LECTURES 11 and 12: Globalization of Financial Markets Lecture 11: Measuring financial integration Foreign exchange markets (more in Appendix) Liberalization & interest rate arbitrage How to manage risk: The forward exchange market Lecture 12: Financial globalization, continued Should countries open up to international capital flows? Advantages of financial integration Disadvantages of financial integration
Measuring International Financial Integration 1970-2004 I. Direct measures of barriers, e.g., IMF count of freedom from KA restrictions. II. Quantity tests III. Price tests All show general trend toward financial integration. Source: Kose, Prasad, Rogoff & Wei (2009)
-1 0 1 2 3 I. Direct Measure of Financial Barriers: Chinn-Ito tally of capital controls, from IMF data Figure 1: Development of KAOPEN for Different Income Groups Rapid financial liberalization in 1990s 1970 1980 1990 2000 2010 year Industrial Countries Emerging Markets Less Developed Menzie Chinn & Hiro Ito, "A New Measure of Financial Openness" (Journal of Comparative Policy Analysis, 2008), updated July 2010 http://web.pdx.edu/~ito/chinn-ito_website.htm.
Chinn-Ito Measure of Financial Openness 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.
Graph 2 II. Quantity measures One comprehensive indicator of gross financial transactions: the volume of turnover in foreign exchange markets. FX trading has continued to grow rapidly. { Most trading is among banks; only 9% is with non-financial customers.
FX transactions now exceed $5 trillion per day Graph 3 } Spot transactions < ½. More are forwards & related derivatives.
IMF Quantity test shows rising integration
III. Price Measure: Test arbitrage by price of the same asset across borders Chinese firms stock prices, onshore relative to offshore Premium of A shares (held domestically), over H shares (held in Hong Kong). } Higher prices onshore Robert McCauley, CFR conference on Internationalization of the RMB, Beijing, Nov.2011, Graph 5. Data Source: Bloomberg, BIS Note: company composition of the two indices differs. Investing in Chinese shares, Economist, Sept. 27, 2014
Price Measure: 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 1974. {
Liberalization in another country that had controls on capital inflows 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 => 1979. interest differential. { Source: Frankel (1985), The Yen/Dollar Agreement Japan removed controls on outflows, 1979-83. Why? Foreign investors Again, were arbitrage banned eliminated from holding the interest Japanese differential. assets.
Liberalization in a country that had controls on outflows UK interest rates in 1977-78 were lower domestically than those available offshore. Controls against capital outflow kept domestic investors from taking money out. { Thatcher removed the controls in 1979. Interest differential fell to 0. {
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.
Daily exchange rates Spot rate Transaction cost Forward: Selling at a forward discount against the $: Turkish lire Argentine peso Brazilian real Selling at a forward premium against the $: Yen New Taiwan $ UAE dirham Source: Financial Times Accessed 11/2/2007
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, 2003-2011 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 School of Business & Economics, Lisbon, Jan. 2012 http://run.unl.pt/handle/10362/9528
Appendix 1: 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. I. Direct measures of barriers (1970-2004), e.g., count of freedom from KA restrictions, IMF. II. Quantity tests Source: Kose, Prasad, Rogoff & Wei (2009)
III. Price test: Price of the same asset across borders Chinese firms stock prices, onshore relative to offshore: A shares, which domestic residents held, sold at a premium to B shares, which Chinese firms could issue to foreign investors. } Higher prices on-shore Source: Vicki Wei Tang (2011) In the 1990s, foreign residents held B shares, listed in Shenzhen or Shanghai. In 2001, Chinese citizens were allowed to buy B shares.
H shares (held in Hong Kong) became more important. Chinese firms stock prices, onshore relative to offshore:. Premium of A shares (held domestically), over H shares { Higher prices on-shore R. McCauley, CFR conference on Internationalization of the RMB, Beijing, Nov.2011. Data Source: Bloomberg, BIS Note: company composition of the two indices differs.
Liberalization in a 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, 1993. France kept its controls on capital outflows until the late 1980s. Again, 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.
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) { { {
Appendix 2: Measures of activity in global foreign exchange markets. Trading volume in forex markets rose rapidly in the 1990s. Forward contracts (including swaps) became more than half of the total.
The world s largest financial center, as measured by FX, is London, not New York. In 2010, UK banks accounted for 36.7% of forex turnover, followed by the US (18%), Japan (6%), Singapore (5%), Switzerland (5%), Hong Kong SAR (5%) & Australia (4%).
Global fx market turnover was 20% higher in 2010 than in 2007, with average daily turnover of $4.0 trillion compared to $3.3 trillion. The rise was driven by the 48% growth in turnover of spot transactions, (=37% of fx turnover; spot turnover rose to $1.5 tr. in 2010 from $1.0 tr. in 2007.) Daily turnover in OTC interest rate derivatives grew by 24%, to $2.1 trillion in 2010. The dollar remains the leading vehicle currency, used in 85% of transactions. Source: BIS, Triennial Central Bank Survey: Report on global foreign exchange market activity in 2010 (Basel, Dec.2010).
2004
Securitization, internationally 1982 International debt crisis: Banks lose enthusiasm for lending to developing countries. 1987 Basel I Agreement sets standards for international banks (e.g., minimum capital requirements). 1989 Brady bonds securitize bad bank loans to developing countries. 1994 Mexican peso crisis hits when foreign investors lose willingness to hold CETES & tesobonos. 1997 Thai baht crisis also features a larger role for securities. 2007-08 International securitization of US mortgages ( MBS ) ends in tears, with the sub-prime mortgage market crisis. 2011 Basel III: AAA ratings for MBSs, ABSs or CDOs > 0 risk.