Industrial and Commercial Bank of China In October 2006, the Industrial and Commercial Bank of China, or ICBC, successfully completed the world's largest ever initial public offering (IPO), raising some $21 billion. It beat Japan's 1998 IPO of NTT DoCoMo by a wide margin to earn a place in the record books (NTT raised $18.4 billion in its IPO). The ICBC offering followed the IPOs of a number of other Chinese banks and corporations in recent years. Indeed, Chinese en- terprises have been regularly tapping global capital markets for the last decade, as the Chinese have sought to fortify the balance sheets of the country’s largest companies, to improve corporate governance and transparency, and to give China's industry leaders global recognition. Since 2000, Chinese companies have raised more than $100 billion from the equity markets. About half of that came in 2005 and 20086, largely from the country’s biggest banks. Shares sold by Chinese companies are also accounting for a greater share of global equity sales—around 10 percent in 2006 Compared to 2.8 percent in 2001, surpassing the total amount raised by companies in the world’s second largest economy, Japan. To raise this amount of capital, Chinese corporations have been aggressively courting international investors. In the case of ICBC, It simultaneously listed its IPO sheres on the Shanghai stock exchange and the Hong Kong exchange. The rationale forthe Hong Kong listing was that regulations in Hong Kong are in accordance with ‘Scanned with CamSeannet _4The Global Capital Market LEARNING OBJECTIVES iter you have read this chapter, you should: rapidly over the last quarter century. Be able to articulate the benefits of the global capital market. Understand why the global capital market has grown so Be familiar with the risks associated with the globalization of capital markets, eurocurrency market, the global bond market, and global equity markets. Understand how foreign exchange risk impacts upon the cost of capital intermational standards, while those in Shanghai have some way to go. By listing in Hong Kang, ICBC signaled to Potential investors that it would adhere to the strict ‘eporting and governance standards expected of the top global companies, The ICBC listing attracted considerable interest from foreign investors, who saw it as a way to invest in the Chinese economy. ICBC has a nationwide bank network of More than 18,000, the largest in the nation. It claims 2.5 milion corporate’ customers and 150 million personal accounts, Same 1,000 Institutions from across the Globe reportedly bid for shares in the IPO. Total orders ‘fom these institutions were equivalent to 40 times the @ Appreciate the benefits and risks associated with the amount of stock offered for sale. In other words, the offering was massively oversubscribed. Indeed, the issue generated total demand of some $430 billion, almost twice the value of Citicorp, the world's largest bank by market capitalization The listing on the Hong Kong exchange attracted some $350 billion in orders from global investors, more than any other offering in Hong Kong's history. The domestic portion of the stock sales, through the Shanghai exchange, attracted some $80 billion in orders. This massive ‘oversubscription enabled ICBC to raise the issuing price for its shares and reap some $2 billion more than initially plonned! ‘Scanned with CamSeannerpart 4 >) The Global Monotary S¥S2” (Introduction ~The case described at the begin overcame the limited capital me $ ss how China’ largest bank, Icy ofthe chapter senses ho ge ban, able within China © execute the largest initial me a rie from foreign investors who subscriggs rook the world’ leading stock mais they offering in history, raising “ Sxchanges. What ICBC achieved wor" Post ce flow of money oa nchanges globalization of capital markers 90 ; based elsewhere with relative ease. “Fac sepresents a sharp break from tHe practice common daing much of the 20 century. In the past, substantial regulatory barriers separated national cape markets from carl ether, It was often dificult 0 take Yea out ofa country and tes it dew, cach over Typorations lacked the ability £0 On shares on stock markets outside of eect tome nations. These regulacory barciers i ie ie difficult for corporations 10 attrac Significant capital from foreign investors “Tce barriers eumbled fast during the 1980s and 1500s. By the middle ofthe 1990s, a uly global capital marker was eme!ging This capital market enabled firms to attract capital from international investors, tO list their stock on matple exchanges, and co raise funds by ising equity of debt around the world Fr Trample, in 1994 Daimler-Benz, Germany’ Ives ‘dustrial company, raised $300 milion by issuing new shares, nt in. Germanys but it ‘Singapore? Similarly, in 1996 the German telecommunications provider, Deutsche ‘Telekom, raised some $13.3 billion by ee oy lings shares forsale on stock eschanBes Frankfurt, London, New lected to rais it i York, and Tokyo. These German companies ¢ aise equity-throughrforeign market» by 2 A ie dementepal marke as s0@ mel ee jr cost of capital they tapped into the large requil Jercose. To lower thei sect highly liquid global capital market. By 2006, estimanes suggested that some $6.5 tilion a year in capital was flowing across national borders ‘and that this figure was growing by 11 percent a year? Capital markets have become highly inte and corporations borrow money from each other to me ae oer tal paper. The market for commercial paper isa tuly global ca Tnxerbenke Offered Rare (LIBOR), and marker participants fom rates are set by the London vFlver the workd enter into exchanges with each other. Is efficient operation is vital forthe fanctioning of the global economy. Wi very nearly occurred in the fall of 2008 a5 6 f "This situation, previously unimaginable, gicbal a ea commercial paper seized up following, the bankruptcy & ‘man Brothers in the United States. The resulting financial contagion rapidly sp" saad the glabe but was then halted by quick action from several national governments sihicheffecively stepped into add new liquidity o this marketplace We begin this chapuer by looking atthe benefits associaced with the globalization © capital markets. This discussion is followed by a more detailed look at the growth o international pit market and the macrocconomc risks associated with Sach grow. Not ‘eurocurrency market, the internat important segments of the global capital ee 5 tisual, we elose the chapter end bond mare, and the international equ et 4 eee pointing out some of the implications for the Pra" ions bast connected in this global, informacion age. Bunks et their short-term needs by isting jpital marker—interes ({ fonefits of the Global Capital Market “Although this section is about th out the global capital tons ofa generic capital market. Then we ae re markets and discuss the benefits of using global capital ee oe al markets, sing the fim ymestic aap" al ‘Scanned with CamSeannet‘The Global Capital Market Chapter 11 om yuNCTIONS OF A GENERIC CAPITAL MARKET py do we have capital markets? What is their function? A.capi ther sce Figure 11.1). sh, individuals, and Is and insurance companies). Those who panies, and governments, Between these "rs are the financial service companies that 0 ly of indirectly. They include commercial (oaks (eg Citicomp and U.S. Bank) and inves eg, Merril an tats (oe investment banks (e.g., Merrill Lynch and c " {Those who want to invest money include corporations with surplus ca Mepank financial institutions (eg. pension fund a age to bortow money include individuals, com wm groups are the market makers, Market make rane investors and borrowers, either direct FIGURE 11.1 ‘The Main Players in 2 Generic Capital Market Gommercial-banks»petformranvindirect-connectiomfurrctiof They take cash deposits from corporations and individuals and pay them a rate of interest in return. They then lend that money to borrowers at a higher rate of interest, making a profit from the difference in inerest rates (commonly referred to as the incerest rate spread). Inuestment-banks.pesforma direomeonneetionefunction. They bring investors and borrowers together and charge commissions for doing so. For example, Merrill Lynch may act as a stockbroker for an individual who wants to invest some money. Its personnel will advise her as to the most attractive purchases and buy stock on her behalf, charging a fee for the service. Capital market loans to corporations are either equity loans or debt loans. An equisjaloas, the money the corporation receives in return for its stock can be used to purchase plants and equipment, fund R&D projects, pay ‘wages, and s0 on. A share of stock gives its holder a claim toa firms profi stream. Ulimately, the corporation honors this claim by paying dividends to the stockholders (although many fasegrowing young corporations do nor start co issue dividends uncil their business has natured and their growth rate slows down). The amount of the dividends is not fixed in advance, Rather it ig determined by management based on how much profit the corporation is making, Investors purchase stock both for its dividend yield and in anticipation of gains in the price of the svock, which in theory reflect future dividend yields. Stock prices increase ‘hen a corporation is projected to have greater earnings in che Future, which increases the probability that it will raise future dividend payments. | redetetmined portionof-theloan-amaune nei specified interest) attegulansintervalsregardlessof tow 7 Seo hhas no discretion as t0 the amount it will pay investors: Debt loans include cash foans from banks and funds raised from the sale of Corporate bonds to investors. When an investor purchases a corporate bond, she purchases therigh co receive a specified fied stream of income from the corporation for a specified umber of years (i.e. until the bond maturity date). (the sum of the ATTRACTIONS OF THE GLOBAL CAPITAL MARKET Why do we need a global capital market? Why are domestic cpitl markets not sufficient? tlobal capital marker benefits both borrowers and investors, nal roe OTT FS nr eS ‘Scanned with CamSeanner372 FIGURE 11.2 Market Liquidity and the Cost of Capital jobal Monetary Syste Part 4 )) Theci . j= ' restors is limited t0 resid in a purely domestic <3} T marker, ee pool of ine sstors is siden of Ina purely domestic capita pe supply of funds avallale © borrowers. In othe country. This places an uppet Hirt soar pediguidinpofthesmasketiitn my sage back of te limited liquidity of a purely dome ds to be higher than ic is nan internation, ing money, which is the rate of return thy one ton debe loans and the dividend vied the purely domestic market, the limited pol og pay more t© persuade investors 0 lend them thi ral market implies that borrowers wil ig that the cost of capita he price of borro “This isthe interest capital market market. The cost of cap borrowers must pay investors. and expected capital gains on equity investors implies that borrowers must money, The larger pool of investors in be able to pay less. . ‘The argument is ilustrated in Figure 11-2, VE the accompanying Management F $13 billion by simultaneously Tokyo. The vertical axis in Figure 11.2 and the horizontal axis, the amount of money an internatior Deutsche Telekom as an example (ee is). Deutsche Telekom raised over feature for devai i Tor eale in Frankfurt, New York, London, and as cost of capital (the price of borrowing mone) Glable ae varying incerest races. DD isthe Deutsche Telekom demand curve for borrowings: Note that the Deutsche Telekom demand Forfands varies with the cost of capita the lower the cost of capital, the more money Petthe Telekom will borrow. (Money is just like anything else; the lower its pric, the more of it people can afford.) SS, is the supply, Surve of funds available in the German capital market, and SS, represents the funds available in the global capital market. Nore that Fae fe Telekom can borrow more funds more cheaply 0° the global capital marker. As Figure 11.2 illustrate, the greater pool of resources ip the global capital market—the greater liquidity——both lowers the cost of capital and increases the amount Deutsche Telekom can sasr Thus, the advantage ofa global capital marker ro borrowers is that it lowers the cost of capital. Problems of limited liquidity are not restricted to less developed nations, which naturally sem eave smaller domestic capital markets. In recent decades, even very large entete! rage nsyme ofthe worlds most advanced industrialized nations have tapped the inet rat capital markets in thei search for greater liquidity and a lower cose of capita suchss Germany's Deutsche Telekom.* Cost of Capital Dollars. ‘Scanned with CamSeanneta ©) peutsche Telekom Taps the Global Capital Market gased in the world's third largest industrial economy, peutsche Telekom is one of the world's largest tele. prone companies. Until late 1996, the company was wanally-owned by the German government, However, in the mid-1990s, the German government formulated plans to privatize the utility, selling shares to the public. ‘The privatization effort was driven by two factors: (1) a realization that state-owned enterprises tend to be in- herently inefficient, and (2) the impending deregulation of the European Union telecommunications industry in 1998, which promised to expose Deutsche Telekom to foreign competition for the first time. Deutsche Telekom realized that, to become more competitive, it needed massive investments in new telecommunications infra- structure, including fiber optics and wireless, lest it start losing share in its home market to more efficient com- petitors such as AT&T and British Telecom after 1998, Financing such investments from state sources would have been dificult even under the best of circumstances and almost impossible in the late 1990s, when the Ger- man government was trying to limit its budget deficit to meet the criteria for membership in the European mone- tary union. With the active encouragement of the gov- emment, Deutsche Telekom hoped to finance its Investments in capital equipment through the sale of shares to the public. From a financial perspective, the privatization looked ‘anything but easy. In 1996, Deutsche Telekom was valued ‘at about $60 billion. If it maintained this valuation as @ private company, it would dwarf all others listed on the German stock market. However, many analysts doubted there was anything close to $60 billion available in Germany for investment in Deutsche Telekom stock. One Problem was that there was no tradition of retail stock investing in Germany. In 1996, only 1 in 20 German Thadnvestor’s Perspective: Portfolio Diversification= By using the global capital market, citizens owned shares, compared with 1 in every 4 or Sin the United States and Britain. This lack of retail interest in stock ownership makes for a relatively liquid stock mar- ket, Nor did banks, the traditional investors in company stocks in Germary, sem enthused about underwriting such a massive privatization effort. A further problem was that a wave of privatizations was already sweeping through Germany and the rest of Europe, so Deutsche Telekom would have to compete with many other state- owned enterprises for investors’ attention, Given these factors, probobly the only way that Deutsche Telekom ‘could raise $60 billion through the German capital mar- ket would have been by promising investors a dividend Yield that would raise the company’s cost of capital above levels that could be serviced proftably. Deutsche Telekom managers concluded they had to privatize the company in stages and sell a substantial potion of Deutsche Telekom stock to foreign investors. The company’s plans called for an intial public offering (10) of 713 million shares of Deutsche Telekom stock, representing 25 percent of the company’s total value, for about $18.50 per share. With a total projected value in ‘excess of $13 billion, even this “limited” sale of Deutsche Telekom represented the largest IPO in European history {and the second largest in the world after the 1987 sale of shares in Japan's telephone monopoly, NTT, for $156 billion. Concluding that there was no way the German capital market could absorb even this partial sale of Deutsche Telekom equity. the managers of the company decided to simultaneously list shares and offer them for sale in Frankfurt (where the German stock exchange is located), London, New York, and Tokyo, attracting investors from all over the world, The IPO was successfully executed in November 1996 and raised $1333 bilion for the company arket. The most significant consequence of Ppotcuntis, than in a purely domestic capital m: Uh cote the insenonrcanaduasiythssspotialionincernaiondiy-dhre re Consider how this works in the case of stock holdings, made for bond holdings. although the same argument could be _— ‘Scanned with CamSeanner374 Part 4 The Global Monetary System Consider an investor who buys stock ina biotech £m that as rons oli onsider an investor who PUf® Crack is very volatile—investars are buying and sey procaine the Pr of ge information about ce Hl ross sf duce, but in ca ge all the money ifthe Fem fils 0 come up wig, carpe aner eae eis associated with holding this ockg rd against oduct that sells, Investors can guard a6! ae in eeving ote Crock, particularly those weakly oF 1b: ely correlated with i « wGiversified portfolio, the losses in biotech stock. By holding a variety of stocks i io the tet Biotech sock, By holding a pir promise ate oft y the ESN enjoyed hy other stocks exceed their promise. "Ae a investor inereases the number of stocks in her portfolio, the portfolio’ risk yi Pa eset ic decline is rapid. Soon, howeves, the rate of decline falls off ang Fen Te pe ihespstematic Fak of the market. asymptotically approaches the ffecsingeall.firmsinanaeconomjimiathab. fren. The aaa ae eee ihe level of nondiversifiable risk in an economy. Figure 11.5 illustrates this ml ee Vsing data from a classic study by Solnik.® His dat relationship for che United Sta fuggested that a fly diversified U.S. portfolio is only about 27 percent as risky a8 pied individual stock. By diversifying a portfolio internationally, an investor can reduce the level of risk even farther becatce the movements of stock market prices across countries are not perfectly conclated, For example, one study looked at the correlation between three stock marker indexes, The Standard &¢ Poor's 500 (S&P 500) summarized the movement of large US, Stocks, The Morgan Stanley Capital International Europe, Australia, and Far East Inder (EAFE) summarized stock matket movements in other developed nations. The tind index, the International Finance Corporation Global Emerging Markets Index (IFC) summarized stock markee movements in less developed “emerging economies.” From 1981 to 1994, the corzeation berween the S&P 500 and EAFE indexes was 0.45, suggesting they moved together only about 20 percent of the time (i.c., 0.45 x 0.45 = 0.2025). ‘The correlation between the S8eP 500 and IFC indexes was even lower at 0.32, suggesting they moved together only a litte over 10 percent of the time.” More recent studies have confirmed that despite casual obsecvations different national stock matkes apps be only meray create One study Found tha between 1972 ad 20 the average paie-wise correlation between the world’s four largest equity markets, in the United States, United Kingdom, Getmany, and Japan, was 0.475, suggesting that tht markets moved in tandem only about 22 percent of the time (0.475 x 0.472 = 0.22022 percent of shared variance).* The relatively low coneehaionsberween=tiremnroverrerrerof=rreckenricersiTrUtffeen: countsiesssetlects-twozbasic-factors. Firsrmcountries=purs i conagric tions, 5 dc Giffen forces and can move in diffrent wye For ca te cocoon he cemetkes of several Aan counties, including South Kone, Mana aed los ver 50 percent of thee value in response tothe Asis Roe while ae same time the S&P 500 increased in valve by ove 20 ee ce jue by over 20 percent, hat is, by (although as noted earlier, such restrictions 2 restrictions include limits on the amount ® . limits on the ability of a country’s citizens © For example, unt iewas aif ty: For example, until recently it'was diffi gt restrictions on cross-border capital floy declining rapidly). The most common i firm's stock that a foreigner can own ani invest their money outside that count foreigners to own more than 30 perce ‘nt of the equity of South Korean enterprises limit the ability of capi assets. Such barriers to cross-border capital fo%! Jona am the wold lyn search ofthe nhs ei i return. Consequently, at any one tit ‘Auently, at any one time, there may be too much capital invested if $ ‘Scanned with CamSeannet‘The Global Capital Market ||) Chapter 14 sprkets and ro litle in others. This will end to sare stock markets.” The implication is that © roduce differences in rates of return y diversifying a portfol ud gn stocks, an investor can reduce che level ofr fying a portfolio ro include toa eel level of risk below that incurred by holding just Figute 113 aso illustrates the relationship be ional di found in the classic study by Bruno sali ee eee nee ned foroio that contains stock from many counties is ess than all as sky a al diversified portfolio that contains only U.S. stocks. Solnik found that a fll dive fed prkfnesionl sock only about 2 percents iia pe individual ck Mires a fully diversified portfolio of U.S. stocks is about 27 i individual stock. is percent a5 risky asa typical ‘There is a perception, increasingly common am« im : ong inves nals, that in the ust 10 years the growing integration of the global Se aa eal ‘ roe a a ie ——————————————— (@} Risk Reduction through Domestic Diversification 10 Portfolio Return Variance of Return on Typical Stock US. Stocks 0.27 Variance systematic |! Risk jt 1 10 20 30 40 50, Number of Stocks. (0) Risk Reduction through Domestic end Intemational Diversification 10 US. Stocks, International Stocks Variance of Portfolio Return Variance of Return on Typical Stock 30 40. 50 ‘Number of Stocks 1 10 20 375 FIGURE 11.3 Risk Reduction through Portfolio Diversification Source: B. Solnik, "Why Not Diversify Internacionally Rather ‘Than Domestically?” Adapted with permission fom Financial Analy: Journal, JalyfAugust 1974, p17. ‘Copyright 1974. nancial Analyss Federation, Charlonesil, VA. All right reserved. ‘Scanned with CamSeannetPart 4 |) The Global Monetary System™ ron between different stock markets, reduc 4 Ueaton. Today, iis argued ifthe U.S, economy oe aaacr otad she U.S. stock market declines rapidly other mats flow sie study by Solnik suggests that there may’ be some truth this asseron, Pat thatthe ae gp integration is not occurring as rapidly 2s the popular per a eae = 10 belive Soli and his associate looked at the correlation bets maior stock markt developed countries between 1971 and 1998. They found ¢ aa a a ee he colton monthly stock marker returns increased from 0.66 in 1971 to Bee icra cating some convergence overtime, but that “the regression" real were weak which ues hac eae resyeclasionship was not strong, and that there was consiier & variation amon Seg iy 6 2 na tats dg er even today a portfolio equally diversified across all available ra Ss ea reduce portfolio righ to about 35 percent of the volatii single market (i.e 2 65 percent reduction in risk).!? ‘The implication here is that internati Moreover, the correlation between stock ma markets seems to be much lower, and the rise o} China, has given international investors many more opP' diversification." i “The rsk-reducing ffecs of international portfolio diversification would be greater werie not for the volatile exchange rates associated with the current floating exchange rate regime Floating exchange rates introduce an additional element of risk into investing in forign assets. As we have said repeatedly, adverse exchange rate movements can transform otherwise profitable investments into unprofitable investments. The uncertainty engendered by volte Exchange rates may be acting asa brake on the otherwise rapid growth of the international capital marker. capital market have increased the correl: benefits of internati nt ity associated with 2 jonal portfolio diversification can stil reduce ris itket movements in developed and emerging stock markets in developing nations, such ¢ jortunitics for international portfolin GROWTH OF THE GLOBAL CAPITAL MARKET ‘According to data from the Bank for International Settlements, the global capital markeris growing at a rapid pace."® By late 2012, the stock of cross-border bank loans stood :t $33,913 billion, compared to $17,875 billion in 2006, $7,859 billion in 2000, and $3,600 billion in 1990. There were $21,979 billion in outstanding international bonds in late 2012, up from $17,561 billion in 2006, $5,908 billion in 2000, and $3,515 billion in 1997. What factors allowed the international capital: market to bloom in the 1980s, 1990s and 2000s? There seems to be two answers—advances in information technology and deregulation by governments. Information Technolo: Financial services is an information-intensive indust cd Financial censive industry. Ie draws on large volumes information about markt sks, exchange rates, interest rates, creditworthiness 28 on, Ir ws this information to make decisions about what to invest wher, how mk ® charge borrowers, how much interest to pay to deposivon value and riskiness of range of financial assets including corporate bende seen ea currencies. ” ‘enacts of this information intensity, the financial services industry is bt evolucioninad more than any other industry by advances in information technolog) the 19708, The growth of intetnational communications technology has fei instantaneous communication between any two poines on the globe, te se 6 rapid advances in data processing capabilit, process large volumes of information from, arnt lowed marker makers 10 absorb because of these technological developme, processing information fell by 95 percen stocks, government securities ‘Scanned with CamSeannet‘The Global Capital Market || Chapter 11 ; st of recording, tf has allen by a similar amount since 1990 and is now trivial such developments have facilitated the emengenee of ‘ tegrated international capital patket He aoeaehaelosicaly. posible for-inancil serves companiee so evmece Jhboucseday-rading, whether i stocks, bonds, foreign exchange, or any other financial ic Processing technology, the international ial matket never sleeps. San Francisco closes ge he Shs pod adn continues in New Zealand °° MoM before Tolyo opens, but during ‘The integration facilitated by technology has a dark side." “Shocks" that ocur in one fiance center now spread around the globe very quickly, The collaee of US. stock prices on the notorious Black Monday of October 19, 1987, immediately triggered similar collapses in all che world’s major stock markets, wiping billions of dotlans ctf the value of corporate stocks worldwide. Similarly, the Asian fieancial eivis of 1997 snc dod woes sound th oud and precipitated a selloff in word stock markets, although the effects of the shock were short lived. However, most market participants would arse thatthe benefits of an integrated global capital fer outweigh any is ‘market far outweigh any potential costs. Moreover, despite the face that shocks in national financial markets do seem to spill over into other markers, on average the correlation between movements in national equity matkets remains relatively low, suggesting that such shocks may have a relative small longeterm impact outside of their home market." o_o ansmitting, and processing information Deregulation. Incountry after country, the financial services industry has historically been the most tightly regulated of all industries. Governments around the world have traditionally kept other countries financial service firms from entering their capital markets. In some eases, they have also restricted the overseas expansion of their domestic financial services firms. In many countries, the law has also segmented the domestic financial services industry. In the United States, for example, untit recently commercial banks were prohibited from performing the functions of investment banks, and vice versa. Historically, many counties have limited the abiliy of foreign investors to purchase significant equity positions in domestic companies. They have also limited the amount of foreign investment that their citizens could undertake. ln the 1970s, for example, capital controls made it very difficult for a British investor to Purchase American stocks and bonds. ince the early 1980s. In pare, this has which from the beginning, ined later in the chapter) It has also been a which have long wanted to operate ina ess regulated environment. Increasing-accepiance of the free marketideologyassociated vith an individuals politcal philosophy also has alot o do with the global trend coward the deregulation of financial markets (see Chapter 2). Whatever the reason, deregulation in A number of key countries has undoubtedly facilitated the growth of the international ‘pital market ‘The trend began in the United States in che late 1970s and early 1980s with a series of ‘hanges that allowed foreign banks to enter the U.S. capital market and domestic banks to ‘pind their operations overseas. In Great Britain, the so-called Big Bang of October 1986 ‘emoved barriers that had existed beeween banks and stockbrokers and allowed foreign nancial service companies to enter the British stock marker. Restrictions on the entry of teign securities houses have been relaxed in Japan, and Japanese banks are now allowed to QPen international banking facilities. In France, the “Little Bang” of 1987 opened the "Tench stock market to outsiders and to foreign and domestic banks. In Germany, foreign anks are now allowed to lend and manage foreign curo issues, subject to reciprocity eeements.” All of this has enabled financial services companies to transform themselves, ‘Scanned with CamSeanner378 Part 4.) The Global Monetary System from primarily domestic companies into global operations with major offices around the world—a prerequisite for the development of a truly international capital market. As we saw in Chapter 5, in late 1997 the World Trade Organization brokered a deal that removed many of the restrictions on cross-border trade in financial services. This deal facilitared further growth in the size of the global capital market. In addition tothe deregulation of the financial services industry, many countries beginning in the 1970s started to dismantle capital controls, loosening both restrictions on inward investment by foreigners and outward investment by their own citizens and corporations By the 1980s, this trend spread from developed nations to the emerging economies of the world 48 countries across Latin America, Asia, and Eastern Europe started to dismantle decades-old restrictions on capital flows. As of 2008, the trends toward deregulation of financial services and removal of capital controls were still firmly in place. However, the global financial crisis of 2008 and 2009 did Prompt many to wonder if deregulation had gone too far. Attention turned to the question of whether or not thete was a need for new regulations to govern certain sectors of the financial services industry, especially the hedge funds, which operate largely outside of existing regulatory boundaries, (Hedge funds are private investment funds that position themselves to make “long bets” on assets that they think will increase in value, and “short bets” om assets that they chink will decline in value.) However, notwithstanding the current contraction, given the benefits associated with the globalization of capital, the growth of the global capital market can be expected to continue over the long term. While most commentators see this as a positive development, there are those who believe that the globalization of capital has serious inherent risks. oi lobal Capital Market Risks Some analysts are concerned that due to deregulation and reduced controls on cross- border capital flows, individual nations are becoming more vulnerable to speculative capital flows. They sce this as having a destabilizing effect on national economies” Harvard economist Martin Feldstein, for example, has argued that mostaafathe-capital thacsmoves-internationally:is:pursuing-temporary ‘gtinsmandeiteshifisnineand.outsof counstiss-as.quicklyeas-conditions.change.*" He distinguishes between this short-term capital, or “hot money,” and “patient money” that would supporc long-term cross-border capital flows. To Feldstein, patient money is still relatively raze, although capital is free to move internationally, keep most of it at home. Feldstein supports his ar that although vast amounts of money flow thtough the foreign exchange markets every day, “when the dust secles, most of the savings done in each country stays in that country." Feldstein argues that th lack of patient money is due to the relative paucity of information that investors have about foreign investments. In his view, if investors had better information about foreign assets, the global capital market would work more efficiently and be less subject to short-term speculative capital flows. Feldstein claims that Mexico's economic problems in the mid-1990s were the result of too much hot money flowing in and out of the country and too little patient money. This example is reviewed in derail in the accompanying Country Focus feature. A lack of information abour the fundamental quality of foreign investments may encourage speculative flows in the global capital market. Faced with a lack of quality information, investors may react to dramatic news events in foreign nations and pull chet money out too quickly. Despite advances in information technology, it is stil difficult for fh investor to get access to the same quantity and quality of information about foreign investment opportunities that he can get about domestic investment opportunities. This information gap is exacerbated by different accounting conwentions in ifferenc counties which makes the direct comparison of cross-border investment opportunities difficult for all but the most sophisticated investor (sce Chapter 19 for details), Por example, German primarily because its owners and managers still prefer to 'guments with statistics that demonstrate ‘Scanned with CamSeannerpid the Global Capital Markets Fail Mexico? In early 1994, soon after the passage of the North Amerk can Fee Trade Agreement (NAFTA), Mexico wos widely adiied among Me international community as a shining example of a developing country with a bright economic fume, Since the late 1980s, the Mexican government hac pursued sound monetary, budget, tax, and trade policies, ay historical standards, inflation was low, the country was experiencing solid economic growth, and exports were booming, This robust picture attracted capital rom foreign investors; between 1991 and 1993, foreigners invested over $75 billon in the Mexican economy, more than in any ‘ther developing nation. Irthere was @ blot on Mexico's economic report card It ‘was the county's growing current account (trade) deft Mexican exports were booming, but so were its imports. In the 1989-1990 period, the current account deficit was. equivalent to about 3 percent of Mexico's gross domestic product. In 1891, it increased to 5 percent; by 1894, it was running at an annual rate of over 6 percent. Bad as this right seem, itis not unsustainable and should not bring an economy crashing down. The United States has been run- ning @ current account deficit for decades with apparently litle in the way of il effects. A current account deficit will ot be a problem for a country as long ¢s foreign investors take the money they earn from trade with that country and ‘einvest it within the country. This has been the case in the United States for years, and during the early 1990s, it was ccurting in Mexico too. Thus, companies such as Ford took the pesos they eared from exports to Mexico and ‘elnvested those funds in productive capacty in Mexico building auto plants to serve the future needs of the Mex!- an market and to export elsewhere. Unfortunately for Mexico, much of the $25 billion an- "Wal inflow of capita it received during the early 1990s was "otthe kind of patient long-term money that Ford was put- tig into Mexico, Rather, according to economist Martin Feldstein, much of the inflow was short-term capital that {0uld Nee if economic conditions changed for the worst This 's what seems to have occurred. In February 1994, the US. Federal Reserve began to increase US. interest rates. This led to a rapid fall in US. bond prices. At the same time, te yen began to appreciate sharply ageinst the US. ‘oler These events resulted in large losses for many men~ 88'S of short-term capita, such as hedge fund managers 5nd banks, who had been betting on exactly the opposite happening, Many hedge fund managers had anticipated that interes rates woud fal, Bond prices would rise, and the dollar would appreciate against he yen Faced with large losses, money managers tried to re- duce the riskiness of thelr portfolios by pulling out of un- certain stuatons. About the same time, events took a turn for the worse in Mexico. An armed uprising in the southern slate of Chiapas, the assessination ofthe leading candi date in the presidential election campaign, and an acceler- ating Infation rate all helped produce @ feeling that Mexican Investments were riskier than had been assumed. Money managers began to pull many of thelr short-term Investments out of he county As hot money flowed out. the Mexican government re atized it could not continue to count on capital iniows to finance its current account defict. The government had assumed the inflow was mainly composed of patient, long-term money In really, much of I appeared to be shortterm money. As money flowed out of Mexico, the Mexican government had to commit more foreign re- serves to defending the value ofthe peso ageinst the US. doll, which was pegged at 35 to the dollar. Cur. rency specultors entered the picture and began to bet egaint the Mexican government by seling pesos shor. Events came to a head in December 1994 when capital flows essentially forced the Mexican government to abandon is support fr the peso. Over the next month, the peso lost 40 percent of its value agains! the dolla, the government was forced to Introduce an economic austery program, and the Mexican economic booth came to an abrupt end According to Martin Feldstein, the Mexican economy wes brought down not by currency speculation on te for eign exchange market, But by 8 lack of long-term patient money. He argued that Mexico offered, and stil offers, many atvactve ong:term investment opportunites, but because ofthe lack of information on longterm invest ment opportunites In Mexico, most ofthe eapial owing Into he county from 1991101993 was shortterm, specular tive money, the Now of which coula quickly be reversed foreign investors had beter information, Felesten argued, Mexlco should have been able to fnance tis curert se count dete from Inward coptl ows because petien capt! woud netutly gravitate toward atvactve Mexican investment opportunties.* ‘Scanned with CamSeannerPart 4 (|) The Global Monetary System accounting principles are different from those found in the United States and can present quite a different picture ofthe health of a company. Thus, when the German company Daimler-Benz translated its German financial accounts into U.S.-style accounts in 1993, as it had t0 do to be listed on the New York Stock Exchange, it found chat while it had made a profit of $97 million under German rules, under U.S. rules it had lose $548 million!” Given the problems created by differences in the quantity and quality of information, many investors have yet to venture into the world of cross-border investing, and those who do ate prone to reverse their decision on the basis of limited (and perhaps inaccurate) information. However, if the international capital market continues co grow, financial intermediaries likely will increasingly provide quality information about foreign investment opportunities. Better information should increase the sophistication of investment decisions and reduce the frequency and size of speculative capital flows. Although concerns about the volume of “hot money” sloshing around in the global capital market increased as a result of the Asian financial crisis, IMF research suggests there has not been an increase in the volatility of financial markets since the 1970s. Bae Eurocurrency Market sutside ofits country of origin. Eurodollars, which account for about two-thitds of all eurocurrencies, are dollars banked outside of the United States. Other important eurocurrencies include the euroyen, the europound, and the euro- ‘euro! The term eurocurrency is actually a misnomer because a eurocurrency can be created anywhere in the world; the persistent ewro- prefix reflects the European origin of the market. ‘The eurocurrency market has been an important and relatively low-cost source of funds for international businesses. GENESIS AND GROWTH OF THE MARKET ‘The eurocurrency market was born in the mid-1950s when Eastern European holders of dollats, including the former Soviet Union, were afraid to deposit cheir holdings of dollars in the United Staes lest they be seized by the U.S. government to settle U.S. residents’ claims resulting from business losses during the Communist takeover of Eastern Europe.?® These countries deposited many of their dollar holdings in Europe, particularly in London. Additional dollar deposits came from various Western European central banks and from ‘companies that earned dollars by exporting to the United States. These two groups deposited their dollars in London banks, rather than U.S. banks, because they were able to earn a higher rate of interest (which will be explained shortly), ‘The eurocurrency market received a major push in 1957 when the British government prohibited its banks from lending British pounds to finance non-British trade, a business, thac had been very profitable for British banks. British banks began financing the same trade by attracting dollar deposits and lending dollars to companies engaged in international trade and investment. Because of this historical event, London became, and has remained, the leading center of eurocurrency trading, The eurocurtency market received another push in the 1960s when the U.S. government enacted regulations that discouraged its banks from lending to those who were not US. residents. Would-be dollar borrowers outside the United States found it increasingly difficult ‘0 borrow dollars in the United States to finance international trade, so they turned to the ceurodollar market to obtain the necessary dollar funds. ‘The U.S. government changed its policies after the 1973 collapse of the Bretton Woods system (see Chapter 10), removing an important impetus to the growth of the curocurrency market. However, another political event, the oil price increases engineered by OPEC in the 1973-1974 and 1979-1980 periods, gave the market another big shove. ‘Scanned with CamSeannetFIGURE 11.4 Interest Rate Spreads in Domestic and Eurocurrency Markets ‘The Global Capital Market |) Chapter 11 gaa As a result of the oil pri increases, the Arab members of OPEC accumulated huge amounts of dollars. They were afraid to place their money in U.S. banks or their European branches lest the U.S. government attempt to confiscate them. (Their fear was not unfounded; President Carter froze Iranian assets in U.S. banks and their European branches in 1979 after Americans were taken hostage at the U.S. embassy in Tehran.) Instead, these countries deposited their dollars with banks in London, further increasing the supply of eurodollars. Although these various political events contributed to the growth of the eurocurrency market, they alone were not responsible for it. The market grew because it offered real financial advantages—initially to those who wanted to deposit dollars or borrow dollars and later to those who wanted to deposit and borrow other currencies. We now look at the source of these financial advantages. ATTRACTIONS OF THE EUROCURRENCY MARKET ‘The main factor-thaeemakes-the-eurocurrencyemarker-attractive to both depositors and borrowers isitslackof government.regulation «This allows banks to offer higher interest rates on eurocurrency deposits than on deposits made in the home currency, making eurocurrency deposits attractive to those who have cash to deposi. The lack of regulation also allows banks to charge borrowers a lower interest rate for eurocurrency borrowings than for borrowings in the home currency, making eurocurrency loans attractive for those who want to borrow money. In other words, the spread berween the eurocurrency deposit rate and the curocurrency lending rate is less than the spread between the domestic deposit and lending rates (see Figure 11.4). To understand why this is so, we must examine how government regulations raise the costs of domestic banking. Domestic currency deposits are regulated in all industrialized countries. Such regulations ‘ensure that banks have enough liquid funds to satisfy demand if large numbers of domestic depositors should suddenly decide to withdraw their money. All countries operate with ‘certain reserve requirements. For example, each time a U.S. bank accepts a deposit in dollars, ix must place some fraction of that deposit in a non-interest-bearing account at a Federal Reserve Bank as part of its required reserves. Banks are given much more freedom in their dealings in foreign currencies, however. For example, the British government does not impose reserve requirement restrictions on deposits of foreign currencies within its borders. Nor are the London branches of USS. banks subject to U.S. reserve requirement regulations, provided those deposits are payable only outside the United States, Ths gives eurobanks a competitive advantage. ‘Scanned with CamSeannetPart 4 (/))) The Global Monetary System «re ore faces 10 percent 676 FAMITEMEN. Aco Suppose a bank bused in New YOO ES’ $99 deposit it can lend oUt no more ‘i to this requirement if the baa 100 depos vimcres esting secona rust place the remaining a ane nok ea FR fer chat the bank has annual operating costs of i loans. The high ct hares 10 percent interest OD heist $100 of depesi Ts sifer i Be tors and stl cover costs is 8 percent pr sr rae ie et aepaye che owner of the $100 depen” (0.08 * $100 =) Shen {o'10' $50 =) $9 onthe Fraction ofthe deposit 8 allowed to lend, and just covers jg operating costs. | Tn conrast, a eurobank can offer a higher int its costs. The eurobank, with no reserve req dc out mo god depen i fore it ean earn 0:10 X $100 = $10 at a loan rae of sent Ifthe eurobank has the same operating cost the New York bank ($1 per 100 ial tecan pa its deposivors an inerest ate oF 9 perce a percentage pig higher than that paid by the New York bank, and sil covert cows, Thats ican pay pire TS 100 = $9 to ite depositor, receive $10 from the borrowen a0 Oe lee with $1 ta Cover operating cots. Alternatively, the eurobank might pay the depositor 8.5 percent (ahich ys sil sbove the rte paid by the New York bank), charge borrowers 9.5 percent {cll less than the New York bank charges), and cover is operaritg cous Sv better. Thu, the eurobank has a competitive advantage vi the New York bank in both its deposit rate and its loan rate, ‘Clearly, companies have strong financial motivations to use the euracurrency mani. By doing so, they receive a higher interest aceon deposi and pay les for loans. Civen this, the surprising thing isnot that che curomarket has grown rapidly buc that ic hasnt grown cn faser, Why do any depositors hold deposits in their home currency when they could ge better yields in the eurocurrency market? ne at, erest rate on dollar deposits and stil cove, iments regarding dollar deposits, can leng DRAWBACKS OF THE EUROCURRENCY MARKET “The eurocusrency-matkerharewordrawbacks. Fit eystemthey-knowsthaptheprobabiliryofa bank fal chat would cause them to lose the eposits iseveryolow. Regulation maintains the liquidity of the banking system. In an unregulated system such asthe-eurocurrency-marker, the probability of a-bank failure tat would cause depositors to lose their money imgreater (although in absolute terms, sil low) Thus, the lower interest rate received on home-country deposits reflects the costs of insuring against bank failure. Some depositors are more comfortable with the security of such a: system and are willing to pay the price. . : omallyccarn For example, considera U.S. company that uses the eurocurtency masket «0 bose pay because it can pay a lover interest rate on europound loans thet Seen aca dolar cost of tepaying the europound loan and ss the tie vy: ‘ P ca ‘ing the forward exchange market can insure against PH pons (s we sin Chapter 9), bu the forward exchange market des not af pate Fie ereiae aon gh the eurocurrency markets may offer more a7" (tthe Global Bond —— “The global bond market ; grew rapidly duis fo do so in the new century. Bond during the 1980s and 1990s, and has conti companies. The most cor S are an important mean: nancing for d ‘Scanned with CamSeanner‘Tho Global Capital Market) Chapter 11 co purchases a fixed-rate bond receives a fixed set of cash payoffs. Each year until the bond ‘matures, the investor gets an interest payment and hem ae maturity he gets back the Face value of the bond. International bonds are of two types: foreign bonds and eurobonds. 7 inaubhich-shayareissuech Thus, when Dow Chemical issues bonds in Japanese yen and sells them in Japan, i is issuing foreign bonds. Many foreign bonds have nicknames; foreign bonds sold in the United States are called Yankee bonds, foreign bonds sold in Japan are Samurai bonds, and foreign bonds sold in Great Britain are bulldogs. Companies will issue international bonds if they believe that it wll lower their cost of capital. For example, during the late 1990s and early 2000s many companies isued Samurai bonds in Japan to take advantage of the very low interest rates in Japan. In early 2001, 10-year Japanese government bonds yielded 1.24 percent, compared with 5 percent for comparable U.S. government bonds. Against this background, companies found that they could raise debt at a cheaper rate in Japan than in the United States. ‘For example, a German corporation may issue a bond denominated in U.S. dollars, and an international syndicate of banks may sell it to investors outside of the United States. Eurobonds are routinely issued by multinational corporations, large domestic corporations, sovereign governments, and international institations. They are usually offered simultaneously in several national capital markets, but neither in the capital market of the country nor to residents of the country in whose currency they are denominated. Historically, curobonds accounted for the lion's share of international bond issues, but increasingly they are being eclipsed by foreign bonds. ATTRACTIONS OF THE EUROBOND MARKET “Three features of the eurobond market make it an appealing alternative ro most major do- mestic bond markets: specifically, + An absence of regulatory interference. «© Less seringent disclosure requirements than in most domestic bond markets. +A favorable eax status. Regulatory-interference= i controls on domestic and foreign issuers of bonds donomingeed in the local currency and sold within theie national boundaries, Thhese.conteols ise.the.costof isuing,bonds. However, government limitations are generally less ‘Rringene for securities denominated in foreign curencies and sold o holders of those foreign aerrescies, Eurobonds fall ouside of the regulatory domain of any single nation. As such, they can often be issued at a lower cost to the issuer. Disclosure.Requirements entswtenditorborlesestringentthan:those-of-several a For example, if a firm wishes to issue dollar-denominated bonds thin the United States, it must first comply with SEC disclosure requirements, The em must disclose detailed information about its activities, the salaries and other eMpensation of senior executive, stock trades by its senior executives, and the lke, Th ition, che issuing fem must submie nancial accounts that conform ro U.S, accounting aacideids, For non-U.S. fiems, doing cheir accounts to make them consistent with U.S seanteds can be very time consuming and expensive. Therefore, many firms have found ‘Scanned with CamSeannerGlobal Capital Markets in Crisis In 2008, a serious crisis swept through global capital markets that very nearly froze the financial pipes that lubricate the wheels of the global economy. Unseen 10 most people, investment institutions, banks, and corporations around the world routinely lend and borrow trillions of dollars between themselves. Most banks and corporations issue unsecured notes known as commercial! oper with a fixed maturity of between 1 and 270 days. This is a way for those firms to get access to cash to meet short-term obligations, including payroll, making investments, paying suppliers, or financing other borrowings. Because the notes are unsecured, and thus not backed by any specific assets, only banks and corporations with excellent credit ratings will be able 10 sell their commercial paper at a reasonable price. Typically this price is set with reference to the London Interbank Offered Rate (LIBOR). The notes are calculated daily for 10 currencies based on a survey of 12 to 16 banks for each currency. AS the name suggests, the LIBOR is the rate at Which banks lend to each other. In normal times, the LIGOR rate is very close to the rate charged by national central banks, such as the US. Federal Reserve for the dollar In the fall of 2008, however, the times were anything but normal. Earlier in the year, banks in several countries had started to run into trouble as it became clear that the value of the mortgage-backed securities that they held were collapsing, This was due to a fall in housing prices and rising default rates on mortgages, most notably in the United States and Britain, where aggressive lenders had written increasingly risky mortgages over the preceding fow years. These mortgages were typically bundled into securities, then sold to other financial institutions. Moreover, many institutions held complex derivatives, the value of which was tied to the underlying value of mortgage-backed securities. Now these institutions were facing large write-offs on thelr portfolios of morigage- backed securities and the associated derivatives. One of these institutions, Lehman Brothers, had taken particularly aggressive positions in the market for mortgage-backed securities. in September 2008, the firm collapsed into bonkruptey after the US, government decided not to step in and save it. The government’ reasoning wes that it did trot want to save @ management team thet had made very aa ivestment decisions: MAR FOFCES TY a, yg be allowed to operate: However, Lehman's bankruptcy Had untore, consequences. sent shockwaves THOUGH the gy corveit markets. n effect, the US. GOVEtrMeTt Nad sy rat was prepared 10 fet arGe Nanci stuns Immediately, banks reduced theif short-term loans. Thy, tha this fortwo reasons. Fist, they felt 2 Need t0 hog Cash, sinee they no longer knew the value ofthe morigagg caeied secures they held on thelr own balance shew econd. they were affaid t0 lend to other Danks, since those banks might fail and they might not get thelr oa ack, As a result, LIBOR rates quickly splked. The dota, mate, for example, had been 0.2 percent over the rate on three-month US. treasury bils in 2007, which Is a nomal spread. However. the spread Increased 10 33 percentby Inte 2008, raising the cost of short-term borrowing sone te old, Many corporations found that they could not rase capita at a reasonable price. Money market funds, whieh ‘hnormal times are large buyers of commercial paper fed to ultresafe assets, such as US. Treasury bonds. This pushed the yield on three-month Treasury bills downto historic lows and also led to a sharp rise in the value ofthe US. dollar In essence, the financial plumbing of the global economy was rapidly freezing up. If nothing was done about it, many firms could become insolvent and a wave of bankruptcies could sweep around the globe, plunging "@ ‘world into a serious recession, or even a depression Fortunately, several national governments stepped into the breach. In October 2008, the US. Federal Reserve entered the commercial paper market, seting\? 2 fund to purchase commercial paper at rates close 1 rates for U.S. Treasuries, Central banks in Japan, Brita and the European Union took similar action. OF Participants in the global capital markets saw that’ nations! governments were willing to enter the commercial P22 market, they too started to ease their lending restictors and LIBOR rates stated to fall again. Moreover. the government began to inject capital into troubled penks: signaling that there would be no more bankruptces Lehman's, This too helped to unfreeze the mate commercial paper. A major crisis had been acverte™ only just27 ‘Scanned with CamSeanner‘The Global c; Hobal Capital Market Chapter 41 — ix cheaper to issue eurobonds, including tho dollr-denominated bonds within the Unsect Soe dollars, than to issue Favorable Tax Status Before 1984, U.S. corporations issuin, 30 percent of each interest pay ‘encourage foreigners to hold bi operational in many countti ceurobonds. United States laws igners for U.S. income tax. This did nox bonds issued by U.S. corporations, Similar tax laws were St that time, and they limited market demand for $s Were revised in 1984 to exe foreigr found it Feasible for the first time to sell en © sell eurobonds ditecly to foreigners. Repeal of th US. lave cuted ort governments—inchiding those of France, Gertosy and hes Uperalie their tax laws likewise to avoid outflows of capital rom thoy maken. The consequence was an upsurge in demand for eurobor i advantage of their tax benefits, eurobonds from investors who wanted to take a the Global Equity Market Although we have talked about the growth ofthe global equity market, there is no international equity market in the sense that there are bond markets. Rather, there are internatio corporate stock is trad strictly speaking mare ee ynal currency and ‘any countries have their own domestic equity markets in which led. The largest of these domestic equity markers ae to te found ca United States, Britain, and Japan. Although each domestic equity market is still dominated by investors who are citizens of that country and companies incorporated in that country, developments are internationalizing the world-equicy market, Investors are spending heavily in foreign equity markets to diversify their porefolios. Facilitated by deregulation and advances in information technology, this trend seems to be here to stay. An interesting consequence of the trend toward international equity investment is the internationalization of corporate ownership. Increasingly citizens of one country are buying stock in companies incorporated abroad, while foreigners are buying stock in companies incorporated in their country. Looking into the future, Robert Reich has mused about “the coming irelevance of corporate nationality. A second development internationalizing the world equity marker is that companies with historic roots in one nation are broadening their stock ownership by listing theie stock in the ‘equity markets of other nations. The reasons are primarily financial. Listing stock on a foreign market is often a prelude to issuing stock in that market to raise capital. The idea is to tap into the liquidity of foreign mackets, thereby increasing the funds avaiable for investment and lowering the firm's cost of capital. (The relationship between liquidity and the cost of capital was discussed earlier in the chapter) Firms also often list their stock on foreign equity markets to facilitate fucure acquisitions of foreign companies. Other reasons fr listing a companys stock on a foreign equity market are that the companys stack and stock options can be used to compensate local management and employee, it satisfies the desire for local ownership, and it increases the company’s visibility with local employees, customers, suppliers, and bankers. Alchough firms based in developed nations were the first ae changes, increasingly firms from developing countries ‘o start listing their stock on foreign exchanges, ee ee who find their own growth limited by an illiquid domestic cap as a Cpportuniy For example, firms from the Czech Republic have turned ro the London sto ‘xchange to raise equity capital (ee the next Country Focus feature on page 385). B “Foreign Exchange Risk and the ‘ost of Capital aan borrow funds ata fower cost on the global We have emphasized repeatedly that a firm can Dot’ ave also mentioned that Spital marker than on the domestic capital market. ee ‘Scanned with CamSeanner‘The Search for Capital in the Czech Republic has left the majort institutions and FOU Following the collapse of communism and the shift toward a more market-oriented system, the Czech Republic in tially emerged as one of the more vibrant and market: driven economies in Eastern Europe. By eerly 1998. however, a shortage of capital was holding back the eco- nomic development of the Czech Republic. The problem was rooted in macroeconomic conditions and institutional problems. (On the macroeconomic front, 1997 saw a combina~ tion of adverse developments, inciuding 2 rise In infla~ tion, @ growing government deficit, and @ speculstive attack on the Czech currency that forced the govern ment to abandon its fixed exchange rate policy for 8 floating exchange rate system. After the shift to a float- ing exchange rate system, the Czech currency declined by about 10 percent against the German deutschemark and over 15 percent against the U.S. dollar. Since many internationally traded commodities, such as oil, ere traded in dollars, this devaluation added fuel to the Czech Republic's inflation rate fire, The government re- sponded by tightening monetary policy, raising interest rates to around 16 percent. These macroeconomic problems had a predictably negative effect on the Prague stock market. The PX5O, the key index of Czech shares listed on the Prague ‘exchange, declined from around 520 to a low of 430 by June 1998. Much of the decline was due to foreign investment capital leaving the country for more attractive investment opportunities in neighboring Hungary and Po- land, where macroeconomic conditions were more favor- ‘able and where local stock markets were performing better. But that wasn’t the only problem for the Prague stock market. Many Wester investors had been discouraged rom investing in Czech stocks by the poor reputation of the prague stock exchange, That institution Is reportedly sife vuith stock manipulation by insiders, Insider trading that Would be illegal in more developed markets, a lack of pro- tection for minorty stockholders, poor corporate reporting, sand fraud. Also, mast state-ovined enterprises in the Czech Republic were privatized through a voucher scheme that ty of shareholdings In the hangs gp ps that are preoccupied vith ming Ing earl over thelr companies onc OPPOSE to any reppt to raise coptal through NeW CALI ‘sug temel queny, he Prague tock markets mal nd iquigy Try imted, These factors nave combined 0 increase ty oa of capt for individual Czech enterprises Fettonaly, many Czech fitms forged tight relation, ups with banks and borrowed money {fom them, Hoy sree with interest rates at 16 percent and meny banks reining in credit to make up for past largesse, i wasn, Creasingly expensive for Czech companies 10 ase cap tar through borrowings. As for the Czech stock markt ts poor reputation and [ow liquidity made almost imposs- bie to raise capital by issuing new shares. In mid-297, one of the Czech Republic's most dynamic and preftable ew enterprises, Bonton, a film and music compary, fempted to raise $30 to $40 million through an inti public offering on the Prague exchange. This would have been only the second IPO in the history of the Prague ‘exchange, and the only one of any significance. A suc- cessful IPO would have helped to legitimize the market, but Bonton canceled the IPO when the Prague market declined to yearlong lows In the wake of the Asian fina cial crisis, Despite all these problems, most agree that the Czech economy has a bright future. However, this future cannet be realized unless Czech companies can raise the cepts! to invest in the necessary plants and equipment. A nut ber of prominent Czech companies in 1998 announced thelr intentions to make international equity issues. At beginning of 1997, only two Czech companies had fore? listings, both of them large banks. However, another fe significant companies sought listings on the London soo aie in 1998, The first to list was Ceske RadioxOr™ paces stewed radio, television, and telecon ae mpany thet successtly raised $134 milion” ee Global Depository Receipts ge, Increasing its equity by 36 percent” decreasing the state holding in the company t0 2°" 51 percent? ‘Scanned with CamSeannet‘The Global Capital Market Chapter 11 ad under a losting exchange rate regime, sfovements in foreign exchange rates Ihens which is what happened to financial crisi ‘Consider a South Korean fir foreign exchange risk complicates this picture. Adverse can substantially increase the cost of foreign currency ‘many Asian companies during the 1997-1998 Asian a irm that wants to borrow 1 billion Korean won for one year al investment project. The ‘company can borrow this money from a Korean tank at an interest rate of 10 percent and at the end of the year pay back the loan plus ine oral of W710 ion. Or he fin could bor dels Nom an international fankeat a6 percent interest rate. Ar the prevailing exchange rate of $1 — rm bani gboreow SU milion, and thevral oan cousealt be 8106 lon, or WIG billon By borrowing dollars, the firm could reduce its cost of capital by 4 percent, or W40 million. However this saving is predicated on the assumption that during the year of the loan, the dollar/won exchange rate stays constant. Instead, imagine that the won depreciates sharply against the U.S. dollar during the year and ends the year at $1 = W/1,500. (This occurted inlate 1997 when the won declined in value fiom $1 = W1,000 ro $1 = W1,500 in two months. The firm still has to pay the international bank $1.06 million at the end of the year, but now this costs the company W159 billion (i.e, $1.06 = W1,500). As a result of the depreciation in the value of the won, the cost of borrowing in U.S. dollars has soared from 6 percent to 59 percent, a huge rise in the firm’s cost of capital, Although this may seem like an extreme example, it happened to many South Korean firms in 1997 at the height of the Asian financial crisis. Not surprisingly, many of them were pushed into technical default on their loans. Unpredictable movements in exchange rates can inject risk into foreign currency borrowing, making something that initially seems less expensive ultimately much more expensive. The-borrower.can-hedge-against-such.a possibility. by. entering. into-a-forward . (see Chapter 9 for details). Although this will raise the borrower’ cost of capital, the added insurance limits the risk involved in such a transaction, Unfortunately, many Asian borrowers did not hedge their dollar-denominated short-term debt, so when their curcencies collapsed against the dollar in 1997 many saw a sharp increase in their cost of capital. ‘When a firm borrows funds from the global capital marker, ie must weigh the benefits ofa lower interest rate against the risks of an inctease in the real cost of capital due ro adverse exchange rate movements. Although using forward exchange markets may lower foreign exchange risk with short-term borrowings, it cannot remove the risk. Most importantly, the forward exchange market does not provide adequate coverage for long- term borrowings. Ye it IMPLICATIONS FOR MANAGERS 5 ST ‘The implications ofthe material discussed inthis chapter fr international Business re quite staigntforwaré but no less important for belng obvious The glow Of he joka capi market hes created opportunites fr intmatonal Businesses Vat Sees eerrow and/or Invest money. On the borrowing side, by using the global crores marker fine can often borrow funds at @ lover cost Ina Is possile It 8 Foren omoatc capital market, Tis conclusion holds 90 mate: Wet form of Comowing a tm uses-equty, ponds, oF ash ons The ower cos ‘capital on the global market refiects their greater iguidly ane Ne SS enn s0vemment regulation, Government regulation tends to raise Ne Fost cept mest Gomestic captor markets, The global market, belng transnational @Ssepes regulation, ‘Scanned with CamSeannetS88 Part4 ‘The GI Balanced against foreign currency. On the investment si for firms, institutions, and in diverse portfolio of stocks an 1a lower level than can foreign exchange ti The trends noted in this cha ease in both importar ye the emergence a developt continuing to incr significant development will b currency within the EU. Such internationalization of the capital market 0 business are likely to be postive. CHAPTER SUMMARY ide, the grow! dividuals to diver id bonds in differen be achieved in a purel Mea complicating fect skis compteetoem likely to continue, with the global capt ya nce ant jobal Monetary System nis, however, is the forelg} th of the n exchange risk associated with bore, 4 in a global capital markets Providing opty Sry their investments 10 limit tsk. By hoy { nations, an investor can reduce tots nt Iy domestic setting. ONCE again, Noyes wi degree of Integration. Perhaps the m oof a unified capital market and comme! Bent could pave the way for even more rap ‘coming years. I this Occurs, the implications fay ‘This chapter explained the functions and form of the global capital market and defined the implications of these for international business practice. This chapter made the following points: 1. The function ofa capital market is to bring those who want to invest money together with those who want to borrow money. 2. Relative to a domestic capital market, the global capital market has a greater supply of funds avail- able for borrowing, and this makes fora lower cost of capital for borrowers. 3, Relative to a domestic capital market, the global capital market allows investors to diversify port- folios of holdings internationally, thereby reduc- ing risk. 4, The growth of the global capital market during recent decades can be attribured ro advances in information technology, the widespread deregu- lation of financial services, and the relaxation of regulations governing cross-border capital flows. 5. A eurocurrency is any currency banked outside its councry of origin. The lack of government regula- Gong makes the eurocurrency market attractive to both depositors and borrowers. Due to the absence of regulation, the spread between the eurocurrency eposit and lending ras s less than the spread be- fueen the domestic deposit and lending rates. This gives eurobanks a competitive advantage. 6. The global bond market has two classifications: the foreign bond market and the eurobond market, 10, Foreign bonds are sold outside of the borrowers country and are denominated in the currency of he country in which they are issued. A eurobond issue is normally underwritten by an international synd- cate of banks and placed in countries other than the ‘one in whose currency the bond is denominated. Burobonds account for the lion's share of intern tional bond issues. ‘The eurobond market is an attractive way for companies to raise funds due to the absence of regulatory interference, less stringent disclosue requirements, and eurobonds’ favorable ux status. Forcign investors are investing in other counties equity markets to reduce risk by diversifying thst stock holdings among nations. Many companies are now listing their stock in equity markets of other nations, primarily 32 prelude to issuing stock in those markers t0 additional capital. Other reasons for listing s in another country’s exchange are to facilitate ture stock swaps; to enable the company t0 us stock and stock options for compensating lo management and employees; to satisfy Tocal ow | ership desires; and to increase the company’s VS" bility among its local employees, custom™™ suppliers, and bankers. When borrowing funds from the global api — companies must weigh the benefits © lower interest rate against the risks of gt" costs of capital due to adverse exchans® Movements, ate “a ‘Scanned with CamSeannetThe: One major implication of the global eapital ket for international business is thay ee can ofien borrow funds ata lower cost of the international capital market than there the domestic capital market, aT that companies Global Capital Market Chapter 11 389 12, The global capital marker provides greater op- portunities for businesses and individuals to build a cruly diversified portfolio of interna- tional investments in financial assets, which lowers tisk critical Thinking and Discussion Questions L ‘Why has the global capital market grown so rap- idly in recent decades? Do you think this groweh will continue throughout this decade? Why? Reread the Country Focus feature on the search for capital in the Czech Republic. What are the advantages to Czech firms of listing their equity on the London stock exchange? Can you see any disadvantages? AA firm based in Mexico has found that its growth is restricted by the limited liquidity of the Mexican capital market. List the firm’s options for raising money on the global capital market. Discuss the pros and cons of each option, and make a recom- mendation. How might your recommended op- tions be affected if the Mexican peso depreciates significantly on the foreign exchange matkets over the next two years? Happy Company wants to raise $2 million with debt financing. The funds are needed to finance working capital, and the firm will repay them with interest in one year. Happy Company's treasurer is considering three options: 2. Borrowing U.S. dollars from Security Pacific Bank at 8 percent. b. Borrowing British pounds from Midland Bank at 14 percent. & Borrowing Japanese yen from Sanwa bank at 5 percent. If Happy Company borrows foreign currency, it will not cover the currency; that is, it will simply change forcign currency for dollars at today’s spot rate and buy the same foreign currency a year later at the spot rate then in effect. Happy Company estimates the pound will depreciate by 5 percent relative to che dollar and the yen will appreciate 3 percent relative to the dollar in the next year. From which bank should Happy Company borrow? Research Task Qomeoce) giobatedge.msu.eau Global Capital Markets Use the globalEDGE™ site to complete the following exercises: Exercise 1 The top management of your company is looking for somebody to analyze the current position of Singapore in world trade, Remembering what you have learned about the dynamics of the balance of payments, you decide to prepare the analysis of the latest state of Singapore trade. Exercise 2 ‘The Bureau of Economic Analysis is an agency of the U.S. Department of Commerce. It lists data about the USS. International Accounts, including current invest- ment positions and the amount of direct investment by multinational corporations. Prepare a brief report regard- ing the direct investments of other countries in the United States. Which are the leading countries in foreign direct investment? ‘Scanned with CamSeannetee Part 4) The Global Monetary System China Mobile China Mobile (Hong Kong) Ltd. is 2 Hong Kong-based provider of wireless telephone service and one of the largest providers of mobile telephone service in the world. In 1996, the company was spun out of China Mobile Com- munications Corporation, a state-owned provider of mo- bile telephone service in Mainland China, which retained a 75 percent ownership stake in China Mobile (Hong Kong) Lid. The spin-out was part of the Chinese government’ strategy for privatizing its telecommunications network. ‘China Mobile was given the right to expand into Mainland China. By September 2000, the company was the largest provider of mobile communications in China, 23.9 million subscribers and a market leadership position in six provinces. In late 2000, China was finishing up negotiations to enter the World Trade Organization. Under the terms of the WTO agreement, China would have co progressively open up its celecommunications market to foreign tele- communications service providers. Galvanized by the im- pending threat of new competition in this fast-growing atket, China Mobile realized that it needed to accelerate its expansion into Mainland China in order to preempt foreign competitors. Accordingly, in October 2000, China Mobile reached an agreement to purchase mobile necworks in an additional seven provinces from its state- owned parent company. The purchase of these networks would give China Mobile an additional 15.4 million sub- scribers. It would also give the Hong Kong company a geographically contiguous market covering all of the Coastal regions of Mainland China, a 56 percent share of all cellular subscribers in Mainland China, and service coverage of approximately 48 percent of the total population. The price tag for this deal was $32.8 billion. For China Mobile, a critical question was how to finance the deal. It ‘could issue additional equity or debt in Hong Kong, but Hong Kong's capital market might not be big enough to absorb a multbillion-dollar offering without driving up the price of the capital to an unacceptably high level. For example, China Mobile might be required co pay a rela- tively high interest rate in order to sell sufficient bonds Hong Kong to finance part of its acquisition of the pro- vincial necworks, thereby raising its cost of capital. After consulting its underwriters, which included the U.S. ‘companies Goldman Sachs and Merrill Lynch, China Mobile opted for an international offering of equity and debt. The shares of China Mobile were already listed on the New York Stock Exchange as American Depository Receipts (ADRs). Each ADR represented and controlled five shares in the Hong Kong company. China Mobi opted to sell ADRs worth approximately $6.6 billion ang in addition, to raise a further $600 million from the sale of five-year convertible bonds. (Convertible bonds ar bonds that can be converted into equity at some futur date, in this case after five years. They ate considered 1 be a hybrid between conventional stock and bonds) Iy addition, China Mobile agreed to sell a2 percent stakein the company to Vodafone PLC, Europe's largest wits service provider, for $2.5 billion. The remainder ofthe $32.8 billion purchase price for the mainland wires networks was to be financed by issuing new shares state-owned China Mobile Communications Corpor. tion, which would rerain for now its 75 percent stake in the company despite the issuing of new equity. ‘A significant portion of the ADRs would be offered for sale in New York. However, the underwriters also planned to offer ADRs in Asia and Europe. Similarly, the convert ible bond issue would be priced in U.S. dollars and of fered to global investors. The equity and bond offerings were closed in November 2000. Both offerings were sub- stantially oversubscribed. The equity portion of the off ing was 2.6 times oversubscribed. This was 2 remarkable achievement for what was at the time the largest ever Asian equity issue outside of Japan. In total, China Mo bile raised some $8.24 billion, over $1 billion more than planned for. Some $690 million came from the sale of convertible bonds, and the remainder from the sale of uity. The convertible bonds carried a 2.25 percent inet rate, significantly less than the 2.75 percent rate initaly targeted (as bond prices are bid up, the interest rate of feted by the bond goes down). This lowered China Mo- bile’ cost of capital. The oversubscription of the equi! portion of the offering had a similar effect. Moreover, be offering was truly global in nature. While 55 percent of the placement was in the United States, another 25 pe ent went to Asian investors, and 20 percent 0 Europes? investors. Case Discussion Questions 1. Why did China Mobile feel it was necessary (0 sue equity in markets outside of its home bast ® Hong Kong? What are the advantages of su‘ * move? 2. Why did China Mobile price the bond issue # USS. dollars instead of Hong Kong dollars? 3. Can you see any downside to China Mobil ternational equity and bond issue? es io" ‘Scanned with CamSeanner‘The Global Capital Market, Notes 1, K Linebaugh, "Record IPO Could Have Been Even Bigger” The Wall rect Journal, October 21, 2006, p. B3; "Deals That Changed the Market in 2006: ICBC’ Initial Public Offering” Euromoney, February 7, 2007, p. 1; and T. Mitchell, “ICBC Discovers That Good Things Come to Those Who Wait? Financial Times, October 26, 2006, p. 40. 2, D. Waller"Daimler in $250m Singapore Placing Financial Times, May 10, 1994, p. 17. 3, A. Raw, Capital Rules (Boston: Harvard University Pres, 2006); and M. Rees, “Why Money Can Now Make Its Way around the World,” The Wall Stet Journal, Febeuaty 14, 2007, p. D12. 4, Waller, "Daimler in $250m Singapore Placing” 5, J.0. jackson, “The Selling ofthe Big Pink." Time, December 2, 1996, p. 46; 8. Ascarelli, “Privatization Is Worrying Deutsche Telekom,” The Wall Siret Journal, February 3, 1995, p. Al; “Plunging into Foreign Markets,” The Beonomit, September 17, 1994, pp. 86-87; and A, Raghavan and M. R. Sesit, “Financing Boom: Foreign Firms Raise More and More Money in the U.S. Market” The Wall Sieet Jounal, October 5, 1993, p. Al 6, B. Solnik, “Why Not Diversify Internationally Rather than Domestically?” Financial Analysts Journal, July 1974, p. 17. 7. C. G. Luck and R. Choudhury, “International Equity Diversification for Pension Funds,” Journal of Investing 5, no. 2 (1996), pp. 43-53. 8 WEN. Goetzmana, L. Li, and K. G. Rouwenhorst, “Long ‘Term Global Market Correlations.” The Journal of Business January 2005, pp. 78-126. 9. 1 Domowitz J. Glen, and A. Madhavan, “Matket Segmen- tation and Stock Prices: Evidence from an Emerging Mar- ex Journal of Finance 3, no. 3 (1997), pp 1059-68. 10, B Solnik, "Why Not Diversify Internationally Rather than Domescically?” Financial Analysts Journal, July 1974, p.l7, 11, A. Lavine, “With Overseas Markets Now Moving in Sync with U.S. Markets, Its Getting Harder to Find True Diversification Abroad,” Financial Planning, December 1, 2000, pp. 37-40. 12. B, Solnik and J. Roules, “Dispersion as Cross Sectional Cor- relation,” Financial Analysts Journal, 56(1), 2000, Pp. 54-61 13, WN. Goetamana, L. Li, and K. G, Rouwenhorst, “Long, ‘Term Global Market Correlations,” The Journal of Busines, January 2005, pp. 78-126. 14, Bid. ba 20. a 2, 23. 24, 25, 26, 2. 28, 29, 30. Chapter 11 ood Bank for International Settlements, B/S Quarterly Reviews March 2007, Basle, Switzerland. T. B Huertas, “U.S. Multinational Banking: History and Prospects,” in Banks as Multinational, ed. G. Jones (London: Routledge, 1990). G.J. Millman, The Vandal? Grown (New York Free Press, 1995). Goetzmann, Li, and Rouwenhorst, “Long Term Global Mar- ket Correlations.” Dicken, Global Shit: The Inernationalizaton of Economic

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