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Log in to Wiley Online Library. Purchase Instant Access. View Preview. Learn more Check out. Volume 48 , Issue 3 September Pages Related Information. Close Figure Viewer. Browse All Figures Return to Figure. Previous Figure Next Figure. Differences in the mix of fiscal and monetary policies between the United States and other industrial countries over the past decade have directly affected exchange rates for the dollar. The large movements of the dollar against other major currencies since the s, in turn, have contributed to increases in sales and purchases of dollar-denominated securities and the expansion of foreign-currency trading.
In , differentials approaching 6 percentage points or more in interest rates between the United States and Germany attracted capital to Germany from the United States and other countries.
Following unification, Germany relied on high interest rates to dampen inflationary pressures arising from the huge costs of revitalizing the economy of the former East Germany. Also in the early s, rapid economic growth in East Asian countries and large export surpluses in those countries have generated pools of savings that flow into the global economy to finance the investments that offer the highest rates of return. Technology is another force that has changed the operation and structure of international financial markets.
Information and telecommunications technologies have greatly increased the speed with which information is processed and disseminated. Around the world, market participants are bombarded with a plethora of information and a cacophony of opinions, reports, and rumors, much of which is communicated by computers.
In addition, electronic trading has allowed orders to move across continents, directly from customers to brokers and dealers. Automated trade execution and international clearing and settlement have also encouraged cross-listing of securities and further integrated world financial markets. Today, traders have access to instruments and overseas markets after U.
If they choose to, they can also "pass the book" to their affiliates in foreign markets, who can continue trading in daylight hours overseas. Automated trading execution systems provide a hour trading market, allowing traders to enter buy and sell orders that are automatically matched according to price and time preferences.
Key U. Round-the-clock trading is expanding because increases in speed and control over the direction of information flows can result in large profits or reduced losses in financial markets.
Table of contents
The greater ease with which financial traders can gain access to different markets and their reduced costs have enabled them to take advantage of even small profit margins around the world. Furthermore, interactions among markets, which have been facilitated by technological innovations, have provided market participants with opportunities to diversify, hedge, and increase profits on their investments, thereby promoting the use of new financial products and instruments.
Over the past several years, there has been rapid growth in financial derivatives, such as forwards, futures, options, swaps, and sophisticated combinations of them on interest rates, exchange rates, stocks, and bonds. A primary purpose of these instruments is to hedge exposure against risk, and many are traded across borders. Accompanying this rise in derivatives has been the rapid expansion of over-the-counter markets that involve trading over computer networks in securities tailored to the specific needs of individual investors, borrowers, and intermediaries. A detailed discussion of financial derivatives is presented in Chapter 4.
The easing of capital controls, the liberalization of financial markets, and technological innovations have stimulated competition among financial and nonfinancial institutions in various countries. This, in turn, has further transformed the structure of world financial markets. Over the past 25 years, a notable development in international finance has been the growth of securitization —a process of converting assets that would normally serve as collateral for a bank loan into securities that are more liquid and can be traded at a lower cost than the underlying asset.
This process has been fostered, among other things, by technological innovations. With computers and electronic record-keeping, financial institutions can cheaply bundle together a portfolio of loans originally, mortgage loans with small denominations, collect the interest and princi-.
This process of pooling loans and selling securities backed by the loans has been found by financial institutions to be more efficient than traditional financing through financial intermediaries in certain situations, and it has been used, for example, for auto loans and credit card obligations. In an environment of deregulation, nonbank financial companies have devised new and different ways to move money from savers to borrowers. In recent years in the United States, for example, pension funds, money market funds, and insurance companies, among others, have increasingly lured savings away from bank deposits.
In turn, these institutional investors, which are better able than individuals to acquire the needed information for foreign investment, have heavily invested in foreign securities, fostering the rapid expansion of international bond and equity markets.
Services on Demand
Meanwhile, multinational corporations that produce and sell goods and services on a global scale seek worldwide sources for their financing and investment needs. To serve these clients, financial institutions have diversified the services they offer, among which are transactions in foreign exchange, money market instruments, and derivative products, all on a worldwide scale.
These sophisticated financial instruments allow investors an array of alternatives for hedging and shifting risks, which, at a cost, can provide greater certainty of international receipts and payments, or, in some cases, for taking on exposure with a highly leveraged position. There is a large market for such instruments in today's environment, as international businesses, speculators, and investors are faced with volatile exchange rates, interest rates, and commodity prices.
A study by a private financial consulting firm estimated that holdings of foreign stocks by U. In , foreign stocks accounted for almost 8 percent of assets of corporate pension funds and about 5. As a result, more and more debt and equity products now originate and are traded in several world financial centers and in different currencies.
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For example, hedging and other position taking can be carried out with financial and commodity futures and options; they can also be undertaken with interest rate swaps and forward agreements for major exchange rates and commodity prices. Hedging operations can also be combined with other lending arrangements for example, in a commodity swap to secure—at a cost—both access to additional funds and greater protection from changing international interest rates and commodity prices. In addition, some multinational corporations act, in effect, as their own in-house financial intermediaries, raising funds wherever they are cheapest and moving them through diverse channels including offshore—foreign—holding companies to where they are needed.
To some extent, these organizations can be thought of as arbitraging national financial markets. Overall, these private firms, both financial and nonfinancial, now rely heavily for their funding on marketable instruments; the use of commercial paper, 6 floating rate notes, bonds, convertible bonds, shares, and related instruments has grown rapidly in recent years at the expense of traditional bank deposits and loans in financing big businesses.
According to a recent Federal Reserve study Post, , the U. Business enterprises turned to commercial paper to avoid high interest rates on long-term funds and bank loans in an expanding economy. Two other developments in the late s also increased the issuance of commercial paper: the numerous mergers and acquisitions and the expansion of the swaps market, as borrowers combined commercial paper with swaps to create liabilities in other currencies.
Asset-backed commercial paper also came into use, providing off-balance-sheet financing for trade and credit card receivables. Commercial paper consists of short-term unsecured promissory notes, which are issued mostly by corporations. Off-balance-sheet activities are business transactions that do not generally involve recording assets or liabilities in the balance sheet: examples include trades in swaps, options, futures, and foreign exchange forwards and the granting of standby commitments and letters of credit.
Over the past decade, commercial paper outstanding grew at an average annual rate of about 17 percent. In the size of the commercial paper market even temporarily surpassed that of the market in U. Treasury bills. The issuers of commercial paper in the United States have included foreign corporations and foreign financial institutions. According to the Federal Reserve study Post, , commercial paper will remain a major source of short-term funds for corporations in the s.
High-rated foreign corporations in the United States, attracted by the liquidity and the low cost of the market, are likely to be among the new issuers. While foreign corporations have been raising capital in the United States, the use of foreign financial centers by U. Offshore bank loans to U. In this competitive environment, banking activities have also significantly changed. During the late s and the early s, large commercial banks in many countries, including those in the United States, sought to boost their profits by lending large sums to developing countries.
Since then, although deposit-taking and lending have remained the core business of commercial banks, an increasing portion of their income has come from sources other than the differentials between the interest they pay on deposits and the interest they charge on loans. To improve profit margins, in addition to offering fee-paying business advisory services, banks have increasingly packaged assets not traditionally traded such as mortgage loans, car loans, corporate receivables, and credit card receivables into tradable securities.
They also have turned to derivative instruments as opportunities have declined in traditional interbank deposit markets. The growth of offshore loans declined after the Federal Reserve removed the relevant reserve requirements in The sharp cutback in interbank business has been attributed to the low returns and potentially large counterparty risks related to this type of business Bank for International Settlements, a. Currently, an increasing proportion of banks' credit and liquidity exposures has been incurred off their balance sheets see Chapter 4.
With the growth of nonbank financial institutions, banks have also offered backup lines of credit or guarantees to these institutions, such as the backing of commercial paper issues. Under the Basle Capital Accord, banks' recommended capital requirements for these activities are much lower than for regular loans. Yet another development in the structure of world financial markets is that, with the rise in the use of derivative instruments by both bank and nonbank financial institutions, securities, forwards, futures, and options markets have become increasingly linked.
Advances in telecommunications technologies have facilitated interactions among these markets. Several benefits have been cited as a result of the changes in the structure and operation of international financial markets. Capital mobility and financial innovations are credited with having provided savers and borrowers with a wider range of investment alternatives and easier and cheaper access to external financing.
They are also believed to have facilitated greater diversification of portfolios and increased the size of markets. Internationalization of capital markets is said to have facilitated the financing of global payments imbalances and encouraged more efficient allocation of global resources. Nonetheless, there has also been a widespread perception that deregulation, globalization, and financial innovations have complicated the formulation and the implementation of monetary and fiscal policies, led to greater volatility in financial markets, and introduced new and highly complex elements of risk that can.
The Basle Capital Accord refers to the minimum capital standards agreed to by the Basle Committee on Banking Supervision for the supervision of international banking groups and their cross-border establishments. The Basle Committee is made up of the banking supervisors of the Group of Ten industrial countries and Luxembourg. The accord called for a minimum 8-percent ratio of a bank's capital to its risk-weighted exposure to credit risk, which was to be attained by the end of Proposals for capital standards covering market risks are under discussion.
International capital mobility not only has led to growing linkages of world financial markets, but also has increased the extent to which macroeconomic policies and market conditions of one country can significantly affect those of others. Meanwhile, the securitization of transactions and growth in the use of financial derivative instruments have made international financial flows more complex and less transparent, complicating supervision of financial institutions. This section discusses several aspects of the effect of new global realities in financial markets on a nation's economic policies and financial oversight.
Interest rates and the availability of capital in an industrial country are now much more influenced than in the past by interest rates and credit availability in other countries. A corollary is that monetary and fiscal developments in a major industrial country have larger macroeconomic effects on other countries than they did when capital was less mobile internationally. A vivid example was the effect in of high interest rates in Germany on other members of the European Monetary System, as well as on other industrial countries, including the United States.
The freer flow-of-funds among countries does not necessarily bring their interest rates into line with one another. Interest rates can differ among countries when there exists an expectation that exchange rates will change or when there is a premium related to other types of risk. Nonetheless, a change in interest rates in a major industrial country can strongly affect both interest rates and exchange rates in other countries.
The growth in cross-border deposits also has implications for monetary policies. When cross-border deposits were small and relatively stable, they could be ignored when examining the behavior of domestic monetary aggregates. In recent years, however, the growth in these deposits has added to questions about the usefulness of monetary aggregates as indicators of the tightness or slack of U. The three major measures are M1, M2, and M3. M1 includes currency outside the Treasury Department, Federal Reserve banks, and the vaults of depository institutions; traveler's checks of nonbank issuers; demand deposits at all commercial.
Furthermore, it is argued that under floating exchange rates, increased international capital mobility can quicken the speed with which tight monetary policies slow inflation, since currencies tend to appreciate in response to higher interest rates.
The Eurocurrency Markets, Domestic Financial Policy and International Instability | SpringerLink
The unusual speed of the U. Enhanced capital mobility also affects fiscal policy. In the past, when a country's fiscal policy led to a large budget deficit, the effect was primarily domestic, in the form of more rapid expansion of national income and output and possibly also in some crowding out of private investment as the government borrowed more and interest rates rose. Now a significant result may be a large trade deficit, if high interest rates attract funds from abroad and the exchange rate appreciates.
This phenomenon was evident in the United States in the s, when large federal budget deficits were accompanied by large trade deficits. Today, external imbalances are in many cases more easily financed than in the past by movements of foreign capital. As a result, large trade surpluses and deficits may cause less concern to market participants and to policy makers. From another perspective, the more ready availability of international capital may provide domestic officials with more time to undertake the adjustments needed to correct domestic and external imbalances.
Changes in current account balances do, of course, affect domestic income and employment. And sustained imbalances can lead to the build-up of large international debtor and creditor positions that affect the real incomes and debt burdens of future generations. Yet another effect of capital mobility on domestic macroeconomic policies is that tax incentives to boost domestic savings for example, through increased tax deductions for individual retirement accounts may be less likely than in the past to generate a rise in capital for domestic investment.
Uncertainty about effects has. Overnight Eurodollar deposits of U. Term Eurodollar deposits held by U. They increasingly do so when they calculate they can earn higher rates of return, after allowing for exchange risk. As funds move more easily and more readily from one country to another, the prices of financial instruments for example, securities and foreign exchange may be subject to greater volatility. Increasingly, exchange rates the prices of foreign exchange are affected by ''news"—the flow of new information—and by the expectations it engenders.
The prices of bonds and stocks are similarly influenced. And exchange rates and securities prices interact with each other. Hence, securities prices in one country can now be affected by the behavior of foreign as well as domestic lenders and investors, although the degree of influence differs from one situation to another, depending on a variety of circumstances. Thus, when the U. In principle, enhanced capital mobility could lead to more stable markets rather than to greater volatility of securities prices and exchange rates, since it makes markets less "thin" in terms of numbers of participants and potential flows of funds.
Nonetheless, the information revolution, which has increased familiarity with economic, financial, and political conditions around the world and thereby encouraged international lending and investing, also brings a constant flow of news that can cause lenders and investors to make abrupt changes in their holdings in their own and other countries. Thus, markets are vulnerable to larger swings—both in the short and medium term—in a world of integrated financial markets and enormous worldwide liquidity.
The price dynamics created by derivative instruments can also exacerbate this potential. In foreign exchange markets, such swings in prices have led at times to coordinated intervention by central banks aimed at dampening the short-and medium-term volatility of exchange rates. Since the February meeting of the Group of Seven finance ministers and central bank governors at the Louvre, the monetary authorities of those countries have attempted to maintain their exchange rates within broad ranges.
The enormous volume of funds flowing across national boundaries and from one currency to another creates a risk that a breakdown in one financial system could spread across the world. The U. To make the required payments, they are dependent on receipts from others. If one intermediary in the payments mechanism finds itself unable, for whatever reason, to make the payments for which it is liable and others will not lend to it, problems for other institutions and in other centers can develop quickly.
In the commercial banking system, central banks have long been prepared to act as lenders of last resort to enable banks to cope with liquidity problems. The bank examination process also aims to guard against insolvency in commercial banks, and there is close international cooperation among supervisors of commercial banks, who meet regularly at the Bank for International Settlements at Basle. But there are questions as to whether nonbank financial intermediaries—including brokers and dealers and investment banks—are equally well supervised and, if these nonbank institutions are adequately supervised, whether central banks should also act as their lenders of last resort.
There have been some initiatives in the United States and abroad to improve the clearing and settlement systems since then. The Technical Committee of the International Organization of Securities Commissions has been working toward international risk-based capital adequacy standards for securities firms. Efforts are being made to reconcile the differences between the capital requirements applicable to nonbank securities firms and those applicable to banks that engage in securities activities.
In the United States, Congress recently provided authority to the Commodity Futures Trading Commission to more fully share information and cooperate with foreign regulators. In addition, the Securities and Exchange Commission is considering adjusting U. Central banks and financial regulators have also become concerned about the risk exposure of participants engaging in derivatives transactions. Risks are posed in many ways, including by the volatility of the underlying markets.
A market participant's exposure can change drastically with fluctuations in interest rates or equity prices: a small shift in share prices, for example, can result in a big change in the value of a stock-index option. Other risks pertain to the management of sizable positions by large financial institutions and the credit quality of these "wholesale" enterprises and their customers. Still another risk concerns illiquidity.
The Eurocurrency Markets, Domestic Financial Policy and International Instability
Although derivatives traded on exchanges have many buyers and sellers, those tailored to specific customers' needs such as those traded in the over-the-counter markets are more difficult to liquidate since they are more difficult to value and to hedge against. In addition, the opaqueness of some of these transactions, especially over-the-counter contracts, compounds the difficulty for regulators of monitoring market participants in derivatives. Furthermore, as more and larger traders, driven by technical trading methods, seek to move increasingly large sums between markets, market volatility is likely to increase.
The closer linkages among markets that are fostered by the growth of derivatives mean that financial shocks can be transmitted across markets quickly. The growth in derivative instruments has created not only complex chains of counterparty buyer or seller exposures but also, in the case of exchange rate contracts, a significant expansion of international payment and settlement activities.
To reduce risks and guard against payment "gridlock," the Federal Reserve and other central banks are closely monitoring their payment and settlement mechanisms. In addition, the Basle Committee has focused on ways of expanding the Basle Capital Accord to cover credit risk and various types of market risks, such as foreign exchange rate risk, interest rate risk, and position risks in traded equity securities. For a discussion of the various types of risks arising from derivatives transactions, see Federal Reserve Board of Governors et al.
In sum, the interactions among countries' interest rates, exchange rates, and securities prices, hastened by the increase in capital mobility and the linkages of world financial markets, have major policy implications. The economic performance of one country—especially an industrial one with high capital mobility—will be affected by policies and market developments in other coun-.
There is a blurring of the traditional distinction between domestic and international economic policy. Policy makers in major industrial countries need to take account of policies and policy intentions elsewhere. In a world of growing interdependence among nations, enhanced capital mobility will, in some cases, help policy makers achieve their domestic macroeconomic objectives; in other cases, however, it may undercut the effect of national policies on domestic economic performance.
In this new global economic environment, to better formulate U.
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At the same time, the unprecedented changes in global financial markets have reduced the effectiveness of traditional data collection methods and the adequacy of the existing data. This section provides an overview and some examples of the deficiencies of the existing data. The rest of the report addresses the shortcomings in detail and presents the panel's recommendations for data improvement. The present U. At that time, portfolio investment was largely channeled through such traditional financial instruments as bank loans and deposits, denominated mostly in U. The current system, as it has evolved, still emphasizes the collection of data on traditional international banking transactions.
But the rise in nonbank market participants in particular, institutional investors , the surge in international financial flows and their diversification across currencies, the increase in offshore financial activities, and the burgeoning international trade in derivative financial instruments have outstripped the coverage of the U. Rapid technological innovations have also allowed numerous transactions to bypass domestic financial intermediaries, and such transactions are beyond the reach of the traditional reporting mechanisms, thus raising questions about the adequacy of relying largely on domestic data filers.
Meanwhile, as U. The conceptual framework under which the existing data are collected, that of the balance of payments, defines U. See Chapter 2 for a detailed discussion of the U.
The purpose of this framework is to compile information on economic exchanges that cross the border between the United States and the rest of the world. These data provide vital information needed to understand the external sector of the economy and how it affects domestic economic activity.
International transactions, defined in this way, are a component of the national accounts which include the national income and product accounts, the flow-of-funds accounts, and the balance sheets of the U. However, as financial activities have become global in nature, the resident-nonresident distinction has become inadequate to fully depict all facets of these activities. Increasingly, cross-border financial exchanges represent capital transfers among the worldwide offices and branches of U. There is also a growing presence of foreign-owned firms in the U. These developments have complicated the identification of resident versus nonresident transactions.
More important, as discussed above, internationalization of financial transactions has given rise to policy concerns about the liquidity, solvency, and stability of the U. These are issues the balance-of-payments framework was not designed to treat. There is need to supplement the existing balance-of-payments data with other information on U. In its report Kester, , the Panel on Foreign Trade Statistics recommended supplementing the existing trade statistics, collected under the balance-of-payments framework, with economic information collected outside it to better depict the globalized U.
Such a broader framework would greatly assist in addressing such issues as U. This report makes recommendations to improve the coverage and accuracy of the existing data, but it also proposes ways to supplement them. The need for improved data is further evidenced by the incomplete accounting of the sizable U. A few examples follow. But the statistical discrepancy of the U. Thus, the direction of the net capital flow could have been the opposite of that reported in the U. When initially released, data for on the U. The press referred to the United States as being "a debtor nation" for the first time since before World War I.
The cumulating liabilities, whose burden could fall on the next generation as well, were deemed to imply the obligation to pay future interest, dividends, profits, and amortization to foreign investors. However, the U. Some analysts believed that this source of understatement in the U. Yet others pointed out a measurement error in the other direction: the cumulative statistical discrepancy in the U.