International Financial Management

There are various factors on which MNCs or international business depends and one of the major factors is financial markets, or better way of saying is efficient and effective international financial markets. Effective and efficient international financial markets are crucial not only for the largest MNCs in the world but also for the small- and medium- sized enterprises. MNCs rely on international financial markets because these companies must be aware of how their foreign competitors will be affected by movements in exchange rates, foreign interest rates, labor costs and inflation. These factors highly affect the economic policies of a firm.

 After getting a basic idea what does international business look like and how it is connected with international financial markets, it is logical to go deeper into understanding of these markets.

International Financial Markets

Mishkin F.S. in his book states that “many economists view markets as an ideal mechanism for allocating recourses”. Having analyzed several close definitions of financial markets (Madura & Fox, (2007) and Mishkin, (1989)) we determined financial markets as markets in which funds are transferred from those who have excess funds available (lenders) to those who have a shortage (borrowers). Funds could be channelled through direct or indirect finance. Direct finance assumes that there are no intermediaries between borrowers and lenders in financial markets (Mishkin, 1989).

Financial markets play a crucial role in economy and there are several reasons for that. First of all they help individuals with investment opportunities to capitalize on funds from persons who don’t have such opportunities. Secondly, they improve the wealth-being of customers by permitting them to time their purchases.  As a result financial markets, which are operating efficiently, contribute to higher production and efficiency of the overall economy, hence the economic welfare of everyone in the society. (Mishkin, 1989).

Frederic Mishkin in his book suggested several classifications of financial markets according to their structure. Thus, we can distinguish Debt and Equity Markets (two main ways of raising capital, through issuing a debt instrument such as a bond or a mortgage or by issuing equities such as common stock), Primary and Secondary Markets (the initial selling of the new issues of a security to a buyers takes place at the Primary market they could be than resold on the Secondary market) Exchanges and over-the-country Markets (we can distinguish organized markets or exchanges and unorganized ones or over-the-country markets) Money and Capital Markets (short-term debt instruments are traded on the Money market, long-term debt and equity instruments are traded on the Capital market).  (Mishkin, 1989)

The development of international business and emerge of Multinational Corporations contributed greatly into the expansion of international financial markets. The main reason behind this was that investors and creditors discovered that they could generate more money and transfer their financial risks by speculating on foreign country’s favourable economic conditions. (Madura & Fox, 2007)

Today we can single out five main international arenas for investors and creditors to operate, namely:

1. International bond market
2. International stock market
3. Foreign exchange market - “The trading of currencies and bank deposits denominated in particular currency takes place in the foreign exchange market” (Mishkin, 1989) The main purpose of the foreign exchange market is to facilitate international trade and financial transactions. This is achieved by allowing currencies to be exchanged. This market is organized as over-the-country market and is heavily regulated by government which sharply distinguishes it from any other market. The reason behind that is simple the change of the currency effects on all good’s prices denominated in that currency). (Madura & Fox, 2007)
4. International money market
5. International credit market

Below, there are specific examples of how particular forms of international business such as export/import and FDI can be influenced by financial markets.

How currency fluctuations affect importers and exporters

In current scenario, there is a huge volatility in FX markets. This volatility can work against both, an importer and an exporter.

Importers: If a payment in a foreign currency has to be made at a future date. There is no way to guarantee that the price in the currency market will be the same in the future; it is quite possible that the price will move against the company, making the payment cost more and reducing margin for the importer. On the other hand, the market can also move in a business' favour, making the payment cost less in terms of their home currency.

Exporters: Generally, firms that export goods to other countries benefit when their home currency depreciates, since their products become cheaper in other countries. Firms that import from other countries benefit when their currency becomes stronger, since it enables them to purchase more.

If an export/import company conducts business in a volatile market, it is exposed to a higher degree of currency rate risk. Sudden changes can be disastrous for a company that does not plan ahead by detracting from its bottom line.

Foreign Direct Investment

“Foreign direct investment is investment of foreign assets into domestic structures, equipment, and organizations. It does not include foreign investment into the stock markets.” (About.com)

One of the best examples of FDI is the evolution of Nike Inc. In 1962 Phil Knight, a business student at Stanford’s business school had a better idea on how a US firm could use Japanese technology to break the German dominance of the athletic shoe industry in the United States. Knight signed an agreement with a Japanese company Unitsuka Tiger Shoe Company to produce shoes in Japan and sold it in US under the name Blue Ribbon Sports (BRS). In 1972, Knight exported his shoes to various countries like Canada, Australia. He licensed factories in Taiwan and Korea to produce athletic shoes and then sold in Asian countries. In 1978, BRS became Nike Inc. and began to export shoes to various parts of Europe (Nike.com). As a result of exporting and FDI, Nike’s international sales reached $1 billion by 1992 and were about $6 billion by 2008 (Findarticles.com).

In our opinion, Nike achieved the above figures because of investing in different financial markets across the globe. Has it been a poor economy in say, Korea or Taiwan, it could not have managed to sell its products in Asian countries. Hence, it is very much true that the one of major factors in success of Nike was efficient and effective financial markets.

Valuation of cash flows for an international business (Eun & Resnick, 2007)

Exhibit 2: Foreign cash flow of a MNC (Madura & Fox, 2007)

 The risk pie for the MNC’s is bigger than the domestic companies. Their valuation model depends on various factors like different economies and value of exchange rates. These factors affect the revenues and costs. The model of evaluating cash flows for an international business can be defined as –

ECFh = ∑ (ECFf) X (FX-R)

ECFh = Expected cash flow in home currency

(ECFf) = Expected cash flow in foreign currency

(FX-R) = Foreign exchange rate

 

Therefore, Value of a firm can be stated as -

V = ECFh / (1+R) T

V = Value of the firm

R = rate of return or risk

T = time period

Value of firm depends on the present value of future expected cash flows. If GBP is depreciating in comparison with EURO then the value of firm today is less than what we calculated. Foreign exchange is dependent on the economy of the country and thus depends on the financial markets. Thus, it can be concluded that the foreign exchange rates play an important role in the value of the firm or alternatively in determining how an international business is doing.

As long as global collaboration generates millions of dollars towards everyone’s welfare, it may also show its backside.  When tough times come and poor management and over liberal financial system cause an economy of one particular country to suffer from credit shortages, almost anyone on the globe has to pull in their belts.

Current Financial Crisis

Ongoing global financial crisis was triggered by the bursting of a bubble in the US sub-prime-mortgage market which led to extensive mortgage foreclosures in the United States, with severe consequences for banks and financial markets throughout the world in addition to rising of oil and food prices. The crisis which became apparent only now, has revealed a bunch of weaknesses in global financial system.

Buchanan (2008) says that common financial incentives persuade people to strive for their own short-term benefit, while saddling someone else with longer-term risks. In the case of the sub-prime mortgage market, for instance, brokers were collecting commissions on mortgages that required no deposit and no proof of income. Since the brokers were not lending their own money, it was for them a risk-free business. Meanwhile, investment banks took on these risky loans and merged them together into "collateralized debt obligations" (CDOs). Once the risks were safely made unclear, the banks were able to sell the CDOs on at a healthy profit. But suddenly, careless lending turned its back to investors forcing the whole domino pyramid into ruins. It seems like innovations in financial system such as CDOs were first met without trust, then were facing unprecedented demand and finally made a trap for their creators causing global economic downfall; and this is cyclical dependence. Careless lending of one financial system caused global shortage of credits, leaving business without vital cash inflows which in their turn are wanted by financial institutions which are now really picky in their investment decisions.

Tumbling dollar (Economist.com)

But even before the US sub-prime mortgage market ruined causing massive credit crunch, there were apparent signs that something is wrong with US financial markets.

The mighty status enjoyed by dollar as an international reserve currency over half a century is under attack as never before. Since early 2002, dollar has fallen in alarming proportions for most of the major currencies in the world as depicted in the graph underneath. Notably, the drop against Euro (35%) and Pound Sterling (29%) is the steepest.

Exhibit 3: The dollar decline

As a result, the global financial system is under immense strain because there is an increasing fear of losing money in a depreciating currency. For instance, in 2005 Q3, the dollar’s share in foreign exchange reserves was almost three times larger than the euro’s but has fallen from 71% in 2001 to 66 ½ % in 2005 (IMF, 2006).  Moreover, Russia’s currency basket peg is split 60-40 between US dollar and European single currency highlighting the need of an alternate currency (IMF, 2004).

The implications of weakening dollar are far reaching not only for America and its businesses but also for other nations. For that reason, American businesses are finding difficult to raise capital overseas because of speculations on the looming recession and at the same time imports are becoming expensive for US raising doubts over slackening world trade (Business Week, 2001). Consider the following examples on this issue:

Impact of tumbling dollar on Indian economy

India entered the export market in mid-80s to cover its import costs. However, this could not last long because of rise in oil prices in 80s. Due to which there was a huge gap in India’s balance of payment (BOP). BOP is a record of the economic and financial transactions that take place over a specified time period for a given country in the form of double entry book-keeping. Exports and FDI contributed to FX markets and thus helped in reducing the BOP gap.

The consequences were Indian rupee appreciating with respect to US dollars or US dollars depreciating against Indian rupees. During the periods when the dollar was moving high against the rupee, exporters stood to gain, when $1 = Rs. 48, was getting them Rs. 4800 for every $100. Since the beginning of the year 2007, rupee appreciated by about 10%. With its value of rupee Rs. 39.35 = $1 as on 16 Nov 2007, for every $100, exporters would get only Rs. 3935. Dollar depreciation affected the profit margins for BPOs and exporters. (Chillibreeze.com)

On the other hand, importers were benefited from the rupee appreciation. With the same scenario as given for export, an importer is paying Rs. 3935 now instead of Rs. 4800 paid during yester years for every $100. This gain on FX is likely to create savings in cost, which could be passed on to consumers, thereby contributing to control inflation. (Chillibreeze.com)

Conclusively, appreciation and depreciation of rupee cannot certainly be taken as beneficial to the Indian economy in general. On one hand the rupee appreciation will affect exporters, BPOs, etc., on the other, rupee depreciation will affect importers. Thus the international business really depends on the US financial markets.

Sea food trading in Japan (Allbusiness.com)

While the yen has stabilized against the dollar recently, exporters to the Japanese market are not likely to benefit from any further strengthening this year. As far as M. Yoshioka can see, the cost of sea foods "will inevitably increase because of the weakening yen." And if history is a guide, that does not bode well for increased sales of fishery products.

Yoshioka's address focused on the effects of currency fluctuations on the Japanese seafood trade over the past decade. Noting that overall imports have increased 2.6 times since 1980, he pointed out that seafood purchases from abroad have multiplied by an even greater factor of 3.5, reaching a value of $10 billion two years ago. Volume has risen from 1 million metric tons to 2.4 million during the last 10 years. The growth of imports is not only influenced by the impact of supply and demand on price, but also by shifts in foreign exchange values - particularly as regards the yen and dollar. With the yen's remarkable appreciation since the autumn of 1985, imports of seafood and other products gained rapidly.

The sea-food business for Mr. Yoshioka is clearly dependent on the financial markets of Japan and US. If the markets remain efficient and effective, we can experience continuing development in the sea-food business viz-a-viz international business.

Cadbury Schweppes plc

Effect of exchange rates and inflation on 2004 reported results Over 80% of the Group’s sales and profits in 2004 were generated outside the United Kingdom. The Group’s reported results have been affected by changes in the exchange rates used to translate the results of non-UK operations. In 2004 compared with 2003, the biggest exchange rate impact on the Group’s results was the 12% weakening of the US dollar followed by the weakening Mexican Peso, which fell by 16%. The weakness in the US dollar was partially offset by the Canadian dollar (up 4%) and the Australian dollar (up 2%). The overall impact of exchange rate movements on the Group’s Profit and Loss statement and free cash flow generation was adverse and is shown separately. In 2004, movements in exchange rates, primarily the US dollar reduced the Group’s sales by 4%, underlying pre-tax profit by 7% and underlying earnings per share by 7%. There was a greater impact on underlying operating profit than turnover as the Group generated higher profits in the currencies that have weakened during the year compared to those that have strengthened. The adverse impact of currency movements on free cash flow was 16%. The reason for the greater impact on free cash flow relative to profits was due to the higher margin generation of US Dollar sales in the Americas beverages region.

Conclusion

In our work we have reviewed an understanding of what is meant by International Business, Financial Markets and current economic crises and how and why we can observe the interaction between these three. Through the examples provided in the last part of the essay we attempted to reveal that the development of international business is depended on effective and efficient financial markets as well as market efficiency is defined by strong and rational management of MNCs.

One of the major reasons behind the current US financial crisis was poor management of MNCs, as the mortgage loans were given like pennies. Due to this negligence and when home prices started to go down and a year or so later, borrowers of subprime mortgages started to default on their loans, the financial system became unstable. Thus due to instability of the US economy we are facing problems in all international businesses across the globe. Thus we can conclude - international business and financial markets are a part of vicious circle. They are mutually dependent and working of one depends and affects both the working of other.  

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