G. Russell Kincaid
Financial markets in major industrial countries have experienced rapid growth and substantial institutional change during the 1970s and 1980s. Domestic financial markets have become less segmented, and the major financial centers more integrated. At the same time the structural changes in financial markets have improved efficiency by lowering intermediation costs; increasing the ability to hedge financial risks associated with currency, interest rate, and price volatility; and opening up access to new sources of savings.
These changes have also had widespread implications for the global allocation of savings, volatility in markets, international reserve creation, supervision of financial markets, and the domestic impact and their international transmission of macroeconomic policies. This article focuses on the macroeconomic policy, and in particular the monetary policy, consequences of the structural developments in financial markets. A more detailed discussion of the range of implications is contained in the Fund’s most recent survey of International Capital Markets. An analysis of the nature of the structural changes in financial markets is crucial for understanding the complex issues confronting macroeconomic policymakers. These changes have been shaped by technology, liberalization, and market innovation.
The widespread application of computer and telecommunications technology to financial markets has permitted markets to process a significantly larger volume of transactions, to communicate developments more rapidly and more widely, to react more quickly to new information, to devise innovative instruments and trading procedures, and to link markets in different time zones.
An example of the expansion in activity is the rapid growth in flows through international capital markets during 1976-86, which increased two and one half times faster than the growth of nominal income in major industrial countries. Another indication is the daily foreign exchange turnover of $200 billion in the three major markets (London, New York, and Tokyo).
Communications technology has also increased the global integration of financial markets by making possible round-the-clock trading. In addition, improved computer technology has allowed the use of new methods for hedging against risks, including financial options and futures, and has opened up arbitrage opportunities based on computer-generated and computer-executed transactions—computer trading.
The above changes in financial markets have contributed to price volatility—in currency, bond, and equity markets. Events during October 1987 clearly demonstrated that financial markets have become highly integrated. This is true even for the equity markets, which have traditionally been viewed as the least integrated.
Financial liberalization has also diminished the segmentation of domestic financial markets and increased the integration of international financial centers. Liberalization has been prompted by official policies to promote greater efficiency in domestic financial markets and to increase the access of domestic institutions to international sources of finance. Moreover, the expanding Euromarkets have led to competitive pressures on domestic financial markets and have made it easier to circumvent regulations.
Liberalization has proceeded along two basic lines: relaxation of price and quantity restrictions and the easing of limitations on certain types of financial activities. The most significant liberalization measures were the easing of exchange controls in the three major industrial countries that had maintained such controls—France, Japan, and the United Kingdom. This relaxation permitted residents of these countries access to foreign currency investments, thereby increasing the substitutability of domestic and foreign assets. Similarly, restrictions on access by foreign borrowers to national markets, and on their ability to borrow in national currencies, have also been eased, further integrating domestic and foreign financial markets. During the period under review, there has also been a move toward treatment of foreign financial institutions on the same basis as national institutions, frequently on a reciprocal basis. Thus, foreign banks’ share of total assets of national banking systems has doubled in all of the major industrial countries from 1970 to 1985.
Other liberalization measures have included the relaxation of restrictions on the right of establishment (such as interstate banking in the United States), on financial activities with certain sectors of the economy, and on the portfolios that financial institutions may hold, especially in terms of maturity and type of instruments. Market participants have been allowed to issue instruments that previously were not permitted, such as floating rate notes in the Federal Republic of Germany, certificates of deposit in France, Germany, and Japan, and commercial paper in France and the United Kingdom. In countries where banks and securities companies were separated by law, such as Japan and the United States, or by custom, as in the United Kingdom, regulations limiting competition between banks and securities houses have been lowered as a means to stimulate efficiency. In the United Kingdom, a major reform of the financial sector was undertaken in 1986—the so-called “Big Bang” (see box). In total, the measures noted above have tended to blur the distinctions between segments of national financial markets and between financial markets in key centers.
The “Big Bang” for the financial markets in London occurred on October 27, 1986 when the structure of the Stock Exchange was changed. Following an agreement made in 1983 between the Stock Exchange and the Secretary for Trade and Industry, fixed commissions on stock purchases were abolished and the Exchange’s operations were liberalized through the introduction of new trading practices and systems. Since March 1, 1986, nonmembers have been allowed to form new member firms, as well as acquire 100 percent ownership of existing firms. Hence, commercial and merchant banks are permitted to enter directly or indirectly into securities brokering and dealing business. In addition, as of October 1986, all Stock Exchange members can deal directly with investors, that is, buy and sell securities either as agents or principals.
In line with the changes to the structure of the Stock Exchange, the gilt-edged market (i.e., the market in government securities) has been reorganized. The new structure resembles the market for US Government securities, although there are some significant differences. There are a large number of competitive primary dealers (market-makers) able to act both as principals and agents. The primary dealers are served by a number of interdealer brokers who can facilitate anonymous direct dealing among brokers, and by Stock Exchange brokers who (as at present) can arrange stock borrowing and assist in the financing of their positions. The gilt-edged market is supervised by the Bank of England and the Stock Exchange.
In addition, the Financial Services Bill came into effect in January 1987. The Secretary for Trade and Industry was empowered to authorize businesses to provide financial services and to regulate their activities. These powers are expected to be delegated to the Securities and Investments Board, which will be able to recognize several self-regulatory organizations covering activities in the securities and investment area. Financial institutions undertaking a range of financial market activities may require authorization from several self-regulatory organizations. Foreign financial firms in banking, insurance, or investment business may be subject to a reciprocity requirement. The application of a new regulatory environment to activities in pound sterling, as well as non-sterling markets in the United Kingdom, means that the previously unregulated Euromarkets in London will, for the first time, operate within a national regulatory framework. Furthermore, in March 1987, a joint United Kingdom-United States convergence proposal for monetary capital adequacy was issued. This proposal marks a major step toward a common supervisory framework that would significantly reduce the opportunities for regulatory arbitrage by banks. In June 1987, Japanese authorities announced their support, in principle, for this proposal.
Innovative instruments are the third major force transforming financial markets. These instruments fall into two broad categories, credit- or liquidity-creating, and risk-transferring. Under the first category, the greater use of tradable assets issued directly by the borrower—securitization—has been the most important element. In particular, syndicated loans have been displaced to a large degree by issues of international bonds, by the use of note issuance facilities, and by issues of Eurocommercial paper not underwritten by financial institutions. In addition to this shift from bank credit to securities, securitization has involved the packaging of assets that were not previously traded (e.g., bank credits, mortgages, corporate receivables) into tradable assets. Banks have been deeply involved in this process. They have provided stand by facilities to underpin the liquidity of Eurocommercial paper and note issuance facilities. They have also participated in the expansion of bond markets by issuing, selling, and buying securities. As a result of this securitization process, the distinctions between bank credit markets and bond markets have tended to become blurred, and the relative importance of traditional bank credit flows has declined.
Risk-transferring innovations have occurred in the area of hedging instruments such as financial options, financial futures, and interest rate and currency swaps. These new instruments permit various risks to be unbundled, separately priced, and sold to new portfolios willing to assume the risk. Swaps have furthered the integration of international capital markets by allowing access to markets in maturity ranges that previously were uneconomic. For example, currency swaps have effectively extended the maturity range for which forward cover is available to about ten years. Thus, intermediation opportunities that were previously unattractive, because of the inability to hedge currency risk, have become possible. Data on swap activity are incomplete, but it is estimated that US banks participated in swaps—interest rate and currency—totaling more than $500 billion in 1986. Options and futures markets have also permitted hedging of financial risks (e.g., interest rate, basis rate, exchange rate, equity price). Such contracts are traded on exchanges in Amsterdam, Chicago, Frankfurt, London, New York, Paris, Singapore, and Tokyo. Improved hedging opportunities allow markets to experience greater price fluctuations while maintaining liquidity and intermediation volume. However, these instruments also permit investors to acquire additional risks which can weaken financial intermediation and produce greater volatility in financial markets.
The developments described above have significantly altered the financial environment in which policy actions must be taken. They impinge on the operation of fiscal and monetary policy as they affect the domestic economy as well as the transmission of the effects of these policies internationally. This article addresses the most important and general implications for macroeconomic policy in a world of floating, but managed, exchange rates. A more detailed consideration for a particular country would need to specify the structural parameters of the economy, particularly the process by which wages are determined and expectations are formed (especially for inflation and the exchange rate), the asset structure, and alternative government financing strategies.
Increased financial integration has major implications for the mix of fiscal and monetary policies, as these policies are affected in different ways. Specifically, international financial integration increases the short-run scope for an independent fiscal stance, while it decreases the independence of monetary policy. Indeed, within the European Monetary System during the 1980s, monetary aggregates have converged, even as fiscal deficits have widened on average.
Greater capital mobility makes it easier for countries in the short run to finance fiscal and current account deficits. However, this greater availability of finance may also encourage countries to delay adjustments to underlying structural imbalances in their fiscal accounts, by permitting, as indicated above, a more independent stance for fiscal policy. Indeed, the “crowding out” of private borrowing due to increased public borrowing—which could have acted as a brake to such borrowing—is less likely to occur when private sector borrowers can seek finance abroad. In that event, the burden of crowding out may be shared internationally, with a reduction in foreign savings available for investment in other countries. In addition, foreign savers may desire to finance the deficit country’s fiscal imbalances directly, because of attractive interest or exchange rates. In such cases, the inflows of foreign capital may produce upward pressure on the exchange rate; such appreciation would dampen activity in the exchange rate-sensitive sectors, altering the incidence of fiscal policy. The impact of fiscal imbalances on aggregate activity in the domestic economy may also diminish, even as it is transmitted more rapidly to other countries.
The changed financial environment has also had important implications for the conduct and effectiveness of national monetary policy. The analysis of financial market conditions, the meaning of monetary aggregates, the linkage of monetary policy to the real economy, and inflation can all be influenced to varying degrees by structural changes in financial markets. The transparency of conditions in financial markets has been lessened considerably in recent years because markets have developed in areas where statistical coverage is as yet weak. In particular, the relative importance of bond markets and off-balance sheet activities of financial institutions (such as interest and currency swaps) has increased substantially. New instruments for credit or liquidity creation, as well as increased access to international markets, have made it more difficult to evaluate conditions in financial markets and judge the proper course for policy.
Liberalization and innovation have made the usefulness of monetary instruments and the timing, incidence, and ultimate impact of monetary policy more difficult to predict. The utility of monetary targets has been affected in several, though not all, industrial countries. The introduction of financial instruments that combine liquidity with market rates of return (e.g., money market mutual funds, certificates of deposit, commercial paper) has required periodic redefinition of various monetary aggregates, and the control of these aggregates by means of traditional instruments has become more difficult. On the other hand, changes in financial markets have facilitated the conduct of monetary policy through market measures. The broadening and deepening of domestic money markets has allowed monetary authorities in some countries, such as France and Japan, to rely more on open market or discount operations than on credit controls, while in other countries, such as Germany, monetary authorities have been able to supplement traditional discount operations with open market operations in the form of repurchase agreements.
In the past, restrictive monetary policy in some countries relied on the rationing of credit, especially to certain sectors of the economy, such as housing. This rationing may have occurred because of ceilings on interest rates for financial institutions, direct limitations on credit expansion by the banking system, or the segmented nature of financial markets, which resulted in the burden of monetary policy falling more heavily on certain market segments or maturities. With liberalization, these forms of credit rationing have been relaxed and the role of market forces in allocating credit flows has been enhanced. Moreover, the removal or relaxation of capital controls has allowed borrowers access to external financial markets, and this, in turn, has diminished the effectiveness of domestic credit controls. Thus, the channels through which monetary policy affects the domestic economy have tended to shift from credit rationing to price rationing by interest rates.
As interest rate volatility has increased during the 1980s, financial markets have expanded the use of variable interest rate instruments and interest rate hedging techniques, particularly in those countries that have experienced large swings in interest rates. These developments have influenced the impact of interest rates on the economy in two ways. First, higher interest rates have induced corporations and consumers to postpone spending financed by borrowing. However, it has been argued that instruments based on variable, rather than fixed interest rates, have also reduced the penalty for spending at times when interest rates are cyclically high. Thus, the impact of higher interest rates has been diminished. Second, it may also be argued that, with fixed interest rate financing, higher interest rates depress spending partly owing to the adverse wealth effect on existing bond holders, while with floating rate instruments, so long as the borrower remains solvent, the price of the instruments would not fall and the wealth effect on such bonds could be nil. Interest rate swaps, options, and futures also may have an impact on the incidence of monetary policy to the extent that the effect of changes in interest rates is borne by corporations and individuals that have different sensitivities to these changes, or to the extent they are transferred to foreigners.
The risk-transferring instruments mentioned above can either diminish and retard the effectiveness of monetary policy or enhance and quicken its impact, depending on how risks are distributed. To the degree that, as a result of structural changes, interest rate changes have a broader and more diffused effect, greater changes in interest rates may be needed to have the same overall impact on the economy. The closer integration of instruments and segments of financial markets may lead more quickly to a generalized movement in the entire maturity spectrum of interest rates as domestic monetary authorities seek to influence financial conditions in one segment of the market. If the incidence of monetary policy is less sector-specific, then monetary authorities may be less constrained in their use of monetary policy.
A stable and predictable relationship between the targeted monetary aggregate and nominal income is essential for a successful monetary policy. Financial innovations and institutional changes may alter the interest and income elasticity of the demand for money. Moreover, the relevant monetary aggregate may be more difficult to distinguish from other financial aggregates. Both of these factors can contribute to larger prediction errors for the demand for money, with a tendency toward underestimation of the desired real balances. Such underestimation has been prevalent in some industrial countries, especially in the United States and the United Kingdom, although no consensus has emerged as to the contribution of structural changes in financial markets. These episodes of under-prediction may be only temporary, resulting from the transition from one financial regime to another. However, to the extent that these developments yield a financial structure where instrument and institutional distinctions are blurred, then a more sustained degree of uncertainty may result.
Financial market integration, which increases domestic market sensitivity to variations in foreign interest rates and exchange rates, has significant implications for monetary policy which have been the subject of extensive discussion in the economic literature. In particular, greater substitutability of domestic and foreign assets ties national financial markets more closely together because of the larger volume of cross-border flows.
The Bank for International Settlements, in its 1987 Annual Report, presented data indicating that the correlation of changes in long-term interest rates for government bonds among the Group of Ten countries and Switzerland had increased during the period 1980–86 compared with 1975–79. This increased correlation is significant in two ways. First, higher correlation of long-term interest rates could stem from increased integration of financial markets, implying less independence for domestic monetary policy and a greater sensitivity of domestic interest rates to movements in foreign interest rates. Second, the higher correlation could also derive from greater policy coordination, especially of exchange rate and monetary policies, such as exists under the European Monetary System. While monetary and exchange rate policy coordination, especially among EMS countries, has increased, the near doubling in the correlation coefficient of US interest rates with those in Germany, Japan, and the United Kingdom would seem to be due primarily to greater financial integration. However, the correlation coefficient still remains well below one.
The relative importance of the interest rate channel, compared to the exchange rate channel, declines as international financial integration proceeds. Consequently, changes in domestic or foreign monetary policy can lead to greater short-term movements in the exchange rate than in interest rate movements. This implies that the incidence of monetary policy—like that of fiscal policy—has increasingly shifted to the exchange rate-sensitive sectors and away from the interest rate-insensitive sectors. The significance of this shift varies from one country to another. Among larger, less open economies, such as the United States, the impact of monetary policy on interest rates remains the dominant avenue for influencing the domestic economy, while in smaller, more open economies, such as Canada and the Netherlands, the exchange rate channel may be more important.
Nevertheless, even in the United States the exchange rate implications of monetary policy have gained in importance. The strong US dollar that prevailed during the early to mid-1980s has been one reason for the deterioration in the US trade account and the calls for increased protectionism among elements of the US economy. More generally, rising protectionism—particularly nontariff barriers—among industrial countries and structural rigidities in the nonfinancial sectors of these economies have hampered the ability of goods and labor markets to respond to changes in macroeconomic policies and external developments. Meanwhile, keener competition, reduced market segmentation, and new technology have increased the speed at which financial markets adjust to these same factors. A greater divergence in the adjustment of these two elements could increase volatility—overshooting of interest rates and exchange rates—as financial markets react more sharply than before to compensate for rigidities elsewhere in the economic structure. Indeed, changes in exchange rates may need to be greater to have the same aggregate impact on the trade account, while the incidence of adjustment in the trade account would fall more heavily on the segments of the traded-goods sector that had not been accorded special protection.
This is not to suggest that trade protection argues for capital controls. In any case, capital controls would probably be ineffectual in today’s world of electronically linked capital markets with large and instantly transmitted capital flows. As already indicated, increased financial integration also implies that developments in foreign financial markets are transmitted more rapidly and with greater impact to domestic financial markets. Hence, the conduct of an independent monetary policy is constrained by the response of currency and capital markets. In such conditions, domestic policy actions may have a more powerful impact on both the domestic and international economy when reinforced with coordinated policy changes elsewhere.
These developments would argue for heightened policy coordination among industrial countries. The case for a strengthening of multilateral surveillance has been recognized in the Report by the Deputies of the Group of Ten on “The Functioning of the International Monetary System” (July 1985) and in a special study group of the BIS, “Recent Innovations in International Banking” (April 1986). Since these reports were prepared, coordination has been enhanced as the Fund has begun work on objective indicators to assist in its surveillance over the exchange rate policies of its industrial country members. Such surveillance seeks to focus on the international policy consistency and on the compatibility of external payments positions.
This article has described the revolutionary nature of the changes in financial markets wrought by financial liberalization measures and the recent wave of financial innovations. These changes have enhanced market efficiency, hedging opportunities, and blurred the traditional distinctions in financial markets, both domestically and internationally. At the same time, this transformation of financial markets has complicated, at least temporarily, the conduct of macroeconomic policies, especially monetary policy.