International Financial Integration

403 Pages·1990·9.399 MB·English

by  Professor Dr. Lars Oxelheim (auth.)

Lars Oxelheim
International
Financial
Integration
With 44 Figures
Springer-Verlag
Berlin Heidelberg N ew York
London Paris Tokyo
Hong Kong
Professor Dr. Lars Oxelheim
The Industrial Institute for Economic and Social Research
Industrihuset, Storgatan 19, P.O. Box 5501
S-114 85 Stockholm, Sweden
ISBN-I3: 978-3-642-64779-6 e-ISBN-I3: 978-3-642-61293-0
001: 10.1007/978-3-642-61293-0
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© Springer-Verlag Berlin· Heidelberg 1990
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Foreword
There is widespread agreement in the current social and economic debate that the
nations of the world are becoming increasingly integrated. Many structural signs in
society also suggest that this is so. Integration has become a catchword in the prepara
tions for the internal market of the EC, and a keynote in the debate about association
for the European countries which do not belong to the Community. But when we turn
to the question of how this integration should be measured, there is very little con
sensus. Instead there are numerous problems, not only about how to measure integra
tion but even about how to define it.
In this book I shall discuss the import and implications of a particular type of
integration, namely financial integration, and then look at the most important
problems connected with measuring it. In the empirical investigation reported below I
felt the need for an integrated micro-macro approach. Further, I decided to illustrate
the measurement problems by studying a small and relatively open economy where
exchange controls have been imposed by the government in an attempt to reduce the
flow of interest-sensitive capital out of the country, and thus to acquire autonomy for
the national monetary policy. An interview study has been carried out with a view to
illustrating among other things how expectations are formed among the major actors
on the financial market, and this provided additional input for an analysis of the level
of financial integration.
For much intellectual support I would like to thank Professor Clas G. Wihlborg,
University of Southern California and Professor Thomas D. Willett, Claremont Gradu
ate School. Valuable comments have also been made by many seminar members at the
Gothenburg School of Economics, the Industrial Institute for Economic and Social
Research (lUI), and the central bank of Sweden (Sveriges lliksbank).
I would also like to thank Professor Gunnar Eliasson, director of lUI, who made
facilities available to me for writing this book at the Institute. Moreover, I wish to
thank .;the Banking Research Institute in Stockholm for its role in providing financial
support for the translation by Nancy Adler, to whom I also express my thanks.
Any remaining errors and omissions are of course entirely my responsibility.
Stockholm, January 1990
Lars Oxelheim
A note to my readers
This book is the third in a trilogy which describes how disturbances or shocks on the
world market are transmitted to the small open economy and then to the individual
corporate profit and loss account.
In the present book I discuss the first stage in this transmission, i.e. how the
disturbance is transmitted to the small open economy. Oxelheim and Wihlborg (1987)
presented a frame for analysing the second stage in the transmission, i.e. how corporate
managers should cope with such disturbances or more generally with fluctuations in the
conditions on the world market. Finally, in Oxelheim (1985) I discussed the last step in
the transmission, Le. how the effect of the disturbance on the world market should be
assessed and reported to external corporate stakeholders.
In this book I am addressing three categories of readers, each with its own store of
previous knowledge and its own particular interests. One group consists of researchers
in economics and business administration, who should find something to interest them
in all parts of the book. I have also had this group particularly in mind in writing
Chapter 3.
The second category consists of students of economics and business administration,
particularly those with a special interest in financial markets and international finan
cial and investment analysis. The conceptual side is generally of greatest interest to
students, while empirical results are probably less important. I therefore recommend
this group of readers to study Chapters 1-2, 4 and 8.1-8.5, including appendices.
Students who are particularly interested in analysis should also look at Chapter 3,
which describes the analytical problems that have arisen in previous studies, and/or
Chapters 5-8, which describe the analytical method adopted here.
The third reader category consists of business executives, bankers and politicians
interested in empirically grouped conclusions about levels of integration and interest
rate autonomy, or in opportunities for profiting from international arbitrage. I
recommend this group of readers to look at Chapters 1, 2.3, 2.8-2.9, 4.4--4.5, 5.4, 6.4,
7.5,8 and 9.
Because I hope to reach such a broad readership, those who decide to read the book
in its entirety may find that I have repeated myself in defining the meaning of certain
expressions of crucial importance. For this I crave their indulgence.
CONTENTS
Page
Chapter 1 The Global Interdependence of National Financial Markets 1
1.1 Many signs of increasing market integration 1
1.2 Previous integration studies demonstrate difficulties
in measurement and interpretation 2
1.3 The aim is to measure the level of financial integration 4
1.4 Different forms of financial integration 4
1.5 Interest rate differential or capital flow as dependent
variable? 6
1.6 What types of interest rate are relevant to an analysis
of financial integration? 7
1.7 What interest rates are the leaders as the influence
II II ,
of the US rate declines? 8
1.8 Why is the level of financial integration interesting
in a macro-perspecti ve? 10
1.9 What is the significance of the level of financial integration
in a micro or corporate perspective? 12
1.10 Is the interest rate in a small open economy determined
on foreign mark~ts? 13
1.11 Growing uncertainty raises demands for higher risk premiums 14
1.12 The internationalization of trade 14
1.13 The internationalization of financing 15
1.14 The internationalization of production 16
1.15 Design of the analysis 16
1.16 Plan of the book 17
Chapter 2 What Is Financial Integration, and Can It Be Measured? 19
2.1 Introduction 19
2.2 Are interest rates determined at home or abroad? 20
2.3 Capital flows and the links between markets 34
viii
2.4 Exchange rate determinants and market expectations 42
2.5 Transaction costs and different types of risk premium 50
2.6 The link between risk and return 59
2.7 Financial integration and monetary autonomy - some measures
and analytical approaches 62
2.8 Applied definition and the choice of model 69
2.9 Disintegration and monetary autonomy by way of controls 72
2.10 Problems of measurement and standardization 74
2.11 Collecting primary data 78
2.12 Concluding comment on the methodological problems 80
Appendix
2.1 Fisher (Domestic) Effect 81
2.2 Variability in interest rates after tax 81
2.3 The International Fisher Effect 83
2.4 Model for determining the exchange rate 86
2.5 Example of a portfolio approach 87
2.6 The interest rate parity theory 91
2.7 Swedish industrial groups with a turnover
exceeding SEK 1 billion in 1981 94
Chapter 3 Results and Findings from Earlier Studies of Financial
Integration 105
3.1 Introduction 105
3.2 Studies of the interest-sensitivity of capital flows 105
3.3 Equal expected returns as an indicator of direct
financial integration 111
3.4 Observations from the literature - a summary 134
Appendix
3.1 Adjusting portfolios in an open economy 136
Chapter 4 Characteristic Features of the Financial Market in a Small
Open Economy - the Case of Sweden 141
4.1 Introduction 141
ix
4.2 Actors on the Swedish financial market 142
4.3 Rates of interest and administrative control mechanisms 148
4.4 Swedish exchange controls and their effect on segmentation 156
4.5 The Swedish krona - historical exchange rate patterns
and the formation of expectations on the market 170
4.6 Specific measurement problems 188
Appendix
4.1 Date of abolition of monetary policy regulations, 1978-85 193
4.2 Exchange rate index 194
4.3 Standard deviations in the forward and spot rates 195
4.4 Foreign exchange flows 1974-84 195
4.5 Current account reporting according to SCB 201
Chapter 5 Fluctuations in Swedish Interest Rates - Historical Patterns 205
5.1 Introduction 205
5.2 Nominal and real Swedish interest rates 1974-84 205
5.3 Correlation between successive quotations of Swedish
interest rates 215
5.4 The interest rate pattern and direct financial integration 217
Chapter 6 Swedish Interest Rate Fluctuations in an International
Perspective 223
6.1 Introduction 223
6.2 How Swedish nominal interest rates deviate from foreign
interest rates 223
6.3 Deviations of Swedish real interest rates from foreign real
interest rates 243
6.4 What does this initial comparison suggest about financial
integration? 245
Chapter 7 Swedish Interest Rate Dependence: A Correlation Analysis 247
7.1 Introduction 247
x
7.2 Covariation between Swedish and foreign real interest rates 248
7.3 Covariation between the Swedish nominal interest rate
and the foreign rate 251
7.4 Covariation between the Swedish interest rate and
the forward-covered foreign interest rate 257
7.5 The correlation analysis and direct financial integration 263
Chapter 8 A Model-Based Analysis of Direct Financial Integration 267
8.1 Introduction 267
8.2 Analysis of deviations from the International Fisher Effect 268
8.3 Analysis of deviations from interest rate parity 275
8.4 The forward rate as an unbiased estimate of the future
exchange rate 279
8.5 Presentation of the model 281
8.6 Analysis of the gap between Swedish and foreign
discount rates 294
8.7 Analysis of the gap between Swedish and foreign interest
rates on treasury discount notes 304
8.8 Analysis of the gap between Swedish and foreign prime rates 314
8.9 Analysis of the gap between the Swedish interest rate on
government bonds/government notes and the corresponding
foreign rate 321
8.10 Analysis of the gap between Swedish and foreign interest
rates on industrial bonds 329
Chapter 9 Interest Rate Autonomy and the Foreign Dependence
of the Swedish Financial Market - A Summary 341
Supplement 1 Mean and standard deviation in the international
interest rates 1974-84 355
Supplement 2 List of variables and abbreviations 360
Index 364
Bibliography 371
List of Figures
1.1 Equilibrium relationships between changes in exchange rates,
rates of inflation and interest differentials 9
1.2 The monetary policy triangle 10
2.1 Supply and demand for capital - the real equilibrium interest rate 24
2.2 National and international financial markets 30
2.3 Euromarket versus national market 31
2.4 Information flows and financial links 35
2.5 Outline of total financial integration under different market
assumptions 37
2.6 Factors affecting the Swedish money supply in the budget year
1983/84 38
2.7 Corporate risks 54
2.8 Choice of approach in analysing financial integration 67
A2.1 Expected return and standard deviation on portfolios
based on two assets 90
A2.2 Efficient portfolios 91
A2.3 Arbitrage argument - deviations from interest rate parity 93
3.1 Nominal financial balances in relation to trade flows, 1963-84 107
4.1 Outstanding sums for different instruments on the Swedish
money market 1980-85 150
4.2 Money market interest rates in Sweden and the central bank's
discount rate 1978-85 154
4.3 Interest rate scale for banks' borrowing from the central bank 155
4.4 Exchange rate index SEK/foreign currencies 1970-84 175
4.5 Weekly changes in the (spot) price in Swedish kronor of the most
important currencies in the Swedish currency basket 1974-84 177
4.6 Real effective exchange rates - major OECD countries 1976-86 179
4.7 Real effective exchange rates - small and relatively open economies
1976-86 180
4.8 Non-government capital flows according to SCB's and the central
bank's estimates 1974-84 192
5.1 Nominal interest rates 1900-1985 206
5.2 Penalty rate and interest rate on three-months treasury discount notes
1982-85 209
5.3 Real interest rate trend 1900-1985 212