PART ONE
THE GLOBAL FINANCIAL
ENVIRONMENT
Part One of this text (Chapters 1–3) presents an overview of the global financial environment. Chapter 1 develops the goal of the multinational company to be used in the financial decision-making process and examines the role of global finance in achieving this goal. Chapter 2 examines motives for world trade and foreign investment. Before considering foreign trade and foreign investment separately in the forth coming chapters, we will discuss key trade and investment theories in this chapter. Chapter 3 describes the balance of payments and the international monetary system.
Chapter 1
GLOBALIZATION AND THE GLOBAL COMPANY
“Globalization” stands for the idea of integrating the world marketplace, creating a so-called “borderless world” for goods and services. In addition, to some extent, we already have such a world. Consider physical communications (mail, the telephone, the Internet, and airline and ocean shipping networks); entertainment (film and TV, music, news, and sports); economic and business exchange (banking and insurance networks, dependable foreign exchange and stock markets, and reciprocal trade arrangements); and even ideas and competing spiritual values through evangelical Christianity, Islam, and others.1
The increasing economic integration of goods, services, and financial markets presents opportunities and challenges for governments, business firms, and individuals. Although business operations in countries across the globe have existed for centuries, the world has recently entered an era of unprecedented worldwide production and distribution. Worldwide production and distribution are critical for the survival of the multinational corporation (MNC) — its ability to produce products and sell them at a profit. International finance is an integral part of total management and cuts across functional boundaries because it expresses inputs, outputs, plants, and results in monetary terms.
This book deals with the financial decisions of an MNC, decisions which both large and small MNCs must make. Thus, the underlying financial principles are basically the same for both types of companies. In this introductory chapter, we lay the foundation for the entire text with seven separate sections. Section 1.1 explains reasons to study international finance. Section 1.2 identifies the primary goal of the MNC and the functions of the financial manager necessary to achieve this primary goal. Section 1.3 analyzes MNCs and their performance. Section 1.4 discusses the major principles of global finance which favor MNCs over domestic companies. Sections 1.5 and 1.6 describe two major constraints that impede an MNC’s effort to achieve its goal: large agency costs and environmental differences. Section 1.7 gives an overview of the book.
1.1. REASONS TO STUDY INTERNATIONAL FINANCE
A college student, such as yourself, should study international finance. “I am not an international finance major,” you say. “Why should I have to take a course in international finance?” That is a reasonable question. It is true that most readers of this book will not necessarily work in the international finance department of a large company such as Exxon Mobil or the foreign exchange department of a large bank such as the Bank of America. All textbooks on business and economics teach that resources are scarce. We know that your time is one of those scarce resources. Hence, we will give you just a few reasons why you should study international finance.
1.1.1. To Understand a Global Economy
The world has recently reached the climax in a drama of economic change. No one can deny the effects of these changes on our hopes for peace and prosperity: the disintegration of the Soviet Union; political and economic freedom in Eastern Europe; the emergence of market-oriented economies in Asia; the creation of a single European market; trade liberalization through regional trading blocs, such as the European Union, and the world’s joint memberships, such as the World Trade Organization. As global integration advances amid intensified international competition, the United States, East Asia, and Europe are expected to lead the world toward a system of free trade and open markets.
Three recent changes have had a profound effect on the international financial environment: the end of the Cold War, the emergence of growing markets among the developing countries of East Asia and Latin America, and the increasing globalization of the international economy. Understanding these changes should help you see where the international economy is headed in the future so that you can more effectively respond to these challenges, fulfill your responsibilities, and take advantage of these opportunities.
Most large and many medium-size companies around the world have international business operations. In recent years, it has become clear that international events significantly affect companies which do not have foreign operations. Business school graduates have an advantage in moving their companies forward if they understand the basic elements of international finance. Apart from career interests, persons who want to improve their knowledge of the world will be seriously handicapped if they do not understand the economic dynamics and policy issues of finance, trade, and investment flows among nations.
1.1.2. To Create Value in the Multinational Company
Every multinational company (MNC) attempts to generate profit and value for its owners and stockholders. Today, the MNC create value for its stakeholders by combining two critical elements, globalization and information. Knowledge/information is the driving force for globalization because information/new technology is transforming most local, regional, and national events (economics and business, entertainment, physical communications, and even ideas and competing spiritual values) into global events without borders. Knowledge/ information workers are the link to all of the organization’s other investments. They provide focus, creativity, and leverage in using those investments to better achieve the organization’s objectives. Knowledge/information is an integral part of total management because it teaches us to do a better job in all functional areas, such as production, marketing, financing, and others. Consequently, a typical worker in the information and knowledge age outperforms the counterpart of the industrial age many times over.2
1.1.3. To Make Intelligent Personal Decisions
When you graduate from college and decide to take a job, you may have the advantage of comparing two job offers: one from JPMorgan Chase (JPM) and another one from Nomura Securities. When you decide to buy a car, your choice between the latest models offered by Ford Motors and Volkswagen may well depend on the exchange rate between the dollar and the euro. When you begin a career and save for your retirement, you may choose between US securities and non-US securities. When you take your next vacation, you may spend it at Tokyo Disneyland or at Euro Disneyland. Although these are not international finance jobs, they all require significant knowledge of international finance to make intelligent decisions. In all of these cases, the important point is that you will participate not just in the US economy but in economies around the world.
1.2. COMPANY GOALS AND FUNCTIONS OF FINANCIAL MANAGEMENT
1.2.1. MNC Goals
Management is motivated to achieve a number of objectives, some of which conflict with each other. Such conflicts arise because the firm has a number of constituents, such as stockholders, employees, customers, creditors, suppliers, and the local community, whose desires do not necessarily coincide. It is management’s responsibility to satisfy such differing desires. Hence, the conflicting objectives confronting management raise the problem of setting priorities. In addition, it is essential for management to set priorities for the most efficient use of a company’s scarce resources. Setting priorities by an MNC is particularly important and difficult because it has highly diversified groups of constituents in many countries.
The commonly accepted objective of an MNC is to maximize stockholder wealth on a global basis, as reflected by stock price. The stock price reflects the market’s evaluation of the firm’s prospective earnings stream over time, the riskiness of this stream, the dividend policy, and quality aspects of the firm’s future activities. Quality aspects of future activities include stability, diversification, and growth of sales.
Stockholder wealth maximization is generally accepted as the primary goal of a company in the United States and the United Kingdom. In some other countries, such as Germany and Japan, however, the goal of a company is to maximize corporate wealth. “Corporate wealth” includes not only the company’s stockholder wealth but also its marketing, technical, and human resources. Under this model, a company should treat shareholders on a par with other corporate constituents. In other words, management should strive to increase the corporate wealth for the benefit of all constituents.
There are a number of compelling reasons for management to focus on stockholder wealth maximization. First, because stockholders are the owners of the company, management has a fiduciary obligation to act in their best interests. Second, stockholders provide the risk capital that protects the welfare of other constituents. Third, stockholder wealth maximization — a high stock price — provides the best defense against a hostile takeover or a forced corporate restructuring. Fourth, if a company enhances shareholder value, it is easier for the company to attract additional equity capital. For these and other reasons, many financial economists believe that stockholder wealth maximization is the only way to maximize the economic welfare of all constituents.3
1.2.2. Functions of the International Financial Manager
In order to achieve the firm’s primary goal of maximizing stockholder wealth, the financial manager performs three major functions: (1) financial planning and control (supportive tools); (2) the efficient allocation of funds among various assets (investment decisions); and (3) the acquisition of funds on favorable terms (financing decisions).
1.2.2.1. Financial planning and control
Financial planning and control must be considered simultaneously. For purposes of control, the financial manager establishes standards, such as budgets for comparing actual performance with planned performance. The preparation of these budgets is a planning function, but their administration is a controlling function.
The foreign exchange market and international accounting play a key role when an MNC attempts to perform its planning and control function. For example, once a company crosses national boundaries, its return on investment depends not only on its trade gains or losses from normal business operations, but also on exchange gains or losses from currency fluctuations.
International reporting and controlling have to do with techniques for controlling the operations of an MNC. Meaningful financial reports are the cornerstone of effective management. Accurate financial data are especially important in international business, where business operations are typically supervised from a distance.
1.2.2.2. Allocation of funds (investment)
When the financial manager plans for the allocation of funds, the most urgent task is to invest funds wisely within the firm. Every dollar invested has alternative uses. Thus, funds should be allocated among assets in such a way that they will maximize the wealth of the firm’s stockholders.
There are 200 countries in the world where large MNCs, such as General Electric and Royal Dutch/Shell Group, can invest their funds. Obviously, there are more investment opportunities in the world than in a single country, but there are also more risks. International financial managers should co...