International economic ch21

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

 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

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?

 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

Figure 21-1: The Three Types of International Transaction
Goods
and
Services
Assets
Goods
and
Services
Assets
Home Foreign

 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 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 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.

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

Figure 21-2: Borrowing in 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

 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.

• 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

 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 interest
rate 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 through
extensive regulation of their domestic banking
systems.

• 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.

 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.

 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.

• 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.

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.

 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.

Figure 21-3: Saving and Investment Rates for 25 Countries,
1990-1997 Averages

 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.

Figure 21-4: Comparing Eurodollar and Onshore United States Interest
Rates

 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

– 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)

• 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.

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.

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.

 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

International economic ch21

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