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?
Thursday, December 11, 2008
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
Tuesday, December 9, 2008
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.
Monday, December 8, 2008
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).
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).
Sunday, December 7, 2008
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.
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.
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.
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