Global corporate finance - Kim

314 INTERNATIONAL BANKING ISSUES AND COUNTRY RISK ANALYSIS

SUMMARY

This chapter has discussed international banking operations, international loans, and country risk analysis. The management of international banks is more complex than that of domestic banks. Country risk analysis illustrates this problem. Recent events in many debtor countries have brought analysts and investors to question international bankers about loans to economically risky countries. For some banks, international lending can be as important as their domestic operations. Thus, international banks must reduce the impact of country risk through systematic assessment and management.

Questions

1Discuss the types of functions that international banks perform.

2Discuss the types of foreign banking offices.

3What were the two major causes of the Asian financial crisis of 1997–8?

4What are major differences between domestic and foreign loans?

5What were the major causes of the international debt crisis of the 1980s?

6Explain the various steps taken by debtor countries and international banks to solve the international debt problems of the 1980s.

7What is syndicated lending? Why do banks sometimes prefer this form of lending?

8What is country risk? How can we assess country risk?

9Describe policy responses to solve the Asian crisis.

Problems

1In addition to the two debt ratios described in this chapter, the World Bank recommends the use of four additional debt ratios in assessing a country’s risk: the ratio of total external debt to GNP, the ratio of total external debt to exports, the debt-service ratio (accrued debt service to exports), and the interest-service ratio (accrued interest service to exports). In 1998, Mexico had $380 billion in gross national product (GNP), $160 billion in total external debt, $140 billion in exports, and $29 billion in accrued debt service, and $13 billion in accrued interest service. Calculate the above four debt ratios for Mexico.

2In 1998, Poland had $157 billion in GNP, a debt-to-GNP ratio of 0.32, a debt-to-export ratio of 1.12, a debt-service ratio of 0.11, and an interest-service ratio of 0.06. Calculate

316 INTERNATIONAL BANKING ISSUES AND COUNTRY RISK ANALYSIS

Case Problem 12: The World Bank

Representatives of 44 governments founded the World Bank on July 1, 1944, during their conference at Bretton Woods, New Hampshire. The Bank is a sister institution to the International Monetary Fund (IMF), but has a separate, distinct objective. The Bank was largely the brainchild of the economist John Maynard Keynes, who envisioned an institution that would initially focus on postwar reconstruction in Europe and Asia and then shift to focusing on development of poor countries. As such, the Bank’s overriding modern purpose is to spur development worldwide through loans and grants to underdeveloped countries. To help stress this goal, the mission statement of the Bank is the elegant and simple sentence: “Our dream is a world free from poverty.”

The Bank consists of 184 countries that all share this goal. Membership of the Bank is only allowed for countries that are first members of the IMF. Typically, countries join both organizations. Member countries are shareholders who carry ultimate decision-making power in the World Bank. Each member nation appoints a Governor and an Alternate Governor to carry out these responsibilities. The Board of Governors, who are usually officials such as Ministers of Finance or Planning, meets annually at the Bank’s Meetings each fall. The chairperson of the Board of Governors is the President of the World Bank. The governors decide on key Bank policy issues, admit or suspend country members, decide on changes in the authorized capital stock, determine the distribution of income, and endorse financial statements and budgets.

Specifically, their policy discussions during the annual meetings cover a variety of issues, such as poverty reduction, international economic development, and global development finance. This annual gathering provides a forum for international cooperation and enables the Bank to better serve its member countries. The meetings are traditionally held in Washington two years out of three and, in order to reflect the international character of the two institutions (the World Bank and the IMF), every third year in a different member country.

Because these ministers meet only once a year, the bulk of the Governors’ powers are delegated throughout the year to the Board of Executive Directors. Every member government of the World Bank Group is represented at the Bank’s headquarters in Washington, DC, by an Executive Director. The five largest shareholders – France, Germany, Japan, the UK, and the USA – each appoint an Executive Director, while the other member countries are represented by 19 Executive Directors who are elected by groups of countries (constituents). Some countries – China, Russia, and Saudi Arabia – have formed single-country constituencies, while others have joined together in multi-country constituencies. The 24 Executive Directors normally meet twice a week to oversee the Bank’s business, such as loan applications and guarantees, new policies, the administrative budget, country assistance strategies, and borrowing and financial decisions.

The World Bank is part of a larger organization, the World Bank Group. The World Bank Group consists of five closely associated institutions, all owned by member countries that carry ultimate decision-making power. As explained below, each institution plays a distinct role in the mission to fight poverty and improve living standards for people in the developing world.

The term “World Bank Group” encompasses all five institutions. The term “World Bank” refers specifically to two of the five, the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA). Table 12.9 shows a brief summary of each organization that makes up the World Bank Group.

The Bank has taken some specific actions that it rightly boasts about. It has become the world’s largest external funder of education. Since its education funding began in 1963, the World Bank has provided some $31 billion in loans and credits, and it currently finances 158 education projects in 83 countries. It is also the largest external funder of the fight against AIDS/HIV. As a co-sponsor of UNAIDS, which coordinates the global response to the epidemic, the Bank has committed more than $1.7 billion to combating the spread of HIV/AIDS around the world. The Bank has pledged that no country with an effective HIV/AIDS strategy will go without funding and, in partnership with African governments, it has launched the MultiCountry HIV/AIDS Program (MAP), which makes significant resources available to civil society organizations and communities.

Case Questions

1Table 12.9 summarizes the five organizations of the World Bank Group, and this chapter has discussed the Asian financial crisis. How might each part of the World Bank Group have helped after the crisis started?

Table 12.9 The organization of the World Bank Group

318 INTERNATIONAL BANKING ISSUES AND COUNTRY RISK ANALYSIS

Table 12.9 (continued)

2Many critics claim that the World Bank Group is too large and attempts to do too much. Additionally, they claim that many of the Bank’s activities overlap with the work of the World Trade Organization, the International Monetary Fund, and the United Nations. How valid do you find this criticism?

3Imagine that you are the President of the World Bank. Who are your most powerful constituents? How much power do you have? Would you want this job?

4What are the major differences between the IMF and the World Bank?

5Visit the World Bank’s website, www.worldbank.org, to discover its current projects.

Sources: J. Einhorn, “The World Bank’s Mission Creep,” Foreign Affairs, Vol. 80, No. 5, pp. 22–35; M. M. Phillips, “World Bank Rethinks Strategy for Poor: Political Change is Necessary, Not Economic Growth Alone, a Study Suggests,” The Wall Street Journal, Sept. 13, 2000, p. A2; and www.worldbank.org.

CHAPTER 13

Financing Foreign Trade

Opening Case 13: US Export–Import Bank Seeks Private Investors

The official US export finance agency is seeking private investors to help it provide billions of dollars in loan guarantees and risk insurance for American exporters. On February 16, 2000, the Export–Import Bank (Ex–Im Bank) asked investment banks, commercial banks, insurance companies, and other financial institutions for proposals on how they might share the risks and rewards from future Ex–Im Bank financial deals. The Ex–Im Bank, which supported almost $17 billion in US sales overseas in 1999, hopes to raise $1 billion or more through this new proposal.

In essence, the Ex–Im Bank wants to sell, to one or more partners, stakes in future export-financing deals, in the hopes of making its own resources go further at a time when the US trade deficit is piling on the records. The agency is leaving it up to the private financial institutions – American or foreign – to come up with a creative way to structure the deal. The idea is for a private partner to put a certain amount of money or credit at Ex–Im Bank’s disposal, and then share in Ex–Im Bank’s fees. The financial institution might limit how that investment can be used – perhaps setting a dollar limit for a particular country – but not approve or reject individual Ex–Im Bank decisions.

In an unusual move, the agency put 1,500 pages of its own financial and institutional information on a website to make it easier for potential investors to perform due-diligence research. Hoping for quick action, the Ex–Im Bank held a pre-proposal conference on March 7, 2000. Ex–Im Bank officials first conceived of the idea in 1997. Private institutions showed interest, but pulled back soon after the Asian financial crisis sent US banks and investors fleeing the developing markets. Ex–Im Bank revived the concept after the crisis subsided.

Source: M. M. Philips, “Ex–Im Bank Seeks Investors for Guarantees,” The Wall Street Journal, Feb. 16, 2000, p. B10.

320 FINANCING FOREIGN TRADE

This book emphasizes financial problems that arise when managing multinational operations. However, the financial manager of a multinational company (MNC) must be familiar with certain mechanics of financing foreign trade, because most MNCs are frequently engaged in foreign trade activities.

This chapter consists of three major sections. The first section discusses three basic documents involved in foreign trade: the draft, the bill of lading, and the letter of credit. The second section analyzes the various payment terms of foreign trade. The third section describes the major sources of financing foreign trade.

13.1 Basic Documents in Foreign Trade

Three important documents involved in foreign trade are:

1A draft, which is an order to pay.

2A bill of lading, which is a document involved in the physical movement of the merchandise by a common carrier.

3A letter of credit, which is a third-party guarantee of the importer’s creditworthiness.

13.1.1Basic objectives of documentation

Documentation in foreign trade is supposed to assure that the exporter will receive the payment and the importer will receive the merchandise. More specifically, a number of documents in foreign trade are used to eliminate noncompletion risk, to reduce foreign-exchange risk, and to finance trade transactions.

NONCOMPLETION RISK The risk of noncompletion is greater in foreign trade than in domestic trade. This is why exporters want to keep title to the goods until they are paid and importers are reluctant to pay until they receive the goods. Foreign trade and domestic trade use different instruments and documents. Most domestic sales are on open-account credit. Under this credit, a buyer does not need to sign a formal debt instrument, because credit sales are made on the basis of a seller’s credit investigation of the buyer. Buyers and sellers are typically farther apart in foreign trade than in domestic trade. Thus, the sellers are seldom able to ascertain the credit standing of their overseas customers. The buyers may also find it difficult to determine the integrity and reputation of the foreign sellers from whom they wish to buy. Much of this noncompletion risk is reduced through the use of three key documents: the draft, the bill of lading, and the letter of credit.

FOREIGN-EXCHANGE RISK Foreign-exchange risk arises when export sales are denominated in a foreign currency and are paid at a delayed date. In international trade, the basic foreignexchange risk is a transaction risk. Transaction risk is the potential exchange loss from outstanding obligations as a result of exchange rate fluctuations. Forward contracts, futures contracts, currency options, and currency denomination practices can be used to reduce foreign-exchange risk associated with foreign trade.

TRADE FINANCING Because all foreign trade involves a time lag, funds are tied up in the shipment of goods for some period of time. Most trade transactions are free of noncompletion and foreign-exchange risks due to well-drawn trade documents and forward contracts. Banks are thus willing to finance goods in transit or even prior to shipment. Financial institutions at both ends of the cycle offer a variety of financing alternatives that reduce or eliminate either party’s (exporter or importer) working capital needs.

13.1.2 Drafts

A draft or a bill of exchange is an order written by an exporter that requires an importer to pay a specified amount of money at a specified time. Through the use of drafts, the exporter may use its bank as the collection agent on accounts that the exporter finances. The bank forwards the exporter’s drafts to the importer directly or indirectly (through a branch or a correspondent bank) and then remits the proceeds of the collection back to the exporter.

A draft involves three parties: the drawer or maker, the drawee, and the payee. The drawer is a person or business issuing a draft. This person is ordinarily the exporter who sells and ships the merchandise. The drawee is a person or business against whom the draft is drawn. This person is usually an importer who must pay the draft at maturity. The payee is a person or business to whom the drawee will eventually pay the funds. A draft designates a person or bank to whom payment is to be made if the draft is not a negotiable instrument. Such a person, known as the payee, may be the drawer himself or a third party such as the drawer’s bank. However, this is generally not the case, because most drafts are a bearer instrument. Drafts are negotiable if they meet a number of conditions:

1They must be in writing and signed by the drawer–exporter.

2They must contain an unconditional promise or order to pay an exact amount of money.

3They must be payable on sight or at a specified time.

4They must be made out to order or to the bearer.

If a draft is made to order, the funds involved should be paid to the person specified. If it is made to the bearer, the funds should be paid to the person who presents it for payment.

When a draft is presented to a drawee, the drawee or his bank accepts it. This acceptance acknowledges in writing the drawee’s obligation to pay a sum indicated on the face of the draft. When drafts are accepted by banks, they become bankers’ acceptances. Because bankers’ acceptances are highly marketable, the exporter can sell them in the market or discount them at his bank. Whenever they are sold or discounted, the seller adds his endorsement on the back of the draft. In the event an importer fails to pay at maturity, the holder of the draft will have recourse for the full amount of the draft from the last endorser.

Drafts are used in foreign trade for a number of reasons:

1They provide written evidence of obligations in a comprehensive form.

2They allow both the exporter and the importer to reduce the cost of financing and to divide the remaining cost equitably.

3They are negotiable and unconditional; that is, drafts are not subject to disputes that may occur between the parties involved.