Abstract

In its communique of September 25, 1989, the Interim Committee “encouraged the Executive Board to continue improving the analytical and empirical framework underlying multilateral surveillance, including the measurement, determinants, and systemic consequences of international capital flows.” This study addresses the determinants and systemic consequences of international capital flows. A study on the measurement of international capital flows is under preparation.

In its communique of September 25, 1989, the Interim Committee “encouraged the Executive Board to continue improving the analytical and empirical framework underlying multilateral surveillance, including the measurement, determinants, and systemic consequences of international capital flows.” This study addresses the determinants and systemic consequences of international capital flows. A study on the measurement of international capital flows is under preparation.

The first section identifies four of the main trends in capital flows during the 1970s and 1980s. First, there has been a sharp expansion in the scale of net and gross capital flows among the industrial countries, as well as a much increased participation by foreign investors and by foreign financial institutions in the major domestic financial markets. Available indicators suggest that this expansion has been significantly greater than that of international trade flows over the same period. Second, the easing of capital controls and the broader liberalization of financial markets in industrial countries have stimulated competition and brought about a growing integration of domestic and offshore markets—which in turn has generated important efficiency gains. The degree of integration of international capital markets is captured better by rate-of-return differentials (appropriately defined) between markets than by the scale of capital flows themselves. Third, private rather than official capital flows have been the principal source of financing the historically large current account and fiscal imbalances of the industrial countries in the 1970s and 1980s, and within these private flows, flows of securities have increasingly dominated banking flows. Private flows accounted for approximately 75 percent of the financing of the cumulative U.S. current account deficit during 1983–88. Fourth, after borrowing heavily from international banks in the 1970s, many indebted developing countries found their access to international financial markets sharply curtailed in the 1980s, resulting in a pattern of official and private capital flows to them in the late 1980s that was similar to that of the early 1970s. Net nondebt-creating flows nearly matched the cumulative current account deficit of indebted developing countries over the period 1987–89.

The second section examines the determinants of net and gross capital flows. Net capital flows, which serve as the financial counterpart to the transfer of real resources through a trade or current account imbalance, arise only when saving and investment are imbalanced within countries. Gross capital flows, which allow individuals and firms to adjust the form of financial claims issued and held, can be important in improving the liquidity of port-folios and in diversifying risks. Since gross capital flows can be mutually offsetting across countries, they need not involve a transfer of real resources.

Over the past two decades, net and gross capital flows have responded to economic fundamentals, official policies, and market distortions. These economic fundamentals included the global investment opportunities available, the covariances between expected returns on various investments, the growth of wealth in different countries, and differences across economic agents in their willingness to assume risk and in rates of time preference. The relevant official policies include tax policies; official guarantees; capital controls; limitations on the entry of foreign firms into domestic markets; restrictions on the domestic activities, products, locations, and interest rates charged by financial institutions; misaligned real exchange rates; restrictive trade policies; debt-servicing arrears and reschedulings; and unstable macroeconomic policies. Distortions or imperfections inherent in the operation of private markets, such as transaction costs and asymmetric information among market participants, can also limit portfolio diversification and sometimes even distort asset prices.

It has proved difficult to obtain stable empirical relationships between (gross or net) capital flows and their underlying determinants. A key reason is that capital markets can respond to a shock either through capital flows, or through a change in asset prices, or through some combination of the two. Most econometric models have by now forsaken traditional capital flow equations in favor of modeling financial linkages via (arbitrage-type) interest rate parity relationships. Nevertheless, the experience of the past two decades highlights particular fundamentals and/or distortions as playing an important role in explaining particular capital flow developments. It would be hard, for example, to understand the large-scale capital outflows from Germany1 in 1987–89 without reference to the planned withholding tax on interest income; or the large capital inflow into the United States during 1981–85 without reference to the sharp differences in the monetary/fiscal policy mix between the United States on the one hand and Japan and Germany on the other; or the large-scale capital flight from many developing countries during 1977–84 without reference to uncompetitive interest and exchange rates, large fiscal deficits, and high external debt burdens in these countries.

The third section discusses the systemic consequences of international capital flows for both industrial and developing countries. While it is widely recognized that the closer integration of major domestic and offshore financial markets has yielded important efficiency benefits, structural changes in these financial markets may have reduced the effectiveness of monetary and fiscal policy, may have created new systemic risks associated with increased asset price variability, and may have made more uncertain the access by many developing countries to these markets.

Financial innovation and liberalization provide market participants with “safety valve” sources of credit (whenever domestic credit conditions tighten) and with alternatives for the placement of funds that offer market-related rates of return. This process generally weakens the predictability of the relationship between the authorities’ operating instruments, monetary aggregates, and nominal income; reduces the effect of a change in the level of interest rates on the substitution between money and nonmonetary assets; and implies that monetary policy now works more through changes in interest rates and exchange rates than through liquidity or credit constraints. However, the track record of industrial countries in the 1980s does not suggest that the ability of monetary policy to promote price stability has been impaired.

The increased availability of external funding for financing fiscal imbalances raises the issue of whether “fiscal discipline” has been weakened. One answer is that private markets will impose such discipline progressively on errant borrowers by first charging a widening interest rate differential and then, only if this warning is ignored, by excluding the borrower from the market. But if market discipline is to operate in such a progressive manner, the following four conditions need to be satisfied: (1) there must not be any explicit or implicit guarantee of a bailout by the central or regional authorities; (2) there must not be a “monetization” of the borrower’s debts by central bank purchases of these debts; (3) market participants must be fully aware of the debtor’s obligations so that an accurate assessment can be made of its debt-servicing obligation and capacity; and (4) the financial system must be strong enough that no single borrower is regarded as “too large to fail.” Experience suggests that these conditions have often not been fulfilled.

The growing integration of international capital markets has also increased the incentives and pressures for greater coordination of macroeconomic and financial policies. The increased incentives come partly from the potentially larger “spillover effects” of domestic macroeconomic policy actions when linkages among financial markets are stronger. Given the speed with which major financial shocks can now spread across global markets (as in the equity market crash of October 1987), the case for coordinated crisis management policies, especially among central banks, seems to have been strengthened. In addition, official measures in industrial countries to limit contagion effects in international financial markets have centered on strengthening the structures of major financial institutions and of payments, clearance, and settlement systems as well as on developing better techniques of crisis management.

Official capital flows represent yet another mechanism by which asset prices and the geographical distribution of global saving and investment can be influenced. Except for military assistance, the dominant official capital flows among industrial countries have reflected exchange market intervention. The usefulness and limits of sterilized intervention are by now well known. The key implication of conducting intervention in an environment of potentially large private capital flows is that it will be more difficult for authorities in a single country to achieve their objectives by “going it alone”; if anything, the case for concerted intervention (rather than unilateral intervention) would seem to be strengthened.

Official capital flows from industrial to developing countries encompass a broad range of economic, humanitarian, and military assistance and have been supplied under highly heterogeneous terms and conditions. The availability of official flows helped cushion the sharply reduced access to private international financial markets by many developing countries since 1982. The 1980s suggest that re-establishing creditworthiness can be a lengthy process, even for countries taking strong adjustment measures, and that official flows can make a valuable contribution during the transition.

This section also reviews more broadly the extent to which developing countries can benefit from a more integrated international financial system. It is argued that the outcome depends largely on whether perceptions of creditworthiness are subject to “contagion effects,” on how adept developing countries become in utilizing financial instruments and markets most suitable to their needs, on how successful developing country policy reforms are in both attracting greater private inflows and stemming capital flight, and on whether external resources are put to productive uses.

Private capital flows to developing countries in the 1970s were dominated by commercial bank lending. Flows of securities, including the use of market-based hedging instruments, and direct foreign investment are likely to play a relatively larger role in the 1990s. During the late nineteenth century and the 1920s, long-term bond financing was the principal vehicle for resource transfer between industrial and developing countries. Such bonds can be used to match the maturity of a long-term investment with its financing. At present, considerations of creditworthiness limit the number of developing countries that can tap this market; as creditworthiness is restored, bond markets should become a more prominent source of external finance. Equally promising are equity-related capital flows, namely, foreign direct investment and portfolio investment in equities. One constraint is that only a small number of developing countries presently offer foreign investors free and unrestricted repatriation of capital and of income from shares.

International capital markets can also be used to advantage by developing countries to manage their foreign asset and liability positions. Short-term hedging operations can be carried out using financial and commodities futures and options, and medium-term hedges can be constructed with interest rate caps and forward agreements for major exchange rates and commodity prices. Despite some nontrivial costs and constraints associated with using these hedging instruments, developing country recourse to them has expanded in recent years.

Although the measurement of capital flight raises difficult conceptual and measurement issues, empirical analyses have generally concluded that the domestic residents of many developing countries sharply increased their holdings of external assets during the 1970s and 1980s. While this increase has in part reflected the desire of residents to hold internationally diversified portfolios, it has also been a response to the perceived risks of holding domestic financial instruments. Sound macroeconomic policies, financial liberalizations, and other structural reforms are likely to be key elements in creating incentives for the residents of developing countries to hold their savings in domestic rather than external financial markets.

Studies dealing with systemic risks in payments, clearance, and settlement systems, the determinants of foreign direct investment, and the pricing of risk in securities markets comprise the other chapters in this Occasional Paper.

Trends in International Capital Flows

This section reviews trends in international capital flows among industrial and developing countries during the 1970s and 1980s. The discussion is based on the data presented in the IMF’s Balance of Payments Yearbook, International Financial Statistics, and International Banking Statistics, which reflect the conceptual framework for the capital account described in the Fund’s Balance of Payments Manual (1977).

Measurement of Capital Flows

A comprehensive examination of the problems associated with measuring international capital flows will be made in a forthcoming report of the Working Party on the Study of the Measurement of International Capital Flows. The measurement of capital account transactions raises the fundamental issues of defining what constitutes a cross-border financial transaction2 and of deciding how to treat changes in the value of holdings of foreign financial instruments that do not arise as a result of transactions with a nonresident.3 If all countries4 adopted symmetrical accounting treatments of cross-border transactions, the reported capital outflows and inflows of all countries would, in principle, just match. However, discrepancies can arise if a transaction is not recorded or recorded asymmetrically in the accounts of the capital exporting and capital importing countries.5 Moreover, the scale of capital flows may be understated if a transaction is missed in both sets of accounts. These measurement difficulties are reflected in the global capital account discrepancy, which averaged SDR 35 billion a year during 1982–88 (Table 1).6

Table 1.

Global Balances on Capital Account, 1982–88

(In billions of SDRs)

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Source: International Monetary Fund, Balance of Payments Statistics, Vol. 40, Part 2.

Including exceptional financing transactions.

New financial instruments and institutional arrangements in major domestic and offshore financial markets have contributed to these measurement problems.7 New instruments, such as interest rate and exchange rate swaps, required that new reporting channels be developed. More generally, changes in computer and telecommunication technologies have increased the ability of domestic institutions to undertake transactions with nonresidents that are beyond the reach of existing domestic reporting requirements. The extent to which these structural changes have led to an underreporting of capital flows is not yet known. In what follows, it is assumed that measurement problems are not severe enough to invalidate the broad trends evident in existing data.

Major Trends

Four key trends have characterized capital flows during the 1970s and 1980s.

Sharp Expansion in Scale of Net and Cross Capital Flows in Major Industrial Countries

The sharp upswing in the level of net capital flows among the major industrial countries has been the counterpart to the historically large current account imbalances during the 1970s and 1980s (Table 2). Although large current account imbalances were evident in 1973–75 and in 1979–81, net capital flows between the industrial countries expanded most rapidly after 1982. Germany had an average annual net capital outflow of $1 billion (equivalent to 0.5 percent of GNP) in 1970–72; in 1985–88, this outflow had grown to an average of $38 billion a year (equal to nearly 4 percent of GNP). Over the same period, Japan’s capital outflow rose from $5 billion a year to $75 billion a year (3.6 percent of GNP). The net capital inflow into the United States accelerated from an average of $2 billion a year (0.1 percent of GNP) in 1970–72 to an average of $129 billion a year (3 percent of GNP) in 1985–88.

Table 2.

Net International Capital Flows of Major Industrial Countries, 1970–88

(Period averages)

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Source: International Monetary Fund, Balance of Payments Statistics.

This is taken as the counterpart to the current account imbalance. A positive value indicates a capital account surplus (inflow).

An even more rapid expansion has occurred in the scale of gross capital flows (Table 3), which has been reflected in increased cross-border banking and flows of securities, the development of the offshore (Eurocurrency) markets, and the entry of foreign institutions into domestic markets. For example, the stock of international loans (net of redepositing by banks) rose from $175 billion at the end of December 1973 (5 percent of industrial countries’ GNP) to $2,490 billion at the end of September 1989 (17 percent of industrial countries’ GNP). The stock of Eurocurrency and foreign bonds also increased from $259 billion at the end of 1982 (3 percent of industrial countries’ GNP) to $1,085 billion at the end of 1988 (8 percent of industrial countries’ GNP). Moreover, between 1979 and 1988, the volume of international equity transactions increased on average by 18 percent a year; and reached $1.2 trillion in 1988.

Table 3.

International Bank Lending and International Bonds, 1973–First Three Quarters of 19891

(In billions of U.S. dollars)

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Sources: Bank for International Settlements (BIS); Organization for Economic Cooperation and Development (OECD); International Monetary Fund, International Banking Statistics (IBS); and IMF staff estimates.

IMF-based bank lending data on cross-border changes in bank claims are derived from the Fund’s International Banking Statistics (cross-border interbank accounts by residence of borrowing bank plus international bank credits to nonbanks by residence of borrower), excluding changes attributed to exchange rate movements. BIS-based data are derived from quarterly statistics contained in the BIS’s International Banking Developments; the figures shown are adjusted for the effects of exchange rate movements. Differences between the IMF data and the BIS data are mainly accounted for by the different coverages. The BIS data are derived from geographical analyses provided by banks in the BIS reporting area. The IMF data derive cross-border interbank positions from the regular money and banking data supplied by member countries, while the IMF analysis of transactions with nonbanks is based on data from geographical breakdowns provided by the BIS reporting countries and additional banking centers. Neither the IBS nor the BIS series are fully comparable over time because of the expansion of coverage.

Provisional data.

The “foreign” presence in major domestic financial markets has also increased as the need to finance large fiscal and current account balances in the industrial countries has created pressures for the breakdown of restrictions on domestic and external financial transactions. Data on the residency of the holders of industrial countries’ bonds are notoriously poor; nonetheless the United States reported that, while foreign and international entities held 7 percent of the Federal Government’s outstanding securities at the end of 1970, the proportion reached nearly 17 percent at the end of 1988. In Germany, central government debt held by foreigners was reported to have increased from 5 percent at the end of 1974 to 34 percent at the end of 1988. As cross-border holdings of equity have expanded, Salomon Brothers (1989) have estimated, for example, that the average correlation between U.S. stock prices and those in other major markets has increased from 0.35 in 1975–79 to 0.62 in 1985–88. In any case, it has become evident that large shocks can be quickly transmitted across these markets (such as in October 1987 and October 1989). Competitive pressures in major domestic financial markets have also been increased by the entry of foreign institutions. Between 1970 and 1985 the number of foreign banking offices in the United States rose from about 50 to over 780, whereas in Germany, foreign banking offices rose from 77 to 287.

Increased competition has also generated important efficiency gains in major domestic and offshore markets, which have been reflected in a sharp decline in bid-ask spreads.8 In the Eurocurrency markets, for example, bid-ask spreads for three- and six-month time deposits denominated in some currencies had declined by the late 1980s to only one fifth of the levels evident in the early 1980s (Table 4). These spreads are now relatively uniform across currencies.

Table 4.

Bid-Ask Spreads on Eurocurrency Deposits1

(Average of daily spreads)

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Source: Data Resources, Incorporated.

Measured in basis points.

Globalization and Integration of Offshore and Major Domestic Financial Markets

The progressive relaxation of capital controls as well as the broader financial liberalization in the industrial countries has brought about a growing integration and globalization of major offshore and domestic financial markets. Indeed, the integration of global financial markets has proceeded much more rapidly than that of goods markets—in part because the latter has been inhibited by protectionism. As discussed in the final section, this growing integration of financial markets has important implications for the effectiveness of macroeconomic policies and systemic risks.

There are several different approaches to measuring the degree of integration of financial markets. A high degree of integration can be present even without a large volume of capital flows. For example, trading of some benchmark U.S. Government securities often takes place simultaneously on markets both inside and outside the United States. The announcement of an unanticipated event (such as an increase in the Federal Reserve’s discount rate) can trigger an immediate adjustment of the prices of these securities in the markets in all countries without any capital flows or even any transactions occurring. Capital flows between countries are likely to occur only if participants in the different markets have conflicting views on the effects of the unanticipated event. This suggests that other measures besides the scale of capital flows must be examined when attempting to gauge the degree of integration between financial markets.

One measure of the integration of major domestic and offshore markets is the interest differential between the cost of interbank funds denominated in the same currency in the two markets.9 As indicated in Chart 1, these differentials have been reduced dramatically during the 1980s, especially for countries such as France, which have relaxed their capital controls.

Chart 1.
Chart 1.

Domestic and Offshore Interest Rates: United States and France, June 1973–December 1989

(In percent)

Sources: Data Resources, Incorporated; Organization for Economic Cooperation and Development (OECD).1 Three-month Eurocurrency deposit bid rate.2 Rate on negotiable three-month certificates of deposit, secondary market.3 Three-month interbank loan rate (OECD).

Another measure of interest rate relationships is the covered interest rate differential. It can be defined as the difference between the interest rates on instruments issued by comparable borrowers but denominated in different currencies, adjusted for the cost of cover in the forward exchange market.10 Covered interest rate parity (CIP) is achieved when this difference is arbitraged to zero. Recent empirical studies11 have concluded that the removal or weakening of exchange controls in the industrial countries has helped establish CIP in many short-term markets. Such arbitrage has been most clearly evident in the relationship between interest rates on Eurocurrency deposits (Chart 2) and between onshore and offshore interest rates for comparable monetary instruments.12

Chart 2.
Chart 2.

Covered and Uncovered Interest Rate Differentials:1 U.S. Dollar Versus Other Currencies

Source: Data Resources, Incorporated.1 The uncovered differential is the rate on three-month Eurocurrency U.S. dollar deposits minus the rate on three-month Eurocurrency deposits denominated in the specified currency. The covered differential is the uncovered differential minus the three-month forward exchange rate premium.

Yet a third indicator is provided by deviations from uncovered interest parity (UIP), where the interest rate differential is adjusted for the expected rate of depreciation of the domestic currency rather than for the cost of forward cover. This concept is more general in the sense that it can be applied to even long-maturity instruments where forward cover is not available. However, judging whether UIP has been satisfied requires estimating the expected rate of depreciation, which is not directly observable. Empirical analyses13 suggest that departures from UIP could therefore reflect either a lack of integration, or errors in measuring expected exchange rate depreciation, or a risk premium.14

Capital market integration can also be measured in terms of departures from real interest rate parity.15 Such deviations can reflect the failure of either UIP or purchasing power parity (PPP). Since the expected change in the exchange rate and in price levels at home and abroad are not directly observable, it has proved difficult to identify the most important sources of real interest rate spreads. On an ex post basis, real interest rate spreads, especially on longer-term instruments, have remained significantly large (Chart 3).16

Chart 3.
Chart 3.

Real Interest Rate Differentials1

(In percent per annum)

Sources: International Monetary Fund, International Financial Statistics; Data Resources, Incorporated.1 This differential equals the difference between the real rate of interest on instruments denominated in each currency. The real interest rate in each country is defined as the three-month Eurocurrency deposit rate adjusted for the inflation (as measured by the consumer price index) that occurred during the subsequent three months.

To sum up, recent studies of interest rate differentials suggest that integration in major financial markets has proceeded quite far for short-term instruments. In contrast, the presence of exchange risk still limits the degree of financial integration for longer-term markets—although returns on longer-term debt and equity instruments have recently shown a greater tendency to move together—especially during periods of turbulence, such as October 1987.

In a world characterized by highly integrated capital markets, domestic saving and investment need not be tightly linked, since domestic investors can rely on external financing. However, starting with work by Feldstein and Horioka (1980), it has generally been found that the ratios of investment to income and saving to income have in practice been highly correlated, and this holds for both industrial and developing countries.17

This apparent conflict between high correlations of national saving and investment (which suggest low capital mobility) and the shrinking of crossborder interest rate differentials (which suggest high capital mobility) has in turn brought forth several explanations, ranging from government policy responses to current account developments, to barriers that inhibit net wealth transfers, to differences between private and official behavior.18 At this point, the evidence needed to discriminate among these alternative hypotheses is not yet available.19

Dominant Role of Private Flows In Financing Fiscal and Current Account Imbalances

Private capital flows provided most of the cross-country financing of fiscal and current account imbalances for the developing countries in the 1970s and for the industrial countries in the 1970s and 1980s. Moreover, while banking flows were the dominant source of private financing to developing countries in the 1970s, transactions in securities became an increasingly important element in private capital flows among the industrial countries throughout the 1970s and 1980s.

A hallmark of the period 1973–81 was that the financing of the current account imbalances of the non-oil developing countries (Tables 5 and 6) and of the oil exporting developing countries20 (Tables 7 and 8) relied much more than in earlier periods on the use of indirect finance (through financial intermediaries) and less on direct finance (through bond issuance or foreign direct investment).21 The large current account surpluses of the oil exporting developing countries initially led to the placement of funds in bank deposits and short-term government securities in the industrial countries and offshore markets; only later was a large proportion of these surpluses invested in long-term securities and other less liquid assets.22 By the same token, nearly three fourths of the current account deficits for the non-oil developing countries were financed by other net external borrowing.23

Table 5.

Non-Oil Developing Countries: External Financing, 1969–79

(In billions of U.S. dollars)

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Source: International Monetary Fund, World Economic Outlook, various issues.Note: Except where otherwise footnoted, estimates shown here are based on national balance of payments statistics. These flows are not always easily reconcilable with year-to-year changes in either debtor- or creditor-reported debt statistics, in part because the latter are affected by changes in valuation.

Equivalent to current account deficit less official transfers. In this table, official transfers are treated as external financing.

Pertains primarily to export credit.

Positioned here on the presumption that estimates reflect primarily unrecorded capital outflows.

Includes use of Fund credit under General Resources Account, Trust Fund, structural adjustment facility, and enhanced structural adjustment facility. The impact of prospective programs is incorporated.

Comprise short-term borrowing by monetary authorities from other monetary authorities.

Estimates of net disbursements by official creditors (other than monetary authorities) derived from debt statistics. Official net disbursements include the increase in official claims caused by the transfer of officially guaranteed claims to the guarantor agency in the creditor country, usually in the context of debt reschedulings.

Residually calculated. Except for discrepancies in coverage, amounts shown reflect net external borrowing from private creditors and short-term official flows (primarily interest arrears on official debt).

Based on changes in cross-border bank claims reported in the Fund’s International Banking Statistics, adjusted for valuation changes attributed to exchange rate movements. Excludes six offshore banking centers covered by the World Economic Outlook (The Bahamas, Bahrain, Hong Kong, Netherlands Antilles, Panama, and Singapore).

Table 6.

Non-Oil Developing Countries: External Financing, 1980–89

(In billions of U.S. dollars)

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Source: International Monetary Fund, World Economic Outlook, various issues.Note: Except where otherwise footnoted, estimates shown here are based on national balance of payments statistics. These flows are not always easily reconcilable with year-to-year changes in either debtor- or creditor-reported debt statistics, in part because the latter are affected by changes in valuation.

Equivalent to current account deficit less official transfers. In this table, official transfers are treated as external financing.

Pertains primarily to export credit.

Positioned here on the presumption that estimates reflect primarily unrecorded capital outflows.

Includes use of Fund credit under General Resources Account, Trust Fund, structural adjustment facility, and enhanced structural adjustment facility. The impact of prospective programs is incorporated.

Comprises short-term borrowing by monetary authorities from other monetary authorities.

Estimatesof net disbursements by official creditors (other than monetary authorities) derived from debt statistics. Official net disbursements include the increase in official claims caused by the transfer of officially guaranteed claims to the guarantor agency in the creditor country, usually in the context of debt reschedulings.

Residually calculated. Except for discrepancies in coverage, amounts shown reflect net external borrowing from private creditors and short-term official flows (primarily interest arrears on official debt).

Based on changes in cross-border bank claims reported in the Fund’s International Banking Statistics, adjusted for valuation changes attributed to exchange rate movements. Excludes six offshore banking centers covered by the World Economic Outlook (The Bahamas, Bahrain, Hong Kong, Netherlands Antilles, Panama, and Singapore).

Table 7.

Oil Exporting Developing Countries: External Financing, 1969–79

(In billions of U.S. dollars)

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Source: International Monetary Fund, World Economic Outlook, various issues.Note: Except where otherwise footnoted, estimates shown here are based on national balance of payments statistics. These flows are not always easily reconcilable with year-to-year changes in either debtor- or creditor-reported debt statistics, in part because the latter are affected by changes in valuation.

Equivalent to current account deficit less official transfers. In this table, official transfers are treated as external financing.

Pertains primarily to export credit.

Positioned here on the presumption that estimates reflect primarily unrecorded capital outflows.

Includes use of Fund credit under General Resources Account, Trust Fund, structural adjustment facility, and enhanced structural adjustment facility. The impact of prospective programs is incorporated.

Comprises short-term borrowing by monetary authorities from other monetary authorities.

Estimates of net disbursements by official creditors (other than monetary authorities) derived from debt statistics. Official net disbursements include the increase in official claims caused by the transfer of officially guaranteed claims to the guarantor agency in the creditor country, usually in the context of debt reschedulings.

Residually calculated. Except for discrepancies in coverage, amounts shown reflect net external borrowing from private creditors and short-term official flows (primarily interest arrears on official debt).

Based on changes in cross-border bank claims reported in the Fund’s International Banking Statistics, adjusted for valuation changes attributed to exchange rate movements. Excludes six offshore banking centers covered by the World Economic Outlook (The Bahamas, Bahrain, Hong Kong, Netherlands Antilles, Panama, and Singapore).

Table 8.

Oil Exporting Developing Countries: External Financing, 1980–89

(In billions of U.S. dollars)

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Source: International Monetary Fund, World Economic Outlook, various issues.Note: Except where otherwise footnoted, estimates shown here are based on national balance of payments statistics. These flows are not always easily reconcilable with year-to-year changes in either debtor- or creditor-reported debt statistics, in part because the latter are affected by changes in valuation.

Equivalent to current account deficit less official transfers. In this table, official transfers are treated as external financing.

Pertains primarily to export credit.

Positioned here on the presumption that estimates reflect primarily unrecorded capital outflows.

Includes use of Fund credit under General Resources Account, Trust Fund, structural adjustment facility, and enhanced structural adjustment facility. The impact of prospective programs is incorporated.

Comprises short-term borrowing by monetary authorities from other monetary authorities.

Estimates of net disbursements by official creditors (other than monetary authorities) derived from debt statistics. Official net disbursements include the increase in official claims caused by the transfer of officially guaranteed claims to the guarantor agency in the creditor country, usually in the context of deb t reschedulings.

Residually calculated. Except for discrepancies in coverage, amounts shown reflect net external borrowing from private creditors and short-term official flows (primarily interest arrears on official debt).

Based on changes in cross-border bank claims reported in the Fund’s International Banking Statistics, adjusted for valuation changes attributed to exchange rate movements. Excludes six offshore banking centers covered by the World Economic Outlook (The Bahamas, Bahrain, Hong Kong, Netherlands Antilles, Panama, and Singapore).

Any description of capital flows of developing countries should also pay attention to the development of capital flight. Notwithstanding the considerable conceptual and measurement problems involved, previous World Economic Outlook studies24 have estimated the scale of capital flight from developing countries as $165-200 billion in 1975–85. The pace of capital flight was uneven—with about $5 billion a year occurring during 1975–78, and $25-30 billion a year during 1979–82. Since both net lending by foreign creditors to developing countries and capital flight increased sharply during the second half of the 1970s, the intermediation between domestic savings and investment in some developing countries was essentially internationalized: a portion of domestic savings was placed offshore, and this portion was offset by increased bank claims on national governments and private corporations. With the onset of debt-servicing difficulties for many developing countries in the 1980s, this intermediation process stopped. At this point, capital flight involved a net real resource transfer in the sense that the residents of the indebted developing countries could obtain net external claims only through larger net exports of goods and services to the rest of the world.

In many of the industrial countries during the 1970s and 1980s, large fiscal deficits were financed primarily through bond issuance;25 domestic bond markets therefore expanded sharply,26 with foreigners purchasing an increasing share of these bonds. In addition, cross-border transactions in private securities and foreign direct investment expanded sharply. Perhaps the most striking feature was the surge in cross-border portfolio investment flows. While the United States experienced an average portfolio capital inflow of $0.1 billion in 1970–82, this inflow increased to an average of $40 billion in 1983–88. For Japan, an average annual inflow of $1 billion of portfolio investment in 1970–82 changed to an average annual outflow of $52 billion in 1983–88.

This pattern of private flows was most evident in the capital accounts of the United States, Germany, and Japan. Between 1983 and 1988, when the United States ran a cumulative current account deficit of $664 billion, inflows of portfolio investment, other private short-term capital, and net foreign direct investment financed about 75 percent of the external deficit.27

One counterpart to the large U.S. current account deficits was current account surpluses in Germany and Japan. Over the period 1983–88, for example, Germany and Japan had cumulative current account surpluses of $165 billion and $357 billion, respectively. However, the composition of their capital flows differed. While cumulative foreign direct investment abroad was equivalent to about 22 percent of the cumulative current account surplus for both countries during 1983–88, cumulative net portfolio investment abroad amounted to $314 billion for Japan (88 percent of its cumulative current account surplus) versus $16 billion for Germany (10 percent of its cumulative current account surplus). In Japan, moreover, other long-term capital outflows equaled $118 billion (33 percent of the cumulative current account surplus) and reserve holdings increased by $64 billion (18 percent of the cumulative current account surplus). In contrast, other long-term capital outflows from Germany amounted to only $11 billion (6 percent of the cumulative current account surplus) and reserve accumulation was $8 billion (5 percent of the cumulative current account surplus). The most significant difference in the pattern of capital flows was in short-term flows. While Germany experienced a short-term outflow of $112 billion in 1983–88, Japan experienced an inflow of $219 billion.28

Similarities Between Early 1970s and Late 1980s in Pattern of Official and Private Capital Flows to Developing Countries

By the late 1980s, the pattern of official and private capital flows to net debtor developing countries was similar in a number of respects to that in the early 1970s. In both periods, limited access to international financial markets29 resulted in nondebt-creating capital flows, especially from official sources, providing most of the financing for the current account deficits of the indebted developing countries (Tables 9 and 10 and Chart 4). For example, nondebt-creating flows, which represented 58 percent of the net debtors’ current account imbalances in 1971–72, amounted to only 33 percent of their current account deficits in 1973–82. However, in 1987–89, such flows provided 98 percent of the financing of this group’s current account deficits.30 Moreover, the sum of official transfers and net long-term borrowing from official creditors represented an even larger proportion of the net debtors’ current account deficit in 1987–89 (115 percent) than in 1971–72 (69 percent).31 These official transfers and loans were also equivalent to about 1.3 percent of the net debtors’ GNPs in both 1971–72 and 1987–89.

Table 9.

Net Debtor Developing Countries: External Financing, 1969–79

(In billions of U.S. dollars)

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Source: International Monetary Fund, World Economic Outlook, various issues.Note: Except where otherwise footnoted, estimates shown here are based on national balance of payments statistics. These flows are not always easily reconcilable with year-to-year changes in either debtor- or creditor-reported debt statistics, in part because the latter are affected by changes in valuation.

Equivalent to current account deficit less official transfers. In this table, official transfers are treated as external financing.

Pertains primarily to export credit.

Positioned here on the presumption that estimates reflect primarily unrecorded capital outflows.

Includes use of Fund credit under General Resources Account, Trust Fund, structural adjustment facility, and enhanced structural adjustment facility. The impact of prospective programs is incorporated.

Comprises short-term borrowing by monetary authorities from other monetary authorities.

Estimates of net disbursements by official creditors (other than monetary authorities) derived from debt statistics. Official net disbursements include the increase in official claims caused by the transfer of officially guaranteed claims to the guarantor agency in the creditor country, usually in the context of debt reschedulings.

Residually calculated. Except for discrepancies in coverage, amounts shown reflect net external borrowing from private creditors and short-term official flows (primarily interest arrears on official debt).

Based on changes in cross-border bank claims reported in the Fund’s International Banking Statistics, adjusted for valuation changes attributed to exchange rate movements. Excludes six offshore banking centers covered by the World Economic Outlook (The Bahamas, Bahrain, Hong Kong, Netherlands Antilles, Panama, and Singapore).

Table 10.

Net Debtor Developing Countries: External Financing, 1980–89

(In billions of U.S. dollars)

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Source: International Monetary Fund, World Economic Outlook, various issues.Note: Except where otherwise footnoted, estimates shown here are based on national balance of payments statistics. These flows are not always easily reconcilable with year-to-year changes in either debtor- or creditor-reported debt statistics, in part because the latter are affected by changes in valuation.

Equivalent to current account deficit less official transfers. In this table, official transfers are treated as external financing.

Pertains primarily to export credit.

Positioned here on the presumption that estimates reflect primarily unrecorded capital outflows.

Includes use of Fund credit under General Resources Account, Trust Fund, structural adjustment facility, and enhanced structural adjustment facility. The impact of prospective programs is incorporated.

Comprise s short-term borrowing by monetary authorities from other monetary authorities.

Estimatesof net disbursements by official creditors (other than monetary authorities) derived from debt statistics. Official net disbursements include the increase in official claims caused by the transfer of officially guaranteed claims to the guarantor agency in the creditor country, usually in the context of debt reschedulings.

Residually calculated. Except for discrepancies in coverage, amounts shown reflect net external borrowing from private creditors and short-term official flows (primarily interest arrears on official debt).

Based on changes in cross-border bank claims reported in the Fund’s International Banking Statistics, adjusted for valuation changes attributed to exchange rate movements. Excludes six offshore banking centers covered by the World Economic Outlook (The Bahamas, Bahrain, Hong Kong, Netherlands Antilles, Panama, and Singapore).

Chart 4.
Chart 4.

External Debt-Creditor Breakdown

(In billions of U.S. dollars)

Official flows were important for financing the current account deficits of both the net debtor developing countries that experienced debt-servicing difficulties and those that did not. For example, official transfers and net long-term loans from official creditors to the net debtor developing countries with recent debt-servicing problems rose from the equivalent of 46 percent of this group’s current account deficit in 1971–72 to 101 percent in 1987–89, whereas for the net debtor developing countries without debt-servicing difficulties the corresponding proportion rose from 114 percent to 154 percent. However, this overstates the importance of these official flows lo the countries without debt-servicing difficulties, since their current account deficits were smaller than those of the countries with debt-servicing difficulties in both the early 1970s and the late 1980s. An alternative perspective is provided by the fact that these official flows increased from the equivalent of 1.2 percent to 1.6 percent of the combined GNPs of the net debtor developing countries with recent debt-servicing difficulties between 1971–72 and 1987–89; but, during the same period, they fell from the equivalent of 1.8 percent to 1.0 percent of the combined GNPs of those countries without debt-servicing difficulties.32

One difference in the position of the net debtor developing countries in the early 1970s and the late 1980s, however, was that exceptional financing (including arrears and reschedulings with both private and official creditors) was equivalent to only 4 percent of their current account imbalances in 1971–72 but to nearly 145 percent in 1987–89. In addition, as discussed in the final section, the residents of these countries also held a much larger stock of external assets at the end of the 1980s than at the beginning of the 1970s.

Determinants of International Capital Flows

The sharp changes in the pattern of net and gross international capital flows during the 1970s and 1980s raise the issues of what factors motivated these Hows and of how they affected the performance of the international economy. As noted in the previous section, the private component of these flows has reflected both the reallocation of global savings across countries and the international diversification of portfolios. This section examines how cross-border transactions have responded to economic fundamentals, official policies, and capital market distortions.

Role of Financial Markets and the Fundamental Determinants of Capital Flows

The primary function of domestic and international financial markets is to channel resources from surplus units—households, firms, or governments—that are spending less than their revenues, or saving, to deficit units—that are spending more than their revenues, or dissaving. Such financial market transactions can help overcome the limitations imposed by self-financing investment expenditures and, by directing savings toward the most productive investments, can raise the overall productivity of investment. As a result, savers can realize a higher average yield from postponing consumption. This function of financial markets gives rise to net flows of funds among economic units. Net international capital flows are the financial counterpart to a real transfer of resources through a trade or current account imbalance, which occurs only when saving and investment are unbalanced across countries.

Channeling resources from surplus to deficit units is clearly not the only function of international financial markets. Many economic units are simultaneously borrowers and lenders: most financial intermediaries borrow in one form and lend in another. In addition, both households and firms diversify their portfolio holdings to reduce risks. Gross capital flows between countries, which may be mutually offsetting, can be important in improving the liquidity of a portfolio and in diversifying risks. Diversifying across assets located in different countries may be particularly useful in reducing country-specific risk: for example, cocoa production in Cote d’lvoire is affected by very different events than is cadmium production in Canada, so the returns to these activities have low covariance. A portfolio combining shares in these two activities would be less risky than a portfolio limited to one or the other.33

In contrast to net capital flows, gross capital flows do not necessarily correspond to a transfer of real resources across countries. Indeed, most gross capital flows arise as portfolio managers attempt to improve the composition of their existing portfolios (to diversify risks or minimize tax burdens) rather than the scale of their portfolios.

Gross international flows of capital have risen sharply over the last two decades as investors (often institutional investors such as insurance companies and pension funds) have sought to diversify their portfolios internationally.34 This diversification has been facilitated by new computer and telecommunications technologies that have allowed investors to examine a broader range of investments in many countries and to manage more effectively the risks inherent in their global portfolios.

While international capital flows can potentially play an important role in improving economic efficiency, this contribution can be realized only if financial markets evaluate correctly the portfolio preferences of savers; identify and fund the most productive investments; establish asset prices that appropriately reflect the underlying risks and returns; and help overcome limitations introduced by uncertainty and incomplete information.35 By now, an extensive literature has developed on how financial markets incorporate risks and returns into the prices of financial claims.36 In the absence of distortions, assets would be priced so that the more risky assets offered higher rates of return. Moreover, while overall risk could be reduced to some minimum level by holding a diversified portfolio, some nondiversifiable (systematic) risk would remain and would have to be reflected in the prices of the risky assets. In addition, since an asset’s contribution to the riskiness of the portfolio would depend not only on its own riskiness but also on the covariance of its return with the returns on other assets in the market portfolio,37 investors would have to be compensated, via higher returns, for a higher covariance. These considerations imply that the fundamental determinants of capital flows in the absence of distortions would include the set of investment opportunities available throughout the global economy, the covariances between the expected returns on various investment projects, and the growth of wealth in different countries; the preferences of households in different countries for present and future consumption; and their willingness to assume risks.

A problem of attempting to measure empirically the relative influence of these fundamental factors on capital flows is that international capital markets can respond to a shock in one country either through capital flows or through changes in the prices of the country’s financial claims, or through some combination of capital flows and asset price changes. As noted in the previous section, there can be a trade-off between asset price adjustment and net capital flows in helping to restore capital market equilibrium. As markets become more highly integrated and portfolios become more internationally diversified, asset price changes are likely to substitute increasingly for net capital flows to restore market equilibrium. This again illustrates one of the dangers of using the volume of capital flows to measure the degree of integration.

This trade-off between asset price changes and capital flows also helps to explain why most studies have had difficulties in obtaining stable empirical relationships between measures of gross and net capital flows and the fundamental determinants of capital flows. Since changes in the fundamentals impinge on both capital flows and international rate-of-return differentials, and since the direction of influence depends on the source of the shock, it is even in principle difficult to trace a stable relationship between interest differentials and capital flows.

Early empirical studies attempted to trace a relationship between international capital flows and their determinants, with particular attention to the role of international interest rate differentials.38 For example, Branson (1968) started with a portfolio framework in which desired holdings of foreign assets depended on total wealth, domestic and foreign interest rates, and risk considerations. Gross capital flows were then explained in terms of changes in domestic and foreign interest rates, as well as in other factors reflecting changes in wealth and risk.

Kouri and Porter (1974) pointed out that, because capital flows themselves affect interest rates, Branson’s approach could yield biased estimates, leading to an underestimate of the effect of interest differentials on capital flows; the bias could be particularly serious in economies that were highly open to capital movements. Kouri and Porter also focused on the role of net capital movements in adapting to other portfolio shifts, arguing that for instance an increase in desired holdings of money may lead wealth-holders to draw down their holdings of both domestic and foreign bonds, leading to a net inflow of capital. Accordingly, they examined the effects on capital flows of changes in the determinants of demand for money and in domestic credit, and also estimated offset coefficients representing the role of net capital flows in offsetting domestic monetary policy. This focus on net capital flows, along with the development of the monetary approach to the balance of payments, also spawned a large body of empirical literature.

The search for an appropriate empirical model of the determination of capital flows was exemplified by successive versions of the Multicoun-try Model (MCM) developed at the Board of Governors of the U.S. Federal Reserve System.39 The early versions of the MCM incorporated the effects of interest rate differentials on gross capital flows, but the estimated empirical relationships had poor explanatory power and yielded implausible results in policy simulations. Later versions of the model sought to explain net flows of capital, either by specifying net liabilities to foreigners as a function of domestic and foreign wealth and the covered interest rate differential, or by trying to explain exchange rate movements rather than the flows of capital themselves. Neither approach proved successful in explaining capital movements. Such lackluster results have typified the empirical literature on capital flows in general; even when stable empirical relationships have been identified within a given period, they have often turned out to provide poor forecasts in subsequent periods. As a result, most econometric models now incorporate financial linkage across countries in terms of interest rate parity relationships that link domestic interest rates through arbitrage to foreign interest rates and to anticipated exchange rate movements. In essence, it has been found easier to specify the asset price linkages that are the outcome of arbitrage between markets—rather than the capital flows that are part of the arbitrage process.

Official Policies, Market Imperfections, and Capital Flows

In addition to the “fundamentals,” government policies and capital market imperfections inherent in the functioning of private markets also affected international capital flows during the 1970s and 1980s. It is difficult, however, to quantify the impact of these policies and distortions on the levels and pattern of capital flows. In part, this reflects the fact that, while many of these policies and imperfections created barriers to cross-border financial transactions, others (such as those created by tax policies) stimulated gross capital flows. Moreover, the effects of such policies and distortions on net capital flows depend ultimately on their impact on saving and investment relationships across countries; these impacts in turn are difficult to gauge with the present lack of empirical evidence. Nonetheless, it is possible to identify some of the qualitative effects of official policies and other factors on capital flows and asset prices.

Influence of Official Policies

Capitai controls, which have been the most important impediments to market access, have seldom completely eliminated all flows, but they have made international transactions more costly and have eliminated certain types of flows. As a result, although foreign assets account for a growing proportion of portfolios, international diversification is far from complete.40

Capital controls have often been supplemented by restrictions on the entry of foreign financial firms into domestic markets. While such restrictions have typically been designed to limit foreign ownership of domestic financial institutions, they have reduced competition both within domestic financial systems and in the provision of financial services across countries. As these restrictions have been removed in the industrial countries, the presence of foreign financial institutions in major domestic markets has sharply expanded; for example, in 1960, only 8 U.S. banks had foreign branches, but by the late 1980s the tally had increased to over 200.41 To some extent, the entry of foreign financial institutions has led to a reduction in measured capital flows even though the provision of financial services by foreign institutions may have increased.

Restrictions on the domestic activities, interest rates, products, and location of financial institutions—which have been used to minimize the risks assumed by certain financial institutions and to separate commercial and investment banking activities—have also influenced international capital flows. Financial institutions often responded to these regulations by providing restricted financial services to domestic enterprises through offshore subsidiaries or branches. The resulting gross international capital flows in reality represented the intermediation of domestic saving and investment. Indeed, the periods of most rapid growth in the Eurocurrency markets in the 1970s often occurred either when Eurocurrency deposit interest rates rose above administered interest rates in major countries or when financial institutions were able to introduce new instruments or services that were not available in domestic markets.

While official guarantees (such as deposit insurance) and the availability of a lender of last resort have enhanced the stability of the financial system in times of crises, they can also lead to a mispricing of risk. In particular, a moral hazard can be created if the managers of large financial institutions, their depositors, and their creditors take the view that some institutions are “too large to fail,” and, as a result, will receive emergency assistance during any period of market disturbance. Such official guarantees can then create a “veil” between the risks assumed by the financial institutions and the perceived risks that depositors or creditors believe they are assuming when making funds available to these institutions. This moral hazard can result in excessive risk being taken by some institutions and in savings being directed to excessively risky investments both within and across countries.42

Taxation may also affect the pattern and scale of capital flows. Holdings of foreign assets are sometimes subject to double taxation, while sometimes they can be used to avoid (or evade) taxation altogether. Divergent tax withholding rates have at times caused capital flows into countries or offshore markets where tax is not withheld.43 Turnover and other taxes on transactions in securities have tended to shift such transactions to other countries or offshore markets.

Since most financial claims are denominated in national currencies,44 domestic monetary policies can induce changes in domestic interest rates, exchange rates, and inflation, which alter the expected relative returns to assets denominated in different currencies. The perception that the monetary policies of the major industrial countries were at times pursuing conflicting or inconsistent objectives led to abrupt adjustments in exchange rates and other asset prices. In developing countries, monetary and exchange rate policies that have created expectations of exchange rate movements have often given rise to currency substitution (that is, shifts between holding foreign and domestic currency) even if they have caused no other capital flows. This phenomenon appears to have been particularly important when the combination of high inflation and ceilings on domestic interest rates has resulted in highly negative real rates of return on domestic bank deposits.

The use of money, and the resulting potential for governments to levy an inflation tax, also implies that a country’s reputation for financial stability may have an important effect on capital flows. Assets denominated in currencies issued by governments with a reputation for sound finance tend to bear lower rates of return than assets denominated in other currencies. Differences in credibility may lead primarily to differences in asset returns, but may also lead to actual gross flows of capital. Another issue associated with the credibility of the government is sovereign risk, which arises because the enforcement of contracts made by the government or residents of a country depends on the cooperation of that government itself. The occurrence of debt-servicing arrears, reschedulings, and default can create barriers to capital mobility and have direct and indirect effects on capital flows.

The role of fiscal imbalances in generating net flows of capital has been emphasized in the World Economic Outlook reports of the 1980s. An excess of government expenditures over revenues must be financed through a net inflow of capital, unless it is offset by an excess of domestic private saving over investment, fn an economy closed to capital movements, the increase in net private saving required by an increased fiscal deficit would have to be brought about through an increase in interest rates. Opening an economy to capital Hows removes the necessity for interest rates to rise in response to an increased fiscal imbalance, unless the country in question is very large; capital flows can thus be a short-run substitute for interest rate increases and the resulting private sector adjustments.45

It has been evident during the 1980s that the cross-country mix of monetary and fiscal policies can affect the pattern of capital flows. For example, the combination of large fiscal deficits and a relatively restrictive monetary policy in the United States was at times associated with both an appreciation of its currency and a large capital inflow, as well as higher domestic interest rates. Such inflows were often intensified when other major countries simultaneously pursued less restrictive monetary policies and less expansionary fiscal policies.

Exchange rate arrangements can influence both the scale and the direction of capital flows, especially where there is significant overvaluation or undervaluation of exchange rates. For example, Makin (1974) argued that during the late 1960s and early 1970s, an overvaluation of the U.S. dollar, which increased the costs of producing in the United States relative to abroad, distorted the pattern of foreign direct investment flows between the industrial countries. While Makin was concerned with the distortions created by a system of fixed exchange rates, more flexible exchange rate systems could also potentially experience currency misalignments which, although transitory, could be sufficiently long-lived to distort capital flows. If bandwagon effects or speculative “bubbles’” drive exchange rates away from values consistent with economic fundamentals, capital flows may be inhibited by increased exchange rate risk and rapidly changing asset prices. Some have also argued (Feldstein (1990), for example) that attempts by the authorities to stabilize exchange rates when inflation rates differ can lead to persistent trade imbalances, unwarranted exchange rate trends, and rising interest rates. If the authorities succeed in creating the expectation that exchange rates will be stable, investors will then purchase the bonds with the highest nominal yields, which tend to occur in countries with the highest rates of inflation. Such portfolio shifts could lead interest rates in the low-inflation countries to rise and the exchange rates of the high-inflation countries to appreciate.

Market Imperfections

In practice, significant costs are entailed in carrying out transactions in financial assets. These costs reflect the bringing together of buyers and sellers, setting prices at which assets can be bought and sold, and undertaking the actual transfers of funds and assets. Such costs are responsible in part for international differentials in rates of return on otherwise similar assets.46 They likewise help to explain attempts to economize on the costs of trading through the standardization of financial assets, the existence of financial centers in which trading activity is concentrated, and the establishment of accompanying specialized firms providing financial services as brokers, dealers, and specialist traders. Transaction costs also figure in the failure of many individuals to hold portfolios of assets that are diversified, especially across countries: the transaction costs of buying, and gradually adding to, a diversified portfolio of assets may exceed the benefits for many individuals of limited wealth. Indeed, transaction costs are the principal reason why much of the international diversification of portfolios in the industrial countries during the 1980s has been carried out by large institutional investors (pension funds, insurance companies, and mutual funds). Unlike individual investors, they have been able to reduce significantly their per unit transaction cost by pooling transactions, by negotiating commission charges, and by using the private placement markets.

While transaction costs are inevitable, their magnitude and the nature of the barriers they erect are not; more specifically, these costs and barriers are affected by the regulatory, technological, and tax structure. The liberalization of major financial markets (which has increased competition in the provision of financial services) and new computer technologies have reduced transaction costs and allowed residents to hold a wider range of financial assets.

Obtaining the information needed to evaluate and to monitor a borrower’s investment activities can be quite costly. As a result, financial market participants often are faced with asymmetrical information, a problem that can be made more serious as a result of different national systems for accounting standards, disclosure requirements, and the commercial codes governing the enforcement of contracts. The absence of adequate information increases the uncertainly that economic agents face, and can lead savers to demand that a large risk premium be incorporated into yields on securities issued by entities whose creditworthiness is doubtful.

Asymmetrical information also provides a clue as to why lending and deposit taking by financial intermediaries and direct foreign investment have been such important components of international capita! flows. Since information is costly and subject to economies of scale, financial intermediaries can gather information, monitor the activities of borrowers, and diversify at lower cost than can most individuals. This advantage is one of the principal reasons why cross-border bank lending expanded by 19 percent a year during 1973–88. However, the development of new computer and telecommunication technologies, the expanded global role of credit rating agencies, the increased importance of institutional investors, and improved disclosure of corporate financial information have combined to erode the informational advantages of intermediaries such as commercial banks. As a result, the international role of banks has changed from one of simply extending credit to one of facilitating transactions,47 and transactions in securities have become an increasingly important element in international capital flows.

In an international context, asymmetrical information also provides a rationale for the existence of multinational corporations, which allow for direct supervision of foreign investments.48 Direct investment is also, in some respects, a solution to the problem of transaction costs and barriers to capital flows: a multinational corporation, with a broad network of transactions in goods and assets, can frequently find a means, inaccessible to private individuals, of circumventing these barriers.

Since savers and investors seldom deal with each other directly, especially in cross-border transactions, competitive financial arrangements work well only if they ensure that the savers’ agents act in the interest of savers (the principals). While complex institutional and supervisory frameworks have evolved in most countries to meet this requirement, the extension of this protection to international transactions has raised intricate legal, regulatory, and supervisory issues. As discussed in the final section, progress has been made in the international coordination of the supervision of bank branches and subsidiaries or foreign branches of securities houses, and of legal codes governing international capital flows. Nonetheless, many legal, accounting, and disclosure requirements (as well as taxes) have not been harmonized across countries, creating incentives for “regulatory arbitrage”—the shifting of financial activities to locations with the fewest restrictive financial regulations, the least comprehensive supervision, or the lowest taxes. Such regulatory and tax arbitrage has created pressures on the authorities to harmonize tax and regulatory systems; it has also raised concerns that “competitive” deregulation could eventually lead to a structure of supervision and regulation that does not adequately protect savers and investors.

Systemic Consequences and Policy Issues

Although the closer integration of major capital markets has generated significant efficiency gains, there are concerns that the rapid integration of capital markets could subject the world economy to various systemic strains. In part, these concerns reflect the experience with increased variability of asset prices and the demonstrated speed with which major financial shocks can be transmitted across global markets. In addition, major domestic and offshore financial markets have undergone extensive structural changes that have created uncertainty about the nature of not only financial market linkages between countries but also the environment in which monetary and fiscal policies must be implemented. This section examines some of the risks created by the rapid integration of global financial markets and the policy options for managing these risks.

Financial Integration and Innovation, Macroeconomk Policy Effectiveness, and Policy Coordination

As the linkages between major domestic and offshore financial markets have increased, the environment in which monetary and fiscal policies are implemented has changed dramatically. Financial innovation and the availability of credit from offshore markets have forced the monetary authorities to move away from quantitative restrictions on domestic lending toward instruments that operate more through “market prices,” namely, exchange rates and interest rates. In addition, the availability of external savings has allowed credit-worthy countries to finance larger fiscal and current account deficits longer than previously. Moreover, as the “spillover effects” of macroeconomic policies have increased, financial market participants have come to respond more rapidly to cross-country policy uncertainties and conflicts. This has underscored the importance of credible and coordinated macroeconomic and financial policies for a system of stable exchange rates and asset prices.

Effectiveness of Monetary Policy

During the 1950s and 1960s, financial institutions and regulatory structures in each of the major industrial countries evolved in relative isolation from external developments, in part reflecting the comprehensive systems of capital and exchange controls in some industrial countries (such as France, Japan, and the United Kingdom). These diverse financial structures naturally led the monetary authorities to employ quite different operational techniques. While some authorities (such as in France) relied heavily on direct controls on domestic credit expansion by financial institutions, other countries (such as the United States) relied more heavily on indirect money market instruments (such as open market operations). Moreover, the channels by which monetary policy influenced economic activity were often affected by domestic financial regulations. Even where direct credit controls were not employed, liquidity and credit constraints were often key elements in transmitting monetary policy effects. A rise in market interest rates could reduce the volume of credit as financial institutions lost deposits when market interest rates rose relative to regulated interest rates on deposits. The resulting credit rationing often induced an abrupt reduction in spending in certain sectors of the economy (such as housing investment) that had few alternative sources of credit.

During the 1970s, institutional structures and monetary policy operating procedures were forced to adapt to greater macroeconomic instability, to the need to finance large fiscal and current account imbalances, and to the expansion of offshore markets. The latter in particular provided large enterprises and financial institutions with a “safety valve” source of credit (whenever domestic credit conditions were tightened) and an alternative for the placement of funds that offered market-related rates of return.

To allow institutional structures to adjust to these new macroeconomic conditions, the authorities in the major industrial countries removed or relaxed capital controls and eliminated a variety of restrictions on domestic financial market activities, instruments, and interest rates. Increased use was made of market-based instruments (such as open market operations), and greater emphasis was placed on controlling the growth of monetary aggregates as part of a medium-term strategy for bringing down inflation.

The potential contribution of intermediate monetary aggregate targets to a successful anti-inflation program depended on a predictable relationship between the central bank’s instruments and the intermediate targets, and a stable relationship between the intermediate targets and nominal demand or inflation. In some countries, however, financial liberalization and changes in computer and telecommunication technologies resulted in institutional changes and financial innovations that created difficulties for (1) measuring monetary aggregates; (2) controlling the expansion of the aggregates; and (3) maintaining the stability of the velocity relationships between the aggregates and nominal demand. For example, abrupt changes in the rate of expansion of key monetary aggregates sometimes occurred as households and firms substituted holdings of new interest-bearing deposit accounts and instruments (such as money market mutual funds) for traditional transaction balances, which often bore no interest.49 For broader monetary aggregates, which typically encompassed both interest-bearing and noninterest-bearing deposits, this type of substitution was less of a problem in some countries;50 but the ability of major enterprises and financial institutions to hold deposits in offshore banks stimulated the development of comparable domestic instruments (such as negotiable certificates of deposit) that required the redefinition of some broader aggregates. Moreover, foreign holdings of domestic currency at times had a strong influence on the behavior of narrow aggregates.51

Since the financial liberalizations typically involved the removal of interest rate ceilings, they also affected the predictability of the relationship between monetary aggregates and the authorities’ operating instruments (usually short-term money market interest rates).52 As the yields on bank deposits became increasingly governed by market forces, a change in the level of interest rates no longer induced as large a portfolio substitution between money and nonmonetary assets. This weakened one channel through which the behavior of monetary aggregates had been influenced, and it also implied that monetary policy would have to rely more on its effects on the level of interest rates than on its effects on the spread between money and nonmonetary assets.

Even if financial innovation has made short-run control over monetary aggregates less precise, broad objectives for monetary aggregates can still be important medium-term guides for anti-inflation policies if there is a relatively predictable long-run velocity relationship between monetary aggregates and nominal income. However, while velocity relationships in Germany and Japan were relatively stable during the late 1970s and early 1980s, other countries experienced considerable variability throughout the period.53

The difficulties with monetary targeting and direct credit controls have led the authorities in a number of industrial countries toward a more “eclectic” approach to monetary policy. While this approach has continued to involve the announcement of targets for certain monetary aggregates, a broader range of indicators of monetary conditions has also been monitored. The focus is mainly on nominal variables (such as nominal spending), since experience suggests that relying on real variables alone puts inflation too much at risk. However, there is no consensus on what variables should receive the most weight.

Price data from centralized auction markets such as bond, foreign exchange, and commodity markets are nonetheless increasingly viewed as providing useful “summaries of or aggregators of information embodying the knowledge and expectations of large numbers of buyers and sellers who have incentives to make informed decisions in an uncertain world.”54 Since such asset market prices embody expectations about future developments, they can contain information about inflation expectations and can be a much better indicator of market conditions during a crisis than most forms of monetary or reserve aggregates.55

As a result of these structural changes, the effects of monetary policy are increasingly transmitted through induced changes in interest rates and exchange rates rather than through liquidity or credit constraints. Consumption is influenced through wealth effects, income effects, and inter-temporal substitution effects as purchases are either brought forward or delayed depending on the real cost of credit and the real return on saving.56 Business investment can be affected through current income/cash flow effects in the short run and the user cost of capital in the long run.57

The scope that the authorities have for pursuing an eclectic independent monetary policy is naturally influenced by the country’s exchange rate arrangements. While an increase in the degree of capital mobility will affect the channels by which monetary policy is transmitted under any exchange rate regime, the loss of monetary policy effectiveness will be greatest with a fixed exchange rate.58 Indeed, there is the question of whether the degree of capital mobility is currently so high as to have eliminated all vestiges of domestic monetary policy independence for countries with no capital controls and a fixed exchange rate such as those in the European Monetary System (EMS). Any elements of independence would have to reflect the existence of a subset of domestic borrowers and intermediaries that have only limited ties to international markets.59 This could allow the authorities to influence the cost and availability of credit from local intermediaries, through the use of reserve requirements, credit ceilings, direct credit surveillance, or through deposit interest rate ceilings (to the extent that such ceilings still exist). A problem with such controls is that they create strong incentives, even for smaller firms, to develop linkages with external financial institutions; and they put local intermediaries at a cost disadvantage relative to foreign intermediaries, which could threaten their longer-term survival.60

Fiscal Policy

During the 1970s and 1980s, the fiscal authorities in the major industrial countries used a variety of financial instruments to attract new domestic and foreign creditors and to add flexibility to their debt management operations. In addition, withholding taxes on foreign holdings of government securities have generally been removed, and turnover taxes that inhibited domestic trading of government (and private) securities have been progressively eliminated. The result has been a sharp increase in foreign holdings of government securities (see above).

The increased availability of external funding to finance fiscal imbalances has raised the issue of whether “fiscal discipline” has been weakened in the major industrial countries. Since fiscal deficits in the industrial countries have been primarily financed through bond issuance, the degree of fiscal discipline has increasingly reflected the discipline that private markets impose on a borrower whose creditworthiness deteriorates.61

The ultimate form of market discipline for any borrower is the complete denial of credit at any interest rate. If such discipline is applied abruptly, it necessitates a sharp adjustment of the borrower’s spending activity unless an alternative nonmarket source of finance is available. An important question is whether private financial markets will only impose discipline abruptly or whether they indicate earlier that such discipline will be imposed unless the borrower acts to improve its debt or debt-servicing position.

Market discipline is said to operate in stages. At first, there should be a widening differential between the interest rate paid by the private or public sector debtor whose creditworthiness is deteriorating and that paid by creditworthy borrowers. Only if this warning is ignored should the market apply the ultimate sanction of exclusion from the market.62 For markets to operate in such a progressive manner, four fundamental conditions need to be fulfilled. First, there must not be any explicit or implicit guarantee that the borrower will be bailed out by the government or, if it is a central government, by a regional government body. If such a guarantee existed, the interest rate charged to the borrower would reflect the creditworthiness of the guarantor rather than the borrower. Second, market participants must be aware of the full magnitude of the debtor’s obligations to make an assessment of its debt-servicing obligations and capacity. In evaluating the obligations of the central government, the position of commercial trading or financial entities owned or guaranteed by the state would also have to be considered. Third, the financial system must be strong enough that no single borrower is regarded as too large to fail. If a borrower were too large, it might be able to force the domestic authorities (or, if the borrower was the central government, other governments or regional authorities) to provide emergency assistance to prevent the bankruptcy (or default) of not only the borrower but other financial institutions that are large holders of the borrower’s obligations.63 A final condition is that the borrower’s debts are not “monetized” through central bank purchases. Such purchases could lead to inflation or exchange rate depreciation that would erode the real value of debts denominated in the borrower’s currency, making it difficult for private markets to price appropriately the risk of holding such debt.

In practice, it is unlikely that all of these conditions will be fully satisfied. Many borrowers are in fact viewed as carrying explicit or implicit guarantees either from some government entity or, if government units, from the central government or regional government bodies. The perception that the authorities consider some financial institutions too large to fail is hard to dispel, short of actually allowing some large institutions to fail. Moreover, it could prove difficult to establish credibility that large sovereign borrowers would not be assisted if the failure to rescue could lead to fragmentation of regional institutions in which members have already invested high political stakes.

Most institutional investors also find it too costly to undertake their own analysis of each borrower’s creditworthiness. Instead, they hold instruments of a certain minimum credit standing as defined by major credit rating agencies. While the ratings of these agencies arc widely accepted and play a key role in pricing securities, problems can arise about the timing and accuracy of the credit evaluations, the uncertainties created by the evaluation process, and the evaluation of new factors or events.

One concern has been that the ratings of borrowers tend to be relatively “sticky,” reflecting changes in a borrower’s debt-servicing capacity only with a considerable lag. Credit agencies face the problem that an adverse change in a borrower’s credit rating may become a self-fulfilling prophecy if creditors quickjy withdraw funding from the borrower, Moreover, it may be difficult for the agencies to obtain complete information about a borrower, especially in the early stages of a deterioration of debt-servicing capacity, since management may not have an incentive to reveal relevant information before officially mandated reporting dates. In addition, in an era when a growing number of state enterprises are being privatized, it may be unclear what “residual” government guarantees still apply to the enterprises.

When a significant unanticipated event occurs, the credit agencies often indicate that the borrower’s rating will be reviewed (the “credit watch” period). Since the extent of any change in the borrower’s credit rating may be uncertain, a new element of risk enters into the pricing of the borrower’s debt obligations. Moreover, the evaluation of new events or factors can present a particular problem. For example, since the position of the existing senior debt of a corporation can be eroded during leveraged buyouts (LBO) as the corporation issues new debt (“event risk”), the credit rating agencies were forced during the late 1980s to develop a supplementary rating system for assessing the quality of event risk covenants on new debt issues.

Also, only creditworthy large corporations and sovereign borrowers can efficiently raise funds from the securities markets, where credit ratings predominate. Most borrowers rely on credit from financial intermediaries. However, there is considerable evidence that bank and nonbank financial intermediaries respond to a deterioration in a borrower’s creditworthiness in the same way as do the securities markets. Nonetheless, the experience with lending to developing countries in the 1970s, with real estate and energy sector loans in the 1980s, and with leveraged buyouts, suggests that the risks inherent in lending operations, especially those arising from systemic or economy-wide shocks, may not always be fully incorporated into lending decisions.

This issue has been examined most extensively in the literature on the behavior of interest rate spreads on bank loans (that is, the loan rate minus the Eurodollar London interbank offer rate) to developing countries in the mid-to-late 1970s.64 Attention has focused on why the spreads did not widen gradually to reflect the deteriorating relationship between the scale of debt-service payments and capacity, and on why the transition to highly restricted access was so abrupt. One element contributing to the relalively narrow loan spreads during the late 1970s appears to have been the presence of both explicit and perceived guarantees—relating to cither debt-servicing support for indebted countries or the safety of the deposit liabilities of large international banks.65 Such guarantees could produce an underpricing of risk. Lenders also may not always have known the extent and maturity structure of the external debts of some heavily indebted developing countries that lacked centralized debt-management offices. Moreover, some lenders believed that they were holding a diversified portfolio of loans to developing countries that were at different stages of development, in different regions, and with different exports. What was apparently not adequately recognized was that systemic shocks (such as higher real interest rates and depressed commodity prices) might cause a sharp simultaneous downturn in the economic position of all developing countries in certain regions or facing similar economic conditions. The realization that institutions were holding a highly concentrated—rather than diversified-portfolio may have played a major role in the spread of credit rationing to all developing countries in certain regions or facing similar economic conditions.66

Concerns about the ability of the market to evaluate creditworthiness properly and to apply discipline smoothly and gradually have led to proposals for fixed rules for fiscal policy. For example, the Delors Committee’s Report on Economic and Monetary Union in the European Community, published in April 1989, stressed the need to coordinate fiscal and budgetary policies throughout the European Community (EC) to achieve “internal balance.” To achieve fiscal prudence, it proposed that binding budgetary rules be set to exclude monetary financing and put limits on external borrowing. Such rules could clearly play a role in establishing fiscal discipline, but they also raise a number of operational questions such as how to take into account the different levels of development of the members of the Community.67

The fundamental question is whether the authorities in a country will accept either the market signals about the sustainability of their fiscal position or the constraints imposed on their fiscal actions by existing rules. Experience suggests that governments will from time to time ignore signals and rules until credit becomes unavailable from either private or official sources.68

Coordination of Financial and Macroeconomic Policies

The growing integration of major domestic and offshore financial markets has increased the pressure for greater coordination of financial and macroeconomic policies.69 Since financial institutions are now relatively free to relocate their activities, differences in regulatory or tax policies can induce a shift of activities from one market to another. This has led inter alia to a coordinated and uniform approach to bank capital adequacy requirements across the Group of Ten countries. Efforts are also under way to develop more uniform treatment of capital adequacy for securities houses, disclosure requirements, accounting standards, and the legal codes governing financial transactions. In addition, the authorities in the major industrial countries have faced pressures to eliminate withholding taxes on interest income paid to foreign holders of domestic securities and taxes on transactions in securities.70

As noted earlier, the spillover effects from domestic macroeconomic policies have also increased as the linkages between major financial markets have expanded. Monetary policy effects are increasingly transmitted through interest rates and exchange rates, which are at the cutting edge of the short-term linkages between countries. Also, since foreign savers have played an increasingly important role in the financing of fiscal deficits, an economic downturn in one country, which reduces the funds that domestic residents could invest in foreign bonds, could have a major impact on the financing of fiscal imbalances in other countries.

The externalities created by these spillover effects suggest that policies designed in isolation are unlikely to generate an appropriate supply of the international public good of worldwide economic stability. The case for the international coordination of macroeconomic policies rests essentially on internationalizing these externalities.

Major movements in asset prices (especially exchange rates, interest rates, and equity prices) have often played a key role in intensifying efforts to improve policy coordination. News about anticipated policy developments tends to be quickly reflected in asset prices even without immediate changes in output or activity. This link between asset prices and underlying policies underscores the importance of credible and coordinated macro-economic and financial policies for a stable system of exchange rates, interest rates, and equity prices.

While much of the recent discussion of the coordination of policies has tended to focus on monetary, fiscal, financial, and exchange rate policies, the growing integration of major financial markets has also created a need for coordinated crisis management policies, especially among central banks. Indeed, this may be the area where the need for a coordinated official response has increased most during the 1980s. The equity market crash of October 1987 demonstrated both the speed with which major financial shocks can spread across global markets and the types of liquidity, settlement, and clearance problems that can arise in money and equity markets.71 Since the global markets for key government securities and foreign exchange operate on a 24-hour basis, emergency liquidity support during a major financial crisis may need to be coordinated to provide both continuing market support and the appropriate amount in different currencies. For example, the transfer of U.S. dollar-denominated funds occurs continuously throughout the day, with various offshore payments systems operating during the time when U.S. domestic markets and payments systems are closed for business. These systems function smoothly only if the banks, which serve as the “offshore” clearing agencies, are willing to extend the “nighttime” credits that may be needed by some participants to make payments before the U.S. markets open. In a major liquidity crisis, such credits might not be extended if banks were uncertain about what their own liquidity position might be when the U.S. markets opened.

Institutional Structure, Stability, and Contagion

International capital Hows will yield an efficient reallocation of savings across countries only if global capital markets generate prices that appropriately reflect the underlying risks of holding financial claims. As discussed in the previous section, both official policies and factors inherent in the operation of private markets (such as asymmetrical information) can work to distort asset prices, to reduce market liquidity, and to prevent the emergence of markets for certain types of financial claims and services. While many industrial countries have undertaken financial liberalizations designed to reduce or eliminate the distortions created by official restrictions, some observers have argued that the process of deregulation, globalization, and innovation in financial markets has been a two-edged sword.72 On one side, these developments have increased financial market efficiency; on the other, they have increased volatility in financial markets and introduced new and highly complex elements of risk—some of a systemic variety—that make the pricing of financial instruments more difficult and that can contribute to abrupt changes in credit flows once previously unforeseen risks become evident.

Efficiency and Stability in international Financial Markets

Authorities in the major industrial countries have had to confront a number of financial crises during the past two decades that have had an international as well as a domestic dimension. These crises have shared some common features (Table 11). Several were preceded by the introduction of a new financial instrument or by a sharp increase in debt, and lenders accepted a concentration of risks and charged interest rates that, ex post, did not reflect underlying risks. This was particularly evident with the growth of interbank positions prior to 1974, the expansion of developing country debt prior to 1982, the large issuance of floating rate notes in the early 1980s, the accumulation of high-risk real estate loans and noninvestment grade bonds by U.S. thrift institutions during the 1980s, and the highly concentrated lending of Canadian regional banks to the agriculture and energy sectors in the early 1980s. Some crises were also preceded by major, often unanticipated, changes in macroeconomic conditions or policies. To take an example, the emergence of debt-servicing problems for many heavily indebted developing countries was preceded by a collapse of commodity prices, a sharp increase in oil prices, and historically high international real interest rates. Finally, the emergence of a major crisis has typically resulted in sharp increases in the risk premiums charged to certain classes of borrowers and in more restrictive credit rationing. The collapse of Bank-haus Herstatt in June 1974 was such a case, where there was a “tiering” of interest rates charged for interbank borrowing, with some large Italian and Japanese banks paying premiums as high as 200 basis points.73

Table 11.

Characteristics of Selected Financial Crises in Major Industrial Countries and Eurocurrency Markets, 1970–89

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Source: Davis (1989).