Foreign Finance. Sherif Khalifa. Sherif Khalifa () Foreign Finance 1 / 48

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1 Sherif Khalifa Sherif Khalifa () Foreign Finance 1 / 48

2 Definition Balance of payments is a summary statement of a nation s financial transactions with the outside world. Definition Current account is the portion of a balance of payments that states the market value of a country s visible and invisible exports and imports. Definition Capital account is the portion of a country s balance of payments that shows the voluem of private foreign investment and public grants and loans that flow into and out of a country over a given period. Sherif Khalifa () Foreign Finance 2 / 48

3 Current Account Export Receipts Import Payments Net Investment Income Debt Service Net Remittances Foreign Direct Investment Capital Account Foreign Portfolio Investment Foreign Loans Increase in Foreign Assets Resident Capital Outflow Developing Developed Sherif Khalifa () Foreign Finance 3 / 48

4 Definition Cash account or international reserve account is the balancing portion of a country s balance of payments, showing how cash balances or foreign reserves and short term financial claims have changed in response to current account and capital account transactions. Definition International reseves is a country s balance of gold, hard currencies, and special drwaing rights used to settle international transactions. Definition Hard currency is the currency of a moajor industrial country or currency area that is freely convertible into other currencies. Sherif Khalifa () Foreign Finance 4 / 48

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8 Definition Surplus is an excess of revenues over expenditures. Definition Deficit is an excess of expenditure over revenues. The balance on the current account and the capital account must be offset by the balance on cash account. If the country is poor, it is likely to have limited stock of these international reserves. The overall balance of payments deficit place severe strains on the entire economy. Sherif Khalifa () Foreign Finance 8 / 48

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12 Definition External debt is the total private and public foreign debt owed by a country. Definition Debt service is the sum of interest payments and repayments of principal on external public and publicly guranteed debt. Debt service is the payment of amortization, liquidation of principle, and accumulated interest. Sherif Khalifa () Foreign Finance 12 / 48

13 The accumulation of external debt is a common phenomenon of developing countries at the stage of development where the supply of domestic savings is low, current account deficits are high, and imports of capital are needed. Developing countries sought to sustain high growth and industrialziation through borrowing. Concessional lending from offi cial sources was insuffi cient to satisfy growth needs. In the wake of the first oil price shock, the surplus of oil export earnings were deposited in commercial banks in developed countries. Sherif Khalifa () Foreign Finance 13 / 48

14 Developing countries turned to commercial banks and other private lenders. Commercial banks, facing low demand for capital from the industrialzied countries due to the recession, competed in lending to developing countries. Commercial banks began playing a larger role in international lending by recycling surplus petrodollars. Commercial banks issued general purpose loans to developing countries to provide balance of payments support. The main cost associated with the accumulation of a large external debt is debt service. Sherif Khalifa () Foreign Finance 14 / 48

15 Debt service payments must be made with foreign exchange, and debt service obligations can be met only with export earnings, curtailed imports, or further external borrowing. There was an increase in oil import bills and a decrease in export earnings due to to slowed growth in developed countries and a decline in primary products prices. Total external debt of developing countries increased significantly and they sought to face this with further borrowing. Huge debt service obligations accumulated so that some countries faced severe diffi culties in paying even the interest on the debt. These economies could no longer borrow funds in the world s private capital markets. Sherif Khalifa () Foreign Finance 15 / 48

16 Developing countries sought loans and assistance from international financial organizations. This requires that the countries follow restrictive fiscal and monetary policies called conditionality. Definition Conditionality is the requirement imposed by the International Monetary Fund that a borrowing country undertake fiscal, monetary and international commercial reforms as a condition for receiving a loan to resolve balance of payments diffi culties. Sherif Khalifa () Foreign Finance 16 / 48

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19 Definition Debtor s cartel is a group of debtors who join together to bargain as a group with creditors. Definition Debt restructuring is altering the terms of debt repayment, usually by lowering interest rates or expanding the repayment period. Definition Debt for equity swap is a mechanism used by indebted developing countries to reduce the value of external debt by exchanging equity in domestic companies, stocks, or fixed interest obligations of the government, bonds, for private foreign debt at large discounts. Sherif Khalifa () Foreign Finance 19 / 48

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27 Definition Foreign direct investment is overseas equity investments by private multinational corporations. Definition Multinational corporation is a corporation with production activities in more than one country. Definition A multinational corporation is a corporation or an enterprise that conducts and controls productive activities in more than one country. Sherif Khalifa () Foreign Finance 27 / 48

28 The objective of Multinational corporations is to maximize their return on capital and to seek best profit opportunities. Private capital gravitates toward countries with the highest financial returns and the greatest perceived safety. Where debt problems are severe, governments are unstable, and economic reforms remain incomplete, the risk of capital loss is high. Before the financial crisis, most of global foreign direct investment wnet to industrial countries and the fastest growing developing countries. After the financial crisis, developing countries received more than half of global foreign direct investment flows. Multinationals carry with them technologies of production, tastes and styles of living, managerial philosophies and diverse business practices. Sherif Khalifa () Foreign Finance 28 / 48

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34 Two characteristics of MNCs are their large size and the fact that their worldwide operations and activities tend to be centrally controlled by parent companies. The largest multinational corporations control most of world trade, and control the production, distribution and sale of many goods from developing countries. Most poorer countries are dwarfed in size by any of the major MNCs, and this combined with limited competition conveys great bargaining power. This situation gives them the ability to manipulate prices and profits, to collude with other firms to determine areas of control and restrict potential competition by dominating new technologies and skills. Sherif Khalifa () Foreign Finance 34 / 48 Foreign Finance Definition Global factories are production facilities whose various operations are distributed across a number of countries to take advantage of existing price differentials.

35 Pros for Development It fills the gaps between the locally mobilized domestic savings, and the desired level of investment. It fills the gap between the targeted foreign exchange requirements and those derived from net export earnings plus foreign aid. It fills the gap between targeted governmental tax revenues and locally raised taxes by taxing MNC profits. It fills the gap in management experience, entrepreneurial abilities, and technological skills. Sherif Khalifa () Foreign Finance 35 / 48

36 Cons for Development MNCs lower domestic savings and investment rates by stifling competition through exclusive production agreements with host governments. The current account may deteriorate as a result of substantial importation of intermediate products and capital goods. The capital account may worsen because of the overseas repatriation of profits, interest royalties, and management fees. Their contribution to public revenue is less than it should be as a result of liberal tax concessions and disguised public subsidies and tariff protection. Have little impact on developing local resources and may inhibit the growth of indigenous entrepreneurship as a result of their dominance of local markets. Sherif Khalifa () Foreign Finance 36 / 48

37 Cons for Development They promote the interests of local factory managers and modern sector workers against the interests of the rest. They divert resources from food production to the manufacture of sophisticated products catering to the demands of the elite and foreign consumers. They stimulate inappropriate consumption patterns through advertising, and produce this with inappropriate technologies of production. They worsen the imbalance between rural and urban economic opportunities by locating in urban enclaves and thus contributing to excessive rural urban migration. They use their economic power to influence government policies in directions unfavorable to development by extracting concessions. They may damage host economies by suppressing domestic entrepreneurship using their knowledge, contacts and skills to drive out local small scale competitors. Sherif Khalifa () Foreign Finance 37 / 48

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40 Definition Foreign portfolio investment consists of foreign purchases of the stocks, bonds, certificates of deposit and commercial paper. Definition Foreign portfolio investment is financial investments by private individuals, and mutual funds in stocks, bonds, vertificates of deposits, and notes issued by private companies and the public agencies. Sherif Khalifa () Foreign Finance 40 / 48

41 With the increased liberalization of financial markets, private portfolio investment accounts for a significant share of overall net flows to developing countries. Investing in the emerging countries markets permits investors to increase their returns while diversify their risks. For recipients, it is a vehicle for raising capital for domestic firms, and improving the effi ciency of the financial sector by monitoring the allocation of funds to industries with the highest potential returns. The destabilizing effect of large and volatile private portfolio flows, especially that as perceived profits decline speculators withdraw their investments as quickly as they brought them in. Sherif Khalifa () Foreign Finance 41 / 48

42 Migration can hamper development because of the loss of skilled workers via the brain drain. Balancing this concern is the benefit through remittances to relatives in migrants country of origin. Remittances provide a significant pathway out of poverty as migrants build houses for their families and send money for school. Remittances increased due to the increase in the number of migrants and the advances in financial intermediation that reduce the cost of remitting funds. Sherif Khalifa () Foreign Finance 42 / 48

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45 Definition Concessional terms are terms for the extension of credit that are more favorable to the borrower than those available through standard financial Sherif Khalifa () Foreign Finance 45 / 48 Foreign Finance Definition Foreign aid is the international transfer of public funds in the form of loans or grants either directly from one government to another or indirectly through the vehicle of a multilateral assistance agency. Definition Foreign aid encompasses all offi cial grants and concessional loans, in currency or in kind. It is broadly aimed at transferring resources from developed to less developed countries on development, poverty, or income distribution grounds. Its objective should be noncommercial from the point of view of the donor. It should be characterized by concessional terms, that is the interest rate and repayment period should be softer than commercial terms.

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48 Donor countries used foreign aid as political lever to support friendly political regimes. Aid programs were oriented towards purchasing security for strategic alliances rather than promoting long term economic development. Increases in aid to countries with public health crises is due to concerns that disease may spread internationally. Sherif Khalifa () Foreign Finance 48 / 48