International Financial Markets: Globalization and Deregulation

Introduction to Global Capital Flows and Financial Integration

During the past several decades, a trend of increased volume and mobility of capital flows has been observed in global financial markets. According to a rough estimate, the annual value of global GNP is now less than the volume of financial transactions across all the world's financial markets. The increase in financial mobility can be attributed both as a result and a cause of the increased financial integration of the world economy. Increased financial integration also plays a vital role in creating an impact on domestic financial markets. Some powerful economies' governments have held negotiations among themselves to focus on each other's policy stances with regard to interest rates, monetary policy, and exchange rates.

In earlier years, capital flows resulting from interest rate differentials were not directed towards industrial countries in any consistent way. In the 1990s, however, these capital flows began to target emerging markets as their destinations. According to one estimate, capital flows were only $15 billion in the early 1990s, rising to more than $100 billion by 1993. This rapid change in capital flows was the result of three key reasons. First, developing countries with high current account surpluses and strong growth rates became very attractive for investment, as they possessed high potential for currency appreciation and capital gains. Second, the interest rates of industrial countries decreased due to recession. Third, major U.S. institutional investors adopted international diversification of investment portfolios in pursuit of increased potential for capital gains and growth (Tornell and Martinez, 2003, pp. 110–112).

In earlier years, the regulation of domestic financial markets was considered a success, as it aligned with effective and efficient economic performance. Financial conditions in other countries are dependent on changes in a given country's interest rate. In order to increase financial and capital flows between countries, control of interest rates must be carefully considered. As a result, the efficacy of monetary policy instruments — generally aimed at domestic macroeconomic balance — becomes limited.

Countries began pursuing financial deregulation because the regulation of financial markets was no longer achieving expected results: partly due to increasing financial integration, and partly because the regulations began to create hindrances in the efficient functioning of markets that they had previously served well. It should be kept in mind that deregulation is not without its challenges. It resulted in increased interdependence and diminished the functioning of the macro-economy in ways that were difficult to anticipate. The behavior of interest rates, exchange rates, and capital flows has been affected by financial deregulation in unexpected ways (Tornell and Westermann, 2005, p. 43).

The adoption of financial deregulation by emerging markets resulted in increased efficiency through the reaping of benefits from global capital market linkages, while also incurring associated costs. Capital flows are directly proportional to a country's economic prospects: as prospects improve, capital flows increase, widening growth and investment opportunities while making resources relatively scarcer. Increased capital flows can result in currency appreciation at the expense of export industry competitiveness, or they can lead to domestic credit expansion that drives inflation higher. The financial integration of the global capital market has made policy options considerably more diverse than before.

Financial globalization is the process of creating a single integrated market through the unification of all the world's financial markets.

International diversification is a risk-reduction technique that involves investing across more than one market.

Definition of Key Terms

Cost of capital is defined as the rate of return a company could obtain by investing in another project with the same risk exposure.

Cost of equity is the rate of return a company provides to its stockholders.

Impacts of Financial Deregulation and Capital Controls on Financial Globalization

Cost of debt is the interest rate a company pays on its borrowings.

Increased penetration of financial deregulation and the relaxation of capital controls have resulted in the diversification and globalization of financial markets. Financial deregulation and capital controls have also paved the way for financial market growth, which in turn has produced a more competitive, restructured, and lower-cost financial services industry. Alongside this, the fast-paced pace of deregulation has caused the volume of financial transactions to exceed that of international trade in goods and services. The resulting economic instability and uncertainty pose threats to the international diversification of capital flows. Global financial markets operate around the clock and respond so quickly to change that the danger of chain reactions — which could precipitate a global financial market crisis — is growing.

Financial markets are a prime example of an economic activity in which capital controls and regulations can produce inefficiency and distortions rather than promoting effectiveness and efficiency. These markets have the capacity to adapt to changes rapidly and efficiently. Fungible assets are generally traded in these markets. "Due to improvements in computer technology and communication, the fungibility of assets is prevailing at a global level, with minimized transaction costs" (Schneider and Tornell, 2004, pp. 883–913). This fungibility of assets does not depend on currency denomination. This type of financial environment encourages swift price changes that affect all assets, creating a broad impact on the global market. Market equilibrium can readily be restored by these rapidly adjusting prices in response to changing financial conditions.

Nevertheless, the financial services industry represents only a single segment of any economy. In this industry, expectations, trust, and confidence have a more sudden and powerful influence on reactions and actions than in virtually any other segment. One of the main rationales for regulating financial markets is to maintain the level of trust in financial agents. This has historically resulted in broader economic policy objectives being pursued through financial market regulation — for example, using credit controls and interest rates to serve monetary policy, or using capital controls to stabilize exchange rates. Thus, controls and regulation of financial markets have helped reduce financial volatility and its feedback effects on factor markets more broadly.

This relatively stable arrangement persisted until the early 1980s, when the encroachment of the public sector on economic activities emerged as a growing concern for industrial countries. This concern was also engaged intellectually through the classical economic theories of the nineteenth century, and a free-market reformist stance was promoted among policymakers and governments of the leading industrial economies.

As a result of this shift, the deregulation of economic activities took place, with the financial markets experiencing deregulation most rapidly and pronouncedly. Competition was stimulated along with substantial innovation and a resulting liberalization of financial activities. Capital market efficiency gains from liberalization increased with greater liquidity, and the costs of financial intermediation were reduced. Short-term liability and asset management also improved with the introduction of risk-minimization techniques. Finally, this liberalization and deregulation resulted in an improved ability to withstand risks and to increase capitalization (Ranciere and Westermann, 2006, p. 65).

These recent transformations of the global capital market have also resulted in increased financial and economic costs. Risks associated with off-balance-sheet exposures emerged as commercial banks expanded securities lending. These off-balance-sheet risks could potentially mortgage the future solvency of banks. At the same time, monetary policy implementation was made more complicated by the increased volatility of global financial markets, together with the heightened substitutability of money for financial instruments.

Generally speaking, one of the most serious impacts of financial deregulation is the disconnection between the financial markets and other sectors of the economy. The financial services industry has grown more rapidly than other segments of the economy in major industrial countries, resulting in an increased volume of financial capital flow transactions. The increased volatility of financial markets poses destabilization risks for all other sectors of the economy.

Conclusion

Ranciere, R., Tornell, A., and Westermann, F. (2006). Decomposing the effects of financial liberalization: crises vs. growth. Journal of Banking and Finance (forthcoming), p. 65.

Schneider, M., and Tornell, A. (2004). Balance sheet effects, bailout guarantees and financial crises. Review of Economic Studies, 71, 883–913.

Tornell, A., and Westermann, F. (2005). Boom-Bust Cycles and Financial Liberalization. Cambridge, MA: MIT Press, p. 43.

Tornell, A., Westermann, F., and Martinez, L. (2003). Liberalization, growth and financial crisis: lessons from Mexico and the developing world. Brookings Papers on Economic Activity, 2003(2), 110–112.