Global Capital Markets
5Current Multinational Challenges and the Global Economy CHAPTER 1
additional securities have been created from the existing securities—derivatives, whose value is based on market value changes in the underlying securities. The health and security of the global financial system relies on the quality of these assets.
Institutions. The institutions of global finance are the central banks, which create and control each country’s money supply; the commercial banks, which take deposits and extend loans to businesses, both local and global; and the multitude of other financial institutions created to trade securities and derivatives. These institutions take many shapes and are subject to many different regulatory frameworks. The health and security of the global financial system relies on the stability of these financial institutions.
Linkages. The links between the financial institutions, the actual fluid or medium for exchange, are the interbank networks using currency. The ready exchange of currencies in the global marketplace is the first and foremost necessary element for the conduct of financial trading, and the global currency markets are the largest markets in the world. The exchange of currencies, and the subsequent exchange of all other securities globally via currency, is the international interbank network. This network, whose primary price is the London Interbank Offered Rate (LIBOR), is the core component of the global financial system.
The movement of capital across borders and continents for the conduct of business has existed in many different forms for thousands of years. Yet, it is only within the past 50 years that these capital movements have started to move at the pace of an electron, either via a phone call or an email. And it is only within the past 20 years that this market has been able to reach the most distant corners of the earth at any moment of the day. This market has seen an explosion of innovative products and services in the past decade, some of which proved, as in the case of the 2008–2009 crisis, somewhat toxic to the touch.
The Market for Currencies The price of any one country’s currency in terms of another country’s currency is called a foreign currency exchange rate. For example, the exchange rate between the U.S. dollar ($ or USD) and the European euro (€ or EUR) may be stated as “1.4565 dollar per euro” or simply abbreviated as $1.4565/€. This is the same exchange rate as when stated “EUR1.00 = USD1.4565.” Since most international business activities require at least one of the two parties in a business transaction to either pay or receive payment in a currency, which is dif- ferent from their own, an understanding of exchange rates is critical to the conduct of global business.
A quick word about currency symbols. As noted, USD and EUR are often used as the symbols for the U.S. dollar and the European Union’s euro. These are the computer sym- bols (ISO-4217 codes) used today on the world’s digital networks. The field of international finance, however, has a rich history of using a variety of different symbols in the financial press, and a variety of different abbreviations are commonly used. For example, the British pound sterling may be £ (the pound symbol), GBP (Great Britain pound), STG (British pound sterling), ST£ (pound sterling), or UKL (United Kingdom pound). This book will also use the simpler common symbols—the $ (dollar), the € (euro), the ¥ (yen), the £ (pound)—but be warned and watchful when reading the business press!
Exchange Rate Quotations and Terminology. Exhibit 1.2 lists currency exchange rates for Thursday, January 12, 2012, as would be quoted in New York or London. The exchange rate listed is for a specific country’s currency—for example, the Argentina peso against the U.S. dollar—Peso 3.9713/$, the European euro—Peso $5.1767/€, and the British pound—Peso 6.1473/£. The rate listed is termed a “mid-rate” because it is the middle or average of the rates currency traders buy currency (bid rate) and sell currency (offer rate).
EXHIBIT 1.2 Selected Global Currency Exchange Rates
January 12, 2012 Country Currency Symbol Code
Currency to equal 1 Dollar
Currency to equal 1 Euro
Currency to equal 1 Pound
Argentina peso Ps ARS 4.3090 5.5143 6.6010
Australia dollar A$ AUD 0.9689 1.2413 1.4859
Bahrain dinar — BHD 0.3770 0.4825 0.5776
Bolivia boliviano Bs BOB 6.9100 8.8428 10.5855
Brazil real R$ BRL 1.7874 2.2873 2.7380
Canada dollar C$ CAD 1.0206 1.3061 1.5635
Chile peso $ CLP 502.050 642.473 769.090
China yuan ¥ CNY 6.3178 8.0849 9.6783
Colombia peso Col$ COP 1,843.30 2,358.87 2,823.75
Costa Rica colon C// CRC 508.610 650.869 779.141
Czech Republic koruna Kc CZK 20.0024 25.5970 30.6416
Denmark krone Dkr DKK 5.8114 7.4368 8.9024
Egypt pound £ EGP 6.0395 7.7288 9.2519
Hong Kong dollar HK$ HKD 7.7679 9.9405 11.8996
Hungary forint Ft HUF 241.393 308.910 369.789
India rupee Rs INR 51.6050 66.0389 79.0537
Indonesia rupiah Rp IDR 9,160.0 11,722.1 14,032.2
Iran rial — IRR 84.5000 231.8950 89.1256
Israel shekel Shk ILS 3.8312 4.9027 5.8690
Japan yen ¥ JPY 76.7550 98.2234 117.581
Kenya shilling KSh KES 87.6000 112.102 134.195
Kuwait dinar — KWD 0.2793 0.3574 0.4278
Malaysia ringgit RM MYR 3.1415 4.0202 4.8125
Mexico new peso $ MXN 13.5964 17.3993 20.8283
New Zealand dollar NZ$ NZD 1.2616 1.6145 1.9327
Nigeria naira N NGN 162.050 207.375 248.244
Norway krone NKr NOK 6.0033 7.6824 9.1965
Pakistan rupee Rs. PKR 90.1050 115.3070 138.0320
Peru new sol S/. PEN 2.6925 3.4456 4.1247
Phillippines peso P PHP 44.0550 56.3772 67.4879
Poland zloty — PLN 3.4543 4.4204 5.2916
Romania new leu L RON 3.3924 4.3425 5.1983
Russia ruble R RUB 31.6182 40.4618 48.4360
Saudi Arabia riyal SR SAR 3.7504 4.7994 5.7452
Singapore dollar S$ SGD 1.2909 1.6520 1.9775
South Africa rand R ZAR 8.0743 10.3326 12.3690
South Korea won W KRW 1,158.10 1,482.02 1,774.09
Sweden krona SKr SEK 6.9311 8.8698 10.6178
Switzerland franc Fr. CHF 0.9460 1.2106 1.4492
Taiwan dollar T$ TWD 29.9535 38.3315 45.8858
Thailand baht B THB 31.8300 40.7329 48.7604
Tunisia dinar DT TND 1.5184 1.9431 2.3261
Turkey lira YTL TRY 1.8524 2.3706 2.8377
United Arab Emirates
dirham — AED 3.6733 4.7007 5.6271
United Kingdom pound £ GBP 1.5319 0.8354
Ukraine hrywnja — UAH 8.0400 10.2888 12.3165
Uruguay peso $U UYU 19.4500 24.8902 29.7955
United States dollar $ USD 1.2797 1.5319
Venezuela bolivar fuerte Bs VEB 4.2947 5.4959 6.5790
Vietnam dong d VND 21,035.0 26,918.5 32,223.5
Euro euro € EUR 1.2797 1.1971
Special Drawing Right
— — SDR 0.6541 0.8370 1.0019
Note that a number of different currencies use the same symbol (for example both China and Japan have traditionally used the ¥ symbol, yen or yuan, meaning round or circle). That is one of the reasons why most of the world’s currency markets today use the three-digit currency code for clarity of quo- tation. All quotes are mid-rates, and are drawn from the Financial Times, January 12, 2012.
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7Current Multinational Challenges and the Global Economy CHAPTER 1
The U.S. dollar has been the focal point of most currency trading since the 1940s. As a result, most of the world’s currencies have been quoted against the dollar—Mexican pesos per dollar, Brazilian real per dollar, Hong Kong dollars per dollar, etc. This quotation convention is also followed against the world’s major currencies as listed in Exhibit 1.2. For example, the Japanese yen is commonly quoted as ¥83.2200/$, ¥108.481/€, and ¥128.820/£.
Quotation Conventions. Several of the world’s major currency exchange rates, however, fol- low a specific quotation convention that is the result of tradition and history. The exchange rate between the U.S. dollar and the euro is always quoted as “dollars per euro” ($/€), $1.3036/€ as listed in Exhibit 1.2. Similarly, the exchange rate between the U.S. dollar and the British pound is always quoted as $/£, for example, the $1.5480/£ listed under “United States” in Exhibit 1.2. Many countries that were formerly members of the British Commonwealth will commonly be quoted against the dollar as U.S. dollars per currency (e.g., the Australian or Canadian dollars).
Eurocurrencies and LIBOR One of the major linkages of global money and capital markets is the Eurocurrency market and its interest rate known as LIBOR. Eurocurrencies are domestic currencies of one country on deposit in a second country. Eurodollar time deposit maturities range from call money and overnight funds to longer periods. Certificates of deposit are usually for three months or more and in million-dollar increments. A Eurodollar deposit is not a demand deposit; it is not created on the bank’s books by writing loans against required fractional reserves, and it can- not be transferred by a check drawn on the bank having the deposit. Eurodollar deposits are transferred by wire or cable transfer of an underlying balance held in a correspondent bank located within the United States. In most countries, a domestic analogy would be the transfer of deposits held in nonbank savings associations. These are transferred by the association writing its own check on a commercial bank.
Any convertible currency can exist in “Euro-” form. Note that this use of “Euro-” should not be confused with the new common European currency called the euro. The Eurocur- rency market includes Eurosterling (British pounds deposited outside the United Kingdom); Euroeuros (euros on deposit outside the euro zone); Euroyen (Japanese yen deposited outside Japan) and Eurodollars (U.S. dollars deposited outside the United States). The exact size of the Eurocurrency market is difficult to measure because it varies with daily decisions made by depositors about where to hold readily transferable liquid funds, and particularly on whether to deposit dollars within or outside the United States.
Eurocurrency markets serve two valuable purposes: 1) Eurocurrency deposits are an effi- cient and convenient money market device for holding excess corporate liquidity; and 2) the Eurocurrency market is a major source of short-term bank loans to finance corporate working capital needs, including the financing of imports and exports.
Banks in which Eurocurrencies are deposited are called Eurobanks. A Eurobank is a financial intermediary that simultaneously bids for time deposits and makes loans in a currency other than that of the currency in which it is located. Eurobanks are major world banks that conduct a Eurocurrency business in addition to all other banking functions. Thus, the Eurocurrency operation that qualifies a bank for the name Eurobank is in fact a department of a large commercial bank, and the name springs from the performance of this function.
The modern Eurocurrency market was born shortly after World War II. Eastern Euro- pean holders of dollars, including the various state trading banks of the Soviet Union, were afraid to deposit their dollar holdings in the United States because these deposits might be attached by U.S. residents with claims against communist governments. Therefore, Eastern
8 CHAPTER 1 Current Multinational Challenges and the Global Economy
European holders deposited their dollars in Western Europe, particularly with two Soviet banks: the Moscow Narodny Bank in London, and the Banque Commerciale pour l’Europe du Nord in Paris. These banks redeposited the funds in other Western banks, especially in London. Additional dollar deposits were received from various central banks in Western Europe, which elected to hold part of their dollar reserves in this form to obtain a higher yield. Commercial banks also placed their dollar balances in the market because specific maturities could be negotiated in the Eurodollar market. Such companies found it financially advanta- geous to keep their dollar reserves in the higher-yielding Eurodollar market. Various holders of international refugee funds also supplied funds.
Although the basic causes of the growth of the Eurocurrency market are economic effi- ciencies, many unique institutional events during the 1950s and 1960s helped its growth.
! In 1957, British monetary authorities responded to a weakening of the pound by imposing tight controls on U.K. bank lending in sterling to nonresidents of the United Kingdom. Encouraged by the Bank of England, U.K. banks turned to dollar lending as the only alternative that would allow them to maintain their leading position in world finance. For this they needed dollar deposits.
! Although New York was “home base” for the dollar and had a large domestic money and capital market, international trading in the dollar centered in London because of that city’s expertise in international monetary matters and its proximity in time and distance to major customers.
! Additional support for a European-based dollar market came from the balance of payments difficulties of the U.S. during the 1960s, which temporarily segmented the U.S. domestic capital market.
Ultimately, however, the Eurocurrency market continues to thrive because it is a large international money market relatively free from governmental regulation and interference.
Eurocurrency Interest Rates: LIBOR. In the Eurocurrency market, the reference rate of interest is LIBOR—the London Interbank Offered Rate. LIBOR is now the most widely accepted rate of interest used in standardized quotations, loan agreements or financial deriva- tives valuations. LIBOR is officially defined by the British Bankers Association (BBA). For example, U.S. dollar LIBOR is the mean of 16 multinational banks’ interbank offered rates as sampled by the BBA at 11 A.M. London time in London. Similarly, the BBA calculates the Japanese yen LIBOR, euro LIBOR, and other currency LIBOR rates at the same time in London from samples of banks.
The interbank interest rate is not, however, confined to London. Most major domes- tic financial centers construct their own interbank offered rates for local loan agreements. These rates include PIBOR (Paris Interbank Offered Rate), MIBOR (Madrid Interbank Offered Rate), SIBOR (Singapore Interbank Offered Rate), and FIBOR (Frankfurt Inter- bank Offered Rate), to name but a few.
The key factor attracting both depositors and borrowers to the Eurocurrency loan market is the narrow interest rate spread within that market. The difference between deposit and loan rates is often less than 1%. Interest spreads in the Eurocurrency market are small for many reasons. Low lending rates exist because the Eurocurrency market is a wholesale market, where deposits and loans are made in amounts of $500,000 or more on an unsecured basis. Borrowers are usually large corporations or government entities that qualify for low rates because of their credit standing and because the transaction size is large. In addition, overhead assigned to the Eurocurrency operation by participating banks is small.
Deposit rates are higher in the Eurocurrency markets than in most domestic currency markets because the financial institutions offering Eurocurrency activities are not subject to
9Current Multinational Challenges and the Global Economy CHAPTER 1
many of the regulations and reserve requirements imposed on traditional domestic banks and banking activities. With these costs removed, rates are subject to more competitive pressures, deposit rates are higher, and loan rates are lower. A second major area of cost avoided in the Eurocurrency markets is the payment of deposit insurance fees (such as the Federal Deposit Insurance Corporation, FDIC, and assessments paid on deposits in the United States).
The Theory of Comparative Advantage The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect competition, no uncertainty, cost- less information, and no government interference. The theory’s origins lie in the work of Adam Smith, and particularly with his seminal book The Wealth of Nations published in 1776. Smith sought to explain why the division of labor in productive activities, and subsequently inter- national trade of those goods, increased the quality of life for all citizens. Smith based his work on the concept of absolute advantage, where every country should specialize in the production of that good it was uniquely suited for. More would be produced for less. Thus, by each country specializing in products for which it possessed absolute advantage, countries could produce more in total and exchange products—trade—for goods that were cheaper in price than those produced at home.
David Ricardo, in his work On the Principles of Political Economy and Taxation pub- lished in 1817, sought to take the basic ideas set down by Adam Smith a few logical steps further. Ricardo noted that even if a country possessed absolute advantage in the produc- tion of two products, it might still be relatively more efficient than the other country in one good’s product than the other. Ricardo termed this comparative advantage. Each country would then possess comparative advantage in the production of one of the two products, and both countries would then benefit by specializing completely in one product and trad- ing for the other.
Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for a variety of reasons. Countries do not appear to specialize only in those products that could be most efficiently produced by that country’s particular factors of production. Instead, governments interfere with com- parative advantage for a variety of economic and political reasons, such as to achieve full employment, economic development, national self-sufficiency in defense-related industries, and protection of an agricultural sector’s way of life. Government interference takes the form of tariffs, quotas, and other non-tariff restrictions.
At least two of the factors of production, capital and technology, now flow directly and easily between countries, rather than only indirectly through traded goods and services. This direct flow occurs between related subsidiaries and affiliates of multinational firms, as well as between unrelated firms via loans, and license and management contracts. Even labor flows between countries such as immigrants into the United States (legal and illegal), immigrants within the European Union, and other unions.
Modern factors of production are more numerous than in this simple model. Factors considered in the location of production facilities worldwide include local and managerial skills, a dependable legal structure for settling contract disputes, research and development competence, educational levels of available workers, energy resources, consumer demand for brand name goods, mineral and raw material availability, access to capital, tax differentials, supporting infrastructure (roads, ports, and communication facilities), and possibly others.
Although the terms of trade are ultimately determined by supply and demand, the process by which the terms are set is different from that visualized in traditional trade theory. They are determined partly by administered pricing in oligopolistic markets.
10 CHAPTER 1 Current Multinational Challenges and the Global Economy
Comparative advantage shifts over time as less developed countries become more devel- oped and realize their latent opportunities. For example, over the past 150 years comparative advantage in producing cotton textiles has shifted from the United Kingdom to the United States, to Japan, to Hong Kong, to Taiwan, and to China. The classical model of comparative advantage also did not really address certain other issues such as the effect of uncertainty and information costs, the role of differentiated products in imperfectly competitive markets, and economies of scale.
Nevertheless, although the world is a long way from the classical trade model, the general principle of comparative advantage is still valid. The closer the world gets to true international specialization, the more world production and consumption can be increased, provided the problem of equitable distribution of the benefits can be solved to the satisfaction of consum- ers, producers, and political leaders. Complete specialization, however, remains an unrealistic limiting case, just as perfect competition is a limiting case in microeconomic theory.
Global Outsourcing of Comparative Advantage Comparative advantage is still a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of both MNEs and domestic firms. The comparative advantage of the twenty-first century, however, is one that is based more on services, and their cross border facilitation by telecommunications and the Internet. The source of a nation’s comparative advantage, however, still is created from the mixture of its own labor skills, access to capital, and technology. Many locations for supply chain outsourcing exist today.
Exhibit 1.3 presents a geographical overview of this modern reincarnation of trade-based comparative advantage. To prove that these countries should specialize in the activities shown you would need to know how costly the same activities would be in the countries that are
China
Eastern Europe
Russia Philippines
Mexico
Costa Rica South Africa
United States
IndiaMonterrey
Guadalajara
Shanghai
London
Paris
Berlin Budapest
Moscow
San Jose
Johannesburg Bombay Hyderabad Bangalore
Manila
MNEs based in many industrial countries are outsourcing intellectual functions to providers based in traditional emerging market countries.