Lecture 11: Measuring financial integration• Foreign exchange markets (more in Appendix)

• Liberalization & interest rate arbitrage• How to manage risk: The forward exchange market

Lecture 12: Financial globalization, continued• Should countries open up to international capital flows?

• Advantages of financial integration • Disadvantages of financial integration

LECTURES 11 and 12:Globalization of Financial Markets

ITF220 Prof.J.Frankel

I. Direct measures of barriers, e.g., IMF count of freedom from KA restrictions.

II. “Quantity tests”

III. “Price tests”Source: Kose, Prasad, Rogoff & Wei (2009)

Measuring International

Financial Integration

All show general trend toward financial integration.

1970-2004

Menzie Chinn & Hiro Ito, "A New Measure of Financial Openness" (Journal of Comparative Policy Analysis, 2008), updated July 2010

http://web.pdx.edu/~ito/Chinn-Ito_website.htm.

I. Direct Measure of Financial Barriers: Chinn-Ito tally of capital controls, from IMF data

Rapid financial liberalization in 1990s

Chinn-Ito Measure of Financial Openness

The calculations are based on 4 categories in the IMF’s Annual Report on Exchange Arrangements & Exchange Restrictions: multiple exchange rates, current account

restrictions, capital account restrictions, and required surrender of export proceeds.

Graph 2

Most trading is among banks;only 9% is with non-financial

customers.

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II. Quantity measures

One comprehensive indicator of gross financial transactions:

the volume of turnover in foreign exchange markets.

FX trading has continued to grow rapidly.

FX transactions now exceed $5 trillion per day

Spot transactions < ½. More are forwards & related derivatives.

Graph 3

}

Quantity test shows rising integration

IMF

.

Robert McCauley, CFR conference on Internationalization of the RMB, Beijing, Nov.2011, Graph 5. Data Source: Bloomberg, BIS

Note: company composition of the two indices differs.“Investing in Chinese shares,” Economist, Sept. 27, 2014

}

Premium of “A shares” (held domestically), over “H shares” (held in Hong Kong)

Higher prices onshore

Chinese firms’ stock prices, onshore relative to offshore

III. Price Measure: Test arbitrage by price of the same asset across borders

Price Measure:Covered interest arbitrage

German interest rates in Frankfurtin 1973 >> rates available in marks

offshore in London(whether measured in euromarks

or covered eurodollars).

Why? Stringent capital controls penalized foreign investors who

wanted to acquire German assets.

Germany removed capital controlsafter the need to defend the fixed ex-

change rate had been overtaken by events,

=> The interest differentialdisappeared in 1974.

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{ITF220 Prof.J.Frankel

Similarly, Tokyo interest rates

were higher than those available in yen offshore (“euroyen”),

until 1979.

Why? Foreign investors

were banned from holding

Japanese assets.

{Japan removed

controls on outflows, 1979-83.

Again, arbitrage eliminated the

interest differential.

In 1978, Japan still prohibited foreigners from holding deposits in Tokyo => interest differential.

Liberalization in another country that had controls on capital inflows

Source: Frankel (1985), The Yen/Dollar Agreement ITF220 Prof.J.Frankel

ITF220 Prof.J.Frankel

UK interest rates in 1977-78 were lower domestically than those available offshore.

{

{ Thatcher removed the controls in 1979.Interest differential fell to 0.

Liberalization in a country that had controls on outflows

Controls against capital outflow kept domestic investorsfrom taking money out.

ITF220 Prof.J.Frankel

COVERED INTEREST PARITY

=> $ (1 + iUS) = $ (1 + fd)(1 + iUK).

= $ (1 + fd + iUK + fd iUK ).

Forward discount: fd (F - S)/S

where S is the spot rate in $/£ and F is the forward rate.

If the U.S. nominal interest rate exceeds the U.K. rate, the $ sells at a discount in the forward exchange market.

+ iUS £(1/S) (1+iUK) (F $/£)= $ 1

=> 1 + fd F/S

Because (fd iUK) is small, iUS fd + iUK.

ITF220 Prof.J.Frankel Source: Financial TimesAccessed 11/2/2007

Selling at a forward discountagainst the $:Turkish lireArgentine pesoBrazilian real

Selling at a forward premiumagainst the $:

YenNew Taiwan $UAE dirham

Spot rateDaily exchange rates

Forward: Transaction cost

In late 2008 Covered Interest Parity surprisingly failed,in a Global-Financial-Crisis rush to the $ as safe haven.

Significant determinants are apparently counterparty risk & liquidity, proxied by financial stock CDS, VIX, implied fx volatility, OIS bid-ask spreads & Fed swap lines.

Inês Isabel Sequeira de Freitas Serra, ”Covered Interest Parity,” NOVA – School of Business & Economics, Lisbon, Jan. 2012 http://run.unl.pt/handle/10362/9528

Covered interest differentials, using Overnight Index Swap interest rates, 2003-2011

ITF220 Prof.J.Frankel

I. Direct measures of barriers(1970-2004), e.g., count of freedom

from KA restrictions, IMF.

II. “Quantity tests”

Source: Kose, Prasad, Rogoff & Wei (2009)

Measuring International Financial Integration for Developing Countries

Appendix 1:

For emerging markets, liberalization has been more rapid de facto than de jure: Capital controls are hard to enforce.

A shares, which domestic residents held, sold at a premium to B shares, which Chinese firms could issue to foreign investors.

Source: Vicki Wei Tang (2011)

In the 1990s, foreign residents held B shares, listed in Shenzhen or Shanghai. In 2001, Chinese citizens were allowed to buy B shares.

} Higher prices

on-shore

III. Price test: Price of the same asset across borders

Chinese firms’ stock prices, onshore relative to offshore:

.

R. McCauley, CFR conference on Internationalization of the RMB, Beijing, Nov.2011. Data Source: Bloomberg, BISNote: company composition of the two indices differs.

Premium of “A shares” (held domestically), over “H shares”

{ Higher prices on-shore

Chinese firms’ stock prices, onshore relative to offshore:

“H” shares (held in Hong Kong) became more important.

France kept its controls on capital outflows until the late 1980s.

Again, they produced an offshore-onshore differential, which shot up whenever there was speculation of a franc devaluation.

Again, the differential disappeared after controls were removed.

{

Liberalization in a country

that had controls on outflows

From: M. Mussa and M. Goldstein, “The Integration of World Capital Markets,” Changing Capital Markets: Implications for Monetary Policy, Fed.Res.Bk. Kansas City, 1993.

ITF220 Prof.J.Frankel

The forward premium + the country premium add up to the differential

{ {{

between Brazilian interest rates and $ interest rates in London (LIBOR)

Price test: Sovereign spread on Brazilian debt

ITF220 Prof.J.Frankel

Trading volume in forex markets rose rapidly in the 1990s.

Forward contracts (including swaps) became more than half of the total.

ITF220 Prof.J.Frankel

Appendix 2: Measures of activity in

global foreign exchange markets.

ITF220 Prof.J.Frankel

The world’s largest financial center, as measured by FX, is London, not New York.

In 2010, UK banks accounted for 36.7% of forex turnover, followed by the US (18%), Japan (6%), Singapore (5%), Switzerland (5%), Hong Kong SAR (5%) & Australia (4%).

ITF220 Prof.J.Frankel

ITF220 Prof.J.FrankelSource: BIS, Triennial Central Bank Survey: Report on global foreign exchange market activity in 2010 (Basel, Dec.2010).

The dollar remains the leading vehicle currency, used in 85% of transactions.

Global fx market turnover was 20% higher in 2010 than in 2007, with average daily turnover of $4.0 trillion compared to $3.3 trillion.

Daily turnover in OTC interest rate derivatives grew by 24%, to $2.1 trillion in 2010.

The rise was driven by the 48% growth in turnover of spot transactions, (=37% of fx turnover; spot turnover rose to $1.5 tr. in 2010 from $1.0 tr. in 2007.)

ITF220 Prof.J.Frankel

2004

ITF220 Prof.J.Frankel

Securitization, internationally

1982 – International debt crisis: Banks lose enthusiasm for lending to developing countries.

1987 – Basel I Agreement sets standards for international banks (e.g., minimum capital requirements).1989 – Brady bonds securitize bad bank loans to developing countries.

1994 – Mexican peso crisis hits when foreign investors lose willingness to hold CETES & tesobonos.

1997 – Thai baht crisis also features a larger role for securities.

2007-08 – International securitization of US mortgages (“MBS”)ends in tears, with the sub-prime mortgage market crisis.

2011 – Basel III: AAA ratings for MBSs, ABSs or CDOs ≠> 0 risk.