The World Of
International Finance
By C.P Chandrasekhar
06 November, 2004
Frontline
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.