International finance plays an essential role in the global economy. As people and companies engage in cross-border ventures, the ability to raise funds in other parts of the world is critical.
From an investor perspective, international finance provides an opportunity to seek returns outside of domestic financial markets. Most financial advisors will recommend that any personal investment portfolio should include some international component. This could be 5% or even 10% of the portfolio. Most importantly, global capital markets allow for greater diversification than domestic investing. Even different asset classes will be correlated in a domestic market due to the underlying economic conditions. International finance looks for opportunities beyond the boundaries of a single country.
For investors in an advanced economy, the first step beyond the border is typically other advanced economies. The IMF provides a list of the various groups (e.g., G-10) of countries that comprise this core of the developed countries. Beyond this are “emerging markets,” such as Brazil, Russia, and others. The “BRICS” are the emerging markets of Brazil, Russia, India, China, and South Africa. Further out on the development spectrum are “frontier markets” like other countries in Africa, Central America, and the Middle East. The World Bank is a development agency that can play a significant role in these economies.
The IMF publishes a World Economic Outlook twice a year that includes the forecast of IMF economists for various economies and the global economy as a whole. This report always highlights the wide range of economic performance across the globe.
International investing is highly connected to index investing. It is often difficult or even impossible to buy individual securities in a foreign market. However, there are many funds that track indexes focused on particular geographic markets. The MSCI Indexes are widely used for this purpose. MSCI provides a breakdown of the countries that are in their developed markets and emerging markets. Such indexes can be designed to track unique asset classes such as equity or fixed-income.
Due to the frictions and restrictions in international investing, many foreign companies will list shares of the company on a foreign exchange. An American Depositary Receipt (ADR) is an example of such a cross-listing.
Even for those who are not actively investing internationally, international finance provides a valuable window into the global economy. For instance, Asian markets often lead European markets which often lead U.S. markets. Global news travels across the globe with open trading hours, therefore it tends to have an east-to-west direction.
One of the key indicators of the global economy is commodities. Commodities are basic elements such as energy (oil and gas), metals (copper and silver), and agricultural. The prices of commodities are global in nature, so their prices are driven by global demand. They are the ultimate “tradeable good.” This connection to the global economy produces something called the “commodity super cycle.” When global demand is high, then commodity prices can soar. Likewise, when demand falls, so do commodity prices. This can create a boom-bust cycle in commodity prices. Interestingly, many still view gold as a global safe haven.
International finance also involves the flow of funds across borders. International interest rates are a key factor in this international search for yield. When central banks lower rates, funds tend to flow out of the country. Conversely, raising rates causes funds to flow into a country. Therefore, when central banks in the advanced economies engage in monetary stimulus, the emerging markets tend to benefit. Quantitative easing has flattened yield curves in advanced economies around the world, especially Germany and Japan. When central banks reverse course, it can create a painful outflow for emerging economies. With the tapering of QE in the U.S., some emerging market politicians complained of a giant “sucking sound.”
The “carry trade” is a classic example of borrowing in low-rate currencies and investing in high-rate currencies.
With COVID, many emerging markets are also struggling with high Debt to GDP. They have a reduced economic outlook due to prior fiscal stimulus. There is limited ability of smaller governments to provide support.
Lastly, there is the issue of international financial interconnectedness. The global financial crisis highlighted this with mortgage-backed securities. Investors around the world bought these securities and paid the price.