The Role of Financial Markets

To what extent can these facts be explained by developments in global financial markets? As noted above, there are few places where the impact of new information and communications technologies has been more pronounced than in the financial sphere.

Their impact, combined with that of the relaxation of regulatory restrictions on foreign financial investment, has been profound. Falling transactions and information costs have led to a reduction in home bias and to an increasing volume of two-way capital flows.

The results are evident in a rise since 1990 in the share of residents’ holdings of foreign bonds and equity relative to domestic bonds and equity in countries like Canada, Germany, Japan and the United Kingdom.

It is important to recognize the relatively recent vintage of this phenomenon.While the securitization of financial claims has been underway since at least the 1970s,most extensively in the United States, the relaxation and removal of capital controls isrelatively recent. In the advanced-industrial countries other than the United States, it dates only from the 1980s. In emerging markets the trend is more recent still (Eichengreen and Mussa et al. 1998).

Be this as it may, the effects are undeniable. One consequence has been that theshare of portfolios devoted to foreign financial assets has risen in both advanced countries and emerging markets. Two corollaries of the increased willingness of foreigners to adjust their portfolio shares in response to changes in expected rates of return are that the size of current account balances has risen on average and that their dispersion across countries has widened. On both counts, then, external deficits have become easier to finance. While the evidence of increased dispersion of current account balances is less pronounced in emerging markets than in the advanced countries, recent replications of the analysis in Feldstein and Horioka (1980) suggest that even in the developing world the trend has been in the same direction. But increased capital mobility can be a mixed blessing. In the present context one can imagine how the decline of obstacles to capital flows and the greater elasticity of external finance with respect to changes in rate of return differentials can moderate the pressure for countries to address current account and fiscal imbalances. The United States has been able to finance its twin deficits more cheaply, limiting the pressure to adjust. This phenomenon, known as the Greenspan Conundrum, is plausibly attributable to the influence of capital inflows.25 As a result of the single market and the euro, there has been an increase in capital mobility among European countries (Blanchard and Giavazzi 2002), to which the big ones have responded by relaxing budgetary discipline. Developing countries enjoyed a sharp compression of bond spreads in the first half of the decade, and in response to this increase in investor demand for their debt securities they

allowed their public debt ratios to rise further.

Financial innovation has also figured in the substitution of the bond market for syndicated bank loans as the mechanism through which emerging markets can meet their international financial needs. Bonds, recent experience suggests, have superior risksharing characteristics. For lenders, it is easier to build and manage diversified asset portfolios and easier to close out positions, assuming of course that there exists a liquid secondary market. For borrowers, bonds have the advantage of longer maturity. These favorable risk-sharing characteristics are further enhanced by efforts to provide for contingencies in the design of bond covenants, for example by including collective action clauses and trustee provisions to facilitate negotiation in the event that there is the need for restructuring, and by indexing returns to the rate of growth (as in the case of

Argentina’s GDP warrants) so that both lenders and borrowers share the fruits of policy

reform.

The Future of Global Financial Markets-Introduction

Forecasting is always difficult, especially when it involves the future. More than the usual degree of difficulty is involved when the task is forecasting the future of global financial markets. In the mid-1970s, when Ernesto Zedillo, the editor of this volume,and I were in graduate school at Yale, global financial markets and private capital flows to developing countries were just beginning to awaken from a long period of somnolence.

Those who anticipated that World Bank loans and official development assistance would remain the predominant sources of external finance for developing countries were surprised by the rapid growth of bank lending to Latin America and Eastern Europe by money-center banks recycling the surpluses of oil exporters and selected industrial economies. But no sooner had observers assimilated these facts than lending to emerging markets collapsed in 1982 in response to rising interest rates in the U.S. and UK and debt crises in the developing world. The result was the lost decade of the 1980s, when resources flowed upstream from developing to developed economies and growth stagnated in Latin America. The inability of governments to credibly commit to repay their borrowings, it was argued, constituted a fundamental obstacle to sovereign lending to emerging markets, and efforts by the International Monetary Fund to paper over the cracks were dismissed as creating more problems than they solved.

But no sooner had observers accustomed themselves to this brave new world than nonperforming bank loans were converted into bearer bonds. The Brady Plan jump-started the market in fixed income securities, which quickly became the vehicle for renewed lending to emerging markets.

Bond markets transferred an impressive quantity of resources to developing countries in the course of the 1990s, but the decade was also punctuated by a series of emerging-market crises that repeatedly interrupted the flow of finance, sent spreads skyrocketing, and prompted emergency intervention by the IMF. This period drew to a close with Argentinaís default at the end of 2001. Borrowers and lenders drew back from the market as if they had finally taken the lessons of the 1990s to heart. Developing countries shifted from external deficit to surplus, accumulating unprecedented quantities of international reserves. They repaid external debt to their private creditors and the IMF.

By early 2006 no major Latin American or Asian country was in debt to the IMF, and

virtually the entire stock of Brady bonds had been retired from the market.

The United States emerged as the worldís principal deficit country and capital importer, absorbing some two-thirds of the net savings of the rest of the world. But the idea, which gained

currency following the Argentine crisis, that international investors had learned that the returns from lending to emerging markets did not justify the risks was again dissolved by the subsequent resurgence of flows into local markets and the decline in emerging market spreads to unprecedented lows (below 200 basis points in the spring of 2006).

If one thing is sure, it is that the future will bring more surprises. Any effort to forecast by mechanically projecting recent events is certain to be wrong. This uncertainty creates a dilemma for an author whose assigned topic is the future of global financial markets.