International Financial System Meaning and Components

International Financial System Meaning

The international financial system encompasses a complex network of regulations, practices, instruments, markets, and institutions that facilitate global transactions and capital movement. In recent years, the international financial system has undergone tremendous growth. New financial instruments have emerged, leading to an unprecedented surge in transaction volumes. Technological advancements, the expansion of global trade, and the dismantling of financial barriers are fueling the profound transformation of international financial markets.

From an economic standpoint, developments in the international financial system have made financial markets more efficient because financial capital can more easily flow around the world to wherever it will earn the highest return. As time unfolds, the increased efficiency in resource allocation should result in substantial economic growth for both developed and developing nations. As a result, this will lead to a substantial improvement in living standards around the world, which should rise more than they otherwise would have.

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A more globalised environment can also entail costs. A disturbance in one financial market or one country can have immediate effects on other countries and the entire international financial system.

International Financial System Definition

According to Alan Greenspan, “These global financial markets, engendered by the rapid proliferation of cross-border financial flows and products, have developed a capability of transmitting mistakes at a far faster pace throughout the financial system in ways that were unknown a generation ago”.

The international financial system includes the international money and capital markets, as well as the foreign exchange market. The international money market trades short-term claims with an original maturity of one year or less, and the international capital market trades capital market instruments, including mutual funds, stocks, bonds, and mortgages, with an original maturity of more than one year. In recent times, the financial landscape has witnessed the introduction of numerous new international financial products to ease the facilitation of increased financial flows. These include various types of mutual funds that allow individuals to invest in developed and emerging economies.

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Components of International Financial System

The international financial system consists of the international financial market, international financial institutions and international financial instruments. Three sections make up this division.

1. International Financial Market
2. Global/International Financial Instions
3. International Financial Instruments

International Financial Market

International financial markets are essential in promoting economic well-being by bringing buyers and sellers together. When a multinational company finalises its foreign investment project, it needs to select a particular source or a mix of sources of funds to finance the investment project. It’s noteworthy that multinational companies hold a more favourable position than domestic firms in the context of fund acquisition.

A domestic firm usually gets funds from domestic sources. It does get funds from the international financial market too but it is not as easy as in the case of a multinational enterprise. The latter can use the parent company’s funds for its foreign investment project. It can also get funds from the host country’s financial market, but more importantly, it tries to get funds from the international financial market. It selects a particular source or a mix of sources or a particular type or type of funds that suit its corporate objectives.

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When one discusses the sources of funds in the international financial market, the discussion takes into account both, the supply aspect and the demand aspect. It embraces, on one hand, the official and non-official sources of funds and the changing profile of the international financial market over the past few decades; and on the other, the selection of the sources of funds by the multinational firms depending on the fulfilment of the corporate objectives.

International Financial Institutions

An international financial institution is an organisation, whether established by a treaty or not, that consists of two or more states, government agencies or publicly funded bodies as members. Its primary purpose is to oversee a shared financial interest through a governing body. The purpose of such a multinational institution is to achieve international cooperation in dealing with issues of an economic, technical, social, cultural or humanitarian character. This could be cooperation in the field of governance, security, finance, scientific research, business environment or the realisation of joint technical, economic, financial or social projects. A multinational institution is an institution with an international membership, scope, or presence.

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The following are the important international financial institutions:

1. International Monetary Fund (IMF)
2. World Bank
3. Asian Development Bank (ADB)
4. Bi-lateral Development Banks and Agencies
5. Export Credit Agencies (ECAs)

1) International Monetary Fund (IMF)

The primary objective behind establishing the International Monetary Fund was to stabilize exchange rates and provide support for the reconstruction of the global international payment system. Countries contributed to a pool that could be borrowed from, temporarily, by countries with payment imbalances. The International Monetary Fund (IMF) played an important role when it was first created because it helped the world to effectively stabilise the economic system. Even today, the International Monetary Fund (IMF) continues to hold significant relevance because it works to improve the economic conditions of its member nations.

2) World Bank

The World Bank functions as an international organisation that combats poverty by providing developmental assistance to middle-income and low-income countries. By giving loans, as well as advice and training in both the private and public sectors, the World Bank aims to eliminate poverty by empowering people to help themselves. Under the World Bank Group, there are complimentary institutions that aid in its goals to assist.

3) Asian Development Bank (ADB)

The applicability of international development banks’ norms cannot be uniform due to their diverse identities and the varying economic requirements of different regions. The needs of some of the regions remained unmet and this led to the creation of the regional development banks that took into account the economic and political identities of their regions. The result of the Asian Development Bank (ADB) appeared as a response to this context.

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Efforts to create ADB had started in August 1963, but they gained momentum only after the USA and Japan offered to subscribe U.S. $200 million each during April 1965. The completion of formalities took place by mid-1966, leading to the establishment of ADB on the 22nd of August of that year. It started functioning in December 1966. Membership was accessible to both regional countries and non-regional developed countries, which were potential sources of resources. Asian Development Bank (ADB) has 67 members (as of 2 February 2007).

4) Bi-lateral Development Banks and Agencies

These are the development agencies of individual countries and their policies and projects are completely under the jurisdiction of the country’s government. For instance, one of the bilateral development agencies in the United States is the U.S. Agency for International Development (USAID). Other high-volume bilateral development agencies include the Swedish International Development Cooperation Agency (SIDA) and the U.K. Department for International Development (DFID).

5) Export Credit Agencies (ECAs)

Export Credit Agencies, commonly known as ECAs, are bilateral public entities that provide government-backed loans, guarantees and insurance to corporations in their home countries that seek to do business abroad in emerging markets. The majority of industrialised nations have at least one ECA. They are now the world’s biggest class of public finance institutions operating internationally, collectively exceeding in size of the World Bank Group, and funding more private-sector projects in the developing world than any other class of finance institutions. ECAs collectively finance more than double the World Bank Group’s number of extractive sector projects (oil, gas, mining). ECAS generate odious debt and abet corruption, and some even support the export of arms and military equipment to dictatorial regimes. As ECA-backed projects often despoil the environment and disrupt the lives of local communities, they are truly part of a race to the bottom.

International Financial Instruments

The international financial market raises funds by selling securities, including international equities and Euro bonds, among others. Presently, the use of securities is widespread in various industries.

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Following are the various types of international financial instruments:

1. Foreign Bonds
2. Euro Commercial Papers
3. Euro Bonds
4. Euro Equities/International Equities
5. Global bonds
6. Global Depository Receipt (GDR)
7. American Depository Receipt (ADR)

1) Foreign Bonds

A foreign bond involves the issuance of a bond by a foreign entity within the currency of the domestic market. Domestic market authorities regulate foreign bonds and assign them nicknames corresponding to the domestic market of issuance. Since foreign bonds are usually the residents of the domestic country, investors find them attractive because they can add foreign content to their portfolios without the added exchange rate exposures.

2) Euro Commercial Papers

This is a promissory note like the short-term Euro notes although it is different from Euro notes in some ways. Euro Commercial Papers do not involve underwriting, whereas Euro notes require underwriting procedures. Companies with high degree ratings exclusively issue ECP, underscoring the rationale behind this practice. Investors play a significant role in shaping the ECP route for fund-raising, demonstrating its investor-driven feature.

3) Euro Bonds

Eurobonds are a major source of borrowing within the Eurocurrency market. A bond is a debt security issued by a borrower, purchased by an investor, and involves intermediaries such as underwriters and merchant bankers. Eurobonds are bonds of international borrowers sold in various markets simultaneously by a group of international banks. The bonds are issued on behalf of governments, large multinational corporations, and other entities.

4) Euro Equities/International Equities

International equities or Euro-equities do not represent debt, nor do they represent foreign direct investment. They are comparatively a new instrument for foreign portfolio equity investment. In this case, the investor gets the dividend and not the interest in the case of debt instruments. On the other hand, it does not have the same pattern of voting rights that it does have in the case of foreign direct investment. International equities serve as a harmonious amalgamation between the debt and the foreign direct investment.

5) Global Bonds

Global bonds are debt instruments that are issued simultaneously in several cores. The bonds are usually issued by large multinational organisations and sovereign entities, both of which regularly carry out large fund-raising exercises. By issuing global bonds, an issuing entity can attract funds from a vast set of investors and reduce its cost of borrowing. These bonds are specifically designed to be traded in any financial market.

6) Global Depository Receipt (GDR)

It is a global finance vehicle that enables an entity to raise capital in multiple markets simultaneously through a global offering. GDRs may be used in both the public and private markets whether within or outside the United States. They are marketed internationally, primarily to financial institutions. Global Depository Receipt – certificate issued by an international bank, which can be subject to worldwide circulation on capital markets. GDRs are emitted by banks, which purchase shares of foreign companies and deposit them in the accounts. Global Depository Receipt facilitates the trading of shares, especially those from emerging markets. Prices of GDRs are often close to the values of related shares.

7) American Depository Receipt (ADR)

An American Depositary Receipt (ADR) represents trades in U.S. financial markets and ownership in the shares of a non-U.S. company. Many non-US companies’ stocks are traded on US stock exchanges through the use of ADRs. ADRs provide a convenient and secure avenue for US investors to purchase shares in foreign companies, eliminating the risks and cross-currency transactions. ADRs carry prices in US dollars, and pay dividends in US dollars, providing investors with the convenience of trading them just like shares of US-based companies. 

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