI, 405

Why Do Firms Invest Overseas?, 409

Trade Barriers, 409

Imperfect Labor Market, 409

Intangible Assets, 410

Vertical Integration, 411

INTERNATIONAL FINANCE IN PRACTICE: Linear Sequence in Manufacturing: Singer & Company, 412

Product Life Cycle, 412

Shareholder Diversification Services, 413

Cross-Border Mergers and Acquisitions, 413

Political Risk and FDI, 418

Summary, 425

M I N I CA S E : Enron versus Bombay Politicians, 427

CHAPTER 17

International Capital Structure and the

Cost of Capital, 431

Cost of Capital in Segmented versus Integrated Markets, 432

Does the Cost of Capital Differ among Countries?, 434

CA S E A P P L I CAT I O N: Novo Industri, 436

Cross-Border Listings of Stocks, 438

Capital Asset Pricing under Cross-Listings, 443

The Effect of Foreign Equity Ownership Restrictions, 445

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xxii C O N T E N T S

Pricing-to-Market Phenomenon, 446

CA S E A P P L I CAT I O N: Nestlé, 446

Asset Pricing under Foreign Ownership Restrictions, 447

The Financial Structure of Subsidiaries, 449

Summary, 452

A P P E N D I X 17A: Pricing of Nontradable Assets: Numerical Simulations, 456

CHAPTER 18

International Capital Budgeting, 457

Review of Domestic Capital Budgeting, 458

The Adjusted Present Value Model, 459

Capital Budgeting from the Parent Firm’s Perspective, 461

Generality of the APV Model, 463

Estimating the Future Expected Exchange Rate, 464

CA S E A P P L I CAT I O N: The Centralia Corporation, 464

Risk Adjustment in the Capital Budgeting Analysis, 468

Sensitivity Analysis, 469

Purchasing Power Parity Assumption, 469

Real Options, 469

Summary, 471

M I N I CA S E 1: Dorchester, Ltd., 473

M I N I CA S E 2: Strik-it-Rich Gold Mining Company, 474

CHAPTER 19

Multinational Cash Management, 476

The Management of International Cash Balances, 476

CA S E A P P L I CAT I O N: Teltrex’s Cash Management System, 476

Bilateral Netting of Internal and External Net Cash Flows, 481

Reduction in Precautionary Cash Balances, 483

Cash Management Systems in Practice, 484

Summary, 485

M I N I CA S E 1: Efficient Funds Flow at Eastern Trading Company, 486

M I N I CA S E 2: Eastern Trading Company’s New MBA, 486

CHAPTER 21

International Tax Environment and Transfer

Pricing, 498

The Objectives of Taxation, 498

Tax Neutrality, 498

Tax Equity, 499

Types of Taxation, 499

Income Tax, 499

Withholding Tax, 501

Value-Added Tax, 501

National Tax Environments, 503

Worldwide Taxation, 503

Territorial Taxation, 503

Foreign Tax Credits, 504

Organizational Structures, 504

Branch and Subsidiary Income, 504

Tax Havens, 505

Controlled Foreign Corporation, 506

Transfer Pricing and Related Issues, 506

INTERNATIONAL FINANCE IN PRACTICE: On or Off? It’s a Matter of Degree, 507

CASE APPLICATION: Mintel Products Transfer Pricing Strategy, 507

INTERNATIONAL FINANCE IN PRACTICE: Transfer Pricing Is the Most Important International Tax Issue, 511

INTERNATIONAL FINANCE IN PRACTICE: Wake Up and Smell the Coffee, 514

Miscellaneous Factors, 514

Advance Pricing Agreement, 515

Blocked Funds, 515

Summary, 516

M I N I CA S E 1: Sigma Corp.’s Location Decision, 518

M I N I CA S E 2: Eastern Trading Company’s Optimal Transfer Pricing Strategy, 519

Glossary, 520 Index, 527

CHAPTER 20

International Trade Finance, 487

A Typical Foreign Trade Transaction, 487

Forfaiting, 490

Government Assistance in Exporting, 490

INTERNATIONAL FINANCE IN PRACTICE: First Islamic Forfaiting Fund Set Up, 491

The Export-Import Bank and Affiliated Organizations, 491

Countertrade, 492

Forms of Countertrade, 492

INTERNATIONAL FINANCE IN PRACTICE: Armed Forces Tops in Countertrade List, 494

Some Generalizations about Countertrade, 494

Summary, 495

M I N I CA S E : American Machine Tools, Inc., 497

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International Financial Management

Seventh Edition

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O U

T L

IN E

PART ONE

1 Globalization and the Multinational Firm

2 International Monetary System

3 Balance of Payments

4 Corporate Governance Around the World

PART ONE

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PART ONE lays the macroeconomic and institutional foundation for all the topics to follow. A thorough understanding of this material is essential for understanding the advanced topics covered in the remaining sections.

CHAPTER 1 provides an introduction to International Financial Management. The chapter discusses why it is important to study international finance and distinguishes international finance from domestic finance.

CHAPTER 2 introduces the various types of international monetary systems under which the world economy can function and has functioned at various times. The chapter traces the historical development of the world’s international monetary systems from the early 1800s to the present. Additionally, a detailed discussion of the European Monetary Union is presented.

CHAPTER 3 presents balance-of-payment concepts and accounting. The chapter shows that even a country must keep its “economic house in order” or else it will experience current account deficits that will undermine the value of its currency.

CHAPTER 4 provides an overview of corporate governance around the world. Corporate governance structure varies greatly across countries, reflecting diverse cultural, economic, political, and legal environments.

Foundations of International Financial Management

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C H

A P

T E

R O

U T

L IN

E 1 Globalization and the Multinational Firm

AS THE TITLE International Financial Management indicates,

in this book we are concerned with financial management in

an international setting. Financial management is mainly con-

cerned with how to optimally make various corporate financial

decisions, such as those pertaining to investment, financing,

dividend policy, and working capital management, with a view

to achieving a set of given corporate objectives. In Anglo-

American countries as well as in many advanced countries with

well-developed capital markets, maximizing shareholder wealth

is generally considered the most important corporate objective.

Why do we need to study “international” financial manage-

ment? The answer to this question is straightforward: We are now

living in a highly globalized and integrated world economy .

American consumers, for example, routinely purchase oil

imported from Saudi Arabia and Nigeria, TV sets from Korea,

automobiles from Germany and Japan, garments from China,

shoes from Indonesia, handbags from Italy, and wine from

France. Foreigners, in turn, purchase American-made aircraft,

software, movies, jeans, smart phones, and other products.

Continued liberalization of international trade is certain to further

internationalize consumption patterns around the world.

Like consumption, production of goods and services has

become highly globalized. To a large extent, this has happened

as a result of multinational corporations’ (MNCs) relentless

efforts to source inputs and locate production anywhere in the

world where costs are lower and profits are higher. For example,

personal computers sold in the world market might have been

assembled in Malaysia with Taiwanese-made monitors, Korean-made keyboards, U.S.-

made chips, and preinstalled software packages that were jointly developed by U.S.

and Indian engineers. It has often become difficult to clearly associate a product with a

single country of origin.

Recently, financial markets have also become highly integrated. This development

allows investors to diversify their investment portfolios internationally. In 2011, for

instance, U.S. investors collectively invested $83 billion in foreign securities, such

as stocks and bonds, whereas foreigners invested $337 billion in U.S. securities. 1

In particular, Asian and Middle Eastern investors are investing heavily in U.S. and

other foreign financial markets in efforts to recycle their large trade surpluses. In

addition, many major corporations of the world, such as IBM, Toyota, and British

Petroleum, have their shares cross-listed on foreign stock exchanges, thereby render-

ing their shares internationally tradable and gaining access to foreign capital as well.

Consequently, Toyota’s venture, say, in China can be financed partly by American

investors who purchase Toyota shares traded on the New York Stock Exchange.

What’s Special about International Finance? Foreign Exchange and Political Risks

Market Imperfections

Expanded Opportunity Set

Goals for International Financial Management Globalization of the World Economy: Major Trends and Developments

Emergence of Globalized Financial Markets

Emergence of the Euro as a Global Currency

Europe’s Sovereign Debt Crisis of 2010

Trade Liberalization and Economic Integration

Privatization

Global Financial Crisis of 2008–2009

Multinational Corporations Summary Key Words Questions Internet Exercises MINI CASE: Nike and Sweatshop Labor

References and Suggested Readings APPENDIX 1A: Gain from Trade: The Theory of

Comparative Advantage

1This information is from International Financial Statistics, April 2013.

CHAPTER

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Undoubtedly, we are now living in a world where all the major economic

functions—consumption, production, and investment—are highly globalized. It is thus

essential for financial managers to fully understand vital international dimensions of

financial management. This global shift is in marked contrast to a few decades ago,

when the authors of this book were learning finance. At that time, most professors

customarily (and safely, to some extent) ignored international aspects of finance. This

parochial attitude has become untenable since then.

What’s Special about International Finance? Although we may be convinced of the importance of studying international finance,

we still have to ask ourselves, what’s special about international finance? Put another

way, how is international finance different from purely domestic finance (if such a

thing exists)? Three major dimensions set international finance apart from domestic

finance. They are:

1. Foreign exchange and political risks.

2. Market imperfections.

3. Expanded opportunity set.

As we will see, these major dimensions of international finance largely stem from the

fact that sovereign nations have the right and power to issue currencies, formulate their

own economic policies, impose taxes, and regulate movements of people, goods, and

capital across their borders. Before we move on, let us briefly describe each of the key

dimensions of international financial management.

Suppose Mexico is a major export market for your company and the Mexican peso depre-

ciates drastically against the U.S. dollar, as it did in December 1994. This means that your

company’s products can be priced out of the Mexican market, as the peso price of American

imports will rise following the peso’s fall. If such countries as Indonesia, Thailand, and

Korea are major export markets, your company would have faced the same difficult situ-

ation in the wake of the Asian currency crisis of 1997. In integrated financial markets,

individuals or households may also be seriously exposed to uncertain exchange rates. For

example, since the EU accession, many Hungarians have borrowed in terms of the euro or

Swiss franc to purchase houses. They were initially attracted by the easy availability and

low interest rates for foreign currency mortgage loans. However, as the Hungarian cur-

rency, forint, was falling against the euro and Swiss franc during the recent global financial

crisis, the burden of mortgage payments in terms of forint has increased sharply, forcing

many borrowers to default. The preceding examples suggest that when firms and indi-

viduals are engaged in cross-border transactions, they are potentially exposed to foreign exchange risk that they would not normally encounter in purely domestic transactions.

Currently, the exchange rates among such major currencies as the U.S. dollar,

Japanese yen, British pound, and euro fluctuate continuously in an unpredictable

manner. This has been the case since the early 1970s, when fixed exchange rates were

abandoned. As can be seen from Exhibit 1.1 , exchange rate volatility has exploded

since 1973. Exchange rate uncertainty will have a pervasive influence on all the major

economic functions, including consumption, production, and investment.

Another risk that firms and individuals may encounter in an international setting is

political risk. Political risk ranges from unexpected changes in tax rules to outright

expropriation of assets held by foreigners. Political risk arises from the fact that a

sovereign country can change the “rules of the game” and the affected parties may

not have effective recourse. In 1992, for example, the Enron Development Corpo-

ration, a subsidiary of a Houston-based energy company, signed a contract to build

India’s largest power plant. After Enron had spent nearly $300 million, the project

Foreign Exchange and Political Risks

https://www.cia.gov/library/ publications/the-world- factbook

Website of The World Factbook

published by the CIA provides

background information, such

as geography, government,

and economy, of countries

around the world.

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6 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

was canceled in 1995 by nationalist politicians in the Maharashtra state who argued

India didn’t need the power plant. For another example, in April 2012 the Argentine

governent nationalized a majority stake in YPF, the country’s largest oil company, worth

approximately $10 billion, held by the Spanish parent company, Repsol, accusing the

latter for underproducing oil in Argentina. Broadly, the seizure of YPF is a part of the

campaign to bring strategic industries under government control. Both the Enron and

Repsol episodes illustrate the difficulty of enforcing contracts in foreign countries. 2

Multinational firms and investors should be particularly aware of political risk when

they invest in those countries without a tradition of the rule of law. The meltdown of

Yukos, the largest Russian oil company, provides a compelling example. Following the

arrest of Mikhail Khodorkovsky, the majority owner and a critic of the government, on

fraud and tax evasion charges, the Russian authorities forced Yukos into bankruptcy. The

authorities sued the company for more than $20 billion in back taxes and auctioned off

its assets to cover the alleged tax arrears. This government action against Yukos, widely

viewed as politically motivated, inflicted serious damage on international shareholders

of Yukos, whose investment values were wiped out. It is important to understand that the

property rights of shareholders and investors are not universally respected.

Although the world economy is much more integrated today than was the case 10 or

20 years ago, a variety of barriers still hamper free movements of people, goods, ser-

vices, and capital across national boundaries. These barriers include legal restrictions,

excessive transaction and transportation costs, information asymmetry, and discrimi-

natory taxation. The world markets are thus highly imperfect. As we will discuss later

in this book, market imperfections , which represent various frictions and impedi-

ments preventing markets from functioning perfectly, play an important role in moti-

vating MNCs to locate production overseas. Honda, a Japanese automobile company,

for instance, decided to establish production facilities in Ohio, mainly to circumvent

trade barriers. One might even say that MNCs are a gift of market imperfections.

Imperfections in the world financial markets tend to restrict the extent to which inves-

tors can diversify their portfolios. An interesting example is provided by the Nestlé

Corporation, a well-known Swiss MNC. Nestlé used to issue two different classes of

common stock, bearer shares and registered shares, and foreigners were allowed to hold

Market Imperfections

2Since then, Enron has renegotiated the deal with the Maharashtra state while the Spanish government retaliated

by restricting imports from Argentina.

Source: International Monetary Fund, International Financial Statistics , various issues.

EXHIBIT 1.1

Monthly Percentage

Change in Japanese

Yen-U.S. Dollar

Exchange Rate

–15

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

–10

–5

P er

ce nt

ag e

ch an

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C H A P T E R 1 GLOBALIZATION AND THE MULTINATIONAL FIRM 7

only bearer shares. As Exhibit 1.2 shows, bearer shares used to trade for about twice

the price of registered shares, which were exclusively reserved for Swiss residents. 3

This kind of price disparity is a uniquely international phenomenon that is attributable to

market imperfections.

On November 18, 1988, however, Nestlé lifted restrictions imposed on foreign-

ers, allowing them to hold registered as well as bearer shares. After this announce-

ment, the price spread between the two types of Nestlé shares narrowed drastically.

As Exhibit 1.2 shows, the price of bearer shares declined sharply, whereas that of

registered shares rose sharply. This implies that there was a major transfer of wealth

from foreign shareholders to domestic shareholders. Foreigners holding Nestlé bearer

shares were exposed to political risk in a country that is widely viewed as a haven from

such risk. The Nestlé episode illustrates both the importance of considering market

imperfections in international finance and the peril of political risk.

When firms venture into the arena of global markets, they can benefit from an

expanded opportunity set . As previously mentioned, firms can locate production in

any country or region of the world to maximize their performance and raise funds

in any capital market where the cost of capital is the lowest. In addition, firms can gain

from greater economies of scale when their tangible and intangible assets are deployed

on a global basis. A real-world example showing the gains from a global approach

to financial management is provided by the following excerpt from The Wall Street Journal (April 9, 1996):

Another factor binding bond markets ever closer is large companies’ flexibility to issue bonds

around the world at will, thanks to the global swap market. At the vanguard are companies such

as General Electric of the U.S. Mark VanderGriend, who runs the financing desk at Banque

Paribas, says it took “about 15 minutes” to put together a four billion franc ($791.6 million)

deal for GE. By raising the money in francs and swapping into dollars instantly, GE will save

five hundredths of a percentage point—or about $400,000 annually on the nine-year deal.

“They have such a huge requirement for capital that they are constantly looking for arbitrages,”

adds Mr. VanderGriend. “And they don’t care much how they get there.”

Expanded Opportunity Set

EXHIBIT 1.2

Daily Prices of Nestlé’s

Bearer and Registered

3It is noted that bearer and registered shares of Nestlé had the same claims on dividends but differential voting

rights. Chapter 17 provides a detailed discussion of the Nestlé case.

Source: Reprinted from Journal of Financial Economics, Volume 37, Issue 3, Claudio Loderer and Andreas Jacobs, “The Nestlé Crash,” pp. 315–39, 1995, with kind permission from Elsevier Science S.A., P.O. Box 564, 1001 Lausanne, Switzerland.

12001

Dec. 28, 1990Jan 4, 1990

November 18, 1988Nestlé registered stock price

Nestlé voting bearer stock price

Dec. 29, 1988Jan 4, 1988Jan 5, 1987

10001

8001

6001

Sw is

s F

ra nc

4001

2001

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8 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

Individual investors can also benefit greatly if they invest internationally rather than domes-

tically. Suppose you have a given amount of money to invest in stocks. You may invest

the entire amount in U.S. (domestic) stocks. Alternatively, you may allocate the funds

across domestic and foreign stocks. If you diversify internationally, the resulting interna-

tional portfolio may have a lower risk or a higher return (or both) than a purely domestic

portfolio. This can happen mainly because stock returns tend to covary less across coun-

tries than within a given country. Once you are aware of overseas investment opportunities

and are willing to diversify internationally, you face a much expanded opportunity set and

you can benefit from it. It just doesn’t make sense to play in only one corner of the sand-

box. Thus, an important “normative” theme we will study throughout this book is: how

to maximize the benefits from the global opportunity set, while judiciously controlling

currency and political risks and managing various market imperfections.

Goals for International Financial Management The foregoing discussion implies that understanding and managing foreign exchange

and political risks and coping with market imperfections have become important parts

of the financial manager’s job. International Financial Management is designed to

provide today’s financial managers with an understanding of the fundamental con-

cepts and the tools necessary to be effective global managers. Throughout, the text

emphasizes how to deal with exchange risk and market imperfections, using the vari-

ous instruments and tools that are available, while at the same time maximizing the

benefits from an expanded global opportunity set.

Effective financial management, however, is more than the application of the new-

est business techniques or operating more efficiently. There must be an underlying

goal. International Financial Management is written from the perspective that the fun-

damental goal of sound financial management is shareholder wealth maximization.

Shareholder wealth maximization means that the firm makes all business decisions

and investments with an eye toward making the owners of the firm—the shareholders—

better off financially, or more wealthy, than they were before.

Whereas shareholder wealth maximization is generally accepted as the ultimate

goal of financial management in “Anglo-Saxon” countries, such as Australia, Canada,

the United Kingdom, and especially the United States, it is not as widely embraced

a goal in other parts of the world. In countries like France and Germany, for exam-

ple, shareholders are generally viewed as one of the “stakeholders” of the firm, oth-

ers being employees, customers, suppliers, banks, and so forth. European managers

tend to consider the promotion of the firm’s stakeholders’ overall welfare as the most

important corporate goal. In Japan, on the other hand, many companies form a small

number of interlocking business groups called keiretsu , such as Mitsubishi, Mitsui,

and Sumitomo, which arose from consolidation of family-owned business empires.

Although keiretsu have weakened in recent years, Japanese managers still tend to

regard the prosperity and growth of their keiretsu as the critical goal; for instance, they

tend to strive to maximize market share, rather than shareholder wealth.

It is pointed out, however, that as capital markets are becoming more liberalized and

internationally integrated in recent years, even managers in France, Germany, Japan, and

other non-Anglo-Saxon countries are beginning to pay serious attention to shareholder

wealth maximization. In Germany, for example, companies are now allowed to repur-

chase stocks, if necessary, for the benefit of shareholders. In accepting an unprecedented

$203 billion takeover offer by Vodafone AirTouch, a leading British wireless phone com-

pany, Klaus Esser, CEO of Mannesmann of Germany, cited shareholder interests: “The

shareholders clearly think that this company, Mannesmann, a great company, would be

better together with Vodafone AirTouch. . . . The final decision belongs to shareholders.” 4

4The source for this information is The New York Times, February 4, 2000, p. C9.

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C H A P T E R 1 GLOBALIZATION AND THE MULTINATIONAL FIRM 9

Obviously, the firm could pursue other goals. This does not mean, however, that the

goal of shareholder wealth maximization is merely an alternative, or that the firm should

enter into a debate as to its appropriate fundamental goal. Quite the contrary. If the firm

seeks to maximize shareholder wealth, it will most likely simultaneously be accomplish-

ing other legitimate goals that are perceived as worthwhile. Shareholder wealth maximi-

zation is a long-run goal. A firm cannot stay in business to maximize shareholder wealth

if it treats employees poorly, produces shoddy merchandise, wastes raw materials and nat-

ural resources, operates inefficiently, or fails to satisfy customers. Only a well-managed

business firm that profitably produces what is demanded in an efficient manner can expect

to stay in business in the long run and thereby provide employment opportunities.

While managers are hired to run the company for the interests of shareholders, there

is no guarantee that they will actually do so. As shown by a series of recent corporate

scandals at companies like Enron, WorldCom, and Global Crossing, managers may pur-

sue their own private interests at the expense of shareholders when they are not closely

monitored. This so-called agency problem is a major weakness of the public corporation.

Extensive corporate malfeasance and accounting manipulations at these companies even-

tually drove them into financial distress and bankruptcy, devastating shareholders and

employees alike. Lamentably, some senior managers enriched themselves enormously

in the process. Clearly, the boards of directors, the ultimate guardians of the interests of

shareholders, failed to perform their duties at these companies. In the wake of these corpo-

rate calamities that have undermined the credibility of the free market system, the society

has painfully learned the importance of corporate governance , that is, the financial and

legal framework for regulating the relationship between a company’s management and

its shareholders. Needless to say, the corporate governance problem is not confined to the

United States. In fact, it can be a much more serious problem in many other parts of the

world, especially emerging and transition economies, such as Indonesia, Korea, China,

and Russia, where legal protection of shareholders is weak or virtually nonexistent.

As we will discuss in Chapter 4 in detail, corporate governance structure varies

greatly across countries, reflecting different cultural, legal, economic, and political

environments in different countries. In many countries where shareholders do not have

strong legal rights, corporate ownership tends to be concentrated. The concentrated

ownership of the firm, in turn, may give rise to the conflicts of interest between domi-

nant shareholders (often the founding family) and small outside shareholders. The col-

lapse of Parmalat, a family-controlled Italian company, after decades of accounting

frauds, provides an example of corporate governance risk. The company allegedly hid

debts, “invented” assets, and diverted funds to bail out failing ventures of the family

members. Because only the Tanzi (founding) family and close associates knew how

the company was run, it was possible to hide the questionable practices for decades.

Outside shareholders who collectively control a 49 percent stake did not know how

Parmalat was operating. Franco Ferrarotti, professor of sociology at the University

of Rome, was quoted as saying, “The government is weak, there is no sense of state,

public services are bad and social services are weak. The family is so strong because it

is the only institution that doesn’t let you down.” 5

Shareholders are the owners of the business; it is their capital that is at risk. It is

only equitable that they receive a fair return on their investment. Private capital may not

have been forthcoming for the business firm if it had intended to accomplish any other

objective. As we will discuss shortly, the massive privatization that has been taking place

in developing and formerly socialist countries, which will eventually enhance the stan-

dard of living of these countries’ citizens, depends on private investment. It is thus vitally

important to strengthen corporate governance so that shareholders receive fair returns on

their investments. In what follows, we are going to discuss in detail: (i) the globalization

of the world economy, and (ii) the growing role of MNCs in the world economy.

5USA Today, February 4, 2004, p. 2B.

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10 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

Globalization of the World Economy: Major Trends and Developments

The term “globalization” became a popular buzzword for describing business prac-

tices in the last few decades, and it appears as if it will continue to be a key word for

describing business management throughout the current century. In this section, we

review several key trends and developments of the world economy: (i) the emergence

of globalized financial markets, (ii) the emergence of the euro as a global currency,

(iii) Europe’s sovereign debt crisis of 2010, (iv) continued trade liberalization and eco-

nomic integration, (v) large-scale privatization of state-owned enterprises, and (vi) the

global financial crisis of 2008–2009.

The 1980s and 90s saw a rapid integration of international capital and financial

markets. The impetus for globalized financial markets initially came from the govern-

ments of major countries that had begun to deregulate their foreign exchange and capi-

tal markets. For example, in 1980 Japan deregulated its foreign exchange market, and

in 1985 the Tokyo Stock Exchange admitted as members a limited number of foreign

brokerage firms. Additionally, the London Stock Exchange (LSE) began admitting for-

eign firms as full members in February 1986.

Perhaps the most celebrated deregulation, however, occurred in London on

October 27, 1986, and is known as the “Big Bang.” On that date, as on “May Day”

in 1975 in the United States, the London Stock Exchange eliminated fixed brokerage

commissions. Additionally, the regulation separating the order-taking function from the

market-making function was eliminated. In Europe, financial institutions are allowed

to perform both investment-banking and commercial-banking functions. Hence, the

London affiliates of foreign commercial banks were eligible for membership on the

LSE. These changes were designed to give London the most open and competitive capi-

tal markets in the world. It has worked, and today the competition in London is espe-

cially fierce among the world’s major financial centers. The United States repealed the

Glass-Steagall Act, which restricted commercial banks from investment banking activi-

ties (such as underwriting corporate securities), further promoting competition among

financial institutions. Even developing countries such as Chile, Mexico, and Korea

began to liberalize by allowing foreigners to directly invest in their financial markets.

Deregulated financial markets and heightened competition in financial services pro-

vided a natural environment for financial innovations that resulted in the introduction

of various instruments. Examples of these innovative instruments include currency

futures and options, multicurrency bonds, international mutual funds, country funds,

exchange-traded funds (ETFs), and foreign stock index futures and options. Corpora-

tions also played an active role in integrating the world financial markets by listing their

shares across borders. Such well-known non-U.S. companies as BHP Billiton, Petro-

bras, China Mobile, Nokia, Wipro, Honda Motor, Telmex, ING, BP, Korea Telecom,

and UBS are directly listed and traded on the New York Stock Exchange. At the same

time, U.S. firms such as IBM and GE are listed on the Frankfurt, London, and Paris

stock exchanges. Such cross-border listings of stocks allow investors to buy and sell

foreign shares as if they were domestic shares, facilitating international investments. 6

Last but not least, advances in computer and telecommunications technology con-

tributed in no small measure to the emergence of global financial markets. These tech-

nological advancements, especially Internet-based information technologies, gave

investors around the world immediate access to the most recent news and information

Emergence of Globalized Financial Markets

www.imf.org

Offers an overview of

globalization and financial

development.

6Various studies indicate that the liberalization of capital markets tends to lower the cost of capital. See, for

example, Peter Henry, “Stock Market Liberalization, Economic Reform, and Emerging Market Equity Prices,”

Journal of Finance (2000), pp. 529–64.

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C H A P T E R 1 GLOBALIZATION AND THE MULTINATIONAL FIRM 11

affecting their investments, sharply reducing information costs. Also, computerized

order-processing and settlement procedures have reduced the costs of international

transactions. Based on the U.S. Department of Commerce computer price deflator, the

relative cost index of computing power declined from a level of 100 in 1960 to 15.6 in

1970, 2.9 in 1980, and only 0.5 by 1999. As a result of these technological develop-

ments and the liberalization of financial markets, cross-border financial transactions

have exploded in recent years.

The advent of the euro at the start of 1999 represents a momentous event in the history

of the world financial system that has profound ramifications for the world economy.

Currently, more than 300 million Europeans in 17 countries (Austria, Belgium,

Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,

Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain) are using the com-

mon currency on a daily basis. No single currency has circulated so widely in Europe

since the days of the Roman Empire. Considering that many new members of the EU,

including the Czech Republic, Hungary, and Poland, would like to adopt the euro

eventually, the transactions domain of the euro may become larger than that of the

U.S. dollar in the near future.

Once a country adopts the common currency, it obviously cannot have its own mon-

etary policy. The common monetary policy for the euro zone is now formulated by the

European Central Bank (ECB) that is located in Frankfurt and closely modeled after

the Bundesbank, the German central bank. ECB is legally mandated to achieve price

stability for the euro zone. Considering the sheer size of the euro zone in terms of pop-

ulation, economic output, and world trade share, the euro has a potential for becoming

another global currency rivaling the U.S. dollar for dominance in international trade

and finance. Reflecting the significance of the euro’s introduction, Professor Robert

Mundell, who is often referred to as the intellectual father of the euro, recently stated:

“The creation of the euro area will eventually, but inevitably, lead to competition with

the dollar area, both from the standpoint of excellence in monetary policy, and in the

enlistment of other currencies.” 7 If the euro maintains its credibility, the world faces

the prospect of a bipolar international monetary system.

Since its inception in 1999, the euro has already brought about revolutionary

changes in European finance. For instance, by redenominating corporate and govern-

ment bonds and stocks from many different currencies into the common currency, the

euro has precipitated the emergence of continentwide capital markets in Europe that

are comparable to U.S. markets in depth and liquidity. Companies all over the world

can benefit from this development as they can raise capital more easily on favorable

terms in Europe. In addition, the recent surge in European M&A activities, cross-

border alliances among financial exchanges, and lessening dependence on the banking

sectors for capital raising are all manifestations of the profound effects of the euro.

Since the end of World War I, the U.S. dollar has played the role of the dominant

global currency, displacing the British pound. As a result, foreign exchange rates of

currencies are often quoted against the dollar, and the lion’s share of currency trad-

ing involves the dollar on either the buy or sell side. Similarly, international trade

in primary commodities, such as petroleum, coffee, wheat, and gold, is conducted

using the U.S. dollar as the invoice currency. Reflecting the dominant position of

the dollar in the world economy, central banks of the world hold a major portion

of their external reserves in dollars. The ascendance of the dollar reflects several

key factors such as the dominant size of the U.S. economy, mature and open capital

markets, price stability, and the political and military power of the United States.

Emergence of the Euro as a Global Currency

7Source: Robert Mundell, 2000, “Currency Area, Volatility and Intervention,” Journal of Policy Modeling 22 (3),

281–99.

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12 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

It is noted that the dominant global currency status of the dollar confers upon the

United States many special privileges, such as the ability to run trade deficits without

having to hold much in foreign exchange reserves, that is, “deficits without tears,”

and to conduct a large portion of international transactions in dollars, without bear-

ing exchange risks. However, once economic agents start to use the euro in earnest

as an invoice and reserve currency, the dollar may have to share the aforementioned

privileges with the euro.

Recently, however, the euro’s emergence as a global currency was dealt a serious set-

back in the midst of Europe’s sovereign debt crisis. The crisis started in December

2009 when the new Greek government revealed that its budget deficit for the year

would be 12.7 percent of GDP, not the 3.7 percent previously forecast. The previous

government had falsified the national account data. Unbeknownst to the outside world,

Greece was in a serious violation of Europe’s stability pact, which limits the annual

budget deficit of a euro-zone country to a maximum of 3 percent of GDP. This news

surprised financial markets and prompted investors, who became worried about sov-

ereign default, to sell off Greek government bonds. The Greek predicament is attrib-

utable to excessive borrowing and spending, with wages and prices rising faster than

productivity. With the adoption of the euro, Greece no longer can use the traditional

means of restoring competitiveness, i.e., depreciation of the national currency.

The panic spread to other weak European economies, especially Ireland, Portugal,

and Spain. In the spring of 2010, both Standard & Poor’s and Moody’s, credit rating

agencies, downgraded the government bonds of the affected countries, making bor-

rowing and refinancing more costly. In particular, the Greek government bond was

downgraded to “junk,” ineligible for institutional investment. The unfolding “Greek

drama” is illustrated in Exhibit 1.3 , which plots the two-year government bond yields

for Greece and Germany, as well as the dollar-euro exchange rate. As can be seen

from the exhibit, Greece paid a minimal or practically nonexistent premium above the

German interest rate until December 2009. This was possible owing to Greece’s mem-

bership in the euro club. However, the Greek interest rate began to rise sharply there-

after, reaching 18.3 percent on May 7, 2010, before it fell following the announcement

of the bailout package on May 9. Also, the specter of chaotic sovereign defaults led to

a sharp fall of the euro’s exchange value in currency markets.

Europe’s Sovereign Debt Crisis of 2010

1.60

1.55

1.50

1.45

1.40

1.35

1.30

1.25

1.20

D ol

la r-

eu ro

e xc

ha ng

e ra

te (

$/ €

)

1.15

1.10

1.05

1.00

Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10

$/€ rate

Greek bond yield

German bond yield

T w

o- ye

ar g

ov er

nm en

t- bo

nd y

ie ld

s (%

)

EXHIBIT 1.3

The Greek Drama

Source: Bloomberg.

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C H A P T E R 1 GLOBALIZATION AND THE MULTINATIONAL FIRM 13

The sovereign debt crisis in Greece, which accounts for only about 2.5 percent of

euro-zone GDP, quickly escalated to a Europe-wide debt crisis, threatening the nascent

recovery of the world economy from the severe global financial crisis of 2008–2009.

Facing the spreading crisis, the European Union (EU) countries, led by France and

Germany, jointly with the International Monetary Fund (IMF), put together a massive

€750 billion package to bail out Greece and other weak economies. It is noted that

Europe’s lack of political union and fragmented decision-making structure made it

slow and contentious for EU countries to reach agreement on the bailout plan, making

the rescue more expensive than it may otherwise have been.

Europe’s sovereign-debt crisis of 2010 revealed a profound weakness of the euro as

the common currency: Euro-zone countries have achieved monetary integration by adopt-

ing the euro, but without fiscal integration. While euro-zone countries share the com-

mon monetary policy, fiscal policies governing taxation, spending, and borrowing firmly

remain under the control of national governments. Hence, a lack of fiscal discipline in a

euro-zone country can always become a Europe-wide crisis, threatening the value and

credibility of the common currency. The long-term viability of the euro and its potential

as a global currency thus critically depend on how this disparity between monetary and

fiscal integration will be addressed. Regarding this challenge, Jean-Claude Trichet, former

president of the European Central Bank (ECB), recently called for making a “quantum

leap” in the euro zone’s economic governance and urged Europe to form a “fiscal con-

federation.” It remains to be seen whether Europe will be able to meet these challenges.

International trade, which has been the traditional link between national economies,

has continued to expand. As Exhibit 1.4 shows, the ratio of merchandise exports to

GDP for the world has increased from 7.0 percent in 1950 to 22.6 percent in 2011.

This implies that, over the same time period, international trade increased nearly three

times as fast as world GDP. For some countries, international trade grew much faster;

for Germany, the ratio rose from 6.2 percent to 50.2 percent, while for Korea it grew

from 1.0 percent to 56.2 percent over the same time period. Latin American coun-

tries such as Argentina, Brazil, and Mexico used to have relatively low export-to-GDP

ratios. In 1973, for example, the export-to-GDP ratio was 2.1 percent for Argentina,

2.6 percent for Brazil, and 2.2 percent for Mexico. This reflects the inward-looking,

protectionist economic policies these countries pursued in the past. Even these once-

protectionist countries are now increasingly pursuing free-market and open-economy

Trade Liberalization and Economic Integration

EXHIBIT 1.4

Long-Term Openness

in Perspective

(Merchandise Exports/GDP at 1990 Prices, in Percent)

Country 1870 1913 1929 1950 1973 2011

United States 2.5 3.7 3.6 3.0 5.0 14.0 Canada 12.0 12.2 15.8 13.0 19.9 31.2 Australia 7.4 12.8 11.2 9.1 11.2 21.3 United Kingdom 12.0 17.7 13.3 11.4 14.0 32.5 Germany 9.5 15.6 12.8 6.2 23.8 50.2 France 4.9 8.2 8.6 7.7 15.4 27.0 Spain 3.8 8.1 5.0 1.6 5.0 30.3 Japan 0.2 2.4 3.5 2.3 7.9 15.2 Korea 0.0 1.0 4.5 1.0 8.2 56.2 Thailand 2.1 6.7 6.6 7.0 4.5 76.9 Argentina 9.4 6.8 6.1 2.4 2.1 21.8 Brazil 11.8 9.5 7.1 4.0 2.6 11.9 Mexico 3.7 10.8 14.8 3.5 2.2 31.7

World 5.0 8.7 9.0 7.0 11.2 22.6

Source: Various issues of World Financial Markets, JP Morgan, World Development Indicators, International Trade Statistics, and International Financial Statistics, IMF.

eun61604_ch01_002-026.indd 13eun61604_ch01_002-026.indd 13 1/3/14 10:13 AM1/3/14 10:13 AM

14 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

policies because of the gains from international trade. In 2011, the export-to-GDP ratio

was 21.8 percent for Argentina, 11.9 percent for Brazil, and 31.7 percent for Mexico.

The principal argument for international trade is based on the theory of compara- tive advantage , which was advanced by David Ricardo in his seminal book, Prin- ciples of Political Economy (1817). According to Ricardo, it is mutually beneficial

for countries if they specialize in the production of those goods they can produce

most efficiently and trade those goods among them. Suppose England produces tex-

tiles most efficiently, whereas France produces wine most efficiently. It then makes

sense if England specializes in the production of textiles and France in the produc-

tion of wine, and the two countries then trade their products. By doing so, the two

countries can increase their combined production of textiles and wine, which, in turn,

allows both countries to consume more of both goods. This argument remains valid

even if one country can produce both goods more efficiently than the other country. 8

Ricardo’s theory has a clear policy implication: Liberalization of international trade will enhance the welfare of the world’s citizens . In other words, international trade

is not a “zero-sum” game in which one country benefits at the expense of another

country—the view held by the “mercantilists.” Rather, international trade could be an

“increasing-sum” game at which all players become winners.

Although the theory of comparative advantage is not completely immune to valid

criticism, it nevertheless provides a powerful intellectual rationale for promoting free

trade among nations. Currently, international trade is becoming further liberalized at

both the global and regional levels. At the global level, the General Agreement on Tariffs and Trade (GATT) , which is a multilateral agreement among member coun-

tries, has played a key role in dismantling barriers to international trade. Since it was

founded in 1947, GATT has been successful in gradually eliminating and reducing

tariffs, subsidies, quotas, and other barriers to trade. Under the auspices of GATT,

the Uruguay Round launched in 1986 aims to (i) reduce import tariffs worldwide

by an average of 38 percent, (ii) increase the proportion of duty-free products from

20 percent to 44 percent for industrialized countries, and (iii) extend the rules of world

trade to cover agriculture, services such as banking and insurance, and intellectual

property rights. It also created a permanent World Trade Organization (WTO) to

replace GATT. The WTO has more power to enforce the rules of international trade.

China recently joined WTO. China’s WTO membership will further legitimize the idea

of free trade. The latest round of talks, the Doha Round commenced at Doha, Qatar, in

2001, is still continuing. Its objective is to lower trade barriers around the world, pro-

moting free trade between developed and developing countries. However, negotiations

have stalled over a divide between the developed countries led by the United States,

European Union, and Japan and the developing countries led by Brazil, China, and

India. The main disagreements are over opening up agricultural and industrial markets

of various countries and how to reduce rich countries’ agricultural subsidies.

Inspired by Deng Xiaoping’s pragmatic policies, that is, “to get rich is glori-

ous,” China began to implement market-oriented economic reforms in the late

1970s. Since then, the Chinese economy has grown rapidly, often at an astounding

rate of 10 percent per annum, and in the process has lifted tens of millions of local

citizens from poverty. China’s impressive economic growth has been driven by bur-

geoning international trade and foreign direct investment. China’s demand for natu-

ral resources, capital goods, and technologies, in turn, has boosted exports to China

from the rest of the world. India has also joined China in recent years in opening

its economy and attracting foreign investment. India has implemented its own mar-

ket-oriented reforms since the early 1990s, gradually dismantling the “license-raj”

or quota system in all economic spheres and encouraging private entrepreneurship.

As is well known, India has emerged as the most important center for outsourcing

www.wto.org

The World Trade Organization

website covers news and

data about international trade

development.

8Readers are referred to Appendix 1A for a detailed discussion of the theory of comparative advantage.

eun61604_ch01_002-026.indd 14eun61604_ch01_002-026.indd 14 1/3/14 10:13 AM1/3/14 10:13 AM

C H A P T E R 1 GLOBALIZATION AND THE MULTINATIONAL FIRM 15

information technology (IT) services, back-office support, and R&D functions. The

huge supplies of labor, highly skilled and disciplined, in China and India are bound to

alter the structure of the world economy in a major way. China already is the second

largest economy in the world, second only to the United States. India, on the other

hand, is the third largest economy ahead of Japan in terms of purchasing power. The

importance of China and India is likely to grow further, profoundly altering the pattern

of international production, trade, and investment.

On the regional level, formal arrangements among countries have been instituted to

promote economic integration. The European Union (EU) is a prime example. The

European Union is the direct descendent of the European Community (formerly the

European Economic Community), which was established to foster economic integra-

tion among the countries of Western Europe. Today the EU includes 27 member states

that have eliminated barriers to the free flow of goods, capital, and people. The mem-

ber states of the EU hope this move will strengthen its economic position relative to

the United States, China, and Japan. In January 1999, 11 member countries of the EU

successfully adopted a single common currency, the euro, which may potentially rival

the U.S. dollar as a dominant currency for international trade and investment. Greece

joined the euro club in January 2001. Subsequently, five more EU member countries—

Cyprus, Estonia, Malta, Slovenia, and Slovakia—adopted the euro. The launch of the

euro has spurred a rush by European companies into seeking pan-European and global

alliances. Merger and acquisition (M&A) deals in Europe have become comparable to

the figure for U.S. deals in recent years.

Whereas the economic and monetary union planned by the EU is one of the most

advanced forms of economic integration, a free trade area is the most basic. In 1994,

Canada, the United States, and Mexico entered into the North American Free Trade Agreement (NAFTA) . Canada is the United States’ largest trading partner and

Mexico is the third largest. In a free trade area, most impediments to trade, such as

tariffs and import quotas, are eliminated among members. The terms of NAFTA call

for phasing out tariffs over a 15-year period. Many observers believe that NAFTA will

foster increased trade among its members, resulting in an increase in the number of

jobs and the standard of living in all member countries. It is interesting to note from

Exhibit 1.4 that for Mexico, the ratio of export to GDP has increased dramatically

from 2.2 percent in 1973 to 31.7 percent in 2011. This dramatic increase in Mexico’s

propensity to trade should be attributed to NAFTA.

The economic integration and globalization that began in the 1980s picked up speed

in the 1990s via privatization. Through privatization , a country divests itself of the

ownership and operation of a business venture by turning it over to the free market

system. Privatization did not begin with the fall of the Berlin Wall; nevertheless, its

pace has quickly accelerated since the collapse of communism in the Eastern Bloc

countries. It is ironic that the very political and economic system that only a short

while ago extolled the virtues of state ownership should so dramatically be shifting

toward capitalism by shedding state-operated businesses. President Calvin Coolidge

once said that the business of America is business. One might now say that business is

the business of the world.

Privatization can be viewed in many ways. In one sense it is a denationalization

process. When a national government divests itself of a state-run business, it gives

up part of its national identity. Moreover, if the new owners are foreign, the country

may simultaneously be importing a cultural influence that did not previously exist.

Privatization is frequently viewed as a means to an end. One benefit of privatization

for many less-developed countries is that the sale of state-owned businesses brings

to the national treasury hard-currency foreign reserves. The sale proceeds are often

used to pay down sovereign debt that has weighed heavily on the economy. Addi-

tionally, privatization is often seen as a cure for bureaucratic inefficiency and waste;

www.lib.berkeley.edu/ doemoff/govinfo/intl/ gov_eu.html

The University of California at

Berkeley library provides a web

guide to resources related to

the European Union.

Privatization

eun61604_ch01_002-026.indd 15eun61604_ch01_002-026.indd 15 1/3/14 10:13 AM1/3/14 10:13 AM

16 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

some economists estimate that privatization improves efficiency and reduces operating

costs by as much as 20 percent.

There is no one single way to privatize state-owned operations. The objectives of

the country seem to be the prevailing guide. For the Czech Republic, speed was the

overriding factor. To accomplish privatization en masse, the Czech government essen-

tially gave away its businesses to the Czech people. For a nominal fee, vouchers were

sold that allowed Czech citizens to bid on businesses as they went on the auction

block. From 1991 to 1995, more than 1,700 companies were turned over to private

hands. Moreover, three-quarters of the Czech citizens became stockholders in these

newly privatized firms.

In Russia, there has been an “irreversible” shift to private ownership, according

to the World Bank. More than 80 percent of the country’s nonfarm workers are now

employed in the private sector. Eleven million apartment units have been privatized,

as have half of the country’s 240,000 other business firms. Additionally, via a Czech-

style voucher system, 40 million Russians now own stock in over 15,000 medium- to

large-size corporations that recently became privatized through mass auctions of state-

owned enterprises.

In China, privatization has proceeded by way of listing state-owned enterprises

(SOEs) on the organized exchanges, thereby making SOEs eligible for private

ownership. In the early 1980s, China launched two stock exchanges—the Shanghai

Stock Exchange and the Shenzhen Stock Exchange—as a part of concerted efforts

toward market-oriented reform. Since their inception, the Chinese stock markets have

grown at a phenomenal pace, becoming some of the largest stock markets in Asia in

terms of capitalization. Currently, more than 2,000 companies are listed on China’s

stock exchanges. China’s stock markets now play a vital role in privatization of SOEs,

raising new capital for business investments and ventures, and propagating corporate

ownership among citizens. Foreigners may also participate in the ownership of Chinese

firms mainly by investing in the so-called B-shares listed on the Shanghai or Shenzen

stock exchanges or in those shares that are directly listed on the Hong Kong Stock

Exchange (H-shares), New York Stock Exchange, or other international exchanges.

It is noted that A-shares of Chinese firms are mostly reserved for domestic inves-

tors. While individual and institutional investors are now actively investing in Chinese

shares, the Chinese government still retains the majority stakes in most public firms.

For some countries, privatization has meant globalization. For example, to achieve

fiscal stability, New Zealand had to open its once-socialist economy to foreign capi-

tal. Australian investors now control its commercial banks, and U.S. firms purchased

the national telephone company and timber operations. While workers’ rights have

changed under foreign ownership and a capitalist economy, New Zealand now ranks

high among the most competitive market environments. Fiscal stability has also been

realized. In 1994, New Zealand’s economy grew at a rate of 6 percent and inflation

was under control. As can be seen from the experiences of New Zealand, privatization

has spurred a tremendous increase in cross-border investment.

The subprime mortgage crisis in the United States that began in the summer of 2007 led

to a severe credit crunch, making borrowing and refinancing difficult for households,

firms, and banks. The credit crunch, in turn, escalated to a full-blown global financial

crisis in 2008–2009. The defining moment of the crisis came on September 14, 2008,

when Lehman Brothers, a major U.S. investment bank with a global presence, went

bankrupt. The abrupt failure of an iconic U.S. bank touched off a major crisis of confi-

dence in financial markets and institutions around the world. Stock prices fell precipi-

tously. Output fell and unemployment rose sharply. As shown in Exhibit 1.5 , the Dow

Jones Industrial Average (DJIA), a popular U.S. stock market index, fell rapidly from a

peak of 14,164 reached on October 9, 2007, to a trough of 7,062 on February 27, 2009,

a 50 percent decline, while the U.S. unemployment rate began to rise from 4.4 percent

Global Financial Crisis of 2008–2009

eun61604_ch01_002-026.indd 16eun61604_ch01_002-026.indd 16 1/3/14 10:13 AM1/3/14 10:13 AM

C H A P T E R 1 GLOBALIZATION AND THE MULTINATIONAL FIRM 17

in May 2007 to reach 10.1 percent in October 2009. At the same time, international

trade has been shrinking rapidly. The crisis engulfed not only the advanced economies,

such as the United States, Japan, and the European Union, but also many emerging

economies, including Brazil, China, and Russia, albeit less severely. The world was

sliding into the “Great Recession,” the most serious, synchronized economic downturn

since the Great Depression.

Subprime mortgages are a financial instrument designed to facilitate home owner-

ship for low and modest income households. Most subprime mortgages are adjustable-

rate mortgages and are refinanced relatively frequently. Mortgage banks raise funds for

making subprime loans mainly by securitization. Once subprime mortgage loans are

originated, they are pooled and packaged into a variety of mortgage-backed securities

and sold to various institutional investors in the United States and abroad. Subprime

mortgages worked as designed while house prices were rising during 1996–2005. But

as U.S. interest rates began to rise in early 2004 due to the tightening monetary policy

of the Federal Reserve, house prices stopped rising and began to decline in 2006. Sub-

sequently, subprime borrowers started to default, spreading risk among investors and

eroding the bank capital base in the United States and abroad.

What caused the global financial crisis? While it may be early to provide a defini-

tive answer for this important question, it is possible to identify several factors that

are likely to have contributed to the crisis. First, households and financial institutions

borrowed too much and took too much risk. This excessive borrowing and risk taking

is, in turn, attributable to the ample supply of liquidity and credit that is due to (i) the

“easy money” policy of the Federal Reserve Bank, a legacy of its former chairman,

Allan Greenspan, and also (ii) the massive inflow of foreign money associated with the

recycling of trade surpluses of Asian countries, including China, Japan, and Korea, and

the oil-exporting countries in the Middle East. Second, the crisis was amplified many-

fold and transmitted globally by securitization. Securitization allows loan origina-

tors to avoid bearing the default risk, which leads to a compromised lending standard

and increased moral hazard. Also, financial engineers designed opaque and complex

mortgage-based securities that could be used for excessive risk-taking. These securi-

ties were traded infrequently and were often difficult to value. Third, the “invisible

hands” of free markets apparently failed to self-regulate its excesses, contributing to

the banking crisis. At the same time, “light touch” regulations by government agen-

cies, such as the Securities and Exchange Commission (SEC) and the Federal Reserve,

Source: Bloomberg.

15000

14000

13000

12000

11000

D JI

A I

nd ex

10000

9000

8000

7000

6000

20 00

.0 2

20 00

.1 1

20 01

.0 8

20 02

.0 5

20 03

.0 2

20 03

.1 1

20 04

.0 8

20 05

.0 5

20 06

.0 2

20 06

.1 1

20 07

.0 8

20 08

.0 5

20 09

.0 2

20 09

.1 1

U .S

. u ne

m pl

oy m

en t

ra te

( %

)

DJIA

Great Recession

U.S. unemployment rate

EXHIBIT 1.5

U.S. Unemployment Rate

and Dow Jones Industrial

Average (DJIA)

eun61604_ch01_002-026.indd 17eun61604_ch01_002-026.indd 17 1/3/14 3:49 PM1/3/14 3:49 PM

18 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

led to a failure to detect the rising risk in the financial system and to take regulatory

actions in a timely fashion to prevent the crisis. This laissez-faire regulatory stance

reflects the broad deregulation of the U.S. economy that has taken place since the

1980s. The repeal of the Glass-Steagall Act in 1999 is the prima facie example of

the deregulatory trend in the United States. The Act, which was adopted in the wake

of the Great Depression, built a firewall between commercial and investment bank-

ing activities. Its repeal may have encouraged banks to take risks excessively. Fourth,

international financial markets are highly interconnected and integrated nowadays.

Defaults of subprime mortgages in the United States came to threaten the solvency of

the teachers’ retirement program in Norway as the latter invested in U.S. mortgage-

backed securities. The U.S. government was compelled to rescue AIG, a U.S. insur-

ance company, with a $180 billion package, the most costly bailout of a single firm

in history, as it feared that if AIG were allowed to fail, it might start a chain reaction

of bankruptcies of AIG’s international counterparties that included Goldman Sachs,

Deutsche Bank, Barclays, Union Bank of Switzerland (UBS), Société Générale, and

Merrill Lynch. So AIG was found to be not only too big, but also too interconnected to

fail. In the contemporary world economy, a local financial shock originating in a mar-

ket can quickly be transmitted to other markets through contagion and other channels.

No market or institution is an island in an integrated world.

Facing the severe credit crunch and economic downturn, the U.S. government took

forceful actions to save the banking system and stimulate the economy. As a matter

of fact, the government acted as the lender of last resort as well as the spender of last

resort to keep the economy floating. Specifically, the Bush administration- implemented

Troubled Asset Relief Program (TARP), which was enacted in October 2008. Seven

hundred billion dollars of the TARP fund were injected into the financial system to buy

nonperforming assets and mortgage-related securities from banks and also to directly

strengthen banks’ capital reserves. The Obama administration, in turn, implemented

an $850 billion economic stimulus program to boost economic activities and create

jobs. Many governments around the world, notably the U.K., France, Germany, China,

and Korea, implemented similar stimulating measures. In addition, to prevent future

financial crises and costly bailouts, the U.S. government adopted much tighter rules of

finance in July 2010. Among other things, the new rules prohibit banks from making

risky investments with their own money, which may endanger the core capital of banks.

In addition, a new independent Consumer Financial Protection Bureau was set up to

protect consumers from predatory lending. Also, a new Financial Stability Oversight

Council of regulators chaired by the Treasury secretary would be responsible for care-

fully monitoring the systemic risk affecting the entire financial market.

Lastly, it is noteworthy that during the course of the global financial crisis of 2008–

2009, the G-20, composed of both leading developed countries, such as Germany, Japan,

and the United States, and major developing countries, such as Brazil, China, India,

Korea, and South Africa, has emerged as the premier forum for discussing international

economic issues and coordinating financial regulations and macroeconomic policies. We

will revisit and discuss these and other related issues in greater detail in Chapter 11 .

Multinational Corporations In addition to international trade, foreign direct investment by MNCs is a major force

driving globalization of the world economy. According to a UN report, there are about

60,000 MNCs in the world with over 500,000 foreign affiliates. 9 Since the 1990s,

foreign direct investment by MNCs grew at the annual rate of about 10 percent. In

comparison, international trade grew at the rate of 3.5 percent during the same period.

9The source for this information is the United Nations’ World Investment Report, various issues.

eun61604_ch01_002-026.indd 18eun61604_ch01_002-026.indd 18 1/3/14 10:13 AM1/3/14 10:13 AM

As indicated in the International Finance in Practice box, “Multinationals More Effi-

cient,” MNCs are reshaping the structure of the world economy.

A multinational corporation (MNC) is a business firm incorporated in one coun-

try that has production and sales operations in many other countries. The term sug-

gests a firm obtaining raw materials from one national market and financial capital

from another, producing goods with labor and capital equipment in a third country,

and selling the finished product in yet other national markets. Indeed, some MNCs

have operations in dozens of different countries. MNCs obtain financing from major

money centers around the world in many different currencies to finance their opera-

tions. Global operations force the treasurer’s office to establish international banking

relationships, place short-term funds in several currency denominations, and effec-

tively manage foreign exchange risk.

Exhibit 1.6 lists the top 40 of the largest 100 MNCs ranked by the size of for-

eign assets. The list was compiled by the United Nations Conference on Trade and

Development (UNCTAD). Many of the firms on the list are well-known MNCs

www.unctad.org/wir

This UNCTAD website provides

a broad coverage of cross-

border investment activities by

multinational corporations.

Foreign-owned manufacturing companies in the world’s most highly developed countries are generally more pro- ductive and pay their workers more than comparable locally owned businesses, according to the Organisation for Economic Co-operation and Development.

The Paris-based organization also says that the pro- portion of manufacturing under foreign ownership in European Union countries rose substantially during the 1990s, a sign of increasing economic integration.

In a report on the global role of multinationals, the OECD points out that for some countries, the level of production abroad by foreign subsidiaries of national businesses was comparable to total exports from these countries.

The finding underlines the increasing importance in the world economy of large companies with bases scat- tered across the globe.

Gross output per employee, a measure of productiv- ity, in most OECD nations tends to be greater in multina- tionals than in locally owned companies, the report says.

This is partly a factor of the multinationals being bigger and more geared to operating according to world- class levels of efficiency. But it also reflects their ability to transfer new thinking in production technologies through an international factory network.

Reflecting the greater efficiencies, workers in foreign- owned plants tend to earn more money than those in locally owned ones.

In Turkey, employees of multinationals earn double the wages of their counterparts. The equivalent figure in the UK is 23 percent and in the US it is 9 percent.

In the EU in 1998, a quarter of total manufactur- ing production was controlled by a foreign subsidiary of a bigger company compared to 17 percent in 1990. The figure has probably increased since then, and is

expected to climb further as the impact of the euro tight- ens the link between member countries’ economies.

Measuring Globalisation: The Role of Multinationals in OECD Economies. For details see www.oecd.org

Source: Peter Marsh, Financial Times, March 20, 2002, p. 6. Reprinted with permission.

Multinationals More Efficient INTERNATIONAL FINANCE IN PRACTICE

Source: OECD, Activities of Foreign Affiliates database.

Ir el

an d

H u n g ar

L u x em

b o u rg

C an

ad a

P o la

n d *

N et

h er

la n d s

F ra

n ce

U K

* *

C ze

ch R

ep *

N o rw

S w

ed en U S

F in

la n d *

It al

y * *

T u rk

G er

m an

Ja p an

*1999 **1997

Foreign companies’ share in manufacturing production 1998 or latest year (%)

eun61604_ch01_002-026.indd 19eun61604_ch01_002-026.indd 19 1/3/14 10:13 AM1/3/14 10:13 AM

20 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

EXHIBIT 1.6

The World’s Top 40 Nonfinancial MNCs Ranked by Foreign

Assets, 2011

Ranking by Assets Sales Employment Foreign (in $ Billions) (in $ Billions) (in Thousands) assets Corporation Country Industry Foreign Total Foreign Total Foreign Total

1 General Electric Co United States Electrical & electronic 502.61 717.24 77.48 147.30 170.00 301.00 equipment 2 Royal Dutch Netherlands/U.K. Petroleum 296.45 345.26 282.67 470.17 75.00 90.00 Shell plc 3 BP plc United Kingdom Petroleum 263.58 293.07 308.44 386.46 68.01 83.43 4 Exxon Mobil United States Petroleum 214.23 331.05 316.69 433.53 49.50 82.10 Corporation 5 Toyota Motor Japan Motor vehicles 214.12 372.57 142.89 235.20 123.66 325.91 Corporation 6 Total SA France Petroleum 211.31 228.04 197.48 256.73 61.07 96.10 7 GDF Suez France Electricity, gas 194.42 296.65 82.73 126.04 110.55 218.87 and water 8 Vodafone Group Plc United Kingdom Telecommunications 171.94 186.18 65.45 74.09 75.48 83.86 9 Enel SpA Italy Electricity, gas 153.67 236.04 66.82 110.53 36.66 75.36 and water 10 Telefonica SA Spain Telecommunications 147.90 180.19 63.01 87.35 231.07 286.15 11 Chevron United States Petroleum 139.82 209.47 139.34 236.29 31.00 61.00 Corporation 12 E.ON AG Germany Electricity, gas 133.01 212.50 90.96 157.01 43.76 78.89 and water 13 Eni SpA Italy Petroleum 122.08 198.70 106.24 153.63 45.52 78.69 14 ArcelorMittal Luxembourg Metal and metal 117.02 121.88 93.68 93.97 197.15 260.52 products 15 Nestlé SA Switzerland Food, beverages 116.13 121.26 92.17 94.19 318.30 328.00 and tobacco 16 Volkswagen Group Germany Motor vehicles 115.08 221.49 173.39 221.49 277.11 501.96 17 Siemens AG Germany Electrical & electronic 112.36 141.75 87.42 102.49 244.00 360.00 equipment 18 Anheuser-Busch Belgium Food, beverages 106.34 112.43 34.94 39.05 108.45 116.28 InBev NV and tobacco 19 Honda Motor Japan Motor vehicles 105.15 143.20 78.13 100.59 109.40 179.06 Co Ltd 20 Deutsche Germany Telecommunications 102.05 170.34 44.89 81.53 113.57 235.13 Telekom AG 21 Pfizer Inc United States Pharmaceuticals 100.39 188.00 40.49 67.43 64.42 103.70 22 Mitsubishi Japan Wholesale trade 98.17 153.01 47.16 254.72 17.62 58.72 Corporation 23 EDF SA France Electricity, gas 95.00 322.08 35.49 90.78 28.90 156.17 and water 24 Daimler AG Germany Motor vehicles 94.16 205.91 120.64 148.10 103.69 271.37 25 Iberdrola SA Spain Electricity, gas 88.05 134.70 23.21 44.90 19.44 31.89 and water 26 Sanofi France Pharmaceuticals 85.77 139.23 42.09 46.41 55.38 113.72 27 Fiat S.p.A. Italy Motor vehicles 85.24 111.25 69.92 82.79 134.44 197.02 28 ConocoPhillips United States Petroleum 82.68 153.23 85.68 230.86 8.53 29.80 29 BMW AG Germany Motor vehicles 79.35 171.57 77.79 95.66 73.32 100.31 30 EADS N.V. France Aircraft 77.79 122.99 61.67 68.29 84.72 133.12 31 Hutchison Hong Kong, China Diversified 77.29 92.79 23.48 30.02 206.99 250.00 Whampoa Limited 32 General Motors Co United States Motor vehicles 77.09 144.60 69.05 150.28 106.00 207.00 33 Ford Motor United States Motor vehicles 77.00 179.25 65.10 136.26 85.00 164.00 Company 34 Wal-Mart Stores Inc United States Retail & Trade 74.66 180.66 109.23 421.85 800.00 2100.00 35 Sony Corporation Japan Electrical & 73.84 161.61 55.54 82.18 109.20 168.20 electronic equipment 36 France Telecom S.A. France Telecommunications 73.08 133.56 23.82 62.94 66.70 171.95 37 Nissan Motor Japan Motor vehicles 71.91 134.58 90.88 119.08 82.22 155.10 Co Ltd 38 Xstrata PLC Switzerland Mining & quarrying 71.77 74.83 30.43 33.88 38.25 40.39 39 Procter & United States Diversified 68.08 138.35 48.71 82.56 94.62 129.00 Gamble Co 40 Anglo American plc United Kingdom Mining & quarrying 68.04 72.44 28.64 30.58 94.00 100.00

Source: World Investment Report 2012, UNCTAD.

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C H A P T E R 1 GLOBALIZATION AND THE MULTINATIONAL FIRM 21

with household names because of their presence in consumer product markets. For

example, General Electric (GE), General Motors, British Petroleum (BP), Toyota,

BMW, Sony, Wal-Mart Stores, Procter & Gamble, Nestlé, Pfizer, and Siemens are

names recognized by most people. By country of origin, U.S. MNCs, with 22 out

of the total of 100, constitute the largest group. France has 16 MNCs and the U.K.

13 in the top 100, followed by Germany with 12, Japan with 6 and Switzerland

with 5. It is interesting to note that some Swiss firms are extremely multinational.

Nestlé, for instance, derives about 98 percent of its sales from overseas markets,

and employs about 318,000 workers, 97 percent of its total employment, outside

Switzerland. Obviously, MNCs make a significant contribution to the creation of

job opportunities around the world.

MNCs may gain from their global presence in a variety of ways. First of all, MNCs

can benefit from the economy of scale by (i) spreading R&D expenditures and adver-

tising costs over their global sales, (ii) pooling global purchasing power over suppliers,

(iii) utilizing their technological and managerial know-how globally with minimum

additional costs, and so forth. Furthermore, MNCs can use their global presence to

take advantage of underpriced labor services available in certain developing countries,

and gain access to special R&D capabilities residing in advanced foreign countries.

MNCs can indeed leverage their global presence to boost their profit margins and cre-

ate shareholder value.

In recent years, companies are increasingly using offshore outsourcing as a way

of saving costs and boosting productivity. For example, when Microsoft entered the

video game market, it decided to outsource production of the Xbox gaming console

to Flextronics, a Singapore-based contract manufacturer. Flextronics, in turn, decided

to manufacture all Xbox consoles in China. This outsourcing decision allows Micro-

soft, a company mainly known for its strength in software, to benefit from the manu-

facturing and logistics capabilities of Flextronics and low labor costs in China. Like

Microsoft, many companies around the world are using outsourcing to enhance their

competitive positions in the marketplace.

SUMMARY This chapter provided an introduction to International Financial Management.

1. It is essential to study “international” financial management because we are now

living in a highly globalized and integrated world economy. Owing to the (a) con-

tinuous liberalization of international trade and investment, and (b) rapid advances

in telecommunications and transportation technologies, the world economy will

become even more integrated.

2. Three major dimensions distinguish international finance from domestic finance.

They are (a) foreign exchange and political risks, (b) market imperfections, and

3. Financial managers of MNCs should learn how to manage foreign exchange and

political risks using proper tools and instruments, deal with (and take advan-

tage of) market imperfections, and benefit from the expanded investment and

financing opportunities. By doing so, financial managers can contribute to share-

holder wealth maximization, which is the ultimate goal of international financial

management.

4. The theory of comparative advantage states that economic well-being is

enhanced if countries produce those goods for which they have comparative

advantages and then trade those goods. The theory of comparative advantage

provides a powerful rationale for free trade. Currently, international trade is

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22 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT w

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QUESTIONS

KEY WORDS corporate governance, 9

European Central

Bank, 11

European Union

(EU), 15

expanded opportunity

set, 7

foreign exchange risk, 5

General Agreement

on Tariffs and Trade

(GATT), 14

globalized and integrated

world economy, 4

market imperfections, 6

multinational corporation

(MNC), 19

North American Free

Trade Agreement

(NAF TA), 15

outsource, 21

political risk, 5

privatization, 15

shareholder wealth

maximization, 8

systemic risk, 18

theory of comparative

advantage, 14

transactions domain, 11

World Trade

Organization

(WTO), 14

1. Why is it important to study international financial management?

2. How is international financial management different from domestic financial

management?

3. Discuss the major trends that have prevailed in international business during the

last two decades.

4. How is a country’s economic well-being enhanced through free international trade

in goods and services?

becoming liberalized at both the global and the regional levels. At the global

level, WTO plays a key role in promoting free trade. At the regional level, the

European Union and NAFTA play a vital role in dismantling trade barriers

within regions.

5. The subprime mortgage crisis in the United States that began in the summer of

2007 led to a severe credit crunch. The credit crunch, in turn, escalated to a major

global financial crisis in 2008–2009. The global financial crisis may be attribut-

able to several factors, including (i) excessive borrowing and risk taking by both

households and banks, (ii) failure of government regulators to detect the rising

risk in the financial system and take timely preventive actions, and (iii) the inter-

connected and integrated nature of financial markets. In addition, the world econ-

omy was buffeted by Europe’s sovereign-debt crisis. The crisis started in Greece

in December 2009 when it was disclosed that the country’s budget deficit would

be far worse than previously forecasted. The panic spread among weak European

economies. The interest rates in these countries rose sharply and, at the same time,

the euro depreciated sharply in currency markets, hurting its credibility as a major

global currency.

6. A major economic trend of the recent decades is the rapid pace with which former

state-owned businesses are being privatized. With the fall of communism, many

Eastern Bloc countries began stripping themselves of inefficient business operations

formerly run by the state. Privatization has placed a new demand on international

capital markets to finance the purchase of the former state enterprises, and it has also

brought about a demand for new managers with international business skills.

7. In modern times, it is not a country per se but rather a controller of capital

and know-how that gives the country in which it is domiciled a comparative

advantage over another country. These controllers of capital and technology are

multinational corporations (MNCs). Today, it is not uncommon for an MNC to

produce merchandise in one country, on capital equipment financed by funds

raised in a number of different currencies, through issuing securities to investors

in many countries and then selling the finished product to customers all over

the world.

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C H A P T E R 1 GLOBALIZATION AND THE MULTINATIONAL FIRM 23

5. What considerations might limit the extent to which the theory of comparative

advantage is realistic?

6. What are multinational corporations (MNCs) and what economic roles do they

play?

7. Ross Perot, a former presidential candidate of the Reform Party, which was a third

political party in the United States, had strongly objected to the creation of the

North American Free Trade Agreement (NAFTA), which nonetheless was inaugu-

rated in 1994. Perot feared the loss of American jobs to Mexico, where it is much

cheaper to hire workers. What are the merits and demerits of Perot’s position on

NAFTA? Considering the recent economic developments in North America, how

would you assess Perot’s position on NAFTA?

8. In 1995, a working group of French chief executive officers was set up by the

Confederation of French Industry (CNPF) and the French Association of Private

Companies (AFEP) to study the French corporate governance structure. The group

reported the following, among other things: “The board of directors should not

simply aim at maximizing share values as in the U.K. and the U.S. Rather, its goal

should be to serve the company, whose interests should be clearly distinguished

from those of its shareholders, employees, creditors, suppliers and clients but still

equated with their general common interest, which is to safeguard the prosperity

and continuity of the company.” Evaluate the above recommendation of the work-

ing group. 10

9. Emphasizing the importance of voluntary compliance, as opposed to enforce-

ment, in the aftermath of such corporate scandals as those involving Enron and

WorldCom, U.S. President George W. Bush stated that while tougher laws might

help, “ultimately, the ethics of American business depends on the conscience of

America’s business leaders.” Describe your view on this statement.

10. Suppose you are interested in investing in shares of Samsung Electronics of Korea,

which is a world leader in mobile phones, TVs, and home appliances. But before

you make an investment decision, you would like to learn about the company. Visit

the website of Yahoo ( http://finance.yahoo.com ) and collect information about

Samsung Electronics, including the recent stock price history and analysts’ views

of the company. Discuss what you learn about the company. Also discuss how the

instantaneous access to information via Internet would affect the nature and work-

ings of financial markets.

1. Visit the corporate websites of Nestlé, one of the most multinational companies

in the world, and study the scope of geographical diversification of its sales and

revenues. Also, gather and evaluate the company’s financial information from the

related websites. You may use such Internet search engines as Google and Yahoo.

MINI CASE Nike and Sweatshop Labor

Nike, a company headquartered in Beaverton, Oregon, is a major force in the sports footwear and fashion industry, with annual sales exceeding $12 billion, more than half of which now come from outside the United States. The company was co-founded in 1964 by Phil Knight, a CPA at Price Waterhouse, and Bill Bowerman, college track

INTERNET EXERCISES

WWW

10This question draws on the article by François Degeorge, "French Boardrooms Wake Up Slowly to the Need

for Reform," in the Complete MBA Companion in Global Business, Financial Times, 1999, pp. 156–60. w w

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coach, each investing $500 to start. The company, initially called Blue Ribbon Sports, changed its name to Nike in 1971 and adopted the “Swoosh” logo—recognizable around the world—originally designed by a college student for $35. Nike became highly successful in designing and marketing mass-appealing products such as the Air Jordan, the best-selling athletic shoe of all time.

Nike has no production facilities in the United States. Rather, the company manu- factures athletic shoes and garments in such Asian countries as China, Indonesia, and Vietnam using subcontractors, and sells the products in the U.S. and interna- tional markets. In each of those Asian countries where Nike has production facili- ties, the rates of unemployment and under-employment are relatively high. The wage rate is very low in those countries by U.S. standards—the hourly wage rate in the manufacturing sector is less than $2 in those countries, compared with about $35 in the United States. In addition, workers in those countries often operate in poor and unhealthy environments and their rights are not particularly well protected. Understandably, host countries are eager to attract foreign investments like Nike’s to develop their economies and raise the living standards of their citizens. Recently, how- ever, Nike came under worldwide criticism for its practice of hiring workers for such a low rate of pay—“next to nothing” in the words of critics—and overlooking poor work- ing conditions in host countries.

Initially, Nike denied the sweatshop charges and lashed out at critics. But later, the company began monitoring the labor practices at its overseas factories and grading the factories in order to improve labor standards. Nike also agreed to random factory inspections by disinterested parties.

Discussion points

1. Do you think the criticism of Nike is fair, considering that the host countries are in dire needs of creating jobs?

2. What do you think Nike’s executives might have done differently to prevent the sensitive charges of sweatshop labor in overseas factories?

3. Do firms need to consider the so-called corporate social responsibilities in making investment decisions?

Basic Finance References

Bodie, Zvi, Alex Kane, and Alan J. Marcus. Investments , 9th ed. New York: Irwin/McGraw-Hill,

2010.

Ross, Stephen A., Randolph W. Westerfield, and Jeffrey F. Jaffee. Corporate Finance , 9th ed. New

York: Irwin/McGraw-Hill, 2011.

International Accounting References Choi, Frederick D.S. International Accounting , 5th ed. Pearson Education, 2007.

Meuller, Gerhard G., Helen Gernon, and Gary Meek. Accounting: An International Perspective ,

5th ed. Burr Ridge, Ill.: Richard D. Irwin, 2000.

International Economics References Baker, Stephen A. An Introduction to International Economics. San Diego: Harcourt Brace

Jovanovich, 1990.

Husted, Steven, and Michael Melvin. International Economics, 9th ed. Pearson, 2012.

Krugman, Paul R., and Maurice Obstfeld. International Economics: Theory and Policy , 8th ed.

Reading, Mass.: Addison-Wesley, 2008.

Rivera-Batiz, Francisco L., and Luis Rivera-Batiz. International Finance and Open Economy Mac- roeconomics , 2nd ed. Upper Saddle River, N.J.: Prentice Hall, 1994.

REFERENCES & SUGGESTED READINGS

24 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

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Appendix

Gain from Trade: The Theory of Comparative Advantage

The theory of comparative advantage was originally advanced by the 19th-century

economist David Ricardo as an explanation for why nations trade with one another.

The theory claims that economic well-being is enhanced if each country’s citizens

produce that which they have a comparative advantage in producing relative to the citi-

zens of other countries, and then trade products. Underlying the theory are the assump-

tions of free trade between nations and that the factors of production (land, labor,

technology, and capital) are relatively immobile. Consider the example described in

Exhibit A.1 as a vehicle for explaining the theory.

Exhibit A.1 assumes two countries, A and B, which each produce only food and

textiles, but they do not trade with one another. Country A and B each have 60,000,000

units of input. Each country presently allocates 40,000,000 units to the production of

food and 20,000,000 units to the production of textiles. Examination of the exhibit

shows that Country A can produce five pounds of food with one unit of production

or three yards of textiles. Country B has an absolute advantage over Country A in the

production of both food and textiles. Country B can produce 15 pounds of food or

four yards of textiles with one unit of production. When all units of production are

employed, Country A can produce 200,000,000 pounds of food and 60,000,000 yards

of textiles. Country B can produce 600,000,000 pounds of food and 80,000,000 yards

of textiles. Total output is 800,000,000 pounds of food and 140,000,000 yards of tex-

tiles. Without trade, each nation's citizens can consume only what they produce.

While it is clear from the examination of Exhibit A.1 that Country B has an absolute

advantage in the production of food and textiles, it is not so clear that Country A (B)

has a relative advantage over Country B (A) in producing textiles (food). Note that in

using units of production, Country A can “trade off ” one unit of production needed to

produce five pounds of food for three yards of textiles. Thus, a yard of textiles has an

opportunity cost of 5/3 = 1.67 pounds of food, or a pound of food has an opportunity

cost of 3/5 = .60 yards of textiles. Analogously, Country B has an opportunity cost

of 15/4 = 3.75 pounds of food per yard of textiles, or 4/15 = .27 yards of textiles per

pound of food. When viewed in terms of opportunity costs it is clear that Country A

EXHIBIT A.1

Input/Output

without Trade

Country

A B Total

I. Units of input (000,000) Food 40 40 Textiles 20 20 II. Output per unit of input (lbs. or yards) Food 5 15 Textiles 3 4 III. Total output (lbs. or yards) (000,000) Food 200 600 800 Textiles 60 80 140 IV. Consumption (lbs. or yards) (000,000) Food 200 600 800 Textiles 60 80 140

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26 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

is relatively more efficient in producing textiles and Country B is relatively more effi-

cient in producing food. That is, Country A’s (B’s) opportunity cost for producing

textiles (food) is less than Country B’s (A’s). A relative efficiency that shows up via a

lower opportunity cost is referred to as a comparative advantage.

Exhibit A.2 shows that when there are no restrictions or impediments to free

trade, such as import quotas, import tariffs, or costly transportation, the economic

well-being of the citizens of both countries is enhanced through trade. Exhibit A.2

shows that Country A has shifted 20,000,000 units from the production of food to

the production of textiles where it has a comparative advantage and that Country B

has shifted 10,000,000 units from the production of textiles to the production of food

where it has a comparative advantage. Total output is now 850,000,000 pounds of

food and 160,000,000 yards of textiles. Suppose that Country A and Country B agree

on a price of 2.50 pounds of food for one yard of textiles, and that Country A sells

Country B 50,000,000 yards of textiles for 125,000,000 pounds of food. With free

trade, Exhibit A.2 makes it clear that the citizens of each country have increased their

consumption of food by 25,000,000 pounds and textiles by 10,000,000 yards.

PROBLEMS 1. Country C can produce seven pounds of food or four yards of textiles per unit

of input. Compute the opportunity cost of producing food instead of textiles.

Similarly, compute the opportunity cost of producing textiles instead of food.

2. Consider the no-trade input/output situation presented in the following table for

countries X and Y. Assuming that free trade is allowed, develop a scenario that will

benefit the citizens of both countries.

EXHIBIT A.2

Input/Output with

Free Trade

Input/Output

without Trade

Country

A B Total

I. Units of input (000,000) Food 20 50 Textiles 40 10 II. Output per unit of input (lbs. or yards) Food 5 15 Textiles 3 4 III. Total output (lbs. or yards) (000,000) Food 100 750 850 Textiles 120 40 160 IV. Consumption (lbs. or yards) (000,000) Food 225 625 850 Textiles 70 90 160

Country

X Y Total

I. Units of input (000,000) Food 70 60

Textiles 40 30 II. Output per unit of input (lbs. or yards) Food 17 5 Textiles 5 2 III. Total output (lbs. or yards) (000,000) Food 1,190 300 1,490 Textiles 200 60 260 IV. Consumption (lbs. or yards) (000,000) Food 1,190 300 1,490 Textiles 200 60 260

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C H

A P

T E

R O

U T

L IN

THIS CHAPTER EXAMINES the international monetary system , which defines the overall financial environment in

which multinational corporations and international investors

operate. As mentioned in Chapter 1 , the exchange rates among

major currencies, such as the U.S. dollar, British pound, Swiss

franc, and Japanese yen, have been fluctuating since the fixed

exchange rate regime was abandoned in 1973. Consequently,

corporations nowadays are operating in an environment in which

exchange rate changes may adversely affect their competitive

positions in the marketplace. This situation, in turn, makes it

necessary for many firms to carefully measure and manage their

exchange risk exposure. Similarly, international investors face

the problem of fluctuating exchange rates affecting their portfo-

lio returns. As we will discuss shortly, however, many European

countries have adopted a common currency called the euro ,

rendering intra-European trade and investment much less sus-

ceptible to exchange risk. The complex international monetary

arrangements imply that for adroit financial decision making, it

is essential for managers to understand, in detail, the arrange-

ments and workings of the international monetary system.

The international monetary system can be defined as the

institutional framework within which international pay- ments are made, movements of capital are accommodated,

and exchange rates among currencies are determined . It is a

complex whole of agreements, rules, institutions, mechanisms,

and policies regarding exchange rates, international payments,

and the flow of capital. The international monetary system has

evolved over time and will continue to do so in the future as the

fundamental business and political conditions underlying the

world economy continue to shift. In this chapter, we will review

the history of the international monetary system and contem-

plate its future prospects. In addition, we will compare and con-

trast the alternative exchange rate systems, that is, fixed versus

flexible exchange rates. For astute financial management, it is important to understand

the dynamic nature of international monetary environments.

Evolution of the International Monetary System The international monetary system went through several distinct stages of evolution.

These stages are summarized as follows:

1. Bimetallism: Before 1875.

2. Classical gold standard: 1875–1914.

3. Interwar period: 1915–1944.

CHAPTER

International Monetary System

Evolution of the International Monetary System Bimetallism: Before 1875 Classical Gold Standard: 1875–1914 Interwar Period: 1915–1944 Bretton Woods System: 1945–1972 The Flexible Exchange Rate Regime: 1973–Present The Current Exchange Rate Arrangements European Monetary System The Euro and the European Monetary Union

A Brief History of the Euro

What Are the Benefits of Monetary Union?

Costs of Monetary Union

Prospects of the Euro: Some Critical Questions

The Mexican Peso Crisis The Asian Currency Crisis

Origins of the Asian Currency Crisis

Lessons from the Asian Currency Crisis

The Argentine Peso Crisis Fixed versus Flexible Exchange Rate Regimes Summary Key Words Questions Internet Exercises MINI CASE: Will the United Kingdom Join the

Euro Club?

References and Suggested Readings

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28 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

4. Bretton Woods system: 1945–1972.

5. Flexible exchange rate regime: Since 1973.

We now examine each of the five stages in some detail.

Bimetallism: Before 1875 Prior to the 1870s, many countries had bimetallism , that is, a double standard in that

free coinage was maintained for both gold and silver. In Great Britain, for example,

bimetallism was maintained until 1816 (after the conclusion of the Napoleonic Wars)

when Parliament passed a law maintaining free coinage of gold only, abolishing the

free coinage of silver. In the United States, bimetallism was adopted by the Coinage

Act of 1792 and remained a legal standard until 1873, when Congress dropped the sil-

ver dollar from the list of coins to be minted. France, on the other hand, introduced and

maintained its bimetallism from the French Revolution to 1878. Some other countries

such as China, India, Germany, and Holland were on the silver standard.

The international monetary system before the 1870s can be characterized as

“bimetallism” in the sense that both gold and silver were used as international means

of payment and that the exchange rates among currencies were determined by either

their gold or silver contents. 1 Around 1870, for example, the exchange rate between the

British pound, which was fully on a gold standard, and the French franc, which was offi-

cially on a bimetallic standard, was determined by the gold content of the two currencies.

On the other hand, the exchange rate between the franc and the German mark, which

was on a silver standard, was determined by the silver content of the currencies. The

exchange rate between the pound and the mark was determined by their exchange rates

against the franc. It is also worth noting that, due to various wars and political upheavals,

some major countries such as the United States, Russia, and Austria-Hungary had irre-

deemable currencies at one time or another during the period 1848–1879. One might say

that the international monetary system was less than fully systematic up until the 1870s.

Countries that were on the bimetallic standard often experienced the well-known

phenomenon referred to as Gresham’s law . Since the exchange ratio between the

two metals was fixed officially, only the abundant metal was used as money, driv-

ing more scarce metal out of circulation. This is Gresham’s law, according to which

“bad” (abundant) money drives out “good” (scarce) money. For example, when gold

from newly discovered mines in California and Australia poured into the market in the

1850s, the value of gold became depressed, causing overvaluation of gold under the

French official ratio, which equated a gold franc to a silver franc 15½ times as heavy.

As a result, the franc effectively became a gold currency.

Classical Gold Standard: 1875–1914 Mankind’s fondness for gold as a storage of wealth and means of exchange dates back

to antiquity and was shared widely by diverse civilizations. Christopher Columbus

once said, “Gold constitutes treasure, and he who possesses it has all he needs in this

world.” The first full-fledged gold standard , however, was not established until 1821

in Great Britain, when notes from the Bank of England were made fully redeemable

for gold. As previously mentioned, France was effectively on the gold standard begin-

ning in the 1850s and formally adopted the standard in 1878. The newly emergent

German empire, which was to receive a sizable war indemnity from France, converted

to the gold standard in 1875, discontinuing free coinage of silver. The United States

adopted the gold standard in 1879, Russia and Japan in 1897.

1 This does not imply that each individual country was on a bimetallic standard. In fact, many countries were on

either a gold standard or a silver standard until the 1870s.

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C H A P T E R 2 INTERNATIONAL MONETARY SYSTEM 29

One can say roughly that the international gold standard existed as a historical

reality during the period 1875–1914. The majority of countries got off gold in 1914

when World War I broke out. The classical gold standard as an international monetary

system thus lasted for about 40 years. During this period, London became the center

of the international financial system, reflecting Britain’s advanced economy and its

preeminent position in international trade.

An international gold standard can be said to exist when, in most major countries,

(i) gold alone is assured of unrestricted coinage, (ii) there is two-way convertibility

between gold and national currencies at a stable ratio, and (iii) gold may be freely

exported or imported. In order to support unrestricted convertibility into gold, bank-

notes need to be backed by a gold reserve of a minimum stated ratio. In addition, the

domestic money stock should rise and fall as gold flows in and out of the country. The

above conditions were roughly met between 1875 and 1914.

Under the gold standard, the exchange rate between any two currencies will be

determined by their gold content. For example, suppose that the pound is pegged to

gold at six pounds per ounce, whereas one ounce of gold is worth 12 francs. The

exchange rate between the pound and the franc should then be two francs per pound.

To the extent that the pound and the franc remain pegged to gold at given prices, the

exchange rate between the two currencies will remain stable. There were indeed no

significant changes in exchange rates among the currencies of such major countries

as Great Britain, France, Germany, and the United States during the entire period. For

example, the dollar–sterling exchange rate remained within a narrow range of $4.84

and $4.90 per pound. Highly stable exchange rates under the classical gold standard

provided an environment that was conducive to international trade and investment.

Under the gold standard, misalignment of the exchange rate will be automatically

corrected by cross-border flows of gold. In the above example, suppose that one

pound is trading for 1.80 francs at the moment. Since the pound is undervalued in

the exchange market, people will buy pounds with francs, but not francs with pounds.

For people who need francs, it would be cheaper first to buy gold from the Bank of

England and ship it to France and sell it for francs. For example, suppose that you

need to buy 1,000 francs using pounds. If you buy 1,000 francs in the exchange mar-

ket, it will cost you £555.56 at the exchange rate of Fr1.80/£. Alternatively, you can

buy 83.33 5 1,000/12 ounces of gold from the Bank of England for £500:

£500 5 (1,000/12) 3 6

Then you could ship it to France and sell it to the Bank of France for 1,000 francs.

This way, you can save about £55.56. 2 Since people only want to buy, not sell, pounds

at the exchange rate of Fr1.80/£, the pound will eventually appreciate to its fair value,

namely, Fr2.0/£.

Under the gold standard, international imbalances of payment will also be corrected

automatically. Consider a situation where Great Britain exported more to France than

the former imported from the latter. This kind of trade imbalance will not persist under

the gold standard. Net export from Great Britain to France will be accompanied by a

net flow of gold in the opposite direction. This international flow of gold from France

to Great Britain will lead to a lower price level in France and, at the same time, a

higher price level in Great Britain. (Recall that under the gold standard, the domestic

money stock is supposed to rise or fall as the country experiences an inflow or outflow

of gold.) The resultant change in the relative price level, in turn, will slow exports from

Great Britain and encourage exports from France. As a result, the initial net export

from Great Britain will eventually disappear. This adjustment mechanism is referred

2 In this example, we ignored shipping costs. But as long as the shipping costs do not exceed £55.56, it is still

advantageous to buy francs via “gold export” than via the foreign exchange market.

eun61604_ch02_027-061.indd 29eun61604_ch02_027-061.indd 29 1/3/14 10:14 AM1/3/14 10:14 AM

30 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

to as the price-specie-flow mechanism , which is attributed to David Hume, a Scottish

philosopher. 3

Despite its demise a long time ago, the gold standard still has ardent supporters in

academic, business, and political circles, which view it as an ultimate hedge against

price inflation. Gold has a natural scarcity and no one can increase its quantity at will.

Therefore, if gold serves as the sole base for domestic money creation, the money sup-

ply cannot get out of control and cause inflation. In addition, if gold is used as the sole

international means of payment, then countries’ balance of payments will be regulated

automatically via the movements of gold. 4 As a result, no country may have a persis-

tent trade deficit or surplus.

The gold standard, however, has a few key shortcomings. First of all, the supply of

newly minted gold is so restricted that the growth of world trade and investment can be

seriously hampered for the lack of sufficient monetary reserves. The world economy

can face deflationary pressures. Second, whenever the government finds it politically

necessary to pursue national objectives that are inconsistent with maintaining the gold

standard, it can abandon the gold standard. In other words, the international gold stan-

dard per se has no mechanism to compel each major country to abide by the rules of

the game. 5 For such reasons, it is not very likely that the classical gold standard will be

restored in the foreseeable future.

Interwar Period: 1915–1944 World War I ended the classical gold standard in August 1914, as major countries such

as Great Britain, France, Germany, and Russia suspended redemption of banknotes in

gold and imposed embargoes on gold exports. After the war, many countries, espe-

cially Germany, Austria, Hungary, Poland, and Russia, suffered hyperinflation. The

German experience provides a classic example of hyperinflation: By the end of 1923,

the wholesale price index in Germany was more than 1 trillion (!) times as high as

the prewar level. Freed from wartime pegging, exchange rates among currencies were

fluctuating in the early 1920s. During this period, countries widely used “predatory”

depreciations of their currencies as a means of gaining advantages in the world export

market.

As major countries began to recover from the war and stabilize their economies,

they attempted to restore the gold standard. The United States, which replaced Great

Britain as the dominant financial power, spearheaded efforts to restore the gold stan-

dard. With only mild inflation, the United States was able to lift restrictions on gold

exports and return to a gold standard in 1919. In Great Britain, Winston Churchill, the

chancellor of the Exchequer, played a key role in restoring the gold standard in 1925.

Besides Great Britain, such countries as Switzerland, France, and the Scandinavian

countries restored the gold standard by 1928.

The international gold standard of the late 1920s, however, was not much more than

a facade. Most major countries gave priority to the stabilization of domestic economies

and systematically followed a policy of sterilization of gold by matching inflows and

outflows of gold respectively with reductions and increases in domestic money and

credit. The Federal Reserve of the United States, for example, kept some gold outside

the credit base by circulating it as gold certificates. The Bank of England also followed

3 The price-specie-flow mechanism will work only if governments are willing to abide by the rules of the game

by letting the money stock rise and fall as gold flows in and out. Once the government demonetizes (neutralizes)

gold, the mechanism will break down. In addition, the effectiveness of the mechanism depends on the price

elasticity of the demand for imports.

4 The balance of payments will be discussed in detail in Chapter 3 .

5 This point need not be viewed as a weakness of the gold standard per se, but it casts doubt on the long-term

feasibility of the gold standard.

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C H A P T E R 2 INTERNATIONAL MONETARY SYSTEM 31

the policy of keeping the amount of available domestic credit stable by neutralizing

the effects of gold flows. In a word, countries lacked the political will to abide by the

“rules of the game,” and so the automatic adjustment mechanism of the gold standard

was unable to work.

Even the facade of the restored gold standard crumbled down in the wake of the

Great Depression and the accompanying financial crises. Following the stock mar-

ket crash and the onset of the Great Depression in 1929, many banks, especially in

Austria, Germany, and the United States, suffered sharp declines in their portfolio

values, touching off runs on the banks. Against this backdrop, Britain experienced

a massive outflow of gold, which resulted from chronic balance-of-payment deficits

and lack of confidence in the pound sterling. Despite coordinated international efforts

to rescue the pound, British gold reserves continued to fall to the point where it was

impossible to maintain the gold standard. In September 1931, the British government

suspended gold payments and let the pound float. As Great Britain got off gold, coun-

tries such as Canada, Sweden, Austria, and Japan followed suit by the end of 1931.

The United States got off gold in April 1933 after experiencing a spate of bank failures

and outflows of gold. Lastly, France abandoned the gold standard in 1936 because of

the flight from the franc, which, in turn, reflected the economic and political instability

following the inception of the socialist Popular Front government led by Leon Blum.

Paper standards came into being when the gold standard was abandoned.

In sum, the interwar period was characterized by economic nationalism, halfhearted

attempts and failure to restore the gold standard, economic and political instabilities,

bank failures, and panicky flights of capital across borders. No coherent international

monetary system prevailed during this period, with profoundly detrimental effects on

international trade and investment. It is during this period that the U.S. dollar emerged

as the dominant world currency, gradually replacing the British pound for the role.

Bretton Woods System: 1945–1972 In July 1944, representatives of 44 nations gathered at Bretton Woods, New Hampshire,

to discuss and design the postwar international monetary system. After lengthy discus-

sions and bargains, representatives succeeded in drafting and signing the Articles of

Agreement of the International Monetary Fund (IMF), which constitutes the core of

the Bretton Woods system . The agreement was subsequently ratified by the major-

ity of countries to launch the IMF in 1945. The IMF embodied an explicit set of rules

about the conduct of international monetary policies and was responsible for enforc-

ing these rules. Delegates also created a sister institution, the International Bank for

Reconstruction and Development (IBRD), better known as the World Bank, that was

chiefly responsible for financing individual development projects.

In designing the Bretton Woods system, representatives were concerned with how

to prevent the recurrence of economic nationalism with destructive “beggar-thy-

neighbor” policies and how to address the lack of clear rules of the game plaguing

the interwar years. The British delegates led by John Maynard Keynes proposed an

international clearing union that would create an international reserve asset called

“bancor.” Countries would accept payments in bancor to settle international transac-

tions, without limit. They would also be allowed to acquire bancor by using overdraft

facilities with the clearing union. On the other hand, the American delegates, headed

by Harry Dexter White, proposed a currency pool to which member countries would

make contributions and from which they might borrow to tide themselves over dur-

ing short-term balance-of-payments deficits. Both delegates desired exchange rate sta-

bility without restoring an international gold standard. The American proposal was

largely incorporated into the Articles of Agreement of the IMF.

Under the Bretton Woods system, each country established a par value in rela-

tion to the U.S. dollar, which was pegged to gold at $35 per ounce. This point is

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32 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

illustrated in Exhibit 2.1 . Each country was responsible for maintaining its exchange

rate within 61 percent of the adopted par value by buying or selling foreign exchanges

as necessary. However, a member country with a “fundamental disequilibrium” may

be allowed to make a change in the par value of its currency. Under the Bretton Woods

system, the U.S. dollar was the only currency that was fully convertible to gold; other

currencies were not directly convertible to gold. Countries held U.S. dollars, as well as

gold, for use as an international means of payment. Because of these arrangements, the

Bretton Woods system can be described as a dollar-based gold-exchange standard .

A country on the gold-exchange standard holds most of its reserves in the form of cur-

rency of a country that is really on the gold standard.

Advocates of the gold-exchange system argue that the system economizes on gold

because countries can use not only gold but also foreign exchanges as an international

means of payment. Foreign exchange reserves offset the deflationary effects of limited

addition to the world’s monetary gold stock. Another advantage of the gold-exchange

system is that individual countries can earn interest on their foreign exchange holdings,

whereas gold holdings yield no returns. In addition, countries can save transaction

costs associated with transporting gold across countries under the gold-exchange sys-

tem. An ample supply of international monetary reserves coupled with stable exchange

rates provided an environment highly conducive to the growth of international trade

and investment throughout the 1950s and 1960s.

Professor Robert Triffin warned, however, that the gold-exchange system was pro-

grammed to collapse in the long run. To satisfy the growing need for reserves, the

United States had to run balance-of-payments deficits continuously, thereby supply-

ing the dollar to the rest of the world. Yet if the United States ran perennial balance-

of-payments deficits, it would eventually impair the public confidence in the dollar,

triggering a run on the dollar. Under the gold-exchange system, the reserve-currency

country should run balance-of-payments deficits to supply reserves, but if such defi-

cits are large and persistent, they can lead to a crisis of confidence in the reserve cur-

rency itself, causing the downfall of the system. This dilemma, known as the Triffin paradox , was indeed responsible for the eventual collapse of the dollar-based gold-

exchange system in the early 1970s.

The United States began to experience trade deficits with the rest of the world in

the late 1950s, and the problem persisted into the 1960s. By the early 1960s the total

value of the U.S. gold stock, when valued at $35 per ounce, fell short of foreign dollar

holdings. This naturally created concern about the viability of the dollar-based system.

Against this backdrop, President Charles de Gaulle prodded the Bank of France to buy

gold from the U.S. Treasury, unloading its dollar holdings. Efforts to remedy the prob-

lem centered on (i) a series of dollar defense measures taken by the U.S. government and

(ii) the creation of a new reserve asset, special drawing rights (SDRs) , by the IMF.

EXHIBIT 2.1

The Design of the

Gold-Exchange System German

mark

British

pound

French

franc

U.S. dollar

Pegged at $35/oz.

Par value Par value

Gold

Par value

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C H A P T E R 2 INTERNATIONAL MONETARY SYSTEM 33

In 1963, President John Kennedy imposed the Interest Equalization Tax (IET) on U.S.

purchases of foreign securities in order to stem the outflow of dollars. The IET was

designed to increase the cost of foreign borrowing in the U.S. bond market. In 1965,

the Federal Reserve introduced the U.S. voluntary Foreign Credit Restraint Program

(FCRP), which regulated the amount of dollars U.S. banks could lend to U.S. multi-

national companies engaged in foreign direct investments. In 1968, these regulations

became legally binding. Such measures as IET and FCRP lent a strong impetus to the

rapid growth of the Eurodollar market, which is a transnational, unregulated fund market.

To partially alleviate the pressure on the dollar as the central reserve currency, the

IMF created an artificial international reserve called the SDR in 1970. The SDR,which

is a basket currency comprising major individual currencies, was allotted to the mem-

bers of the IMF, who could then use it for transactions among themselves or with the

IMF. In addition to gold and foreign exchanges, countries could use the SDR to make

international payments.

Initially, the SDR was designed to be the weighted average of 16 currencies of those

countries whose shares in world exports were more than 1 percent. The percentage

share of each currency in the SDR was about the same as the country’s share in world

exports. In 1981, however, the SDR was greatly simplified to comprise only five major

currencies: U.S. dollar, German mark, Japanese yen, British pound, and French franc.

As Exhibit 2.2 shows, the weight for each currency is updated periodically, reflecting

the relative importance of each country in the world trade of goods and services and the

amount of the currencies held as reserves by the members of the IMF. Currently, the

SDR is composed of four major currencies—the U.S. dollar (41.9 percent weight),

euro (37.4 percent), British pound (11.3 percent), and Japanese yen (9.4 percent).

The SDR is used not only as a reserve asset but also as a denomination currency for

international transactions. Since the SDR is a “portfolio” of currencies, its value tends

to be more stable than the value of any individual currency included in the SDR. The

portfolio nature of the SDR makes it an attractive denomination currency for interna-

tional commercial and financial contracts under exchange rate uncertainty.

The efforts to support the dollar-based gold-exchange standard, however, turned out

to be ineffective in the face of expansionary monetary policy and rising inflation in the

United States, which were related to the financing of the Vietnam War and the Great

Society program. In the early 1970s, it became clear that the dollar was over-valued,

especially relative to the mark and the yen. As a result, the German and Japanese

central banks had to make massive interventions in the foreign exchange market to

maintain their par values. Given the unwillingness of the United States to control its

monetary expansion, the repeated central bank interventions could not solve the under-

lying disparities. In August 1971, President Richard Nixon suspended the convertibil-

ity of the dollar into gold and imposed a 10 percent import surcharge. The foundation

of the Bretton Woods system began to crack under the strain.

www.imf.org/external/fin.htm

Provides detailed information

about the SDR, such as SDR

exchange rates, interests,

allocations, etc.

Currencies 1981–85 1986–90 1991–95 1996–2000 2001–2005 2006–2010 2011–

U.S. dollar 42% 42% 40% 39% 45% 44% 41.9% Euro — — — — 29 34 37.4 German mark 19 19 21 21 — — — Japanese yen 13 15 17 18 15 11 9.4 British pound 13 12 11 11 11 11 11.3 French franc 13 12 11 11 — — —

a The composition of the SDR changes every 5 years.

Source: The International Monetary Fund.

EXHIBIT 2.2 The Composition of the Special Drawing Right (SDR) a

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34 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

In an attempt to save the Bretton Woods system, 10 major countries, known as

the Group of Ten, met at the Smithsonian Institution in Washington, D.C., in

December 1971. They reached the Smithsonian Agreement , according to which

(i) the price of gold was raised to $38 per ounce, (ii) each of the other countries reval-

ued its currency against the U.S. dollar by up to 10 percent, and (iii) the band within

which the exchange rates were allowed to move was expanded from 1 percent to

2.25 percent in either direction.

The Smithsonian Agreement lasted for little more than a year before it came under

attack again. Clearly, the devaluation of the dollar was not sufficient to stabilize the sit-

uation. In February 1973, the dollar came under heavy selling pressure, again prompt-

ing central banks around the world to buy dollars. The price of gold was further raised

from $38 to $42 per ounce. By March 1973, European and Japanese currencies were

allowed to float, completing the decline and fall of the Bretton Woods system. Since

then, the exchange rates among such major currencies as the dollar, the mark (later suc-

ceeded by the euro), the pound, and the yen have been fluctuating against each other.

The Flexible Exchange Rate Regime: 1973–Present The flexible exchange rate regime that followed the demise of the Bretton Woods sys-

tem was ratified after the fact in January 1976 when the IMF members met in Jamaica

and agreed to a new set of rules for the international monetary system. The key ele-

ments of the Jamaica Agreement include:

1. Flexible exchange rates were declared acceptable to the IMF members, and

central banks were allowed to intervene in the exchange markets to iron out

unwarranted volatilities.

2. Gold was officially abandoned (i.e., demonetized) as an international reserve

asset. Half of the IMF’s gold holdings were returned to the members and the

other half were sold, with the proceeds to be used to help poor nations.

3. Non-oil-exporting countries and less-developed countries were given greater

access to IMF funds.

The IMF continued to provide assistance to countries facing balance-of-payments and

exchange rate difficulties. The IMF, however, extended assistance and loans to the mem-

ber countries on the condition that those countries follow the IMF’s macroeconomic

policy prescriptions. This “conditionality,” which often involves deflationary macroeco-

nomic policies and elimination of various subsidy programs, provoked resentment among

the people of developing countries receiving the IMF’s balance-of-payments loans.

As can be expected, exchange rates have become substantially more volatile since

March 1973 than they were under the Bretton Woods system. Exhibit 2.3 summarizes

the behavior of the dollar exchange rate since 1960. The exhibit shows the exchange rate

between the U.S. dollar and a weighted basket of 21 other major currencies. The decline

of the dollar between 1970 and 1973 represents the transition from the Bretton Woods

to the flexible exchange rate system. The most conspicuous phenomena shown in

Exhibit 2.3 are the dollar’s spectacular rise between 1980 and 1984 and its equally spec-

tacular decline between 1985 and 1988. These unusual episodes merit some discussion.

Following the U.S. presidential election of 1980, the Reagan administration ush-

ered in a period of growing U.S. budget deficits and balance-of-payments deficits. The

U.S. dollar, however, experienced a major appreciation throughout the first half of the

1980s because of the large-scale inflows of foreign capital caused by unusually high

real interest rates available in the United States. To attract foreign investment to help

finance the budget deficit, the United States had to offer high real interest rates. The

heavy demand for dollars by foreign investors pushed up the value of the dollar in the

exchange market.

http://www.federalreserve. gov/releases/h10/hist/

Provides historical exchange

rates.

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C H A P T E R 2 INTERNATIONAL MONETARY SYSTEM 35

The Value of the U.S. Dollar since 1960 a

The value of the dollar reached its peak in February 1985 and then began a persis-

tent downward drift until it stabilized in 1988. The reversal in the exchange rate trend

partially reflected the effect of the record-high U.S. trade deficit, about $160 billion in

1985, brought about by the soaring dollar. The downward trend was also reinforced by

concerted government interventions. In September 1985, the so-called G-5 countries

(France, Japan, Germany, the U.K., and the United States) met at the Plaza Hotel in

New York and reached what became known as the Plaza Accord . They agreed that

it would be desirable for the dollar to depreciate against most major currencies to

solve the U.S. trade deficit problem and expressed their willingness to intervene in

the exchange market to realize this objective. The slide of the dollar that had begun in

February was further precipitated by the Plaza Accord.

As the dollar continued its decline, the governments of the major industrial countries

began to worry that the dollar may fall too far. To address the problem of exchange rate

volatility and other related issues, the G-7 economic summit meeting was convened in

Paris in 1987. 6 The meeting produced the Louvre Accord , according to which:

1. The G-7 countries would cooperate to achieve greater exchange rate stability.

2. The G-7 countries agreed to more closely consult and coordinate their macro-

economic policies.

The Louvre Accord marked the inception of the managed-float system under which

the G-7 countries would jointly intervene in the exchange market to correct over- or

undervaluation of currencies. Following the Louvre Accord, exchange rates became

relatively more stable for a while. During the period 1996–2001, however, the U.S.

dollar generally appreciated, reflecting a robust performance of the U.S. economy

fueled by the technology boom. During this period, foreigners invested heavily in the

United States to participate in the booming U.S. economy and stock markets. This

helped the dollar to appreciate. In 2001, however, the U.S. dollar began to depreciate

due to a sharp stock market correction, the ballooning trade deficits, and the increased

political uncertainty following the September 11 incident.

6 The G-7 is composed of Canada, France, Japan, Germany, Italy, the U.K., and the United States.

EXHIBIT 2.3

a The value of the U.S. dollar represents the nominal exchange rate index (2005 5 100) with weights derived from trade among 21 industrialized countries.

Source: International Financial Statistics.

180

160

Collapse of

Bretton Woods

Jamaica

Agreement

Reagan

Era

Louvre

Accord

Plaza

Agreement

Technology

Boom

Global

Financial

Crisis

140

120

100

N om

in al

E ff

ec ti

ve E

xc ha

ng e

R at

60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

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36 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

The Current Exchange Rate Arrangements Although the most actively traded currencies of the world, such as the dollar, the yen,

the pound, and the euro, may be fluctuating against each other, a significant number

of the world’s currencies are pegged to single currencies, particularly the U.S. dollar and

the euro, or baskets of currencies such as the SDR. The current exchange rate arrange-

ments as classified by the IMF are provided in Exhibit 2.4 . The classification system

used in Exhibit 2.4 is based on IMF member countries’ actual, de facto arrangements,

as identified by IMF staff, which can be different from the officially announced, de jure

arrangements. The system classifies exchange rate arrangements primarily based on the

degree to which the exchange rate is determined by the market rather than by official

government action, with market-determined rates generally being more flexible.

As can be seen from the exhibit, the IMF currently classifies exchange rate arrange-

ments into 10 separate regimes: 7

No separate legal tender: The currency of another country circulates as the sole

legal tender. Adopting such an arrangement implies complete surrender of the

monetary authorities’ control over the domestic monetary policy. Examples

include Ecuador, El Salvador, and Panama.

Currency board: A currency board arrangement is a monetary arrangement

based on an explicit legislative commitment to exchange domestic currency for a

specified foreign currency at a fixed exchange rate, combined with restrictions on

the issuing authority to ensure the fulfillment of its legal obligation. This implies

that domestic currency is usually fully backed by foreign assets, eliminating tra-

ditional central bank functions such as monetary control and lender of last resort,

and leaving little room for discretionary monetary policy. Examples include

Hong Kong, Bulgaria, and Brunei.

Conventional peg: For this category the country formally (de jure) pegs its cur-

rency at a fixed rate to another currency or a basket of currencies, where the

basket is formed, for example, from the currencies of major trading or financial

partners and weights reflect the geographic distribution of trade, services, or capi-

tal flows. The anchor currency or basket weights are public or notified to the IMF.

The country authorities stand ready to maintain the fixed parity through direct

intervention (i.e., via sale or purchase of foreign exchange in the market) or indi-

rect intervention (e.g., via exchange-rate-related use of interest rate policy, impo-

sition of foreign exchange regulations, exercise of moral suasion that constrains

foreign exchange activity, or intervention by other public institutions). There is no

commitment to irrevocably keep the parity, but the formal arrangement must be

confirmed empirically: the exchange rate may fluctuate within narrow margins of

less than 61 percent around a central rate—or the maximum and minimum value

of the spot market exchange rate must remain within a narrow margin of 2 percent

for at least six months. Examples include Jordan, Saudi Arabia, and Morocco.

Stabilized arrangement: Classification as a stabilized arrangement entails a spot

market exchange rate that remains within a margin of 2 percent for 6 months or

more (with the exception of a specified number of outliers or step adjustments)

and is not floating. The required margin of stability can be met either with

respect to a single currency or a basket of currencies, where the anchor currency

or the basket is ascertained or confirmed using statistical techniques. Examples

are Cambodia, Angola, and Lebanon.

Crawling peg: Classification as a crawling peg involves the confirmation of the

country authorities’ de jure exchange rate arrangement. The currency is adjusted

7 We draw on IMF classifications provided in Annual Report on Exchange Arrangements and Exchange Restrictions 2012.

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3 7

Exchange Rate Regimes and Anchors of Monetary Policy (As of April 30, 2012)EXHIBIT 2.4

Monetary Policy Framework

Exchange rate arrangement (number of countries)

Exchange rate anchor Monetary aggregate

target Inflation-targeting

framework Other1

U.S. dollar (43) Euro (27) Composite (13) Other (8) (31) (32) (38) No separate Ecuador Palau Kosovo Kiribati legal tender (13) El Salvador Panama Montenegro Tuvalu

Marshall Islands Timor-Leste San Marino Micronesia Zimbabwe

Currency ECCU Djibouti Bosnia and Brunei board (12) Antigua and Hong Kong Herzegovina Darussalam

Barbuda SAR Bulgaria Dominica Lithuania2

Grenada St. Kitts and Nevis St. Lucia St. Vincent and the Grenadines

Conventional Aruba Oman Cape Verde Fiji Bhutan peg (43) Bahamas, The Qatar Comoros Kuwait Lesotho

Bahrain Saudi Arabia Denmark2 Libya Namibia Barbados Turkmenistan Latvia2 Morocco Nepal Belize Curaçao and Sint

United Arab Emirates

São Tomé and Príncipe

Samoa Swaziland

Eritrea Venezuela WAEMU Jordan Benin Netherlands Burkina Faso Antilles Côte d’Ivoire

Guinea-Bissau Mali Niger Senegal Togo CAEMC Cameroon Central African Rep. Chad (Continued)

eun61604_ch02_027-061.indd 37 eun61604_ch02_027-061.indd 37

1/3/14 10:14 A M

3 8

Congo, Rep. of Equatorial Guinea Cabon

Stabilized arrangement (16)

Cambodia Guyana Iraq

Lebanon Maldives (04/11) Suriname Trinidad and

Macedonia, FYR

Vietnam5 Tajikistan4,5 (9/11) Ukraine5

Guatemala5(6/11) Angola4,5(11/10) Azerbaijan Egypt4,6(04/11) Lao P.D.R.5

Tobago

Crawling peg (3) Nicaragua Botswana Bolivia4,5 (11/10)

Crawl-like arrangement (12)

Ethiopia Honduras (07/11)

Jamaica (06/11) Kazakhstan

Croatia Argentina5

China5

Rwanda5

Uzbekistan5,7 (04/08)

Dominican Republic5

Haiti5

Tunisia6(09/11)

Pegged exchange rate within horizontal bands (1)

Tonga

Other managed arrangement (24)

Liberia4 (11/11) Algeria Iran Singapore4

(09/11) Syria4 (04/11) Vanuatu

Bangladesh (12/11) Burundi (07/11) Congo, Democratic Republic (11/11) Guinea Kyrgyz Malawi (08/11) Nigeria Paraguay Yemen

Belarus (05/11) Costa Rica Malaysia Mauritania Myanmar Russia Solomon Islands (02/11) Sudan Switzerland (09/11)

Floating (35) Afghanistan Albania India Gambia, The Armenia Mauritius Guinea Brazil Kenya Colombia Madagascar Georgia8

Mongolia Ghana Mozambique Pakistan4

Hungary Iceland

EXHIBIT 2.4 Exchange Rate Regimes and Anchors of Monetary Policy (As of April 30, 2012) (continued)

Monetary Policy Framework

Exchange rate arrangement (number of countries)

Exchange rate anchor Monetary aggregate

target Inflation-targeting

framework Other1

U.S. dollar (43) Euro (27) Composite (13) Other (8) (31) (32) (38)

eun61604_ch02_027-061.indd 38 eun61604_ch02_027-061.indd 38

1/3/14 5:05 P M

3 9

Papua New Guinea Paraguay

Indonesia (02/11)

Seychelles Sierra Leone

Korea Moldova

Sri Lanka (02/12) Peru (04/11) Tanzania Philippines Uganda Romania Zambia Serbia

South Africa Thailand Turkey (10/08) Urguay

Free floating (31) Australia Japan Canada Somalia Chile United States Czech Rep. EMU Israel (08/11) Austria Mexico (11/11) Belgium New Zealand Cyprus Norway Estonia (01/11) Poland (12/11) Finland Sweden United Kingdom

France Germany Greece Ireland Italy Luxembourg Malta Netherlands Portugal Slovak Rep. Slovenia Spain

Source: IMF Annual Report.

Note: If the member country’s de facto exchange rate arrangement has been reclassified during the reporting period, the date of change is indicated in parentheses. 1Includes countries that have no explicitly stated nominal anchor, but rather monitor various indicators in conducting monetary policy. 2The member participates in the European Exchange Rate Mechanism (ERM II). 3Within the framework of an exchange rate fixed to a currency composite, the Bank Al-Maghrib (BAM) adopted a monetary policy framework in 2006 based on various inflation indicators with the overnight interest rate as its operational target to pursue its main objective of price stability. Since March 2009, the BAM reference interest rate has been set at 3.25%. 4The exchange rate arrangement was reclassified retroactively, overriding a previously published classification. 5The de facto monetary policy framework is an exchange rate anchor to the dollar. 6The de facto monetary policy framework is an exchange rate anchor to a composite. 7This reclassification reflects only a methodological correction and does not imply a judgment that there was an alteration in the exchange arrangement or other policies. The change is applied retroactively to April 30, 2008, the date on which the Revised System for the Classification of Exchange Rate Arrangements became effective. 8The central bank has taken preliminary steps toward inflation targeting and is preparing for the transition to full-fledged inflation targeting.

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1/3/14 10:14 A M

40 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

in small amounts at a fixed rate or in response to changes in selected quantitative

indicators, such as past inflation differentials vis-à-vis major trading partners or

differentials between the inflation target and expected inflation in major trading

partners. Examples are Bolivia and Nicaragua.

Crawl-like arrangement: The exchange rate must remain within a narrow

margin of 2 percent relative to a statistically identified trend for six months or

more (with the exception of a specified number of outliers), and the exchange

rate arrangement cannot be considered as floating. Usually, a minimum rate

of change greater than allowed under a stabilized (peg-like) arrangement is

required. Ethiopia, China, and Croatia are examples.

Pegged exchange rate within horizontal bands: The value of the currency is

maintained within certain margins of fluctuation of at least 61 percent around

a fixed central rate, or the margin between the maximum and minimum value of

the exchange rate exceeds 2 percent. Tonga is the only example.

Other managed arrangement: This category is a residual, and is used when

the exchange rate arrangement does not meet the criteria for any of the other

categories. Arrangements characterized by frequent shifts in policies may fall

into this category. Examples are Costa Rica, Switzerland, and Russia.

Floating: A floating exchange rate is largely market determined, without an

ascertainable or predictable path for the rate. In particular, an exchange rate that

satisfies the statistical criteria for a stabilized or a crawl-like arrangement will

be classified as such unless it is clear that the stability of the exchange rate is not

the result of official actions. Foreign exchange market intervention may be either

direct or indirect, and serves to moderate the rate of change and prevent undue

fluctuations in the exchange rate, but policies targeting a specific level of the

exchange rate are incompatible with floating. Examples include Brazil, Korea,

Turkey, and India.

Free floating: A floating exchange rate can be classified as free floating if

intervention occurs only exceptionally and aims to address disorderly market

conditions and if the authorities have provided information or data confirming

that intervention has been limited to at most three instances in the previous six

months, each lasting no more than three business days. Examples are Canada,

Mexico, Japan, Israel, U.K., United States, and euro zone.

As of April 2012, a large number of countries (31), including Australia, Canada, Japan,

the United Kingdom, euro area, and the United States, allow their currencies to float

freely against other currencies; the exchange rates of these countries are essentially deter-

mined by market forces. Thirty-five countries, including India, Brazil, and Korea, adopt

floating exchange rates that are largely market determined. In contrast, 13 countries do

not have their own national currencies. For example, Panama and Ecuador are using the

U.S. dollar. Twelve countries, including Bulgaria, Hong Kong SAR, and Dominica, on

the other hand, maintain national currencies, but they are permanently fixed to such

hard currencies as the U.S. dollar or euro. The remaining countries adopt a mixture

of fixed and floating exchange rate regimes. As is well known, the European Union

has pursued Europe-wide monetary integration by first establishing the European Mon-

etary System and then the European Monetary Union. These topics deserve a detailed

discussion.

European Monetary System According to the Smithsonian Agreement, which was signed in December 1971,

the band of exchange rate movements was expanded from the original plus or

minus 1 percent to plus or minus 2.25 percent. Members of the European Economic

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C H A P T E R 2 INTERNATIONAL MONETARY SYSTEM 41

Community (EEC), however, decided on a narrower band of 61.125 percent for their

currencies. This scaled-down, European version of the (quasi-) fixed exchange rate sys-

tem that arose concurrently with the decline of the Bretton Woods system was called

the snake . The name “snake” was derived from the way the EEC currencies moved

closely together within the wider band allowed for other currencies like the dollar.

The EEC countries adopted the snake because they felt that stable exchange rates

among the EEC countries were essential for promoting intra-EEC trade and deepening

economic integration. The snake arrangement was replaced by the European Mon- etary System (EMS) in 1979. The EMS, which was originally proposed by German

Chancellor Helmut Schmidt, was formally launched in March 1979. Among its chief

objectives are:

1. To establish a “zone of monetary stability” in Europe.

2. To coordinate exchange rate policies vis-à-vis the non-EMS currencies.

3. To pave the way for the eventual European monetary union.

At the political level, the EMS represented a Franco-German initiative to speed up

the movement toward European economic and political unification. All EEC member

countries, except the United Kingdom and Greece, joined the EMS. The two main

instruments of the EMS are the European Currency Unit and the Exchange Rate

Mechanism.

The European Currency Unit (ECU) is a “basket” currency constructed as a

weighted average of the currencies of member countries of the European Union (EU).

The weights are based on each currency’s relative GNP and share in intra-EU trade.

The ECU serves as the accounting unit of the EMS and plays an important role in the

workings of the exchange rate mechanism.

The Exchange Rate Mechanism (ERM) refers to the procedure by which EMS

member countries collectively manage their exchange rates. The ERM is based on a

“parity grid” system, which is a system of par values among ERM currencies. The par

values in the parity grid are computed by first defining the par values of EMS curren-

cies in terms of the ECU.

When the EMS was launched in 1979, a currency was allowed to deviate from the

parities with other currencies by a maximum of plus or minus 2.25 percent, with the

exception of the Italian lira, for which a maximum deviation of plus or minus 6 percent

was allowed. In September 1993, however, the band was widened to a maximum of

plus or minus 15 percent. When a currency is at the lower or upper bound, the central

banks of both countries are required to intervene in the foreign exchange markets to

keep the market exchange rate within the band. To intervene in the exchange markets,

the central banks can borrow from a credit fund to which member countries contribute

gold and foreign reserves.

Since the EMS members were less than fully committed to coordinating their eco-

nomic policies, the EMS went through a series of realignments. The Italian lira, for

instance, was devalued by 6 percent in July 1985 and again by 3.7 percent in January

1990. In September 1992, Italy and the U.K. pulled out of the ERM as high German

interest rates were inducing massive capital flows into Germany. Following German

reunification in October 1990, the German government experienced substantial budget

deficits, which were not accommodated by the monetary policy. Germany would not

lower its interest rates for fear of inflation, and the U.K. and Italy were not willing to

raise their interest rates (which was necessary to maintain their exchange rates) for

fear of higher unemployment. Italy, however, rejoined the ERM in December 1996

in an effort to participate in the European monetary union. However, the U.K. still

remains outside the European monetary union.

Despite the recurrent turbulence in the EMS, European Union members met at Maas-

tricht (Netherlands) in December 1991 and signed the Maastricht Treaty . According

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42 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

1951 The treaty establishing the European Coal and Steel Community (ECSC), which was inspired by French Foreign Minister Robert Schuman, was signed in Paris by six countries: France, Germany, Italy, Netherlands, Belgium, and Luxembourg.

1957 The treaty establishing the European Economic Community (EEC) was signed in Rome.

1968 The Custom Union became fully operational; trade restrictions among the EEC member countries were abolished and a common external tariff system was established.

1973 The U.K., Ireland, and Denmark became EEC members. 1978 The EEC became the European Community (EC). 1979 The European Monetary System (EMS) was established for the purpose

of promoting exchange rate stability among the EC member countries. 1980 Greece became an EC member. 1986 Portugal and Spain became EC members. 1987 The Single European Act was adopted to provide a framework within

which the common internal market could be achieved by the end of 1992. 1991 The Maastricht Treaty was signed and subsequently ratified by

12 member states. The treaty establishes a timetable for fulfilling the European Monetary Union (EMU). The treaty also commits the EC to political union.

1994 The European Community was renamed the European Union (EU). 1995 Austria, Finland, and Sweden became EU members. 1999 A common European currency, the euro, was adopted by 11 EU

member countries. 2001 Greece adopted the euro on January 1. 2002 Euro notes and coins were introduced; national currencies were

withdrawn from circulation. 2004 EU expanded by admitting 10 new member countries: Cyprus, Czech

Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovak Republic, and Slovenia.

2007 Bulgaria and Romania were admitted to the EU. Slovenia adopted the euro.

2008 Cyprus and Malta adopted the euro. 2009 Slovakia adopted the euro. 2010 Europe's sovereign debt crisis. 2011 Estonia adopted the euro. 2013 Croatia joined the EU. 2014 Latvia adopted the euro.

EXHIBIT 2.5

Chronology of the

European Union

to the treaty, the EMS would irrevocably fix exchange rates among the member cur-

rencies by January 1, 1999, and subsequently introduce a common European currency,

replacing individual national currencies. The European Central Bank, to be located in

Frankfurt, Germany, would be solely responsible for the issuance of common currency

and conducting monetary policy in the euro zone. National central banks of individual

countries then would function pretty much like regional member banks of the U.S.

Federal Reserve System. Exhibit 2.5 provides a chronology of the European Union.

To pave the way for the European Monetary Union (EMU), the member countries

of the European Monetary System agreed to closely coordinate their fiscal, monetary,

and exchange rate policies and achieve a convergence of their economies. Specifically,

each member country shall strive to: (i) keep the ratio of government budget deficits

to gross domestic product (GDP) below 3 percent, (ii) keep gross public debts below

60 percent of GDP, (iii) achieve a high degree of price stability, and (iv) maintain its

currency within the prescribed exchange rate ranges of the ERM. Currently, “conver-

gence” is the buzz word in such countries as the Czech Republic, Hungary, and Poland

that may join the EMU in the future.

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C H A P T E R 2 INTERNATIONAL MONETARY SYSTEM 43

The Euro and the European Monetary Union On January 1, 1999, an epochal event took place in the arena of international finance:

Eleven of 15 EU countries adopted a common currency called the euro, voluntarily

giving up their monetary sovereignty. The original euro-11 includes Austria, Belgium,

Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and

Spain. Four member countries of the European Union—Denmark, Greece, Sweden,

and the United Kingdom—did not join the first wave. Greece, however, joined the euro

club in 2001 when it could satisfy the convergence criteria. Subsequently, Slovenia

adopted the euro in 2007, and Cyprus and Malta did so in 2008. Slovakia adopted the

euro in 2009 and Estonia did the same in 2011.

The advent of a European single currency, which may potentially rival the

U.S. dollar as a global currency, has profound implications for various aspects of inter-

national finance. In this section, we are going to (i) describe briefly the historical back-

ground for the euro and its implementation process, (ii) discuss the potential benefits

and costs of the euro from the perspective of the member countries, and (iii) investigate

the broad impacts of the euro on international finance in general.

Considering that no European currency has been in circulation since the fall of the

Roman Empire, the advent of the euro in January 1999 indeed qualifies as an epochal

event. The Roman emperor Gaius Diocletianus, A.D. 286–301, reformed the coinage

and established a single currency throughout the realm. The advent of the euro also

marks the first time that sovereign countries voluntarily have given up their monetary

independence to foster economic integration. The euro thus represents a historically

unprecedented experiment, the outcome of which will have far-reaching implications.

If the experiment succeeds, for example, both the euro and the dollar will dominate

the world of international finance. In addition, a successful euro may give a powerful

impetus to the political unionization of Europe.

The euro should be viewed as a product of historical evolution toward an ever deep-

ening integration of Europe, which began in earnest with the formation of the European

Economic Community in 1958. As discussed previously, the European Monetary

System (EMS) was created in 1979 to establish a European zone of monetary stabil-

ity; members were required to restrict fluctuations of their currency exchange rates.

In 1991, the Maastricht European Council reached agreement on a draft Treaty on the

European Union, which called for the introduction of a single European currency by

1999. With the launching of the euro on January 1, 1999, the European Monetary Union (EMU) was created. The EMU is a logical extension of the EMS, and the

European Currency Unit (ECU) was the precursor of the euro. Indeed, ECU contracts

were required by EU law to be converted to euro contracts on a one-to-one basis.

As the euro was introduced, each national currency of the euro-11 countries was irre- vocably fixed to the euro at a conversion rate as of January 1, 1999. The conversion rates

are provided in Exhibit 2.6 . On January 1, 2002, euro notes and coins were introduced

to circulation while national bills and coins were being gradually withdrawn. Once the

changeover was completed by July 1, 2002, the legal-tender status of national curren-

cies was canceled, leaving the euro as the sole legal tender in the euro zone countries.

Monetary policy for the euro zone countries is now conducted by the European Central Bank (ECB) headquartered in Frankfurt, Germany, whose primary objec-

tive is to maintain price stability. The independence of the ECB is legally guaranteed

so that in conducting its monetary policy, it will not be unduly subjected to political

pressure from any member countries or institutions. By and large, the ECB is modeled

after the German Bundesbank, which was highly successful in achieving price stability

in Germany. Willem (Wim) Duisenberg, the first president of the ECB, who previously

served as the president of the Dutch National Bank, defined “price stability” as an

annual inflation rate of “less than but close to 2 percent.”

A Brief History of the Euro

www.ecb.int

Website of the European

Central Bank offers a

comprehensive coverage of

the euro and links to EU central

banks.

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44 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

1 Euro Is Equal to

Austrian schilling 13.7603 Belgian franc 40.3399 Dutch guilder 2.20371 Finnish markka 5.94573 French franc 6.55957 German mark 1.95583 Irish punt 0.78756 Italian lira 1936.27 Luxembourg franc 40.3399 Portuguese escudo 200.482 Spanish peseta 166.386

Source: The Wall Street Journal .

EXHIBIT 2.6

Euro Conversion Rates

The national central banks of the euro zone countries will not disappear. Together with

the European Central Bank, they form the Eurosystem , which is in a way similar to the

Federal Reserve System of the United States. The tasks of the Eurosystem are threefold:

(i) to define and implement the common monetary policy of the Union; (ii) to conduct

foreign exchange operations; and (iii) to hold and manage the official foreign reserves of

the euro member states. In addition, governors of national central banks will sit on the

Governing Council of the ECB. Although national central banks will have to follow the

policies of the ECB, they will continue to perform important functions in their jurisdic-

tion such as distributing credit, collecting resources, and managing payment systems.

Before we proceed, let us briefly examine the behavior of exchange rate between

the dollar and euro. Panel A of Exhibit 2.7 plots the daily dollar–euro exchange

rate since the inception of the euro, whereas Panel B plots the rate of change of the

exchange rate. As can be seen from Panel A, since its introduction at $1.18 per euro

in January 1999, the euro was steadily depreciating against the dollar, reaching a low

point of $0.83 per euro in October 2000. The depreciation of the euro during this

period reflects the robust performance of the U.S. economy and massive European

investments in the United States. From the start of 2002, however, the euro began

to appreciate against the dollar, reaching a rough parity by July 2002. This, in turn,

reflects a slowdown of the U.S. economy and lessening European investments in the

United States. The euro continued to strengthen against the dollar, reaching $1.60 per

euro in July 2008 before it started to fall as the global financial crisis spread. During a

crisis period, the dollar tends to become stronger, reflecting investors’ preference for

the dollar as a safe haven. Although the euro began to rebound in early 2009, it started

to fall again against the dollar as Europe’s sovereign debt crisis hurt the euro’s cred-

ibility. Panel B confirms that the dollar–euro exchange rate is highly volatile.

The euro zone countries obviously decided to form a monetary union with a common cur-

rency because they believed the benefits from such a union would outweigh the associated

costs—in contrast to those eligible countries that chose not to adopt the single currency. It

is thus important to understand the potential benefits and costs of monetary union.

What are the main benefits from adopting a common currency? The most direct and

immediate benefits are reduced transaction costs and the elimination of exchange rate

uncertainty. There was a popular saying in Europe that if one travels through all EU

countries, changing money in each country but not actually spending it, one returns

home with only half the original amount. Once countries use the same currency,

transactions costs will be reduced substantially. These savings will accrue to prac-

tically all economic agents, benefiting individuals, companies, and governments.

Although it is difficult to estimate accurately the magnitude of foreign exchange trans-

action costs, a consensus estimation is around 0.4 percent of Europe’s GDP.

What Are the Benefits of Monetary Union?

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C H A P T E R 2 INTERNATIONAL MONETARY SYSTEM 45

Economic agents should also benefit from the elimination of exchange rate uncer-

tainty. Companies will not suffer currency loss anymore from intra–euro zone transac-

tions. Companies that used to hedge exchange risk will save hedging costs. As price

comparison becomes easier because of the common currency, consumers can ben-

efit from comparison shopping. Increased price transparency will promote Europe-

wide competition, exerting a downward pressure on prices. Reduced transaction costs

and the elimination of currency risk together will have the net effect of promoting

cross-border investment and trade within the euro zone. By furthering the economic

integration of Europe, the single currency will promote corporate restructuring via

mergers and acquisitions, encourage optimal business location decisions, and ulti-

mately strengthen the international competitive position of European companies.

Thus, the enhanced efficiency and competitiveness of the European economy can be

regarded as the third major benefit of the monetary union.

The advent of the common European currency also helps create conditions con-

ducive to the development of continental capital markets with depth and liquid-

ity comparable to those of the United States. In the past, national currencies and a

localized legal/regulatory framework resulted in largely illiquid, fragmented capital

markets in Europe, which prevented European companies from raising capital on

competitive terms. The common currency and the integration of European financial

markets pave the way for a European capital market in which both European and non-

European companies can raise money at favorable rates. A study by Bris, Koskinen,

and Nilsson (2004) indeed documents that the adoption of the euro as the common

European currency has lowered firms’ cost of capital in the euro zone and enhanced

the firm value by about 17 percent on average. The increases in firm valuation are

larger for firms that were exposed to intra-European currency risks, that is, those firms

that were expected to benefit more from the common currency.

EXHIBIT 2.7 The Daily Dollar-Euro Exchange Rate since the Euro’s Inception

1.8

Panel A: The dollar-euro exchange rate

1.6

1.4

1.2

D ol

la r

pe r

eu ro

0.8

0.6

1 9 9 9 .0

2 0 0 0 .0

2 0 0 1 .0

2 0 0 2 .0

2 0 0 3 .0

2 0 0 4 .0

2 0 0 5 .0

2 0 0 6 .0

2 0 0 7 .0

2 0 0 8 .0

2 0 0 9 .0

2 0 1 0 .0

2 0 1 1 .0

2 0 1 2 .0

2 0 1 3 .0

Panel B: The dollar-euro exchange rate changes

P er

ce nt

ag e

2 0 1 0 .0

2 0 1 1 .0

2 0 1 2 .0

2 0 1 3 .0

1 9 9 9 .0

2 0 0 0 .0

2 0 0 1 .0

2 0 0 2 .0

2 0 0 3 .0

2 0 0 4 .0

2 0 0 5 .0

2 0 0 6 .0

2 0 0 7 .0

2 0 0 8 .0

2 0 0 9 .0

2 0 1 0 .0

0.04

0.03

0.02

0.01

–0.01

–0.02

–0.03

–0.04

Source: IMF, International Financial Statistics, www.exchange-rates.org.

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46 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

Last but not least, sharing a common currency should promote political coopera-

tion and peace in Europe. The founding fathers of the European Union, including Jean

Monnet, Paul-Henri Spaak, Robert Schuman, and their successors, took a series of

economic measures designed to link European countries together. They envisioned a

new Europe in which economic interdependence and cooperation among regions and

countries would replace nationalistic rivalries, which so often led to calamitous wars

in the past. In this context Helmut Kohl, a former German chancellor, said that the

European Monetary Union was a “matter of war and peace.” If the euro proves to be

successful in the long run, it will advance the political integration of Europe in a major

way, eventually making a “United States of Europe” feasible.

The main cost of monetary union is the loss of national monetary and exchange rate

policy independence. Suppose Finland, a country heavily dependent on the paper and

pulp industries, faces a sudden drop in world paper and pulp prices. This price drop

could severely hurt the Finnish economy, causing unemployment and income decline

while scarcely affecting other euro zone countries. Finland thus faces an “asymmetric

shock.” Generally speaking, a country is more prone to asymmetric shocks the less

diversified and more trade-dependent its economy is.

If Finland maintained monetary independence, the country could consider lowering

domestic interest rates to stimulate the weak economy as well as letting its currency depre-

ciate to boost foreigners’ demand for Finnish products. But because Finland has joined the

EMU, the country no longer has these policy options at its disposal. Further, with the rest

of the euro zone unaffected by Finland’s particular problem, the ECB is not likely to tune

its monetary policy to address a local Finnish shock. In other words, a common monetary

policy dictated in Frankfurt cannot address asymmetric economic shocks that affect only

a particular country or subregion; it can only effectively deal with euro zone–wide shocks.

If, however, wage and price levels in Finland are flexible, then the country may

still be able to deal with an asymmetric shock; lower wage and price levels in Finland

would have economic effects similar to those of a depreciation of the Finnish currency.

Furthermore, if capital flows freely across the euro zone and workers are willing to

relocate to where jobs are, then again much of the asymmetric shock can be absorbed

without monetary adjustments. If these conditions are not met, however, the asymmet-

ric shock can cause a severe and prolonged economic dislocation in the affected coun-

try. In this case, monetary union will become a costly venture. According to the theory

of optimum currency areas , originally conceived by Professor Robert Mundell of

Columbia University, the relevant criterion for identifying and designing a common

currency zone is the degree of factor (i.e., capital and labor) mobility within the zone;

a high degree of factor mobility would provide an adjustment mechanism, providing

an alternative to country-specific monetary/currency adjustments.

Considering the high degree of capital and labor mobility in the United States, one

might argue that the United States approximates an optimum currency area; it would be

suboptimal for each of the 50 states to issue its own currency. In contrast, unemployed

workers in Helsinki, for example, are not very likely to move to Amsterdam or Stuttgart

for job opportunities because of cultural, religious, linguistic, and other barriers. The

stability pact of EMU, designed to discourage irresponsible fiscal behavior in the post-

EMU era, also constrains the Finnish government to restrict its budget deficit to 3 percent

of GDP at most. At the same time, Finland cannot expect to receive a major transfer pay-

ment from Brussels, because of a rather low degree of fiscal integration among EU coun-

tries. These considerations taken together suggest that the European Monetary Union

will involve significant economic costs. Due to the sluggish economic conditions, France

and Germany often let the budget deficit exceed the 3 percent limit. This violation of the

stability pact compromises the fiscal discipline necessary for supporting the euro.

An empirical study by von Hagen and Neumann (1994) identified Austria,

Belgium, France, Luxembourg, the Netherlands, and Germany as nations that satisfy

the conditions for an optimum currency area. However, Denmark, Italy, and the United

Costs of Monetary Union

www.columbia.edu/~ram15

This homepage of Professor

Robert Mundell provides a

synopsis of his academic

works, Nobel lecture, etc.

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C H A P T E R 2 INTERNATIONAL MONETARY SYSTEM 47

International Bonds Population GDP Annual World Outstanding Economy (Million) ($ Trillion) Inflation Trade Share ($ Billion)

United States 314.8 15.6 2.4% 10.2% 7183.5 Euro zone 332.8 12.2 2.2% 14.1% 7636.7 Japan 127.5 5.9 20.3% 4.6% 474.1 United Kingdom 63.2 2.4 2.9% 3.1% 1187.0

a The inflation rate is the annual average from 1999–2012. The international bonds outstanding refer to international bonds and notes outstanding by December 2012 by currency of issue. The remaining data are 2012 figures.

Source: IMF, International Financial Statistics, European Commission Economic and Financial Affairs.

EXHIBIT 2.8

Macroeconomic Data for

Major Economies a

Kingdom do not. It is noted that Denmark and the United Kingdom actually chose

to stay out of the EMU. Von Hagen and Neumann’s study suggests that Italy joined

the EMU prematurely. It is interesting to note that some politicians in Italy blame the

country’s economic woes on the adoption of the euro and argue for the restoration of

Italian lira. The International Finance in Practice box, “Mundell Wins Nobel Prize in

Economics,” explains Professor Mundell’s view on the monetary union.

Will the euro survive and succeed in the long run? The first real test of the euro

will come when the euro zone experiences major asymmetric shocks. A successful

response to these shocks will require wage, price, and fiscal flexibility. A cautionary

note is in order: Asymmetric shocks can occur even within a country. In the United

States, for example, when oil prices jumped in the 1970s, oil-consuming regions such

as New England suffered a severe recession, whereas Texas, a major oil-producing

state, experienced a major boom. Likewise, in Italy, the highly industrialized Genoa–

Milan region and the southern Mezzogiorno, an underdeveloped region, can be in

very different phases of the business cycle. But these countries have managed their

economies with a common national monetary policy. Although asymmetric shocks are

no doubt more serious internationally, one should be careful not to exaggerate their

significance as an impediment to monetary union. In addition, since the advent of the

EMS in 1979, the EMU member countries have restricted their monetary policies in

order to maintain exchange rate stability in Europe. Considering that intra–euro zone

trade accounts for about 60 percent of foreign trade of the euro zone countries, benefits

from the EMU may exceed the associated costs. Furthermore, leaders in political and

business circles in Europe have invested substantial political capital in the success of

the euro. So long as Europe can resolve internal frictions and imbalances as revealed

in the Greek debt crisis, it seems safe to predict that the euro will survive. Despite the

bailout funds and austerity programs, however, if southern European countries, i.e.,

Greece, Portugal, and Spain, fail to reduce debts and restart economic growth in the

near future, they may reach the tipping point where people can no longer sustain job

loss and other economic pains and demand the exit from euro zone. Thus, the future of

the euro as the common currency critically depends on whether or not these countries

can find a way of growing their economies while retaining the euro. At the moment,

the jury is still out on this question.

Will the euro become a global currency rivaling the U.S. dollar? The U.S. dollar

has been the dominant global currency since the end of the First World War, replacing

the British pound as the currency of choice in international commercial and financial

transactions. Even after the dollar got off the gold anchor in 1971, it retained its domi-

nant position in the world economy. This dominance was possible because the dollar

was backed by the sheer size of the U.S. economy and the relatively sound monetary

policy of the Federal Reserve. Now, as can be seen from Exhibit 2.8 , the euro zone is

comparable to the United States in terms of population size, GDP, and international

Prospects of the Euro: Some Critical Questions

eun61604_ch02_027-061.indd 47eun61604_ch02_027-061.indd 47 1/3/14 10:14 AM1/3/14 10:14 AM

INTERNATIONAL FINANCE IN PRACTICE

Robert A. Mundell, one of the intellectual fathers of both the new European common currency and Reagan-era supply-side economics, won the Nobel Memorial Prize in Economic Science.

Mr. Mundell conducted innovative research into com- mon currencies when the idea of the euro, Europe’s new currency, was still a fantasy. The 66-year-old Columbia University professor, a native of Canada, also examined the implications of cross-border capital flows and flex- ible foreign-exchange rates when capital flows were still restricted and currencies still fixed to each other.

"Mundell chose his problems with uncommon— almost prophetic—accuracy in terms of predicting the future development of international monetary arrange- ments and capital markets,” the selection committee said in announcing the prize.

An eccentric, white-haired figure who once bought an abandoned Italian castle as a hedge against infla- tion, Mr. Mundell later became a hero of the economic Right with his dogged defense of the gold standard and early advocacy of the controversial tax-cutting, supply- side economics that became the hallmark of the Reagan administration.

While the Nobel committee sidestepped his political impact in awarding Mr. Mundell the $975,000 prize for his work in the 1960s, his conservative fans celebrated the award as an endorsement of supply-side thinking.

“I know it will take a little longer, but history even- tually will note that it was Mundell who made it pos- sible for Ronald Reagan to be elected president,” by providing the intellectual backing for the Reagan tax cuts, wrote conservative economist Jude Wanniski on his website.

Mr. Mundell’s advocacy of supply-side economics sprang from his work in the 1960s examining what fiscal

and monetary policies are appropriate if exchange rates are either fixed—as they were prior to the collapse of the gold-based Bretton Woods system in the early 1970s— or floating, as they are in the U.S. and many other coun- tries today.

One major finding has since become conventional wisdom: When money can move freely across borders, policy makers must choose between exchange-rate sta- bility and an independent monetary policy. They can’t have both.

Mundell Wins Nobel Prize in Economics

Mundell’s View

Great currencies and great powers according to Robert Mundell:

Country Period Greece 7th–3rd C. B.C. Persia 6th–4th C. B.C. Macedonia 4th–2nd C. B.C. Rome 2nd C. B.C.–4th C. Byzantium 5th–13th C. Franks 8th–11th C. Italian city states 13th–16th C. France 13th–18th C. Holland 17th–18th C. Germany (thaler) 14th–19th C. France (franc) 1803–1870 Britain (pound) 1820–1914 U.S. (dollar) 1915–present E.U. (euro) 1999

Source: The Euro and the Stability of the International Monetary System, Robert Mundell, Columbia University.

trade share. Exhibit 2.8 also shows that the euro is as important a denomination cur-

rency as the dollar in international bond markets. In contrast, the Japanese yen plays

an insignificant role in international bond markets. As previously discussed, there is

little doubt that the ECB will pursue a sound monetary policy. Reflecting both the size

of the euro zone economy and the mandate of the ECB, the euro is emerging as the

second global currency, challenging the dollar’s sole dominance. The Japanese yen is

likely to be a junior partner in the dollar–euro condominium. However, the emergence

of the euro as another global currency may prompt Japan and other Asian countries to

explore cooperative monetary arrangements for the region.

The Mexican Peso Crisis On December 20, 1994, the Mexican government under new president Ernesto Zedillo

announced its decision to devalue the peso against the dollar by 14 percent. This deci-

sion, however, touched off a stampede to sell pesos as well as Mexican stocks and

eun61604_ch02_027-061.indd 48eun61604_ch02_027-061.indd 48 1/3/14 5:20 PM1/3/14 5:20 PM

Mr. Mundell’s work has long had an impact on pol- icy makers. In 1962, he wrote a paper addressing the Kennedy administration’s predicament of how to spur the economy while facing a balance-of-payments deficit. “The only correct way to do it was to have a tax cut and then protect the balance of payments by tight money,” he recalled in a 1996 interview. The Kennedy administra- tion eventually came around to the same way of thinking.

Mr. Mundell traces the supply-side movement to a 1971 meeting of distinguished economists, including Paul Volcker and Paul Samuelson, at the Treasury Depart- ment. At the time, most economists were stumped by the onset of stagflation—a combination of inflationary pressures, a troubled dollar, a worsening balance of pay- ments and persistent unemployment. They thought any tightening of monetary or fiscal policy would bolster the dollar and improve the balance of payments, but worsen unemployment. An easing of monetary or fiscal policy might generate jobs, but weaken the dollar, lift prices and expand the balance-of-payments deficit.

Mr. Mundell suggested a heretical solution: Raise interest rates to protect the dollar, but cut taxes to spur the economy. Most others in the room were aghast at the idea, fearing tax cuts would lead to a swelling budget deficit—something many nonsupply-siders believe was exactly what happened during the Reagan years.

“I knew I was in the minority,” he said in an 1988 interview. “But I thought my vote should count much more than the others because I understood the subject.”

At the University of Chicago early in his career, Mr. Mundell befriended a student named Arthur Laffer, and together they were at the core of the supply-side movement. Even today, Mr. Mundell predicts similar pol- icies will be necessary to keep the U.S. economic expan- sion going. “Monetary policy isn’t going to be enough to stay up there and avoid a recession,” he said in an inter- view yesterday. “We’ll have to have tax reduction, too.”

While in Chicago, he found himself constantly at odds with Milton Friedman, who advocated monetary rules

and floating exchange rates. Mr. Mundell joined Colum- bia in 1974, two years before Mr. Friedman won the eco- nomics Nobel.

Ever the maverick, Mr. Mundell remains a fan of the gold standard and fixed exchange rates at a time when they’re out of favor with most other economists. “You have fixed rates between New York and California, and it works perfectly,” he said.

The Nobel committee also praised Mr. Mundell’s research into common currency zones, which laid the intellectual foundation for the 11-country euro. In 1961, when European countries still clung to their national cur- rencies, he described the circumstances in which nations could share a common currency.

“At the time, it just seemed like such a wacko thing to work on, and that’s why it’s so visionary,” said Kenneth Rogoff, a Harvard economist.

In particular, Mr. Mundell argued that in any success- ful currency zone, workers must be able to move freely from areas that are slowing to areas that are boom- ing. Some critics suggest the euro nations don’t fit his description.

But Mr. Mundell believes the new currency will even- tually challenge the dollar for global dominance. “The benefits will derive from transparency of pricing, stability of expectations and lower transactions costs, as well as a common monetary policy run by the best minds that Europe can muster,” Mr. Mundell wrote last year. He began working on the euro project as a consultant to European monetary authorities in 1969.

Outside academia, Mr. Mundell has led a colorful life. Worried about the onset of inflation in the late 1960s, he bought and renovated a 16th century Italian castle originally built for Pandolfo Petrucci, the “Strong Man of Siena.” Mr. Mundell has four children, who range in age from one to 40.

bonds. As Exhibit 2.9 shows, by early January 1995 the peso had fallen against the

U.S. dollar by as much as 40 percent, forcing the Mexican government to float the

peso. As concerned international investors reduced their holdings of emerging market

securities, the peso crisis rapidly spilled over to other Latin American and Asian finan-

cial markets.

Faced with an impending default by the Mexican government and the possibility of

a global financial meltdown, the Clinton administration, together with the International

Monetary Fund (IMF) and the Bank for International Settlement (BIS), put together

a $53 billion package to bail out Mexico. 8 As the bailout plan was put together and

announced on January 31, the world’s, as well as Mexico’s, financial markets began

to stabilize.

8 The United States contributed $20 billion out of its Exchange Stabilization Fund, whereas IMF and BIS

contributed, respectively, $17.8 billion and $10 billion. Canada, Latin American countries, and commercial

banks collectively contributed $5 billion.

eun61604_ch02_027-061.indd 49eun61604_ch02_027-061.indd 49 1/3/14 10:14 AM1/3/14 10:14 AM

50 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

The Mexican peso crisis is significant in that it is perhaps the first serious inter-

national financial crisis touched off by cross-border flight of portfolio capital. Inter-

national mutual funds are known to have invested more than $45 billion in Mexican

securities during a three-year period prior to the peso crisis. As the peso fell, fund

managers quickly liquidated their holdings of Mexican securities as well as other

emerging market securities. This had a highly destabilizing, contagious effect on the

world financial system.

As the world’s financial markets are becoming more integrated, this type of conta-

gious financial crisis is likely to occur more often. Two lessons emerge from the peso

crisis. First, it is essential to have a multinational safety net in place to safeguard the

world financial system from the peso-type crisis. No single country or institution can

handle a potentially global crisis alone. In addition, the usually slow and parochial

political processes cannot cope with rapidly changing market conditions. In fact, the

Clinton administration faced stiff opposition in Congress and from foreign allies when

it was working out a bailout package for Mexico. As a result, early containment of the

crisis was not possible. Fortunately, the G-7 countries endorsed a $50 billion bailout

fund for countries in financial distress, which would be administered by the IMF, and a

series of increased disclosure requirements to be followed by all countries. The reluc-

tance of the outgoing Salinas administration to disclose the true state of the Mexican

economy, that is, the rapid depletion of foreign exchange reserves and serious trade

deficits, contributed to the sudden collapse of the peso. Transparency always helps

prevent financial crises.

Second, Mexico excessively depended on foreign portfolio capital to finance its

economic development. In hindsight, the country should have saved more domesti-

cally and depended more on long-term rather than short-term foreign capital invest-

ments. As Professor Robert MacKinnon of Stanford University pointed out, a flood of

foreign money had two undesirable effects. It led to an easy credit policy on domestic

borrowings, which caused Mexicans to consume more and save less. 9 Foreign capital

influx also caused a higher domestic inflation and an overvalued peso, which hurt

Mexico’s trade balances.

9 See “Flood of Dollars, Sunken Pesos,” New York Times , January 20, 1995, p. A2g.

EXHIBIT 2.9

U.S. Dollar versus

Mexican Peso Exchange

Rate (November 1,

1994–January 31, 1995)

$0.30

$0.25

$0.20

$0.15

$0.10

$0.05

$0.00

1 /3

1 /9

D ol

la rs

p er

p es

1 /2

4 /9

1 /1

7 /9

1 /1

0 /9

1 /3

/9 5

1 2 /2

7 /9

1 2 /2

0 /9

1 2 /1

3 /9

1 2 /6

/9 4

1 1 /2

9 /9

1 1 /2

2 /9

1 1 /1

5 /9

1 1 /8

/9 4

1 1 /1

/9 4

eun61604_ch02_027-061.indd 50eun61604_ch02_027-061.indd 50 1/3/14 10:14 AM1/3/14 10:14 AM

C H A P T E R 2 INTERNATIONAL MONETARY SYSTEM 51

The Asian Currency Crisis On July 2, 1997, the Thai baht, which had been largely fixed to the U.S. dollar, was

suddenly devalued. What at first appeared to be a local financial crisis in Thailand

quickly escalated into a global financial crisis, first spreading to other Asian

countries—Indonesia, Korea, Malaysia, and the Philippines—then far afield to Russia

and Latin America, especially Brazil. As can be seen from Exhibit 2.10 , at the height

of the crisis the Korean won fell by about 50 percent in its dollar value from its precri-

sis level, whereas the Indonesian rupiah fell an incredible 80 percent.

The 1997 Asian crisis was the third major currency crisis of the 1990s, preceded

by the crises of the European Monetary System (EMS) of 1992 and the Mexican peso

in 1994–95. The Asian crisis, however, turned out to be far more serious than its two

predecessors in terms of the extent of contagion and the severity of resultant economic

and social costs. Following the massive depreciations of local currencies, financial

institutions and corporations with foreign-currency debts in the afflicted countries

were driven to extreme financial distress and many were forced to default. What’s

worse, the currency crisis led to an unprecedentedly deep, widespread, and long-lasting

recession in East Asia, a region that, for the last few decades, has enjoyed the most

rapidly growing economy in the world. At the same time, many lenders and inves-

tors from the developed countries also suffered large capital losses from their invest-

ments in emerging-market securities. For example, Long Term Capital Management

(LTCM), one of the largest and, until then, profitable hedge funds, experienced a near

bankruptcy due to its exposure to Russian bonds. In mid-August 1998, the Russian

ruble fell sharply from 6.3 rubles per dollar to about 20 rubles per dollar. The prices

of Russian stocks and bonds also fell sharply. The Federal Reserve System, which

feared a domino-like systemic financial failure in the United States, orchestrated a

$3.5 billion bailout of LTCM in September 1998.

Given the global effects of the Asian currency crisis and the challenges it poses for

the world financial system, it would be useful to understand its origins and causes and

discuss how similar crises might be prevented in the future.

EXHIBIT 2.10

Asian Currency Crisis

Exchange rates are indexed (U.S. $/Asian currency on 4/2/97 100). Exchange rates on 4/2/97: 0.00112 U.S. $/ Korean won, 0.03856 U.S. $/Thai baht, and 0.00041 U.S. $/Indonesian rupiah.

120.0

100.0

80.0

60.0

40.0

20.0

0.0

Indonesian Rupiah

Thai Baht

Korean Won

4 /2

/9 7

4 /1

6 /9

4 /3

0 /9

5 /1

4 /9

5 /2

8 /9

6 /1

1 /9

6 /2

5 /9

7 /9

/9 7

7 /2

3 /9

8 /6

/9 7

8 /2

0 /9

9 /3

/9 7

9 /1

7 /9

1 0 /1

/9 7

1 0 /1

5 /9

1 0 /2

9 /9

1 1 /1

2 /9

1 1 /2

6 /9

1 2 /1

0 /9

1 2 /2

4 /9

1 /7

/9 8

1 /2

1 /9

2 /4

/9 8

2 /1

8 /9

C ur

re nc

y in

de x

(U .S

. $ /A

si an

c ur

re nc

eun61604_ch02_027-061.indd 51eun61604_ch02_027-061.indd 51 1/3/14 10:14 AM1/3/14 10:14 AM

52 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

Several factors are responsible for the onset of the Asian currency crisis: a weak

domestic financial system, free international capital flows, the contagion effects of

changing market sentiment, and inconsistent economic policies. In recent decades,

both developing and developed countries were encouraged to liberalize their financial

markets and allow free flows of capital across countries. As capital markets were liber-

alized, both firms and financial institutions in the Asian developing countries eagerly

borrowed foreign currencies from U.S., Japanese, and European investors, who were

attracted to these fast-growing emerging markets for extra returns for their portfolios.

In 1996 alone, for example, five Asian countries—Indonesia, Korea, Malaysia, the

Philippines, and Thailand—experienced an inflow of private capital worth $93 billion.

In contrast, there was a net outflow of $12 billion from the five countries in 1997.

Large inflows of private capital resulted in a credit boom in the Asian countries

in the early and mid-1990s. The credit boom was often directed to speculations in

real estate and stock markets as well as to investments in marginal industrial projects.

Fixed or stable exchange rates also encouraged unhedged financial transactions and

excessive risk-taking by both lenders and borrowers, who were not much concerned

with exchange risk. As asset prices declined (as happened in Thailand prior to the cur-

rency crisis) in part due to the government’s effort to control the overheated economy,

the quality of banks’ loan portfolios also declined as the same assets were held as

collateral for the loans. Clearly, banks and other financial institutions in the afflicted

countries practiced poor risk management and were poorly supervised. In addition,

their lending decisions were often influenced by political considerations, likely lead-

ing to suboptimal allocation of resources. However, the so-called crony capitalism

was not a new condition, and the East Asian economies achieved an economic miracle

under the same system.

Meanwhile, the booming economy with a fixed or stable nominal exchange rate

inevitably brought about an appreciation of the real exchange rate. This, in turn, resulted

in a marked slowdown in export growth in such Asian countries as Thailand and Korea.

In addition, a long-lasting recession in Japan and the yen’s depreciation against the dol-

lar hurt Japan’s neighbors, further worsening the trade balances of the Asian developing

countries. If the Asian currencies had been allowed to depreciate in real terms, which

was not possible because of the fixed nominal exchange rates, such catastrophic, sud-

den changes of the exchange rates as observed in 1997 might have been avoided.

In Thailand, as the run on the baht started, the Thai central bank initially injected

liquidity to the domestic financial system and tried to defend the exchange rate by

drawing on its foreign exchange reserves. With its foreign reserves declining rapidly,

the central bank eventually decided to devalue the baht. The sudden collapse of the

baht touched off a panicky flight of capital from other Asian countries with a high

degree of financial vulnerability. It is interesting to note from Exhibit 2.11 that the

three Asian countries hardest hit by the crisis are among the most financially vulner-

able as measured by (i) the ratio of short-term foreign debts to international reserve

and (ii) the ratio of broad money, M2 (which represents the banking sector’s liabilities)

to international reserve. Contagion of the currency crisis was caused at least in part

by the panicky, indiscriminate flight of capital from the Asian countries for fear of a

spreading crisis. Fear thus became self-fulfilling. As lenders withdrew their capital and

refused to renew short-term loans, the former credit boom turned into a credit crunch,

hurting creditworthy as well as marginal borrowers.

As the crisis unfolded, the International Monetary Fund (IMF) came to rescue

the three hardest-hit Asian countries—Indonesia, Korea, and Thailand—with bailout

plans. As a condition for the bailing out, however, the IMF imposed a set of austerity

measures, such as raising domestic interest rates and curtailing government expen-

ditures, that were designed to support the exchange rate. Since these austerity mea-

sures, contractionary in nature, were implemented when the economies had already

been contracting because of a severe credit crunch, the Asian economies consequently

Origins of the Asian Currency Crisis

eun61604_ch02_027-061.indd 52eun61604_ch02_027-061.indd 52 1/3/14 10:14 AM1/3/14 10:14 AM

C H A P T E R 2 INTERNATIONAL MONETARY SYSTEM 53

suffered a deep, long-lasting recession. According to a World Bank report (1999), one-

year declines in industrial production of 20 percent or more in Thailand and Indonesia

are comparable to those in the United States and Germany during the Great Depres-

sion. One can thus argue that the IMF initially prescribed the wrong medicine for

the afflicted Asian economies. The IMF bailout plans were also criticized on another

ground: moral hazard. IMF bailouts may breed dependency in developing countries

and encourage risk-taking on the part of international lenders. There is a sentiment that

taxpayers’ money should not be used to bail out “fat-cat” investors. Former U.S. sena-

tor Lauch Faircloth was quoted as saying: “Through the IMF we have privatized profits

and socialized losses.” No bailout, however, can be compared with the proposal to get

rid of the only fire department in town so that people will be more careful about fire.

Generally speaking, liberalization of financial markets when combined with a weak,

underdeveloped domestic financial system tends to create an environment susceptible to

currency and financial crises. Interestingly, both Mexico and Korea experienced a major

currency crisis within a few years after joining the OECD, which required a signifi-

cant liberalization of financial markets. It seems safe to recommend that countries first

strengthen their domestic financial system and then liberalize their financial markets.

A number of measures can and should be undertaken to strengthen a nation’s domes-

tic financial system. Among other things, the government should strengthen its system

of financial-sector regulation and supervision. One way of doing so is to sign on to the

“Core Principle of Effective Banking Supervision” drafted by the Basle Committee

on Banking Supervision and to monitor its compliance with the principle. In addition,

banks should be encouraged to base their lending decisions solely on economic merits

rather than political considerations. Furthermore, firms, financial institutions, and the

government should be required to provide the public with reliable financial data in a

timely fashion. A higher level of disclosure of financial information and the resultant

transparency about the state of the economy will make it easier for all the concerned

parties to monitor the situation better and mitigate the destabilizing cycles of investor

euphoria and panic accentuated by the lack of reliable information.

Lessons from the Asian Currency Crisis

www.adb.org

Provides a broad coverage of

Asian financial developments.

Financial Vulnerability

Indicators

Source: The World Bank, International Monetary Fund.

EXHIBIT 2.11

700

600

500

400

300

200

100

June 1997

0 25050 200150100

KoreaIndonesia

Thailand Mexico

Argentina Russia Brazil

Philippines

Malaysia

Colombia Chile

Peru

R at

io o

f M

2 to

in te

rn at

io na

l r es

er ve

s (%

)

Ratio of short-term debt to international reserves (%)

eun61604_ch02_027-061.indd 53eun61604_ch02_027-061.indd 53 1/3/14 10:14 AM1/3/14 10:14 AM

54 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

Even if a country decides to liberalize its financial markets by allowing cross-border

capital flows, it should encourage foreign direct investments and equity and long-term

bond investments; it should not encourage short-term investments that can be reversed

overnight, causing financial turmoil. As Chile has successfully implemented, some

form of “ Tobin tax” on the international flow of hot money can be useful. Throwing

some sand in the wheels of international finance can have a stabilizing effect on the

world’s financial markets.

A fixed but adjustable exchange rate is problematic in the face of integrated inter-

national financial markets. Such a rate arrangement often invites speculative attack at

the time of financial vulnerability. Countries should not try to restore the same fixed

exchange rate system unless they are willing to impose capital controls. According

to the so-called “trilemma” that economists are fond of talking about, a country can

attain only two of the following three conditions: (i) a fixed exchange rate, (ii) free

international flows of capital, and (iii) an independent monetary policy. It is very dif-

ficult, if not impossible, to have all three conditions. This difficulty is also known as

the incompatible trinity . If a country would like to maintain monetary policy inde-

pendence to pursue its own domestic economic goals and still would like to keep a

fixed exchange rate between its currency and other currencies, then the country should

restrict free flows of capital. China and India were not noticeably affected by the Asian

currency crisis because both countries maintain capital controls, segmenting their cap-

ital markets from the rest of the world. Hong Kong was less affected by the crisis for

a different reason. Hong Kong has firmly fixed its exchange rate to the U.S. dollar

via a currency board and allowed free flows of capital; in consequence, Hong Kong

gave up its monetary independence. A currency board is an extreme form of the fixed

exchange rate regime under which local currency is “fully” backed by the dollar (or

another chosen standard currency). Hong Kong has essentially dollarized its economy.

As previously mentioned, China maintained a fixed exchange rate between its cur-

rency, renminbi (RMB), otherwise known as the yuan, and the U.S. dollar at 8.27

RMB per dollar for a long while. As can be seen from Exhibit 2.12 , however, the RMB

was allowed to appreciate from mid-July 2005 for about three years before it reverted

back to a (quasi-) fixed rate at around 6.82RMB per dollar in mid-July 2008. This

reversion is attributable to the heightened economic uncertainty associated with the

global financial crisis. But from late June 2010, RMB began to float again. The latest

floating decision is related to the mounting pressure from China’s trading partners for

a stronger RMB as a way of reducing their trade deficits vis-à-vis China. But it is also

Source: Bloomberg.

EXHIBIT 2.12

Renminbi (RMB) versus

U.S. Dollar Exchange

Rate

R M

B /$

( in

ve rt

ed s

ca le

)

2 0 0 1

2 0 0 0

9.0

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 1 1

2 0 1 2

2 0 1 3

8.5

8.0

7.5

7.0

6.5

6.0

5.5

eun61604_ch02_027-061.indd 54eun61604_ch02_027-061.indd 54 1/3/14 10:14 AM1/3/14 10:14 AM

C H A P T E R 2 INTERNATIONAL MONETARY SYSTEM 55

related to China’s own broad move toward liberalized capital markets. In recent years,

China has been gradually lowering barriers to international capital flows. At the same

time, China has been promoting a greater usage of the RMB in international transac-

tions, with the long-term goal of establishing the RMB as a major global currency

like the U.S. dollar. Considering the large transactions domain of the RMB, measured

in terms of population, GDP, or international trade share, China’s currency has the

potential to become a global currency. However, for the RMB to become a full-fledged

global currency, China will need to meet a few critical, related conditions, such as

(i) full convertibility of its currency, (ii) open capital markets with depth and liquidity,

and (iii) the rule of law and protection of property rights. Note that the United States

and euro zone satisfy these conditions.

The Argentine Peso Crisis The 2002 crisis of the Argentine peso, however, shows that even a currency board

arrangement cannot be completely safe from a possible collapse. Exhibit 2.13 shows

how the peso–dollar exchange rate, fixed at parity throughout much of the 1990s, col-

lapsed in January 2002. Short of a complete dollarization (as is the case with Panama,

for example), a currency board arrangement can collapse unless the arrangement is

backed by the political will and economic discipline to defend it.

When the peso was first linked to the U.S. dollar at parity in February 1991 under

the Convertibility Law, initial economic effects were quite positive: Argentina’s

chronic inflation was curtailed dramatically and foreign investment began to pour in,

leading to an economic boom. Over time, however, the peso appreciated against the

majority of currencies as the U.S. dollar became increasingly stronger in the second

half of the 1990s. A strong peso hurt exports from Argentina and caused a protracted

economic downturn that eventually led to the abandonment of the peso–dollar parity

in January 2002. This change, in turn, caused severe economic and political distress

in the country. The unemployment rate rose above 20 percent and inflation reached a

monthly rate of about 20 percent in April 2002. In contrast, Hong Kong was able to

successfully defend its currency board arrangement during the Asian financial crisis, a

major stress test for the arrangement.

Although there is no clear consensus on the causes of the Argentine crisis, there are at

least three factors that are related to the collapse of the currency board system and ensu-

ing economic crisis: (i) the lack of fiscal discipline, (ii) labor market inflexibility, and

EXHIBIT 2.13

Collapse of the Currency

Board Arrangement in

Argentina

Source: Bloomberg.

5.0

4.0

3.0

2.0

P es

o pe

r U

.S . d

ol la

1.0

0.0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Peso/$ = 1.00

January 17, 2002

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56 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

(iii) contagion from the financial crises in Russia and Brazil. Reflecting the traditional

sociopolitical divisions in the Argentine society, competing claims on economic resources

by different groups were accommodated by increasing public sector indebtedness.

Argentina is said to have a “European-style welfare system in a Third World economy.”

The federal government of Argentina borrowed heavily in dollars throughout the 1990s.

As the economy entered a recession in the late 1990s, the government encountered

increasing difficulty with rising debts, eventually defaulting on its internal and external

debts. The hard fixed exchange rate that Argentina adopted under the currency board

system made it impossible to restore competitiveness by a traditional currency deprecia-

tion. Further, a powerful labor union also made it difficult to lower wages and thus cut

production costs that could have effectively achieved the same real currency depreciation

with the fixed nominal exchange rate. The situation was exacerbated by a slowdown of

international capital inflows following the financial crises in Russia and Brazil. Also, a

sharp depreciation of the Brazil real in 1999 hampered exports from Argentina.

While the currency crisis is over, the debt problem has not been completely

resolved. The government of Argentina ceased all debt payments in December 2001

in the wake of persistent recession and rising social and political unrest. It represents

the largest sovereign default in history. Argentina faces a complex task of restructuring

over $100 billion borrowed in seven different currencies and governed by the laws of

eight legal jurisdictions. In June 2004, the Argentine government made a “final” offer

amounting to a 75 percent reduction in the net present value of the debt. Foreign bond-

holders rejected this offer and asked for an improved offer. In early 2005, bondholders

finally agreed to the restructuring, under which they took a cut of about 70 percent on

the value of their bond holdings.

Fixed versus Flexible Exchange Rate Regimes Since some countries, including the United States, the United Kingdom, and possi-

bly Japan, prefer flexible exchange rates, while others, notably the members of the

EMU and many developing countries, would like to maintain fixed exchange rates,

it is worthwhile to examine some of the arguments advanced in favor of fixed versus

flexible exchange rates.

The key arguments for flexible exchange rates rest on (i) easier external adjustments

and (ii) national policy autonomy. Suppose a country is experiencing a balance-of-

payments deficit at the moment. This means that there is an excess supply of the coun-

try’s currency at the prevailing exchange rate in the foreign exchange market. Under a

flexible exchange rate regime, the external value of the country’s currency will simply

depreciate to the level at which there is no excess supply of the country’s currency. At

the new exchange rate level, the balance-of-payments disequilibrium will disappear.

As long as the exchange rate is allowed to be determined according to market forces,

external balance will be achieved automatically. Consequently, the government does

not have to take policy actions to correct the balance-of-payments disequilibrium. With

flexible exchange rates, therefore, the government can use its monetary and fiscal poli-

cies to pursue whatever economic goals it chooses. Under a fixed rate regime, however,

the government may have to take contractionary (expansionary) monetary and fiscal

policies to correct the balance-of-payments deficit (surplus) at the existing exchange

rate. Since policy tools need to be committed to maintaining the exchange rate, the

government cannot use the same policy tools to pursue other economic objectives. As

a result, the government loses its policy autonomy under a fixed exchange rate regime.

Using the British pound as the representative foreign exchange, Exhibit 2.14 illus-

trates the preceding discussion on how the balance-of-payment disequilibrium is cor-

rected under alternative exchange rate regimes. Note that in Exhibit 2.14 , the dollar

price of the British pound, which is the exchange rate, is measured vertically, whereas

the quantity of British pounds demanded or supplied at different exchange rates is

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C H A P T E R 2 INTERNATIONAL MONETARY SYSTEM 57

measured horizontally. As is the case with most other commodities, the demand for

British pounds would be downward sloping, whereas the supply of British pounds

would be upward sloping. Suppose that the exchange rate is $1.60/£ at the moment.

As can be seen from the exhibit, the demand for British pounds far exceeds the sup-

ply (i.e., the supply of U.S. dollars far exceeds the demand) at this exchange rate. The

United States experiences trade (or balance of payment) deficits. Under the flexible

exchange rate regime, the dollar will simply depreciate to a new level of exchange rate,

$1.80/£, at which the excess demand for British pounds (and thus the trade deficit)

will disappear. Now, suppose that the exchange rate is “fixed” at $1.60/£, and thus the

excess demand for British pounds cannot be eliminated by the exchange rate adjust-

ment. Facing this situation, the U.S. Federal Reserve Bank may initially draw on its

foreign exchange reserve holdings to satisfy the excess demand for British pounds.

If the excess demand persists, however, the U.S. government may have to resort to

contractionary monetary and fiscal policies so that the demand curve can shift to the

left (from D to D* in the exhibit) until the excess demand for British pounds can be

eliminated at the fixed exchange rate, $1.60/£. In other words, it is necessary for the

government to take policy actions to maintain the fixed exchange rate.

A possible drawback of the flexible exchange rate regime is that exchange rate

uncertainty may hamper international trade and investment. Proponents of the fixed

exchange rate regime argue that when future exchange rates are uncertain, businesses

tend to shun foreign trade. Since countries cannot fully benefit from international

trade under exchange rate uncertainty, resources will be allocated suboptimally on a

global basis. Proponents of the fixed exchange rate regime argue that fixed exchange

rates eliminate such uncertainty and thus promote international trade. However, to the

extent that firms can hedge exchange risk by means of currency forward or options

contracts, uncertain exchange rates do not necessarily hamper international trade.

As the preceding discussion suggests, the choice between the alternative exchange

rate regimes is likely to involve a trade-off between national policy independence and

international economic integration. If countries would like to pursue their respective

domestic economic goals, they are likely to pursue divergent macroeconomic policies,

rendering fixed exchange rates infeasible. On the other hand, if countries are commit-

ted to promoting international economic integration (as is the case with the core mem-

bers of the European Union like France and Germany), the benefits of fixed exchange

rates are likely to outweigh the associated costs.

EXHIBIT 2.14

External Adjustment

Mechanism: Fixed versus

Flexible Exchange Rates

$1.80

$1.60

0 S D = S D

Quantity of British pounds

D ol

la r

pr ic

e pe

r po

un d

(e xc

ha ng

e ra

te )

Contractionary policies (fixed regime)

Dollar depreciates (flexible regime)

Demand (D*)

Demand (D)

Trade deficit

Supply (S)

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58 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT w

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A “good” (or ideal) international monetary system should provide (i) liquidity,

(ii) adjustment, and (iii) confidence. In other words, a good IMS should be able to

provide the world economy with sufficient monetary reserves to support the growth of

international trade and investment. It should also provide an effective mechanism that

restores the balance-of-payments equilibrium whenever it is disturbed. Lastly, it should

offer a safeguard to prevent crises of confidence in the system that result in panicked

flights from one reserve asset to another. Politicians and economists should keep these

three criteria in mind when they design and evaluate the international monetary system.

SUMMARY This chapter provides an overview of the international monetary system, which

defines an environment in which multinational corporations and international inves-

tors operate.

1. The international monetary system can be defined as the institutional framework

within which international payments are made, the movements of capital are

accommodated, and exchange rates among currencies are determined.

2. The international monetary system went through five stages of evolution:

(a) bimetallism, (b) classical gold standard, (c) interwar period, (d) Bretton Woods

system, and (e) flexible exchange rate regime.

3. The classical gold standard spanned 1875 to 1914. Under the gold standard, the

exchange rate between two currencies is determined by the gold contents of the

currencies. Balance-of-payments disequilibrium is automatically corrected

through the price-specie-flow mechanism. The gold standard still has ardent sup-

porters who believe that it provides an effective hedge against price inflation.

Under the gold standard, however, the world economy can be subject to deflation-

ary pressure due to the limited supply of monetary gold.

4. To prevent the recurrence of economic nationalism with no clear “rules of the

game” witnessed during the interwar period, representatives of 44 nations met at

Bretton Woods, New Hampshire, in 1944 and adopted a new international mon-

etary system. Under the Bretton Woods system, each country established a par

value in relation to the U.S. dollar, which was fully convertible to gold. Countries

used foreign exchanges, especially the U.S. dollar, as well as gold as international

means of payments. The Bretton Woods system was designed to maintain stable

exchange rates and economize on gold. The Bretton Woods system eventually

collapsed in 1973 mainly because of U.S. domestic inflation and the persistent

balance-of-payments deficits.

5. The flexible exchange rate regime that replaced the Bretton Woods system was

ratified by the Jamaica Agreement. Following a spectacular rise and fall of the

U.S. dollar in the 1980s, major industrial countries agreed to cooperate to achieve

greater exchange rate stability. The Louvre Accord of 1987 marked the incep-

tion of the managed-float system under which the G-7 countries would jointly

intervene in the foreign exchange market to correct over- or undervaluation of

currencies.

6. In 1979, the EEC countries launched the European Monetary System (EMS) to

establish a “zone of monetary stability” in Europe. The two main instruments of

the EMS are the European Currency Unit (ECU) and the Exchange Rate Mecha-

nism (ERM). The ECU is a basket currency comprising the currencies of the EMS

members and serves as the accounting unit of the EMS. The ERM refers to the

procedure by which EMS members collectively manage their exchange rates. The

ERM is based on a parity grid that the member countries are required to maintain.

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C H A P T E R 2 INTERNATIONAL MONETARY SYSTEM 59

7. On January 1, 1999, 11 European countries, including France and Germany,

adopted a common currency called the euro. Greece adopted the euro in 2001.

Subsequently, five other countries—Cyprus, Malta, Slovakia, Slovenia, and

Estonia—adopted the euro. The advent of a single European currency, which

may eventually rival the U.S. dollar as a global vehicle currency, will have major

implications for the European as well as world economy. Euro zone countries will

benefit from reduced transaction costs and the elimination of exchange rate uncer-

tainty. The advent of the euro will also help develop continentwide capital markets

where companies can raise capital at favorable rates.

8. Under the European Monetary Union (EMU), the common monetary policy

for the euro zone countries is formulated by the European Central Bank (ECB)

located in Frankfurt. The ECB is legally mandated to maintain price stability in

Europe. Together with the ECB, the national central banks of the euro zone coun-

tries form the Eurosystem, which is responsible for defining and implementing the

common monetary policy for the EMU.

9. While the core EMU members, including France and Germany, apparently prefer

the fixed exchange rate regime, other major countries such as the United States

and Japan are willing to live with flexible exchange rates. Under the flexible

exchange rate regime, governments can retain policy independence because the

external balance will be achieved by the exchange rate adjustments rather than by

policy intervention. Exchange rate uncertainty, however, can potentially hamper

international trade and investment. The choice between the alternative exchange

rate regimes is likely to involve a trade-off between national policy autonomy and

international economic integration.

KEY WORDS bimetallism, 28

Bretton Woods system, 31

currency board, 36

euro, 27

European Central Bank

(ECB), 43

European Currency Unit

(ECU), 41

European Monetary

System (EMS), 41

European Monetary

Union (EMU), 43

Exchange Rate

Mechanism (ERM), 41

Eurosystem, 44

gold-exchange

standard, 32

gold standard, 28

Gresham’s law, 28

incompatible trinity, 54

international monetary

system, 27

Jamaica Agreement, 34

Louvre Accord, 35

Maastricht Treaty, 41

managed-float system, 35

optimum currency

areas, 46

par value, 31

Plaza Accord, 35

price-specie-flow

mechanism, 30

Smithsonian

Agreement, 34

snake, 41

special drawing rights

(SDRs), 32

sterilization of gold, 30

“Tobin tax,” 54

Triffin paradox, 32

1. Explain Gresham’s law.

2. Explain the mechanism that restores the balance-of-payments equilibrium when it

is disturbed under the gold standard.

3. Suppose that the pound is pegged to gold at 6 pounds per ounce, whereas the

franc is pegged to gold at 12 francs per ounce. This, of course, implies that the

equilibrium exchange rate should be two francs per pound. If the current market

exchange rate is 2.2 francs per pound, how would you take advantage of this situ-

ation? What would be the effect of shipping costs?

4. Discuss the advantages and disadvantages of the gold standard.

5. What were the main objectives of the Bretton Woods system?

QUESTIONS w

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e 60 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

6. Comment on the proposition that the Bretton Woods system was programmed to

an eventual demise.

7. Explain how special drawing rights (SDRs) are constructed. Also, discuss the cir-

cumstances under which the SDRs were created.

8. Explain the arrangements and workings of the European Monetary System (EMS).

9. There are arguments for and against the alternative exchange rate regimes.

a. List the advantages of the flexible exchange rate regime.

b. Criticize the flexible exchange rate regime from the viewpoint of the propo-

nents of the fixed exchange rate regime.

c. Rebut the above criticism from the viewpoint of the proponents of the flexible

exchange rate regime.

10. In an integrated world financial market, a financial crisis in a country can be

quickly transmitted to other countries, causing a global crisis. What kind of mea-

sures would you propose to prevent the recurrence of an Asia-type crisis?

11. Discuss the criteria for a “good” international monetary system.

12. Once capital markets are integrated, it is difficult for a country to maintain a fixed

exchange rate. Explain why this may be so.

13. Assess the possibility for the euro to become another global currency rivaling the

U.S. dollar. If the euro really becomes a global currency, what impact will it have

on the U.S. dollar and the world economy?

1. Using the data from http://federalreserve.gov/releases/h10/hist , first plot the

monthly exchange rate between the euro and the U.S. dollar since January 2000,

and try to explain why the exchange rate behaved the way it did.

INTERNET EXERCISES

WWW

MINI CASE Will the United Kingdom Join the Euro Club?

When the euro was introduced in January 1999, the United Kingdom was conspic- uously absent from the list of European countries adopting the common currency. Although the previous Labour government led by Prime Minister Tony Blair appeared to be in favor of joining the euro club, the current Tory goverment is not in favor of adopting the euro and thus giving up monetary sovereignty of the country. Public opinion is also divided on the issue.

Whether the United Kingdom will eventually join the euro club is a matter of con- siderable importance for the future of the European Union as well as that of the United Kingdom. If the United Kingdom, with its sophisticated finance industry, joins, it will most certainly propel the euro into a global currency status rivaling the U.S. dollar. The United Kingdom for its part will firmly join the process of economic and political unionization of Europe, abandoning its traditional balancing role.

Investigate the political, economic, and historical situations surrounding British participation in the European economic and monetary integration and write your own assessment of the prospect of Britain joining the euro club. In doing so, assess from the British perspective, among other things, (i) potential benefits and costs of adopt- ing the euro, (ii) economic and political constraints facing the country, and (iii) the potential impact of British adoption of the euro on the international financial system, including the role of the U.S. dollar.

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C H A P T E R 2 INTERNATIONAL MONETARY SYSTEM 61

REFERENCES & SUGGESTED READINGS

Bris, Arturo, Yrjö Koskinen, and Mattias Nilsson. The Euro and Corporate Valuation. Working Paper

(2004).

Chinn, Menzie, and Jeffrey Frankel. “Why the Euro Will Rival the Dollar,” International Finance

11 (2008), pp. 49–73.

Cooper, Richard N. The International Monetary System: Essays in World Economics . Cambridge,

Mass.: MIT Press, 1987.

Eichengreen, Barry. The Gold Standard in Theory and History . Methuen: London, 1985, pp. 39–48.

Eichengreen, Barry. Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the Inter- national Monetary System . Oxford University Press, 2011.

Friedman, Milton. Essays in Positive Economics . Chicago: University of Chicago Press, 1953.

Jorion, Philippe. “Properties of the ECU as a Currency Basket.” Journal of Multinational Financial Management 1 (1991), pp. 1–24.

Machlup, Fritz. Remaking the International Monetary System: The Rio Agreement and Beyond .

Baltimore: Johns Hopkins Press, 1968.

Mundell, Robert. “A Theory of Optimum Currency Areas.” American Economic Review 51 (1961),

pp. 657–65.

———. “Currency Areas, Volatility and Intervention,” Journal of Policy Modeling 22 (2000),

pp. 281–99.

Nurkse, Ragnar. International Currency Experience: Lessons of the Interwar Period . Geneva:

League of Nations, 1944.

Obstfeld, Maurice, Jay Shambaugh, and Alan Taylor. “The Trilemma in History: Tradeoffs among

Exchange Rates, Monetary Policies, and Capital Mobility.” Review of Economics and Statistics .

87 (2005), pp. 423–38.

Solomon, Robert. The International Monetary System , 1945–1981 . New York: Harper & Row, 1982.

Stiglitz, Joseph. “Reforming the Global Economic Architecture: Lessons from Recent Crisis.”

Journal of Finance 54 (1999), pp. 1508–21.

Tobin, James. “Financial Globalization,” Unpublished manuscript presented at American Philosophi-

cal Society, 1998.

Triffin, Robert. Gold and the Dollar Crisis . New Haven, Conn.: Yale University Press, 1960.

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C H

A P

T E

R O

U T

L IN

THE TERM balance of payments is often mentioned in the

news media and continues to be a popular subject of economic

and political discourse around the world. It is not always clear,

however, exactly what is meant by the term when it is mentioned

in various contexts. This ambiguity is often attributable to mis-

understanding and misuse of the term. The balance of payments,

which is a statistical record of a country’s transactions with the

rest of the world, is worth studying for a few reasons.

First, the balance of payments provides detailed information

concerning the demand and supply of a country’s currency. For

example, if the United States imports more than it exports, then this

means that the supply of dollars is likely to exceed the demand in

the foreign exchange market, ceteris paribus . One can thus infer

that the U.S. dollar would be under pressure to depreciate against

other currencies. On the other hand, if the United States exports

more than it imports, then the dollar would be likely to appreciate.

Second, a country’s balance-of-payment data may signal its

potential as a business partner for the rest of the world. If a coun-

try is grappling with a major balance-of-payment difficulty, it may

not be able to expand imports from the outside world. Instead, the

country may be tempted to impose measures to restrict imports

and discourage capital outflows in order to improve the balance-

of-payment situation. On the other hand, a country experiencing

a significant balance-of-payment surplus would be more likely to

expand imports, offering marketing opportunities for foreign enterprises, and less likely

to impose foreign exchange restrictions.

Third, balance-of-payments data can be used to evaluate the performance of the coun-

try in international economic competition. Suppose a country is experiencing trade defi-

cits year after year. This trade data may then signal that the country’s domestic industries

lack international competitiveness. To interpret balance-of-payments data properly, it is

necessary to understand how the balance-of-payments account is constructed.

Balance-of-Payments Accounting The balance of payments can be formally defined as the statistical record of a coun- try’s international transactions over a certain period of time presented in the form of double-entry bookkeeping. Examples of international transactions include import

and export of goods and services and cross-border investments in businesses, bank

accounts, bonds, stocks, and real estate. Since the balance of payments is recorded

over a certain period of time (i.e., a quarter or a year), it has the same time dimension

as national income accounting. 1

CHAPTER

Balance of Payments 3 Balance-of-Payments Accounting Balance-of-Payments Accounts

The Current Account

The Capital Account

Statistical Discrepancy

Official Reserve Account

The Balance-of-Payments Identity Balance-of-Payments Trends in Major Countries Summary Key Words Questions Problems Internet Exercises MINI CASE: Mexico’s Balance-of-Payments

Problem

References and Suggested Readings APPENDIX 3A: The Relationship Between

Balance of Payments and National Income Accounting

1 In fact, the current account balance, which is the difference between a country’s exports and imports, is a component

of the country’s GNP. Other components of GNP include consumption and investment and government expenditure.

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Generally speaking, any transaction that results in a receipt from foreigners

will be recorded as a credit, with a positive sign, in the U.S. balance of payments,

whereas any transaction that gives rise to a payment to foreigners will be recorded

as a debit, with a negative sign. Credit entries in the U.S. balance of payments result

from foreign sales of U.S. goods and services, goodwill, financial claims, and real

assets. Debit entries, on the other hand, arise from U.S. purchases of foreign goods

and services, goodwill, financial claims, and real assets. Further, credit entries give

rise to the demand for dollars, whereas debit entries give rise to the supply of dollars.

Note that the demand (supply) for dollars is associated with the supply (demand) of

foreign exchange.

Since the balance of payments is presented as a system of double-entry book-

keeping, every credit in the account is balanced by a matching debit and vice

versa.

EXAMPLE 3.1

For example, suppose that Boeing Corporation exported a Boeing 747 aircraft to

Japan Airlines for $50 million, and that Japan Airlines pays from its dollar bank

account kept with Chase Manhattan Bank in New York City. Then, the receipt

of $50 million by Boeing will be recorded as a credit (+), which will be matched

by a debit (−) of the same amount representing a reduction of the U.S. bank’s

liabilities.

EXAMPLE 3.2

Suppose, for another example, that Boeing imports jet engines produced by Rolls-

Royce for $30 million, and that Boeing makes payment by transferring the funds

to a New York bank account kept by Rolls-Royce. In this case, payment by Boeing

will be recorded as a debit (−), whereas the deposit of the funds by Rolls-Royce will

be recorded as a credit (+).

As shown by the preceding examples, every credit in the balance of payments

is matched by a debit somewhere to conform to the principle of double-entry

bookkeeping.

Not only international trade, that is, exports and imports, but also cross-border

investments are recorded in the balance of payments.

EXAMPLE 3.3

Suppose that Thomson Corporation, a U.S. information services company,

acquires Reuters, a British news agency, for $750 million, and that Reuters depos-

its the money in Barclays Bank in London, which, in turn, uses the sum to purchase

U.S. treasury notes. In this case, the payment of $750 million by Thomson will be

recorded as a debit (−), whereas Barclays’ purchase of the U.S. Treasury notes will

be recorded as a credit (+).

The above examples can be summarized as follows: Transactions Credit Debit

Boeing’s export 1$50 million Withdrawal from U.S. bank 2$50 million Boeing’s import 2$30 million Deposit at U.S. bank 1$30 million Thomson's acquisition of Reuters 2$750 million Barclays’ purchase of U.S. securities 1$750 million

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64 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

Balance-of-Payments Accounts Since the balance of payments records all types of international transactions a country

consummates over a certain period of time, it contains a wide variety of accounts.

However, a country’s international transactions can be grouped into the following

three main types:

1. The current account.

2. The capital account.

3. The official reserve account.

The current account includes the export and import of goods and services, whereas

the capital account includes all purchases and sales of assets such as stocks, bonds,

bank accounts, real estate, and businesses. The official reserve account , on the other

hand, covers all purchases and sales of international reserve assets such as dollars,

foreign exchanges, gold, and special drawing rights (SDRs).

Let us now examine a detailed description of the balance-of-payments accounts.

Exhibit 3.1 summarizes the U.S. balance-of-payments accounts for the year 2011 that

we are going to use as an example.

Exhibit 3.1 shows that U.S. exports were $2,843.7 billion in 2011 while U.S. imports

were $3,182.8 billion. The current account balance, which is defined as exports minus

imports plus unilateral transfers, that is, (1) + (2) + (3) in Exhibit 3.1 , was negative,

−$473.6 billion. The United States thus had a balance-of-payments deficit on the cur-

rent account in 2011. The current account deficit implies that the United States used

The Current Account

Source: IMF, International Financial Statistics Yearbook, 2012.

Note: Liquidation and repatriation of foreign debt securities ($73.1 billion) and other investment ($40.4 billion) are recorded with a positive sign.

EXHIBIT 3.1

A Summary of the U.S.

Balance of Payments for

2011 (in $ billion)

Credits Debits

Current Account (1) Exports 2,843.7 (1.1) Merchandise 1,501.5 (1.2) Services 603.5 (1.3) Factor income 738.7 (2) Imports −3,182.8 (2.1) Merchandise −2,236.8 (2.2) Services −428.3 (2.3) Factor income −517.7 (3) Unilateral transfer 19.5 −154.0 Balance on current account −473.6 [(1) 1 (2) 1 (3)]

Capital Account (4) Direct investment 227.9 −406.2 (5) Portfolio investment 166.9 −14.7 (5.1) Equity securities 20.9 −87.8 (5.2) Debt securities 139.2 73.1 (5.3) Derivatives, net 6.8 (6) Other investment 395.8 40.4 Balance on capital account 410.1 [(4) 1 (5) 1 (6)] (7) Statistical discrepancies 79.4 Overall balance 15.9 Official Reserve Account −15.9

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C H A P T E R 3 BALANCE OF PAYMENTS 65

up more output than it produced. 2 Since a country must finance its current account

deficit either by borrowing from foreigners or by drawing down on its previously

accumulated foreign wealth, a current account deficit represents a reduction in the

country’s net foreign wealth. On the other hand, a country with a current account sur-

plus acquires IOUs from foreigners, thereby increasing its net foreign wealth.

The current account is divided into four finer categories: merchandise trade, ser-

vices, factor income, and unilateral transfers. Merchandise trade represents exports

and imports of tangible goods, such as oil, wheat, clothes, automobiles, computers, and

so on. As Exhibit 3.1 shows, U.S. merchandise exports were $1,501.5 billion in 2011

while imports were $2,236.8 billion. The United States thus had a deficit on the trade balance or a trade deficit. The trade balance represents the net merchandise export. As

is well known, the United States has experienced persistent trade deficits since the early

1980s, whereas such key trading partners as China, Japan, and Germany have generally

realized trade surpluses. This persistent trade imbalance between the United States and

her key trading partners has been a source of international contention.

Services , the second category of the current account, include payments and receipts

for legal, consulting, and engineering services, royalties for patents and intellectual

properties, insurance premiums, shipping fees, and tourist expenditures. These trades

in services are sometimes called invisible trade . In 2011, U.S. service exports were

$603.5 billion and imports were $428.3 billion, realizing a surplus of $175.2 billion.

Clearly, the United States performed better in services than in merchandise trade. It

is noted that thanks to the rapid advancement of information technology (IT), many

services that were previously nontradable are becoming tradable. For example, X-ray

pictures taken at a local hospital in the United States may be transmitted overnight via

the Internet to an IT outsourcing center in India. Then, doctors there would examine

the digital images and data and e-mail their diagnosis back to the U.S. hospital for a

fee. In this case, the U.S. effectively imported medical service from India.

Factor income , the third category of the current account, consists largely of pay-

ments and receipts of interest, dividends, and other income on foreign investments that

were previously made. If United States investors receive interest on their holdings of

foreign bonds, for instance, it will be recorded as a credit in the balance of payments.

On the other hand, interest payments by U.S. borrowers to foreign creditors will be

recorded as debits. In 2011, U.S. residents paid out $517.7 billion to foreigners as fac-

tor income and received $738.7 billion, realizing a $221 billion surplus. Considering,

however, that the United States has heavily borrowed from foreigners in recent years,

U.S. payments of interest and dividends to foreigners are likely to rise significantly.

This can increase the U.S. current account deficit in the future, ceteris paribus. Unilateral transfers , the fourth category of the current account, involve

“unrequited” payments. Examples include foreign aid, reparations, official and private

grants, and gifts. Unlike other accounts in the balance of payments, unilateral transfers

have only one-directional flows, without offsetting flows. In the case of merchandise

trade, for example, goods flow in one direction and payments flow in the opposite

direction. For the purpose of preserving the double-entry bookkeeping rule, unilateral

transfers are regarded as an act of buying goodwill from the recipients. So a coun-

try that gives foreign aid to another country can be viewed as importing goodwill

from the latter. As can be expected, the United States made a net unilateral transfer of

$134.5 billion, which is the receipt of transfer payments ($19.5 billion) minus transfer

payments to foreign entities ($154.0 billion).

www.bea.gov

Website of the Bureau of

Economic Analysis, U.S.

Department of Commerce,

provides data related to the

U.S. balance of payments.

2 The current account balance (BCA) can be written as the difference between national output (Y) and domestic

absorption, which comprises consumption (C), investment (I), and government expenditures (G):

BCA = Y − (C + I + G)

If a country’s domestic absorption falls short of its national output, the country’s current account must be in

surplus, for more detailed discussion, refer to Appendix 3A.

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66 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

The current account balance, especially the trade balance, tends to be sensitive to

exchange rate changes. When a country’s currency depreciates against the currencies

of major trading partners, the country’s exports tend to rise and imports fall, improving

the trade balance. For example, Mexico experienced continuous deficits in its trade

balance of about $4.5 billion per quarter throughout 1994. Following the depreciation

of the peso in December 1994, however, Mexico’s trade balance began to improve

immediately, realizing a surplus of about $7 billion for the year 1995.

The effect of currency depreciation on a country’s trade balance can be more com-

plicated than the case described above. Indeed, following a depreciation, the trade

balance may at first deteriorate for a while. Eventually, however, the trade balance will

tend to improve over time. This particular reaction pattern of the trade balance to a

depreciation is referred to as the J-curve effect , which is illustrated in Exhibit 3.2 . The

curve shows the initial deterioration and the eventual improvement of the trade balance

following a depreciation. The J-curve effect received wide attention when the British

trade balance worsened after a devaluation of the pound in 1967. Sebastian Edwards

(1989) examined various cases of devaluations carried out by developing countries

from the 1960s through the 1980s, and confirmed the existence of the J-curve effect in

about 40 percent of the cases.

A depreciation will begin to improve the trade balance immediately if imports and

exports are responsive to the exchange rate changes. On the other hand, if imports and

exports are inelastic, the trade balance will worsen following a depreciation. Following

a depreciation of the domestic currency and the resultant rise in import prices, domestic

residents may still continue to purchase imports because it is difficult to change their con-

sumption habits in a short period of time. With higher import prices, the domestic country

comes to spend more on imports. Even if domestic residents are willing to switch to less

expensive domestic substitutes for foreign imports, it may take time for domestic produc-

ers to supply import substitutes. Likewise, foreigners’ demand for domestic products,

which become less expensive with a depreciation of the domestic currency, can be inelastic

essentially for the same reasons. In the long run, however, both imports and exports tend to

be responsive to exchange rate changes, exerting positive influences on the trade balance.

The capital account balance measures the difference between U.S. sales of assets to for-

eigners and U.S. purchases of foreign assets. U.S. sales (or exports) of assets are recorded

as credits, as they result in capital inflow . On the other hand, U.S. purchases (imports) of

foreign assets are recorded as debits, as they lead to capital outflow . Unlike trades in goods

and services, trades in financial assets affect future payments and receipts of factor income.

Exhibit 3.1 shows that the United States had a capital account surplus of $410.1 billion

in 2011, implying that capital inflow to the United States far exceeded capital outflow.

The Capital Account

EXHIBIT 3.2

A Currency Depreciation

and the Time-Path of

the Trade Balance: The

J-Curve Effect

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C H A P T E R 3 BALANCE OF PAYMENTS 67

Clearly, the current account deficit was substantially offset by the capital account sur-

plus. As previously mentioned, a country’s current account deficit must be paid for either

by borrowing from foreigners or by selling off past foreign investments. In the absence

of the government’s reserve transactions, the current account balance must be equal

to the capital account balance but with the opposite sign. When nothing is excluded, a

country’s balance of payments must necessarily balance.

The capital account can be divided into three categories: direct investment, port-

folio investment, and other investment. Direct investment occurs when the investor

acquires a measure of control of the foreign business. In the U.S. balance of payments,

acquisition of 10 percent or more of the voting shares of a business is considered giv-

ing a measure of control to the investor.

When Honda, a Japanese automobile manufacturer, built an assembly factory in

Ohio, it was engaged in foreign direct investment (FDI) . Another example of direct

investment was provided by Nestlé Corporation, a Swiss multinational firm, when

it acquired Carnation, a U.S. firm. Of course, U.S. firms also are engaged in direct

investments in foreign countries. For instance, Coca-Cola built bottling facilities

all over the world. In recent years, many U.S. corporations moved their production

facilities to Mexico and China, in part, to take advantage of lower costs of produc-

tion. Generally speaking, foreign direct investments take place as firms attempt to

take advantage of various market imperfections, such as underpriced labor services

and protected markets. In 2011, U.S. direct investment overseas was $406.2 billion,

whereas foreign direct investment in the United States was $227.9 billion.

Firms undertake foreign direct investments when the expected returns from for-

eign investments exceed the cost of capital, allowing for foreign exchange and politi-

cal risks. The expected returns from foreign projects can be higher than those from

domestic projects because of lower wage rates and material costs, subsidized financ-

ing, preferential tax treatment, exclusive access to local markets, and the like. The

volume and direction of FDI can also be sensitive to exchange rate changes. For

instance, Japanese FDI in the United States soared in the latter half of the 1980s,

partly because of the sharp appreciation of the yen against the dollar. With a stronger

yen, Japanese firms could better afford to acquire U.S. assets that became less expen-

sive in terms of the yen. The same exchange rate movement discouraged U.S. firms

from making FDI in Japan because Japanese assets became more expensive in terms

of the dollar.

Portfolio investment , the second category of the capital account, mostly repre-

sents sales and purchases of foreign financial assets such as stocks and bonds that do

not involve a transfer of control. International portfolio investments have boomed in

recent years, partly due to the general relaxation of capital controls and regulations in

many countries, and partly due to investors’ desire to diversify risk globally. Portfolio

investment comprises equity, debt, and derivative securities. Exhibit 3.1 shows that in

2011, foreigners invested $166.9 billion in U.S. financial securities, whereas Ameri-

cans invested $14.7 billion in foreign securities, realizing a surplus, $152.2 billion, for

the United States. Much of the surplus represents foreigners’ investment in U.S. debt

securities and U.S. liquidation and repatriation of foreign debt securities. Exhibit 3.1

shows that foreigners invested $139.2 billion in U.S. debt securities in 2011, whereas

U.S. investors divested $73.1 billion in foreign debt securities.

Investors typically diversify their investment portfolios to reduce risk. Since secu-

rity returns tend to have relatively low correlations among countries, investors can

reduce risk more effectively if they diversify their portfolio holdings internationally

rather than purely domestically. In addition, investors may be able to benefit from

higher expected returns from some foreign markets. 3

3 Refer to Chapter 15 for a detailed discussion of international portfolio investment.

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68 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

In recent years, government-controlled investment funds, known as sovereign wealth funds (SWFs), are playing an increasingly visible role in international invest-

ments. SWFs are mostly domiciled in Asian and Middle Eastern countries and

usually are responsible for recycling foreign exchange reserves of these countries

swelled by trade surpluses and oil revenues. It is noted that SWFs invested large

sums of money in many western banks that were severely affected by subprime

mortgage–related losses (i.e., housing loans made to borrowers with marginal cred-

itworthiness). For example, Abu Dhabi Investment Authority invested $7.5 billion in

Citigroup, which needed to replenish its capital base in the wake of subprime losses,

whereas Temasek Holdings, Singapore’s state-owned investment company, injected

$5.0 billion into Merrill Lynch, one of the largest investment banks in the United

States. Although SWFs play a positive role in stabilizing the global banking system

and help the balance-of-payment situations of the host countries, they are increas-

ingly under close scrutiny due to their sheer size and the lack of transparency about

the way these funds are operating.

The third category of the capital account is other investment , which includes

transactions in currency, bank deposits, trade credits, and so forth. These invest-

ments are quite sensitive to both changes in relative interest rates between countries

and the anticipated change in the exchange rate. If the interest rate rises in the United

States while other variables remain constant, the United States will experience capi-

tal inflows, as investors would like to deposit or invest in the United States to take

advantage of the higher interest rate. On the other hand, if a higher U.S. interest rate

is more or less offset by an expected depreciation of the U.S. dollar, capital inflows

to the United States will not materialize. 4 Since both interest rates and exchange

rate expectations are volatile, these capital flows are highly reversible. In 2011, the

United States experienced a major inflow of $395.8 billion in this category. At the

same time, U.S. investors divested $40.4 billion in their holdings of foreign assets

in this category.

Exhibit 3.1 shows that there was a statistical discrepancy of $79.4 billion in 2011,

representing omitted and misrecorded transactions. Recordings of payments and

receipts arising from international transactions are done at different times and places,

possibly using different methods. As a result, these recordings, upon which the balance-

of-payments statistics are constructed, are bound to be imperfect. While merchandise

trade can be recorded with a certain degree of accuracy at the customs houses, provi-

sions of invisible services like consulting can escape detection. Cross-border financial

transactions, a bulk of which might have been conducted electronically, are far more

difficult to keep track of. For this reason, the balance of payments always presents a

“balancing” debit or credit as a statistical discrepancy. 5 It is interesting to note that the

sum of the balance on capital account and the statistical discrepancy more than offset

the balance of current account in magnitude, −$473.6 billion. This suggests that finan-

cial transactions may be mainly responsible for the discrepancy.

When we compute the cumulative balance of payments including the current

account, capital account, and the statistical discrepancies, we obtain the so-called

overall balance or official settlement balance . All the transactions comprising the

overall balance take place autonomously for their own sake. 6 The overall balance is

Statistical Discrepancy

4 We will discuss the relationship between the relative interest rates and the expected exchange rate change in

Chapter 6 .

5 Readers might wonder how to compute the statistical discrepancies in the balance of payments. Statistical

discrepancies, which represent errors and omissions, by definition, cannot be known. Since, however, the

balance of payments must balance to zero when every item is included, one can determine the statistical

discrepancies in the “residual” manner.

6 Autonomous transactions refer to those transactions that occur without regard to the goal of achieving the

balance-of-payments equilibrium.

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C H A P T E R 3 BALANCE OF PAYMENTS 69

significant because it indicates a country’s international payment gap that must be

accommodated with the government’s official reserve transactions.

It is also indicative of the pressure that a country’s currency faces for depreciation

or appreciation. If, for example, a country continuously realizes deficits on the overall

balance, the country will eventually run out of reserve holdings and its currency may

have to depreciate against foreign currencies. In 2011, the United States had a $15.9

billion surplus on the overall balance. This means that the United States received a net

payment equal to that amount from the rest of the world. If the United States had real-

ized a deficit on the overall balance, the United States would have made a net payment

to the rest of the world.

When a country must make a net payment to foreigners because of a balance-of-

payments deficit, the central bank of the country (the Federal Reserve System in the

United States) should either run down its official reserve assets , such as gold, foreign

exchanges, and SDRs, or borrow anew from foreign central banks. On the other hand,

if a country has a balance-of-payments surplus, its central bank will either retire some

of its foreign debts or acquire additional reserve assets from foreigners. Exhibit 3.1

shows that to accommodate a $15.9 billion balance-of-payment surplus, the U.S.

increased its external reserve holdings by the same amount. When the United States

increases its reserve holdings by either adding to its reserve holdings or retiring debts,

it will spend funds, which will be recorded under debits.

The official reserve account includes transactions undertaken by the authorities

to finance the overall balance and intervene in foreign exchange markets. When the

United States and foreign governments wish to support the value of the dollar in the

foreign exchange markets, they sell foreign exchanges, SDRs, or gold to “buy” dollars.

These transactions, which give rise to the demand for dollars, will be recorded as a

positive entry under official reserves. On the other hand, if governments would like

to see a weaker dollar, they “sell” dollars and buy gold, foreign exchanges, and so

forth. These transactions, which give rise to the supply of dollars, will be recorded as a

negative entry under official reserves. The more actively governments intervene in the

foreign exchange markets, the greater the official reserve changes.

On September 6, 2011, the Swiss National Bank (SNB), the central bank of Swit-

zerland, surprised financial markets by announcing that it will intervene in currency

markets “without limit” in order to keep the Swiss franc from appreciating beyond

SFr1.20/€, which is equivalent to about €0.833/SFr. The central bank announced that

“with immediate effect, the bank will no longer tolerate an exchange rate in the euro

against the Swiss franc below the minimum rate of SFr1.20. The SNB will enforce

this minimum rate with the utmost determination and is prepared to buy foreign cur-

rency in unlimited quantities.” As Switzerland was receiving safe-haven investment

flows from the eurozone uncertainties, the Swiss franc has been steadily appreciat-

ing from €0.61 per Swiss franc in early 2008 to a near-parity with the euro in August

2011, hurting the export-driven economy of Switzerland. To prevent the appreciation

of the Swiss franc, the SNB has been buying up euros by printing and selling francs.

The intervention was focused on the euro because the euro zone is by far the largest

export market for the Swiss products. As can be seen in Exhibit 3.3, the official reserve

assets of Switzerland were essentially constant in 2008, implying non-intervention, but

began to rise fast since 2009, reflecting the SNB intervention. Despite the intervention,

the Swiss franc continued to appreciate against the euro, pushing the Swiss economy

toward recession. Against this backdrop, the SNB announced the drastic measure to

intervene in currency markets without limit in order to keep the minimum exchange

rate of SFr1.20 against the euro. Exhibit 3.3 shows that the Swiss franc fell sharply

upon the announcement and the SNB was successful in keeping the Swiss franc at the

minimum rate. As a result of the central bank interventions over the years, the official

reserve assets of Switzerland have increased from under $50 billion in 2008 to nearly

Official Reserve Account

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70 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

EXHIBIT 3.3

Swiss Intervention

in Foreign Exchange

Markets € 0.833/SFr

1.00

Euro/Swiss Franc Exchange Rate Official Reserve Assets

of Switzerland (in $ billion)

0.95

0.90

0.85

0.80

0.75

0.70

0.65

0.60

0.55

2008 2009 2010 2011 2012 2013

600

500

400

300

100

200

2008 2009 2010 2011 2012 2013

Source: Datastream and International Financial Statistics.

$500 billion in 2013. The Swiss episode shows that the negative effect of the so-called

“market-determined exchange rate” on the real economy can force the government to

tie up the “invisible hands” of the market.

Until the advent of the Bretton Woods System in 1945, gold was the predominant

international reserve asset. After 1945, however, international reserve assets comprise:

1. Gold.

2. Foreign exchanges.

3. Special drawing rights (SDRs).

4. Reserve positions in the International Monetary Fund (IMF).

As can be seen from Exhibit 3.4 , the relative importance of gold as an international

means of payment has steadily declined, whereas the importance of foreign exchanges

has grown substantially. As of 2012, foreign exchanges account for about 94 percent

EXHIBIT 3.4

Composition of Total

Official Reserves

(in Percent)

Foreign exchange

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Year

100

P er

ce nt

ag e

Reserve position in the fund

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

P er

ce nt

ag e Gold1

SDRs

1Values at SDR 35 per ounce.

Source: IMF, International Financial Statistics.

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C H A P T E R 3 BALANCE OF PAYMENTS 71

of the total reserve assets held by IMF member countries, with gold accounting for less

than 1 percent of the total reserves. Similar to gold, the relative importance of SDRs

and reserve positions in the IMF have steadily declined. However, due to the IMF’s

issuance of $250 billion in new SDRs, SDRs’ share in global reserves rose to about

4 percent in 2009. The new issuance of SDRs was based on the recommendation of the

G-20 summit meeting held in London in April 2009. The objective of the new issuance

was to boost global liquidity.

As can be seen from Exhibit 3.5 , the U.S. dollar’s share in the world’s for-

eign exchange reserves was 50.9 percent in 1991, followed by the German mark

(15.7 percent), ECU (10.0 percent), Japanese yen (8.7 percent), British pound

(3.4 percent), French franc (2.8 percent), Swiss franc (1.2 percent), and Dutch guilder

(1.1 percent). The “predecessor” currencies of the euro, including the German mark,

French franc, Dutch guilder, and ECU, collectively received a substantial weight,

about 30 percent, in the world’s foreign exchange reserves. For comparison, in

1997, the world’s reserves comprised the U.S. dollar (59.1 percent), German mark

(13.7 percent), Japanese yen (5.1 percent), British pound (3.3 percent), French

franc (1.5 percent), ECU (5.0 percent), Swiss franc (0.5 percent), Dutch guilder

(0.5 percent), and miscellaneous currencies (11.3 percent). In other words, the

U.S. dollar’s share increased substantially throughout the 1990s at the expense of

other currencies. This change could be attributed to a strong performance of the dollar

in the 1990s and the uncertainty associated with the introduction of the new currency,

that is, the euro. In 2011, the world reserves comprised the U.S. dollar (62.1 percent),

euro (24.9 percent), Japanese yen (3.6 percent), British pound (3.8 percent), Swiss

franc (0.3 percent), and miscellaneous currencies (5.3 percent). The dollar’s dominant

position in the world’s reserve holdings may decline to a certain extent as the euro

becomes a better “known quantity” and central banks wish to diversify their reserve

holdings. In fact, the euro’s share has increased from 13.5 percent in 1999 to 27.4 percent

in 2009. In 2011, however, it declined somewhat to 24.9 percent due to the euro-zone

debt crisis.

In addition to the emergence of the euro as a credible reserve currency, continued

U.S. trade deficits and foreigners’ desire to diversify their currency holdings away from

U.S. dollars could further diminish the position of the U.S. dollar as the dominant reserve

currency. Particularly, the value of the U.S. dollar would also be very much affected by

the currency diversification decisions of Asian central banks. These banks collectively

hold an enormous amount of foreign currency reserves, mostly in dollars, arising from

trade surpluses. Asian central banks also purchase U.S. dollars in foreign exchange mar-

kets in order to limit appreciation of their local currencies against the dollar.

Currency Composition of the World’s Foreign Exchange Reserves

(Percent of Total) EXHIBIT 3.5

Source: IMF, Annual Report of the Executive Board, various issues.

Currency 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

U.S. dollar 51.9 50.9 56.2 53.4 59.1 64.9 66.9 63.8 66.9 64.1 62.1 62.1 Japanese yen 7.3 8.7 8.0 6.7 5.1 5.4 5.5 4.8 3.6 2.9 3.0 3.6 Pound sterling 2.6 3.4 3.1 2.8 3.3 3.6 4.0 4.4 3.6 4.7 4.3 3.8 Swiss franc 1.4 1.2 1.2 0.5 0.5 0.4 0.5 0.4 0.1 0.2 0.1 0.3 Euro — — — — — 13.5 16.7 19.7 24.0 26.3 27.4 24.9 Deutsche mark 18.0 15.7 14.1 14.7 13.7 — — — — — — — French franc 1.4 2.8 2.2 2.4 1.5 — — — — — — — Dutch guilder 1.1 1.1 0.6 0.5 0.5 — — — — — — — ECU 10.5 10.0 8.3 6.8 5.0 — — — — — — — Other currencies 5.7 6.2 6.2 12.1 11.3 12.1 6.4 6.8 1.7 1.8 3.1 5.3

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72 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

The Balance-of-Payments Identity When the balance-of-payments accounts are recorded correctly, the combined balance

of the current account, the capital account, and the reserves account must be zero, that is,

BCA 1 BKA 1 BRA 5 0 (3.1)

where:

BCA 5 balance on the current account

BKA 5 balance on the capital account

BRA 5 balance on the reserve account

The balance on the reserves account, BRA, represents the change in the official reserves.

Equation 3.1 is the balance-of-payments identity (BOPI) that must necessar-

ily hold. The BOPI equation indicates that a country can run a balance-of-payments

surplus or deficit by increasing or decreasing its official reserves. Under the fixed

exchange rate regime, countries maintain official reserves that allow them to have

balance-of-payments disequilibrium, that is, BCA + BKA is nonzero, without adjusting

the exchange rate. Under the fixed exchange rate regime, the combined balance on the

current and capital accounts will be equal in size, but opposite in sign, to the change

in the official reserves:

BCA 1 BKA 5 2BRA (3.2)

For example, if a country runs a deficit on the overall balance, that is, BCA + BKA

is negative, the central bank of the country can supply foreign exchanges out of its

reserve holdings. But if the deficit persists, the central bank will eventually run out

of its reserves, and the country may be forced to devalue its currency. This is roughly

what happened to the Mexican peso in December 1994.

Under the pure flexible exchange rate regime, central banks will not intervene in

the foreign exchange markets. In fact, central banks do not need to maintain official

reserves. Under this regime, the overall balance thus must necessarily balance, that is,

BCA 5 2BKA (3.3)

In other words, a current account surplus or deficit must be matched by a capital

account deficit or surplus, and vice versa. In a dirty floating exchange rate system

under which the central banks discreetly buy and sell foreign exchanges, Equation 3.3

will not hold tightly.

Being an identity, Equation 3.3 does not imply a causality by itself. A current

account deficit (surplus) may cause a capital account surplus (deficit), or the oppo-

site may hold. It has often been suggested that the persistent U.S. current account

deficits made it necessary for the United States to run matching capital account

surpluses, implying that the former causes the latter. One can argue, with equal jus-

tification, that the persistent U.S. capital account surpluses, which may have been

caused by high U.S. interest rates, have caused the persistent current account deficits

by strengthening the value of the dollar. The issue can be settled only by careful

empirical studies.

Balance-of-Payments Trends in Major Countries Considering the significant attention that balance-of-payments data receive in the

news media, it is useful to closely examine balance-of-payments trends in some

of the major countries. Exhibit 3.6 provides the balance on the current account

(BCA) as well as the balance on the capital account (BKA) for each of the five key

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C H A P T E R 3 BALANCE OF PAYMENTS 73

countries, China, Japan, Germany, the United Kingdom, and the United States,

during the period 1982–2011.

Exhibit 3.6 shows first that the United States has experienced continuous deficits

on the current account since 1982 and continuous surpluses on the capital account.

Clearly, the magnitude of U.S. current account deficits is far greater than any that

other countries ever experienced during the 30-year sample period. In 2006, the

U.S. current account deficit reached $812 billion before it started to decline due to

the recession. The U.S. balance-of-payments trend is illustrated in Exhibit 3.7 . The

exhibit shows that the U.S. current account deficit has increased sharply since 1997.

This situation has led some politicians and commentators to lament that Ameri-

cans are living far beyond their means. As a matter of fact, the net international

investment position of the United States turned negative in 1987 for the first time

in decades and continued to deteriorate. The overseas debt burden of the United

States—the difference between the value of foreign-owned assets in the United

States and the value of U.S.-owned assets abroad—reached about $2,540 billion

at the end of 2006, when valued by the replacement cost of the investments made

abroad and at home. As recently as 1986, the United States was considered a net

creditor nation, with about $35 billion more in assets overseas than foreigners

owned in the United States. The International Finance in Practice box “The Dollar

and the Deficit” addresses the issues associated with the U.S. trade deficit. Since

Balances on the Current (BCA) and Capital (BKA) Accounts of Five Major

Countries: 1982–2011 ($ billion) a EXHIBIT 3.6

China Japan Germany United Kingdom United States

Year BCA BKA BCA BKA BCA BKA BCA BKA BCA BKA

1982 5.7 0.6 6.9 211.6 4.9 22.0 8.0 210.6 211.6 16.6 1983 4.2 20.1 20.8 219.3 4.6 26.6 5.3 27.1 244.2 45.4 1984 2.0 21.9 35.0 232.9 9.6 29.9 1.8 22.8 299.0 102.1 1985 211.4 9.0 51.1 251.6 17.6 215.4 3.3 20.7 2124.5 128.3 1986 27.0 5.0 85.9 270.7 40.9 235.5 21.3 5.0 2150.5 150.2 1987 0.3 4.5 84.4 246.3 46.4 224.9 28.1 28.2 2166.5 157.3 1988 23.8 6.2 79.2 261.7 50.4 266.0 229.3 33.9 2127.7 131.6 1989 24.3 3.8 63.2 276.3 57.0 254.1 236.7 28.6 2104.3 129.5 1990 12.0 0.1 44.1 253.2 48.3 241.1 232.5 32.5 294.3 96.5 1991 13.3 1.3 68.2 276.6 217.7 11.5 214.3 19.0 29.3 3.5 1992 6.4 28.5 112.6 2112.0 219.1 56.3 218.4 11.7 261.4 57.4 1993 211.6 13.4 131.6 2104.2 213.9 20.3 215.5 21.0 290.6 91.9 1994 6.9 23.5 130.3 2105.0 220.9 18.9 22.3 3.8 2132.9 127.6 1995 1.6 20.9 111.0 252.4 222.6 29.8 25.9 5.0 2129.2 138.9 1996 7.2 24.5 65.9 230.7 213.8 12.6 23.7 3.2 2148.7 142.1 1997 29.7 6.1 94.4 287.8 21.2 2.6 6.8 211.0 2166.8 167.8 1998 31.5 26.3 120.7 2116.8 26.4 17.6 28.0 0.2 2217.4 151.6 1999 21.1 5.2 106.9 231.1 218.0 240.5 231.9 31.0 2324.4 367.9 2000 20.5 2.0 116.9 275.5 218.7 13.2 228.8 26.2 2444.7 443.6 2001 17.4 34.8 87.8 251.0 1.7 224.1 232.1 31.5 2385.7 419.9 2002 35.4 32.3 112.4 266.7 43.4 270.4 226.2 17.3 2473.9 572.7 2003 45.9 52.7 136.2 67.9 54.9 279.3 230.5 24.8 2530.7 541.2 2004 68.7 110.7 172.1 22.5 120.3 2146.9 235.2 10.4 2640.2 553.9 2005 160.8 58.9 165.8 2122.7 131.8 2151.2 255.0 73.8 2754.9 763.3 2006 249.9 6.0 170.5 2102.3 150.8 2179.8 277.6 49.0 2811.5 830.8 2007 371.8 70.4 210.5 2187.2 263.1 2325.3 274.7 66.2 2726.6 663.7 2008 426.1 18.9 156.6 2172.6 243.9 2300.8 239.9 21.5 2706.1 509.9 2009 297.1 144.8 142.2 2130.2 168.0 2185.9 228.7 38.1 2419.8 474.9 2010 237.8 229.2 203.9 2155.1 200.7 2194.8 275.2 79.5 2470.9 472.9 2011 201.7 180.6 119.1 57.1 204.3 2201.2 246.0 51.2 2473.4 489.5

a The balance on the capital account (BKA) in this table includes statistical discrepancies. Most discrepancies occur in the capital account.

Source: IMF, International Financial Statistics Yearbook, various issues.

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INTERNATIONAL FINANCE IN PRACTICE

The Dollar and the Deficit The dollar is looking vulnerable. It is propped up not by the strength of America’s exports, but by vast imports of capital. America, a country already rich in capital, has to borrow from abroad almost $2 billion net every working day to cover a current-account deficit forecast to reach almost $500 billion this year.

To most economists, this deficit represents an unsus- tainable drain on world savings. If the capital inflows were to dry up, some reckon that the dollar could lose a quarter of its value. Only Paul O’Neill, America’s trea- sury secretary, appears unruffled. The current-account deficit, he declares, is a “meaningless concept,” which he talks about only because others insist on doing so.

The dollar is not just a matter for America, because the dollar is not just America’s currency. Over half of all dollar bills in circulation are held outside American’s bor- ders, and almost half of America’s Treasury bonds are held as reserves by foreign central banks. The euro cannot yet rival this global reach. International financiers borrow and lend in dollars, and international traders use dollars, even if Americans are at neither end of the deal. No asset since gold has enjoyed such widespread acceptance as a medium of exchange and store of value. In fact, some economists, such as Paul Davidson of the University of Tennessee and Ronald McKinnon of Stanford University, take the argument a step further (see references at end).

They argue that the world is on a de facto dollar standard, akin to the 19th-century gold standard.

For roughly a century up to 1914, the world’s main cur- rencies were pegged to gold. You could buy an ounce for about four pounds or twenty dollars. The contemporary “dollar standard” is a looser affair. In principle, the world’s currencies float in value against each other, but in reality few float freely. Countries fear losing competitiveness on world markets if their currency rises too much against the greenback; they fear inflation if it falls too far. As long as American prices remain stable, the dollar therefore pro- vides an anchor for world currencies and prices, ensuring that they do not become completely unmoored.

In the days of the gold standard, the volume of money and credit in circulation was tied to the amount of gold in a country’s vaults. Economies laboured under the “tyranny” of the gold regime, booming when gold was abundant, deflating when it was scarce. The dollar stan- dard is a more liberal system. Central banks retain the right to expand the volume of domestic credit to keep pace with the growth of the home economy.

Eventually, however, growth in the world’s economies translates into a growing demand for dollar assets. The more money central banks print, the more dollars they like to hold in reserve to underpin their currency. The more business is done across borders, the more dollars traders

7Mercantilism, which originated in Europe during the period of absolute monarchies, holds that precious metals

like gold and silver are the key components of national wealth, and that a continuing trade surplus should be a

major policy goal as it ensures a continuing inflow of precious metals and thus continuous increases in national

wealth. Mercantilists, therefore, abhor trade deficits and argue for imposing various restrictions on imports.

Mercantilist ideas were criticized by such British thinkers as David Hume and Adam Smith. Both argued that

the main source of wealth of a country is its productive capacity, not precious metals.

2006, however, the current account deficit has declined for the U.S., reflecting the

effect of the “Great Recession.”

Second, Exhibit 3.6 reveals that Japan has had an unbroken string of current

account surpluses since 1982 despite the fact that the value of the yen rose steadily

until the mid-1990s. The same point can be seen clearly from Exhibit 3.7 . As can be

expected, during this period Japan realized capital account deficits in most years;

Japan invested heavily in foreign stocks and bonds, businesses, real estates, art

objects, and the like to recycle its huge, persistent current account surpluses. Con-

sequently, Japan emerged as the world’s largest creditor nation, whereas the United

States became the largest debtor nation. Japan had a capital account surplus in 2003,

2004 and 2011, reflecting increased foreign investments in Japanese securities and

businesses. The persistent current account disequilibrium was a major source of

friction between Japan and its key trading partners, especially the United States. In

fact, Japan has often been criticized for pursuing mercantilism to ensure continuous

trade surpluses. 7 In more recent years, however, China replaced Japan as the trading

partner, realizing the largest trade surplus with the U.S. As a result, China has been

under pressure to let its currency appreciate against the dollar.

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Third, like the United States, the United Kingdom recently experienced continu-

ous current account deficits, coupled with capital account surpluses. The magnitude,

however, is far less than that of the United States. Germany, on the other hand, tradition-

ally had current account surpluses. Since 1991, however, Germany has been experienc-

ing current account deficits. This is largely due to German reunification and the resultant

need to absorb more output domestically to rebuild the East German region. This has left

less output available for exports. Since 2001, however, Germany began to realize current

account surpluses and capital account deficits, returning to the earlier pattern.

Fourth, like Japan, China tends to have a balance-of-payment surplus on the current

account. Unlike Japan, however, China tends to realize a surplus on the capital account as

well. In 2011, for instance, China had a $201.7 billion surplus on the current account and,

at the same time, a $180.6 billion surplus on the capital account. This implies that China’s

official reserve holdings must have gone up for the year. In fact, China’s official reserves

have increased sharply in recent years, reaching $3.30 trillion as of the end of 2012.

It is clear from Exhibit 3.6 that the United States and United Kingdom tend to

realize current account deficits, whereas China, Japan, and Germany tend to realize

current account surpluses. This “global imbalance” implies that the United States

and United Kingdom generally use up more outputs than they produce, whereas the

opposite holds for China, Japan, and Germany. Thus, if the global imbalance is to be

reduced, it would be desirable for deficit countries to consume less and save more and

for surplus countries to consume more and save less. 8

www.ecb.int/stats

This website provides

balance-of-payment data

on the euro zone countries.

need to cover their transactions. If the greenback is the new gold, Alan Greenspan, the Federal Reserve chairman, is the world’s alchemist, responsible for concocting enough liquidity to keep world trade bubbling along nicely.

But America can play this role only if it is happy to allow foreigners to build up a huge mass of claims on its assets—and if foreigners are happy to go along. Some economists watch with consternation as the rest of the world’s claims on America outstrip America’s claims on the rest of the world. As they point out, even a dollar bill is an American liability, a promise of ultimate pay- ment by the US Treasury. Can America keep making these promises to foreigners, without eventually empty- ing them of value?

According to Mr. Davidson, the world cannot risk America stopping. America’s external deficit means an extra $500 billion is going into circulation in the world economy each year. If America reined in its current account, international commerce would suffer a liquidity crunch, as it did periodically under the gold standard. Hence America’s deficit is neither a “meaningless concept” nor a lamentable drain on world savings. It is an indis- pensable fount of liquidity for world trade.

Spigot by Nature But is the deficit sustainable? Many of America’s credi- tors, Mr. McKinnon argues, have a stake in preserving the dollar standard, whatever the euro’s potential charms. In particular, a large share of America’s more liquid assets are held by foreign central banks, particularly in Asia,

which dare not offload them for fear of undermining the competitiveness of their own currencies. “Willy nilly,” Mr. McKinnon says, “foreign governments cannot avoid being important creditors of the United States.” China, for one, added $60 billion to its reserves in the year to June by ploughing most of its trade surplus with America back into American assets.

This is not the first time America’s external deficits have raised alarm. In 1966, as America’s post-war trade surpluses began to dwindle, The Economist ran an article entitled “The dollar and world liquidity: a minority view.” According to this view, the build-up of dollar claims by foreigners was not a “deficit” in need of “correction.” Rather, the American capital market was acting like a global financial intermediary, providing essential liquid- ity to foreign governments and enterprises. In their own ways, Mr. Davidson and Mr. McKinnon echo this minor- ity view today. A “correction” of America’s current defi- cit, they say, would create more problems than it would solve. Whether the world’s holders of dollars will always agree remains to be seen.

“Financial Markets, Money and the Real World” by Paul Davidson. Edward Elgar 2002.

“The International Dollar Standard and Sustainability of the U.S. Cur- rent Account Deficit” by Ronald McKinnon 2001. Available on www. stanford.edu/~mckinnon/papers.htm

Source: The Economist, September 14, 2002, p. 74. Reprinted with permission.

8The current account balance (BCA) is equal to national output (Y) minus domestic absorption (which

comprises consumption, investment, and government expenditure), i.e., BCA = Y − (C + I + G).

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76 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

While perennial balance-of-payments deficits or surpluses can be a problem, each

country need not achieve balance-of-payments equilibrium every year. Suppose a

country is currently experiencing a trade deficit because of the import demand for

capital goods that are necessary for economic development projects. In this case, the

trade deficit can be self-correcting in the long run because once the projects are com-

pleted, the country may be able to export more or import less by substituting domestic

products for foreign imports. In contrast, if the trade deficit is the result of importing

consumption goods, the situation may not correct itself. Thus, what matters is the

nature and causes of the disequilibrium.

Lastly, let us briefly examine which countries the United States trades with most

actively. Exhibit 3.8 provides the list of top 15 trading partners of the United States

in terms of merchandise imports and exports. As can be expected, the United States

trades most with Canada, its northern neighbor and a member of NAFTA, import-

ing $324.2 billion and exporting $292.4 billion in 2012. China is the second most

Balance-of-Payments Trends: 1982–2011EXHIBIT 3.7

Source: IMF, International Financial Statistics.

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

–900

–700

–500

–300

–100

100

300

500

700

900 U.S.

Capital account

Current account

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

–200

–150

–100

–50

100

150

200

250

Japan

Current account

Capital account

Current account

Capital account

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

–50

100

150

200

250

300

350

400

450

China

B al

an ce

o f

pa ym

en ts

( $

bi lli

on )

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C H A P T E R 3 BALANCE OF PAYMENTS 77

important trading partner for the United States, importing $425.6 billion and export-

ing $110.6 billion in 2012. Clearly, imports from China far exceed exports to China,

resulting in a bilateral trade deficit of $315 billion for the United States in 2012.

This large trade surplus for China (and deficit for the United States) is a major factor

driving appreciation of Chinese renminbi (RMB) against the United States dollar in

recent years. Mexico, a southern neighbor of the United States and another member

of NAFTA, is the third most important trading partner of the United States, followed

by Japan and Germany. It is noted that the United States had trade deficits with most

of its trading partners in 2012.

SUMMARY 1. The balance of payments can be defined as the statistical record of a country’s

international transactions over a certain period of time presented in the form of

double-entry bookkeeping.

2. In the balance of payments, any transaction resulting in a receipt from foreigners

is recorded as a credit, with a positive sign, whereas any transaction resulting in a

payment to foreigners is recorded as a debit, with a minus sign.

3. A country’s international transactions can be grouped into three main categories:

the current account, the capital account, and the official reserve account. The cur-

rent account includes exports and imports of goods and services, whereas the capi-

tal account includes all purchases and sales of assets such as stocks, bonds, bank

accounts, real estate, and businesses. The official reserve account covers all pur-

chases and sales of international reserve assets, such as dollars, foreign exchanges,

gold, and SDRs.

4. The current account is divided into four subcategories: merchandise trade, ser-

vices, factor income, and unilateral transfers. Merchandise trade represents

exports and imports of tangible goods, whereas trade in services includes pay-

ments and receipts for legal, engineering, consulting, and other performed ser-

vices and tourist expenditures. Factor income consists of payments and receipts

of interest, dividends, and other income on previously made foreign investments.

Lastly, unilateral transfer involves unrequited payments such as gifts, foreign aid,

and reparations.

EXHIBIT 3.8 Trade Total Rank Country Imports Exports Balance Trade

1 Canada 324.2 292.4 –31.8 616.7 2 China 425.6 110.6 –315.0 536.2 3 Mexico 277.7 216.3 –61.4 494.0 4 Japan 146.4 70.0 –76.4 216.4 5 Germany 108.5 48.8 –59.7 157.3 6 United Kingdom 54.9 54.8 –0.1 109.8 7 Korea, South 58.9 42.3 –16.6 101.2 8 Brazil 32.1 43.7 11.6 75.8 9 Saudi Arabia 55.7 18.1 –37.6 73.8 10 France 41.6 30.8 –10.8 72.4 11 Taiwan 38.9 24.4 –14.5 63.2 12 Netherlands 22.3 40.7 18.4 63.0 13 India 40.5 22.3 –18.2 62.9 14 Venezuela 38.7 17.6 –21.1 56.4 15 Italy 36.9 16.0 –20.9 52.9

Source: Census Bureau.

Top U.S. Trading

Partners, 2012 (in billions

of dollars)

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78 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT w

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5. The capital account is divided into three subcategories: direct investment, port-

folio investment, and other investment. Direct investment involves acquisitions

of controlling interests in foreign businesses. Portfolio investment represents

investments in foreign stocks and bonds that do not involve acquisitions of control.

Other investment includes bank deposits, currency investment, trade credit, and

the like.

6. When we compute the cumulative balance of payments including the current

account, capital account, and the statistical discrepancies, we obtain the overall bal-

ance or official settlement balance. The overall balance is indicative of a country’s

balance-of-payments gap that must be accommodated by official reserve transac-

tions. If a country must make a net payment to foreigners because of a balance-of-

payments deficit, the country should either run down its official reserve assets, such

as gold, foreign exchanges, and SDRs, or borrow anew from foreigners.

7. A country can run a balance-of-payments surplus or deficit by increasing or

decreasing its official reserves. Under the fixed exchange rate regime, the com-

bined balance on the current and capital accounts will be equal in size, but opposite

in sign, to the change in the official reserves. Under the pure flexible exchange rate

regime where the central bank does not maintain any official reserves, a current

account surplus or deficit must be matched by a capital account deficit or surplus.

KEY WORDS balance of payments, 62

balance-of-payments

identity (BOPI), 72

capital account, 64

current account, 64

factor income, 65

foreign direct investment

(FDI), 67

invisible trade, 65

J-curve effect, 66

mercantilism, 74

merchandise trade, 65

official reserve account, 64

official reserve assets, 69

official settlement

balance, 68

other investment, 68

overall balance, 68

portfolio investment, 67

services, 65

trade balance, 65

unilateral transfers, 65

QUESTIONS 1. Define balance of payments.

2. Why would it be useful to examine a country’s balance-of-payments data?

3. The United States has experienced continuous current account deficits since the

early 1980s. What do you think are the main causes for the deficits? What would

be the consequences of continuous U.S. current account deficits?

4. In contrast to the United States, Japan has realized continuous current account sur-

pluses. What could be the main causes for these surpluses? Is it desirable to have

continuous current account surpluses?

5. Comment on the following statement: “Since the United States imports more than

it exports, it is necessary for the United States to import capital from foreign coun-

tries to finance its current account deficits.”

6. Explain how a country can run an overall balance-of-payments deficit or surplus.

7. Explain official reserve assets and its major components.

8. Explain how to compute the overall balance and discuss its significance.

9. Since the early 1980s, foreign portfolio investors have purchased a significant por-

tion of U.S. Treasury bond issues. Discuss the short-term and long-term effects of

foreigners’ portfolio investment on the U.S. balance of payments.

10. Describe the balance-of-payments identity and discuss its implications under the

fixed and flexible exchange rate regimes.

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C H A P T E R 3 BALANCE OF PAYMENTS 79

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1. Study the website of the International Monetary Fund (IMF), www.imf.org , and

discuss the role of the IMF in dealing with balance-of-payment and currency crises.

PROBLEMS 1. Examine the following summary of the U.S. balance of payments for 2000

(in $ billion) and fill in the blank entries.

11. Exhibit 3.6 indicates that in 1999, Germany had a current account deficit and at

the same time a capital account deficit. Explain how this can happen.

12. Explain how each of the following transactions will be classified and recorded in

the debit and credit of the U.S. balance of payments:

a. A Japanese insurance company purchases U.S. Treasury bonds and pays out of

its bank account kept in New York City.

b. A U.S. citizen consumes a meal at a restaurant in Paris and pays with her

American Express card.

c. An Indian immigrant living in Los Angeles sends a check drawn on his LA

bank account as a gift to his parents living in Mumbai.

d. A U.S. computer programmer is hired by a British company for consulting and

gets paid from the U.S. bank account maintained by the British company.

13. Construct a balance-of-payments table for Germany for the year 2010 which is

comparable in format to Exhibit 3.1 , and interpret the numerical data. You may

consult International Financial Statistics published by IMF or search for useful

websites for the data yourself.

14. Discuss the possible strengths and weaknesses of SDRs versus the dollar as the

main reserve currency. Do you think the SDR should or could replace the U.S.

dollar as the main global reserve currency?

Source: IMF, International Financial Statistics Yearbook, 2001.

Credits Debits

Current Account (1) Exports 1,418.64 (1.1) Merchandise 774.86 (1.2) Services 290.88 (1.3) Factor income 352.90 (2) Imports −1,809.18 (2.1) Merchandise (2.2) Services −217.07 (2.3) Factor income −367.68 (3) Unilateral transfer 10.24 −64.39 Balance on current account

Capital Account (4) Direct investment 287.68 −152.44 (5) Portfolio investment 474.59 −124.94 (5.1) Equity securities 193.85 −99.74 (5.2) Debt securities 280.74 −25.20 (6) Other investment 262.64 −303.27 Balance on capital account

(7) Statistical discrepancies Overall balance 0.30 Official Reserve Account −0.30

INTERNET EXERCISES

WWW

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80 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT w

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MINI CASE Mexico’s Balance-of-Payments Problem

Mexico experienced large-scale trade deficits, depletion of foreign reserve holdings, and a major currency devaluation in December 1994, followed by the decision to freely float the peso. These events also brought about a severe recession and higher unemploy- ment in Mexico. Since the devaluation, however, the trade balance has improved.

Investigate the Mexican experiences in detail and write a report on the subject. In the report, you may:

1. Document the trend in Mexico’s key economic indicators, such as the balance of payments, the exchange rate, and foreign reserve holdings, during the period 1994.1 through 1995.12.

2. Investigate the causes of Mexico’s balance-of-payments difficulties prior to the peso devaluation.

3. Discuss what policy actions might have prevented or mitigated the balance-of- payments problem and the subsequent collapse of the peso.

4. Derive lessons from the Mexican experience that may be useful for other developing countries.

In your report, you may identify and address any other relevant issues concerning Mexico’s balance-of-payments problem. International Financial Statistics published by the IMF provides basic macroeconomic data on Mexico.

REFERENCES & SUGGESTED READINGS

Edwards, Sebastian. Real Exchange Rates, Devaluation and Adjustment: Exchange Rate Policy in Developing Countries. Cambridge, Mass.: MIT Press, 1989.

Grabbe, Orlin. International Financial Markets . New York: Elsevier, 1991.

Kemp, Donald. “Balance of Payments Concepts—What Do They Really Mean?” Federal Reserve Bank of St. Louis Review , July 1975, pp. 14–23.

Ohmae, Kenichi. “Lies, Damned Lies and Statistics: Why the Trade Deficit Doesn’t Matter in a

Borderless World.” Journal of Applied Corporate World , Winter, 1991, pp. 98–106.

Salop, Joan, and Erich Spitaller. “Why Does the Current Account Matter?” International Monetary

Fund, Staff Papers , March 1980, pp. 101–34.

U.S. Department of Commerce. “Report of the Advisory Committee on the Presentation of the Bal-

ance of Payments Statistics.” Survey of Current Business , June, 1991, pp. 18–25.

Yeager, Leland. International Monetary Relations. New York: Harper & Row, 1965.

eun61604_ch03_062-081.indd 80eun61604_ch03_062-081.indd 80 1/3/14 10:15 AM1/3/14 10:15 AM

This section is designed to explore the mathematical relationship between balance-of-

payments accounting and national income accounting and to discuss the implications

of this relationship. National income (Y), or gross domestic product (GDP), is identi-

cally equal to the sum of nominal consumption (C) of goods and services, private

investment expenditures (I), government expenditures (G), and the difference between

exports (X) and imports (M) of goods and services:

GDP ; Y ; C 1 I 1 G 1 X 2 M. (3A.1)

Private savings (S) is defined as the amount left from national income after consump-

tion and taxes (T) are paid:

S ; Y 2 C 2 T, or (3A.2)

S ; C 1 I 1 G 1 X 2 M 2 C 2 T. (3A.3)

Noting that the BCA ; X 2 M, equation (3A.3) can be rearranged as:

(S 2 I) 1 (T 2 G) ; X 2 M ; BCA. (3A.4)

Equation (3A.4) shows that there is an intimate relationship between a country’s BCA

and how the country finances its domestic investment and pays for government expen-

ditures. In equation (3A.4), (S 2 I) is the difference between a country’s savings and

investment. If (S 2 I) is negative, it implies that a country’s domestic savings is insuf-

ficient to finance domestic investment. Similarly, (T 2 G) is the difference between

tax revenue and government expenditures. If (T 2 G) is negative, it implies that tax

revenue is insufficient to cover government spending and a government budget deficit

exists. This deficit must be financed by the government issuing debt securities.

Equation (3A.4) also shows that when a country imports more than it exports,

its BCA will be negative because through trade foreigners obtain a larger claim to

domestic assets than the claim the country’s citizens obtain to foreign assets. Conse-

quently, when BCA is negative, it implies that government budget deficits and/or part

of domestic investment are being financed with foreign-controlled capital. In order for

a country to reduce a BCA deficit, one of the following must occur:

1. For a given level of S and I, the government budget deficit (T 2 G) must be

reduced.

2. For a given level of I and (T 2 G), S must be increased.

3. For a given level S and (T 2 G), I must fall.

The Relationship Between Balance of Payments and National Income Accounting 3A

Appendix

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Corporate Governance Around the World

IN CHAPTER 1 , we argue that the key goal of financial man-

agement should be shareholder wealth maximization. In real-

ity, however, there is no guarantee that managers would run

the company to maximize the welfare of shareholders. In fact,

the recent spate of corporate scandals and failures, including

Enron, WorldCom, and Global Crossing in the United States,

Daewoo Group (a major chaebol ) in Korea, Parmalat in Italy,

and HIH (a major insurance group) in Australia, has raised

serious questions about the way public corporations are gov-

erned around the world. When “self-interested” managers take

control of the company, they sometimes engage in actions that

are profoundly detrimental to the interests of shareholders and

other stakeholders. For example, such managers may give them-

selves excessive salaries and indulgent perquisites, squander

resources for corporate empire building, divert the company’s

cash and assets for private benefits, engage in cronyism, and

steal business opportunities from the company. A recent report

in the Harvard Business Review (January 2003) describes how

American executives “treat their companies like ATMs, awarding

themselves millions of dollars in corporate perks.” In many

less developed and transitional countries, corporate governance

mechanisms are either very weak or virtually nonexistent. In

Russia, for example, a weak corporate governance system

allows managers to divert assets from newly privatized compa-

nies on a large scale.

When managerial self-dealings are excessive and left

unchecked, they can have serious negative effects on cor-

porate values and the proper functions of capital markets. In

fact, there is a growing consensus around the world that it is

vitally important to strengthen corporate governance to pro-

tect shareholder rights , curb managerial excesses, and restore

confidence in capital markets. Corporate governance can be

defined as the economic, legal, and institutional framework in which corporate control and cash flow rights are distributed among shareholders, managers, and other stake- holders of the company . Other stakeholders may include workers, creditors, banks,

institutional investors, and even the government. As we will see later, corporate gover-

nance structure varies a great deal across countries, reflecting divergent cultural, eco-

nomic, political, and legal environments. It is thus essential for international investors

and multinational corporations to have a solid understanding of the corporate gover-

nance environments around the world. An example of governance risk is provided by

Citigroup’s dealings with Parmalat. According to BBC News (March 18, 2005), Wil-

liam Mills of Citigroup said, “Citigroup is a victim of Parmalat’s fraud and lost more

than 500 million euros as a result…. If Citigroup had known the truth, it would not

have done business with Parmalat.”

Governance of the Public Corporation: Key Issues The Agency Problem Remedies for the Agency Problem

Board of Directors

Incentive Contracts

Concentrated Ownership

Accounting Transparency

Debt

Overseas Stock Listings

Market for Corporate Control

Law and Corporate Governance Consequences of Law

Ownership and Control Pattern

Private Benefits of Control

Capital Markets and Valuation

Corporate Governance Reform Objectives of Reform

Political Dynamics

The Sarbanes-Oxley Act

The Cadbury Code of Best Practice

The Dodd-Frank Act

Summary Key Words Questions Internet Exercises MINI CASE: Parmalat: Europe’s Enron

References and Suggested Readings

CHAPTER C

H A

P T

E R

O U

T L

IN E

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C H A P T E R 4 CORPORATE GOVERNANCE AROUND THE WORLD 83

Governance of the Public Corporation: Key Issues The public corporation , which is jointly owned by a multitude of shareholders pro-

tected by limited liability, is a major organizational innovation with powerful economic

consequences. The majority of global corporations that drive economic growth and

innovations worldwide, such as Apple, Google, General Electric (GE), IBM, Toyota,

Samsung Electronics, British Petroleum (BP), and BMW, are chartered as public cor-

porations rather than as private companies. The genius of public corporations stems

from their capacity to allow efficient sharing or spreading of risk among many inves-

tors, who can buy and sell their ownership shares on liquid stock exchanges and let

professional managers run the company on behalf of shareholders. This efficient risk-

sharing mechanism enables public corporations to raise large amounts of capital at

relatively low costs and undertake many investment projects that individual entrepre-

neurs or private investors might eschew because of the costs and/or risks. Public cor-

porations have played a pivotal role in spreading economic growth and capitalism

worldwide for the last few centuries.

However, the public corporation has a key weakness—namely, the conflicts of

interest between managers and shareholders. The separation of the company’s owner-

ship and control, which is especially prevalent in such countries as the United States

and the United Kingdom, where corporate ownership is highly diffused, gives rise

to possible conflicts between shareholders and managers. In principle, shareholders

elect the board of directors of the company, which in turn hires managers to run the

company for the interests of shareholders. In the United States, managers are legally

bound by the “duty of loyalty” to shareholders. Managers are thus supposed to be

agents working for their principals, that is, shareholders, who are the real owners of

the company. In a public company with diffused ownership, the board of directors

is entrusted with the vital tasks of monitoring the management and safeguarding the

interests of shareholders.

In reality, however, management-friendly insiders often dominate the board of

directors, with relatively few outside directors who can independently monitor the

management. In the case of Enron and similarly dysfunctional companies, the boards

of directors grossly failed to safeguard shareholder interests. Furthermore, with dif-

fused ownership, few shareholders have strong enough incentive to incur the costs of

monitoring management themselves when the benefits from such monitoring accrue to

all shareholders alike. The benefits are shared, but not the costs. When company own-

ership is highly diffused, this “free-rider” problem discourages shareholder activism.

As a result, the interests of managers and shareholders are often allowed to diverge.

With an ineffective and unmotivated board of directors, shareholders are basically

left without effective recourse to control managerial self-dealings. Recognition of this

key weakness of the public corporation can be traced at least as far back as Adam

Smith’s Wealth of Nations (1776), which stated:

The directors of such joint-stocks companies, however, being the managers rather of other

people’s money than of their own, it cannot well be expected that they should watch over it

with the same anxious vigilance with which the partners of a private copartnery frequently

watch over their own. . . . Negligence and profusion, therefore, must always prevail, more or

less, in the management of the affairs of such a company.

Two hundred years later, Jensen and Meckling (1976) provided a formal analysis of

the “agency problem” of the public corporation in their celebrated paper “Theory of

the Firm: Managerial Behavior, Agency Costs, and Ownership Structure.” The Jensen-

Meckling agency theory drew attention to this vitally important corporate finance

problem.

It is suggested, however, that outside the United States and the United Kingdom,

diffused ownership of the company is more the exception than the rule. In Italy, for

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84 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

instance, the three largest shareholders control, on average, about 60 percent of the

shares of a public company. The average comparable ownership by the three larg-

est shareholders is 54 percent in Hong Kong, 64 percent in Mexico, 48 percent in

Germany, 40 percent in India, and 51 percent in Israel. 1 These large shareholders

(often including founding families of the company) effectively control managers and

may run the company for their own interests, expropriating outside shareholders in one

way or another. In many countries with concentrated corporate ownership, conflicts

of interest are greater between large controlling shareholders and small outside share-

holders than between managers and shareholders.

In a series of influential studies, La Porta, Lopez-de-Silanes, Shleifer, and Vishny

(LLSV, hereafter) document sharp differences among countries with regard to (i) corpo-

rate ownership structure, (ii) depth and breadth of capital markets, (iii) access of firms

to external financing, and (iv) dividend policies. LLSV argue that these differences

among countries can be explained largely by how well investors are protected by law

from expropriation by the managers and controlling shareholders of firms. LLSV also

argue that the degree of legal protection of investors significantly depends on the “legal

origin” of countries. Specifically, English common law countries, such as Canada, the

United States, and the United Kingdom, provide the strongest protection for investors,

whereas French civil law countries, such as Belgium, Italy, and Mexico, provide the

weakest. We will revisit the issue of law and corporate governance later in the chapter.

Shareholders in different countries may indeed face divergent corporate governance

systems. However, the central problem in corporate governance remains the same

everywhere: how to best protect outside investors from expropriation by the control- ling insiders so that the investors can receive fair returns on their investments . How

to deal with this problem has enormous practical implications for shareholder welfare,

corporate allocation of resources, corporate financing and valuation, development of

capital markets, and economic growth. In the rest of this chapter, we will discuss the

following issues in detail: 2

• Agency problem

• Remedies for the agency problem

• Law and corporate governance

• Consequences of law

• Corporate governance reform

The Agency Problem Suppose that the manager (or entrepreneur) and the investors sign a contract that speci-

fies how the manager will use the funds and also how the investment returns will be

divided between the manager and the investors. If the two sides can write a complete contract that specifies exactly what the manager will do under each of all possible

future contingencies, there will be no room for any conflicts of interest or manage-

rial discretion. Thus, under a complete contract, there will be no agency problem .

However, it is practically impossible to foresee all future contingencies and write a

complete contract. This means that the manager and the investors will have to allocate

the rights (control) to make decisions under those contingencies that are not specifi-

cally covered by the contract. Because the outside investors may be neither qualified

www.ecgi.org

This site provides an overview

of corporate governance in

European countries.

1Source: R. La Porta, F. Lopez-de-Silanes, A. Shleifer, and R. Vishny, “Law and Finance,” Journal of Political Economy 106 (1998), pp. 1113–55. 2Our discussion here draws on the contributions of Jensen and Meckling (1976), Jensen (1989), La Porta,

Lopez-de-Silanes, Shleifer, and Vishny (1997–2002), and Denis and McConnell (2002).

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C H A P T E R 4 CORPORATE GOVERNANCE AROUND THE WORLD 85

nor interested in making business decisions, the manager often ends up acquiring most

of this residual control right . The investors supply funds to the company but are not

involved in the company’s daily decision making. As a result, many public companies

come to have “strong managers and weak shareholders.” The agency problem refers

to the possible conflicts of interest between self-interested managers as agents and

shareholders of the firm who are the principals.

Having captured residual control rights, the manager can exercise substantial dis-

cretion over the disposition and allocation of investors’ capital. Under this situation,

the investors are no longer assured of receiving fair returns on their funds. In the con-

tractual view of the firm described above, the agency problem arises from the dif-

ficulty that outside investors face in assuring that they actually receive fair returns on

their capital. 3

With the control rights, the manager may allow himself or herself to consume exor-

bitant perquisites. For example, Steve Jobs, the former CEO of Apple Inc., reportedly

had a $90 million company jet at his disposal. 4 Sometimes, the manager simply steals

investors’ funds. Alternatively, the manager may use a more sophisticated scheme, set-

ting up an independent company that he owns and diverting to it the main company’s

cash and assets through transfer pricing . For example, the manager can sell the main

company’s output to the company he owns at below market prices, or buy the output of

the company he owns at above market prices. Some Russian oil companies are known

to sell oil to manager-owned trading companies at below market prices and not always

bother to collect the bills. 5

Self-interested managers may also waste funds by undertaking unprofitable proj-

ects that benefit themselves but not investors. For example, managers may misallocate

funds to take over other companies and overpay for the targets if it serves their private

interests. Needless to say, this type of investment will destroy shareholder value. What

is more, the same managers may adopt antitakeover measures for their own company

in order to ensure their personal job security and perpetuate private benefits. In the

same vein, managers may resist any attempts to be replaced even if shareholders’

interests will be better served by their dismissal. These managerial entrenchment efforts are clear signs of the agency problem.

As pointed out by Jensen (1989), the agency problem tends to be more serious in

companies with “free cash flows.” Free cash flows represent a firm’s internally gener-

ated funds in excess of the amount needed to undertake all profitable investment proj-

ects, that is, those with positive net present values (NPVs). Free cash flows tend to be

high in mature industries with low future growth prospects, such as the steel, chemical,

tobacco, paper, and textile industries. It is the fiduciary duty of managers to return free

cash flows to shareholders as dividends. However, managers in these cash-rich and

mature industries will be most tempted to waste cash flows to undertake unprofitable

projects, destroying shareholders’ wealth but possibly benefiting themselves.

There are a few important incentives for managers to retain cash flows. First, cash

reserves provide corporate managers with a measure of independence from the capital

markets, insulating them from external scrutiny and discipline. This will make life eas-

ier for managers. Second, growing the size of the company via retention of cash tends

to have the effect of raising managerial compensation. As is well known, executive

compensation depends as much on the size of the company as on its profitability, if not

more. Third, senior executives can boost their social and political power and prestige

by increasing the size of their company. Executives presiding over large companies are

likely to enjoy greater social prominence and visibility than those running small com-

panies. Also, the company’s size itself can be a way of satisfying the executive ego.

3The contractual view of the firm was developed by Coase (1937) and Jensen and Meckling (1976). 4Source: Financial Times, November 27, 2002, p. 15. 5Source: A. Shleifer and R. Vishny, “A Survey of Corporate Governance,” Journal of Finance (1997).

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86 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

In the face of strong managerial incentives for retaining cash, few effective mech-

anisms exist that can compel the managers to disgorge cash flows to shareholders.

Jensen cites a revealing example of this widespread problem (1989, p. 66):

A vivid example is the senior management of Ford Motor Company, which sits on nearly

$15 billion in cash and marketable securities in an industry with excess capacity. Ford’s

management has been deliberating about acquiring financial service companies, aerospace

companies, or making some other multibillion-dollar diversification move—rather than

deliberating about effectively distributing Ford’s excess cash to its owners so they can decide

how to reinvest it.

He also points out that in the 1980s, many Japanese public companies retained enor-

mous amounts of free cash flow, far exceeding what they needed to finance profitable

internal projects. For example, Toyota Motor Company, with a cash hoard of more than

$10 billion, was known as the “Toyota Bank.” Lacking effective internal control and

external monitoring mechanisms, these companies went on an overinvestment binge

in the 1980s, engaging in unprofitable acquisitions and diversification moves. This

wasteful corporate spending is, at least in part, responsible for the economic slump

that Japan has experienced since the early 1990s.

The preceding examples show that the heart of the agency problem is the conflicts

of interest between managers and the outside investors over the disposition of free cash

flows. However, in high-growth industries, such as biotechnology, financial services,

and pharmaceuticals, where companies’ internally generated funds fall short of profit-

able investment opportunities, managers are less likely to waste funds in unprofitable

projects. After all, managers in these industries need to have a “good reputation,” as

they must repeatedly come back to capital markets for funding. Once the managers of

a company are known for wasting funds for private benefits, external funding for the

company may dry up quickly. The managers in these industries thus have an incentive

to serve the interests of outside investors and build a reputation so that they can raise

the funds needed for undertaking their “good” investment projects.

Remedies for the Agency Problem Obviously, it is a matter of vital importance for shareholders to control the agency

problem; otherwise, they may not be able to get their money back. It is also impor-

tant for society as a whole to solve the agency problem, since the agency problem

leads to waste of scarce resources, hampers capital market functions, and retards eco-

nomic growth. Several governance mechanisms exist to alleviate or remedy the agency

problem:

1. Independent board of directors

2. Incentive contracts

3. Concentrated ownership

4. Accounting transparency

5. Debt

6. Overseas stock listings

7. Market for corporate control

In the following sections, we discuss the corporate governance role of each of these

mechanisms.

In the United States, shareholders have the right to elect the board of directors, which

is legally charged with representing the interests of shareholders. If the board of direc-

tors remains independent of management, it can serve as an effective mechanism

for curbing the agency problem. For example, studies show that the appointment of

Board of Directors

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C H A P T E R 4 CORPORATE GOVERNANCE AROUND THE WORLD 87

outside directors is associated with a higher turnover rate of CEOs following poor firm

performances, thus curbing managerial entrenchment. In the same vein, in a study of

corporate governance in the United Kingdom, Dahya, McConnell, and Travlos (2002)

report that the board of directors is more likely to appoint an outside CEO after an

increase in outsiders’ representation on the board. But due to the diffused ownership

structure of the public company, management often gets to choose board members

who are likely to be friendly to management. As can be seen from the International

Finance in Practice box “When Boards Are All in the Family,” the insider-dominated

board becomes a poor governance mechanism.

The structure and legal charge of corporate boards vary greatly across countries.

In Germany, for instance, the corporate board is not legally charged with representing

the interests of shareholders. Rather, it is charged with looking after the interests of

stakeholders (e.g., workers, creditors) in general, not just shareholders. In Germany,

there are two-tier boards consisting of supervisory and management boards. Based

on the German codetermination system, the law requires that workers be represented

on the supervisory board. Likewise, some U.S. companies have labor union represen-

tatives on their boards, although it is not legally mandated. In the United Kingdom, the

majority of public companies voluntarily abide by the Code of Best Practice on cor-

porate governance recommended by the Cadbury Committee . The code recommends

that there should be at least three outside directors and that the board chairman and

the CEO should be different individuals. Apart from outside directors, separation of

the chairman and CEO positions can further enhance the independence of the board

of directors. In Japan, most corporate boards are insider-dominated and are primarily

concerned with the welfare of the keiretsu to which the company belongs.

As previously discussed, managers capture residual control rights and thus have enor-

mous discretion over how to run the company. But they own relatively little of the equity

of the company they manage. To the extent that managers do not own equity shares, they

do not have cash flow rights. Although managers run the company at their own discre-

tion, they may not significantly benefit from the profit generated from their efforts and

expertise. Jensen and Murphy (1990) show that the pay of American executives changes

only by about $3 per every $1,000 change of shareholder wealth; executive pay is nearly

insensitive to changes in shareholder wealth. This situation implies that managers may

not be very interested in the maximization of shareholder wealth. This “wedge” between

managerial control rights and cash flow rights may exacerbate the agency problem.

When professional managers have small equity positions of their own in a company with diffused ownership, they have both power and a motive to engage in self-dealings .

Aware of this situation, many companies provide managers with incentive contracts , such as stocks and stock options, in order to reduce this wedge and better

align the interests of managers with those of investors. With the grant of stocks or

stock options, managers can be given an incentive to run the company in such a way

that enhances shareholder wealth as well as their own. Against this backdrop, incentive

contracts for senior executives have become common among public companies in the

United States. As we have seen lately, however, senior executives can abuse incen-

tive contracts by artificially manipulating accounting numbers, sometimes with the

connivance of auditors (for example, Arthur Andersen’s involvements with the Enron

debacle), or by altering investment policies so that they can reap enormous personal

benefits. It is thus important for the board of directors to set up an independent com-

pensation committee that can carefully design incentive contracts for executives and

diligently monitor their actions.

An effective way to alleviate the agency problem is to concentrate shareholdings. If

one or a few large investors own significant portions of the company, they will have a

strong incentive to monitor management. For example, if an investor owns 51 percent

Incentive Contracts

Concentrated Ownership

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of the company, he or she can definitely control the management (he can easily hire or

fire managers) and will make sure that shareholders’ rights are respected in the conduct

of the company’s affairs. With concentrated ownership and high stakes, the free-rider

problem afflicting small, atomistic shareholders dissipates.

In the United States and the United Kingdom, concentrated ownership of a public

company is relatively rare. Elsewhere in the world, however, concentrated ownership

is the norm. In Germany, for example, commercial banks, insurance companies, other

companies, and families often own significant blocks of company stock. Similarly,

extensive cross-holdings of equities among keiretsu member companies and main banks

are commonplace in Japan. Also in France, cross-holdings and “core” investors are

common. In Asia and Latin America, many companies are controlled by founders or

their family members. In China, the government is often the controlling shareholder for

public companies. Previous studies indicate that concentrated ownership has a positive

effect on a company’s performance and value. For example, Kang and Shivdasani (1995)

report such positive effects for Japan, and Gorton and Schmid (2000) for Germany. This

suggests that large shareholders indeed play a significant governance role.

Of particular interest here is the effect of managerial equity holdings. Previous stud-

ies suggest that there can be a nonlinear relationship between managerial ownership

share and firm value and performance. Specifically, as the managerial ownership share

increases, firm value may initially increase, since the interests of managers and outside

investors become better aligned (thus reducing agency costs). But if the managerial

ownership share exceeds a certain point, firm value may actually start to decline as

managers become more entrenched. With larger shareholdings, for example, managers

may be able to more effectively resist takeover bids and extract larger private benefits

at the expense of outside investors. If the managerial ownership share continues to

rise, however, the alignment effect may become dominant again. When managers are

large shareholders, they do not want to rob themselves. To summarize, there can be an

“interim range” of managerial ownership share over which the entrenchment effect is

dominant.

INTERNATIONAL FINANCE IN PRACTICE

There is much talk these days about the need to increase the independence of directors on company boards. That has been obvious for a long time. Indeed, it is fairly easy to spot those boards for which chief executives have handpicked friends or business associates who are not truly independent.

This characteristic is a reliable indicator of whether a chief executive acts as a baronial owner of the company, or as one chosen by—and responsible to—the stakehold- ers. In fact, one can argue that making boards more inde- pendent is the single most important thing we can do in the current reform climate to restore public confidence.

By now it is well documented that boards dominated by their chief executives are prone to trouble. W.R. Grace is a good example. Peter Grace, the company’s chief executive, was too powerful. He controlled his board as if the enterprise were his personal fief.

Even though the business was foundering in the late 1990s, the board allowed Mr. Grace to negotiate a retirement package that included generous perks— including use of a corporate jet and a company-owned

apartment. The directors also sold a subsidiary to Mr. Grace’s son and bestowed other benefits that they neglected to disclose to shareholders. This non-disclo- sure was against the law and resulted in an SEC-type enforcement action.

Another example is Apple, whose board I was once asked, briefly, to consider joining. Apart from Steve Jobs, the CEO, the board currently has only four mem- bers while Mr. Jobs searches for a replacement for his friend Larry Ellison of Oracle, who resigned from Apple’s board in September.

That is all to the good, as Mr. Ellison attended fewer than half of Apple’s board meetings anyway. Bill Camp- bell, another director, is nominally independent but may not be truly so. Mr. Campbell, who chairs the company’s audit committee, qualifies as an independent director, because he is not currently connected with Apple. But he formerly worked at Apple and sold his software com- pany, Claris, to Apple.

Another member of Apple’s audit committee, Jerome York, is the chief executive of MicroWarehouse, whose

When Boards Are All in the Family

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This situation is illustrated in Exhibit 4.1 , depicting a possible relationship between

managerial ownership share and firm value. According to Morck, Shleifer, and Vishny

(1988), who studied the relationship for Fortune 500 U.S. companies, the first turning

point ( x ) is reached at about 5 percent and the second ( y ) at about 25 percent. This means

that the “entrenchment effect” is roughly dominant over the range of managerial owner-

ship between 5 percent and 25 percent, whereas the “alignment effect” is dominant for

the ownership shares less than 5 percent and exceeding 25 percent. 6 The relationship

between managerial ownership and firm value is likely to vary across countries. For

instance, Short and Keasey (1999) indicate that the inflection point ( x ) is reached at

12 percent in the United Kingdom, a much higher level of managerial ownership than

in the United States. They attribute this difference to more effective monitoring by U.K.

institutional investors and the lesser ability of U.K. managers to resist takeover.

Considering that major corporate scandals, such as Enron and Parmalat, are associ-

ated with massive accounting frauds, strengthening accounting standards can be an

effective way of alleviating the agency problem. Self-interested managers or corporate

insiders can have an incentive to “cook the books” (for example, inflating earnings

and hiding debts) to extract private benefits from the company. The managers need

a veil of opaque accounting numbers to pursue their own interests at the expense of

shareholders. Therefore, if companies are required to release more accurate account-

ing information in a timely fashion, managers may be less tempted to take actions

that are detrimental to the interests of shareholders. Basically, a greater accounting

transparency will reduce the information asymmetry between corporate insiders and

the public and discourage managerial self-dealings.

To achieve a greater transparency, however, it is important for (i) countries to reform

the accounting rules and (ii) companies to have an active and qualified audit committee.

Accounting Transparency

6It is noted that the authors actually used “Tobin’s q” to measure firm value. Tobin’s q is the ratio of the market

value of company assets to the replacement costs of the assets.

Mac Warehouse catalogue was responsible for nearly $150m of Apple’s $5.4bn sales in 2001. As a former chief financial officer for International Business Machines and Chrysler Mr. York is well qualified but his presence on the all-important audit committee had to be treated as an exceptional circumstance by the NASDAQ market.

Such choices, to my mind, can yield bad judgment. In January 2000, for example, Apple’s board awarded Mr. Jobs 20m shares, worth $550m if the share price increased 5 percent over 10 years. They also authorised the company to buy a $90m Gulfstream jet for him. The share price sank, putting Mr. Jobs’s options under water. So the board granted him 7.5m more shares. At the time of the grant, Apple shares were underperforming other stocks in their industry sub-class by 28 percent.

There is plenty of evidence that public scrutiny and a spotlight can help improve corporate governance. The California Public Employees’ Retirement System began pressing underperforming companies to change the com- position of their boards in 1993. Calpers drew up a list of corporate governance standards: make independent directors a majority on boards; let these directors meet the chief executive separately three times a year; make boards perform an annual assessment of their own per- formance, and so on.

A study by Wilshire Associates looked at the per- formance of 62 companies named by Calpers as poor performers. These companies’ stocks underperformed the Standard & Poor’s 500 index by an average of 89 percent in the five years before they were singled out. After the spotlight was shone on them, they outper- formed the index by an average of 23 percent over five years.

This does not, of course, mean all companies will fail without a model board of directors. At Warren Buffett’s Berkshire Hathaway, the seven directors include Mr. Buffet’s wife, his son, his business partner Charlie Munger, a partner at his company’s law firm and a co-investor with Berkshire Hathaway in other companies.

Mr. Buffett makes a persuasive argument that the best directors may well be those who have the greatest personal economic stake in the company. But the cor- relation of seduced boards with underperforming or ethically flawed enterprises suggests that independent overseers are much less likely to give in to temptation or corruption.

Source: Arthur Levitt, Financial Times, November 27, 2002. p. 15. Reprinted with permission.

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90 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

As we will discuss later in this chapter, the Sarbanes-Oxley Act of 2002 aims, among

other things, to promote a greater accounting transparency in the United States.

Although managers have discretion over how much of a dividend to pay to

shareholders, debt does not allow such managerial discretion. If managers fail to pay

interest and principal to creditors, the company can be forced into bankruptcy and its

managers may lose their jobs. Borrowing and the subsequent obligation to make inter-

est payments on time can have a major disciplinary effect on managers, motivating

them to curb private perks and wasteful investments and trim bloated organizations.

In fact, debt can serve as a substitute for dividends by forcing managers to disgorge

free cash flow to outside investors rather than wasting it. For firms with free cash

flows, debt can be a stronger mechanism than stocks for credibly bonding managers to

release cash flows to investors. 7

Excessive debt, however, can create its own problem. In turbulent economic condi-

tions, equities can buffer the company against adversity. Managers can pare down or

skip dividend payments until the situation improves. With debt, however, managers

do not have such flexibility and the company’s survival can be threatened. Excessive

debt may also induce the risk-averse managers to forgo profitable but risky investment

projects, causing an underinvestment problem. For this reason, debt may not be such

a desirable governance mechanism for young companies with few cash reserves or

tangible assets. In addition, companies can misuse debt to finance corporate empire

building. Daewoo, a Korean chaebol , borrowed excessively to finance global expan-

sion until it went into bankruptcy; its debt-to-equity ratio reached 600 percent before

bankruptcy.

Companies domiciled in countries with weak investor protection, such as Italy, Korea,

and Russia, can bond themselves credibly to better investor protection by listing their

stocks in countries with strong investor protection, such as the United States and the

Debt

Overseas Stock Listings

EXHIBIT 4.1

The Alignment versus

Entrenchment Effects of

Managerial Ownership

7Leveraged buyouts (LBOs) can also be viewed as a remedy for the agency problem. LBOs involve managers

or buyout partners acquiring controlling interests in public companies, usually financed by heavy borrowing.

Concentrated ownership and high level of debt associated with LBOs can be effective in solving the agency

problem.

x y

Managerial Ownership (%)

F ir

m V

al ue

( $)

Alignment AlignmentEntrenchment

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C H A P T E R 4 CORPORATE GOVERNANCE AROUND THE WORLD 91

United Kingdom. In other words, foreign firms with weak governance mechanisms

can opt to outsource a superior corporate governance regime available in the United

States via cross-listings. Suppose that Fiat, an Italian automobile company, announces

its decision to list its stock on the New York Stock Exchange (NYSE). 8 Since the level

of shareholder protection afforded by the U.S. Securities and Exchange Commission

(SEC) and the NYSE is much higher than that provided in Italy, the action will be

interpreted as signaling the company’s commitment to shareholder rights. Then, inves-

tors both in Italy and abroad will be more willing to provide capital to the company and

value the company shares more. Generally speaking, the beneficial effects from U.S.

listings will be greater for firms from countries with weaker governance mechanisms.

Studies confirm the effects of cross-border listings. Specifically, Doidge, Karolyi, and

Stulz (2002) report that foreign firms listed in the United States are valued more than

those from the same countries that are not listed in the United States. They argue that

firms listed in the United States can take better advantage of growth opportunities and

that controlling shareholders cannot extract as many private benefits. It is pointed out,

however, that foreign firms in mature industries with limited growth opportunities are

not very likely to seek U.S. listings, even though these firms face more serious agency

problems than firms with growth opportunities that are more likely to seek U.S. listings.

In other words, firms with more serious problems are less likely to seek the remedies.

Emerging stock markets, such as China, India, Russia, and Vietnam, are highly

imperfect, reflecting inadequate disclosure and regulation, opaque legal and gover-

nance framework, and ownership restrictions. In the case of China, for example, stock

markets are dominated by a multitude of small individual investors who are neither

well informed nor protected. So far, institutional investors, such as mutual funds, pen-

sion funds, and insurance companies, who can produce high-quality information about

listed companies and effectively protect shareholders’ rights, play a relatively minor

role in China. However, public Chinese companies can offer the so-called “B-shares”

to foreign investors that are listed on domestic stock exchanges alongside A-shares

for local investors, or directly list their shares on the Hong Kong Stock Exchange

as “H-shares” or on other foreign stock exchanges, including the New York Stock

Exchange. Eun and Huang (2007) found that domestic Chinese investors pay higher

prices for local A-shares of those Chinese companies that offer B- or H-shares to inter-

national investors. This is in recognition of the facts that (i) the issuance of international

shares, that is, B-shares and H-shares, is subject to much more stringent disclosure and

listing standards, making more information available to shareholders; and (ii) that for-

eign shareholders, especially institutional investors, may provide more rigorous moni-

toring of the management, thereby benefiting Chinese local shareholders as well. The

Eun and Huang study also found that ceteris paribus , Chinese investors pay a premium

for dividend-paying stocks as dividends convincingly signal the management’s willing-

ness to return cash flows to outside shareholders, rather than expropriating them.

Suppose a company continually performs poorly and all of its internal governance

mechanisms fail to correct the problem. This situation may prompt an outsider (another

company or investor) to mount a takeover bid. In a hostile takeover attempt, the bid-

der typically makes a tender offer to the target shareholders at a price substantially

exceeding the prevailing share price. The target shareholders thus have an opportunity

to sell their shares at a substantial premium. If the bid is successful, the bidder will

acquire the control rights of the target and restructure the company. Following a suc-

cessful takeover, the bidder often replaces the management team, divests some assets

or divisions, and trims employment in an effort to enhance efficiency. If these efforts

are successful, the combined market value of the acquirer and target companies will

Market for Corporate Control

8Fiat is actually listed on the New York Stock Exchange.

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92 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

become higher than the sum of stand-alone values of the two companies, reflecting the

synergies created. The market for corporate control, if it exists, can have a disciplinary

effect on managers and enhance company efficiency.

In the United States and the United Kingdom, hostile takeovers can serve as a dras-

tic governance mechanism of the last resort. Under the potential threat of takeover,

managers cannot take their control of the company for granted. In many other coun-

tries, however, hostile takeovers are relatively rare. This is so partly because of concen-

trated ownership in these countries and partly because of cultural values and political

environments disapproving hostile corporate takeovers. But even in these countries,

the incidence of corporate takeovers has been gradually increasing. This can be due,

in part, to the spreading of equity culture and the opening and deregulation of capital

markets. In Germany, for instance, takeovers are carried out through transfer of block

holdings. In Japan, as in Germany, interfirm cross-holdings of equities are loosening,

creating capital market conditions that are more conducive to takeover activities. To

the extent, however, that companies with poor investment opportunities and excess

cash initiate takeovers, it may be a symptom, rather than a cure, of the agency problem.

Law and Corporate Governance When outside investors entrust funds to the company, they receive certain rights that

are legally protected. Among these are the rights to elect the board of directors, receive

dividends on a pro-rata basis, participate in shareholders’ meetings, and sue the com-

pany for expropriation. These rights empower investors to extract from management

fair returns on their funds. However, the content of law protecting investors’ rights and

the quality of law enforcement vary a great deal across countries. According to the stud-

ies of La Porta, Lopez-de-Silanes, Shleifer, and Vishny (LLSV), many of the observed

differences in international corporate governance systems arise from the differences in

how well outside investors are protected by law from expropriation by managers and

other corporate insiders. LLSV argue that the legal protection of investor rights system-

atically varies, depending on the historical origins of national legal systems.

Legal scholars show that the commercial legal systems (for example, company,

security, bankruptcy, and contract laws) of most countries derive from relatively few

legal origins :

• English common law

• French civil law

• German civil law

• Scandinavian civil law

The French and German civil laws derived from the Roman law, whereas the

Scandinavian countries developed their own civil law tradition that is less derivative of

Roman law. The civil law tradition, which is the most influential and widely spread, is

based on the comprehensive codification of legal rules . In contrast, English common

law is formed by the discrete rulings of independent judges on specific disputes and

judicial precedent. These distinct legal systems, especially English common law and French civil law ,

spread around the world through conquest, colonization, voluntary adoption, and subtle

imitation. The United Kingdom and its former colonies, including Australia, Canada,

India, Malaysia, Singapore, South Africa, New Zealand, and the United States, have the

English common law system. France and the parts of Europe conquered by Napoleon,

such as Belgium, the Netherlands, Italy, Portugal, and Spain, ended up with the French

civil law tradition. Further, many former overseas colonies of France, the Netherlands,

Portugal, and Spain, such as Algeria, Argentina, Brazil, Chile, Indonesia, Mexico, and

the Philippines, also ended up with the French civil law system. The German civil law

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C H A P T E R 4 CORPORATE GOVERNANCE AROUND THE WORLD 93

family comprises Germany and the Germanic countries of Europe, such as Austria and

Switzerland, and a few East Asian countries such as Japan and Korea. The Scandi-

navian civil law family includes four Nordic countries: Denmark, Finland, Norway,

and Sweden. Thus, in most countries, the national legal system did not indigenously

develop but rather was transplanted from one of several legal origins. Although national

legal systems have evolved and adapted to local conditions, it is still possible to classify

them into a few distinct families. Such a classification is provided in Exhibit 4.2 . The

exhibit also provides the indexes for shareholder rights and rule of law for each country

as computed by LLSV (1998).

Exhibit 4.2 shows that the average shareholder rights index is 4.00 for English com-

mon law countries, 2.33 for both French and German civil law countries, and 3.00 for

Scandinavian civil law countries. Thus, English common law countries tend to offer

the strongest protection for investors, French and German civil law countries offer the

weakest, and Scandinavian civil law countries fall in the middle. The quality of law

enforcement, as measured by the rule of law index, is the highest in Scandinavian and

German civil law countries, followed by English common law countries; it is lowest in

French civil law countries.

Clearly, there is a marked difference in the legal protection of investors between

the two most influential legal systems, namely, English common law and French civil

law. A logical question is: Why is the English common law system more protective

of investors than the French civil law system? According to the prevailing view, the

state historically has played a more active role in regulating economic activities and

has been less protective of property rights in civil law countries than in common law

countries. In England, control of the court passed from the crown to Parliament and

property owners in the seventeenth century. English common law thus became more

protective of property owners, and this protection was extended to investors over time.

This legal tradition in England allows the court to exercise its discretionary judgment

or “smell test” over which managerial self-dealings are unfair to investors. In France

as well as in Germany, parliamentary power was weak and commercial laws were

codified by the state, with the role of the court confined to simply determining whether

the codified rules were violated or not. Since managers can be creative enough to

expropriate investors without obviously violating the codified rules, investors receive

low protection in civil law countries.

Glaesser and Shleifer (2002) offer an intriguing explanation of the English and

French legal origins based on the divergent political situations prevailing in the Middle

Ages. In France, local feudal lords were powerful and there were incessant wars.

Under this turbulent situation, there was a need for the protection of adjudicators from

local powers, which can only be provided by the king. France came to adopt a royal

judge-inquisitor model based on the Justinian code of the Roman Empire in the thir-

teenth century. According to this model, judges appointed by the king collect evidence,

prepare written records, and determine the outcome of the case. Understandably, royal

judges were mindful of the preferences of the king. The French legal tradition was for-

malized by the Code Napoleon . Napoleon extensively codified legal rules, bright line rules in legal terms, and required state-appointed judges to merely apply these rules.

In England, in contrast, local lords were less powerful and war was less frequent. In

a more peaceful England, which partly reflects the country’s geographical isolation,

local magnates were mainly afraid of royal power and preferred adjudication by a local

jury that was not beholden to the preferences of the crown and was more knowledge-

able about local facts and preferences. Initially, the jury consisted of 12 armed knights

who were less likely to be intimidated by local bullies or special pressure groups. After

the adoption of Magna Carta in 1215, local magnates basically paid the crown for

the privilege of local, independent adjudication and other rights. The divergent legal

developments in England and France came to have lasting effects on the legal systems

of many countries.

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94 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

Legal Origin

Country Shareholder Rule of

Rights Index Law Index

1. English common law Australia 4 10.00 Canada 5 10.00 Hong Kong 5 8.22 India 5 4.17 Ireland 4 7.80 Israel 3 4.82 Kenya 3 5.42 Malaysia 4 6.78 New Zealand 4 10.00 Nigeria 3 2.73 Pakistan 5 3.03 Singapore 4 8.57 South Africa 5 4.42 Sri Lanka 3 1.90 Thailand 2 6.25 United Kingdom 5 8.57 United States 5 10.00 Zimbabwe 3 3.68 English-origin average 4.00 6.46 2. French civil law Argentina 4 5.35 Belgium 0 10.00 Brazil 3 6.32 Chile 5 7.02 Colombia 3 2.08 Ecuador 2 6.67 Egypt 2 4.17 France 3 8.98 Greece 2 6.18 Indonesia 2 3.98 Italy 1 8.33 Jordan 1 4.35 Mexico 1 5.35 Netherlands 2 10.00 Peru 3 2.50 Philippines 3 2.73 Portugal 3 8.68 Spain 4 7.80 Turkey 2 5.18 Uruguay 2 5.00 Venezuela 1 6.37 French-origin average 2.33 6.05 3. German civil law Austria 2 10.00 Germany 1 9.23 Japan 4 8.98 South Korea 2 5.35 Switzerland 2 10.00 Taiwan 3 8.52 German-origin average 2.33 8.68 4. Scandinavian civil law Denmark 2 10.00 Finland 3 10.00 Norway 4 10.00 Sweden 3 10.00 Scandinavian-origin average 3.00 10.00

Note: Shareholder rights index scales from 0 (lowest) to 6 (highest). Rule of law index scales from 0 (lowest) to 10 (highest).

Source: Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, Robert W. Vishny, “Law and Finance,” Journal of Political Economy 106 (1998), pp. 1113–55.

EXHIBIT 4.2

Classification of

Countries by Legal

Origins

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C H A P T E R 4 CORPORATE GOVERNANCE AROUND THE WORLD 95

Consequences of Law Protection of investors’ rights not only has interesting legal origins, but the concept is

shown to have major economic consequences on the pattern of corporate ownership

and valuation, the development of capital markets, economic growth, and others. To

illustrate, let us consider two European countries, Italy and the United Kingdom. As

shown in Exhibit 4.3 , Italy has a French civil law tradition with weak shareholder pro-

tection, whereas the United Kingdom, with its common law tradition, provides strong

investor protection. In Italy (U.K.), the three largest shareholders own 58 percent

(19 percent) of the company, on average. Company ownership is thus highly concen-

trated in Italy and more diffuse in the United Kingdom. In addition, as of 1999, only

247 companies were listed on the stock exchange in Italy, whereas 2,292 companies

were listed in the United Kingdom. In the same year, the stock market capitalization as

a proportion of the annual GDP was 71 percent in Italy but 248 percent in the United

Kingdom. The stark contrast between the two countries suggests that protection of

investors can have significant economic consequences. Concentrated ownership can be

viewed as a rational response to weak investor protection, but it may create different

conflicts of interest between large controlling shareholders and small outside share-

holders. We now discuss some of the issues in detail.

Companies domiciled in countries with weak investor protection may need to have

concentrated ownership as a substitute for legal protection. With concentrated owner-

ship, large shareholders can control and monitor managers effectively and solve the

agency problem. LLSV (1998) indeed found that corporate ownership tends to be

more concentrated in countries with weaker investor protection. As can be seen from

Exhibit 4.4 , the three largest shareholders own 43 percent of companies on average

in English common law countries, and 54 percent of companies on average in French

civil law countries.

If large shareholders benefit only from pro-rata cash flows, there will be no con-

flicts between large shareholders and small shareholders. What is good for large share-

holders should be good for small shareholders as well. Since investors may be able to

derive private benefits from control, however, they may seek to acquire control rights

exceeding cash flow rights. Dominant investors may acquire control through various

schemes, such as:

1. Shares with superior voting rights

2. Pyramidal ownership structure

3. Interfirm cross-holdings

Many companies issue shares with differential voting rights, deviating from the

one-share one-vote principle. By accumulating superior voting shares, investors can

acquire control rights exceeding cash flow rights. In addition, large shareholders, who

Ownership and Control Pattern

Italy U.K.

Legal origin French civil law English common law Shareholder rights 1 (low) 5 (high) Ownership by three largest shareholders 58% 19% Market cap/GDP 71% 248% Listed stocks 247 2,292

Note: Shareholder rights refer to the antidirector rights index as computed by La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998). Both the ratio of stock market capitalization to GDP and the number of listed stocks are as of 1999.

Source: Various studies of LLSV and the CIA’s World Factbook.

EXHIBIT 4.3

Does Law Matter?: Italy

versus the U.K.

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96 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

Legal Origin

Country Ownership External Domestic

Concentration Cap/GNP Firms/Population

1. English common law Australia 0.28 0.49 63.55 Canada 0.40 0.39 40.86 Hong Kong 0.54 1.18 88.16 India 0.40 0.31 7.79 Ireland 0.39 0.27 20.00 Israel 0.51 0.25 127.60 Kenya na na 2.24 Malaysia 0.54 1.48 25.15 New Zealand 0.48 0.28 69.00 Nigeria 0.40 0.27 1.68 Pakistan 0.37 0.18 5.88 Singapore 0.49 1.18 80.00 South Africa 0.52 1.45 16.00 Sri Lanka 0.60 0.11 11.94 Thailand 0.47 0.56 6.70 United Kingdom 0.19 1.00 35.68 United States 0.20 0.58 30.11 Zimbabwe 0.55 0.18 5.81 English-origin average 0.43 0.60 35.45 2. French civil law Argentina 0.53 0.07 4.58 Belgium 0.54 0.17 15.50 Brazil 0.57 0.18 3.48 Chile 0.45 0.80 19.92 Colombia 0.63 0.14 3.13 Ecuador na na 13.18 Egypt 0.62 0.08 3.48 France 0.34 0.23 8.05 Greece 0.67 0.07 21.60 Indonesia 0.58 0.15 1.15 Italy 0.58 0.08 3.91 Jordan na na 23.75 Mexico 0.64 0.22 2.28 Netherlands 0.39 0.52 21.13 Peru 0.56 0.40 9.47 Philippines 0.57 0.10 2.90 Portugal 0.52 0.08 19.50 Spain 0.51 0.17 9.71 Turkey 0.59 0.18 2.93 Uruguay na na 7.00 Venezuela 0.51 0.08 4.28 French-origin average 0.54 0.21 10.00 3. German civil law Austria 0.58 0.06 13.87 Germany 0.48 0.13 5.14 Japan 0.18 0.62 17.78 South Korea 0.23 0.44 15.88 Switzerland 0.41 0.62 33.85 Taiwan 0.18 0.86 14.22 German-origin average 0.34 0.46 16.79 4. Scandinavian civil law Denmark 0.45 0.21 50.40 Finland 0.37 0.25 13.00 Norway 0.36 0.22 33.00 Sweden 0.28 0.51 12.66 Scandinavian-origin average 0.37 0.30 27.26

Note: Ownership concentration measures the average share ownership by three largest shareholders. External Cap/GNP is the ratio of the stock market capitalization held by minority shareholders (other than three shareholders) to the gross national product for 1994. Domestic Firms/Population is the ratio of the number of domestic firms listed in a given country to its population (million) in 1994.

Source: Various studies of LLSV.

EXHIBIT 4.4 Consequences of Law: Ownership and Capital Markets

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C H A P T E R 4 CORPORATE GOVERNANCE AROUND THE WORLD 97

are often founders and their families, can use a pyramidal ownership structure in

which they control a holding company that owns a controlling block of another com-

pany, which in turn owns controlling interests in yet another company, and so on. Also,

equity cross-holdings among a group of companies, such as keiretsu and chaebols ,

can be used to concentrate and leverage voting rights to acquire control. Obviously, a

combination of these schemes may also be used to acquire control.

Hutchison Whampoa, the third most valuable public company in Hong Kong,

provides an interesting example of pyramidal control structure. The company is

43.9 percent controlled by another public company, Cheung Kong Holdings, which is

the fifth-largest publicly traded company in Hong Kong. Cheung Kong Holdings, in

turn, is 35 percent controlled by the Li Ka-Shing family. The cash flow rights of the

Li family in Hutchison Whampoa are thus 15.4 percent (.35 × .439 = .154), but the

family’s control rights in Hutchson Whampoa is 43.9 percent. The chain of control of

Hutchison Whampoa is illustrated in Exhibit 4.5 . In Korea, the ownership structure

can be more complicated. Take Samsung Electronics, Korea’s most valuable com-

pany. Lee Keun-Hee, the chairman of the Samsung chaebol and the son of Samsung’s

founder, controls 8.3 percent of Samsung Electronics directly. In addition, Lee controls

15 percent of Samsung Life, which controls 8.7 percent of Samsung Electronics and

14.1 percent of Cheil Chedang, which controls 3.2 percent of Samsung Electronics

and 11.5 percent of Samsung Life. This byzantine web of cross-holdings enables Lee

to exercise an effective control of Samsung Electronics. 9

As in Asia, concentrated ownership and a significant wedge between control and

cash flow rights are widespread in continental Europe. Exhibit 4.6 illustrates the

pyramidal ownership structure for Daimler-Benz, a German company, at the begin-

ning of the 1990s. 10 The company has three major block holders: Deutsche Bank

Source: R. La Porta, F. Lopez-de-Silanes, A. Shleifer, and R. Vishny, “Corporate Ownership around the World,” Journal of Finance 54 (1999), p. 483.

EXHIBIT 4.5

Hutchison Whampoa: The

Chain of Control

Hutchison Whampoa

Chairman: Li Ka-Shing Vice Chairman: Richard Li

Cheung Kong Holdings

(Chairman: Li Ka-Shing)

The Li Ka-Shing Family

(Ka-Shing, Richard, Victor)

43.9% ownership

35% ownership

9Examples here are from R. La Porta, F. Lopez-de-Silanes, A. Shleifer, and R. Vishny, “Corporate Ownership

around the World,” Journal of Finance 54 (1999), pp. 471–517. 10This example is from Julian Franks and Colin Mayer, “Ownership and Control of German Corporations,”

Review of Financial Studies 14 (2001), pp. 943–77. Note that the ownership structure of Daimler-Benz has been

significantly altered since 1990.

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9 8

Source: Julian Franks and Colin Mayer, “Ownership and Control of German Corporation,” Review of Financial Studies 14 (2001), p. 949.

EXHIBIT 4.6 Ownership Structure of Daimler-Benz AG, 1990

Daimler-Benz AG

Kuwait government

Dresdner Bank

Mercedes- Automobil

Holding AG Widely heldDeutsche Bank

28.3% 14% 25.23% 32.37%

25% 25% 25% 25% 25% 25% 25% 25%

25% 25% 50%

Widely held

Kornet Automobil

Beteiligungsges mbH

Robert Bosch GmbH

Bayerische Landesbank

Stella Automobil Beteiligungsges

mbH

Stern Automobil Beteiligungsges

mbH Widely held

Commerzbank J. M. Voith GmbH

Star Automobil Beteiligungsges

mbH

Südwest-Star Automobil

Beteiligungsges mbH

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C H A P T E R 4 CORPORATE GOVERNANCE AROUND THE WORLD 99

(28.3 percent), Mercedes-Automobil Holding AG (25.23 percent), and the Kuwait

government (14 percent). The remaining 32.37 percent of shares are widely held. The

pyramidal ownership structure illustrated in Exhibit 4.6 makes it possible for large

investors to acquire significant control rights with relatively small investments. For

example, Robert Bosch GmbH controls 25 percent of Stella Automobil, which in

turn owns 25 percent of Mercedes-Automobil Holding, which controls 25 percent of

Daimler-Benz AG. Robert Bosch can possibly control up to 25 percent of the voting

rights of Daimler-Benz AG with only 1.56 percent cash flow rights in the company.

Once large shareholders acquire control rights exceeding cash flow rights, they may

extract private benefits of control that are not shared by other shareholders on a pro-

rata basis. A few studies document the existence and magnitude of private benefits.

Nenova (2001) computed the premium for voting shares relative to nonvoting shares

in different countries. The voting premium, defined as the total vote value (value of a

vote times the number of votes) as a proportion of the firm’s equity market value, is

only about 2 percent in the United States and 2.8 percent in Canada. This implies that

private benefits of control are not very significant in both countries. In contrast, the

voting premium is 23 percent in Brazil, 9.5 percent in Germany, 29 percent in both

Italy and Korea, and 36 percent in Mexico, suggesting that in these countries, domi-

nant shareholders extract substantial private benefits of control. Unless investors can

derive significant private benefits of control, they will not pay substantial premiums

for voting shares over nonvoting shares.

Dyck and Zingales (2004), on the other hand, computed “block premium,” that is,

the difference between the price per share paid for the control block and the exchange

price after the announcement of the control transaction, divided by the exchange price

after the control transaction. Obviously, control blocks will command premiums only

if block holders can extract private benefits of control. Similar to Nenova’s findings,

Dyck and Zingales report that during the period 1990–2000, the average block pre-

mium was only 1 percent in Canada, the United Kingdom, and the United States, and

2 percent in Australia and Finland. However, the average block premium was much

higher in other countries—65 percent in Brazil, 58 percent in the Czech Republic,

27 percent in Israel, 37 percent in Italy, 16 percent in Korea, and 34 percent in Mexico.

Clearly, large shareholders extract significant private benefits of control in those coun-

tries where the rights of minority shareholders are not well protected.

The legal analysis of corporate governance predicts that investor protection promotes

the development of external capital markets. When investors are assured of receiving

fair returns on their funds, they will be willing to pay more for securities. To the extent

that this induces companies to seek more funds from outside investors, strong inves-

tor protection will be conducive to large capital markets. LLSV (1997) empirically

document that countries with strong shareholder protection tend to have more valuable

stock markets and more companies listed on stock exchanges per capita than countries

with weak protection. Also, a few studies report that higher insider cash flow rights

are associated with higher valuation of corporate assets, whereas greater insider con-

trol rights are associated with lower valuation of corporate assets. Exhibit 4.4 shows

that the stock market capitalization held by minority shareholders (excluding the three

largest shareholders) as a proportion to the GNP for the year 1994 is 0.60 in English

common law countries and 0.21 in French civil law countries. The exhibit also shows

that the number of domestic firms listed on stock exchanges per population (million)

is about 35 in English common law countries, compared with only 10 in French civil

law countries.

Weak investor protection can also be a contributing factor to sharp market declines

during a financial crisis. In countries with weak investor protection, insiders may treat

outside investors reasonably well as long as business prospects warrant continued

Private Benefits of Control

Capital Markets and Valuation

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100 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

external financing. However, once future prospects dim, insiders may start to expropri-

ate the outside investors as the need for external funding dissipates. The accelerated

expropriation can induce sharp declines in security prices. Johnson, Boon, Breach, and

Friedman (2000) provide evidence that during the Asian financial crisis of 1997–98,

stock markets actually declined more in countries with weaker investor protection.

The existence of well-developed financial markets, promoted by strong investor

protection, may stimulate economic growth by making funds readily available for

investment at low cost. Earlier, Schumpeter (1934) argued that financial develop-

ment promotes economic growth. Several studies now document the empirical link

between financial development and economic growth, supporting the Schumpeter

hypothesis. 11 According to Beck et al. (2000), financial development can contrib-

ute to economic growth in three major ways: (i) It enhances savings; (ii) it channels

savings toward real investments in productive capacities, thereby fostering capital

accumulation; and (iii) it enhances the efficiency of investment allocation through the

monitoring and signaling functions of capital markets.

Corporate Governance Reform In the wake of the Asian financial crisis of 1997–98 and the spectacular failure of sev-

eral major companies like Daewoo, Enron, WorldCom, and Parmalat, scandal-weary

investors around the world are demanding corporate governance reform. The failure of

these companies hurts shareholders as well as other stakeholders, including workers,

customers, and suppliers. Many employees who invested heavily in company stock for

their retirement were dealt severe financial blows. It is not just the companies’ internal

governance mechanisms that failed; auditors, regulators, banks, and institutional inves-

tors also failed in their respective roles. Failure to reform corporate governance will

damage investor confidence, stunt the development of capital markets, raise the cost of

capital, distort capital allocation, and even shake confidence in capitalism itself.

During the 1980s, when the economies of Germany and Japan were strong performers,

the governance systems of the two countries received much attention and admiration.

In both Germany and Japan, banks and a few permanent large shareholders play the

central role in corporate governance. This “bank-centered” governance system was

seen as guiding corporate managers to pursue long-term performance goals and also

as effectively supporting companies when they were in financial distress. In contrast,

the “market-centered” governance system of the United States was viewed as inducing

short-term-oriented corporate decisions and being ineffectual in many ways. However,

as the U.S. economy and its stock market surged ahead in the 1990s, with Germany and

Japan lagging behind, the U.S.-style market-centered governance system replaced the

German-Japanese system as a subject of admiration. The American market-oriented

system seemed the wave of the future. But then, the subsequent slowdown of the U.S.

economy and stock market and the shocking corporate scandals again dethroned the

U.S. system. It seems fair to say that no country has a perfect system for other coun-

tries to emulate.

There is a growing consensus that corporate governance reform should be a matter

of global concern. Although some countries face more serious problems than others,

existing governance mechanisms have failed to effectively protect outside investors

in many countries. What should be the objective of reform? Our discussion in this

chapter suggests a simple answer: Strengthen the protection of outside investors from expropriation by managers and controlling insiders . Among other things, reform

requires: (i) strengthening the independence of boards of directors with more outsiders,

(ii) enhancing the transparency and disclosure standard of financial statements, and

www.gcgf.org

This site is for the Global

Corporate Governance Forum,

founded by the World Bank

and the OECD to improve

the institutional framework

and practices of corporate

governance.

Objectives of Reform

11Examples include King and Levine (1993), Rajan and Zingales (1998), and Beck, Levine, and Loayza (2000).

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C H A P T E R 4 CORPORATE GOVERNANCE AROUND THE WORLD 101

(iii) energizing the regulatory and monitoring functions of the SEC (in the United

States) and stock exchanges. In many developing and transition countries, it may be

necessary to first modernize the legal framework.

However, as we have seen from the experiences of many countries, governance reform

is easier said than done. First of all, the existing governance system is a product of

the historical evolution of the country’s economic, legal, and political infrastructure.

It is not easy to change historical legacies. Second, many parties have vested interests

in the current system, and they will resist any attempt to change the status quo. For

example, Arthur Levitt, chairman of the SEC during much of the 1990s, attempted to

reform the accounting industry, but it successfully resisted the attempt through the

use of lobbyists and advertising. In Levitt’s words ( The Wall Street Journal , June 17,

2002, p. C7): “The ferocity of the accounting profession’s opposition to our attempt

to reform the industry a few years ago is no secret. . . . They will do everything pos-

sible to protect their franchise, and will do so with little regard for the public interest.”

This earlier failure to reform the accounting industry contributed to the breakout of

corporate scandals in the United States. It is noted that the former executives of World-

Com were indicted for allegedly orchestrating the largest accounting fraud in history,

with the help of conniving auditors. 12 In another example, following the Asian finan-

cial crisis, the Korean government led efforts to reform the country’s chaebol system

but met with stiff resistance from the founding families, which were basically afraid

of losing their private benefits of control. Nevertheless, reform efforts in Korea were

partially successful, partly because the weight and prestige of the government were

behind them and partly because public opinion was generally in favor of reform.

To be successful, reformers should understand the political dynamics surrounding

governance issues and seek help from the media, public opinion, and nongovernmen-

tal organizations (NGOs). The role of NGOs and the media can be illustrated by the

success of the People’s Solidarity for Participatory Democracy (PSPD) in Korea, orga-

nized by Hasung Jang of Korea University. The PSPD and Professor Jang have utilized

legal pressure and media exposure to create public opinion and to shame corporate

executives into changing their practices. For example, PSPD successfully challenged

the transfer pricing of SK Telecom. Specifically, SK Telecom transferred huge prof-

its to two subsidiaries, Sunkyung Distribution, which is 94.6 percent owned by SK

Group Chairman Choi Jong-Hyun, and Daehan Telecom, fully owned by Choi’s son

and his son-in-law, thereby expropriating outside shareholders of SK Telecom. The

PSPD exposed this practice to the media, and the episode was reported in the Finan- cial Times as well as local newspapers and television. Facing unfavorable public opin-

ion, SK Telecom finally agreed to stop the practice. 13

Facing public uproar following the U.S. corporate scandals, politicians took actions

to remedy the problem. The U.S. Congress passed the Sarbanes-Oxley Act in July

2002. The key objective of the Act is to protect investors by improving the accuracy

and reliability of corporate disclosure, thereby restoring the public’s confidence in

the integrity of corporate financial reporting. The major components of the Sarbanes-

Oxley Act are:

• Accounting regulation—The creation of a public accounting oversight board

charged with overseeing the auditing of public companies, and restricting the

consulting services that auditors can provide to clients.

• Audit committee—The company should appoint independent “financial

experts” to its audit committee.

Political Dynamics

http://leadership.wharton. upenn.edu/governance/index. shtml

This site offers online

resources and academic

readings concerning corporate

governance.

The Sarbanes-Oxley Act

12New York Times, September 2, 2002, p. A16. 13Alexander Dyck and Luigi Zingales, “The Corporate Governance Role of the Media,” working paper (2002).

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102 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

• Internal control assessment—Public companies and their auditors should

assess the effectiveness of internal control of financial record keeping and

fraud prevention.

• Executive responsibility—Chief executive and finance officers (CEO and CFO)

must sign off on the company’s quarterly and annual financial statements.

If fraud causes an overstatement of earnings, these officers must return any

bonuses.

The Sarbanes-Oxley Act represents one of the most important securities legislations

since the original securities laws of the 1930s. As mandated by the Act, the NYSE and

the NASDAQ also strengthened the listing standards by adopting various measures to

protect investors. These measures call for, among other things: (i) listed companies

to have boards of directors with a majority of independents; (ii) the compensation,

nominating, and audit committees to be entirely composed of independent directors;

and (iii) the publication of corporate governance guidelines and reporting of annual

evaluation of the board and CEO. These measures, if properly implemented, should

improve the corporate governance regime in the United States.

Evidences regarding the effect of the Sarbanes-Oxley Act on the corporate disclo-

sure and governance standards are generally positive. For example, Lobo and Zhou

(2006) found a marked increase in “conservatism” in financial reporting following the

enactment. Specifically, firms began to report lower discretionary accruals (meaning

less active earnings management) and recognize losses more quickly than gains when

they report income in the post-Act period. It is noted that Enron managed earnings

very aggressively by prematurely recognizing revenue and hiding or shifting losses and

liabilities to many non-consolidated special purpose entities. These dubious accounting

practices, which eventually led to Enron’s implosion, declined partly because of the

harsh penalties on CEO and CFO imposed by the Sarbanes-Oxley Act (up to a $5 mil-

lion fine and 20 years in prison) for falsely certifying financial statements that do not

satisfy the requirements of the Act. Another study by Linck, Netter, and Yang (2009)

found substantial changes in the company boards and directors as well following the

Sarbanes-Oxley enactment. Specifically, the study noted that (i) board committees meet

more often, (ii) boards become larger and more independent, and (iii) board members

are more likely to be lawyers, consultants, or financial experts and less likely to be cor-

porate insiders. These findings indicate that the boards of directors became more proac-

tive for fulfilling their responsibilities and also better qualified for doing their duties.

The implementation of the Sarbanes-Oxley Act, however, was not free from fric-

tions. Many companies find the compliance with a particular provision of the act,

Section 404, onerous, costing millions of dollars. Section 404 requires public com-

panies and their auditors to assess the effectiveness of internal control of financial

record keeping and fraud prevention and file reports with the Securities and Exchange

Commission (SEC). Clearly, the cost of compliance disproportionately affects smaller

companies. In addition, many U.S.-listed foreign firms that have different governance

structures at home also find it costly to comply with the Sarbanes-Oxley Act. Since the

passage of the act, some foreign firms have chosen to list their shares on the London

Stock Exchange and other European exchanges, instead of U.S. exchanges, to avoid

the costly compliance.

Like the United States, the United Kingdom was hit by a spate of corporate scandals in

the 1980s and early 1990s, resulting in the bankruptcy of such high-profile companies

as Ferranti, Colorol Group, BCCI, and Maxwell Group. The “scandalous” collapse of

these prominent British companies was popularly attributed to their complete corpo-

rate control by a single top executive, weak governance mechanisms, and the failure

of their boards of directors. Against this backdrop, the British government appointed

the Cadbury Committee in 1991 with the broad mandate of addressing corporate

The Cadbury Code of Best Practice

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C H A P T E R 4 CORPORATE GOVERNANCE AROUND THE WORLD 103

governance problems in the United Kingdom. Sir Adrian Cadbury, CEO of Cadbury

Company, chaired the committee. 14 The work of the committee led to successful gov-

ernance reform in the United Kingdom.

In December 1992, the Cadbury Committee issued its report, including the Code of Best Practice in corporate governance. The code recommends that (i) boards of

directors of public companies include at least three outside (nonexecutive) directors,

and that (ii) the positions of chief executive officer (CEO) and chairman of the board

(COB) of these companies be held by two different individuals; boards of directors

of most British companies were dominated by insiders, with the positions of CEO

and COB often held by the same individuals. Specifically, the code prescribed that:

The board should meet regularly, retain full and effective control over the company and moni-

tor the executive management. There should be a clearly accepted division of responsibilities

at the head of a company, which will ensure a balance of power and authority, such that no

one individual has unfettered power of decisions. Where the chairman is also the chief execu-

tive, it is essential that there should be a strong and independent element on the board, with

a recognized senior member. The board should include non-executive directors of significant

calibre and number for their views to carry significant weight in the board’s decisions.

The Cadbury Code has not been legislated into law, and compliance with the code

is voluntary. However, the London Stock Exchange (LSE) currently requires that

each listed company show whether the company is in compliance with the code and

explain why if it is not. This “comply or explain” approach has apparently persuaded

many companies to comply rather than explain; currently, 90 percent of all LSE-

listed companies have adopted the Cadbury Code. According to a study by Dahya,

McConnell, and Travlos (2002), the proportion of outside directors rose from 26 per-

cent before the adoption to 47 percent afterwards among those companies newly

complying with the code. On the other hand, joint CEO/COB positions declined

from 37 percent of the companies before the adoption to 15 percent afterwards. This

means that even though the compliance is voluntary, the Cadbury Code has made

a significant impact on the internal governance mechanisms of U.K. companies.

The Dahya et al. study further shows that the “negative” relationship between CEO

turnover and company performance became stronger after the introduction of the

Cadbury Code. This means that the job security of chief executives has become

more sensitive to company performance, strengthening managerial accountability

and weakening its entrenchment.

Following the subprime mortgage crisis and the bailout of large financial institu-

tions with taxpayers’ money, the U.S. government passed the Dodd-Frank Wall Street

Reform and Consumer Protection Act in July 2010. Among other things, the act aims

at strengthening government regulation of banking firms and their internal gover-

nance mechanisms, thereby preventing similar financial crises in the future. The act

represents the most comprehensive overhaul of the rules of finance since the Great

Depression and is likely to have a major impact on the way decisions are made within

financial firms. The key features of the Dodd-Frank Act include:

• Volker rule—Deposit-taking banks will be banned from proprietary trading

and from owning more than a small fraction of hedge funds and private equity

firms. The rule is named after Paul Volker, former Federal Reserve chairman,

who argued that banks should not be allowed to engage in casino-like activities

that endanger the safety of depositors’ money.

The Dodd-Frank Act

14For a detailed discussion of the Cadbury Committee and its effect on corporate governance in the U.K., refer

to Dahya, McConnell, and Travlos (2002).

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104 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

• Resolution authority—The government can seize and dismantle a large bank in

an orderly manner if the bank faces impending failure and poses a systemic risk

to the broader financial system. This authority aims, in part, to reduce the cost

and risk associated with the bailing out of banks that are “too big to fail.” Banks

that are deemed too big to fail can have skewed incentives for excessive risk-

taking. Shareholders at big firms get nonbinding votes on executive pay and

golden parachutes, to control skewed executive incentives.

• Derivative securities—Derivatives trading in over-the-counter markets will

be transferred to electronic exchanges, with contracts settled through central

clearing houses, to increase transparency and reduce counter-party risk.

• Systemic risk regulation—A Financial Stability Oversight Council of government

regulators chaired by the Treasury secretary will identify systemically important

financial firms and monitor their activities and financial conditions. These firms

must draw up a “living will” to describe how they would be liquidated if they fail.

• Consumer protection—A new, independent Consumer Financial Protection

Bureau will monitor predatory mortgage loans and other loan products.

The Dodd-Frank Act is focused on controlling banks’ excessive risk-taking and miti-

gating the systemic risk in the financial system. If the act is successfully implemented,

it would strengthen bank governance and help reduce the probability and cost of finan-

cial crises in the future.

Lastly, it is noted that corporate governance reforms would not only strengthen

shareholders’ cash flow rights but also enhance corporate performance. For instance,

in their study of U.S. firms, Gompers, Ishii, and Metrick (2003) found that firms with

stronger corporate governance have higher firm value, higher profits, higher sales

growth, and lower capital expenditure, and make fewer corporate acquisitions. They

also found that an investment strategy based on buying firms with the strongest corpo-

rate governance and selling firms with the weakest corporate governance would have

earned a large “abnormal return” during their study period. Their study shows that

enhancement of corporate governance would improve firm performance, boost firm

value, and raise stock returns. In a comparative study of corporate valuation around the

world, Chua, Eun, and Lai (2007) found that despite international financial integration

in recent years, corporate valuation varies a great deal across countries. Specifically,

corporate valuation is directly related to the quality of corporate governance, as well as

the economic growth options and the degree of financial openness.

SUMMARY In the wake of recurrent financial crises and high-profile corporate scandals and fail-

ures in the United States and abroad, corporate governance has attracted a lot of atten-

tion worldwide. This chapter provides an overview of corporate governance issues,

with the emphasis on intercountry differences in the governance mechanisms.

1. The public corporation, which is jointly owned by many shareholders with limited

liability, is a major organizational innovation with significant economic conse-

quences. The efficient risk-sharing mechanism allows the public corporation to

raise large amounts of capital at low cost and profitably undertake many invest-

ment projects, boosting economic growth.

2. The public corporation has a major weakness: the agency problem associated with

the conflicts of interest between shareholders and managers. Self-interested man-

agers can take actions to promote their own interests at the expense of sharehold-

ers. The agency problem tends to be more serious for firms with excessive free

cash flows but without growth opportunities.

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C H A P T E R 4 CORPORATE GOVERNANCE AROUND THE WORLD 105

3. To protect shareholder rights, curb managerial excesses, and restore confidence in

capital markets, it is important to strengthen corporate governance, defined as the

economic, legal, and institutional framework in which corporate control and cash

flow rights are distributed among shareholders, managers, and other stakeholders

of the company.

4. The central issue in corporate governance is: how to best protect outside inves-

tors from expropriation by managers and controlling insiders so that investors can

receive fair returns on their funds.

5. The agency problem can be alleviated by various methods, including (a) strength-

ening the independence of boards of directors; (b) providing managers with incen-

tive contracts, such as stocks and stock options, to better align the interests of

managers with those of shareholders; (c) concentrated ownership so that large

shareholders can control managers; (d) using debt to induce managers to disgorge

free cash flows to investors; (e) listing stocks on the London or New York stock

exchange where shareholders are better protected; and (f ) inviting hostile takeover

bids if the managers waste funds and expropriate shareholders.

6. Legal protection of investor rights systematically varies across countries, depend-

ing on the historical origin of the national legal system. English common law

countries tend to provide the strongest protection, French civil law countries the

weakest. The civil law tradition is based on the comprehensive codification of

legal rules, whereas the common law tradition is based on discrete rulings by

independent judges on specific disputes and on judicial precedent. The English

common law tradition, based on independent judges and local juries, evolved to be

more protective of property rights, which were extended to the rights of investors.

7. Protecting the rights of investors has major economic consequences in terms

of corporate ownership patterns, the development of capital markets, economic

growth, and more. Poor investor protection results in concentrated ownership,

excessive private benefits of control, underdeveloped capital markets, and slower

economic growth.

8. Outside the United States and the United Kingdom, large shareholders, often

founding families, tend to control managers and expropriate small outside share-

holders. In other words, large, dominant shareholders tend to extract substantial

private benefits of control.

9. Corporate governance reform efforts should be focused on how to better protect

outside investors from expropriation by controlling insiders. Often, controlling

insiders resist reform efforts, as they do not like to lose their private benefits of

control. Reformers should understand political dynamics and mobilize public

opinion to their cause.

KEY WORDS agency problem, 84

Cadbury Code, 103

complete contract, 84

concentrated

ownership, 88

corporate governance, 82

Dodd-Frank Act, 103

English common law, 92

equity cross-holdings, 97

Free cash flows, 85

French civil law, 92

incentive

contracts, 87

legal origins, 92

managerial

entrenchment, 85

private benefits of

control, 99

public corporation, 83

pyramidal ownership, 97

residual control

rights, 85

Sarbanes-Oxley Act, 101

shareholder rights, 82

1. The majority of major corporations are franchised as public corporations. Discuss

the key strength and weakness of the “public corporation.” When do you think the

public corporation as an organizational form is unsuitable?

QUESTIONS

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106 P A R T O N E FOUNDATIONS OF INTERNATIONAL FINANCIAL MANAGEMENT

2. The public corporation is owned by a multitude of shareholders but run by profes-

sional managers. Managers can take self-interested actions at the expense of share-

holders. Discuss the conditions under which the so-called agency problem arises.

3. Following corporate scandals and failures in the United States and abroad, there

has been a growing demand for corporate governance reform. What should be

the key objectives of corporate governance reform? What kinds of obstacles can

thwart reform efforts?

4. Studies show that the legal protection of shareholder rights varies a great deal

across countries. Discuss the possible reasons why the English common law tradi-

tion provides the strongest protection of investors and the French civil law tradi-

tion the weakest.

5. Explain “the wedge” between control and cash flow rights and discuss its implica-

tions for corporate governance.

6. Discuss different ways that dominant investors may establish and maintain control

of a company with relatively small investments.

7. The Cadbury Code of Best Practice , adopted in the United Kingdom, led to a

successful reform of corporate governance in the country. Explain the key require-

ments of the code and discuss how it contributed to the success of reform.

8. Many companies grant stock or stock options to managers. Discuss the benefits

and possible costs of using this kind of incentive compensation scheme.

9. It has been shown that foreign companies listed on U.S. stock exchanges are valued

more than those from the same countries that are not listed in the United States.

Explain why U.S.-listed foreign firms are valued more than those that are not. Also

explain why not every foreign firm wants to list stocks in the United States.

10. Explain “free cash flows.” Why do managers like to retain free cash flows instead

of distributing it to shareholders? Discuss what mechanisms may be used to solve

this problem.

INTERNET EXERCISES

WWW

It is often mentioned that the United States has a “market-centered” corporate gover-

nance system, whereas Germany has a “bank-centered” system. Review the website

of the OECD, www.oecd.org , or any other relevant websites and answer the following

questions:

(a) Compare and contrast the corporate governance systems of the two countries.

(b) How did the two countries come to have the particular governance systems?

countries?

Parmalat: Europe’s Enron

Following such high-profile corporate scandals as Enron and WorldCom in the United States, European business executives smugly proclaimed that the same could not hap- pen on their side of the Atlantic as Europe does not share America’s laissez-faire capi- talism. Unfortunately, however, they were proved wrong quickly when Parmalat, a jewel of Italian capitalism, collapsed spectacularly as a result of massive accounting frauds.

Parmalat was founded in 1961 as a dairy company. Calisto Tanzi, the founder, trans- formed Parmalat into a national player by embarking on an aggressive acquisition pro- gram in the 1980s when local governments of Italy privatized their municipal dairies. While solidifying its dominant position in the Italian home market, Parmalat aggres- sively ventured into international markets during the 1990s, establishing operations in 30 countries throughout the Americas, Asia/Pacific, and Southern Africa. To finance its rapid expansion, the company borrowed heavily from international banks and investors.

MINI CASE

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Worldwide sales of Parmalat reached €7.6 billion in 2002 and its aspiration to become the Coca-Cola of milk seemed within reach. However, things began to unravel in 2003.

4.5

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0 Jan 2001 Jul 2001 Jan 2002 Jul 2002 Jan 2003

Date

Parmalat’s Stock Price

St oc

k P

ri ce

( E

ur o)

Jul 2003 Jan 2004 Jul 2004

Data Source: DataStream.

C H A P T E R 4 CORPORATE GOVERNANCE AROUND THE WORLD 107

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Parmalat first defaulted on a $185 million debt payment in November 2003, which prompted a scrutiny of the firm’s finances. Auditors and regulators soon found out that a $4.9 billion cash reserve supposedly held in a Bank of America account of the Cayman Island subsidiary of Parmalat actually did not exist, and that the total debt of the company was around €16 billion—more than double the amount (€7.2 billion) shown on the balance sheet. Italian investigators subsequently discovered that Par- malat managers simply “invented assets” to cover the company’s debts and falsified accounts over a 15-year period. Following the discovery of massive frauds, Parmalat was forced into bankruptcy in December 2003. Calisto Tanzi, founder and former CEO, was arrested on suspicion of fraud, embezzlement, false accounting, and mis- leading investors. The Parmalat saga represents the largest and most brazen corpo- rate fraud case in European history and is widely dubbed Europe’s Enron.

Enrico Bondi, a new CEO of Parmalat, filed a $10 billion lawsuit against Citigroup, Bank of America, and former auditors Grant Thornton and Deloitte Touche Tohmatsu, for sharing responsibility for the company’s collapse. He also filed legal actions against UBS of Switzerland and Deutsche Bank for the transactions that allegedly contributed to the collapse of Parmalat. Bondi has alleged that Parmalat’s foreign “enablers,” including international banks and auditors, were complicit in the frauds. He maintained that they knew about Parmalat’s fraudulent finances and helped the company to disguise them in exchange for fat fees. Bondi effectively declared a war on Parmalat’s international bankers and creditors.

The following graph illustrates Parmalat’s share price behavior. Following a sharp drop in share price, trading of the company’s shares was suspended on December 22, 2003.

Discussion Points

1. How was it possible for Parmalat managers to “cook the books” and hide it for so long?

2. Investigate and discuss the role that international banks and auditors might have played in Parmalat’s collapse.

3. Study and discuss Italy’s corporate governance regime and its role in the failure of Parmalat.

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REFERENCES & SUGGESTED READINGS

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C H A P T E R 4 CORPORATE GOVERNANCE AROUND THE WORLD 109

w w

w. m

hh e.

co m

/e r7

Nenova, T., “The Value of Corporate Votes and Control Benefits: A Cross-Country Analysis.” Work-

ing Paper (2001).

Rajan, R., and L. Zingales. “Financial Dependence and Growth.” American Economic Review 88

(1998), pp. 559–86.

Reese, W. A., Jr., and M. S. Weisbach. “Protection of Minority Shareholder Interests, Cross-listings

in the United States, and Subsequent Equity Offerings.” Working Paper, NBER (2001).

Schumpeter, J. The Theory of Economic Development . Translated by R. Opie. Cambridge, MA:

Harvard University Press, 1934.

Shleifer, A., and R. Vishny. “A Survey of Corporate Governance.” Journal of Finance 52 (1997),

pp. 737–83.

Short, H., and K. Keasey. “Managerial Ownership and the Performance of Firms: Evidence from the

UK.” Journal of Corporate Finance 5 (1999), pp. 79–101.

Smith, Adam. An Inquiry Into the Nature and Causes of the Wealth of Nations. (1776).

Stulz, R., and R. Williamson. “Culture, Openness, and Finance.” Journal of Financial Economics 10

(2003), pp. 313–49.

Zingales, L. “The Value of the Voting Right: A Study of the Milan Stock Exchange Experience.”

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O U

T L

IN E

5 The Market for Foreign Exchange

6 International Parity Relationships and Fore- casting Foreign Exchange Rates

7 Futures and Options on Foreign Exchange

PART TWO

110

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PART TWO begins with a discussion of the organization of the market for foreign exchange. Both spot and forward transactions are studied. The next chapter examines exchange rate determination. The discussion focuses on how changes in the exchange rate between two countries’ currencies depend on the relative difference between the nominal interest rates and inflation rates between the two countries. The final chapter of this section introduces currency derivative contracts useful for managing foreign currency exposure.

CHAPTER 5 provides an introduction to the organization and operation of the spot and forward foreign exchange market. This chapter describes institutional arrangements of the foreign exchange market and details of how foreign exchange is quoted and traded worldwide.

CHAPTER 6 presents the fundamental international parity relationships among exchange rates, interest rates, and inflation rates. An understanding of these parity relationships is essential for practicing financial management in a global setting.

CHAPTER 7 provides an extensive treatment of exchange-traded currency futures and options contracts. Basic valuation models are developed.

The Foreign Exchange Market, Exchange Rate Determination, and Currency Derivatives

111

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112

C H

A P

T E

R O

U T

L IN

E CHAPTER

5 The Market for Foreign Exchange

MONEY REPRESENTS PURCHASING power. Possessing

money from your country gives you the power to purchase

goods and services produced (or assets held) by other residents

of your country. However, to purchase goods and services pro-

duced by the residents of another country generally requires

first purchasing the other country’s currency. This is done by

selling one’s own currency for the currency of the country with

whose residents you desire to transact. More formally, one’s

own currency has been used to buy foreign exchange , and in

doing so the buyer has converted his purchasing power into the

purchasing power of the seller’s country.

The market for foreign exchange is the largest financial mar-

ket in the world by virtually any standard. It is open somewhere

in the world 365 days a year, 24 hours a day. The 2013 trien-

nial central bank survey compiled by the Bank for International

Settlements (BIS) places worldwide daily trading of spot and

forward foreign exchange at $4.95 trillion. This is equivalent

to $700 in daily transactions for every person on earth. This

represents a 33 percent increase over 2010 at current exchange

rates. The increase in turnover can be attributed to an increase

in trading activity by financial institutions other than reporting

dealers, i.e., smaller banks, pension funds, insurance companies,

and hedge funds. London remains the world’s largest foreign

exchange trading center. According to the 2013 triennial survey,

daily trading volume in the U.K. is estimated at $2.33 trillion,

a 44 percent increase from 2010. The U.S. daily turnover was

$1.19 trillion, which represents a 45 percent increase from 2010.

Exhibit 5.1 presents a pie chart showing the shares of global for-

eign exchange turnover.

Broadly defined, the foreign exchange (FX) market encom-

passes the conversion of purchasing power from one currency

into another, bank deposits of foreign currency, the extension of

credit denominated in a foreign currency, foreign trade financ-

ing, trading in foreign currency options and futures contracts, and

currency swaps. Obviously, one chapter cannot adequately cover

all these topics. Consequently, we confine the discussion in this chapter to the spot and

forward market for foreign exchange. In Chapter 7 , we examine currency futures and

options contracts, and in Chapter 14 , currency swaps are discussed.

This chapter begins with an overview of the function and structure of the foreign

exchange market and the major market participants that trade currencies in this

market. Following is a discussion of the spot market for foreign exchange. This section

covers how to read spot market quotations, derives cross-rate quotations, and devel-

ops the concept of triangular arbitrage as a means of ensuring market efficiency. The

chapter concludes with a discussion of the forward market for foreign exchange.

Function and Structure of the FX Market FX Market Participants

Correspondent Banking Relationships

The Spot Market Spot Rate Quotations

Cross-Exchange Rate Quotations

Alternative Expressions for the Cross-Exchange Rate

The Bid-Ask Spread

Spot FX Trading

The Cross-Rate Trading Desk

Triangular Arbitrage

Spot Foreign Exchange Market Microstructure

The Forward Market Forward Rate Quotations

Long and Short Forward Positions

Non-Deliverable Forward Contracts

Forward Cross-Exchange Rates

Forward Premium

Swap Transactions

Exchange-Traded Currency Funds Summary Key Words Questions Problems Internet Exercises MINI CASE: Shrewsbury Herbal Products, Ltd.

References and Suggested Readings

www.bis.org

This is the website of the Bank

for International Settlements.

Many interesting reports and

statistics can be obtained

here. The report titled Triennial

Central Bank Survey can be

downloaded for study.

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113

www.newyorkfed.org

This is the website of the

Federal Reserve Bank of

New York. The online booklet

titled “The Story of Foreign

Trade and Exchange” can

be downloaded for study.

The report titled The Foreign

Exchange and Interest Rate

Derivatives Markets Survey:

Turnover in the United States

can also be downloaded.

Forward market quotations are presented, the purpose of the market is discussed, and

the purpose of swap rate quotations is explained.

This chapter lays the foundation for much of the discussion throughout the remain-

der of the text. Without a solid understanding of how the foreign exchange market

works, international finance cannot be studied in an intelligent manner. As authors, we

urge you to read this chapter carefully and thoughtfully.

Function and Structure of the FX Market The structure of the foreign exchange market is an outgrowth of one of the primary

functions of a commercial banker: to assist clients in the conduct of international com-

merce. For example, a corporate client desiring to import merchandise from abroad

would need a source of foreign exchange if the import was invoiced in the exporter’s

home currency. Alternatively, the exporter might need a way to dispose of foreign

exchange if payment for the export was invoiced and received in the importer’s home

currency. Assisting in foreign exchange transactions of this type is one of the services

that commercial banks provide for their clients, and one of the services that bank cus-

tomers expect from their bank.

The spot and forward foreign exchange markets are over-the-counter (OTC) markets ; that is, trading does not take place in a central marketplace where buyers and

sellers congregate. Rather, the foreign exchange market is a worldwide linkage of bank

currency traders, nonbank dealers, and FX brokers, who assist in trades, connected to

one another via a network of telephones, computer terminals, and automated dealing

systems. Thomson Reuters and ICAP are the largest vendors of quote screen monitors

used in trading currencies. The communications system of the foreign exchange market

is second to none, including industry, government, the military, and national security and

intelligence operations. The International Finance in Practice box “The Mouse Takes

Over the Floor” describes the electronic nature of today’s FX trading environment.

Twenty-four-hour-a-day currency trading follows the sun around the globe. Three

major market segments can be identified: Australasia, Europe, and North America.

http://thomsonreuters.com

This website explains the

various Thomson Reuters spot

and forward FX electronic

trading systems.

www.icap.com

This website explains ICAP’s

spot and forward FX electronic

dealing systems.

Note: Percent of total reporting foreign exchange turnover, adjusted for local inter-dealer double-counting.

Source: Tabulated from data in Table 6 in the Triennial Central Bank Survey, Preliminary Results. Bank for Interna- tional Settlements, Basle, September 2013.

EXHIBIT 5.1

Shares of Reported

Global Foreign Exchange

Turnover by Country,

2013

Countries with

shares less than

1% not included.

Singapore

Japan 6%

Hong Kong SAR 4%

Switzerland 3%

Australia 3%

France 3%

Germany 2% Canada 1%

Denmark 2%

United States

19%

United Kingdom

41%

Netherlands 2%

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Australasia includes the trading centers of Sydney, Tokyo, Hong Kong, Singapore, and

Bahrain; Europe includes Zurich, Frankfurt, Paris, Brussels, Amsterdam, and London;

and North America includes New York, Montreal, Toronto, Chicago, San Francisco,

and Los Angeles. Most trading rooms operate over a 9- to 12-hour working day,

although some banks have experimented with operating three eight-hour shifts in order

to trade around the clock. Especially active trading takes place when the trading hours

of the Australasia centers and the European centers overlap and when the hours of the

European and the North American centers overlap. More than half of the trading in the

United States occurs between 8:00 a.m. and noon eastern standard time (1:00 p.m. and

5:00 p.m. Greenwich Mean Time [London]), when the European markets are still open.

Certain trading centers have a more dominant effect on the market than others. For

example, trading diminishes dramatically in the Australasian market segment when the

Tokyo traders are taking their lunch break! Exhibit 5.2 provides a general indication of

the participation level in the global FX market by showing average electronic conver-

sations per hour. All conversations do not result in a completed trade.

The market for foreign exchange can be viewed as a two-tier market. One tier is the

wholesale or interbank market and the other tier is the retail or client market . FX

market participants can be categorized into five groups: international banks, bank

customers, nonbank dealers, FX brokers, and central banks.

INTERNATIONAL FINANCE IN PRACTICE

When electronic trading first began to make a significant dent in the foreign exchange market, traders reportedly concerned about the loss of the human factor in dealing were heard to grumble that a computer wasn’t going to buy them a beer.

Ten years ago a deal was still done when somebody yelled “done” into one of their telephones amid the back- ground noise of other traders doing the same while voice broker prices were constantly being pumped out via a Tan- noy system known as the squawkbox or the “hoot’n holler.”

“It was bloody noisy and bloody good fun,” reminisced one ex-dealer, who felt the advent of technology had robbed the market of much of its personality.

Today, that roar is more of a steady hum as traders face banks of screens and hold electronic conversations while the “hoot’n holler” is used to spread analyst assess- ments of the latest economic data. The old noise level has been transplanted to bars where, it seems, plenty of beers are still being bought.

Thomson Reuters’ first screen-based trading system was launched in 1982 for the interbank market, where the majority of foreign exchange dealing takes place. The company launched a conversational dealing product in 1989 and an anonymous “matching” platform in 1992, but faced its first stiff competition only in 1993 with the launch of Electronic Broking Services (EBS), a platform owned by a number of the big banks and designed with the express purpose of preventing Thomson Reuters from gaining a monopoly position. [EBS was acquired by ICAP, a British-based interdealer, in 2006.] Now, both

platforms still dominate the interbank market but face competition from the Internet, where a number of web- based portals are encouraging new participants to trade directly.

In simple volume terms the online platforms look like minnows. EBS reports average daily volumes worth about $100bn whereas the larger Internet platforms have average volumes between $15bn–$20bn. But Justyn Trenner of Client-Knowledge calculates the com- bined value of all online trading is now worth $100bn a day and highlights the rapid growth in the sector.

Platforms such as FXAll, Hotspot FXi and e-Speed are quick to dismiss suggestions of direct competition with the giants. Instead, they say they offer different parties, such as corporate treasurers or fund managers, the opportunity to participate directly and trade outside their usual banking relationships.

If electronic technology in the interbank market helped smaller banks access price transparency in the interbank market, the latest generation of Internet plat- forms is doing the same for those banks’ clients.

“We’re not going for the interbank market; we live in the space where banks face out to clients,” says John Eley, chief executive of Hotspot foreign exchange, who says bank clients, who would previously call three or four dealers for quotes, can get the same range in seconds off a web-based platform, and then deal themselves.

“Multibank portals lower the barriers for third-party foreign exchange trades by cutting costs and reducing risk,” adds Mark Warms, chief marketing officer at FXAll,

The Mouse Takes Over the Floor

FX Market Participants

114

www.Fxall.com

This is the website for the

Internet FX trading platform

discussed in the article “The

Mouse Takes Over the Floor.”

It is a Thomson Reuters

Company.

eun61604_ch05_110-139.indd 114eun61604_ch05_110-139.indd 114 1/3/14 10:25 AM1/3/14 10:25 AM

who says the volumes traded by hedge funds have tri- pled on the platform.

Rick Sears, head of foreign exchange at the Chicago Mercantile Exchange, says volumes in its foreign exchange products had risen sharply since its electronic Globex platform allowed investors to trade its futures contracts 24 hours a day. Between 40 and 45 percent of CME’s foreign exchange participants are commodity trading accounts (CTAs) and hedge funds.

“These groups are a lot more comfortable dealing electronically than before. They used to worry about exe- cution risk but e-trading is increasingly popular,” he says.

The considerable growth of online platforms, and the survival of a number of different models has surpassed most observers’ expectations. Early predictions were that multibank portals such as FXAll, which offer prices from a wide range of banks, would surpass proprietary platforms owned by a single bank. Instead, both are growing rap- idly. A recent survey by Greenwich Associates, the US con- sultancy group, listed both FXAll and UBS’s proprietary platforms as leading online trading volumes.

There were also initial fears that the sudden surge in trading outlets could fragment liquidity, hampering trad- ing, but this does not yet appeared to have happened. “Instead, it is more channels for the same market—a price on one platform or another is virtually the same,” says Fabian Shey, global head of foreign exchange distribution at UBS.

Mr. Trenner suggested that overall, the shrinking of foreign exchange trading into a few global centers— Tokyo, London and New York—and banks’ reorganization to follow suit had instead consolidated liquidity.

When EBS was first launched, dealers raised con- cerns about the demise of voice brokers’ and dealers’

market-making role, warning that removing the obliga- tion to quote two-way prices could weaken liquidity in times of crisis with dealers happy to take prices and less prepared to quote them.

But 11 years on, the market has not suffered a signifi- cant problem and very little evidence of prices lurching through “grapping”—when the new bid-offer spread does not overlap with the last price posted.

The relative smoothness of price moves is proof, says Jack Jeffery, chief executive of EBS, that the marketplace has evolved with the development of trading technologies.

“The market is so liquid with so many diverse views and flows that marketmaking has changed,” he said. “It is now about participation. If you participate, you are contributing to liquidity, not just taking it out.”

Some still fret, however, that the market’s current dependence on technology leaves it at the mercy of com- puter servers.

Outages are extremely rare, however, and long-time participants are sanguine about the risks posed.

“Yes, there’s a risk, but the market is very adaptable,” says Nick Beecroft, head of foreign exchange trading at Standard Chartered.

“In the event of a serious IT meltdown, there are plenty of lines from broking houses to dealing floors and it would just be a question of pulling all the ex-spot bro- kers back on to the phones, from other products. FX is a highly resilient marketplace.”

It seems fears about the loss of the human factor are as yet groundless.

Source: Jennifer Hughes, Financial Times, Special Report: Foreign Exchange, May 27, 2004, p. 1.

115

Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, www,ny.frb.org. .

EXHIBIT 5.2

Average Electronic FX

Conversations per Hour

(Monday–Friday, 2001)

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

25,000

20,000

15,000

10,000

5,000

Greenwich Mean

Time

10 am

In Tokyo

Lunch

In Tokyo

Europe

Opening

Asia

Closing

Americas

Open

London

Closing

Afternoon

in America

6 pm

In NY

Tokyo

opens

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116 P A R T T W O THE FOREIGN EXCHANGE MARKET, EXCHANGE RATE DETERMINATION, AND CURRENCY DERIVATIVES

International banks provide the core of the FX market. Approximately 100 to

200 banks worldwide actively “make a market” in foreign exchange, that is, they stand

willing to buy or sell foreign currency for their own account. These international banks

serve their retail clients, the bank customers , in conducting foreign commerce or making

international investment in financial assets that require foreign exchange. Bank custom-

ers broadly include MNCs, money managers, and private speculators. According to 2013

BIS statistics, retail or bank client transactions account for approximately 9 percent of

FX trading volume. The other 91 percent of trading volume is from interbank trades

between international banks or nonbank dealers. Nonbank dealers are large nonbank

financial institutions such as investment banks, mutual funds, pension funds, and hedge

funds, whose size and frequency of trades make it cost-effective to establish their own

dealing rooms to trade directly in the interbank market for their foreign exchange needs.

In 2013, nonbank dealers accounted for 52 percent of interbank trading volume.

Part of the interbank trading among international banks involves adjusting the inven-

tory positions they hold in various foreign currencies. However, most interbank trades

are speculative or arbitrage transactions, where market participants attempt to correctly

judge the future direction of price movements in one currency versus another or attempt

to profit from temporary price discrepancies in currencies between competing dealers.

Market psychology is a key ingredient in currency trading, and a dealer can often infer

another’s trading intention from the currency position being accumulated.

FX brokers match dealer orders to buy and sell currencies for a fee, but do not take

a position themselves. Brokers have knowledge of the quotes offered by many dealers

in the market. Today, however, only a few specialized broking firms still exist. The vast

majority of interbank trades flows over Thomson Reuters and ICAP platforms. The

International Finance in Practice box “Where Money Talks Very Loudly” explains how

FX trading has changed over the past dozen or so years and how nonbank dealers using

electronic trading platforms can compete with bank traders and other non-bank dealers.

One frequently sees or hears news media reports that the central bank (national mon-

etary authority) of a particular country has intervened in the foreign exchange market in

an attempt to influence the price of its currency against that of a major trading partner,

or a country that it “fixes” or “pegs” its currency against. Intervention is the process of

using foreign currency reserves to buy one’s own currency in order to decrease its supply

and thus increase its value in the foreign exchange market, or alternatively, selling one’s

own currency for foreign currency in order to increase its supply and lower its price. For

example, intervention that successfully increases the value of one’s currency against a

trading partner may reduce exports and increase imports, thus alleviating persistent trade

deficits of the trading partner. Central bank traders intervening in the currency market

often lose bank reserves in attempting to accomplish their goal. There is little evidence

that interventions conducted by a single central bank are successful; however, coordi-

nated joint interventions involving several central banks have had more success.

The interbank market is a network of correspondent banking relationships , with

large commercial banks maintaining demand deposit accounts with one another, called

correspondent banking accounts. The correspondent bank account network allows for

the efficient functioning of the foreign exchange market, as Example 5.1 demonstrates.

EXAMPLE 5.1: Correspondent Banking Relationship As an example of how the network of correspondent bank accounts facilitates

international foreign exchange transactions, consider U.S. Importer desir-

ing to purchase merchandise from Dutch Exporter invoiced in euros, at a cost

of €750,000. U.S. Importer will contact his U.S. Bank and inquire about the $/€

exchange rate. Say U.S. Bank offers a price of $1.3092/€1.00. If U.S. Importer

See the following websites

that are examples of online FX

trading platforms as discussed

in the International Finance in

Practice box “Where Money

Talks Very Loudly.”

www.bgcpartners.com

www.currenex.com

www.forexster.com

Correspondent Banking Relationships

continued

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C H A P T E R 5 THE MARKET FOR FOREIGN EXCHANGE 117

accepts the price, U.S. Bank will debit U.S. Importer’s demand deposit account

$981,900 5 €750,000 3 1.3092 for the purchase of the euros. U.S. Bank will

instruct its correspondent bank in the euro zone, EZ Bank, to debit its corre-

spondent bank account €750,000 and to credit that amount to Dutch Exporter’s

bank account. U.S. Bank will then credit its books $981,900, as an offset to the

$981,900 debit to U.S. Importer’s account, to reflect the decrease in its corre-

spondent bank account balance with EZ Bank.

This rather contrived example assumes that U.S. Bank and Dutch Exporter both

have bank accounts at EZ Bank. A more realistic interpretation is to assume that

EZ Bank represents the entire euro zone banking system. Additionally, the example

implies some type of communication system between U.S. Bank and EZ Bank. The

Society for Worldwide Interbank Financial Telecommunication (SWIFT) allows inter-

national commercial banks to communicate instructions of the type in this example to

one another. SWIFT is a private nonprofit message transfer system with headquarters

in Brussels, with intercontinental switching centers in the Netherlands and Virginia.

The Clearing House (CHIPS) , formerly known as the Clearing House Interbank Pay- ments System , in cooperation with the U.S. Federal Reserve Bank System, called Fed-

wire, provides a clearinghouse for the interbank settlement for over 95 percent of U.S.

dollar payments between international banks. CHIPS processes an average of $1.5 trillion

of payments each day. Returning to our example, suppose U.S. Bank first needed to

purchase euros in order to have them for transfer to Dutch Exporter. U.S. Bank can use

CHIPS for settling the purchase of euros for dollars from, say, Swiss Bank, with struc-

tured invoice information via SWIFT to Swiss Bank to deposit the euros in its account

with EZ Bank and to EZ Bank to transfer ownership to Dutch Exporter. The transfer

between Swiss Bank and EZ Bank would in turn be accomplished through correspon-

dent bank accounts or through CHIPS multilateral netting capability.

In August 1995, Exchange Clearing House Limited (ECHO) , the first global clearing-

house for settling interbank FX transactions, began operation. ECHO was a multilateral

netting system that on each settlement date netted a client’s payments and receipts in

each currency, regardless of whether they are due to or from multiple counterparties.

Multilateral netting eliminates the risk and inefficiency of individual settlement. In 1997,

ECHO merged with CLS Services Limited and operates currently as part of CLS Group.

Seventeen currencies are currently eligible for settlement among 60 members.

The Spot Market The spot market involves almost the immediate purchase or sale of foreign exchange.

Typically, cash settlement is made two business days (excluding holidays of either

the buyer or the seller) after the transaction for trades between the U.S. dollar and a

non–North American currency. For regular spot trades between the U.S. dollar and the

Mexican peso or the Canadian dollar, settlement takes only one business day. 1 Accord-

ing to BIS statistics, spot foreign exchange trading accounted for 41 percent of FX

trades in 2013. Exhibit 5.3 provides a detailed analysis of foreign exchange turnover

by instrument and counterparty.

Spot rate currency quotations can be stated in direct or indirect terms. To understand

the difference, let’s refer to Exhibit 5.4 . The exhibit shows currency quotations by

bank dealers from ICAP and other sources as of 4:00 p.m. eastern time for Wednesday,

June 5, 2013. The first column provides direct quotations from the U.S. perspective,

www.swift.com

www.chips.org

www.cls-group.com

1 The banknote market for converting small amounts of foreign exchange, which travelers are familiar with, is

different from the spot market.

Spot Rate Quotations

EXAMPLE 5.1: continued

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INTERNATIONAL FINANCE IN PRACTICE

Foreign exchange is the largest, most dynamic market in the world. About $4.95 trillion worth of currency is traded daily in a market that literally does not sleep. Centered in Tokyo, London and New York, traders deal smoothly across borders and time zones, often in multiples of $1bn, in transactions that take less than a second.

The market’s development into its current form has left it virtually unrecognizable from 10 years ago.

Then, banks dealt currencies on behalf of their clients via traders holding multiple telephone conversations or perhaps using the relatively new electronic systems offered by Thomson Reuters and Electronic Broking Ser- vices (EBS). Today, clients can deal alongside banks on a number of platforms and the quiet hum of comput- ers has done much to reduce the noise level on trading floors.

Old timers complain that a lot of the “personality” has been drained from trading by the rise of faceless sys- tems. But the marketplace itself is, if anything, more vig- orous now than then. Many banks and trading platforms are reporting stiff rises in recent volumes traded and, allowing for some growth in market share, most believe overall trading activity has risen as the transparency of the market, and access to it, has improved.

EBS recently said that half of its top 35 busiest trad- ing days since the launch of the company 10 years ago had been in the first two months of 2004. Thomson Reuters said it saw growth of 35 percent year-on-year in 2003 in spot market transactions and that year-to-date,

it estimated spot volumes to be 50 percent higher from a year ago.

“FX has come of age as an asset class over the last five years,” says Nick Beecroft, head of foreign exchange trading at Standard Chartered. “There is much more activity, from active hedgers and from asset managers in other classes who tend to worry about FX much more than they did five, let alone 10 years ago.”

Then, the market largely consisted of deals between banks and the technologies being introduced were designed to replicate that. Roughly 50 percent of for- eign exchange deals were conducted by conversations between two counterparties and a further 35 percent were conducted through voice brokers, who “matched” bids and offers without either side knowing who the counterparty was.

Thomson Reuters had launched its first screen-based system in 1982, and in 1989 followed it up with a con- versational platform designed to mimic dealers’ tele- phone trades. In 1992 it went live with a matching system aimed at reproducing the role played by voice brokers. EBS’s matching platform was launched in 1993 in a bid by banks to curb Thomson Reuters’ development of a monopoly position. [EBS was acquired by ICAP in 2006.]

The advent of electronic broking for the interbank market gave smaller banks, which previously had little access to the best prices, the opportunity to deal along- side the bigger banks on an even basis because of the transparency afforded by electronic price provision.

Where Money Talks Very Loudly

Source: Euromoney , May 2012.

118

Foreign Exchange Survey 2012

Nonfinancial Overall Corporations Banks

Company Market Share % Company Market Share % Company Market Share %

Deutsche Bank 14.57 Citi 15.27 Deutsche Bank 17.28 Citi 12.26 HSBC 9.49 UBS 14.01 Barclays 10.95 Deutsche Bank 8.86 Barclays 13.02 UBS 10.48 RBS 7.09 Citi 11.93 HSBC 6.72 JPMorgan 5.68 HSBC 7.67 JPMorgan 6.60 Societé Générale 5.48 RBS 5.65 RBS 5.86 Barclays 5.01 JPMorgan 5.16 Credit Suisse 4.68 BNP Paribas 4.04 Credit Suisse 4.72 Morgan Stanley 3.52 UBS 3.98 Commerzbank 2.14 Goldman Sachs 3.12 Bank of America BNP Paribas 2.10 Merrill Lynch 3.47

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Today, only a few specialist voice-broking firms still operate and the bulk of interbank business flows over Thomson Reuters and EBS’s platforms.

Since then however, there has been another seismic shift in the foreign exchange (FX) marketplace; the extension of price transparency to clients outside the banking world.

Through an array of web-based platforms fund man- agers and hedge funds, for example, can rapidly view a series of quotes for a particular currency pair, and conduct the deal themselves. On some platforms, the counterparty could as easily be another fund manager as a bank.

“The market has changed more in the last three years than the previous seven,” says John Nelson, global head of FX markets at ABN Amro. “One stroke of a key will send a trade from the back office of one counterparty and settle in the back of the other almost instantly.”

Rapid price dissemination has, to a great extent, now leveled the playing field and extended the reach of FX trading well beyond the core investment bank market.

“What differentiated banks from customers then was that banks could see the real market prices and custom- ers couldn’t. Fast-forward to now, and I can see real-time market prices streaming over my desktop,” says Justyn Trenner, chief executive of ClientKnowledge, an inde- pendent research firm. “This greatly facilitates the more sophisticated fund managers in actively trading FX as an asset class.” The near instant dissemination of news, data and price information has led to what market theorists call “efficiency”—an accurate price at any given time. But it has affected the way in which currency pairs move.

“You get more zigs and zags within a trend than you used to see because everybody reacts to every piece of

news at the same time,” says Chris Furness, senior cur- rencies strategist at 4Cast economic consultancy, who likened today’s behaviour to a school of fish that all change direction at the same time. The upshot of more dramatic intraday price movement, particularly over the past two years, is greater overall volatility.

“Having absorbed the uncertainties around the launch of the euro and despite a contraction in the number of traders, this is a very healthy time for the market,” says Mark Robson, head of treasury and fixed income at Thomson Reuters.

But although there are new direct players as a result of new trading opportunities and as the price playing field has been leveled, many of the smaller banks have been relegated to the sidelines.

Once more they may specialise in their regional cur- rency but they are more usually clients of the bigger banks because of the expense of the new wave of trading technology.

The few banks with the deepest pockets have devel- oped and operate successful e-trading platforms of their own that add to the volumes they trade and their profits. In turn, they can afford to offer clients the tailormade products that are becoming the norm.

“The intense competition in this space means every- one is trying to distinguish themselves through cus- tomisation,” says Joe Noviello, chief information officer at e-speed, Cantor Fitzgerald’s online platform, which expanded to offer FX trading last year.

Source: Excerpted from Jennifer Hughes, Financial Times, Special Report: Foreign Exchange, May 27, 2004, p. 2.

119

E-Trading, E-Trading, Multibank and Leveraged Funds Proprietary Platforms Independent Platforms

Company Market Share % Company Market Share % Company Market Share %

Deutsche Bank 15.76 Deutsche Bank 16.84 FXall 21.70 Barclays 13.42 Citi 14.81 FX Connect 18.71 UBS 10.62 Barclays 13.69 Reuters Dealing 3000 Direct 18.53 JPMorgan 8.21 UBS 11.42 360 Treasury Systems 15.09 Citi 7.82 JPMorgan 5.47 Currenex 8.31 Morgan Stanley 7.24 RBS 5.32 FX Trading on Bloomberg 7.74 HSBC 6.06 Credit Suisse 4.92 Integral – FX Inside 4.85 RBS 5.96 HSBC 4.62 Hotspot FXi 3.34 Credit Suisse 5.83 Morgan Stanley 3.65 Gain GTX 0.79 Bank of America 4.07 Goldman Sachs 3.53 SaxoTrader 0.45 Merrill Lynch

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120 P A R T T W O THE FOREIGN EXCHANGE MARKET, EXCHANGE RATE DETERMINATION, AND CURRENCY DERIVATIVES

that is, the price of one unit of the foreign currency in U.S. dollars. For example, the

spot quote for one U.K. pound was $1.5405. (Forward quotations for one-, three-, and

six-month contracts, which will be discussed in a following section, appear directly

under the spot quotations for five currencies.) The second column provides indirect quotations from the U.S. perspective, that is, the price of one U.S. dollar in the foreign

currency. For example, we see that the spot quote for one dollar in U.K. pound sterling

was £0.6491. Obviously, the direct quotation from the U.S. perspective is an indirect

quote from the British viewpoint, and the indirect quote from the U.S. perspective is a

direct quote from the British viewpoint.

It is common practice among currency traders worldwide to both price and trade cur-

rencies against the U.S. dollar. For example, BIS statistics indicate that in 2013, 87 percent

of currency trading in the world involved the dollar on one side of the transaction. In

recent years, however, the use of other currencies has been increasing, especially in deal-

ing done by smaller regional banks. For example, in 2013, 34 percent of all currency

trading worldwide involved the euro on one side of the transaction. With respect to other

major currencies, 22 percent involved the Japanese yen, 12 percent the British pound,

9 percent the Australian dollar, and 5 percent each the Swiss franc and the Canadian dol-

lar. Exhibit 5.5 provides a detailed analysis of foreign exchange turnover by currency.

Most currencies in the interbank market are quoted in European terms , that is, the

U.S. dollar is priced in terms of the foreign currency (an indirect quote from the U.S.

perspective). By convention, however, it is standard practice to price certain curren-

cies in terms of the U.S. dollar, or in what is referred to as American terms (a direct

quote from the U.S. perspective). Prior to 1971, the British pound was a nondecimal

currency; that is, a pound was not naturally divisible into 10 subcurrency units. Thus,

it was cumbersome to price decimal currencies in terms of the pound. By necessity,

the practice developed of pricing the British pound, as well as the Australian dollar

and New Zealand dollar, in terms of decimal currencies, and this convention continues

today. When the common euro currency was introduced, it was decided that it also

would be quoted in American terms. To the uninitiated, this can be confusing, and it is

something to bear in mind when examining currency quotations.

In this textbook, we will use the following notation for spot rate quotations. In gen-

eral, S ( j / k ) will refer to the price of one unit of currency k in terms of currency j . Thus,

the American term quote from Exhibit 5.4 for the British (U.K.) pound on Wednesday,

EXHIBIT 5.3

Average Daily Foreign

Exchange Turnover

by Instrument and

Counterparty

Note: Turnover is net of local and cross-border interdealer double-counting.

Source: Tabulated from data in Table 4 in the Triennial Central Bank Survey, Preliminary Results, Bank for International Settlements, Basle, September 2013.

Instrument/Counterparty Turnover in USD (billion) Percent

Spot $2,046 41 With reporting dealers 675 14 With other financial institutions 1,183 24 With nonfinancial customers 188 4

Outright Forwards 680 14 With reporting dealers 182 4 With other financial institutions 402 8 With nonfinancial customers 96 2

Foreign Exchange Swaps 2,228 45 With reporting dealers 1,085 22 With other financial institutions 999 20 With nonfinancial customers 143 3 Total $4,954 100

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C H A P T E R 5 THE MARKET FOR FOREIGN EXCHANGE 121

EXHIBIT 5.4 Exchange Rates

Currencies June 5, 2013

U.S.-dollar foreign-exchange rates in late New York trading

US$ vs, — Wed — YTD chg

Country/currency in US$ Per US$ (%)

Americas

Argentina peso .1889 5.2931 7.7 Brazil real .4700 2.1277 3.9 Canada dollar .9668 1.0344 4.2 Chile peso .001986 503.50 5.0 Colombia peso .0005263 1900.22 7.5 Ecuador US dollar 1 1 unch Mexico peso .0778 12.8567 unch Peru new sol .3696 2.705 6.3 Uruguay peso .04959 20.1650 5.6 Venezuela b. fuerte .157480 6.3500 46.0

Asia-Pacific

Australian dollar .9542 1.0480 8.9 1-mos forward .9521 1.0503 8.2 3-mos forward .9482 1.0546 8.2 6-mos forward .9425 1.0610 8.1 China yuan .1632 6.1274 21.7 Hong Kong dollar .1288 7.7613 0.1 India rupee .01759 56.855 3.4 Indonesia rupiah .0001021 9792 1.6 Japan yen .010094 99.07 14.2 1-mos forward .010095 99.06 12.4 3-mos forward .010099 99.02 12.5 6-mos forward .010106 98.95 12.5 Malaysia ringgit .3243 3.0835 0.9 New Zealand dollar .7970 1.2547 3.9 Pakistan rupee .01015 98.495 1.3 Philippines peso .0238 42.049 2.5 Singapore dollar .8003 1.2496 2.3 South Korea won .0008936 1119.02 5.2 Taiwan dollar .03339 29.953 3.1 Thailand baht .03274 30.547 20.1 Vietnam dong .00004774 20948 0.8

US$ vs, — Wed — YTD chg

Country/currency in US$ Per US$ (%)

Europe

Czech Rep. koruna .05076 19.700 3.6 Denmark krone .1756 5.6938 0.7 Euro area euro 1.3092 .7638 0.8 1-mos forward 1.3093 .7638 0.8 3-mos forward 1.3098 .7635 0.8 6-mos forward 1.3107 .7629 0.8 Hungary forint .004394 227.58 3.1 Norway krone .1721 5.8103 4.4 Poland zloty .3056 3.2726 5.8 Russia ruble .03105 32.211 5.6 Sweden krona .1518 6.5894 1.3 Switzerland franc 1.0614 .9421 2.9 1-mos forward 1.0617 .9418 2.9 3-mos forward 1.0624 .9412 2.9 6-mos forward 1.0636 .9402 3.0 Turkey Iira .5283 1.8928 6.1 UK pound 1.5405 .6491 5.5 1-mos forward 1.5402 .6493 5.2 3-mos forward 1.5396 .6495 5.2 6-mos forward 1.5389 .6498 5.2

Middle East/Africa

Bahrain dinar 2.6525 .3770 unch Egypt pound .1431 6.9877 9.9 Israel shekel .2727 3.6668 21.7 Jordan dinar 1.4123 .7081 20.3 Kuwait dinar 3.5080 .2851 1.4 Lebanon pound .0006614 1511.85 0.7 Saudi Arabia riyal .2666 3.7504 unch South Africa rand .0999 10.0073 18.3 UAE dirham .2723 3.6730 unch

Close Net Chg % Chg YTD%Chg

WSJ Dollar Index 73.30 20.20 20.27 5.46

Sources: The Wall Street Journal , June 6, 2013, p. C5. Reprinted by permission of The Wall Street Journal , © 2013 Dow Jones & Company, Inc. All Rights Reserved Worldwide. Euro area exchange rates are 4 p.m. ET rates on June 5, 2013, from Bloomberg.

June 5, is S ( $ / £ ) = 1.5405. The corresponding European quote is S ( £ / $ ) = .6491. When

the context is clear as to what terms the quotation is in, the less cumbersome S will be

used to denote the spot rate.

It should be intuitive that the American and European term quotes are reciprocals

of one another. That is,

S($/£) 5 1 ______ S ( £ / $ )

(5.1)

1.5406 5 1 _____ .6491

where the difference from 1.5405 is due to rounding.

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122 P A R T T W O THE FOREIGN EXCHANGE MARKET, EXCHANGE RATE DETERMINATION, AND CURRENCY DERIVATIVES

Analogously,

S(£/$) 5 1 ______ S($/£)

.6491 5 1 ______ 1.5405

(5.2)

Let’s ignore the transaction costs of trading temporarily while we develop the concept

of a cross-rate. A cross-exchange rate is an exchange rate between a currency pair

where neither currency is the U.S. dollar. The cross-exchange rate can be calculated

from the U.S. dollar exchange rates for the two currencies, using either European or

American term quotations. For example, the €/£ cross-rate can be calculated from

American term quotations as follows:

S(€/£) 5 S ( $ / £ )

______ S ( $ /€ )

(5.3)

where from Exhibit 5.4 ,

S(€/£) 5 1.5405

______ 1.3092

5 1.1767

That is, if £1.00 costs $1.5405 and €1.00 costs $1.3092, the cost of £1.00 in euros is

€1.1767. In European terms, the calculation is

S(€/£) 5 S( € /$ )

______ S ( £ / $ )

(5.4)

5 .7638 ______ .6491

5 1.1767

Analogously,

S ( £ / € ) 5 S ( $/ € )

______ S ( $ /£ )

(5.5)

5 1.3092 _______ 1.5405

5 .8499

Cross-Exchange Rate Quotations

Currency Turnover Stated in USD (billions) percent

U.S. dollar $4,309 87 Euro 1,698 34 Japanese yen 1,067 22 Pound sterling 597 12 Australian dollar 429 9 Swiss franc 260 5 Canadian dollar 230 5 Other currencies 1,318 27 Total—double-counted $9,908 200 Total—not double-counted $4,954 100

Note: Since there are two sides to each transaction, each currency is reported twice. Turnover is net of local and cross-border interdealer double-counting.

Source: Tabulated from data in Table 5 in the Triennial Central Bank Survey, Preliminary Results, Bank for International Settlements, Basle, September 2013.

EXHIBIT 5.5

Average Daily Foreign

Exchange Turnover by

Currency against All

Other Currencies

http://money.cnn.com/data/ currencies

This subsite at the CNN,

Fortune, and Money magazines

website provides a currency

converter. As an example, use

the converter to calculate the

current S (€/£) and S (£/€) cross-

exchange rates.

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C H A P T E R 5 THE MARKET FOR FOREIGN EXCHANGE 123

and

S(£/€) 5 S(£/$)

______ S(€/$)

(5.6)

5 .6491 ______ .7638

5 .8498

where the difference from .8499 is due to rounding.

Equations 5.3 to 5.6 imply that given N currencies, one can calculate a triangular

matrix of the N 3 ( N –1)/2 cross-exchange rates. Available on Bloomberg are 55 cross-

exchange rates for all pair combinations of eleven key currencies that are stated as S ( j / k )

and S ( k / j ). Exhibit 5.6 presents an example of the table for Wednesday, June 5, 2013.

For some purposes, it is easier to think of cross-exchange rates calculated as the prod-

uct of an American term and a European term exchange rate rather than as the quotient

of two American term or two European term exchange rates. For example, substituting

S (€/ $ ) for 1/ S ( $ / € ) allows Equation 5.3 to be rewritten as:

S(€/£) 5 S($/£) 3 S(€/$) (5.7)

5 1.5405 3 .7638

5 1.1766

where the difference from 1.1767 is due to rounding.

In general terms,

S( j/k) 5 S($/k) 3 S( j/$) (5.8)

and taking reciprocals of both sides of Equation 5.8 yields

S(k/j) 5 S(k/$) 3 S($/j) (5.9)

Note the $ signs cancel one another out in both Equations 5.8 and 5.9.

Up to this point in our discussion, we have ignored the bid-ask spread in FX transactions.

Interbank FX traders buy currency for inventory at the bid price and sell from inventory

at the higher offer or ask price . Consider the Reuters quotations from Exhibit 5.4 . What

are they, bid or ask? Most likely they are mid-rates, that is, the average of the bid and ask

rates. For ease of discussion, however, and without loss of generality, we will assume

that the “per US $” quotations are buying, or bid quotes, and the “in US $” quotations are

Alternative Expressions for the Cross-Exchange Rate

The Bid-Ask Spread

USD EUR JPY GBP CHF CAD AUD NZD HKD NOK SEK

Sweden 6.5895 8.6268 .06647 10.149 6.9919 6.3692 6.2850 5.2423 .84899 1.1334 — Norway 5.8139 7.6115 .05865 8.9543 6.1690 5.6195 5.5453 4.6253 .74907 — .83230 Hong Kong 7.7616 10.161 .07829 11.954 8.2356 7.5020 7.4029 6.1747 — 1.3350 1.1779 New Zealand 1.2570 1.6456 .01268 1.9359 1.3337 1.2150 1.1989 — .16195 .21620 .19076 Australia 1.0484 1.3726 .01058 1.6148 1.1125 1.0134 — .83409 .13508 .18033 .15911 Canada 1.0346 1.3545 .01044 1.5934 1.0978 — .98679 .82308 .13330 .17795 .15701 Switzerland .94244 1.2338 .00951 1.4515 — .91093 .89890 .74977 .12142 .16210 .14302 UK .64929 .85004 .00655 — .68894 .62758 .61929 .51655 .08365 .11168 .09853 Japan 99.136 129.79 — 152.68 105.19 95.821 94.555 78.868 12.773 17.051 15.044 Euro .76384 — .00771 1.1764 .81049 .73830 .72855 .60768 .09841 .13138 .11592 U.S. — 1.3092 .01009 1.5401 1.0611 .96656 .95380 .79555 .12884 .17200 .15176

EXHIBIT 5.6 Key Cross-Currency Rates

Source: Composite 4 p.m. ET values on June 5, 2013, from Bloomberg.

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124 P A R T T W O THE FOREIGN EXCHANGE MARKET, EXCHANGE RATE DETERMINATION, AND CURRENCY DERIVATIVES

selling, or ask quotes. Thus the European term quotations are interbank bid prices and

the American term quotations are interbank ask prices.

To be more specific about the £/$ quote we have been using as an example, we can

specify that it is a bid quote by writing S b ( £ / $ ) = .6491, meaning the bank dealer will

bid, or pay, £0.6491 for one U.S. dollar. However, if the bank dealer is buying dollars for

British pounds, it must be selling British pounds for U.S. dollars. This implies that the

$/£ quote we have been using as an example is an ask quote, which we can designate as

S a ( $ / £ ) = 1.5405. That is, the bank dealer will sell one British pound for $1.5405.

Returning to the reciprocal relationship between European and American term quo-

tations, the recognition of the bid-ask spread implies:

Sa($/£) 5 1 ______ Sb(£/$)

(5.10)

In American terms, the bank dealer is asking $1.5405 for one British pound; that means

the bank dealer is willing to pay, or bid, less. Interbank bid-ask spreads are quite small.

Let’s assume the bid price is $0.0005 less than the ask; thus S b ( $ / £ ) = 1.5400. Similarly,

the bank dealer will want an ask price in European terms greater than its bid price.

The reciprocal relationship between European and American term quotes implies:

Sa(£/$) 5 1 ______ S b ( $ / £ )

(5.11)

5 1 ______ 1.5400

5 .6494

Thus, the bank dealer’s ask price of £0.6494 per U.S. dollar is indeed greater than

its bid price of £0.6491.

The following table summarizes the reciprocal relationship between American and

European bid and ask quotations.

Note that in each row the quotations refer to buying or selling one unit of the

denominator currency, in the first row £s and in the second row $s.

Examination of Exhibit 5.4 indicates that for most currencies, quotations are carried

out to four decimal places in both American and European terms. However, for some

currencies (e.g., the Colombian peso, Indian rupee, Indonesian rupiah) quotations in

European terms are carried out to zero or only two or three decimal places, but in

American terms the quotations may be carried out to as many as seven decimal places

(see, for example, the South Korean won).

In the interbank market, the standard-size trade among large banks in the major

currencies is for the U.S.-dollar equivalent of $10,000,000, or “ten dollars” in trader

jargon. Dealers quote both the bid and the ask, willing to either buy or sell up to

$10,000,000 at the quoted prices. Spot quotations are good for only a few seconds. If

a trader cannot immediately make up his mind whether to buy or sell at the proffered

prices, the quotes are likely to be withdrawn.

In conversation, interbank FX traders use a shorthand abbreviation in express-

ing spot currency quotations. Consider the $/£ bid-ask quotes from above, $1.5400–

$1.5405. The “1.54” is known as the big figure , and it is assumed to be known by all

traders. The second two digits to the right of the decimal place are referred to as the

Spot FX Trading

Bid Ask

S ( $ / £ ) 1.5400 1.5405

reciprocal reciprocal equals equals

S ( £ / $ ) .6491 .6494

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C H A P T E R 5 THE MARKET FOR FOREIGN EXCHANGE 125

small figure . Assuming spot bid-ask spreads for the British pound sterling are around

5 “points,” it is unambiguous for a trader to respond with “00 to 05” when asked what

is his quote for British pound sterling. Similarly, “97 to 02” is a sufficient response for

a quote of $1.5397–$1.5402, where the big figures are 1.53 and 1.54 respectively, for

the bid and ask quotes.

The establishment of the bid-ask spread will facilitate acquiring or disposing of

inventory. Suppose most $/£ dealers are trading at $1.5400–$1.5405. A trader believ-

ing the pound will soon appreciate substantially against the dollar will desire to acquire

a larger inventory of British pounds. A quote of “01–06” will encourage some traders

to sell at the higher-than-market bid price, but also dissuade other traders from pur-

chasing at the higher offer price. Analogously, a quote of “99–04” will allow a dealer

to lower his pound inventory if he thinks the pound is ready to depreciate.

The retail bid-ask spread is wider than the interbank spread; that is, lower bid and

higher ask prices apply to the smaller sums traded at the retail level. This is necessary to

cover the fixed costs of a transaction that exist regardless of which tier the trade is made in.

Interbank trading rooms are typically organized with individual traders dealing in

a particular currency. The dealing rooms of large banks are set up with traders dealing

against the U.S. dollar in all the major currencies: the Japanese yen, euro, Canadian dollar,

Swiss franc, and British pound, plus the local currency if it is not one of the majors. Indi-

vidual banks may also specialize by making a market in regional currencies or in the cur-

rencies of less-developed countries, again all versus the U.S. dollar. Additionally, banks

will usually have a cross-rate desk where trades between two currencies not involving

the U.S. dollar are handled. It is not uncommon for a trader for an active currency pair to

make as many as 1,500 quotes and 400 trades in a day. 2 In smaller European banks accus-

tomed to more regional trading, dealers will frequently quote and trade versus the euro.

Earlier in the chapter, it was mentioned that most interbank trading goes through the dollar.

Suppose a bank customer wants to trade out of British pounds into Swiss francs. In dealer

jargon, a nondollar trade such as this is referred to as a currency against currency trade.

The bank will frequently (or effectively) handle this trade for its customer by selling Brit-

ish pounds for U.S. dollars and then selling U.S. dollars for Swiss francs. At first blush,

this might seem ridiculous. Why not just sell the British pounds directly for Swiss francs?

To answer this question, let’s return to Exhibit 5.6 of the cross-exchange rates. Suppose a

bank’s home currency was one of the 11 currencies in the exhibit and that it made markets

in the other 10 currencies. The bank’s trading room would typically be organized with 10

trading desks, each for trading one of the nondollar currencies against the U.S. dollar. A

dealer needs to be concerned only with making a market in his nondollar currency against

the dollar. However, if each of the 11 currencies was traded directly with the others, the

dealing room would need to accommodate 55 trading desks. Or worse, individual traders

would be responsible for making a market in several currency pairs, say, the €/$, €/£, and

€/SF, instead of just the €/$. As Grabbe (1996) notes, this would entail an informational

complexity that would be virtually impossible to handle.

Banks handle currency against currency trades, such as for the bank customer who

wants to trade out of British pounds into Swiss francs, at the cross-rate desk. Recall from

Equation 5.8 that a S ( SF / £ ) quote can be obtained from the product of S ( $ / £ ) and S ( SF / $ ).

Recognizing transaction costs implies the following restatement of Equation 5.8:

Sb(SF/£) 5 Sb($/£) 3 Sb(SF/$) (5.12)

The bank will quote its customer a buying (bid) price for the British pounds in terms of

Swiss francs determined by multiplying its American term bid price for British pounds

and its European term bid price (for U.S. dollars) stated in Swiss francs.

The Cross-Rate Trading Desk

2 These numbers were obtained during a discussion with the manager of the spot trading desk at the New York

branch of UBS.

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126 P A R T T W O THE FOREIGN EXCHANGE MARKET, EXCHANGE RATE DETERMINATION, AND CURRENCY DERIVATIVES

EXAMPLE 5.2: Calculating the Cross-Exchange Rate Bid-Ask Spread. Let’s assume (as we did earlier) that the $/£ bid-ask prices are $1.5400–$1.5405 and

the £/$ bid-ask prices are £0.6491–£0.6494. Let’s also assume the $/€ bid-ask prices

are $1.3087–$1.3092 and the €/$ bid-ask prices are € 0.7638 – € 0.7641. These bid and

ask prices and Equation 5.12 imply that S b ( € / £ ) 5 1.5400 3 .7638 5 1.1763. The recip-

rocal of S b ( € / £ ) implies that S a ( £ / € ) 5 .8501. Analogously, Equation 5.13 suggests that

S a ( € / £ ) 5 1.5405 3 .7641 5 1.1771, and its reciprocal implies that S b ( £ / € ) 5 .8495.

That is, the € / £ bid-ask prices are € 1.1763– € 1.1771 and the £ / € bid-ask prices are

£ 0.8495– £ 0.8501. Note that the cross-rate bid-ask spreads are much larger than

the American or European bid-ask spreads. For example, the € / £ bid-ask spread is

€ 0.0008 versus a € / $ spread of € 0.0003. The £ / € bid-ask spread is £ 0.0006 versus

the $ / € spread of $0.0005, which is a sizable difference since a British pound is priced

at more than 1.5 dollars. The implication is that cross-exchange rates implicitly incor-

porate the bid-ask spreads of the two transactions that are necessary for trading out

of one nondollar currency and into another. Hence, even when a bank makes a direct

market in one nondollar currency versus another, the trade is effectively going through

the dollar because the “currency against currency” exchange rate is consistent with a

cross-exchange rate calculated from the dollar exchange rates of the two currencies.

Exhibit 5.7 provides a more detailed presentation of cross-rate foreign exchange

transactions.

Taking reciprocals of Equation 5.12 yields

Sa(£/SF ) 5 Sa(£/$ ) 3 Sa($/SF ) (5.13)

which is analogous to Equation 5.9. In terms of our example, Equation 5.13 says the

bank could alternatively quote its customer an offer (ask) price for Swiss francs in

terms of British pounds determined by multiplying its European term ask price (for

U.S. dollars) stated in British pounds by its American term ask price for Swiss francs.

American Terms European Terms

Bank Quotations Bid Ask Bid Ask

British pounds 1.5400 1.5405 .6491 .6494 Euros 1.3087 1.3092 .7638 .7641

a. Bank Customer wants to sell £1,000,000 for euros. The Bank will sell U.S. dollars (buy British pounds) for $1.5400. The sale yields Bank Customer: £1,000,000 3 1.5400 5 $1,540,000. The Bank will buy dollars (sell euros) for €0.7638. The sale of dollars yields Bank Customer: $1,540,000 3 €0.7638 5 €1,176,252. Bank Customer has effectively sold British pounds at a €/£ bid price of €1,176,252/£1,000,000 5 €1.1763/£1.00.

b. Bank Customer wants to sell €1,000,000 for British pounds. The Bank will sell U.S. dollars (buy euros) for €0.7641. The sale yields Bank Customer: €1,000,000 4 .7641 5 $1,308,729. The Bank will buy dollars (sell British pounds) for $1.5405. The sale of dollars yields Bank Customer: $1,308,729 4 1.5405 5 £849,548. Bank Customer has effectively bought British pounds at a €/£ ask price of €1,000,000/£849,548 5 €1.1771/£1.00. From parts (a) and (b), we see the currency against currency bid-ask spread for British pounds is €1.1763 – €1.1771.

EXHIBIT 5.7

Cross-Rate Foreign

Exchange Transactions

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C H A P T E R 5 THE MARKET FOR FOREIGN EXCHANGE 127

Market microstructure refers to the basic mechanics of how a marketplace operates.

Five empirical studies on FX market microstructure shed light on the operation of

the spot FX marketplace. Huang and Masulis (1999) studied spot FX rates on DM/$

trades over the period from October 1, 1992 to September 29, 1993. They found that

bid-ask spreads in the spot FX market increased with FX exchange rate volatility and

decreased with dealer competition. These results are consistent with models of market

microstructure. They also found that the bid-ask spread decreased when the percentage

of large dealers in the marketplace increased. They concluded that dealer competition

is a fundamental determinant of the spot FX bid-ask spread.

Lyons (1998) tracked the trading activity of a DM/$ trader at a large New York

bank over a period of five trading days. The dealer he tracked was extremely profitable

over the study period, averaging profits of $100,000 per day on volume of $1 billion.

Spot Foreign Exchange Market Microstructure

EXAMPLE 5.3: Taking Advantage of a Triangular Arbitrage Opportunity To illustrate a triangular arbitrage, assume the cross-rate trader at Deutsche Bank

notices that Crédit Lyonnais is buying dollars at S b ( € / $ ) 5 .7638, the same as

Deutsche Bank’s bid price. Similarly, he observes that Barclays is buying British

pounds at S b ( $ / £ ) 5 1.5400, also the same as Deutsche Bank. He next finds that

Crédit Agricole is making a direct market between the euro and the pound, with a

current ask price of S a ( € / £ ) 5 1.1705. Cross-rate Equation 5.12 implies that the € / £

bid price should be no lower than S b ( € / £ ) 5 1.5400 3 .7638 5 1.1763. Yet Crédit

Agricole is offering to sell British pounds at a rate of only 1.1705!

A triangular arbitrage profit is available if the Deutsche Bank traders are

quick enough. A sale of $5,000,000 to Crédit Lyonnais for euros will yield

€ 3,819,000 5 $5,000,000 3 .7638. The € 3,819,000 will be resold to Crédit Agricole

for £3,262,708 5 € 3,819,000/1.1705. Likewise, the British pounds will be resold to

Barclays for $5,024,570 5 £3,262,708 3 1.5400, yielding an arbitrage profit of $24,570.

Exhibit 5.8 presents a diagram and a summary of this triangular arbitrage example.

Obviously, Crédit Agricole must raise its asking price above € 1.1705/£1.00. The

cross-exchange rates (from Exhibit 5.7 ) gave € /£ bid-ask prices of € 1.1763 2 € 1.1771.

These prices imply that Crédit Agricole can deal inside the spread and sell for less

than € 1.1771, but not less than € 1.1763. An ask price of € 1.1767, for example,

would eliminate the arbitrage profit. At that price, the € 3,819,000 would be resold

for £3,245,517 5 € 3,819,000/1.1767, which in turn would yield only $4,998,096 5

£3,245,517 3 1.5400, or a loss of $1,904. In today’s “high-tech” FX market, many

FX trading rooms around the world have developed in-house software that receives

a digital feed of real-time FX prices from the EBS Spot electronic broking system

to explore for triangular arbitrage opportunities. Just a few years ago, prior to the

development of computerized dealing systems, the FX market was considered too

efficient to yield triangular arbitrage profits!

Certain banks specialize in making a direct market between nondollar currencies, pric-

ing at a narrower bid-ask spread than the cross-rate spread. Nevertheless, the implied

cross-rate bid-ask quotations impose a discipline on the nondollar market makers. If

their direct quotes are not consistent with cross-exchange rates, a triangular arbitrage

profit is possible. 3 Triangular arbitrage is the process of trading out of the U.S. dollar

into a second currency, then trading it for a third currency, which is in turn traded for

U.S. dollars. The purpose is to earn an arbitrage profit via trading from the second to

the third currency when the direct exchange rate between the two is not in alignment

with the cross-exchange rate.

Triangular Arbitrage

3 An arbitrage is a zero-risk, zero-investment strategy from which a profit is guaranteed.

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128 P A R T T W O THE FOREIGN EXCHANGE MARKET, EXCHANGE RATE DETERMINATION, AND CURRENCY DERIVATIVES

Lyons was able to disentangle total trades into those that were speculative and those

that were non-speculative, or where the dealer acted as a financial intermediary for a

retail client. He determined that the dealer’s profits came primarily from the dealer’s

role as an intermediary. This makes sense, since speculative trading is a zero-sum

game among all speculators, and in the long run it is unlikely that any one trader has a

unique advantage. Interestingly, Lyons found that the half-life of the dealer’s position

in nonspeculative trades was only 10 minutes! That is, the dealer typically traded or

swapped out of a nonspeculative position within 20 minutes.

Ito, Lyons, and Melvin (1998) studied the role of private information in the spot FX

market. They examined ¥/$ and DM/$ between September 29, 1994, and March 28,

1995. Their study provides evidence against the common view that private information

is irrelevant, since all market participants are assumed to possess the same set of public

information. Their evidence came from the Tokyo foreign exchange market, which prior

to December 21, 1994, closed for lunch between noon and 1:30 p.m. After December 21,

1994, the variance in spot exchange rates increased during the lunch period relative to

the period of closed trading. This was true for both ¥/$ and DM/$ trades, but more so for

the ¥/$ data, which is to be expected since ¥/$ trading is more intensive in the Tokyo FX

market. Ito, Lyons, and Melvin attributed these results to a greater revelation of private

information in trades being allocated to the lunch hour. This suggests that private infor-

mation is, indeed, an important determinant of spot exchange rates.

Cheung and Chinn (2001) conducted a survey of U.S. foreign exchange traders

and received 142 usable questionnaires. The purpose of their survey was to elicit

information about several aspects of exchange rate dynamics not typically observ-

able in trading data. In particular they were interested in traders’ perceptions about

news events—innovations in macroeconomic variables—that cause movements in

exchange rates. The traders they surveyed responded that the bulk of the adjustment to

EXHIBIT 5.8

Triangular Arbitrage

Example

Barclays

Sb($/£) = 1.5400

Crédit Agricole

Sa ( /£) = 1.1705

Deutsche Bank arbitrage strategy

Sell U.S. dollars for euros

Sell euros for British pounds

Sell British pounds for U.S. dollars

Arbitrage profit

5,000,000 × .7638

3,819,000 ÷ 1.1705

3,262,708 × 1.5400

5,024,570 5,000,000

24,570

Crédit Lyonnais

Sb( /$) = .7638

$ –$

Sa( /£) must be greater than or equal to the no-arbitrage

bid price to prevent triangular arbitrage; this is Sb( /£) =

Sb($/£) × Sb( /$) = 1.5400 × .7638 = 1.1763.

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C H A P T E R 5 THE MARKET FOR FOREIGN EXCHANGE 129

economic announcements regarding unemployment, trade deficits, inflation, GDP, and

the Federal funds rate takes place within one minute. In fact, “about one-third of the

respondents claim that full price adjustment takes place in less than 10 seconds”! They

also found that central bank intervention does not appear to have a substantial impact

on exchange rates, but intervention does increase market volatility. Dominguez (1998)

confirmed this latter finding.

The Forward Market In conjunction with spot trading, there is also a forward foreign exchange market. The

forward market involves contracting today for the future purchase or sale of foreign

exchange. The forward price may be the same as the spot price, but usually it is higher

(at a premium) or lower (at a discount) than the spot price. Forward exchange rates are

quoted on most major currencies for a variety of maturities. Bank quotes for maturi-

ties of 1, 3, 6, 9, and 12 months are readily available. Quotations on nonstandard, or

broken-term, maturities are also available. Maturities extending beyond one year are

becoming more frequent, and for good bank customers, a maturity extending out to 5,

and even as long as 10 years, is possible.

To learn how to read forward exchange rate quotations, let’s examine Exhibit 5.4 .

Notice that forward rate quotations appear directly under the spot rate quotations

for five major currencies (the British pound, Australian dollar, Japanese yen, Swiss

franc, and euro) for one-, three-, and six-month maturities. As an example, the settle-

ment date of a three-month forward transaction is three calendar months from the spot

settlement date for the currency. That is, if today is Wednesday, June 5, 2013 and spot

settlement is June 7, then the forward settlement date would be September 9, 2013

(since September 7 falls on a Saturday), a period of 94 days from June 7.

In this textbook, we will use the following notation for forward rate quotations. In

general, F N ( j / k ) will refer to the price of one unit of currency k in terms of currency

j for delivery in N months. N equaling 1 denotes a one-month maturity based on a

360-day banker’s year. Thus, N equaling 3 denotes a three-month maturity. When the

context is clear, the simpler notation F will be used to denote a forward exchange rate.

Forward quotes are either direct or indirect, one being the reciprocal of the other.

From the U.S. perspective, a direct forward quote is in American terms. As an exam-

ple, let’s consider the American term Swiss franc forward quotations in relationship to

the spot rate quotation for Wednesday, June 5, 2013. We see that:

S($/SF ) 5 1.0614

F 1 ($/SF ) 5 1.0617

F 3 ($/SF ) 5 1.0624

F 6 ($/SF ) 5 1.0636

From these quotations, we can see that in American terms the Swiss franc is trading at

a premium to the dollar, and that the premium increases out to six months, the further

the forward maturity date is from June 5. As we will more formally learn in the next

chapter, under certain conditions the forward exchange rate is an unbiased predictor of

the expected spot exchange rate N months into the future. 4 Thus, according to the for-

ward rate, when the Swiss franc is trading at a premium to the dollar in American terms,

we can say the market expects the dollar to depreciate , or become less valuable, relative

to the Swiss franc. Consequently, it costs more dollars to buy a Swiss franc forward.

European term forward quotations are the reciprocal of the American term quotes.

In European terms, the corresponding Swiss franc forward quotes to those stated above

Forward Rate Quotations

4 The forward exchange rate is an unbiased predictor of the expected spot exchange rate under an assumption of

risk-neutrality.

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130 P A R T T W O THE FOREIGN EXCHANGE MARKET, EXCHANGE RATE DETERMINATION, AND CURRENCY DERIVATIVES

are:

S(SF/$) 5.9421

F 1 (SF/$) 5.9418

F 3 (SF/$) 5.9412

F 6 (SF/$) 5.9402

From these quotations, we can see that in European terms the dollar is trading at a dis- count to the Swiss franc and that the discount increases out to six months, the further

the forward maturity date is from June 5. Thus, according to the forward rate, when

the dollar is trading at a discount to the Swiss franc in European terms, we can say the

market expects the Swiss franc to appreciate , or become more valuable, relative to

the dollar. Consequently, it costs fewer Swiss francs to buy a dollar forward. This is

exactly what we should expect, since the European term quotes are the reciprocals of

the corresponding American term quotations.

One can buy (take a long position) or sell (take a short position) foreign exchange forward.

Bank customers can contract with their international bank to buy or sell a specific sum

of freely traded FX for delivery on a certain date. Likewise, interbank traders can estab-

lish a long or short position by dealing with a trader from a competing bank. Exhibit 5.9

graphs both the long and short positions for the three-month Swiss franc contract, using

the American quote for June 5, 2013, from Exhibit 5.4 . The graph measures profits or

losses on the vertical axis. The horizontal axis shows the spot price of foreign exchange

on the maturity date of the forward contract, S 3 ( $ / SF ). If one uses the forward contract,

he has “locked in” the forward price for forward purchase or sale of foreign exchange.

Regardless of what the spot price is on the maturity date of the forward contract, the trader

buys (if he is long) or sells (if he is short) at F 3 ( $ / SF ) = 1.0624 per unit of FX. Forward

contracts can also be used for speculative purposes, as Example 5.4 demonstrates.

Because of government-instituted capital controls, the currencies of some emerg-

ing market countries are not freely traded and thus it is not possible to obtain these

currencies offshore in the spot market to settle a forward position. For many of these

currencies (such as the Chinese yuan and Russian ruble), trading in non-deliver- able forward (NDF) contracts exists. A non-deliverable forward contract is set-

tled in cash, usually U.S. dollars, at the difference between the spot exchange on the

maturity date of the contract and the NDF rate times the notional amount of the con-

tract. For example, a long position in a NDF contract on CNY12,000,000 with a for-

ward price of F($/CNY) 5 .1653 would be settled by the long receiving $6,000 5

(.1658 2 .1653) 3 CNY12,000,000 from the short if the spot rate at the maturity date

of the NDF contract is S($/CNY) 5 .1658. This cash settlement is in lieu of the long receiv-

ing CNY12,000,000, with a spot dollar value of $1,989,600 5 (CNY12,000,000 3

$0. 1658), for payment of the forward price $1,983,600 5 (CNY12,000,000 3 $0.1653),

a $6,000 difference in sums.

Forward cross-exchange rate quotations are calculated in an analogous manner to spot

cross-rates, so it is not necessary to provide detailed examples. In generic terms,

FN( j/k) 5 F N ( $ / k )

_______ F N ( $ / j )

(5.14)

FN( j/k) 5 F N ( j /$ )

_______ F N ( k / $ )

(5.15)

and

FN(k/j) 5 F N ( $/j )

_______ F N ( $ / k )

(5.16)

Long and Short Forward Positions

Non-Deliverable Forward Contracts

Forward Cross-Exchange Rates

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C H A P T E R 5 THE MARKET FOR FOREIGN EXCHANGE 131

FN(k/j) 5 F N ( k / $ )

_______ F N ( j / $ )

(5.17)

For example, using the forward quotations in Exhibit 5.4 , the three-month AD/SF

cross-exchange forward rate using American term quotes (Equation 5.14) is:

F 3 (AD/SF ) 5

F 3 ($/SF )

________ F

3 ($/AD)

5 1.0624 ______ .9482

5 1.1204

and using European term quotes (Equation 5.15) is:

F 3 (AD/SF ) 5

F 3 (AD/$)

________ F

3 (SF/$)

5 1.0546

______ .9412

5 1.1205.

where the difference from 1.1204 is due to rounding.

EXAMPLE 5.4: A Speculative Forward Position

It is June 5, 2013. Suppose the $/SF trader has just heard an economic forecast

from the bank’s head economist that causes him to believe that the dollar will

likely appreciate in value against the Swiss franc over the next three months. If he

decides to act on this information, the trader will short the three-month $/SF con-

tract. We will assume that he sells SF5,000,000 forward against dollars. Suppose

the forecast has proven correct, and on September 5, 2013, spot $/SF is trading at

$1.0554. The trader can buy Swiss franc spot at $1.0554 and deliver it under the

forward contract at a price of $1.0624. The trader has made a speculative profit of

($1.0624 2 $1.0554) 5 $0.0070 per unit, as Exhibit 5.9 shows. The total profit from

the trade is $35,000 5 (SF5,000,000 3 $0.0070). If the dollar depreciated and S 3

was $1.0654, the speculator would have lost ($1.0624 2 $1.0654) 5 2$0.0030 per

unit, for a total loss of 2$15,000 5 (SF5,000,000)(2$0.0030).

EXHIBIT 5.9

Graph of Long and Short

Position in the Three-

Month Swiss Franc

Contract F3($/SF )

Profit ($)

–F3($/SF)

–

–.0030

.0070

1.0554

S3($/SF)

Long

position

Short

position

F3($/SF) = 1.0624

1.0654

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132 P A R T T W O THE FOREIGN EXCHANGE MARKET, EXCHANGE RATE DETERMINATION, AND CURRENCY DERIVATIVES

It is common to express the premium or discount of a forward rate as an annual-

ized percentage deviation from the spot rate. The forward premium (or discount) is

useful for comparing against the interest rate differential between two countries, as we

will see more clearly in Chapter 6 on international parity relationships. The forward premium or discount can be calculated using American or European term quotations,

as Example 5.5 demonstrates.

Forward Premium

EXAMPLE 5.5: Calculating the Forward Premium/Discount The formula for calculating the forward premium or discount for currency j in

American terms is:

f N,j

5 F

N ( $ / j ) 2 S ( $/ j )

_____________ S ( $/ j )

3 360/days (5.18)

When the context is clear, the forward premium will simply be stated as f .

As an example of calculating the forward premium, let’s use the June 5 quotes

from Exhibit 5.4 to calculate the three-month forward premium or discount for the

Japanese yen versus the U.S. dollar. The calculation is:

f 3,¥

5 .010099 2 .010094 __________________ .010094

3 360 ____ 94

5 .0019

We see that the three-month forward premium is .0019, or .19 percent. In

words, we say that the Japanese yen is trading at a .19 percent premium

versus the U.S. dollar for delivery in 94 days.

In European terms the forward premium or discount for the U.S. dollar is

calculated as:

f N,$

5 F

N ( j /$ ) 2 S ( j/ $ )

_____________ S ( j/ $ )

3 360/days (5.19)

Using the June 5 three-month European term quotations for the Japanese yen

from Exhibit 5.4 yields:

f 3,$

5 99.02299.07 ____________ 99.07

3 360 ____ 94

5 2.0019

We see that the three-month forward discount is −.0019, or −.19 percent. In words,

we say that the U.S. dollar is trading versus the Japanese yen at a .19 percent dis-

count for delivery in 94 days.

Forward swap trades can be classified as outright or swap transactions. In conduct-

ing their trading, bank dealers do take speculative positions in the currencies they

trade, but more often traders offset the currency exposure inherent in a trade. From

the bank’s standpoint, an outright forward transaction is an uncovered speculative

position in a currency, even though it might be part of a currency hedge to the bank

customer on the other side of the transaction. Swap transactions provide a means for

the bank to mitigate the currency exposure in a forward trade. A forward swap transac-

tion is the simultaneous sale (or purchase) of spot foreign exchange against a forward

purchase (or sale) of approximately an equal amount of the foreign currency.

Forward swap transactions account for approximately 45 percent of interbank FX

trading, whereas outright forward trades are 14 percent. (See Exhibit 5.3 .) Both for-

ward swaps and outright forward transactions are exempt from new over-the-counter

regulation as “swaps” under the Dodd-Frank Act. Because swap transactions are the

more common type of interbank forward trades, bank dealers in conversation among

themselves use a shorthand notation to quote bid and ask forward prices in terms of

forward points that are either added to or subtracted from the spot bid and ask quota-

tions, as Example 5.6 demonstrates.

Swap Transactions

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C H A P T E R 5 THE MARKET FOR FOREIGN EXCHANGE 133

Assume the Swiss franc/U.S. dollar ( SF /$) bid-ask rates are SF0.9421–SF0.9424.

With reference to these rates, forward prices might be displayed as:

Spot .9421–.9424 One-Month 3–1 Three-Month 9–5 Six-Month 19–13

When the second number in a forward point “pair” is smaller than the first, the

dealer “knows” the forward points are subtracted from the spot bid and ask prices

to obtain the outright forward rates. For example, the spot bid price of SF0.9421

minus .0003 (or 3 points) equals SF0.9418, the one-month forward bid price. The

spot ask price of SF0.9424 minus .0001 (or 1 point) equals SF0.9423, the one-

month ask price. Analogously, the three-month outright forward bid-ask rates

are SF0.9412–SF0.9419 and the six-month outright forward bid-ask rates are

SF0.9402–SF0.9411. 5 The following table summarizes the calculations.

Spot .9421–.9424

Forward Point Quotations Outright Forward Quotations

One-Month 3–1 .9418–.9423 Three-Month 9–5 .9412–.9419 Six-Month 19–13 .9402–.9411

Three things are notable about the outright prices. First, the dollar is trading at

a forward discount to the Swiss franc. Second, all bid prices are less than the cor-

responding ask prices, as they must be for a trader to be willing to make a market.

Third, the bid-ask spread increases in time to maturity, as is typical. These three

conditions prevail only because the forward points were subtracted from the spot

prices. As a check, note that in points the spot bid-ask spread is 3 points, the one-

month forward bid-ask spread is 5 points, the three-month spread is 7 points, and

the six-month spread is 9 points.

If the forward prices were trading at a premium to the spot price, the second

number in a forward point pair would be larger than the first, and the trader would

know to add the points to the spot bid and ask prices to obtain the outright forward

bid and ask rates. For example, if the three-month and six-month swap points

were 5–9 and 13–19, the corresponding three-month and six-month bid-ask rates

would be SF0.9426–SF0.9433 and SF0.9434–SF0.9443. In points, the three- and

six-month bid-ask spreads would be 7 and 9, that is, increasing in term to maturity.

EXAMPLE 5.6: Forward Point Quotations

5 If the one-month forward points quotation were, say, 12–12, further elaboration from the market maker would

be needed to determine if the forward points would be added to or subtracted from the spot prices. An electronic

dealing system would state forward points as 212 –212 if they were to be subtracted.

Exhibit 5.10 presents spot and forward point quotations for the euro on June 17,

2013. Forward point quotations are for maturities of one week to 18 months. Note that

for each pair the ask number of points is larger than the bid; therefore, they are to be

added to the spot quotes. The 18 months forward points are 43.5 (bid) and 53.84 (ask).

Since the spot quotes are 1.3331 – 1.3332, the 18-month outright forward quotes are

1.337450 – 1.338584.

Quoting forward rates in terms of forward points is convenient for two reasons. First,

forward points may remain constant for long periods of time, even if the spot rates fluctu-

ate frequently. Second, in swap transactions where the trader is attempting to minimize

currency exposure, the actual spot and outright forward rates are often of no consequence.

What is important is the premium or discount differential, measured in forward points.

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134 P A R T T W O THE FOREIGN EXCHANGE MARKET, EXCHANGE RATE DETERMINATION, AND CURRENCY DERIVATIVES

To illustrate, suppose a bank customer wants to sell dollars three months forward against

Swiss francs. The bank can handle this trade for its customer and simultaneously neutral-

ize the exchange rate risk in the trade by selling (borrowed) dollars spot against Swiss

francs. The bank will lend francs for three months until they are needed to deliver against

the dollars it has purchased forward. The dollars received will be used to liquidate the

dollar loan. Implicit in this transaction is the interest rate differential between the dollar

borrowing rate and the Swiss franc lending rate. The interest rate differential is captured

by the forward premium or discount measured in forward points. As a rule, when the

interest rate of the quoted (indirect) currency is less than the interest rate of the quoting

(direct) currency, the outright forward rate is greater than the spot exchange rate, and vice

versa. This will become clear in Chapter 6 on international parity relationships, where in

American terms it is shown that the forward premium ( F 2 S )/ S < i $ 2 i f , the difference

between the U.S. dollar and foreign currency interest rates.

As in the spot market, the bid-ask spread in the forward retail market is wider than

the interbank spread. In addition to the bid-ask spread, banks will typically require

their retail clients to maintain a compensating balance to cover the cost of the bank’s

advisory services in assisting with forward foreign exchange transactions and for other

bank services. During the depths of the global financial crisis, banks, fearing that some

of their cash-strapped customers might default, started asking customers to post col-

lateral of as much as 2 percent of the value of the deal to cover the credit risk that the

banks assume when writing forward contracts—as when a customer’s long (short) for-

ward position becomes unfavorable because the spot price falls below (rises above) the

contractual forward price. From the customer’s perspective, this represented a massive

withdrawal of credit.

Exchange-Traded Currency Funds An exchange-traded fund (ETF) is a portfolio of financial assets in which shares

representing fractional ownership of the fund trade on an organized exchange. In recent

years, ETFs have been created representing investment in a number of stock market

indices. Like mutual funds, ETFs allow small investors the opportunity to invest in port-

folios of financial assets that they would find difficult to construct individually. In 2005,

Bid Ask

Spot 1.3331 1.3332

Term Forward Points 1W FWD 0.37 0.47 2W FWD 0.79 0.92 3W FWD 1.04 1.56 1M FWD 1.67 2.01 2M FWD 3.84 3.99 3M FWD 5.84 6.39 4M FWD 8.08 8.71 5M FWD 10.11 10.95 6M FWD 12.32 13.45 7M FWD 15.27 17.14 8M FWD 17.72 19.47 9M FWD 20.20 21.82 10M FWD 23.04 25.93 11M FWD 25.42 28.60 12M FWD 28.33 30.77 18M FWD 43.50 53.84

EXHIBIT 5.10

Spot and Forward Point

Quotations for the Euro

in American Terms

Source: www.fxstreet.com , June 17, 2013.

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C H A P T E R 5 THE MARKET FOR FOREIGN EXCHANGE 135

w w

w. m

hh e.

co m

/e r7

a firm associated with Guggenheim Investments first offered an ETF on the euro com-

mon currency named the CurrencyShares Euro Trust. The fund is designed for both

institutional and retail investors who desire to take a position in a financial asset that

will track the performance of the euro with respect to the U.S. dollar. Upon obtaining

dollars from investors, the trust purchases euros that are held in two deposit accounts,

one of which earns interest. Guggenheim issues baskets of 50,000 shares for trading,

with each share representing 100 euros. Individual shares are denominated in the U.S.

dollar and trade on the New York Stock Exchange. The net asset value (NAV) of one

share at any point in time will reflect the spot dollar value of 100 euros plus accumu-

lated interest minus expenses. Guggenheim has since created eight additional currency

trusts on the Australian dollar, British pound sterling, Canadian dollar, Chinese yuan,

Japanese yen, Singapore dollar, Swedish krona, and the Swiss franc. The total NAV of

all nine currency trusts stood at $1.7 billion in June 2013. Currency is now recognized

as a distinct asset class, like stocks and bonds. Guggenheim currency trusts facilitate

investing in these nine currencies.

SUMMARY This chapter presents an introduction to the market for foreign exchange. Broadly