1. LECTURES 16 & 17: INTERNATIONAL INTEGRATION OF FINANCIAL MARKETS
Question 1: What are the pros and cons of open financial markets?
Question 2: How high is international capital mobility, and what are the remaining barriers?

2. Advantages of financial opening
For a successfully-developing country, with high return to domestic capital, investment can be financed more cheaply by borrowing abroad than out of domestic saving alone.
Investors in richer countries can earn a higher average return on their saving by investing in emerging markets than they could domestically.
Everyone benefits from the opportunity to diversify away risks and smooth disturbances.

3. Further advantages of financial opening in emerging-market countries
Letting foreign financial institutions into the country improves the efficiency of domestic financial markets It subjects over-regulated and potentially-inefficient domestic institutions
to the harsh discipline of competition and
to the demonstration effect of examples to emulate.
Governments face the discipline of the international capital markets in the event they make policy mistakes.

4. Welfare gains from open capital markets, by analogy with trade in goods.
Even without intertemporal reallocation of output, consumers are better off at B than A (borrowing from abroad to smooth consumption).
In addition, firms can borrow abroad to finance investment, then consuming at C .

5. Does this theory ever work in practice?
When Norway discovered North Sea oil in 1970s, it temporarily ran a large CA deficit,
to finance investment (while the oil fields were being developed) &
consumption (as was rational, since Norwegians knew they would be richer in the future).

6. CAPITAL ACCOUNT LIBERALIZATION: THEORY, EVIDENCE, AND SPECULATION
Effect, when countries open their stock markets to foreign investors, on cost of capital Liberalization occurs in “Year 0.”
CAPITAL ACCOUNT LIBERALIZATION: THEORY, EVIDENCE, AND SPECULATION
Peter Blair Henry Working Paper

7. CAPITAL ACCOUNT LIBERALIZATION: THEORY, EVIDENCE, AND SPECULATION
Effect, when countries open their stock markets to foreign investors, on investment
CAPITAL ACCOUNT LIBERALIZATION: THEORY, EVIDENCE, AND SPECULATION
Peter Blair Henry Working Paper

8. CAPITAL ACCOUNT LIBERALIZATION: THEORY, EVIDENCE, AND SPECULATION
Effect, when countries open their stock markets to foreign investors, on growth
CAPITAL ACCOUNT LIBERALIZATION: THEORY, EVIDENCE, AND SPECULATION
Peter Blair Henry Working Paper

9. Indications that financial markets do not always work so well
Crises => Financial markets work imperfectly
the 1982 international debt crisis,
crisis in the European Exchange Rate Mechanism,
Mexico, E.Asia, esp. Thailand, Korea & Indonesia Russia, 2000 Turkey, 2001 Argentina
2008
U.S. & U.K. !
Iceland, Hungary, Latvia, Ukraine, Pakistan, …

10. Indications that financial markets do not always work so well, continued
It is difficult to argue that investors punish countries when and only when governments follow bad policies:
Large inflows often give way suddenly to large outflows, with little news appearing in between to explain the change in sentiment.
Second, contagion sometimes spreads to countries that are unrelated, or where fundamentals appear strong.
Recessions hitting emerging markets in such crises have been so big, it is hard to argue that the system is working well.

11. 1997-98 economic crash in Asia Source: Guillermo Calvo, 2006.

12. Indications that financial markets do not always work well (continued)
More generally, capital flows have:
often been procyclical, not countercyclical,
been the disturbance source, not the smoother;
not on average gone from rich (high K/L) to poor (low K/L) countries – The “Lucas paradox.”

13. Empirical studies of financial openness and economic performance, reviewed by Kose, Prasad, Rogoff & Wei (2009),
often find little systematic relationship.

14. => Conventional wisdom regarding sequencing:
Some studies find that financial openness is helpful only if countries have already attained an adequate level of:
income -- Biscarri, Edwards, & Perez de Grarcia (2003); Klein & Olivei (1999); Edwards (2001); Martin & Rey (2002); Ranciere, Tornell & Westermann (2008);
financial depth, institutional quality, and other reforms -- Kaminsky & Schmukler (2003); Chinn & Ito (2002); Klein (2003); Obstfeld (2009); Kose, Prasad & Taylor (2009); Wei & Wu (2002); Prasad, Rajan, & Subramanian (2007).
macroeconomic discipline -- Arteta, Eichengreen & Wyplosz (2001).
=> Conventional wisdom regarding sequencing:
it is better liberalize financial markets only after other reforms have been put in place.
-- McKinnon (1993), Edwards (1984, 2008), and Kaminsky & Schmukler (2003).

15. Measuring International Financial Integration
Source: Kose, Prasad, Rogoff & Wei (2009)
Direct measures of barriers, e.g., IMF’s count of freedom from KA restrictions.
II. “Price tests”
III. “Quantity tests”

16. Measuring International Financial Integration, cont.
II. “Price” tests
1.Uniform price across markets, e.g.,
i) Arbitrage of price of a stock listed on two exchanges (or ADRs or GDRs)
ii) Arbitrage between a Country Fund and its constituent assets
2. Interest rate parity (IRP)
i) Covered interest parity (CIP)
a) within one location
b) across national borders (or other ways of controlling for the currency premium, such as sovereign spreads)
ii) Uncovered interest parity (UIP)
iii) Real interest parity (RIP)

17. Country funds Differential
The NYC price of a Mexican basket of stocks ≠ the Net Asset Value of the components traded in Mexico City => imperfect arbitrage.
Note: In the peso crisis of 1994, the local NAV fell
(i) more than the price of the fund in NYC, and (ii) before the devaluation hit --
suggesting that locals might have had better information.

18. IRP: WHY DOES i NOT EQUAL i* ?
Currency factors
Expected currency depreciation
Exchange risk premium
The currency premium can be measured as the forward discount, or the differential between domestic & local $-linked bonds
II. Country factors

19. WHY DOES i NOT EQUAL i* ? II. Country factors, continued
Capital controls
Taxes on cross-border investments
Transaction costs
Imperfect information
Default risk
Risk of future capital controls
The country premium can be measured by the sovereign spread on bank loans or bonds (EMBI), or the covered interest differential (for countries with forward markets), or the differential between local $-linked bonds & US T-bills.

21. COVERED INTEREST PARITY
(1 + iTurkey) =
Forward discount fd  (F-S)/S
=> 1 + fd  F/S
=>
(1 + iTurkey) = (1 + fd) (1 + iUS).
= (1 + fd + iUS + fd iUS).
Because (fd iUS) is small, iTurkey ≈ fd + iUS .
=> If the Turkish nominal interest rate exceeds the U.S. rate, then the lira sells at a discount in the forward exchange market.
(1/S)
(1 + iUS) F
where S is the spot rate in TL/$ and F is the forward rate.

22. Source: Financial Times
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

23. Selling at a forward discount
Financial Times Jan. 30, 2009
Selling at a forward discount
against the $:
Hungarian forint
Russian ruble
Turkish lire
Argentine peso
Indonesian rupiah
S.African rand
Selling at a forward premium
against the $:
S.Korean won

24. FOUR INTEREST RATE PARITY CONDITIONS
Investors decide whether to hold:
so arbitrage => parity condition.
Does it hold in practice?
Covered interest parity within-market
$ deposits vs. covered £ deposits, both within New York market
i$NY - i£NY = fd.
Yes, perfectly.
Covered interest parity across countries
$ deposits in New York vs. covered £ deposits in London
i$NY - i£L = fd.
Yes, if capital controls & default risk are low.
Uncovered interest parity
$ deposits in New York vs. £ deposits in London uncovered.
i$NY - i£L = Δse
If risk is unimportant. Hard to tell in practice.
Real interest parity
Arbitrage is not directly relevant
i$NY - i£L
= ΔpUSe- ΔpUKe
No, not in short run.
CIP
CIP
UIP
RIP

25. Liberalization in a country that had controls on capital inflows.

26. { France kept its controls on capital outflows until the late 1980s.
Liberalization in a country
that had controls on capital 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.
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.

27. Spreads on South African Dollar Debt Downtrend in SA country risk premium, to below 100 basis points by 2006, in tandem with upgrades by rating agencies Source: SA Treasury

28. as among other emerging markets
That spreads were so low for Emerging Market bonds in 2005, and even lower for South Africa, was an indication that global investors were under-pricing risk
-- as also reflected in US corporate spreads, options prices, etc. --
all of which shot back up in

29. the implicit volatility in options prices, such as the VIX.
Low risk perception in led to low spreads in emerging markets around the world – until
Low risk perception in led to low spreads in emerging markets around the world – until
Perception of risk
can be measured by
the implicit volatility
in options prices,
such as the VIX.
Perhaps it responds to
US monetary policy: low in 1993 and 2004.
Source: “The EMBI in the Global Village,” Javier Gomez May 18, juanpablofernandez.wordpress.com/2008/05/

30. DECOMPOSITION OF THE NOMINAL INTEREST DIFFERENTIAL
The country premium could be measured by the sovereign spread, as easily as the covered interest differential.
The currency premium could be measured by the local spread of $-linked vs. domestic-currency bonds, as easily as by the forward discount.

31. Total interest differential (Brazil rate minus LIBOR) =
Currency premium (forward premium) + Country premium (spread)

32. CONCLUSIONS
Some industrialized countries retained capital controls as recently as 1986 (France & Italy), but by 1990 rich countries had liberalized.
Developing countries (“emerging markets”) began to follow.
Nevertheless, all interest differentials remain substantial. Why?
Among rich countries, country premiums are close to zero, but currency premiums are as large as ever.
Among developing countries, country premiums are also big, due particularly to default risk (also capital controls, etc.).
Even if interest rates were equalized on bonds, it would not follow that countries could finance all investment unconstrained by domestic saving. Information barriers are greater for, e.g., home mortgages than foreign (though this was temporarily forgotten, ).

33. III. QUANTITY TESTS OF FINANCIAL INTEGRATION all point to surprisingly low international integration
Home bias in portfolios: Do citizens of each country hold a basket of assets that is optimally diversified internationally?
Consumption risk-sharing: Are countries’ consumption levels correlated with each other more than country incomes?
Feldstein-Horioka test: Do countries’ Investment rates vary independently of their National Saving rates?
Regression is: (I/GDP) = α + β (NS/GDP) + v. Feldstein (1980) argued that if capital were perfectly mobile, would find β = Instead, β was much closer to 1. No No No

34. Appendices Country premium vs. currency premium
Feldstein-Horioka tests

35. Appendix I Total interest differential (Local – US ) = (Currency
premium) (country
premium) = (Δse +
exchange risk premium) (country premium)

36. Appendix II: Critiques of Feldstein Horioka in cross-country samples
“A theoretical model can be constructed in which capital mobility is perfect and yet the saving-investment correlation is high.” Not that useful a statement.
“National Saving is endogenous.” – More serious.
Private saving The “Intertemporal Optimization” critique: Saving varies with the business cycle, or with population or productivity growth.
Fiscal policy The “Maintained external balance critique:
Governments react to trade imbalances to correct them.
Both critiques are true, but can be addressed.

37. there is little observed tendency for it to fall over time.
Three findings that are puzzling, if the saving-investment coefficient is to be interpreted as a measure of barriers to international financial integration:
the coefficient is statistically far above zero (the original Feldstein-Horioka finding),
it is even higher for industrialized than for developing countries, and
there is little observed tendency for it to fall over time.
Michael Dooley, Jeffrey Frankel and Don Mathieson, “International Capital Mobility in Developing Countries vs. Industrial Countries: What Do Saving-Investment Correlations Tell Us?” IMF Staff Papers, 1987.

38. Puzzle:
The coefficient is no lower for industrial countries than for developing countries.

39. Feldstein-Horioka coefficient (β)
may have fallen slightly in the 1980s & 1990s

40. Coefficient is lower for developing
Everyone points out that National Saving is endogenous.
But results change little when using instrumental variables. (Military spending is an exogenous determinant of govt. saving and dependency ratio is an exogenous determinant of private saving.)
Coefficient is lower for developing
countries;
No decline
over time !

41. Feldstein-Horioka coefficient B > 1 if:
4. NS endogenous, so error u in I is correlated with r, even if RIP holds.
3. Real exchange rate expected to change, so RIP fails even if UIP holds.
2. Exchange risk matters, so UIP fails
even if CIP holds.
1. CIP fails

42. DECOMPOSITION OF THE REAL INTEREST DIFFERENTIAL