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4.4.2 Development of Textile Exports in Y

ABC Development Bank, after a thorough study of Y's economy, had highlighted an important opportunity for growth in the development of the important textile business toward export. The textile sector already constituted an important part of Y's local economy but, with a loan from ABC, investment could be made to contribute even more toward growth by benefiting from global trade.

The goals were specifically two: the growth of the textile exporting industry and, through influx of hard currency in the country, the development of the currently rudimentary capital market into a more developed kind. The loan from ABC would be accompanied by technical aid. The local participants would be the Industrial and Commercial Bank of Y (a state-backed financial institution, in charge of lending the funds received from ABC to the textile manufacturers) and participating financial institutions charged with initiating transactions between local and hard currency. Consultants would work with the textile manufacturer to offer advice on anything from project management to foreign marketing, and others would work with the participating financial institutions in order to advise on key concepts of public-side banking such as compliance, control, collateral, and risk management, and so on.

The project was structured as shown in Figure 4.8 with the following key transactions:

┠ABC would issue a loan in USD to the Industrial and Commercial Bank of Y at LIBOR plus spread.

┠For a portion of the total size of the loan, the Industrial and Commercial Bank of Y would enter into a USD versus Y currency cross currency swap with a participating financial institution in which there would be initial and final exchange of principals, and the ICB would pay a fixed rate in Y currency and the participating financial institution would pay LIBOR plus spread on the USD principal.

┠The Industrial and Commercial Bank of Y would lend the Y currency principal obtained from the participating financial institution at a fixed rate to a textile manufacturer.

┠The textile manufacturer would invest the funds into the exporting business and receive income in USD.

┠The textile manufacturer would enter into an FX derivative with a participating financial institution in order to hedge the FX exposure

A representation of the relationship between the different parties involved in the textile export development project.

FIGURE 4.8 A representation of the relationship between the different parties involved in the textile export development project.

resulting from the difference in currency between its income and its liability to the Industrial and Commercial Bank.

The structure described above ensures that ABC's loan is repaid in USD with the hard currency income earned from the export business. The route through which the income returns to ABC is such that it injects liquidity and development in the local capital market. Some of the risks faced by each party are:

┠ABC is exposed to the credit risk of the Industrial and Commercial Bank of Y.

┠The Industrial and Commercial Bank of Y mitigates[1] some of the FX risk through the cross currency swap but is exposed to USD LIBOR risk.

┠The Industrial and Commercial Bank of Y is also exposed to the credit risk of the manufacturers.

┠The textile manufacturers hedge their FX risk through the FX derivative with the participating financial institution but are exposed, through the loan, to local interest rate risk.

┠For the participating financial institutions, the FX derivative with the manufacturers and the cross currency swap with the Industrial and Commercial Bank of Y partly offset their FX risk but they are still exposed to USD LIBOR risk.

This particular project, with its focus on local and foreign currencies and local and foreign interest rates, is important in showing how a development project, if successfully carried out, can bring considerable financial expertise to a developing economy.

  • [1] The risk is only mitigated and not completely canceled since the swap is fixed for floating.
 
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