This chapter covers 11 The foreign exchange

This chapter covers: 11 • The foreign exchange markets • Foreign exchange quotations Financial Forces • Currency exchange risks • Currency exchange controls • How financial forces affect business • Sovereign debt • Small business in a developing country International Business by Ball, Mc. Culloch, Frantz, Geringer, and Minor Mc. Graw-Hill/Irwin Copyright © 2006 The Mc. Graw-Hill Companies, Inc. All rights reserved.

Chapter Objectives § Realize that money is made, and lost, in the foreign exchange markets § Understand foreign exchange quotations, including cross rates § Recognize currency exchange risks § Understand currency exchange controls § Understand financial forces that affect business § Explain sovereign debt, its causes, and its solutions § Recognize the role of small business in a developing country 11 -2

Uncontrollable Financial Forces n n n n Foreign Currency Exchange Risks National Balances of Payment Taxation Tariffs National monetary and fiscal policies Inflation National business accounting rules 11 -4

Fluctuating Currency Values n Most currencies in the world are free to fluctuate against each other n Fluctuations may be quite large n Financial managers must understand how to protect against losses or optimize gains n Another risk is encountered when a national suspends or limits convertibility of its currency n International currency exchange quotes can be found in business publications 11 -5

Foreign Exchange Quotations § In the world’s currency exchange markets § the U. S. dollar is the common unit being exchanged for other currencies § Reasons for the continued central position of the U. S. dollar include that the U. S. dollar is the main central reserve asset of many countries n is the most used vehicle currency and intervention currency n is in great demand worldwide as a result of its safe haven aspect and its universal acceptance n 11 -6

Foreign Exchange Quotations § Exchange Rates § By using the reciprocal of the US$ equivalent rate, the currency per US$ rate can be reached and vice versa. 1 US$ equivalent rate = currency per US$ rate 1 currency per US$ rate = US$ equivalent rate 11 -7

Exchange Rates § Spot rates § The exchange rate between two currencies for delivery within two business days § Forward rate § The exchange rate between two currencies for delivery in the future. § Commonly 30, 60, 90, or 180 days 11 -8

Exchange Rates § Trading at a premium § When a currency’s forward rate quotes are stronger than spot § Trading at a discount § When a currency’s forward rate quotes are weaker than spot § Premium or a discount depends on the expectations of the world financial community, businesses, individuals, and governments about what the future will bring 11 -9

Exchange Rates § Cross Rates § Currency exchange rates directly between non-U. S. dollar currencies § Use of the Japanese yen and European euro is increasing 11 -10

Currency Exchange Controls § Government controls that limit the legal uses of a currency in international transactions § Value of currency is arbitrarily fixed at a rate higher than its market value § If you see “official rate” next to a currency rate quotation, that country has currency exchange controls in place 11 -11 § A black market typically surfaces as a result of currency exchange controls § However, this type of currency exchange transaction is illegal § The black market is rarely able to accommodate transactions of the size involved in a multinational business

Balance of Payments (BOP) § The state of a nation’s BOP can tell about the state of that country’s economy. § If the BOP is slipping into deficit § the government is probably considering one or more market or nonmarket measures to correct or suppress that deficit § Currency devaluation or restrictive monetary or fiscal policies to induce deflation are likely § Currency or trade controls may be near 11 -12

BOP § If BOP slipping into deficit § Companies may want to start shopping for export incentives § Export incentives include § tax breaks, lower-cost financing, foreign aid, and other government related incentives to make exporting easier and more profitable 11 -13

Taxation n Tariffs and duties used interchangeably n Taxes on imported goods n Important for business to minimize them n Many tariffs have been lowered or abolished world wide n If a business can lower taxes, it can lower prices to customers 11 -14 n Taxation in different countries n Income tax is generally the biggest revenue earner for governments n Other types of taxes include n sales or value-added taxes on goods or services n capital gains taxes, property taxes, and social security

Inflation n Inflation’s Effects on Interest Rates n The inflation rate determines the real cost of borrowing n Real interest rates are found by subtracting inflation from the nominal interest rates n When borrowed money is repaid in the future after inflation, it is worth that much less to the lender 11 -15

Inflation § Monetary and Fiscal Policies Affect Inflation § Monetary policies § control the amount of money in circulation, whether it is growing, and, if so, at what pace § Fiscal policies § address the collecting and spending on money by governments 11 -16

Inflation and the International Company §High inflation rates § Encourage borrowing because the loan will be repaid with cheaper money § Bring high interest rates § Discourage lending § Make capital expenditure planning more difficult § Cause the cost of goods and services to rise n Tend to cause BOP deficits n Could lead to more restrictive fiscal or monetary policies, currency controls, export incentives, and import obstacles 11 -17

Accounting Practices n n 11 -18 Vary widely from country to country Must use host country’s practices then translate into home country practices U. S. uses Financial Accounting Standards Board n Establishes GAAP n Rule based Rest of the world follows International Accounting Standards Board n Principle based

Countries Went Bust § The sovereign debt crisis surfaced during the 1980 s § Poland’s sovereign debt crisis occurred in 1981 § The sovereign debt crisis for Mexico, Brazil, Argentina, and others occurred in 1982 and later § IMF took lead in resolving these crises, BIS made bridge loans in the interim n The immediate causes of the growing country debts were the jumps in oil prices 11 -19

Debt Problem Solutions § Short-Term Solutions § Rescheduling of debts that countries were unable to pay as they came due § Renegotiations are becoming more difficult § BIS, commercial banks, § 11 -20 and central banks are reluctant to come up with more money IMF’s resources are limited § Long-Term Solutions § The Baker Plan § Market-oriented strategies to encourage growth and bring inflation under control § The Brady Plan § Private banks with money backed by funds from IMF, World Bank, and developed country governments

Debt Problem Solutions n n The three mechanisms of the Brady debt relief 1) The exchange of old debt for new at a discount 2) The exchange of old debt for new at a lower interest rate 3) The buying back of debt from creditor banks at a discount This mechanism has resulted in debtor countries buying their own debt and retiring it 11 -21

Debt Problem Solutions n n The Paris Club, which is a group of Western creditor governments n forgave half of Poland’s debt ($17. 5 billion) The U. S. forgave the Egyptian debt n as an expression of thanks for Egypt’s support in the war against Iraq 11 -22 n The World Bank, the IMF, and the Paris Club n approved a plan to relieve the massive debt load of some of the world’s most heavily indebted poor countries (HIPC) n Assistance can be defended on a humanitarian basis n Most of these countries are in sub-Saharan Africa

United States in Debt n Net negative international investment position n n is the difference between the value of overseas assets owned by Americans and the value of U. S. assets owned by foreigners Differences in U. S. debt n n 11 -23 First, over $300 billion of the U. S. foreign-owned assets are obligations of the U. S. Treasury or U. S. corporations traded daily in world financial markets Second, U. S. foreign assets are often measured at book value which results in an estimated undervaluation of up to $200 billion Third U. S. assets abroad reportedly earn more in interest and dividend per dollar of investment than foreign holdings earn in America Fourth, It is denominated in U. S. dollars

Sample Rates Bid vs. Offer AUD/USD BID 0. 6979 OFFER 0. 6989 EUR/CHF 1. 5447 1. 5457 EUR/CZK 31. 3150 31. 4150 EUR/DKK 7. 4375 7. 4395 EUR/GBP 0. 67940 0. 68040 EUR/JPY 133. 68 133. 78 EUR/USD 1. 21830 1. 21930 GBP/CHF 2. 27150 2. 27350 GBP/JPY 196. 57 11 -24 196. 77

Australian Currency 11 -25

U. S. BOP 2002 Category I. Current Account Receipts Payments Net A. Merchandise Account (Exports/Imports) 848, 678 -1, 224, 417 -375, 739 B. Income Account (Rents, Interest, Profits) 352, 866 -367, 658 -14, 792 C. Transfers -54, 136 Current Account Balance -444, 667 II. Capital Account A. Foreign Investment in the U. S. 1, 024, 218 B. U. S. Investment Abroad C. Statistical Discrepancy 1, 401 Capital Account Balance 444, 667 0 III. Balancing Account (Official Reserve Transfers) Source: Economic Report of the President 2002 -580, 952

U. S. Inflation Rates per CPI & RPI 11 -27 Retail Price Index Consumer Price Index

List of 41 highly indebted poor countries n Angola Benin Bolivia Burkina Faso Burundi Cameroon Central African Republic Chad Congo, Dem Rep. Côte d'Ivoire Ethiopia The Gambia Ghana Guinea-Bissau Guyana Honduras Kenya Lao PDR Liberia n Madagascar Malawi Mali Mauritania Mozambique Myanmar Nicaragua Niger Rwanda Sierra Leone São Tomé Principe Senegal Somalia Sudan Tanzania Togo Uganda Vietnam Yemen, Rep. of Zambia