A. Buckley_Multinational Finance

multinational finance

multinational finance

mu

ltinatio

nal finance

Adrian Buckley

Adrian Buckley

Buckley

fifth edition

fifth edition

Multinational Finance is an authoritative and comprehensive description of the theoryand practice of international finance and its management.

This fifth edition builds on the strengths of previous editions, offering a user-friendlyguide to the subject that moves through the basics to the advanced with clarity andconciseness. The content has been thoroughly revised to incorporate the most up-to-date information in terms of markets, coverage of new financial instruments, and thelatest empirical work (in particular in relation to discount rates and required rates ofreturn). A key feature of this edition is its strong European orientation, a theme thatruns throughout the book and makes Multinational Finance unique in its field.

New to this edition:

Up-to-date coverage of international accounting (IFRS) and recent empirical studies.

Foreign exchange coverage fully revised with euro currency referenced throughout the book.

Improved coverage of essential areas and issues such as international capital budgeting and country risk brings students entirely up-to-date.

Two-colour text design greatly improves readability.

Companion Website with extra support for both lecturers and students at www.booksites.net/buckley.

New end of chapter questions with answers provided at the back of the book.

Features:

Strong European orientation with full coverage of markets and issues relating to this region make the book ideal for courses in Europe.

Plenty of exercises and multiple choice questions are provided for each part to allow students to track their own progress.

Each chapter ends with an extensive summary, sign-postedwith bullet points to ease the revisionof key points.

Much-praised, comprehensive glossary.

Multinational Finance is recommended for undergraduate, MBAand other postgraduate courses in international financialmanagement taken as a part of a degree programme in finance orinternational business. The book also caters for profes-sionals in the financial field.

The authorDr Adrian Buckley is Professor of International Finance atCranfield School of Management, Cranfield University, and

fifth

ed

ition

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Multinational Finance

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A Companion Website accompanies Multinational Finance, fth edition, by Adrian Buckley

Visit the Multinational Finance Companion Website at www.booksites.net/buckley to nd valuable teaching and learning material including:

For Students:n Study material designed to help you improve your resultsn Learning objectives and summaries for each chaptern Multiple choice questions to help test your learningn Extra question material

For Lecturers:n A secure, password protected site with teaching materialn Complete, downloadable Instructors Manualn Extra question and answer materialn OHT Masters that can be downloaded

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Multinational Finance

Fifth Edition

ADRIAN BUCKLEY

Pearson Education LimitedEdinburgh GateHarlowEssex CM20 2JEEngland

and Associated Companies throughout the world

Visit us on the World Wide Web at:http://www.pearsoned.co.uk

First published under the Philip Allan imprint, 1986Second and third editions published under the Prentice Hall Europe imprint, 1992, 1996Fourth edition, 2000Fifth edition, 2004

Prentice Hall Europe 1992, 1996 Pearson Education Limited 2000, 2004

The right of Adrian Buckley to be identied as author of this work has been assertedby him in accordance with the Copyright, Designs and Patents Act 1988.

All rights reserved. No part of this publication may be reproduced, stored in aretrieval system, or transmitted in any form or by any means, electronic, mechanical,photocopying, recording or otherwise, without either the prior written permission of thepublisher or a licence permitting restricted copying in the United Kingdom issued bythe Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP.

ISBN 0-273-68209-1

British Library Cataloging-in-Publication DataA catalogue record for this book can be obtained from the British Library

10 9 8 7 6 5 4 3 209 08 07 06 05

Typeset in 10/12.5pt Sabon by 35Printed and bound by Ashford Colour Press Ltd, Gosport

The publishers policy is to use paper manufactured from sustainable forests.

Contents

Preface and acknowledgements xv

Part A ESSENTIAL BACKGROUND

1 Introduction 31.1 What do bankers sell? 71.2 The creation of Eurodollars 81.3 Facts about the foreign exchange markets 111.4 Summary 13

2 The international monetary system 15

2.1 The gold standard 152.2 The Great Depression 182.3 Exchange rates: 1914 to 1944 192.4 The Bretton Woods system 212.5 The role of gold up to 1971 222.6 The Second Amendment 242.7 International reserves 252.8 Exchange rate arrangements 262.9 The European Monetary System 292.10 The exchange rate mechanism of the EMS 292.11 The European single currency the euro 322.12 Summary 332.13 End of chapter questions 35

3 Corporate finance around the world 36

3.1 World equity markets 363.2 World bond markets 413.3 Corporate governance and corporate nance 433.4 Corporate reporting around the world 463.5 Different corporate tax systems 483.6 Summary 503.7 End of chapter questions 50

vi Contents

Part B FOREIGN EXCHANGE

4 Exchange rates: the basic equations 534.1 Foreign exchange markets 534.2 Some basic relationships 544.3 Interest rates and exchange rates 564.4 Purchasing power parity applied 664.5 Big Mac purchasing power parity 724.6 Summary 724.7 End of chapter questions 75

5 Foreign exchange markets 765.1 The players 765.2 Methods of quotation 775.3 Forward contracts and quotations 795.4 Spot settlement 825.5 Forward value dates 825.6 Main purpose of the forward market 835.7 Summary 845.8 End of chapter questions 85

6 The balance of payments 866.1 The essence of international trade 866.2 The balance of payments and foreign exchange rates 876.3 Balance of payments accounting 916.4 Forecasting exchange rates and the balance of payments 956.5 Summary 966.6 End of chapter questions 97

7 Theories and empiricism on exchange rate movements 987.1 Ination and interest rate differentials 997.2 The balance of payments approach 997.3 The monetary approach 1027.4 Overshooting the Dornbusch model 1047.5 The portfolio balance theory 1067.6 The role of news 1087.7 Chartism 1097.8 The efcient markets hypothesis 1157.9 Empiricism and purchasing power parity 1167.10 Empiricism and the Fisher effect 1227.11 Empiricism and the international Fisher effect 1227.12 Empiricism and interest rate parity 1247.13 Empiricism and expectations theory 1257.14 Empiricism and foreign exchange market efciency 1267.15 Summary 1317.16 End of chapter questions 134

Contents vii

8 Definitions of foreign exchange risk 1358.1 Transaction exposure 1368.2 Translation exposure 1368.3 Economic exposure 1418.4 Summary 1438.5 End of chapter questions 144

9 Financial accounting and foreign exchange 1459.1 FASB 8 1469.2 FAS 52 1479.3 SSAP 20 1529.4 Derivatives 1559.5 FAS 133 1559.6 FRS 13 1579.7 IAS 39 1589.8 Summary 1599.9 End of chapter questions 160

TEST BANK 1 161Exercises 161Multiple choice questions 164

Part C HEDGING

10 Does foreign exchange exposure matter? 16910.1 Transaction exposure 16910.2 Economic exposure 17110.3 Translation exposure 17310.4 Forecasting exchange rates 17710.5 Summary 17810.6 End of chapter questions 179

11 Principles of exposure management 18011.1 Why hedge anyway? 18011.2 What does exposure management aim to achieve? 18011.3 The arguments against corporate hedging 18111.4 The arguments for corporate hedging 18511.5 Information for exposure management 19011.6 What kind of foreign exchange exposure is signicant? 19111.7 The transaction exposure information system 19311.8 Histogramming 19511.9 Reinvoicing vehicles 19811.10 Strategies for exposure management 19811.11 Economic exposure revisited 201

viii Contents

11.12 Macroeconomic exposure 20111.13 Value at risk 20411.14 Summary 20711.15 End of chapter questions 210

12 Internal techniques of exposure management 21212.1 Netting 21212.2 Matching 21512.3 Leading and lagging 21612.4 Pricing policy 21712.5 Asset and liability management 22112.6 Summary 22212.7 End of chapter questions 223

13 External techniques of exposure management 22413.1 Forward markets 22413.2 Trading purpose of the forward market 22513.3 Short-term borrowing 22913.4 Discounting foreign-currency-denominated bills receivable 23113.5 Factoring foreign-currency-denominated receivables 23113.6 Currency overdrafts 23213.7 Exchange risk guarantees 23313.8 Counterparty risk 23313.9 Summary 23413.10 End of chapter questions 236


Part D DERIVATIVES

14 Swaps 24514.1 Swaps the basics 24514.2 Interest rate swaps 24714.3 Calculation of interest 25314.4 Currency swaps 25914.5 Assessing risk in swaps 26414.6 Summary 26714.7 End of chapter questions 268

15 Financial futures and foreign exchange 26915.1 Financial futures in general 26915.2 Currency contracts 273

Contents ix

15.3 Hedging a borrowing 27415.4 Basis risk 27515.5 Use of currency futures market 27615.6 Summary 27615.7 End of chapter questions 277

16 Options 278

16.1 Call options 27816.2 Put options 28016.3 Writing options 28216.4 Reading the Financial Times 28316.5 Combinations of options 28316.6 Valuing options 28616.7 An option-pricing formula 29016.8 An option-pricing table 29916.9 Summary 30116.10 End of chapter questions 301

17 Currency options 303

17.1 How currency option markets work 30317.2 Currency option strategies 30717.3 Average rate option 30917.4 Hedging a currency option 31217.5 Option pricing models 31617.6 Option pricing models for stocks and currencies:

the empirical evidence 32017.7 Corporate use of currency options 32417.8 Summary 32917.9 End of chapter questions 330

18 Interest rate risk 331

18.1 The term structure of interest rates 33118.2 Interest rate exposure 33518.3 Forward rate agreements 33818.4 Interest rate futures 33918.5 Interest rate swaps 33918.6 Interest rate options 34018.7 Summary 34118.8 End of chapter questions 343

19 Financial engineering 344

19.1 Forward contracts 34419.2 Option contracts 34619.3 Some nancial instruments 351

x Contents

19.4 Summary 35619.5 End of chapter questions 356


Part E INTERNATIONAL CAPITAL BUDGETING

20 The internationalization process 36320.1 Foreign direct investment 36320.2 The sequential process 36520.3 Market imperfections 36820.4 Transaction cost theory 37420.5 Internalization and rm-specic advantages 37520.6 Location-specic advantages 37720.7 The product life cycle 37820.8 The eclectic theory 38320.9 Globalization 38620.10 Game theory and international strategy 38820.11 The new trade theory 39020.12 Summary 39220.13 End of chapter questions 39320.14 Appendix 1: Inward stock of world foreign direct investment 39420.15 Appendix 2: Outward stock of world foreign direct investment 395

21 Exchange controls and corporate tax in international investment 39621.1 Exchange controls 39621.2 Prots repatriation 39821.3 Circumventing prot repatriation restrictions 39921.4 Other techniques of unblocking funds 40321.5 International corporate taxation 40321.6 Taxation of UK multinationals 40721.7 Multicurrency management centres 40821.8 Co-ordination centres 40921.9 Foreign exchange rate strategy 41121.10 Summary 41221.11 End of chapter questions 413

22 The international capital budgeting framework 41422.1 The international complications 41522.2 NPV or APV? 42022.3 Foreign investment and the cost of capital 422

Contents xi

22.4 The basic model 42222.5 Empirical studies of international investment appraisal 42422.6 Summary 42922.7 End of chapter questions 430

23 The international capital budgeting model 43223.1 International project appraisal 43323.2 Taxation 43423.3 Project evaluation with no exchange controls 43623.4 Growth opportunities aka real operating options 44023.5 Valuing real operating options 44223.6 Project evaluation with exchange controls 44623.7 Debtequity swaps 45223.8 Sensitivity analysis 45323.9 Summary 45323.10 End of chapter questions 456

24 International investment: what discount rate? 45724.1 The original US evidence 45824.2 The new international evidence 46024.3 Arithmetic or geometric mean? 46124.4 The equity premium puzzle 46624.5 Mean reversion 46924.6 The equity risk premium 47124.7 The international risk premium 47224.8 Gains from international diversication 47524.9 The international capital asset pricing model 47624.10 Emerging markets 47824.11 Summary 48224.12 End of chapter questions 482

25 Country risk analysis and political risk 48425.1 Country risk analysis 48425.2 Sources of country risk 48525.3 Measuring country risk 48625.4 Political risk 48925.5 The measurement of political risk 48925.6 Managing political risk 49325.7 Post-expropriation policies 49525.8 Political risk analysis in international capital budgeting 49725.9 Summary 50125.10 End of chapter questions 502

26 International capital budgeting: the practicalities 50326.1 Net present value and adjusted present value 50326.2 Overseas project appraisal: Alpha NV 504

xii Contents

26.3 Summary 51226.4 End of chapter questions 512


Part F INTERNATIONAL FINANCING

27 International debt instruments 519

27.1 Short-term borrowing 52127.2 Medium-term borrowing 52327.3 Euromarkets 52427.4 Denitions of key Eurocurrency terms 52527.5 Eurodollar deposits and loans 52627.6 Historical underpinnings of the Eurocurrency market 52827.7 The players in the market 52927.8 Euromarket deposits and borrowings 53127.9 The Eurocredit market 53127.10 Loan syndication 53127.11 Securitization 53527.12 Eurocurrency interest rates and their linkage with

domestic rates 53627.13 The international bond market 53927.14 Disintermediation 54627.15 The advantages of the Eurobond market to borrowers 54727.16 The advantages of Eurobonds to investors 54727.17 Summary 54827.18 End of chapter questions 549

28 Financing the multinational and its overseas subsidiaries 550

28.1 The international nancing choice 55028.2 Minimization of global taxes 55128.3 Managing risk 55228.4 Financial market distortions 55328.5 The multinationals capital structure 55428.6 Political risk 55528.7 Exchange control risk 55628.8 Currency risk 55728.9 Losses earned by subsidiaries 55728.10 Inter-company credit 55828.11 Taxation effects 55828.12 Dividend policy 55928.13 Other methods of prot transfer 559

Contents xiii

28.14 Parent company guarantees 55928.15 Partly owned subsidiaries 56028.16 Euroequity or crosslisting 56128.17 Some more empirical evidence 56428.18 Measuring the cost of international borrowing 56628.19 The advantages of borrowing internationally 56728.20 The risks of borrowing internationally 56828.21 Foreign currency nancing decisions 57028.22 Summary 57328.23 End of chapter questions 574

29 Cash management 57529.1 Banking relationships 57529.2 Electronic banking 58129.3 Cash collection and disbursement 58229.4 Cash centres 58429.5 Short-term investments 58529.6 Summary 58629.7 End of chapter questions 586

30 Project finance 58730.1 Limited recourse nance 58930.2 Ownership structures 59030.3 Financing structures 59130.4 Loan structuring 59930.5 Resource risk 60030.6 Raw material and supplies risk 60130.7 Completion risk 60130.8 Operating risk 60330.9 Marketing risk 60430.10 Financial risk 60530.11 Political and regulatory risk 60630.12 Force majeure risk 60630.13 How does project nance create value? 60630.14 The nancial analysis of investments with project nancing 60830.15 Summary 61130.16 End of chapter questions 611

31 Financing international trade and minimizing credit risk 61231.1 Cash with order 61231.2 Open account 61431.3 Documentation in foreign trade 61531.4 Bills of exchange 62031.5 Documentary letters of credit trading 62331.6 Government assistance schemes 626

xiv Contents

31.7 Sources of export nance 62831.8 Forfaiting 63031.9 Countertrade 63231.10 Summary 63231.11 End of chapter questions 63231.12 Appendix: Some terms encountered in trade nance 633

Part G Miscellaneous

32 Miscellaneous issues in multinational finance 63932.1 Overseas subsidiary performance measurement 63932.2 Problems in overseas performance evaluation 64032.3 Treasury management performance 64432.4 Centralization of exposure management 64532.5 The treasury as a prot centre 64732.6 Authority and limits 64732.7 Foreign exchange dealing with banks 64932.8 Dealing room security 65032.9 Commercial paper 65132.10 Credit rating 65332.11 Transfer pricing 65732.12 Capital ight 65832.13 Corporate hedging policies 65932.14 Summary 67132.15 End of chapter questions 673


Suggested answers to end of chapter questions 679Suggested answers to selected exercises 696Solutions to multiple choice questions 708

Appendix 1 Present value of $1 711Appendix 2 Present value of $1 received annually for n years 713Appendix 3 Table of areas under the normal curve 715Appendix 4 Black and Scholes value of call option expressed

as a percentage of the share price 716Appendix 5 Present value of $1 with a continuous discount

rate, r, for T periods. Values of ert 719Appendix 6 SWIFT codes 723

Glossary 729References 753Index 772

Preface and acknowledgements

This book describes the theory and practice of multinational nance. The increasinginternationalization of business, the emergence of the euro and the deregulation ofcapital markets around the world have made the study of multinational nance farmore pertinent than ever before.

Thirty ve years ago the majority of nancial executives in The Times 1,000 com-panies did not have to appreciate what impelled exchange rates to move, what were the opportunities to raise money outside the United Kingdom, what inuenced theevaluation of overseas capital investment projects, and so on. The decisions to moveaway from the xed exchange rate system and to abandon exchange controls in theUnited Kingdom were the most important factors which changed all that. The nan-cial manager in the United Kingdom had to start to learn new tricks in the 1970s.Those who were slow to learn made mistakes. They borrowed in Swiss francs becausethe interest cost was low; they failed to cover Deutschmark payables as sterlingdeclined precipitously; they failed to realize the opportunities created by the demiseof exchange controls; they did not appreciate the benets that accrue from currencyoptions; and so on.

The majority of nancial executives are probably accountants and it is to beregretted that the professional accounting bodies in the United Kingdom respondedwith too little, too late. In short, they failed to provide an adequate test of knowledgein the eld of multinational nancial management as part of their professional train-ing and examinations. This lacuna in their training, in conjunction with a paucity ofcoverage of the total treasury area corporate nance, currency management, fund-ing management and liquidity management was one of the reasons for the growthand increasing importance in the United Kingdom of the Association of CorporateTreasurers and similar professional bodies elsewhere. There are few wide-rangingBritish texts on multinational nance. This book is intended to improve managementpractice in this most important area of business.

y ReadershipThis text is aimed primarily at students on courses in multinational nance or n-ancial aspects of international business. They may be on MBA courses or pursuingundergraduate or postgraduate studies. But the book is also structured to meet the

xvi Preface and acknowledgements

needs of aspiring accountants, bankers and treasurers. The emphasis on a studentmarket is not to say that the book is inappropriate for the businessperson who needsto know about nance in the international arena. The intention is that it should berelevant to the requirements of nancial managers who want to study this special areaof nance as well as to non-nancial managers who need to know about interna-tional money and its implications. My intention is essentially practical. It is that thisbook should improve performance and awareness in the treasury management area.

y Changes to the fifth editionNowadays, the eld of international nancial management is probably the mostdynamic segment of all business activity. It is changing at a pace that is no less thanstaggering. Hence, there have been many things happening in theory and practicesince the fourth edition of this book came out in 2000. This fth edition has beenrevised and updated. Both the content and number of chapters have been rationalizedand reorganized. The reading and learning features are facilitated by the inclusion ofend-of-part test banks comprising exercises and multiple-choice questions. Suggestedanswers to a selection of the exercises and all multiple-choice questions are given atthe end of the text allowing for self-assessment. Each chapter ends with an extensivesummary, signposted with bullet points to ease the revision of key aspects by stu-dents. A new feature is the inclusion of questions at the end of all chapters (exceptChapter 1). Answers to all of these appear at the end of the book.

A separately published Teachers Manual includes teaching notes, case study sugges-tions, visual aid masters, and suggested answers to the exercises not given in the text.

y AcknowledgementsI am most grateful to the Association of Corporate Treasurers for permission to re-produce some of their examination questions in the test banks. And I am especiallygrateful to Liz Tribe who deciphered my handwriting and cheerfully typed themanuscript. Lizs ability to deal with my quirky sense of humour and to put up withmy tendency to lose bits of text is also to be applauded. Errors should be debited tomy account though.

I would also like to express my gratitude to the anonymous survey respondents,and to various people who have used the fourth edition of this book and pointed out errors and improvements. That list includes the following: Mark Ashley-Hacker, Ruth Bender, Soumitro Bhattacharyya, Alexei Bogdanov, Abir Clark, YanFeng, Melisa Hoffman, Ajay Khandelwal, Bryan King, Walter Marques, Jose Olea,Roberto Pace, Jason Parrish, Claudio Santos, Amanda Solomon, Mayan Shah,Louise Streeter and Jianglong Zhou.

Adrian Buckley

y Publishers acknowledgementsWe are grateful to the following for permission to reproduce copyright material:

Tables 3.1, 24.2, 24.3 and 24.4 from Triumph of the Optimists, copyright 2002by Elroy Dimson, Paul March and M. Staunton, reprinted by permission of PrincetonUniversity Press; Table 3.11 and Figure 3.1 from Comparative International Account-ing, 5th edition and 7th edition respectively (Nobes, C. and Parker, R. 1998, 2002)and Appendices 1 and 2 to Chapter 20 from International Business, 3rd edition(Rugman, A.M. and Hodgetts, R.M. 2003), reproduced with permission of PearsonEducation; Tables 24.5 and 24.6 from Stocks for the Long Run (Siegel, J.J. 2002),copyright 2002, reproduced with permission of The McGraw-Hill Companies;Table 27.6 from The credit rating industry, Quarterly Review, Vol. 19, No. 2(Cantor, R. and Packer, F. 1994), reproduced with permission of the Federal ReserveBank of New York; Table 28.1 from Issues in Business Taxation (Tucker, J. 1994),copyright 1994, reproduced with permission of Ashgate Publishing Limited;Figure 20.4 from Britain and the Multinationals (Stopford, J.M. and Turner, L.1985), copyright 1985 John Wiley & Sons Limited, reproduced with permission;Figure 20.5 from Case studies and failure by Marquise Cvar, Chapter 15 fromCompetition in Global Industries (Porter, M.E. 1986), Harvard Business SchoolPress, 1986; Figure 20.6 adapted from The Competitive Advantage of Nations(Porter, M.E. 1990), with permission of the Free Press, a Division of Simon &Schuster Adult Publishing Group, copyright 1990, 1998 by Michael E. Porter, all rights reserved; Figure 32.1 from Currency changes and management control:resolving the centralization/decentralization dilemma, The Accounting Review,Vol. LII, No. 3, July, pp. 62837 (Lessard, D.R. and Lorange, P. 1977), copyright American Accounting Association.

We are grateful to the Association of Corporate Treasurers for permission to includeexamination questions from a selection of their examination papers, Associationof Corporate Treasurers.

Every effort has been made by the publisher to obtain permission from the appro-priate source to reproduce material which appears in this book. In some instances wehave been unable to trace the owners of copyright material, and we would appreci-ate any information that would enable us to do so.

Preface and acknowledgements xvii

Part A

Essential background

With any topic, there are certain key facts that set the scene and are essentialto an understanding of a subject. This is as true of multinational finance as it isof any other subject. In this first section we present some of these key factsabout the international monetary system and the internationalization process.

Introduction

Financial management traditionally focuses upon three key decisions the acquisi-tion of funds, their investment and the payment of dividends. The former is termedthe nancing decision and it is concerned with obtaining funds, either internally orexternally, at the lowest cost possible. The second key area of nance is the invest-ment decision, which is concerned with the allocation of funds to opportunities inorder to earn the greatest value for the rm. The study of nancial management isbuilt upon the hypothesis that judicious nancing, investment and dividend decisionspositively affect the present value of shareholder wealth. Most writers on nancialmanagement arrive at their theories by way of a process of deductive reasoning. Theythen look at data from empirical tests of these hypotheses and from this base buildan armoury of rules and recommendations which help us to analyse opportunitiesand choose the course of action which maximizes shareholder value.

Domestic nancial management is concerned with the costs of nancing sourcesand the payoffs from investment. In the domestic arena, movements in exchangerates are substantially ignored. But when we move outside this purely domestic eld,there is no way that we can analyse international nancing and investment opportu-nities without an understanding of the impact of foreign exchange rates upon thebasic model of nancial management. We are still concerned with raising funds atminimum cost, but there are clearly complications of analysis if a UK-based com-pany is raising funds by way of a Swiss franc borrowing. We are still concerned withinvestment opportunities chosen to create maximum shareholder value, but what ifthe income and cash ow of our UK-based companys investments arise from theUnited States in dollars? Or from Mexico in pesos? And what if exchange controlsplace barriers on remittances of some proportion of prot?

Obviously multinational nance possesses a dimension that makes it far more complicated than domestic nancial management. Indeed we make no bones aboutit multinational nance is a complex area of study. It has been sired by the inter-nationalization of business. If money is the language of business, foreign exchange isthe language of international business. We are therefore deeply concerned in thisbook with foreign exchange markets throughout the world and with the pressuresthat impel exchange rates to move upwards and downwards. In addition to evaluat-ing theories of exchange rate movements, multinational nance is concerned with therisks that ow from holding assets and liabilities denominated in foreign currency.Clearly, the home currency value of such assets and liabilities changes as exchangerates move. Exposure to these changes creates foreign exchange risk. We are concerned not only with dening and classifying foreign exchange risk but also with

1

4 Chapter 1. Introduction

reporting, managing and controlling this risk. But multinational nance is not onlyconcerned with foreign exchange exposure, it also embraces political risk: that is, the exposure which a rm takes on when it enters into business operations locatedoverseas. Again a practical orientation towards the study of multinational nancesuggests that we should focus upon managing and controlling this exposure. A sys-tematic study of nance in the international arena requires that we consider the funding of international trade, the evaluation of cross-frontier investment decisionsand the nancing of overseas associate and subsidiary companies as well as under-standing international nancial markets, the impact of tax regimes in different coun-tries and the ways in which exchange controls affect multinational businesses. Thesetopics are the subject matter of this book.

Multinational nancial management is so riddled with complications that there isa critical need to put the subject over simply. One of the motivations for writing thisbook is that most other texts which devote themselves to international money fail to present a clear picture to their readers. When they do, they are invariably excess-ively wordy. And there are also a good many texts on multinational nance whichapproach the subject at a high level of abstraction and with an emphasis upon math-ematics that could easily be daunting to even the best of MBA students.

Given this background, the intention of the author is that this text should be oriented towards the requirements of students of international nance who need tounderstand the theory and practice of multinational nance. A certain amount ofmathematics is necessary but the intention has been to keep it to a minimum.

The authors assumption is that the readership will be drawn not only from stu-dents but also from businesspeople. Among student readers, it is anticipated thatsome will be aspiring accountants, bankers and treasurers, some will be under-graduates, majoring in multinational business and international nance, and somewill be postgraduates on specialist MSc courses as well as on MBA programmes. It is considered that this text should also appeal to businesspeople drawn from theranks of treasurers, accountants, bankers and corporate planners who require acoherent presentation of the theory and practice of multinational nance. However,inasmuch as there is an increasing need for non-nancial managers line managersand members of a companys top-level decision coalition to understand nance inthe international arena, it is intended that this text should meet their needs too.

It is assumed by the author that readers have a basic knowledge of nancial man-agement. This would probably embrace such topics as sources of corporate nance,the investment, nancing and dividend decision and the efcient markets hypothesis but such knowledge is not necessarily expected to be at a high level of competence.The line manager with a general managers understanding of nance should not bedisadvantaged as he or she explores most of the topics in this text. Summarized, it is presumed that readers are familiar with the following foundation stones of corporate nance:

n The central hypothesis of corporate nancial theory is that the value of the rm (V)is a function of the investment decision (I), the nancing decision (F), the dividenddecision (D) and the management of corporate resources (M). In other words:

V = f(I, F, D, M)

Chapter 1. Introduction 5

n The nancing decision is concerned with the obtaining of funds by the corpora-tion; the investment decision is all about the application of resources so obtainedand the management of resources (M, above) is all about the efciency of runningthe corporate entity. The dividend decision concerns ows of monies back toshareholders and, so the hypothesis goes, since equity investors obtain theirremuneration via dividend, then enhanced dividend ows increase shareholdervalue. So much for the theory, what about the empirical evidence?

n Empirically the evidence suggests that shareholder value is affected by the invest-ment decision, the nancing decision and the management of resources. Evidenceis inconclusive on dividends.

n The investment decision affects shareholder value. Relatively high net presentvalue (NPV) projects create relatively high shareholder value.

n High-returns projects are generally underpinned by market imperfections (forexample, barriers to entry, patent protection, product differentiation and so on).After all, for a project in perfect competition circumstances it should earn a normal prot which, when discounted, should give rise to a zero NPV.

n Over time, the benets accruing to a project usually erode as the market imper-fections themselves are eroded.

n The successful business gives birth to new products and gains from the market imperfection created. And it regenerates old products by seeking new market imperfections.

n The successful business also tries to transfer market imperfections from the homemarket to overseas markets.

n The nancing decision affects shareholder value. The suggestion is that there isan optimum capital structure. Moving towards it creates value for shareholders.

Given the target audience of this book, the mathematics has deliberately been keptat a reasonably unsophisticated level. The authors desire is very much to present acomplex subject in the style of a good communicator. And this means that mathem-atics is our servant, not our god.

It is the intention that this book should be adopted by instructors for class use inteaching multinational nance. Having studied the content of this book, the readershould be able:

n to appreciate the historic background and existing institutional framework ofinternational money;

n to understand the history and nature of Economic and Monetary Union in theEuropean Union culminating in the introduction of the single currency, the euro,by various European countries;

n to understand the roles and signicance of equity and bond markets around theworld;

n to understand the workings and methods of quotation in the foreign exchangemarkets;


n to understand the theoretical relationship between spot and forward exchangerates, interest differentials, expected ination differentials and expectations offuture spot rates, and know how well they stand up in the real world;

n to understand the essence of theories for predicting future exchange rates;

n to understand how to use purchasing power parity data to forecast the futureexchange rate;

n to estimate implied future exchange rates via the international Fisher effect;

n to dene and distinguish different types of foreign exchange risk and recommendappropriate management action given the existence of these different kinds of exposure;

n to design an information system relevant to a multinational companys need tocontrol, cost-effectively, foreign exchange exposure;

n to appreciate the opportunities which the multinational has to control foreignexchange exposure internally that is, without the need to enter into contractswith third parties;

n to understand the essence of eliminating foreign exchange risk via forward mar-kets, nancial futures and currency options;

n to assess the international capital investment decision in a manner consistentwith the parent companys desire to maximize the wealth of its shareholders;

n to obtain a general idea of the mode of working, opportunities and pitfalls created by exchange control regulations in countries in which the multinationalcorporation operates;

n to understand the sources and nature of country risk and political risk for theinternational company and, moreover, recommend appropriate managementaction to mitigate their impact in different circumstances;

n to understand the nature of and participants in the Eurocurrency markets and toassess why there might be opportunities to borrow in the Euromarkets at ratesbelow those in comparable domestic markets;

n to appreciate the problems in nancing an overseas subsidiary and make re-commendations on the most appropriate nancial structure given different setsof circumstances;

n to measure and compare the true cost of borrowing in the international nancialarena;

n to appreciate how currency swaps and Euronote markets work and how marketimperfections create opportunities in these directions for the astute corporate treasurer;

n to understand how corporate tax rules in many countries create opportunitiesand pitfalls for international nancing and cross-frontier operations;


n to understand the nature of project nance and appreciate how it can createvalue for shareholders;

n to understand the opportunities available to nance international trade and min-imize credit risk;

n to understand the difculties and possible solutions to the problem of how tomeasure overseas subsidiary company performance and also appreciate the com-plexity of treasury performance measurement;

n to understand how and, more importantly, where market imperfections createprotable opportunities for the astute international nancial manager.

It is as well for the reader to remember that analysis of international nancial andinvestment opportunities with a view to maximizing shareholder wealth for themultinational investor involves searching out market imperfections and temporarydisequilibria. And these are usually far more plentiful in the international arena thanin its domestic counterpart. Clearly, avoidance of those that are potentially adverseand exploitation of those from which protable outturns seem likely is the recom-mended course of action.

In the remainder of this chapter we describe a few key facts that are pertinent tothe study of nance in the multinational arena. They have been set out here becausestudents of the subject repeatedly nd themselves asking about these topics. It will therefore be as well for readers to bear them in mind as they peruse the text. Thetopics briey considered here are the products that banks market, the creation ofEurocurrency and a range of facts about the size of and participants in the foreignexchange markets.

The reader should be aware that we may denote currencies with their normalabbreviations ($ or a) or their SWIFT codes (USD or EUR). We do this deliberatelyto get students used to these two approaches. A list of world currencies with theirSWIFT codes appears in Appendix 6. (Knowing these stands you in good stead forquizzes!) Where we merely use the term $, it refers to US dollars. For other dollars,like Australian dollars or New Zealand dollars, we tend to use their SWIFT codes,for example AUD and NZD, respectively.

1.1 y What do bankers sell?Banks play a central role in nancial management, whether in the domestic or in theinternational market place. Too often students of nance accept that banks occupythis vital position without asking themselves what kind of services bankers actuallysell.

Most rms have a clearly visible product, for example Ford produces cars andGlaxoSmithKline produces pharmaceuticals. But confusion surrounds what banksactually produce. The answer is that banks basically produce money in the form ofdemand and time deposits. Demand deposits are those where the investor placesmoney with the bank but the money is repayable to the investor without notice thatis, on demand. This contrasts with time deposits where the investor places money


with the bank but the money is only repayable (except with penalty) after the expira-tion of a xed time. Most time deposits involve the bank in paying interest to theinvestor; some demand deposits also attract interest, but some do not. The receiptsfrom these deposits provide the wherewithal to make loans and buy securities andother assets that yield an interest income for the bank. Banks have numerous activ-ities from which they receive fee income. They advise companies, manage trusts andso on. But the bread and butter activity of banking involves trading in demand andtime deposits and loans.

Banks deal with two groups of customers depositors and borrowers. Most bor-rowers are also depositors; some depositors are also borrowers. Business rms tendto be predominantly borrowers. Households tend to be primarily depositors. Banksare intermediaries between the depositors, who want a safe, secure and convenientplace to store some of their wealth, and the borrowers, who want to expand theircurrent production or consumption more rapidly than they can on the basis of theirexisting wealth and current income. The spread or mark-up between the interestrates bankers charge borrowers as against the cost of borrowing covers theirexpenses and is the source of their prots.

Prots in banking depend on four factors. The rst two of these are their market-ing skills in attracting deposits and their investment skills in making loans. Depositscoming in and loans going out appear on the banks balance sheet respectively as liabilities and assets of the bank. The third source of prot is the bankers marketing,innovative and technical skills in rendering off-balance sheet services such as cor-porate nance advice and services relating to international trade. The fourth key toa banks prot is, of course, management skills. Historically, the skills of bankers interms of attracting deposits have been the key in determining how rapidly theirbanks grow. More recently, an emphasis upon off-balance sheet factors has becomemore evident including the intermediation of money to borrowers from lenders andthe practice of innovative services.

Investment skills involve matching the yields on loans and other assets with theirrisks. Riskier loans should attract higher yields. Banks seek those assets that offer thehighest return for the risk. The banks that are best able to determine which assets areunderpriced relative to their risks earn the highest returns. Banks that earn the high-est returns are better able to increase the interest rates they pay on deposits, andhence they can grow more rapidly than their competitors.

1.2 y The creation of EurodollarsThe traditional denition of a Eurodollar is a dollar deposited in a bank outside theUnited States.1 A Euro-yen is a yen deposited in a bank outside Japan. A Eurosterlingdeposit is created by depositing UK pounds in a bank account outside the UnitedKingdom. The term Eurocurrency is used to embrace all forms of Eurodeposits. A certain amount of care needs to be exercised when interpreting information in this eld because the term Eurodollars is sometimes used as a generic term for allEurocurrency deposits.


No mystery attaches to the production of Eurodollar deposits. In essence, the process is the same as when an individual with a deposit in one New York bank transfers funds to another bank in New York. The only difference is that theEurobank in London is across the Atlantic rather than across the Big Apple. If anindividual with a dollar deposit in New York decides to move funds to the Londonbranch of the same bank, the bank ends up producing an offshore dollar deposit. TheLondon bank deposits the cheque in its account in a US bank. The investor nowholds a dollar deposit in a bank in London as opposed to a dollar deposit in a bankin New York. Total deposits of the banks in the United States are unchanged.Individual investors hold smaller deposits in the United States and they hold largerdeposits in London. The London bank now has a larger deposit in the United States.The increase in the London banks deposits in the New York bank is matched by theincrease in dollar deposits for the world as a whole. But it is important to note thatthe volume of dollar deposits in New York remains unchanged, while the volume inLondon increases. To illustrate, take an example. Assume that an investor places$5m in a deposit account in a US bank in the United States (transaction A). Thissame investor subsequently requests his US bank to move his deposit to Londbank,a UK bank in London (transaction B). The T-account entries in the books of the USbank and the UK bank are respectively shown below.

Entries in US bank books

Investor

Transaction B $5m Transaction A $5m

Cash

Transaction A $5m

Londbank

Transaction B $5m

Entries in Londbank books

Investor

Transaction B $5m

US bank

Transaction B $5m


The T-accounts show that the transaction creating the Eurodollars left unchangedthe volume of dollars deposited in the United States and that the Eurodollar depositin London is backed by dollars in a domestic bank account in the United States.

In the domestic economy, the capacity of banks to expand their deposits is limited by the monetary authorities. They determine both the reserve base of the banking system (the supply of high-powered money) and reserve requirements. Butin the external currency market that is, the Euromarkets there are no reserve requirements. Eurobanks sell additional deposits whenever the interest rates they are willing to pay are sufciently high to attract new depositors.

The absence of reserve requirements on offshore deposits does not mean that thereis the potential for an innite expansion of deposits and credit. In the absence ofreserve requirements domestically, there would not be an innite expansion ofdomestic deposits and credit because bankers themselves would maintain prudentialreserves. The growth of offshore deposits is limited by the willingness of investors to acquire such deposits in competition with domestic deposits. For investors, the relevant comparison involves the risk and return on offshore deposits and the riskand return on domestic deposits. The Eurobank system in dollars is an offshoreextension of the domestic banking system, just as the Eurobank system in yen is anoffshore extension of the domestic yen banking system. Eurobanks are offshorebranches of the major international banks.

Dollar deposits in London differ from New York dollar deposits in terms of polit-ical risk. They are subject to the actions of a different set of government authorities.Maybe investors who continue to hold dollars in New York believe that London dollars are too risky, and that the additional interest income is not justied in termsof the possible loss if a move of funds back to New York were somehow restricted, perhaps as a package of exchange controls or an attack on the Eurobanking system.The continued growth in external deposits during the 1960s reected increasing investor condence that the additional risks attached to external deposits were small. The risks of holding dollars offshore seemed small, particularly when viewedin the light of the differential in dollar interest rates on offshore deposits relative to domestic deposits.

One popular explanation for the genesis of the Eurocurrency markets in the 1950sis that the Soviet government agencies wanted to maintain currency deposits in dollars because the dollar was the most accepted currency for nancing their inter-national transactions. They were reluctant to hold their dollars in deposits in NewYork because of the threat that the US authorities might freeze these deposits. So theSoviet dollars moved to London. The Soviets effectively believed that the politicalrisk of London dollar deposits was lower than in New York.

While the Soviets may have been the cause of the rapid growth of offshore depositsduring the 1950s, the big growth in the 1960s reected other factors. The foremostof these was the increasing differential between Eurodollar and domestic interestrates, which made it increasingly protable to escape national regulation. On top ofthis, growth was fuelled by the increasing size of the multinational rm and the greatcompetitive expansion of banks.

Depositors contemplating a move of their funds to the Eurocurrency markets mustdecide whether to acquire external deposits in London, Zurich, Paris or some other


centre. Depositors choose among centres on the basis of their estimates of politicalrisk. This rules out many potential centres where regulation or the threat of regula-tion is evident. Even though there may be an interest rate that would induce lendersto acquire dollar deposits in Soa, banks issuing these deposits would not necessarilyhave the investment opportunities to justify paying such high interest rates.

1.3 y Facts about the foreign exchange marketsFor the majority of foreign exchange markets, there are no individual, physical market places. The market is made up of banks and dealers carrying out transactionsvia telephone and other telecommunication devices. The major players in the marketare as follows:

n Commercial banks, investment banks and merchant banks, which may be dealing foreign currency on behalf of their clients engaged in international tradeor which may be investing, speculating or hedging on their own account or forcustomers.

n Central banks, which may be managing their reserves or smoothing uctuationsin their own currency.

n Foreign exchange brokers, which act as intermediaries between other participants.

n Investment funds, moving from one currency to another.

n Corporations, which require foreign currency for trade or which may be hedgingor speculating.

n High-net-worth individuals who may be investors or speculators.

The high-street bank customer, requiring foreign exchange for travel or holiday pur-poses, is an utterly insignicant participant in terms of the overall market.

The total world foreign exchange market is the largest of all markets on Earth.Trading around the world is estimated almost to have doubled between 1989 and1992 and has increased by around 50 per cent to $1,210bn* per day in 2001, downfrom $1,450bn in 1998. This is well over 100 times the size of the New York StockExchange. The market is a twenty-four hour market which moves from one centreto another from Tokyo to Hong Kong to Singapore to Bahrain to London to NewYork to San Francisco to Sydney as the sun moves round the world.2 Foreignexchange turnover in 1973 averaged a mere $15bn per day.

The largest centre of foreign exchange dealing is located in London with an estim-ated 2001 turnover3 of $504bn per day in 2001, down from $637bn in 1998. Thiscompares with $187bn per day in 1989, $291bn per day in 1982 and $464bn perday in 1995. New York is next in the league table with a daily turnover in 2001

* In this book, unless otherwise stated, $ will always refer to US dollars. One billion means one thou-sand million.


of $254bn (1998 $351bn, 1995 $244bn) and Tokyos daily turnover is put at$147bn (1998 $149bn, 1995 $161bn). Next comes Singapore with a daily gureof $101bn; Germany, Switzerland, Hong Kong and Australia follow with respectivedaily turnovers of $88bn, $71bn, $67bn and $52bn as of 2001. It should be notedthat merely aggregating the above gures indicates a total in excess of the estimatedworld turnover. The apparent anomaly is a result of double counting of individualdeals that involve two centres. Between 1998 and 2001, most centres experiencedfalling turnover as inter-dealer business dropped, being replaced by electronicbroking systems. Also, the introduction of the euro resulted in a decline in overallforeign exchange transactions.

Trade accounts for only 2 per cent of all foreign exchange deals. The lions shareof turnover is made up of capital movements from one centre to another and the taking of positions by bankers in different currencies.

Between 90 and 95 per cent of all foreign exchange transactions involve banks.This high preponderance is reected by banks taking and unravelling positions incurrencies and dealing on behalf of corporate customers. Around 90 per cent of alltrades involve the US dollar. If a Swiss importer wishes to pay a UK exporter, thebank will calculate the Swiss franc/sterling rate as the combination of the Swissfranc/dollar rate and the dollar/sterling rate.

There is a spot market in which deals are arranged with immediate effect and thereis a forward market in which purchase or sale is arranged today at an agreed rate butwith delivery some time in the future. Forward markets do not exist for all curren-cies for example, there is no forward market for some South American currencies.For a few currencies the forward market goes out to ten years or more; for many itis up to ve years; for others it is out to one or two years and for others again it isonly in existence for up to six months. The term deep market refers to those cur-rencies that are widely dealt for example US dollars, euros, sterling. At the oppos-ite end of the spectrum, the term shallow or thin market is applied to currenciessuch as many developing countries currencies which are only occasionally traded.

The foreign exchange market is the cheapest market in the world in which to deal.If one were to start with $1m, switch this into euros and then immediately reversethe transaction so that one returned to US dollars, the proceeds would be less than$1m by the amount of twice the bid/offer spread (the rate for selling and the rate forbuying) for euros against US dollars after all, two deals have been done. But thetotal amount by which one would be out of pocket would only be $250 or so. Formajor currencies, the large banks act as market-makers. This means that they holdstocks of foreign currencies and are prepared to deal in large amounts at stated prices.

Foreign exchange dealers can make or lose a lot of money for the banks whichemploy them. While they can make half a million dollars a day for the bank, they canalso lose this sum. Their salaries and bonuses are high too. Some make $1m perannum. But their business life is strenuous watching currency movements for tenhours per day in the bank (and having a foreign exchange rate screen at home) anddealing on the nest of margins take a toll. Dealers on banks foreign exchange desksseem to be aged between 20 and just over 30. Perhaps beyond 30, reexes are slower;perhaps the adrenaline ows more slowly or maybe dealers have made so muchmoney already that motivation is not quite so great.


1.4 y Summaryn A Eurodollar is a dollar deposited in a bank account outside the United States

(with some exceptions see note 1 at the end of the chapter).

n A Euro-yen is a yen deposited in a bank account outside Japan.

n Eurosterling is represented by pounds deposited in a bank account outside theUnited Kingdom.

n Eurocurrency embraces all forms of Eurodeposit.

n The term Euro-euro is not used. But euros deposited in a bank account outsidethe eurozone area become Eurocurrency.

n The term Eurodollars is sometimes used (loosely and strictly incorrectly) toinclude all Eurocurrency deposits.

n The creation of Eurodollars leaves the volume of dollar deposits in the UnitedStates unchanged.

n Eurodollar deposits are backed by dollars in bank accounts in the United States.

n In the domestic banking market, government regulation is exercised through capital adequacy ratios, reserve asset requirements, the nod and wink and othermeans usually via the central bank and other monetary authorities.

n In the Euromarkets, there is no regulation, therefore no reserve asset require-ments and no other controls.

n Dollars deposited in London or in the United States do not differ in terms ofexchange rate risk but they do in terms of political risk. They do in terms ofcredit risk, if the deposits are with different bankers.

n Signicant participants in the foreign exchange market include commercialbanks, investment banks, merchant banks, central banks, foreign exchange brokers, investment funds and institutions, corporations and high-net-worthindividuals.

n The foreign exchange market is the largest market on Earth.

n Volume as at 2001 was running at an average of $1,210bn per day in excess of100 times that of the New York Stock Exchange. The 1998 gure was around$1,450bn per day.

n The foreign exchange market is a twenty-four hour market.

n The largest trading centre in the foreign exchange (FX) market is London withan estimated 2001 turnover of $504bn per day. Comparable New York guresare of $254bn per day and $147bn per day for Tokyo. Respective gures for1998 were around $637bn, $351bn and $149bn.

n Trade accounts for only 2 per cent of all FX turnover.


Notes

1. This definition is referred to as traditional because, since December 1981, it has been possible for certain US financial institutions to establish, within the United States,international banking facilities, commonly termed IBFs. The IBFs accepting foreigndeposits are exempted from reserve requirements and interest rate restrictions and canmake loans to foreign borrowers. In certain circumstances dollars deposited with an IBFeffectively become Eurodollars.

2. The author is in no way quietly suggesting a resurgence of the Ptolemaic view of theheavens in preference to the Copernican theory. He merely feels that the above form ofwords far better conveys the message than saying as the world moves around the sun!

3. Figures include only spot and forward deals and foreign exchange swaps. Thesetransactions are explained in subsequent chapters.

The international monetarysystem

What do we mean by the international monetary system? Essentially it encompassesthe institutions, instruments, laws, rules and procedures for handling internationalpayments, in particular those in nal settlement of inter-country debts. Money hassometimes been dened as whatever is used in nal settlement of debt. Internation-ally, central banks have come to be the institutions that make nal settlements, andhence the assets they use may be termed international money. Central banks holdreserves of international money. These have also been termed reserve assets.

Prior to the Second World War there was no international central bank. Usuallycentral banks of individual countries made nal settlements through transfers ofgold, sterling or US dollars. A transfer of gold, sterling or US dollars from one coun-try (other than the United Kingdom or the United States) to another (again leavingaside the United Kingdom and the United States) reduced the formers reserve assetsand increased the latters. A transfer of sterling from the United Kingdom to anothercountry could be made by creating sterling deposit liabilities owed to the other coun-try. The same was true for the United States. Thus reserve currency countries (as the United Kingdom and the United States came to be termed) had a different statusfrom that of other countries. They could nance purchases, loans and investments bycreating debt. They were effectively bankers to the world. They could create inter-national money. If other countries had decits in their balance of payments, they hadto export gold or sterling or US dollars, thus reducing their holdings of internationalmoney. But as long as foreign countries accepted dollars or sterling, the United Statesand the United Kingdom could settle decits by creating international money.

In this chapter we trace the international monetary system from before the FirstWorld War to the present time.

2.1 y The gold standardThe international monetary system that operated immediately prior to the 191418war was termed the gold standard. Then, countries accepted two major assets gold and sterling in settlement of international debt. So the term gold/sterling standard might be more appropriate.

Most major countries operated the gold standard system. A unit of a countryscurrency was dened as a certain weight a part of an ounce of gold. It also

2

16 Chapter 2. The international monetary system

provided that gold could be obtained from the treasuries of these countries inexchange for money and coin of the country concerned.

The pound sterling could be converted into 113.0015 grains of ne gold, and theUS dollar into 23.22 grains. The pound was effectively dened as 113.0015/23.22times as much gold as the dollar or 4.8665 times as much gold. Through gold equivalents, the pound was worth $4.8665. This amount of dollars was termed thepar value of the pound.

A country is said to be on the gold standard when its central bank is obliged to givegold in exchange for its currency when presented to it. When the United Kingdomwas on the gold standard before 1914, anyone could go to the Bank of England anddemand gold in exchange for bank notes. The United Kingdom came off the goldstandard in 1914, but in 1925 it returned to a modied version termed the gold bullion standard. Individual bank notes were no longer convertible into gold, butgold bars of 400 ounces were sold and bought by the Bank of England. Other coun-tries adopted either this system or the gold exchange standard, under which theircentral banks would exchange home currency for the currency of some other coun-try on the gold standard rather than for gold itself. The United Kingdom was forcedto abandon the gold standard in 1931.

The gold standard was a keystone in the classical economic theory of equilibriumin international trade. The currency of countries on the gold standard was freely con-vertible into gold at a xed exchange rate and enabled all international debt settle-ment to be in gold. A balance of payments surplus caused an inow of gold into thecentral bank. This enabled it to expand its domestic money supply without fear ofhaving insufcient gold to meet its liabilities. The increase in the quantity of moneytended to raise prices, resulting in a fall in the demand for exports and therefore a reduction in the balance of payments surplus. In the event of a decit in the balanceof payments, the reverse was expected to happen. The outow of gold would beaccompanied by a relative money supply contraction, resulting in exports becomingmore competitive and the decit automatically becoming corrected.

The adoption of the gold standard began in the United Kingdom early in the nine-teenth century. An attempt was made in the 1860s by a number of European coun-tries to establish the Latin Monetary Union, involving bimetallism for gold andsilver. The intention was that both gold and silver should be used for internationaldebt settlement. But the establishment of the gold standard in Germany in 1871,together with less demand for silver in other areas, led to a diminished use of silveras international money. The United States was forced to abandon redemption ofpaper money in metal during the Civil War, but the redemption of paper money forgold began in 1879.

Key dates for the adoption of the gold standard in selected countries are summar-ized in Table 2.1.

The First World War had a serious effect on the international monetary system.The United Kingdom was forced to abandon the gold standard because of thewartime decit on its balance of payments, and its reluctance at that time to providegold to settle international differences. This was, perhaps, the beginning of a reduc-tion in condence in sterling as an international reserve asset.

Chapter 2. The international monetary system 17

Many other countries abandoned the gold standard temporarily, but none had thesame signicance as the action of the United Kingdom because sterling had nanced90 per cent of world payments. The UK government, recognizing the importance ofsterling and of UK institutions in international nance, wished to return to the goldstandard as soon as possible. Delay occurred because of the recession in the UnitedStates in 1920 and 1921, coupled with the post-First World War ination, whichreversed itself as rapidly as it had occurred. Recovery came in the United States, anda degree of recovery also occurred in the United Kingdom. After its disastroushyperination, ending with the value of the mark at 4 trillion to the dollar, Germanyalso experienced stabilization and returned to the gold standard in 1924.

The gold standard to which major countries returned in the mid-1920s was dif-ferent from that which had existed before the First World War. The major differencewas that instead of two international reserve assets gold and sterling there wereseveral. Both the United States and France had become much more important ininternational nance, and dollar and franc deposits were used for much nancing.However, generally speaking, countries other than the United Kingdom had onlysmall amounts of gold. When some countries, including France, accumulated sterlingbalances, they sometimes attempted to convert these into gold, drawing upon theUnited Kingdoms gold reserves. When sterling had been the only international cur-rency apart from gold, operating the international monetary system had not beendifcult, but when there were a number of countries whose bank deposits constitutedinternational money, and when condence in different currencies varied, the systembecame more difcult to operate.

A second important difference was that exibility in costs and prices no longerexisted as it had before the First World War. This was especially important in theUnited Kingdom which had returned to the gold standard based on pre-war par values. But only with a decline in relative costs and prices could the former par value

Table 2.1 Dates for the adoption of the gold standard

United Kingdom 1816Germany 1871Sweden, Norway and Denmark 1873France, Belgium, Switzerland, Italy and Greece 1874Holland 1875Uruguay 1876United States 1879Austria 1892Chile 1895Japan 1897Russia 1898Dominican Republic 1901Panama 1904Mexico 1905

Source: Chandler (1948).


of the pound have been maintained in the long run. Given that exibility in costs andprices was lacking, condence in sterling deteriorated, culminating in the UnitedKingdom abandoning the gold standard in 1931. Most other countries followed theUK example in quitting the gold standard.

But there were other forces impinging on the United Kingdom in the early 1930swhich also had a signicant effect on its decision to discard the gold standard. Twoof these were the Great Depression of the late 1920s and early 1930s and the inter-national nancial crisis of 1931; each of these topics is now summarized with a focusupon their impact on the international monetary system.

2.2 y The Great DepressionA detailed discussion of the causes of the Great Depression is outside the terms of reference of a work of this sort. Nonetheless various questions may spring to thereaders mind. Some of these are pertinent to the international monetary system; some are not. To what extent was the stock market crash in 1929 a cause of theDepression? How did the big contraction in money supply contribute to a decline inbusiness activity? Was the decline in rates of prot, which began in 1929, signicant?Some of the explanations propounded do have signicance in terms of their effectson the United Kingdom and the gold standard.

One such is the fact that the expansion in money and credit in the late 1920s in theUnited States was greater than that needed for trade and commerce, and the excessfound its way into stock market and real estate speculation. When the credit expan-sion ceased, stock market levels and real estate prices fell. A relevant question is whythe expansion of money and credit did not result in a greater increase in either realoutput or prices of commodities and services. And one possible answer is that wagerates did not increase much, with the result that consumer spending did not rise suf-ciently to cause any marked rise in either real or nominal gross national product (GNP).

Interest rates and the availability of credit in the United States are inextricablylinked to the United Kingdoms plight. Following the sharp rise in stock marketprices in 1927 to 1929, the Federal Reserve Bank raised the discount rate as part ofthe classical prescription for slowing the growth of money supply. This resulted inhigher interest rates in the United States and this had the tendency to attract foreignfunds particularly from the United Kingdom. Remember that we are talking aboutan environment with xed exchange rates. So funds moved out of the UnitedKingdom to take advantage of higher relative interest rates at the same time as goldwas leaving the country because of the United Kingdoms overvalued exchange rate.

Discussing the Depression, Friedman and Schwartz (1963) have argued that whatbegan life as a minor recession was transformed into a major depression because asbusiness declined, the money supply was reduced. With the United States committedto deation accompanied by a reduction in its money supply, the impact on the rest of the world was devastating. Friedman and Schwartz demonstrate impressiveevidence of a correlation between declines in business activity and declines in themoney stock, not only during the Great Depression but in the ve other instances


between 1867 and 1960. They point out that in each case the decline in the moneysupply preceded the decline in business activity.

Furthermore, the United States had imposed import restrictions in 1922 and againin 1930. Countries heavily dependent upon exports found their incomes fallingsharply, their unemployment levels rising and their consumption falling. They couldnance their essential imports neither from their exports nor from their reserves.

Add to a world economic system under strain the precariousness of an inter-national monetary system, balanced like an inverse pyramid upon a relatively smallbase of gold holdings, and our structure is weak indeed. Strains on those countrieswithout substantial gold holdings could cause difculties for the gold exchange standard countries. Moreover, strains on a gold standard country resulting in a owof gold reserves to another country could easily precipitate a nancial crisis. Manyeconomists are convinced that the supply of gold at that time was inadequate to support the international nancial structure of the day.

Exchange rates were out of line with cost structures in different countries. TheUnited Kingdoms return to the old par value for sterling was undoubtedly an error;Frances devaluation of the franc in the 1920s was too great; fundamental dis-equilibria existed. And the system was inadequate to cope with them. Faced with anovervalued currency in deep depression, one of the United Kingdoms responses wasto abandon the gold standard.

2.3 y Exchange rates: 1914 to 1944With the First World War, the stability of exchange rates for major currencies ended.This had been a key feature in the international monetary system before 1914. Whenthe First World War began, the combination of payments via London for importsunder bank credits and acceptances of London merchant banks together with uttercondence in sterling meaning that there were no signicant withdrawals of ster-ling deposits caused the exchange rate for the pound to rise sharply. Sterling roseas high as $7 to the . But as wartime expenditures occurred the sterling exchangerate began to fall, and it had dropped as low as $3.18 by early 1920.

As explained earlier in this chapter, the early 1930s saw the international monet-ary system then in use begin to disintegrate. By the beginning of 1933 the majoreconomies of the world could be categorized as those of the gold bloc (France,Switzerland, the Netherlands and Belgium) which maintained the value of their cur-rencies in terms of gold; those that maintained their currencies values by strictexchange controls (such as Germany) enforced under a dictatorship; and those thatpermitted their currencies to depreciate. Many currencies depreciated by as much as35 to 50 per cent during the rst half of the decade. Those countries that did not per-mit their currencies to depreciate for example, the United States, France, Belgium,Switzerland and the Netherlands resorted to strong deationary pressures. A fre-quent complaint was that some countries deliberately encouraged currency depreci-ation, engaging in a beggar-my-neighbour policy. International trade was at a lowlevel, and international capital ows virtually stopped.


The depreciation of currencies in the 1930s especially that of the pound (see Figure 2.1) meant a decline in the foreign exchange component of internationalreserves relative to the gold component. With limited production of gold and withstrong ows thereof to the United States, most countries found their gold holdingsreduced. Large uctuations in exchange rates, accompanied by low levels of inter-national trade and world depression, led to inuential calls in the late 1930s andearly 1940s in favour of a return to a stable exchange rate environment.

However, the Second World War led to more extensive and tighter controls on international trade and investment. Transactions with enemy countries becameillegal, and much of the trade between friendly nations consisted of munitions andwarfare supplies. Private markets (as opposed to inter-governmental ones) for mostcurrencies almost ceased to exist. Much of the trade that continued was under vari-ous inter-governmental agreements. But even the inter-governmental transactionsthat took place then were generally either barter transactions or grants made to carryon hostilities against the enemy. There was virtually no role for international nance.Foreign exchange markets, exchange rates and other institutional mechanisms wereeffectively suspended during the war and were not re-established until the war ended.Trade controls and exchange controls frequently meant that the usual methods ofnancing could not be used. So the nancing of trade was not an urgent problemduring the war.

By the end of the Second World War, many commentators, bankers and econom-ists were agreed upon the need for a new monetary system. Sterlings dominance ofinternational trade had gone; the era of the gold standard was passed. Governmentsmight have waited for a new international monetary order to evolve to replace the

Figure 2.1 The sterling/dollar exchange rate, 191939 (range based on monthly averages).


system that had worked well before 1914 but which had failed in the period from1914 to 1944. However, this would have meant uncertainty. Action was urgentlyneeded. The action taken stemmed from the Bretton Woods agreement and saw thecreation of a new international institution, the International Monetary Fund. Themonetary system that emerged from Bretton Woods occupied the international stagefor the immediate post-1945 period through to 1971.

2.4 y The Bretton Woods systemThe framework for a new international monetary system was created in July 1944 inthe United States at Bretton Woods, New Hampshire. The prime movers were JohnMaynard Keynes and Harry Dexter White, the respective UK and US representatives.The key innovations of the Bretton Woods agreement were as follows:

n A new permanent institution, the International Monetary Fund (IMF), was to beestablished to promote consultation and collaboration on international monet-ary problems and to lend to member countries in need due to recurring balanceof payments decits.

n Each fund member would establish, with the approval of the IMF, a par value forits currency and would undertake to maintain exchange rates for its currencywithin 1 per cent of the declared par value. Countries that freely bought and soldgold in settlement of international transactions were deemed to be adhering tothe requirement that they maintain exchange rates within 1 per cent margins.Hence the United States, the only country that met this condition, was notexpected to intervene in the foreign exchange markets. Other countries wouldintervene by buying or selling dollars against their own currencies, to keep theirrates within 1 per cent of their parities with the dollar.

n Members would change their par values only after having secured IMF approval.This approval would be granted only if there were evidence that the country wassuffering from a fundamental disequilibrium in its balance of payments. It wasgenerally agreed that a long and continuing large loss of reserve assets in supportof an exchange rate would be evidence of this fundamental disequilibrium.

n Each IMF member country would pay into the IMF pool a quota, one-quarterbeing in gold with the remainder in its own currency. The size of the quota wasa function of each members size in the world economy.

n The IMF would be in a position, from the subscription to quotas, to lend tocountries in ongoing decit.

A new monetary framework was thus established which created xed exchange rates subject to alteration should fundamental disequilibria emerge. Since there wasa mechanism for discontinuous adjustment to exchange rates, the system becameknown as the adjustable peg system.


During its early years, the Bretton Woods system played a positive part in a rapidexpansion in world trade. However, its success obscured one of its basic short-comings there was no provision for expanding the supply of international reservesnecessary to support growing trade ows. The unmet demand for international re-serves eventually led to increased holdings of national currencies and in particular itstrengthened the US dollars position as an international reserve currency.

The dollars expanding role in international trade and nance raised new prob-lems in monetary relations. This difculty has been referred to as the Trifn dilemmaafter Trifn (1960) who focused attention upon it. Because the US dollar played thepart of a reserve currency, US balance of payments decits were necessary in orderto increase international liquidity. But as US liabilities to foreign central banks grew,so condence in the convertibility of dollars into gold wavered. US gold reserveswere becoming a decreasing fraction of foreign liabilities. This method of providinginternational liquidity could continue only as long as no central bank attempted arun on the US gold reserves. Concern over this dilemma led to the introduction of anew international reserve asset administered by the IMF. This asset, the specialdrawing right (SDR), was proposed and ratied in 1969.

SDRs were allocated to individual countries by the IMF through the deliberate decision of IMF members to accept them as a new form of international reserve. These credits were allocated to IMF members in proportion to their quotas ratherlike a bonus issue of shares in a company. A country holding SDRs may use them toacquire foreign currency by transferring them, via the IMF special drawing account,to another country in exchange for foreign currency. Only member states of the IMFand certain designated ofcial institutions may legally hold SDRs.

2.5 y The role of gold up to 1971Gold has long existed as a medium of international exchange. But in its role as areserve asset it has signicant shortcomings. First, it is wasteful to use a commoditywith a signicant positive cost of production to perform a function that couldequally well be performed by a nancial instrument with a zero cost of production.Secondly, the use of gold gives benets to the country where the gold is produced andwhich may not necessarily benet the world economy. And there have been objec-tions to the political nature of the worlds largest gold producer, South Africa.Thirdly, the increase in the supply of gold may not reect the worlds increasing needfor extra international liquidity. Indeed increases in gold supplies may be unrelatedto the worlds needs. They may be inuenced, though, by the need for foreignexchange on the part, for example of South Africa.

The price of gold was xed in 1933 at $35 an ounce and this xed value held upto the early 1970s. Since the currencies were xed in relation to the dollar, centralbanks could exchange their currencies for dollars and with their dollars they couldobtain gold. The US Federal Reserve Bank was willing to buy and sell gold at thisrate. This willingness of the United States to back the world monetary system isunderstandable given that the United States, at the end of the Second World War,


had a gold stock valued at $20bn or 60 per cent of the total of ofcial gold reserves.As long as the dollar and its gold backing was considered invulnerable, foreign cent-ral banks had an incentive to hold currencies, which earned interest, rather thangold, which earned nothing.

In 1954 a gold market was opened in London in which private buyers and sellerscould operate. A central bank gold pool of $80m was set up in 1962. The gold poolwas an arrangement among eight countries, including the United States, to sell orbuy gold in the free market to keep the price close to the ofcial price of $35 anounce. France left the gold pool in 1967.

By the late 1960s there existed a situation whereby the dollar had become con-vertible into gold not only by foreign central banks but also by private speculatorsall over the world. Until 1968, under the gold pool arrangement, major central banksclubbed together to hold the gold price at $35 an ounce. As there was no prospect ofthe gold price going down, but a good prospect of it going up, this gave speculatorsa one-way option. In 1968 central banks were forced to set the gold price free forcommercial transactions. However, for settlements between themselves, they agreedto stick to the old price and not to sell gold on the free market. The central banksexpected that under this two-tier gold system, the free-market gold price would staywithin easy reach of the ofcial price. It did not do so for long.

Increasingly, xed exchange rates were becoming more and more difcult todefend and various governments around the world were very reluctant to devalueand revalue despite what many would have described as fundamental disequilibria.In other words, national governments were abusing the system.

In 1971 the system was clearly under pressure on two fronts the xed gold priceand xed exchange rates made little sense. Matters were brought to a head whenPresident Nixon, as a preparation to the 1972 election, sought to expand demand inthe United States. Speculation against the dollar mounted and many central banks incontinental Europe and Japan were forced to buy dollars to keep their currencieswithin the narrow bands required by Bretton Woods rather than rising, which eco-nomic and speculative pressures were favouring. The free-market gold price rosesharply. This led several countries to demand conversion of their surplus dollars intogold at the ofcial price of $35 per ounce. The United States, with $10bn in goldreserves versus liabilities of $50bn in other countries reserves, decided to suspendconvertibility in August 1971 and the US dollar was set free to oat.

There being considerable anxiety about the international monetary system, a con-ference of nance ministers was summoned in December 1971 at the SmithsonianInstitute in the United States. The so-called Smithsonian Agreement resulted. Thisincreased the xed exchange rate band spread to 4.5 per cent, allowing central banksmore room for manoeuvre before intervention became necessary. At the same timeupward revaluations of various currencies against the US dollar were agreed, withthe dollar formally devaluing against gold. The price of the metal was increased from$35 per ounce to $38 per ounce an effective dollar devaluation of 9 per cent.

The dollar-based international monetary system continued to function for justover another year, when the failure of the US balance of payments to respond to thedollars initial devaluation led to a second realignment. The dollar was devaluedagain in February 1973; this raised the ofcial gold price to $41.22 per ounce. But


this realignment was almost immediately brought under excessive strain when a newexchange crisis emerged in March 1973 and European central banks refused to buydollars. In mid-March the Bretton Woods era nally crumbled when fourteen majorindustrial nations abandoned the adjustable peg and allowed their currencies to oatagainst the dollar. But we are not universally in a oating exchange rate world now,as we shall see shortly.

2.6 y The Second AmendmentFollowing abandonment of pegged exchange rates in March 1973, oating exchangerates were introduced for many countries. In Europe, the opinion was widespreadthat oating should be only temporary, a view most forcibly expressed by theFrench. In the United States, opinion favoured a continuing oat.

Discussions at summit level moved from Rambouillet in France in November 1975to Jamaica in January 1976 and culminated in a new IMF article on exchange ratepractices. This amendment, the second in the history of the IMF, was ratied by therequired majority and became effective on 1 April 1978.

The Second Amendment provided for the reform of three key aspects of inter-national monetary relations. First, it allowed substantially more exibility in themanagement of exchange rates and expanded the IMFs responsibility for supervis-ing the international monetary system. Secondly, it altered the nature of the SDR toincrease its attractiveness as an international reserve asset. And nally, it simpliedand expanded the IMFs ability to assist members in nancing short-term imbalancesin their international payments accounts.

Under the rst innovation, IMF members are expected to collaborate with thefund and other members to assure orderly exchange arrangements and to promote a stable system of exchange rates (IMF, 1978). Their method of collaboration is leftto members discretion.

Members obligations regarding their exchange practices are specied underArticle IV of the funds Articles of Agreement. Under this amended article (IMF,1978), each member shall:

n endeavour to direct its economic and nancial policies towards the objective offostering orderly economic growth with reasonable price stability, with dueregard to its circumstances;

n seek to promote stability by fostering orderly underlying economic and nancialconditions and a monetary system that does not tend to produce erratic disruptions;

n avoid manipulating exchange rates or the international monetary system in orderto prevent effective balance of payments adjustment or to gain an unfair com-petitive advantage over other members.

In April 1977, the IMF adopted principles (IMF, 1977) to provide additional guid-ance in the choice of an exchange policy. These principles of exchange rate manage-ment state that:


n a member shall avoid manipulating exchange rates or the international monetarysystem to prevent effective balance of payments adjustment or t

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A. Buckley_Multinational Finance