International finance management research study

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International finance management research study

  1. 1. InternationalFinanceManagementFinance Management Topic Subin Umar Rahman S3 MBEM
  2. 2. International Finance Management P a g e |1CONTENTS General ......................................................................................................................... 3 Evolution of International monetary systems ................................................................ 3 1. The Gold Standard .......................................................................................................... 3 The Collapse of Gold Standard- reasons ............................................................................ 4 The Bretton Woods Era ...................................................................................................... 4 The International Bank for Reconstruction and Development (IBRD) ............................... 4 International Monetary Fund (IMF) ................................................................................... 5 The End of the Bretton Woods System .............................................................................. 6 Post Bretton Woods System & the Floating Rate Era ........................................................ 7 Concepts of Globalization and MNCs ............................................................................. 7 The Growth of International Trade .................................................................................... 8 Multi-National Corporations ............................................................................................ 11 Important International Players in Global Finance .......................................................... 13 International Finance Markets: Foreign Exchange Market ............................................ 14 Organisation of Foreign exchange market ....................................................................... 14 Foreign Exchange Transactions ........................................................................................ 15 Exchange Rates ................................................................................................................. 15 Exchange Rate Quotes ...................................................................................................... 15 Exchange Rate Systems .................................................................................................... 15 Triangular Arbitrage.......................................................................................................... 15 International Money Market ............................................................................................ 16 International Credit Market ............................................................................................. 16 Syndicated Loans .............................................................................................................. 16 International Stock Markets ............................................................................................. 17 Methods Used for International Investment ................................................................... 17 Balance of Payment .................................................................................................... 18 International Trade Flows................................................................................................. 19 Factors Affecting International Trade Flows .................................................................... 19 International Capital Flows ............................................................................................... 19 Agencies That Facilitate International Flows.................................................................... 19Project Finance Management Nov 2012
  3. 3. International Finance Management P a g e |2 Asian Development Bank ............................................................................................ 20 General ............................................................................................................................. 20 ADB’s window of operation .............................................................................................. 21 Instruments to assist PPP projects ................................................................................... 21 Pune Nirvana Hills Slum Rehabilitation Project- study ................................................. 22 Project Identification and Description.............................................................................. 22 Alignment with ADB Strategy and Operations ................................................................. 23 The Proposed ADB Assistance .......................................................................................... 24 Risks of the Project ........................................................................................................... 25 Budget for the Rehabilitation Plan ................................................................................... 25 References .................................................................................................................. 25 Books ................................................................................................................................ 26 Reports.............................................................................................................................. 26 Lectures ............................................................................................................................ 26 Websites ........................................................................................................................... 26Project Finance Management Nov 2012
  4. 4. International Finance Management P a g e |3GENERALInternational finance is the branch of financial economics broadly concerned with monetaryand macroeconomic interrelations between two or more countries. International financeexamines the dynamics of the global financial system, international monetary systems,balance of payments, exchange rates, foreign direct investment, and how these relate tointernational trade.Also referred as multinational finance, international finance is additionally concerned withmatters of international financial management. Investors and multinational corporationsmust assess and manage international risks such as political risk and foreign exchange risk,including transaction exposure, economic exposure, and translation exposure.Some examples of key concepts within international finance are the Mundell–Flemingmodel, the optimum currency area theory, purchasing power parity, interest rate parity, andthe international Fisher effect.EVOLUTION OF INTERNATIONAL MONETARY SYSTEMSThe international monetary system establishes the rules by which countries value andexchange their currencies. It also provides a mechanism for correcting imbalances betweena country’s international payments and its receipts. Further, the cost of converting foreignmoney into firm’s home currency-a variable critical to the profitability of internationaloperations depends on the smooth functioning of the international monetary system.Thehistory of monetary system started when in ancient time (seventh century B.C.1) tribes &city-states of India, Babylon & Phoenicia used gold & silver as media of exchange in trade.The total history of international monetary system is discussed below in a chronologicalorder.1. The Gold StandardMeaning: Buying and selling of paper currency in exchange for gold on the request of anyindividual of firm2. The theory of the gold standard rests on the idea that inflation is causedby an increase in the supply of money, an idea advocated by David Hume, and thatuncertainty over the future purchasing power of currency depresses business confidenceand leads to reduced trade and capital3.First to Adopt: In United Kingdom at 1821. It created a fixed exchange rate system becauseeach country tied the value of its currency.Representative money and the Gold Standard protect citizens from hyperinflation and otherabuses of monetary policy, as were seen in some countries during the Great Depression.However, they were not without their problems and critics, and so were partiallyabandoned via the international adoption of the Bretton Woods System. That systemeventually collapsed in 1971, at which time all nations had switched to full fiat money.Project Finance Management Nov 2012
  5. 5. International Finance Management P a g e |4The Collapse of Gold Standard- reasons World War I Post-War Conferences & Re-adaptation of Gold Standard Implementation of Floating Rate System By Bank of England Competitive Devaluation of Currencies & Increased Tariff Rate Effect of beggar-thy-neighbor policies (World War 2The Bretton Woods EraPost-War Situation: World War II created inflation, unemployment and an instable politicalsituation. Every country was struggling to rebuild their war-torn economy.Bretton Woods Conference: Not to repeat the mistakes that had caused World War II, topromote worldwide peace & prosperity and to construct the postwar internationalmonetary system representatives of 44 countries met at a resort in Bretton Woods, NewHampshire in 1944.Conference has presented the world two historic agreements. These are as follows:A. Agreement of conferees to renew the gold standard on a modified basis.B. Agreement to create two new international organizations to assist the rebuilding of theworld economy and the international monetary system. These areInternational Bank for Reconstruction and Development (IBRD)International Monetary Fund (IMF)The International Bank for Reconstruction and Development (IBRD)The International Bank for Reconstruction and Development (IBRD) is the official name ofthe World Bank. Established in 1945, the World Banks initial goal was to help financereconstruction of the war-torn European economics. With the assistance of the MarshallPlan, the World Bank accomplished this task by the mid-1950s. The Bank then adopted anew mission—to build the economies of the worlds developing countries. As its mission hasexpanded over time, the World Bank created three affiliated organizations:a. International Development Association (IDA)b. International Finance Corporation (IFC)c. Multilateral Investment Guarantee Agency (MIGA)Together with the World Bank, these constitute the World Bank Group. The World Bankiscurrently owned by the 185 member countries. The World Bank’s activities arefocused onthe reduction of global poverty, focusing on the achievement of theMillenniumDevelopment Goals (MDGs), goals calling for the elimination of poverty andtheimplementation of sustainable development. United States is the bank’s largestshareholder.Project Finance Management Nov 2012
  6. 6. International Finance Management P a g e |5International Monetary Fund (IMF)International Monetary Fund (IMF) was created to monitor and control the functioning ofthe international monetary system. It is an international organization that oversees theglobal financial system by observing exchange rates and balance of payments, as well asoffering financial and technical assistance. Its objectives are as follows: i. To promote international monetary cooperation. ii. To facilitate the expansion and balanced growth of international trade. iii. To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation. iv. To assist in the establishment of a multilateral system of payments. v. To give confidence to members by making the general resources of the Fund temporarily available to them and to correct maladjustments in their balances of payments. vi. To shorten the duration and lessen the degree of disequilibrium in the interactional balances of payments of members.A Dollar-Based Gold Standard: The IMF and the World Bank provided the institutionalframework for the post war international monetary system. All countries agreed to peg thevalue of their currencies to gold. However, only the United States pledged to redeem itscurrency for gold at the request of a foreign central bank. Thus the U.S. dollar became thekey-stone of the Bretton Woods system.In the early post war years, only the U.S. and Canadian dollars were convertible currencies,that is, ones that could be freely exchanged for other currencies without legal restrictions.Countries had faith in the U.S. economy and so were willing to accept U.S. dollars to settletheir transactions. As the British pound sterling had been in the nineteenth century, the U.S.dollar became the preferred vehicle for settling most international transactions. The effectof the Bretton Woods conference was thus to establish a U.S. dollar-based gold standard.Under the Bretton Woods Agreement each country pledged to maintain the value of itscurrency within ±1% of its par value. If the market value of its currency fell outside thatProject Finance Management Nov 2012
  7. 7. International Finance Management P a g e |6range, a country was obligated to intervene in the foreign-exchange market to bring thevalue back within ±1% of par value. This stability in exchange rates benefited internationalbusinesses, since the Bretton Woods system generally provided an assurance that the valueof each currency would remain stable.Bretton Woods System as Adjustable Peg : The Bretton Woods system is oftendescribed asusing an adjustable peg because currencies were pegged to gold but thepegs themselvescould be altered under certain conditions. The arrangement of BrettonWoods Systemworked well as long as pessimism about a country’s economy wastemporary. But, if acountry suffered from structural macroeconomic problems, majordifficulties could arise.The End of the Bretton Woods SystemShortcoming of Dollar-Based Gold Standard Under Bretton Woods System &TriffinParadox:The British and French central banks were a precursor to a run on the most important bankin the Bretton Woods system—the U.S. Federal Reserve Bank. Ironically, the reliance of theBretton Woods system on the dollar ultimately led to the systems undoing. Because thesupply of gold did not expand in the short run, the only source of the liquidity needed toexpand international trade was the U.S. dollar. Under the BrettonWoods system, theexpansion of international liquidity depended on foreigners willingness to continuallyincrease their holdings of dollars. Foreigners were perfectly happy to hold dollars as long asthey trusted the integrity of the U.S. currency, and during the 1950s and 1960s the numberof dollars held by foreigners rose steadily.As foreign dollar holdings increased, however, people began to question the ability oftheUnited States to live up to its Bretton Woods obligation. This led to the Triffinparadox.The paradox arose because foreigners needed to increase their holdings of dollars to financeexpansion of international trade. But the more dollars they owned, the less faith they had inthe ability of the United States to redeem those dollars for gold. The less faith foreignershad in the United States, the more they wanted to rid themselves of dollars and get gold inreturn. But if they did this, international trade and the international monetary system mightcollapse because the United States didnt have enough gold to redeem all the dollars held byforeigners. The shortcomings are listed below in brief- Limited gold. Liquidity problem. Foreigners’ behavior of continuous increasing in dollar holding. Foreigners’ less faith on United States.Agreement to Create Special Drawing Rights (SDRs): To inject more liquidity into theinternational monetary system while reducing the demands placed on the dollar as areserve currency, IMF members created the special drawing rights in 1967. SDR is a creditgranted by the IMF that can be used to settle official transactions among central banks. ThusSDRs are sometimes called "paper gold". The value of an SDR is a function of the currentvalue of five different currencies from which it is comprised. They include the U.S. dollar, theJapanese yen, the United Kingdom pound sterling, and the respective euro values ofProject Finance Management Nov 2012
  8. 8. International Finance Management P a g e |7Germany and France. An SDRs value is currently calculated daily as a weighted average ofthe market value offive major currencies (U.S. dollar, German mark, French franc, Japaneseyen, andwas worth $1.54 in U.S. dollars.Outcome of Creating SDRs: SDRs solved the liquidity problem for the internationalmonetary system, but if failed to solve the problem related to the glut of dollars held byforeigners & faith. By mid-1971, the Bretton Woods system was tottering, the victim of fearsabout the dollars instability. In the first seven months of 1971, theUnited States sold onethird of its gold reserves15. It became clear to the marketplace that the United States didnot have sufficient gold on hand to meet the demands of those who still wanted toexchange their dollars for gold.Official Ending of Bretton Woods System: The Bretton Woods system officially endedwhenin a dramatic address on August 15, 1971, President Richard M. Nixon announcedthat theUnited States would no longer redeem gold at $35 per ounce.Post Bretton Woods System & the Floating Rate EraMost foreign currencies began to float, their values being determined by supply anddemand in the foreign-exchange market. The value of the U.S. dollar fell relative to most ofthe worlds major currencies. But the nations of the world were not yet ready to abandonthe fixed exchange-rate system.At the Smithsonian Conference in December 1971, centralbank representatives from the Group of Ten16 agreed to restore the fixed exchange-ratesystem but with restructured rates of exchange between the major trading currencies. TheU.S. dollar was devalued to $38 per ounce but remained inconvertible into gold, and the parvalues of strong currencies such as the yen were revalued upward. Currencies were allowedto fluctuate around their new par values by =2.25%, which replaced the narrower ± 1.00%range authorized by the Bretton Woods Agreement.CONCEPTS OF GLOBALIZATION AND MNCSThe concept of globalization refers to the increasing connectivity and integration ofcountries and corporations and the people within them in terms of their economic, political,and social activities.Because of globalization, multinational corporations dominate thecorporate landscape. A multinational corporation (MNC) produces and sells goods orservices in more than onenation. A prototypical example is the Coca-Cola Company, whichoperates in more than 200countries.The link between a large European company and a large company from anemergingeconomy is no coincidence. Recent years have seen strong growth in Brazil, Russia,India,and China (sometimes called the BRICs). Today, the BRICs account for 15% of theworld’sgross domestic product (GDP) and more than 50% of the GDP of all emergingcountries.The international scope of business creates new opportunities for firms, but it alsoposes many challenges. Globalization affects all aspects of society, but economically, twomain trends define it. First, countries continue to expand their trade in goods and services.Second, countries continue to reduce their barriers to capital flows. We discuss each in turn.Project Finance Management Nov 2012
  9. 9. International Finance Management P a g e |8The Growth of International TradeTrade LiberalizationBeginning with the writings of David Ricardo in the 19th century, economists have knownthat countries gain from trade if each nation specializes in the production of those goodsinwhich it has a comparative advantage. Even if one country is more productive atproducinga given item than other countries, it should still focus its production on thosegoods in whichit is relatively most efficient, and doing so will make all trading partnersbetter off. There also appears to be a link in the data between trade and growth: More opencountries tend togrow faster. Unfortunately, many countries restricting international tradethrough tariffs on imports, non-tariff barriers such as subsidies to local producers, quotas onimported products, onerous regulations applying to imported products, and soforth.Wacziarg and Welch (2008) pinpointed when various countries liberalized their traderegimes—in other words, when the countries became open to trade. They looked at avariety of criteria, including the extent of the countries’ tariffs and non-tariff barriers, andstate control on major export sectors. In 1960, only about 20% of countries were open totrade. These countries included the United Kingdom and the United States, who had a longtradition of openness to international trade, and many European countries that liberalizedin 1959 or 1960, after the creation of the European Economic Community(EEC) . The EEC setout to establish free trade among a number of European countries, later turning into theEuropean Union. The idea that economies should be open to trade got a further boost in theearly 1980s, when Western governments started to deregulate their economies andprivatize government firms. More than 70% of countries open to trade by 2000.International Efforts to Promote Free TradeThe General Agreement on Tariffs and Trade (GATT), signed in 1947, was designed toencourage free trade between member states by regulating and reducing tariffs ontradedgoods and by providing a common mechanism for resolving trade disputes. GATTsignatories occasionally negotiated new trade agreements to reduce tariffs, called“Rounds,” to which countries would agree.The Uruguay Round, begun in 1986, establishedthe World Trade Organization (WTO) in 1995 to replace the GATT Treaty. GATT succeeded inlowering trade barriers in a multilateral, worldwide way, but a number of important regionaltrade agreements have slashed trade barriers even more in particular regions. The bestknown of these regional agreements are the European Union (EU), the North America FreeTrade Agreement (NAFTA) ,Mercosur in South America, and the Association of SoutheastAsian Nations (ASEAN) .Maintenance, facilities management, and logistics—to specialistfirms to reduce costs. Today, outsourcing IT work to low-cost countries, such as India, hasbecome commonplace.These developments led to a new focus for trade policy: increasingthe internationaltradability of services.Project Finance Management Nov 2012
  10. 10. International Finance Management P a g e |9The Growth in TradeThe evolution of trade openness dramatically increased trade flows between countries.Onemeasure of trade openness is the sum of exports and imports in a given year divided byameasure of output, such as GDP presents some data on this relative size of thetrade sector.Between 1985 and 2000, the trade sectors mostlygrew, especially in France, Germany, andAustralia, but over the past decade, only Germanyhas witnessed a substantial increase in itstrade sector. Of the countries shown, Germany isthe most open, with its trade sectorcomprising 75% of GDP in 2009, while Japan is the leastopen, with trade comprising just27% of its GDP.In large, developing countries such as Brazil, India, and China witnessed increasesin therelative size of their trade sectors. India’s trade sector evolved from less than10% of GDP in1970 to over 45% in 2009. China’s trade sector nearly doubled between 1985and 2000 andwas over 50% of GDP in 2009. This increase reflects the major trade reformsChinaundertook during the 1980s and 1990s, including China’s accession to the WTO in2001. Theaccession, in turn, led to a steady decrease in tariffs on imports. Because of itslarge size andincreased openness, China has become a major player in the world economy.Although the global trend is toward freer trade, some countriesare clearly more open thanothers. Many factors affect why, how much, and with whomcountries trade. For example,countries that border oceans tend to trade more than inlandcountries. Large countries tendto trade relatively less than smaller countries as evidencedby the U.S. numbers relative tomost other countries; and, indeed, China is a relative outlier.The Globalization of Financial MarketsThe globalization of financial markets and the profound changes they have undergone since1980 have also dramatically changed how MNCs manage their business risks, improved theiraccess to foreign capital, and enhanced their ability to reduce financing costs. We provide ashort overview of the major developments.Trends in Financial OpennessA country is financially open if it allows foreigners to invest in its capital markets and allowsits citizens to invest abroad. After World War II, most countries had controls or restrictionsin place that prevented the free flow of capital across borders. However, in the 1980s, manydeveloped countries began liberalizing their capital markets. For example, Japan started toliberalize in 1984; in Europe, the movement toward the Single Market forced manycountries to abolish their capital controls, with France abolishing capital controls in 1986,Italy in 1988, and Belgium in 1990. In the late 1980s and during the 1990s, many developingcountries began a financial liberalization process, relaxing restrictions on foreign ownershipof their assets and taking other measures to develop their capital markets, often in tandemwith macroeconomic and trade reforms. These developments created a new asset class inwhich to invest: emerging markets.A Global Financial CrisisFrom 2007 through 2010, the world witnessed a full-blown financial crisis that started in theProject Finance Management Nov 2012
  11. 11. International Finance Management P a g e | 10United States and led to a global recession, the longest and deepest in the postwar era. Wewill discuss a number of important economic crises in this book, but the scale and the depthof this recent crisis raise deep issues about the functioning of the global financial system,making it deserve special attention. The following figure depicts how a financial crisistypically unfolds, consisting of rapidly falling asset prices and financial institutions thatbecome insolvent or are hit by liquidity crises.Suppose asset prices fall. Consumers are now less wealthy and spend less. Firms may have aharder time financing themselves because the value of their collateral drops, causing themto invest less. As financial institutions take losses, aggregate lending to both consumers andfirms is reduced as well, causing them to spend less. Both chains of events reduce aggregateoutput and lead to layoffs. The bad economic conditions feed back into asset prices and thehealth of financial institutions through several channels. It entails in turn reduce asset pricesfurther. Increased uncertainty about the economic and financial future may makecompanies delay investments and further reduce output. Facing defaults on their loans,caused by the bad economic conditions, and perhapsbecause of their direct exposure toasset prices, certain financial institutions may also curtail lending and perhaps even gobankrupt. Once depositors and investors are sufficiently worried about the health of theirfinancial institutions, a liquidity crisis may erupt. In a liquidity crisis, a financial or otherinstitution does not have enough liquid assets to make the payments it has promised. It maybe solvent—that is, its assets may exceed its liabilities—but if counterparties who areworried about its solvency insist on immediate payment, the institution is forced to sellliquid assets at fire-sale prices. This may push the institution into insolvency and freeze upthe markets in which the institution plays a big role.Project Finance Management Nov 2012
  12. 12. International Finance Management P a g e | 11Multi-National CorporationsA multinational corporation (MNC) consists of a parent company in the firm’s originatingcountry and the operating subsidiaries, branches, and affiliates it controls both at home andabroad. The United Nations refers to such firms as transnational corporations to emphasizethat the operation and ownership of these enterprises is spread throughout the world.ManyMNCs initially start out simply as exporting or importing firms. Later, an MNC may use manymethods to expand and spread out such asLicensing in which the MNC gives local firms abroad the right to manufacture the company’sproducts or provide its services in return for fees, typically called royalties. It doesn’t requiremuch investment while expanding globally but can be difficult for licensing firms to maintaintheir product quality standards.Franchising involves somewhat more involvement. Here, the firm provides a specializedsales or service strategy,offers support at various levels, and may even initially invest in thefranchise in exchange for periodic fees. E.g. McDonald’s is the best-known franchising firm.Joint Venture is another way to penetrate foreign markets where, a company that is jointlyowned and operated by two or more firms. For example, Walmart, the gigantic U.S. retailer,set up a joint venture with India’s Bharti Enterprises in 2007 to start a chain of wholesalecash-and-carry stores in India.MNCs also enter foreign markets by setting up production and distribution facilitiesabroadeither by acquiring or merging with foreign companies or by simply establishing newoperations in the countries (in what are called greenfield investments ). These lattercategories constitute the bulk of foreign direct investment (FDI).Goals of an MNCThe appropriate goal of the management of any corporation, including a multinationalcorporation, is to maximize shareholder wealth. They maximize shareholder wealth bymaking investments in projects whose returns are sufficiently large to compensate itsshareholders, through dividends and capital gains, for the risk involved in the projects. Investment Time Horizon Stakeholder Alternative Agency Theory and Corporate GovernanceCorporate Governance around the WorldWhen reviewed of corporate governance and control, five ways of overcoming agencyproblems are examined. The pros and cons of the different approaches are discussed. An Independent Board of Directors Concentrated Ownership Executive Compensation Shareholder Activism and Litigation Hostile TakeoversProject Finance Management Nov 2012
  13. 13. International Finance Management P a g e | 12Foreign direct investment (FDI) in MNCsIt occurs when a company from one country makes a significant investment that leads to atleast a 10% ownership interest in a firm in another country. The outstanding stock of FDIwas estimated to be worth around $18 trillion in 2009 and has grown 30-fold between 1980and 2009. FDI inflows and outflows relative to GDP between 1980 and 2009 for developed countries, for developing countries, and for two countries in Asia (Japan and China)Between 1980 and 2000, the FDI>GDP ratio essentially grew by a factor of 10 in bothdeveloped countries (from 1% to 9%) and in developing countries (from 0.4% to 4.3%). Overthe last decade, FDI flows stalled, and they decreased during the global crisis. AlthoughProject Finance Management Nov 2012
  14. 14. International Finance Management P a g e | 13much was made of Japan’s international investments in the 1980s, it now has a lowerFDI>GDP ratio than China, whose FDI flows have grown quickly. There is another notabledifference between the two countries. Japan’s FDI outflows are about six times as large asFDI inflows to Japan. In contrast, China’s inflows in 2009 were twice as large as its outflows.Overall, the United States remains the country with the largest dollar amount of FDI inflowsand outflows.An important part of FDI involves international mergers and acquisitions(M&A), in which a corporation in one country merges with or acquires a corporation inanother country.Important International Players in Global FinanceIn the course of its international business activities, an MNC may need financing fromaninternationally active bank, use economic information provided by an internationalorganization, operate within a regulatory framework set by local governments orinternational institutions, and deal with investor relations in several countries. Some ofthese international players in finance are mentioned below. International Banks International Institutions o The International Monetary Fund (IMF) o The World Bank o Multilateral Development Banks (MDBs) o The World Trade Organization (WTO) o The Organization for Economic Cooperation and Development (OECD) o The Bank for International Settlements (BIS) o The European Union (EU) Governments Individual and Institutional Investors o Individual Investors o Institutional Investors o Sovereign Wealth Funds o Hedge Funds and Private Equity FirmsProject Finance Management Nov 2012
  15. 15. International Finance Management P a g e | 14INTERNATIONAL FINANCE MARKETS: FOREIGN EXCHANGE MARKETThe foreign exchange market allows for the exchange of one currency for another. Largecommercial banks serve this market by holding inventories of each currency, so that theycan accommodate requests by individuals or MNCs. Individuals rely on the foreign exchangemarket when they travel to foreign countries. The exchanges of money occur in the foreignexchange market. Because different countries use different kinds of money, theglobalization process of the past 30 years has led to spectacular growth in the volumestraded on this market.The institutional structure allows corporations, banks, internationalinvestors, and tourists to convert one currency to another.At the core of the foreignexchange market are traders at large financial institutions. For one currency to beexchanged for another currency, there needs to be an exchange rate that specifies the rateat which one currency can be exchanged for another.The system used for exchangingforeign currencies has evolved from the gold standard, to an agreement on fixed exchangerates, to a floating rate system.Organisation of Foreign exchange marketThe foreign exchange (sometimes abbreviated “forex”) has the customers of the foreignexchange dealers buy and sell foreign currencies. These customers are the multinationalcorporations that market goods and services throughout the world and the institutionalinvestors and money managers that invest capital or speculate throughout the world.Project Finance Management Nov 2012
  16. 16. International Finance Management P a g e | 15Foreign Exchange TransactionsThe “foreign exchange market” should not be thought of as a specific building or locationwhere traders exchange currencies. Companies normally exchange one currency for anotherthrough a commercial bank over a telecommunications network. The most common type offoreign exchange transaction is for immediate exchange at the so-called spot rate. Themarket where these transactions occur is known as the spot market.If a bank begins to experience a shortage in a particular foreign currency, it can purchasethat currency from other banks. This trading between banks occurs in what is often referredto as the interbank market. Within this market, banks can obtain quotes, or they can contactbrokers who sometimes act as intermediaries, matching one bank desiring to sell a givencurrency with another bank desiring to buy that currency. About 10 foreign exchangebrokerage firms handle much of the interbank transaction volume.Exchange RatesAn exchange rate is the relative price of two monies, such as the Japanese yen price of theU.S. dollar, the British pound price of the euro, or the Brazilian real price of the Mexicanpeso. The contractual parties use abbreviations. In banking and commercial transactions, itis important that all parties understand which currencies are being used. Hence, there is aneed for standardization of the abbreviations which is done by the InternationalOrganization for Standardization.Exchange Rate QuotesBecause exchange rates are relative prices, they can be expressed in two ways. Exchangerates can be quoted in direct terms as the domestic currency price of the foreign currency orin indirect terms as the foreign currency price of the domestic currency.Exchange Rate SystemsExchange rate systems can be classified according to the degree by which exchange ratesare controlled by the government. Exchange rate systems normally fall into one of thefollowing categories: Fixed Freely floating Managed float PeggedTriangular ArbitrageTriangular arbitrage is a process that keeps cross-rates (such as euros per British pound) inline with exchange rates quoted relative to the U.S. dollar. A trader can conduct a triangulararbitrage in many ways. For example, a trader might start with euros, buy pounds with theeuros, then simultaneously sell those pounds for dollars and sell those dollars for euros.Inother words, instead of exchanging just two currencies, the trader exchanges three(hencetheterm “triangular” arbitrage). If the number of euros the trader has at the end ofProject Finance Management Nov 2012
  17. 17. International Finance Management P a g e | 16these three transactions is greater than the number of euros at the beginning, there is aprofit.If such transactions can be done profitably, the trader can generate pure arbitrage profits—that is, earn risk-free profits. Obviously, in perfectly competitive financial markets, it isimpossible to earn arbitrage profits for very long. If the euro price of the pound were notequal to the euro price of the U.S. dollar multiplied by the U.S. dollar price of the pound,arbitrage activity would immediately restore equality between the quoted cross-rate andthe cross-rate implied by two dollar quotes:Euros / Pound = Euros / Dollarx Dollars / PoundInternational Money MarketIn most countries, local corporations commonly need to borrow short-term funds to supporttheir operations. Country governments may also need to borrow short-term funds tofinance their budget deficits. Individuals or local institutional investors in those countriesprovide funds through short-term deposits at commercial banks. In addition, corporationsand governments may issue short-term securities that are purchased by local investors.Thus, a domestic money market in each country serves to transfer short-term fundsdenominated in the local currency from local surplus units (savers) to local deficit units(borrowers).The international money market includes large banks in countries around theworld. Two other important components of the international money market are theEuropean money market and the Asian money market.International Credit MarketMultinational corporations and domestic firms sometimes obtain medium-term fundsthrough term loans from local financial institutions or through the issuance of notes(medium-term debt obligations) in their local markets. However, MNCs also have access tomedium-term funds through banks located in foreign markets. Loans of one year or longerextended by banks to MNCs or government agencies in Europe are commonly calledEurocredits or Eurocredit loans. These loans are provided in the so called Eurocredit market.The loans can be denominated in dollars or many other currencies and commonly have amaturity of 5 years.Syndicated LoansSometimes a single bank is unwilling or unable to lend the amount needed by a particularcorporation or government agency. In this case, a syndicate of banks may be organized.Each bank within the syndicate participates in the lending. A lead bank is responsible fornegotiating terms with the borrower. Then the lead bank organizes a group of banks tounderwrite the loans. The syndicate of banks is usually formed in about 6 weeks, or less ifthe borrower is well known, because then the credit evaluation can be conducted morequickly.International bonds are typically classified as either foreign bonds or Eurobonds. A foreignbond is issued by a borrower foreign to the country where the bond is placed. For example,Project Finance Management Nov 2012
  18. 18. International Finance Management P a g e | 17a U.S. corporation may issue a bond denominated in Japanese yen, which is sold to investorsin Japan. In some cases, a firm may issue a variety of bonds in various countries. Thecurrency denominating each type of bond is determined by the country where it is sold.These foreign bonds are sometimes specifically referred to as parallel bonds.International Stock MarketsMNCs and domestic firms commonly obtain long-term funding by issuing stock locally. Yet,MNCs can also attract funds from foreign investors by issuing stock in international markets.The stock offering may be more easily digested when it is issued in several markets. Inaddition, the issuance of stock in a foreign country can enhance the firm’s image and namerecognition there.Methods Used for International InvestmentFor investors attempting international stock diversification, five common approaches areavailable: Direct purchases of foreign stocks Investment in MNC stocks American depository receipts (ADRs) Exchange-traded funds (ETFs) International mutual funds (IMFs)Project Finance Management Nov 2012
  19. 19. International Finance Management P a g e | 18BALANCE OF PAYMENTA country’s balance of payments (BOP) records the value of the transactions between itsresidents, businesses, and government with the rest of the world for a specific period oftime, such as a month, a quarter, or a year. Hence, the balance of payments summarizes theinternational flows of goods and services and changes in the ownership of assets acrosscountries. There are two major BOP accounts: the current account and the capital account.In recent years, most countries have renamed the capital account as the “financial account”in order to comply with the recommendations of the International Monetary Fund (IMF).Because the terminology capital account has a long tradition and continues to be used in thefinancial press, we continue to use it here.The current account records: Goods and services transactions Transactions associated with the income flows from the ownership of foreign assets Unilateral transfers of money between countriesThe capital account records the purchases and sales of foreign assets by domestic residentsas well as the purchases and sales of domestic assets by foreign residents.{The definition of an asset is all inclusive: It encompasses both financial assets (bank deposits andloans, corporate and government bonds, and equities) and real assets (factories, real estate,antiques, and so forth)}Balance of Payment follows a Double Entry Accounting System. Each transaction gives riseto two entries: One entry is a credit, and the other entry is a debit of equal value. The rulesfor determining credits and debits on the balance of payments are analogous to those infinancial accounting.Credit transactions Give rise to conceptual inflows or sources of foreign exchange purchases of goods and assets by foreign residents from domestic residents are credits because they are a source of foreign exchange Increase the supply of foreign money in the foreign exchange market.Debit transactions give rise to conceptual outflows or uses of foreign exchange purchases of goods and assets by domestic residents from foreign residents are debits because they cause an outflow of foreign exchange increase the demand for the foreign money in the foreign exchange marketCurrent Account Transactions- Every current account transaction can be considered to havea corresponding flow of foreign money associated with it, and this flow of foreign money isrecorded as a capital account transaction.Capital Account Transactions- Some capital account transactions arise naturally, asdemonstrated in the case of payment flows associated with current accountProject Finance Management Nov 2012
  20. 20. International Finance Management P a g e | 19transactions.However, some transactions involve situations in which both entries arerecorded exclusively on the capital account.Because the two major accounts of the balance of payments are the current account andthe capital account, we see immediately that a current account deficit must have a capitalaccount surplus as its counterpart. In other words, if we list credit items with a 1 + 2 anddebit items with a 1 - 2, we can add the accounts, and they must sum to zero: Current account + Capital account = 0International Trade FlowsCanada, France, Germany, and other European countries rely more heavily on trade thanthe United States does. Canada’s trade volume of exports and imports per year is valued atmore than 50 percent of its annual gross domestic product (GDP). The trade volume ofEuropean countries is typically between 30 and 40 percent of their respective GDPs. Thetrade volume of the United States and Japan is typically between 10 and 20 percent of theirrespective GDPs. Nevertheless, for all countries, the volume of trade has grown over time.As of 2006, exports represented about 18 percent of U.S. GDP.Factors Affecting International Trade FlowsBecause international trade can significantly affect a country’s economy, it is important toidentify and monitor the factors that influence it. The most influential factors are: Inflation National income Government policies Exchange ratesInternational Capital FlowsOne of the most important types of capital flows is direct foreign investment. Firmscommonly attempt to engage in direct foreign investment so that they can reach additionalconsumers or can rely on low-cost labour. In 2006, the total amount of direct foreigninvestment (by firms or government agencies all over the world) into all countries was about$1.2 trillion. Exhibit 2.7 shows a distribution of the regions where the DFI was targetedduring 2006. Notice that Europe attracted almost half of the total DFI in 2006. WesternEuropean countries attracted most of the DFI, but Eastern European countries such asPoland, Hungary, Slovenia, Croatia, and the Czech Republic also attracted a significantamount of DFI. This is not surprising since these countries are not as developed as those inWestern Europe and have more potential for growth. They also have relatively low wages.The United States attracted about $177 billion in DFI in 2006, or 14 percent of the total DFI.Agencies That Facilitate International Flows International Monetary Fund World Bank Multilateral Development Banks (MDBs) The World Trade Organization (WTO)Project Finance Management Nov 2012
  21. 21. International Finance Management P a g e | 20 The Organization for Economic Cooperation and Development (OECD) The Bank for International Settlements (BIS) Asian Development BankASIAN DEVELOPMENT BANKGeneralADB is a multilateral financial institution dedicated to reducing poverty in Asia and thePacific. It was established in 1966 and now owned by 63 member countries, of which 42 areconsidered developing. It is headquartered in Manila, with 27 other offices around theworld and more than 2,000 employees from 50 countries. ADB provides financial assistanceto governments and to public and private enterprises. In the year 2004 the approvalsinclude: $5.8 billion in loans, equity investments, guarantees, and technical assistance.Some of the important functions of ADB areADB catalyses and mobilizes the capital for the PPP project. It leads private capital to development projects in countries or sectors with perceived high risks (e.g. transition economies, small countries, frontier sectors). Provides comfort to co-investors by taking the same risks through direct participation in projects (i.e., being on the “same boat”). Mitigates perceived risks through credit enhancement instruments such as guarantees. Assures financial closure in critical infrastructure projects requiring large financing.ADB’s value system Better loan terms and financial structure to improve project’s viability. Mutually beneficial concession contracts. Improved environmental and social risk mitigation. enhanced public consultation. Improved corporate governance in the project. “Certification” of projects on issues of environmental protection, good governance, etc. on the strength of ADB’s value system.Some of the targeted Infrastructure Segments for ADB financing are Power: generation, transmission, distribution, renewables. Oil and gas: pipelines, terminals, distributions systems. Transport: roads, bridges, ports, airports, rail transport systems. Telecommunication: backbone networks, rural telecom. Water: supply, distribution, wastewater treatment. Urban services: waste management, mass rapid transit, and other transport systems.Project Finance Management Nov 2012
  22. 22. International Finance Management P a g e | 21Types of Infrastructure project that have been assisted are Greenfield: start-up projects, including BOOs, BOOTs, BOTs and other similar contractual structures. Brownfield: expansion, rehabilitation, modernization of existing facilities with private sector participation. Privatization: state-owned utilities.ADB’s window of operationPublic Sector Window o Deals with the government o Instrument: sovereign loans , technical assistance, guaranteesPrivate Sector Window o Direct assistance to private enterprises o Instruments: Equity investments, non- sovereign loans, guarantees, complementary financing schemeInstruments to assist PPP projects o Equity investments o Loans without sovereign guarantees o Complementary financing scheme (CFS) o Political risk guarantee (PRG) o Partial credit guarantee (PCG) o Sovereign loans to finance the host government’s equity in a PPP project, if needed.ADB’s Initiatives in Local Currency LendingLocal currency financing is needed to mitigate the risk of currency mismatches.ADB canissue its own local currency denominated bonds to generate local currency funds for onlending to borrowers in the host country (e.g., India and Thailand).ADB can also generatelocal currency funds via cross currency swaps in the market.ADB’s partial credit guarantee isavailable to credit enhance local currency borrowings or bond issues by clients.Single project exposure limit:The lesser of $250 million or 25% of project cost.This applies to the aggregate of equity investment, loan, PCG (present value), and PRG (riskweighted).PRG transaction limit:Up to $250 million (or higher under special conditions);if without sovereign counter-guarantee.No pre-specified limit ;if with sovereign counterguarantee.CFS / Guarantor of Record: no pre-specified limit.Project Finance Management Nov 2012
  23. 23. International Finance Management P a g e | 22PUNE NIRVANA HILLS SLUM REHABILITATION PROJECT- STUDYProject Identification and DescriptionIndia suffers from an acute shortage of housing, estimated at 24.71 million housing units,and Maharashtra has the greatest shortage at 3.72 million units.1 The problem will increasedue to rapid urbanization and population growth, amongst other factors. Given thistremendous shortage of housing, substandard housing and slums are proliferating. TheAsian Development Bank (ADB) was approached by Deutsche Bank, a leading real estatefinancing bank in India, to provide financing for this slum rehabilitation project. The projectis considered to be one of the best opportunities for ADB to support slum rehabilitationbecause of its good location, high development impact, and strong sponsor, Kumar UrbanDevelopment Limited (KUDL).DesignPune, the second-largest city in Maharashtra, has a population of approximately 5.5 millionpeople, of which about 32.5% to 40% live in slums. The project is situated on a prime pieceof real estate, advantageously located in the Kothrud area of southwest Pune, near thePune–Mumbai expressway. Residential housing is in short supply across the city and inparticular in the Kothrud area. The project represents one of a few new developments inKothrud, which also suffers from a lack of retail and office space.The project covers a site of 76 acres and entails the in-situ rehabilitation of slum dwellingsand the development of mixed-use residential and office and retail space, which the sponsoris entitled to sell at market prices. Currently a large number of slum households are living insubstandard conditions on the site. The sponsor will construct (i) multiple buildings to re-house the slum dwellers, each building with 11 floors of 13 units each, and severalcommercial spaces for small businesses that are operating in the slum area; (ii) residentialbuildings with apartments, office space, and retail space; and (iii) amenities andinfrastructure for the use of the re-housed slum dwellers—housing society offices, a self-employment center for women, playgrounds, daycare facilities, community and seniorcitizen recreation centers, libraries, a primary and secondary school, and a park.The project is expected to be constructed in 7 years, including a 4-year construction periodfor the rehabilitation buildings that started in 2011. A phased approach is being used tomanage the construction and regulatory approval process and to minimize the need fortransit housing. During construction, the slum dwellers will either be moved into temporaryhousing on the site or be paid a monthly rental allowance until they are moved into theirnew, permanent housing. Additionally, for eligible and ineligible slum dwellers under theSRS (para. 6), the developer will pay a moving allowance before the slum dwellers vacatetheir homes, and when the slum dwellers move into their new apartments. The architect ofthe commercially saleable portion of the project (the “free-sale” area) is P.G. PatkiArchitects Pvt. Ltd., which has designed several well-known projects in India.Project Finance Management Nov 2012
  24. 24. International Finance Management P a g e | 23Operation and maintenance of the rehabilitation buildings is carried out by the housingsociety, formed by the apartment owners, which will outsource such work to externalparties. The sponsor will deposit a fixed amount per slum household in an escrow account,which is jointly managed by the SRA and the housing society. Interest earned from this isexpected to be sufficient to cover such costs. The households pay their own monthlyelectricity and running-water costs. These costs are expected to be relatively low and, inmany cases, are already being borne by the households.Alignment with ADB Strategy and OperationsConsistency with Strategy 2020The project is consistent with ADB’s Strategy 2020, which promotes private sectorinvestment in the infrastructure sector, as well as an improvement in public healthstandards. Strategy 2020 also states that ADB will continue to emphasize gender equalityand the empowerment of women as fundamental elements of achieving inclusive growth.The project is expected to yield tangible benefits for women and empower them, e.g.,through joint ownership of apartments and job and skills training. Also, under Strategy2020, cities constitute a key focus, specifically in terms of promoting livable cities that aresocially inclusive. The project promotes, in an inclusive and innovative way, the privatesector’s participation in the slum rehabilitation sector.This is a sector which the governmenthas so far and can be expected to support only to a limited extent.Consistency with Country and Sector StrategyThe project is consistent with the country partnership strategy (CPS) 2009–2012 for India.The CPS aims to significantly strengthen ADB’s infrastructure activities and to encourageinnovative financing. The CPS further notes that ADB’s ongoing urban sector operations willcombine infrastructure development with targeted poverty reduction components. Finally,the project is in line with ADB’s desire to undertake projects that have targeted povertyreduction components and promote inclusive growth. The project is also consistent withADB’s strategies and plans for private sector development, poverty reduction, and urbanoperations. The poverty reduction strategy supports the need to undertake sustainablehousing projects implemented by the private sector. ADB’s draft urban operations planstates that ADB’s support for inclusive cities must include support to slum upgrading,housing, land tenure, and development and housing finance.Project Cost and Financing PlanThe project will be financed through sales advances, sponsor equity, and the remaining by acombination of CCDs (compulsory convertible debenture) and debt from ADB;FMO(NederlandseFinancierings-MaatschappijvoorOntwikkelingslanden N.V. (NetherlandsDevelopment Finance Company)), (with participation from GuarantCo) and Deutsche Bank.The debt investors will provide direct onshore loans to Kumar Sinew Developers PrivateLimited (Project Company). FMO and GuarantCo have already funded the project throughProject Finance Management Nov 2012
  25. 25. International Finance Management P a g e | 24CCDs and Deutsche Bank has provided debt. FMO and GuarantCo will further invest in theform of debt, as Nonconvertible debentures (NCDs), and Deutsche Bank will provide furtherdebt.Implementation Arrangements Aspects Arrangements Regulatory framework Slum Rehabilitation Scheme and Slum Rehabilitation Authority of Pune. Management Sponsor’s project management team. Implementation Multiple ADB CCD infusions expected to be made in 2012–2014. Period Construction Kumar Sinew Developers is responsible for the supervision of the Arrangements construction activities. Construction works will be competitively bid out on a turnkey basis to qualified contractors. Revenue structure Revenue from pre-sales and sales of residential apartments and commercialspace, and from lease rentals of the retail space. Operation and Housing societies will be responsible for the operation and maintenance maintenance of the common areas of the buildings Performance Key performance indicators will be reported by KUDL as per ADB’s monitoring requiredinformation covenants. A semiannual market valuation of the proposed securitywillbe provided by an independent real estate consultant. An independentexternal consultant will monitor compliance with ADB’s Safeguard Policy Statement (2009).The Proposed ADB AssistanceThe AssistanceADB proposes to provide the rupee equivalent of up to $35 million to the project in the formof CCDs, which will be issued by KUL UDPL (issuer). CCDs have been used in the past byforeign investors for slum rehabilitation projects, as well as for projects in other sectors.The issuer is expected to pay to ADB and other CCD holders a fixed coupon amount, payablequarterly. ADB is expected to have the right to nominate one director for appointment tothe board of the issuer. To facilitate exit arrangements, ADB will grant to the sponsor a calloption under which it will have an option to buy the CCDs, or on default, for apredetermined amount that would both pay the amount invested by ADB and provide areturn on such investment. Should the sponsor not exercise the option, the CCDs willautomatically convert to shares of the issuer. The CCD investors may also force a conversionif the issuer defaults on its CCD obligations.Security-The OPCD (optionally convertible debenture) loan from the issuer to the projectcompany will be secured by a mortgage on land and buildings of the project at a minimumcollateral value in relation to the loan amount. Additional collateral satisfactory to the CCDholders will be provided if the collateral value declines below a certain level. The value ofthe collateral will be reviewed on a semi-annual basis by an internationally recognizedProject Finance Management Nov 2012
  26. 26. International Finance Management P a g e | 25independent real estate company and valuator. In addition, the OPCD loan will be securedby a guarantee from the sponsor. All proceeds in an enforcement scenario will be sharedparipassu among Deutsche Bank, the NCD holders, and the OPCD holders. In anenforcement situation, conversion to shares will thus give the CCD holders the ability toenforce the project company’s obligations to repay the issuer’s OPCD loan and, if necessary,to (i) exercise the security for the OPCD loan and (ii) call on the sponsor guarantee. Incertain circumstances, control of the issuer may also enable the investors to recover theirinvestments by selling the project company as a whole or by causing it to liquidate.Value Added by ADB AssistanceADB’s value addition to the project is expected to be the following:(i) Funding for the real estate sector, particularly for slum rehabilitation projects, is notreadily available from commercial banks. The project will play a pioneering role indemonstrating the commercial viability of slum rehabilitation projects undertaken throughthe SRS(Slum Rehabilitation Scheme) in India, which may help to catalyze commercial bankfinancing for future slum rehabilitation projects.(ii) ADB’s participation will further strengthen the project through the application of ADB’ssocial safeguards, gender and development targets, and environmental standards, whichare of particular importance.Risks of the Project Real Estate Market Risk Project Risk Sponsor Risk Social Safeguards Risk Regulation Risk Reputational Risk Corporate Governance RiskBudget for the Rehabilitation PlanThe budget for the rehabilitation plan has been developed based on the number of eligibleand non-eligible families. The budget provides indicative costs (in Indian Rupees) for thefollowing options:Option I: Cash Compensation at Replacement Value; and;Option II: Low Cost Housing linked to the RAY (Rajeev AwazYojana);Option III: Non-SRA/KUL allocated housing without FSI advantage.REFERENCESProject Finance Management Nov 2012
  27. 27. International Finance Management P a g e | 26Books 1. International Financial Management Second Edition by Geert Bekaert and Robin Hodrick 2. International Financial Management Ninth Edition by Jeff Madura, Florida Atlantic UniversityReports 1. The Future of the Global Financial System -A Near-Term Outlook and Long-Term Scenarios:A World Economic Forum Report In Collaboration With Oliver Wyman 2. Infrastructure PPP Projects: Financing & Risk Mitigation Instruments of the Asian Development Bank by Jean-Pierre Verbiest, Thailand Resident Mission ,Asian Development BankLectures 1. History of International Monetary System byMd. AzimFerdous, Dept. of Management Studies, University of Dhaka 2. Lecture on Evolution of International Financial System by AkilaWeerapana 3. Global Financial System in PerspectiveWebsites 1. Rehabilitation Planning Document : Pune Nirvana Hills Slum Rehabilitation Projecthttp://www.adb.org/sites/default/files/projdocs/2012/44940-01-ind-rp- 01.pdf 2. www.adb.org › › Projects › DocumentsProject Finance Management Nov 2012

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