INTERNATIONAL FINANCE Flashcards
(19 cards)
What is financial globalisation and name the three types of foreign capital/investment flows
Countries are increasingly importing and exporting financial capital (money), leading to financial globalisation.
International finance refers to the movement of capital/money between countries.
Examples:
- foreign direct investment (FDI) - a foreign investor directly invests in a country by setting up a firm or acquiring management control. The investor brings capital and receives profit in return
- portfolio investment - foreign investors buy stocks and bonds in another country. They bring capital and receives profit dividends or interest in return.
- loan inflows - a foreign bank or investor lends money to a firm or government in another country, earning interest as a return.
What are the capital and current account made up of?
The current account reflects what happens in the real economy, ie trade. Current account balance = exports - imports.
A current account surplus occurs when exports exceed imports
A current account deficit occurs when imports exceed exports
The capital account reflects what happens in the financial economy. Capital account balance = import of capital - export of capital
How are the current and capital account linked?
A current account surplus leads to a capital account deficit as the country earns foreign capital which will be invested abroad.
A current account deficit leads to a capital account surplus as the country needs foreign capital to finance the deficit so the country needs capital inflows from foreign investors.
What happens in the real economy (current account) is mirrored by the financial economy (capital account)
Explain what, with an example, happens to the capital account as a result of a current account surplus
Suppose there is a current account surplus in china (accounted as a positive in the real economy), the excess capital for firms can either be spent domestically or abroad.
If Chinese firms choose to spend domestically, they will exchange the excess dollars for yuan with the Chinese central bank. This increases the central bank’s foreign exchange reserves of dollars. This is accounted for as a negative in the financial economy (capital account)
If Chinese firms choose to spend abroad, ie by lending dollars to a foreign bank or buying shares of a foreign company, there will be a capital account deficit as the country is a net exporter of savings
Explain what, with an example, happens to the capital account as a result of a current account deficit
Suppose china has a current account deficit (accounted for as a negative in the real economy), firms must finance the deficit from foreign sources.
This can be done by importing money/capital from abroad. Ie borrowing dollars from a foreign bank or selling shares to foreign investors. This would make firms a net importer of savings from abroad (noted as a positive in the financial economy)
Or this can be done by buying dollars from the Chinese central bank. This decreases the central bank’s foreign exchange reserves (noted as a positive in the financial economy)
Why are persistent and growing current account deficits dangerous?
A persistent current account deficit must be financed by either:
1. Running down foreign reserves - this is unsustainable in the long run, once reserves are depleted, the country must drastically reduce imports and increase exports.
2. Capital inflows from abroad - can lead to dependence on foreign investment, which may suddenly reverse, causing a financial crisis.
What is a floating exchange rate and why do countries adopt it?
A floating exchange rate is one that is determined by market forces, ie supply and demand of the currency.
It helps to prevent excessive trade and capital imbalances over time, ie avoid large deficits and surpluses through automatic adjustments
Using an example, explain how a floating exchange rate works
Consider the exchange rate between US dollars and Mexican pesos.
If the exchange rate says 1 dollar = 12 pesos, this means 1 dollar is worth or can buy 12 pesos.
Demand for pesos comes from foreigners selling dollars to buy pesos ie for Mexican exports or investments
Supply of pesos comes from Mexicans selling pesos to buy dollars, ie for American imports or investments
An increase in demand for US goods or assets means more Mexicans are buying dollars and hence selling pesos so the supply of peso increases and the peso depreciates against the dollar
An increase in demand for Mexican goods or assets means more Americans are buying pesos so demand for pesos increases and the peso appreciates against the dollar
What is the effect of inflation on a the exchange rate under a flexible system?
Consider the trade flow between Mexico and usa. Mexico exports goods such as shoes to usa valued at $5bn and usa exports goods such as laptops to Mexico valued at $5bn. The trade balance for both countries is 0 and the initial exchange rate is $1 = 12 pesos.
If inflation in Mexico rises by 10%, Mexican goods become more expensive so demand for Mexican exports falls
Demand for pesos decreases, causing the peso to depreciate, $1 = 14 pesos
Mexican exports become cheaper in dollar terms, boosting exports again
The exchange rate adjusts to neutralise the effect of inflation and stabilise the trade balance
What is the effect of interest rate changes on exchange rates under a flexible system?
Consider capital flows between Mexico and usa. Initially US investors invest $5bn in Mexican banks at a 2% interest rate and Mexican investors invest $5bn worth into American banks at a 2% interest rate. The capital account balance for both countries is 0.
If the us raises interest rates to 5%, more Mexican investors will move their money to us banks due to higher returns.
There is an increase in capital outflows, creating a capital account deficit in Mexico.
More pesos are sold for dollars so the supply of pesos increases causing a depreciation of the peso
The depreciating makes investing in the us less attractive over time, balancing capital flows
What is a fixed exchange rate system and why may countries want to adopt it?
A fixed exchange rate is when a country’s currency is fixed against another country’s currency.
For a country to fix their exchange rate, they first need to set the target rate, then change the value of the currency to the target rate, and then keep the value of the currency at the target rate by intervening.
The upside of a fixed exchange rate system is nominal currency stability.
Explain how a country can devaluate their currency?
Consider the exchange rate between Mexico and usa, $1 = 12 pesos. Suppose the Mexican central bank wants to fix the exchange rate so $1= 15 pesos (depreciating the value of the peso) to boost exports.
The Mexican central bank intervenes by printing more pesos and using this to buy dollars.
The increased supply of pesos makes pesos cheaper, devaluing the peso.
The central bank puts the dollars in the foreign exchange reserves.
Explain how a country currency can revalue their currency?
Suppose the Mexican central bank wants to make their currency more expensive to reduce import prices.
The central bank interferes in the currency market, using the accumulated foreign exchange reserves of dollars to buy pesos.
This increases the demand for pesos, pushing up its value.
What are the downsides to having a fixed exchange rate?
Consider a trade flow between Mexico and usa. Suppose inflation in Mexico is 8% higher than in usa.
Mexico’s current account goes into deficit as demand for exports falls. Because the nominal exchange rate is fixed, there is no automatic adjustment. So competitiveness erodes.
Consider an asset based model between Mexico and usa. Suppose the interest rate is 3% higher in the USA. Mexico’s capital account goes into deficit as Mexican investors will invest more so capital outflows exceed capital inflows.
What are the options a country’s currency has under a fixed exchange rate to fix a capital account deficit?
Consider the capital flows between usa and Mexico. If interest rates in usa increase there will be more capital outflows from Mexico and Mexico will fall into a capital account deficit.
1. Mexican policymakers increase their interest rates to match the usa’s. This increases capital inflows from Americans investors, pushing the capital account back into balance. BUT, this compromises Mexico’s monetary independence.
2. Mexican policymakers introduce restrictions on capital outflows rather than raising interest rates. Eg Mexico place a limit on the amount of capital that can come in and out of Mexico. This directly reduces capital outflows, bringing the capital account back into balance. BUT, this compromises their openness to foreign investment.
Therefore it is nearly impossible to have a fixed exchange rate, monetary policy independence and free capital mobility.
For a country with a floating exchange rate, how can they deal with a demand shock that has caused a current account deficit?
There will be an automatic depreciation of the currency
Exports become cheaper and imports become more expensive
Current account deficit will automatically shrink
For a country with a fixed exchange rate, how can they deal with a demand shock that has caused a current account deficit?
- Nominal devaluation, increases exports and decreases imports, CA deficit shrinks
- Monetary contraction, decreases AD, decreases imports, CA deficit shrinks
- Fiscal contraction, decreases AD, decreases imports, CA deficit shrinks
How can a country in a monetary union (ie Greece in the euro) deal with a demand shock that has caused a current account deficit?
Fiscal contraction, decreases AD, decreases imports, CA deficit shrinks
- Nominal devaluation is not possible as the country does not have control over its currency
- Monetary contraction is not possible as monetary policy decisions are made by the ECB
