Newspaper Article

There are two interesting articles that appeared in the press in the last couple of days. Friday's New York Times article titled "Chinese Savings Helped Inflate American Bubble" is long but instructive. It demonstrates how all nations are linked to each other in this global economy. Yesterday' Wall Street Journal included a major long article titled "The Isle That Rattled the World ". Please make sure to read at least one of these articles.

Not Quite Global Finance

Some years ago I was frequently hosting in my office a representative of one of the largest textbook publishers. The guy is no longer with this company and, yet, he felt compelled to write me for advice regarding the situation in capital markets. Here is his message:


It has been a long time. I hope you and your loved ones are doing well. I was just contemplating the repercussions of an over supply of T bills and thought you might explain what the treasury and fed can do to counter this serious problem. I thought at first the fed could print more money which may result later in hyper inflation, but I still need your opinion. Please see the Bloomberg article below:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aiw3cE2FfsLU&refer=home

Thanks for taking the time to respond.


Following is my response:
Hi:
Good hearing from you. I believe the Treasury is in a bind. Currently, it is able to sell a bunch of T-bills because of the flight-to-safety effect; investors, motivated by anxiety regarding capital markets, are more than glad to lend their money to the Treasury at practically zero interest. Should the Treasury be successful in comforting investors, interest rates will go up as they will require higher rates. At some point, to avoid too high of interest rates, the Fed will have to interfere by printing money. High inflation might follow. I was aware of this possibility in September when I moved a bunch of money into TIPS (Treasury Inflation Protected Securities) and promptly lost 7%.Markets' fear of deflation pushed down the value of such inflation-linked securities (they pay less interest when the CPI declines though their face value cannot sink below 100%). Markets have reversed themselves to a large extent. My current loss on such TIPS has declined to just 1.2%.
At my stage of life, my goal is to guard the purchasing power of my savings. I was not hyperventilating over the 7% loss because, had deflation taken place, my consumption would have cost less. In this sense, I was hedged. Since you are far from retirement and you might need the money for your daughters' education, I am not sure that long-term TIPS are for you. You may want to consider I-Bond sold directly to the public by the Federal Reserve Bank (of Richmond, given your Roanoke domicile). I believe that currently, you can do so up to $10,000 per year (down from $30,000 a couple of years ago). Your wife can purchase a similar amount.

I Hope all is well with you.

Happy New Year.

A concluding remark: my students too are invited to write me in the future when they encounter a work or personal life financial dilemmas. I am proud for granting my students five-year warranty on they finance education.

Vareity of WSJ Articles

There are several good articles that you should read in today's Wall Street Journal. Even before you get to the Money and Investments section, you should find in page A12 an article describing (for the n-th time) what the carry trade is all about (I intend to write a special entry on this). The second paragraph refers to the "policy rate". This is no other than the federal funds rate. You might recall how the FRB controls this rate (not always successfully) by lending and borrowing Treasury securities through repurchase agreements (see previous posting on repos). A similar reference to the federal funds rate can be found in page C2 ("For Dollar, December Blues").

Let's move to the Market Place section. The main item is titled: "Siemens to Pay Huge Fine in Bribery Inquiry". Corruption is a major problem in international trade. The book (Bekaert and Hodrick (p. 510) provides a short analysis of this issue. The book mentioned the Transparency International Index. Table 14.1 provides a table of Legal Systems Quality. I fail to see why these measures convey any information. For example, is the U.S. legal system more efficient than Germany because it evicts tenants faster (40 vs. 331 days) or is this a reflection of the fact that capital has more say in our country?
At any rate: The book refers to the Transparency International corruption index. In its 2008, this organization ranked Germany as number 14 in the world in terms of transparency while Argentina is 109. Is a country "transparent" because it gives rather than takes bribes? Another good source is the Global Integrity organization reporting that The wealthier G8 (Investigate!!!)countries suffer from similar corruption challenges as developing countries.
And then there is the Journal Report section whose subject today is Business Insights. Why don't you look into the Global Business article titled: "In Emerging Markets, Know What Your Partner Expects". All of these expectations have something to do with thuggery. The "pleasures" of doing business in emerging markets: first you have to look for a partner who will help you with bribery and then you are pursued by the SEC for paying bribes. Usually the "partner" is the ruler's cousin (as is often the case in Saudi Arabia) isn't that some type of bribery?

Sovereign Risk

Bekaert and Hodrick (p. 508) define sovereign risk as the risk of a government defaulting on its bonds payments (this is different from what appears on Investopedia and YourDictionary). You should read an article in today's Washington post titled:"Calling Foreign Debt 'Immoral' Leader Allows Ecuador to Default". Yesterday's Wall Street Journal also had an auricle on this subject that you might (or not) want to use for your next submission. I am using the Post's article because it relates a comment from a Moody's senior analyst. Well, less than a month ago,Moody's has downgraded Ecuador's sovereign debt but gently: it moved it to Caa1. It was only last April that Moody's still rated Ecuador as B3. At any rate, as you can read in the Post's article, investors have already taken this into consideration and traded this debt at a very deep discount (though not as bad a discount as Moody's stock which lost 75% of its value in the last two years.

The relevant chapter to read is: Chapter 14. BUT: please skip all sections that contain formulas Such as 14.2.

No Extraordinary News

I have not found something of value in today's press. I suggest you watch the Short View from yesterday about the end of the dollar rally.
In a different vein (it has nothing to do with Global Finance)read the press today about the Adventures of Mr. Madoff. The guy stole $50 billion from his customers. These customers included some of the biggest finance brains on Wall Street and, yet, they believed his record of 1.00% to 1.20% (per month ) month after month for years. This is the equivalent of offering the Brooklyn Bridge at a discount

A Common Fallacy Regarding USD "Abroad"

A Tuesday (12/9) column in the New York Times suggested the following partial solution to the current credit crunch: Give U.S. MNC corporations a tax holiday so that they repatriate their foreign retained earnings.
Many U.S. Corporations have foreign subsidiaries that do not use their earnings to pay their American parent company dividends. The writer suggests a tax "amnesty" (since these companies broke no law why is that an amnesty?) that will encourage the U.S parents to order their subsidiaries to start paying dividends. This, according to the writer, will "bring home dollars held abroad without paying corporate taxes of 35%". These extra dollars should supposedly help alleviate the credit crunch.

To understand why this argument is nonsensical you should recall that foreign subsidiaries keep their retained earnings in foreign currencies abroad. For them to bring this money back home they will need to convert it into USD. When selling their foreign currency, these corporations are going to be paid with a check drawn on a U.S. bank. The final outcome of this exercise would therefore be for ownership of these dollars (that are already deposited in a NY bank) to change. No new dollars are added to the banking system and liquidity remains unchanged.
Besides, What is the columnist talking about when he refers to a 35% tax rate? According to the U.S. Tax Code, parent owes no tax on dividends paid by a wholly owned subsidiary. Even dividends from a partially owned subsidiary are not taxed at this rate. Is there any tax accountant in this class who can help me with this?

Chinese Yuan (CHY)

A student sent me the following question:
China for some time has undertaken policies to devalue its currency (speculated to be ~15-40%) to maintain its competitive position in regards to pricing of exports. First question is does China use it reserves to maintain this artificial valuation? Secondly, the money expansion in the Chinese economy could have contributed to the free capital bubble of late; is this a reasonable conclusion?


Here is the story: Until recently, all foreign currency collected by Chinese importers had to be converted in the People Bank of China (PBC) into Yuan at a rate that most economists consider as artificially low. This favorable rate made Chinese goods over-competitive in world markets. The undervaluing policy achieved two things:
1. It kept the Chinese economy humming (full employment is extremely important to the Chinese government)
2. It allowed the People Bank to accumulate huge foreign currency reserves that it invested mostly in the U.S. (this serves as a buffer against quick capital outflow from China)
Look at the above graph extracted from Yahoo Finance. As you can see, the yuan (CHY) was convertible at the People Bank at 8.26 CHY/USD for a long period. Starting in mid 1985, due to pressure from the U.S. and Europe, the People Bank started revaluing the yuan (lower number means more value; member this?). So my answer to this student is: yes, China is maintaining its currency on what most economists consider an artificially low level. But no, it does not use its reserves to do so. It actually accumulates reserves in the process.
A note: because the current global crisis brought about a decline in demand for Chinese manufactured goods, the PBC started recently to, again, let the CHY slip in value to increase demand. It is currently trading at about 6.8563 CHY/USD

China's Currency

Today's Currency section of the WSJ has an article on the status of China's currency (Yuan or Rininmbi; two names for same currency. You may want to complement this article with a short video on the Financial Times Short View section (under the title The China Fear)

Doha Talks

There is a short note in today's WSJ relating to the Doha trade talks. Please read it and connect it with the information provided in our textbook (pp. 3-4). To enhance your understanding, you might want to use a search engine. The list of tariffs levied by the U.S. on foreign goods is just mind boggling. You can access the International Trade Commission's to inspect the list. Note that horses can be imported for free but asses require some tariff!! Likewise, a tariff of 9.9 cents/kg is levied on Brazil nuts while only 4.4 cents/kg should be paid on imported Cashew nuts.

REPO Transactions

Did you know that there is an extremely active market in which banks borrow from (lend to) each other overnight? This market is called the . Banks usually borrow in this market for one of two reasons:
1. They have reserves shortage and borrow in order to reach the reserves ratio required by the FRB (currently, this ratio (reserves to demand deposits) is 10%.
2. When they need to respond to customers' cash needs immediately and simply don't have the money.

One of the most important tools available to the FRB in controlling the money supply in the economy is by intervening in this market. For example: If the FRB aims at increasing the money supply, it should lend money to say security dealers. This loan is made by crediting they accounts in their commercial banks. Banks have now more money to lend and the money supply goes up. To contract the money supply, the FRB will call back such loans. Let's look at the cash flow associated with such a loan:



The problem is that the dealer in the above transaction may default on her loan. The Fed therefore needs some collateral. This is achieved by tailoring this loan as a repurchase agreement:



Note that if the security dealer fails to repay the loan on Tuesday (by repurchasing the securities from the FRB for $10,001,100), the FRB keeps the securities “sold” to it on Monday.

Exercise:
Do you see the similarity between this repurchase agreement and the “forward” transaction executed between Goldman Sachs and in Example 3.7 in the book? (page 89).

Leveraged Buyouts

Here is a short Tutorial about leveraged buyouts (LBO)

An LBO firm (such as Carlyle, the Apollo Group) is acting along the following line:
1. Identify a firm that is inefficiently managed (call it target)
2. Obtain a bridge loan from a bank (say $10 billion)
3. Use the loan to purchase the stock of the target in addition to $0.200 billion of its own equity
4. Once the LBO firm owns 100% of the target's equity, it makes it borrow A LOT (say $9.8 billion)
5. The LBO firm makes target pay it a dividend of $10 billion
6. The LBO firm repays the bank
Final result:
The LBO firm invested $200 million in a highly leveraged target.
If target does well, the LBO firm is bound to double or triple its money. This is usually carried out by selling the levered company to a third party or by selling it in a public stock issuance. If the opposite is true, the target will go bankrupt and the LBO is not likely to recoup its $200 million investment.
A relevant articles from the WSJ are: "The Bell Tolls for Private Equity" and "Appollo VI Faces a a Bumpy Landing"

Where else can the process fail?
By the time the takeover deal is finalized, the bank may withdraw the bridge loan leaving the LBO firm in hot waters.

Foreign Direct Investments

Definition
This term appears in Chapter 1 that I requested you read before our first meeting. As you may recall from this chapter (p. 15) FDI occurs when a company makes a significant investment that leads to a significant ownership (usually >10%) of a company in another country.
Example
BMW establishes a manufacturing facility in South Carolina. It establishes a fully-owned U.S. subsidiary and invests money in it.

In contrast:
Portfolio Investment is an investment that does not result in influencing the foreign company. (see page 119)
Example:
A U.S. mutual fund buys 5% ownership in a Japanese company.


How significant is FDI?
Exhibit 1.6 in the book is supposed to inform us that FDI is really important. Problem is, unless you are a developmental economist, the term in this table make no sense to you (what is the difference between FDI inflows and FDI inward flows for example?). To point out the importance of DFI, I refer you to a very important publication: The Federal Reserve Bank’s Flow of Funds Accounts of the United States. In page 30 of this publication you will find (Line 36) that in the first two quarters of 2008, foreign residents poured $696.8 billion into the U.S. in the form of DFI while, from line 56, you may learn that during the same two quarters U.S. residents invested $618.60 billion abroad. In sum, we are talking big bucks here.

Argument in favor of FDI (bottom of page 27)
1. Allocative efficiency (is that English?). Employing capital when it is most
productive.
This is nothing but a code word for employing labor where it is cheapest.

2. Technology spillover. Proponents claim that when U.S. companies manufacture in China, the host country gain access to U.S. technology not available to China.
Why is that good? Usually, host country operators will sooner or later confiscate this new technology and compete with the U.S. directly.

3. Additional savings Missing from the book is an obvious argument: to sell in Thailand for example and avoid shipping cost, you may want to establish a plant in Thailand.

Before committing to any FDI, the risk associated with such investments should be fully understood. This risk is usually referred to as country risk (the whole of Chapter 14 is dedicated to this subject. READ IT!!!)

Country Risk is usually divided into two components:
a. Political risk
i. Probability of nationalization. See the case of how Exxon has been kicked out of Venezuela. So the book’s claim that “outright expropriations have been rare in recent times” is somewhat outdated. You may also want to learn about the travails of BP in Russia
ii. Contract repudiation. See examples in the book (page 509).
iii. Taxes and egulations. In addition to the examples in the book, see yesterday’s WSJ article (12/6/08) about how the Indian tax authority decided to levy a $2 billion retroactive capital gains tax on Vodafone.( “Vodafone's Tax Bill to Slow Deals in India”)
iv. Exchange controls
v. Ethnic unrest
vi. Home country restrictions

b. Economic/financial risk
See factors in page 508 in the book.