LECTURES 11 and 12: Globalization of Financial Markets Lecture 11: The post-war financial system Measuring financial integration Foreign exchange markets (more in Appendix) Liberalization & interest rate arbitrage Innovation in financial markets Ways to manage risk: The forward exchange market Securitization Lecture 12: Financial globalization, continued Should countries open up to international capital flows? Advantages of financial integration Disadvantages of financial integration

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.

Menzie Chinn & Hiro Ito, "A New Measure of Financial Openness" (Journal of Comparative Policy Analysis, 2008), updated July I. Direct Measure of Financial Barriers : Chinn-Ito tally of capital controls, from IMF data Rapid financial liberalization in 1990s

II. Quantity measures One comprehensive indicator of gross financial transactions: the volume of turnover in foreign exchange markets. Trading volume rose rapidly in the 1990s. Forward contracts (including swaps) became more than half of the total. ITF220 Prof.J.Frankel

FX trading has continued to grow rapidly. Graph 2 Most trading is among banks. Only 9% is with non-financial customers. {

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

Quantity test shows rising integration IM F

III. Price Measure: Test arbitrage by price of the same asset across borders. 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. Premium of “A shares” (held domestically), over “H shares” (held in Hong Kong) { Higher prices on-shore Chinese firms’ stock prices, onshore relative to offshore:

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 { { ITF220 Prof.J.Frankel

Similarly, Tokyo interest rates were higher than those available in yen offshore (“euroyen”), until Why? Foreign investors were banned from holding Japanese assets. { Japan removed controls on outflows, 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

UK interest rates in were lower domestically than those available offshore. { { Thatcher removed the controls in 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.

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, ITF220 Prof.J.Frankel

COVERED INTEREST PARITY => $ (1 + i US ) = $ (1 + fd)(1 + i UK ). = $ (1 + fd + i UK + fd i UK ). Because (fd i UK ) is small, i US  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

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

ITF220 Prof.J.Frankel Securitization, internationally 1982 – International debt crisis: Banks lose enthusiasm for lending to developing countries – Basel I Agreement sets standards for international banks (e.g., minimum capital requirements) – Brady bonds securitize bad bank loans to developing countries – Mexican peso crisis hits when foreign investors lose willingness to hold CETES & tesobonos – Thai baht crisis also features a larger role for securities – International securitization of US mortgages (“MBS”) ends in tears, with the sub-prime mortgage market crisis – Basel III: AAA ratings for MBSs, ABSs or CDOs => 0 risk. /

ITF220 Prof.J.Frankel I.Direct measures of barriers ( ), 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.

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

Appendix 2: Measures of activity in global foreign exchange markets. 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

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 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 )

ITF220 Prof.J.Frankel 2004

Daily exchange rates: Source: Financial Times, Oct.23, 2001 Emerging markets/ developing countries spot (i.e., immediate delivery) ITF220 Prof.J.Frankel