international financial mannagement-icfp

International Financial Management ________________________________________________

@ 2007 International College of financial Planning Ltd.

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INTERNATIONAL FINANCIAL MANAGEMENT

By

Dr. Vinod Kumar Mithilesh Kumar



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Contents: � International Trade Theories…………………………..…..4 � Balance of Payment……………………………………….20 � Exchange rate theories……………………………………30 � Foreign Exchange Exposure Measurement……….……..39 � Multinational Capital Budgeting …………………………....48 � Multinational Corporation………………………….……….52 � Political Risk Management ………………………..………62 � International Portfolio Investment……………………….69 � Foreign Exchange Market………………………….…….76 � Transfer Pricing ………………………………………..…86 � Interest rate Swaps …………………………………….93 � International Monetary System ………………………..100 � Financial Deregulation………………………………….143



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INTERNATIONAL FINANCE When once we have recognized how close is the connection between finance and trade, we have gone a long way towards seeing the greatness of the service that finance renders to mankind, whether it works at home or abroad. At home we owe our factories and our railways and all the marvelous equipment of our power to make things that are wanted, to the quiet, prosaic, and often rather mean and timorous people who have saved money for a rainy day, and put it into industry instead of into satisfying their immediate wants and cravings for comfort and enjoyment . Abroad, the work of finance has been even more advantageous to mankind, for since it has been shown that international finance is a necessary part of the machinery of international trade, it follows that all the benefits, economic and other, which international trade has wrought for us, are inseparably and inevitably bound up with the progress of international finance. For the present we are concerned with the benefits of international finance, which have been shown to begin with its enormous importance as the handmaid of international trade. Trade between nations is desirable for exactly the same reason as trade between one man and another, namely, that each is, naturally or otherwise, better fitted to grow or make certain things, and so an exchange is to their mutual advantage. If this is so, as it clearly is, in the case of two men living in the same street, it is evidently very much more so in the case of two peoples living in different climates and on different soils, and so each of them, by the nature of their surroundings, able to make and grow things that are impossible to the other International trade and finance, if given a free hand, may be trusted to bring about, between them, the utmost possible development of the power of the world to grow and make things in the places where they can be grown and made most cheaply and abundantly, in other words, to secure for human effort, working on the available raw material, the greatest possible harvest as the reward of its exertions.



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Introduction to Trade Theory:

The first purpose of trade theory is to explain observed trade. That is, we would like to be able to start with information about the characteristics of trading countries, and from those characteristics deduce what they actually trade, and be right. That’s why we have a variety of models that postulate different kinds of characteristics as the reasons for trade.

Secondly, it would be nice to know about the effects of trade on the domestic economy.

A third purpose is to evaluate different kinds of policy. Here it is good to remember that most trade theory is based on neoclassical microeconomics, which assumes a world of atomistic individual consumers and firms. The consumers pursue happiness (“maximizing utility”) and the firms maximize profits, with the usual assumptions of perfect information, perfect competition, and so on. In this world choice is good, and restrictions on the choices of consumers or firms always reduce their abilities to optimize. This is essentially why this theory tends to favor freer trade.

Varieties of Theory:

Neoclassical theory has been successful because it is simple (though it may not always look simple when you’re learning it). For example most neoclassical trade theories assume that the world only has two countries (which means that country A’s exports must be country B’s imports). They also usually assume only two commodities in international trade. If you try to “generalize” by adding more countries or commodities, the math breaks down and you don’t get clear results.

One of the most important, and limiting, assumptions in neoclassical trade theory is that firms produce under conditions of perfect competition. Any industry that is controlled by a small number of firms is not perfectly competitive. There is a whole area of economics, initially developed by Joan Robinson in the 1920's, that explores what happens under imperfect competition. We won’t get into it in this course, but if there are significant “economies of scale” (which means that per-unit costs are smaller for bigger firms), then you can get very different policy recommendations out of your model.

Does this mean that the simple neoclassical models are useless? No. Their most important use is as a way to help you think through a set of issues. Neoclassical theory is especially good at pointing out the links between different markets. But you should be suspicious if you hear anyone saying that a theory “shows” that one policy or another is the right one in the real world.

The most famous neoclassical model is also the simplest — the model developed by the English political economist David Ricardo in the early 1800s. It’s simple because Ricardo assumes that there is only one “factor of production” (i.e. type of input) — labor. This model makes the point that trade should, in principle, benefit both parties even if one is more efficient. More sophisticated models were developed in the current century as economists learned more math. The best-known is the Heckscher-Ohlin model, named after a couple of Swedish economists, which is often called Heckscher-Ohlin-Samuelson (HOS) because of the important contributions made by the U.S. economist Paul Samuelson. HOS includes two factors of production (e.g. labor and land), and it shows that particular factors of production may be hurt by trade, though it still agrees with Ricardo that there are overall gains from trade.



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There are many other varieties of trade theory, making different assumptions and getting different results. One kind that has gotten a lot of attention in recent years assumes increasing returns to scale, which means that large producers are more efficient than smaller producers. Ricardo, as noted above, assumed constant scale returns. Neoclassical theories like HOS assume decreasing returns and get generally similar results. If you allow increasing returns then bigger is better, and one nation may end up dominating an industry, but it's hard to say which nation will do so. In this case, the ability to intimidate and bluff may be important. So increasing returns undermines the ability of theory to explain or predict observed trade. Perhaps more seriously, scale economies may stack the deck against late-developers.

A One-factor World: The Ricardian Model:

The Production Possibility Frontier (PPF):

This is a simple way of thinking about what a nation can produce and consume. Under conditions of no trade (sometimes called "autarky") what a country produces and what it consumes must be identical. Trading provides the possibility of consuming a different "bundle" of goods and services from that which you produce.

Start with the small country of Utopia -- a country that represents a small enough part of world markets that international market prices will not change appreciably whether it trades or not. Let's start with a simple straight-line ppf, based on the assumption that Utopia has a fixed endowment of 1,000 units of labor, and that it requires 100 units to build a motor car, and 1 unit to make a bar of chocolate. (Assume that these are the only commodities in existence.)

In that case, its ppf, and the shaded are that represents the set of (motor car, chocolate) bundles that it can consume, can be drawn as follows:

If you are not clear on how we got this graph, take a look at these notes on the PPF.

(If you already know some microeconomics you might want to look at this note on indifference curves, but it's not essential here.)

Trade

Now suppose that Utopia decides to trade. It will find that cars and chocolate are traded at some price ratio in the international economy. Since there are only 2 goods, it's easy enough just to assume a barter economy, with prices for

cars being quoted in terms of chocolate and vice versa. Thus the price within Utopia, prior to trade, would be that one car sells for 100 chocolate bars, and vice versa.



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Let us suppose that in the international economy, one car sells for 200 chocolate bars. In that case Utopia can maximize its set of consumption possibilities by specializing in cars, producing no chocolate, and trading cars for chocolate. Thus is shown below.

If instead the international price ratio were one car to 50 chocolate bars, then Utopia would be better off specializing in chocolate and trading for cars. If by chance the international price ratio were one car to 100 chocolate bars, then Utopia would gain nothing by trading. But it still would be no worse off. The core point is that under trade, the set of points representing Utopia's possible consumption bundles is no smaller than the set before trade, and is almost certainly larger.

(If you know some microeconomics you can the effects of trade with a set of indifference curves here.)

Be able, if given information about the international price ratio, to show on a graph what the country should produce, and what are its possible consumption points. Also be able to say what the slope of the pre-trade ppf shows (essentially the ability to substitute between goods, given existing technology and the assumption that we produce as much of both goods as we can) and what the slope of the "trading line" shows -- the international price ratio. Be clear on the difference between being on and inside your ppf.

Comparative, Not Absolute, Advantage:

Now please notice something else. All Utopia cares about, in international trade, is the ratio at which it can trade chocolate for cars (and vice versa) or terms of trade. It does not care what lies behind those ratios in terms of how other countries use their resources. Take the international price ratio of 200 chocolate bars to one motor car that we supposed above. Suppose

• the international economy can produce a car with 50 units of labor and a bar of chocolate with 1/4 of a unit of labor (i.e. it's more efficient in both goods)

• the international economy can produce a car with 150 units of labor and a bar of chocolate with 3/4 of a unit of labor (i.e. it's more efficient in chocolate than Utopia, less efficient in cars)



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• the international economy can produce a car with 2000 units of labor and a bar of chocolate with 5 units of labor (i.e. the international economy is way less efficient in both)

All of these possibilities produce the same international price ratio, which is all Utopia cares about. Example b above corresponds to Adam Smith's "absolute advantage." But a,b, and c all fall under David Ricardo's broader notion of "comparative advantage."

Be able to define comparative advantage and distinguish it from absolute advantage. Here's one definition of comparative advantage, adapted from Todaro’s textbook: "A country has a comparative advantage over another if in producing a commodity it can do so at a relatively lower opportunity cost in terms of the foregone alternative commodities that could be produced. Taking two countries, A and B, each producing two commodities, X and Y, country A is said to have a comparative advantage in producing X if, in order to make another unit of X, it has to give up fewer units of Y than would be the case in country B.

To summarize: without trade, getting more of one good means giving up some of the other good according to a fixed ratio. With trade, you have the possibility of another ratio: the international price ratio of the two goods. If this ratio is at all different from the domestic ratio, you can gain from trade. The core result of this theory is theory is that all that matters is the ratios, not the absolute amounts of labor required to produce the goods. No matter how wretched you are, you will almost certainly have a comparative advantage in one or the other good, and you should produce that and trade for the other good. Hence this is more general and powerful than Smithian “absolute advantage.”

Assessment:

The core insight of Ricardo is that trade gives a country more options in terms of what to do with its productive apparatus. Without trade, if we want more chocolate, we have to pull resources out of making something else and put them to work on chocolate. With trade we have the additional possibility of making something that is in demand abroad and trading it for chocolate.

But there are also a couple of blind spots that this theory has in common with a lot of trade theories. First, we talk rather loosely about “us” or the well-being of an entire country. But countries are made up of a lot of different people, and the benefits or costs of a change in trade policy are seldom very evenly spread. Second, this theory only makes sense if countries use their resources fully — in graphical terms, if they are on their PPF. If there are idle resources, then the effects of trade are not clear.

Also remember that the Ricardian comparative advantage model assumes:

• constant costs: no matter whether Utopia is making a lot of cars or very few, the amount of labor per car is the same. A more formal way of putting this is constant returns to scale.

• easy movement of factors of production between different industries: when Utopia decides to specialize in cars and stop making chocolate, the chocolate workers have no trouble finding employment in car-making. Many anti-liberalization arguments focus in on this question.

• factors of production cannot move between countries.



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What does the comparative advantage approach predict? Nations should specialize in making what they are relatively good at, and import other things. For that reason you would expect countries to import and export very different things. What policies tend to follow from a comparative advantage approach? Broadly, that nation should not try to restrict imports.

Two-Factor World: The Heckscher-Ohlin-Samuelson Model

Initial Assumptions

The Ricardian model supposed a world of 2 countries, 2 goods, and 1 factor of production. In the Heckscher-Ohlin-Samuelson (HOS) model we have a world with 2 countries, 2 goods, and 2 factors. Each country has a free-market economy consisting of consumers and competitive firms. The only point of contact between countries is trade in goods: factors can not move between countries. We assume that technologies are identical, but that each good uses one of the factors more intensively.

In this diagram we have two countries, Angola and Botswana, two goods, shoes and potatoes, and two factors, land and labor. Shoes are a relatively labor-intensive good, requiring only a little land to graze cattle for hides, but a lot of labor. Potatoes need a lot of land and only some labor. Note that in this diagram the two countries differ by theor relative endowments of factors: Angola has a lot of land and not much labor; Botswana has a lot of labor and not much land. In this picture they do not trade.

Now these two countries, which had previously sealed their borders, begin trading. Basically, each specializes. The country with a lot of labor specializes in the labor-intensive good, and vice versa. Here is how the diagram would change:



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We can show the same process by using production possibility frontiers for the two countries.

The diagram shows how production and consumption change with trade. Here is an annotated version of the Angola diagram in the picture above, which may make it clearer:



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The numbers are just added to help the explanation. Note that Angola's trade has to be the opposite of Botswana's.

Factor-Price Equalization

Let’s go back to the pre-trade situation. Without trade, labor is relatively scarce in Angola and we would expect it to command a high price. But in Botswana, labor is plentiful while land is scarce. We would expect the relative payments that these factors receive to reflect this. So in Angola the annual wage might be twice the annual rent on an acre of land, while in Botswana the annual wage might be one-half the annual rent on an acre.

You can see this is in the shapes of the PPFs above. Before trade, a pair of shoes might trade for ten bushels of potatoes in Angola, but for only two bushels in Botswana. Since labor is more intensively used in shoes, labor's reward relative to land will be higher in Angola.

With trade, this changes. Angola does not have to rely on its own scarce labor to make shoes. It can use its plentiful land to make potatoes, and trade potatoes for Botswanan shoes instead. Angolan wages will fall (relative to Angolan rents).

The reverse happen in in Botswana.



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Further Implications

The HOS model has two basic implications, illustrated above:

� Under free trade, countries tend to export the good that uses their relatively- abundant factor & relatively intensively.

� Under free trade, relative factor prices will be the same in all countries.

There are two further implications about how prices and trading patterns change. One is that if a country's factor endowments change, its trade will change as well. Suppose Angola's labor force grew while all other factor endowments remained unchanged.

Angola will now be somewhat less reliant on trade, having a less skewed factor endowment than before. It will make more shoes, and slightly fewer potatoes, than it did before.

seems reasonable to expect that this change would also affect the international price, expecially if our world consists of only two countries. If previously the international price was 5 bushels of potatoes per pair of shoes, now it might go to only 4 bushels per pair. Botswana will now make a few more potatoes and a few fewer shoes. Here is the corresponding. block diagram. Essentially the trading pattern is the same but volume of trade is less



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Finally, what happens to relative factor prices? If the relative price of the two traded goods changes for any reason, then the factor that is used relatively more intensively in the good that is now more expensive will benefit. The factor that is used relatively more intensively in the good that is now cheaper will lose. Thus the fact that shoes are now relatively cheaper ends up hurting labor everywhere. (This is a "long-run" result, once land and labor have had the time to move between industries.) Thus the relative abundance of land and labor in Angola have an effect on the relative returns to land and labor in Botswana, even though the land and labor markets are not directly linked -- workers cannot move from one country to the other, for example.



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Tariff :

A tariff is a fee assessed on imports. This can be imposed in various ways but we’ll stick with the “specific tariff,” a simple per-unit charge. The tariff represents a per-unit charge that has to be paid to the government by whomever brings the good across the border and into the country. If there is a $1,000 tariff on imported automobiles, then no new car can be imported into the United States without paying $1,000 to customs agents as it is brought in.

To do our analysis, we have to know whether the international price of the good in question will be affected by changes in our demand for it. The easiest case is the “small country” in which the international price will not change when our demand for the good changes, so we can treat it as a given. Suppose we are the nation of Monaco, and we are importing tubas. Let us suppose that the standard international price of a tuba is $200. This is a price which is not going to fall if we demand fewer tubas, or rise if we demand more, because we represent an insignificant part of the total global tuba market.

What does it mean? First, the assumption we just made of an unchanging international price is reflected in the horizontal foreign supply schedule. Whether we buy one foreign made tuba or 500, foreign suppliers will always ask $200 per tuba. (Monaco is to the world tuba market as I am to the Seattle espresso market: if I double my espresso intake, the price of espresso will not rise.)

Second, there are also domestic tuba producers, who show up as a domestic supply schedule. What this curve says is the higher the price that domestic tuba makers can get, the larger the quantity they will be willing to supply. We usually base this, in micro, on the assumption that producers face rising per-unit costs of

making goods. As drawn, the first tuba costs $101 to make, the second $102, the third $103, and the hundredth $200. If domestic producers made 101 tubas, the 101st tuba would cost them $201 to manufacture. So if the price they can get is only $200 per tuba, they will make only 100 tubas, not 101 tubas. (Remember that we assume prefect competition in this simple micro model, in which individual suppliers take the price they observe in the market as given and react accordingly.)

Finally, we have a demand schedule, the thick line which represents the quantity of tubas that consumers in Monaco will buy at each different price. (Review the market model: Why do consumers buy larger amounts of tubas at lower prices? If there were no foreign tubas permitted, what would be the quantity of tubas produced and sold in Monaco? At what price? Why?)



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If there are no restrictions whatever on tuba imports, what happens? Well, it’s pretty clear that there will be imports, and that the market price will be $200. Look at the demand schedule. Buyers have no reason to pay more than $200, because they can always get an imported tuba for $200. Domestic producers have no reason to sell for less than $200. In these conditions domestic suppliers will make 100 tubas, domestic consumers will buy 400, and imports of 300 will make up the difference between domestic demand and domestic supply.

Be sure you can see this before moving on. Think about why domestic producers, foreign producers, and domestic consumers behave as they do.

Now let us suppose that the Monagesque Tuba Maker’s Society bribes enough politicians to have a $50 tariff imposed on each imported tuba. This means that while the international price remains $200, the price that consumers within Monaco face for an imported tuba now rises to $250. What will the new domestic price be? The new domestic quantities demanded and supplied? How much will imports be?

The diagram shows the effect of this tariff on the domestic price and the quantities consumed, produced by the domestic industry, and imported. Who gains? Who loses?



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We can deepen the analysis of gains and losses from the tariff by using a couple of ideas from microeconomics. Think, first, about the suppliers of a good — take the example of the domestic suppliers in the example above. Their total revenue received is quantity (150) times price ($250) or $37,500.

What of their costs? From the above description of the supply curve, the first unit cost them $100, the second $101, and so on. Adding up these costs to make each unit gives you the area under the supply schedule, up to Q=150, as the cost of making 150 units. Don’t worry about the exact cost

and profit numbers in the example, but see if you can make sense of the idea that the region underneath the supply curve represents total (variable) costs (there's another category called fixed costs; don't worry about that now). The difference between total revenue and these costs is “producer surplus.”

What did the introduction of a tariff do to domestic producers’ surplus?

We can introduce an analogous concept of “consumer surplus,” though the reasoning may seem a bit less concrete. Start with a very simple market model like this

In this example consumers actually paid $60,000 for 300 widgets at $200 per widget. But how much were those widgets actually worth to the consumers? Look at the demand curve. It tells us, for example, that had the market price been $300 rather than $200, 100 people would still have bought widgets. If the price had been $400, 1 person would have bought one widget — there’s one person in the economy for whom a widget is actually worth $400, then another person who would buy a widget at $399, and so on. So when widgets are actually sold for only $200, the people who would have paid a higher price, if they had been required to, actually get widgets for less. And they are

very, very happy. So, we can add up a triangle, as shown, of what people would have paid but did not have to, and call that “consumers’ surplus.” Now we can put our analysis together. When the domestic price rose in our Monaco example, that reduced consumers’ surplus by the amount of the shaded area shown below.



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So the first losers in our story are consumers in Monaco. They pay more, and we can use the shaded area as a measure of how much worse off consumers are after this tariff. The question follows, as night the day: was consumers’ loss someone else’s gain? The answer is for the most part yes. Part of what consumers lost was gained by government, and part by domestic producers

What of the remaining two little triangles? Those are termed “deadweight loss,” meaning that they are a loss that is nobody else’s gain.

We now have a geometrical way to talk about who gains and who loses from a tariff. Our answer in this case is that domestic consumers lose, but that most of that loss is made back by the protected firms and by government — another way to put it is that there is a transfer from consumers to government and protected firms. A Tariff in a Large Country In the case of a large country which consumes a significant part of global production of a good, it is reasonable to assume that the foreign supply schedule slopes up, rather than being a horizontal line.

For ease in exposition, we’re going to assume that this is a good that is not domestically produced in the country in question, so we don’t have to deal with a domestic supply curve. Let’s suppose we are looking at U.S. demand for coffee. Without restrictions, we end up at a market equilibrium of $4 a pound and 200 million pounds sold. Now let us suppose that the U.S. government imposed a $2 tariff on every pound of coffee. The



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result would be that U.S. consumers would end up paying $2 more per pound than foreign producers received. The market would end up an equilibrium like this, with a quantity demanded and supplied at which the price paid by consumers was exactly $2 higher than the price received by the foreign suppliers. Now we can use our analytical apparatus, developed above, to examine the winners and losers. As in the earlier example, there has been a loss in consumers’ surplus, as shown in the green area below: coffee is more expensive than before, some people can no longer afford it, and those who still can are paying more than they used to. So once again consumers, clearly, are losers.

Government, however, has gained quite a lot in the form of tariff revenue — $300 million, in this case (the cross-hatched area). The government’s $300 million gain more than offsets the $175 million of lost consumer surplus.

Foreign producers, finally, lose. the tariff forces them down their supply curve, and they end up exporting less coffee and selling it for a lower price. So they suffer a loss in producer surplus of $175 million. The total losses exceed the gains, but the loss in producers’ surplus is suffered by foreigners and — ha ha! — we don’t care about them. From a purely national point of view (in this example), this tariff has produced a net gain. You can see from this why reductions in tariffs

often have to be negotiated reciprocally between countries



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Quota :

A quota (or quantitative restriction) is a limit on the quantity of a good that is allowed to enter a country.

Look first at the coffee example that we used to illustrate the large-country tariff.

Suppose that instead of assessing a tariff, the U.S. government allowed only 150 million pounds of coffee to be imported each year. What would happen? The supply curve tells us that the foreign suppliers would be able to supply this much coffee at a price of $3 a pound, but why should they charge such a low price? A glance at the demand curve tells them that they can get rid of 150 million pounds at a price of $5 a pound. In other words at $5 a pound they can sell all the coffee they are allowed to export to us, so that’s the price they will charge. Bottom line: we end up with the same loss of consumers’ surplus as in the tariff above — $175 million. The net effect on foreign suppliers is the combination of the loss of the same light blue-shaded region that we

saw in this diagram in the tariff analysis

(-$175 million), plus the gain of $300 million in extra profits from being able to charge a higher price — the same area as the one the government got in tariffs in the previous example.

So with the simple quota consumers lose, government gets nothing, and foreign producers may actually gain. (Whether foreign producers make a net gain as compared to free trade depends on the size of the quota and the slopes of the curves — you can see for example that if the quota were a lot smaller, say only 5 million pounds, then foreign producers would make a net loss.) The government could make back some or even all of this by selling import licenses, but we won’t worry much about that. Now let’s go back to our Monaco tuba market example. Suppose that instead of imposing a tariff on imported tubas of $50, the government imposed a quota:



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No more than 225 tubas could be imported each year. Again, remember that the foreign tuba makers aren’t stupid, and will charge whatever price they can get. The result again looks strangely familiar.

We will end up with the same change in domestic price and in total quantity sold domestically. Here, since we have domestic producers, the results for them will be exactly the same as in the tariff example discussed earlier. So the fall in consumer surplus, and the gain in producers’ surplus for domestic producers, are identical with the tariff analysis developed above. The difference is that the tariff revenue that was gained by government is gained instead by foreign suppliers.

So in terms of domestic price and total quantity sold, and in particular in terms of the amount of the domestic market you preserve for domestic manufacturers, you can get exactly the same result with a tariff as with a quota. The key advantage with a tariff is that the government gets revenue, which it gives up with a simple quota.

Why would any sane government use quotas? Mainly because they provide a greater capacity to fine-tune imports. If the purpose of a restriction is to stop the decline of an import-threatened domestic industry, it’s fairly easy to work out how much that industry wants to sell, how much



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imports are, and how big a quota you need, and you can adjust that quota from month to month. Figuring out the tariff that will do the same job requires that you know where the supply and demand curves are, which can be hard to figure out.



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Balance of payments: According to Sodersten: “The Balance of payment is merely a way of listing receipts & payments in international transaction for a country “ The balance of payments, or balance of international payments, is an accounting statement of the economic transactions that have taken place between the residents of one country (including its government) and the residents of other countries during a specified time, usually a year or a quarter. The term also refers to the difference between receipts and payments in some categories of international transactions, often merchandise trade or the current account. This in turn may be the subject of economic analysis (what explains the state of this balance or what the consequences of such a balance are) and the object of government policy (how to attain what is judged to be a desirable state of this balance). The balance-of-payments statement is based on double-entry bookkeeping in which each economic transaction gives rise to a credit and a debit. Any transaction which results in a receipt from foreigners is entered as a credit and is given a positive sign. Any transaction which results in a payment to foreigners is entered as a debit and is given a negative sign. A record of all transactions made between one particular country and all other countries during a specified period of time. BOP compares the dollar difference of the amount of exports and imports, including all financial exports and imports. A negative balance of payments means that more money is flowing out of the country than coming in, and vice versa. Balance of payments may be used as an indicator of economic and political stability. For example, if a country has a consistently positive BOP, this could mean that there is significant foreign investment within that country. It may also mean that the country does not export much of its currency. This is just another economic indicator of a country's relative value and, along with all other indicators, should be used with caution. The BOP includes the trade balance, foreign investments and investments by foreigners. The balance of payments (or BOP) measures the payments that flow between any individual country and all other countries. It is used to summarize all international economic transactions for that country during a specific time period, usually a year. The BOP is determined by the country's exports and imports of goods, services, and financial capital, as well as financial transfers. It reflects all payments and liabilities to foreigners (debits) and all payments and obligations received from foreigners (credits )The balance of payments (BOP) is the method countries use to monitor all international monetary transactions at a specific period of time. Usually, the BOP is calculated every quarter and every calendar year. All trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how much money is going in and out of a country. If a country has received money, this is known as a credit, and, if a country has paid or given money, the transaction is counted as a debit. Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance. But in practice this is rarely the case and, thus, the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the discrepancies are stemming.



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The Balance of Payments Divided The BOP is divided into three main categories: the current account, the capital account and the financial account. Within these three categories are sub-divisions, each of which accounts for a different type of international monetary transaction The Balance of Payments for a country is the sum of the Current account, the Capital account, the financial account, and the change in Official Reserves.

Current account: The current account is the sum of net sales from trade in goods and services, net factor income (such as interest payments from abroad), and net unilateral transfers from abroad. Positive net sales from abroad correspond to a current account surplus; negative net sales from abroad correspond to a current account deficit. Because exports generate positive net sales, and because the trade balance is typically the largest component of the current account, a current account surplus is usually associated with positive net exports. The Income Account or Net Factor Income, a sub account of the Current Account, is usually presented under the headings "Income Payments", as outflows, and "Income Receipts", as inflows. If the Income Account is negative, the country is paying more than it is taking in interest, dividends, etc. For example, the United States' net income has been declining exponentially since it allowed the Dollar's price relative to other currencies be determined by the market to a point where income payments and receipts are roughly equal. The various subcategories in the Income Account are linked to specific respective subcategories in the Financial account. From here, economists and central banks determine implied rates of return on the different types of capital exchanged in the Financial Account. The United States, for example, gleans a substantially larger rate of return from foreign capital than foreigners from domestic capital. When analyzing the current account theoretically, it is often written as a function X of the real exchange rate, p, domestic GDP, Y, and foreign GDP, Y*. Thus the current account can be written as X(p, Y, Y*). According to theory, the current account X should increase if (1) the domestic currency depreciates (p increases), (2) domestic GDP decreases, or (3) foreign GDP increases. Domestic currency depreciation makes domestic goods relatively cheaper, boosting exports relative to imports. A decrease in domestic GDP reduces domestic demand for foreign goods, lowering imports without affecting exports. An increase in foreign GDP increases foreign demand for domestic goods, increasing exports without affecting imports. Current account =

� Trade Balance � Net Exports (Exports - Imports) of Merchandise (tangible goods) � Net Exports (Exports - Imports) Services (such as legal and consulting services) � + Net Factor Income From Abroad (such as interest and dividends) � + Net Unilateral Transfers From Abroad (such as foreign aid, grants, gifts, etc.)

Capital Account The capital account used to entitle the section now familiarly known as the financial account. This section usually includes special debt transactions between nations and migrants' goods as they cross a country's borders.



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Official Reserves The official reserve account records the government's current stock of reserves. Reserves include official gold reserves, foreign exchange reserves, and IMF Special Drawing Rights (SDRs). Reserve accounts typically are dominated by monetary authority intervention in the official currency's exchange rate. Countries who try to control the price of their currency will have large net changes in their Official Reserve Accounts. Some of the most extreme examples include China and Japan. Japan in particular recently had a change in its reserves approximately one half of the entire net reported Balance of Payments. In 2003 and 2004, Japan had an outflow of reserves, yen, by more than equivalently one third of one trillion US Dollars. In general, net increases in the Official Reserve Account will indicate that a country is buying its currency to try to keep the price dear from the perspective of whatever resource is being sold to acquire the currency. Countries with net decreases in the Official Reserve Account are usually attempting to keep the price of their currency cheap relative to whatever resource they are purchasing in exchange for the currency. Some countries are much more difficult to detect in this regard. The United Kingdom is a good example. Its net changes in the Official Reserve Account are small, but this is because the monetary authorities of the UK borrow from one source, principally the IMF and its' SDR reserve, to buy back pounds in the form of bonds and money market accounts. Financial account The financial account is the net change in foreign ownership of domestic assets. If foreign ownership of domestic assets has increased more quickly than domestic ownership of foreign assets in a given year, then the domestic country has a financial account surplus. On the other hand, if domestic ownership of foreign assets has increased more quickly than foreign ownership of domestic assets, then the domestic country has a financial account deficit The accounting entries in the financial account record the purchase and sale of domestic and foreign assets. These assets are divided into categories such as Foreign Direct Investment (FDI), Portfolio Investment (which includes trade in stocks and bonds), and Other Investment (which includes transactions in currency and bank deposits). Financial account =

� Increase in foreign ownership of domestic assets � Increase of domestic ownership of foreign assets

Balance of Payments Identity The Balance of Payments is the sum of the Current Account and the Capital Account. The Balance of Payments Identity states that: Current Account + Capital Account = Change in Official Reserve Account Typically, in the United States, the change in official reserves in a given year is small relative to the Current Account and the Capital Account. Therefore it is sometimes approximated as zero. For example, if a government runs a current account deficit and has no change in official reserves, then the current account deficit must be balanced by a capital account surplus. The basic principle behind the identity is that a country can only consume more than it produces (a



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current account deficit) if it borrows from abroad (a capital account surplus). The United States has been carrying a negative current account balance for many years, and this debt has been primarily financed by issuing securities. This interpretation of the data, however, is disputed by Milton Friedman (Balance of Trade) claiming that cheaper, riskier, foreign capital is exchanged for "riskless", expensive, US capital and that the difference is made up with extra goods and services. Nevertheless, Friedman's interpretation is incomplete with respect to countries that interfere with the market prices of their currencies through the changes in their reserves. A country will have a negative balance of payments (a net decrease in official reserves) if the net of the current account and the capital account is a deficit. Similarly, there will be a positive balance of payments (a net increase in official reserves) if the net of the current and the capital account results in a surplus. Balance of Payments Equilibrium A Balance of Payments Equilibrium is defined as a condition where the sum of debits and credits from the Current Account match the Financial Account; in other words, equilibrium is where Current Account - Financial Account = 0 This is a condition where there are no changes in Official Reserves.



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India's foreign exchange reserves stand at $214.835 bn billion for the week ended July, 2007

India's Balance of Payments (2001-05) (In $ million)



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What sets India apart from the ‘Big Five?’ HARISH DAMODARAN Forex Reserve Build-up The accumulation of forex reserves, rather than being the outcome of a booming export economy, can be a peculiar problem of a rupee rendered increasingly weak at home and strong abroad. Instead of recognising these realities, the academic fashion of making virtue of current account deficits is flawed, says HARISH DAMODARAN.

If one were to single out the most significant macroeconomic development of the country’s post-‘reform’ era, the unprecedented build-up of its foreign exchange reserves would probably emerge a clear winner. Sustained inflows over this period have not merely ushered in a regime of soft interest rates; by making the management of excess liquidity a systemic concern like never before, they have even fundamentally redefined the conduct of monetary and fiscal policy. Apart from these visible impacts, the accumulation of reserves has been useful for bolstering national self-confidence and the country’s overall international standing (whether these intangible gains have been truly leveraged to the nation’s advantage is beside the point). A far cry, indeed, from the days when the nation’s gold stocks had to be physically pledged with the Bank of England to raise a paltry $405 million! The Big Five Since March 1990, India’s forex reserves have mounted from a low of $3.96 billion to $199.18 billion at the end of 2006-07 and $218.96 billion as on July 13. Today, there are only five others with bigger reserve chests — China ($1,333 billion), Japan ($914 billion), Russia ($406 billion), Taiwan ($266 billion) and South Korea ($251 billion). Table 1 provides a broad picture of the way these Big Five have amassed their fortunes in recent times. China’s reserves zoomed by some $1,300 billion since 1990. Well over half of this has been on account of accumulated current account surpluses, arising from an excess of its exports of goods and services over imports during this period. The rest has been by way of attracting foreign investment and other capital inflows. Japan offers an even more instructive case, with a cumulative current account surplus of $1,959 billion for 1990-2006 far exceeding its reserve accretion of $835 billion. Thus, its current earnings have flowed over the brim, so much so to make Japan the world’s leading capital exporter.



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But whether it is China, Japan, Russia, Taiwan or Korea, there is a simple common thread running through their reserve accumulation process. All of them have, year after year, been exporting much more than what they have been importing. The resultant surpluses have then been ploughed back to expand their forex kitty (or spilt over as capital exports). This process is no different from how companies apportion a part of annual profits after tax to the ‘reserves and surplus’ account of their balance-sheets. India’s story

The Indian story, on the other hand, follows a marked deviation from the above predictable pattern. Table 2 shows that the country’s export of goods for the entire period from 1990-91 to 2006-07, at $807 billion, was way below its corresponding import bill of $1,109 billion, leaving a cumulative deficit of $302 billion on the merchandise trade account. This deficit was, nevertheless, partially offset by a surplus of $259 billion on the ‘invisibles’ account. The latter term essentially refers to export and import of services, as counterpoised to physical shipment of goods. They encompass items such as software, remittance transfers (from export of ‘labour power’), tourism, insurance, freight, and a host of business, financial, project consultancy and miscellaneous services. Invisible payments further include interest, dividends, royalties and other current outgo on foreign loans and equity investments.



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Humongous invisibles From the Table, it can be seen that the country’s gross invisible receipts, at $617 billion, were quite comparable to revenues from export of goods ($807 billion) over the 17-year period. Roughly 55 per cent of these receipts comprised earnings from remittances, and software exports. This feature of having a humongous invisibles account sets India apart from the Big Five (the only other country with a similarly disproportionate services export profile in its balance of payments is, in fact, the US). But even a $259-billion invisibles surplus has not been enough to neutralise a still wider deficit on the merchandise trade account. The result is a cumulative current gap of almost $44 billion, which is in stark contrast to the massive surpluses of the Big Five. India represents a unique phenomenon of an economy to have built up its forex reserves exclusively on the basis of capital inflows — something that has never happened before in history on such as grand scale. Between 1990-91 and 2006-07, net capital inflows were $218 billion, consisting mainly of foreign investments (both portfolio and direct), External Commercial Borrowings and non-resident Indian deposits. Only in three years during this whole period (2001-02, 2002-03 and 2003-04) did the country manage to post current account surpluses. Compare this to China, where there was one exceptional year (1993) through the 1990s and the present decade to have returned a deficit! What do these trends suggest? The conventional route of reserve accumulation through generation of current account surpluses arguably signifies a more dynamic and virtuous engagement with globalisation. There is a certain endogenous growth impulse at work here, leading to the enhancement of the economy’s productive base and cost-competitiveness over time. External capital infusions are only supplementary to revenues from exports, built on solid manufacturing foundations and supportive infrastructure. This is unlike in India, where robust exporting capacities are confined to a few sectors such as software, pharmaceutical, auto-ancillaries and light engineering; the bulk of shipments are highly vulnerable to exchange rate fluctuations (textiles, agro-products) or embody low domestic value-addition (gems and jewellery, iron ore). If Taiwan and China are today the factories of the world, the analogy one could draw for India is of a virtual bank where capital gushes in and out. As the economy’s ability to absorb these inflows is limited, they add to the reserve chest without really contributing to the country’s productive potential. Moreover, by creating currency instability, they further blunt export competitiveness. Alternatively, they are a source of runaway monetary expansion: When the Reserve Bank of India mops up the surplus dollars to prevent the rupee’s undue appreciation, it releases counterpart domestic currency into the system, stoking inflationary pressures. The accumulation of forex reserves, rather than being the outcome of a booming export economy, becomes symptomatic of a peculiar problem of a rupee rendered increasingly weak at home and strong abroad. Current account deficits Instead of recognising these realties, the current academic fashion is to make a virtue of current account deficits. These are considered not just natural but necessary to any developing economy that is savings-constrained and hence requires foreign capital to maintain high rates of investment.



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The existence of current account deficits reflects domestic savings-investment gaps, which have to be plugged through external financing. This proposition is then transposed to imply that foreign investment presupposes a country running a current account deficit. Nothing could be farther from such mechanical, if not dubious, theoretical formulations; the examples of China and the East Asian Tigers are proof that it is possible to post current account surpluses and still attract large investments from abroad. To view current account deficits as a sustainable or even desirable option is akin to believing that a loss-making company will indefinitely receive venture capital funding simply on the basis of the promise for the future. All Ponzi games, at some point, are bound to unravel one way or the other.



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Exchange Rate Theories: There are three theories of the determination of foreign exchange rate. The first is the Mint Parity Theory, the second is the Purchasing Power Parity Theory, and the third is the Balance of Payments Theory. We discuss these theories one by one. The Mint Parity Theory: This theory is associated with the working of the international gold standard. Under this system, the currency in use was made of gold or was convertible into gold at a fixed nite. The value of the currency ur.it was defined in terms of certain weight of gold, that is, so many grains of gold to the rupee, the dollar, the pound, etc. The central bank of the country was always ready to buy and sell gold at the specified price. The rate at which the standard money of the country was convertible into gold was called the mint price of gold. If the official British price of gold was £6 per ounce and of the US price of gold $ 36 per ounce, they were the mint prices of gold in the respective countries. The exchange rate between the dollar and the pound would be fixed at $ 36/ £6 = $ 6. This rate was called the mint parity or mint par of exchange because it was based on the mint price of gold. Thus under the gold standard, the normal or basic rate of exchange was equal to the ratio of their mint par values (R=$/£). But the actual rate of exchange could vary above and below the miss parity by the cost of shipping gold between the two countries. To illustrate this, suppose the US has a deficit in its balance of payments with Britain. The difference between the value of imports and exports will have to be paid in gold by US importers because the demand for pounds exceeds the supply of pounds. But the transshipment of gold involves transportation cost and other handling charges, insurance, etc. Suppose the shipping cost of gold from the US to Britain is 3 cents. So the US importers will have to spend $ 6.03 ($ 6 + .03c) for getting £ 1. This could be the exchange rate which is the US gold export point or upper specie point. No US importer would pay more than $ 6.03 to obtain one pound because he can buy $ 6 worth of gold from the US treasury and ship it to Britain at a cost of 3 cents per ounce. Similarly, the exchange rate of the pound cannot fall below $ 5.07 in the case of a surplus in the US balance of payments. Thus the exchange rate of $ 5.97 to a pound is the US gold import point or lower specie point. The exchange rate under the gold standard is determined by the forces of demand and supply between the gold points and is prevented from moving outside the gold points by shipments of gold. Figure 1.1 shows the determination of the exchange rate under the gold standard. The exchange rate OR is set up at point E where the demand and supply curves DD' and SS' intersect. The exchange rate need not be at the mint parity. It can be anywhere between the gold points depending on the shape of the demand and supply curves. The mintparity is simply meant to define the US gold" export point ($ 6.03) and the US gold import point ($ 5.97). Since the US treasury is prepared to sell any amount of gold at the price of $ 36 per ounce, no American would pay more than $ 6.03 per pound, because he can get any quantity of pounds at that price by exporting gold. That is why, the US supply curve of pounds becomes perfectly elastic or horizontal at the US gold export



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Fig: 1.1

point. This is shown by the horizontal portion S' of the SS' supply curve. Similarly, as the U,S treasury is prepared to buy any quantity of gold at $ 36 per ounce, no American would sell pounds less than $ 5.97 because he can sell any quantity of pounds at that price by gold imports. Thus the US demand curve for pounds becomes perfectly elastic at the US gold import point. This is shown by the horizontal portion D' of the demand curve DD'. The mint parity theory has long been discarded ever

since the gold standard broke down. No country is on the gold standard. There are neither free m,)vcments of gold nor gold parities: So this theory has only an academic interest. The Purchasing Power Parity Theory The purchasing power parity theory was developed by Gustav Cassel in 1920 to determine the exchange rate between countries on inconvertible paper currencies. The theory states that equilibrium exchange rate between two inconvertible paper currencies is determined by the equality of their purchasing power. In other words, the rate of exchange between two countries is determined by their relative price levels. The theory can be explained with the help of an example. Suppose India and England are on inconvertible paper standard and by spending ing Rs. 18 the same bundle of goods can be purchased in India as can be bou, by spending £ 1 in England. Thus according to the purchasing power pal theory, the rate of exchange will be Rs 18 = £ 1. If the price levels in the two countries remain the same but the exchange n moves to Rs 16 = £ 1. This means that less rupees are required to buy the same bundle of goods in India as compared to one pound in England. It is a case overvaluation of the exchange rate. This will encourage imports and discourage exports by India. As a result, the demand for pounds will increase and that I rupees fall. This process will ultimately restore the normal exchange rate of Rs I = £ 1. In the converse case, if the exchange rate moves to Rs. 20 = £ 1, the India currency becomes undervalued. As a result, exports are encouraged and import are discouraged. The demand for rupees will rise and that for pounds will fall so that the normal exchange rate of Rs 18 = £ 1 will be restored.



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According to the theory, the exchange rate between two countries is determined at a point which expresses the equality between the respective purchasing powers of the two currencies. This is the purchasing power parity which is a moving par and not a fixed par as under the gold standard. Thus with every change in the price level, the exchange rate, also changes. To calculate the new equilibrium exchange rate, the following formula is used: R = Domestic Price of a Foreign Currency x Domestic Price Index / Foreign Price Index According to Cassel, the purchasing power parity is "determined by the quotients of the purchasing powers of the different currencies." This is what the formula does. To explain it in terms of our above example. Before the change in the price level, the exchange rate was Rs 18 = £ 1. Suppose the domestic (Indian) price index rises to 300 and the foreign (England) price index rises to 200. Thus the new equilibrium exchange rate will be R = £l x 300 /200 = £1.5 or Rs 18 = £ 1.5 This will be the purchasing power parity between the two countries. In reality, the parity will be modified by the cost of transporting goods including duties, insurance, banking and other charges. These costs of transporting goods from one country to another are, in fact, the limits within the exchange rate can fluctuate depending upon the demand and supply of a country's currency. There is the upper limit, called the commodity export point; and the lower limit, known as the commodity import point. These limits are not as definite as the gold points under the mint par theory. Fig. 1.2

The purchasing power parity theory is illustrated in Figure 1.2 where DD is the demand curve for foreign currency (pound in our example) and SS is the I supply curve of currency. OR is the rate of exchange which is determined by their I intersection at point E so that the demand for and supply of foreign exchange equal OQ quantity. The purchasing power curve shows that with relative change in the price levels, the exchange rate tends to fluctuate along this curve above or below the normal exchange rate. But there is a limit up to which the purchasing power parity curve can move up and down. The upper and lower limits are set by the commodity export point and the commodity

import point respectively. Its Criticisms. Cassell's purchasing power parity theory became very popular among economists during 1914-1924 and was widely accepted as a realistic explanation of the determination of



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foreign exchange rate under inconvertible paper currencies. But it has been severely criticised for its weak theoretical base. Some of the criticisms are discussed as under. 1. One of the serious defects of the theory is that of calculating the price levels in the two countries. The use of index number in calculations presents many. difficulties such as the base year, coverage and method of calculation. These may not be the same in both countries. The two countries may not include the same types of commodities in calculating the index numbers. Such difficulties make the index numbers only a rough guide for measuring the price levels and thus fail to give a correct purchasing power parity between the two countries. 2. According to the theory, the purchasing power parity between two countries is determined by comparing their general price levels. But the price level may be made up of internally traded plus internationally traded goods, or of the internationally traded goods. If the price level is calculated in terms of the internally traded goods, then the prices tend to equality in both countries, even allowing for the cost of transportation, tariffs, etc. Thus, according to Keynes, "confined to internationally traded commodities, the purchasing power parity becomes an empty truism."J On the other hand, if the price level includes both internally and internationally traded goods, then price of internally traded goods may move in the opposite direction of internationally traded goods, at least in the short period. Thus the real exchange rate may not conform to the parities. Further if the price level includes both types of goods, there is the technical difficulty of people spending their money differently in the two countries, so that the basis for complete and accurate comparisons of price levels is lacking. 3. Another weakness of the purchasing power parity theory is that it applici> to countries whose balance of payments is determined by the merchandise tnldc account. It is, therefore, not applicable to such countries whose exchange rate is influenced more by capital account. 4. The theory assumes the balance of payments to be in equilibrium in the base period for the determination of the new equilibrium exchange rate. This is a serious defect because it is difficult to find the base year when the exchange rate was initially in equilibrium. 5. The theory is also based on the assumption that there have been no structural changes in the factors underlying the equilibrium in the base period. Such factors are changes in technology, resources, tastes, etc. This assumption is highly unrealistic because changes are bound to take place in these factors which, in turn, are likely to affect exchange rate. 6. The theory is based on the assumption of zero-capital movements. There are many items in the balance of payments such as insurance, shipping, and banking transactions, capital movements, etc. which are not affected by changes in the general price level. But these items affect the exchange rate by influencing the demand for and supply of foreign currencies. The theory is thus weak for it neglects the influence of these factors in determining the exchange rate. 7. The theory further assumes that changes in the. price level bring about changes in exchange rates. But changes in exchange rates do affect the price level. For instance, if the external value of rupee falls, imports will become dearer. As a result, the costs and prices of goods using imported materials will rise. On the other hand, exports will become cheaper with fall in the external value of the rupee. Consequently, their demand will increase which will raise the demand for factors used for producing exports, and their prices will also rise. Thus changes in exchange rates do influence the price level.



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8. Again, the theory assumes that the barter terms of trade do not change between the two trading countries. This assumption is unrealistic because the barter terms of trade constantly change due to changes in the demand for foreign goods, in the volume of external loans, in the supply of exported goods, in transport costs, etc. 9. The theory is based on the assumption of free trade and laissez-faire policy. But governments do not follow these policies these days. Rather, they impose a number of restrictions on the movement of goods between countries. Such trade restrictions are tariff, import quotas, customs duties and various exchange control devices which tend to reduce the volume of imports. These, in turn, cause wide deviations between the actual exchange rate and the exchange rate set by the purchasing power parity. 10. The equilibrium exchange rate may not be determined by the purchasing power parity between the two countries. Rather, a sudden increase in the demand for goods of one country may raise the demand for its currency on the part of the other country. This will lead to a rise in the exchange rate. 11. According to Keynes, one of the serious defects of this theory is that it fails to consider the elasticity’s of reciprocal demand. In fact, the exchange rate is determined not only by changes in relative prices, but also by the elasticity’s of reciprocal demand between the two trading countries. 12. Ragnar Nurkse points out that the theory is one sided in that it is based exclusively on changes in relative prices and neglects all factors that influence the demand for foreign exchange. The theory treats demands as a function of price but neglects the influence of aggregate income and expenditure on the volume and value of foreign trade, these are important factors which affect the exchange rate of a country. Conclusion: Despite these criticisms, Haberler finds the theory useful. According to him, "While the price levels of different countries may diverge, their price systems are nevertheless interrelated and interdependent, although the relation need not be that of equality. Moreover, supporters of the theory are quite right in contending that the exchanges can always be established at any desired level of appropriate changes in the volume of money.



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The Balance of Payments Theory: According to this theory, under free exchange rates, the exchange rate of the currency of a country depends upon its balance of payments. A favourable balance of payments raises the exchange rate, while an un-favourable balance of payments reduces the exchange rate. Thus the theory implies that the exchange rate is determined by the demand for and supply of foreign exchange. The demand for foreign exchange arises from the debit side of the balance of payments. It is equal to the value of payments made to. the foreign country for goods and services purchased from it plus loans and investments made abroad. The supply of foreign exchange arises from the credit side of the balance of payments. It equals all payments made by the foreign country to our country for goods and services purchased from us plus loans disbursed and investments made in this country. The balance of payments balances if debits and credits are equal. If debits exceed credits, the balance of payments is un-favorable. On the contrary, if credits exceed debits. It is favorable. When the balance of payments is un-favorable, it means that the demand for foreign currency is more than its supply. This causes the external value of the domestic currency to fall in relation to the foreign currency. Consequently, the exchange rate falls. On the other hand, in case the balance of payments is favourable, the demand for foreign currency is less than its supply at a given exchange rate. This causes the external value of the domestic currency to rise in relation to the foreign currency. Consequently, the exchange rate rises. When the exchange rate falls below the equilibrium exchange rate in a situation of adverse balance of payments, exports increase and the adverse balance of payments is eliminated, and the equilibrium exchange rate is re-established. On the other hand, when under a favourable balance of payment situation, the exchange rate rises above the equilibrium exchange rate, exports decline, the favourable balance of payments disappears and the equilibrium exchange rate is re-established. Thus at any point of time, the rate of exchange is determined by the demand for and supply of foreign exchange as

represented by the debit and credit side of the balance of payments. "Any change in the conditions of demand or of supply reflects itself in a change in the exchange rate, and at the ruling rate the balance of payments balances from day to day or from moment to moment." The determination of exchange rate under the balance of payments theory is illustrated in Figure 1.3. DD is the demand curve for foreign currency. It slopes downward to the left because when the rate of exchange rises, the demand for foreign currency falls, and vice versa. SS is the supply curve of foreign exchange which slopes upward from left to right. This is because when the

exchange rate falls, the amount of foreign currency offered for sale will be less, and vice versa. The two curves intersect at E where OR equilibrium exchange rate is determined. At this rate, the quantity of foreign exchange demanded and supplied equals OQ. E is also the point where the balance of payments is in equilibrium. Any exchange rate above or below OR will mean disequilibrium in the balance of payments. Suppose the exchange rate rises to OR I' The demand for foreign exchange RIA is less than its supply RIB. It means that there is a favourable balance of payments. When the exchange rate is more than the equilibrium rate, exports decline and imports increase. Consequently, the demand for foreign exchange will rise and the supply will fall. Ultimately, the equilibrium exchange rate OR will be restored where demand and supply of foreign exchange equal at point E . In



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the opposite case, when the exchange rate falls below the equilibrium rate to OR2, the demand for foreign exchange R2H is greater than its supply R2G. It implies an un favourable balance of payments. But fall in the exchange rate leads to inctease in exports and decline in imports. As a result the demand for foreign currency starts falling and the supply starts rising till the equilibrium exchange rate OR is re-established with the equality of demand and supply of foreign exchange at point E. However, it is the shapes of the demand and supply curves of foreign exchange that determine the exchange rate. For this purpose, four elasticities are relevant: (i) the foreign elasticity of demand for exports, (ii) the domestic elasticity of supply for exports, (iii) the domestic elasticity of demand for imports, and (iv) the foreign elasticity of supply for

imports. The equilibrium exchange rate tends to be stable if the demand elasticities are high and the supply elasticities are low. Criticisms. The balance of payments theory has been criticised by economists on the following counts. 1. The main defect of the theory is that the balance of payments is independent of the exchange rate. In other words, the theory states that the balance of payments determines the exchange rate. This is not wholly true because it is changes in the exchange rate that bring about equilibrium in the balance of payments. 2. Another defect of the theory is that it neglects the role of the price level in influencing the balance of payments of a country and hence its exchange rate. But the fact is that price changes do affect the balance of payments and the exchange rates between countries. 3. The theory is based on the assumption of free trade. This is unrealistic because free trade is not practised these days. Governments impose a number of restrictions to reduce imports and adopt measures to encourage exports. This is how they try to correct disequilibrium in the balance of payments. 4. The theory presupposes that there is an equilibrium exchange rate where balance of payments balances. This is a truism. But the equilibrium exchange rate may not be one of balance of payments equilibrium. In fact, exchange rates between countries continue to prevail under conditions of surplus or deficit in the balance of payments and there is no tendency for the balance of payments to be in equilibrium over the long run. Despite these criticisms, the balance of payments theory is the most satisfactory explanation of the determination of exchange rate. It studies the problem of determination of exchange rate under the framework of the general equilibrium. analysis in terms of demand and supply. It studies the actual forces which lie ~ behind the demand and supply of foreign exchange, such as the current account and the capital account of the balance of payments. That is why, it is regarded superior to the mint par' and purchasing power parity theories of exchange rate.



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Causes of Changes in the Exchange Rate : The exchange rate between countries changes due to changes in demand or supply in the foreign exchange market. The factors which cause changes in demand and supply are discussed as under. 1. Changes in Prices. It is changes in the relative price levels that cause changes in the exchange rate. Suppose the price level in Britain rises relative to the US price level. This will lead to the rises in the price of British goods in terms of pound. British goods wHI become dearer in the US. This will lead to reduction in British exports to the US. So the supply of dollars to Britain will diminish. On the other hand, the American goods become cheaper in Britain and their imports into Britain increase. So the demand for dollars will increase. Thus the supply curve for dollars will shift to the left so that the exchange rate is established at a higher level from the point of view of the US. It implies appreciation of the value of the dollar and depreciation of the value of the pound. 2. Changes in Exports and Imports. The demand and supply of foreign exchange is also influenced by changes in exports and imports. If exports of the country are more than imports, the demand for its currency increases so that the rate of exchange moves in its favour. Conversely, if imports are more than exports, the demand for the foreign currency increases and the rate of exehange will move against the country. 3. Capital Movements. Short-term or long-term capital movements also influence the exchange rate. Capital-flows tend to appreciate the value of the currency of the capital-importing country and depreciate the value of the currency of the capital-exporting country. The exchange rate will move in favour of the capitalimporting country and against the capital-exporting country. The demand for the currency of the capital-importing country will rise and its demand curve will shift upward to the right and the exchange rate will be determined at a higher level, given the supply curve of foreign exchange. 4. Influence of Banks. Banks also affect the exchange rate through their operation. They include the purchase and sale of bank drafts, letters of credit, arbitrage, dealing in bills of exchange, etc. These banking operations influence the demand for and supply of foreign exchange. If the commercial banks issue a large number of drafts and letters of credit on foreign banks, the demand for foreign currency rises. The bank rate also influences the exchange rate. If the bank rate rises relative to other countries, more funds will flow into the country from abroad to earn high interest rate. It will tend to raise the demand for the domestic currency and the exchange rate will move in favour of the country. Converse will be the case when the bank rate falls. 5. Influence of Speculation. The growth of speculative activities also influences the exchange rate. Speculation causes short-run fluctuations in the exchange rate. Uncertainty in the international money market encourages speculation in foreign exchange. If the speculators expect a fall in the value of currency in the near future, they will sell that currency and start buying the other currency



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they expect to appreciate in value. Consequently, the supply of the former currency will increase and its exchange rate will fall. While the demand for the other currency will rise and its exchange rate will go up. 6. Stock Exchange Influences. Stock exchange operations in foreign securities, debentures, stocks and shares, etc . exert significant influence on the exchange rate. If the stock exchanges help in the sale of securities, debentures, shares etc. to foreigners, the demand for the domestic currency will rise on the part of the foreigners and the exchange rate also tends to rise. The opposite will be the case if the foreigners purchase securities, debentures, shares, etc. through the domestic stock exchanges. 7. Structural Influences. Structural changes is another important factor which influences the exchange rate of a country. Structural changes are those changes which bring changes in the consumer demand for commodities. They include technological changes, innovations, etc. which also affect the cost structure along with the demand for products. Such structural changes tend to increase the foreign dp.mand for domestic products. It implies increase in exports, greater demand for domestic currency, appreciation of its value and rise in the exchange rate. 8. Political Conditions. Political conditions in. the country have a significant influence on the exchange rate. If there is political stability and the government is strong and efficient, foreigners will have tendency to invest their funds into the country. With the inflow of capital, the demand for domestic currency will rise and the exchange rate will move in favour of the country. On the contrary, if the government is weak, inefficient and dishonest and there is no safety to life and property, capital will flow out of the country and the exchange rate will move against the country.



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Foreign Exchange Exposure Measurement: AS BUSINESS BECOMES increasingly global, more and more firms find it necessary to pay careful attention to foreign exchange exposure and to design and implement appropriate hedging strategies. Suppose, for example, that the U.S. dollar substantially depreciates against the Japanese yen, as it often has since the mid-eighties. This change in the exchange rate can have significant economic consequences for both U.S. and Japanese firms. For example, it can adversely affect the competitive position of Japanese car makers in the highly competitive U.S. market by forcing them to raise dollar prices of their cars by more than their U.S. competitors do. The same change in exchange rate, however, will tend to strengthen the competitive position of import-competing U.S. car makers. On the other hand, should the dollar appreciate against the yen, it would bolster the competitive position of Japanese car makers at the expense of U.S. makers. A real-world example of the effect of exchange rate changes is provided in the International Finance in Practice box on page 286, “U.S. Firms Feel the Pain of Peso’s Plunge.” The box explains how U.S. companies were adversely affected by the collapse of the Mexican peso during the period 1994–95. Changes in exchange rates can affect not only firms that are directly engaged in international trade but also purely domestic firms. Consider, for example, a U.S. bicycle manufacturer that sources only domestic materials and sells exclusively in the U.S. market, with no foreign-currency receivables or payables in its accounting book. This seemingly purely domestic U.S. firm can be subject to foreign exchange exposure if it competes against imports, say, from a Taiwanese bicycle manufacturer. When the Taiwanese dollar depreciates against the U.S. dollar, this is likely to lead to a lower U.S. dollar price of Taiwanese bicycles, boosting their sales in the United States, thereby hurting the U.S. manufacturer. Changes in exchange rates may affect not only the operating cash flows of a firm by altering its competitive position but also dollar (home currency) values of the firm’s assets and liabilities. Consider a U.S. firm that has borrowed Swiss francs. Since the dollar amount needed to pay off the franc debt depends on the dollar/franc exchange rate, the U.S. firm can gain or lose as the Swiss franc depreciates or appreciates against the dollar. Aclassic example of the peril of facing currency exposure is provided by Laker Airways, a British firm founded by Sir Freddie Laker, which pioneered the concept of mass-marketed, low-fare air travel. The company heavily borrowed U.S. dollars to finance acquisitions of aircraft while it derived more than half of its revenue in sterling. As the dollar kept appreciating against the British pound (and most major currencies) throughout the first half of the 1980s, the burden of servicing the dollar debts became overwhelming for Laker Airways, forcing it to default.

Key Terms in Foreign Currency Exposure :It is important that you are familiar with some of the important terms which are used in the currency markets and throughout these sections:

DEPRECIATION - APPRECIATION Depreciation is a gradual decrease in the market value of one currency with respect to a second currency. An appreciation is a gradual increase in the market value of one currency with respect another currency.

SOFT CURRENCY - HARD CURRENCYA soft currency is likely to depreciate. A hard currency is likely to appreciate.



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DEVALUATION – REVALUATION Devaluation is a sudden decrease in the market value of one currency with respect to a second currency. A revaluation is a sudden increase in the value of one currency with respect to a second currency.

WEAKEN – STRENGTHEN If a currency weakens it losses value against another currency and we get less of the other currency per unit of the weaken currency ie. if the £ weakens against the DM there would be a currency movement from 2 DM/£1 to 1.8 DM/£1. In this case the DM has strengthened against the £ as it takes a smaller amount of DM to buy £1.

LONG POSITION - SHORT POSITION

A short position is where we have a greater outflow than inflow of a given currency. In FX short positions arise when the amount of a given currency sold is greater than the amount purchased. A long position is where we have greater inflows than outflows of a given currency. In FX long positions arise when the amount of a given currency purchased is greater than the amount sold.

Foreign currency exposures into three types: • Economic exposure • Transaction exposure • Translation exposure Economic exposure can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. Any anticipated changes in exchange rates would have been already discounted and reflected in the firm’s value. As we will discuss later in this chapter, changes in exchange rates can have a profound effect on the firm’s competitive position in the world market and thus on its cash flows and market value. Transaction exposure, can be defined as the sensitivity of “realized” domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Since settlements of these contractual cash flows affect the firm’s domestic currency cash flows, transaction exposure is sometimes regarded as a short-term economic exposure. Transaction exposure arises from fixed-price contracting in a world where exchange rates are changing randomly. Translation exposure, refers to the potential that the firm’s consolidated financial statements can be affected by changes in exchange rates. Consolidation involves translation of subsidiaries’ financial statements from local currencies to the home currency. Consider a U.S. multinational firm that has subsidiaries in the United Kingdom and Japan. Each subsidiary will produce financial statements in local currency. To consolidate financial statements worldwide, the firm must translate the subsidiaries’ financial statements in local currencies into the U.S. dollar, the home currency. As we will see later, translation involves many controversial issues. Resultant translation gains and losses represent the accounting system’s attempt to measure economic exposure ex post. It does not provide a good measure of ex ante economic exposure. In the remainder of this chapter, we will focus on how to measure and manage economic exposure.



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How to Measure Economic Exposure Currency risk or uncertainty, which represents random changes in exchange rates, is not the same as the currency exposure, which measures “what is at risk.” Under certain conditions, a firm may not face any exposure at all, that is, nothing is at risk, even if the exchange rates change randomly. Suppose your company maintains a vacation home for employees in the British countryside and the local price of this property is always moving together with the pound price of the U.S. dollar. As a result, whenever the pound depreciates against the dollar, the local currency price of this property goes up by the same proportion. In this case, your company is not exposed to currency risk even if the pound/dollar exchange rate fluctuates randomly. The British asset your company owns has an embedded hedge against exchange risk, rendering the dollar price of the asset insensitive to exchange rate changes. Consider an alternative situation in which the local (pound) price of your company’s British asset barely changes. In this case, the dollar value of the asset will be highly sensitive to the exchange rate since the former will change as the latter does. To the extent that the dollar price of the British asset exhibits “sensitivity” to exchange rate movements, your company is exposed to currency risk. Similarly, if your company’s operating cash flows are sensitive to exchange rate changes, the company is again exposed to currency risk. As the economy becomes increasingly globalized, many firms are engaged in international activities such as exports, cross-border sourcing, joint ventures with foreign partners, and establishing production and sales affiliates abroad. The cash flows of such firms can be quite sensitive to exchange rate changes. The objective of managing operating exposure is to stabilize cash flows in the face of fluctuating exchange rates. Since a firm is exposed to exchange risk mainly through the effect of exchange rate changes on its competitive position, it is important to consider exchange exposure management in the context of the firm’s long-term strategic planning. For example, in making such strategic decisions as choosing where to locate production facilities, where to purchase materials and components, and where to sell products, the firm should consider the currency effect on its overall future cash flows. Managing



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operating exposure is thus not a short-term tactical issue. The firm can use the following strategies for managing operating exposure: 1. Selecting low-cost production sites. 2. Flexible sourcing policy. 3. Diversification of the market. 4. Product differentiation and R&D efforts. 5. Financial hedging To reduce the currency mismatch, Merck first considered the possibility of redeploying resources in order to shift dollar costs to other currencies. The company, however, decided that relocating employees and manufacturing and research sites was not a practical and cost-effective way of dealing with exchange exposure. Having decided that operational hedging was not appropriate, Merck considered the alternative of financial hedging. Merck developed a five-step procedure for financial hedging: 1. Exchange forecasting. 2. Assessing strategic plan impact. 3. Hedging rationale. 4. Financial instruments. 5. Hedging program. Step 1: Exchange Forecasting The first step involves reviewing the likelihood of adverse exchange movements. The treasury staff estimates possible ranges for dollar strength or weakness over the fiveyear planning horizon. In doing so, the major factors expected to influence exchange rates, such as the U.S. trade deficit, capital flows, the U.S. budget deficit, and government policies regarding exchange rates, are considered. Outside forecasters are also polled on the outlook for the dollar over the planning horizon. Step 2: Assessing Strategic Plan Impact Once the future exchange rate ranges are estimated, cash flows and earnings are projected and compared under the alternative exchange rate scenarios, such as strong dollar and weak dollar. These projections are made on a five-year cumulative basis rather than on a year-to-year basis because cumulative results provide more useful information concerning the magnitude of exchange exposure associated with the company’s long-range plan. Step 3: Deciding Whether to Hedge In deciding whether to hedge exchange exposure, Merck focused on the objective of maximizing long-term cash flows and on the potential effect of exchange rate movements on the firm’s ability to meet its strategic objectives. This focus is ultimately intended to maximize shareholder wealth. Merck decided to hedge for two main reasons. First, the company has a large portion of earnings generated overseas while a disproportionate share of costs is incurred in dollars. Second, volatile cash flows can adversely affect the firm’s ability to implement the strategic plan, especially investments in R&D that form the basis for future growth. To succeed in a highly competitive industry, the company needs to make a long-term commitment to a high level of research funding. But the cash flow uncertainty caused by volatile exchange rates makes it difficult to justify a high level of research spending. Management decided to hedge in order to reduce the potential effect of volatile exchange rates on future cash flows.



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Step 4: Selecting the Hedging Instruments The objective was to select the most cost-effective hedging tool that accommodated the company’s risk preference. Among various hedging tools, such as forward currency contracts, foreign currency borrowing, and currency options, Merck chose currency options because it was not willing to forgo the potential gains if the dollar depreciated against foreign currencies as it has been doing against major currencies since the mideighties. Merck regarded option costs as premiums for the insurance policy designed to preserve its ability to implement the strategic plan. Step 5: Constructing a Hedging Program. Having selected currency options as the key hedging vehicle, the company still had to formulate an implementation strategy regarding the term of the hedge, the strike price of the currency options, and the percentage of income to be covered. After simulating the outcomes of alternative implementation strategies under various exchange rate scenarios, Merck decided to (1) hedge for a multiyear period using long-dated options contracts, rather than hedge year-by-year, to protect the firm’s strategic cash flows, (2) not use far out-of-money options to save costs, and (3) hedge only on a partial basis, with the remainder self-insured.

Foreign Exchange (FX) Strategies and Techniques:

In simple terms, Foreign Exchange Exposure occurs when business takes place in a currency other than your base currency. But not necessarily just then. Any company selling products overseas or importing goods from abroad has a foreign exchange exposure. Indeed, even a company manufacturing and selling only in one country can have a significant degree of economic exposure to changing foreign exchange rates. It must be noted that a sterling based company doing business in the domestic marketplace will suffer foreign exchange exposure if any of its competitors are based in a foreign country even though prices are in sterling. For example, a UK video manufacturer making equipment sourced entirely from the UK parts and sold entirely to the UK market has a Japanese Yen exposures if the company has Japanese competitors, because a weak Japanese Yen (unlikely recently) gives his Japanese competitors in the UK market an advantage. For a group such as ICI, with manufacturing plants in 40 countries, selling organisations in another 60 and sales in at least 150 of the 160 or so sovereign states, the management of foreign exchange risk has long been a task of the treasury function.



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The following table illustrates the foreign exchange problem.

The foreign exchange risk dilemma

Type of exposure

Transaction Exposure

Translation Exposure

Economic Exposure

Identification system

Short-term cashflow forecast by currency

Balance sheet and/or income statement forecast

Long-term cashflow forecasts of uncommitted transactions by currency

Risk/Return Attitude

Strategy Defensive Strategy Automatic Hedging

Aggressive Strategy Selective Hedging

Internal Techniques



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Techniques Controls

External Techniques

Evaluation Evaluate cost effectiveness of strategy techniques

From the table the following questions are important:

1. What types of exposure are to be managed?. There are three main types of risk which we will consider in a later section. We must analysis this exposure and the company should have a clear policy and direction from the Board. Companies may differ in the way they conceptualise foreign exchange risk (especially economic exposure). The industry type will sometimes shape the way the treasurer views the exposure. Exposures can give rise to cash flow effects and others are accounting (affecting financial statements). Since these positions are subject to rapid change. Changes in foreign currencies need to be anticipated.

2. What sources of financial information should your company have in identifying their exposure.? What currency/interest rate expertise input is there when arketing/purchasing decision are made?. How effective are the company and their advisors at forecasting future currency rates?. The time horizon of the information sources is important. The extent to which a company believes it can forecast exchange rate movements will be a basic determinant of its risk management positions.

3. What is the company's attitude to risk?

4. Which exposure reducing techniques should it employ? What knowledge of instruments and what they achieve does the treasurer have?, Should we use internal or external instruments?. What controls should be placed on these procedures?

5. Judgement of risk and reward and feedback of the results of the strategy adopted.

Company Strategy to Currency Risk



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A common problem in managing currency risk is that companies only realise that they have a risk when the exposure has been generated. However, currency risk management should begin before exposure risks have been generated otherwise fundamental operating decisions have been taken on the basis of complete information. Companies approaches to exposure vary widely; perhaps by the nature of the business, the competition or the culture of the company. A company could accept a high degree of risk and expect commensurate returns or it could be very risk averse and be prepared to pay quite a high price for certainty. Indeed it may have no stance on currency at all and take everything as it comes with a 'swings and roundabouts' approach.

If a company decides to take an active approach to foreign currency management this will centre around the concept of hedging. Hedging a particular currency exposure means establishing an offsetting currency position such that whatever is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. Volatile foreign earnings can cause volatile growth which is more costly than slow stable growth. Hedging can reduce the company's volatility of cash flows because the company's payments and receipts are not forced to fluctuate in accordance with currency movements. This can, in the extreme, reduce the possibility of bankruptcy and therefore allow easier access to credit and lower interest payments due to lower perceived risk. Hedging should also allow for greater certainty about future receipts and payments and consequently enhanced budgetary decisions. Most hedging strategies are costly in terms of fees, premiums or the time involved.

Hedging involves taking an equal and opposite position to the asset or liability which is exposed.

- Exposed asset (or liability) loses value the hedge compensates by increasing in value - Exposed asset (or liability) gains value, the hedge compensates by decreasing in value.

However, it is often not as clear cut as hedging can involve different policies:

- Static Hedging - where the overriding concern to avoid risk. - Dynamic hedging -where we "take a view" and can foresee an opportunity to make a gain

in market and activate the hedging policy accordingly.

The treasurer's approach will depend on;

• Management attitude to risk



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The policy in hedging or covering can range from leaving the risk entirely open (0% cover) to a fully covered position (100%).

- No cover: Some treasurers will argue that they do not manage foreign exchange risk as exchange movements should be matched by price movements according to the purchasing power parity theory. The Purchasing Power Parity theory specifies a precise relationship between relative inflation rates of two countries and their exchange rate. Thus although the price of imports will increase if the home currency depreciates the cost of producing domestically should also increase due to inflation. For this argument to be valid purchasing power parity must hold and even if it does hold the time horizon over a long period this may not help the importer in the short term. There are sizable deviations for the theory in the real world.

- Another argument for deciding to do nothing in relation to foreign currency risk is that forecasting the direction of foreign exchange movements is as close to a zero sum gain as you can get (in the long term average foreign exchange gains will cancel out foreign exchange losses) Shareholders should be left to make their own judgements about the effect of currency movements on their company's profits. This assumes that the shareholder's have complete information and are able to access the hedging markets. It also assumes that company can survive in the long term and the company will not be sent into foreign exchange receivership because of foreign exchange losses before it receives any gains. Alternatively, some companies may not hedge because they do not consider it will have a significant material impact on their cash flows.

- 100% CoverUnder this system the company would tend to hedge most or all their net positions in the foreign currency. Of course not all of this hedging will be beneficial, in fact it is argued that such a policy will on average result in the same cash flows and outflows as not hedging. However, it does provide the advantages of knowing with certainty future cash inflows and outflows in the home currency and this should aid company planning in such areas as pricing and profit margins.

- iii. Averaging: A treasurer who feels they can estimate the future sales revenue of the company fairly accurately may choose to dampen the effects of volatile exchange rates by covering a proportion of a year’s expected receipts over a number of preceding years.

International Financial Management ______________________________________

_____________________________________________________________________ @ 2007 International College of Financial Planning Ltd.

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Multinational Capital Budgeting :

Whenever we make an expenditure that generates a cash flow benefit for more than one year, this is a capital expenditure. Examples include the purchase of new equipment, expansion of production facilities, buying another company, acquiring new technologies, launching a research & development program, etc., etc., etc. Capital expenditures often involve large cash outlays with major implications on the future values of the company. Additionally, once we commit to making a capital expenditure it is sometimes difficult to back-out. Therefore, we need to carefully analyze and evaluate proposed capital expenditures.

Capital budgeting is what is relevant. Here are some examples of what is relevant to project cash flows:

1. Depreciation: Capital assets are subject to depreciation and we need to account for depreciation twice in our calculations of cash flows. We deduct depreciation once to calculate the taxes we pay on project revenues and we add back depreciation to arrive at cash flows because depreciation is a non-cash item.

2. Working Capital: Major investments may require increases to working capital. For example, new production facilities often require more inventories and higher salaries payable. Therefore, we need to consider the net change in working capital associated with our project. Changes in net working capital will sometimes reverse themselves at the end of the project.

3. Overhead: Many capital projects can result in increases to allocated overheads, such as computer support services. However, the subjective nature of overhead allocations may not make any difference at all. Therefore, you need to assess the impact of your capital project on overhead and determine if these costs are relevant.

4. Financing Costs: If we plan on financing a capital project, this will involve additional cash flows to investors. The best way to account for financing costs is to include them within our discount rate. This eliminates the possibility of double-counting the financing costs by deducting them in our cash flows and discounting at our cost of capital which also includes our financing costs.



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METHODS OF INTERNATIONAL CAPITAL BUDGETING: There are two different procedures for evaluating international projects. Table 3.1 ( lines the steps involved in both methods. They both focus on nominal values of flows, exchange rates, and costs of capital as opposed to real values, although there two similar procedures for projects evaluated in real terms. We focus on nominal value because these are the ones most typically projected in reality. The first method of evaluating foreign projects, generally called decentralized Capital budgeting, discounts local currency cash flows at the foreign cost of capital and converts the net present value into home currency units at the prevailing spot exchange rate . In mathematical notation, decentralized capital budgeting is represented by

[ ]0

01 *)

Nt

Ott

E CFPV S

COC=

=

+ ∑

where PV is present value, Eo[ CFt] is the expected cash flow denominated in the local currency, COC* is the cost of capital in the local currency, and So is the current exchange rate. For simplicity, this formula assumes that the cost of capital is constant, implying that the term structure is flat The second method of evaluating foreign projects, called centralized capital budgeting, converts all local currency cash flows into the home currency, then discounts the cash flows at the domestic cost of capital. In mathematical notation, centralized capital budgeting is represented by

( )

0

0 1

t t

nCFS

tt

EPV

COC

=

=+

∑

where COC is the cost of capital in the home currency, St is the exchange rate in period l, and all other variables are as previously defined. Again, the formula assumes the cost of capital is constant. Note that centralization and decentralization here refer to the method of analyzing a project, rather than to the location of decision-making, but that there is a parallel between the two. If the headquarters office undertakes the analysis, there will be a tendency to convert local currency cash flows into the home currency, then discount at the domestic cost of capital; hence, the term "centralization" is appropriate. If the subsidiaries undertake the capital budgeting analysis, there



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will be a tendency to discount local currency cash flows at the local cost of capital and then convert to home currency units for reporting to the parent; hence, the term "decentralized" is appropriate. Both methods of international capital budgeting begin by estimating the project's local currency cash flows. In estimating the cash flows over a long horizon, the firm should make projections based on long-run comparative and competitive advantages vis-a-vis the market or industry, whether the project is domestic or foreign. In international capital budgeting, a firm evaluating a foreign production site or entering a new foreign market should base the estimated future cash flows over a long horizon on longrun purchasing power parity exchange rates, rather than on what might be a current, short-run deviation from the competitive equilibrium or from the purchasing power parity exchange rate. Together, these bases ensure that the firm undertakes projects that are profitable, and therefore sensible, in the long run. Projected cash flows should always represent incremental cash flows to the firm. In other words, the firm wants to figure the value to the parent, rather than simply the value of the project. If a new subsidiary reduces exports from the parent, for example, the project's revenues should be adjusted downward to reflect this. As always, money already spent is usually an unrecoverable sunk cost and should therefore be excluded. Table : 1.1 Methods of capital Budgeting: Steps Decentralized Centralized 1)

Forecast the cash flow in local currency

Forecast the cash flow in local currency

2)

Discount cash flows using the foreign costs of capital

Convert cash flows into home currency of the exchange rate

3)

Convert to home currency at the prevailing spot exchange rate

Discount cash flow using the domestic cost of capital

Similarly, anything in the project associated with an opportunity cost, such as use of company property which would otherwise be rented out, must be included. However, costs which are not otherwise opportunity costs should be excluded. For example, if the new subsidiary pays a license fee to the parent that is not otherwise an opportunity cost (that is, if the license fee would not be received by the parent if the subsidiary were not established), the costs of the project should be adjusted downward to reflect this & If there are government limits on the amount of profits that can be repatriated, there wm be a further distinction between the cash flows to the parent and the cash flows to the project. The project is probably worth less, but this depends on the nature of the limit to repatriation. The estimated cash flows must also be net of tax payments. This, in reality, is more difficult than it sounds. One issue firm’s face is that corporate taxes are not based on cash-flow but on accounting profits, which differ from cash flows for many reasons, including depreciation of physical assets over their useful lives and accruals of some current assets and liabilities. .An issue arising in the international context is that taxes must be paid to two national governments, the host



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government and the home government. Additional problems arises because the amount of taxes a firm pays generally depends on the amount of profits repatriated Table 1.1 also specifies that, once cash flows are estimated in local currency units the firm must decide whether to decentralize or centralize capital budgeting. This decision is much more difficult than it appears. The decentralized capital budgeting method requires the foreign cost of capital, which is not usually readily available to the firm. Although the firm may have very good information concerning the domestic cost of capital from the domestic financial markets in which it operates or from its history~ projects undertaken, that knowledge is not directly applicable to the foreign environment. Unless the company has extensive operations in the foreign country under consideration, it is hard to judge exactly what the required rate of return on the firm capital, placed in the foreign country for the given project, is. The alternative, centralized capital budgeting is not any easier, though. With this method, the firm faces converting estimated future -foreign currency flows into home currency units. This conversion requires forecasts of the future exchange rates, while are certainly not easy to formulate. The conversion will be even more difficult if the estimated local currency cash flows depend on the estimated exchange rate. Hence, the choice of decentralized or centralized capital budgeting partially depends on the relative expertise the firm has in determining a foreign cost of capital. Future exchange rates. As it turns out, the method of capital budgeting chosen is irrelevant if (1) National capital markets are integrated into a single global capital. (2) Local currency cash flows are independent of the exchange rate.



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Multinational Corporation

A multinational corporation (MNC) is a corporation or enterprise that manages production establishments or delivers services in at least two countries. Very large multinationals have budgets that exceed those of many countries. Multinational corporations can have a powerful influence in international relations and local economies. Multinational corporations play an important role in globalization; some argue that a new form of MNC is evolving in response to globalization—e.g. the 'globally integrated enterprise'.

History

There is a dispute as to which was the first MNC. Some have argued that the Knights Templar, founded in 1118, became a multinational when it stumbled into banking in 1135. However, others claim that the British East India Company or the Dutch East India Company were in fact the first proper multinationals.

Multinational corporate structure

Multinational corporations can be divided into three broad groups according to the configuration of their production facilities:

• Horizontally integrated multinational corporations manage production establishments located in different countries to produce the same or similar products. (example: McDonalds)

• Vertically integrated multinational corporations manage production establishment in certain country/countries to produce products that serve as input to its production establishments in other country/countries. (example: Adidas)

• Diversified multinational corporations manage production establishments located in different countries that are neither horizontally or vertically integrated. (example: Microsoft)

Others argue that a key feature of the multinational is the inclusion of back-office functions (e.g. supply, procurement, finance and human resources) in each of the countries in which they operate. Effectively the multinational creates a small version of itself in each country. The globally integrated enterprise, which some see as the next stage in the evolution of the multinational, does away with this requirement.

International power

Large multinational corporations can have a powerful influence in international relations, given their large economic influence in politicians' representative districts, as well as their extensive financial resources available for public relations and political lobbying.

Multinationals have played an important role in globalization. Prospective country locations for MNC production establishments, and sometimes regions within countries, must compete with each other to have MNCs locate their facilities (and subsequent tax revenue, employment, and economic activity) within a region. To compete, countries and regional political districts offer incentives to MNCs such as tax breaks, pledges of governmental assistance or improved infrastructure, or lax environmental and labor standards. This process of becoming more



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attractive to foreign investment can be characterized as a race to the bottom, a push towards greater freedom for corporate bodies, or both.

An inaccurate claim is that out of the 100 largest economies in the world, 51 are multinational corporations. This claim is based on a miscalculation, where two numbers describing totally different things are compared: the GDP of nations to gross sales of corporations. The problem with the comparison is that GDP takes into account only the final value, whereas gross sales don't measure how much was produced outside the company. According to Swedish economist Johan Norberg, if we were to compare nations and corporations, we should be comparing GDP to goods only produced within the particular company (gross sales do not take into account goods purchased from 3rd party vendors and resold, just as GDP does not take into account imported goods). That correction would make only 37 of 100 largest economies corporations and all of them would be in bottom box: only 5 corporations would be in top 50.

Because of their size, multinationals can have a significant impact on government policy, primarily through the threat of market withdrawal.[2] For example, in an effort to reduce health care costs, some countries have tried to force pharmaceutical companies to license their patented drugs to local competitors for a very low fee, thereby artificially lowering the price. When faced with that threat, multinational pharmaceuticals firms have simply withdrawn from the market, which often leads to limited availability of advanced drugs. In those cases, governments have been forced to back down from their efforts. Similar corporate and government confrontations have occurred when governments tried to force companies to make their intellectual property public in an effort to gain technology for local entrepreneurs. When companies are faced with the option of losing their core competitive advantage (technology) and losing a national market, they may choose to withdraw from the national market. This withdrawal often causes governments to change policy. Countries that have been most successful in this type of confrontation with multinational corporations are large countries such as India and Brazil, which have viable indigenous market competitors.

Multinational corporate lobbying is directed at a range of business concerns, from tariff structures to environmental regulations. There is no unified multinational perspective on any of these issues. Companies that have invested heavily in pollution control mechanisms may lobby for very tough environmental standards in an effort to force non-compliant competitors into a weaker position. For every tariff category that one multinational wants to have reduced, there is another multinational that wants the tariff raised. Even within the U.S. auto industry, the fraction of a company's imported components will vary, so some firms favor tighter import restrictions, while others favor looser ones.

In addition to efforts by multinational corporations to affect governments, there are many actions taken by governments to affect corporate behavior. The threat of nationalization (forcing a company to sell its local assets to the government or to other local nationals) or changes in local business laws and regulations limit a multinational's power.

The mobility of capital brought by multinational corporations can create "a race to the bottom". This refers to efforts by governments to change their laws and regulations to become more corporate friendly in order to attract multinational investment. As they become more responsive to the interests of multinational corporations, there is the risk that governments can become less responsive to local constituents. Examples of this are laws that bar unionization or permit lax environmental standards. Those laws are often chosen because governments also find the corporate-friendly rules comfortable. China, for example, bars unionization in most cases, but it



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also bars almost every other civil society organization above the very local level that is not government controlled.

Examples

List of multinational corporations

• British Petroleum • The Coca-Cola Company • DaimlerChrysler AG • General Electric • Honda Motor Company • International Business Machines • McDonalds Corporation • Microsoft Corporation • Nintendo Company, Limited • Intel Corporation • Nokia Corporation • Siemens AG • Sony Corporation • Texas Instruments • Toyota Motor Corporation • Wal-Mart Stores, Inc • Ford motors • Mittal steel



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Foreign Direct Investment (FDI)

Foreign direct investment (FDI) plays an extraordinary and growing role in global business. It can provide a firm with new markets and marketing channels, cheaper production facilities, access to new technology, products, skills and financing. For a host country or the foreign firm which receives the investment, it can provide a source of new technologies, capital, processes, products, organizational technologies and management skills, and as such can provide a strong impetus to economic development.

Foreign direct investment, in its classic definition, is defined as a company from one country making a physical investment into building a factory in another country. The direct investment in buildings, machinery and equipment is in contrast with making a portfolio investment, which is considered an indirect investment. In recent years, given rapid growth and change in global investment patterns, the definition has been broadened to include the acquisition of a lasting management interest in a company or enterprise outside the investing firm’s home country. As such, it may take many forms, such as a direct acquisition of a foreign firm, construction of a facility, or investment in a joint venture or strategic alliance with a local firm with attendant input of technology, licensing of intellectual property,

In the past decade, FDI has come to play a major role in the internationalization of business. Reacting to changes in technology, growing liberalization of the national regulatory framework governing investment in enterprises, and changes in capital markets profound changes have occurred in the size, scope and methods of FDI. New information technology systems, decline in global communication costs have made management of foreign investments far easier than in the past. The sea change in trade and investment policies and the regulatory environment globally in the past decade, including trade policy and tariff liberalization, easing of restrictions on foreign investment and acquisition in many nations, and the deregulation and privitazation of many industries, has probably been been the most significant catalyst for FDI’s expanded role.

The most profound effect has been seen in developing countries, where yearly foreign direct investment flows have increased from an average of less than $10 billion in the 1970’s to a yearly average of less than $20 billion in the 1980’s, to explode in the 1990s from $26.7billion in 1990 to $179 billion in 1998 and $208 billion in 1999 and now comprise a large portion of global FDI.. Driven by mergers and acquisitions and internationalization of production in a range of industries, FDI into developed countries last year rose to $636 billion, from $481 billion in 1998. (Source: UNCTAD)

Proponents of foreign investment point out that the exchange of investment flows benefits both the home country (the country from which the investment originates) and the host country (the destination of the investment). Opponents of FDI note that multinational conglomerates are able to wield great power over smaller and weaker economies and can drive out much local competition. The truth lies somewhere in the middle.

For small and medium sized companies, FDI represents an opportunity to become more actively involved in international business activities. In the past 15 years, the classic definition of FDI as noted above has changed considerably. This notion of a change in the classic definition, however, must be kept in the proper context. Very clearly, over 2/3 of direct foreign investment is still made in the form of fixtures, machinery, equipment and buildings. Moreover, larger multinational corporations and conglomerates still make the overwhelming percentage of FDI.



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But, with the advent of the Internet, the increasing role of technology, loosening of direct investment restrictions in many markets and decreasing communication costs means that newer, non-traditional forms of investment will play an important role in the future. Many governments, especially in industrialized and developed nations, pay very close attention to foreign direct investment because the investment flows into and out of their economies can and does have a significant impact

How Has FDI Changed in the Past Decade?

As mentioned above, the overwhelming majority of foreign direct investment is made in the form of fixtures, machinery, equipment and buildings. This investment is achieved or accomplished mostly via mergers & acquisitions. In the case of traditional manufacturing, this has been the primary mechanism for investment and it has been heretofore very efficient. Within the past decade, however, there has been a dramatic increase in the number of technology startups and this, together with the rise in prominence of Internet usage, has fostered increasing changes in foreign investment patterns. Many of these high tech startups are very small companies that have grown out of research & development projects often affiliated with major universities and with some government sponsorship. Unlike traditional manufacturers, many of these companies do not require huge manufacturing plants and immense warehouses to store inventory. Another factor to consider is the number of companies whose primary product is an intellectual property right such as a software program or a software-based technology or process. Companies such as these can be housed almost anywhere and therefore making a capital investment in them does not require huge outlays for fixtures, machinery and plants.

In many cases, large companies still play a dominant role in investment activities in small, high tech oriented companies. However, unlike in the past, these larger companies are not necessarily acquiring smaller companies outright. There are several reasons for this, but the most important one is most likely the risk associated with such high tech ventures. In the case of mature industries, the products are well defined. The manufacturer usually wants to get closer to its foreign market or wants to circumvent some trade barrier by making a direct foreign investment. The major risk here is that you do not sell enough of the product that you manufactured. However, you have added additional capacity and in the case of multinational corporations this capacity can be used in a variety of ways.

High tech ventures tend to have longer incubation periods. That is, the product tends to require significant development time. In the case of software and other intellectual property type products, the product is constantly changing even before it hits the marketplace. This makes the investment decision more complicated. When you invest in fixtures and machinery, you know what the real and book value of your investment will be. When you invest in a high tech venture, there is always an element of uncertainty. Unfortunately, the recent spate of dot.com failures is quite illustrative of this point.

Therefore, the expanded role of technology and intellectual property has changed the foreign direct investment playing field. Companies are still motivated to make foreign investments, but because of the vagaries of technology investments, they are now finding new vehicles to accomplish their goals. Consider the following:

� Licensing and technology transfer: Licensing and tech transfer have been essential in promoting collaboration between the academic and business communities. Ever since legal hurdles were removed that allowed universities to hold title to research and



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development done in their labs, licensing agreements have helped turned raw technology into finished products that are viable in competitive marketplaces. With some help from a variety of government agencies in the form of grants for R&D as well as other financial assistance for such things as incubator programs, once timid college researchers are now stepping out and becoming cutting edge entrepreneurs. These strategic alliances have had a serious impact in several high tech industries, including but not limited to: medical and agricultural biotechnology, computer software engineering, telecommunications, advanced materials processing, ceramics, thin materials processing, photonics, digital multimedia production and publishing, optics and imaging and robotics and automation. Industry clusters are now growing up around the university labs where their derivative technologies were first discovered and nurtured. Licensing agreements allow companies to take full advantage of new and exciting technologies while limiting their overall risk to royalty payments until a particular technology is fully developed and thus ready to put new products into the manufacturing pipeline.

� Reciprocal distribution agreements. Actually, this type of strategic alliance is more trade-based, but in a very real sense it does in fact represent a type of direct investment. Basically, two companies, usually within the same or affiliated industries, agree to act as a national distributor for each other’s products. The classical example is to be found in the furniture industry. A U.S.-based manufacturer of tables signs a reciprocal distribution agreement with a Spanish-based manufacturer of chairs. Both companies gain direct access to the other’s distribution network without having to pay distributor support payments and other related expenses found within the distribution channel and neither company can hurt the other’s market for its products. Without such an agreement in place, the Spanish manufacturer might very well have to invest in a national sales office to coordinate its distributor network, manage warehousing, inventory and shipping as well as to handle administrative tasks such as accounting, public relations and advertising.

� Joint venture and other hybrid strategic alliances: The more traditional joint venture is bi-lateral, that is it involves two parties who are within the same industry who are partnering for some strategic advantage. Typical reasons might include a need for access to proprietary technology that might tip the competitive edge in another competitor’s favor, desire to gain access to intellectual capital in the form of ultra-expensive human resources, access to heretofore closed channels of distribution in key regions of the world. One very good reason why many joint ventures only involve two parties is the difficulty in integrating different corporate cultures. With two domestic companies from the same country, it would still be very difficult. However, with two companies from different cultures, it is almost impossible at times. This is probably why pure joint ventures have a fairly high failure rate only five years after inception. Joint ventures involving three or more parties are usually called syndicates and are most often formed for specific projects such as large construction or public works projects that might involve a wide variety of expertise and resources for successful completion. In some cases, syndicates are actually easier to manage because the project itself sets certain limits on each party and close cooperation is not always a prerequisite for ultimate success of the endeavor.



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� Portfolio investmen.: Yes, we know that you’re paying attention and no we’re not trying to trip you up here. Remember our definition of foreign direct investment as it pertains to controlling interest. For most of the latter part of the 20th century when FDI became an issue, a company’s portfolio investments were not considered a direct investment if the amount of stock and/or capital was not enough to garner a significant voting interest amongst shareholders or owners. However, two or three companies with "soft" investments in another company could find some mutual interests and use their shareholder power effectively for management control. This is another form of strategic alliance, sometimes called "shadow alliances". So, while most company portfolio investments do not strictly qualify as a direct foreign investment, there are instances within a certain context that they are in fact a real direct investment.

Why is FDI important for any consideration of going global?

The simple answer is that making a direct foreign investment allows companies to accomplish several tasks:

Avoiding foreign government pressure for local production. Circumventing trade barriers, hidden and otherwise. Making the move from domestic export sales to a locally-based national sales office. Capability to increase total production capacity. Opportunities for co-production, joint ventures with local partners, joint marketing arrangements, licensing, etc;

A more complete response might address the issue of global business partnering in very general terms. While it is nice that many business writers like the expression, “think globally, act locally”, this often used cliché does not really mean very much to the average business executive in a small and medium sized company. The phrase does have significant connotations for multinational corporations. But for executives in SME’s, it is still just another buzzword. The simple explanation for this is the difference in perspective between executives of multinational corporations and small and medium sized companies. Multinational corporations are almost always concerned with worldwide manufacturing capacity and proximity to major markets. Small and medium sized companies tend to be more concerned with selling their products in overseas markets. The advent of the Internet has ushered in a new and very different mindset that tends to focus more on access issues. SME’s in particular are now focusing on access to markets, access to expertise and most of all access to technology.

What would be some of the basic requirements for companies considering a foreign investment?

Depending on the industry sector and type of business, a foreign direct investment may be an attractive and viable option. With rapid globalization of many industries and vertical integration rapidly taking place on a global level, at a minimum a firm needs to keep abreast of global trends in their industry. From a competitive standpoint, it is important to be aware of whether a company’s competitors are expanding into a foreign market and how they are doing that. At the same time, it also becomes important to monitor how globalization is affecting domestic clients. Often, it becomes imperative to follow the expansion of key clients overseas if an active business relationship is to be maintained.



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New market access is also another major reason to invest in a foreign country. At some stage, export of product or service reaches a critical mass of amount and cost where foreign production or location begins to be more cost effective. Any decision on investing is thus a combination of a number of key factors including:

Assessment of internal resources, competitiveness, Market analysis Market expectations.

From an internal resources standpoint, does the firm have senior management support for the investment and the internal management and system capabilities to support the set up time as well as ongoing management of a foreign subsidiary?

Has the company conducted extensive market research involving both the industry, product and local regulations governing foreign investment which will set the broad market parameters for any investment decision? Is there a realistic assessment in place of what resource utilization the investment will entail? Has information on local industry and foreign investment regulations, incentives, profit retention, financing, distribution, and other factors been completely analyzed to determine the most viable vehicle for entering the market (Greenfield, acquisition, merger, joint venture, etc.)?

Has a plan been drawn up with reasonable expectations for expansion into the market through that local vehicle? If the foreign economy, industry or foreign investment climate is characterized by government regulation, have the relevant government agencies been contacted and concurred? Have political risk and foreign exchange risk been factored into the business plan?



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Appendix: India continues to be the best place to start a business, says a global services location index by AT Kearney. In another AT Kearney study, India has displaced the US to become the second-most favoured destination for foreign direct investment after China. It has now been named as the top reformer in South Asia in the annual Doing Business Report issued by the International Finance Corporation (IFC).

It is evident. India is in the reckoning. And the figures appear to be improving by the day. While FDI equity flows were US$ 5.5 billion in 2005-06, it increased almost three times to US$ 15.7 billion in 2006-07, representing a growth rate of 184 per cent. With this, the cumulative FDI inflows in to the country since 1991 reached US$ 54.6 billion.

Further, the Government seeks to double the FDI inflow to US$ 30 billion this fiscal in order to maintain a growth rate of 9 per cent per annum over the next five years.

According to the World Bank, India cornered a major portion of US$ 40.1 billion net capital inflows to South Asia in 2006. In fact, India has overtaken the erstwhile East Asian Tigers — Thailand, Malaysia, Indonesia, the Philippines, Taiwan and South Korea — in terms of FDI flows. If one excluded Singapore and Hong Kong from the list — they are not comparable as FDI in these countries is more into trading activities — India would be No. 2 destination for FDI in Asia.

The principal sources of FDI between 1991 and March 2007 have been Mauritius, US, UK, The Netherlands, Japan, Germany and Singapore (in that order). The principal sectors attracting FDI during this period have been electrical equipment, services, telecommunications, transportation, fuels, chemicals and construction (in that order).

In a bid to stimulate this sector, the Government has taken on a series of ambitious economic reforms.

• The Centre has divested some of its own powers of approving foreign investments that it exercised through the Foreign Investment Promotion Board (FIPB) and has handed them over to the general permission route under the RBI.

• The FDI cap for telecommunications has been increased to 74 per cent, up from the earlier ceiling of 49 per cent.

• It has set up an Investment Commission that will garner investments in the infrastructure sector among others, and plans to increase the limit for investment in the infrastructure sector.

• The Government approved sweeping reforms in FDI with a first step towards partially opening retail markets to foreign investors. It will now allow 51 per cent FDI in single brand products in the retail sector. Besides retail, other sector are being opened:

• 100 per cent is allowed in new sectors such as power trading, processing and warehousing of coffee and rubber.

Economic Survey 2006-07 says:

There was a strong growth in Foreign Direct Investment (FDI) flows with three quarters of such flows in the form of equity. The growth rate was 27.4 per cent in 2005-06, which was followed by 98.4 per cent in April-September 2006. At US$ 4.2 billion during the first six months of this fiscal, FDI was almost twice its level in April-September, 2005. Capital flows into India remained strong on an overall basis even after gross outflows under FDI with domestic corporate entities seeking a global presence to harness scale, technology and market access advantages through acquisitions overseas.



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• FDI limit raised to 100 per cent under automatic route in mining of diamonds and precious stones, development of new airports, cash and carry wholesale trading and export trading, laying of natural gas pipelines, petroleum infrastructure, captive mining of coal and lignite.

• Subject to other regulations, 100 per cent FDI is allowed in distillation and brewing of potable alcohol, industrial explosives and hazardous chemicals.

• Indian investor allowed to transfer shares in an existing company to foreign investors. • Foreign funds would be allowed to own up to 26 per cent stake in entities that would be

set up by state-owned banks, mutual funds and financial institutions to manage pension funds.

As pointed out by Minister of State for Industries, Dr Ashwani Kumar, nearly 98 per cent of the Indian economy is open to FDI through the automatic route. To accelerate inflow of FDI in to the country the Government is planning to further deregulate the FDI regime across various sectors. Among others, the following decisions could be made:

• Allow 51 per cent FDI in multi-brand lifestyle retail like sports goods, apparel and gems, & jewellery.

• Allow 100 per cent FDI in the creation of merchant airports and in limonite mining (titanium ore)

• Cable TV operators could be allowed to increase their FDI cap from the existing 49 per cent to 74 per cent to bring them at par with the telecom sector.

• The Government is planning to fix a higher FDI ceiling for five sub-sectors of the aviation industry -- maintenance, training facilities, cargo handling, passenger handling and chartered service -- from 49 per cent to 100 per cent

The inflow of FDI in to the country continues to grow. In the first half of June, the Government has approved 40 FDI proposals which together constitute US$ 132.72 million investment.

The growing attractiveness of the Indian economy across various sectors with respect to FDI has been validated by various projections made:

• According to Ernst & Young, the telecom sector will see investments of up to US$ 25 billion over the next five years. Besides, India, along with China, will become one of the most attractive countries for investment in renewable energy projects by 2012.

• According to a report by property consultants Jones Lang LaSalle on rising FDI in real estate, an estimated US$ 10 billion foreign investment is expected to enter the Indian real estate sector in the next 12-18 months.

• According to financial advisory firm PricewaterhouseCoopers, India, along with China, will remain one of the top two targets for mergers and acquisitions in the region.

Political Risk Management

Political risk is a broad term to collectively describe the risks companies and investors face due to the exercise of political power. These include potential losses from expropriation, nationalization and regulatory changes, as well as the potential risk of a government or government agency not honoring a contract. Political risks also include potential losses due to riots, civil-war and terrorism, as well as soft threats such as reputation damage and firm specific boycotts. Political risks are sometimes divided into country specific risks (which affect all companies operating within a particular country) and investment specific risks (such as discriminatory regulations). Political risks to portfolio investors tend to be country specific whereas political risks to foreign direct investors and individual companies tend to be investment specific.2 It is the company’s chief financial officer or the risk manager who is responsible for assessing a company’s exposure to political risks, as well as to develop specific risk mitigation strategies. Companies frequently outsource the country analysis to political risk advisory firms, which specialize in assessing these types of risks. Companies may also develop relations with relevant authorities and community groups to mitigate investment specific risks. Political risk is always a factor in international commerce due to the unavoidable differences between the laws, customs and policies of foreign governments. As foreigners entering new markets, we often lack the local market knowledge and culture to understand these differences and must depend on outside sources for information and forecasts. In most Westernized nations, a vast library of economic statistics and political analysis is publicly available for review. These countries tend to have well-developed and predictable economies and relatively stable governments. Developing countries offer less transparency and access to accurate economic or industry statistics may not exist at all. By understanding the elements of political and economic risk, it is easier to define a model for risk management and decision-making and to collect appropriate data for analysis. This article will review the various components of economic and political risk and offer a method used for quantifying and comparing the "riskiness" of doing business in different countries. If a company has global business interests, your assets and investments may be at risk. A foreign marketplace not only offers great business opportunities, it also presents greater financial uncertainty. Some of the unforeseeable events include:

� Economic instability � War & Political violence � Foreign Policy changes � Confiscation � Fluctuation in Currency Exchange � Deprivation of capital � Embargo or license cancellation

Political Risk management helps mitigate the risk to your assets, while allowing your business to expand its international interests. Protect your company against:

� Unpredictable changes in government policy towards foreign investors � Repatriation of profits, intra-company fees or dividends, which can be interrupted if

the host country’s economic priorities change and approvals for foreign exchange and currency transfer and not forthcoming

� Physical damage to your assets due to politically motivated violence � Losses of permanent, mobile and leased assets due to confiscation, non-repossession,

or political violence There are many services that measure Political country risk. The appendix provides information on the following providers:

1. Bank of America World Information Services 2. Business Environment Risk Intelligence (BERI) S.A. 3. Control Risks Information Services (CRIS) 4. Economist Intelligence Unit (EIU) 5. Euro-money 6. Institutional Investor 7. Standard and Poor's Rating Group 8. Political Risk Services: International Country Risk Guide (ICRG) 9. Political Risk Services: Coplin-O'Leary Rating System 10. Moody's Investor Services

Shifts in global conditions are changing the acceptance rate for international resource projects. Major projects, unviable as recently as two to three years ago, are now attractive investments. Rising prices in commodity markets, strong demand growth from China and increasingly India, combined with limited mineral and energy prospects in developed nations, have caused resource companies to look to a new geographical frontier for mining and energy projects. This frontier – in places where mineral or energy exploitation has not previously occurred, or was deemed too remote, dangerous or difficult – is not well understood and faces a number of issues including changing agendas of governments, the presence of separatist groups, ethnic and cultural conflict, and civil war. The new frontier is complex and introduces an element of risk for investors which management must consider. Political risk is 'the possibility that political decisions, conditions, or events in a country will affect the business climate in such as a way they investors will lose money or not make as much money as they expected when the investment was made. Risk evaluation is 'an effort to determine the level of risk pr probability of losses, given the character of the situation'. The requires a method of forecasting risk because 'there is much less utility in simply describing conditions to day than there is in what the conditions will be in 18 months of five years when investments achieve some kind of maturity.' 1 A number of models formulated to evaluate risk are reviewed below.

Formal Political risk evaluation models: Formal risk evaluation models scrutinize statistic and are unlikely to omit significant risk factors, allowing countries to be compared on a direct statistical basis. 'They are systematic, lend credibility to analysis, employ experts who test the viability of the models or their components and serve as a 'cross-check against subjective assessments. Formal systems help companies not wishing to formulate in-house models, which are expensive, time-consuming and of little geographic coverage. They help to educate staff in their target country and they are generally transparent, allow company officials to 'see the reasoning and methodology behind a judgment.' Formal systems can be, however inflexible. Their statistical base may cause analysts to overlook important country-specific variables. They may appear objective while based on subjective foundations, and the accent on statistic may emphasize economic data at the expense of political input. Dependence on systems may impede judgment. The quest for objective may detract from a desirable 'subjective element,' leading to an overly-scientific approach. The selection of factors, the importance attributed to them and the interpretation of results are subjective judgments.

� Checklist systems aim to be comprehensive. They include 'specific indicators and general questions that need answering through a subjective judgment.' they aim at 'a country risk Rating with the maximum objective' achieved via a ' scientific route.' Checklists offer a 'formal ' score, but specific indicators must carefully assessed. Analysts may favour quantifiable factors and statistics, but statistics can be misleading and do not guarantee objectivity. Though analysts select 'the important factors', the selection process is a subjective one. Analysts could improve checklists by combining them with other models. While checklists are useful, there is no guarantee that 'relationship that existed during the period of empirical observation remain valid now or in the future. They might add more increases and cross-referenced so that they 'cover some of the same ground as a way of guarding against misleading statistics.'

� Statistical systems use' a weighted set of indicators' to predict risk. The system samples

countries which have rescheduled debts and others that have not. Variables are then identified to differentiate the two groups of countries. These systems are a 'useful cross-check' against other method and function as an early warning device. If rescheduling is expected, 'resources can then be focused on an in-depth country risk investigation, including visits, relying on the economic, political and social structure.'

� Sampling, however, is not an objective process, and the factors that lead countries to

reschedule can vary if economic and trade circumstances change. Consequently, definitive judgments about countries cannot be made, and if the economic paradigm changes, comparisons become invalid. System should be redesigned to forecast debt rescheduling, rather than explain it retrospectively.

� Economic forecasting, or econometric modeling, is useful, though time-consuming. It

may help analysts to understand an economy, but data is often unreliable or incomplete as 'developing countries are relatively less stable than developed countries'. Econometric

models' suffer from the difficulty of securing current sources of data for many of the important independent variables necessary for the analysis.'

� Scenario analysis seeks to forecast country risk by the 'elaboration of two or more

alternative scenarios'. A 'sensitivity analysis' then indicates 'the importance of particulars parameters to the final outcome.' Firstly, the parameters have to be selected:external factors (world trade growth, oil prices) and internal factors (national trade polices, political regime etc.). Then the scenarios are plotted. This is good, general method which can be adapted to include specific country indicators. It is a useful ' framework for analyzing a group of countries to provide a comparative analysis.'

� Bank evaluate risk with economic and credit surveys, quantitative or statistical analysis,

political, social and strategic analysis, or a qualitative analysis of economic, social, political and financial situation).

� Survey-based models often combine expert opinions with a scoring system for country

risk ranking. A model that linked ' political instability to the accumulation of public external debt, private capital outflow, income distribution, restrictions on capital outflow and repudiation of external debt' would be an improvement. This is in progress.

� Statistical models, though arguably more objective than politico-judgmental models, are

not necessarily more reliable. They have methodological weaknesses and assume that' historical data has significant value for predicting future outcomes.'

� Country rating systems have generally been unsuccessful. The problem may lie not with

the individual analyses but ' in the way they are exploited.' While an analysis may accurately describe country risk, it may not effectively applied.

� Selection of the appropriate model depends on the purpose for a bank's assessment of risk.

� Qualitative models may prove sufficient if comparisons are required, some

quantification of risk is required. Qualitative models can allocate score, but it is difficult to ensure a 'consistency of approach to all countries. 'Though subjectivity cannot be wholly removed, the process should be ' as scientific as possible.'

� Though 'economic risk factors involve some subjectivity', decisions can be based on

them. Political factors such as internal unrest or external conflict offer no hard data on which to base a judgment.

� A mixed-model may be the solution, perhaps a checklist scoring system supported by a

statistical model ' or a qualitative report-orientated system'

� While 'experts based system can be criticized for not always making causal relationships explicit and for their potential bias in the judgment of its members. They ' can help a great deal in lending order and some precision to qualitative analysis . Expert and Delphi systems 'exploit the expertise of analysts', but while they enjoy the 'strength of group forecasting', analysts 'must be extremely diligent about the selection of "experts" as they tend to disagree as often as the agree.

What tools are there available to understand and manage political risk? While quantifying these abstract issues remains important, embracing shades of grey requires the firm to look very closely at the tools that generate the assumptions underlying their numbers. To ask the right questions, for both the initial investment decision and ongoing monitoring of the project, the assessment should include the academic or expert regional perspective and the technical experts in conjunction with a number of other key sources. This allows for a strategic framework which provides context from which political risk can be better understood. Context is critical because it leads to better questions, analysis of the correct information and improved assumptions upon which decisions can be made. The ideal evaluation of political risk should be made on the basis of the following tools: Academic Expertise: Engaging experts on the culture and history of a region is an important aspect of understanding political risk. While too much emphasis, we believe, can be put on their interpretations, this background information is critical in providing the context for understanding contemporary issues. Technical Acumen: A basic understanding of the technical aspects of the economic cycle, business decision making and resource projects is required to evaluate political risk. This allows a broader review of influencing factors to be considered. Humint or (Human intelligence): On-the-ground information is critical for new projects. In regions where there are no other international resource projects, and a lack of press reporting, knowing what is occurring at the street level is critical. Trend Analysis: Contextual trend analysis, such as the work done by the Australian Office of National Assessments, can provide important information and context which is not obvious to regional or country experts and not initially obvious to business. This involves continuous review of demographic, social, environmental, financial, military and political trends across states and across regions. Given the significant value of new resource projects coming on stream over the next few years, political risk will become a significant success factor for a number of companies.



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Case Study:

Enron versus Bombay Politicians: On August 3, 1995, the Maharashtra state government of India, dominated by the nationalist, right-wing Bharatiya Janata Party (BJP), abruptly canceled Enron’s $2.9 billion power project in Dabhol, located south of Bombay, the industrial heartland of India. This came as a huge blow to Rebecca P. Mark, the chairman and chief executive of Enron’s international power unit, who spearheaded the Houston-based energy giant’s international investment drive. Upon the news release, Enron’s share price fell immediately by about 10 percent to $331⁄2. Mark sprang to action to resuscitate the deal with the Maharashtra state, promising concessions. This effort, however, was met with scorn from BJP politicians. Enron’s Dabhol debacle cast a serious doubt on the company’s aggressive global expansion strategy, involving some $10 billion in projects in power plants and pipelines spanning across Asia, South America, and Middle East. Enron became involved in the project in 1992 when the new reformist government of the Congress Party (I), led by Prime Minister Narasimha Rao, was keen on attracting foreign investment in infrastructure. After meeting with the Indian government officials visiting Houston in May, Enron dispatched executives to India to hammer out a “memorandum of understanding” in just 10 days to build a massive 2,015-megawatt Dabhol power complex. New Delhi placed the project on a fast track and awarded it to Enron without competitive bidding. Subsequently, the Maharashtra State Electricity Board (MSEB) agreed to buy 90 percent of the power Dabhol produces. Two other U.S. companies, General Electric (GE) and Bechtel Group, agreed to join Enron as partners for the Dabhol project. In the process of structuring the deal, Enron made a profound political miscalculation .It did not seriously take into consideration a rising backlash against foreign investments by an opposition coalition led by the BJP. During the state election campaign in early 1995, the BJP called for a reevaluation of the Enron project. Jay Dubashi, the BJP’s economic advisor, said that the BJP would review all foreign investments already in India, and “If it turns out that we have to ask them to go, then we’ll ask them to go.” Instead of waiting for the election results, Enron rushed to close the deal and began construction, apparently believing that a new government would find it difficult to unwind the deal when construction was already under way. Enron was not very concerned with local political sentiments. Enron fought to keep the contract details confidential, but a successful lawsuit by a Bombay consumer group forced the company to reveal the details: Enron would receive 7.4 cents per kilowatt-hour from MSEB and Enron’s rate of return would be 23 percent, far higher than 16 percent over the capital cost that the Indian government guaranteed to others. Critics cited the disclosure as proof that Enron had exaggerated project costs to begin with and that the deal might have involved corruption. The BJP won the 1995 election in Maharashtra state and fulfilled its promise. Manohar Joshi, the newly elected chief minister of Maharashtra, who campaigned on a pledge to “drive Enron into the sea,” promptly canceled the project, citing inflated project costs and too high electricity rates. This pledge played well with Indian voters with visceral distrust of foreign companies since the British colonial era. (It helps to recall that India was first colonized by a foreign company, the British East India Company.) By the time the project was canceled, Enron already had invested some $200 million. Officials of the Congress Party who championed the Dabhol project in the first place did not come to the rescue of the project. The BJP criticized the Congress Party, rightly or wrongly, for being too corrupt to reform the economy and too cozy with business interests. In an effort to pressure Maharashtra to reverse its decision, Enron “pushed



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like hell” the U.S. Energy Department to make a statement in June 1995 to the effect that canceling the Enron deal could adversely affect other power projects. The statement only compounded the situation. The BJP politicians immediately criticized the statement as an attempt by Washington to bully India. After months of nasty exchanges and lawsuits, Enron and Maharashtra negotiators agreed to revive the Dabhol project. The new deal requires that Enron cut the project’s cost from $2.9 billion to $2.5 billion, lower the proposed electricity rates, and make a state-owned utility a new 30 percent partner of the project. A satisfied Joshi, the chief minister, stated: “Maharashtra has gained tremendously by this decision.” Enron needed to make a major concession to demonstrate that its global power projects are still on track. The new deal led Enron to withdraw a lawsuit seeking $500 million in damages from Maharashtra for the cancellation of the Dabhol project. Discussion Points: 1. Discuss the chief mistakes that Enron made in India. 2. Discuss what Enron might have done differently to avoid its predicament in India.



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International Portfolio Investment: In light of the various capital crises in the past few years, there has been a tendency to denigrate Portfolio investment, while singing the praises of direct investment. Yet, it is also recognized that efficient capital markets help to mobilize financing for growth and development. Both direct and Portfolio investment can promote sustainable growth in developing, and industrialized, economies, albeit in different ways. Both portfolio and direct investment provide economic benefits, and the two together can enhance those benefits. It is not helpful to discriminate against one type of investment or the other, although it is necessary to recognize their differences. With the right policies, both can contribute to a strong and healthy economy. Benefits – Complementarily and Differences: Adequate capital flows are a basic and now universally acknowledged requirement for economic Growth. The provision of capital is probably the most fundamental point of complementarily between portfolio and direct investment. Both forms of foreign investment provide capital flows beyond those available through domestic savings. Both serve to boost investment and economic activity in the domestic economy, allowing a higher level of economic growth than would otherwise be possible. Both foreign direct and portfolio investment bring a range of benefits for economic growth, though there may be a marked difference between those benefits. Benefits of Foreign Portfolio Investment Foreign portfolio investment increases the liquidity of domestic capital markets, and can help develop market efficiency as well. As markets become more liquid, as they become deeper and broader, a wider range of investments can be financed. New enterprises, for example, have a greater chance of receiving start-up financing. Savers have more opportunity to invest with the assurance that they will be able to manage their portfolio, or sell their financial securities quickly if they need access to their savings. In this way, liquid markets can also make longer-term investment more attractive. Foreign portfolio investment can also bring discipline and know-how into the domestic capital markets. In a deeper, broader market, investors will have greater incentives to expend resources in researching new or emerging investment opportunities. As enterprises compete for financing, they will face demands for better information, both in terms of quantity and quality. This press for fuller disclosure will promote transparency, which can have positive spill-over into other economic sectors. Foreign portfolio investors, without the advantage of an insider’s knowledge of the investment opportunities, are especially likely to demand a higher level of information disclosure and accounting standards, and bring with them experience utilizing these standards and a knowledge of how they function. Foreign portfolio investment can also help to promote development of equity markets and the shareholders’ voice in corporate governance. As companies compete for finance the market will reward better performance, better prospects for future performance, and better corporate governance. As the market’s liquidity and functionality improves, equity prices will increasingly reflect the underlying values of the firms, enhancing the more efficient allocation of capital flows. Well functioning equity markets will also facilitate takeovers, a point where portfolio and direct investment overlap. Takeovers can turn a poorly functioning firm into an efficient and more profitable firm, strengthening the firm, the financial return to its investors, and the domestic economy.



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Foreign portfolio investors may also help the domestic capital markets by introducing more sophisticated instruments and technology for managing portfolios. For instance, they may bring with them a facility in using futures, options, swaps and other hedging instruments to manage portfolio risk. Increased demand for these instruments would be conducive to developing this function in domestic markets, improving risk management opportunities for both foreign and domestic investors. In the various ways outlined above, foreign portfolio investment can help to strengthen domestic capital markets and improve their functioning. This will lead to a better allocation of capital and resources in the domestic economy, and thus a healthier economy. Open capital markets also contribute to worldwide economic development by improving the worldwide allocation of savings and resources. Open markets give foreign investors the opportunity to diversify their portfolios, improving risk management and possibly fostering a higher level of savings and investment. For foreign portfolio investment, strong and well-regulated financial markets are necessary to deal with the inherent volatility. The financial system must have the capacity to assess and manage risks if it is to prudently and productively invest capital flows, foreign or domestic. Its central role of financial intermediation and credit allocation is a key element of economic growth and development. and bring additional strengths and benefits, but those benefits will be most effective when working within a healthy financial system. For a financial system to maintain its health, the institutions within it must be able to identify, monitor and manage business risks efficiently. The payments system, through financial nstitutions and clearing houses, must be efficient and reliable. The financial system must also have the ability to withstand economic shocks, such as a substantial shift in the exchange or interest rates, or a sudden capital withdrawal. It must, as well, be able to withstand systemic shocks, such as financial distress or bank failure. Systemic risk, from economic or systemic shocks, is a central, and perhaps unique, element of capital markets. It demands adequate capitalization and risk management capabilities. As has been shown above, foreign portfolio investment can be an important player in this function, Revenue Related:

� Attract new sources of demand (to increase growth once growth has stopped in the home market).

� Enter new profitable markets. � Exploit monopolistic advantages (enter a new market to exploif resources or skills

not available in those markets). � React to trade restrictions (if you can not import into a specific country, then build

the product in the foreign country, i.e., Japanese automobiles built in the US) Cost Related

� Fully benefits from economies of scale (by producing more it can sell at lower prices).

� Use foreign factors of production, raw material and technology. I

International Portfolio Investment Investment Decision



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When it comes to investments, we could make the following the statements: 1. Expected returns are enough to guide the investment decision only for investors who are neutral toward risk. 2. For investors who are risk averse, the decision about where to invest takes into account both the expected return and risk of the investment. 3. Investors generally require a higher expected return to compensate for risk. Risky investments must offer a premium over the riskless return. Risk premium = Expected Return – Risk less Return 4. Investors must decide if the risk premium is adequate compensation for the level of risk they face in buying a security with an uncertain future value. Investment decision depends on two types of factors: Objective Factors Risk less Return: Prevailing rates on government securities determine the return an investor gets for giving up the use of their investment capital, that is, the compensation available for the time value of money. Market Price of Risky Security: Normally, an investor can buy a security at a price near the one at which it is currently trading. We can think of these factors as being the same for all investors, since they are market prices. These factors are easy to observe. Subjective Factors: Expected Future Value of Security : Together with the two objective factors, this determines the risk premium. However, the premium perceived by one investor may differ from that seen by another because they may have different forecasts of future value. Required Compensation for Risk : This depends on the investor’s attitude toward risk. If they are neutral toward risk, then it is zero; if they are risk averse it is positive. It will be convenient to measure the degree of risk aversion by an investor’s required compensation for risk, stated as a percent. These factors can vary across investors. They are not easily observed; instead the investor must determine them by introspection. Variation in these subjective factors is what can lead different investors to make different investment decisions and it is because of this that many investors decide to invest internationally.

Why do investors invest abroad? In order to diversify his /her investment. That is, the investor hopes to benefit from market imperfections between countries in an attempt to obtain a similar - or higher - return at a lower level of risk.



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International diversification The attempt to reduce risk by investing in more than one nation. By diversifying across nations whose economic cycles are not perfectly in phase, investors can typically reduce the variability of their return. A diversified portfolio has systematic risk and unsystematic risk. Systematic risk is the risk ofthe market itself. Unsystematic risk is the risk of individual securities within the market and the portfolio. Increasing the number of securities in the portfolio reduces and ultimately eliminates the unsystematic risk the risk of the individual securities leaving only the risk of the market, the systematic risk. Though foreign investing is likely to be beneficial to overall performance, it differs from domestic investing in one major respect: security holdings will be denominated in several different currencies rather than one currency - the U.S. $. Because international investing means holding securities denominated in different currencies whose relative value may fluctuate, it involves a foreign exchange risk: that is exposure to gains or losses on assets denominated in another currency. For obvious reasons, this additional risk (i.e., exchange rate or currency risk) should be taken into consideration when considering the strategy that will be used when investing abroad. Exchange Rate and Risk Considerations Currency risk for a portfolio, like currency risk for a firm or a currency speculator, can be positive or negative. If an investor buys a security denominated in a currency, which then appreciates against the home currency of the investor, it increases the expected returns of the investor in home currency terms. Different international portfolios and portfolio managers deal with this concern very differently. Some international portfolios wish to hedge the currency risk as much as possible, focusing on the expected returns and risks of the individual assets for their portfolio goals. Other managers, however, use the currency of denomination of the asset as part of the expected returns and risks from which the manager is trying to profit.



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Return and Risk of an International Investment Return on Foreign Currency (FC) investment Return on Foreign Currency (FC) investment has two components: 1. Return in foreign currency (FC) terms, and 2. Change in value of foreign currency (FC) in terms of home currency (HC) (i.e., any appreciation/depreciation due to changes in foreign exchange) Home currency (HC) return of a Foreign Portfolio:

(1 )(1 ) 1FC FC

RHC R= + + ∆ −

1(1 ) 1 1 1FC

O

SRHC R

S

= + + − −

Where , RFC = foreign Currency (FC) Return includes an expected dividend yield an expected change in local market value Where , RFC = foreign currency (FC) return = includes an expected dividend yield and expected change in local market value Bonds

1 0

1

CF C

B BR

B

++=

where B = bond price in FC; C = coupon in FC Stocks

1 0

1

CP PF C

P

R+ +=

where P = stock price in FC; D = dividend in FC Example :Suppose an investor buys a Taiwanese bond with a face value of NT2O,000,

1

0

(1 ) 1FC

SRHC R

S

= + −



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which is priced at NT$19,500 and bears a coupon ofNT$1,700. At the end of the year, the investor sells the bond at a price of NT$ 18,030. During the year, the exchange rate goes from NT$1 = U.S.$0.0375 to NT$l = U.S.$0.0425. What was the investor’s U.S. dollar return on this bond?

Solution:

( )1 0.012757

0.0424(1 0.012757 ) 1

0.037514.77%

18.030 19500 17000.012757

180300.0425

1 1 10.0375HC

HC

RHC

FC

R

R

R

= +

= + −

=

− += =

+ − −

Portfolio Returns of a US & Foreign portfolio: Assuming we invest a% in a portfolio composed of U.S Securities & (1-a)% in a portfolio of foreign securities we have that :

(1 )( )us a RHCp aR

R+ −=

Along with these two factors come two sources of risks:

1. Risk of FC Return 2. ER risk

Where ER risk is a significant component of the risk that US investors face in FC investment.



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How to manage currency risk: There exists several strategies that may be followed when trying to reduce foreign exchange risk Hedging: In order to protect against currency risk , investors may hedge by borrowing or entering into forward currency contracts. Passive Strategy:

� Invest across many foreign markets � In this manner, losses on weak currencies would tend to be offset by gains on strong

currencies . � This has proven to be effective over the short-term , however , in the long term this is not

so effective. How to invest passively:

� One way of investing passively is to create an international index fund, just loke domestic investors would do in recreating the market index( i.e., Invest in securities that compose the index)

� When investing internationally, the investors would try to replicate the performance of the world market.

� However, there exits many problems : 1. There is no index that investors generally agree is representatives of the world

market portfolio 2. Many foreign markets are dominated by only handful of companies 3. There may exists a large degree of mis-pricing in foreign markets than in the US.

To deal with these problems:

� Within individual markets countries try to reduce the number of companies but maintain representation. That is , choose a set of companies from the ones that have the highest weight in the market portfolio , then those which have less etc.

� Focus on major markets countries that tends to dominate the market weighting of an index.

Active Strategy

� Here investors overweight attractive countries or markets & underweight unattractive markets .

� This strategy actually causes investors to become exposed to currency risk because the investor is taking about on the currency in addition to markets.

Benefits of diversification For a diversify investor:

� Foreign markets offer a wider array of securities � The correlation of assets between countries is relatively low. In this case , the investors

may accepts a low expected return on stocks which provide significant diversification benefits .

� Measure risk of a security by the risk which is not elimininated by adding it their portfolio.



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The Capital Asset Pricing Model (CAPM) has simple advice for investors : In equlibirum , a portfolio which holds assets in proportion to their value to the entire market is efficient . This suggest holding the value –weighted positions in each equity markets. Identify the set efficient portfolios using the Variance – Covariance matrix of returns , where the correlation co-efficient have been estimated using return on the market indexes. The indexes are market weighted indexes with each stock’s proporation in the index determined by its market weighted indexes with each stock’s proportion in the index determined by its markets value divided by the aggregate market f all stocks.



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Foreign Exchange Market: The foreign exchange (currency or forex or FX) market exists wherever one currency is traded for another. It is by far the largest market in the world, in terms of cash value traded, and includes trading between large banks, central banks, currency speculators, multinational corporations, governments, and other financial markets and institutions. The trade happening in the forex markets across the globe currently exceeds US$1.9 trillion/day (on average). Retail traders (individuals) are currently a very small part of this market and may only participate indirectly through brokers or banks and may be targets of forex scams.

Market size and liquidity: The foreign exchange market is unique because of:

� its trading volume, � the extreme liquidity of the market, � the large number of, and variety of, traders in the market, � its geographical dispersion, � its long trading hours - 24 hours a day (except on weekends). � the variety of factors that affect exchange rates,

Exchange-traded forex futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts. Forex futures volume has grown rapidly in recent years, but only accounts for about 7% of the total foreign exchange market volume. Average daily global turnover in traditional foreign exchange market transactions totalled $2.7 trillion in April 2006 according to IFSL estimates based on semi-annual London, New York, Tokyo and Singapore Foreign Exchange Committee data. Overall turnover, including non-traditional foreign exchange derivatives and products traded on exchanges, averaged around $2.9 trillion a day. This was more than ten times the size of the combined daily turnover on all the world’s equity markets. Foreign exchange trading increased by 38% between April 2005 and April 2006 and has more than doubled since 2001. This is largely due to the growing importance of foreign exchange as an asset class and an increase in fund management assets, particularly of hedge funds and pension funds. The diverse selection of execution venues such as internet trading platforms has also made it easier for retail traders to trade in the foreign exchange market. Because foreign exchange is an OTC market where brokers/dealers negotiate directly with one another, there is no central exchange or clearing house. The biggest geographic trading centre is the UK, primarily London, which according to IFSL estimates has increased its share of global turnover in traditional transactions from 31.3% in April 2004 to 32.4% in April 2006. Other large centres include the US (with a 18.2% global share), Japan (7.6%) and Singapore (5.7%) Most of the remainder was accounted for by trading in Germany, Switzerland, Australia, Canada, France and Hong Kong.



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Market participants Unlike a stock market, where all participants have access to the same prices, the forex market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest investment banking firms. Within the inter-bank market, spreads, which are the difference between the bid and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle. As you descend the levels of access, the difference between the bid and ask prices

widens. This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the forex market are determined by the size of the “line” (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there are usually smaller investment banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail forex market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001-2004 period in terms of both number and overall size” Central banks also participate in the forex market to align currencies to their economic needs.

Banks

The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account.

Until recently, foreign exchange brokers did large amounts of business, facilitating inter-bank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems, such as EBS, Reuters Dealing 3000 Matching (D2), the Chicago Mercantile Exchange, Bloomberg and TradeBook(R). The broker squawk box lets traders listen in on ongoing inter-bank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.

Source: Euromoney FX survey

10 Currency Traders % of overall volume, May 2006 Rank

Name % of volume

1 Deutsche Bank 19.26

2 UBS 11.86

3 Citigroup 10.39

4 Barclays Capital 6.61

5 Royal Bank of Scotland 6.43

6 Goldman Sachs 5.25

7 HSBC 5.04

8 Bank of America 3.97

9 JPMorgan Chase 3.89

10 Merrill Lynch 3.68



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Commercial companies

An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants.

Central banks

National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high — that is, to trade for a profit based on their more precise information. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.

The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives, however. The combined resources of the market can easily overwhelm any central bank. Several scenarios of this nature were seen in the 1992-93 ERM collapse, and in more recent times in Southeast Asia.

Investment management firms

Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager with an international equity portfolio will need to buy and sell foreign currencies in the spot market in order to pay for purchases of foreign equities. Since the forex transactions are secondary to the actual investment decision, they are not seen as speculative or aimed at profit-maximization.

Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades.

Hedge funds

Hedge funds, such as George Soros's Quantum fund have gained a reputation for aggressive currency speculation since 1990. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor.



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Retail forex brokers

Retail forex brokers or market makers handle a minute fraction of the total volume of the foreign exchange market. According to CNN, one retail broker estimates retail volume at $25-50 billion daily, which is about 2% of the whole market.

Trading characteristics

There is no single unified foreign exchange market. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of interconnected marketplaces, where different currency instruments are traded. This implies that there is no such thing as a single dollar rate - but rather a number of different rates (prices), depending on what bank or market maker is trading. In practice the rates are often very close, otherwise they could be exploited by arbitrageurs.

The main trading centers are in London, New York, Tokyo, and Singapore, but banks throughout the world participate. As the Asian trading session ends, the European session begins, then the US session, and then the Asian begin in their turns. Traders can react to news when it breaks, rather than waiting for the market to open.

There is little or no 'inside information' in the foreign exchange markets. Exchange rate fluctuations are usually caused by actual monetary flows as well as by expectations of changes in monetary flows caused by changes in GDP growth, inflation, interest rates, budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions. Major news is released publicly, often on scheduled dates, so many people have access to the same news at the same time. However, the large banks have an important advantage; they can see their customers' order flow.

Currencies are traded against one another. Each pair of currencies thus constitutes an individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217 international three-letter code of the currency into which the price of one unit of XXX is expressed. For instance, EUR/USD is the price of the euro expressed in US dollars, as in 1 euro = 1.3045 dollar. Out of convention, the first currency in the pair, the base currency, was the stronger currency at the creation of the pair. The second currency, counter currency, was the weaker currency at the creation of the pair.

The factors affecting XXX will affect both XXX/YYY and XXX/ZZZ. This causes positive currency correlation between XXX/YYY and XXX/ZZZ.

On the spot market, according to the BIS study, the most heavily traded products were:

• EUR/USD - 28 % • USD/JPY - 18 % • GBP/USD (also called sterling or cable) - 14 %

Top 6 Most Traded Currencies

Rank Currency ISO 4217 Code Symbol

1 United States dollar USD $

2 Euro zone EUR €

3 Japanese yen JPY ¥

4 British pound sterling GBP £

5-6 Swiss franc CHF -

5-6 Australian dollar AUD $



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and the US currency was involved in 89% of transactions, followed by the euro (37%), the yen (20%) and sterling (17%). (Note that volume percentages should add up to 200% - 100% for all the sellers, and 100% for all the buyers).

Although trading in the euro has grown considerably since the currency's creation in January 1999, the foreign exchange market is thus far still largely dollar-centered. For instance, trading the euro versus a non-European currency ZZZ will usually involve two trades: EUR/USD and USD/ZZZ. The only exception to this is EUR/JPY, which is an established traded currency pair in the interbank spot market.



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Factors affecting currency trading

Although exchange rates are affected by many factors, in the end, currency prices are a result of supply and demand forces. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.

Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.

Economic factors

These include economic policy, disseminated by government agencies and central banks, economic conditions, generally revealed through economic reports, and other economic indicators.Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).

Economic conditions include:

Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.

Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.

Inflation levels and trends: Typically, a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency.

Economic growth and health: Reports such as gross domestic product (GDP), employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.

Political conditions

Internal, regional, and international political conditions and events can have a profound effect on currency markets.

For instance, political upheaval and instability can have a negative impact on a nation's economy. The rise of a political faction that is perceived to be fiscally responsible can have the opposite



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effect. Also, events in one country in a region may spur positive or negative interest in a neighboring country and, in the process, affect its currency.

Market psychology

Perhaps the most difficult to define (there are no balance sheets or income statements), market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

� Flights to quality: Unsettling international events can lead to a "flight to quality" -with investors seeking a "safe haven". There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts.

� Long-term trends: Very often, currency markets move in long, pronounced trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.

� "Buy the rumor, sell the fact:" This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought".

Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect - the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.

Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form patterns that may be recognized and utilized by traders for the purpose of entering and exiting the market, leading to short-term fluctuations in price. Many traders study price charts in order to identify such patterns.

Algorithmic trading in forex

With steady growth of the FX markets and the increasing adoption of E-FX among the market participants, algorithmic trading is emerging as the next level of trading technology for market participants to contend with. Although there is much confusion about the technique, most market participants seem to agree that it will be used increasingly frequently. According to financial consultancy Celent estimates, by 2008 up to 25% of all trades by volume will be executed using algorithm, up from about 18% in 2005.



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Financial instruments in Forex Market :

There are several types of financial instruments commonly used.

� Spot: A spot transaction is a two-day delivery transaction, as opposed to the futures contracts, which are usually three months. This trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. The data for this study come from the spot market. Spot has the largest share by volume in FX transactions among all instruments.

� Forward transaction: One way to deal with the Forex risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be a few days, months or years.

� Futures: Foreign currency futures are forward transactions with standard contract sizes and maturity dates — for example, 500,000 British pounds for next November at an agreed rate. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.

� Swap: The most common type of forward transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not contracts and are not traded through an exchange.

� Options: A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world.



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Comparison of Various Financial Markets

Market Structure

Over the Counter (OTC) or Exchanged Traded, with Electronic Communication Network (ECN) routing available for both.

Exchanged Traded through open outcry in trading pits; some contracts are traded by ECN after hours.

Over the Counter (OTC) market with access to price determined by the market maker.

Spreads Spreads fluctuate according to demand and supply.

Spreads fluctuate according to demand and supply.

Spreads fluctuates on Inter-bank market, many online market makers have fix spread.

Execution Orders on listed stocks are placed with a specialist, who matches buyers and sellers, providing liquidity from his own account as well. OTC orders can be sent to market makers who take the opposite side of the trade at their quoted side.

Orders are executed via open outcry at the exchange pit for each future contract. Orders entered electronically are routed to the pits to be executed.

Orders on the Inter-bank market are sent directly to the counter party via Reuters or EBS. Orders executed with online market makers are executed at the market maker with the market maker as the counter party.

Order Types Market, Limit, Stop, Fill or Kill, All or None, Opening Price Guaranteed, Market on Close, Stop-limit, Market if Touched, Good Until Cancelled, Day Order

Market, Limit, Stop, Fill or Kill, All or None, Market on Open, Market on Close, Stop-limit, Market if Touched, Good Until Cancelled, Day Order

Market, Stop, Stop-limit, Limit

Trading Hours

Typically 9:30am to 4:00pm local time. Off-hours trading can occur through ECN's but it is illiquid.

Vary by product, usually starts from 9:00am to 3:00pm local time. Off-hours trading is possible but illiquid.

24 hours during weekdays.

Volume Available Available Not Available Market Size 100-200 billion USD

daily volume in the US. 300-500 billion USD daily volume in the US.

1.5 trillition daily volume worldwide.

Transaction Cost

Spread and commission/service charge.

Spread and commission/service charge.

Spread only.



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Transfer pricing:

Transfer pricing refers to the pricing of goods and services within a multi-divisional organization, particularly in regard to cross-border transactions. For example, goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary, with the choice of the transfer price affecting the division of the total profit among the parts of the company. This has led to the rise of transfer pricing regulations as governments seek to stem the flow of taxation revenue overseas, making the issue one of great importance for multinational corporations.

Economic theory:

The discussion below explains an economic theory, but in practice a great many factors influence the transfer prices that are used by multinationals, including performance measurement, capabilities of accounting systems, import quotas, customs duties, VAT, taxes on profits, and (in many cases) simple lack of attention to the pricing.

From marginal price determination theory, we know that generally the optimum level of output is that where marginal costs equals marginal revenue. That is to say, a firm should expand its output as long as the marginal revenue from additional sales is greater than their marginal costs. In the diagram that follows, this intersection is represented by point A, which will yield a price of P*, given the demand at point B.

When a firm is selling some of its product to itself, and only to itself (ie.: there is no external market for that particular transfer good), then the picture gets more complicated, but the outcome remains the same. The demand curve remains the same. The optimum price and quantity remain the same. But marginal cost of production can be separated from the firms total marginal costs. Likewise, the marginal revenue associated with the production division can be separated from the marginal revenue for the total firm. This is referred to as the Net Marginal Revenue in production (NMR), and is calculated as the marginal revenue from the firm minus the marginal costs of distribution.It can be shown :



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algebraically that the intersection of the firms marginal cost curve and marginal revenue curve (point A) must occur at the same quantity as the intersection of the production divisions marginal cost curve with the net marginal revenue from production (point C).



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If the production division is able to sell the transfer good in a competitive market (as well as internally), then again both must operate where their marginal costs equal their marginal revenue, for profit maximization. Because the external market is competitive, the firm is a price taker and must accept the transfer price determined by market forces (their marginal revenue from transfer and demand for transfer products becomes the transfer price).

If the market price is relatively high (as in Ptr1 in the next diagram), then the firm will experience an internal surplus (excess internal supply) equal to the amount Qt1 minus Qf1. The actual marginal cost curve is defined by points A,C,D. If the firm is able to sell its transfer goods in an imperfect market, then it need not be a price taker. There are two markets each with its own price (Pf and Pt in the next diagram). The aggregate market is



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Transfer Pricing with a Competitive External Market: constructed from the first two. That is, point C is a horizontal summation of points A and B (and likewise for all other points on the Net Marginal Revenue curve (NMRa)). The total optimum quantity (Q) is the sum of Qf plus Qt

Transfer Pricing with an Imperfect External Market: Role of administrative regulations and guidelines Although there is sound economic theory behind the selection of a transfer pricing method, the fact remains that it can be advantageous to arbitrarily select prices such that, in terms of bookkeeping, most of the profit is made in a country with low taxes, thus shifting the profits to reduce overall taxes paid by a multinational group. However, most countries enforce tax laws based on the arm's length principle as defined in the OECD(Organisation for Economic Co-operation and Development) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, limiting how transfer prices can be set and ensuring that that country gets to tax its "fair" share. In the United States, the pricing of transactions between related parties that are reported for tax purposes are governed by Section 482 of the Internal Revenue Code and the regulations thereunder. From the corporation's position, running afoul of such regulations can prove to be a costly mistake, as illustrated by GlaxoSmithKline's announcement on September 11, 2006 that they had settled a long-running transfer pricing dispute with the US tax authorities, agreeing to pay $3.1 billion in taxes related to an assessed income adjustment due to improper transfer pricing. However, proper use of the regulations also provides a method of protecting against double taxation, provided that the transactions are carried out between divisions in countries bound by bilateral tax treaties. In the GlaxoSmithKline case, however, the company has indicated that they will not pursue competent authority negotiations for the relief of U.S.-U.K. double taxation. Calculation of the arm's length price: Although there are discrepancies in the specifics of each country's laws concerning the calculation of the arm's length price, the fact that they are primarily based in the OECD Guidelines means that, although such a strategy carries a greater taxation risk than solutions tailored to each country, global transfer pricing policies can be effectively used to determine an appropriate range representing the arm's length price for transactions carried out across a global enterprise.



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However, different countries may accept different methods of calculating the transfer price (i.e. Japan requires that the three "traditional" methods be systematically discounted before allowing the use of alternative methods, while the United States accepts the most appropriate method regardless), so care must be taken in such circumstances. The following definitions are thus based on the OECD Guidelines. Traditional methods

� Comparable Uncontrolled Price method The comparable Uncontrolled price (CUP) method compares the price at which a controlled transaction is conducted to the price at which a comparable uncontrolled transaction is conducted. This makes it the easiest to conceptually grasp, as the arm's length price is, quite simply, determined by the sale price between two unrelated corporations. However, the fact that virtually any minor change in the circumstances of trade (billing period, amount of trade, branding, etc.) may have a significant effect on the price makes it exceedingly difficult to find a transaction--much less transactions--that are sufficiently comparable. Should they exist, such comparable transactions fall into two categories: external comparables and internal comparables. The former is a comparable uncontrolled transaction in the purest sense of the term--if Company A, in France, sells widgets to its subsidiary A(sub) in Turkey, then an external comparable transaction would be the sale of widgets from French Company B to Turkish Company C (an unrelated enterprise) on identical terms as the trade between A and A(sub). An internal comparable transaction, then, would be either the trade of widgets between Company A and Company C, or the trade of widgets between Company B and Company A(sub), with the term "internal" referring to the fact that one of the parties involved in the tested transaction is also involved in the comparable uncontrolled transaction.

� Cost Plus method The Cost Plus (CP) method, generally used for the trade of finished goods, is determined by adding an appropriate markup to the costs incurred by the selling party in manufacturing/purchasing the goods or services provided, with the appropriate markup being based on the profits of other companies comparable to the tested party. For example, the arm's length price for a transaction involving the sale of finished clothing to a related distributor would be determined by adding an appropriate markup to the cost of materials, labour, manufacturing, and so on.

� Resale Price method The Resale Price (RP), while similar to the CP method, is found by working backwards from transactions taking place at the next stage in the supply chain, and is determined by subtracting an appropriate gross markup from the sale price to an unrelated third party, with the appropriate gross margin being determined by examining the conditions under which it the goods or services are sold and comparing said transaction to other, third-party transactions. In our clothing example, then, the arm's length price would be determined by subtracting an appropriate gross margin from the price at which the distributor sold the products received from the manufacturer to third-party retailers--department stores, boutiques, etcetera. In this example, both the CP and RP methods are being used to examine the same transaction--the one between the manufacturer and the distributor--meaning that the selection of one for use is ultimately dependent on the availability of data and comparable transactions. This flexibility is not available in other transactions, particularly those involving intangible goods (i.e. it is



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exceedingly difficult to determine the costs involved in developing technological know-how, and so the arm's length price for the payment of royalties from one company to another is best determined by working backwards from the profits gained based on the usage of the know-how--in other words, the RP method). Non-traditional methods There are any number of non-traditional methods available for determining the arm's length price, with the most common being the Profit Split (PS) method and the Transactional Net Margin method (TNMM).

� The PS method:

The PS method (and its derivatives, including the Comparative and Residual Profit Split methods) is applied when the businesses involved in the examined transaction are too integrated to allow for separate evaluation, and so the ultimate profit derived from the endeavor is split based on the level of contribution--itself often determined by some measurable factor such as employee compensation, payment of administration expenses, etc.--of each of the participants in the project. To present a highly simplified example, if Company A above sent three researchers to Company A(sub) to aid in the development of widgets tailored for the Turkish market while Company A(sub) allocated seven identically-compensated researchers to aid in the development, we would expect that Company A(sub) would pay Company A 30% of the ultimate profits as a royalty fee for the technical knowledge provided by Company A's researchers. TNMM, meanwhile, is a method that requires a thorough examination of the company in question in order to determine the net profit margin relative to an appropriate base of costs to be realized through the examined transaction. Essentially, TNMM is a unified version of the RP and CP methods whereby comparable companies are used to ensure an appropriate margin is applied. Although not one of the traditional three methods, TNMM is gaining recognition as a relatively accurate, easy method of calculating the arm's length price.

� Advance Pricing Agreement An Advance Pricing Agreement/Arrangement (the specific terminology varies by country), or APA, is an agreement between the taxpayer and the competent taxation authorities that a future transaction will be conducted at the agreed-upon price, which is recognized as the arm's length price for the period designated. Although retroactive APAs can be used to reduce tax exposure in past years, APAs are primarily used to avoid the risk of future income assessment adjustments which, as in the case of GlaxoSmithKlein, could lead to hefty payments in the future. There are two types of APAs: unilateral and bilateral/multilateral APAs. A unilateral APA is, as its name suggests, an agreement between a corporation and the authority of the country where it is subject to taxation. Although simpler to implement than a bilateral/multilateral APA, a unilateral APA will not be recognized by a foreign tax authority, meaning that a U.S. company securing a unilateral APA for trade with its British subsidiary would still run the risk of being assessed should the foreign tax authorities not agree with the method of calculating the arm's length price, resulting in double taxation. Bilateral/multilateral APAs, however, do provide such coverage, although their implementation requires a more lengthy application process, including consultation between and the agreement of all competent authorities involved.



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� Mutual agreement procedures

A mutual agreement procedure is an instrument used for relieving international tax grievances, including double taxation. Although the specifics vary based on the laws of each country, they are only carried out between authorities of countries or principalities with existing tax treaties--for example, it is impossible to relieve double taxation by holding mutual agreement procedures between the authorities of China and Taiwan. Although most conventions require that each party to put forth all reasonable effort to resolve such disputes, they are generally not required to come to any sort of agreement. This means that although mutual agreement procedures can be an effective tool for the relief of taxation grievances, they are not fail-safes.



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Interest rate swap:

(i) An interest rate swap is a contractual agreement entered into between two counterparties under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. The principal amount is notional because there is no need to exchange actual amounts of principal in a single currency transaction: there is no foreign exchange component to be taken account of. Equally, however, a notional amount of principal is required in order to compute the actual cash amounts that will be periodically exchanged.

Under the commonest form of interest rate swap, a series of payments calculated by applying a fixed rate of interest to a notional principal amount is exchanged for a stream of payments similarly calculated but using a floating rate of interest. This is a fixed-for-floating interest rate swap. Alternatively, both series of cashflows to be exchanged could be calculated using floating rates of interest but floating rates that are based upon different underlying indices. Examples might be Libor and commercial paper or Treasury bills and Libor and this form of interest rate swap is known as a basis or money market swap.

(ii) Pricing Interest Rate Swaps

If we consider the generic fixed-to-floating interest rate swap, the most obvious difficulty to be overcome in pricing such a swap would seem to be the fact that the future stream of floating rate payments to be made by one counterparty is unknown at the time the swap is being priced. This must be literally true: no one can know with absolute certainty what the 6 month US dollar Libor rate will be in 12 months time or 18 months time. However, if the capital markets do not possess an infallible crystal ball in which the precise trend of future interest rates can be observed, the markets do possess a considerable body of information about the relationship between interest rates and future periods of time.

In many countries, for example, there is a deep and liquid market in interest bearing securities issued by the government. These securities pay interest on a periodic basis, they are issued with a wide range of maturities, principal is repaid only at maturity and at any given point in time the market values these securities to yield whatever rate of interest is necessary to make the securities trade at their par value.

It is possible, therefore, to plot a graph of the yields of such securities having regard to their varying maturities. This graph is known generally as a yield curve -- i.e.: the relationship between future interest rates and time -- and a graph showing the yield of securities displaying the same characteristics as government securities is known as the par coupon yield curve. The classic example of a par coupon yield curve is the US Treasury yield curve. A different kind of security to a government security or similar interest bearing note is the zero-coupon bond. The zero-coupon bond does not pay interest at periodic intervals. Instead it is issued at a discount from its par or face value but is redeemed at par, the accumulated discount which is then repaid representing compounded or "rolled-up" interest. A graph of the internal rate of return (IRR) of zero-coupon bonds over a range of maturities is known as the zero-coupon yield curve.

Finally, at any time the market is prepared to quote an investor forward interest rates. If, for example, an investor wishes to place a sum of money on deposit for six months and then reinvest that deposit once it has matured for a further six months, then the market will quote today a rate at which the investor can re-invest his deposit in six months time. This is not an exercise in "crystal



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ball gazing" by the market. On the contrary, the six month forward deposit rate is a mathematically derived rate which reflects an arbitrage relationship between current (or spot) interest rates and forward interest rates. In other words, the six month forward interest rate will always be the precise rate of interest which eliminates any arbitrage profit. The forward interest rate will leave the investor indifferent as to whether he invests for six months and then re-invests for a further six months at the six month forward interest rate or whether he invests for a twelve month period at today's twelve month deposit rate.

The graphical relationship of forward interest rates is known as the forward yield curve. One must conclude, therefore, that even if -- literally -- future interest rates cannot be known in advance, the market does possess a great deal of information concerning the yield generated by existing instruments over future periods of time and it does have the ability to calculate forward interest rates which will always be at such a level as to eliminate any arbitrage profit with spot interest rates. Future floating rates of interest can be calculated, therefore, using the forward yield curve but this in itself is not sufficient to let us calculate the fixed rate payments due under the swap. A further piece of the puzzle is missing and this relates to the fact that the net present value of the aggregate set of cashflows due under any swap is -- at inception -- zero. The truth of this statement will become clear if we reflect on the fact that the net present value of any fixed rate or floating rate loan must be zero when that loan is granted, provided, of course, that the loan has been priced according to prevailing market terms. This must be true, since otherwise it would be possible to make money simply by borrowing money, a nonsensical result However, we have already seen that a fixed to floating interest rate swap is no more than the combination of a fixed rate loan and a floating rate loan without the initial borrowing and subsequent repayment of a principal amount. The net present value of both the fixed rate stream of payments and the floating rate stream of payments in a fixed to floating interest rate swap is zero, therefore, and the net present value of the complete swap must be zero, since it involves the exchange of one zero net present value stream of payments for a second net present value stream of payments.

The pricing picture is now complete. Since the floating rate payments due under the swap can be calculated as explained above, the fixed rate payments will be of such an amount that when they are deducted from the floating rate payments and the net cash flow for each period is discounted at the appropriate rate given by the zero coupon yield curve, the net present value of the swap will be zero. It might also be noted that the actual fixed rate produced by the above calculation represents the par coupon rate payable for that maturity if the stream of fixed rate payments due under the swap are viewed as being a hypothetical fixed rate security. This could be proved by using standard fixed rate bond valuation techniques.

(iii) Financial Benefits Created By Swap Transactions

Consider the following statements:

(a) A company with the highest credit rating, AAA, will pay less to raise funds under identical terms and conditions than a less creditworthy company with a lower rating, say BBB. The incremental borrowing premium paid by a BBB company, which it will be convenient to refer to as a "credit quality spread", is greater in relation to fixed interest rate borrowings than it is for floating rate borrowings and this spread increases with maturity.

(b) The counterparty making fixed rate payments in a swap is predominantly the less creditworthy participant.



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(c) Companies have been able to lower their nominal funding costs by using swaps in conjunction with credit quality spreads.

These statements are, I submit, fully consistent with the objective data provided by swap transactions and they help to explain the "too good to be true" feeling that is sometimes expressed regarding swaps. Can it really be true, outside of "Alice in Wonderland", that everyone can be a winner and that no one is a loser? If so, why does this happy state of affairs exist?

(a) The Theory of Comparative Advantage

When we begin to seek an answer to the questions raised above, the response we are most likely to meet from both market participants and commentators alike is that each of the counterparties in a swap has a "comparative advantage" in a particular and different credit market and that an advantage in one market is used to obtain an equivalent advantage in a different market to which access was otherwise denied. The AAA company therefore raises funds in the floating rate market where it has an advantage, an advantage which is also possessed by company BBB in the fixed rate market.

The mechanism of an interest rate swap allows each company to exploit their privileged access to one market in order to produce interest rate savings in a different market. This argument is an attractive one because of its relative simplicity and because it is fully consistent with data provided by the swap market itself. However, as Clifford Smith, Charles Smithson and Sykes Wilford point out in their book MANAGING FINANCIAL RISK, it ignores the fact that the concept of comparative advantage is used in international trade theory, the discipline from which it is derived, to explain why a natural or other immobile benefit is a stimulus to international trade flows. As the authors point out: The United States has a comparative advantage in wheat because the United States has wheat producing acreage not available in Japan. If land could be moved -- if land in Kansas could be relocated outside Tokyo -- the comparative advantage would disappear. The international capital markets are, however, fully mobile. In the absence of barriers to capital flows, arbitrage will eliminate any comparative advantage that exists within such markets and this rationale for the creation of the swap transactions would be eliminated over time leading to the disappearance of the swap as a financial instrument. This conclusion clearly conflicts with the continued and expanding existence of the swap market.

It would seem, therefore, that even if the theory of comparative advantage does retain some force -- not withstanding the effect of arbitrage -- which it almost certainly does, it cannot constitute the sole explanation for the value created by swap transactions. The source of that value may lie in part in at least two other areas.

(b) Information Asymmetries

The much- vaunted economic efficiency of the capital markets may nevertheless co- exist with certain information asymmetries. Four authors from a major US money centre bank have argued that a company will -- and should -- choose to issue short term floating rate debt and swap this debt into fixed rate funding as compared with its other financing options if:

(1) It had information -- not available to the market generally -- which would suggest that its own credit quality spread (the difference, you will recall, between the cost of fixed and floating rate debt) would be lower in the future than the market expectation.



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(2) It anticipates higher risk- free interest rates in the future than does the market and is more sensitive (i.e. averse) to such changes than the market generally.

In this situation a company is able to exploit its information asymmetry by issuing short term floating rate debt and to protect itself against future interest rate risk by swapping such floating rate debt into fixed rate debt.

(c) Fixed Rate Debt and Embedded Options

Fixed rate debt typically includes either a prepayment option or, in the case of publicly traded debt, a call provision. In substance this right is no more and no less than a put option on interest rates and a right which becomes more valuable the further interest rates fall. By way of contrast, swap agreements do not contain a prepayment option. The early termination of a swap contract will involve the payment, in some form or other, of the value of the remaining contract period to maturity.

Returning, therefore, to our initial question as to why an interest rate swap can produce apparent financial benefits for both counterparties the true explanation is, I would suggest, a more complicated one than can be provided by the concept of comparative advantage alone. Information asymmetries may well be a factor, together with the fact that the fixed rate payer in an interest rate swap -- reflecting the fact that he has no early termination right -- is not paying a premium for the implicit interest rate option embedded within a fixed rate loan that does contain a pre-payment rights. This saving is divided between both counterparties to the swap.

(iv) Reversing or Terminating Interest Rate Swaps

The point has been made above that at inception the net present value of the aggregate cashflows that comprise an interest rate swap will be zero. As time passes, however, this will cease to be the case, the reason for this being that the shape of the yield curves used to price the swap initially will change over time. Assume, for example, that shortly after an interest rate swap has been completed there is an increase in forward interest rates: the forward yield curve steepens. Since the fixed rate payments due under the swap are, by definition, fixed, this change in the prevailing interest rate environment will affect future floating rate payments only: current market expectations are that the future floating rate payments due under the swap will be higher than those originally expected when the swap was priced. This benefit will accrue to the fixed rate payer under the swap and will represent a cost to the floating rate payer. If the new net cashflows due under the swap are computed and if these are discounted at the appropriate new zero coupon rate for each future period (i.e. reflecting the current zero coupon yield curve and not the original zero coupon yield curve), the positive net present value result reflects how the value of the swap to the fixed rate payer has risen from zero at inception. Correspondingly, it demonstrates how the value of the swap to the floating rate payer has declined from zero to a negative amount.

What we have done in the above example is mark the interest rate swap to market. If, having done this, the floating rate payer wishes to terminate the swap with the fixed rate payer's agreement, then the positive net present value figure we have calculated represents the termination payment that will have to be paid to the fixed rate payer. Alternatively, if the floating rate payer wishes to cancel the swap by entering into a reverse swap with a new counterparty for the remaining term of the original swap, the net present value figure represents the payment that the floating rate payer will have to make to the new counterparty in order for him to enter into a swap which precisely mirrors the terms and conditions of the original swap.



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(v) Credit Risk Implicit in Interest Rate Swaps

To the extent that any interest rate swap involves mutual obligations to exchange cashflows, a degree of credit risk must be implicit in the swap. Note however, that because a swap is a notional principal contract, no credit risk arises in respect of an amount of principal advanced by a lender to a borrower which would be the case with a loan. Further, because the cashflows to be exchanged under an interest rate swap on each settlement date are typically "netted" (or offset) what is paid or received represents simply the difference between fixed and floating rates of interest. Contrast this again with a loan where what is due is an absolute amount of interest representing either a fixed or a floating rate of interest applied to the outstanding principal balance. The periodic cashflows under a swap will, by definition, be smaller therefore than the periodic cashflows due under a comparable loan.

An interest rate swap is in essence a series of forward contracts on interest rates.. In distinction to a forward contract, the periodic exchange of payment flows provided for under an interest rate swap does provide for a partial periodic settlement of the contract but it is important to appreciate that the net present value of the swap does not reduce to zero once a periodic exchange has taken place. This will not be the case because -- as discussed in the context of reversing or terminating interest rate swaps -- the shape of the yield curve used to price the swap initially will change over time giving the swap a positive net present value for either the fixed rate payer or the floating rate payer notwithstanding that a periodic exchange of payments is being made.

(vi) Users and Uses of Interest Rate Swaps

Interest rate swaps are used by a wide range of commercial banks, investment banks, non-financial operating companies, insurance companies, mortgage companies, investment vehicles and trusts, government agencies and sovereign states for one or more of the following reasons:

1. To obtain lower cost funding

2. To hedge interest rate exposure

3. To obtain higher yielding investment assets

4. To create types of investment asset not otherwise obtainable

5. To implement overall asset or liability management strategies

6. To take speculative positions in relation to future movements in interest rates.

The advantages of interest rate swaps include the following:

1. A floating-to-fixed swap increases the certainty of an issuer's future obligations.

2. Swapping from fixed-to-floating rate may save the issuer money if interest rates decline.

3. Swapping allows issuers to revise their debt profile to take advantage of current or expected future market conditions.



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4. Interest rate swaps are a financial tool that potentially can help issuers lower the amount of debt service.

Typical transactions would certainly include the following, although the range of possible permutations is almost endless.

(a) Reduce Funding Costs. A US industrial corporation with a single A credit rating wants to raise US$100 million of seven year fixed rate debt that would be callable at par after three years. In order to reduce its funding cost it actually issues six month commercial paper and simultaneously enters into a seven year, nonamortising swap under which it receives a six month floating rate of interest (Libor Flat) and pays a series of fixed semi- annual swap payments. The cost saving is 110 basis points.

(b) Liability Management. A company actually issues seven year fixed rate debt which is callable after three years and which carries a coupon of 7%. It enters into a fixed- to- floating interest rate swap for three years only under the terms of which it pays a floating rate of Libor + 185 bps and receives a fixed rate of 7%. At the end of three years the company has the flexibility of calling its fixed rate loan -- in which case it will have actually borrowed on a synthetic floating rate basis for three years -- or it can keep its loan obligation outstanding and pay a 7% fixed rate for a further four years. As a further variation, the company's fixed- to- floating interest rate swap could be an "arrears reset swap" in which -- unlike a conventional swap -- the swap rate is set at the end and not at the beginning of each period. This effectively extends the company's exposure to Libor by one additional interest period which will improve the economics of the transaction.

(c) Speculative Position. The same company described in (b) above may be willing to take a position on short term interest rates and lower its cost of borrowing even further (provided that its judgment as to the level of future interest rates is correct). The company enters into a three year "yield curve arbitrage swap" in which the floating rate payments it makes under the swap are calculated by reference to a formula. For each basis point that Libor rises, the company's floating rate swap payments rise by two basis points. The company's spread over Libor, however, falls from 185 bps to 144 bps. In exchange, therefore, for significantly increasing its exposure to short term rates, the company can generate powerful savings.

(d) Hedging Interest Rate Exposure. A financial institution providing fixed rate mortgages is exposed in a period of falling interest rates if homeowners choose to pre- pay their mortgages and re- finance at a lower rate. It protects against this risk by entering into an "index-amortising rate swap" with, for example, a US regional bank. Under the terms of this swap the US regional bank will receive fixed rate payments of 100 bps to as much as 150 bps above the fixed rate payable under a straightforward interest rate swap. In exchange, the bank accepts that the notional principal amount of the swap will amortize as rates fall and that the faster rates fall, the faster the notional principal will be amortized.

A less aggressive version of the same structure is the "indexed principal swap". Here the notional principal amount continually amortizes in line with a mortgage prepayment index such as PSA but the amortization rate increases when interest rates fall and the rate decreases when interest rates rise.

(e) Creation of New Investment Assets. A UK corporate treasurer whose company has substantial business in Spain feels that the current short term yield curves for sterling and the peseta which show absolute interest rates converging in the two countries is exaggerated. Consequently he



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takes cash currently invested in the short term sterling money markets and invests this cash in a "differential swap". A differential swap is a swap under which the UK company will pay a floating rate of interest in sterling (6 mth. Libor) and receive, also in sterling, a stream of floating rate payments reflecting Spanish interest rates plus or minus a spread. The flows might be: UK corporation pays six month sterling Libor flat and receives six month Peseta Mibor less 210 bps paid in sterling. Assuming a two year transaction and assuming sterling interest rates remained at their initial level of 5.25%, peseta Mibor would have to fall by 80 bps every six months in order for the treasurer to earn a lower return on his investment than would have been received from a conventional sterling money market deposit.

(f) Asset Management. A German based fund manager has a view that the sterling yield curve will steepen (i.e. rates will increase) in the range two to five years during the next three years he enters into a "yield curve swap "with a German bank whereby the fund manager pays semi- annual fixed rate payments in DM based on the two year sterling swap rate plus 50 bps. Every six months the rate is reset to reflect the new two year sterling swap rate. He receives six monthly fixed rate payments calculated by reference to the five year sterling swap rate and re- priced every six months. The fund manager will profit if the yield curve steepens more than 50 bps between two and five years.



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The International Monetary System: The global financial system (GFS) is a financial system consisting of institutions and regulations that act on the international level, as opposed to those that act on a national or regional level. The main players are the global institutions, such as International Monetary Fund and Bank for International Settlements, national agencies and government departments, e.g., central banks and finance ministries, and private institutions acting on the global scale, e.g., banks and hedge funds. Deficiencies and reform of the GFS have been hotly discussed in recent years. History of financial institutions must be differentiated from economic history and history of money. In Europe, it may have started with the first commodity exchange, the Bruges Bourse in 1309 and the first financiers and banks in the 1400–1600s in central and western Europe. The first global financiers the Fuggers (1487) in Germany; the first stock company in England (Russia Company 1553); the first foreign exchange market (The Royal Exchange 1566, England); the first stock exchange {the Amsterdam Stock Exchange 1602). Milestones in the history of financial institutions are the Gold Standard (1871–1932), the founding of IMF, World Bank at Bretton Woods, and the abolishment of fixed exchange rates in 1973.

The rules and procedures for exchanging national currencies are collectively known as the international monetary system. This system doesn't have a physical presence, like the Federal Reserve System, nor is it as codified as the Social Security system. Instead, it consists of interlocking rules and procedures and is subject to the foreign exchange market, and therefore to the judgments of currency traders about a currency.

Yet there are rules and procedures—exchange rate policies—which public finance officials of various nations have developed and from time to time modify. There are also physical institutions that oversee the international monetary system, the most important of these being the International Monetary Fund.

Exchange Rate Policies

In July 1944, representatives from 45 nations met in Bretton Woods, New Hampshire to discuss the recovery of Europe from World War II and to resolve international trade and monetary issues. The resulting Bretton Woods Agreement established the International Bank for Reconstruction and Development (the World Bank) to provide long-term loans to assist Europe's recovery. It also established the International Monetary Fund (IMF) to manage the international monetary system of fixed exchange rates, which was also developed at the conference.

The new monetary system established more stable exchange rates than those of the 1930s, a decade characterized by restrictive trade policies. Under the Bretton Woods Agreement, IMF member nations agreed to a system of exchange rates that pegged the value of the dollar to the price of gold and pegged other currencies to the dollar. This system remained in place until 1972. In 1972, the Bretton Woods system of pegged exchange rates broke down forever and was replaced by the system of managed floating exchange rates that we have today.



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The Bretton Woods system broke down because the dynamics of supply, demand, and prices in a nation affect the true value of its currency, regardless of fixed rate schemes or pegging policies. When those dynamics are not reflected in the foreign exchange value of the currency, the currency becomes overvalued or undervalued in terms of other currencies. Its price—fixed or otherwise—becomes too high or too low, given the economic fundamentals of the nation and the dynamics of supply, demand, and prices. When this occurs, the flows of international trade and payments are distorted.

In the 1960s, rising costs in the United States made U.S. exports uncompetitive. At the same time, western Europe and Japan emerged from the wreckage of World War II to become productive economies that could compete with the United States. As a result, the U.S. dollar became overvalued under the fixed exchange rate system. This caused a drain on the U.S. gold supply, because foreigners preferred to hold gold rather than overvalued dollars. By 1970, U.S. gold reserves decreased to about $10 billion, a drop of more than 50 percent from the peak of $24 billion in 1949.

In 1971, the U.S. decided to let the dollar float against other currencies so it could find its proper value and imbalances in trade and international funds flows could be corrected. This indeed occurred and evolved into the managed float system of today.

A nation manages the value of its currency by buying or selling it on the foreign exchange market. If a nation's central bank buys its currency, the supply of that currency decreases and the supply of other currencies increases relative to it. This increases the value of its currency.

On the other hand, if a nation's central bank sells its currency, the supply of that currency on the market increases, and the supply of other currencies decreases relative to it. This decreases the value of its currency.

The International Monetary Fund plays a key role in operations that help a nation manage the value of its currency.

The International Monetary Fund: The International Monetary Fund is like a central bank for the world's central banks. It is headquartered in Washington, D.C., has 184 member nations, and cooperates closely with the World Bank, which we discuss in The Global Market and Developing Nations. The IMF has a board of governors consisting of one representative from each member nation. The board of governors elects a 20-member executive board to conduct regular operations. The goals of the IMF are to promote world trade, stable exchange rates, and orderly correction of balance of payments problems. One important part of this is preventing situations in which a nation devalues its currency purely to promote its exports. That kind of devaluation is often considered unfairly competitive if underlying issues, such as poor fiscal and monetary policies, are not addressed by the nation. Member nations maintain funds in the form of currency reserve units called Special Drawing Rights (SDRs) on deposit with the IMF. (This is a bit like the federal funds that U.S. commercial banks keep on deposit with the Federal Reserve.) From 1974 to 1980, the value of SDRs was based on the currencies of 16 leading trading nations. Since 1980, it has been based on the



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currencies of the five largest exporting nations. From 1990 to 2000, these were the United States, Japan, Great Britain, Germany, and France. The value of SDRs is reassigned every five years. SDRs are held in the accounts of IMF nations in proportion to their contribution to the fund. (The United States is the largest contributor, accounting for about 25 percent of the fund.) Participating nations agree to accept SDRs in exchange for reserve currencies—that is, foreign exchange currencies—in settling international accounts. All IMF accounting is done in SDRs, and commercial banks accept SDR-denominated deposits. By using SDRs as the unit of value, the IMF simplifies its own and its member nations' payment and accounting procedures. In addition to maintaining the system of SDRs and promoting international liquidity, the IMF monitors worldwide economic developments, and provides policy advice, loans, and technical assistance in situations like the following:

• After the collapse of the Soviet Union, the IMF helped Russia, the Baltic states, and other former Soviet countries set up treasury systems to assist them in moving from planned to market-based economies.

• During the Asian financial crisis of 1997 and 1998, the IMF helped Korea to bolster its reserves. The IMF pledged $21 billion to help Korea reform its economy, restructure its financial and corporate sectors, and recover from recession.

• In 2000, the IMF Executive Board urged the Japanese government to stimulate growth by keeping interest rates low, encouraging bank restructuring, and promoting deregulation.

• In October 2000, the IMF approved a $52 million loan for Kenya to help it deal with severe drought. This was part of a three-year $193 million loan under an IMF lending program for low-income nations.

Most economists judge the current international monetary system a success. It permits market forces and national economic performance to determine the value of foreign currencies, yet enables nations to maintain orderly foreign exchange markets by cooperating through the IMF.

The EU and the Euro

The biggest news on the foreign currency front over the past few years is the adoption of the euro by the European Union (EU). Twelve member states of the EU use the euro instead of their old local currencies: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain.

Nations that adopt the euro participate in a single EU monetary policy and are subject to fiscal guidelines requiring them to keep deficits to a certain level and to balance their federal budgets by 2006. Although it will reconsider the matter again, Britain has refused to adopt the euro and has stuck with the pound sterling. This reflects England's traditional sense of “apartness” from continental Europe and its reluctance to give up sovereignty over its economic policies.



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The International Monetary Fund (IMF) is an international organization that oversees the global financial system by observing exchange rates and balance of payments, as well as offering financial and technical assistance. Its headquarters are located in Washington, D.C., USA.

Organization and purpose

The IMF describes itself as "an organization of 185 countries, Montenegro being the 185th, as of January 18 2007, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty". With the exception of North Korea, Cuba, Andorra, Monaco, Liechtenstein, Tuvalu, and Nauru, all UN member states participate directly in the IMF. Some are represented by other member states on a 24-member Executive Board but all member countries are members of the IMF's Board of Governors. Vatican City, the Republic of China (Taiwan), the Palestinian Authority and the Sahrawi Arab Democratic Republic (Western Sahara) are the non-UN member entities not participating in the IMF, although the Palestinian Authority currently receives IMF technical assistance.

History

In the Great Depression of the 1930s, economic activity in the major industrial nations slumped. Ricardian comparative advantage states that all countries gain from trade without restrictions. It is noteworthy to mention that, although the "size of the pie" is enhanced according to this theory of free trade, improving all industries, when distributional concerns are taken into account, there are always industries that lose out even as others benefit in any given country. World trade declined sharply, as did employment and living standards in many countries.

As World War II came to a close, the leading allied countries considered various plans to restore order to international monetary relations, and at the Bretton Woods conference the IMF emerged. The founding members drafted a charter (or Articles of Agreement) of an international institution to oversee the international monetary system and to promote both the elimination of exchange restrictions relating to trade in goods and services, and the stability of exchange rates.

The IMF came into existence in December 27, 1945, when the first 29 countries signed its Articles of Agreement. The statutory purposes of the IMF today are the same as when they were formulated in 1944 (see Box 2).

Today

From the end of World War II until the late-1970s, the capitalist world experienced unprecedented growth in real incomes. (Since then, the integration of China and Eastern and Central Europe into the capitalist system has added substantially to the growth of the system.) Within the capitalist system, the benefits of growth have not flowed equally to all (either within or among nations) but overall there has been an increase in prosperity that contrasts starkly with the conditions within capitalist countries during the interwar period. The lack of a recurring global depression is probably due to improvements in the conduct of international economic policies that have encouraged the growth of international trade and helped smooth the economic cycle of boom and bust.



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In the decades since World War II, apart from rising prosperity, the world economy and monetary system have undergone other major changes that have increased the importance and relevance of the purposes served by the IMF, but that has also required the IMF to adapt and reform. Rapid advances in technology and communications have contributed to the increasing international integration of markets and to closer linkages among national economies. As a result, financial crises, when they erupt, now tend to spread more rapidly among countries.

The IMF's influence in the global economy steadily increased as it accumulated more members. The number of IMF member countries has more than quadrupled from the 44 states involved in its establishment, reflecting in particular the attainment of political independence by many developing countries and more recently the collapse of the Soviet bloc. The expansion of the IMF's membership, together with the changes in the world economy, have required the IMF to adapt in a variety of ways to continue serving its purposes effectively.

During April 2007 Ecuador announced its intention to withdraw from the IMF, followed by Venezuela which made this step public on April 30, 2007. As of June 2007, both countries have continued their membership status.

In 1995, the International Monetary Fund (IMF) began work on data dissemination standards with the view of guiding IMF member countries to disseminate their economic and financial data to the public. The International Monetary and Financial Committee (IMFC) endorsed the guidelines for the dissemination standards and they were split into two tiers: The General Data Dissemination System (GDDS) and the Special Data Dissemination Standard (SDDS).

The IMF executive board approved the SDDS and GDDS in 1996 and 1997 respectively and subsequent amendments were published in a revised “Guide to the General Data Dissemination System”. The system is aimed primarily at statisticians and aims to improve many aspects of statistical systems in a country. It is also part of the World Bank Millennium Development Goals and Poverty Reduction Strategic Papers.

The IMF established a system and standard to guide members in the dissemination to the public of their economic and financial data. Currently there are two such systems: General Data Dissemination System (GDDS) and its superset Special Data Dissemination System (SDDS) for those member countries having or seeking access to international capital markets.

The primary objective of the GDDS is to encourage IMF member countries to build a framework to improve data quality and increase statistical capacity building. This will involve the preparation of metadata describing current statistical collection practices and setting improvement plans. Upon building a framework, a country can evaluate statistical needs, set priorities in improving the timeliness, transparency, reliability and accessibility of financial and economic data.

Some countries initialy used the GDDS, but lately upgraded to SDDS.

Some entities that are not itself IMF members also contribute statistical data to the systems:

• Palestinian Authority - GDDS • Hong Kong - SDDS • European Union institutions:

o the European Central Bank for the Eurozone - SDDS



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o Eurostat for the whole EU. - SDDS, thus providing data from Cyprus (not using any DDSystem on its own) and Malta (using only GDDS on its own)

Membership qualifications

Any country may apply for membership to the IMF. The application will be considered first by the IMF's Executive Board. After its consideration, the Executive Board will submit a report to the Board of Governors of the IMF with recommendations in the form of a "Membership Resolution." These recommendations cover the amount of quota in the IMF, the form of payment of the subscription, and other customary terms and conditions of membership. After the Board of Governors has adopted the "Membership Resolution," the applicant state needs to take the legal steps required under its own law to enable it to sign the IMF's Articles of Agreement and to fullfil the obligations of IMF membership.

A member's quota in the IMF determines the amount of its subscription, its voting weight, its access to IMF financing, and its allocation of SDRs. A member state cannot unilaterally increase its quota - increases must be approved of by the Executive Board. For example, in 2001, China was prevented from increasing its quota as high as it wished, ensuring it remained at the level of the smallest G7 economy (Canada).[1] Since then, its contribution has been allowed to be increased slightly further.

As of 2006, participating nations were discussing changes to the voting formula, to increase equity.

Assistance and reforms

The primary mission of the IMF is to provide financial assistance to countries that experience serious financial difficulties. Member states with balance of payments problems may request loans and/or organizational management of their national economies. In return, the countries are usually required to launch certain reforms, which have often been dubbed the "Washington Consensus". These reforms are generally required because countries with fixed exchange rate policies can engage in fiscal, monetary, and political practices which may lead to the crisis itself. For example, nations with severe budget deficits, rampant inflation, strict price controls, or significantly over-valued or under-valued currencies run the risk of facing balance of payment crises in their future. Thus, the structural adjustment programs are at least ostensibly intended to ensure that the IMF is actually helping to prevent financial crises rather than merely funding financial recklessness.

However, this approach is not without its critics, as described below. Many supporters of the IMF contend that some criticisms are the result of the fact that many people are not familiar with the operations and objectives of the IMF, and blame a lack of transparency within the IMF for this, as well as the dense nature of international finance in general. Suggestions for improving these understandings have included greater community outreach efforts, tighter accounting standards, possible regulatory oversight, and changes in the organizational structure of the IMF to include fewer economists, whom many fear are attempting to use developing countries as nothing more than lab rats. Some fear, however, that some of these reforms to the IMF itself introduce political considerations rather than economic considerations, many of which may have resulted in the financial crises in the first place. According to Ulrich Beck, the International Monetary Fund is an international risk community combating the threat of a global financial crisis.



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Criticism

The role of the two Bretton Woods institutions has been controversial to some since the late Cold War period. Critics claim that IMF policy makers deliberately supported capitalistic military dictatorships friendly to American and European corporations. Critics also claim that the IMF is generally apathetic or hostile to their views of democracy, human rights, and labor rights. The controversy has helped spark the anti-globalization movement. Others claim the IMF has little power to democratize sovereign states, although that is not its stated objective, which is to advise and promote financial stability. Arguments in favor of the IMF say that economic stability is a precursor to democracy.

Two criticisms from economists have been that financial aid is always bound to so-called "Conditionalities", including Structural Adjustment Programs. Conditionalities, it is claimed, retard social stability and hence inhibit the stated goals of the IMF, while Structural Adjustment Programs lead to an increase in poverty in recipient countries.

Typically the IMF and its supporters advocate a Keynesian approach. As such, adherents of supply-side economics generally find themselves in open disagreement with the IMF. The IMF frequently advocates currency devaluation, criticized by proponents of supply-side economics as inflationary. Secondly they link higher taxes under "austerity programmes" with economic contraction.

Currency devaluation is recommended by the IMF to the governments of poor nations with struggling economies. Supply-side economists claim these Keynesian IMF policies are destructive to economic prosperity.

That said, the IMF sometimes advocates "austerity programmes," increasing taxes even when the economy is weak, in order to generate government revenue and balance budget deficits, which is the opposite of Keynesian policy. These policies were criticised by Joseph E. Stiglitz, former chief economist and Senior Vice President at the World Bank, in his book Globalization and Its Discontents.[3] He argued that by converting to a more Monetarist approach, the fund no longer had a valid purpose, as it was designed to provide funds for countries to carry out Keynesian reflations.

Complaints are also directed toward International Monetary Fund gold reserve being undervalued. At its inception in 1945, the IMF pegged gold at 35 US dollars per Troy ounce of gold. In 1973 the Nixon administration lifted the fixed asset value of gold in favour of a world market price. Hence the fixed exchange rates of currencies tied to gold were switched to a floating rate, also based on market price and exchange. This largely came about because Petrodollars outside the United States were more than could be backed by the gold at Fort Knox under the fixed exchange rate system. The fixed rate system only served to limit the amount of assistance the organization could use to help debt-ridden countries. Current IMF rules prohibit members from linking their currencies to gold.

Argentina, which had been considered by the IMF to be a model country in its compliance to policy proposals by the Bretton Woods institutions, experienced a catastrophic economic crisis in



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2001 , which some believe to have been caused by IMF-induced budget restrictions — which undercut the government's ability to sustain national infrastructure even in crucial areas such as health, education, and security — and privatization of strategically vital national resources. (Others attribute the crisis to Argentina's maldesigned fiscal federalism, which caused subnational spending to increase rapidly.[4]) The crisis added to widespread hatred of this institution in Argentina and other South American countries, with many blaming the IMF for the region's economic problems.[5] The current — as of early 2006 — trend towards moderate left-wing governments in the region and a growing concern with the development of a regional economic policy largely independent of big business pressures has been ascribed to this crisis.

Another example of where IMF Structural Adjustment Programmes aggravated the problem was in Kenya. Before the IMF got involved in the country, the Kenyan central bank oversaw all currency movements in and out of the country. The IMF mandated that the Kenyan central bank had to allow easier currency movement. However, the adjustment resulted in very little foreign investment, but allowed Kamlesh Manusuklal Damji Pattni, with the help of corrupt government officials, to siphon off billions of Kenyan shillings in what came to be known as the Goldenberg scandal, leaving the country worse off than it was before the IMF reforms were implemented.

Overall the IMF success record is perceived as limited. While it was created to help stabilize the global economy, since 1980 critics claim over 100 countries (or reputedly most of the Fund's membership) have experienced a banking collapse that they claim have reduced GDP by four percent or more, far more than at any time in Post-Depression history. The considerable delay in the IMF's response to any crisis, and the fact that it tends to only respond to rather than prevent them, has led many economists to argue for reform. In 2006, an IMF reform agenda called the Medium Term Strategy was widely endorsed by the institution's member countries. The agenda includes changes in IMF governance to enhance the role of developing countries in the institution's decision-making process and steps to deepen the effectiveness of its core mandate, which is known as economic surveillance or helping member countries adopt macroeconomic policies that will sustain global growth and reduce poverty. On June 15, 2007, the Executive Board of the IMF adopted the 2007 Decision on Bilateral Surveillance, a landmark measure that replaced a 30-year-old decision of the Fund's member countries on how the IMF should analyse economic outcomes at the country level.

Whatever the feelings people in the Western world have for the IMF, research by the Pew Research Center shows that more than 60 percent of Asians and 70 percent of Africans feel that the IMF and the World Bank have a positive effect on their country. This may largely be due to the fact that the media and textbooks in developing countries' schools describe the IMF as having a positive role in their countries, despite claims that there has been an increase in poverty, increase in the debt-burden, and a reduction of economic growth that IMF opponents argue its policies have resulted in.[citation needed] In 2005, the IMF was the first multilateral financial institution to implement a sweeping debt-relief program for the world's poorest countries known as the Multilateral Debt Relief Initiative. By year-end 2006, 23 countries mostly in sub-Saharan Africa and Central America had received total relief of debts owed the IMF.

The documentary Life and Debt deals with the IMF's policies' influence on Jamaica and its economy from a critical point of view. In 1978, one year after Jamaica first entered a borrowing relationship with the IMF, the Jamaican dollar was still worth more on the open exchange than the US dollar; by 1995, when Jamaica terminated that relationship, the Jamaican dollar had eroded to less than USD 2 cents. Such observations lead to skepticism that IMF involvement is necessarily helpful to a third world economy.



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Past managing directors

An unwritten rule establishes that the IMF's managing director must be European and that the president of the World Bank must be from the United States. This established practice is now increasingly being questioned and competition for these two posts may soon open up to include other qualified candidates from any part of the world. Executive Directors, who confirm the managing director are voted in by Finance Ministers from countries they represent. The First Deputy Managing Director of the IMF, the second-in-command, has traditionally been (and is today) an American.

The IMF is for the most part controlled by the major Western Powers, with voting rights on the Executive board based on a quota derived from a monetary stake in the institution. Rarely does the board vote and pass issues contradicting the will of the US or Europeans. There have been some exceptions in the past. Dr. Mohamed Finaish from Libya, the Executive Director representing the majority of the Arab World and Pakistan, was a tireless defender of the developing nations' rights at the IMF. He stood steadfast in his beliefs and principles for fourteen years until his defeat in the 1992 elections to an Egyptian IMF Staff Member.

Mr Rodrigo Rato became the ninth Managing Director of the IMF on June 7, 2004 and he is expected to resign his post in October, 2007, citing personal reasons. His replacement will once again come from Europe.

EU ministers agreed on the candidacy of Dominique Strauss-Kahn as managing director of the IMF at the Economic and Financial Affairs Council meeting in Brussels on 10 July 2007.

Dates Name Country

May 6, 1946 - May 5, 1951 Camille Gutt Belgium

August 3, 1951 - October 3, 1956 Ivar Rooth Sweden

November 21, 1956 - May 5, 1963 Per Jacobsson Sweden

September 1, 1963 - August 31, 1973 Pierre-Paul Schweitzer France

September 1, 1973 - June 16, 1978 Johannes Witteveen Netherlands

June 17, 1978 - January 15, 1987 Jacques de Larosière France



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January 16, 1987 - February 14, 2000 Michel Camdessus France

May 1, 2000 - March 4, 2004 Horst Köhler Germany

June 7, 2004 - present Rodrigo Rato Spain



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Special Drawing Rights (SDRs) Why was the SDR created and what is it used for today? The Special Drawing Right (SDR) was created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system. A country participating in this system needed official reserves—government or central bank holdings of gold and widely accepted foreign currencies—that could be used to purchase the domestic currency in world foreign exchange markets, as required to maintain its exchange rate. But the international supply of two key reserve assets— gold and the U.S. dollar—proved inadequate for supporting the expansion of world trade and financial development that was taking place. Therefore, the international community decided to create a new international reserve asset under the auspices of the IMF. However, only a few years later, the Bretton Woods system collapsed and the major currencies shifted to a floating exchange rate regime. In addition, the growth in international capital markets facilitated borrowing by creditworthy governments. Both of these developments lessened the need for SDRs. Today, the SDR has only limited use as a reserve asset, and its main function is to serve as theunit of account of the IMF and some other international organizations. The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. Holders of SDRs can obtain these currencies in exchange for their SDRs in two ways: first, through the arrangement of voluntary exchanges between members; and second, by the IMF designating members with strong external positions to purchase SDRs from members with weak external positions. SDR valuation The value of the SDR was initially defined as equivalent to 0.888671 grams of fine gold—which, at the time, was also equivalent to one U.S. dollar. After the collapse of the Bretton Woods system in 1973, however, the SDR was redefined as a basket of currencies,today consisting of the euro, Japanese yen, pound sterling, and U.S. dollar. The U.S. dollar-value of the SDR is posted daily on the IMF's website. It is calculated as the sum of specific amounts of the four currencies valued in U.S. dollars, on the basis of exchange rates quoted at noon each day in the London market. The basket composition is reviewed every five years to ensure that it reflects the relative importance of currencies in the world's trading and financial systems. In the most recent review that took place in November 2005, the weights of the currencies in the SDR basket were revised based on the value of the exports of goods and services and the amount of reserves denominated in the respective currencies which were held by other members of the IMF. These changes became effective on January 1, 2006. The next review by the Executive Board will take place in late 2010. The SDR interest rate The SDR interest rate provides the basis for calculating the interest charged to members on regular (non-concessional) IMF loans, the interest paid and charged to members on their SDR holdings, and the interest paid to members on a portion of their quota subscriptions. The SDR interest rate is determined weekly and is based on a weighted average of representative interest rates on short-term debt in the money markets of the SDR basket currencies. SDR allocations Under its Articles of Agreement, the IMF may allocate SDRs to members in proportion to their IMF quotas. Such an allocation provides each member with a costless asset on which interest is



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neither earned nor paid. However, if a member's SDR holdings rise above its allocation, it earns interest on the excess; conversely, if it holds fewer SDRs than allocated, it pays interest on the shortfall. The Articles of Agreement also allow for cancellations of SDRs, but this provision has never been used. The IMF cannot allocate SDRs to itself. There are two kinds of allocations: General allocations of SDRs have to be based on a long-term global need to supplement existing reserve assets. General allocations are considered every five years, although decisions to allocate SDRs have been made only twice. The first allocation was for a total amount of SDR 9.3 billion, distributed in 1970-72. The second allocation was distributed in 1979-81 and brought the cumulative total of SDR allocations to SDR 21.4 billion. A proposal for a special one-time allocation of SDRs was approved by the IMF's Board of Governors in September 1997 through the proposed Fourth Amendment of the Articles of Agreement. This allocation would double cumulative SDR allocations to SDR 42.8 billion. Its intent is to enable all members of the IMF to participate in the SDR system on an equitable basis and correct for the fact that countries that joined the Fund subsequent to 1981—more than one fifth of the current IMF membership—have never received an SDR allocation. The Fourth Amendment will become effective when three fifths of the IMF membership (111 members) with 85 percent of the total voting power accept it. As of end-August, 2006, 131 members with 77.3 percent of total voting power had accepted the proposed amendment. Approval by the United States, with 17.1 percent of total votes, would put the amendment into effect.



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World Bank:

The World Bank (the Bank), a part of the World Bank Group (WBG), was formally established on the 27 December 1945 following the ratification of the Bretton Woods agreement. The concept was originally conceived in July 1944 at the United Nations Monetary and Financial Conference in July 1944. Two years later the Bank issued its first, and largest, loan; $250 million to France for post-war reconstruction; an issue which has remained a primary focus, alongside reconstruction after natural disasters, humanitarian emergencies and post-conflict rehabilitation needs affecting developing and transition economies.

Organization

The World Bank, as it is commonly referred to, consists of two agencies of the five that comprise the World Bank Group:

• The International Bank for Reconstruction and Development (IBRD)

The International Bank for Reconstruction and Development (IBRD) is one of five institutions that comprise the World Bank Group. The IBRD is an international organisation whose original mission was to finance the reconstruction of nations devastated by WWII. Now, its mission has expanded to fight poverty by means of financing states. Its operation is maintained through payments as regulated by member states. It came into existence on December 27, 1945 following international ratification of the agreements reached at the United Nations Monetary and Financial Conference of July 1 to July 22, 1944 in Bretton Woods, New Hampshire.

The IBRD provides loans to governments, and public enterprises, always with a government (or "sovereign") guarantee of repayment. The funds for this lending come primarily from the issuing of World Bank bonds on the global capital markets - typically $12-15 billion per year. These bonds are rated AAA (the highest possible) because they are backed by member states' share capital, as well as by borrowers' sovereign guarantees. (In addition, loans that are repaid are recycled (relent).) Because of the IBRD's credit rating, it is able to borrow at relatively low interest rates. As most developing countries have considerably lower credit ratings, the IBRD can lend to countries at interest rates that are usually quite attractive to them, even after adding a small margin (about 1%) to cover administrative overheads.



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History

Commencing operations on June 25, 1946, it approved its first loan on May 9, 1947 ($250m to France for postwar reconstruction, in real terms the largest loan issued by the Bank to date).

The IBRD was established mainly as a vehicle for reconstruction of Europe and Japan after World War II, with an additional mandate to foster economic growth in developing countries in Africa, Asia and Latin America. Originally the bank focused mainly on large-scale infrastructure projects, building highways, airports, and powerplants. As Japan and its European client countries "graduated" (achieved certain levels of income per capita), the IBRD became focused entirely on developing countries. Since the early 1990s the IBRD has also provided financing to the post-Socialist states of Eastern Europe and the former Soviet Union.

The International Development Association (IDA) created on September 24, 1960, is the part of the World Bank that helps the world’s poorest countries. It complements the World Bank's other lending arm—the International Bank for Reconstruction and Development (IBRD)—which serves middle-income countries with capital investment and advisory services.

The International Development Association (IDA) is responsible for providing long-term interest-free loans to the world's 81 poorest countries, 40 of which are in Africa. IDA provides grants and credits, with repayment periods of 35 to 40 years and no interest. Since its inception, IDA credits and grants have totaled $161 billion, averaging $7–$9 billion a year in recent years and directing the largest share, about 50 percent, to Africa. IDA is part of the World Bank Group based in Washington, D.C.

While the IBRD raises most of its funds on the world's financial markets, IDA is funded largely by contributions from the governments of the richer member countries. Additional funds come from IBRD's income and from borrowers' repayments of earlier IDA credits.

IDA loans address primary education, basic health services, clean water and sanitation, environmental safeguards, business climate improvements, infrastructure and institutional reforms. These projects pave the way toward economic growth, job creation, higher incomes and better living conditions.

Criticisms include the improper use of financial resources as well as its structure of voting power, based on financial contributions (the largest being from the USA).

Mission Statement: The International Development Association (IDA) is the part of the World Bank that helps the earth’s poorest countries reduce poverty by providing interest-free loans and grants for programs aimed at boosting economic growth and improving living conditions. IDA funds help these countries deal with the complex challenges they face in striving to meet the Millennium Development Goals. They must, for example, respond to the competitive pressures as well as the opportunities of globalization; arrest the spread of HIV/AIDS; and prevent conflict or deal with its aftermath.



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IDA’s long-term, no-interest loans pay for programs that build the policies, institutions, infrastructure and human capital needed for equitable and environmentally sustainable development. IDA’s goal is to reduce inequalities both across and within countries by allowing more people to participate in the mainstream economy, reducing poverty and promoting more equal access to the opportunities created by economic growth.

History: The International Bank for Reconstruction and Development (IBRD), better known as the World Bank, was established in 1944 to help Europe recover from the devastation of World War II. The success of that enterprise led the Bank, within a few years, to turn its attention to the developing countries. By the 1950s, it became clear that the poorest developing countries needed softer terms than those that could be offered by the Bank, so they could afford to borrow the capital they needed to grow.

With the United States taking the initiative, a group of the Bank’s member countries decided to set up an agency that could lend to the poorest countries on the most favourable terms possible. They called the agency the "International Development Association." Its founders saw IDA as a way for the "haves" of the world to help the "have-nots." But they also wanted IDA to be run with the discipline of a bank. For this reason, US President Dwight D. Eisenhower proposed, and other countries agreed, that IDA should be part of the World Bank (IBRD).

IDA's Articles of Agreement became effective in 1960. The first IDA loans, known as credits, were approved in 1961 to Chile, Honduras, India and Sudan.

IBRD and IDA are run on the same lines. They share the same staff and headquarters, report to the same president and evaluate projects with the same rigorous standards. But IDA and IBRD draw on different resources for their lending, and because IDA’s loans are deeply concessional, IDA’s resources must be periodically replenished (see "IDA Funding" below). A country must be a member of IBRD before it can join IDA; 165 countries are IDA members.

The Bank consists of 185 member countries, all of whom are shareholders, represented by a Board of Governors, the ultimate policy makers of the Bank. The Board of Governors, generally, consists of member countries’ ministers of finance or development, and these meet once a year at the Annual Meeting of the Board of Governors of the WBG and the International Monetary Fund (IMF). Due to the fact that the meeting occurs once a year, the governors delegate specific duties to 24 on-site Executive Directors. The five largest shareholders; France, Germany, Japan, the United Kingdom and the United States, each appoint one Executive Director while the remaining member countries are represented by 19 other Executive Directors, thus making up the 24. The President of the Bank serves a renewable five-year term. The President is, by tradition, a US citizen nominated by the United States; the bank’s largest shareholder. The Presidential nominee is confirmed by the Board of Governors. As the wealth of a country in terms of its size as a shareholder determines the voting power it will have the World Bank is often labeled undemocratic and unfair.

The President of the Bank, currently Robert Zoellick, is responsible for chairing the meetings of the Boards of Directors and for overall management of the Bank. The Executive Directors make up the Board of Directors, usually meeting twice a week to oversee activities such as the approval of loans and guarantees, new policies, the administrative budget, country assistance strategies and borrowing and financing decisions. The Vice Presidents of the Bank are its principal managers, in



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charge of regions, sectors, networks and functions. There are 24 Vice-Presidents, 3 Senior Vice Presidents and 2 Executive Vice Presidents.

Activities

The World Bank’s activities are focused on the reduction of global poverty, focusing on the achievement of the Millennium Development Goals (MDGs), goals calling for the elimination of poverty and the implementation of sustainable development. The constituent parts of the Bank, the IBRD and the IDA, achieve their aims through the provision of low or no interest loans and grants to countries with little or no access to international credit markets. The Bank is a market based non-profit organisation, using its high credit rating to make up for the low interest rate of loans.

The Bank’s mission is to aid developing countries and their inhabitants achieve the MDGs, through the alleviation of poverty, by developing an environment for investment, jobs and sustainable growth, thus promoting economical growth and through investment in and empowerment of the poor to enable them to participate in development. The World Bank sees the four key factors necessary for economic growth and the creation of a business environment as:

1. Capacity Building – Strengthening governments and educating government officials 2. Infrastructure creation – implementation of legal and judicial systems for the

encouragement of business, the protection of individual and property rights and the honoring of contracts

3. Development of Financial Systems – the establishment of strong systems capable of supporting endeavors from micro credit to the financing of larger corporate ventures

4. Combating corruption – Eradicating corruption to ensure optimal effect of actions

The Bank obtains funding for its operations primarily through the IBRD’s sale of AAA-rated bonds in the world’s financial markets. Although this does generate some profit, the majority of the IBRD’s income is generated from lending its own capital. The IDA obtains the majority of its funds from forty donor countries who replenish the bank’s funds every three years, and from loan repayments, which then become available for re-lending.

The Bank offers two basic types of loans; investment loans and development policy loans. The former are made for the support of economic and social development projects, whereas the latter provide quick disbursing finance to support countries’ policy and institutional reforms. Although the IBRD provides loans with a low interest rate (between 0.5 – 1% for a standard Bank loan), the IDA’s loans are interest free. The project proposals of borrowers are evaluated for their economical, financial, social and environmental aspects to ensure that they are viable before any amount of money is distributed.

The Bank also distributes grants for the facilitation of development projects through the encouragement of innovation, cooperation between organizations and the participation of local stakeholders in projects. IDA grants are predominantly used for:

• Debt burden relief in the most indebted and poverty struck countries • Amelioration of sanitation and water supply • Support of vaccination and immunization programs for the reduction of communicable

diseases such as malaria • Combating the HIV/AIDS pandemic



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• Support civil society organizations • Creating initiatives for the reduction of greenhouse gases

The Bank not only provides financial support to its member states, but also analytical and advisory services to facilitate the implementation of the lasting economic and social improvements that are needed in many under-developed countries, as well as educating members with the knowledge necessary to resolve their development problems while promoting economic growth.

Areas of operation

The World Bank is active in the following areas:

• Agriculture & Rural Development • Conflict & Development • Development Operations & Activities • Economic Policy • Education • Energy • Environment • Financial Sector • Gender • Governance • Health, Nutrition & Population • Industry • Information & Communication Technologies • Information, Computing & Telecommunications • International Economics & Trade • Labor & Social Protections • Law & Justice • Macroeconomic & Economic Growth • Mining • Poverty Reduction • Poverty • Private Sector • Public Sector Governance • Rural Development • Social Development • Social Protection • Trade • Transport • Urban Development • Water Resources • Water Supply & Sanitation



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Comprehensive development framework

According to the World Bank, in virtually all successful assistance projects the country itself was the driving factor, thus the Bank strives to help governments lead and implement their own development strategies and thus take a stronger hand in their own future development. Since 1999 the World Bank has followed a set of philosophies known as the Comprehensive Development Framework . These philosophies state that:

• Development strategies should be comprehensive and shaped by a long-term vision • Development goals and strategies should be “owned” by the country, based on local

stakeholder participation in shaping them • Countries receiving assistance should lead the management and coordination of aid

programs through stakeholder partnerships • Development performance should be evaluated through measurable results on the ground

in order to adjust the strategy to outcomes and a changing world

Poverty reduction strategies

For the poorest developing countries in the world the Bank’s assistance plans are based on Poverty Reduction Strategies; by combining a cross-section of local groups with an extensive analysis of the country’s financial and economical situation the World Bank develops a strategy pertaining uniquely to the country in question. The government then identifies the country’s priorities and targets for the reduction of poverty, and the World Bank aligns its aid efforts correspondingly.

Country assistance strategies

As a guideline to the World Bank's operations in any particular country, a Country Assistance Strategy is produced, in cooperation with the local government and any interested stakeholders and may rely on analytical work performed by the Bank or other parties. In the case of low income countries, the Country Assistance Strategy is derived from the country’s Poverty Reduction Strategy Paper.



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World Trade Organization:

The World Trade Organization (WTO), (OMC - Spanish: Organización Mundial del

Comercio, French: Organisation Mondiale du Commerce), is an international organization designed to supervise and liberalize international trade. The WTO came into being on January 1, 1995, and is the successor to the General Agreement on Tariffs and Trade (GATT), which was created in 1947, and continued to operate for almost five decades as a de facto international organization.

The World Trade Organization deals with the rules of trade between nations at a near-global level; it is responsible for negotiating and implementing new trade agreements, and is in charge of policing member countries' adherence to all the WTO agreements, signed by the bulk of the world's trading nations and ratified in their parliaments. Most of the WTO's current work comes from the 1986-94 negotiations called the Uruguay Round, and earlier negotiations under the GATT. The organization is currently the host to new negotiations, under the Doha Development Agenda (DDA) launched in 2001.

The WTO is governed by a Ministerial Conference, which meets every two years; a General Council, which implements the conference's policy decisions and is responsible for day-to-day administration; and a director-general, who is appointed by the Ministerial Conference. The WTO's headquarters are in Geneva, Switzerland.

ITO and GATT 1947

John Maynard Keynes and Harry Dexter White at the Bretton Woods Conference – Both economists had been strong advocates of a liberal international trade environment, and recommended the establishment of three institutions: the IMF (fiscal and monetary issues), the World Bank (financial and structural issues), and the ITO (international economic cooperation).

The WTO's predecessor, the General Agreement on Tariffs and Trade (GATT), was established after World War II in the wake of other new multilateral institutions dedicated to international economic cooperation - notably the Bretton Woods institutions now known as the World Bank and the International Monetary Fund. Although an agreement covering trade was not negotiated at Bretton Woods, the Conference did recognize the need for a comparable international institution.

In December 1945, the United States invited its war-time allies to enter into negotiations to conclude a multilateral agreement for the reciprocal reduction of tariffs on trade in goods. At the proposal of the United States, the United Nations Economic and Social Committee adopted a resolution, in February 1946, calling for a conference to draft a charter for an International Trade Organization (ITO). A Preparatory Committee was established in February 1946, and worked until November 1947 on the charter of an international organization for trade. By October 1947 an agreement on the GATT was reached in Geneva, and on October 30, 1947 twenty three countries signed the "Protocol of Provisional Application of the General Agreement on Tariffs and Trade".

In March 1948, the negotiations on the ITO Charter were successfully completed in Havana. The Charter provided for the establishment of the ITO, and set out the basic rules for international trade and other international economic matters. The ITO Charter, however, never entered into



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force; while repeatedly submitted to the US Congress, it was never approved. The most usual argument against the new organization was that it would be involved into internal economic issues. On December 6, 1950 President Truman announced that he would no longer seek Congressional approval of the ITO Charter.[ In the absence of an international organization for trade, the GATT would over the years "transform itself" into a de facto international organization.[10]

GATT rounds of negotiations

The GATT was the only multilateral instrument governing international trade from 1948 until the WTO was established in 1995.[11] Despite attempts in the mid 1950s and 1960s to create some form of institutional mechanism for international trade, the GATT continued to operate for almost half a century as a semi-institutionalized multilateral treaty regime on a provisional basis.

From Geneva to Tokyo

Seven rounds of negotiations occurred under the GATT. The first GATT trade rounds concentrated on further reducing tariffs. Then, the Kennedy Round in the mid-sixties brought about a GATT anti-dumping Agreement and a section on development. The Tokyo Round during the seventies was the first major attempt to tackle trade barriers that do not take the form of tariffs, and to improve the system, adopting a series of agreements on non-tariff barriers, which in some cases interpreted existing GATT rules, and in others broke entirely new ground. Because these plurilateral agreements were not accepted by the full GATT membership, they were often informally called "codes". Several of these codes were amended in the Uruguay Round, and turned into multilateral commitments accepted by all WTO members. Only four remained plurilateral (those on government procurement, bovine meat, civil aircraft and dairy products), but in 1997 WTO members agreed to terminate the bovine meat and dairy agreements, leaving only two.[



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Uruguay Round

Well before GATT's 40th anniversary, its members concluded that the GATT system was straining to adapt to a new globalizing world economy. In response to the problems identified in the 1982 Ministerial Declaration (structural deficiencies, spill-over impacts of certain countries' policies on world trade GATT could not manage etc.), the eighth GATT round — known as the Uruguay Round — was launched in September 1986, in Punta del Este, Uruguay.[14] It was the biggest negotiating mandate on trade ever agreed: the talks were going to extend the trading system into several new areas, notably trade in services and intellectual property, and to reform trade in the sensitive sectors of agriculture and textiles; all the original GATT articles were up for review.

The round was supposed to end in December 1990, but the US and EU disagreed on how to reform agricultural trade and decided to extend the talks. Finally, In November 1992, the US and EU settled most of their differences in a deal known informally as "the Blair House accord", and on April 15, 1994, the deal was signed by ministers from most of the 123 participating governments at a meeting in Marrakesh, Morocco. The agreement established the World Trade Organization, which came into being upon its entry into force on January 1, 1995, and replaced GATT as an international organization.[15] It is widely regarded as the most profound institutional reform of the world trading system since the GATT's establishment.

During the Doha Round, the US government blamed Brazil and India for being inflexible, and the EU for impeding agricultural imports. President of Brazil, Luiz Inácio Lula da Silva, responded to the criticisms arguing that progress will be only achieved if the richest countries (especially the US and EU) make deeper cuts in their agricultural subsidies, and open further their markets for agricultural goods.

The GATT still exists as the WTO's umbrella treaty for trade in goods, updated as a result of the Uruguay Round negotiations (a distinction is made between GATT 1994, the updated parts of GATT, and GATT 1947, the original agreement which is still the heart of GATT 1994).[13] The GATT 1994 is not however the only legally binding agreement included in the Final Act; a long list of about 60 agreements, annexes, decisions and understandings was adopted. In fact, the agreements fall into a simple structure with six main parts:

• an umbrella agreement (the Agreement Establishing the WTO); • agreements for each of the three broad areas of trade that the WTO covers: goods and

investment (the Multilateral Agreements on Trade in Goods including the GATT 1994 and the TRIMS), services (GATS), and intellectual property (TRIPS);

• dispute settlement (DSU); and • reviews of governments' trade policies (TPRM).[21]



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Doha Round

For more details on this topic, see Doha Round. See also: Doha Declaration

The WTO launched the current round of negotiations, the Doha Development Agenda (DDA) or Doha Round, at the Fourth Ministerial Conference in Doha, Qatar in November 2001. The Doha round was to be an ambitious effort to make globalisation more inclusive and help the world's poor, particularly by slashing barriers and subsidies in farming.[22] The initial agenda comprised both further trade liberalization and new rule-making, underpinned by commitments to strengthen substantially assistance to developing countries.[23]

The talks have been highly contentious and agreement has not been reached, despite the intense negotiations at Fifth Ministerial Conference in Cancún in 2003 and at the Sixth Ministerial Conference in Hong Kong on December 13 - 18, 2005. On July 24, 2006, at the end of yet another futile gathering of trade ministers in Geneva, Pascal Lamy, the WTO's Director-General, formally suspended the negotiations. Nevertheless, in his report to the WTO General Council on February 7, 2007, Lamy said that "political conditions are now more favorable for the conclusion of the Round than they have been for a long time". He then added that "political leaders around the world clearly want us to get fully back to business, although we in turn need their continuing commitment".

GATT and WTO trade rounds Sources

a)The GATT years: from Havana to Marrakesh, World Trade Organization b)Timeline: World Trade Organization – A chronology of key events, BBC News

c)Brakman-Garretsen-Marrewijk-Witteloostuijn, Nations and Firms in the Global Economy, Chapter 10: Trade and Capital Restriction

Name Start Duration Countries Subjects covered Achievements

Geneva April 1947 7 months 23 Tariffs Signing of GATT, 45,000 tariff

concessions affecting $10 billion of trade

Annecy April 1949 5 months 13 Tariffs Countries exchanged some

5,000 tariff concessions

Torquay September

1950 8 months 38 Tariffs

Countries exchanged some 8,700 tariff concessions,

cutting the 1948 tariff levels by 25%



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Geneva II

January 1956

5 months 26 Tariffs,

admission of Japan $2.5 billion in tariff reductions

Dillon September

1960 11

months 26 Tariffs

Tariff concessions worth $4.9 billion of world trade

Kennedy May 1964 37

months 62

Tariffs, anti-dumping

Tariff concessions worth $40 billion of world trade

Tokyo September

1973 74

months 102

Tariffs, non-tariff measures,

"framework" agreements

Tariff reductions worth more than $300 billion dollars

achieved

Uruguay September

1986 87

months 123

Tariffs, non-tariff measures, rules,

services, intellectual

property, dispute settlement, textiles, agriculture, creation

of WTO, etc

The round led to the creation of WTO, and extended the range of trade negotiations,

leading to major reductions in tariffs (about 40%) and

agricultural subsidies, an agreement to allow full access for textiles and clothing from developing countries, and an

extension of intellectual property rights.

Doha November

2001 ? 141

Tariffs, non-tariff measures,

agriculture, labor standards,

environment, competition, investment,

transparency, patents etc

The round is not yet concluded.



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Mission, functions and principles of WTO:

The WTO's stated goal is to improve the welfare of the peoples of its member countries, specifically by lowering trade barriers and providing a platform for negotiation of trade. Its main mission is "to ensure that trade flows as smoothly, predictably and freely as possible". This main mission is further specified in certain core functions serving and safeguarding five fundamental principles, which are the foundation of the multilateral trading system.

Functions

Among the various functions of the WTO, these are regarded by analysts as the most important:

• It oversees the implementation, administration and operation of the covered agreements. • It provides a forum for negotiations and for settling disputes.

Additionally, it is the WTO's duty to review the national trade policies, and to ensure the coherence and transparency of trade policies through surveillance in global economic policy-making.[29] Another priority of the WTO is the assistance of developing, least-developed and low-income countries in transition to adjust to WTO rules and disciplines through technical cooperation and training.[30] The WTO is also a center of economic research and analysis: regular assessments of the global trade picture in its annual publications and research reports on specific topics are produced by the organization.Finally, the WTO cooperates closely with the two other components of the Bretton Woods system, the IMF and the World Bank.

Principles of the trading system

The WTO establishes a framework for trade policies; it does not define or specify outcomes. That is, it is concerned with setting the rules of the trade policy games. Five principles are of particular importance in understanding both the pre-1994 GATT and the WTO:

1. Nondiscrimination. It has two major components: the most favoured nation (MFN) rule, and the national treatment policy. Both are embedded in the main WTO rules on goods, services, and intellectual property, but their precise scope and nature differ across these areas. The MFN rule requires that a product made in one member country be treated no less favorably that a very similar good that originated in any other country. "Grant someone a special favour and you have to do the same for all other WTO members." According to national treatment, imported and locally-produced goods should be treated equally (at least after the foreign goods have entered the market). National treatment ensures that liberalization commitments are not offset through the imposition of domestic taxes and similar measures.

2. Reciprocity. It reflects both a desire to limit the scope of free-riding that may arise because of the MFN rule, and a desire to obtain better access to foreign markets. A related point is that for a nation to negotiate, it is necessary that the gain from doing so be greater than the gain available from unilateral liberalization; reciprocal concessions intend to ensure that such gains will materialize.

3. Binding and enforceable commitments. The tariff commitments made by WTO members in a multilateral trade negotiation and on accession are enumerated in a schedules (list) of concessions. These schedules establish "ceiling bindings": a country can change its bindings, but only after negotiating with its trading partners, which could



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mean compensating them for loss of trade. If satisfaction is not obtained, the complaining country may invoke the WTO dispute settlement procedures.

4. Transparency. The WTO members are required to publish their trade regulations, to maintain institutions allowing for the review of administrative decisions affecting trade, to respond to requests for information by other members, and to notify changes in trade policies to the WTO. These internal transparency requirements are supplemented and facilitated by periodic country-specific reports (trade policy reviews) through the Trade Policy Review Mechanism (TPRM). The WTO system tries also to improve predictability and stability, discouraging the use of quotas and other measures used to set limits on quantities of imports.

5. Safety valves. In specific circumstances, governments are able to restrict trade. There are three types of provisions in this direction: articles allowing for the use of trade measures to attain non-economical objectives; articles aimed at ensuring "fair competition"; and provisions permitting intervention in trade for economic reasons.

Formal Structure

According to WTO rules, all WTO members may participate in all councils, committees, etc., except Appellate Body, Dispute Settlement panels, and plurilateral committees.[citation needed]

Highest level: Ministerial Conference

The topmost decision-making body of the WTO is the Ministerial Conference, which has to meet at least every two years. It brings together all members of the WTO, all of which are countries or separate customs territories. The Ministerial Conference can make decisions on all matters under any of the multilateral trade agreements [1].

Second level: General Council

The daily work of the ministerial conference is handled by three groups: the General Council, the Dispute Settlement Body, and the Trade Policy Review Body. All three consist of the same membership - representatives of all WTO members - but each meets under different rules .

1. The General Council- is the WTO’s highest-level decision-making body in Geneva, meeting regularly to carry out the functions of the WTO. It has representatives (usually ambassadors or equivalent) from all member governments and has the authority to act on behalf of the ministerial conference which only meets about every two years. The council acts on behalf on the Ministerial Council on all of the WTO affairs. The current chairman is Amb. Muhamad Noor Yacob (Malaysia) [3].

2. The Dispute Settlement Body - Made up of all member governments, usually represented by ambassadors or equivalent. The current chairperson is H.E. Mr. Mr. Bruce Gosper (Australia).

3. The Trade Policy Review Body (TPRB) - the WTO General Council meets as the Trade Policy Review Body to undertake trade policy reviews of Members under the TRPM. The TPRB is thus open to all WTO Members. The current chairperson is H.E. Ms. Claudia Uribe (Colombia

Third level: Councils for Trade



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The Councils for Trade work under the General Council. There are three councils - Council for Trade in Goods, Council for Trade-Related Aspects of Intellectual Property Rights, and Council for Trade in Services - each council works in different fields. Apart from these three councils, six other bodies report to the General Council reporting on issues such as trade and development, the environment, regional trading arrangements and administrative issues.

1. Council for Trade in Goods- The workings of the General Agreement on Tariffs and Trade (GATT) which covers international trade in goods, are the responsibility of the Council for Trade in Goods. It is made up of representatives from all WTO member countries. The current chairperson is Amb. Yonov Frederick Agah (Nigeria).[citation needed]

2. Council for Trade-Related Aspects of Intellectual Property Rights- Information on intellectual property in the WTO, news and official records of the activities of the TRIPS Council, and details of the WTO’s work with other international organizations in the field

3. Council for Trade in Services- The Council for Trade in Services operates under the guidance of the General Council and is responsible for overseeing the functioning of the General Agreement on Trade in Services (GATS). It’s open to all WTO members, and can create subsidiary bodies as required.

Fourth level: Subsidiary Bodies

There are subsidiary bodies under each of the three councils.

1. The Goods Council- subsidiary under the Council for Trade in Goods. It has 11 committees consisting of all member countries, dealing with specific subjects such as agriculture, market access, subsidies, anti-dumping measures and so on. Committees include the following:

• Information Technology Agreement (ITA) Committee • State Trading Enterprises • Textiles Monitoring Body - Consists of a chairman and 10 members acting under it. • Groups dealing with notifications - process by which governments inform the WTO

about new policies and measures in their countries.

2. The Services Council- subsidiary under the Council for Trade in Services which deals with financial services, domestic regulations and other specific commitments.

3. Dispute Settlement panels and Appellate Body- subsidiary under the Dispute Settlement Body to resolve disputes and the Appellate Body to deal with appeals.

Other committee

• Committees on o Trade and Environment o Trade and Development (Subcommittee on Least-Developed Countries) o Regional Trade Agreements o Balance of Payments Restrictions o Budget, Finance and Administration

• Working parties on o Accession



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• Working groups on o Trade, debt and finance o Trade and technology transfer

The WTO operates on a one country, one vote system, but actual votes have never been taken. Decisionmaking is generally by consensus, and relative market size is the primary source of bargaining power. The advantage of consensus decision-making is that it encourages efforts to find the most widely acceptable decision. Main disadvantages include large time requirements and many rounds of negotiation to develop a consensus decision, and the tendency for final agreements to use ambiguous language on contentious points that makes future interpretation of treaties difficult.

In reality, WTO negotiations proceed not by consensus of all members, but by a process of informal negotiations between small groups of countries. Such negotiations are often called "Green Room" negotiations (after the colour of the WTO Director-General's Office in Geneva), or "Mini-Ministerials", when they occur in other countries. These processes have been regularly criticized by many of the WTO's developing country members which are often totally excluded from the negotiations.

Richard Steinberg (2002) argues that although the WTO's consensus governance model provides law-based initial bargaining, trading rounds close through power-based bargaining favouring Europe and the United States, and may not lead to Pareto improvement.[citation needed]

Dispute settlement

In 1994, the WTO members agreed on the Understanding on Rules and Procedures Governing the Settlement of Disputes (DSU) annexed to the "Final Act" signed in Marrakesh in 1994. Dispute settlement is regarded by the WTO as the central pillar of the multilateral trading system, and as a "unique contribution to the stability of the global economy".WTO members have agreed that, if they believe fellow-members are violating trade rules, they will use the multilateral system of settling disputes instead of taking action unilaterally.

The operation of the WTO dispute settlement process involves the DSB panels, the Appellate Body, the WTO Secretariat, arbitrators,

Duration of a Dispute Settlement procedure

These approximate periods for each stage of a dispute settlement procedure are target figures The agreement is flexible. In addition, the countries can settle their dispute themselves at any stage. Totals are also approximate.

60 days Consultations, mediation, etc 45 days Panel set up and panellists appointed 6 months Final panel report to parties 3 weeks Final panel report to WTO members 60 days Dispute Settlement Body adopts report (if no appeal) Total = 1 year (without appeal)

60-90 days Appeals report 30 days Dispute Settlement Body adopts appeals report Total = 1 year 3 months (with appeal)

Source:Understanding the WTO: Settling Disputes - A unique contribution



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independent experts and several specialized institutions. The General Council discharges its responsibilities under the DSU through the Dispute Settlement Body (DSB). Like the General Council, the DSB is composed of representatives of all WTO Members. The DSB is responsible for administering the DSU, i.e. for overseeing the entire dispute settlement process. If a member state considers that a measure adopted by another member state has deprived it of a benefit accruing to it under one of the covered agreements, it may call for consultations with the other member state. If consultations fail to resolve the dispute within 60 days after receipt of the request for consultations, the complainant state may request the establishment of a panel. It is not possible for the respondent state to prevent or delay the establishment of a panel, unless the DSB by consensus decides otherwise. The panel, normally consisting of three members appointed ad

hoc by the Secretariat, sits to receive written and oral submissions of the parties, on the basis of which it is expected to make findings and conclusions for presentation to the DSB. The proceedings are confidential, and even when private parties are directly concerned, they are not permitted to attend or make submissions separate from those of the state in question.

The final version of the panel's report is distributed first to the parties, and two weeks later it is circulated to all the members of the WTO. The report must be adopted at a meeting of the DSB within 60 days of its circulation, unless the DSB by consensus decides not to adopt the report or a party to the dispute gives notice of its intention to appeal.A party may appeal a panel report to a standing Apellate Body, but only on issues of law, and legal interpretations developed by the panel.[51] Members may express their views on the report of the Appellate Body, but they cannot derail it: an Apellate Body report shall be adopted by the DSB and unconditionally accepted by the parties, unless the DSB decides by consensus within thirty days of its circulation not to adopt the report.[

Within thirty days of the adoption of the report, the member concerned is to inform the DSB of its intentions; if the member explains that it is impracticable to comply immediately with the recommendations and rulings, it is to have a "reasonable period of time" in which to comply. If no agreement is reached about the reasonable period for compliance, that issue is to be the subject of binding arbitration. If there is a disagreement as to the satisfactory nature of the measures adopted by the respondent state to comply with the report, that disagreement is to be decided by a panel, if possible the same panel that heard the original dispute, but apparently without the possibility of appeal from its decision.

If all else fails, two more possibilities are set out in the DSU:

• If a member fails within the "reasonable period" to carry out the recommendations and rulings, it may negotiate with the complaining state for a mutually acceptable compensation.

• If no agreement on compensation is reached within twenty days of the expiry of the "reasonable period", the prevailing state may request authorization from the DSB to suspend application to the member concerned of concessions or other obligations under the covered agreements. In contrast to prior GATT practice, authorization to suspend concessions in this context is semi-automatic, in that the DSB "shall grant the authorization within thirty days of the expiry of the reasonable period", unless it decides by consensus to reject the request.

The DSU states that fellow members should give "special attention" to the problems and interest of the developing countries. If one party to a dispute is a developing country, that party is entitled to have at least one panelist who comes from a developing country.Further, if a complaint is



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brought against a developing country, the time for consultations (before a panel is convened) may be expended, and if the dispute goes to a panel, the deadlines for the developing country to make its submissions may be relaxed. Formal complaints against least developed countries are discouraged, and if consultations fail, the Director-General and the Chairman of the DSB stand ready to offer their good offices before a formal request for a panel is made. As to substance, the DSU provides that "particular attention" is to be paid to the interests of the developing countries, and that the report of panels shall "explicitly indicate" how account has been taken of the "differential and more favorable treatment" provisions of the agreement under which the complaint is brought.In order to assist developing countries overcome their limited expertise in WTO law and assist them in the management of complex trade disputes, an Advisory Centre on WTO Law was established in 2001.

Accession and membership

The process of becoming a WTO member is unique to each applicant country, and the terms of accession are dependent upon the country's stage of economic development and current trade regime. The process takes about five years, on average, but it can last more if the country is less than fully committed to the process or if political issues interfere.As is typical of WTO procedures, an offer of accession is only given once consensus is reached among interested parties.

Accession process

Status of WTO negotiations: members (including dual-representation with the European Communities) Draft Working Party Report or Factual Summary adopted Goods and/or Services offers submitted Memorandum on Foreign Trade Regime submitted observer, negotiations to start later or no Memorandum on FTR submitted frozen procedures or no negotiations in the last 3 years no official interaction with the WTO

A country wishing to accede to the WTO submits an application to the General Council, and has to describe all aspects of its trade and economic policies that have a bearing on WTO agreements. The application is submitted to the WTO in a memorandum which is examined by a working party open to all interested WTO Members. After all necessary background information has been acquired, the working party focuses on issues of discrepancy between the WTO rules and the applicant's international and domestic trade policies and laws. The working party determines the terms and conditions of entry into the WTO for the applicant nation, and may consider transitional periods to allow countries some leeway in complying with the WTO rules. The final phase of accession involves bilateral negotiations between the applicant nation and other working



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party members regarding the concessions and commitments on tariff levels and market access for goods and services. The new member's commitments are to apply equally to all WTO members under normal non-discrimination rules, even though they are negotiated bilaterally.[65]

When the bilateral talks conclude, the working party sends to the General Council or Ministerial Conference an accession package, which includes a summary of all the working party meetings, the Protocol of Accession (a draft membership treaty), and lists ("schedules") of the member-to-be's commitments. Once the General Council or Ministerial Conference approves of the terms of accession, the applicant's parliament must ratify the Protocol of Accession before it can become a member.

Members and observers

A world map of WTO participation: members members, dually represented with the European Communities observer, ongoing accession observer non-member, negotiations pending non-member

The WTO has 150 members (almost all of the 123 nations participating in the Uruguay Round signed on at its foundation, and the rest had to get membership). The 27 states of the European Union are represented also as the European Communities. WTO members do not have to be full sovereign nation-members. Instead, they must be a customs territory with full autonomy in the conduct of their external commercial relations. Thus Hong Kong became a GATT contracting party, and Chinese Taipei (Taiwan) acceded to the WTO in 2002. A number of non-members have been observers at the WTO and are currently negotiating their membership. With the exception of the Holy See, observers must start accession negotiations within five years of becoming observers. Some international intergovernmental organizations are also granted observer status to WTO bodies. 15 states and 2 territories so far have no official interaction with the WTO.



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Agreements

The WTO oversees about 60 different agreements which have the status of international legal texts. Member countries must sign and ratify all WTO agreements on accession. A list of WTO agreements can be found here A discussion of some of the most important agreements follows.

Agreement on Agriculture (AoA)

The AoA came into effect with the establishment of the WTO at the beginning of 1995. The AoA has three central concepts, or "pillars": domestic support, market access and export subsidies.

Domestic support

The first pillar of the AoA is "domestic support". The AoA structures domestic support (subsidies) into three categories or "boxes": a Green Box, an Amber Box and a Blue Box. The Green Box contains fixed payments to producers for environmental programmes, so long as the payments are "decoupled" from current production levels. The Amber Box contains domestic subsidies that governments have agreed to reduce but not eliminate. The Blue Box contains subsidies which can be increased without limit, so long as payments are linked to production-limiting programmes.

The AoA's domestic support system currently allows Europe and the USA to spend $380 billion annually on agricultural subsidies alone. "It is often still argued that subsidies are needed to protect small farmers but, according to the World Bank, more than half of EU support goes to 1% of producers while in the US 70% of subsidies go to 10% of producers, mainly agri-businesses". The effect of these subsidies is to flood global markets with below-cost commodities, depressing prices and undercutting producers in poor countries – a practice known as dumping.

Market Access

"Market access" is the second pillar of the AoA, and refers to the reduction of tariff (or non-tariff) barriers to trade by WTO members. The 1995 AoA required tariff reductions of:

• 36% average reduction by developed countries, with a minimum per tariff line reduction of 15% over five years.

• 24% average reduction by developing countries with a minimum per tariff line reduction of 10% over nine years.

Least Developed Countries (LDCs) were exempted from tariff reductions, but either had to convert non–tariff barriers to tariffs—a process called tariffication—or "bind" their tariffs, creating a "ceiling" which could not be increased in future.

Export subsidies

"Export subsidies" is the third pillar of the AoA. The 1995 AoA required developed countries to reduce export subsidies by at least 35% (by value) or by at least 21% (by volume) over the five years to 2000.



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EURO:

The Euro (currency sign: €; banking code: EURO) is the official currency of the Euro-zone (also known as the Euro Area), which consists of the European states of Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Slovenia, and Spain, and will extend to include Cyprus and Malta from 1 January 2008. It is the single currency for more than 317 million Europeans. Including areas using currencies pegged to the Euro, the Euro directly affects more than 480 million people worldwide.[1] With more than €610 billion in circulation as of December 2006 (equivalent to US$802 billion at the exchange rates at the time), the Euro surpasses the US dollar in terms of combined value of cash in circulation.

While all European Union (EU) member states are eligible to join if they comply with certain monetary requirements, not all EU members have chosen to adopt the currency. All nations that have joined the EU since the 1993 implementation of the Maastricht Treaty have pledged to adopt the Euro in due course. Maastricht obliged current members to join the euro; however, the United Kingdom and Denmark negotiated exemptions from that requirement for themselves. Sweden turned down the euro in a 2003 referendum, and has circumvented the requirement to join the euro area by not meeting the membership criteria. Several small European states (The Vatican, Monaco, and San Marino), although not EU members, have adopted the euro due to currency unions with member states. Andorra, Montenegro, and Kosovo have adopted the euro unilaterally.

The Euro was introduced to world financial markets as an accounting currency in 1999 and launched as physical coins and banknotes in 2002. It replaced the former European Currency Unit (ECU) at a ratio of 1:1.

The Euro is managed and administered by the Frankfurt-based European Central Bank (ECB) and the European System of Central Banks (ESCB) (composed of the central banks of its member states). As an independent central bank, the ECB has sole authority to set monetary policy. The ESCB participates in the printing, minting and distribution of notes and coins in all member states, and the operation of the Euro-zone payment systems.

Coins and banknotes

The Euro is divided into 100 cents (sometimes referred to as eurocents). All circulating euro coins (including the €2 commemorative coins) have a common side showing the denomination (value) with the EU-countries in the background and a national side showing an image specifically chosen by the country that issued the coin. Euro coins from any country may be freely used in any nation which has adopted the Euro.

The Euro coins are €2, €1, 50c, 20c, 10c, 5c, 2c, and 1c. In the Netherlands and Finland, where cash transactions are rounded to the nearest five cents, the two smallest denominations are no longer struck (except for collectors), though they remain legal tender there. (See also Linguistic issues concerning the Euro.)

Commemorative coins of various other denominations, not intended for circulation, have been issued. They are legal tender only in the nation which issued them. In addition, members have



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from time to time replaced the national side of the two euro coin with a commemorative design--as Greece did for the 2004 Summer Olympics. These two-euro coins are legal tender throughout the Euro-zone.

All Euro banknotes have a common design for each denomination on both sides. Notes are issued in €500, €200, €100, €50, €20, €10, €5. The design for each of them has a common theme of European architecture in various artistic periods. The front (or recto) of the note features windows or gateways while the back (or verso) has bridges. Care has been taken so that the architectural examples do not represent any actual existing monument, so as not to induce jealousy and controversy in the choice of which monument should be depicted. Some of the higher denominations, such as €500 and €200, are not issued in a few countries, though they remain legal tender throughout the Eurozone.

Payments clearing, electronic funds transfer

All intra-Eurozone transfers shall cost the same as a domestic one. This is true for retail payments, although several ECB payment methods can be used. Credit/debit card charging and ATM withdrawals within the Eurozone are also charged as if they were domestic. The ECB has not standardised paper-based payment orders, such as cheques; these are still domestic-based.

The ECB has set up a clearing system, TARGET, for large euro transactions.

The currency sign €

The official construction of the euro sign, which was specified to be printed in PMS Yellow on a PMS Reflex Blue background

A special euro currency sign (€) was designed after a public survey had narrowed the original ten proposals down to two. The European Commission then chose the final design. The eventual winner was a design created by the Belgian Alain Billiet. The official story of the design history of the euro sign is disputed by Arthur Eisenmenger, a former chief graphic designer for the EEC, who claims to have created it as a generic symbol of Europe.

The glyph is (according to the European Commission) "a combination of the Greek epsilon, as a sign of the weight of European civilization; an E for Europe; and the parallel lines crossing through standing for the stability of the euro".



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The European Commission also specified a euro logo with exact proportions and foreground/background colour tones.[5] While the Commission intended the logo to be a prescribed glyph shape, font designers made it clear that they intended to design their own variants instead. Often the sign is based upon the capital letter C in the respective font so that currency signs have the same width as Arabic numerals.

Placement of the currency sign varies from nation to nation. There are no official standards on where to place the euro symbol. Generally, people in the euro countries have kept the placement of their former currencies.

Another advantage to the final chosen symbol is that it is easily created on a typewriter, by typing a capital 'C', backspacing and overstriking it with the equal ('=') sign.

History (1990-2007)

The euro was established by the provisions in the 1992 Maastricht Treaty on European Union that was used to establish an economic and monetary union. In order to participate in the new currency, member states had to meet strict criteria such as a budget deficit of less than three per cent of their GDP, a debt ratio of less than sixty per cent of GDP, low inflation, and interest rates close to the EU average. In the Maastrict Treaty, the United Kingdom and Denmark were granted exemptions from moving to the stage of monetary union which would result in the introduction of the euro.

Economists that helped create or contributed to the euro include Robert Mundell, Wim Duisenberg, Robert Tollison, Neil Dowling, Fred Arditti and Tommaso Padoa-Schioppa. (For macro-economic theory, see below.)

Due to differences in national conventions for rounding and significant digits, all conversion between the national currencies had to be carried out using the process of triangulation via the euro. The definitive values in euro of these subdivisions (which represent the exchange rates at which the currency entered the euro) are shown at right.

The rates were determined by the Council of the European Union, based on a recommendation from the European Commission based on the market rates on 31 December 1998, so that one ECU (European Currency Unit) would equal one euro. (The European Currency Unit was an accounting unit used by the EU, based on the currencies of the member states; it was not a currency in its own right.) Council Regulation 2866/98 (EC), of 31 December 1998, set these rates. They could not be set earlier, because the ECU depended on the closing exchange rate of the non-euro currencies (principally the pound sterling) that day.

The procedure used to fix the irrevocable conversion rate between the drachma and the euro was different, since the euro by then was already two years old. While the conversion rates for the initial eleven currencies were determined only hours before the euro was introduced, the conversion rate for the Greek drachma was fixed several months beforehand, in Council Regulation 1478/2000 (EC), of 19 June 2000.

The currency was introduced in non-physical form (travellers' cheques, electronic transfers, banking, etc.) at midnight on 1 January 1999, when the national currencies of participating countries (the Eurozone) ceased to exist independently in that their exchange rates were locked at fixed rates against each other, effectively making them mere non-decimal subdivisions of the



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euro. The euro thus became the successor to the European Currency Unit (ECU). The notes and coins for the old currencies, however, continued to be used as legal tender until new notes and coins were introduced on 1 January 2002.

The changeover period during which the former currencies' notes and coins were exchanged for those of the euro lasted about two months, until 28 February 2002. The official date on which the national currencies ceased to be legal tender varied from member state to member state. The earliest date was in Germany; the Mark officially ceased to be legal tender on 31 December 2001, though the exchange period lasted two months. The final date was 28 February 2002, by which all national currencies ceased to be legal tender in their respective member states. However, even after the official date, they continued to be accepted by national central banks for periods ranging from several years to forever in Austria, Germany, Ireland, and Spain. The earliest coins to become non-convertible were the Portuguese escudos, which ceased to have monetary value after 31 December 2002, although banknotes remain exchangeable until 2022.

On 1 January 2007, Slovenia joined the Eurozone.

• the euro is the sole currency in Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Slovenia and Spain. These 13 countries together are frequently referred to as the Eurozone or the euro area, or more informally "euroland" or the "eurogroup". Outside of the area covered by the map, the euro is the legal currency of the French overseas possessions of French Guiana, Réunion, Saint-Pierre et Miquelon, Guadeloupe, Martinique, Saint-Barthélemy, Saint Martin, Mayotte, and the uninhabited Clipperton Island and the French Southern and Antarctic Lands; the Portuguese overseas possessions of the Azores and Madeira; and the Spanish Canary Islands.

• By virtue of some bilateral agreements,[12] the European microstates of Monaco, San Marino, and Vatican City mint their own euro coins on behalf of the European Central Bank. They are, however, severely limited in the total value of coins they may issue.

• Andorra, Montenegro and Kosovo adopted the foreign euro as their legal currency for movement of capital and payments without participation in the ESCB or the right to mint coins. Andorra is in the process of entering a monetary agreement similar to Monaco, San Marino, and Vatican City.

• Several possessions and former colonies of EU states have currencies pegged to the euro. These are French Polynesia, New Caledonia, Wallis and Futuna (the CFP franc); Cape Verde; Morocco; the Comoros; and fourteen nations of Central and West Africa (the CFA franc). See Currencies related to the euro.

Future prospects (2008-)

Pre-2004 EU members

From Greece's participation in 2001 until the EU enlargement in 2004, Denmark, Sweden and the United Kingdom were the only EU member states outside the monetary union. The situation for



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the three older member states also looks different from that of the newer EU members; the three countries have no clear roadmap for adopting the euro:

• Denmark negotiated a number of opt-out clauses from the Maastricht treaty after it had been rejected in a first referendum. On 28 September 2000, another referendum was held in Denmark regarding the euro resulting in a 53.2% vote against joining. However, Danish politicians have suggested that debate on abolishing the four opt-out clauses may possibly be re-opened. In addition, Denmark has pegged its krone to the euro (€1 = DKr 7.46038 ± 2.25%) as the krone remains in the ERM. Although not part of the European Union, both Greenland and the Faroe Islands use the Danish krone (the Faroes in the form of the Faroese króna), and so also fall within the ERM.

• Sweden: According to the 1995 accession treaty, approved by referendum, Sweden is required to join the euro and therefore must convert to the euro at some point. Notwithstanding this, on 14 September 2003, a Swedish referendum was held on the euro, the result of which was 56% against adopting the common currency versus 42% in favour. The Swedish government has argued that staying outside the euro is legal since one of the requirements for Eurozone membership is a prior two-year membership of the ERM II; by simply choosing to stay outside the exchange rate mechanism, the Swedish government is provided a formal loophole avoiding the requirement of adopting the euro. Some of Sweden's major parties continue to believe that it would be in the national interest to join, but they have all pledged to abide by the result of the referendum for the time being and show no interest in raising the issue. An optimistic timetable is to hold a new referendum in 2012 and adopt the euro in 2015. A faster timetable is unlikely, while a slower one is more than likely. Prior to the September 2006 parliamentary elections, all major parties agreed not to raise the question before the following parliamentary elections (to be held in September 2010). The parties seem to agree that Sweden wouldn't adopt the euro until after a second referendum.

• The United Kingdom negotiated an opt-out from the portion of Maastricht requiring adoption of the euro. The nation's eurosceptics believe the single currency is merely a stepping stone to the formation of a unified European superstate, and that removing the UK's ability to set its own interest rates will have detrimental effects on its economy. Others in the UK, usually joined by eurosceptics, advance several economic arguments against membership: the most frequently cited argument concerns the large unfunded pension liabilities of many continental European governments—unlike in the UK—which could, with an ageing population, depress the currency in the future against the UK's interests. An opposing view is that intra-European exports make up to 50% of the UK's total, and a single currency would enhance the single market by removing currency risk. However, financial derivatives are becoming more accessible to small UK businesses, allowing businesses to offset currency risk (albeit at a cost that Eurozone competitors do not bear). An interesting parallel can be seen in the 19th century discussions concerning the possibility of the United Kingdom joining the Latin Monetary Union.[13] Some British people simply want sterling as a currency because it is part of UK heritage, the currency itself inspiring a large amount of national pride. The UK government has set five economic tests that must be passed before it will recommend that the UK join the euro; however, a referendum would still be held for the public to decide whether or not to adopt the currency. In November 1999, in preparation for the introduction of the euro notes and coins across the Eurozone, the European Central Bank announced a total ban on the issuing of banknotes by entities that were not National Central Banks ('Legal



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Protection of Banknotes in the European Union Member States'). Unless a derogation could be negotiated by the UK as a condition of entering the Eurozone, a change from Sterling to the euro would mean an immediate end to the circulation of Scottish and Northern Irish banknotes (see sterling banknotes). The ECB has also stated that even with notes issued by a central bank, there is 'no room for exclusively national arrangements'—all notes must be produced according to the central designs. National variation is allowed in the design of euro coins, and it is possible that the Royal Mint could continue to include the symbols of the home nations on the British designed coinage, although this would have to be included in place of the Queen's portrait. The position of the Crown dependencies is less clear. The European Union has so far strongly resisted attempts to issue euro-equivalent notes by non-EU states unless steps are taken to enter into a suitable monetary agreement, including the adoption of EU banking and finance regulations .

Post-2004 EU members

As of 2007, 11 new EU member states had a currency other than the euro; however, all of these countries are required by their Accession Treaties to join the euro. Some of the following countries have already joined the European Exchange Rate Mechanism, ERM II. They and the others have set themselves the goal of joining the euro (EMU III) as follows:

Currency Abbr. Rate Conv goal

Cypriot pound CYP 0.585274 01/01/2008

Maltese lira MTL 0.429300 01/01/2008

Slovak koruna SKK 35.4424[14] 01/01/2009

Lithuanian litas LTL 3.45280 01/01/2010

Bulgarian lev BGN 1.95583[15] 01/01/2010

Estonian kroon EEK 15.6466 01/01/2010

Latvian lats LVL 0.702804 2011–

Polish złoty PLN — 2011–

Hungarian forint HUF — 2011–



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Czech koruna CZK — 01/01/2012

Romanian leu RON — 01/01/2012

• 1 January 2008 for Cyprus and Malta - Approved by the Ecofin and conversion rate fixed on 10 July 2007

• 1 January 2009 for Slovakia • 1 January 2010 for Estonia , Lithuania,, and Bulgaria • 2011 or later for Hungary, Latvia,[21] Poland, the Czech Republic, and Romania

Too high an inflation rate postponed the entry of Lithuania and Estonia as planned on 1 January 2007. Some of these currencies do not float against the euro, and a subset of those were unilaterally pegged to the euro before joining ERM II. See European Exchange Rate Mechanism, currencies related to the euro, and individual currency articles for more details.

Originally, the Czech Republic aimed for entry into the ERM II in 2008 or 2009, but the current government has officially dropped the 2010 target date, saying it will clearly not meet the economic criteria. The new goal is 2012.

Cyprus, Estonia, Latvia, Lithuania, Malta and Slovakia have already finalised the design for their respective coins' obverse sides.

Public opinion on the euro

Although the failure of the European Constitution to be ratified would have no direct impact on the status of the euro, some debate regarding the euro arose after the negative outcome of the French and Dutch referenda in mid 2005.

• Corresponding to the Flash Eurobarometer 2006 a clear majority (62%) of Austrians had the view that The euro is good for us, it strengthens our position for the future, only a marginal minority (24%) believe the euro rather weakens the country.

• According to the Flash Eurobarometer 2006 a relative majority (46%) of Germans had the opinion The euro is good for us, it strengthens our position for the future, whereas a minority (44%) believe the euro rather weakens the country.

• A poll by Stern magazine released 1 June 2005 found that 56% of Germans would favour a return to the Deutsche Mark.

• In contrast to Germany, a poll in Austria on 7 June 2005 showed overwhelming support for the euro as 73% of the sample said they preferred to keep the common currency with only 21% in favour of returning to the old currency, the Österreichischer Schilling.

• Members of the Northern League, a northern Italian separatist political party, have discussed calling a referendum to return Italy to the lira.

• Members of the right-wing Movement for France political party have proposed holding a referendum to return France to the franc.

• Soon after these suggestions were made, the European Commission issued a statement denying any possibility of this, stating "the euro is here to stay".



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More recently, in April 2006, after the Italian elections, the subject once again came up. Again, the EU strongly rejected this, calling the suggestion "impossible".

Opposition to the euro may also come from those that otherwise support the European Union, such as the "No" campaign, under the slogan "Europe Yes. Euro No", in the United Kingdom, that lasted from 2000 to 2004.

Economists typically cite four criteria, often called the optimum currency area (OCA) criteria, to evaluate the value of switching to a single currency. There are three economic criteria (labour and capital mobility, product diversification, and openness) and one political criterion (fiscal transfers). Since establishing a single currency over a region necessitates surrendering the ability to tailor monetary policy to local conditions, these four characteristics measure the ability of the economy to smooth local economic movements in the absence of monetary policy.

• Robert A. Mundell formulated the idea that perfect capital and labour mobility would mitigate the adverse consequences of asymmetric shocks in a currency area. While capital is quite mobile in the Eurozone, labour mobility is relatively low, especially when compared to the U.S. and Japan.

• Peter Kenen formulated the idea that widely diversified production and export structures that are similar between the areas that form the currency area lower the effect and probability of asymmetric shocks. The Eurozone scores quite well on this criterion, and monetary integration seems to further improve the diversification of production structures.

• Ronald McKinnon formulated the idea that areas which are very open to trade and trade heavily with each other form an optimum currency area. This is because the high trade intensity will lower the significance of the distinction between domestic and foreign goods as competition will equalise the prices of most goods, independently of exchange rates. The Eurozone members trade heavily with each other (intra-European trade is greater than international trade), and all evidence so far seems to indicate that the monetary union has at least doubled trade between members.

• The term "fiscal transfers" refers to the transfer of money between areas. Regions that are economically worse off or suffer from negative economic shocks receive money, creating a counter cyclical effect that lowers the price, wage, and unemployment differentials between regions. Theoretically, Europe has no-bail out clause in the Stability and Growth Pact, meaning that fiscal transfers are not allowed, but it's impossible to know what will happen in practice.

So while Europe scores well on some of the measures characterising an OCA, it has lower labour mobility than the United States and similarly cannot rely on Fiscal federalism to smooth out regional economic disturbances.



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Transaction costs and risks

The most obvious benefit of adopting a single currency is removing from trade the cost of exchanging currency, theoretically allowing businesses and individuals to consummate previously unprofitable trades. On the consumer side, banks in the Eurozone must charge the same for intra-member cross-border transactions as purely domestic transactions for electronic payments (e.g. credit cards, debit cards and cash machine withdrawals).

The absence of distinct currencies also removes exchange rate risks. The risk of unanticipated exchange rate movement has always added an additional risk or uncertainty for companies or individuals looking to invest or trade outside their own currency zones. Companies that hedge against this risk will no longer need to shoulder this additional cost. The reduction in risk is particularly important for countries whose currencies have traditionally fluctuated a great deal, particularly the Mediterranean nations.

Financial markets on the continent are expected to be far more liquid and flexible than they were in the past. The reduction in cross-border transaction costs will allow larger banking firms to provide a wider array of banking services that can compete across and beyond the Eurozone.

Price parity

Another effect of the common European currency is that differences in prices — in particular in price levels — should decrease because of the 'law of one price'. Differences in prices can trigger arbitrage, i.e. speculative trade in a commodity between countries purely to exploit the price differential, which will tend to equalise prices across the euro area. Similarly, price transparency across borders should help consumers find lower cost goods or services. In reality, the effects of the euro over the level of the prices in Europe are disputable. Many citizens cite the strong perceived increase in prices in the years after the introduction of the euro, although numerous empirical studies have failed to find much real evidence of this. [2] It is speculated that the reason for this perception is that the prices of small, everyday items were rounded up significantly. For example, a cup of coffee that once cost two German Mark might now cost €1.50 or even €2.00 - a 50-100% increase. At the same time, a large appliance or rent payment rounded up to the next obvious euro level would be a negligible proportional increase. The fact that the prices people see every day were affected more strongly might explain why so many people perceive the "euro effect" as being significant, while official studies — which look at the breadth of expenditures, in proportion — would downplay it.

Macroeconomic stability

Low levels of inflation are the hallmark of stable and modern economies. Because a high level of inflation acts as a highly regressive tax (seigniorage) and theoretically discourages investment, it is generally viewed as undesirable. In spite of the downside, many countries have been unable or unwilling to deal with serious inflationary pressures. Some countries have successfully contained them by establishing largely independent central banks. One such bank was the Bundesbank in Germany; as the European Central Bank is modelled on the Bundesbank, it is independent of the pressures of national governments and has a mandate to keep inflationary pressures low. Member countries join the bank to credibly commit to lower inflation, hoping to enjoy the macroeconomic stability associated with low levels of expected inflation. The ECB (unlike the Federal Reserve in the United States of America) does not have a second objective to sustain growth and employment.



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National and corporate bonds denominated in euro are significantly more liquid and have lower interest rates than was historically the case when denominated in legacy currencies[citation needed]. While increased liquidity may lower the nominal interest rate on the bond, denominating the bond in a currency with low levels of inflation arguably plays a much larger role. A credible commitment to low levels of inflation and a stable debt reduces the risk that the value of the debt will be eroded by higher levels of inflation or default in the future, allowing debt to be issued at a lower nominal interest rate.

A new reserve currency

The euro is widely perceived to be a major global reserve currency, sharing that status with the U.S. dollar (USD) albeit to a lesser degree. The USD continues to enjoy a unique status as the primary reserve of commercial and central banks worldwide, to ensure their liquidity and facilitate international transactions. A currency is attractive for international transactions when it demonstrates a proven track record of stability, a well-developed financial market to trade the currency, and proven acceptability to others. While the euro has made substantial progress toward achieving these features, there are a few challenges that undermine the ascension of the euro as a major reserve currency. Persistent excessive budget deficits of some member nations, economically weak new members, conservatism of financial markets, and inertia or path dependency are all important factors keeping the euro as a junior international currency to the US dollar. However, at the same time, the USD has increasingly suffered from a double deficit and consequently has its own concerns.

Since its introduction, the euro has been the second most widely-held international reserve currency after the US dollar. The euro inherited this status from the German mark, and since its introduction, has increased its standing somewhat, mostly at the expense of the dollar. The possibility for the euro to become the first international reserve currency in a near future is now widely debated among economists.

As the euro becomes a new reserve currency, Eurozone governments will enjoy substantial benefits. Since money is effectively an interest-free loan to the issuing government by the holder of the currency — foreign reserves act as a subsidy to the country minting the currency (see Seigniorage). However, reserve status also holds risks, as the currency may become overvalued, hurting European exporters, and potentially exposing the European economy to influence by external actors who hold large quantities of euros.



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Criticism

Some European nationalist parties oppose the euro as part of a more general opposition to the principle of a European union. A significant group of these include the members of the Independence and Democracy bloc in the European Parliament. Additionally the Green Party of England and Wales is opposed for anti-globalisation reasons but the rest of the European Green Party bloc in the European Parliament do not share their stances.

In their view, the countries that participate in the EMU have surrendered their sovereign abilities to conduct monetary policy. The European Central Bank is required to pursue a policy that might be at odds with national interests and there is no guarantee of extra-national assistance from their more fortunate neighbours should local conditions necessitate some sort of economic stimulus package. Many critics of the EMU believe the benefits to joining the organisation are outweighed by the loss of sovereignty over local policy that accompanies membership.

The euro is underpinned by the Stability and Growth Pact, which is designed to ensure even fiscal policy across the Eurozone. The SGP has been criticised for removing the ability of national governments to stimulate their own economies to a certain extent, in the only way left to them now that monetary policy is determined supranationally. The failure of some member states to observe the SGP, and its inherent problems have led to minor reforms, and further reforms are likely.



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Financial Deregulation:

One of the most complex public policy issues facing consumer organizations in many industrial countries and increasingly in developing countries is what position to take in regard to legislative and administrative initiatives to roll back the scope of government regulation of financial institutions. These policy initiatives generally focus on depository (banking) institutions, but they often encompass other types of financial institutions, such as finance companies, securities firms, and even insurance companies.

Financial deregulation initiatives generally seek to eliminate price controls, portfolio requirements, product restrictions, and barriers to entry that operate within domestic financial service markets. In a growing number of countries, the initiatives also seek to eliminate restrictions designed to insulate domestic financial service markets from international financial markets and prevent their penetration by multinational financial firms.

Such deregulation initiatives have been variously labeled "financial deregulation", "financial liberalization", or "financial restructuring." This paper will generally use the term "financial deregulation."

The policy argument most commonly advanced to support financial deregulation is that it will provide direct benefits to consumers in the form of product innovation, increased competition, and lower prices. Without question, consumers want vigorous competition in financial service markets in order to hold down the cost of financial services, improve yields offered on savings instruments, and stimulate useful innovation. Yet considerable evidence suggests that financial deregulation can set in motion forces that will prevent it from achieving the goal of broad-based consumer benefit.

First, and somewhat paradoxically, financial deregulation unaccompanied by stronger prudential supervision and regulation to curb excessive risk-taking by financial institutions can lead to a rising incidence of bank failure and a host of direct and indirect injuries to consumers. When banking institutions collapse in the wake of financial deregulation, consumer deposits are at risk. Where governments operate broad deposit protection schemes, consumer deposits may be safe, but consumers may be required to pay for the cost of bank bailouts or failure resolutions through higher taxes. Alternatively, where large banking institutions exercise significant market power over their retail customers, they may be in a position to extract higher profits from consumers in order to cover large losses in their commercial banking operations.

Second, financial deregulation unaccompanied by rigorous competition (antitrust) policy and new mechanisms to more effectively serve consumer information needs is not likely to enhance price competition in retail financial service markets on any sustainable basis. A strong antitrust policy against concentration is needed to ensure that retail financial service markets remain competitive on the supply side. On the demand side, new and more effective consumer information mechanisms are needed to enable consumers to participate effectively in increasingly complex financial service markets. Without both components in place, financial deregulation is not likely to stimulate real price competition.

Third, financial deregulation unaccompanied by access safeguards can diminished access to banking services for lower income persons, low and moderate income neighborhoods, and small businesses. Financial deregulation and technological change produce certain structural and operational changes in the banking industry -- i.e., stronger competitive pressure, industry



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consolidation, standardization of loan products, centralization of loan approval authority, and pressure to maximize fees and service charges. The evidence suggests that these changes tend to reduce both the willingness and the capacity of banking institutions to serve economically disadvantaged or isolated communities, small-sized businesses, and various non-standardized credit needs.

An assessment of financial deregulation from a consumer or public interest perspective must recognize that it affects a broad range of consumer and local community interests. And these interests and impacts must be viewed from a number of very different perspectives or disciplines: prudential control, competition policy, consumer information needs, considerations of social equity, and local economic and community development policy. The complexity of this assessment process is further compounded by a number of subtle interactions and potential trade-offs between key policy goals. For example, increased competition may exacerbate prudential control problems, or proliferation of financial service products may overwhelm consumers with information needs.

Needless to say, the complex web of subtle impacts and interactions makes it difficult to draw balanced conclusions about financial deregulation. Moreover, given this complexity, it is relatively easy for ideologues or powerful vested interests within the financial service industry to present superficially reasonable assessments of financial deregulation that, in fact, overlook or gloss over its impact on important consumer and local community interests.

For consumer and community organizations, however, there may be only limited value in a static debate over the pros and cons of financial deregulation. More to the point is the issue of what type of safeguards should be developed to contain the negative impact of financial deregulation. At least in the industrial countries, financial deregulation in some form has already arrived. Within these countries, price decontrol and elimination of product restrictions within the banking sector are commonplace, although key structural issues remain unresolved -- such as whether to permit banks to affiliate with commercial or industrial firms. Moreover, deregulation of domestic financial service sectors is beginning to unfold in many developing countries, including those which still continue to restrict entry by multinational financial service firms.

Financial deregulation has not only arrived, but in all likelihood, is also here to stay -- at least within the industrial countries. Technological change, the ascendancy of market-based economies, and the globalization of financial markets have guaranteed or at least weigh heavily in favor of this outcome. So the most urgent task is to establish adequate safeguard mechanisms.

The critical safeguard issues posed by financial deregulation can be categorized as follows: (1) prudential control of financial institutions, (2) competition policy, (3) consumer information needs, (4) consumer protection (unfair terms and practices), (5) access to basic financial services for disadvantaged consumers and small business, and (6) in the context of developing countries, the availability of credit for priority economic sectors. It is essential that consumer and local community organizations become actively involved in shaping the necessary safeguard mechanisms. These safeguards touch upon too many vital consumer and local community interests to allow their fashioning to be left exclusively, or even primarily, to the financial service industry itself or even its regulators, who are invariably subject to strong pressure from the financial service industry and generally have a narrow technical perspective.



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II. The Forces Driving Financial Deregulation.

In most industrial countries, financial service markets have traditionally been highly regulated by means of price controls and product restrictions and also segmented into different types of institutions, such as commercial banks, housing finance specialists, cooperative credit institutions, finance companies, life insurers, and property/casualty insurers. Much of this market segmentation evolved over the course of the last 150 years as new types of financial institutions were established with government support to satisfy specific financial service needs not being met by existing financial institutions. Prime examples would include the cooperative credit institutions in Germany, Japan and Canada, the building societies in the U.K., and the savings and loans in the U.S..

The dominant rationale for financial regulation has been the need to maintain stability within the banking sector, exercise monetary control, and assure the solvency or "safety and soundness" of individual financial institutions. However, other goals, including the desire to allocate credit to certain sectors, enhance consumer protection, and, at least in the U.S., restrict financial concentration have also played a role. In many developing countries, the desire to employ financial institutions, especially banking institutions, as vehicles to promote national economic development has exerted a strong influence over the shape of financial regulation.

Over the course of the last 20 years or so, a series of developments have combined to build mounting economic and political pressure for financial deregulation -- first in the industrial countries and then more recently in many developing nations.

First, new technology centering on computers and telecommunications has led to the introduction of many new financial service products, especially by less regulated financial institutions. These new products have frequently undercut the market position of traditional financial service providers. For example, in the U.S. the extensive intrusion of securities products and securities firms into traditional corporate lending, home mortgage lending, and deposit markets has meant that banking institutions have lost many of their best customers and are faced with lower profit margins on some of their traditional products.

Second, the spiraling inflation and economic instability experienced by many industrial and developing countries during the 1970s and 1980s resulted in severe dislocations in many domestic financial markets, which placed many financial institutions under great stress. At least in some countries, the rigidities associated with strict price and product controls for financial institutions came to be seen as a source of instability and even fragility within the financial sector. For example, in the U.S. long-standing regulations prohibiting savings and loans from making variable rate mortgages were a key factor contributing to the tremendous losses and erosion of capital experienced by the savings and loan industry in the environment of escalating interest rates that prevailed during the late 1970s and early 1980s.

Third, aggressive pursuit of economic deregulation policies by the Thatcher, Reagan, and Bush administrations in the U.K. and the U.S. has provided powerful political impetus to financial deregulation. For example, over the last 11 years the U.S. Treasury Department has consistently advocated sweeping deregulation of the U.S. financial sector, including dramatic structural changes that would allow combinations between banks and industrial firms, as well as nationwide branch banking.



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Aggressive advocacy of financial deregulation by the U.K. and the U.S. has not been confined to their own domestic financial markets. The two countries have employed trade negotiations and, in the case of the U.S., strong influence over the IMF and the World Bank to encourage or pressure other countries to deregulate their domestic financial sectors and open these markets to foreign entry. Needless to say, the appeal of such a strategy to the political leadership in the U.S. and the U.K. reflects the close fit between the theory of financial deregulation and the interests of powerful U.S. and U.K. financial service firms that seek entry into and operating flexibility within foreign financial service markets.

For example, while the U.K. has dragged its feet on many aspects of European integration, it has been a powerful influence in steering the European Commission to adopt a policy that not only supports cross-border trade and right of entry for financial service firms within a single European market, but also encourages financial deregulation within each EC member country. The U.S. has employed bilateral trade negotiations with Japan and Korea to exert pressure on both countries to open their domestic financial service sectors to foreign entry and accelerate the pace of domestic financial deregulation. The aggressive U.S. policy favoring financial deregulation in other countries and removal of barriers to entry by multinational financial service firms is also manifest in the draft GATT treaty on trade in financial services produced by the Uruguay Round negotiations in late 1991.

The U.S. has achieved perhaps its greatest success in its campaign for financial deregulation in other countries by means of the powerful leverage that it wields over the policies of the World Bank and the IMF. These multilateral institutions have actively encouraged many developing countries to deregulate their financial service sectors and in some cases have conditioned access to structural adjustment loans on adoption of financial deregulation policies.

III. Need for Prudential Control of Financial Institutions.

The rationale for financial deregulation is generally framed in terms of the superiority of free markets over government intervention. However, sweeping application of free market principles to the financial service sector is unrealistic because it overlooks the irreducible responsibility of governments to maintain stability within financial markets and protect consumer funds entrusted to financial institutions.

Moreover, recent experience with financial deregulation suggests that when the level of competition within the financial service sector increases, there is a tendency toward greater risk-taking by financial institutions, which in turn warrants more rigorous prudential control. Hence, there is a basic paradox: financial deregulation that is successful in increasing competition is likely to create a need for stronger prudential regulation.

1. Competition and Risk-taking in Banking.

The recent experience of U.S. commercial banks provides strong evidence of the connection between competition and risk-taking in banking. During the 1970s and early 1980s, large commercial banks in the U.S. lost many of their more profitable loan and deposit customers to competition from the securities industry. Large corporations began to raise funds by issuing commercial paper (usually underwritten by securities firms) instead of borrowing from commercial banks, while many consumers with large deposit balances shifted their funds from deposit accounts at banks to money market mutual funds (managed by securities firms). At the same time, the finance company affiliates of U.S. auto manufacturers began to provide the banks



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with stiff competition in the market for auto loans. Finally, the integration of home mortgage loans into the capital market -- via the securitization pipeline -- brought a vast new supply of funds into the mortgage market and began to exert downward pressure on mortgage interest rates.

Faced with the prospect of shrinking market shares and declining profitability, many large U.S. commercial banks began to invest their funds in higher-yield loans that also carried greater credit risks -- in particular, loans to developing nations (in the late 1970s and early 1980s) and commercial real estate loans and loans to finance highly-leveraged corporate take-overs in the mid-to-late 1980s. Although overshadowed by the spectacular collapse of the U.S. savings and loan industry, the adverse consequences of this assumption of increased credit risk by commercial banks have also been dramatic. For example, over the last 15 years, the loss rate on the loan portfolios of large commercial banks has increased more than tenfold, rising inexorably from an average annual rate of approximately 0.14% in the 1975-80 period to a rate of 2.22% for the 3rd quarter of 1991.[ (3)] Prior to the late 1980s, the federal deposit insurance program had brought stability and a low bank failure rate to the U.S. banking system. Between 1933, when the program was first established, and 1980, there were on average only 12 commercial bank failures per year. By way of contrast, over the 1987-1990 period, the U.S. has experienced an average of 198 commercial bank failures per year.

The cost of resolving recent commercial bank failures in the U.S. has exhausted the reserve of the deposit insurance fund maintained by the Federal Deposit Insurance Corporation (FDIC) to insure deposits of commercial banks. In November 1991, the U.S. Congress authorized the FDIC to borrow up to $30 billion from the U.S. Treasury to meet the cost of handling future commercial bank failures.[ (4)] Since it is not clear whether the banking industry will have sufficient earnings in future years to provide the FDIC with insurance premium revenues that are adequate to recapitalize the deposit insurance and at the same time enable the FDIC to repay its "borrowing" from the Treasury, this $30 billion loan authorization is already viewed by many observers as an implicit government bailout.

A rising incidence of bank insolvencies can be seen in many other developed countries, although the trend is usually not as dramatic as in the U.S. Even in countries thought to have more stable banking systems, there is evidence of growing stress among depository institutions. For example, in late 1991 the cooperative banks in Germany had to inject DM 900 million in new capital into Deutsche Genossenschaftsbank, the $130 billion banking institution that serves as a wholesale and clearing house bank for Germany's cooperative banking sector. In Switzerland, Spar und Leihkasse Thun, a medium-sized regional bank, abruptly collapsed in early 1992.As more countries pursue strategies of financial deregulation, the level of competition within their domestic financial service markets should rise and this in turn is likely to induce greater risk-taking by their depository institutions.

2. Competition and Risk-taking in Insurance.

A similar relationship between increasing competition and a rising incidence of insolvency is manifest in the U.S. life insurance and property/casualty insurance industries. A number of factors are working to increase competitive pressures within the U.S. insurance industry in particular, new technology, the desire of some insurance companies to improve efficiency by eliminating the use of insurance agents and relying instead on direct marketing, the entry of foreign insurance companies with expansionist ambitions, and growing efforts by banks to sell insurance products.



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Additionally, U.S. insurance companies operate in an economic and social environment that poses major new risks for insurers. Prime examples of such risks include the following: the rising incidence of fraud in the auto insurance market; new environmental liabilities faced by property insurers; financial market risks inherent in holding portfolios of many new life insurance products, such as long-term annuity contracts; and the increasing volatility of commercial real estate assets, which represent a major investment for many life insurance companies.

The combined effect of increasing competition and a riskier operating environment have resulted in a growing number of failures in the U.S. life insurance and property/casualty insurance industry. For example, an average of 35 property/casualty companies failed per year during the 1988-90 period, compared to an annual average of only 10 failures during the 1969-1983 period. Similarly, an estimated average of 35 life insurance companies failed per year during the 1989-1991 period, compared to an annual average of only 6 failures during the 1981-83 period.

IV. Depositor Protection: Necessary but Potentially Costly.

1. Depositor Protection Programs.

National governments in more than 30 countries operate or sanction some type of program to protect depositors at banking institutions in the event of bank failure.Wide variation exists in the administrative structure and coverage of these various national programs. The majority were established in the 1980s, as banking insolvencies became more frequent in a growing number of countries.

Even in countries where there is no depositor protection scheme and no legal obligation for government to rescue depositors of failed banks, national governments often feel compelled to step in and protect depositors when banks are failing, especially large or strategically important banks. For example, in 1984 the Bank of England rescued the small, but internationally strategic, Johnson Matthey Bankers, even though it was under no legal obligation to do so.In 1990, the Australian federal government came to the rescue of the depositors of the troubled Victoria State Bank by requiring the Commonwealth Bank, a large bank owned by the federal government, to acquire Victoria State Bank. This indirect federal government bailout was arranged even though Australia did not have a government deposit insurance scheme.

In these situations, national governments and bank regulators are motivated by a number of considerations -- the need to maintain stability in domestic banking markets, the adverse political repercussions of allowing a large number of depositors to incur financial hardship, and a desire to protect the international competitiveness of their larger banks.

The U.S. has a statutory deposit insurance scheme that provides each depositor with deposit insurance up to $100,000 at each bank in which the depositor maintains deposit funds -- although to a limited extent a depositor may obtain insurance coverage above $100,000 at an individual bank by means of multiple deposit accounts. At larger commercial banks, typically one-third to one-half of deposit balances are above this $100,000 ceiling and thus are not formally insured, while the uninsured deposit ratio is much lower at smaller banks. Notwithstanding the statutory ceiling for deposit insurance coverage, U.S. banking regulators have routinely handled the majority of bank insolvencies including all large bank failures and virtually all savings and loan failures -- by providing financial assistance to a healthy banking institution to acquire the failing institution and thereby assume all of its deposit liabilities, both insured and uninsured. The consequence of this failure resolution policy has been to afford on a de facto basis 100% deposit



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insurance protection to all depositors, at least with respect to larger commercial banks and savings and loans -- in contrast to the statutory protection of only $100,000 per depositor per institution.

A similar failure resolution dynamic was at work in Canada during the 1980s. The Canadian government protected all of the depositors of two regional commercial banks that failed in the mid-1980s, even though the government deposit insurance program only covered deposits up to $60,000 Canadian.

For a number of years, economists have warned that expansive government deposit insurance schemes and failure resolution policies are likely to encourage risk-taking by banking institutions and that such risk-taking must be restrained by rigorous prudential supervision and regulation. In a nutshell, comprehensive government deposit protection, by eliminating most of the incentive for depositors to worry about the financial condition of their bank, enables banking institutions with a taste for high-yield, high-risk assets to fund such assets with low-cost (riskless) deposits. When this strategy works, it reaps high profit for banking institutions; when it fails, most of the losses are borne by the deposit insurance fund or taxpayers.

2. U.S. Savings and Loan Debacle.

The devastating collapse of the U.S. savings and loan industry proves powerful testimony to the danger of mixing broad-based deposit protection policies with weak prudential controls. At the start of the 1980s, the U.S. had approximately 4,000 savings and loans with combined assets of approximately $600 billion -- roughly 25% of the total assets of all U.S. depository institutions. Even though plagued by earnings problems and insolvencies, the savings and loan industry continued to grow during the early and mid-1980s, with its total assets peaking at $1,350 billion in 1988. Over the course of the last 10 years, roughly 1,500 savings and loans with combined assets of $500 billion have failed. Reflecting the escalation of savings and loan failures over the last four years, the total assets of the savings and loan industry have declined from $1,350 billion in 1988 to only $890 billion toward the end of 1991.

The federal government has handled virtually all savings and loan failures in a manner that protects all of their deposit funds, primarily through government assisted mergers and acquisitions. Failed savings and loans have held so many real estate loans in default and worthless real estate equity investments that the cost to the federal government of resolving insolvent savings and loans has on average been equal to about 30% of each failed institution's total assets. Thus, the total cost of dealing with failed savings and loans has been roughly $150 billion measured on a present value basis -- 30% of the $500 billion in total assets of all failed savings and loans.

The federal deposit insurance fund established for savings and loans was for all practical purposes bankrupt by 1987 or 1988 and most of the cost of the savings and loan bailout has been borne directly by U.S. taxpayers. Since 1989, federal expenditures for savings and loan resolutions have been approximately $105 billion, and in February 1992 the Bush Administration asked Congress for an additional appropriation of $55 billion to complete the savings and loan bailout.[

(11)] When the projected interest cost of the U.S. Treasury borrowing that is necessary to finance the federal expenditure on failed savings and loans is taken into consideration, the ultimate taxpayer cost for the savings and loan bailout is likely to be in the neighborhood of $500 billion.



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The broad-based nature of the U.S. depositor protection scheme was a central factor in the savings and loan debacle. During the late 1970s, sharp escalation of interest rates had caused large operating losses at savings and loans and eroded much of their capital base. During the 1980s, several state governments -- most dramatically Texas and California -- and, to a lesser extent, the federal government granted broad new real estate investment powers to savings and loans. At the same time, prudential supervision of savings and loans was reduced in the name of "deregulation." In such circumstances, depositors should have viewed savings and loans as high-risk institutions -- they were thinly capitalized, their assets were becoming increasingly risky, and their regulators were growing increasingly lax. Instead of exercising caution, depositors poured funds into savings and loans because government deposit insurance and failure resolution policies protected virtually all of their deposits from risk of loss. As long as public confidence was maintained, near-insolvent or even insolvent savings and loans were able to continue their operations and even grow. Indeed, aggregate deposits of all savings and loans increased from $500 billion at year-end 1980 to $930 billion by the end of 1987 -- a perverse market boom in an economically troubled industry.

V. Irreducible Role of Government in Protecting Deposits.

The rationale for financial deregulation is generally framed in terms of the superiority of free markets over government intervention. However, sweeping application of free market principles to the financial service sector is unrealistic because it overlooks the irreducible responsibility of government to maintain stability within financial markets and to protect consumer funds entrusted to financial institutions.

1. Efforts to Roll Back Depositor Protection Schemes.

In the U.S., belated recognition that under certain circumstances broad-based government deposit insurance can lead to (1) increased risk-taking by insured depository institutions, (2) a higher failure rate among such institutions, and (3) greater failure resolution costs has led to a rising chorus of calls for a major rollback in the scope of the federal government's deposit protection program. The basic premise underlying such thinking is that if depositors were exposed to the possibility of substantial loss in the event of bank failure, depositors would be far more alert concerning the financial condition of their bank and would generally avoid placing funds in high-risk banks. In large measure, the campaign to roll back federal deposit insurance coverage reflects the belief that depositors can be more effective in disciplining excessive risk-taking by banking institutions than bank regulators.

Concern about the large governmental costs that can result from broad-based deposit protection schemes is not unique to the U.S. During the 1980s, Canada's government-sponsored deposit insurance organization, the Canadian Deposit Insurance Corporation (CDIC), was required to resolve 21 deposit institution failures with an estimated total cost of $4.7 billion Canadian. Most of the institutions that failed were trust and loan companies and mortgage companies -- depository institutions chartered to serve housing finance needs. By 1983, losses resulting from these failures had caused the CDIC to become insolvent.

In 1985 a review committee established by the Canadian federal government to examine the issue of deposit insurance reform recommended that the primary objective of the CDIC should be to insure small, unsophisticated depositors and that it should not bear any responsibility for protecting deposit balances above the official ceiling or the funds of other bank creditors. The



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review committee came out strongly in favor of exposing uninsured depositors to risk of loss as a means of instilling effective market discipline at depository institutions.

2. Too-large-to-fail Syndrome.

A major obstacle to implementing policies that would expose depositors to some level of bank failure risk is the extreme reluctance of banking regulators to stand by passively while a major bank defaults on its deposit liabilities. This "too-large-to-fail" syndrome stems from a number of mutually reinforcing factors: fear that a large bank default could disrupt the payments system and cause serious liquidity problems at other banks; concern that a default by a major bank would impair the international competitiveness of the country's other large banks; and recognition that if a large number of depositors were victimized by a default, they might well have sufficient political influence to gain legislative redress.

The powerful hold of the "too-large-to-fail" syndrome in the U.K. was put succinctly in 1987 by Professors Mervyn Lewis of the University of Nottingham and Kevin Davis of the University of Melbourne:

There would be a public outrage if the Bank of England allowed one of the major banks or depository institutions to fail (whether there would be in the case of a minor institution is less clear). Most customers and staff of the major clearing banks, we contend, are unaware even of the existence of a deposit insurance fund, let alone its limited coverage. The perception of the general public is that banks are made "safe" by the Bank of England, and any attempt to shake that faith would lead to greater financial instability. Moreover, even where large banks are allowed to fail in the sense that their stockholders are wiped out, banking regulators are likely to employ failure resolution procedures that protect all of their deposit liabilities -- in essence, a "too-large-to-default" syndrome.

The conjunction of statutory ceilings on the scope of deposit insurance coverage and the "too-large-to-default" or "too-large-to-fail" syndrome means that some depositors at small banks that fail are likely to suffer losses, while all depositors at large banks that fail will always be protected. Such disparity in treatment between large banks and smaller banks is clearly in evidence in U.S. failure resolution policies. In the U.S., all depositors at large failing banks are routinely protected, while in many instances small banks that fail are liquidated and their depositors paid only up to the amount of the statutory deposit insurance ceiling.

The "too-large-to-default" syndrome has a number of important consequences which tend to be magnified by financial deregulation. The more competition in banking markets increases and the incidence of bank failure rises, the more smaller banks are competitively disadvantaged by the double regulatory standard inherent in the "too-large-to-default" syndrome. Also, the more the scope of formal deposit insurance coverage is rolled back in the name of reducing government intervention in financial markets, the greater the disparity in treatment between large banks and smaller banks.

Further, in cases where the smaller banks that fail have served minority communities, the double standard implicit in the "too-large-to-default" syndrome is likely to engender strong sentiments of social discrimination. For example, when Freedom National Bank, a small black-owned bank based in Harlem and Brooklyn in New York City, failed in 1990, the U.S. Federal Deposit



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Insurance Corporation (FDIC) liquidated the bank and left its uninsured depositors unprotected. Many of the unprotected deposits (balances over $100,000) belonged to social service and church organizations that served the low income black community. In a public hearing on the Freedom National Bank case, U.S. Congressman Charles Schumer of Brooklyn contrasted the FDIC's handling of Freedom National Bank with its treatment of National Bank of Washington, a much larger bank based in Washington, DC that had recently failed and had all of its depositors protected by the FDIC.

The National Bank of Washington's uninsured deposits which were made whole include those of foreign depositors and sophisticated speculators. The Freedom National's deposits, which will not be made whole, include those of churches, charities small and large, and organizations which provide social services, affordable housing and economic sustenance to the communities they and Freedom National serve.

Grace Harewood, Executive Director of the Fort Greene Senior Citizens Council in Brooklyn, expressed local community sentiment in the following blunt terms:

The FDIC's unfortunate and destructive action is a classical action of institutional racism. It is apparent that the FDIC operates using a dual standard: one for the so-called rich and powerful and one for the so-called poor.

The manner in which the recent failure of BCCI has been handled by the Bank of England suggests the working of a similar double standard. BCCI is being liquidated and a number of its depositors in the U.K. -- many of whom come originally from Third World countries -- may recover only 60% of their deposit balances.

In November 1991, the U.S. Congress enacted major banking reform legislation designed to strengthen the prudential supervision and regulation of banking institutions. Although the legislation eschewed any major rollback in the scope of statutory deposit insurance coverage, it does direct the bank regulators to limit their use of failure resolution procedures that provide de

facto 100% deposit insurance protection. However, these new failure resolution guidelines do not become effective until 1995 and the extent to which they will, in fact, circumscribe the "too-large-to-fail" or "too-large-to-default" syndrome remains unclear.

3. Core Bank Proposal.

In the 1991 deliberations by the U.S. Congress on banking reform legislation, the only seriously considered alternative to the current regime of broad-based, government-sponsored deposit insurance was a proposal to confine access to government deposit insurance to banking institutions subject to rigorous curbs on their risk-taking activities -- so-called "core banks" or "narrow banks." Under the proposal, core banks would be free to invest their deposit funds in government securities, consumer loans, home mortgage loans, and small business loans, but other types of lending, such as commercial real estate financing or corporate take-over financing, would be severely restricted. Also, core banks would not be permitted to pay interest on their deposit accounts at a rate greater than the prevailing interest rate on U.S. Treasury securities of comparable maturity.

The core bank proposal represented an effort to employ the government deposit insurance system to support the payments system and retail banking activities, and at the same time eliminate its exposure to higher-risk banking activities, such as commercial real estate lending, financing of



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corporate takeovers, international lending, and various off-balance sheet banking liabilities. On the negative side, the proposal would have reduced to some extent the capacity of banking institutions to serve the business and real estate sectors and the international competitiveness of large U.S. commercial banks. Also, if large banks were permitted to engage in high-risk activities without limitation in unregulated affiliates -- as the core bank proposal would have allowed -- it is unclear whether a core bank strategy would actually lower the overall risk exposure of the U.S banking system and the deposit insurance funds. In any event, the core bank proposal was opposed by the Bush Administration and most larger banks and was defeated on the floor of the House of Representatives.

4. Depositor Insecurity and Bank Instability.

The inherent difficulty with reliance on depositor discipline is that it requires depositors to make sophisticated judgments about the financial condition of banks -- a subject about which as a practical matter it is difficult for them to obtain adequate information. The awkwardness of being placed in this position inevitably leads to insecurity among depositors. As shown by the historical experience of a number of industrial countries prior to the establishment of lender-of-last-resort facilities and deposit protection programs, banking environments characterized by depositor insecurity can quickly lead to bank runs -- i.e., the panicked withdrawal of deposits based on rumors that a bank may be unsound.

It has been suggested that the best answer to the dilemma of depositor protection and bank risk-taking lies in some type of partial deposit insurance scheme in which the risk of bank failure is shared between depositors and the deposit insurance fund. Yet it is difficult to see how such a compromise solution will solve the underlying problem. Most depositors with funds at risk are likely to want to withdraw their funds as fast as possible, irrespective of whether their exposure to loss is 100%, 50%, or only 10%. Moreover, since depositors are likely to take action only after a bank has been damaged by nonperforming loans, their response of rapid deposit withdrawal may well increase the likelihood that troubled banks will fail.

5. Inability of Financial Markets to Judge the Quality of Bank Loans.

Beneath the surface appeal of relying on "depositor discipline" as a means for exerting prudential control over depository institutions and reducing the exposure of deposit insurance funds lie a number of inherent difficulties. Research in the U.S. suggests that financial markets are not very effective in gauging the level of risk embedded in bank assets, especially loan portfolios. Prices of bank stocks and ratings of bank debt securities have not proved to be good leading indicators of loan quality problems at banking institutions.

This inability of financial markets to foresee loan problems or to gauge their true extent once they have become public knowledge should not be viewed as surprising. The inherent risk and underlying value of bank loans is largely determined by a bank's credit underwriting policies and practices and the economic condition of individual borrowers. Much of this information is not public information. This holds true even in the U.S., which has the world's most comprehensive financial reporting laws for depository institutions.

Given the fact that financial market professionals have not been very successful in assessing bank risk on an ex ante basis -- i.e., before loan losses begin to mount -- it seems unrealistic to assign such a task to depositors at large (even high-balance depositors). Depositors in general have far less expertise and less time to devote to the matter than financial market professionals.



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The task of judging the true financial condition of banks is further complicated by the huge increases in banks' off-balance sheet liabilities, such as those arising from credit guarantees or hedging interest rate risk and foreign exchange positions. Needless to say, it is very difficult for market analysts or depositors to assess the level of risk associated with a given bank's particular volume and mix of off-balance sheet liabilities.

6. Role of Banking Institutions as Financial Intermediaries.

The lack of transparency of bank assets and the resulting potential for runs by depositors are characteristics that in large measure are intrinsic to the special role of banking institutions within the broader financial marketplace. Banking institutions engage in a unique form of financial intermediation. They transform savings and checking account balances held by the public (liquid deposits) into credit advanced to borrowers, both consumer and business, who do not have direct access to capital markets (illiquid loans).

Professor Charles Goodhart of the London School of Economics, who served as a Chief Adviser of the Bank of England from 1980-85, has described this unique intermediation role of banking institutions as follows:

The key difference between a collective investment fund and a bank is that the former invests entirely, or primarily, in marketable assets, while the latter invests quite largely in nonmarketable or, at least, non-marketed assets.... In this sense, the particular role of banks is to specialize in choosing borrowers and monitoring their behavior. Public information on the economic condition and prospect of such borrowers is so limited and expensive that the alternative of issuing marketable securities is either nonexistent or unattractive.

The capacity of banking institutions to transform liquid deposits into illiquid loans greatly increases the overall supply of credit available for productive uses. The liquidity-creating and productivity-enhancing role of banking institutions is one of the major reasons why banks are so vital to the economy. A recent study of deposit insurance by the U.S. Federal Deposit Insurance Corporation summarizes this role in the following terms:

Banks issue deposits that satisfy depositors' liquidity needs. By pooling liquidity risk across individuals, the bank will need to hold fewer liquid assets than the depositors would hold if they lacked access to the bank. To the extent that the bank can meet the liquidity needs with fewer liquid (and less productive) assets, there are more funds available to support productive illiquid investment.

It is this unique type of financial intermediation performed by banking institutions that underlies the lack of transparency of their assets. As Professor Mervyn Lewis of the University of Nottingham and Professor Kevin Davis of the University of Melbourne have observed:

But part of the rationale for bank intermediation lies in the existence of imperfect information. Banks have a special role as "inside lenders" based on specialized information about borrowers, so that it is difficult, if not impossible, for outsiders to assess accurately the riskiness of a bank's portfolio.



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However, the very characteristics that make banking institutions such unique and potentially productive financial intermediaries -- portfolios of illiquid loans and extensive nonpublic information -- carry the potential for great instability. Because it is extremely difficult for depositors or even sophisticated market analysts to judge the quality of a bank's assets, there is inevitably a substantial degree of public uncertainty about the true financial condition of banking institutions. This underlying public uncertainty makes banks prone to deposit runs in the event of bad news or even rumors about their condition. Moreover, such deposit runs can quickly spread to other banks, a danger commonly referred to as contagion or systemic risk.

Professors Lewis and Davies have described the consequences of public uncertainty about banks as follows:

One observed characteristic of the banking system, in the absence of a perceived guarantee of deposit safety, is the vulnerability of individual banks to "runs" and the contagious nature of the "run" mentality.... Indeed, in an environment of imperfect information, a bank run is seen to be a logical outcome of a free banking sector, given the usual form of the deposit contract.[ (25)]

The inescapable conclusion is that if banks are to perform their special financial intermediation function effectively, government must provide some form of depositor protection. If such protection is not forthcoming, banking institutions will ultimately have to confine most of their assets to marketable securities in order to enhance their transparency and maintain the confidence of their depositors. However, such a shift in the composition of bank assets would adversely effect the availability of credit for many borrowers, especially small and medium-sized businesses, housing developers, and many consumers. As Arthur J. Murton, as staff economist at the U.S. Federal Deposit Insurance Corporation has observed:

One of the simple results is that, in the face of the threat of bank runs, depositors will require banks to hold more liquid assets than if bank runs were not a threat.... Ex ante, in a world without deposit insurance, the threat of bank runs reduces productive investment.

In short, this analysis indicates that banking institutions are heavily dependent on government support in performing their special financial intermediation function. Without government support in the form of implicit or explicit deposit protection and lender of last resort facilities, the capacity of banking institutions as financial intermediaries would be substantially diminished and their role within the broader financial marketplace would be greatly reduced. Accordingly, even in deregulated and fully privatized financial systems, banking institutions must still be viewed as creatures of government support.

7. Primacy of Prudential Control of Banking Institutions.

The central lesson that should be drawn from the recent banking difficulties in many countries is the primacy of prudential control. Prudential control is paramount because banking institutions are to an important degree insulated from market discipline -- due to their intrinsic nature, but also as a consequence of public policy. The factors behind this insulation include (1) the difficulties encountered by financial markets in evaluating the true quality of bank assets (lack of transparency), (2) the inherent fragility of banking institutions, (3) the economic necessity of maintaining stability within the banking system, and (4) the need to safeguard deposit funds for equitable and political reasons. When financial deregulation is undertaken, strong prudential control becomes even more important because deregulation increases both the opportunities and the incentives for risk-taking by banking institutions.



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VI. Key Elements of Prudential Control.

For a system of prudential control to be robust enough to cope with the risks posed by financial deregulation the following components are essential.

1. Prohibition against High-Risk Activities.

Banking institutions should be prohibited from investing deposit funds in high-risk activities, such as real estate equity, real estate development loans where developers provide little equity, or even large volumes of junk bonds or equity securities. Recent U.S. banking experience has demonstrated dramatically the danger of allowing banking institutions to make such investments. Large losses on high-risk real estate loans and investments were the predominant cause of the massive wave of savings and loan failures during the last 7 years as well as most of the failures of larger commercial banks during the last 3 years.

In the early 1980s, savings and loans, especially savings and loans chartered under state law (as opposed to federal law), were authorized to make equity investments in real estate -- a high-risk investment activity which in the U.S. had traditionally been prohibited for both savings and loans and commercial banks. Analysis of the financial statements filed by all federally-insured savings and loans at year-end 1987 indicates that savings and loans with a substantial level of investment in real estate equity (greater than 3% of total assets) had a dramatically higher insolvency rate than those with no such investment. Among the 2,893 savings and loans based outside Texas, the insolvency rate was 8.6% for those with no investment in real estate equity, compared to an insolvency rate of 36.1% for savings and loans with a substantial level of real estate equity investment. Among the 279 savings and loans in Texas, the insolvency rate was 23.9% for savings and loans with no real estate equity investment and 66.1% for those with substantial real estate equity investment.

Real estate equity investments by savings and loans accounted for losses that were far greater than the amount of such investments themselves. Many loans made to support real estate equity positions proved to be improvident and imposed large losses. Equally important, the ability to combine lending and equity investment served as a powerful magnet drawing real estate developers to gain control of savings and loans with the aim of using deposit funds to support their real estate activities.

2. Curbs on Loans to Support Commercial Affiliates and Insider Loans.

Lending by banks to support their commercial affiliates or to their own insiders has been an important cause of problem loans and bank failures. According to a 1989 report by the World Bank, loans to firms within the same conglomerate as the lending bank have been an important source of loan losses. In fact, in Spain, Chile, Columbia, and Thailand, most bad loans were loans that had been made to affiliated or related firms.In the U.S., a 1988 study by the Comptroller of the Currency, the federal agency that supervises national banks, found that insider abuse, including loans to insiders, was a significant factor in 35% of national bank failures.

The danger inherent in lending to affiliates or insiders is that it subjects bank loan officers to pressures and influences that undermine their ability to exercise independent and balanced judgment in reaching credit decisions. For this reason, lending to affiliates and insiders should be prohibited, or it should be restricted and carefully monitored by bank regulators.



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3. Capital Adequacy Requirements.

Equity capital at banking institutions provides a cushion to absorb losses and gives bank regulators more time to seek corrective action before insolvency occurs. Moreover, poorly capitalized banking institutions have a tendency to gamble on high-risk strategies because they have little equity to lose.

The international capital standards established for commercial banks in 1988 by the Basle Committee on Banking Regulations and Supervisory Practices provide a useful framework for addressing the capital adequacy issue. International capital standards are needed to prevent competition between large banks at the international level from driving capital ratios down to unacceptably low levels.

There are, however, serious technical problems with the Basle capital standards, especially their failure to distinguish between high-risk loans and low or moderate-risk loans and their indirect impact on the allocation of credit. Community and consumer organizations in the U.S. have sharply criticized a key risk-weighting provision of the Basle standards that requires banking institutions to maintain more capital for multi-family and non-standardized housing loans than for standardized or securitized home mortgage loans. In the U.S., this provision has discouraged some banking institutions from serving the housing finance needs of low and moderate income neighborhoods.

While technical adjustments are clearly needed, the overall level of capital required under the rules should be maintained or even strengthened. Countries that have not adopted the Basle standards (or higher standards) should be encouraged to do so.

4. Supervisory Examinations.

Bank regulators must have accurate and timely information on the financial condition of banking institutions if they are to identify and properly supervise problem banks and promptly dispose of failing banks by merger or liquidation. All too often, the financial statements prepared by banking institutions and submitted to their regulators do not accurately reflect the true financial condition of the banks. In some cases, blatant fraud is involved, but more often than not, bank management has merely taken advantage of the broad discretion inherent in financial accounting rules to avoid recognizing and reporting risk and loan losses.

In order to obtain accurate information on the condition of banking institutions, regulators must subject these institutions to in-depth, on-site examinations on a periodic basis. Such supervisory examinations are especially critical in evaluating the quality of a bank's loan portfolio and the adequacy of its loan loss provisions. Such examinations need to be frequent because banking institutions are inherently fragile and their financial condition can deteriorate rapidly.

Recognizing the vital importance of supervisory examinations, the banking reform legislation recently enacted by the U.S. Congress requires the federal bank regulators to examine each large and medium-sized banking institution at least once every 12 months and each small bank (assets less than $100 million) at least once every 18 months.

In a number of countries, there has been a tradition of relying on audits by independent public accountants in lieu of supervisory examinations conducted by the bank regulators. While audits by public accountants undoubtedly have a useful role to play in the monitoring process, they



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should not be seen as a substitute for on-site examinations by bank regulators who bear ultimate responsibility for the condition of the banking system.

5. Accounting Rules and Loan Loss Provisions.

One of the most serious weaknesses in prudential control has been the failure to devise special accounting rules for banking institutions that will give a realistic picture of their financial condition. To some extent this weakness is a consequence of the underlying nature of banks loans. As described above, many bank loans are originated on the basis of nonpublic information and not readily traded in financial markets. When loans of this nature become problem loans, it is very difficult to judge their true market value. Hence, assessing the value of a bank's problem loans and the adequacy of its specific loan loss provisions is an inherently complex and judgmental process.

Another accounting weakness has been the failure to require banking institutions to set aside general loan loss reserves that adequately reflect the level of risk embedded in loans when they are first made. Under existing practices, such general loan loss reserves tend to be much smaller than any realistic projection of likely future loan losses, especially when the banking institution is engaged in high-risk lending. This reflects a failure to link general loan loss provisions to the level of risk associated with different types of loans. In many respects, this accounting shortcoming parallels the failure of the risk-based capital rules to adequately consider the different levels of risk associated with different categories of loans.

In the U.S., the adoption of lax accounting rules for savings and loans was one of the principal techniques by which savings and loans and their regulators masked the growing number of savings and loan insolvencies during the 1980s. More recently, all depository institutions in the U.S. have been required to follow generally accepted accounting principles (GAAP). However, the U.S. General Accounting Office, the auditing arm of the U.S. Congress, has sharply criticized GAAP rules as applied to banking institutions on the ground that they give bank management and its independent public accountants far too much latitude to delay the recognition of loan losses.

Special accounting rules are needed for banking institutions that (1) provide clear guidance for estimating the level of risk associated with different categories of loans when they are originated and require a bank to establish general loan loss reserves that adequately cover this risk, (2) provide clear guidance for determining when bank loans should be classified as "problem loans" on which some loss is probable, and (3) provide clear guidance for estimating the likely level of losses on problem loans and require a bank to establish special loan loss provisions that reflect this estimated loss. In view of the large exposure of deposit insurance funds, government, and ultimately taxpayers when banks fail, the special accounting rules for banking institutions should lean in favor of recognizing risk and loss. Application of these rules to individual banking institutions should be a key part of the on-sight supervisory examinations conducted by the bank regulators.

6. Prompt Supervisory Action.

Bank regulators should be not just empowered, but also mandated to take prompt supervisory action against problem or failing banking institutions. The concept of prompt supervisory action can be summarized as follows. In the case of a problem bank, the regulator should forcefully curb



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risky activities and require a capital infusion to the maximum extent feasible. In the case of an insolvent or near-insolvent bank, rather than allowing the institution to continue to operate under its current management, the regulator should promptly arrange a take-over by a healthy banking institution, place the failing bank under government control, or liquidate the failing bank.

The failure of bank regulators in the U.S. to use their discretionary powers to force problem banks to take corrective measures and to promptly dispose of failing banks has been well documentedRecognizing this weakness, the banking reform legislation enacted by the U.S. Congress in 1991 established a set of prompt supervisory action requirements that are triggered by a progressive decline in a bank's capital ratio

A central lesson of the savings and loan debacle in the U.S. is that the longer bank regulators delay disposition of insolvent banking institutions, the greater the ultimate cost to the deposit insurance fund. The most grievous public injury comes not from bank failures per se, but from bank failures which impose high resolution costs on deposit insurance funds.

If financial deregulation succeeds in increasing competition, then some bank failures would seem to be inevitable. Hence, a mandate for bank regulators to promptly dispose of failing banking institutions is especially important in deregulated financial markets.

7. Public Disclosure of Comprehensive Financial Statements.

Banking institutions, especially large commercial banks, should be required to publicly disclose comprehensive financial statements, including both balance sheet and income statement information. At present, in the vast majority of countries, the financial statements disclosed to the public by banking institutions are woefully inadequate. These financial statements generally fail to include key income statement information, especially interest income data, nonaccrual loan data, and loan charge-off data for different categories of loans and interest expense and fee income data for different categories of deposits.

In many industrial countries, the bank regulators do, in fact, require banking institutions to submit detailed financial information, but this information is not made available to the public. This practice stems from a tradition of regulation-in-secrecy among bank regulators that is inappropriate in an era of financial deregulation. While it is true that bank regulators remain ultimately responsible for monitoring and supervising banking institutions, it is, nonetheless, a mistake to withhold comprehensive financial statement information from the public. Most importantly, lack of public access to this information makes it all but impossible for anyone, including national legislatures, to monitor the performance of the bank regulators on an ongoing basis -- a consequence that is undoubtedly not lost on many bank regulators. Additionally, investors in bank equity and debt securities have a right to this information, and the public markets for bank equity securities would function more efficiently if such information were disclosed.

In the U.S., banking institutions are required by both federal banking law and federal securities law to make public detailed financial statements. In fact, virtually all of the financial statement information submitted on a regular basis by banking institutions to the bank regulators is made available to the public.

8. Public Disclosure of Supervisory Actions by Bank Regulators.



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Bank regulators should be required to make public their supervisory actions, such as orders or agreements directing banks to cease risky practices or raise additional capital. Bank regulators have traditionally viewed such supervisory actions as strictly confidential. However, the resulting lack of transparency in the bank supervision process has made it exceedingly difficult for the legislative bodies that empower bank regulators and the public at large to monitor and evaluate the performance of the regulators. The lack of transparency in bank supervision means that the bank regulators are not publicly accountable for their actions on an ongoing basis. Further, lack of public disclosure of supervisory actions makes it difficult to determine whether supervisory inaction has been an important factor in bank failures and deposit insurance fund losses.

Additionally, the wall of secrecy surrounding supervisory actions tends to insulate the regulators from direct public pressure to take forceful supervisory action. Such pressure is needed to counterbalance the inevitable chorus of pleas from banking institutions for leniency and forbearance.

In the U.S., lack of transparency in the bank supervision process has come to be viewed as a key factor contributing to the reluctance of bank regulators to take prompt supervisory action. With this in mind, the U.S. Congress in 1989 directed the federal banking regulators to make public their enforcement orders. More recently, U.S. banking regulators have begun to make public many of their supervisory agreements with problem banking institutions. Further, in 1991 the Congress directed each federal banking regulator to prepare a report reviewing its supervisory actions in each case where a bank failure results in a material loss to the deposit insurance fund. Congress also mandated that these reports be made available to the public.

VII. Need for Vigorous Antitrust Policy.

Financial deregulation must be accompanied by a vigorous competition (antitrust) policy if the underlying goal of enhancing price competition is not to be undermined by a rising level of concentration and the formation of anticompetitive structures within financial service markets. The experience to date suggests that financial deregulation can set in motion forces leading to waves of bank mergers that sharply increase concentration within the banking sector. The Netherlands and Denmark provide stark examples of this pattern, but the trend is manifest in many different countries, including Australia and the Unites States.

1. Lack of Economies of Scale in Banking.

Without question, mergers between large banks that serve the same or overlapping markets -- known as horizontal mergers -- reduce the level of competition. But they are often justified on the ground that they will improve bank efficiency. Yet a broad body of economic research conducted in the U.S. over the last 30 years suggests that there are no inherent efficiencies resulting from bigness in banking. This research indicates that once a bank achieves a size of $100 million to $500 million in total assets the size of a robust community bank -- there are no significant economies of scale resulting from additional growth in size. The U.S. Federal Reserve Board recently summarized this research as follows:

In general, these studies have not found evidence of a significant cost advantage on the part of larger banks. They find that economies of scale, if they exist, are very small, and most studies do not show such scale economies to exist beyond a small to medium sized bank. Thus, this line of research has not provided strong evidence suggesting that large mergers in general can be counted on to achieve substantial cost savings.



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The lack of economies of scale in banking has important implications for competition policy vis-a-vis the banking sector. Most pointedly, it means that large banks that propose to merge in the name of greater efficiency should be able to achieve the same improvement in efficiency without merging. Indeed, a comprehensive study of 134 bank mergers recently prepared by the Federal Reserve Board found that no more than one merged bank out of ten managed to increase its profitability relative to banks that did not merge.

Thus, the empirical evidence suggests that (1) bank mergers are not necessary to achieve greater efficiency and (2) bank mergers are not likely, in fact, to result in efficiency gains. In light of this evidence, proposed mergers between two large banks that would have significant anticompetitive effects should not be approved on the ground that the anticompetitive effects are likely to be outweighed by gains in efficiency. The anticompetitive effects are clearly predictable, while the efficiency gains projected by bank merger applicants are speculative and run counter to the great weight of the evidence. This analysis suggests the need for special antitrust standards for the banking sector that are in general more restrictive than those applied to the manufacturing sector, where significant economies of scale may be present.

A key factor fueling many recent bank mergers is the process of financial deregulation itself. As financial markets are deregulated, banking institutions often face increased competitive pressure and are more prone to make mistakes and become problem banks. Quite often, problem banks will seek to escape from their difficulties by selling out to a healthy bank. For example, large loan losses were the primary reason why Security Pacific (U.S.) was willing to be acquired by BankAmerica and why Midland Bank (U.K.) is currently the object of acquisition bids from Hongkong & Shanghai Banking Corporation and Lloyds Bank.

When a large bank encounters difficulties, antitrust standards should not be put aside out of fear that the only way to avoid a messy bank failure is to permit another large bank to acquire the problem bank. Anticompetitive effects can be minimized by dividing the branch network of the large problem bank into separate components and selling each component to a different bank. To a modest degree, this was the policy followed by U.S. banking and antitrust regulators in the recent BankAmerica acquisition of Security Pacific. Before the regulators would approve the acquisition, BankAmerica had to agree to divest 220 branch offices out of a pre-merger total of 2,512 branch offices for BankAmerica and Security Pacific combined.

2. Depositor Protection and Competition Policy.

The "too-large-to-fail" syndrome is another important factor that encourages concentration in banking markets. In countries that lack government-sponsored deposit insurance schemes or where such schemes provide only limited coverage, the "too-large-to-fail" syndrome provides an important competitive advantage to large banking institutions. In such countries, consumers are wise to place their deposit funds in one of the larger banks on the assumption that the deposit base of a very large bank will invariably be "protected" if problems should arise. On the other hand, when deposit funds are placed in a smaller bank, the risk of deposit loss in the event of bank failure cannot be safely ignored. This disparity gives large banks an advantage in attracting deposit funds that has nothing to do with economic efficiency or better service. In essence, it represents a spurious "economy of scale" that stems from supervisory policies that discriminate against smaller banking institutions.

Viewed from this perspective, broad-based deposit protection should be seen not just as a consumer protection measure, but also as a key component of competition policy. If deregulated



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banking markets are to provide a level playing field in which small depository institutions -- community banks, credit unions, credit cooperatives -- compete on equal terms with giant banks sheltered by the "too-large-to-fail" syndrome, then a broad-based deposit protection scheme must be established for depository institutions of all sizes.

In the U.S., the existence since the 1930s of a broad-based federal deposit insurance program has been a major factor in the continued vitality of small banks. At present, the U.S. has approximately 9,000 small, community banks with assets of $100 million or less. Since these banks are clearly not protected by the "too-large-to-fail" syndrome, their depositors would bear far greater failure risk than depositors of large banks in the absence of the federal deposit insurance program.

In Hong Kong, which does not have a deposit protection scheme, the leading consumer organization has recognized the vital link between deposit protection and competition policy. According to Professor Edward K. Y. Chen, Chairman of the Hong Kong Consumer Council:

Discrimination in dealing with bank failures will result in unfair competition in the banking sector when there is a crisis of confidence in the banking system. If there is no DPS [deposit protection system], people will tend to transfer their deposits from small banks to large banks, believing that these will not be allowed to fail.

3. Concentration, Deregulation, and High Costs for Consumers and Small Business.

Both economic theory and empirical research indicate that high levels of concentration in banking markets result in higher loan costs and lower deposit yields for bank customers. After reviewing 34 major studies of the relationship between concentration and prices in U.S. banking markets.

The general conclusion seems obvious to me. Selling prices rise with concentration, and buying prices fall with concentration. The banking industry, which has produced about as many concentration-price studies as all the other industries put together, yields massive support for the prediction of conventional oligopoly theory.

Moreover, there are special reasons why concentration in deregulated banking markets can prove disadvantageous to consumers and small businesses. Retail banking and wholesale banking are in many respects different lines of business which operate in very different markets. Wholesale banking markets -- i.e., services for large corporations, large-scale real estate projects, institutional investors, governments, and inter-bank markets -- are national or global in scope, highly competitive, often entail high risks, and can result in large losses for banking institutions. On one hand, many wholesale banking markets provide only narrow profit margins in the best of times; when things go wrong, they can inflict heavy losses. On the other hand, retail banking markets -- which center on services for consumers and small businesses -- tend to be local in nature, generate only limited price competition, and entail comparatively low and relatively predictable levels of risk. As a result, retail banking markets usually provide high profit margins to banking institutions.

Banking institutions in almost all countries do not make public profitability data for their different lines of business, and thus it is difficult to measure with precision the difference in profit levels between wholesale and retail banking activities. Nonetheless, there is mounting evidence which indicates that financial deregulation tends to lower profit margins on wholesale banking activities, while leaving profit margins on retail banking activities relatively unchanged or even rising. In



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fact, where large banks have suffered major losses on their wholesale banking operations, the evidence suggests that they tend to increase profit margins on their retail activities in order to offset their wholesale losses.

Professor Ross Milbourne and Matthew Cumberworth of the University of New South Wales recently examined the net interest margins for the wholesale and retail banking operations of Australian banks as financial deregulation unfolded during the 1980s. The net interest margin represents the spread between loan rates and deposit rates. They found that:

Despite the fall in wholesale margins, retail margins continued to rise over the decade by an average of 0.2% per year. Thus, retail customers found the differential 2% more in 1990 than in 1980.... Corporations have gained the most from deregulation, facing constant or smaller interest margins at greater risk factors. Retail customers have correspondingly lost from deregulation.

The annual reports of a number of large U.S. banking organizations that straddle both consumer and wholesale banking markets indicate that high profits from consumer banking operations have been used to cushion losses resulting from high-risk wholesale banking activities, including Third World lending and the financing of commercial real estate development and corporate take-overs. For example, Citicorp reported that in 1990 its consumer banking operations provided net income of $979 million, while its wholesale banking operations resulted in a loss of $423 million. Similarly, Chase Manhattan reported for 1990 a net income of about $400 million on its retail banking operations (consumer and small business), but a loss of $734 million on its wholesale banking activities.

The U.S. Federal Reserve Board has reported that during 1990 large bank credit card issuers in the U.S. achieved an average pretax rate of return on their credit card portfolios (ROA) of 3.69%.This stands in sharp contrast to the average pretax rate of return on total banking assets of 0.56% achieved by larger U.S. banks in the same time period .

4. Diversification and Cross-Subsidization.

In the U.S., it has been suggested that consolidation of many of the nation's 12,000 commercial banks into a relatively small number of giant banks with nationwide retail branch networks would, by virtue of asset diversification, reduce the level of risk at individual banks and the incidence of bank failure. Yet a policy of encouraging large banks engaged in major wholesale banking operations to acquire extensive retail branch networks would maximize the capacity of such banks to extract high profits from consumers and small businesses in order to cover losses in wholesale banking markets.

Viewed in this light, such "diversification" is to a considerable degree really cross-subsidization at the expense of consumers and small businesses. Such cross-subsidization may, in fact, reduce the incidence of bank failure, but it accomplishes this goal by an extremely regressive means. In deregulated financial markets, the consumers and small businesses who bear the brunt of cross-subsidization tend to be those who have the least bargaining power and are often among the less affluent or economically disadvantaged. A far more direct and equitable approach to curbing the incidence of bank failure is to strengthen prudential control of wholesale banking activities.

To summarize, whenever financial deregulation is undertaken, competition policy vis-a-vis the banking sector needs to be invigorated and assigned a high priority. Competition policy for a deregulated banking sector should adopt and implement the following concepts. First, mergers



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between large banks that would have anticompetitive effects should be rejected. Second, regulatory policy should foster a structurally diverse banking sector that includes a mix of large banks and smaller, community-based depository institutions to prevent domination of retail banking markets by giant commercial banks. Third, explicit deposit protection should be available to depository institutions of all sizes and should be recognized as vital to establishing a level playing field for large and small institutions.

Access to Basic Financial Services for Disadvantaged Consumers, Small Businesses, and Communities.

Access to basic financial services (credit, savings, payment, and insurance) has long been recognized as essential to effective participation by individuals and small enterprises in a modern market-based economy. For this reason, governments in many different countries over the years have pursued a variety of strategies designed to ensure that disadvantaged segments of society have access to basic financial services. Traditional examples of this policy would include (1) the provision of savings account and payment services by government postal systems, (2) government support for a host of public-purpose credit and deposit institutions, and (3) government-sponsored insurance pools that provide coverage to high-risk individuals.

1. Erosion of Access for Disadvantaged Sectors.

Financial deregulation (especially banking deregulation) threatens to undermine some of the traditional access mechanisms and, more generally, exacerbate the problem of access to basic financial services by disadvantaged sectors.

A number of subtle forces underlie this trend toward reduced access. First, the worldwide trends toward privatization of banking institutions and elimination of formal credit allocation schemes undercut the ability of governments to directly control the price and availability of banking services for disadvantaged sectors. Second, banking institutions operating in deregulated financial markets tend to be less inclined to serve low and moderate income depositors, since they present fewer profit opportunities, and more inclined to raise fees and service charges on deposit and payment services for such customers. Third, when banking institutions are under pressure to extract additional profit (or cut operating costs) from their retail banking operations, the brunt of the ensuing fee increases or service cuts tends to fall on individuals and businesses with the least bargaining power -- who are often the ones who can least afford to pay more or are most affected by service cuts. Hence, new and robust access mechanisms are clearly needed to ensure that financial deregulation, including privatization, does not undermine access to basic financial service by disadvantaged sectors.

2. Access Mechanisms in Deregulated Banking Markets: The U.S. Experience.

One important access mechanism that has great relevance to deregulated banking markets is the U.S. Community Reinvestment Act (1977). This law subjects banking institutions to an affirmative obligation to serve the credit needs of the disadvantaged sectors within their communities, especially low and moderate income and minority neighborhoods.

A second, closely-related access mechanism in the U.S. is the Home Mortgage Disclosure Act (1975), which requires banking institutions to publicly disclose information on the geographic distribution of their home mortgage loans. Such public disclosure of loan data indicating the performance of banks in serving the housing credit needs of disadvantaged neighborhoods has



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proved to be indispensable in implementing the affirmative obligation standard of the Community Reinvestment Act..

A third mechanism recently enacted by the U.S. Congress requires banking institutions to publicly disclose information on the scope of their small business lending. This disclosure requirement reflects public concern that smaller firms, especially start-ups, young firms and minority-owned firms, may not have adequate access to credit.

Consumer and community organizations in the U.S. have sought federal legislation that would require banking institutions to offer low cost or no fee savings and checking accounts -- commonly referred to as basic banking services. Although no federal legislation has been enacted in this area, access to basic banking services has been raised as an issue by local community organizations lodging protests under the Community Reinvestment Act, and many agreements negotiated between banks and such organizations contain bank commitments to provide basic banking services Moreover, during the 1980s, a number of states, including Massachusetts, Illinois, Rhode Island, Connecticut, and Minnesota, enacted laws requiring banking institutions to provide various types of basic banking services.

3. Access Mechanisms in Developing Countries.

Another important access mechanism arising in a very different context is provided by the regulatory requirements or procedures employed by a number of developing countries to encourage banking institutions to open branch offices in underdeveloped rural sectors. For example, in Thailand and Malaysia, the central bank requires commercial banks seeking approval to open branch offices in high-growth urban areas to make commitments to open branch offices in less developed rural areas.

For many developing countries, banking deregulation entails the elimination or winding down of formal credit allocation schemes (loan portfolio requirements and interest rate controls) that have traditionally been employed to steer credit to priority sectors, such as small business, housing, and rural areas. In these countries, it will be important to replace the discarded credit allocation rules with new, more flexible access mechanisms. With appropriate modification, some of the access mechanisms employed in industrial countries -- such as the Community Reinvestment Act and the related home mortgage loan and small business loan disclosure provisions -- have relevance for developing countries that deregulate their banking systems. Conversely, access mechanisms established in developing countries may provide useful models for industrial countries, such as the U.S., that seek to revitalize inner-city neighborhoods and promote minority-owned small business.

Many surprising parallels exist between industrial and developing countries when it comes to strategies to mobilize banking institutions to serve access goals in deregulated financial markets. Whether the objective is to promote low-cost housing and minority-owned enterprise in the inner-city neighborhoods of North America or small business start-ups and rural economic development in Indonesia and Thailand, the commitment desired of banking institutions is often the same -- the provision of technical expertise, cooperation with NGOs, participation in government loan guarantee programs, and willingness to absorb some of the above-average administrative costs that are generally associated with community development lending.

4. Access Requirements: Quid-Pro-Quo for Government Support.



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In the U.S., the affirmative obligation standard of the Community Reinvestment Act has been interpreted to mean that banking institutions have an obligation to (1) offer the type of credit services required by the disadvantaged sectors of their local communities, (2) engage in affirmative marketing of these services, and (3) absorb some administrative costs or price some services at cost. This affirmative obligation standard is viewed as an appropriate quid-pro-quo for the extensive government support provided to banking institutions in the form of explicit or implicit protection of deposits, the central bank's lender of last resort facility, and exclusive or privileged access to the payments system. It is important to recognize that even when banking systems are deregulated and privatized, such government support remains vital to the proper functioning of banking institutions. Thus, the worldwide trend toward financial deregulation and privatization should not be seen as undercutting the validity of subjecting banking institutions to some duty to respond to the banking needs of disadvantaged sectors or sectors in need of economic and community development.

Consumer Information Needs.

1. New Hazzards for Consumers.

Financial deregulation creates many new product options for consumers, but also introduces new consumer hazards. Financial institutions often respond to the new opportunities and increased competitive pressure stemming from deregulation by adopting aggressive marketing techniques. Advertizing and promotional material is often designed to obscure the cost of financial service products, especially credit. Hidden fees and the bundling of financial services into complex packages are common tactics. Financial institutions in general adopt more liberal credit standards and many credit institutions become willing to lend to consumers with high debt burdens. As a consequence, the default rate on consumer loans (including home mortgage loans) tends to rise with financial deregulation. For example, the Bank of England reports that the mortgage default rate in the U.K. has risen from an average of about 0.4% during the 1970s to a rate in excess of 2.5% in 1991.

Financial deregulation should be accompanied by strong consumer protection measures designed to provide consumers with adequate information on financial service products and to curb unfair contract terms and practices. However, it is doubtful that the conventional approach to consumer information needs -- product cost and term disclosures provided to the consumer by the financial service provider at the point of sale -- is adequate to the task of informing consumers in deregulated financial service markets. As financial service products become more differentiated and complex, conventional disclosure requirements are increasingly likely to omit key information or, alternatively, overload the consumer with information at the point of sale. Financial service firms are in a position to readily blunt the utility of specific disclosure requirements by redesigning or bundling financial service products. Regulatory and legislative bodies are notoriously slow in modifying disclosure requirements to catch up with innovations in financial service products.

2. Consumer Information Deficit.

Retail financial service markets have been characterized by consumer information gaps -- a chronic problem that is exacerbated by financial deregulation. The information deficit on the consumer side of the market stems from both consumer inertia and consumer ignorance -- the failure to engage in comparison shopping and the failure to examine or understand product terms and characteristics. As economic theory suggests, the failure of consumers to make informed



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decisions (imperfect information) translates into market power for financial service firms that are skilled in exploiting this weakness and is a primary reason why retail financial service markets have higher profit margins than wholesale financial service markets.

Even in countries with detailed consumer disclosure requirements and a large number of institutions competing in retail financial service markets, there is pervasive evidence of a consumer information deficit. For example, in the U.S. there are more than 4,000 credit card issuers, and a number of these offer credit cards at comparatively low interest rates. Yet, card holders have failed to switch to lower-rate cards, and the rate of return on bank credit cards is far in excess of the general rate of return on bank assets.[ (51)] Moreover, one reason why retail deposits are valued so highly by banking institutions is that many consumers are extremely sluggish in responding to price signals in deposit account markets.

Perhaps the most dramatic example of the consumer information deficit in the financial service area is provided by life insurance products. According to a 1985 report issued by the U.S. Federal Trade Commission, 80% of consumers with life insurance policies have not shopped for life insurance, while another 18% of these consumers have not shopped effectively. In other words, only 2% of consumers with life insurance policies have engaged in effective comparison shopping.[ (52)] In a similar vein, a survey undertaken by the U.K. Office of Fair Trading in 1985 found that only 10% of consumers who had purchased life insurance policies had personally engaged in comparison shopping.[ (53)]

3. Need for Collective Information Systems.

What is needed in an era of financial deregulation is a new, collective approach to consumer information that emphasizes the systematic collection and analysis of comparative price and term information on financial service products and the dissemination of such information to individual consumers. To this end, collective information systems should be established to provide financial service consumers with (1) comparative price and term information (shoppers guides) for various financial service products; (2) computerized shopping programs that will scan the market for a specified type of financial service product and select the best buy for a given consumer, taking into consideration the consumer's financial characteristics; and (3) brochures and other publications providing analysis and advice about various financial service products offered in the market.

A collective information system for financial service products would dramatically reduce the search costs faced by individual consumers and would be in an excellent position to employ new computer and telecommunications technology directly to serve consumer information needs. Such a system could respond promptly to the introduction of new financial service products and could provide consumers with sophisticated evaluations of various products -- the kind of evaluation that is often needed to adequately assess inherently complex financial service products.

To be operationally efficient, a collective information system would need to be supported by a legislative or administrative framework that would give it ready access to current price and term information on various banking, credit, and insurance products offered by financial service firms. For example, such firms could be required to report this price and term information directly to the collective information system.



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A collective information system should ultimately be able to generate enough revenues from membership dues and other fees to achieve self-sufficiency or close to it. However, during its start-up and early years of operation, it is likely to need a modest level of government support. Such support is especially important if the collective information system is to provide adequate information services to low and moderate income persons -- the persons who often have the most pressing information needs and the least capacity to pay fees.

A collective information system should be constituted as a consumer membership organization, democratically controlled by its consumer members -- i.e., a financial consumers association. Such consumer control through a democratic structure should impart to the system both a strong incentive to serve consumer information needs and a high degree of political independence.

One way to establish a collective information system would be for the national government to (1) charter a financial consumers association, (2) prescribe democratic rules of governance for the association, (3) provide the association with direct access to price and term information for various financial service products, (4) provide the association with a modest level of support, and (5) subject the association to a special obligation to serve the financial service information needs of low and moderate income persons.

Need for Consumer Participation to Create Adequate of Safeguards.

The available evidence suggests that financial deregulation will not provide sustainable net benefits to consumers on the whole without a comprehensive set of safeguards with respect to prudential control, competition policy, access concerns, consumer information, and consumer protection. Absent adequate safeguards in these areas, financial deregulation is likely to have the following adverse consequences: (1) an undesirable level of concentration within retail financial service markets; (2) periodic cycles of excessive risk-taking by banking institutions in wholesale banking markets followed by large loan losses, with most of the cost of absorbing these losses born by consumers and small business; (3) high profits in retail financial service markets stemming from the failure of consumers to shop effectively, with most of these profits captured by firms with dominant market positions and firms with aggressive, non-price marketing strategies; and (4) reduced access to banking services for consumers in low and moderate income neighborhoods and rural areas and small business in general. In a nutshell, financial deregulation without an adequate framework of safeguards provides aggressive banking institutions with a license to pursue high-risk strategies in high-prestige wholesale banking markets and then, when problems arise, dump the costs on their consumer and small business customers or even taxpayers.

The nature of the required safeguards is such that it is unlikely that they can be established and effectively implemented without active participation by consumer and local community organizations. Several factors work to elevate the importance of NGO participation in the safeguard process.

1. Advocacy by NGOs and the Adoption of Safeguards.

Most of the necessary safeguards are strongly opposed by powerful forces within the banking industry and garner little support from bank regulators or Treasury ministries or departments. Banks generally oppose strong antitrust standards, access requirements, many consumer protection measures, and even some important components of prudential reform, such as greater financial disclosure, prohibitions on high-risk activities, and more disciplined accounting rules.



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Bank regulators generally oppose prudential reforms that would enhance the transparency of the supervisory process or mandate prompt and forceful supervisory action. Bank regulators tend to be biased against strong antitrust standards because they are far more interested in maintaining the stability of banking institutions than in promoting vigorous competition within the banking system. Banking regulators also are generally unsympathetic to access safeguards. In many industrial countries, the Treasury ministries or departments, which usually are charged with drafting banking legislation, do not support most of the necessary safeguards. For example, the sweeping financial deregulation proposal advanced by the U.S. Treasury Department in 1991 ignored the need for access, consumer information, consumer protection, and antitrust safeguards, and the prudential safeguards that it proposed were extremely weak. Faced with opposition from such powerful quarters, adequate safeguards are not likely to be established unless they are championed by NGOs and have broad public support.

2. Participation by NGOs in the Implementation of Safeguards.

Active participation by consumer and local community organizations is important in the implementation of safeguards on financial deregulation -- a process that is quite distinct from the initial establishment of such safeguards. Most of the necessary safeguards do not provide black letter law instructions to the regulators, but instead give them wide latitude in the implementation process. Thus, once established, the safeguards are not self-executing, but rather depend on the exercise of discretion by regulators who at best are not well informed about many of the concerns underlying the safeguards and may not be sympathetic to the underlying purposes of the safeguards. Consequently, there is great need for continuous monitoring of the bank regulators and advocacy for rigorous implementation of the safeguards -- especially to offset pressures for tepid implementation emanating from the banking industry. Since the safeguards touch upon a broad range of consumer and local community interests, it is natural to look to consumer and local community organizations to perform a monitoring and advocacy role.

Several key safeguard mechanisms require extensive participation by consumer or local community organizations in order to function properly. The collective information system -- the key to effective participation by consumers in deregulated financial markets -- is in its very essence a consumer participation process and should be lodged within a consumer organization. Access mechanisms such as the Community Reinvestment Act require a high level of public participation in order to define the particular banking needs of disadvantaged neighborhoods or isolated communities. Equally important, to be fully effective in promoting community development financing in disadvantaged areas, such access mechanisms need to encourage working relationships between banking institutions and local community organizations. Even with respect to implementation of prudential safeguards, there is a degree of dependence on the independent monitoring and advocacy skills that are the hallmark of consumer organizations. For example, reforms to enhance the public accountability of bank regulators by improving the transparency of the supervisory process are likely to lie fallow unless the resulting flow of documents is monitored by consumer or other public interest organizations.

. Key Role for a Financial Consumers Association.



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As discussed previously, the best approach to establishing a collective information system would be for the national or a state government to charter an independent financial consumers association. Such an organization could also be assigned an important monitoring and advocacy role with respect to the other safeguards on financial deregulation -- prudential control, competition policy, access issues, and consumer protection measures. For example, the legislation chartering the financial consumers association could direct the association to (1) operate a collective information system; (2) monitor and report periodically on the prudential control performance of the bank and insurance regulators, the level of competition within retail financial service markets, and the availability of basic financial services to disadvantaged sectors; and (3) serve as an advocate for policies that advance prudential control, competition policy, access to basic financial services, and consumer protection in the financial service sector.

Financial deregulation, by reducing regulation-from-above, creates a vacuum with respect to controls to ensure that the banking system is responsive to a broad range of consumer and local community interests. This void needs to be filled by enhancing NGO participation in the shaping and implementation of safeguard mechanisms. In a sense, the reduction in rigid regulation-from-above needs to be counterbalanced with an increase in flexible regulation-from-below.

A financial consumers association with a broad mandate to address the safeguard issues posed by financial deregulation would provide a much needed institutional structure for organized participation by consumers in the process of establishing and implementing such safeguards. Creating such an organization with the necessary monitoring, advocacy, and information dissemination capacity, lodged within the consumer sector, would seem to be a prerequisite for adequate safeguards on financial deregulation.



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