Chapter 21

The Global Capital Market:

Performance and Policy Problems

Prepared by Iordanis Petsas

To Accompany
International Economics: Theory and Policy,
Policy Sixth Edition
by Paul R. Krugman and Maurice Obstfeld

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

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Slide 21-2

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?
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Slide 21-3

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

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Slide 21-4

The International Capital Market

and the Gains From Trade
Figure 21-1: The Three Types of International Transaction
Home

Foreign

Goods

Goods

and

and

Services

Services

Assets

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Assets

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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.

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Slide 21-6

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.

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Slide 21-7

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 firms profits, rather than to a fixed payment,
and its payoff will vary according to circumstance.

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Slide 21-8

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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Slide 21-9

International Banking and the

International Capital Market
Figure 21-2: Borrowing in the International Capital Market

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Slide 21-10

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

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Slide 21-11

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.
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Slide 21-12

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
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Slide 21-13

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
Feds 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
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Slide 21-14

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.

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Slide 21-15

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.

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Slide 21-16

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.

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Slide 21-17

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.
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Slide 21-18

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.
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Slide 21-19

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.

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Slide 21-20

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.

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Slide 21-21

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.

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Slide 21-22

How Well Has the International

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

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Slide 21-23

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.

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How Well Has the International

Capital Market Performed?
Figure 21-4: Comparing Eurodollar and Onshore United States Interest
Rates

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Slide 21-25

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
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Slide 21-26

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)
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(21-3)
Slide 21-27

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.
Copyright 2003 Pearson Education, Inc.

Slide 21-28

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.
Copyright 2003 Pearson Education, Inc.

Slide 21-29

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 obligations

as an international lender of last resort.
Copyright 2003 Pearson Education, Inc.

Slide 21-30

Summary
The international capital market has contributed to an

increase in international portfolio diversification

since 1970.
The foreign exchange markets record in
communicating appropriate price signals to
international traders and investors is mixed.

Copyright 2003 Pearson Education, Inc.

Slide 21-31