Management Consulting/INTERNATIONAL FINANCIAL MANAGEMENT
1. The International financial flows will have an impact on the structure of balance of payment.” Give your view on this statement.
2. Identify and explain the reasons for the differences in the cost of capital across various countries and discuss about the cut off rate of foreign projects determination.
Request you to respond ASAP. Thanks in advance.
“The International financial flows will have an impact on the structure of balance of payment.” Give your view on this statement.
The current account, the capital account and the financial account make up a country's balance of payments (BOP). Together, these three accounts tell a story about the state of an economy, its economic outlook and its strategies for achieving its desired goals. A large volume of imports and exports, for example, can indicate an open economy that supports free trade. On the other hand, a country that shows little international activity in its capital or financial account may have an underdeveloped capital market and little foreign currency entering the country in the form of foreign direct investment.
Here we focus on the capital and financial accounts, which tell the story of investment and capital market regulations within a given country.
The Capital and Financial Accounts
Along with transactions pertaining to non-financial and non-produced assets, the capital account relates to dealings including debt forgiveness, the transfer of goods and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets, the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, patents, copyrights, royalties and uninsured damage to fixed assets.
Detailed in the financial account are government-owned assets (i.e., special drawing rights at the International Monetary Fund (IMF) or foreign reserves), private sector assets held in other countries, local assets held by foreigners (government and private), foreign direct investment, global monetary flows related to investment in business, real estate, bonds and stocks.
Capital that is transferred out of a country for the purpose of investing is recorded as a debit in either of these two accounts. This is because money is leaving the economy. However, because it is an investment, there is an implied return. This return - whether a capital gain from portfolio investment (a debit under the financial account) or a return made from direct investment (a debit under the capital account) - is recorded as a credit in the current account (this is where income investment is recorded in the BOP). The opposite is true when a country receives capital: paying a return on a said investment would be noted as a debit in the current account.
What Does This Mean?
Theoretically, the BOP should be zero. Thus, the current account on one side and the capital and financial account on the other should balance each other out. When an economy, however, has positive capital and financial accounts (a net financial inflow), the country's debits are more than its credits (due to an increase in liabilities to other economies or a reduction of claims in other countries). This is usually in parallel with a current account deficit; an inflow of money means that the return on an investment is a debit on the current account. Thus, the economy is using world savings to meet its local investment and consumption demands. It is a net debtor to the rest of the world.
If the capital and financial accounts are negative (a net financial outflow), the country has more claims than it does liabilities either because of an increase in claims by the economy abroad or a reduction in liabilities from foreign economies. The current account should be recording a surplus at this stage, indicating that the economy is a net creditor, providing funds to the world.
The capital and financial accounts are intertwined because they both record international capital flows. In today's global economy, the unrestricted movement of capital is fundamental to ensuring world trade and eventually, according to theory, greater prosperity for all. For this to happen, however, countries are required to have "open," or "liberal" capital and financial account policies. Today, many developing economies implement as part of their economic reform program (often in conjunction with the IMF) "capital account liberalization," a process that removes restrictions on capital movement.
This unrestricted movement of capital means that governments, corporations and individuals are free to invest capital in other countries. This then paves the way not only for more foreign direct investment (FDI) into industries and development projects, but for portfolio investment in the capital market as well. Thus, companies striving for bigger markets and smaller markets seeking greater capital and domestic economic goals can expand into the international arena, resulting in a stronger global economy.
The benefits the recipient country reaps from an FDI include an inflow of foreign capital into its country as well as the sharing of technical and managerial expertise. The benefit for a company making a FDI is the ability to expand market share into a foreign economy, thus collecting greater returns. Some have argued that even the country's domestic political and macroeconomic policies become affected in a more progressive fashion because foreign companies investing in a local economy have a valued stake in the local economy's reform process. These foreign companies become "expert consultants" to the local government on policies that will facilitate businesses.
Portfolio foreign investments can encourage capital-market deregulation and stock-exchange volumes. By investing in more than one market, investors are able to diversify their portfolio risk while increasing their returns, which result from investing in an emerging market. A deepening capital market, based on a reforming local economy and a liberalization of the capital and financial accounts, can thus speed up the development of an emerging market.
From Theory to Reality: a Little Control Can Be Good
Aside from political ideologies, some sound economic theories state why some capital account control can be good. Recall the Asian financial crisis in 1997. Some Asian countries had opened up their economies to the world, and an unprecedented amount of foreign capital was crossing borders into these economies, mostly in the form of portfolio investment (a financial account credit and a current account debit). This meant that investments were short term and easy to liquidate instead of more long term and harder to dispose of quickly.
When speculation rose and panic spread throughout the region, the first thing that happened was a reversal in capital flows: money was now being pulled out of these capital markets. Asian economies now had to pay their short-term liabilities (debits in the current account) as securities were sold off before capital gains could be reaped. Not only did stock market activity suffer, but foreign reserves were depleted, local currencies depreciated and financial crises set in.
Analysts argue that financial disaster may have been less severe had there had been some capital account controls. For instance, had the amount of foreign borrowing been limited (which is a debit in the current account), short-term obligations would have been limited and the damage to the economy could have been less severe.
The Bottom Line
Lessons from the Asian financial crisis have resulted in new debates about the best way to liberalize capital and financial accounts. Indeed, the IMF and World Trade Organization have historically supported free trade in goods and services (current account liberalization) and are now faced with the complexities of capital freedom. Experience has proven, however, that without any controls a sudden reversal of capital flows can not only destroy an economy, but can also result in increased poverty for a nation.
Funds flowing into, or out of, a country on account of various types of international transactions are recorded by the monetary authorities of that country in a prescribed statement that is known as the balance of payments. You find an individual maintaining an account of his/her cash receipts and payments. A company prepares a cash-flow statement that shows incoming and outgoing of cash. Similarly, a country records the inflows and outflows of funds in a statement known as the balance of payments. In other words, balance of payments is a statement that records all different forms of funds inflow and outflow and arrives at a conclusion whether there Is a net inflow in the country / outflow out of the country influencing, in turn, the foreign exchange reserves possessed by the country.
Thus any discussion of the balance of payments embraces the explanation of what the different forms of international financial flows are and how they are recorded in the balance of payments. It also involves the discussion of whether the balance of payments experiences any disequilibrium, and if it is there, what would be the ways to make necessary adjustments. These issues form the subject-matter of the present unit. However, the learners shall be acquainted with the recent trends in India's balance of payments in order to make the discussion even more meaningful.
FORMS OF INTERNATIONAL FINANCIAL FLOWS
The various types of transactions leading to international financial flows need some discussion here. Trade flows, invisibles, foreign direct and portfolio investment, external assistance and external commercial borrowings and some short-term flows International Financial
Merchandise Trade Flows
Trade may be related to goods. Alternatively, it may be related to services. The merchandise trade has two sides. While one is export, the other is import. If India exports various goods, it will get convertible currencies and that will be an inflow of funds. On the contrary, it has to make payments in convertible currencies for the imports it makes. Thus export and import of goods lead to international financial flows.
Invisibles include, broadly, trade in services, investment income and unilateral transfers. If an Indian shipping company carries goods of a foreign exporter/importer and gets the freight charges, it will be treated as inflow of funds on account of trade in services. Similarly, if a foreign shipping company carries goods of an Indian exporter, there will be outflow of funds in form of freight charges. There are many examples of international flow of funds on account of trade in services.
Investment income relates to the receipt and payment of dividend, technical service, fees, royalty, interest on loan, etc. A foreign company operating in India remits dividend, etc. to its home country that will represent an outflow of funds. Similarly, an Indian company operating abroad remits to India the dividend and other fees that will represent inflow of funds. Likewise, payment of interest on foreign borrowings represents outflow of funds. Any receipt of interest manifests in inflow of funds.
Unilateral transfers are unidirectional. They represent international financial flows without any services rendered. If an Indian makes a gift to his/her friend in England, it will be a case of outflow of funds on account of unilateral transfer. Similarly,
large number of Indians living abroad remit a part of their income to their family members living in India. This is a case of inflow of funds on account of unilateral transfer.
Foreign investment may be of two kinds. While one is direct, the other is portfolio. Foreign direct investment (FDI) occurs when a firm moves abroad for the production of goods or provision of services and participates in the management of that company located abroad. On the contrary, foreign portfolio investment (FPI) is not at all concerned with the production of goods and rendering of services. The sole purpose of a foreign portfolio investor is to earn a return through investment in foreign securities without any intention of grabbing the voting power in the company whose securities it purchases. In case of FDI too, an investor invests in the shares of a foreign company, but the sole objective is to enjoy the voting power and thereby a say in the management of the foreign company. Thus, it is primarily the voting right that differentiates between FDI and FPI.
Whatever the forms may be, inflow of fiends occurs when a foreign investor makes investment in the country. On the contrary, outflow of funds occurs when the domestic investor invests in a foreign country.
External Assistance and External Commercial Borrowings
External assistance and external commercial borrowings are different in the sense that while the former flows normally from an official institution -bilateral or multilateral, the latter flows from international banks or other private lenders. The rate of interest in the former is usually low along with a longer maturity period. The latter carries market rate of interest and a shorter
maturity. Last but not least, external assistance is manifest often in outright grant that does not require repayment of principal/interest payment. 40 Environment International Financial
Whatever may be the difference between the two, any borrowing from abroad is treated as inflow of fiends Lending abroad, on the other hand, represents outflow of funds, However, repayment of loads is treated just the other way,
Short-term Flow of funds
Normally loans and foreign direct investment are meant for a period exceeding one year 8tit there are financial flows that occur for less than a year. Movement of funds relating to banking channels, euro notes, speculative and arbitrage activities, etc. are the examples of short=term funds that move across countries.
STRUCTURE OF BALANCE OF PAYMENTS
While recording the international financial flows in the balance of payments, a couple of norms need to be followed. One is that the structure of the balance of payments is based just on the principles of the double-entry book-keeping. It means that all the inflows of funds are put on the credit side and all the outflows of funds are debited; and ultimately, the two sides are balanced.
The second norm is that since the different forms of the financial flows vary in nature, they are to be entered accordingly in the two compartments of the balance of payments. It may be mentioned that the balance of payments statement is divided into two compartments. One is known as the current account followed by the other known as the capital account. Those transactions that represent earning or spending are recorded in the current account. For example, when a country earns foreign
exchange through export, the amount is entered in the current account. On the other hand, if' the financial flow does not represent earning, it is entered in the capital account. For example, foreign direct investment or foreign portfolio investment is entered in the capital account. Thus, it is on this basis that the different types of financial flows are recorded in the current and the capital accounts.
Prescribed Format for Recording transactions
As per the prescribed format adopted by the Reserve Bank of India (shown in Table 4.1), in the current account, first, merchandise trade is entered. Export receipts are entered on the credit side and the imports are entered on the debit side. And then, the balance is found out. The difference between the export and the import is known as the balance of trade. Excess of export over import is known as the surplus balance of trade and, on the contrary, the excess of import over export is known as the deficit balance of trade.
The second item to be entered in the current account is nothing but invisibles.
Invisibles, as mentioned earlier, include primarily:
Trade in services
There are both inflows and outflows on account of invisibles. The inflows are entered on the credit side and the outflows are entered on the debit side. However, a common practice is that only the net amount is written in the current account.
After entering the invisibles, balancing is done for the whole of the current account. This balance is known as the balance of current account. The debit side being bigger than the credit side shows a deficit balance of current account. On the contrary, the excess of credit side over the debit side for the whole of the current account shows a surplus balance of current account.
In the capital account, foreign investment -both direct and portfolio - is entered, Sometimes, a part of the investment is taken back by the investors which is known as disinvestment; The usual practice is that the disinvestment are not shown, rather the foreign investment, net of disinterments, is shown in the capital account.
Similarly, external assistance and external commercial borrowing are also shown net repayment. Here the readers must be aware of the fact the repayment is subject matter of capital account whereas the interest payment showing a sort of earning is a part of invisibles. Again, the banking capital is inclusive of both short-term and long-term funds. Short-term credits are purely short-term funds. Finally, the two sides of long-term and short-term funds are balanced that is known as balance of capital account,
After recording different forms of international financial flows in the balance of payments, the statistical discrepancy, often known as errors and omissions, is also recorded. The statistical discrepancy arises on different accounts. Firstly, it arises because of difficulties involved in collecting balance of payments data. There are different sources of data that sometimes differ in their approach. In India, the trade figures differ between those compiled by the Reserve Bank of India and those compiled by the Director-General of Commercial Intelligence and Statistics. Secondly, the movement of funds may lead or lag the transactions that they (funds) are supposed to finance. For example, goods are shipped in March, but the payments are received in April. If figures are compiled on the 31st March, the figures may differ if the shipment is the basis of collecting data from those which are based on the actual payment. Such differences lead to the emergence of statistical discrepancy. Thirdly, certain figures are derived on the basis of estimates. For example, figures for earning on travel and tourism account are estimated on the basis of sample cases. If the sample is defective, there is every possibility for the emergence of errors and omissions. Fourthly, errors and omissions are explained by unrecorded illegal transactions that may be either on debit side or on credit side or on both sides. Only the net amount is written on the balance of payments.
The Overall Balance
After the statistical discrepancy is located, the overall balance is arrived at. The overall balance represents the balancing between the credit items and the debit items appearing on the current account, capital account and the statistical discrepancy.
Official Reserves Account
If the overall balance is surplus, the surplus amount is transferred to the official reserves account that increases the foreign exchange reserves held by the monetary authorities. They comprise of monetary gold, SDR allocations by the IMF and the foreign currency assets. The foreign currency assets are normally held in the form of deposits with foreign central banks and investment in foreign government securities.
It there is deficit, an amount equivalent to the deficit is drawn from the official reserves account bringing the balance of payments into equilibrium. Again, if the amount of foreign exchange reserves is not sufficient to meet the deficit, the government approaches the Internation al Monetary Fund for the balance of payments support.
EQUILIBRIUM, DISEQUILIBRIUM AND ADJUSTMENT
Accounting and Economic Equilibrium
Since the balance of payments is constructed on the basis of double-entry book keeping, credit is always equal to debit. If debit on current account is greater than the credit side, funds flow into the country that are recorded on the credit side of the capital account. The excess of debit is wiped out. It means that the balance of payments is always in accounting equilibrium.
The accounting balance is an ex post concept. It describes what has actually happened over a specific past period. There may be accounting disequilibrium for a short period when the two sides of the autonomous flows differ in size. But in such cases, accommodating flows bring the balance of payments back to equilibrium. To make the distinction between the autonomous flow and accommodating flow more clear, it can be said that foreign investment, external assistance and commercial borrowings are autonomous capital flow because they flows in normal course of business. But when the country borrows from the International Monetary Fund to meet the overall deficit, such borrowings represent accommodating capital flow.
However, in real life, economic equilibrium is not found because the two sides of the current account are seldom equal. Rather it is the economic disequilibrium in the balance of payments that is a normal phenomenon.
Process of Adjustment
The focus of adjustment lies primary on the trade account, although the size of adjusting deficit is sometimes reduced by the net inflow on the invisibles account. There are different views on adjustment that need a brief discussion here.
The Classical Approach
The classical economists were of the view that the balance of payments was self adjusting due to the price-specie-flow mechanism. The mechanism stated that an increase in money supply raises domestic prices. Exports become uncompetitive. Export earnings drop. Foreign goods become cheaper. Imports rise. Current account balance goes deficit in the sequel. Precious metal flows outside the country in order to finance imports. As a result, quantity of money lessens that lowers the price level. Lower prices in the economy lead to greater export. Trade balance reaches back to equilibrium.
The adjustment in the balance of payments disequilibrium is thought of in terms of changes in the fixed exchange rate, that is through devaluation or upward revaluation. But its success is dependent upon the elasticity of demand for export and import.
The elasticity approach is based on partial equilibrium analysis where everything is held constant except for the effects of exchange rate changes on export or import. It is also assumed that elasticity of supply of output is infinite so that the price of export in home currency does not rise as demand increases, nor the price of import falls with a squeeze in demand for imports. Again, the approach ignores the monetary effects of variation in exchange rates.
If the elasticity of demand is greater than unity, the import bill will contract and export earnings will increase as a sequel to devaluation. Trade deficit will be removed. However, the problem is that the trade partner may also devalue its own currency as a retaliatory measure. Moreover, there may be a long lapse of time before the quantities adjust sufficiently to changes in price. Till then, trade balance will be even worse than that before devaluation.
Stem (1973) incorporated the concept of supply elasticity in the elasticity approach. Based on the figures of British exports and imports, Stem has come to a conclusion that the balance of trade should improve if:
1. Elasticity of demand for exports and imports is high and is equal to one coupled with elasticity of supply both for imports and exports which is either high or low.
2. Elasticity of demand for imports and exports is low but the elasticity of supply for imports and exports is lower.
On the contrary, if the elasticity of demand is low matched with high elasticity of supply, the balance of trade should worsen.
The Keynesian Approach
The Keynesian view takes into consideration primarily the income effect that was ignored under the elasticity approach. There are various versions of the Keynesian approach. One is the absorption approach that explains the relationship between domestic output and trade balance and conceives of adjustment. Sidney A. Alexander (1959) treats balance of trade as a residual given by the difference between what the economy produces and what it takes for domestic use or what it absorbs. He begins with the contention that the total output, Y is equal to the sum of consumption, C, investment, I, government spending, G, and net export (X-M). In form of an equation,
Substituting C +l+ G by absorption, A, it can be rewritten as:
This means that the amount, by which total output exceeds total spending or absorption is represented by export over import or the net export which means a surplus balance of
trade. This also means that if A > Y, deficit balance of trade will occur. This is because excess absorption in absence of desired output will cause imports. Thus in order to bring equilibrium in the balance of trade, the government has to increase output or income. Increase in income without corresponding and equal increase in absorption will lead to improvement in balance of trade.
In case of full employment, where resources are fully employed, output cannot be expanded. Balance of trade deficit can be remedied through decreasing absorption without equal fall in output. It may be noted that validity of absorption approach depends upon the operation of the multiplier effect that is essential for accelerating output generation, It also depends on the marginal propensity to absorb that determines the rate of absorption.
J. Black (1959) explains the absorption in a slightly different way. He ignores the governmental expenditure, G and equates X - M with S - I (where S is saving and I is investment). He is of the opinion that when balance of trade is negative, the country has to increase saving on the one hand and to reduce investment, on the other. In case of full employment, he suggests for redistribution of national income in favour of profit earners who possess greater propensity to save. 45 Flows
Again, Mundell (1968) incorporates also interest rate and capital account in the ambit of discussion. In his view, it is not only the government spending but also the interest rate that does have an influence on income as well on the balance of payments. While larger government spending increases income, an increase in income leads to rise in import. With a positive marginal propensity to import, any rise in income as a sequel to increase in government spending will lead to greater imports and worsen the current account. However, changes in interest rate influence both the capital account and the current account. A higher interest rate will lead to improvement in current account through lowering of income. At the same time, a higher interest rate will improve the capital account through attracting the flow of foreign investment.
Yet again, the New Cambridge School approach takes into account savings (S) and investment (I), taxes (T) and government spending (G) and their impact on the trade account. In form of equation, it can be written as:
Or ( S - I ) + (T-G) + ( M-X) = 0
Or (X-M) = ( S - I ) + (T- G)
The theory assumes that (S - I) and (T - G) are determined independently of each other and of the trade gap. (S - I) is normally fixed as the private sector has a fixed net level of saving. And so the balance of payments deficit or surplus is dependent upon (T - G) and the constant (S - I). In other words, with constant (S - I), it is only the manipulation of (T - G) which is a necessary and sufficient tool for balance of payments adjustment.
The monetarists believe that the balance of payments disequilibrium is a monetary phenomenon and not structural (Connolly, 1978). The adjustment is automatic unless the government is intentionally following an inflationary policy for quite a long period. Adjustment is brought about through making changes in monetary variables.
The process of adjustment varies among the types of exchange rate regime the country has opted for. In a fixed exchange rate regime or in gold standard, if the demand
for money, that is the amount of money people wish to hold is greater than the supply of money, the excess demand would be met through the inflow of money from abroad. On the contrary, with the supply of money being in excess of the demand for it, the excess supply is eliminated through the outflow of money to other countries. The inflow and the outflow influence the balance of payments. To explain it further, with constant prices and income and thus constant demand for money, any increase in domestic credit will lead to outflow of foreign exchange as the people will import more to lower the excessive cash balances. In the sequel, the balance of payments will turn deficit. Conversely a decrease in domestic credit would lead to an excess demand for money. International reserves will flow in to meet the excess demand. Balance of payments will improve.
However, in a floating-rate regime, the demand for money is adjusted to the supply of money via changes in exchange rate. Especially in a situation when the central bank makes no market intervention, the international reserves component of the monetary 46 Environment
• All the international financial flows arising out of various international financial transactions are recorded by the monetary authorities of a country in a statement known as balance of payments.
• The international financial flows relate broadly to merchandise trade flows, invisibles such as trade in services, investment income and unilateral transfers, foreign direct and portfolio investment, external assistance and external commercial borrowings and also short-Term movement of funds.
• Recording of funds flow in the balance of payments is based on the double-entry book-keeping having debit and credit entries.
• Balance of payments entries are bifurcated into current and capital accounts based on whether, or not, those entries show the flow of real income.
• While the current account includes merchandise trade and invisibles, capital account embraces foreign investment, external assistance, external commercial borrowing and the movement of short-term funds.
• Statistical discrepancy, if any, is added and then the current account, capital account and the statistical discrepancy are summed up in order to arrive at the overall balance. If the overall balance is positive, it adds to the foreign exchange reserves. If it is negative, foreign exchange reserves are eroded to that extent; or in case of insufficient reserves, IMF is approached to bridge the deficit.
3. Identify and explain the reasons for the differences in the cost of capital across various countries and discuss about the cut off rate of foreign projects determination.
Cut off rate is the minimum rate which will be received by INVESTOR, if he invests hisMONEY . It is just like COST OF CAPTIAL or RETURN on
INVESTMENT.But it is not sure that investor will invest his money at cut off rate because, investor will deeply analyze his investment proposals with different capital budgeting techniques. One of important technique is IRR in which cut off rate is compared with internal rate of return and if any project’s IRR will more than cut off rate, then that project will be accepted.
Many other techniques like NPV and P.I. in which we use cut off rate for calculating the present value of cash outlay and cash inflows.
Following are the major factors which affects cut off rate's determination :-
1. Amount of Investment
Cut off rate is the standard rate and it affects investment decisions. Amount of investment affects cut off rate’s determination. If investment amount is very high in any investment projects, then its cut off rate will be more than 10%.
2. Period of Investment
If any investment project offers to pay the amount of investment in installments, then cut off rate will be very small but if investor has to pay all amounts within one installment, then cut off rate may be very high.
3. Risk factor
If there is high risk with investment, then cut off rate will be high. If there is no risk of money, then investor can invest the money at very low cut off rate.
The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). This is the rate of return that a firm would receive if it invested in a different vehicle with similar risk.
THE COST OF CAPITAL IS DIFFERENT BECAUSE
-is a function of investment.
[investment market varies from country to country.]
-is forward looking.
[market fluctates with different velocity in different countries.]
-is based on market value.
[market rates changes everyday in every country]
-is based on return on investment rate.
-is based on nominal terms, which includes inflation.
[inflation fluctuates in every country ]
-is based on the discount terms offered in the market
[this discount varies from country to country