11543 Global Capital Market 2

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The GlobalCapitalMarket

IntroductionBenefits of the Global Capital Market

Functions of a Generic Capital MarketAttractions of the Global Capital Market

Growth of the Global Capital MarketInformation TechnologyDeregulationGlobal Capital Market Risks

The Eurocurrency MarketGenesis and Growth of the MarketAttractions of the Eurocurrency MarketDrawbacks of the Eurocurrency Market

The Global Bond MarketAttractions of the Eurobond Market

The Global Equity MarketForeign Exchange Risk and the Cost ofCapitalFocus on Managerial ImplicationsChapter SummaryCritical Discussion QuestionsClosing Case: The Surging Samurai BondMarket

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China Mobile (Hong Kong) Ltd. is a Hong Kong–basedprovider of wireless telephone service and one of thelargest providers of mobile telephone service in the world.The company was spun off in 1996 from China MobileCommunications Corporation, a state-owned provider ofmobile telephone service in mainland China, which re-tained a 75 percent ownership stake in China Mobile(Hong Kong) Ltd. The spin-off was part of a strategy by theChinese government for privatizing its telecommunica-tions network. China Mobile was given the right to ex-pand into mainland China. By September 2000, thecompany was the largest provider of mobile communica-tions in China with 23.9 million subscribers and a marketleadership position in six provinces.

In late 2000, China was finishing up negotiations to en-ter the World Trade Organization. Under the terms of theWTO agreement, China would progressively have to openits telecommunications market to foreign telecommuni-cations service providers. Galvanized by the impendingthreat of new competition in its fast-growing market,China Mobile realized it needed to accelerate its expan-sion into mainland China to preempt foreign competitors.Accordingly, in October 2000, China Mobile reached anagreement to purchase mobile networks in an additionalseven provinces from its state-owned parent company.The purchase of these networks would give China Mobilean additional 15.4 million subscribers. It would also givethe Hong Kong company a geographically contiguousmarket covering all the coastal regions of mainland China,a 56 percent share of all cellular subscribers in mainlandChina, and service coverage of approximately 48 percentof the total population.

The price tag for this deal was $32.8 billion. For ChinaMobile, a critical question was how to finance the deal.It could issue additional equity or debt in Hong Kong, butHong Kong’s relatively small capital market might not bebig enough to absorb a multibillion-dollar offering with-out driving up the price of the capital to an unacceptablyhigh level. For example, China Mobile might be requiredto pay a relatively high interest rate in order to sell suffi-cient bonds in Hong Kong to finance part of its acquisi-tion of the provincial networks, thereby raising its cost ofcapital. After consulting its underwriters, which includedthe U.S. companies Goldman Sachs and Merrill Lynch,China Mobile opted for an international offering of equity

and debt. The shares of China Mobile were already listedon the New York Stock Exchange as American Deposi-tory Receipts (ADRs). Each ADR represented and con-trolled five shares in the Hong Kong company. ChinaMobile opted to sell ADRs worth about $6.6 billion andto raise a further $600 million from the sale of five-yearconvertible bonds. (Convertible bonds can be convertedinto equity at some future date, in this case after fiveyears. They are considered to be a hybrid between con-ventional stocks and bonds.) In addition, China Mobileagreed to sell a 2 percent stake in the company to Voda-fone PLC, Europe’s largest wireless service provider, for$2.5 billion. The remainder of the $32.8 billion purchaseprice for the mainland wireless networks was to be fi-nanced by issuing new shares to state-owned China Mo-bile Communications Corporation, which would retainfor now its 75 percent stake in the company despite theissuing of new equity.

A significant portion of the ADRs would be offered forsale in New York. However, the underwriters also plannedto offer ADRs in Asia and Europe. Similarly, the convert-ible bond issue would be priced in U.S. dollars and offeredto global investors. The equity and bond offerings wereclosed in November 2000. Both offerings were substan-tially oversubscribed. The equity portion of the offeringwas 2.6 times oversubscribed. This was a remarkableachievement for what was the largest ever Asian equityissue outside of Japan. In total, China Mobile raised some$8.24 billion, over $1 billion more than planned. Some$690 million came from the sale of convertible bonds, andthe remainder from the sale of equity. The convertiblebonds carried a 2.25 percent interest rate, significantlyless than the 2.75 percent rate initially targeted (as bondprices are bid up, the interest rate offered by the bondgoes down). This lowered China Mobile’s cost of capital.The oversubscription of the equity portion of the offeringhad a similar effect. The offering was truly global in na-ture. While 55 percent of the placement was in the UnitedStates, another 25 percent went to Asian investors and 20percent to European investors.

Sources: China Mobile Hong Kong Ltd., SEC Form F-3, filed October30, 2000; M. Johnson, “Deal of the Month,” Corporate Finance, De-cember 2000, p. 10; and “Jumbo Equity Raid Elevates China Mobileto Big League,” Euroweek, November 3, 2000, pp. 1, 13.

China Mobile

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The opening case describes how China Mobile overcame the financing constraintsimposed by a relatively small and illiquid Hong Kong capital market and raised $8.24billion by simultaneously selling equity and bonds through several different ex-changes, including Hong Kong and New York, to a broad range of international in-vestors. As we saw, China Mobile also lists its shares on the New York StockExchange in addition to the Hong Kong Stock Exchange. By successfully tapping intothe large and liquid global capital market, the Hong Kong–based company was ableto raise more funds than initially planned and lower its cost of capital. (The cost ofcapital refers to the price of money, such as the interest rate that must be paid tobondholders or the dividends and capital appreciation that stockholders expect to re-ceive.) For example, as noted in the opening case, the convertible bonds carried aninterest rate a full half point lower than originally expected, implying a lower cost ofcapital for China Mobile.

Although China Mobile’s international equity and debt offering was among thelargest to date, the tactic of selling equity and debt internationally is becoming in-creasingly common. This represents a sharp break from common practice during muchof the 20th century. In the past, substantial regulatory barriers separated national cap-ital markets from each other. These made it difficult for a company based in one coun-try to list its stock on a foreign exchange. These regulatory barriers tumbled during the1980s and 1990s. By the middle of the last decade, a truly global capital market wasemerging. This capital market enabled firms to list their stock on multiple exchangesand to raise funds by issuing equity or debt around the world. For example, in 1994,Daimler-Benz, Germany’s largest industrial company, raised $300 million by issuingnew shares not in Germany, but in Singapore.1 In 1996, the German telecommunica-tions provider Deutsche Telekom raised some $13.3 billion by simultaneously listingits shares for sale on stock exchanges in Frankfurt, London, New York, and Tokyo. Andin late 2002, China Telecom, China’s largest fixed-line phone company, raised $1.4billion by selling a 10 percent stake in the company to investors in New York andHong Kong.2 Like China Mobile, these three companies elected to raise equitythrough foreign markets because they reasoned that their domestic capital market wastoo small to supply the requisite funds at a reasonable cost. To lower their cost of cap-ital, they tapped into the large and highly liquid global capital market.

We begin this chapter by looking at the benefits associated with the globalizationof capital markets. This is followed by a more detailed look at the growth of the inter-national capital market and the macroeconomic risks associated with such growth.Next, there is a detailed review of three important segments of the global capital mar-ket: the eurocurrency market, the international bond market, and the internationalequity market. As usual, we close the chapter by pointing out some of the implicationsfor the practice of international business.

Although this section is about the global capital market, we open it by discussing thefunctions of a generic capital market. Then we will look at the limitations of domes-tic capital markets and discuss the benefits of using global capital markets.

|Functions of a Generic Capital Market

A capital market brings together those who want to invest money and those who wantto borrow money (see Figure 11.1). Those who want to invest money include corpo-rations with surplus cash, individuals, and nonbank financial institutions (e.g., pen-sion funds, insurance companies). Those who want to borrow money include

380 Part 4 The Global Monetary System

Introduction

Benefits of the Global Capital Market

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individuals, companies, and governments. Between these two groups are the marketmakers. Market makers are the financial service companies that connect investorsand borrowers, either directly or indirectly. They include commercial banks (e.g., Citi-corp, U.S. Bancorp) and investment banks (e.g., Merrill Lynch, Goldman Sachs).

Commercial banks perform an indirect connection function. They take cash depositsfrom corporations and individuals and pay them interest in return. They then lend thatmoney to borrowers at a higher rate of interest, making a profit from the difference in in-terest rates (commonly referred to as the interest rate spread). Investment banks performa direct connection function. They bring investors and borrowers together and chargecommissions for doing so. For example, Merrill Lynch may act as a stockbroker for an in-dividual who wants to invest some money. Its personnel will advise her as to the most at-tractive purchases and buy stock on her behalf, charging a fee for the service.

Capital market loans to corporations are either equity loans or debt loans. An eq-uity loan is made when a corporation sells stock to investors. The money the cor-poration receives in return for its stock can be used to purchase plants andequipment, fund R&D projects, pay wages, and so on. A share of stock gives itsholder a claim to a firm’s profit stream. The corporation honors this claim by payingdividends to the stockholders. The amount of the dividends is not fixed in advance.Rather, it is determined by management based on how much profit the corporationis making. Investors purchase stock both for their dividend yield and in anticipationof gains in the price of the stock, which in theory reflects future dividend yields.Thus, investors may (and often do) purchase equity in companies that do not cur-rently issue dividends to stockholders because they anticipate that the company willdo so in the future.Stock prices increase when a corporation is projected to havegreater earnings in the future, which increases the probability that it will raise (orinitiate) future dividend payments.

A debt loan requires the corporation to repay a predetermined portion of the loanamount (the sum of the principal plus the specified interest) at regular intervals re-gardless of how much profit the company is making. Management has no discretion asto the amount it will pay investors. Debt loans include cash loans from banks and fundsraised from the sale of corporate bonds to investors. When an investor purchases a cor-porate bond, he purchases the right to receive a specified fixed stream of income fromthe corporation for a specified number of years (i.e., until the bond maturity date).

|Attractions of the Global Capital Market

A global capital market benefits both borrowers and investors. It benefits borrowers by in-creasing the supply of funds available for borrowing and by lowering the cost of capital. Itbenefits investors by providing a wider range of investment opportunities, thereby allow-ing them to build portfolios of international investments that diversify their risks.

The Borrower’s Perspective: A Lower Cost of Capital

In a purely domestic capital market, the pool of investors is limited to residents of thecountry. This places an upper limit on the supply of funds available to borrowers. Inother words, the liquidity of the market is limited. (China Mobile faced this problemin the opening case.) A global capital market, with its much larger pool of investors,provides a larger supply of funds for borrowers to draw on.

Chapter 11 The Global Capital Market 381

Figure 11.1

The Main Players in aGeneric Capital Market

Investors: Companies Individuals Institutions

Market Makers: Commercial Bankers Investment Bankers

Borrowers: Individuals Companies Governments

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Perhaps the most important drawback of the limited liquidity of a purely domesticcapital market is that the cost of capital tends to be higher than it is in an interna-tional market. The cost of capital is the price of borrowing money, which is the rateof return that borrowers must pay investors. This is the interest rate on debt loans andthe dividend yield and expected capital gains on equity loans. In a purely domesticmarket, the limited pool of investors implies that borrowers must pay more to persuadeinvestors to lend them their money. The larger pool of investors in an internationalmarket implies that borrowers will be able to pay less.

The argument is illustrated in Figure 11.2, using the China Mobile example. Thevertical axis in the figure is the cost of capital (the price of borrowing money), and thehorizontal axis is the amount of money available at varying interest rates. DD is theChina Mobile demand curve for borrowings. Note that the China Mobile demand forfunds varies with the cost of capital; the lower the cost of capital, the more moneyChina Mobile will borrow. (Money is just like anything else; the lower its price, themore of it people can afford.) SSHK is the supply curve of funds available in the HongKong capital market, and SSI represents the funds available in the global capital mar-ket. Note that China Mobile can borrow more funds more cheaply on the global cap-ital market. As Figure 11.2 illustrates, the greater pool of resources in the global capitalmarket—the greater liquidity—both lowers the cost of capital and increases theamount China Mobile can borrow. Thus, the advantage of a global capital market toborrowers is that it lowers the cost of capital.

Problems of limited liquidity are not restricted to less developed nations, which nat-urally tend to have smaller domestic capital markets. As discussed in the introduction,even very large enterprises based in some of the world’s most advanced industrializednations in recent years have tapped the international capital markets in their searchfor greater liquidity and a lower cost of capital, such as Germany’s Deutsche Telekom.3

The Deutsche Telekom case is discussed in more detail in the Management Focus.

The Investor’s Perspective: Portfolio Diversification

By using the global capital market, investors have a much wider range of investmentopportunities than in a purely domestic capital market. The most significant conse-quence of this choice is that investors can diversify their portfolios internationally,thereby reducing their risk to below what could be achieved in a purely domestic cap-ital market. We will consider how this works in the case of stock holdings, althoughthe same argument could be made for bond holdings.


Figure 11.2

Market Liquidity and theCost of Capital

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Consider an investor who buys stock in a biotech firm that has not yet produced anew product. Imagine the price of the stock is very volatile—investors are buying andselling the stock in large numbers in response to information about the firm’sprospects. Such stocks are risky investments; investors may win big if the firm producesa marketable product, but investors may also lose all their money if the firm fails tocome up with a product that sells. Investors can guard against the risk associated with

Deutsche Telekom Taps the Global Capital Market

Based in the world’s third largest industrialeconomy, Deutsche Telekom is one of theworld’s largest telephone companies. Untillate 1996, the company was wholly owned bythe German government. However, in themid-1990s, the German government priva-tized the utility, selling shares to the public.The privatization effort was driven by two fac-tors: (1) a realization that state-owned enter-prises tend to be inherently inefficient, and(2) the impending deregulation of the Euro-

pean Union telecommunication industry in 1998, whichpromised to expose Deutsche Telekom to foreign com-petition for the first time. Deutsche Telekom realizedthat, to become more competitive, it needed massiveinvestments in new telecommunication infrastructure,including fiber optics and wireless, lest it start losingshare in its home market to more efficient global com-petitors. Financing such investments from statesources would have been difficult even under the bestof circumstances and almost impossible in the late1990s, when the German government was trying tolimit its budget deficit to meet the criteria for member-ship in the European monetary union. With the encour-agement of the government, Deutsche Telekom hopedto finance its investments in capital equipment throughthe sale of shares to the public.

From a financial perspective, the privatizationlooked anything but easy. In 1996, Deutsche Telekomwas valued at about $60 billion. If it maintained thisvaluation as a private company, it would dwarf all oth-ers listed on the German stock market. However,many analysts doubted there was anything close to$60 billion available in Germany for investment inDeutsche Telekom stock. One problem was that therewas no tradition of retail stock investing in Germany. In1996, only 1 in 20 German citizens owned shares,compared with 1 in every 4 or 5 in the United Statesand Great Britain. This lack of retail interest in stockownership makes for a relatively illiquid stock market.Nor did banks, the traditional investors in company

stocks in Germany, seem enthused about underwrit-ing such a massive privatization effort. A further prob-lem was that a wave of privatizations was alreadysweeping through Germany and the rest of Europe, so Deutsche Telekom would have tocompete with many other state-owned en-terprises for investors’ attention. Giventhese factors, probably the only way thatDeutsche Telekom could raise $60 billionthrough the German capital market wouldhave been by promising investors a divi-dend yield that would raise the company’scost of capital above levels that could be serv-iced profitably.

Deutsche Telekom managers concluded they hadto privatize the company in stages and sell a substan-tial portion of Deutsche Telekom stock to foreign in-vestors. The company’s plans called for an initial publicoffering (IPO) of 713 million shares of DeutscheTelekom stock, representing 25 percent of the com-pany’s total value, for about $18.50 per share. With atotal projected value in excess of $13 billion, even this“limited” sale of Deutsche Telekom represented thelargest IPO in European history and the second largestin the world after the 1987 sale of shares in Japan’stelephone monopoly, NTT, for $15.6 billion. Concludingthere was no way the German capital market could ab-sorb even this partial sale of Deutsche Telekom equity,the managers of the company decided to simultane-ously list shares and offer them for sale in Frankfurt(where the German stock exchange is located), Lon-don, New York, and Tokyo, attracting investors from allover the world. The IPO was successfully executed inNovember 1996 and raised $13.3 billion for the com-pany.

Sources: J. O. Jackson, “The Selling of the Big Pink,” Time, De-cember 2, 1996, p. 46; S. Ascarelli, “Privatization Is WorryingDeutsche Telekom,” Wall Street Journal, February 3, 1995,p. A1; “Plunging into Foreign Markets,” The Economist, Sep-tember 17, 1994, pp. 86–87; and A. Raghavan and M. R. Sesit,“Financing Boom: Foreign Firms Raise More and More Moneyin the U.S. Market,” Wall Street Journal, October 5, 1993, p. A1.

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holding this stock by buying other firms’ stocks, particularly those weakly or negativelycorrelated with the biotech stock. By the holding of a variety of stocks in a diversifiedportfolio, the losses incurred when some stocks fail to live up to their promises are off-set by the gains enjoyed when other stocks exceed their promise.

As an investor increases the number of stocks in his portfolio, the portfolio’s riskdeclines. At first this decline is rapid. Soon, however, the rate of decline falls off andasymptotically approaches the systematic risk of the market. Systematic risk refers tomovements in a stock portfolio’s value that are attributable to macroeconomic forcesaffecting all firms in an economy, rather than factors specific to an individual firm. Thesystematic risk is the level of nondiversifiable risk in an economy. Figure 11.3 illus-trates this relationship for the United States. It suggests that a fully diversified U.S.portfolio is only about 27 percent as risky as a typical individual stock.

By diversifying a portfolio internationally, an investor can reduce the level of riskeven further because the movements of stock market prices across countries are not


Figure 11.3

Risk Reduction throughPortfolio Diversification

Source: B. Solnik, “Why Not Diver-sify Internationally Rather than Do-mestically?” Adapted withpermission from Financial AnalystsJournal, July/August 1974, p. 17.Copyright 1974, Financial AnalystsFederation, Charlottesville, VA. Allrights reserved.

Variance ofPortfolio ReturnVariance of Returnon Typical Stock

Variance ofPortfolio ReturnVariance of Returnon Typical Stock

1.0

0.27

10 20 30 40 501

Number of Stocks

U.S. Stocks

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International Stocks0.12

(a) Risk Reduction through Domestic Diversification

(b) Risk Reduction through Domestic and International Diversification

SystematicRisk

TotalRisk

10 20 30 40 501

Number of Stocks

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perfectly correlated. For example, one study looked at the correlation between threestock market indexes. The Standard & Poor’s 500 (S&P 500) summarized the move-ment of large U.S. stocks. The Morgan Stanley Capital International Europe, Aus-tralia, and Far East Index (EAFE) summarized stock market movements in otherdeveloped nations. The third index, the International Finance Corporation GlobalEmerging Markets Index (IFC), summarized stock market movements in less devel-oped “emerging economies.” From 1981 to 1994, the correlation between the S&P500 and EAFE indexes was 0.45, suggesting they moved together only about 20 per-cent of the time (i.e., 0.45 � 0.45 � 0.2025). The correlation between the S&P 500and IFC indexes was even lower at 0.32, suggesting they moved together only a littleover 10 percent of the time.4 Another study reported that for 1970–96, the correlationbetween the U.S. stock market and the U.K. market was 0.51, between the U.S. andFrench markets it was 0.44, and between the U.S. and Japanese markets it was 0.26.5

The relatively low correlation between the movements of stock markets in differentcountries reflects two basic factors. First, countries pursue different macroeconomic poli-cies and face different economic conditions, so their stock markets respond to differentforces and can move in different ways. For example, in 1997, the stock markets of severalAsian countries, including South Korea, Malaysia, Indonesia, and Thailand, lost morethan 50 percent of their value in response to the Asian financial crisis, while at the sametime the S&P 500 increased in value by over 20 percent. Second, different stock marketsare still somewhat segmented from each other by capital controls—that is, by restrictionson cross-border capital flows (although such restrictions are declining rapidly). The mostcommon restrictions include limits on the amount of a firm’s stock that a foreigner canown and limits on the ability of a country’s citizens to invest their money outside thatcountry. For example, until recently it was difficult for foreigners to own more than 30percent of the equity of South Korean enterprises. Tight restrictions on capital flows makeit very hard for Chinese citizens to take money out of their country and invest it in for-eign assets. Such barriers to cross-border capital flows limit the ability of capital to roamthe world freely in search of the highest risk-adjusted return. Consequently, at any onetime, there may be too much capital invested in some markets and too little in others.This will tend to produce differences in rates of return across stock markets.6 The impli-cation is that by diversifying a portfolio to include foreign stocks, an investor can reducethe level of risk below that incurred by holding just domestic stocks.

Figure 11.3 also illustrates the relationship between international diversificationand risk found by a now classic study by Bruno Solnik.7 According to the figure, a fullydiversified portfolio that contains stocks from many countries is less than half as riskyas a fully diversified portfolio that contains only U.S. stocks. A fully diversified port-folio of international stocks is only about 12 percent as risky as a typical individualstock, whereas a fully diversified portfolio of U.S. stocks is about 27 percent as risky asa typical individual stock.

An increasingly common perception among investment professionals is that in thepast 10 years the growing integration of the global economy and the emergence of theglobal capital market have increased the correlation between different stock markets, re-ducing the benefits of international diversification.8 Today, it is argued, if the U.S. econ-omy enters a recession, and the U.S. stock market declines rapidly, other markets followsuit. A recent study by Solnik suggests there may be some truth to this assertion, but therate of integration is not occurring as rapidly as the popular perception would lead one tobelieve. Solnik and his associates looked at the correlation between 15 major stock mar-kets in developed countries between 1971 and 1998. They found that on average, the cor-relation of monthly stock market returns increased from 66 percent in 1971 to 75 percentin 1998, indicating some convergence over time, but that “the regression results wereweak,” which suggests this “average” relationship was not strong, and there was consider-able variation among countries.9 The implication here is that international portfolio di-versification can still reduce risk. As noted earlier, the correlation between stock marketmovements in developed and emerging markets seems to be much lower.


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The risk-reducing effects of international portfolio diversification would be greaterwere it not for the volatile exchange rates associated with the current floating ex-change rate regime. Floating exchange rates introduce an additional element of riskinto investing in foreign assets. As we have said repeatedly, adverse exchange ratemovements can transform otherwise profitable investments into unprofitable ones.The uncertainty engendered by volatile exchange rates may be acting as a brake onthe otherwise rapid growth of the international capital market.

The Home Bias Puzzle

Generally, investors do not hold as many foreign financial assets in their portfolios asthe theory on international portfolio diversification suggests they should. Investorstend to heavily bias their portfolios toward firms located in their country of residence.For example, one study reported that U.S. investors held 94 percent of their invest-ments in domestic equities, Japanese investors held 98 percent, and UK investors 82percent.10 This phenomenon is referred to as the home bias puzzle.

Several explanations have been offered to explain the home bias puzzle.11 One is thatwithin a country, more information is available on domestic firms than foreign firms, andso the home bias reflects information asymmetries. Another explanation is that thetransaction costs associated with purchasing foreign equities (e.g., commissions thatmust be paid to stock brokers) are such that the costs of international equity diversifica-tion outweigh the benefits. To date, however, this puzzle has not been resolved to thesatisfaction of most economists. This tendency of investors to display a preference fordomestic equities may be another force that keeps domestic capital markets segmented.

According to data from the Bank for International Settlements, the global capitalmarket is growing at a rapid pace.12 By late 2002, the stock of cross-border bank loansstood at $9,446 billion, up from $3,600 billion in 1990. There were $8,780 billion inoutstanding international bonds, up from $3,515 billion in 1997 and $620 billion in1994. International equity offerings peaked in 2000, when they exceeded $314 billion.This compared to $90 billion in 1997 and some $18 billion in 1990. By 2002, inter-national equity offerings had fallen to $102 billion, but this drop must be viewed inlight of the general weak performance of global stock markets during the early 2000s,and suggests that the underlying long-term trend is still up.

What factors allowed the international capital market to bloom in the 1980s and1990s? There seem to be two answers—advances in information technology andderegulation by governments.

|Information Technology

Financial services is an information-intensive industry. It draws on large volumes ofinformation about markets, risks, exchange rates, interest rates, creditworthiness, andso on. It uses this information to make decisions about what to invest where, howmuch to charge borrowers, how much interest to pay to depositors, and the value andriskiness of a range of financial assets including corporate bonds, stocks, governmentsecurities, and currencies.

Because of this information intensity, the financial services industry has been rev-olutionized more than any other industry by advances in information technology sincethe 1970s. The growth of international communication technology has facilitated in-stantaneous communication between any two points on the globe. At the same time,rapid advances in data processing have allowed market makers to absorb and processlarge volumes of information from around the world. According to one study, becauseof these technological developments, the real cost of recording, transmitting, and pro-cessing information fell by 95 percent between 1964 and 1990.13 With the rapid rise


Growth of the Global Capital Market

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of the Internet and the massive increase in computing power that we have seen since1990, it seems likely that the cost of recording, transmitting, and processing informa-tion has fallen by a similar amount since 1990 and is now a trivial amount.

Such developments have facilitated the emergence of an integrated internationalcapital market. It is now technologically possible for financial services companies toengage in 24-hour-a-day trading, whether it is in stocks, bonds, foreign exchange, orany other financial asset. Due to advances in communications and data processingtechnology, the international capital market never sleeps. San Francisco closes onehour before Tokyo opens, but during this period trading continues in New Zealand.

But the integration facilitated by technology has a dark side.14 Shocks that occurin one financial center now spread around the globe very quickly. The collapse ofU.S. stock prices on the notorious Black Monday of October 19, 1987, immediatelytriggered similar collapses in all the world’s major stock markets, wiping billions ofdollars off the value of corporate stocks worldwide. Similarly, the Asian financial cri-sis of 1997 sent shock waves around the world and precipitated a sell-off in worldstock markets, although the effects of the shock were short lived. Most market par-ticipants would argue that the benefits of an integrated global capital market far out-weigh any potential costs.

|Deregulation

In country after country, financial services have been the most tightly regulated of allindustries. Governments around the world have traditionally kept other countries’ fi-nancial service firms from entering their capital markets. In some cases, they have alsorestricted the overseas expansion of their domestic financial services firms. In manycountries, the law has also segmented the domestic financial services industry. For ex-ample, until recently U.S. commercial banks were prohibited from performing thefunctions of investment banks, and vice versa. Historically, many countries have lim-ited the ability of foreign investors to purchase significant equity positions in domes-tic companies. They have also limited the amount of foreign investment that theircitizens could undertake. In the 1970s, for example, capital controls made it very dif-ficult for a British investor to purchase U.S. stocks and bonds.

Many of these restrictions have been crumbling since the early 1980s. In part, thishas been a response to the development of the eurocurrency market, which from thebeginning was outside of national control. (This is explained later in the chapter.) Ithas also been a response to pressure from financial services companies, which havelong wanted to operate in a less regulated environment. Increasing acceptance of thefree market ideology associated with an individualistic political philosophy also has alot to do with the global trend toward the deregulation of financial markets (see Chap-ter 2). Whatever the reason, deregulation in a number of key countries has undoubt-edly facilitated the growth of the international capital market.

The trend began in the United States in the late 1970s and early 80s with a seriesof changes that allowed foreign banks to enter the U.S. capital market and domesticbanks to expand their operations overseas. In Great Britain, the so-called Big Bang ofOctober 1986 removed barriers that had existed between banks and stockbrokers andallowed foreign financial service companies to enter the British stock market. Re-strictions on the entry of foreign securities houses have been relaxed in Japan, andJapanese banks are now allowed to open international banking facilities. In France,the “Little Bang” of 1987 opened the French stock market to outsiders and to foreignand domestic banks. In Germany, foreign banks are now allowed to lend and manageforeign euro issues, subject to reciprocity agreements.15 All of this has enabled finan-cial services companies to transform themselves from primarily domestic companiesinto global operations with major offices around the world—a prerequisite for the de-velopment of a truly international capital market. In late 1997, the World Trade Or-ganization brokered a deal that removed many of the restrictions on cross-border trade


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in financial services. This deal facilitated further growth in the size of the global cap-ital market.

In addition to the deregulation of the financial services industry, many countries be-ginning in the 1970s started to dismantle capital controls, loosening both restrictionson inward investment by foreigners and outward investment by their own citizens andcorporations. By the 1980s, this trend spread from developed nations to the emergingeconomies of the world as countries across Latin America, Asia, and Eastern Europestarted to dismantle decades-old restrictions on capital flows. Between 1985 and 1997an index of capital controls in emerging markets computed by the IMF has declinedfrom a high of 0.66 to around 0.56 (the index would be 1.0 if all emerging economieshad tight capital controls, and 0.0 if they had no controls).

As of 2003, the trends toward deregulation of financial services and removal of cap-ital controls were still firmly in place. Given the benefits associated with the global-ization of capital, the growth of the global capital market can be expected to continuefor the foreseeable future. While most commentators see this as a positive develop-ment, some believe there are serious risks inherent in the globalization of capital.

|Global Capital Market Risks

Some observers are concerned that due to deregulation and reduced controls on cross-border capital flows, individual nations are becoming more vulnerable to speculativecapital flows. They see this as having a destabilizing effect on national economies.16

Harvard economist Martin Feldstein, for example, has argued that most of the capitalthat moves internationally is pursuing temporary gains, and it shifts in and out ofcountries as quickly as conditions change.17 He distinguishes between this short-term

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Did the Global Capital Market Fail Mexico?

In early 1994, soon after passage of theNorth American Free Trade Agreement(NAFTA), Mexico was widely admired amongthe international community as a shining ex-ample of a developing country with a brighteconomic future. Since the late 1980s, theMexican government had pursued sound

monetary, budget, tax, and trade policies. By historicalstandards, inflation was low, the country was experi-encing solid economic growth, and exports werebooming. This robust picture attracted capital fromforeign investors; between 1991 and 1993, foreignersinvested more than $75 billion in the Mexican econ-omy, more than in any other developing nation.

If there was a blot on Mexico’s economic reportcard, it was the country’s growing current account(trade) deficit. Mexican exports were booming, but sowere its imports. In the 1989–1990 period, the currentaccount deficit was equivalent to about 3 percent ofMexico’s gross domestic product. In 1991, it in-creased to 5 percent, and by 1994 it was running at anannual rate of more than 6 percent. Bad as this mightseem, it is not unsustainable and should not bring an

economy crashing down. The United States has beenrunning a current account deficit for decades with ap-parently little in the way of ill effects. A current ac-count deficit will not be a problem for a country as longas foreign investors take the money they earn fromtrade with that country and reinvest it within the coun-try. This has been the case in the United States foryears, and during the early 1990s, it was occurring inMexico too. Companies such as Ford took the pesosthey earned from exports to Mexico and reinvestedthose funds in productive capacity in Mexico, buildingauto plants to serve the future needs of the Mexicanmarket and to export elsewhere.

Unfortunately for Mexico, much of the $25 billionannual inflow of capital it received during the early1990s was not the kind of patient long-term moneythat Ford was putting into Mexico. Rather, accordingto economist Martin Feldstein, much of the inflowwas short-term capital that could flee if economic con-ditions changed for the worst. This is what seems tohave occurred. In February 1994, the U.S. Federal Re-serve began to increase interest rates. This led to arapid fall in U.S. bond prices. At the same time, the

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capital, or “hot money,” and “patient money” that would support long-term cross-border capital flows. To Feldstein, patient money is still relatively rare, primarily be-cause although capital is free to move internationally, its owners and managers stillprefer to keep most of it at home. Feldstein supports his arguments with statistics thatdemonstrate that although $1.5 trillion flow through the foreign exchange marketsevery day, “when the dust settles, most of the savings done in each country stays in thatcountry.”18 Feldstein argues that the lack of patient money is due to the relativepaucity of information that investors have about foreign investments. In his view, ifinvestors had better information about foreign assets, the global capital market wouldwork more efficiently and be less subject to short-term speculative capital flows. Feld-stein claims that Mexico’s economic problems in the mid-1990s were the result of toomuch hot money flowing in and out of the country and too little patient money. Thisexample is reviewed in detail in the accompanying Country Focus.

A lack of information about the fundamental quality of foreign investments may en-courage speculative flows in the global capital market. Faced with a lack of quality in-formation, investors may react to dramatic news events in foreign nations and pull theirmoney out too quickly. Despite advances in information technology, it is still difficultfor investors to get access to the same quantity and quality of information about foreigninvestment opportunities that they can get about domestic investment opportunities.This information gap is exacerbated by varying accounting conventions in differentcountries, which makes the direct comparison of cross-border investment opportunitiesdifficult for all but the most sophisticated investor (see Chapter 19 for details).

Given the problems created by differences in the quantity and quality of informa-tion, many investors have yet to venture into the world of cross-border investing, andthose that do are prone to reverse their decision on the basis of limited (and perhaps

it appeared to be short-term money. As money flowedout of Mexico, the Mexican government had to com-mit more foreign reserves to defending the value ofthe peso against the U.S. dollar, which waspegged at 3.5 to the dollar. Currency specula-tors entered the picture and began to betagainst the Mexican government by sellingpesos short. Events came to a head in De-cember 1994 when the Mexican govern-ment was essentially forced by capitalflows to abandon its support for the peso.Over the next month, the peso lost 40 per-cent of its value against the dollar, the gov-ernment was forced to introduce an economicausterity program, and the Mexican economic boomcame to an abrupt end.

Sources: Martin Feldstein, “Global Capital Flows: Too Little, NotToo Much,” The Economist, June 24, 1995, pp. 72–73; R. Dorn-busch, “We Have Salinas to Thank for the Peso Debacle,” Busi-ness Week, January 16, 1995, p. 20; and P. Carroll and C. Torres,“Mexico Unveils Program of Harsh Fiscal Medicine,” Wall StreetJournal, March 10, 1995, pp. A1, A6. See also Martin Feldsteinand Charles Horioka, “Domestic Savings and International Capi-tal Flows,” Economic Journal 90 (1980), pp. 314–29.

www.mhhe.com/hill

yen began to appreciate sharply against the dollar.These events resulted in large losses for many man-agers of short-term capital, such as hedge fund man-agers and banks, which had been betting on exactlythe opposite happening. Many hedge funds had beenexpecting interest rates to fall, bond prices to rise, andthe dollar to appreciate against the yen.

Faced with large losses, money managers tried toreduce the riskiness of their portfolios by pulling outof risky situations. About the same time, events tooka turn for the worse in Mexico. An armed uprising inthe southern state of Chiapas, the assassination ofthe leading candidate in the presidential electioncampaign, and an accelerating inflation rate all helpedproduce a feeling that Mexican investments wereriskier than had been assumed. Money managers be-gan to pull many of their short-term investments outof the country.

As hot money flowed out, the Mexican govern-ment realized it could not continue to count on capitalinflows to finance its current account deficit. The gov-ernment had assumed the inflow was mainly com-posed of patient, long-term money. In reality, much of

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inaccurate) information. However, if the international capital market continues togrow, financial intermediaries likely will increasingly provide quality informationabout foreign investment opportunities. Better information should increase the so-phistication of investment decisions and reduce the frequency and size of speculativecapital flows. Although concerns about the volume of “hot money” sloshing around inthe global capital market increased as a result of the Asian financial crisis, IMF re-search suggests there has not been an increase in the volatility of financial marketsover the past 25 years.19

According to Martin Feldstein, the Mexican economy was brought down not bycurrency speculation on the foreign exchange market, but by a lack of long-term pa-tient money. He argued that Mexico offered, and still offers, many attractive long-terminvestment opportunities, but because of the lack of information on long-term invest-ment opportunities in Mexico, most of the capital flowing into the country from 1991to 1993 was short-term, speculative money, the flow of which could quickly be re-versed. If foreign investors had better information, Feldstein argued, Mexico shouldhave been able to finance its current account deficit from inward capital flows becausepatient capital would naturally gravitate toward attractive Mexican investment op-portunities.

A eurocurrency is any currency banked outside of its country of origin. Eurodollars,which account for about two-thirds of all eurocurrencies, are dollars banked outsidethe United States. Other important eurocurrencies include the euro-yen and the euro-pound. The term eurocurrency is actually a misnomer because a eurocurrency can becreated anywhere in the world; the persistent euro- prefix reflects the European originof the market. The eurocurrency market has been an important and relatively low-costsource of funds for international businesses.

|Genesis and Growth of the Market

The eurocurrency market was born in the mid-1950s when Eastern European holdersof dollars, including the former Soviet Union, were afraid to deposit their holdings inthe United States lest they be seized by the U.S. government to settle U.S. residents’claims against business losses resulting from the Communist takeover of Eastern Eu-rope. These countries deposited many of their dollar holdings in Europe, particularlyin London. Additional dollar deposits came from various Western European centralbanks and from companies that earned dollars by exporting to the United States.These two groups deposited their dollars in London banks, rather than U.S. banks, be-cause they were able to earn a higher rate of interest (which will be explained).

The eurocurrency market received a major push in 1957 when the British govern-ment prohibited British banks from lending British pounds to finance non-Britishtrade, a business that had been very profitable for British banks. British banks beganfinancing the same trade by attracting dollar deposits and lending dollars to compa-nies engaged in international trade and investment. Because of this historical event,London became, and has remained, the leading center of eurocurrency trading.

The eurocurrency market received another push in the 1960s when the U.S. gov-ernment enacted regulations that discouraged U.S. banks from lending to non-U.S.residents. Would-be dollar borrowers outside the United States found it increasinglydifficult to borrow dollars in the United States to finance international trade, so theyturned to the eurodollar market to obtain the necessary dollar funds.

The U.S. government changed its policies after the 1973 collapse of the BrettonWoods system (see Chapter 10), removing an important impetus to the growth of theeurocurrency market. However, another political event, the oil price increases engi-neered by OPEC in 1973–74 and 1979–80, gave the market another big shove. As a


The Eurocurrency Market

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result of the oil price increases, the Arab members of OPEC accumulated hugeamounts of dollars. They were afraid to place their money in U.S. banks or their Eu-ropean branches, lest the U.S. government attempt to confiscate them. (Iranian assetsin U.S. banks and their European branches were frozen by President Carter in 1979 af-ter Americans were taken hostage at the U.S. embassy in Tehran; their fear was notunfounded.) Instead, these countries deposited their dollars with banks in London,further increasing the supply of eurodollars.

Although these various political events contributed to the growth of the eurocur-rency market, they alone were not responsible for it. The market grew because it of-fered real financial advantages—initially to those who wanted to deposit dollars orborrow dollars and later to those who wanted to deposit and borrow other currencies.

|Attractions of the Eurocurrency Market

Its lack of government regulation makes the eurocurrency market attractive to bothdepositors and borrowers. Banks can offer higher interest rates on eurocurrency de-posits than on deposits made in the home currency, making eurocurrency deposits at-tractive to those who have cash to invest. The lack of regulation also allows banks tocharge borrowers a lower interest rate for eurocurrency borrowings than for borrowingsin the home currency, making eurocurrency loans attractive for those who want to bor-row money. In other words, the spread between the eurocurrency deposit rate and theeurocurrency lending rate is less than the spread between the domestic deposit andlending rates (see Figure 11.4). To understand why this is so, we must examine howgovernment regulations raise the costs of domestic banking.

Domestic currency deposits are regulated in all industrialized countries. Such regu-lations ensure that banks have enough liquid funds to satisfy demand if large numbersof domestic depositors should suddenly decide to withdraw their money. All countriesoperate with certain reserve requirements. For example, each time a U.S. bank acceptsa deposit in dollars, it must place some fraction of that deposit in a non-interest-bearing account at a Federal Reserve Bank as part of its required reserves. Similarly,each time a British bank accepts a deposit in pounds sterling, it must place a certainfraction of that deposit with the Bank of England.

Banks are given much more freedom in their dealings in foreign currencies, however.For example, the British government does not impose reserve requirement restrictionson deposits of foreign currencies within its borders. Nor are the London branches of U.S.banks subject to U.S. reserve requirement regulations, provided those deposits arepayable only outside the United States. This gives eurobanks a competitive advantage.

For example, suppose a bank based in New York faces a 10 percent reserve require-ment. According to this requirement, if the bank receives a $100 deposit, it can lend


Figure 11.4

Interest Rate Spreads inDomestic and Eurocur-rency Markets Domestic

Lending Rate

DomesticDeposit Rate

EurocurrencyLending Rate

EurocurrencyDeposit Rate

0%

Rate ofInterest

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out no more than $90 of that and it must place the remaining $10 in a non-interest-bearing account at a Federal Reserve bank. Suppose the bank has annual operatingcosts of $1 per $100 of deposits and that it charges 10 percent interest on loans. Thehighest interest the New York bank can offer its depositors and still cover its costs is 8percent per year. Thus, the bank pays the owner of the $100 deposit (0.08 � $100�)$8, earns (0.10 � $90�) $9 on the fraction of the deposit it is allowed to lend, andjust covers its operating costs.

In contrast, a eurobank can offer a higher interest rate on dollar deposits and stillcover its costs. The eurobank, with no reserve requirements regarding dollar deposits,can lend out all of a $100 deposit. Therefore, it can earn 0.10 � $100 � $10 at a loanrate of 10 percent. If the eurobank has the same operating costs as the New York bank($1 per $100 deposit), it can pay its depositors an interest rate of 9 percent, a full per-centage point higher than that paid by the New York bank, and still cover its costs.That is, it can pay 0.09 � $100 � $9 to its depositor, receive $10 from the borrower,and be left with $1 to cover operating costs. Alternatively, the eurobank might pay thedepositor 8.5 percent (which is still above the rate paid by the New York bank), chargeborrowers 9.5 percent (still less than the New York bank charges), and cover its oper-ating costs even better. Thus, the eurobank has a competitive advantage vis-à-vis theNew York bank in both its deposit rate and its loan rate.

Clearly, there are strong financial motivations for companies to use the eurocur-rency market. By doing so, they receive a higher interest rate on deposits and pay lessfor loans. Given this, the surprising thing is not that the euromarket has grown rap-idly but that it hasn’t grown even faster. Why do any depositors hold deposits in theirhome currency when they could get better yields in the eurocurrency market?

|Drawbacks of the Eurocurrency Market

The eurocurrency market has two drawbacks. First, when depositors use a regulatedbanking system, they know that the probability of a bank failure that would causethem to lose their deposits is very low. Regulation maintains the liquidity of the bank-ing system. In an unregulated system such as the eurocurrency market, the probabilityof a bank failure that would cause depositors to lose their money is greater (althoughin absolute terms, still low). Thus, the lower interest rate received on home-countrydeposits reflects the costs of insuring against bank failure. Some depositors are morecomfortable with the security of such a system and are willing to pay the price.

Second, borrowing funds internationally can expose a company to foreign ex-change risk. For example, consider a U.S. company that uses the eurocurrency marketto borrow euro-pounds—perhaps because it can pay a lower interest rate on euro-pound loans than on dollar loans. Imagine, however, that the British pound subse-quently appreciates against the dollar. This would increase the dollar cost of repayingthe euro-pound loan and thus the company’s cost of capital. This possibility can be in-sured against by using the forward exchange market (as we saw in Chapter 9), but theforward exchange market does not offer perfect insurance. Consequently, many com-panies borrow funds in their domestic currency to avoid foreign exchange risk, eventhough the eurocurrency markets may offer more attractive interest rates.

The global bond market grew rapidly during the past two decades. Bonds are an im-portant means of financing for many companies. The most common kind of bond is afixed-rate bond. The investor who purchases a fixed-rate bond receives a fixed set ofcash payoffs. Each year until the bond matures, the investor gets an interest paymentand then at maturity she gets back the face value of the bond.

International bonds are of two types: foreign bonds and eurobonds. Foreign bondsare sold outside the borrower’s country and are denominated in the currency of the


The Global Bond Market

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country in which they are issued. Thus, when Dow Chemical issues bonds in Japaneseyen and sells them in Japan, it is issuing foreign bonds. Many foreign bonds have nick-names; foreign bonds sold in the United States are called Yankee bonds, foreign bondssold in Japan are Samurai bonds, and foreign bonds sold in Great Britain are bulldogs.Companies will issue international bonds if they believe it will lower their cost of cap-ital. For example, in recent years many companies have been issuing Samurai bonds inJapan to take advantage of very low interest rates. In early 2001, 10-year Japanese gov-ernment bonds yielded 1.24 percent, compared with 5 percent for comparable U.S.government bonds. Against this background, companies found that they could raisedebt at a cheaper rate in Japan than in the United States.

Eurobonds are normally underwritten by an international syndicate of banks andplaced in countries other than the one in whose currency the bond is denominated.For example, a bond may be issued by a German corporation, denominated in U.S.dollars, and sold to investors outside the United States by an international syndicateof banks. Eurobonds are routinely issued by multinational corporations, large domes-tic corporations, sovereign governments, and international institutions. They are usu-ally offered simultaneously in several national capital markets, but not in the capitalmarket of the country, nor to residents of the country, in whose currency they are de-nominated. Historically, eurobonds accounted for the lion’s share of internationalbond issues, but increasingly they are being eclipsed by foreign bonds.

|Attractions of the Eurobond Market

Three features of the eurobond market make it an appealing alternative to most ma-jor domestic bond markets:

• An absence of regulatory interference.• Less stringent disclosure requirements than in most domestic bond markets.• A favorable tax status.

Regulatory Interference

National governments often impose tight controls on domestic and foreign issuersof bonds denominated in the local currency and sold within their national bound-aries. These controls tend to raise the cost of issuing bonds. However, governmentlimitations are generally less stringent for securities denominated in foreign curren-cies and sold to holders of those foreign currencies. Eurobonds fall outside the regu-latory domain of any single nation. As such, they can often be issued at a lower costto the issuer.

Disclosure Requirements

Eurobond market disclosure requirements tend to be less stringent than those of sev-eral national governments. For example, if a firm wishes to issue dollar-denominatedbonds within the United States, it must first comply with Securities and ExchangeCommission (SEC) disclosure requirements. The firm must disclose detailed informa-tion about its activities, the salaries and other compensation of its senior executives,stock trades by its senior executives, and the like. In addition, the issuing firm mustsubmit financial accounts that conform to U.S. accounting standards. For non-U.S.firms, redoing their accounts to make them consistent with U.S. standards can be verytime consuming and expensive. Therefore, many firms have found it cheaper to issueeurobonds, including those denominated in dollars, than to issue dollar-denominatedbonds within the United States.

Favorable Tax Status

Before 1984, U.S. corporations issuing eurobonds were required to withhold forU.S. income tax up to 30 percent of each interest payment to foreigners. This did


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not encourage foreigners to hold bonds issued by U.S. corporations. Similar taxlaws were operational in many countries at that time, and they limited market de-mand for eurobonds. U.S. laws were revised in 1984 to exempt from any withhold-ing tax foreign holders of bonds issued by U.S. corporations. As a result, U.S.corporations found it feasible for the first time to sell eurobonds directly to for-eigners. Repeal of the laws caused other governments—including those of France,Germany, and Japan—to liberalize their tax laws likewise to avoid outflows of cap-ital from their markets. The consequence was an upsurge in demand for eurobondsfrom investors who wanted to take advantage of their tax benefits.

Although we have talked about the growth of the global equity market, strictly speak-ing there is no international equity market in the sense that there are internationalcurrency and bond markets. Rather, many countries have their own domestic equitymarkets in which corporate stock is traded. The largest of these domestic equity mar-kets are to be found in the United States, Great Britain, Japan, and Germany. Al-though each domestic equity market is still dominated by investors who are citizens ofthat country and companies incorporated in that country, developments are interna-tionalizing the world equity market. Investors are investing heavily in foreign equitymarkets to diversify their portfolios. Facilitated by deregulation and advances in in-formation technology, this trend seems to be here to stay.

An interesting consequence of the trend toward international equity investment isthe internationalization of corporate ownership. Today it is still generally possible totalk about U.S. corporations, British corporations, and Japanese corporations, prima-rily because the majority of stockholders (owners) of these corporations are of the re-spective nationality. However, this is changing. Increasingly, U.S. citizens are buyingstock in companies incorporated abroad, and foreigners are buying stock in companiesincorporated in the United States. Looking into the future, Robert Reich has musedabout “the coming irrelevance of corporate nationality.”20

A second development internationalizing the world equity market is that compa-nies with historic roots in one nation are broadening their stock ownership by listingtheir stock in the equity markets of other nations. The reasons are primarily financial.Listing stock on a foreign market is often a prelude to issuing stock in that market toraise capital. The idea is to tap into the liquidity of foreign markets, thereby increas-ing the funds available for investment and lowering the firm’s cost of capital. (The re-lationship between liquidity and the cost of capital was discussed earlier in thechapter.) Firms also often list their stock on foreign equity markets to facilitate futureacquisitions of foreign companies. Other reasons for listing a company’s stock on a for-eign equity market are that the company’s stock and stock options can be used to com-pensate local management and employees, it satisfies the desire for local ownership,and it increases the company’s visibility with local employees, customers, suppliers,and bankers. Although firms based in developed nations were the first to start listingtheir stock on foreign exchanges, increasingly firms from developing countries whofind their own growth limited by an illiquid domestic capital market are exploiting thisopportunity.

While a firm can borrow funds at a lower cost on the global capital market than on thedomestic capital market, foreign exchange risk complicates this picture. Adversemovements in foreign exchange rates can substantially increase the cost of foreign cur-rency loans, which is what happened to many Asian companies during the 1997–98Asian financial crisis.


The Global Equity Market

Foreign Exchange Risk and the Cost of Capital

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Consider a South Korean firm that wants to borrow 1 billion Korean won for oneyear to fund a capital investment project. The company can borrow this money froma Korean bank at an interest rate of 10 percent, and at the end of the year pay back theloan plus interest, for a total of W1.10 billion. Or the firm could borrow dollars froman international bank at a 6 percent interest rate. At the prevailing exchange rate of$1 � W1,000, the firm would borrow $1 million and the total loan cost would be $1.06million, or W1.06 billion. By borrowing dollars, the firm could reduce its cost of cap-ital by 4 percent, or W40 million. However, this saving is predicated on the assump-tion that during the year of the loan, the dollar/won exchange rate stays constant.Instead, imagine that the won depreciates sharply against the U.S. dollar and ends theyear at $1 � W1,500. (This occurred in late 1997 when the won declined in valuefrom $1 � W1,000 to $1 � W1,500 in two months.) The firm still has to pay the in-ternational bank $1.06 million at the end of the year, but now this costs the companyW1.59 billion (i.e., $1.06 � W1,500). As a result of the depreciation in the value ofthe won, the cost of borrowing in U.S. dollars has soared from 6 percent to 59 percent,a huge rise in the firm’s cost of capital. Although this may seem like an extreme ex-ample, it happened to many South Korean firms in 1997 at the height of the Asian fi-nancial crisis. Not surprisingly, many of them were pushed into technical default ontheir loans.

Unpredictable movements in exchange rates can inject risk into foreign currencyborrowing, making something that initially seems less expensive ultimately muchmore expensive. The borrower can hedge against such a possibility by entering into aforward contract to purchase the required amount of the currency being borrowed ata predetermined exchange rate when the loan comes due (see Chapter 9 for details).Although this will raise the borrower’s cost of capital, the added insurance limits therisk involved in such a transaction. Unfortunately, many Asian borrowers did nothedge their dollar-denominated short-term debt, so when their currencies collapsedagainst the dollar in 1997, many saw a sharp increase in their cost of capital.

When a firm borrows funds from the global capital market, it must weigh the ben-efits of a lower interest rate against the risks of an increase in the real cost of capitaldue to adverse exchange rate movements. Although using forward exchange marketsmay lower foreign exchange risk with short-term borrowings, it cannot remove therisk. Most importantly, the forward exchange market does not provide adequate cov-erage for long-term borrowings.

In chapters focusing on the external business environment, theImplications for Business section shows how the concepts apply to thepractice of international business.

The implications of the material discussed in this chapter are quitestraightforward but no less important for being obvious. The growth of theglobal capital market has created opportunities for international businesses that

wish to borrow and/or invest money. By using the global capital market, firms canoften borrow funds at a lower cost than is possible in a purely domestic capital market.This conclusion holds no matter what form of borrowing a firm uses—equity, bonds,or cash loans. The lower cost of capital on the global market reflects greater liquidityand the general absence of government regulation. Government regulation tends toraise the cost of capital in most domestic capital markets. The global market, beingtransnational, escapes regulation. Balanced against this, however, is the foreignexchange risk associated with borrowing in a foreign currency.

On the investment side, the growth of the global capital market is providingopportunities for firms, institutions, and individuals to diversify their investments


Focus On Managerial Implications

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to limit risk. By holding a diverse portfolio of stocks and bonds in differentnations, an investor can reduce total risk to a lower level than can be achieved ina purely domestic setting. Once again, however, foreign exchange risk is acomplicating factor.

The trends noted in this chapter seem likely to continue, with the globalcapital market continuing to increase in both importance and degree ofintegration over the next decade. Perhaps the most significant development willbe the emergence of a unified capital market within the EU by the end of thedecade as those countries continue toward economic and monetary union. SinceEurope’s capital markets are currently fragmented and relatively introspective(with the major exception of Great Britain’s capital market), such a developmentcould pave the way for even more rapid internationalization of the capital marketin the early years of the next century. If this occurs, the implications for businessare likely to be positive.


Chapter Summary

This chapter explained the functions and form of theglobal capital market and defined the implications ofthese for international business practice. The chaptermade these major points:

1. The function of a capital market is to bringthose who want to invest money together withthose who want to borrow money.

2. Relative to a domestic capital market, the globalcapital market has a greater supply of fundsavailable for borrowing, and this makes for alower cost of capital for borrowers.

3. Relative to a domestic capital market, the globalcapital market allows investors to diversify port-folios of holdings internationally, thereby reduc-ing risk.

4. The growth of the global capital market duringrecent decades can be attributed to advances ininformation technology, the widespread deregu-lation of financial services, and the relaxation ofregulations governing cross-border capital flows.

5. A eurocurrency is any currency banked outsideits country of origin. The lack of governmentregulations makes the eurocurrency market at-tractive to both depositors and borrowers. Be-cause of the absence of regulation, the spreadbetween the eurocurrency deposit and lendingrates is less than the spread between the domes-tic deposit and lending rates. This gives eu-robanks a competitive advantage.

6. The global bond market has two classifications:the foreign bond market and the eurobond mar-ket. Foreign bonds are sold outside the bor-rower’s country and are denominated in thecurrency of the country in which they are is-

sued. A eurobond issue is normally underwrit-ten by an international syndicate of banks andplaced in countries other than the one in whosecurrency the bond is denominated. Eurobondsaccount for the lion’s share of internationalbond issues.

7. The eurobond market is an attractive way forcompanies to raise funds due to the absence of reg-ulatory interference, less stringent disclosure re-quirements, and eurobonds’ favorable tax status.

8. Foreign investors are investing in other coun-tries’ equity markets to reduce risk by diversify-ing their holdings among nations.

9. Many companies are now listing their stock inthe equity markets of other nations, primarily asa prelude to issuing stock in those markets toraise additional capital. Other reasons for listingstock in another country’s exchange are to facil-itate future stock swaps; to enable the companyto use its stock and stock options for compen-sating local management and employees; to sat-isfy local ownership desires; and to increase thecompany’s visibility among its local employees,customers, suppliers, and bankers.

10. When borrowing funds from the global capitalmarket, companies must weigh the benefits of alower interest rate against the risks of greaterreal costs of capital due to adverse exchange ratemovements.

11. One major implication of the global capitalmarket for international business is that compa-nies can often borrow funds at a lower cost ofcapital in the international capital market thanthey can in the domestic capital market.

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12. The global capital market provides greater op-portunities for businesses and individuals tobuild a truly diversified portfolio of interna-

tional investments in financial assets, whichlowers risk.

Critical Discussion Questions

1. Why has the global capital market grown sorapidly in recent decades? Do you think thisgrowth will continue throughout the nextdecade? Why?

2. A firm based in Mexico has found that itsgrowth is restricted by the limited liquidity ofthe Mexican capital market. List the firm’s op-tions for raising money on the global capitalmarket. Discuss the pros and cons of each op-tion, and make a recommendation. How mightyour recommended options be affected if theMexican peso depreciates significantly on theforeign exchange markets over the next twoyears?

3. Happy Company wants to raise $2 million withdebt financing. The funds are needed to financeworking capital, and the firm will repay them

with interest in one year. Happy Company’streasurer is considering three options:a. Borrowing U.S. dollars from Security Pacific

Bank at 8 percent.b. Borrowing British pounds from Midland

Bank at 14 percent.c. Borrowing Japanese yen from Sanwa Bank at

5 percent.If Happy borrows foreign currency, it will not

cover it; that is, it will simply change foreign cur-rency for dollars at today’s spot rate and buy thesame foreign currency a year later at the spot ratethen in effect. Happy Company estimates thepound will depreciate by 5 percent relative to thedollar and the yen will appreciate 3 percent rela-tive to the dollar in the next year. From whichbank should Happy Company borrow?

Notes

1. D. Waller, “Daimler in $250m Singapore Plac-ing,” Financial Times, May 10, 1994, p. 17.

2. G. Platt, “China Telecom Issue Poorly Re-ceived in U.S.,” Global Finance, January 2003,p. 19.

3. Waller, “Daimler in $250m Singapore Placing.”4. C. G. Luck and R. Choudhury, “International

Equity Diversification for Pension Funds,” Jour-nal of Investing 5, no. 2 (1996), pp. 43–53

5. K. K. Lewis, “Trying to Explain Home Bias in Eq-uities and Consumption,” Journal of Economic Lit-erature, 37 (1999), pp. 571–608.

6. Ian Domowitz, Jack Glen, and Ananth Madha-van, “Market Segmentation and Stock Prices:Evidence from an Emerging Market,” Journal ofFinance 3, no. 3 (1997), pp. 1059–68.

7. B. Solnik, “Why Not Diversify InternationallyRather Than Domestically?” Financial AnalystsJournal, July 1974, p. 17.

8. A. Lavine, “With Overseas Markets Now Mov-ing in Sync with U.S. Markets, It’s GettingHarder to Find True Diversification Abroad,” Fi-nancial Planning, December 1, 2000, pp. 37–40.

9. B. Solnik and J. Roulet, “Dispersion as Cross Sec-tional Correlation,” Financial Analysts Journal 56,no. 1 (2000), pp. 54–61.

10. A. Serrat, “A Dynamic Equilibrium Model of In-ternational Portfolio Holdings,” Econometrica,69 (2001), pp. 1467–89.

11. For a review, see K. K. Lewis, “Trying to ExplainHome Bias in Equities and Consumption,” Jour-nal of Economic Literature,37 (1999), pp.571–608.

12. Bank for International Settlements, BIS Quar-terly Review, March 2003.

13. T. F. Huertas, “U.S. Multinational Banking: His-tory and Prospects,” in Banks as Multinationals,ed. G. Jones (London: Routledge, 1990).

14. G. J. Millman, The Vandals’ Crown (New York:Free Press, 1995).

15. P. Dicken, Global Shift: The Internationalization ofEconomic Activity (London: The Guilford Press,1992).

16. Ibid.17. Martin Feldstein, “Global Capital Flows: Too Lit-

tle, Not Too Much,” The Economist, June 24,1995, pp. 72–73.

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18. Ibid., p. 73.19. International Monetary Fund, World Economic

Outlook (Washington, DC: IMF, 1998).

20. R. Reich, The Work of Nations (New York: Al-fred A. Knopf, 1991).

Use the globalEDGE™ site to complete the followingexercises:

1. The “Global Financial Stability Report” is a semi-annual report published by the IMF. It reports onthe developments and trends taking place in theworld’s capital markets global and tries to identifypotential systemic weaknesses that could lead tocrises. Locate the latest report and prepare an ex-

ecutive summary of the latest developments inmature markets (major financial centers).

2. IMF’s Global Financial Stability Report also con-tains detailed information regarding the financialmarkets of emerging countries. Utilize the rele-vant section of this report to prepare an executivesummary of the latest developments in theemerging equity markets.

globaledge.msu.eduResearch Task

Clo

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e The Surging Samurai Bond Market

Japan’s low interest rate to issue yen-denominated debt.With the yen/dollar exchange rate relatively stable, thisseems like a shrewd economic bet. Foreign debt offeringsin Japan have been snapped up by yield-hungry retail in-vestors, who are looking for better returns than the 1 to

2 percent they get on post office sav-ings accounts. With the equivalent ofsome $1 trillion in Japanese postalsavings predicted to reach maturitybetween April 2000 and April 2002, ahuge wave of retail money was enter-ing the market looking for higher re-turns. Japan’s equity markets havebeen flirting with 10-year lows, andwith the economy near recession, fewretail investors are putting theirmoney in Japanese stocks. With

Japanese corporations issuing only a few bonds, there arefew investment opportunities there. This leaves foreignbonds as one of the few attractive investment opportu-nities for retail investors looking for higher yields.

A large number of foreigners took advantage of thisopportunity. In 2001, foreigners issuing yen-denominated debt raised some $24 billion in the Japan-ese bond market, up from $9 billion in 1998. Countriesincluding Croatia, Uruguay, and Brazil have raisedmoney for their treasuries by issuing Samurai bonds. Forexample, in February 2002, the government of Uruguayissued ¥30 billion of five-year bonds. The interest rate ithad to pay on those bonds was just 2.2 percent. In con-trast, Uruguay had to pay 7.6 percent for five-year dollarborrowings. Similarly, an increasing number of corpora-tions have been issuing Samurai bonds. In late 2000, Cit-

Since Japan’s stock market and real estate bub-bles imploded in the early 1990s, the countryhas had to contend with a decade of poor eco-nomic performance. The economy has seem-ingly constantly teetered on the brink of aserious recession, and sus-tained growth has remainedelusive. In an effort to keepthe bleak economic clouds at

bay, the Bank of Japan has repeatedlylowered interest rates to try to en-courage corporate and consumerspending. As a result, by early 2001Japan had the lowest interest rates inthe world. In March 2001, 10-yearJapanese government bonds yielded1.24 percent, compared with 5 per-cent for comparable U.S. government debt. Despitethese low interest rates, many Japanese corporationscontinue to focus on restructuring and downsizing,rather than investing in new capacity, as they strugglewith the sustained hangover from the boom years of the1980s and early 1990s. Consequently, Japanese corpora-tions have not rushed to take advantage of the low in-terest rates to issue additional debt. Nor have consumersresponded to the lower interest rates by increasing theirconsumption. Instead, the personal savings rate in Japanremains stubbornly high, even though many Japanesehold the majority of their savings in post office accountsthat pay very low interest rates.

However, there is a silver lining to this bleak eco-nomic outlook—for foreign corporations and govern-ments. They have increasingly been taking advantage of

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igroup completed an offering of ¥155 billion ($1.43 bil-lion) in Samurai bonds. Several U.S. investment banks,including Morgan Stanley, Merrill Lynch, and LehmanBrothers also issued Samurai bonds in 2000. In early2001, the trend continued with a major Samurai bond is-sue placed by Deutsche Telekom, which offered ¥500 bil-lion ($4.5 billion) in bonds. In addition, Posco, SouthKorea’s largest steel company, came to the market with a¥30 billion five-year offering. In both cases, these com-panies chose to raise debt in Japan as opposed to othermarkets because even factoring in the costs of hedgingagainst fluctuations in the value of the Japanese yen,they could significantly reduce their cost of capital bydoing so.

Sources: “Posco to Return to Samurai Market as Yen Offers Cheap Al-ternative to Dollar Funding,” Euroweek, January 19, 2001, p. 13;J. Singer, “Japan’s Woes Benefit World’s Borrowers,” Wall Street Jour-nal, March 8, 2001, p. A17; and “Samurai Market to Scale NewHeights,” Asiamoney, October 2000, pp. 42–43.

Case Discussion Questions

1. What are the macroeconomic underpinnings of theincrease in Samurai bond issues?

2. How might an increase in Japan’s rate of economicgrowth affect the vitality of the Samurai bond market?

3. For a company such as Deutsche Telekom, which issuedyen-denominated debt to raise funds for investmentsoutside of Japan, the lower interest rate must be offsetagainst higher costs. What are these higher costs, andwhat determines their magnitude?

4. What would happen to activity in the Samurai bondmarket if the yen started to appreciate significantlyagainst the dollar but interest rate differentials be-tween the United States and Japan stayed constant?What would happen if the yen depreciated against thedollar? What does this tell you about the risks of issu-ing foreign bonds?

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Money Change 402

Bailing Out Brazil 403

The International Monetary Fund 405

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date to set monetary policy so as to ensure price stability.The ECB, based in Frankfurt, is meant to be independ-ent from political pressure—although critics questionthis. Among other things, the ECB sets interest rates anddetermines monetary policy across the euro zone.

The implied loss of national sovereignty to the ECBunderlies the decision by Great Britain, Denmark, andSweden to stay out of the euro zone for now. In thesecountries, many are suspicious of the ECB’s ability to re-main free from political pressure and to keep inflationunder tight control. In theory, the design of the ECBshould ensure that it remains free of politics. The ECB ismodeled on the German Bundesbank, which historicallyhas been the most independent and successful centralbank in Europe. The Maastricht Treaty prohibits theECB from taking orders from politicians. The executiveboard of the bank, which consists of a president, vicepresident, and four other members, carries out policy byissuing instructions to national central banks. The pol-icy itself is determined by the governing council, whichconsists of the executive board plus the central bankgovernors from the 12 euro zone countries. The govern-ing council votes on interest rate changes. Members ofthe executive board are appointed for eight-year nonre-newable terms, insulating them from political pressuresto get reappointed. Nevertheless, the jury is still out onthe issue of the ECB’s independence, and it will takesome time for the bank to establish its inflation-fightingcredentials.

Another potential drawback of the euro is that theEU is not what economists would call an optimal cur-rency area. In an optimal currency area, similarities inthe underlying structure of economic activity make itfeasible to adopt a single currency and use a single ex-change rate as an instrument of macroeconomic policy.Many of the European economies in the euro zone, how-ever, are very dissimilar. For example, Finland and Por-tugal are very dissimilar economies. The structure ofeconomic activity within each country is very different.They have different wage rates and tax regimes, differentbusiness cycles, and may react very differently to exter-nal economic shocks. A change in the euro exchangerate that helps Finland may hurt Portugal. Obviously,such differences complicate macroeconomic policy. Forexample, when euro economies are not growing in uni-son, a common monetary policy may mean that interestrates are too high for depressed regions and too low forbooming regions.

It will be interesting to see how the EU copes with thestrains caused by such divergent economic performance.One way of dealing with such divergent effects withinthe euro zone might be for the EU to engage in fiscal

On January 1, 2002, the euro completed a three-yeartransition process and became the only legal tender in 12of the 15 nations of the European Union (during the pre-vious two years, euros had circulated side by side withhistoric currencies). For now, Britain, Sweden, and Den-mark have stayed out of what is known as the euro zone.Across all 12 countries, prices are now listed in a com-mon currency, the euro, and centuries-old currencieshave been retired from circulation. Gone are the Frenchfranc, the German deutsche mark, and the Italian lira.Although the change has been emotionally difficult formany people, the European Union did it for solid eco-nomic reasons.

First, the EU believed that business and individualswould realize significant savings from having to handleone currency, rather than many. These savings come fromlower foreign exchange and hedging costs. According tothe European Commission, such savings could amount to0.5 percent of the European Union’s GDP, or about $40billion a year. Second, the adoption of a common cur-rency will make it easier to compare prices across Europe.This should increase competition because it will be mucheasier for consumers to shop around, which should trans-late into substantial gains for European consumers.

Third, faced with lower prices, European producerswill be forced to look for ways to reduce their productioncosts to maintain their profit margins. The introductionof a common currency, by increasing competition,should ultimately produce long-run gains in the eco-nomic efficiency of European companies. Fourth, the in-troduction of a common currency should give a strongboost to the development of a highly liquid pan-European capital market. The development of such acapital market should lower the cost of capital and leadto an increase in both the level of investment and the ef-ficiency with which investment funds are allocated.

Finally, the development of a pan-European, euro-denominated capital market will increase the range ofinvestment options open to both individuals and insti-tutions. For example, it will now be much easier for in-dividuals and institutions based in, let’s say, Holland toinvest in Italian or French companies. This will enableEuropean investors to better diversify their risk, whichagain lowers the cost of capital, and should also increasethe efficiency with which capital resources are allocated.

What then are the potential costs of switching to theeuro? The drawback, for some, of a single currency is thatnational authorities have lost control over monetary pol-icy. Thus, it is crucial to ensure that the EU’s monetarypolicy is well managed. The EU established an inde-pendent European Central Bank (ECB), similar in somerespects to the U.S. Federal Reserve, with a clear man-

Money Change

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Case Bailing Out Brazil 403


1. What are the implications of the establishment of theeuro for (a) European consumers, (b) businesses based inthe EU, and (c) businesses based elsewhere in the world?

2. In your view, do the advantages of the euro outweigh itsperceived disadvantages? Be sure to justify your answer.

3. What are the benefits to Britain, Sweden, and Denmarkof staying out of the euro zone? What are the potentialcosts? Do you think these countries will eventually jointhe euro zone? Under what circumstances will they join?

4. Look at the relative performance of the euro againstthe dollar since 2000. What does this tell you, if any-thing, about the viability if the euro? (The historic ex-change rate between the U.S. dollar and euro can beaccessed on the Web at http://www.x-rates.com/cgi-bin/hlookup.cgi).

5. What are the implications of the euro gaining groundat the expense of the U.S. dollar as a major reserve cur-rency for the world’s central banks?

Sources

1. “Euros Take the Lead.” Euro Week, January 31 2003,pp. 60–61.

2. Fairlamb, D.3. Feldstein, M. “The Political Economy of the European

Economic and Monetary Union.” Journal of EconomicPerspectives 11 (1997), pp. 23–42.

4. “Market Failure: A Survey of Business in Europe.” TheEconomist, June 8, 1991, pp. 6–10.

5. “One Europe, One Economy.” The Economist, No-vember 30, 1991, pp. 53–54.

6. “Super Euro.” Business Week, February 2003, p. 54.7. Wyploze, C. “EMU: Why and How It Might Happen.”

Journal of Economic Perspectives 11 (1997), pp. 3–22.

transfers, taking money from prosperous regions andpumping it into depressed regions. Such a move, how-ever, would open a political can of worms. Would the cit-izens of Germany forgo their “fair share” of EU funds tocreate jobs for underemployed Portuguese workers?

Since its establishment on January 1, 1999, the eurohas had a volatile trading history against the U.S. dollar.After starting life in 1999 at $1.17, the euro steadily felluntil it reached a low of 83 cents to the dollar in Octo-ber 2000. Its fortunes began improving in late 2001,when the dollar weakened, and the currency stood neara robust three-year high of $1.176 on May 30, 2003.Many foreign central banks are now adding euros to theirsupply of foreign currencies. In the first three years of itslife, the euro never reached the 13 percent of global re-serves made up by the deutsche mark and other formereuro zone currencies. The euro didn’t jump that hurdleuntil early 2002, but by 2003 it made up 15 percent ofglobal reserves. Currency specialists say the growing U.S.current account deficit, now at 5 percent, is bound todrive the dollar down further, and the euro still higher,over the next two to four years.

Also contributing to the volatility of the euro againstthe U.S. dollar have been short-term capital flows. In2000, capital from foreign investors surged into theUnited States as they tried to cash in on a stock marketboom, which pushed up the value of the dollar againstother currencies, including the euro. In 2001, that flow be-gan to weaken and it reversed in 2002 as foreign investorstook their money out of a weak U.S. stock market, choos-ing to invest their fund elsewhere. The flow of capital outof dollar-denominated assets (U.S. equities) and intoother assets helped to boost the euro against the dollar.

The decline in the value of the dollar against the eurois a mixed blessing for the EU. A strengthening euro,while a source of pride, will make it harder for euro zoneexporters to sell their goods abroad.

There were several reasons for the current crisis. First,a global economic slowdown had hurt the economies ofSouth America, slowing exports, reducing foreign directinvestment inflows, and leading to an economic recession.Second, earlier in the year, Brazil’s neighbor and largesttrading partner, Argentina, had defaulted on its govern-ment debt. In the first half of 2002, Argentina’s economyshrank by almost 20 percent and unemployment surged to 22 percent. With financial chaos in Argentina, Brazil-ian exports to its neighbor slumped, helping to drive Brazilinto a recession. Third, Brazil was scheduled to hold newpresidential elections in October 2002, and foreign

The International Monetary Fund agreed August 7,2002, to provide Brazil with $30 billion in funds to helpthe country come to grips with a financial crisis that haddriven its currency, the real, down to all-time lowsagainst the U.S. dollar. This was not the first time theIMF had stepped in to help Brazil. The IMF had beenactively assisting Brazil since 1998, when it provided$41.5 billion in financial commitments to the countryto help it ride out a financial crisis that was drivingdown the value of the real on foreign exchange markets.Four years later, the country was back at the IMF askingfor more money.

Bailing Out Brazil

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investors were getting increasingly nervous that a populistleft-wing candidate, Luiz Inacio Lula da Silva (know asLula) would win, replacing President Fernando HenriqueCardoso. As finance minister in the early 1990s, Cardosohad been the mastermind of Brazil’s “real plan,” which suc-ceeded in conquering hyperinflation, a long-term problemin Brazil, and putting the country on a stable growth track.As president, Cardoso had won high marks from the in-ternational financial community for adhering rigorouslyto conditions imposed by the IMF in 1998 in return for itsloans. An important part of that plan called for Brazil’sgovernment to run a budget surplus and use that to paydown government debt.

If Cardoso was replaced by Lula, as seemed likely,many foreign investors feared that the Brazilian govern-ment’s commitment to maintain IMF targets on debt lev-els would be shattered. Publicly, Lula had stated hefavored increasing government spending in times of eco-nomic crisis. To many, this seems like a recipe for moregovernment debt—debt that in all probability would befinanced by printing money, and lead to a resurgence ofhyperinflation. Foreign investors feared that this wouldbe unsustainable, and that Brazil would ultimately followthe example of Argentina and default on its governmentdebt. History provided little comfort for the foreign in-vestment community because Brazil had defaulted on itsgovernment debt in the 1980s.

Rather than wait for the outcome of the October 2002election, foreign investors began to pull money out ofBrazil in early 2002, while inflows of foreign capitalstarted to dry up. This led to a fall in the value of the realagainst the dollar on foreign exchange markets. Sensinga currency crisis, traders began to sell the Brazilian cur-rency short (effectively betting that it would go down).This put more pressure on the real, and its declineagainst the dollar accelerated, falling by 25 percent byearly August from its January levels.

To protect the real from further depreciation, the Brazil-ian central bank started to use its foreign exchange reserves(mainly in the form of U.S. dollars) to buy real on the for-eign exchange markets. The central bank also raised inter-est rates, but this had the effect of increasing the costs ofserving government debt and implied that to meet IMF-mandated debt targets, the Brazilian government wouldhave to further reduce government spending, takingmoney out of an economy that was already on the ropes.

It soon became clear that Brazil was in a very difficultposition. Its foreign exchange reserves were limited, andhigh interest rates could be self-defeating. Without fur-ther assistance from the IMF, the currency could col-lapse, plunging Brazil into a financial crisis. If thishappened, it could destabilize the entire region, and per-haps throw the global financial system into chaos. Withthe 10th largest economy, Brazil was not a bit player onthe world economic scene.

It was against this background that the IMF decidedto extend further loans to Brazil. The $30 billion loanpackage would be spread out over 15 months. In returnfor the loans, the Brazilian government agreed tomaintain a budget surplus of at least 3.75 percent ofGDP, using the surplus to continue retiring debt. How-ever, the IMF did not seek agreement from electioncandidates, such as Lula, to abide by the terms of theagreement. This led to some skepticism on the part ofinvestors, and the real had declined by another 15 per-cent against the dollar by late September. At thispoint, Lula stated that if he won the presidential elec-tion in October, he would abide by the IMF-mandateddebt targets in 2003. This statement helped the cur-rency to stabilize.

Lula did win the presidential election, and his admin-istration was quick to state it would continue to pursuethe free market policies of the prior administration andgrant operational autonomy to the Brazilian central bank,effectively removing politics from decisions about mone-tary policy. The new government also indicated that itwould adhere to the terms of the IMF rescue package.


1. Given that Brazil had already received IMF funding in1998, do you think it should have received fundingagain in 2002?

2. What would have happened to the Brazilian economy,and the world economy, if the IMF had not stepped into help Brazil?

3. The terms of the IMF loan call for Brazil to continue torun a budget surplus and use the proceeds to pay downgovernment debt. What are the benefits of this policyprescription? What are the potential drawbacks?

4. What are the implications for international business ofa potential financial crisis in Brazil involving a melt-down in the value of the real, and the Brazilian gov-ernment defaulting on its debt?

5. What do you think will happen if Lula breaks the com-mitment to the IMF and decides to increase govern-ment spending?

Sources

1. Hall, K. G. “New Leftist Brazilian President Moves toCalm Investors.” Knight Ridder/Tribune News Ser-vice, January 3, 2003.

2. “A Matter of Faith: Brazil and the IMF.” The Econo-mist, August 17, 2002, pp. 56–57.

3. “Race against Time: Brazil.” The Economist, Sep-tember 28, 2002, p. 69.

4. “ Stopping the Rot in Brazil.” The Economist, August3, 2002, pp. 11–12.

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Case The International Monetary Fund 405

First, critics have asserted that the IMF’s policy pre-scriptions are not always appropriate. For example, in thecase of South Korea, which borrowed $21 billion fromthe IMF in the late 1990s, the IMF imposed tight macro-economic policies, including cuts in government spend-ing and curbs on the growth in the money supply.However, South Korea was not suffering from excessivegovernment spending and inflation, but from excessiveprivate-sector debt with deflationary undertones. Ko-rean companies had borrowed too much money, much ofwhich was denominated in dollars, not Korean won.When the value of the won fell on foreign exchangemarket, this increased the won that Korean companieshad to earn to service their dollar-denominated debt,forcing many into bankruptcy. The government hadbeen running a budget surplus for years (it was 4 percentof South Korea’s GDP in 1994–96) and inflation was lowat about 5 percent. Despite this, critics say, the IMF in-sisted on applying the same policies that it applies tocountries suffering from high inflation.

The IMF rejected this criticism. According to theIMF, the central task was to rebuild confidence in theKorean won. Once this has had been achieved, the wonwould recover from its oversold levels, reducing the sizeof South Korea’s dollar-denominated debt burden whenexpressed in won, making it easier for companies to serv-ice their dollar-denominated debt. The IMF also notesthat it does tailor policy prescriptions to specific cases.For example, the IMF required South Korea to removerestrictions on foreign direct investment, which wouldallow foreign capital to flow into the country to take ad-vantage of cheap assets. The idea was to increase demandfor the Korean currency and help to improve the dollar/won exchange rate.

South Korea did recover fairly quickly from the crisis.While the economy contracted by 7 percent in 1998, by2000 it had rebounded and grew at a 9 percent rate(measured by growth in GDP). Inflation, which peakedat 8 percent in 1998, fell to 2 percent by 2000, and un-employment fell from 7 percent to 4 percent over thesame period. The won hit a low of $1 � W1,812 in early1998, but by 2000 was back to an exchange rate of about$1 � W1,200, at which it seems to have stabilized.

The second major criticism of the IMF is that its res-cue efforts lead to a problem known as moral hazard.Moral hazard arises when people behave recklessly be-cause they know they will be saved if things go wrong.Critics point out that many Japanese and Western bankswere far too willing to lend large amounts of capital tooverleveraged Asian companies during the boom yearsof the 1990s. These critics argue that the banks shouldhave been forced to pay the price for their rash lending

Since its foundation in 1944, the International Mone-tary Fund (IMF) has grown to become a major player inthe global economic system and on par with other inter-national institutions such as the World Trade Organiza-tion and the World Bank. As of 2003, the IMF had some184 member states, including all of the world’s major in-dustrial nations.

The IMF was originally founded to promote stabilityin the international monetary system, and in particularto help manage the system of fixed exchange rates thatwas established after World War II. Since the breakdownof the fixed exchange rate system in 1973, however, therole of the IMF has evolved, and now it can be viewed asa lender of last resort to the governments of countries ex-periencing financial crises. The IMF typically steps inwhen a country is experiencing a sharp fall in the valueof its currency on foreign exchange markets. In exchangefor loans that can be used to support the value of its cur-rency, the IMF requires the recipient nations to imple-ment certain macroeconomic policies. The specificpolicies required by the IMF vary depending upon thenature of the crisis, but they have often included cuts ingovernment spending to reduce the level of public-sectordebt and tight controls on the growth of the domesticmoney supply to help rein in inflation. Historically, ex-cessive government spending coupled with loose controlover the domestic money supply, and hence rapid priceinflation, have been major causes of financial crises anda fall in the value of a country’s currency on the foreignexchange market. These policies usually result in a sharpcontraction in the domestic economy of the recipientcountry, leading to a recession. The IMF’s view, however,is that once macroeconomic stability is restored, aneconomy can embark upon a sustainable growth path. Inaddition to its inflation-fighting policies, the IMF hasalso been a persistent advocate of policies to deregulatean economy, privatize state-owned businesses, open theeconomy to foreign investment and international trade,and strengthen the banking system (the belief being thatsuch policies will help a country achieve sustainableeconomic growth).

The track record of the IMF has been somewhatspotty. While some recipient countries have used IMFloans to great effect, and quickly put their economichouse in order, others have failed to do so and returnedto the IMF for more loans. An example of a persistentlytroubled nation would be Turkey, which has had to im-plement 18 IMF programs since 1958! The spotty recordhas led critics to question the effectiveness of IMF-mandated policies. Major critics of the IMF, such as Co-lumbia University economist Jeffrey Sachs, have madetwo main arguments.

The International Monetary Fund

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with the experience of countries such as Turkey that haverequested multiple loans from the IMF over the years.


1. What do you think might have happened to the worldfinancial system if the IMF had never been created?

2. Do you think that the criticisms of the IMF are fair? Towhat extent is there evidence that the IMF (a) adoptsa one-size-fits-all policy, and (b) encourages govern-ments to engage in reckless behavior (moral hazard)?

3. What, if anything, could the IMF do differently to helpensure that countries such as Turkey do not keep re-turning to the IMF for additional rescue packages?

4. The video case highlights the role of the IMF in pro-moting stability in Afghanistan and Uganda, bothchronically poor nations. In some respects, this suggeststhat in addition to its role in solving financial crisis, theIMF is starting to play a role in promoting the develop-ment of poor nations. Do you think this is appropriate?


policies, even if that meant some banks would fail. Onlyby taking such drastic action, the argument goes, willbanks learn the error of their ways and not engage inrash lending in the future. By providing support to thesecountries, the IMF is reducing the probability of debtdefault and in effect bailing out the banks whose loansgave rise to this situation.

For its part, the IMF dismisses this criticism, arguingthat the costs of reckless financial policies are such thatcountries are unlikely to embark upon them just becausethey believe that the IMF will step in with a rescue pack-age if things go wrong. As an IMF representative states inthe video, doing so would be rather like taking out fire in-surance and then leaving candles burning in a house. Justbecause you take out fire insurance, it doesn’t mean thatyou are more reckless about leaving candles burning in ahouse, and just because the IMF is there to step into thebreach in the case of a financial crisis, it doesn’t follow thata government will therefore pursue more reckless policies.The IMF also states that historically this has not been aproblem, although a critic might wonder how this squares

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11543 Global Capital Market 2

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