International Financial Markets

Dr Brinda Sooreea-Bheemul

Introduction

• Basic raison d’être of financial markets: to mediate between those who have a surplus of funds and wish to lend with those who have a deficit and wish to borrow.

BORROWERS FINANCIAL MARKETS LENDERS

• With increased globalisation and deregulation, financial activities have expanded in terms of scope (greater geographical possibilities) and content (wider portfolio of financial instruments).

Globalisation of the Financial Market

• Advocates of globalisation claim that both developed and developing countries have benefited from a more efficient allocation of resources.

• Increased globalisation was expected to set-up a win-win situation.

Capital-abundant Low-return

Ageing Industrialised

Countries

Capital-scarceHigh-return

Young EmergingEconomies

Capital Flows

Financial Players

1. Commercial banks

2. Investment banks

3. Credit card companies

4. Insurance companies

5. Accountancy firms

International Financial Flows and Foreign Exchange Transactions

Ratio of Daily Foreign Exchange Trading to World Trade by value

1973 2:1

1980 10:1

1992 50:1

1995 70:1

• The main objective of such traders is to make a capital gain (short/long-term) by trading a variety of financial instruments.

• Forex transactions are consequently highly speculative in nature.

‘Casino Capitalism’ Susan Strange

• Mad/hot money increases the vulnerability of financial systems and creates uncertainty through increased interconnectedness.

• Role of technology is fundamental.

• Dual characteristics of financial services:– Circulation services

– Financial services as commodities/products in their own rights

Major Financial Centres• Financial activities tend to concentrate in major

metropolitan centres, creating cross-border connections across major cities around the world.

• London, New York, Tokyo, Paris, Frankfurt, Zurich, Toronto, Chicago, Mexico, Rio de Janeiro, Mumbai, Hong Kong, Melbourne

• The extent of integration of the international financial centres in the global network depends on a number of statistical variables. (Reed 1989, 16 variables)

– Volume of international currency clearing– Size of the foreign exchange market– Volume of foreign financial assets (e.g. Portfolio investment)– Number of headquarters of the large international banks

Evolving structure of financial services industry

1. Financial mediation: savings lending/investment; S I

2. Bank deposits used as money to give loans: credit creation multiplier effect; I S

3. Inter-bank lending; less risk of reserve loss; multiplier effect faster

4. Central bank: lender of last resort; no reserve constraint

5. Liability management: market share struggle as non-bank intermediaries enter

6. Securitization: capital adequacy int’l competition

Development of the Global Financial Markets

1. Deregulation and liberalisation of financial activities of both industrialised countries (1970s) and developing countries (1980s). As a consequence, this led to increased geographical mobility, range of financial product and price setting system.

2. The breaking down of the fixed exchange rate system of the Bretton Wood increased the flexibility of the exchange rate and provided investors with more speculative opportunities.

3. Increases in oil price in 1973 and 1979 resulted in vast flows of capital to OPEC countries, who exploited international banking facilities (Petrodollars).

4. The surge in MNCs activities reinforced the globalisation process of the financial system in order to enable cross-border investment.

5. Technological revolution, mainly in the forms of information technology and communication systems, has made the global financial markets electronically connected on a 24-hour basis.

Raw material are information about markets, risks, ER, returns on investment and credit worthiness.

Products are also information about value-added to informational inputs.

Positive Outcomes of the Global Financial Market1. More efficient resource allocation.

2. Diversification of financial instruments reduces the risks of investors and lenders.

3. Better alignment of interest rates. Reductions in interest rate differentials bring about greater macroeconomic stability and reduce exchange rate fluctuations.

4. An increase in the volume of FDI and trade.

5. Policy decisions of governments take into account their likely impacts on other countries.

Weaknesses of the Domestic Financial System

These weaknesses arise because of:• The removal of controls on capital movements across

borders.• The ease with which currencies can be converted.• A lack of supervision over the movements of funds.

History has shown that financial liberalisation should follow the strengthening of the domestic financial system through the reform of prudential supervision and regulatory framework.

ASPECTS OF FINANCIAL LIBERALISATION• The process of financial liberalisation involves the removal of

obstacles to market access in three distinct areas:

• Domestic financial liberalisation allows market forces to work by eliminating controls on lending and deposit rates and on credit allocation and, more generally, by reducing the role of the state in the domestic financial system.

• Capital account liberalisation removes controls on both the movement of capital in and out of a country and also the restrictions on the convertibility of the currency.

• Internationalisation of financial services eliminates discrimination in the treatment of foreign and domestic financial service providers, and removes barriers to the cross-border provision of financial services.

Vulnerability of the ‘Global Casino’

• This increased inter-connectedness can lead to higher risks for the recipients of ‘mad money’.

• Possible inflationary pressures and exchange rate fluctuations.

• Volatility of Foreign Portfolio Investment and other short-term funds can increase the vulnerability of the recipient country by upsetting its national economic policies and draining foreign exchange reserves leading to financial crises.

The unfolding of a financial crisis

Stage I Banking crisis

Domestic financial fragility due to ill-devised financial liberalisation; under-regulated and over-guaranteed banks.

Large capital inflows; bank lending boom, but poor quality of bank loans. Banking sector increasingly vulnerable, possible bank runs.

1) Deterioration of firms and bank balance sheets.2) Drop in asset prices.3) Increase in uncertainty.1) + 2) + 3): Problems of asymmetric information increase.

Stage II Currency crisis

Loss of confidence (foreign) investors; pressure on the exchange rate.

Currency crisis and reversal of capital flows;4) Debt-deflation (debt in foreign currency).5) Interest rate increase.4) + 5): Further increase in problems of asymmetric information.

Stage I Banking crisis

Domestic financial fragility due to ill-devised financial liberalisation; under-regulated and over-guaranteed banks.

Large capital inflows; bank lending boom, but poor quality of bank loans. Banking sector increasingly vulnerable, possible bank runs.

1) Deterioration of firms and bank balance sheets.2) Drop in asset prices.3) Increase in uncertainty.1) + 2) + 3): Problems of asymmetric information increase.

Stage II Currency crisis

Loss of confidence (foreign) investors; pressure on the exchange rate.

Currency crisis and reversal of capital flows;4) Debt-deflation (debt in foreign currency).5) Interest rate increase.4) + 5): Further increase in problems of asymmetric information.

Global Financial Crisis

• The global financial crisis was triggered by the sub-prime mortgage crisis in the US.

• This has destabilized the financial markets of the developed world leading to collapse of notable names in the banking business.

• Production in these economies has also been adversely affected leading to a decline in output.

THE CAUSES

• Globally, companies and individuals have an ever increasing demand for capital for both personal and corporate investments. ‘Irrational demand’

• Traditionally, banks have been very conservative and stringent in their requirements.

• This makes access to finance difficult for the majority of the people.

THE CAUSES

• Banks and other financial institutions, mostly in the USA and the UK, have gone through a long period of inappropriate lending.

• Relaxation of lending terms for mortgages was as a result of the boom in the housing sector.

• Millions of Americans and British with poor credit history who might not have bought their homes were granted sub-prime mortgages.

THE CAUSES

• Traditionally banks finance lending using deposits from customers.

• With increasing demand for mortgage loans, banks moved to a new model where mortgages were being issued on the bond market or with zero percent deposit.

• This led to the growing of the mortgage bond market as mortgage brokers focused on less than ideal clients.

• This proved to be very profitable as banks earned a fee for each mortgage sold and urged brokers to sell more and more.

THE CAUSES

• In the US, the sub-prime mortgages, referred to as Adjustable Rate Mortgages (ARM) had a fixed payment for two years.

• Then reset to higher (double the interest rate) rates and became more expensive for the people to repay.

• Millions of Americans are having their homes repossessed due to failure to repay the mortgages.

• House prices which have been falling at an annual rate of 4.5 percent in the past 3 years and are expected to fall by at least 10 percent in 2008.

Impacts

• Bailouts of financial entities

• The collapse of investment banks (E.g. Lehman Brothers)

• Weaken growth

• Recession

• Reduced demand for imports

Rescue Package – G20?

• Financial regulation: International standards

• Tax havens: Greater transparency

• IMF: Support poor countries

• Global trade: Support trade finance

• Protectionism: Freer trade

• Fiscal stimulus: Injection of $5tn by next year

The Asian Crisis (1997)

• Twin liberalisation: domestic financial liberalisation and capital account liberalisation.

• July 1997-Jan 1998– Malaysia currency lost 44.9% against USD– Philippine: 39.4%– Singapore: 18.8%– Indonesia: 83.6%

• The currency attack was the result of extremely unhealthy banking system. The banking system weakened further as a number of projects was no longer viable post the fall in exchange rate.

Thai Baht - US dollar xrate, inverted scale

10

20

30

40

50

1985 1990 1995 2000 year

exch

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July 1997

Malaysian Ringgit - US dollar xrate, inverted scale

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1985 1990 1995 2000 year

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July 1997

Causes of Asian Financial Crisis

1. Exchange rate problem

2. Asian nationalistic view: conspiracy theory

3. Private sector borrowing abroad

4. Internal weaknesses

5. Poorly conceived projects

6. Export boom

Lessons from the Asian Crisis1. Avoid fixed exchange rates

Exchange controls should be used as a temporary measure as they can lead to destabilising movements in inward and outward capital flows.

2. Precautionary credit line facility This would provide a form of protection against panic-stricken withdrawal of capital. Strong rational for a lender of last resort (IMF???).

3. Greater role of the domestic banking sector.For e.g. within the banking industry, it would bring

more flexibility and communications with creditors and to extend the number and variety of instruments available.

4. Self-help-Learn about the risks of opening up their economies.-Regulate banking, foreign exchange reserve, encourage long-term investment and discourage risky short-term flows.

Mexican Crisis (1994)• In 1994 a large current account deficit, a weak banking

system, and rapid growth in dollar-indexed Mexican government debt led to controlled devaluation of the peso by 4% per annum.

• This devaluation appeared to have triggered the crisis (following NAFTA in 1993).

• This led to a capital flight out of the Mexican economy as investors worried about a higher current account deficit, high government spending and political instability.

• Holders of short-term dollar papers were bailed out by the IMF, while investors in long-term bonds and peso-denominated lenders incurred losses.

• As a consequence, this further triggered international debt in Latin America.