Financing International Trade
21st June 2018 | Dora Hancock
Sourcing finance, both long term and short term, is one important example of the ability to reduce costs through being a multinational rather than a domestic company.
Throughout this book we have suggested that multinational firms have advantages over purely domestic firms that make them more competitive despite the additional costs and risks they may have to bear.
Sourcing finance, both long term and short term, is one important example of this ability to reduce costs through being a multinational rather than a domestic company.
If costs of finance are lowered, companies are able to invest in projects which would otherwise be unprofitable. In addition, funds may be limited in a purely domestic market, whereas this is much less likely to be the case in the global financial market.
As the world has become more and more globalized and capital has been able to move freely between countries, it has become increasingly important for companies to seek the capital they need to operate and grow from sources all over the world in order to minimize costs and to take advantage of opportunities such as the hedging opportunities we discussed in Chapter 8.
We will start with an introduction to capital and capital markets. As before, if you have not studied corporate finance before, the following section will serve to prepare you for the main body of the material in this and the following chapters. If you have studied corporate finance before, you might find the following section a useful refresher or you may wish to skip over it.
Sources of funds
Few companies can thrive and grow without using external sources to fund their working capital or their investment in new assets and expansion into new markets. One of the reasons for the success of privatized businesses is that they are able to borrow money, whereas state-owned operations often have very limited capability to borrow money.
Most businesses are able to generate funds internally through their retained profits or retained earnings but this is not usually enough to fund all the future projects the company has decided to invest in.
External sources of funds are short-term external funds such as borrowing in the money markets, and longer-term external funds such as equities, corporate bonds and bank lending.
Short-term sources are often used to finance international trade, particularly to fund the delay in receiving payment from exports compared to domestic customers.
In this chapter we will focus on long-term sources of funds.
Fundamentally there are two kinds of long-term funding: debt and equity. In practice, there are hybrid instruments which include elements of each but mostly companies issue either debt or equity.
Equity funding or shares
When a company issues shares in exchange for cash they are inviting people – the public or large institutions mostly – to invest in the company. In exchange for buying shares in the company the investor, now a shareholder, gains:
- The right to receive their share of any dividends paid by the company.
- The right to vote at the company’s AGM and at other times. Votes will include the appointment of directors and auditors as well as other matters put to them.
- The right to a share of the assets if the company is wound up, ie ceases to trade and is shut down.
A shareholder would hope to receive capital growth, that is that the share value goes up as well as dividends during the period in which the shares are owned or held. The shares are not usually redeemed – bought back by the company – but shareholders are free to sell their shares at any time.
The cost of equity
Because shareholders are uncertain about the return they will receive, since dividends are discretionary and capital growth is uncertain (higher risk), they require a relatively high level of return to invest in a company. If you are not sure about this, go back and read the section on risk and return in Chapter 1.
In addition, there is generally no tax relief on dividends. These two together make equity expensive for a company; they are expected to pay high levels of dividends and don’t get tax relief on the payments.
People who buy corporate bonds in a company are effectively lending money to the company and so are talked about as being debtholders. Debt can be corporate bonds but might also be a bank loan or a debenture. We can consider all of these as long-term debt.
The definition of long-term debt varies. We can take it as being any debt that doesn’t mature – become due for repayment – in the next 12 months.
Debt holders are entitled to pre-arranged interest payments, that is a fixed amount on fixed dates in the future. They have certainty. Some debt carries variable rates of interest but the payments are largely certain. They are also generally entitled to receive their capital back again at some predetermined date in the future. Again, some debt has a variable redemption date but there is considerable certainty about the capital repayment.
Bonds held to the redemption date do not offer capital growth, although bonds redeemed early will be sold for a different amount to the sum paid for them, so may have some capital growth.
Because there is tax relief on interest payments and the payments to bond holders are lower, debt is cheaper than equity.
While banks do still provide an important source of borrowing, in some countries there has been a significant shift away from banks and towards issuing bonds, an example of a financial instrument in many developed countries, especially the United States and the UK.
Very large loans are often made by a syndicate of banks, with one bank taking on the role of lead bank, because the banks wish to spread the risk. This enables companies to borrow amounts that exceed the maximum amount that any one bank is willing, or able, to lend to one business.
Domestic financial markets
Financial markets, or capital markets, are the place, not necessarily a physical location, where savers or investors can find satisfactory ways of depositing or lending their savings with borrowers who have suitable risk and return profiles. Equally, a capital market is a place where a borrower can go to obtain the funds they need to invest in their business. The banks and other financial services organizations such as pension funds facilitate the transfer of funds from savers to borrowers and are termed financial intermediaries.
So there is a real mismatch between what savers want from a building society – to make small deposits without risk and to be able to get the money back fairly quickly – and what lenders want – to borrow large amounts of money over long periods of time.
Building societies and other financial intermediaries meet the needs of their savers and borrowers, undertaking what is called transformation. They transform savers’ deposits into borrowers’ loans.
The transformations needed are:
- Maturity transformation. To take short-term deposits and turn them into long-term loans. This is done by taking in deposits for many savers, retaining some of those deposits to return to savers who want their money back, and lending the rest. Providing there isn’t a ‘run on the bank’, when a loss of confidence in the bank leads to many savers wanting their money back at the same time, savers should always be able to withdraw their deposits when they want to.
- Size transformation. To take small deposits from savers and turn them into large loans. This is done by aggregating the deposits of many savers to provide the large sums that homebuyers require.
- Risk transformation. Individuals borrowing money to buy their house have some risk of default. Perhaps the loss of a job, illness or a relationship breakdown can mean that a homebuyer can no longer meet their mortgage payments. Building societies take steps to minimize the risk of this happening by checking the creditworthiness of borrowers and trying to ensure that the debt is affordable. They also keep the deeds of the house so that if the borrower cannot repay their mortgage the property can be repossessed and sold to repay the debt if necessary. But they also ‘spread the risk’ by taking the deposits from many savers and transforming them to create loans to many borrowers. Building societies and other financial intermediaries have statistical software which enables them to predict what proportion of their borrowers are likely to run into financial difficulties in any given period of time. They then provide for those losses when calculating how much interest to charge borrowers and how much interest they are able to pay to depositors.
Financial markets do more than provide opportunities for borrowers to raise finance and savers to invest; they also provide a place where savers can withdraw their savings by selling their shares. This is called a secondary market. The primary capital market is the place where securities are bought for the first time from the company or its agents.
Financial markets also need to have a sound legal system that enables rights, particularly property rights, to be enforced.
A well-functioning capital market will be allocatively efficient, that is the funds available will be allocated to the organization that can make the best possible use of those funds.
One of the most interesting aspects of finance is that it is a service industry and survives and thrives when it meets the needs of its customers. Financial instruments and ways of working are designed to meet a perceived need. If the need turns out to be real, then the financial instrument is retained, otherwise it is withdrawn. Capital markets and banks are in a constant state of evolution and must react and innovate to survive in the rapidly changing world in which we find ourselves.
In the 1980s, the financial markets in the United States and the UK were deregulated along with the markets in many other developed countries including Japan.
One of the outcomes of this was a significant decline in bank lending and a shift in all developed countries towards companies issuing corporate bonds, commercial paper and other financial instruments via capital markets because of the lower costs.
Institutional investors in particular were enthusiastic because they prefer the certainty of the cash flows from bonds to the uncertainty of equities. Issuing securities via capital markets is termed securitization. Borrowing from a bank is called using financial intermediation and the bank is termed the financial intermediary.
Securitization became popular because deregulation reduced the costs of using financial markets and enabled companies to reduce costs by avoiding the use of a bank whose costs were going up as a result of increasing global demands for banks to have a stronger capital base. This shift towards securitization was more pronounced in some countries than others. Countries like Germany, where companies retain their very strong relationship with the banks, still use banks for long-term finance. However, the continued use of bank finance, because the financial markets are not providing access to the cheap debt, is widely thought to contribute to the lack of success of companies relative to those in countries that do have such financial markets and thus greater access to the capital they need to grow.
In addition to deregulation, national financial markets have become increasingly integrated. Financial centres are in competition with each other and we see stock exchanges around the world in merger talks with each other to further reduce costs, though few have actually gone through. At the time of writing, the German Börse in Frankfurt has agreed to take over the London Stock Exchange, despite the Brexit vote.
At the same time, companies are increasingly seeking arbitrage opportunities to reduce costs by exploiting regulatory differences between markets, forcing further deregulation and cost cutting on the markets themselves and their regulators.
At the start of this section we talked about innovation in financial markets in the sense of creating new financial instruments that individuals and businesses wanted to hold. That innovation might be the creation of tax-efficient financial instruments to exploit opportunities in the tax system, but as often as not it is about modifying the risk of financial instruments. If a company can issue a financial instrument that meets the needs of a niche market it can lower the required return on the instrument and thus reduce the costs to the company. This competitive edge is unlikely to provide a long-term advantage as competitors quickly enter the market with similar products and the demands of the niche market are soon satiated.
These same processes are at work internationally to provide businesses with the low-cost securities that meet their needs, wherever they are in the world.
When a bank lends money to a company it incurs costs in deciding if the company is going to be able to repay the interest and capital as they fall due. Similarly, when a company issues securities into the market, each putative investor will need to decide if the company is a good investment. This can only be done if sufficient reliable information is available. As the global market becomes more integrated, for example companies’ annual reports become increasingly comparable, the costs of obtaining that information continue to fall, even for foreign firms, and securitization becomes even more attractive.