LECTURES 16 -17:INTERNATIONAL INTEGRATION OF

FINANCIAL MARKETS

Question 1: What are the pros and consof open financial markets?

Question 2:How high is international capital mobility, and what are the remaining barriers?

Advantages of financial opening

• For a successfully-developing country, with high return to domestic capital, investment can be financed more cheaply by borrowing abroad than out of domestic saving alone.

• Investors in richer countries can earn a higher average return on their saving by investing in emerging markets than they could domestically.

• Everyone benefits from the opportunity to diversify away risks and smooth disturbances.

Further advantages of financial openingin emerging-market countries

• Letting foreign financial institutions into the country improves the efficiency of domestic financial markets. It subjects over-regulated and potentially-inefficient domestic institutions – to the harsh discipline of competition and

– to the demonstration effect of examples to emulate.

• Governments face the discipline of the international capital markets in the event they make policy mistakes.

Classic gains from tradetextiles

wine

•

••

In autarky,Portugal can onlyconsume what it produces.(Price mechanism puts it onfull-employment PPF & at the point maximizing consumers’ utility.)

Textiles are cheaper on world markets.

Under free trade, Portugal responds to new relative prices by

shifting into wine, where it has a comparative advantage….

…and Portuguese consumption shifts into textiles, which it imports, thereby reaching a higher indifference curve.

Next, we do the gains from trade again, substituting period 0 & period 1, in place of wine & textiles.

Intertemporal trade:Welfare gains from open

capital markets.

1. Even without intertemporal reallocation of output, consumers are better off at B than A (borrowing from abroad to smooth consumption).

2. In addition, firms can borrow abroad to finance investment, then consuming at C .

today

future

today

future

••

•

Does this theory ever work in practice?

When Norway discovered North Sea oil in 1970s, it temporarily ran a large CA deficit,

• to finance investment (while the oil fields were being developed) &

• consumption (as was rational, since Norwegians knew they would be richer in the future).

Subsequently, Norway ran big CA surpluses.

CAPITAL ACCOUNT LIBERALIZATION: THEORY, EVIDENCE, AND SPECULATION

Peter Blair HenryWorking Paper 12698

http://www.nber.org/papers/w12698

Effect when countries open their stock markets to foreign investors, on cost of capital.

Liberalization occurs in “Year 0.”

CAPITAL ACCOUNT LIBERALIZATION: THEORY, EVIDENCE, AND SPECULATION

Peter Blair HenryWorking Paper 12698

http://www.nber.org/papers/w12698

Effect when countries open their stock markets to foreign investors, on investment.

Liberalization occurs in “Year 0.”

Indications that financial marketsdo not always work as advertised

• Crises => Financial markets work imperfectly the 1982 international debt crisis; 1992-93 crisis in the European Exchange Rate Mechanism;

EM Currency crashes of the late 1990s:1994-95 Mexico;

1997 E.Asia, esp. Thailand, Korea & Indonesia; 1998 Russia, 2000 Turkey, 2001 Argentina.

2008-2010 U.S. & U.K. ! Iceland, Hungary, Latvia, Ukraine, Pakistan; The 2010-2012 euro crisis.

Indications that financial markets

do not always work as advertised, continued

• It is difficult to argue that investors punish countries when and only when governments follow bad policies:

Large inflows often give way suddenly to large outflows, with little news appearing in between to explain the change in sentiment.

Second, contagion sometimes spreads to countries that are unrelated, or where fundamentals appear strong.

Recessions hitting emerging markets in such crises have been so big, it is hard to argue that the system is working well.

Economic crashes can be severe,

Source: Guillermo Calvo, 2006.

such as East Asia 1997-98

Indications that financial marketsdo not always work as advertised (continued)

• More generally, capital flows have:

(i) not on average gone from rich countries (high K/L) to poor (low K/L) – The “Lucas paradox.”

(ii) often been procyclical, not countercyclical.

• Possible explanations: In developing countries,• (i) investors cannot reap the potential returns to capital due to inferior institutions, esp. inadequate protection of property rights…

(Alfaro, Kalemli-Ozcan & Volosovych, 2008)

• (ii) fluctuations that appear cyclical, in truth signal changes in long-run growth prospects. (Aguiar & Gopinath, 2007) .

Empirical studies of financial openness and economic performance,

reviewed by Kose, Prasad, Rogoff & Wei (2009),

often find little systematic relationship, in either direction.

• income -- Biscarri, Edwards, & Perez de Grarcia (2003); Klein & Olivei (1999); Edwards (2001); Martin & Rey (2002); Ranciere, Tornell & Westermann (2008);

• financial depth, institutional quality, & other reforms -- Kaminsky & Schmukler (2003); Chinn & Ito (2002); Klein (2003); Obstfeld (2009); Kose, Prasad & Taylor (2009); Wei & Wu (2002); Prasad, Rajan, & Subramanian (2007).

• Or macroeconomic discipline.-- Arteta, Eichengreen & Wyplosz (2001).

Some studies find that financial openness is helpful only if countries have already attained an adequate level of:

=> Conventional wisdom regarding sequencing: it is better liberalize financial markets only after other reforms have been put in place.-- McKinnon (1993), Edwards (1984, 2008), and Kaminsky & Schmukler (2003).

I. Direct measures of barriers, e.g., IMF’s count of freedom from KA restrictions.

II. “Price tests”

III. “Quantity tests”

Measuring International

Financial Integration

Source: Kose, Prasad, Rogoff & Wei (2009)

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.

I. Direct Measure of Financial Openness: Chinn & Ito

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.

Measuring International Financial Integration, cont.

II. “Price” tests

1.Uniform price of an asset across markets, e.g.,

i) Arbitrage between China’s A-shares and off-shore ii)Arbitrage between a Country Fund & its constituent assets

2. Interest rate parity (IRP) i) Covered interest parity (CIP) ii) Uncovered interest parity (UIP) iii) Real interest parity (RIP)

1. Price of the same asset across borders

Chinese firms’ stock prices, onshore relative to offshore

.

Robert McCauley, CFR conference on Internationalization of the RMB, Beijing, Nov.1-2, 2011, Graph 5 Data Source: Bloomberg, BIS

Premium of “A shares” (held domestically), over “H shares” (held in Hong Kong)

B-shares, which Chinese firms can issue to foreign investors, sold at a discount to A-shares,

which only domestic resident could hold.

Source: Vicki Wei Tang (2011)

Country funds

Differential

The NYC price of a Mexican basket of stocks ≠ the Net Asset Value of the components traded in Mexico City => imperfect arbitrage.

Note: In the peso crisis of 1994, the local NAV fell (i) more than the price of the fund in NYC, and (ii) before the devaluation hit --suggesting that locals might have had better information.

Source: Frankel & Schmukler (1996)

2. Interest Rate Parity:WHY DOES i NOT EQUAL i* ?

I. Currency factors

• Expected currency depreciation

• Exchange risk premium

The currency premium can be measured as the forward discount, or the differential between domestic & local $-linked bonds

II. Country factors

…

WHY DOES i NOT EQUAL i* ?

II. Country factors, continued

• Default risk – • reflected in sovereign spreads or Credit Default Swaps

• Capital controls – • reflected in covered interest differentials

• Taxes on cross-border investments• Transaction costs• Imperfect information• Risk of future capital controls

Total interest differential (Brazil rate minus LIBOR) =Currency premium (forward premium) + Country premium (spread)

Sovereign spreads

}}

Spreads on South African Dollar Debt Downtrend in SA country risk premium,

to below 100 basis points by 2006, in tandem with upgrades by rating agencies

Source: SA Treasury

-

100.00

200.00

300.00

400.00

500.00

600.00

700.00

10

/15

/19

96

2/1

5/1

99

7

6/1

5/1

99

7

10

/15

/19

97

2/1

5/1

99

8

6/1

5/1

99

8

10

/15

/19

98

2/1

5/1

99

9

6/1

5/1

99

9

10

/15

/19

99

2/1

5/2

00

0

6/1

5/2

00

0

10

/15

/20

00

2/1

5/2

00

1

6/1

5/2

00

1

10

/15

/20

01

2/1

5/2

00

2

6/1

5/2

00

2

10

/15

/20

02

2/1

5/2

00

3

6/1

5/2

00

3

10

/15

/20

03

2/1

5/2

00

4

6/1

5/2

00

4

10

/15

/20

04

2/1

5/2

00

5

6/1

5/2

00

5

10

/15

/20

05

2/1

5/2

00

6

6/1

5/2

00

6

Global 06 Global 09 Global 12

Global 14 Global 17

S&P Upgrade (BB+ to BBB-) S&P Upgrade (BBB- to BBB)

S&P Upgrade (BBB to BBB+)Moody's upgrade (Baa3 to Baa2)

Moody's upgrade (Baa2 to Baa1)

Sovereign spreads

as among other emerging markets

50

150

250

350

450

550

650

2-Jun-03

30-Jul-03

26-Sep-03

26-Nov-03

28-Jan-04

26-Mar-04

25-May-04

23-Jul-04

21-Sep-04

19-Nov-04

20-Jan-05

21-Mar-05

18-May-05

18-Jul-05

14-Sep-05

14-Nov-05

13-Jan-06

15-Mar-06

12-May-06

10-Jul-06

EM

BI+

EMBI+

RSA EMBI+

That spreads were so low for Emerging Market bonds in 2005, and even lower for South Africa,

was an indication that global investors were under-pricing risk-- as also reflected in US corporate spreads, options prices, etc. --

all of which shot back up in 2008.

Sovereign spreads, 2003-06

Sovereign spreads for 5 euro countries shot up in the 1st half of 2010

Creditworthiness: Some advanced economics Creditworthiness: Some advanced economics have fallen, as emerging markets have risen.have fallen, as emerging markets have risen.

Source:

Financial Times11//2/2007Selling at a

forward discount

against the $:

Turkish lireArgentine pesoBrazilian real

Selling at a forward premiumagainst the $:

YenNew Taiwan $UAE dirham

The forward market

Selling at a forward discountagainst the $:Hungarian forint

Russian rubleTurkish lireArgentine pesoIndonesian rupiah

S.African rand

Selling at a forward premium

against the $:S.Korean won

Financial Times

Jan. 30, 2009

During Global Financial Crisis

COVERED INTEREST PARITY (1 + iTurkey) =

Forward discount fd (F-S)/S

=> 1 + fd F/S

=>

(1 + iTurkey) = (1 + fd) (1 + iUS).

= (1 + fd + iUS + fd iUS).

Because (fd iUS) is small, iTurkey ≈ fd + iUS .

=> If the Turkish nominal interest rate exceeds the U.S. rate, then the lira sells at a discount in the forward exchange market.

(1/S) F(1 + iUS)

where S is the spot rate in TL/$ and F is the forward rate.

THREE INTEREST RATE PARITY CONDITIONS

Investors decide whether to hold:

Arbitrage => parity condition.

Does it hold in practice?

Covered interest parity

$ deposits in New York vs. covered £ deposits in London

i$NY - i£L =

fd.

Yes, if default risk & capital controls are low .

Uncovered interest parity

$ deposits in NY vs. £ deposits in London uncovered.

i$NY - i£L =

Δse

If risk is unimportant. Hard to tell in practice.

Real interest parity

Arbitrage is not directly relevant

i$NY - i£L =

ΔpUS

e- ΔpUK

e

No, not in short run.

CIP

UIP

RIP

Liberalization in a country that had

controls on capital inflows.

{

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.

{

Liberalization in a country

that had controls on capital 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.

DECOMPOSITION OF THE NOMINAL

INTEREST DIFFERENTIAL i – i* ≡ (i – i*- fd) + fd* ≡

fd) - *i - (i + )s - (fd e + )s ( e

≡ covered exchange expected interest risk nominal differential premium depreciation

premiumcountry

premiumcurrency

The country premium could be measured by the sovereign spread, as easily as the covered interest differential.

The currency premium could be measured by the local spread of $-linked vs. domestic-currency bonds, as easily as by the forward discount.

III. QUANTITY TESTS OF FINANCIAL INTEGRATION all point to surprisingly low international integration

1. Home bias in portfolios: Do citizens of each country hold a basket of assets that is optimally diversified internationally?

2. Consumption risk-sharing: Are countries’ consumption levels correlated with each other more than country incomes?

3. Feldstein-Horioka test: Do countries’ Investment rates vary independently of their National Saving rates?

No

No

No

Appendices

I. Interest Rate ParityCountry premium

• vs. currency premium for Latin America in 1994.• Periphery euro countries versus emerging markets 2006-10.

II. Feldstein-Horioka testsRegression is: (I/GDP) = α + β (NS/GDP) + v.Feldstein (1980) argued that if capital were perfectly mobile, would find β = 0. Instead, β was much closer to 1.

Critiques?

Appendix I:Measuring factors in interest differentials

• Sometimes the effect of capital controls can be isolated by offshore-onshore interest differentials– including by the covered interest differential

to take out currencies difference (for countries with forward markets),

– or differential in local $-linked bonds vs. US T-bills.

• Sometimes currency premia can be decomposed.

• The effect of default risk can be isolated by the sovereign spread on bank loans or bonds (EMBI).

Total interest differential (Local – US )

= (Currency premium) + (country premium)

= (Δse + exchange risk premium) + (country premium)

Appendix I

Sovereign interest rates, in 3 crises

Source: IMF

40Market Nighshift Nov. 16, 2011

Mis-pricing, 2002-08: Sovereign spreads for Greece and other Mediterranean members of the euro

over German interest rates were near zero, 2003-08

Ratings for “Emerging Economies”Ratings for “Advanced Economies”

Sovereign debt credit ratings over 2006-2010 for some advanced countries fell, while ratings for some emerging markets rose.

Appendix II: Critiques of Feldstein Horiokain cross-country samples

• “A theoretical model can be constructed in which capital mobility is perfect and yet the saving-investment correlation is high.” -- Not that useful a statement.

• “National Saving is endogenous.” – More serious.– Private saving. The “Intertemporal Optimization” critique:

Saving varies with the business cycle, or with population or productivity growth.

– Fiscal policy. The “Maintained external balance critique:– Governments react to trade imbalances to correct them.– Both critiques are true, but can be addressed.

Three findings that are puzzling, if the saving-investment coefficient is to be interpreted as a measure of barriers to international financial integration:

1) the coefficient is statistically far above zero (the original Feldstein-Horioka finding),

2) it is even higher for industrialized than for developing countries, and

3) there is little observed tendency for it to fall over time.

Michael Dooley, Jeffrey Frankel and Don Mathieson, “International Capital Mobility in Developing Countries vs. Industrial Countries: What Do Saving-Investment Correlations Tell Us?” IMF Staff Papers, 1987.

Puzzle: The coefficient is no lower for industrial countries than for developing countries.

Feldstein-Horioka coefficient (β)may have fallen slightly in the 1980s & 1990s

Everyone points out that National Saving is endogenous.

But results change little when using instrumental variables. (Military spending is an exogenous determinant of govt. saving and dependency ratio is an exogenous determinant of private saving.)

Coefficient is lower fordevelopingcountries;No declineover time !

Feldstein-Horioka coefficient B > 1 if:

4. NS endogenous,

so error u in I is correlated

with r, even if RIP

holds.

3. Real exchange rate

expected to change, so RIP fails even if UIP holds, or

2. Exchange risk matters, so UIP fails even if CIP holds, or

1. CIP fails, or

DECOMPOSITION OF THE REAL

INTEREST DIFFERENTIAL r – r* ≡

(i – πe ) - ( i*– πe*) ≡ (i – i*) - πe – πe* ≡

fd) - *i - (i + )s - (fd e + *)-s ( eee

≡ covered exchange expected interest risk real differential premium depreciation

premiumcountry

premiumcurrency real