Introduction
We begin this chapter by looking at the benefits associated with the globalization of capital markets. This is followed by a more detailed look at the growth of the international capital market and the risks associated with such growth. Next, there is a detailed review of three important segments of the global capital market: the Eurocurrency market, the international bond market, and the international equity market. As usual, we close the chapter by pointing out some of the implications for the practice of international business.
The Functions of a Generic Capital Market
Commercial banks perform an indirect connection function. They take cash deposits from corporations and individuals and pay them a rate of interest in return. They then lend that money to borrowers at a higher rate of interest, making a profit from the difference in interest rates .Investment banks perform a direct connection function. They bring investors and borrowers together and charge commissions for doing so.
Capital market loans to corporations are either equity loans or debt loans. An equity loan is made when a corporation sells stock to investors. The money the corporation receives in return for its stock can be used to purchase plants and equipment, fund R&D projects, pay wages, and so on. A share of stock gives its holder a claim to a firm's profit stream. The corporation honors this claim by paying dividends to the stockholders. The amount of the dividends is not fixed in advance. Rather, it is determined by management based on how much profit the corporation is making. Investors purchase stock both for their dividend yield and in anticipation of gains in the price of the stock. Stock prices increase when a corporation is projected to have greater earnings in the future, which increases the probability that it will raise future dividend payments.
Attractions of the Global Capital Market
The Borrower's Perspective: A Lower Cost of Capital
In a purely domestic capital market, the pool of investors is limited to residents of the country. This places an upper limit on the supply of funds available to borrowers. In other words, the liquidity of the market is limited. A global capital market, with its much larger pool of investors, provides a larger supply of funds for borrowers to draw on.
Perhaps the most important drawback of the limited liquidity of a purely domestic capital market is that the cost of capital tends to be higher than it is in an international market. The cost of capital is the rate of return that borrowers must pay investors. This is the interest rate on debt loans and the dividend yield and expected capital gains on equity loans. In a purely domestic market, the limited pool of investors implies that borrowers must pay more to persuade investors to lend them their money. The larger pool of investors in an international market implies that borrowers will be able to pay less.
Problems of limited liquidity are not restricted to less developed nations, which naturally tend to have smaller domestic capital markets. As illustrated in the opening case and discussed in the introduction, in recent years even very large enterprises based in some of the world's most advanced industrialized nations have tapped the international capital markets in their search for greater liquidity and a lower cost of capital.
The Investor's Perspective: Portfolio Diversification
By using the global capital market, investors have a much wider range of investment opportunities than in a purely domestic capital market. The most significant consequence of this choice is that investors can diversify their portfolios internationally, thereby reducing their risk to below what could be achieved in a purely domestic capital market. We will consider how this works in the case of stock holdings, although the same argument could be made for bond holdings.
Consider an investor who buys stock in a biotech firm that has not yet produced a new product. Imagine the price of the stock is very volatile--investors are buying and selling the stock in large numbers in response to information about the firm's prospects. Such stocks are risky investments; investors may win big if the firm produces a marketable product, but investors may also lose all their money if the firm fails to come up with a product that sells. Investors can guard against the risk associated with holding this stock by buying other firms' stocks, particularly those weakly or negatively correlated with the biotech stock. By holding a variety of stocks in a diversified portfolio, the losses incurred when some stocks fail to live up to their promises are offset by the gains enjoyed when other stocks exceed their promise.
As an investor increases the number of stocks in her portfolio, the portfolio's risk declines. At first this decline is rapid. Soon, however, the rate of decline falls off and asymptotically approaches the systematic risk of the market. Systematic risk refers to movements in a stock portfolio's value that are attributable to macroeconomic forces affecting all firms in an economy, rather than factors specific to an individual firm. The systematic risk is the level of nondiversifiable risk in an economye.
Growth of the Global Capital Market
Information Technology
Financial services is an information-intensive industry. It draws on large volumes of information about markets, risks, exchange rates, interest rates, creditworthiness, and so on. It uses this information to make decisions about what to invest where, how much to charge borrowers, how much interest to pay to depositors, and the value and riskiness of a range of financial assets including corporate bonds, stocks, government securities, and currencies.
Such developments have facilitated the emergence of an integrated international capital market. It is now technologically possible for financial services companies to engage in 24-hour-a-day trading, whether it is in stocks, bonds, foreign exchange, or any other financial asset. Due to advances in communications and data processing technology, the international capital market never sleeps. The integration facilitated by technology has a dark side. "Shocks" that occur in one financial center now spread around the globe very quickly.
Deregulation
In country after country, financial services have been the most tightly regulated of all industries. Governments around the world have traditionally kept other countries' financial service firms from entering their capital markets. In some cases, they have also restricted the overseas expansion of their domestic financial services firms. In many countries, the law has also segmented the domestic financial services industry. It has also been a response to pressure from financial services companies, which have long wanted to operate in a less regulated environment. Increasing acceptance of the free market ideology associated with an individualistic political philosophy also has a lot to do with the global trend toward the deregulation of financial markets.
Global Capital Market Risks
Some analysts are concerned that due to deregulation and reduced controls on cross-border capital flows, individual nations are becoming more vulnerable to speculative capital flows. They see this as having a destabilizing effect on national economies.14 Harvard economist Martin Feldstein, for example, has argued that most of the capital that moves internationally is pursuing temporary gains, and it shifts in and out of countries as quickly as conditions change. He distinguishes between this short-term capital, or "hot money," and "patient money" that would support long-term cross-border capital flows. To Feldstein, patient money is still relatively rare, primarily because although capital is free to move internationally, its owners and managers still prefer to keep most of it at home.
A lack of information about the fundamental quality of foreign investments may encourage speculative flows in the global capital market. Faced with a lack of quality information, investors may react to dramatic news events in foreign nations and pull their money out too quickly. Despite advances in information technology, it is still difficult for an investor to get access to the same quantity and quality of information about foreign investment opportunities that he can get about domestic investment opportunities. This information gap is exacerbated by different accounting conventions in different countries, which makes the direct comparison of cross-border investment opportunities difficult for all but the most sophisticated investor.
The Eurocurrency Market
Genesis and Growth of the Market
The eurocurrency market was born in the mid-1950s when Eastern European holders of dollars, including the former Soviet Union, were afraid to deposit their holdings of dollars in the United States lest they be seized by the US government to settle US residents' claims against business losses resulting from the Communist takeover of Eastern Europe. These countries deposited many of their dollar holdings in Europe, particularly in London. The eurocurrency market received a major push in 1957 when the British government prohibited British banks from lending British pounds to finance non-British trade, a business that had been very profitable for British banks. British banks began financing the same trade by attracting dollar deposits and lending dollars to companies engaged in international trade and investment. Because of this historical event, London became, and has remained, the leading center of euro currency trading.
The euro currency market received another push in the 1960s when the US government enacted regulations that discouraged US banks from lending to non-US residents. Would-be dollar borrowers outside the United States found it increasingly difficult to borrow dollars in the United States to finance international trade, so they turned to the eurodollar market to obtain the necessary dollar funds.
Although these various political events contributed to the growth of the eurocurrency market, they alone were not responsible for it. The market grew because it offered real financial advantages--initially to those who wanted to deposit dollars or borrow dollars and later to those who wanted to deposit and borrow other currencies. We now look at the source of these financial advantages.
Attractions of the Eurocurrency Market
The main factor that makes the eurocurrency market so attractive to both depositors and borrowers is its lack of government regulation. This allows banks to offer higher interest rates on eurocurrency deposits than on deposits made in the home currency, making eurocurrency deposits attractive to those who have cash to deposit. The lack of regulation also allows banks to charge borrowers a lower interest rate for eurocurrency borrowings than for borrowings in the home currency, making eurocurrency loans attractive for those who want to borrow money. In other words, the spread between the eurocurrency deposit rate and the eurocurrency lending rate is less than the spread between the domestic deposit and lending rates
Domestic currency deposits are regulated in all industrialized countries. Such regulations ensure that banks have enough liquid funds to satisfy demand if large numbers of domestic depositors should suddenly decide to withdraw their money. All countries operate with certain reserve requirements.
In contrast, a eurobank can offer a higher interest rate on dollar deposits and still cover its costs. The eurobank, with no reserve requirements regarding dollar deposits, can lend out all of a $100 deposit. Clearly, there are very strong financial motivations for companies to use the eurocurrency market. By doing so, they receive a higher interest rate on deposits and pay less for loans. Given this, the surprising thing is not that the euromarket has grown rapidly but that it hasn't grown even faster.
Drawbacks of the Eurocurrency Market
The eurocurrency market has two drawbacks. First, when depositors use a regulated banking system, they know that the probability of a bank failure that would cause them to lose their deposits is very low. Regulation maintains the liquidity of the banking system. In an unregulated system such as the eurocurrency market, the probability of a bank failure that would cause depositors to lose their money is greater. Thus, the lower interest rate received on home-country deposits reflects the costs of insuring against bank failure. Some depositors are more comfortable with the security of such a system and are willing to pay the price.
Second, borrowing funds internationally can expose a company to foreign exchange risk.
The Global Bond Market
Attractions of the Eurobond Market
Regulatory Interference
National governments often impose tight controls on domestic and foreign issuers of bonds denominated in the local currency and sold within their national boundaries. These controls tend to raise the cost of issuing bonds. However, government limitations are generally less stringent for securities denominated in foreign currencies and sold to holders of those foreign currencies. Eurobonds fall outside of the regulatory domain of any single nation. As such, they can often be issued at a lower cost to the issuer.
Disclosure Requirements
Eurobond market disclosure requirements tend to be less stringent than those of several national governments. For example, if a firm wishes to issue dollar-denominated bonds within the United States, it must first comply with SEC disclosure requirements. The firm must disclose detailed information about its activities, the salaries and other compensation of its senior executives, stock trades by its senior executives, and the like. In addition, the issuing firm must submit financial accounts that conform to US accounting standards.
Favorable Tax Status
This did not encourage foreigners to hold bonds issued by US corporations. Similar tax laws were operational in many countries at that time, and they limited market demand for Eurobonds. As a result, US corporations found it feasible for the first time to sell eurobonds directly to foreigners. Repeal of the US laws caused other governments--including those of France, Germany, and Japan--to liberalize their tax laws likewise to avoid outflows of capital from their markets. The consequence was an upsurge in demand for eurobonds from investors who wanted to take advantage of their tax benefits.
The Global Equity Market
Although we have talked about the growth of the global equity market, strictly speaking there is no international equity market in the sense that there are international currency and bond markets. Rather, many countries have their own domestic equity markets in which corporate stock is traded.
A second development internationalizing the world equity market is that companies with historic roots in one nation are broadening their stock ownership by listing their stock in the equity markets of other nations. The reasons are primarily financial. Listing stock on a foreign market is often a prelude to issuing stock in that market to raise capital.
Foreign Exchange Risk and the Cost of Capital
Consider a South Korean firm that wants to borrow 1 billion Korean won for one year to fund a capital investment project. The company can borrow this money from a Korean bank at an interest rate of 10 percent, and at the end of the year pay back the loan plus interest, for a total of W 1.10 billion. Or the firm could borrow dollars from an international bank at a 6 percent interest rate. Unpredictable movements in exchange rates can inject risk into foreign currency borrowing, making something that initially seems less expensive ultimately much more expensive. The borrower can hedge against such a possibility by entering into a forward contract to purchase the required amount of the currency being borrowed at a predetermined exchange rate when the loan comes due.
When a firm borrows funds from the global capital market, it must weigh the benefits of a lower interest rate against the risks of an increase in the real cost of capital due to adverse exchange rate movements. Although using forward exchange markets may lower foreign exchange risk with short-term borrowings, it cannot remove the risk. Most importantly, the forward exchange market does not provide adequate coverage for long-term borrowings.
Implications for Business
The implications of the material discussed in this chapter for international business are quite straightforward but no less important for being obvious. The growth of the global capital market has created opportunities for international businesses that wish to borrow and/or invest money. On the borrowing side, by using the global capital market, firms can often borrow funds at a lower cost than is possible in a purely domestic capital market. This conclusion holds no matter what form of borrowing a firm uses--equity, bonds, or cash loans. The lower cost of capital on the global market reflects their greater liquidity and the general absence of government regulation. Government regulation tends to raise the cost of capital in most domestic capital markets. The global market, being transnational, escapes regulation. Balanced against this, however, is the foreign exchange risk associated with borrowing in a foreign currency.
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