1 globalization, finance & china jian chen [email protected] prepared for eseune gemmba program...

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Globalization, Finance & ChinaJian Chen

[email protected] for ESEUNE gemMBA Program

Beijing CampusNovember 4th, 2013

mailto:[email protected]

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Personal Bio

Ph.D. in Computational Finance, Smith Business School, University of Maryland

Serve on the Board of Directors of GCREC

Column writer for CAIXIN media Member of AREUEA CFA Charter Holder

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Working Experience

Managing Director, IFE Group Director of Risk and Modeling, Freddie

Mac, 2010-2012 Director of Capital Markets Risk

Management, Fannie Mae, 2001-2009

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Teaching and Research Teaching

Johns Hopkins Carey Business School Georgetown University Graduate School Renmin University of China

Research Real Estate Finance International Finance Urban Economics Housing Policy Fixed Income Pricing Risk Management

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Agenda

Global Financial System China’s Financial System Doing Business in China Housing Crisis and Its Impact

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Global Financial System

Why is it important? International Monetary System FOREX Exposure & Risk Management Sourcing International Capital Making International Investment Decision

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Road Map

InternationalFinancial RiskManagement

International Monetary

System

SourcingCapital in

Global Markets

ManagingFOREX

Exposure

ForeignInvestmentDecisions

Synthesis

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Creating Firm Value in Global Markets

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The Theory of Comparative Advantage

The theory of competitive advantage provides a basis for explaining and justifying international trade in a model assumed to enjoy

Free trade Perfect competition No uncertainty Costless information No government interference

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The Theory of Comparative Advantage: Limitations

Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today;

Countries do not appear to specialize only in those products that could be most efficiently produced by that country’s particular factors of production

At least two of the factors of production (capital and technology) now flow easily between countries (rather than only indirectly through traded goods and services)

Modern factors of production are more numerous than this simple model

Comparative advantage shifts over time

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The Theory of Comparative Advantage

Comparative advantage is still, however, a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of both MNEs and domestic firms

The comparative advantage of the 21st century, however, is one which is based more on services, and their cross border facilitation by telecommunications and the Internet

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Global Outsourcing of Comparative Advantage

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What is Different About International Financial Management?

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Market Imperfections:A Rationale for the MNE

Firms become multinational for one or several of the following reasons:

Market seekers – produce in foreign markets either to satisfy local demand or export to markets other than their own

Raw material seekers – search for cheaper or more raw materials outside their own market

Production efficiency seekers – produce in countries where one or more of the factors of production are cheaper

Knowledge seekers – gain access to new technologies or managerial expertise

Political safety seekers – establish operations in countries considered unlikely to expropriate or interfere with private enterprise

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International Monetary System Learn how the international monetary system

has evolved from the days of the gold standard to today’s eclectic currency arrangement

Discover the origin and development of the Eurocurrency market

Analyze the characteristics of an ideal currency Explain the currency regime choices faced by

emerging market countries Examine how the euro, a single currency for the

European Union, was created

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History of the InternationalMonetary System

The Gold Standard, 1876-1913 Countries set par value for their currency in terms of

gold This came to be known as the gold standard and

gained acceptance in Western Europe in the 1870s The US adopted the gold standard in 1879 The “rules of the game” for the gold standard were

simple• Example: US$ gold rate was $20.67/oz, the British pound

was pegged at £4.2474/oz• US$/£ rate calculation is $20.67/£4.2472 = $4.8665/£

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Because governments agreed to buy/sell gold on demand with anyone at its own fixed parity rate, the value of each currency in terms of gold, the exchange rates were therefore fixed

Countries had to maintain adequate gold reserves to back its currency’s value in order for regime to function

The gold standard worked until the outbreak of WWI, which interrupted trade flows and free movement of gold thus forcing major nations to suspend operation of the gold standard

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The Inter-War years and WWII, 1914-1944 During WWI, currencies were allowed to fluctuate over wide

ranges in terms of gold and each other, theoretically, supply and demand for imports/exports caused moderate changes in an exchange rate about an equilibrium value• The gold standard has a similar function

In 1934, the US devalued its currency to $35/oz from $20.67/oz prior to WWI

From 1924 to the end of WWII, exchange rates were theoretically determined by each currency's value in terms of gold.

During WWII and aftermath, many main currencies lost their convertibility. The US dollar remained the only major trading currency that was convertible

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Bretton Woods and the IMF, 1944 Allied powers met in Bretton Woods, NH and created

a post-war international monetary system The agreement established a US dollar based

monetary system and created the IMF and World Bank

Under original provisions, all countries fixed their currencies in terms of gold but were not required to exchange their currencies

Only the US dollar remained convertible into gold (at $35/oz with Central banks, not individuals)

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Therefore, each country established its exchange rate vis-à-vis the US dollar and then calculated the gold par value of their currency

Participating countries agreed to try to maintain the currency values within 1% of par by buying or selling foreign or gold reserves

Devaluation was not to be used as a competitive trade policy, but if a currency became too weak to defend, up to a 10% devaluation was allowed without formal approval from the IMF

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The Special Drawing Right (SDR) is an international reserve assets created by the IMF to supplement existing foreign exchange reserves• It serves as a unit of account for the IMF and is also the base

against which some countries peg their exchange rates• Defined initially in terms of fixed quantity of gold, the SDR

has been redefined several times• Currently, it is the weighted average value of currencies of 5

IMF members having the largest exports• Individual countries hold SDRs in the form of deposits at the

IMF and settle IMF transactions through SDR transfers

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Copyright © 2009 Pearson Prentice Hall. All rights reserved.


Fixed exchange rates, 1945-1973 Bretton Woods and IMF worked well post WWII, but

diverging fiscal and monetary policies and external shocks caused the system’s demise• The US dollar remained the key to the web of exchange

rates Heavy capital outflows of dollars became required to

meet investors’ and deficit needs and eventually this overhang of dollars held by foreigners created a lack of confidence in the US’ ability to meet its obligations

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This lack of confidence forced President Nixon to suspend official purchases or sales of gold on Aug. 15, 1971

Exchange rates of most leading countries were allowed to float in relation to the US dollar

By the end of 1971, most of the major trading currencies had appreciated vis-à-vis the US dollar; i.e. the dollar depreciated

A year and a half later, the dollar came under attack again and lost 10% of its value

By early 1973 a fixed rate system no longer seemed feasible and the dollar, along with the other major currencies was allowed to float

By June 1973, the dollar had lost another 10% in value

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The IMF’s Nominal Exchange Rate Index of the Dollar

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Current Exchange Rate Arrangements

36 major currencies, such as the U.S. dollar, the Japanese yen, the Euro, and the British pound are determined largely by market forces.

50 countries, including the China, India, Russia, and Singapore, adopt some forms of “Managed Floating” system.

41 countries do not have their own national currencies! 40 countries, including many islands in the Caribbean, many

African nations, UAE and Venezuela, do have their own currencies, but they maintain a peg to another currency such as the U.S. dollar.

The remaining countries have some mixture of fixed and floating exchange-rate regimes.

Note: As of July 31, 2005.25

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The Euro Product of the desire to create a more integrated

European economy. Eleven European countries adopted the Euro on

January 1, 1999: Austria, Belgium, Finland, France, Germany, Ireland,

Italy, Luxembourg, Netherlands, Portugal, and Spain. The following countries opted out initially:

Denmark, Greece, Sweden, and the U.K. Euro notes and coins were introduced in 2002 Greece adopted the Euro in 2001 Slovenia adopted the Euro in 2007

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FOREX Exposure and Risk Management

Risks involved Foreign Exchange Market

Spot Forward Futures Options

Theory of Foreign Exchange Rates Purchasing Power Parity Interest Rate Parity

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Risk Management -What is special about international finance?

Foreign exchange risk E.g., an unexpected devaluation adversely affects

your export market…Political risk

E.g., an unexpected overturn of the government that jeopardizes existing negotiated contracts…

Market imperfections E.g., trade barriers and tax incentives may affect

location of production…Expanded opportunity sets

E.g., raise funds in global markets, gains from economies of scale…

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The Foreign Exchange MarketThe FX market encompasses:

Conversion of purchasing power from one currency to another; bank deposits of foreign currency; credit denominated in foreign currency; foreign trade financing; trading in foreign currency options & futures, and currency swaps

No central market place World-wide linkage of bank currency traders, non-bank dealers

(IBanks, insurance companies, etc.), and FX brokers—like an international OTC market

Largest financial market in the world Daily trading is estimated to be US$3.21 trillion Trading occurs 24 hours a day London is the largest FX trading center

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Global Foreign Exchange Market Turnover

Source: BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2007.30

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The Foreign Exchange Market The FX market is a two-tiered market:

Interbank Market (Wholesale)• Accounts for about 83% of FX trading volume—mostly

speculative or arbitrage transactions• About 100-200 international banks worldwide stand ready to

make a market in foreign exchange• FX brokers match buy and sell orders but do not carry

inventory and FX specialists Client Market (Retail)

• Accounts for about 17% of FX trading volume Market participants include international banks, their customers,

non-bank dealers, FX brokers, and central banks

Note: Data is from 2007. 31

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Measuring Foreign Exchange Market Activity: Average Electronic Conversions per

Hour

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Spot Transactions

A spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day The settlement date is often referred to as the

value date This is the date when most dollar transactions

are settled through the computerized Clearing House Interbank Payment Systems (CHIPS) in New York

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Outright Forward Transactions This transaction requires delivery at a future value date

of a specified amount of one currency for another The exchange rate is agreed upon at the time of the

transaction, but payment and delivery are delayed Forward rates are contracts quoted for value dates of

one, two, three, six, nine and twelve months Terminology typically used is buying or selling forward A contract to deliver dollars for euros in six months is both

buying euros forward for dollars and selling dollars forward for euros

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Swap Transactions A swap transaction in the interbank market is the

simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

Both purchase and sale are conducted with the same counterpart

A common type of swap is a spot against forward The dealer buys a currency in the spot market and

simultaneously sells the same amount back to the same bank in the forward market

Since this transaction occurs at the same time and with the same counterpart, the dealer incurs no exchange rate exposure

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Size of the FOREX Market

The Bank for International Settlements (BIS) estimates that daily global net turnover in traditional FOREX market activity to be US$3.2 trillion in April 2007 Spot transactions at $1,005 billion/day Outright forward transactions at $363

billion/day Swap transactions at $1,714 billion/day

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Global Foreign Exchange Market Turnover, 1989-2007 (daily averages in April, billions

of U.S. dollars)

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Size of the FOREX Market

The United Kingdom (London) and the United States (New York) make up roughly 50% of the foreign exchange market

The London trade alone makes up 34.1% of daily transactions in the foreign exchange market

Switzerland has grown in recent years and is now the third largest market with 6.1% of world trading

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Foreign Currency Futures

A foreign currency futures contract is an alternative to a forward contract It calls for future delivery of a standard

amount of currency at a fixed time and price These contracts are traded on exchanges

with the largest being the International Monetary Market located in the Chicago Mercantile Exchange

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Contract Specifications Size of contract – called the notional principal, trading

in each currency must be done in an even multiple Method of stating exchange rates – “American terms”

are used; quotes are in US dollar cost per unit of foreign currency, also known as direct quotes

Maturity date – contracts mature on the 3rd Wednesday of January, March, April, June, July, September, October or December

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Contract Specifications Last trading day – contracts may be traded through

the second business day prior to maturity date Collateral & maintenance margins – the purchaser or

trader must deposit an initial margin or collateral; this requirement is similar to a performance bond• At the end of each trading day, the account is marked to

market and the balance in the account is either credited if value of contracts is greater or debited if value of contracts is less than account balance

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Contract Specifications Settlement – only 5% of futures contracts are settled

by physical delivery, most often buyers and sellers offset their position prior to delivery date• The complete buy/sell or sell/buy is termed a round turn

Commissions – customers pay a commission to their broker to execute a round turn and only a single price is quoted

Use of a clearing house as a counterparty – All contracts are agreements between the client and the exchange clearing house. Consequently clients need not worry about the performance of a specific counterparty since the clearing house is guaranteed by all members of the exchange

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Currency Futures and Forwards Compared

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Foreign Currency Options

A foreign currency option is a contract giving the purchaser of the option the right to buy or sell a given amount of currency at a fixed price per unit for a specified time period

The most important part of clause is the “right, but not the obligation” to take an action

Two basic types of options, calls and puts• Call – buyer has right to purchase currency• Put – buyer has right to sell currency

The buyer of the option is the holder and the seller of the option is termed the writer

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Every option has three different price elements The strike or exercise price is the exchange rate at

which the foreign currency can be purchased or sold The premium, the cost, price or value of the option

itself paid at time option is purchased The underlying or actual spot rate in the market

There are two types of option maturities American options may be exercised at any time

during the life of the option European options may not be exercised until the

specified maturity date

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Options may also be classified as per their payouts

At-the-money (ATM) options have an exercise price equal to the spot rate of the underlying currency

In-the-money (ITM) options may be profitable, excluding premium costs , if exercised immediately

Out-of-the-money (OTM) options would not be profitable, excluding the premium costs, if exercised

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Foreign Currency Options Markets

The increased use of currency options has lead the creation of several markets where financial managers can access these derivative instruments

Over-the-Counter (OTC) Market – OTC options are most frequently written by banks for US dollars against British pounds, Swiss francs, Japanese yen, Canadian dollars and the euro• Main advantage is that they are tailored to purchaser• Counterparty risk exists• Mostly used by individuals and banks

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Foreign Currency Options Markets

Organized Exchanges – similar to the futures market, currency options are traded on an organized exchange floor• The Chicago Mercantile and the Philadelphia

Stock Exchange serve options markets• Clearinghouse services are provided by the

Options Clearinghouse Corporation (OCC)

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International Parity Conditions

The economic theories which link exchange rates, price levels, and interest rates together are called international parity conditions

These theories may not always work out to be “true” when compared to what students and practitioners observe in the real world, but they are central to any understanding of how multinational business is conducted

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P$ S = P¥

Where the price of the product in US dollars (P$), multiplied by the spot exchange rate (S, yen per dollar), equals the price of the product in Japanese yen (P¥)

Prices and Exchange Rates

The Law of one price states that all else being equal (no transaction costs) a product’s price should be the same in all markets

Even if prices for a particular product are in different currencies, the law of one price states that

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P

PS

¥

$

Prices and Exchange Rates

Conversely, if the prices were stated in local currencies, and markets were efficient, the exchange rate could be deduced from the relative local product prices

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Purchasing Power Parity & The Law of One Price

If the Law of One Price were true for all goods, the purchasing power parity (PPP) exchange rate could be found from any set of prices

Through price comparison, prices of individual products can be determined through the PPP exchange rate

This is the absolute theory of purchasing power parity

Absolute PPP states that the spot exchange rate is determined by the relative prices of similar basket of goods

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The Hamburger Standard

The “Big Mac Index,” as it has been christened by The Economist is a prime example of this law of one price :

Assuming that the Big Mac is identical in all countries, it serves as a comparison point as to whether or not currencies are trading at market prices

Big Mac in China costs Yuan 11.0 (local currency), while the same Big Mac in the US costs $3,41

The actual exchange rate was Yuan 7.60/$ at the time

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The price of a Big Mac in Chinese Yuan in U.S. dollar-terms was therefore:

The Economist then calculates the implied purchasing power parity rate of exchange using the actual price of the Big Mac in China over the price of the Big Mac in U.S. dollars:

Yuan 11.0Yuan 7.60/$

= $1.45

Yuan 11.0$3.41 = Yuan

3.23/$

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Yuan 3.23/$ - Yuan 7.60/$

Yuan 7.60/$

= -58%


Now comparing the implied PPP rate of exchange, Yuan 3.23/$, with the actual market rate of exchange at that time, Yuan 7.60/$, the degree to which the Chinese yuan is either undervalued or overvalued versus the U.S. dollar is calculated:

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Cash and Carry:The Hamburger Standard

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i = r + + r

Where i is the nominal rate, r is the real rate of interest, and is the expected rate of inflation over the period of timeThe cross-product term, r , is usually dropped due to its relatively minor value

Interest Rates and Exchange Rates

Prices between countries are related by exchange rates and now we discuss how exchange rates are linked to interest rates

The Fisher Effect states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. As a formula, The Fisher Effect is

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i = r + ; i = r + $ $ $ ¥ ¥ ¥

It should be noted that this requires a forecast of the future rate of inflation, not what inflation has been, and predicting the future can be difficult!


Applied to two different countries, like the US and Japan, the Fisher Effect would be stated as

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i i 100 x S

S S $

2

21 ¥


The international Fisher effect, or Fisher-open, states that the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries

if we were to use the US dollar and the Japanese yen, the expected change in the spot exchange rate between the dollar and yen should be (in approximate form)

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Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates

The international Fisher effect predicts that with unrestricted capital flows, an investor should be indifferent between investing in dollar or yen bonds, since investors worldwide would see the same opportunity and compete it away

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The Forward Rate A forward rate is an exchange rate quoted today for

settlement at some future date The forward exchange agreement between currencies

states the rate of exchange at which a foreign currency will be bought or sold forward at a specific date in the future (typically 30, 60, 90, 180, 270 or 360 days)

The forward rate is calculated by adjusting the current spot rate by the ratio of euro currency interest rates of the same maturity for the two subject currencies

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36090

x i 1

36090

x i 1

x S F$

FC

FC/$FC/$90


The Forward Rate

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$Sfr1.4655/ 1.02

1.01 x Sfr1.4800

360

90 x 0.800 1

360

90 x 0.400 1

xSfr1.4800 Sfr/$90F


The Forward Rate example with spot rate of Sfr1.4800/$, a 90-day euro Swiss franc deposit rate of 4.00% p.a. and a 90-day euro-dollar deposit rate of 8.00% p.a.

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100 x days

360 x

Foward

Foward -Spot f FC

For direct quotes ($/FC), then F-S/S should be applied


The forward premium or discount is the percentage difference between the spot and forward rates stated in annual percentage terms

When stated in indirect terms (foreign currency per home currency units, FC/$) then formula is

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Currency Yield Curves and the Forward Premium

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p.a. 3.96% 100 x 90

360 x

Sfr1.4655

Sfr1.4655 - Sfr1.4800 f Sfr

100 x days

360 x

Foward

Foward -Spot f FC

The positive sign indicates that the Swiss franc is selling forward at a premium of 3.96% per annum (it takes 3.96% more dollars to get a franc at the 90-day forward rate)


Using the previous Sfr example, the forward discount or premium would be as follows:

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Interest Rate Parity (IRP)

Interest rate parity theory provides the linkage between foreign exchange markets and international money markets

The theory states that the difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite sign to, the forward rate discount or premium for the foreign currency, except for transaction costs

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In the diagram in the following slide, a US dollar-based investor with $1 million to invest, is shown indifferent between dollar-denominated securities for 90 days earning 8.00% per annum, or Swiss franc-denominated securities of similar risk and maturity earning 4.00% per annum, when “cover” against currency risk is obtained with a forward contract

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Sourcing International Capital

Cost of Capital and Capital Structure Cost of Equity Cost of Debt Optimal Capital Structure

Raising International Equity Capital Raising International Debt Capital

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V

Dt)1(k

V

Ekk deWACC

WherekWACC = weighted average cost of capitalke = risk adjusted cost of equitykd = before tax cost of debtt = tax rateE = market value of equityD = market value of debtV = market value of firm (D+E)

Weighted Average Cost of Capital

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)kk(k k rfmrfe Where

ke = expected rate of return on equitykrf = risk free rate on bondskm = expected rate of return on the

marketβ = coefficient of firm’s systematic

risk

• The normal calculation for cost of debt is analyzing the various proportions of debt and their associated interest rates for the firm and calculating a before and after tax weighted average cost of debt

Cost of Equity and Debt

Cost of equity is calculated using the Capital Asset Pricing Model (CAPM)

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Cost of Debt

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Optimal Capital Structure

Debt/Total Assets

Mar

ket V

alue

of

The

Fir

m

Value ofUn-levered

firm

PV of interesttax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm

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Sourcing Equity Globally

Depositary Receipts Depositary receipts are negotiable certificates

issued by a bank to represent the underlying shares of stock, which are held in trust at a foreign custodian bank• Global Depositary Receipts (GDRs) – refers to certificates

traded outside the US• American Depositary Receipts (ADRs) – are certificates

traded in the US and denominated in US dollars• ADRs are sold, registered, and transferred in the US in the

same manner as any share of stock with each ADR representing some multiple of the underlying foreign share

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Sourcing Equity Globally

Depositary Receipts This multiple allows the ADRs to possess a

price per share conventional for the US market

ADRs are either sponsored or unsponsored Sponsored ADRs are created at the request

of a foreign firm wanting its shares traded in the US; the firm applies to the SEC and a US bank for registration and issuance

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Exhibit 13.2 Mechanics of American Depositary Receipts (ADRs)

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Exhibit 13.3 Characteristics of Depositary Receipt Programs Traded in the United States

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Foreign Equity Listing & Issuance

By cross-listing and selling its shares on a foreign stock exchange a firm typically tries to accomplish one or more of the following objectives:

Improve the liquidity of its existing shares and support a liquid secondary market

Increase its share price by overcoming mispricing in a segmented and illiquid home market

Increase the firm’s visibility and political acceptance to its customers, suppliers, creditors & host governments

Establish a secondary market for shares used for acquisitions Create a secondary market for shares that can be used to

compensate local management and employees in foreign subsidiaries

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Size and Liquidity of Markets

Three key trends in the evolution of modern exchanges: Demutualization or the end of market

ownership by a small, privileged group of “seat owners”

Diversification by exchanges to trade a broader range of products

Globalization or effectively another form of diversification through several techniques

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Foreign Equity Listing & Issuance

Cross-listing is a way to encourage investors to continue to hold and trade shares that may or may not be listed on an investors home market or in a preferred currency

Cross-listing is usually done through ADRs (in the United States, where they are traded and quoted in U.S. dollars)

Global Registered Shares (GRSs), on the other hand, are able to be traded on equity exchanges around the globe in a variety of currencies and are traded electronically

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Effect of Cross-Listingon Share Price

The impact on price of cross-listing on a foreign stock market depends on the degree to which the markets are segmented

As was the situation experienced by Novo, a firm can benefit if a foreign market values a company more highly than a home market (in a highly-segmented situation)

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International Debt Markets

These markets offer a variety of different maturities, repayment structures and currencies of denomination

They also vary by source of funding, pricing structure, maturity and subordination

Three major sources of funding are International bank loans and syndicated credits Euronote market International bond market

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Bank loan and syndicated credits Traditionally sourced in eurocurrency markets Also called eurodollar credits or eurocredits

• Eurocredits are bank loans denominated in eurocurrencies and extended by banks in countries other than in whose currency the loan is denominated

Syndicated credits• Enables banks to risk lending large amounts• Arranged by a lead bank with participation of other bank

Narrow spread, usually less than 100 basis points

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Euronote market Collective term for medium and short term

debt instruments sourced in the Eurocurrency market

Two major groups• Underwritten facilities and non-underwritten

facilities• Non-underwritten facilities are used for the sale

and distribution of Euro-commercial paper (ECP) and Euro Medium-term notes (EMTNs)

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International Debt Markets Euronote facilities

• Established market for sale of short-term, negotiable promissory notes in eurocurrency market

• These include Revolving Underwriting Facilities, Note Issuance Facilities, and Standby Note Issuance Facilities

Euro-commercial paper (ECP) • Similar to commercial paper issued in domestic markets with

maturities of 1,3, and 6 months Euro Medium-term notes (EMTNs)

• Similar to domestic MTNs with maturities of 9 months to 10 years

• Bridged the gap between short-term and long-term euro debt instruments

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International bond market Fall within two broad categories

• Eurobonds• Foreign bonds

The distinction between categories is based on whether the borrower is a domestic or foreign resident and whether the issue is denominated in a local or foreign currency

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Eurobonds A Eurobond is underwritten by an international

syndicate of banks and sold exclusively in countries other than the country in whose currency the bond is denominated

Issued by MNEs, large domestic corporations, governments, government enterprises and international institutions

Offered simultaneously in a number of different capital markets

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International Debt Markets Eurobonds

Several different types of issues• Straight Fixed-rate issue• Floating rate note (FRN)• Equity related issue – convertible bond

Foreign bonds Underwritten by a syndicate and sold principally within the

country of the denominated currency, however the issuer is from another country

These include • Yankee bonds• Samurai bonds

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Exhibit 14.5 International Debt Markets and Instruments

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Unique characteristics of Eurobond markets Absence of regulatory interference

• National governments often impose controls on foreign issuers of securities, however the euromarkets fall outside of governments’ control

Less stringent disclosure Favorable tax status

• Eurobonds offer tax anonymity and flexibility

Rating of Eurobonds & other international issues Moody’s, Fitch and Standard & Poor’s rate bonds just

as in US market

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International Investments

Where to Invest? How to Invest? Global Diversification and Risk

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Where to Invest

Two related behavioral theories behind FDI that are most popular are

Behavioral approach to FDI International network theory

Behavioral Approach – Observation that firms tended to invest first in countries that were not too far from their country in psychic terms

This included cultural, legal, and institutional environments similar to their own

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Where to Invest

International network theory – As MNEs grow they eventually become a network, or nodes that operate either in a centralized hierarchy or a decentralized one

Each subsidiary competes for funds from the parent It is also a member of an international network based

on its industry The firm becomes a transnational firm, one that is

owned by a coalition of investors located in different countries

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How to Invest Abroad: Modes of FDI

Exporting vs. production abroad Advantages of exporting are

• None of the unique risks facing FDI, joint ventures, strategic alliances and licensing

• Political risks are minimal• Agency costs and evaluating foreign units are avoided

Disadvantages are• Firm is not able to internalize and exploit its advantages• Risks losing market to imitators and global competitors

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Licensing/management contracts versus control of assets abroad

Licensing is a popular method for domestic firms to profit from foreign markets without the need to commit sizable funds

Disadvantages of licensing are• License fees are likely lower than FDI profits although ROI

may be higher• Possible loss of quality control• Establishment of potential competitor• Possible improvement of technology by local license which

then enters firm’s original home market

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• Possible loss of opportunity to enter licensee’s market with FDI later

• Risk that technology will be stolen• High agency costs

Management contracts are similar to licensing insofar as they provide for some cash flow from foreign source without significant investment or exposure

These contracts lessen political risk because the repatriation of managers is easy

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Joint ventures versus wholly owned subsidiary A joint venture is a shared ownership in a foreign

business This is a viable strategy if the MNE finds the right

local partner Some advantages include

• The local partner understands the market• The local partner can provide competent management at all

levels• Some host countries require that foreign firms share

ownership with local partner

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Joint ventures versus wholly owned subsidiary Advantages of joint ventures

• The local partner’s contacts & reputation enhance access to host country’s capital markets

• The local partner may possess technology that is appropriate for the local environment

• The public image of a firm that is partially locally owned may improve its position

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Joint ventures versus wholly owned subsidiary Disadvantages of joint ventures

• Political risk is increased if wrong partner is chosen• Local and foreign partners have divergent views on strategy

and financing issues• Transfer pricing creates potential for conflict of interest• Financial disclosure between local partner and firm • Ability of a firm to rationalize production on a worldwide basis

if that would put local partner at disadvantage• Valuation of equity shares is difficult

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Greenfield investment versus acquisition A greenfield investment is establishing a facility

“starting from the ground up”• Usually require extended periods of physical construction

and organizational development Here, a cross-border acquisition may be better

because the physical assets already exist, shorter time frame and financing exposure• However, problems with integration, paying too much for

acquisition, post-merger management, and realization of synergies all exist

102


Strategic alliances can take several different forms

First is an exchange of ownership between two firms

It can be a defensive strategy against a takeover In addition to exchanging shares, a separate joint

venture can be developed Another level of cooperation may be a joint marketing

or servicing agreement

103

The FDI Sequence: Foreign Presence and Foreign Investment

104

Optimal Domestic Portfolio Construction

105

Internationalizing the Domestic Portfolio

If the investor is allowed to choose among an internationally diversified set of securities, the portfolio set of securities shifts to upward and to the left

This is called the internationally diversified portfolio opportunity set

106

The Internationally Diversified Portfolio Opportunity Set

107

Internationalizing the Domestic Portfolio

This new opportunity set allows the investor a new choice for portfolio optimization

The optimal international portfolio (IP) allows the investor to maximize return per unit of risk more so than would be received with just a domestic portfolio

108

The Gains from International Portfolio Diversification

109

International Diversification Kroenckez and Schindler[2011] Ten Regions: US Australia, Canada,

France, Hong Kong, Japan, the Netherlands, Singapore, Sweden, and the UK

Three Major Asset Classes: Equity, Government Bond, Real Estate

27 Years of Monthly Return: 1984-2010 With and without hedging FX risk.

109

110110

111111

112112

Road Map

InternationalFinancial RiskManagement

International Monetary

System

SourcingCapital in

Global Markets

ManagingFOREX

Exposure

ForeignInvestmentDecisions

Synthesis

113

China’s Financial System

OverviewDecision Making SystemPolicy BankCommercial BankChina’s Equity MarketChina’s Bond Market

Growth of China

114

115

Overview

Over the past two decades, financial sector reform has been lagged behind due to sensitivity and complexity issues.

Financial market is featured as being transitional and innovative.

90% of the financing is made through indirect financing controlled by banking system, with direct financing lacking.

116

Decision Making System of China’s Financial Sector

People’s bank of China Ministry of finance National development and reform

commission Ministry of commerce China banking regulatory commission China securities regulatory commission China insurance regulatory commission

117

Policy Banks

National Development Bank Function: Providing long-term financing support for

key projects promoted by government economic plan, e.g. three gorges, gas transfer, etc.

China Import & Export Bank The institution fully owned by government, Providing export credit,

Agricultural Development Bank Mainly to provide current fund for

procurement of grain, cotton, oil, etc

118

Commercial Banks The Big Five national commercial banks 中国工商银行

China Industrial and Commercial Bank 中国农业银行

China Agriculture Bank 中国银行

Bank of China 中国建设银行

China Construction Bank 交通银行

Bank of Communications

119

China’s Banking System Reform by Phases

o 1984－ 1994，o Specialization reform: dual function with division of

responsibility among bankso 1994－ 2003，

Reform of State-owned commercial banks 1994,Separation of policy financing and commercial

financing 1997, with lessons from Asian financial crisis, formed 4

capital asset management corporation to deal with bad loans in commercial banks, to issue special national bond to supplement capital asset of commercial banks, etc.

o 2004 - Now，o 2004, State dominated share holding system reform in

commercial bank.

Other Banks

City Banks Formerly credit unions Beijing Bank Shanghai Bank, etc.

Joint-Stock Banks Minsheng Bank （民生银行） Merchants Bank of Zhejiang （浙商银行）

Post Savings Bank （邮政储蓄）

120

The Financial System in China

The most salient aspect of the system is the dominant role of the State. The State owns controlling stakes in the five largest commercial banks and 100% of the three policy banks. (See Table 1.) The State also holds significant equity stakes in the remaining shareholding commercial banks and all of the postal savings banks, and has a heavy influence on the rural cooperative banks and credit societies

122

Equity Market in China

Only 20 years of history, rapidly grow into a market with more than1300 public companies.

Possessing the characteristics of an emerging and transitional market

With 6 years of depression, investors’ confidence was hit heavily. Nevertheless, many blue-chip companies remain.

Ongoing a reform, aiming at liberalizing trade of formerly non-tradable stock.

123

Growth of China’s Stock Market

10 14 53

177287 311

514

720825

923

10601133

12131287

1353

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

H 股 A 股 B 股

124

China’s Bond Markets

Insight into Chinese Bond Market

Size and composition of Chinese Bond Market

China’s Bond Market Outlook

125

Data source: www.bis.org; www.adb.org ; www.chinabond.com.cn

Indonesia

Hong K

ong,

China

Singapore

Thailand

Malaysia

Taipei, China

Mexico

Austria

Sw

eden

India

Dem

ark

Belgium

Australia

Korea

Holland

Brazil

Canada

UK

Spain

China

Germ

any

France

Italia

Japan

US

A

Corporate bond Treasury bond

Size of Local Currency Bond Markets (USD billion)

China’s OTC Market at a Glance

Bond Issuance

126

By the end of 2009, the RMB bond issuance reached 8.65 CNY trillion. Compared with 2008, the issuance amount grew 22%.

Data Source: www.chinabond.cn

66%

-30%

1%

32%

71%79%

54% 53%35% 40%

-11%

22%

-40%

-20%

0%

20%

40%

60%

80%

100%

0.00

20,000.00

40,000.00

60,000.00

80,000.00

100,000.00

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Bond Issuance

Issuance (CNY billion) Growth Rate (%)

Bond Issuers Profile

127

Treasury Bonds18.80%

Central Bank Bonds46.08%

Policy Bank Bonds13.54%

Commercial Bank Bonds3.30%

Corporate Bonds4.93%

Commercial Papers5.35%

ABS0.00%

Mid-term Notes7.98%

Collecting notes0.01%

International institution bonds

0.01%

ISSURANCE VOLUMES BY BOND TYPE (2009)

Treasury Bonds Central Bank Bonds Policy Bank BondsCommercial Bank Bonds Corporate Bonds Commercial PapersABS Mid-term Notes Collecting notesInternational institution bonds

The MOF, central bank and policy banks are the major issuers. The Issuance of treasury bonds, central bank bills and policy bank bonds are 78% of the total bond issuance.


Bond Issuance Maturity

128

The bond maturity favors shorter than 3 year.


64%10%

8%

6%

7%5%

Issuance by Bond Maturity(2009)

<1Y 1-3Y 3-5Y 5-7Y 7-10Y >10Y

05000

10000150002000025000300003500040000

Bond Maturity Profile (2009)

<1Y 1-3Y 3-5Y 5-7Y 7-10Y >10Y

Bond Deposit Value

129

By the end of 2009, the RMB bond outstanding reached CNY 17.5 trillion, about 52.3% of GDP.

Treasury bond, central bank bills and policy bank bonds are the main depository bond type.

Number under custody

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

180,000

200,000

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Depo

sitor

y Bala

nce

(CNY

Billi

on)

The RMB Bond Depository Balance

33%

24%

26%

3% 6%

3%5%

0%

0%

0%0%

Depository Balance by Bond Type (2009)

Treasury Bonds Central Bank BondsPolicy Bank Bonds Commercial Bank BondsCorporate Bonds Commercial PapersMid-term Notes Collecting notesABS International institution bondsothers


Bond Investors Profile

130

11%

69%

3%

0%1%

9%

4%

0% 1%2%

0%

RMB Bonds Investores Profile

Special Members Commercial Banks Credit Cooperative BanksNon-bank Financial institutions Securuties Companies Insurance InstitutionsFunds Non-financial institutions Individuals Exchanges Others

Commercial banks are the major investors of RMB bond

Notes: commercial banks include national banks and foreign banks.


Bond Investors Profile

131

Foreign banks’ holdings in China’s bond markets are rising.

2005 2006 2007 2008 2009 2010.4

13.35 38.63

95.79 117.83

157.63 173.78

Foreign Hondings of RMB Bonds(USD billion)


Bond Settlement

132

226.59

325.37

250.87

150.75 159.13

42.37

-15.54

78.76 67.83 64.59 60.50 20.47

-50.00

0.00

50.00

100.00

150.00

200.00

250.00

300.00

350.00

0

20000

40000

60000

80000

100000

120000

140000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Bond Settlement

Settlement (CNY billion) Growth Rate (%)

By the end of 2009, the bond settlement of OTC market achieved 122 CNY trillion.


Bond Settlement

133

0 50

100 150 200 250 300 350 400 450

Treasuy Bond Central Bank Bills

Policy Bank Bonds

Corporate Bonds

International Institutuion

Bonds

237

374 401

208

0

Bond Settlement by Bond Type (CNY Trillion)

19%

31%33%

17%

0%

Bond Settlement by Bond Type (%)

Treasuy Bond

Central Bank Bills

Policy Bank Bonds

Corporate Bonds

International Institutuion Bonds

Central bank bills and policy bank bonds generated the highest bond settlement values.



134

Ratio of Bonds Outstanding to GDP

COUNTRIES Treasury Bond (%) Corporate Bond (%) Total (%)

US 70.41 169.15 239.56

KOREA 52.3 61.6 113.9

MALAYSIA 51.4 42.8 94.2

HONGKONG, CHINA 25.6 35.6 61.2

SIGAPORE 48 33.8 81.8

JAPAN 169.6 18.9 188.5

THAILAND 51.6 13.5 65.1

CHINA MAINLAND 43 9.2 52.2

PHILIPINES 33.4 4.6 38

INDONESIA 15 1.6 16.6

The issuance, deposit and settlement values of corporate bond are expected to grow fast.


135

124%

-7%8%

94%

18%

-12%

21%

77%

13%-22%

68%

150%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

140%

160%

Treasuy Bond Central Bank Bills Policy Bank Bonds Corporate Bonds

Growth Rate by Bond Type

Issuance values Deposit values Settlement values


136

The number of non-legal representative investors are expected to increase.

Since 2007, the central bank has permitted supplementary pension, insurance products, trust units and asset management plans to open account in the OTC market.

In 2009, the OTC market increased 941 investors, and the number of increased non-legal representative investors are 525(55.8%).


137

To allow qualified foreign investors to invest in the Chinese inter-bank bond market.

To allow qualified foreign institutions to issue RMB bonds in China, such as the South Korean Government.

To regulate the credit rating system, allowing investors to choose bond credit rating agencies by voting on www.chinabond.com.cn.


Doing Business in China

“Doing business in China can be one of the riskiest yet most rewarding undertakings for the most experienced multinational corporations right through to companies venturing abroad. It is not only the world’s most populous nation with 1.2 billion consumers and one of the fastest booming economies enjoying double-digit growth rates in recent years but China is also a society experiencing breakneck development, an ongoing shift to a market economy and evolution in the rule of law. The opportunities are obvious and so are the challenges.”

--Alastair da Costa, Managing Director, Asia, DLA Piper

138

Investing in China

Import/Export Supply Chain Real Estate Real Estate Investment Trusts

139

Sourcing Capital in China

Obtaining Financing Initial Public Offering Private Equity Venture Capital

140

141

Housing Crisis and Its Impact

Subprime Crisis in 2008 Europe Sovereign Debt Crisis in 2011 Why did it happen? What can we do about it?

141

1 globalization, finance & china jian chen [email protected] prepared for eseune gemmba program...

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