INTRODUCTION LECTURE 1 INTERNATIONAL FINANCE
Outline of presentation • 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 • 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 • 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 • 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. • South Africa, $363bn • Nigeria, $193bn • Angola, $84bn • Botswana, $15bn
Recent events • Euro crisis • Ireland • Greece • Portugal • Spain • Italy • Austerity measures across Europe, and stifling of growth etc. • Crisis unresolved • Fear of Greek default • Weakness of the rand
South African cent per 1 unit of foreign currency 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: • 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 • 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 • 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; 3-year GGILB, Ghana. Other countries that issues ILB include Brazil, Poland, Israel.
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 • 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 cross-country 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: • 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
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