Unit 4 Trade Settlement Methods, Export Finance, International Sources of Finance


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This presentation covers Trade Settlement Methods, Export Finance, Buyers credit and supplier’s credit, International receivables and cash management, and International Sources of Finance such as ECB, FCCB, ADR, GDR, FDI, Loan Syndication.

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Unit 4 Trade Settlement Methods, Export Finance, International Sources of Finance

  1. 1. Unit 4: Trade Settlement Methods, ExportFinance, International Sources of FinanceInternational Finance
  2. 2. Trade Settlement Methods2 Mrs. Charu Rastogi, Asst. Professor
  3. 3. Methods of payment in international trade To succeed in today‟s global marketplace and winsales against International trade presents a spectrumof risk, which causes uncertainty over the timing ofpayments between the exporter (seller) and importer(foreign buyer). For exporters, any sale is a gift until payment isreceived. Therefore, exporters want to receive payment as soonas possible, preferably as soon as an order is placedor before the goods are sent to the importer. For importers, any payment is a donation until thegoods are received. Therefore, importers want to receive the goods assoon as possible but to delay payment as long aspossible, preferably until after the goods are resold togenerate enough income to pay the exporter.3 Mrs. Charu Rastogi, Asst. Professor
  4. 4. Methods of payment in international trade :Cash in Advance / Prepayments With cash-in-advance payment terms, the exportercan avoid credit risk because payment is receivedbefore the ownership of the goods is transferred. Wire transfers and credit cards are the mostcommonly used cash-in-advance options available toexporters. However, requiring payment in advance is the leastattractive option for the buyer, because it createscash-flow problems. Foreign buyers are alsoconcerned that the goods may not be sent if paymentis made in advance. Thus, exporters who insist on this payment method astheir sole manner of doing business may lose tocompetitors who offer more attractive payment terms.4 Mrs. Charu Rastogi, Asst. Professor
  5. 5. Methods of payment in international trade:Letters of Credit Letters of credit (LCs) are one of the most secureinstruments available to international traders. An LC is a commitment by a bank on behalf of thebuyer that payment will be made to theexporter, provided that the terms and conditionsstated in the LC have been met, as verified throughthe presentation of all required documents. The buyer pays his or her bank to render this service. An LC is useful when reliable credit information abouta foreign buyer is difficult to obtain, but the exporter issatisfied with the creditworthiness of the buyer‟sforeign bank. An LC also protects the buyer because no paymentobligation arises until the goods have been shipped ordelivered as promised.5 Mrs. Charu Rastogi, Asst. Professor
  6. 6. Letter of credit: ProcedureBuyer (Importer) Seller (Exporter)Exporter‟s bank(Advising Bank)Importer‟s bank(Issuing Bank)1. Sale Contract3. Send Credit4. Deliver Letterof Credit2. Requestfor Credit5. Deliver Goods7. Present Documents6. PresentDocuments8. Documentsand claim forpayments6 Mrs. Charu Rastogi, Asst. Professor
  7. 7. Types of Letter of Credit Irrevocable and revocable letters of credit A revocable letter of credit can be changed or cancelled by the bank that issued itat any time and for any reason. An irrevocable letter of credit cannot be changed or cancelled unless everyoneinvolved agrees. Irrevocable letters of credit provide more security than revocableones. Confirmed and unconfirmed/Advised letters of credit When a buyer arranges a letter of credit they usually do so with their own bank,known as the issuing bank. The seller will usually want a bank in their country tocheck that the letter of credit is valid. For extra security, the seller may require the letter of credit to be confirmed by thebank that checks it. By confirming the letter of credit, the second bank agrees toguarantee payment even if the issuing bank fails to make it. So a confirmed letter ofcredit provides more security than an unconfirmed one. In case of unconfirmed LC, the advising bank forwards an unconfirmed letter ofcredit directly to the exporter without adding its own undertaking to make paymentor accept responsibility for payment at a future date, but confirming its authenticity.7 Mrs. Charu Rastogi, Asst. Professor
  8. 8. Types of Letter of Credit Transferable letters of credit A transferable letter of credit can be passed from onebeneficiary (person receiving payment) to others. Theyrecommonly used when intermediaries are involved in atransaction. Stand-by LC A standby letter of credit is like a guarantee that is used assupport where an alternative, less secure, method of paymenthas been agreed. It is an assurance from a bank that a buyer is able to pay aseller. The seller doesnt expect to have to draw on the letter ofcredit to get paid.8 Mrs. Charu Rastogi, Asst. Professor
  9. 9. Types of Letter of Credit Revolving LC The revolving credit is used for regular shipments of the same commodity to thesame importer. It can revolve in relation to time or value. If the credit is utilised it isre-instated for further regular shipments until the credit is fully drawn. If the creditrevolves in relation to value once utilised and paid the value can be reinstated forfurther drawings. Revolving letters of credit are useful to avoid the need for repetitious arrangementsfor opening or amending letters of credit. Back to Back LC A back-to-back letter of credit can be used as an alternative to thetransferable letter of credit. Rather than transferring the original letter of creditto the supplier, once the letter of credit is received by the exporter from theopening bank, that letter of credit is used as security to establish a secondletter of credit drawn on the exporter in favour of his importer. Many banks are reluctant to issue back-to-back letters of credit due to thelevel of risk to which they are exposed, whereas a transferable credit will notexpose them to higher risk than under the original credit.9 Mrs. Charu Rastogi, Asst. Professor
  10. 10. Methods of payment in international trade:Documentary Collections/Drafts/Bills of Exchange) A documentary collection (D/C) is a transaction wherebythe exporter entrusts the collection of a payment to theremitting bank (exporter‟s bank), which sends documentsto a collecting bank (importer‟s bank), along withinstructions for payment. Funds are received from the importer and remitted to theexporter through the banks involved in the collection inexchange for those documents. D/Cs involve using a draft that requires the importer to paythe face amount either at sight (document againstpayment) or on a specified date (document againstacceptance). The draft gives instructions that specify the documentsrequired for the transfer of title to the goods. Althoughbanks do act as facilitators for their clients, D/Cs offer noverification process and limited recourse in the event ofnon-payment. Drafts are generally less expensive than LCs.10 Mrs. Charu Rastogi, Asst. Professor
  11. 11. Methods of payment in international trade:Open Account An open account transaction is a sale where the goods areshipped and delivered before payment is due, which isusually in 30 to 90 days. Obviously, this option is the most advantageous option tothe importer in terms of cash flow and cost, but it isconsequently the highest risk option for an exporter. Because of intense competition in export markets, foreignbuyers often press exporters for open account terms sincethe extension of credit by the seller to the buyer is morecommon abroad. Therefore, exporters who are reluctant toextend credit may lose a sale to their competitors. However, the exporter can offer competitive open accountterms while substantially mitigating the risk of non-paymentby using of one or more of the appropriate trade financetechniques, such as export credit insurance.11 Mrs. Charu Rastogi, Asst. Professor
  12. 12. Comparison12 Mrs. Charu Rastogi, Asst. Professor
  13. 13. ComparisonCash inAdvanceLetter of Credit DC/BoE Open AccountTime ofPaymentBeforeShipmentWhen shipment ismadeOn presentation ofdraftAs agreeduponGoodsavailable tobuyersAfter payment After payment After paymentBeforepaymentRisk toexporterNone Very little - NoneDisposal ofunpaid goodsRelies on buyerto pay asagreed uponRisk toimporterRelies onexporter toship goods asorderedAssured shipment butrelies on exporter toship goods asdescribed in thedocumentsRelies on exporterto ship goods asdescribed in thedocumentsNone13 Mrs. Charu Rastogi, Asst. Professor
  14. 14. Export Finance14 Mrs. Charu Rastogi, Asst. Professor
  15. 15. Export Finance Classification Export finance can be: Pre-shipment finance Post shipment finance15 Mrs. Charu Rastogi, Asst. Professor
  16. 16.  Pre-shipment finance refers to finance extended to purchase,processing or packing of goods meant for exports. Pre-shipment credit also known as „Packing credit”. Packingcredit can also be extended as working capital assistance tomeet expenses such as wages, utility payments, travel expensesetc; to companies engaged in export or services. The main objectives behind pre-shipment finance or pre exportfinance is to enable exporter to: Procure raw materials. Carry out manufacturing process. Provide a secure warehouse for goods and raw materials. Process and pack the goods. Ship the goods to the buyers. Meet other financial cost of the business.Pre-Shipment Finance16 Mrs. Charu Rastogi, Asst. Professor
  17. 17.  Pre-shipment finance refers to finance extended to purchase,processing or packing of goods meant for exports. Pre-shipment credit also known as „Packing credit”. Packingcredit can also be extended as working capital assistance tomeet expenses such as wages, utility payments, travel expensesetc; to companies engaged in export or services. The main objectives behind pre-shipment finance or pre exportfinance is to enable exporter to: Procure raw materials. Carry out manufacturing process. Provide a secure warehouse for goods and raw materials. Process and pack the goods. Ship the goods to the buyers. Meet other financial cost of the business.Pre-Shipment Finance17 Mrs. Charu Rastogi, Asst. Professor
  18. 18. Export Finance Methods Accounts Receivable Financing An exporter that needs funds immediately may obtain a bank loan that issecured by an assignment of the account receivable Factoring (Cross-Border Factoring) The accounts receivable are sold to a third party (the factor), that thenassumes all the responsibilities and exposure associated with collectingfrom the buyer. Letters of Credit (L/C) These are issued by a bank on behalf of the importer promising to paythe exporter upon presentation of the shipping documents. The importer pays the issuing bank the amount of the L/C plusassociated fees. Commercial or import/export L/Cs are usually irrevocable. The required documents typically include a draft (sight or time), acommercial invoice, and a bill of lading (receipt for shipment). Sometimes, the exporter may request that a local bank confirm(guarantee) the L/C. Variations include standby L/Cs : funded only if the buyer does not pay the seller as agreed upon transferable L/Cs : the first beneficiary can transfer all or part of the original L/C to athird party assignments of proceeds under an L/C : the original beneficiary assigns the proceedsto the end supplier18 Mrs. Charu Rastogi, Asst. Professor
  19. 19. Export and Import Finance Methods Banker‟s Acceptance (BA) This is a time draft that is drawn on and accepted by a bank (theimporter‟s bank). The accepting bank is obliged to pay the holderof the draft at maturity. If the exporter does not want to wait for payment, it can requestthat the BA be sold in the money market. Trade financing isprovided by the holder of the BA. The bank accepting the drafts charges an all-in-rate (interest rate)that consists of the discount rate plus the acceptancecommission. In general, all-in-rates are lower than bank loan rates. Theyusually fall between the rates of short-term Treasury bills andcommercial papers. Working Capital Financing Banks may provide short-term loans that finance the workingcapital cycle, from the purchase of inventory until the eventual19 Mrs. Charu Rastogi, Asst. Professor
  20. 20. Export and Import Finance Methods Medium-Term Capital Goods Financing (Forfaiting) The importer issues a promissory note to the exporter topay for its imported capital goods over a period thatgenerally ranges from three to seven years. The exporter then sells the note, without recourse, to abank (the forfaiting bank). Countertrade These are foreign trade transactions in which the sale ofgoods to one country is linked to the purchase orexchange of goods from that same country. Common countertrade types includebarter, compensation (product buy-back), and counterpurchase. The primary participants are governments andmultinationals.20 Mrs. Charu Rastogi, Asst. Professor
  21. 21. Factoring V/s ForfaitingOn going arrangement Single transaction basedOpen account sale LC or bank acceptance requiredProvides other than financing Primarily a financing serviceservicesUsed for offering short term credit For medium / long term transactionto regular buyers (up to 180 days) which could be “one-off” (90 days to 7years)Both with and without recourse Is without recourseFor domestic and export receivables Usually for export receivablesNo minimum size Transaction should be minimum USD100,00021 Mrs. Charu Rastogi, Asst. Professor
  22. 22. Buyer‟s Credit and Supplier‟sCredit22 Mrs. Charu Rastogi, Asst. Professor
  23. 23. Buyer‟s Credit A financial arrangement in which a bank or financialinstitution, or an export credit agency in the exportingcountry, extends a loan directly to a foreign buyer orto a bank in the importing country to pay for thepurchase of goods and services from the exportingcountry. This term does not refer to credit extended directlyfrom the buyer to the seller (for example, throughadvance payment for goods and services). Buyer‟s Credit also refers to loans for payment ofimports into India arranged on behalf of the importerthrough an overseas bank. The offshore branchcredits the nostro of the bank in India and the Indianbank uses the funds and makes the payment to theexporter‟ bank as an import bill payment on due date.The importer reflects the buyers credit as a loan onthe balance sheet.23 Mrs. Charu Rastogi, Asst. Professor
  24. 24. Benefits of Buyer‟s Credit The exporter gets paid on due date; whereas importergets extended date for making an import payment asper the cash flows The importer can deal with exporter on sight basis,negotiate a better discount and use the buyers creditroute to avail financing. The funding currency can be in any FCY (USD, GBP,EURO, JPY etc.) depending on the choice of thecustomer. The importer can use this financing for any form oftrade viz. open account, collections, or LCs. The currency of imports can be different from thefunding currency, which enables importers to take afavourable view of a particular currency.24 Mrs. Charu Rastogi, Asst. Professor
  25. 25. Buyer‟s Credit Process Flow Indian customer imports the goods either under DC / LC, DA /DP Indian customer requests the Buyer‟s Credit Consultant beforethe due date of the bill to avail buyers credit finance. Consultant approaches overseas bank for indicativepricing, which is further quoted to Importer. If pricing is acceptable to importer, overseas bank issue‟s offerletter in the name of the Importer. Importer approaches his existing bank to get letter of undertaking/ comfort (LOU / LOC) issued in favour of overseas bank viaswift. On receipt of LOU / LOC, Overseas Bank as per instructionprovided in LOU, will either funds existing bank‟s Nostroaccount or pays the supplier‟s bank directly Existing bank to make import bill payment by utilizing the amountcredited ( On due date existing bank to recover the principal and Interestamount from the importer and remit the same to Overseas Bankon due date.25 Mrs. Charu Rastogi, Asst. Professor
  26. 26. Regulatory Framework Amount and Maturity Maximum Amount Per transaction : $20 Million Maximum Maturity in case of import of non capital goods: upto 1year from the date of shipment Maximum Maturity in case of import of capital goods : upto 3years from the date of shipment Maximum Maturity in case of import of capital goods forcompanies classified as Infrastructure sector: Upto 5 years fromthe date of shipment All-in-cost Ceilings Upto 1 year : 6 Month Libor + 350 bps Upto 3 years : 6 Month Libor + 350 bps Upto 5 years: 6 Month Libor + 350 bps All applications for short-term credit exceeding $20 million forany import transaction are to be forwarded to the Chief GeneralManager, Exchange Control Department, Reserve Bank of India,Central Office, External commercial Borrowing (ECB) Division,Mumbai26 Mrs. Charu Rastogi, Asst. Professor
  27. 27. Costs Involved Foreign bank interest cost Foreign Bank LC Confirmation Cost (Case toCase basis) LC advising and or Amendment cost Negotiation cost (normally in range of 0.10%) Postage and Swift Charges Reimbursement Charges Cost for the usance (credit) tenure. (Indian BankCost)27 Mrs. Charu Rastogi, Asst. Professor
  28. 28. Suppliers Credit Supplier‟s Credit relates to credit for imports intoIndia extended by the overseas suppliers orfinancial institutions outside India.28 Mrs. Charu Rastogi, Asst. Professor
  29. 29. Buyer’s Credit Supplier’s Credit importer of goods appliesfor buyers credit buyers credits can bearranged Sight LC,Usance LC, DA & DPexcluding AdvancePayment uyers credit Buyers Credit quote isarranged for after openingof the LC Withholding Tax may beapplicable in certaincases in a buyers creditbut it is not applicable insuppliers credit. Letter ofUndertaking(LOU)issuance charges areapplicable in case of exporter of goods applies forsuppliers credit Suppliers credit can only bearranged against LC backedtransaction suppliers credit quote is tied upbefore opening of the LC. LC isthen opened as per the terms ofthe funding bank in case ofsuppliers credit. However, whenthe LC is opened before tyingup for the funds in a supplierscredit, it might need amendmentas per the funding bank. suppliers credit is an LC basedtransaction, no Letter ofUndertaking(LOU) charges areapplicable.29 Mrs. Charu Rastogi, Asst. Professor
  30. 30. International Receivables andCash ManagementWorking Capital Management30 Mrs. Charu Rastogi, Asst. Professor
  31. 31. International ReceivablesManagement Receivables management involves convertingreceivables to cash and facilitating : Cash flow forecasting Long-term funding and investment decisions Reduced risk of bad debts Stronger liquidity Stronger balance sheet ratios31 Mrs. Charu Rastogi, Asst. Professor
  32. 32. International Cash Management Cash management can be broadly defined tomean optimization of cash flows andinvestment of excess cash. Cash management refers to the effectiveplanning, monitoring and management ofliquid / near liquid resources including: Day-to-day cash control Money at the bank Receipts Payments Short Term investments and borrowings Foreign exchange32 Mrs. Charu Rastogi, Asst. Professor
  33. 33. Cash flows of a subsidiarySubsidiaryParent Long termprojects andinvestmentsAccountsPayableRawmaterial andsuppliesInventoriesAccountsreceivableSource ofdebt33 Mrs. Charu Rastogi, Asst. Professor
  34. 34. Centralized cash management While each subsidiary is managing its ownworking capital, a centralized cash managementgroup is needed to monitor, and possiblymanage, the parent subsidiary and intersubsidiary cash International cash management can besegmented into two functions: optimizing cash flow movements, and investing excess cashflows.34 Mrs. Charu Rastogi, Asst. Professor
  35. 35. Centralized Cash Flow35 Mrs. Charu Rastogi, Asst. Professor
  36. 36. Techniques to optimize cashflows Accelerating Cash inflows The more quickly the cash inflows are received, themore quickly they can be invested or used for otherpurposes Common methods include the establishment oflockboxes around the world (to reduce mail float) andpreauthorized payments(charging a customer‟s bankaccount directly). Lockboxes are a service provided by a bank, wherebythe bank receives, processes, and deposits all of acompanys receivables. Lockbox services are sometimescalled Remittance Services or Remittance Processing‘ One benefit of the lockbox service to the commercial customeris that it can maintain special mailboxes in different locationsaround the country and a customer sends payment to theclosest lockbox. The company then authorizes a bank tocheck these mailboxes as often as is reasonable, given thenumber of payments that will be received. Because the bank ismaking the collection, the funds that have been received areimmediately deposited into the company’s account without first36 Mrs. Charu Rastogi, Asst. Professor
  37. 37. Techniques to optimize cashflows Minimizing currency conversion costs Netting reduces administrative and transactioncosts through the accounting of all transactions thatoccur over a period to determine one net payment. A bilateral netting system involves transactionsbetween two units, while a multilateral nettingsystem usually involves more complex interchanges Netting involves settling mutual obligations at thenet value of a contract as opposed to its grossdollar value. It leads to reducing the transfer offunds between subsidiaries to a net amount.37 Mrs. Charu Rastogi, Asst. Professor
  38. 38. 38 Mrs. Charu Rastogi, Asst. Professor
  39. 39. Techniques to optimize cashflows Managing blocked funds A government may require that funds remain withinthe country in order to create jobs and reduceunemployment. An MNC can shift cost-incurring activities (like R&D)to the host country, adjust the transfer pricing policy(such that higher fees have to be paid to theparent), borrow locally rather than from the parent,etc39 Mrs. Charu Rastogi, Asst. Professor
  40. 40. Techniques to optimize cashflows Implementing inter-subsidiary cash transfers A subsidiary with excess funds can providefinancing by paying for its supplies earlier than isnecessary. This technique is called leading. Alternatively, a subsidiary in need of funds can beallowed to lag its payments. This technique is calledlagging.40 Mrs. Charu Rastogi, Asst. Professor
  41. 41. Complications in Optimizing Cash Flows Company related characteristics Delay in payment from one subsidiary to another forsupplies received Government restrictions Prohibition of use of netting Restrictions on transfer of cash Characteristics of banking systems Banking system in advanced countries offer a widervariety of services Non-uniformity of banking systems in differentcountries41 Mrs. Charu Rastogi, Asst. Professor
  42. 42. Investing Excess Cash Excess funds can be invested in domestic or foreign short-term securities, such as Eurocurrency deposits, Treasurybills, and commercial papers. Sometimes, foreign short-term securities have higherinterest rates. However, firms must also account for thepossible exchange rate movements Centralized cash management allows for more efficientusage of funds and possibly higher returns. When multiple currencies are involved, a separate poolmay be formed for each currency. Funds can also beinvested in securities that are denominated in thecurrencies needed in the future Given the current online technology, MNCs should be ableto efficiently create a multinational communicationsnetwork among their subsidiaries to ensure thatinformation about their cash positions is continuallyupdated42 Mrs. Charu Rastogi, Asst. Professor
  43. 43. Investing excess cash Diversifying Cash Across Currencies If an MNC is not sure of how exchange rates willchange over time, it may prefer to diversify its cashamong securities that are denominated in differentcurrencies. The degree to which such a portfolio will reduce riskdepends on the correlations among the currencies Use of Dynamic Hedging to Manage Cash Dynamic hedging refers to the strategy of hedgingwhen the currencies held are expected todepreciate, and not hedging when they areexpected to appreciate. •The overall performance is dependent on the firm‟sability to accurately forecast the direction ofexchange rate movements43 Mrs. Charu Rastogi, Asst. Professor
  44. 44. International Sources of FundsSources of funds-•ECBs•FCCBs•ADRs•GDRs•FDI•Syndicated Loans44 Mrs. Charu Rastogi, Asst. Professor
  45. 45. External Commercial Borrowings45 Mrs. Charu Rastogi, Asst. Professor
  46. 46. Indian Companies can borrow fromsources outside India through: ECBs: Bank Loans, Buyer‟s Credit, Supplier‟s Credit,Securitized instruments (e.g. floating rate notes and fixedrate bonds) Foreign Currency Convertible Bonds (FCCBs) Preference Shares (non-convertible or partially/optionallyconvertible) Foreign Currency Exchangeable Bonds (FCEBs) All above instruments are required to conform to RBI‟sECB policy norms ECB Policy norms define: Automatic or Approval Route Eligible Borrowers Recognized Lenders Amount & All-in cost Average Maturity End-use Stipulations46 Mrs. Charu Rastogi, Asst. Professor
  47. 47. Need for ECB Underdeveloped and the developing economiesrequire external assistance due to the shortage ofcapital within the country. The saving generated by the citizens and taxrevenues collected by the government of capital aretoo meager compared to the funds requirement forthe development of the infrastructure sector, theindustry and various other developmental activities . Scarcity of foreign exchange also plays an importantrole as most of the developing economies arecharacterized by an adverse balance of payment .Generally the country‟s exports are not sufficient tocover the large imports of machinery, components,spare parts, materials, and related services. The government of these economies, therefore,generally encourage the inflow of external funds intothe country47 Mrs. Charu Rastogi, Asst. Professor
  48. 48.  Under the ECB window, companies in India areallowed to borrow from overseas, under certainconditions, through different instruments. The Reserve Bank of India (RBI), in its mastercircular on external commercial borrowing andtrade credits (January 2012), defined ECB as“commercial loans in the form of bank loans,buyers‟ credit, suppliers‟ credit, securitizedinstruments (e.g. floating rate notes and fixed ratebonds, non-convertible, optionally convertible orpartially convertible preference shares) availed offrom non-resident lenders with a minimumaverage maturity of three years”.48 Mrs. Charu Rastogi, Asst. Professor
  49. 49.  ECB is allowed through both direct and approvalroutes. Under the direct route, companies inbusinesses, such as hotel, hospitals andsoftware, can access the international market forraising debt up to a limit. Special economic zones and non-governmentorganizations engaged in micro finance activitiesare also allowed to access the ECB window. Companies of industries that can apply throughthe direct route can also take the approval route ifthey need to borrow more than the allowed limitunder the direct route.49 Mrs. Charu Rastogi, Asst. Professor
  50. 50. Forms of External CommercialBorrowings ECB may be in the form of: Commercial bank loans Buyers‟ credit Suppliers‟ credit Securitized instruments Credit from official sector, e.g., window of multilateralfinancial institutions, such as International FinanceCorporation (Washington), Various forms of Euro bonds and syndicated loans50 Mrs. Charu Rastogi, Asst. Professor
  51. 51. Automatic Route Amount Corporates in Industrial Sector or Infrastructure Sector-USD750 mn per annum Corporates in specified Service Sector-USD 200 mn perannum Maturity ECBs up to USD 20 million – 3 years ECBs between USD 20 million and USD 750 million –5 years Eligible Borrowers Corporates in manufacturing sector, infrastructure sector andservice companies in the hotel, hospital, software sectors(registered under the Companies Act, 1956) Infrastructure Finance Companies (IFCs). Units in Special Economic Zones( SEZ) NGOs engaged in micro finance activities Micro Finance Institutions (MFIs).51 Mrs. Charu Rastogi, Asst. Professor
  52. 52. Automatic Route Eligible lenders International banks, International capital markets, Multilateral financial institutions (such as IFC, ADB, etc.) Export credit agencies, Suppliers of equipments, Foreign collaborators and Foreign equity holders. A "foreign equity holder" to be eligible as “recognized lender”under the automatic route would require minimum holding ofpaid-up equity in the borrower company as set out below: For ECB up to USD 5 million - minimum paid-up equity of 25 percent held directly by the lender, For ECB more than USD 5 million - minimum paid-up equity of25 per cent held directly by the lender and ECB liability-equityratio not exceeding 4:152 Mrs. Charu Rastogi, Asst. Professor
  53. 53. Automatic Route : End use ECBs are supposed to be utilized for meeting foreignexchange cost of capital goods and services and alsofor project-related rupee expenditure up to certainlimits The end use to which funds can be put can becategorized into: Forex cost of capital goods and services For project-related rupee expenditure in infrastructureprojects in power, telecom, and railways For telecom sector license fee, payments are approveduse of ECB For project-related rupee expenditure subject to termsand conditions specified in schemes Not to be used in investment in stock markets andspeculation in real estate53 Mrs. Charu Rastogi, Asst. Professor
  54. 54. Approval Route Eligible borrowers Borrowers in eligible in automatic categoryintending to raise more than the amount allowedunder Automatic Route Service sector units, other than those in hotels,hospitals and software, subject to the condition thatthe loan is obtained from foreign equity holders. Corporates which are under investigation by theReserve Bank and / or Directorate of Enforcement. Developers of National Manufacturing InvestmentZones (NMIZs) can avail of ECB for providinginfrastructure facilities within NMIZs.,54 Mrs. Charu Rastogi, Asst. Professor
  55. 55. Approval Route Eligible borrowers Cases falling outside the purview of the automatic routelimit ECB with minimum average maturity of 5 years by Non-Banking Financial Companies (NBFCs) for leasing toinfrastructure projects. Infrastructure Finance Companies (IFCs) beyond 50 percent of their owned funds, for on-lending to theinfrastructure sector as defined under the ECB policy. Foreign Currency Convertible Bonds (FCCBs) byHousing Finance Companies satisfying the followingminimum criteria: (i) the minimum net worth not be lessthan Rs. 500 crore, (ii) a listing on the BSE or NSE, (iii)minimum size of FCCB is USD 100 million and Multi-State Co-operative Societies engaged in manufacturing55 Mrs. Charu Rastogi, Asst. Professor
  56. 56. Approval Route Additional end use permitted under approval route Repayment of Rupee loans availed from domesticbanking system Companies which are in the infrastructure sector(except powercompanies), as defined under the extant ECB guidelines , arepermitted to utilise 25 per cent of the fresh ECB raised bythem towards refinancing of the Rupee loan/s availed by themfrom the domestic banking system. Power companies are allowed to utilize 40% of the fresh ECBfor repayment of Rupee Loans availed form domestic banks. Bridge Finance Companies which are in the infrastructure sector, are permittedto import capital goods by availing of short term credit(including buyers‟ / suppliers‟ credit) in the nature of bridgefinance„. The bridge finance can be replaced with a long termECB.56 Mrs. Charu Rastogi, Asst. Professor
  57. 57. Approval Route Additional end use permitted under approvalroute Refinancing of Rupee loans raised by Telecomcompanies to pay spectrum allocation fees. Working capital for aviation sector Repayment of Rupee loans and/or fresh Rupeecapital expenditure for companies with forexearnings Take out Financing Companies in infrastructure project should have a tripartiteagreement with domestic banks and overseas recognizedlenders for either conditional or unconditional take-out of theloan within three years of the scheduled CommercialOperation Date (COD). The scheduled date of occurrence57 Mrs. Charu Rastogi, Asst. Professor
  58. 58. Benefits of ECBs ECBs are very economical source of raising funds,since the interest rate is far less as compared to theinterest rate on the debt raised in India. ECBs provide foreign currency funds to the corporatesector that are necessary for import of capital goodsetc. There is no need for credit rating. Moreover, ECBscarry fewer covenants as compared to the debt raisedfrom Financial Institutions/Banks in India. Helps broad base borrowers Larger amounts can be raised58 Mrs. Charu Rastogi, Asst. Professor
  59. 59. The down side of ECBs The borrower can be in trouble if the position is nothedged properly and the currency depreciatessharply, which will lead to increase in the company‟sliability. Also, at the macro level, higher level of borrowingfrom overseas may push the currency toappreciate, which makes exports uncompetitive in theinternational market. Access to overseas market and cheaper credit is anadvantage for bigger companies that can borrowabroad, while smaller companies have to deal withhigher cost of capital in the domestic market. Dependence of the country on short-term debtflow, such as ECB, is rising to fund the currentaccount deficit and can have negative consequences.59 Mrs. Charu Rastogi, Asst. Professor
  60. 60. FCCBs60 Mrs. Charu Rastogi, Asst. Professor
  61. 61. Foreign Currency Convertible Bonds FCCB is a quasi-debt instrument that is issued in acurrency different the issuer‟s domestic currency withoptions to either redeem it at maturity or convert it intoissuing company‟s stock It gives two options. One is, to get the regular interest andprincipal and the other is to convert the bond in to equities.It is a hybrid between bond and stock In other words, the money being raised by the issuingcompany is in the form of a foreign currency. A convertible bond is a mix between a debt and equityinstrument. It acts like a bond by making regular coupon and principalpayments, but these bonds also give the bondholder theoption to convert the bond into stock.61 Mrs. Charu Rastogi, Asst. Professor
  62. 62. Foreign Currency Convertible Bonds They carry a fixed interest or coupon rate and areconvertible into a certain number of ordinary shares ata preferred price They are convertible into ordinary shares of theissuing company either in whole, or in part, on thebasis of any equity-related warrants attached to thedebt instruments. These bonds are listed and traded abroad. Tillconversion, the company has to pay interest in dollars, and if the conversion option is not exercised, theredemption is also made in dollars. Thus, foreign investors prefer convertible bondswhereas Indian companies prefer to issue GDRs.62 Mrs. Charu Rastogi, Asst. Professor
  63. 63. Process of Issuing FCCB Obtain prior permission of the Department ofEconomic Affairs, Ministry of Finance, Government ofIndia. An issuing company shall have a consistent trackrecord of good performance (financial or otherwise)for a minimum period of three years. On the completion of finalization of issue structure theissuing company shall obtain the final approval forproceeding ahead with the issue from the Departmentof Economic Affairs. The Foreign Currency Convertible Bonds shall bedenominated in any freely convertible foreigncurrency and the ordinary shall be denominated inIndian rupees .63 Mrs. Charu Rastogi, Asst. Professor
  64. 64. Process of Issuing FCCB When an issuing company issues ordinary shares orbonds under this Scheme, to a Domestic CustodianBank who will, in terms of agreement, instruct theOverseas Depositary Bank to issue bonds held by theDomestic Custodian Bank The provisions of any law relating to issue of capitalby an Indian company shall apply in relation to theissue of Foreign Currency Convertible Bonds. Provisions relating to end-use of FCCB proceeds,repatriation of proceeds, etc., would be altered by thegovernment from time to time depending on inflowand outflow in to forex reserves64 Mrs. Charu Rastogi, Asst. Professor
  65. 65. Advantages of FCCBs It is a low cost debt as the interest rates given to FCCBonds are normally 30-50 per cent lower than themarket rate because of its equity component. Conversion of bonds into stocks takes place at apremium price to market price. Conversion price is fixed when the bond is issued So,lower dilution of the company stocks Simple regulatory process65 Mrs. Charu Rastogi, Asst. Professor
  66. 66. Disadvantages of FCCBs FCC Bonds are ideal for the bull market scenario asthe conversion occurs at a premium price lowering thedilution. But if the stock price plummet like what we arewitnessing right now due to the economicdownturn, then investors will not go for conversion, andthey go for redemption at maturity value. So companies have to re-finance to fulfill the redemptionpromise Earnings will get hit because of the redemptions. If the investors do not go for conversion, then companieswill be forced to lower the conversion price (previouslyfixed) to entice the investors to go for conversion whichwill lead to higher dilution.66 Mrs. Charu Rastogi, Asst. Professor
  67. 67. Disadvantages of FCCBs If the stock price goes below the conversion price, then theissuer loses an opportunity to dilute at a higher price. Exchange risk is more in FCCBs as interest on bond wouldbe payable in foreign currency. If the exchange rate goes-up, then the issuer has to pay moreto the investors Thus companies with low debt equity ratios, large forexearnings potential only opt for FCCBs. FCCB means creation of more debt and a forex outflow interms of interest which is in foreign exchange In case of convertible bond the interest rate is low (around3 to 4%) but there is exchange risk on interest as well asprincipal if the bond is not converted in to equity.67 Mrs. Charu Rastogi, Asst. Professor
  68. 68. FCCBs in India Following the sustained liberalisation programme undertaken bythe Indian Government to integrate with the global economy, theforeign currency convertible bond (FCCB) market took aquantum leap during the bull run of 2005– 2008. Reports statethat 201 Indian companies raised approximately US$16bnthrough FCCBs during that period Companies issued FCCBs to reduce their borrowing costs. Theyissued the bonds at very low coupon rates; some were even zerocoupon. However, they fixed the conversion prices between 25per cent and 150 per cent higher than the prevailing marketprices in expectation of an increase in share prices. This theoryfell flat with the subsequent crash in global equity markets. It isestimated that two thirds of the FCCBs due to mature beforeMarch 2013 will not be converted into equity shares.68 Mrs. Charu Rastogi, Asst. Professor
  69. 69. FCCBs in India Most of the FCCBs that will mature in 2012 were issued in theyears 2007–2008, when the foreign exchange rate wasapproximately 42 Indian rupees (INR) to a US dollar. The INRhas since lost more than 30 per cent against the US dollar. Thishas added approximately US$2bn to the value of FCCBmaturities in 2012. In cases where the current price is trading at a significantdiscount to the conversion price, it appears that the companieswill need to adopt other alternatives to pay back their investors.Although a number of companies have managed to convert theirFCCBs to equity, low investor appetite and the expensive debtmarket are making it difficult for further conversions to takeplace. In the present market, companies have the followingoptions69 Mrs. Charu Rastogi, Asst. Professor
  70. 70. FCCBs in News for wrongreasons Wind turbine manufacturer Suzlon Energy hasdefaulted on $221 million worth of foreigncurrency convertible bonds (FCCBs) maturing onOctober 11, 2012, after it failed to get anextension from bondholders. This is the biggest FCCB default by an Indiancorporate, topping Sterling Biotech‟s $184-milliondelinquency in May and takes the quantum ofdefaults on convertibles to $664 million this year,according to data compiled by Bloomberg. More on FCCBs And more70 Mrs. Charu Rastogi, Asst. Professor
  71. 71. American Depository Receipt71 Mrs. Charu Rastogi, Asst. Professor
  72. 72. American Depository Receipt An American Depositary Receipt (or ADR) represents ownershipin the shares of a non- U. S. company and trades in U.S.financial markets . The stock of many non-U. S. companies tradeon U.S. stock exchanges through the use of ADRs. ADRs enable U. S. investors to buy shares in foreign companieswithout the hazards or inconvenience of cross-border and cross– currency transactions. ADRs carry prices in U.S. dollars, paydividends in U. S. dollars, and can be traded like the shares of U.S. based companies. Each ADR is issued by a U. S. Depositary bank and canrepresent a fraction of a share , a single share, or multipleshares of the foreign stock . An owner of an ADR has the right to obtain the foreign stock itrepresents, but US investors usually find it more convenientsimple to own the ADR. For meeting large requirements of funds, raising funds throughADR is the solution72 Mrs. Charu Rastogi, Asst. Professor
  73. 73. Benefits of ADRsBenefits to the Issuing Company : An ADR programme can stimulate investorinterest, enhance a company‟s visibility, broaden itsshareholder base, and increase liquidity. By enabling a company to tap US equity markets, the ADRoffers a new avenue for raising capital ,often at highlycompetitive costs. For companies with a desire to build a stronger presencein the United States, an ADR programme can help financeUS initiatives or facilitate US acquisitions. ADRs provide an easy way for us employees of non-UScompanies to invest in their companies ‟ employee stockpurchase plans . May increase local prices as a result of global demand /trading through a more broadened and a more diversified73 Mrs. Charu Rastogi, Asst. Professor
  74. 74. Benefits of ADRsBenefits to the Investors: Increasingly investors aim to diversify their portfolios internationally. Obstacles, however, such as undependable settlements, costlycurrency conversions, unreliable custodial services, poorinformation flow, unfamiliar market practices , confusing taxconvention and internal investment policy may discourageinstitutions and private investors from venturing outside their localmarket. As negotiable securities, ADRs are quoted in US dollars and paydividend or interest in US dollars . They overcome the obstacles that mutual funds, pension funds andother institutions may have in purchasing and holding securitiesoutside the local market . Depository Receipts are easy to Buy and Sell: Investors purchase and sell depository receipts through their US brokersin exactly the same way as they purchase or sell securities of UScompanies. Many regional NASD brokers/dealers, and virtually all New Yorkbrokers/dealers, make market in and know how to create depositoryreceipts. Depository Receipts are Liquid : Depository receipts are as liquid as their74 Mrs. Charu Rastogi, Asst. Professor
  75. 75. Global Depository Receipt75 Mrs. Charu Rastogi, Asst. Professor
  76. 76. Global Depository Receipt It is global finance vehicle that allows an issuer to raisecapital simultaneously in two or more markets through aglobal offering They are marketed internationally, mainly to financialinstitutions. Global Depository Receipt (GDR) –certificate issued byinternational bank, which can be subject of worldwidecirculation on capital markets. For example, a European investor wanting an exposure inIndian securities could do so via two routes: Enter the Indian stock market and buy the company‟sstock on one of the Indian markets. But this would also expose the investor to exchange risksand statutory rules and regulations governing purchaseand sale of securities in the Indian markets. Through GDRs which would give the investor ownershipof the Indian company‟s stock without being subject toIndian stock market regulations to a great extent.76 Mrs. Charu Rastogi, Asst. Professor
  77. 77. Global Depository Receipt GDRs have become synonymous with selling equity in theEuromarkets. This is so because fresh shares are issued by thecompany which is raising money from the markets, andtransferred to a depository which , in turn, issues a receiptwhich is quoted and traded at any stock exchange whereit is listed. Thus, a GDR is a negotiable instrument denominated indollars or some other freely convertible currency. It is used as a funding vehicle for raising capital The GDR structure allows for simultaneous issuance ofsecurities in multiple markets . This facilitates greater liquidity trough cross border tradingGDRs can be issued in either public or private markets inthe US other countries.77 Mrs. Charu Rastogi, Asst. Professor
  78. 78.  A GDR gives its holder the right to get equity sharesof the issuer company against the GDR as per theterm of the offer. Till such exchange or conversion takes place, theGDR does not carry any voting rights. The sharesrepresented by a GDR are identical to other equityshares in all respects. Once a GDR is issued, it can be traded freely amonginternational investors. GDRs are freely tradable inthe overseas market like any other dollardenominated security either on a foreign stockexchange or in the OTC market.78 Mrs. Charu Rastogi, Asst. Professor
  79. 79. Benefits Access to capital markets outside the home market. Enhancement of company visibility. Increases potential liquidity by enlarging the market for thecompany‟s shares. It helps the issuing company to extend its research base toforeign countriesBenefits to Investors: They facilitate diversification into foreign securities. Eliminate custody charges. Can be easily compared to securities of similar companies. Permit prompt dividend payments and corporate actionnotifications. GDRs offer most of the same corporate rights, especiallyvoting rights, to the holders of GDRs.79 Mrs. Charu Rastogi, Asst. Professor
  80. 80. FDI80 Mrs. Charu Rastogi, Asst. Professor
  81. 81. Foreign Direct Investment The United Nation‟s World Investment Report(UNCTAD,1999) defines FDI as “an investmentinvolving a long – term relationship and reflecting alasting interest and control of a resident entity in oneeconomy (foreign direct investor or parent‟ enterprise)in an enterprise resident in an economy other thanthat of the foreign direct investor (FDI ) enterprise,affiliate enterprise or foreign affiliate).” The term “long-term” used in the last definition inorder to distinguish FDI from portfolio investment; FDIdoes not have the portfolio investment characteristicof being short – term in nature, involving a highturnover of securities.81 Mrs. Charu Rastogi, Asst. Professor
  82. 82. Types of FDI Horizontal It refers to FDI in the same industry in which the organizationoperates in the home nation. For example, Cemex, Mexico‟s largest cement manufacturer,embarked upon its international expansion strategy by acquiringestablished cement makers in Venezuela, Colombia, Indonesiaand Egypt. In 2000, it acquired Houston based Southland, a largecement company of the United States of America, by paying 2.5billion dollars . Vertical It refers to the FDI by an organization in order to sell the outputs ofdomestic firms or it refers to the investment which provides inputs to thedomestic organization For example, in 2001, Russia‟s largest oil company , LU Koil, acquiredthe Getty Petroleum of U.S.A., which provided it a retail network of about1300 gasoline staions. The firms such as Shell, British Petroleum ,RTZ, Acoa and so on ,have gone for FDI in oil extractive industry ,in order to get aregular and stable supply of the inputs82 Mrs. Charu Rastogi, Asst. Professor
  83. 83. Types of FDI Green field Investments It is the direct investment in new facilities or theexpansion of existing facilities. It is the principal mode of investing in developingcounters. Mergers & Acquisitions It occurs when a transfer of existing assets from local firmstakes place83 Mrs. Charu Rastogi, Asst. Professor
  84. 84. Benefits of FDI To Host Country Availability of Scarce Factors of Production: FDI helps attain aproper balance among different factors of production through thesupply of scarce factors and fosters the pace of economicdevelopment. FDI brings in capital and supplements the domestic capital. Thisis a significant contribution where the domestic savings rate is toolow to match the warranted rate of investment. It brings in scarce foreign exchange that activates the domesticsavings that would not have been put into investment in absenceof the availability of foreign exchange . Improvement in the Balance of Payments: FDI helps improve thebalance of payments of the host country. The inflow of investment is credited to the capital account. At the same time, the current account improves because FDIhelps either import substitution or export promotion. The host country is able to produce those items that were beingimported earlier.84 Mrs. Charu Rastogi, Asst. Professor
  85. 85. Benefits of FDITo host country (contd.) Building of Economic and Social Infrastructure: When the foreign investors invest in sectors such as the basic economicinfrastructure, social infrastructure, financial markets and the marketing system, thehost country is able to develop a support system that is necessary for rapidindustrialization. Even if there is no investment in these sectors, the very presence of foreigninvestors in the host country creates a multiplier effect and the support systemdevelops automatically. Fostering of Economic Linkages : Foreign firms have forward and backward linkages. They make demand for variousinputs that in turn helps develop the input-supplying industries which is known ascrowding – in effect. They employ labor force and so help raises the income of the employed peoplethat in turn raises the demand and industrial production in the country. Strengthening of Government Budget : The foreign firms are a source of tax income for the government . They pay not only income tax , but tariff on their import as well . At the same time , help reduce the governmental expenditure requirementsthrough supplementing the government‟s investment activities . All this eases theburden on the national budget.85 Mrs. Charu Rastogi, Asst. Professor
  86. 86. Benefits of FDI To Home Country Improvement in Balance of payment : inflow of foreigncurrencies in the form of dividend , interests etc. Industrial Activity: FDI increases export of machinery , equipment, technology etc fromthe home country to host country . This is enhances the industrial activity of the home country.Employment Generation The increased industrial activity in the homecountry enhances employment opportunities. Learning Skills : The firm and other country firms can learnskills from its exposure to the host country and transfer thoseskill to the industry in the home country . Improved Political relations: FDI is complement to foreign aid;it helps develop closer political ties between the home countryand the host country which is beneficial for both the countries.86 Mrs. Charu Rastogi, Asst. Professor
  87. 87. Costs of FDI To host country Adverse Effects on Competition: The new foreign subsidiariesmay grow to have more economic power and moreattractively priced products than the host country companies . Adverse Effects on Balance-of –Payments : If the foreignsubsidiary imports large quantities – this contributes to thehome country having a balance-of-payments deficit. Adverse Effects on Natural Resources: Raw materials areexploited keeping in view the interest of the home country thatis sometimes detrimental to the interest of the host country. No Employment Opportunities: As far as employment of localsis concerned, the MNCs normally show reluctance to train thelocal people . Technology being normally capital-intensive does not assurelarger employment .87 Mrs. Charu Rastogi, Asst. Professor
  88. 88. Costs of FDI To home country Undesired outflow of factor of production The cost accruing to the home country is only little, However, it cannot be denied that making investment abroadtakes away capital ,skilled manpower & managerialprofessional from the country. Sometimes the outflow of these factors of production is solarge that it hampers the home country‟s interest Possibility of conflict with the host –country government The MNCs operates in different countries in order to maximize theiroverall profit . To this end, they adopt various techniques that may not be in theinterest of the host country. This leads to a tussle between the host government & the homegovernment which may have a deleterious effect on bilateral relations88 Mrs. Charu Rastogi, Asst. Professor
  89. 89. Loan Syndication89 Mrs. Charu Rastogi, Asst. Professor
  90. 90. Loan Syndication When the size of the lending is huge running into a fewhundred millions or billions, a few banks join together andprovided the loan. It owes its evolution to U.S. laws, which fixed certain limitson lending exposure of a single bank on a single borrower. A syndicate credit is the agreement between two or morelending institutions to provide a borrower a credit facilityutilizing common loan documentation. A syndicated loan is defined as: “International syndicated credit are managed and underwrittenby one or more financial institutional normally from a locationother than domicile of the borrower to include lenders fromdiffering banking geographic which provide the borroweraccess to more than its own currency of domicile”.90 Mrs. Charu Rastogi, Asst. Professor
  91. 91. Loan Syndication Syndicated Loan involves many banks comingtogether to meet debt requirement of a client. It typically involves one or more banks underwritingthe loan and acting as Mandated Lead Arrangers(MLAs). Minimum amount of syndicated loan raised isnormally 50 millions U.S. dollar and the maximum isnormally 5 billion U.S. dollar and are given for aperiod ranging from 365 days to 20 years.91 Mrs. Charu Rastogi, Asst. Professor
  92. 92. Players in Syndicated Loan Managing Bank/Mandated Lead Manager: Managing bank is appointed by the borrower to arrange the credit. Themanaging bank helps the borrower to draw up the loan application, itnegotiates the terms and conditions with other banks and arranges thesyndicate. The managing bank‟s role come to an end with the signing of loanagreement by the borrower and the participating banks. Lead Bank : Lead bank is the bank which provides the major chunk of the loan. Agent Bank : Agent bank is the bank appointed by the lenders to look after theirinterest once the loan agreement is signed. They take over from themanaging bank. Participating Bank: The participating in a syndicated loan fall into the following segments. The wholesale large commercial banks, who arrange the credits, takelion‟s shares. The retail sector small banks take whatever share is given to them andtake a participation in the loan syndication.92 Mrs. Charu Rastogi, Asst. Professor
  93. 93. Advantages Advantages Allows raising of large amount even running into billions ofdollars. Better visibility for both banks as well the company as thesetransactions are typically accompanied by news coverage aswell as road shows in which many banks not present in thecountry are invited. Common Documentation as well as facility agents ensure thattransactions are smooth. Banks are able to distribute credit risk on a client. Credit risk is spread / distributed among many banks . In viewof exposure limit and higher capital, adequacy ratio notconsidered prudent for one bank to undertake such lending. Syndicated loan facility strengthens the relationship betweenthe borrowers and a bank , thereby providing opportunity toenter into new market segments of high net worth borrowers There is a secondary market for the syndicated loan –anybank can at a later stage sell its share to other takers93 Mrs. Charu Rastogi, Asst. Professor
  94. 94. Disadvantages Disadvantages Generally take longer than bilateral loans Documentation is more complex. Generally costlier than bilateral loans. Generally borrowers with credit profile in upperbracket are able to raise through this route If borrowing countries are unable to meet theirobligations on time, the banks will be forced to rollover their loans indefinitely.94 Mrs. Charu Rastogi, Asst. Professor
  95. 95. 95 Mrs. Charu Rastogi, Asst. Professor