Implications for Business

The implications of the material discussed in this chapter for international business are quite straightforward but no less important for being obvious. The growth of the global capital market has created opportunities for international businesses that wish to borrow and/or invest money. On the borrowing side, by using the global capital market, firms can often borrow funds at a lower cost than is possible in a purely domestic capital market. This conclusion holds no matter what form of borrowing a firm uses--equity, bonds, or cash loans. The lower cost of capital on the global market reflects their greater liquidity and the general absence of government regulation. Government regulation tends to raise the cost of capital in most domestic capital markets. The global market, being transnational, escapes regulation. Balanced against this, however, is the foreign exchange risk associated with borrowing in a foreign currency.

On the investment side, the growth of the global capital market is providing opportunities for firms, institutions, and individuals to diversify their investments to limit risk. By holding a diverse portfolio of stocks and bonds in different nations, an investor can reduce total risk to a lower level than can be achieved in a purely domestic setting. Once again, however, foreign exchange risk is a complicating factor.

The trends noted in this chapter seem likely to continue, with the global capital market continuing to increase in both importance and degree of integration over the next decade. Perhaps the most significant development will be the emergence of a unified capital market and common currency within the EU by the end of the decade as those countries continue toward economic and monetary union. Since Europe's capital markets are currently fragmented and relatively introspective (with the major exception of Britain's capital market), such a development could pave the way for even more rapid internationalization of the capital market in the early years of the next century. If this occurs, the implications for business are likely to be positive.

Chapter Summary

This chapter explained the functions and form of the global capital market and defined the implications of this for international business practice. This chapter made the following points:

1. The function of a 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 available for borrowing, and this makes for a lower cost of capital for borrowers.

3. Relative to a domestic capital market, the global capital market allows investors to diversify portfolios of holdings internationally, thereby reducing risk.

4. The growth of the global capital market during recent decades can be attributed to advances in

information technology, the widespread deregulation of financial services, and the relaxation of regulations governing cross-border capital flows.

5. A eurocurrency is any currency banked outside its country of origin. The lack of government regulations makes the eurocurrency market attractive to both depositors and borrowers. Due to the absence of regulation, the spread between the eurocurrency deposit and lending rates is less than the spread between 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. Foreign bonds are sold outside of the borrower's country and are denominated in the currency of the country in which they are issued. A eurobond issue is normally underwritten by an international syndicate of banks and placed in countries other than the one in whose currency the bond is denominated. Eurobonds account for the lion's share of international bond issues.

7. The eurobond market is an attractive way for companies to raise funds due to the absence of regulatory interference, less stringent disclosure requirements, and eurobonds' favorable tax status.

8. Foreign investors are investing in other countries' equity markets to reduce risk by diversifying their stock holdings among nations.

9. Many companies are now listing their stock in the equity markets of other nations, primarily as a prelude to issuing stock in those markets to raise additional capital. Other reasons for listing stock in another country's exchange are to facilitate future stock swaps; to enable the company to use its stock and stock options for compensating local management and employees; to satisfy local ownership desires; and to increase the company's visibility among its local employees, customers, suppliers, and bankers.

10. When borrowing funds from the global capital market, companies must weigh the benefits of a lower interest rate against the risks of greater real costs of capital due to adverse exchange rate movements.

11. One major implication of the global capital market for international business is that companies can often borrow funds at a lower cost of capital in the international capital market than they can in the domestic capital market.

12. The global capital market provides greater opportunities for businesses and individuals to build a truly diversified portfolio of international investments in financial assets, which lowers risk.

Critical Discussion Questions

1. Why has the global capital market grown so rapidly in recent decades? Do you think this growth will continue throughout the 2000s? Why?

2. A 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 recommendation. How might your recommended options be affected if the Mexican peso depreciates significantly on the foreign exchange markets over the next two years?

3. 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:

   1. Borrowing US dollars from Security Pacific Bank at 8 percent.

   2. Borrowing British pounds from Midland Bank at 14 percent.

   3. Borrowing Japanese yen from Sanwa bank at 5 percent.

If Happy borrows foreign currency, it will not cover it; that is, it will simply change foreign 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 the dollar and the yen will appreciate 3 percent relative to the dollar in the next year. From which bank should Happy Company borrow?

Closing Case The Search for Capital in the Czech Republic

Following the collapse of communism and the shift toward a more market-oriented system, the Czech Republic initially emerged as one of the more vibrant and market-driven economies in Eastern Europe. By early 1998, however, the economic development of the Czech Republic was being held back by a shortage of capital. The problem was rooted in macroeconomic conditions and institutional problems.

On the macroeconomic front, 1997 saw a combination of adverse developments, including a rise in inflation, a growing government deficit, and a speculative attack on the Czech currency that forced the government to abandon its fixed exchange rate policy for a floating exchange rate system. After the shift to a floating exchange rate system, the Czech currency declined by about 10 percent against the German deutsche mark and over 15 percent against the US dollar. Since many internationally traded commodities, such as oil, are traded in dollars, this devaluation added fuel to the Czech Republic's inflation rate fire. The government responded 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 PX50, 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 Poland, where macroeconomic conditions were more favorable and where local stock markets were performing better.

But that wasn't the only problem for the Prague stock market. Many Western investors had been discouraged from investing in Czech stocks by the poor reputation of the Prague stock exchange. That institution is reportedly rife with stock manipulation by insiders, insider trading that would be illegal in more developed markets, a lack of protection for minority stockholders, poor corporate reporting, and fraud. Also, most state-owned enterprises in the Czech Republic were privatized through a voucher scheme that has left the majority of shareholdings in the hands of institutions and groups that are preoccupied with maintaining control over their companies and opposed to any attempt to raise capital through new equity issues. Consequently, the Prague stock market is small and liquidity is very limited.

These factors have combined to increase the cost of capital for individual Czech enterprises. Traditionally, many Czech firms forged tight relationships with banks and borrowed money from them. However, with interest rates at 16 percent and many banks reining in credit to make up for past largesse, it was increasingly expensive for Czech companies to raise capital through borrowings. As for the Czech stock market, its poor reputation and low liquidity made it almost impossible to raise capital by issuing new shares. In mid-1997, one of the Czech Republic's most dynamic and profitable new enterprises, Bonton, a film and music company, attempted to raise $30 to $40 million through an initial 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 successful 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 financial crisis.

Despite all these problems, most agree that the Czech economy has a bright future. However, this future cannot be realized unless Czech companies can raise the capital to invest in the necessary plants and equipment. A number of prominent Czech companies in 1998 announced their intentions to make international equity issues. At the beginning of 1997, only two Czech companies had foreign listings, both of them large banks. However, another five significant companies sought listings on the London stock exchange in 1998. In a sign that this strategy may work, the first to list was Ceske Radiokomunikace, a state-owned radio, television, and telecommunications company that successfully raised $134 million in equity by listing Global Depository Receipts on the London exchange, increasing its equity by 36 percent and decreasing the state holding in the company to around 51 percent.

http://www.henge.com/~vspina/index.shtml

Source: R. Anderson, "Czech Groups Cast Their Net Abroad in Search of Funds," Financial Times, May 26, 1997, p. 27; V. Boland, "The Czech Stockmarket: Looking Beyond Recent Turmoil," Financial Times, December 1, 1997, p. 4; and "Ceske Radiokomunikace Equity Offer Raises $134 million," Financial Times, May 27, 1998, p. 38.