What is Foreign Trade Finance and FDI

FOREIGN TRADE FINANCE

Trade finance is the financing of international trade flows. It represents the financial instruments and products that are used by companies to facilitate international trade and commerce. There are two players in a trade transaction: 

(1) an exporter, who requires payment for their goods or services, 

(2) an importer who wants to make sure they are paying for the correct quality and quantity of goods. Trade finance exists to mitigate, or reduce, the risks involved in an international trade transaction. Trade finance makes it possible and easier for importers and exporters to transact business through trade. Trade finance is an umbrella term meaning it covers many financial products that banks and companies utilize to make trade transactions feasible.

As international trade takes place across borders, with companies that are unlikely to be familiar with one another, there are various risks to deal with. These include:

Payment risk: Will the exporter be paid in full and on time? Will the importer get the goods they wanted?

Country risk: A collection of risks associated with doing business with a foreign country, such as exchange rate risk, political risk and sovereign risk. For example, a company may not like exporting goods to certain countries because of the political situation, a deteriorating economy, the lack of legal structures, etc.

Corporate risk: The risks associated with the company (exporter/importer): what is their credit rating? Do they have a history of non-payment?

To reduce these risks, banks – and other financiers – have stepped in to provide trade finance products.

 

The parties involved in trade finance are numerous and can include:

•        Banks

•        Trade finance companies

•        Importers and exporters

•        Insurers

•        Export credit agencies and service providers

INTERNATIONAL TRADE PAYMENT METHODS

The five major processes of transaction in international trade are the following −

1.      Prepayment: Prepayment occurs when the payment of a debt or instalment payment is done before the due date. A prepayment can include the entire balance or any upcoming part of the entire payment paid in advance of the due date. In prepayment, the borrower is obligated by a contract to pay for the due amount. Examples of prepayment include rent or loan repayments.

2.      Letter of Credit: A Letter of Credit is a letter from a bank that guarantees that the payment due by the buyer to a seller will be made timely and for the given amount. In case the buyer cannot make payment, the bank will cover the entire or remaining portion of the payment. 3. Drafts

Sight Draft − It is a kind of bill of exchange, where the exporter owns the tle to the transported goods until the importer acknowledges and pays for them. Sight drafts are usually found in case of air shipments and ocean shipments for financing the transactions of goods in case of international trade.

Time Draft − It is a type of foreign check guaranteed by the bank. However, it is not payable in full until the duration of time after it is obtained and accepted. In fact, time drafts are a short-term credit vehicle used for financing goods’ transactions in international trade.

4.      Consignment: It is an arrangement to leave the goods in the possession of another party to sell. Typically, the party that sells receives a good percentage of the sale. Consignments are used to sell a variety of products including artwork, clothing, books, etc. Recently, consignment dealers have become quite trendy, such as those offering specialty items, infant clothing, and luxurious fashion items.

 

5.      Open Account: Open account is a method of making payments for various trade transactions. In this arrangement, the supplier ships the goods to the buyer. After receiving and checking the concerned shipping documents, the buyer credits the supplier's account in their own books with the required invoice amount. The account is then usually settled periodically; say monthly, by sending bank drafts by the buyer, or arranging through wire transfers and air mails in favour of the exporter.

TRADE FINANCE METHODS

The most popular trade financing methods are the following −

1. FACTORING: Factoring is a financial service in which the business entity sells its bill receivables to a third party at a discount in order to raise funds. Factoring involves the selling of all the accounts receivable to an outside agency. Such an agency is called a factor. The seller makes the sale of goods or services and generates invoices for the same. The business then sells all its invoices to a third party called the factor. The factor pays the seller, after deducting some discount on the invoice value. However, the factor does not make the payment of all invoices immediately to the seller. Rather, it pays only up to 75 to 80 percent of the invoice value after deducting the discount. The remaining 20 to 25 percent of the invoice value is paid after the factor receives the payments from the seller’s customers. It is called factor reserve.

FACTORING PROCESS

The following steps are involved in the process of factoring:

§  The seller sells the goods to the buyer and raises the invoice on the customer.

§  The seller then submits the invoice to the factor for funding. The factor verifies the invoice.

§  After verification, the factor pays 75 to 80 percent to the client/seller.

§  The factor then waits for the customer to make the payment to him.

§  On receiving the payment from the customer, the factor pays the remaining amount to the client.

§  Fees charged by factor or interest charged by a factor may be upfront i.e. in advance or it may be in arrears. It depends upon the type of factoring agreement.

§  In case of non – recourse factoring services factor bears the risk of bad debt so in that case factoring commission rate would be comparatively higher.

§  The rate of factoring commission, factor reserve, the rate of interest, all of them is negotiable. These are decided depending upon the financial situation of the client.

 

 

ADVANTAGES OF FACTORING

The following are the advantages:

§  It reduces the credit risk of the seller.

§  The working capital cycle runs smoothly as the factor immediately provides funds on the invoice.

§  Sales ledger maintenance by the factor leads to a reduction of cost.

§  Improves liquidity and cash flow in the organization.

§  It leads to improvement of cash in hand. This helps the business to pay its creditors in a timely manner which helps in negotiating better discount terms.

§  It reduces the need for the introduction of new capital in the business.

§  There is a saving of administration or collection cost.

 

DISADVANTAGES OF FACTORING

The following are the disadvantages:

§  Factor collecting the money on behalf of the company can lead to stress in the company and the client relationships.

§  The cost of factoring is very high.

§  Bad behaviour of factor with the debtors can hamper the goodwill of the company.

§  Factors often avoid taking responsibility for risky debtors. So the burden of managing such debtor is always in the company.

§  The company needs to show all the details about company customers and sales to factor.

2.      Letters of Credit: A letter of credit or "credit letter" is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. It may be offered as a facility.

Because a letter of credit is typically a negotiable instrument, the issuing bank pays the beneficiary or any bank nominated by the beneficiary. If a letter of credit is transferable, the beneficiary may assign another entity, such as a corporate parent or a third party, the right to draw. Banks also collect a fee for service, typically a percentage of the size of the letter of credit. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits oversees letters of credit used in international transactions. There are several types of letters of credit available.

3.      Bankers Acceptance

A banker’s acceptance (BA) is a short-term debt instrument that is issued by a firm that guarantees payment by a commercial bank. BAs are used by firms as a part of the commercial transaction. These instruments are like T-Bills and are often used in case of money market funds.

BAs are also traded at a discount from the actual face value on the secondary market. This is an advantage because the BA is not required to be held until maturity. BAs are regular instruments that are used in international trade.

For the company that issues it, a banker's acceptance is a way to pay for a purchase without borrowing to do so. For the company that receives it, the bill is a guaranteed form of payment.

yA banker's acceptance requires the bank to pay the holder a set amount of money on a set date. They are most commonly issued 90 days before the date of maturity but can mature at any later date from one to 180 days. They are typically issued in multiples of $100,000.

BAs are issued at a discount to their face value. Thus, like a bond, they earn a return. They also can be traded like bonds in the secondary money market.

There is no penalty for cashing them in early, except for the lost interest that would have been earned had they been held until their maturity dates.

 

4.      Working Capital Finance

Working capital finance is a process termed as the capital of a business and is used in its daily trading operations. It is calculated as the current assets minus the current liabilities. For many firms, this is fully made up of trade debtors (bills outstanding) and the trade creditors (the bills the firm needs to pay).

5.      Forfaiting

Forfaiting is a means of financing that enables exporters to receive immediate cash by selling their medium and long-term receivables—the amount an importer owes the exporter—at a discount through an intermediary. The exporter eliminates risk by making the sale without recourse. It has no liability regarding the importer's possible default on the receivables.

The forfaiter is the individual or entity that purchases the receivables, and the importer then pays the receivables amount to the forfaiter. A forfaiter is typically a bank or a financial firm that specializes in export financing. 

A forfaiter's purchase of the receivables expedites payment and cash flow for the exporter. The importer's bank typically guarantees the amount.

The purchase also eliminates the credit risk involved in a credit sale to an importer. Forfaiting facilitates the transaction for an importer that cannot afford to pay in full for goods upon delivery. It is most commonly used in cases of large, international sales of commodities or capital goods where the price exceeds $100,000.

The importer's receivables convert into a debt instrument that it can freely trade on a secondary market. The receivables are typically in the form of unconditional bills of exchange or promissory notes that are legally enforceable providing security for the forfaiter or a subsequent purchaser of the debt.

These debt instruments have a range of maturities from as short as one month to as long as 10 years. Most maturities fall between one and three years from the time of sale.

Advantages of Forfaiting

-        Forfaiting eliminates the risk that the exporter will receive payment. 

-        The practice also protects against credit risk, transfer risk, and the risks posed by foreign exchange rate or interest rate changes.

-        Forfaiting simplifies the transaction by transforming a credit-based sale into a cash transaction. This credit-to-cash process gives immediate cash flow for the seller and eliminates collection costs. Additionally, the exporter can remove the accounts receivable, a liability, from its balance sheet.

-        Forfaiting is flexible. A forfaiter can tailor its offering to suit an exporter's needs and adapt it to a variety of international transactions. Exporters can use forfaiting in place of credit or insurance coverage for a sale. 

-        Forfaiting is helpful in situations where a country or a specific bank within the country does not have access to an export credit agency (ECA). 

-        The practice allows an exporter to transact business with buyers in countries with high levels of political risk.

Disadvantages of Forfaiting

-        Forfaiting mitigates risks for exporters, but it is generally more expensive than commercial lender financing leading to higher export costs. These higher costs are generally pushed onto the importer as part of the standard pricing.

-        Additionally, only transactions over $100,000 with longer terms are eligible for forfaiting, but forfaiting is not available for deferred payments.

-        Some discrimination exists where underdeveloped countries are concerned compared to Western countries. For example, only selected currencies are taken for forfaiting because they have international liquidity. 

-        Lastly, there is no International Credit Agency that can provide guarantees for forfaiting companies. This lack of guarantee affects long-term forfaiting.

FACTORING	FORFAITING
Factoring is a financial arrangement whereby a supplier of goods sells its trade receivables to the factor at discounted price for immediate cash payment.	Forfaiting is selling the claim on trade receivables by an exporter to a forfeiter at discounted price for immediate cash payment.
Factoring can be with or without recourse	Forfaiting is always without recourse
Factoring refers to discounting of trade receivables of short maturities.	Although discounted receivables often have maturities over medium terms of 1 to 3 years they can be as short as 1 month or as long as 10 years.
Factoring involves trade receivable on ordinary goods.	Forfaiting usually takes place on trade receivable on capital goods, but it can be applied to a wide range of trade related and even purely financial receivables and payment instruments.
Factoring transaction does not set up in Negotiable Instrument.	Forfaiting establishes on negotiable instrument.
Factoring does not deal in secondary market.	Forfaiting may involve dealing in secondary market
Factor disburses  payment of the invoices immediately  to the customer, which will be usually up to 80% of their value,	The exporter  gets  100 percent financing , and  also escapes from various types of risks involved in export business viz. interest rate risk, currency risks, credit risk and political risk etc. involved in deferred payments.

 

 

6. Countertrade

Countertrade is a reciprocal form of international trade in which goods or services are exchanged for other goods or services rather than for hard currency. This type of international trade is more common in developing countries with limited foreign exchange or credit facilities. Countertrade can be classified into three broad categories: barter, counterpurchase, and offset.

In any form, countertrade provides a mechanism for countries with limited access to liquid funds to exchange goods and services with other nations. Countertrade is part of an overall import and export strategy that ensures a country with limited domestic resources has access to needed items and raw materials. Additionally, it provides the exporting nation with an opportunity to offer goods and services in a larger international market, promoting growth within its industries.

1.      Barter: Bartering is the oldest countertrade arrangement. It is the direct exchange of goods and services with an equivalent value but with no cash settlement. The bartering transaction is referred to as a trade. For example, a bag of nuts might be exchanged for coffee beans or meat.

2.      Counterpurchase: Under a counterpurchase arrangement, the exporter sells goods or services to an importer and agrees to also purchase other goods from the importer within a specified period. Unlike bartering, exporters entering into a counterpurchase arrangement must use a trading firm to sell the goods they purchase and will not use the goods themselves.

3.      Offset: In an offset arrangement, the seller assists in marketing products manufactured by the buying country or allows part of the exported product's assembly to be carried out by manufacturers in the buying country. This practice is common in aerospace, defense and certain infrastructure industries. Offsetting is also more common for larger, more expensive items. An offset arrangement may also be referred to as industrial participation or industrial cooperation.

 

Benefits and Drawbacks

A major benefit of countertrade is that it facilitates the conservation of foreign currency, which is a prime consideration for cash-strapped nations and provides an alternative to traditional financing that may not be available in developing nations. Other benefits include lower unemployment, higher sales, better capacity utilization, and ease of entry into challenging markets.

A major drawback of countertrade is that the value proposition may be uncertain, particularly in cases where the goods being exchanged have significant price volatility. Other disadvantages of countertrade include complex negotiations, potentially higher costs and logistical issues.

Additionally, how the activities interact with various trade policies can also be a point of concern for open-market operations. Opportunities for trade advancement, shifting terms, and conditions instituted by developing nations could lead to discrimination in the marketplace.

DOCUMENTARY COLLECTIONS IN INTERNATIONAL TRADE

A documentary collection is a process by which an exporter's bank collects funds from the importer's bank in exchange for documents detailing shipped merchandise. A documentary collection is a trade transaction in which exporters allow their bank to act as a collection agent for payment of shipped goods to the buyer. A documentary collection (D/C) is so-called because the exporter receives payment from the importer in exchange for the shipping documents, with the funds and documents channelled through their respective banks. Shipping documents are documents required for the buyer to clear customs and take delivery of the goods. Shipping documents include a commercial invoice, certificate of origin, insurance certificate, and packing list. A key document in documentary collections is the bill of exchange or draft, which is a formal demand for payment from the exporter to importer.

Types of Documentary Collections

D/Cs can be classified into two types, depending on when the payment is made to the exporter:

1.      Documents against payment (D/P): It requires the importer to pay the face amount of the draft at sight. In other words, the payment must be made to the bank before the buyer's bank or collecting bank releases the documents. A D/P is also called a Sight Draft or Cash against Documents.

2.      Documents against acceptance (D/A) : It requires the importer to pay on a specified future date. A D/A/ involves the buyer or importer to make a promise to pay, which is called a time draft. Once the buyer accepts the time draft and the promise to pay, the bank releases the documents to the buyer.

Special Considerations: The Documentary Collection Process

The D/C process involves the exporter (or the seller), the importer (or the buyer), the remitting bank (or the seller's bank), and the collecting bank (or the buyer's bank). Below is the step-by-step process:

1.      The sale is made when the buyer and seller agree on the amount to be paid, the shipping details, and that the transaction will be a documentary collection. Then, the exporter delivers the goods to the port or location where the merchandise will be exported from, which is usually through a freight forwarder.

2.      The documents are prepared and sent to the exporter's bank, which is also known as the remitting bank. The exporter's bank then forwards the documents to the importer’s bank, which is known as the collecting bank.

3.      The importer's or buyer's bank receives the documents and notifies the buyer that documents have been received. The buyer's bank requests payment from the buyer in exchange for the documents.

4.      The buyer might pay the collecting bank on sight or called cash against documents, or the buyer might agree to accept a time draft whereby the buyer will pay at a future date. If the importer signs the time draft, it becomes a binding obligation to pay by the due date shown on the draft.

5.      Once the buyer's bank has been paid, or the buyer has accepted the time draft, the bank releases the documents to the buyer. The buyer takes the documents to the point of entry or shipment such as a port and uses the documents to collect the merchandise.

6.      The buyer's bank transfers the funds to the exporter's bank or notifies the exporter's bank that the time draft has been accepted. The exporter's bank then pays the exporter once funds have been collected from the buyer's bank.

Other Considerations: The Risks of Documentary Collections

The exporter's risk is higher with a time draft versus a sight draft. The exporter might not get paid in the case of a time draft. Also, the buyer's bank would have released the documents with the buyer's acceptance of the time draft meaning the buyer would have the merchandise.

If the transaction is a sight draft, the seller's risk is limited if the buyer didn't pay. With a sight draft, the buyer would not have access to the goods because the buyer's bank would not release the documents without payment. The seller would have to find another buyer or pay to have the goods shipped back home.

Unfortunately, D/Cs can be exploited by fraudsters posing as either the exporter or importer. As a result, D/Cs are not recommended for exports to nations that are politically or economically unstable. D/Cs are best suited for established trade relationships in sound export markets, and for transactions involving ocean shipments rather than air or land shipments, which are more difficult to control.

FOREIGN DIRECT INVESTMENT

A foreign direct investment (FDI) is an investment made by a firm or individual in one country into business interests located in another country. Generally, FDI takes place when an investor establishes foreign business operations or acquires foreign business assets in a foreign company. 

Foreign direct investments are commonly made in open economies that offer a skilled workforce and above-average growth prospects for the investor, as opposed to tightly regulated economies. Foreign direct investment frequently involves more than just a capital investment. It may include provisions of management or technology as well. The key feature of foreign direct investment is that it establishes either effective control of or at least substantial influence over the decision-making of a foreign business.

Types of Foreign Direct Investment

Foreign direct investments are commonly categorized as being horizontal, vertical or conglomerate. 

-        A horizontal direct investment refers to the investor establishing the same type of business operation in a foreign country as it operates in its home country, for example, a cell phone provider based in the United States opening stores in China. 

-        A vertical investment is one in which different but related business activities from the investor's main business are established or acquired in a foreign country, such as when a manufacturing company acquires an interest in a foreign company that supplies parts or raw materials required for the manufacturing company to make its products.

-        A conglomerate type of foreign direct investment is one where a company or individual makes a foreign investment in a business that is unrelated to its existing business in its home country. Since this type of investment involves entering an industry in which the investor has no previous experience, it often takes the form of a joint venture with a foreign company already operating in the industry.

Methods of FDI

-        Greenfield investment: In this parent company opens a subsidiary in another country. Instead of buying an existing facility in that country, the company begins a new venture by constructing new facilities in that country. Construction projects may include more than just a production facility. They sometimes also entail the completion of offices, accommodations for the company's staff and management, as well as distribution centres

-        Brownfield investments: They occur when an entity purchases or leases an existing facility to begin new production. Companies may consider this approach a great time and money saver since there is no need to go through the motions of building a brand new building.

Benefits/ Advantages of Foreign Direct Investment for the host country (recipient country)

1.  Increased Employment and Economic Growth

Creation of jobs is the most obvious advantage of FDI. It is also one of the most important reasons why a nation, especially a developing one, looks to attract FDI. Increased FDI boosts the manufacturing as well as the services sector. This in turn creates jobs, and helps reduce unemployment among the educated youth - as well as skilled and unskilled labour - in the country. Increased employment translates to increased incomes, and equips the population with enhanced buying power. This boosts the economy of the country.

2.  Human Resource Development

This is one of the less obvious advantages of FDI. Hence, it is often understated. Human Capital refers to the knowledge and competence of the workforce. Skills gained and enhanced through training and experience boost the education and human capital quotient of the country. Once developed, human capital is mobile. It can train human resources in other companies, thereby creating a ripple effect.  

3.  Development of Backward Areas

This is one of the most crucial benefits of FDI for a developing country. FDI enables the transformation of backward areas in a country into industrial centres. This in turn provides a boost to the social economy of the area. 

4.  Provision of Finance & Technology

Recipient businesses get access to latest financing tools, technologies and operational practices from across the world. Over time, the introduction of newer, enhanced technologies and processes results in their diffusion into the local economy, resulting in enhanced efficiency and effectiveness of the industry.

5.  Increase in Exports

Not all goods produced through FDI are meant for domestic consumption. Many of these products have global markets. The creation of 100% Export Oriented Units and Economic Zones have further assisted FDI investors in boosting their exports from other countries.

6.  Exchange Rate Stability

The constant flow of FDI into a country translates into a continuous flow of foreign exchange. This helps the country’s Central Bank maintain a comfortable reserve of foreign exchange. This in turn ensures stable exchange rates.

7.  Stimulation of Economic Development

This is another very important advantage of FDI. FDI is a source of external capital and higher revenues for a country. When factories are constructed, at least some local labour, materials and equipment are utilised. Once the construction is complete, the factory will employ some local employees and further use local materials and services. The people who are employed by such factories thus have more money to spend. This creates more jobs. 

These factories will also create additional tax revenue for the Government, that can be infused into creating and improving physical and financial infrastructure. 

8.  Improved Capital Flow

Inflow of capital is particularly beneficial for countries with limited domestic resources, as well as for nations with restricted opportunities to raise funds in global capital markets.

9.  Creation of a Competitive Market

By facilitating the entry of foreign organisations into the domestic marketplace, FDI helps create a competitive environment, as well as break domestic monopolies. A healthy competitive environment pushes firms to continuously enhance their processes and product offerings, thereby fostering innovation. Consumers also gain access to a wider range of competitively priced products.

 

 

Benefits/ Advantages of Foreign Direct Investment for the home country

 

•        Market diversification

•        Tax incentives

•        Lower labour costs

•        Preferential tariffs

•        Subsidies

Costs/ Disadvantages of Foreign Direct Investment for the host country (Recipient country)

Despite the many advantages that foreign direct investment portends for the host countries, many economists have criticized it as a measurement of economic growth. This is because the foreign direct investment is only beneficial in the short term. After firms obtain their initial investments and begin making profits, their original countries benefit more than the host countries. The following are some of the disadvantageous effects that foreign direct investment may have on the host countries:

•        Loss of taxes and revenues. Most host countries especially the developing ones tend to implement policies that favour foreign investors including tax holidays. This is usually done to incentivize the foreign investors and can result in loss of revenue for the host countries. Additionally, in the long run the multinational corporations also benefit more from their ventures in the host countries as opposed to the governments and economies.

•        Employment issues: Most multinational corporations tend to change the dynamics of the labour sector in order to lower costs of production. This is often evident in measures such automation which lead to loss of employment.

•        Kills local manufacturing industry: Since multinational corporations often have more muscle and experience as compared to the local manufacturers, they often end up edging out the nascent local companies. This hinders development of local manufacturers.

•        Exploitation of local raw materials and labourers. Local raw materials are usually over exploited by the foreign direct investors. This can lead to disadvantages for the host countries as their resources can be fast depleted. Many multinational corporations have also been accused of being exploitative towards local labourers. This reduces benefits for the domestic workers.

Costs/ Disadvantages of Foreign Direct Investment for the home country 

-        Uncertainty in Government Policies – Change in government policies is unpredictable sometimes and it may have an adverse effect on FDIs.

-        Risk of the Unknown – Even in the case where the investor possesses rich experience in the industry in which the company operates this experience might fall flat on its face in a foreign (host) country owing to differences in the culture and preferences of the consumers there.

Hence, detailed and comprehensive market research of the target demographic is imperative before deciding on foreign investment.

American Depositary Receipts (ADR): They are negotiable security instruments that are issued by a US bank, that represent a specific number of shares in a foreign company that is traded in US financial markets. ADRs pay dividends in US dollars and trade like regular shares of stock. Companies can now purchase stocks of foreign companies in bulk and reissue them on the US market. ADRs are listed on the NYSE, NASDAQ, AMEX and can be sold over-the-counter.

Before the introduction of ADRs in 1927, investors in the US faced numerous hurdles when attempting to invest in stocks of foreign companies. American investors could purchase the shares on international exchanges only, and that meant dealing with currency exchange rates and regulatory differences in foreign jurisdictions. They needed to familiarize themselves with different rules and risks related to investing in companies without a US presence. However, with ADRs, investors can diversify their portfolio by investing in foreign companies without having to open a foreign brokerage account.

Investors willing to invest in American Depositary Receipts can purchase them from brokers or dealers. The brokers and dealers obtain ADRs by buying already-issued ADR in the US financial markets or by creating a new ADR. Already-issued ADR can be obtained from the NASDAQ or NYSE.

Creating a new ADR involves buying the stocks of the foreign company in the issuer’s home market and depositing the acquired shares in a depository bank in the overseas market. The bank then issues ADRs that are equal to the value of the shares deposited with the bank, and the dealer/broker takes the ADR to US financial markets to sell them. The decision to create an ADR depends on the pricing, availability, and demand.

Investors who purchase the ADRs are paid dividends in US dollars. The foreign bank pays dividends in the native currency, and the dealer/broker distributes the dividends in US dollars after factoring in currency conversion costs and foreign taxes. This makes it easy for US investors to invest in a foreign company without worrying about currency exchange rates. The US banks that deal with ADRs require the foreign companies to furnish them with their financial information, which investors use to determine the company’s financial health.

Types of American Depositary Receipts

The ADRs that are sold in US financial markets can be categorized into sponsored and unsponsored.

1.  Sponsored ADR

For a sponsored ADR, the foreign company issuing shares to the public enters into an agreement with a US depositary bank to sell its shares in US markets. The US bank is responsible for recordkeeping, sale, and distribution of shares to the public, distribution of dividends, etc. Sponsored ADRs can be listed on the US stock exchanges.

2.  Non-Sponsored ADR

A non-sponsored ADR is created by brokers/dealers without the cooperation of the foreign company issuing the shares. Non-sponsored ADRs are traded in US over-the-counter markets without requiring registration with the Securities and Exchange Commission (SEC). Before 2008, any brokers and dealers trading in ADRs were required to submit a written application before being allowed to trade in the US. The 2008 SEC amendment provided an exemption to foreign issuers that met certain regulatory conditions. Non-sponsored ADRs are only traded on over-the-counter markets.

Levels of American Depositary Receipts

ADRs are grouped into three levels depending on the extent of the foreign company’s access to the US trading market.

1.  Sponsored Level I

Level I is the lowest level at which sponsored ADRs can be issued. It is the most common level for foreign companies that do not qualify for other levels or that do not want their securities listed on US exchanges. Level I ADRs are subject to the least reporting requirements with the Securities and Exchange Commission, and they are only traded over the counter. The companies are not required to issue quarterly or annual reports like other publicly-traded companies. However, Level I issuers must have their stock listed on one or more exchanges in the country of origination. Level I can be upgraded to Level II when the company is ready to sell through US exchanges.

2.  Sponsored Level II ADRs

Level II ADRs have more requirements from the SEC than Level I, and the company gets an opportunity to establish a higher trading presence on the US stock markets. The company must file a registration statement with the SEC. Also, the company must file Form-20-F in accordance with the GAAP or IFRS standards. Form 20-F is the equivalent of Form-10-K which is submitted by US publiclytraded companies. If the issuer fails to comply with these requirements, it may be delisted or downgraded to Level I.

3.  Sponsored Level III ADRs

Level III is the highest and most prestigious level that a foreign company can sponsor. A foreign company at this level can float a public offering of ADRs to raise capital from American investors through US exchanges. Level III ADRs also attract stricter regulations from the SEC. The company must file Form F-1 (prospectus) and Form 20-F (annual reports) in accordance with GAAP or IFRS standards. Any materials distributed to shareholders in the issuer’s home country must be submitted to the SEC as Form 6-K. 

Termination or Cancellation

ADRs are subject to cancellation at the discretion of either the foreign issuer or the depositary bank that created them. The termination results in the cancellation of all ADRs issued and delisting from the US exchange markets where the foreign stock was trading. Before the termination, the company must write to the owners of ADRs, giving them the option to swap their ADR for foreign securities represented by the receipts. If the owners take possession of the foreign securities, they can look for brokers who trade in that specific foreign market. If the owner decides to hold onto their ADR certificates after the termination, the depositary bank will continue holding onto the foreign securities and collect dividends, but will not sell more ADR securities.

 

GLOBAL DEPOSITORY RECEIPTS 

They are securities certificates issued by intermediaries such as banks for facilitating investments in foreign companies. A GDR represents a certain number of shares in a foreign company that is not traded on the local stock exchange. One GDR usually holds 10 shares, but the ratio can be anything higher or lower than this. The shares in the GDR trade on their domestic stock exchange. 

•        Financial Intermediaries such as depository banks purchase the shares in one country, create a GDR containing those shares, and sell the GDR in the foreign market. It helps companies raise capital from foreign markets.

•        GDR is a negotiable instrument, which can be denominated in any freely convertible security.

•        Global Depository Receipts are based on the historical American Depository Receipts, the difference being ADRs are traded in America and GDRs are traded in multiple countries.

Characteristics of Global Depository Receipts

•        Exchange Traded – Global Depository Receipts are exchange-traded instruments. The intermediary buys a bulk quantity of a foreign company and creates the GDRs which are then traded on the local stock exchange. Since GDRs are for multiple countries, they can trade on multiple stock exchanges at the same time.

•        Conversion Ratio – The Conversion Ratio, which means the number of shares of a company that one GDR holds can be anything ranging from a fraction to a very high number. It depends on the type of investors that the intermediary is planning to target. Usually, one GDR certificate holds 10 shares. But the range is flexible.

•        Unsecured – Global Depository Receipts are unsecured securities. They are not backed by any asset other than the value of the shares that are held in that certificate.

•        Price Based on Underlying – The price of a GDR is based on the price of the shares that it holds. The price also depends on the supply and demand of a particular GDR which can be managed. The intermediary might price it a touch higher than just the value of the securities in terms of transaction costs etc to make a profit for being the intermediary.

Advantages of Global Depository Receipts

The following are the advantages of global depository receipts (GDR)

•        Liquidity – Global Depository Receipts are liquid instruments that are traded on stock exchanges. The liquidity can be managed by managing the supply-demand of the instruments.

•        Access to Foreign Capital – GDRs have emerged as one of the most essential mechanisms to raise capital from foreign markets in today’s world. The securitization process is being carried out by big names such as JP Morgan, Deutsche, Citibank, etc. It is giving companies all over the world access to foreign capital through a relatively simpler mechanism. It is also helping companies increase their worldwide visibility by issuing GDRs in multiple countries.

•        Easily Transferrable – Global Depository Receipts can be easily transferred from one person to another. This makes trading them easy even for non-resident investors. The transfer of GDR does not involve heavy documentation like some other securities.

•        Potential Forex Gains – Since GDRs are international capital market instruments, they are exposed to foreign exchange rate volatility. The dividends paid for every share in a GDR is denominated in the domestic currency of the company whose shares are being held in the GDR. A favorable exchange rate movement can potentially provide gain beyond just the capital gains and the dividends received for the shares in a GDR.

Disadvantages of Global Depository Receipts

The following are the disadvantages of global depository receipts(GDR)

•        High Regulation – Since Global Depository receipts are issued in multiple countries, they become subject to regulation from multiple financial regulators. It is important to adhere to

all the regulations and even a small mistake can lead to a company being heavily reprimanded. Companies might have to bear huge consequences for even a small mistake.

•        Forex Risk – As we stated earlier, Global Depository Receipts are exposed to the foreign exchange rate volatility. Since the dividends received and the original price of the shares are denominated in the foreign currency, an appreciation of foreign currency can reduce the return generated and even cause losses to the investors.

•        Suitable for HNIs – Global Depository Receipts are usually issued with the multiple numbers of shares in each certificate to lower the transaction costs. Small investors might not be able to shell out that kind of money and might be unable to take advantage of the GDR. In this case, it becomes a more suitable product for HNIs

•        No Voting Rights – Under the mechanism of the Global Depository Receipts, the shares of a company are sold in bulk to an intermediary in another country who further securitizes them into GDRs. Therefore, the voting rights in the company are retained by the intermediary who has directly bought the shares, and not by investors who buy the GDR.

FOREIGN PORTFOLIO INVESTMENT

Foreign portfolio investment (FPI) consists of securities and other financial assets held by investors in another country. It does not provide the investor with direct ownership of a company's assets and is relatively liquid depending on the volatility of the market. Along with foreign direct investment (FDI), FPI is one of the common ways to invest in an overseas economy. FDI and FPI are both important sources of funding for most economies.

Portfolio investment involves passive investment of securities, done with the expectation of earning a return. In foreign portfolio investment, these securities can include stocks, american depositary receipts (ADRs), or global depositary receipts of companies headquartered outside the investor's nation. Holding also includes bonds or other debt issued by these companies or foreign governments, mutual funds, or exchange traded funds (ETFs) that invest in assets abroad or overseas.

An individual investor interested in opportunities outside their own country is most likely to invest through an FPI. On a more macro level, foreign portfolio investment is part of a country’s capital account and shown on its balance of payments (BOP). The BOP measures the amount of money flowing from one country to other countries over one monetary year.

Advantages:

-        Portfolio Diversification: Foreign portfolio investment gives investors an opportunity to engage in international diversification of portfolio assets, which in turn helps achieve a higher risk-adjusted return. 

-        International Credit: Investors who have foreign investment portfolios have a broader credit base because they can access credit in foreign countries where they have significant investments. This is advantageous when credit sources available at home are expensive or unavailable due to various factors. The ability to get credit on favourable terms and as quickly as possible can determine whether a business executes a new project or not.

-        Benefit From Exchange Rate: International currency exchange rates keep changing. Sometimes the currency of the investor's home country may be strong, and sometimes it may be weak. There are times when a stronger currency in the foreign country where an investor has a portfolio may benefit the investor.

-        Access to a Bigger Market: Foreign markets, however, offer a less competitive and sometimes larger market. 

-        Liquidity: Where foreign portfolio investments are very liquid, they can be bought and sold quickly and easily. Higher liquidity means greater buying power for investors, as it gives

them access to a ready stream of cash. That means that investors holding foreign portfolio investments are better-positioned to act quickly when good purchase opportunities arise.

 

CROSS BORDER MERGERS AND ACQUISITIONS

As companies grow, domestic M&A allows them to access new product ranges, customers, and aids market consolidation. Cross-border M&A is a tactic used to quickly enter new markets globally by merging with a foreign firm.

Firms consider international deals, despite the extra effort involved, due to the substantial benefit it can afford. Benefits come in many forms, which we have listed below, in order of importance:

1.      Portfolio diversification – Like a stock portfolio, companies should seek to diversify their revenue streams. This should be in the form of both product and geographic diversification;

2.      Cost synergies – reaching capacity takes time. Entering a new market through acquisition can aid cost efficiencies if it increases sales;

3.      Scale efficiencies – as with above, new customers help you scale fast;

4.      Intellectual property – if competitors have an advantage based on technology that is patented, you can purchase them;

5.      New market – this is the most obvious benefit. New market = new customers

6.      Access to new talent – If you are looking for a population of a certain skill set, it is often easier to acquire a company in a population with those skills than training staff;

7.      Distribution – it’s common to have the strongest distribution network in your local market. Although possible to launch into new markets without a transaction, you will struggle to get a network as strong as a domestic player;

8.      Production capacity – Building production capacity is costly and more importantly timely. Rapid demand increases may result in the inability to fulfill orders, you can quickly reach your desired capacity by acquiring it; and

9.      Tax structuring – international revenue streams or a relocation of your company’s head office can have a substantial tax benefit.  

 

The risks of cross-border M&A

Like with every strategic decision, the positives must not hide the negatives. Below we outline a few negative factors that must be taken into consideration;

1.      Tax – Every country has different tax laws. Although at first glance these may seem tedious, getting blindsided by tax regulation can be costly. Due to the complicated nature of international tax, we recommend using a local professional;  

2.      Regulatory landscape – laws, and regulations may not stay stagnant in an economy. Investigate the most obvious ones within the targets sectors;

3.      Financial information – the availability, accuracy, and reliability of the target’s financial information can be harder to obtain than originally thought. Decisions are often made without the full picture;

4.      Political landscape – a country’s political stability can also blindside you, largely in the form of a change in Government; and

5.      Compliance – these vary country by country. In the US we suggest you investigate the compliance of the target’s home country with the US Foreign Corrupt Practices Act, and similar anti-bribery, and anti-money laundering regulations.