International Finance

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International Finance

• Dr. Darius Miller

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The Good of International Investing

• We just saw, International stocks can lower
  portfolio risk because of there low correlation
  with other markets
• This creates a positive shift in the Risk-Return
  trade off, which is good.
• However.

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Country Risk may not be captured by traditional
risk measures (such as covariance)

• High Transactions Costs and Illiquidity
• Lengthy Settlement (or complete lack of)
• Lack of transparency and information disclosure
• Corruption
• Capital Controls
• Ownership Restrictions
• Cultural differences
• Political Risk

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Recall How do we asses a stocks risk?

• One option is to use classic finance tools
• For example Mean/Variance Analysis
• However, there are many important cross-country
  differences that matter
• Country Risk
• Lets look at one risk that may not be captured by
  traditional risk measures, Information Risk

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Information Production is not an accident

• Accounting firms are perhaps the most fundamental
  and important institutions of information in
  financial markets
• Why do they work so well in the US?
• US Disclosure Laws Securities Act of 1933,
  Reporting Act of 1934
• Mandate quarterly and annual filings of all
  public firms
• The rules are well-understood standards (GAAP)
  that are audited and certified
• The rules are enforced with rigor by the US
  government (SEC)

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Information Production is not an accident

• Information production is results from a
  deliberate effort to establish
• Laws
• Institutions
• In the US, we take this for granted. However, in
  many countries the view is that the secrecy of
  corporate information is more important than the
  dissemination of information to the investor.

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International Accounting Practices An Investors
Nightmare?

• In Russia, one study reported that there are no
  regulations (including company law) that specify
  disclosure requirements in detail. Out of 5,000
  enterprises privatized, about 100 publish
  financial statements. Their balance sheets,
  however, consist of three lines on the assets and
  two lines on the liabilities, without footnotes,
  which is just nonsense

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International Accounting Practices An Investors
Nightmare?

• A 1998 study by the United Nations reviewed the
  accounting practices in Korea, Thailand,
  Indonesia, Malaysia, and the Philippines and
  found
• Only 1/3 of the firms disclosed related-party
  borrowing and lending
• Only 19 disclosed FX gains/losses under IAS
• Over 80 did not disclose gains/losses of
  derivatives or even their terms
• They concluded that poor accounting helped to
  magnify the size of the Asian crisis

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International Accounting Practices An Investors
Nightmare?

• Alphatec, once Thailands preeminent high-tech
  firm, came crashing down in 1997 because of
• ..the mingling of funds among listed and closely
  held companies run by the same family, the use of
  multiple sets of accounting books and misleading
  accounting methods, the highly paid, rubber stamp
  board,- these mirror the problems at other Thai
  companies that have brought this countrys
  economy to the brink of collapse
• Wall Street Journal, Sept 8, 1997

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International Accounting Practices An Investors
Nightmare?

• Because of the lack of disclosure laws and sound
  accounting standards, reported information can be
  misleading or just plain wrong
• Even in countries that have well developed
  accounting systems, they may favor the firm over
  the investor
• An example DaimlerChrysler

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International Accounting Practices An Investors
Nightmare?

• WSJ, Setember 10, 1998
• In Mexico, information is power.Just try to get
  your hands on any, from the mundane to the
  profound. Everything from the number of
  billboards in Mexico City to the details of the
  past presidential lives is closely guarded by
  government and business. What happened during the
  post 1994 bail out? Finance ministry officials
  say they are reluctant to give out sensitive
  information to Congress, citing the countrys
  bank secrecy laws, which, uniquely, protect not
  just data on deposits, but also on loans

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International Accounting Practices An Investors
Nightmare?

• Lawmakers suspect the Ministry is trying to
  protect hundreds of well-connect businessman
  whose bum debts end up being bought by Mexicos
  deposit insurance fund which will, in the end, be
  borne by taxpayers
• Another example When an event is not an event?

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International Accounting Practices An Investors
Nightmare?

• Overall, there are notable international
  differences in financial disclosure requirements
• This impacts the quality and quantity of
  information available for investors
• Can lead to front-running or inside dealing
  You may get ripped off
• Who gets hurt the most?

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Transactions Costs

• That is, How much does it cost to buy and sell
  securities. What do think are T.C.s components?
• Direct costs Commissions, Fees, Taxes etc.
• These get recorded in financial statements
• Indirect Market Impact
• These do not

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In the U.S., these are relatively low, what about
globally?

• Why is this important know?
• T.C. can wipe out trading profits, so ignoring
  them lead to incorrect asset allocation
  strategies.
• Price impact in emerging markets, a.k.a. hot
  money, can destabilize markets.
• Large costs in foreign markets can lead firms to
  list their stock in the U.S., further hindering
  domestic market development

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Until very recently, we didnt have any answers.

• This is because it has been almost impossible to
  gather data from around the world that is
  comparable in all the dimensions of T.C.
• Luckily, some famous finance professors recently
  quit the ivory tower and gave us some answers
• Domowitz, Glen, and Madhavan

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Liquidity, Volatility, and Equity Trading Costs
Across Countries and Across Time

• Data from Elkins/McSherry Co., a firm that
  conducts cost studies for institutional traders
  and serves as a consultant to stock exchanges
• Elkins/McSherry Co. receives trade data on all
  global trades by institutional traders and
  computes measures of trading costs.
• For example, in 1998, the institutional traders
  in the data represented 135 firms, of whom 105
  are pension funds, 27 are investment managers,
  and 4 are brokers.
• These institutions accounted for 28 billion
  shares in 632,547 trades, using 700 global
  managers and 1,000 brokers
• Data runs from 1996-1998
• Lets see what they find.

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Findings

• Enormous variation in one-way equity trading
  costs across countries, ranging from a high of
  198 bp in Korea to a low of 30 bp in France
• Total T.C. in Emerging Markets are 95 larger
  relative to developed markets, with much of this
  difference coming from implicit T.C.
• Considerable consistency in cost rankings from
  year to year
• There is variation in the composition of costs
  across countries, but both implicit and explicit
  costs are economically substantial in all cases

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Findings

• Very important to returns The equally-weighted
  portfolio of all countries has one-way trading
  costs of 71.3 bp.
• If this portfolio is turned over every six
  months, annual costs of 2X2X71.3285bp are
  incurred.
• By contrast, the average annual portfolio return
  (pre-cost) is 4X3071228.
• Trading costs constitute 23 percent of raw
  returns in this scenario.
• Important stuff

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Settlement

• After you place your order, when do you get the
  stock or get the
• Related How long does it take to collect your
  dividend
• Many markets (Malaysia, Venezuela) have highly
  inefficient settlement (sometime use paper to
  record transactions)
• When volume swells, it overloads the system

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GSCS Settlement Benchmarks

• Newsletter

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Corruption

• Illegitimate payments and favors outside the rule
  of law
• Corruption occurs to some extent in all
  countries, large differences across countries
  exist
• And states, remember Im from Louisiana

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Measuring Corruption

• "There is no end in sight to the misuse of power
  by those in public office - and corruption levels
  are perceived to be as high as ever in both the
  developed and developing worlds," said Peter
  Eigen, Chairman of Transparency International,
  speaking today on the launch of the Corruption
  Perceptions Index.
• Lets take a look at the latest index from
  Transparency International

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Lets look at the latest index
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Corruption in the Developed World

• "Corruption in the most prosperous countries in
  the world has many manifestations, and
  Transparency International is increasing its
  efforts to stimulate actions to secure greater
  transparency in politics, business and banking.
  We aim to publish a new Bribe Payers Index in
  early 2002 to shine the spotlight on the
  propensity of western firms to use bribes in
  emerging market economies."

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Transparency International Bribe Payers Index
2002 The Supply Side

• 835 business experts in 15 leading emerging
  market countries were asked In the business
  sectors with which you are most familiar, please
  indicate how likely companies from the following
  countries are to pay or offer bribes to win or
  retain business in this country?
• A perfect score, indicating zero perceived
  propensity to pay bribes, is 10.0, and thus the
  ranking below starts with companies from
  countries that are seen to have a low propensity
  for foreign bribe paying.

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Transparency International Bribe Payers Index
2002
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Transparency International Bribe Payers Index 2002

• "The BPI results signal the rejection by
  multinational firms of the spirit of
  international anti-bribery conventions, while
  their actions lead to a huge misallocation of
  very scarce resources in developing countries,"
  said TI Advisory Council Chairman Kamal Hossain
  at a press conference in Hong Kong.
• "The data also points to very heavy bribe-paying
  by domestic firms in developing countries.
  Today's BPI underscores the fact that we have a
  global problem of corporate bribe-paying that
  demands concerted global actions by official
  international organizations, civil society
  organizations and national governments," he said.

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Bribery in business sectors

• How likely is it that senior public officials in
  this country would demand or accept bribes, e.g.
  for public tenders, regulations, licensing in the
  following business sectors?
• The scores are mean averages from all the
  responses on a 0 to 10 basis where 0 represents
  very high perceived levels of corruption, and 10
  represents extremely low perceived levels of
  corruption.

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Bribery in business sectors
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Bribery in business sectors

• "The BPI shows that the most flagrant corruption
  is seen in the public works/construction and arms
  and defense sectors, which are plagued by endemic
  bribery by foreign firms. In a new study by the
  UK chapter of TI, it is estimated, for example,
  that foreign bribery is associated with tens of
  billions of dollars of defense deals," said Kamal
  Hossain.
• While even agriculture, the sector considered
  least likely to involve bribery by foreign
  companies, scored only 6.9 against a clean score
  of 10, public works/construction was deemed
  highly corrupt, with a score of 1.3, followed by
  arms and defense with 1.9, and the oil and gas
  sector with a score of 2.7.

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Transparency International Bribe Payers Index
2002, Review

• Russian, Chinese, Taiwanese and S. Korean
  companies widely seen using bribes in developing
  countries
• High propensity to bribe overseas also seen for
  companies from Italy, Hong Kong, Malaysia, United
  States, Japan, France and Spain
• Construction and arms industries top sectors of
  heaviest bribery

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Are these Costs Large? The Cost of doing
Business Under the Table

• World Bank Survey of over 3000 East European
  firms ten year after the collapse of communism
• Also surveyed entrepreneurs and businesspeople in
  20 countries to estimate the bribe tax in each
  country, payment directly to government officials

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The Cost of doing business Under the Table
Source Survey by the World Bank
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Findings

• Firms in Eastern Europe pay bribes that amount to
  as much as 8 of total revenues!
• This is in addition to the already high
  official tax
• The average bribe in the former Soviet Union is
  almost twice the size of firms in central and
  eastern Europe

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Findings

• Transition success countries like Poland and
  Hungary also bribe a lot!
• Small companies bribe more often than large
  companies
• Overall, bribes can hurt economic growth by
  misallocation of resources

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What about Capital Controls ?

• Various foreign exchange controls are often
  imposed, especially in EM.

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Ownership Restrictions Example China

• Chinas Qualified Foreign Institutional Investor
  (QFII) program allows selected global managers to
  invest in yuan-denominated securities, including
  Class A stocks
• First Investment July 2003, by UBS
• Total QFII Quota USD 4 billion, but just
  announced (7/2005) to expand to 10billion. (hot
  flows a good think for market given recent
  performance?)
• Number of applicants 26
• Largest Quota Holder UBS (800 Mill), Smallest
  Several with 50mil each
• China Stock Market Capitalization 450Billion at
  end of 2004

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Capital Controls cont.

• Different class of shares and their pricing
  shares for foreign investors may sell at a
  discount or premium to domestic shares. (E.G., A
  B shares in China, Alien board in Thailand)
• Other historical Examples FIIs in India,
  Industry restrictions (banking, defense),
  ownership restrictions in Korea, Brazil
• Repatriation restrictions (see CGSC China report)
• Differential Taxation Rates

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One Stock, Two Prices? Infosys Techhologies
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One Stock, Two Prices Infosys

• Infosys Technologies
• Is traded on both Nasdaq as well as Indian
  domestic stock (BSE) market, often much different
  prices
• What could explain this? Think about the law of
  one price
• What are the restrictions that could matter?

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Ownership Restrictions in India for Infosys

• Non-Indian investors can own DRs or the domestic
  shares, but government has restricted the of
  foreing ownership. These vary from industry to
  industry.
• For IT companies, since 2001 the limited was
  100, but no single foreign investor can hold
  more than 10. In July 2002, Infosys shareholders
  passed a resolution allowing 100 foreign
  ownership
• Infosys is a limited Depositary Receipt
  program Investors can convert existing shares
  into DR only if some DRs from the initial
  issuance have been converted back into domestic
  shares.
• Lets see how many are converted back

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First, a unrestricted two way DR program
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Infosys
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Infosys cont
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So, limits to arbitrage can allow a premium. But
WHY would investors pay a premium?

• Lower cost of capital for DR investors?
• Recall that foreign investors can purchase the
  domestic shares
• Taxes?
• If foreign (US) investors pay higher taxes on
  dividends and capital gains when buying domestic
  shares, then they may be willing to pay a premium
• US investors who trade in Indian domestic stocks
  do not pay taxes on dividends, but pay a 30
  short-term capital gains tax on stocks held less
  than one year, and a 10 long-term capital gains
  tax, that can be used as a foreign tax credit to
  offset US taxes.
• -therefore, taxes dont seem to be it

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So, limits to arbitrage can allow a premium. But
WHY would investors pay a premium?

• Lower transactions costs?
• Indian government requires that foreign
  institutional investors who want to invest in
  domestic shares register with the Securities and
  exchange Board of India (SEBI) and the Reserve
  Bank of India, as well as provide detail
  background information (and pay a 10,000 fee).
• What kind of investors do you think will be
  harmed?

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Average share ownership of DR holders and
Foreign Institutional Investors (FIIs) over time
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Downward sloping demand curves?

• Since the supply of DRs is limited, investors
  with the highest reservation price will set the
  price.
• Since riskless arbitrage is not possible, the
  domestic and DR price may be priced
  independently.
• Lets look some major corporate events and track
  the two prices

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Other evidence the prices are set differently

• The variation in the Infosys DR is better
  explained by variation in the NASDAQ composite
  index (R-sqared is 0.55) than by variation in the
  Indian stock market index (r-squared is 0.35)
• On the other hand, the variation in the infosys
  domestic returns is better explained by the
  variation in the Indian stock market (R-squared
  is 0.47) than the variation in the NASDAQ
  composite (R-squared is 0.37)

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Can firms benefit from the premium?
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Infosys is a cash rich firm
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So, what would you do?

• In a tender offer, Infosys invited domestic
  shareholders to tender their domestic shares for
  conversion to DRs. The allotment for conversion
  was done on a proportionate basis, so more shares
  were tendered by large shareholders.
• Not surprising, the first tender offer was
  oversubscribed.
• 10, 164 domestic sharholders tendered 14.86
  million shares for conversion into DRs. Infosys
  only accepted three million
• The founders, directors and executives of infosys
  accounted for over 30 of the shares, and
  shareholders with over 1 ownership accounted for
  over 60

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One Stock, Two Prices
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Political Risk

• Violent political conflict (i.e., civil war,
  terrorism, racial and ethnic discord, coup
  d'etat, and systemic collapse) can have profound
  negative effects on foreign direct and indirect
  investment.
• The business environment is also influenced by
  elections, government corruption, labor disputes,
  institutional reform, and shifts in public
  policy.

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This is the last bond issued by the Russian
Czarist Government in 1917 before the Soviet
Revolution
How about a safe international Government Bond?
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Measuring Political Risk

• Political risk measurements can be used in
  project financing. (discount rates)
• Measuring political risks is still an art rather
  than a science.

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Political Risk Measures

• Institutional Investors Country Credit Ratings
• Institutional Investor survey of Bankers
• Published semiannually since 1979
• Survey of 75-100 bankers on country risk
• Since survey based, can be forward looking
• Lets take a look at a sample

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Political Risk Measures
Institutional Investors Country Credit Ratings
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Other Political Risk Measures

• Other Country Credit Risk Measures
• Political Risk Services International Country
  Risk Guide
• Explore risk surrogates
• Political Risk,
• Economic Risk,
• Financial Risk and
• Country Credit Ratings

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Political Risk Measures
Political risk. International Country Risk Guide
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Political Risk Measures
Financial risk. International Country Risk Guide
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Political Risk Measures
Economic risk. International Country Risk Guide
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Political Risk Measures
International Country Risk Guide Risk Categories
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Political Risk Measures
Country Risk Ratings are correlated with
Sovereign bond ratings
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Political Risk Measures
Country Risk Ratings are correlated with
Sovereign bond ratings
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Political Risk Measures
Country Risk Ratings are correlated with
Sovereign bond ratings
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4. Country Risk Rating Model
Time-series of ratings
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So, barriers to capital flows exist

• High Transactions Costs
• Lengthy Settlement (or complete lack of)
• Lack of transparency and information disclosure
• Corruption
• Capital Controls
• Ownership Restrictions
• Cultural differences
• Political Risk

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What can we do?

• Invest in securities that overcome many of these
  barriers
• ADRs, Country Funds, WEBs,
• More on these soon
• Mitigate the remaining risks
• Buy insurance
• Structure deals accordingly

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Strategies for managing country risk

• Negotiate the investment environment with the
  host country prior to investment
• The investment environment
• The financial environment
• Structure foreign operations to minimize country
  risk while maximizing expected return
• Obtain political risk insurance

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Political risk insurance

• You trust your foreign customer. Do you trust
  your foreign customers Government?
• Countries dont go bankrupt, do they?

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Political risk insurance

• Insurable political risks include
• ConfiscationPolitical ViolenceWarAbrogationCha
  nge of LawDeprivationEmbargo Currency
  InconvertibilityForced AbandonmentForced
  DivestitureFailure to RepossessArbitration
  Award DefaultLicense CancellationSelective
  Discrimination

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Political risk insurance

• Political risk insurers
• International
• World Banks Multilateral Investment Guarantee
  Agency
• Government export credit agencies
• United States - Overseas Private Investment
  Corporation
• United Kingdom - Export Credits Guarantee
  Department
• Private
• American International Group
• Lloyds of London

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Political risk and thestructure of foreign
operations

• Structure foreign operations to minimize country
  risk while maximizing expected return
• Limit the scope of technology transfer to foreign
  affiliates to include only non-essential parts of
  the production process
• Limit dependence on any single partner
• Enlist local partners
• Use more stringent investment criteria
• Plan for disaster recovery

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What does finance theory tell us about Country
Risk? Country risks and the MNCs cost of capital

• From shareholders perspective, only
  nondiversifiable country risks should affect the
  cost of capital
• Whether a particular country risk is
  diversifiable depends on whether investors are
  locally or globally diversified
• From managers perspective, country risks are
  often not diversifiable
• This creates an agency conflict as managers
  represent shareholders

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The evidence onCountry risks and required returns

• Erb, Harvey, and Viskanta found that country risk
  measures - particularly financial risk measures -
  are correlated with future equity returns and
  risks
• A decrease (increase) in country risk tends to be
  followed by a rise (fall) in equity returns in
  that country.
• Countries with high country risk tend to have
  more volatile returns than countries with low
  country risk.
• Countries with high country risk tend to have
  lower betas (systematic risks) than countries
  with low country risk.

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Where are we now?

• We have seen the benefits to international
  investing in terms of mean-variance analysis
• We have investigated the various risks in
  international capital markets
• Now, we try to integrate these ideas into a
  framework to understand how they affect
  investors, security prices, and capital market
  development
• Law and Finance
• But lets do a case first to illustrate the issues