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International Finance. FIN45 Michael Dimond. The Balance of Payments. The measurement of all international economic transactions between the residents of a country and foreign residents is called the Balance of Payments (BOP) The IMF is the primary source of similar statistics worldwide
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International Finance FIN45Michael Dimond
The Balance of Payments The measurement of all international economic transactions between the residents of a country and foreign residents is called the Balance of Payments (BOP) The IMF is the primary source of similar statistics worldwide Multinational businesses use various BOP measures to gauge the growth and health of specific types of trade or financial transactions by country and regions of the world against the home country
The Balance of Payments Monetary and fiscal policy must take the BOP into account at the national level Businesses need BOP data to anticipate changes in host country’s economic policies driven by BOP events BOP data may be important for the following reasons BOP is important indicator of pressure on a country’s exchange rate, thus potential to either gain or lose if firm is trading with that country or currency Changes in a country’s BOP may signal imposition (or removal) of controls over payments, dividends, interest, etc BOP helps to forecast a country’s market potential, especially in the short run Rule of thumb to understand the BOP: follow the cash flow
Fundamentals of BOP Accounting The BOP must balance Elements in measuring international economic activity: Identifying what is/is not an international economic transaction Understanding how the flow of goods, services, assets, money create debits and credits Understanding the bookkeeping procedures for BOP accounting
Typical BOP Transactions Examples of BOP transactions from US perspective Honda US is the distributor of cars manufactured in Japan by its parent, Honda of Japan US based firm, Fluor Corp., manages the construction of a major water treatment facility in Bangkok, Thailand US subsidiary of French firm, Saint Gobain, pays profits (dividends) back to parent firm in Paris An American tourist purchases a small Lapponia necklace in Finland A Mexican lawyer purchases a US corporate bond through an investment broker in Cleveland
Defining International Economic Transactions Current Account Transactions The export of merchandise, goods such as trucks, machinery, computers is an international transaction Imports such as French wine, Japanese cameras and German automobiles are international transactions The purchase of a glass figure in Venice by an American tourist is a US merchandise import Financial Account Transactions The purchase of a US Treasury bill by a foreign resident
BOP as a Flow Statement Exchange of Real Assets – exchange of goods and services for other goods and services or for monetary payment Exchange of Financial Assets – Exchange of financial claims for other financial claims
The Current Account Goods Trade – export/import of goods. Services Trade – export/import of services; common services are financial services provided by banks to foreign investors, construction services and tourism services Income – predominately current income associated with investments which were made in previous periods. Additionally the wages & salaries paid to non-resident workers Current Transfers – financial settlements associated with change in ownership of real resources or financial items. Any transfer between countries which is one-way, a gift or a grant,is termed a current transfer Typically dominated by the export/import of goods, for this reason the Balance of Trade (BOT) is widely quoted
U.S. Balances, 1985-2009 ($Bn) U.S. Trade Balance and Balance on Services and Income
The Capital and Financial Accounts Capital account measures transfers of fixed assets such as real estate and acquisitions/disposal of non-produced/non-financial assets Financial account components: Direct Investment: Net balance of capital which is dispersed from and into a country for the purpose of exerting control over assets. This category includes foreign direct investment Portfolio Investment: Net balance of capital which flows in and out of the country but does not reach the 10% ownership threshold of direct investment. The purchase and sale of debt or equity securities is included in this category Other Investment Assets/Liabilities: Consists of various short and long-term trade credits, cross-border loans, currency and bank deposits and other accounts receivable and payable related to cross-border trade
The Other Accounts Net Errors and Omissions – Account is used to account for statistical errors and/or untraceable monies within a country Official Reserves – total reserves held by official monetary authorities within a country. These reserves are typically comprised of major currencies that are used in international trade and financial transactions and reserve accounts (SDRs) held at the IMF Under a fixed rate regime official reserves are more important as the government assumes the responsibility to maintain parity among currencies by buying or selling its currency on the open market Under a floating rate regime the government does not assume such a responsibility and the importance of official reserves is reduced
Global Finance in Practice: China’s Twin Surpluses China’s twin surpluses aka “double surplus” in the current and financial accounts is highly unusual Typically, these relationships are inverses of one another The reason for the twin surpluses is due to the exceptional growth of the Chinese economy
Official Foreign Exchange Reserves Between 2001 – 2010 China increased foreign exchange reserves from $200 billion to $2,500 billion, more than a 10-fold increase China is now able to manage its currency to maintain competitiveness worldwide China can also maintain a relatively stable fixed exchange rate against other major currencies
Balance of Payments Interactions A nation’s balance of payments interacts with nearly all of its key macroeconomic variables: Gross domestic product (GDP) The exchange rate Interest rates Inflation rates
Balance of Payments Interactions In a static (accounting) sense, a nation’s GDP can be represented by the following equation: GDP = C + I + G + X – M C = consumption spending I = capital investment spending G = government spending X = exports of goods and services M = imports of goods and services X – M = Current accountbalance
The Balance of Payments and Exchange Rates A country’s BOP can have a significant impact on the level of its exchange rate and vice versa depending on that country’s exchange rate regime The effect of an imbalance in the BOP of a country works somewhat differently depending on whether that country has fixed exchange rates, floating exchange rates, or a managed exchange rate system Under a fixed exchange rate system the government bears the responsibility to assure a BOP near zero Under a floating exchange rate system, the government of a country has no responsibility to peg its foreign exchange rate
The relationship between BOP and exchange rates can be illustrated by use of a simplified equation: CI = capital inflows CO = capital outflows FI = financial inflows FO = financial outflows FXB = official monetary reserves The Balance of Payments and Exchange Rates Current Account Balance (X-M) Capital Account Balance (CI - CO) Financial Account Balance (FI - FO) Reserve Balance (FXB) Balance of Payments BOP + + + =
The Balance of Payments and Interest Rates Apart from the use of interest rates to intervene in the foreign exchange market, the overall level of a country’s interest rates compared to other countries does have an impact on the financial account of the balance of payments Relatively low interest rates should normally stimulate an outflow of capital seeking higher interest rates in other country-currencies In the U.S. however, the opposite has occurred as a result of attractive growth rate prospects, high levels of productive innovation, and perceived political stability
The Balance of Payments and Inflation Rates Imports have the potential to lower a country’s inflation rate In particular, imports of lower priced goods and services places a limit on what domestic competitors charge for comparable goods and services
Trade Balances and Exchange Rates A simple concept in principle: Changes in exchange rates changes the relative prices of imports and exports which in turn result in changes in quantities demanded In reality the process is less straight-forward
The J-Curve Adjustment Path Trade balance adjustment occurs in three stages over a varying and often lengthy period of time The currency contract period Adjustment is uncertain due to existing contracts that must be fulfilled The pass-through period Importers and exporters must eventually pass along the cost changes Quantity adjustment period The expected balance of trade is eventually realized U.S. trade balance = (P$xQx) – (S$/fc PfcM QM)
The J-Curve Trade Balance Adjustment to Exchange Rate Changes
MNCs are exposed to risk from exchange rates Resulting from Market Forces Resulting from Accounting EconomicExposure Purely Accounting Based
Foreign Exchange Exposure Foreign exchange exposure is a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates These three components (profits, cash flow and market value) are the key financial elements of how we view the relative success or failure of a firm While finance theories tell us that cash flows matter and accounting does not, we know that currency-related gains and losses can have destructive impacts on reported earnings – which are fundamental to the markets opinion of that company
Types of Foreign Exchange Exposure Transaction Exposure – measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rate changes Translation Exposure – the potential for accounting derived changes in owner’s equity to occur because of the need to “translate” financial statements of foreign subsidiaries into a single reporting currency for consolidated financial statements Operating Exposure – measures the change in the present value of the firm resulting from any change in expected future operating cash flows caused by an unexpected change in exchange rates
Why Hedge? Hedging protects the owner of an asset (future stream of cash flows) from loss However, it also eliminates any gain from an increase in the value of the asset hedged against Since the value of a firm is the net present value of all expected future cash flows, it is important to realize that variances in these future cash flows will affect the value of the firm and that at least some components of risk (currency risk) can be hedged against Companies must first decide what they are trying to accomplish through their hedging program.
Why Hedge - the Pros & Cons Proponents of hedging give the following reasons: Reduction in risk in future cash flows improves the planning capability of the firm Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum Management has a comparative advantage over the individual investor in knowing the actual currency risk of the firm Markets are usually in disequilibirum because of structural and institutional imperfections
Why Hedge - the Pros & Cons Opponents of hedging give the following reasons: Shareholders are more capable of diversifying risk than the management of a firm; if stockholders do not wish to accept the currency risk of any specific firm, they can diversify their portfolios to manage that risk, investors have already factored the foreign exchange effect into a firm’s market valuation Currency risk management does not increase the expected cash flows of a firm; currency risk management normally consumes resources thus reducing cash flow The expected NPV of hedging is zero (Managers cannot outguess the market; markets are in equilibrium with respect to parity conditions) Management’s motivation to reduce variability is sometimes driven by accounting reasons; management may believe that it will be criticized more severely for incurring foreign exchange losses in its statements than for incurring similar or even higher cash cost in avoiding the foreign exchange loss Management often conducts hedging activities that benefit management at the expense of shareholders
Measurement of Transaction Exposure Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely Purchasing or selling on credit goods or services when prices are stated in foreign currencies Borrowing or lending funds when repayment is to be made in a foreign currency Being a party to an unperformed forward contract and Otherwise acquiring assets or incurring liabilities denominated in foreign currencies
Purchasing or Selling on Open Account Suppose Caterpillar sells merchandise on open account to a Belgian buyer for €1,800,000 payable in 60 days Further assume that the spot rate is $1.2000/€ and Caterpillar expects to exchange the euros for €1,800,000 x $1.2000/€ = $2,160,000 when payment is received Transaction exposure arises because of the risk that Caterpillar will something other than $2,160,000 expected If the euro weakens to $1.1000/€, then Caterpillar will receive $1,980,000 If the euro strengthens to $1.3000/€, then Caterpillar will receive $2,340,000
Purchasing or Selling on Open Account Caterpillar might have avoided transaction exposure by invoicing the Belgian buyer in US dollars (risk shifting), but this might have lead to Caterpillar not being able to book the sale If the Belgian buyer agrees to pay in dollars, Caterpillar has transferred the transaction exposure to the Belgian buyer whose dollar account payable has an unknown euro value in 60 days
Borrowing and Lending A second example of transaction exposure arises when funds are loaned or borrowed Example: PepsiCo’s largest bottler outside the US is located in Mexico, Grupo Embotellador de Mexico (Gemex) On 12/94, Gemex had US dollar denominated debt of $264 million The Mexican peso (Ps) was pegged at Ps$3.45/US$ On 12/22/94, the government allowed the peso to float due to internal pressures and it sank to Ps$4.65/US$. In January it reached Ps$5.50
Borrowing and Lending Gemex’s peso obligation now looked like this Dollar debt mid-December, 1994: US$264,000,000 Ps$3.45/US$ = Ps$910,800,000 Dollar debt in mid-January, 1995: US$264,000,000 Ps$5.50/US$ = Ps$1,452,000,000 Dollar debt increase measured in Ps Ps$541,200,000 Gemex’s dollar obligation increased by 59% due to transaction exposure
Other Causes of Transaction Exposure When a firm buys a forward exchange contract, it deliberately creates transaction exposure; this risk is incurred to hedge an existing exposure Example: US firm wants to offset transaction exposure of ¥100 million to pay for an import from Japan in 90 days Firm can purchase ¥100 million in forward market to cover payment in 90 days
Contractual Hedges Transaction exposure can be managed by contractual, operating, or financial hedges The main contractual hedges employ forward, money, futures and options markets Operating and financial hedges use risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies A natural hedge refers to an offsetting operating cash flow, a payable arising from the conduct of business A financial hedge refers to either an offsetting debt obligation or some type of financial derivative such as a swap
Risk Management in Practice Which Goals? The treasury function of most firms is usual considered a cost center; it is not expected to add to the bottom line However, in practice some firms’ treasuries have become aggressive in currency management and act as though they were profit centers Which Exposures? Transaction exposures exist before they are actually booked yet some firms do not hedge this backlog exposure However, some firms are selectively hedging these backlog exposures and anticipated exposures
Risk Management in Practice Which Contractual Hedges? Transaction exposure management programs are generally divided along an “option-line;” those which use options and those that do not Also, these programs vary in the amount of risk covered; these proportional hedges are policies that state which proportion and type of exposure is to be hedged by the treasury
Translation Exposure Translation exposure arises because the financial statements of foreign subsidiaries must be restated in the parent’s reporting currency for the firm to prepare its consolidated financial statements Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported income caused by a change in exchange rates since the last transaction Translation methods differ by country along two dimensions One is a difference in the way a foreign subsidiary is characterized depending on its independence The other is the definition of which currency is most important for the subsidiary
Subsidiary Characterization Most countries specify the translation method to be used by a foreign subsidiary based upon its operations A foreign subsidiary can be classified as Integrated Foreign Entity – one which operates as an extension of the parent company, with cash flows and line items that are highly integrated with the parent Self-sustaining Foreign Entity – one which operates in the local economy independent of its parent The foreign subsidiary should be valued in terms of the currency that is the basis of its economic viability
