Significance of International Finance

International Finance is related to business decisions such as asset selection, resource allocation and financial management.

1. For Business Firms:

Every firm faces the four important decision-making areas in financial management.

These are:

i. Investment decision

ii. Financing decision

iii. Working capital management decision

iv. Dividend decision.

Firms with a presence in different factor and product markets have to grapple with complex issues unique to their operations. Decisions regarding where to set up a new plant (investment decision), in the capital structure and where to raise finances (financing decision), how much cash to hold, which currency to choose for denominating receivables and payables, the sources of short-term funds (working capital management decisions) and whether to pay dividend or not (dividend decision) are routine areas in financial management, for which standard evaluation techniques and management methods exist.

However, in the globalized scenario, each decision acquires layers of complexity as it needs to be taken in the context of differences between countries in their political and judicial systems, economic conditions and financial infrastructure.

Will policies with regard to foreign investment be subjected to sudden and violent change? How safe are assets held in other countries? Firms with several overseas affiliates are confronted with the most complex web of problems, since value maximizing decisions have to be made for the group as a whole rather than just for the parent company, or for each of its subsidiaries. International Finance is often discussed from the perspective of the MNC because it has to contend with political risk and exchange rate risk in numerous countries on a daily basis.

i. Investment Decision:

When an MNC decides to set up or acquire an affiliate overseas, it conducts a financial evaluation. A capital budgeting proposal is evaluated in accordance with accepted measures such as the Net Present Value (NPV) and the Internal Rate of Return (IRR). But an overseas capital budgeting proposal involves exchange rate forecasting, political risk assessment and tax planning.

Differences in corporate tax rates between countries, availability of subsidies in the host country, and displacement of profits from exports must be accommodated into the framework of the overseas capital budgeting evaluation process.

ii. Financing Decision:

Once the location is chosen, the next question is how and from where the money needed for the project would be raised. This is essentially related to the capital structure. Will the affiliate have the same capital structure as that of the parent, or will it be allowed to decide on the capital structure? What are the factors that govern the composition of a global capital structure, and how are they different from those within a single country?

What are the various sources of short-term, medium-term and long-term funds? What is the distinction between Global Depository Receipts (GDRs) and American Depository Receipts (ADRs)? How will future convergence of accounting standards affect reporting requirements? Is the dividend income of overseas holders of ADRs and GDRs affected by the issuer’s home country currency appreciation? Does two-way fungibility reduce arbitrage profits when the domestic currency appreciates?

What are the regulatory restrictions in the MNCs home country and in the host country and how will they affect the overall cost of capital? Therefore, managers require a thorough understanding of the nature, structure and functioning of overseas financial markets, the degree of financial integration, and an overview of the regulatory restrictions that are in place.

In 1992, Indian companies were permitted to borrow money at market-determined rates from overseas under annually announced external commercial borrowing (ECB) limits. The quantum of ECBs has risen both in terms of volume and the number of corporates opting for them as a source of finance.

Companies compare ECB costs with the cost of domestic borrowing:

a. What are the rules and regulations governing ECBs?

b. Some ECBs are raised in the euro currency market. What is the euro currency market and what type of instruments are issued?

c. Are listing norms and disclosure requirements as stringent as in the domestic market?

d. Can a foreign currency loan be repaid in some other currency? Can interest payments be made in one currency and principal repayment in another?

e. What are the methods by which a company can protect itself against adverse movements in exchange rates during the term of the overseas borrowing?

f. What is LIBOR and how is it computed? Can a company protect itself against rising interest in a LIBOR-based loan, and if so how?

g. If a firm takes a LIBOR-based loan, can it subsequently swap this loan for a fixed interest loan? What then are swaps?

Thus, the functioning of the euro-currency market, its rules and regulations, movements of LIBOR, the operation of the overseas call money market and its impact on the interest burden on Indian corporates, and the activities in the swap market, began to be closely studied.

iii. Working Capital Decision:

An MNC’s numerous inter-affiliate transactions affect tax collections in the respective host countries, and offer opportunities to the parent company to reduce conversion costs. Suppose an MNC has three affiliates A, B, and C, located in different countries. A located in Thailand sources raw materials from Indonesian affiliate B, and sells the finished product to Malaysian affiliate C.

What is the rate at which the affiliates price the products? This is related to a concept called Transfer Pricing. Several countries have enacted Transfer Pricing rules for intra- group transactions. It is important for the affiliates and the parent MNC to be aware of the Transfer Pricing regimes in each country and the degree of latitude they offer in cross-border inter-affiliate pricing decisions.

A related question is that of cash management. A firm’s cash holdings are attributed to the transaction motive, precautionary motive and speculative motive respectively. This money may be deployed in the money market and converted to cash as and when required. How much autonomy will the parent give its affiliates with respect to cash management? It involves an assessment of the direction of movement of exchange rates and its impact on funds required by affiliates. Globalization, exchange rate volatility and financial and technological innovations have converted cash management into a part of the treasury management function—exchange rate forecasting is as important as funds procurement and deployment.

iv. Dividend Decision:

An MNC is entitled to receive dividend from its wholly owned overseas subsidiary, and on its equity holding in an overseas firm. What are the dividend tax regulations in MNC’s home and the host countries? Is dividend tax imposed on the company declaring it, as well as in the hands of the recipient? In some countries, such as the USA, dividend is taxed in the hands of the parent company only when it is brought into the US. So, the parent company may choose not to have the dividend remitted.

Does the host country have dividend remittance restrictions? If so, the affiliate, in consultation with the parent MNC, may choose to transmit the un-remittable dividend through legitimate but indirect routes. One of the most common methods is through under-invoicing and over-invoicing between affiliates or between the parent and the affiliate. The mode of transmission depends on whether there are any business dealings between the associate concerns and/or the parent.

This method also serves the objective of moving funds from a country with a higher corporate tax structure to one with a lower tax rate. The result is that the affiliate located in the country with the higher corporate tax structure ends up with a lower tax burden. But governments have woken up to these modes of transmission and have brought in Transfer Pricing regulations.

Accounting Decision:

Consolidated financial statements for the whole group are prepared at the end of each accounting year. This necessitates conversion of the profit and loss statement and the balance sheet of each affiliate into the parent company’s home currency.

For this purpose, the following points should be noted:

1. Internationally accepted methods with respect to conversion

2. Differences in the methods and the impact on the profit and loss of the parent

3. The degree of harmonization of accounting standards

4. The periodicity and transparency in reporting, stringency of accounting standards, the accounting treatment of cross-border financial leases, derivatives contracts, provisioning for foreign exchange losses and use of Economic Value Added (EVA)

International Finance and Domestic Firms:

Import and export orders inevitably bring the foreign exchange market and exchange rate movements into the forefront of the decision-making process. The firm will have to monitor changes in import and export rules and regulations, understand the documentation involved the agencies that finance foreign trade and the types of non-financial assistance available from agencies within and outside the country. It must also be conversant with mechanisms to hedge its exchange rate risk.

2. For Investors:

Exchange rate movements affect returns from overseas security holdings. That is, the expected return on the security is not the sole factor that determines the investor’s ‘buy’ decision. Exchange rate risk is equally important, and it has to be factored into the decision­-making process.

Foreign portfolio investments (and foreign institutional investors) move between overseas markets in search of investments that offer a higher return. Returns in a foreign currency get neutralized by adverse exchange rate movements. Of course, the reverse can hold, and favourable exchange rate movements can magnify the portfolio return. It is important to be able to forecast the likely exchange rate at the end of the holding period. Exchange rate forecasting plays a significant role in portfolio destination.

Speculators play an important role in the foreign exchange market by imparting liquidity.

Their ability to make a profit rests on their constant following of exchange rate movements, and accurate assessment of the impact on exchange rates of policy pronouncements, geopolitical maneuvers, interest rate movements and economic growth. Foreign exchange markets are extremely sensitive to new information, which is almost instantaneously factored into currency pricing.

This underscores both the inherent fragility of the foreign exchange market and the interdependence of financial markets across the globe. Individuals are also concerned with exchange rate movements in their capacity as depositors and investors. When they are free to move their deposits between countries, they compare interest rates, and factor in the effect of exchange rates on their holdings.

3. For Central Banks:

Central banks are investors too, and are concerned with the gyrations of exchange rates in that capacity. Since the RBI holds a portion of its foreign exchange reserves in the form of US Treasury Bills, dollar depreciation affects the rupee value of its portfolio.

International Finance and Banks:

Commercial banks play an active role in foreign exchange markets all over the world. They lubricate the working of the foreign exchange market in a country, and often serve as the link between the foreign exchange market at home and in other countries. They buy, sell and hold various foreign currencies on behalf of their clients (corporate and non-corporate), and offer two-way quotes in multiple currencies. These quotes are extremely competitive. Since the rates change on a daily basis, banks are keen observers of the market and the effect of demand and supply imbalances on exchange rates.

Sometimes, a commercial bank may be asked to buy or sell foreign exchange on behalf of the central bank. Banks conduct proprietary trades and usually hold several foreign currencies as part of their asset holdings. They have to be able to take a call on exchange rate movements. In many countries around the world, commercial banks are the only entities that offer foreign exchange risk management solutions to corporate clients.

When a country’s financial market lacks a currency derivatives exchange, corporate clients have no alternative but to depend entirely on OTC contracts with a bank as the counter-party. International banks offer and/ or participate in the syndicated foreign exchange loan market.

Banks arrange and provide foreign exchange loans to corporate clients, and sovereign loans to governments, underwrite the corporate issue of securities in the euro currency and international bond markets, and participate extensively in international trade transactions.

4. For Regulators:

The flow of capital between countries is impeded by capital controls. The removal of capital controls requires careful sequencing and must be preceded by ‘the creation of institutional structures ensuring the stability of the financial system’. The fewer the controls on capital movement, the greater is the financial openness of an economy, and the better the chances that domestic financial market will get integrated with financial markets in other countries.

In other words, capital account convertibility (or capital account liberalization) is viewed as the predecessor to financial integration. Developed countries are characterized by open financial systems, in contrast to the financial markets of many developing countries.

The benefits of financial openness include higher inflows of private capital in the form of FDI and FII. Since capital inflows are associated with development, employment generation, and growth, they are much sought after. But continuing inflows cause domestic currency appreciation. This affects the country’s export competitiveness. A decline in exports has an adverse effect on Balance of Trade.

The second and more serious effect of capital inflows is that the money supply within a country increases. Price rise makes domestic goods more expensive in world markets, and acts as a deterrent to exports. The balance of trade deteriorates further. A rise in inflation also affects market expectations.

What can the central bank do? It can let these forces play themselves out. But more often than not, it is galvanized into action. Monetary policy is revisited, interest rates are re-adjusted, steps are taken to arrest domestic currency appreciation, and management of foreign exchange reserves is re-assessed. The responses vary with time, but currency appreciation due to capital inflows evokes prompt and timely action by market regulators and governments.

One of the biggest dangers of regulation is that there is a need for continuous fine-tuning, and there is no guarantee that it will always work. The central bank’s efforts to stabilize the domestic currency’s value can be stymied by factors beyond its control—such as hot money flows, and interest rate changes in other countries.

Financial openness gives frightening speed to money entering and leaving an economy. It also increases the ferocity of the financial crisis, as the domestic currency is susceptible to sudden and large appreciation and depreciation. Regulators watch the foreign exchange market, ready to intervene but unsure whether their efforts will yield the expected results.

These are some of the fascinating contradictions that make International Finance a dynamic discipline that changes in accordance with market needs. Since International Finance is concerned with the structure and functioning of the foreign exchange market, it follows that its importance grows in tandem with the rise of cross-border movements of money.

The issues discussed above are by no means an exhaustive list of the reasons why knowledge of International Finance is so crucial. But it does give the reader an idea of how essential it is to develop an understanding of foreign exchange markets, international financial markets, domestic financial markets, the linkages between both, and the array of institutional and regulatory structures that shape the movement of funds between countries.