international banking international capital flows session 10 --hilla shahpur maneckji

International Banking


International Capital FlowsSession 10

--Hilla Shahpur Maneckji


Introduction (1)

The integration of the financial markets across the globe and the increase in the quantum of international trade had caused the capital to flow from one part of the globe to the other.

In a world, characterized by liberalization and globalization, firms are looking for places to invest that offer specific advantages.

Till recently, the global capital flows were determined by factors like favorable investment climate, market growth prospects, natural resources, labor markets, etc.,


Introduction (2)

But now, the macroeconomic factors like good monetary policies, tax policies, exchange rate policies, etc., have taken precedence over the factors stated above.


CAPITAL FLOWS


Capital Flows (1)

As many countries are moving towards globalization and liberalization, many global firms are showing great interest in investment in communications, services, marketing networks, infrastructure, etc.

The flows of capital-debt, portfolio equity, and direct and real estate investment between one country and others are recorded in the capital account of its Balance of Payments.

Outflows include residents purchases of foreign assets and repayment of foreign loans; inflows include foreigners investments in home country financial markets and property and loans to home country residents.


Capital Flows (2)

Freeing transactions like these from restrictions, that is, allowing capital to flow freely in or out of a country without controls or restrictions is known as Capital Account Liberalization.

Classic economic theory argues that international capital mobility, allows countries with limited savings to attract financing for productive domestic investment projects, enables investors to diversify their portfolios that spreads investment risk more broadly, and promotes inter-temporal trade—the trading of goods today for goods in the future.


Capital Flows (3)

More specifically: 1. Capital mobility means that households, firms

or even countries can smoothen consumption by borrowing money from abroad when incomes are low in the home country and repaying when incomes are high. The ability to borrow abroad can thus dampen business cycles by allowing households and firms to continue buying and investing when domestic production and incomes have fallen.


Capital Flows (4)

2. By lending money abroad, households and firms can reduce their vulnerability to domestic economic disturbances. Companies can protect themselves against sudden cost increases in the home country, for example, by investing in branch plants in several countries. Capital mobility thus enables investors to achieve higher risk-adjusted rates of return. In turn, higher rates of return can encourage saving and investment that deliver faster economic growth.

Thus capital flows result in a free flow of capital throughout the globe from one sector to another.


Capital Flows (5)

Free flow of capital is necessary for the welfare of the society.

The international flows of capital have become everyday fact of life in the international economy, and because of their enormous size, are important.

Capital flows can affect lot of factors like exchange rates, forex rates, interest rates and monetary policy.

Various factors such as the level of human capital, political stability, and the depth of domestic financial markets, define a country’s ability to attract foreign capital.

Most of the capital flows are in the form of Foreign Direct Investments (FDIs) in different countries.


Capital Flows (6)

This happens when a domestic firm acquires ownership or control over the operations of a foreign subsidiary firm.

A firm is said to directly invest abroad if it has a direct or indirect ownership interest of 10% or more in a foreign business enterprise.

Today, FDI has become the single most important source of private development financing for the developing countries and plays an important role in the economic growth and development of the developing countries.


FOREIGN DIRECT

INVESTMENTS (FDIS)


Reasons for FDIs


Reasons (1)

Individual firms may not maximize profits, keeping in view the interest of the stockholders, but, instead, they maximize growth in terms of firms size.

In such cases, FDI is preferred because firms cannot depend on foreign managed firms to operate in their best interests.

Other reasons are based on the superior skills, knowledge, or information of the domestic firms as compared to the foreign firms.

Such advantages would allow the foreign subsidiary of the domestic firm to earn a higher return than is possible by a foreign-managed firm.


Reasons (2)

FDI may involve new technologies and expertise not available in the domestic economy.


FDIs In Pakistan


FDIs In Pakistan (1)

The fact that FDI helps accelerate the process of economic development in host countries made Pakistan realize the importance of new technologies for economic growth.

Of late the Government of Pakistan is also recognizing the fact that it has to overcome some past practices and adopt the emerging ones in order to make Pakistan compete globally.

In the process, it has brought about major changes in its national policies on FDI.

In the recent past, it has dramatically reduced barriers to FDI, and is wooing multinational firms.


FDIs In Pakistan (2)

The Government of Pakistan started promoting FDI through various means such as direct subsidies, extension of tax holidays, and exemptions from import duties.


Determinants of FDIs In Pakistan


Determinants of FDI (1)

In a developing country like Pakistan, certain factors like regulations and effective administration, infrastructure, labor costs and taxes playa vital role in determining the quality and quantity of FDI.

1. For promoting FDI in a country, the investment community always calls for a transparent system and efficient practices in business, administration, and prospects for profits in the country. Therefore the Government of Pakistan is taking relevant steps to create a favorable climate for FDI in the country.



2. Another area of strategic significance is the infrastructure. It is well known that infrastructure is crucial for aiding growth and in turn development of economy. Reliability on power, transport, and communication is vital as they are the engines of economic growth. Many nations give due importance to FDI involvement in the infrastructure owing to its role in the economy. In the absence of FDI in infrastructural development, it is very difficult for a large developing country like Pakistan to finance solely. Apart from the above social sector, investment in education and wealth will take an active role in increasing the per capita and quality of life, which the government has to finance on its own.



3. Location is strategic not only for attaining profits, and lower costs but can also make sense in exporting those goods back to investing nation. Reducing tariffs and barriers are often done to boost trade. Export Processing Zones (EPZs) are created by the Government of Pakistan to promote exports and facilitate the exporters to become globally competitive.

4. Labor costs, and tax rates also influence FDI investment. Per unit labor cost of the final output is vital in a developing country like Pakistan. The labor laws in Pakistan are being made flexible and are tuned in accordance with the developed economies.


Issues Relating to FDIs In Pakistan


Issues Relating to FDIs (1)

Some of major issues, which make Pakistan less attractive for FDI compared to other countries, are its poor infrastructure, and productivity of labor.

Apart from the above two issues, some of the major obstacles are:

1. Lack of Transparency in FDI Policy:This is evident from actual investment being made into sectors compared to committed FDI. Red-tapism has often curtailed the interest of some of the companies and they have eventually cancelled or dropped out of the projects due to delays caused in approvals.



2. FDI Regime: No doubt, there has been an improvement regarding policies, clearances but still there are restrictions on foreign ownership in certain sectors like defense and railways. It also takes a lot of time for government approval. Deregulation in infrastructure sector would be welcome sign.

3. High Tariff Rates: Despite reduction of the tariffs, they are still high compared to global economy standards. Though the post-WTO regime is still on its course, the high tariff rates is one of deterrents for major MNCs to invest in Pakistan.



4. Financial Sector:In spite of an improvement in terms of opening insurance sector, and banking sector, the ownership issue still needs clarification in terms of 100% FDI into these sectors. The Pakistani financial sector had its own share of debacles in terms of crisis and scams from 1991. Accordingly, transparency has become a crucial issue now.

5. Labor Laws: The labor laws in Pakistan give companies reasonable hedge in terms of hiring and firing employees without seeking the permission of the state government, unlike in India.



6. Decisions from the State Government: The state governments were passive to the reform process as most of reform process was concentrated in substantial initiative in attracting FDI, and they still have to depend on central government in terms of freedom, with respect to certain infrastructure areas.

7. Export Processing Zones (EPZs): We need more EPZs in terms of scale, government initiative in terms of incentives, labor reforms, regulations so as become real export houses for the nation.



So considering all these issues, the major areas that require improvement are:

1. Bureaucracy: Bureaucracy has been a bugbear for the clearance of FDI. The delays due to multiple agencies at both center and state governments hinder processes. This is where Pakistan lags behind China despite being a democratic country where decisions are expected to be taken on time. Systems have to be fine tuned so as minimize delays in getting necessary clearances. A lot of improvement needs to be done with respect to consolidation of various regulatory agencies, and single window clearances procedures.



2. Tax and Tariffs: The complex tax & tariff structure has been a major issue not only for the foreign businessmen but also domestic businessman. Though central taxes are in right direction, other areas call for a major overhaul. Tax & tariff structure is very perplexing, and the amount of time taken to clear issues is enormous.



3. Leveraging the Labor Force: Though there is no dearth for skilled labor in Pakistan, educated and English speaking sections forms a small part of economy. Owing to this factor, we have seen the reasonable growth in the IT and Pharmaceutical sectors. The thrust on export based and knowledge intensive products along with traditional products can provide the extra growth. Recently automobile industry is one of the sectors reaching global standards. The thrust on domestic market and also reliance of the MNCs on Pakistan as an export base is enabling us to place ourselves on the global map, as well as provide jobs and investments needed for development of ancillary industries.



On the flipside, FDIs also do not come free of cost.

They are definitely required but excessive use may lead to turmoil as happened in East-Asia, Mexico and Chile.


Costs Associated With FDIs


Costs Associated With FDIs (1)

Foreign capital inflows can work both ways for a country.

We have seen that from many economies like Mexico, South-East Asian countries which had economic crisis.

Thus certain economies are small and have structural deficiencies, which are not conducive for FDI.

Entry of MNCs in capital-intensive sector would reduce the demand for labor, thereby intensifying the unemployment.

In other case, reduction in tariffs can reduce the revenue for the government.



Without proper competition policy, MNCs over time can reduce competitors through their power, which can affect domestic economy in terms of job losses, reduction in consumer welfare society at large.

The domination of MNCs in global market is a huge concern for the developing countries which have sizable population.

These countries have own reasons to develop economy due to huge population, backwardness, for want of capital and technology.

The MNC can drive out domestic players once they get a foothold in a market, monopolizing the market in future.



FDI affects the domestic entrepreneurship adversely as competition and cost structure can become huge barriers for the infant industries.

The larger social issues pertaining to culture and values are taken care of.

So, given the distractions in most of the developing countries in terms of economic, infrastructure, and government policies, attracting FDI can worsen the overall development due to further disparity between rich and poor in the society.


THE EAST-ASIAN CRISIS


The East-Asian Crisis (1)

The East-Asian miracle economies became a major attraction for foreign investors during the 1990s.

These economies were well managed, had been growing rapidly, their exports were internationally competitive, governments were well disposed to foreign investment, and labor was hardworking, well-trained, and motivated.

With stock markets expanding, and privatization of several public enterprises underway, these were ideal emerging markets, promising high returns with relatively low perceived risk.

The East-Asia region as a whole received almost US$ 500 billion (or a little under 40% of the world total) in net capital inflows during the five-year period 1993-97.



About 60% of the inflows consisted of FDI and portfolio investment.

The macroeconomic fundamentals of the East-Asian economies remained strong on the whole right up to the outbreak of the crisis with the devaluation of the Thai baht.

For instance, Indonesia, Korea, Malaysia and Thailand had all enjoyed strong economic growth for many years and their inflation rates were in single figures.

Their domestic savings rates were among the highest in the world and their levels of investment were very high.

Government fiscal balances were either in surplus or showed only small sustainable deficits.



All had the ability to service their debts in the long-term. GDP growth for Indonesia, Malaysia and Thailand during

the 1990s averaged at rates higher than those prevailing in the previous two decades, though in Korea’s case it was a little lower, but still an impressive 7.5% a year.

But the other side of the coin was that each of these countries started to run high current account deficits, though at least in the case of Korea and Indonesia not quite as large as those witnessed in the earlier Latin American crises.

With government accounts more or less in balance, it was the private sector in each of these countries that was rapidly accumulating foreign liabilities.



A number of observers have explained the East-Asian crisis in terms of misguided investments in real estate, “crony capitalism” in which governments and private enterprise engage in reciprocal favors, lack of prudential regulation of domestic financial institutions, and various other failures.

While each of these explanations had some factual basis, and cannot be dismissed offhand, they give rise to awkward questions.

Why were these weaknesses not evident to foreign investors before it was too late?

Or, if they were evident, why were they not taken into account in their investment decisions?



The close government/business relationship in East-Asia, though widely denoted in the press as corruption, had been applauded as an example of successful partnership in economic management, which other countries needed to follow.

The soft prudential regulation and other weaknesses of the financial sector were also well known, and noted by the World Bank in its country reports.

But granting that these weaknesses already existed points only to one conclusion, that the opening up of the capital account and financial deregulation in the East-Asian economies was premature and should have been undertaken only after the correction of the weaknesses that are now held to explain the crisis.



It was the rapid opening up of the capital accounts and deregulation of the financial sectors that attracted the massive capital inflow (especially short-term loans) into the region’s economies, and should be considered as the major cause of the crisis.

In any case, the purveyors of foreign capital once again demonstrated their inability, or unwillingness, to see the financial strains and avoid another financial collapse.

Perhaps the problem of “moral hazard”, which had been noted in the context of the Mexico crisis, is real: private lenders from the north shared the expectation born out of past experience that they would be bailed out by governments or international public agencies in time of trouble.



The IMF responded with policy prescriptions that it had applied in other countries with altogether different conditions and circumstances.

It also insisted on a broad range of socio-political institutional measures, to deal with labor market reforms, corporate governance, government/business relations and corruption, among other things, and to further open up to foreign investors.

In prescribing a regime of sharp demand compression, accompanied by steep increases in interest rates, the IMF may have deepened instead of alleviating the East-Asian crisis.



In the event, the steep rise in interest rates failed to prevent the currency collapse, but the two together raised the burden of external and internal debt to unsustainable levels, resulting in the technical bankruptcy of major segments of the domestic private sector.

Industrial disruption has been widespread, with declining domestic output and sharply rising unemployment.

The resolution of a serious financial crisis is bound to inflict the pain of adjustment; on an economy.

But a situation where adjustment reduces, rather than enhances, the economy’s ability to cope with the crisis can hardly be regarded as a remedy.



The IMF has therefore come under considerable criticism, and not only from the quarters generally hostile to the institution.

Recently, certain well-known mainstream economists, including some in the World Bank, have questioned the soundness of the IMF’s diagnosis and the standard remedies prescribed for the countries in deep trouble.

These comments are a welcome addition to the more long-standing critiques of the Washington consensus, which so far has been unshakable.


CHILE & MEXICAN CRISIS


Chile’s Experience in Regulating Capital Flows (1) Chile should be studied for lessons in tackling Asia’s

present problems. Unlike other Latin American countries in the 1980s,

its crisis was created in the private sector, and it took action to stem short-term capital inflows.

The fixed exchange rate had encouraged heavy borrowing in US$.

With peso devaluation, debt repayments faltered and the government bailed out the banks by taking over loans to foreign creditors.

Assistance totaled about 20% of GDP, setting off a major recession.


Chile’s Experience in Regulating Capital Flows (2)

Several steps were taken by Chile. A 1986 banking law, set strict operational guidelines,

applied by an independent supervisor, that prohibit banks from holding shares in companies or other banks, prevent build-up of currency mismatches in borrowing and lending, and establish firm provisioning requirements for loans.

In addition, since 1991 foreign lenders must deposit 30% of the loan amount with the Central Bank, which holds it for one year without interest.

To reduce volatility this measure was extended to stock-market inflows; under another regulation, FDI requires Central Bank approval.



Chile also adopted a strong macroeconomic framework that led to surpluses of 1% - 3% of GDP.

Monetary policy, under an independent Central Bank, responded quickly to signs of overheating.

A flexible exchange rate policy has kept the current account deficit in check.

The system may have flaws and be hard to replicate elsewhere, but one exportable lesson is that well-regulated banks are absolutely essential for financial stability.

The regulations also encourage long-term rather than short-term capital.



Statistics of outflows (not controlled) indicate that speculative inflows could still occur: high interest rates make loopholes profitable, and export advances or FDI can be used for short-term inflows.

In addition, large companies with access to foreign capital have issued new shares or borrowed abroad.

Policymakers do not appear to be concerned about this because the banking system is not exposed, depositors funds are safe, and the broad objective of dampening the volatility of short-term flows has been achieved.


Mexican Crisis & Comparison With Thailand (1)

Private capital inflows financed a boom in private consumption in Mexico, but private investment in Thailand.

Both countries experienced a pre-crisis surge in private capital flows, a sharp increase in credit to the private sector, and concerns about sustainability of rising current account deficits and loss of competitiveness (exchange rates and inflation).

The banking systems were weak, especially in Thailand (higher private sector external debt).

Thailand’s investment rate rose steadily after 1983 (28% of GDP 1983-89, 40% in 1990 and onward).



Domestic savings increased (32%-36% in the 90s) but the shortfall was financed by foreign capital, generating current account deficits of 5%-9%.

Investment was both public (infrastructure) and private (industrial and real estate).

In Mexico, stabilization programs of 1987 were aimed at reducing inflation (then 160%).

By 1993, it fell to a single digit (first time in two decades).

Real interest rates turned positive, and access to credit increased, unleashing private consumption while private saving fell from about 20% in 1988 to 13% in 1990 and 11% in 1994.



Pre-crisis investment was only about 21% of GDP (half Thailand’s rate).

Private sector spending widened the current account deficit from around 2.5% of GDP in 1988-89 to 7% in 1994, financed (as in Thailand) by private inflows.

Growth of export demand, needed to sustain Thailand’s increasing industrial capacity, faltered in 1996; a decline in inflated real estate (collateral for loans), along with sharp currency devaluation, hit commercial banks balance sheets and their ability to repay foreign borrowings (some of which was channeled into property).



Mexican crisis also affected its financial sector. Higher interest, devaluation, and economic slowdown

(reducing borrowers ability to repay loans) hurt banks balance sheets though asset values declined relatively little compared to Thailand, where the impact on the financial sector was more widespread and called for deeper restructuring.

The explosive growth of international financial transactions and capital flows is one of the most far-reaching economic developments of the late twentieth century.

Net private capital flows to developing countries tripled to more than $150 billion a year during 1995-97 from roughly $50 billion a year during 1987-89.



At the same time, the ratio of private capital flows to domestic investment in developing countries increased to 20% in 1996 from only 3% in 1990.

Powerful forces have driven the rapid growth of international capital flows, including the trend in both industrial and developing countries toward economic liberalization and the globalization of trade.

Revolutionary changes in information and communications technologies have transformed the financial services industry worldwide.



Computer links enable investors to access information on asset prices at minimal cost on a real-time basis, while increased computing power enables them to rapidly calculate correlations among asset prices and between asset prices and other variables.

At the same time, new technologies make it increasingly difficult for governments to control either inward or outward international capital flows when they wish to do so.

All this means that the liberalization of capital markets and, with it, the likely increases in the volume and the volatility of international capital flows is an ongoing and to some extent, irreversible process.



It has contributed to higher investment, faster growth, and rising living standards in many countries.

But financial liberalization—both domestic and international has also been associated with costly financial crises in several cases.

This underscores that liberalization carries risks as well as benefits and has major implications for the policies that governments will find it feasible and desirable to follow.


OTHER SOURCES OF

CAPITAL INFLOWS


Introduction (1)

Apart from the FDIs and FIIs, capital flows in Pakistan are entertained through the Non-Resident Pakistan (NRP) deposits, Foreign Currency Non-Resident (Bank) Account, and External Commercial Borrowings (ECBs).

NRPs can freely invest in government securities or company shares or debentures with repatriation rights.

They are also allowed to park their funds in shares/debentures of Pakistani companies through stock exchange under portfolio investment scheme with repatriation rights.

An NRP can acquire any immovable property in Pakistan other than agricultural land/farm house/plantation property.


Introduction (2)

They are allowed to hold Resident Foreign Currency (RFC) Account to keep their foreign currency assets.

The funds in RFC accounts can be freely used without any restrictions including investments outside Pakistan.

Deposits—NRPs and Persons of Pakistani Origins (PPOs) can open, hold and maintain the following two types of accounts with an authorized dealer in Pakistan, that is, a bank authorized to deal in foreign exchange.

1. Foreign Currency Non-Resident (Bank) Account—FCNR(B) Account.

2. Non-Resident (External) Rupee Account—NRE Account.


Foreign Currency Non-Resident Bank Account—FCNR(B)

Account


Foreign Currency Non-Resident Bank Account—FCNR(B) Account (1)

Only NRPs and Overseas Corporate Bodies (OCBs) can open this type of account.

Accounts can be denominated in Pound Sterling, US Dollar, Japanese Yen or Euro.

This account is of time deposit nature. The duration of these accounts varies between

1 year and 3 years. Both principal and interest can be repatriated. Nomination is permitted.



Regarding interest rates, the banks are free to determine the rates, however within the ceiling prescribed by the RBP.

At present, the interest rates on FCNR(B) deposits are subject to a ceiling of LIBOR rates for the corresponding maturities minus 25 basis points.

In respect of deposits of one year and above, interest shall be paid within the ceiling rate of LIBOR/SWAP rates for the respective currency/corresponding maturities minus 25 basis points.

On floating rate deposits, interest shall be paid within the ceiling of SWAP rates for the respective currency/maturity minus 25 basis points.



For floating rate deposits, the interest-reset period shall be six-months.

However, in respect of Yen deposits, banks have the freedom to set the FCNR(B) deposit rates, which may be equal or less than LIBOR.

Loans and overdraft facilities are available to the account holders.

Since the FCNR(B) account is denominated in foreign currency, the account holder is protected against changes in Pakistani Rupee value against the currency in which the account is denominated.


Non-Resident (External) Rupee

Account—NRE Account


Non-Resident (External) Rupee Account—NRE Account (1)

Like FCNR(B) Account, NRE Account is also open to only NRPs and OCBs.

This type of account can be in any form, that is, savings, current or term deposits account.

The account is denominated in Pakistani Rupees only.

Deposit accepting banks have enough discretion regarding the duration of the fixed deposit.

There is normally no ceiling on interest rates, that is, banks are free to determine the interest rates.


Non-Resident (External) Rupee Account—NRE Account (2)

Under the NRE scheme, deposits are received in foreign currency and converted into rupees, and converted back into foreign currency on maturity loans and overdraft facilities are available to the account holders.


External Commercial Borrowings (ECB)


External Commercial Borrowings (ECB) (1)

External Commercial Borrowings (ECB) are borrowings from lenders and investors outside Pakistan, who are permitted by the Government as a source of finance for Pakistani corporates for expansion of existing capacity as well as for fresh investment.

These include commercial bank loans, buyers credit, suppliers credit, securitized instruments such as Floating Rate Notes and Fixed Rate Bonds, etc., credit from official export credit agencies and commercial borrowings from the private sector window of Multilateral Financial Institutions.

The RBP seeks to keep an annual cap or ceiling on access to ECB, consistent with prudent debt management.



The Government has decided to place fresh ECB approvals up to US$ 50 millions under the automatic route.

Under this scheme, Pakistani companies are allowed to raise ECBs up to $50 million without any approval from the Government or the RBP.

The advantages of ECBs route to the Pakistani corporates is obvious: it provides a source of the foreign currency funds, which will be cheaper than the rupee funds.

The average maturity for ECB is less than or equal to US $20 million is 3 years, above that it is 5 years except 100% Export Oriented Units which is three years.



Though Pakistan’s FDIs are not attractive compared to other countries it is increasingly being recognized due to its democracy, size resilience, stability, growing economy and financial system with its vast educated, well-trained man power, entrepreneurial capabilities and institutional set-up.

However, the huge government deficit has been a problem.

But Pakistan has been growing at a stable rate and this is a promise, which international investors cannot ignore.


SOURCES OF INTERNATIONAL

CAPITAL INFLOWS


Introduction

Sources of capital inflows are associated with forex risks since they deal in foreign currencies.

Therefore, many banks and corporates are resorting to the following two instruments to raise foreign capital.

1. Global Depository Receipts (GDRs)2. American Depository Receipts (ARDs)


Global Depository Receipts (GDRs)


Global Depository Receipts (GDRs) (1)

The advent of GDRs in Pakistan has been mainly due to the Balance of Payments crisis in the early 90s.

At this time Pakistan did not have enough foreign exchange balance to meet even the requirements of a fortnight's imports.

International institutions were not willing to lend because of non-investment credit rating of Pakistan.

Out of compulsion, rather than by choice, the government (accepting the World Bank suggestions on tiding over the financial predicament) gave the permission to allow fundamentally strong private corporates to raise funds in international capital markets through equity or equity-related instruments.



The Foreign Exchange Regulation Act (FERA) was modified to facilitate investment by foreign investors up to 51% of the equity-capital of the companies.

Investment even beyond this limit is also being permitted by the government in certain sectors.

Prior to this, the companies in need of the foreign exchange component or resources for their projects had to rely on the Government of Pakistan or otherwise rely partly on the government and partly on the financial institutions.



These foreign currency loans utilized by the companies (whether through the financial institutions or through the government agency) were paid from the government allocation from the IMF, World Bank or other governments credits.

This, in turn, created liability for the remittance of interest and principal, in foreign currencies which was to be met by way of earnings through exports and other grants received by the government.

However, with a rapid deterioration in the foreign exchange reserves consequent to Gulf War and its subsequent oil crisis, the companies were asked to get their own foreign currencies which led to the advent of the GDRs.


GDR Instruments (1)

GDRs are essentially those instruments which possess certain number of underlying shares in the custodial domestic bank of the company.

That is, a GDR is a negotiable instrument which represents publicly traded local currency equity share.

By law, a GDR is any instrument in the form of a depository receipt or certificate created by the Overseas Depository Bank outside Pakistan and issued to non-resident investors against the issue of ordinary shares or foreign currency convertible bonds of the issuing company.


GDR Instruments (2)

Usually, a typical GDR is denominated in US$ whereas the underlying shares would be denominated in the local currency of the issuer.

GDRs may be, at the request of the investor, converted into equity shares by cancellation of GDRs through the intermediation of the depository and the sale of underlying shares in the domestic market through the local custodian.

GDRs, are considered as common equity of the issuing company and are entitled to dividends and voting rights since the date of its issuance.


GDR Instruments (3)

The company effectively transacts with only one entity—the Overseas Depository—for all the transactions.

The voting rights of the shares are exercised by the Depository as per the understanding between the issuing company and the GDR holders.


American Depository Receipts (ADRs)


American Depository Receipts (ADRs) (1)

Until 1990, companies had to issue separate receipts in the US (ADRs) and in Europe (IDRs) to access both the markets.

The weakness was that there was no cross-border trading possible as ADRs had to be traded, settled and cleared through the Depository Trust Company (DTC) in the US, while the IDRs could be traded and settled via Euroclear in Europe.

It was in April, 1990 when changes in Rule 144A and Regulations of the SEC of the US allowed non-US companies to raise capital in the US market without having to register the securities with the SEC or changing the financial statements to reflect the US accounting principles.


American Depository Receipts (ADRs) (2)

Rule 144A is designed to facilitate certain investment bodies called Qualified Institutional Buyers (QIBs) to invest in overseas (non-US) companies without those companies needing to go through the SEC registration process.


ADR Instrument (1)

ADR is a Dollar Denominated Negotiable Certificate, which represents non-US company’s publicly traded equity.

It was devised in the late 1920s to help Americans invest in overseas securities and to assist non-US companies wishing to have their stock traded in the American markets.

ADRs are divided into three levels based on the regulation and privilege of each company's issue.

1. ADR Level-I 2. ADR Level-II3. ADR Level-III


ADR Instrument (2)

ADR Level-I: It is often the first step for an issuer into the US public equity market. Issuer can enlarge the market for existing shares and thus diversify the investor base. In this instrument only minimum disclosure is required to the SEC and the issuer need not comply with the US GAAP (Generally Accepted Accounting Principles). This type of instrument is traded in the US OTC market. The issuer is not allowed to raise fresh capital or list on anyone of the national stock exchanges.


ADR Instrument (3)

ADR Level-II: Through this level of ADR, the company can enlarge the investor base for existing shares to a greater extent. However, significant disclosures have to be made to the SEC. The company is allowed to list in the American Stock Exchange (AMEX) or New York Stock Exchange (NYSE) which implies that the company must meet the listing requirements of the particular exchange.

ADR Level-III: This level of ADR is used for raising fresh capital through public offering in the US capital markets. The company has to be registered with the SEC and comply with the listing requirements of AMEXINYSE while following the US-GAAP.


ADR Instrument (4)

The reason for this may be attributed to the stiff disclosure requirements and accounting standards as per the US GAAP.

Intermediaries that are involved in an ADR issue perform the same work as in the case of a GDR issue.

Additionally, the intermediaries involved will liaison with the QIBs for investing in ADRs.

Some of the well known intermediaries for ADRs/GDRs are, Merrill Lynch International Ltd., Goldman Sachs & Co., James Capel & Co., Lehman Brothers International, Robert Fleming Inc., Jardine Fleming, CS First Boston, JP Morgan, etc.


CAPITAL FLIGHT


Capital Flight (1)

Capital flight refers to the large capital outflows resulting from unfavorable investment conditions in a country.

The expected risk and return are the determinants of the foreign investment.

When the risk of investment in a country rises sharply and/or expected return falls, large outflows of investment funds take place, and the country experiences massive current account deficits.

Such outflows are descriptively referred to as Capital Flight.


Capital Flight (2)

The change in the risk-return relationship that gives rise to capital flight may be due to political or financial crisis, tightening capital controls, tax increases, or fear of domestic-currency devaluation.

One of the most important aspects of the capital flight is that fewer resources are available at home to service the debts, and more borrowing is required.

Also, capital flight may be associated with a loss of international reserves and greater pressure for devaluation of the domestic currency.


Capital Flight (3)

The capital flight serves the importance of political and economic stability for encouraging domestic investment.

A stable, growing developing country faces little, if any, capital flight and attracts foreign capital to aid in expanding its productive capacity.


INTERNATIONAL LIQUIDITY


International Liquidity (1)

International liquidity refers to the generally accepted means of international payments available for the settlement of the international transactions.

International liquidity encompasses the international reserves and the facilities for international borrowing for financing the Balance of Payments deficit.

The international reserves include official holdings of gold, foreign exchange, Special Drawing Rights (SDRs), and reserve position in the IMF.

International reserves do not include private holdings of gold, private holdings of foreign exchange and long-term international financing.



The IMF provides international liquidity in accordance with the purpose of the fund specified in the Articles of Agreement.

Part of the liquidity takes the form of reserve assets that can be used for Balance of Payments financing (unconditional liquidity), while the other part takes the form of credit to members that is generally subject to certain conditions (conditional liquidity).

Unconditional liquidity is supplied through allocation of SDRs and also in the form of reserve positions in the fund which are claims corresponding to the resources that countries have made available to the fund.



Members holding SDRs and reserve positions in the fund can use them to finance Balance of Payments deficits without having to enter into policy commitments with the fund.

Conditional liquidity is provided by the IMF under its various lending activities.

Most of the fund’s credit extended under these arrangements requires an adjustment program that is intended to promote a sustainable external position for the member.

In addition, it is often the case when the member obtains fund financing under agreed conditions, its access to capital markets is enhanced.



This kind of a catalytic role of the fund has become more important in recent times when private lending institutions have been less willing to engage in international lending.


The End

international banking international capital flows session 10 --hilla shahpur maneckji

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