Economics 721 International Finance
Week I
Lecture 1: Introduction
What is financial globalization? The increasing importance and even dominance of international financial transactions in the global economy. This affects economic growth, stability and equality.
What has been the Impact of Financial Globalization? Economic growth Inequality Instability Distribution of power classes, nations Trajectory of national economics and world economy
What are the contradictions and trajectories of this phase of global capitalist development?
What has been the impact on the ability of national institutions the state to chart their own courses?
Fred Block: Distinction between open and closed economies
Distinction between open and closed NOT whether there are international flows of goods or finance, but whether these are dominated by international capitalist markets and institutions, as opposed to national capitalists states or other noncapitalist institutions
Block: Goals of US in post wwii reconstruction To get other countries to adopt open economies Not just fighting communism but also national capitalist economies in europe and elsewhere
US Capitalists, and economy benefit But finance dominated by industry
Eric Helleiner Over post-war period, finance makes a come back. Increase financial power over the period. Now, many argue that the power of finance supreme (Dumenil and Levy, Crotty)
Obstfeld and Taylor Organize their history by idea of trilemma in international economy.
Bradford
Questions about Trilemma How do governments choose where on triangle to be? What are the role of class forces and coalitions? What is the role of underlying productive structre?
Questions about Trilemma What are the impacts of different choices in terms of income distribution, economic growth, class power? Where do IMF/World Bank push countries to be and why? Domestic capitalists? What are their interests?
Capital Mobility and Financialization Finance push for financial liberalization and capital mobility What are impacts?
Summary of Two Related Framework: Trilemma and policy Choice Trilemma Stable Exchange Rate Free capital mobility Autonomous macroeconomic policy Conflicts Capital labor Finance industry Center periphery (country s location in the international economy and structure of corporate governance and financial markets)
Two other big frameworks of great relevance to understanding dynamics of international finance I. International Monetary Regime Organization of the International Monetary System 2. International Credit Regime - organization of the supply, demand and enforcement of credit relations
International Trade Regime This is a third framework of key importance But we will not directly address this much in this class except where it clearly and significantly interacts with the other two
International Monetary Regime - It Involves: Exchange Rate Mechanism (fixed; floating; managed) Currency (ies) Used in various roles Reserve currency International medium (a) of exchange International means of payment N-1 Country Mechanisms of coordination and monitoring
Which Countries can issue hard currencies Key divide in global economy (medium of exchange, and means of payment dollars; pesos?)
Key Currencies Store of value (reserves) Medium of exchange (vehicle currency) Intervention currency (intervene in foreign exchange markets) Means of payment (service debts)
International Monetary Systems See next slide
International Credit Regime: Has Two Components Operating in Tandem Enforcement Regime: The institutions and policies implemented by creditors to punish non-payment and reward payment Repayment Regime: the institutions and policies implemented by debtors to credibly signal that they will repay
International Credit Regime has a Third Component Working in Tension with the Other Two The Keynesian/Mynskian Imperative: Competition, behavioral aspects, and fundamental uncertainty: Excessive lending and bubbles
Enforcement Regime in Tension and Contradiction Enforcement Regime Repayment Regime Keynsian/Minskian Imperatives
Current Aspects of International Credit Regime
International Credit Regime (continued)
Implicit in These are Different Theories/Models of International Capital Markets
Different Theories Walrasian: interest rates clear markets; exogenous enforcement of contracts; rationality and perfect information New Keynesian/Asymmetric Information: non-market clearing; non exogenous enforcement; principal-agent problems Power Laden: non exogenous enforcement (marxian, neo-marxian)
Different Theories: continued Keynesian/Minskyian: fundamental uncertainty; endogenous cycles Behavioral Finance: psychological departures from rationality
Survey of Some Current Financial Markets/Institutions
Current value of Daily Forex trading 1.9 trillion dollars daily
Source: Bank for International Settlements
Types of financial flows: Debt -portfolio -banks Equity -portfolio -FDI Derivatives and other exotic transactions
4 Figure 1: Increasing Capital Account Openness High Income Countries 3.5 Capital Account Openness 3 2.5 2 1.5 1 Lower Middle Income Countries Upper Middle Income Countries Low Income Countries All Countries 0.5 0 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 Source: Jayadev and Lee, 2005
This Surge in Trading and Flows Relatively new During 1930 s, WWII, and early post-war period, tight regulations over forex trading and capital flows.
Capital Controls Quantity based: prohibitions on trading of assets denominated in foreign exchange (forex). Examples: exchange controls, restrictions on buying or selling foreign assets Price Based: taxes on inflows or outflows of capital
Distinction Between De-jure and De-facto financial liberalization De-jure: legal restrictions (or the absence there-of) De-facto: quantity of flows
Financial Integration and Economic Growth
Uses of international financial system Transfer capital to those who have too much to those who have too little Help diversify risks Help smooth consumption Help generate jobs (FDI)
Critiques of International financial flows Problem: most capital is flowing from the poorer countries to the richer countries (primarily the US) When capital does flow to poorer countries, it can (and often does) lead to financial instability and crisis.
Source: Obstfeld /Taylor
Bretton Woods Institutions (BWI s) IMF World Bank Formed in 1944, Bretton Woods Conference
Original Functions IMF, to help stabilize the international financial system and to help avoid the deflationary bias of the world Economy in the 1930 s
World Bank Medium to longer term lending for reconstruction after war and for developing countries
IMF Became more and more involved in longer term lending structural adjustment Interfering in operations of domestic economies
Pushed International financial Liberalization Internal: free up domestic financial markets External: reduce capital controls
Washington Consensus Financial Liberalization Privatization Trade Liberalization Cut Budget Deficits
Washington Consensus Export led growth and free markets Making countries attractive for international investment These are the keys to economic growth
Prabhat Patnaik Illusionism of Finance
3 defining moments Third World Debt Crisis, 1982 Asian Financial Crisis, 1997 9/11 Iraq and the Election of progressive leaders in Latin America, opposed to Washington consensus
4 Figure 1: Increasing Capital Account Openness High Income Countries 3.5 Capital Account Openness 3 2.5 2 1.5 1 Lower Middle Income Countries Upper Middle Income Countries Low Income Countries All Countries 0.5 0 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 Source: Jayadev and Lee, 2005
International Financial Crises Third World Debt Crisis of 1982; defining moment in world economy
Third World Debt Crisis Background Impacts Led to neo-liberal globalization Increasing role of IMF and structural adjustment Neo-liberalism and Washington Consensus
Asian Financial Crisis 2 nd defining moment What went wrong with neo-liberalism?
International Financial Crises Third World Debt Crisis of 1982; defining moment in world economy Asian Financial Crisis of the 1990 s
Third World Debt Crisis Background Impacts Led to neo-liberal globalization Increasing role of IMF and structural adjustment Neo-liberalism and Washington Consensus
Are capital flows volatile Pro-cyclical Sudden stops
What happens when capital flows and then sudden stops Individuals, companies and governments build up debts Debts denominated in foreign currencies Rely on future flows to service past flows
Debt Service Debt Service =interest payments plus amortization (repaying debt)
If debts in foreign currency When forex stops flowing in, creates problem If raise interest rates, problem worse If exchange rate falls, problem becomes worse debts denominated in foreign currency becomes greater in domestic currency
Effect of depreciation on value of debt Exchange rate: 1 peso = 1dollar 100 dollars debt = 100 pesos debt Exchange rate devalues (depreciates): 2 pesos = 1 dollar Now the country has 200 pesos worth of debt!!
Such depreciations can lead to bankruptcies
Volatility of Different Capital Flows FDI, Investment of Choice?
Does more capital flows increase economic growth?
No Clear Relationship between financial openess And Economic Growth
Conditioning on other factors
Volatility and Financial Integration Look here Source: IMF
Source: IMF
Differences between trade in Goods and in Financial Assets Financial Assets are bets on the future; trade is production in the present Trade is based on newly produced goods generates jobs. Finance ---already produced assets. Creation of a financial asset necessarily creates a debt.
A trade-off between Finance and Trade?
Scepticism about Washington Consensus Post-Washington Consensus More Policy space Not all one size fits all Capital controls?
Scepticism about Washington Consensus Post-Washington Consensus More Policy space Not all one size fits all Capital controls?
Increasing Concern Even Among Neo-liberal institutions like IMF
Raghuram G. Rajan Economic Counselor and Director of Research Has Financial Development Made the World Riskier?
Financial Landscape Altered Technical Change De-regulation Institutional Change
Risk: Spreading and Concentration: role of banks Securitization: selling assets ( plain vanilla assets: financial commodities) Banks holding onto less liquid assets.
Implications for Systemic Risk? Incentives facing bank managers and investors increasing systemic risk? Banks and other investment institutions have more incentive to take on risk:
Incentives to take on Risk Compensation: asymmetric: upside is compensated more than downside is penalized Performance judged relative to peers -incentive to take hidden risk -incentive to herd (ass covering) Reinforce each other in boom -willing to bear low probablity TAIL RISK
Tail Risk Non-normal probability distributions
Biggest Concern Will Banks be able to provide liquidity in the case of tail risk materializes In the past banks played that role Based on their sound balance sheets allowing them to attract liquidity in a crisis that they could on-lend
Illiquidity Risk? Banks today require liquid markets to hedge their bets, making them less able to provide the liquidity assurance they have provided in the past
Conclusion Even though there are far more participants today able to absorb risk, the financial risks that are being created by the system are greater. More pro-cyclicality Increased probablility of catastrophic meltdown.