International Monetary Financial

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 Chapter 7
The International Financial
Architecture and Emerging Economies
Chapter Outline
International Capital Flows
Capital Market Liberalization and International Financial Crises
Exchange Rate Regimes and Financial Crises
Does the International Financial Architecture Need a Redesign?
Chapter Summary
Questions and Problems
Online Application
Selected References and Further Reading

Teaching Tips

Part 2, Chapter 7: Issues to discuss or research on the Web:

1. The international financial architecture represents the international institutions, government and
non-governmental organizations, and policies that govern activity in international monetary and
financial markets. Since the collapse of the Bretton Woods system the most important feature in
the international financial system has been the increased volume of financial flows between
nations. Growth in Foreign Direct Investment (FDI) has been one of the most important
developments in the evolution of global capital markets. Cross-border mergers and acquisitions
are the driving force behind the recent surge in FDI within developed economies. A second
important development in the recent evolution of global capital markets is the growth of private
capital flows to emerging economies, exceeding $600 billion per year. Domestic savers can
diversify internationally and reduce their exposure to domestic shocks. Foreign capital inflows
allow domestic savers to enjoy higher risk-adjusted returns spurring even higher levels of savings
and investments which induce additional economic growth. Wider availability of the various
hedging instruments can reduce precautionary saving. There are two views of the contribution of
the financial sector expansion to long-run economic development. First, some argue that the
development of real resources such as plant and equipment and the development of technology
and human capital are the crucial determinants of long-run economic performance, which
minimizes the role of the financial sector. Second, others argue that the financial sector induces
changes in economic fundamentals and affects private agents’ long–term saving and borrowing
decisions and therefore effects long-run investment decisions. Despite arguments for capital
market liberalization, financial market imperfections and policy-created distortions may cause a
nation’s financial system to fail in contributing to its economic development. For example,
asymmetric information can bring about an inefficient distribution of capital through resulting
problems of adverse selection, herding behavior, and moral hazard. Capital flows can respond to
policy-created distortions which occur when government policy results in a market-producing

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 Chapter 7/The International Financial Architecture and Emerging Economies ❖ 29

level of output that is different from the economically efficient level of output. When market
imperfections and policy-created distortions are severe, financial instability and financial crisis
may result. Financial intermediaries can funnel savings to borrowers with minimum inefficiencies
resulting in a larger growth impact. Financial intermediaries can reduce inefficiencies by making
it possible to pool funds, which increases the amount of savings to support business investment
and can reduce the degree of information asymmetries.

2. Advocates of capital market liberalization argue that unhindered capital movements allow savings
to flow to their most productive uses and markets to direct funds to their most efficient uses.
Domestic businesses and consumers can continue borrowing during periods of domestic
downturns and can then repay savers during periods of growth, smoothing economic activity
between nations. Developing nations’ access to FDI and portfolio capital inflows reduces the cost
of financing investments, and more investment can be made, resulting in higher growth. Thus,
financial sector development can attract global capital and promote domestic savings. Although
the availability of hedging instruments might reduce saving. Some economists argue that the
development of real resources, rather than the financial sector, is crucial to long-run development.
Others argue that the financial sector can attract more foreign capital and affect long-run
economic performance strategies. Nevertheless, the risk of capital market imperfections and
policy-created distortions may harm economic development. For example, many economists
believe asymmetric information can result in inefficient distribution of capital, causing adverse
selection (potential support of unworthy projects), herding behavior (catalyst for contagion and
reduction in asset prices causing financial instability), and moral hazard (potential for borrower to
engage in riskier investments). Policy-created distortions results when government leads a market
to produce an inefficient level of output. Domestic institution may locate or operate abroad to
avoid domestic regulation and supervision. These distortions could result in severe financial
instability and may trigger a crisis. Some researchers have concluded that financial liberalization
has in general led to more efficient capital allocation and deepening of financial markets. A key
function of intermediaries is to funnel savings to borrowers while absorbing a smaller fraction of
each dollar so a larger amount goes to the investment. They also reduce inefficiencies by pooling
funds from many savers to produce economies of scale that reduce average fund management
costs. An efficient system of financial intermediaries may also reduce information asymmetries
and improve capital allocation and enhance financial market stability.

3. Capital market liberalization also carries risks such as attracting long-term FDI and short-term
portfolio capital inflows. Because portfolio flow is a relatively liquid form of investment it can
leave as fast as it arrives, aggravating a financial crisis (due to liquidity or solvency issues),
whereas FDI has a more stabilizing impact. Portfolio flow tends to be a more volatile source of
funds compared to FDI. The experience from recent crisis events indicate that portfolio capital
outflows can aggravate currency depreciation, and reliance on portfolio flows can be
destabilizing. Portfolio flows react more quickly to a loss of confidence in a nation’s
macroeconomic and microeconomic policies, political stability, and soundness of financial
markets. Most economists are skeptical of controls on capital although they may make sense on
capital inflows to lengthen maturity.

4. Did the fixed exchange rate regimes of the 1990s and 2000s contribute to financial crises in
Mexico, Asia, Brazil, Russia, Turkey, and Argentina? Two schools of thought: first, policymakers
should not peg to targets or parity values because if market participants view the peg as not
credible and sell local currency assets in large volumes, the country may not be able to defend
their currency. A second school says the exchange rate peg constitutes a rule for monetary policy
and market participants can check if policymakers are following the rule. Intermediate policy was
found to be unacceptable, so a third view is the corner hypothesis: either fix or float because mid-

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30 ❖ Daniels/Van Hoose, International Monetary and Financial Economics

positioning is unsupportable. A growing number of economists support dollarization in which an

emerging market adopts foreign currency as legal tender. The most important benefit is that it
eliminates currency risk, reducing risk premiums and interest rates in emerging markets. Second,
it might promote further integration with larger economies by using that currency. The cost is loss
of seigniorage revenues or profit from issuing its own currency, cost of buying back all domestic
currency, and giving up future seigniorage revenues. More recently economists have rejected the
corner hypothesis since it lacks theoretical basis and empirical support. Also, it is argued no
single exchange rate is right for all countries. Some economists point to the “impossible trinity
dilemma” or a combination three-part policy mix (combination of pegged exchange rates,
discretionary monetary policy, and capital market liberalization) that led to financial crises.
Policymakers may choose any two, but not all three to avoid crises, or that as a country moves
toward liberalized capital markets, a stable policy configuration requires foregoing either
discretionary monetary policy or fixed exchange rates. Unstable configuration results if all three
goals are pursued.

5. Do the IMF and World Bank need restructuring? In the case of the IMF there are two problems:
adverse selection, or the possibility that some borrowers may be most likely to misuse the IMF,
and the other is moral hazard, or the potential for a borrower to take greater risks than desired by
the lender after receiving the loan. IMF does not publicly announce terms of lending agreements
with specific nations, so investors don’t know what is happening until after the fact when IMF
imposes more difficult constraints, which may cause swift adverse market reactions worsening
the country’s condition. Second, it is common for the IMF to initially place only very general
conditions on loans with high conditionally coming when the borrower violates the low
conditionality agreement. IMF has already failed to avoid the moral hazard problem and this
undermines IMF credibility with actual and potential new borrowers. In the case of the World
Bank it continues to make loans to nations that have little trouble attracting private funds. Critics
argue that the World Bank distorts the market for private capital and encourages a kind of
inefficient investment. Critics also contend that it is inappropriate that China, with a current
account surplus and massive international reserves, receive World Bank loans at below market
interest rates. There are several strong efforts underway for debt relief and forgiveness for heavily
indebted poorer countries where debt was incurred long ago by corrupt government no longer in
power, and where servicing that debt has reduced funding for education and welfare programs.
These efforts are not well funded to date.

6. The last section explores whether the international financial architecture needs a redesign since it
has not headed off financial crises before they happen, and there has be criticism of the operations
of these institutions. Crises definitely exist when a nation’s currency experiences a nominal
depreciation of at least 25 percent within a year that follows a depreciation of at least 10 percent
in the previous year. Other researchers found that credit ratings do not help predict financial
crises since moral hazard problems are not a key contributor to financial crises. No limited set of
indicators has yet been found to predict financial crises in a timely enough manner to allow
international institutions to correct the problem. There is a need to focus on instituting
fundamental institutional factors such as property and contract rights, credible legal systems, and
establishing independent central banks and transparent budget processes for fiscal authorities.
There must be strategies for making these reforms last. A list of proposed major changes in
institutional changes is provided in Table 7-4, but few proposals for altering the international
architecture have led to actual change.

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 Chapter 7/The International Financial Architecture and Emerging Economies ❖ 31

Suggested Answers to End of Chapter Questions

1. The difference between direct and indirect financing has to do with whether the borrower and lender
seek each other out or whether an intermediary matches borrowers and lenders. Direct financing
requires no intermediary to match savers and borrowers. An economy will benefit from having both
direct and indirect financing because both are appropriate ways to save and invest under different
circumstances. As discussed in the text, financial intermediaries absorb a fraction of each saver’s
dollar that is borrowed. Thus, the intermediary takes some of the funds that otherwise would have
gone to a borrower. However, the financial intermediary provides an important service by reducing
information asymmetries, allowing savers to pool risk, and matching risk and return. Therefore, when
an individual cannot research these issues on his/her own, the intermediary is necessary to help the
financial markets operate. However, a strong bond market, in which borrowers and savers can directly
interact, allows for informed parties to save the funds that otherwise would go to an intermediary.
This, in turn, uses the savings more efficiently.

2. Portfolio flows are relatively short term in nature (have a shorter term to maturity), involve lower
borrowing costs, and can generate near-term income. They also do not require a firm to give up
control to a foreign investor. Consequently, they may help to improve capital allocation within an
economy and help the economy’s financial sector develop. These are all potential benefits of portfolio
investments. By the same token, they are also relatively easy to reverse, which is a potential
disadvantage of portfolio investment.

In contrast, foreign direct investment (FDI) involves some degree of ownership and control of a
foreign firm, is typically long term in nature, and helps provide a stabilizing influence on a nation’s
economy. As such, FDI is typically more difficult to arrange.

It is not advantageous to rely on either type of investment exclusively, in so far as each type
accomplishes different goals for an economy. Both near- and long-term capital are important for an
economy’s growth.

3. As either portfolio investment or FDI Exchange Rate

increase, the demand for the domestic S(foreign/domestic)
currency rises (e.g., there is a shift
from D0 to D1), which puts upward S
pressure on the value of the currency,
from exchange rate S0 to S1. If the
central bank expects to hold the value B
of the currency constant at S0, it will S1
have to increase the quantity of the A
S0
domestic currency supplied (e.g.,
accommodate the excess quantity
demanded at the initial spot rate S0) to
maintain the peg. The opposite would D1
hold for capital outflows. D0

QA QB Quantity
(domestic currency)

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32 ❖ Daniels/Van Hoose, International Monetary and Financial Economics

4. Suppose that a multinational bank (MNB) headquartered in a developed economy enters a developing
economy. The MNB has gained considerable expertise in working as a financial intermediary, and
likely has achieved economies of scale in doing so. By entering a foreign market, it helps to allocate
the savings more efficiently through its intermediation services; which in turn will lead to additional
economic development. Specifically, it should help to make sure that the best investment projects are
funded. Moreover, the competition it introduces into the capital market helps to improve the quality
of the indigenous financial intermediaries. This, in turn, should also add to financial stability.

5. Savers and borrowers can also benefit from the regulation of financial intermediaries when portfolio
capital flows dominate a country’s capital inflows. It can be argued that regulation to limit short-term
inflows can stabilize the economy and that these regulations can be gradually lifted as the economy
becomes more stable (financial markets develop) and resilient to external shocks. These regulations
do impose costs in that they require resources to enforce, and may inhibit otherwise helpful capital
inflows which may aid economic development. However, these costs must be considered against the
potential losses that may be incurred if the absence of capital controls would lead to more volatile
capital markets (which may deter the inflow of foreign capital).

6. Policymakers might undertake actions that attract both portfolio capital flows and FDI flows. Actions
that improve transparency in both the private and public sector reduces information asymmetries and
their associate problems, thereby making portfolio flows more stable, reducing the risk of massive
capital outflows. Policymakers may also undertake actions that promote education, improve the tax
structure and tax collection, and improve the country’s infrastructure. These actions may, in turn,
attract FDI.

7. In the following two examples it is assumed that the policymaker maintains a pegged-exchange rate
regime and does not opt for a floating-rate regime. Hence, the policymaker may either intervene and
maintain the peg or change the value of the peg. In both cases there is pressure for the domestic
currency to appreciate vis-à-vis the foreign currency.
a. If the exchange rate pressure is only temporary, then the policymaker may intervene by
accommodating the excess quantity demanded, as explained in question 3 above.
b. Because the exchange rate pressure is longer term in nature, the policymaker would be well
advised to revalue the domestic currency.

8. The World Bank was initially established to help countries rebuild after WWII, and in the 1960s was
expanded to also make long-term loans to developing nations in order to help reduce poverty and
improve living standards. Recently, some of the World Bank’s activities have begun to overlap the
IMF’s activities to finance long-term structural adjustments and provide refinancing for some heavily
indebted countries. Critics may argue that the tasks that are duplicated by the IMF and the World
Bank create conflicting goals for the World Bank. Thus, the two organizations may each benefit by
focusing on different aims. For instance, the IMF may return to financing shorter term objectives and
leave the World Bank to worry about longer term projects.

Another conflicting line of reasoning involves donors’ expectation that the World Bank maintain a
revenue stream from its projects. This can be argued as unrealistic, however, in that the poorest
countries are less likely to yield a payoff for the desired projects; and these are precisely the countries
that the World Bank is designed and intended to help. On the other hand, the less-risky projects,
which could provide a positive revenue stream, are likely to attract private capital.

© 2014 Pearson Education, Inc

 Chapter 7/The International Financial Architecture and Emerging Economies ❖ 33

9.
View
The first cause of a crisis could
be an imbalance in the
economy. In other words, an
incongruity in economic
fundamentals could cause a
crisis.
A second cause is that of self-
fulfilling expectations and
contagion effects. In this case,
mere expectations of a potential
inability to maintain a specified
exchange rate or a slight
incongruity between economic
conditions and the market
exchange rate may cause a
cascade of speculation that
leads to a crisis.
Finally, the structural moral
hazard problem may indicate a
crisis.
Indicator
Possible indicators include
theoretical divergences
between various economic
variables such as the exchange
rate and interest rates, income,
and money supply.
Since this is based on
perception, it is difficult to find
an indicator. One possible
indicator would be trading
volumes of currency for
countries that may be at risk
from the viewpoint of
economic fundamentals.
In this case, a credit rating
bureau such as Moody’s may
provide the data needed to
indicate a potential crisis.
Evaluation
In terms of evaluation, if
fundamental economic
variables seem to be out of line,
there may be an impending
crisis.
If trading volumes grew
quickly, a crisis may be on the
horizon.
The quality of the credit rating
would be relatively easy to
interpret as indicating a
potential crisis.

10. Answers will vary. A potential strength of this proposal would be the centralized, and assumedly
unified, efforts to stabilize the global economic environment. If it works, the global economy would
be more stable. A potential weakness involves the question of how practical this proposal would be
and how easy it would be to match individual countries’ domestic policy goals with the organization’s
global goals and economic interventions. A potential of conflict between the organization’s
interventions and national interests could be a significant weakness.

11. It can be argued that such below-market-interest-rate loans are critical for a developing nation’s
economy in order for the economy to grow unburdened by high interest payments when it is trying to
funnel profits back into the economy and sustain growth. Conversely, providing these non-market-
rate loans can also be argued to distort the market for loanable funds and attract inefficient
investment. Students’ perspectives will vary as to which argument is the best.

12. According to the corners hypothesis, a rigid regime is most consistent with this policy combination.
Hence, a conventional peg and a currency board are the most consistent.

© 2014 Pearson Education, Inc