Chapter 21 The Global Capital Market: Performance and Policy Problems

Kernel of the Chapter 
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?

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Introduction  International capital market ± 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? 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: ± goods or services for goods or services ± goods or services for assets ± assets for assets 4 .

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. 5 .  Portfolio Diversification as a Motive for International Asset Trade ± International capital markets make this diversification possible.

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 ± Equity instruments ± A share of stock 6 .

International Banking and the International Capital Market  The Structure of the International Capital Market ‡ The main actors in the market : ± Commercial banks ± Corporations ± Nonbank financial institutions ± Central banks and other government agencies 7 .

International Banking and the International Capital Market  Growth of the International Capital Market ‡ The removal of barriers. ‡ A policy ³trilemma´ refers to three available options: ± Fixed exchange rate ± Monetary policy oriented toward domestic goals ± Freedom of international capital movements 8 .

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International Banking and the International Capital Market  Offshore Banking and Offshore Currency Trading ‡ Offshore banking ± Banks operate offshore though any of three types of institution: ‡ Offshore currency trading ± Trade in bank deposits denominated in currencies of countries other than the one in which the bank is located 10 .

International Banking and the International Capital Market ‡ Eurodollars ‡ Eurobanks ‡ Eurocurrency trading has grown for three reasons: ± Growth in world trade ± Evasion of financial regulations like reserve requirements ± Political concerns 11 .

S. banks ± Move to floating exchange rates in 1973 ± Oil dollar 12 . restrictions on capital outflows and U.S.S.International Banking and the International Capital Market  The Growth of Eurocurrency Trading ‡ The early growth in the Eurodollar market was due to: ± Growing volume of international trade ± Cold War ± New U. banking regulations ± Federal Reserve regulations on U.

13 .International Banking and the International Capital Market ‡ International banking facilities (IBFs) ± accept time deposits and make loans to foreign customers. ± not subject to reserve requirements or interest rate ceilings. ± exempt from state and local taxes.

14 . Governments attempt to prevent bank failures through extensive regulation of their domestic banking systems.Regulating International Banking  The Problem of Bank Failure ‡ A bank fails when it is unable to meet its obligations to ‡ its depositors.

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. 15 .S.Regulating International Banking ‡ The main U.

There is uncertainty over which central bank is responsible for providing LLR assistance in international banking. 16 . The absence of reserve requirements reduces the stability of the banking system.Regulating International Banking  Difficulties in Regulating International Banking ‡ Deposit insurance is essentially absent in international ‡ ‡ ‡ banking. Bank examination to enforce capital requirements and asset restrictions becomes more difficult in an international setting.

17 .Regulating International Banking  International Regulatory Cooperation ‡ Basel Committee ± It enhances regulatory cooperation in the international area. ± Its 1975 Concordat allocated national responsibility for monitoring banking institutions and provided for information exchange.

Securitization has increased the need for international cooperation in monitoring and regulating nonbank financial institutions.Regulating International Banking ‡ In the 1990s new emerging markets appeared as ‡ sources and destinations for private capital flows. 18 .

19 .  The Extent of Intertemporal Trade ‡ Some observers claim that the extent of international trade. as measured by countries¶ current account balances.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. has been too small.

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. 20 . ± Data shows that rates of return on similar deposits issued in the major financial centers are quite close. ± Large interest rate differences would be strong evidence of unrealized gains from trade.

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

How Well Has the International Capital Market Performed?  The Efficiency of the Foreign Exchange Market ‡ Studies Based on Interest Parity ± The interest parity condition: Rt ± R*t = (Eet+1 ± Et)/Et (21-1) 22 .

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) 23 .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.

Rt ± R*t = (Eet+1 ± Et)/Et + Vt (21-4) ‡ Tests for Excessive Volatility ± They yield a mixed verdict on the foreign exchange performance.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 Bottom Line ± Evidence on foreign exchange market is ambiguous. 24 . more research and experience are needed.