The new financial instruments of globalisation Stabroek News January 28, 2001 Promise Last week I promised to consider some of the new financial instruments that have developed with globalisation. It should be observed that although regulatory changes and communications and information technology have played important roles in the explosive growth of global finance, the contribution of financial innovation to this growth should not be underestimated. This observation underscores a continuing theme of this series, which is, that competition in the global market place is now driven as much by price, as it is by continuous product innovation. Bank loans Up to the early 1980s the syndicated bank loan dominated the global financial landscape. The commercial banks were then fully loaded with short-term funds, and the demand for these funds in the developed economies was not enough to absorb them all. In pursuit of profits, the banks turned to granting loans to governments in the developing countries. Indeed they actively solicited this type of borrowing, as the interest rates they obtained were very attractive. As we all know now this eventually led to the debt crisis, and the precipitous decline of this type of bank lending in the global market place. The share of the syndicated bank loan to developing countries in global finance is now vastly reduced, and in its place has arisen the new kinds of financial instruments we are considering today. The hallmark, of these new instruments is that they are based on flows of funds to the private sector and not to governments. Derivatives The largest and most important new financial instrument is the financial derivative. As the name suggests, derivatives are financial products that derive their value from other assets on which they are based. The key element of a derivative is the buying and selling of the risk attached to an asset, without trading in the asset itself. Originally, derivatives were based on trade in minerals and other goods. Since the early 1970s, however, their underlying base has been financial assets. There are several such assets that are widely used, including currencies, bonds, bills, and interest, stock and bond indexes. Trade in these financial derivatives cover forwards, futures, and swaps. At present the outstanding value of financial derivatives in global financial markets has been estimated at over US$60 trillion. Next to current markets, these therefore constitute the largest financial market in the world. This trade is carried on by global securities houses on a round-the-clock, round-the-world basis where distance and borders do not matter! International bonds Next in importance to the derivatives is the international bond. The outstanding value of these has been estimated to be US$7-8 trillion. Bonds are issued by firms, governments, and multilateral institutions (e.g., the World Bank) in order to raise cash in return for the payment of interest. The length of life (or term) of these bonds is fixed at the time of issue. Typically, the life of an international bond runs from one to 30 years. In recent years developing countries have relied heavily on the international bond market for raising funds, thereby replacing the commercial bank loans of yesteryear. Indeed, these bonds are now the single largest market for raising funds by developing countries. International bonds come in a wide variety, such as inflation-indexed bonds, zero-coupon bonds, senior and subordinated bonds, callable bonds, and convertible bonds. Mutual funds/unit trusts Next in importance is the mutual fund or unit trust as it is called in Caricom countries. Basically, a mutual fund/unit trust is a collection of financial securities owned by a group of investors and managed by an investment company, bank, or brokerage house specializing in this activity. Because they are run by professional specialist companies they offer better returns than the individual investor would normally obtain. The range of mutual funds is considerable, but are usually classed into three groups, namely stock or equity funds, bond funds, and money market funds. The last group is a lot like savings accounts, in that they are usually very stable in price. The other two funds, however, vary with the price of equities and bonds in the market. Some of these funds are openended funds in that there is no limit to the amount of shares an investor may buy. Some are closed-end funds in that only a fixed number of shares are traded. The funds are also classified geographically as global, regional, or country funds. GDR The fourth major new financial instrument is the Global Depository Receipt (GDR). This is a means of raising equity in the international financial market. It requires that overseas depository banks are authorised to issue GDRs outside the country. These are then listed in any overseas stock exchange where non-residents may trade in them in foreign currency. Miscellaneous Finally, there is a miscellaneous category of financial investments that has emerged as developing countries have sought ways to have large infrastructure projects financed. This is particularly the case for roads, bridges, power plants, airports, harbours, and drainage and irrigation works. These arrangements allow large transnational firms to secure financing for these projects up-front. The financing may take the form of equity or debt (that is bonds or loans) or some combination of them. The financing is sought from both private and government sources. In recent times governments have tended to guarantee such projects. Failing this the firms turn to agencies like the Multilateral Investment Guarantee Agency (MIGA). Some of these financial arrangements have been discussed in relation to infrastructure financing in Guyana, most notably in the case of Guyana 21. Such arrangements are based on a number of principles, including build-operate-transfer (BOT) or build-own-operate-transfer (BOOT) or build-own-operate (BOO). The attraction of these arrangements is that it relieves the host country of the need to find the massive finance required for major infrastructure projects. Follow the goings-on in Guyana in Guyana Today