1. Chapter 21 The Global Capital Market: Performance and Policy Problems Prepared by Iordanis Petsas To Accompany International Economics: Theory and Policy International Economics: Theory and Policy, Sixth Edition by Paul R. Krugman and Maurice Obstfeld

2. Slide 21-2Copyright © 2003 Pearson Education, Inc.  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

3. Slide 21-3Copyright © 2003 Pearson Education, Inc. 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?

4. Slide 21-4Copyright © 2003 Pearson Education, Inc.  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

5. Slide 21-5Copyright © 2003 Pearson Education, Inc. 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 HomeForeign

6. Slide 21-6Copyright © 2003 Pearson Education, Inc.  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. The International Capital Market and the Gains From Trade

7. Slide 21-7Copyright © 2003 Pearson Education, Inc.  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 International Capital Market and the Gains From Trade

8. Slide 21-8Copyright © 2003 Pearson Education, Inc.  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. The International Capital Market and the Gains From Trade

9. Slide 21-9Copyright © 2003 Pearson Education, Inc. 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

10. Slide 21-10Copyright © 2003 Pearson Education, Inc. Figure 21-2: Borrowing in the International Capital Market International Banking and the International Capital Market

11. Slide 21-11Copyright © 2003 Pearson Education, Inc.  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 International Banking and the International Capital Market

12. Slide 21-12Copyright © 2003 Pearson Education, Inc.  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. International Banking and the International Capital Market

13. Slide 21-13Copyright © 2003 Pearson Education, Inc. 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 International Banking and the International Capital Market

14. Slide 21-14Copyright © 2003 Pearson Education, Inc.  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 and the International Capital Market

15. Slide 21-15Copyright © 2003 Pearson Education, Inc. 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. International Banking and the International Capital Market

16. Slide 21-16Copyright © 2003 Pearson Education, Inc. 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.

17. Slide 21-17Copyright © 2003 Pearson Education, Inc. 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. Regulating International Banking

18. Slide 21-18Copyright © 2003 Pearson Education, Inc.  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. Regulating International Banking

19. Slide 21-19Copyright © 2003 Pearson Education, Inc.  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. Regulating International Banking

20. Slide 21-20Copyright © 2003 Pearson Education, Inc. 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. Regulating International Banking

21. Slide 21-21Copyright © 2003 Pearson Education, Inc. 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.

22. Slide 21-22Copyright © 2003 Pearson Education, Inc. How Well Has the International Capital Market Performed?  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.

23. Slide 21-23Copyright © 2003 Pearson Education, Inc. Figure 21-3: Saving and Investment Rates for 25 Countries, 1990-1997 Averages How Well Has the International Capital Market Performed?

24. Slide 21-24Copyright © 2003 Pearson Education, Inc.  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. How Well Has the International Capital Market Performed?

25. Slide 21-25Copyright © 2003 Pearson Education, Inc. Figure 21-4: Comparing Eurodollar and Onshore United States Interest Rates How Well Has the International Capital Market Performed?

26. Slide 21-26Copyright © 2003 Pearson Education, Inc.  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: R t – R* t = (E e t+1 – E t )/E t (21-1) where: R t is the date-t interest rate on home currency deposits R* t is the date-t interest rate on foreign currency deposits E e t+1 is the expected exchange rate E t is the exchange rate How Well Has the International Capital Market Performed?

27. Slide 21-27Copyright © 2003 Pearson Education, Inc. –The forecast error made in predicting future depreciation: u t+1 = (E t+1 – E t )/E t - (E e t+1 – E t )/E t (21-2) –Under interest parity, this hypothesis can be tested by writing u t+1 as actual currency depreciation less the international interest difference: u t+1 = (E t+1 – E t )/E t - (R t – R* t ) (21-3) How Well Has the International Capital Market Performed?

28. Slide 21-28Copyright © 2003 Pearson Education, Inc. 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,  t : R t – R* t = (E e t+1 – E t )/E t +  t (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. How Well Has the International Capital Market Performed?

29. Slide 21-29Copyright © 2003 Pearson Education, Inc. 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.

30. Slide 21-30Copyright © 2003 Pearson Education, Inc. 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.

31. Slide 21-31Copyright © 2003 Pearson Education, Inc.  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