(VII) INTERNATIONAL INTEGRATION OF FINANCIAL MARKETS

LECTURES 20 - 22

Question 1: What are the arguments in favor of open financial markets?

Question 2:Does it really work this way?

Question 3: How integrated are financial markets, 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.

• Symmetrically, investors in rich countries can earn a higher return on their saving by investing in emerging markets than they could domestically.

• Households can smooth consumption over time.• In the presence of uncertainty, investors can

diversify away some risks.

Classic gains from tradewine

textiles

•

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….

…Portuguese consumption in textiles rises, 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.

today

future

•

•

Intertemporal optimizationWe will maximize the intertemporal utility function:u[C0] + β u[C1] where C0 ≡ consumption today; C1 ≡ consumption tomorrow;

u'(C) > 0; u''(C) < 0; β ≡ subjective discount factor, reflecting patience. 0<β<1.

Total resources available = Y0 + Y1.

where Y0 ≡ income today; Y1 ≡ income tomorrow; r ≡ real interest rate.

Total spending discounted to today = C0 + C1 .

Budget constraint: C1 = (1+r)(Y0-C0 ) + Y1.

Intertemporal utility subject to budget constraint: u[C0] + β u[(1+r)(Y0-C0 ) + Y1]

To maximize, differentiate with respect to C0: Þ Euler equation: u'[C0] + β u'[C1](-(1+r)) = 0.

Þ u'[C0]/u'[C1] = β (1+r)

A simple functional form

Let’s try the case of log utility: log[C0] + β log[C1] (a special case of iso-elastic utility functions)

Then Euler equation u'[C0]/u'[C1] = β (1+r)

becomes [1/C0]/[1/C1] = β (1+r).

=> = β (1+r).

Result: Agents choose higher consumption tomorrow than today if r is high and/or they are patient.

ITF220 Prof.J.Frankel

Welfare gains from open capital markets:

1. Even without intertemporalreallocation of output, Y0 & Y1,

consumers are better off (borrowing from abroad to smooth consumption).

2. In addition, firms can borrow abroad to finance investment.

WTP, 2007

The intertemporal optimization theory of the current account

ITF220 Prof.J.Frankel

The intertemporal-optimization theory of the current account, and welfare gains from international borrowing

Source: Caves, Frankel & Jones (2007) Chapter 21.5, World Trade & Payments, 10th ed.

=> domestic residents borrow from abroad, so that they can consume more in Period 0.

Assume interest rates in the outside world are closer to 0

than they were at home(the slope of the line

is closer to -1.0).

Welfare ishigher at

point B.

1. Financial opening with fixed output

●

●

future

today

High interest rate encourages agents to postpone consumption.

Y0

Y1

=> C0↑

THE INTERTEMPORAL-OPTIMIZATION THEORY OF THE CURRENT ACCOUNT, AND WELFARE GAINS FROM INTERNATIONAL BORROWING, continued

Source: Caves, Frankel & Jones (2007) Chapter 21.5, World Trade &Payments.

Shift production from Period 0 to 1,and yet consume more in Period 0,thanks to foreigncapital flows.

Assume interest rates in the outsideworld are closer to 0 than

they were at home.

Welfare is higher at point C.

2. Financial opening with elastic output

●

●

●

future

today

ITF220 Prof.J.Frankel

Does this theory ever work in practice?

Norway discovered North Sea oil in 1970s. It temporarily ran a large CA deficit,

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

• & to finance consumption (as was rational, since Norwegians knew they would be richer

in the future).

}

} Subsequently, Norway ran big CA surpluses.

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

Liberalization occurs in “Year 0.”

Cost of capital falls,on average.

Peter Henry (2007) “Capital Account Liberalization: Theory, Evidence, and Speculation,“JEL, 45(4): 887-935.

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

Liberalization occurs in “Year 0.”

Investment rises,on average.

Peter Henry (2007) “Capital Account Liberalization: Theory, Evidence, and Speculation,“JEL, 45(4): 887-935.

Indications that financial marketsdo not always work as advertised

1) The Lucas Paradox

2) Pro-cyclical capital flows

3) Crises

Indications that financial markets do not always work as advertised

1) The Lucas paradox:

• Capital flows do not systematically go from rich countries (high K/L) to poor (low K/L). – Robert Lucas (1990), “Why Doesn’t Capital Flow from Rich

to Poor Countries?” AER.– Capital “flows uphill.”

• Possible explanation: In many developing countries investors cannot reap the potential returns to capital due to inferior institutions, especially inadequate protection of property rights. • -- Alfaro, Kalemli-Ozcan & Volosovych (2008).

Indications that financial markets do not always work as advertised

2) Pro-cyclicality:• Capital flows tend to be pro-cyclical, not counter-cyclical.

– E.g., Kaminsky, Reinhart & Végh (2005) “When it rains, it pours.”

• Possible explanations: In developing countries,• (i) given imperfect creditworthiness, investors require

collateral, e.g., tangible foreign exchange earnings. The value of the collateral is higher in booms than busts.

• (ii) Fluctuations that appear cyclical, in truth may signal changes in long-run growth prospects.

• -- Aguiar & Gopinath (2007).

Indications that financial markets do not always work as advertised

• Debt crises, currency crises, banking crises 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, 2002 Uruguay.

2008-2015 2008-09 GFC (U.S. & U.K.: “North Atlantic Financial Crisis” !) Iceland, Hungary, Latvia, Ukraine, Pakistan…; The 2010-15 euro crisis (Greece, Ireland, Portugal, Spain, Cyprus…).

3) Crises

Indications that financial markets do not always work as advertised, cont.

• Do 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.

Contagion sometimes spreads to countries that are unrelated, or where fundamentals appear stronger.

Recessions have been so big, it seems hard to argue that the system works well.

Economic crashes can be severe,

Source: Guillermo Calvo, 2006.

such as the East Asia crisis of 1997-98.

Empirical studies of financial opennessand 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 to 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 2013 http://web.pdx.edu/~ito/Chinn-Ito_website.htm.

I. Direct Measure of Financial Liberalization 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., arbitrage between China’s A shares and off-shore. 2. Interest rate parity (IRP): i) Covered interest parity (CIP); ii) Uncovered interest parity (UIP); iii) Real interest parity (RIP).

*Tracks the price premium (discount) of A-shares to H-shares of the largest and most liquid mainland China companies.From: Charles Schwab, 12/11/2014, “Surging Chinese A-Shares: What’s Next? ” Data source: FactSet, Bloomberg, as of 12/9/14.

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

1. Price of the same asset across borders

Shanghai-Hong Kong Stock Connect went into effect Nov. 17, 2014

PBoC cut interest rates Nov. 21.

2. Interest Rate Parity:Why does i not equal i* ?

I. Currency factors • Expected currency depreciation• Exchange risk premiumThe total currency premium can be measured as the forward discount, or swap rate, or differential between domestic & local $-linked bonds.

II. Country factors…

Decomposition of the Nominal Interest Differential

i – i* ≡ country premium + currency premiume.g., ≡ ( i – i* - fd ) + fd

The country premium could be measured by the sovereign spread,Credit Default Swap, or covered interest differential (i-i*-fd).

The currency premium could be measured by the forward discount (fd), currency swap rate, or local spread of $-linked vs. domestic-currency bonds.

}fd ≡ (fd - Δse) + (Δse) exchange + expected risk nominal premium depreciation

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

Sovereign spreads

}}

Brazilian interest rate decomposed

1995-98

country premium + currency premium + LIBOR

Total spread over US T bill rate Currency swap rateCountry premium

Country premium ≡ total spread adjusted for currency premium

Total spread for Mexican sovereign bonds over US Treasury bill interest rate

Currency premium ≡ pesos/$ swap rate

Mexican spread decomposed: currency premium + country premium

Wenxin Du & Jesse Schreger, “Sovereign Risk, Currency Risk & Corporate Balance Sheets,” Oct. 14, 2014

Sovereign spreads

2004-13

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+

Spreads were low for Emerging Market bonds in 2006, and even lower for South Africa.

Sovereign spreads, 2003-06

Global investors were under-pricing risk-- as also reflected in US corporate spreads, options prices, etc.

All of them shot back up in 2008.

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

Source:

Financial Times11/2/2007

Selling at a forward discountagainst the $:

Turkish lireArgentine pesoBrazilian real

Selling at a forward premiumagainst the $:

YenNew Taiwan $UAE dirham

The forward market

Spread is wider for Sol than є

┌┐┌┐ ┌ ┐┌┐ The forward market

Selling at a forward discountagainst the $:Hungarian forintRussian rubleTurkish lireArgentine pesoIndonesian rupiahS.African rand

Selling at a forward premiumagainst 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.

=

Liberalization in a country that had controls on capital inflows.

}

Domestic & offshore interest rates,Germany, 1973-74

From: Marston (1989)

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 & M. Goldstein, “The Integration of World Capital Markets,” FRBKC, 1993.

Domestic & offshore interest rates,France, June 1973- June 1993

In late 2008 Covered Interest Parity surprisingly failed,in the Global Financial Crisis rush to the $ as safe haven.

Significant determinants are apparently counterparty risk & liquidity, proxied by financial stock CDS, VIX, implied fx volatility, OIS bid-ask spreads & Fed swap lines.

Inês Isabel Sequeira de Freitas Serra, ”Covered Interest Parity,” NOVA – School of Business & Economics, Lisbon, Jan. 2012 http://run.unl.pt/handle/10362/9528

Covered interest differentials, using Overnight Index Swap interest rates, 2003-2011

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 =

πUS

e- πUK

e

No, not in short run.

CIP

UIP

RIP

Summary of Interest Rate Parity conditionsto be used in L23-24: Exchange Rate Models

Covered interest parity i – i* = fd

+

No risk premium fd = Δse

=>

Uncovered interest parity i – i* = Δse,+

Ex ante Relative Δse = πe – π*e

Purchasing Power Parity

}

=> Real interest parity i – i* = πe – π*e .

}

III QUANTITY TESTS: some show rising integration

IMF

Quantity tests 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

Feldstein-Horioka test of capital mobility

Regression: (I/GDP) = α + β (NS/GDP) + v.

Feldstein (1980) argued that if capital were perfectly mobile, we would find β = 0:countries with good investment opportunities could borrow abroad to finance them.

Instead, β was much closer to 1:Countries are apparently savings-constrained.

The Feldstein-Horioka, still as high as 0.7 in the 1980s, declined in the 90s and until 2007.

Kristin Forbes, “Financial “deglobalization”?: Capital flows, banks, and the Beatles,” Bank of England, 18 Nov., 2014

Appendices: Country risk

• Appendix 1: Inter-shuffling of credit-worthiness between advanced & developing countries– Recent credit rating rankings– The end of “original sin”?

• Appendix 2: EM Sovereign Spreads – More examples– “Risk on – risk off”

• 1) Since the crisis of the euro periphery began in Greece in 2010, we have become aware that “advanced” countries also have sovereign default risk.

• 2) Since 2000, Emerging Market Countries have increasingly been able to borrow in their own currencies, so their debt carries currency risk (not just default risk).

Appendix 1: The blurring of lines between debt of advanced countries and developing countries

1) Country creditworthiness was inter-shuffled

“Advanced” countries EM & “Developing” countriesAAA Germany, UK Singapore, Hong KongAA+ US, FranceAA Belgium ChileAA- Japan ChinaA+ KoreaA Malaysia, South AfricaA- Brazil, Thailand, BotswanaBBB+ Ireland, Italy, Spain BBB- Iceland Colombia, IndiaBB+ Indonesia, PhilippinesBB Portugal Costa Rica, JordanB Burkina FasoSD Greece

S&P ratings, Feb.2012 updated 8/2012

47

Spreads for Italy, Greece, & other Mediterranean membersof € were near zero, from 2001 until 2008

and then shot up in 2010

Market Nighshift Nov. 16, 2011

2) The end of Original Sin:After 2000, Emerging Markets successfully issued more debt

in their own local currencies (LC), instead of $-denominated (FC).

Fig. 2 from Jesse Schreger & Wenxin Du“Local Currency Sovereign Risk,” HU, March 2013

Turkey is able to borrow in local currency (lira),but has to pay a high currency premium to do so.

{Pure default risk premium on lira debt {

Total premium on Turkey’s lira debt over US treasuries

Fig. 5 from Schreger & Du, “Local Currency Sovereign Risk,” HU, March 2013

Appendix 2: EM sovereign spreads

EMBI, 1994-2001Spreads shot up in 1990s crises

Sovereign spreads

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

1996-2006

Sovereign spreads on South African Dollar Debt

WesternAsset.com

Spreads fell to low levels by 2007.

EM sovereign spreadsSovereign spreads

Spreads rose againin Sept. 2008,

• especially on $-denominated debt

• & in Eastern Europe.

World Bank

Bpblogspot.com

EM sovereign spreads Sovereign spreads

What determines spreads?

Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, March 2011

EMBI is correlated with risk perceptions

“risk on”

risk off

Sovereign spreads