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Copyright 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 21

FinancialGlobalization:

Opportunityand Crisis

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Copyright 2012 Pearson Addison-Wesley. All rights reserved.21-2

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Gains from trade

Portfolio diversification

Players in the international capital markets

Attainable policies with international capitalmarkets

Offshore banking and offshore currency trading

Regulation of international banking

Tests of how well international capital marketsallow portfolio diversification, allow intertemporaltrade, and transmit information

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International Capital Markets

International asset (capital) markets are a groupof markets (in London, Tokyo, New York,Singapore, and other financial cities) that tradedifferent types of financial and physical assets

(capital), including stocks

bonds (government and private sector)

deposits denominated in different currencies

commodities (like petroleum, wheat, bauxite, gold) forward contracts, futures contracts, swaps, options contracts

real estate and land

factories and equipment

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Gains from Trade

How have international capital markets increasedthe gains from trade?

When a buyer and a seller engage in a voluntary

transaction, both receive something that theywant and both can be made better off.

A buyer and seller can trade

goods or services for other goods or services

goods or services for assets assets for assets

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Copyright 2012 Pearson Addison-Wesley. All rights reserved. 21-5

Fig. 21-1: The Three Types ofInternational Transaction

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Gains from Trade (cont.)

The theory of comparative advantage describesthe gains from trade of goods and services forother goods and services:

With a finite amount of resources and time, use thoseresources and time to produce what you are mostproductive at (compared to alternatives), then tradethose products for goods and services that you want.

Be a specialist in production, while enjoying many goods

and services as a consumer through trade.

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The theory of intertemporal trade describes thegains from trade of goods and services for assets,of goods and services today for claims to goodsand services in the future (todays assets).

Savers want to buy assets (claims to future goods andservices) and borrowers want to use assets to consumeor invest in more goods and services than they can buywith current income.

Savers earn a rate of return on their assets, whileborrowers are able to use goods and services when theywant to use them: they both can be made better off.

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The theory of portfolio diversification describesthe gains from trade of assets for assets, of assetswith one type of risk for assets with another type ofrisk.

Investing in a diverse set, or portfolio, of assets is a wayfor investors to avoid or reduce risk.

Most people most of the time want to avoid risk: theywould rather have a sure gain of wealth than invest inrisky assets when other factors are constant.

People usually display risk aversion: they are usuallyaverse to risk.

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Portfolio Diversification

Suppose that 2 countries have an asset offarmland that yields a crop, depending on theweather.

The yield (return) of the asset is uncertain, butwith bad weather the land can produce 20 tons ofpotatoes, while with good weather the land canproduce 100 tons of potatoes.

On average, the land will produce 1/2 x 20 + 1/2x 100 = 60 tons if bad weather and good weatherare equally likely (both with a probability of 1/2).

The expected valueof the yield is 60 tons.

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Portfolio Diversification (cont.)

Suppose that historical records show that whenthe domestic country has good weather (highyields), the foreign country has bad weather (lowyields).

and that we can assume that the future will be like the past.

What could the two countries do to avoid sufferingfrom a bad potato crop?

Sell 50% of ones assets to the other party andbuy 50% of the other partys assets:

diversify the portfolios of assets so that both countries alwaysachieve the portfolios expected (average) values.

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Portfolio Diversification (cont.)

With portfolio diversification, both countries couldalways enjoy a moderate potato yield and notexperience the vicissitudes of feast and famine.

If the domestic countrys yield is 20 and the foreigncountrys yield is 100, then both countries receive50% x 20 + 50% x 100 = 60.

If the domestic countrys yield is 100 and the foreigncountrys yield is 20, then both countries receive

50% x 100 + 50% x 20 = 60. If both countries are risk averse, then both countries

could be made better off through portfolio diversification.

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Classification of Assets

Assets can be classified as either

1. Debt instruments

Examples include bonds and deposits.

They specify that the issuer must repay a fixedamountregardless of economic conditions.

or

2. Equity instruments

Examples include stocks or a title to real estate. They specify ownership (equity = ownership) of variable

profits or returns, which vary according to economicconditions.

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International Capital Markets

The participants:

1. Commercial banks and other depositoryinstitutions:

Accept deposits. Lend to commercial businesses, other banks,

governments, and/or individuals.

Buy and sell bonds and other assets.

Some commercial banks underwritenew stocks andbonds by agreeing to find buyers for those assets at aspecified price.

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International Capital Markets(cont.)

2. Nonbank financial institutions such as securitiesfirms, pension funds, insurance companies,mutual funds:

Securities firms specialize in underwriting stocks andbonds (securities) and in making various investments.

Pension funds accept funds from workers and investthem until the workers retire.

Insurance companies accept premiums from policy

holders and invest them until an accident or anotherunexpected event occurs.

Mutual funds accept funds from investors and investthem in a diversified portfolio of stocks.

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International Capital Markets(cont.)

3. Private firms:

Corporations may issue stock, may issue bonds, or mayborrow to acquire funds for investment purposes.

Other private firms may issue bonds or may borrow

from commercial banks.

4. Central banks and government agencies:

Central banks sometimes intervene in foreign exchangemarkets.

Government agencies issue bonds to acquire funds, andmay borrow from commercial banks or securities firms.

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Offshore Banking

Offshore banking refers to banking outside of theboundaries of a country.

There are at least 3 types of offshore banking

institutions, which are regulated differently:1. An agency officein a foreign country makes loans and

transfers, but does not accept deposits, and is thereforenot subject to depository regulations in either thedomestic or foreign country.

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Offshore Banking (cont.)

2. A subsidiary bankin a foreign country follows theregulations of the foreign country, not the domesticregulations of the domestic parent.

3. A foreign branch of a domestic bank is often subject to

both domestic and foreign regulations, but sometimes maychoose the more lenient regulations of the two.

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Offshore Currency Trading

An offshore currency depositis a bank depositdenominated in a currency other than the currencythat circulates where the bank resides.

An offshore currency deposit may be deposited in asubsidiary bank, a foreign branch, a foreign bank, oranother depository institution located in a foreign country.

Offshore currency deposits are sometimes (confusingly)referred to as eurocurrency deposits, because these

deposits were historically made in European banks.

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Offshore Currency Trading (cont.)

Offshore currency trading has grown for three

reasons:

1. growth in international trade and international business

2. avoidance of domestic regulations and taxes3. political factors (ex., to avoid confiscation by a

government because of political events)

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Offshore Currency Trading (cont.)

Reserve requirementsare the primary exampleof a domestic regulation that banks have tried toavoid through offshore currency trading.

Depository institutions in the U.S. and other countries arerequired to hold a fraction of domestic currencydepositson reserve at the central bank.

These reserves cannot be lent to customers and do notearn interest in many countries, therefore the reserve

requirement reduces income for banks. But offshore currency deposits in many countries are not

subject to this requirement, and thus can earn interest onthe full amount of the deposit.

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Regulation of International Banking

Banks fail because they do not have enough or theright kind of assets to pay for their liabilities.

The principal liability for commercial banks and otherdepository institutions is the value of deposits, and banks

fail when they cannot pay their depositors.

If the value of assets decline, say because many loans gointo default, then liabilities could become greater than thevalue of assets and bankruptcy could result.

In many countries there are several types ofregulations to avoid bank failure or its effects.

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Regulation of International Banking(cont.)

1. Deposit insurance

Insures depositors against losses up to $100,000 in theU.S. when banks fail.

Prevents bank panics due to a lack of information:

because depositors cannot determine the financialhealth of a bank, they may quickly withdraw their fundsif they are not sure that a bank is financially healthyenough to pay for them.

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Creates a moral hazard for banks to take excessive riskbecause they are no longer fully responsible for failure.

Moral hazard: a hazard that a party in a transaction willengage in activities that would be considered inappropriate(ex., too risky) according to another party who is not fully

informed about those activities

2. Reserve requirements

Banks required to maintain some deposits on reserve atthe central bank in case they need cash.

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3. Capital requirements and asset restrictions

Higher bank capital (net worth) means banks have morefunds available to cover the cost of failed assets.

Asset restrictions reduce risky investments by preventing abank from holding too many risky assets and encouragediversification by preventing a bank from holding too muchof one asset.

4. Bank examination

Regular examination prevents banks from engaging inrisky activities.

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5. Lender of last resort

In the U.S., the Federal Reserve System may lend tobanks with inadequate reserves (cash).

Prevents bank panics.

Acts as insurance for depositors and banks, in additionto deposit insurance.

Creates a moral hazard for banks to take excessive riskbecause they are not fully responsible for the risk.

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6. Government-organized bailouts

Failing all else, the central bank or fiscal authorities mayorganize the purchase of a failing bank by healthierinstitutions, sometimes throwing their own money into

the deal as a sweetener. In this case, bankruptcy is avoided thanks to the

governments intervention as a crisis manager, butperhaps at public expense.

Safeguards were not nearly sufficient to prevent

the financial crisis of 20072009.

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Difficulties in Regulating InternationalBanking

1. Deposit insurance in the U.S. covers losses up to$100,000, but since the size of deposits ininternational banking is often much larger, theamount of insurance is often minimal.

2. Reserve requirements also act as a form ofinsurance for depositors, but countries cannotimpose reserve requirements on foreign currencydeposits in agency offices, foreign branches, orsubsidiary banks of domestic banks.

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Difficulties in Regulating InternationalBanking (cont.)

3. Bank examination, capital requirements, andasset restrictions are more difficultinternationally.

Distance and language barriers make monitoring

difficult.

Different assets with different characteristics (ex., risk)exist in different countries, making judgment difficult.

Jurisdiction is not clear in the case of subsidiary banks:

for ex., if a subsidiary of an Italian bank is located inLondon but primarily has offshore U.S. dollar deposits,which regulators have jurisdiction?

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Difficulties in Regulating InternationalBanking (cont.)

4. No international lender of last resort for banksexists.

The IMF sometimes acts a lender of last resort forgovernmentswith balance of payments problems.

5. The activities of nonbank financial institutions aregrowing in international banking, but they lackthe regulation and supervision that banks have.

6. Derivatives and securitized assets make it harder

to assess financial stability and risk becausethese assets are not accounted for on thetraditional balance sheet.

A securitized asset is a combination of different illiquidassets like loans that is sold as a security.

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International Regulatory Cooperation

Basel accords(in 1988 and 2006) providestandard regulations and accounting forinternational financial institutions.

1988 accords tried to make bank capital measurements

standard across countries.

They developed risk-based capital requirements, wheremore risky assets require a higher amount of bankcapital.

Core principles of effective bankingsupervision was developed by the BaselCommittee in 1997 for countries without adequatebanking regulations and accounting standards.

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Extent of International PortfolioDiversification

In 1999, U.S.-owned assets in foreign countriesrepresented about 30% of U.S. capital, whileforeign assets in the U.S. represented about 36%of U.S. capital.

These percentages are about 5 times as large aspercentages from 1970, indicating that internationalcapital markets have allowed investors to diversify.

Likewise, foreign assets and liabilities as a percent

of GDP has grown for the U.S. and other countries.

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Table 21-1: Gross Foreign Assets and Liabilitiesof Selected Industrial Countries, 19832007(percent of GDP)

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Extent of International PortfolioDiversification (cont.)

Still, some economists argue that it would beoptimal if investors diversified more by investingmore in foreign assets, avoiding the home biasof investment.

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Extent of International IntertemporalTrade

If some countries borrow for investment projects(for future production and consumption) whileothers lend to these countries, then nationalsaving and investment levels should not be highly

correlated. Recall that national saving investment = current account.

Some countries should have large current account surpluses asthey save a lot and lend to foreign countries.

Some countries should have large current account deficits as

they borrow a lot from foreign countries.

In reality, national saving and investment levelsare highly correlated.

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Fig. 21-2: Saving and Investment Ratesfor 24 Countries, 19902007 Averages

Source: World Bank, World DevelopmentIndicators.

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Extent of International IntertemporalTrade (cont.)

Are international capital markets unable to allowcountries to engage in much intertemporal trade?

Not necessarily: factors that generate a high

saving rate, such as rapid growth in productionand income, may also generate a high investmentrate.

Governments may also enact policies to avoid

large current account deficits or surpluses.

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Extent of Information Transmission andFinancial Capital Mobility

We should expect that interest rates on offshorecurrency deposits and those on domestic currencydeposits within a country should be the same if

the two types of deposits are treated as perfect

substitutes,

assets can flow freely across borders, and

international capital markets are able to quickly andeasily transmit information about any differences in rates.

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Extent of Information Transmission andFinancial Capital Mobility (cont.)

In fact, differences in interest rates haveapproached zero as financial capital mobility hasgrown and information processing has becomefaster and cheaper through computers and

telecommunications.

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Fig. 21-3: Comparing Onshore andOffshore Interest Rates for the Dollar

Source: Board of Governors of the Federal Reserve System, monthly data.

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Extent of Information Transmissionand Financial Capital Mobility (cont.)

If assets are treated as perfect substitutes, then we expectinterest parity to hold on average:

RtR*t= (Eet+1Et)/Et (21-1)

Under this condition, the interest rate difference is the

markets forecast of expected changes in the exchange rate.

If we replace expected exchange rates with actual futureexchange rates, we can test how well the market predictsexchange rate changes.

But interest rate differentials fail to predict large swings in actualexchange rates and even fail to predict in which direction actualexchange rates change.

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Given that there are few restrictions on financial capital inmost major countries, does this mean that internationalcapital markets are unable to process and transmitinformation about interest rates?

Not necessarily: if assets are imperfect substitutes, thenRtR*t= (E

et+1Et)/Et + t (21-4)

Interest rate differentials are associated with exchange ratechanges and with risk premiums that change over time.

Changes in risk premiums may drive changes in exchange ratesrather than interest rate differentials.

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RtR*t= (Eet+1Et)/Et + t

Since both expected changes in exchange rates and riskpremiums are functions of expectations and sinceexpectations are unobservable,

it is difficult to test if international capital markets are able toprocess and transmit information about interest rates.

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Exchange Rate Predictability

In fact, it is hard to predict exchange rate changesover short horizons based on money supply growth,government spending growth, GDP growth, andother fundamental economic variables.

The best prediction for tomorrows exchange rate appearsto be todays exchange rate, regardless of economicvariables.

But over long time horizons (more than 1 year), economic

variables do better at predicting actual exchange rates.

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Summary

1. Gains from trade of goods and services for other goodsand services are described by the theory of comparativeadvantage.

2. Gains from trade of goods and services for assets are

described by the theory of intertemporal trade.3. Gains from trade of assets for assets are described by the

theory of portfolio diversification.

4. Policy makers can choose only 2 of the following: a fixedexchange rate, a monetary policy for domestic goals, freeinternational flows of assets.

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Summary (cont.)

8. As international capital markets have developed,diversification of assets across countries has grown anddifferences between interests rates on offshore currencydeposits and domestic currency deposits within a countryhave shrunk.

9. If foreign and domestic assets are perfect substitutes, theninterest rates in international capital markets do not predictexchange rate changes well.

10. Even economic variables do not predict exchange rate

changes well in the short run.

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