Chapter 21

The Global Capital Market:

Performance and Policy Problems
 Kernel of the Chapter
 The International Capital Market and the Gains from
Trade
 International Banking and the International Capital
Market
 Regulating International Banking
 How Well Has the International Capital Market
Performed?

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 Introduction
 International capital market
– How has the international capital market enhanced
countries’ gains from trade?
– What caused the rapid growth in international financial
activity that has occurred since the early 1960s?
– How can policymakers minimize problems raised by a
worldwide capital market without sharply reducing the
benefits it provides?

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The International Capital Market
and the Gains From Trade
 Three Types of Gain From Trade
• All transactions between the residents of different
countries fall into one of three categories:
– goods or services for goods or services
– goods or services for assets
– assets for assets

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The International Capital Market
and the Gains From Trade
 Risk Aversion
• The risk associated with a trade of assets is shared when
assets are traded internationally.

 Portfolio Diversification as a Motive for International

Asset Trade
– International capital markets make this diversification
possible.

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The International Capital Market
and the Gains From Trade
 The Menu of International Assets: Debt Versus
Equity
• International portfolio diversification can be carried
out through the exchange of:
– Debt instruments
– Bonds and bank deposits
– Equity instruments
– A share of stock

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 International Banking and the
International Capital Market
 The Structure of the International Capital Market
• The main actors in the market :
– Commercial banks
– Corporations
– Nonbank financial institutions
– Central banks and other government agencies

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 International Banking and the
International Capital Market
 Growth of the International Capital Market
• The removal of barriers.
• A policy “trilemma” refers to three available options:
– Fixed exchange rate
– Monetary policy oriented toward domestic goals
– Freedom of international capital movements

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9
 International Banking and the
International Capital Market
 Offshore Banking and Offshore Currency Trading
• Offshore banking
– Banks operate offshore though any of three types of
institution:
• Offshore currency trading
– Trade in bank deposits denominated in currencies of
countries other than the one in which the bank is located

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International Banking and the
International Capital Market
• Eurodollars
• Eurobanks
• Eurocurrency trading has grown for three reasons:
– Growth in world trade
– Evasion of financial regulations like reserve
requirements
– Political concerns

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 International Banking and the
International Capital Market
 The Growth of Eurocurrency Trading
• The early growth in the Eurodollar market was due to:
– Growing volume of international trade
– Cold War
– New U.S. restrictions on capital outflows and U.S.
banking regulations
– Federal Reserve regulations on U.S. banks
– Move to floating exchange rates in 1973
– Oil dollar

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International Banking and the
International Capital Market
• International banking facilities (IBFs)
– accept time deposits and make loans to foreign
customers.
– not subject to reserve requirements or interest rate
ceilings.
– exempt from state and local taxes.

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 Regulating International Banking
 The Problem of Bank Failure
• A bank fails when it is unable to meet its obligations to
its depositors.
• Governments attempt to prevent bank failures through
extensive regulation of their domestic banking
systems.

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 Regulating International Banking
• The main U.S. safeguards to reduce the risk of bank
failure:
– Deposit insurance
– Reserve requirements
– Capital requirements and asset restrictions
– Bank examination
– Lender of last resort (LLR) facilities
– The Fed lends to banks facing massive deposit outflows to
satisfy their depositors’ claims.

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 Regulating International Banking
 Difficulties in Regulating International Banking
• Deposit insurance is essentially absent in international
banking.
• The absence of reserve requirements reduces the
stability of the banking system.
• Bank examination to enforce capital requirements and
asset restrictions becomes more difficult in an
international setting.
• There is uncertainty over which central bank is
responsible for providing LLR assistance in
international banking.
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 Regulating International Banking
 International Regulatory Cooperation
• Basel Committee
– It enhances regulatory cooperation in the international
area.
– Its 1975 Concordat allocated national responsibility for
monitoring banking institutions and provided for
information exchange.

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 Regulating International Banking
• In the 1990s new emerging markets appeared as
sources and destinations for private capital flows.
• Securitization has increased the need for international
cooperation in monitoring and regulating nonbank
financial institutions.

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 How Well Has the International
Capital Market Performed?
 The Extent of International Portfolio Diversification
• The international capital market has contributed to an
increase in international portfolio diversification since
1970.

 The Extent of Intertemporal Trade

• Some observers claim that the extent of international
trade, as measured by countries’ current account
balances, has been too small.

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 How Well Has the International
Capital Market Performed?
 Onshore-Offshore Interest Differentials
• If the world capital market is functioning well,
international interest rates should move closely together
and not differ too greatly.
– Large interest rate differences would be strong evidence of
unrealized gains from trade.
– Data shows that rates of return on similar deposits issued in the
major financial centers are quite close.

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 How Well Has the International
Capital Market Performed?
Figure 21-4: Comparing Eurodollar and Onshore United States Interest
Rates

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 How Well Has the International
Capital Market Performed?
 The Efficiency of the Foreign Exchange Market
• Studies Based on Interest Parity
– The interest parity condition:
Rt – R*t = (Eet+1 – Et)/Et (21-1)

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How Well Has the International
Capital Market Performed?
– The forecast error made in predicting future
depreciation:

ut+1 = (Et+1 – Et)/Et - (Eet+1 – Et)/Et (21-2)

– Under interest parity, this hypothesis can be tested by

writing ut+1 as actual currency depreciation less the
international interest difference:

ut+1 = (Et+1 – Et)/Et - (Rt – R*t) (21-3)

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How Well Has the International
Capital Market Performed?
• The Role of Risk Premiums
– If bonds denominated in different currencies are
imperfect substitutes for investors,
Rt – R*t = (Eet+1 – Et)/Et + t (21-4)
• Tests for Excessive Volatility
– They yield a mixed verdict on the foreign exchange
performance.
• The Bottom Line
– Evidence on foreign exchange market is ambiguous;
more research and experience are needed.

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