I. Overview of Developments and Key Issues
- International Monetary Fund
- Published Date:
- January 1990
This report presents the annual survey of international capital market developments and prospects. It reviews trends in the main market segments and seeks to analyze the principal forces underlying these developments, in particular the progressive integration of markets and the related globalization of investor and borrower behavior. Against this background, the study examines the financing of the current account imbalances among the main industrial countries, and reviews recent developments affecting capital market financing for developing countries. The paper also looks at a number of issues that have arisen from these developments, including efforts to promote an efficient and stable system of capital markets, the process of trade liberalization in the financial services sector, the pressures toward international harmonization of tax systems, and recent initiatives to foster debt reduction for heavily indebted developing countries.
Financial Market Trends
Against a background of more stable macroeconomic conditions, activity in international capital markets rebounded in 1988 and 1989 from the relatively low levels experienced following the October 1987 equity market break. Current account imbalances in the main industrial countries were principally financed by private capital flows, rather than from official sources as in 1987. The shift in financing patterns was accompanied by a surge in intermediation through bond markets relative to 1987 when official intervention had boosted flows through the interbank market. Direct investment and syndicated credits also increased strongly in 1988, in part reflecting the high level of merger and acquisition activity. In 1989, continued growth in bond issues was concentrated in equity warrants, while activity in other bond market segments weakened, as did syndicated bank lending. With regard to capital market financing for developing countries, spontaneous flows remained strictly limited in 1988 and 1989, while concerted lending proved increasingly difficult to arrange. In the second half of 1989, a number of heavily indebted countries reached agreements with bank creditors on packages including debt reduction, which would be financed mainly from official sources.
Macroeconomic Background and Capital Flows
Buoyant activity in international capital markets during 1988 and 1989 reflected a continued strong economic expansion in most industrial countries, a high level of investment activity, an increase in the volume of world trade, and an environment of relatively stable prices and exchange rates (Table 1). The broad exchange market stability in this period, which reflected in part the resolve of the authorities of the Group of Seven (G-7) to stabilize exchange rates in the wake of the Plaza agreement, meant that nominal interest rate differentials had a greater influence than in 1987 on financial flows.
|Total of current account deficits1||176||158||192||198||246||234||259||281|
|Total of fiscal balances for seven major industrial countries|
|Overall current account balances of developing countries2||−77||−58||−27||−22||−41||4||−9||−16|
|Reserve accumulation of developing countries (accumulation +)||−35.8||2.5||11.0||18.4||4.2||55.1||—||22.5|
|Growth rate in value of world trade||−6.0||−2.0||5.9||0.7||9.7||17.4||14.2||10.5|
|Growth rate of real GNP of industrial countries||−0.3||2.7||4.9||3.4||2.6||3.5||4.4||3.5|
|Inflation rate of industrial countries (GNP deflators)||7.5||5.2||4.5||3.6||3.4||3.0||3.2||4.1|
|Interest rates (six-month Eurodollar deposit rate)3||13.6||9.9||11.3||8.6||6.8||7.3||8.1||9.3|
In response to concerns about emerging price pressures, the stance of monetary policy in major industrial countries was tightened during 1988 and early 1989, and this was reflected in a widespread increase in short-term interest rates. Longer-term interest rates generally remained stable and yield curves consequently flattened and even became inverted, reflecting in part the confidence of market participants in the authorities’ determination to control inflation. During this period, interest rate differentials gradually widened in favor of the U.S. dollar, in particular vis-à-vis the Japanese yen, and this contributed to the strengthening of the currency. From the second quarter of 1989, inflationary pressures began to subside, particularly in the United States, which allowed for a reduction in U.S. interest rates, and a reversal of interest rate differentials against other currencies.
The sum of the external current accounts of industrial countries registering current account deficits, an indicator of the required net movement of capital through the system, increased to about $200 billion in 1988, and is estimated to have risen to almost $225 billion in 1989.1 These deficits, which were accounted for in large part by the United States and the United Kingdom, represent over three fourths of the sum of current account deficits in the world (Table 1). The financing of these current account imbalances changed significantly in 1988 and 1989. The relative stability of exchange markets allowed for a substantial return to autonomous financing through the capital account in 1988, in contrast to 1987 when large-scale intervention by central banks had played a major role (Table 2). An exception to this was the Federal Republic of Germany where outflows through the capital account, particularly through bond markets, rose sharply, partly as a result of the announced introduction of a withholding tax. In 1989, official intervention continued to play a reduced role in the major industrial countries, with the notable exception of the United Kingdom.
|United States||Japan||Fed. Rep.|
|United Kingdom||United States||Japan||Fed. Rep.|
|United Kingdom||United States1||Japan2||Fed. Rep.|
|Net direct investment||2.7||−18.3||−7.3||−17.0||40.9||−34.7||−8.7||−13.6||25.1||−41.2||−6.5||−5.9|
|In the reporting country||46.9||1.2||1.9||13.5||58.4||−0.5||1.7||13.6||58.5||−0.3||4.0||25.7|
|Change in official reserves||9.1||−37.9||−21.5||−20.2||−4.0||−16.5||15.4||−4.9||−29.5||15.0||−1.3||6.7|
|Acquisition of liabilities by foreign monetary authorities||47.7||—||1.2||25.5||40.2||—||3.0||6.8||18.7||—||15.2||15.9|
|Residual financing need||−83.5||30.7||17.9||−18.1||−49.0||28.4||58.5||−37.8||−99.9||34.2||61.0||20.8|
|Public sector bonds||−2.4||−62.3||11.5||3.9||27.1||−106.5||2.6||0.7||40.8||−85.2||4.9||0.1|
|Deposit money banks3||46.5||62.1||−7.9||−18.6||14.8||38.4||−2.9||19.2||0.3||−27.8||2.0||24.3|
|Long term, net||0.6||−9.7||−1.2||1.8||10.5||−6.1||6.8||1.0||−8.7||−3.8||7.6||0.7|
|Errors and omissions||1.3||−3.7||1.0||16.4||−10.7||3.1||0.6||18.7||47.9||−10.6||−10.3||24.7|
The return to financing through autonomous capital account flows in 1988 and 1989 was embodied in strong increases in net direct investment and net financing through international bond markets. By contrast, financing through equity markets played less of a role than in the past, as did net lending through the banking system. The increase of cross-border flows of net direct investment was connected in part with the continued high level of mergers and acquisitions. Outflows were particularly marked in the case of Japan, with the bulk of flows being directed to the United States. The Federal Republic of Germany and the United Kingdom also registered net outflows of direct investment, albeit at levels comparable with those in 1987. The revival of cross-border financing through bond markets was also reflected in large net inflows into the United States, particularly through purchases of U.S. Treasury bonds, and continued net outflows from Japan and the Federal Republic of Germany. The United Kingdom shifted from being a net importer of capital through bond markets in 1987 to a net exporter in 1988 and 1989 despite the substantial widening of its current account deficit.
Although changes in portfolio investment in corporate equities played less of a role in the financing of current account imbalances during 1988 and 1989 than in 1987, there were wide swings in these flows. For instance, both the United Kingdom and the United States shifted from being net importers of capital through equity markets in 1987 to net exporters in 1988 and 1989. With regard to net lending through the banking system, according to balance of payments statistics, net inflows through commercial banks in the United States and Japan, which had reached record levels in 1987, declined substantially in 1988 and in Japan’s case turned to net outflows in the first half of 1989. This reversal was the counterpart of the reduced reliance on official intervention. In the United Kingdom, there was a sharp swing in net flows through the banking sector as net outflows of 1987 gave way to net inflows in 1988 and 1989. In effect, these latter inflows, together with substantial amounts of other unidentified inflows, provided the bulk of financing for the large current account deficit that emerged in the United Kingdom in this period.
Developments in Major Market Sectors
Cross-border bank lending to industrial countries fell from $547 billion in 1987 to $475 billion in 1988 and declined further in the first three quarters of 1989, owing to the contraction of the interbank market (Table 3).2 The decline in interbank transactions since 1987 can be attributed to various factors. In particular, the reduced amount of official intervention lowered the need for banks to readjust their positions through interbank activities. Other factors included the impact of the new Basle capital adequacy standards, the completion of portfolio adjustments associated with the creation of the Tokyo Offshore Market, and flat or inverted yield curves. Data on syndicated credit commitments show a substantial rebound of activity in 1988, in large part related to merger and acquisition activity, but lending commitments dropped off in 1989 as activity subsided in all the main market segments. The surge of activity on international bond markets in 1988 and 1989 was facilitated by the continued expansion of the swaps market, which allowed the portfolio preferences of borrowers and lenders to be more easily matched. The relative stability of exchange rates and flat yield curves stimulated growth in fixed rate bond instruments in 1988, and was associated with a shift in investor’s preferences toward currencies with high nominal interest rates, particularly the U.S. dollar (Chart 1). In 1989, issues of equity-linked bonds—primarily used by Japanese corporations as a means of issuing equity without incurring the costs of flotation directly on the Tokyo market—were boosted by the strength of the Tokyo stock market, and such issues accounted for almost all the growth of the bond market. After expanding very rapidly for some years, cross-border equity flows in 1988 were more subdued than in 1987, depressed in the aftermath of the October 1987 market break. However, by early 1989, growth had resumed in this area, as investors sought to diversify their portfolios, while companies aimed to establish a broader and more liquid market for their stock.
|Total change in claims2||170||181||276||536||795||552||466||514|
|Capital importing developing countries3,7||26||12||5||3||20||−13||−16||3|
|Non-oil developing countries3,8||24||14||3||2||20||−14||−16||6|
|Fifteen heavily indebted countries||11||5||−6||−1||2||−16||−12||−2|
|Total change in liabilities9||166||185||300||592||751||532||430||497|
|Capital importing developing countries3,7||27||24||20||8||38||24||19||25|
|Non-oil developing countries3,8||26||22||15||16||38||24||19||22|
|Fifteen heavily indebted countries||10||14||5||−4||10||5||6||9|
|Change in total net claims10||4||−4||−24||−57||44||20||36||17|
|Capital importing developing countries3,7||—||−12||−15||−5||−18||−37||−35||−22|
|Non-oil developing countries3,8||−2||−8||−12||−14||−18||−38||−35||−17|
|Fifteen heavily indebted countries||1||−8||−10||3||−7||−21||−18||−11|Chart 1.Currency Composition of International Bond Issues, 1984–891
Source: Organization for Economic Cooperation and Development, Financial Statistics Monthly.
1 Based on rates prevailing at time of bond issue.
The number of financial futures and options contracts (derivative products) traded internationally and the volume of outstanding open positions have continued to grow rapidly. Apart from foreign exchange contracts, there are now markets in futures and options covering interest rates in most of the major government bond markets, both at the short and at the long end of the maturity spectrum. Contracts on interest rates on private sector instruments have been slower to develop, reflecting the less homogeneous nature of the underlying contracts, but markets for three-month Eurodeposits have been established in U. S. dollars, and more recently in yen and deutsche mark. One notable development in the past year has been the introduction of “diff” contracts on the future spread of interest rates between different currencies, which allow the hedging of foreign currency interest exposure at a lower cost than through the simultaneous use of interest rate and exchange rate futures. In the area of derivative products based on stock indexes, however, there has been some decline in activity, in reflection of subdued stock market sentiment and a decline in the popularity of trading strategies utilizing such instruments.
Transactions with Developing Countries
Recent participation in international capital markets of developing countries, particularly outside Asia and Europe, has been rather limited, and remains well below the levels recorded at the start of the decade. Flows of spontaneous market lending to developing countries as a group (excluding offshore banking centers) have declined sharply and are restricted almost exclusively to countries that have not restructured their debt in recent years. Portfolio equity flows, in particular through investment funds, have nevertheless increased, although, as with bond financing, the total remains limited. However, the potential for raising foreign financing through the expansion and further opening of securities markets in developing countries is substantial.
With regard to the group of highly indebted countries, bank financing packages proved increasingly difficult to arrange in 1988, and there were further delays in early 1989 arising from uncertainties related to the evolution of the debt strategy. However, in the second half of the year, agreements were reached with Mexico, the Philippines, and Costa Rica on packages that provide for substantial debt and debt service reduction, occurring through cash buy-backs and collateralized debt exchanges financed mainly from official sources. Negotiations are now continuing with several other countries. The acceptance of debt and debt service operations by banks has been facilitated by official actions to clarify their accounting, regulatory, and tax treatment and by recent increases in bank provisioning levels.
Factors Underlying Developments
The market developments discussed in the previous section have been influenced by a number of more fundamental processes. One is a strengthening of the linkages between the individual markets, thus integrating national economies and providing a deeper market for instruments of different characteristics. A second and related process is the globalization of behavior in the sense that market participants operate with increasing freedom in the various segments of the international financial system, treating it as an integrated whole in making decisions. This process is looked at in this section from the perspective of the investor, although similar processes have been at work for some time on the borrower’s side.
Integration of Markets
Underlying recent developments in international capital markets has been a process of integration between countries, between different market sectors, between institutions, and between maturities and instruments. This process is leading to a network of closely linked capital markets, through which savings and investment can in principle be intermediated more efficiently, thereby reducing the cost of capital to firms and increasing the returns to savers. These markets allow the pricing and reallocation of a broadening spectrum of risks, thus increasing the scope for, and the efficiency of, international and intertemporal resource allocation. However, this process may be engendering new risks that are not fully understood, and moreover allowing shocks and disturbances to be transmitted very rapidly between markets.
As discussed in previous reports in this series, the integration of capital markets has been supported by policy initiatives aimed at liberalizing restrictions in domestic markets. During the past year, such initiatives have continued to be important. In particular, in Japan, the authorities have pushed on with the program to free interest rates through a further reduction in the minimum size of deposits bearing full market rates, and measures have also been taken to promote the development of a domestic money market and to liberalize Euro-yen lending. In Europe, the elimination of certain restrictions on the Eurocurrency markets in the Federal Republic of Germany and the United Kingdom has further promoted the merging of domestic and offshore capital markets. In the United States, the division between banking and securities business has continued to be eroded.
The process of market integration has also been encouraged through the removal of restrictions on the entry of foreign banks and financial institutions to domestic markets. Such action tends to make domestic markets more competitive, in particular because foreign financial institutions usually lack a domestic retail base, and hence tend to do most of their business with institutional customers or other banks. However, while the industrial countries are all party to the code on freedom of capital movements of the Organization for Economic Cooperation and Development (OECD), some continue to have reservations about the takeover of larger domestic banks and securities houses by nonresidents.
Dramatic strides toward the international integration of financial markets are being taken under the U.S. Canada Free Trade Agreement and within the European Community. Several steps have already been taken toward the establishment of a single European market in financial services. The Second Banking Directive will allow a bank established in one Community country to perform throughout the Community all the functions it is authorized to perform in its home country. The Solvency Directive harmonizes the capital adequacy standards for the banks in the Community, and the Investment Services Directive that is being elaborated should do the same for investment houses. Finally, the Directive on Undertakings for Collective Investment on Transferable Securities (UCITS) allows the sale of unit trusts and mutual funds throughout the European Community.
Given these commitments, remaining restrictions within the Community designed to give national authorities control over domestic currency markets (such as restrictions on the nationality of lead managers for Eurocurrency issues or on the taking over of large financial institutions by institutions from other countries) will be increasingly difficult to maintain. Moreover, the freedom of capital movements and of establishment throughout the European Community (EC) will put pressure on the authorities to harmonize taxes and other regulations, or at least to reduce differences to such an extent that their effect on factor movements is minimal.
Another tendency prevailing in international capital markets is toward the blurring of distinctions between different instruments. The distinction between syndicated loans and bonds remains, but syndicate banks are becoming more like underwriters, selling off participation in loans to other institutions and keeping little on their own books. Moreover, the flexible note issuing programs that are now available to corporate borrowers provide investors with the sort of finance that, in the past, a bank would have provided.
The growth of the derivative product markets is a sign of the increasing integration and efficiency of financial markets, both nationally and internationally. At the national level, these markets facilitate the integration of the pricing of instruments with different maturities and risk characteristics, by creating means by which arbitrage opportunities can rapidly be seized. They also permit participants on financial markets to adjust quickly the amount of risk they take on and to restructure their portfolios rapidly, including through the use of program trading. Internationally, these markets permit the linking of national financial markets both at the short end of the maturity spectrum and now increasingly at the longer end. While this implies the more rapid transmission of disturbances from market to market, in the normal course of events it also permits a more rapid and efficient adjustment of markets to changing international conditions.
Globalization and Investor Behavior
Over the past few years, the demand for assets issued on international capital markets has come to be dominated by large institutional investors including insurance companies, pension funds, mutual funds, and other investment trusts. Institutional investors have certain characteristics that lead to a different pattern of behavior from individual investors, which has important implications for the development of capital markets. First, they have the capability to follow developments and analyze investment prospects for a wider variety of borrowers and markets, which allows them to be more diversified in their asset holdings. Second, they are generally regulated by the authorities as the price for receiving certain tax concessions and in order to protect individuals holding claims on the institutions. Third, institutions may be expected to respond more rapidly to market developments than individual investors. Technological developments allow institutions to follow market developments closely and to execute their decisions promptly; they, are better placed than individuals to utilize the derivative product markets to adjust their portfolios or take positions on market developments; they are also under intense competitive pressure to perform. Finally, the very factors that allow a rapid response to market developments may also mean that institutional investors have a shorter time horizon than do individuals, although the evidence for this is not unequivocal.
Over the last decade, institutional investors have increasingly turned to foreign assets as a means of reducing the volatility of their returns while increasing their earnings.3 In most countries, regulations, often originally imposed for prudential reasons, had limited the range of the investments that insurance companies and pension funds were permitted to make, and in particular the amount of foreign assets they could acquire. However, such regulations have been reduced under strong pressure and the realization that there are prudential reasons to accommodate them.
Developments in financial information and communications technology have played a major part in the move toward globalization and changing the roles of institutional investors and financial intermediaries. In particular, the emergence of the derivative products markets and the advances of communications technology, together with the wholesale market power of institutional investors, have greatly increased the scope and reduced the cost of financial engineering, that is, the creation of customized products for both borrower and investor. This has been related to the rapid growth of the private placement market in many countries, where institutional investors can obtain tailor-made claims that are not available to the general public. Technological advances are also beginning to allow institutional investors direct real-time access to capital markets and to bid directly on securities as they are issued, thus circumventing the middleman function of the securities houses. In the future, corporate treasurers may be able to raise funds from institutional investors directly, using screen-based auction systems, leaving the securities houses to compete for paper to sell on the retail market.
While the trend to broader international portfolios is most evident among institutional investors, small investors have also diversified. The announcement and subsequent introduction of a withholding tax on interest income in the Federal Republic of Germany led to a massive shift of funds abroad by domestic German investors. Similar tax-related motivation has led Belgian residents to invest heavily in Luxembourg funds. The October 1987 market developments may have dissuaded many investors from venturing abroad into markets in which they might not feel familiar. Since then, however, there has been a large effort to induce such investors to return and the process should be accelerated throughout Europe by increased competition in financial services as banks in different countries try to position themselves in the retail markets of others.
Financial Policy Issues
National authorities have several objectives when determining policies toward financial markets. First, they wish to ensure that their financial markets constitute efficient channels between savers and investors, and provide the financial services needed by the economy; second, they wish to ensure that their financial markets are stable; and third, that adequate protection exists for investors and depositors. These goals are interrelated: for a financial system to provide consistently the services the economy needs, it must operate efficiently and be able to withstand financial shocks; measures to enhance stability (for example, prevention of bank runs) may be an essential element of depositor protection; clearing and settlement systems, which can smoothly accommodate a large volume of transactions, serve the goals of both efficiency and stability. On the other hand, there can also be trade-offs among these objectives: action to protect depositors, for example, through deposit insurance, may discourage the correct pricing of risk, and thus make efficiency harder to attain; supervisory action to ensure financial institutions have sufficient capital backing and adequate systems to limit risk taking may inhibit these institutions from using their capital optimally and may ultimately induce the development of alternative forms of intermediation that avoid costly regulatory requirements.
The liberalization of domestic capital markets, and the removal of barriers to the cross-border provision of financial services or the establishment of financial institutions, has been largely in search of more efficient and better structured financial systems. At the same time, the increased attention being paid to prudential regulation in banking and securities markets has been largely designed to promote the objectives of stability and depositor and investor protection. Competitive pressures that may enhance efficiency in the short run may also lead to greater volatility and damage investors and depositors. The next two subsections deal with some of these issues.
Containing Systemic Risk
With the rapid increase in the size of financial markets, both domestic and international, the remarkable structural change that has been occurring in these markets, and the evidence of their increased volatility, policymakers have come to devote more attention to the issues of stability and systemic risk. If financial crises are to be prevented, sound macroeconomic policies and appropriate coordination are needed to create a stable environment for the functioning of these markets. At the microeconomic level, the authorities have sought to ensure that the financial system is sufficiently robust to cope with shocks.
Over the last decade, international capital markets have financed smoothly a pattern of unprecedentedly large current account imbalances. This has been possible in part because of the internationalization of investors’ portfolios described above. The gross two-way flows of direct investment, bank lending, and portfolio investment in bonds and equities have been so large that they have generally been able to provide the net finance required by the current account deficits. It seems probable that the process of portfolio internationalization has much further to go, and thus may be able to continue to accommodate substantial imbalances for some time.4
Nevertheless, there is also a danger that a sudden change in market sentiment could disrupt the process. This danger is illustrated by events following the stock market break in October 1987, during and following which investors tended to sell their foreign assets before domestic assets, although it was less evident in similar circumstances in October 1989. More generally, if asset holders suddenly wished to change the composition of their portfolios, for example, to reduce their holdings of U.S. dollar assets, their attempt to do so might result in a sudden and sharp depreciation of the U.S. dollar. Thus one concern is how to prevent such a shift in sentiment from emerging in a sudden and destabilizing way. Financial markets tend to react particularly sharply to news when there is underlying unease about the sustainability of particular exchange and interest rates. Hence, an important means to bolster financial stability is through ensuring that the economic fundamentals are not such as to engender disquiet. Market confidence in the soundness of underlying economic policies, and in the resulting pattern of exchange and interest rates, can promote a longer-term pattern of intermediation, characterized by the use of the long-term bond and equity markets. If such instruments are taken up by nonbank institutions, this can contribute to the overall robustness of the system, as any shock will be less likely to threaten the survival of financial intermediaries.
Actions to promote robust international financial structures at the microeconomic level have taken several forms, among which are ensuring an adequate capital base for financial institutions, ensuring that clearing and settlement systems function efficiently and safely, developing coordinated procedures for crisis management, and placing limits on market volatility.
The most important move to strengthen the capital base of financial institutions has been the agreement on bank capital adequacy reached in the forum of the Basle Committee of Bank Supervisors in July 1988. This multilateral agreement, which is to come fully into effect by the end of 1992, sought to bring the minimum capital bases of banks up to common and generally higher standards. Since then, the standards have been incorporated in national regulations, and banks have been active in floating new capital in world markets. The Basle Committee standards generally fix the minimum amount of capital that a bank must have as a function of the credit risk it has incurred both on-and off-balance sheet. However, there are other sorts of risk which can, and have had, serious consequences for bank solvency. Work is now proceeding in the Basle Committee on the treatment of such forms of market risk as interest rate and foreign exchange risk. Nevertheless, there remain difficult technical problems that still have to be resolved in these areas.
Work has also been continuing on the appropriate capital base for securities houses. This work, conducted by the International Organization of Securities Commissions (IOSCO), has in some ways paralleled the work of the Basle Committee in the area of banking. Just as the agreement of the latter was facilitated by an initial agreement between the United States and the United Kingdom on a common approach, an agreement that was later joined by Japan, so in the area of securities houses, the convergence of the system of capital adequacy in the United States with that in the United Kingdom and Japan has provided a major impetus to IOSCO’s work. At its meeting in Venice in September 1989, IOSCO supported a number of recommendations of its working group on capital adequacy for securities firms covering the need for capital in relation to the risks that securities firms take on.
One problem in this area, from a competitive viewpoint, is that of defining equivalent capital standards for different types of institution undertaking the same business. In some countries, virtually all securities market activity is done by banks; in others, both banks and securities houses, and possibly other institutions, do such business; while in a third group (including notably Japan and the United States) banks are generally excluded from securities business. To the extent that different institutions, being supervised on a different basis, may be required to put up different amounts of capital, or to constrain their risk-taking in different ways, there is a danger of giving some institutions competitive advantages and distorting the market.
Another subject paid considerable attention by national authorities has been clearing and settlement systems. Clearance and settlement systems form part of the “plumbing” of financial markets, and any breakdown can have serious consequences for the stability and efficiency of the system. The enormous volume of transactions occurring at times of market disturbance can overwhelm the capacity of clearance systems to process orders. Moreover, at times of system overload, credit risks can increase significantly as the completion of transactions may be in doubt. Clearing systems typically deal with the failure of a participant in the system in one of two ways. Either the bad debt of the failed institution to other participants is covered by the guarantor, which may be the clearing house itself or the authorities, or all transactions involving the failed participant have to be unwound. The willingness of the authorities to take over the risk implies that participants may not be charged appropriately for the risk; alternatively, the unwinding of all transactions with the failed participant may leave an unexpected pattern of uncovered exposures, leading to more failures.
The approach adopted to reform of clearance and settlement systems so far has concentrated on efforts to strengthen such systems through improvements in liquidity and the capital positions of participants, in particular through limits on “daylight” overdrafts, and through increased collateralization requirements. In addition, it has been proposed to reduce credit risk in securities transactions by shortening settlements periods, with a report by the Group of Thirty recommending movement of all systems to a three-day settlement period by 1992.5 This step should prevent prolonged doubt about the solvency of counterparties.
A related issue is that posed by the integration of different payments systems. When two instruments are exchanged, there may be credit risk if one side of the transaction is settled before the other. This may occur within a country if the two markets have different settlement periods, and may also occur internationally, where for example the yen side of a payment originating in Japan can be finalized in Tokyo at the end of the day, but the dollar side will have to await the closure of the U.S. business day. Supervisors are considering ways of resolving these difficulties and dealing with any problems that failure to complete such transactions may involve.
A further issue in promoting confidence in the financial system is that of establishing an effective system of crisis management. This requires the provision of general liquidity by a lender of last resort to prevent unnecessary failures of financial institutions resulting from a sudden drying up of liquidity in the system and the possible support of particular solvent but illiquid institutions whose failure could have a catastrophic effect on the system. An increasingly international financial system gives scope for confusion about which national authorities are responsible for injecting liquidity in the event of a crisis and harbors a danger that delayed or insufficient action in one country could lead to the spread of problems to others. However, the extent of international agreement on the division of responsibilities to provide liquidity or to rescue institutions in the event of a crisis is not public knowledge. In part this reflects the possibility that knowledge of the circumstances in which a financial institution would be rescued might prompt its management and its creditors to behave with less prudence.
With regard to the recent sharp breaks in equity markets, market reports suggest that the provision of emergency liquidity assistance was much more orderly and better coordinated in October 1989 than in October 1987, although the monetary authorities of the major industrial countries tried to downplay their role. Moreover, there were also reports of indirect official intervention in equity markets. Such a role would raise important policy issues. To the extent that such official intervention (either directly or indirectly) occurs in the equity markets, it may reduce the perceived risks of holding equity instruments by implicitly providing a floor on the return to equity investments, at least during periods of crisis. This poses the questions of whether extending the official safety net to equity markets and related institutions will lead to excessive risk taking by the private sector, and of whether significant public sector liabilities may eventually arise from providing support for institutions that do get into trouble in future crises.
Measures to place limits on equity market volatility have been the chief concern of those that view equity price volatility as arising from the trading strategies employed in equity markets rather than variability in the fundamentals. While it is often difficult to discern exactly what model lies behind the proposals put forth by this group, it seems to be a variant of the “noisy trading” model in which the market is viewed as being composed of both traders that respond to news about fundamentals (value traders) and traders that respond solely to price movements (noise traders). One view seems to be that, as the number of traders using computer-driven trading strategies has risen, the proportion of noise traders has risen relative to value traders, which makes it more likely that the market will experience sudden price changes. As a result, the proposals of this group have focused on directly limiting the use of certain computer-driven trading strategies (program trading) and on introducing “circuit breakers” that limit daily price movements in stock and derivative markets. Steps in this direction have recently been taken on the major U.S. exchanges.
While recent policy actions may have strengthened the financial system’s ability to withstand the effects of shocks, at the same time they also have tended to raise the costs of satisfying regulatory requirements while reducing the liquidity benefits of operating through organized markets and exchanges. This has created a growing incentive for large portfolio managers and corporate treasurers to transact directly with each other rather than through financial intermediaries or exchanges. Computer and telecommunications technologies now make such direct trading between large traders both feasible and (in a growing number of activities) efficient. Between October 1987 and October 1989, for example, such off-exchange trading was evident whenever the New York Stock Exchange suspended the processing of program trading orders. Program traders responded by undertaking direct transactions with each other and only later reporting these transactions to the exchange (to satisfy regulatory requirements). More generally, it has been observed that the most rapidly growing activities in international capital markets in recent years have involved off-exchange trading of securities. Thus we may be witnessing a re-enactment of the migration of financial activity similar to that evident in the late 1960s and early 1970s, when the presence of exchange controls and a variety of national restrictions on financial activities and interest rate flexibility created cost incentives that induced many borrowers and lenders to shift a growing share of their activities to the offshore markets.
Liberalizing Trade in Financial Services
Liberalization of domestic financial markets, the removal of barriers to the cross-border provision of financial services, and the freedom of establishment of foreign financial institutions have been seen by governments as ways of making the financial sector more efficient. Such actions allow cheaper provision of services to the rest of the economy, lower the cost of capital, ensure its more efficient allocation, and give savers better returns on their investments. However, liberalization of the financial services sector is complicated by concerns that it might reduce systemic stability or weaken protection for investors.
To date the main framework for multilateral trade liberalization in the financial services area has been the OECD codes on liberalization of current invisible operations and of capital movements, which constitute binding legal agreements under which signatories are committed to the progressive elimination of restrictions. The current Uruguay Round of multilateral trade negotiations within the General Agreement on Tariffs and Trade (GATT) is aiming at producing a general agreement on trade in services, and one issue has been the extent to which this agreement should cover trade in financial services. There has been concern that negotiations on removing some trade barriers in this sector could disrupt or destabilize financial markets as participants rushed to respond to a new incentive structure, and that monetary and development policy considerations preclude the surrender of national freedom of action. Moreover, a basic problem raised by negotiators is that nondiscriminatory market access requires the acceptance of the adequacy of the prudential and other standards imposed by the home country on the financial institutions in question. For this reason, the precondition for the creation of a single market in financial services in the European Community has been the harmonization of minimum standards and mutual recognition of other standards. Finally, the experience of financial liberalization in the OECD countries has been that the effective cross-border provision of financial services is closely linked to the freedom of financial institutions to establish themselves in the other market. Some participants in the Uruguay Round are unwilling to see concessions extended to the area of inward foreign investment.
Influence of Taxes on Capital Flows
National tax systems, and the differences between them, have always been a major influence on the relative attractiveness of different capital market instruments and thus on the structure of international capital flows. The increasing freedom of capital movements among the industrial countries and the continuing advances in capital market technology make it possible for market participants to respond to differential incentives established by national tax systems more rapidly and on a much larger scale than hitherto. This point is illustrated by the massive capital flows that took place in 1988 and early 1989 following announcement of a withholding tax on interest income by the German authorities. Other examples include the development of Euromarket trading based in London in order to avoid stamp duties and other transaction taxes in a number of European countries.
The pervasive effects of taxes on international capital movements have led to suggestions that if the remaining barriers to international capital movements are eliminated, different countries’ tax systems must be harmonized, or all capital will tend to flow to the lowest-tax area. For example, in the European Community, the impending removal of remaining controls on capital movement and liberalization of competition in banking services has led to attempts to negotiate the harmonization of withholding taxes in the member countries. This has proven difficult, however, given the substantial differences in national tax policies and concerns about the impact of an EC-wide withholding tax on the competitiveness of EC financial markets vis-à-vis the rest of the world.
In considering the need for tax harmonization, it should be stressed that taxes cannot generate net flows of capital except to the extent that they affect the savings-investment balance in each country. Thus, even if capital does move freely, the fact that many considerations other than taxes influence the after-tax profitability of investment implies that many tax-induced capital flows will be bi-directional—that is, they will largely be only more tax-efficient, if circuitous, ways of financing the same investment, rather than net flows of capital.
Net flows of capital will occur to the extent that tax discrepancies affect the cost of capital, and to this extent the result will be inefficient international allocation of investment. Furthermore, there are real resource costs to avoiding or evading taxes, including costs of devising tax-efficient alternatives and transactions costs of moving funds abroad, and this is a further source of inefficiency arising from international tax discrepancies. These inefficiencies arising from tax differences must be weighed against other national objectives in determining the extent to which it would be desirable to harmonize different countries’ tax regimes.
Integration of Developing Countries in International Capital Markets
The degree of integration of most developing countries in the international financial system, when measured in terms of gross capital flows, is less now than it was at the start of the decade. This, of course, largely reflects the market’s reappraisal of the risks involved in bank lending to the public sector of the now highly indebted countries, and a similar process has also occurred in bond markets, where the volume of bonds issued by developing country borrowers is less than it was at the start of the 1980s. Nonetheless, there are some positive developments: the amount of foreign direct investment in these countries has been rising over the past few years, in part related to debt-equity conversion schemes; interest in portfolio investment in developing country equity markets is increasing, as indicated by the number of investment funds being established; and some countries, particularly in Asia, have continued to expand their links with the international financial markets, both as users and suppliers of funds.
The processes described in this and earlier reports create both problems and opportunities for developing countries. The increase in capital mobility that appears to be occurring worldwide, and the increasing competition on financial markets, means that developing countries will need to ensure that their policies foster an attractive financial environment for investors if they are to be able to tap these markets. Moreover, domestic savers and investors are also affected by the more global outlook and the investment opportunities abroad. Since financial liberalization and technological development have made capital movements easier, including movements of funds out of developing countries, the need to raise domestic financial market standards is increasingly important as a means of discouraging capital flight.
Financial markets that are more integrated with those of the rest of the world need not inevitably result in the net transfer of savings abroad. If on a risk-adjusted basis, returns are higher domestically than elsewhere, the integration of domestic capital markets should attract capital from abroad. Indeed, the global outlook of investors, the increased importance of institutional investors, and the freer movement of funds offer considerable opportunities to developing countries. The underlying rates of return on many investment projects in such countries are high, and if they can avoid allowing this return to be offset by country risk, many stand in a good position to attract the capital they need. Within the enormous total of funds devoted to cross-border investment, there is scope for investors to devote at least a small part to high-risk, high-yielding investments, such as those developing countries might well offer. One sign of this interest is the premium over underlying asset values of several closed end mutual funds that invest in such markets. A small movement of institutional investment funds into such assets could have a major impact on the supply of capital available to developing countries.
To attract funds from both residents and foreign investors, well-functioning domestic financial systems must exist. In particular, interest rates need to be market determined in order to set appropriate price signals for both the suppliers and the users of funds. In the past, financial repression has meant that savers have not been able to earn the rate of return that investors are willing to pay. Financial systems must also be more efficient in directing funds to the most productive uses. One of the main causes of the current debt-servicing difficulties of some developing countries was the insufficiently productive way in which borrowed money was spent.
Two further obstacles prevent fuller utilization of international financial markets by developing countries: creditworthiness and the standards of investor protection on domestic financial markets. Lack of creditworthiness impedes new financial flows. Banks that wish to acquire a claim on any one of a number of developing countries can do this by acquiring existing claims through the secondary market at a very low price, which reflects a high risk premium that contractual obligations will not be met. Re-establishment of creditworthiness is essential if the element of country risk is to be reduced to a minimum. In some cases, the burden of existing contractual claims is so large relative to the country’s debt-servicing capacity that an orderly restructuring of such claims is needed before remaining obligations can be met. In other cases, however, the problem is to give existing and potential creditors confidence that the authorities will do nothing to prevent the implementation of contractual terms on financial obligations. In all cases, creditworthiness will ultimately be founded on a set of macroeconomic and structural policies that foster sustained growth consistent with stable financial environment and external financing needs compatible with the availability of funds.
Foreign investors are also looking for similar standards of protection on developing country markets that they can obtain elsewhere. These include strong bank supervision to give confidence in the creditworthiness of domestic financial partners. In this connection, the application of the Basle capital adequacy standards by some developing countries and offshore centers is encouraging, as is their participation in the work of IOSCO. If investors are going to channel funds through the equity markets of developing countries, they need assurance that these markets operate efficiently and transparently, and that international standards of investor protection are met. Finally, they need to be sure that their claims will receive protection that meets international standards in the courts of the country, and that they will not be subject to arbitrary treatment or discrimination on account of being nonresidents. The establishment and activities of the Multilateral Investment Guarantee Agency (MIGA) are in part designed to generate this confidence.
Developing countries have a vital interest in international financial market developments and in the safety and soundness of the international financial system. These markets offer them the possibility of attracting the funds they need for their development, and in a form that is more appropriate than the balance of payments lending of the 1970s. There is considerable pressure from domestic residents, both savers and borrowers, to have access to these markets. Rightly used, and by keeping domestic market standards up to international ones, these forces could provide the impetus for the reintegration of many developing countries in the international financial system in the 1990s, serving to promote both market efficiency and the inflow of correctly priced and directed capital that these countries need.
In view of the persistence of the world aggregate current account discrepancy, caution is needed in interpreting these figures. See International Monetary Fund, World Economic Outlook, October 1989: A Survey by the Staff of the International Monetary Fund, World Economic and Financial Surveys (Washington, 1989), Supplementary Note.
Based on data contained in the International Banking Statistics collected by the Fund; these data cover a broader definition of banks than do the balance of payments statistics.
For example, the share of foreign equities and bonds in the total portfolio of U.K. pension funds is estimated to have risen from 5 percent in 1979 to 20 percent at the end of 1988. Foreign assets of German investment funds (Kapitalanlagegesellschaften) at the end of May 1989 amounted to 60 percent of total assets. In Japan, the share of foreign securities in total securities holdings of life insurance companies rose from 15 percent in 1981 to 31 percent in 1988, of nonlife insurance companies from 8 percent to 22 percent, of trust banks from 4 percent to 15 percent, and of securities investment trusts from 4 percent to 14 percent.
See Michael Dealtry and Jozef Van’t dack, “The U.S. External Deficit and Associated Shifts in International Portfolios,” BIS Economic Papers No. 25 (Basle: Bank for International Settlements, September 1989).
The Group of Thirty, Report on Clearance and Settlement Systems in the World Security Markets (Paris, 1989).