Foreign Sources of Finance

FINANCIAL MANAGEMENT

INTRODUCTION

• Countries like India have to depend on foreign capital for financing their development programs as they suffer from low level of income and low level of capital accumulation.

• The degree of dependence varies from country to country depending upon its level of mobilization of domestic capital, technology development.

Foreign Sources Of Finance

• Official Foreign Sources of Finance• Non Official Foreign Sources of Finance

NECESSITY OF FOREIGN SOURCES OF FINANCE

• Lack of Domestic Sources – Foreign Sources of finance is required to meet the huge requirements of development projects in the path of rapid economic development and industrialization.

• The Initial Risk - Due to lack of experience, expertise and heavy initial risk, there is always a lack of flow of domestic capital into lines of production. The foreign sources of finance taking initial risk stimulates the flow of domestic capital and stock entrepreneurship.

• Balance of Payment Support - Foreign sources of finance is needed to face the crisis of balance of payments due to heavy imports of capital goods, technical know-how, spare parts and even industrial raw materials.

• The Technology Gap - Lot of technology gap which necessitates import of foreign technology. Such technology usually comes along with foreign capital in the form of private foreign investment or foreign collaborations.

OFFICIAL FOREIGN SOURCES OF FINANCE

• Foreign Collaboration: In India joint participation of foreign and domestic capital has been quite common in recent years. Foreign collaboration could be either in the form of joint participation between private firms, or between foreign firms and Indian Government, or between foreign governments and Indian Government.

• NRI Deposits and Investments: Non-resident Indian have always been making a contribution in economy. Government has been making efforts to encourage their deposits and investments.

• Bilateral Government Funding Arrangement: Generally, advanced countries provide aid in the form of loans and advances, grants, subsidies to governments of under-developed and developing countries.

• Loans from International Financial Institutions : International Bank for Reconstruction and Development (IBRD), International Monetary Fund (IMF), Asian Development Bank (ADB), and World Bank have been the major source of external finance to India.

EXTERNAL COMMERCIAL BORROWINGS (ECB)

• External Commercial Borrowings (ECBs) include bank loans, suppliers' and buyers' credits, fixed and floating rate bonds (without convertibility) and borrowings from private sector windows of multilateral Financial Institutions such as International Finance Corporation. Euro-issues include Euro-convertible bonds and GDRs.

In India, External Commercial Borrowings are being permitted by the Government for providing an additional source of funds to Indian corporates and PSUs for financing expansion of existing capacity and as well as for fresh investment, to augment there sources available domestically. ECBs can be used for any purpose (rupee-related expenditure as well as imports) except for investment in stock market and speculation in real estate.

EXTERNAL COMMERCIAL BORROWINGS (ECB) ARE DEFINED TO INCLUDE

• Commercial bank loans

• Buyer’s credit

• Supplier’s credit

• Securitized instruments such as floating rate notes, fixed rate bonds etc., credit from official export credit agencies,

• Commercial borrowings from the private sector window of multilateral financial institutions such as IFC, ADB, AFIC, CDC etc.

• Investment by Foreign Institutional Investors (FIIs) in dedicated debt funds

• Applicants are free to raise ECB from any internationally recognized source like banks, export credit agencies, suppliers of equipment, foreign collaborations, foreign equity - holders, international capital markets etc.

NON OFFCIAL FOREIGN SOURCES OF FINANCE

Foreign direct investment (FDI) or foreign investment refers to long term participation by country A into country B. It usually involves participation in management, joint-venture, transfer of technology and expertise.

There are two types of FDI: inward foreign direct investment and outward foreign direct investment, resulting in a net FDI inflow (positive or negative) and "stock of foreign direct investment", which is the cumulative number for a given period. Direct investment excludes investment through purchase of shares.

A foreign direct investor may be classified in any sector of the economy and could be any one of the following:

• An individual, a group of related individuals, an incorporated or unincorporated entity, a public company or private company, a group of related enterprises, a government body, an estate (law), trust or other social institution, any combination of the above.

CONTD…

• Foreign Institutional Investors (FII) are organizations which pool large sums of money and invest those sums in securities, real property and other investment assets. They can also include operating companies which decide to invest its profits to some degree in these types of assets.

• Types of typical investors include banks, insurance companies, retirement or pension funds, hedge funds, investment advisors and mutual funds. Their role in the economy is to act as highly specialized investors on behalf of others. For instance, an ordinary person will have a pension from his employer

• Institutional investors will have a lot of influence in the management of corporations because they will be entitled to exercise the voting rights in a company. They can actively engage in corporate governance. Furthermore, because institutional investors have the freedom to buy and sell shares, they can play a large part in which companies stay solvent, and which go under. Influencing the conduct of listed companies, and providing them with capital are all part of the job of investment management.

EURO ISSUE

Depository Receipt

ADR

GDR

FCCB

AMERICAN DEPOSITARY RECEIPT (ADR)

• A negotiable certificate issued by a U.S. bank representing a specified number of shares (or one share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas. ADRs help to reduce administration and duty costs that would otherwise be levied on each transaction.

There are three different types of ADR issues: • Level 1 - This is the most basic type of ADR where foreign companies either don't

qualify or don't wish to have their ADR listed on an exchange. Level 1 ADRs also have the loosest requirements from the Securities and Exchange Commission (SEC).

• Level 2 - This type of ADR is listed on an exchange or quoted on Nasdaq. Level 2 ADRs have slightly more requirements from the SEC, but they also get higher visibility trading volume.

• Level 3 - The most prestigious of the three, this is when an issuer floats a public offering of ADRs on a U.S. exchange. Level 3 ADRs are able to raise capital and gain substantial visibility in the U.S. financial markets.

GLOBAL DEPOSITARY RECEIPT (GDR)

• A bank certificate issued in more than one country for shares in a foreign company. The shares are held by a foreign branch of an international bank. The shares trade as domestic shares, but are offered for sale globally through the various bank branches.

• A financial instrument used by private markets to raise capital denominated in either U.S. dollars or euros.

FOREIGN CURRENCY CONVERTIBLE BOND - FCCB• A type of convertible bond issued in a currency different than the issuer's domestic currency. It

acts like a bond by making regular coupon and principal payments, but these bonds also give the bondholder the option to convert the bond into stock.

• A foreign currency convertible bond (FCCB) is a type of corporate bond issued by an Indian listed company in an overseas market and hence, in a currency different from that of the issuer. The highlight of the FCCB, however, is the option of converting the bonds into equity at a price determined at the time the bond is issued.

• It also has the benefits of a debt instrument as it includes guaranteed returns or yields which are payable in foreign currency.

• FCCBs have a maturity period of about five years during which no call or put option can be exercised.

• Earlier this week, the RBI announced plans to withdraw the facility of allowing companies to buy back FCCBs from January. This is line with the improving economy as well as buoying stock prices.

• In fact, a few companies, including L&T , Tata Power and Rai Agro, have started the process of issuing FCCBs for capital inflow in the last two months, while Unitech is in the process of getting approvals.

PRO’S OF FCCB:• FCCB’s are much cheaper than other forms of debt instruments simply because it offers

the advantage of equity conversion. Normally FCCB’s are issued at the cost, which is at least 30-50% lower than the cost of other debt instruments issued by them.

• Raising finance is considered to be beneficial to both investors and issuers. This is mainly because investors get an opportunity to convert the bond in to stock and thus become part owners of the company.

• Investors not only get the benefit of capital protection, but also an opportunity to profit from the price appreciation of company’s shares after conversion. Whereas as far as companies are concerned, a low cost debt instrument will definitely give a boost to their margins.

CON’S OF FCCB:• FCCB’s are considered to be perfect source of financing in the rising market. This

is mainly because investors will get the opportunity to take advantage of price rise in case of conversion.

• Company issuing FCCB’s will face exchange risk, simply because the repayment to bond holders will be done in foreign currency, which are quiet volatile.

• FCCB’s will be shown as debt in the company’s books until they are completely redeemed or converted. This would impact the debt equity ratio of the company.

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