23 Foreign Capital Flows

Dr. Savita

1. Learning Objective

After completing this module, you will be able to:

i. Understand the meaning and concept of Foreign Capital Flows

ii. Understand the importance of Foreign Capital Flows

iii. Know about the factors affecting Foreign Capital Flows

iv. Understand about the problems in Foreign Capital Flows and

v. Know about various instruments for raising foreign capital

2. Introduction

Over recent decades, there has been a steady increase in cross-border financial flows around the world. With the rapidly changing world economy, every country around the globe is trying to integrate its economy with rest of the world, leading to a higher standard of living. In other words, competition, gains in productivity, lower trade barriers and lower cost of external financing on a worldwide basis are the key factors that have led to growth in world trade and rising standards of living. A key feature of global financial integration during the past three decades is the shift in the composition of capital flows to developing and emerging market economies.

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Foreign Capital flows have been playing a key role in promoting international business and co-operation among different countries. Almost every developed country of the world in its initial stages of development had made use of foreign capital to make the deficiency of its domestic savings. In the 17th and 18th century, England borrowed from Holland and in the 19th and 20th century England gave loans to many countries. US, the richest country of the world, had borrowed heavily in the 19th century and now, it has become the biggest lender country of the world. US provides facilities for ﬁnancing foreign trade transactions of different countries and creates the environment for lending and borrowing internationally. The capital transactions take place through global integration of ﬁnancial instruments and capital ﬂows between different countries.

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The ﬁnancial market in the US is one of the most powerful international ﬁnancial markets. It has many innovative instruments which attracts the finance from global players. The Euro market is a major global market. The Japanese market has also many funding instruments of which Samurai bonds are the most popular foreign Yen bonds. Similarly, German market and Swiss financial market are also an important financial markets of the world. The borrowers in this market are banks, corporate organization, government and other countries. The Swiss market is attractive because it has political stability and a very high rate of savings. The Australian market is known for offshore bonds. Their Yankee Kangaroo bonds are well known in the international markets especially in the American, Asian and Euro market. The London Money Market is the most signiﬁcant ﬁnancial market for pound sterling. Thus, foreign capital flows have been significant in promoting integration of financial markets.

3. Meaning of Foreign Capital

Foreign capital refers to the investment of capital by a foreign government, institution, private individuals, international organisation in a country. Foreign capital includes foreign aid, commercial borrowings and foreign investment. Foreign aid includes foreign grants, concessional loans etc. Foreign capital is invested in the form of foreign currency, foreign machines and foreign technical know-how. Foreign capital has many forms like foreign collaborations, loan in the form of foreign currency, investments in equity capital etc. The government, time to time, frame new policies for attracting foreign capital. It is used as a tool for promoting economic development and to make the balance of payment favourable. India’s domestic financial market comprises the money market, the credit market, the government securities market, the equity market, the corporate debt market and the foreign exchange market.

4. Importance of Foreign Capital

Foreign capital has many beneﬁts. Primarily it integrates different countries together. There is an advantage for both the developed and the developing countries in assisting each other. The developed countries transfer their resources to develop the resources of the developing countries. In return for their services, the developed countries earn a rate of interest on the services and the capital provided by them. Some of the advantages of developing foreign capital in a country are as follows:

i) Integration: Foreign capital helps to internationalize a country from a closed economy to an open one. When a-country has surplus funds to invest, there is an outﬂow of capital from the country and an inﬂow into another country which has paucity for funds.

ii) Technology: Movement of capital creates a network whereby production can be carried out at the country where labour is cheap and technology is backward. Transfer of technology from technologically superior country to at less developed country upgrades the facilities and technologies of the developing country.

iii) Penetration of Products: Foreign capital is able to bring about competition and increase in products by offering choices to the population. New products will create new markets and more business for different countries. Capital will flow from one country to another, wherever it is desired.

iv) Utilization of Productive Capacity: When demand for a product is accelerated internationally, the productive capacity of production units is fully utilized. This will bring about higher proﬁts and will upgrade technologically sound products.

v) Risks Sharing: When two countries decide to do business together, there would be sharing of risks in capital ﬁnancing. This reduces the risk for both the countries.

vi) Competition: A protected market without any competition is unable to grow because of restrictions. In India, government followed pa restrictive policy with the state playing the main role in development. There were many barriers in trade due to restrictions and regulations. The non-competitive attitude became a restraining factor in India’s development. In 1991, it had to liberalize its economic policies to let the market forces operate. Competition through demand and supply conditions opened up the market and encouraged growth in business and development in industries.

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vii) Economic growth: The contribution of foreign investments encourages economic growth in a country through development of skills, technology, communication and computer networks. It also brings about employment. The saving and investment process is accelerated with higher business and greater production.

5. Factors Affecting International Capital Flows

There are many factors which affect international movement of capital from one country to another. Some of them are given as follows:

i) Rate of Interest: The rate of interest attracts the inﬂow of capital. It moves from countries which give a low rate of interest to countries which provide a higher rate of interest on capital ﬂows.

ii) Proﬁt: Proﬁt motivates foreign capital movement. It moves to countries where it expects to earn a good rate of return on its investments. The return follows capital investments with a gestation period. Therefore, attractive returns will create an interest for inﬂows of capital.

iii) Production Costs: Advanced countries look for opportunities to network with developing countries if the costs of production is low in that country. The cost of labour and raw materials is a decision making factor for a country to make its investments. A low cost in production means that the earnings will be high and there will be proﬁtability.

iv) Government Policies: The policies relating to inﬂow of capital encourage or discourage foreign countries to take a decision to invest in a country. If A ﬂexible government policy which is interested in two-way ﬂows is a good precondition for creating a supportive environment for movement of capital. A controlled government with strict policies and closed door interests cannot encourage other countries to bring in capital to its country. The government policies towards tariffs, foreign exchange control, taxation and foreign collaboration should be carefully prepared if a country is keen on international trade.

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v) Political Factors: A country which has political stability can inﬂuence capital movements. Political stability creates an environment of freedom of occupation, security of life and reasonable opportunity for making proﬁts. This brings about an interest from foreign countries in making investments.

vi) Infrastructural Facilities: The facilities provided with respect to movement of goods and human resources, as well as an integrated banking and ﬁnancial system, helps to globalize and integrate global trade and capital movements.

6. Problems in Foreign Capital Flows

Foreign capital ﬂows have many advantages for a country but there are many problems associated with foreign capital ﬂows as discussed next. –

i) Legal Differences: The legal environment of different countries cannot have a similarity because it is country speciﬁc. A law which is required in India may not be required in Singapore because the working system is very different. Before a country decides on capital inﬂows to another country, it must study the legal and economic environment of the country. If a capital ﬂow has been made, and it is not favourable at a later date it will result in a loss. Therefore, after carefully analysing the legal situation of investment, one party should decide in making investment in another country. Sometimes within a country laws are region speciﬁc. In such a case, the foreign investment has to be made after a careful scrutiny of the regional law.

ii) Cultural Differences: The methodology of business depends on the culture of a country. For example, in some countries gifts and commissions are required for conducting business. Another country may not consider such commissions necessary for conducting business. Their policy may be to make direct contracts without any intermediary, whereas the host country may have the cultural system of working through intermediaries.

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iii) Currency Units: The currency units are different from one country to another. This creates problems of currency convertibility due to exchange rate ﬂuctuations. The Euro currency binds 16 countries with one common currency. Hence, business dealings become simpler because converting from one currency to another can bring about losses.

iv) Trade Restrictions: Some countries impose high import duties and are liberal with export duties. Other countries have both high import and high export duties. This creates a problem of capital inﬂows especially in agreements on transfer payments, and sale and purchase of specialized items between them.

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Despite the problems of international capital ﬂows, countries are keen on capital inﬂows and outﬂows. The main reasons which can be attributed to such ﬂows are because of the ‘pull’ and ‘push’ factors. The ‘pull’ factors are the forces of attraction which motivate a country to internationalize itself to earn proﬁt and encourage growth within the country. The ‘push’ factors are the compulsions of saturated markets within a country to internationalize it.

7. Types of International Financial Instruments

Foreign capital is brought into the country through various ﬁnancial instruments. These instruments help the institutions to raise capital in foreign currency. The important instruments used for raising foreign capital are discussed as below:

i) Euro Bonds: The Euro bond market has different kinds of ﬁnancial instruments. The Euro bonds are unsecured and have a ﬁxed rate of interest. They are redeemable at their face value by the borrower on maturity of the bond. The income on these bonds is exempt from tax deducted at source but has to be reported as part of income within the countries regulations. Capital gains and losses are possible and they can be transferred easily from one user to another. Euro bonds can be denominated in more than one currency. It is then called ‘a multi-currency bond’. Euro bonds can also be equity linked bonds, Euro convertible bonds, ﬂoating rate notes and Euro callable bonds. Euro bonds are usually listed on London Stock Exchange.

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ii) Convertible Bonds: The straight bonds were innovated into convertible bonds. These bonds give the option of converting them into equity shares of the borrowing company. The conversion price is ﬁxed above the market price of equity shares on the date of the bond issue. When they are converted, the borrowing company issues new equity shares. Convertible bonds have a lower interest than the straight Euro bonds. The instrument is safer than the straight Euro bonds because investors get foreign exchange protection. The company issuing convertible bonds has the advantage of paying a low rate of interest and receives a premium on the price of shares. The issuing company also has the disadvantage of outﬂow of foreign capital, if the bond is not converted into equity shares at the time of redemption.

iii) Floating Rate Bonds: These bonds are issued for short-term period of time. They have a ﬁxed rate of interest. They can be converted into another bond which has the same nominal value but a longer maturity period. These bonds become ‘Drop Lock Bonds’ when they are automatically converted into ﬁxed bonds with speciﬁed rate of interest.

iv) Multiple Tranche Bonds: These are another form of Euro bonds and are issued in small parts of the total bond. The market conditions prevailing in the country provide the basis of decision making to the issuing company for the initial issue or the part amount to be issued on the bonds. The subsequent issues are based on the perception of the issuer of the bonds. These bonds are issued when the market conditions project a low rate of interest.

v) Currency Option Bonds: The currency option bonds involve more than one currency at a time. The bonds give the investor the freedom of buying the bond in one currency and accepting the interest in another currency. The principal sum and the interest can be paid and received respectively in different countries.

vi) Floating Rate Notes (FRNs): These bonds are little different to the above bonds because they offer adjusted returns periodically. They reﬂect the changes in short-term money markets by adjusting the rate of interest every six months. They resemble Euro dollar bonds in denomination of $1,000 each. The, main difference is that they carry spread or margin above six months London Inter-bank of Rate (LIBOR) for Eurodollar deposits.

vii) Floating Rates Certiﬁcate of Deposits: These ﬁnancial instruments have a ﬂoating rate of interest. They are negotiable instruments and can be transferred from one person to another as they are bearer instruments. They have short-term interest rates of six months which are adjusted through a spread above the inter-bank rate of six months of the US dollar deposits in LIBOR.

viii) Global Bonds: Global bonds were issued by the World Bank in 1990. These bonds were economical, had low transaction, cost and high liquidity. These global bonds-cost only 10 cents for deals of $ 25 million, clearing and settlement cost are also low on these bonds. The number of days for clearing such bonds are also few. It can be borrowed by different currencies depending on the attractive rates of return.

ix) Euro Notes: Euro notes are global bonds and are known as Euro commercial papers. These notes can be underwritten by banks. If notes are underwritten, there is a commitment by the banks to purchase the bonds. If they are not underwritten dealers sell them in the open market. These notes are of short-term duration and do not have any guarantees. The underwritten as well as non-underwritten notes supplement syndicated loans, commercial paper of the US as well as ﬂoating rate notes. In many countries, Euro -notes have been popular and they are legally underwritten by banks. Some countries which use the -Euro notes are the US, Canada, Japan, UK and France. Interest is paid on these notes. The non-bank investors of Euro notes are insurance companies and fund managers.

x) Forward Rate Agreements (FRAs): These are agreements between two counter parties to lend or borrow a principal sum of money. One party wants to protect itself against a future fall of interest rate. The other party is interested in protecting itself against a future rise of interest. Both parties agree to pay an interest rate for a period of three months which would begin after six months. On the maturity date, the difference is paid between the agreed ‘rate and current interest rate. This is similar to a ﬁnancial future contract. It has a ﬁxed settlement date. The FRAs have a maximum trade denominated in USA dollars.

xi) Global Depository Receipts: GDRs are an instrument for raising equity capital by organizations which are in Asian countries. They are placed in the US, Europe and Asia. They have a low cost and help in bringing liquidity. A company usually raises capital simultaneously from two countries. For example, the GDR may be issued in India and simultaneously placed in the US and Europe through one security. The issuer deals with a single depository bank which facilitates the secondary and inter-market trading among investors which are, situated in different countries.

It is a fungible instrument and the issuer does not have any exchange risk. He can freely use the foreign exchange collected from this issue. Government of India allowed Indian companies to mobilize funds from foreign markets through Euro issues of global depository receipts and foreign currency convertible bonds. Companies with a good track record can issue GDR’s for developing infrastructure projects in power, telecommunications, and petroleum and in construction and development of roads, airports and ports in India.

xii) American Depository Receipts: The American depository ‘receipts were started in America in 1920 to invest in overseas markets and to provide a base to non-US companies who wanted to invest in the stock market in the American Depositary Receipts (ADRs) are securities offered by non-US companies who want to list on any of the US exchange. Each ADR represents a certain number of a company’s regular shares. These are deposited in a custodial account in the US. ADRs allow US investors to buy shares of these companies without the costs of investing directly in a foreign stock exchange. ADRs are issued by an approved New York bank or trust company against the deposit of the original shares. When transactions are made, the ADRs change hands, not the certificates. This eliminates the actual transfer of stock certificates between the US and foreign countries.

Summary:

In this module we have learnt about the meaning and concept of foreign capital flows, its importance, factors affecting foreign capital flows, problems in foreign capital flows and types of instruments used for raising foreign capital. Foreign capital refers to the investment of capital by a foreign government, institution, private individuals, international organisation in a country. Foreign capital includes foreign aid, commercial borrowings and foreign investment. Foreign aid includes foreign grants, concessional loans etc. Foreign capital is invested in the form of foreign currency, foreign machines and foreign technical know-how. Foreign capital has many forms like foreign collaborations, loan in the form of foreign currency, investments in equity capital etc. Foreign Capital flows have been playing a key role in promoting international business and co-operation among different countries. Almost every developed country of the world in its initial stages of development had made use of foreign capital to make the deficiency of its domestic savings. It is used as a tool for promoting economic development and to make the balance of payment favourable.

Suggested Readings

Sundharam K.P.M. and Datt Ruddar (2010). Indian Economy, S. Chand & Sons, New Delhi.
Sharan Vyptakesh (2003). International Business: Concept, Environment and Strategy. Pearson Education, New Delhi
Cullen. (2010). International Business. Routledge.
Bennett Roger (2011). International Business. Pearson Education, New Delhi
Paul Justin (2010). Business Environment-Text and Cases. Tata McGraw Hill, New Delhi.
Cherunilam Francis (2010). International Business. Prentice Hall of India Private Limited. New Delhi.
Cherunilam Francis (2013). Global Economy and Business Environment. Himalaya Publishing House, New Delhi.
Levi MauriceD. (2009). International Finance. Routledge.
Conklin David w. (2011). The Global Environment of Business. Sage Publications.
Mithani D M. (2009). Economics of Global Trade and Finance. Himalaya Publishing House New Delhi.
Cherunilam Francis (2011). International Business Environment. Himalaya Publishing House, New Delhi.
Saleem Shaikh (2010). Business Environment. Pearson Education, New Delhi.