Chapter 21 The Global Capital Market: Performance and Policy Problems

1. Chapter 21 The Global Capital Market: Performance and Policy Problems Prepared by Iordanis Petsas To Accompany International Economics: Theory and Policy, Sixth Edition by Paul R. Krugman and Maurice Obstfeld

3. Chapter Organization • Introduction • The International Capital Market and the Gains from Trade • International Banking and the International Capital Market • Regulating International Banking • How Well Has the International Capital Market Performed? • Summary

4. Introduction • International capital market • The group of closed interconnected markets in which residents of different countries trade assets such as currencies, stocks and bonds • This chapter focus on three main questions: • How has the international capital market enhanced countries’ gains from trade? • What caused the rapid growth in international financial activity that has occurred since the early 1960s? • How can policymakers minimize problems raised by a worldwide capital market without sharply reducing the benefits it provides?

5. The International Capital Market and the Gains From Trade • Three Types of Gain From Trade • All transactions between the residents of different countries fall into one of three categories: • Trades of goods or services for goods or services • Trades of goods or services for assets • Trades of assets for assets

6. Goods and Services Goods and Services Assets Assets The International Capital Market and the Gains From Trade Figure 21-1: The Three Types of International Transaction Home Foreign

7. The International Capital Market and the Gains From Trade • Risk Aversion • The risk associated with a trade of assets is shared when assets are traded internationally. • When people are risk averse, countries can gain through the exchange of risky assets. • International capital markets make these trades possible.

8. The International Capital Market and the Gains From Trade • Portfolio Diversification as a Motive for International Asset Trade • International portfolio diversification can allow residents of all countries to reduce the variability of their wealth. • International capital markets make this diversification possible.

9. The International Capital Market and the Gains From Trade • The Menu of International Assets: Debt Versus Equity • International portfolio diversification can be carried out through the exchange of: • Debt instruments • Bonds and bank deposits • They specify that the issuer of the instrument must repay a fixed value regardless of economic circumstances. • Equity instruments • A share of stock • It is a claim to a firm’s profits, rather than to a fixed payment, and its payoff will vary according to circumstance.

10. International Banking and the International Capital Market • The Structure of the International Capital Market • The main actors in the international capital market are: • Commercial banks • Corporations • Nonbank financial institutions • Central banks and other government agencies

11. International Banking and the International Capital Market Figure 21-2: Borrowing in the International Capital Market

12. International Banking and the International Capital Market • Growth of the International Capital Market • The removal of barriers to private capital flows across countries’ borders has contributed to rapid growth in the international capital market. • A policy “trilemma” refers to three available options: • Fixed exchange rate • Monetary policy oriented toward domestic goals • Freedom of international capital movements

13. International Banking and the International Capital Market • Offshore Banking and Offshore Currency Trading • Offshore banking • The business that banks’ foreign offices conduct outside of their home countries • Banks operate offshore though any of three types of institution: • Agency office • Subsidiary bank • Foreign branch • Offshore currency trading • Trade in bank deposits denominated in currencies of countries other than the one in which the bank is located • It is referred to as Eurocurrency trading.

14. International Banking and the International Capital Market • Eurodollars • Dollar deposits located outside the U.S. • Eurobanks • Banks that accept deposits denominated in Eurocurrencies • Eurocurrency trading has grown for three reasons: • Growth in world trade • Evasion of financial regulations like reserve requirements • Political concerns

15. International Banking and the International Capital Market • The Growth of Eurocurrency Trading • London is the leading center of Eurocurrency trading. • The early growth in the Eurodollar market was due to: • Growing volume of international trade • Cold War • New U.S. restrictions on capital outflows and U.S. banking regulations • Federal Reserve regulations on U.S. banks (e.g., the Fed’s Regulation Q) • Move to floating exchange rates in 1973 • Reluctance of Arab OPEC members to place surplus funds in American banks after the first oil shock

16. International Banking and the International Capital Market • International banking facilities (IBFs) • Banks that accept time deposits and make loans to foreign customers. • They are not subject to reserve requirements or interest rate ceilings. • They are exempt from state and local taxes.

17. Regulating International Banking • The Problem of Bank Failure • A bank fails when it is unable to meet its obligations to its depositors. • Governments attempt to prevent bank failures through extensive regulation of their domestic banking systems.

18. Regulating International Banking • The main U.S. safeguards to reduce the risk of bank failure: • Deposit insurance • Reserve requirements • Capital requirements and asset restrictions • Bank examination • Lender of last resort(LLR) facilities • The Fed lends to banks facing massive deposit outflows to satisfy their depositors’ claims.

19. Regulating International Banking • Difficulties in Regulating International Banking • Deposit insurance is essentially absent in international banking. • The absence of reserve requirements reduces the stability of the banking system. • Bank examination to enforce capital requirements and asset restrictions becomes more difficult in an international setting. • There is uncertainty over which central bank is responsible for providing LLR assistance in international banking.

20. Regulating International Banking • International Regulatory Cooperation • Offshore banking is largely unprotected by the safeguards national governments have imposed to prevent domestic bank failures. • Basel Committee • It is a group of central bank heads from 11 industrialized countries. • It enhances regulatory cooperation in the international area. • Its 1975 Concordat allocated national responsibility for monitoring banking institutions and provided for information exchange.

21. Regulating International Banking • A major change in international financial relations in the 1990s has been the rapidly growing importance of new emerging markets as sources and destinations for private capital flows. • The trend toward securitization has increased the need for international cooperation in monitoring and regulating nonbank financial institutions.

22. How Well Has the International Capital Market Performed? • The Extent of International Portfolio Diversification • The international capital market has contributed to an increase in international portfolio diversification since 1970. • The extent of diversification appears small compared with what economic theory would predict.

23. How Well Has the International Capital Market Performed? • The Extent of Intertemporal Trade • Some observers claim that the extent of international trade, as measured by countries’ current account balances, has been too small. • These claims are hard to evaluate.

24. How Well Has the International Capital Market Performed? Figure 21-3: Saving and Investment Rates for 25 Countries, 1990-1997 Averages

25. How Well Has the International Capital Market Performed? • Onshore-Offshore Interest Differentials • If the world capital market is functioning well, international interest rates should move closely together and not differ too greatly. • Large interest rate differences would be strong evidence of unrealized gains from trade. • Data shows that rates of return on similar deposits issued in the major financial centers are quite close.

26. How Well Has the International Capital Market Performed? Figure 21-4: Comparing Eurodollar and Onshore United States Interest Rates

27. How Well Has the International Capital Market Performed? • The Efficiency of the Foreign Exchange Market • Exchange rates provide important signals to those who engage in international trade and investment. • Studies Based on Interest Parity • The interest parity condition: Rt– R*t = (Eet+1 – Et)/Et(21-1) where: Rt is the date-t interest rate on home currency deposits R*t is the date-t interest rate on foreign currency deposits Eet+1 is the expected exchange rate Et is the exchange rate

28. How Well Has the International Capital Market Performed? • The forecast error made in predicting future depreciation: ut+1 = (Et+1 – Et)/Et - (Eet+1 – Et)/Et(21-2) • Under interest parity, this hypothesis can be tested by writing ut+1 as actual currency depreciation less the international interest difference: ut+1 = (Et+1 – Et)/Et - (Rt – R*t)(21-3)

29. How Well Has the International Capital Market Performed? • The Role of Risk Premiums • If bonds denominated in different currencies are imperfect substitutes for investors, the international interest rate difference equals expected currency depreciation plus a risk premium, t: Rt – R*t= (Eet+1 – Et)/Et + t(21-4) • Tests for Excessive Volatility • They yield a mixed verdict on the foreign exchange performance. • The Bottom Line • Evidence on foreign exchange market is ambiguous; more research and experience are needed.

30. Summary • When people are risk averse, countries can gain through the exchange of risky assets. • International portfolio diversification can be carried out though the exchange of debt instruments of equity instruments. • One important component in the international capital market is the foreign exchange market. • Banks are at the center of the international capital market, and many operate offshore.

31. Summary • Regulatory and political factors have encouraged offshore banking and currency trading. • Creation of a Eurocurrency deposit does not occur because that currency leaves its country of origin. • It poses no threat for central banks’ control over their domestic monetary bases. • The Basel Committee has worked to enhance regulatory cooperation in the international area. • There is uncertainty about a central bank’s obligations as an international lender of last resort.

32. Summary • The international capital market has contributed to an increase in international portfolio diversification since 1970. • The foreign exchange market’s record in communicating appropriate price signals to international traders and investors is mixed.