Thesis on "International Lending Implications"

Thesis 8 pages (2293 words) Sources: 3 Style: MLA

[EXCERPT] . . . .

International Lending Implications

International lending - historical evolution and potential causes

International movements of capital fluctuated a lot in the last 150 years. The reasons that generated these fluctuations were subject to a considerable number of economic studies.

Eichengreen (1990a) brought into discussion three potential explanations for this pattern. The first explanation referred to the international gold standard, which would explain the high volume of international capital flows because this standard minimized exchange rate risk, considered to be one of the factors discouraging international investment. The gold standard implies that the value of money in circulation is linked to the store of gold. When currencies are fixed to a gold standard it means that these currencies are fixed to each other and one of the main implications is their predictable currency exchanges. The international gold standard was established in the 19th century, generated by a silver currency crisis in England and by Germany adopting a strict gold standard currency for its Reich mark. The opposite of gold standard currency is fiat currency, which means that central banks can increase and/or decrease money supply in the economy without having a fixed standard. Regarding international gold standard, the various policy-makers did not find it necessary to regulate foreign lending or minimize imbalances in the current account in the beginning of the 20th century as long as they didn't lose their reserves. The post WWI experience suggests that policy makers targeting a minimal current account policy were actually what promoted an exceptional international lending volume, rather than exchange rate stability (Eichengreen, 1990b). The same policy-makers, however, found it essential to regulate international lending by defending exchange rates after 1913, which is a question left unanswered given their minimal current account policy.

A second explanation is given by the "stages of indebtedness" theory. This theory links country indebtedness stages to its industrialization pattern, with some authors arguing that indebtedness is a phenomenon generated in the course of internationalization of productive capital and therefore a direct consequence of capitalism (Yaghmaian, 1997). In the early stages of industrialization, households' current income is significantly lower than expected future income, which incentives them to borrow from abroad, rather than save. As industrialization happens, incomes and implicitly savings increase and the domestic savings exceed domestic investments as domestic investments generating high return diminish, thus slowly transforming the capital importer into a capital exporter.

A third potential explanation is given through the perspective of boom and bust cycles in international capital markets. In this model, the boom phase is characterized by enthusiasm, which in some cases leads to unsustainable international lending. The bust phase characterizes the difficulties faced by countries, while meeting debt obligations. Boom and bust cycles have several potential reasons that generate them, such as: 'push' factors - changes in U.S. interest rates may increase or decrease relative attractiveness of investment in other countries; 'pull' factors - macroeconomic policies developed by developing countries that stimulate capital flows in these countries. Capital inflows and outflows can be driven by both internal and external factors. The internal factors include the macroeconomic policies adopted by the authorities and the external ones refer to the international capital markets movements. The implications of booms and busts of capital flows can have devastating impacts on developing countries as they are depending on capital inflows, and this situation makes them vulnerable to unexpected shocks (Moreno, 2000). Moreno (2000) also concluded that although both investors and recipients gain from increased capital flows, the recipients are likely to be more vulnerable to sudden reversals.

International lending is particularly challenging due to the different currencies involved in capital flows. Many countries have their own currency and the parity between these currencies fluctuates according to many factors. A high fluctuation in currency exchange/parity can have a devastating impact on the economy. Thus, countries can adopt a fixed currency exchange, in which the value of their currencies is matched to the value of other currency or to another measure of values (e.g. gold). This measure can stimulate investment and trade between two particular countries. However, it can have negative implications, such as the reference value fluctuates, so does the currency attached to it. Moreover, governments adopting this measure lose their capacity of using monetary policy as a tool to achieve macroeconomic stability.

One other way to offset currency exchange fluctuation implications would be for several countries to adopt a common currency, such as the euro in European Monetary Union. Exchange rate risk between member countries is significantly reduced, interest rate differentials are smoothed in time and relative price variability kept under control. The disadvantages of such measure include the loss of monetary policy independence, pressure for fiscal convergence, increased inflation imported from member countries and limited budget deficits imposed by union rules.

What is international lending?

International lending includes:

All claims that domestic banks offices have on foreign residents

All claims that foreign banks offices have on domestic residents

All claims that domestic banks offices have on domestic residents in foreign currency

Additionally, all deposits classified as above can be considered international lending. A special type of international lending is constituted by Eurocurrency deposits. Those are deposits made by banks outside the country whose currency the deposits are denominated in.

Risks associated with international lending

International lending is particularly risky because besides the usual borrower credit worthiness, there are additional risks associated to it, such as: country risk, foreign exchange risk, interest rate risk, funding risk and clearing risk.

The country risk refers to the situation in which the borrowers in a given country are unwilling or unable to meet their international obligations due to reasons beyond usual risk associated to international lending. Unusual risk includes situations of major socio-political changes in the borrowing country (e.g. war) or unpredictable phenomena (e.g. natural disasters, oil shocks). Due to these unusual situations that can generate lending risk, country risk assessment can turn out to be very difficult for lending entities. The risk assessment for developed countries is based on existing national statistics, whereas in less developed countries this is based on data produced by international organizations such as OECD (Organization for Economic Co-operation and Development) or IMF (International Monetary Fund).

The foreign exchange risk usually refers to the situation in which entities conduct business in several countries, working with several currencies. These entities have to exchange foreign currencies into the domestic one, while dealing with the receivable operations and exchange the domestic currency into foreign ones, while dealing with payable operations. When the currency parities change, foreign exchange can become risky. In these cases, hedging can help mitigate foreign exchange risk, namely forwards and options. Forward contracts serve to freeze the exchange rate at which the transactions will be made in the future. The option contacts offers the possibility for an entity to choose a given exchange rate level at which the transactions will be made in the future.

Foreign exchange-related international lending risks can be very diversified. Featherston et.al. (2006) bring into discussion at least three components of foreign exchange risk incurred by microfinance institutions: (1) devaluation or depreciation risk, (2) convertibility risk and (3) transfer risk.

The devaluation or depreciation risk increases as microfinance institutions acquire debt in foreign currency and afterwards lends these fund in domestic currency. Exchange rate fluctuations between the currencies transacted can have a devastating impact on these institutions.

The convertibility risk is associated with the risk of not being able to convert a certain domestic currency into foreign currency. The risk includes the occurrence of capital controls meant to prevent the international transfer of funds.

The transfer risk is attributed to the situation in which foreign currency transfers are blocked by national government regardless of their sources.

Interest rate risk is that which exists in an interest-bearing asset, such as a loan or a bond, due to the possibility of a change in the asset's value resulting from the variability of interest rates" (Investopedia, Accessed October 2008). Just as it can be used in foreign exchange risk, hedging can be used to mitigate interest rate risk. Forwards, futures, swaps and options are tools that can be used to deal with this type of risk.

In international markets, the interest rate risk is stronger as the international arena is more volatile and/or more dynamic than the domestic market. Thus, the interest rate risk is identified as the extent to which the rate of return for a bond or any other derivative product is uncertain. The interest rate risk in international markets encompasses the changes in profits, firm valuation and cash flow movements generated by changes in interest rates. The debt-related risk is associated with interest rate risk as this risk is concerned with long-term debt instruments issued by an entity.

In general, risk managers are concerned with liquidity on the funding side, which refers to the ease of using various available funding sources to finance cash shortfalls. In international markets, the access to immediate funding is conditioned by several factors. For instance developing countries have restricted… READ MORE

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