INTERNATIONAL FINANCE-

INTRODUCTION
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Course Instructor:
Dr. Juhi Gupta
THE WORLD OF INTERNATIONAL
FINANCE
 International finance looks at various monetary interactions between countries, such as trade, foreign direct
investment and foreign exchange rates.
 All finance is essentially become international:
Lower barriers to international trade and financial flows,
Communications technology directly linking every major financial center,
Domestic financial markets are increasingly internationally integrated.

 There are special problems that arise from financial and trading relations between nations.

 Problems unique to international finance such as exchange rate between currencies and political barriers
can have profound effects on sales, costs, profits, asset and liability values, and individual well-being.

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THE BENEFITS OF STUDYING INTERNATIONAL FINANCE

 It can help a financial manager decide how international events will affect a firm and what steps can be
taken to exploit positive developments and insulate the firm from harmful ones.
 Events to be managed: changes in exchange rate, inflation rate, interest rate, and asset values.

 The amount of risk depends crucially on the way exchange rates and other financial prices are connected.

 Example: Declining exchange rates are associated with high inflation and interest rates; stock prices of
export-oriented companies are more profitable after currency depreciation; stock prices of companies with
foreign-currency denominated debt lose when the company’s home currency declines.
 These connections mean that foreign exchange is not simply a risk that is added to other business risks.
Instead, the amount of risk depends crucially on the way exchange rates and other financial prices are
connected.

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THE BENEFITS OF STUDYING INTERNATIONAL FINANCE
 Inflation is more strongly affected by exchange rate fluctuations when a large fraction of country’s
international trade is done in foreign currencies.
As of July 2022, USD accounts for about 88% of global foreign exchange market turnover, followed by
the Euro, Japanese Yen and Pound Sterling. The Indian rupee accounts for a mere 1.7%.
 Even companies that operate only domestically but compete with firms producing abroad and selling in
their local market are affected by international developments.
 Example:
1. Indian clothing or appliance manufacturers with no overseas sales will find their sales and profit
margins affected by exchange rates which influence the prices of imported clothing and appliances.
2. Bond investors holding their own government’s bonds, denominated in their own currency, and
spending all their money at home, are affected by changes in exchange rates if exchange rates prompt
changes in interest rates.
 If governments increase interest rates to defend their currencies when their currencies fall in value on the foreign
exchange markets, holders of domestic bonds will find their assets falling in value along with their currencies:
bond prices fall when interest rates increase.

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International trade (sum of exports and imports of goods and services) as a percent of GDP

Year World India growth

growth p.a p.a
2017 3.216 1.647
2018 2.593 7.055
2019 -2.098 -8.509
2020 -7.175 -5.265
2021 8.282 20.801
2022 29.669 7.799

Source: World Bank

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THE GROWING IMPORTANCE OF
INTERNATIONAL TRADE AND FINANCE
 International trade has a pervasive importance for our standard of living and our daily lives. Examples:
camera and electrical equipment from Japan, automobiles from Germany, Japan, tea from India etc. These
products are the result of complex international trading and financial linkages.
 A strong currency improves a country’s standard of living: the currency buys more in world markets.
 Not only does a strong currency allow citizens to buy more imports, they can also buy more domestically produced
products that are internationally traded because a country’s citizens have to compete with foreigners for their own
country’s tradable products.
 Citizens gain from the efficient global allocation of capital: when capital is allocated to its best uses on a
global scale, overall returns for global investors are higher.

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THE GROWING IMPORTANCE OF
INTERNATIONAL

TRADE
Reasons for growing importance of international trade:
& FINANCE
A liberalization of trade and investment via free-trade areas (European Union, North American Free
Trade Agreement (now United States-Mexico-Canada Agreement (USMCA)), Association of South East
Asian Nations), reductions in tariffs, quotas, currency controls, and other impediments to the
international flow of goods and capital.
An unprecedented shrinkage of ‘‘economic space’’ (significant reduction in barriers to flow of goods and
services)via rapid improvements in communication and transportation technologies, and consequent
reductions in costs.
Rise of multinational corporations (MNCs) and transnational alliances: MNCs have increasingly engaged
in international trade to seek raw materials, explore new markets to buy and sell products and services,
minimize costs, seek knowledge, and exploit financial market imperfections.
 Transnational alliances involve associations of firms in different countries working together to
overcome the limitations of working alone. One motivation to form a transnational alliance is
cooperation over research where costs and risks may be too high for any one firm, or where different
firms may possess different abilities. Example: Hero Honda (Joint venture), Starbucks and Barnes &
Noble
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THE REWARDS AND RISKS OF INTERNATIONAL TRADE
Rewards of international trade:
 Theory of comparative advantage: Specialization by countries can increase production efficiency. International
trade has increased prosperity by allowing nations to specialize in producing those goods and services at which
they are relatively efficient and importing other goods and services.
Example: France has a comparative advantage in producing wine due to its favorable climate and soil
conditions for grape cultivation. India has a comparative advantage in textile manufacturing due to a well-
established textile industry and access to raw materials like cotton.
All nations (generally) simultaneously gain from exploiting their comparative advantages, as well as from the
larger scale production and broader choice of products that is made possible by international trade.

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THE REWARDS AND RISKS OF INTERNATIONAL TRADE
Rewards of international trade:
 Competitive advantage: A nation’s competitiveness depends on the capacity of its industry to innovate and
upgrade. Example: Singapore and Hong Kong have witnessed a rapid growth with limited resources.
 Imperfect markets theory: If each country’s markets were closed to all other countries, then there would be no
international business. If markets are perfect then the factors of production are easily transferable, eliminating the
comparative cost advantage which is rationale for international trade. In real world, market are imperfect where
factors of production are somewhat immobile, i.e., costs and other restrictions affect the transfer of labor and
other resources used for production. It provides an incentive for firms to seek out foreign opportunities.
 Product life cycle theory: A product life cycle is the length of time from a product first being introduced to
consumers until it is removed from the market. There are four stages in a product’s life cycle: introduction,
growth, maturity, and decline. As a firm matures, international trade provides opportunities outside its
domestic market.

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INTERNATIONAL PRODUCT LIFE
CYCLES

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THE REWARDS AND RISKS OF INTERNATIONAL TRADE
Risks of international trade:
 Uncertainty about exchange rates: Unexpected changes in exchange rates have important impacts on
sales, prices and profits of exporters and importers.
In order to determine the effect of a change in exchange rates, it is crucial to examine how inflation and
exchange rates are related.
Example: If a medicine costs $100 and rupee depreciates from Rs. 82 per dollar to Rs. 86 per dollar,
then the price of medicine imported from the US becomes Rs 8600 compared to Rs. 8200 earlier (Rs.
400 increase). However, if there is deflation in the US and the medicine cost reduces to $70, then the
increase in price is Rs. 280 (from 5740 to 6020).

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THE REWARDS AND RISKS OF INTERNATIONAL TRADE
Risks of international trade:
 Country risk: Country risk refers to the economic, social, and political conditions and events in a foreign
country that may adversely affect a firm's operations.
It applies to foreign investment as well as to credit granted in trade.
It exists because it is difficult to use legal channels or reclaim assets when the investment is in another
political jurisdiction.
Furthermore, foreign companies may be willing but unable to pay because their government
unexpectedly imposes currency exchange restrictions. Possible imposition or change of import tariffs or
quotas, possible changes in subsidization of local producers, and possible imposition of nontariff barriers
such as quality requirements can also pose as risks.
Special type of risk-reducing instruments such as export credit insurance, and letters of credit can be
used to manage these risks.
Multilateral Investment Guarantee Agency (MIGA) (a member of the World Bank Group) facilitates
private investment by providing political risk insurance. It provides expropriation cover, war and civil
disturbance cover, breach of contract cover, currency inconvertibility and transfer restriction cover etc.
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INCREASED GLOBALIZATION OF
FINANCIAL AND REAL-ASSET MARKETS
 Alongside the growing importance of international trade, there has been a parallel growth in the importance
of foreign investment in the money market, the bond market, the stock market, and the real-estate market.
 In catering to the expanding horizons of investors and borrowers, there has been an explosion of
internationally oriented financial products such as internationally diversified, global, and single foreign
country mutual funds. Example: International funds, global funds, emerging country funds etc.
 Rewards of globalization of investment:
Improvement in the efficiency of the global allocation of capital and an enhanced ability to diversify
investment portfolios.
An enhanced ability to smooth consumption over time by international lending and borrowing: countries
can borrow abroad during bad years and pay back in good years.

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INCREASED GLOBALIZATION OF
FINANCIAL AND REAL-ASSET MARKETS
 Costs of globalization of investment:
Unanticipated changes in exchange rates cause uncertainty in home-currency values of assets and
liabilities.
Contagion: Increasing interdependence between financial markets of countries diminishes the
diversifications gains.
Country risk: Possibility of expropriation or confiscation of property, or its destruction by war or
revolution. It also involves the possibility of changes in taxes on foreign income and the imposition of
restrictions on repatriating income from abroad.

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INTERNATIONAL MONETARY
SYSTEM
The international monetary system refers primarily to the set of policies, institutions, practices, regulations,
and mechanisms that determine the rate at which one currency is exchanged for another.
A brief historical overview:
1. The gold standard: Oldest system in operation till the first World War. It is durable, storable, portable,
easily recognized, divisible, easily standardized, and costly to manipulate.
Gold specie standard: actual currency in circulation consisted of gold coins with a fixed gold content.
Gold bullion standard: basis of money remains a fixed weight of gold but the currency in circulation
consists of paper notes with the monetary authorities. Existence of fixed conversion ratio.
Gold exchange standard: the authorities stand ready to convert, at a fixed rate, the paper currency issued
by them into the paper currency of another country which is operating a gold-specie or gold-bullion
standard.
Assumption: There must be free flows of gold between countries on gold standard.
The money supply in the country must be tied to the amount of gold the monetary authorities have in
reserve. If this amount decreases, money supply must contract and vice versa.

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INTERNATIONAL MONETARY
SYSTEM
2. Bretton Woods system: Following the second world war, International monetary system was established
at the Bretton Woods Conference in 1944. It also gave birth to two supranational institutions: The
International Monetary Fund (referred to as IMF or The Fund) and the World Bank.
The main features of the Bretton Woods system were the relatively fixed exchange rates of individual
currencies in terms of the U.S. dollar and the convertibility of the dollar into gold for foreign official
institutions.
The US government undertook to convert the US dollar freely into gold at a fixed parity of $35 per
ounce.
Other member countries of the IMF agreed to fix the parities of their currencies vis-à-vis the dollar with
variation within 1 per cent on either side of the central parity being permissible. If the exchange rate hit
either of the limits, the monetary authorities of the country were obliged to “defend” it by standing ready
to buy or sell dollars against their domestic currency.
The member countries were entitled to have access to credit facilities from the IMF to carry out their
intervention in the currency markets.
These fixed exchange rates were supposed to reduce the riskiness of international transactions, thus
promoting growth in world trade.

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INTERNATIONAL MONETARY
SYSTEM
2. Bretton Woods system: The functioning of the system imposed a degree of discipline on the
participating nations’ economic policies.
For example, a country that followed policies leading to a higher rate of inflation would experience a
balance-of-payments deficit as its goods became more expensive.
 This would increase the supply of the deficit country’s currency on the foreign exchange markets. The
excess supply would depress the exchange value of that country’s currency, forcing its authorities to
intervene.
 The country would be obligated to “buy” with its reserves the excess supply of its own currency.
Moreover, as the country’s reserves were gradually depleted through intervention, the authorities
would be force to change economic policies to eliminate the source of the reserve-draining deficit.
 The reduction in the money supply and the adoption of restrictive policies would reduce the country’s
inflation, thus bringing it in line with the rest of the world.
The reluctance of governments to change currency values or to make the necessary economic adjustments to
ratify the current values of their currencies led to periodic foreign exchange crises.

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INTERNATIONAL MONETARY
SYSTEM
2. Bretton Woods system: This system could work as long as other countries had confidence in the
stability of the US dollar and in the ability of the US treasury to convert dollars into gold on demand at
the specified conversion rate.
Throughout the 1960s and early 1970s, there was excessive supply of U.S. dollars on Forex markets in
exchange for other currencies. By the 1960s, a surplus of U.S. dollars caused by foreign aid, military
spending, and foreign investment threatened this system, as the United States did not have enough gold
to cover the volume of dollars in worldwide circulation at the rate of $35 per ounce; as a result, the dollar
was overvalued. Problem of dollar overhang.
In 1971, the dollar-gold convertibility was suspended, essentially marking the death of the Bretton
Woods system.
Principal reason of the collapse: When the United States expanded its money supply, to finance budget
deficits, it caused lower U.S. interest rates and had inflationary consequences. This led to increased
demand for foreign currency by investors and traders. However, the United States was not obligated to
intervene to maintain the fixed exchange rates since the United States was not fixing to anyone. Rather, it
was the obligation of the nonreserve countries to intervene, buy dollars, sell their own currencies, and
consequently run BoP surpluses. These surpluses resulted in the growing stock of dollar reserves abroad.

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INTERNATIONAL MONETARY
SYSTEM
3. Current scenario: Currently, countries follow either of the five market mechanisms for establishing
exchange rates: free float, managed float, target-zone arrangement, fixed-rate system, and the current
hybrid system.

INCREASED VOLATILITY OF EXCHANGE RATES

 Real exchange rate volatility has increased, not decreased, since floating began.
 This instability reflects, in part, non-monetary (or real) shocks to the world economy, such as uncertainty
over future government policies, changing oil prices and shifting competitiveness among countries.
 The volatility has made it considerably more challenging to plan international investment decisions.

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QUESTIONS
1. India has record high reserves, why does it not use the reserves to intervene in the Forex markets?
 When governments intervene in currency markets to subsidize their exports, they violate the principles of free trade
and force the market to ignore normal pressures of supply and demand. Government intervention in currency
markets distorts trade flows and undermines free trade agreements.
 Currency manipulation is a policy used by governments and central banks of some of America’s largest trading
partners to artificially lower the value of their currency (in turn lowering the cost of their exports) to gain an unfair
competitive advantage. Manipulating currency to gain an unfair competitive advantage is prohibited for members of
the IMF and WTO.
 One of the criteria of currency manipulation is that foreign currency intervention exceeds 2 percent of the GDP.

2. US treasury yield has changed even though data on interest rates has not been released, how does
this work?
 Data on the US labor market suggests higher employment and stability, leading to the expectations that Federal
Reserve would cut its benchmark interest rate.

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RBI INTERVENTION IN FOREX
MARKETS
 Forex reserves witnessed a significant decline, plummeting by $5.89 billion to reach $617.3 billion for the
week ending January 5, as revealed in the latest weekly data from the Reserve Bank.
 The recent decline in reserves can be attributed to the central bank's intervention in defending the rupee,
responding to pressures primarily stemming from global developments since the previous year.

Source: RBI

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COMPOSITION OF INDIA’S FOREX
RESERVES
1. Foreign currency assets: Assets denominated in a foreign currency that are held by a nation’s central
bank. It includes foreign currencies, bonds, treasury bills, and other government securities.
Most of these reserves are held in the U.S. dollar since it is the most traded currency in the world.
Changes in foreign currency assets are caused by the Reserve Bank of India's (RBI) intervention as well
as the appreciation or depreciation of foreign assets held in the reserves.
2. Gold assets
3. Special drawing rights (SDR): The SDR (created by IMF) itself is not a currency but an interest-
bearing asset that holders can exchange for currency when needed.
When SDRs are initially allocated to an IMF member country, the member is given two positions. The
two positions are the “SDR holdings” and the “SDR allocations.” Countries receive interest on their
holdings and pay interest based on their allocations position. The interest amount for both positions is
based on the SDR interest rate. The two positions’ values start out the same. Therefore, the interest
received and interest paid cancel each other out.

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COMPOSITION OF INDIA’S FOREX
RESERVES
When a country trades SDRs for freely usable currencies, their holdings decrease and their foreign
exchange reserves increase. This causes the holdings to fall below the allocations. The country will pay
more interest than it receives.
The amount of SDRs that are allocated to each country is based on their individual IMF quotas, that in
turn are based broadly on the country’s economic position relative to other members. Currently,
India’s quota is 2.75%.
Currencies that are included in the SDR basket must meet two criteria: (i) it should be one of the top five
world exporters, and (ii) it is widely used in payments for international transactions and widely traded in
the principal exchange markets.
Currently, the SDR basket comprises: US dollar (43.38%), Euro (29.31%), Chinese Renminbi (12.28%),
Japanese Yen (7.59%), Pound Sterling (7.44%).
The SDR value in terms of the US dollar is determined daily based on the spot exchange rates observed
at around noon London time.

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COMPOSITION OF INDIA’S FOREX
RESERVES
4. Reserve position with IMF: Reserve tranche position is an emergency account that IMF members can
access at any time without agreeing to conditions or paying a service fee.
In theory, members can borrow over 100% of their quota.
However, if the amount being sought by the member nation exceeds its reserve tranche position (RTP),
then it becomes a credit tranche that must be repaid in three years with interest.
A quota determines the subscription or contribution of each member to the capital of the Fund
Each member is required to pay to the Fund part (not exceeding 25 per cent) of its quota in gold (now
SDR and acceptable currency), and the balance in its own currency (cash or government securities).
The gold (or reserve) tranche is generally the difference between a member’s quota and the Fund’s
holdings of its currency. For a member that has had no transactions with the Fund and that originally paid
25 per cent of its quota in gold and 75 per cent in its own currency, the gold tranche is 25 per cent of its
quota.

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REFERENCES
 Maurice D. Levi, International Finance- Chapter 1 (4 th edition), Taylor & Francis Group
 Jeff Madura, International Financial Management- Chapter 1 (14 th edition), Cengage Learning
 Alan C. Shapiro, Multinational Financial Management- Chapter 1 and 3 (9 th edition), Wiley
 PG Apte, International Financial Management- Chapter 5

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