The world of international finance

Print edition : November 19, 2004

Counting dollar bills, in Manila. Being recipients of foreign capital flows that were not needed to finance their balance of payments, developing countries in Asia accumulated $164 billion in foreign exchange reserves in 2003. - ROMEO RANOCO/REUTERS

The global operations of financial firms have registered a galloping growth, leading to a deluge of capital into developing countries irrespective of their needs and, ultimately, limiting the policy space of their governments.

MOST economists agree that a distinguishing feature of the nebulously defined process of "globalisation" is the growing importance of cross-border financial flows. Financial liberalisation has substantially increased the global operations of financial firms and this has significantly influenced real economic activity.

How large is the world of finance globally? Demarcating the world of finance is indeed a difficult proposition. It includes a range of agents such as banks, merchant banks, insurance companies, securities firms and non-bank financial institutions. The distinction between the activities of these entities has increasingly been eroded as a result of financial liberalisation that encourages financial consolidation and the conversion of the larger financial entities into financial supermarkets or universal banks that undertake diverse financial activities. Finally, there are a range of markets varying from equity and debt markets to markets for derivatives and foreign exchange. Derivatives themselves are financial instruments the value of which is based on some other security, such as a stock or a bond. And within derivatives there are those that are "exchange-traded" and are, therefore, subject to some regulation, and those that are created and exchanged in private "over-the-counter" (OTC) deals, which are neither regulated nor officially recorded.

Given this diversity of agents, instruments and markets and the lack of transparency in over-the-counter markets, it is extremely difficult to guage the size and nature of the world of finance. But the available figures do point to galloping growth in the global operations of financial firms. In the early 1980s, the volume of transactions of bonds and securities between domestic and foreign residents accounted for about 10 per cent of gross domestic product (GDP) in the United States, Germany and Japan. By 1993, the figure had risen to 135 per cent for the U.S., 170 per cent for Germany and 80 per cent for Japan. Much of these transactions were of bonds of relatively short maturities.

Since then not only have these transactions increased in volume, but a range of less traditional transactions have come to play an even more important role. Traditional bank claims, though important, are by no means dominant. Banks reporting to the Bank of International Settlements (BIS) record foreign claims on residents of all countries at $15.7 trillion at the end of 2003. This compares with the annual global GDP of $36,400 trillion in that year.

Non-bank transactions have been far more important. In 1992, the daily volume of foreign exchange transactions in international financial markets stood at $820 billion, compared with the annual world merchandise exports of $3.8 trillion or a daily value of world merchandise trade of $10.3 billion. According to the recently released Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, in April 2004, the average daily turnover (adjusted for double-counting) in foreign exchange markets stood at $1.9 trillion. With the average GDP generated globally in a day standing at close to $100 trillion in 2003, this appears to be a small 2 per cent relative to real economic activity across the globe. But the sum involved is huge relative to the daily value of world trade. In 2003, the value of world merchandise exports touched $7.3 trillion, while that of commercial services trade rose to $1.8 trillion. Thus, the daily volume of transactions in foreign exchange markets exceeded the annual value of trade in commercial services and was in excess of one quarter of the annual merchandise trade.

More significant is the trade in derivatives. The Triennial Survey indicates that the average daily volume of exchange-traded derivatives amounted to $4.5 trillion in 2004. In the OTC derivatives market, the average daily turnover amounted to $1.2 trillion at current exchange rates. The OTC market section consists of "non-traditional" foreign exchange derivatives - such as cross-currency swaps and options - and all interest rate derivatives contracts. Thus total derivatives trading stood at $5.7 trillion a day, which together with the $1.9 trillion daily turnover in the foreign exchange market adds up to $7.6 trillion. This exceeds the annual value of global merchandise exports in 2003.

THE massive increase in international liquidity that these developments imply have found banks and non-bank financial institutions desperately searching for means to keep their capital moving. At first, there were booms in consumer credit and housing finance in the developed industrial nations. But when those opportunities petered out, a number of developing countries were discovered as the "emerging markets" of the global financial order. Capital in the form of debt and equity investments began to flow into these countries, especially those that were quick to liberalise rules relating to cross-border capital flows and regulations governing the conversion of domestic into foreign currency. The result of these developments was that there were a host of new financial assets in the emerging markets, which were characterised by higher interest rates ostensibly because of the greater risks of investment in these areas. The greater `perceived risk' associated with financial instruments originating in these countries provided the basis for a whole range of new derivatives, which bundled these risks and offered a hedge against risk in different individual markets, each of which promised high returns.

One consequence of these developments is that at different points in time one or another group of developing countries is discovered as a "favourable" destination for foreign financial investors. Increasingly, this has meant that the international flows of capital to developing countries have little to do with the need of these countries either for balance of payments or investment finance. Thus, since 2000, developing and other emerging market countries as a group (as defined by the International Monetary Fund's World Economic Outlook) have recorded a surplus in the current account of their balance of payments. That surplus was just short of $150 billion in 2003. Yet, in 2003, residents of this group of countries borrowed from abroad to the tune of $91.5 billion and foreign direct and portfolio investment in these countries exceeded $140 billion. Being recipients of foreign capital flows that were not needed to finance their balance of payments, these countries as a group increased their foreign exchange reserve holdings by as much as $298 billion. Of this increase in reserves, as much as $164 billion was accounted for by developing countries in Asia.

Since much of these reserves are invested in United States government securities that offer an extremely low rate of interest, these countries are paying out huge returns to foreign investors, but are obtaining little by way of return on their own investments. Further, the growing presence of foreign financial firms creates a whole host of difficulties. To start with, sudden and whimsical reversals in flows are known to occur, which can set off currency speculation in the host country and lead to a currency collapse. Initially, a decline in investor confidence results in a withdrawal of funds invested in equities and also prevents the rollover of short-term debt by multinational banks. Then, there is a scramble for dollars on the part of domestic banks and corporations with imminent dollar commitments, the domestic currency costs of which are rising in the wake of depreciation. And finally, there is an increase in speculative operations by domestic and international traders cashing in on currency volatility.

Secondly, if a country is suddenly chosen as a preferred site for foreign portfolio investment, it can lead to huge inflows, which in turn cause the currency to appreciate. As a result, investment gets diverted away from tradables to nontradables. Typically, internationally accessed capital goes to sustain an "investment boom" in stock and real estate markets, raising rates of return on such investments and fuelling the thrust to garner quick profits through arbitrage. This renders the country prone to financial failure.

Finally, the inflow of capital imposes a deflationary environment on these countries. One requirement for keeping financial investors happy is to reduce substantially the deficit of the government or its expenditures financed with borrowing. Financial interests are against deficit-financed spending by the state for a number of reasons. To start with, deficit financing is seen to increase the liquidity overhang in the system, and therefore as being potentially inflationary. Inflation is anathema to finance since it erodes the real value of financial assets. Second, since government spending is "autonomous" in character, the use of debt to finance such autonomous spending is seen as introducing into financial markets an arbitrary player not driven by the profit motive, whose activities can render interest rate differentials that determine financial profits more unpredictable. Finally, if deficit spending leads to a substantial build-up of the state's debt and interest burden, it may intervene in financial markets to lower interest rates with implications for financial returns. Financial interests wanting to guard against that possibility tend to oppose deficit spending. Given the consequent dislike of expansionary fiscal policy on the part of financial investors, countries seeking to attract financial flows or satisfy existing financial investors are forced to adopt a deflationary fiscal stance, which limits their policy option.

Further, if a country is successful in attracting financial flows, the consequent tendency for its currency to appreciate, forces the central bank to intervene in currency markets to purchase foreign currency and prevent excessive appreciation. The consequent build-up of foreign currency assets, while initially sterilised through sale of domestic assets, especially government securities, soon reduces the monetary policy flexibility of the central bank. Faced with these conditions, Governments in Asia, especially India, are increasingly resorting to trade and capital account liberalisation to expend foreign currency and reduce the compulsion on the central bank to keep building foreign reserves. That is, if financial liberalisation is successful, in the first instance, in attracting capital flows, it inevitably triggers further liberalisation, including of capital outflows, leading to an increase in financial fragility.

Thus, financial liberalisation that successfully attracts capital flows increases vulnerability and limits the policy space of the government. Unfortunately, the dominance of finance globally has meant that such debilitating flows occur even when developing countries, individually or as a group have no need for such flows to finance their balance of payments or augment their savings.

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