Chapter 5 Page 1 of 6

International Equity Markets

Concepts

FDI - FDI is the acquisition of a controlling interest in a foreign firm or affiliate

(branch, subsidiary, etc.). There are a variety of ways that FDI can occur, including
building new foreign facilities from scratch ("Greenfield investment"), merging with a
foreign firm, taking over a foreign firm, and entering a partnership with a foreign firm
(Example; a joint venture).

Horizontal FDI involves investing in a firm that is in the same industry. Vertical
FDI involves investing in a supplier or customer firm.

PI - Portfolio investments consist mainly of the holding of transferable securities or

guaranteed by the govt. of the capital importing country. Such holdings do not amount to
right to control the company. E.g. shares, debenture, bonds etc.

GDR - “Global Depositary Receipts mean any instrument in the form of a depositary
receipt or certificate (by whatever name it is called) created by the Overseas Depositary
Bank outside India and issued to non-resident investors against the issue of ordinary
shares or Foreign Currency Convertible Bonds of issuing company.”

They are negotiable certificates that usually represent a company’s publicly traded
equities and can be denominated in any freely convertible foreign currency.

They are listed on a European stock exchange, often Luxembourg or London.

Each DR represents a multiple number or fraction of underlying shares or alternatively
the shares correspond to a fixed ratio, for example, 1 GDR = 10 Shares.

ADR - A GDR issued in America is an American Depositary Receipt (ADR). An ADR

represents an ownership interest in foreign securities. It is a negotiable instrument issued
by an American Depository bank certifying that shares of a non-US issuing company are
held by the depository’s custodian bank abroad.

Each unit of ADR is called an American Depository Share (ADS). They are an
ideal way for foreign companies to raise funds to expand their international capital base
and get name and product exposure in the US. ADR could be listed on the New York
stock exchange, NASDAQ or could be issued as private placement securities under rule
144a in the US.

1. Explain and discuss the various factors responsible for FDI inflows.

A1. Introduction

Foreign investment can take two forms: foreign equity investors can simply buy a stake
in an enterprise or take a direct interest in its management. The first, indirect form of investment
is called foreign portfolio investment. Foreign direct investment (FDI) involves more than just
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buying a share or a security. It is the amount of financing provided by a foreign owner who is
also directly involved in the management of the enterprise. For statistical purposes, the
International Monetary Find (IMF) defines foreign investment as (FDI) when the investor holds
10% or more of the equity of an enterprise.

Foreign investment has clearly been a major factor in stimulating economic growth and
development in recent times. Foreign Direct Investment (FDI) is one of the most important
sources of capital. FDI links the host economy with the global markets and fosters economic
growth.

The main factors are:

1. Market size and growth rate are principal determinants of FDI flows - Every
nation has to compete in the international market for scarce resources. Macro-
Economic stability and low inflation have been successful in attracting external
capital. Maintaining inflation under 5% and recording a growth rate of 7% would
make India an attractive place for foreign investments. India is a favorite among
Asian countries because of it's sheer size.

2. A hospitable environment for foreign investors - by providing essential guarantees

for investors to:
- Enter and exit
- Operate on equal terms alongside local operators
- Repatriate their investments when needed

3. Availability of the required infrastructure - in form of serviceable roads, ports,

telecommunications, airports, water and power facilities is a pre-requisite for
attracting large volumes foreign investments.

4. Method and ease of entry - There are currently six possible entry routes/ clearing
mechanisms for FDI, depending on the sector, extent of foreign equity desired, level
of investment and geographical location of the project. This system is perceived to be
complex by many foreign investors and analysts. Consequently it appears that the
number of entry routes should be reduced to only two, viz. the Automatic Approval
(AA) Route of RBI and the FIPB.

5. Scope of operations - The Indian system has both a positive list and a negative list.
The positive list comprises of sectors where automatic approval is granted, subject to
certain conditions. In the negative list foreign investment is currently not allowed.

6. Political stability - Different governments follow a different policy framework for

FDI. One government may follow a liberal approach whereas the other may follow a
conservative one. Thus political instability deters FDI from coming to any country.
While India has now emerged as the second most-sought-after FDI destination in Asia
after China, the actual inflows into India are less than a tenth of those received by
China. This should make the government reflect on the shortcomings in the policy
framework. Incidentally, successive governments wasted considerable time
identifying the desirable sectors where the FDI could be encouraged and those where
it must be discouraged. Some coalition partners in the present as well as the previous
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government were totally opposed to inviting FDI because of their misplaced sense of
Swadeshi.

7. Access to resources and low production costs - the availability of natural, capital,
technological and human resources are an important consideration when attracting
FDI inflows. Also, the costs at which these resources can be obtained are a deciding
factor.

8. Cultural-cum-geographic proximity – the similarities in culture and geographic

nearness to the foreign investors own land makes the destination country easier for
the investor to enter, since he is surer of certain factors, or rather, more comfortable
getting into a land which is as similar as home.

9. Access to export markets – the markets that one can service from the destination
country, i.e. it's strategic location gives the country a one-up against competing
nations in attracting foreign investments. Not only the location, but also its trade
relations with the neighboring nations is an important factor.

2. Explain and discuss the objectives of FDI and PI.

A2. Need for foreign capital

The following arguments are advanced in favour of foreign capital:

1. Sustaining a high level of investment - Since the underdeveloped countries want to

industrialized themselves within a short period of time, it becomes necessary to raise
the level of investment substantially. This requires, in turn, a high level of savings.
However, because of general poverty of masses, the savings are often very low.
Hence emerges a resource gap between investment and savings. This gap has to be
filled through foreign capital.

2. Technological gap - The under developed countries have very low level of
technology as compared to the advanced countries. However they possess strong urge
for industrialization to develop their economies and to wriggle out of the low level
equilibrium trap in which they are caught. This raises the necessity for importing
technology from advanced countries. Such technology usually comes with foreign
capital when it assumes the form of private foreign investment or foreign
collaboration. In the Indian case technical assistance received from abroad has helped
in filling the technological gap through the following three ways:
(a) Provision for expert services
(b) Training of Indian personnel
(c) Education research and training institution in the country

3. Exploitation of natural resources - A number of underdeveloped countries possess

huge mineral resources, which await exploitation. These countries themselves do not
possess the required technical skill and expertise to accomplish this task. As a
consequence, they have to depend upon foreign capital to undertake the exploitation
of their mineral wealth.
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4. Undertaking the initial risk - Many under developed countries suffer from acute
private entrepreneurs. This creates obstacles in the programs of industrialization. An
argument advanced in favour of the foreign capital is that it undertakes the risk of
investment in host countries and thus provides the much-needed impetus to the
process of industrialization. Once the programme of industrialization gets started with
the initiative of foreign capital, domestic industrial activity starts picking up as more
and more of the host country enter the industrial field.

5. Development of basic economic infrastructure - It has been observed that the

domestic capital of the under developed countries is often too inadequate to build up
the economic infra structure of its own. Thus these countries require the assistance of
foreign capital to undertake this task. In the latter half of the 20th century, especially
during the last 3-4 decades, international financial institutions and many governments
of advanced countries have made substantial capital available to the under developed
countries to develop their system of transport and communications, generation and
distribution of electricity, development of irrigation facilities, etc.

6. Improvement in balance of payments position - In the initial phase of the economic

development, the under developed countries need much larger imports (in the form of
machinery, capital goods, industrial raw materials, spares and components), then they
can possibly export. As a result, the balance of payments generally turns adverse. This
creates a gap between the earnings and foreign exchange. Foreign capital presents
short run solution to the problem.

This shows that the economic development of an underdeveloped country should

obviously receive a boost as a result of foreign capital.
Accordingly, if foreign capital is obtained on easy terms and without any ‘strings’, it
should be welcomed. However, as noted by John P. Lewis, “despite denials, the fact is that all
foreign aid carries strings and every foreign aid relationship involves bargaining, however
genteel, between aiding and receiving parties.”

3. Discuss the different instruments available with a corporate body in India to raise
equity capital abroad.

A3. Introduction

Equity capital can flow to a developing country in the following ways: -

1. Developed country investors can directly purchase shares in the stock market of a
developing country.
2. Companies from developing countries, can issue shares or depository receipts in stock
markets of developed countries

Out of both these options, the second one is concerned with an Indian corporate’s ability to
raise equity from foreign markets.

Types of Equity Instruments

Equity instruments can be classified into the following categories based on the different
characteristics with which they are floated in the market:
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Equity
shares

Equity shares represent ownership capital, as equity shareholders collectively own the
company.

Preference shares
Preference shares refer to a form of shares, which lie in between pure equity and debt.
These are shares, which do not carry voting rights.

Warrants
Warrant is a certificate giving the holder the right to purchase securities at a stipulated
price within a specified time limit or perpetually. Sometimes a warrant is offered with securities
as an inducement to buy. The warrant acts as a sweetener because the holder of the warrant has
the right but not the obligation of investing in the equity at the indicated rate

The above three are instruments that are used in domestic markets. The GDRs and ADRs
are instruments used in foreign markets to raise equity. We will now go ahead with the
explanations of GDRs and ADRs and how they can be used to raise finance for an Indian
corporate from international markets.

Note - (Before going on to the mechanism about how ADRs and GDRs wrok, we need to
know a few concepts. These concepts do not form a part of the answer. They are only
given here for better understanding of the mechanism.)

Relevant Concepts

Domestic Custodian Bank

It means, a banking company, which acts as a custodian bank for the ordinary shares or
Foreign Currency Convertible Bonds, which are issued by it against depository receipts or
certificates.

Issuing Company

It means, any Indian company permitted to issue Foreign Currency Convertible Bonds, or
ordinary shares of that company against depository receipts.

Overseas Depository Bank

It means, a bank authorized by the Issuing Company to issue depository receipts against
issue of Foreign Currency Convertible Bonds or ordinary shares of the Issuing
Company.
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Mechanism- how it works

In the recent years, a number of European and Japanese companies have got themselves
listed on foreign stock exchanges such as New York and London. Shares of many firms are
traded indirectly in the form of depository receipts. In this mechanism, a depository, usually a
large international bank, who receives dividends, reports etc. and issues claims against these
shares, holds the shares issued by a firm.

The claims are called depository receipts with each receipt being a claim on specified
number of shares. The depository receipts are denominated in a convertible currency, usually the
US$. The depository receipts may be listed and traded on major stock exchanges or may trade in
the OTC market.

The issuer firm pays dividend in its home currency, which is converted into Dollars by
the depository and distributed to the holders of the depository receipts. This way, the issuing firm
avoids listing fees and onerous disclosure and reporting requirements, which would be obligatory
if it were to be directly listed on the foreign stock exchange.

This mechanism originated in the US and is called the American Depository Receipt. The
recent years have seen the emergence of European Depository Receipts (EDRs) and Global
Depository Receipts, which can be used to tap multiple markets with a single instrument.

Indian Corporate Appoint

Delivery of ordinary shares or

bonds

Co-ordinate Lead Manager

Domestic Custodian activities
Bank Co-ordinate activities

Instruction to issue Overseas Depository

depository receipts Bank
or certificates

Listing

Purchase of
Depository receipts
Foreign
Stock Exchange

Investor
Base Payment of
Interest / Dividend