INTERNATIONAL

FINANCIAL AND FOREIGN

EXCHANGE MARKETS

INTRODUCTION
February 18th, 2019
 What is International Finance?
• International finance is the branch of economics that studies the dynamics
of exchange rates, foreign investment, the global financial system, and how
these affect international trade. It also studies international projects,
international investments and capital flows, and trade deficits. It includes the
study of futures, options and currency swaps. International finance is a
branch of international economics.

• Important theories in international finance include the Mundell-Fleming

model, the optimum currency area (OCA) theory, as well as the purchasing
power parity (PPP) theory. Whereas international trade theory makes use of
mostly microeconomic methods and theories, international finance theory
makes use of predominantly macroeconomic methods and concepts.
 The Textbook
Maurice Levi, International Finance, 5°Edition, 2009

• A comprehensive reading, covering the financial markets, the economic

environment and management of multinational business.

• A good blend of both macro and micro economic analyses. It sets operational
finance in the appropriate macroeconomic framework.

• Covers practical managerial topics such as how to evaluate foreign investment

opportunities, where to borrow and invest, how exchange rates affect cash
flows, how to measure foreign exchange risk and exposure, how to do business
in the current global financial environment.
 Other sources of information on
International finance

IMF Global Financial Stability BIS Annual Report

Report (October 2016) 2014-2015 (June 2016)
Other sources of information on
International finance

• Institute of International Finance (IIF) (the private institution that has

negotiated with Greece the restructuring of the country’s debt); various

reports and publications

• www.worldbank.org, www.oecd.org, www.euromoney.com

(Periodical Reports on Country Risk).

 Purpose of this Introduction
• Why it is important to study IF.

• Why IF has grown so much.

• What are the pros and cons of IF.

• What are the basic notions that are needed to approach IF.

• What are the main players in IF, how big they are and how they interact.
INTRODUCTION - Part I

INTERNATIONAL
FINANCE
Its pros and cons
 Benefits of studying IF
• Among the events that affect the firm and that must be managed are changes in
exchange rates, inflation rates, and asset values (and these events are often
themselves related).

• Because of the integration of financial markets, events in distant lands have

effects that reverberate in other regions of the world (domino effects, contagion,
systemic risk).

• Even companies with a domestic focus are affected by the global financial
environment as they compete with firms that are internationally active.

• Inflation, jobs, economic growth rates, bonds and stock prices, oil and food
prices, government revenues and other important financial variables are all tied
to exchange rates and other developments in the increasingly integrated
financial market.

• For students in economics or business administration understanding IF is of

fundamental importance.
 Growing importance of IF
• Over the last decades international financial flows have grown much faster than
world GDP or world trade.
• This trend is in large parte a reflection of international trade and the process of
globalization.
• However, international financial flows have grown much faster than the real
economy.
• Between 2002 and 2007 (before the start of the current crisis) international
financial flows (gross) have grown from 5% to 17% of world GDP.
• While IF contributes to world prosperity through the efficient allocation of capital
worldwide, it is also a source of concern for the challenges that it poses for
financial stability as shown by the recent financial crises.
• Financial flows are extremely volatile. After the Lehman default (gross)
international financial flows plummeted to 1% of GDP in 2008!!
• IF has become as subject of immense importance and a great deal of attention is
being payed to gain a better understanding of the way financial markets work.
 Market capitalization of listed
companies
Market capitalization (also known as market value) is the share price times the
number of shares outstanding. Listed domestic companies are the domestically
incorporated companies listed on the country's stock exchanges at the end of the
year. Listed companies does not include investment companies, mutual funds, or
other collective investment vehicles. Data are in current U.S. dollars.
DOMESTIC MARKET
CAPITALIZATION

Source: World
Federation of
Exchanges, 2017
 Market capitalization of listed
companies

Source: Standard & Poor's, Global Stock Markets Factbook and supplemental S&P data
Factors behind the growth of IF
• Growth of International Trade (finance associated to commercial trade)

• Growth of Multinational Corporations (finance associated to FDIs and M&A

activity) and Multinational Banking

• Growth of the eurodollar market

• Growth of International Finance per se (finance associated to the growth of

global saving and the need to improve risk-return trade-offs)
 Growth of International Trade
• Since 1950 world trade has grown by 6% per annum on average, roughly twice
world output over the same period.

• Since 1970 trade growth accelerated, with commercial flows expanding by a

factor of 35 times.

• International trade has benefitted from the liberalization carried out in the post
war period that has allowed the mechanisms of comparative and competitive
advantages to operate in full.

• Global trade now accounts for about 30% of world GDP (see Table 1.1 in Levi).

• IT has implications for IF by way of: the monetary and credit flows associated
with import and export activity; the exchange of national currencies with foreign
currencies; the need to cover against exchange rate risk and/or the country risk;
the need to finance commercial trade deficits.
Values of merchandise exports
and imports (annual, 2005-2015)
This table shows the value of total merchandise exports and imports by economic grouping expressed in millions
of dollars at current prices and current exchange rates in millions

Source: UNCTAD, 2017

 Increased importance of MCE
• Chapter 20 of Levi

• The UN estimates that there are more than 35,000 multinational corporations,
with the largest 100 of these possibily being responsible for approximately 16%
of the world’s productive assets.

• MCE are responsible for FDIs (Foreign Direct Investment), which means
producing directly abroad (instead of exporting in a foreign country).

• FDI is an hybrid between a real and a financial flow. Foreign direct investment
reflect the objective of obtaining a lasting interest by a resident entity in one
economy (‘‘direct investor’’) in an entity resident in an economy other than that of
the investor (‘‘direct investment enterprise’’).

• The lasting interest implies a significant degree of influence on the management

of the (direct investment) enterprise (the OECD definition: 10% of the ordinary
shares or the voting power).
 World's largest corporations,
Ran
2018 Revenues Employee
Company Industry Country
k ($b) s
1 Walmart Retail 500,343 2,300,000 USA
2 State Grid Electricity 348,903 913,546 China
3 Sinopec Oil and gas 326,953 667,793 China
China National
4
Petroleum Oil and gas 326,008 1,470,193 China
Netherlands-
5
Royal Dutch Shell Oil and gas 311,870 84,000 UK
6 Toyota Automotive 265,172 369,124 Japan
7 Volkswagen Automotive 260,028 642,292 Germany
8 BP Oil and gas 244,582 74,000 UK
9 Exxon Mobil Oil and gas 244,363 71,200 USA
10 Berkshire Hathaway Financials 242,137 377,000 USA
11 Apple Electronics 229,234 123,000 USA
12 Samsung Electronics 211,940 320,671 South Korea
13 McKesson Healthcare 208,357 68,000 USA
Switzerland-
14
Glencore Mining 205,476 82,681 UK
… …. …. …. …. ….
19 Exor Financials 161,677 307.637 Italy

Source: Forbes, 2018

Growth of Multinational Banking
• Chapter 22 of Levi

• Through the opening of representative offices, agencies, and branches and

through the acquisition or establishment of subsidiaries, banking has
become a truly multinational business.

• In the US more than 500 foreign banks had offices in 2004. By 2007,
foreign banks owned 24% of total US banking assets.

• In most countries domestic and foreign banks compete normally on the

market for deposits and loans. In order to protect the domestic banks,
countries may put restrictions to the entry of foreign banks.
 Factors behind Multinational
Banking
Beyond those factors that contribute to the internationalization of
business in general, there are specific factors that apply to banking.

1. Market information. To get useful and timely information on how markets

develop the best is to operate locally.

2. Borrower information. To better assess the creditworthiness of your clients,

the best is to get ‘fresh’ information on the spot and have regular contacts
with your borrowers.

3. Serving clients. If your clients invest internationally, it may be best to ‘follow’

them in the foreign market and support their operations directly (not through
a correspondent), otherwise you risk that your clients go to local banks.

4. Custodial services. Obtaining by clients the custody of stocks and bonds

require physical proximity.

5. Avoiding regulation. Banks are the most regulated sector of the economy in
every part of the world. By operating internationally banks try to avoid or
soften regulation (reserve requirements, deposit insurance, reporting
requirements, interest-rate ceilings, etc.)
 How big are multinational banks
Countr Total assets % of World % of USA % of EU
Bank
y $Bn GDP GDP GDP
ICBC China 4.009 4,7 19,5 21,0
China Construction
China 3.400 4,0 16,6 17,8
Bank
Agricoltural Bank of
China 3.235 3,8 15,8 16,9
China
Bank of China China 2.991 3,5 14,6 15,7

Mitsubishi UFJ Japan 2.784 3,3 13,6 14,6

JPMorgan Chase & Co. USA 2.533 3,0 12,3 13,3

 HSBC UK 2.521 3,0 12,3 13,2

BNP Paribas France 2.357 2,8 11,5 12,3

US Bank of America USA 2.281 2,7 11,1 11,9

Crédit Agricole France 2.117 2,5 10,3 11,1

Wells Fargo & Co. USA 1.951 2,3 9,5 10,2

Japan Post Bank Japan 1.874 2,2 9,1 9,8

Citigroup Inc. USA 1.842 2,2 9,0 9,6
… … … … … …
Unicredit Italy 1.004 1,2 4,9 5,3

Source: Forbes, 2018

 The Eurodollar Market
• Chapter 22 of Levi.

• Bank accounts in different currencies exist side-by-side in just about every

financial center. In London you can open a bank deposit in € (a foreign
currency in the UK) and obtain a loan in US $.

• A Eurodollar deposit is a US dollar-denominated bank deposit outside the US.

• ‘Offshore currencies’ is a generalization to all currencies that are treated in

markets outside the country of origin of the currency.

• There are no reliable estimates of how big is the offshore currency market but
it is certainly very big! As for domestic banking, offshore deposits may give
rise to multiplier effect that raise the supply of global liquidity.
 Factors behind the Growth of
the Eurodollar Market
• During the 50s - Soviet Union $ deposits in British and French Banks, which
were preferred to US banks by the soviets.
• During the 60s and 70s - Regulation Q put limitations on interest rates that US
banks could pay on deposits. It became more convenient to deposit $ in banks
outside the US, especially in Europe. Most US banks decided to open branches
in the old continent.
• Regulation M imposed the keeping of reserves against deposits, which created
another incentive for offshore operations.
• Interest equalization tax (1963-1974): a tax on US loans to foreigners, which
made convenient to get loans on the eurodollar market to avoid the tax.
• Despite the removal of these restrictions, the eurodollar market continued to
grow.

• Same factors (mostly avoiding regulatory restrictions) contributed to the growth

of the offshore market for other currencies
 Growth of cross border financial
flows
• Parallel to trade, in the world war period and especially after the 70s there has
been an enormous growth in cross border financial flows of all kinds: foreign
investment in the money market (e.g. interbank market), the bond market, the
stock market and the real estate market.
• The importance of foreign investment may overshadow that of domestic
investments and investors (for instance the role of foreign investors is of crucial
importance for the successful sales of US Treasury bills as well as Italian BOTs)
• There has been an explosion of internationally oriented financial products such
as mutual funds, which can be globally or regionally diversified or focused on a
single foreign country market.
• Fig. 1.1 Since the mid-70s Americans have increased their investments abroad
by more than 10 times while non-US investors have increased their interest in
US assets by 20 times.
• The US moved from being the largest net creditor to the largest net debtor in
only a quarter of a century.
• Both advanced, emerging and developing economies are nowadays strictly
dependent on foreign financing.
 Benefits from international
•
investment
Micro perspective: an investor can search for higher returns abroad (for instance investing in
emerging market stocks and bonds) and better diversify risk than he could do by investing his
savings only domestically.

• Macro perspective 1: finance can flow from high saving countries (typically the advanced
economies), where returns are low, to the low saving ones where returns are normally higher (fig.
1B.1)

• Macro perspective 2: borrowing from abroad allows a country to smooth consumption over time
(when national income is low and hence consumption is low, one can use foreign capital to keep
consumption constant) (fig. 1B.2)

Investing internationally is better than investing only at home.

The gain from a better allocation
of capital
Utility from different consumption
patterns
 Home bias
• We have seen that cross-border financial flows are very consistent and that
international investment is indeed convenient from a micro and macro
perspective…

• ..and yet investors from all over the world prefer domestic assets to foreign
assets as empirical evidence shows, especially for the case of equities.

• This phenomenon is called ‘home bias’ and can (partly) be explained by: (i)
legal restrictions to foreign investment, (ii) double taxation, (iii) informational
asymmetries (investors normally have more information on domestic firms).

• None of these explanation is fully convincing, hence economists speak of a

“home bias puzzle”.

• Given the existence of a home bias, there is still much room for financial
globalization!!!
Home Bias in Equities in 2008 for
Selected Countries
 Financial Instability
• Financial instability is the ‘dark side’ of international finance. It may consist of:

- excess volatility of exchange rates (especially amongst major

currencies) which can be disruptive for trade and financial flows;

- excess volatility in stock and bond markets, which makes difficult to

evaluate investments;

- excess instability of financial flows, which can move from one

country to another massively and with extreme rapidity giving rise to bubbles

or financial crises having real economic consequences.

Euro Stoxx 50 Volatility
 World slides toward deflation
Historic inflation CPI (Consumer Price Index) – by year

Germany Japan USA Italy

Source: Eurostat 2015

 Financial crises
In recent years heavily disruptive financial crises have dominated the scene
of global finance and put into question the benefits from financial
globalization.

• 1982 Latin American Debt Crisis

• 1992 ERM crisis
• 1994 Mexican crisis
• 1997 Asian Crisis
• 1998 Russian Crisis
• 2000/01 New Economy Bubble Burst
• 2001 Argentina’s financial crisis
• The Great Crisis 2007-2010
• Greece and the Euro Crisis 2011-2015
INTRODUCTION - Part II

Main notions
and players
in International
Finance
 Main components of global
finance
• Currencies

• Market and policy variables (exchange rates, interest rates, risk, ratings)

• Assets/financial instruments (cash and deposits, bonds, stocks, loans,

derivatives, insurance contracts, etc.)

• Players (international organizations, central banks, supervisory authorities,

accounting standard setting bodies, rating agencies, commercial and
investment banks, institutional investors, sovereign funds, MCEs, financial
lobbies, etc.)

• Markets: the (physical or virtual) places or ‘centres’ where financial

transactions take place
 The Global Financial System

GOVERNMENT SUPERVISORY
TREASURIES AUTHORITIES
ACCOUNTING
CENTRAL
STANDARD
BANKS CURRENCIES BODIES

INTERNATIONAL EXCHANGE COMMERCIAL MULTINATIONAL

FINANCIAL ENTERPRISES
RATES BANKS
INSTITUTIONS (MCE)

FINANCIAL
INVESTMENT MARKETS INSTITUTIONAL
BANKS INVESTORS
SOVEREIGN RATING
FUNDS AGENCIES
 A world of currencies
• When dealing with IF one has to face the problems of having different currencies
and how to exchange one for another (through exchange rates).
• The number of national currencies remains very high notwithstanding 18 national
currencies have disappeared with the introduction of the euro.
• Not only money and bank deposits but also financial assets are denominated in a
national currency.
• Reserve currencies are those mostly used in international transactions (US $,
Euro, Yen, once the British pound).
• The US $ is still used to price oil.
• Central banks normally hold relevant quantities of reserve currencies to use in the
money and exchange markets for their operations in addition to gold.
• The IMF Special Drawing Rights (SDR) is an international currency albeit it is
not physical but only serves as an accounting unit.
• The US $ still accounts for 60% of all international reserves (Table on distribution
of international reserves)
 World Currency Composition of Official Foreign
Exchange Reserves
  2017Q1 2017Q2 2017Q3 2017Q4 2018Q1 2018Q2 2018Q3
Total Foreign Exchange 
10.897.524,50 11.117.660,71 11.291.014,48 11.440.456,61 11.600.361,57 11.463.765,81 11.396.623,72
Reserves

Allocated Reserves 8.833.321,35 9.256.894,68 9.642.755,27 10.014.040,63 10.401.811,64 10.514.874,74 10.705.449,30

U.S. dollars 5.713.272,77 5.909.031,17 6.125.427,78 6.280.608,85 6.530.537,49 6.560.943,57 6.631.092,07

Euro 1.703.136,99 1.847.188,58 1.934.684,15 2.019.239,17 2.117.557,69 2.129.550,29 2.192.106,73

Chinese renminbi 94.888,27 99.449,72 108.155,27 123.473,32 145.667,41 192.968,48 192.538,87

Japanese yen 400.762,76 428.603,00 436.192,13 491.011,33 477.280,55 511.376,24 532.796,90

Pounds sterling 376.975,69 408.666,94 433.281,71 454.117,84 486.124,18 469.711,68 480.831,00

Australian dollars 155.980,62 161.871,09 170.762,38 180.009,14 176.959,77 178.582,20 180.818,31

Canadian dollars 167.491,33 178.769,42 192.885,01 202.798,47 193.294,93 200.183,28 208.711,39

Swiss francs 14.752,40 16.034,82 16.530,33 18.088,67 17.934,91 16.595,93 16.586,53

Other currencies 206.060,52 207.279,92 224.836,52 244.693,84 256.454,70 254.963,07 269.967,50

Unallocated Reserves 2.064.203,16 1.860.766,03 1.648.259,21 1.426.415,99 1.198.549,93 948.891,07 691.174,42

Source: International Financial Statistics (IFS), 2019

Data extracted from http://data.imf.org/ on: 2/15/2019 5:39:56 AM
 World –Allocated Reserves by
Currency (in Percent)

Source: IMF, 2019

The rise of Renmimbi as an International
Currency
 China Total Goods Trade settled in
Renminbi

Source: HSBC
The Internationalization Of The Renminbi

Source: HSBC
Renminbi offshore developments
(in billions of US dollars)

Source: Monthly data from CEIC and the Hong Kong Monetary Authority
 Gold
• Gold still represents an important share of international reserves (see IMF
statistics).

• Most of gold is held by central banks and the IMF but private institutions like
investment funds also have gold in their asset portfolios.

• The US and most European countries hold more than 70% of their foreign reserves
in gold bars.

• Why is gold so important?

• Gold still represents an important store of value. Albeit its price changes daily on a
market basis, its value does not depend on ‘trust’ like in the case of currencies.
 Gold Reserves
International Financial Statistics, January 2019
Ran Country/O Gold holdings (in
% of reserves
k rg. tonnes)
1 USA 8,133.5 73,9%
2 Germany 3,369.7 69,2%
3 IMF 2,814.0 N/A
4 Italy 2,451.8 65,5%
5 France 2,436.0 59,0%
6 Russia 2,066.2 17,6%
7 China 1,842.6 2,3%
8 Switzerla 1,040.0
5,1%
nd
9 Japan 765.2 2,4%
10 Netherlan 612.5
65,5%
ds 2019
Source: World Gold Council,
Gold reserves per capita
 Exchange rates
• Exchange rates determine the rate of change in the market of a currency with another
(or with gold).

• The US $/euro exchange rate is the number of $ units that are needed to get 1 euro.

• When left to market forces exchange rates may vary considerably and even abruptly.

• When the euro was introduced on Jan. 1 1999 its value was initially set at 1.17$ but at
the beginning of 2002 it went to 0.85$. Its quotation is now around 1.13$*.

• Most countries define their exchange rate in ‘direct terms’, that is ‘units of national
currency against 1unit of a foreign currency’ (UK is an exception). This is sometimes
called ‘uncertain for certain’.

• One has always to make sure of what is the currency at the numerator and which one
at the denominator

*February 15, 2019

Chinese Renmimbi Vs. Dollar, Euro, Yen,
Won
 Fixed vs flexible exchange
rates
• The determination of an exchange rate may be left to market forces (demand
and supply of currencies) or may be fixed in terms of another currency or
benchmark (e.g. gold). What ‘regime’ to chose is a political decision.

• Before WWI, exchange rates were internationally set in terms of gold and were
thus fixed (gold standard), not left to market forces.

• After WWI till 1971-73 exchange rates were fixed in terms of the US $ which
was the dominant reserve currency.

• In the present ‘system’ we observe a large variety of exchange rates regimes (a

non-system?). Flexible regimes are as much frequent as fixed regimes.

• There is no theoretical or empirical evidence that a given regime is better than

another (in terms of growth and employment creation or in terms of financial
stability)

• The exchange rates of the major reserve currencies are left to market forces
 Relevance of exchange rates
• Exchange rates lie at the heart of IF.

• The ‘interbank foreign exchange market’ (i.e. the market where international
banks exchange deposits in different currencies) is the largest financial market
in the world, with an average turnover of $4 trillion per day.

• The changes or levels of an exchange rate have important effects on sales

prices and costs of imported goods and raw materials and hence influence the
profits of importers and exporters (see Exhibit 1.1 Currency matters: corporate
experiences )

• They influence a country’s BoP and inflation rate through the valuation of
exports and cost of imports especially of oil and raw materials.

• They may be related to the persistence of external imbalances at the global

level (consider the debate on the overvaluation of chinese yuan).
 Some taxonomy on
exchange rates
• Exchange rate ‘regime’: is the type of criterion that a country choses to set
the value of its exchange rate, whether flexible (i.e. determined by market
forces) or fixed or any other form between these two extremes.

• Exchange Rate ‘System’: refers to an agreement by which some countries,

in a region or at the global level, set their (reciprocal) exchange rates
according to a given mechanism (e.g. the Bretton Woods System of
exchange rates 1944-1973).

• Devaluation/Revaluation: a fixed exchange rate that is devalued/revalued

by the country’s authorities (the exchange rate parity is revised).

• Depreciation/Appreciation: a flexible exchange rate that registers a

depreciation/appreciation on the foreign exchange market.
 More on exchange rates
Prof. A. Ziliotto

• Spot and forward rates, ask and bid spread

• Banks, brokers and typologies of foreign exchange makets

• Interbank market and SWIFT

• Triangular arbitrage

• Swaps

• Currency futures and options contracts

• Etc, etc.
 Interest rates
See also:
- The relationship between spot, forward and money market rates
- FX parity conditions and their deviations

• Interest rates are another fundamental factor of IF. They influence in a

significant way cross border financial flows searching for the best risk/return
combinations.

• Interest rates indicate the returns on financial assets and vary according to
the degree of liquidity and the risk embedded in each asset (bank deposits,
corporate bonds, treasury bonds, investment funds, etc)

• Market interest rates vary on a daily basis but are influenced by the ‘policy’
rates set by the monetary authorities. These are the rates at which central
banks lend money to the commercial banks (e.g. the FED overnight rate).

• Economic theory has paid a lot of attention to the equilibrium level of

interest rates in an international economy (interest parity conditions,
Chapter 6)
 Federal Funds Rate
Banks hold the reserve requirement either at their local Federal Reserve branch
office or in their vaults. If a bank is short of cash at the end of the day, it borrows
from a bank with extra money. The Fed funds rate is the rate that banks charge
each other for overnight loans to meet these reserve balances. The amount lent
and borrowed is known as the Fed funds.

The Federal Reserve, through its Federal Open Market Committee (FOMC),
targets a particular level for the Fed funds rate.
It uses open market operations to push the Fed funds rate to its target. If it wants
the rate lower, the Fed purchases securities from its member banks. It deposits
credit onto the banks' balance sheets, giving them more reserves than they
need. That means the banks need to lower the Fed funds rate to lend out the
extra funds to each other.

When the Fed wants rates higher, it does the opposite. It sells its securities to
banks, removing funds from their balance sheet, giving them fewer reserves.
That allows them to raise rates.
 Federal Funds Rate
The current Fed funds rate is targeted to be between 0.50% and 0.75%. The FOMC
raised it on December 15, 2016.
The Fed uses the Fed funds rate as a tool to control U.S. economic growth. That
makes it the most important interest rate in the world. Banks use the Fed funds rate
to base all other short-term interest rates. That includes LIBOR, which is the interest
rate that banks charge each other for one-month, three-month, six-month, and one-
year loans, and the prime rate, which is the rate banks charge their best customers.
That's how it also affects interest rates paid on deposits, bank loans, credit cards,
and adjustable-rate mortgages.
Longer-term interest rates are indirectly influenced. Usually, investors want a higher
rate for a longer-term Treasury note. The yields on Treasury notes drive long-
term conventional mortgage interest rates.
Federal Funds Rate-Historical chart

How the Fed Uses It to Control the Economy

The FOMC changes the Fed funds rate to control inflation while
maintaining healthy economic growth. The FOMC members watch economic
indicators to determine if the economy is speeding up (inflation) or slowing down
(recession). The key indicator for inflation is the core inflation rate. The most
important indicator in predicting a slowdown is the durable goods report.
Interest rates and financial crises
• An inappropriate ‘level’ of some (reference) interest rates may be at the root of
a financial crisis (interest rates reflect the ‘stance’ of monetary policy).
• When interest rates are too high on a reserve currency, this may cause
financial problems in the periphery:
- the Latin American crisis in 1982 was (also) due to the change in monetary
policy operated by Paul Volcker
- the ERM crisis in the early 90s was (also) a consequence of the Bundesbank
policy of high interest rates (after German Unification)
• When interest rates are too low for a sustained period they are also a cause
for concern as they may reflect too much liquidity in the system that in turn
leads to inflation and/or a lax credit policy.
• Greenspan legacy: In autumn 2001, as a decisive reaction to the September
11 attack and various corporate scandals which undermined the economy, the
Greenspan-led Federal Reserve initiated a series of interest cuts that brought
down the Federal Funds rate to 1% in 2004. Most critics attribute the rapid rise
in commodity prices and asset inflation as well as a weak dollar to
Greenspan's loose monetary policy.
 Risk
See also:
Working within an international context: arising risks and
available mechanisms for hedge
• Interest rates vary according to the degree of risk embedded in financial assets.
The higher the risk for the lender or the investor to get his money back, the
higher the interest rate that he demands.
• International investors face all kinds of risk that are typical in the activity of
lending/borrowing money: i.e. credit risk, operational risk, etc. What kinds of
(additional) risks an international investor face?
• Exchange rate risk: when investing in an asset denominated in a foreign
currency, the exchange rate prevailing at the end of the investment period is
going to affect significantly the final return. Ex. An European investor buying
US Treasury bonds at $/€=1.2 will sustain a reduction in his return if at the end
of the period $/€=1.3 (the dollar has depreciated vis-à-vis the euro).
• Country risk: the risk that a country may default (totally or partially) on its
foreign obligations due to economic, political or social problems. Ex. In Europe a
measure of country risk is given by the spread between returns on Government
bonds using German bonds as the risk-free benchmark.
• Exchange rate risk and country risk are normally (positively) related. The higher
the probabilty that a country may default on its debt, the higher the risk of a
devaluation/depreciation of its currency (e.g. Argentina’s 2001 default).
 Exchange Rate Risk
A European Investor wants to buy US Treasury Bonds, which offer a yearly
return of 10%.

He has 100 € to invest and the exchange rate is $/€ = 1

Therefore, he exchanges his 100 euro in $ and buys $100 of US Treasury
Bonds.

At the end of the period he gets back his capital plus interest, hence = $110.
In $ terms, he has earned $10.

However, our investor lives in Europe and he is therefore interested in having

his money back in euros. To this aim, he will have to convert the $110 in euros

Assume that in the meantime the dollar has depreciated by 10% vis-à-vis the
euro. Hence $/€ = 1,1

His total capital in euros will then be: 110/1,1=100 which means that in

‘real’ terms his return is zero!!!

Yields and spreads relative to the
German Bund for some euro area
countries

Source: Rabobank, 2016

 10-years Government bond
yield Italy Vs Germany

Source: Countryeconomy.com
 Risk aversion
Individuals and investors are normally risk adverse. There a two fundamental
ways to cope with risk.

1. Diversification: an international investor has additional opportunities

compared to a domestic investor as he can diversify his portfolio over a much
larger number of assets, countries and regions of the world.

2. Hedging (especially against ex. rate risk): special types of contracts

designed to enable investors as well as importers and exporters to cover the
risk of unexpected changes in exchange rates (Chapter 15, Prof. Ziliotto).
 Systemic Risk
• SR is the risk that a crisis may involve an entire region or even the global
economy.
• A systemic crisis can originate in a single country (or region) and spill over to the
entire system through various financial and real channels (‘contagion’ or
‘domino’ effect).
• The financial system with its multiple links is a major channel of transmission of
shocks.
• In a systemic crisis rational behaviour – like running away from too risky assets
or countries – may be heightened by irrational components (herding or panic).
• Financial globalization has hightened systemic risk.
• Large financial institutions (like Lehman Brothers) may be ‘too large to fail’ and
hence be classified as ‘systemically’ important.

Systemic risk in the globalized economy is drawing a lot of attention on the part
of both economists and policy makers.
 Commercial Banks
See also: International finance and the
global economy
• Commercial (or deposit) banks are at the centre of global financial system.
Virtually any financial transaction involves a commercial bank.
• To buy a stock or a bond, a capital good or an apartment, to exchange
currencies or making a loan, you have always to do with a commercial bank and
move money in and out of your deposit.

• Systemick risk (at the local or wider level) is intrinsic to commercial banking.
Hence, it is not by chance that commercial banks are the most regulated sector
in any economic system!
• Banks are supervised by banking authorities that have special skills and not
necessarily coincide with the national central banks, whose main purpose is to
provide liquidity.
• Prudential supervision is the dominant approach in dealing with financial
instability. Banks have to respect some minimum capital requirements as a
proportion of their total assets. This capital provides a buffer in the case of crisis.
 Investment Banks
• Investment banks are involved in the business of raising capital for companies.
They sell securities to public investors in order to raise cash and these
securities can come in the form of stocks or bonds.

• Full-service investment banks usually provide both advisory and financing

banking services, as well as the sales, market making, and research on a broad
array of financial products including equities, credit, rates, currency,
commodities, and their derivatives.
• The difference between how a typical investment bank and a typical commercial
bank operate is simple: a commercial bank takes deposits for checking and
savings accounts from consumers while an investment bank does not.
• The biggest full service investment banks include Bank of America, Barclays
Capital, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan
Chase, Lazard, Morgan Stanley, Nomura Securities, UBS, Wells Fargo
Securities.
 Top 10 Investment Banks

Source: Bloomberg, 2017

 Institutional Investors
• This category refers to a variety of entities that intermediate savings: insurance
companies, pension funds, mutual funds, hedge and speculative funds, etc. etc.

• They manage huge pools of money and have no less influence than banks in
affecting financial markets and the global economy.

• Institutional investors may invest in all kinds of assets, from real estate to the
most complex financial instruments depending on their specific mandate. Some
have a more long-term perspective (like pension and insurance funds), others
are more short-term oriented (like hedge and speculative funds).

• As shareholders, institutional investors can play important roles in the

governance of large corporations and be entitled to voting rights.

• Institutional investors play a vital role in capital markets as they diversify

portfolios across asset classes, economic sectors, countries, and regions of the
world. However, as they move huge flows of funds, they can exert a daunting
influence on financial markets and the real economies.
 Sovereign Wealth Funds
• SWF are a special kind of investment funds in that they are not private but state-
owned funds.
• They hold and manage the wealth accumulated by a country through its central
banks’ activity, its balance of payments (mostly oil revenues) or its state-owned
entreprises.
• The first SWF was the Kuwait Investment Authority, that was created in 1953
from oil revenues. It is now worth approximately $300 billion.
• Sovereign wealth funds have been around for decades but since 2000 their
number and importance has increased dramatically.
• There are several reasons why the growth of sovereign wealth funds is
attracting close attention: (1) their potential impact on financial markets given
their sheer size; (2) the concern that SWF can get control of strategically
important industries for political and not economic reasons; (3) their lack of
transparency.
• It’s estimated that taken together, governments of SWFs, largely those in
emerging economies, have access to a pool of funds totalling $20 trillion.
• The Santiago Principles (2008) set out the best practices that SWFs should
follow, on a voluntary basis, in their operations.
 Sovereign Wealth Funds
by Funding Source and by Region
Other
Americas
Total Oil & 2,8% 1,4%
Total Other Gas Related Europe
43,1% 13,1% Asia
56,9%
39,7%

Middle East
40,2%
Africa
2,7%

SWF by SWF by
Source
Source: SWFI, 2017
Region
 Top 10 Sovereign Wealth Fund by
Country
Assets
Sovereign Wealth Fund Asset Inception Origin
Name $billion
Norway GPFG 885 1990 Oil

China China Investment Co. 813 2007 Non commodity

UAE Abu Dhabi Abu Dhabi Invest. Authority 792 1976 Oil

Kuwait K. Invest. Authority 592 1953 Oil

Saudi Arabia SAMA 576 n/a Oil
China SAFE 474 1997 Non commodity

China-Hong Kong H.K.M. Authority Inv Portfolio 457 1993 Non commodity

Singapore Singapore Inv.Corp. 350 1981 Non commodity

Qatar Qatar Inv.Authority 335 2005 Oil

National Social Security
China 295 2000 Non commodity
Fund

Source: SWFI, 2017

 Central Banks
• Central banks are major actors in financial markets as they create
money (fiat money) and regulate the amount of liquidity in the system.
• They play a fundamental role in financial crises by discharging the
‘lender of last resort function’.
• In systemic crises they can help avoid a liquidity crunch (see the role the
ECB is playing in the current euro crisis) by providing cheap money to
banks or (exceptionally) through the subscription/acquisition of
government debt or other assets (e.g. bad loans from banks).
• Approches differ from central bank to central bank. For instance, there is
a major difference between the FED, whose mandate includes the
objective of supporting economic growth, and the ECB, that targets
inflation (less than 2%).
• In some cases CBs are also charged with banking supervision, in others
they are not (e.g. Prudential Regulation Authority-PRA in the UK).
 The Basel Capital Accord (s)
See also:
Working within an international context: arising risks and available mechanisms for hedge

• The Basle Accord is the way prudential supervision is implemented at the

international level, with the purpose of avoiding ‘competitive deregulation’.

• The Accord is an outcome of the work of the Basle Committe on Banking

Supervision, a forum for regular cooperation on banking supervisory matters
that was established in 1974 after the default of the Herstatt bank.

• The Committee is headquartered at the BIS (Bank for International Settlements)

(see Levi p. 515). Its objective is to enhance the understanding of key
supervisory issues and improve the quality of banking supervision worldwide.

• The Basel Accord sets the minimum capital requirements that banks around the
world should hold on a prudential basis.

• The level at which capital requirements are set is a major determinant of the
banks’ capacity to provide credits and of the likelihood that financial crises
occur.
 Brief History of the Capital
Accord
• Basel I – 1988
Focused on credit risk. Assets of banks were classified and grouped in five
categories according to credit risk, carrying risk weights of zero (for example
home country sovereign debt), 10, 20, 50, and up to 100 percent (this category
include, among others, most corporate debt). Banks with international presence
were required to hold capital equal to 8 % of the ‘risk-weighted assets’.
• Basel II – 2004
Uses a "three pillars" concept – (1) minimum capital requirements (addressing
risk), (2) supervisory review and (3) market discipline. Extends the focus to
‘operational risk’ and ‘market risk’. Relies heavily on ratings either set by rating
agencies or directly by banks.
• Basel III – 2010-11
A much wider and complex approach to banking supervision developed in
response to the deficiencies in financial regulation revealed by the late-2000s
financial crisis. In addition to raising basic capital requirement levels, it
introduces additional capital buffers in order to reduce: (i) leverage, (ii) the
maturity mismatch, and (iii) countercyclical effects.
 Government Bonds
• Government Treasuries are another important player in international
financial markets mainly through the issuance of short, medium and long-
term bonds.

• In 2015, the U.S. Treasury issued $2.1 trillion in new long-term securities,
almost three times the $788.5 billion issued in 2006.

• The U.S. Treasury bond market outstanding was $13.2 trillion as of end-
2015, up three-fold from end-2006.

Bonds
Notes 27% 3%
U.S. Treasury
Bond Issuance By
Tenor, 2015
Total: $7.0 trillion Bills
70%
 Government Bonds
• European government bond issuance is estimated at €1.24 trillion in

2012, compared to €1.19 trillion in 2010.

• Italian government bond issuance was €60 billion in 2015

• Italian government bond issuance in 2019: €400 billion

Do government bonds still represent the risk-free asset?

 Ratings
• Ratings help assess the creditworthiness of firms, banks and countries (government
bonds) when they operate internationally. They are a measure of the ‘quality’ of credits.

• Standard&Poors, Moody’s and Fitch are the best known (international) rating agencies
but there are a lot more.

• Ratings go from AAA of Std&Poors (Aaa for Moody’s and Fitch) to Bbb or ‘C’ (junk
bonds.) Assets with a rating above BBB are said ‘investment grade’.

• Bank regulation relies significantly on ratings (Basel Accord)

• Institutional Investors also rely on ratings in their investment decisions. Fund

managers may set a threshold rating above which investments are allowed (this
implies that if an asset that is present in the fund portfolio falls below the threshold
rating it is to be dismissed).
How reliable are rating agencies?
There is a serious debate on the validity of ratings, on rating agencies and their
methods. Rating agencies are accused of:

- setting often the wrong ratings (e.g. subprime loans)

- failing in predicting financial/corporate crises thus issuing downgrades when it is

too late (see Lehman Brothers)

- aggravating financial or corporate crises due to the wrong timing of

downgradings (see the recent downgrading of several European countries
during the euro crisis)

- being in a conflict of interest as they are paid by the firms that ask to be rated.

Yet, it is difficult to imagine a world without ratings!

The 3 giants of rating
Other rating agencies
 International Accounting
Standards
• Accounting Standards are an important variable in the context of financial
crises, as they may contribute to the spread of financial instability depending on
the way assets are valued in financial statements.

• Recording assets at their ‘historical’ values may not reflect over time their true
value.

• Using the ‘mark-to-market’ principle (i.e. the market price or quotation), however,
introduces ‘instability’ in financial statements.

• During financial/liquidity crises, application of the mark-to-market principle may

trigger a downward spiral: assets prices go down, financial statements worsen
and this may lead to more asset sales.

• This spiral was certainly at work during the recent crisis, and has hit especially
banks.

Economists and accountants are debating on how to mitigate the undesired

effects of the mark-to-market principle.
 International Financial
Organizations
• International financial organizations, like the World Bank and the
IMF, provide liquidity to countries with temporary or structural
problems and hence may influence financial markets.

• The WB issues AAA-rated bonds in order to finance projects in

developing countries (long term financing).

• The IMF supports countries with liquidity problems due to a

worsening of the BoP and helps prevent or resolve financial crises
(short terms or emergency financing).
• The IMF supervises economic and financial policies around the
world and is the true guardian of financial and exchange rate
stability.
• It has intervened in almost every recent financial crisis episode, but
it failed to predict the Great Crisis.
 Back to Financial Crises
• Financial Crises touch most of the variables and players we have
discussed.

• They normally affect (i) the exchange rate; (ii) the banking system; (iii) the
BoP and the external debt of a country…

• .. and can trigger domino effects.

• Causes of financial crises vary from case to case and can be found in both
‘internal’ and ‘external’ factors.

• Internal factors are normally to be found in unsound domestic policies

(typically fiscal policy) and inefficiencies in the economy.

• External factors may be found in the instability of international financial flows

and/or too high (international) interest rates.

In every financial crisis economists and policy makers debate on how

relevant are the internal factors vis-à-vis the external ones.
THE END