International Finance
International finance, also named as, international macroeconomics, is the transaction of money between two or more countries. It especially focuses on areas such as foreign direct investment and currency exchange rates. They are performed by large institutions such as the International Finance Corporation. Here are the top five elements of international finance.
1. Foreign Exchange Markets
The foreign exchange market is the place from where one can buy, sell, or exchange currencies. As of now, it is the biggest financial market in the world. Presently the total value of the forex industry is $2.73 quadrillion. According to the 39th survey of North American Foreign Exchange Volume, the average daily volume in total OTC foreign exchange instruments in April 2024 was $1,165.2 billion. This is an increase of 14.1% from October 2023 and an increase of 26.9% from the previous year.
The foreign exchange market was basically formed to bring structure to the rapidly growing global economy. It is constituted by a global network of financial centers that perform transactions 24 hours a day. When one major foreign hub closes, another hub from a different part of the world will open. These financial centers close only on weekends.
Currencies are always traded in pairs. That is, the value of one of the currencies is relative to the other. The value of a country’s currency is determined by the fact that whether it is a free float or fixed float. The value of free-floating currencies is determined by free market forces, and the value of fixed-floating currencies is determined by the government body ruling the country. The US dollar, British pound, etc, are examples of free-floating currencies, and the Saudi Riyal and Hong Kong Dollar are examples of fixed-floating currencies.
Here are the three main types of forex market:
- Spot Forex Market
Spot market is the exchange of currency between buyers and sellers at the present exchange rate. This constitutes the majority of the daily currency. Commercial, investment, central banks, dealers, brokers, etc, are the major participants in the spot market. They are mostly the starting point for beginners in forex trading because of its relative simplicity. In these markets, trades are always conducted directly between parties without a central exchange.
- Forward Forex Market
Here, two parties will agree in advance to trade a currency for a set value and quantity at a future date. These two parties can be individuals, corporations, government, etc. They are used to mitigate the risk associated with currency exchange and are done by locking exchange rates for future transactions. The contracts can be customized to meet specific needs, such as the amount and date of the parties involved.
- Future Forex Market
They are just like the forward market but differ in the fact that they use centralized exchanges that protect traders from counterparty risk. Organized exchanges like the Chicago Mercantile Exchange are the most traded exchanges in this market. The participants of this market must maintain margin accounts to cover potential losses. All the prices and trading volumes are publicly available, which reduces counterparty risk.
2. FDI
Foreign Direct Investment is the investment in a company by an investor, company, or government from another country. They play a vital role in international economic integration as it creates a strong and enduring link between economies.
However, FDI is not just capital investment; it also involves transfer management practices, technology, and equipment. They are generally of three types.
- Horizontal FDI: Investments where a company invests in the same industry abroad as it operates domestically. For instance, a US-based clothing provider buying a chain of clothing stores in India is a horizontal FDI.
- Vertical FDI: Investments where a company invests in a foreign company offering complementary business. For instance, a US-based shoe company investing in a foreign company that offers raw materials for making shoes.
- Conglomerate FDI: An investment made by a company in a foreign company whose business is not at all related to its business. For instance, a US-based jewelry business investing in a China-based tech company.
FDI can increase and maintain the economic growth of both the investor’s country and the recipient country. For developing countries, it gives opportunities for local workers and contributes to the construction of new infrastructure in the country. FDI helps MNCs by expanding their footprints into international markets. One disadvantage of FDI is that it involves the regulation and monitoring of different governments, which can lead to political risks.
3. Balance of Payments
The balance of payments is a statement containing details of all transactions conducted between one country and another country for a specific period of time, such as a quarter or a year. The BOP is divided into three main types: current account, capital account, and financial account.
A country’s total trade in goods and services, its total revenue from cross-border investments, and its net transfer payments constitute the current account. A country’s balance of trade (BOT) is determined by the total goods and services imported and exported from the country. BOT deficit shows that the country imports more than it exports, and BOT surplus shows that it exports more than it imports. The current account also holds credits like workers’ remittances. These are actually salaries sent back to the home country by workers working abroad.
A country’s transactions in financial instruments and central bank reserves constitute a capital account. These are accounts where all international capital transfers are recorded. Basically, it refers to the purchase or selling of non-financial assets like land and non-produced assets like raw mines that are used for the extraction of diamonds. For instance, a foreign investor buying assets in a country and a resident selling assets abroad are recorded in the capital account.
A financial account includes investments in businesses, real estate, stocks, and other financial assets. It includes FDIs, portfolio investments, etc. For instance, if a foreign investor invests in a domestic company or a resident buys a foreign stock, these are recorded in a financial account.
4. International Monetary System
The international monetary system (IMS) is a body comprising investors, multinational companies, and financial institutions. It governs international payments, exchange rates, and mobility of capital. IMS is also known as the ‘international monetary and financial system’ or ‘international financial architecture.’ The main focus of IMS is on facilitating the exchange of capital and goods across different countries. To establish stability in the financial system, IMS established two international finance institutions in 1944 – the International Monetary Fund and the World Bank.
Over the years, the International Monetary System has undergone modification or has evolved through four different stages:
- Gold Standard:
The gold standard was the monetary system from 1880 to 1914. In this, countries pegged their currencies in terms of gold. With the adoption of the gold standard, countries had a fixed exchange rate system having some fluctuations. As the exchange rate was fixed, it enhanced the international trade during this period.
- Interwar Period:
The interwar period was between World War I and II, from 1915 to 1944. As the world war created a great depression, all the world economies had a higher inflation rate. During this period, the United States of America replaced Britain as the dominant financial powerhouse. The gold standard collapsed with a higher supply of money and there were fluctuations in the exchange rates.
- Bretton Woods System:
The Bretton Woods System was established in the year 1944 after World War II to rebuild the world economy. This system created a dollar-based fixed exchange system. The currencies of different countries were pegged to the U.S. dollar, which was backed by reserve gold. This system collapsed in 1971, when the U.S. suspended the convertibility of gold due to high inflation rates and trade deficits, leading to a hike in the gold process.
- Current International Monetary System:
After the collapse of the Bretton Woods System, the global economy adopted a flexible exchange rate system. In 1976, the global economy formalized the Managed Float System with the Jamaica Agreement. Under the Managed Float System, constant fluctuations of rates will be there according to the demand and supply in markets. Thereby, it facilitates the free flow of different currencies in the open market. In the 1980s, the international monetary system was regulated by G-5 countries. Currently, there are 20 countries, and the group is called G-20.
5. International Finance Institutions
The global economic framework is closely linked to the functions and influence of International financial institutions or IFIs. These institutions are established to develop international monetary cooperation, promote economic stability, and facilitate trade internationally. They comprise organizations such as:
- International Monetary Fund:
The International Monetary Fund (IMF) encourages global economic growth and financial stability. It was formed as a part of the Bretton Woods Agreement in 1945 for exchange rates and to lend reserve currencies to nations with economic challenges. Currently, the IMF is based in Washington D.C. and was composed of 44 founding members, now reaching 190 countries as its members. IMF fulfills three critical missions with its member countries. These are fostering international monetary cooperation, encouraging international trade and growth, and discouraging policies that harm prosperity. They also provide financial support to restore the economic stability of countries suffering from crises like natural disasters, pandemics, political instability, weak financial systems, etc.
- World Trade Organization:
World Trade Organization, or WTO, is based in Geneva, Switzerland, that oversees and manages international trade. It acts as the guardian of the global trading system and deals with the trading rules between nations. It was formed from the General Agreement on Tariffs and Trade (GATT) in 1995. Like GATT, the WTO also aims to lower the trade barriers between different countries and encourage multinational trade. There are 166 members in the WTO.
- World Bank Group:
The World Bank is also an international organization and is the largest source of funding in the world for developing countries. There are five institutions working under the World Bank Group; they are – The International Bank for Reconstruction and Development (IBRD), The International Development Association (IDA), The International Finance Corporation (IFC), The Multilateral Investment Guarantee Agency (MIGA), and The International Centre for Settlement of Disputes (ICSID). All these five institutions aim to reduce poverty, increase shared prosperity, and promote sustainable development. They provide developing countries with low-interest loans, credits with zero to low interest, and grants. The World Bank’s headquarters is in Washington D.C. and has 189 member countries.
- International Finance Corporation:
The International Finance Corporation (IFC) was established as a member of the World Bank Group in 1956. IFC is focused on promoting economic development by financing for private sector growth in developing countries. It is situated in Washington D.C. and works with more than 100 nations. The IFC provides loans, direct investments, and advisory services for companies in the private sector of developing countries.
Finally, international finance facilitates cross-border trade, investments, and financial transactions, promoting global economic integration. Global economic stability is maintained by foreign exchange markets, foreign direct investment (FDI), balance of payments, the international monetary system, and international financial institutions. Through international collaboration, currency rate stabilization, and financial aid to developing nations, these systems and institutions boost economic growth. These core concepts will remain essential to understanding and navigating international finance as the global economy evolves.