Lecture 5

1. Lecture 5 International Finance ECON 243 – Summer I, 2005 Prof. Steve Cunningham

2. International Lending • International capital movement: the flow of capital claims between lenders and borrowers across international boundaries. • These are usually broken down by: • Private vs. Government (official) • Long term vs. Short term • Note that we do not differentiate between equity and debt, other than equity positions are always considered long term. • What is “equity”? “Debt equity”?

3. Breakdown of Capital • Private lending and investing • Long Term • Direct Investment (lending to or purchasing shares in, a foreign enterprise largely owned and controlled by the investor) • Loans (to a foreign borrower) with maturity of more than one year, mostly by banks • Portfolio Investment (purchasing stock or bonds with a maturity of more than one year, issued by a gov’t or foreign enterprise not controlled by the investor) • Short Term (lending to a foreign borrower, or purchasing bonds issued by the gov’t or a foreign enterprise not controlled by the investor, maturing in a year or less) • Official lending and investment (by a gov’t or institution like the IMF or World Bank. Mostly lending, both long term and short term.

4. Who is doing the lending? • From WWII until the early 1980s, the U.S. was the single largest lender, joined in the 1970s by the newly rich oil exporters. • The major type of lending was official loans from governments and direct foreign investments (DFI) • Since the early 1980s, the dominant lender has been Japan. • The major type of lending has been private loans and portfolio investment.

5. Benefits of Int’l Lending • It amounts to intertemporal trade • The lender gives up resources today in order to receive more in return in the future. • The borrower gets resources today, but will be able to generate more product in the future, which he must share with the lender. • It allows lenders and investors to enjoy broader diversification, lowering the overall risk of their portfolios. • What is diversification? • There may be no equivalent domestic investment/lending opportunity.

6. Gains to Lending and Borrowing • Optimality depends upon: • The world being stable and predictable, • Borrowers fully honoring their commitments to repay • In such a world, lending is Pareto optimal. • The welfare effects of international lending exactly parallel the welfare effects of free trade.

7. Gains from Int’l Lending • Free international lending raises world product and national incomes—world product is maximized. • If a country is dominant enough to have power over the world market rate of return, it can exploit this market power to its own advantage, at the expense of other countries, and the world as a whole. • Just as oil producers are able to raise world oil prices by controlling supply, a world lender (like Japan) could raise world interest rates.

8. Lending Among Industrialized Countries • Int’l lending and borrowing between industrialized countries is generally well-behaved and nonpredatory. • This may be because even though one country may dominate lending, other countries have other areas that they dominate, and each is afraid of retaliation in another market. • Also, these countries present little default risk. • The record of int’l lending by industrialized countries to developing countries has been quite different. • It has been risky, highly political, and, at times predatory.

9. Lending to Developing Countries • A developing country sometimes runs into problems, and is unable to service its debts. • Such countries sometimes must default—fail to make their loan payments as required under the loan agreements. • Lenders then cut back or stop new lending, worsening the problems within the developing country.

10. 1974 - 1982 • Oil shocks of the 1970s led to a surge in private int’l lending to developing countries. • Between 1970 and 1980, developing country debt increased by 7 times. • Oil shocks caused the price of oil to skyrocket, causing high inflation and recession in the industrialized countries. • The windfall profits to the oil producers went primarily to saving (and lending), reaching investments in the U.S. and world money centers. • Productivity was not growing in the large, industrialized nations, so people were becoming pessimistic about the profitability of capital formation in these countries. Therefore, the lenders targeted developing nations. • Developing countries had also come to dislike FDI because it meant giving up domestic control of its businesses. This made more attractive. • Banks too aggressively sought to lend, taking on too risky loans.

11. Debt Crisis of 1982 • August 1982, Mexico defaults on its large foreign debt. Other countries quickly followed with defaults. • In 1982, driven by fed actions attempting to end the high inflation of the 1970s, interest rates in the U.S. increased sharply. • The U.S. and other industrialized countries fell into deep recession. • Developing countries’ exports and export prices fell dramatically. • Their interest payments were rising, but their revenues were falling!

12. Debt Crisis of 1982 (Continued) • With such large loans defaulting, some banks were in financial danger. • Larger banks couldn’t get rid of the bad loans, and wound up rescheduling the payments and making more smaller loans to allow the gov’ts to attempt to work through their short-term problems. (“Too large to fail” problem.) • While this prevented immediate problems, it greatly reduced the flow of lending to these countries.

13. Debt Crisis of 1982 (Continued) • Brady Bill • U.S. Treasury plan to help the debtor countries restore growth and financial viability. • The debts were reduced and most of the remaining debt was refinanced at much better terms via “Brady bonds.” • By 1994 most of the bank debt had been converted and repackaged as bonds. • The debt crisis was over.

14. 1980-2001Long-term financial flows Billions of U.S. dollars

15. The 1990s • Around 1990, lending to developing countries began to recover. • The Brady Plan restored confidence. • As each country agreed to a Brady deal, it was usually able to achieve private loans immediately. • U.S. interest rates were very low. • The gov’ts of developing countries, eager to attract capital, made changes that made them much more attractive to lenders. • Deregulation • Privatization of gov’t-owned enterprises • Trade policy liberalization

16. Mexican Crisis, 1994-1995 • Investors began to move heavily into Mexico in the early 1990s when that country made significant economic reforms and entered NAFTA. • The exchange rate of the peso rose. • Mexican inflation was higher than the U.S. • Mexico’s CA deficit rose to 8% of its GDP in 1994. • Mexican bank supervision and regulation was poor by int’l standards. • Bank lending grew rapidly, as did defaults. • 1994 was an election year, there were two political assassinations, and an a political uprising, leading to concerns about the stability of the government.

17. More on theMexican Crisis, 1994-1995 • These events put increasing downward pressure on the peso. The gov’t used sterilized intervention to defend the exchange rate, causing a drain on int’l reserves. • The gov’t replaced the peso-denominated debt with short-term dollar-indexed gov’t debt (tesobonos). • The citizens began to fear currency devaluation, and capital flight ensued. This created a huge supply of pesos on the int’l market. • The Mexican gov’t was forced to allow the peso to depreciate against major currencies, and attempted to “roll over” the dollar-indexed debt. • Investors refused to roll-over in tesobonos, and wanted to receive repayment of principal in dollars. Mexico could probably not repay them all at once… • Investors pulled out of Mexico, but also many other developing (esp. Latin American) countries—the “tequilla effect”. • The U.S. arranged a bail-out package, allowing Mexico to borrow up $50 billion from the U.S. and the IMF.

18. The Asian Crisis, 1997 • Impressed with their rapid growth rates, budget surpluses, liberal trade policies, and low inflation, investors were attracted to Southeast and East Asian countries in the 1990-1996 period. • Gov’t bank regulation and supervision was poor. Banks took on excessive risks by engaging in foreign exchange speculation, and risky local lending practices. • Probably as a result of high real exchange rates, the countries began to suffer worsening trade balances. • In 1996, the prospect of worsening export sales caused a collapse in Thailand’s stock market. The Thai real estate market began to dive. Finally the exchange rate of the Thai baht took a nosedive, and the gov’t had to let it depreciate in 1997.

19. More on The Asian Crisis, 1997 • Those Thai citizens with uncovered positions began to sell off baht to move into foreign currency assets. • Banks that had speculated and made risky loans came under pressure. • The fear spread to other Asian countries, especially Indonesia, Korea, Malaysia, and the Phillipines. • The IMF put together a large array of loan packages to the countries involved.

20. The Russian Crisis, 1998 • Russia still hasn’t solidified its economic position since the break-up of the USSR. • In 1998 it had large fiscal budget deficits and heavy government borrowing. • Ultimate, lenders said “no more”. • The IMF organized a bail-out including a credit line of $23 billion, with the IMF contributing $5 billion. • Russia failed to enact policy changes required as conditions for the loan package. • Capital flight ensued, and the ruble crashed. This was followed by a collapse in Russian stock and bond prices.

21. More onThe Russian Crisis, 1998 • In August 1998, Russia unilaterally defaulted on ruble-denominated debt, wiping out most of the value due the lenders. This nearly brought down Brazil, who required an IMF loan to survive. Brazil floated its currency, the real. • It placed a 90-day freeze on payments of foreign currency obligations to protect Russian banks. • It allowed the ruble to float and depreciate. • Russia asked for the next installment of loans from the IMF, but given these actions, the IMF refused. • Foreign investors were in shock, and pulled out of any and all Russian investments they could. • The stock market crashed.

22. The Brazilian Crisis, 1999 • Brazil was hard hit by the Russian crisis. • In November 1998, the IMF arranged for Brazil to be able to borrow up to $41 billion, but demanded fiscal reforms. • Brazil had a large current account deficit. • Brazil was defending a crawling exch rate with intervention and high interest rates. • January 1999, Brazil allowed its currency to float, and the real depreciated. • Brazil’s banking system remained sound, and ultimately Brazil was able to sell new bonds to foreign investors.

23. The Turkish Crisis, 2001 • Turkey had borrowed continually from the IMF since 1958. • In January 2000, Turkey borrowed $8 billion more from the IMF and World Bank. As part of the deal, Turkey pledged to: • Reduce its inflation rate (100%) • Improve bank regulation • Privatize state-owned businesses • End subsidies • Reduce its fiscal deficit • Adopt a crawling exchange rate, pegged to the euro and dollar

24. More onThe Turkish Crisis, 2001 • Turkey made progress on inflation, but: • Continued to run large budget and current account deficits • Suffered more bank corruption • Foreign lenders pulled back • Overnight interest rates rose to 2000% • The IMF promised $7.5 billion more in loans • February 2001, the gov’t was in gridlock over passing reforms, interest rates skyrocketed, and the gov’t was expending enormous resources trying to defend its fixed exchange rate. • The gov’t finally gave up and let the lira float. It lost a third of its value in two days. Banks too huge losses. • More IMF loans…

25. Financial Crises: What goes wrong? • It seems that five major forces can and do lead to financial crises: • Waves of over-lending and over-borrowing • Explain in next slide • Exogenous international shocks • Can make repayment difficult • Exchange rate risk • Can make repayment difficult • Fickle international short-term lending • Countries structure their debt badly, relying too much on short-term loans • Global contagion (social psychology, herding behavior, generalizing notions, reacting on too little information)

26. Over-borrowing/Over-lending • Is this a coordination failure? Herding behavior? • Investors all move toward what appears to be a region with high expected returns. • Too much is lent and borrowed. • This leads to debt-overhang: the amount by which the debt obligations exceed the present value of the resource transfer that will be made to service the debt. (Trans.: They can’t possible make a high enough return to pay their loan payments!) • For the borrower, the benefits of default exceed the costs!

27. Rescue Packages • Structure and Purposes: • Loans in the package compensate for lack of availability of private lending during the crisis. • Restore investor confidence by supporting the currency and government. Hopefully, this will help reduce the capital flight. • Reduce contagion effects that could spread the crisis to other countries. • IMF imposes conditions requiring policy changes to change the fundamentals. This usually includes tighter money (anti-inflation policy) and tighter fiscal policy (reduced deficits and gov’t debt). May include tightening regulation of banks and trade liberalization.

28. Can this lead to a moral hazard? • Moral hazard: insurance leads the insured to to be more less careful and more likely to incur the very thing that the insured is trying to protect against. The insurance makes the event less costly.

29. Handling the Debt • Debt restructuring is simply changing when the payments are due, allowing the borrower more time to make the payments. • Debt reduction lowers the amount of debt. Banks or gov’ts either “forgive” part of the debt in an effort to get some of their principal back (instead of none). This leads to “too big to fail.” Governments or IMF may used its funds or issue bonds to pay off some of the private debt. • There is a coordination problem with either as individual lenders try to hold out. Each wants the others to make the adjustments so that they can get all of their principal back now. This is a form of the free-rider problem.

30. DFI: The Fear • Developing countries are afraid that foreigners will end up owning all the industry, and therefore re-patriot all the profits. Morever, they fear that this will reduce the long-term prospects for raising their standard of living. • Perhaps this is a fear of colonization? • What about national security issues? Do you want foreigners controlling critical industries?

31. DFI: The Fear (Continued) • For this reason, developing countries often require: • A significant degree of local ownership and management, • Local R&D, • Local training programs, • Locally purchased raw materials, • Profits to stay in the country (perhaps through tax laws)

32. DFI: The Incentives • To attract DFI, countries offer: • Subsidies • Tax incentives • Free real estate • Special privileges

33. DFI • Direct foreign investment is defined as any flow of lending to, or purchases of ownership in, a foreign enterprise that is largely owned by residents (usually firms) of the investing country. • A multinational firm is a firm that controls enterprises in more than one country. Often this involves a parent corporation and foreign subsidiaries.

34. DFI (Continued) • Often little financial capital is moved initially. By borrowing in the country in which they are investing, the firm can minimize: • Exchange rate risk, and • Political risk. • What is more important is the firm’s intangible assets—its name, its reputation, its management skill, its technology, its marketing skills and access to markets.

35. Why DFI? • It is a form of financial capital flow, seeking the highest risk-adjusted return. • Does not explain why firms would choose to establish managerial control over the firm. • Perfect competition? Probably not. • DFI is not easy to accomplish. It is hard to run companies at a distance, and the investing firm does not know the local market, laws, customs, etc. • DFI does not happen randomly.

36. DFI as Imperfect Competition • The Hymer View • In essence, the DFI investor is seeking a monopoly or oligopoly position in a market. • The investor seeks to fight off competition and protect its market power. • The investor seeks to preserve market share or preemptively establish market share. • This is defensive investment.

37. DFI as Imperfect Competition • The Appropriability Theory (Magee) • The firm wishes to appropriate all available potential gains, and often finds that it is better to keep control and ownership to do this. • If it did not keep such control, its firm-specific advantages might be lost. • The firm also would not want to share its secrets with a foreign partner who might eventually become a competitor.

38. Tax Issues • Firms seek out the best tax environment for their operations as they attempt to minimize their tax liability. They shop taxes. • Multinational firms engage in international transfer pricing to move profits to the lowest tax countries. • Much of international trade occurs as intra-firm trade, between units of the multinational firm located in different countries.