Class 1A

International Finance

Class 1 & 2

Issues in International Finance

· Raising Finance from International Market

§ Raise from Domestic Market

§ Raise from International Market

ü Short Term Finance

· Trade related exposure

· Domestic Expenses (Foreign Currency loan to meet export order; Import machine – Capital Expansion)

ü Medium Term Finance

ü Long Term Finance

· Equity Issue – Retain funds from international market on long term loans

Ø ADR – US (American) Deposit receipts. Company feels easy to raise equity from international market

· Debt

Ø FCCB – Foreign currency convertible bond. Till 7 years, it is debt, post which it can be converted to equity at a pre-determined price

· Managing the Risk (Exposure)

§ Commercial

ü Institutional Shield

ü Instruments (manage risks)

§ Country

ü Consultancy to provide country data

ü Own methods of qualitative / quantitative survey

§ Currency

· Country specific regulation – If domestic currency can’t earn inside, pressure on foreign currency

· Sector wise gap – To dis-allow foreign investor to take over industry

· Local tax discrimination between domestic & foreign investments. Ex – China. Ajanta Quartz faced protests from local people in China as they paid less tax than local companies

· Different accounting practices (which norm to follow for financial reporting)

Company wants to go for massive expansion (like $ 300 million) – Syndication Process

Emerging Trends

1) Cross border movement of Capital / Goods. Example – Euro Trade union & Euro (consolidate strength of 11 European countries)

2) Open economy –

a. Significant shifts – Easy inflow & outflow of money

b. Liberalization of imports (capital goods imports)

c. Concentrated efforts for export promotion – liberal borrowing policy of country (local & foreign currency loans) & FDI. Example – Indonesia allowed loan in foreign currency before crisis of 1997 without loan applicant to specify the purpose of loan

d. Through exports, a country actually earns actual trade surplus (real foreign exchange)

3) Freedom for raising capital from global market (cost of funds are cheaper)

4) Cheaper credit from off-shore market

5) Reduction of currency control

Global Economy

Carry Trade Losses

In 2008, USD = 123 Yen. Interest Rate on Yen is 0.17%. Hence, a trader borrows 123 Yen @ 0.17%, converts it into USD and in-turn in INR and invests in India at 8%.

In 2009, USD = 90 Yen. Hence, the profit earned in India is eroded when USD is converted back to Yen and now 1 USD only gives 90 Yen instead of 123 Yen.

Corporate today

1) Euro / Dollar (Off-shore Market) – USD $ traded outside USA. After World War-2, Russian market started accepting USD $.

2) Reuter / Bloomberg Screen

3) Currency Movements

4) Interest Rate Difference

5) Arbitrage opportunity

6) Joint Ventures / Cross border trades (Tata Steel taking over Corus)

7) One Set of transactions (Lending by Europe to Nigeria via Singapore Market)

8) Joint Ventures in SA pharma today

9) Trading office in Dubai / Singapore

Need for International Finance

1) Counter party can be anywhere

2) Country need not to consume / produce all items (hence, need to export. Hence, may need international finance to support the export)

3) Domestic projects needs external finance, domestic funds may not be sufficient (Infra-structure, Power Project). Example – China’s investment in India in 2010-11 is $ 8.4 billion dollars

4) Cost of funding may be cheaper in foreign market

Euro $ / Offshore Market

1) Ceiling on interest rate for deposits in USA, hence, funds move outside the country

2) Deposits

a. Insure Deposits. Hence, pay premium of 0.05%

b. Reserve with Central Bank (CRR) – 5%

c. Interest on deposits – 6%

d. Hence, Cost of funds = 6% + 0.05% = 6.05%

3) Balance of Payment Crisis (1960s)

a. US put restrictions on giving loans (VFCRP)

b. Tax on interest earnings – 1963 (IET)

c. GBP can be used to only finance UK industries

d. Hence, US dollar mobilized outside US and off-shore market developed

$ 4.2 Trillion / day = Forex Transaction (70% in London Market) = Easy to quote bid / offer prices

Nostro Account – Actual mobilization of $ account in US, but in books of foreign country bank. Because of it, US sustain huge trade deficit (as though money moves within US banks only, the owners are outside US / non-US companies)

Balance of Trade = Difference between exports and imports (only physical goods are included, no services)

Capital account transaction =Resident company creating asset / liability in foreign currency (loan) raised in home country

· Resident company raising loan in domestic currency – No effect on current or capital account (as home currency is not affected by any currency fluctuation outside)

· Example – All non-resident of Singapore creating an asset / liability in Singapore by investing in a company is Capital Account Transaction

Current Account Transactions – Inflow + Outflow (is +ve if Inflow > Outflow)

· Inflow of foreign exchange

ü Physical exports (Current Account Transaction)

ü Invisible services (Current Account Transaction)

§ Repatriation of Income by Non residents

§ Example – Providing software solution

ü Foreign aids / Donation / Gifts (Current Account Transaction)

§ Collection from entire globe / subsidiaries transferred to Central / Parent office

ü Interest & Dividend receipts (Current Account Transaction)

§ Dividend declared locally after 60 days after finalizing balance sheet of foreign subsidiaries

ü Freight Collections

§ Selling their currency to buy local – even medical tourism

ü Other Sources

§ FDI – Technology + Management control + minimum locking period + long term (Capital Account Transaction)

§ FII – more concerned about short term gains (Capital Account Transaction)

§ External Commercial borrowings (ECB) (Capital Account Transaction)

§ FCCB (ADR, GDR issues) – Equity raised in foreign market (Capital Account Transaction)

§ NRI – Non Resident investment (Capital Account Transaction)

· Outflow of foreign exchange

ü Physical import (Current Account Transaction)

ü Repatriation of FDI (Capital A/C Transaction)

ü Repayment of loans (FCCB), foreign investment (Capital A/C Transaction)

Capital Account + Current Account = Balance of Payment

Forex Reserve

Components

1) Balance of payment surplus

2) Gold reserve

3) Undrawn SDR (special drawing rights) – OD facility depending on contribution to IMF funds to countries

a. Can be used when the country has advance balance of payment position

b. Can be used when the currency movement is erratic

4) Balance with IMF (contribution to IMF or payment left with IMF)

Convertibility of a currency

Full convertibility – It is the freedom to

1) Possess foreign exchange – In any currency, in any account

2) Use foreign exchange for any purpose – Bank will not ask reason while remitting

3) Exchange rate of currency to be decided by market forces

Example – USD, Euro, Pound Sterling, Swiss Franks

Impact of BOP / BOT data

Currency is under pressure, if BOT is under deficit (more import)

When a company can go for full convertibility

1) Rate of inflation to be under control (Inflation can’t be zero)

2) No erratic movement of exchange rate

3) NPA level of banking system

1991 – IMF lending condition to lend to India

1) Financial sector reform – Government control to be lessened on banks, NPA level to be brought down (24% in 1991)

2) Full convertibility in phased manner – 1994 (current account convertibility)

3) CRR should be brought down (as it is low yielding)

a. CRR - From 18.5% to 5%

b. SLR – From 38.5% to 25%

c. Priority Sector lending – Remains at 16%

d. Reduction ensured 17% availability (73% to 57%)

e. Earlier only 27% was left to lend to general public

4) Minimum reserve maintenance for meeting 6 month import commitment

5) People /company can take dividend out