FINANCIAL MANAGEMENT INTERNATIONAL FINANCE

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE FINAL GROUP - III PAPER - 12 STUDY NOTES THE INSTITUTE OF COST AND WORKS ACCOUNTANTS OF INDIA 12, SUDDER STREET, KOLKATA - 700 016 First Edition : May 2008 Published by : Directorate of Studies The Institute of Cost and Works Accountants of India 12, Sudder Street, Kolkata - 700 016 Printed at : Swapna Printing Works Private Limited 52, Raja Rammohan Sarani, Kolkata - 700 009 E-mail : spw@cal.vsnl.net.in Copyright of these Study Notes is reserved by the Institute of Cost and Works Accountants of India and prior permission from the Institute is necessary for reproduction of the whole or any part thereof SYLLABUS Paper 12: Financial Management & International Finance (One Paper: hours:100 marks) OBJECTIVES Understand the scope, goals and objectives of Financial Management To provide expert knowledge on concepts, methods and procedures involved in using Financial Management for managerial decision-making Learning Aims Understand and apply theories of financial management Identify the options available in financial decisions and using appropriate tools for strategic financial management Identify and evaluate key success factors in the financial management for organisation as a whole Evaluate strategic financial management options in the light of changing environments and the needs of the enterprise Determining the optimal financial strategy for various stages of the life-cycle of the enterprise Critically assess the proposed strategies Skill set required Level C: Requiring all six skill levels - knowledge, comprehension, application, analysis, synthesis, and evaluation CONTENTS Overview of Financial Management 10% Financial Management Decisions 15% Financial Analysis & Planning 10% Operating and Financial Leverages Financial Strategy 15% Investment Decisions 15% Project Management 10% International Finance 10% Sources of International Finance 5% International Monetary and Financial System 5% 10 5% Overview of Financial Management Finance and Related Disciplines Scope of Financial Management, Planning environment Key decisions of Financial Management Emerging role of finance managers in India Earnings distributions policy Compliance of regulatory requirements in formulation of financial strategies Sources of finance – long term, short term and international Exchange rate – risk agencies involved and procedures followed in international financial operations Financial Management Decisions Capital structure theories and planning Cost of capital Designing Capital Structure Capital budgeting Lease financing Working capital management Financial services Dividend and retention policies Criteria for selecting sources of finance, including finance for international investments Effect of financing decisions on Balance Sheet and Ratios Financial management in public sector Role of Treasury function in terms of setting corporate objectives, funds management – national and international Contemporary developments – WTO, GATT, Corporate Governance, TRIPS, TRIMS, SEBI regulations as amended from time to time Financial analysis & planning Funds flow and cash flow analysis Financial ratio analysis -Ratios in the areas of performance, profitability, financial adaptability, liquidity, activity, shareholder investment and financing, and their interpretation Limitations of ratio analysis Identification of information required to assess financial performance Effect of short-term debt on the measurement of gearing Operating and financial leverages Analysis of operating and financial leverages Concept and nature of leverages operating risk and financial risk and combined leverage Operating leverage and Cost volume Profit analysis – Earning Before Interest and Tax (EBIT) and Earning Per Share (EPS), indifference point Financial Strategy Financial and Non-Financial objective of different organizations Impact on Investment, finance and dividend decisions Sources and benefits of international financing Alternative Financing strategy in the context of regulatory requirements Modeling and forecasting cash flows and financial statements based on expected values for variables – economic and business Sensitivity analysis for changes in expected values in the models and forecasts Emerging trends in financial reporting Investment Decisions Costs, Benefits and Risks analysis for projects Linking investment with customer’s requirements Designing Capital Structure The impact of taxation, potential changes in economic factors and potential restrictions on remittance on these calculations Capital investment real options Venture Capital financing Hybrid financing / Instruments Project Management Project Identification and Formulation Identification of Project opportunities Project Selection Consideration and Feasibility Studies Project appraisal & Cost Benefit analysis Source of Project Finance & Foreign Collaboration International Finance Minimization of risk, Diversification of risk Forward and futures, Forward rate agreements Interest rate swaps Caps, floors and collars Parity theorems FDI Money market hedge Options Sources of International Finance Rising funds in foreign markets and investments in foreign projects Forward rate agreements and interest rate guarantees Transaction, translation and economic risk, Interest rate parity, purchasing power parity and the Fisher effects Foreign Direct Investment 10 International Monetary and Financial System Understanding the International Monetary System Export and Import Practices International Financial Management: Important issues and features, International Capital Market International Financial Services and Insurance: Important issues and features PAPER - 12 FINANCIAL MANAGEMENT AND INTERNATIONAL FINANCE Contents Study Note - Overview of Financial Management Section Particulars Page No Section Finance and Related Disciplines 1-11 Section Scope of Financial Management 12-13 Section Planning Environment 14 Section Key Decisions of Financial Management 15-16 Section Emerging Role of Finance Managers in India 17-24 Section Earning Distribution Policy 25 Section Compliance of Regulatory Requirements in Formulation Section of Financial Strategies 26-27 Sources of Finance- Long Term, Short Term and 28-29 International Section Exchange rate - Risk Agencies Involved and Procedure followed in International Financial Operations 30 Study Note - Financial Management Decisions Section Capital Structure Theory and Planning 31-37 Section Cost of Capital 38-42 Section Capital Budgeting 43-60 Section Lease Financing 61-63 Section Working Capital Management 64-75 Section Financial Services 76-78 Section Dividend and Retention Policies 79-81 Section Criteria For Selecting Sources of Finance 82-83 Section Effect of Financing Decisions on Balance Sheet and Ratios 84-85 Section 10 Financial Management in Public Sector 86 Section 11 Role of Treasury Function 87-90 Section 12 Contemporary Developments 91-94 Study Note - Financial Analysis and Planning Section Fund Flow Analysis 95-99 Section Cash Flow Analysis 100-105 Section Financial Ratio Analysis 106-110 Study Note - Capital Budgeting Section Particulars Page No Section Cost-Volume-Profit Analysis 111-113 Section Concept and Nature of Leverages 114 Section Operating and Financial Leverages 115-117 Study Note - Financial Strategy Section Introduction to Financial Stratgy Section Financial & Non-Financial Objectives of different organization Section 123-145 Alternative Financing Strategy in the context of Regulatory Requirement Section 118-122 146-148 Modeling and Forecasting Cash Flows and Financial Statements 149-150 Section 5&6 Sensitivity Analysis for changes in expected values in the Section Models and Forecasts 151-154 Emerging Trends in Financial Reporting 155-168 Study Note - Investment Decisions Section Cost, Benefits and Risks Analysis for Projects 169-171 Section Real Options in Capital Investement Decisions 172-176 Section Venture Capital Financing 177-187 Section Hybrid Financing / Instruments 188-199 Study Note - Project Management Section Overview of Project Management 200-201 Section Project Identification and Formulation 202-204 Section Identification of Project Opportunities 205-206 Section Project Selection Considerations and Feasibility 207-210 Section Project Appraisal and Cost Benefit Analysis 211-216 Section Source of Project Finance & Foreign Collaboration 217-220 Study Note - International Finance Section Risk Assessment and Management 221-222 Section Interest Rate Risk 223-226 Section Forward Rate Agreement 227-230 Section Interest Rate Swaps 231-234 Section Interest Rate Caps, Floors And Collars 235-236 Section Options 237-243 Section Comprehensive Illustration on Risk Management Through Derivative Products 244-256 Study Note - Sources of International Finance Section Particulars Section Rising Funds in Foreign Markets And Investment Page No In Foreign Projects 257-259 Section Forward Rate Agreement And Interest Rate Guarantees 260-262 Section Exposures in International Finance 263-265 Section Foreign Direct Investment 266-268 Study Note - 10 International Monetary Fund and Financial System Section Understanding International Monetary System 269-280 Section Import and Export Procedures and Practices 281-286 Section International Financial Management:Important Issues and Features,International Capital Market Section 287-289 International Financial Services and Insurance : Important Issues and Features 290-295 STUDY NOTE - OVERVIEW OF FINANCIAL MANAGEMENT SECTION- FINANCE AND RELATED DISCIPLINES This Section include • • • • • • • • • • • • • • Basic Concepts of Finace and Relatid Desciplines Case Study Finance and Related Disciplines Costing Taxation Treasury Management Banking Insurance International Finance Risk Management Information Technology Management Soft Skills Case Study 1.1 FINANCE AND RELATED DISCIPLINES 1.1.1 Finance refers to funds required for a business or an activity ‘Finance’ requirements of an enterprise is not ‘one time’ but recurring The discipline of financial management as a separate and distinct subject of study has evolved over a period of time The subject has its origins in Economics However, it has today grown into a specialized discipline, integrating knowledge from many diverse fields as explained further in this chapter The head of finance, also called Chief Financial Officer (CFO) must posses adequate skills and exposure in the following areas 1.2 ECONOMICS 1.2.1 The mother discipline relating to human’s economic endeavors is Economics It deals with various factors of production, the returns available on each of them, costs and revenues and so on A fundamental knowledge of Economics is essential for the finance manager to understand the macroeconomic environment in which an organization operates and the micro economic or firm level impact of macro economic environment FINANCIAL MA NAGEMENT & INTERNATIONAL FINANCE SECTION - IMPORT AND EXPORT PROCEDURES & PRACTICES This Section includes Procedures for Imports Export Procedures Important Note: The import and export trade of a country is governed by the country’s governmental policies, rules and regulations Detailed procedures covering every aspect of the trade are available, and the subject is a matter of extensive study as a separate discipline These are further backed with extensive documentation, inspection and assessment procedures The number of intermediaries involved in the process is also numerous This chapter, therefore, only provides a glimpse of the process The student is well advised to refer to the relevant rules and regulations laid down by the Ministries of Finance, Commerce, and various authorities such as the Office of the Director General of Foreign Trade 2.1 PROCEDURES FOR IMPORTS 2.1.1 Import Restrictions Licensing, Quotas And Prohibitions: Import approval is based on compliance with procedures whereby specific items may be imported by certain types of importers under certain types of licences Importers are divided into three categories for the purpose of import licensing: actual users; An actual user applies for and receives a licence to import any item or an allotment of an imported item as required for his own use, not for business or trade in that item registered exporters; defined as those who have a valid registration certificate issued by an export promotion council, commodity board or other registered authority designated by the Government for purposes of export-promotion others The two types of actual user licence are: general currency area licences which are valid for imports from all countries, except those countries from which imports are prohibited; specific licences which are valid for imports from a specific country or countries Aside from the types of licences listed, the Open General Licence is perhaps the most liberalized type of licence available for certain items and certain types of importers FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE 281 INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM Licences are valid for 24 months for capital goods and 18 months for raw materials components, consumable and spares, with the licence term renewable Import licences may be obtained from the director general of foreign trade (Office of Chief Controller of Imports and Exports, Ministry of Commerce, Udyog Bhawan, New Delhi 110011) Traders are advised to consult the Handbook of Procedures which is published by the Ministry of Commerce and is part of the Import and Export Policy for further details 2.1.2 The importer importing the goods has to follow prescribed procedures for import by ship/air/road There is separate procedure for goods imported as a baggage or by post 2.1.3 Bill of Entry This is a very vital and important document which every importer has to submit under section 46 The Bill of Entry should be in prescribed form Bill of Entry should be submitted in quadruplicate – original and duplicate for customs, triplicate for the importer and fourth copy is meant for bank for making remittances A BIN (Business Identification Number) is allotted to each importer and exporter w.e.f 1.4.2001 It is a 15 digit code based on PAN of Income Tax (PAN is a 10 digit code) [Earlier an EC (Import Export code) number issued by DGFT was required to be mentioned on Bill of Entry] 2.1.4 Documents to be submitted by Importer are Invoice Packing List Bill of Landing / Delivery Order GATT declaration form duly filled in Importers / CHAs declaration duly signed Import Licence or attested photocopy when clearance is under licence Letter of Credit / Bank Draft wherever necessary Insurance memo or insurance policy Industrial License if required 10 Certificate of country of origin, if preferential rate is claimed 11 Technical literature 12 Test report in case of chemicals 13 Advance License / DEPB in original, where applicable 14 Split up of value of spares, components and machinery 15 No commission declaration – A declaration in prescribed form about correctness of information should be submitted – Chapter Para and of CBE&C’s Customs Manual, 2001 282 FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE 2.1.5 Electronic submission under EDI system – Where EDI system is implemented, formal submission of Bill of Entry is not required, as it is generated in computer system 2.1.6 Importer should submit declaration in electronic format to ‘Service Centre’ A signed paper copy of declaration for non-repudiability should be submitted 2.1.7 Bill of Entry number is generated by system which is endorsed on printed check list Original documents are to be submitted only at the stage of examination 2.1.8 Assessment of Duty and Clearance: The documents submitted by importer are checked and assessed by Customs authorities and then goods are cleared 2.1.9 Payment of Customs Duty - After assessment of duty, necessary duty is paid Regular importers and Custom House Agents keep current account with Customs department The duty can be debited to such current account, or it can be paid in cash/DD through TR-6 challan in designated banks After payment of duty, if goods were already examined, delivery of goods can be taken from custodians (port trust) after paying their dues 2.2 EXPORT PROCEDURES 2.2.1 Documents Required: Certain documentation takes place while exporting from India Special documents may be required depending on the type of product or destination Certain export products may require a quality control inspection certificate from the Export Inspection Agency Some food and pharmaceutical product may require a health or sanitary certificate for export Shipping Bill/ Bill of Export is the main document required by the Customs Authority for allowing shipment 2.2.2 Every exporter should take following initial steps Obtain BIN (Business Identification Number) from DGFT It is a PAN based number Open current account with designated bank for credit of duty drawback claims Register licenses / advance license / DEPB etc at the customs station, if exports are under Export Promotion Schemes Submission of Shipping Bill (export by sea or air) or Bill of export (for export by road) Assessment of goods for duty - even if no duty is payable for most of exports, as ‘Nil Duty’ assessment is also an assessment Shipping Bill or bill of export should be submitted in quadruplicate If drawback claim is to be made, one additional copy should be submitted 2.2.3 There are five forms a Shipping Bill for export of goods under claim for duty drawback - these should be in Green colour b Shipping Bill for export of dutiable goods - this should be yellow colour FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE 283 INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM c Shipping bill for export of duty free goods - it should be in white colour d Shipping bill for export of duty free goods ex-bond - i.e from bonded store room - it should be pink colour e Shipping Bill for export under DEPB scheme - Blue colour 2.2.4 Requirements of Shipping Bill a The shipping bill form requires details like name of exporter, consignee, Invoice Number, details of packing, description of goods, quantity, FOB Value etc b Appropriate form of shipping bill should be used c Relevant documents i.e copies of packing list, invoices, export contract, letter of credit etc are also to be submitted Usually the Shipping Bill is of four types and the major distinction lies with regard to the goods being subject to certain conditions which are mentioned below: Export duty/ cess Free of duty/ cess Entitlement of duty drawback Entitlement of credit of duty under DEPB Scheme Re-export of imported goods 2.2.5 Documents Required for Post Parcel Customs Clearance: In case of Post Parcel, no Shipping Bill is required The relevant documents are mentioned below: Customs Declaration Form - It is prescribed by the Universal Postal Union (UPU) and international apex body coordinating activities of national postal administration It is known by the code number CP2/ CP3 and to be prepared in quadruplicate, signed by the sender Despatch Note, also known as CP2 It is filled by the sender to specify the action to be taken by the postal department at the destination in case the address is non-traceable or the parcel is refused to be accepted Prescriptions regarding the minimum and maximum sizes of the parcel with its maximum weight : Minimum size: Total surface area not less than 140 mm X 90 mm Maximum size: Lengthwise not over 1.05 m Measurement of any other side of circumference 0.9 m./ 2.00 m Maximum weight: 10 kg usually, 20 kg for some destinations 2.2.6 Excise formalities at the time of Export - If the goods are cleared by manufacturer for export, the goods are accompanied by ARE-1 (earlier AR-4): This form should be submitted to customs authorities 284 FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE The Customs Officer certifies that the goods under this form have indeed been exported This form has then to be submitted to Maritime Commissioner for obtaining ‘proof of export’ The bond executed by Manufacturer-exporter with excise authorities is released only when ‘proof of export’ is accepted by Maritime Commissioner or Assistant Commissioner, where bond was executed Duty drawback formalities - If the exporter intends to claim duty draw back on his exports, he has to follow prescribed procedures and submit necessary papers He has to make endorsement of shipping bill that claim for duty drawback is being made G R / SDF / SOFTEX Form under FEMA - Reserve Bank of India has prescribed GR / SDF form under FEMA “G R” stands for ‘Guaranteed Receipt’ form, while SDF stands for ‘Statutory Declaration Form’) SDF form is to be used where shipping bills are processed electronically in customs house, while GR form is used when shipping bills are processed manually in customs house 2.2.7 Other documents required for export - Exporter also has to prepare other documents such as the following: (a) Four copies of Commercial Invoice (b) Four copies of Packing List (c) Certificate of Origin or pre-shipment inspection where required (d) Insurance policy (e) Letter of Credit (f) Declaration of Value (g)Excise ARE-1/ARE-2 form as applicable (h) GR / SDF form prescribed by RBI in duplicate (i) Letter showing BIN Number 2.2.8 RCMC certificate from Export Promotion Council - Various Export Promotion Councils have been set up to promote and develop exports (e.g Engineering Export Promotion Council, Apparel Export Promotion Council, etc.) Exporter has to become member of the concerned Export Promotion Council and obtain RCMC - Registration cum membership Certificate Terms used in the trade Commercial invoice - Issued by the seller for the full realisable amount of goods as per trade term Consular Invoice - Mainly needed for the countries like Kenya, Uganda, Tanzania, Mauritius, New Zealand, Burma, Iraq, Ausatralia, Fiji, Cyprus, Nigeria, Ghana, Zanzibar etc It is prepared in the prescribed format and is signed/ certified by the counsel of the importing country located in the country of export FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE 285 INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM Customs Invoice - Mainly needed for the countries like USA, Canada, etc It is prepared on a special form being presented by the Customs authorities of the importing country It facilitates entry of goods in the importing country at preferential tariff rate Legalised/ Visaed Invoice - This shows the seller’s genuineness before the appropriate consulate/ chamber of commerce/ embassy It not have any prescribed form Certified Invoice - It is required when the exporter needs to certify on the invoice that the goods are of a particular origin or manufactured/ packed at a particular place and in accordance with specific contract Sight Draft and Usance Draft are available for this Sight Draft is required when the exporter expects immediate payment and Usance Draft is required for credit delivery Packing List - It shows the details of goods contained in each parcel/ shipment Certificate of Inspection - It shows that goods have been inspected before shipment Black List Certificate - It is required for countries which have strained political relation It certifies that the ship or the aircraft carrying the goods has not touched those country(s) Weight Note - Required to confirm the packets or bales or other form are of a stipulated weight Manufacturer’s/ Supplier’s Quality/ Inspection Certificate Manufacturer’s Certificate - It is required in addition to the Certificate of Origin for few countries to show that the goods shipped have actually been manufactured and are available Certificate of Chemical Analysis - It is required to ensure the quality and grade of certain items such as metallic ores, pigments, etc Certificate of Shipment - It signifies that a certain lot of goods have been shipped Health/ Veterinary/ Sanitary Certification - Required for export of foodstuffs, marine products, hides, livestock etc Certificate of Conditioning - It is issued by the competent office to certify compliance of humidity factor, dry weight, etc Antiquity Measurement - Issued by Archaeological Survey of India in case of antiques Transhipment Bill - It is used for goods imported into a customs port/ airport intended for transhipment Shipping Order - Issued by the Shipping (Conference) Line which intimates the exporter about the reservation of space of shipment of cargo through the specific vessel from a specified port and on a specified date Cart/ Lorry Ticket - It is prepared for admittance of the cargo through the port gate and includes the shipper’s name, cart/ lorry No., marks on packages, quantity, etc Shut Out Advice - It is a statement of packages which are shut out by a ship and is prepared by the concerned shed and is sent to the exporter Short Shipment Form - It is an application to the customs authorities at port which advises short shipment of goods and required for claiming the return Shipping Advice - It is prepared in aligned document to be used to inform the overseas customer about the shipment of goods 286 FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE SECTION - INTERNATIONAL FINANCIAL MANAGEMENT: IMPORTANT ISSUES AND FEATURES, INTERNATIONAL CAPITAL MARKET This Section includes International Financial Markets Eurocurrency markets Asian Currency market International capital markets International banking 3.1 INTERNATIONAL FINANCIAL MARKETS 3.1.1 International financial markets are a major source of funds for international transactions Most countries have recently internationalized their financial markets to attract foreign business 3.1.2 Internationalization involves both a harmonization of rules and a reduction of barriers that will allow for the free flow of capital and permit all firms to compete in all markets 3.2 EUROCURRENCY MARKETS 3.2.1 Eurocurrency market consists of banks that accept deposits and make loans in foreign currencies outside the country of issue These deposits are commonly known as Eurocurrencies Thus, US dollars deposited in London are called Eurodollars; British pounds deposited in New York are called Eurosterling, etc 3.2.2 Eurocurrency markets are very large, well organized and efficient They serve a number of valuable purposes for multinational business operations Eurocurrencies are a convenient money market device for MNCs to hold their excess liquidity They are a major source of short term loans to finance corporate working capital needs and foreign trade 3.3 ASIAN CURRENCY MARKET 3.3.1 In 1968, an Asian version of the Eurodollar came into existence with the acceptance of dollar denominated deposits by commercial banks in Singapore, which was an ideal FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE 287 INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM location for the birth of the Asian currency market due to its excellent communication network, important banks and a stable government 3.3.2 Asian currency market developed when the Singapore branch of the bank of America proposed that the monetary authority of Singapore relax taxes and restrictions 3.4 INTERNATIONAL CAPITAL MARKETS 3.4.1 International capital market consists of international bond market and the international equity market The New York Stock Exchange, the NASDAQ, the London stock exchange and the Tokyo stock exchange are the world’s four biggest markets, measured in market value a International bond market: These are bonds sold outside the country of the borrower International bond consist of foreign bonds, Eurobonds and global bonds The currency of issue is not necessarily the same as the country of issue b Foreign bonds: These are bonds sold in a particular national market by foreign borrower, underwritten by a syndicate of brokers from that country, and denominated in the currency of that country Dollar denominated bonds sold in New york by a Mexican firm are foreign bonds are foreign bonds, but should be registered with the US securities Exchange Commission c Eurobonds: These are bonds underwritten by an international syndicate of brokers and sold simultaneously in many countries other than the country of the issuing entity These are bonds issued outside the country in whose currency they are denominated d Global bonds: These are bonds which are sold both inside and outside the country in whose currency it is denominated 3.5 INTERNATIONAL BANKING 3.5.1 International banking has grown with the unprecedented expansion of economic activity since the world war 3.5.2 International banks perform many vital tasks to help the international transactions of multinational companies They finance foreign trade and foreign investment, underwrite international bonds, borrow and lend in the Eurodollar market, organize syndicated loans, participate in international cash management, solicit local currency deposits and loans and give information and advice to clients 3.5.3 Interbank clearing house systems: There are three key clearing house systems of interbank fund transfers which transfer funds between banks through wire and facilitate international trade a 288 The clearing house interbank payments system(CHIPS): This is used to move dollars among New York offices of about 150 financial institutions that handle 95 percent of all foreignexchange trades and almost all Eurodollar transactions FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE b The clearing house payments assistance system(CHPAS): This began its operations in 1983 and provides services similar to those of CHIPS It is used to move funds among London offices of most financial institutions c The Society for Worldwide Interbank Financial Telecommunications (SWIFT): It is an interbank communication network which carries messages for financial transactions It represents a common denominator in the international payment system and uses the latest communication technology It has reduced multiplicity of formats used by banks in different parts of the world International payments can be made very cheaply and efficiently 3.6 FINANCING FOREIGN TRADE There are three major documents involved in foreign trade, namely, a draft, a bill of lading and a letter of credit Documentation in foreign trade is supposed to assure that the exporter will receive the payment and the importer will receive the merchandise Many of these documents are used to eliminate non completion risk, to reduce forex risk and finance trade transactions A draft or bill of exchange is an order written by an exporter that requires an importer to pay a specified amount of money at a specified time Through the draft, the exporter may use its bank as the collection agent on accounts that the exporter finances A bill of lading is a shipping document issued to an exporting firm or its bank by a common carrier which transports goods It is simultaneously a receipt, contract and a document of title As a receipt, the bill of lading indicates that specified goods have been received by the carrier As a contract, it is evidence that the carrier is obliged to deliver the goods to the importer in exchange for certain charges As a document of title, it establishes ownership of the goods Bill of lading can be used to insure payment before the goods are delivered Letter of credit is a document issues by a bank at the request of an importer In this, the bank agrees to honor a draft drawn on the importer if the draft accompanies specified documents such as the bill of lading The importer asks that his local bank write a letter of credit In exchange for the bank’s agreement to honor the demand for payment that results from the import transactions, the importer promises to pay the bank the amount of the transaction and a specified fee A letter of credit is advantageous to both exporters and importers because it facilitates foreign trade FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE 289 INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM SECTION - INTERNATIONAL FINANCIAL SERVICES AND INSURANCE: IMPORTANT ISSUES AND FEATURES This Section includes Introduction Implications of a large, rapidly growing home market for International Financial Services (IFS) in India: What drives the demand for IFS? The impact of globalization on IFS demand and on IFCs: Projections for revenue potential of Mumbai as an IFC Insurance Integration and Globalization of Financial Services: 4.1 INTRODUCTION 4.1.1 The term financial services refers to services provided by the finance industry The finance industry encompasses a broad range of organizations that deal with the management of money Among these organizations are commercial banks, investment banks, asset management companies, credit card companies, insurance companies, consumer finance companies, stock brokerages, and investment funds 4.1.2 A detailed discussion on the subject is presented in Module 4.2 IMPLICATIONS OF A LARGE, RAPIDLY GROWING HOME MARKET FOR INTERNATIONAL FINANCIAL SERVICES (IFS) IN INDIA 4.2.1 A little appreciated aspect of India’s impressive growth from 1992 onwards is that it has resulted in even faster integration of India with the global economy and financial system There has been a rapid escalation of two-way flows of trade and investment Since 1992, India has globalised more rapidly than it has grown, with a distinct acceleration in globalisation after 2002 Capital flows have been shaped by: (a) global investors in India (portfolio and direct); and (b) Indian firms investing abroad (direct) 4.2.2 Indian investors – corporate, institutional and individual – have as yet been prevented from making portfolio investments abroad on any significant scale by the system of 290 FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE capital controls By the same token, Indian firms have borrowed substantially abroad But foreign firms and individuals have yet to borrow from India Capital controls still preclude that possibility 4.2.3 Despite the controls that remain, these substantially increased two-way flows reflect an increase in demand-supply for IFS related to trade/investment transactions in India Put another way, there has been an increase in IFS consumption by Indian customers and by global customers in India Demand for IFS from both has been growing exponentially Cumulative two-way flows in 1992–2005 were a multiple of such flows in 1947–92 The degree of ‘globalisation-integration’ that has occurred in the last 15 years, since reforms began in earnest, is much larger than in the 55 years between independence and India embarking on ‘serious’ reforms We have made up for six lost decades of economic interaction with the world in a decade and a half Still, what has happened over the last 15 years is a small harbinger of what is to follow over the next twenty: particularly if the current growth rate of 8% per annum is accelerated to 9–10% as is evocatively being suggested, and if India continues to open up the economy on both trade and capital flows 4.2.4 The typical discussion about an Indian International Financial Services Centre (IFC) exporting IFS (especially made by those arguing for locating such an IFC in a SEZ) has been analogous to that for software exports: i.e., a sterile relationship between Indian producers and foreign customers of ‘support services’ However, in the case of IFS, India is itself a large, fast growing customer of IFS Conservative estimates of IFS consumption in India just a few years out, amount to $48 billion a year That is more than the output of many Indian industries today 4.3 WHAT DRIVES THE DEMAND FOR IFS? 4.3.1 An understanding of what drives rapidly the growing demand for IFS in India needs to take into account two features: IFS demand is driven by increases in gross two-way financial flows that have occurred in transactions with the rest of the world It is not driven by net flows Demand for IFS by Indian customers – as well as foreign firms trading with and investing in India – is driven by imports and exports India-related purchases of IFS are related to inbound and outbound FDI/FPI The annual growth of gross flows has accelerated dramatically in recent years India’s external linkages have been transformed since 1991–92 But that transformation has been more radical since 2002 The Indian economy is now exhibiting signs of a ‘takeoff’ both in growth and even more rapidly in its globalisation (or integration with the world economy) Hong Kong and China FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE 291 INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM Hong Kong evolved as an enclave IFC to provide IFS for traders dealing with a closed China In the 1970s and 1980s, Hong Kong had superior institutions, and provided IFS to North Asia (China, Taiwan and Korea) as well as part of ASEAN (the Philippines and Vietnam which are closer to Hong Kong than to Singapore) But, as a colonial artifice, Hong Kong’s role as an IFC was compromised, if not damaged, as China opened up and connected itself to the world through Shanghai and Beijing Since the 1980s, China has not required its economic partners to deal with it exclusively through Hong Kong With the gradual rise of Shanghai as an IFC, Hong Kong’s role as an IFC serving China is diminishing, although it is unlikely to be completely eclipsed At the same time ASEAN regional finance has gravitated decisively toward Singapore 4.4 THE IMPACT OF GLOBALIZATION ON IFS DEMAND AND ON IFCS 4.4.1 When the economy of a country or region (e.g., the EU or ASEAN) engages with the world through its current and capital accounts, a plethora of IFS are purchased as part-and-parcel of these cross-border transactions The hinterland effect of a rapidly growing national or regional economy has been a crucial driver of growth in IFCs 4.4.2 The 21st century has yet to unfold But the emergence of China and India as global economic powers is likely (as in the US, EU and ASEAN) to provide the same raison d’etre for these two economies evolving their own IFCs to interface with those that serve other regions History suggests that no country or regional economy can become globally significant without having an IFC of its own But the emergence of IFCs has not always been a tale of growth potential and start-up followed by prolonged competitive success in exporting IFS to global markets The trajectories of IFCs can wax and wane depending on how world events unfold Growth in Indian IFS demand is driven by the progressive, inexorable integration of the Indian economy with the world economy As such integration deepens it triggers a variety of needs for IFS For example: 4.4.3 Current account flows involve payments services, credit and currency risk management Inbound and outbound FDI (as well as FPI like private equity and venture capital) involves a range of financial services including investment banking, due diligence by lawyers and accountants, risk management, etc Issuance of securities outside the country involves fees being paid by Indian firms to investment bankers in IFCs around the world The stock of cross-border exposure (resulting from accumulation of annual flows) requires risk management services to cover country risk, currency risk, etc This applies in both directions: foreign investors require IFS to protect the market value of their exposure in India while Indian investors require the same services to protect the market value of their exposure outside the country 292 FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE The shift to import-price-parity (owing to trade reforms) implies that Indian firms that not import or export are nevertheless exposed to global commodity price and currency fluctuations These firms require risk management services Many foreign firms are involved in complex infrastructure projects in India Indian firms are involved in infrastructure projects abroad These situations involve complex IFS The same applies to structuring and financing privatizations (especially those involving equity sales to foreign investors) and public–private partnerships which are becoming a growing feature in infrastructure development around the world The growth of the transport industry (shipping, roads, rail, aviation, etc) involves financing arrangements for fixed assets at terminals (ports, etc.) as well as for mobile capital assets with a long life: i.e., ships, planes, bus and auto fleets, taxis, etc That is done by specialised firms engaged in ‘fleet financing’ India is now one of the world’s biggest customers of aircraft buying roughly 40% of the world’s new output of planes in 2006 This requires buying 40% of the world’s aircraft financing services Indian individuals and firms control a growing amount of globally dispersed assets They require a range of IFS for wealth management and asset management 4.4.4 Outbound FDI by Indian firms in joint ventures and subsidiaries abroad has increased since 2004–05 as they have globalised Foreign investments by Indian firms began with the establishment of organic presence, and acquisitions of companies, in the US and EU in the IT-related services sectors Now they encompass pharmaceuticals, petroleum, automobile components, tea and steel And, geographically, Indian firms are spreading well beyond the US and EU by establishing a direct presence or acquiring companies in China, ASEAN, Central Asia, Africa and the Middle East Such outward investments are funded through: draw-down of foreign currency balances held in India, capitalization of future export revenue streams, balances held in EEFC accounts, and share swaps 4.4.5 Outward investments are also financed through funds raised abroad: e.g., ECBs, FCCBs and ADRs/GDRs Leveraged buy-outs related to these investments and executed through SPVs abroad are not captured in the overseas investment transactions data The Tata Steel-Corus transaction, for example, involved substantial IFS revenues going to financial firms in Singapore and London When two firms across the globe agree to undertake current or capital account buy–sell transactions, the associated IFS are usually bought by the firm with better access to high quality, low cost IFS Consider the example of an Indian firm exporting complex engineering goods to a firm in Germany It can contract and invoice in: INR, USD or EUR Because India has limited IFS capabilities, and a stunted currency trading market, the transaction is likely to be contracted in INR or USD But the German importer generates revenues in EUR It has to buy INR or USD to pay the Indian firm It may have to use a currency derivative (future, forward or option) to cover the risk of a movement in the exchange rate of the INR or USD vs the EUR between placing the order and receiving the goods This would typically be done in London 4.4.6 FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE 293 INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM 4.4.7 However, if India had a proper currency spot and derivatives market, the Indian exporter would be able to invoice in EUR Local IFS demand would be generated by this local firm converting locked-in future EUR revenues into current INR revenues at a known exchange rate Indian exporters are not as flexible as they wish to be in their choice of the INR or of global currencies for invoicing (i.e., USD, JPY, EUR or GBP) – or even the choice of currencies such as the SGD or CNY for trade with ASEAN and China If they were, that could influence the effective price received by them When goods are sold by an Indian exporter, and a German importer pays IFS charges in London for converting EUR into INR and managing the exchange risk, the net price received by the Indian exporter is lower When the Indian exporter sells in EUR, and local IFS are purchased for conversion of EUR receipts into INR, the price received would be higher 4.4.8 These differences are invisible in standard BoP data, which not separate out and recognise charges for IFS being purchased or sold as part and parcel of contractual structures on the current or the capital account For this reason, the standard BoP data grossly understate the size and importance of the global IFS market Focusing on the transactional aspects of trade flows would tend to understate IFS demand since this tends to ignore the risk management business which rides on trade flows 4.5 PROJECTIONS FOR REVENUE POTENTIAL OF MUMBAI AS AN IFC 4.5.1 The median (base case) projections involve IFS demand in India rising from $ 13 billion in 2006 to $ 48 billion in 2015 A low-case assumption would see IFS consumption rising from US$ 6.6 to nearly US$ 24 billion over the same period A more optimistic (but not implausible) ‘high-case’ assumption would see it grow from US$ 19.7 to nearly US$ 72 billion 4.6 INSURANCE 4.6.1 4.6.2 294 Finance and insurance have much in common Each provides its customers with tools for managing risks The valuation techniques in both finance and insurance are formally same: The fair value of a security and an insurance policy is the discounted expected value of the future cash flows they provide to their owners The definition of risk is the same: The variation of future results (cash flows) from expected values Finally, the management of insurable and financial risks rely on the same two fundamental concepts: risk pooling and risk transfer Since the early 1990’s, we have seen substantial convergence between finance and insurance A shortage of property and liability insurance in the 1980s forced many corporate insurance customers to consider alternatives to traditional insurance, such as selfinsurance, captive insurers, and contingent borrowing arrangements to finance losses Investment bankers and insurance brokers provided many of these alternatives The demand for catastrophe insurance in the 1990s led to the development of options and futures for this type of insurance Investment banks, sometimes with insurance company or insurance broker partners, formed subsidiaries to offer catastrophe and other high-demand coverage through new financing arrangements FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE 4.6.3 Life insurers have developed products with embedded options on stock portfolios Insurers have begun to use structured securities, such as bonds with indexed coupons, in their investment portfolios 4.6.4 Thus, in the 1990s, financial markets offered products for managing risks traditionally handled by insurers The high demand for catastrophe insurance on property started the movement We now see convergence in the investment markets as well as in various new alliances, partnerships and joint ventures 4.7 INTEGRATION AND GLOBALIZATION OF FINANCIAL SERVICES 4.7.1 C hanging customer needs, more knowledgeable and demanding customers, new technology, liberalization, deregulation, and a combination of other forces are blurring the lines between financial products, institutions, sectors, and countries Regulators are responding to market pressures by allowing more inter-sectoral competition Banks, securities firms, insurance companies, and other financial intermediaries increasingly compete with each other by offering similar products and services and by entry into fields previously reserved for one sector only 4.7.2 Financial services integration occurs when financial products and services traditionally associated with one class of financial intermediaries are distributed by another class of financial intermediaries 4.7.3 Financial services convergence is the tendency of financial products and services traditionally one sector to take on characteristics traditionally observed with financial products and services of another financial services sector 4.7.4 Convergence occurs through customer demand across traditional sector lines Examples include the introduction by insurance companies of variable (unit linked) life and annuity products that contain both insurance and securities features Another burgeoning area is the banking industry’s creation of securitized mortgage and corporate debt portfolios, which involves packaging a group of mortgages or other loans into marketable securities that are sold to investors 4.7.5 As banks, securities firms, and insurers construct products and offer services that resemble the features of their competitors, product convergence will be an important driving force toward financial services integration 4.7.6 This integration gave birth to financial services conglomerates A Financial services conglomerate is a firm or group of firms under common control which offers financial services that extend beyond the traditional boundaries of any one sector The two most commonly discussed arrangements are bancassurance and universal banks 4.7.7 Bancassurance describes arrangements between banks and insurers for the sale of insurance through banks, wherein insurers are primarily responsible for production and banks are primarily responsible for distribution 4.7.8 Universal banks are financial intermediaries that typically offer commercial and investment banking services, and also insurance FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE 295 ... 10% International Finance 10% Sources of International Finance 5% International Monetary and Financial System 5% 10 5% Overview of Financial Management Finance and Related Disciplines Scope of Financial. .. power.” FINANCIAL MA NAGEMENT & INTERNATIONAL FINANCE 11 SECTION -2 SCOPE OF FINANCIAL MANAGEMENT This Section include • • Scope of Financial Management: Expanding Scope of Financial Management: ... Market International Financial Services and Insurance: Important issues and features PAPER - 12 FINANCIAL MANAGEMENT AND INTERNATIONAL FINANCE Contents Study Note - Overview of Financial Management