Chapter 21Chapter 21The Global Capital Market:The Global Capital Market:
Performance and Policy ProblemsPerformance and Policy Problems
Prepared by Iordanis Petsas
To AccompanyInternational Economics: Theory and PolicyInternational Economics: Theory and Policy, Sixth Edition
by Paul R. Krugman and Maurice Obstfeld
Introduction
The International Capital Market and the Gains fromTrade
International Banking and the International CapitalMarket
Regulating International Banking
How Well Has the International Capital MarketPerformed?
Summary
Chapter Organization
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Introduction
The International Capital Market and the Gains fromTrade
International Banking and the International CapitalMarket
Regulating International Banking
How Well Has the International Capital MarketPerformed?
Summary
Introduction International capital market
• The group of closed interconnected markets in whichresidents of different countries trade assets such ascurrencies, 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 aworldwide capital market without sharply reducing thebenefits it provides?
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International capital market• The group of closed interconnected markets in which
residents of different countries trade assets such ascurrencies, 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 aworldwide capital market without sharply reducing thebenefits it provides?
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
The International Capital Marketand the Gains From Trade
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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
The International Capital Marketand the Gains From Trade
Figure 21-1: The Three Types of International Transaction
GoodsandServices
GoodsandServices
Home Foreign
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Assets Assets
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.
The International Capital Marketand the Gains From Trade
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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.
Portfolio Diversification as a Motive for InternationalAsset Trade• International portfolio diversification can allow
residents of all countries to reduce the variability oftheir wealth.
– International capital markets make this diversificationpossible.
The International Capital Marketand the Gains From Trade
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Portfolio Diversification as a Motive for InternationalAsset Trade• International portfolio diversification can allow
residents of all countries to reduce the variability oftheir wealth.
– International capital markets make this diversificationpossible.
The Menu of International Assets: Debt VersusEquity• 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.
The International Capital Marketand the Gains From Trade
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The Menu of International Assets: Debt VersusEquity• 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.
International Banking and theInternational 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
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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
Figure 21-2: Borrowing in the International Capital Market
International Banking and theInternational Capital Market
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Growth of the International Capital Market• The removal of barriers to private capital flows across
countries’ borders has contributed to rapid growth inthe 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
International Banking and theInternational Capital Market
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Growth of the International Capital Market• The removal of barriers to private capital flows across
countries’ borders has contributed to rapid growth inthe 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
Offshore Banking and Offshore Currency Trading• Offshore banking
– The business that banks’ foreign offices conduct outsideof their home countries
– Banks operate offshore though any of three types ofinstitution:
– 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.
International Banking and theInternational Capital Market
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Offshore Banking and Offshore Currency Trading• Offshore banking
– The business that banks’ foreign offices conduct outsideof their home countries
– Banks operate offshore though any of three types ofinstitution:
– 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.
• 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 reserverequirements
– Political concerns
International Banking and theInternational Capital Market
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• 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 reserverequirements
– Political concerns
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
International Banking and theInternational Capital Market
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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
• International banking facilities (IBFs)– Banks that accept time deposits and make loans to
foreign customers.
– They are not subject to reserve requirements or interestrate ceilings.
– They are exempt from state and local taxes.
International Banking and theInternational Capital Market
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• International banking facilities (IBFs)– Banks that accept time deposits and make loans to
foreign customers.
– They are not subject to reserve requirements or interestrate ceilings.
– They are exempt from state and local taxes.
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 throughextensive regulation of their domestic bankingsystems.
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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 throughextensive regulation of their domestic bankingsystems.
• The main U.S. safeguards to reduce the risk of bankfailure:
– 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.
Regulating International Banking
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• The main U.S. safeguards to reduce the risk of bankfailure:
– 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.
Difficulties in Regulating International Banking• Deposit insurance is essentially absent in international
banking.
• The absence of reserve requirements reduces thestability of the banking system.
• Bank examination to enforce capital requirements andasset restrictions becomes more difficult in aninternational setting.
• There is uncertainty over which central bank isresponsible for providing LLR assistance ininternational banking.
Regulating International Banking
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Difficulties in Regulating International Banking• Deposit insurance is essentially absent in international
banking.
• The absence of reserve requirements reduces thestability of the banking system.
• Bank examination to enforce capital requirements andasset restrictions becomes more difficult in aninternational setting.
• There is uncertainty over which central bank isresponsible for providing LLR assistance ininternational banking.
International Regulatory Cooperation• Offshore banking is largely unprotected by the
safeguards national governments have imposed toprevent 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 forinformation exchange.
Regulating International Banking
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International Regulatory Cooperation• Offshore banking is largely unprotected by the
safeguards national governments have imposed toprevent 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 forinformation exchange.
• A major change in international financial relations inthe 1990s has been the rapidly growing importance ofnew emerging markets as sources and destinations forprivate capital flows.
• The trend toward securitization has increased the needfor international cooperation in monitoring andregulating nonbank financial institutions.
Regulating International Banking
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• A major change in international financial relations inthe 1990s has been the rapidly growing importance ofnew emerging markets as sources and destinations forprivate capital flows.
• The trend toward securitization has increased the needfor international cooperation in monitoring andregulating nonbank financial institutions.
How Well Has the InternationalCapital Market Performed?
The Extent of International Portfolio Diversification• The international capital market has contributed to an
increase in international portfolio diversification since1970.
• The extent of diversification appears small comparedwith what economic theory would predict.
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The Extent of International Portfolio Diversification• The international capital market has contributed to an
increase in international portfolio diversification since1970.
• The extent of diversification appears small comparedwith what economic theory would predict.
How Well Has the InternationalCapital Market Performed?
The Extent of Intertemporal Trade• Some observers claim that the extent of international
trade, as measured by countries’ current accountbalances, has been too small.
– These claims are hard to evaluate.
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The Extent of Intertemporal Trade• Some observers claim that the extent of international
trade, as measured by countries’ current accountbalances, has been too small.
– These claims are hard to evaluate.
Figure 21-3: Saving and Investment Rates for 25 Countries,1990-1997 Averages
How Well Has the InternationalCapital Market Performed?
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Onshore-Offshore Interest Differentials• If the world capital market is functioning well,
international interest rates should move closelytogether and not differ too greatly.
– Large interest rate differences would be strong evidenceof unrealized gains from trade.
– Data shows that rates of return on similar deposits issued in themajor financial centers are quite close.
How Well Has the InternationalCapital Market Performed?
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Onshore-Offshore Interest Differentials• If the world capital market is functioning well,
international interest rates should move closelytogether and not differ too greatly.
– Large interest rate differences would be strong evidenceof unrealized gains from trade.
– Data shows that rates of return on similar deposits issued in themajor financial centers are quite close.
Figure 21-4: Comparing Eurodollar and Onshore United States InterestRates
How Well Has the InternationalCapital Market Performed?
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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
How Well Has the InternationalCapital Market Performed?
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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
– The forecast error made in predicting futuredepreciation:
ut+1 = (Et+1 – Et)/Et - (Eet+1 – Et)/Et (21-2)
– Under interest parity, this hypothesis can be tested bywriting ut+1 as actual currency depreciation less theinternational interest difference:
ut+1 = (Et+1 – Et)/Et - (Rt – R*t) (21-3)
How Well Has the InternationalCapital Market Performed?
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– The forecast error made in predicting futuredepreciation:
ut+1 = (Et+1 – Et)/Et - (Eet+1 – Et)/Et (21-2)
– Under interest parity, this hypothesis can be tested bywriting ut+1 as actual currency depreciation less theinternational interest difference:
ut+1 = (Et+1 – Et)/Et - (Rt – R*t) (21-3)
• The Role of Risk Premiums– If bonds denominated in different currencies are
imperfect substitutes for investors, the internationalinterest rate difference equals expected currencydepreciation 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.
How Well Has the InternationalCapital Market Performed?
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• The Role of Risk Premiums– If bonds denominated in different currencies are
imperfect substitutes for investors, the internationalinterest rate difference equals expected currencydepreciation 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.
Summary
When people are risk averse, countries can gainthrough the exchange of risky assets.
International portfolio diversification can be carriedout though the exchange of debt instruments of equityinstruments.
One important component in the international capitalmarket is the foreign exchange market.• Banks are at the center of the international capital
market, and many operate offshore.
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When people are risk averse, countries can gainthrough the exchange of risky assets.
International portfolio diversification can be carriedout though the exchange of debt instruments of equityinstruments.
One important component in the international capitalmarket is the foreign exchange market.• Banks are at the center of the international capital
market, and many operate offshore.
Summary
Regulatory and political factors have encouragedoffshore banking and currency trading.
Creation of a Eurocurrency deposit does not occurbecause 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 enhanceregulatory cooperation in the international area.• There is uncertainty about a central bank’s obligations
as an international lender of last resort.
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Regulatory and political factors have encouragedoffshore banking and currency trading.
Creation of a Eurocurrency deposit does not occurbecause 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 enhanceregulatory cooperation in the international area.• There is uncertainty about a central bank’s obligations
as an international lender of last resort.
The international capital market has contributed to anincrease in international portfolio diversification since1970.
The foreign exchange market’s record incommunicating appropriate price signals tointernational traders and investors is mixed.
Summary
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The international capital market has contributed to anincrease in international portfolio diversification since1970.
The foreign exchange market’s record incommunicating appropriate price signals tointernational traders and investors is mixed.
