Commanding Heights: Episode 3 (Chapters 11-14); available at online at http://www.pbs.org/wgbh/commandingheights/lo/story/index.html – With communism discredited, more and more nations harness their fortunes to the global free-market. China, Southeast Asia, India, Eastern Europe and Latin America all compete to attract the developed world’s investment capital, and tariff barriers fall. In the United States Republican and Democratic administrations both embrace unfettered globalization over the objections of organized labor. But as new technology and ideas drive profound economic change, unforeseen events unfold. A Mexican economic meltdown sends the Clinton administration scrambling. Internet-linked financial markets, unrestricted capital flows, and floating currencies drive levels of speculative investment that dwarf trade in actual goods and services. Fueled by electronic capital and a global workforce ready to adapt, entrepreneurs create multinational corporations with valuations greater than entire national economies.
When huge pension funds go hunting higher returns in emerging markets, enterprise flourishes where poverty once ruled, but risk grows, too. In Thailand the huge reservoir of available capital proves first a blessing, then a curse. Soon all Asia is engulfed in an economic crisis, and financial contagion spreads throughout the world, until Wall Street itself is threatened. A single global market is now the central economic reality. As the force of its effects is felt, popular unease grows. Is the system just too complex to be controlled, or is it an insiders’ game played at outsiders’ expense? New centers of opposition to globalization form and the debate turns violent over who will rewrite the rules. Yet prosperity continues to spread with the expansion of trade, even as the gulf widens further between rich and poor. Imbalances too dangerous for the system to ignore now drive its stakeholders to devise new means to include the dispossessed lest, once again, terrorism and war destroy the stability of a deeply interconnected world.
The Bush Bailout Plan (Rounds 1 and 2) Round 1: Allow the Treasury to borrow up to $700 billion to buy mortgage-related assets from US financial institutions over the next 2 years. –May stabilize the capital markets ( could protect investment and retirement funds) – MAY stabilize housing prices. Consequences of doing nothing: -Small businesses will fail. -Companies may not be able to make payroll -People, even those with good credit records, may not be able to get credit for mortgages, car loans, student loans, or credit cards. -People will lose jobs. Round 2: Same deal: with same possible benefits. House version of the bill: $350 billion upfront; $350 billion later unless congress holds it back. -NO new golden parachutes if the institution sells more than $300 million in assets -Must try to “claw back” past bonuses if based on misleading financial statements -No golden parachutes when the treasury has ownership stake in the firm (.ie., it is failing).
Defined Contribution Retirement Plans – A defined contribution plan provides an individual account for each participant. The benefits are based on the amount contributed into the plan and are also affected by income, expenses, gains and loses. There are no promises of a set monthly benefit at retirement. Some examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans and profit sharing plans. Contagion – The tendency to spread, as of a doctrine, influence, or emotional state. When one nation’s economy is negatively affected because of changes in the asset PRICES of another country’s financial market Foreign Direct Investment – Is when a firm invests resources in facilities to produce and/or market a product in a foreign country.
Horizontal FDI versus Vertical FDI – Horizontal FDI: investment in the same industry in which a firm operates at home. Vertical FDI: investment in an industry that provides inputs for a firm’s domestic operations or that sells the outputs of the firm’s domestic operations. Backward Vertical FDI versus Forward Vertical FDI- Backward vertical FDI: an investment in an industry abroad that provides inputs for a firm’s domestic production processes. Forward Vertical FDI: an investment in an industry abroad that sells the outputs of a firm’s domestic production processes. BACKWARD vertical means that there are more places to help build the product. Stock versus Flow of FDI – Stock flow is the total accumulated value. Flow of FDI is the value over time. Gross Fixed Capital Formation – GFCF is a flow value.
It is usually defined as the total value of additions to fixed assets by resident producer enterprises, less disposals of fixed assets during the quarter or year, plus additions to the value of non-produced assets (such as discoveries of mineral deposits, or land improvements). Greenfield Investment – Establishing a new operation Acquisition – When one firm buys an interest in another firm Merger – When two firms agree to integrate their operations on a relatively co-equal basis.
Exporting – The sale of products produced in one country to residents of another country Licensing – when one firm (the licensor) grants the right to produce its product, use its production processes, or use its brand name or trademark to another firm (the licensee) Tacit versus Codified Knowledge – Tacit knowledge: information that is intuitive and difficult to articulate or codify in writing. (Can be gained through personal experience or interaction. Shared knowledge might be dispersed throughout the company.) Theoretical Explanations for FDI: Transportation Costs, Market Imperfections, Strategic Behavior, Product Life Cycle, and Location-Specific Advantages –
Impediments to the Sale of Know-How – Impediments to the sale of know-how explain why firms prefer horizontal FDI to licensing. These impediments arise when: (a) a firm has valuable know-how that cannot be adequately protected by a licensing contract, (b) a firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (c) a firm’s skills and know-how are not amenable to licensing. Multi-Point Competition – Arises when two or more enterprises encounter each other in different regional markets, national markets, or industries. The Radical, Free Market and Pragmatic Nationalism Views of FDI Benefits and Costs of FDI for a Host Country – Resource transfer effects, employment effects, balance of payments effects, effect on competition and economic growth. Host country benefits from initial capital inflow when MNC establishes business—FINANCIAL CREDIT Host country benefits if FDI substitutes for imports of goods and services—CURRENT ACCOUNTCREDIT Host country benefits when MNC uses its foreign subsidiary to export to other countries—Credit on CURRENT ACCOUNT Resource-Transfer Effects: Capital, Technology and Management Employment Effects: Direct, Indirect, Substitution, and Acquisition Restructuring – -Mergers and acquisitions are quicker to execute.
-Foreign firms have valuable strategic assets that would be risky and time consuming to develop. -Acquiring firm believes it can use its core competencies to increase the efficiency of the acquired firm. Balance-of-Payments Effects of FDI for the Home and Host Countries – Home country – The balance of payments account is improved by the inward flow of repatriated earnings. The balance of payments account is improved if the foreign subsidiary needs home country equipment, component parts, etc. National Sovereignty – Sovereignty is the exclusive right to control a government, a country, a people, or oneself. A sovereign is the supreme lawmaking authority. Benefits and Costs of FDI for a Home Country – Balance of payments effects, employment effects. Home Country Policies to Encourage and Restrict Outward FDI – Restrict: Limits on capital outflows, tax incentives to invest at home, Nation-specific prohibitions Encourage: Foreign Risk Insurance, Capital Assistance, Tax Incentives to Invest Abroad, Political Pressure.
Host Country Policies to Encourage and Restrict Inward FDI – Restrict: Ownership Restraints Encourage: To gain from the resource-transfer and employment effects of FDI, to capture FDI away from other potential host locations. Performance Requirements – An expectation placed on a foreign direct thingy requiring them to do certain things like having some local employees. Basically, this puts restrictions on them like local production requirements. Regional Economic Integration –refers to agreements among countries in a geographic region to reduce and ultimately remove, tariff and non-tariff barriers to the free flow of goods, services, and factors of production between each other. Levels of Economic Integration: Free Trade Area: Remove internal Barriers Customs Union: Common External Barriers Common Market: Free Movement of Factors Economic Union: Common Economic Policy Political Union: Political Integration The Case for and the Case against Regional Integration – For: Increases world production, stimulates growth, regional economic integration can provide additional gains from free trade beyond the international agreements such as GATT and TWO.
Against: a regional trade agreement is beneficial only if it creates more trade than it diverts. Impediments to Regional Integration – Nation as a whole may benefit but certain groups within countries may be hurt. Concerns about loss of national sovereignty and control over the nation’s sovereignty and control over the nations monetary, fiscal and trade policies. Trade Creation versus Trade Diversion – When an inefficient non member nation replaces an efficient member nation (NAFTA). Like Mexico replacing China in the textile business. Creation: occurs when free trade leads to the substitution of inefficient domestic production for efficient production in another member country.
Diversion: Occurs when efficient non-member production is replaced by inefficient production by a member nation as a result of high trade barriers for non-members. The European Union (EU) – is composed of 27 member countries, covers an area of 4 million square kilometers and has approximately 460 million inhabitants. The EU’s member states combined represent the world’s largest economy by GDP, the seventh largest territory in the world by area and the third largest by population. Political Structure of the European Union: European Commission, Council of the European Union, European Parliament and Court of Justice Optimal Currency Area – In economics, an optimum currency area (OCA), also known as an optimal currency region (OCR), is a geographical region in which it would maximize economic efficiency to have the entire region share a single currency. It describes the optimal characteristics for the merger of currencies or the creation of a new currency. Copenhagen Criteria – are the rules that define whether a nation is eligible to join the European Union.
The criteria require that a nation have the institutions to preserve democratic governance and human rights, a functioning market economy, and that the nation accept the obligations and intent of the EU. The Lisbon Treaty – The Treaty of Lisbon (also known as the Reform Treaty) is a treaty designed to streamline the workings of the European Union (EU) with amendments to the Treaty on European Union (TEU, Maastricht) and the Treaty establishing the European Community (TEC, Rome), the latter being renamed Treaty on the Functioning of the European Union (TFEU) in the process.
The stated aim of the treaty is “to complete the process started by the Treaty of Amsterdam and by the Treaty of Nice with a view to enhancing the efficiency and democratic legitimacy of the Union and to improving the coherence of its action.” The North American Free Trade Agreement (NAFTA): Pros and Cons of NAFTA – Pros: Labor intensive industries move to Mexico, resulting in better resource allocation, Mexico gets investment and employment, increased Mexican income to buy US/Canadian goods, demand for goods increases jobs, consumers get lower prices. Cons: Loss of jobs to Mexico for people who don’t have other employment options, Mexican firms have to compete against efficient US/Canadian firms, environmental degradation, loss of national sovereignty.
The Andean Community – The Andean Community is mainly a trade block formerly called the Andean Group (Grupo Andino, in Spanish) which saw light after the Andean Pact (Pacto Andino) or more formally the Cartagena Agreement (Acuerdo de Cartagena) was signed in 1969, in Cartagena (Colombia). Mercado Común del Sur (MERCOSUR) – Argentina, Brazil, Paraguay, Uruguay, and Venezuala. Was originally envisioned as a common market but has yet to reach that goal. Critics contend the agreement results in more trade diversion than trade creation as a result of the high external tariffs. Free Trade Area of the Americas –was a proposal to expand NAFTA to include all countries in the Western Hemisphere, except Cuba. This region has 850 million people and a $13.5 trillion economy. Talks are stalled and stronger support would be needed by the USA and Brazil for this agreement to become a reality. Association of Southeast Asian Nations (ASEAN) / ASEAN Free Trade Area – Indonesia, Malaysia, Philippines, Singapore, Thailand, Brunei, Vietnam, Laos, Myanmar, and Cambodia.
Total population of 500 million, GDP of US $740 billion, and a total trade of US $720 billion A free trade area among some of the nations exists, but several nations are refusing to lower all tariffs. Asia-Pacific Economic Cooperation (APEC) – Founded in 1990 to promote open trade and economic cooperation. Currently has 21 members including the United States, Japan and China. Members account for 57% of the world’s GNP and 46% of global trade. Despite little progress, it could potentially become the world’s largest free trade area. Fiscal versus Monetary Policy – Market economies have regular fluctuations in the level of economic activity which we call the business cycle. It is convenient to think of the business cycle as having three phases. The first phase is expansion when the economy is growing along its long term trends in employment, output, and income. But at some point the economy will overheat, and suffer rising prices and interest rates, until it reaches a turning point — a peak — and turn downward into a recession (the second phase).
Recessions are usually brief (six to nine months) and are marked by falling employment, output, income, prices, and interest rates. Most significantly, recessions are marked by rising unemployment. The economy will hit a bottom point — a trough — and rebound into a strong recovery (the third phase). The recovery will enjoy rising employment, output, and income while unemployment will fall. The recovery will gradually slow down as the economy once again assumes its long term growth trends, and the recovery will transform into an expansion. Foreign Exchange Market –a market for converting the currency of one country into the currency of another. Exchange Rate – the rate at which one currency is converted into another. Foreign Exchange Risk – the risk of an investment’s value changing due to changes in the currency exchange rates. Arbitrage – the purchase of a product in one market for immediate resale in a second market in order to profit from a price discrepancy.
Currency Speculation – short-term movement of funds from one currency to another in hopes of profiting from shifts in exchange rates. Spot Exchanges –the exchange rate at which a foreign exchange dealer would convert one currency to into another currency on that day. Forward Exchanges – the exchange rate at which a foreign exchange dealer will agree to convert one currency into another currency on a specific date in the future. Hedging: Forward Contracts versus Options Selling on a Discount versus Selling at a Premium Currency Swaps – A currency swap (or cross currency swap) is a foreign exchange agreement between two parties to exchange a given amount of one currency for another and, after a specified period of time, to give back the original amounts swapped. Economic Theories of Exchange Rate Determination – Law of One Price – The law of one price is an economic law stated as: “In an efficient market all identical goods must have only one price.”
The intuition for this law is that all sellers will flock to the highest prevailing price, and all buyers to the lowest current market price. In an efficient market the convergence on one price is instant. Purchasing Power Parity – The purchasing power parity (PPP) theory uses the long-term equilibrium exchange rate of two currencies to equalize their purchasing power. Developed by Gustav Cassel in 1920, it is based on the law of one price: the theory states that, in an ideally efficient market, identical goods should have only one price. Big Mac Index – The Big Mac Index is an informal way of measuring the purchasing power parity (PPP) between two currencies and provides a test of the extent to which market exchange rates result in goods costing the same in different countries. As stated in The Economist, it “seeks to make exchange-rate theory a bit more digestible” In 120 nations the big mac is the same.
How Increasing the Money Supply Impacts Exchange Rates Price Discrimination – Price discrimination or yield management occurs when a firm charges a different price to different groups of consumers for an identical good or service, for reasons not associated with costs. Fisher Effect / International Fischer Effect Real versus Nominal Interest Rates 8% interest + 2%inflation = 10% nominal interest. $100 on $1000 loan. Investor Psychology and Bandwagon Effects The Efficient Market School versus the Inefficient Market School – Efficient: Those who believe the foreign exchange market actually predicts things accurately. Fundamental versus Technical Analysis Currency Convertibility: Freely, Externally, and Nonconvertible Currencies Capital Flight – Capital flight, in economics, occurs when assets and/or money rapidly flow out of a country, due to an economic event that disturbs investors and causes them to lower their valuation of the assets in that country, or otherwise to lose confidence in its economic strength.
This leads to a disappearance of wealth and is usually accompanied by a sharp drop in the exchange rate of the affected country (depreciation in a variable exchange rate regime, or a forced devaluation in a fixed exchange rate regime). Transaction versus Translation versus Economic Exposure – Economic exposure: the extent to which a firm’s future international earning power is affected by changes in exchange rates. Lead versus Lag Strategies – Lead: an attempt to collect foreign currency receivables when a foreign currency is expected to depreciate.
Lag: An attempt to delay the collection of foreign currency receivables if that currency is expected to appreciate. Delay paying foreign currency payables if the foreign currency is expected to depreciate. International Monetary System – are institutional arrangements countries adopt to govern exchange rates. Exchange Rate Regimes: Formal Dollarization, Fixed, Currency Boards, Pegged, Dirty/Managed Floats and Independently Floating – The Gold Standard – Pegging currencies to gold and guaranteeing convertibility is known as the gold standard. Gold Par Value – The amount of a currency in an ounce, one ounce of gold was referred to as the gold par value.
The Bretton Woods Exchange Rate System – Created a fixed exchange rate system where the countries agreed to peg their currencies to the US dollar which was convertible to gold at $35 an ounce. Countries agreed to defend the value of their currencies to within 1% of par value. Currency, Banking and Foreign Debt Crises – Currency speculators believed that the devaluation of the dollar was inevitable. President Nixon dropped the gold standard conversion and the dollar was devalued. Following a second round of speculative attacks, the US dollar was allowed to float against other world currencies. Concerns about the IMF’s Policy Prescriptions – The system of adjustable parities allowed for the devaluation of a country’s currency by more than 10 percent if the IMF agreed that a country’s balance of payments was in “fundamental disequilibrium.” Moral Hazard – arises when people behave recklessly because they know they will be saved if things go wrong. Capital Market – The capital market is the market for securities, where companies and governments can raise longterm funds.
The capital market includes the stock market and the bond market. Financial regulators, such as the U.S. Securities and Exchange Commission, oversee the capital markets in their designated countries to ensure that investors are protected against fraud. The capital markets consist of the primary market, where new issues are distributed to investors, and the secondary market, where existing securities are traded. Cost of Capital – The cost of capital is an expected return that the provider of capital plans to earn on their investment. Initial Public Offering – Initial public offering (IPO), also referred to simply as a “public offering”, is when a company issues common stock or shares to the public for the first time. They are often issued by smaller, younger companies seeking capital to expand, but can also be done by large privately-owned companies looking to become publicly traded. Commercial Banks versus Investment Banks Equity Loan: An equity loan is a mortgage placed on real estate in exchange for cash to the borrower. For example, if a person owns a home worth $100,000, but does not currently have a lien on it, they may take an equity loan at 80% loan to value (LTV) or $80,000 in cash in exchange for a lien on title placed by the lender of the equity loan.
Debt Loans: A loan is a type of debt. This article focuses exclusively on monetary loans, although, in practice, any material object might be lent. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower. Corporate Bonds – A Corporate Bond is a bond issued by a corporation. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date. Systematic Risk – In finance, Systemic Risk is that risk which is common to an entire market and not to any individual entity or component thereof. It can be defined as “financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries”. It refers to the movements of the whole economy and has wide ranging effects. It is also sometimes erroneously referred to as “systematic risk”.
Portfolio Diversification – By using the global capital market, investors have a much wider range of investment opportunities than in a purely domestic capital market. The most significant consequence of this choice is that investors can diversify their portfolios internationally, thereby reducing their risk to below what could be achieved in a purely domestic capital market. Drivers of the Global Capital Market: Information Technology: Financial services is an information-intensive industry. It draws on large volumes of information about markets, risks, exchange rates, interest rates, creditworthiness, and so on. It uses this information to make decisions about what to invest where, how much to change borrowers, how much interest to pay to depositors, and the value and riskiness of a range of financial assets including corporate bonds, stocks, government securities, and currencies.
Deregulation: Many restrictions have been crumbling in the US since the early 80s. In this part, this has been a response to the development of the Eurocurrency market, which from the beginning was outside of national control. Hot Money: In economics, hot money refers to funds which flow into a country to take advantage of a favorable interest rate, and therefore obtain higher returns. They influence the balance of payments and strengthen the exchange rate of the recipient country while weakening the currency of the country losing the money. These funds are held in currency markets by speculators as opposed to national banks or domestic investors. As such, they are highly volatile in Mexico and East Asian financial crisis. Patient Money: Selling land in large blocks under frontier conditions is to sell at a time before it begins yielding much if any rent. It is bid in by those few who have large discretionary funds of patient money.
Eurocurrency – Eurocurrency is the term used to describe deposits residing in banks that are located outside the borders of the country that issues the currency the deposit is denominated in. For example a deposit denominated in US dollars residing in a Japanese bank is a Eurocurrency deposit, or more specifically a Eurodollar deposit. Attractions and Drawbacks of the Eurocurrency Market Attractions: Lack of government regulation. Drawbacks: When depositors use a regulated banking system they know that the probability of a bank failure that would cause them to lose their deposits is very low. Secondly, borrowing funds internationally can expose a company to foreign exchange risk. Reserve Requirements – The reserve requirement (or required reserve ratio) is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. These reserves are designed to satisfy withdrawal demands, and would normally be in the form of fiat currency stored in a bank vault (vault cash), or with a central bank.
Foreign Bonds vs. Eurobonds: A Eurobond is an international bond that is denominated in a currency not native to the country where it is issued. It can be categorised according to the currency in which it is issued. London is one of the centers of the Eurobond market, but Eurobonds may be traded throughout the world – for example in Singapore or Tokyo. Attractions of the Eurobond Market – Absence of regulatory interference. Less stringent disclosure requirements than in most domestic bond markets. A favorable tax status. The Impact of Exchange Rate Risk on the Cost of Capital Benefits and Costs of Financial Globalization Inter-Temporal Trade – Consumption smoothing usually between advanced economies and developing economies. Developing economies need money NOW.
Capital Mobility – The ability of money to cross national borders. The free flow of money in and out of a country. Impossible Trinity – The Impossible Trinity (also known as the Inconsistent Trinity, Triangle of Impossibility or Unholy Trinity) is the hypothesis in international economics that it is impossible to have all three of the following at the same time: Exchange Rate Stability, Independent Monetary Policy, and Capital Mobility. You can only have 2 of these 3 things at the same time ever. The Exchange Rate is simply the relative price of currencies. For example: It tells you how many Euros you can get for a dollar.
A government has to main monetary policies it can use: The Fiscal Policy, or the Monetary Policy The Fiscal Policy concerns government expenditures and tax collection The Monetary Policy concerns the interest rate in the economy. The interest rates are established to help stabilize the economy.