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World Affairs
Vol. 4, Number 1 (Jan.–Mar. 2000)
The Challenge of Managing Global Capital Flows
By Ismail Shariff
As financial markets become increasingly globalised, a resilient and transparent financial system is crucial for stable global capital flows
The financial crisis that erupted in Asia in 1997 vividly demonstrated the risks associated with free capital flows. But capital mobility is a goal worth pursuing, given the potential benefits. With the right policies, countries can manage the risk while increasing their markets’ access to global financial markets.
Manuel Guitian
Director, IMF’s Monetary and Exchange Affairs Departments
Capital mobility is generally a desirable economic activity when unrestricted private capital is allowed to flow freely across transnational borders in search of higher yield opportunities. The only way to do this is to direct it towards its most productive uses on an international scale. It is a fact relevant particularly to developing countries, where domestic investments tend to be in short supply that they stand to gain in attracting foreign investment, as this would generate faster economic growth and improve standards of living, as well as contribute to the deepening and broadening of domestic financial markets.
In a way the evolutionary process underway in world finance is characterised by three simultaneous developments. First, the financial markets are becoming increasingly globalised. Second, old kinds of debt are being made into new kinds of securities. Third, the distinction between banks and brokers is breaking down. Each of these developments will have a profound influence on everybody involved in the financial business in a global set-up. In this context an attempt will be made in this paper to not only identify the challenge that lie ahead, but also to suggest ways and means to deal with them with an eye to creating a stable global capital flow.
Globalisation of Financial Markets
The process of globalisation has been taking place for some time. US banks developed worldwide branch networks in the 1960s and 1970s for loans, payments, clearings, and foreign exchange trading. US securities firms also began to build up their operations abroad, starting in the 1970s at first in London, in the Eurobond market, but then into other markets, including now in Tokyo. Foreign firms expanded into the United States, first the banks and later on the securities houses.
Trading in individual markets has become globalised. In the 1970s, foreign exchange became a 24-hour market, with the major banks dealing with each other through their offices in the markets in the Far East (Tokyo, Hong Kong, Singapore), the Middle East (once Beirut, now Bahrain), then Europe (London, Frankfurt, Zurich), and finally, the United States (New York for interbank trading and Chicago for futures trading). In the 1980s, the market in US government securities moved virtually to a 24-hour basis. Foreign investors have bought substantial amounts of US Treasury bills, notes, and bonds, and many prefer to trade during their working hours rather than during ours. Primary dealers of US government securities have opened offices in London, Tokyo, and other places to accommodate such trading. Foreign firms have geared up for this trading by establishing primary dealerships in the United States.
The stock markets have also opened up, although not in an extended time frame for individual markets. Instead, companies are listing their stocks on different exchanges around the world. For example, some 50 non-Japanese firms have been listed on the Tokyo Stock Exchange and this number is likely to double over the year ahead as Japanese investors focus increasingly on foreign stocks. The flow goes both ways. US investors in Japanese stocks are frequently prepared to stay up late at night to gain a minute-by-minute report on the market in Tokyo. Financial futures markets also are spreading around the world, with market acronyms such as LIFFE for London and SIMEX in Singapore. Instruments traded include government bonds, foreign exchange, stock market indexes, and a whole array of traditional products such as foodstuffs and metals. In Japan, the authorities have considered futures and options to be highly speculative — and thereby dangerous — and are moving slowly to allow such trading. A futures contract on Japanese government bonds, introduced in Tokyo last year, has been a huge success. In 1987, the Japanese government expected to lift the ban on Japanese trading in US financial futures. Japan’s major institutional investors hold billions of dollars of US government securities and are eager to develop the means to hedge the portfolios should they want to.
Globalisation is an ongoing process. The London markets are in the first stages of the so-called "Big Bang" in which the trading of both equities and gilt-edged securities has been revamped into a much more streamlined, modern, and competitive structure. Foreign firms have been allowed to participate fully in those markets. In Tokyo, the process of opening the market has gone more slowly. US banks have gained increasing access to domestic financing mechanisms in Japan. Non-Japanese securities houses are now becoming members of the Tokyo Stock Exchange. Under pressure from the United States, the process of liberalisation in Japan is bound to continue.
International finance is a Darwinian world — survival will go to the fittest — and most financial firms are coming to the conclusion that to survive as a force in any one of the world’s leading financial markets, a firm must have a significant presence in all of them.
As with institutions in other countries, the Big Four Japanese securities firms (Nikko, Nomura, Daiwa, and Yamaichi) have adopted a global strategy. The companies are still based in Japan, of course, but they have built up their offices in New York and London so that they have three profit centres with trading and distribution capability in Japan, Western Europe, and the United States. The Big Four have increased the capital of their subsidiaries and have hired local people for many key positions. American and foreign firms are doing the same in Tokyo, hiring Japanese staff for key positions.
Old Types of Debt Into New Kinds of Securities
The second major development underway in world finance is that old kinds of debt are being made into new kinds of securities. Twenty years ago banks handled most of the short and medium-term financing around the world. But several things happened. One was that banks lost their ability to attract low-cost funds from depositors on favourable terms through demand deposits or passbook savings. Banks now must compete for funds with a wide range of institutions at market rates. Another factor was that borrowers developed the means to obtain funds directly from lenders, such as through commercial paper marketed by securities houses rather than by banks. A third factor was that banks got caught in a series of loan loss experiences on developing countries, on petroleum, on agriculture, and on real estate. The relief for some of these bad loan situations has been to securitize the loans, creating a primary or secondary market. For example, there is now an active market among banks in participations on developing countries debt with discounts on the original loan values, which fluctuate with the fortunes of each country. Some firms, again brokerage houses, publish regular quotation sheets of these country-by-country discounts.
The list of other kinds of new securities is very long: mortgage-backed securities of all sorts, floating-rate versus fixed rate, zero coupon and low price versus high coupon and high price, along with every conceivable kind of call, convertibility, or indexing features. Each of these innovations has a justification in terms of the borrower’s or the lender’s needs, but some are recognised by many market participants as newfangled gimmicks.
Banks and securities houses are under pressure to be innovative. Each firm, to differentiate itself from the others, is forced to come up with something new and different as often as possible — new ideas, new products, new wrinkles on old products. Mathematicians or economists with a mathematical bent are being recruited to develop these products. These people are popularly called rocket scientists in view of the vast amount of numbers they must deal with. High tech is becoming as important to financial firms as it is to manufacturing.
From these innovative efforts, programmed trading — an exercise which pits computer against computer — was developed in the stock market. Programmed trading has made money for firms in the US and some of the same firms are trying to develop the same techniques in the Tokyo and London stock markets.
Occasionally one of these new products fizzles out. Early this year, for example, in the Eurobond market, someone offered a floating rate note, that is, an instrument on which the coupon is adjusted to market rates every six months, but which has no final maturity at all. In effect it would be in perpetuity; you could trade it tomorrow or hold it forever. For the borrower, this was a great idea: he never has to repay, and the securities were priced to give a favourable yield since they were based on a six-month rate of interest. The lenders, however, were not so sure, given that there is a long time between six months and eternity on a credit. So the houses that tried to sell these notes found them difficult to move and suffered substantial losses.
Even mortgage-backed securities proved to be a nightmare to some firms. Earlier in 1999, in the US when homeowners took advantage of the decline in long-term interest rates to refinance their mortgages, the firms which packaged the mortgages into securities were caught in the middle as high-yield portions of the packages were being liquidated.
Distinctions Between Banks and Brokers
The third major development worthy of discussion revolves around the diminishing distinctions among different kinds of financial firms. Every financial firm wants to be in the most profitable product line and have the flexibility to shift to another, more promising, product line. In the United States, until recently, the Glass-Steagall Act separated commercial banks from investment banks (only repealed in October of 1999 by the US Congress). Japan has a similar provision, Article 65 of the Securities and Exchange Act, which separates the two kinds of banking activities. In recent years, commercial banking in the world has not been as profitable as it was, while some kinds of investment banking have been extremely profitable. As a result, commercial banks in the United States and Japan have sought to break down the barriers established by Glass-Steagall and Article 65 to engage in investment banking activities. Some of the big banks in New York are even threatening to give up their banking charters so as to fully qualify as investment banks.
At the same time, investment banks have been encroaching into areas of activity that were traditionally the preserve of the banks. One of the biggest moves, in my opinion, was into money market mutual funds, which drew billions of dollars away from banks in the late 1970s and early 1980s until banks were allowed to offer money market deposit accounts to their customer. In addition, investment banks moved into commercial paper. Also investment banks are now extremely active in foreign exchange.
In the international sphere, there are two assaults on the Glass-Steagall and Article 65 barriers. One assault is being made directly by US and Japanese firms in the two markets. Thus, Merrill Lynch has proposed that it open a branch of its London banking subsidiary in Tokyo, which would put Merrill Lynch — an investment bank par excellence — in the banking business in Tokyo, something which Japanese investment banks cannot do. Chase Manhattan has also pressed to have its capital markets subsidiary open a branch in Tokyo to trade securities, something which Japanese commercial banks cannot do. Sumitomo Bank, one of Japan’s premium commercial banks, has just made a major investment in Goldman Sachs, another excellent US investment bank; the Federal Reserve Board stripped the deal of any joint venture characteristics, however, leaving it as a passive investment. More recently, the Industrial Bank of Japan purchased Aubrey Langston, a primary dealer in US government securities through its Schroder Bank subsidiary in New York.
The second assault on Glass-Steagall-type barriers comes from European banks, which operate without such stringent separations between commercial banking and investment banking in the United States and Japan. In Britain, there was a distinction between the major clearing banks and the merchant banks, but that has been pretty well blown away in the competitive environment leading up to the Big Bang. Many European financial institutions have developed the capability — perfectly legal — to do both commercial banking and investment banking in the United States and Japan. United States and Japanese institutions have countered by opening multipurpose activities in Europe, with brokerage houses starting up banking subsidiaries.
Looking Ahead
The upshot of all this, we believe, is a further painful evolution of the international financial system. Ten years from now there will be a core of some 30 to 50 financial institutions — banks, securities houses, and perhaps insurance companies — at the centre of international finance. They will be operating in New York, London, Frankfurt, Tokyo, and elsewhere, and they will compete head-to-head to do business with the world’s major corporations and portfolio managers. They will have capabilities in equities, fixed-income, futures and options, and foreign exchange. They will retain a flavour of their original nationality — Merrill Lynch will always be bullish on America and Yamaichi will always evoke the image of Mount Fuji. But they will all employ graduates from the best universities in the United States, England and Japan, as well as graduates from the school of hard knocks from numerous countries.
For private firms, the challenge is clear. Both adequate capital and disciplined management are required. International finance has increasingly become a risky business; fat commissions and fat fees are a luxury of the past. Exposures in excess of a billion dollars are common place now. Also commonplace are profits and losses amounting to tens of millions of dollars. Last May, for example, after the US Treasury’s refunding, the bond market dropped sharply. At one point, we found that the collective losses to the buyers of securities from the US Treasury exceeded $1.5 billion and that a large portion of that loss was borne by the community of government securities who still had substantial inventories of notes and bonds. Thus, a slight miscalculation by any firm can turn into a monumental loss, so an even more monumental cushion is needed.
Conclusion
In the final analysis, the IMF and the central banks of the leading industrialised countries have a dominant role to play in ensuring the orderly globalisation of capital flows, as well as an important contribution to the analysis of capital markets — through surveillance activities (which consist of monitoring developments in member countries and the international economy and warn of impending problems) which are traditionally attached to its loans (which calls for borrowing countries to make certain agreed policy and structural changes). The IMF can provide capital markets with information on country policies, thus reducing instances of market failures and the need for market arbitrage.
The continued unrestricted capital flow is always desirable for "re-regulation" for two fundamental reasons. One is the desirability of observing time consistency in the direction of policy. What would be the good of deregulating domestic financial sectors and liberalising the capital markets today only to impose controls tomorrow? The other reason is purely for the freedom of capital controls which have so far proven to be ineffective as they were in Indonesia and Thailand.
What is most important is to keep a steady course and not to back on it arbitrarily. As a general rule, policy on capital movements should favour openness and liberalisation is not licentiousness — hence the need for supervision. We need to be sure in an overall perspective about the course that ensures the betterment of the international economy given its global nature. In a way, interpretation and interdependence are perceived in reality today as given, and are desirable objectives when the focus is placed on their potential benefits to everyone involved in a global set up. Therefore, the choice we face is real. The global community can devote its resources to surveillance and conditionality to protect the good of integration. Or the global community can instead go the route of controls and re-regulation ushering a global economy starving for the life-blood that can move it forward for the betterment of everyone involved in the global economy. As for controlling the speculative aspect which is evident more now than ever before in the last five years, the Central Banks of the Western countries can play a crucial role in reining in the speculative attack on foreign exchange in the absence of a fixed exchange rate. For large fluctuations in the exchange rates of major currencies can be extremely costly, not only for the countries directly involved but also for the rest of the world.
While floating exchange rate regimes have always been subject to attacks, the greater mobility of capital over the past five years — and the spectacular currency crisis associated with it have led to a profound rethinking of possible Central Bank defences. To be specific the Central Banks should concentrate on efficiency monitoring and taking appropriate measures in a timely fashion. According to IMF Research Staff, they should adopt in all earnest the following steps:
• Bank covering operations for forward contract positions
Speculators attack a currency through short sales, generally by selling it to a bank through long-dated (at least one month) forward contracts. As standard practice, to balance the long domestic currency position that this transaction initiates, the counterparts bank will immediately sell the domestic currency spot for, say, dollars for the conventional two-day settlement. While the bank will have balanced its currency mismatch, it still faces a maturity mismatch, which it typically closes through a foreign exchange swap entailing a delivery of dollars for domestic currency spot and a delivery of the currency for dollars 30 days forward.
• Forward intervention by the central bank
The central bank may be a customer in the forward market. If its forward purchase of domestic currency matches a forward sale of some other customer, its forward intervention will absorb the spot sales of its currency, making a direct intervention in the spot market unnecessary. By entering into a forward contract, the central bank implicitly supplies domestic currency credit directly to the short seller of its currency.
Credit Provision
In a currency crisis with the potential for a one-sided bet, few private parties would be willing to be net suppliers of domestic credit. Nevertheless, to fuel a speculative attack, the banking system must provide credit to the short sellers. If the central bank does not supply the credit directly through forward intervention, the credit must come through either its money market operations or its standing facilities. In either case, the currency provided by the banking system is a pass-through of credit from the central bank, which must be the ultimate counter party in both legs of the position-balancing transactions of the banking system.
Interest Rate Defence
A standard defence in a currency crisis is for the central bank to raise interest rates to squeeze short sellers. Nevertheless, to the extent that it continues to lend, the central bank partly finances the attack by providing funds at a ceiling interest rate, as the demand for domestic credit increases. This defence is designed to make speculators’ financing costs higher than their anticipated capital gains in the event of a devaluation, which might force an eventual closing of short positions.
Controls on Foreign Exchange Swaps
Unfortunately, the interest costs of a squeeze are also imposed on agents that are short in the currency for commercial reasons and may thus affect economic activity. To mitigate these costs, a central bank may charge differential interest rates to identified speculators and concessionary rates to non-speculators through credit controls. One way to do this is to identify as speculators foreign addresses that engage in foreign exchange swaps with domestic banks and ban such swaps or insist that heavy forward discounts be imposed on the forward legs. Similarly, domestic banks may be forbidden from providing on-balance-sheet overnight or longer maturity credit to foreign addresses. Such controls generate a spread between onshore and offshore interest rates on domestic currency loans, along with a strong incentive to circumvent the controls.
In addition to the above preventive steps, the central banks should be on the lookout to implement concrete steps to strengthen the international financial structure. These must include:
Therefore a resilient and a transparent financial system is key to stable global capital flows. The stability of the capital flows in turn depends on how strong and consistent macro-economic, financial, and structural policies are being crafted on a global level to ensure sustained capital flows between countries in the new millennium.