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This Document Contains Chapters 11 to 12 CHAPTER 11 COUNTRY RISK ANALYSIS I moved this chapter from the section on foreign investment analysis to this section because I have concluded that the international economic environment is heavily dependent on the policies individual countries pursue. Given the close linkage between a country’s economic policies and the degree of exchange risk, inflation risk, and interest rate risk that multinational companies and investors face, it is vital in studying and attempting to forecast those risks to understand their causes. Simply put, attempts to forecast exchange rates, inflation rates, or interest rates are helped immensely by a deeper understanding of how those economic parameters are affected by national policies. At the same time, no one can intelligently assess a country’s risk profile without comprehending its economic and political policies and how those policies are likely to affect the country’s prospects for economic growth. I spend some time discussing the nature of property rights and their implications for political risk and economic development. The chapter examines the experiences of Latin American countries and Eastern European countries and addresses the question of what it takes to promote economic growth. A good discussion of property rights and their effects on economic growth can be based on the end-of-chapter problems. This discussion serves to introduce the topic of country risk analysis – the assessment of the potential risks and rewards associated with making investments and doing business in a country. This is a vital task for multinational firms and international banks, who must constantly assess the business environments of the countries they are already operating in as well as the ones they are considering investing in. Similarly, private and public investors alike are interested in determining which countries offer the best prospects for sound investments. Ultimately, investors are interested in whether sensible economic policies are likely to be pursued because countries adopting such policies will generally have good business environments in which enterprise can flourish. However, because political considerations often lead countries to pursue economic policies that are detrimental to business and to their own economic health, the focus of a country risk analysis cannot be exclusively economic in nature. By necessity, it must also study the political factors that give rise to particular economic policies. This is the subject matter of political economy – the interaction of politics and economics. Such interactions occur on a continuous basis and affect not just monetary and fiscal (tax and spending) policies but also a host of other policies that impact the business environment, such as currency or trade controls, changes in labor laws, regulatory restrictions, and requirements for additional local production. SUGGESTED ANSWERS TO CHAPTER 11 QUESTIONS 1. What are some indicators of country risk? Of country health? Answer: The chapter points to the following indicators of country risk: A large government deficit relative to GNP A high rate of money expansion, especially when combined with a relatively fixed exchange rate Substantial government expenditures yielding low rates of return Price controls, interest rate ceilings, trade restrictions, and other barriers to the smooth adjustment of the economy to changing relative prices Vast state owned firms run for the benefit of their managers and workers A citizenry that demands, and a political system that accepts, government responsibility for maintaining and expanding the nation’s standard of living through public sector spending and regulations Here are key indicators of a nation’s long run economic health: -- A structure of incentives that rewards risk taking in productive ventures --A legal structure that stimulates the development of free markets -- Minimal regulations and economic distortions -- Clear incentives to save and invest -- An open economy 2. What can we learn about economic development and political risk from the contrasting experiences of East and West Germany, North and South Korea, and communist China and Taiwan, Hong Kong and Singapore? Answer: These countries provide us with as close to a controlled economic experiment as we are ever going to find in this world: same peoples, same language, same history, same culture, even members of the same families in many instances, divided by an accident of history. And what we see is that those societies that respect the rights of property and that subject their enterprises to the rigors of competition, particularly global competition, grow more rapidly, create far more wealth, are more innovative, more willing to take risk, and are far more productive than those nations with centrally planned economies. The lesson is as clear as possible: Incentives matter, and they matter greatly. 3. What role do property rights and the price system play in national development and economic efficiency? Answer: With property rights, people have a strong incentive to husband their assets and utilize them efficiently. They also have a strong incentive to practice thrift, bear risk, and work hard to accumulate more assets. Soviet communes founder on the question of “Who will stay up all night with the sick cow?” If the cow belongs to the commune, no one wants to stay up. In other words, everyone has an incentive to be a free rider. But if it’s Ivan’s cow, Ivan stays up. The mere formality of “owning in common” has nothing like the practical bite of actually involving each participant in ownership. Property rights work in conjunction with the price system to ensure economic growth and wealth creation. By signaling members of society as to the relative scarcity of goods and resources, the price system ensures that society’s assets are employed in their highest valued use. Market prices, in conjunction with property rights, also motivate people to create more wealth by using appropriate combinations of capital, labor, and other resources. The market price of risk, as reflected in the cost of capital signals people as to which risks are worth taking and rewards them for taking those risks. 4. What indicators would you look for in assessing the political riskiness of an investment in Eastern Europe? Answer: Here are some key indicators to look for in assessing the political riskiness of investing in Eastern Europe: i) Do they free prices quickly or continue the old system of administered prices that are based heavily on state subsidies? Although a free economy will need free prices, the public still expects the state to protect it against unexpected events. So the working public expects its wages to rise precisely in line with rising prices. If the governments give in on this point and index wages to inflation, they will institutionalize inflation. ii) Do they dismantle and sell state-owned monopolies quickly? iii) Will Eastern Europeans be willing to see successful businessmen grow rich? Unfortunately, most of Eastern European society doesn’t understand business and the concept of making money. There are no role models or business traditions as there are in the West. Two generations in Eastern Europe have never experienced private contracts, free markets, or inventive enterprise. Instead, Communism mandated lethal doses of envy in everyone. They were taught to despise those who got ahead, and to pull them down. To avoid social self-destruction, Eastern Europeans need to learn to tame envy. They need to encourage one another to succeed, and to praise and honor those who do. Unfortunately, it might take a generation for negative attitudes concerning hard work and wealth to fade from the Eastern European psyche and be replaced with respect for honesty and enterprise. iv) Do they establish all the paraphernalia of capitalism--including capital markets, tax regimes, and contract law – to go along with their new-found enthusiasm for free markets? These are not mere details. Completing such tasks will embroil the region in all the wrangles about wealth distribution and the size and role of the state which Western countries have spent generations trying to resolve. Another key indicator of political risk would be seeing governments give in to the temptation to fine-tune their economies in order to reduce the costs of making the transition to a market economy. The constant changes of policy involved in fine-tuning will reduce government credibility--just when it is crucial--and increase the likelihood and costs of policy mistakes. The only hope for success is to devise a complete reform program and implement it as quickly as possible. Governments must convey that their commitment to the program is absolute. Some setbacks along the way are inevitable, but they must do the best they can. Milton Friedman has often said, “Don’t let the best be the enemy of the good.” Perhaps most important of all, the reform program should include a set of simple rules to govern how policy makers and the public are to operate. This will boost credibility, reduce investor uncertainty, and discourage any efforts by special interest groups, who will be hurt by some of the reforms, to forestall the reform program. ADDITIONAL CHAPTER 6 QUESTIONS AND ANSWERS 1. How might a government budget deficit lead to inflation? Answer: Instead of financing the deficit by raising taxes (unpopular) or issuing debt (expensive), the government could print money (a noninterest-bearing liability that need never be redeemed). The expansion in the supply of money without a corresponding increase in the demand for money will cause inflation. 2. What political realities underlie a government budget deficit? Answer: Generally speaking, government spending is popular and taxation is unpopular. So governments tend to be quick to spend money, but reluctant to tax their citizens to finance these expenditures. As government promises expand more rapidly than its ability to generate taxes through economic growth, the government faces a choice: Cut the growth in spending, raise taxes, or do neither. The Soviet Union is facing this choice now. And it is doing what governments often do: Take the easy way out and do neither. 3. What obstacles do Third World countries like Argentina, Brazil, and Ghana face in becoming developed nations with strong economies? Answer: These countries have not established and enforced the property rights that give their peoples the incentive to make the investments and take the risks that lead to economic growth. They have also not shed their statist dogma – economic nationalism, state ownership, protectionism, price controls, subsidies, and monopolies – in favor of market economics. At the same time, their cultures tend not to value those traits necessary for economic development--an emphasis on education, a willingness to break with tradition, and entrepreneurship. 4. What is the link between a controlled exchange rate system and political risk? Answer: A controlled exchange rate system, used to protect an overvalued currency, presents the risk of tighter currency controls, the likelihood of a large devaluation, and various economic distortions that lead to increasing government control of the rest of the economy. 5. Milton Friedman has suggested that public-sector firms in Latin American countries should simply be given away, possibly to their employees. How do you think workers would feel about being given (for free) ownership of the public sector firms that employ them? Why? Answer: Workers would most likely oppose such arrangements. Under state ownership, a firm’s survival depends on its access to the national treasury, not on its economic efficiency. Thus state owned firms can, and often do, pay exorbitant wages and tolerate enormous overstaffing, with the excess costs covered by government subsidies. Private-sector companies cannot tolerate such labor practices. If a private-sector company’s costs exceed its revenues that company will die. Thus, workers who benefit from high pay and low effort at state owned companies will, and do, oppose privatization. 6. How did capital flight contribute to the international debt crisis? Answer: Capital flight – the flow of capital from debtor developing countries – occurs for several reasons, most of which have to do with inappropriate economic policies. These reasons include government regulations, controls, and taxes that lower the return on domestic investments. Perhaps the most powerful motive for capital flight is political risk. In unstable political regimes (and in some stable ones) wealth is not secure from government seizure, especially when changes in regime occur. It exacerbated the international debt crisis by reducing the foreign currency assets available to service developing country debts. SUGGESTED SOLUTIONS TO CHAPTER 11 PROBLEMS 1. Comment on the following statement discussing Mexico’s recent privatization. “Mexican state companies are owned in the name of the people, but are run and now privatized to benefit Mexico’s ruling class.” Answer: Historically, Mexican state companies have been run to benefit politicians as well as their bureaucrats and workers rather than consumers and taxpayers (who wound up subsidizing these firms). Whether privatization benefits Mexico’s ruling class depends on how prices are set and the terms of the sale. Even if privatization takes places at unrealistically low prices, it will benefit all Mexicans, provided that (a) no laws restrict the ability of domestic or foreign firms to compete with privatized firms and (b) the government ends its subsidies to them. Competition will force privatized firms to be more efficient and lower their prices to consumers, while cutting subsidies will end a major drain on the Mexican treasury. 2. Between 1981 and 1987, direct foreign investment in the Third World plunged by more than 50%. The World Bank is concerned about this decline and wants to correct it by improving the investment climate in Third World countries. Its solution: Create a Multilateral Investment Guarantee Agency (MIGA) that will guarantee foreign investments against expropriation at rates to be subsidized by Western governments. 2.a. Assess the likely consequences of MIGA on both the volume of Western capital flows to Third World nations and the efficiency of international capital allocation. Answer: By lowering the risk adjusted return required by investors, MIGA will increase the flow of Western capital to Third World nations. At the same time, however, subsidizing investment insurance will tend to produce less efficient capital allocation; more money will be channeled to those countries that have the greatest risk of expropriation (since these are the countries that will receive the greater implicit subsidy from MIGA). Because respect for property rights is critical for economic growth, these are also the nations with the poorest economic prospects. Under MIGA, American taxpayers will wind up subsidizing the expropriation of American property. Thus, MIGA becomes another welfare scheme, not a business venture. 2.b. How will MIGA affect the probability of expropriation and respect for property rights in Third World countries? Consider this question from an option pricing perspective. Answer: Governments always have the option of expropriating foreign property in their nations. The decision of whether to expropriate this property depends on the cost of exercising this option. By lowering the cost of expropriation, MIGA would make expropriation more advantageous for Third World governments and, hence, more likely. Instead of Third World governments compensating MIGA insured investors, Western governments would provide this compensation. 2.c. Is MIGA likely to improve the investment climate in Third World nations? Answer: Quite the contrary. MIGA would counter the decline in private investment not by making foreign investment safer, but by having Western governments pay for the costs of Third World expropriations. If the World Bank really wants to improve the investment climate in the Third World, it could simply stop giving money to Third World governments that subvert their own development by expropriating foreign investors. 2.d. According to a senior World Bank official (Wall Street Journal, December 22, 1987, p. 20), “There is vastly more demand for political risk coverage than the sum total available.” Is this a valid economic argument for setting up MIGA? Answer: In general, a shortage of a good or service reflects underpricing. This situation is no exception. The problem is not that private insurance is not available – several private entities such as Lloyd’s of London offer insurance for foreign investments – but that its costs accurately reflect the true risk of placing one’s money in countries where property rights are routinely violated. In other words, the demand for low priced political risk insurance exceeds its supply. At the right price, enough insurance would be available to exactly satisfy the market’s demand. The purpose of MIGA is to boost FDI in Third World countries, most of which suffer from capital flight. The fact that the countries’ own citizens don’t trust the government is a clue that investment there is unsafe. 2.e. Assess the following argument made on behalf of MIGA by a State Department memo: “We should avoid penalizing a good project [by not providing subsidized insurance] for bad government policies over which they have limited influence. … Restrictions on eligible countries [receiving insurance subsidies because of their doubtful investment policies] will decrease MIGA’s volume of business and spread of risk, making it harder to be self sustaining.” (Quoted in the Wall Street Journal, December 22, 1987, p. 20.) Answer: MIGA’s approach to foreign investments seems to be based more on a protection of greedy governments than on a respect for property rights. The World Bank seems to see expropriations as events that involve no human responsibility or blame. The World Bank refuses to loudly condemn Third World governments for seizing Western property. Countries throughout Africa that have nationalized foreign corporations have afterward received World Bank loans at subsidized rates to help run the new state owned industries. A question that the MIGA official failed to ask is, “Why should taxpayers of developed countries subsidize the self-destructive behavior of Third World countries?” Some countries, like South Korea, Taiwan, and Hong Kong, have done very well at attracting foreign investment. MIGA would play down the differences in how governments treat investors, thus penalizing nations that honor property rights and rewarding nations that violate them. Given the crucial role that property rights play in economic development, this is a perverse set of incentives. 3. In the early 1990s, China decided that by 2000 it would boost its electricity-generating capacity by more than half. To do that, it is planning on foreigners’ investing at least $20 billion of the roughly $100 billion tab. However, Beijing has informed investors that, contrary to their expectations, they will not be permitted to hold majority stakes in large power-plant or equipment-manufacturing ventures. In addition, Beijing has insisted on limiting the rate of return that foreign investors can earn on power projects. Moreover, this rate of return will be in local currency without official guarantees that the local currency can be converted into dollars and it will not be permitted to rise with the rate of inflation. Beijing says that if foreign investors fail to invest in these projects, it will raise the necessary capital by issuing bonds overseas. However, these bonds will not carry the “full faith and credit of the Chinese government.” 3.a. What problems do you foresee for foreign investors in China’s power industry? Answer: Since the return is set in nominal yuan terms, high inflation – a perennial Chinese problem – will reduce the real value of this return. This high inflation, in turn, will put pressure on the yuan to devalue, lowering the dollar value of the return. Finally, the local currency returns may be blocked. In other words, the dollar return is likely to be lower than the yuan return and the dollar return may never be realized because of inconvertibility. 3.b. What options do potential foreign investors have to cope with these problems? Answer: Don’t invest under these terms. If they do invest, they can buy political risk insurance against currency inconvertibility. They should also negotiate for higher yuan returns to compensate for the anticipated yuan devaluation and the cost of political risk insurance. 3.c. How credible is the Chinese government’s fallback position of issuing bonds overseas to raise capital in lieu of foreign direct investment? Answer: Not very credible. If the bonds don’t carry the “full faith and credit of the Chinese government,” then investors will either not buy them or, if they do, they will demand an interest rate that will compensate them for the political risks associated with the absence of the guarantee. The bonds will have to be dollar denominated and the interest rate will have to be as high as the dollar yield that investors would expect if they invested directly in the power plants themselves. In other words, the Chinese government will realize no benefit by financing the power projects through issuing bonds as opposed to enticing investors to provide equity financing for the projects. 4. You have been asked to head up a special presidential commission on the Russian economy. Your first assignment is to assess the economic consequences of the following seven policies and suggest alternative policies that may have more favorable consequences. Note: Since this set of questions was first written, Russia has undergone massive changes. Yet many of the policies discussed here still persist and the consequences are as predicted. 4.a. Under the current Russian system, any profits realized by a state enterprise are turned over to the state to be used as the state sees fit. At the same time, shortfalls of money do not constrain enterprises from consuming resources. Instead, the state bank automatically advances needy enterprises credit, at a zero interest rate, to buy the inputs they need to fulfill the state plan and to make any necessary investments. Answer: The system as described completely destroys all incentive to be efficient and profitable. In effect, it penalizes success and rewards failure. At the same time, the ability to borrow unlimited amounts of money at a zero interest rate encourages firms to squander capital without penalty and reduces the incentive to cut costs. Moreover, the absence of any constraints on the ability of state banks to print money to cover shortfalls guarantees rapid expansion of the money supply and inflation. Short of an immediate and complete overhaul of the current system, the government should quit printing rubles and allocate the available supply of capital by auctioning it off to firms. To ensure that firms are realistic in the price they are willing to pay for capital, the state would have to allow enterprises that can’t service their debts to go bankrupt. Managers of profitable enterprises should be allowed to keep, say, 70% of their profits to reinvest or pay bonuses (equivalent to a 30% corporate tax rate). Enterprises that show losses should be forced to borrow at the auction-determined interest rate to cover their shortfalls or go out of business. At the same time, bankers should be similarly incentivized to make money, thereby forcing them to assess the creditworthiness of potential borrowers. 4.b. The Russian fiscal deficit had risen from 2.5% of GNP when Mikhail Gorbachev assumed power in 1985 to an estimated 13.1% of GNP in 1989. This deficit has been financed almost exclusively by printing rubles. Concurrently, prices are controlled for most goods and services. Answer: By printing money while controlling prices, the government guarantees that there will be massive shortages of goods and services throughout the Soviet Union. At the same time, black markets will arise in controlled products while prices of uncontrolled products will skyrocket. Shutting down the printing presses will end suppressed inflation. Decontrolling prices will end shortages. Gorbachev can eliminate the deficit by raising taxes or cutting spending. Alternatively, he can finance the deficit by borrowing from the public. This latter approach, however, will require the government to pay an interest rate that yields a positive real return to savers. 4.c. Russian enterprises are allocated foreign exchange to buy goods and services necessary to accomplish the state plan. Any foreign exchange earned must be turned over to the state bank. Answer: This system of foreign exchange allocation destroys any incentive to conserve on foreign exchange, and allows bureaucrats to decide what amount of foreign exchange is needed to accomplish the state plan. It also discourages Soviet exports since the government imposes what is, in effect, a 100% tax on foreign exchange earnings. A partial solution to this problem is to free up the market for foreign exchange. By allowing enterprises to buy or sell foreign exchange as they see fit, they will have a stronger incentive to earn foreign exchange and to conserve on its use. 4.d. In an effort to introduce a more market oriented system, some Russian enterprises have been allowed to set their own prices on goods and services. However, other features of the system have not been changed: Each enterprise is still held accountable for meeting a certain profit target; only one state enterprise can produce each type of good or service; and individuals are not permitted to compete against state enterprises. Answer: The basic problem with this system is that without the possibility of competition, the state enterprises become unregulated monopolies. Since their goods are already underpriced, deregulated enterprises can reach their profit target by raising their prices rather than by cutting costs or producing higher quality goods. In fact, they appear to have not only raised prices but also cut production, thereby simplifying their lives. In other words, freeing prices for goods produced by monopoly factories just enables producers to reap monopoly profits. The answer here is to permit competition, from individuals, other state enterprises, and foreign companies. At the same time, producers must be able to keep most of their profits. Otherwise, they will have no incentive to produce more and better goods. 4.e. Given the disastrous state of Russian agriculture, the Russian government has permitted some private plots on which anything grown can be sold at unregulated prices in open air markets. Due to their success, the government has recently expanded this program, giving Russian farmers access to more acreage. At the same time, a number of Western nations are organizing massive food shipments to the Russia to cope with the current food shortages. Answer: Although the Western nations are well-intentioned (we think; they may be using this as a means of dumping the agricultural surpluses they have accumulated by subsidizing their domestic farmers), the effect of food aid will be to drive down the price of food in the Russia, thereby reducing the incentive of Russian farmers to produce food. If Western nations wish to aid the Russia, they can provide it with advice and money tied to the implementation – not just the promise – of genuine economic and political reforms. After all, food shortages reflect a combination of price controls and lack of incentive faced by farmers; it is not an act of nature. 4.f. The U.S. and other Western nations are considering instituting a Marshall Plan for Eastern Europe that would involve massive loans to Russia and other Eastern Bloc nations in order to prop up Gorbachev and the reform governments. Answer: The key here is to recognize that we are dealing with a political problem, not an economic problem, and political problems cannot be solved with money alone. The basic problem with massive loans to these nations is that by alleviating their economic crisis, it would reduce the governments’ incentive to institute real economic and political reform. It also boosts the power of the bureaucrats at the expense of the private sector. Thus, any loans should be tied to the implementation of genuine reforms. Better still, money should be provided directly to private companies on close-to-market terms, thereby building up the private – not the public – sector. As Mr. Gorbachev has already proved to the world’s satisfaction, no matter how many Harvard economists he puts to work, he will not be able to restructure the Soviet economy and still preserve the power of the Communist Party. The two things are antithetical. You can’t have a free-market economy and an economy run by and for a Communist Party elite. The contradictions inherent in this attempt ultimately led to the downfall of communism in the Soviet Union, as it also will in China. 5. The president of Mexico has asked you to advise him on the likely economic consequences of the following five policies designed to improve Mexico’s economic environment. Describe the consequences of each policy, and evaluate the extent to which these proposed policies will achieve their intended objective. 5.a. Expand the money supply to drive down interest rates and stimulate economic activity. Answer: Rapid expansion of the money supply will lead to higher inflation and higher nominal interest rates. It will also raise real interest rates to the extent that savers demand a bigger inflation risk premium for the higher inflation risk that they must now bear. Higher inflation will make it more difficult for business to plan and lead to a reduction in business investment. It will also reduce the reliability of price signals, thereby reducing the efficiency with which the Mexican economy operates. The net effect will be higher interest rates and slower economic growth, exactly the opposite of what is desired. 5.b. Increase the minimum wage to raise the incomes of poor workers. Answer: Workers covered by the higher minimum wage and who keep their jobs will see their incomes rise. However, many workers will lose their jobs since the new wages will exceed the value of their work (low wages typically signal low productivity and few salable worker skills, not exploitation). The most seriously affected companies will be those facing foreign competition, since they will be unable to raise their prices much. Such companies will attempt to lower their costs by substituting capital for labor, moving offshore, or just reducing their workforce. Moreover, those workers who are not covered will find more competition for their jobs, leading to a fall in wages in the uncovered sector of the economy. The net effect will be higher unemployment and a workforce that is worse off overall. To the extent that companies can offset their higher labor costs by raising prices, their customers will be worse off. 5.c. Impose import restrictions on most products to preserve the domestic market for local manufacturers and, thereby, increase national income. Answer: Import restrictions will lead to higher domestic prices for lower quality products. It will also stifle innovation and make domestic firms less competitive. The evidence is that countries that follow an export-oriented growth strategy grow much more rapidly than those that seek to grow through import substitution. Thus, this policy will reduce Mexico’s national income, not increase it. 5.d. Raise corporate and personal tax rates from 50% to 70% to boost tax revenues and reduce the Mexican government deficit. Answer: The odds are that the Mexican government will collect less tax revenue at a 70% tax rate than at a 50% rate. People will have greater incentive to cheat on their taxes and less incentive to work if 70% of what they earn goes to the government. Thus, both actual and reported income will probably be sufficiently lower at a 70% tax rate than at a 50% rate that the rise in the tax rate will be more than offset by the decline in taxable income. At the same time, economic growth will be reduced and there will be more demands on the government to “do something,” which usually means spending more money. The net result will be a higher deficit. 5.e. Fix the nominal exchange rate at its current level in order to hold down the cost to Mexican consumers of imported necessities (assume that inflation is currently 100% annually in Mexico). Answer: Mexico and many other Latin American countries already tried this during the 1970s and early 1980s. To summarize the conclusions in the Mexican Peso case, the resulting jump in the real exchange rate boosted imports, cut exports, and led to capital flight and huge and unsustainable trade and government budget deficits. Sorting out the mess cost Latin America a decade of economic misery and lost economic growth. Fixing the exchange rate with inflation running at 100% annually, as proposed here, will double the real value of the peso in a year. This will bring on the troubles just described even faster than in the 1980s. ADDITIONAL CHAPTER 11 PROBLEMS AND SOLUTIONS 1. The president of Brazil has just appointed you to work with the country’s cabinet ministers to launch a radical restructuring of the Brazilian economy. Inflation is running at over 1,000% annually, and the federal government is running a deficit in excess of 10% of GNP (the U.S. deficit is about 3% of GNP). To finance the deficit, the government has incurred huge debts, both internally and externally. In your initial discussions with the cabinet ministers, you realize that there is considerable disagreement about a number of specific program proposals. Your job is to assess the issues and the relative merits of the proposed policies. 1.a. The Governor of the Banco do Brasil, Brazil’s central bank, wants to cease its purchases of government bonds issued by the Ministry of Finance to fund the ongoing federal budget deficit. The Banco do Brasil has acquired 50% to 60% of all government bonds issued in the past several years with money expressly created for that purpose. In other words, it has been monetizing the deficit. Other cabinet ministers are afraid that this policy will lead to higher interest rates and wonder how the deficit can be financed otherwise. Answer: Ending monetization of the deficit will reduce the growth in the money supply. This change in policy will actually lower nominal interest rates by reducing inflation, which is the primary cause of high rates. Ending the threat of inflation would lead to lower nominal rates and – as the inflation risk premium imbedded in nominal rates shrinks – to lower real rates as well. The government can reduce the deficit by cutting spending, leading to a healthier economy and stronger growth, or by increasing taxes, which will likely weaken the economy. Alternatively, the government can sell bonds to the market. This will probably boost real interest rates, but the nominal interest rate will still be lower than it was before. Borrowing from the private sector to finance large deficits, however, is not a sustainable policy. Sooner or later, the government will have to face the issue once again of whether to raise taxes, monetize the deficit, or cut spending. The latter can be done by selling off money-losing state enterprises. An alternative, and less traumatic way to reduce the deficit is to reduce the rate of increase in government spending and then allow the natural rise in tax revenues from a growing economy to eventually narrow the gap between tax revenues and spending. 1.b. The Minister of Infrastructure has proposed that his ministry begin privatizing the hundreds of state owned enterprises under his administration. These enterprises include virtually all of Brazil’s steel industry, mining industry, electric utilities, the telephone company, national oil company, chemical companies, and a wide range of manufacturers. Opponents claim that this move will lead to massive unemployment and the bankruptcy of vital national industries. Answer: Privatization is probably the single most valuable step that Brazil can take to deal with its economic crisis. Privatization will lead to efficiency gains for the whole economy by forcing the privatized companies to earn their keep in a competitive market. At the same time, the government will convert what has traditionally been a series of deficit-plagued companies into both a one-time source of revenue through the sell-off as well as an continuing stream of tax revenue from now-profitable companies. Consumers will likely receive higher-quality service at lower prices (assuming that the government permits competition in what have historically been run as government monopolies). The reason that state-owned enterprises are money losers is that most of them are way overmanned and very inefficient. Privatization will force them to cut their workforces. But to argue that this will result in massive unemployment ignores the fact that these enterprises are squandering vast resources that could be used more efficiently elsewhere in the economy and lead to higher economic growth. The laid-off workers will have to find jobs in the private sector of the economy. This leads to further gains in efficiency, as unproductive workers from the privatized firms become productive members of society. The surest guarantee of getting and keeping a job in the private sector is to be worth more than your compensation. The argument that giving people jobs, regardless of their productivity, helps the nation brings to mind the old solution to eliminate unemployment: Put half the population to work digging holes and let the other half fill them in. Everyone will be working, but to what end? Taxpayers and consumers subsidize the inefficiency of state-owned enterprises. If taxpayers and consumers decide they want to pay the redundant workers to do nothing, they should do so directly. Transparency is the key to allowing taxpayers and consumers to make informed decisions as to how they want to spend their money – on goods and services they value or on overpaid, underworked state employees. The bankruptcy argument ignores the fact that bankruptcy doesn’t destroy assets; it simply transfers them to those who are able to use them more efficiently. It also ends the possibility of cross-subsidization by the private sector through the tax collection mechanism. 1.c. The Minister of Political Economy has proposed that Brazil enter into free trade agreements with its Latin American neighbors. This would involve eliminating all tariffs, duties, and fees on imports. A number of other government leaders oppose this move, because the Brazilian market is larger and generally more protected than those of its neighbors. They feel that opening the border would expose Brazil to rapid growth in imports that exceed any incremental export activity. Answer: The more protected an economy is, the greater the disruption when it opens its borders, but also the greater the economic benefit that it reaps. Consumers will benefit because free trade will expand the quality and variety of goods and services available to them--and at better prices too. Opening the economy to imports will also force inefficient protected Brazilian firms to become more efficient to survive. Brazilian exporters will gain as well by being able to substitute higher-quality, lower-priced imports for domestic supplies. To the extent that the opening of free trade does lead to a net increase in Brazilian imports, that net increase will be financed by additional, voluntary inflows of foreign capital; that is, Brazil can run a deficit only if other nations are willing to finance it. Such a situation will not boost unemployment or slow down economic growth, the fear underlying resistance to free trade. If Brazilians demand more imports than foreigners demand Brazilian exports, the real’s value will fall until equilibrium is again established in trade. The net result from free trade, therefore, will be a more competitive Brazil and happier Brazilian consumers. 1.d. The Minister of Finance has proposed creating a new consumption tax and lowering income tax rates. His concern is that Brazil’s personal savings rate has been close to zero over the past several years. He believes increased savings will help to dampen inflation, lower interest rates on the federal debt, and promote exports. Critics of this proposal argue that the vast majority of Brazil’s population are living very near the poverty line and that a consumption tax would be highly regressive (hit the poor relatively harder than the rich). It also would tend to dampen domestic demand, the principal engine of economic growth in Brazil. Answer: The shift from an income tax to a consumption tax will increase the incentive to save while at the same time increasing the incentive to engage in productive activity (income, after all, is the return to productive activity), thereby stimulating economic activity. The problem facing Brazil is not a lack of consumption. Indeed Brazil is consuming too much relative to its income; otherwise, it could not have run such huge trade deficits. The main effect of higher savings will be to lower imports and free up resources to service the export market, thereby cutting the current-account deficit. It should also lead to lower interest rates and more investment. But increased savings will not lead to less inflation, unless the government uses those savings to substitute for newly printed money as a means of financing its deficit. Only from a static standpoint could one be concerned about the poor being hurt by the new tax system. From a dynamic standpoint, the increase in investment brought about by the additional savings will increase worker productivity and raise their wages. At the same time, the regressivity of the consumption tax can be reduced or eliminated by providing generous allowances to lower-income residents. Specifically, the consumption tax will tax workers on the difference between what they earn and what they save. By providing generous dependent deductions, the consumption tax can do away with taxes on the poor. Although a consumption tax will stifle consumption initially, by making Brazilians wealthier over time (by increasing their productivity), it will eventually lead to higher consumption and a higher standard of living. At the same time, even though consumption will fall at first, investment will rise since the increased saving will lower the cost of capital faced by companies, leading to more positive NPV projects. In other words, there is no necessary reason to expect that a nation with a high savings rate will have a low growth rate. Japan is a good example of a nation with a high savings rate and a (historically) high growth rate. Any excess domestic savings (that is, savings not invested domestically) are exported abroad as capital by running a current account surplus. 1.e. The Minister of Labor has proposed raising the minimum wage to raise the income of poor workers and, thereby, offset the effects of restructuring on them. Other cabinet members are concerned about the effects this policy will have on employment and competitiveness. Answer: Raising the minimum wage will boost incomes for those workers who retain their jobs. However, it will also cause higher unemployment among unskilled workers and make Brazilian industry less competitive. The most seriously affected Brazilian companies will be those facing foreign competition, since they will be unable to raise their prices much. Such companies will attempt to lower their costs by substituting capital for labor, moving offshore, or just reducing their workforce. 1.f. The Central Bank has proposed that it replace the current fixed exchange rate system with a freely floating exchange rate system. Critics of this proposal argue that floating the real will devalue the currency and raise the cost of living (by boosting the price of imported necessities) for Brazilians. Answer: The argument that floating the real will lead to currency devaluation implies that the real is currently overvalued. Although devaluation will raise the cost of imported goods, it will also end the subsidies used to maintain real overvaluation. These subsidies can be given directly to Brazilians instead of only to those who buy imported products. At the same time, devaluation will make Brazilian industry more competitive internationally and boost Brazil’s GNP, benefiting all. Finally, Brazil will be unable to maintain an overvalued currency forever. Hence, the only question is whether the real is devalued today or tomorrow. The longer Brazil waits, the more foreign exchange it will squander trying to preserve an overvalued currency. 1.g. To reduce the money supply and, thereby, suppress inflation, the Minister of Finance has proposed freezing all bank accounts. Depositors will be able to withdraw only the real equivalent of about $1,000. However, other cabinet ministers are concerned about possible adverse consequences of such a freeze. Answer: This policy smacks of lunacy. It destroys faith in the monetary system and discourages savings and the work that leads to those savings. Nonetheless, Brazil tried this in early 1990. The result, as predicted, was economic chaos. The message such an action sent is that work and saving aren’t the ways to get ahead. Citizens figured that such an action was likely to reoccur and responded with capital flight, increased consumption, and less investment. CHAPTER 12 INTERNATIONAL FINANCING AND NATIONAL CAPITAL MARKETS I begin this session by discussing the evolutionary process under way in world finance, which is characterized by three simultaneous developments. (1) Financial markets are becoming increasingly globalized. (2) Old kinds of debt are being made into new kinds of securities. (3) The distinction between commercial and investment banks is breaking down. Each of these developments will have a profound influence on everybody involved in the financing business. The process of globalization has been taking place for some time. U.S. banks developed worldwide branch networks in the 1960s and 1970s for loans, payments, clearings, and foreign exchange trading. U.S. securities firms also began to build up their operations abroad, starting in the 1970s at first in London with the Eurobond market, but then into other markets, including now Tokyo, Hong Kong, and Singapore. Foreign firms expanded into the U.S., first the commercial banks and later on the securities houses. Trading in individual markets has globalized. International finance is a Darwinian world – only the fittest will survive – and most financial firms have concluded that to survive as a force in any one of the world’s leading financial markets, a firm must have a significant presence in all of them. The second major development under way in world finance is the process of securitization. Twenty years ago, banks handled most of the short and medium term financing around the world. But corporate borrowers developed the means to obtain lower cost funds directly from lenders, such as through commercial paper marketed by investment banks rather than by commercial banks. The third major development is the diminishing distinctions among different kinds of financial firms. Every financial firm wants to be in the most profitable product line and have the flexibility to shift to another, more promising, product line. In the U.S., the Glass Steagall Act separates commercial banks from investment banks. Japan has a similar provision, Article 65 of the Securities and Exchange Act, separating the two kinds of banking activities. In recent years, commercial banking has not been as profitable as it was, while some kinds of investment banking have been extremely profitable. As a result, commercial banks in the U.S. and Japan have sought to break down the barriers established by Glass Steagall and Article 65 to engage in investment banking activities. At the same time, investment banks have been encroaching into areas of activity that were traditionally the preserve of banks. One of the biggest moves was into money market mutual funds, which drew billions of dollars from banks in the late 1970s and early 1980s until banks were allowed to offer money market deposit accounts to their customers. I then discuss the differences in national financing patterns and relate these differences to some of the factors discussed in the chapter. Principal factors are differences in profitability and growth among national firms and differences in the role of banks and permissible banking activities. I note, however, that the evolutionary process discussed above is leading to a convergence of financing practices among countries. Finally, I discuss the role of international development banks in financing LDCs and private-sector alternatives. SUGGESTED ANSWERS TO “BEIJING TRIES TO OVERHAUL BANKS THROUGH IPOS” 1. Would you expect loans to SOEs to be safer or riskier than other Chinese bank loans? Explain. Answer: From a strict credit risk standpoint, loans to SOEs are much riskier. These companies are basically bankrupt, with few assets and lots of liabilities. Moreover, the loan proceeds go mostly to pay for current operating expenses rather than to purchase assets that will eventually generate cash to repay the loans. As such, these loans are unlikely to ever be paid off. On the other hand, one could argue that the government stands behind these loans since the borrowers are owned by the state. So far, the government has been bailing out the banks directly rather than the SOEs themselves by buying up the bad loans and injecting capital into the banks to compensate for their losses. 2. How can IPOs improve the sorry performance of Chinese banks? Answer: The problem with the banks is that they lack accountability and transparency and are subject to the whims of Communist Party officials in making lending decisions. By replacing party bosses with a board of directors accountable to shareholders, and by subjecting the banks to the scrutiny of international regulators that go along with a public listing, an IPO can improve the corporate governance of these banks and reduce the influence of Communist Party officials in lending decisions. 3. What difficulties will China face in preparing their state-owned banks for IPOs? Answer: There are several obvious difficulties. First, the state-owned banks have little experience or expertise in credit risk assessment and loan pricing. Second, the banks still have huge portfolios of nonperforming loans that have to be sorted out and resolved before they can function like normal banks. Third, Communist Party officials are unlikely to just walk away from the power they currently exercise and turn over the governance reins to outside investors. 4. What other steps can the Chinese government take to improve the performance of their banks? Answer: The biggest step would be for the government to reduce the role of the Communist Party in running the banks. One way to accomplish this is to have the banks report to independent boards rather than to Communist Party bosses. The government can also set financial goals for the banks that make them accountable for bank profit and reward or penalize bank executives based on achieving profit targets. 5. How would a more efficient banking system benefit China? Answer: A more efficient banking system leads to more effective capital allocation in the economy. This would lead to fewer credit losses and more capital accumulation. It would also result in better projects being selected, yielding higher Chinese growth at a lower cost in terms of foregone consumption. 6. What is the downside of introducing market forces into China’s banking system? Answer: The downside from the government’s standpoint is that market-oriented banks would quit making loans to SOEs, putting millions of people out of work and creating the possibility of riots and revolt by the unemployed. However, the government can mitigate this problem by making direct grants to the SOEs for a transitional period, giving the SOEs and their workers a grace period during which to restructure their businesses. In any event, the problem of bankrupt SOEs and their excess supply of workers is independent of whether the banks are state owned or privately owned. SUGGESTED ANSWERS TO “SIEMENS NEGOTIATES A EUROCURRENCY LOAN” 1. What are the net proceeds to Siemens from each of these syndicated loan proposals? Answer: With an up-front syndication fee of 1.125%, net proceeds to Siemens from the Bank of America loan proposal are: $500,000,000 - (0.01125 * 500,000,000) = $494.375 million. Similarly, after paying the 0.75% syndication fee with the Deutsche Bank proposal, Siemens would end up with $496.25 million. 2. Assuming that six-month LIBOR is currently at 4.35%, what is the effective annual interest cost to Siemens for the first six months of each loan? Answer: The interest rate on the Bank of America loan is set at LIBOR + 0.25%, with LIBOR reset every six months. Given an initial LIBOR6 rate of 4.35%, the first semiannual debt service payment is 0.5 * (0.0435 + 0.0025) x 500,000,000 = $11,500,000 Siemen’s effective annual interest rate for the first six months is thus 11,500,000/493,750,000 * 2 * 100 = 4.658% The interest rate on the Deutsche Bank loan is set at LIBOR + 0.375%, with LIBOR reset every six months. Given an initial LIBOR6 rate of 4.35%, the first semiannual debt service payment is 0.5 * (0.0435 + 0.00375) * 500,000,000 = $11,812,500 Siemen’s effective annual interest rate for the first six months is thus 11,812,500/496,250,000 * 2 * 100 = 4.761% The corresponding effective annual rate on the Deutsche Bank proposal is 4.725% (4.35% + 0.375%). 3. Which of these two loans would you select on the basis of cost, all else being equal? Answer: This is a capital budgeting problem. By going with the Bank of America loan proposal, Siemens would pay an additional syndication fee of $1,875,000 (0.01125 – 0.0075) * $500,000,000. In return, Siemens would save interest expense of $625,000 each year for five years. This annual interest savings is the difference between paying LIBOR6 + 0.25% vs. LIBOR6 + 0.375% (0.00375 – 0.0025) * $500,000,000. The cash flows associated with going with the Bank of America proposal instead of the Deutsche Bank loan are thus: 0 1 2 3 4 5 (1,875,000) 625,000 625,000 625,000 625,000 625,000 These cash flows yield an internal rate of return of 24.29%, significantly higher than any reasonable estimate of the appropriate cost of capital for Siemens. Hence, the Bank of America loan proposal has the lowest effective cost. 4. What other factors might you consider in deciding between these two loan proposals? Answer: You might also want to consider how long it would take to put together the syndicates, the banking relationship you have with each of the banks, financial advice the banks might be able to provide, whether using the Bank of America syndicate would introduce Siemens to a new group of banks that it might be able to tap later on for more loans, the covenants associated with each loans, and the willingness of the banks to renegotiate these covenants at a later date. SUGGESTED ANSWERS TO CHAPTER 12 QUESTIONS 1. What are some basic differences between the financing patterns of U.S. and Japanese firms? What might account for some of these differences? Answer: The basic differences between the financing patterns of U.S. and Japanese firms are in the source of financing internal versus external-- and the composition of external finance bank borrowing versus debt securities. Historically, U.S. companies have received 60% to 70% of their funds from internal sources. By contrast, Japanese companies have relied heavily on external funds to finance their strategy of making huge industrial investments and pursuing market share at the expense of profit margins. Industry’s sources of external finance also differ widely between Japan and the U.S. Japanese firms rely heavily on bank borrowing, while U.S. firms raise much more money directly from financial markets by the sale of securities. 2. What is securitization? What forces underlie it and how has it affected MNC financing policies? Answer: Securitization is the process of matching up borrowers and savers by way of the financial markets. By contrast, financial intermediation involves the use of financial institutions such as banks and thrifts to bring together borrowers and savers. These institutions make a large number of loans and fund them by issuing liabilities (e.g., deposits) in their own name. Securitization largely reflects a reduction in the cost of using financial markets at the same time that the cost of bank borrowing has risen. Multinational companies and other large firms have participated in the securitization process. Instead of raising money in the form of nonmarketable loans provided by financial intermediaries, they are now issuing negotiable securities to the public capital markets. 3. Why is bank lending on the decline worldwide? How have banks responded to their loss of market share? Answer: Three economic forces underlie the decline of bank lending worldwide. (1) Upward pressure on the cost of bank intermediation, especially higher capital requirements not matched by a fall in the cost of capital at a time when transactions costs for both securities placement and risk management are falling. (2) An increase in financial risk, especially in interest rate volatility. Banks responded to higher interest rate volatility by sharply cutting back on loan commitments, thereby reducing the value of a banking relationship to corporate customers. (3) Increased competition to relationship lenders from banks and other financial institutions has reduced the perceived cost of severing a banking relationship. The perception that asset quality declined at many banks and that some might be vulnerable to liquidity problems in adverse market conditions also undermined bank credibility and the value of the banking relationship. Banks have responded to their loss of market share by eliminating the unprofitable aspect of the traditional lending relationship (retention of loans on the balance sheet) while reshaping their lending activity to retain the element crucial to the borrower (access to funds). Thus origination of loans for sale has emerged as a new business line. Banks have also expanded their nonlending services that produce fee income and are not (yet) covered by capital requirements. This includes engaging in investment banking activities such as underwriting commercial paper, foreign exchange trading, giving advice on mergers and acquisitions, and arranging swaps; providing credit commitments such as NIFs; and issuing standby letters of credit to guarantee the debt obligations of customers (called credit enhancement). 4.a. What is meant by the globalization of financial markets? Answer: The globalization of financial markets refers to the increasing integration of national financial markets. Markets for U.S. government securities and certain stocks, foreign exchange trading, interbank borrowing and lending to cite a few examples operate continuously around the clock and around the world and in enormous size. Foreign financial firms are increasing their participation in the world’s leading financial markets. Investors are scanning the globe to place their capital where it can realize the best risk return combination, while companies are seeking to raise money wherever in the world they can receive the best terms and conditions. In effect, globalization reflects the process of breaking down the artificial barriers that separate domestic from foreign capital markets. True globalization will come when the price of risk and the time value of money are identical worldwide. 4.b. How has technology affected the process of globalization? Recent technological improvements in such areas as data manipulation and telecommunications have greatly reduced the costs of gathering, processing, and acting on information from anywhere in the world. This has facilitated the process of arbitrage across financial markets, which has brought prices of securities with similar risks and returns closer in line with each other and turned the world into a vast interconnected market. 4.c. How has globalization affected government regulation of national capital markets? Answer: Because the globalization of financial markets and institutions has been brought about by technology and innovation, it cannot be reversed in any material way by regulation or legislation. National systems of supervision and regulation that were created many years ago were not designed for a marketplace of worldwide dimensions in which firms with differing charters and national origins compete head to head with each other around the clock and around the world. Governments that try to restrict domestic financial institutions will find that foreign firms have a competitive advantage. Similarly, restrictions on domestic financial markets drives business overseas. The net result has been to increase pressure for loosening controls on domestic financial institutions and markets to enable them to be more competitive and to speed the process of financial deregulation. 5. Many financial commentators believe that bond owners and traders today have an enormous collective influence over a nation's economic policies. Explain why this might be correct. Answer: Bond owners and traders influence national access to capital markets. To the extent that a nation requires this access (and most do, at least at some point in time), this exerts a strong disciplinary effect on the types of economic policies a nation is likely to select. A policy perceived as being economically harmful will restrict the nation’s access to capital on favorable terms. 6. Why are large MNCs located in small countries such as Sweden, Holland, and Switzerland interested in developing a global investor base? Answer: Large MNCs located in these small countries often need to raise substantial capital to continue growing. Quite often, the domestic market cannot provide this amount of capital on reasonable terms because local investors already have a large exposure to the local MNC. To add additional MNC paper will make their portfolios even less diversified, leading local investors to demand an added risk premium. By going overseas, MNCs from small countries such as Sweden and the Netherlands can find investors who view stocks and bonds from Dutch and Swedish MNCs as a source of diversification. In other words, although stocks of Dutch and Swedish MNCs comprise a large fraction of local portfolios, they comprise a small fraction of global wealth. The net result is a lower cost of capital for these MNCs from small countries (and hence a higher market value). In addition, developing a global investor base gives these MNCs access to capital in the event their local markets are subject to some event (most likely political) that restricts the ability of MNCs to raise capital there regardless of price. 7. Why are many U.S. MNCs seeking to improve their visibility with foreign investors, even going so far as to list their shares on foreign stock exchanges? Answer: There are several reasons for companies to list their shares on foreign stock exchanges: • Diversification of equity funding risk: A pool of funds from a diversified shareholder base insulates a company from the vagaries of a single national market. • Increase stock price: By selling stock overseas, a company can expand its investor base, thereby lowering its cost of equity capital and increasing its market value. • Boost foreign sales: An international stock offering can spread the firm’s name in local markets and increase its sales overseas. 8. List some reasons a U.S. based corporation might issue debt denominated in a foreign currency. Answer: A U.S. company might issue foreign currency debt because it • Wants to hedge a foreign currency exposure; or • Can borrow money at a lower effective interest rate. This is especially true for those bond issues that are combined with swaps. 9. In an attempt to regain business lost to foreign markets, Swiss authorities abolished stamp duties on transactions between foreigners as well on as new bond issues by foreign borrowers. However, transactions involving Swiss citizens will still attract a 0.15% tax, and bond issues by Swiss borrowers were also made more expensive. What are the likely consequences of these changes for Swiss financial markets? Answer: The reduced taxes on foreign investors and borrowers will slow down the loss of trading business to foreign markets, but it will not reverse it. Large Swiss companies that operate overseas (as most of them do) will try harder than ever to raise capital abroad and the big Swiss banks, well-established in London, have little reason to bring any of their Eurobond business back home. The trend for Swiss shares to increasingly trade abroad will not abate. Indeed, more Swiss companies are launching or are thinking of launching American Depository Receipts. 10. What is the difference between a Eurocurrency loan and a Eurobond? Answer: The fundamental distinction between a Eurobond and a Eurocurrency loan stems from the financing mechanism. A Eurobond is issued by the final borrower directly, whereas a Eurocurrency loan is made by a bank. Thus, Eurobond investors hold a claim on the issuer directly, whereas Eurocurrency loans are funded by investors who hold short term claims on banks that then act as intermediaries to transform these deposits into long term claims on final borrowers. 11. What is the difference between a foreign bond and a Eurobond? Answer: A foreign bond is an issue sold in the domestic bond market by a foreign company or government. As such, foreign bonds are subject to local laws and must be denominated in the local currency. By contrast, a Eurobond is sold outside the country in whose currency it is denominated. Eurobonds are also almost entirely free of official regulation. 12. What is the basic reason for the existence of the Eurodollar market? What factors have accounted for its growth over time? Answer: The Eurodollar market, exists because it enables borrowers and lenders alike to avoid a variety of U.S. banking regulations and controls, and it gives them an opportunity to escape the payment of some taxes. Some of the factors that have affected the growth of the Eurodollar market include the interest equalization tax, U.S. withholding tax on interest received by foreign owners of domestic securities, Regulations M and Q, and regulations from the U.S. Office of Foreign Direct Investment (OFDI). 13. Why have Eurobonds traditionally yielded less than comparable domestic bonds? Answer: Eurobonds are issued in bearer form, meaning they are unregistered, with no record to identify the owners. This feature allows investors to collect interest in complete anonymity and, thereby, evade taxes. Although U.S. law discourages the sale of such bonds to U.S. citizens or residents, bonds issued in bearer form are common overseas. As expected, investors are willing to accept lower yields on bearer bonds than on nonbearer bonds of similar risk. ADDITIONAL CHAPTER 12 QUESTIONS AND ANSWERS 1. Suppose the Swiss government imposes an interest rate ceiling on Swiss bank deposits. What is the likely effect on Euro franc interest rates of this regulation? Answer: If the Swiss government imposes an interest rate ceiling on Swiss bank deposits, holders of Swiss francs will shift some of their deposits into the Euro franc market to earn a higher rate. As the supply of Euro francs rises relative to the demand for francs, the Euro franc interest rate should decline. 2. What factors account for the rise and recent decline of the Eurobond market as a source of financing for American companies? Answer: The Eurobond market, like the Eurocurrency market, exists because it enables borrowers and lenders alike to avoid a variety of monetary authority regulations and controls, and it provides them with an opportunity to escape the payment of some taxes. As long as governments attempt to regulate domestic financial markets but allow a (relatively) free flow of capital among countries, the various external financial markets will survive. If tax and regulatory costs rise, these markets will grow in importance. The Eurobond market’s slump in recent years may be largely traced to a reversal of many of these tax and regulatory costs. The 1984 repeal of U.S. withholding tax on interest paid to foreign bondholders made domestic bonds, particularly U.S. Treasuries, more attractive to foreign investors. At the same time, the U.S. began permitting well known companies precisely the ones that would otherwise use the Eurobond market to bypass complex securities laws when issuing new securities, by using the "shelf registration" procedure. By lowering the cost of issuing bonds in the U.S. and dramatically speeding up the issuing process, shelf registration improved the competitive position of the U.S. capital market relative to the Eurobond market. Other nations such as Japan, France, and England also embarked on a program of deregulating their financial markets. The dollar’s weakness has also played a role in the slump in Eurobond financing. Although more foreign investors are buying U.S. securities, most of them still turn first to the Euro market for dollar denominated bonds. Thus, if foreigners want to diversify out of dollar bonds, the Euro market gets hit first. Another possible reason is the substitution of Euro notes for Eurobonds. 3. It had been said that if other European interest rates converged toward German rates, ECU bonds would soar in value. Explain why this would occur. Answer: ECU bonds are priced based on a weighted average of the interest rates of the currencies that comprise the ECU. Because of fears of higher inflation and hence currency devaluation in most European countries other than Germany, the weighted average interest rate on ECU bonds tends to exceed, often by a large margin, the German rate for a similar maturity DM issue. Hence, for other European interest rates to converge toward German rates, they would have to fall. Since bond prices move inversely to interest rates, a drop in ECU rates would boost ECU bond prices. SUGGESTED SOLUTIONS TO CHAPTER 12 PROBLEMS 1. A European company issues common shares that pay taxable dividends and bearer shares that pay an identical dividend but offer an opportunity to evade taxes: Bearer shares come with a large supply of coupons that can be redeemed anonymously at banks for the current value of the dividend. 1.a. Suppose taxable dividends are taxed at the rate of 10%. What is the ratio between market prices of taxable and bearer shares? If a new issue is planned, should taxable or bearer shares be sold? Answer: Under these conditions, the taxable proceeds are (1 0.10) = 90% of the bearer proceeds. Hence, the taxable shares will sell for 90% of the bearer shares. Bearer shares should be sold. 1.b. Suppose, in addition, that it costs 10% of proceeds to issue a taxable dividend, whereas it costs 20% of the proceeds to issue bearer stocks because of the expense of distribution and coupon printing. What type of share will the corporation prefer to issue? Answer: In this case, the taxable proceeds are (1 .10)(1 .10) = 81% of gross bearer proceeds, and net bearer proceeds are 1 .20 = 80% of gross bearer proceeds. The firm will now prefer to issue taxable equity. 1.c. Suppose now that individuals pay 10% taxes on dividends, and corporations pay no taxes, but bear an administrative cost of 10% of the value of any bearer dividends. Can you determine the relative market prices for the two types of shares? Answer: In this case, both issues yield 90% of gross bearer proceeds. Both types of shares will, therefore, sell for the same price and the firm will be indifferent between the two. 2. Suppose that the current 180 day interbank Eurodollar rate is 9% (all rates are stated on an annualized basis). If next period’s rate is 9.5%, what will a Eurocurrency loan priced at LIBOR plus 1% cost? Answer: Eurodollar loans are made on a floating rate basis, with the rate set at a fixed margin over LIBOR. Thus, if next period’s annualized LIBOR is 13%, then the Eurocurrency loan will be at 14% (13% + 1%) on an annualized basis. 3. Citibank offers to syndicate a Eurodollar credit for the government of Poland with the following terms: Principal US$1,000,000,000 Maturity 7 years Interest rate LIBOR + 1.5%, reset every six months Syndication fee 1.75% 3.a. What are the net proceeds to Poland from this syndicated loan? Answer: Poland will receive $982,500,000, which equals the $1 billion less the 1.75% syndication fee. 3.b. Assuming that six-month LIBOR is currently at 6.35%, what is the effective annual interest cost to Poland for the first six months of this loan? Answer: At LIBOR6 + 1.5%, Poland will pay interest at an annual rate of 7.85% (6.35% + 1.5%). 4. IBM needs to raise $1 billion and is trying to decide between a domestic dollar bond issue and a Eurobond issue. The U.S. bond can be issued at a coupon of 6.75%, paid semiannually, with underwriting and other expenses totaling 0.95% of the issue size. The Eurobond costs only 0.55% to issue but would bear an annual coupon of 6.88%. Both issues mature in 10 years. 4.a. Assuming all else is equal, which is the least expensive issue for IBM? Answer: The least expensive issue can be found by comparing the yield to maturity (YTM) for each bond, computed as the internal rate of return or IRR. For the domestic bond issue, the YTM is the solution r to the following equation: where the $990,500,000 in bond proceeds equals the billion dollar issue less 0.95% in issuance costs. The solution turns out to be r = 3.44%. Since this is a semiannual yield, we must convert it to annualized basis. The annualized YTM is found as (1.0344)2 - 1, or 7.00%. For the Eurobond issue, the YTM is the solution k to the following equation: The solution to this equation turns out to be k = 6.96%. Since this YTM is less than the annualized YTM for the U.S. bond, the Eurobond is the less expensive bond to issue. 4.b. What other factors might IBM want to consider before deciding which bond to issue? Answer: IBM might like to consider whether by issuing a Eurobond it can increase its investment presence among a different class of investor. It should also take into account the terms of the call and other provisions. Moreover, if it has any thoughts of revising the terms of the bond issue in the future, it should consider the greater difficulty it would have with the Eurobond issue (because buyers are largely anonymous). ADDITIONAL CHAPTER 12 PROBLEMS AND SOLUTIONS 1. Suppose that Zimbabwe has a choice of two possible $100 million, five-year Eurodollar loans. The first loan is offered at LIBOR + 1% with a 2.5% syndication fee, whereas the second loan is priced at LIBOR + 1.5% and a 0.75% syndication fee. Assuming that Zimbabwe has a 9% cost of capital, which loan is preferable? Hint: View this as a capital budgeting problem. Answer: The dollar cash flows associated with these two spread-syndicate fee combinations are as follows: Loan Option Fee Interest Spread (Years 1-5) Loan 1 (2.5% fee, 1% spread) $2,500,000 $1,000,000 Loan 2 (0.75% fee, 1.5% spread) $750,000 $1,500,000 Using a 9% discount rate, we can compare the present values of these two combinations: Based on these comparisons, we can see that at a 9% discount rate, the first loan fee-spread combination is the least expensive one. 2. Refer to the example of Exxon’s zero coupon Eurobond issue in the section titled The Euromarkets. 2.a. How much would Exxon have earned if the yield on the stripped Treasurys had been 12.10%? 12.25%? Answer: As we saw in the chapter, Exxon realized proceeds of about $199 million from its $1.8 billion zero coupon Eurobond issue. It would have cost Exxon about $183 million to purchase the $1.8 billion in stripped Treasury bonds at an interest rate of 12.10%: Bond value = $1,800,000,000/(1.1210)20 = $183,000,000 At this price, Exxon would have earned the difference of about $16 million. If the yield on stripped Treasuries had been 12.25%, Exxon could have purchased $1.8 billion in Treasuries for $178 million: Bond value = $1,800,000,000/(1.1225)20 = $178,000,000 At this price, Exxon would have earned the difference of about $21 million. 2.b. Suppose the Japanese government taxed the accretion in the value of zero coupon bonds at a rate of 15%. Assuming the same 11.65% after tax required yield, how would this tax have affected the price Japanese investors were willing to pay for Exxon’s Eurobond issue? What is pre tax yield at this new price? Would any arbitrage incentive still exist for Exxon? Answer: At maturity, investors receive (1 0.15)(1.8B P), where P represents the amount paid for the bonds. Using the after tax yield of 11.6% to set price, we get the following equation: Price = P = 0.85 * (1.8B P)/1.116520 or P = $154 million. The yield can now be found by solving the following equation: 154,000,000 = 1,800,000,000/(1 + r)20, or r = 13.08% The pre tax rate of 13.08% exceeds Exxon’s investment rate of 12.2%, so no arbitrage is possible. 2.c. Suppose Exxon had sold its zero coupon Eurobonds to yield 11.5% and bought stripped Treasury bonds yielding 12.30% to meet the required payment of $1.8 billion. How much would Exxon have earned through its arbitrage transaction? Answer: At 11.5%, bond proceeds = 1.8B/1.115020 = $204 million. At 12.3%, bond cost = 1.8B/1.123020 = $177 million. Thus, profit = $204 million - $177 million = $27 million. 3. British Telecom (BT) has issued $1 billion in Euro-CP maturing in 75 days and priced to yield 5.8% annually based on a 360-day year. 3.a. What are BT’s proceeds from the issue? Answer: According to Equation 13.7, the market price of a Euro-CP issue can be computed as follows: Substituting in the values for BT results in estimated proceeds of $988,060,930, computed as follows: 3.b. What is the discount rate on BT’s issue? Answer: According to Equation 13.6, the relation between the annual yield and the discount rate can be expressed as follows: By reversing Equation 13.6, we can solve for the discount rate as 5.73%: Solution Manual for Foundations of Multinational Financial Management Atulya Sarin, Alan C. Shapiro 9780470128954
