unit 3: foreign direct investment unit...

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ECON 401 The Changing Global Economy Unit 3: Foreign Direct Investment Unit Overview Introduction The growth of foreign direct investment (FDI) is a key aspect of today’s global economy. World GDP increased by 45 percent between 1992 and 2006, but FDI increased by 700 percent. The acceleration of economic development in many parts of the less developed world is tied to increases in FDI. FDI may provide more (and cheaper) capital, access to new technologies and business practices, and improved access to developed country markets. FDI growth reflects the growing relative importance of multinational corporations (MNCs) in the global economy. While the investment activities of these giants often bring important economic benefits, critics are concerned that these MNCs may possess undue political influence and distort the pattern of economic development. Note: The textbook refers to multinational corporations as “multinational enterprises” or MNEs. Either term is acceptable, but we use MNC throughout these course materials. Web Links These articles on the WTO Web site address specific issues related to foreign direct investment.   Foreign direct investment seen as primary motor of globalization , says WTO Director - General   Trade and foreign direct investment”—New Report by the WTO   Does globalization cause a higher concentration of international trade and investment flows ? (select ERAD-98-08 under the year 1998) References Statistics Canada. (2008). Canada’s international investment position, 2007. Catalogue No. 67-202-X. Ottawa: Minister of Industry. Page 1 of 52

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ECON 401The Changing Global Economy

Unit 3: Foreign Direct Investment

Unit Overview

Introduction

The growth of foreign direct investment (FDI) is a key aspect of today’s global economy. World GDP increased by 45 percent between 1992 and 2006, but FDI increased by 700 percent.

The acceleration of economic development in many parts of the less developed world is tied to increases in FDI. FDI may provide more (and cheaper) capital, access to new technologies and business practices, and improved access to developed country markets.

FDI growth reflects the growing relative importance of multinational corporations (MNCs) in the global economy. While the investment activities of these giants often bring important economic benefits, critics are concerned that these MNCs may possess undue political influence and distort the pattern of economic development.

Note: The textbook refers to multinational corporations as “multinational enterprises” or MNEs. Either term is acceptable, but we use MNC throughout these course materials.

Web Links

These articles on the WTO Web site address specific issues related to foreign direct investment. 

Foreign direct investment seen as primary motor of globalization, says WTO Director-General “Trade and foreign direct investment”—New Report by the WTO  Does globalization cause a higher concentration of international trade and investment flows? (select ERAD-98-08 under the year 1998)

References

Statistics Canada. (2008). Canada’s international investment position, 2007. Catalogue No. 67-202-X. Ottawa: Minister of Industry.

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Section 3.1: Foreign Direct Investment

Reading Assignment and Learning Objectives

In the textbook:Chapter 7 (pp. 240–254; pp. 257–262; pp. 265–268)Closing Case: Cemex's Foreign Direct Investment (pp. 269–270)

After completing Section 3.1, you should be able to

describe recent trends in the levels and directions of foreign direct investment (FDI) in 1.Canada and worldwide. define the following terms:2. 

foreign portfolio investment foreign direct investment multinational enterpriselicensinginternalization theorygreen-field investmentslocation-specific advantages 

explain the “market imperfection” theory of FDI.3. explain the “strategic behavior” theory of FDI.4. explain the main factors that will determine whether a firm will export, license, or engage 5.in FDI. discuss the main costs and benefits of FDI to host or receiving nations.6. discuss the main costs and benefits of FDI to sending nations.7. explain why the composition of foreign direct investment has shifted more toward services 8.over the past two decades.

Types of Foreign Investment

The integrated nature of economies and financial markets has increased the ease and flexibility with which foreign investors and corporations can seek out and take advantage of opportunities that yield higher rates of return, diversified portfolios, and reduced risk. This

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section describes some basic theories of foreign investment and reasons that firms undertake foreign direct investment rather than simply exporting products. We will also discuss recent patterns of foreign investment in Canada.

Foreign investment can take different forms. One is simply to lend money (in the form of bank loans or new bond purchases) or to buy relatively small blocks of stock in companies. The injection of funds into the host economy does not involve any control over the assets of that country. There is foreign funding but no foreign ownership or control; the transaction transfers funds and represents a portfolio investment. This type of investment is called foreign portfolio investment and involves very low transaction and transportation costs, as it is often just an electronic transfer of funds.

Foreign investment can also involve the outright purchase of a Canadian asset such as a factory. This type of investment is called foreign direct investment (FDI), and can take the form of purchasing enough stock in an existing firm to become a controlling shareholder, taking over a firm outright or building a new plant or enterprise from scratch. It may or may not result in additional investment in Canada, depending on the financing. If the foreign investor uses their own funds to create a new plant in Canada, Canada’s capital stock has increased and, therefore, Canada’s capacity to produce goods and services has increased. Even if the foreign investor buys an existing plant from Canadian owners, it may eventually lead to new capital formation (investment). In that case, the Canadian seller would have to use the money from the sale to create new capital in Canada. If the seller uses the money to buy assets in another country, spends it on high living, or uses it to retire somewhere warm, Canada does not benefit from increased capacity. Similarly, if the foreign investor uses Canadian funds for their venture into Canada, there is no gain. A substantial number of foreign takeovers are financed by loans from Canadian banks.

With FDI, a firm could have a significant ownership in a foreign operation and the potential to affect managerial decisions. By using FDI, multinational corporations are able to circumvent the effects of changing exchange rates, enabling them to secure and maintain market share.

A firm may choose to undertake FDI in a particular foreign market or region because of location-specific advantages, perhaps to gain access to specific natural resources (e.g., Alberta’s energy industry) or expertise (e.g., Silicon Valley in California or Ottawa), or to be located near customers, specific feedstocks, or suppliers with unique characteristics (e.g., Fort Saskatchewan’s petrochemical industry).

Recent FDI Trends in Canada

Table 3.1 highlights Canada’s current international investment position, with information on direct and portfolio investment by Canadians abroad as well as foreign investment in Canada. The important trend to observe from this table is the significant gap between total Canadian investment abroad ($1,176,870,000) and total foreign investment in Canada ($1,309,392,000). The predominance of foreign investment in Canada has been a key feature in Canada for years; in 2007, direct investment abroad decreased due to the appreciation of the Canadian dollar against foreign currencies. Canadian direct investments abroad are denominated in foreign currencies. Consequently, the appreciation of the

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Canadian dollar lowered the value of the assets held abroad. Canadian investment abroad is split between direct and portfolio investment, as is foreign investment. There are significantly more holdings of Canadian stocks than bonds.

Table 3.1 Canada’s International Investment Position, 2007

AssetsCanadian Direct Investment Abroad $ 514,540,000Portfolio Investment 346,765,000

(Foreign Bonds: $136,701,000)(Foreign Stocks: $210,064,000)

Other Investment 315,565,000(Loans: $76,122,000)(Allowances: $0)(Deposits: $156,890,000)(Official International Reserves: $40,593,000)(Other Assets: $41,960,000)

Total 1,176,870,000 

LiabilitiesForeign Direct Investment in Canada $ 500,851,000Portfolio Investment 486,738,000

(Canadian Bonds: $382,080,000)(Canadian Stocks: $82,658,000)(Canadian Money Market Instruments: $21,999,000)

Other Investment 321,804,000(Loans: $52,971,000)(Deposits: $243,525,000)(Other Liabilities: $25,307,000)

Total 1,309,392,000 

Net International Investment Position -132,522,000

Adapted from Statistics Canada. (2008). Canada’s international investment position, Second Quarter 2008. Catalogue No. 67-202-X, Minister of Industry. Note. Discrepancies due to rounding.

Figure 3.1 and Figure 3.2, below, illustrate (by geographic area) the foreign direct investment flows in Canada from abroad and the direct investment abroad by Canadians. Note that “other EU” includes Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Austria, Finland, Sweden, Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, the Slovak Republic, and Slovenia.

Figure 3.1 FDI in Canada, 2007 (percent of total)

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Source: Statistics Canada. (2008). Canada’s international investment position, Second Quarter 2008. Catalogue No. 67-202-X, Minister of Industry.

According to the figures above, the United States is, by far, the largest direct investor in Canada, followed by other EU countries (excluding the United Kingdom). The American share of total foreign direct investment has fallen steadily since its peak of 70 percent in 1999. This is despite the fact that the overall level of FDI in Canada has nearly doubled over this period. As we discussed in Unit 1, the relative share of US investment has fallen as the relative shares of other nations have risen, led by strong FDI from the United Kingdom and other EU nations. Direct investment in Canada by foreign companies has been expanding rapidly, and this has had a major impact on the Canadian economy. It has affected Canadian trade, employment prospects, industrial and business location, and regional economic growth prospects, and it has also led to the appreciation of the Canadian dollar.

Figure 3.2 Canadian FDI Abroad, 2007 (percent of total)

Source: Statistics Canada. (2008). Canada’s international investment position, Second Quarter 2008. Catalogue No. 67-202-X, Minister of Industry.

In 2007, US assets accounted for only 44 percent of total Canadian direct investment

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abroad, the lowest proportion on record. American investors accounted for 58 percent of FDI in Canada. Net direct investment with the United States has never been positive, meaning that American investors have always held more assets in Canada than Canadian investors have held in the United States.

Figure 3.3 below highlights the trends in Canada’s direct investment abroad (outflows) and foreign direct investment in Canada (inflows). Since 1980, the average annual inflow of FDI totalled $204.4 billion and grew by an annual average rate of 7.9 percent. By comparison, the average annual outflow of direct investment totalled $207.9 billion and grew at an average annual rate of 11.3 percent.

Figure 3.3 Canada’s International Investment Position (millions of dollars)

Source: Statistics Canada. (2008). Canada’s international investment position, Second Quarter 2008. Catalogue No. 67-202-X, Minister of Industry.

The influx of FDI into Canada was significant in the early 1980s—more than twice that of Canadian direct investment abroad. Even during the Canadian recessions of the early 1980s and 1990s, FDI continued to expand. One of the attractions of the Canadian economy was the Canadian dollar, which was undervalued against the US dollar, making Canadian purchases cheaper for foreigners. Land and labour costs were significantly lower than in competing countries. As well, the Canadian dollar returns abroad rose, due to a dollar appreciation against other major currencies. Foreign investors were attracted to Canada’s dynamic and stable economy and favourable political environment. The significance of NAFTA also created a new market for foreign investors. Governments at all levels in Canada provide a favourable investment climate for foreign companies. Not only does the federal government place few restrictions on foreign investors, but provincial and municipal governments compete vigorously for investments by offering tax and financial incentives.

Canadian direct investment abroad has become greater than foreign direct investment in Canada. This change occurred in 1997. This unprecedented trend reflects an economy in an expansionary phase of the business cycle, with strong natural resource prices. Firms earning strong corporate profits are able to invest abroad. In addition, Canadian investors’ holdings of foreign stocks have risen due to the higher foreign content limits for Registered Retirement Savings Plans. The rapid rise in inflows can also be interpreted by comparing this trend with Canada’s production and trade patterns over the same period. Despite the

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general decline in trade barriers, growth in foreign direct investment since 1980 has exceeded growth in nominal GDP and exports.

Globally, FDI has taken off since the mid 1970s. In 1975, global FDI amounted to $25 billion. It increased to $1.2 trillion in 2000, and remained at this level until 2006. Rates of growth of world output, trade, and FDI provide a picture of the globalizing economy. Consider the following:

Between 1992 and 2006, world output increased by 45 percent.Between 1992 and 2006, world trade increased by 150 percent.Between 1992 and 2006, FDI increased by 700 percent.

Why has FDI increased so rapidly? There are a number of reasons:

FDI can help a firm overcome trade barriers. Deregulation and privatization has opened up “economic space” that had been closed off to private investment in the past. Trade and investment are complements, not substitutes, in many cases. A high proportion of trade consists of intra-firm trade between divisions of a single firm. Firms may invest in many different regions in order to best capture location economies. The new information and communication technologies have reduced the cost of managing at a distance. Russia and eastern Europe are no longer under communist rule. Government regulations that limited FDI in many countries have been replaced by a new receptiveness to FDI. Many multinational firms wanting to sell in multiple markets may believe they need a presence close to their consumers in order to serve them properly. In other words, they feel exporting is a poor substitute for direct investment.

It should not be surprising that most FDI comes from the developed world, but it may be surprising that most FDI goes to the developed world. As Figure 7.3 on page 244 of the textbook shows, although FDI flowing to the developed world has increased substantially over the 1990s and beyond, the proportion going to the developing world has increased marginally.

Theories of Foreign Direct Investment

Hill identifies five key factors that help to explain the relative attractiveness of FDI, exporting, and licensing:

transportation costsmarket imperfectionsstrategic behaviourproduct life cyclelocation-specific advantages

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If transportation costs are relatively high, then exporting may simply not be cost effective. Cement, for example, is not widely traded.

Many international firms have developed unique competitive advantages on the basis of their technology, marketing strategies, or management know-how and ability. If this collective know-how is employed across a wider market, profits will be greater. A firm will choose FDI over licensing if the costs of doing so are lower. Transportation costs, tariffs, and non-tariff barriers often raise the cost of exporting.

Licensing is the main method by which firms sell the rights to their know-how. Unfortunately, markets for such knowledge are likely to be incomplete. A licence generally gives the purchaser the right to use the production methods, technologies, and management and marketing practices of the seller. However, it is difficult to protect ownership once the information has been shared. Hill refers to the case of RCA, which licensed its technology to Sony and Matsushita. Soon after, the Japanese companies were able to take the US technology, make some minor adaptations to it that rendered US patents invalid, and produce in competition with RCA. Sony managed to capture much of RCA’s market in the United States.

Pricing is also difficult with a licensing agreement. Skills, know-how, and procedures are extremely difficult to specify, let alone price efficiently, because the true value of the technology or the management practice cannot really be known until it has been employed in the field by the licensee. Only the seller has a good idea of how much these are worth (sometimes even the seller cannot value this properly), and the buyer has inadequate information. This alone precludes an efficient market solution.

The selling firm may also be concerned about the purchaser's devaluing the selling firm’s “brand” value. A restaurant chain may highly value its reputation for a clean eating environment, but by licensing its brand, it runs the risk of finding itself working with a partner that does not wish to pay the costs of keeping such a clean environment. The brand may become devalued or the selling firm may have to spend a lot of money monitoring and enforcing very detailed licensing agreements.

A licensee that is given a regional exclusive agreement may not expand as rapidly as the selling firm wishes. The selling firm relinquishes substantial control over production and expansion, and the selling firm may not wish to give up so much control.

Licensing is unlikely to be an efficient solution when one of the following three conditions applies:

The selling firm has valuable know-how that cannot be protected in a licensing contract.1. The selling firm wishes to have control over the business strategy of the licensee in 2.order to maximize global profits. The selling firm’s know-how is simply not amenable to licensing. (Hill, p. 251)3.

Hill (pp. 251–252) summarizes two alternative explanations of FDI. Strategic Behaviour theory begins with the assumption that FDI is a strategic tool of oligopolistic competitors. Raymond Vernon's Product Life Cycle theory argues that a firm will pioneer a new product in its home market first, but as the market for the product grows in other regions, and as production methods become routine and standardized, it may be profitable to shift

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production to other locations with lower labour costs. Vernon argued that many firms’ FDI in developing countries fits this explanation.

Location-Specific Advantages

There are some resources or assets that may be more valuable in one location than in others. Obviously, this applies to resource-based industries and agriculture. It also applies to a number of technologically advanced industries. Silicon Valley in California has become one of the world’s leading centres of cutting-edge research and development for the computing and semiconductor industries. Local universities turn out large numbers of graduates who are well trained for these sectors. There are hundreds of small firms that are world leaders in niche markets. The knowledge that exists in Silicon Valley is difficult to reproduce elsewhere. Firms seeking to establish production and new product development in these sectors will seek to go where the best knowledge is and can be tapped into fairly easily. The existence of such pools of knowledge or talent (think of the fashion design houses in France and Italy) tends to attract new entrants and the expansion of existing firms. This knowledge pool constitutes an external benefit that is available only in this location.

This also explains why governments everywhere attempt to subsidize the development of centres of excellence for particular sectors or technology applications. They are attempting to catch up and overtake the first-mover advantage claimed by Silicon Valley and similar centres in other sectors.

See Figure 7.6 in the textbook (p. 266) for a useful decision framework that firms implicitly use when facing the decision to export, license, or engage in FDI.

Benefits and Costs of FDI

The major benefits of FDI are the following:

increased access to capitalaccess to superior technologyaccess to superior management methods (pp. 257–260)

FDI will often mean an injection of new investment in the host country. This is one of the main benefits of FDI. Multinational firms can often access international capital at a lower price than is available to domestic firms. In addition, FDI is often attached to investment decisions that local firms are unprepared or unwilling to make, thus increasing the domestic rate of investment and economic growth.

New technologies are often not for sale or lease but become available only if the owners of those technologies decide to invest in the domestic market. Governments will often attempt to negotiate terms that include provisions for the transfer of technology to other sectors of the local economy. Multinational firms are usually unwilling to license or sell key technologies, but host economies can capture many of the benefits of these technologies through FDI.

These are the resource-transfer effects that host countries are most interested in capturing. FDI from global multinational firms often brings new technologies and management practices that are simply not available elsewhere. Local managers hired by multinational

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firms learn new managerial practices. Host governments often attempt to maximize the local benefit of the investment by ensuring that provisions are made for local training and hiring, local purchasing, technology transfers to local partners, and so on. Section 3.2, “The Age of the Multinational,” examines these issues in more depth.

Hill identifies three additional benefits:

employment effectsa.balance-of-payments effectsb.effects on competition and economic growth c.

FDI alone will not have an impact on the rate of unemployment in an economy at or near full employment, but in some less developed countries (LDCs), FDI will usually contribute to a relative expansion of the higher paid segment of the labour force. Multinational firms operate in sectors that typically pay wage rates that are between 50 percent and 100 percent higher than local wage rates for comparable skill levels. In countries where regulations keep labour markets from approaching full employment levels, FDI alone can cause the rate of unemployment to fall.

FDI normally involves flows of capital in both directions. Initially, capital flows in as a multinational firm acquires local assets or builds facilities. This produces an initial positive impact on the host country’s balance of payments through enhanced exports.

Study Questions

Provide complete answers for each of the following study questions—you need to be able to explain how and why a factor or consideration is important or relevant. Students often lose marks on their assignments or examinations by providing answers that are too short and incomplete. Some questions have answers provided at the end of this section. The rest of the answers can be found in the assigned readings or the lesson notes. If you still have problems answering any question, contact the Call Centre.

What is the difference between a green-field investment and acquiring or merging with 1.an existing firm? Describe the trends and characteristics of FDI in the past 30 years.2. Consider why firms selling products with low value-to-weight ratios choose FDI over 3.exporting. Answer What are location-specific advantages, and why might they be an important factor in 4.explaining FDI? Answer Under what circumstances might a firm prefer to engage in FDI rather than exporting or 5.licensing? Answer What are the advantages and disadvantages of licensing as compared to FDI? Answer6. What are the main advantages of FDI for host (recipient) countries?7. What are the potential costs of FDI for host (recipient) countries?8.

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 What are the possible costs and benefits of FDI for sending (home) countries?9. Which theoretical explanation (or explanations) of FDI best explain(s) Cemex's FDI? 10.Answer

Answers to Selected Study Questions

3. Products with low value-to-weight ratios, such as soft drinks or cement, are frequently produced in the market where they are consumed. When transportation costs are added to production costs, it becomes unprofitable to shift such products over a long distance. For firms that can produce low value-to-weight products at almost any location, the attractiveness of exporting decreases and FDI or licensing becomes more appealing. Back

4. Location-specific advantages are advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets. Natural resources such as oil and minerals, for example, are specific to certain locations. Firms must undertake FDI to exploit such foreign resources. Back

5. A firm will favour foreign direct investment over exporting as an entry strategy when transportation costs or trade barriers make exporting unattractive. Furthermore, the firm will favour foreign direct investment over licensing (or franchising) when it wishes to maintain control over its technological know-how or its operations and business strategy or when the firm's capabilities are simply not amenable to licensing, as may often be the case. Back

6. Licensing occurs when a domestic firm (the licensor) licenses a foreign firm (the licensee) to produce the licensor’s product, to use its production processes, or to use its brand name or trademark. In return, the licensor collects royalty fees on every unit the licensee sells or on total revenues.

The advantage of this type of arrangement over FDI is that the licensor does not have to pay (in terms of cost, time, or risk) to open up a foreign market, as this has already been established by the licensee. There are several disadvantages to licensing as a strategy to exploit foreign market opportunities. Licensing may require that a firm relinquish valuable knowledge or technology to a potential foreign competitor. Licensing does not give the firm adequate control over the manufacturing, marketing, and strategy-making aspects of a business located in a foreign country. As well, the firm providing the licence may not feel that the licensee is adequately exploiting all of the profit potential inherent in the foreign market. Back

10. Cemex is a cement company. Consequently, exporting is difficult because of the weight of the product. If Cemex wants to expand into new markets, the company would either need to license a local company or make an investment in the market directly. Cemex’s success is due in part to its top-notch customer service and its relationship with distributors. Because these advantages could be difficult to transfer,

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the company will probably choose to invest directly. Back

Section 3.2: The Age of the Multinational

Reading Assignment and Learning Objectives

In the Reading File:Age of the Multinational, by Robert Gilpin. The Challenge of Global Capitalism: The World Economy in the 21st Century, pp. 163–192

In the textbook:Government Policy Instruments and FDI, pp. 262-265

In the DRR:Worldbeater, Inc. The Economist, November 22, 1997, pp. 93–95

After completing Section 3.2, you should be able to

explain how MNCs have accelerated the integration of the global economy.1. describe how the national ownership of MNCs has changed over the past 40 years.2. describe the regional allocation of MNC investment.3. explain why countries are interested in attracting MNC investment.4. explain some potential costs and concerns related to MNC investment.5. explain the meaning of performance requirements.6. discuss why there is no set of international rules governing global investment that would be 7.similar to global trading rules. discuss what principles might be built into a new Multilateral Agreement on Investment 8.(MAI).

The Age of the Multinational Enterprise and FDI

In the assigned reading “Age of the Multinational,” Gilpin examines how MNCs have established an overwhelming and growing presence in the global economy. MNCs are behind much of the very rapid growth in FDI over the past 25 years. An MNC may be defined as a “firm of a particular nationality with partially or wholly owned subsidiaries

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within two or more national economies” (Gilpin, p. 164).

In earlier days, the purpose of much investment by MNCs was to gain access to raw materials or to establish a presence in a major market that was protected by tariffs. FDI was often seen as a way of “jumping over” tariff walls.

FDI by MNCs has now changed in dramatic ways. The globalization of production introduced in Unit 1 describes how MNCs have begun to “unbundle” the components and services that are used to produce a final product and reallocate the production site for each separate component or service to the most efficient location. Outsourcing is a part of this phenomenon.

We have seen that FDI has grown much faster than trade over the past quarter century, and FDI is the way in which MNCs expand into new territory. MNCs are key actors in the emergence of the global economy.

Technological change and a more open, market-friendly approach to FDI has facilitated MNC expansion. The new communications technologies have greatly reduced the cost of managing at a distance. Industrial and distribution systems can be effectively managed on a global scale now. This has greatly reduced the costs of such coordination, essentially permitting firms, for the first time, the opportunity to search the world for the best location for a specific activity. In the not too distant past, communication and coordination costs would simply rise too rapidly if an organization tried to globalize production the way many MNCs do today.

The globalization of production via FDI is integrating the world economy in a much more profound way than the globalization of markets ever could. As MNCs search the world for the best location for a new call centre, a new factory to produce tires, or a site to conduct research and development activities, national governments come to understand that their economic success will depend, in large part, on developing the ability to find a niche or a role to play in the global investment plans of MNCs. Corporate investment strategy is affected by many policies of potential host countries: tariff policies, tax policies, regulatory environment, and so on.

Although initially the United States dominated MNC FDI, the situation has changed dramatically since 1980. MNC FDI has grown rapidly in Europe, Japan, South Korea, Canada, and, to a lesser extent, a few Southeast Asian countries. At present, MNC FDI is concentrated in the high-income regions of the world. North American, European, and Japanese MNCs are largely investing in each other’s markets. MNC activity in less developed countries is still surprisingly small, although it is growing rapidly. As Figure 6.1 in Gilpin shows, MNC FDI in less developed countries rose from about US$22 billion in 1990 to over US$120 billion by 1997. MNC FDI in the less developed regions was very concentrated as well—China alone received over 31 percent of the FDI going to less developed countries. Mexico, Brazil, Poland, Indonesia, and Malaysia also received significant amounts. Very little MNC FDI was recorded in Africa.

MNCs are crucial sources of capital, technology, management methods, and access to new markets for almost all countries, especially the less developed countries that, in the absence of MNCs, simply would not have access to these benefits. National policy makers have come to recognize that market-friendly regimes have simply outperformed market-unfriendly regimes in all regions of the globe. As a result, there has been a shift worldwide, from regulatory regimes that attempt to keep out MNCs toward regulatory regimes that attempt to attract MNC investment.

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Economic and Political Significance of the MNC

Gilpin comments that a bargaining relationship exists between MNCs and host governments. While it is true that attracting the investment of MNCs can accelerate economic development, the terms on which that investment is available are very important. Host nations will attempt to maximize the external benefits that may arise. For example, a government might

seek to ensure that locals are employed, trained, and taught how to use specific technologies seek to ensure that the MNC meets export targets and sources inputs from domestic producers attempt to force the MNC to work in partnership with a local firm and promote technology transfer to that firm.

These obligations are called performance requirements.

While host governments are interested in deriving maximum benefit from the MNC, the MNC will also attempt to bargain for maximum benefits for itself. This bargaining is not a one-time affair; it will continue as long as the MNC continues to operate in the host country. The MNC may seek a wide range of benefits, including

protection from import competitionlower tax ratessubsidized power and watertax holidaysdirect and indirect subsidiesresearch and development tax creditslow-interest loansa less burdensome regulatory environmentimproved public infrastructure.

Many nations also wish to protect certain sectors of the economy from foreign involvement. Canada, for example, limits the activities of foreign firms in banking, airlines, and all media or cultural industries such as film, television, radio, and publishing.

Governments that are home to a large number of MNCs worry from time to time about possible negative impacts of MNC investment in other countries. The question that is asked is, Wouldn’t it be better for us if company X invested at home rather than in a foreign country?

It is important to remember the comparative advantage argument raised when we examined trade. Free trade allows each region to specialize in those activities for which it possesses a comparative, or relative, advantage. As resources are limited, it is best to focus on what we do best and not try to do all things. MNC investment abroad produces the same kind of advantages. It permits those agents with unique technologies or business practices to locate production facilities in the most efficient location.

For example, an American MNC might choose to operate its call centre out of India. If it was prohibited from doing so, then it would be at a competitive disadvantage compared to other international firms that were free to locate production and other facilities in the most desirable location. There is also no guarantee that this investment would take place by the firm in the United States. The firm might simply buy call centre services from an Indian firm operating in India.

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Nations that are home to many MNCs often object to the performance requirements imposed by other governments. These are often seen as detrimental to the home country. Boeing has recently signed an agreement with China to produce aircraft in China, but under the terms of the agreement, Boeing must form a joint partnership with a Chinese firm and produce the aircraft in China. The United States is concerned that China may gain access to valuable technology which might have military applications.

Gilpin (p. 181) notes that regionalization, as opposed to globalization, characterizes much MNC investment in recent years. American MNCs focus on Mexico and Latin America, European MNCs are focusing on eastern Europe, and Japanese MNCs are concentrated in the lower income areas of Asia. This may permit MNC networks to remain physically closer to their main markets, while taking advantage of lower wage costs in nearby regions.

In the assigned textbook reading (pp. 262–265), Hill notes that many governments have policies that both promote and restrict outward and inward FDI. This may not be as contradictory as it sounds. Canada, for example, attempts to attract MNC investment in most sectors, but has regulations in place that limit foreign investment in banking, transportation, cultural industries, and other sectors. Over the past 20 years or so, there has been a growing recognition that MNC investment can, and usually does, accelerate economic growth, especially in the less developed regions of the world, and more countries have adopted MNC-friendly investment policies that are designed to attract, as opposed to repel, foreign investment. However, it is still a major political issue in most countries that attract substantial amounts of FDI; concern that local control or national sovereignty will be reduced due to the dominating position of these foreign entities is seldom far from the surface.

Rules for FDI and MNCs

World trade is governed via a host of global (e.g., WTO) and regional (e.g., NAFTA) trade agreements that set out the rules that all must follow. Free trade agreements usually require that signatories agree not to impose tariffs on goods from other parties to the agreement and spell out, often in great detail, the limits on the use of non-tariff barriers (rules on subsidies, anti-dumping, and so forth). Normally, a general objective is to ensure that foreign goods are treated in the same manner as domestically produced goods. This kind of trading regime provides the incentive structure that will permit firms to produce efficiently on a global basis.

It is somewhat odd that no similar agreements exist with respect to investment rules. No common set of rules exists, so each nation must establish its own rules. Economists generally favour an even-playing-field approach, one that would ensure that foreign firms are treated in the same way as domestic firms with respect to rules governing investments, but this is seldom the case.

It is fairly easy for MNCs to set up operations in the United States, and few performance requirements are needed. In Canada, it is easy for MNCs to set up operations in many sectors; indeed, foreign MNCs dominate many sectors of the Canadian economy. In other sectors, foreign ownership is severely limited. In Europe and much of the developing world, detailed performance requirements are the norm. Japan has shown little interest in permitting foreign MNCs access to the local marketplace and has used a variety of bureaucratic measures to keep them out. South Korea and many other LDCs have adopted

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aggressive industrial policies that aim to develop local industrial champions in major sectors of the economy. These governments provide subsidies and various types of protection to these firms, including a type of “infant industry” protection model in which the government picks out and protects firms it hopes will develop into leading world-class firms.

Gilpin argues that globally, efficiency could be enhanced if the world were able to develop a global investment regime based on “universal and neutral principles” analogous to the free trade principle (p. 191). This would have the same advantages as a global free-trade agreement, in that investment and output would tend to move according to the dictates of comparative advantage, not according to which government was offering the largest subsidies at the moment.

A global investment regime would likely have the following characteristics:

the right of establishmentthe right of national treatmentthe right of non-discrimination (Gilpin p. 183)

In 1995, the United States proposed a Multilateral Agreement on Investment (MAI) that attempted to establish such global principles. Massive opposition to this idea arose in many countries. It quickly became apparent that such an agreement would limit the ability of states to pursue independent industrial policies or policies to promote and subsidize approved firms. Such policies are firmly entrenched in many nations.

Gilpin sees little hope for such an international rules-based approach to global investment. There are a number of difficult technical questions, such as how to tax profits earned in a supply chain that includes more than one nation. However, the major challenges are political. The terms under which investment takes place are seen as critical by many national governments, and they are not willing to surrender their right to negotiate technology transfer, employment, export, and local content performance requirements.

Study Questions

Provide complete answers for each of the following study questions—you need to be able to explain how and why a factor or consideration is important or relevant. Students often lose marks on their assignments or examinations by providing answers that are too short and incomplete. The answers can be found in the assigned readings or the lesson notes. If you still have problems answering any question, contact the Call Centre.

Why does Gilpin regard the post-1980 era as the “era of the MNC”?1. Describe how the pattern of ownership of MNCs has changed over the past 25 years.2. What are the possible advantages to a nation of attracting MNC investment?3. What are the major concerns that national governments may have with respect to 4.attracting MNC investment? What kinds of policies might national governments use to attract MNC investment?5. Define performance requirements and indicate when they might be used.6.

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 What are the arguments in favour of developing a global set of rules governing MNC 7.investment? Why has it been so difficult for nations to agree on such a set of rules?8.

ECON 401The Changing Global Economy

Unit 4: The Global Monetary System

Unit Overview

Introduction

Unit 3 discussed the tremendous growth in capital flows over the past 30 years. The volume of foreign direct investment has grown much more rapidly than the volume of world trade in recent years. There are several potential benefits to this trend, including the ability of capital to move into regions where it is scarce and valuable. Foreign direct investment can make a positive contribution to a host economy by supplying capital, new technology, and management resources that would otherwise not be available. This is particularly the case for the less developed countries and poorer regions of the world.

Firms and governments around the world are increasingly able to access the global capital markets. Innovations in telecommunications systems have created instantaneous access to global financial markets, while the banking industry is being revolutionized to meet the needs of institutional changes required to remain competitive. These technological advances have created new opportunities to develop alternative banking instruments, and they provide greater access to financing. Capital can be moved around the globe at a keystroke, and at virtually no cost.

In Unit 4, we will look at the

specific functions of the foreign exchange market  tools designed to deal with and manage the risk of adverse consequences of unpredictable changes in exchange and interest rates different types of exchange rate regimes current theories used to determine the future value of exchange rates  growth of global capital markets.

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There are many debates surrounding the global financial market instability. While the International Monetary Fund (IMF) has pushed LDCs toward financial market liberalization, many economists have challenged this wisdom. These debates and the recent experience in Mexico, the Congo, and Russia are examined briefly in this unit, and the Asian crisis is examined more fully in Unit 5.

Web Links

The following Web links highlight some interesting issues related to the role of the IMF and the debate that surrounds that effectiveness of the IMF’s macroeconomic stabilization policies (see Section 4.4).

The IMF at a Glance

International Capital Markets: Developments, Prospects, and Key Policy Issues

Finance and Development

The IMF and its Critics

The following Web links highlight some interesting issues related to global capital market (see Section 4.5) as presented by the IMF as well as some issues surrounding the use of capital controls.

IMF Global Financial Stability Report

Institute of Economic Affairs

IMF Policy Discussion Paper

References

World Bank. (2002). Globalization, growth, and poverty: Building an inclusive world economy . Washington, DC and New York: World Bank and Oxford University Press.

Section 4.1: Foreign Exchange Markets

Reading Assignment and Learning Objectives

In the textbook:Chapter 9 (pp. 322–330 only)

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After completing Section 4.1, you should be able to

describe the major functions of the foreign exchange market.1. explain the factors that determine the demand and supply of foreign exchange.2. define spot exchange rates .3. define forward exchange rates .4. define foreign exchange risk .5. describe how firms might use forward exchange markets to manage foreign exchange risk.6. explain the meaning of the following terms:7. 

exchange ratecurrency speculationcurrency swapsarbitrage.

Foreign Exchange Rates

You have probably bought an American dollar at one time or another. Before vacationing in the United States, you might go to your bank to buy American dollars and pay for them with Canadian dollars. Foreign exchange markets deal in American dollars, Canadian dollars, pounds sterling, and all other currencies. These markets are complex networks of institutions, banks, foreign exchange dealers, and government agencies through which the currency of one country may be exchanged for that of another. In many ways, these markets operate in the same way as the markets for apples or French wine. There is a supply of a foreign currency and a demand for it; in a free market, supply and demand interact to determine the price.

Your textbook defines an exchange rate as “the rate at which one currency is converted into another” (p. 324). There are two ways to report the exchange rate between Canadian and US currency: one way is to state that one Canadian dollar is now worth US$0.82, and the other is to report that one US dollar is worth Can$1.22.

In one sense, the price of a currency is unique. We can speak of the price of the Canadian dollar, for example, only by relating it to the value of another currency, often the US dollar. We could, however, correctly speak of the price of Canadian dollars measured in Turkish lire or British pounds. When we speak of the price of beef, chicken, or stereos, on the other hand, we measure price in terms of units of the domestic currency.

To convert US$1 into Canadian dollars, perform the following calculations:

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1÷current exchange rate= 1÷$0.82= Can$1.22

To convert Can$1 into US dollars, perform the following calculations:

1÷current exchange rate= 1÷$1.22= US$0.82

Under a flexible exchange rate system, the value of a currency is determined by the demand and supply for that currency. This is determined in the foreign exchange market.

The demand for US dollars comes mainly from non-US citizens or firms who wish to buy American goods and services, travel to the United States, or invest in the United States. International visitors to the United States must first go to their local bank to purchase US dollars (by selling local currency to their bank) in order to have US currency to spend while in the country.

If you live in Europe and want to purchase American-produced cars, CDs, or beer, you must arrange to acquire US dollars to buy the goods. These transactions show up in the Balance of Payments as exports from the United States. If Toyota, the Japanese car producer, wishes to build a car plant in the United States, it must exchange its Japanese yen for US dollars in order to make this investment in the United States. If an individual living in Malaysia wishes to buy shares in a firm listed on the New York Stock Exchange (NYSE), he will first have to sell some Malaysian currency in order to buy US dollars to make the purchase. Often the individual is not even aware that such an exchange takes place. The Malaysian investor will likely have an account with a Malaysian stockbroker and enter an order to purchase stocks on the NYSE. His Malaysian currency account is reduced by a certain amount, and the broker makes the purchase on his behalf.

The demand for US currency is determined largely by

exports of US goodsforeign direct investment into the United Statesthe purchase of US financial instruments by those living outside the United Statesforeign visitors to the United States.

These are the major determinants of demand, but there are a few other activities that produce a demand for US currency.

Factors that influence the value of currency include

political instabilityinvestor psychologyperception and rumourthe level of domestic and foreign economic activitythe level of domestic and foreign interest ratesbandwagon effects (which will be discussed in the next section).

As you know from your introductory economics course, demand is only one side of the equation. Where does the supply come from? It is helpful to remember that, in a foreign exchange market, those supplying one currency in the marketplace do so only to purchase

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another currency. If I sell US dollars in the foreign exchange market, I am doing so to purchase another currency. Who in the United States will want to sell US dollars in order to purchase Japanese yen, Canadian dollars or other currencies? The answer is, those in the United States who wish to

purchase goods produced abroadmake investments in other countriespurchase stocks, bonds, or other financial instruments issued in other countriestravel to other countries.

You will notice that this list is a mirror of the list above that explains the demand for US currency.

Not surprisingly, the demand curve for US dollars has the familiar downward slope. If the price of US currency (in terms of foreign currency) rises, the quantity demanded will fall. For example, if the cost of purchasing one US dollar rises (in terms of Canadian dollars), which is the same as stating that the value of the Canadian dollar falls, Canadians will buy fewer US goods; Canadian FDI into the United States will fall; purchases of US stocks, bonds, and other financial instruments by Canadian residents will fall; and Canadians will take fewer holidays in the United States. If the price of US dollars is relatively high, it will be more expensive in terms of local currency, and individuals and firms will reduce their purchases of US dollars.

The supply curve also looks like a normal supply curve, although in the case of foreign exchange, it is important to remember that the supply of US dollars in the marketplace really represents the demand for all currencies other than the US dollar.

Why does the supply of US dollars slope upward, as in Figure 4.1 below? If the price of the US dollar rises, then, by definition, the price of the currency it is being measured against has fallen, and the quantity of the non-US currency demanded will go up as its price has fallen. To US residents, a rise in the US dollar means that foreign travel becomes cheaper, foreign goods become cheaper, it becomes cheaper (in terms of US dollars) to buy foreign stocks and bonds, and so on.

Figure 4.1 The Demand and Supply of Foreign Exchange

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Looking for the moment at the demand curve, we can see that if the price of US dollars is high, at Can$1.50, only Q

0 units are demanded. If the price is lower, at Can$1.25, then Q

1

units are demanded.

Similarly, if the price of US dollars is high (meaning that the price of Canadian dollars is low), then the supply of US dollars in the foreign exchange market is high. When the price of US$1.00 is Can$1.36, Qd = Qs, and the market is in equilibrium.

Figure 4.2 Demand and Supply Shifts

The market for foreign exchange adjusts in the same way that other markets adjust to changes in the determinants of demand or supply. If, for example, more foreign tourists wish to visit the United States, the demand for US currency will rise, shifting D to the right to D

2. The new equilibrium exchange rate will be higher, at Can$1.45.

Other factors could have shifted the demand curve to the right. If foreigners wanted to buy more US goods, then US exports would rise, shifting the demand curve to the right. If foreigners wanted to buy more US stocks or bonds, the effect would be the same.

To understand what causes shifts in the supply curve, you need to remember that the desire to sell US dollars in the foreign exchange markets exists only because firms and individuals want to buy other currencies. If US citizens want to take more trips to France, the supply curve above will shift to the right. If US citizens want to buy more Canadian or British stocks, or make more investments in other countries, the supply curve will also shift to the right. If D

1 is the initial demand for US dollars (and the price is Can$1.36) and S

1 is

the initial supply curve, any of the above changes would cause the supply curve of US dollars to shift to the right, to S

2. This causes the equilibrium value of the price of the US

dollar to fall from Can$1.36 to Can$1.28.

Spot and Forward Exchange Markets

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Foreign exchange markets are like auction markets—demand and supply interact constantly, and the price may rise or fall many times over the course of a day or even an hour. This is called the spot market for foreign exchange. When you check the newspaper to find out the current rate of exchange, you will most likely see the rate established at the end of trading on the previous day.

Forward exchange rates are rates established today for a specified date in the future. This may seem a bit odd, but there are good reasons for such markets to exist. Basically, they permit those who know they will need foreign exchange at a certain date in the future to buy that foreign exchange now at a given price. As every act of buying foreign exchange also entails an act of selling a different currency, it means there is both a “demand crowd” and a “supply crowd” willing and able to make such a market function.

Consider the Canadian farmer who plants wheat in the spring for fall harvest and sale. Assume that much of the harvest is sold in the United States and abroad. The farmer makes a business decision regarding what and how much to plant based on an understanding of expected costs and revenues. But the spot price of foreign exchange can move around quite a bit over a six-month period. The farmer faces a number of risks, many of which he can do little about. The weather may be good or bad, farm prices in the fall may be high or low, and so on. But if he plans on selling abroad, he also a faces a different risk: foreign exchange risk. This is the risk that he may get less when he exchanges his Canadian dollars for another currency six months into the future than he could get now. As a farmer and businessman, he may be willing to take on certain risks, but the forward exchange market allows him to lock in the price of foreign exchange. He buys a contract to sell Canadian dollars for US dollars at a price fixed today, to be executed when he sells his grain six months from today. In this way, the farmer can determine, today, the price of foreign exchange in the future.

In practice, many market participants prefer to lock in future prices of foreign exchange today, and as long as there are individuals prepared to buy and sell such contracts, these markets will exist.

Currency swap is also an important term to understand. A currency swap occurs when a firm or bank simultaneously buys and sells a certain amount of foreign exchange for two different valuation dates. A firm will engage in a currency swap to eliminate foreign exchange risk. Hill illustrates the merits of a currency swap by discussing Apple Computer, which buys parts from Japan, assembles computers in the United States, and then sells some computers to consumers in Japan. Reread this detailed example on page 328 of the textbook and ensure that you understand this concept.

Arbitrage

Fluctuating currencies are an opportunity to speculate on currencies and, it is hoped, gain a profit. Consider the following illustration. A Spanish professor, while a graduate student, lived in Mexico with a group of American and Canadian students who, like himself, had limited funds. When they had some free time, they made money by going to various currency exchange outlets, trading dollars for pesos or pesos for dollars. The exchange rates varied slightly from one exchange site to another. For example, the First Bank of Mexico City exchanged 255 pesos for Can$1, and the Mexican Bank of Commerce exchanged 252 pesos for Can$1. The students had Can$100 between them. At First Bank, they bought 25,500 pesos. They then walked to the Commerce Bank and used 25,200 of those pesos to buy $100. They now had a 300 peso profit. Returning to First Bank, they

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used their $100 to buy 25,500 pesos. Back at the Commerce, they bought $100 with 25,200 of their pesos, for another 300 peso profit and a total profit of 600 pesos. They continued the exercise until they had enough profit for each to buy a drink at a local hotel. It was hard work, but a sure profit. These students were engaged in what is called arbitrage. In today’s world of computers, it is unlikely that you could earn much money this way, but arbitrage still exists and it is very important.

Arbitrage is defined as the simultaneous buying and selling of currencies or commodities for profit in two or more markets with inconsistent prices. Arbitrage can exist in any type of market. If wheat prices in London and Toronto vary by more than can be explained by shipping costs and other trade barriers, a profit can be made by buying in the lower-priced center and selling in the higher-priced centre. Our concern in this course is how arbitrage influences foreign exchange rates.

It is possible for a bank to make a profit from inconsistent prices, but it must work fast, because all of the big banks watch for such inconsistencies. An employee of a Canadian bank calls New York and sells Can$10,000,000 for US$7,519,000. At the same time, another employee calls Toronto and sells US$7,515,000 for Can$10,000,000. The profit is US$4,000, less the costs of the transaction—not bad for a couple of minutes work on the phone. In addition to the profit the Canadian bank made from the transaction, this buying and selling increased the demand for American money in New York (or it increased the supply of Canadian dollars). As a result, the bank brought down the price of Canadian money in New York. On the other hand, it increased the demand for Canadian money in Toronto and, as a result, increased the price of Canadian money in Toronto. The process of arbitrage continues until the price for Canadian money is the same in both markets. Arbitrage ensures that prices in all markets are the same.

Study Questions

Provide complete answers for each of the following study questions—you need to be able to explain how and why a factor or consideration is important or relevant. Students often lose marks on their assignments or examinations by providing answers that are too short and incomplete. Some questions have answers provided at the end of this section. The rest of the answers can be found in the assigned readings or the lesson notes. If you still have problems answering any question, contact the Call Centre. 

What is the difference between a spot exchange rate and a forward exchange rate? 1.Answer What are the main determinants of demand for a nation’s currency in the foreign 2.exchange market? What are the main determinants of supply of a nation’s currency in the foreign 3.exchange market? Answer What are the main uses of foreign exchange markets for international business? Answer4. Explain how each of the following will affect the price of the US dollar:5. 

There is an increase in the number of foreign tourists heading to Disneyland in a.California.

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American consumers decide to buy more French wine.b.Japanese investors decide to purchase more US stocks and bonds.c.Prices in the United States begin to rise more rapidly than prices in the rest of the d.world. 

Explain how a firm or an individual can use forward exchange rates to reduce or 6.eliminate foreign exchange risk. What is arbitrage?7. Explain how currency swaps work and why a firm may engage in a currency swap. 8.Answer

Answers to Selected Study Questions

1. The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. Spot exchange rates are reported daily in the financial section of the newspapers. Spot rates are continually changing, their value being determined by supply and demand for that currency relative to others. A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future. Exchange rates governing such transactions are referred to as forward rates. Most major currencies are quoted 30, 90, and 120 days into the future. Back

3. There are a number of factors that determine the supply of a domestic currency in the foreign exchange market. If we consider the case of the Canadian dollar, supply of the Canadian dollar is determined by the change in the amount of goods and services imported. For example, as an economy’s employment and output rises, there is greater demand for foreign-produced goods and services, which leads to a greater supply of Canadian dollars as Canadians convert their currency into the foreign currency. This is also the case if there is a greater amount of FDI made by Canadians to foreign markets or if more Canadians are visiting international locations such as the United States. If international interest rates are higher than those found in Canada, Canadians would purchase international financial instruments rather than Canadian instruments, causing the supply of Canadian dollars in the foreign exchange market to rise. Back

4. The foreign exchange market serves four primary functions for international companies:

The market is used to convert payments a company receives in foreign currencies into the currency of its home country. The market is used to convert the currency of a company's home country into another currency when the company must pay a foreign company for its products and services in the currency of the foreign company's country. International businesses may use foreign exchange markets when they have

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spare cash that they wish to invest for short terms in money markets (of another country). The market is used for currency speculation. Back

8. A currency swap is the simultaneous purchase and sale of a certain amount of foreign exchange for two different valuation dates. This activity is conducted in order to eliminate foreign exchange risk. Swaps can be conducted between banks, between a firm and a bank, or between governments where large amounts of currency are moved from one location to another. Back

Section 4.2: Theories of Exchange Rate Determination

Reading Assignment and Learning Objectives

In the textbook:Chapter 9 (pp. 331–343 only)

After completing Section 4.2, you should be able to

explain the purchasing power parity (PPP) theory of exchange rate determination.1. calculate predicted exchange rates using PPP.2. explain why PPP may not work well in the short run.3. explain how a change in the rate of expected inflation will affect the exchange rate.4. explain what is meant by5. 

law of one price the Fisher Effectthe International Fisher Effect (IFE)real and nominal interest ratesbandwagon effectscapital flightefficient and inefficient markets . 

explain currency convertibility and why governments may attempt to limit it.6.

Purchasing Power Parity

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One of the most difficult economic indicators to forecast is the value of a domestic currency. An exchange rate is determined by the market forces of demand and supply. These forces can be influenced by factors such as political instability, perception and rumour, commodity price fluctuations, the level of domestic and foreign economic activity, and the level of domestic and foreign interest rates, all of which make it difficult to determine the value of a currency in the coming year with any degree of certainty.

One of the simplest theories of exchange rates is called purchasing power parity (PPP), which states that a unit of any given currency should be able to buy the same quantity of goods in all countries. For example, Can$5 should buy one Big Mac in Canada, while Can$5, when converted to US dollars, should buy the same Big Mac in the United States.

PPP theory predicts that exchange rates are determined by relative prices and that changes in relative prices will cause changes in exchange rates. Many economists believe that the theory of PPP determines the long-run value of a currency. The theory asserts that if a commodity has two different prices in two different locations, forces are set in motion to equalize the prices. If a Canadian dollar can buy more coffee in Canada than in the United States, international traders could profit from buying coffee in Canada and selling it in Japan (an example of arbitrage, which we discussed in the Section 4.1). The export of coffee to Japan from Canada will cause the price of Canadian coffee to rise and the price of Japanese coffee to fall. Eventually, the two prices equalize. This is called the law of one price, which states that a Canadian dollar should be able to buy the identical amounts of a certain good in two different markets. The textbook provides a good example of this law on the bottom of page 331.

There is an important conclusion to be drawn from PPP theory. PPP predicts that if prices in country A rise by more than prices in country B, then the value of the currency in A will fall by an amount that exactly offsets the price change difference, in order to maintain PPP. This is, in fact, a logical conclusion to be drawn if PPP holds.

Suppose Canada and the United States both have inflation rates of 5 percent and PPP holds. If inflation starts to accelerate in Canada, the value of the Canadian dollar will have to fall in order to maintain PPP. This is one reason the Bank of Canada has a significant preoccupation with keeping inflation under control in Canada. Canada’s high inflation affects Canada’s competitive position vis-à-vis its trading partners and puts downward pressure on the value of the dollar. This is true for all countries: other things being equal, an acceleration of the rate of inflation relative to major trading partners will cause the value of the domestic currency to fall.

Money Supply, Prices, and Exchange Rates

We have seen that PPP predicts that a change in relative inflation between two countries will lead to an equal and opposite change in the value of the exchange rate.

In your introductory economics course, you learned that inflation is a monetary phenomenon. Consider an economy with output growing at 3 percent per annum. We can say that the economy will need its money supply to grow at roughly 3 percent per annum to ensure that cash balances are adequate for households and firms to make their planned

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purchases. What happens, though, if the money supply grows at a higher rate, say at 5 percent, and the real supply of physical goods rises by only 3 percent? This means that demand for goods is rising by 5 percent per year, but since the supply of goods is rising by only 3 percent, the only possible outcome is that prices will have to rise.

The money supply, therefore, gives market actors a good idea of what is likely to happen to exchange rates. If the money supply in country A increases rapidly, we expect that prices will also rise rapidly in the not too distant future. If the money supply in country B is rising only modestly, we do not expect inflation to rise significantly. Given this information, we would expect that the currency in country A will fall relative to the value of the currency in country B.

Economists often use newspaper articles to issue stern warnings to governments that are bent on expanding the money supply to pay for an ambitious agenda. The warning is always the same: If you expand the money supply rapidly, prices will rise, and if prices rise more rapidly at home than they do for our trading partners, we can expect the value of our currency to fall.

Empirical Tests of PPP Theory

If markets were competitive, transportation costs were zero, there were no non-traded goods, and uncertainty was not an issue, we would expect exchange rates to be determined by PPP most of the time. While the theory of PPP is a simple model to determine exchange rates over the long run, it does have limitations:

It is not completely accurate, in that exchange rates do not always move to ensure that a Canadian dollar has the same purchasing power in all countries. It does not address differences in transportation costs and barriers to trade and investment, which could also influence prices.

It does not account for investor psychology or for the fact that perception can cause a herd mentality or the bandwagon effect. Capital flows may be guided, to a much greater extent, by investor perceptions of expected profits, and these may be linked only weakly to relative price inflation.

It may not hold if markets are dominated by several large MNCs that may have influence over market prices.

All of these factors will cause actual exchange rates to differ from those predicted by PPP. Also, the theory is less useful for predicting short-term exchange-rate movements between nations that have relatively small inflation-rate differentials. However, most economists argue that PPP is the exchange value that real exchange rates will tend toward in the long run, but in the short run, many variables can keep the PPP exchange rate from being realized.

Interest Rates and Exchange Rates

Investors and borrowers are primarily interested in the real interest rate, not the nominal

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interest rate, which is simply the rate of interest charged on a loan or attached to a financial instrument. A nominal rate of 10 percent is quite good if the rate of inflation is 1 percent; this means that the actual rate of return, after taking inflation into account, is 9 percent. If, on the other hand, inflation is running at 10 percent, that nominal rate of 10 percent implies that the investor will receive an after-inflation rate of return of zero (10 percent minus 10 percent). Investors are interested in real, inflation-adjusted rates of interest, not nominal rates of interest.

Thus, we can say that the nominal rate of interest, let's call it i, is equal to the real rate of interest, r, plus the expected rate of inflation, I. This relationship can be written as

i = r + I

When expressed in this form, it is referred to as the Fisher Effect, after Irvin Fisher, the economist who first formalized the relationship.

In a world where capital is free to move across borders, arbitrage is going to make sure that the real rate of interest, r , is the same in all countries, assuming that the level of risk is the same. If risk is higher in one country than in another, then the real rate of return required to induce investors to invest in the risky country will have to be higher. For the moment, let us assume that we are looking at only two countries and that there is no risk differential between the two.

In this case, we can see why the real rate of interest in the two countries will have to be the same. If, for example, risk-free government bonds offer a 5 percent rate of interest in the United States and a 5 percent rate of interest in Canada and expected inflation is equal to zero in both countries, then the real rate of return is 5 percent in both countries.

What if the real rate of return was higher in Canada? Let us assume, for the moment, that the US government decided that interest rates were too high in the United States and decided to expand the money supply to lower interest rates in order to stimulate economic activity. As the nominal interest rate fell in the United States, a gap would open up between the real interest rate in Canada and the real interest rate in the United States. Let us assume that nominal and, therefore, real rates of interest fall to 3 percent in the United States.

Is this likely to be a stable situation? Clearly, the answer is “no”—real interest rates are 5 percent in Canada, but only 3 percent in the United States. Will investors alter their behaviour now? Yes, they most certainly will. Investors will sell off US stocks, bonds, and other assets to buy Canadian stocks, bonds, and other financial assets that can earn a higher rate of return. This will also cause the value of the Canadian dollar to appreciate as foreign capital flows into Canada.

This is simply engaging in arbitrage. The demand for financial instruments (stocks, bonds, and so on) will rise in Canada, and the demand for financial instruments in the United States will fall. Through the simple interaction of demand and supply, real and nominal interest rates in Canada will rise, and real and nominal rates in the United States will fall. Equilibrium will be restored only when the real rates of interest are the same in both countries again.

If the real interest rate is the same worldwide (for the moment, we need to assume away differences in risk and government regulations limiting capital flows), then what will explain differences in nominal interest rates? It has to be the expected rate of inflation. If, for

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example, real interest rates are 5 percent in both Canada and the United States, but the nominal rate is 10 percent is Canada and 6 percent in the United States, it means that the expected rate of inflation in Canada is 5 percent (10 minus 5), and the expected rate of inflation in the United States is 1 percent (6 minus 5).

The International Fisher Effect summarizes the relationship between exchange rates, interest rates, and inflation. It states that “for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries” (pp. 337–338).

This is simply the logical conclusion to what we have learned about the relationships between interest rates, inflation, and the exchange rate. If real interest rates are the same in two countries, then nominal interest rates will differ only because of differing rates of inflation. If the rate of inflation in one country is higher than it is in the other country, the value of the currency of the inflating country must fall.

Investor Psychology, Bandwagon Effects, and Short-run Exchange Rate Movements

PPP and the International Fisher Effect are based on sound economic principles, but in the short run, we often find that exchange rates are not based on these principles. It is often said that these principles will determine exchange rates in the long run, or that exchange rates are tending toward the exchange rates predicted by these principles, but that, in the short run, exchange rates can be well above or well below predicted values. There appears to be a lot of “overshooting” or “undershooting” when an exchange rate begins to move.

Why might this be the case? Hill suggests that investor information is often poor, especially concerning risks in emerging countries, and that investors will often tend to follow bursts of optimism (during which expectations of economic performance are very rosy) by bursts of pessimism (when expectations turn dramatically downward). This kind of boom/bust investor psychology will result in exchange rates that do not quickly settle down at predicted values.

Currency Convertibility

Freely convertible currency—the domestic government places no restrictions on residents or non-residents with respect to the buying and selling of currency. Externally convertible currency—the domestic government places no restrictions on non-residents with respect to the buying and selling of currency, although it may place some restrictions on residents. Non-convertible currency—neither residents nor non-residents are permitted to convert the domestic currency to a foreign currency.

Countries may limit convertibility in order to protect foreign exchange reserves. Not surprisingly, it is the weaker economic countries that most often limit convertibility. If a government of a particular country fears that market participants may wish to sell off that country’s currency, that government may take action to limit convertibility. This will usually occur if the government has done something that would likely lead to a fall in the value of

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its currency. If a government attempts to spend money that it does not possess by printing more money and increasing the money supply, a rise in the domestic inflation rate would normally result. If inflation in that country suddenly rises, we would expect the value of its exchange rate to fall, as market participants move to sell that currency and buy foreign exchange.

This great rush by residents and non-residents to convert their holdings of domestic currency to foreign currency is known as capital flight (Hill, p. 343). It is a danger that can occur when government policies are expected to lead to very high rates of inflation. Investors fear that, if the government stays on the path to high inflation, it will have to permit the currency to devalue in the near future.

Study Questions

Provide complete answers for each of the following study questions—you need to be able to explain how and why a factor or consideration is important or relevant. Students often lose marks on their assignments or examinations by providing answers that are too short and incomplete. Some questions have answers provided at the end of this section. The rest of the answers can be found in the assigned readings or the lesson notes. If you still have problems answering any question, contact the Call Centre.

Explain the theory of purchasing power parity (PPP). Use an example to show how PPP 1.can help explain exchange rates. Answer In a two-country, one-good model, Trinidad and Jamaica both produce only rum. The 2.domestic price of one bottle of rum in Jamaica is 10 Jamaican dollars. The domestic price of one bottle of rum in Trinidad is 15 Trinidadian dollars. What will the exchange rate between the two countries be, according to PPP? Why might PPP not be a good predictor of exchange rates in the short run? Answer3. What is the International Fisher Effect?4. What is the relationship between interest rates, the rate of inflation, and exchange 5.rates? Consider the following scenario. The rate of inflation in Malaysia is 10 percent; in 6.Singapore, it is 5 percent. The nominal rate of interest in Malaysia is 3 percent; in Singapore, it is also 3 percent. Is this a stable equilibrium position? If not, explain what will happen to capital flows, nominal interest rates, and the exchange rate between the two countries. Assume that both currencies are fully convertible. Answer What is the most common approach to exchange rate forecasting?7. What is meant by currency convertibility ?8. What is meant by capital flight ?9. What is meant by non-convertibility ?10.

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Answers to Selected Study Questions

1. PPP theory states that, given relatively efficient markets, the price of a basket of goods should be roughly equivalent in each country. So, if a basket of goods costs $200 in the United States and ¥20,000 in Japan, PPP predicts that the dollar/yen exchange should be $200/¥20,000 or US$.01 per Japanese yen. Back

3. There are a number of reasons why exchange rates may differ from the exchange rates predicted by the PPP theory.

The PPP theory assumes no transportation costs or barriers to trade, but we know that there are differences in transportation costs and trade barriers between countries. Government intervention in cross-border trade affects the efficient workings of the market, as prices of goods and services are influenced.  Government intervention in the form of buying and selling currencies in the foreign exchange market further weakens the link between price changes and changes in exchange rates. The PPP theory tends to be less useful when applied to currencies of advanced industrialized nations that have small differences in inflation rates.  The PPP theory also does not take into account the influence of the changes in investor psychology or perceptions that can lead to large changes in the exchange rates. Back

6. This is not a stable equilibrium situation because the real interest rates are higher in Malaysia than in Singapore. This situation will lead to investors looking to take advantage of the higher rate of return in Malaysia. Investors located in Singapore will sell off their stocks, bonds, and other assets and then convert them to the Malaysian currency. This creates an increase in the demand for the Malaysian currency in the foreign exchange market, which leads to an appreciation of the currency as capital flows into Malaysia. The demand for financial instruments will rise in Malaysia, and the demand for financial instruments in Singapore will fall. Conversely, as investors leave Singapore, there is a capital outflow and greater supply of Singapore’s currency in the foreign exchange market, which leads to a depreciation of the currency. An opposing influence to all of this is that arbitrage will soon equalize the differences in real interest rates. Because the real interest rate is lower in Singapore, investors will borrow money in Singapore and invest it in Malaysia, causing an increase in the demand for money in Singapore. This has the effect of raising the real interest rate, while the increase in the supply of money flowing into Malaysia will lower the real interest rate in Malaysia. Equilibrium will be restored only when the real rates of interest are the same in both countries.

Another issue to consider is the fact that the inflation rates are vastly different between Malaysia and Singapore. Inflation in Malaysia is double that of Singapore, which will put downward pressure on Malaysia’s currency. To slow this trend, nominal interest rates have to rise. Back

Section 4.3: The International Monetary System

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Sect o 3 e te at o a o eta y Syste

Reading Assignment and Learning Objectives

In the textbook:Chapter 10 (pp. 352–369 only)

After completing Section 4.3, you should be able to

explain the meaning of the following terms:1. 

floating exchange ratepegged exchange ratedirty floatIMF conditionalityfixed exchange ratecurrency board 

explain how the gold standard worked and why it collapsed.2. explain the objectives and key components of the Bretton Woods system established in 3.1944. explain the factors that led to the collapse of the Bretton Woods system.4. compare the advantages and disadvantages of flexible and fixed exchange rates.5. discuss the role of the IMF in the post-war international monetary system.6.

Exchange Rate Models

Floating Exchange Rate

The model of exchange rate determination introduced in Section 4.1 is the model of a floating exchange rate. Simply put, a floating exchange rate system is said to exist when the forces of demand and supply in the marketplace are permitted to determine the value of the exchange rate.

This is not the only model in use, however. It probably won’t surprise you to find out that governments intervene, in varying degrees, in an effort to control, manage, or affect the exchange rate. This is because the price of foreign exchange, especially in an economy that is relatively open to foreign trade and investment, is the most important price in the economy.

Why do you think this might be so? Remember that, as the exchange rate changes, so does the price of all imports and exports and so does the relative profitability of investing at

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home relative to investing in other countries. It is no wonder that governments pay so much attention to the value of the domestic currency.

There are three other important exchange rate models: pegged, fixed, and dirty float.

Pegged Exchange Rate

Under a pegged exchange rate regime, a government declares that it will not permit the value of its currency to deviate by more than a small margin from a chosen reference currency, usually a major one like the US dollar or the Japanese yen. For example, Trinidad may declare that it is pegging its dollar to the US dollar at a rate of, say, seven Trinidadian dollars to one US dollar.

But what does this mean and why would Trinidad do it? In practice, it means simply that the government of Trinidad promises to intervene in foreign exchange markets and buy or sell foreign exchange if necessary to keep the value of the Trinidadian dollar from changing from the pegged rate of 7 to 1. So, if there is a sell-off of Trinidadian dollars in the marketplace and the price of the currency is threatening to fall, the Trinidadian central bank will intervene by selling US dollars or other currency in the foreign exchange markets and buying up Trinidadian dollars.

A central issue is the credibility of the peg. Does the central bank have enough foreign exchange reserves to ensure that it can buy up enough Trinidadian dollars if there is a large sell-off? A problem arises if markets suspect that the government is engaging in policy changes that will cause the value of the currency to fall. If, for example, a government wants to engage in a public spending spree but does not have the tax revenues, it can simply increase the money supply (print more money) and ensure that new funds are lent to the government. This acceleration of the rate of growth of the money supply will lead to more inflation. Do you remember what happens to a floating exchange rate if the rate of inflation in country A begins to increase relative to the rate of inflation in country B? The value of country A’s currency must fall. country A’s prices rise, and it finds it more difficult to compete in foreign markets. Exports decline and the balance of trade moves toward a deficit position. Country A is not earning as much foreign exchange (from exports) as before.

If markets conclude that the pegged rate is too high (because the peg is sustaining a rate that, under a floating exchange rate, would be falling), then the pegged rate can be maintained only as long as the central bank has enough foreign exchange reserves to continue purchasing domestic currency. When foreign exchange reserves fall too low, markets will conclude that the central bank may not be able to sustain its peg at the established level. Speculators may make (or lose) fortunes by making large bets against the ability of central banks to maintain pegged exchange rates.

Dirty Float

It is possible to manage an exchange rate regime that is neither fully pegged nor completely floating. This is often called a “dirty float.” A dirty float is said to exist when a country has not formally adopted a pegged or fixed exchange rate regime, but its central bank will intervene from time to time to buy or sell foreign exchange in order to keep the value of the currency from rising or falling too much or too rapidly. Many central banks may engage in such “smoothing” currency sales or purchases because they do not like to see highly volatile exchange rates. Canada essentially operates under a dirty float exchange rate regime.

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Fixed Exchange Rate

A fixed exchange rate is similar to a pegged exchange rate, but in the case of a fixed exchange rate, two or more nations agree to fix their exchange rates against each other.

The Gold Standard

The gold standard was a special form of fixed exchange regime that existed in many countries between the 1870s and 1914. Countries that were on the gold standard fixed their domestic currency in terms of gold and promised to convert currency into gold. The British pound was fixed at £1 = 113 grains of gold, and the US dollar was fixed as being equivalent to 23.22 grains of gold. This effectively fixed the exchange rate between US dollars and British pounds.

The gold standard imposed monetary discipline on participating nations. As nations on the gold standard had to maintain a ratio between paper currency and gold supplies, a country that began to “lose gold” because its imports exceeded its exports would have to reduce its money supply. This would cause the economy to slow down, imports to fall, domestic prices to fall, exports to rise, and the gold outflow to eventually stop. Losing gold amounted to imposing a restrictive or contractionary monetary policy.

The central problem with a fixed exchange rate regime is that any major economic dislocation will inevitably alter the underlying economic conditions that allowed that specific fixed rate to work. Fixed exchange rate regimes seldom survive wars, for example, and WW I destroyed the gold standard. In order to finance various war efforts, governments wanted to print more money and they were not willing to see the war effort scaled back or halted because the loss of gold was causing the money supply to contract. In 1914, most nations at war abandoned the gold standard and opted for flexible exchange rates that would allow them to print money at will.

After the end of the WW I, many nations attempted to return to the gold standard or some form of pegged exchange rate. They agreed to fix the price of their currency to gold under the gold standard and to accept the monetary discipline that gold imposed, but these agreements collapsed under the weight of the Great Depression of the 1930s.

As the Depression spread, each country saw its exports to other nations fall. In an effort to boost exports, countries unilaterally devalued their currency against gold or against the US dollar. In 1933, the United States devalued its dollar relative to gold by a substantial amount. This amounted to a devaluation against other currencies.

Each country devalued its currency, based on the belief that rising exports would keep domestic employment from falling and lead to a domestic economic recovery. Unfortunately, this strategy could not succeed for all countries at the same time. If country A devalues its exchange rate relative to country B, it expects its imports to B to fall, since B’s prices (in A’s currency) are now higher, and it expects its exports to B to rise, since A’s exports (in B’s currency) are cheaper.

To B, however, this is a disaster. It sees its exports to A fall and its other industries losing market share to A’s exporters. B follows the same path and devalues its currency. Thus begins a pattern of competitive devaluations that attempt to stimulate local employment by reducing foreign employment. These devaluations have often been called “beggar thy neighbour” devaluations. It should be no surprise that world trade largely collapsed during

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the depression of the 1930s. Confidence in the world trading and financial system also collapsed.

The Bretton Woods System

In 1944, the statesmen of 44 countries convened a historic conference with an ambitious agenda at Bretton Woods, New Hampshire. The world’s leading nations wanted to establish an agreement on an international monetary system that would keep the world economy from slipping back into a deep economic recession. John Maynard Keynes from the United Kingdom was one of the main architects of what has come to be known as the “Bretton Woods system.” To Keynes, and to almost all other participants, the key problem was how to devise a set of rules governing international monetary arrangements that all would agree to follow and that would keep the world from falling back into the protectionist trend of the 1930s. The natural tendency for a country with international economic difficulties is to try to export the problem by devaluing its currency; this raises the demand for its domestic goods and services and, at the same time, reduces its imports, which have become more expensive. Unfortunately, once one nation devalues its currency in order to improve its competitive position relative to other countries, it is very likely that other countries will follow suit, and international trade and investment could collapse again. The central issue for Keynes and the other participants was how to ensure that international markets were kept open.

Keynes saw that a successful international monetary regime had to provide both discipline and flexibility. Adhering to a fixed exchange rate regime means that competitive devaluations are not a permissible policy option. It also forces all nations to pursue monetary stability. If a certain country increased its money supply too quickly, domestic prices would rise, and it would soon face emerging balance-of-payments deficits as exports fell and imports rose. The only way of restoring the balance of payments would be to restrict the rate of growth of its money supply to reduce the rate of inflation. Fixed exchange rate regimes are a way of disciplining governments to follow a non-inflationary monetary policy.

Discipline alone would not likely produce a long-lasting monetary regime. Some flexibility was also required. It was important that, when underlying economic fundamentals changed, a corresponding change to the fixed exchange rate was reflected. As well, a country might very well experience a short-term disequilibrium in its balance of payments. If the prices of its main exports, for example, fell by an unusually large amount, a country might find that its new lower export earnings did not earn enough foreign exchange to pay for its imports. If this was a short-term problem, reducing the money supply and raising interest rates would also reduce investment and would likely throw the economy into a recession. The Bretton Woods system devised a mechanism by which nations experiencing short-term balance-of-payments difficulties could borrow foreign exchange from a new international organization, the International Monetary Fund (IMF).

The Role of the International Monetary Fund

The IMF was a new multinational institution established at Bretton Woods. It was charged with the task of maintaining order in the international monetary system. Member nations

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paid contributions to the IMF and, under the Bretton Woods Agreement, agreed to establish a system of fixed exchange rates that would be policed by the IMF. Nations also agreed not to use devaluation as a tool to improve competitive trading positions.

Nations would have to go to the IMF when they ran into difficulty maintaining the fixed exchange rate they had committed to keeping. Small devaluations were permitted on a regular basis, but for devaluations in excess of 10 percent, IMF approval was required.

Nations that ran into balance-of-payments difficulties could also borrow limited quantities of foreign exchange from the IMF without any conditions. If the problem was very temporary, this would often be sufficient. If, however, the underlying problem was sufficiently large and deemed to be permanent, the borrowing country would have to agree to economic conditions imposed by the IMF. This provision is called "IMF conditionality." IMF conditions could be contingent on the debtor nation's agreeing to a program of trade liberalization, deflation, deregulation, and reduced government spending. Opening borders to trade and investment is viewed as a necessary condition as is, under some circumstances, reducing the value of the currency in order to promote export growth and improvement in the trade balance.

A country facing persistent deficits was permitted to borrow funds to give it time to make the necessary adjustments to whatever new economic realities existed or to correct macroeconomic policies that were not consistent with the fixed exchange rate. These adjustments usually required a tightening of monetary policy, which meant higher interest rates and unemployment in the short run. Access to IMF funds allowed countries to avoid hard, sharp economic collapses and steeply rising unemployment, while giving them time to put their economic houses in order.

If a borrowing country failed to take the required policy actions to restore balance-of-payments equilibrium, however, the IMF would step in and impose “conditionality” on additional borrowing. It would review this country’s economic and macroeconomic policies and specify, often in great detail, the macroeconomic policies it needed to follow if it wanted to access additional amounts of foreign exchange.

The Collapse of the Fixed Exchange Rate System

The fixed exchange rate system proved to be rather stable for almost 30 years. During this era of fixed exchange rates the world economy grew at a remarkable pace. Trade and international investment also grew more rapidly than world output, and the Bretton Woods system was associated with this period of growth and stability.

And yet, like other fixed exchange rate systems, it too eventually collapsed. As Hill notes, a fixed exchange rate system has a difficult time coping with major economic changes in important countries, especially when a major country is determined to introduce a monetary policy that will cause inflation to rise. This is precisely what happened in the United States between 1968 and 1972. The US government was not willing to reduce spending on either the Vietnam War or the “Great Society” welfare programs that were dear to President Lyndon Johnson’s heart. Inflation in the United States accelerated and the US trade deficit began to soar. Speculators began selling off US dollars and buying other currencies, which forced other central banks, especially the German Bundesbank, to sell German Deutschmarks in order to accumulate more dollars to keep the German DM from rising. Other nations did not want to increase their holdings of US dollars when common

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sense told them that the United States would have to either reduce spending domestically or devalue its own currency.

The Floating Exchange Rate Regime

In 1976, the Jamaica Agreement formally revised the IMF’s Articles of Agreement to formally permit flexible exchange rates. IMF quotas were increased, which meant that the IMF had more resources to lend to countries experiencing balance-of-payments difficulties.

Since 1973, exchange rates have become more volatile. Major economic shocks continue to create balance-of-payments problems for many countries, who often seek IMF short-term loans to help deal with these problems. The choice of exchange rate regime is a major issue facing all countries today. Unfortunately, economics provides no clear-cut answer.

Fixed and Floating Exchange Rates

There are advantages and disadvantages to both fixed and floating exchange rate regimes. You should be able to explain the meaning of each of the factors listed below.

Fixed Exchange RatesAdvantages Disadvantages

Limit destabilizing effects of uncertainty and speculation Provide international monetary stability Limit foreign exchange risk; reduce uncertainty regarding the value of the exchange rate

Can become unfixed; when rates are expected to become unfixed, currency speculation can cause severe economic dislocation 

(Note that the following two points are identical—what some authors see as an advantage, others see as a disadvantage!)

Limit a central bank’s ability to implement independent monetary policy—the advantage, as argued by some authors, is that fixed exchange rates impose much-needed monetary discipline on governments. Since they cannot engage in monetary policy that is unduly inflationary, they must, therefore, adjust monetary policies so as to maintain the value of the fixed exchange rate.

Limit a central bank’s ability to implement independent monetary policy—the disadvantage, as argued by other authors, is that if a government wants to stimulate the economy with an expansionary monetary policy (thereby reducing interest rates), it will not be able to do so under a fixed exchange rate regime.

Flexible Exchange RatesAdvantages Disadvantages

Can implement independent domestic monetary policies Help adjust trade balances

Add to uncertainty of currency movements and speculation

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Who is right?

There is no definitive answer. A completely fixed exchange rate regime will not be able to manage major changes in economic fundamentals that dictate an adjustment in the exchange rate. It is, therefore, probably unworkable, and we are not likely to see one emerge. On the other hand, many less developed countries are willing to give up much monetary independence in order to reduce foreign exchange risk and attract foreign capital. These countries have opted for pegging their currencies to one of the major world currencies, often the US dollar.

These pegs, however, may last only as long as the underlying economic fundamentals remain constant. When these change, the exchange rate will likely have to change as well.

Currency Boards

A currency board, like the one operating in Hong Kong, is a strong form of a pegged exchange rate. The government of Hong Kong announced that it was pegging its dollar to the US dollar. It also took the additional step of announcing that the currency board would hold US dollars equal to 100 percent of the local currency issued, which ensured that it would have enough foreign exchange to meet a speculative sell-off of Hong Kong dollars. This also meant that Hong Kong was giving up the ability to implement an independent monetary policy.

Before you conclude that a currency board is the best way to ensure that foreign investment flows into a country and that monetary discipline is imposed on a government that would otherwise likely print too much money (leading to runaway inflation), you should consider the case of Argentina (see pp. 352–353 and pp. 368–369).

Argentina’s currency board appeared to be working well for a few years. Then some important underlying economic fundamentals changed. The Argentinean peso was pegged to the US dollar, but the US dollar was rising against other currencies, especially the Brazilian real. Argentina did a lot of trade with Brazil. As the US dollar rose in value, so did the Argentinean peso, and its exports were too expensive in Brazil and other countries. World prices for several important Argentine exports also fell, causing a recession in Argentina. However, the currency board arrangements kept the Argentine government from responding to the deepening recession with an expansionary monetary policy to lower interest rates. The opposite happened. In order to retain the foreign exchange reserves necessary to make the currency board work, interest rates in Argentina rose substantially, investment fell, and unemployment rose to over 25 percent. The currency board kept Argentina from responding to the recession in the usual manner of stimulating demand by pursuing an expansionary monetary policy and letting interest rates fall.

As the economic situation in Argentina worsened, foreign capital began to flee the country, due to fear that the pegged rate regime was not going to be sustained. Argentina did not fulfill its function of providing an effective “guarantee” to foreign investors that the exchange rate was indeed pegged to the US dollar. When the currency board was finally abandoned and a floating regime put in place, the Argentine peso fell from 1 to the US dollar to 3.5 to the US dollar.

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Study Questions

Provide complete answers for each of the following study questions—you need to be able to explain how and why a factor or consideration is important or relevant. Students often lose marks on their assignments or examinations by providing answers that are too short and incomplete. Some questions have answers provided at the end of this section. The rest of the answers can be found in the assigned readings or the lesson notes. If you still have problems answering any question, contact the Call Centre.

Explain how a flexible exchange rate system operates. What are the advantages and 1.disadvantages of this model? Debate the relative merits of fixed and floating exchange rate regimes. From the 2.perspective of an international business, what are the most important criteria for choosing between the systems? Which system is the more desirable for an international business? Answer What were international policy makers most concerned about when they gathered in 3.1944 in Bretton Woods, New Hampshire? What were the key elements of the post–WW II international monetary system that was 4.put together at Bretton Woods? What factors led to the breakdown in the fixed exchange regime between 1968 and 5.1972? What is a currency board? Why do countries choose this type of system? What are the 6.disadvantages of this type of arrangement? Answer What role does the IMF play in the international economy?7.

Answers to Selected Study Questions

2. The case for fixed exchange rates rests on arguments about monetary discipline, speculation, uncertainty, and the lack of connection between the trade balance and exchange rates. In terms of monetary discipline, the need to maintain fixed exchange rate parity ensures that governments do not expand their money supplies at inflationary rates. In terms of speculation, a fixed exchange rate regime precludes the possibility of speculation. In terms of uncertainty, a fixed rate regime introduces a degree of certainty in the international monetary system by reducing volatility in exchange rates. Finally, in terms of trade balance adjustments, critics question the closeness of the link between the exchange rate and the trade balance. The case for floating exchange rates has two main elements: monetary policy autonomy and automatic trade balance adjustments. In terms of the former, it is argued that a floating exchange rate regime gives countries monetary policy autonomy. Under a fixed rate system, a country’s ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity.

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In terms of automatic trade balance adjustments, under the Bretton Woods system, if a country developed a permanent deficit in its balance of trade that could not be corrected by domestic policy, the IMF would agree to a currency devaluation. Critics of this system argue that the adjustment mechanism works much more smoothly under a floating exchange rate regime. They argue that if a country is running a trade deficit, the imbalance between the supply and demand of that country’s currency in the foreign exchange markets will lead to depreciation in its exchange rate. An exchange rate depreciation should correct the trade deficit by making the country’s exports cheaper and its imports more expensive. Which system is better for an international business is a matter of personal opinion. We do know, however, that a fixed exchange rate regime modelled along the lines of the Bretton Woods system will not work. Nevertheless, a different kind of fixed exchange rate system might be more enduring and might foster the kind of stability that would facilitate more rapid growth in international trade and investment. Back

6. A country that introduces a currency board commits itself to converting its domestic currency on demand into another currency at a fixed exchange rate. To make the commitment credible, the currency board holds reserves of foreign currency equal, at the fixed exchange rate, to at least 100% of the domestic currency issued. The system is attractive because it limits the ability of the government to print money and thereby create inflationary pressure. Under a strict currency board, interest rates will adjust automatically. However, critics point out that if local inflation rates remain higher than the inflation rate in the country to which the currency is pegged, the currencies of countries with currency boards can become uncompetitive and overvalued. Also, the system does not permit governments to set interest rates. Back

Section 4.4: Crisis Management by the IMF

Reading Assignment and Learning Objectives

In the textbook:Chapter 10 (pp. 369–371 to The Asian Crisis)Case: The Tragedy of the Congo, pp. 412–413Case: The Russian Ruble Crisis and Its Aftermath, pp. 413–415

After completing Section 4.4, you should be able to

discuss the role and function of the IMF.1.  explain the meaning of the following terms:2. 

currency crisisa.

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banking crisisb.foreign debt crisis.c. 

discuss the factors that led to the Mexican peso crisis of 1995.3. discuss the factors that led to the Russian ruble crisis of 1997/98.4. discuss the role played by the World Bank and the IMF in the Congo since the 1970s.5.

The IMF and Financial Crises

One of the major functions of the IMF is to provide emergency loans to countries experiencing balance-of-payments difficulties. The purpose of these loans is to ease the transition while that country makes necessary policy reforms to restore the external account to equilibrium. IMF loans are contingent upon a debtor country's agreeing to follow IMF-approved economic policies aimed at restoring external balance.

External balance can be restored only by actions that serve to reduce a particular country’s need for foreign exchange and increase its capacity to earn foreign exchange. The IMF is generally not concerned with the question of whether the debtor is to be blamed for the crisis. If external circumstances have changed for the worse (e.g., rising interest rates and falling commodity prices), domestic policies must be reoriented accordingly. Nevertheless, there has emerged a typical IMF view as to the origins of the crisis and the policies needed to return the debtor to external equilibrium and a sustainable growth path.

The IMF claims that it does not attempt to influence development strategies. Its advice is of a technical nature, designed to achieve external equilibrium, which is a precondition to restoring economic growth. Critics argue that, in practice, the IMF has moved far beyond merely offering technical advice and that it has rejected virtually all alternatives to its own strategy.

As mentioned earlier, an IMF agreement is usually contingent upon the debtor nation's agreeing to a program of liberalization, deflation, and privatization. Liberalization involves removing barriers to trade and eliminating government interference in financial markets and global capital markets. Trade liberalization, an aspect of liberalization that has received widespread support, opens borders to trade and investment and leads to greater economic growth and higher standards of living. Countries that have attempted to open trade have typically done better than those who restrict access to international trade and foreign investment.

The IMF also wants to see evidence of monetary discipline—usually, a measure of deflation. If a certain country has pegged its exchange rate and inflation in this country is increasing more rapidly than in that of its trading partners, then its exports will fall, imports will rise, and foreign exchange reserves will be further reduced. As well, if this government is running a deficit, it must borrow to finance the deficit, and this reduces the available supply of funds for private-sector investment. This “crowding out” of investment is viewed as being harmful to growth prospects.

In many less developed countries, budget problems may emerge because the government has chosen to rely on government-owned firms (usually protected with a local monopoly) to produce key goods and services. These public-sector monopolies often require extensive

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subsidies, which can cause public-sector deficits to rise, and are often both inefficient and corrupt.

Less developed countries have also tended to rely on exchange rates pegged to a major currency, usually the US dollar, whereas developed countries have tended to rely on flexible exchange rates since the collapse of the Bretton Woods system in the early 1970s. This reliance on flexible exchange rates may explain, in large part, why developed nations have not had to rely on IMF lending to deal with balance-of-payments problems since 1973.

Financial Crises in the Post–Bretton Woods Era

There are three important aspects of a financial crisis, and any particular financial crisis may contain one or more of these aspects:

Currency crisis—happens when a country with a pegged exchange rate finds its currency being sold off in large volumes in foreign exchange markets to the extent that the ability of the government to maintain the peg is threatened. This crisis may also happen when widespread selling is taking place and the value of the domestic currency is falling. Currency crises often accompany more fundamental economic crises or imbalances.

Banking crisis—happens when there is widespread loss of confidence in the banking system; may show up as a run on banks, when depositors attempt to remove deposits on a large scale.

Foreign debt crisis—happens when a country either cannot service its foreign debt obligations or is in danger of not being able to service those debts.

These crises tend to have macroeconomic causes and can arise very quickly. One type of crisis can often quickly lead to the emergence of one or both of the other types (e.g., a foreign debt crisis can lead to a currency crisis and a banking crisis).

Mexican and Russian Currency Crises

The Mexican currency crisis shows what can happen under a fixed exchange rate regime when economic fundamentals (inflation and interest rates) become inconsistent with the exchange rate. In Mexico, the government permitted the money supply to grow rapidly in the early 1990s, and prices were accelerating much more rapidly than prices in the United States, its main trading partner. This caused Mexico’s trade deficit to rise as Mexican exports were priced out of foreign markets. Mexico’s leaders declared that they would defend the value of the peso if it came under attack by investors and speculators. For a while, this lulled investors into a sense of security, and foreign investment poured into the country: $64 billion between 1990 and 1994 alone.

As currency traders became aware that only the massive capital inflow was preventing a currency collapse (as the trade deficit would otherwise have been unsustainable), they started to sell off financial assets in Mexico and buy non-Mexican assets. There was only one action open to the government of Mexico if it wished to maintain its fixed exchange rate: it would have to sell off its foreign exchange reserves in order to buy up the Mexican pesos that investors were dumping into the foreign exchange market. Eventually, the government realized that it was running out of foreign exchange reserves, and it could no

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longer defend the peso. The government announced a devaluation in mid-1994 that caught many investors by surprise. The mood of optimism was replaced by one of pessimism, and more investors attempted to sell Mexican stocks and bonds. The peso continued to fall.

Finally, Mexico arranged for massive loans from both the IMF and the US government. In the absence of these loans, Mexico would no doubt have had to default on many of its international financial obligations.

In order to restore external equilibrium, the IMF insisted on its usual array of economic policies. Money supply growth was reversed, interest rates rose rapidly, public spending was reduced, and investment and output fell. Eventually, imports also fell, exports picked up, and Mexico climbed out of the deep recession it had fallen into.

Read Hill’s description of the Russian ruble crisis (pp. 413–415 of the textbook). Russia faced unique problems as it attempted to make the transition from a centrally planned economy to a market economy.

We will examine the Asian crisis (pp. 371–374) in Unit 5.

Case Study: The Tragedy of the Congo

This case study (textbook, pp. 412–413) illustrates an important limitation of a strictly economic analysis of balance-of-payments problems. The citizens of the Democratic Republic of the Congo have long had the misfortune to live in one of the most corrupt nations in the world. In the 1980s and 1990s, the then dictator Mobutu Sese Seko set new records regarding theft of national wealth. Mobutu and his colleagues regularly raided the national treasury and placed the expropriated funds in personal accounts in Europe and the Caribbean. Private investors soon learned that the government would simply steal earned profits, if possible, and most private-sector investment dried up.

The economy stagnated and infrastructure deteriorated. However, Mobutu had one key supporter. He declared that he was a strong anti-communist, and this stance so pleased the US government that it used its influence to ensure that the World Bank continued to make large loans to the Congo. As Hill notes, Mobutu and his cronies were taking these funds out of the back door of the banks shortly after the international institutions had deposited them via the front door.

Most of the World Bank and IMF monies arrived as loans, not grants. The post-Mobutu governments in the Congo have argued that these loans are not legitimate loans that the new government is responsible for, because the World Bank, the US government, and the IMF were all aware of what was happening. The question of whether the desperately poor citizens of the Congo should be held responsible for the repayment of these loans remains an outstanding issue.

Study Questions

Provide complete answers for each of the following study questions—you need to be able to explain how and why a factor or consideration is important or relevant. Students often

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lose marks on their assignments or examinations by providing answers that are too short and incomplete. Some questions have answers provided at the end of this section. The rest of the answers can be found in the assigned readings or the lesson notes. If you still have problems answering any question, contact the Call Centre.

Name the three types of financial crisis and describe the characteristics of each.1. How did the Mexican peso crisis differ from the Russian ruble crisis?2. Compare and contrast currency crises, banking crises, and foreign debt crises. Answer3. Why do you think IMF and World Bank lending to the Congo failed to have the expected 4.results? Should the citizens of the Congo be held accountable for the loans incurred by the 5.government of Mobutu Sese Seko? Why or why not?

Answers to Selected Study Questions

3. A currency crisis occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency or forces authorities to expend large volumes of international currency reserves and to sharply increase interest rates in order to defend the prevailing exchange rate. In contrast, a banking crisis refers to a loss of confidence in the banking system that leads to a run on banks as individuals and companies withdraw their deposits. Finally, a foreign debt crisis is a situation in which a country cannot service its foreign debt obligations, whether private-sector or government debt. Back

Section 4.5: The Global Capital Market

Reading Assignment and Learning Objectives

In the textbook:Chapter 11 (pp. 386–404)

After completing Section 4.5, you should be able to

discuss the functions and nature of capital markets.1. explain the role of commercial banks and investment banks in mediating between savers 2.

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and investors. explain what is meant by cost of capital and how it is determined.3. explain the main advantages to eliminating the restrictions on the development of global 4.capital markets. outline the reasons for the recent growth of the global capital market.5. explain the difference between hot money and patient money.6. discuss the functions and nature of the Eurocurrency market, the global bond market, and 7.global equity investments.

What are Capital Markets?

Global capital markets play a very important role in our global economy. They are institutions through which savers can directly provide funds to borrowers and investors; that is, they help match one person’s savings with another person’s investment. The process of saving and investment are key ingredients to long-run economic growth and productivity.

Commercial and investment banks mediate between savers and investors. A commercial bank will take deposits from firms and individuals that wish to save out of current income and lend to individuals and firms that wish to spend more than current income. In the household sector, such borrowing may be either for consumption purposes—say, to finance a holiday—or for investment purposes—say, to finance the purchase of a house. In the business sector, such borrowing is almost always for business or investment purposes.

Investment banks bring lenders and borrowers directly together. In the case on pages 386–387 of the textbook, the Industrial and Commercial Bank of China completed the world’s largest ever initial public offering by raising $21 billion. Given that this amount of capital could not be raised entirely in China, the Bank had to attract foreign investors by listing the shares on one of the world’s largest stock market exchanges, the Hong Kong stock exchange. It was the only way to attract the necessary investors.

Two important markets constitute capital markets—the bond market and the stock market. When a firm issues a bond, it sells a promise to pay a fixed amount, plus a fixed rate of interest, according to a fixed schedule. Thus, a firm might issue or sell a 10-year $1,000 bond with an interest rate of 8 percent per annum. The firm promises to pay the interest each year and the principal at the end of the stated time period.

On the other hand, a stock certificate is a certificate of ownership. If, for example, a family that owns a steel mill wishes to expand into new markets, it will need funds for this investment. The family might decide to retain only 50 percent ownership of the firm and to sell off the remaining 50 percent through the issuance and sale of stock certificates to private investors. Investment banks provide advice and assistance to firms seeking to raise new capital in this manner.

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The Cost of Capital

The term cost of capital refers to the cost of raising or borrowing capital. In the example discussed on the previous page, a firm issued a bond with an interest rate of 8 percent. This 8 percent is said to be the cost of capital for this firm. The cost of capital will vary according to the expected risk of default. Bonds issued by the Canadian and US governments are regarded as almost risk-free financial instruments and are very popular with investors who do not wish to bear very much risk. If a firm with a strong balance sheet and good prospects issues a bond, it can expect to pay a higher price than that attached to Canadian and US government bonds, but not as high a price as investors will demand for buying bonds issued for a smaller firm with heavy debt and, perhaps, an uncertain future. The cost of capital, therefore, may vary from borrower to borrower.

Figure 4.3 The Cost of Domestic Capital Figure 4.3 illustrates a national market for capital. In capital markets, as in most markets, it is the demand and supply that will determine the equilibrium price. As you can see, the demand for capital varies inversely with its price. If the rate of interest is high, savers will provide more dollars into the market. At a high rate of interest, however, the demand for borrowed funds will be relatively low. At a low rate of interest, borrowers wish to borrow more (called demand), but suppliers are not willing to risk as much.

The equilibrium rate of interest, or the cost of capital in this case, will be r = 9 percent.

So far, we have considered only a national or domestic market for capital. We have implicitly assumed that capital cannot cross national borders. What will happen when we allow international capital flows to take place?

Let us assume that Figure 4.3 represented the market in a typical less developed country. Capital is scarce, at least relative to the situation in more developed countries, so the price of capital is fairly high. But what if these firms could borrow in international markets? The potential supply of capital would be much greater. This situation is represented in Figure 4.4, below.

Figure 4.4 The Cost of International Capital S2 represents the supply of capital

facing the same firm if it had access to global capital markets. For such firms, the ability to borrow abroad would lower the cost of capital and would also

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increase the amount of borrowing. From the perspective of the developing country as a whole, access to global capital markets means, therefore, access to capital at lower rates of interest. Lower rates of interest usually mean higher levels of investment and output. If this hypothetical firm had access to global capital markets, it would be able to borrow at 7 percent, and it would borrow (and invest) more.

So, for less developed countries, where domestic capital tends to be relatively scarce and, therefore, relatively expensive, access to global capital markets can be very important.

What about countries in the developed world? In the developed world, capital is relatively abundant, and so its price will be relatively low, which means that investors are accepting a relatively low rate of return. Let us say that investors are accepting a rate of return (the borrower’s cost of capital) of only 5 percent. If, however, they are able to lend to our hypothetical firm abroad or to other firms in global capital markets, they will be able to lend in markets where capital is scarce and the price of capital is high.

What does it mean when capital markets are limited by national boundaries as outlined above? It means that the price of capital will be lower in the developed regions of the world where capital is relatively abundant, and the price of capital will be higher in the less developed regions where capital is relatively scarce.

Does this not seem to violate the “law of one price,” since the price of capital is not the same in all regions? It does indeed. By eliminating barriers on capital flows, we allow capital to move out of regions where it is relatively abundant. This is reflected in a relatively low cost of capital that simply reflects the relatively low productivity of capital at the margin in capital-abundant regions. Capital will move to regions where it is scarce; hence, the price of capital is high. Thus, capital will move toward those regions where the rate of return on the investment of that capital is highest. Global efficiency and output will increase by moving to a policy of free capital flows, assuming that there are no market imperfections.

In the next unit, we will see that market imperfections for certain capital markets in less developed regions are a very real and significant problem. Many authors now argue that governments of less developed countries should impose some capital controls to limit the damage that can be caused by unduly large and quick inflows and outflows of capital. However, the main advantage remains; if capital markets are opened, then the global allocation will be more efficient, and if less developed regions have access to global capital markets, the cost of capital in such regions will decline and investment will rise.

The Growth of the Global Capital Market

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p

In the past 20 years, there has been a significant rise in the number of international bond and equity offerings in the global capital market. This market is seen as an extremely easy and effective mechanism to raise capital. The growth in the global capital market is due to a number of factors, including the advancements in information technology, the widespread deregulation of financial services, and the relaxation of regulations governing cross-border capital flows.

As mentioned in the previous section, capital controls are a major hindrance to the efficient movement of capital and foreign direct investment. In its study entitled Globalization, Growth and Poverty: Building an Inclusive World Economy (2002), the World Bank observes that

controls on capital outflows from high-income countries were gradually lifted: for example, the United Kingdom removed capital controls in 1979. Governments in developing countries have also gradually adopted less hostile policies toward investors. Partly as a result of these policy changes and partly due to the oil shock of the 1970s, significant amounts of private capital again began to flow to developing countries. (p. 42)

Global Capital Market Risks

In the next unit, we will consider the issue of financial crises in less developed countries more thoroughly. For now, though, it is important to make a distinction between short-term capital flows, often called “hot money,” and longer term investments, which Feldstein has called “patient money” (textbook, p. 396).

FDI, for example, is not often associated with currency, banking, or debt crises. By definition, FDI means that a firm has built or purchased real assets that it is using to produce goods or services. Hot money, on the other hand, refers to various kinds of international investments in financial instruments that can be liquidated and taken out of the country at very short notice.

Feldstein argues that hot money can move around the globe very quickly, searching out the highest short-run returns. However, investors involved in this sector usually have very poor information about the firms and economies in which they are investing. Money floods in when short-run returns appear to be high relative to other countries and there is a lot of enthusiasm and optimism regarding investing opportunities in that country. However, these sentiments often tend not to be grounded in economic reality. Access to large amounts of such funds over a short period of time often leads to overbuilding and the eventual emergence of excess capacity. This excess capacity will cause profit margins to fall or disappear, and the “boom” psychology is replaced by investor panic and a “bust” psychology as foreign investors all make a mad dash for the exit. They rush to sell off stocks and bonds or to call in international loans to convert local currency to US dollars or other foreign currencies to take out of the country. The hot money flows out as quickly as it flowed in, but the outflow takes place at the worst possible time, as the economy is attempting to deal with a recession brought on by overinvestment and excess capacity. This can easily lead to a currency crisis as foreigners attempt to sell off local currency, which leads to inflation and forces the government to raise interest rates in an often futile effort to reverse the capital outflow.

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As we will see in Unit 5, many less developed countries do not have the efficient and transparent financial markets that are needed to manage large shifts in demand or supply of financial instruments in the short run, and thus financial markets do not operate efficiently. In the next unit, we will examine a number of different policy approaches that may be adopted to deal with financial instability.

In the Asian financial crisis, many Asian firms had taken advantage of the lower cost of capital in international markets by borrowing abroad, in US dollars or other foreign currency, and then investing at home in what was often a booming market. This pattern of borrowing meant that these investors were taking on a substantial amount of foreign exchange risk. They might borrow in world markets at 6 percent, when the lending rate from domestic institutions was, for example, 10 percent, but this lending was denominated in US dollars. If the value of the local currency against the dollar fell unexpectedly, then these firms would face often dramatically increased costs of servicing their debt, as their incomes were received in the local currency. This pattern of borrowing, followed by a currency depreciation, was a major component of the Asian financial crisis.

Eurocurrencies, and the Global Bond and Equity Markets

Any currency that is banked outside of its country of origin is called a eurocurrency. National governments tend not to impose regulations on banks regarding the holding of foreign currency deposits. Nor do they provide deposit insurance to those holding eurocurrency bank accounts. The relative absence of regulations means that banks can offer higher deposit rates and lower lending rates to consumers willing to bear the additional risk of depositing or lending in this market. Many large firms do indeed borrow in the eurocurrency market, and the relatively high rate of interest has attracted many depositors as well.

Similarly, firms may issue international bonds that face fewer regulatory requirements—hence, lower costs to the issuer—than is normally the case with bonds denominated in the local currency of the issuer and sold within the domestic market.

There are two types of international bonds:

Foreign bonds are sold outside the borrower’s country and denominated in a currency other than that of the borrower. If a Canadian firm issues a bond denominated in US dollars and sells it in the United States (a Yankee bond), it is called a foreign bond.

Eurobonds are slightly different. If a US firm issues a bond denominated in Japanese yen and sells it in Europe and Asia, it is called a eurobond.

Advances in information technology and falling barriers to capital flows have facilitated the growth of investment in cross-border equity markets. The growth of mutual funds has also helped accelerate this trend. It is now fairly easy for an investor in Toronto or Manila to buy shares in a firm listed on the New York, Tokyo, London, or Hong Kong stock markets. Many investors seek to diversify their portfolios geographically in order to reduce overall risk.

The development of the mutual fund industry has allowed many small investors to participate in the rapid growth of Asian economies without having to become well informed about distant markets.

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Study Questions

Provide complete answers for each of the following study questions—you need to be able to explain how and why a factor or consideration is important or relevant. Students often lose marks on their assignments or examinations by providing answers that are too short and incomplete. Some questions have answers provided at the end of this section. The rest of the answers can be found in the assigned readings or the lesson notes. If you still have problems answering any question, contact the Call Centre.

What is a capital market? Define market makers . Answer1. Describe how a domestic capital market functions, and explain what is meant by cost of 2.capital. What are the benefits of a global capital market as compared to a purely domestic 3.capital market? Answer What is the role of commercial and investment banks?4. Describe the growth of the global capital market over the past 15 years.5. What are the major factors that account for the growth of the global capital market?6. What is the eurocurrency market, and why is it an attractive market to both lenders and 7.depositors? Answer Describe the difference between "hot money" and "patient money. " Which of the two is 8.preferable to enhance economic development and prosperity? Why?

Answers to Selected Study Questions

1. A capital market brings together those who want to invest money and those who want to borrow money. Those who want to invest money include corporations with surplus cash; individuals; and non-bank financial institutions. Those who want to borrow money include individuals, companies, and governments. Between these two groups are the market makers. Market makers are the financial service companies that connect investors and borrowers, either directly or indirectly. They include commercial banks and investment banks. Back

3. In a purely domestic capital market, the pool of investors is limited to residents of the country. This places an upper limit on the supply of funds available to borrowers. In other words, the liquidity of the market is limited. A global capital market, with its much larger pool of investors, provides a larger supply of funds for borrowers to draw on. An important drawback of the limited liquidity of a purely domestic capital

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market is that the cost of capital tends to be higher than it is in an international market.In a purely domestic market, the limited pool of investors implies that borrowers must pay more to persuade investors to lend them their money. The larger pool of investors in an international market implies that borrowers will be able to pay less. Back

7. A eurocurrency is any currency banked outside of its country of origin. Eurodollars, which account for about two-thirds of all eurocurrencies, are dollars banked outside the United States. Other important eurocurrencies include the euroyen, the europound, and the euro-euro. A eurocurrency can be created anywhere in the world; the persistent "euro" prefix reflects the European origin of the market. The main factor that makes the eurocurrency market attractive to both depositors and borrowers is its lack of government regulation.This means that the spread between the eurocurrency deposit rate and the eurocurrency lending rate is less than the spread between the domestic deposit and lending rates. Companies have strong financial motivations to use the eurocurrency market. By doing so, they receive a higher interest rate on deposits and pay less for loans. Back

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