LECTURES 11 and 12: Globalization of Financial Markets

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1 LECTURES 11 and 12: Globalization of Financial Markets Lecture 11: Measuring financial integration I) Direct measures of barriers II) Quantity measures III) Price tests, esp. interest rate arbitrage Managing risk: The forward exchange market Appendix 1: How big are foreign exchange markets? Appendix 2: Measuring financial integration in developing countries Lecture 12: Financial globalization, continued Should countries open up to international capital flows? Advantages of financial integration Disadvantages of financial integration

2 Measuring International Financial Integration I. Direct measures of barriers, e.g., IMF count of freedom from KA restrictions. II. Quantity tests e.g., intl. assets+liabilities/gdp III. Price tests BGP620 Prof.J.Frankel All show general trend toward financial integration. Source: Kose, Prasad, Rogoff & Wei (2009)

3 I. Direct Measure of Financial Barriers: Figure 1: Development of KAOPEN for Different Income Groups Chinn-Ito tally of capital controls, from IMF data Advanced countries underwent rapid financial liberalization in the 1980s. EM countries in the 1990s year Industrial Countries Emerging Markets Less Developed The calculations are based on 4 categories in the IMF s Annual Report on Exchange Arrangements & Exchange Restrictions: multiple exchange rates, current account restrictions, capital account restrictions, and required surrender of export proceeds. Menzie Chinn & Hiro Ito, "A New Measure of Financial Openness (J.Comparative Policy Analysis, 2008), updated July

4 II. Quantity test shows rising integration, e.g., in Latin America International assets plus liabilities as a % of GDP IMF Source: Lane & Milesi-Ferretti database BGP620 Prof.J.Frankel

5 Measuring International Financial Integration, cont. III. Price tests 1.Uniform price of an asset across markets. Examples from China: i) Gap between China s A shares & off-shore shares. ii) Gap between exchange rate on-shore & in Hong Kong 2. Interest rate parity (IRP) i. Currency premium ii. Country premium iii. The forward market & Covered Interest Parity (CIP)

6 1. Price of the same asset across borders i) Chinese firms stock prices remain higher onshore than offshore. Premium of A shares (held in Shanghai), over H shares (held in Hong Kong) } Summer 2015: Shanghai stock market & RMB begin to fall; China s authorities pressure domestic institutions to buy stocks. Source: FT, Feb.29, 2016 Prof.J.Frankel

7 Test arbitrage by price of the same asset across borders ii) Differential between RMB onshore & offshore RMB/$ Depreciation shows up more in Hong Kong than Shanghai. BGP620 Prof.J.Frankel

8 i) Currency factors 2. Interest Rate Parity: Why does i not equal i*? Expected currency depreciation Exchange risk premium The currency premium can be measured as the forward discount, or swap rate, or differential between domestic & local $-linked bonds. ii) Country factors

9 Decomposition of the nominal interest differential i i* country premium + currency premium e.g., ( i i* - fd ) + fd fd (fd - Δs e ) + (Δs e ) exchange + expected risk nominal premium depreciation The country premium could be measured by the sovereign spread, Credit Default Swap, or covered interest differential (i-i*-fd). The currency premium could be measured by the forward discount (fd), currency swap rate, or local spread of $-linked vs. domestic-currency bonds.

10 Why does i not equal i*? ii) Country factors, continued Capital controls reflected in covered interest differentials Taxes on cross-border investments Transaction costs Default risk reflected in sovereign spreads or Credit Default Swaps Imperfect information Risk of future capital controls

11 Covered interest arbitrage German interest rates in Frankfurt in 1973 >> rates available in marks offshore in London (whether measured in euromarks or covered eurodollars). Why? Stringent capital controls penalized foreign investors who wanted to acquire German assets. Germany removed capital controls after the need to defend the fixed exchange rate had been overtaken by events, => The interest differential disappeared in { { BGP620 Prof.J.Frankel

12 Liberalization in another country that had controls on capital inflows: Japan Similarly, Tokyo interest rates In 1978, were Japan higher still than prohibited those available foreigners in yen from offshore holding ( euroyen ), deposits in Tokyo until => interest differential. { Source: Frankel (1985), The Yen/Dollar Agreement BGP620 Prof.J.Frankel Japan removed controls on outflows, Why? Foreign investors Again, were arbitrage banned eliminated from holding the interest Japanese differential. assets.

13 Liberalization in a country that had controls on outflows UK interest rates in were lower domestically than those available offshore. Controls against capital outflow kept domestic investors from taking money out. { Thatcher removed the controls in Interest differential fell to 0. { BGP620 Prof.J.Frankel

14 Liberalization in another country that had controls on outflows { From: M. Mussa and M. Goldstein, The Integration of World Capital Markets, Changing Capital Markets: Implications for Monetary Policy, Fed.Res.Bk. Kansas City, France kept its controls on capital outflows until the late 1980s. A gain, they produced an offshore-onshore differential, which shot up whenever there was speculation of a franc devaluation. Again, the differential disappeared after controls were removed. BGP620 Prof.J.Frankel

15 Sovereign spreads for 5 euro countries shot up in early 2010

16 Covered Interest Parity $ 1 + i US = (F $/ ) (1/S) (1+i UK ) where S is the spot rate in $/ and F is the forward rate. Forward discount: fd (F - S)/S => 1 + fd F/S => $ (1 + i US ) = $ (1 + fd)(1 + i UK ). Because (fd i UK ) is small, i US fd + i UK. = $ (1 + fd + i UK + fd i UK ). If the U.S. nominal interest rate exceeds the U.K. rate, the $ sells at a discount in the forward exchange market. BGP620 Prof.J.Frankel

17 Snapshot of spot & forward exchange rates on Aug. 14, 2014 Spot rate Transaction cost Forward rates Selling at a forward discount vs. the $ * * Selling at a forward premium * Value of and are shown in terms of $. All other exchange rates are local per $.

18 Spot and forward exchange rates on Aug. 14, 2014, continued Spot rate Transaction cost Forward rates Selling at a forward discount vs. the $ $ pegs

19 In late 2008 Covered Interest Parity surprisingly failed, in a Global-Financial-Crisis rush to the $ as safe haven. Covered interest differentials, using Overnight Index Swap interest rates, Significant determinants are apparently counterparty risk & liquidity, proxied by financial stock CDS, VIX, implied fx volatility, OIS bid-ask spreads & Fed swap lines. Inês Isabel Sequeira de Freitas Serra, Covered Interest Parity, NOVA BGP620 School Prof.J.Frankel Business & Economics, Lisbon, Jan

20 End of Lecture 11 BGP620 Prof.J.Frankel

21 Graph 2 Appendix 1: Measures of activity in global foreign exchange markets. One comprehensive indicator of gross financial transactions: the volume of turnover in foreign exchange markets. FX trading has grown rapidly; > $5 trillion per day { Most trading is among banks; only 7% is with non-financial customers. Triennial Central Bank Survey Foreign exchange turnover in April 2016, Monetary and Economic Department, Bank for International Settlements, September Adjusted for local and cross-border interdealer double-counting

22 Spot transactions are now only 1/3 of total, vs. forward transactions & other derivatives. Triennial Central Bank Survey Foreign exchange turnover in April 2016, Monetary and Economic Department, Bank for International Settlements, September 2016 BGP620 Prof.J.Frankel

23 BGP620 Prof.J.Frankel

24 The world s largest financial center, as measured by FX, is London, not New York. In 2010, UK banks accounted for 37% of forex turnover, followed by the US (18%), Japan (6%), Singapore (5%), Switzerland (5%), Hong Kong SAR (5%) & Australia (4%). BGP620 Prof.J.Frankel

25 I. Direct measures of barriers ( ), e.g., count of freedom from KA restrictions, IMF. II. Quantity tests Appendix 2: Measuring international financial integration for developing countries For emerging markets, liberalization has been more rapid de facto than de jure: Capital controls are hard to enforce. Source: Kose, Prasad, Rogoff & Wei (2009) BGP620 Prof.J.Frankel

26 BGP620 Prof.J.Frankel III. Price test: Sovereign spread on Brazilian debt The forward premium + the country premium add up to the differential between Brazilian interest rates and $ interest rates in London (LIBOR) { { {

27 Securitization, internationally 1982 International debt crisis: Banks lose enthusiasm for lending to developing countries Basel I Agreement sets standards for international banks (e.g., minimum capital requirements) Brady bonds securitize bad bank loans to developing countries Mexican peso crisis hits when foreign investors lose willingness to hold CETES & tesobonos Thai baht crisis also features a larger role for securities International securitization of US mortgages ( MBS ) ends in tears, with the sub-prime mortgage market crisis Basel III: AAA ratings for MBSs, ABSs or CDOs > 0 risk. BGP620 Prof.J.Frankel