PHILIPPINE CHRISTIAN UNIVERSITY
1648 Taft Avenue corner Pedro Gil St., Manila
MASTER IN BUSINESS ADMINISTRATION
GLOBAL ECONOMY
CHAPTER 21: FINANCIAL GLOBALIZATION: OPPORTUNITY AND CRISIS
IN-CAMPUS MBA PROGRAM
SUBMITTED BY:
KATRIZIA CERIZE L. FAUNI
SUBMITTED TO:
JUNAID KARIM, PROF.
Financial Globalization: Opportunity and Crisis
International Capital Markets
• International asset (capital) markets are a group of markets (in London, Tokyo, New York, Singapore,
and other financial cities) that trade different types of financial and physical assets (capital), including:
– stocks
– bonds (government and private sector)
– deposits denominated in different currencies
– commodities (like petroleum, wheat, bauxite, gold)
– forward contracts, futures contracts, swaps, options contracts
– real estate and land
– factories and equipment
GAINS FROM TRADE
Theory of Comparative Advantage
Comparative advantage is the economic reality describing the work gains from trade for individuals,
firms, or nations, which arise from differences in their factor endowments or technological progress. In
an economic model, agents have a comparative advantage over others in producing a particular good if
they can produce that good at a lower relative opportunity cost or autarky price, i.e. at a lower relative
marginal cost prior to trade.[3] One shouldn't compare the monetary costs of production or even the
resource costs (labor needed per unit of output) of production. Instead, one must compare the
opportunity costs of producing goods across countries.
Theory of Intertemporal Trade
describes the gains from trade of goods and services for assets, of goods and services today for claims
to goods and services in the future (today’s assets).
– Savers want to buy assets (claims to future goods and services) and borrowers want to use assets to
consume or invest in more goods and services than they can buy with current income.
– Savers earn a rate of return on their assets, while borrowers are able to use goods and services when
they want to use them: they both can be made better off.
Theory of Portfolio Diversification
The theory of portfolio diversification describes the gains from trade of assets for assets, of assets with
one type of risk for assets with another type of risk.
– Investing in a diverse set, or portfolio, of assets is a way for investors to avoid or reduce risk.
– Most people most of the time want to avoid risk: they would rather have a sure gain of wealth than
invest in risky assets when other factors are constant.
• People usually display risk aversion: they are usually averse to risk.
Suppose that 2 countries have an asset of farmland that yields a crop, depending on the
weather.
The yield (return) of the asset is uncertain, but with bad weather the land can produce 20 tons
of potatoes, while with good weather the land can produce 100 tons of potatoes.
On average, the land will produce 1/2 x 20 + 1/2 x 100 = 60 tons if bad weather and good
weather are equally likely (both with a probability of 1/2). – The expected value of the yield is 60
tons.
Suppose that historical records show that when the domestic country has good weather (high
yields), the foreign country has bad weather (low yields). – and that we can assume that the
future will be like the past.
What could the two countries do to avoid suffering from a bad potato crop?
Sell 50% of one’s assets to the other party and buy 50% of the other party’s assets: – diversify
the portfolios of assets so that both countries always achieve the portfolios’ expected (average)
values.
With portfolio diversification, both countries could always enjoy a moderate potato yield and
not experience the vicissitudes of feast and famine.
If the domestic country’s yield is 20 and the foreign country’s yield is 100, then both countries
receive 50% x 20 + 50% x 100 = 60.
If the domestic country’s yield is 100 and the foreign country’s yield is 20, then both countries
receive 50% x 100 + 50% x 20 = 60.
If both countries are risk averse, then both countries could be made better off through portfolio
diversification.
Classification of Assets
Assets can be classified as either
1. Debt instruments
– Examples include bonds and deposits.
– They specify that the issuer must repay a fixed amount regardless of economic conditions.
or
2. Equity instruments
– Examples include stocks or a title to real estate.
– They specify ownership (equity = ownership) of variable profits or returns, which vary
according to economic conditions.
International Capital Markets
The Participants:
1. Commercial banks and other depository institutions
2. Nonbank financial institutions such as securities firms, pension funds, insurance companies,
mutual fund
3. Private firms
4. Central banks and government agencies
Offshore banking
refers to banking outside of the boundaries of a country.
1. Agency office
2. Subsidiary bank
3. Foreign branch
Offshore Currency Trading
An offshore currency deposit is a bank deposit denominated in a currency other than the
currency that circulates where the bank resides.
Offshore currency trading has grown for three reasons:
1. Growth in international trade and international business
2. Avoidance of domestic regulations and taxes
3. Political factors (ex., to avoid confiscation by a government because of political events)
Reserve requirements are the primary example of a domestic regulation that banks have tried to avoid
through offshore currency trading.
Depository institutions in the U.S. and other countries are required to hold a fraction of domestic
currency deposits on reserve at the central bank.
These reserves cannot be lent to customers and do not earn interest in many countries, therefore the
reserve requirement reduces income for banks.
But offshore currency deposits in many countries are not subject to this requirement, and thus can earn
interest on the full amount of the deposit.
Regulation of International Banking
Banks fail because they do not have enough or the right kind of assets to pay for their liabilities.
In many countries there are several types of regulations to avoid bank failure or its effects.
Governments Safeguard against Financial Instability
1. Deposit insurance
2. Reserve requirements
3. Capital requirements and asset restrictions
4. Bank examination
5. Lender of last resort
6. Government-organized bailout
Difficulties in Regulation International Banking
1. Deposit insurance in the U.S. covers losses up to $100,000, but since the size of deposits in
international banking is often much larger, the amount of insurance is often minimal.
2. Reserve requirements also act as a form of insurance for depositors, but countries cannot
impose reserve requirements on foreign currency deposits in agency offices, foreign branches,
or subsidiary banks of domestic banks.
3. Bank examination, capital requirements, and asset restrictions are more difficult
internationally.
4. No international lender of last resort for banks exists.
5. The activities of nonbank financial institutions are growing in international banking, but they
lack the regulation and supervision that banks have.
6. Derivatives and securitized assets make it harder to assess financial stability and risk because
these assets are not accounted for on the traditional balance sheet.
Financial Trilema
Regulations of the type used in the United States and other countries become even less effective
in an international environment where banks can shift their business among different regulatory
jurisdictions.
To see why an international banking system is harder to regulate than a national system, look at
how the effectiveness of the U.S. safeguards described earlier is reduced as a result of offshore
banking activities.
A financial trilemma constrains what policymakers in an open economy can achieve. At most
two goals from the following list of three are simultaneously feasible:
1.Financial stability.
2.National control over financial safeguard policy.
3.Freedom of international capital movements
International Regulatory Cooperation
Basel accords (in 1988 and 2006) provide standard regulations and accounting for international
financial institutions.
Core principles of effective banking supervision was developed by the Basel Committee in 1997
for countries without adequate banking regulations and accounting standards.
The financial crisis made obvious the inadequacies of the Basel II regulatory framework, so in
2010 the Basel Committee proposed a tougher set of capital standards and regulatory
safeguards for international banks, Basel III.
In April 2009, at the height of the global crisis, the Financial Stability Forum became the
Financial Stability Board (FSB), with a broader membership (including a number of emerging
market economies) and a larger permanent staff.
Many countries have embarked on far-reaching national reforms of their financial systems.
Macroprudential Perspective
Ensuring that each individual financial institution is sound will not ensure that the financial
system as a whole is sound.
National financial regulators often face fierce lobbying from their home financial institutions,
which argue that stricter rules would put them at a disadvantage relative to foreign rivals.
The Basel multilateral process plays an essential role in allowing governments to overcome
domestic political pressures against adequate oversight and control of the financial sector.
Extent of International Portfolio Diversification
Still, some economists argue that it would be optimal if investors diversified more by investing
more in foreign assets, avoiding the “home bias” of investment.
Extent of International Intertemporal Trade
If some countries borrow for investment projects (for future production and consumption) while
others lend to these countries, then national saving and investment levels should not be highly
correlated.
In reality, national saving and investment levels are highly correlated.
Extent of Information Transmission and Financial Capital Mobility
We should expect that interest rates on offshore currency deposits and those on domestic
currency deposits within a country should be the same if
– the two types of deposits are treated as perfect substitutes,
assets can flow freely across borders, and
international capital markets are able to quickly and easily transmit information about any
differences in rates.
If assets are treated as perfect substitutes, then we expect interest parity to hold on average:
R t – R*t = (Eet+1 – Et)/Et
Under this condition, the interest rate difference is the market’s forecast of expected changes
in the exchange rate.
– If we replace expected exchange rates with actual future exchange rates, we can test how
well the market predicts exchange rate changes.
– But interest rate differentials fail to predict large swings in actual exchange rates and
even fail to predict in which direction actual exchange rates change.
Exchange Rate Predictability
In fact, it is hard to predict exchange rate changes over short horizons based on money supply
growth, government spending growth, GDP growth, and other “fundamental” economic
variables.
