International Financial Markets

Silvia Marchesi
Building U6, 3rd floor, Room 3073
Email: silvia.marchesi@unimib.it
Office hour: arrange by e-mail

Course Tutor: Mattia Longhi

Building U6, 3rd floor
Email: m.longhi@campus.unimib.it
Office hour: arrange by e-mail

Lectures:
Monday: 15.30 - 17.45, U7-08
Thursday: 15.30 - 17.45, U7-09
 Grading

Grading will be based on:

1. Standard written exam (60%) (90-minute exam
either at the end of the course or on other exam
dates)
2. Project work: weight 3 credits (40%)
 Project Work

Each student will have to write an empirical project. the topic

of the project can be freely chosen among the topics of the
papers not compulsory (i.e., not marked in * in the syllabus).
• Projects can be carried out as a team (of up to 2
students).
• The evaluation of the empirical project will be based on
both quality and originality.
 Project Work (cont’d)
Each project has to contain the following:
1. Description of the research question within the related
literature
2. Description of the data used
3. Description of the empirical methodology and interpretation of
the results within the related literature
4. Conclusion and extensions
•The deadline is on the date of the exam you decide to register
to
• Submission by email to: silvia.marchesi@unimib.it
 Course outline

The main goals of the course are to analyse:

1. Financial globalization and its effects,
2. Sovereign Debt and imperfections in international
markets,
3. International Financial Architecture and the role of
the IMF
 Financial globalisation and its effects

• Basic facts and theories

• The effects of financial globalisation. Capital flows and
Financial frictions
 Sovereign Debt

• Introduction: definitions of sovereign debt

• Incentives: why do countries repay their debts?
Sanctions and Reputation
• Distortions: debt overhang, maturity and foreign
currency composition
• Remedies: debt restructuring and debt relief
 Managing globalisation: IMF

• About the IMF

• Who controls the IMF
• Implementation and effects of conditionality
I FINANCIAL GLOBALISATION AND ITS
EFFECTS
(i) BASIC FACTS AND THEORIES
 Drivers of Globalization
• Economic globalization
• International trade
• Cross border investment and international outsourcing
• Cross border migration
• Financial market integration
• Non-economic aspects of globalization
• Cultural integration (e.g., globalized media)
• Environmental integration
• Political globalization (Multilateral International
Organizations, internationalization of policies)
 Evolution of Globalization
• The free flow of ideas, people, goods, services, and capital across
national borders leads to greater economic integration. But
globalization has seen good and bad times over the decades.
• Those trends are coming into sharper focus this year as
policymakers work to understand and address the prospect of
geoeconomic fragmentation, which threatens to undo the
integration that has improved the lives and livelihoods of billions of
people.
• Looking back over a century and a half of data, the main phases of
globalization are clearly visible using the trade openness metric—
the sum of exports and imports of all economies relative to global
gross domestic product.
 Main phases of globalization
• The Industrialization era: global trade—dominated by Argentina,
Australia, Canada, Europe, and the United States—was facilitated
by the gold standard. It was largely driven by transportation
advances that lowered trade costs and boosted trade volumes.
• The Interwar era: reversal of globalization due to international
conflicts and the rise of protectionism. Trade became regionalized
amid trade barriers and the breakdown of the gold standard into
currency blocs.
• The Bretton Woods era: United States emerge as the dominant
economic power with the dollar, then pegged to gold, underpinning
a system with other exchange rates pegged to the dollar. The post-
war recovery and trade liberalization spurred rapid expansion in
Europe, Japan, and developing economies, and many countries
relaxed capital controls. But expansionary US fiscal and monetary
policy driven by social and military spending ultimately made the
system unsustainable. In the early 1970s, the US and many
countries switched to floating exchange rates.
 Main phases of globalization (cont’d)
• The Liberalization era: gradual removal of trade barriers in China
and other large emerging market economies and unprecedented
international economic cooperation, including the integration of the
former Soviet bloc. Liberalization accounted for most of the increase
in trade, and the World Trade Organization, established in 1995,
became a new multilateral overseer of trade agreements,
negotiations and dispute settlement. Cross-border capital flows
surged, increasing the complexity and interconnectedness of the
global financial system.
• The “Slowbalization” that followed the global financial crisis has
been characterized by a prolonged slowdown in the pace of trade
reform, and weakening political support for open trade amid rising
geopolitical tensions.
 Fragmentation
• Geoeconomic fragmentation matters most in: Trade, Debt, and
Climate Action
• The longer-term cost of trade fragmentation alone could range from
0.2 percent of global output in a limited fragmentation scenario to
almost 7 percent in a severe scenario (about the combined annual
output of Germany and Japan). Including the costs due to barriers
to the spread of technology some countries could see losses of up
to 12 percent of GDP.
• The full impact would likely be even larger, depending on how
many channels of fragmentation are factored in. In addition to trade
restrictions and technology isolation, fragmentation could be felt
through restrictions on cross-border migration, reduced capital
flows, and a sharp decline in international cooperation that would
leave us unable to address the challenges of a more shock-prone
world.
 Fragmentation (cont’d)

• This would be especially challenging for those who are most

affected by fragmentation.
• Lower-income consumers in advanced economies would lose
access to cheaper imported goods. Small, open-market
economies would be hard-hit (e.g., most of Asia)
• And emerging and developing economies would no longer
benefit from technology spillovers that have boosted productivity
growth and living standards. Instead of catching up they would
fall further behind.
• First, strengthen the international trade system.
• Second, help vulnerable countries deal with debt.
• Third, step up climate action.
 Geopolitical rivalry and its consequences for
the global financial system

• The world is entering a new era of great power rivalry.

• How these developments affect the global economy and
global finance.
• Existing research in international finance mostly relies
on evidence since the 1970s–from an era dominated by
the US and in which states had limited influence on
capital flows.
• The emergence of other international actors, most
notably China may change the picture
 The emergence of China as a global player

Source: Horn, Reinhart and Trebesch (2019)

 The emergence of China as a global player
(cont’d)
• China has not opened yet its capital markets, still has
taken steps to facilitated international participation
• China as a “new lender of last resort” (Horn Reinhart and
Trebesch, 2019, 2023)
• Mainly low income countries
• Also large emerging countries have high debt to China
and Chinese enterprises
• Total lending amounts around 20% of IMF lending
• Mainly directed to countries with high debt to Chinese
banks and enterprises.
• Similar to Eurozone bailout and past US bilateral rescue
lending
 New challenges ahead

• How does geopolitics and great power rivalry determine

the level, composition and direction of international
capital flows?
• How do geopolitical shocks such as wars affect financial
returns and how can investors hedge against these risks?
• And how do rising powers use infrastructure investments
as a strategic tool to extend their influence abroad?
 Countries classification
World Bank member economies (189) and all other economies with
populations of more than 30,000.
GNI per capita
(2022 US$)

Low income 1085 or less

Lower middle-income 1086 - 4,255
Upper middle-income 1,086 - 13,205

High income 13,205

Source: World Bank, World Development Indicators
• Low income: most sub-Saharan countries, Syria, Yemen, Afghanistan
• Lower middle-income: India, Indonesia, Pakistan, Tajikistan, Bolivia, Iran
• Upper middle-income: Russian Federation, Brasil, Mexico, Malaysia, South
Africa, Bulgaria, Armenia, Guatemala, Jordan, Iraq, Argentina
• High income: EU (except Bulgaria), USA, Japan, Croatia, Singapore, South
Arabia, Oman, United Arab Emirates, Kuwait, Qatar, Panama, Chile,
Uruguay
 Current account

• Savings – Investment = current account (CA) balance

• CA balance = trade balance + net revenues from
investment + net transfers

• S < I implies a deficit in the CA and capital inflows

• S > I implies a CA surplus and capital outflows

 Global imbalances

• Go back 20 years. If had had to guess ten years ago the

implications of capital market integration, most would
have guessed:
• Emerging countries.
- Low wage, access to technology, so high I and low S
- Large current account deficits.
• Rich countries
- Lower I and higher S
- Large current account surpluses.
• We are seeing just the opposite: flows go from emerging
to rich countries (even worse after the 2007 crisis)
Current account balance by country groups
 Global imbalances (cont’d)

• The US current account deficit reflects a vote of

confidence of the rest of the world in the United States.
• Emerging countries have been saving a lot.
• Financial intermediation and other problems limit
investment in emerging countries.
• A preference for US assets (low risk and high liquidity.
US T-bill market)
 Global imbalances (cont’d)

Why are emerging countries saving so much? Uncertainty,

both individual, and aggregate; and oil revenues
• Individual uncertainty, and high private saving.
- China. With markets, collapse of the safety net.
Precautionary saving, even in the poor country side.
• Aggregate uncertainty, and the build up of reserves.
- Accumulation of reserves, as a reaction to the Asian
and other crises. Self insurance in case of sudden stops.
• Saving out of oil revenues.
 Financial intermediation, and investment

• Investment in emerging countries typically high (eg

China): higher than in rich countries, but lower than
saving. Why?
• Low wages and technology are not enough: Property
rights are essential.
• Poor financial intermediation. Domestic residents want
low risk while investment are highly risky
 Future prospects

• Going forward, the direction of flows will depend on the

relative strength of several forces. Another surge in EMDE
saving is unlikely, given China’s gradual adjustment to a
slower, more consumption-oriented growth model
• Stronger growth and infrastructure needs in EMDEs, as
well as structural changes like demographics in advanced
economies, could push excess saving to EMDE
• Global uncertainties remain large and the rising risk of
protectionism could predominantly hurt emerging markets
 Future prospects (cont’d)

• Exchange rate flexibility, in particular, can help insulate

EMDEs from changes in global financial conditions (such as
higher US interest rates and a stronger US dollar.
• Robust institutions and policy frameworks (Obstfeld 1998,
Kose et al. 2006, Ghosh et al. 2016), including well-
functioning domestic and international financial markets
(Igan et al. 2016), remain crucial to harness the benefits of
capital inflows
 Obstfeld and Taylor, 2017

• International Monetary Relations: Taking Finance

Seriously
 Intro
• The paper reviews how financial conditions have posed
difficulties for each of the main international monetary systems
in the last 150 years:
a. the Gold standard;
b. the Bretton Woods system;
c. the current system of floating exchange rates
• Even as the world economy has evolved over different policy
regimes—fundamental challenges for any international financial
system have remained, such as:
i. How Should Exchange Rates Be Determined?
ii. How Can Countries Have Access to Adequate International
Liquidity?
 Intro (cont’d)

• Interactions of the international monetary system with

financial conditions
• A basic constraint on the design of all international monetary
systems is the monetary policy trilemma: a country can
enjoy two of the following three features simultaneously, but
not all three:
• Exchange-rate stability, freedom of cross-border payments,
and independent monetary policy
• For more than a century, efforts to cope with the monetary
trilemma have varied across time and space, with mixed
success
The Policy Trilemma for Open Economies
Exchange
rate stability

Monetary Freedom of
policy Floating exchange rate capital
autonomy movement
 The Policy Trilemma for Open Economies (cont’d)
• The gold standard (late 19th to early 20th centuries) implied
fixed exchange rates because all gold-standard central banks
fixed their currencies’ values in terms of gold. Coupled with
international capital mobility, the gold standard meant that
autonomous monetary policy was infeasible.
• Conversely, the Bretton Woods system (end of World War II
to early 1970s) mandated fixed exchange rates but, as long as
international capital mobility was blocked, countries could, to
some degree, use monetary policy for domestic goals.
• Recent decades, many advanced economies have moved to
a system of floating exchange rates: their tradeoff was to
sacrifice fixed exchange rates in order to allow both
international capital mobility and a monetary policy for
domestic objectives
 The Gold Standard
• Under the pre-1914 gold standard, the monetary trilemma was
resolved in favor of exchange stability and freedom of foreign
transactions.
• While these features tended to promote an expansion of trade
and international lending, the system severely limited the role
monetary policy could potentially play in macro stabilization.
• The stability of the banks and the financial system was not
assured by gold convertibility of currency.
• The Figure (next page) shows the pattern of financial crises
affecting advanced economies since 1870.
Financial Crises, 1870–Present
 Capital Mobility and Incidence of Banking
Crises

Sources: Reinhart and Rogoff (2009), who combine own data with Kaminsky and Reinhart (1999), Bordo et al. (2001), Obstfeld
and Taylor (2004), and Caprio et al. (2005). The index of capital mobility is the subjective index from Obstfeld and Taylor
(2004).
 The Interwar Period
• World War I surpassed previous wars not only in its scope
and destructiveness, but also in the extent to which
economic relationships between nations broke down
• That breakdown was in part a result of direct government
actions, including widespread suspension of the gold
standard and, significantly, pervasive official control over
external payments (see figure next page). Two lasting
legacies of this period:
1. A fear of “beggar-thy-neighbor” policies, countries tried in
several ways to bottle in domestic demand at the expense of
their trading partners (through high tariff walls and strict
exchange controls) and to switch demand between countries
through competitive currency depreciation.
2. Controls on financial markets.
Pegging to Gold and Capital Mobility, 1870–1938
 Bretton Woods and the Creation of the IMF
• Post–World War II reconstruction offered an opportunity to
construct a new international monetary system.
• Under the system designed at Bretton Woods in 1944,
exchange rates were fixed, with every country pegging to the
US dollar (and thereby stabilizing the N – 1 exchange rates
among the N currencies), while the United States was
supposed to peg the dollar price of gold
• Unlike the euro-area monetary union of recent times, the
Bretton Woods system mandated no external constraints on
government budgets, allowing fiscal policy to be used more
freely as a tool of macro stabilization
• With the recognition that countries with fixed exchange rates
might run short of international reserves, the International
Monetary Fund was created as an emergency lender
 Bretton Woods and the Creation of the IMF (cont’d)
• Countries also had the capacity, subject to IMF approval, to
devalue or revalue their currencies in circumstances of
“fundamental disequilibrium”
• The idea was that countries running persistent balance of
payments deficits should not be forced to maintain what
appeared to be an unsustainably exchange rate through
monetary contraction, fiscal austerity or unemployment
• “Fixed but adjustable” exchange parities do face the
drawback that markets can often see the changes coming
(or imagine that they will come), making room for
speculative capital flows (ot selffulfilling attacks)
• Capital and exchange controls remained and domestic
financial systems were constrained, reducing crisis risk and
limiting speculative responses to possible parity changes.
Bretton Woods and the Creation of the IMF (cont’d)

• In sum, by eliminating capital mobility, the Bretton Woods

system set up a resolution of the monetary trilemma based on
exchange-rate stability and a degree of autonomy of monetary
policy.
• Long-run inflation trends would be determined de facto by US
monetary policy but in extremis, countries could also adjust
currency values.
• IMF funding was meant to ensure that such adjustments would
occur only in response to highly persistent shocks
• An inclination for tight regulation, coupled with relatively
uncomplicated financial systems, made the Bretton Woods
period up to about 1970 almost crisis-free compared with the
decades that preceded and followed it.
 Weaknesses in the Bretton Woods Architecture
Stability of the Bretton Woods fixed exchange rates depended
on continuing limited cross-border capital mobility.
1.To support the rebirth of global trade, the opportunity for
capital flows inevitably grew and fixed exchange rates became
harder to maintain.
2.The migration of financial activity to less-regulated venues,
both through the location of banking activity offshore and
domestic financial innovation
3.International liquidity. Governments around the world were
accumulating US dollars to hold as international reserves, while
the United States had promised to redeem foreign official dollars
at a price of $35 per ounce. Redemption would become
increasingly problematic as global dollar reserves in foreign
hands continued to grow.
 Floating Exchange Rates: Monetary
Independence and Financial Instability
• By March 1973, generalized floating exchange rates emerged
as a measure in the face of continuing speculative attacks.
• What was at the time intended as a temporary retreat has now
lasted more than four decades.
• The monetary trilemma implies that, without exchange rate
stability, countries could orient monetary policy toward
domestic goals while still allowing additional freedom of capital
movements across borders.
• The share of countries with pegged exchange rates fell from
90% in 1970 to about 40% by the 1980s (see Fig. next page.
• Conversely, the level of capital mobility was relatively low in
the mid-1980s, but then rose dramatically into the early 2000s,
before leveling off and even declining during the last decade.
Fixed Exchange Rates and Capital Mobility,
1970–Present
Monetary Independence and Financial Instability
(cont’d)

• Since 1973, both exchange-rate flexibility and capital

mobility have increased, but the process has not been
smooth or consistent around the world.
• Many countries kept some form of pegged exchange rates,
most of them emerging economies and developing
countries,
• Notably many European countries that established their
own fixed exchange rate system in the 1970s, a precursor
of the euro.
• In recent years, more countries have chosen to limit capital
flows, especially after the 2008 global crisis.
 The European Example: Pegged or Stable
Exchange Rates and Financial Fragility
• The nations of western Europe have charted a hybrid path for
monetary institutions in the post–Bretton Woods era.
• After the breakdown of fixed rates, the members of what was
at the time called the European Economic Community (EEC)
limited currency fluctuations within their group.
• By 1979, an important subset of EEC members pegged their
mutual exchange rates in what was known as the European
Monetary System.
• The resulting exchange rate mechanism ended up functioning
much like a miniature Bretton Woods system—with periodic
crises and exchange rate parity adjustments, only now with
Germany as the center country.
• In line with the trilemma, some members, including France
and Italy, maintained capital controls
 The European Example (cont’d)
• In 1992 the Maastricht Treaty moved toward so-called
economic and monetary union. “Economic” meant a single
market concept under which capital controls had to disappear
and “monetary” meant that fixed exchange rates became the
stepping stone to the common currency.
• The future members of the euro area thus embraced the vertex
of the monetary policy trilemma based on capital mobility and
exchange-rate stability vis-à-vis each other, but with jointly
floating exchange rates against outside currencies.
• However, just as the earlier Bretton Woods treaty had
neglected financial stability concerns, the Maastricht Treaty of
1991 setting up the European economic and monetary union
likewise turned a blind eye to financial stability (as opposed to
macro stability)
 The European Example (cont’d)
• There was no mechanism built into the euro to address a
situation in which some countries ran continuous and large
trade surpluses while others ran large and continuous deficits.
• There was no common framework of prudential banking and
financial regulation, much less any pooling of bank failure risk
(for example, deposit insurance).
• As became evident in subsequent euro area crises, banks and
governments could even run out of liquidity despite the single
currency, amplifying financial stability risks.
• Unlike the 1950s and 1960s, when a quite repressive global
financial environment ensured that the neglect of these issues
under Bretton Woods would not prove too costly, the
disregard for financial stability in the euro architecture in a
time of rampant financialization proved to be painful
How Should Exchange Rates Be Determined?
The case for floating Exchange Rates

There are three arguments in favor of floating

exchange rates:
– Monetary policy autonomy
– Symmetry
– Exchange rates as automatic stabilizers
 The case against floating Exchange Rates
There are five arguments against floating rates:
– Discipline (they do not provide discipline for central
banks)
– Destabilizing speculation and money market
disturbances (they allow destabilizing speculation and
countries can be caught in a “vicious circle” of
depreciation and inflation)
– Injury to international trade and investment (they hurt
international trade and investment because they make
relative international prices more unpredictable)
– Uncoordinated economic policies (they leave countries
free to engage in competitive currency depreciations)
How Should Exchange Rates Be Determined?
• At the national level, as we have seen, floating exchange
rates clearly cannot provide insulation against all global
financial or real shocks.
• But floating still does facilitate some measure of domestic
insulation, and policymakers can provide additional shock
absorbers by adopting sound fiscal and structural policies,
and even by using measures to limit capital flow in some
circumstances.
• While floating or soft peg exchange rates have helped
mitigate policymakers’ domestic challenges, debate has
continued over whether floating is a suitable solution for the
international system as a whole.
• While floating exchange rates can allow individual countries
to stabilize to a degree, they also raise the age-old problem
of competitive currency depreciations, in which demand is
just being shifted between countries.
 How Can Countries Have Access to Adequate
International Liquidity?
• Under the Bretton Woods system, countries held foreign
exchange reserves (mostly in US dollar assets) to peg their
exchange rates.
• The advent of floating exchange rates led many economists to
predict that central banks would reduce their demands for
reserves.
• As in the last few decades, aside from the role that reserves
play in foreign exchange intervention, they can also play a
potential role in buffering balance of payments shocks when
other means of external financing become expensive or
unavailable, for example, in a sudden stop.
• As next figure shows, the reserves held by emerging and
developing countries have risen sharply, from about 7% of GDP
in 1993 to about 25% of GDP by 2007
Stocks of International Reserves, 1993–2015
 How Can Countries Have Access to Adequate
International Liquidity? (cont’d)
• Emerging and developing economies have raised their reserve
holdings for two main reasons.
• First, even though their exchange rates have generally
become more flexible in the last few decades, they continue to
intervene in foreign exchange markets to moderate currency
volatility or to enhance export.
• Second, more open international capital markets have raised
the precautionary demand for reserves. E.g., for emerging
market economies, larger balance-sheet liabilities, some
denominated in foreign currencies and at short term, imply a
greater risk of capital-flow reversal and repayment of gross
liabilities.
 How Can Countries Have Access to Adequate
International Liquidity? (cont’d)
• These problems could be ameliorated if instead emerging and
developing countries had better access to credit lines.
• Traditional IMF lending cannot fulfill this role, as IMF programs
are subject to conditionality and time-consuming negotiation.
• Over the years, the IMF has tried to offer various more-flexible
credit facilities for prequalified borrowers, but few countries
have signed up, fearing either the stigma of asking for a credit
line or of receiving one and later being disqualified.
• In any case, a globally systemic crisis would strain the Fund’s
capacity.
 Summing Up

• One of the most important realizations to come out of the

global financial crisis of 2007–09 and its aftermath was that
standard models of macro stabilization had not paid sufficient
attention to finance and financial markets.
• Policy practice and intellectual debate have been struggling for
centuries to address financial stability concerns.
• In the last few decades, the task has become even more
urgent in the face of rapidly evolving financial markets, pushing
risky activities outside the perimeters of regulation.
• Economic analysis still needs to bring the risks of financial
instability into its core frameworks, from the analysis of
business cycles to that of international economic interactions.