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International economic ch21
1. Chapter 21Chapter 21
The Global Capital Market:The Global Capital Market:
Performance and Policy ProblemsPerformance and Policy Problems
Prepared by Iordanis Petsas
To Accompany
International Economics: Theory and PolicyInternational Economics: Theory and Policy, Sixth Edition
by Paul R. Krugman and Maurice Obstfeld
2. 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
Chapter Organization
3. 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?
4. 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 Market
and the Gains From Trade
5. The International Capital Market
and the Gains From Trade
Figure 21-1: The Three Types of International Transaction
Goods
and
Services
Assets
Goods
and
Services
Assets
Home Foreign
6. 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 Market
and the Gains From Trade
7. 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.
The International Capital Market
and the Gains From Trade
8. 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.
The International Capital Market
and the Gains From Trade
9. 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
10. Figure 21-2: Borrowing in the International Capital Market
International Banking and the
International Capital Market
11. 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
International Banking and the
International Capital Market
12. 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.
International Banking and the
International Capital Market
13. • 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
International Banking and the
International Capital Market
14. 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 the
International Capital Market
15. • 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.
International Banking and the
International Capital Market
16. 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.
17. • 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.
Regulating International Banking
18. 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.
Regulating International Banking
19. 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.
Regulating International Banking
20. • 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.
Regulating International Banking
21. 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.
22. 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.
23. Figure 21-3: Saving and Investment Rates for 25 Countries,
1990-1997 Averages
How Well Has the International
Capital Market Performed?
24. 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.
How Well Has the International
Capital Market Performed?
25. Figure 21-4: Comparing Eurodollar and Onshore United States Interest
Rates
How Well Has the International
Capital Market Performed?
26. 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= (Ee
t+1 – Et)/Et (21-1)
where:
Rtis the date-t interest rate on home currency deposits
R*tis the date-t interest rate on foreign currency deposits
Ee
t+1is the expected exchange rate
Et is the exchange rate
How Well Has the International
Capital Market Performed?
27. – The forecast error made in predicting future
depreciation:
ut+1 = (Et+1 – Et)/Et - (Ee
t+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)
How Well Has the International
Capital Market Performed?
28. • 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, ρt:
Rt – R*t= (Ee
t+1 – Et)/Et+ ρt (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 International
Capital Market Performed?
29. 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.
30. 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.
31. 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.
Summary