Transcript opportunity cost

Globalization and the
Multinational Firm
Chapter One
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
What’s Special about
“International” Finance?
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Foreign Exchange Risk
Political Risk
Market Imperfections
Expanded Opportunity Set
1-2
What’s Special about
“International” Finance?
 Foreign Exchange Risk
– This is risk that foreign currency profits may
evaporate in dollar terms due to unanticipated
unfavorable exchange rate movements.
– Suppose $1 = ¥100 and you buy 10 shares of Toyota
at ¥10,000 per share. One year later the investment is
worth ten percent more in yen: ¥110,000.
– But, if the yen has depreciated to $1 = ¥120, your
investment has actually lost money in dollar terms.
1-3
What’s Special about
“International” Finance?
 Political Risk
– Sovereign governments have the right to
regulate the movement of goods, capital, and
people across their borders. These laws
sometimes change in unexpected ways.
1-4
What’s Special about
“International” Finance?
 Market Imperfections
– Legal restrictions on the movement of goods,
people, and money
– Transactions costs
– Shipping costs
– Tax arbitrage
1-5
The Example of Nestlé’s Market Imperfection
 Nestlé used to issue two different classes of
common stock bearer shares and registered
shares.
– Foreigners were only allowed to buy bearer
shares.
– Swiss citizens could buy registered shares.
– The bearer stock was more expensive.
 On November 18, 1988, Nestlé lifted restrictions
imposed on foreigners, allowing them to hold
registered shares as well as bearer shares.
1-6
Nestlé’s Foreign Ownership Restrictions
12,000
10,000
Bearer share
SF
8,000
6,000
4,000
Registered share
2,000
0
11
20
31
9
18
24
Source: Financial Times, November 26, 1988 p.1. Adapted with permission.
1-7
The Example of Nestlé’s Market Imperfection
 Following this, the price spread between the two
types of shares narrowed dramatically.
– This implies that there was a major transfer of
wealth from foreign shareholders to Swiss
shareholders.
 Foreigners holding Nestlé bearer shares were
exposed to political risk in a country that is
widely viewed as a haven from such risk.
 The Nestlé episode illustrates both the
importance of considering market imperfections
and the peril of political risk.
1-8
What’s Special about
“International” Finance?
 Expanded Opportunity Set
– It doesn’t make sense to play in only one
corner of the sandbox.
– True for corporations as well as individual
investors.
1-9
Goals for International Financial
Management
 Maximization of shareholder wealth?
1-10
Maximize Shareholder Wealth
 Long accepted as a goal in the Anglo-Saxon
countries, but complications arise.
– Who are and where are the shareholders?
– In what currency should we maximize their
wealth?
1-11
Other Goals
 In other countries shareholders are viewed as
merely one among many “stakeholders” of the
firm including:
– Employees
– Suppliers
– Customers
 In Japan, managers have typically sought to
maximize the value of the keiretsu—a family of
firms to which the individual firms belongs.
1-12
Other Goals
 As shown by a series of recent corporate
scandals at companies like Enron, WorldCom,
and Global Crossing, managers may pursue
their own private interests at the expense of
shareholders when they are not closely
monitored.
 These calamities have painfully reinforced the
importance of corporate governance, i.e., the
financial and legal framework for regulating the
relationship between a firm’s management and
its shareholders.
1-13
Other Goals
 These types of issues can be much more serious in
many other parts of the world, especially emerging
and transitional economies, such as Indonesia,
Korea, and Russia, where legal protection of
shareholders is weak or virtually non-existing.
 No matter what the other goals, they cannot be
achieved in the long term if the maximization of
shareholder wealth is not given due consideration.
1-14
Globalization of the World Economy:
Major Trends and Developments
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Emergence of Globalized Financial Markets
Emergence of the Euro as a Global Currency
Europe’s Sovereign Debt Crisis of 2010
Trade Liberalization and Economic Integration
Privatization
Global Financial Crisis of 2008-2009
1-15
Emergence of Globalized Financial
Markets
 Deregulation of Financial Markets
coupled with
 Advances in Technology
– have greatly reduced information and
transaction costs, which has led to:
 Financial Innovations, such as
–
–
–
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Currency futures and options
Multi-currency bonds
Cross-border stock listings
International mutual funds
1-16
Emergence of the Euro as a Global Currency
 A momentous event in the history of world
financial systems.
 Currently more than 300 million Europeans in 16
countries are using the common currency on a
daily basis.
 In May 2004, 10 more countries joined the
European Union.
 The “transaction domain” of the euro may
become larger than the U.S. dollar’s in the near
future.
1-17
Euro Area
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Austria
Belgium
Cyprus
Finland
France
Germany
Greece
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Ireland
Italy
Luxembourg
Malta
The Netherlands
Portugal
Slovenia
Slovakia
Spain
1-18
4/28/2011
12/14/2009
8/1/2008
3/20/2007
11/5/2005
6/23/2004
2/9/2003
9/27/2001
5/15/2000
1/1/1999
Value of the Euro in U.S. Dollars
1.6
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
1-19
Europe’s Sovereign-Debt Crisis of 2010
 In December of 2009 the new Greek government
revealed that its budget deficit for the year would
be 12.7% of GDP, not the 3.7% forecast.
 Investors sold off Greek government bonds and the
ratings agencies downgraded them to “junk.”
 While Greece represents only 2.5% of euro-zone
GDP, the crisis became a Europe-wide debt crisis.
 The challenge remains that fiscal indiscipline of one
euro-zone country can escalate to a Europe-wide
crisis.
1-20
The Greek Drama
 Greece paid no premium above the German rate
until late fall 2009.
 The Greek interest rate rose until the bailout
package on May 9.
1-21
Economic Integration
 Over the past 50 years, international trade
increased about twice as fast as world GDP.
 There has been a change in the attitudes of
many of the world’s governments, who have
abandoned mercantilist views and embraced
free trade as the surest route to prosperity for
their citizenry.
1-22
Privatization
 The selling of state-run enterprises to investors
is also known as “denationalization.”
 Privatization is often seen in socialist economies
in transition to market economies.
 By most estimates, this increases the efficiency
of the enterprise.
 It also often spurs a tremendous increase in
cross-border investment.
1-23
Chinese Privatization
 State-owned enterprises have been listed on
organized stock exchanges.
 More than 1,500 companies are currently listed
on China’s stock exchanges.
 The Chinese government still retains the
majority stakes in most public firms.
 Chinese citizens can buy “A” shares, while
foreigners are limited to “B” shares.
1-24
Global Financial Crisis of 2008—2009
 The “Great Recession” was the most serious,
synchronized economic downturn since the
Great Depression of the 1930s.
 Factors included:
– Households and financial institutions
borrowed too much and took too much risk.
– This risk was repackaged with securitization,
and so defaults on subprime mortgages in the
U.S. came to threaten the solvency of a
teacher’s retirement plans in Norway.
1-25
Global Financial Crisis 2008—2009
 During the course of the crisis, the G-20 emerged
as the premier forum for discussing international
economic issues and coordinating financial
regulations and macroeconomic policies.
1-26
Multinational Corporations
 A multinational corporation (MNC) is a firm
that has been incorporated in one country and
has production and sales operations in other
countries.
 There are about 60,000 MNCs in the world.
 Many MNCs obtain raw materials from one
nation, financial capital from another, produce
goods with labor and capital equipment in a
third country, and sell their output in various
other national markets.
1-27
Top 10 MNCs
1
General Electric
United States
2
Royal Dutch/Shell Group
UK/Netherlands
3
Vodafone Group PLC
United Kingdom
4
British Petroleum Co. PLC
United Kingdom
5
Toyota Motor Corporation
Japan
6
ExxonMobile Corporation
United States
7
Total
France
8
E.ON AG
Germany
9
Electricité De France
France
10
ArcelorMittal
Luxembourg
1-28
The Theory of Comparative
Advantage
 A comparative advantage exists when one party can
produce a good or service at a lower opportunity
cost than another party.
 The opportunity cost of making one additional
unit of a good (or service) can be defined as the
value of some other good that you have to give up
in order to produce this additional unit.
– For example, if you can work as many hours as you like
at your current employer and get paid $10 per hour,
then the opportunity cost of your leisure is $10 per
hour.
1-29
Arguments in Favor of Free Trade
 Both partners gain from trade; we have more
material goods.
 “Freedom” is a good thing in and of itself.
– In this case, consumers have the freedom to
choose imported goods and producers have
the freedom to choose to sell to foreigners.
1-30
Evolution of the
International Monetary System
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Bimetallism: Before 1875
Classical Gold Standard: 1875-1914
Interwar Period: 1915-1944
Bretton Woods System: 1945-1972
The Flexible Exchange Rate Regime: 1973Present
1-31
Bimetallism: Before 1875
 Bimetallism was a “double standard” in the
sense that both gold and silver were used as
money.
 Some countries were on the gold standard,
some on the silver standard, and some on both.
 Both gold and silver were used as an
international means of payment, and the
exchange rates among currencies were
determined by either their gold or silver
contents.
1-32
Gresham’s Law
 Gresham’s Law implies that the least valuable
metal is the one that tends to circulate.
 Suppose that you were a citizen of Germany
during the period when there was a 20 German
mark coin made of gold and a 5 German mark
coin made of silver.
– If gold suddenly and unexpectedly became
much more valuable than silver, which coins
would you spend if you wanted to buy a 20mark item and which would you keep?
1-33
Classical Gold Standard: 1875-1914
 During this period in most major countries:
– Gold alone was assured of unrestricted
coinage.
– There was two-way convertibility between
gold and national currencies at a stable ratio.
– Gold could be freely exported or imported.
 The exchange rate between two country’s
currencies would be determined by their
relative gold contents.
1-34
Classical Gold Standard: 1875-1914
For example, if the dollar is pegged to gold at
U.S. $30 = 1 ounce of gold, and the British
pound is pegged to gold at £6 = 1 ounce of gold,
it must be the case that the exchange rate is
determined by the relative gold contents:
$30 = 1 ounce of gold = £6
$30 = £6
$5 = £1
1-35
Classical Gold Standard: 1875-1914
 Highly stable exchange rates under the classical
gold standard provided an environment that
was conducive to international trade and
investment.
 Misalignment of exchange rates and
international imbalances of payment were
automatically corrected by the price-specie-flow
mechanism.
1-36
Price-Specie-Flow Mechanism
 Suppose Great Britain exports more to France than
France imports from Great Britain.
 This cannot persist under a gold standard.
– Net export of goods from Great Britain to France will
be accompanied by a net flow of gold from France to
Great Britain.
– This flow of gold will lead to a lower price level in
France and, at the same time, a higher price level in
Britain.
 The resultant change in relative price levels will
slow exports from Great Britain and encourage
exports from France.
1-37
Interwar Period: 1915-1944
 Exchange rates fluctuated as countries widely
used “predatory” depreciations of their
currencies as a means of gaining advantage in
the world export market.
 Attempts were made to restore the gold
standard, but participants lacked the political
will to “follow the rules of the game.”
 The result for international trade and
investment was profoundly detrimental.
1-38
Bretton Woods System: 1945-1972
 Named for a 1944 meeting of 44 nations at
Bretton Woods, New Hampshire.
 The purpose was to design a postwar
international monetary system.
 The goal was exchange rate stability without the
gold standard.
 The result was the creation of the IMF and the
World Bank.
1-39
Bretton Woods System: 1945-1972
British
pound
German
mark
French
franc
Par
Value
• The U.S. dollar was
pegged to gold at
$35 /ounce and other
currencies were pegged
to the U.S. dollar.
U.S. dollar
Pegged at $35/oz.
Gold
1-40
The Flexible Exchange Rate Regime:
1973-Present
 Flexible exchange rates were declared
acceptable to the IMF members.
– Central banks were allowed to intervene in
the exchange rate markets to iron out
unwarranted volatilities.
 Gold was abandoned as an international reserve
asset.
 Non-oil-exporting countries and less-developed
countries were given greater access to IMF
funds.
1-41
Current Exchange Rate Arrangements
 Free Float
– The largest number of countries, about 33, allow
market forces to determine their currency’s value.
 Managed Float
– About 46 countries combine government
intervention with market forces to set exchange rates.
 Pegged to another currency
– Such as the U.S. dollar or euro.
 No national currency
– Some countries do not bother printing their own
currency. For example, Ecuador, Panama, and El
Salvador have dollarized. Montenegro and San
Marino use the euro.
1-42
Current Exchange Rate Arrangements
 Currency Board
– Fixed exchange rates combined with restrictions on
the issuing government.
– Eliminates central bank functions such as monetary
policy and lender of last resort (e.g., Hong Kong).
 Conventional Peg
– Exchange rate publicly fixed to another currency or
basket of currencies.
– Country buys or sells foreign exchange or uses other
means to control the price of the currency (e.g., Saudi
Arabia, Jordan, and Morocco).
1-43
Current Exchange Rate Arrangements
 Stabilized Arrangement
– A spot market exchange rate that remains within a
margin of 2 percent for six months or more and is not
floating (e.g., China, Angola, and Lebanon).
 Crawling Peg
– Like the conventional peg, but the crawling peg is
adjusted in small amounts at a fixed rate of change or
in response to changes in macro indicators, (e.g.,
Bolivia, Iraq, and Nicaragua).
1-44
The Value of the U.S. Dollar since 1960
1-45
The Euro
 The euro is the currency of the European
Monetary Union, adopted by 11 Member States
on January 1, 1999.
 There are 7 euro notes and 8 euro coins.
 The notes are: €500, €200, €100, €50, €20, €10,
and €5. The coins are: 2 euro, 1 euro, 50 euro
cent, 20 euro cent, 10, euro cent, 5 euro cent, 2
euro cent, and 1 euro cent.
 The euro itself is divided into 100 cents, just like
the U.S. dollar.
1-46
The Long-Term Impact of the Euro
 As the euro proves successful, it will advance
the political integration of Europe in a major
way, eventually making a “United States of
Europe” feasible.
 It is possible that the U.S. dollar will lose its
place as the dominant world currency.
 The euro and the U.S. dollar will be the two
major currencies.
1-47
Costs of Monetary Union
 The main cost of monetary union is the loss of
national monetary and exchange rate policy
independence.
– The more trade-dependent and less
diversified a country’s economy is, the more
prone to asymmetric shocks that country’s
economy would be.
1-48
The Mexican Peso Crisis
 On December 20, 1994, the Mexican government
announced a plan to devalue the peso against
the dollar by 14 percent.
 This decision changed currency trader’s
expectations about the future value of the peso,
and they stampeded for the exits.
 In their rush to get out the peso fell by as much
as 40 percent.
1-49
The Mexican Peso Crisis
 The Mexican Peso crisis is unique in that it
represents the first serious international financial
crisis touched off by cross-border flight of
portfolio capital.
 Two lessons emerge:
– It is essential to have a multinational safety
net in place to safeguard the world financial
system from such crises.
– An influx of foreign capital can lead to an
overvaluation in the first place.
1-50
The Asian Currency Crisis
 The Asian currency crisis turned out to be far
more serious than the Mexican peso crisis in
terms of the extent of the contagion and the
severity of the resultant economic and social
costs.
 Many firms with foreign currency bonds were
forced into bankruptcy.
 The region experienced a deep, widespread
recession.
1-51
The Asian Currency Crisis
1-52
Origins of the Asian Currency Crisis
 As capital markets were opened, large inflows of
private capital resulted in a credit boom in the
Asian countries.
 Fixed or stable exchange rates also encouraged
unhedged financial transactions and excessive
risktaking by both borrowers and lenders.
 The real exchange rate rose, which led to a
slowdown in export growth.
 Also, Japan’s recession (and yen depreciation)
hurt.
1-53
The Asian Currency Crisis
 If the Asian currencies had been allowed to
depreciate in real terms (not possible due to the
fixed exchange rates), the sudden and catastrophic
changes in exchange rates observed in 1997 might
have been avoided
 Eventually something had to give—it was the Thai
bhat.
 The sudden collapse of the bhat touched off a
panicky flight of capital from other Asian countries.
1-54
Lessons from the Asian Currency Crisis
 A fixed but adjustable exchange rate is
problematic in the face of integrated
international financial markets.
– A country can attain only two the of three
conditions:
1. A fixed exchange rate.
2. Free international flows of capital.
3. Independent monetary policy.
1-55
China’s Exchange Rate
 China maintained a fixed exchange rate between the renminbi (RMB) yuan
and the U.S. dollar for a long time.
– The RMB floated between 2005 and 2008 and then again starting in 2010.
 There is mounting pressure from China’s trading partners for a stronger
RMB.
1-56
Potential as a Global Currency
 For the RMB to become a full-fledged global
currency, China will need to satisfy these
conditions:
– Full convertibility of its currency.
– Open capital markets with depth and
liquidity.
– The rule of law and protection of property
rights.
 The United States and the euro zone satisfy these
conditions.
1-57
The Argentinean Peso Crisis
 In 1991 the Argentine government passed a
convertibility law that linked the peso to the U.S.
dollar at parity.
 The initial economic effects were positive:
– Argentina’s chronic inflation was curtailed.
– Foreign investment poured in.
 As the U.S. dollar appreciated on the world
market the Argentine peso became stronger as
well.
1-58
The Argentinean Peso Crisis
 However, the strong peso hurt exports from
Argentina and caused a protracted economic
downturn that led to the abandonment of peso–
dollar parity in January 2002.
– The unemployment rate rose above 20
percent.
– The inflation rate reached a monthly rate of 20
percent.
1-59
The Argentinean Peso Crisis
 There are at least three factors that are related to
the collapse of the currency board arrangement
and the ensuing economic crisis:
– Lack of fiscal discipline.
– Labor market inflexibility.
– Contagion from the financial crises in Brazil
and Russia.
1-60
Currency Crisis Explanations
 In theory, a currency’s value mirrors the
fundamental strength of its underlying economy,
relative to other economies, in the long run.
 In the short run, currency trader expectations play a
much more important role.
 In today’s environment, traders and lenders, using
the most modern communications, act on fight-orflight instincts. For example, if they expect others
are about to sell Brazilian reals for U.S. dollars, they
want to “get to the exits first.”
 Thus, fears of depreciation become self-fulfilling
prophecies.
1-61
Fixed versus Flexible Exchange Rate
Regimes
 Arguments in favor of flexible exchange rates:
– Easier external adjustments.
– National policy autonomy.
 Arguments against flexible exchange rates:
– Exchange rate uncertainty may hamper
international trade.
– No safeguards to prevent crises.
1-62
Fixed versus Flexible Exchange Rate
Regimes
 Suppose the exchange rate is $1.40/€ today.
 In the next slide, we see that demand for the euro
far exceeds supply at this exchange rate.
 The United States experiences trade deficits.
 Under a flexible exchange rate regime, the dollar
will simply depreciate to $1.60/€, the price at which
supply equals demand and the trade deficit
disappears.
1-63
Dollar price per €
(exchange rate)
Fixed versus Flexible Exchange Rate
Regimes
$1.60
$1.40
Supply
(S)
Dollar depreciates
(flexible regime)
Demand
(D)
Trade deficit
QS
Q D = QS
QD
Q of €
1-64
Fixed versus Flexible Exchange Rate
Regimes
 Instead, suppose the exchange rate is “fixed” at
$1.40/€, and thus the imbalance between supply
and demand cannot be eliminated by a price
change.
 The government would have to shift the
demand curve from D to D*.
– In this example, this shift corresponds to
contractionary monetary and fiscal policies.
1-65
Dollar price per €
(exchange rate)
Fixed versus Flexible Exchange Rate
Regimes
Supply
(S)
Contractionary
policies
(fixed regime)
Demand (D)
$1.40
Demand (D*)
QD* = QS
Q of €
1-66