1. The Global Capital Market: Performance and Policy Problems
Chapter 21
The Global Capital Market:
Performance and Policy Problems

2. Chapter Organization 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

3. 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. 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

5. 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

6. 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.

7. 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.

8. 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.

9. 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. International Banking and the International Capital Market
Figure 21-2: Borrowing in the International Capital Market

11. International Banking and the International Capital Market
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

12. International Banking and the International Capital Market
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.

13. International Banking and the International Capital Market
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

14. International Banking and the International Capital Market
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

15. International Banking and the International Capital Market
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.

16. 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. 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.

18. 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.

19. 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.

20. 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.

21. 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. 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. How Well Has the International Capital Market Performed?
Figure 21-3: Saving and Investment Rates for 25 Countries,
Averages

24. How Well Has the International Capital Market Performed?
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.

25. How Well Has the International Capital Market Performed?
Figure 21-4: Comparing Eurodollar and Onshore United States Interest Rates

26. How Well Has the International Capital Market Performed?
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

27. How Well Has the International Capital Market Performed?
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)

28. How Well Has the International Capital Market Performed?
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.

29. 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. 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. Summary
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.