Financial Globalisation: Opportunity and Crisis

The Global Capital Market The international capital market is the market in which residents of different countries trade assets. It is not a single market but a group of closely interconnected markets. An example of a global capital transaction would be the exchange of Toyota stock for US T-bills.

Q: Why such trades? There are gains to be made from such trades. International transactions fall under three categories: – Goods and services for other goods and services. – Goods and services for assets (i.e. future g&s) – Assets for other assets

Risk Aversion Generally, ceteris paribus, people dislike risk. For example, you have a chance of winning or losing Tk What is the expected value of this gamble? EV = 0.5*(1000) + 0.5*(-1000) = 0 If an agent is risk averse, (s)he will not take the gamble. Risk aversion explains investment in a portfolio of assets rather than a single asset.

Portfolio Diversification: The Motivation for International asset Trade Bonds may be denominated in different currencies, interest rates may differ => the interest parity condition does not hold. However, holding a portfolio of a number of currencies may help to reduce risk.

An example of Portfolio Diversification Two countries: Home and Foreign. Only one asset owned: Land (yielding rice). Yield of the land is uncertain. 50% of the time, Home’s land yields 100 tons of rice (good times), while at the same time Foreign’s land yields 50 tons of rice (bad times). 50% of the time, Home’s land yields 50 tons of rice (bad times), while at the same time Foreign’s land yields 100 tons of rice (bad times).

Q: What is the harvest of each country on average? Home: 0.5* *50 = = 75 tons. Foreign: 0.5* *100 = = 75 tons. However, the residents of home and foreign do not know what the yield will be in any following year.

Suppose Home and Foreign can trade shares in the ownership of each other’s land. Thus, a Home resident who owns a 10% share in Foreign’s land gets 10% of Foreign’s rice. Similarly, a Foreign resident who owns a 10% share in Home’s land gets 10% of Home’s rice. Q: What would be the optimal outcome of a trade? A: Home residents buy a 50% share in Foreign’s land while Foreign residents buy a 50% share in Home’s land.

Calculate the returns from the ownership structure. Good times Home (corresponding to bad times Foreign): 50% of % of 50 = = 75 tons (Home yield) (Foreign yield) Bad times Home(corresponding to good times Foreign): 50% of % of 100 = = 75 tons (Home yield) (Foreign yield)

A similar calculation can be carried out for Foreign. We note that under the ownership structure, residents of Home and Foreign are guaranteed a certain yield which is equivalent to the expected return. Risk averse residents will agree to ownership of 50% of the other country’s land in exchange for 50% of their own land for a sure return of 75 tons of rice every year.

Debt vs. Equity: The menu of international assets Debt instruments: Bonds, Bank Deposits (there is an obligation to repay). Equity instruments: Stocks, shares (a claim to ownership).

International Banking and the International Capital Market Structure of the international capital market: – Commercial Banks (regulatory asymmetry) – Corporations – Non-bank Financial Institutions (eg. Investment banks) – Central Banks and other Government Agencies. Regulatory asymmetry: Reserve requirements may be waived for foreign currency deposits. Overseas branches may not be subjected to parent country regulations. These may generate competitive advantages. Abandonment of fixed exchange rates allows international capital mobility and domestically oriented monetary policy.

Offshore Banking and Offshore Currency Trading Offshore Banking: – Agency office abroad: arranges loans and transfers, no deposit taking. – Subsidiary: Subject to host country regulations not parent country regulations. – Foreign branch: Subject to host and parent country regulations.

Offshore currency Trading: Eurodollars 1957: The British government prohibited lending sterling to finance non-British trade. British banks attracted US$ deposits instead and lent the dollars instead of pounds. Laws prevented this from affecting domestic asset markets. Hence London became the leading centre for Eurocurrency trading. A position it holds to this day.

Offshore Banking The growth of offshore currency trading has gone hand in hand with that of offshore banking. Offshore deposit: Bank deposit in one country in a foreign currency. Ex.: A US$ deposit in a Bangladeshi bank (a “Eorodollar” deposit). Offshore currency deposit: Eurocurrencies. Offshore US$ deposits: Eurodollars. Banks which accept Eurocurrencies: Eurobanks.

Growth of Offshore Banking Growth of international trade may explain part of the growth of offshore banking. But there are other reasons as well: – Escape domestic government regulations – Avoid domestic taxes – Politically motivated reasons

Regulatory Asymmetries Domestic authorities are able impose regulation and exert control over domestic currency transactions. They have control over domestic money supply. However, domestic authorities can exert far less regulation over foreign currency transactions.

An Example Consider a US bank – it must maintain a US$ reserve requirement. However, if the bank has a branch in the UK then that branch will not be subject to a US reserve requirement since, in the UK, only GBP deposits are subject to reserve requirements. Thus, the London Eurobank has a comparative advantage in attracting US$ deposits. It can pay more interest to its depositors than (say) New York banks, while still covering operating costs. It avoids the US “tax” (reserve requirement).

Regulatory Asymmetry Financial centres imposing fewest restrictions on foreign currency deposits and transactions. London, Luxembourg, Bahrain, Hong Kong, Singapore, Dubai …

Regulation of International Banking Q: Is the unregulated nature of global banking activity a threat to stability? Could it lead to massive bank failure? When does a bank fail? It fails when it is unable to meet its obligations to its depositors. Liquidation of assets may not always be feasible and neither can it ensure satisfaction of debt obligations. Bank failures have greater macroeconomic consequences.

Safeguards to Bank Failure Deposit insurance (FDIC in the US). Reserve requirements. Capital requirements and asset restrictions. – Bank’s assets – Bank’s liabilities = Bank’s capital (or net worth) – Holding risky assets like stock is prohibited – Lending restrictions Stress testing (or Bank “examinations”) Lender of last resort facility (Central Banks)

Difficulty in Regulating International Banking Absence of deposit insurance. Absence of reserve requirements. Bank examinations and asset restrictions are difficult to enforce internationally. Which CB has jurisdiction? Often unclear. The Basel Committee (Switzerland, 1973) was set up to facilitate international regulatory cooperation.

How well has the International Currency Market Performed? This is an empirical issue. We can examine data on on – The extent of international portfolio diversification. – The extent of intertemporal trade. – Onshore – Offshore interest differentials (should be close to zero). – Efficiency of the foreign exchange market.

How to measure the efficiency of the forex market? This is largely an econometric issue. Consider The LHS is the market forecast while the RHS is the actual change. Usually the LHS is a bad predictor.

Tests for Excessive Volatility Once again, an econometric issue. Exchange rates are by their very nature volatile. Volatility clustering is often noticed. Possible to use ARCH or GARCH to test for volatility clustering. ARCH, GARCH vs. Random Walk