Foreign Exchange and the Global Capital Markets
Read this chapter to learn about currencies, foreign exchange rates, and global capital markets. It gives us a real-world example of a company that has to deal with different currencies. Small changes in the daily foreign currency market can significantly affect a company's costs and profitability. At the end of the chapter, read the ethical dilemmas. What would your responses be? Would you recommend that Walmart set up an offshore company? Why or why not?
Understanding International Capital Markets
Learning Objectives
- Understand the purpose of capital markets, domestic and international.
- Explore the major components of the international capital markets.
- Understand the role of international banks, investment banks, securities firms, and financial institutions.
What Are International Capital Markets?
A
capital market is basically a system in which people, companies, and
governments with an excess of funds transfer those funds to people,
companies, and governments that have a shortage of funds. This transfer
mechanism provides an efficient way for those who wish to borrow or
invest money to do so. For example, every time someone takes out a loan
to buy a car or a house, they are accessing the capital markets. Capital
markets carry out the desirable economic function of directing capital
to productive uses.
There are two main ways that someone accesses
the capital markets - either as debt or equity. While there are many
forms of each, very simply, debt is money that's borrowed and must be
repaid, and equity is money that is invested in return for a percentage
of ownership but is not guaranteed in terms of repayment.
In
essence, governments, businesses, and people that save some portion of
their income invest their money in capital markets such as stocks and
bonds. The borrowers (governments, businesses, and people who spend more
than their income) borrow the savers' investments through the capital
markets. When savers make investments, they convert risk-free assets
such as cash or savings into risky assets with the hopes of receiving a
future benefit. Since all investments are risky, the only reason a saver
would put cash at risk is if returns on the investment are greater than
returns on holding risk-free assets. Basically, a higher rate of return
means a higher risk.
For example, let's imagine a beverage
company that makes $1 million in gross sales. If the company spends
$900,000, including taxes and all expenses, then it has $100,000 in
profits. The company can invest the $100,000 in a mutual fund (which are
pools of money managed by an investment company), investing in stocks
and bonds all over the world. Making such an investment is riskier than
keeping the $100,000 in a savings account. The financial officer hopes
that over the long term the investment will yield greater returns than
cash holdings or interest on a savings account. This is an example of a
form of direct finance. In other words, the beverage company bought a
security issued by another company through the capital markets. In
contrast, indirect finance involves a financial intermediary between the
borrower and the saver. For example, if the company deposited the money
in a savings account, and then the savings bank lends the money to a
company (or a person), the bank is an intermediary. Financial
intermediaries are very important in the capital marketplace. Banks lend
money to many people, and in so doing create economies of scale. This
is one of the primary purposes of the capital markets.
Capital
markets promote economic efficiency. In the example, the beverage
company wants to invest its $100,000 productively. There might be a
number of firms around the world eager to borrow funds by issuing a debt
security or an equity security so that it can implement a great
business idea. Without issuing the security, the borrowing firm has no
funds to implement its plans. By shifting the funds from the beverage
company to other firms through the capital markets, the funds are
employed to their maximum extent. If there were no capital markets, the
beverage company might have kept its $100,000 in cash or in a low-yield
savings account. The other firms would also have had to put off or
cancel their business plans.
International capital markets are
the same mechanism but in the global sphere, in which governments,
companies, and people borrow and invest across national boundaries. In
addition to the benefits and purposes of a domestic capital market,
international capital markets provide the following benefits:
- Higher returns and cheaper borrowing costs. These allow companies and governments to tap into foreign markets and access new sources of funds. Many domestic markets are too small or too costly for companies to borrow in. By using the international capital markets, companies, governments, and even individuals can borrow or invest in other countries for either higher rates of return or lower borrowing costs.
- Diversifying risk. The international capital markets allow individuals, companies, and governments to access more opportunities in different countries to borrow or invest, which in turn reduces risk. The theory is that not all markets will experience contractions at the same time.
The structure of the capital markets falls into two
components - primary and secondary. The primary market is where new
securities (stocks and bonds are the most common) are issued. If a
corporation or government agency needs funds, it issues (sells)
securities to purchasers in the primary market. Big investment banks
assist in this issuing process as intermediaries. Since the primary
market is limited to issuing only new securities, it is valuable but
less important than the secondary market.
The vast majority of
capital transactions take place in the secondary market. The secondary
market includes stock exchanges (the New York Stock Exchange, the London
Stock Exchange, and the Tokyo Nikkei), bond markets, and futures and
options markets, among others. All these secondary markets deal in the
trade of securities. The term securities includes a wide range of
financial instruments. You're probably most familiar with stocks and
bonds. Investors have essentially two broad categories of securities
available to them: equity securities, which represent ownership of a
part of a company, and debt securities, which represent a loan from the
investor to a company or government entity.
Creditors, or debt
holders, purchase debt securities and receive future income or assets in
return for their investment. The most common example of a debt
instrument is the bond. When investors buy bonds, they are lending the
issuers of the bonds their money. In return, they will receive interest
payments usually at a fixed rate for the life of the bond and receive
the principal when the bond expires. All types of organizations can
issue bonds.
Stocks are the type of equity security with which
most people are familiar. When investors buy stock, they become owners
of a share of a company's assets and earnings. If a company is
successful, the price that investors are willing to pay for its stock
will often rise; shareholders who bought stock at a lower price then
stand to make a profit. If a company does not do well, however, its
stock may decrease in value and shareholders can lose money. Stock
prices are also subject to both general economic and industry-specific
market factors.
The key to remember with either debt or equity
securities is that the issuing entity, a company or government, only
receives the cash in the primary market issuance. Once the security is
issued, it is traded; but the company receives no more financial benefit
from that security. Companies are motivated to maintain the value of
their equity securities or to repay their bonds in a timely manner so
that when they want to borrow funds from or sell more shares in the
market, they have the credibility to do so.
For companies, the
global financial, including the currency, markets (1) provide stability
and predictability, (2) help reduce risk, and (3) provide access to more
resources. One of the fundamental purposes of the capital markets, both
domestic and international, is the concept of liquidity, which
basically means being able to convert a noncash asset into cash without
losing any of the principal value. In the case of global capital
markets, liquidity refers to the ease and speed by which shareholders
and bondholders can buy and sell their securities and convert their
investment into cash when necessary. Liquidity is also essential for
foreign exchange, as companies don't want their profits locked into an
illiquid currency.
Major Components of the International Capital Markets
International Equity Markets
Companies
sell their stock in the equity markets. International equity markets
consists of all the stock traded outside the issuing company's home
country. Many large global companies seek to take advantage of the
global financial centers and issue stock in major markets to support
local and regional operations.
For example, ArcelorMittal is a
global steel company headquartered in Luxembourg; it is listed on the
stock exchanges of New York, Amsterdam, Paris, Brussels, Luxembourg,
Madrid, Barcelona, Bilbao, and Valencia. While the daily value of the
global markets changes, in the past decade the international equity
markets have expanded considerably, offering global firms increased
options for financing their global operations. The key factors for the
increased growth in the international equity markets are the following:
- Growth of developing markets. As developing countries experience growth, their domestic firms seek to expand into global markets and take advantage of cheaper and more flexible financial markets.
- Drive to privatize. In the past two decades, the general trend in developing and emerging markets has been to privatize formerly state-owned enterprises. These entities tend to be large, and when they sell some or all of their shares, it infuses billions of dollars of new equity into local and global markets. Domestic and global investors, eager to participate in the growth of the local economy, buy these shares.
- Investment banks. With the increased opportunities in new emerging markets and the need to simply expand their own businesses, investment banks often lead the way in the expansion of global equity markets. These specialized banks seek to be retained by large companies in developing countries or the governments pursuing privatization to issue and sell the stocks to investors with deep pockets outside the local country.
- Technology advancements. The expansion of technology into global finance has opened new opportunities to investors and companies around the world. Technology and the Internet have provided more efficient and cheaper means of trading stocks and, in some cases, issuing shares by smaller companies.
International Bond Markets
Bonds are the most common form of debt instrument, which is basically a loan from the holder to the issuer of the bond. The international bond market consists of all the bonds sold by an issuing company, government, or entity outside their home country. Companies that do not want to issue more equity shares and dilute the ownership interests of existing shareholders prefer using bonds or debt to raise capital (i.e., money). Companies might access the international bond markets for a variety of reasons, including funding a new production facility or expanding its operations in one or more countries. There are several types of international bonds, which are detailed in the next sections.
Foreign Bond
A foreign bond is a bond sold by a company, government, or entity in another country and issued in the currency of the country in which it is being sold. There are foreign exchange, economic, and political risks associated with foreign bonds, and many sophisticated buyers and issuers of these bonds use complex hedging strategies to reduce the risks. For example, the bonds issued by global companies in Japan denominated in yen are called samurai bonds. As you might expect, there are other names for similar bond structures. Foreign bonds sold in the United States and denominated in US dollars are called Yankee bonds. In the United Kingdom, these foreign bonds are called bulldog bonds. Foreign bonds issued and traded throughout Asia except Japan, are called dragon bonds, which are typically denominated in US dollars. Foreign bonds are typically subject to the same rules and guidelines as domestic bonds in the country in which they are issued. There are also regulatory and reporting requirements, which make them a slightly more expensive bond than the Eurobond. The requirements add small costs that can add up given the size of the bond issues by many companies.
Eurobond
A Eurobond is a bond issued outside the country in whose currency it is denominated. Eurobonds are not regulated by the governments of the countries in which they are sold, and as a result, Eurobonds are the most popular form of international bond. A bond issued by a Japanese company, denominated in US dollars, and sold only in the United Kingdom and France is an example of a Eurobond.
Global Bond
A global bond is a bond that is sold simultaneously in several global financial centers. It is denominated in one currency, usually US dollars or Euros. By offering the bond in several markets at the same time, the company can reduce its issuing costs. This option is usually reserved for higher rated, creditworthy, and typically very large firms.
Did You Know?
As
the international bond market has grown, so too have the creative
variations of bonds, in some cases to meet the specific needs of a buyer
and issuer community. Sukuk, an Arabic word, is a type of financing
instrument that is in essence an Islamic bond. The religious law of
Islam, Sharia, does not permit the charging or paying of interest, so
Sukuk securities are structured to comply with the Islamic law. "An IMF
study released in 2007 noted that the Issuance of Islamic securities
(sukuk) rose fourfold to $27 billion during 2004–06. While 14 types of
sukuk are recognized by the Accounting and Auditing Organization of
Islamic Finance Institutions, their structure relies on one of the three
basic forms of legitimate Islamic finance, murabahah (synthetic
loans/purchase orders), musharakah/mudharabah (profit-sharing
arrangements), and ijara (sale-leasebacks), or a combination
thereof".
The
Economist notes "that by 2000, there were more than 200 Islamic
banks…and today $700 billion of global assets are said to comply with
sharia law. Even so, traditional finance houses rather than Islamic
institutions continue to handle most Gulf oil money and other Muslim
wealth".
"More worrying still, the rules for Islamic finance are
not uniform around the world. A Kuwaiti Muslim cannot buy a Malaysian
sukuk (sharia-compliant bond) because of differing definitions of what
constitutes usury (interest). Indeed, a respected Islamic jurist
recently denounced most sukuk as godless. Nor are banking licenses
granted easily in most Muslim countries. That is why big Islamic banks
are so weak. Often they are little more than loose collections of
subsidiaries. They also lack home-grown talent: most senior staff are
poached from multinationals". But in 2009, one entrepreneur, Adnan
Yousif, made headlines as he tried to change that and create the world's
biggest Islamic bank. While his efforts are still in progress, it's
clear that Islamic banking is a growing and profitable industry
niche".
Eurocurrency Markets
The
Eurocurrency markets originated in the 1950s when communist governments
in Eastern Europe became concerned that any deposits of their dollars
in US banks might be confiscated or blocked for political reasons by the
US government. These communist governments addressed their concerns by
depositing their dollars into European banks, which were willing to
maintain dollar accounts for them. This created what is known as the
Eurodollar - US dollars deposited in European banks. Over the years,
banks in other countries, including Japan and Canada, also began to hold
US dollar deposits and now Eurodollars are any dollar deposits in a
bank outside the United States. (The prefix Euro- is now only a
historical reference to its early days). An extension of the Eurodollar
is the Eurocurrency, which is a currency on deposit outside its country
of issue. While Eurocurrencies can be in any denominations, almost half
of world deposits are in the form of Eurodollars.
The Euroloan
market is also a growing part of the Eurocurrency market. The Euroloan
market is one of the least costly for large, creditworthy borrowers,
including governments and large global firms. Euroloans are quoted on
the basis of LIBOR, the London Interbank Offer Rate, which is the
interest rate at which banks in London charge each other for short-term
Eurocurrency loans.
The primary appeal of the Eurocurrency market
is that there are no regulations, which results in lower costs. The
participants in the Eurocurrency markets are very large global firms,
banks, governments, and extremely wealthy individuals. As a result, the
transaction sizes tend to be large, which provides an economy of scale
and nets overall lower transaction costs. The Eurocurrency markets are
relatively cheap, short-term financing options for Eurocurrency loans;
they are also a short-term investing option for entities with excess
funds in the form of Eurocurrency deposits.
Offshore Centers
The first tier of centers in the world are the world financial centers, which are in essence central points for business and finance. They are usually home to major corporations and banks or at least regional headquarters for global firms. They all have at least one globally active stock exchange. While their actual order of importance may differ both on the ranking format and the year, the following cities rank as global financial centers: New York, London, Tokyo, Hong Kong, Singapore, Chicago, Zurich, Geneva, and Sydney.
Did You Know?
The
Economist reported in December 2009 that a "poll of Bloomberg
subscribers in October found that Britain had dropped behind Singapore
into third place as the city most likely to be the best financial hub
two years from now. A survey of executives…by Eversheds, a law firm,
found that Shanghai could overtake London within the next ten
years". Many of these
changes in rank are due to local costs, taxes, and regulations. London
has become expensive for financial professionals, and changes in the
regulatory and political environment have also lessened the city's
immediate popularity. However, London has remained a premier financial
center for more than two centuries, and it would be too soon to assume
its days as one of the global financial hubs is over.
In addition
to the global financial centers are a group of countries and
territories that constitute offshore financial centers. An offshore
financial center is a country or territory where there are few rules
governing the financial sector as a whole and low overall taxes. As a
result, many offshore centers are called tax havens. Most of these
countries or territories are politically and economically stable, and in
most cases, the local government has determined that becoming an
offshore financial center is its main industry. As a result, they invest
in the technology and infrastructure to remain globally linked and
competitive in the global finance marketplace.
Examples of
well-known offshore financial centers include Anguilla, the Bahamas, the
Cayman Islands, Bermuda, the Netherlands, the Antilles, Bahrain, and
Singapore. They tend to be small countries or territories, and while
global businesses may not locate any of their operations in these
locations, they sometimes incorporate in these offshore centers to
escape the higher taxes they would have to pay in their home countries
and to take advantage of the efficiencies of these financial centers.
Many global firms may house financing subsidiaries in offshore centers
for the same benefits. For example, Bacardi, the spirits manufacturer,
has $6 billion in revenues, more than 6,000 employees worldwide, and
twenty-seven global production facilities. The firm is headquartered in
Bermuda, enabling it to take advantage of the lower tax rates and
financial efficiencies for managing its global operations.
As a
result of the size of financial transactions that flow through these
offshore centers, they have been increasingly important in the global
capital markets.
Ethics in Action
Offshore financial centers
have also come under criticism. Many people criticize these countries
because corporations and individuals hide wealth there to avoid paying
taxes on it. Many offshore centers are countries that have a zero-tax
basis, which has earned them the title of tax havens.
The Economist notes that offshore financial centers
are
typically small jurisdictions, such as Macau, Bermuda, Liechtenstein or
Guernsey, that make their living mainly by attracting overseas
financial capital. What they offer foreign businesses and well-heeled
individuals is low or no taxes, political stability, business-friendly
regulation and laws, and above all discretion. Big, rich countries see
OFCs as the weak link in the global financial chain…
The most
obvious use of OFCs is to avoid taxes. Many successful offshore
jurisdictions keep on the right side of the law, and many of the world's
richest people and its biggest and most reputable companies use them
quite legally to minimise their tax liability. But the onshore world
takes a hostile view of them. Offshore tax havens have "declared
economic war on honest US taxpayers," says Carl Levin, an American
senator. He points to a study suggesting that America loses up to $70
billion a year to tax havens…
Business in OFCs is booming, and as
a group these jurisdictions no longer sit at the fringes of the global
economy. Offshore holdings now run to $5 trillion–7 trillion, five times
as much as two decades ago, and make up perhaps 6–8 percent of
worldwide wealth under management, according to Jeffrey Owens, head of
fiscal affairs at the OECD. Cayman, a trio of islands in the Caribbean,
is the world's fifth-largest banking centre, with $1.4 trillion in
assets. The British Virgin Islands (BVI) are home to almost 700,000
offshore companies.
All this has been very good for the OFCs'
economies. Between 1982 and 2003 they grew at an annual average rate per
person of 2.8 percent, over twice as fast as the world as a whole (1.2
percent), according to a study by James Hines of the University of
Michigan. Individual OFCs have done even better. Bermuda is the richest
country in the world, with a GDP per person estimated at almost $70,000,
compared with $43,500 for America…On average, the citizens of Cayman,
Jersey, Guernsey and the BVI are richer than those in most of Europe,
Canada and Japan. This has encouraged other countries with small
domestic markets to set up financial centres of their own to pull in
offshore money - most spectacularly Dubai but also Kuwait, Saudi Arabia,
Shanghai and even Sudan's Khartoum, not so far from war-ravaged Darfur.
Globalisation
has vastly increased the opportunities for such business. As companies
become ever more multinational, they find it easier to shift their
activities and profits across borders and into OFCs. As the well-to-do
lead increasingly peripatetic lives, with jobs far from home, mansions
scattered across continents and investments around the world, they can
keep and manage their wealth anywhere. Financial liberalisation - the
elimination of capital controls and the like - has made all of this
easier. So has the internet, which allows money to be shifted around the
world quickly, cheaply and anonymously.
The Role of International Banks, Investment Banks, Securities Firms, and Global Financial Firms
The
role of international banks, investment banks, and securities firms has
evolved in the past few decades. Let's take a look at the primary
purpose of each of these institutions and how it has changed, as many
have merged to become global financial powerhouses.
Traditionally,
international banks extended their domestic role to the global arena by
servicing the needs of multinational corporations (MNC). These banks
not only received deposits and made loans but also provided tools to
finance exports and imports and offered sophisticated cash-management
tools, including foreign exchange. For example, a company purchasing
products from another country may need short-term financing of the
purchase; electronic funds transfers (also called wires); and foreign
exchange transactions. International banks provide all these services
and more.
In broad strokes, there are different types of banks,
and they may be divided into several groups on the basis of their
activities. Retail banks deal directly with consumers and usually focus
on mass-market products such as checking and savings accounts, mortgages
and other loans, and credit cards. By contrast, private banks normally
provide wealth-management services to families and individuals of high
net worth. Business banks provide services to businesses and other
organizations that are medium sized, whereas the clients of corporate
banks are usually major business entities. Lastly, investment banks
provide services related to financial markets, such as mergers and
acquisitions. Investment banks also focused primarily on the creation
and sale of securities (e.g., debt and equity) to help companies,
governments, and large institutions achieve their financing objectives.
Retail, private, business, corporate, and investment banks have
traditionally been separate entities. All can operate on the global
level. In many cases, these separate institutions have recently merged,
or were acquired by another institution, to create global financial
powerhouses that now have all types of banks under one giant, global
corporate umbrella.
However the merger of all of these types of
banking firms has created global economic challenges. In the United
States, for example, these two types - retail and investment banks -
were barred from being under the same corporate umbrella by the
Glass-Steagall Act. Enacted in 1932 during the Great Depression, the
Glass-Steagall Act, officially called the Banking Reform Act of 1933,
created the Federal Deposit Insurance Corporations (FDIC) and
implemented bank reforms, beginning in 1932 and continuing through 1933.
These reforms are credited with providing stability and reduced risk in
the banking industry for decades. Among other things, it prohibited
bank-holding companies from owning other financial companies. This
served to ensure that investment banks and banks would remain separate -
until 1999, when Glass-Steagall was repealed. Some analysts have
criticized the repeal of Glass-Steagall as one cause of the 2007–8
financial crisis.
Because of the size, scope, and reach of US
financial firms, this historical reference point is important in
understanding the impact of US firms on global businesses. In 1999, once
bank-holding companies were able to own other financial services firms,
the trend toward creating global financial powerhouses increased,
blurring the line between which services were conducted on behalf of
clients and which business was being managed for the benefit of the
financial company itself. Global businesses were also part of this
trend, as they sought the largest and strongest financial players in
multiple markets to service their global financial needs. If a company
has operations in twenty countries, it prefers two or three large,
global banking relationships for a more cost-effective and lower-risk
approach. For example, one large bank can provide services more cheaply
and better manage the company's currency exposure across multiple
markets. One large financial company can offer more sophisticated
risk-management options and products. The challenge has become that in
some cases, the party on the opposite side of the transaction from the
global firm has turned out to be the global financial powerhouse itself,
creating a conflict of interest that many feel would not exist if
Glass-Steagall had not been repealed. The issue remains a point of
ongoing discussion between companies, financial firms, and policymakers
around the world. Meanwhile, global businesses have benefited from the
expanded services and capabilities of the global financial powerhouses.
For
example, US-based Citigroup is the world's largest financial services
network, with 16,000 offices in 160 countries and jurisdictions, holding
200 million customer accounts. It's a financial powerhouse with
operations in retail, private, business, and investment banking, as well
as asset management. Citibank's global reach make it a good banking
partner for large global firms that want to be able to manage the
financial needs of their employees and the company's operations around
the world.
In fact this strength is a core part of its marketing
message to global companies and is even posted on its website
(http://www.citigroup.com/citi/products/instinvest.htm): "Citi puts the
world's largest financial network to work for you and your
organization".
Ethics in Action
Outsourcing Day Trading to China
American
and Canadian trading firms are hiring Chinese workers to "day trade"
from China during the hours the American stock market is open. In
essence, day trading or speculative trading occurs when a trader buys
and sells stock quickly throughout the day in the hopes of making quick
profits. The New York Times reported that as many as 10,000 Chinese,
mainly young men, are busy working the night shift in Chinese cities
from 9:30 p.m. to 4 a.m., which are the hours that the New York Stock
Exchange is open in New York.
The motivation is severalfold.
First, American and Canadian firms are looking to access wealthy Chinese
clients who are technically not allowed to use Chinese currency to buy
and sell shares on a foreign stock exchange. However, there are no
restrictions for trading stocks in accounts owned by a foreign entity,
which in this case usually belongs to the trading firms. Chinese traders
also get paid less than their American and Canadian counterparts.
There
are ethical concerns over this arrangement because it isn't clear
whether the use of traders in China violates American and Canadian
securities laws. In a New York Times article quotes Thomas J. Rice, an
expert in securities law at Baker & McKenzie, who states, "This is a
jurisdictional mess for the U.S. regulators. Are these Chinese traders
essentially acting as brokers? If they are, they would need to be
registered in the U.S". While the regulatory issues may not be clear,
the trading firms are doing well and growing: "many Chinese day traders
see this as an opportunity to quickly gain new riches". Some American
and Canadian trading firms see the opportunity to get "profit from
trading operations in China through a combination of cheap overhead,
rebates and other financial incentives from the major stock exchanges,
and pent-up demand for broader investment options among China's
elite".
Key Takeaways
- Capital markets provide an efficient mechanism for people, companies, and governments with more funds than they need to transfer those funds to people, companies, or governments who have a shortage of funds.
- The international equity and bond markets have expanded exponentially in recent decades. This expansion has been fueled by the growth of developing markets, the drive to privatize, the emergence of global financial powerhouses including investment banks, and technology advancements.
- The international bond market consists of major categories of bonds - including foreign bonds, Eurobonds, and global bonds - all of which help companies borrow funds to invest and grow their global businesses.
Exercises
(AACSB: Reflective Thinking, Analytical Skills)
- What is a capital market? What is an international capital market?
- What is the role of bond and equity markets.
- Select one global financial center and research its history and evolution to present times. Do you feel that the center will remain influential? Why or why not? Which other global financial centers compete with the one you have chosen?