ECO 401: International Economics Lecture Aisha Khan Winter 2009 BSC IV Section B & C

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?

The International Capital Market and the Gains From Trade 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 Copyright © 2003 Pearson Education, Inc. The International Capital Market and the Gains From Trade Figure 21-1: The Three Types of International Transaction Home Foreign Goods and Services Goods and Services Assets Assets

The International Capital Market and the Gains From Trade Copyright © 2003 Pearson Education, Inc. The International Capital Market and the Gains From Trade 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 Copyright © 2003 Pearson Education, Inc. The International Capital Market and the Gains From Trade 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 Copyright © 2003 Pearson Education, Inc. The International Capital Market and the Gains From Trade 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.

International Banking and the International Capital Market Copyright © 2003 Pearson Education, Inc. 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

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

International Banking and the International Capital Market Copyright © 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 Copyright © 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 Copyright © 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 Copyright © 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 Copyright © 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.

Regulating International Banking Copyright © 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.

Regulating International Banking Copyright © 2003 Pearson Education, Inc. Regulating International Banking 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 Copyright © 2003 Pearson Education, Inc. Regulating International Banking 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 Copyright © 2003 Pearson Education, Inc. Regulating International Banking 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 Copyright © 2003 Pearson Education, Inc. Regulating International Banking 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.

How Well Has the International Capital Market Performed? Copyright © 2003 Pearson Education, Inc. 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.

How Well Has the International Capital Market Performed? Copyright © 2003 Pearson Education, Inc. 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.

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

How Well Has the International Capital Market Performed? Copyright © 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: Rt – R*t = (Eet+1 – Et)/Et (21-1) where: Rt is the date-t interest rate on home currency deposits R*t is the date-t interest rate on foreign currency deposits Eet+1 is the expected exchange rate Et is the exchange rate

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

How Well Has the International Capital Market Performed? Copyright © 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: Rt – R*t = (Eet+1 – Et)/Et + 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.