INR 2002 Exam 3 Study Guide December 13th 10 00 am 12 00 pm Chapter 8 International Financial Relations Types of Investment o Portfolio investment Why invest abroad Why borrow abroad Investments in a foreign country via the purchase or stocks equities bonds or other financial instruments Portfolio investors do not exercise managerial control of the foreign operation Take little or no part in running their investment their interest is simply in the rate of return o Sovereign lending Loans from private financial institutions in one country to sovereign governments in other countries Is most of the portfolio investment that goes to developing countries o Foreign direct investment FDI Investment in a country via the acquisition of a local facility or the establishment of a new facility Direct investors maintain managerial control of the foreign operation and also bears the full long term risk o Many international investors want to take money from capital rich developed countries to capital poor developing countries o Banks corporations and individuals in rich countries invest more than 800 billion every year in developing nations About half in direct investment from multinational corporations The other half in loans and related investments o Hecksher Ohlin Theory Foreign Investment A country s average profit depends on how plentiful capital is The greater scarcity of capital as well as higher interest rates in developing than developed countries encourages capital flow from richer to poor countries o Only about 10 percent of all international investment in the past couple of decades has gone to the developing world due to the lower risk of cross border investment in rich countries o International investment involves a very specific risk that a foreign government over which the investor has no influence may do things that reduce the value of the investment Especially true for loans to a foreign government Risk of International Investment Concessional Finance Why is international finance controversial o Concessional finance is money lent to developing countries by government agencies and international organizations it is typically lent at interest rates well below those available in the marketplace For example World Bank loans to the poorest nations bear no interest to promote economic development o There has been less political controversy about concessional finance because loans from individual governments are negotiated directly and relatively cheap o Private lending to foreign governments has historically been the most important and most politically conflictual component of international investment o As more capital comes into the nation it is cheaper and easier for people in the recipient country to borrow but sovereign debts can quickly become a burden to debtor nations Governments often cut spending and raise taxes in order to earn money to pay off their loans they raise interest rates and reduces imports and increases exports These measures weaken an economy and can lead to Recession a sharp slowdown in the rate of economic growth and activity Depression a severe downturn in the business cycle a sever contraction of credit and sustained high unemployment Default to fail to make payments on a debt o How does a rise in US interest rates lead to a crisis in debtor nations Most of the debts owed by developing countries to international banks were at floating interest rates adjusted every six months in line with American interest rates as American rates went up so did the cost of outstanding loans This was one of the causes of the debt crisis of the 1980s Also an international recession that reduces demand for debtors exports can make it hard to service loan such as what occurred during the Great Depression and caused almost every debtor nation to default o Domestic conflict within creditor nations over international lending Many people resent their governments for bailouts because they rescue banks and allow small farms and businesses to go under Examples US bailing out Mexican government after another Mexican crisis in 1994 US and EU financial rescues after the global crisis that Debtor Creditor Interactions began in 2008 o For debtor nations in crisis making prompt and full debt service payments can mean austerity the application of policies to reduce consumption typically by cutting government spending raising taxes and restricting wages o Financial weapons available to creditors The principal bargaining weapon available to the debtor government is the threat of default or suspension of payment on the debt But creditors also have financial weapons available they can cut off debtor governments from future lending and they may be able to retaliate in related areas such as freezing debtor governments bank accounts or taking other government owned properties o International debtor creditor interactions are characterized by incomplete information Institutions of International Finance o Bank for International Settlement BIS o International Monetary Fund IMF Established in 1930 explicitly to help oversee relations between one of the world s most problematic debtor nations Germany and its international creditors One of the oldest international financial organizations Its members include the world s principal central banks and under its auspices they attempt to cooperate in the financial realm A major international economic institution that was established in 1944 to manage international monetary relations and that has gradually reoriented itself to focus on the international financial system especially debt and current crises Today its principal concern is financial crises in developing nations Includes both borrowing and lending countries How does the IMF facilitate international agreements It provides a set of financial and macroeconomic standards and a wealth of other information that can be used to assess the behavior of debtor nations It makes cooperation more attractive by increasing the likelihood that debtor creditor relations will be repeated It can help verify a debtor government s compliance And the IMF can act on behalf of the collectivity of creditor nations Why do corporations go multinational Why is the IMF unusual The IMF negotiates agreements directly with an individual country s government Even more unusual the IMF s involvement is typically closely tied to relations between the debtor government and private international creditors Views of supporters and opponents
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