Krugman Obstfeld Ch21

8/13/2019 Krugman Obstfeld Ch21

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Chapter 21

The Global Capital Market:

Performance and Policy Problems

Prepared byIordanis Petsas

To Accompany

International Economics: Theory and Policy, Sixth Edition

byPaul R. Krugman and Maurice Obstfeld


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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 MarketPerformed?

Summary

Chapter Organization


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Introduction

International capital market

The group of closed interconnected markets in whichresidents 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 financialactivity 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?


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Three Types of Gain From Trade

All transactions between the residents of differentcountries fall into one of three categories:

Trades of goods or services for goods or servicesTrades of goods or services for assets

Trades of assets for assets

The International Capital Market

and the Gains From Trade


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Figure 21-1: The Three Types of International Transaction

Goods

and

Services

Assets

Goods

and

Services

Assets

Home Foreign


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Risk Aversion

The risk associated with a trade of assets is shared whenassets are traded internationally.

When people are risk averse, countries can gain throughthe exchange of risky assets.

International capital markets make these trades possible.




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Portfolio Diversification as a Motive for International

Asset Trade

International portfolio diversificationcan allow

residents of all countries to reduce the variability oftheir wealth.

International capital markets make this diversification

possible.




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The Menu of International Assets: Debt Versus Equity

International portfolio diversification can be carriedout 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 firms profits, rather than to a fixed payment,

and its payoff will vary according to circumstance.




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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


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Figure 21-2: Borrowing in the International Capital Market




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Growth of the International Capital Market

The removal of barriers to private capital flows acrosscountries 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




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Offshore Banking and Offshore Currency Trading

Offshore bankingThe business that banks foreign offices conduct outside

of their home countries

Banks operate offshore though any of three types ofinstitution:

Agency office

Subsidiary bank

Foreign branch Offshore currency trading

Trade in bank deposits denominated in currencies ofcountries other than the one in which the bank is located

It is referred to as Eurocurrency trading.




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EurodollarsDollar deposits located outside the U.S.

Eurobanks

Banks that accept deposits denominated inEurocurrencies

Eurocurrency trading has grown for three reasons:Growth in world trade

Evasion of financial regulations like reserve

requirements

Political concerns




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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 tradeCold War

New U.S. restrictions on capital outflows and U.S.banking regulations

Federal Reserve regulations on U.S. banks (e.g., theFeds Regulation Q)

Move to floating exchange rates in 1973

Reluctance of Arab OPEC members to place surplusfunds in American banks after the first oil shock



i l ki d h


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International banking facilities (IBFs)Banks that accept time deposits and make loans to

foreign customers.

They are not subject to reserve requirements or interestrate ceilings.

They are exempt from state and local taxes.




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The Problem of Bank Failure

A bank fails when it is unable to meet its obligations toits depositors.

Governments attempt to prevent bank failures throughextensive regulation of their domestic banking

systems.


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The main U.S. safeguards to reduce the risk of bankfailure:

Deposit insurance

Reserve requirementsCapital requirements and asset restrictions

Bank examination

Lender of last resort(LLR)facilities

The Fed lends to banks facing massive deposit outflows tosatisfy their depositors claims.



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Difficulties in Regulating International Banking

Deposit insurance is essentially absent in internationalbanking.

The absence of reserve requirements reduces thestability of the banking system.

Bank examination to enforce capital requirements andasset restrictions becomes more difficult in an

international setting.

There is uncertainty over which central bank isresponsible for providing LLR assistance in

international banking.



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International Regulatory Cooperation

Offshore banking is largely unprotected by thesafeguards national governments have imposed to

prevent domestic bank failures.

Basel CommitteeIt 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 forinformation exchange.



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A major change in international financial relations inthe 1990s has been the rapidly growing importance of

new emerging marketsas sources and destinations for

private capital flows.

The trend toward securitization has increased the needfor international cooperation in monitoring and

regulating nonbank financial institutions.


H W ll H th I t ti l


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How Well Has the International

Capital Market Performed?

The Extent of International Portfolio Diversification

The international capital market has contributed to anincrease in international portfolio diversification since

1970. The extent of diversification appears small compared

with what economic theory would predict.



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The Extent of Intertemporal Trade

Some observers claim that the extent of internationaltrade, as measured by countries current account

balances, has been too small.These claims are hard to evaluate.



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Figure 21-3: Saving and Investment Rates for 25 Countries,1990-1997 Averages





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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.





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Figure 21-4: Comparing Eurodollar and Onshore United States InterestRates





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The Efficiency of the Foreign Exchange Market

Exchange rates provide important signals to those whoengage in international trade and investment.

Studies Based on Interest ParityThe interest parity condition:

RtR*t = (E

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

where:

Rt is the date-tinterest rate on home currency deposits

R*tis the date-tinterest rate on foreign currency deposits

Eet+1 is the expected exchange rate

Etis the exchange rate





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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+1as actual currency depreciation less the

international interest difference:

ut+1= (Et+1Et)/Et- (RtR*t) (21-3)





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The Role of Risk PremiumsIf bonds denominated in different currencies are

imperfect substitutes for investors, the internationalinterest rate difference equals expected currency

depreciation plus a risk premium, t:R

tR*

t= (Eet+1Et)/Et+ t (21-4)

Tests for Excessive VolatilityThey 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.




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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 equityinstruments.

One important component in the international capital

market is the foreign exchange market.

Banks are at the center of the international capitalmarket, and many operate offshore.


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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 banks obligationsas an international lender of last resort.


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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 markets record incommunicating appropriate price signals to

international traders and investors is mixed.

Summary

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Krugman Obstfeld Ch21