Week 6 Notes:


Globalization

Globalization is the process of managers assessing the impact of international activities on the future of their companies. Globalization is a continuous process; at its most basic level, a purely domestic company’s ability to compete is influenced by changes in foreign exchange rates, technological issues, cultural diversity, and international and political issues. This week’s reading introduce you to a broad array of economic and accounting topics associated with the globalization of business.

Chapter 1- Introduction: Chapter 1 emphasizes the internationalization of business and economic activity that has occurred since the end of World War II. Although international business activities have existed for centuries, primarily in the form of exporting and importing, it is only in the postwar period that multinational firms have become preeminent. The distinguishing characteristic of the MNC is its emphasis on global, rather than affiliate, performance. Specifically, MNCs ask, "Where in the world should we build our plants, sell our products, raise capital, and hire personnel?" Thus the true multinational is characterized more by attitude than the physical reality of an integrated system of marketing and production activities worldwide. It involves looking beyond the boundaries of the home country, and treating the world as "our oyster." Good examples include the globalization of GE's medical systems division and Arco Chemical.

The chapter starts with an introduction to the concept of the multinational corporation (MNC). The author then introduces the financial decisions that multinationals must make. The chapter begins by discussing the key concepts and lessons from domestic finance that apply directly to international corporate finance. The lessons include the emphasis on cash flow rather than accounting earnings, the time value of money, the importance of taxes, and the unwillingness of investors to reward companies for activities (like corporate diversification), which investors could replicate for themselves at no greater cost.

The key concepts, which arise time and again in the reading material for this week and next, are arbitrage, market efficiency, and the separation of risk into systematic risk, which must be rewarded, and unsystematic risk, which is not rewarded. The latter concept, of course, is the intuition underlying both the capital asset pricing model (CAPM) and the arbitrage pricing theory (APT). Although imperfect, the theoretical framework of domestic corporate finance provides a useful frame of reference, and understanding it is essential before proceeding with the more complex aspects of international financial management. I devote some time to explaining that total risk matters, even if the CAPM or APT holds. Otherwise the astute student will see a conflict between the irrelevance of unsystematic risk and hedging activities.

The chapter also outlines the key decision areas in international financial management: foreign exchange risk management, managing working capital and the internal financial system, financing foreign units, capital budgeting, and evaluation and control. The author emphasizes the additional parameters that MNC financial executives must cope with, including multiple currencies, rates of inflation, tax systems, and capital markets, as well as foreign exchange and political risks.

Chapter 2 - The determination of exchange rates: The purpose of this chapter is to explain what an exchange rate is and how it is determined in a freely-floating exchange rate regime, that is, in the absence of government intervention. This is done using a simple two·country model. Because of its pervasiveness, the book also examines the different forms and consequences of central bank intervention in the foreign exchange markets. Since an exchange rate can be considered as the relative price of two financial assets, the chapter discusses the asset market model of currencies and the role of expectations in exchange rate determination. A separate section discusses the real changes in a nation's economy that cause exchange rate changes.

Key points:

  1. Absent government intervention, exchange rates respond to the forces of supply and demand, which, in turn, depend on relative inflation rates, interest rates, and GNP growth rates.

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  2. Monetary policy is crucial. If the central bank expands the money supply at a faster rate than money demand, the purchasing power of money declines both at home (inflation) and abroad (currency depreciation).

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  3. The healthier the economy is, the stronger the currency is likely to be.

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  4. Exchange rates are crucially affected by expectations of future exchange rate changes, which depend on forecasts of future economic and political conditions.

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  5. In order to achieve certain economic or political objectives, governments often intervene in the currency markets to affect the exchange rate. Although the mechanics of such intervention vary, the general purpose of each variant is basically the same: to increase the market demand for one currency by increasing the market supply of another. Alternatively, the government can control the exchange rate directly by setting a price for its currency and then restricting access to the foreign exchange market.

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  6. A critical factor which helps explain the volatility of exchange rates is that with a fiat money there is no anchor to a currency's value, nothing around which beliefs can coalesce. Since people are unsure about what to expect, any new piece of information can dramatically alter their beliefs. Thus, if the underlying domestic economic policies are unstable, exchange rates will be volatile as traders react to new information.
Chapter 3 - The international monetary system: The purpose of this chapter is to help students understand what the international monetary system is and how the choice of system affects currency values. It also provides a historical background of the international monetary system. This enables students to gain perspective when trying to interpret the likely consequences of new policies in the area of international finance.

This chapter describes how exchange rates are determined under four different mechanisms··free float, managed float, fixed·rate system, and target·zone system. Under the latter three systems, governments intervene in the currency markets in one form or another to affect the exchange rate.

Key points:

  1. Under the latter three systems, which involve varying degrees of central bank intervention, the real exchange rate is liable to change, with important implications for exchange risk management (as discussed in Chapters 9 through 11).

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  2. Regardless of the form of intervention, fixed rates don't remain fixed for long. Neither do floating rates. The basic reason that exchange rates don't stay fixed for long in either a fixed· or floating·rate system is that governments subordinate exchange rate considerations to domestic political considerations.

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  3. The gold standard is a specific type of fixed exchange rate system, one that required participating countries to maintain the value of their currencies in terms of gold. Calls for a new gold standard remind us of the fundamental lack of trust in fiat money due to the historical unwillingness of the monetary authorities to desist from tampering with the money supply.

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  4. Intervention to maintain a disequilibrium rate is usually either ineffective or injurious when pursued over lengthy periods of time. Seldom, if ever, have policy makers been able to outsmart for any extended period the collective judgment of buyers and sellers. The current volatile market environment, a consequence of unstable U.S. and world financial conditions, cannot for long be arbitrarily directed by government officials.

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  5. Examining US experience since the abandonment of fixed rates, we find that free·market forces did indeed correctly reflect economic realities. The dollar's value dropped sharply from 1973 to 1980 when the US experienced high inflation and weakened economic conditions. It rose beginning in 1981 when American policies dramatically changed under the leadership of the Fed and a new president, and fell when foreign economies strengthened relative to the US economy.
Chapter 4 - The balance of payments and international economic linkages: The purpose of this chapter is to help students understand the financial and real linkages between the domestic and world economies and how these linkages affect business viability. It identifies the basic forces underlying the flows of goods, services and capital between countries and relates these flows to key political, economic, and cultural factors. These trade and capital flows are summarized in the balance of payments statistics.

Key points:

  1. The balance of payments is an accounting statement that shows the sum of economic transactions of individuals, businesses and government agencies located in one nation with those located in the rest of the world during a specified period. Thus, the U.S. balance of payments for a given year is an accounting of all transactions between Americans and non·Americans during the year.

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  2. The balance-of-payments statement is based on double·entry bookkeeping; every transaction recorded as a credit requires an equal and offsetting debit entry, and vice versa. A debit entry shows a purchase of foreign goods, services, and assets or a decline in liabilities to foreigners. A credit entry shows a sale of domestic goods, services, and assets or an increase in liabilities to foreigners.

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  3. The balance of payments often is divided into several different components. Each shows a particular kind of transaction such as merchandise exports or foreign purchases of U.S. government securities. The most basic distinction among transactions in the balance of payments is between those that represent purchases and sales of goods and services in the current period, called the current account, and those that represent capital transactions, called the capital account. Changes in official reserves appear on the official reserves account.

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  4. Since double·entry bookkeeping ensures that debits equal credits, the sum of all transactions is zero. Absent official reserve transactions, a capital account surplus must just offset the current account deficit, and a capital account deficit must offset a current account surplus.

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  5. The total size of the current account deficit is a macroeconomic phenomenon; there is a basic accounting identity that a nation's current account deficit reflects excess domestic spending. Equivalently, a current account deficit equals the excess of domestic investment over domestic savings. Taking government explicitly into account yields a new relation: The domestic spending balance equals the private savings·investment balance minus the government budget deficit.

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  6. In order to reduce the current account deficit, domestic savings must rise, private investment must decline, or the government deficit must be reduced. Absent any of these changes, the current account deficit will not diminish, regardless of the trade barriers imposed or the amount of dollar depreciation.

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  7. The long·term consequences for a nation that runs a current account deficit depend on how the resulting capital inflow is used. If the capital account surplus finances productive investment, then the nation is better off; the returns from these added investments will service the foreign debts and leave something extra. Conversely, a capital account surplus that finances consumption will increase the nation's well·being today at the expense of its future well·being.
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