NATURE AND FUNCTIONSInternational financial markets undertake intermediation by transferringpurchasing power from lenders and investors to parties who desire to acquireassets that they expect to yield future benefits. International financial transactionsinvolve exchange of assets between residents of different financial centresacross national boundaries. International financial centres are reservoirs ofsavings and transfer them to their most efficient use irrespective of where thesavings are generated.

There are three important functions of financial markets. First, the interactionsof buyers and sellers in the markets determine the prices of the assets tradedwhich is called the price discovery process. Secondly, the financial marketsensure liquidity by providing a mechanism for an investor to sell a financialasset. Finally, the financial markets reduce the cost of transactions andinformation.

MONEY AND CAPITAL MARKETSLike their domestic counterpart, international financial markets may be dividedinto money and capital markets. Money markets deal with assets created ortraded with relatively short maturity, say less than a year. Capital markets dealwith instruments whose maturity exceeds one year or which lack definite maturity.Again on lines similar to domestic markets, in the international financial marketsalso we have primary and secondary markets dealing with issue of newinstruments and trading in existing instruments and negotiable debt instruments,respectively. In international financial markets as in the domestic markets thereis a symbiotic relationship between primary and secondary markets.

INTERNATIONAL

FINANCIAL MARKETS1

International Financial Markets and India2

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CATEGORIES OF MARKETSAccording to Garbbe (see reference at the end of the chapter) internationalfinancial markets consist of international markets for foreign exchange, Eurocurrencies and Euro bonds. In view of the development and rapid growth ofswaps and globalisation of equity markets, international financial markets havebeen categorised into five markets here: foreign exchange market; lending byfinancial institutions; issue and trading of negotiable instruments of debt; issueand trading of equity securities; and lastly internationally arranged swaps. Therates of foreign exchange as well as interest rates fluctuate and to hedge againstthe risk of loss arising out of changes in them derivative instruments are tradedin the organised exchanges as well as in over-the-counter markets. Most of thederivatives except the interest rate swaps are short term in nature. Derivativesinvolve creation of assets that are based on other financial assets.

GROWTH OF INTERNATIONAL FINANCIAL MARKETSSince the 1960’s, the growth of international financial transactions has beenprofoundly influenced by the growth in international trade involving exchange ofgoods and services. The value of imports in US dollars for the world as a wholewent up in the last five decades by a multiple of 14 from about $ 590 billion in1960 to about $ 8000 billion in 2000. While international trade can exist in theabsence of international financing arrangements as under direct exchange, barterand cash payment in gold, there are no international finance or markets whereno goods and services are exchanged between residents of different countries.There would be no reason for borrowing, lending or investing between countriessince nothing could be bought with the product of loan or investment.

BenefitsInternational financial markets and the transactions therein have howeverfacilitated and helped the expansion of international trade based on comparativeabsolute advantage resulting in welfare benefits in terms of higher income amongparticipant nations. Further, the growth of international financial markets hasfacilitated cross-country financial flows which contribute to a more efficientallocation of resources. Efficiency in use rather than origin of or abundancegoverns allocation of resources internationally. This means that potentially highreturn projects in countries with low savings will not be neglected in favour oflow return projects in high saving countries simply because of where savingsare generated.1 American and British institutional money is flooding foreignmarkets.

1. Ephrain, Clark, Michael, Levasseur and Patrick, Rousseau, International Finance,Chapman and Hall, London, 1993.

International Financial Markets

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Table 1.1: Estimated Net Financing in International Financial Markets (1985–2000)

(Billions of US $)

Components of Net International Financing

Stock at year end1985

CHANGES Outstanding

amount at end 2000

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Total International Claims of reporting banks

3137.1 657.2 764.8 510.9 807.1 589.0 (-)103.4 146.7 316.5 263.2 608.1 532.7 1142.6 331.0 276.1 1171.8 10764.4

Minus·lnter bank redepositing 1652.1 4522.0 444.8 250.9 397.1 209.0 (-)183.3 -18.3 121.5 83.2 314.1 184.1 719.8 228.1 (-)214.3 658.7 6262.8

A. Net International bank credit 1485.0 205.0 320.0 260.0 410.0 380.0 80.0 165.0 195.0 180.0 330.0 420.0 465.0 115.0 61.8 1113.1 4501.6

B. Net Money market instruments 16.0 13.4 23.4 19.5 6.9 32.0 34.9 40.4 72.1 140.2 17.4 41.1 19.8 7.4 66.4 86.5 346.1

Total completed bond and note issues - 220.5 180.0 220.7 263.6 239.4 319.7 332.7 437.1 381.8 536.8 859.6 1014.0 1167.8 1163.9 1148.2 6168.7

Minus: redemption and repurchases - 64.6 73.0 82.6 89.4 108.4 149.3 223.0 306.8 227.9 291.0 363.4 460.5 497.5 – – –

C. Net bond and note financing 572.5 155.9 107.0 138.1 174.3 131.0 170.5 109.7 133.3 153.9 245.8 496.2 553.5 676.3 – – –

D. Total international financing (A+B+C) 2073.5 374.3 450.4 417.2 591.2 543.0 285.4 315.1 397.5 474.1 593.1 957.3 1038.3 792.7 – – –

Minus: double counting 133.5 79.3 50.4 67.6 76.2 78.0 40.4 70.1 127.5 69.1 48.1 197.3 163.3 227.7 – – – E. Total net 1940.0 295.0 400.0 350.0 515.0 465.0 245.0 245.0 27.0 405.0 545.0 760.0 875.0 565.0 6410.4 295.7 11016.4

International Financing

Source: BI8, Annual Reports 1991, 1994, 1998 and 1999 and International Banking and Financial Market Developments,November 1994, May 1995, March 1998, March 1999 and June 2000.

International Financial Markets and India4

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SEGMENTATION OF THE GLOBAL CAPITAL MARKETMartin Feldstein in a study on Global Capital Flows1, argues that the worldcapital market remains essentially segmented along national lines. “Capital maybe free to move internationally, but its owners and managers prefer to keep allof each individual nation’s savings at home.”2 Feldstein argues that the bestevidence of this segmentation is the strong correlation between national ratesof saving and investment. He observes that if there were perfectly integratedworld capital markets, the differences in national savings rates would not leadto differences among countries in national rates of investment in businessequipment and inventories. Capital would flow from the high saving countriesto the best investment opportunities around the globe.

Feldstein finds that much of the capital that moves internationally is pursuingtemporary gains and shifts quickly as conditions change. The large grossinternational flows of funds are often part of offsetting transactions that leaveno net transfer of capital from one country to another. Feldstein argues that thesegmented nature of the world capital market is confirmed by the strong, home-country bias of institutional portfolios. Only 10 per cent of the value of assetsin the 500 largest institutional portfolios in the world is invested in foreignsecurities despite the advice of economists and financial analysts who advocateglobal diversification as a way of increasing returns and reducing overallportfolio risk. No country can count on sustained inflows of foreign capital tofinance domestic investment even when their local investment opportunities areattractive. Mexico’s economic crisis in 1994 broke out because it let its savingsrates slip from 14 to 10 per cent and looked to the rest of the world to financeits savings gap. Mexico’s low saving rate was the problem because of thelimited international flow of capital. The crisis arose out of the fact that too littlecapital crosses borders and not too much.

ESTIMATED NET FINANCING IN INTERNATIONAL FINANCIAL

MARKETSWhile world imports went up by a multiple of 14, the growth of internationalfinancial activity as measured by the external assets of banks reporting to theBank for International Settlements3 rose from US$ 37.7 billion in 1968 to

1. The Economist, June 24, 1995.2. Ibid.3. Includes Austria, Belgium, Luxembourgh, Denmark, Finland, France, Germany,

Ireland, Italy, Netherlands, Norway, Spain, Sweden, Switzerland, United Kingdom,Japan, United States, Bahamas, Bahrain, Cayman Islands, Hongkong, NetherlandsAntilles, Singapore and branches of US banks in Panama.

International Financial Markets 5

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$ 11,016.4 billion in 2000. Apart from the external assets of banks there was alarge growth in Euro notes and Euro bonds.

Table 1.1 presents the estimated net financing in international financialmarkets between 1985–2000. The Table presents, apart from external claims,net international bank credit, net money market instruments (including commercialpaper, short-term Euro notes and medium-term notes), bonds and total netinternational financing. Outstanding net international bank credit largely consistingof syndicated loans rose from $ 1,485 billion in 1985 to $ 4,501.6 billion in 2000(a 203 per cent increase); money market instruments from $ 16 billion to $ 346.1billion (2,063 per cent); bond financing from $ 572.5 billion to $ 6,168.7 billion(947.5 per cent); and total net international financing from $ 1,940 billion to$ 11,016.4 billion (468 per cent).

MONEY MARKET AND CAPITAL MARKET INSTRUMENTSIn the international money market, short-term notes, bankers’ acceptancesincluding, Euro commercial paper are traded. The assets created and tradedhave relatively short maturities. The outstanding amount at end-2000 was$ 333.8 billion consisting of commercial paper ($ 223.3 billion) and other short-term paper ($ 110.5 billion).

International capital markets deal in assets with maturities above one yearor those which lack definite maturities. These instruments consist of Euro medium-term notes ($ 879.3 billion at end 2000), bonds ($ 6,049.7 billions at end-2000);and Euro loans ($ 7,878 billion at end-2000).

The secondary markets are important for securities and negotiated debtinstruments. The securities consist of certificates of deposits and bankersacceptances.

EURO MARKETIn international lending and trading of securities some operations are called‘Euro’. It refers to types of financial activity that take place outside the countriesin whose currencies they are denominated. Euro dollar markets are offshoremoney and capital markets, in the sense that the currency denomination is notthe official currency of the country where the transaction takes place. The term‘Euro’ was first used for US dollar deposits made in London after the SecondWorld War when the US dollar replaced pound sterling as the leading internationalcurrency. The term Euro dollar market was later generalised to Euro currencywhen offshore centres for other currencies emerged. The reason for thepopularity of Euro dollar or Euro markets was that Euro markets were lessregulated than the U.S. markets. Further, the absence of reserve requirements,