Foreign Exchange Issues, Capital Markets and International Banking in the 1990s (RLE Banking & Finance)

Khosrow Fatemi, Dominick Salvatore

• Publisher: Routledge
• Year: 2012
• ISBN:
  9781136267444
• Edition: 1
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

The need for continued analysis and evaluation of the international financial system is as pressing now as it was when this book was originally published. This volume provides an in-depth analysis of certain aspects of the international financial system. Specifically it addresses four of the most important financial and monetary issues of the present time: exchange rate, capital markets, international banking and external debt and international financial management.

Chapter 1

Introduction

Dominick Salvatore and Khosrow Fatemi

The worldwide deregulation movement of the 1980s and the resultant globalization of financial markets have led to increased efficiency in the utilization of financial capital and direct investments around the world, but also to greater interdependence of financial markets and to the development of many new financial instruments to meet changed needs and conditions. Furthermore, they pointed to the crucial need to fully understand the implications of recent changes for the functioning of the present international financial and economic systems. This volume addresses some of these important issues. Specifically, as the title indicates, it deals with the effect of recent changes in the international economy on the operation of foreign exchange markets, capital markets, and international banking in the 1990s. The volume includes the most important papers on international finance presented at the first international meeting of the International Trade and Finance Association held in cooperation with the Ecole International des Affaires in Marseilles, France, from 31 May to 2 June 1991.

RECENT CHANGES IN INTERNATIONAL FINANCE ADDRESSED IN THIS VOLUME

One of the most striking aspects of the present international financial system is the great volatility of exchange rates and the inability of empirical models of exchange rate determination to explain and forecast exchange rate movements. While exchange rate risks can generally be hedged at a cost, persistent exchange rate misalignments can and have greatly disrupted the pattern of international specialization and created serious disruptions in the international economy. An example of this was the sharp overvaluation of the U.S. dollar during most of the 1980s and the loss of competitiveness of otherwise internationally efficient U.S. manufacturing firms. Indeed, the problem does not seem to end with the elimination of the exchange rate misalignments. Economists have borrowed from physicists the term hysteresis to describe a situation in which trade does not return to equilibrium even after the exchange rate misalignment has been eliminated. Thus, is is important to know what the equilibrium exchange rates are and to avoid large and persistent exchange rate misalignments and excessive fluctuations. The fact is that no model has been able to correctly and consistently forecast exchange rates. There are three main reasons for this. First, most models of exchange rate determination emphasize a particular aspect of the economy to the exclusion of other important aspects. Second, exchange rate expectations in exchange rate models are generally based on unrealistic assumptions. Third, new information alters exchange rate expectations instantly and may dominate exchange rate movements. Thus, a more general and eclectic model that incorporates the best of existing models and that can be shown to better predict exchange rates is certainly a welcome development. Such seems to be the model developed by Vincent Dropsy in Chapter 2.

Exchange rate movements also reflect the changed international financial environment, and often, as during the current period of rapid changes, theoretical developments that consider the effect of such changes lag behind actual market developments. A good example of this is in the pricing of currency options in the face of foreign exchange agreements, as for example, the European Monetary System (EMS). It is important to see how arrangements that constrain exchange rate movements affect the pricing of currency options, especially as they become more inclusive and widespread in the international economy. This important aspect is examined in Chapter 3 of this volume. Chapter 4 examines the way in which the large dollar overvaluation during most of the 1980s permanently harmed the international competitiveness of U.S. firms and also interfered with international specialization and trade, because the dollar is still the most important vehicle currency of international trade and finance in the world today. Exchange rate problems, however, do not arise only as a result of misalignment. As pointed out in Chapter 5, if a country such as Japan does not allow the appreciation of the yen toward its equilibrium level from being reflected in lower import prices and higher export prices for Japan, the equilibrating effect of the yen appreciation is not allowed to take place. The same occurs if Japan takes other measures, such as a contractionary fiscal policy that neutralizes the effect of the appreciation of the yen. It is then important to understand that the problem does not lie in the fact that the international economy and international financial markets do not respond to exchange rate changes, but to these other forces that prevent exchange rates from accomplishing their equilibrating function. To examine clearly and isolate the effect of exchange rate changes from other forces simultaneously at work requires the use of counterfactual simulations. If this is not recognized and the problem is attributed instead to economic and financial markets not responding to exchange rate changes, then the wrong policies are likely to be employed.

Another important topic that has traditionally received a great deal of attention is the efficiency of the forward market for foreign exchange. While there is some evidence in support of forward market efficiency, a large body of empirical evidence has rejected the forward rate as an unbiased or efficient predictor of future spot rates. In short, no model seems to outperform a random walk of exchange rates in an out-of-sample period. Many conflicting explanations have been advanced for this, for example, the many risk-averse agents of foreign markets, irrational behavior of agents, financial markets that do not clear, fundamentals that exhibit strong short-term volatility, speculative bubbles, and central bank intervention. A great deal of research has taken place, but no firm conclusion has been reached as to which of these explanations is most important. Chapter 6 of this volume examines the notion that the presence of risk premium in the foreign exchange market allows the forward rate to be an unbiased predictor of the future spot rate without sacrificing the notion of market efficiency.

Another important topic of research into exchange rates deals with the theoretical arguments for and against monetary integration. While this is not, of course, a new topic of research, it has acquired great importance and immediacy today as the result of the formation of the EMS and its movement toward full monetary union. It is important, therefore, to revive the old theoretical arguments and examine them in the light of the experience of the EMS today and in terms of projections for its future. These topics are investigated in Chapter 7 by an observer who is very close to the debate.

A second major area of interest in the present international financial system that is very much in the news these days is the operation of capital markets in a global-economy context. One aspect of the topic addressed in this volume (Chapter 8), especially after the merger frenzy of the 1980s, is the optimal level of leverage or debt-equity ratio for a firm. Another important topic (discussed in Chapter 9) is whether diversification in international capital markets is beneficial. The importance of this topic in international finance in general and international capital markets in particular can hardly be exaggerated if one remembers that two decades ago U.S. pension funds had never been invested outside the United States, and investment of pension funds in many other countries was prohibited.

Today many U.S. pension funds have 10 to 15% of their assets invested internationally and the value of foreign assets that they hold has reached nearly $100 billion. A similar trend toward international investments has occurred in Europe and Japan. This has been the result of the deregulation movement of the 1980s and the increasing recognition of the benefits of international diversification in terms of risks and returns. Since 1986 foreign banks and organizations were allowed to become members of the most important stock exchanges around the world, global around-the-clock trading has become a reality, and Europe is moving toward complete financial integration. Besides examining the optimal level of leverage or debt-equity ratio for a firm and the benefits of diversification in international capital markets, the other papers in Part Two of this volume examine defeased debt in international capital markets, evidence of the co-movement of two Scandinavian stock markets, the American experience with the deregulation of savings and loans associations, “round-tripping” effects of debt-equity swaps, and emerging capital markets and economic development.

A third major area of interest is international financial management. While the basic principles of domestic and international financial management are basically the same, international financial management is more challenging and dynamic because it must consider a wider range of possibilities, opportunities, and challenges than purely domestic financial management. International financial management requires the firm to consider the impact of fluctuating exchange rates and international taxation on the management strategy of the firm. The flow of funds within the units of an international firm, the management of international accounts receivable and payable, and the management of longterm assets are much more complicated and difficult than the flow of funds within a purely domestic corporation or the management of domestic accounts. All of this has led to an explosion of interest in the facets of international financial management, some of which are explored in Part Three of this volume.

One aspect of international financial management examined in this study is the investigation of the presence of nonlinear dependence in daily stock returns on several stock exchanges of different countries. While there is no unanimity regarding the best stochastic generating model, the most commonly accepted position is that U.S. stock returns are approximately uncorrected, but not independent, and described by distributions with fatter tails. It is not known, however, whether this is true for other capital markets around the world, which are generally much smaller and thinner than American markets. Chapter 15 examines this topic for nine countries around the world. Other international financial management topics examined in this volume are the statistical properties of nondeflated and deflated constant dollar accounting signals, the survival analysis theory to business failures, and the desirability of joint ventures in Eastern Europe.

A fourth major area of interest in international finance is international banking as it relates to the external debt of Central and Eastern European and developing countries. There is today a real danger of complete economic collapse in the countries of Eastern Europe and in the former Soviet Union after the fall of communism in the late 1980s and early 1990s. These economies urgently need massive help from the West in the form of capital and technology to restructure their economies along market lines and to integrate them into the world economy. A continuing challenge to the international banking system is also provided by the huge international debt facing many developing countries, which these countries are finding difficult to repay or even service. Large-scale defaults have been avoided so far only by coordinated efforts of debtors and creditors. The problem, however, lingers on. Defaults on such debt could make some of the largest commercial banks in the United States insolvent and possibly lead to a world financial collapse reminiscent of the 1930s. While the danger of default had somewhat diminished by the early 1990s, the persistence of the debt problem was seriously interfering with the process of economic development in many developing countries.

These topics and their suggested solutions are taken up in Part Four of this volume. It is generally agreed today that to avoid complete economic collapse in the countries of Eastern Europe and the former Soviet Union and for the debt problem to be overcome and sustained growth to resume in developing countries, a large increase in the flow of equity capital in the form of direct investments from developed countries and the opening of developed-country markets more widely to the exports of Eastern European and developing countries are required.

OVERVIEW OF THE CONTENT OF THE VOLUME

In Chapter 2, “Diversified Expectations and Speculation in the Foreign Exchange Market,” Vincent Dropsy develops an eclectic model of spot and forward exchange rate determination that incorporates both economic fundamentals and expectations. He shows that this model predicts exchange rate dynamics better than purchasing power parity or the monetary approach model. Dropsy also shows the potentially destabilizing role of technical expectations and examines the possible reasons that traders consistently make forecasting errors.

In Chapter 3, “Pricing Options on a Constrained Currency Index: Some Simulation Results,” Tom Berglund, Staffan Ringbom, and Laura Vajanne point out that the assumption in the classical pricing of options that the exchange rate has a lognormal distribution is not justified in the presence of an exchange rate agreement, such as the EMS. Using a simulation model, they show that allowing exchange rate movements and the probability of a jump to be mutually dependent has significant effects on the valuation of currency options. In Chapter 4, “Exchange Rate Variations and U.S. Multinational Corporations’ Profits: The Case of the 1980s,” Luc Moens shows with the use of an econometric model that the appreciation of the U.S. dollar during the first half of the 1980s led to permanent negative effects on the profitability of U.S. firms in tradable goods industries. This resulted because the appreciation of the dollar sharply reduced the profits U.S. firms and the internal funds needed for sustained investments in crucial areas.

Chapter 5, “Real Exchange Rates and the Sectoral Composition of Output: Some Evidence from Japan,” by Sadequl Islam, examines the relationship between movements in the real exchange rate and output in the industrial sector of the Japanese economy. Empirical results suggest that the real exchange rate, the relative price of imports, and output are not cointegrated, implying no statistically significant relationship among these variables. The author points out that this may be due to the small “pass-through” between exchange rate appreciations and the price of tradable goods or to expansionary fiscal policies and technological changes that have counterbalanced the effect of the exchange rate appreciation. Chapter 6, “Time-Varying Risk Premia and the Efficiency of the New Zealand Foreign Exchange Market,” by Dimitri Margaritis and Phay Hoon Teo, begins by pointing out that a risk premium in the foreign exchange market provides an alternative way of examining the proposition that the forward rate is an unbiased predictor of the future spot rate, without having to give up the notion of market efficiency. The authors tested this proposition empirically by distinguishing between an inefficient market and a time-varying premium, and they found that while time-varying premia do exist in the foreign exchange market, the attempt to model risk premia in the context of the asset price theory was not supported by the data. Chapter 7, “Européan Monetary Integration: Theoretical Issues and Practical Implications,” by Andre Fourçans, examines the theoretical arguments for and against monetary integration in general and for the European Monetary Union in particular. The study supports the formation of the European Monetary Union with a common currency. This, however, requires increased monetary coordination among its members. The author recommends two basic strategies of accomplishing this. The first is for each country to set up growth objectives for its internal money supply in line with internal price stability and real growth. The second strategy consists of fixing a money supply growth for the European Community as a whole. Both strategies would be facilitated by the establishment of a central bank.

In Chapter 8, “Optimal Leverage of a Dynamically Competitive Firm,” Dilip Ghosh determines the optimum leverage of a firm in terms of two alternative hypotheses—payout maximization and utility maximization—by using the income-generating process in a dynamic environment with debt and equity accumulation. The author shows that under perfectly competitive conditions, the optimum equity debt ratio of a firm can be uniquely determined in intertemporal maximization models of investor behavior and that the results are basically the same even under different behavioral hypotheses. Chapter 9, “Is Diversification in International Capital Markets Beneficial?,” by Krishnan Dandapani and Jerry Haar examines the benefits of diversifying in international equity markets in terms of different performance measures for the years 1987 to 1990. The authors show that a U.S. investor could have gained substantially by investing in the international equity market during the period examined, even after adjusting for transactions and commission costs. In Chapter 10, “International Co-Movements of Capital Markets: Evidence from Two Scandinavian Stock Markets,” Teppo Martikainen, Ilkka Virtanen, and Paavo Yli-Olli examine evidence on the co-movement of two Scandinavian stock markets. This is done by using an internationally extended market model for Finnish stocks, where the return of a given Finnish asset is assumed to be dependent on the return of Finnish and Swedish stock markets. This multimarket model of Finnish securities reveals that several Finnish stocks have significant Swedish risk components. These international risk components, however, do not seem to contain incremental information in explaining the cross-sectional variation of expected stock returns with respect to the systematic risk components produced by the Arbitrage Pricing Model (APM).

Chapter 11, “Defeased Debt in International Capital Markets: Benefits and Problems,” by Emiel Owens and Ronald Singer, discusses the potential financial consequences of an in-substance defeasance transaction by evaluating potential levels of wealth transfer among bond and stockholders of a defeased corporation. The authors’ empirical results show that the Financial Accounting Standard Board's (FASB) Statement 76 issued in the United States in 1983 resulted in no significant pattern of daily residuals around the announcement date but that the cumulative average residuals became negative throughout the postannouncement period. Because in-substance defeasance can be interpreted as a reduction in the level of debt, the negative abnormal return around the announcement date can be explained by the signaling effect associated with the general reduction in debt. Chapter 12, “Deregulation of Financial Institutions: Lessons from the North American Experience with Savings and Loan Associations,” by William Dowling and George Philippatos, examines the question of whether scale economies existed in the U.S. savings and loan industry. The authors employ two distinctly different methodologies to deter...

Table of contents

• Front Cover
• Half Title
• Title Page
• Copyright
• Contents
• Preface
• Chapter 1 Introduction
• Part One Foreign Exchange Rules
• Part Two Capital Markets
• Part Three International Financial Management
• Part Four International Banking and External Debt
• Index