Sometimes referred to as multinational finance, international finance is additionally concerned with matters of international financial management. Investors and multinational corporations must assess and manage international risks such as political risk and foreign exchange risk, including transaction exposure, economic exposure, and translation exposure.[4][5]
The foreign exchange and political risk dimensions of international finance largely stem from sovereign nations having the right and power to issue currencies, formulate their own economic policies, impose taxes, and regulate movement of people, goods, and capital across their borders.[6]
History
China and fiat currency
The idea of fiat currency was established just over a thousand years ago in China during the Yuan, Tang, Song and Ming dynasties. In the Tang Dynasty (618-907) there was a high demand for metallic currency that exceeded the supply of precious metals. The people were already familiar with the use of credit notes, and they rapidly began accepting pieces of paper or paper drafts.[7]
A shortage of coins forced these people to change from coins to notes. During the Song Dynasty (960-1276), there was a booming business in the Sichuan region that led to a shortage of copper money. This led to traders issuing private notes covered by a monetary reserve. This was considered to be the first ever legal tender. Paper money became the only legal tender in the Yuan Dynasty (1276-1367) and issuing of notes was conferred to the Ministry of Finance during the Ming Dynasty (1368-1644).[7] Fiat money can serve as a good currency if it can handle the role that a nation's economy needs of its monetary unit: storing value, providing a numerical account, and facilitating exchange. It also has excellent seigniorage, meaning it is more cost-efficient than a currency directly tied to produce than a currency directly tied to a commodity.[8]
On the International stage fiat currencies were not truly relevant until the US removed its currency from the gold standard in 1971.[8] At this point other nations followed suit creating an environment where an infinite amount of money could be created. Before this, a nation's currency—which was unaccredited by precious metals—would not be accepted in exchange for goods and services outside of the host country where it was produced.[9]
The Establishment of the International Monetary Fund (IMF) and the World Bank are one of the most significant turning points in the History of international finance. Through Decades of negotiation between international powers and the persistence of economic superpowers no single event inspired unity of determining the fair rules of trade and monetary policy than the Second World War. In Bretton Woods, New Hampshire, delegates from 44 nations gathered to determine what would be the rules for international trade after the war.[10]
After the Bretton Woods Conference was completed the framework for the IMF and World Bank were laid out and begun to be developed. As a result, international trade skyrocketed since exchange between countries and between continents finally had a measurable way to determine exchange rates and fair value of currency.[11] Individual countries' banks were no longer the determining factor in determining a fair exchange rate, removing inconsistencies between individual countries' monetary systems.[12]
The Bretton Woods system did not last very long, as after WW2 the United States was the physical owner of most of the world's gold supply. This meant countries' currencies were supposed to be pegged to a resource over which the US had a near monopoly. This state of affairs only lasted around 20 years as most notably in 1971 the French who were skeptical of the US dollar being the world's reserve currency reclaimed most of their gold that they exported to the US for protection.[13] This action was inherently a destabilizing force to the US dollar since at any time before this individuals or businesses were able to exchange their US dollars for gold. Many other nations followed suit in a metaphorical "Gold Rush" to get gold from the US by exchanging dollars. The result of this action was the world's reserve currency, the US dollar, no longer being pegged to gold from 1971, with Richard Nixon removing the convertibility factor of the US dollar. This fundamentally changed international finance as no longer was the world's currency based on anything physical, it transitioned into a fiat currency (money without intrinsic value that is used as money because of government decree).[14]
↑ (Blume, Lawrence; Steven N. Durlauf, eds. (2008). The new Palgrave dictionary of economics (2nd ed.). Basingstoke, Hampshire: Palgrave Macmillan. pp. 544–546)
A currency is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins. A more general definition is that a currency is a system of money in common use within a specific environment over time, especially for people in a nation state. Under this definition, the British Pound sterling (£), euros (€), Japanese yen (¥), and U.S. dollars (US$) are examples of (government-issued) fiat currencies. Currencies may act as stores of value and be traded between nations in foreign exchange markets, which determine the relative values of the different currencies. Currencies in this sense are either chosen by users or decreed by governments, and each type has limited boundaries of acceptance; i.e., legal tender laws may require a particular unit of account for payments to government agencies.
A gold standard is a monetary system in which the standard economic unit of account is based on a fixed quantity of gold. The gold standard was the basis for the international monetary system from the 1870s to the early 1920s, and from the late 1920s to 1932 as well as from 1944 until 1971 when the United States unilaterally terminated convertibility of the US dollar to gold, effectively ending the Bretton Woods system. Many states nonetheless hold substantial gold reserves.
In economics, inflation is a general increase in the prices of goods and services in an economy. This is usually measured using the consumer price index (CPI). When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money. The opposite of CPI inflation is deflation, a decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualized percentage change in a general price index. As prices faced by households do not all increase at the same rate, the consumer price index (CPI) is often used for this purpose.
A reserve currency is a foreign currency that is held in significant quantities by central banks or other monetary authorities as part of their foreign exchange reserves. The reserve currency can be used in international transactions, international investments and all aspects of the global economy. It is often considered a hard currency or safe-haven currency.
The global financial system is the worldwide framework of legal agreements, institutions, and both formal and informal economic action that together facilitate international flows of financial capital for purposes of investment and trade financing. Since emerging in the late 19th century during the first modern wave of economic globalization, its evolution is marked by the establishment of central banks, multilateral treaties, and intergovernmental organizations aimed at improving the transparency, regulation, and effectiveness of international markets. In the late 1800s, world migration and communication technology facilitated unprecedented growth in international trade and investment. At the onset of World War I, trade contracted as foreign exchange markets became paralyzed by money market illiquidity. Countries sought to defend against external shocks with protectionist policies and trade virtually halted by 1933, worsening the effects of the global Great Depression until a series of reciprocal trade agreements slowly reduced tariffs worldwide. Efforts to revamp the international monetary system after World War II improved exchange rate stability, fostering record growth in global finance.
Monetary reform is any movement or theory that proposes a system of supplying money and financing the economy that is different from the current system.
Monetary policy is the policy adopted by the monetary authority of a nation to affect monetary and other financial conditions to accomplish broader objectives like high employment and price stability. Further purposes of a monetary policy may be to contribute to economic stability or to maintain predictable exchange rates with other currencies. Today most central banks in developed countries conduct their monetary policy within an inflation targeting framework, whereas the monetary policies of most developing countries' central banks target some kind of a fixed exchange rate system. A third monetary policy strategy, targeting the money supply, was widely followed during the 1980s, but has diminished in popularity since that, though it is still the official strategy in a number of emerging economies.
A store of value is any commodity or asset that would normally retain purchasing power into the future and is the function of the asset that can be saved, retrieved and exchanged at a later time, and be predictably useful when retrieved.
In economics, standard of deferred payment is a function of money. It is the function of being a widely accepted way to value a debt, thereby allowing goods and services to be acquired now and paid for in the future.
The Bretton Woods system of monetary management established the rules for commercial relations among the United States, Canada, Western European countries, and Australia as well as 44 other countries after the 1944 Bretton Woods Agreement. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent states. The Bretton Woods system required countries to guarantee convertibility of their currencies into U.S. dollars to within 1% of fixed parity rates, with the dollar convertible to gold bullion for foreign governments and central banks at US$35 per troy ounce of fine gold. It also envisioned greater cooperation among countries in order to prevent future competitive devaluations, and thus established the International Monetary Fund (IMF) to monitor exchange rates and lend reserve currencies to nations with balance of payments deficits.
Fractional-reserve banking is the system of banking in all countries worldwide, under which banks that take deposits from the public keep only part of their deposit liabilities in liquid assets as a reserve. Bank reserves are held as cash in the bank or as balances in the bank's account at the central bank. Fractional-reserve banking differs from the hypothetical alternative model, full-reserve banking, in which banks would keep all depositor funds on hand as reserves.
The foreign exchange market is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the credit market.
Money creation, or money issuance, is the process by which the money supply of a country, or an economic or monetary region, is increased. In most modern economies, money is created by both central banks and commercial banks. Money issued by central banks is termed reserve deposits and is only available for use by central bank account holders, which are generally large commercial banks and foreign central banks. Central banks can increase the quantity of reserve deposits directly, by engaging in open market operations or quantitative easing. However, the majority of the money supply used by the public for conducting transactions is created by the commercial banking system in the form of bank deposits. Bank loans issued by commercial banks expand the quantity of bank deposits.
Foreign exchange risk is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arises when there is a risk of an unfavourable change in exchange rate between the domestic currency and the denominated currency before the date when the transaction is completed.
Modern monetary theory or modern money theory (MMT) is a heterodox macroeconomic theory that describes currency as a public monopoly and unemployment as evidence that a currency monopolist is overly restricting the supply of the financial assets needed to pay taxes and satisfy savings desires. According to MMT, governments do not need to worry about accumulating debt in a currency of which that government itself, or the central bank thereof, is the sole issuer, since any and all obligations can always be met by the creation of new money. MMT argues that the primary risk of excess increases in government debt, or money creation in other forms, is inflation. MMT argues that sustaining government expenditures at a higher level than tax revenues is necessary for sustained full employment. Spending past the point of full employment, or non-targeted discretionary "pump priming", is believed to be inflationary. According to MMT the only real constraints on government spending is the availability of physical resources. MMT also argues that inflation can be addressed by increasing taxes to reduce the spending capacity of the private sector.
Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are: medium of exchange, a unit of account, a store of value and sometimes, a standard of deferred payment.
A fixed exchange rate, often called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold.
An international monetary system is a set of internationally agreed rules, conventions and supporting institutions that facilitate international trade, cross border investment and generally the reallocation of capital between states that have different currencies. It should provide means of payment acceptable to buyers and sellers of different nationalities, including deferred payment. To operate successfully, it needs to inspire confidence, to provide sufficient liquidity for fluctuating levels of trade, and to provide means by which global imbalances can be corrected. The system can grow organically as the collective result of numerous individual agreements between international economic factors spread over several decades. Alternatively, it can arise from a single architectural vision, as happened at Bretton Woods in 1944.
Fiat money is a type of currency that is not backed by a precious metal, such as gold or silver. It is typically designated by the issuing government to be legal tender, and is authorized by government regulation. Since the end of the Bretton Woods system in 1971, the major currencies in the world are fiat money.
Monetary policy in the United States is associated with interest rates and availability of credit.
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