Aliber’s Currency Premium Theory Essay Example

regarding the role of exchange rates in the export of equity capital from the home country. "Investments in other currency areas are often overlooked. The investors take no account of the exchange risks involved in the repatriation of profits to the parent firm.

Thus the assets of, say, a US firm operating in the UK, are valued by the market as though they were dollar assets instead of sterling assets.It follows that if the currency premium on dollars is lower than the currency premium on sterling (dollars are the preferred currency) then the market rate of interest on the debt of the US based MNE will be lower than on the debt of an indigenous UK firm, after allowance for expected currency depreciation. Thus the US based MNE can borrow more cheaply than the UK firm to finance any form of capital expenditure in the UK.One implication of this is that a US firm can realise an immediate profit by financing the takeover of a UK firm.

Drawing from Kindleberger, Aliber also argued that foreign investments resulted from the trade-off between tariff barriers and economies of scale. The underlying assumption is that domestic production reduces costs by achieving economies of scale, while foreign production reduces costs by avoiding tariff barriers. However Aliber missed factors such as skill levels, unionisation rates, and technological progress. Furthermore, he operated under the simplifying assumption of standardised products.

The currency premium theory did well to predict the direction of post war expansion of MNEs. However, it failed to explain anything about capital flows within currency areas. It was also not able to account for cross investments between currency areas. For instance,

we do know that the Japanese yen depreciated from 90 to the dollar in 1995 to 130 to the dollar in 1997. The currency premium theory would then advocate inflows of FDI into Japan from the US during this period. Also, FDI outflows from Japan to the US must have diminished.