International Finance: A Deep Dive into Multinational Enterprises and Foreign Exchange

Posted on Aug 3, 2024 in Economy

Multinational Enterprises (MNEs)

MNEs are companies that operate in multiple countries, conducting business through branches, foreign subsidiaries, or joint ventures with local firms.

Foreign Currency Exchange Rate

The foreign currency exchange rate is the price of one country’s currency expressed in terms of another country’s currency. For example, the US Dollar ($ or USD) / European euro (€ or EUR) exchange rate might be stated as “1.3654 dollars per euro” or as $1.3654/€. Most exchange rates are quoted against the US dollar.

Eurocurrencies

Eurocurrencies are domestic currencies of one country held in deposits in banks located in a second country. Any convertible (exchangeable) currency can exist in “Euro-” form (don’t confuse this term with the European Euro). Eurocurrency markets serve two important purposes:

  1. They act as a money market instrument for managing excess corporate liquidity.
  2. They provide a source of short-term bank loans.

Eurocurrency Interest Rates

The reference rate of interest in the Eurocurrency market is LIBOR – the London Interbank Offered Rate. LIBOR is used in standardized quotations, loan agreements, and financial derivatives valuations. It is officially defined by the British Bankers Association. US dollar LIBOR is calculated as the average of interbank offered rates from 16 multinational banks, sampled at 11 am London time. Yen LIBOR, EURO LIBOR, and all other LIBOR rates are calculated in the same way.

Why Firms Become Multinational

Firms expand to become multinational for several reasons:

  • Market seeking
  • Access to raw materials
  • Production efficiency
  • Knowledge acquisition
  • Political safety

The Globalization Process

The globalization process refers to the structural and managerial changes and challenges a firm experiences as it transitions from operating domestically to operating globally.

Global Transition I: From Domestic to International Trade

This phase involves increased exports, imports, products, and services, placing greater demands on financial management compared to domestic business.

Foreign Exchange Risk

Pricing and payment methods may differ across countries, and the value of currencies can fluctuate.

Credit Risk Management

Evaluating the creditworthiness of foreign buyers and sellers becomes crucial.

Global Transition II: From International Trade to Multinational Trade

This phase involves a greater depth and breadth of international activity.

Foreign Direct Investment Sequence

This includes establishing foreign sales offices, entering into licensing agreements, and setting up manufacturing operations abroad.

Currency Boards

Currency boards exist when a country’s central bank commits to backing its monetary base entirely with foreign reserves. This means the domestic currency cannot be introduced into the economy without an equivalent increase in foreign exchange reserves.

Dollarization

Dollarization is the use of the US dollar as the official currency of a country.

Pros:

  • Eliminates currency crises.
  • Promotes greater market integration.

Cons:

  • Loss of monetary policy control and seigniorage (the ability to profit from printing money).
  • The central bank can no longer act as a lender of last resort.

Floating vs. Fixed Exchange Rates

  • Fixed: The currency and exchange rate are set by a governing board.
  • Floating: Supply and demand forces determine the currency’s value.

Balance of Payments (BOP)

The balance of payments records all transactions between residents of a country and foreign residents. It functions similarly to a cash flow statement, tracking ongoing purchases and payments rather than the value of assets and liabilities. The BOP always balances and is composed of two primary subaccounts:

  1. Current Account
  2. Capital/Financial Account

The BOP also tracks government transactions and includes a fourth account that focuses on the overall balance. It can significantly impact exchange rates. For example, low-interest rates can stimulate capital outflow, while imports can lower a country’s interest rates.

Three Elements of Measuring International Economic Activity

  1. Identifying international transactions.
  2. Understanding how transactions create debits and credits.
  3. Understanding bookkeeping procedures for accounting.

Components of the Current Account

  • Goods Trade: Export and import of physical goods.
  • Services Trade: Export and import of services.
  • Income: Current income from investments made in previous periods and wages earned by non-resident workers.
  • Current Transfers: One-way transfers between countries, such as gifts.

Capital Account

The capital account records the transfer of financial assets and acquisitions of non-produced/non-financial assets.

Components of the Financial Account

  • Direct Investment: The net balance of long-term capital invested in a country to gain control of assets.
  • Portfolio Investment: The net balance of short-term capital flowing in and out of a country, where ownership remains below 10%.
  • Other Asset Investment: Includes various short and long-term trade credits, cross-border loans, currency deposits, and other receivables and payables related to cross-border trade.

Net Errors/Omissions

This category accounts for statistical discrepancies and untraceable funds.

Official Reserves

Official reserves represent the total reserves held by a country’s monetary authorities.

China’s Twin Surplus

China’s simultaneous surplus in both its financial and current accounts is unusual, as these typically run in opposite directions. This is likely a result of the country’s unprecedented economic growth.

BOP and Exchange Rate

The relationship between the balance of payments and the exchange rate can be represented as follows:

(Exports – Imports) + (Capital Inflow – Capital Outflow) + (Financial Inflow – Financial Outflow) + Change in Reserves

J Curve Path

The J Curve illustrates the impact of currency changes on the balance of trade over time:

  1. Currency Contract Period: Adjustment is uncertain due to pre-existing contracts.
  2. Pass-Through Period: Importers and exporters gradually pass exchange rate changes onto their product prices.
  3. Quantity Adjustment Period: The expected balance of trade materializes.

Trade Balance

The trade balance can be calculated as follows:

(P$ x Qx) – (SS/fcPfcMQM)

Where:

  • P$ = Price of exports in domestic currency
  • Qx = Quantity of exports
  • SS = Spot exchange rate (domestic currency/foreign currency)
  • fcPfc = Price of imports in foreign currency
  • MQM = Quantity of imports

Types of Foreign Exchange Transactions

Spot Transaction

A spot transaction involves the purchase of foreign exchange with delivery and payment between banks occurring on the following business day (value date).

Forward Transaction

A forward transaction involves the exchange of a specified amount of one currency for another currency on a future date at a predetermined exchange rate.

Swap Transaction

A swap transaction involves the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

Bank for International Settlements (BIS)

The BIS measures global foreign exchange market turnover. The UK and US account for approximately 60% of the market, with Asia experiencing rapid growth.

Foreign Exchange Quotes

A foreign exchange quote is a statement of willingness to buy or sell a currency at an announced rate.

Direct Quote

A direct quote expresses the exchange rate as the domestic currency per unit of foreign currency (e.g., USD/EUR).

Indirect Quote

An indirect quote expresses the exchange rate as the foreign currency per unit of domestic currency (e.g., EUR/USD).

Cross Rate

: Used to check on opportunities for intermarket arbitrage; calculates using 3rd party quote divided by first quote

%ChangeFC Indirect: (Beginning Rate- Ending Rate/Ending Rate) x100; %ChangeFCDirect: (Ending Rate-Beginning Rate/Beginning Rate)x100

F^FCIndirect: Spot-forward/forward x 360/days x 100; F^FCDirect: Forward-Spot/Spot x 360/days x 100

Cash Flows Into US: Credit; Cash Flows Out of US: Debit

ExAccount defecit; BOP defecit; Demand for domestic currency; supply for domestic current; domestic currency falls (D>S)

Ex>Im: Current Account Surplus; BOP surplus; Demand for domestic currency; supply for domestic currency; domesticcurrency value rises (S

1/4USD/P & 1.7USD/Euro: Euro per pound rate is 1/7/1.4