1. 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

2. 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

3. 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.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

4. 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.

5. Graph 2 Most trading is among banks; only 9% is with non-financial customers. { 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.

6. FX transactions now exceed $5 trillion per day Spot transactions < ½. More are forwards & related derivatives. Graph 3 }

7. Quantity test shows rising integration IMF

8. . 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

9. Price Measure: Covered interest arbitrage German interest rates in Frankfurt in 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 controls after the need to defend the fixed ex- change rate had been overtaken by events, => The interest differential disappeared in 1974. { { ITF220 Prof.J.Frankel

10. 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

11. 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 investors from taking money out.

12. ITF220 Prof.J.Frankel COVERED INTEREST PARITY => $ (1 + i US ) = $ (1 + fd)(1 + i UK ). = $ (1 + fd + i UK + fd i UK ). 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. + i US £ (1/S) (1+i UK ) (F $/£ ) = $ 1 => 1 + fd  F/S Because (fd i UK ) is small, i US  fd + i UK.

13. ITF220 Prof.J.Frankel Source: Financial Times Accessed 11/2/2007 Selling at a forward discount against the $: Turkish lire Argentine peso Brazilian real Selling at a forward premium against the $: Yen New Taiwan $ UAE dirham Spot rate Daily exchange rates Forward: Transaction cost

14. 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

15. 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.

16. 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:

17. . R. McCauley, CFR conference on Internationalization of the RMB, Beijing, Nov.2011. Data Source: Bloomberg, BIS Note: 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.

18. 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

19. 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

20. 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.

21. 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%).

22. ITF220 Prof.J.Frankel

23. Source: BIS, Triennial Central Bank Survey: Report on global foreign exchange market activity in 2010 (Basel, Dec.2010).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. )

24. ITF220 Prof.J.Frankel 2004

25. 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.