Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating

<< Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps

FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk >>

Corporate Finance FIN 622

Lesson 44

EXCHANGE RATE SYSTEM & MULTINATIONAL COMPANIES (MNCs)

We shall take care of following topics in this hand out:

Exchange rate determination

Purchasing power parity theory

PPP model

International fisher effect

Exchange rate system

Fixed

Floating

Multinational companies (MNC)

Reasons of growth in MNCs

Exchange Rate Determination:

There is no established standard or model that could measure the size of change in the exchange rate of two

currencies. It is possible for a currency to depreciate relative to the other while appreciating against others.

The exchange rate is normally measured against different benchmarks.

Most of our foreign exchange deals in Pak rupees are in exchange for US $ and some international trade is

conducted only in US$. Pak rupees exchange rate with different currencies weighted according to the

pattern of Pak trade will give a useful indication of the exchange rate of Pak rupees with rest of the

currencies.

Changes and fluctuations in the exchange rate emerges from the change in the demand and supply of the

currency. These fluctuations or changes are due to international trade. If our exports are more than our

imports than this means the demand of our currency is rising and our currency will strengthen against the

other currencies. Whereas, if our imports are greater than our exports, this means we need more foreign

exchange or foreign currencies to pay import bill. Demand for foreign currencies will rise resulting in

weakening of our local currency.

The exchange rate changes are also due to capital movements between economies. These transactions are

effectively moving bank deposits from one currency to another. These flows are now more important than

the volume of trade in goods and services. Thus, supply and demand for a currency may reflect events on

the capital account.

Purchasing Power Parity Theory:

Purchasing power parity (PPP) is a theory, which states that exchange rates between currencies are in

equilibrium when their purchasing power is the same in each of the two countries. This means that the

exchange rate between two countries should equal the ratio of the two countries' price level of a fixed

basket of goods and services. When a country's domestic price level is increasing (i.e., a country experiences

inflation), that country's exchange rate must depreciated in order to return to PPP.

The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs,

competitive markets will equalize the price of an identical good in two countries when the prices are

expressed in the same currency. For example, a particular TV set that sells for 750 Canadian Dollars [CAD]

in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the

US is 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would

prefer buying the TV set in Vancouver. If this process (called "arbitrage") is carried out at a large scale, the

US consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian

goods more costly to them. This process continues until the goods have again the same price. There are

three caveats with this law of one price. (1) As mentioned above, transportation costs, barriers to trade, and

other transaction costs, can be significant. (2) There must be competitive markets for the goods and services

in both countries. (3) The law of one price only applies to tradable goods; immobile goods such as houses,

and many services that are local, are of course not traded between countries.

Purchasing power parity is an economic technique used when attempting to determine the relative values of

two currencies. It is useful because often the amount of goods a currency can purchase within two nations

varies drastically; based on availability of goods, demand for the goods, and a number of other, difficult to

determine factors.

Purchasing power parity solves this problem by taking some international measure and determining the cost

for that measure in each of the two currencies, then comparing that amount.

145

Corporate Finance FIN 622

Purchasing power parity (PPP) is in economics the method of using the long-run equilibrium exchange rate

of two currencies to equalize the currencies' purchasing power. It is based on the law of one price, the idea

that, in an efficient market, identical goods must have only one price.

Purchasing power parity is often called absolute purchasing power parity to distinguish it from a related

theory relative purchasing power parity, which predicts the relationship between the two countries' relative

inflation rates and the change in the exchange rate of their currencies.

A purchasing power parity exchange rate equalizes the purchasing power of different currencies in their

home countries for a given basket of goods. These special exchange rates are often used to compare the

standards of living of two or more countries. The adjustments are meant to give a better picture than

comparing gross domestic products (GDP) using market exchange rates. This type of adjustment to an

exchange rate is controversial because of the difficulties of finding comparable baskets of goods to compare

purchasing power across countries.

International Fisher Effect:

Nominal interest rates consists of two parts

- Return required by lenders

- Return to cover inflation

If real interest rates are same in all places due to free capital movement and because of law of one price,

then any difference in interest rates will be due to inflation level at difference places. If the real interest rates

in countries have not properly affected inflation rate, the capital will move from low to high interest

country. Countries with high interest rate will register capital inflow and will result in appreciation in

exchange rate.

Countries with low interest rate will experience capital outflow and will result in depreciation in exchange

rate. This is known as interest rate parity model. Interest rate parity model shows that exchange rate can be

predicted by taking into account the differences in nominal exchange rates.

If the forward rates for PKR against US $ is the same as spot rate between the two currencies but the

nominal interest rates are higher in US then following would be the situation:

Pak investor will shift funds to US to earn higher return. There will be outflow of capital from PAK to US.

Pak interest rate will increase and spot $ rate will move up.

Exchange Rate System:

An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the

value of another country's currency compared to that of your own. If you are traveling to another country,

you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the price at which

you can buy that currency. Theoretically, identical assets should sell at the same price in different countries,

because the exchange rate must maintain the inherent value of one currency against the other.

Fixed

There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a

rate the government (central bank) sets and maintains as the official exchange rate. A set price will be

determined against a major world currency (usually the U.S. dollar, but also other major currencies such as

the euro, the yen, or a basket of currencies). In order to maintain the local exchange rate, the central bank

buys and sells its own currency on the foreign exchange market in return for the currency to which it is

pegged.

If, for example, it is determined that the value of a single unit of local currency is equal to USD 3.00, the

central bank will have to ensure that it can supply the market with those dollars. In order to maintain the

rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign

currency held by the central bank which it can use to release (or absorb) extra funds into (or out of) the

market. This ensures an appropriate money supply, appropriate fluctuations in the market

(inflation/deflation), and ultimately, the exchange rate. The central bank can also adjust the official

exchange rate when necessary.

Floating

Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and

demand. A floating rate is often termed "self-correcting", as any differences in supply and demand will

automatically be corrected in the market. Take a look at this simplified model: if demand for a currency is

low, its value will decrease, thus making imported goods more expensive and thus stimulating demand for

local goods and services. This in turn will generate more jobs, and hence an auto-correction would occur in

the market. A floating exchange rate is constantly changing.

146

Corporate Finance FIN 622

In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence

changes in the exchange rate. Sometimes, when a local currency does reflect its true value against its pegged

currency, a "black market" which is more reflective of actual supply and demand may develop. A central

bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the

unofficial one, thereby halting the activity of the black market.

In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid

inflation; however, it is less often that the central bank of a floating regime will interfere.

Between 1870 and 1914, there was a global fixed exchange rate. Currencies were linked to gold, meaning

that the value of a local currency was fixed at a set exchange rate to gold ounces. This was known as the

gold standard. This allowed for unrestricted capital mobility as well as global stability in currencies and

trade; however, with the start of World War I, the gold standard was abandoned.

At the end of World War II, the conference at Bretton Woods, in an effort to generate global economic

stability and increased volumes of global trade, established the basic rules and regulations governing

international exchange. As such, an international monetary system, embodied in the International Monetary

Fund (IMF), was established to promote foreign trade and to maintain the monetary stability of countries

and therefore that of the global economy.

It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S. dollar, which in

turn was pegged to gold at USD 35/ounce. What this meant was that the value of a currency was directly

linked with the value of the U.S. dollar. So if you needed to buy Japanese yen, the value of the yen would be

expressed in U.S. dollars, whose value in turn was determined in the value of gold. If a country needed to

readjust the value of its currency, it could approach the IMF to adjust the pegged value of its currency. The

peg was maintained until 1971, when the U.S. dollar could no longer hold the value of the pegged rate of

USD 35/ounce of gold.

From then on, major governments adopted a floating system, and all attempts to move back to a global peg

were eventually abandoned in 1985. Since then, no major economies have gone back to a peg, and the use

of gold as a peg has been completely abandoned.

Why Peg?

The reasons to peg a currency are linked to stability. Especially in today's developing nations, a country may

decide to peg its currency to create a stable atmosphere for foreign investment. With a peg, the investor will

always know what his/her investment value is, and therefore will not have to worry about daily fluctuations.

A pegged currency can also help to lower inflation rates and generate demand, which results from greater

confidence in the stability of the currency.

Fixed regimes, however, can often lead to severe financial crises since a peg is difficult to maintain in the

long run. This was seen in the Mexican (1995), Asian and Russian (1997) financial crises: an attempt to

maintain a high value of the local currency to the peg resulted in the currencies eventually becoming

overvalued. This meant that the governments could no longer meet the demands to convert the local

currency into the foreign currency at the pegged rate. With speculation and panic, investors scrambled to

get out their money and convert it into foreign currency before the local currency was devalued against the

peg; foreign reserve supplies eventually became depleted.

Countries with pegs are often associated with having unsophisticated capital markets and weak regulating

institutions. The peg is therefore there to help create stability in such an environment. It takes a stronger

system as well as a mature market to maintain a float. When a country is forced to devalue its currency, it is

also required to proceed with some form of economic reform, like implementing greater transparency, in an

effort to strengthen its financial institutions.

Some governments may choose to have a "floating," or "crawling" peg, whereby the government reassesses

the value of the peg periodically and then changes the peg rate accordingly. Usually the change is

devaluation, but one that is controlled so that market panic is avoided. This method is often used in the

transition from a peg to a floating regime, and it allows the government to "save face" by not being forced

to devalue in an uncontrollable crisis.

Although the peg has worked in creating global trade and monetary stability, it was used only at a time when

147

Corporate Finance FIN 622

all the major economies were a part of it. In addition, while a floating regime is not without its flaws, it has

proven to be a more efficient means of determining the long-term value of a currency and creating

equilibrium in the international market.

Multinational companies (MNC):

Economists are not in agreement, as to how multinational or transnational corporations should be defined.

Multinational corporations have many dimensions and can be viewed from several perspectives.

Ownership criterion: some argue that ownership is a key criterion. A firm becomes multinational only

when headquarter or parent company is effectively owned by nationals of two or more countries. For

example, Shell and Unilever, controlled by British and Dutch interests, are good examples. However, by

ownership test, very few multinationals are multinational. The ownership of most MNCs is uni-national.

Depending on the case, each is considered an American multinational company in one case, and each is

considered a foreign multinational in another case. Thus, ownership does not really matter.

Nationality Mix of Headquarter Managers: An international company is multinational if the managers

of the parent company are nationals of several countries. Usually, managers of the headquarters are

nationals of the home country. This may be a transitional phenomenon. Very few companies pass this test

currently.

In other word, a MNC is a parent company that

1. engages in foreign production through its affiliates located in several countries,

2. exercises direct control over the policies of its affiliates,

3. Implements business strategies in production, marketing, finance and staffing that transcend

national boundaries.

In other words, MNCs exhibit no loyalty to the country in which they are incorporated.

A MNC is a company that generates at least 25% of its total sales from foreign countries.

A MNC has offices / production facilities/ branches / subsidiaries spread across more than one country

(home country). May have capital raised in billion in more than one location, using tax heavens, employing

cheap labor.

the activities of several MNCs are of prime importance because of their size and the role they play in world

economy. Some of the large MNCs are operating in more than 100 countries around the globe.

MNCs have received special attention in developing and less developed countries. This is a twin face issue.

On one side, they bring necessary capital need to developing countries, contributing to their growth and

reducing unemployment. On the other side, these MNCs exploit cheap labor and tax heavens in these

developing countries.

Reason for MNC Growth:

Analysis has focused on those factors, which need to be present if the transformation of a national

company into MNC is to be successful and these will be looked at in some depth. Of course, from one

point of view one could say that the MNC results from a natural expansion from one country to another.

The process has been greatly facilitated by the advancement in communication, both by physical and

electronic and by the international mobility of capital.

With the restriction on capital mobility were reduces the companies in US and Europe found it beneficial to

move their capital to the countries, who offered protection to their investments and also provided some

incentives, in order to increase the return on their investments. By reducing the payroll cost and by paying

far less taxes in developing countries, MNCs made filthy profits and significant portion of these were

repatriated to their home country.

During the past two decades, the developing countries have eased many of the formalities for set up new

business by designing business-friendly policies and removing barriers to make their country attractive to

the foreign investors. In addition, these countries have reduced the tariffs to maximum extent in order to

facilitate international trade between the countries.

148

Table of Contents: