SCHOOLS BRIEF Capital goes global The rapid rise in international financial flows is often blamed for making financial markets less stable. The blame is undeserved A DECADE ago, about $190 billion passed through the hands of currency traders in New York, London and Tokyo every day. By 1995 daily turnover had reached almost $1.2 trillion. In 1990, $50 billion of private capital flowed into emerging markets; last year that figure was $336 billion. These bald figures confirm what every financier from Wall Street to Warsaw will tell you: that the world’s capital markets have been transformed. Ever larger sums of money are moving across borders, and ever more countries have access to international finance. Under the Bretton Woods system of fixed exchange rates that was set up after the second world war and lasted until the early 1970s, the international flow of capital was severely controlled. A British investor, for instance, could not easily buy American stocks or bonds. Mainstream economic opinion felt that capital mobility was unnecessary, and often undesirable. By the early 1960s markets had found ways of getting around some of these controls through the growth of the “Euromarkets”, where banks located in one country could take deposits and make loans in the currencies of other countries. When the fixed exchange rate system broke down in the early 1970s, the richer economies began dismantling their capital controls. In the late 1980s and the early 1990s, developing countries, too, began to open up. In theory, greater international capital flows should bring important benefits. Savings and investment are allocated more efficiently. Poor countries, with large investment needs, are no longer hamstrung by a lack of capital. Savers are not confined to their home market, but can seek investment opportunities that offer the highest returns around the world. Risk is diversified as investors can spread their portfolios more widely. Yet in many eyes, the integration of financial markets is dangerous and destabilising. Bond traders and currency speculators have supposedly supplanted political leaders in determining macroeconomic policy. Financial markets are said to be more volatile as money moves across borders with a mere computer keystroke. Such extremes of optimism and pessimism are both misplaced. For, despite all the hyperbole, a global capital market does not yet exist. Market power

	It is easy to see how the mistake has arisen. Chart 1 is an index of capital controls in emerging markets compiled by the IMF. It shows that capital restrictions have fallen remarkably in recent years. As this has occurred, foreign financial flows to these countries have risen (see charts 2 and 3). This has fostered the belief that the world now has a global capital market. However, the measure of a country’s net inflow or outflow of capital is its current account. If the capital market were truly global, some countries with high investment needs might be expected to have very large current-account deficits, and countries with large savings would be expected to have large surpluses. This has not occurred. In rich countries, current-account imbalances have averaged 2-3% of GDP during the 1990s. Even at their peak in the late 1980s, Japan’s and Germany’s current-account surpluses reached only 4-5% of GDP. To gauge the extent to which capital markets have historically been integrated, Alan Taylor, an economic historian at Northwestern University in Illinois, has calculated a “capital-mobility index” (chart 4). This measures the average of several countries’ current-account imbalances relative to GDP. Although the index is rising, it has yet to reach the peaks of the early 20th century. The relationship between national saving and investment tells the same story, since a country’s current-account imbalance is the difference between the amount it saves and invests. In a world of perfectly mobile capital there should be little relationship between the two variables. Yet, as Martin Feldstein and Charles Horioka famously pointed out in 1980, countries’ savings and investment rates tend to be highly correlated. There is some evidence that this link has weakened a little in recent years. But it is still true that most investment is financed domestically. In the 1990s, for instance, only 10% of the domestic investment in emerging economies has been financed from abroad. This, again, suggests that capital markets do not fully transcend national boundaries. Unequal returns Examining the prices of financial assets leads to the same conclusion. If the world market for capital were perfectly integrated, then identical assets would command the same price everywhere. In particular, the returns paid on comparable financial instruments would equalise, so that the rate of interest on a safe dollar-denominated bond of a given maturity would be the same as on a similar sterling-denominated bond, after allowing for the cost of “cover” against the exchange-rate risk. If this were not the case, then arbitragers could make money risklessly. To see why, consider the following example. An American investor has $1,000 to invest. American interest rates are 6% and British interest rates are 8%. By keeping his money in America, the investor would receive $1,060 at the end of one year. Alternatively he could take the $1,000 and convert it into sterling at the prevailing exchange rate, say $1.60 per pound. This would give him £625, which in one year’s time will pay £675 (at the 8% interest rate). To eliminate any risk in the transaction, the investor would arrange to sell these £675 at a fixed price a year from now. If the forward exchange rate is $1.57, the investor would have $1,060 in a year’s time, the same return that he would make on his dollar deposit. If the forward exchange rate were the same as the spot rate ($1.60) then the investor would receive $1,080 in a year’s time, and would have made more money risklessly. So competing investors will push down the forward exchange rate until it hits $1.57, the level at which the two investments end up equal. As industrial countries have removed their capital controls, this is exactly what has happened. The divergences from “covered interest-rate parity” have fallen significantly. At least among rich countries, capital markets are so integrated that riskless arbitrage opportunities have vanished. A lack of arbitrage opportunities, however, is not the same as a global capital market. Full integration would equalise the expected rates of return on countries’ bonds when measured in a single currency. If investors see British and American bonds as perfect substitutes, then the expected movements of their currencies against one another should equalise the differential between their interest rates. Even amongst rich economies this condition does not hold, largely because investors still worry about the risk of unforeseen exchange-rate depreciation. An even stricter test of capital-market integration, and the one on which the flows of saving and investment really depend, is that real (ie, inflation-adjusted) interest rates should be equal across countries. For this to occur, a number of tough conditions must hold. Not only must investors regard assets in different countries as perfect substitutes, but expected changes in exchange rates must also equal the expected inflation differential between two countries.

	In practice, neither of these tough conditions holds. Investors do not regard assets in different currencies as perfect substitutes, nor do exchange rates always reflect inflation differentials. As chart 5 shows, real interest rates differ substantially among rich countries. Between rich and poor the differentials are even larger. There is no “world” interest rate, and, hence, no single global capital market. Reassessing the risks Just as the extent of capital integration is often exaggerated, so is the extent to which capital mobility has actually changed the environment in which governments work. Two charges are often made: that financial markets are much more volatile now than they used to be, and that governments’ macroeconomic policies are less effective. The first charge is simply false. Flexible exchange rates have, almost by definition, brought greater volatility in currency markets. But it is not clear that the prices of other types of assets are more volatile. Careful statistical studies show that share prices, for example, fluctuate no more today than they did when capital flows were limited. Bond markets have on average been no more volatile during this decade than in the 1970s. The claim that governments’ macroeconomic policies are becoming less effective is more complicated. Governments retain their basic tools of fiscal and monetary policy just as much as they ever did. The difference lies in the impact each tool has. In an economy where capital cannot flow easily across borders, two basic economic truths hold. The first is that greater government borrowing will eventually push up interest rates. The second is that excessive monetary growth will eventually result in higher inflation. These basic constraints are not magically removed with capital mobility. The big change comes in the relative power of fiscal and monetary policy. In a closed economy, greater government spending and monetary expansion may increase output in the short term, but in the long term one results in higher interest rates and the other in higher inflation. In an economy open to capital flows, the impact of these levers depends on the exchange rate. If the exchange rate is fixed, then fiscal policy is very effective while monetary policy is muted. If the exchange rate floats, then monetary policy is very effective while fiscal policy is muted. Only in one area has capital-market mobility truly limited governments’ choices: exchange rates. When capital was not mobile, governments, at least in the short run, were able to have the the stability of a fixed exchange rate while still being able to use monetary policy to expand the economy. This is no longer possible. In a world of more mobile capital, if governments want to fix their exchange rates, then monetary policy must be devoted solely to that goal. This means that if investors begin to pull out of a country and sell its currency, interest rates must be raised enough to stem the flow or else the exchange-rate peg will be broken. If the banking system is weak, such an increase in interest rates may cause widespread bank failures. Pegging the exchange rate to some foreign currency does not automatically make an economy more stable. If domestic economic policies are inconsistent with the rate that has been chosen, a fixed rate can lead instead to greater instability. At the same time, however, it is true that countries with relatively small and unsophisticated financial markets face greater risks from opening up to foreign capital than more advanced countries do. One is that capital could suddenly flee if, as occurred in Mexico in 1994 and in Thailand in 1997, investors lose confidence in a country’s economic policies. Another is that investors can lose confidence in one country because other countries around it are in trouble. There are a number of ways in which countries can attempt to deal with these risks. Following sensible macroeconomic policies is one. Making sure that banks are well regulated and well capitalised is another. A more controversial defence is to be cautious about how quickly to open up capital flows. Some countries, notably Chile, have retained controls on short-term capital inflows, to minimise their vulnerability to currency speculators. Economists disagree about how effective such controls are in the long term. But it is certainly sensible for countries with underdeveloped financial markets and weak banks to open their financial sectors gradually. A trickier question—and one that is on the minds of many Asian policymakers today—is whether it makes sense to reimpose controls in a crisis. The Thai government tried that strategy this year, hoping to buy time. It did not work. Not only are effective capital controls quite difficult to reimpose, they are also likely to undermine investors’ confidence yet further. Having investors vote with their feet—or their money—is no bad thing, for the broad trend towards greater financial integration is a healthy one. Although a single global financial market is still far off, the trend is at least in the right direction.