LECTURES 16 -18:
INTERNATIONAL INTEGRATION
OF FINANCIAL MARKETS
Question 1:
What are the pros & cons
of 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 smooth disturbances
– and to diversify away risks.
Further advantages of financial opening
in emerging market economies
• Letting in foreign financial institutions improves
the efficiency of domestic financial markets.
It subjects over-regulated and inefficient banks
– to the harsh discipline of competition and
– to the demonstration effect of examples to emulate.
• Governments face the discipline
of the international capital markets
if they make policy mistakes.
Classic gains from trade
textiles
future
…Portuguese consumption in textiles rises too, which
it imports, thereby reaching a higher indifference curve.
•
•
In autarky,
Portugal can only
consume what it produces.
(Price mechanism puts it on
full-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….
wine
today
Next, we do the gains from trade again, substituting
period 0 & period 1, in place of wine & textiles.
Maximize u(C0) + β u(C1) subject to constraint. u’(C)>0; u’’(C)<0; β<1.
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 .
future
•
•
today
future
•
today
Does this theory ever
work in practice?
•
Norway discovered
NorthSea 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).
}
ITF220 Prof.J.Frankel
Subsequently,
Norway ran big
CA surpluses.
Effect when countries open their
stock markets to foreign investors,
on cost of capital.
CAPITAL ACCOUNT LIBERALIZATION: THEORY,
EVIDENCE, AND SPECULATION
Peter Blair Henry
NBER Working Paper 12698
Liberalization occurs in “Year 0.”
Cost of capital falls,
on average.
Effect when countries open their
stock markets to foreign investors,
on investment.
CAPITAL ACCOUNT LIBERALIZATION: THEORY,
EVIDENCE, AND SPECULATION
Peter Blair Henry
NBER Working Paper 12698
Liberalization occurs in “Year 0.”
Investment rises,
on average.
Indications that financial markets
do 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
 GFC (U.S. & U.K.: “North Atlantic Financial Crisis” !)
 Iceland, Hungary, Latvia, Ukraine, Pakistan…;
 The 2010 euro crisis (Greece, Ireland, Portugal, Spain…).
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 is hard
to argue that the system works well.
Economic crashes can be severe,
such as East Asia 1997-98
Source: Guillermo Calvo, 2006.
Other indications that financial markets
do not always work as advertised
• 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 pro-cyclical, not counter-cyclical.
• 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 may 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.
Some studies find that financial openness is helpful only
if countries have already attained an adequate level of:
• 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).
=> 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).
Measuring
International
Financial
Integration
I. Direct measures
of barriers,
e.g., IMF’s count of freedom
from KA restrictions.
II. “Price tests”
III. “Quantity tests”
Source: Kose, Prasad, Rogoff & Wei (2009)
I. Direct Measure of Financial Liberalization Openness: Chinn & Ito
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.
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.
Macro-prudential regulations such as reserve requirements,
are an increasingly important alternative to capital controls
Housing market regulations:
LTV ≡ maximum Loan-to-Value ratio. DSTI ≡ maximum Debt Service to Income ratio.
Source:
PIMCO, April 2011
Global Central Bank Focus
http://www.pimco.com/en/insights/pages/the-end-of-qeii-it%E2%80%99s-time-to-make-the-donuts.aspx
Kenneth Kuttner & Ilhyock Shim, BIS WPs, 2013, “Taming the Real Estate Beast:
The Effects of Monetary and Macroprudential Policies on Housing Prices and Credit”
tightened in response to housing bubble concerns.
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 CountryFund & 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
(i) Chinese firms’ stock prices, onshore relative to offshore:
A shares, which domestic residents held, sold at a premium
to B shares, which Chinese firms could issue to foreign investors.
}
Higher prices
on-shore
Source: Vicki Wei Tang (2011)
In the 1990s, foreign residents held B shares, listed in Shenzhen or Shanghai.
In 2001, Chinese citizens were allowed to buy B shares.
Chinese firms’ stock prices, onshore reltive to offshore, continued
Now “H shares” (held in Hong Kong) are more important.
Premium of “A shares” (held domestically), over “H shares”
.
}
Higher prices onshore
Higher prices
on-shore
Robert McCauley, CFR conference on Internationalization of the RMB, Beijing, Nov.2011, Graph 5. Data Source: Bloomberg, BIS
company
composition
of the two indices
differs.
“Investing inNote:
Chinese
shares,”
Economist,
Sept.
27, 2014
(ii) Country funds
Differential
Source: Frankel & Schmukler (1996)
The NYC price of a Mexican basket of stocks ≠ the Net Asset Value
of the components traded in Mexico City
=> imperfect arbitrage.
Notice: In the 1994 peso crisis, the local NAV fell
(i) more than the fund price in NYC, and (ii) before the devaluation hit
=> suggesting that locals might have had better information.
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 swap rate, or
differential between domestic & local $-linked bonds.
II. Country factors
…
Decomposition of the Nominal Interest Differential
i – i* ≡ country premium + currency premium
e.g.,
≡ ( i – i* - fd )
+
fd
fd ≡ (fd - Δse) + (Δse)
exchange + expected
risk
nominal
premium depreciation
The country premium could be measured by
the covered interest differential (i-i*-fd), sovereign spread, or Credit Default Swap.
The currency premium could be measured by the forward discount (fd),
currency swap rate, or local spread of $-linked vs. domestic-currency bonds.
WHY DOES i NOT EQUAL i* ?
II. Country factors, continued
• Default risk –
• reflected in sovereign spreads or Credit Default Swaps
• Capital controls –
• reflected in covered interest differentials
• Taxes on cross-border investments
• Transaction costs
• Imperfect information
• Risk of future capital controls
Sovereign spreads
Brazilian interest rate decomposed
country premium + currency premium + LIBOR
}
}
Total spread (Brazil rate minus LIBOR) =
Currency premium (forward premium) + Country premium (spread)
1995-98
Sovereign spreads
Mexican spread decomposed: currency premium + country premium
2004-13
Total spread for Mexican sovereign bonds
over US Treasury bill interest rate
Currency premium
≡ pesos/$ swap rate
Country premium ≡ total spread
adjusted for currency premium
Total spread over US T bill rate
Country premium
Currency swap rate
Wenxin Du & Jesse Schreger, “Sovereign Risk, Currency Risk & Corporate Balance Sheets,” Oct. 14, 2014
Sovereign spreads
Sovereign 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
700.00
S&P Upgrade (BB+ to BBB-)
S&P Upgrade (BBB- to BBB)
Moody's upgrade
(Baa3 to Baa2)
S&P Upgrade (BBB to BBB+)
600.00
Moody's upgrade
(Baa2 to Baa1)
500.00
400.00
300.00
200.00
100.00
Global 06
Global 09
Global 14
Global 17
Global 12
1996-2006
6/15/2006
2/15/2006
10/15/2005
6/15/2005
2/15/2005
10/15/2004
6/15/2004
2/15/2004
10/15/2003
6/15/2003
2/15/2003
10/15/2002
6/15/2002
2/15/2002
10/15/2001
6/15/2001
2/15/2001
10/15/2000
6/15/2000
2/15/2000
10/15/1999
6/15/1999
2/15/1999
10/15/1998
6/15/1998
2/15/1998
10/15/1997
6/15/1997
2/15/1997
10/15/1996
-
Sovereign spreads, 2003-06
650
as among other emerging markets
550
EMBI+
450
350
250
EMBI+
RSA EMBI+
150
50
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03
03
04
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05
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05
05
05
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06
Spreads were low for Emerging Market bonds in 2006,
and even lower for South Africa,
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
┌┐
┌┐┌┐
┌┐
The forward market
Source:
Financial Times
11//2/2007
Selling at a
forward
discount
against the $:
Spread is wider for Sol than є
Turkish lire
Argentine peso
Brazilian real
Selling at a
forward
premium
against the $:
Yen
New Taiwan $
UAE dirham
During Global Financial Crisis
Financial Times
Jan. 30, 2009
Selling at a
forward
discount
against the $:
Hungarian forint
Russian ruble
Turkish lire
Argentine peso
Indonesian rupiah
S.African rand
Selling at a
forward
premium
against the $:
S.Korean won
COVERED INTEREST PARITY
( 1 + iTurkey )
=
(1/S) ( 1 + iUS ) F
where S is the spot rate in TL/$ and F is the forward rate.
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.
Liberalization in a country that had controls on capital inflows.
Domestic & offshore interest rates,
Germany, 1973-74
}
From: Marston (1989)
Liberalization in a country that had controls on capital outflows
Domestic & offshore interest rates,
France, June 1973- June 1993
{
From:
M. Mussa and M. Goldstein, “The Integration of World Capital Markets,” FRBKC, 1993.
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.
THREE INTEREST RATE PARITY CONDITIONS
Investors decide
whether to hold:
Arbitrage =>
parity
Does it hold
condition.
in practice?
CIP
$ deposits in New i$NY - i£L =
Covered York vs. covered £
fd.
interest parity deposits in London
Yes, if default risk
& capital controls
are low .
$ deposits in NY vs. i$NY - i£L =
UIP
Uncovered £ deposits in
Δse
interest parity London uncovered.
If risk is
unimportant.
Hard to tell in
practice.
Real
Arbitrage is not
RIP
interest parity directly relevant
i$NY - i£L =
e
e
πUS - πUK
No, not in short
run.
Summary of Interest Rate Parity conditions
to be used in L19: Exchange Rate Models
Covered interest parity
i  i *  fd
+
No risk premium
fd   s
e
}
=>
Uncovered interest parity
i  i*   s ,
e
+
Ex ante Relative
Purchasing Power Parity
=>
Real interest parity
}
s     *
e
e
e
i  i*     . *
e
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?
No
2. Consumption risk-sharing:
Are countries’ consumption levels correlated
with each other more than country incomes?
No
3. Feldstein-Horioka test:
Do countries’ Investment rates vary independently
of their National Saving rates?
No
Feldstein-Horioka test of capital mobility
Regression:
(I/GDP) = α + β (NS/GDP) + v.
Feldstein (1980) argued that if capital
were perfectly mobile, 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.
Appendices: Country risk
• Appendix 1: EM Sovereign Spreads
– More examples
– “Risk on – risk off”
• Appendix 2: Inter-shuffling of credit-worthiness
between advanced & developing countries
– Recent credit rating rankings
– The end of “original sin”?
Appendix 1: EM sovereign spreads
Spreads shot up in 1990s crises
EMBI, 1994-2001
EM sovereign spreads
Spreads fell to low levels by 2007.
WesternAsset.com
EM sovereign spreads
Spreads rose again
in Sept. 2008,
• especially on $denominated debt
Bpblogspot.com
• & in
Eastern
Europe.
World Bank
What determines spreads?
EMBI is correlated with risk perceptions
risk off
“risk on”
Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, March 2011
Appendix 2: The blurring of lines between debt
of advanced countries and developing countries
• 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).
1) Country creditworthiness was inter-shuffled
“Advanced” countries
AAA Germany, UK
AA+ US, France
AA
Belgium
AAJapan
A+
A
ABBB+ Ireland, Italy, Spain
BBB- Iceland
BB+
BB
Portugal
B
SD
Greece
(Formerly) “Developing” countries
Singapore, Hong Kong
Chile
China
Korea
Malaysia, South Africa
Brazil, Thailand, Botswana
Colombia, India
Indonesia, Philippines
Costa Rica, Jordan
Burkina Faso
S&P ratings, Feb.2012 updated 8/2012
Sovereign debt credit ratings over 2006-2010
for some advanced countries fell, while ratings for some emerging markets rose.
Ratings for “Advanced Economies”
Ratings for “Emerging Economies”
Spreads for Italy, Greece, & other Mediterranean members
of € were near zero, from 2001 until 2008
and then shot up in 2010
Market Nighshift Nov. 16, 2011
49
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.
{
Total premium on
Turkey’s lira debt
over US treasuries
Pure default risk premium on lira debt
Fig. 5 from Schreger & Du, “Local Currency Sovereign Risk,” HU, March 2013
{