AIM COLLEGE-HISAR
International Financial Management (FM-406) Contact: 92533-50008, 94164-43238
Ques 1: What is International Finance? Briefly discuss the distinguish features of
International Finance.
Ans 1:- A multinational Corporation (MNC) is a company involved in producing and
selling goods and service in more than one country. It usually consists of a parent
company located in its home country with numerous foreign subsidiaries. As business
expands the awareness of opportunities in foreign markets also increases. This,
ultimately, evolves into some of them becoming MNCs so that they can enjoy the
benefits of international business opportunities.
Knowledge of International Finance is crucial for MNCs in two important ways.
First, it help the companies and financial managers to decide how international events
will affect the firm and what steps can be taken to gain from positive developments and
insulate from harmful ones. Second, it helps the companies to recognize how the firm
will be affected by movements in exchange rates, interest rates, inflation rates and asset
values.
The consequences of events affecting the state markets and interest rates of one
country immediately show up interdependent financial environment which exists around
the world. Also, their have been close links between money and capital markets. All this
makes it necessary for every MNC and aspiring manager to take a close look at the ever
changing and dynamic field of international Finance.
Distinguishing features of International Finance:International finance is a distinct field of study and certain features set it apart
from other fields. The important distinguish features of international finance are
discussed below:-
Foreign Exchange Risk:-
An understanding of the foreign exchange risk is essential for managers and invested in
the modern day environment of unforeseen changes in foreign exchange rates. In a
domestic economy this risk is generally ignored because a single national currency serves
as the main medium of exchange within a country. When different national currencies are
exchanged for each other there is a definite risk of volatility in foreign exchange rates.
The present international Monetary system is characterized by a mix of floating and
managed exchange rate polices adopted by each nation keeping in view its interests. In
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International Financial Management (FM-406) Contact: 92533-50008, 94164-43238
fact, this variability of exchange rates is widely regarded as the most serious international
financial problem facing corporate managers and policy maker.
At present, the exchange rates among some major currencies such as the US
dollar, British Pound, Japanese Yen and the Euro fluctuate in a totally unpredictable
manner, exchange rates were fluctuated since the 1970s after the fixed exchange rates
were abandoned. Exchange rate variation affect the profitability of firms and all firms
must understand foreign exchange risks in order to anticipate increased competition from
imports or to value increased opportunities for exports.
-
Expanded Opportunities Sets:-
When firms go global, they also tend to benefit from expanded opportunities
which are available now. They can raise funds in capital markets where cost of capital is
the lowest. In addition, firms can also gain from greater economies of scale when they
operate on a global basis.
-
Market Imperfections:The final feature of he international finance that distinguishes it from the domestic
finance is that world markets today are highly imperfect. There are profound differences
among nations law, tax systems, business practices and general cultural environments,
imperfection in the world financial markets tend to restrict the extent to which investors
can diversify their port jobs. Though there are risks and cost in coping with these market
imperfections, they also offer managers of international firms abundant opportunities.
Thus, the job of the manager of MNC is both challenging and risky. The key to
such management is to make the diversity and complexity of the environment work for
the benefit of the firm.
Ques 2:- Briefly explain the evolution the International Monetary System?
Ans 2:- Evolution of the International Monetary System can be analyzed in four stages as
follows:1)
Gold Standard, 1876-1913
2)
Inter-war Years, 1914-1944
3)
Bretton Woods Systems, 1945-1973
4)
Flammable exchange Rate Regime since 1973
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International Financial Management (FM-406) Contact: 92533-50008, 94164-43238
1)
The Gold Standard 1876-1913:The fundamental principle of the classical gold standard was that each country
should set a par value its currency in terms of gold and them try to maintain this value.
Thus, each country had to establish the rate at which its currency could be converted to
the weight of gold. Also, under the gold standard, the exchange rate between any two
currencies was determined by their gold content.
Thus, the three important features of the gold standard were, First, the
government of each country defines its national monetary unit in terms of gold. Second,
free import or export of gold and third two way convertibility between gold and national
currencies at a stable rates. These conditions were met during the period 1875-1914.
The united states, for example declared the dollar to be convertible to gold at a
rate of $20.67/ounce of gold. The British pound was pegged at £4.2474/ ounce of gold.
Thus the dollar pound exchange rate would be determined as follows:$20.67/ounce of gold
= $4.86656/ £
£ 4.2474/Ounce of gold
Each country’s government then agreed to buy or sell gold at its own fixed parity rate on
demand. Thus helped to preserve the value of each industrial currency in terms of gold
and hence, the fixed partner between currencies. Under this system, it was extremely
important for a country to back its currency value by maintaining adequate resources of
gold.
Because of the rigidity of the system, it was a matter of time before major
countries decided to abandon the gold standard, starting with the United Kingdom in
1931 in the midst of a worldwide recession. With a 12% unemployment problem.
2)
Inter war years, 1914-1944
The gold standard as an International Monetary System worked well until
World War I interrupted trade flows and distorted the stability of exchange rates for
currencies of major countries. There was widespread fluctuation in currencies in terms of
gold during Word War I and in the early 1920s. As countries began to recover from the
war and stabiles their economies, they made several attempts to return to the standard.
The United States returned to gold in 1919 and the United Kingdom in 1925. The key
currency involved in the attempt to restore the international gold standard was the pound
sterling which returned to gold in 1925 at the old mint parity exchange rate of $4.87/ £.
From 1934 till the end of World War II, exchange rates were theoretically determined by
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each currency’s value in terms of gold. World War II also resulted in many of the
World’s major currencies closing their convertibility. The only major currency that
continued to remain convertible was the dollar.
3)
The Bretton Woods System, 1945-1972:
The negotiations at Bretton Wood made recommendations in 1944:
- Each nation should be at liberty to use macro-economic policies for full employment.
- A monetary system was needed that would recognize that exchange rates were both a
national and an international concern.
The establishment of International Monetary System created two new institutions:- IMF
and World Bank. The basic purpose of this new monetary system was to facilitate the
expansion of world trade and to use the US dollar as a standard of value. Thus the main
points of the post war system evolving from the Bretton Woods conference were:A new institution, IMF would be established in Washington DC.
-
The US Dollar would be designated as reserve currencies, and other nations
would maintain their foreign exchange reserves principally in the form of dollars
or pounds.
-
Each fund member would establish a par value for its currency and maintain the
exchange rates for its currency within one percent of par value.
-
A fund member could change its par value only with fund approval and only if the
country’s balance of payments was in fundamental disequilibirium”
This system worked without major changes from 1947 till 1971. the system however
suffered from a member of inherent structural problems. There was imbalance in the roles
and responsibilities of the surplus and deficits nations.
4)
The Flambé exchange Rate Regime, 1973- Present
Since 1973, most industrial concerns & many other developing countries allowed
their currencies to float with government intervention, whenever necessary, in the foreign
exchange market. The alternative exchange rate system which followed are as follows:Page : 4/25
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-
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Crawling peg:-
A cross between a fixed rate system and a fully flexible system are the semi-fixed
systems such as the crawling peg. This differ from fixed rates because of their greater
flexibility in terms of the exchange rate movements.
-
Flexible (Floating) system:-
Under a flexible or floating system, the market force, based on demand and
supply determines a currency’s value. A surplus in a country immediate higher prices,
mass reserve, and opportunities costs. In addition, too much money on reserve leads to a
loss of investment opportunities. On the other hand, a countries deficit will lower its
currency value.
In the absence of government intervention, the float is said to be ‘clean’. It
becomes ‘dirty’ when there is a control bank intervention to influence exchange rates,
which is a common action, especially by those with inflation and trade problems. Critics
of floating exchange rates contend that the system causes uncertainty which discourages
trade while promoting speculation.
Ques 3:Discuss the various methods which MNCs adopt to increase
international business?
Ans 3:- Foreign Direct Investment is investment made by a transnational corporation to
increase its international business. When firms become multinational, they undertake
FDI. Direct Foreign Investment is a common method of engaging in international
business. But this method is generally expensive. However, there are several alternatives
methods of entering foreign markets that are less risky and also involve a smaller initial
outlay than FDI.
The various alternatives are:
a)
A joint venture
b)
Merges and acquisitions
c)
Licensing
d)
Franchising
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International Financial Management (FM-406) Contact: 92533-50008, 94164-43238
a)
Joint Venture:A joint venture between a multinational firm and a host country partner is a viable
strategy if one finds the right local partner, eg. Consider a firm in USA that has expertise
in the technology to build automobiles and plans to establish business in West Germany.
As this firm is not familiar with German rules and codes, it may consider a joint venture
with a German Firm. These two firms could then combine to establish a business in West
Germany that would not have been possible by either individual firm.
Some of the advantage of joint venture are:-
The local partner understands the customs, cultural restrictions and various
institutions of the local environment. For the multinational firms to acquire
knowledge on its own, it might take a considerable period of time with a lot of
problem attached to it.
-
The local partner can provide competent management both at the top and also at the
middle level.
-
The contracts and reputation of the local partner may help the foreign firm in
gaining access to the capital market.
-
If the purchase of the investment is to target local sales, the foreign form may
benefit from a venture that is partially locally owned.
The above gains a list of advantages of a joint venture between a MNC and a host
country if, and only if, one finds the right local partner.
In certain situation, MNCs fear interference by the local partner in certain decision areas.
The important area of conflict are:-
Political risk increases if a wrong partner is chosen.
There may be difference in views of various issues like the need to distribute cash
dividends, amount of retained earnings etc between the local & foreign partners.
IN some cases, control of financing can be a potential source of conflict.
How much to disclose and what amount of financial disclosure is necessary need to
be decided between the local firm and the foreign firm. But in case of a joint
venture, financial disclosure is governed by the rules of the host country.
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b)
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Mergers and Acquisitions/Cross Border Acquisitions
Firms are maintained to engage in cross border mergers and acquisitions to
increase their competitive positions in the world market by acquiring special assets from
other firms or using their own assets on a larger scale. FDI usually takes place through
green field investments which involve building new production facilities in a foreign
country or through cross border acquisition which involve buying existing foreign
business. Synergistic gains may or may not arise form cross border acquisitions
depending on the motive of the acquiring firms. Gains will result when the acquired
merger is motivated to take advantage of market imperfections.
A cross border merger has the following advantages as against green field investments.
-
It is a cost effective way to capture advanced and valuable technology rather that
developing it internally.
It is also an easy and quicker way to establish an opportunity preserve in a host
country.
Economies of scale and synergistic benefits can be achieved with the merger.
Foreign exchange exposure is reduced. As against these advantages, a cross border
merger may have the following problems.
Cultural differences may prevent the joining of two organizations of different
customs, values & nationality.
Labor problems can arise because of favoritism unequal union contracts, seniority
etc.
The price paid by the acquirer may be too high and the method of financing too
costly.
Strategic alliances are currently very popular all over the world as a way of
conducting international business. Such alliance are specially popular in areas
where the cost of resources and development is high and timely introduction of
improvements is important. e.g. consider the strategic alliance between crisit and
standard and poor. Both firms are in the credit rating industry. Both firms have
retained them separate individual identity and the strategic alliance between the two
mainly refers to sharing of knowledge, helping each other develop professionally in
their area of specialization.
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C)
Licensing:
Licensing is a popular method used by MNCs to profit from foreign markets
without the need to commit sizeable funds.
In licensing, a local firm in the host country producers the goods to the licensing
corporations specification. When the goods are sold, a portion of the revenues, as
specified by the agreement are sent to the licensor.
The main advantages of licensing are:-
Transportation costs are avoided as exporting is not required.
Direct foreign investment is not required as a local firm handles production in
the host country.
The advantages of licensing are:-
It is difficult to ensure quality control of the local firms production process.
License fees are generally lower than DFI profits although the return on the
investment might be higher.
D)
Franchising
In this method, an individual firm is allowed to sell its products in a specific territory.
The firm usually revives an initial fee plus periodic royalty payments in return MC
Donald and Pizza Hut have franchise all over the world.
Ques 4:
Briefly explain have an MNC can calculate its cost of equity capital?
Also explain how the weighted cost of capital for an MNC can be calculated?
Ans 4:- Cost of capital for a domestic firm is the rate that must be earned in order to
satisfy the required rate of return of the firm’s investors. Simply put, it is the minimum
acceptable rate of return for capital investments. If there are two firms with the same
returns on their investments. The firm with the lower cost of capital will be valued higher
as the residual value to shareholders will be greater. Since countries posse’s different
economic characteristics and business environments, an MNCs required rate of return
cannot be the same across the boarder. This implies that there are different in inherent
risks for the firm for each country and as such the required return is calculated for
specific projects being undertaken by an MNC.
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THE COST OF EQUITY CAPITAL
The cost of equity capital is the required rate of return needed to motivate the investors to
buy the firms stock. Calculation of the cost of equity is a different process and needs
more approximations than calculating the cost of debt. For established firms, the dividend
growth model may be used for computing the cost of equity. This model is also called the
Gordon Model.
Kc = D1/P0 + g
Where,
Kc Is the cost of equity capital
D1 are dividends imparted in year one.
P0 is the current market price of firms stock
g
is the compounded annual rate of growth in dividends or earnings.
Alternatively, the cost of equity capital may be calculated by using the modern capital
market theory. Accordingly to this theory, an equilibrium relationship exists between an
assets required rate of return and its associated risk which can be calculated by the capital
asset pricing model ( CAPM). The cost of equity may be calculated by the CAPM by
using the following formula.
E(R)j = Rf + Bj [ E(R)m – Rf ]
Where,
E(R)j = the rate of return rate of return on a risk free assets measured by the current rate
of return or yield on treasury bonds.
E(R)m = is the expected rate of return on a broad market index such as the standard and
index of industrial stocks.
Bj = is the beta of stock j, measured by the relative volatility of the rate of return volatility
of rate of return on the stock compared to the variability of the return on a broad market
index. A beta of 1 (unit) denotes a risk equivalent to the one entered in an investment in a
diversified portfolio of stocks.
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Figure below shows the capital assets pricing model
Security Market Line
E(R)j)
E(R)m)
Rf
1.0
1
Both the Gordon model and the CAPM, yield a risk adjusted rate of return on equity. The
major difference is that the latter utilizes beta which is a measure of the market related or
systematic risk rather than total risk which is traditionally measured by the standard
derivation. Both methods yield acceptable and conceptually defensible estimates of the
rate required by the investors given the degree of risk inherent in the investment. For
firms with no established track record and for which beta coefficients are not available,
the cost of equity may derived by adding an arbitrary risk premium to the firms recent
borrowing rate.
COMPUTING THE WEIGHTED COST OF CAPITAL
A Firms’ weighted cost of capital is a composite of the individual costs of financing
weighted by the percentage of financing provided by each source. Therefore, a firms
weighted cost of capital is a function of individual cost of capital, the make up of the
capital structure i.e. the percentage of funds provided by debt, preferred stock and
common stock.
Thus, when a firm has both debt and equity in its capital structure, its financing
cost can be represented by the weighted average cost of capital. This can be computed by
weighting the after tax borrowing cost of the firm and the cost of equity capital structure
i.e. the percentage of funds provided by debt, preferred stock and common stock.
Thus, when a firm has both debt and equity in its capital structure, its financing
cost can be represented by the weighted average cost of capital. This can be completed by
weighting the after tax borrowing cost of the firm and the cost of equity capital using debt
ratio as the weight.
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Specially
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K= (1-Wd) Ke + Wd (1-T) i
Where K is weighted average cost of capital
Ke is the cost of equity capital
i is before tax borrowing cost.
T is the corporate marginal tax rate and
Wd is debt to total market value ratio.
In general both Ke and i increase as the proportion of debt in the firm’s capital structure
increases. At the optimal combination of debt and equity financing. However the
weighted average cost of capital (K) will be the lowest.
The firms cost of capital can also be measured as the weighted average cost of individual
sources of long term financing. Specially
K0 =
Wd Kd (i-t)+ WP WP + We Re
Where Re refers to the relative share of equity capital to the total long term funds of the
organization.
WP Refers to the weighted preference share capital
Wd Refers to the weighted cost of debt and
Ke, KP and Kd Refers to the cost of equity, preference and debt specifically. The weights
used to calculated the relative proportions of Wd, WP and We could be based on book
value or market value. Generally, market value weights are considered to be more
superior to the book value weights as they request the current market scenario.
Ques 5:- Enumerate the various problem and issues in foreign investment analysis..
Ans 5:- Multinational capital budgeting is an increasingly vital area in the foreign
operations of MNCs. The fundamental goal of the financial manager is to maximize
shareholder’s wealth. Shareholder’s wealth is maximized when the firm, out of a list of
prospectus investments, selects a combination of those projects that maximize the
companies value to its shareholders.
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Capital budgeting for the MNCs uses the same framework as domestic capital budgeting.
However, multinational firms engaged in evaluating foreign projects face a number of
complications many of which are not there in the domestic capital budgeting process.
Problem and Issue in Foreign Investment Analysis
-
Foreign Exchange Risk:-
Multinational firms investing abroad are exposed to foreign exchange risk. The
risk that the currency will appreciate or depreciate over a period of time. Understanding
of foreign exchange risk is important in the evaluation of cash flow generated by the
project over its life cycle. To incorporate the foreign exchange risk is the cash flow
estimates of the project, the host country during the life span of the project. The cash
flow, in terms of local currency, are then adjusted upwards for the inflation factor. Then
the cash flows are converted into the parent’s currency at the spot exchange rate
multiplied by an expected depreciation or appreciation rate calculated on the basis of
purchasing power parity. In certain specific situations, the conversion can also be made
on the basis of some exchange rate accepted by the management.
-
Remittance Restrictions:
Where there are restrictions on the repatriation of income, substantial differences
exist between project cash flows and cash flow received by the parent firm. Only those
flows that are remittable to the parent are relevant from the MNCs perspective. Many
countries impose a variety of restrictions on transfer of profits depreciation and other fees
accruing to the parent company. Project cash flows consist of profits and depreciation
charges whereas parents cash flows consist of the amounts that can be legally transfer by
the affiliate.
In cases where the remittances are legally limited, the restrictions can be
circumvented to some extend by using techniques like internal transfer prices, overhead
payments, and so on. To obtain a conservative estimate of the contribution by the project,
the financial manager can include only the income which is remittable via legal and open
channels. If this value is positive no more additions are made. If it is negative, we can add
income that is remittable via other methods not necessary legal. Another adjustment in
multinational capital budgeting is the problem of Blocked funds. Accounting for blocked
funds in the capital budgeting process depends on the opportunity cost of blocked funds.
If the blocked funds can be utilized in a foreign investment, the project cost to the
investors may be below the local project construction cost. Also, if the opportunity cost
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of the blocked funds is zero the entire amount released for the project should be
considered as a reduction in the initial investment.
The Tax Issue:Both in domestic & multinational capital budgeting, only after tax cash flows are
relevant for project evaluation. However, in multinational capital budgeting, the tax
issue is complicated by the existence of the taxing jurisdiction, plus a number of other
factors. The other factors include the form of remittance to the parent, dividends
management, fees, royalties etc. tax withholding provisions in the host country,
existence of tax treaties, etc. in addition, tax laws in many host countries discriminate
between transfer of realized projects as against local reinvestment of these profits.
The ability of the management firm to reduce its overall tax burden through the
transfer pricing mechanism should also be considered.
To calculate the actual after-tax cash flow accruing to the parent the higher of the
home or host country tax rate can be used. This will represent a conservative scenario in
the sense that if the project proves acceptable under this alternative then it will
necessarily be acceptable under the more favorable tax scenario. If not, other tax saving
may be incorporated in the calculation to determine whether or not the project crosses the
hurdle rate.
Ques 6:-
Briefly explain the various techniques to assess country risk?
Ans 6:- Country risk is an indispensable tool for asset management as it requires the
assessment of economic opportunity against political odds. A firm should incorporate the
country risk assessment in its decision of whether to continue (or begin) investment in a
particular country or not. Also, the country risk needs to be monitored continuously, since
if risk becomes too high, the MNC will have to divest its subsidiaries in that country.
Techniques it assess country risk
The techniques to assess country risk mainly try and identify certain key
economic political, and financial variables including a country’s economic growth rate,
its current account balance relative to gross domestic products and various ratios-debt to
GDP, debt service payments to GDP, saving to investments etc. some of the more
popular indicators to assess country risk are: Page : 13/25
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A)
International Financial Management (FM-406) Contact: 92533-50008, 94164-43238
Debt Related Factors:-
The debt related factors are the quickest variables employed test the possibility of
a country defaulting due to debt. To predict the risk of default, there are two different
theoretical approaches. One approach regards default as arising out of an unintended
deterioration in the borrowing country’s capacity to service its debt. The other approach
views the probability of default of external debt as an international decision made by the
borrower based on an assessment of the costs and benefits to rescheduling. Difficulties in
debt servicing could be a result of short term liquidity problems or could be a result of
short term liquidity problems or could be attributed to long term solvency problems.
For example, countries with a high export growth rate are more likely to be able
to service their debt and are expected to enjoy better creditworthiness rating since exports
are the main source of foreign exchange earnings for most countries. Thus, lower export
earnings are likely to increase the likelihood of short term liquidity problems and hence
difficulties with debt serving. Similarly, a decline in the growth of output could
contribute to long term insolvency problem and lower the country’s credit rating.
The debt service indicators include:-
Debt/GDP
-
Debt/foreign exchange receipts
-
Short term debts/total exports
-
Debt service ratio.
-
Interest payments/Foreign exchange receipts
-
Current account balance on GNP.
B)
Balance of payments: The fundamental determinate of a country’s vulnerability is its balance of
payment. The balance of payment management is a function of among other things,
internal goals and changing external circumstances.
A useful indicator of country risk analysis is the current account balance. It
summarizes the country’s total transactions with the rest of the world for goods and
services and represents the difference between national income and expenditure. It also
indicates the rate at which a country is building foreign assets.
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The BOP on current account is negatively related to the probability of default
since the current account deficit broadly equals the amount of new financing required.
Countries with large current account deficits are thus less creditworthy.
The balance of payments indicators include:-
Foreign income elasticity of demand for the exports
-
Imports of goods and services/GDP
-
Effective exchange rate index
-
Non essential consumer goods and services/ total imports
-
External reserves/imports
-
Reserves as % of imports
C)
Economic Performance: -
Economic performance can be measured in terms of country’s rate of
growth and its rate of inflation. The inflation rate can be regarded as a proxy for the
quality of economic management. Thus higher the inflation rate, lower the credit
worthiness rating. The economic performance can be measured by a set of ratios that
focus on the long term growth prospects and any economic imbalances of that country.
The significant ratios that can be used to measure economic performance are:-
GNP per capita
-
Gross investment/gross Domestic product
-
Inflation (Change in consumer prices as an average in %. This measures the
quality of economic policy)
D)
-
Money supply (serves as an early indicator for future inflation)
-
Gross Domestic savings/Gross National Product
Political Instability:-
There have been several occasions when sovereign borrowers with the capacity to
service their external debts have defaulted for purely political reasons. Political instability
undermines the economic capacity of a country to service its debt. Political instability has
both direct and indirect effect on the credit rating of a country.
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Political instability has an indirect effect on debt serving difficulties within a
country and reduces a country’s willingness to service debt. Indirectly, political
instability generates adverse consequences for economic growth, inflation, and domestic
supply level of import dependency and creates foreign exchange shortage from an
imbalance between the exports and imports.
The direct effect of political instability on debt service problems emerge in the
form of an unwillingness rather than an inability to service the debt.
E)
The political instability indicates which can be considered are:The political protest, for example protest demonstration, political strikes, riots
etc.
Successful and unsuccessful irregular transfer eg. Coup attempt etc.
Checklist approach:-
A number of relevant indicators that contribute to a firms assessment of a country
risk are chosen and a weight is attached to each. All aspects of risk are summarized in a
single country rating that can be readily integrated into the decision making process.
Factors having greater influence on country risk are assigned greater weights.
The weighted checklist approach employs a combination of statistical and
judgmental factors. Statistical factors try and assess the performance of a country’s
economy in the recent past in the expectation that this will provide an insight into the
future. These factors can be complied earlier. The analyst can choose from a wide range
of statistical factors- rapid rise in production costs, real GDP growth, debt/GDP, import
GDP.
The induction of judgmental factors gives some indication of a country’s future
ability and willingness to repay. Factors in this category includes – exchange rate
management, political stability, balance of payments problems.
Ques 7:-
Write a detailed note on European Monetary System (EMS)?
Ans 7:- European countries were concerned about the negative impact of volatile
exchange rates on their respective economies since the collapse of the Bretton Woods
Agreement on fixed exchange rates in the early 1970s. Attempts were made to salvage
the Bretton Woods system by defining the parties and widening the bonds of variations to
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2.25%. This was the Smithsoman Agreement, which was signed in December 1971 and
was also known as the snake. The ‘Snake’ was designed to keep the European Economic
Community countries exchange rates within a narrower bond of 1.125% for their
currencies. Thus this system allowed a wider bond of 2.25% against the currencies of
other countries while maintaining a narrower bond of 1.125% for their currencies. The
‘Snake’ get its name from the way EEC currencies moved together closely within the
wider bond allowed for other currencies like the dollar.
The Snake was adopted by the EEC countries because they felt that stable
exchange rates among the EEC countries was essential for deepening economic
integration and promoting intra EEC trade. However the snake agreement was replaced
by the European Monetary system in 1979 and has since then undergone a number of
major changes including major crisis and reorganization in 1992 and 1993.
The chief objective of the EMS are:To form a zone of monetary stability in Europe
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To coordinate the exchange rate policies vis-a vis the non EMS currencies.
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To help in the eventual formation of a European Monetary. The EMS has three
components.:
i)
Exchange Rate Mechanism (ERM)
ii)
European Currency Unit (ECU)
iii)
European Monetary Cooperation fund (EMCF)
i)
Exchange Rate Mechanism (ERM)
It refers to the producer by which the EMS member countries collectively manage
their exchange rates. The ERM is based on a ‘parity grid mechanism’ that places an
upper and lower limit on the possible exchange rates between each pair of member
currencies . in a parity grid mechanism each country is obliged to intervene whenever its
exchange rate reaches the upper or lower limit against any other currency. The parity grid
system, in the ERM, is in the form of a matrix showing for each pair of currencies the par
value in addition to the highest and earnest permitted exchange rates. Each currency is
then allowed to fluctuate 2¼ percent above and below the par rates. Each currency has
hence got three exchange rates:a) The par value , b) an upper limit and c) a lower limit.
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1)
2)
3)
ii)
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A bilateral responsibility for the maintenance of exchange rates.
Availability of additional support mechanism that helps in maintaining the
parities.
If the currencies irretrievably diverge from parity a last resort or safety value of
agreed upon realignments.
European Currency Unit:-
The ECU is a “basket” currency based on a weighted average of the currencies of
member countries of the European Unit. The weights are based on each country’s
relative size of GNP and on each member’s share of intra-European Union trade. The
ECU’s Value varies over time as the member currencies float jointly with respect to the
US dollar and other non-member currency.
The ECU serves as the accounting unit of the EMS and helps in the working of
the exchange rate mechanism. Infect the ECU since Jan’1999 has evolved into the
common currency of the European Union and is called the ‘Euro’.
The kinds of mechanism were energized in the EMS. One mechanism was based
on the parity grid while the other was in terms of a divergence indicator defined with
reference to the ECU.
Ques 8:- Write short note on World Bank and International Monetary Fund.
Ans 8:- At the Bretton woods conference in 1944, it was decided to establish a new
monetary order that would expand inter national trade, promote international capital
flows and contribute to monetary stability. The IMF and the World Bank were born out
of this conference at the end of World War II. The World Bank was established to help
the restoration of economies disrupted by War by facilitating the investment of capital for
productive purposes and to promote the long range balanced growth of international
trade. On the other had, IMF is primarily a supervisory institution for coordinating the
efforts of member countries to achieve greater cooperation in the formulation of
economic policies. It helps to promote exchange stability and orderly exchange relations
among its member countries.
The World Bank
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The World Bank group is multinational financial institution established at the end of
World War II to help provide long term capital for the reconstruction and the
development of member countries. The group is important to MNC’s because it provides
much of the planning and financing for economic development projects involving billions
of dollars for which private business can act as contractors and suppliers of goods and
engineering related services.
The purpose for the setting up the bank are:To assist in the reconstruction and development of territories of members by
facilitating the investment of capital for production purposes, including the restoration of
economies destroyed or disrupted by War.
To promote the long-range balanced growth of international trade and the
maintenance of equilibrium in the balance of payments by encouraging international
investment for the development of the productive resources of members, thereby assisting
in raising productivity, the standard of living etc.
To arrange the loans made or guaranteed by it in relation to international loans
through other channels so that the more useful and urgent projects, large & small alike,
can be dealt with first.
To conduct its operations with due regard to the effect of international investment
on business conditions in the territories of member.
The World Bank is the International Bank for reconstruction and Development
(IBRD) and the International Development Association (IDA). The IBRD has two
affiliates, the International Finance Corporation and the Multilateral Investment
Guarantee Agency. The Bank, IFC and MIGA are sometimes referred to as the “World
Bank Group”.
The World Bank is the world’s largest source of development assistance. The
bank uses its financial resources, its highly trained staff and its extensive knowledge base
to individually help each developing country. The main focus is on helping the poor
people and the poorest countries but for its clients, the Bank emphasis the need for
investing in people, particularly through basic health and education, protecting the
environment, strengthening the ability of the governments to deliver quality services
efficiently, promoting reforms to create a stable macroeconomic environment conducive
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to investment and long term planning, focusing on social development inclusion,
governance and institution building as key elements of poverty reduction. The bank is
also helping countries to strengthen and sustain the fundamental conditions that help to
attract and retain private investment.
INTERNATIONAL MONETARY FUND
The International Monetary Fund (IMF) came into official existence on December
27,1945 when 29 countries signed its Article of Association agreed at a conference held
in Bretton Woods, USA from July 1-22, 1944. the IMF commenced financial operation
on March 1. 1947. Its current membership is 182 countries.
IMF is a cooperative institution that 182 countries have voluntarily joined because
they see the advantage of consulting with one another on this forum to maintain a stable
system of buying and selling their currencies so that payments in foreign currency can
take place between countries smoothly and without delay. Its policies and activities are
guided by its charter known as the Articles of Agreements.
IMF lends money to members having trouble meeting financial obligations to
other members, but only on the condition that they undertake economic reforms to
eliminate these difficulties for their own goods and that of the entire membership.
On Joining the IMF, each member country contributes a certain sum of money
called a ‘quota subscription’ as a sort of credit union deposit. Quotas serve various
purposes.
They form a pool of money that the IMF can draw from to lend to members in
times of the financial difficulties.
They form the basis of determining the special Drawing Rights (DWR)
They determine the voting power of the members.
Statutory purposes.
The purposes of the IMF are:-
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To promote international monetary cooperation through a permanent institution
which provides the machinery for consultation on international monetary
problems.
To promote exchange stability, to maintain orderly exchange arrangements among
members and to avoid competitive exchange depreciation.
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Ques 9:-
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Write a short note on GATT?
Ans 9:- The General Agreement on Tariff and Trade during World War II, the world
economy was badly shattered. Immediately after the war ended, the reconstruction of the
world economy and the restoration of trade, which had virtually stopped during the war,
become of permanent global concern. The many import restrictions instituted during the
great depression of the 1930s continued to be a major stumbling block in promoting
trade. GATT was founded to alleviate this problem. GATT was negotiated in 1947 and
went into effect in January 1948. the twenty three countries that originally singed it were
engaged at the time in drawing up the charter for a proposed international trade
organization (ITO) which would have been a United Nations special agency.
GATT based largely on select parts of the draft ITO charter, was concluded
quickly in order to speed trade liberalization. It was expected that ITO would soon
assume responsibility. However, plans for ITO were abandoned when it become clear
that its charter would never be rectified and GATT becomes the only international
instrument of trade rules accepted by the world’s major trade nations. Only international
instrument of trade rules accepted by the world’s major trade nations.
Today GATT is a multilateral treaty subscribed to by ninety governments which
together account for more than four-fifths of world trade, GATT’s rules govern the trade
of its member countries and the conduct of their trade relations with one another. The
contractual rights and obligations that it embodies have been accepted voluntarily in the
mutual interest of its member countries. Overseeing the application of these rules is an
important and continuing part of GATT’s . actually GATT is also a means whereby
countries negotiate and work together for the reduction of trade barriers in pursuit of the
constant and fundamental aim of further liberalization of word trade. In successive
multilateral negotiation through GATT, obstacles to trade have been progressively
reduced.
Since GATT has been in force, its activities have evolved in response to major
changes in the world economic scene. These changes have included shifts in the relative
economic strength of important countries or group of countries, the emergence of the
developing third world as a major force in international affairs, the towards regional or
preferential economic groups, new monetary and payments difficulties, and the growing
participation of Eastern European Countries in GATT. These changes have emphasized
GATT’s role as a forum where such developments can be discussed and disputes
resolved so that their undesirable effects can be countered through continuing efforts
toward further liberalization of world trade.
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Ques 10:- Write a brief note on Taxation for multinational firms.
Ans 10:- The yield of tax planning for multinational operations is an extremely complex
but vitally important aspect of international business. The basic purpose of the
multinational tax planning to minimize the firms worldwide tax burden.
Double Taxation Avoidance Agreements
Double taxation relief:
Double taxation means taxation of some income of a person in more than one
country. This results due to countries following different rules for income taxation. There
are two main rules of income taxation (a) source of income rule and (b) residence rule.
As per source of income rule, the income may be subject to tax in the country
where the source of such income exist whether the income earner is a resident of such
country or not.
On the other hand income earner may be taxed on the basis of his residential
status in that country. e.g. if a person is resident of a country, he may have to pay tax of
any income earned outside that country as well.
Further some countries may follow a mixture of the above two rules.
Thus the problem of double taxation arises if a person is taxed in respect of any income
on the basis of source of income rule in one country and on the basis of residence in
another country or on the basis of mixture of above two rules.
Relief against such hardship can be provided mainly in two ways:- (a) Bilateral relief (b)
Unilateral relief.
(a) Bilateral Relief
The governments of the two countries can enter into agreement of provide relief
against double taxations worked out on the basis of mutual agreement between the two
concerned sovereign states. This may be called a scheme of bilateral relief’ as both
concerned powers agree as to the basis of the relief to be granted by either of them.
Agreement for bilateral relief may be of following two kinds:Agreement where two countries agree that income from various specified sources, which
are likely to be taxed in both the countries, should either be taxed in only one of them or
that each of the two countries should tax only a particular specified portion of the income
so that there is no overlapping. Such an agreement will result in a complete avoidance of
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double taxation of the same income in the two countries. This is known as the exemption
method of relief.
The agreement that does not envisage any such scheme of single taxability but
merely provides that, if any item of income is taxed in both the countries, the assesses
should get relief in a particular manner. Under this type of agreement, the assesse is liable
to have his income taxed in both the countries but is given a deduction, from the tax
payable by him in India, of a part of taxes paid by him thereon, usually the lower of the
two taxes paid. This is known as tax credit method of relief.
Bilateral agreements ensure that either country is to reform from taxing the whole
or part of the income only if the other country has kept to its part of the bargain. The
relief under either of these types of agreements depends on an agreement between the
countries concerned.
b)
Unilateral relief:
The above procedure for granting relief will not be sufficient to meet all cases. No
country will be in a position to arrive at such agreement as envisaged above with al the
country of the world fro all time. The hardship of the taxpayer, however, is a crippling
one in all such cases. Some relief can be provided even in such cases by home country
irrespective of whether the other country concerned has any agreement with India or has
otherwise provided for any relief at all in respect of such double taxation. This relief is
known as unilateral relief.
Double Taxation Relief Provisions in India.
In India the relief against the double taxation is provided under section 90 dn 91
of the Income Tax Act.
Where there is agreement with Foreign Countries
[Bilateral Relief] [Section 90]
The Central Government may enter into an agreement with the government of any
country outside India to provide for the following:
A relief in respect of income on which both Income tax under this Act and
income-tax in that country have been paid.
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The type of income, which shall be chargeable to tax in either country so that
there is avoidance of double taxation of income under this Act and under the
corresponding law in force in that country.
In addition the central Government may enter into an agreement to provide:For exchange of information for the prevention of avoidance of income tax
chargeable under this Act or under the corresponding law in force in that
country.
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For recovery of income tax under this act and under the corresponding law in
force in that country.
Countries with which NO agreement exists
[Unilateral Relief] [Section 91]
If any person who is resident in India in any previous years proves that, in respect
of his income which accrued during the previous year, he has paid in any country with
which there is no agreement U/s 90 for the relief or avoidance of double taxation, income
tax, by deduction or otherwise, under the law enforce in that country, he shall be entitled
to the deduction from the Indian income tax payable by him of a sum calculated on such
doubly taxed income at the Indian rate of tax or the rate of tax of eh said country,
whichever is the lower, or at the Indian rate of tax of both the rates are equal.
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