Notes on International Business Finance Portion – 2

Example on Balance of Payment (BOP):

Example 1

You are required to find out the overall balance, showing clearly all the hub-balances
from the following data:
(1) UC Corporation of the USA invests in India Rs 3,00,000 to modernize its Indian
subsidiary.
(2) A tourist from Egypt buys souvenirs worh Rs 3000 to carry with him. He also pays
hotel and travel bills of Rs 5,000 to Delhi Tourist Agency.
(3) The Indian subsidiary of UC Corporation remits, as usual, Rs 5,000 as dividends to its
parent company in the USA.
(4) This Indian subsidiary of UC Corporation sells a part of its production in other Asian
countries for Rs 1,00,000.
(5) The Indian subsidiary borrows a sum of Rs 2,00 000 (to be paid back in a year’s time)
from the German money market to olve its urgent liquidity problem.
(6) An Indian company buys a machine for Rs 1,00,000 from Japan and 60 per cent
payment is made immediately; the remaining amount is to be paid after 3 yeaa
(7) An Indian subsidiary of French Company borrows Rs 50,000 from thc Indian public
tp invest in its modernization programme.

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There is a net surplus of Rs 5,43,000 in the balance of payments. This means, there will
be an increase of reserves by this amount.

Note: The transaction No. 7 did not enter into the BOP Statement since this transaction
does not involve any foreign country. The entire transaction has taken place in Indian
rupees within India.

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INTERNATIONAL MONETARY SYSTEM:

INTRODUCTION:

International transactions and resulting balance f payments problems need to be solved so

thaf’ international operations do not suffer, adequate finances are to be arranged
(particularly for less developed/ developing countries) so that international transactions
take place smoothly. In the context of’ international trade, the problems that crop up
relate to; (i) liquidity, (ii) adjustment, and (iii) stability.

Liquidity is necessary to finance the transactions that are done on cash basis. Adjustment
is needed to bridge the gap that emanates because of imbalance between demand and
supply at existing exchange rates. Similarly, stability is necessary with intent to limir the
degree of uncertainty in international business decisions.

International monetary system addresses itself to provide mechanisms to solve the above
problems. Since these cannot be solved by any nation in isolation, it is desirable that all
interacting nations agree to a certain modus operandi to find solutions to common
problems.

EVOLUTION OF INTERNATIONAL MONETARY SYSTEM:

There has been a rapid growth of the international monetary system, over the period. It
has successfully tackled periods of stresses and strains. It has passed through a period of
transition from the system of fixed exchange rates to the system of floating rates.

Gold Exchange Standard was the first major step towards the establishment of an
international monetary system. This system was put into effect in 1850. The participants
were the UK, France, Germany and the USA. In this system, each currency was linked to
a weight of gold. The system was institutionalized at the Conference of Genes in 1922.
Since gold was convertible into currencies of the major developed countries, central
banks of different countries either held gold or the currency of these developed countries.
But after the Conference of Genes (1922), there was tremendous speculative activity,
accompanied by economic crisis, high inflation in Germany, protectionism following the
crisis of 1929, competitive devaluations for providing impetus to exports, and finally the
Second World War.

THE SYSTEM OF BRETTON WOODS (1944-71):

A conference was held at Bretton Woods in’ the USA, in July 1944, in order to put in
place a new international monetary system. The major objectives of this conference were:
(i) to review the existing rules, (ii) to devise a system to encourage international
monetary cooperation, and (iii) to establish an international institution to ensure good
functioning of the system.

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Main characteristics of the international monetary system developed at Breton Woods
can be summarized as follows:

• Fixed rates in terms of gold (i.e. a system of gold standard), but only the US dollar was
convertible into gold as the USA ensured convertibility of dollars into gold at
international level.

• A procedure for mutual international credits.

• Creation of International Monetary Fund (IMF) to supervise and ensure smooth

functioning of the system. Countries were expected to pursue the economic and monetary
policies in a manner so that fluctuations of currency remained within a permitted margin
of ± I per cent That is, the central bank of every country had to intervene to buy or sell
foreign exchange, depending on the need.

• Devaluations or reevaluations of more than 5 per cent had to be done with the
permission of the IMF. This measure was necessary to avoid chain devaluations like the
ones which occurred before the Second World War.

INTERNATIONAL MONETARY FUND (IMF):

The International Monetary Fund (IMF) had 44 countries as its members in 1946.
Currently almost all the countries are members of this, institution. The only exception is
Cuba. The main functions of the IMF are:

• To help member countries in stabilizing their currency:

• To supervise the evolution of exchange rates and provide guidance to countries on their
exchange rate policies;

• To accord temporary financing to tide over balance of payments difficulties.

Resources of the IMF:

The capital of the IMF is constituted by the totality of the subscriptions of member states,
known as quotas. These quotas are determined as per the economic importance of each
country reflected/measured in terms of national income, exports, etc. In 1994, the capital
of the IMF was SDR 144.6 billion.

Since 1970, a new instrument of reserve has been created, namely SDR (Special Drawing
Right). The value of SDR represents a weighted average of 5 currencies that is the US
dollar (40 per cent). German Deutschmark (21 per cent), the UK pound sterling (11 per
cent), the French franc (11 per cent), and the Japanese yen (17 per cent). These weights
reflect the relative strength of economies of these countries.

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The quotas of different countries are paid to the IMF in the ratio of 25 per cent as SDRs
and 75 per cent in national currency.

Besides the quotas of member countries as explained above, the IMP can also have
recourse to loans from member states to augment its resources. These loans are drawn in
SDRs.

Also, under the General Agreement to Borrow (GAB) signed by the Group of Ten
Countries (the Group of Ten (also known as Paris Club) consists of ten major
industrialized countries: Belgium, Canada, France. Germany, Italy, Japan, the
Netherlands, Sweden, the UK and the USA), the IMF can borrow in order to have
supplementary resources in convertible currencies. This agreement allows the IMF to
finance from this borrowing even those countries which are not members of the Group of
Ten. The agreement is renewed every 5 years; the last one was in 1993.

Activities of the IMF:

Good functioning of the international monetary system requires:

• Appropriate adjustment mechanisms;

• An attentive surveillance of the policies adopted by the member states relating to the
exchange rate.

Member countries have an absolute claim on the IMF up to the amount of gold
subscriptions they have made. In operational terms, they can draw this amount (equal to
25 per cent of their quota) from the IMF any time. This is called reserve tranche (or gold
tranche) and is treated as the reserve of the country concerned. However, this sum is to be
reimbursed to the IMF within a specified period varying between 3 months to 5 years.

Beyond 25 per cent a country can draw upon its credit tranche: the additional credit the
IMF can grant. The credit tranches consist of the amount of drawings beyond the reserve
or gold tranche that would raise the Fund’s total holdings of that country to 200 per cent
of the quota. Temporary increases of the credit tranche to 400 per cent of the quota have
been allowed in the past. Approval from the IMF is necessary for a country to draw on its
credit tranche. This approval usually comes with restrictions that become increasingly
tight as the drawings on this credit rise. Thus, this additional credit is used more often to
finance temporary disequilibrium in balance of payments than to provide temporary
liquidity.

Besides the reserve (or gold) and credit tranches, the IMF has three permanent credit
facilities: (i) the compensatory financing facility (established in 1963 and liberalized in.
1975); (ii) the buffer stock financing facility (established in 1969); and (iii) the extended
facility (established in 1974 and expanded in’ 1983). There are other temporary facilities
created in response to specific needs such as oil price increases, and the Special
Emergency Fund created by the General Agreement to Borrow (GAB).

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Apart from the credits advanced by the IMF it gives technical aid as well to its member
countries.

It may be noted that conditions of borrowing from the IMF become more stringent with
increases in the borrowed amount. This is in consonance with the general principles of
finance where the lender (IMF) will like to be assured of security and repayment of the
sum so lent along with interest (if charged).

The IMF exercises a firm surveillance on the exchange rate policy of the member states
and adopts specific principles to guide them. In order that the system of exchange rate be
effective, the Fund recommends adoption of an anti-inflationary policy. Over the past
years, in many countries, the budget deficit had become very high which resulted in a
heavy external debt. Serious problems of adjustment were a natural consequence of such
a situation. The Fund had to incite the countries to put in place the exchange rate policies
compatible with an overall medium-term strategy of adjustment.

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The member states have adopted an exchange rate policy, varying from free floating to
pegging to a single major currency. There is no, or very little, government intervention to
maintain an exchange rate in the case of completely floating currencies. For example, the
USA, Canada and European Monetary System (EMS) as a group, axe the examples
where currency floats without any intervention. Among the currencies participating in the
EMS, a system of fixed rates exists, fluctuation being possible within a permitted range.
Of course, individual countries may abandon the agreement from time to time as did the
UK and Italy in 1992. Italy entered the EMS again in 1996.

THE INTERNATIONAL BANK FOR RECONSTRUCTION AND

DEVELOPMENT (THE WORLD BANK):

This institution was also created at the time of the creation of the IMF. Initially, its
principal role was to facilitate the reconstruction of the countries affected by the Second
World War and to aid these countries to develop their economies. The IBRD has two
other associated institutions, namely the International Finance Corporation (IFC) and the
Interactional Development Association (IDA), established in 1956 and 1960 respectively.

The Role of the IBRD:

The IBRD accords debt financing of long-term, for periods up to 15-20 years. Financing
is done for (i) the development of infrastructure such as roads, rail, telecommunications,
(ii) the development of energy resources, electricity, gas and petrol; (iii) the regional
development programmes, irrigation projects, agricultural development, education, and
the projects to promote investments in small and medium enterprises.

The Bank also gives technical assistance. It participates in numerous research projects
and economic studies with other organizations to finance the projects in different fields
such as education, health and agriculture.

Loans are provided to governments or to enterprises with their government as guarantoit

The projects should he economically viable and the income generated should suffice to
refund the loan within the prescribed time limits. Interest rates are contingent to the rates
of the Bank’s borrowing.

The Resources of the IBRD:

Every member country subscribes to the fixed capital of the Bank. Member’s share is
payable in two parts:

• The first corresponds to a deposit of 10 per cent-1 per cent payable in gold or US
dollars and 9 per cent in national currency;

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• The second corresponds to a deferred deposit of 90 per cent. This represents a
commitment to respond to the eventual needs of the Bank.

The Bank can also issue bonds on principal financial markets. Bonds are issued either in
US dollars or in currency of some other countries. Duration of these bonds varies from 6
to 35 years.

Affiliated Institutions:

International Finance Corporation (1FC):

It was established in 1956. Its role is to encourage private sector in developing countries.
It lends without government guarantees and may participate in the capital of certain
institutions. Loan periods may vary from 5 to 15 years and interest rates conform to that
of the market:

International Development Association (IDA):

Created in 1960, its role is to lend to the poorest countries, with conditions that Jo not
weigh heavily on the balance of payments. Most loans are for a period of 50 years, with
the rate of interest being very low or nil. Loans are refused in the currency of the
borrowing county. Credits of the IDA are accorded only to the governments.

THE INTERNATIONAL MONETARY SYSTEM SINCE 1971:

The system of Bretton Woods worked satisfactorily for many years but difficulties started
from 1958 when the trade balances of the USA became highly negative and a very large
amount of US dollars was held outside the USA; it was more than the total gold holdings
of the USA. Anticipating a devaluation of the US dollar, speculators bought gold while
other governments demanded conversion of US dollars into gold.

To remedy this situation, a ‘gold pool’ was established with the cooperation of the UK,
France, Germany, Italy, Belgium, the Netherlands and Switzerland. The gold pool was
used to sell gold to maintain its price at $ 35 per ounce. In return, the USA was expected
to improve its external trade.

But since the US could not reduce its trade deficit, some of the European countries started
demanding again for conversion of their dollar holdings into gold. Finally, the ‘gold pool’
arrangement broke down. Eventually, a series of devaluations and speculations led to
breaking down of the fixed rate system of Bretton Woods.

On 15 August 1971, President Nixon of the USA suspended the system of convertibility
of gold and dollar. For some time, the system of fixed-rates with an adjustment margin of
± 2.5 per cent was tried but did not work. Finally, the fixed rate system was abandoned
and the floating rate system came into effect.

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In December 1971, the Smithsonian Agreement was signed at Washington; its major
features were as follows:

• Devaluation of the dollar and reevaluation of other currencies; gold passed from $ 35
per ounce to $ 38;

• New fluctuation margins: changing from ± I per cent to ± 2.25 per cenq

• Non-convertibility of the dollar.

In 1973, another devaluation of the dollar took place. Petrol shock added to the
international monetary crisis. Exchange rates became volatile.

In 1976, Jamaica Agreements were signed focusing on the:

• Legalization of the floating exchange rate;

• Demonetization of gold as the currency of reserves.

Thus, the part of quota which was hitherto required to be deposited in gold could be
deposited in foreign exchange. At the same time, the IMF sold one-third of its gold
reserves.

Tn 1977 and 1978, in the wake- of inflation in the USA, the dollar further depreciated
The Federal Reserve practised a strict monetary policy. Between 1980 and 1985, the
dollar appreciated but at the same time the American BOP situation deteriorated.

Now, the members of G-7 (G-7 consists of Canada, France, Germany, Italy, Japan, UK,
USA) meet from time to rime to coordinate the policies so that exchange rate stability can
be maintained. But, this coordination is not always successful. Nevertheless, their
meeting regularly has an effect of avoiding protectionist tendencies on the part of any one
or more of them.