Development in International Finance - Report Example

Development in International Finance According to Keohane and Nye, globalization increases international capital flows, creating interdependence among countries and continents. Technology perpetuates the globalization process (Das 1). These networks develop over time, and involve different areas, with finance being one of them (Das 1). With the onset of the 1973 global oil crisis and the crash of the Bretton Woods era, financial globalization was created (Mundell). The contemporary financial system is a product of domestic financial system integration with the global financial markets and institutions, resulting in liberalization and deregulation of domestic financial sectors and capital accounts (Das 1). However, this integration is unequal and unstable, oftentimes resulting in crises. Different countries and institutions address the problems depending on the subsector of the financial market they aim to address. So far, only G 20 countries have produced recommendations addressing the causes of the global imbalance that affect all subsectors. Global Deregulation and Financial Instability Current financial system creates instability in international business. According to Das, contagion spillovers are a result of financial globalization (12). The current 2008 crisis is one such example, where the American mortgage markets caused a global crisis, leading to an increased fiscal burden, disruption of the stock markets, job losses, depression and social turbulence, as the one witnessed in Greece. In equations (1) and (2), the relationship between a crisis and interconnectedness through a common debtor, such as Deutsche Bank in the Greece and the rest of the EU is exhibited. is exchange market pressure, is change in country’s exchange rate, is foreign exchange reserves, are pooled mean and standard deviation of the index, and is the crisis index. The rest are parameters (Caramazza, Ricci & Salgado 56). (1) = 0, else (2) Financial linkages and volatility have increased over the years (see fig. 1). As a result, value in equation (2) is more often unity, increasing the occurrence of an economic crisis (Caramazza et al. 66). According to Das, the probability of a random country experiencing an economic crisis has doubled since 1973 (13). So far, two Basel Accords have been unsuccessful. Basel I and II both failed because they failed to control technological advancements and resulting innovations in the financial sectors, though they attempted to control risk and increase transparency (Das 14 – 15). It is to be seen if Basel III will manage to protect banks and financial institutions from capital outflows and sudden currency depreciations. Euro System Despite the common currency use, the Euro system has been susceptible to crises as well. There are two explanations of the current Euro crisis, of which Greece has gained the most coverage in international media (Perez – Caldentey & Vernengo 1). First explanation is that fiscal overspending in the periphery created a debt crisis, which affected other countries in the Euro zone (Perez – Caldentey & Vernengo 1). The second explanation is that, coupled with financial deregulation and monetary unification, the core countries conducted an export – led policy, while they promoted imports in the economically less developed periphery (Perez – Caldentey & Vernengo 1). As a result, the periphery accumulated debt, which led to instability in Greece, Portugal and Ireland (Perez – Caldentey & Vernengo 2). The EU is indicative of the financial fragility in current economies. Though a common currency is present, deregulation and interconnectedness have exacerbated imbalances in economic development and stability among the EU countries. As a result, different solutions to different segments of the financial markets have been addressed in order to mitigate the effects of a financial crisis, and prevent any future escalation. Foreign Exchange Practice Foreign exchange (FX) was in 2011 worth $5 trillion (Worachate & Goodman). This is the most liquid and transparent type of financial markets (Euromoney 4). The cause of its liquidity lies in FX being treated as an asset by investors (Euromoney 4). Hedge funds are the most prominent drivers of FX trading (Euromoney 4). Between 1999 and 2006, this asset performed between negative 4.9 and positive 14.9 percent, which makes it one of the best performing assets (Euromoney 4). Actors in this market demand better practice. In 2004, FX Commission composed of major financial institutions published 60 best practices (Euromoney 6). The EU and the UK called on companies to conduct business in a transparent and expedient manner (Euromoney 6). Moreover, firms in the EU are required to obtain authorization before trading (Euromoney 8). Current policies attempt to decrease currency fluctuations and speculations. Special Drawing Rights (SDRs) and the International Monetary Fund (IMF) SDRs are another solution offered by some to resolve debt and fiscal spending imbalances. In 1969, the IMF designed SDRs as a supplementary international reserve asset (Griffith – Jones & Kimmis 2). SDRs are an artificial currency unit, which serve as credit (Griffith – Jones & Kimmis 3; Chelsky 1). The rationale was that the gold reserves were limited and the Triffin Dilemma also arose, according to which total holdings of US dollars could be higher than the American gold reserves, thus causing a global crisis (Griffith – Jones & Kimmis 2). By 2000, two allocations by the IMF were conducted, the last one having taken place in 1981 (Griffith – Jones & Kimmis 2). Mostly the IMF, International Development Association and several finance institutions denominate their lending in SDRs (Chelsky 3). SDRs are a disputed topic. Most countries believe that global reserves are high enough to replace SDRs (Griffit – Jones & Kimmis 2). Moreover, disputes about their use damaged financial stability of developing countries which were in need of SDRs and relied on this help, but did not obtain it (Griffith – Jones & Kimmis 2). However, Griffith – Jones and Kimmis argue that SDRs could decrease adverse effects of financial crises. Currency crises always involve a liquidity shortage (Griffith – Jones & Kimmis 2). SDRs could provide additional liquidity to the countries experiencing capital outflows (Griffith – Jones & Kimmis 3). Moreover, SDRs could supplement developing countries’ reserves to satisfy their required reserve requirements (Griffith – Jones & Kimmis 3). Chelsky further argues that diversification of currencies in SDR would decrease risk from single currency fluctuations, a trend which is visible and influenced by the IMF (3, 5). G 20 Recommendations and the IMF However, SDRs only mitigate the crisis and do not prevent it. Instead of SDRs, Chelsky argues that G 20’s Mutual Assessment Process from 2009 provides guidelines on prevention of crises (5). The IMF is a crucial actor through its provision of technical analysis (IMF). G 20 collects information on individual countries and makes an assessment of their impact on the global economy (IMF). The IMF in turn creates estimates of a best and worst case scenario, as well as individual country’s compliance with the G 20 goals (IMF). Furthermore, in 2011, G 20 countries identified key actions needed to decrease imbalances, such as country debt or fiscal imbalance, and assessed compatibility between objectives and policies (IMF). In short, deregulation and interconnectedness of financial systems have increased the probability and scale of financial crises. Even a single currency market is no longer immune. A problem in addressing financial markets is that they are not unified. Thus, focus only on FX does not solve the causes of crises. Instead, solutions must be economy wide. Works cited Caramazza, Francesco, Ricci, Luca and Salgado, Ranil. “International Financial Contagion in Currency Crises.” Journal of International Money and Finance 23.1 (2004): 51 – 70. Web. 30 Nov. 2012. . Chaboud, Alain and Weinberg, Steven. Foreign Exchange Markets in the 1990s: Intraday Market Volatility and the Growth of Electronic Trading. BIS Papers 12, 2002. Web. 1 Dec. 2012. < http://www.bis.org/publ/bppdf/bispap12h.pdf >. Chelsky, Jeff. The SDR and Its Potential as an International Reserve Asset. The World Bank, 2011. Web. 30 Nov. 2012. < https://openknowledge.worldbank.org/handle/10986/10095 >. Das, Dilip K. “Globalization in the World of Finance: An Analytical History.” Global Economy Journal 6.1 (2006): 1 – 22. Web. 28 Nov. 2012. < http://ideas.repec.org/a/bpj/glecon/v6y2006i1n2.html >. Euromoney. Best practice in foreign exchange markets. Euromoney, 2007. Web. 30 Nov. 2012. < http://www.euromoney.com/images/628/FXall.pdf >. Griffith – Jones, Stephany and Kimmis, Jenny. The Role of the SDR in the International Financial System. University of Sussex, n.d.. Web. 30 Nov. 2012. < http://www.ids.ac.uk/files/griffkim2.pdf >. International Monetary Fund (IMF). The G – 20 Mutual Assessment Process. IMF, 2012. Web. 30 Nov. 2012. < http://www.imf.org/external/np/exr/facts/g20map.htm >. Keohane, Robert and Nye, Joseph. Governance in a Globalizing Word Washington DC: Brookings Institution Press, 2001. Print. Perez – Caldentey, Esteban and Vernengo, Matias. The Euro Imbalances and Financial Deregulation: A Post-Keynesian Interpretation of the European Debt Crisis. Levy Economics Insitute, Working Paper No. 702. Web. 30 Nov. 2012. < http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1980886 >. Worachate, Anchalee and Goodman, David. Currency Trading at $5 Trillion a Day Surpassed Pre-Lehman High, BIS Says. Bloomberg, 12 Mar. 2012. Web. 1 Dec. 2012. . Appendix Figure 1. Foreign Exchange Daily Global Trading from Chaboud, Alain and Weinberg, Steven. Foreign Exchange Markets in the 1990s: Intraday Market Volatility and the Growth of Electronic Trading. BIS Papers 12, 2002. Web. 1 Dec. 2012; Worachate, Anchalee and Goodman, David. Currency Trading at $5 Trillion a Day Surpassed Pre-Lehman High, BIS Says. Bloomberg, 12 Mar. 2012. Web. 1 Dec. 2012. Read More