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Globalization and the Multinational Firm Chapter One McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. What’s Special about “International” Finance? Foreign Exchange Risk Political Risk Market Imperfections Expanded Opportunity Set 1-2 What’s Special about “International” Finance? Foreign Exchange Risk – This is risk that foreign currency profits may evaporate in dollar terms due to unanticipated unfavorable exchange rate movements. – Suppose $1 = ¥100 and you buy 10 shares of Toyota at ¥10,000 per share. One year later the investment is worth ten percent more in yen: ¥110,000. – But, if the yen has depreciated to $1 = ¥120, your investment has actually lost money in dollar terms. 1-3 What’s Special about “International” Finance? Political Risk – Sovereign governments have the right to regulate the movement of goods, capital, and people across their borders. These laws sometimes change in unexpected ways. 1-4 What’s Special about “International” Finance? Market Imperfections – Legal restrictions on the movement of goods, people, and money – Transactions costs – Shipping costs – Tax arbitrage 1-5 The Example of Nestlé’s Market Imperfection Nestlé used to issue two different classes of common stock bearer shares and registered shares. – Foreigners were only allowed to buy bearer shares. – Swiss citizens could buy registered shares. – The bearer stock was more expensive. On November 18, 1988, Nestlé lifted restrictions imposed on foreigners, allowing them to hold registered shares as well as bearer shares. 1-6 Nestlé’s Foreign Ownership Restrictions 12,000 10,000 Bearer share SF 8,000 6,000 4,000 Registered share 2,000 0 11 20 31 9 18 24 Source: Financial Times, November 26, 1988 p.1. Adapted with permission. 1-7 The Example of Nestlé’s Market Imperfection Following this, the price spread between the two types of shares narrowed dramatically. – This implies that there was a major transfer of wealth from foreign shareholders to Swiss 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 and the peril of political risk. 1-8 What’s Special about “International” Finance? Expanded Opportunity Set – It doesn’t make sense to play in only one corner of the sandbox. – True for corporations as well as individual investors. 1-9 Goals for International Financial Management Maximization of shareholder wealth? 1-10 Maximize Shareholder Wealth Long accepted as a goal in the Anglo-Saxon countries, but complications arise. – Who are and where are the shareholders? – In what currency should we maximize their wealth? 1-11 Other Goals In other countries shareholders are viewed as merely one among many “stakeholders” of the firm including: – Employees – Suppliers – Customers In Japan, managers have typically sought to maximize the value of the keiretsu—a family of firms to which the individual firms belongs. 1-12 Other Goals As shown by a series of recent corporate scandals at companies like Enron, WorldCom, and Global Crossing, managers may pursue their own private interests at the expense of shareholders when they are not closely monitored. These calamities have painfully reinforced the importance of corporate governance, i.e., the financial and legal framework for regulating the relationship between a firm’s management and its shareholders. 1-13 Other Goals These types of issues can be much more serious in many other parts of the world, especially emerging and transitional economies, such as Indonesia, Korea, and Russia, where legal protection of shareholders is weak or virtually non-existing. No matter what the other goals, they cannot be achieved in the long term if the maximization of shareholder wealth is not given due consideration. 1-14 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 1-15 Emergence of Globalized Financial Markets Deregulation of Financial Markets coupled with Advances in Technology – have greatly reduced information and transaction costs, which has led to: Financial Innovations, such as – – – – Currency futures and options Multi-currency bonds Cross-border stock listings International mutual funds 1-16 Emergence of the Euro as a Global Currency A momentous event in the history of world financial systems. Currently more than 300 million Europeans in 16 countries are using the common currency on a daily basis. In May 2004, 10 more countries joined the European Union. The “transaction domain” of the euro may become larger than the U.S. dollar’s in the near future. 1-17 Euro Area Austria Belgium Cyprus Finland France Germany Greece Ireland Italy Luxembourg Malta The Netherlands Portugal Slovenia Slovakia Spain 1-18 4/28/2011 12/14/2009 8/1/2008 3/20/2007 11/5/2005 6/23/2004 2/9/2003 9/27/2001 5/15/2000 1/1/1999 Value of the Euro in U.S. Dollars 1.6 1.5 1.4 1.3 1.2 1.1 1 0.9 0.8 1-19 Europe’s Sovereign-Debt Crisis of 2010 In December of 2009 the new Greek government revealed that its budget deficit for the year would be 12.7% of GDP, not the 3.7% forecast. Investors sold off Greek government bonds and the ratings agencies downgraded them to “junk.” While Greece represents only 2.5% of euro-zone GDP, the crisis became a Europe-wide debt crisis. The challenge remains that fiscal indiscipline of one euro-zone country can escalate to a Europe-wide crisis. 1-20 The Greek Drama Greece paid no premium above the German rate until late fall 2009. The Greek interest rate rose until the bailout package on May 9. 1-21 Economic Integration Over the past 50 years, international trade increased about twice as fast as world GDP. There has been a change in the attitudes of many of the world’s governments, who have abandoned mercantilist views and embraced free trade as the surest route to prosperity for their citizenry. 1-22 Privatization The selling of state-run enterprises to investors is also known as “denationalization.” Privatization is often seen in socialist economies in transition to market economies. By most estimates, this increases the efficiency of the enterprise. It also often spurs a tremendous increase in cross-border investment. 1-23 Chinese Privatization State-owned enterprises have been listed on organized stock exchanges. More than 1,500 companies are currently listed on China’s stock exchanges. The Chinese government still retains the majority stakes in most public firms. Chinese citizens can buy “A” shares, while foreigners are limited to “B” shares. 1-24 Global Financial Crisis of 2008—2009 The “Great Recession” was the most serious, synchronized economic downturn since the Great Depression of the 1930s. Factors included: – Households and financial institutions borrowed too much and took too much risk. – This risk was repackaged with securitization, and so defaults on subprime mortgages in the U.S. came to threaten the solvency of a teacher’s retirement plans in Norway. 1-25 Global Financial Crisis 2008—2009 During the course of the crisis, the G-20 emerged as the premier forum for discussing international economic issues and coordinating financial regulations and macroeconomic policies. 1-26 Multinational Corporations A multinational corporation (MNC) is a firm that has been incorporated in one country and has production and sales operations in other countries. There are about 60,000 MNCs in the world. Many MNCs obtain raw materials from one nation, financial capital from another, produce goods with labor and capital equipment in a third country, and sell their output in various other national markets. 1-27 Top 10 MNCs 1 General Electric United States 2 Royal Dutch/Shell Group UK/Netherlands 3 Vodafone Group PLC United Kingdom 4 British Petroleum Co. PLC United Kingdom 5 Toyota Motor Corporation Japan 6 ExxonMobile Corporation United States 7 Total France 8 E.ON AG Germany 9 Electricité De France France 10 ArcelorMittal Luxembourg 1-28 The Theory of Comparative Advantage A comparative advantage exists when one party can produce a good or service at a lower opportunity cost than another party. The opportunity cost of making one additional unit of a good (or service) can be defined as the value of some other good that you have to give up in order to produce this additional unit. – For example, if you can work as many hours as you like at your current employer and get paid $10 per hour, then the opportunity cost of your leisure is $10 per hour. 1-29 Arguments in Favor of Free Trade Both partners gain from trade; we have more material goods. “Freedom” is a good thing in and of itself. – In this case, consumers have the freedom to choose imported goods and producers have the freedom to choose to sell to foreigners. 1-30 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: 1973Present 1-31 Bimetallism: Before 1875 Bimetallism was a “double standard” in the sense that both gold and silver were used as money. Some countries were on the gold standard, some on the silver standard, and some on both. Both gold and silver were used as an international means of payment, and the exchange rates among currencies were determined by either their gold or silver contents. 1-32 Gresham’s Law Gresham’s Law implies that the least valuable metal is the one that tends to circulate. Suppose that you were a citizen of Germany during the period when there was a 20 German mark coin made of gold and a 5 German mark coin made of silver. – If gold suddenly and unexpectedly became much more valuable than silver, which coins would you spend if you wanted to buy a 20mark item and which would you keep? 1-33 Classical Gold Standard: 1875-1914 During this period in most major countries: – Gold alone was assured of unrestricted coinage. – There was two-way convertibility between gold and national currencies at a stable ratio. – Gold could be freely exported or imported. The exchange rate between two country’s currencies would be determined by their relative gold contents. 1-34 Classical Gold Standard: 1875-1914 For example, if the dollar is pegged to gold at U.S. $30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold, it must be the case that the exchange rate is determined by the relative gold contents: $30 = 1 ounce of gold = £6 $30 = £6 $5 = £1 1-35 Classical Gold Standard: 1875-1914 Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism. 1-36 Price-Specie-Flow Mechanism Suppose Great Britain exports more to France than France imports from Great Britain. This cannot persist under a gold standard. – Net export of goods from Great Britain to France will be accompanied by a net flow of gold from France to Great Britain. – This flow of gold will lead to a lower price level in France and, at the same time, a higher price level in Britain. The resultant change in relative price levels will slow exports from Great Britain and encourage exports from France. 1-37 Interwar Period: 1915-1944 Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market. Attempts were made to restore the gold standard, but participants lacked the political will to “follow the rules of the game.” The result for international trade and investment was profoundly detrimental. 1-38 Bretton Woods System: 1945-1972 Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire. The purpose was to design a postwar international monetary system. The goal was exchange rate stability without the gold standard. The result was the creation of the IMF and the World Bank. 1-39 Bretton Woods System: 1945-1972 British pound German mark French franc Par Value • The U.S. dollar was pegged to gold at $35 /ounce and other currencies were pegged to the U.S. dollar. U.S. dollar Pegged at $35/oz. Gold 1-40 The Flexible Exchange Rate Regime: 1973-Present Flexible exchange rates were declared acceptable to the IMF members. – Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities. Gold was abandoned as an international reserve asset. Non-oil-exporting countries and less-developed countries were given greater access to IMF funds. 1-41 Current Exchange Rate Arrangements Free Float – The largest number of countries, about 33, allow market forces to determine their currency’s value. Managed Float – About 46 countries combine government intervention with market forces to set exchange rates. Pegged to another currency – Such as the U.S. dollar or euro. No national currency – Some countries do not bother printing their own currency. For example, Ecuador, Panama, and El Salvador have dollarized. Montenegro and San Marino use the euro. 1-42 Current Exchange Rate Arrangements Currency Board – Fixed exchange rates combined with restrictions on the issuing government. – Eliminates central bank functions such as monetary policy and lender of last resort (e.g., Hong Kong). Conventional Peg – Exchange rate publicly fixed to another currency or basket of currencies. – Country buys or sells foreign exchange or uses other means to control the price of the currency (e.g., Saudi Arabia, Jordan, and Morocco). 1-43 Current Exchange Rate Arrangements Stabilized Arrangement – A spot market exchange rate that remains within a margin of 2 percent for six months or more and is not floating (e.g., China, Angola, and Lebanon). Crawling Peg – Like the conventional peg, but the crawling peg is adjusted in small amounts at a fixed rate of change or in response to changes in macro indicators, (e.g., Bolivia, Iraq, and Nicaragua). 1-44 The Value of the U.S. Dollar since 1960 1-45 The Euro The euro is the currency of the European Monetary Union, adopted by 11 Member States on January 1, 1999. There are 7 euro notes and 8 euro coins. The notes are: €500, €200, €100, €50, €20, €10, and €5. The coins are: 2 euro, 1 euro, 50 euro cent, 20 euro cent, 10, euro cent, 5 euro cent, 2 euro cent, and 1 euro cent. The euro itself is divided into 100 cents, just like the U.S. dollar. 1-46 The Long-Term Impact of the Euro As the euro proves successful, it will advance the political integration of Europe in a major way, eventually making a “United States of Europe” feasible. It is possible that the U.S. dollar will lose its place as the dominant world currency. The euro and the U.S. dollar will be the two major currencies. 1-47 Costs of Monetary Union The main cost of monetary union is the loss of national monetary and exchange rate policy independence. – The more trade-dependent and less diversified a country’s economy is, the more prone to asymmetric shocks that country’s economy would be. 1-48 The Mexican Peso Crisis On December 20, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent. This decision changed currency trader’s expectations about the future value of the peso, and they stampeded for the exits. In their rush to get out the peso fell by as much as 40 percent. 1-49 The Mexican Peso Crisis The Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off by cross-border flight of portfolio capital. Two lessons emerge: – It is essential to have a multinational safety net in place to safeguard the world financial system from such crises. – An influx of foreign capital can lead to an overvaluation in the first place. 1-50 The Asian Currency Crisis The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social costs. Many firms with foreign currency bonds were forced into bankruptcy. The region experienced a deep, widespread recession. 1-51 The Asian Currency Crisis 1-52 Origins of the Asian Currency Crisis As capital markets were opened, large inflows of private capital resulted in a credit boom in the Asian countries. Fixed or stable exchange rates also encouraged unhedged financial transactions and excessive risktaking by both borrowers and lenders. The real exchange rate rose, which led to a slowdown in export growth. Also, Japan’s recession (and yen depreciation) hurt. 1-53 The Asian Currency Crisis If the Asian currencies had been allowed to depreciate in real terms (not possible due to the fixed exchange rates), the sudden and catastrophic changes in exchange rates observed in 1997 might have been avoided Eventually something had to give—it was the Thai bhat. The sudden collapse of the bhat touched off a panicky flight of capital from other Asian countries. 1-54 Lessons from the Asian Currency Crisis A fixed but adjustable exchange rate is problematic in the face of integrated international financial markets. – A country can attain only two the of three conditions: 1. A fixed exchange rate. 2. Free international flows of capital. 3. Independent monetary policy. 1-55 China’s Exchange Rate China maintained a fixed exchange rate between the renminbi (RMB) yuan and the U.S. dollar for a long time. – The RMB floated between 2005 and 2008 and then again starting in 2010. There is mounting pressure from China’s trading partners for a stronger RMB. 1-56 Potential as a Global Currency For the RMB to become a full-fledged global currency, China will need to satisfy these conditions: – Full convertibility of its currency. – Open capital markets with depth and liquidity. – The rule of law and protection of property rights. The United States and the euro zone satisfy these conditions. 1-57 The Argentinean Peso Crisis In 1991 the Argentine government passed a convertibility law that linked the peso to the U.S. dollar at parity. The initial economic effects were positive: – Argentina’s chronic inflation was curtailed. – Foreign investment poured in. As the U.S. dollar appreciated on the world market the Argentine peso became stronger as well. 1-58 The Argentinean Peso Crisis However, the strong peso hurt exports from Argentina and caused a protracted economic downturn that led to the abandonment of peso– dollar parity in January 2002. – The unemployment rate rose above 20 percent. – The inflation rate reached a monthly rate of 20 percent. 1-59 The Argentinean Peso Crisis There are at least three factors that are related to the collapse of the currency board arrangement and the ensuing economic crisis: – Lack of fiscal discipline. – Labor market inflexibility. – Contagion from the financial crises in Brazil and Russia. 1-60 Currency Crisis Explanations In theory, a currency’s value mirrors the fundamental strength of its underlying economy, relative to other economies, in the long run. In the short run, currency trader expectations play a much more important role. In today’s environment, traders and lenders, using the most modern communications, act on fight-orflight instincts. For example, if they expect others are about to sell Brazilian reals for U.S. dollars, they want to “get to the exits first.” Thus, fears of depreciation become self-fulfilling prophecies. 1-61 Fixed versus Flexible Exchange Rate Regimes Arguments in favor of flexible exchange rates: – Easier external adjustments. – National policy autonomy. Arguments against flexible exchange rates: – Exchange rate uncertainty may hamper international trade. – No safeguards to prevent crises. 1-62 Fixed versus Flexible Exchange Rate Regimes Suppose the exchange rate is $1.40/€ today. In the next slide, we see that demand for the euro far exceeds supply at this exchange rate. The United States experiences trade deficits. Under a flexible exchange rate regime, the dollar will simply depreciate to $1.60/€, the price at which supply equals demand and the trade deficit disappears. 1-63 Dollar price per € (exchange rate) Fixed versus Flexible Exchange Rate Regimes $1.60 $1.40 Supply (S) Dollar depreciates (flexible regime) Demand (D) Trade deficit QS Q D = QS QD Q of € 1-64 Fixed versus Flexible Exchange Rate Regimes Instead, suppose the exchange rate is “fixed” at $1.40/€, and thus the imbalance between supply and demand cannot be eliminated by a price change. The government would have to shift the demand curve from D to D*. – In this example, this shift corresponds to contractionary monetary and fiscal policies. 1-65 Dollar price per € (exchange rate) Fixed versus Flexible Exchange Rate Regimes Supply (S) Contractionary policies (fixed regime) Demand (D) $1.40 Demand (D*) QD* = QS Q of € 1-66