Lecture 7 - 120324

St.
Petersburg School of Economics and Management,

Department of management
GLOBAL BUSINESS
ENVIRONMENT
Regional Economic Integration
St. Petersburg, 2024

REGIONAL ECONOMIC INTEGRATION
A review
What is regional economic integration?
• an attempt to achieve economic gains from the free flow of trade and investment between
neighboring countries
What are the levels of economic integration?
• A free trade area – barriers to trade are removed, but independent external trade policy
• Customs union – internal barriers to trade are removed, common external trade policy
• Common market – factors of production move freely among countries
• Economic union – establishment of a common currency and the harmonization of tax rates
• Full political union – aligning economic, social and foreign policy of the member states
Where are NAFTA and the EU on the list above?
What are the drawbacks of economic integration?
• Benefits the majority with costs to the minority (short-term shocks, unemployment)
• National security concerns for countries (Brexit)
2
A review
What is trade diversion?
• High cost domestic producers are replaced by low cost producers within free trade area
What is trade creation?
• Lower cost domestic producers are replaced by higher cost suppliers in free trade area
Regional integration will not increase economic welfare if the trade creation effects in
the free trade area are outweighed by the trade diversion effects
• Regional trade agreements benefit the world if trade creates more than it diverts
When did China launch the BRI project?
• 2013
What will lowering the barriers to trade and investment among countries within a trade
group probably be followed by?
• Heterogeneous tax regimes • Increased price competition
• Decrease in cost economies • More differences in product standards
3
FOREIGN EXCHANGE MARKET
A review
What are the two functions of foreign exchange market?
• 1. Convert currencies 2. provide insurance against foreign exchange risk
How can foreign exchange risk be reduced?
• Forward exchange rates
• Currency swaps
What is the main postulate of the PPP theory?
• The price of a basket of particular goods should be roughly equivalent in each country
What are the 3 types of exposure to foreign exchange risk?
• Transaction exposure
• Translation exposure
• Economic exposure
4
INTERNATIONAL MONETARY SYSTEM
Understanding the International Monetary System
• The international monetary system refers to the institutional arrangements
that govern exchange rates.
• The foreign exchange market is the primary institution for determining
exchange rates, with demand and supply determining the relative value of
currencies.
• The demand and supply of currencies are influenced by their respective
countries’ relative inflation rates and interest rates.
Floating Exchange Rate Regimes
• The U.S. dollar, the European Union’s euro, the Japanese yen, and the British
pound are all free to float against each other.
• These exchange rates are determined by market forces and fluctuate against
each other day to day, if not minute to minute.
5
Other Institutional Arrangements
• Many developing nations peg their currencies, primarily to the dollar or the
euro.
• Other countries try to hold the value of their currency within some range
against an important reference currency, such as the U.S. dollar or a “basket”
of currencies.
• This is often referred to as a managed-float system or a dirty-float system.
Fixed Exchange Rates
• Some countries have operated with a fixed exchange rate, where the values
of a set of currencies are fixed against each other at some mutually agreed-on
exchange rate.
• Before the introduction of the euro in 1999, several member states of the
European Union operated with fixed exchange rates within the context of the
European Monetary System (EMS).
• For a quarter of a century after World War II, the world’s major industrial
nations participated in a fixed exchange rate system. 6
Dollarization
• A country can abandon its own currency and adopt another currency (typically
the U.S. dollar), sometimes used when a country is suffering from severe
macroeconomic problems.
• This was the case with Ecuador in 2000 and is now being considered as an
option for Venezuela.
Implications for International Business
• The exchange rate policy adopted by a government can have an important
impact on the outlook for business operations in a given country.
• The policies adopted by the IMF can have an impact on the economic outlook
for a country and, accordingly, on the costs and benefits of doing business in
that country.
7
Mechanics of the gold standard
• Gold standard pegs currencies to gold, ensuring convertibility.
• Adopted by major trading nations by 1880.
• Common gold standard allows easy determination of currency value in units
of other currencies.
• 1 U.S. dollar equivalent to 23.22 grains of "fine" gold.
• One ounce of gold cost $20.67 due to 480 grains in an ounce.
• Gold par value, the amount needed to purchase one ounce of gold, is
calculated.
• British pound valued at 113 grains of fine gold, resulting in one ounce of gold
costing £4.25.
• Exchange rate for converting pounds into dollars was £1 = $4.87.
8
The Gold Standard: Strengths and Consequences
Strengths of the Gold Standard
• The gold standard was a mechanism for achieving balance-of-trade
equilibrium by all countries.
• A country is in balance-of-trade equilibrium when its residents earn from
exports equal to the money its residents pay to other countries for imports.
• Under the gold standard, when Japan has a trade surplus, there is a net flow
of gold from the United States to Japan, which reduces the U.S. money
supply and swells Japan’s money supply.
9
The Gold Standard: Strengths and Consequences
The Period Between the Wars: 1918–1939
• The gold standard worked well from the 1870s until the start of World War I.
• During the war, several governments financed military expenditures by
printing money, leading to inflation and higher prices.
• The U.S. returned to the gold standard in 1919, Great Britain in 1925, and
France in 1928.
• Great Britain pegged the pound to gold at the prewar gold parity level of £4.25
per ounce, but this priced British goods out of foreign markets, pushing the
country into a deep depression.
• The U.S. followed suit, raising the dollar price of gold from $20.67 per ounce
to $35.00 per ounce, effectively amounted to a devaluation of the dollar
relative to other currencies.
• This led to a cycle of competitive devaluations that shattering any remaining
confidence in the system. 10
The Bretton Woods System
• In 1944, representatives from 44 countries met at Bretton Woods, New
Hampshire, to design a new international monetary system.
• The agreement established two multinational institutions—the International
Monetary Fund (IMF) and the World Bank.
• All countries were to fix the value of their currency in terms of gold but were
not required to exchange their currencies for gold.
• All participating countries agreed to try to maintain the value of their
currencies within 1 percent of the par value by buying or selling currencies or
gold as needed.
• The agreement also committed not to use devaluation as a weapon of
competitive trade policy.
11
The Role of the IMF in the Bretton Woods Agreement
• The Bretton Woods agreement, influenced by global financial collapse,
competitive devaluations, trade wars, high unemployment, hyperinflation, and
economic disintegration, aimed to prevent a repeat of these chaos through
discipline and flexibility.
• Fixed exchange rate regimes impose discipline by preventing competitive
devaluations and monetary discipline on countries, thereby reducing price
inflation.
• The IMF's Articles of Agreement fostered flexibility by providing IMF lending
facilities and adjustable parities.
• IMF lending facilities were designed to help countries manage short periods of
balance-of-payments deficits, reducing pressures for devaluation and allowing
for a more orderly adjustment.
12
The World Bank's Role
• The World Bank, officially the International Bank for Reconstruction and
Development (IBRD), was established to finance the rebuilding of Europe's
economy.
• The bank initially focused on public-sector projects, particularly power
stations, road building, and other transportation investments.
• In the 1950s, the bank began lending money to support agriculture, education,
population control, and urban development.
• The IBRD scheme raises money through bond sales in the international
capital market, offering low-interest loans to risky customers with poor credit
ratings.
• The International Development Association (IDA), an arm of the bank, funds
IDA loans through subscriptions from wealthy members, only going to the
poorest countries.
13
The Collapse of the Fixed Exchange Rate System
• The system of fixed exchange rates established at Bretton Woods worked
well until the late 1960s, when it began to show signs of strain.
• The collapse of the fixed exchange rate system was due to the special role of
the U.S. dollar in the system.
• The U.S. macroeconomic policy package of 1965–1968 led to a rise in price
inflation and a deteriorating U.S. trade balance.
• The dollar could only be devalued if all countries agreed to simultaneously
revalue against the dollar.
• President Richard Nixon announced that the dollar was no longer convertible
into gold and a new 10% tax on imports would remain in effect until U.S.
trading partners agreed to revalue their currencies against the dollar.
14
The Collapse of the Fixed Exchange Rate System
• In December 1971, an agreement was reached to devalue the dollar by about
8% against foreign currencies.
• The U.S. balance-of-payments position continued to deteriorate throughout
1973, leading to speculation that the dollar was still overvalued.
• The foreign exchange market was closed in February 1973, leading to the
currencies of Japan and most European countries floating against the dollar.
• The floating exchange rate regime was formalized in January 1976, when IMF
members agreed to the rules for the international monetary system.
15
Jamaica Agreement Revisited IMF's Articles of Agreement
• Floating rates declared acceptable, allowing IMF members to enter the foreign
exchange market.
• Gold abandoned as a reserve asset, returned to members at current market
price, and sold at market price.
• Total annual IMF quotas increased to $41 billion, now $767 billion, with
membership expanded to include 188 countries.
Variability of Exchange Rates Since 1973
• Volatility due to unexpected shocks to the world monetary system, including
the 1971 oil crisis, the 1977-1978 U.S. inflation rate rise, the 1979 oil crisis,
unexpected rise in the dollar, rapid fall of the U.S. dollar against the Japanese
yen and German deutsche mark, partial collapse of the European Monetary
System in 1992, 1997 Asian currency crisis, global financial crisis of 2008–
2010, and sovereign debt crisis in the European Union. 16
Debt Fluctuations Against Index of Trading Varies
• Rapid rise in the value of the dollar between 1980 and 1985 and subsequent
fall between 1985 and 1988.
• Similar, though less pronounced, rise and fall in the value of the dollar
occurred between 1995 and 2012.
• Uptick in the value of the dollar between mid-2014 and early 2019.
17
The Dollar's Fall
• The fall in the value of the dollar between 1985 and 1988 was caused by
government intervention and market forces.
• The rise in the dollar, which priced U.S. goods out of foreign markets and
made imports relatively cheap, contributed to a dismal trade picture.
• The Group of Five major industrial countries reached the Plaza Accord in
1985, announcing that it would be desirable for most major currencies to
appreciate vis-à-vis the U.S. dollar.
• The dollar continued to decline until 1987, when the Louvre Accord was
reached, agreeing to support the stability of exchange rates by intervening in
the foreign exchange markets.
19
The Dollar's Appreciation in the Late 1990s
• The dollar began to appreciate against most major currencies, including the
euro after its introduction, in the late 1990s.
• Foreigners continued to invest in U.S. financial assets, primarily stocks and
bonds, driving up the value of the dollar on foreign exchange markets.
• By 2002, foreigners had started to lose their appetite for U.S. stocks and
bonds, and the inflow of money into the U.S. slowed.
• Factors contributing to the reluctance of foreigners to invest in the U.S.
included a slowdown in U.S. economic activity during 2001–2002, the
expansion of the U.S. government’s budget deficit after 2001, and U.S.
government officials “talking down” the value of the dollar from 2003 onward.
• The dollar slid on the foreign exchange markets, hitting an index value of 80.5
in June 2011.
• From mid-2008 through early 2009, the dollar staged a moderate rally against
major currencies, despite the American economy being suffering from a
serious financial crisis. 20
Dollar Value and Exchange Rate Regimes
• The dollar's value increased significantly between 2014 and 2019, largely due
to the strength of the U.S. economy.
• Market forces and government intervention have determined the value of the
dollar in recent history.
• Governments intervene in the market to limit market volatility and correct
overvaluation or potential undervaluation of the dollar.
• Government officials' statements often influence the value of the dollar.
• The frequency of government intervention in the foreign exchange market is
referred to as a managed-float system or a dirty-float system.
• The breakdown of the Bretton Woods system has led to renewed debate
about the merits of fixed versus floating exchange rate regimes.
• The case for floating rates is discussed, and why critics yearn for a system of
fixed rates. 21
The Case for Floating Exchange Rates
Monetary Policy Autonomy
• Advocates argue that a fixed system limits a country's ability to expand or
contract its money supply.
• Monetary expansion can lead to inflation, putting downward pressure on a
fixed exchange rate.
• Monetary contraction requires high interest rates, reducing the demand for
money.
• Advocates argue that floating exchange rates restore monetary control to a
government.
22
Trade Balance Adjustments
• Under the Bretton Woods system, a country's permanent trade deficit requires
currency devaluation.
• Advocates argue that a floating exchange rate regime allows for smoother
adjustment mechanisms.
• If a country runs a trade deficit, the imbalance between the supply and
demand of its currency in foreign exchange markets leads to depreciation in
its exchange rate.
23
Crisis Recovery
• Advocates of floating exchange rates argue that exchange rate adjustments
can help a country deal with economic crises.
• Currency declines during a severe economic crisis can stimulate exports.
• However, the declining value of the currency raises import prices and
increases inflation.
• The case of Greece, where the economy imploded following the 2008–2009
global financial crisis, highlights the need for a falling local currency to
stimulate economic recovery.
24
The Case for Fixed Exchange Rates
Monetary Discipline
• Fixed exchange rates ensure governments do not expand their money
supplies at inflationary rates.
• Advocates of fixed rates argue that governments often give in to political
pressures and expand the monetary supply too rapidly, causing unacceptably
high price inflation.
Speculation
• Critics of a floating exchange rate regime argue that speculation can cause
fluctuations in exchange rates.
• They point to the dollar’s rapid rise and fall during the 1980s, which they claim
were caused by speculation.
25
The Case for Fixed Exchange Rates
Uncertainty
• Speculation adds to the uncertainty surrounding future currency movements.
• The unpredictability of exchange rate movements in the post–Bretton Woods
era makes business planning difficult and adds risk to exporting, importing,
and foreign investment activities.
• Advocates of a fixed exchange rate argue that by eliminating such
uncertainty, it promotes the growth of international trade and investment.
Trade Balance Adjustments and Economic Recovery
• Advocates of floating exchange rates argue that floating rates help adjust
trade imbalances and assist with economic recovery after a crisis.
• Critics question the closeness of the link between the exchange rate, the
trade balance, and economic growth.
• They argue that depreciation in a currency will lead to inflation, which will wipe
out any apparent gains in cost competitiveness that arise from currency
depreciation. 26
Fixed/Floating Exchange Rates, Who is Right?
• Economists cannot agree on which side is right in the debate between those
who favor a fixed exchange rate and those who favor a floating exchange
rate.
• A fixed exchange rate regime modeled along the lines of the Bretton Woods
system probably will not work.
Exchange Rate Regimes in Practice
• Governments around the world pursue a number of different exchange rate
policies.
• Some 21 percent of the IMF’s members allow their currency to float freely,
while 23 percent intervene in only a limited way.
• A further 5 percent of IMF members now have no separate legal tender of
their own.
27
Peggered Exchange Rates
• Pegging exchange rates involve a country pegging its currency's value to that
of a major currency.
• This regime is popular among smaller nations and is argued to impose
monetary discipline and lead to low inflation.
• For example, if Belize pegs its currency to the U.S. dollar, it must ensure its
inflation rate is similar to the U.S., or else it may be pressured to devalue the
Belizean dollar.
• To maintain the peg, the chosen currency must also have sound monetary
policy.
• An IMF study found that countries with pegged exchange rates had an
average annual inflation rate of 8%.
• However, many countries operate with only a nominal peg and are willing to
devalue their currency.
• Maintaining a peg against another currency can be challenging due to capital
flows and currency speculation. 28
Currency Boards and Crisis Management by the IMF
• Hong Kong's currency board successfully maintained its currency value
against the U.S. dollar during the 1997 Asian currency crisis.
• The board committed to converting its domestic currency on demand into
another currency at a fixed exchange rate.
• The board holds reserves of foreign currency equal at the fixed exchange rate
to at least 100 percent of the domestic currency issued.
• The currency board can issue additional domestic notes and coins only when
there are foreign exchange reserves to back it.
• This system limits the government's ability to print money and create
inflationary pressures.
• Interest rates adjust automatically under a strict currency board system.
• The system has been successful in several developing countries, including
Argentina, Bulgaria, Estonia, and Lithuania. 29
Criticisms of Currency Boards
• If local inflation rates remain higher than the inflation rate in the country to
which the currency is pegged, the currencies of countries with currency
boards can become noncompetitive and overvalued.
• The government lacks the ability to set interest rates under a currency board
system.
• The economic collapse in Argentina in 2001 and the subsequent decision to
abandon its currency board dampened much of the enthusiasm for this
mechanism of managing exchange rates.
30
IMF's Role in Crisis Management
• Initially, observers believed the collapse of the Bretton Woods system would
diminish the role of the IMF within the international monetary system.
• Despite these concerns, the IMF's activities have expanded over the past 30
years.
• The IMF has repeatedly lent money to nations experiencing financial crises,
requesting governments to enact certain macroeconomic policies.
• Critics argue these policies have not always been as beneficial as the IMF
might have hoped and may have made things worse.
31
Financial Crises in the Post-Bretton Woods Era
Types of Financial Crises
• Currency Crisis: A speculative attack on a currency's exchange value leads to
a sharp depreciation or increased interest rates.
• Banking Crisis: A loss of confidence in the banking system leads to a run on
banks.
• Foreign Debt Crisis: A country cannot service its foreign debt obligations.
Macroeconomic Causes
• High relative price inflation rates, a widening current account deficit, excessive
domestic borrowing, high government deficits, and asset price inflation.
• At times, elements of currency, banking, and debt crises may be present
simultaneously.
32
Financial Crises in the Post-Bretton Woods Era
• The IMF looked at the macroeconomic performance of 53 countries from 1975
to 1997.
• Found 158 currency crises, 55 episodes where a country’s currency declined
by more than 25%, and 54 banking crises.
• Developing nations were more than twice as likely to experience currency and
banking crises as developed nations.
South Korea's Crisis
• South Korea's economy was on the verge of collapse, leading to a decline in
the South Korean currency and stock market.
• The South Korean government requested $20 billion in standby loans from
the IMF.
• In 1997, the IMF and South Korea reached a deal to lend $55 billion to the
country. 33
Critiques of IMF's Macroeconomic Policies
Inappropriate Policies
• Critics argue that the IMF's traditional macroeconomic policies are not
suitable for many countries.
• For instance, South Korea's tight policies during the 1997 Asian crisis were
not suitable for countries with a private-sector debt crisis with deflationary
undertones.
• The IMF required South Korea to maintain an inflation rate of 5%, which led to
an increase in short-term interest rates and increased corporate defaults.
IMF's Response
• The IMF emphasized rebuilding confidence in the won and removing
restrictions on foreign direct investment to improve the Korean currency.
• South Korea's economy recovered quickly from the crisis, supporting the
IMF's position. 34
Critiques of IMF's Macroeconomic Policies
Moral Hazard
• Critics argue that the IMF's rescue efforts exacerbate moral hazard, where
reckless behavior is encouraged due to the promise of saving.
• They argue that banks should be forced to pay the price for their rash lending
policies, even if it meant some banks would have closed.
• The IMF insisted on the closure of banks in South Korea, Thailand, and
Indonesia after the 1997 Asian financial crisis.
Lack of Accountability
• Critics argue that the IMF lacks a mechanism for accountability, with a staff of
less than 1,000.
• Critics suggest reforming the IMF to make greater use of outside experts and
open its operations to greater scrutiny.
Despite criticisms, the IMF has shown notable accomplishments, including
containing the Asian crisis and promoting a free market philosophy. 35
IMF's Policy Shifts in Economic Mismanagement
• IMF cannot force countries to adopt policies to correct economic
mismanagement.
• Internal political problems can hinder governments from implementing
corrective actions.
• Withholding money could trigger financial collapse.
• In response to the 2008-2009 global financial crisis, the IMF urged fiscal
stimulus and monetary easing.
• Some economists suggest higher inflation rates could lead to greater
aggregate demand growth, helping nations escape recession.
• The IMF's "new approach" seems tailored to address excessive debt, not high
inflation rates.
36
Implications for International Businesses
Currency Management
• Companies need to understand the mixed nature of the foreign exchange
market, which includes government intervention and speculative activity.
• Companies should adjust their foreign exchange transactions accordingly.
• Volatile exchange rate movements can increase foreign exchange risk, which
is detrimental for businesses.
• The foreign exchange market has developed instruments like the forward
market and swaps to help mitigate foreign exchange risk.
37
Business Strategy
• The volatility of the global exchange rate regime presents a challenge for
international businesses.
• Firms can use the forward exchange market to mitigate uncertainty about
future currency values.
• Strategies that increase strategic flexibility and reduce economic exposure are
necessary to mitigate exchange rate movements.
• Dispersing production to different locations can be a hedge against currency
fluctuations.
• Contracting out manufacturing can help reduce economic exposure and shift
suppliers in response to exchange rate movements.
38
Roles of the IMF and the World Bank
• The IMF acts as the macroeconomic police of the world economy, insisting on
countries seeking significant borrowings adopting IMF-mandated macroeconomic
policies.
• These policies can lead to a contraction of demand in the short run, but can
promote economic growth and expansion of demand in the long run.
Corporate-Government Relations
• Businesses can influence government policy towards the international monetary
system.
• Businesses should promote an international monetary system that facilitates
international trade and investment growth.
• A fixed or floating regime is optimal, but exchange rate volatility creates an
environment less conducive to international trade and investment. 39
YOUR QUESTIONS
40
GLOBAL CAPITAL MARKET
Globalization of Capital Markets
• Capital markets have transitioned from regulatory barriers to globalization
over the past 30 years.
• This shift has benefits for corporations but also risks.
• In 2018, 33 Chinese firms raised $9 billion in capital through IPOs in the U.S.,
leveraging stronger demand for Chinese tech shares.
• Regulatory differences can make certain markets more attractive for capital
raising, such as New York's ability to establish duel ownership structures and
variable interest entities.
• The chapter examines the benefits of globalization of capital markets, the
growth of the international capital market, and the macroeconomic risks
associated with its growth.
• The chapter reviews three key segments of the global capital market: the
Eurocurrency market, the international bond market, and the international
equity market. 41
Benefits of the Global Capital Market
• Capital markets unite individuals, corporations, and nonbank financial
institutions.
• Market makers, including commercial banks and investment banks, connect
investors and borrowers.
• Commercial banks take cash deposits from corporations and individuals, pay
them a rate of interest, and lend that money to borrowers at a higher rate of
interest.
• Investment banks bring investors and borrowers together and charge
commissions for doing so.
42
Capital Market Loans to Corporations
• Equity loans are made when a corporation sells stock to investors.
• Debt loans require the corporation to repay a predetermined portion of the loan
amount at regular intervals.
• Debt loans include cash loans from banks and funds raised from the sale of
corporate bonds to investors.
Attractions of the Global Capital Market
• Benefits borrowers by increasing the supply of funds available for borrowing
and by lowering the cost of capital.
• Benefits investors by providing a wider range of investment opportunities,
allowing them to build portfolios of international investments that diversify their
risks.
43
Borrower’s Perspective: Lower Cost of Capital
• In a purely domestic capital market, the pool of investors is limited to residents
of the country, limiting the supply of funds available to borrowers.
• A global capital market with its larger pool of investors provides a larger supply
of funds for borrowers to draw.
• The cost of capital tends to be higher in a global market than in a purely
domestic market.
• The advantage of a global capital market to borrowers is that it lowers the cost
of capital.
• Large enterprises based in some of the world’s largest economies have tapped
the international capital markets in their search for greater liquidity and a lower
cost of capital.
44
45
Portfolio Diversification: An Investor's Perspective
Global Capital Market and Portfolio Diversification
• Investors can diversify their portfolios internationally, reducing risk to less than
what could be achieved in a purely domestic capital market.
• Diversification can be beneficial in stock and bond holdings, as it allows
investors to guard against the risk associated with holding volatile stocks.
Systematic Risk and Portfolio Diversification
• Systematic risk refers to movements in a stock portfolio’s value due to
macroeconomic forces affecting all firms in an economy, not specific to an
individual firm.
• A fully diversified U.S. portfolio is only about 27 percent as risky as a typical
individual stock.
• Diversifying a portfolio internationally can reduce the level of risk even further
due to the non-perfect correlation of stock market prices across countries. 47
Reasons for Low Correlation
• Countries pursue different macroeconomic policies and face different economic
conditions, resulting in different stock markets responding to different forces and
moving in different ways.
• Some stock markets are segmented from each other by capital controls, limiting
the ability of capital to roam the world freely in search of the highest risk-adjusted
return.
The Implication of Diversification
• Diversifying a portfolio to include foreign stocks can reduce the level of risk
below that incurred by holding only domestic stocks.
• A fully diversified portfolio that contains stocks from many countries is less than
half as risky as a fully diversified portfolio that contains only U.S. stocks.
48
Contradictions and Future Directions
• The growing integration of the global economy and the emergence of the global
capital market may have increased the correlation between different stock
markets, reducing the benefits of international diversification.
• A portfolio equally diversified across all available markets can reduce portfolio
risk to about 35 percent of the volatility associated with a single market.
International Portfolio Diversification Risks
• Volatile exchange rates in floating exchange rate regime increase risk in foreign
asset investments.
• Adverse exchange rate movements can transform profitable investments into
unprofitable ones.
• Uncertainty from volatile exchange rates may impede the rapid growth of the
international capital market. 49
Global Capital Market Growth and Deregulation
Growth of the Global Capital Market
• The global capital market is rapidly expanding, with stocks, bonds, and bank
loans currently totaling over $300 trillion.
• The growth is driven by advances in information technology and deregulation
by governments.
Information Technology
• Financial services is an information-intensive industry, requiring large
volumes of information about markets, risks, exchange rates, interest rates,
and creditworthiness.
• Advances in information technology have revolutionized the industry,
facilitating instantaneous communication and data processing capabilities.
• The cost of recording, transmitting, and processing information fell by 95%
between 1964 and 1990. 50
Global Capital Market Growth and Deregulation
Deregulation and Capital Controls
• Many countries began in the 1970s to dismantle capital controls, loosening both
restrictions on inward investment by foreigners and outward investment by their
own citizens and corporations.
• The global financial crisis of 2008–2009 prompted questions about deregulation
and the need for new regulations to govern certain sectors of the financial
services industry, including hedge funds.
• Despite the current contraction, the growth of the global capital market is
expected to continue over the long term due to the benefits associated with
globalization of capital.
51
Global Capital Market Risks
• Deregulation and reduced controls on crossborder capital flows are making
nations more vulnerable to speculative capital flows.
• Harvard economist Martin Feldstein argues that most international capital
moves for temporary gains, shifting in and out of countries as conditions
change.
• Feldstein distinguishes between short-term capital, or "hot money," and
"patient money" that supports long-term cross-border capital flows.
• He believes that the lack of patient money is due to the relative lack of
information investors have about foreign investments.
• Feldstein argues that if investors had better information about foreign assets,
the global capital market would work more efficiently and be less subject to
short-term speculative capital flows.
52
The Eurocurrency Market
• The Eurocurrency market was born in the mid-1950s when eastern European
holders of dollars were afraid to deposit their holdings in the U.S. due to fear of
U.S. residents seized their dollars.
• The market received a major push in 1957 when the British government
prohibited British banks from lending British pounds to finance non-British trade.
• The U.S. government enacted regulations that discouraged U.S. banks from
lending to non-U.S. residents in the 1960s.
• The 1973 collapse of the Bretton Woods system and the oil price increases
engineered by OPEC in the 1973–1974 and 1979–1980 periods gave the market
another big push.
• The market grew because it offered real financial advantages—initially to those
who wanted to deposit dollars or borrow dollars and later to those who wanted to
deposit and borrow other currencies. 53
Attractions of the Eurocurrency Market
• The Eurocurrency market's lack of government regulation makes it attractive to
depositors and borrowers.
• This lack of regulation allows banks to offer higher interest rates on
Eurocurrency deposits and lower interest rates for Eurocurrency borrowings.
• The spread between the Eurocurrency deposit rate and the Eurocurrency
lending rate is less than the spread between the domestic deposit and lending
rates.
• Government regulations raise the costs of domestic banking, as domestic
currency deposits are regulated in all industrialized countries.
• Reserve requirements exist in all countries, ensuring banks have enough liquid
funds to satisfy demand if large numbers of domestic depositors withdraw their
money.
54
Attractions of the Eurocurrency Market
• Eurobanks have a competitive advantage due to their freedom in dealings in
foreign currencies.
• For example, a bank based in New York can offer a higher interest rate on
dollar deposits and still cover its costs.
• The Eurobank has a competitive advantage in both its deposit rate and its loan
rate.
• The financial motivations for companies to use the Eurocurrency market are
strong, as they receive a higher interest rate on deposits and pay less for loans.
55
Drawbacks of the Eurocurrency Market and Global Bond Market
Drawbacks of the Eurocurrency Market
• Regulation maintains liquidity, reducing the probability of bank failures causing
deposit loss.
• International borrowing exposes companies to foreign exchange risk.
• Companies often borrow funds in their domestic currency to avoid foreign
exchange risk, despite Eurocurrency markets offering attractive interest rates.
56
Drawbacks of the Eurocurrency Market and Global Bond Market
Global Bond Market
• The global bond market has grown rapidly over the last four decades.
• Bonds are an important financing means for many companies.
• The most common type of bond is a fixed-rate bond, with an interest payment
and face value at maturity.
• Two types of international bonds: foreign bonds and Eurobonds.
• Foreign bonds are sold outside the borrower's country and denominated in the
country of issue.
• Eurobonds are usually underwritten by an international syndicate of banks and
placed in countries other than the one in whose currency the bond is
denominated.
• Historically, Eurobonds accounted for the majority of international bond issues,
but are increasingly being eclipsed by foreign bonds.
57
Attractions of the Eurobond Market
Regulatory Interference
• National governments often impose controls on bond issuers, increasing the
cost of issuing bonds.
• Eurobonds fall outside the regulatory domain of any single nation, making them
cheaper to issue.
Disclosure Requirements
• Eurobond market disclosure requirements are less stringent than most
domestic bond markets.
• Firms must disclose detailed information about activities, salaries, and stock
trades.
• Financial accounts must conform to U.S. accounting standards.
58
Favorable Tax Status
• Before 1984, U.S. corporations was required to withhold U.S. income tax on
each interest payment to foreigners.
• U.S. laws were revised in 1984 to exempt foreign holders of bonds issued by
U.S. corporations, allowing them to sell Eurobonds directly to foreigners.
Global Equity Market
• Regulatory barriers separated national equity markets, making it difficult for
corporations to attract significant equity capital from foreign investors.
• The global equity market enables firms to attract capital from international
investors, list their stock on multiple exchanges, and raise funds by issuing equity
or debt around the world.
• Companies like Daimler-Benz and Deutsche Telekom raised equity through
foreign markets to lower their cost of capital.
• Chinese companies have also been raising equity capital through foreign stock
issues. 59
Internationalization of Corporate Ownership
• The trend toward international equity investment is internationalizing the world
equity market.
• Investors are investing heavily in foreign equity markets to diversify their
portfolios.
• The internationalization of corporate ownership is changing, with U.S. citizens
buying stock in companies incorporated abroad and foreigners buying stock in
companies incorporated in the U.S.
60
Internationalizing the World Equity Market
• Companies with roots in one nation are expanding their stock ownership by
listing in other nations' equity markets.
• This is primarily financial, as it taps into foreign markets' liquidity, increasing
investment funds and lowering the firm's cost of capital.
• Firms often list their stock on foreign equity markets to facilitate future
acquisitions of foreign companies.
• The company's stock and stock options can be used to compensate local
management and employees, satisfy the desire for local ownership, and increase
visibility with local employees, customers, suppliers, and bankers.
61
Foreign Exchange Risk and the Cost of Capital
• Adverse movements in foreign exchange rates can significantly increase the
cost of foreign currency loans.
• This risk was a significant issue during the 1997–1998 Asian financial crisis,
leading to technical defaults on loans.
• The borrower can hedge against this risk by entering into a forward contract to
purchase the required amount of the currency being borrowed at a
predetermined exchange rate when the loan comes due.
• Despite using forward exchange markets to lower foreign exchange risk with
short-term borrowings, it cannot remove the risk and does not provide adequate
coverage for long-term borrowings.
62
Global Capital Market Growth and its Implications for International
Business
• The global capital market offers opportunities for international businesses to
borrow and invest money.
• Borrowing costs are often lower due to greater liquidity and absence of
government regulation.
• The global market, being transnational, avoids regulation, reducing the cost of
capital.
• Foreign exchange risk associated with borrowing in a foreign currency is a
concern.
• Investment diversification is possible through holding a diverse portfolio of
stocks and bonds in different nations.
• However, foreign exchange risk is a complicating factor.
63
THE FOREIGN EXCHANGE MARKET
YOUR QUESTIONS
64
SEMINAR 7 ASSIGNMENT
Check Smart LMS system later today
1. Read chapters 11,12 and apply the knowledge to submit the assigned case to
Smart LMS before the deadline
2. Get ready to actively participate in class discussion
Will you get any points for presenting your submission at the seminar?
No, only participation in the discussion counts. Students present to start a discussion.
How many points can you get for active participation?
+3 points for active participation (3 if questions\answers are based on course materials, or
2 if questions\answers are incomplete but close to correct, or 1 if answers\questions lack
structure or references to course materials)
What can you do to ensure the maximum possible score for the LMS submission?
(!)You can add full sentences in the slide notes, in your presentations (no online docs)
+5 points for LMS submission (2 points if on time, +3 points if the answers are complete,
demonstrate the knowledge of focal concepts, or +2 points if the answers lack reasoning,
not complete or close to correct or +1 point if substantial part of the answer is missing)
What can be done to get 9 and 10?
If you have got 8 and used additional sources and ideas other than mentioned in the book

Lecture 7 - 120324

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lecture 7 - 120324

Uploaded by

Copyright:

Available Formats

St.

Petersburg School of Economics and Management,

St. Petersburg, 2024

You might also like