PROJECT REPORT OF INTERNATIONAL FINANCE ON

The Refinancing of Shanghai General Motors

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Contents

1.

Brief info about the case: ................................................................................................................ 3 Major issues of the Case ..................................................................................................................... 3 Questions addressed ........................................................................................................................... 4

2. 3. 4. 5. 6. 7. 8.

About Shanghai General Motors .................................................................................................... 5 Capital Structure of SGM ................................................................................................................ 5 Cost of Initial Financing ................................................................................................................... 5 Currency Composition of SGM........................................................................................................ 7 Identification of the Problem .......................................................................................................... 8 Possible Solutions ......................................................................................................................... 10 Risks Faced .................................................................................................................................... 12

Conclusion & Updates about the case .................................................................................................. 13 References ............................................................................................................................................ 14

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Acknowledgements
We shall not fail or falter; we shall not weaken or tire...Give us the tools and we will finish the job
- Sir Winston Churchill, 1941

This report has been inspired and is the result of ten weeks of hard work and dedication. Although it was challenging at times, the process was interesting and motivating, and provided us with a deeper knowledge in the area Project Financing and preferences. This research however, would not have been made possible if it had not been for a number of people. First and foremost, we would like to take the opportunity to express our gratitude to our mentor, Prof. T. Srinivasan, professor at the Indian Institute of Management, Lucknow Noida Campus for his help and guidance throughout the process of this research. We would also like to thank those who helped us in gathering the information who took time out of their busy schedules to participate in this study and therefore made this research possible.

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1. Brief info about the case:

"This case provides the outcome of "The Refinancing of Shanghai General motors (A)" in which the CFO of General Motors' joint ventured in Shanghai, Shanghai General Motors (SGM), who wants to refinance almost $900 million of project finance it rose to begin its operations. The highest priority is improving the terms of the financing with regard to costs and specific covenants. Several factors complicate the CFO's objective, including the presence of capital controls, the impending entry of China into the World Trade Organization, the joint venture partner's captive finance subsidiary, and the conflicting goals of the joint venture partners. The case illustrates how subsidiary financial decisions must trade off entity-level and parent-level concerns. It also illustrates how multinational financial decision making--including transfer pricing, repatriation, and funding decisions must be designed to accommodate governance concerns, financial objectives, and the potentially divergent interests of joint venture partners. The framework of the ongoing operational and investment decisions that Shanghai General Motors undertakes in its early growth demonstrates the "life cycle" of subsidiary finance. The case also touches on elements of foreign governments' attempts to regulate capital markets, the dynamic between domestic and international banks in competing for lending opportunities to multinational subsidiaries, and how subsidiary management can achieve the most desirable funding terms."

Major issues of the Case

Joint ventures-how are organizational form and ownership decisions made within multinational firms and how do recent trends in international trade and finance impact these decisions? SGMs refinancing-how should Newman prioritize to his current financing? How can financing decisions interact with business risks? Financial policy inside the firm-how should GM and multinationals make major financing decisions inside the firm?

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Internal capital markets-Can the internal capital markets of multinational firms serve as a competitive advantage to these firms?

Questions addressed
Some of the questions we have tried to answer in this report based on our analysis: 1. Why a joint venture was required? 2. For its upcoming SAIL project, should SGM use project-financing on existing terms or re-finance its existing debts altogether and start afresh? 3. How to hedge the foreign currency risk of SGM given the restrictive nature of derivative trading in China? 4. How to address the above problems What are the options and solution? 5. What are the learnings from the case? 6. SGMs refinancing-how should Newman prioritize to his current financing? How can financing decisions interact with business risks? 7. Financial policy inside the firm-how should GM and multinationals make major financing decisions inside the firm? 8. Internal capital markets-Can the internal capital markets of multinational firms serve as a competitive advantage to these firms?

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2. About Shanghai General Motors

Shanghai General Motors is where East meets West in the automotive world. The company, a joint venture between leading Chinese car maker Shanghai Automotive Industry Corporation Group (SAIC; 51%) and General Motors (GM; 49%), manufactures and markets vehicles, engines, and transmissions from three plants. It concentrates on making sedans, including models under the Buick, Chevrolet, and Cadillac brands. The company's operations are supported by a network of dealerships, repair facilities, and auto parts centres throughout the country. Shanghai GM, which was established in 1997, is one of the fastest-growing car companies in China.

3. Capital Structure of SGM

4. Cost of Initial Financing

USD Loan was costing Floating LIBOR +105 bps Chinese RMB Loan was costing Floating PBOC rate

China was a promising market and GM had the means to do it all alone. Then why did it choose to go for a joint venture?
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As MNCs increasingly serve global markets, they have to structure production across countries in ways that minimize worldwide costs. Local partners that are focused on the local market may not have the same priorities, giving rise to conflicts over sourcing and selling decision. If an MNC is serving a global market, then local knowledge becomes less critical and local partners less valuable. Furthermore, local partners have a stake in the profitability of the local venture only, not in optimizing the overall value of the MNC. This can make it more difficult for an MNC to set transfer prices for intercompany transactions or to structure finances in a way that would minimize its global tax burden since these decisions may affect the profitability of the local venture. Joint ventures and shared ownership make sense when the focus of operations is purely local; once an industry starts to globalize, then outright ownership of foreign affiliates is a more efficient structure for an MNC. The broader evidence also suggests that transferring intellectual property can also make joint ventures less desirable. Now the next question is Why firms may seek full ownership of foreign subsidiaries instead of using joint ventures? Biggest impact of the partnership: Chinas WTO accession poses several challenges for SGM: in the short run, it will have to cope with higher tariffs and more competition. Over the long run, though, Chinas entry into the WTO will result in low tariffs and more open trade. These changes will make it possible for GM to achieve lower costs, especially if GM can restructure its worldwide operations more efficiently. SAICs priorities, however, will also change with Chinas WTO accession; for example, SAIC may see SGM as becoming a more global player and even competing directly with GM around the world. Over time, it is likely that the joint venture will become less and less valuable to the respective partners.

Let us first understand Project financing and how they are distinctive from general corporate financing?

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Project finance is the long term financing of infrastructure and industrial projects based upon the projected cash flows of the project rather than the balance sheets of the project sponsors. Usually, a project financing structure involves a number of equity investors, known as sponsors, as well as a syndicate of banks that provide loans to the operation. The loans are most commonly non-recourse loans, which are secured by the project assets and paid entirely from project cash flow, rather than from the general assets or creditworthiness of the project sponsors, a decision in part supported by financial modeling. The financing is typically secured by all of the project assets, including the revenue-producing contracts. Project lenders are given a lien on all of these assets, and are able to assume control of a project if the project company has difficulties complying with the loan terms. Whereas corporate finance is the finance dealing with financial decisions business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize corporate value while managing the firm's financial risks. Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

5. Currency Composition of SGM

At its founding, SGM was required to divide its debt equally between U.S. dollars and Chinese renminbi and to pay down its debt evenly in its currency. This is a problem, as indicated below: to understand the currency mismatch: all of SGMs revenues are in RMB while its costs ( including financing) are split between U.S.$ and RMB.

How to characterize this investment as a financial play; what is SGM naturally long in and short in?
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Long - The buying of a security such as a stock, commodity or currency, with the expectation that the asset will rise in value. Short - Short selling (often "selling short") is a technique used by trader who wants to profit from the falling price of a currency pair. For example, consider an investor who wants to sell short EURUSD, believing the Euro is overpriced, the US Dollar is ready for a rally and EURUSD will fall. If the price of the currency pair drops, she "covers the short position" by buying back the EURUSD. The profit is the difference between the price at which the currency pair was sold and the cost to buy it back, minus the spread and any interest rollover. But if the price of EURUSD increases the position will create a loss. SGM is naturally long RMB as it has RMB revenues and some dollar operating costs. How should currency decisions on debt respond to these natural exposures? Borrowing in the local currency would at least not compound that natural exposure. In contrast, large amount of dollar debt amplify this risk. If the US$ appreciates against the RMB, this would create significant problems for SGM because it is short in US$. The US$ component of its debt means that SGM has significant financial risk layered onto its operating risk. If it is opposite, there are implications of capital account nonconvertibility. Where else in the world currency mismatches between revenues and financing costs have been problematic? That implies the currency mismatch between SGMs revenues and costs creates financial risk and that may affect its current financing, how?

6. Identification of the Problem

Primary problem of the case is: For its upcoming SAIL project, should SGM use projectfinancing on existing terms or re-finance its existing debts altogether and start afresh? And How to hedge the foreign currency risk of SGM given the restrictive nature of derivative trading in China Problems of Existing Financing Terms: High cost of debt due to Asian Crisis. Situations have improved since then and loans are available at more favorable terms. Restrictive clauses of existing financial terms has caused any finance related decision needed a super-majority
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approval of the existing bank committee. All existing and future assets of SGM were pledged and Equal use and pro-rata repayment of Chinese and American currency loans. The super-majority clause was restricting decision making in areas such as expansion, capital expenditure etc. USD LIBOR rates at 6.2% were higher than the Chinese RMB rate of 5.85%, yet re-adjustment was not possible due to the proportionate borrowing clause between USD and RMB Use of derivatives for hedging risks was also restricted except for forward contracts. The controlled supply of foreign currency by SAFE made the repayment of USD loan uncertain What does Mark Newman want to change in SGMs debt? Newman aims to increase the RMB component of SGMs debt to better match the companys revenues and lower financial risk. He also wants to take advantage of opportunities for lower interest rates on the RMB denominated debt since there appears to be an abundance of local currency and capital controls currently limit investors ability to invest RMB abroad. Recalling - Capital structure and dividend policy are two key financial policy decisions for every firm that they will likely consider. In an idealized world, capital structure is irrelevant, but in a world with taxes, firms generate interest tax shields by taking on debt. The optimal amount of debt for a firm is a trade-off between tax benefits and the cost of financial distress. A firms dividend policy is also irrelevant in an idealized world. If dividends are taxed, tax costs typically deter dividends as firms could instead repurchase their shares and avoid tax costs. Nonetheless, firms do pay regular dividends. This behavior is usually attributed to informational and agency problems. Predictable, increasing dividend payouts signal that a firm is profitable and growing and regular dividends reassure investors that managers are not retaining profits for their private benefit. GM and all MNCs face analogous problems inside the firm when they make decisions about capital structure and dividend policy for their subsidiaries

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Currency crises provide a good example of how MNCs gain benefits from their internal financial networks when markets are highly distorted. In the aftermath of sharp currency depreciations, when the local economy is weakened, local firms experience declines in sales and investment. Multinational affiliates, in contrast, increase their sales and investments in the aftermath of currency crises. They are able to do so because of their access to internal markets. These internal markets provide affiliates with both sales outlets for their products and access to capital when the external capital markets are most distorted. The loan agreement also stipulated that long-term borrowings would be made evenly as practicable, drawing down equal amounts in US$ and in RMB. Similarly, repayments of longterm debt would be made pro-rata, with denominated in each currency being paid down at the same rate.

7. Possible Solutions
REFINANCING Interest rates in China has been lower than the 6 month LIBOR rates on which the USD loans were based

LIBOR 8 6 4 2 0 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03

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The chart below shows quite a stable exchange rate between USD and CNY during the period under discussion. Hence there is not much risk of loss in repatriation of profit due to currency appreciation in U.S.

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Inflation rates in US have been historically higher than that of China

Based on the above three statistics, we feel that even if the interest rate parity and purchasing power parity holds loosely, it will be more profitable to borrow in Chinese currencies. Hence the course of action available to SGM is: Borrow in Chinese currency and repay the old loans Reduce exposure to foreign exchange as there are not many hedging options available Become self-sufficient, i.e. reduce dependency on parent company

Other option is to take no action: Continued dependency on the existing banking committee. Decision making will be slow and SGM will not be able to react quickly to the increased competition when China joins WTO. GM cannot take advantage of the interest rate differentials. In the face of increased competition, SGM will not be able to reduce its
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interest expense. Chinas entry into the WTO means that tariffs will come down and, in the long run, lower tariffs will lower costs. In the short run, however, SGM will gain little and may lose somewhat. SGM will immediately lose its preferential tariffs based on localization ratios with Chinas WTO entry, meaning it will have to pay the same tariffs as all its competitors. Since lower tariffs will be phased in gradually, SGMs tariff costs will actually increase for a period. Priorities as Newman approaches this refinancing SGM faced various hurdles in its original financing: it was a start-up venture; the Asian financial crisis meant that debt providers were very cautious; and the host government imposed various requirements on SGM. SGMs financing, therefore, was both restrictive and expensive. The initial project was defined in detail and SGM required approval from all its lenders for any changes-and those lenders would demand fees for such changes. SGMs introduction of a new model required cumbersome negotiations with the lenders bank committee and made it difficult for SGM to respond quickly to the market. Such restrictions are typical of project finance, where lenders seek to limit their risks by imposing strict controls on how funds are used. One of Newmans aims in the refinancing is to gain more flexibility for SGM so it can take advantage of growth opportunities. Newmans goal is to move SGM more toward a corporate finance model based on relationship with a smaller number of banks and loans with restrictive covenants.

8. Risks Faced
Interest Rate Risk - Risk of an increase in 6mnth LIBOR or PBOC rates Currency Exchange Rate Risk - Risk of depreciation of Chinese currency and thus dearer imports from US. Risk of SAFE not supplying enough USD to make payments

Mitigating Interest Rate Risk 1. Since there arent any derivatives available, interest rate risk can be mitigated only by an interest rate cap. Forward Rate Agreements or Interest rate swap if possible

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2. Localization: reducing dependency on US imports and thus reducing USD liability 3. Refinancing: Change the borrowings from USD loans to Chinese RMB loans to avoid payment in USD 4. Export: Export products to US in order to balance out payables and receivables in the same currency

Conclusion & Updates about the case

The terms of SGMs successful refinancing are explained in the follow -up case, The Refinancing of Shanghai General Motors (B), HBS Case No. 204 -025. Newman gained approval from the SGM board for refinancing and the transaction was completed in June 2001. SGMs robust cash flows allowed Newman to reduce the total debt to $700 million, composed of $160 million in USD and $540 million in RMB. SGM lowered its interest costs on both the USD and RMB components of the debt and the number of banks in the lending syndicate was reduced from 39 to 15. The term sheet included only standard financial ratio covenants and thus freed SGM from the many restrictive covenants of the original financing. In recent years, GM has tried to minimize the costly duplication of product design, engineering and production across its subsidiaries and announced its commitment to global product developmenta move towards the vertical model of multinationals described in the case. SAIC continues to partner with both GM and Volkswagen in the Chinese market while also pursuing new partnerships abroad, notably in Korea. SAIC sold its own passenger car in China by 2007, a step towards its announced goal of becoming a global player in its own right.
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References
1. Cases and Theories discussed in International Finance Class conducted at IIML-Noida Campus by Prof T. Srinivasan. 2. www.wikipedia.com 3. "1995, GM Links with SAIC". history.gmheritagecenter.com. General Motors Company. 2011. Archived from the original on 2011-05-30. Retrieved 2011-05-30. "GM signed a milestone agreement with Chinas Shanghai Automotive Industry Corporation (SAIC) for a proposed automotive joint venture, a joint venture technical center, and several other projects in and around the city of Shanghai..." 4. "1982 -1999, Globalization, One Company, One Team". history. gmheritagecenter. com. General Motors Company. 2011. Archived from the original on 2011-05-30. Retrieved 2011-05-30. "Also in 1995, the company entered into a joint venture agreement with Shanghai Automotive Industry Corporation (SAIC) in China, laying the foundation for unprecedented growth over the next few years. Four years later, the Buick Regal was being assembled in China for the Chinese market..."
5.

"1999, Buick is Back in Shanghai". history.gmheritagecenter.com. General Motors Company. 2011. Archived from the original on 2011-05-30. Retrieved 2011-05-30.
"The General Motors-SAIC joint venture plant in Shanghai began building Buick Regals for the Chinese market, marking the Buick brands proud return to China."

6. "GM's Shanghai joint venture opens new plant". The Star. 28 May 2005. Retrieved 10 January 2013. 7. "General Motors Sets Sales Record in China in 2011" (Press release). General Motors. January 8, 2012. Retrieved 10 January 2013. 8. Nathan Bomey (April 18, 2012). "GM regains 50% stake in its largest Chinese partnership". The Detroit Free Press. 9. http://www.shanghaidaily.com/sp/article/2010/201002/20100224/article_429322.h tm 10. "G.M. Cuts the Price On 2 Cars in China". The New York Times. 4 January 2012. 11. "GM says 2006 China vehicle sales up 32 pct". Reuters. 7 January 2012. Retrieved 02.02.2013
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12. "GM's China sales growth slows on VW and Ford competition". The New York Times. 10 January 2012. 13. "GM China sales growth slumps to 6% in 2008". China Daily. 6 January 2012. Retrieved 5 Feb 2013. 14. "G.M. Sales in China Rose 67% in 2009". The New York Times. 4 January 2010. Retrieved 5 Feb 2013. 15. "Summary: Shanghai GM's sales performance from 2002 to 2012". Gasgoo. 19 Feb 20103. Retrieved 6 January 2013. 16. "Ford, GM Report Record China Sales". The Street. 9 January 2011. Retrieved 5 January 2013. 17. "GM 2012 global sales rise 2.9 pct on strong Chevy demand". Reuters. 14 January 2012. Retrieved 20 January 2013.

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