The International Financial Architecture and Emerging Economies INTERNATIONAL MONETARY AND FINANCIAL ECONOMICS Third Edition Joseph P. Daniels David D. VanHoose Copyright © South-Western, a division of Thomson Learning. All rights reserved.

2 International Financial Architecture The international financial architecture is the set of international institutions, governmental and nongovernmental organizations, and the policies that govern activity in the international monetary and financial markets.

3 International Capital Flows Growth in foreign direct investment (FDI) is one of the most important developments in international capital markets. An FDI inflow is an acquisition of domestic financial assets that results in foreign residents owning 10 percent or more of a domestic entity. An FDI outflow is an acquisition of foreign financial assets that results in domestic residents owning 10 percent or more of a foreign entity.

4 Mergers and Acquisitions Cross-border mergers and acquisitions are a driving force of recent growth in FDI in the developed economies. Cross-border mergers and acquisitions entail combining of firms located in different nations in which one firm absorbs the assets and liabilities of another firm (merger) or purchases the assets and liabilities of another firm (acquisition).

5 Cross-Border Mergers and Acquisitions During , M&A inflows of the developed nations increased by more than 500 percent while inflows of the developing nations increased by nearly 600 percent.

6 Net Capital Flows to Emerging Economies Despite recent financial crises, private capital flows to the emerging economies have grown at a remarkable rate.

7 Emerging Economies of the Western Hemisphere Prior to the 1994 Mexican peso crisis, a large portion of FDI inflows consisted of portfolio capital. Since 1994, FDI flows are a greater proportion of the total capital flows.

8 Emerging Economies of Asia Though the emerging economies of East Asia attracted substantial FDI flows during the mid-1990s, they relied heavily on portfolio, bank loans, and other forms of short-term capital.

9 Capital Allocations and Growth With access to foreign capital, domestic residents and businesses can continue to save and invest during domestic economic downturns, thereby smoothing business cycles. Access to global capital can also reduce investment costs for a developing economy, thereby spurring greater investment spending.

10 Financial-Sector Development Because financial intermediaries perform an important role in channeling capital, financial- sector development—the strengthening and growth of the nation’s financial sector institutions, payments systems, and regulatory agencies—contributes to attracting global capital and promoting domestic saving.

11 Capital Misallocations Market imperfections, such as asymmetric information, adverse selection, herding behavior, and moral hazard (Chapter 6) may lead to capital misallocation. Policy-created distortions—government policies that result in a market producing a level of output that is different from the economically efficient level of output—may also result in capital misallocations.

12 Capital Market Liberalization Capital market liberalization—policy actions designed to allow relatively open issuance and competition in a nation’s stock and bond market—entails seeking to maximize the benefits of capital inflows while minimizing the risk of financial instability and crisis.

13 Liberalization and Financial Crises Both portfolio flows and FDI flows have their benefits and risks. Portfolio Investment –Involves the acquisition of foreign financial assets that results in less than a 10 percent ownership share in the entity. Hence, portfolio flows can reverse direction quickly, generating financial instability. Foreign Direct Investment (FDI) –A long-term investment strategy in which the source of funds establishes financial control, making FDI a stabilizing influence on a nation’s economy.

14 Capital Controls Some economists advocate the use of capital controls—legal restrictions on the ability of a nation’s residents to hold and exchange assets denominated in foreign currencies. Most economists are skeptical of the effectiveness of capital controls because empirical studies indicate that only temporary controls on capital inflows may prove to be effective.

15 Schools of Thought on Exchange Rate Regimes In the 1990s, there were two schools of thought on exchange rate regimes. The first school of thought was that there should not be an explicit target for the exchange rate because small misses of the target could cause perception or credibility problems. The second school of thought was that without an explicit target, policymakers are unable to establish policy credibility.

16 The Corners Hypothesis By the end of the 1990s a third view, the corners hypothesis, emerged. This view was that countries should not necessarily fix or float. Rather, they should have a firm commitment to one end of the spectrum or the other. In other words, policymakers should adopt either a rigid peg or a pure float.

17 Dollarization Since the collapse of Argentina's currency-board arrangement, a growing number of economists have advocated dollarization—the replacement of the domestic currency with the currency of another nation— for emerging economies. Two possible problems are the loss of seigniorage revenues and the loss of discretionary monetary policy. Panama, El Salvador and Ecuador are dollarized.

18 Which Regime? Today, prominent economists such as Frankel and Calvo, argue that it all three broad types of exchange-rate regimes, fixed, float and intermediate may be appropriate. The point is that it is the circumstances (business cycles and institutions) of the nation that are most important.

19 International Monetary Fund The International Monetary Fund: A multinational organization that promotes international monetary cooperation and that provides temporary financial assistance to nations experiencing balance-of- payments difficulties. Growth in IMF Membership: The number of member nations in the IMF is now about six times larger than it was when the organization was founded. Conditionality: The limitations on the range of allowable actions of a government that is a recipient of IMF loans.

20 World Bank Lending Even though Africa has the world’s poorest nations, it has received only 19 percent of total World Bank loans since 1990.

21 Crisis Prediction and Early Warning Financial Crisis Indicator: An economic variable that normally moves in a specific direction and by a certain relative amount in advance of a financial crisis, thereby helping to predict a coming crisis. Early Warning System: A mechanism that multinational institutions might use to track financial crisis indicators to determine that a crisis is on the horizon, thereby permitting a rapid response to head off the crisis.