International Finance

What is International Finance?

International finance can be defined in simple terms as the business taking place between two or more than two countries.

International finance is the branch of financial economics broadly concerned with monetary and macroeconomic interrelations between two or more countries. International finance examines the dynamics of the global financial system, international monetary systems, balance of payments, exchange rates, foreign direct investment, and how these topics relate to international trade.

Sometimes referred to as multinational finance, international finance is additionally concerned with matters of international financial management. Investors and multinational corporations must assess and manage international risks such as political risk and foreign exchange risk, including transaction exposure, economic exposure, and translation exposure.

International finance in an important factor in the decision-making process of companies.


Features of International Finance

  1. Foreign exchange risk
  2. Political risk
  3. Expanded opportunity sets
  4. Market imperfections

Foreign exchange risk

An understanding of foreign exchange risk is essential for managers and investors in the modern day environment of unforeseen changes in foreign exchange rates. In a domestic economy, this risk is generally ignored because a single national currency serves as the main medium of exchange within a country.

When different national currencies are exchanged for each other, there is a definite risk of volatility in foreign exchange rates. The present International Monetary System setup is characterised by a mix of floating and managed exchange rate policies adopted by each nation keeping in view its interests.

In fact, this variability of exchange rates is widely regarded as the most serious international financial problem facing corporate managers and policy-makers.

Political risk

Another risk that firms may encounter in international finance is political risk. Political risk ranges from the risk of loss (or gain) from unforeseen government actions or other events of a political character such as acts of terrorism to outright expropriation of assets held by foreigners.

MNCs must assess the political risk not only in countries where it is currently doing business but also where it expects to establish subsidiaries.

Expanded opportunity sets

When firms go global, they also tend to benefit from expanded opportunities which are available now. They can raise funds in capital markets where cost of capital is the lowest. In addition, firms can also gain from greater economies of scale when they operate on a global basis.

Market imperfections

The final feature of international finance that distinguishes it from domestic finance is that world markets today are highly imperfect. There are profound differences among nations’ laws, tax systems, business practices and general cultural environments. Imperfections in the world financial markets tend to restrict the extent to which investors can diversify their portfolio.

Though there are risks and costs in coping with these market imperfections, they also offer managers of international firms abundant opportunities.

Thus, the job of the manager of a MNC is both challenging and risky. The key to such management is to make the diversity and complexity of the environment work for the benefit of the firm.


Importance of International Finance

India and other developing countries feel the need for increasing their share in international exchange of goods, services, capital and technology. Some of the important steps taken over during the last 25 years can be summarised as below:

  • Establishment of unified market determined exchange-rate.

  • Iintroduction of current account convertibility and introduction of capital account convertibility in a phased or later period.

  • Reduction in import duties.

  • Liberalisation of portfolio and FDI.

Goals of International Finance

Following are the goals of international finance:

  1. To achieve higher rate of profits
  2. Expansion of production capacities
  3. Severe competition in the home country
  4. Limited home market
  5. Political stability vs political instability
  6. Availability of technology and skilled human resources
  7. High cost of transportation
  8. Nearness to raw materials
  9. Availability of quality human resources
  10. Liberalisation and globalisation
  11. Increased market share
  12. To achieve higher rate of economic development
  13. Tariffs and import quotas

To achieve higher rate of profits

International companies search for foreign markets that hold promise for higher rates of profits. Thus, the objective of profit affects and motivates the business to expand its operations to foreign countries.

For example, Hewlett-Packard in the US earned 86.2% of its profits from foreign markets, compared to that of domestic markets, in 2007. Apple earned US $ 730 million as net profit from the foreign markets and only US $ 620 mn. as net profit, from its domestic market, in 2007.

Expansion of production capacities

Some of the domestic companies expanded their production capacities more than the demand for the product in the domestic countries. These companies in such cases, are forced to sell their excess production in foreign developed countries. Toyota of Japan is an example.

Severe competition in the home country

The weak companies which could not meet the competition of the strong companies in the domestic country started entering the markets of the developing countries.

Limited home market

When the size of the home market is limited due to the smaller size of the population or due to lower purchasing power of the people or both, the companies internalize their operations.

For example, most of the Japanese automobile and electronic firms entered the U.S., Europe and even African markets due to the smaller size of the home market. I.T.C. entered the European market due to the lower purchasing power of Indians with regard to high-quality cigarettes.

Political stability vs political instability

Political stability does not simply mean that continuation of the same party in power, but it does not mean the continuation of the same policies of the Government for a quieter longer period. It is viewed that the U.S.A. is a politically stable country.

Similarly, UK, France, Germany, Italy and Japan are also politically stable countries. International companies prefer, to enter politically stable countries and are restrained from locating their business operations in politically unstable countries. In fact, business companies shift their operations from politically unstable countries to politically stable countries.

Availability of technology and skilled human resources

Availability of advanced technology and competent human resources, in some countries act as PULLING FACTORS for international companies.

The developed countries due to these reasons attract companies from the developing world American and European companies, depended on Indian companies for software products and services through their BPOs.

The cost of professionals in India is 10 to 15 times less compared to US and European markets. These factors helped Indian software industry to grow at a faster rate with world class standards. Added to this, satellite communications help Indian companies to serve the global business without going globally.

High cost of transportation

The major factor in lower profit margins to international companies, is the cost of transportation of the products. Under such conditions, the foreign companies are inclined to increase their profit margin by locating their manufacturing facilities in foreign countries, where there is enough demand either in one country or in a group of neighbouring countries.

For example, Mobil, which was supplying the petroleum products to Ethiopia, Kenya, Eritrea, Sudan, etc. from its refineries, in Saudi Arabia, established its refinery facility in Eritrea, in order to reduce the cost of transportation.

Nearness to raw materials

The source of highly qualitative raw materials and bulk raw materials is a major factor for attracting companies from various foreign countries. Most of the US-based and European-based companies located their manufacturing facilities in Saudi Arabia, Bahrain, Qatar, Iran, etc. due to the availability of petroleum.

Availability of quality human resources

This is a major factor for software, high technology, and telecommunication companies to locate their operations in India. India is a major source for high-quality and low-cost human resources.

Liberalisation and globalisation

Most of the countries in the world liberalized their economies and opened their countries to the rest of the world.

Increased market share

Some of the large scale international companies like to enhance their market share in the world market by expanding and intensifying their operations in various foreign countries.

For example, Ball Corporation, the third-largest beverage cans manufacturer in the USA, bought the European Packaging operations of a continental can company. Then it expanded its operations in Europe and met the Europe demand, which is 200 percent more than that of the USA. Thus, it increased its global market share of soft drink cans.

To achieve higher rate of economic development

International companies help the governments to achieve higher growth rate of the economy, increase the total and per capita GDP, industrial growth, employment and income levels.

Tariffs and import quotas

It was quite common before globalization that governments imposed tariffs or duty on imports to protect domestic companies.

Sometimes government also fixes import quotas to reduce the competition to the domestic companies from competent foreign companies. To avoid high tariffs and quotas companies prefer direct investments to go globally. For example, companies like Sony, Honda, and Toyota preferred direct f


Challenges in International Finance

The following are the important challenges in international finance:

  1. Varied Economic Systems
  2. Tariff and non-tariff trade barriers
  3. Political Risks
  4. Environmental safeguards
  5. Dumping
  6. Cultural differences
  7. Language differences
  8. Intellectual property rights
  9. Cyber crimes
  10. Transfer Pricing
  11. International Taxation
  12. Economic and Currency Crisis
  13. Interest Rates Charging
  14. Foreign Exchange Risk
  15. Cold war between countries
  16. International business cycle
  17. Operational risks
  18. International terrorism

Varied Economic Systems

An economic system refers to the kind of governance of a country. It may be on the basis of the principles of communism, capitalism, socialism, and mixed economy, rules, and ideologies. International companies have to navigate with country-specific economic systems.

American companies are looked at with scepticism by Japan, European and Gulf countries and vice versa. The economic system issue is not possible to address but MNCs may harness it for their economic gains.

Tariff and non-tariff trade barriers

The progress of world trade is dependent on FREE TRADE POLICY. Many countries distorted the free trade among themselves and this trade restriction is called a trade barrier. The opposite of free trade is a trade barrier. These barriers are of two kinds:

  • Tariff
  • Non-tariff

Political Risks

The instability in the governance by a political system in different countries is a major setback for international companies. The draconian rules and policies of some countries restrict market access.

Environmental safeguards

One of the major challenges today in the world is global warming. The carbon dioxide emissions by different countries and the greenhouse effect therein resulted in the depletion of the ozone layer.

The relentless use of natural resources is the route cause for environmental delay. International trade and environmental protection should go hand in hand in the interest of the future generation.

Dumping

It refers to selling a product at a high price in the home currency and relatively at a LOW PRICE in the host country by an international company. This practice ruins industries and employment opportunities in the host country especially micro and small scale industries.

For example, the Chinese goods like goods sold in Dipawali, Holi and other festivals are sold, at very low prices in India.

Cultural differences

Every country has a unique cultural heritage that shapes values and influences the conduct of business. Even within geographic regions that are considered relatively homogeneous, different sub-cultures are prevailing. International companies have to cope with these differences and adopt to the culture and sub-culture of the countries, where they operate.

MNCs find that matters such as defining the appropriate goals of the company, attitudes toward risk, dealing with employees, and the ability to curtail and profitable operations vary dramatically from one country to the next.

Language differences

The ability to communicate is critical in all business, including international transactions. The Indian and US. citizens are often at a disadvantage because they are generally fluent in English, while European and German people are usually fluent in several languages including English.

Intellectual property rights

The trinity of intellectual properties is patents (for inventions) trademarks (for a brand name, image etc.) and copyright (for author, musicians, lyrics, filmmakers). The invention of new things requires world-class Research and Development set up by foreign firms.

The problem of privacy is haunting several leading companies and brands. India, after a great fight with USA has registered patent protection for Basmati rice, turmeric and tomato. In the case of pharma products, a large number of patent infringements is happening around the world especially the life saving drugs. This is a vital issue in international business and finance.

Cyber crimes

Cybercrime is a crime committed with the use of computer and internet. Today, all around the world e-commerce and e-business, e-governance, are flourishing. The flip side of e-commerce is cyber crimestantalising international finance.

The privacy is interrupted, money in some other accounts are withdrawn, manipulated and transferred. The cybercrimes if unabated will pose a great danger to world business. The WTO has asked all the member countries to have in place a proper and comprehensive cyber law in place to check the maladies and anomalies of cybercrimes.

Transfer Pricing

In any international business there are normally a large number of transfers of goods, services, technology and other resources between the parent company and foreign subsidiaries. The price at which goods, services and others are transferred between affiliates within the company is called transfer price.

Transfer price also affects an international company’s ability to monitor the performance of individual corporate subsidiaries and to reward or punish managers responsible for their performance.

International Taxation

Taxes have a significant impact on areas, as diverse as making foreign investment decisions, managing exchange risks, planning capital structures, determining financing costs, and managing inter-affiliate funds flows.

For the international business with activities in many countries, the various treaties have important implications for how the international company should structure its internal payments system among the foreign subsidiaries and the parent company.

Economic and Currency Crisis

The Asian crisis, Malaysian crisis, Pacific-Rim country crisis are in relation to economic crisis wherein they have experienced. RECESSION and ADVERSE, BALANCE OF PAYMENTS position.

The same countries along with Japan experienced a currency crisis in that the value of currencies was either depreciated or devalued and further they were exposed to a shortage of foreign exchange reserves.

Interest Rates Charging

The rate of interest charged by the World Bank on its loans disbursed is 7.5 percent p.a. and Asian Development Bank’s concessional interest rate is 4 percent p.a. The equity cost of capital is less when compared to debt funds in the global capital market.

The increasing interest rate raises the cost of capital and the profitability of the company is lessened interest rate is a parameter in global finance which plays a dominant role in production and operational risks of global corporates.

Foreign Exchange Risk

Exchange Rate refers to the price of one currency against another currency. The exchange of currency happens in two ways — fixed exchange rate and floating exchange rate. The exchange rate risk is more pronounced under flexible or floating exchange rate.

This is because the floating exchange rate is based on market forces of DEMAND for and SUPPLY of foreign currencies, at a particular time Trade surplus/deficit vis-a-vis the currencies of the countries, a host of economic factors like GNP, Fiscal Deficit, balance of payments position. Industrial production data, and employment data, inflation rate differentials, and interest rate differentials.

Cold war between countries

The enmity, animosity, difference of opinion between and among countries be routed out at the surface level. Hatred is external while jealousy is internal. The cold war among nations is because of the twin pests — hatred and jealousy between the countries in the world.

International business cycle

Countries are subject to times of good trade and bad trade. Goal trade is characterized by increased economic activities, production, profitability and revenue. The opposites are low economic activities, production and other parameters representing the bad trade.

Business or trade cycle is international in character, recurring in nature and time period of each stage of the cycle such as inflation, deflation, revival and recession are uncertain.

Operational risks

The operational risk encompasses commercial risks, foreign exchange risk, political risks and country-specific risks. Different currencies, payments and receipts socioeconomic systems, laws, habits, tasks preferences, and environmental aspects lead to higher risks in the form of credit, market access, currency and exchange risks.

International terrorism

The growing menance of international terrorism is ruining international business. Terrorism obstructs the smooth flow of economic activities. It pushes the economy into bankruptcy and insolvency. It worsens import and export trade. The countries which want to have cordial business relations with other countries will rethink and hesitate to have relationship with terror hit countries. The free flow of foreign investment is affected due to terrorism.


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