International Financial Management P G Apte LONG TERM BORROWING IN THE GLOBAL FINANCIAL MARKETS

Introduction Phenomenal changes have swept financial markets around the world during the 1980's and the 1990s Financial markets everywhere serve to facilitate transfer of resources from surplus units (savers) to deficit units (borrowers), the former attempting to maximise the return on their savings while the latter looking to minimise their borrowing costs An efficient financial market thus achieves an optimal allocation of surplus funds between alternative uses and healthy financial markets also offer the savers a wide range of instruments enabling them to diversify their portfolios

Introduction Globalisation of financial markets during the eighties has been driven by two underlying forces –Growing (and continually shifting) imbalance between savings and investment within individual countries –Increasing preference on the part of investors for international diversification of their asset portfolios

Introduction Liberalisation and integration of financial markets The markets themselves have proved to be highly innovative, responding rapidly to changing investor preferences and increasingly complex needs of the borrowers by designing new instruments and highly flexible risk management products The combined result of these processes has been the emergence of a vast, seamless global financial market transcending national boundaries

Introduction It is by no means true that controls and government intervention have entirely disappeared For developing countries, as far as debt finance is concerned, external bonds and syndicated credits are the two main sources of funds

Legal Framework in India for Foreign Investment In India the Legal framework for foreign investment in India is segregated primarily in two parts; one governs the investment in capital and the other borrowings. The set of rules that govern the investment in capital is commonly called Foreign Direct Investment (FDI) Regulations. Whereas the set of rules that governs foreign investment in form of borrowings is called External Commercial Borrowing (ECB) Regulations. Let us first have a closer look to what exactly falls under which set of rules. Foreign Direct Investment as the name suggests is the investment made towards core capital of an organization viz. investment in equity shares, convertible preference share and convertible debentures.

Till late there was ambiguity about the partially convertible preference shares and debentures being considered as part of Foreign Direct Investment. However in June 2007 the Reserve Bank of India has clarified as follows : Only instruments which are fully and mandatorily convertible into equity within a specified time would be reckoned as part of equity under the FDI Policy and will be eligible to be issued to person’s resident outside India under the Foreign Direct Investment Scheme.

Thus it is now crystal clear that the investment in non- convertible or partially convertible preference shares and debentures or any instrument with no definite period for conversion in equity will come under the purview of ECB Guidelines. Moreover any investment as commercial loans [in the form of bank loans, buyers’ credit, suppliers’ credit, securitised instruments (e.g. floating rate notes and fixed rate bonds)] availed from non-resident lenders with minimum average maturity of 3 years will also come under the purview of ECB Guidelines.

Deficits and External Financing - Developing & Emerging Market Economies ( $ Bill.) _________________________________________________ ITEM BALANCE ON CURRENT ACCOUNT NET EXTERNAL FINANCING NON-DEBT FLOWS NET EXTERNAL BORROWING (FROM OFFICIAL SOURCES) (FROM PRIVATE SOURCES)

CAPITAL FLOWS INTO INDIA

Borrowing on International Capital Markets ($ Bill) Syndicated Credit Facilities Borrowers from (i) Developed Countries (ii) Developing Countries Debt Securities (Net Issues) Issuers from (i) Developed Countries (ii) Developing Countries a Money Market Instruments * b Bonds and Notes

Introduction Indian entities began accessing external capital markets towards the end of seventies as gradually the amount of concessional assistance became inadequate to meet the increasing needs of the economy The Indian authorities adopted a selective approach and permitted only a few select banks, all India financial institutions, and large public and private sector companies to access the market

Foreign Portfolio Investment Flows Country Portfolio Inflows (US $ billion) Price-Earnings Ratio (Per cent) Hong Kong Chile India South Korea Philippines Thailand Note: 1. Data for China, Chile, Hong Kong and Philippines for 2003 are up to September and for Thailand up to June. 2. Data for price-earnings ratio are for end-March Data for India relates to financial year.

Till a few years ago, external commercial borrowings was the major source of non- governmental external funding. By and large, India's borrowings have been by way of syndicated bank loans, buyers' credits and lines of credits We will obtain an overview of the major segments of the global debt markets in terms of funding avenues, general regulatory framework, accessibility and some procedural aspects Examine the analytics of the international financing decisions from the borrower's point of view and risk-return considerations from the investor's point of view

India’s External Debt (Commercial) End March (USD Mio) Item Commercial Bank Loans Securitized Borrowings Other NRI&FC (B&O) Deposits Export Credit Total LT Debt Total Debt

FUNDS RAISED ON GLOBAL DEBT MARKETS (USD BILL) SYNDICATED BONDS&NOTES MONEY MARKET CREDITS NET ISSUES INST.(NET ISSUES) Q Q Q1 CHINA INDIA S.KOREA BRAZIL MEXICO

The Major Funding Avenues The funding avenues potentially open to a borrower in the global capital markets can be categorised as follows –Bonds : Foreign Bonds and Eurobonds Straight Bonds Floating Rate Notes (FRNs) Zero-coupon and deep discount bonds Bonds with a variety of option features embedded in them

The Major Funding Avenues Syndicated Credits –These are bank loans, usually at floating rate of interest, arranged by one or more lead managers (banks) with a number of other banks participating in the loan Medium Term Notes (MTNs) –Initially conceived as instruments to fill the maturity gap between short-term money market instruments like commercial paper and long-term instruments like bonds, these subsequently evolved into very flexible borrowing instruments

The Major Funding Avenues Committed Underwritten Facilities –The basic structure under this is the Note Issuance Facility (NIF), these instruments were popular for a while before introduction of risk-based capital adequacy norms rendered them unattractive for banks Money Market Instruments –These are short-term borrowing instruments and include commercial paper, certificates of deposit and bankers' acceptances among others

The Major Funding Avenues Another innovation to have emerged during the last decade or so is Project Finance and its novelty lies in the way the financing package is put together including the rights and obligations of the parties involved, allocation of various operating and financial risks to those who are best equipped to bear them, incorporation of various guarantees and so forth

The Major Funding Avenues Most of the funding instruments discussed above also have their "domestic" and "offshore" segments Borrowers often access a currency-market segment which offers ease of access, cheaper all-in cost or some other attractive feature and then use swaps to reconfigure their liabilities in terms of currency and interest rate basis

SIGNED SYNDICATED CREDIT FACILTIES ( US$ BILLION) BORROWERS FROM Q1 Q2 ALL COUNTRIES DEVELOPED DEVELOPING ASIA-PACIFIC INDIA CHINA S.KOREA

INTERNATIONAL DEBT SECURITIES ( ALL ISSUERS, NET ISSUES, US$ BILLION) ISSUERS FROM Q1 Q2 ALL COUNTRIES DEVELOPED DEVELOPING ASIA-PACIFIC INDIA CHINA S.KOREA

INTERNATIONAL DEBT SECURITIES ( CORPORATE ISSUES, US$ BILLION) ISSUERS FROM Q1 ALL COUNTRIES DEVELOPED DEVELOPING ASIA-PACIFIC INDIA CHINA S.KOREA

INTERNATIONAL MONEY MARKET INSTRUMENTS (NET ISSUES US$ BILL.EQUIVALENT) Q1 TOTAL ISSUES COMMERCIAL PAPER CORPORATE ISSUERS FINANCIAL INSTITUTIONS OTHER INSTRUMENTS CORPORATE ISSUERS FINANCIAL INSTITUTIONS

The Major Funding Avenues Bond Markets –A bond is a debt security issued by the borrower, purchased by the investor, usually through the intermediation of a group of underwriters Straight Bond Callable Bond Puttable bond Sinking Fund Bond

The Major Funding Avenues FRN Zero Coupon Bond Convertible Bond Warrants –A large number of other variants have been brought to the market –Yankee Bonds –Samurai Bonds and Shibosai Bonds –Shogun Bonds and Geisha Bonds

The Major Bond Market Segments –Eurobonds : Unregistered, bearer Foreign Bonds : Non-resident issues in a country’s domestic capital market –Yankee Bonds : Public issues in US. Strict regulation – Private placements : Less strict regulation –Samurai Bonds : Public Issues in Japan – Shibosai Bonds,Shogun Bonds and Geisha Bonds Private placements in Japan Swiss and German Bonds : Public Issues and Private placements –Bulldog Bond : UK Public Issues –Rembrandt Bonds : Holland Public Issues

INTERNATIONAL BONDS AND NOTES (NET ISSUES, US$ BILL.EQUIVALENT) Q1 TOTAL ISSUES FLOATING RATE CORPORATE ISSUERS FINANCIAL INSTITUTIONS STRAIGHT FIXED RATE CORPORATE ISSUERS FINANCIAL INSTITUTIONS EQUITY RELATED CORPORATE ISSUERS FINANCIAL INSTITUTIONS

Fig.A.19.3 The UK/European Three-tier Structure A TRADITIONAL SYNDICATE

RISK OF A FOREIGN BOND FROM THE INVESTOR'S VIEWPOINT Recall that the sensitivity of the price of a coupon bearing instrument to changes in interest rate is measured by the duration of the security : where P is the price of the bond and r is the yield. Thus duration is the (negative) of the elasticity of bond price with respect to the discount factor (1+r). A simple measure[of duration known as "Macaulay Duration" (MD) is given by[

Now consider a foreign bond. Its price in its currency of denomination (the "foreign currency") is denoted P. To an investor with a different "home" currency, its value in that currency is V = PS where S is the spot rate in units of home currency per unit of foreign currency. Take logs and differentiate to yield dlnV = dlnP + dlnS But dlnP = dP/P = -D[dr/(1+r)] Hence

The variance of dV is given by Var(dV) = (PS) 2 {a 2 Var(dr)+Var(dlnS) - 2a Cov(dr,dlnS)}) where a = D/(1+r). Thus risk of a foreign bond from the investor's viewpoint depends not only upon the duration of the security but also upon how volatile interest rates are in the country of the currency of denomination of the bond, the volatility of the spot rate and the covariance of the two. The contribution of these separate sources of risk varies depending upon the domicile of the investor and the country of issue and currency of the bond.

EXPECTED EXCHANGE RATES, TAXES AND CURRENCY OF BORROWING Tax treatment of foreign exchange gains and losses on foreign currency liabilities will determine the after-tax cost of borrowing for the borrower. If exchange losses on foreign currency liabilities are allowed to be set off against operating profits like interest payments, then a post-tax comparison of effective borrowing cost between two currencies will yield same result as pre-tax comparison. Thus suppose an Indian company is planning to borrow for one year. The choice is between a dollar borrowing and a yen borrowing. The nominal rates are 4% and 2% respectively and the expected appreciation is 5% for the dollar and 7% for yen. The effective pre-tax cost is 9% for both dollar and yen. If the Indian company's tax rate is 50% the post-tax costs are 4.5%. On either basis, the company would be indifferent between the two.

EXPECTED EXCHANGE RATES, TAXES AND CURRENCY OF BORROWING From the investor's point of view, if exchange gains are treated as capital gains and taxed at a lower rate, bonds denominated in a faster appreciating currency would be more attractive. Thus suppose the above Indian company's lenders are dollar based investors who have identical expectations about exchange rate movements so that they expect the yen to appreciate 2% against the dollar. Suppose the tax rates for these investors are 40% on interest income and 20% on exchange gains. Then the after-tax return would be 2.4% on the dollar asset [= (1-0.4)  4%] and 2.8% on the yen denominated asset [= (1-0.4)  2% + (1-0.2)  2%]. Investors might lower the nominal rate on Yen loans.

Syndicated Credits –A traditional Eurosyndicated loan is usually a floating rate loan with fixed maturity, a fixed drawdown period and a specified repayment schedule –Lead managers, Syndicate members and Agent bank –A typical Eurocredit would have maturity between five and 10 years, amortisation in semiannual instalments, and interest rate reset every three or six months with reference to LIBOR –Club Loans : Private deals, unpublicised –Revolving Credit

Syndicated Credits –Standby facility –The cost of a loan consists of interest and a number of fees - management fees, participation fees, agency fees and underwriting fees when the loan is underwritten by a bank of a group of banks –Apart from the Euromarkets, syndicated credits can be arranged in some of the national capital markets such as Japan and UK.

Fig.A.19.1

Other Securitised Funding Avenues MTNS and EMTNs –Originally evolved as a bridge between short-term money market products and long term bonds –The main advantage of borrowing via an MTN or EMTN programme is its flexibility and much less onerous formalities of documentation compared to a bond issue; timing flexibility, multicurrency facility –The market is accessible only to issuers with good credit rating

Underwritten Facilities NIF and Related Facilities –Highly rated borrowers decided to short circuit the banks and raise financing directly from investors by issuing their own paper –A Note Issue Facility (NIF) is a medium-term legally binding commitment under which a borrower can issue short-term paper in its own name, but where underwriting banks are committed either to purchase any notes which the borrower is unable to sell, or to provide standing credit

NIFs and RUFs –If at any roll-over the borrower is unable to place the entire issue with the market, the underwriting banks either take up the remainder or provide a short-term loan and the arrangement under which the banks provide credit to make up the shortfall is known as a Revolving Underwriting Facility (RUF) –Have lost popularity with introduction of capital adequacy requirements against commitments.

Project Finance –The central idea in project financing is to arrange a financing package which will permit the transfer or sharing of various risks among several parties including project promoters with a no recourse or limited recourse feature –The lenders evaluate the project as an independent entity and have claims on the cash flows generated by the project for their interest payments and principal repayments without recourse to any other assets owned by the project promoters. –Lenders would like to maximise the chances of project success. Involve project contractors as an equity partner, take-or pay guarantees from major customers of project output, guarantees from suppliers, counter-guarantees etc.

Project Finance –The lenders may require guarantees –In some circumstances, third party guarantees can be arranged –The sources of equity and debt finance for projects have been numerous –An innovation in project finance is the BOT device which stands for Build, Own and Transfer (some times also called BOOT - Build, Own, Operate and Transfer )

–Concept of co-finance – Joint financing by private lenders and multilateral agencies like World Bank –A variety of funding techniques, risk sharing strategies and risk management tools such as swaps and options are packaged together for a large project The nature of all these markets and instruments is very dynamic In the Indian context, the government's regulatory stance on accessing these funding avenues needs to be kept in mind

The International Financing Decision The issue of the optimal capital structure and subsequently the optimal mix of funding instruments is one of the key strategic decisions for a corporation The actual implementation of the selected funding programme involves several other considerations such as satisfying all the regulatory requirements, choosing the right timing and pricing of the issue, effective marketing of the issue and so forth

The International Financing Decision

The critical dimensions of this decision for a firm to chose funding avenues –Interest rate basis : Mix of fixed rate and floating rate debt –Maturity : The appropriate maturity composition of debt; long term or short-term rolled over –Currency composition of debt –Which market segments should be tapped –Take advantage of any market imperfections –Take advantage of subsidized financing opportunities –All-in cost, currency risk, interest rate risk

The International Financing Decision These dimensions interact to determine the overall character of the firm's debt portfolio The overall guiding principles in choosing a debt portfolio –“ The nature of financing should normally be driven by the nature of the business, in such a way as to make debt-service payments match the character and timing of operating earnings. Because this reduces the probability of financial distress, it allows the firm to have greater leverage and therefore a greater tax shield. Deviation from this principle should occur only in the presence of privileged information or some other market imperfection. Market imperfections that provide cheaper financing exist in practice in a wide range of circumstances.” - Giddy

The International Financing Decision Overriding these considerations are issues of regulation and market access In viewing the risks associated with funding activity, a portfolio approach needs to be adopted Currency and interest rate exposures arising out of funding decisions should not be viewed in isolation but as total risk of asset-liability portfolio and exposures arising out of regular operations.

The International Financing Decision In comparing funding options the following parameters have to be examined under alternative scenarios –The all-in cost of a particular funding instrument – under alternative simulations of paths of interest rates and exchange rates –Interest rate and currency exposure arising from using a particular financing vehicle

The International Financing Decision Consider a firm which is contemplating a fixed rate foreign currency loan (or a fixed rate foreign currency bond issue) –The nominal rate of interest is I (expressed as a fraction not percentage), the maturity is N years, interest is paid annually and repayment is bullet –The principal amount is A

The International Financing Decision –The rate of exchange at time t is denoted S t expressed as units of home currency per unit of foreign currency –The real cost of this loan consists of three components viz. the nominal interest, appreciation of the foreign currency and domestic inflation is R = I + ŝ -  –ŝ denotes proportionate change in the spot rate and  is the domestic rate of inflation –The variance of the real cost therefore is Var(R) = Var(ŝ) + Var (  ) - 2Cov (ŝ,  )

The International Financing Decision –To compare the variances of real costs, the covariance term is important –Between two currencies, if the variance of both is nearly equal, the one which obeys PPP with the home currency more closely will have a lower variance of real cost of borrowing –If the real cost risk is ignored, the choice of currency should be based on a comparison of effective interest rates which consist of the nominal interest rate I, and the expected rate of appreciation of the foreign currency S e –

The International Financing Decision –When the nominal interest rate itself is not fixed - as with a floating rate loan or FRNs - an additional source of risk is introduced viz. the variance of the nominal interest rate and its covariances with the exchange rate and domestic inflation rate

A bond issue with an embedded currency option from a class of instruments called Indexed Currency Option Notes (ICONS). In 1985 Bankers Trust (BT) lead managed for Long Term Credit Bank (LTCB) of Japan an issue of $120 million Eurobonds with a coupon of 11.5% p.a. and maturity of 10 years. The redemption amount R at maturity will depend upon the value at that time of the spot ¥/$ exchange rate S as follows : If S  169, R = $120 million If S < 169 R = $( ){1 – [(169-S)/S]} Effectively, the investors in the bond have granted LTCB a put option on dollars against yen at a strike price of ¥169.00/$ for an amount of $120 million.

BT purchased the put option from LTCB in return for a reduction in LTCB's borrowing cost. This was achieved as follows. It arranged for an issue of Yen bonds with a coupon of 6.65% p.a., 10 year maturity and face amount of ¥24,240,000,000, converted this to $120 million at the then spot rate of ¥202/$ and loaned the dollars to a counterparty at 10.7% p.a. Yen interest payments on the bonds were covered by means of a series of $/¥ forward contracts and the yen principal was left unhedged. The market rates at the time were : 10-year US treasury bond rate was 10.5% p.a. 10-year Japanese Government bond rate was 6.5%.

At maturity of the yen bond issue (and the dollar loan), the worst-case scenario for BT is it will have to buy yen at the rate of ¥169/$. For $120 million this will yield ¥20,280,000,000 leading to a shortfall of ¥[ ] = ¥3,960, This translates into an annual payment of ¥293,454,573. The net result is that BT realises a profit stream which is equivalent to a 10-year annuity of $1,566,024 at a discount rate of 10.5%. If all of this gain is passed on to LTCB (which is unlikely), LTCB's borrowing cost will come down to 10.2%

Country Risk Analysis The essence of country risk analysis is an assessment of factors that will affect a country's ability and willingness to service its external obligations. A variety of political, economic and psycho-social considerations are relevant. Many rating systems have been evolved which attempt to precisely define, measure and weight these factors to arrive at a single indicator of a country's creditworthiness. The economic factors can be broadly grouped into three categories. The first of these pertains to the resource base of the country. This category includes natural resources like land, mineral deposits etc., human resources including quality and depth of managerial and technical skills, strength of the entrepreneurial spirit and trainability of the labour force and financial resources which pertains to saving rate of the economy.

Country Risk Analysis The second set of factors refers to macroeconomic performance and the quality of economic management. High and steady growth, high per capita income, high rate of capital formation etc. indicate good macroeconomic performance. Lenders tend to be favourably biased towards political and legal systems that provides incentives to individual enterprise with minimum of government regulation, and fiscal and monetary conservatism. Professional competence of key officials in the finance ministry and the central bank of the country, a well trained cadre of middle level officials, a relatively independent monetary authority, an efficient and facilitative bureaucracy and a government with the political will to implement tough decisions are highly valued Bankers prefer a long term development strategy that emphasizes output growth, stable prices, an "outward" orientation and "sound external finance". Administered interest rates, subsidies, administrative credit allocation, overvalued exchange rates, exchange controls etc. are generally frowned upon.

Country Risk Analysis The third set of factors refers to the external position of the country. This is the bottom line. Several indicators are used to assess the country's ability to generate sufficient foreign exchange to service its liabilities. Among the most important of these are : 1. State of the current account. Chronic deficits are regarded as a danger signal. Deficits in excess of 2-3% of GDP are considered excessive. 2. A rapid and stable growth of exports and a diversified export base are desirable attributes. 3. Existing Debt/GDP ratio and the debt service ratio. The latter is defined as the ratio of debt service payments on existing liabilities to the export earnings. A value in excess of 25% is a cause for concern. 4. Ratio of reserves to normal imports. 5. The country's access to IMF for meeting temporary BOP difficulties.