International banking lesson 08

73 International Financing by Multinational Banks LESSON 8 INTERNATIONAL FINANCING BY MULTINATIONAL BANKS CONTENTS 8.0 Aims and Objectives 8.1 Introduction–Equity Financing 8.2 New

71 International Financing by Multinational Banks

UNIT IV

72

International Banking

73 International Financing by Multinational Banks

LESSON

8

INTERNATIONAL FINANCING BY

MULTINATIONAL BANKS

CONTENTS

8.0 Aims and Objectives

8.1 Introduction–Equity Financing

8.2 New Trends in the Stock Markets

8.2.1 Stock Market Alliances

8.2.2 Cross-listing

8.2.3 Stock Market Concentration

8.3 Privatisation

8.4 Interbank Clearing House Systems

8.5 International Bond Financing

8.5.1 International Bonds

8.5.2 Currency Option Bonds

8.5.3 Currency Cocktail Bonds

8.6 Types of International Bonds

8.6.1 Straight Bonds (Fixed-Rate Bonds)

8.6.2 Floating-rate Notes

8.6.3 Convertible Bonds

8.6.4 Bonds with Warrants

8.6.5 Other Bonds

8.7 International Loans

8.7.1 The Spread and the Reference Rate

8.8 Risk Sharing and Reduction

8.9 Syndicated Loans

8.10 Advantages and Disadvantages

8.11 Direct Loans

8.12 Intracompany Loans

8.13 Drawbacks of Parallel and Back-to-Back Loans

8.14 Let us Sum up

8.15 Lesson End Activity

8.16 Keywords

8.17 Questions for Discussion

8.18 Suggested Readings

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International Banking 8.0 AIMS AND OBJECTIVES

After studying this lesson, you should be able to understand:

z The equity capital market – An important source of financing

z The new trends in the stock market

8.1 INTRODUCTION – EQUITY FINANCING

Besides debt instruments such as the Eurodollar and bond markets, the equity capital market is another important source of financing Evidence indicates that the final decade of the twentieth century will go down in history as the period in which much

of the world discovered the stock market as a major source of funds for their global expansion Companies will increasingly turn to the stock market to raise money This section focuses on how ownership in publicly owned corporations is traded throughout the world The stock market consists of the primary market and the secondary market The primary market is a market in which the sale of new common stock by corporations to initial investors occurs The secondary market is a market in which the previously issued common stock is traded between investors

8.2 NEW TRENDS IN THE STOCK MARKETS

In recent years, a number of new trends have begun to emerge in the stock markets around the world:

(1) alliance, (2) cross-listing, and (3) concentration

8.2.1 Stock Market Alliances

There are some 150 stock exchanges in the world Within the past 10 years, these stock exchanges have scrambled to align with each other Markets in Paris, Amsterdam, and Brussels have agreed to form Euronext, while a group of Scandinavian markets has agreed to form Norex Those deals prompted the London Stock Exchange and Frankfurt's Deutsche Bourse to consider a merger into a new market, but that deal fell through in September 2000 In 2001, the Lisbon Exchange decided it would join Euronext NASDAQ has joint ventures and alliances in Japan, Hong Kong, Australia, Canada, the UK, and Germany In September 2002, Euronext and the Tokyo Stock Exchange signed an alliance for cooperation and investor protection In November 2002, the New Zealand Stock Exchange and the Hong Kong Stock Exchange signed an information-sharing agreement The New York Stock Exchange has recently discussed alliances with markets in Canada, Latin America, Europe, and Asia

There is a variety of reasons for this consolidation of stock exchanges: the growing speed and power of telecommunication links, big and small investors' keen interest in stocks from all parts of the world, and the fear of being left behind Moreover, if national exchanges do not take the initiative, they could be bypassed by new electronic trading systems These same forces have caused the burgeoning of online trading and have pushed national securities firms to expand their business overseas

8.2.2 Cross-listing

With the rise of cross-border mergers during the 1990s and the early 2000s, there arises a need for companies to cross-list their stocks on different exchanges around the world Companies are obligated to adhere to the securities regulations of all countries

75 International Financing by Multinational Banks

where their shares are listed A decision to cross-list in the USA means that any

company, domestic or foreign, must meet the accounting and disclosure requirements

of the US Securities and Exchange Commission Rules for listing requirements differ

markedly from country to country, but analysts regard US requirements as the most

restrictive in the world Reconciliation of a company's financial statements to US

standards can be a laborious process Some foreign companies are reluctant to disclose

hidden reserves and other pieces of company information It might not appear too

difficult for US companies to cross list on certain foreign exchanges because their

listing requirements are not that restrictive, but certain barriers still exist, such as a

foreign country's specific rules and reporting costs By cross-listing its shares on

foreign exchanges, an MNC hopes to:

1 Allow foreign investors to buy their shares in their home market

2 Increase the share price by taking advantage of the home country's rules and

regulations

3 Provide another market to support a new issuance

4 Establish a presence in that country in the instance that it wishes to conduct

business there

5 Increase its visibility to its customers, creditors, suppliers, and the host

government

6 Compensate local management and employees in the foreign affiliates

8.2.3 Stock Market Concentration

European stock markets have become more integrated since the European Union's

decision to switch their monetary union from the European Currency Unit to the euro,

which was launched in 1999 Increasing integration, as reflected in converging price

dynamics across markets, results from various structural changes in European stock

markets There is already a large amount of cross-listing and trading among

exchanges Competition among exchanges for listing and order flow has long

characterized European securities markets In addition, exchanges have become

subject to competition for order flow from alternative trading systems Because there

are benefits from achieving large size and attracting liquidity, another important

response to competitive pressures has consisted of mergers among exchanges

The concentration of stock market capitalization is not an "ED phenomenon," but

reflects a worldwide trend towards a single global market for certain instruments The

three largest stock markets accounted for 60 percent of the total market capitalization

in 1995 and 2001 Furthermore, the share of the five and ten largest stock markets has

increased from 1995 to 2001 These statistics indicate a trend toward concentration of

the world stock markets

Check Your Progress 1

1 What are the reasons for stock market alliances?

………

………

2 Mention the benefits of cross-listing

………

………

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International Banking 8.3 PRIVATISATION

Privatisation is a situation in which government-owned assets are sold to private

individuals or groups In recent years, even many developing countries have been selling government-owned enterprises to private investors For example, the amount

of money raised through privatization by the Indian government increased from

$100 million in 1996 to $1,234 million in 1999 In May 2000, the Indian government announced that it would privatize most of the government owned enterprises, including Air India, which is the international flag carrier for India The global amount of money raised through privatization by developing countries surged from almost nothing in the early 1980s to $67 billion in 1997, before decreasing to

$42 billion in 1999 The World Bank estimates that cumulative privatization revenues worldwide have exceeded $1 trillion by 2000 Privatization could play an important role in the ongoing transformation of emerging capital markets: due to its high profile, privatization may facilitate a switch from investment in bonds to investment in equities

First, governments try to assist the development of capital markets by increasing market capitalization and liquidity Second, a closely related motive is to widen share ownership and to create a "shareholder culture" in the population at large Third, governments use privatization to raise money Fourth, by replacing public-sector decision-making and control with those of the private sector, privatization is inducing notable changes in the corporate governance structure in important segments of the economy Finally, privatisation enables governments to use their resources more efficiently By 1990, state-owned enterprises (SOEs) consumed nearly 20 percent of gross domestic investment in developing economies, while producing just more than

10 percent of gross domestic product: "Overall, privatization has dramatically improved the performance of former SOEs" (The World Bank 2003b, p 96)

Privatization takes many forms First, a government sells state-owned companies directly to a group of ultimate investors Second, the government divests itself of a company it owns through public offerings of equity in the primary market The primary market is a market in which the sale of new securities occurs Third, the government may sell residual stocks of partly privatized companies in the secondary market The secondary market is a market for securities that have already been issued and sold Finally, other privatization methods include leasing, joint ventures, management contracts, and concessions In 1998, direct sales of government-owned enterprises by developing countries accounted for almost 75 percent of privatization revenues and public offerings contributed to most of the remaining sales

What are the essential elements for a successful privatization? Any successful privatization involves at least three elements First, a government needs a political agreement to sell all or part of a company it owns Second, the company should have the potential to transform itself into a profit-making entity rather than a government-subsidized burden Third, the government has to find underwriters who will distribute and market the shares domestically and internationally

8.4 INTERBANK CLEARING HOUSE SYSTEMS

This section describes three key clearinghouse systems of interbank fund transfers These three systems transfer funds between banks through wire rather than through checks The Clearing House Interbank Payments System (CHIPS) is used to move dollars among New York offices of about 150 financial institutions that handle 95 percent of all foreign-exchange trades and almost all Eurodollar transactions The Clearing House Payments Assistance System (CHPAS) began its operation in 1983 and provides services similar to those of the CHIPS It is used to move funds among the London offices of most financial institutions

77 International Financing by Multinational Banks

The Society for Worldwide Interbank Financial Telecommunications (SWIFT) is an

interbank communication network that carries messages for financial transactions It

was founded in 1973 by European and North American banks Since 1973, its

membership has expanded to include many Asian and Latin American banks The

SWIFT network represents a common denominator in the international payment

system and uses the latest communication technology The network has vastly reduced

the multiplicity of formats used by banks in different parts of the world Banks can

execute international payments more cheaply and efficiently than ever before, because

of the common denominator in the international payment system and the speed of

electronic transactions Currently, 6,000 live network users send 10 million messages

daily through the SWIFT; its usage increases at an annual average growth rate of

15 per cent Messages transferred through this system include bank transfers,

customer transfers, and special messages

8.5 INTERNATIONAL BOND FINANCING

The international capital market consists of the international bond market and the

international equity market Given Table shows selected indicators at year-end 2001

on the size of the capital markets around the world Several inferences can be drawn

from this table First, the world's stock market capitalization was almost as big as the

world's gross domestic product (GDP) Second, the US GDP was only 1.4 times as big

as the combined GDP of some 130 emerging market countries, but its stock market

capitalization was 7.1 times as big as the combined stock market capitalization of

these emerging market countries Third, G-5 countries (the USA, Japan, Germany, the

UK, and France) accounted for 61 percent of the world's GDP, 71 percent of the

world's total equity market capitalization, and 75 percent of the world's total debt

securities These statistics indicate how powerful these G-5 countries are in terms of

their wealth and capital market activities

8.5.1 International Bonds

International bonds are those bonds that are initially sold outside the country of the

borrower International bonds consist of foreign bonds, Eurobonds, and global bonds

An important issue with bond financing has to do with the currency issue The

currency of issue is not necessarily the same as the country of issue, although the two

may coincide For example, if a US company sells a yen-denominated bond in Japan,

the currency of issue is that of the country of issue However, if a US company sells a

dollar-denominated bond in Japan, the currency of issue is not that of the country of

issue In the former of these situations, the bond is called a foreign bond; in the latter,

the bond is called a Eurobond A global bond is hybrid in nature, because it can be

sold inside as well as outside the country in whose currency it is denominated For

example, a dollar-denominated bond tradable in New York (domestic market) and

Tokyo (Eurobond market) is called a global bond Let us provide a more general

description of these three international bonds: foreign bonds, Eurobonds, and global

bonds

Foreign bonds: Bonds sold in a particular national market by a foreign borrower,

underwritten by a syndicate of brokers from that country, and denominated in the

currency of that country are called foreign bonds Of course, foreign bonds fall under

the regulatory jurisdiction of national or domestic authorities Dollar-denominated

bonds sold in New York by a Mexican firm are foreign bonds; these bonds should be

registered with the US Securities and Exchange Commission (SEC) Foreign bonds

are similar in many respects to the public debt sold in domestic capital markets, but

their issuer is a foreigner The first foreign bond was issued in 1958 Most large

foreign-bond issues have been floated in the USA, the UK, and Switzerland The

weakening British pound in the late 1950s reduced the importance of the domestic

British capital market for foreign firms The Interest Equalization Tax (1963-74) of

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International Banking the USA effectively stopped New York's usefulness as a capital market for new

foreign bonds Thus, international borrowers and investors shifted their activities from the USA to Europe This shift caused the Eurobond market to develop

Eurobonds: Bonds underwritten by an international syndicate of brokers and sold

simultaneously in many countries other than the country of the issuing entity are called Eurobonds In other words, since the term "foreign bonds" refers to those bonds that are issued in the external sectors of financial markets - sectors that fall outside the regulatory environment of national authorities - Eurobonds are, therefore, issued outside the country in whose currency they are denominated The Eurobond market is almost entirely free of official regulation, but is self regulated by the Association of International Bond Dealers For example, dollar-denominated bonds sold outside the USA are Eurobonds; these bonds are not registered under the US Securities Act and may not be offered or sold to Americans as part of the distribution The first Eurobond issue was launched in 1963 Eurobonds are direct claims on leading MNCs, governments, or governmental enterprises They are sold simultaneously in many countries through multinational syndicates of underwriting brokers The Eurobond market is similar to the Eurodollar market in one respect Both markets are "external," because obligations available in these markets are denominated in foreign currencies outside the country of issue

Global Bonds: These are bonds sold inside as well as outside the country in whose

currency they are denominated For example, dollar-denominated bonds sold in New York (domestic bond market) and Tokyo (Eurobond market) are called dollar global bonds Similarly, pound-denominated bonds sold in London and Los Angeles are pound global bonds While global bonds follow the domestic market practice of registration of bonds, they follow the Eurobond market practice regarding their distribution Dollar global bonds combine SEC registration and US clearing arrangements with separate clearing on the Eurobond market The World Bank issued the first such bonds in September 1989 and still remains the leading issuer of global bonds The Bank raised $1.5 billion through a dollar global bond issue that was offered in the USA as well as in Eurobond markets It has issued in US dollars, euros, Japanese yen, and British pounds

By allowing issuers to solicit demand for a variety of markets and to offer greater liquidity to investors, global bonds have potential to reduce borrowing costs Such cost savings might be, however, offset by the fixed costs of borrowing through the global format, such as registration and clearing arrangements These costs for global bonds are presumably higher than for comparable Eurobond issues

8.5.2 Currency Option Bonds

The holders of currency option bonds are allowed to receive their interest income in the currency of their option from among two or three predetermined currencies at a predetermined exchange rate The original bond contract contains the currencies of choice and the exchange rates The currency option enhances the exchange guarantee for the investor Thus, the investor will make some gain if all currencies included in the contract do not depreciate against the desired currency

8.5.3 Currency Cocktail Bonds

Bonds denominated in a standard "currency basket" of several different currencies are called currency cocktail bonds A number of these bonds have been developed to minimize or hedge foreign-exchange risk associated with single-currency bonds The currency diversification provided by these bonds can be replicated by individual investors Thus, currency cocktail bonds have never gained wide acceptance with Euromarket borrowers

79 International Financing by Multinational Banks

Check Your Progress 2

Define the following:

1 International Bonds

………

………

2 Global Bonds

………

………

3 Currency Cocktail Bonds

………

………

8.6 TYPES OF INTERNATIONAL BONDS

Five types of international bonds are straight (fixed-rate) bonds, floating-rate notes,

convertible bonds, bonds with warrants, and other bonds

8.6.1 Straight Bonds (Fixed-Rate Bonds)

These bonds have fixed maturities and carry a fixed rate of interest Straight bonds are

repaid by amortization or in a lump sum at the maturity date The amortization method

refers to the retirement of a long-term debt by making a set of equal periodic

payments These periodic payments include both interest and principal Alternatively,

a borrower may retire his or her bonds by redeeming the face value of the bonds at

maturity Under this method, a fixed interest on the face value of the bonds is paid at

regular intervals

These are technically unsecured, debenture bonds, because almost all of them are not

secured by any specific property of the borrower Because of this, debenture

bondholders become general creditors in the event of default; they look to the nature

of the borrower's assets, its earning power, and its general credit strength Perhaps the

greatest advantage of all types of international bonds for individual investors is that

interest income on them is exempt from withholding taxes at the source Investors

must report their interest income to their national authorities, but both tax avoidance

and tax evasion are extremely widespread Official institutions hold a large portion of

investment in international bonds and are not liable for tax Another large class of

investors in international bonds consists of private institutions These private

institutions legally avoid tax by being in tax-haven countries

8.6.2 Floating-rate Notes

These notes are frequently called Floating-rate bonds The rate of return on these

notes is adjusted at regular intervals, usually every 6 months, to reflect changes in

short-term market rates Because one of their main objectives is to provide dollar

capital for non-US banks, most Floating-rate notes are issued in dollars Like other

international bonds, Floating-rate notes are issued in denominations of $ 1,000 each

They usually carry a margin of 1/4th per cent above the LIBOR, and this margin is

normally adjusted every 6 months The link between the rate of return on Floating-rate

notes and LIBOR rates is intended to protect the investor against capital loss

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International Banking 8.6.3 Convertible Bonds

Bonds of this type are convertible into parent common stock The conversion price is usually fixed at a certain premium above the market price of the common stock on the date of the bond issue Investors are free to convert their fixed-income securities into common stock at any time before the conversion privilege expires; the borrowing company is obliged to issue new stock for that purpose The convertible provision is designed to increase the marketability of fixed-rate Eurobonds Convertible bonds provide investors with a steady income and an opportunity to participate in rising stock prices Thus, their interest rates have been 1.5 to 2 per cent below those on fixed-rate bonds Because international investors are in Ration-conscious, they prefer convertible bonds, which maintain the purchasing power of money

8.6.4 Bonds with Warrants

Some international bonds are issued with warrants A warrant is an option to buy a stated number of common shares at a stated price during a prescribed period Warrants pay no dividends, have no voting rights, and become worthless at expiration unless the price of the common stock exceeds the exercise price Convertible Eurobonds do not bring in additional funds When they are converted, common stock increases, and the convertible securities are retired When warrants are exercised, common stock and cash increase simultaneously

8.6.5 Other Bonds

A major portion of other bonds consists of zero-coupon bonds, which provide all of the cash payment (interest and principal) when they mature These bonds do not pay periodic interest, but are sold at a deep discount from their face value The return to the investor is the excess of the face value over the market price Zero-coupon bonds have several advantages over conventional bonds First, there is immediate cash inflow to the issuing company but no periodic interest to pay Second, a big tax advantage exists for the issuing company, because any discount from the maturity value may be amortized for tax purposes by the company over the life of the bond

8.7 INTERNATIONAL LOANS

Large international loans to developing countries have become extremely important for European, Japanese, and US banks For some banks, international loans have become as important as their domestic banking operations On the other hand, recent global debt problems have raised serious questions about large loans to developing and former Eastern-bloc countries Pricing an international loan, which amounts to the determination of the interest charged to the borrower, depends on a number of factors

It is also influenced by a combination of risk evaluation, market conditions, and shifts

in the demand for and supply of loans The following factors are important for determining the interest rate charged to the borrower

8.7.1 The Spread and the Reference Rate

The interest paid on syndicated loans is usually computed by adding a spread to the London Interbank Offer Rate (LIBOR) or another reference rate such as the US prime rate or the Singapore Interbank Offer Rate (SIBOR) The following factors determine the spread:

1 The availability of liquidity or loanable funds relative to demand Spreads are likely to be higher in a market that is characterised by a shortage of liquidity and excess demand for loanable funds

2 The creditworthiness of the borrower, as high-quality borrowers are charged lower spreads than low-quality borrowers