International Financial Management

P G Apte
LONG TERM BORROWING IN
THE GLOBAL FINANCIAL
MARKETS
Introduction
Phenomenal changes have swept financial markets
around the world during the 1980's and the 1990s
Financial markets everywhere serve to facilitate
transfer of resources from surplus units (savers) to
deficit units (borrowers), the former attempting to
maximise the return on their savings while the latter
looking to minimise their borrowing costs
An efficient financial market thus achieves an
optimal allocation of surplus funds between
alternative uses and healthy financial markets also
offer the savers a wide range of instruments enabling
them to diversify their portfolios
Introduction
Globalisation of financial markets during
the eighties has been driven by two
underlying forces
Growing (and continually shifting)
imbalance between savings and investment
within individual countries
Increasing preference on the part of
investors for international diversification of
their asset portfolios


Introduction
Liberalisation and integration of financial
markets
The markets themselves have proved to be
highly innovative, responding rapidly to
changing investor preferences and increasingly
complex needs of the borrowers by designing
new instruments and highly flexible risk
management products
The combined result of these processes has
been the emergence of a vast, seamless global
financial market transcending national
boundaries
Introduction
It is by no means true that controls and
government intervention have entirely
disappeared
For developing countries, as far as debt
finance is concerned, external bonds and
syndicated credits are the two main
sources of funds
Legal Framework in India for Foreign Investment

In India the Legal framework for foreign investment in
India is segregated primarily in two parts; one governs the
investment in capital and the other borrowings.

The set of rules that govern the investment in capital is
commonly called Foreign Direct Investment (FDI)
Regulations. Whereas the set of rules that governs foreign
investment in form of borrowings is called External
Commercial Borrowing (ECB) Regulations.

Let us first have a closer look to what exactly falls under
which set of rules. Foreign Direct Investment as the name
suggests is the investment made towards core capital of an
organization viz. investment in equity shares, convertible
preference share and convertible debentures.
Till late there was ambiguity about the partially
convertible preference shares and debentures being
considered as part of Foreign Direct Investment.
However in June 2007 the Reserve Bank of India has
clarified as follows :
Only instruments which are fully and mandatorily
convertible into equity within a specified time would be
reckoned as part of equity under the FDI Policy and will be
eligible to be issued to persons resident outside India under
the Foreign Direct Investment Scheme.
Thus it is now crystal clear that the investment in non-
convertible or partially convertible preference shares and
debentures or any instrument with no definite period for
conversion in equity will come under the purview of ECB
Guidelines.
Moreover any investment as commercial loans [in the
form of bank loans, buyers credit, suppliers credit,
securitised instruments (e.g. floating rate notes and fixed
rate bonds)] availed from non-resident lenders with
minimum average maturity of 3 years will also come under
the purview of ECB Guidelines.

Deficits and External Financing - Developing &
Emerging Market Economies ( $ Bill.)
_________________________________________________
ITEM 2001 2002 2003

BALANCE ON CURRENT
ACCOUNT 38 84 121

NET EXTERNAL FINANCING 148 160 254

NON-DEBT FLOWS 181 144 156

NET EXTERNAL
BORROWING -33 16 98
(FROM OFFICIAL SOURCES) 33 10 19
(FROM PRIVATE SOURCES) -66 6 79
CAPITAL FLOWS INTO INDIA
Borrowing on International Capital Markets ($ Bill)

2007 2008
1 Syndicated Credit
Facilities 2770 1682
Borrowers from
(i) Developed
Countries 2257 1304
(ii) Developing
Countries 442 316
2 Debt Securities 2977 2436
(Net Issues)
Issuers from
(i) Developed
Countries 2763 2345
(ii) Developing
Countries 155 28
2a Money Market
Instruments
*
199 82
2b Bonds and Notes 2778 2355


Introduction
Indian entities began accessing external capital
markets towards the end of seventies as
gradually the amount of concessional assistance
became inadequate to meet the increasing
needs of the economy
The Indian authorities adopted a selective
approach and permitted only a few select
banks, all India financial institutions, and large
public and private sector companies to access
the market

Foreign Portfolio Investment Flows
Country Portfolio Inflows (US $ billion)

Price-Earnings
2001 2002 2003 Ratio (Per cent)

Hong Kong -1.2 -0.9 -1.4 17.8
Chile 1.4 1.3 1.0 18.6
India 2.0 1.0 11.4 14.3
South Korea 12.2 4.9 14.2 14.6
Philippines 1.4 2.3 1.1 16.8
Thailand -0.6 -0.7 0.3 9.0

Note:
1. Data for China, Chile, Hong Kong and Philippines for 2003 are up to
September and for Thailand up to June.
2. Data for price-earnings ratio are for end-March 2004.
3. Data for India relates to financial year.

Till a few years ago, external commercial
borrowings was the major source of non-
governmental external funding.
By and large, India's borrowings have been by
way of syndicated bank loans, buyers' credits
and lines of credits
We will obtain an overview of the major
segments of the global debt markets in terms of
funding avenues, general regulatory
framework, accessibility and some procedural
aspects
Examine the analytics of the international
financing decisions from the borrower's point
of view and risk-return considerations from the
investor's point of view
Indias External Debt (Commercial)
End March (USD Mio)
Item 1999 2000 2001 2002

Commercial Bank
Loans 20978 19943 24215 23338

Securitized
Borrowings 10343 10094 9899 9971

Other 863 776 622 489

NRI&FC (B&O)
Deposits 11794 13559 16568 17154

Export Credit 6789 6780 5923 5005

Total LT Debt 92612 94327 97504 95744

Total Debt 96886 98263 101132 98489
FUNDS RAISED ON GLOBAL DEBT MARKETS
(USD BILL)

SYNDICATED BONDS&NOTES MONEY MARKET
CREDITS NET ISSUES INST.(NET ISSUES)

2008 2009Q1 2008 2009Q1 2008 2009Q1

CHINA 18.4 8.0 1.9 ---- 0.4 -0.3
INDIA 21.1 2.5 1.0 -0.7 -0.1 ----
S.KOREA 16.2 2.9 0.6 3.0 -2.8 0.5
BRAZIL 15.0 1.5 -3.8 0.9 1.2 -0.5
MEXICO 12.3 1.5 -3.4 -2.2 0.1 -0.1
The Major Funding Avenues
The funding avenues potentially open to a
borrower in the global capital markets can be
categorised as follows
Bonds : Foreign Bonds and Eurobonds
Straight Bonds
Floating Rate Notes (FRNs)
Zero-coupon and deep discount bonds
Bonds with a variety of option features
embedded in them

The Major Funding Avenues
Syndicated Credits
These are bank loans, usually at floating rate of
interest, arranged by one or more lead managers
(banks) with a number of other banks participating
in the loan
Medium Term Notes (MTNs)
Initially conceived as instruments to fill the maturity
gap between short-term money market instruments
like commercial paper and long-term instruments
like bonds, these subsequently evolved into very
flexible borrowing instruments
The Major Funding Avenues
Committed Underwritten Facilities
The basic structure under this is the Note I ssuance
Facility (NI F), these instruments were popular for a
while before introduction of risk-based capital
adequacy norms rendered them unattractive for
banks
Money Market Instruments
These are short-term borrowing instruments and
include commercial paper, certificates of deposit
and bankers' acceptances among others
The Major Funding Avenues
Another innovation to have emerged during the
last decade or so is Project Finance and its
novelty lies in the way the financing package is
put together including the rights and
obligations of the parties involved, allocation of
various operating and financial risks to those
who are best equipped to bear them,
incorporation of various guarantees and so
forth
The Major Funding Avenues
Most of the funding instruments discussed
above also have their "domestic" and
"offshore" segments
Borrowers often access a currency-market
segment which offers ease of access, cheaper
all-in cost or some other attractive feature and
then use swaps to reconfigure their liabilities in
terms of currency and interest rate basis
SIGNED SYNDICATED CREDIT FACILTIES
( US$ BILLION)

BORROWERS FROM 2007 2008 2009 2009
Q1 Q2
ALL COUNTRIES 2770 1656 194.3 254.7
DEVELOPED 2257 1289 157.6 210.4
DEVELOPING 442 309 30.6 38.5
ASIA-PACIFIC 134 96 14.7 12.1
INDIA 36.0 20.4 3.3 5.0
CHINA 17.8 17.2 6.3 0.6
S.KOREA 31.6 14.7 2.1 2.5
INTERNATIONAL DEBT SECURITIES
( ALL ISSUERS, NET ISSUES, US$ BILLION)

ISSUERS FROM 2007 2008 2009 2009
Q1 Q2
ALL COUNTRIES 2977 2432 668 837
DEVELOPED 2764 2342 650 747
DEVELOPING 154 27 -4.7 22
ASIA-PACIFIC 42.5 8.2 0.3 10.1
INDIA 15.7 3.4 -1.5 0.8
CHINA 8.6 5.6 -1.4 0.4
S.KOREA 10.9 -3.0 3.2 11.7
INTERNATIONAL DEBT SECURITIES
( CORPORATE ISSUES, US$ BILLION)
ISSUERS FROM 2007 2008 2009Q1

ALL COUNTRIES 279 307 170.1
DEVELOPED 241 298 169.9
DEVELOPING 34 8.6 -0.9
ASIA-PACIFIC 9.9 -0.1 -0.8
INDIA 8.5 2.4 -0.4
CHINA 3.6 2.2 ---
S.KOREA -0.8 0.9 0.9
INTERNATIONAL MONEY MARKET
INSTRUMENTS
(NET ISSUES US$ BILL.EQUIVALENT)
2007 2008 2009Q1

TOTAL ISSUES 199 82 -71
COMMERCIAL PAPER 15 71 -32
CORPORATE ISSUERS -6.5 26.7 -8.6
FINANCIAL INSTITUTIONS 13.0 -31.7 -7.1
OTHER INSTRUMENTS 183.9 11.1 -38.9
CORPORATE ISSUERS -0.5 1.0 -0.5
FINANCIAL INSTITUTIONS 184.2 9.7 -37.3


The Major Funding Avenues
Bond Markets
A bond is a debt security issued by the
borrower, purchased by the investor, usually
through the intermediation of a group of
underwriters
Straight Bond
Callable Bond
Puttable bond
Sinking Fund Bond


The Major Funding Avenues
FRN
Zero Coupon Bond
Convertible Bond
Warrants
A large number of other variants have been brought
to the market
Yankee Bonds
Samurai Bonds and Shibosai Bonds
Shogun Bonds and Geisha Bonds
The Major Bond Market Segments
Eurobonds : Unregistered, bearer
Foreign Bonds : Non-resident issues in a countrys
domestic capital market
Yankee Bonds : Public issues in US. Strict
regulation
Private placements : Less strict regulation
Samurai Bonds : Public Issues in Japan
Shibosai Bonds,Shogun Bonds and Geisha Bonds
Private placements in Japan
Swiss and German Bonds : Public Issues and
Private placements
Bulldog Bond : UK Public Issues
Rembrandt Bonds : Holland Public Issues
INTERNATIONAL BONDS AND NOTES
(NET ISSUES, US$ BILL.EQUIVALENT)
2007 2008 2009Q1

TOTAL ISSUES 2778.1 2354.6 740.4
FLOATING RATE 1129.8 1206.3 103.1
CORPORATE ISSUERS 23.6 ---- -4.4
FINANCIAL INSTITUTIONS 1110.0 1215.3 93.6
STRAIGHT FIXED RATE 1612.4 1140.5 644.0
CORPORATE ISSUERS 253.3 280.2 185.1
FINANCIAL INSTITUTIONS 1237.2 766.8 334.9
EQUITY RELATED 35.9 7.8 -6.7
CORPORATE ISSUERS 8.9 -0.4 -1.5
FINANCIAL INSTITUTIONS 27.3 8.3 -5.1




Fig.A.19.3
The UK/European Three-tier Structure

A TRADITIONAL SYNDICATE
RISK OF A FOREIGN BOND FROM THE INVESTOR'S
VIEWPOINT
Recall that the sensitivity of the price of a coupon bearing
instrument to changes in interest rate is measured by the duration of
the security :




r)) + (1
r) + d(1
P
dP
- = D

where P is the price of the bond and r is the yield. Thus duration is
the (negative) of the elasticity of bond price with respect to the
discount factor (1+r). A simple measure[of duration known as
"Macaulay Duration" (MD) is given by



)
t
r + (1
CF
t
T = t
1 = t
)
t
r + (1
CF
t
t
T = t
1 = t
= MD

Now consider a foreign bond. Its price in its currency of

denomination (the "foreign currency") is denoted P. To an
investor with a different "home" currency, its value in that
currency is
V = PS
where S is the spot rate in units of home currency per unit of
foreign currency. Take logs and differentiate to yield

dlnV = dlnP + dlnS
But dlnP = dP/P = -D[dr/(1+r)]

Hence


dlnS(PS) (PS)
r) + (1
dr
D - = dV
The variance of dV is given by

Var(dV) = (PS)
2
{a
2
Var(dr)+Var(dlnS) - 2a Cov(dr,dlnS)})

where a = D/(1+r).

Thus risk of a foreign bond from the investor's viewpoint
depends not only upon the duration of the security but also
upon how volatile interest rates are in the country of the
currency of denomination of the bond, the volatility of the
spot rate and the covariance of the two.

The contribution of these separate sources of risk varies
depending upon the domicile of the investor and the country
of issue and currency of the bond.
EXPECTED EXCHANGE RATES, TAXES AND
CURRENCY OF BORROWING

Tax treatment of foreign exchange gains and losses on foreign
currency liabilities will determine the after-tax cost of
borrowing for the borrower. If exchange losses on foreign
currency liabilities are allowed to be set off against operating
profits like interest payments, then a post-tax comparison of
effective borrowing cost between two currencies will yield same
result as pre-tax comparison. Thus suppose an Indian company
is planning to borrow for one year. The choice is between a
dollar borrowing and a yen borrowing. The nominal rates are
4% and 2% respectively and the expected appreciation is 5%
for the dollar and 7% for yen. The effective pre-tax cost is 9%
for both dollar and yen. If the Indian company's tax rate is
50% the post-tax costs are 4.5%. On either basis, the company
would be indifferent between the two.

EXPECTED EXCHANGE RATES, TAXES AND
CURRENCY OF BORROWING
From the investor's point of view, if exchange gains are treated
as capital gains and taxed at a lower rate, bonds denominated
in a faster appreciating currency would be more attractive.

Thus suppose the above Indian company's lenders are dollar
based investors who have identical expectations about exchange
rate movements so that they expect the yen to appreciate 2%
against the dollar. Suppose the tax rates for these investors are
40% on interest income and 20% on exchange gains.

Then the after-tax return would be 2.4% on the dollar asset
[= (1-0.4) 4%]
and 2.8% on the yen denominated asset
[= (1-0.4) 2% + (1-0.2) 2%].
Investors might lower the nominal rate on Yen loans.
Syndicated Credits

A traditional Eurosyndicated loan is usually a
floating rate loan with fixed maturity, a fixed
drawdown period and a specified repayment
schedule
Lead managers, Syndicate members and Agent
bank
A typical Eurocredit would have maturity between
five and 10 years, amortisation in semiannual
instalments, and interest rate reset every three or six
months with reference to LIBOR
Club Loans : Private deals, unpublicised
Revolving Credit
Syndicated Credits
Standby facility
The cost of a loan consists of interest and a number
of fees - management fees, participation fees, agency
fees and underwriting fees when the loan is
underwritten by a bank of a group of banks
Apart from the Euromarkets, syndicated credits can
be arranged in some of the national capital markets
such as Japan and UK.

Fig.A.19.1

Other Securitised Funding Avenues
MTNS and EMTNs
Originally evolved as a bridge between short-term
money market products and long term bonds
The main advantage of borrowing via an MTN or
EMTN programme is its flexibility and much less
onerous formalities of documentation compared to a
bond issue; timing flexibility, multicurrency facility
The market is accessible only to issuers with good
credit rating

Underwritten Facilities
NIF and Related Facilities
Highly rated borrowers decided to short circuit the
banks and raise financing directly from investors by
issuing their own paper
A Note Issue Facility (NIF) is a medium-term legally
binding commitment under which a borrower can
issue short-term paper in its own name, but where
underwriting banks are committed either to
purchase any notes which the borrower is unable to
sell, or to provide standing credit
NIFs and RUFs
If at any roll-over the borrower is unable to place
the entire issue with the market, the underwriting
banks either take up the remainder or provide a
short-term loan and the arrangement under which
the banks provide credit to make up the shortfall is
known as a Revolving Underwriting Facility (RUF)
Have lost popularity with introduction of capital
adequacy requirements against commitments.
Project Finance
The central idea in project financing is to arrange a
financing package which will permit the transfer or
sharing of various risks among several parties
including project promoters with a no recourse or
limited recourse feature
The lenders evaluate the project as an independent
entity and have claims on the cash flows generated
by the project for their interest payments and
principal repayments without recourse to any other
assets owned by the project promoters.
Lenders would like to maximise the chances of
project success. Involve project contractors as an
equity partner, take-or pay guarantees from major
customers of project output, guarantees from
suppliers, counter-guarantees etc.
Project Finance
The lenders may require guarantees
In some circumstances, third party guarantees can
be arranged
The sources of equity and debt finance for projects
have been numerous
An innovation in project finance is the BOT device
which stands for Build, Own and Transfer (some
times also called BOOT - Build, Own, Operate and
Transfer)
Concept of co-finance Joint financing by private
lenders and multilateral agencies like World Bank
A variety of funding techniques, risk sharing
strategies and risk management tools such as swaps
and options are packaged together for a large
project
The nature of all these markets and instruments is very
dynamic
In the Indian context, the government's regulatory
stance on accessing these funding avenues needs to be
kept in mind
The International Financing Decision
The issue of the optimal capital structure and
subsequently the optimal mix of funding
instruments is one of the key strategic decisions
for a corporation
The actual implementation of the selected
funding programme involves several other
considerations such as satisfying all the
regulatory requirements, choosing the right
timing and pricing of the issue, effective
marketing of the issue and so forth
The International Financing Decision
The International Financing Decision
The critical dimensions of this decision for a
firm to chose funding avenues
Interest rate basis : Mix of fixed rate and floating
rate debt
Maturity : The appropriate maturity composition of
debt; long term or short-term rolled over
Currency composition of debt
Which market segments should be tapped
Take advantage of any market imperfections
Take advantage of subsidized financing
opportunities
All-in cost, currency risk, interest rate risk
The International Financing Decision
These dimensions interact to determine the
overall character of the firm's debt portfolio
The overall guiding principles in choosing a
debt portfolio
The nature of financing should normally be driven by the
nature of the business, in such a way as to make debt-service
payments match the character and timing of operating
earnings. Because this reduces the probability of financial
distress, it allows the firm to have greater leverage and
therefore a greater tax shield. Deviation from this principle
should occur only in the presence of privileged information or
some other market imperfection. Market imperfections that
provide cheaper financing exist in practice in a wide range of
circumstances. - Giddy

The International Financing Decision
Overriding these considerations are issues of
regulation and market access
In viewing the risks associated with funding
activity, a portfolio approach needs to be
adopted
Currency and interest rate exposures arising
out of funding decisions should not be viewed
in isolation but as total risk of asset-liability
portfolio and exposures arising out of regular
operations.
The International Financing Decision
In comparing funding options the
following parameters have to be
examined under alternative scenarios
The all-in cost of a particular funding
instrument under alternative simulations
of paths of interest rates and exchange rates
Interest rate and currency exposure arising
from using a particular financing vehicle

The International Financing Decision
Consider a firm which is contemplating a
fixed rate foreign currency loan (or a
fixed rate foreign currency bond issue)
The nominal rate of interest is I (expressed
as a fraction not percentage), the maturity is
N years, interest is paid annually and
repayment is bullet
The principal amount is A

The International Financing Decision
The rate of exchange at time t is denoted S
t

expressed as units of home currency per unit of
foreign currency
The real cost of this loan consists of three
components viz. the nominal interest, appreciation
of the foreign currency and domestic inflation is R =
I + -
denotes proportionate change in the spot rate and
is the domestic rate of inflation
The variance of the real cost therefore is
Var(R) = Var() + Var () - 2Cov (, )

The International Financing Decision
To compare the variances of real costs, the
covariance term is important
Between two currencies, if the variance of both is
nearly equal, the one which obeys PPP with the
home currency more closely will have a lower
variance of real cost of borrowing
If the real cost risk is ignored, the choice of currency
should be based on a comparison of effective interest
rates which consist of the nominal interest rate I,
and the expected rate of appreciation of the foreign
currency S
e


The International Financing Decision
When the nominal interest rate itself is
not fixed - as with a floating rate loan
or FRNs - an additional source of risk
is introduced viz. the variance of the
nominal interest rate and its
covariances with the exchange rate and
domestic inflation rate
A bond issue with an embedded currency option
from a class of instruments called Indexed Currency
Option Notes (ICONS).
In 1985 Bankers Trust (BT) lead managed for Long Term Credit Bank
(LTCB) of Japan an issue of $120 million Eurobonds with a coupon of
11.5% p.a. and maturity of 10 years. The redemption amount R at
maturity will depend upon the value at that time of the spot /$ exchange
rate S as follows :
If S 169,
R = $120 million
If S < 169
R = $(120000000){1 [(169-S)/S]}
Effectively, the investors in the bond have granted LTCB a put option on
dollars against yen at a strike price of 169.00/$ for an amount of $120
million.
BT purchased the put option from LTCB in return
for a reduction in LTCB's borrowing cost. This was
achieved as follows. It arranged for an issue of Yen
bonds with a coupon of 6.65% p.a., 10 year maturity
and face amount of 24,240,000,000, converted this
to $120 million at the then spot rate of 202/$ and
loaned the dollars to a counterparty at 10.7% p.a.
Yen interest payments on the bonds were covered by
means of a series of $/ forward contracts and the
yen principal was left unhedged. The market rates at
the time were :
10-year US treasury bond rate was 10.5% p.a.
10-year Japanese Government bond rate was 6.5%.

At maturity of the yen bond issue (and the dollar
loan), the worst-case scenario for BT is it will have to
buy yen at the rate of 169/$. For $120 million this will
yield 20,280,000,000 leading to a shortfall of
[24240000000-20280000000] = 3,960,000000. This
translates into an annual payment of 293,454,573.
The net result is that BT realises a profit stream which
is equivalent to a 10-year annuity of $1,566,024 at a
discount rate of 10.5%. If all of this gain is passed on
to LTCB (which is unlikely), LTCB's borrowing cost
will come down to 10.2%

Country Risk Analysis
The essence of country risk analysis is an assessment of factors that will
affect a country's ability and willingness to service its external obligations.
A variety of political, economic and psycho-social considerations are
relevant.
Many rating systems have been evolved which attempt to precisely define,
measure and weight these factors to arrive at a single indicator of a
country's creditworthiness.
The economic factors can be broadly grouped into three categories.
The first of these pertains to the resource base of the country.
This category includes natural resources like land, mineral deposits etc.,
human resources including quality and depth of managerial and technical
skills, strength of the entrepreneurial spirit and trainability of the labour
force and financial resources which pertains to saving rate of the economy.

Country Risk Analysis
The second set of factors refers to macroeconomic performance and the
quality of economic management.
High and steady growth, high per capita income, high rate of capital
formation etc. indicate good macroeconomic performance.
Lenders tend to be favourably biased towards political and legal systems
that provides incentives to individual enterprise with minimum of
government regulation, and fiscal and monetary conservatism.
Professional competence of key officials in the finance ministry and the
central bank of the country, a well trained cadre of middle level officials, a
relatively independent monetary authority, an efficient and facilitative
bureaucracy and a government with the political will to implement tough
decisions are highly valued
Bankers prefer a long term development strategy that emphasizes output
growth, stable prices, an "outward" orientation and "sound external
finance". Administered interest rates, subsidies, administrative credit
allocation, overvalued exchange rates, exchange controls etc. are generally
frowned upon.

Country Risk Analysis
The third set of factors refers to the external position of the country. This
is the bottom line. Several indicators are used to assess the country's
ability to generate sufficient foreign exchange to service its liabilities.
Among the most important of these are :
1. State of the current account. Chronic deficits are regarded as a danger
signal. Deficits in excess of 2-3% of GDP are considered excessive.
2. A rapid and stable growth of exports and a diversified export base are
desirable attributes.
3. Existing Debt/GDP ratio and the debt service ratio. The latter is defined
as the ratio of debt service payments on existing liabilities to the export
earnings. A value in excess of 25% is a cause for concern.
4. Ratio of reserves to normal imports.
5. The country's access to IMF for meeting temporary BOP difficulties.