INTRODUCTION
LECTURE 1
INTERNATIONAL FINANCE
Outline of presentation
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Learning objectives
Introduction to international finance
Risk and returns
Country-risk
Financial Process
Concluding remarks
Review questions
UNIT 1: KEY CONCEPTS IN FINANCE
INTRODUCTION
What is finance?
• Allocation of scarce resources over time.
• Differences between financial and other resource allocation
decisions:
– Spread out over time
– Often not known with certainty in advance by either decision makers
or anybody else.
• The financial system is used by economic agents in the
exchange of assets and risks.
• Financial system is given as a set of markets and institutions
that facilitate transactions involving the exchange of assets
and risks.
• Investment, a function of finance, has a direct effect on
economic development.
Sub-themes in finance
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Personal finance
Corporate finance
Public finance
International finance
Development finance
What is international finance?
• It is concerned with the dynamics of:
– exchange rates,
– foreign investment, and how these affect international trade.
• International finance also studies:
– international projects,
– capital flows,
– trade deficits etc
International finance
• Covers several topical issues
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What has/will happened to the rand, the dollar etc?
Should China devalue the yuan?
Should the UK give up its pound to join the euro?
Should Greece default on its national debt?
Should SA impose capital controls whenever the rand is
too strong?
– Should SADC share a single currency?
– Should SACU continue to transfer resources to Swaziland
and Lesotho?
International finance
• International finance is due to the effect of the influence of
economic activity in other countries on local economies.
– Countries trade with one another but different countries often have
different currencies.
– What determines the relative values of the various competing
currencies.
– Countries/cross-border firms borrow from each other.
– International borrowing and lending economic opportunities are
expanded and households’ welfare are improved.
• Existence of banks makes bank runs possible similarly the
international financial system makes international financial
crisis possible.
Regimes of international financial
systems
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Bimetallism
Gold standard
WWI, Depression gold standard breaks down
Bretton Woods
– Breaksdown due to OPEC and Vietnam war
– Can we blame globalistion?
• Current non-system
Current non-system
• Some major currencies float, eg. Japan, US, UK
• Some countries have eliminated their currencies to form
currency unions, the euro.
• Some countries peg to other major currencies: dollar, eg.
China and many Asian countries.
• Some countries ‘dirty float’ or manage exchange rates.
• Currency boards and its variants.
• Currency substitution, eg. Zimbabwe.
Selected facts about the
international financial system
• In Sept 2011, international currency trade was 4 trillion US
dollars/day. (Bloomberg).
• Outstanding bonds world wide at the end of 2010 was 95
trillion dollars.
• Size of world trade in 2010 was 15.2 trillion dollars.
• US GDP 14.5 trillion; China 4.5trillion
• Selected GDPs in Africa.
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South Africa, $363bn
Nigeria, $193bn
Angola, $84bn
Botswana, $15bn
Recent events
• Euro crisis
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Ireland
Greece
Portugal
Spain
Italy
• Austerity measures across Europe, and stifling of growth etc.
• Crisis unresolved
– Fear of Greek default
• Weakness of the rand
Brief tour of recent SA data
FDI (R million)
South African cent per 1 unit of foreign
currency
Year
Botswana
Pula
Japanese
Yen
Indian
Rupee
British
Pound
US Dollar
1990
139.9
1.8
14.8
461.4
258.8
1995
131.0
3.9
11.2
572.4
362.7
2000
136.0
6.4
15.4
1048.6
693.5
2005
125.3
5.8
14.2
1180.8
636.2
2007
114.6
6.0
17.1
1411.5
676.7
2008
120.4
8.1
18.9
1512.5
825.7
2009
117.7
9.0
17.4
1311.8
843.7
2010
107.8
8.3
16.0
1131.5
732.2
Source: SARB data files, 2012
Role of international finance in
economic development
• All competing growth theories are unanimous
regarding the place of capital in determining
economic growth.
• Capital is finance by investments
– Local and foreign.
• Scarcity of capital locally creates necessitates
sourcing of capital from overseas.
• Hence the importance of international finance.
Summary: Theory
• Financial instruments, markets, and institutions arise to lessen the effects
of information, enforcement, and transactions costs.
• How well financial systems reduce information, enforcement, and
transactions costs influences:
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savings rates,
investment decisions,
technological innovations,
growth rates.
• Changes in economic activity may impact financial systems with
implications for economic growth.
• The financial sector does play an important role in the development
process.
Summary: Evidence
• Empirical literature on finance on growth.
• Better functioning financial systems ease the external
financing constraints that impede firm and industrial
expansion.
– This is one channel through which financial development matters for
growth.
• Countries with better functioning banks and markets grow
faster, but the degree to which a country is bank-based or
market-based does not matter much.
Reference:
Levine, Ross (1997), ‘‘Financial Development and Economic Growth: Views and Agenda,’’ Journal of Economic
Literature, vol. 35, pp. 688-726
UNIT 1: OVERVIEW OF KEY CONCEPTS IN FINANCE
UNCERTAINTY, RISK AND RETURNS
Key concepts in finance
• Key concepts
– Risks
– Returns
• Financial Processes
• The finance and monetary systems
• Concluding Remarks
Risk
• Definition:
– There are various attempts at defining risk in the
literature [Holton, G.A. (2004), Defining risk, Financial Analysis Journal
60:6, 19-25]
– Risk, according to Glyn Holton (2004) has two
components:
• Exposure
• Uncertainty
• Risk is defined here is as exposure to a proposition for which
one is uncertain.
Risk cont’d
• Harry Markowitz’s seminal work that constitutes the
basis of portfolio theory constitutes a body of
models/theories that describes how investors can
balance risk and returns.
• Markowitz did not explicitly define risk in his work.
• In Portfolio theory, risk is defined as the “variability
of return on a given asset”
Risk cont’d
• Portfolio theory identifies two main kinds of
risk:
– Systematic/systemic risk
– Unsystematic (idiosyncratic) risk
• There are several forms of risk
• Some of the risk forms may be related and
hence difficult to isolate one from the other,
but it’s not impossible to do so.
Types of risk
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Business risk
Financial risk
Purchasing power risk/inflation risk
Interest rate risk
Exchange rate risk
Market risk
Specific/idiosyncratic risk
Project risk
Country risk
Business risk
• Related to business operations and related
decision-making processes.
• Associated with the profit potential.
• A firm may be successful (profitable) or fail
(incur a loss).
• Generally, business risk may arise from the
uncertainty associated with business
objectives: market size, revenues, profit etc
Financial risk
• Probability of loss emanating from the type of
financing which could impair ability to provide
adequate return.
• The type of financial assets that constitute the
capital structure of a business determines degree if
financial risk.
• In the event of failure, claimants to the firm’s assets
are paid in the order of seniority.
• Question: what happens to a heavily geared or
leveraged firm’s profitability when interest rates
suddenly escalates?
Financial risk cont’d
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the receiver/liquidator
certain preferred creditors (eg. Tax authorities)
secured creditors (eg. trade creditors)
holders of floating charges over assets
unsecured creditors (eg.unsecured loans)
holders of unsecured preference shares and loan
stocks
• ordinary share holders (equity)
Inflation risk
• The likelihood of inflation eroding the purchasing
power of expected return or value of assets.
• Issuance of inflation-linked bonds (ILB) are meant to
provide inflation-adjusted/compensated returns to
make bonds attractive.
• South Africa: Inflation linked retail savings bonds; 3year GGILB, Ghana. Other countries that issues ILB
include Brazil, Poland, Israel.
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Interest rate risk
• Risk to returns to capital due to variations in interest
rates.
• Interest rates surges immediately after purchasing
bonds returns to the bond holder falls and the
market value of the bond also falls.
• Asset purchases with loans at variable interest rates
transfer the burden of interest rate risk solely on the
borrower
Exchange rate/currency risk
• Holding financial asset or liability other than
one’s own currency exposes on to exchange
rate risk.
Exchange rate/currency risk cont’d
• Exchange-rate risk may be the single biggest
risk for holders of bonds that make interest
and principal payments in a foreign currency.
– A Namibian company A pays interest and principal on a
R1,000mn bond with a 5% coupon in N$. If the exchange
rate at the time of purchase is 1:1, then the 5% coupon
payment is equal to N$50mn, and because of the exchange
rate, it is equal to R50mn. If in a year’s time, the exchange
rate is 1:085. The bond’s 5% coupon payment is still
N$50mn, but its worth only R42.50mn. The South African
investor has lost a portion of his return for reasons that
has nothing to do with the Namibian issuer’s ability to pay.
Market risk
• Three different views of market risk can be
identified:
• Market theory perspective
– Sensitivity of a security to changes in the broad
market index (beta coefficient).
• Development finance view
– Marketability of a security, securities can’t be
converted to cash easily e.g. Investing in securities
on illiquid Exchanges.
Project risk
• Project risk ensues when a project is undertaken
with long-term financing based on projected cash
flow from the project.
• If guarantees are provided by a Government,
sovereign guarantee- then the lender deals with
country risk instead of project risk.
• Example: SA Gov’t loan guarantees for Eskom shifts
project risk to country risk from the point of view of
the lenders
Idiosyncratic/specific risk
• Specific risk associated with the changes in a
company’s share price due to firm specific
factors.
• It may be due:
– Raw material price changes
– Industrial action
– Take-over bid (Massmart and Walmat deal)
– Technology discovery of consequence to the firm
Country risk
• This is the risk of default or rescheduling of national debt.
• Independent institutions have developed models for
measuring country risk.
• Assessment is based on a large number of factors.
• The rating of a country may affect the financial institutions in
the country.
• Poor ratings results in high cost of capital.
• High cost of capital have negative effect on economic growth.
– Eg. Greece’s 10yr bond yield is 28 percent with a credit rating of junk
status.
– Germany with investment grade rating of AAA borrows at less than 2
percent.
UNIT 1: KEY CONCEPTS IN FINANCE
NOMINAL AND REAL RETURNS
RETURNS
• Returns are compensations for deferred
consumption.
• Desire to protect the value of financial assets.
• Payment for accepting the risk of postponing
consumption.
• The trade-off between risk and returns
underpins capital market theory.
KEY CONCEPTS IN INTERNATIONAL FINANCE
COUNTRY RISK
Quantitative method
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Econometric approach and modelization
Analytical approach: crisis typology (Indosuez)
Principal Component Analysis
Logit Analysis
Non-linear conditional analysis (threshold levels
& breaking points: TAC)
Quantitative method
• Approach:
– Transforming a number of observations (Delphi
method, surveys) or quantitative indicators into one
number.
• The various indicators may be weighted in terms
of their impact on creditworthiness and risk.
• End-product:
– one single grade to assess past and current country
risk situation with possible cross-country comparisons
across time.
Assessment of country risk
• Qualitative
– a qualitative assessment of the financial, macroeconomic,
legal, regulatory and political situation in a given country.
– Some of the rating agencies that use the qualitative
approach include Euromoney and Beri SA.
– Example: Euromoney uses a 32-man panel of eminent
economists in international financial institutions and
another panel of political analysts to measure short-term
risk of destabilization.
– Outputs of the two panels are then weighted and used in
coming up with the ratings.
– Eg. Economic Intelligence Unit, Nord/Sud Export, e.t.c.
Pros and cons of country risk analysis
• Disadvantages/Cons
– “reductionist”
– Overly simplistic
– risk of self-fulfilling
prophecy
– little predictive value
– weighted average
tends to bury salient
trends
– Gives “market
consensus” often made
of herd instinct
• Advantages/Pros
– Simple
– Allows for crosscountry comparison.
– Comparison over time.
– Compresses a large
number of variables
into one single grade.
Rating agencies
• The agencies are expected to be independent
third parties that are consulted in the course
of a market transaction.
• The goal is to deal with asymmetric
information between both parties in the
market using standardised assessement
methods
Weaknesses of the rating agencies
• Power without accountability.
• Conformity bias.
• Penalisingof disobedient firms/countries that do not
request a rating.
• Pro-cyclical bias, hence following the majority
opinion of market participants without early
warning.
• Downgrades amplify procyclicality.
– E.g., cutting AIG’s debt rating in 2008, “sent
investors rushing for the exit”.
Response to short-comings of rating
agencies.
• Reliance on external rating has been reduced in
some countries:
– Japan (securities registration)
– Argentina (for pension fund investments)
Country risk analysis
• The international capital market is a private initiative
with no governmental influence, except legitimate
regulatory initiatives.
• The country risk outcome is usually reflected in the
sovereign credit rating.
• A favourable sovereign credit rating suggests that a
country or private borrower from a given country can
access capital at a relatively more favourable cost.
There are many institutions that provide credit rating
services.
Credit Rating Agencies (CRA)
• Credit Rating Agencies received heavy criticism for their role
in the economic crisis that started in 2007 and continues
currently.
• America’s new Dodd-Frank Act now ensures a tighter
supervision of CRAS in the US.
• There currently over 76 rating agencies in the world.
• Big three Credit Rating Agencies are:
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Standard and Poor’s (40% of market share)
Fitch Ratings (40% of market share)
Moody’s Investor Services (14 % of market share)
Other +70 agencies (~ 6%)
Selected ratings from S&P
• Prime: AAA+,
– Canada, Germany, UK
• High grade: AA+,
– US, France
• Upper medium grade:
A-,
– Botswana
• Lower medium grade:
– Brazil, BBB;
– SA, BBB+
• Non-investment grade
speculative:
– Angola,BB –
– Indonesia, BB+, etc
• Highly speculative:
– Kenya, B+; Nigeria, B+
– Greece, CC
Credit rating rankings for 2007
Concluding remarks
• Country-risk analysis is a very demanding task.
• Generally, no matter the rating agency or approach
adopted in undertaking country risk assessment,
qualitative or qualitative, a wide range of factors
ought to be considered.
• It is one thing to identify shortcomings of ratings,
quite another to find alternative standards that are
superior.
UNIT 1: OVERVIEW OF KEY CONCEPTS IN FINANCE
THE FINANCIAL PROCESS
FINANCIAL PROCESSES
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Mobilisation
Intermediation
Maturity transformation
Risk transfer
Financial deepening and financial repression
(1) Mobilisation
• Mobilisation is concerned with moving funds from savers to
users of funds.
• In developing countries savers have little inclination to place
funds in financial assets even if they have access to them.
• The thrust of the mobilisation effort is to encourage savers to
invest in productive assets and not to invest in non-productive
assets such as gold and cash.
• In developing countries, informal financial institutions are also
engaged in mobilisation of funds from savers.
• Governments in most developing countries are directly
involved in mobilisation through the sale of bonds.
(2) Intermediation
• The basic and most important
• See to link savers and borrowers
• Intermediaries provide indirect means of transferring funds
from savers to borrowers
– Transfer risk from lenders to intermediaries/borrowers
– It provides focus in the form of institution/market attract potential
borrowers
– Opportunity for savers to deposit surplus funds and earn a return
• Some savers will be unwilling to invest
• Prospective savers may be unable to invest because they
don’t have surplus funds.
• The theory of intermediation is fundamental to financial
repression.
(3) Maturity transfer
• Financial institutions also transfer short-term financial
instruments into long-term financial instruments.
• This important for long-term or project finance.
• Two methods for maturity transfer
– Taking short term deposits for long-term on lending
• The law of large numbers enable financial institutions/banks to borrow “short” and
lend “long”.
• Large number of depositors reduces the risk of unexpected upsurge in withdrawals.
– International banking lending (Eurocurrency market): funds are often
deposited for 6months or less but monies are lent out for medium
term duration i.e., 10yrs, 12yrs and sometimes 15yrs.
• Buildings societies traditionally mobilize short-term funds and
then lend them for long term, as mortgages may be payable in
excess of 20years.
(4) Risk transfer
• In any investment, either in financial or physical assets risk is
involved.
• The division/apportionment of risk is important in mobilising
and supply of fund for investment.
• The simplest way of passing on the risk is for the party in a
stronger position to refuse taking on the risk
• Risk is transferred by:
– Taking a security of one form or the other
– By choice of financial instrument eg. DFI may take an equity stake or
provide a loan. The more it puts in a loan the more risk it apportions
to the other shareholders.
5. Financial deepening and
financial repression
• Financial deepening suggest an accumulation of financial
assets at a faster rate the accumulation of non-financial
wealth.
• The thrust of the theory is that development of financial
institutions and markets is a necessary condition for economic
growth (Shaw 1973 and Mckinnon, 1973).
• Developing countries suffer from financial repression which
keeps finance “shallow” and thus restricting economic
growth.
• Financial repression is characterised by controls on interest
rate either by government or oligopolistic institutions or
markets; capital controls, over-valued exchange rates
Financial deepening and financial
repression cont’d
• Poor development of the financial sector and or absence of
institutions such as pension funds, capital and equity markets
etc
• Financial repression removes the incentives for private
financial savings
• Private individuals and institutions invest in non-financial
assets: gold, land.
• Theory is monetary based: money supply, its real value and
real cost do matter in the process of economic growth.
• The policy response leads to liberalisation of financial markets
eg. Interest rates, removal of capital controls etc
CONCLUSION
Conclusion
• Importance of finance in the development
process.