LECTURE 1: WORLD TRADE AND THE INTERNATIONAL

MONETARY SYSTEM

The Goals of the Multinational Corporation (1)

Figure 1: Governance of the MNC

Figure 2: Stakeholders and Their Claims

The Goals of the Multinational Corporation (2)

Stakeholders:
● Labor: Level of wages, job security,...
● Customers: Price, quality, image, sustainability,...
● Suppliers: Reliability, price paid, contracts,...
● Managers: Different goals than shareholders and debtholders (agency costs)
● Government: Law, taxes, ...

Countries differ in the extent to which they protect different stakeholders

Managers must work within the rules and respect the sensitivities of different societies

Potentially, managers can align stakeholder and shareholder interests

The Challenges of Multinational Operations: Risk Exposure

Country risk: Risk that the business environment in a host country or the host country’s
relationship with another country will unexpectedly change

Two sources of country risk

1- Political risk: Business environment changes unexpectedly due to political events
2- Financial risk: Unexpected change in financial or economic environment
● Currency risk, also called foreign exchange, forex, FX risk

The Opportunities of Multinational Operations

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Discounted cash flow approach:

E(CFt)= expected cash flows

Enhancing revenues and reducing costs:

● Global marketing
● Access to low-cost labor or raw materials
● Flexibility in global site selection
● Flexibility in sourcing and production
● Economies of scale and scope, increasing returns to scale
● Multinational tax planning

Financial opportunities:
● Access to liquid international markets
● Financial opportunities from financial market imperfections

Perfect Financial Markets (1)

In a perfect financial market, rational investors have equal access to market prices and
information in a frictionless market.

1. Frictionless markets: No transaction costs, taxes, government intervention, agency costs,

costs of financial distress ⇒ A. Operational Efficiency
2. Equal access to market prices: No single party can influence prices (i.e. ‘price taker’)
3. Rational investors
4. Equal access to costless information
⇒ B. Informational Efficiency

A. and B. → Allocational Efficiency (i.e. capital allocated towards most productive uses)

Perfect Financial Markets (2)

Arbitrage: Simultaneous purchase and sale of the same or equivalent asset (currencies) in
order to ensure a profit with no net investment risk.
● Promotes all three types of market efficiency
● Ensures that market prices do not diverge significantly from their fair value

Corporate financial policy is irrelevant in perfect financial markets (Modigliani and Miller):
● Individual investors can replicate or reverse any action the firm can take

Multinational Opportunities and Firm Value

If financial policy is to increase firm value, then it must increase the firm’s expected cash
flows or decrease the discount rate

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 ● Create value through financial policies:
● Hedging policy
● MNC cost of capital if there are capital flow barriers
● Reducing taxes through multinational operations
● Capital flow barriers
● Currency risk and the cost of capital

Multinational Opportunities and Firm Value: An Illustration (1)

Figure 3: Potential Benefits of Multinationality

Multinational Opportunities and Firm Value: An Illustration (2)

Figure 3: Potential Benefits of Multinationality

2 The International Financial Environment

Integration of the World’s Markets

Integrated market: Equivalent assets sell for the same price in every location.
Segmented markets: The price of an asset is not necessarily the same in every location.

Over the last decades markets have become increasingly integrated:

● Rise of regional and global trade pacts (e.g., WTO established in 1995)

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 ● Break up of Soviet Union and accompanied migration of countries towards the EU
● Creation of Euro, expansion of Euro area
● IT advancements, ya no necesitamos brokers ya que nos suponían más gastos

Growing Importance of Cross-border Trade

Figure 4: Worldwide Exports of Goods and Services as a Percentage of GDP

World Market Integration: Recent Developments

But recently also sentiment against globalization and rise of protectionism

Recommended articles in The Economist:

Anti-globalists Why they’re wrong
The world economy An open and shut case

Trade Imbalances: A Cause for Concern?

Figure 5: US Trade with China (Billion of U.S. Dollars)

Global Cross-border Capital Flows

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International capital flows are very volatile

Figure 6: Global Cross-border Capital Flows (Trillion of U.S. Dollars)

Balance-of-Payments Statistics (1)

Bretton Woods Conference 1944:

● Goal: create a postwar financial system to promote trade and prevent another Great
depression
● Created ‘World Bank’ and ‘International Monetary Fund’ (IMF)

IMF assists countries in defending their currencies against trade or supply/demand

imbalances.
● Balance-of-Payments Statistics
● BoP statistics track cross-border trade financial markets

Balance-of-Payments Statistics (2)

Figure 7: Balance of Payments - An Example

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Current account: Measures import-export activity on a broad level. Includes goods, services,
royalties, patent payments, travel and tourism, gifts, grants, and individual investment
income.

Capital account: Shows credit and debit entries for non-produced non- financial assets and
capital trans- fers across countries. Includes, among others, land sold to em- bassies and
sales of leases and li- censes.

Financial account: Covers cross- border transactions associated with changes in ownership
of financial asset or liabilities. Balance of FA conceptually equals sum of balance of current
and capital account.

Exchange Rate Systems: IMF Classification

Exchange rates are important for a country‘s balance of payments and economic growth

Fall in currency value relative to other currencies leads to an increase in exports

IMF classifies exchange rate arrangements in three broad categories:

Fixed Exchange Rate Systems (1)

Governments try to force currency values on market participants

If peg can be maintained, reduce exposure to currency risk for MNCs

Devaluation
i.e. decrease in currency value
Revaluation
i.e. increase in currency value

Example: Chinese gov’t changes official exchange rate from $0.13095/CNY to

$0.13099/CNY

→ Dollar has a devaluation against the CNY.

(∆ = 1/0.13099 – 1/0.13095 = -CNY0.002332/$)

→ CNY has a revaluation against the dollar.

Fixed Exchange Rate Systems (2)

Drawbacks of a fixed exchange rate system:

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1. Forges a direct link between inflation and employment.
2. Difficult to sustain fixed exchange rates when they diverge from market rates.

Note: Currency risk is not absent in a fixed rate system! (→ Sudden jumps)

Examples of fixed exchange rate system:

● Denmark: Pegs value of the krone around the value of the Euro
● Saudi Arabia: Pegs value of the riyal to the dollar (reason: oil exports are priced in
dollars)
● Others: E.g. peg value of currency to the value of a composite index (like Special
drawing rights (SDRs) denoted in bookkeeping units)

Floating Rate Systems

Allow currency values to fluctuate according to market supply and demand without direct
inferences by government authorities.

Depreciation
i.e. decrease in currency value
Appreciation
i.e. increase in currency value

Major advantage: Exchange rates can adjust to differences in inflation rates between
countries

Major disadvantage: Continuous changes of exchange rates creates uncertainty about value
of a future cash flows in foreign currencies

But, derivatives like forwards, futures, options and swaps allow for hedging

Exchange Rate Regimes: An Overview

Figure 8: 2014 Exchange Rate Regimes

A Brief History of the International Monetary System: Major Events (1)

Before WW II:
● Currencies are pegged to gold
● ‘Classical Gold Standard’ (prior 1914)/ ‘Gold Exchange Standard’ (until 1931)

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1944 – 1971: Bretton Woods
● Pegged exchange rate system
● Price of an ounce of gold was set in U.S. dollars at $35 per ounce
● Only U.S. dollars were convertible into gold at this par value of $35
● Intervention of other member nations only if currency moved more than 1% away
from official rate
● High U.S. inflation during 1960s → Run on dollar and buying gold with dollars at $35
per ounce
● President Nixon took the U.S. off the gold standard in August 1971

A Brief History of the International Monetary System: Major Events (2)

1970s: Efforts to resurrect a pegged exchange rate system

● Currencies began to float and attempts to resurrect gold standard failed
● European Exchange Rate Mechanism (1979): EEC currencies in a 2.25% band
around central rates.

1991: Treaty of Maastricht

● Single European currency is proposed as the ultimate goal of monetary union

● EC members agree to an agenda of economic, financial and monetary reforms:

- Inflation rates within 1.5% of three best-performing EU countries

- Budget deficits no higher than 3% of GDP
- Exchange rate stability within the ERM for at least two years - Long-term interest rates
within 2% of three best-performing EU countries
- Government debt less than 60% of GDP

A Brief History of the International Monetary System: Major Events (3)

1998: Convergence in inflation, interest rates, and budget deficit criteria among the EMU
countries. However, not all criteria were fulfilled:
● Only 3 of 11 EMU countries met the 60% debt limit
● Greece did not meet any of the convergence criteria and was unable to join until
2001

1999: Euro becomes unit-of account; EMU currencies pegged to Euro

Since 2002: Euro begins public circulation

Troubles became apparent after the 2008 crisis:

● Greek debt was downgraded to junk bonds status due to its consistent budget
deficits
● Greece’s debt exceeded 200% of GDP

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Currency Crisis and the Role of the IMF

IMF makes short-term loans to countries with temporary funding shortages or liquidity crisis
(more information at http://www.imf.org/en/About/Factsheets/IMF-Lending)

Contributing factors in each crisis:

I. Fixed exchange rate system that overvalued the local currency
II. Large amount of foreign currency debt

Consequences of currency crises:

● Currency crises have a pronounced negative short-term impact on the local
economy.
● Government depleted foreign currency reserves in defense of the currency and was
unable to maintain the fixed exchange rate.

The Mexican Peso Crisis of 1995 (1)

Pre-crisis setting:
● Thriving economy during the 1980s/early 1990s in response to economic
liberalization (NAFTA, privatizations, decreasing inflation, balanced budget)

The Mexican Peso Crisis of 1995 (2)

Mistakes by the government:

1. Maintaining high value of the peso by buying pesos on international markets.
→ Foreign currency reserves fell to $5bn

2. Roll-over of $23 bn of short-term, peso-denominated debt into short-term

dollar-denominated liabilities.

In late 1994, Mexico’s foreign exchange reserves were depleted

→ Exchange rate could not be sustained and peso fell by 50% → Doubling the peso value of
dollar-denominated obligations
US and IMF assembled stand-by credit, which Mexico repaid in 2000

Peso crisis was short-lived liquidity crisis

The Fall of the Russian Ruble in 1998

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Figure 10: Crisis in Russia

Transition from planned to market economy: $804b GDP in 1991 fell to $282b GDP in 1998

1993: Russia placed ruble in crawling peg, soft peg

1997: Russia rolled over ruble-denominated debt into dollar-denominated Eurobonds.
1998: Ruble under speculative pressure. Gets IMF loans.
→ Difficulty to refinance its dollar debt.
→ Abandon exchange rate peg + defaulted
2004: Devaluation helps, Russia repays IMF in 2004

The Post-2008 Depression in Greece

Greece fell into a depression after 2008 and is still facing difficulties

Crisis in Greece shares elements with the other currency crises:

● A fixed exchange rate system (€) that inhibits market mechanisms from reallocating
resources within Greece and within Europe
● A large amount of government debt

Particularly: Local wages (reduced) could not easily adjust downward

Wages and prices in Greece were forced to adjust through wage reductions and
unemployment

Extensive social support program increased budget deficit

The International Monetary Fund (IMF)

Proponents of IMF lending policies believe:

● Short term loans help countries overcome temporary financial crises, prevent crisis
from spreading to other countries

Critics of IMF lending believe:

● Risk of ‘Moral Hazard’ because of bailouts: In absence of IMF bailouts, lenders must
assess and bear the risk.
● Develop policies that both promote economic stability and ensure that costs of poor
investment decisions are borne by investors and not by taxpayers.

Moral Hazard: Risk that the existence of a contract will change the behaviors of parties to
the contract. Example: Liability insurance

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Helpful Overview of Notations for Next Lecture

General Remark
● Upper Case Symbols = Prices
● Lower Case Symbols = Changes in a price

Notations

Note: Time subscripts are dropped when it is unambiguous to do so.

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