INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

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INBU 4200INTERNATIONALFINANCIAL MANAGEMENT

• Lecture 2 Financial Market Globalization

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Beginning Quote

• Globalization is the inexorable integration of
  markets, transportation systems, and
  communication systems to a degree never witnessed
  before -- in a way that is enabling corporations,
  countries, and individuals to reach around the
  world farther, faster, deeper, and cheaper than
  ever before...
• Thomas Friedman, The World is Flat (2005)

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Viewing Globalization

• The act of becoming world wide in scope.
• Thus, it can be viewed as an increasingly freer
  flow of
• Goods,
• Companies,
• People,
• Ideas (technology RD),
• Services (including financial services),
• Capital
• . . . across national borders.
• Refer to Appendix 1 for a discussion of the
  history of globalization, Appendix 2 for examples
  of globalization by business functions and
  Appendix 3 for contemporary issues surrounding
  globalization.

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Globalizations Two Main Trends

• The globalization process can be divided into two
  main trends
• (1) The globalization of the markets for goods
  and non-financial services.
• Recent trend began after WWII with GATT rounds
  (1947) and the WTO (1995 on).
• (2) The globalization of financial markets and
  financial services.
• Recent trend began in the 1980s with developed
  countries liberalizing their capital markets
  followed by developing countries in the 1990s.

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Globalizations Potential Impacts on Business
Firms

• Impacts on the target markets where companies
  sell and/or buy.
• consumer goods
• industrial goods, and
• financial services
• Impacts on where companies source the factors of
  production for their enterprises
• capital (where firms finance),
• technology,
• labor

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Globalizations Potential Impacts on Business
Firms

• Impacts on mergers and acquisitions.
• Firms can now be the target of or acquirer of
  foreign firms.
• Buying other firms technology, market share,
  patents, etc.
• Expands the opportunity set for acquiring
  firms.
• Impacts on types and degree of risk associated
  with an increasingly global enterprise.
• Associated with the unique business and financial
  risks that confront firms in a global
  environment.
• Exchange rates, global competition, cultural
  differences, foreign governments, variations in
  economic environments.

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Globalizations Potential Impacts on Investors

• Potential Positive Diversification Impacts.
• Investors can construct portfolios consisting of
  a combination of domestic and foreign securities
  and in a combination of different currencies.
• This can have an impact on a Portfolios
  Systematic Risk (market risk).
• Through international diversification, investors
  can reduce a portfolio's systematic risk and
  increase the portfolio's return.
• Potential Negative Impacts.
• Increase portfolio risk associated with exchange
  rates, country risk, contagion financial market
  effects.

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Globalizations Potential Impacts on Countries

• Globalization has resulted in countries becoming
  more open.
• Exports as a percent of GDP
• Germany 6.2 to 31.3 (1950 to 2003)
• Mexico 3.5 to 26.3 (1950 to 2003)
• United States 4.9 to 9.3 (1960 to 2007)
• Imports as a percent of GDP
• United States 4.4 to 14.4 (1960 to 2007)
• Consequences
• Countries become increasingly dependent upon
  foreign markets for their domestic growth
  (exports) and supplies (imports).
• Coupling effects

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How Does International Business Differ from
Domestic?

• Global Business Deals with
• Different cultures
• Different consumers
• Different governments
• Different legal system and laws
• Different regulatory environments (including
  regulators)
• Different business/management styles
• Differences in corporate goals
• Differences in corporate governance
• Different economies and economic conditions
• Different financial markets
• Different currencies

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Dealing with Exchange Rates

• One of the major differences between global firms
  and purely domestic firms, is that the former
  need to deal in different currencies and are
  therefore subject to the potential for exchange
  rate risk.
• Exchange rate risk results from a firm having
  exposure in a foreign currency and that foreign
  currency moves in a manner detrimental to the
  firm.
• Refer to Appendix 5 for a complete discussion of
  the differences between domestic and
  international finance (including exchange rate
  risk).

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Quick History of Exchange Rates

• After WWII
• World turns to the US and agrees on a system of
  stable exchange rates to renew confidence in the
  global system.
• Bretton Woods System, 1944
• After Bretton Woods
• World turns to floating exchange rates, 1973

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Foreign Exchange Risk

• Critical questions for global company in this
  contemporary floating rate environment
• How will changes in these foreign currencies
  affect their consolidated financial performance?
• Revenues and Costs components.
• How volatile are the currencies it is dealing in?
• Short term moves and longer term trend changes.
• Managers must be aware of potential impact of
  exchange rate changes on their companies along
  with the potential of exchange rate volatility.
• Managers must also understand the techniques for
  managing the risk associated with this floating
  rate environment?
• See the following slides for examples of long
  term trend changes and intermediate term and
  short term currency movements. See Appendix 5 for
  more detail.

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Trend Changes The Euro Against the Dollar,
January 1999 - Present
Source http//fx.sauder.ubc.ca/
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Intermediate Moves About the Trend Euro in 2007
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Short Term Moves U.S. Dollar, August 28, 2008
(Surprise Upward Revision of GDP)
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Short Term Moves U.S. Dollar, August 29, 2008
(Larger than expected increase in NAPM-Chicago
index)
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Short Term Moves British Pound Noon (MST)
January 11, 2007 (Surprise interest rate increase)
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Globalization of Financial Markets

• Definition of Financial Market Globalization
  Process The integration of a country's domestic
  financial system into the international arena.
• And, as a result, individual domestic financial
  markets become so closely integrated with others
  that, taken as a whole, they can be considered as
  a single market.
• Financial market globalization has resulted from
• (1) the liberalization of capital flow
  restrictions worldwide and
• (2) advancing technology (in communications).

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The Globalization of Financial Markets Summary

• Financial markets now function in many ways as
  one integrated market covering the globe.
• This integration is represented by
• Large trading volumes across borders.
• Securities of different nations (corporate and
  government issues) trading in many major
  financial market centers.
• Financial events in one country affect other
  countries.
• Major central bank actions, U.S. stock market.
• Today, companies look at funding possibilities in
  financial markets around the world.
• Today, investors can select from opportunities
  offered by a vast array of countries.

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Appendix 1 The History of Globalization

• The following slides discuss the history of
  globalization in general and of financial markets
  in particular

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Quick History of Globalization

• About 200 years ago Free Trade Era
• Second British Empire and Industrial Revolution
• Last half of the 18th Century.
• New (Free Market) Economic Thought of the Time
• Adam Smith (1776) and David Ricardo (1817)
• Both showed how countries would benefit from free
  trade.
• WW I (1914-1918) 1940s Abandonment of Free
  Trade
• High protectionism especially during Great
  Depression (1929 early 1940s)
• Hawley-Smoot Tariff Act in U.S. (1930) imposed
  the highest duties on agricultural products and
  manufactured goods in U.S. history.

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Quick History of Globalization

• Period Immediately After WWII (1939 1945) Slow
  Return to Globalization Process
• Formation of GATT in 1948
• Goal To reduced tariffs and expand world trade.
• How Through trade rounds among member countries.
• Bretton Woods Agreements in 1944
• Goal To restored exchange rate stability.
• How Return to fixed exchange rates to promote
  world trade. (created the Bretton Woods
  International Monetary System)
• International Monetary Fund established in 1944
• Goal To maintain exchange rate stability by
  assisting countries whos currencies were under
  attack.
• How By providing short term funds for
  intervention.

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Quick History of Globalization

• 1970s and 1980s Acceleration of goods trade
  liberalization among worlds industrial countries
  and eventually among the developing counties.
• Accounted for by the continuing impact of GATT,
  and
• Impact of negotiated trade agreements and
  regional trading blocs (e.g., the EU and later
  NAFTA) on cross border trade.
• 1994 Establishment of WTO
• Goal To replace GATT as the worlds forum for
  trade negotiations and the settlement of trade
  disputes.
• 2006/07 Failure of Doha Round (2001 agricultural
  subsidies, manufacturing and services trade
  talks).
• What does this mean for the future of goods
  globalization?

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Brief History of Financial Market Globalization
Early 20th Century

• After the severe financial and economic
  disruptions of the 1930s, many government policy
  makers questioned whether free capital flows and
  liberalized capital markets were desirable.
• As a result, many countries restricted outward
  capital transfers either because
• (1) they preferred their capital to be invested
  within their domestic economies or
• (2) because they wished to prevent downward
  pressure on their exchange rates.
• Countries also put severe restrictions on inward
  investments, many fearing foreign control of
  their domestic companies, economies and/or
  financial markets.

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Brief History of Financial Market Globalization
Mid 20th Century

• During the 1950s and 1960s, each countries
  financial institutions/markets and their
  regulatory structures evolved in relative
  isolation from the rest of the world.
• During those years, most countries, including the
  United States, imposed restrictions on
  international capital movements.
• 1964 U.S. Interest Equalization Tax a 15 tax
  imposed on foreign borrowers in the US (lifted in
  1974).
• 1965 Foreign Credit Restraint Program restricted
  the ability of U.S. banks to extend loans to US
  and foreign borrowers for foreign purposes
  (lifted in 1974).

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Brief History of Financial Market Globalization
Late 20th Century

• During the 1980s, capital account liberalization
  was seen as an essential step on the path to a
  countrys economic development.
• In many ways this was analogous to the earlier
  reductions in barriers to international trade in
  goods and services.
• Refer to Appendix 3 for a comparison of the pace
  of goods and financial market globalization since
  1980.
• Capital account liberalization meant the
  reduction in restrictions on cross border capital
  flows.
• Portfolio investment and foreign direct
  investment.

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Financial Market Deregulation in the 1980s

• In the 1980s, the capital markets underwent
  extensive reforms.
• The markets became increasingly
  internationalized, as government deregulations
  allowed foreign-owned banks to extend their
  operations in local markets.
• There was also extensive restructuring of
  domestic financial market as interest-rate
  ceilings were abolished and competition between
  different financial institution intensified.
• The lead in financial market deregulation
  occurred in the industrial/developed countries.

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Deregulations of Financial Markets Among
Developed Countries

• United States Abolished capital controls in
  1974.
• The removal of the Glass Steagall Act in 1999.
• U.K. Lifted currency inconvertibility
  restrictions in 1979.
• U.K. Big Bang in 1986 (LSE stock market
  deregulations)
• Japan Big Bang in 1996-98
• Lifting restrictions on capital movements in and
  out of Japan including restrictions preventing
  non-banks from conducting foreign exchange
  business
• Japan Phasing in of universal financial
  institutions legislation (2005/2006)
• EU Lisbon Agreements (2000) goal of opening up
  financial markets and promoting single market in
  financial services by 2010.

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Deregulations of Financial Markets Among
Developing Countries

• Compared with the situation in industrial
  countries, financial market liberalization
  occurred at a slower pace in developing
  countries.
• After the Third World Debt Crisis (in the early
  1980s), bank loans to developing countries dried
  up and a result these countries needed to attract
  new sources of capital.
• By the 1990s many developing countries had
  greatly liberalized their foreign investment
  regimes, as well as reduced their controls over
  capital movements.
• Individual country stock markets were established
  or expanded as part of developing country
  financial sector reforms.
• These markets have been used in many developing
  countries to facilitate privatization by
  attracting foreign portfolio capital.
• Process slowed somewhat by the Asia currency
  crisis in 1997.

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Appendix 2 Globalization by Business Functions

• The following are examples of globalization
  impacts on selling, producing, and financial
  services on selected U.S. companies

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Examples of Business Functions

• Selling (Products) Function
• McDonalds Corporation
• Starbucks
• Production (of Products) Function
• Nike Corporation
• Financial Services (commercial banking,
  investment banking, insurance, asset management)
  Function
• Citigroup

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Selling Function

• McDonalds operates in 120
• Countries.
• - 66 of 2004 sales were from international
  operations.
• Starbucks in 2005, had 2,691 international
• retail coffee stores (company owned and
• licensed stores) operating in 34 countries.
• - These represented 26 of their stores.
• - Major markets included Japan, U.K. and Canada
• - International stores accounted for about 16
  of Starbucks 2005 earnings.

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Production Function

• Nike 99 of all its brand apparel is produced
  outside the United States, in 35 different
  countries.
• Country Percent
• China 38
• Indonesia 27
• Vietnam 18
• Thailand 16
• Note 60 of Nike 2004 revenues from outside U.S.

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Financial Services Function

• Citigroup operates in over
• 100 countries in
• banking, insurance,
• and investment services.
• In 2005, 46 of its revenues from operations
  resulted from activities outside of the United
  States.
• - Mexico is a major foreign market for Citigroup.

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Summary

• As a result of globalization, business firms are
  discovering new opportunities beyond their
  domestic markets
• New markets for their products.
• New sources (including capital) for their inputs.
• Globalization, however, introduces new and more
  complex sources of risk.
• These need to be managed to survive.
• Governments are also involved in this globalized
  world through their policies.
• Their involvement can hurt or help companies.

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Appendix 3 Contemporary Issues Facing the
Globalization Process

• The following are some of the major criticisms of
  the current globalization process

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Contemporary Issues Surrounding the Globalization
Process

• Has the globalization process has been uneven for
  various categories of countries?
• Claim that rich countries have benefited at the
  expense of poorer countries.
• Claim that rich countries continue to protect
  their key sectors (historically agriculture
  textiles).
• Has globalization resulted in greater financial
  and economic instability?
• Currency and economic crises of the 1990s on.
• Has globalization (countries becoming more
  connected through trade and financial flows)
  contributed to this?

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Contemporary Issues Surrounding the Globalization
Process

• Has globalization resulted in a disruptive level
  of outsourcing?
• A political issue in many developed
  (industrial) countries.
• United States, Western Europe, Japan
• Where are the major country outsourcing sites?
• Production China
• Services India
• Question Unfair trading or comparative
  advantage?
• Suggested follow up reading The World is Flat,
  by Thomas Friedman (2005).
• Discusses the rise and issues surrounding
  globalization (and outsourcing).
• Concludes Economic stability will not be a
  feature of the 21st century.

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Appendix 4 Comparing the Pace of Trade and
Financial Globalization

• The following slide is from a 2004 study which
  compared the percent of countries identified as
  opening their economies to trade and to financial
  flows. It reveals that the pace of financial
  market globalization has been slower than that of
  trade globalization.

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Measuring Trends Globalization

• Globalization study by Kose, Prasad, and Terrones
  (December, 2004 in Finance Development) looked
  at 85 countries over the last 20 (1980 2003)
  years.
• Findings
• Trade (Exports and Imports) liberalization rose
  from 30 to 85 (of sample)
• Financial (Capital Flows) liberalization rose
  from 20 to 55 (of sample)
• Thus, more countries in the sample had engaged in
  trade liberalization than financial market
  liberalization.

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Appendix 5 Why is International Finance
Different from Domestic Finance?

• The following slides illustrate the differences
  between a purely domestic business and a global
  (international) firm

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Why is International Finance Difference
from Domestic Finance?

• Foreign Exchange Risk
• Risks associated with doing business in different
  currencies.
• Political Risk
• Policies of different national governments can
  affect corporate performance (e.g., exchange rate
  policies, tax and profit remittance policies,
  monetary policy).
• Expanded Opportunities for Financing and
  Investing
• Financing and investment options now expand
  beyond domestic borders.
• Cultural Differences
• Country differences in equity cultures and
  corporate cultures complicate global business.
• Corporate Governance and Regulation Differences
• Country differences in the relationship between
  managers and investors (owners) as well as
  differences in regulations.

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Foreign Exchange Risk

• Global companies take positions in foreign
  currencies as a result of their global
  activities.
• Foreign currency denominated assets
• Resulting from subsidiary sales overseas, export
  accounts receivable and owned overseas financial
  assets
• Foreign currency denominated liabilities
• Results from subsidiary liabilities overseas,
  import accounts payable and overseas financial
  liabilities

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Foreign Exchange Risk

• Critical questions for global company
• How will changes in these foreign currencies
  affect their consolidated financial performance?
• Revenues and Costs components.
• How volatile are the currencies it is dealing in?
• Short term moves and longer term trend changes.
• Next four slides show how currencies are subject
  to short term moves and longer term trend
  changes.
• Managers must be aware of this potential
  volatility and understand the techniques for
  managing this risk?

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Short Term Change in Exchange Rate British
Pound, January 11, 2007

• The Bank of England surprised markets on
  Thursday, January 11, 2007, by raising interest
  rates a quarter percentage point to 5.25 percent,
  saying the economy had less spare capacity and
  price pressures were increasing.
• Only one of the 50 analysts polled by Reuters had
  predicted the move, which took borrowing costs to
  their highest level in 5-1/2 years.
• Most had thought the central bank would wait at
  least another month to see whether wages were
  heading up in the new year and for a clearer
  reading on the consumer sector.
• The pound rose from 1.935 to over 1.950 within
  a matter of 15 minutes.
• See next slide for chart.
• Chart trades the exchange rate on January 11 from
  700 am until around 100 pm. Note the movement
  around noon at the time of the announcement.

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Pound Exchange Rate January 11, 2007
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Longer term Trend Changes in Exchange Rates

• Currencies are also subject to changes in longer
  term trends.
• These occur as changes in relative economic data
  occur and are priced into prices.
• For example the Euro has experienced two major
  trends since its introduction on January 1, 1999.
• Weakening until early 2002
• Strengthening since early 2002
• Note that there have been shorter term trend
  reversals during these two major periods (e.g.,
  in 2005).

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The Euro Against the Dollar

• Source http//fx.sauder.ubc.ca/

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Currency Volatility Summary

• Today, major currencies appear to be potentially
  volatile, in that they are
• Subject to longer term trend reversals.
• Subject to (sudden) short term movements.
• Why?
• Rates are constantly adjusting to new information
  and
• Governments are less (or no longer) involved in
  managing (i.e., supporting) their currencies.
• Market forces, therefore, determine these rates.
• As a result, exchange rates have become more
  volatile because market forces now play a
  dominant role in setting prices and establishing
  trends.

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Political Risk

• Involves the role and activities of a foreign
  government in affecting the financial performance
  of a global firm.
• Foreign exchange market.
• Managing rates and government intervention.
• Profit repatriation process.
• Government regulations determine how easy (or
  difficult) it is to remove profits from foreign
  operations.
• Taxation policies.
• Governments set withholding taxes on subsidiary
  dividends paid out of country to parent companies
  and negotiate tax treaties.
• Monetary policies.
• Government policies will affect the cost of
  borrowing local capital.
• Contract enforcement.
• Governments establish legislation for the
  protection of private property and contracts.

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Global Differences in Monetary Policy Central
Bank Target Rates, August 2006

• Rate Difference from U.S.
• United States 5.25 ---
• Japan 0.25 -5.00
• Switzerland 1.27 -3.98
• Euro Zone 3.00 -2.25
• Canada 4.25 -1.00
• South Korea 4.50 - 0.75
• United Kingdom 4.75 0.50
• Australia 6.00 0.75
• Russian Federation 11.50 6.25
• Brazil 14.75 9.50
• Source http//www.bis.org/cbanks.htm

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Expanded Financial Opportunities

• Borrowers
• Now have access to financial markets all over the
  world, including
• Individual national markets and offshore markets.
• Includes short term borrowing options, long term
  debt options, and equity financing.
• Investors
• Now have access to financial assets all over the
  world, including
• Government and corporate debt, and corporate
  equity.
• Global borrowing and global investing carries new
  risks not experienced with domestic activities.
• Exchange rate risk.
• Information (not understanding these markets)
  risk.

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Corporate Structural Differences

• Two distinct and different corporate models
  exist
• Shareholder Wealth Structure (Anglo-American or
  Anglo-Saxon) Model
• Believes that a firms objective should be to
  maximize shareholder wealth.
• These countries include the US, Canada,
  Australia, United Kingdom.
• Corporate Wealth Structure (Non-Anglo-American)
  Model
• Believe that a firms objective should be to
  maximize corporate wealth (which includes all
  stakeholders e.g., employees, community, banks,
  owners)
• These countries include the EU, Japan and Latin
  American countries.
• There is some evidence that some corporate wealth
  model countries are adopting aspects of the
  shareholder wealth model.
• Japans changing corporate structure and
  corporate objective is one example
• Many Japanese companies are now concern with the
  bottom line.
• Have hired non-Japanese to modernize their
  companies (e.g., Sony).

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Shareholder Wealth Structure

• This model focuses on the importance of
  shareholders to the corporate structure.
• Wealth is strictly financial.
• Within this context, management tools measure
  impact of their decisions on equity (common
  stock) values.
• Capital budgeting techniques
• Net Present Value
• Internal Rates of Return
• Aimed at securing returns greater than the firms
  cost of capital and thereby increasing returns to
  shareholders.
• Within this model, there is an acceptance of
  hostile takeovers to ensure appropriate
  financial performance.
• Again to the benefit of shareholders.

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Corporate Wealth Structure

• Definition of corporate wealth is much broader
  than the Shareholder Wealth (Anglo-American)
  viewpoint
• Consideration given to the implications of
  strategic moves affecting all parties such as
  human resources, community, state, etc.
• Advisory Committees important in Europe (part of
  corporate structures and involved by law in
  corporate decisions)
• Strict labor laws (e.g., on firing employees) in
  Europe.
• Life time employment concept in Japan in early
  post war years.
• Weakened substantially in Japan in the 1990s.
• Less attention in Japan of Anglo Saxon capital
  budgeting techniques especially equity cost of
  capital.
• Came about because of
• Distrust of Anglo-American capitalism especially
  in Post World War II Europe (thus, a search for
  the Third-Way).
• Friendly takeovers are the rule (although this is
  changing as well, in Japan and in Europe).

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Equity Cultural Differences

• Anglo Saxon countries (U.S., U.K., Canada)
• Generally have a well developed equity culture
• Understanding and acceptance of ownership and,
  especially, equity capital risk.
• Thus, this sector is an important source of funds
  for corporate financing.
• But, perhaps, it also affects corporate goals.
• Management tends to focus on shareholders.
• Non-Anglo Saxon Countries (Continental Europe and
  many Asian countries)
• Relatively poorly developed equity culture
• Thus, risk is not as well understood or
  tolerated.
• Thus there is a reliance on debt and bank
  financing.
• And, corporate goals become more diverse with a
  wider range of stakeholders.

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Corporate Governance

• Defined The financial and legal framework for
  regulating the relationship between managers and
  owners.
• Very important to shareholders (as owners of
  firms).
• Thus, historically important in Anglo-American
  markets but less so in other markets.
• Also involves the issue of financial market
  transparency (important information available to
  all at the same time).
• This too is very important to shareholders.
• Corporate governance has become (relatively) well
  defined in the United States.
• Undoubtedly recent abuses have contributed to
  this
• Waste Management and Sunbeam (1998) and Enron
  (2001).
• Abuses resulted in passage of Sarbanes-Oxley Act
  (2002)
• But there is no similar regulation in foreign
  countries.
• Issue of applying this act to foreign companies
  in the U.S.