Chapter 21. The Global Capital Market and the Gains from Trade.
The global capital market • Much of our discussion of international macroeconomics has taken the operation of the global capital market for granted. How does it operate? What is its structure? How has it evolved? • Some key issues to look at: – When we speak of the “gains from trade” we have an idea what this means in the goods market? But what does that phrase mean in the capital market? – Why has global financial market activity vastly expanded in scale and scope since the 1960s? – What costs and risks have been associated with that expansion, and can policymakers minimize such dangers, without also reducing the gains from trade ?
Motives for asset trade: intertemporal trade • An example of trade over time. • What if there is a sudden negative shock to your income, but it is only transitory? • Optimal to borrow in the short run, repay later when income recovers, and keep your consumption level smooth. – Example: demand for US goods temporarily collapses; optimal for US agents to borrow. • In the case of a country opening to global capital markets, this is another possible “gain from trade”. Without it, such output volatility would directly impinge on consumption volatility and welfare. • In this set up, some shocks (of course) cannot be avoided, e.g. a global shock common to all countries.
Motives for asset trade: diversified portfolio • An example of trade across “states of nature.” • As above, (home) income is volatile. But suppose there exist other (foreign) assets in the world whose returns are not perfectly correlated with your income. • It would pay to hold a diversified portfolio. – Example: when demand for GM cars collapses, demand for Toyotas rises; optimal for US agents to hold a mix of GM and Toyota stock. • In a world of risk aversion, agents base choice of assets on risk, as well as return. • Unlike simple arbitrage on returns, we now may hold stocks/bonds with different returns, if the combination offers a better (lower) level of risk. • In the case of a country opening to global capital markets, this is another possible “gain from trade.” Again, a global shock common to all countries cannot be avoided (aggregate risk is “not diversifiable”).
The players • Commercial banks – Commonly take deposits and issue loans, either of which may go cross-border and be in home or foreign currency. May also make interbank deposits (“lending” to other banks, also potentially cross-border), and they may buy bonds. – Actions depend on regulatory/legal scenario. Often more restricted at home than overseas. • Corporations – Overseas equity and debt (loan/corporate bond) issues. • Nonbank Financial Institutions – Not banks at all in the normal sense, e.g. investment banks. – Specialize in underwriting and placing debt/equity issues of corporations and governments. – E.g., J.P. Morgan, Goldman Sachs, Deutsche Bank; and (outside the U.S.) Citibank, Bankers Trust. • Central banks, treasuries, and government agencies – Former are involved whenever they do ForEx intervention. – Others are major borrowers using bonds or loans.
Risky business? inherent difficulties of international banking and systemic dangers • Many U.S. banking rules and regulations have evolved (esp. since 1933) to prevent bank instability. • Deposit insurance – Federal Deposit Insurance Corporation insure against losses up to $100000.banks are required to make contributions to cover this cost. • Reserve requirements – channel through which the central bank influences the relation between the monetary base and monetary aggregates. It forces the bank to hold a portion of its assets in a liquid form. • Capital requirements and asset restrictions – bank capital = bank assets – bank liabilities. Bank capital = equity that the bank share holders acquire when they buy the bank’s stock (portion that is not owed to the depositors. US regulators set the minimum of bank capital. • Bank examination – Fed, FDIC and the Office of the Comptroller of the Currency examine the bank’s books to ensure compliance with bank capital standards (banks might be forced to sell assets that are too risky or write off loans)
Risky business? inherent difficulties of international banking and systemic dangers • At the global level, such policies are weak or nonexistent. Why? – Deposit insurance is impractical because of the size of typical offshore deposits (n.b. FDIC limit) – There is no global “lender of last resort” to fulfill the role the Fed assumes in a liquidity crisis (why? there is no global currency they can print, and the reserves on hand, e.g. @ IMF, are woefully small). – Reserve restrictions harder to police on offshore banks, and a first mover problem in imposing them (offshore banks profit from low/zero reserve requirements). Group action needed. • BIS in Basel is slowly working away on this (capital adequacy ratios; value at risk evaluations; etc.). – Check back in 2006 or thereabouts. – A supranational authority? Again, we expect implementation problems (e.g. Japanese banking)
The global capital market: performance and historical perspective • Has global capital market lived up to its potential? What do we know about – The extent of intertemporal trade? – The extent of portfolio diversification? – The ease with which capital can move? • Why the variation over time, and the big surge since the 1970s? • Political economy: the trilemma – Open economies face a trilemma. Can only pick two from three (i.e., must drop one): • Fixed exchange rate • Capital mobility • Activist monetary policy