International Financial Integration

A major development in the international monetary system over the 1970s was the substantial rise in the volume of international capital flows. The high degree of capital mobility, and the volume of funds involved, is a major feature of the international monetary system and the world economy. The degree of financial integration between countries that has now been reached, in large part associated with international capital flows and the expansion of euro-currency markets, has important implications for the conduct of monetary policy. This has become particularly important in the United Kingdom since the abolition of exchange control in October 1979. The extent of financial integration has a major bearing upon both the effectiveness of monetary policy in any one country and the extent to which individual countries are able to pursue a monetary policy strategy independently of that of other countries. Increasingly, monetary policy has had to be framed within the constraints imposed by a high degree of financial integration in the world economy.

A convenient means of focusing upon the impact international capital movements have on the domestic economy is through the analysis of stabilisation policy. An extensive literature establishes that the response of income and employment to fiscal and monetary policies¹ depends both upon the exchange-rate system and the interest-rate sensitivity of international capital movements. The analysis of stabilisation policy is reviewed in this chapter within a generalised, essentially Keynesian, framework which incorporates the monetary aspects of the balance of payments.

In the previous chapter the domestic monetary effects of the balance of payments were incorporated in the standard IS/LM paradigm, and the two-way direction of causation between changes in the domestic money supply and the balance of payments was highlighted. In this extended model full macro-economic equilibrium requires zero excess demand/supply of foreign exchange so that, with a fixed exchange rate, there are no continuing externally induced changes in the money supply, and the exchange rate is in equilibrium in the floating-rate case. It also establishes that, with a fixed exchange rate and in the absence of sterilisation, monetary policy has no long-run effect upon the level of real income irrespective of the interest-rate sensitivity of capital movements. In the identity M ≡ H + R, policy-induced changes in the domestic component of high-powered money are offset by equal and opposite changes in the external reserves and external component of the monetary base. On the other hand, monetary policy becomes potentially powerful combined with a floating exchange rate though this power derives from induced exchange-rate movements.

The analysis of international capital flows, and their impact on exchange rates and the domestic economy, becomes more complex though more realistic when forward as well as spot exchange transactions are incorporated. The role of the forward market is important in three ways: (i) movements in the forward exchange rate affect arbitrage calculations which determine international capital flows: (ii) forward exchange transactions and changes in the forward rate are important elements in interest-rate and monetary linkages between countries; and (iii) official (central bank) intervention in the forward exchange market is a potentially powerful means of influencing the volume and pattern of capital flows. More specifically, autonomous forward exchange transactions (such as speculative forward sales of a currency) may influence the relative rates of return between investments in different currencies, and hence cause wealth-holders to rearrange their portfolio of wealth between countries. Also, counterpart forward transactions to spot capital flows induce movements in forward rates which in turn alter the arbitrage calculation resulting from interest-rate changes. In this sense, movements in the forward rate have an equilibrating effect and tend to moderate the magnitude of capital flows in response to changes in interest-rate differentials. In this way the forward exchange market can be an important insulating mechanism which limits the extent of international financial interdependence through capital account transactions.

In Chapter 2 the simple IS/LM paradigm was extended to incorporate the monetary effects of the balance of payments. While this paradigm, despite its many and well-known limitations, was found to be a useful general analytical framework, it is particularly weak in its representation of the theory of international capital movements. In particular, the notion of a stable F schedule implicitly assumes that: (i) capital flows in response to interest-rate levels; (ii) capital movements take place on an uncovered basis;¹ and (iii) domestic interest rates move independently of foreign interest rates so that a rise in the domestic rate induces a corresponding widening of the interest-rate differential against foreign assets. In this chapter we find that each of these assumptions is unwarranted both theoretically and empirically.

Consideration is given in this chapter to empirical relationships between interest rates and forward exchange rates in different financial centres: Three-month forward premia and discounts of four currencies are shown in Charts 7.1 and 7.2. Each has experienced sharp fluctuations, associated with interest-rate movements and changing expectations about movements in the spot rate. Sterling was at a forward discount for most of the period after 1971, though, following a very sharp fall in U.K. interest rates, moved to a small premium towards the end of 1977 for the first time in close on six years.

Speculative and interest arbitrage capital movements may clearly have a powerful impact upon the domestic economy through their effect on domestic monetary conditions and the exchange rate. The interest-rate sensitivity of capital movements also affects the power of stabilisation policy in general and the degree of monetary policy independence in particular. In view of this, monetary authorities have frequently sought to devise policy measures to influence capital movements and offset their undesired consequences. In this chapter an outline is given of the broad policy options available to monetary authorities faced with undesired capital inflows. The focus of attention is on the issue of monetary control and hence upon measures to discourage capital inflows. We shall not consider the more general measures of exchange control which many governments, notably those of the United Kingdom, France and Italy, have imposed to limit long-term direct and portfolio capital outflows.

A substantial proportion of international capital movements takes place through the euro-currency markets, and from time to time policy-makers contemplate direct policy measures to limit the role and power of the markets to contribute to international capital movements. Such measures envisage restricting the institutions which create the markets rather than altering the fundamental forces making for international capital transfers. Implicit in the argument must be the notion that the markets add to the volume of world credit and capital movements compared with what would be the case if the markets did not exist. If, on the other hand, the euro-currency markets are simply alternative mechanisms or channels for credit creation and capital movements that would occur in some other way, control of the markets would have little rationale.

In earlier chapters the forward exchange rate, and its relation to the spot rate, was viewed as a key element in international arbitrage. A significant proportion of international capital transfers is conducted on a covered basis, and the forward market is an important medium for exchange-market speculation.

The broad options were outlined in Chapter 8, together with a summary of the main policy instruments applied by European Governments in the 1960s and 1970s to inhibit undesired capital inflows. Most of the specific measures noted in Table 8.1 (p. 108) are self-explanatory. In this chapter more detailed analysis is given of two measures: (i) the use of reserve requirements on bank and non-bank external borrowing; and (ii) the two-tier or dual exchange market. A review is also made of the limited empirical evidence about their effectiveness.

One of the major analytical and practical issues in the analysis of the open economy is the extent to which governments are able to pursue independent monetary policies. As noted in earlier chapters, one strand of the theoretical literature establishes that a key difference between fixed and floating exchange-rate systems is the degree of monetary independence afforded to governments. The broad conclusions of this theoretical analysis are that when the exchange rate is fixed the domestic monetary counterpart of foreign-exchange market intervention effectively means that the monetary authorities lose control over the domestic money supply. On the other hand, the domestic money supply is largely insulated from external developments with a floating exchange rate.

A central feature of the analysis of earlier chapters has been the complex linkage of monetary conditions between countries brought about by international capital movements. An important aspect of the international monetary system is therefore the extent to which, under various exchange-rate regimes, countries are able to pursue independent monetary policies. In particular, the extent to which interest rates in different financial centres move together is one measure of the degree of interdependence of national monetary systems.

One of the central issues under review has been the degree of monetary independence available to individual countries in a world of efficient international money markets. In fact there are two related issues to be considered: (1) the actual degree of monetary independence; and (2) whether monetary independence is in the final analysis a significant policy issue. If monetary independence does not confer on policy-makers an effective means of securing their policy objectives, the lack of independence is of only second-order importance.