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Home -> Hartley Withers -> International Finance -> Chapter 3

International Finance - Chapter 3

1. Preface

2. Charter 1

3. Chapter 2

4. Chapter 3

5. Chapter 4

6. Chapter 5

7. Chapter 6

8. Chapter 7

9. Chapter 8



So far we have only considered what happens to the money of those who
save as long as it is left in the hands of their bankers, and we have
seen that it is only likely to be employed internationally, if invested
by bankers in bills of exchange which form a comparatively small part of
their assets. It is true that bankers also invest money in securities,
and that some of these are foreign, but here again the proportion
invested abroad is so small that we may be reasonably sure that any
money left by us in the hands of our bankers will be employed at home.

But in actual practice those who save do not pile up a large balance at
their banks. They keep what is called a current account, consisting of
amounts paid in in cash or in cheques on other banks or their own bank,
and against this account they draw what is needed for their weekly and
monthly payments; sometimes, also, they keep a certain amount on deposit
account, that is an account on which they can only draw after giving a
week's notice or more. On their deposit account they receive interest,
on their current account they may in some parts of the country receive
interest on the average balance kept. But the deposit account is most
often kept by people who have to have a reserve of cash quickly
available for business purposes. The ordinary private investor, when he
has got a balance at his bank big enough to make him feel comfortable
about being able to meet all probable outgoings, puts any money that he
may have to spare into some security dealt in on the Stock Exchange, and
so securities and the Stock Exchange have to be described and examined
next. They are very much to the point, because it is through them that
international finance has done most of its work.

Securities, then, are the stocks, shares and bonds which are given to
those who put money into companies, or into loans issued by
Governments, municipalities and other public bodies. Let us take the
Governments and public bodies first, because the securities issued by
them are in some ways simpler than those created by companies.

When a Government wants to borrow, it does so because it needs money.
The purpose for which it needs it may be to build a railway or canal, or
make a harbour, or carry out a land improvement or irrigation scheme, or
otherwise work some enterprise by which the power of the country to grow
and make things may be increased. Enterprises of this kind are usually
called reproductive, and in many cases the actual return from them in
cash more than suffices to meet the interest on the debt raised to carry
them out, to say nothing of the direct benefit to the country in
increasing its output of wealth. In England the Government has
practically no debt that is represented by reproductive assets. Our
Government has left the development of the country's resources to
private enterprise, and the only assets from which it derives a revenue
are the Post Office buildings, the Crown lands and some shares in the
Suez Canal which were bought for a political purpose. Governments also
borrow money because their revenue from taxes is less than the sums that
they are spending. This happens most often and most markedly when they
are carrying on war, or when nations are engaged in a competition in
armaments, building navies or raising armies against one another so as
to be ready for war if it happens. This kind of debt is called
dead-weight debt, because there is no direct or indirect increase, in
consequence of it, in the country's power to produce things that are
wanted. This kind of borrowing is generally excused on the ground that
provision for the national safety is a matter which concerns posterity
quite as much as the present generation, and that it is, therefore, fair
to leave posterity to pay part of the bill.

Municipalities likewise borrow both for reproductive purposes and for
objects from which no direct revenue can be expected. They may invest
money lent them in gas or electric works or water supply or tramways,
and get an income from them which will more than pay the interest on
the money borrowed. Or they may put it into public parks and recreation
grounds or municipal buildings, or improvements in sanitation, thereby
beautifying and cleansing the town. If they do these things in such a
way as to make the town a pleasanter and healthier place to live in,
they may indirectly increase their revenue; but if they do them
extravagantly and badly, they run the risk of putting a burden on the
ratepayers that will make people shy of living within their borders.

Whatever be the object for which the loan is issued, the procedure is
the same by which the money is raised. The Government or municipality
invites subscriptions through a bank or through some great financial
house, which publishes what is called a prospectus by circular, and in
the papers, giving the terms and details of the loan. People who have
money to spare, or are able to borrow money from their bankers, and are
attracted by the terms of the loan, sign an application form which is
issued with the prospectus, and send a cheque for the sum, usually 5 per
cent. of the amount that they apply for, which is payable on
application. If the loan is over-subscribed, the applicants will only
receive part of the sums for which they apply. If it is not fully
subscribed, they will get all that they have asked for, and the balance
left over will be taken up in most cases by a syndicate formed by the
bank or firm that issued the loan, to "underwrite" it. Underwriting
means guaranteeing the success of a loan, and those who do so receive a
commission of anything from 1 to 3 per cent.; if the loan is popular and
goes well the underwriters take their commission and are quit; if the
loan is what the City genially describes as a "frost," the underwriters
may find themselves saddled with the greater part of it, and will have
the pleasure of nursing it until such time as the investing public will
take it off their hands. Underwriting is thus a profitable business when
times are good, and the public is feeding freely, but it can only be
indulged in by folk with plenty of capital or credit, and so able to
carry large blocks of stock if they find themselves left with them.

To take a practical example, let us suppose that the King of Ruritania
is informed by his Minister of Marine that a battleship must at once be
added to its fleet because his next door neighbour is thought to be
thinking of making himself stronger on the water, while his Minister of
Finance protests that it is impossible, without the risk of serious
trouble, to add anything further to the burdens of the taxpayers. A loan
is the easy and obvious way out. London and Paris between them will find
two or three millions with pleasure. That will be enough for a
battleship and something over in the way of new artillery for the army
which can be ordered in France so as to secure the consent of the French
Government, which was wont to insist that a certain proportion of any
loan raised in Paris must be spent in the country. (It need hardly be
said that all these events are supposed to be happening in the years
before the war.) Negotiations are entered into with a group of French
banks and an English issuing house. The French banks take over their
share, and sell it to their customers who are, or were, in the habit of
following the lead of their bankers in investment with a blind
confidence, that gave the French banks enormous power in the
international money market. The English issuing house sends round a
stockbroker to underwrite the loan. If the issuing house is one that is
usually successful in its issues, the privilege of underwriting anything
that it brings out is eagerly sought for. Banks, financial firms,
insurance companies, trust companies and stockbrokers with big
investment connections will take as much underwriting as they are
offered, in many cases without making very searching inquiry into the
terms of the security offered. The name of the issuing house and the
amount of the underwriting commission --which we will suppose in this
case to be 2 per cent.--is enough for them. They know that if they
refuse any chance of underwriting that is offered, they are not likely
to get a chance when the next loan comes out, and since underwriting is
a profitable business for those who can afford to run its risks, many
firms put their names down for anything that is put before them, as long
as they have confidence in the firm that is handling the loan. This
power in the hands of the big issuing houses, to get any loan that they
choose to father underwritten in a few hours by a crowd of eager
followers, gives them, of course, enormous strength and lays a heavy
responsibility on them. They only preserve it by being careful in the
use of it, and exercising great discrimination in the class of
securities that they handle.

While the underwriting is going on the prospectus is being prepared by
which the subscriptions of the public are invited, and in the meantime
it will probably happen that the newspapers have had a hint that a
Ruritanian loan is on the anvil, so that preliminary paragraphs may
prepare an atmosphere of expectancy. News of a forthcoming new issue is
always a welcome item in the dull routine of a City article, and the
journalists are only serving their public and their papers in being
eager to chronicle it. Lurid stories are still handed down by City
tradition of how great City journalists acquired fortunes in days gone
by, by being allotted blocks of new loans so that they might expand on
their merits and then sell them at a big profit when they had created a
public demand for them. There seems to be no doubt that this kind of
thing used to happen in the dark ages when finance and City journalism
did a good deal of dirty business between them. Now, the City columns of
the great daily papers have for a very long time been free from any
taint of this kind, and on the whole it may be said that finance is a
very much cleaner affair than either law or politics. It is true that
swindles still happen in the City, but their number is trivial compared
with the volume of the public's money that is handled and invested. It
is only in the by-ways of finance and in the gutters of City journalism
that the traps are laid for the greedy and gullible public, and if the
public walks in, it has itself to blame. A genuine investor who wants
security and a safe return on his money can always get it. Unfortunately
the investor is almost always at the same time a speculator, and is apt
to forget the distinction; and those who ask for a high rate of
interest, absolute safety and a big rise in the prices of securities
that they buy are only inviting disaster by the greed that wants the
unattainable and the gullibility that deludes them into thinking they
can have it.

To return to our Ruritanian loan, which we left being underwritten. The
prospectus duly comes out and is advertised in the papers and sown
broadcast over the country through the post. It offers ?1,500,000 (part
of ?3,000,000 of which half is reserved for issue in Paris), 4-1/2 per
cent. bonds of the Kingdom of Ruritania, with interest payable on April
1st and October 1st, redeemable by a cumulative Sinking Fund of 1 per
cent., operating by annual drawings at par, the price of issue being 97,
payable as to 5 per cent. on application, 15 per cent. on allotment and
the balance in instalments extending over four months. Coupons and drawn
bonds are payable in sterling at the countinghouse of the issuing firm.
The extent of the other information given varies considerably. Some
firms rely so far on their own prestige and the credit of those on whose
account they offer loans, that they state little more than the bare
terms of the issue as given above. Others deign to give details
concerning the financial position of the borrowing Government, such as
its revenue and expenditure for a term of years, the amount of its
outstanding debt, and of its assets if any. If the credit of the
Kingdom of Ruritania is good, such a loan as here described would be,
or would have been before the war, an attractive issue, since the
investor would get a good rate of interest for his money, and would be
certain of getting par or ?100, some day, for each bond for which he now
pays ?97. This is ensured by the action of the Sinking Fund of 1 per
cent. cumulative, which works as follows. Each year, as long as the loan
is outstanding the Kingdom of Ruritania will have to put ?165,000 in the
hands of the issuing houses, to be applied to interest and Sinking Fund.
In the first year interest at 4-1/2 per cent. will take ?135,000 and
Sinking Fund (1 per cent. of ?3,000,000) ?30,000; this ?30,000 will be
applied to the redemption of bonds to that value, which are drawn by
lot; so that next year the interest charge will be less and the amount
available for Sinking Fund will be greater; and each year the
comfortable effect of this process continues, until at last the whole
loan is redeemed and every investor will have got his money back and
something over. The effect of this obligation to redeem, of course,
makes the market in the loan very steady, because the chance of being
drawn at par in any year, and the certainty of being drawn if the
investor holds it long enough, ensures that the market price will be
strengthened by this consideration.

Such being the terms of the loan we may be justified in supposing--if
Ruritania has a clean record in its treatment of its creditors, and if
the issuing firm is one that can be relied on to do all that can be done
to safeguard their interests, that the loan is a complete success and is
fully subscribed for by the public. The underwriters will consequently
be relieved of all liability and will pocket their 2 per cent., which
they have earned by guaranteeing the success of the issue. If some
financial or political shock had occurred which made investors reluctant
to put money into anything at the time when the prospectus appeared or
suggested the likelihood that Ruritania might be involved in war, then
the underwriters would have had to take up the greater part of the loan
and pay for it out of their own pockets; and this is the risk for which
they are given their commission. Ruritania will have got its money less
the cost of underwriting, advertising, commissions, 1 per cent. stamp
payable to the British Government, and the profit of the issuing firm.
Some shipyard in the north will lay down a battleship and English
shareholders and workmen will benefit by the contract, and the investors
will have got well secured bonds paying them a good rate of interest and
likely to be easily saleable in the market if the holders want to turn
them into cash. The bonds will be large pieces of paper stating that
they are 4-1/2 per cent, bonds of the Kingdom of Ruritania for ?20,
?100, ?500 or ?1000 as the case may be, and they will each have a sheet
of coupons attached, that is, small pieces to be cut off and presented
at the date of each interest payment; each one states the amount due
each half year and the date when it will have to be met.

Bonds are called bearer securities, that is to say, possession of them
entitles the bearer to receive payment of them when drawn and to collect
the coupons at their several dates. They are the usual form for the
debts of foreign Governments and municipalities, and of foreign railway
and industrial companies.

In England we chiefly affect what are called registered and inscribed
stocks--that is, if our Government or one of our municipalities issues a
loan, the subscribers have their names registered in a book by the
debtor, or its banker, and merely hold a certificate which is a receipt,
but the possession of which is not in itself evidence of ownership.
There are no coupons, and the half-yearly interest is posted to
stockholders, or to their bankers or to any one else to whom they may
direct it to be sent. Consequently when the holder sells it is not
enough for him to hand over his certificate, as is the case with a
bearer security, but the stock has to be transferred into the name of
the buyer in the register kept by the debtor, or by the bank which
manages the business for it.

When the securities offered are not loans by public bodies, but
represent an interest in a company formed to build a railway or carry on
any industrial or agricultural or mining enterprise, the procedure will
be on the same lines, except that the whole affair will be on a less
exalted plane. Such an issue would not, save in exceptional
circumstances, as when a great railway is offering bonds or debenture
stock, be fathered by one of the leading financial firms. Industrial
ventures are associated with so many risks that they are usually left to
the smaller fry, and those who underwrite them expect higher rates of
commission, while subscribers can only be tempted by anticipations of
more mouth-filling rates of interest or profit. This distinction between
interest and profit brings us to a further difference between the
securities of companies and public bodies. Public bodies do not offer
profit, but interest, and the distinction is very important. A
Government asks for your money and promises to pay a rate for it,
whether the object on which the money is spent be profit-earning or no,
and, if it is, whether a profit be earned or no. A company asks
subscribers to buy it up and become owners of it, taking its profits,
that it expects to earn, and getting no return at all on their money if
its business is unfortunate and the profits never make their appearance.
Consequently the shareholders in a company run all the risks that
industrial enterprise is heir to, and the return, if any, that comes
into their pockets depends on the ability of the enterprise to earn
profits over and above all that it has to pay for raw material, wages
and other working expenses, all of which have to be met before the
shareholder gets a penny.

In order to meet the objections of steady-going investors to the risks
involved by thus becoming industrial adventurers, a system has grown up
by which the capital of companies is subdivided into securities that
rank ahead of one another. Companies issue debts, like public bodies, in
the shape of bonds or debenture stocks, which entitle the holders of
them to a stated rate of interest, and no more, and are often repayable
at a due date, by drawings or otherwise. These are the first charge on
the concern after wages and other working expenses have been paid, and
the shareholders do not get any profit until the interest on the
company's debt has been met. Further, the actual capital held by the
shareholders is generally divided into two classes, preference and
ordinary, of which the preference take a fixed rate before the ordinary
shareholders get anything, and the ordinary shareholders take the whole
of any balance left over. Sometimes, the preference holders have a
right to further participation after the ordinary have received a
certain amount of dividend, or share of profit, and there are almost
endless variations of the manner in which the different classes of
holders may claim to divide the profits, by means of preference,
preferred, ordinary, preferred ordinary, deferred ordinary, founders'
shares, management shares, etc., etc.

All these variations in the position of the shareholder, however, do not
alter the great essential difference between him and the creditor, the
man who lends money to a Government or enterprise with a fixed rate of
interest, and, in most cases, a claim for repayment sooner or later. The
shareholder, whether preference or ordinary, puts his money into a
venture with no claim for repayment, unless the company is wound up, in
which case his claim ranks, of course, after that of every creditor. If
he wants to get his money out again he can only do so by selling his
stock or shares at any price that they will fetch in the stock market.

Thus, if we take as an example a Brewery company with a total debt and
capital of three millions, we may suppose that it will have a million
4-1/2 per cent, debenture stock, entitling the creditors who own it to
interest at that rate, and repayment in 1935, a million of 6 per cent.
cumulative preference stock, giving holders a fixed dividend, if earned,
of 6 per cent, which dividend and all arrears have to be paid before the
ordinary shareholders get anything, and a million in ordinary shares of
?10 each, whose holders take any balance that may be left. This is the
total of the money that has been received from the public when the
company was floated and put into the brewery plant, tied houses, or
other assets out of which the company makes its revenue.

These bonds and stocks and shares are the machinery of international
finance, by which moneylenders of one nation provide borrowers in others
with the wherewithal to carry out enterprises, or make payments for
which they have not cash available at home. It was shown in a previous
chapter that bills of exchange are a means by which the movements of
commodities from market to market are financed, and the gap in time is
bridged between production and consumption. Stock Exchange securities
are more permanent investments, put into industry for longer periods or
for all time. Midway between them are securities such as Treasury bills
with which Governments raise the wind for a time, pending the collection
of revenue, and the one or two years' notes with which American
railroads lately financed themselves for short periods, in the hope that
the conditions for an issue of bonds with longer periods to run, might
become more favourable.

So far we have only considered the machinery by which these securities
are created and issued to the public, but it must not be supposed that
investment is only possible when new securities are being offered. Many
investors have a prejudice against ever buying a new security,
preferring those which have a record and a history behind them, and
buying them in the market whenever they have money to invest. This
market is the Stock Exchange in which securities of all kinds and of all
countries are dealt in. Following the history of the Ruritanian loan,
we may suppose that it will be dealt in regularly in that section of the
Stock Exchange in which the loans of Foreign Governments are marketed.
Any original subscriber who wants to turn his bonds into money can do so
by instructing his broker to sell them; anyone who wants to do so can
acquire a holding in them by a purchase. The terms on which they will be
bought or sold will depend on the variations in the demand for, and
supply of, them. If a number of holders want to sell, either because
they want cash for other purposes, or because they are nervous about the
political outlook, or because they think that money is going to be
scarce and so there will be better opportunities for investment later
on, then the price will droop. But if the political sky is serene and
people are saving money fast and investing it in Stock Exchange
securities, then the price will go up and those who want to buy it will
pay more. The price of all securities, as of everything else, depends on
the extent to which people who have not got them demand them, in
relation to the extent to which those who have got them are ready to
part with them. Price is ultimately a question of what people think
about things, and this is why the fluctuations in the price of Stock
Exchange securities are so incalculable and often so irrational. If a
sufficient number of misguided people with money in their pockets think
that a bad security is worth buying they will put the price of it up in
the face of the logic of facts and all the arguments of reason. These
wild fluctuations, of course, take place chiefly in the more speculative
securities. Shares in a gold mine can go to any price that the credulity
of buyers dictates, since there is no limit to the amount of gold that
people can imagine to be under the ground in its territory.

All the Stock Exchanges of the world are in communication with one
another by telegraph, or telephone, and so their feelings about prices
react on one another's nerves and imaginations, and the Stock Exchange
price list may be said to be the language of international finance, as
the bill of exchange is its currency.

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