IFM Final Study Material

INSTITUTE OF ENGINEERING AND
TECHNOLOGY
DEPARTMENT OF MBA
Srinivas Nagar Mukka, Mangalore 575025
BACKGROUND STUDY MATERIAL
INTERNATIONAL FINANCIAL MANAGEMENT
Compiled by
Prof. Swapna Raghupathi
MBA IV SEMESTER
Contents
Syllabus Teaching Plan

xii
1 International Economics and International Finance
xv
i
1
1.1 Global Economy - A Historical Perspective .............................. 1
1.2 Financial Globalization - The Missing Link .............................. 2
1.3 Interdependence of National Economies .................................. 3
1.3.1 AspectsofInterdependence ........................................ 4
1.3.2 Inter-dependenceofIndiaonothercountries ..................... 5
1 3.3 Challenges of increasing economic interdependence on each other 5
1.3.4 Issues of Increasing Economic Interdependence .................. 6
1.4 National Competitive Advantage .......................................... 7
1.4.1 FactorEndowments................................................. 8
1.4.2 DemandConditions................................................. 9
1.4.3 Related and Supporting Industries ................................ 9
1.4.4 FirmStrategy,Structure, andRivalry ............................. 9
1.5 International Business ...................................................... 10
1.5.1 Features of International Business ................................ 11
1.6 International Financial Management ...................................... 13
1.7 Functions of International Financial Manager ............................ 14
1.8 Self Study Questions ...................................................... 15

2 International Monetary System 16
2.1 Whatisthe InternationalMonetarySystemand howshould itfunction? 17
2.2 TheEvolution ofthe InternationalMonetarySystem(inBrief) .......... 18
2.2.1 The Gold Standard ................................................ 18
2.2.2 Bretton Woods ................................................... 19
2.2.3 TheCurrentHybridSystem ........................................ 19
2.2.4 TheWayForward...................................................20
2.2.4.1 Increased Use of Special DrawingRights.............. 21
2.2.4.2 A Substitution Account ................................ 21
2.3 Specie Commodity Standard .............................................. 22
2.4 Bimetallism ................................................................ 22
2.5 Gold Standard...............................................................23
2.5.1 How the Gold Standard Worked ..................................24
2.5.2 Performance of the Gold Standard ................................ 26
ii
Srinivas University IV Semester MBA
2.5.3 Suspension ofGoldStandard .................................................................... 27
2.5.4 Conclusion ................................................................................................. 27
2.6 Inter-WarYears ......................................................................................................27
2.7 Bretton Woods System of Exchange Rates ............................................................ 28
2.7.1 Fixed Parity System ................................................................................... 28
2.7.2 Collapse of Fixed Parity System ............................................................... 29
2.7.3 Smithsonian Arrangement ............................................................................... 30
2.8 ExchangeRateRegimeSince1973 .................................................................30
2.8.1 Floating Rate Regime ................................................................................ 31
2.8.2 ManagedFloating ...................................................................................... 32
2.8.3 Pegging ofCurrency ..................................................................................34
2.8.4 Target–Zone Arrangement ................................................................................ 34
2.9 International Liquidity .................................................................................................... 35
2.9.1 TheThreeBases ................................................................................ 35
2.9.2 Creation ofSDRs .............................................................................. 36
2.9.3 IMF‘s Funding Facilities .......................................................................... 37
2.9.4 AnAppraisalofLiquidityPromotionMeasures ........................................ 39

2.10 IMFSolutionforFinancialCrisis .................................................................... 40
2.10.1 Nature ofFinancialCrisis ......................................................................... 40
2.10.2 IMFResponse ................................................................................... 41
2.11 Major Financial Crises ........................................................................................... 42
2.11.1 LatAmsovereigndebtcrisis–1982 .................................................... 42
2.11.2 Savings andloans crisis–1980s ......................................................... 43

2.11.3 Stockmarket crash – 1987 .................................................................. 44
2.11.4 Junk bond crash – 1989 ...................................................................... 44
2.11.5 Tequila crisis– 1994 .......................................................................... 45
2.11.6 Asia crisis – 1997 to 1998 ..................................................................45
2.11.7 Dotcombubble – 1999 to 2000 ...........................................................46
2.11.8 Globalfinancial crisis – 2007 to 2008 ................................................. 46
2.11.9 Lessonslearnt? .......................................................................................... 47
2.12 Self Study Questions .............................................................................................. 47
3 International flow of funds 49
3.1 Formsofinternationalfinancialflows .................................................................... 49
3.1.1 MerchandiseTradeFlows.......................................................................... 49
3.1.2 Invisibles.......................................................................................... 50
3.1.3 ForeignInvestment ................................................................................... 50
3.1.4 External Assistance and External Commercial Borrowings ....................... 50
3.1.5 Short-term Flowoffunds .......................................................................... 51
3.2 Capital Flowsand Flight ......................................................................................... 51
3.2.1 Capital Flows ............................................................................................ 51
3.2.2 CapitalFlight .................................................................................... 51
3.3 International Liquidity.................................................................................................... 52
3.4 Balance of Payments: Meaning & Structure ........................................................... 52
3.4.1 BasicPrinciples ................................................................................ 54
3.4.2 Components ofBOP/Prescribed FormatforRecording transac
tions 54
3.4.2.1 CurrentAccount ...................................................................... 54
3.4.2.2 Capital Account ....................................................................... 55
3.4.2.3 Statistical Discrepancy ............................................................ 55
3.4.2.4 TheOverallBalance .......................................................... 56
3.4.2.5 OfficialReserves Account ...................................................... 56
3.5 BOP Equilibrium, Disequilibrium and Adjustment ..................................................... 56 3.5.1
AccountingandEconomicEquilibrium................................................... 56 3.5.2 Process of
Adjustment............................................................................. 56 3.5.2.1 TheClassical
Approach .......................................................... 57
3.5.2.2 ElasticityApproach ................................................................. 57
3.5.2.3 TheKeynesianApproach ........................................................ 57
3.5.2.4 MonetaryApproach .................................................................. 59
3.6 Significance ofBOPtoMultinationalCorporation.................................................. 60 3.7 Trendsin
IndianBalance of Payments .................................................................... 60 3.7.1
Trends&problemsofIndia‘sBOP-1949-50to1999-2000.................61 3.7.1.1 Protectionist
Policies .............................................................. 61
3.7.1.2 ExternalDebt .................................................................... 61
3.7.1.3 ExchangeRate .................................................................. 62
3.7.2 TrendsinIndia‘sBOP(2000-2010) ................................................... 62 3.7.3
ForeignInvestment ....................................................................................62 3.7.4
CurrentAccountofBOP .................................................................... 63
3.8 FundamentalsofBalanceofPaymentsAccounting ................................................. 64 3
.9 Role ofIMF in BOPCrisis............................................................................. 66
3.9.1 Whydo balance of payments problems occur? ........................................ 66 3.9.2 How
IMFlending helps ............................................................................. 66
3.9.3 IMFlendinginaction ......................................................................... 67
3.9.4 Rapid IMFLending During PastCrises .....................................................67 3.10 ExternalDebt
andEquityFinancing ........................................................................68
3.10.1 ExternalDebt.....................................................................................68
3.10.2 External Equity .......................................................................................... 69
3.11 Self Study Questions .............................................................................................. 72
4 International Financial Markets and Instruments 76 4.1 Introduction
.......................................................................................................... 76
4.2 NatureandFunctions ............................................................................................... 79 4.3
InternationalCapitalMarkets ..................................................................................79
4.3.1 Major Components of the International Capital Markets ............................ 81
4.3.1.1 InternationalEquityMarkets.................................................... 81
4.3.1.2 InternationalBondMarkets ......................................................82
4.3.1.3 ForeignBond .................................................................... 82
4.3.1.4 Eurobond ................................................................................. 83 4
3.1.5 GlobalBond.......................................................................83
3.1.6 EurocurrencyMarkets ............................................................. 83
4.3.1.7 OffshoreCenters ......................................................................84
4.3.1.8 The Role of International Banks, Investment Banks, Securities
Firms, and Global Financial Firms ............................................................................................. 84
4.4 InternationalMoneyMarket .................................................................................... 86
4.4.1 ReturnsonMoneyMarketInstruments ......................................................87
4.5 Arbitrage Opportunities ................................................................................................. 88 4.5.1
Basicsofusingthestrategy ................................................................. 89 4.5.2
Typesofarbitragestrategiesandtheirapplication ...................................... 89
4.5.3 Conclusion ................................................................................................. 91
4.6 Integration ofMarkets .............................................................................................91
4.7 InstrumentsinInternationalCapital&MoneyMarket .............................................93
4.7.1 American DepositaryReceipts(ADRs) .................................................... 93
.7.2 Global DepositaryReceipts(GDRs) ........................................................ 97
4.7.3 Eurobonds ................................................................................................. 99
4.7.4 Commercial Papers(CPs) ....................................................................... 101
4.7.5 Floating RateNotes(FRNs) ....................................................................102
4.7.6 Euro Deposits ......................................................................................... 103
4.7.7 Eurocurrencymarket .............................................................................. 103
4.8 Self Study Questions ............................................................................................ 105
5 Financing of Foreign Trade 106 5.1 Introduction to International Trade
.......................................................................... 106
5.1.1 RisksAssociatedwithInternationalTrade ...............................................106
5.2 FeaturesofInternationalTradeDocument ............................................................. 107
5.3 TermsAssociatedWithExport-Import Pricing (INCOTERMS).......................... 108
5.4 FinancingofInternationalTrade ............................................................................111
5.4.1 International Trade and Documentary Credit .............................................111
5.4.2 TypesofExportCredit .....................................................................112
5.4.2.1 Pre-ShipmentCredit .............................................................. 112
5.4.2.2 Post-ShipmentExportCredit .................................................. 114
5.4.3 LetterofCredit ................................................................................ 115
5.4.3.1 Features of Letters of Credit.................................................. 116
5.4.3.2 TypesofLettersofCredit................................................. 117
5.4.4 ExportCreditinForeignCurrencies ........................................................ 118
5.4.4.1 Pre-shipment Export Credit in Foreign Currencies .................. 119
5.4.4.2 Post-shipment Export Credit in Foreign Currency ................... 119
5.4.5 Uniform Customs and Practice for Documentary Credit ........................... 120
5.4.5.1 UCP 600 ......................................................................... 120
5.5 Consignment Sales ............................................................................................... 121
5.5.1 Difference between a Sale and aConsignment ........................................ 121
5.5.2 Commission or Consignee‘s Remuneration .............................................. 122
5.5.3 ConsignmentSalesinInternationalBusiness ........................................... 122
5.5.3.1 CharacteristicsofConsignment .............................................. 123
5.5.3.2 KeyPointsregardingConsignment ........................................ 123
5.5.3.3 HowtoExport onConsignment............................................. 124
5.5.3.4 Partnership in Exporting on Consignment ............................... 124
5.6 Bankers‘ acceptance .............................................................................................. 124
5.7 Self Study Questions .............................................................................................126
6 Foreign Exchange Market 127 6.1 Introduction toForexMarket:
............................................................................. 127
6.2 ForeignExchangeMarket,TradingVolumes ............................................................ 128
6.3 ForexMarketParticipants .................................................................................... 129
6.3.1 Typesofforexmarket participants .......................................................... 129
6.3.1.1 Wholesale Forex Market ....................................................... 131
6.3.1.2 Foreign Exchange Dealers and Brokers ................................. 131
6.3.1.3 Hedger, Speculatorsand Arbitrageurs ...................................... 134
6.3.1.4 CentralBanks andTreasuries................................................ 134
6.3.1.5 RetailMarket .................................................................. 134
6.4 TheSpotMarket ........................................................................................... 135
6.4.1 SpotQuotations ....................................................................................... 135
6.4.2 CurrencyArbitrage ................................................................................. 138
6.4.3 The Mechanics of Spot Transactions ...................................................... 140
6.5 TheForwardMarket .............................................................................................. 141
6.5.1 Forward Quotations ....................................................................................... 142
.6 Market Infrastructure ....................................................................................................145
6.1 Dealing rooms ........................................................................................ 145
6.6.2 Informationanddealingsystems .............................................................. 146
6.6.3 Payment and communication systems....................................................... 146
6.6.4 Forex Tradingand SWIFT ...................................................................... 146
6.6.5 Robots&ForexTrading .................................................................. 147
6.7 Setting The Equilibrium Spot ExchangeRate ...................................................... 147
6.7.1 Demand for aCurrency ........................................................................... 148
6.7.2 Supply ofaCurrency ...............................................................................148
6.7.3 Factors That Affect the EquilibriumExchangeRate ................................ 148
6.7.4 CalculatingExchangeRateChanges ....................................................... 150
6.8 Arbitrage and the Law of One Price ....................................................................... 150
6.9 PurchasingPowerParity ........................................................................................ 153
6.10 TheFisherEffect .......................................................................................... 156
6.11 The InternationalFisher Effect .............................................................................. 158
6.12 Interest RateParity Theory .................................................................................... 160
6.13 TheRelationshipBetween the ForwardRate and the Future Spot Rate . 163
6.14 CurrencyForecasting(ExchangeRateForecasting) .............................................. 164
6.15 Self Study Questions ............................................................................................. 169
7 Indian Foreign Exchange Market 178
.1 The Foreign Exchange Management Act, 1999 ....................................................178
7.1.1 BroadSchemeoftheFEMA ............................................................ 179
7.1.2 ImportantTerms UnderFEMA ............................................................... 180
7.1.3 Important Featuresof FEMA................................................................... 181
7.1.3.1 Investments Abroad by Indian Residents ............................... 181
7.1.3.2 ExternalCommercialBorrowings(ECB) ............................... 182
7.1.3.3 BorrowingsThroughLoans/Deposits .......................................... 183
7.2 ConvertibilityofIndianRupee ..............................................................................183
7.2.1 CurrentaccountconvertibilityvsCapitalaccountconvertibility. 185
7.2.2 Shouldwe go forCapital account convertibility? ..................................... 186
7.3 ExchangeControl .................................................................................................. 187
7.4 Export-Import (EXIM) Policy ............................................................................. 195
7.4.1 Policy Backdrop ...................................................................................... 196
7 4.2 The Foreign Trade Regime: Analytical Phases And Changes Overtime 197
7.4.3 India‘s EXIM Policy: Phases and Changes ............................................ 198
.4.4 India‘sImport Regime (1950-89): Major Features ................................. 200
7.4.5 Export Policies AndIncentives (1950-89) .............................................. 201
7.4.6 EXIM PoliciesIn The 90s............................................................... 204
7.4.6.1 EXIM Policy, 1990 ........................................................ 204
7.4.6.2 EXIM Policy (1992-97)................................................. 206
7.4.6.3 EXIMPolicyChanges(1992-93) .................................... 207
7.4.6.6 EXIM Policy Aligned on ITC (HS) Classification ................ 210
7.4.7 Export-Import Policy (1997-2002) ......................................................... 210

7.4.8 Export-Import Policy (2002-07) ............................................................. 212
7.5 Export-ImportDocumentation............................................................................. 216
5.1 Need ................................................................................................ 216
5.2 DocumentsinExportTrade ..................................................................... 216
7.5.2.1 Kinds of Documents ...............................................................216
7.5.2.2 PrincipalExportDocuments .................................................. 218
7.5.2.3 AuxiliaryDocuments............................................................. 228
7.5.3 DocumentsinImportTrade ......................................................................229
7.5.4 ExportDocumentationandProcedures-StepBy-Step ............................. 230
7.5.5 SomeUsefulTips ................................................................................. 234
8 Measuring Exposure to Exchange Rate Fluctuations 237 8.1 RelevanceofExchangeRateRisk
.................................................................237
8.1.1 TheInvestorHedgeArgument ................................................................ 238
8.1.2 Currency Diversification Argument .......................................................... 239
8.1.3 Stakeholder Diversification Argument ...................................................... 240
8.2 ForeignExchangeExposures ................................................................................ 241
8.2.1 TransactionExposure ..............................................................................241
8.2.2 TranslationExposure ............................................................................... 242
8.2.3 Economic Exposure/Operating Exposure .................................................. 243
8.3 Conclusion ............................................................................................................ 243
9 Managing Transaction Exposure 245
9.1 PoliciesforHedgingTransactionExposure ........................................................... 245
9.1.1 HedgingMost oftheExposure ................................................................ 245
9.1.2 Selective Hedging ................................................................................... 246
9.2 HedgingExposuretoPayablesandReceivables .................................................... 246
9.3 InternalTechniquesforManagementofTransactionExposure.............................. 247
9.3.1 Choice of a particular currency forinvoicing .......................................... 247
9.3.2 LeadsandLags ................................................................................ 247
9.3.3 Netting ............................................................................................ 248
9.3.4 Back-to-Back Credit Swap...................................................................... 249
9.3.5 SharingRisk .................................................................................... 249
9.4 ExternalTechniquesforManagementofTransactionExposure ........................... 251
9.4.1 UseofCurrencyForwardMarket............................................................. 251
9.4.2 UseofMoneyMarket ......................................................................252
9.4.3 Use ofCurrencyOptionsMarket ............................................................ 254
9.4.4 Use ofCurrency FuturesMarket..............................................................256
9.5 Limitations ofHedging ........................................................................................ 259
9.5.1 LimitationofHedginganUncertainPayment ........................................... 259
9.5.2 LimitationofRepeatedShort-TermHedging........................................... 259
9.6 Alternative Hedging Techniques ............................................................................. 260
9.6.1 Leading andLagging............................................................................... 260
9.6.2 Cross-Hedging ........................................................................................ 260
9.6.3 Currency Diversification ............................................................................... 261
10 Managing Economic Exposure andTranslation Exposure 268
0.1 ManagementofEconomic (Operating)Exposure.................................................. 268
International Financial Management vii

10.1.1 DefiningOperatingExposure ................................................................. 269
10.1.2 OperatingExposure:Impact on cash flows ............................................. 271
10.1.3 Operating Exposure Management at Operational Level ............................ 274
10.1.3.1 Matching Currency Cashflows ............................................... 274
10.1.3.2 Risk Sharing Agreement ....................................................... 275
10.1.3.3 Reinvoicing centers ............................................................... 276
10.1.3.4 CurrencySwap ...................................................................... 276
10.1.4 OperatingExposureManagement:AtStrategicLevel ............................ 278
10.1.4.1 DiversifyingOperation .......................................................... 279
10.1.4.2 DiversifyingFinancing ......................................................... 280
10.1.4.3 Operating exposure management and forwards, fu turesandoptions
contracts ..................................................... 281
10.2 ManagementofTranslation(Accounting)Exposure ............................................. 282
10.2.1 Defining Accounting/Translation Exposure ............................................. 282
10.2.2 Transaction andEconomicExposureVs. Translation exposure . 283
10 2.3 Consolidated Reporting Requirement and Accounting Standards 283
10.2.4 Identification/classification of Foreign Operation .................................... 287
10.2.5 MeasurementofTranslationExposure .....................................................288
10.2.5.1 Current/Non-Currentmethod ...................................................... 289
10.2.5.2 Monetary/Non- Monetary Method .......................................... 289
10.2.5.3 CurrentRateMethod ............................................................. 289
10.2.6 ManagementofTranslationexposure ...................................................... 290
11 Swaps and Interest Rate Derivatives 296 11.1 InterestRate
andCurrencySwaps ........................................................................ 296
11.1.1 InterestRate Swaps ................................................................................ 297
11.1.2 CurrencySwaps ....................................................................................... 300
11.1.3 EconomicAdvantages of Swaps ............................................................. 304
1.2 InterestRateForwardsAndFutures ....................................................................... 305
11.2.1 Forward Forwards.......................................................................................... 305
11.2.2 ForwardRateAgreement......................................................................... 306
11.2.3 EurodollarFutures ...................................................................................307
11.3 StructuredNotes .................................................................................................... 309
11.3.1 Inverse Floaters....................................................................................... 310
11.3.2 Callable Step-Up Note ............................................................................. 311
11.3.3 Step-DownCouponNote......................................................................... 311
11.4 CreditDefault Swaps ............................................................................................ 311
11.5 Self Study Questions............................................................................................. 313
12 Country Risk Analysis 316
12.1 CountryRiskCharacteristics ................................................................................. 316
12.1.1 PoliticalRisk Characteristics.................................................................. 316
12.1.1.1 Attitude of Consumers in theHost Country ............................. 317
12.1.1.2 Actions ofHostGovernment ..................................................317
12.1.1.3 Blockage ofFund Transfers .................................................. 318
12.1.1.4 Currency Inconvertibility ........................................................... 318
12.1.1.5 War ........................................................................................... 318
12.1.1.6 InefficientBureaucracy.......................................................... 318
12.1.1.7 Corruption.............................................................................. 319
12.1.2 FinancialRiskCharacteristics ................................................................ 319
12.1.2.1 Economic Growth .................................................................. 319
12.2 Measuring(Assessing)CountryRisk .................................................................... 320
12.2.1 TechniquestoAssessCountryRisk ........................................................ 321
12.2.1.1 ChecklistApproach ............................................................... 321
12.2.1.2 DelphiTechnique .................................................................. 321
12.2.1.3 Quantitative Analysis .................................................................. 322
12.2.1.4 Inspection Visits ........................................................................ 322
12.2.1.5 CombinationofTechniques .................................................. 322
12.2.2 Deriving aCountryRiskRating ............................................................... 322
12.2.3 ComparingRiskRatingsamongCountries ..............................................324
12.3 Preventing Host Government Takeovers ..................................................................... 325
12.3.1 Use aShort-TermHorizon ...................................................................... 325
12.3.2 Rely on Unique Supplies orTechnology.................................................. 326
12.3.3 HireLocalLabor ............................................................................. 326
12.3.4 Borrow Local Funds ................................................................................ 326
12.3.5 PurchaseInsurance .................................................................................. 326
12.3.6 UseProjectFinance ......................................................................... 327
12.4 Significance ofCountry Risk Analysis................................................................. 327
13 Managing Short Term Assets and Managing Working Capital in a Multi- national
Firm329
13.1 WorkingCapitalManagement............................................................................... 329
13.1.1 Definitions ofWorkingCapital ............................................................... 329
13.1.2 Inventory Management .................................................................................. 329
13.1.3 CashManagement ...................................................................................330
13.1.4 CurrencyRiskManagement .................................................................... 330
13.1.5 CurrentliabilitiesManagement ............................................................... 330
13.2 International Cash Management .............................................................................. 331
13.2.1 Organization ............................................................................................331 13.2.2
CollectionandDisbursementofFunds .................................................. 332 13.2.3 Payments Netting in International
Cash Management ................................. 333
13.2.4 ManagementoftheShort-TermInvestmentPortfolio .............................. 336
13.2.5 OptimalWorldwideCashLevels ............................................................. 338
13.2.6 CashPlanningandBudgeting .................................................................. 338
13.2.7 BankRelations ................................................................................ 341
13.3 Centralised Versus Decentralised Cash Management .............................................. 342
13.3.1 Netting ............................................................................................ 342
13.3.2 ExposureManagement ............................................................................ 342
13.3.3 CashPooling ....................................................................................343
13.3.4 Disdavantages of Centralised Cash Management.................. 345
13.4 AccountsReceivableManagement ...................................................................... 345
13.4.1 Credit Extension ...................................................................................... 346
13.5 Inventory Management ................................................................................................ 347
13.5.1 Production Location and Inventory Control ............................................... 347
13.5.2 Advance Inventory Purchases ................................................................... 348
13.5.3 InventoryStockpiling ............................................................................. 348
13.6 Short-TermFinancing .......................................................................................... 349
13.6.1 KeyFactorsin Short-TermFinancing Strategy ....................................... 349
13.6.2 Short-TermFinancingObjectives .......................................................... 350
13.6.3 Short-TermFinancingOptions ............................................................... 351
13.6.3.1 IntercompanyFinancing ........................................................ 351
13.6.3.2 LocalCurrency Financing..................................................... 351
13.6.3.3 BankLoans ..................................................................... 351
13.6.3.4 CommercialPaper ................................................................. 355
14 Financing Decisions by MNCs and Long TermInvestment Appraisal 357
14.1 CostofCapitalForInternationalInvestments........................................................ 357
14.1.1 TheCostofEquityCapital ............................................................... 358
14.1.2 TheCostofDebtCapital .................................................................. 359
14.1.3 WeightedAverageCostofCapitalforForeignProjects ........................... 361
14.1.4 DiscountRatesforForeignInvestments ................................................. 361
14.1.4.1 Evidence From the Stock Market .......................................... 363
14.1.4.2 Key Issues in Estimating Foreign Project Discount
Rates.............................................................................. 363
14.2 Capital Budgetingfor MNCs ................................................................................ 370
14.2.1 EvaluationCriteria................................................................................... 370
14.2.1.1 Net PresentValue (NPV) ....................................................... 370
14.2.1.2 Adjusted PresentValue (APV) .............................................. 375
15 Transfer Pricing and Divisional Performance Analysis 381
15.1 Transfer Pricing ..................................................................................................... 381
15.1.1 Lowmarkup andhighmarkuppolicy ...................................................... 383
15 1.2 TransferPricing:MethodsofComputationofArm‘sLengthPrice385
15.2 DivisionalPerformanceAnalysis .......................................................................... 389
15.2.1 Specific andGeneralKnowledge ............................................................ 390
15.2.2 Alternative Divisional Performance Measures ........................................ 391
15.2.2.1 CostCenters .................................................................... 391
15.2.2.2 RevenueCenters.................................................................... 393
15.2.2.3 ProfitCenters ......................................................................... 394
15.2.2.4 InvestmentCenters andEVA ............................................................ 395
15.2.2.5 ExpenseCenters .................................................................... 396
15.2.3 InternalChargebackSystemsandDecentralizationofPartofthe Control
Function 397
15.2.4 The Locus of Uncertainty Problem ..........................................................398
15.2.5 Choice ofPerformance Measure .............................................................. 399
SYLLABUS
Course Objectives: To impart a specialized knowledge of significance of Foreign exchange and its relevance
to survive in international market.
Pedagogy and work load: 4 hours per week consisting of Lectures, assignments, practical exercises,
discussions, seminars.
Examination: 2 hours; 50 marks
Course content:
Chapter 1: International economics and international finance

Interdependence of national economics - competitive advantage - Capital flows and flight - Meaning of Balance
of payments – components of BOP, Significance of BOP to the multinational corporation, trends of Indian
Balance of payments- BOP Accounting
Chapter 2: International financial Markets and Foreign trade financing International capital and money
markets - Arbitrage opportunities - International capital and money market instruments GDRs, ADRs,
Euro-Bonds, CPs, FRNs, Euro deposits, Eurocurrency markets.
Pre and post shipment credit, LCs,UCPDC INCO TERMS- cash in advance and consignment sales - Bankers
acceptances.
Chapter 3: Foreign Exchange Market

Foreign exchange Market Structure- major participants, Spot market, quotations, cross rates, currency
arbitrage, forward market, forward quotations, relationship between forward rate and future spot rate,
Forecasting exchange rates, determinants of exchange rates, Exchange rate behavior, Law of one price,
purchasing power parity, interest rate parity, Fisher effect, International Fischer effect – implications.
Chapter 4: Measuring Exposure to Exchange rate fluctuations

Managing Transaction Exposure - Hedging exposure to payables and receivables – Forward or Futures Hedge,
Money Market Hedge, Options Hedge - Managing Economic exposure and Translation exposure - Translation
methods; current / noncurrent, monetary / non monetary, current rate methods. Economic exposure- How to
measure economic exposure, determinants of operating exposure, managing operating exposure
Chapter 5: Managing short term assets and managing working capital in MNC Concept of Working
Capital. Cash, receivables and inventory – short term asset financing, centralized V/S decentralized cash
management, bilateral and multilateral netting of internal and external net cash flow. Management of
receivables, management of inventory, Short term financing
Chapter 6: Financing Decisions and capital budgeting by MNCs

Cost of capital for international investments – cost of equity capital, Cost of debt, Weighted average cost of
capital, Discount rates for foreign investments, capital budgeting in MNCs– NPV method
International Financial Management xv

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15. MadhuVij-InternationalFinancialManagement-ExcelBooks,NewDelhi. 16. Kevin S - Fundamentals
oflnternational Financial Management-Prentice Hall In- dia. 17.
DunandBroadstreet-ForeignexchangeMarkets-TataMcGrawHillPublishing Company Ltd.
18. GeertJBekaertandRobertJ.Hodrick-InternationalFinancialManagement(2nd Edition) (Prentice Hall
Series inFinance)
19. Rajwade A.V. - Cash &Derivatives markets in foreign exchange-Tata McGraw Hill education Pvt.
Ltd., New Delhi.
20. Eun School and Resnick Bruce-International Financial Management- Tata Mc- Graw hillpublishing
company Ltd., New Delhi.
21. Madura - International Corporate finance- cengage learning India Pvt. Ltd., New Delhi. 22. Janakiraman
Sundram, - Derivatives and Risk Management- Dorling Kindersley India Pvt. Ltd. 23.
SomanathVS-InternationalFinancialManagement-I.K.InternationalPublish- ing o House Pvt. Ltd., New Delhi.
24. C.Jeevanandan - Foreign Exchange and Risk Management-, Sultan Chand and Sons, New Delhi .
25. Francis Chenmilam - International Business- Prentice Hall India
26. Prasanna Chandra - Finance Sense
27. Prasanna Chandra - Projects
International Financial Management xv i

Srinivas University IV Semester MBA TEACHING PLAN
Session Topic
1 International economics and international finance
2 Interdependence of national economics
3 competitive advantage
4 International Monetary System - Meaning
5 Evolution ofInternationalMonitory system-Bimetallism,Classical

gold standard, Interwar Period, Bretton Woods System of
exchange rate, exchange rate regime since 1973
6 International Liquidity
7 IMF solution for financial crisis
8 Major financial crisis
9 Capital flows and flight

10 External debt and equity financing
11 Meaning of Balance of payments - components of BOP
12 Significance of BOP to the multinational corporation
13 Trends of Indian Balance of payments
14 Role of IMF in BOP crisis
15 International capital and Money markets
16 Arbitrage opportunities, Integration of markets
17 International capital and money market instruments - GDRs,

ADRs, Euro-Bonds, CPs, FRNs, Eurodeposits, Eurocurrency
markets
18 Financing of foreign trade - Pre and post shipment credit, LCs, UCPDC
19 INCOTERMS, Cash in advance and consignment sales,

Bankers‘ acceptances
20 Foreign Exchange Market Structure, market infrastructure,

major participants
21 Spot market and currency quotations
22 Cross rates and currency arbitrage
23 Forwardmarketandforwardquotations,relationshipbetweenforwa
rd rate and future spot rate
24 Exchange ratebehavior,Determinantsof exchange rates

andForecasting exchange rates
25 ParityTheories: LawofOnePrice, PurchasingPower

Parity,InterestRate Parity, Fisher Effect, International Fischer
Effect
26 Problems on Parity Theories
27 Overview of the Foreign Exchange Management Act
28 Convertibility of rupee and Exchange control
29 Indian exports & imports policies, practices and documentation
30 Measuring Exposure to Exchange rate fluctuations: The investor

hedge argument, Currency diversification argument, Stakeholder
diversification argument
31 Types of exposure – Transaction exposure, economic

exposure, translation exposure
32 ManagingTransactionExposure:Hedgingexposure-ForwardorFuture
s Hedge, Money Market Hedge, Options Hedge
International Financial Management 17

33 Alternativehedgingtechniques-parallelloan,leadingandlagging,cro
ss hedging, currency diversification
34 Limitations of Hedging, Problems on hedging
35 Translationmethods;current/noncurrent,monetary/nonmonetary,cu
rrent rate methods
36 Problems on translation
37 Economic exposure, How to measure economic exposure,

determinants of operating exposure, managing operating
exposure
38 Problems on hedging
39 Interest rate swaps, currency swaps
40 Interest rate forwards, futures, structured notes
41 CountryRiskAnalysis:Significanceofcountryriskanalysis-political
and financial risk, assessment of risk factors
42 Country risk ratings, techniques to assess country risk
43 Measuring country risk, preventing host government takeovers
44 Concept of Working Capital, Cash, receivables and inventory
45 Short term asset financing, centralized vs decentralized cash

management, bilateral and multilateral netting of internal and
external net cash flow
46 Management of receivables, management of inventory, Short

term financing
47 International investment decisions, Discount rates for foreign investments
48 Cost of capitalforinternational investments- cost of equity

capital,Cost of debt, Weighted average cost of capital
49 Capital budgeting in MNCs - NPV, APV methods
50 Problems on Capital Budgeting
51 Transfer pricing and divisional performance analysis
52 Lowmark up andhighmarkup policy,Methodsfor establishing an

arm‘s length pricing
53 Problems form old question papers
54 Problems form old question papers
55 Review of entire syllabus
56 Value Addition: International Taxation
57 Value Addition: International Banking
58 Value Addition: International Accounting

Chapter 1
International Economics and International Finance
1.1 Global Economy - A Historical Perspective

The process of globalization is not a new phenomenon. Some communication and trade took place among distant
civilizations even in ancient times. In spite of occasional in- terruptions, the degree of economic globalization
among different societies, around the world has generally been rising. More than a century ago, Marx and Engels
rightly sensed the unprecedented efficiency of the industrial capitalism and predicted that capitalism would sweep
through the entire world. Eventually capitalism spread to
nearly the entire world, in a complex and sometimes fierce process. (Brookings Papers on Economic Activity,
1995). Indeed, during the past half century, the pace of economic globalization has been particularly rapid. With the
exception of human migration, global economic integration today is greater than it ever has been and islikely to
deepen further. It wasthe instrument of colonial expansion rather than the economic reforms through which the global
capitalism came into existent. Western European powers with their superior industrial and military powers expanded
their kingdom around the world. By the 1870s, the industrial revolution and colonial expansion led to establish, a
global market. Improvements in the technological progress in transportation and communication sectors, changing
tastes
and preferences of individuals and societies and public policies have significantly influenced the character and pace
of economic globalization. Global economic system started functioning with the development of long distance
communication system. Monetary standards, based on gold and silver,
provided the vital support for the stability and spread of economic globalization. First World War, Great
Depression of the 1930s and political upheaval created unprecedented crises to global economy. The free trade
regimes of 19th century were replaced by highly protected trade, state planning, authoritarianism and limited market
based economy. At the end of the Second World War, the international economic system wasin a state of collapse.
International markets for trade in goods, services, and financial assets were essentially nonexistent. However, there
was a silver lining in the midst of black cloud. It gave an opportunity for a completely new beginning for the world
economy.
The new beginning started in the formation of International Monetary Fund for
world level monetary standard. It also led in the establishment of various other international institutions like the
International Bank for Reconstruction and Development, General Agreement on Trade and Tariff etc. Those
institutions have contributed in the integration of world economy. After the World War II, most national governments
began to lower their entry barriers, to make them more permeable forworld trade.
The multilateral negotiations under the auspices of the General Agreement on Trade and Tariffs (GATT) stand out
asthe most prominent examples of reduction of barriers fortrade in goods. The years between 1970 and 1990 have
witnessed the most remark- able institutional harmonization and economic integration among nations in the world
history. The decade of 1980, witnessed the integration of the communist world with the world economy as
capitalism spread to their economies. The decade of 1980s also witnessed the practice of open economy
macroeconomic policies by many developing
countries. Several Latin American and Asian Countries had implemented financial reform policies or eliminated
Government control of domestic interest rates, credit allocation and exchange rate etc. Countries like Korea,
Malaysia, Chile, Argentina, Uruguya, Japan, Hong Kong, India and China have liberalized their economies. They
have under- taken many policy decisions to reform their financial markets. One of the primary aims of financial
reforms programme of these countries has been to integrationofthevarious segments of financial markets.
The decade of 1990s is generally considered as the decade of re-unification of global economy. The world
reached its climax in the process of integration of developed and developing worlds.

Disintegration ofthe Soviet Union, the emergence of market- oriented economies in Asia, the creation of a single
European market, formation of new era of trade liberalization through World Trade Organization etc., are few
events of 1990s which led to global financial and economic integration. Development of IT- based communication
system and services have significantly contributed in the further expansion of global financialsystem.
1.2 Financial Globalization - The Missing Link

If there is any arena of economic activity that has become extremely global in recent decades, it is finance. The
world offinance has changedmarkedly overthe past 40 years orso. During the early part of 1970s world economy
witnessed scarcity of international liquidity primarily due to gold linked fixed monetary standard. There was also a
growing realization that for achieving sustained growth with stability, it would be necessary
tohaveopentrade,liberalizedexternal capitalmovements anda relatively flexible domestic monetary policy.
Industrialized countries and emerging market economies took steps to liberalize capital account and
allowcapitaltomove acrossthe globe.
Simultaneously, efforts were made to remove distortions in the domestic financial sector through financial sector
reform measures. With the technological improvements in electronic payments, world economy became
increasingly integrated in terms of trade, investment and financial flows among countriesoverthepastdecades.
There are primarily three traceable aspects of the growth of financial markets, which have led to financial
globalization. These are:
1. Significant expansion and deepening of the existing markets,

2. Emergence of new financial markets like derivatives
3. Development ofsecondary marketsfor many instruments.
A number of developing countries, especially in Asia, that moved early on to the path of economic liberalization
had experienced large capital inflows. Large capital inflows, however, carried with itrisk of financial sector
vulnerability. The world economy had witnessed many financial crises. The experiences helped in for setting
regulatory and supervisory framework, in proper place, to ensure the safety and stability of financial systems. The
costs of financial crisis falling on the sovereign governments, the notion of financial stability has come to occupy a
centre-stage in public policy along with the requirement of ensuring that the efficiency of financialsector is high.
The sub-prime crisis, which engulfed the world economy, has called for establishing a new internationalfinancial
architecture. According to the IMF‘s Global Financial Stability Report (GFSR), the widening and deepening
fallout from the U.S. subprime mortgage crisis would have profound implications on financial system. Financial mar-
kets remain considerably stressed because of a combination of weakening balance sheets of financial institutions,
continued process of deleveraging, free fall in asset prices and difficult macroeconomic environment in the wake of
debilitating global growth.
The global financial system has proved to be woefully inadequate, particularly in view of the manifest structural
deficienciesin meeting the regulatory requirements of the present-day international financial system of the Bretton
Woods architecture. The extraordinarily synchronized nature of the sub-prime crisis makes it necessary to launch the
creation of a ―Global Monitoring Authorityǁ to promote global supervision of cross- border investment, trade and
banking with the fast-growing economies. Even in this era of sweeping globalization, the free play of unfettered
market mechanism is fraught with great danger. The market on its own is not enough. Accordingly, the
governments must play an important role in shaping the economic policies andthebroaderframe of reference.
1.3 Interdependence of National Economies

Economic interdependence is a relationship between two or more people, regions, nations or other

entities in which each is dependent on the other for various economic variables such as goods, services, currency,
financial tie-ups, etc. Economic interdependence often occurs when all parties are specialized in the fulfillment of
some requirements, and must trade with others for unmet requirements.
This economic interdependence or economic integration centers on the four main economic flows that
characterize globalization:
• Goods and services, e.g. exports plusimports as a proportion of national income or per capita of population:
higher the percentage higher is the intensity of globalization of the country because its shows higher
interdependence between this country and other countries (of course, both exports and imports must be high, only
imports will not do)Â
• Labor, e.g. netmigration rates; inward or outwardmigration , weighted by population - higher the incidence of
migration, preferably both ways, higher is the
interdependence between this country and other countries.
• Capital, e.g. inward or outward direct investment as a proportion of national income or per headofpopulation-
thehigheristheflowofonecountry‘scitizens‘ investmentinother countries andvice a versa, the higher isthe
interdependence among countriesin termstheir common interest in the growth anddevelopment of all countries, and
therefore higher isthe extent of globalization.
• Technology, e.g. international research & development flows; proportion of pop- ulations using particular
inventions; the more different countries co-operate and collaborate on technological progress and take each other‘s
help on technology adaptation, the greater is the interdependence among them and greater theextent of globalization.
1.3.1 Aspects of Interdependence

1. Foreign Trade: Foreign trade is the oldest indication of international economic interdependence.
Howeverrecently, the rapid expansion ofworld trade at a rate higherthan that ofworld output growth, and the
changesin itsrelative composition and geographic distribution have contributed to and reflected the qualitative
difference inthenature anddegreeofinterdependencewhichhasoccurred over this period.
2. Foreign Direct Investment: Foreign direct investment ( FDI) has become an increasingly important activity
over the last twenty years or so. The motivation behind corporate decisions to undertake foreign investment is
diverse but can be grouped under the two broad categories of cost and/or market considerations, including trade
substitution and import barrier evasion. Foreign direct investment has become particularly important in the services
sector. Although in earlier decades FDI was concentrated in raw materials and other primary products, today the main
sectors are services andtechnology-intensivemanufacturing.
3. Globalization of Technology: Technological resources and R&D activities remain largely concentrated in the
Triad countries (US, Japan, EC). The dependence of countries outside this group on Triad technology is therefore
very substantial and transfer of this techno-logy, generally through direct investment by Triad multinational
enterprises, is of prime importance. Within the Triad, the level of technological interdependence is high and
increasing further, particularly in the new high
techareas,promptingthecoiningoftermssuchas "technoglobalism".
4. TransitionalInformation Flows and Network: Data communication services are one of the most rapidly
expanding areas of economic activity. The rapid expansion of these new services can be expected to outstrip the
growth of voice communications and, in the long run, they could become more important in abso- lute economic
terms.
5. Economic Networking: The developments outlined in the preceding section have been instrumental in
promoting the spread of new forms of corporate strategies at the international level. These strategies are based
concurrently on cooperation
and competition between economic operators engaged in various forms of joint value creating activity. The
resulting interrelationships are usually referred to as "networking" while some analysts now
increasinglyspeakofthe emergence of a "networked economy".
6. Financial Market: The emergence of a global financial market is the most highly developed and pervasive
aspect of economic interdependence. The advances in informatics and communications technology, within the last
ten years, have permitted the development of instantaneous and continuous trading in currencies and financial
assets acrossthe world, thus creating the most truly global market.
1.3.2 Inter-dependence of India on other countries

India‘s economic liberalization and export orientation after 1991 has yielded better growth rates compared to the
decades before. The new economic policy is regarded as the only strategy to cope with the problems of
underdevelopment and unemployment in the long run. Indian government is planning to diversify energy imports and
acquire equity oil by India‘s state owned oil companies.
At present India is the sixth largest consumer of energy and the third largest consumer of oil and gas in Asia only
afterJapan and China. India‘s main domestic energy resources are coal,hydro,gas,oil and nuclear power. Allthe
forecast predictthatIndia‘s hunger for energy will increase as a result of growing population and rapid industrial-
ization. And by 2030, India‘s importing oil supplies percentage will increase from70% to 90% and overall import
dependence will be around 40% by then.
Cooperation between China and India are the common development of the Ya- davaran oil fieldsin Iran. She has
also extended their cooperation to regions like Africa where Indian and Chinese companies have cooperated in
Sudan. Besides China, the quest for energy and oil & gas has also intensified India‘srelation withRussia and
AfricanCountriesrespectively. Apartfromthis,Germany and USA based companies are leading luxury car selling
companies in India. Most of the petroleum products of India are imported fromgulf countries. Thusthe fluctuation
in the petroleum pricesin these countries affectsthe prices of petroleum productsin India.
This needs of energy by India reflect the new constraints of interdependence that India is confronted with in the era
of globalization. On one side it shows India‘s new economic and political strength in international affairs, on the
other side one sees India‘s new dependences and vulnerabilities because of the linkage with many security issues.
However India will probably benefit from the new interdependence although it will introduce new constraints on
her foreign policy. This way India‘s growing economic
interdependence will change the discourse in the long term perspective. This clearly shows the dependence of
India on other countriesfor itsresources.
1.3.3 Challenges of increasing economic interdependence on each other 1. A Stable and Open World
Economy: The various forms of international economic make up an intensive and complex system of global
interdependence. The interlink ages between individual economies are too strong and the momentum of
globalization too great for the process to be reversed. In such a system, where wealth-creating activities are increasingly
transnational, it makessense to facil itate these activities by providing an open and stable world economic environment. This
requires effective policy co-ordination between governments, at least of those economies whose size is such that they can have
a significant impact on the global economy. Economic liberalization: An open environment means more than an open
trade regime. It entails open regimes for foreign direct investment, for capital flows, for accessto networks and for
allforms ofinternational economic activity.
2. To address imbalances: Economic interdependence is strongest and most intri- cate among the countries of the
industrialized world. It is by no means limited to these countries. The direct links between western industrialized
economies and the Third World may still be less complex but they are, nonetheless,significant and two-way.
3. A closer partnership with the developing world: Involving the developing countries more fully in the
international structures required to manage international economic activity will promote their economic progress
and assure their political will to undertake the obligationsthis entails. At the same time, a more consistent effort to
reinforce political relations with these countries, by engaging them in a more comprehensive and constructive
political dialogue would help to promote a greater sense of commonality of interests.

4. Towards a More Global and Comprehensive Regulatory Framework: One consequence of the
globalisation of economic activity is that it is now more difficult to distinguish between its variousforms and the
motivation behind them. Its effects are also becoming less clear. As economic globalisation proceeds, a more
comprehensive and more coordinated approach to international regulation is called for. The growing complexity of
international economic interconnections means that the present "Compartmentalization" of regulatory issues is
becoming increasingly inappropriate. It is,
therefore,becomingmorewidely acceptedthat international rulemaking will have to cover new areas of economic
activity and address new concerns, as well asshifting current types of rulesfrom the national to the international.
1.3.4 Issues of Increasing Economic Interdependence

1. Loss of Flexibility: Regional integration can make it difficult for national gov- ernmentsto create and
implement policies based on their own particular needs. This can be problematic when the specific economic
conditions within a member country require actions such as adjusting the money supply or increasing public debt
in order to finance infrastructure development or entitlements. These policies, while necessary for one member
nation, could skew the economies of other member nations. Additionally, richer member nations may be forced to
bail out poorer member nations or risk devaluating their currency and diminishing the whole regional economy.
2. Increasing Political Influence of Corporations: As national economies become more intertwined, the
advocates of the free market exercise an unprecedented amount of political autonomy and influence. By nature of
being decentralized due to access to resources including cheap labor, no governmentcaneffectivelyexert influence
on a corporation of sufficient size. In the United States, for example, corporationsfund lobbying entitiesto
exercise their political capital.
3. Widening Gulf of Wealth: This autonomy of profit-making entities ensures that the bulk of the wealth
generated by economic activity can be fed back to the upper management of these entities without oversight or
controversy. The result, as seen during the economic crisis of 2008 is an increase in economic inequality, where a
tiny sliver of the world‘s population has amassed a relatively gigantic proportion of the world‘s money where the
share of that wealth by the middle andlower classes has
actually decreased.
4. Labor Exploitation: One major consequence of globalization is that as demand grows for manufactured goods,
the pressure to drive down the costs of manufacturing is manifested. This usually means that labor becomes
devalued, wages are driven down and unions are eliminated, discouraged or severely weakened due to the emphasis
placed on unskilledlabor
5. Resources: If one country in a region has resources the other states lack, these resources rightly or wrongly
are often seen by others as a political weapon. Battles have raged in Eastern Europe over the relations between
Ukraine and Russia. Rus- sia has offered a regional integration scheme many times wherein regional states such as
Armenia and Kazakhstan can share resources and open markets. Ukraini- ans have responded by accusing Russia of
using its superior oil and gas wealth to hold the Ukrainian economy hostage. This use of resources as a weapon,
real or perceived, can be anotherresult ofimbalancesinregionalpowerarrangements.
Globalization of economic activity and hence growing economic interdependence is an inescapable fact, although its
implications are not always fully recognized or understood. International economic interdependence means that
competing economies have a common interest in assuring macroeconomic stability, an open world economic sys-
tem and a multilateral framework of rules and institutions to manage global economic activity. Sustained economic
growth in the new market economies and the developing countries, and their integration into the emerging global
economic system will benefit the industrialized countries as well. It is in the interest of the latter to promote world-
wide economic development.
1.4 National Competitive Advantage
In 1990 Michael Porter of Harvard Business School published the results of intensive research to determine why
some nations succeed and others fail in international competition. Porter and his team looked at 100 industries
in 10 nations. The book that contains the results of this work. The Competitive Advantage of Nations, has made
an important contribution to thinking about trade. Like the work of the new trade theorists,
Porter‘s work was driven by a belief that the existing theories of international trade told only part of the story.
Porter hoped to explain why a nation achieves international success in a particular industry. Why does Japan do
so well in the automobile industry? Why does Switzerland excel in the production and export of precision
instruments and pharmaceuticals? Why do Germany and the United States do so well in the chemical industry?
These questions cannot be answered easily by the Heckscher-Ohlin theory, and the theory of comparative advantage
offers only a partial explanation. The theory of
comparative advantage would say that Switzerland excels in the production and export of precision instruments
because it uses its resources very efficiently in these industries. Although this may be correct, this does not explain
why Switzerland is more productive in thisindustry than Great Britain, Germany, or Spain. It isthis puzzle that
Portertries to solve.
Porter‘s thesis is that four broad attributes of a nation shape the environment in which local firms
compete,andtheseattributespromoteorimpedethecreationofcom- petitionadvantage.These attributes
are:i)factorendowments;ii)Demandconditions;
iii) Relating and supporting industries; iv) Firm strategy, structure, and rivalry. Porter speaks of these four
attributes as constituting the diamond. He argues that firms are most likely to succeed in industries or industry
segments where the diamond is most favorable. He also argues that the diamond is amutually reinforcing system.
The effect of one attribute is contingent on the state of others. For example, Porter argues, favourable demand
conditions will not result in competitive advantage unless the state of rivalry is sufficient to cause firmsto respond
to them.
Porter maintains that two additional variables can influence the national diamond in important ways: chance and
government. Chance events, such as major innovations, create discontinuities that can reshape industry structure and
provide the opportunity for one nation‘s firms to supplant another‘s. Government, by its choice of policies, can
detract from or improve national advantage. For example, regulation can alter home demand conditions, antitrust
policies can influence the intensity of rivalry within an
industry,andgovernmentinvestmentsineducationcanchangefactorendowments.
1.4.1 Factor Endowments

Factor endowments lie at the center of the Heckscher-Ohlin theory. While Porter does not propose anything
radically new, he does analyse the characteristics of factors of production in some detail. He recognises hierarchies
among factors, distinguishing between basic factors (e.g., natural resources, climate, location, and demographics)
and advanced factors (e.g., communications infrastructure, sophisticated and skilled labour, research facilities, and
technological know-how). He argues that advanced factors are the most significant for competitive advantage. Unlike
basic factors (which are naturally endowed), advanced factors are a product of investment by individuals, companies,
and governments. Thus, government investments in basic and higher education, by improving the general skill and
knowledge level of the population and by stimulating advanced research at higher education institutions, can upgrade
a nation‘s advanced factors.
The relationship between advanced and basic factors is complex. Basic factors can provide an initial advantage that
is subsequently reinforced and extended by investment in advanced factors. Disadvantages in basic factors can
create pressures to invest in advanced factors. The most obvious example of this phenomenon is Japan, a country
that lacks arable land and mineral deposits and yet has built a substantial endowment of advanced factors. Porter
notes (hat Japan‘s large pool of engineers (reflecting a much higher number of engineering graduates per capita
than almost any other nation) has
been vital to Japan‘ssuccessin many manufacturing industries.
1.4.2 Demand Conditions

Porter emphasizes the role home demand plays in providing the impetus for upgrading competitive advantage. Firms
are typically most sensitive to the needs of their clos- est customers. Thus, the characteristics of home demand are
important in shaping the attributes of domestically made products and in creating pressuresfor innovation and
quality. Porter argues that a nation‘s firms gain competitive advantage if their domestic consumers are sophisticated
and demanding. Such consumers pressure local firms to meet high standards of product quality and to produce
innovative products. Porter notes that Japan‘s sophisticated and knowledgeable buyers of cameras helped stimulate
the Japanese camera industry to improve product quality and to introduce innovativemod- els. A similar example can
be found in the cellular phone equipment industry, where sophisticated and demanding local customers in
Scandinavia helped push Nokia of Fin- landandEricssonofSwedentoinvestincellularphonetechnology long before
demand for cellular phones took off in other developed nations. As a result, Nokia and Erics- son, along with
Motorola, are today dominant playersin the global cellulartelephone equipment industry.
1.4.3 Related and Supporting Industries

The Third broad attribute of national advantage in an industry is the presence of suppliers or related industries that
are internationally competitive. The benefits of investments in advanced factors of production by related and
supporting industries can spill over into an industry, helping it achieve a strong competitive position internationally.
Swedish strength in fabricated steel products (e.g., ball bearings and cutting tools) has drawn on strengths in
Sweden‘s specialty steel industry. Technological leadership in the US semiconductor industry until the mid-1980s
provided the basis for US success in per- sonal computers and several other technically advanced electronic products.
Similarly, Switzerland‘s success in pharmaceuticals is closely related to its previous international success in the
technologically related dye industry.
One consequence of this is that successful industries within a country tend to be groupedintoclusters ofrelated
industries. Thiswas one ofthemost pervasive findings of Porter‘sstudy. One such cluster is the German textile and
apparel sector, which includes high-quality cotton, wool, synthetic fibers, sewing machine needles, and a wide range
of textile machinery.
1.4.4 Firm Strategy, Structure, and Rivalry

The fourth broad attribute of national competitive advantage in Porter‘s model is the strategy, structure, and rivalry
of firms within a nation. Porter makes two important points here. Hisfirst isthat nations are characterised by
different "management ideolo- gies," which either help them or do not help them build national competitive
advantage. For example. Porter notes the predominance of engineers on the top-management teams of German and
Japanese firms. He attributes this to these firms‘ emphasis on improving manufacturing processes and product design.
!n contrast, Porter notes a predominance of people with finance backgrounds on the top-management teams ofmany
US firms. Helinksthistomany US firms‘ lack of attention to improving manufacturing processes and product design,
particularly during the 1970s and 1980s. He also argues that the dominance of finance has led to an overemphasis
on maximizing short-term financial returns. According to Porter, one consequence of these different management
ideolo- gies has been a relative loss of US competitiveness in those engineering-based industries where manufacturing
processes and product design issues are important (e.g., the automobile industry). Porter‘s second point is that there
is a strong association between vigorous domestic rivalry and the creation and persistence of competitive advantage in
an industry. Vigor- ous domestic rivalry induces firmstolookforwaystoimproveefficiency,whichmakes them better
international competitors. Domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to
invest in upgrading advanced factors. All of this helps to create world-class competitors.

Porter‘s argument isthat the degree towhich a nation islikely to achieve inter- nationalsuccessin a certain
industry is a function of the combined impact of factor endowments, domestic demand conditions, related and
supporting industries, and domestic rivalry. He argues that for this diamond to boost competitive performance usu-
allyrequiresthepresenceof allfour components(althoughthere are some exceptions). Porter
alsocontendsthatgovernment caninfluence eachofthe four components either positively or negatively. Factor
endowments can be affected by subsidies, policies toward capital markets, policiestoward education, and the like.
Government can shape domestic demand through local product standards or with regulations that mandate or
influence buyer needs. Government policy can influence supporting and related industries through regulation and
influence firm rivalry through such devices as capitalmarket regulation, tax policy, and antitrustlaws.
IfPorteris correct,wewouldexpecthismodeltopredictthepatternofinternational trade that we observe in the real world.
Countries should be exporting products from those industries where all four components of the diamond are
favorable, while importing in those areas where the components are not favourable. Much about the theory
ringstrue, but the same can be said forthe new trade theory, the theory of comparative advantage, and the Heckcher-
Ohlin theory. In reality it may be that each of these theories explains something about the pattern of international
trade. In many respects these theories complement each other.
1.5 International Business

International business comprises all commercial transactions (private and governmental, sales, investments, logistics,
and transportation) that take place between two or more regions, countries and nations beyond their political
boundaries. Usually, private companies undertake such transactions for profit; governments undertake them for profit
and for political reasons. The term ―international businessǁ refers to all those business activities which involve
cross-border transactions of goods, services,
resources between two or more nations. Transactions of economic resources include capital, skills, people etc. for
international production of physical goods and services such as finance, banking, insurance, construction etc.
International business transactions have resulted in the creation of multinational corporations or MNCs in short. A
MNC is a corporation that has its facilities and other assets in at least one country other than its home country.
Such companies have offices and/or factories in different countries and usually have a centralized head office where
they co-ordinate global
management. Very large multinationals have budgets that exceed those of many small countries.
It has been seen thatfirms becomemultinationalsthrough a gradual process. Afirm tries to exploit factor advantages
internationally and to attempt to reduce the competitive threats by others. Companies gradually increase their
commitment to international business. The sequence normally involves exporting, setting up an international
operations department, establishing a marketing subsidiary, entering into licensing agreements and eventually creating
facilities for manufacturing abroad. It is not necessary that all com
paniesfollow this evolutionary process, This processrepresents a sequence of moving from a relatively low-risk,
low-return, export-based strategy to a higher-risk, higher- return, production-based strategy.
Starting the internationalization process from exports has certain advantages. Cap- ital needed is low, risk is low and
profits are immediate. This phase provides an opportunity to the exporting firm to learn about demand conditions,
competitors, financial systemabroad and payment and hedging techniques etc. As the learning process ma- tures.
Companies expand their marketing and start dealing with foreign distributors leading to setting up of new service
facilities and warehouses.
The advantage of creating manufacturing base abroad is that the MNC will be able to realize full sales potential of
its product. This enables the firm to keep abreast with newer developments in the market demand, to meet the
customer needs faster, to provide better after-sales service and to keep track of the competition which can be
outwitted with innovation and R&D efforts. Most firms selling in foreign
markets eventually start manufacturing abroad. Foreign production may cover a wide variety of activitiessuch as
packaging, finishing, assembling or full manufacture.
When an MNCsets up production facility abroad, one ofthe important decisionsit is confronted with is whether to
create its own affiliate or to acquire a going concern. The advantage of acquisition is that the local firm provides
readily available marketing network. Larger and more experienced firms use acquisition route less often than
smaller and relatively less experienced ones. At times, of course, a parent may not have a choice to acquire abroad
simply because there is no local firm available having special technology or equipment needed to manufacture its
product.
MNCs also use licensing agreements as an alternative to setting up manufacturing facilities. In return they receive
royalties and other forms of payments. Licensing has the advantage of smaller investment requirement, faster market
entry and lower financial risk. But there are disadvantages associated with licensing. The licensee may turn into a
competitor in due course. Besides, the licensor gets lower revenue stream and may find it difficult to maintain
quality standards.
1.5.1 Features of International Business

The nature and characteristics or features of international business are:-
1. Large scale operations: In international business, all the operations are conducted on a very huge scale.
Production and marketing activities are conducted on a large scale. It first sells its goodsin the localmarket. Then
the surplus goods are exported.
2. Intergration of economies: International business integrates the economies of many countries. This is because
it uses finance from one country, labour from another country, and infrastructure from another country. It designs the
product in one country, produces its parts in many different countries and assembles the product in another
country. It sells the product in many countries, i.e. in the international market.
3. Dominated by developed countries and MNCs: International businessis dominated by developed countries
and their multinational corporations (MNCs). At present, MNCs from USA, Europe and Japan dominate (fully
control) foreign trade. This is because they have large financial and other resources. They also have the best
technology and research and development (R & D). They have highly skilled employees and managers because
they give very high salaries and other benefits. Therefore, they produce good quality goods and services at low
prices. This helps them to capture and dominate the world market.
4. Benefits to participating countries: International business gives benefits to all participating countries.
However, the developed (rich) countries get the maximum benefits. The developing (poor) countries also get
benefits. They get foreign capital and technology. They get rapid industrial development. They get more
employment opportunities. All this results in economic development of the developing countries. Therefore,
developing countries open up their economies through liberal economic policies.
5. Keen competition: International business has to face keen (too much) competition in the world market. The
competition is between unequal partners i.e. developed and developing countries. In this keen competition,
developed countries and their MNCs are in a favourable position because they produce superior quality goods and
services at very low prices. Developed countries also have many contacts in the world market. So, developing
countries find it very difficult to face competition from developed countries.
6. Special role ofscience and technology: International business gives a lot ofim- portance to science and
technology. Science and Technology (S & T) help the business to have large-scale production. Developed countries
use high technologies. Therefore, they dominate global business. International business helps them to transfer such
top high-end technologies to the developing countries.
7. International restrictions: International business faces many restrictions on the inflow and outflow of capital,
technology and goods. Many governments do not allow international businesses to enter their countries. They have
many trade blocks, tariff barriers, foreign exchange restrictions, etc. All this is harmful to international business.
8. Sensitive nature: The international business is very sensitive in nature. Any changes in the economic
policies, technology, political environment, etc. has a huge impact on it. Therefore, international business must
conduct marketing research to find out and study these changes. They must adjust their business activities and
adapt accordingly to survive changes.
1.6 International Financial Management

The main objective of international financial management is to maximise shareholder wealth. This would require
making sound investment and financing decisions that would result in adding value to the firm. One ofthe main
reasonsforfocusing on shareholder wealth isthat the companies who do not do so maybe takenoverbyothers.Ifthe
shareholder wealth is maximized or, in other words, ifshare price is made to go up hostile takeover becomes
difficult and costly. Also, it becomes easier for a company to attract additional capital from the investors if it cares
for increasing shareholder wealth. Com- panies which create more value will have more money to distribute to
allstakeholders not only shareholders-be they employees, managers or other beneficiaries in the society. It has been
argued, and very rightly so, that maximizing shareholder wealth is not the best way but the only way to benefit all
stakeholders.
Traditionally financial management is separated into two basic functions. The first is concerned with acquisition of
funds, also known as financing decision. This function involves generating funds from internal as well as external
sources. The effort is to get funds at the lowest cost possible. The second, that is, investment decision is
concernedwithdeploymentofthe acquiredfundsinamannerso as to maximize shareholder wealth. Other decisions
relate to dividend payment, working capital and capital structure etc. In addition, risk management involves both
financing and investment decision.
A finance manager in an MNC faces many challengesthat his counterpart in a domestic firm does not encounter.
These challenges include political risks leading to ex- propriation or confiscation of assets, exchange rate risk,
control on repatriation of profits, different tax laws, multiple money markets and different interest rates etc.
MNCs and their financial managers have to be abreast with the changes taking place all the time and develop ways
to take advantages of the changes while reducing risks that these changes create. They have operations in different
countries. This gives them opportunity to access segmented capital markets to lower their overall cost of capital.
They can shift profits to lower the tax outflows. They have ability to move people, money andmaterial on a global
basisto derive the maximumadvantageoutoftheseresources- They are able to practise the economic adage, "do not
put all your eggs in one basket". International diversification of markets and production facilities reduces their risk.
Operating globally gives MNCs continuous access to information on the latest process technologies and latest
R&D activities of their competitors. They are able to access world‘s capital markets and thus diversify their
funding sources.
International finance manager has to analyze and balance international risks and advantages. Some of the key
challenges he must be prepared to face are listed hereunder:
1. Tounderstand the interrelationship between environmental changes and corporate response. For
example,howwillthe credit conditionsbe impactedbystockmar- ket crash? How will defaults by some debtor
countries affect funding ability in the international capital market?
2. Tounderstand the development and use of new instrumentssuch as options, forwards futures and swaps for
effective management.
3. Todevelopwaystominimizerisksthroughinternalandexternaltechniques. 4. To take a balanced view of successes
and failures, treating them as experiences to learn from. Decisions such as taking loan in a currency that has
started appreciating fast, taking a fixed rate financing when rates have started going down will have an adverse
impact and impelfinancemanagerto containthe damage to the extent possible.
International financial management will involve the study of (a) exchange rate and currency markets, (b) theory and
practice of estimating future exchange rate, (c) various risks such as political/country risk, exchange rate risk and
interestrate risk,(d) various risk management techniques, (e) cost of capital and capital budgeting in international
context,(t)working capitalmanagement,(g) balance of payment, and(h)international financial institutions etc.
1.7 Functions of International Financial Manager

In order to achieve the firm‘s primary goal of maximizing stockholders‘ wealth, the financial manager performs
three major functions:
1. Financial planning and control (supportive tools);
2. Efficient allocation offunds among various assets(investment decisions); 3. Acquisition of
funds on favorable terms(financing decisions).
Financial planning and control must be considered simultaneously. For purposes of control, the financial manager
establishes standards, such as budgets, for comparing actual performance with planned performance. The
preparation of these budgets is a planning function, but their administration is a controlling function.
The foreign exchange market and international accounting play a key role when an MNC attempts to perform its
planning and control function. For example, once a company crosses national boundaries, its return on investment
depends on not only its trade gains or losses from normal business operations but also on exchange gains or losses
from currency fluctuations. International reporting and controlling have to do with techniques for controlling the
operations of an MNC.
Meaningful financial reports are the cornerstone of effective management. Accurate financial data are especially
important in international business, where business operations are typically supervised from a distance. When the
financial manager plans for the allocation of funds, the most urgent task is to invest fundswiselywithinthefirm.Every
dollar invested has alternative uses. Thus, fundsshould be allocated among assets in such a way that they will
maximize the wealth ofthe firm‘sstockholders. There are 200
countries in the world where a large MNC, can invest its funds. Obviously, there are more investment opportunities
in the world than in a single country, but there are also more risks. International financial managers should consider
these two simultaneously when they attempt to maximize their firm‘s value throughinternationalinvestment.
One of the primary roles of the financial manager is to acquire funds on favorable terms. If projected cash outflow
exceeds cash inflow, the financial manager will find it necessary to obtain additional funds from outside the firm.
Funds are available from many sources at varying costs, with different maturities, and under various types of
agreements. The critical role of the financial manager is to determine the combination of financing that most
closely suits the planned needs of the firm. This requires obtaining the optimal balance between low cost and the
risk of not being able to pay bills as they become due. MNCs can still raise their funds in many countries thanks
to recent financial globalization.
This globalization is driven by advances in data processing and telecommunications, liberalization of restrictions on
cross-border capital flows, and deregulation of domestic capital markets. International financial managers use a
puzzling array of fund acquisition strategies. Instead of merely focusing on the efficient allocation of funds
among various assets and the acquisition of funds on favorable terms, financial managers must now concern
themselves with corporate strategy. The chief financial officer is emerging as a strategic planner. In an era of
heightened global competition and hard-to-make- stick price increases,the financialfinepoints of
anynewstrategyaremore crucialthan ever before.
1.8 Self Study Questions

1. Discuss the Interdependency of national economies

2. Discuss the competitive advantage ofnations
3. Discusshowcompetitiveadvantageofnationsleadstointernationalbusiness 4. Discuss the methods through which
the companies can carry out international business 5. Compare
andcontrastdifferentmethodsofinternationalisationofbusiness 6. What is International financial management?
Highlight the importance of international financial management withexamples.
7. Discuss the evolution of multi-national corporations (MNCs). Outline the process involved in overseas expansion
ofMNCs.
8. Discuss the interdependence of national economies taking the recent global financial crisis as an example. Do
you advocate the continuation of the present system of free trade to take benefit of the competitive advantage of
nation?
9. Why should the firms get involved in international trade?
10. Criticallyanalyzetheeffectsofinterdependenceofnationaleconomiesandtheir abilitiesto take advantageofthe
competitive advantagesof eachnation.

Chapter 2
International Monetary System
The term, international monetary system, refers to the institutions, norms and the entire environment that facilitate the
settlement of international payments. It can be defined as the institutional framework within which international
payments are made, movements of capital are accommodated, and exchange rates among currencies are
determined. We can take a simple example here. Suppose you have to pay for the import invoiced in US dollar;
You will go to your banker to get US dollars for rupees. If you are an exporter getting euro, you will go to your
banker to convert eurosinto rupees. This is nothing but the exchange of currencies. There are many other cases
where currency is exchanged.
Whenever one currency is exchanged for the other, a basic question arises as to how many units of a currency
would be foregone to fetch one unit of the other currency. This is the question of the relationship between value
of two currencies exchanged. In common terminology, it is known as the exchangerate.Exchangerate
thusplaysavital role inthe settlementofinternationalpayments andsoany arrangementinthiscontext formsthe subject
matter of the international monetary system.
The nature of exchange rate arrangement has undergone changes over past couple of centuries. There was a time
when costly metals were used as medium of international exchange of commodities under a specific arrangement,
known asspecie commodity standard.Itwasfollowedbygoldstandardthatwas a more sophisticated version ofthe
exchange rate arrangement and that had set rules. It enjoyed merits, but at the same time there were some
limitationsto thatsystem that led to itssuspension forsome time and subsequently to its abandonment. The
abandonment of the gold standard led to upheavalsin the exchange rates and then to check it, the IMFwas
established. The present chapter givesthe details of such differentstages of evolution of International Monetary
System.
Besides the exchange rate arrangement, it is the ability of a country to pay that lies at the root of the settlement of
international payments. The ability to pay is interpreted in terms of liquidity. A country should have the desired
liquidity to make international payments. A country‘s liquidity is necessarily tagged with the international
liquidity. It is the International Monetary Fund (IMF) whose main concern is to maintain and improve
international liquidity. Thus any discussion of the IMF‘s role in maintaining international liquidity too forms the
subject-matter of the international monetary system. In response to the worst financial crisis since the 1930s, policy-
makers around the globe are providing unprecedented stimulus to support economic recovery and are pursuing a
radicalset ofreformsto build a more resilient financial system. However, even this heavy agenda may not ensure
strong, sustainable, and balanced growth over the medium term. We must also consider whether to reform the
basic framework that un- derpins global commerce: the international monetary system.
While there were many causes of the crisis, its intensity and scope reflected unprecedented disequilibria. Large and
unsustainable current account imbalances across major economic areas were integral to the buildup of vulnerabilities
in many asset markets. In recent years, the international monetary system failed to promote timely and orderly
economic adjustment.
This failure has ample precedents. Over the past century, different international monetary regimes have struggled to
adjust to structural changes, including the integration of emerging economies into the global economy. In all cases,
systemic countries failed to adapt domestic policies in a manner consistent with the monetary system of the day. As a
result, adjustment was delayed, vulnerabilities grew, and the reckoning, when it came, was disruptive for all.
Policy-makers must learn these lessons from history. The G-20 commitment to promote strong, sustainable, and
balanced growth in global demand—launched two weeks ago in St. Andrews, Scotland—is an importantstep in the
right direction.

2.1 What is the International Monetary System andhow should it function?
Theinternationalmonetarysystemconsistsof(i)exchangeratearrangements;(ii)capitalflows; and(iii) a collection of
institutions, rules, and conventionsthat govern its operation. Domestic monetary policy frameworks dovetail, and
are essential to, the global system. A well-functioning system promotes economic growth and prosperity through the
efficient allocation of resources, increased specialization in production based on comparative advantage, and the
diversification of risk. It also encourages macroeconomic and financial stability by adjusting real exchange rates
to shifts in trade and capital flows.
To be effective, the international monetary system must deliver both sufficient nominal stability in exchange rates
and domestic prices, and timely adjustment to shocks andstructural changes.Attaining
thisbalancecanbeverydifficult.Changesinthegeo- graphic distribution of economic and political power, the global
integration of goods and asset markets, wars, and inconsistent monetary and fiscal policies all havethepotential to
undermine a monetary system. Pastsystems could not incentsystemic countriesto adjust policies in a timely
manner. The question is whether the current shock of inte- grating onethird ofhumanity into the global economy -
positive asitis-will overwhelm the adjustment mechanisms of the current system.
There are reasons for concern. China‘s integration into the global economy alone represents a much bigger shock
to the system than the emergence of the United States at the turn of the last century. China‘s share of global GDP
has increased faster and its economy is much more open. As well, unlike the situation when the United States was
on the gold standard with all the other major countries, China‘s managed exchange rate regime today is distinct from
the market-based floating rates of other major economies. History showsthatsystems dominated by fixed or pegged
exchange ratesseldom cope well with major structuralshocks.
This failure is the result of two pervasive problems: an asymmetric adjustment process and the downward
rigidity of nominal prices and wages. In the short run, it is generally much less costly, economically as well as
politically, for countries with a balance of paymentssurplusto run persistent surpluses and accumulate
reservesthan it is for deficit countries to sustain deficits. This is because the only limit on reserve accumulation is
its ultimate impact on domestic prices. Depending on the openness of the financialsystem and the degree
ofsterilization, this can be delayed for a very long time. In contrast, deficit countries must either deflate orrun
down reserves.
Flexible exchange rates prevent many of these problems by providing less costly and more symmetric adjustment.
Relative wages and prices can adjust quickly to shocks through nominal exchange rate movements in order to
restore external balance. When the exchange rate floats and there is a liquid foreign exchange market, reserve
holdings are seldom required. Most fundamentally, floating exchange rates overcome the seemingly innate
tendency of countriesto delay adjustment.
A brief review of how the different international monetary regimes failed to manage this trade-off between
nominal stability and timely adjustment provides important insights for current challenges.
2.2 The Evolution of the International Monetary Sys- tem (in Brief) The Evolution of the International
Monetary System has been presented briefly in this section. Following sections give a detailed account of each
stage of evolution of the monetary system.
2.2.1 The Gold Standard

Under the classical gold standard, from 1870 to 1914, the international monetary system was largely decentralized
and market-based. There was minimal institutional support, apart from the joint commitment of the major economies
to maintain the gold price of their currencies. Although the adjustment to external imbalances should, in theory, have
been relatively smooth, in practice it was not problem-free. Surplus countries did not always abide by the
conventions of the system and tried to

frustrate the adjustment process by sterilizing gold inflows. Deficit countries found the adjustment even more
difficult because of downward wage and price stickiness. Once the shocks were large and per sistent enough, the
consequences of forfeiting monetary independence and asymmetric adjustment ultimately undermined thesystem.
The gold standard did not survive World War I intact. Widespread inflation caused by money-financed war
expenditures and major shifts in the composition of global economic power undermined the pre-war gold parities.
Crucially, there was no mechanism to coordinate an orderly return to inflation-adjusted exchange rates. When
countries, such as the United Kingdom in 1925, tried to return to the gold standard at overvalued parities, they were
forced to endure painful deflation of wages and prices in order to restore competitiveness. Though this was always
going to be difficult, it proved impossible
when surplus countries thwarted reflation.
During the Great Depression, with an open capital account and a commitment to the gold-exchange standard, the
United States could not usemonetary policy to offset the economic contraction. Fidelity to gold meant that the
deflationary pressures from the United States spread quickly, further weakening the global economy. Unable to adjust
to these pressures, countries were forced to abandon the system. Though deficit countries experienced the first crisis,
all countries suffered from the eventual collapse - a lesson
that was repeated in subsequentsystems.
2.2.2 Bretton Woods

The Bretton Woods system of pegged, but adjustable, exchange rates was a direct response to the instability ofthe
interwar period. Bretton Woods was very different from the gold standard: it wasmore administered than market-
based; adjustment was coordinated through the International Monetary Fund (IMF); there were rulesratherthan
conventions; and capital controls were widespread.
Despite these institutional changes, surplus countries still resisted adjustment. Fore- shadowing present problems,
countries often sterilized the impact of surpluses on domestic money supply and prices. Like today, these
interventions were justified by ar- guing that imbalances were temporary and that, in any event, surpluses were
evidence more of virtue than ―disequilibria.ǁ In contrast, the zero bound on
reservesremaineda binding constraintfor deficit countries, which eventually ran out oftime. The Bretton Woods
system finally collapsed in the early 1970s after U.S. policy became very expansionary, its trade deficit
unsustainable, and the loosening of capital controls began to put pressure on fixed exchange rates. Once again,
all countries suffered from the aftershocks.
2.2.3 The Current Hybrid System

Afterthe breakdown oftheBrettonWoodssystem, the internationalmonetary system reverted to a more decentralized,
market-based model. Major countries floated their exchange rates, made their currencies convertible, and gradually
liberalized capital flows. In recent years, several major emerging markets adopted similar policies after expe-
riencing the difficulties ofmanaging pegged exchange rate regimes with increasingly open capital accounts. The
move to more market-determined exchange rates has in creased control of domestic monetary policy and inflation,
accelerated the development of financial sectors, and, ultimately, boosted economic growth.
Unfortunately, this trend has been far from universal. In many respects, the recent crisis represents a classic
example of asymmetric adjustment. Some major economies have frustrated real exchange rate adjustments by
accumulating enormousforeign reserves and sterilizing the inflows. While theirinitial objective was to self-insure
against future crises, reserve accumulation soon outstripped these requirements. In some cases, persistent exchange
rate intervention has served primarily to maintain
undervalued exchange rates and promote export-led growth. Indeed, given the scale of its economic miracle, it
isremarkable that China‘sreal effective exchange rate has not appreciated since 1990.
This flip side of these imbalances was a large current account deficit in the United States, which was reinforced by
expansionary U.S. monetary and fiscal policies in the wake of the 2001 recession. In combination with high
savings rates in East Asia, these policies generated large global imbalances and
massive capital flows, creating the ―co- nundrumǁ of very low long-term interest rates, which, in turn, fed the
search for yield and excessive leverage. While concerns over global imbalances were frequently expressed in the
run-up to the crisis, the international monetary system once again failed to
promote the actions needed to address the problem. Vulnerabilities simply grew until the breaking point. Some
pressures remain. The financial crisis could have long-lasting effects on the composition and rate of global
economic growth. Since divergent growth and inflation prospects require different policy mixes, it is unlikely that
monetary policy suitable for United States will be appropriate for most other countries. However, those countries
with relatively fixed exchange rates and relatively open capital accounts are acting asif it is. If this divergence in
optimal monetary policy stance increases, the strains on the system will grow.
Postponed adjustment will only serve to increase vulnerabilities. In the past, the frustration of adjustment by
surplus countries generated deflationary pressures on the rest of the world. Similarly, today, the adjustment burden is
being shifted to others. Advanced countries—including Canada,
Japan, andtheEuroarea -haverecentlyseen sizable appreciations of their currencies. The net result could be a
suboptimal global recovery, in which the adjustment burden in those countries with large imbalances falls largely on
domestic prices and wages rather than on nominal exchange rates. History suggests that this process could take
years, repressing global output and welfare in the interim.
2.2.4 The Way Forward

To avoid these outcomes, there are several options.
The first is to reduce overall demand for reserves. Alternatives include regional reserve pooling mechanisms and
enhanced lending and insurance facilities at the IMF. While there is merit in exploring IMF reforms, their effect on
those systemic countries that already appear substantially overinsured would likely be marginal. As I will touch on in
a moment, the G-20 process may have a greater impact.
On the supply side, several alternative reserve assets have been suggested. The motivation of these proposals is
primarily to redistribute the so-called ―exorbitant privilegeǁ that accrues to the United States as the principal
supplier of reserve currency. As such, the United States receives an advantage in the form oflowerfinancing costsin
its own currency.This advantagewouldbe shared(andpossiblyreduced in aggregate) if there were competing reserve
currencies. In turn, this could marginally reduce the collective imbalances of reserve currency countries.
Over the longer term, it is possible to envision a system with other reserve currencies inadditiontotheU.S.
dollar.However,withfewalternativesreadytoassume a reserve role, the U.S. dollar can be expected to remain the
principal reserve currency for the foreseeable future. Despite the exuberant pessimism reflected in the gold price,
total gold stocks represent only $1 trillion or about 10 per cent of global reserves and a much smaller proportion
of global money supply. The renminbi‘s prospects are moot absent convertibility and open capital markets, which
would themselves likely do much to reduce any pressure for a change.
2.2.4.1 Increased Use of Special Drawing Rights

At first glance, Special Drawing Rights (SDRs) would be an intriguing alternative reserve asset.12 Using SDRs
appeals to a sense of fairness in that no one country would enjoy the exorbitant privilege of reserve currency
status. Like a multiple reserve currency system, it may reduce the aggregate incentives of countries that supply
the con- stituent currencies of the SDR to run deficits. In addition, thereappearstobenotechni- cal reason why the
use of SDRs could not be expanded.
However, the question must be asked: to what end? Merely enhancing the role of the SDR would do little either to
increase the flexibility of the system or change the incentives ofsurplus countries. By providing a ready swap of
existing reserve currencies into a broader basket, SDR reserves could also

further displace adjustment onto other freely trading currencies, thus exacerbating the imbalances in the current
system. Indeed, by providing instant diversification, SDR reserves could entrench some of the existing strategies
of surplus countries.
This would change if the proposal were taken to its logical extreme: the SDR as the single global currency. Setting
aside the fact that the world is not an optimum currency area (not least due to the absence of free mobility of
labour, goods, and capital), this appears utopian. While the level of international co-operation has certainly
increased since the crisis, it would be a stretch to assert that there is any appetite for the creation ofthe independent
global central bank that would be required. As a result, any future SDR issuance is likely to be ad hoc.
2.2.4.2 A Substitution Account

Greater use of SDRs might be best suited to encouraging a transition to a more stable international monetary
system by facilitating any desired reserve diversification. Es- tablishing, on a temporary basis, an enhanced
substitution account at the IMF would allowlarge reserve holdersto exchangeU.S.- dollar reserves for SDR-
denominated securities, thereby diversifying their portfolios. With the IMF bearing the risk of changes in the U.S.-
dollar exchange rate, an appropriate burden-sharing arrangement among its members would have to be agreedupon.
A substitution account would create considerable moral hazard, since reserve hold- erswould be tempted
toengageinfurtheraccumulation.Inaddition,asubstitutionac- count would not address the fundamental asymmetry of
the adjustment process. Thus, it would appear essential that a substitution account mark the transition from the current
hybrid system to an international system characterized by more flexible exchange rates for all systemic countries.
In general, alternatives to the dollar as the reserve currency would not materially improve the functioning of the
system. While reserve alternatives would increase pressures on the United States to adjust, since ―artificialǁ
demand for their assets would be shared with others, incentives for the surplus countries that have thwarted
adjustment would not change. The common lesson ofthe gold standard, the Bretton Woods system and the current
hybrid system is that it is the adjustment mechanism, not the choice of reserve asset, that ultimately matters. With
the adjustments that would arise automatically from floating exchange rates or unsterilized intervention muted, the
burden is squarely on policy dialogue and cooperation.
2.3 Specie Commodity Standard

In early days, prior to the evolution of an international monetary system, trade payments were settled through barter,
but there were many inconveniences; and so to overcome those difficulties, traders began using metal, especially
gold or silver, for settling payments. Subsequently, metal took the form of coinwhichhad the stamp ofthe
sovereign on the basis ofweight and fineness giving birth to the specie commodity standard. The coins were full-
bodied coins meaning that their value was equal to the value of metal contained therein. However, with the lapse of
time, the process of coin debasement started. Lower-value metal was mixed with the coin with the result that the
value of metal came to be lower than the face value of the coin. Debased coins were largely used as medium of
exchange. Full-bodied coins were mainly used forstore of value and for
meltingandsellingthemasgoldandsilver.Theprocess of coin debasementinEngland during 1542-1551 drove the full-
bodied coins almost completely out of circulation by 1560andQueenElizabeth I had toreplace debased coins
byfull-bodied coins.
The Coinage Act of 1792 in the USA accepted the dollar as the monetary unit of the country and fixed its value
in terms of gold and silver. This led to the emergence ofthe bimetallic standard. France adopted the bimetallic
standard in 1803 but the mint ratio between gold and silver was 1:15 in the USA as compared to 1:15.5 in
France. This difference led to theUS export of gold to France forthe purchase ofsilver. The diminution of gold
stock in the USA led that country to adopt a mono-metallic
silver standard. But then with changesin gold-silver mint ratio to 1:16, the US Government was able to follow a
mono-metallic gold standard. These currencies helped settlement of trade and other payments.
2.4 Bimetallism
Bimetallism, monetary standard or system based upon the use of two metals, traditionally gold and silver, rather
than one (mono metallism). The typical 19th-century bimetallic system defined a nation‘s monetary unit by law in
terms of fixed quantities of gold and silver (thus automatically establishing a rate of exchange between the two
metals). The system also provided a free and unlimited market for the two metals, imposed no restrictions on the
use and coinage of either metal, and made all other moneyin circulation redeemable in either gold orsilver. Amajor
problemin the international use of bimetallism was that, with each nation independently setting its own rate of
exchange between the two metals,the resulting rates often differedwidely fromcountry to country. In an attempt
to establish the bimetallic system on an international scale, France, Belgium, Italy, and Switzerland formed
theLatin Monetary Union in 1865. The union established amintratio between the two metals and provided for use of
the same standard units and issuance of coins. The system was undermined by the monetary manipulations of Italy
and Greece (which had been admitted later) and came to a speedy end with the Franco-German War (1870–71).
The future of the bimetallic standard apparently had been sealed at an international monetary conference held in
Parisin 1867, when most of the delegates voted for thegold standard.
Supporters of bimetallism offer three arguments for it: (1) the combination of two metals can provide greater
monetary reserves; (2) greater price stability will result from the larger monetary base; and (3) greater ease in the
determination and stabilization of exchange rates among countries using gold,silver, or bimetallic standards will
result. Arguments advanced against bimetallism are: (1) it is practically impossible for a single nation to use such a
standard without having international cooperation; (2) such a system is wasteful in that the mining, handling, and
coinage of two metals is more costly; (3) because price stability is dependent on more than the type ofmonetary base,
bimetallism does not provide greater stability of prices; and (4) most importantly, bimetallism in effect freezes the
ratio of the prices of the twometalswithoutregard tochangesin their demand and supply conditions.
In economics, bimetallism is a monetary standard in which the value of the monetary unit is defined as
equivalentbothto a certainquantityofgoldandtoa certainquantityof silver; such a system establishes a fixed rate of
exchange between the two metals. The defining characteristics of bimetallismare: 1. Both gold and silver money
are legal tender in unlimited amounts.
2. The government will convert both gold and silver into legal tender coins at a fixed rate for individuals in
unlimited quantities. This is called free coinage because the quantity is unlimited, even if a fee is charged.
The combination of these conditions distinguishes bimetallism from a limping standard, where both gold and silver
are legal tender but only one is freely coined (example: France, Germany, or the United States after 1873), or
trade money where both metals are freely coined but only one is legal tender and the other is trade money
(example: most of the coinage of western Europe from the 13th to 18th centuries.) Economists also distinguish
legal bimetallism, where the law guarantees these conditions, and de facto bimetallism where both gold and silver
coins actually circulate at a fixed rate.
Bimetallism was intended to increase the supply of money, stabilize prices, and facilitate setting exchange rates.
Some authors, such as Angela Redish or Charles Kindle- berger have argued that bimetallism was, by
construction, unstable. Changes in gold- silver exchange were, in their eyes, leading to massive changes in the
money supply. Bimetallism was thus inherently flawed and the advent of the gold standard was in- evitable. This
view has been challenged by Friedman and Flandreau who wrote that the option to pay in gold or in silver had in
fact a stabilizing effect.
2.5 Gold Standard

The gold standard was a commitment by participating countries to fix the prices of their domestic

currencies in terms of a specified amount of gold. National money and other forms of money (bank deposits and
notes) were freely converted into gold at the fixedprice. England adopted a de facto gold standard in 1717 afterthe
master ofthe mint, Sir Isaac Newton, overvalued the guinea in terms ofsilver, and formally adopted the gold
standard in 1819. The United States, though formally on a bimetallic (gold and silver) standard,switched to gold de
facto in 1834 and de jure in 1900 when Congress passed the Gold Standard Act. In 1834, the United States fixed
the price of gold at $20.67 per ounce,where it remained until 1933. Othermajor countriesjoined the gold standard in
the 1870s. The period from1880 to 1914 is known asthe classical gold standard. During that time, the majority of
countries adhered (in varying degrees) to gold. It was also a period of unprecedented economic growth with
relatively free trade in goods, labor, and capital. The gold standard broke down during World War I, as major
belligerents resorted to inflationary finance, and was briefly reinstated from 1925 to 1931 as the Gold Exchange
Standard. Under this standard, countries could hold gold or dollars or pounds as reserves, except for the United
States and the United Kingdom, which held reserves only in gold. This version broke down in 1931 following
Britain‘s departure from gold in the face of massive gold and capital outflows. In 1933, President Franklin D.
Roosevelt nationalized gold owned by private citizens and abrogated contracts in which payment was specified in
gold. Between 1946 and 1971, countries operated under the Bretton Woods system. Under this further modification
of the gold standard, most countries settled their international balances in U.S. dollars, but the U.S. government
promised to redeem other central banks‘ holdings of dollars for gold at a fixed rate of thirty-five dollars per ounce.
Persistent U.S. balance-of-payments deficits steadily reduced U.S. gold reserves, however, reducing confidence in
the ability of the United States to redeem its currency in gold. Finally, on August 15, 1971, President Richard
M.NixonannouncedthattheUnitedStateswouldnolongerredeem currency for gold. This was the final step in
abandoning the gold standard. Widespread dissatisfaction with high inflation in the late 1970s and early 1980s
brought renewed interest in the gold standard. Although that interest is notstrong today, itseemsto strengthen every
time inflation moves much above 5 percent. This makes sense: whatever other problems there were with the gold
standard, persistent inflation was not one of them. Between 1880 and 1914, the period when the United States was
onthe ―classicalgoldstandard,ǁ inflation averagedonly 0.1percent peryear.
2.5.1 How the Gold Standard Worked

The gold standard was a domestic standard regulating the quantity and growth rate of a country‘s money supply.
Because new production of gold would add only a small frac- tion to the accumulated stock, and because the
authorities guaranteed free convertibility of gold into nongold money, the gold standard ensured that the money
supply, and hence the price level,would not varymuch. But periodic surgesin the world‘s gold stock,such as the gold
discoveries in Australia and California around 1850, caused price levels to be very unstable in the short run. The
gold standard was also an international standard determining the value of a country‘s currency in terms of other
countries‘ currencies. Because adherents to the standard maintained a fixed price for gold, rates of exchange
between currencies tied to gold were necessarily fixed. For example, the United States fixed the price of gold at
$20.67 per ounce, and Britain fixed the price at £3 17s. 10½ per ounce. Therefore, the exchange rate between
dollars and pounds—the ―par exchange rateǁ—necessarily equaled $4.867 per pound.
Because exchange rates were fixed, the gold standard caused price levels around the world to move together. This
comovement occurred mainly through an automatic balance-of-payments adjustment process called the
price-specie-flow mechanism. Here is how the mechanism worked. Suppose that a technological innovation brought
about faster real economic growth in the United States. Because the supply of money (gold) essentially wasfixed in
the shortrun, U.S. pricesfell. Prices of U.S. exports then fell relative to the prices of imports. This caused the
British to demand more U.S. exports and Americans to demand fewer imports. A U.S. balance-of-payments
surplus was created, causing gold (specie) to flow from the United Kingdom to the United States. The gold inflow
increased the U.S. money supply, reversing the initial fall in prices. In the United Kingdom, the gold outflow
reduced the money supply and, hence, lowered the price level. The net result was balanced prices among

countries.
The fixed exchange rate also caused bothmonetary and nonmonetary (real)shocks to be transmitted via flows of
gold and capital between countries. Therefore, a shock in one country affected the domestic money supply,
expenditure, price level, and real income in another country.
The California gold discovery in 1848 is an example of a monetary shock. The newly produced gold increased
the U.S. money supply, which then raised domestic expenditures, nominal income,
and,ultimately,thepricelevel.Theriseinthedomestic price levelmade U.S. exportsmore expensive, causing a deficit
in the U.S. balance of payments. For America‘s trading partners, the same forces necessarily produced a balance-of-
trade surplus. The U.S. trade deficit wasfinanced by a gold (specie) outflow to its trading partners, reducing the
monetary gold stock in the United States. In the trading partners, the money supply increased, raising domestic
expenditures, nominal incomes, and, ultimately, the price level. Depending on the relative share of the
U.S. monetary gold stock in the world total, world prices and income rose. Although the initial effect of the gold
discovery was to increase real output (because wages and prices did not immediately increase), eventually the full
effect was on the price level alone.
For the gold standard to work fully, central banks, where they existed, were supposed to play by the ―rules of the
game.ǁ In other words, they were supposed to raise their discount rates—the interest rate at which the central bank
lends money to member banks—to speed a gold inflow, and to lower their discountratesto facilitate a gold
outflow. Thus, if a country wasrunning a balance-of-payments deficit, the rules of the game required it to allow a
gold outflow until the ratio of its price level to that of its principal trading partners wasrestored to the par
exchange rate.
The exemplar of central bank behavior was the Bank of England, which played by the rules overmuch of the period
between 1870 and 1914. Whenever Great Britain faced a balance-of-payments deficit and
theBankofEnglandsawitsgoldreservesdeclining, it raised its ―bank rateǁ (discount rate). By causing other interest
rates in the United Kingdom to rise as well, the rise in the bank rate was supposed to cause the holdings of
inventories and other investment expenditures to decrease. These reductions would then cause a reduction in overall
domestic spendingand a fallin the price level. At the same time, the rise in the bank rate would stem any short-
term capital outflow and attract short-term funds from abroad.
Most other countries on the gold standard—notably France andBelgium—did not follow the rules of the game.
They never allowed interest rates to rise enough to decrease the domestic price level. Also, many countries
frequently broke the rules by ―steriliza- tionǁ—shielding the domestic money supply from external disequilibrium
by buying or selling domestic securities. If, for example, France‘s central bank wished to prevent an inflow of gold
from increasing the nation‘s money supply, it would sell securities for gold, thus reducing the amount of gold
circulating.
Yet the central bankers‘ breaches of the rules must be put into perspective. Although exchange rates in principal
countries frequently deviated from par, governments rarely debased their currencies or otherwise manipulated the gold
standard to support domestic economic activity. Suspension of convertibility in England (1797-1821, 1914-1925)
and the United States (1862-1879) did occur in wartime emergencies. But, as promised, convertibility at the
original parity was resumed after the emergency passed. These resumptionsfortified the credibility of the gold
standard rule.
2.5.2 Performance of the Gold Standard

Asmentioned,the great virtue ofthe gold standardwasthatit assured long-termprice stability. Compare the
aforementioned average annual inflation rate of 0.1 percent between 1880 and 1914 with the average of 4.1
percent between 1946 and 2003. (The reason for excluding the period from 1914 to 1946 isthat it was neither a
period of the classical gold standard nor a period during which governments
understood how to manage monetary policy.)
But because economies under the gold standard were so vulnerable to real and monetary shocks, prices were highly
unstable in the short run. A measure of short-term price instability is the coefficient of variation—the ratio of the
standard deviation of annual percentage changes in the price level to the

average annual percentage change. The higher the coefficient of variation, the greater the short-term instability.
For the United States between 1879 and 1913, the coefficient was 17.0, which is quite high. Be- tween 1946 and
1990 it was only 0.88. In the most volatile decade of the gold standard, 1894-1904, the mean inflation rate was
0.36 and the standard deviation was 2.1, which gives a coefficient of variation of 5.8; in themost volatile decade
ofthe more recent period, 1946-1956, the mean inflation ratewas 4.0, the standard deviationwas 5.7, and the
coefficient of variation was 1.42.
Moreover, because the gold standard gives government very little discretion to use monetary policy, economies on
the gold standard are less able to avoid or offset either monetary or real shocks. Real output, therefore, is more
variable underthe gold standard. The coefficient of variation for real output was 3.5 between 1879 and 1913, and
only 0.4 between 1946 and 2003. Not coincidentally, since the government could not have discretion over monetary
policy, unemployment was higher during the gold standard years. It averaged 6.8 percent in the United States
between 1879 and 1913, and 5.9 percent
between 1946 and 2003.
Finally, any consideration of the pros and cons of the gold standard must include a large negative: the resource cost
of producing gold. Milton Friedman estimated the cost of maintaining a full gold coin standard for the United
Statesin 1960 to be more than
2.5 percent of GNP.In 2005, this cost would have been about $300 billion.
2.5.3 Suspension of Gold Standard

Constancy in money supply helped maintain price stability but it came in the way of the expansionary process.
When the First World War broke out in 1914, the warring nations required expansion in money supply forfinancing
thewar activities. Thiswas not easy underthe gold standard. Moreover, the strained political relations impeded free
flow of gold from one country to another, which considerably impaired automatic adjustment in external balance.
The warring nations increased the money supply and had to suspend convertibility of currency into gold. The
exchange rate parity was then greatly disturbed. All this was a deviation from the norms of the gold standard. Be-
sides, there was a transfer-of-funds problem that shook the balance of payments. USA demanded repayment of war
debt from France, and France demanded reparation from Germany to meet the war debt. USA joined the War in
1917. Prior to that, it supplied goodstoEurope andthis helpedherto enjoy a trade surplus.Thedollar turned stronger
whereas the European currencies became weak. For these reasons, the gold standard
was suspended during the FirstWorld War.
2.5.4 Conclusion
Although the last vestiges of the gold standard disappeared in 1971, its appeal isstill strong. Those who oppose
giving discretionary powers to the central bank are attracted by the simplicity of its basic rule. Othersviewit as
aneffective anchorfortheworld price level. Still otherslook back longingly to the fixity of exchange rates. Despite
its appeal, however, many of the conditions that made the gold standard so successful vanished in 1914. In
particular, the importance that governments attach to full employment means that they are unlikely to make
maintaining the gold standard link and its
corollary, long-run price stability, the primary goal of economic policy.
2.6 Inter-War Years

After the end of the First World War, the countries on the gold standard during pre- War years came back to it. The
USA adopted it in 1919, the UK in 1925, and France in 1926.The other European countries followed soon after.
However in Germany and Austria, which were in the grip of hyper inflation, in the early 1920s, parity between the
currency and the goldwasset at higherthan the pre-War level. On the contrary, the pre-War parity was conceived in
the UK in the sequel of temporary deflation as well as of recommendations of Cunliffe Committee. When deflation
ended, the pre-War level parity created problems. The pound stood overvalued, especially after France devalued its
currency and imbalances between internal and external values of the pound emerged. Consequently, the gold
standard was not very successful after war.
Another feature of gold standard during 1920s was that it was mainly a gold exchange standard.The reason was
that the central banks of a number of European countries did not have sufficient gold as reserves. The production
of gold during 1915-1922 was lower as also there was a colossal outflow of gold to the USA. Had the gold stan-
dard in its purestformbeen re-established, there would have been a scramble for gold leading to an unmanageable
upswing in gold prices.England return from the gold standard led to floating-exchange-rate regime. Ex- change
rates were volatile. Investors preferred gold to foreign currency denominated securities and the scramble for gold
increased. Nor did it leave US dollar untouched: The gold stock of US monetary authorities too dwindled rapidly.
This led US govern- menttoabandonthegoldstandardin1933.Someother countriesfollowedthe lead.The collapse of
the standard was evident in two stages: One when the UK and the USA left it and other when the France and other
net creditor countries abandoned it in 1936.
Following the collapse of the gold standard, there came up various currency areas especially for the purpose
ofstabilizing exchange rates. France and other net creditor countries, such as Belgium, Italy the Netherlands,
Sweden and Switzerland formed the Gold-Bloc. England, along with all Commonwealth countries, except Canada,
formed the Sterling Area. The currencies of the Commonwealth countries maintained a fixed relationship with
pound sterling.
The countries oftheNorth,Central andSouthAmericamaintained a fixed parity of their currencies with the US
Dollar. This group was known as the Dollar area. There were countries maintained their own exchange rates
system. Germany and Austria maintained the external value of their currency through variousmethods of exchange
control.
Economic prosperity began during the late 1930s but the Second World War broke out in 1939 that hit
thenprevailingexchange rate regime.Exchange ratewas controlled on a large scale. The US economy was not hurt
as the country joined the war much later. Rather it enjoyed a large trade surplus on account of its supplying goods
to the warring nations. Thus on the whole, from 1914 through the Second World War years, the international
monetary system was never in stable shape; the exchange rateswere highly volatile, exchange control was rampant
and retaliatory measures werecommon.
2.7 Bretton Woods System of Exchange Rates

In the view of the unstable exchange rates during the 1930s and early 1940s, various moves were afoot to create an
orderly international monetary system. Finally, at the BrettonWoodsConference, it was resolved to create the
International Monetary Fund. The IMF, that evolved a novel exchange rate system was established in1945. Since
the new system was the outcome of the Bretton Woods Conference,itisoftentermedasthe Bretton Woods system.
2.7.1 Fixed Parity System

The IMF articles provided for an orderly exchange rate regime. Eachmember country was to set a fixed value-
called the par value that determined the rate within a narrow band of one per cent above and below the established
parties could not be ruled out and were to be corrected through active interventionofthemonetaryauthoritiesofthe
concerned country.
It may, however, be mentioned that the fixed parity under the Bretton Woods system was not like that of the standard
of 1880-1914. it was a fixed parity with adjustable pegs meaning that any member country could alter the value of
its currency or, in other words, could devalue its currency in case of ―fundamental disequilibriumǁ in the balance of
payments. Changes up to fiveper cent did notrequire prior approval was necessary. Fundamental disequilibrium was
never formally defined; but in practice, it meant continued and chronic balance of payments problems and colossal
loss of reserves. The
purpose of the adjustable peg system was, therefore, to establish a balance between of the objectives of stable
exchange rate and the macroeconomic goals of the countries going forsuch adjustments also so to help avoid any
use of exchange control and trade- restrictive measures. In other words, it bought flexibility in the fixed exchange
rate system for the purpose of attaining equilibrium in the balance of payments. The provision also contained
caution so that there might not be competitive devaluation. It was maintainedthrough supervision andscrutiny over
desired exchange rate changes.

Again,animportantaspectoftheBrettonWoodsexchangeratesystemwasthatthe USdollarintogoldat
afixedrateof$35pertroyounceofgold.Theothercurrencies were convertible into gold via the US dollar. This
currency was given the position of intervention currency in the system in the view of the fact that in the
immediate post-war period, it was strongest currency. This system was, therefore, linked with the gold-convertible
currency and not necessarily into gold directly. In the post-war system, the US dollar came to be intervention
currency replacing the British pound which had played this part during the early decades of the twentieth century.
2.7.2 Collapse of Fixed Parity System

The Bretton Woods system established exchange rates but there were some inherent weaknesses. The adjustable
peg system was highly rigid and by the time a fundamental disequilibrium could be manifest, colossal losses had
occurred in member countriesin the form of mis-allocation ofresources. Moreover, the fixed parity system failed to
consider the fast-growing actives of the MNC‘s which caused large flow of funds among different countriesthat
necessitated changesin exchange rates. More importantly, the element of confidence lay at the root system failed to
consider the fast-growing activities of the MNCs which cause large flow of funds among different countries that
necessi- tate changesin exchange rates. More importantly, the element of confidence lay at the root of the system.
The moment confidence was shaken, the system was bound to collapse. During the first decade, there was no
confidence problem. The member countries
heldlargereservesintheformofdollar-dominatesassetsandthefunctioningofthe exchange rate system was smooth but
in the late 1950s, the US balance payments swung into deficit because ofits ambitious economic aid programand
otherfactorsuch as expansionary domestic policies,
etc. Viewing this deficit, the European countries began to lose confidence in US dollar and began converting their dollar-
denominated assets into gold. The gold-holdings of the US Treasury plummeted by $ 8.0 billion by 1960. This
eroded confidence again in the US dollar. A vicious circle emerged and was accelerated by rapid deterioration in
US balance of payments during 1960s in the wake of the Viet
Nam war. Financing the war caused large budgetary deficit and monetary expansion and inflation followed. It led in
turn to deficit on current account and the dollar stood overvalued which resulted in preference for gold, when the
gold conversion ability of theUS treasurywas not beyond doubt. ThatUS citizens were barred from buying gold
further eroded confidence. Expectation of a record deficit in 1971 in the US balance of paymentsresulted
inmassive selling ofthe dollarin the internationalmarket. Gold price in the free market rose putting there by an
adverse influence on the fixed paritybetween the US dollar and gold. A speculative run on the dollar, which would
have been impossible for the US governmenttosustain,wasexpected.Atthesametime,Germany decided to flit its
currency against dollar, the Netherlands followed suit and Austria and Switzerland revalued their currency. By August
1971, a full blown crisis had developed against dollar. During the first half of that month, the US government‘s
reserves fell by $ 1.1 billion. The Nixon Administration then suspended covert ability of the dollar into gold thus
dealing a serious blow to the fixed parity system.
2.7.3 Smithsonian Arrangement

In December 1971,a conference was held at the Smithsonian Institute in Washington DC which decide totake the
followingactionstorestore stabilityofthe system:
• Realignment of the par value of major currencies so as to better conform to their realistic values. For this
purpose,the gold parity of the US dollar was changed from35to38.02pertroyounce
entailingadevaluationof8.57percent. Onthe other hand,the currencies ofsurplus countries were valued upward by
percentages ranging from 7.4 for the Canadian dollar to 16.9 forJapanese Yen.
• The band for the fluctuation from the par values was widened from +/-1.0 percent to +/-2.25 percentwith aviewto
providingmore leeway tomember countriesto manage their exchange rates and their monetary policies.
In short, the purpose of the Smithsonian Arrangement was to inject greater flexibility into the par value system,
although convertibility of the US dollar was never guaranteed. Unfortunately, the arrangement could not go far. There
was a tide of speculation against the weak currencies, such as the dollar and the
Pound sterling, and of a massive flow of capital towards strong-currency countries, such as Germany, Switzerland,
the Nether- lands, France and Japan. The US government wasforced to Devalue the dollar by 10.0 percent raising
the price of gold to $42.22 per troy ounce in February 1973.It could the currency flow in favor of European
countries and Japan. At last exchange market were closed in march 1973 to avert a crisis. When they reopened,
themajor currencies came on to float thus delivering a death blow to theBrettonWoods exchange rate regime.
2.8 Exchange Rate Regime Since 1973

In view of the collapse of the Bretton Woods system of exchange rate, the Board of Governors of the IMF
appointed Committee of 20 to suggest guidelines for evolving an exchange rate system that could be acceptable to
the member countries. The report suggested various optionsthat were discussed atRambouillet in November 1975
and approved at the Jamaica meet in January 1976.They were formally incorporated into the text of the Second
Amendment to the Articles of Agreement that came into force from April 1,1978. The broad options underthe
newexchange rate regime were:
• Floating –Independent and Managed
• Pegging of currency
– to a single currency
– to a basket of currencies
– to SDRs
• Crawling peg
• Target –Zone arrangement
The new regime conferred upon the member countries many options that they could choose according
totheirownconvenience anddependingupontheirownmacroeco- nomicvariables.Thiswaythesystem was more
flexible than the adjustable peg system. A few industrialized countries chose independent floating while some others
including a few developing countries went for managed floating. A few developing countries chose the crawling peg,
while a majority of the developing countries opted to peg _eithertoa single currency, a basket of currencies or to
SDR.
2.8.1 Floating Rate Regime

In a floating-rate regime, the exchange rate is determined by the market forces—the forces ofsupply and demand
in respect of a particularforeign currency. It is notfixed, nor administered, and it moves along with the changesin
demand and supply positions. Now the question is whether the floating-rate regime issuperior to fixed-rate regime.
On the ground of economic efficiency, it is argued that rates are auto-a fixed-rate regime does not need hedging of
exchange rate risk and so it does not entail expenditure of resources, not that it needs establishment of elaborate
hedging mechanism. But this benefitisoutweighedbyotherconsiderations. In a fixed-rate regime,the exchange rate is
not fixed for ever. It isrealigned in order to suit the changing economic scenario. If it is not realigned according to
changes in macro-economic indicators, there arises a gap between nominal and real exchange rates which in turn
hampers, among other things, the export performance. But if realignment is made, it is often costly and painful. It
may involve loss of foreign exchange to the monetary authorities and to other parties. InMexico, afterthe 1994
devaluation ofpeso,manynon-Mexicanbondholders abroad, and share traders suffered huge losses. Thus it would be
wrong to say that the fixed- rate regime does satisfy completely the economic efficiency norm. On the contrary, in
a floating-rate regime, exchange rate tends to change automatically in line with the changes in macro-economic
variables and so there does not appear any gap between the real and the nominal exchange rates (Friedman, 1953).
For example, if inflation grows, the domestic currency depreciates automatically in a floating-rate regime.
Naturally, there is no cost or pains of adjustment.
Secondly, as far as stability in the exchange rate is concerned, floating-rate regime scores quite high. The
exchange rate does move but it tendsto be closer to the equilibrium in the long run. If there is inflation, the
currency depreciates, but depreciation in currency leads to greater volume of export and,

ultimately,. greater export leadsto currency appreciation. The equilibrium ismaintained. Thirdly, the advocates of
the floating-rate regime argue that this system has insulation properties and hence the currency remains isolated
from the shocks emanating abroad. The government can adopt an independent economic policy (Friedman, 1953).
This is quite in contrast with the fixed-rate regime where the insulation properties are absent. The experiences from
Thailand reveal the situation. Thai currency, baht, was pegged to US dollar. During 1980s and early 1990s, when
the US dollar had depreciated, Thailand experienced export boom. But in 1996, when the US dollar appreciated,
Thai economy had to suffer heavy losses on trade account. Had baht been on float, it would have remained
unaffected by dollar appreciation.
However, the empirical findings do not essentially support the arguments in favour of floating-rate regime.
MacDonald (1988) finds that the exchange rate changes among the countries on floating rate during 1973-85 were
much more volatile than warranted by changes in fundamental monetary variables. Dunn (1983) finds absence of
insulation properties. During the early 1980s, when the USA was practicing a tight monetary policy through raising
of interest rates, the European countries raised interest rates so as to prevent large outflow of capital to the USA.
Again,since the nominal exchange rate tended to adjust more rapidly than themarket prices of goods, nominal
exchange rate turbulence was closely related to real exchange rate turbulence (Frenkel and Mussa, 1980). It is
very difficult to confirm that greater uncertainty in real exchange rates has caused stagnation in international trade
during the past two decades; but Cushman (1983) feelsit has adversely affected trade among several industrialised
countries. Dunn (1983) gives an example of Canadian firms borrowing long-term funds from the USA. They faced
heavy losses due to 14 per cent real
depreciation of Canadian dollar during 1976¬79. He also finds that substantial appreciation in the real value of the
pound during the late 1970s had led to insolvency of many UK firms as their products turneduncompetitive
intheworldmarket.
Developing countries in particular do not find floating rates suitable for them. Since their economy is not diversified
and since their export issubject to frequent changesin demand and supply, they face frequent changes in exchange
rates. This is more, especially when foreign demand for their productsis price inelastic. When the value of their
currency depreciates, export earnings usually sag in view of inelastic demand abroad. Again, greater flexibility in
exchange rates between a developed and a developing coun try generates greater exchange risk in the latter because
of the low economic profile of developing countries and also because they have limited access to the forward
market and to other risk-reducing mechanisms.In short,itis difficultto saywhetherflexible exchange rate regime is
better than the fixed rate one or vice versa. A government adopts a particular regime which is better suited to its
macro economic environment.
2.8.2 Managed Floating
Floating is generally managed in the sense that the system of managed floating involves direct or indirect intervention
by the monetary authorities of the country to stabilise the exchange rate. It is different from independent floating
which does not involve intervention. This is why independent floating is often termed as clean floating, whereas
managed floating is known as dirty floating. However, the difference is only theoretical. In practice, intervention is
found also in the case of independent floating. In independent floating, the purpose of intervention is simply to
moderate the exchange rate and to
prevent any undue fluctuation. In the case of managed floating, it is meant to establish a level for the exchange
rate. When the monetary authorities stabilise the exchange rate through changing the in terest rates, it is indirect
intervention. In the case of direct intervention, on the other hand, the monetary authorities purchase and sell foreign
currency in the domestic market. When they sell foreign currency, its supply increases, and domestic currency appre-
ciates against the foreign currency. When they purchase foreign currency, its demand increases and the domestic
currency tendsto depreciate vis a-vis the foreign currency. The IMF permits such intervention. If intervention is
aimed at preventing long-term changes in exchange rate away from equilibrium, it is known as leaning-against-the-
wind intervention. But if the intervention supports the current trend in the exchange rate already moving towards
equilibrium, it is known as leaning-with-the-wind intervention.

Intervention helps move the value of domestic currency up or down also through the expectations channel. When
the monetary authorities begin supporting the foreign currency,speculators begin buying itforward in the expectation
thatitwill appreciate. Its demand rises and in turn, its value appreciates vis a-vis the domestic currency. Intervention
may be stabilising or destabilising. Stabilising intervention helps move the exchange rate towards equilibrium, while
destabilising intervention is found in cases where rates are moving away from the equilibrium despite intervention.
The former causes gain of foreign exchange, while the latter causes loss of foreign exchange. Sup- pose the rupee
depreciates from 33 a dollar to 36 a dollar. The Reserve Bank sells US $ 1000 and the rupee improves to 33. The
RBI will be able to replenish the lost reserves through buying the dollar at Rs. 33/US $. The gain will be US $
(36000/33 - 1000) or US $ 91. But afterintervention, ifthe rupee fallsto 40 a dollar, the loss will be US $
(36000/40 - 1000) or US $ 100. The monetary authorities do not normally resort to
destabilising intervention, but it is very difficult to know in advance whether intervention would be really
destabilising. The empirical studies show both the stabilising and destabilising intervention. Longworth‘s study
(1980) finds stabilising intervention in case of the Canadian dollar, while Taylor (1982) finds destabilising
intervention in the case of some European countries and Japan during the 1970s.
Again, intervention may be sterilised or non-sterilised, When the monetary authorities purchase foreign currency
with the help of created money, the money supply in the country increases. It leadsto inflation.
Thisisanexampleofnonsterilisedintervention. But if simultaneously, securities are sold in the market to mop up the
excess supply of money, intervention does not lead to inflation. It takes the form of sterilised intervention. The
study of Obstfeld (1983) reveals that sterilised intervention has generally been ineffective; on the other hand, non-
sterilised intervention is common. However, on the whole,
Loopesko (1984) confirms the effect of intervention on exchange rate stabilisation. Finally, the intervention may be
a coordinated one where central banks of two or more countries are simultaneously involved in stabilising a
particular currency. The G-5 governments attempted for making US dollar consistent with the then economic
indicators under the Plaza Agreement of 1985. At Louvre Palace in Paris in 1987, they noted their success,
although as Bordo and Schwartz (1991) feel, the coordinated intervention under the Plaza Agreement distorted the
foreign exchange market and the central banks had to face excessive risk of loss.
2.8.3 Pegging of Currency

Normally, a developing country pegsits currency to a strong currency orto a currency with which it has a very
large part of its trade. Pegging involves a fixed exchange rate with the result that the trade payments are stable,
but in case of trading with other countries, stability cannot be country‘s trade is diversified. In such cases, pegging
to a basket of currency is advised; but if the basket is very large, multi currency intervention may prove costly.
Pegging to SDR is not different insofar as the value of SDR itself is pegged to a basket offive currencies.
UgoSacchetti(1979) observesthatmany countries did not like to peg to SDRin view ofits declining value.
Statisticsshow that the number of currencies pegged to SDR fell from seven in 1989 to two during the third quarter
of 1997(IMF,1998).
Again,afewcountrieshadasystemofacrawlingpeg.Underthissystem,acountry pegsits currency to the currency of
another country but allows the parity value to change gradually over time to catch up with the changesin the
market-determined rates. It is a hybrid offixed-rate and flexible-rate systems. So this system avoids too much of
instability and too much of rigidity. Edwards (1983) confirms this advantage incase of a sample of some
developingcountries.
Last but not least, in a currency board arrangement, the country does not have a central bank,ratherit has a currency
board that links the domestic currency stock to the foreign exchange holding. In other words, the currency board
pegs the domestic currency to the currency of another nation and buys and sellsthe foreign currency reserves in
order to maintain the parity value. The purchase and sale of the foreign currency determines the amount of
domestic money in circulation. However, the currency board
has normally only limited functions and powers compared to a central bank and so it cannot frame a discretionary
monetary policy as central banks do.

2.8.4 Target–Zone Arrangement

In case of target-zone arrangement, a group of countries either maintain fixed exchange rate among their currency
through a common currency or have a common currency instead of their own currency. A few European countries
opted for a target-zone arrangement which came to be known as the European Monetary System (EMS) or later
asthe European Monetary Union (EMU). Each currency in the EMU had a central rate expressed in terms of a
European Currency Unit (ECU) that has been substituted by the Euro since 1999. This led to a fixed exchange
rate among the members‘ curren cies, although fluctuation was allowed within the prescribed band. When the
exchange rate fluctuations moved towards the prescribed limit and tried to cross it, the central banksintervened asin
the case of managedfloatingandifinterventiondidnotsucceed, realignment of the parity grid tookplace.
Ten European countries opted for a target-zone arrangement which came to be known as the European Monetary
System (EMS) or later as the European Monetary Union (EMU).Each currency in the EMU had a central rate
expressed in terms of a European Currency Unit (ECU) that has been substituted by the Euro since 1990.This led
to a fixed exchange rate among the members currencies, although fluctuation was allowed within the prescribed
band. When the exchange rate fluctuation moved towards the prescribed limit and tried to cross it, the central banks
intervened as in the case of managed floating and if intervention did not succeed, realignment of the parity grid took
place. This arrangement provided stability at least to some extent in the exchange rates within the Union, but since
the performance ofthe different member countries was not uniform, the emergence of disparity between the value of
different currencies could not be ruled out. Even intervention was helpless on many occasions as a result of which
there occurred many realignments in the value of the members‘ currencies during the 1980s. However, with greater
efforts towards convergence in the wake of the Delors Plan and with the Euro coming into being finally as the sole
currency of the EMU, the earlier problems are over. ThedetailsabouttheEMUaregiveninthestudytopic tothis chapter
for guidance of the readers.
2.9 International Liquidity

2.9.1 The Three Bases
The other important aspect of the international monetary system is international liquidity. In the early IMF system,
stock of gold lay at the very root of international liquidity. Again,since the US dollar was convertible into gold and
since the US treasury had held around three-fourths of the world‘s gold holding, stock of US dollar-denominated
assets provided sufficient liquidity. Yet again, there was a provision for an international pool of reserves with the
IMF to which the members contributed according to their quota prescribed on the basis oftheir GNP and foreign
trade etc. One quarter ofthe contribution was in form of gold and the rest in form of their own currency, usually non-
interest- bearing notes. In return, a member country could draw from the pool up to a prescribed limit for meeting its
balance of payments deficit. The drawingsinvolved the purchase of other members‘ currencies, normally the US
dollar or other scarce currencies, in exchange for the drawer‘s own currency. Thus, the size of international liquidity
was dependent not only upon the size of gold holding and the elasticity and strength of the reserve currency, say, the
US dollar, but also upon the size of the reserves pool with the IMF. Now the question is whether these three elements
of international reserves were sufficient for meeting the demand for international liquidity since the supply of gold
which was the principal component, was limited by the conditions of its production and the rise of production cost
relative to its fixed price.
As regards the US dollar, which was the other important component of international reserves, there was no problem
in the initial years of the IMF but since the late 1950s, when the US balance of payments faceddeficit andwhenthe
ratio ofreservesto import in the USA fell from 122 per cent in 1959 to 41 per cent in 1969, international liquidity
faced constraints. The weakening of the US dollar and the consequent loss of confidence in it added fuel to the fire.
The countries possessing large dollar denominated assets began converting those assets into gold. By 1968, the US
gold stock covered only two- thirds of US liabilities to all foreign official holders.
As a result, international liquidity was jeopardised. The size of the reserves pool with the IMF, though
it was augmented with upward revisions of quotas of member countries, was limited in view of the growing need
for it. At the end of 1968, the outstanding drawings (net) which amounted to US $ 6.7 billion were far from being
adequate. The resources with the IMF were supplemented through borrowings from ten industrialised countries under
the General Arrangements to Borrow (GAB) scheme from 1962, but they fell short of the requirements. More
recently, in early 1997 following the Mexican crisis, the IMF announced a New Arrangement to Borrow (NAB)
scheme that could provide up to 34 billion SDRs or US $ 48 billion, the borrowing to be made from 25 potential
participants when supplementary resources would be needed by the IMF to deal with some exceptional situations
This decision was in effect originally for five years but it was extended in 2002 for another term of five years.
2.9.2 Creation of SDRs

With the persisting wide gap between the supply of, and demand for, international reserves, several ideas were
floated during the 1960sforthe creation ofinternationalfiat money, the stock of which could be controlled by the
IMF so asto generate confidence in it. At the 1967Rio de Janeiro annualmeeting, it was decided to create such a
reserves asset, called the Special Drawing Rights (SDRs) that could supplement the then existing reserves asset.
This decision international entered into force with the first amendment to the Articles of Agreement reserves asset in
July 1969. The reserves asset of the member countries was to be created by the ‘ IMF increased through the
allocation of SDRs to them in proportion of their quota. The first allocation, based on the need for international
liquidity,
amounted to US $ 9.5 billion during 1970-72. The second allocation of SDRs 12.3 billion was made in 1979 for a
three-year period. The third allocation approved by the IMF Board in September 1997 amounted to US $ 21.4
billion and was meant for those countries that had joined the IMF after the second allocation, namely the East
European countries and a few others. The SDRs possess members‘ confidence insofar as they are handled by a
supra-national body. Again, in order to make the system of international liquidity more viable, the IMF decided to
reduce the role of gold in the international monetary system. It took a con- crete shapewith the second
amendmentto the articlesof agreementthat came into from April 1978 which made SDRs the principal reserves
asset of the world monetary sys tem. The role of gold as a common denominator ofthe par value of the
currencies endedinfavorof SDRs and the obligation to use gold in transactionwith IMFcame to an end.SDRs
replaced gold as a means of payment by the members to the IMF.This means that they were to pay25 percent of
their quota to the reserves pool not in gold but in SDRs. The IMF sold 25 million ounces of gold and used the
proceedsforthe benefit ofthe poorer developing countries. A similar amount of gold wasrestituted to themembers.
The official price of gold was abolished. IMF‘s borrowings etc. were denominated inSDRs. Anumber
ofinternational organisations also adoptedSDRs as the unit of account.
The value of SDR was fixed initially in terms of gold with the same gold content as the 1970 US dollar. Till
November 1971, one unit of SDR was equal to one unit of US dollar, but with the devaluation of the US dollar,
the value of the SDR appreciated vis-à-vis US dollar. During February 1974,SDR 1 was equal to US $
1.20635.From July 1974,the value of SDR came to be determined in terms of a basket of 16 currencies whoseshare
intheworldtradewasmorethanonepercentduring1968- 72.Since the basis of valuation of SDRs‘ was broad, their
value remained almoststable. From January 1981, the basket came to comprise five currencies that share the
largest part of the world export. They were the US dollar, the British pound, the French franc, the German mark
and the Japanese Yen. Effective from January 1999, the German mark and the French franc were replaced by Euro
for the valuation of SDR, based on fixed conversion rate announced by the European Council on the closing day of
1998.The weight remained changing from time to time. Beginning from 2001, the SDR valuation basket weights
came to be: 45%for US dollar, 29% for Euro, 15% for Japanese Yen, and 11% for British pound. The value is
established daily on the basis of the representative market exchange rates.
The supply of SDRs depends upon their creation and allocation. Any allocation is effected by a minimum vote of
85%.Cancellation requiressimilar percentage of votes. TheSDRholding issubjectto

interest receipt and payments. If a member country holds SDRs in excess of its allocation, it earns interest on the
difference. If the holding is below the allocated amount, it has to pay interest in line with the market rate of
interest rate that is equal to those on primary domestic market instrumentsin the fivecountries whose currencies
from the basket. The rate is calculated weekly.
Thus, with creation and allocation of SDRs, the position of international liquidity has eased considerably. Moreover
to ease it further, the IMF has created several facilities for drawing from the reserves pool. These facilities
arediscussed hereunder.
2.9.3 IMF’s Funding Facilities

The funding facilities of the IMF can be grouped under four heads:
• Permanent facilitiesfor general balance of paymentssupport:
– Reserve tranche facilities
– Credit tranche facilities
• Permanent facilities for specific purposes:
– Extended fund facility
– Compensatory and contingency financingfacility
– Buffer-stock financing facility
– Supplemental reserve facility
• Temporary facilities:
– Supplementaryfinancingfacilitysubstitutedbyenlargedaccessfacility – Oil facility
– Trust fund facility
– Systemic transformation facility
• Special Disbursement Account facility
– Structural adjustment facility
– Enhanced structural adjustmentfacility
Reserve tranche drawings indicate unconditional borrowings of a part of the quota held by a particular member. A
few experts do not consider such drawings as the using of IMF credit as it is the amount deposited by the
borrower.
The credit tranche is often known as the IMF‘s basic financing facility. Such credits are made available in tranches-
each tranche being equivalent to 25 per cent of the member‘s quota. The tranche does not involve major
constitutionalities and the receiv- ing country has simply to assure reasonable use of the funds. Subsequent
tranches, however, require performance criteria in terms of budgetary and credit policies. The policies
aremonitored by the IMFduring the period inwhich the installments of credit are disbursed. The period of
creditrangesfrom three to five years. The extended fund facilitywas established in September 1974 for making
available long-term resources of larger magnitude than available under credit tranches. It is provided when the
balance of payments problem is structural; a member country can use the credit tranche and extended fund facility
resources subject to an annual limit of 100 per cent of quota (net of scheduled repurchases) and a cumulative limit
of 300 percent of the quota.
The compensatory financing facility was established in February 1963 and under this, credit is proved to meet the
fluctuation in export earnings due to circumstances beyond the control of the member government. Since 1981,
credit under this facility is also provided to cover the fluctuation in cereal import cost. The main gainers are the
primary producing countries. The extent of shortfall in export earningsis determined on the basis of relationship
between the latest export preceding the request and the trend value of export earnings calculated as a geometric
average. This facility was substituted by the compensatory and contingency financing facility in August 1988 through
adding a mechanism for
contingency financing to support the adjustment process approved by the IMF.

The buffer stock financing facility was set up in June 1969.It assists mainly the primary producing countries in
financing their contribution to international buffer stocks under international commodity agreements. Supplemental
service facility was created in December 1997. It provides assistance to those member countries that experience
exceptional balance of payments problem due to large short
term financing vis-a-vis sudden loss of market confidence.
The supplementary financing facility was introduced in February 1979 to provide the balance of payments support
normally in excess of the quota. It was substituted by the enlarged excess facility in May 1981, but was terminated
in November 1992 after the ninth review ofthe quota. It was conditional credit with repaymentsstretching up to10
years. The oilfacilitywas created in June 1974in thewake ofraising oil import bill of the net-oil importing
countries. It met excess oil import bill. By May 1976, when this scheme was dropped, 55 countries had availed of
this facility. The most seriously affected countries were treated liberally. An interest subsidy account was created to
reduce the cost of serving bythem.
The trustfund facility was created in the late 1970‘s out ofthe sale ofIMF‘s gold holdings for US $ 4.6 billion. A
sum of US $1.3billion was transferred directly to 104 developing countries in proportion of their quota and the
rest as loans to 37 low- income countries. The systematic transformation facility wasset up in April 1993 for the
purpose of assisting those countries whose balance of payments was disrupted owing to a shift from a controlled
economy to a market-based economy. The beneficiaries were east European countries. This scheme was
terminated in 1995. The structural
adjustmentfacility (SAF)wasset upinMarch 1986 for providingadditional balanceof payments support in the form
of loans on concessional terms to low-income developing countries orto IDA-only countries. The resourcesforthis
purpose come fromtheTrust Fund re flow,interestincome fromsuch loans and the amountthatmayhaveremained
unused under the supplementary financing facility. A member country can getsuch loans up to 70 per cent of
itsquota.
In December 1987, IMF set up an enhanced structural adjustment facility (ESAF) for providing loans in addition
to the SAF loans. Resources come from the ESAF Trust set up for this purpose, loans and contributions, and special
disbursement account. Such loans can go up to 250 per cent of the quota or even more in special cases. Interest
rate on loansis very low being 0.50 per cent maturity extendsfor ten years. In Novem- ber 1999, ESAF was
renamed as Poverty Reduction and Growth Facility (PRGF). The latest facility that the IMF has set up is known as
contingent credit lines. It is precau tionary line of defense against financial contagion. It will help countries with
strong macroeconomic policies against future balance of payments problem that may arise due to unjustified panic
on the part of investors.
2.9.4 An Appraisal of Liquidity Promotion Measures

It is a fact that IMF has tuned its financing facility in response to the needs of the members, especially among
developing countries. Butthe issuesthat need evaluation are whether: • The SDR allocations have a relevance in
the changing world capital marketsce- nario; •
ThedrawingsfromIMFhavehelpedimprovetheexternalbalanceofthemember countries; • Conditionalities
associatedwiththedrawingshaveprovedtobeofbenefittothe member countries;
• The developing countries have been able to make greater use of the IMF resources; and • IMF resources
have been able to meet the current account deficit in the member countries. It is believed in some quarters, that in
view of phenomenal growth in the international capital market where ample funds are available, SDR allocations
do not have as much significance as in the earlier decades, but at the same time, it is observed that the supply
ofinternational liquidity has been erratic and unreliable owing to lack of coordination in policies among creditors,
especially the private sector creditors. The terms of lending have also been harder. All this has renewed the
significance of the
SDR allocation. Moreover, there is also a provision in the Articles of Agreement for checking unwar ranted
liquidity creation through cancellations. In fact, SDR allocations are normally moderate and improve overall quality
of international reserves. However, they are based on a quota and so do not take into account the liquidity need of
individual member countries.
As regards the second question, a few studies can be referred to. Connors (1979) felt that the IMF‘s funding
facilities were mostly ineffective. Reichmann and Stillson (1978) found that during 1963-72, only one-quarter of 79
standby agreements helped improve the balance of payments of the drawing countries. They felt thatforthe
following three years, the IMF‘s contribution in this respect was less than satisfactory.
As far as conditionality, which is associated virtually with all the drawings except reserve tranche drawings, is
concerned, it is justified on the ground that it helps in proper utilisation of funds, particularly in low income
countries where the administrative machinery is too weak to do this. The economic, social and political structure in
these countries, however, is such that they cannot abide by the conditionalities and they fail to get desired funds
from the IMF for that reason. Again, the quota of individual developing countries in relative terms has not in-
creased over time despite increase in the overall quota because when the SDR scheme was established,it wasthe
global liquidity, and not the liquidity needs ofthe individual member country, that was taken into consideration. The
study of Granade (1972) reveals that a developing country drew far lessthan a developed country. At the end of
1971, the withdrawal of a developing countrywas on an average SDR25million as compared to SDR 441 million
by an industrialised country. However, in September 1997, the IMF Board decided to distribute 75 per cent of the
SDR allocation on the basis of the existing proportion ofthe holdings. Fifteen per cent ofthe remainder were to be
allocated on the basis of some selective criteria, such as economic strength of the member country and ten per cent
on the basis of some ad hoc considerations. But, despite the policy changes, the low-income countries have been
the lowest beneficiary ofIMF funds.
Again, notably,the IMFresource flowhaslagged behind the size of current account deficit of the net-oil importing
countries. It is found that deficit on current account of these countriesrose fromUS $ 11.5 billion in 1973 toUS$
97.5 billion in 1981 butthe IMF resources available to them accounted for 4.0 to 11.5 per cent of the deficit (Sha-
ran, 1985). This state of affairs leaves these countries with two options: one, that they go in for non-official credits,
in which case, their debt problem may become unmanageable; and two, that they resort to forced adjustments
with the resources available with them which too would be a painful process in that the welfare cost associated
with the decline in national income would be very high. The study of Dell and Lawrence (1980) confirmsthat the
losses on account of diminution in economic growth and in the levels of living standard were considerable among
developingcountries asa sequeltoforced adjustments during mid-1970s.
2.10 IMF Solution for Financial Crisis

2.10.1 Nature of Financial Crisis
Besidesthe design and management of the exchange rate regime and international liquidity in normal course of
business, the IMF helps manage financial crisis faced occa- sionally by member countries. The financial crisis has
been gripping both the developed countries and the developing countries, but its frequency and intensity has been
greater in case of the developing countries.
Financial crisis manifests in different ways. One of the forms is currency crisis. In this case, speculative attacks
on the exchange rate of the currency tend to push down the value of the currency. The situation does not
improvemuch even aftermarket intervention by the monetary authorities of the country. The second
formoffinancial crisis is known as banking crisis. Thisinvolves potential or actual bank runs. The monetary
authorities suspend the internal convertibility of banks‘ liabilities and provide financial assistance. But this action
sometimesleadsto the loss of confidence among the borrowers and

depositors. Loss of confidence leads to bank runs. The third form, known as the systemic financial crisis brings
disruption in the financial market causing large-scale disinvestments. If disinvestment pertains to the foreign
institutional investors, it may lead to currency crisis. The fourth form is the foreign debt crisiswhere the country
findsit difficult to service external debt either on account of very high interestrates or on account of mal-utilization
of the borrowed funds.
All these different forms of crisis have normally a common origin; which is, unsustainable economic imbalances
and malalignment of asset prices or exchange rates often in the context of financial sector distortions and structural
rigidities. There is sudden loss of confidence in currency or the banking system prompted by sudden correction of
asset prices or by disruption of credit or external financial flows underlying economic and financial weaknesses.
These different forms of crisis are inter-linked. Theworstis when all the different forms of crisis occur
simultaneously.
2.10.2 IMF Response

The IMFprovidessizeable financial assistance either out ofits own funds orin collabo- rationwithsome other
agencies, such as the World Bank or any other agency. Moreover, it helps implement reforms in macroeconomic
policies so that the financial assistance is put to the best possible use and the crisisis resolved. Tomention a
fewexamples, to solve the international debt crisis of 1980s, especially when Mexico announced its inability to
service foreign debt in 1982, the IMF arranged for greater financial assis-
tanceundertheBakerPlanandtheBradyPlanandatthesametime,initiateddebt-relief measures.
In the case of the Russian Rouble crisis of 1992-95, when the value of the rouble vis-a-visthe US
dollarfellfrom$1=R125to$1=R5130andwheninflationratewas four-digit, the IMF helped build up the country‘s
tax system and the system of public spending. It provided over $ 11 billion support in orderto stabilise the rouble.
Again, to resolve the Mexican currency crisis of mid-1990s when the peso had fallen by over 40 per cent and the
country had witnessed huge current account deficit, the IMF provided $ 50 billion assistance to help stabilise peso
and help the Mexican Government repay $ 47 billion debt which it owed to the public and private sector lenders. It
also asked the Mexican Governmenttobringreformsinsomeofthemacro-economicpolicies.
The Asian crisis of 1997 was more serious in the sense that all forms of the financial crisis occurred almost
simultaneously. High growth rate sans strong financial sector, loss of export competitiveness and deteriorating
capital account balance, upsurge in the credit facilities to the private corporate sector and structural rigidities in the
financial sector were at the root of the crisis. The crisis began in the first quarter of 1997 in Thailand with a sharp
fall in the price bubble in the real estate sector and also a sharp fall in the equity prices, that in turn led to a fast
depreciation of the baht. The Govern- ment
announced to float baht, but because of the weak economy, it depreciated further. The spill-over effects spread to other
neighbouring countries. The neighbouring governments, viz. Indonesia, Malaysia, Philippines, etc. took restrictive
measures to revamp the economy in general and to stabilise the external value of the currency, but that did not
serve anything. It was because such measures led to erosion of confidence in the economy. By October 1997, the
cumulative decline of the currency of the above four countries against the US dollar exceeded 20-30 per cent.
Mounting political uncertainty added fuel to the fire. In order to contain damages, the IMF provided $ 117 billion to
these countries and helped implement the macro-economic policy reforms. The measures could be categorised in
fourgroups.
Firstly, there were financial and corporate sector reforms including closure of insolvent financial institutions with
their assets transferred to restructuring agency, limited use of public funds for bank restructuring,strengthening of
prudential normsforloan operation, liberalisation offoreign investment
in domesticbanks,restructuring of domestic and external corporate debt, etc. Secondly, the measures were
related to competition and governance policies. It included the liberalisation of restrictive marketing arrangements of
some key commodities, privatisation of government assets, strengthening of bankruptcy laws and exit policies, and
liberalisation of FDI in non-financial sector.
Thirdly, the social policy included labour-intensive public work programmes, price control of essential

items meant for low-income persons, stress on health and education and the development of small scale industry.
Fourthly,measureswere related to trade reformssuch asimportliberalisation and export promotion.
2.11 Major Financial Crises

Financial crises have been an unfortunate part of the industry since its beginnings. Bankers and financiers readily
admit that in a business so large, so global and so complex, it is naive to think such events can ever be avoided. A
look at a number of financial crises over the last 30 years suggests a high degree of commonality: excessive
exuber- ance, poor regulatory oversight, dodgy accounting, herd mentalities and, in many cases, a sense of
infallibility.
William Rhodes has been involved in the industry for more than 50 years and has lived through nearly every
modern-day financial crisis, many of which are detailed in his book, ―Banker to the Worldǁ. As he puts it, there is
a common theme of countries and markets wanting to believe that they are different and that they are not as connected
to the rest ofthe world‘s economy. In his view,many aspects ofthe LatinAmerican debt crisis of 1982 have been
repeated a number of times and there is much from this crisisthatwe canapplytowhatis
currentlyhappeninginEurope andbeyond.
2.11.1 LatAm sovereign debt crisis – 1982

This crisis developed when Latin American countries, which had been gorging on cheap foreign debt for years,
suddenly realised they could not repay it. The main culprits, Mexico, Brazil and Argentina, borrowed money for
development and infrastructure programmes. Their economies were booming, and banks were happy to provide
loansto the point where Latin American debt quadrupled in seven years. When theworld‘s
economywentintorecessioninthe late1970stheproblemcompoundeditself.Interest
rates on bond payments rose while Latin American currencies plummeted. The crisis officially kicked
offinAugust1982whenMexico‘sfinanceministerJesusSilva-Herzog said the country could not pay itsbills.
It took years to sort out the crisis, with Latin American nations eventually turning to the IMF for a bailout in
exchange for pro-market reforms and austerity programmes. It also led in 1989 to the novel creation of Brady
bonds, which were designed to reduce debt in these countries by converting distressed sovereign debt into a number
of different types of bonds. Furthermore, banks could exchange claims on thesedebtsfortradable assets, which
enabled them to get the debt off their balance sheets.
Rhodes recalls it as a tense period, but says that strong political leadership enabled themto get through
thecrisis.Helaments,however,thatthelessonsofthecrisisweren‘t heeded.
―Time and again, be it in the Asian crisis or the eurozone crisis, we have seen how governments have failed to
draw lessons from the Latin American crisis,ǁ he said. ―They have repeatedly taken the view that their countries and
regions are different and unique and,thereforeeventsinotherpartsoftheworldcannot provideanyrelevantlessonsfor
them.
―And yet key developments seen in the Latin American crisis – the dangers of contagion, the need for urgent
and bold political leadership, the risks of over-leveraged banks
– have been characteristics of every sovereign debt crisis since then.ǁ
2.11.2 Savings and loans crisis – 1980s

While the solution to the Latin American crisis was being put together, a domestic one was happening right in
front of the US regulators. The so-called savings and loans crisis took place throughout the 1980s and even into the
early 1990s, when more than 700 savings and loan associations in the US went bust.
These institutions were lending long term at fixed rates using short-term money. As interest rates rose, many
became insolvent. But thanks to a steady stream of deregulation under President Ronald Reagan, many firms were
able to use accounting gimmicks to make them appearsolvent. In a sense, many of themresembledPonzischemes.
The government responded with a set of regulations called the Financial Institutions Reform, Recovery

and Enforcement Act of 1989. While the act tightened up the rules on S&Ls, it also gave Freddie Mac and
FannieMaemore responsibility forsupporting mortgages for lower-income individuals. Someone who
remembersthe savings and loan crisis all too well is William Black. Duringthe1980she served aslitigation director
for the Federal Home Loan Bank Board and deputy director of the Federal Savings and Loan Insurance Corp. He
was instrumental in the investigation into one of the most notorious S&L villains, Charles Keating, who
infamously sent a memo saying he wanted Black dead.
In Black‘s view, the act didn‘t go nearly far enough and in many ways contributed to the continuation and
expansion of predatory lending that would ultimately become a huge factor in the 2008 financial crisis.
―The credit crisis is a continuation of the savings and loan crisis,ǁ he said. ―It‘s not that they did nothing
about it, it‘s that they undid everything that worked. They could have thought, ‗we‘ve seen this before, this is bad,
this is disastrous‘ and we had regulations that worked and could have reinstalled.ǁ
When askedwhy the government‘ssolution to theS&Lcrisiswasto some degree to regulate the industry even less,
and why people such as Keating maintain that excessive regulation was the cause of the S&L crisis, he says: ―One
is ideology. They hate government involvement of any kind. Second, imagine yourself answering the ... question
of why did none of you get this right? You‘re 55 years-old, are you going to say, ‗sorry, everything I‘ve ever said
and written and worked on is false? And everything I‘ve said created a criminogenic environment? And by the
way, I have no useful skills‘? Maybe one in 1,000 would say that, but it‘s not likely.ǁ
2.11.3 Stock market crash – 1987

Despite the shock of the savings and loans crisis, two more crisestook place before the 1989 Act. The
mostmemorable wasthe 1987 stockmarket crash. Onwhat became known asBlackMonday, global stock markets
crashed, including in the US, where the Dow Jones index lost 508 points or 23% of its value. The causes are still
debated. Much blame has been placed on the growth of programme trading, where computers were executing a
high number of tradesin rapid fashion. Many were programmed to sell as prices dropped, creating something of a
self-inflicted crash.
Roger Ibbotson, a finance professor at Yale University and chairman of Zebra Cap- ital, has written extensively
about the crash. He recalls teaching a class when itwas happening, and every fewminutes anewstudentwould
dropinto his classsaying the market had hit another low. ―The whole week was chaos,ǁ he said. ―The futures
market was a mess, butyou could actually make good money if you were up for some risk. A lot of people tried to
set up brokerage accounts to take advantage ofsome ofthe valuations.ǁ
Yetoneoftheoddestpartsofsucha significantcrash,herecalls,washowlittleeffect itseemed to have. It was ultimately a
short-lived event. The market continued to fall into November, but by December it was up and it ended the year
positively. Ibbotson saysthings basically just went back to normal. A few changes were made, notably the
introduction of circuit breakers that could halt trading, but apart from that, many people just shrugged and went
back to making money.
2.11.4 Junk bond crash – 1989
Next up was the 1989 junk bond collapse, which resulted in a significant recession in the US. There is some
disagreement asto what caused it, but most point to the collapse of theUS$6.75bn buyout ofUAL as the main
trigger. Others point to the Ohio Mattress fi- asco, a deal that would become known as ―burning bedǁ and remains
widely considered to be among the worst deals in modern finance. The culmination ofthe crashis considered to be
the collapse ofDrexelBurnhamLambert,whichwasforced into bankruptcy in early 1990, largely due to its heavy
involvement in junk bonds. At one point it had been the fifth-largest investment bank in the US.
Ted Truman, now a senior fellow at the Peterson Institute for International Eco- nomics, was then director of the
international finance division at the Federal Reserve. He remembersthe crisis as having similar undertones to the
more recent financial and sovereign debt crises, where banks were underwater
and the government had to bail out various institutions to avert furtherproblems. ―You essentially had at the
same time the last phase of the S&L crisis,ǁ Truman said. ―To some degree this was the mop-up phase. There is
a view out there that any time there is a rescue, it encourages people to take risks. That‘s the moral hazard issue.
But I think that‘s a little unfair because most people who get rescued pay a high price in the process. The system
isrescued not the perpetrators. Reputationsarebesmirched.ǁ
2.11.5 Tequila crisis – 1994

In 1994 a sudden devaluation of the Mexican peso triggered what would become known as the Tequila crisis, which
would become a massive interest rate crisis and result in a bond rout. Analystsregard the
crisisasbeingtriggeredbyareversalineconomicpolicy in Mexico, whereby the new president, Ernesto Zedillo,
removed the tight currency controls his predecessor had put in place. While the controls had established a degree
ofmarketstability,theyhadalsoput anenormousstrainonMexico‘sfinances.
PriortoZedillo, banks had been lending large amounts ofmoney at very lowrates. Witharebellioninthe poorsouthern
state ofChiapas adding to Mexico‘srisk premium, the peso‘s value fell by nearly 50% in one week.
The US government stepped in with a US$50bn bailout in the form of loan guarantees. Yields on Mexican debt
shot up to 11%, and capital markets activity ground to a halt not only in Mexico but across the entire region,
especially in Argentina – where yields went as high as 20%. It also hit markets acrossthe developed world.
Eventually, the Mexican peso stabilised and the country‘s economy returned to growth. Three years later it was
able to repay all of its US Treasury loans.
Martin Egan, global head of primary markets and origination at BNP Paribas, as well as the firm‘s UKhead
offixed income,saysthat ofthemoments of crises he has experienced, this one sticks out particularly strongly.
―1994 is still quite vivid. Numerous rate increases including a 0.75 basis point upward movement on November
16 as the Fed attempted to control inflationary pressures resulted in a dramatic collapse of market activity,ǁ Egan
said.
―If you look at what happens now,sensitivity to rate changesis always around and marketslike to have visibility.
Back thenwe knewrates needed to go up, butthe speed and swiftness of the move derailed the market for a long
time and we saw a dramatic collapse in volumes, and serious strains in the financialsystem.
―Confidence started to rebuild eventually, but it was brutal because it dragged the markets into an awfully
defensive mode. It was one of the most problematic years ever in fixed income. It was a reminderto all
participantsthat thisisthe real world and the real economy at stake.ǁ
2.11.6 Asia crisis – 1997 to 1998

More than 15 years after the Latin American debt crisis of 1982, history would indeed repeat itself in
Asia.InJuly1997Thailand‘s currency,thebaht, collapsedwhenthegov- ernment wasforced into floating it on the open
market. The country owed a huge amount of debtto foreign entitiesthatit couldn‘t pay even before the currency
plummeted. Sim- ilarly to what was experienced in Latin America in the 1980s and present-day Europe,the crisis
spread acrossthe region, with South Korea, Indonesia, Laos, Hong Kong and Malaysia also affected.Rhodessays he
spent considerable timewarningAsian governments about the risksthey faced, butthat his concernswere largely
ignored.
―I was told by the Asians: ‗We‘re different from Latin America because we have Asian values and because we
work harder and have a savings culture‘,ǁ Rhodessaid. ―But theywere involved in the same practices of
overlending to the consumer area and in real estate. There is a similar phenomenon in all of these crises, which is
that people like to think they are different and that experiences elsewhere do not apply to them.ǁ The crisis
certainly took many by surprise. Most Asian governments believed they had the right economic and spending
policies in place, but nonetheless the crisis necessitated a US$40bn bailout by the IMF.Only one yearlater, in 1998,
a nearly carbon-copy crisis happened in Russia.
2.11.7 Dotcom bubble – 1999 to 2000

Markets would yet again forget the lessons of the past in the dotcom bubble and subsequent crash in 2000. Asin
most crises, it was preceded by a bull rush into one sector. In this case it was technology and internet-related stocks.
Individuals became millionaires overnight through companies such as eBay and Amazon. The hysteria reached such
a pitch that the inconvenientfact thatfew ofthese companies made any money scarcely mattered. By 2000, however,
the game was up. The economy had slowed and interest rate hikes had diluted the easy money that was propping
up these companies. Many dotcoms
went bust and wereliquidated.
Kay Steffen, head ofsyndication and corporate broking atDZBank,wasinvolved in bringing more than 80 ofthese
companiesto themarket. He believesthe dotcomcrash wassimply a case of a feeding frenzy that went out of control,
and was a symptom of the market‘s underlying irrationality. ―Everyone knew this was something that was not
sustainable, but it‘s not always easy to take that view and resist all the different groups that want in on the market,ǁ
he said. ―I feel this is just the natural behaviour of people. We see this happen every few years in various market
segments. We see it happeningtodayinsomebonds.Peopleare looking for yield and ifthey see a 7% coupon they
neglect what is behind it.ǁ
2.11.8 Global financial crisis – 2007 to 2008

It was only a few yearslaterthat an even nastier crisis would hit the entire world‘s financial markets. In many
ways it has still has not ended, with the billions in losses and slowing global economy manifesting themselves in the
current European sovereign debt crisis. It resulted in the collapse of a number of large financial institutions and is
considered by many economists to be the worst crisis since the Great Depression. While the causes are numerous,
the main trigger is considered to be the crash oftheUS housing market.
Jean-PierreMustierwas at the forefront ofthe crisis asthe head ofSociete Gen- erale‘s corporate and investment
bank, and had to manage the aftermath of rogue trader Jerome Kerviel‘s C4.9bn trading losses. In his mind, the
crisis has changed banking for the better, and he is a supporter of the new regulations as well assimpler business
structures. ―Toacertainextent,peoplebecametoodependenton models,ǁ says Mustier, who is now head of CIB at
UniCredit. ―Suddenly, the crisis showed that you shouldnotrelyon models only and more on common sense. What
you do hasto be connected to reality.
I think the combination of the Basel III approach and leverage ratio is actually a good thing, but I also think the
lesson we learned is, let‘s use our common sense and not blindly accept models.ǁ
2.11.9 Lessons learnt?

Is financial history destined to repeat itself? It would appear to be something of a result of the way markets
function. A boom creates excessive interest and lofty prices. The ensuing crash results in ―never-againǁ style
regulations, only for another crisis to pop up, sometimes as soon as the next year. Most recently, the world has had
to cope with the European sovereign debt crisis, a problem that never seemsabletogoawayentirely and seemsto get
worse with each ensuing multi-billion dollar bailout.
Rhodesarguesthatmanyoftheseincidentsareavoidable,butinmanywayswhatis more importantishow theyare resolved.
Above all,he seesstrongpoliticalleadership as one ofthemost crucial elements, along witha competentplan
thatthepopulacewill understand as being good in the long term.
―One of the things that is clear in all of the crises is that strong leadership is crucial,ǁ he says. ―To take some
international examples,such as Brazil in 1994, South Korea in 1998andTurkeyin2001,theheads
ofstateandfinanceministerssoldtheirprogrammes to their citizenssaying that while these included tough measures,
they were well planned and would lead to growth – and they did. This kind of leadership is missinginEurope.ǁ

1. Givean accountofsub-prime crisis.
2. Describe theAsianFinancialCrisis.
3. Discuss the evolution of International Monetary System?
4. DiscussBimetallism monetary system and bring out its weaknesses. 5. Discuss Gold Standard
monetary system and bring out its weaknesses and advantages. 6. Discuss Bretton Woods System of
Exchangerate.
7. Discuss the evolution of exchange rate regime since 1973
8. Discuss how the monetary system evolved prior to 1973
9. Discuss the concept of international liquidity and highlight the importance of IMF in international
liquidity
10. Discuss how financial crisis affects acountry.
11. Discuss how we can avoid financialcrisis.
12. Discuss the role of World Bank in international finance
13. Discuss the role of IMF in international Finance
14. Critically analyse the various exchange rate regimes.
15. Critically evaluate the different exchange rate systems in international monetary system. 16. Describe
the structure of International Monetary System.
17. Describe the various exchange rateregimes.
18. Discuss the features of various exchange rate regimes.
19. Explain the distinguishing features of Gold standard andBrettonWoodsSystem. 20.
Explainthefeaturesofgoldstandard,Brettonwoodssystem,TargetRatemecha- nism, floating rate system and
managed floating rate system.
21. Whatisexchangerateregime?Criticallyexaminedifferentexchangerateregimes.

Chapter 3
International flow of funds
Funds flowing into, or out of, a country on account of various types of international transactions are recorded by
the monetary authorities of that country in a prescribed statement that is known as the balance of payments. You find
an individual maintaining an account of his/her cash receipts and payments. A company prepares a cash-flow state-
ment that shows incoming and outgoing of cash. Similarly, a country records the inflows
andoutflowsoffundsinastatementknownasthebalanceofpayments.Inotherwords, balance of payments is a statement
that records all different forms of funds inflow and outflow and arrives at a conclusion whether there Is a net inflow
in the country/outflow out of the country influencing, in turn,the foreign exchange reserves possessed by the
country.
Thus, any discussion ofthe balance of payments embracesthe explanation of what thedifferentformsof
internationalfinancialflows areandhowtheyarerecordedinthe balanceofpayments.Italsoinvolvesthe discussion of
whether the balance of payments experiences any disequilibrium, and if it is there, what would be the waysto make
necessary adjustments. These issuesformthe subject-matter ofthe present unit along with various related topics
like capital flow and flight, international liquidity and external debt and equity financing.
3.1 Forms of international financial flows

The various types of transactions leading to international financial flows need some discussion here. Trade flows,
invisibles, foreign direct and portfolio investment, external assistance and external commercial borrowings and
some short-termflows.
3.1.1 Merchandise Trade Flows

Trade may be related to goods. Alternatively, it may be related to services. The merchandise trade has two sides.
While one is export, the other is import. If India exports various goods, it will get convertible currencies and that
will be an inflow of funds. On the contrary, it hasto make paymentsin convertiblecurrenciesfortheimportsitmakes.
Thus export and import of goodslead to international financialflows.
3.1.2 Invisibles
Invisibles include, broadly, trade in services, investment income and unilateral transfers. If an Indian shipping
company carries goods of a foreign exporter/ importer and gets the freight charges, it will be treated as inflow of
funds on account of trade in services. Similarly, if a foreign shipping company carries goods of an Indian exporter,
there will be outflow of funds in form of freight charges. There are many examples of international flow of funds on
account of trade in services. Investment income relates to the receipt and payment of dividend, technical service,
fees, royalty, interest on loan, etc. A foreign company operating in India remits dividend, etc. to its home country
that will represent an outflow of funds. Similarly, an Indian company operating abroad remitsto India the dividend
and other fees that will represent inflow of funds. Likewise, payment of interest on foreign borrowings repre sents
outflow of funds. Any receipt of interest manifests in inflow of funds. Unilateral transfers are unidirectional. They
represent international financial flows without any services rendered. If an Indian makes a gift to his/her friend in
England, it will be a case of outflow of funds on account of unilateral transfer. Similarly, a large number of Indians
living abroad remit a part of their income to their family members livinginIndia.Thisis a
caseofinflowoffundsonaccountofunilateraltransfer.
3.1.3 Foreign Investment

Foreign investment may be of two kinds. While one is direct, the other is portfolio. Foreign direct investment
(FDI) occurs when a firm moves abroad for the production of goods or provision ofservices and participatesin the
management of that company located abroad. On the contrary,foreign portfolio

investment(FPI)isnot at all concerned with the production of goods and rendering ofservices. The sole purpose of a
foreign portfolio investor is to earn a return through investment in foreign securities without any intention of grabbing
the voting power in the company whose securities it purchases. In case of FDI too, an investor investsin the shares of
a foreign company, but the sole objective isto enjoy the voting power and thereby a say in the management ofthe
foreign company.Thus, itis primarily the voting right that differentiates between FDI and FPI. Whatever the forms
may be, inflow of fiends occurs when a foreign investor makes investment in the country. On the contrary, outflow of
funds occurs when the domestic investor invests in a foreign country.
3.1.4 External Assistance and External Commercial Borrowings External assistance and external
commercial borrowings are different in the sense that while the former flows normally from an official institution
-bilateral or multilateral, the latter flows from international banksorotherprivate lenders.The rateofinterestinthe
formerisusuallylowalongwithalongermaturity period. The latter carries market rate of interest and a shorter
maturity. Last but not least, external assistance is manifest often in outright grant that does not require repayment of
principal/interest payment. Whatever may be the difference between the two, any borrowing from abroad is treated
as inflow of fiends Lending abroad, on the other hand, represents outflow of funds, However, repayment of
loadsistreated just the other way.
3.1.5 Short-term Flow of funds

Normally loans and foreign direct investment are meant for a period exceeding one year but if there are financial
flows that occur for less than a year, they are termed as short-term flow of funds. Movement offundsrelating to
banking channels, euro notes, speculative and arbitrage activities, etc. are the examples of short-term funds that
move across countries.
3.2 Capital Flows and Flight

3.2.1 Capital Flows
Capital flows refer to the movement of money for the purpose of investment, trade or business production. Capital
flows occur within corporations in the form of investment capital and capital spending on operations and research &
development. On a larger scale, governments direct capital flows from tax receipts into programs and operations, and
through trade with other nations and currencies. Individual investors direct savings and investment capital into
securities like stocks, bonds and mutualfunds.
Capital flows are aggregated by the government and other organizations for the purpose of analysis, regulation and
legislative efforts. Different sets of capital flows that are often studied include the following:
• Asset-classmovements–measuredascapitalflowsbetweencash,stocks,bonds, etc. • Venture capital –
investments in start-up businesses
• Mutual fund flows – net cash additions or withdrawalsfrom broad classes of funds •
Capital-spending budgets – examined at corporations as a sign of growth plans •
Government/Central Budget – governmentspending plans
Capital flows can help to show the relative strength or weakness of capital markets, especially in contained
environments like the stock market or the federal budget. In- vestors also look at the growth rate of certain capital
flows, like venture capital and capital spending, to find any trends that might indicate future investment opportunities
or risks.
3.2.2 Capital Flight

Capitalflight, in economics, occurs when assets ormoney rapidly flow out of a country, due to an event of
economic consequence. Such events could be an increase in taxes oncapitalorcapitalholdersorthe government of
the country defaulting on its debt that disturbs investors and causes them to lower their

Srinivas University IV Semester MBA valuation of the assets in that country, or otherwise to lose confidence
in its economic strength. This leads to a disappearance of wealth, and is usually accompanied by a sharp drop in the
exchange rate of the affected country - depreciation in a variable exchange rate regime, or a forced devaluation in a
fixed exchange rate regime. This fall is particularly damaging when the capital belongs to the people of the affected
country, because not only are the citizens now burdened by the loss in the economy and devaluation of their
currency, but probably also, their assets have lost much of their nominal value. This leads to dramatic decreases in
the purchasing power of the country‘s assets and makes it increasingly expensive to import goods and acquire and
form of foreign facilities i.e. medical facilities.
3.3 International Liquidity

Please refer to Chapter 2
3.4 Balance of Payments: Meaning & Structure

The Balance of Payments (BOP) of a country is a systematic record of all its economic transactions with the
outside world in a given year. It is merely a way of listing receipts and payments in international transaction for a
country. The Balance of payments accounts of a country are constructed on the principle of double-entry book-
keeping. Each transaction is enteredon the credit anddebitsideofthe balance sheet. Payment is received from a
foreign country is credit transaction and payment to a foreign country is a debit transaction. The collection of all
exports, imports and financial transactionsin a BOP account are grouped into three main categories.
• Current Account: Import and export of goods and services and unilateral transfer of goods and servicesincluding
transfer of money forfamily living expenses.
• Capital Account: Transactions related to changes in foreign assets and liabilities. This includes short-term and
long-term borrowings, private and government investments and international capitalflows.
• Reserves Account: It also relates to international assets and liabilities for such transactions which the country‘s
monetary authorities uses to settle the deficits and surpluses that arise on the other two categories of accounts.
The structure of BOP account is provided here-under using the BOP of India. India‘s Balance
of Payments: Aril - September, 2014 (INR billion)
Item Credi Debit Net
t
A. CURRENT ACCOUNT
I. MERCHANDISE 10,054 14,463 -4,40

9
II. INVISIBLES (a+b+c) 7,003 3,67 3,32

4 8
a) Services 4,571 2,399 2,17

2
i) Travel 556 479 76
ii) Transportation 541 484 57
iii) Insurance 69 34 35
iv) G.n.i.e. 16 30 -14
v) Miscellaneous 3,38 1,371 2,01

9 8
Of which :
Software Services 2,118 75 2,04

3

t
Business Services 851 788 64
Financial Services 177 136 41
Communication Services 57 37 20
b) Transfers 2,111 139 1,97

2

i) Official 9 32 -23
ii) Private 2,102 107 1,99

5
c) Income 320 1,136 -816
i) Investment Income 217 1,051 -833
ii) Compensation of Employees 103 86 17
Total Current Account (I+II) 17,056 18,137 -1,08

1
B. CAPITAL ACCOUNT
1. Foreign Investment (a+b) 9,413 7,104 2,31

0
a) Foreign Direct Investment (i+ii) 1,443 469 974
i. In India 1,254 245 1,00

9
Equity 898 238 660
Reinvested Earnings 250 0 250
Other Capital 106 7 99
ii. Abroad 189 224 -35
Equity 189 98 91
Reinvested Earnings 0 35 -35
Other Capital 0 91 -91
b) Portfolio Investment 7,971 6,63 1,33

5 6
In India 7,953 6,61 1,34

0 4
FIIs 7,953 6,61 1,34

0 4
of which:
Equity 5,625 5,229 396
Debt 2,328 1,381 947
ADRs/GDRs 0 0 0
Abroad 17 25 -8
2. Loans (a+b+c) 4,022 3,77 247
5
a) External Assistance 156 119 37
i) By India 2 16 -14
ii) To India 154 104 51
b) Commercial Borrowings(MT&LT) 1,065 858 206
i) By India 49 11 38
ii) To India 1,016 847 169
c) Short Term To India 2,801 2,797 4
i) Buyers‘ credit & Suppliers‘ Credit >180 days 2,721 2,797 -76
ii) Suppliers‘ credit up to 180 days 80 0 80
3. Banking Capital (a+b) 2,614 2,646 -33
a) Commercial Banks 2,600 2,646 -47
i) Assets 621 681 -60
ii) Liabilities 1,979 1,965 13
of which: Non-Resident Deposits 1,921 1,531 390

t
b) Others 14 0 14
4. Rupee Debt Service 0 3 -3
5. Other Capital 752 953 -201
Total Capital Account (1 to 5) 16,801 14,481 2,32

0
C. Errors & Omissions 0 152 -152
D. Overall Balance (A+B+C) 33,85 32,77 1,08

7 1 6
E. Monetary Movements (i+ii) 0 1,086 -1,08

6

i) I.M.F. 0 0 0
ii) Foreign Exchange Reserves 0 1,086 -1,08
6
( Increase - / Decrease +)
In accounting sense balance of payments always balances since all international transactions are recorded as per
double entry book-keeping methods. However,various subsets of BOP account can have deficit and/or surplus which
have economic interpre- tations. Tosay that theBOPalways balancesisto interpret that a net credit balance in one
of these accounts must have a counterpart net debit balance in one of the other accounts or in a combination of the
two other accounts.
3.4.1 Basic Principles

While recording the international financial flows in the balance of payments, a couple of norms need to be followed.
One isthatthe structureofthebalanceofpaymentsisbased just on the principles ofthe double entry book-keeping.
Itmeansthat all the inflows of funds are put on the credit side and all the outflows of funds are debited; and
ultimately, the two sides are balanced.
The second norm isthatsince the differentforms ofthe financial flows vary in nature, they are to be entered
accordingly in the two compartments of the balance of payments. Itmay bementioned that the balance of payments
statement is divided into two compartments. One is known as the current account followed by the other known as the
capital account. Those transactions that represent earning or spending are recorded in the current account. For
example, when a country earns foreign exchange through
export, the amount is entered in the current account. On the other hand, if the financial flow does not represent
earning, it is entered in the capital account. For example, foreign direct investment or foreign portfolio investment is
entered in the capital account. Thus, it is on this basis that the different types of financial flows are recorded in the
current and the capital accounts.
3.4.2 Components of BOP/Prescribed Format for Recording transactions 3.4.2.1 Current
Account
As per the prescribed format adopted by the Reserve Bank of India in the current account, first, merchandise
trade is entered.Exportreceipts are enteredonthe creditside and the imports are entered on the debit side. And then,
the balance is found out. The difference between the export and the import is known asthe balance oftrade. Excess
of export overimportis known asthe surplus balanceoftrade and, onthe contrary,the excess of import over export is
known asthe deficit balance of trade.
The second item to be entered in the current account is nothing but invisibles. Invis- ibles, as mentioned earlier,
include primarily: Trade in services, Investment income and Unilateral transfers. There are both inflows and outflows
on account of invisibles. The inflows are entered on the credit side and the outflows are entered on the debit side.
However, a common practice is that only the net amount is written in the current account. After enteringthe
invisibles,balancingisdone forthewholeofthe current account. This balance is known as the balance of current
account. The debit side being bigger than the credit side shows a deficit balance of current account. On the
contrary, the excess of credit side over the debit side for the whole of the current account shows a surplus balance
of current account.
3.4.2.2 Capital Account

In the capital account, foreign investment -both direct and portfolio - is entered, Some- times, a part of the
investment is taken back by the investors which is known as disinvestment; The usual practice is thatthe
disinvestment are notshown,ratherthe foreign investment, net of disinvestment, is shown in the capital account.
Similarly, external assistance and external commercial borrowing are also shown net
repayment. Here the readersmust be aware ofthe fact the repayment issubjectmatter of capital account whereas the
interest payment showing a sort of earning is a part of invisibles. Again, the banking capital is inclusive of both
short-term and long-term funds. Short-term credits are purely short-term funds. Finally, the two sides of long-
termand short-termfunds are balanced that is known as balance of capital account.
3.4.2.3 Statistical Discrepancy

After recording different forms of international financial flows in the balance of payments, the statistical
discrepancy, often known as errors and omissions, is also recorded. The statistical discrepancy arises on different
accounts. Firstly, it arises because of difficulties involved in collecting balance of payments data. There are
differentsources of data that sometimes differ in their approach. In India, the trade figures differ between those
compiled by the Reserve Bank of India and those compiled by the Director- General of Commercial Intelligence
and Statistics. Secondly, the movement of funds mayleadorlagthe transactionsthatthey(funds)are
supposedtofinance.For example, goods are shipped inMarch, but the payments are received inApril. Iffigures are
compiled on the 31st March, the figures may differ if the shipment is the basis of collecting data from those which
are based on the actual payment. Such differences lead to the emergence ofstatistical discrepancy. Thirdly, certain
figures are derived on the basis of estimates. For example, figures for earning on travel and tourism account are
estimated on the basis of sample cases. If the sample is defective, there is every possibility for the emergence of
errors and omissions. Fourthly, errors and omissions are explained by unrecorded illegal transactions that may be
either on debit side or on creditside or on both sides. Only the net amount is written on the balance of payments.
3.4.2.4 The Overall Balance

After the statistical discrepancy is located, the overall balance is arrived at. The overall balance represents the
balancing between the credit items and the debit items appearing on the current account, capital account and the
statistical discrepancy.
3.4.2.5 Official Reserves Account

If the overall balance is surplus, the surplus amount is transferred to the official reserves account that increases the
foreign exchange reserves held by the monetary authorities. They comprise of monetary gold, SDR allocations by
the IMF and the foreign currency assets. The foreign currency assets are normally held in the form of deposits
with foreign central banks and investment in foreign governmentsecurities.
It there is deficit, an amount equivalent to the deficit is drawn from the official reserves account bringing the
balance of payments into equilibrium. Again, if the amount of foreign exchange reserves is not sufficient to meet the
deficit, the government ap- proachesthe International Monetary Fund for thebalanceofpaymentssupport.
3.5 BOP Equilibrium, Disequilibrium and Adjustment

3.5.1 Accounting and Economic Equilibrium
Since the balance of paymentsis constructed on the basis of double-entry book keeping, credit is always equal to
debit. If debit on current account is greaterthan the creditside, funds flow into the country that are recorded on the
credit side of the capital account. The excess of debit is wiped out. It meansthat the balance of paymentsis
alwaysin accounting equilibrium. The accounting balance is an ex post concept. It describes what has actually
happened over a specific past period. There may be accounting disequilibrium for a short period when the two
sides of the autonomous flows differ in size. But in such cases, accommodating flows bring the balance of
payments back to equilibrium. To make the distinction between the autonomousflow and accommodating flow
more clear, it can be said that foreign investment, external assistance and commercial borrowings are autonomous
capital flow because they flows in normal course of business. But when the country borrows from the International
Monetary Fund to meet the overall deficit,such borrowings represent accommodating capitalflow.
However, in real life, economic equilibrium is not found because the two sides of the current account are seldom
equal. Rather it is the economic disequilibrium in the balance of payments that is a normal phenomenon.

3.5.2 Process of Adjustment
The focus of adjustment lies primary on the trade account, although the size of adjusting deficit is sometimes
reduced by the net inflow on the invisibles account. There are different views on adjustment that need a brief
discussion here.
3.5.2.1 The Classical Approach

The classical economists were of the view that the balance of payments was self adjusting due to the price-specie-
flow mechanism. The mechanism stated that an increase in money supply raises domestic prices. Exports become
uncompetitive. Export earnings drop. Foreign goods become cheaper. Imports rise. Current account balance
goes deficit in the sequel. Precious metal flows outside the country in order to finance imports. As a
result,quantityofmoneylessensthatlowerstheprice level.Lowerprices in the economyleadtogreater
export.Tradebalance reachesbacktoequilibrium.
3.5.2.2 Elasticity Approach

The adjustment in the balance of payments disequilibrium is thought of in terms of changes in the fixed exchange
rate, that is through devaluation or upward revaluation. But itssuccessis dependent upon the elasticity of demand for
export and import. Mar- shall (1924) and Lerner (1944) explained this phenomenon through the "elasticity" ap-
proach.
The elasticity approach is based on partial equilibrium analysis where everything is held constant except for the
effects of exchange rate changes on export or import. It is also assumed that elasticity of supply of output is infinite
so that the price of export in home currency does not rise as demand increases, nor the price of import falls with a
squeeze in demand for imports. Again, the approach ignoresthemonetary effects of variation in exchange rates.
If the elasticity of demand is greater than unity, the import bill will contract and export earnings will increase as a
sequel to devaluation. Trade deficitwill be removed. However, the problem isthat the trade partner may also
devalue its own currency as a retaliatorymeasure. Moreover, theremay be a long lapse of time before the quantities
adjustsufficiently to changesin price. Till then, trade balance will be even worse than that before devaluation.
Stem(1973)incorporated the concept ofsupply elasticity in the elasticity approach. Based on the figures of British
exports and imports, Stem has come to a conclusion that the balance of trade should improveif:
1. Elasticity of demand for exports and importsis high and is equal to one coupled withelasticity
ofsupplybothforimports andexportswhichiseitherhighorlow.
2. Elasticityofdemandforimportsandexportsislowbuttheelasticityofsupplyfor imports and exports islower.
On the contrary, if the elasticity of demand is low matched with high elasticity of supply, the balance of trade
shouldworsen.
3.5.2.3 The Keynesian Approach

The Keynesian view takes into consideration primarily the income effect that was ignored under the elasticity
approach. There are various versions of the Keynesian approach. One is the absorption approach that explains the
relationship between domestic output and trade balance and conceives of adjustment. Sidney A. Alexander (1959)
treats balance of trade as a residual given by the difference between what the economyproduces and what it
takesfor domestic use or what it absorbs. He begins with the contention that the total output, Y is equal to the sum
of consumption, C, investment, I,
governmentspending, G, and net export(X-M).In form of an equation,
Y = C + I + G + (X − M)
Substituting C + I + G by absorption, A, it can be rewritten as:
Y=A+X−M
or
Y−A=X−M
Thismeansthat the amount, by which total output exceedstotalspending or ab sorption isrepresented by export
over import or the net export which means a surplus balance of trade. This alsomeansthat if A is greaterthan
Y,deficit balance oftrade will occur. This is because excess absorption in absence of desired output will cause
imports. Thus in order to bring equilibrium in the balance of trade, the government has to increase output or
income. Increase in income without correspondingandequal increase in absorption will lead to improvement in
balance of trade. In case of full employment, where resources are fully employed, output cannot be expanded.
Balance of trade deficit can be remedied through decreasing absorption without equal fall in output. It may be noted
that validity of absorption approach depends upon the operation of the multiplier effect that is essential for
accelerating output gen- eration,It also depends on themarginal propensity to absorbthatdetermines therateof
absorption.
J. Black (1959) explains the absorption in a slightly different way. He ignores the governmental expenditure, G
and equates X - M with S - I (where S is saving and I is investment). He is of the opinion that when balance of
trade is negative, the country has to increase saving on the one hand and to reduce investment, on the other. In case
offull employment, he suggestsforredistribution of national incomeinfavourofprofit earners who possess greater
propensity to save.
Again, Mundell (1968) incorporates also interest rate and capital account in the ambit of discussion. In his view, it
is not only the government spending but also the interestrate that does have an influence on income as well on the
balance of payments. While larger government spending increases income, an increase in income leads to rise in
import. With a positive marginal propensity to import, any rise in income as a sequel to increase in government
spending will lead to greater imports and worsen thecurrent account. However, changes in interest rate influence
both the capital account and the current account.
A higher interest rate will lead to improvement in current account through lowering ofincome. At the same time, a
higher interest rate will improve the capital account through attracting the flow of foreign investment.
Yet again, the New Cambridge School approach takesinto accountsavings(S) and investment (I), taxes (T) and
government spending (G) and their impact on the trade account. In form of equation, it can be written as:
S+T+M=G+X+I
or
(S − I) + (T − G) + (M − X ) = 0
or
(X − M) = (S − I) + (T − G)
The theory assumes that (S - I) and (T - G) are determined independently of each other and of the trade gap. (S - I)
is normally fixed as the private sector has a fixed net level of saving. And so the balance of payments deficit or
surplus is dependent upon (T - G) and the constant (S - I). In other words, with constant (S - I), it is only the
manipulation of (T - G) which is a necessary and sufficient tool for balanceofpayments adjustment.
3.5.2.4 Monetary Approach

The monetarists believe that the balance of payments disequilibrium is a monetary phenomenon and not structural
(Connolly, 1978). The adjustment is automatic unless the government is intentionally following an inflationary
policy for quite a long period. Ad- justment is brought about through making changesinmonetary variables.
Theprocessofadjustmentvariesamongthetypesofexchangerateregimethecoun- try has opted for. In a fixed exchange
rate regime or in gold standard, if the demand for money, that is the amount of money people wish to hold is
greater than the supply of money, the excess demand would be met through the inflowofmoney fromabroad.On the
contrary, with the supply of money being in excess of the demand for it, the excess supply is eliminated through the
outflow of money to other countries. The inflow and the outflow influence the balance of payments. To explain it
further, with constant prices and income and

thus constant demand for money, any increase in domestic credit will lead to outflow of foreign exchange as the
people will import more to lower the excessive cash balances. In the sequel, the balance of payments will turn
deficit. Conversely a decrease in domestic credit would lead to an excess demand formoney.International reserves
will flow in to meet the excess demand. Balance of payments will improve.
However,in a floating-rate regime,the demand formoney is adjusted to the supply ofmoney via changes in exchange
rate. Especially in a situation when the central bank makes no market intervention, the international reserves
component of the monetary base remains unchanged. The balance of payments remains in equilibrium with neither
surplus nor deficit. The spot exchange rate is determined by the quantity of money supplied and the quantity of
money demanded.
When the central bank increases domestic credit through open market operations, supply of money is greater than
the demand for it. The households increase their imports. With increased demand for imports, the domestic
currency will depreciate and it will continue depreciating until supply of money equalsthe demand formoney. Con-
versely, with decrease in domestic credit, the households reduce their import. Domestic currency will appreciate and
it will continue appreciating until supply of money equals demand for money.
In case of managed floating, the central bank often intervenes to peg the rates at some desired level. And so this
case is a mix of fixed and floating rate regimes. Itmeans that changes in the monetary supply and demand do
influence the exchange rate but also the quantum of international reserves. 3.6 Significance of BOP to
Multinational Corporation
Balance of payments data of home country and host country are have significance to government officials,
international businessmanagers, investors, and consumers, because such data influence and are influenced by
other key macroeconomic variables such as gross domestic product (GDP), employment, price levels, exchange
rate, and interestrates. Therefore balance of paymentsmay be used as an indicator of economic and political
stability. For example, if a country has a consistently positive BOP, this couldmeanthatthere
issignificantforeigninvestmentwithinthat country.Itmayalso mean that the country does not export much of its
currency.
The Balance of payment of Manual published by the International Monetary Fund (IMF), i.e., IMF is the primary
source of BOP and similar statistics data worldwide. It prepares balance of payments manual and publishesthe
same in a Balance of Payments Year Book. Monetary and fiscal policy must take the BOP into account at the
national level. Multinational businesses use various BOP measures to gauge the growth and health of specific types
of trade or financial transactions by country and regions of the world against the home country Businesses need
BOP data to anticipate changes in host country‘s economic policies driven by BOP events. BOP data may be
important for the following reasons:
1. BOP indicates a countries financial position vis-à-vis foreign countries, thereby a country‘s ability to buy
foreign goods or services.
2. BOP is important indicator of pressure on a country‘s exchange rate, and thus on the potential of a firm trading
with or investing in that country to experience foreign exchange gains or losses. ChangesinBOP may presage the
impositions of foreign exchange controls.
3. BOP data helps in knowing the changes in a country‘s BOP may also signal im- position (or removal) of
controls over payments, dividends, and interest, license fees, royalty fees, or other cash
disbursementstoforeignfirmsorinvestors.
4. BOP data helpsto forecast a country‘s market potential, especially in the shortrun. Acountry experiencing a
serious BOP deficit is not likely to import as much as it would if it were running a surplus.
5. BOPdata can also signalincreased riskiness oflending to particular country and it also helps to in the
formulation of trade and fiscal policies.
3.7 Trends in Indian Balance of Payments
Balance of Payments (BOP) of a country shows its economic strengths and weaknesses. Most of the

developing countries are deficit in their Balance of Accounts, India being no exception. Since independence,India
has been facing this deficit or disequilibriumintermsofBOP,largelyobservedasa
disasterin1990-91,theyearofthesevereBOP crisis.Atthattime,Indiahadforeignexchangereserveof meager1 billion
dollar,hardly sufficient to finance a month‘s import bill. The nation was on the edge of defaulting. This crisis
resulted in large scale amendments in the country‘s economic policy, par ticularlyknown
astheStructuralAdjustmentProgramorNewEconomicPolicy (NEP) regime, center of attention being liberalization
and globalization ofthe economy.
We opted for a very vigilant approach and at present after having surmounted the initial glitches of a newly
liberalized economy, we have a somewhat comfortable BOP condition. Even though we have arrived at a
comfortable BOP position showing signs of a strong rising economy, BOP management still remains a tough walk for
policy makers for taking any discussion, as now we are uncovered to each and every change in the global
economic set-up.
3.7.1 Trends & problems of India’s BOP - 1949-50 to 1999-2000 3.7.1.1

Protectionist Policies
The main intention of the Second Five Year Plan (1956-57 to 1960-61) wasto achieve self reliance through
industrialization. Selfreliancewasto be realized through import substitution. Forthis, essential industries had to be
established which required import of capital goods. Exports were anticipated to take-off by own with advent of
industrialization. It was felt that with advent of industrialization, there will be an increase in production at home
that will be reflected in greater export earnings." The approach for importsubstitution was based on physical-
interventionist, non-price policieslike quotas, licensing and other physical ceilings on imports. Heavy capital
goods were imported however other
imports were relentlessly restricted to shut off competition for promoting domestic industries. Mainly focus was on
import substitution, with gross disregard of exports. These inward looking protectionist policies did resulted in
some self-reliance in the consumergoodsindustries, butmost ofthe capital goods industries remained majorly
import intensive.
The elevated degree of protection to Indian industries resulted in to inefficiency and poorquality products basically
due to lack of competition. The high cost of production further wrinkled our competitive strength. Rise in petroleum
products demand, harvest failure, two oil shocks, all put acute strain on the economy. The BOP condition remained
weak for the period of 1980s, till it arrived at the crisis situation in 1990-91; When Indiawas on the brink of
defaultingmainly due to intense debt burden and continually widening trade deficit.
3.7.1.2 External Debt

India had been an exercising choice to large scale foreign borrowings for its develop- mental activities in the field
of fundamental social and industrial infrastructure. The country‘s reserves were very much restricted due to low
level of per capita income and savings. The situation aggravated because Government ofIndia resorted to large
amounts of foreign borrowingsto rectify the BOP situation in the short run out of frightening condition. With
Seventh Five Year Plan, the debt service obligations increased sharply due to stiffer average provisions of external
debt, including repayments to the IMF, commercial borrowing, and a drop in concessional aid flow.Even though
by the Sixth Five Year Plan we had overcome the need of food grain imports and some crude oil was also produced
domestically, BOP position was still not at ease attributed to low exports. The essential need for promoting export
was realized during the 1960s. The Third Five Year Plan commenced certain
promotion policies pertaining to export like tax exemptions, duty drawbacks, cash compensatory schemes, Rupee
devaluation etc. However it didn‘t showed significant improvements in exports. Indian exports depended largely on
situation of world trade.
We were chiefly primary product exporters, for which fluctuations in prices are very high in entire world market
demand. Primary products exporting countries generally have unfavourable term of trade. The
incomesfromprimary product exportswere unstable and low. Secondly, the Indian products were not up to the mark
in terms of quality and standard to sustain in world market. Third, mainly residue products were

exported. The fact that export earnings contribute significantly to economic development was dis regarded.
Cumbersome procedures, rules and regulations for license etc served as dis- incentives for exporters. Domestic
inflation further diminished the competitiveness of India‘s export.
3.7.1.3 Exchange Rate

The fluctuation in the exchange value of the rupee was another posing problem. The steady devaluations (to
promote exports) enhanced the amount of external debt. The value of rupee was administered by the central bank
(fixed exchange rate). The considerable gap between official and market exchange rate generated difficulties for
the exporters and importers. The stringent foreign exchange controls also persuaded Hawala trade.
3.7.2 Trends in India’s BOP (2000-2010)

The benefits of foreign trade were overlooked year after year. Indian entrepreneurs were withdrawing with
low-priced, outdated technology and demolishing subsidies, generating a heavy national burden of large ailing
public sector undertakings. Despite acting through an incentive based approach, government protection in fact
damaged our industrial growth.
The New Economic Policy of the nineties targeted for opening up of the economy, to permit free trade and
competition and condense the role of government considerably in foreign trade issues. Restrictions on
international trade were detached, foreign investments were allowed and a completely new Liberalized Exchange
Management Systemwasbroughtintogarnerthebenefitsofcompetitionand offsetthedrawbacksof a closed, inward
looking trade policy.
The alterations towards liberalization and globalization of the Indian economy were conceded out very vigilantly
inphases.
3.7.3 Foreign Investment

Indiaeffectivelyattractedforeigninvestorstothecountrywithitsearnestpositive economic transforms like reduced
cumbersome formalities and other paperwork. From a scanty US$103 million A net foreign investment in the
year 1990-91, it has grown to us$ 8669 million A in 2008-09. Foreign investments kept the country buoyant
during the recent global meltdown period. Because the consequences of recession were worst in the developed
countries, the investors turned to the less affected rising economies like China and India. While initially foreign
investment in the country did slow down significantly due to risk repugnance in the phase ofthe recession, but it
picked up over again because rising economies like India and China were quick to execute corrective procedures to
fight recession, showing creditable elasticity to the recession which badly affected the much developed economies.
There was massive turn down in net capital flows from US $ 106.6 billion in 2007-2008 (8% of GDP) to US $
7.2 billion (0.6 % of GDP) IN 2008-09. The turn down was mainly due to net outflows under portfolio investment.
Despite this, the FDI inflow remained floating at US $ 21.0 billion during Apr- Sept. 2009 as against US $ 20.7
billion in Apr.-Sept. 2008. FDIinflow has been primarilyincommunication services,manufacturing, and real
estate sector.
3.7.4 Current Account of BOP

The current account of BOP consists of the merchandise trade (export and import) and the invisibles (services,
transfers etc.). The liberalized policy and reasonably hassle free formalities for export and imports have provided a
push to our export industries as well as industries catering to domestic demands. Exports and imports both witnessed
double digit growth rate. India is now a principally manufactured goods and services exporter deriving benefits from a
better term of trade, as compared to what it was earlier, primary goods exporter, prior to 1991. The contribution of
India‘s exports in world trade has
increased from0.7%in2000 to 1.2%in 2008. Servicestoo haveextended tovarious fields catering to both
domestic and international consumers.
The current account balance broadened in 2008-09 (-2.4 % of GDP) compared to that of 2007-08 (- 1.3% of
GDP) attributed to recession, but it wassustainable. The external demand shock resulted in
Srinivas University IV Semester MBA to the decline of export growth from 57 % in April- June‘08 to (-)
8.4 % in Oct- Dec‘08 and further to (-) 20 % in January-March‘09, a decline for the first time since 2001-02.
Importstoo turn downed similarly due to domestic industrial demand and sharp fall in international crude oil and
some other primary commodity prices. India‘s net invisibles rose by 18.7% in 2008-09. With the economy
(domestic as well as global) getting its pace of momentum once again, there is hope of glare once again in the trade
and financial world. India having cruisedreasonablysuccessfulthrough theunevenscrapofrecessioncanlookfurtherto
garnering greater profit from world market, at least till the time the developed economies which were poorly affected
by recession, revitalize fully. In short, the situation of BOP is quite well administered and contented. However,
lessons from the occurrences of the financial crises taking place in various parts of the world from time to time,
we are required to continue our vigilant approach towards BOP management. The country cannot meet the expense
of a setback to its economic growth attained through large scale changes in national economic policies. India
indeed has arrived a long way from the time of the days of the protectionist policies, but there is a lot to be
accomplished yet, particularly in the sector of infrastructure, in order to become a strong economy.
3.8 Fundamentals of Balance of Payments Accounting
Recording of international economic transaction is made on the basis of double entry principle in which every
transaction involves two entries-one credit (+) and one debit (-) and leaving aside errors and omissions; the total of
credits must exactly tally with the total of debits. In other words, the balance of payment always balances. Table
below summarizes the account used in balance of payments accounting. According to the fundamental principle
of double entry system, all transactionsresulting in immediate or prospective payment from the rest of the world
to the country are recorded as credit entries. Conversely, all transactionsresulting in an actual or perspective
paymentfromthe country to the rest of the world are shown as debits.All transactions resulting in an increase in
demand for foreign exchange are to be recorded as a debit entry,whereas a reduction in foreign assets or an
increase in foreign liabilities are shown as credit in BOP statement. Capital outflow such as when a resident purchase
foreign securities or parts off a foreign bank loan isrecorded on the debitside of the statement and credit entry is
made when a capital inflow in terms of disbursement of a World Barf loan takes place. Lets us take few examples:
Debits (-) Credits (-)
Import of goods Export of goods
Purchase of services from Sale of services to foreigners

foreigners
Payment of interest, dividends, Receipt of interests, dividends,

rents and royalties to foreigners rents and royalties from foreigners
Gifts to foreigners Gifts from foreigners
Direct Investments by Direct Investment by

residents in foreign countries foreigners in home country
Portfolioinvestmentbyresident Portfolio Investment by

sin foreign country foreigners in home country
Long-term claims on foreigners Long-term claims from foreigners
Decrease in long-term Increaseinlong-termliabilities

liabilities to foreigners to foreigners
Short-term claims to foreigners Short-term claims from foreigners
Decrease in short-term liabilities Increase in short-term liabilities
Increase in official reserves of gold Decrease in official reserves

of gold
Increase in official reserves of Decrease in official reserves

foreign exchange of foreign exchange

Example 1: A resident of country X exports goods to a resident of country Y. He signs a bill of exchange,
denominated in country Y‘s currency, with a maturity period of 90 days. In country X‘s BOP, an export has
occurred and a short-term claim on a foreigner has been acquired. The debit&
creditpositionofthetransactionwillbe:
Dr- Short-term claims on foreigners(The bill of exchange) Cr - Export of goods Example 2: The exporter in
Example 3.1 holds the bill to maturity when receives payment in country currency. The exporter now has claim (the
payment in Y‘s currency) on a bank in country Y.Effectively, the debit and credit are, therefore, in the same
account:
Dr - Short-term claims on foreigners (the amount in Y‘s currency) Cr - Short-term claims on foreigners(the bill
of exchange)
Example 3: A US resident on holiday in country X changes dollar travelers‘ cheques for country X‘s currency at an
airport bank. All this isspent on vacation. This will be recorded in BOP as: Dr- Short-termclaims on foreigners(the
holding of USdollars). Cr - Travel services to foreigners. Example 4: Country A gifts medical supplies, blankets
and so on, worth 500 crore to country B. This is shown as:
Dr - Unrequited transfers Cr-Merchandiseexports
Example 5: A resident of country Y sends a cheque to a relative in Japan. In country Y‘s balance of payment, this
transaction will be shown as:
Dr - Gifts to foreigners
Cr - Short-term liabilities to foreigners (the cheque)
Itmay be noted that current account and capital accountmovements are called autonomous‘ in balance of
payments parlance. Official reserves movements are desig- nated as ‘compensating‘ or ‘line‘, respectively. While
‘above the line‘ term connotes autonomous accounts, balance of which shows whether the balance of payments is
in surplus or deficit, accounts ‘below the line‘ are compensating accountsshowing how the balance of payments
surplus or deficit was funded.
When autonomous receipts exceed autonomous payments, the balance of payments is said to be in surplus, signifying
international purchasing power of the country accompanied by an increase in foreign reserves or decrease in
official liabilities in compensating accounts. Conversely, the balance of payments will be deficit if autonomous
receiptsfallshort of autonomous payments and the resultant decrease in international purchasing power of the
country and decrease in foreign reserves or an increase in liabilities to foreigners. Surplus in balance of payments
puts an upward pressure on the external value of the home currency. In contrast, balance of payments deficit puts a
down purchase on the external value of the home currency.
The BOP must always balance. However, each of the various accounts need not balance. Thus, there are
disequilibriums (deficits/surplus) in current account and capital account but the entire BOP of a country is always
balanced. Surpluses/deficits in different BOP account are distinguished because of their own significance. The trade
deficit (excess of merchandise imports over merchandise exports) is the one on which the country enjoys good
control, and hence it is most trans- parent. The GNP net export comprising both merchandise as well asinvisibles,
exports and imports, affects GNP and reveals the gap between domestic investment and saving, and hence its
significance in financing the country‘s
investment through foreignsaving. The current accountdeficitindicatesthe change inindebtednessofthe nation to the
rest ofthe world and hence, the international bankerslook at this while considering loansto such countries. As
opposed to this, the capital account surplus shows the extent to which the country is using its assetsto meet its current
expenditures over and. above its current earnings and hence index of the long-termprosperity ofthe country. The
changes in official reserves tell the decrease or increase in the liquidity position of the nation, signifying short-run
ability of the nation to meet various disequilibriumsin international transactions.
3.9 Role of IMF in BOP Crisis

Balance of payments difficulties can arise - and, in theworst case, build into crises- even in the face of strong
prevention efforts. Economic and financial crises can take many forms. The IMF assists
countries hit by crises by providing them financial support to create breathing room as they implement corrective
policies to restore economic stability and growth. As crisis prevention is more effective than crisis resolution, the
Fund also provides precautionary financing to help prevent and insure against crises. The IMF‘s lending
instruments have evolved in recent years to meet countries‘ changing needs.
3.9.1 Why do balance of payments problems occur?

Thecausesofcrisesarevariedandcomplex, andcanbedomestic aswell as external. 1. Domestic factors include
inappropriate fiscal and monetary policies, which can lead to large economic imbalances(such as current account
and fiscal deficits and high levels of external and public debt); an exchange rate fixed at an inappropriate level,
which can erode competitiveness and lead to persistent current account deficits and loss of official reserves; and a
weak financial system, which can create economic booms and busts.
2. External factors include shocks ranging from natural disasters to large swings in commodity prices. These are
common causes of crises especially for low- income countries, which have limited capacity to prepare for such
shocks and are dependent on a narrow range of export products. Also, in an increasingly globalized economy, even
countries with sound fundamentals could be severely affected by spillovers of economic crises and policiesin other
countries.
Whether the cause is domestic or external in origin, crises can take many different forms: balance of payment
problems occur when a nation is unable to pay for essential imports or service its debt repayments; financial
crisesstem from insolvent or illiquid financial institutions; and fiscal crises are caused by excessive fiscal deficits
and debt. Often, countriesthat come to the IMF face more than one type of crisis as challengesin one sector
spread throughout the economy. Crises generally result in higher unemployment, lower incomes and greater
uncertainty which cause a deep recession. In acute crisis cases,defaults orrestructuring ofsovereign debtmay
become unavoidable.
3.9.2 How IMF lending helps

IMF lending aims to give countries breathing room to implement adjustment policies in an orderly manner, which
willrestore conditionsfor a stable economy and sustainable growth. These policies will vary depending upon the
country‘s circumstances. For instance, a country facing a sudden drop in the prices of key exports may need
financial assistance while implementing measures to strengthen the economy and widen its export base. A country
suffering from severe capital outflows may need to address the problems that led to the loss of investor confidence—
perhaps interest rates are too low; the budget
deficitanddebtstockaregrowingtoofast;orthebankingsystemisinefficientorpoorly regulated. In the absence of IMF
financing, the adjustment process for the country would be more abrupt and difficult. For example, if investors are
unwilling to provide new financing, the country would have no choice but to adjust—often through a painful
compres- sion of government spending, imports and economicactivity.IMFfinancingfacilitates a more gradual and
carefully considered adjustment. To support members with sound policies against external shocks and help boost
market confidence during periods of heightened risks, the IMF recently introduced the Flexible Credit Line (FCL)
and the Precautionary and Liquidity Line (PLL), which are aimed mainly at crisis prevention but can also be used for
crisis resolution. Other new instruments, such as the Rapid Financing Instrument (RFI), and the corresponding
Rapid Credit Facility (RCF) for low-income countries, were created to provide rapid assistance to countries with
urgent balance of payments need, including from commodity price shocks, natural disasters, and domestic
fragilities.
3.9.3 IMF lending in action

The IMF providesfinancialsupport upon request by its member countries. Following such a request, an IMF staff
team holds discussions with the government to assess the economic and financial situation and agree on the
appropriate policy response. IMF staff and the government also assess the size of the country‘s overall financing
needs and the appropriate role of IMF resourcesin the crisisresponse.
Typically, a country‘s government and the IMF must agree on a program of economic policies before the IMF
provides lending to the country. A country‘s commit- ments to undertake certain policy actions, known as policy
conditionality, are in most cases an integral part of IMF lending. Progress is typically reviewed by monitoring the
implementation of these policy actions. However, in the case of FCL and PLL arrangements, countries can use
IMF resources with no or limited conditionality as they have already established their commitment to sound
policies. In general, a country‘sreturn to economic and financial health ensures that IMF funds are repaid so that
they can be made available to other membercountries.
Once an understanding has been reached on policies and a financing package, a recommendation is made to the
IMF‘s Executive Board to endorse the country‘s policy intentions and extend accessto IMF
resources.Thisprocesscanbeexpeditedunderthe IMF‘s emergency financing procedures.
3.9.4 Rapid IMF Lending During Past Crises
The Fund has emergency proceduresin place to help provide financing atshort notice. The Emergency Financing
Mechanism was used in 1997 during the Asian crisis; in 2001 for Turkey; in 2008-09 for Armenia, Georgia,
Hungary, Iceland, Latvia, Pakistan, and Ukraine; and in 2010-13 for Greece, Ireland, Portugal and Cyprus.
When can it be used? When a member country faces an exceptional situation that threatens its financial stability
and a rapid response is needed to contain the damage to the country or the international monetary system.
How does it work? (i) The Executive Board is informed about a member‘s request forassistance;(ii) a staffteamis
quickly deployed to the country; and (iii) assoon as staff reaches an understanding with the government, the Board
considers the requestto support a program within 48-72hours.
3.10 External Debt and Equity Financing

The twentieth century has seen massive cross-border flows of capital. However, till the 80‘s, it was
pre¬dominantly debt capital in the form of bank loans and bond issues. The international new issues equity market
with globally syndicated offerings emerged during the eighties and grew rapidly till the stock market crash of
October 1987. While some emerging stock markets remained bullish despite the crash, institu¬tional investors
reduced their exposure to equities in general during 1988 and 1989. The trend turned upward again and after some
initial hesitation the emerging economies of East Asia and some in Latin America became the darlings of global
portfolio managers in developed economies. The years 1991-96 saw a substantial increase in the flow of equity
investment in emerging markets. The Asian currency crisis of 1997 followed by the Russian debacle in 1998 and
an "almost-crisis" in Brazil put a damper on the enthusi-
asmshownbyrichcountryinvestorstowardemergingstockmarkets formuchof1998 and early 1999. By then, some of
the Asian economies had recovered from the crisis and their domestic stockmarkets were booming driven to some
extent by the boomon US exchanges and investor euphoria over technology stocks. The long feared slowdown in the
US economy finally struck during the closing days of 2000. Prospects of a serious slowdown in the US
economy coupled with a none too bright picture in Japan and uncertainty in EMU 11, induced a bearish mood in
the stock markets around the world. During the last couple of years, the sentiment is bullish once again with emerg-
ing country capital markets scaling new heights and a significant increase in portfolio
investment by global institutional investors in emerging stock markets. The initial thrust to cross-border flows of
equity investment came from the desire on the part of institutional investorsto diversify their portfolios globally
in search of both higher return and risk reduction. Financial deregulation and elimination of exchange controls in a
number of developed countries at the beginning of eighties permitted large institutional investors to increase their
exposure to foreignequities.
3.10.1 External Debt

External debt (or foreign debt) is the total debt a country owes to foreign creditors. The debtors can be the
government, corporations or citizens of that country. The debt includes money owed to private
commercial banks, other governments, or international financial institutions such as the International Monetary
Fund (IMF) and World Bank. Note that the use of gross liability figures greatly distorts the ratio for countries
which contain major money centers such as the United Kingdom due to London‘s role as a financial capital.
Contrast net international investment position. According to the In ternational Monetary Fund, "Gross external
debt is the amount, at any given time, of disbursed and outstanding contractual liabilities of residents of a country
to nonresi- dents to repay principal, with or without interest, or to pay interest, with or without principal". In this
definition, the IMF definesthe key elements asfollows:
Outstanding and Actual Current Liabilities: Debt liabilities include arrears of both principal and interest.
Principal and Interest: When the cost of borrowing is paid periodically, as commonly occurs,itisknownas an interest
payment. All other payments of economic value by the debtor to the creditor that reduce the principal
amountoutstandingareknownasprin- cipalpayments. However,thedefinitionofexternaldebt does not distinguish
between principal payments or interest payments, or payments for both. Also, the definition does not specify that the
timing of the future payments of principal and/or interest need be known for a liability to be classified as debt.
Residence: To qualify as external debt, the debt liabilities must be owed by a resident to a nonresident. Residence
is determined by where the debtor and creditor have their centers of economic interest typically, where they are
ordinarily located—and not by their nationality.
Current and Not Contingent: Contingent liabilities are not included in the definition of external debt. These are
defined as arrangements under which one or more conditions must be fulfilled before a financial transaction takes
place.
However, from the viewpoint of understanding vulnerability, there is analytical interest in the potential impact of
contingent liabilities on an economy and on particular institutional sectors, such as the government.
Generally, external debt is classified into four heads:
(1) public and publicly guaranteed debt; (2) private non-guaranteed credits; (3) central bank deposits; and (4) loans
due to the IMF. However, the exact treatment varies from country to country. For example, while Egypt
maintainsthisfour-head classification, in India it is classified in seven heads: (a) Multilateral, (b) Bilateral, (c)
IMF loans, (d) Trade credit, (e) Commercial borrowings, (f) Non resident Indian and person of Indian origin
deposits, (g) Rupee debt, and (h) NPR debt.
Savvy individual investors, economic analysts, mutual fund managers, government officials and big institutional
investors often conduct an "external debt sustainability analysis" in an attempt to determine the suitability of a
country for investment. This analysis takes into account monetary and fiscal policies; micro- and macroeconomic
situations; and various scenarios that consider possible instabilities and adverse events. Investors of all stripes must
keep an eye on external debt, whether it appliesto their home economy or to foreign ones. Recent debt crises in
Europe – most notably in countries with high external debt such as Greece, Portugal, Ireland, Spain and Italy –
have exerted adverse ripple affects against the Eurozone and international stock markets. It is incredibly difficult, and
some say impossible, for a country to experience long- term economic growth, increased business activity and/or
foreign investment without
sustainable levels of external debt.
3.10.2 External Equity

The volume of new equity issues in the international markets increased dramatically between 1983 and 1987.
During the 1990‘s, institutional investors from developed countries increased their exposure to equity from
emerging markets though there was a setback to this trend after the Asian currency crisis. From the side of the
issuers, the driving force was the desire to tap low cost sources of financing, broaden the shareholder base,
acquire a springboard for international activities such as acquisitions and grant of ESOPsto foreign employees and
generally improve accessto long-term fund ing. From the point of view of investors the primary motive has been
diversification. The technology

boom of the 1990‘s has also attracted investors from developed markets towards technology stocks from
emerging markets.
Sincemany companies have accessed the global equitymarket primarily for estab- lishingtheirimageas global
companies, the major consideration has been visibility and post-issue considerations related to investorrelations,
liquidity ofthe stock (orinstru- ments based on the stock such as depository receipts which are listed and traded on
foreign stock exchanges)in the secondarymarket and regulatorymatters pertaining to reporting and disclosure.
Otherrelevant considerations are the price at which the issue can be placed, costs of issue and factors related to
taxation (such as withholding tax which can affect the attractiveness of the issue to investors).
As we have seen above, if the international markets were integrated, a given stock would be priced identically by
allinvestors and therewould be no advantage in choos- ing one market over another apart from cost-of-issue
considerations. However, with segmented markets, the price that can be obtained would vary from one market to
another. Countries with high saving ratessuch asJapan (and those like Switzerland with access to others‘
investible funds) would normally have low cost of equity. However, some of these markets may not be readily
accessible except to very high quality issuers. When the issue size islarge, the issuer may consider a simultaneous
offering in two or more markets. Such issues are known as Euroequities.
Issue costs are an important consideration. In addition to the underwriting fees (which may be in the 3-5% range),
there are substantial costs involved in preparing for an equity issue particularly for issuers from developing countries
who are not very well known to developed country investors. Generally speaking, issue costs tend to be lower in large
domestic markets such as the US and Japan.
Startingwaybackin1970s, anumberofEuropeanandJapanese companieshavegot themselveslisted on foreign stock

exchangessuch asNewYorkandLondon. Shares of many firms are traded indirectly in the form of depository
receipts. In this mechanism the shares issued by a firm are held by a depository,23 usually a large international bank,
which receives dividends, reports, etc. and issues claims against these shares. These claims are called depository
receipts with each receipt being a claim on a specified number ofshares. The depository receipts are denominated
in a convertible currency- usually US dollars. The depository receipts may be listed and traded on major stock
exchanges ormay trade in the OTC market. The issuer firm pays dividends in its home currency which is converted
into dollars by the depository and distributed to the holders of depository receipts. This mechanism originated in the
US - the so-called American Depository Receipts or ADRs. Recent years have seen the emergence of European
Depository Receipts (EDRs) and Global Depository Receipts (GDRs) which can be used to tap multiple markets
with a single instrument. The early Indian issuers such as Reliance preferred the GDR route since listing and
disclosure requirements are less onerous. In recent years, many Indian IT companies have preferred to use the
ADR route with listing on major US exchanges such as NASDAQ and NYSE. The main reason for this is that
their mergers and acquisition activity and foreign subsidiaries are mostly in US. Hence it was crucial for them to
get listed on US exchanges and use the dollar-denominated instruments as "currency" for acquisitions in US and
grant of ESOPs. Also, the US capital markets are the largest and most prestigious and a listing on US exchanges
gives the company a highly visible global image. The strict US standards pertaining to disclosure and reporting are
also said to improve corporate governance. Transactionsin depository receipts are settled by means of
computerized book transfers in international clearing systems such as EUROCLEAR and CEDEL.
After a hesitant start in 1992 following the experience of the first ever GDR issue by an Indian corporate, a fairly
large number of Indian companies have taken advantage of the improved market outlook to raise equity capital in
international markets. As mentioned above, the initial issues were

GDRs made in the European centers. More recent issues have been ADRs with listing on major US
exchanges.From the point of view of the issuer, GDRs and ADRs represent non-voting stock with a distinct
identity which do not figure in its books. There is no exchange risk since dividends are paid by the issuer in its
home currency. Apart from imparting global visibility, the device allows the issuer to broaden its capital base by
tapping large foreign equity markets. The risk is that the price of GDRs may drop sharply after issue due to
problemsin the local markets and damage the issuer‘sreputation which may harm future issues. From the investors‘
point of view, they achieve portfolio diversification while acquiring an instrument which is denominated in a
convertible currency and is traded on developed stock markets. Of course the investors bear exchange risk and all
the other risks borne by an equity
holder (dividend uncertainty, capital loss). There are also taxes such as withholding taxes on dividends and capital
gains taxes. For instance, the Indian government imposes a 10% withholding tax on dividends and a 65%
maximum marginal capital gainstax on short-term capital gains(tax on long-term capitalgainsis only 10% thus
encouraging the investor to hold on to the stock).
Amajorproblemandconcernwithinternational equityissuesisthatofflowback i.e. the investors will sell the shares

back in the home stock market of the issuing firm. Authorities of some countries have imposed a minimum
lock-in period during which foreign investors cannot unload the shares in the domestic market. Withholding taxes
on dividends paid to non-residents reduce the attractiveness of the asset to foreign shareholders andconsequently
raisesthe costtothe issuer. Some giant multinationals have used the device of a finance subsidiary located in a tax
haven country like the Bahamas to issue shares in the international markets. The usefulness and feasibility of this
vehicle depends upon the tax laws and other regulations in the issuer‘s home country. During 1993-94 GDR issues
were a very popular device for many large Indian companies. Yields in developing countrymarketswere
ratherlowandmany Indianissues offered attractive returns alongwith diversification benefits. The economic
liberalisation policy of the government made Indian issues an attractive investment vehicle for foreign investors.
In subsequent years, a variety of problems with the workings of the Indian capital markets- lack of adequate
custodial and depository services, long settle ment periods, delivery and payment delays, suspicions of price
rigging, etc. - led to the wearing off of investor enthusiasm. Added to these factors wasincreasing political un-
certainty as the elections were approaching. From roughly mid-1994 to nearly the end of 1995, market for Indian
GDR issues remained luke warm. There was a brief revival in 1996 but the Asian crisis again turned rich country
investors away from emerging markets. Starting in 1999, a number of Indian IT companies have been successfully
listed on US stock exchanges and their ADRs had been performing quite well till the NASDAQ nose-dived in late
2000-early 2001.
The market revived thereafter and forty Indian companies have accessed the market over the period 2002 - mid-
2005. The global stock markets are becoming increasingly integrated at least as far as investor sentiment is
concerned and the NASDAQ appears to drive markets around the world.

1. Discussthe scope and limitations of external debt and equity financing 2. What is External Debt Financing?
Discussitsrole, importance, advantages and limitations. 3.
WhatisExternalEquityFinancing?Discussitsrole,importance,advantagesand limitations. 4. Compare and
contrast between external debt and equity financing
5. Discuss Capital flow and Capitalflight.
6. Discussthe factorsthat influence the capital flows and flight.
7. Discuss what is Balance of Payments of a country
8. Explain Balance of Payments with special reference to Indian Balance of Pay- ments. 9.
ExplainvariouselementsofBalanceofPaymentsanddescribehoweachelement is measured. 10.
ShowvariouscomponentsofBalanceofPaymentsintheformofastatementand explain each element.
11. What isthe significance of Balance of Paymentsto a MNC? Explain.
12. Describe the trends in the Balance of Payments of India.
13. Discussthe role of IMF in Balance of Payments crisis of a country. 14. Discuss how various international
transactions of a country is recorded in Balance of Payments of that country.
15. Why should a corporatemanager monitor balance of payments developments? 16. Discuss the importance of
Balance of payments to a country with special reference to India. 17. Assume thepointofviewof
countryAandthatA‘scurrencyisdollars($),Do the following for the transactions given in (a) to (g):
(a) Indicate the account to be debited and credited in each case

(b) Enter these transactionsin the appropriate ―T accountsǁ.
(c) Prepare the balance of payments for country A. Assume that all the short term capital movements are of a
compensating nature.
i. A imports goods from B for $ 2000 and A‘simporters pay B‘s exporters for the $ 2000 with a loan inB‘s
currency which they getfromA‘sbank.
ii. A resident of country A, Mr. X goes on vocation to country B. He spends all the money he hadwith him,
$25000,forservice received while on his vacation in countryB. iii. A businessman of A, Mr. Y,decidesto build a
subsidiary plant inB. Therefore, he shipstoB all necessarymaterialsforthis purpose,which cost $200,000.
iv. Mr. Y very soon finds out that he needs another $ 50,000 for the com- pletion of the plant. Thus, he issues
bonds on the parent company for this amount and sells them to the citizens of B. v. Mr. Y makes $ 35,000 profit
during the first year of operation which Mr. Y uses to enlarge his business in B. A‘s citizens are very impressed by
the successful operation of Mr. Y‘s plant in B. Therefore,A‘scitizens buy from B‘s citizens half of the
bondsissued by Mr. Y. vi. B is a producer of gold. During the period of time for which the BOP is completed, B
produces $ 15 million worth of gold. Half of this is consumed at home. However, 25% issold to A‘s Central Bank
and 10% is exported to A for industrial use. For the amount of gold exported to A, B accepts a deposit with the
Central Bank of Country A.
vii. A citizen of A, Mr. M, who migrated there from B a long time ago, finds out that he has inherited the
property of his uncle. The property consists of a farm worth $ 1,50,000 and a deposit of $ 10,000 in B‘s bank.
18. Assume the point of viewof countryAand thatA‘scurrency is dollars($),Do the following for the transactions
given in (a) to (g):
(a) Indicate the account to be debited and credited in each case
(b) Enter these transactionsin the appropriate "T accounts".
(c) Prepare the balance of payments for country A. Assume that all the short term capital movements are of a
compensating nature.
i. A business man of A, Mr Y decides to build a subsidiary plant in B, therefore,he ships to B all necessary
materialsfor this purpose, which cost $50,000.
ii. Mr. Y very soon finds out that he need another $20,000 for the comple- tion of the plant. Thus, he issues bonds
on the parent company forthis amount and sells them to the citizen of B. iii.
MrYmakes$10000profitduringthefirstyearofoperationwhichMr.Y usesto enlarge his businessinB.A‘scitizens are
very impressed by thesuccessful operation ofMr.Y‘splantinB.Therefore, A‘scitizen buy from B‘s citizens half of the
bonds issued by Mr.Y.
iv. A resident of B. Mr.Z, migratesto A. His only property is $1000 in B‘s currency, which he carries with him to
A and his house in B which he rentsto a friend for $100 a month. The house is worth$8,000.Norent payment,
however, has been received.
v. Mr.Z decides to sell his house to his friend for $8000, the payment is arranged as follows: $4000 in cash and
$40000 in five years. Mr. Z depositsthismoney with his old bank inB(everything here isin terms of B‘s currency).
vi. Mr.Zhoweverthinks he should give back to the church of his village $1000. Therefore $1000 istransferred
from Mr.Z‘s account iri B‘s bank to the account of church. vii. B is producer of Gold. During the period of time
for which the balance of payment is completed, B produces $1 million worth of gold. Half of this is consumed at
home. However, 20% is sold to A‘s central bank and 10% is exported to Aforindustrial use. Forthe amount of
gold exported toA,acceptsadepositwiththecentralbankofcountryA.
19. The following transactions take place during a year (expressed US $ in billions). Calculate the US merchandise
trade, Current account, capital account and official reserves balance. (a) TheUSexports $ 300 of goods andreceives
paymentsin the formofforeign demand deposits abroad.
(b) The US imports $ 225 of goods and paysforthem by drawing down its foreign demand deposits.
(c) TheUSpays$15toforeignersindividendsdrawnonUSdemanddeposits. (d) An American tourist spends $ 30
overseas using travellers‘ cheque drawn on the US banks in the homecountry.
(e) Americans buy foreign stocks with $ 60 using foreign demand depositsheld abroad. (f) In a currency support
operation, the US government uses its foreign demand depositsto purchase $ 8 from private foreignersin the US.
20. The following transaction (expressed in US $ billions) take place during a year. Calculate the US
merchandise-trade, current account, capital account and official reserve balances. (a) The United States exports $
450 of goods and receives payment in the form of foreign demand deposits abroad.
(b) The United States imports $ 337.5 of goods and pays for them by drawing down its foreign demand deposits.
(c) The United States pays $ 22.5 to foreignersin dividends drawn an U.S. demand deposits here. iv. American
touristsspend $ 45 overseas using trav- eller‘s cheque‘s drawn on US banks here. (d)
Americanbuyforeignstockswith$90usingforeigndemanddepositsheld abroad. (e) TheUS governmentsells $ 67.5 in
gold forforeign demand deposits abroad. (f) In a currency support operation, the US government uses its foreign
demand depositsto purchase$12fromprivateforeignersintheUnitedStates.
Chapter 4
International Financial Markets and Instruments
4.1 Introduction
The global economy is massive and growing . According to the World Bank, global GrossDomestic Product(GDP)
had grown from$71. 83 trillionin 2012 to approxi- mately $74 . 91 trillion in 2013 . The United States accounted
for over 22% of global GDP in 2013, but this percentage has been declining over time owing to the emergence of
the economies in India, China, Brazil, and other developing countries. A sometimes overlooked factor in this
global growth is that it is facilitated by ever-growing and increasingly complex economic interconnections between
countries. Economist Frederick Hayek referred to this phenomenon as Catallaxy - specialization of tasks and
functions that
leads to the exchange of specialties among specialists and, consequently, economic growth. One can observe that
Catallaxy is now occurring at the national level—some nations are specializing in fostering innovation in some
industries, others are specializing in providing the infrastructure for large scale manufacturing, and yet others are
serving as hubs for the provision of services . The global flow of goods and services produced by this phenomenon
is large . Manyika et al . (2014) report that the global flow of goods,services, and finance was almost $26 trillion
in 2012, or 36% of global GDP that year.
While such global flowsincrease the size of the global economic pie, they also en- gender greater inter
connectedness among the financial systems of the world because an increasing share of global economic activity
takes place across borders . The McKin- sey Global Institute Connectedness Index measures the connectedness of
131 countries across all flows of goods, services, finance, people, and data and communication . It reflects the level
of inflows and outflows adjusted for the size of the country The data show that connectedness has been on the rise
in most countries and that global financial flows accounted for almost half of all global flows in 2012 . An
important reason for this is the growing significance of the financial sector as a percentage of the overall economy
in developed countries, and
the development of financial markets in the emerging countries to support their rapidly growing economies and
burgeoning trade flows.
At a very basic level, the global financial market links savers to investors across national boundaries by offering
investors a vast array of investment products across a dazzling variety offinancialmarkets. Wecan think ofthe
financialmarket as consisting of the capital markets, commodities markets, and derivatives markets.
The capital markets consist of the markets for stocks, bonds, mutual funds, and exchange-traded funds(ETFs).
Atthe end of 2012, according to theBank forInter- national Settlements, over 46,000 stocks were traded globally,
and the global market consistedofmore than $54trillionworth oftraded stocks . A stock is essentially an equity
(or ownership) claim on the cash flows and assets of a company.
Abond is a debtsecurity thatrepresents a fixed-income claimon the cash flows and assets of a company. The global
bond market was valued at about $80 trillion in 2012, in terms ofthe aggregate value ofthe
bondstraded.Thatmeanstheglobalbondmarket was about 50% bigger than the global stock market in 2012.
Mutual funds are pools of cash collected from investors and invested in diversified baskets of traded securities .
The securities include stocks, bonds, and other money market instruments . Mutual funds provide a very
convenient and low-cost way for investorsto diversify their portfolios across numerous industries and firm sizes .
They initially came into prominence in the United States during the 1980s to provide investors with a meansto earn
high returns at low risk because Regulation Q ceilings on deposit
interest rates prevented investors from earning adequate returns on bank deposits during periods of high inflation .
Although notinsured by the government,mutualfunds provided investors with low risk due to diversification, with
returns that were 5%—7% higher than attainable on (insured) bank deposits in the

1980s. Thisresulted in large flows from insured bank deposit accounts into mutual funds and spurred the growth of
the industry Today that is no longer the dominant motivation for the existence of the industry, but it is an industry
that has nonetheless grownworldwide . The Investment Company Institute estimatesthat in 2012 the mutual fund
industry had assets of about $26 8 trillion globally, with the U S mutualfundmarketrepresenting about $13 trillion
of that amount.
Exchange-Traded Funds provide many of the same benefits as mutual funds. An ETF tracks an index, a
commodity, or a basket of assets like an index (mutual) fund, but unlike amutualfund,it trades on an exchange like
an individualstock. By owning anETF, an investor can obtain the diversification benefits of an index fund and can
also sellshort, buy onmargin, and purchase small quantities(e g , one share) ETFs have been around only since
the 1990s, but they have experienced explosive growth, with $2 trillion in assets as of year-end 2012.
Commodities markets offer investors the opportunity to invest in physical commodities . As such, they
provideinvestorswithdiversificationopportunitiesthatgobeyond those provided by the capital markets . About 50
major commodity markets exist worldwide, and they involve trade in about 100 primary commodities, including
mined natural resources (gold, silver, oil, etc ) and agricultural products and livestock (soy, wheat, pork bellies, etc.).
As ofyear-end 2011, commoditymutualfunds—whichprovide investors with a way to invest in commodities
without trading directly in the primary commodities themselves—had $47 7 billion in assets, but this number is
small compared with the size of global commodity markets. The monthly global trading volume in commodity
futures and options markets as of year-end 2011 was almost $11 trillion, and the total annual globalsalesin the spot
marketstood at about $6 4 trillion. The derivatives market involves trade in derivative contracts. As the name
suggests, these are financial contracts whose value is driven by the value of some other asset or security
Commonly used derivatives are forwards, futures, options, and swap contracts The total notional amount of over-the-
counter derivatives at the end of 2013 was about $710 . 2 trillion globally.
The large magnitudes involved in global financial markets reflect, in some sense, boththedesireonthe
partofinvestorstoinvestgloballyanddiversifyacross agrowing number ofsecurities and the constantly rising global
trade flows. Thus, globally interconnected financial markets foster global economic growth both directly by
facilitating trade flows and indirectly by increasing the wealth of individual investors that then enables them to
increase their demand for goods and services and thus contributes further to global economic growth. But how
specifically does the global financial system promote economic growth on MainStreet?
The globalfinancialsystempromotes economic growth in six ways: (1) by creating money and money like claims;
(2) by facilitating specialization and promoting trade;
(3) by facilitating risk management; (4) by mobilizing resources globally and thereby improving the effectiveness
with which local challenges are met; (5) by obtaining information for the evaluation of business and individuals
and allocating capital; and (6) by increasing the set of opportunities available to companies, entrepreneurs, and
individuals to participate in and contribute to global economic growth.
Global financial institutions, the central banksthat regulate them, the interconnections between these central
banks, and the regulations that affect these banks all play a role in how companies access the global markets. This
discussion highlights how highly interconnected different countries are, simply through the global financial insti-
tutionsthat operate in these countries. An event in one country may at first seem quite remote to those living in
another country—such asthe crash of the Japanese stock mar ket may seem to Americans—but if it affects the
banks in the affected country, then it can affect the lending behavior of those banks in other countries, thereby
transmitting economic shocks across the globe through such interconnectedness.
Apart from interconnectedness, banks are also profoundly affected by the regulations to which they are subject,
and bank regulation is increasingly being internationally harmonized, especially across Europe, Canada, and the
United States. The report highlights key aspects of international regulation,

with a focus on the microprudential regulation of banks. These regulations affect economic growth as
wellasthelikelihood of economic upheavals through financialcrises.
Market-based financing plays a large role in the global markets. The subprime crisis of 2007–09 originated in the
United States in the housing finances system. The crisis turned the spotlight on shadow banking, not just in the
United States, but globally. The business community and regulators have learned from the experience of the crisis, so
behavior going forward will differ significantly from the set of events that precipitated the crisis. While the term
shadow banking conjures images of shadows and mysteries—in part because the term has become a part of our
lexicon only in the past few years—it simply refers to a host of nondepository financial institutions that connect
savers and investors in the financial market. FormerChairman ofthe FederalReserve SystemBen Bernanke defined
shadow banks as ―financial entities other than regulated depository institutions (commercial banks, thrifts, and credit
unions) that serve as intermediaries to channel savings into investment.ǁ6 Such channeling occurs through
securitization and secured funding techniques.7 The market-based financing sector is important not only because
itprovidessignificant economic servicestotheglobal economybyaidingcap- italformation for businesses, but also
because it islarge (and growing) and magnifies the interconnectedness of different countries‘ economies. As of
year-end 2011, the size of the global shadow banking sector was estimated at $67 trillion. Moreover, because
marketbased financing involves investing in and borrowing against
asset-backed securities, it createsinterconnectedness between institutions and investorsin one country and the
assets that spawned the asset-backed securities in another country. For example, mortgage backed securities
created in the United States were held by banks all over the world prior to the subprime crisis, creating a scenario
in which price movements in the U.S. housing market would potentially reverberate through many other
countries. The market-based financing system is well understood as a vehicle for economic growth. In fact, in the
November 2014 communique, G-20 leaders resolved to work in partnership to uplift growth, boost economic
resilience, and strengthen global institutions—recognizingthatwellfunctioningmarketssupportprosperity.
4.2 Nature and Functions

Internationalfinancialmarketsundertake intermediationbytransferringpurchasingpower from lenders and investors to
parties who desire to acquire assets that they expect to yieldfuturebenefits.International
financialtransactionsinvolveexchangeof assetsbe- tween residents of differentfinancial centres across national
boundaries. International financial centres are reservoirs ofsavings and transfer them to their most efficient use
irrespective of where the savings are generated.
There are three important functions of financial markets. First, the interactions of buyers and sellers in the markets
determine the prices of the assets traded which is called the price discovery process. Secondly, the financial
markets ensure liquidity by providing a mechanism for an investor to sell a financial asset. Finally, the financial
markets reduce the cost of transactions and information.
4.3 International Capital Markets
A capital marketsis basically a system in which people, companies, and governments with an excess of funds
transfer those funds to people, companies, and governments that have a shortage of funds. This transfer mechanism
provides an efficient way for those who wish to borrow or invest money to do so. For example, every time
someone takes out a loan to buy a car or a house, they are accessing the capital markets.Capitalmarkets carry
outthe desirable economic functionofdirecting capitaltoproductive uses.
There are two main ways that someone accesses the capital markets—either as debt or equity. While there are
many forms of each, very simply, debt is money that‘s borrowed and must be repaid, and equity is money that is
invested in return for a percentage of ownership but is not guaranteed in terms of repayment.
In essence, governments, businesses, and people that save some portion of their income invest their money in
capital markets such as stocks and bonds. The borrowers (governments, businesses, and

people who spend more than their income) borrow the savers‘ investments through the capital markets. When savers
make investments, they convertrisk-free assetssuchascashorsavingsintoriskyassetswith the hopes ofreceiv- ing a
future benefit. Since all investments are risky, the only reason a saver would put cash at risk is if returns on the
investment are greater than returns on holding risk-free assets. Basically, a higher rate of return means a higher
risk.
For example, let‘s imagine a beverage company that makes $1 million in gross sales. If the company spends
$900,000, including taxes and all expenses, then it has $100,000 in profits. The company can invest the $100,000
in a mutual fund (which are pools of money managed by an investment company), investing in stocks and bonds all
over the world. Making such an investment is riskier than keeping the $100,000 in a savings account. The financial
officer hopes that over the long term the investment will yield greaterreturnsthan cash holdings orinterest on a
savings account. Thisis an example of a form of direct finance. In other words, the beverage company bought a
security issued by another company through the capital markets. In contrast, indirect finance involves a financial
intermediary between the borrower and the saver. For example, if the company deposited the money in a savings
account, and then the savings bank lends the money to a company (or a person), the bank is an intermediary.
Financial intermediaries are very important in the capital marketplace. Bankslend money to many people, and in
so doing create economies ofscale. This is one of the primary purposes of the capital markets.
Capital markets promote economic efficiency. In the example, the beverage company wants to invest its
$100,000 productively. There might be a number of firms around the world eager to borrow funds by issuing a
debt security or an equity security so that it can implement a great business idea. Without issuing the security, the
borrowing firm has no funds to implement its plans. By shifting the funds fromthe beverage company to other firms
through the capital markets, the funds are employed to their maximum extent. If there were no capital markets, the
beverage company might have kept its $100,000 in cash orin a low-yield savings account. The otherfirms would
also have had to put off or cancel their business plans.
International capital markets are the same mechanism but in the global sphere, in which governments, companies,
and people borrow and invest across national boundaries. In addition to the benefits and purposes of a domestic
capital market, international capital markets provide the followingbenefits: 1. Higher returns and cheaper borrowing
costs. These allow companies and governments to tap into foreign markets and access new sources of funds. Many
domestic markets are too small or too costly for companies to borrow in. By using the international capital
markets, companies, governments, and even individuals can borrow or invest in other countries for either higher
rates of return or lower borrowing costs.
2. Diversifying risk. The international capital markets allow individuals, companies, and governments to access more
opportunities in different countries to borrowor invest, which in turn reduces risk. The theory isthat not all markets
will experience contractions at the same time. The structure of the capital markets falls into two components—
primary and secondary. The primary market is where new securities (stocks and bonds are the most common) are
issued. If a corporation or government agency needs funds, it issues (sells) securities to purchasers in the primary
market. Big investment banks assist in thisissuing process asintermediaries. Since the primary market is limited to
issuing only new securities, it is valuable but less important than the secondary market. The vast
majority of capital transactions take place in the secondary market. The secondary market includes stock exchanges
(the New York Stock Exchange, the Lon- don Stock Exchange, and the Tokyo Nikkei), bond markets, and futures
and options markets, among others. All these secondary markets dealinthetradeofsecurities.The term
securitiesincludes a wide range of financial instruments. You‘re probably most familiar with stocks and bonds.
Investors have essentially two broad categories of se curities available to them: equity securities, which represent
ownership of a part of a company, and debtsecurities,whichrepresentaloanfromtheinvestortoacompanyor
government entity. Creditors, or debt holders, purchase debt securities and receive future income or assets in return
for their investment. The most common example of a debt instrument is the bond. When investors buy bonds, they
are lending the issuers of the bonds their money. In return, they will receive interest

payments usually at a fixed rate for the life ofthe bond and receive the principal when the bond expires. All types
of organizations can issue bonds. Stocks are the type of equity security with which most people are familiar.
When investorsbuystock,they becomeownersof a shareof a company‘s assets and earnings. If a company is
successful, the price that investors are willing to pay for its stock will often rise;shareholderswho boughtstock at a
lower price then stand tomake a profit. If a company does not do well, however, itsstock may decrease in value and
shareholders can lose money. Stock prices are also subject to both general economic and industry- specific market
factors.
The key to remember with either debt or equity securities is that the issuing entity, a company or government, only
receives the cash in the primary market issuance. Once the security is issued, it is traded; but the company receives
no more financial benefit from that security. Companies are motivatedtomaintainthevalueoftheirequitysecu-
ritiesortorepaytheirbondsinatimelymannersothat when they want to borrow funds from or sell more shares in the
market, they have the credibility to do so. For companies, the global financial, including the currency, markets (1)
provide stability and predictability, (2) help reduce risk, and (3) provide access to more resources. One of the
fundamental purposes ofthe capital markets, both domestic and international, isthe concept ofliquidity,which
basically means being able to convert a noncash asset into cash without losing any of the principal value. In the
case of global capital markets, liquidity refers to the ease and speed by which shareholders and bondholders can
buy and sell their securities and convert their investment into cash when necessary. Liquidity is also essential for
foreign exchange, as companies don‘t want their profits locked into an illiquid currency.
4.3.1 Major Components of the International Capital Markets 4.3.1.1

International Equity Markets
Companies sell their stock in the equity markets. International equity markets consists of all the stock
tradedoutside the issuingcompany‘shome country. Manylargeglobal companies seek to take advantage of the global
financial centers and issue stock in major markets to support local and regional operations.
Forexample,ArcelorMittalisaglobalsteelcompanyheadquarteredinLuxembourg;
it is listed on the stock exchanges of New York, Amsterdam, Paris, Brussels, Luxem- bourg, Madrid, Barcelona,
Bilbao, and Valencia. While the daily value of the global markets changes, in the past decade the international
equity markets have expanded considerably, offering global firms increased options for financing their global
operations. The key factors for the increased growth in the international equitymarkets are the following:
• Growth of developing markets. As developing countries experience growth, their domestic firms seek to expand into
global markets and take advantage of cheaper and more flexible financial markets. • Drive to privatize. In the past
two decades, the general trend in developing and emerging markets has been to privatize formerly state-owned
enterprises. These entitiestend to be large, and when they sell some or all of their shares, it infuses billions of
dollars of new equity into local and global markets. Domestic and global investors, eager to participate in the
growth of the local economy, buy these shares.
• Investment banks. With the increased opportunities in new emerging markets and the need to simply expand their
own businesses, investment banks often lead the way in the expansion of global equitymarkets.These
specializedbanksseektobe retained by large companies in developing countries or the governments pursuing
privatization to issue and sell the stocks to investors with deep pockets outside the local country.
• Technology advancements. The expansion of technology into global finance has opened new opportunities to
investors and companies around the world. Technol- ogy and the Internet have provided more efficient and cheaper
means of trading stocks and, in some cases, issuing shares by smaller companies.
4.3.1.2 International Bond Markets

Bonds are the most common form of debt instrument, which is basically a loan from the holder to the

issuer of the bond. The international bond market consists of all the bonds sold by an issuing company,
government, or entity outside their home country. Com- panies that do not want to issue more equity shares and
dilute the ownership interests of existing shareholders prefer using bonds or debt to raise capital (i.e., money).
Com- panies might accessthe international bond marketsfor a variety of reasons, including funding a new
production facility or expanding its operations in one or more countries. There are severaltypesofinternational
bonds,whicharedetailed in thenextsections.
4.3.1.3 Foreign Bond

A foreign bond is a bond sold by a company, government, or entity in another country and issued in the currency of
the country in which it is being sold. There are foreign exchange, economic, and political risks associated with
foreign bonds, and many sophisticated buyers and issuers of these bonds use complex hedging strategies to reduce
the risks. For example, the bonds issued by global companies in Japan denominated in yen are called samurai
bonds. As you might expect, there are other names for similar bond structures. Foreign bonds sold in the United
States and denominated in US dollars are called Yankee bonds. In the United Kingdom, these foreign bonds are
called bull- dog bonds. Foreign bonds issued and traded throughout Asia except Japan, are called dragon bonds,
which are typically denominated in US dollars. Foreign bonds are typically subject to the same rules and
guidelines as domestic bonds in the country in which they are issued. There are also regulatory and reporting
requirements, which make them a slightly more expensive bond than the Eurobond. The requirements add small
costs that can add up given the size of the bond issues by many companies.
4.3.1.4 Eurobond
A Eurobond is a bond issued outside the country in whose currency it is denominated. Eurobonds are not regulated
by the governments of the countries in which they are sold, and as a result, Eurobonds are the most popular form of
international bond. A bond issued by a Japanese company, denominated in US dollars, andsoldonlyintheUnited
Kingdom and France is an example of a Eurobond.
4.3.1.5 Global Bond

A global bond is a bond that issold simultaneously in several global financial centers. It is denominated in one
currency, usually US dollars or Euros. By offering the bond in several markets at the same time, the company can
reduce itsissuing costs. This option is usually reserved for higher rated, creditworthy, and typically very large
firms.
4.3.1.6 Eurocurrency Markets

The Eurocurrency markets originated in the 1950s when communist governments in Eastern Europe became
concerned that any deposits of their dollars in US banks might be confiscated or blocked for political reasons by
the US government. These communist governments addressed their concerns by depositing their dollars into
European banks, which were willing to maintain dollar accounts for them. This created what is known as the
Eurodollar—US dollars deposited in European banks. Over the years, banks in other countries, including Japan and
Canada, also began to hold US dollar deposits and nowEurodollars are
anydollardepositsinabankoutsidetheUnitedStates.(Theprefix Euro-isnowonly a historical reference to its early
days.) An extension of the Eurodollar is the Eurocurrency, which is a currency on deposit outside its country of
issue. While Eurocurrencies can be in any denominations, almost half of world deposits are in the form of
Eurodollars.
The Euroloan market is also a growing part of the Eurocurrency market. The Eu- roloan market is one of the least
costly for large, creditworthy borrowers, including governments and large global firms. Euroloans are quoted on
the basis of LIBOR, the London Interbank Offer Rate, which is the interest rate at which banks in London charge
each other for short-term Eurocurrencyloans.
The primary appeal of the Eurocurrency market is that there are no regulations, which results in lower costs. The
participants in the Eurocurrency markets are very large global firms, banks, governments, and extremely wealthy
individuals. As a result, the transaction sizestend to be large,which

provides an economy ofscale and nets overall lower transaction costs. The Eurocurrency markets are relatively
cheap,short-term financing options for Eurocurrency loans; they are also a short-term investing option for entities
with excessfundsin the form of Eurocurrency deposits.
4.3.1.7 Offshore Centers

The firsttierof centersin theworldare theworldfinancial centers,whichare in essence central pointsfor business and
finance. They are usually home to major corporations and banks or at least regional headquartersfor global firms.
They all have at least one globally active stock exchange. While their actual order of importance may differ both
on the ranking format and the year, the following cities rank as global financial centers: New York, London,
Tokyo, Hong Kong, Singapore, Chicago, Zurich, Geneva, and Sydney.
In addition to the global financial centers are a group of countries and territories that constitute offshore financial
centers. An offshore financial center is a country or territory where there are few rules governing the financial
sector as a whole and low overall taxes. As a result, many offshore centers are called tax havens. Most of these
countries or territories are politically and economically stable, and in most cases, the local government has
determined that becoming an offshore financial centerisitsmain industry. As a result, they invest in the technology
and infrastructure to remain globally linked and competitive in the global finance marketplace.
Examples of well-known offshore financial centers include Anguilla, the Bahamas, the Cayman Islands, Bermuda,
the Netherlands, the Antilles, Bahrain, and Singapore. They tend to be small countries or territories, and while global
businesses may not locate any of their operations in these locations, they sometimes incorporate in these offshore
centers to escape the higher taxes they would have to pay in their home countries and to take advantage of the
efficiencies of these financial centers. Many global firms may house financing subsidiaries in offshore centers for
the same benefits. For example, Bacardi, the spirits manufacturer, has $6 billion in revenues, more than 6,000
employees worldwide, and
twenty-seven global production facilities. The firm is headquartered in Bermuda, enabling it to take advantage ofthe
lowertax rates and financial efficiencies for managing its global operations. As a result ofthe size
offinancialtransactionsthatflowthrough these offshore centers, they have been increasingly important in the
global capital markets.
4.3.1.8 The Role ofInternational Banks,Investment Banks, Securities Firms, and Global Financial
Firms
The role of international banks, investment banks, and securities firms has evolved in the past few decades. Let‘s take
a look at the primary purpose of each of these institutions and how it has changed, as many have merged to become
global financial powerhouses. Traditionally, international banks extended their domestic role to the global arena by
servicing the needs of multinational corporations (MNC). These banks not only received deposits and made loans but
also provided tools to finance exports and imports and offered sophisticated cash-management tools, including
foreign exchange. For example, a company purchasing products from another country may need short-term financing
of the purchase; electronic funds transfers (also called wires); and foreign exchange transactions. International
banks provide all these services and more.
In broad strokes, there are different types of banks, and they may be divided into several groups on the basis of their
activities. Retail banks deal directly with consumers and usually focus on mass-market products such as checking
and savings accounts, mortgages and other loans, and credit cards. By contrast, private banks normally provide
wealth-management services to families and individuals of high net worth. Business banks provide servicesto
businesses and other organizationsthat are medium sized, whereas the clients of corporate banks are usually major
business entities. Lastly, investment banks provide services related to financial markets, such as mergers and acqui-
sitions. Investment banks also focused primarily on the creation and sale of securities (e.g., debt and equity) to
help companies, governments, and large institutions achieve their financing objectives. Retail, private, business,

corporate, and investment banks have traditionally been separate entities. All can operate on the global level. In
many cases, these separate institutions have recently merged, or were acquired by another in
stitution,tocreateglobalfinancialpowerhousesthatnowhavealltypesofbanksunder one giant, global corporate
umbrella.
However the merger of all of these types of banking firms has created global economic challenges. In the United
States, for example, these two types—retail and investment banks—were barred from being under the same
corporate umbrella by the Glass-Steagall Act. Enacted in 1932 during the Great Depression, the Glass-Steagall
Act, officially called the Banking Reform Act of 1933, created the
Federal Deposit In- surance Corporations (FDIC) and implemented bank reforms, beginning in 1932 and
continuing through 1933. These reforms are credited with providing stability and reduced risk in the banking
industry for decades. Among other things, it prohibited bank- holding companies from owning otherfinancial
companies. Thisserved to ensure that investment banks and banks would remain separate—until 1999, when Glass-
Steagall was repealed. Some analysts have criticized the repeal of Glass-Steagall as one cause of the 2007–8
financial crisis.
Because of the size, scope, and reach of US financial firms, this historical reference point is important in
understanding the impact of US firms on global businesses. In 1999,oncebank-holdingcompanies were able to own
other financial services firms, the trend toward creating global financial powerhouses increased, blurring the line
between which services were conducted on behalf of clients and which business was being managed for the
benefit of the financial company itself. Global businesses were also part of this trend, as they sought the largest and
strongest financial players in multiple markets to service their global financial needs. If a company has operations in
twenty countries, it prefers two or three large, global banking relationships for a more cost-effective and lower-risk
approach. For example, one large bank can provide services more cheaply and better manage the company‘s
currency exposure across multiple markets. One large financial company can offer more sophisticated risk
management options and products. The challenge has become that in some cases, the party on the opposite side of
the transaction from the global firm has turned out to be the global financial powerhouse itself, creating a conflict
ofinterest that many feel would not exist if Glass-Steagall had not been repealed. The issue remains a point of
ongoing discussion between companies, financial firms, and policymakers around the world. Meanwhile, global
businesses have benefited from the expanded services and capabilities of the global financial powerhouses. For
example, US-based Citigroup is the world‘s largest financial services network, with 16,000 offices in 160 countries
and jurisdictions, holding 200 million customer accounts. It‘s a financial powerhouse with operations in retail,
private, business, and investment banking, as well as asset management. Citibank‘s global reach make it a good
banking partner for large global firms that want to be able to manage the financial needs of their employees and the
company‘s operations around the world. In fact this strength is a core part of its marketing message to global
companies and is even posted on its website ―Citi puts the world‘slargest financialnetworktoworkforyouandyour
organization.ǁ
4.4 International Money Market

A money market is a market for instruments and a means of lending (or investing) and borrowing funds for
relatively short periods, typically regards as from one day to one year. Such means and instruments include short
term bank loans. Treasury bills, bank certificates of deposit, commercial paper, banker‘s acceptances and
repurchase agreements and other short term asset backed claims.
As a key elements of the financial system of a country, the money market plays a crucial economic role that if
reconciling the cash needs of so called deficit units (such as farmers needing to borrow in anticipation of their later
harvest revenues), with the investment needs of surplus units (such as insurance companies wanting to invest cash
productively prior to making long term investment choices). Holding or borrowing liquid claims is more
productive than holding cash balances. A smoothly functioning money market can perform these functions very
efficiently if borrowing lending
spreads (or bid offers spreads for traded instruments) are small (operational efficiency), and if funds are lent to
those who can make the most productive use of them (allocation efficiency). Both borrowers and lenders prefer to
meet their short term needs without bearing the liquidity risk or interest rate risk that characterizes longer term
instruments, and money market instruments allow this. In addition money market investors tend not to want to spend
much time analyzing credit risk, so money market instruments are generally characterized by a high degree
ofsafety of principal. Thusthe money market sets a market interest rate that balances cash management needs, and
sets different rates for different uses that balance their risks and potential for productive use. Unlike stock or futures
markets, the money markets of the major industrial countries have no central location;theyoperate as a
telephonemarketthat is accessible fromallpartsoftheworld. The international money market can be regarded as the
market for short term financing and investment instruments that are issued or traded internationally. The core of this
market is the Eurocurrency market, where bank deposits are issued and traded outside
of the country that issued the currency.
Other instruments to be discussed in this chapter such as Euro commercial paper and floating rate notes, serve some
what different purposes and attract a different investment clientele. However, each is to a degree a substitute for each
of the other instruments, and the yield and price of each are sensitive to many of the same influences, se we may
feel justified in lumping them together in something called a market. The fact that many of the other instruments
of the international money market are priced off LIBOR, the interest rate of Eurodollar deposits, suggest that market
participants themselves regard the different instruments as having a common frame of reference.
Today many domestic cash and derivative instruments, such as US. Treasury bills and Eurocurrency futures
contracts are traded globally and so are effectively parts of the international money market. Euromarkets
instruments simply represent part of a spectrum of financial claims available in the money market of a particular
currency, claimsthat are distinguished by risk, cost and liquidity just like domestic money market instrument.
However domestic money markets are called upon to play public as wellasprivateroles.Thelatterinclude the
following three functions.
• The money market, along with the bond market, is used to finance the government deficit. • The transmission of
monetary policy (including exchange rate policy) is typically done through themoneymarket, eitherthrough banks
orthrough freely traded money market instruments. • The government uses the institutions of the money market to
influence credit allocation toward favored uses in the economy.
4.4.1 Returns on Money Market Instruments

The manager of cash will wish to consider the alternative money market instruments she has at her disposal by
comparing their returns, risks and other characteristics. In principle, the rage includes all the instruments in two
dozen or so domestic money markets open to international investors. Realistically, through one would normally limit
one‘s attention to a few major currencies and to the more liquid instruments.
Forsome the starting pointwould be USTreasury bills and some will be constrained to that class of risk. Most
international investors will look for a better return than can be had in government Treasury bills, however,so
theirstaring pointwould be shortterm Euro deposits.
To compare instruments one should be able to express their returns on a comparable basis. Doing so is complicated
by the different maturities and payment characteristics of even the limited range of investments considered here,
and by the different delivery and accrued interest calculations adopted byparticipantsindifferentmarkets.
The basisidea of a retunesisthat you invest a sumofmoney today and you getsome more back at a later date. The
increase, expressed as an annualized percentage of the original investment, istypically how we measure return.
Thus if you invest Y100 today and you receive Y107 in one year the return is 7 percent.Inpractice thisidea
takesthree different forms.
1. The bank discount rate: The bank discount rate method is a formula devised to make

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INSTITUTE OF ENGINEERING AND

Srinivas Nagar Mukka, Mangalore 575025

BACKGROUND STUDY MATERIAL

INTERNATIONAL FINANCIAL MANAGEMENT

Prof. Swapna Raghupathi

Syllabus Teaching Plan

1.1 Global Economy - A Historical Perspective .............................. 1

1.2 Financial Globalization - The Missing Link .............................. 2

1.3 Interdependence of National Economies .................................. 3

1.3.1 AspectsofInterdependence ........................................ 4

1.3.2 Inter-dependenceofIndiaonothercountries ..................... 5

1 3.3 Challenges of increasing economic interdependence on each other 5

1.3.4 Issues of Increasing Economic Interdependence .................. 6

1.4 National Competitive Advantage .......................................... 7

1.4.3 Related and Supporting Industries ................................ 9

1.4.4 FirmStrategy,Structure, andRivalry ............................. 9

1.5 International Business ...................................................... 10

1.5.1 Features of International Business ................................ 11

1.6 International Financial Management ...................................... 13

1.7 Functions of International Financial Manager ............................ 14

1.8 Self Study Questions ...................................................... 15

2.5.3 Suspension ofGoldStandard .................................................................... 27

2.5.4 Conclusion ................................................................................................. 27

2.6 Inter-WarYears ......................................................................................................27

2.7 Bretton Woods System of Exchange Rates ............................................................ 28

2.7.1 Fixed Parity System ................................................................................... 28

2.7.2 Collapse of Fixed Parity System ............................................................... 29

2.7.3 Smithsonian Arrangement ............................................................................... 30

2.8 ExchangeRateRegimeSince1973 .................................................................30

2.8.1 Floating Rate Regime ................................................................................ 31

2.8.2 ManagedFloating ...................................................................................... 32

2.8.3 Pegging ofCurrency ..................................................................................34

2.8.4 Target–Zone Arrangement ................................................................................ 34

2.9 International Liquidity .................................................................................................... 35

2.9.1 TheThreeBases ................................................................................ 35

2.9.2 Creation ofSDRs .............................................................................. 36

2.9.3 IMF‘s Funding Facilities .......................................................................... 37

2.9.4 AnAppraisalofLiquidityPromotionMeasures ........................................ 39

2.10.1 Nature ofFinancialCrisis ......................................................................... 40

2.10.2 IMFResponse ................................................................................... 41

2.11 Major Financial Crises ........................................................................................... 42

2.11.1 LatAmsovereigndebtcrisis–1982 .................................................... 42

2.11.2 Savings andloans crisis–1980s ......................................................... 43

7.4.7 Export-Import Policy (1997-2002) ......................................................... 210

International Financial Management vii

Chapter 1: International economics and international finance

Chapter 3: Foreign Exchange Market

Chapter 4: Measuring Exposure to Exchange rate ﬂuctuations

Chapter 6: Financing Decisions and capital budgeting by MNCs

International Financial Management xv

International Financial Management xv i

1 International economics and international ﬁnance

2 Interdependence of national economics

4 International Monetary System - Meaning

5 Evolution ofInternationalMonitory system-Bimetallism,Classical

7 IMF solution for ﬁnancial crisis

8 Major ﬁnancial crisis

9 Capital ﬂows and ﬂight

11 Meaning of Balance of payments - components of BOP

12 Signiﬁcance of BOP to the multinational corporation