Financial forces in international business

Rai, Manju KumariShrestha, Ruchi

Thapa Magar, Dipesh Nepal, Rhishikesh

Foreign Exchange

• Foreign exchange, or Forex, is the conversion of one country's currency into that of another.

• The value of any particular currency is determined by market forces based on trade, investment, tourism, and geo-political risk

• Foreign exchange is handled globally between banks and all transactions fall under the auspice of the Bank of International Settlements. 

Factors affecting Demand and Supply of Exchange rate • Imports and Exports

a rise in import will increase the supply of one’s currency consequence, is depreciation of the currency. Vice versa for exports.

• Money supply of the currency

decrease in money supply of the currency will reduce its supply in the market and shift the supply curve to left giving a rise to the price of the currency

• Increase in foreign cash inflow

an increase in foreign inflow of cash will increase the demand for the currency appreciating the price.

Changes in Demand and Supply of foreign exchange

Example of foreign exchange rate implication on business.• For example, a firm completes a project in Germany and is

paid 1,000,000 Euros for doing so. However, the firm's domestic currency (the US dollar) is strong and is worth 2 Euros. As such, the exchange of the currency when the profits are brought home will yield a $500,000 profit domestically. Contrastingly, if the dollar is weak and 1 Euro is worth $2, the project will yield the company $2,000,000 in profit after the exchange of funds. Because exchange rates change daily, profits realized from a lengthy foreign project can be eroded unexpectedly. The company can leave the profits overseas until markets improve, but many countries (including the US) are beginning to tax companies for doing so in an effort to have them bring money home sooner

Exchange rate systems and international businessFree-Floating Systems

• In a free-floating exchange rate system, governments and central banks do not participate in the market for foreign exchange

• A free-floating system has the advantage of being self-regulating.

• Suppose, for example, that a dramatic shift in world preferences led to a sharply increased demand for goods and services produced in Canada. This would increase the demand for Canadian dollars, raise Canada’s exchange rate, and make Canadian goods and services more expensive for foreigners to buy. Some of the impact of the swing in foreign demand would thus be absorbed in a rising exchange rate. In effect, a free-floating exchange rate acts as a buffer to insulate an economy from the impact of international events.

• The primary difficulty with free-floating exchange rates lies in their unpredictability

• Fluctuating exchange rates make international transactions riskier and thus increase the cost of doing business with other countries.

Managed Float Systems

• Government or central bank participation in a floating exchange rate system is called a managed float.

• Countries that have a floating exchange rate system intervene from time to time in the currency market in an effort to raise or lower the price of their own currency

• Still, governments or central banks can sometimes influence their exchange rates. Suppose the price of a country’s currency is rising very rapidly.

• Suppose the price of a country’s currency is rising very rapidly. The country’s government or central bank might seek to hold off further increases in order to prevent a major reduction in net exports.

Maintaining a Fixed Exchange Rate through Intervention

• Initially, the equilibrium price of the British pound equals $4, the fixed rate between the pound and the dollar. Now suppose an increased supply of British pounds lowers the equilibrium price of the pound to $3. The Bank of England could purchase pounds by selling dollars in order to shift the demand curve for pounds to D2. Alternatively, the Fed could shift the demand curve to D2 by buying pounds.

• Fixed exchange rate systems offer the advantage of predictable currency values—when they are working.

• But for fixed exchange rates to work, the countries participating in them must maintain domestic economic conditions that will keep equilibrium currency values close to the fixed rates.

• Sovereign nations must be willing to coordinate their monetary and fiscal policies. Achieving that kind of coordination among independent countries can be a difficult task.

Taxation and tariffs

• A tariff or customs duty is a tax levied upon goods as they cross national boundaries, usually by the government of the importing country. The words tariff, duty, and customs are generally used interchangeably.

• Tariffs may be levied either to raise revenue or to protect domestic industries,

Tariffs are implied by the government because;

• To protect fledgling domestic industries from foreign competition.

• To protect aging and inefficient domestic industries from foreign competition.

• To protect domestic producers from dumping by foreign companies or governments. Dumping occurs when a foreign company charges a price in the domestic market which is "too low". In most instances "too low" is generally understood to be a price which is lower in a foreign market than the price in the domestic market. In other instances "too low" means a price which is below cost, so the producer is losing money.

How tariff is affecting international trade?

• It makes foreign products more expensive, which means that consumers have to pay more.

• It also means the inefficient firms in the protected industry get a free ride. That is very bad for the economy. It means people will earn less in the country over all, and pay more for foreign goods. It means less people will have jobs. It means inflation will be higher.

• . In the long term, businesses may see a decline in efficiency due to a lack of competition, and may also see a reduction in profits due to the emergence of substitutes for their products.

How Do Tariffs Affect Prices And Business?

• The overall effect is a reduction in imports, increased domestic production and higher consumer prices.

Inflation and deflation

• Inflation can be defined as an increase in the average price level of goods and services.

• Deflation can be defined as a fall in the average price level of goods and services

Causes of inflation

• 1. Demand-pull. This means buyers want to buy more than sellers can actually produce; so sellers start to put prices up.

• 2. Cost-push. This means business costs start to rise (eg oil prices rise, or wages start to rise) and sellers need to put prices up to compensate.

• 3. Monetarist view. This means the government allows too much money to be created . If the supply of money rises, then the price falls just as if the supply of potatoes rises, then the price falls. The price of money here is how many goods and services it will buy. If the price of money falls, then it will buy fewer goods and services ie prices of goods and services rise and the value of money falls. This is inflation.

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The impact of inflation on international business

• Cost increases can be passed on to consumers more easily if there is a general increase in prices.

• The real value of debts owed by companies will fall. This means that, because the value of money is falling, when a debt is repaid it is repaid with money of less value than the original loan. Thus, highly geared companies see a fall in the real value of their liabilities.

• Rising prices are also likely to affect assets held by firms, so the value of fixed assets, such as land and building, could rise. This will increase the value of business and, when reflected on the balance sheet, make the company more financially secure.

• Since stocks are bought in advance and then sold later, there is an increased margin from the effect of inflation.

• during inflation that are not excessive, business could decide to raise their own prices, borrow more to invest and ensure that increased asset value appear on their balance sheet. However, high rates of inflation say 10% and above can be damaging for the business

• Staff will become much more concerned about the real value of their incomes. Higher wage demands are likely and there could be an increase in industrial disputes.

• Consumers are likely to become much more price sensitive and look for bargains rather than big names.

• Rapid inflation will often lead to higher rates of interest. These higher rates could make it very difficult for highly geared companies to find the cash to make interest payments, despite the fact that the real value of the debts is declining.

• Cash flow problems may occur for all businesses as they struggle to find more money to pay the higher costs of materials and other costs.

• If inflation is higher in one country than in other countries then business will lose its competiveness in overseas market

• Business that sell goods on credit will be reluctant to offer extended credit periods the repayments by creditors will be with money that is losing value rapidly.

• Consumers may stockpile some items or transfer their disposable income t commodities that are more likely to hold or increase value.

• Business may be forced to cut back spending, cut profit margins to limit their price rises, reduce borrowing to levels at which the interest payments are manageable hindering stimulation of investment, and layoff workers.

Balance Of Payment: Another financial environmental force

• The balance of payment is a statistical record of a country’s transactions with the rest of the world.

• Payments made to other countries are tracked as debit(-), while payments from other countries are tracked as credits(+). The BOP is considered as a double-entry accounting statement in which total credit and debits are always equal.

The Current Account

• Goods • Current Transfers • Income • Services

Why a Current account is considered harmful to economy

• If a current account deficit is financed through borrowing it is said to be more unsustainable.

• Borrowing is unsustainable in the long term and countries will be burdened with high interest payments. E.g. Russia was unable to pay its foreign debt back in 1998. Other developing countries have experience similar repayment problems Brazil, African c (3rd World debt)

• Foreigners have an increasing claim on UK assets, which they could desire to be returned at any time. E.g. a severe financial crisis in Japan may cause them to repatriate their investments

• Export sector may be better at creating jobs• A Balance of Payments deficit may cause a loss of confidence

However a current account deficit is not necessarily harmful

• Current Account deficit could occur during a period of inward investment (surplus on financial account)

• E.g. US ran a current account deficit for a long time as it borrowed to invest in its economy. This enabled higher growth and so it was able to pay its debts back and countries had confidence in lending the US money

• Japanese investment has been good for UK economy not only did the economy benefit from increased investment but the Japanese firms also helped bring new working practices in which increased labor productivity.

• With a floating exchange rate a large current account deficit should cause a devaluation which will help reduce the level of the deficit

• It depend on the size of the budget deficit as a % of GDP, for example the US trade deficit has nearly reached 5% of GDP (02/03) at this level it is concerning economists

What is indebtness?

• Indebtness is the state of a nation being in debt. The national debt of nation can be raised from domestic market as well as external debt.

• Deflation The reduction in demand reduced business activity and caused further unemployment.

• In a more direct sense, more bankruptcies also occurred due both to increased debt cost caused by deflation and the reduced demand effectively made debt more expensive

Conclusion

national debt

recession

worsening of BOP and

unemployment

losing business competitiveness

start of rapid money supply and inflation