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1、Slides prepared by Thomas BishopCopyright 2009 Pearson Addison-Wesley. All rights reserved.Chapter 21The Global Capital Market:Performance and Policy ProblemsPreviewGains from tradePortfolio diversificationPlayers in the international capital marketsAttainable policies with international capital mar
2、ketsOffshore banking and offshore currency tradingRegulation of international bankingTests of how well international capital markets allow portfolio diversification, allow intertemporal trade and transmit information2Copyright 2009 Pearson Addison-Wesley. All rights reserved.International Capital Ma
3、rketsInternational asset (capital) markets are a group of markets (in London, Tokyo, New York, Singapore, and other financial cities) that trade different types of financial and physical assets (capital), includingstocks bonds (government and private sector) deposits denominated in different currenc
4、iescommodities (like petroleum, wheat, bauxite, gold)forward contracts, futures contracts, swaps, options contractsreal estate and landfactories and equipment 3Copyright 2009 Pearson Addison-Wesley. All rights reserved.Gains from TradeHow have international capital markets increased the gains from t
5、rade?When a buyer and a seller engage in a voluntary transaction, both receive something that they want and both can be made better off.A buyer and seller can tradegoods or services for other goods or servicesgoods or services for assetsassets for assets4Copyright 2009 Pearson Addison-Wesley. All ri
6、ghts reserved.Fig. 21-1: The Three Types of International Transaction Trade5Copyright 2009 Pearson Addison-Wesley. All rights reserved.Gains from Trade (cont.)The theory of comparative advantage describes the gains from trade of goods and services for other goods and services: with a finite amount o
7、f resources and time, use those resources and time to produce what you are most productive at (compared to alternatives), then trade those products for goods and services that you want.be a specialist in production, while enjoying many goods and services as a consumer through trade.6Copyright 2009 P
8、earson Addison-Wesley. All rights reserved.Gains from Trade (cont.)The theory of intertemporal trade describes the gains from trade of goods and services for assets, of goods and services today for claims to goods and services in the future (todays assets). Savers want to buy assets (claims to futur
9、e goods and services) and borrowers want to use assets to consume or invest in more goods and services than they can buy with current income.Savers earn a rate of return on their assets, while borrowers are able to use goods and services when they want to use them: they both can be made better off.7
10、Copyright 2009 Pearson Addison-Wesley. All rights reserved.Gains from Trade (cont.)The theory of portfolio diversification describes the gains from trade of assets for assets, of assets with one type of risk with assets of another type of risk.Investing in a diverse set, or portfolio, of assets is a
11、 way for investors to avoid or reduce risk. Most people most of the time want to avoid risk: they would rather have a sure gain of wealth than invest in risky assets when other factors are constant.People usually display risk aversion: they are usually averse to risk.8Copyright 2009 Pearson Addison-
12、Wesley. All rights reserved.Portfolio DiversificationSuppose that 2 countries have an asset of farmland that yields a crop, depending on the weather.The yield (return) of the asset is uncertain, but with bad weather the land can produce 20 tonnes of potatoes, while with good weather the land can pro
13、duce 100 tonnes of potatoes.On average, the land will produce 1/2 * 20 + 1/2 * 100 = 60 tonnes if bad weather and good weather are equally likely (both with a probability of 1/2).The expected value of the yield is 60 tonnes.9Copyright 2009 Pearson Addison-Wesley. All rights reserved.Portfolio Divers
14、ification (cont.)Suppose that historical records show that when the domestic country has good weather (high yields), the foreign country has bad weather (low yields).and that we can assume that the future will be like the past.What could the two countries do to avoid suffering from a bad potato crop
15、?Sell 50% of ones assets to the other party and buy 50% of the other partys assets: diversify the portfolios of assets so that both countries always achieve the portfolios expected (average) values.10Copyright 2009 Pearson Addison-Wesley. All rights reserved.Portfolio Diversification (cont.)With por
16、tfolio diversification, both countries could always enjoy a moderate potato yield and not experience the vicissitudes of feast and famine. If the domestic countrys yield is 20 and the foreign countrys yield is 100 then both countries receive: 50%*20 + 50%*100 = 60. If the domestic countrys yield is
17、100 and the foreign countrys yield is 20 then both countries receive: 50%*100 + 50%*20 = 60. If both countries are risk averse, then both countries could be made better off through portfolio diversification.11Copyright 2009 Pearson Addison-Wesley. All rights reserved.Classification of AssetsAssets c
18、an be classified as either1.Debt instrumentsExamples include bonds and depositsThey specify that the issuer must repay a fixed amount regardless of economic conditions.2.Equity instrumentsExamples include stocks or a title to real estateThey specify ownership (equity = ownership) of variable profits
19、 or returns, which vary according to economic conditions.12Copyright 2009 Pearson Addison-Wesley. All rights reserved.International Capital MarketsThe participants:1.Commercial banks and other depository institutions: accept deposits lend to commercial businesses, other banks, governments, and/or in
20、dividualsbuy and sell bonds and other assets Some commercial banks underwrite new stocks and bonds by agreeing to find buyers for those assets at a specified price.13Copyright 2009 Pearson Addison-Wesley. All rights reserved.International Capital Markets (cont.)2.Non-bank financial institutions: sec
21、urities firms, pension funds, insurance companies, mutual fundsSecurities firms specialize in underwriting stocks and bonds (securities) and in making various investments.Pension funds accept funds from workers and invest them until the workers retire.Insurance companies accept premiums from policy
22、holders and invest them until an accident or another unexpected event occurs.Mutual funds accept funds from investors and invest them in a diversified portfolio of stocks. 14Copyright 2009 Pearson Addison-Wesley. All rights reserved.International Capital Markets (cont.)3.Private firms: Corporations
23、may issue stock, may issue bonds or may borrow 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 exchange markets.Government agencies issue bonds to acq
24、uire funds, and may borrow from commercial banks or securities firms.15Copyright 2009 Pearson Addison-Wesley. All rights reserved.International Capital Markets (cont.)Because of international capital markets, policy makers generally have a choice of 2 of the following 3 policies:1.A fixed exchange r
25、ate2.Monetary policy aimed at achieving domestic economic goals3.Free international flows of financial capital16Copyright 2009 Pearson Addison-Wesley. All rights reserved.International Capital Markets (cont.)A fixed exchange rate and an independent monetary policy can exist if restrictions on flows
26、of assets prevent speculation and capital flight.An independent monetary policy and free flows of financial capital can exist when the exchange rate fluctuates.A fixed exchange rate and free flows of financial capital can exist if the central bank gives up its domestic goals and maintains the fixed
27、exchange rate.17Copyright 2009 Pearson Addison-Wesley. All rights reserved.Offshore BankingOffshore banking refers to banking outside of the boundaries of a country. There are at least 4 types of offshore banking institutions, which are regulated differently:1.An agency office in a foreign country m
28、akes loans and transfers, but does not accept deposits, and is therefore not subject to depository regulations in either the domestic or foreign country.18Copyright 2009 Pearson Addison-Wesley. All rights reserved.Offshore Banking (cont.)2.A subsidiary bank in a foreign country follows the regulatio
29、ns of the foreign country, not the domestic regulations of the domestic parent. 3.A foreign branch of a domestic bank is often subject to both domestic and foreign regulations, but sometimes may choose the more lenient regulations of the two.19Copyright 2009 Pearson Addison-Wesley. All rights reserv
30、ed.Offshore Banking (cont.)4.International banking facilities are foreign banks in the U.S. that are allowed to accept deposits from and make loans to foreign customers only. They are not subject to reserve requirements, interest rate ceilings and state and local taxes.Bahrain, Singapore, and Japan
31、have similar regulations for offshore banks.20Copyright 2009 Pearson Addison-Wesley. All rights reserved.Offshore Currency TradingAn offshore currency deposit is a bank deposit denominated in a currency other than the currency that circulates where the bank resides.An offshore currency deposit may b
32、e deposited in a subsidiary bank, a foreign branch, a foreign bank or another 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.21Copyright 2
33、009 Pearson Addison-Wesley. All rights reserved.Offshore Currency Trading (cont.)Offshore currency trading has grown for three reasons:1.growth in international trade and international business2.avoidance of domestic regulations and taxes3.political factors (ex., to avoid confiscation by a governmen
34、t because of political events)22Copyright 2009 Pearson Addison-Wesley. All rights reserved.Offshore Currency Trading (cont.)Reserve requirements are the primary example of a domestic regulation that banks have tried to avoid through offshore currency trading.Depository institutions in the U.S. and o
35、ther countries are required to hold a fraction of domestic currency deposits on reserve at the central bank.These reserves can not be lent to customers and do not earn interest in many countries, therefore the reserve requirement reduces income for banks.But offshore currency deposits in many countr
36、ies are not subject to this requirement, and thus can earn interest on the full amount of the deposit. 23Copyright 2009 Pearson Addison-Wesley. All rights reserved.Balance Sheet for Bank AssetsLiabilities + Net worthReservesLoans-business-home-car-real estateGovernment and corporate bondsDepositsBor
37、rowed fundsNet worth = bank capital24Copyright 2009 Pearson Addison-Wesley. All rights reserved.Regulation of International BankingBanks fail because they do not have enough or the right kind of assets to pay for their liabilities.The principal liability for commercial banks and other depository ins
38、titutions is the value of deposits, and banks fail when they can not pay their depositors.If the value of assets decline, say because many loans go into default, then liabilities could become greater than the value of assets and bankruptcy could result.In many countries there are several types of re
39、gulations to avoid bank failure or its effects.25Copyright 2009 Pearson Addison-Wesley. All rights reserved.Regulation of International Banking (cont.)1.Deposit insuranceInsures depositors against losses up to $100,000 in the U.S. when banks failPrevents bank panics due to a lack of information: bec
40、ause depositors can not determine the financial health of a bank, they may quickly withdraw their funds if they are not sure that a bank is financially healthy enough to pay for themCreates a moral hazard for banks to take more risk because they are no longer fully responsible for failureMoral hazar
41、d: a hazard that a party in a transaction will engage in activities that would be considered inappropriate (ex., too risky) according to another party who is not fully informed about those activities 26Copyright 2009 Pearson Addison-Wesley. All rights reserved.Regulation of International Banking (co
42、nt.)2.Reserve requirementsBanks are historically required to maintain some deposits on reserve at the central bank in case of a need for cash3.Capital requirements and asset restrictionsHigher bank capital (net worth) allows banks to have more funds available to cover the cost of failed assetsBy pre
43、venting a bank from holding (too many) risky assets, asset restrictions reduce risky investmentsBy preventing a bank from holding too much of one asset, asset restrictions also encourage diversification27Copyright 2009 Pearson Addison-Wesley. All rights reserved.Regulation of International Banking (
44、cont.)4.Bank examinationRegular examination prevents banks from engaging in risky activities5.Lender of last resort In the U.S., the Federal Reserve System may lend to banks with inadequate reserves (cash)Prevents bank panicsActs as insurance for depositors and banks, in addition to deposit insuranc
45、eCreates a moral hazard for banks to take more risk because they are no longer fully responsible for the risk28Copyright 2009 Pearson Addison-Wesley. All rights reserved.Difficulties in Regulating International Banking1.Deposit insurance in the U.S. covers losses up to $100,000, but since the size o
46、f deposits in international banking is often much larger, the amount of insurance is often minimal. 2.Reserve requirements also act as a form of insurance for depositors, but countries can not impose reserve requirements on foreign currency deposits in agency offices, foreign branches, or subsidiary
47、 banks of domestic banks.29Copyright 2009 Pearson Addison-Wesley. All rights reserved.Difficulties in Regulating International Banking (cont.)3.Bank examination, capital requirements and asset restrictions are more difficult internationally.Distance and language barriers make monitoring difficult.Di
48、fferent assets with different characteristics (ex., risk) exist in different countries, making judgment difficult.Jurisdiction is not clear in the case of subsidiary banks: if a subsidiary of an Italian bank located in London that primarily has offshore U.S. dollar deposits, which regulators have ju
49、risdiction?30Copyright 2009 Pearson Addison-Wesley. All rights reserved.Difficulties in Regulating International Banking (cont.)4.No international lender of last resort for banks exists.The IMF sometimes acts a “lender of last resort” for governments with balance of payments problems.5.The activitie
50、s of non-bank financial institutions are growing in international banking, but they lack the regulation and supervision that banks have.6.Derivatives and securitized assets make it harder to assess financial stability and risk because these assets are not accounted for on the traditional balance she
51、et.A securitized asset is a combination of different illiquid assets like loans that is sold as a security.31Copyright 2009 Pearson Addison-Wesley. All rights reserved.International Regulatory CooperationBasel accords (in 1988 and 2006) provide standard regulations and accounting for international f
52、inancial institutions.1988 accords tried to make bank capital measurements standard across countries.They developed risk-based capital requirements, where more risky assets require a higher amount of bank capital.Core principles of effective banking supervision was developed by the Basel Committee i
53、n 1997 for countries without adequate banking regulations and accounting standards.32Copyright 2009 Pearson Addison-Wesley. All rights reserved.Extent of International Portfolio DiversificationIn 1999, U.S. owned assets in foreign countries represented about 30% of U.S. capital, while foreign assets
54、 in the U.S. represented about 36% of U.S. capital.These percentages are about 5 times as large as percentages from 1970, indicating that international capital markets have allowed investors to diversify.Likewise, foreign assets and liabilities as a percent of GDP has grown for the U.S. and other co
55、untries.33Copyright 2009 Pearson Addison-Wesley. All rights reserved.Table 21-1: Gross Foreign Assets and Liabilities of Selected Industrial Countries (percent of GDP)34Copyright 2009 Pearson Addison-Wesley. All rights reserved.Extent of International Portfolio Diversification (cont.)Still, some eco
56、nomists argue that it would be optimal if investors diversified more by investing more in foreign assets, avoiding the “home bias” of investment.35Copyright 2009 Pearson Addison-Wesley. All rights reserved.Extent of International Intertemporal TradeIf some countries borrow for investment projects (f
57、or future production and consumption) while others lend to these countries, then national saving and investment levels should not be highly correlated.Recall that national saving investment = current accountSome countries should have large current account surpluses as they save a lot and lend to for
58、eign countries.Some countries should have large current account deficits as they borrow a lot from foreign countries.In reality, national saving and investment levels are highly correlated.36Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 21-2: Saving and Investment Rates for 24 Coun
59、tries, 19902005 AveragesSource: World Bank, World Development Indicators.37Copyright 2009 Pearson Addison-Wesley. All rights reserved.Extent of International Intertemporal Trade (cont.)Are international capital markets unable to allow countries to engage in much intertemporal trade?Not necessarily:
60、factors that generate a high saving rate, such as rapid growth in production and income, may also generate a high investment rate.Governments may also enact policies to avoid large current account deficits or surpluses.38Copyright 2009 Pearson Addison-Wesley. All rights reserved.Extent of Informatio
61、n Transmission and Financial Capital MobilityWe should expect that interest rates on offshore currency deposits and those on domestic currency deposits 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 intern
62、ational capital markets are able to quickly and easily transmit information about any differences in rates. 39Copyright 2009 Pearson Addison-Wesley. All rights reserved.Extent of Information Transmission and Financial Capital Mobility (cont.) In fact, differences in interest rates have approached ze
63、ro as financial capital mobility has grown and information processing has become faster and cheaper through computers and telecommunications. 40Copyright 2009 Pearson Addison-Wesley. All rights reserved.Fig. 21-3: Comparing Onshore and Offshore Interest Rates for the DollarSource: Board of Governors
64、 of the Federal Reserve, monthly data.41Copyright 2009 Pearson Addison-Wesley. All rights reserved.Extent of Information Transmission and Financial Capital Mobility (cont.)If assets are treated as perfect substitutes, then we expect interest parity to hold on average: Rt R*t = (Eet+1 Et)/Et(21-1)Und
65、er 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 future exchange rates, we can test how well the market predicts exchange rate changes.But interest rate differentials fail to predict la
66、rge swings in actual exchange rates and even fail to predict which direction actual exchange rates change.42Copyright 2009 Pearson Addison-Wesley. All rights reserved.Extent of Information Transmission and Financial Capital Mobility (cont.)Given that there are few restrictions on financial capital i
67、n most major countries, does this mean that international capital markets are unable to process and transmit information about interest rates?Not necessarily: if assets are imperfect substitutes then Rt R*t = (Eet+1 Et)/Et + t (21-4)Interest rate differentials are associated with exchange rate chang
68、es and with risk premiums that change over time.Changes in risk premiums may drive changes in exchange rates rather than interest rate differentials. 43Copyright 2009 Pearson Addison-Wesley. All rights reserved.Extent of Information Transmission and Financial Capital Mobility (cont.)Rt R*t = (Eet+1
69、Et)/Et + t Since both expected changes in exchange rates and risk premiums are functions of expectations and since expectations are unobservable, it is difficult to test if international capital markets are able to process and transmit information about interest rates.44Copyright 2009 Pearson Addiso
70、n-Wesley. All rights reserved.Exchange Rate Predictability In fact, it is hard to predict exchange rate changes over short horizons based on money supply growth, government spending growth, GDP growth and other “fundamental” economic variables.The best prediction for tomorrows exchange rate appears
71、to be todays exchange rate, regardless of economic variables.But over long time horizons (more than 1 year) economic variables do better at predicting actual exchange rates.45Copyright 2009 Pearson Addison-Wesley. All rights reserved.Summary1.Gains from trade of goods and services for other goods an
72、d services are described by the theory of comparative advantage.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 only choose 2 of
73、 the following: a fixed exchange rate, a monetary policy for domestic goals, free international flows of assets.46Copyright 2009 Pearson Addison-Wesley. All rights reserved.Summary (cont.)5.Several types of offshore banks deal in offshore currency trading, which developed as international trade has
74、grown and as banks tried to avoid domestic regulations.6.Domestic banks are regulated by deposit insurance, reserve requirements, capital requirements, restrictions on assets, and bank examinations. The central bank also acts as a lender of last resort.7.International banking is generally not regula
75、ted in the same manner as domestic banking, and there is no international lender of last resort.47Copyright 2009 Pearson Addison-Wesley. All rights reserved.Summary (cont.)8.As international capital markets have developed, diversification of assets across countries has grown and differences between
76、interests rates on offshore currency deposits and domestic currency deposits within a country has shrunk.9.If foreign and domestic assets are perfect substitutes, then interest rates in international capital markets do not predict exchange rate changes well.10.Even economic variables do not predict exchange rate changes well in the short run.48Copyright 2009 Pearson Addison-Wesley. All rights reserved.
