Financial forces in

international business

Foreign Exchange
Foreign exchange, or Forex, is the conversion of one
country's currency into that of another.
The value of any particular currency is determined by
market forces based on trade, investment, tourism,
and geo-political risk
Foreign exchange is handled globally between banks
and all transactions fall under the auspice of the Bank
of International Settlements.

Factors affecting Demand and

Supply of Exchange rate
Imports and Exports
a rise in import will increase the supply of ones currency
consequence, is depreciation of the currency. Vice versa for
exports.
Money supply of the currency
decrease in money supply of the currency will reduce its
supply in the market and shift the supply curve to left giving a
rise to the price of the currency
Increase in foreign cash inflow
an increase in foreign inflow of cash will increase the demand
for the currency appreciating the price.

Changes in Demand and Supply of foreign exchange

Example of foreign exchange rate

implication on business.
For example, a firm completes a project in Germany and is
paid 1,000,000 Euros for doing so. However, the firm's
domestic currency (the US dollar) is strong and is worth 2
Euros. As such, the exchange of the currency when the profits
are brought home will yield a $500,000 profit domestically.
Contrastingly, if the dollar is weak and 1 Euro is worth $2, the
project will yield the company $2,000,000 in profit after the
exchange of funds. Because exchange rates change daily,
profits realized from a lengthy foreign project can be eroded
unexpectedly. The company can leave the profits overseas
until markets improve, but many countries (including the US)
are beginning to tax companies for doing so in an effort to
have them bring money home sooner

Exchange rate systems and international business

Free-Floating Systems

In a free-floating exchange rate system, governments and

central banks do not participate in the market for foreign
exchange
A free-floating system has the advantage of being selfregulating.

 Suppose, for example, that a dramatic

shift in world preferences led to a sharply
increased demand for goods and services
produced in Canada. This would increase
the demand for Canadian dollars, raise
Canadas exchange rate, and make
Canadian goods and services more
expensive for foreigners to buy. Some of
the impact of the swing in foreign demand
would thus be absorbed in a rising
exchange rate. In effect, a free-floating
exchange rate acts as a buffer to insulate

 The primary difficulty with free-floating exchange

rates lies in their unpredictability
Fluctuating exchange rates make international
transactions riskier and thus increase the cost of doing
business with other countries.

Managed Float Systems

Government or central bank participation in a floating
exchange rate system is called amanaged float.
Countries that have a floating exchange rate system
intervene from time to time in the currency market in
an effort to raise or lower the price of their own
currency
Still, governments or central banks can sometimes
influence their exchange rates. Suppose the price of a
countrys currency is rising very rapidly.
Suppose the price of a countrys currency is rising very
rapidly. The countrys government or central bank might
seek to hold off further increases in order to prevent a
major reduction in net exports.

Maintaining a Fixed Exchange

Rate through Intervention

 Initially, the equilibrium price of the British pound

equals $4, the fixed rate between the pound and
the dollar. Now suppose an increased supply of
British pounds lowers the equilibrium price of the
pound to $3. The Bank of England could purchase
pounds by selling dollars in order to shift the
demand curve for pounds toD2. Alternatively, the
Fed could shift the demand curve toD2by buying
pounds.

 Fixed exchange rate systems offer the advantage

of predictable currency valueswhen they are
working.
But for fixed exchange rates to work, the countries
participating in them must maintain domestic
economic conditions that will keep equilibrium
currency values close to the fixed rates.
Sovereign nations must be willing to coordinate
their monetary and fiscal policies. Achieving that
kind of coordination among independent countries
can be a difficult task.

Taxation and tariffs

A tariff or customs duty is a tax levied
upon goods as they cross national
boundaries, usually by the government of
the importing country. The words tariff,
duty, and customs are generally used
interchangeably.
Tariffs may be levied either to raise
revenue or to protect domestic industries,

Tariffs are implied by the

government because;
To protect fledgling domestic industries from
foreign competition.
To protect aging and inefficient domestic
industries from foreign competition.
To protect domestic producers from dumping by
foreign companies or governments. Dumping
occurs when a foreign company charges a price in
the domestic market which is "too low". In most
instances "too low" is generally understood to be
a price which is lower in a foreign market than the
price in the domestic market. In other instances
"too low" means a price which is below cost, so

How tariff is affecting international trade?

It makes foreign products more expensive, which
means that consumers have to pay more.
It also means the inefficient firms in the protected
industry get a free ride. That is very bad for the
economy. It means people will earn less in the
country over all, and pay more for foreign goods.
It means less people will have jobs. It means
inflation will be higher.
. In the long term, businesses may see a decline
in efficiency due to a lack of competition, and
may also see a reduction in profits due to the
emergence ofsubstitutesfor their products.

How Do Tariffs Affect Prices And Business?

 The overall effect is a reduction in imports,

increased domestic production and higher
consumer prices.

Inflation and deflation

Inflation can be defined as an increase in the
average price level of goods and services.
Deflation can be defined as a fall in the average
price level of goods and services

Causes of inflation
1. Demand-pull. This means buyers want to buy more than
sellers can actually produce; so sellers start to put prices up.
2. Cost-push. This means business costs start to rise (eg oil
prices rise, or wages start to rise) and sellers need to put
prices up to compensate.
3. Monetarist view. This means the government allows too
much money to be created . If the supply of money rises,
then the price falls just as if the supply of potatoes rises, then
the price falls. The price of money here is how many goods
and services it will buy. If the price of money falls, then it will
buy fewer goods and services ie prices of goods and services
rise and the value of money falls. This is inflation.

The impact of inflation on international business

Cost increases can be passed on to consumers more easily
if there is a general increase in prices.
The real value of debts owed by companies will fall. This
means that, because the value of money is falling, when a
debt is repaid it is repaid with money of less value than the
original loan. Thus, highly geared companies see a fall in the
real value of their liabilities.
Rising prices are also likely to affect assets held by firms, so
the value of fixed assets, such as land and building, could
rise. This will increase the value of business and, when
reflected on the balance sheet, make the company more
financially secure.
Since stocks are bought in advance and then sold later,
there is an increased margin from the effect of inflation.

 during inflation that are not excessive, business could decide to raise
their own prices, borrow more to invest and ensure that increased
asset value appear on their balance sheet. However, high rates of
inflation say 10% and above can be damaging for the business
Staff will become much more concerned about the real value of their
incomes. Higher wage demands are likely and there could be an
increase in industrial disputes.
Consumers are likely to become much more price sensitive and look
for bargains rather than big names.
Rapid inflation will often lead to higher rates of interest. These higher
rates could make it very difficult for highly geared companies to find
the cash to make interest payments, despite the fact that the real
value of the debts is declining.
Cash flow problems may occur for all businesses as they struggle to
find more money to pay the higher costs of materials and other costs.

 If inflation is higher in one country than in other

countries then business will lose its competiveness in
overseas market
Business that sell goods on credit will be reluctant to
offer extended credit periods the repayments by
creditors will be with money that is losing value rapidly.
Consumers may stockpile some items or transfer their
disposable income t commodities that are more likely to
hold or increase value.
Business may be forced to cut back spending, cut profit
margins to limit their price rises, reduce borrowing to
levels at which the interest payments are manageable
hindering stimulation of investment, and layoff workers.

Balance Of Payment: Another financial

environmental force

The balance of payment is a statistical record of a

countrys transactions with the rest of the world.
Payments made to other countries are tracked as
debit(-), while payments from other countries are
tracked as credits(+). The BOP is considered as a
double-entry accounting statement in which total
credit and debits are always equal.

The Current Account

Goods
Current Transfers
Income
Services

Why a Current account is considered harmful to economy

If a current account deficit is financed through borrowing it is

said to be more unsustainable.
Borrowing is unsustainable in the long term and countries will
be burdened with high interest payments. E.g. Russia was
unable to pay its foreign debt back in 1998. Other developing
countries have experience similar repayment problems Brazil,
African c (3rd World debt)
Foreigners have an increasing claim on UK assets, which they
could desire to be returned at any time. E.g. a severe financial
crisis in Japan may cause them to repatriate their investments
Export sector may be better at creating jobs
A Balance of Payments deficit may cause a loss of confidence

However a current account deficit is not necessarily

harmful
Current Account deficit could occur during a period of inward
investment (surplus on financial account)
E.g. US ran a current account deficit for a long time as it borrowed
to invest in its economy. This enabled higher growth and so it was
able to pay its debts back and countries had confidence in lending
the US money
Japanese investment has been good for UK economy not only did
the economy benefit from increased investment but the Japanese
firms also helped bring new working practices in which increased
labor productivity.
With a floating exchange rate a large current account deficit should
cause a devaluation which will help reduce the level of the deficit
It depend on the size of the budget deficit as a % of GDP, for
example the US trade deficit has nearly reached 5% of GDP (02/03)
at this level it is concerning economists

What is indebtness?
Indebtness is the state of a nation being in debt.
The national debt of nation can be raised from
domestic market as well as external debt.
Deflation The reduction in demand reduced
business activity and caused further
unemployment.
In a more direct sense, morebankruptciesalso
occurred due both to increased debt cost caused
by deflation and the reduced demandeffectively
made debt more expensive

Conclusion