Financial Markets and International Capital

1. Introduction Globalisation, undoubtedly the defining phenomenon of modern times is also its most debated and discussed issue. Whilst globalisation is by no means a modern day occurrence, its rapid proliferation during the last two decades has brought about an intensification of research and study, as also a polarisation of opinion, on the subject.

Accepted to be an irreversible progression of events by governments, policymakers, media, and academics, globalisation is being concurrently praised, as the source of enormous global benefits, and castigated for contributing towards and accentuating a range of social and economic ills (Mishkin, 2007).

Adventurers in legend and history, Sindbad the Sailor and Marco Polo the traveller among them, along with emperors, traders, businessmen, and governments, have constantly striven to create a globalised world through the establishment of trade, commerce and vigorous interaction between peoples of different countries who were separated by physical distance, as well as by ethnicity, culture, tradition and religion (Neal, 2000).

Imperialism, as also its offshoot colonialism, for all its ills and oppressive consequences, became instrumental in pushing globalisation forward in the last three centuries, connecting vast areas of land and peoples of different cultures through trade, religion, and adoption of common languages (Neal, 2000).

The astonishing technological advances of the last two decades in information technology and communication, along with substantial reductions in costs of travel and significant geopolitical and economic developments have pushed the process of globalisation to unprecedented levels, a development that has been accompanied with extraordinary developments in trade and commerce, movement of people, goods, industries, services, and of course capital (Mishkin, 2007). This essay takes up the issue of globalisation, with special reference to the opening up of global investment opportunities and the risks that accompany such investment opportunities.

The effect of the recent financial meltdown, first in the US and then in other global markets, is dealt with in detail, especially in connexion with the risks associated with cross country investment from Europe to the United States, which houses the largest financial market in the world. This introduction is followed, first by a structured commentary and analysis, wherein separate issues are taken up sequentially for investigation and analysis, and thereafter by the conclusion. 2. Commentary and Analysis

Economic Globalisation: An Overview Globalisation is one of the most controversial issues of the modern day. Discussed ad infinitum in the media, at public forums, and among policy makers, it is seen by many as a sure and fast route to global prosperity and attendant benefits, even as it is berated as a tool that is increasingly being used by resource rich economies and organisations for their own enrichment, whilst further impoverishing poorer economies, widening the rich poor gap, and intensifying environmental damage (Kenen, 2007).

As a term globalisation is immensely wide in its definition and includes economic, cultural, political, and other implications. Its impact, for all practical purposes, is however being felt most in economic matters; with economic activity between countries having increased manifold countries in recent years. Referring to the increasing interaction and dependence of global economies because of the growing dimensions of international commodity trade, technology transfer, and capital flows, economic globalisation appears to be a one way and irreversible phenomenon.

Represented by the galloping growth in international trade and assimilation of market boundaries, and driven by rapidly increasing information in a vast range of production and service activity, scientific and technological developments, intense international marketing activity, and border crossing labour divisions that have percolated to production chains inside ventures and organisations of different nations, globalisation is based upon the spread and adoption of new liberal economic policies and free market economics across the countries of the globe, irrespective of their individual political and economic systems (Gianaris, 2007).

This spurt in global business interaction and trade has received rich support from the downward movement in critical costs. Current day shipping and airfreight costs are a fraction of those that existed 50 years ago in terms of real costs (Davis & Gallman, 2001). The prices of computers have been on a downward spiral for the last two decades, and the internet and satellite technology not only enables operators in Hyderabad, India to service customers in downtown Manhattan but for doctors at Johns Hopkins to oversee operations in Vietnam on a real time basis.

With prices and time compacted and coordination and goods movement infinitely faster, it is possible for a customer in India to order an IPod in the US, have it manufactured in China with parts sourced from three different countries and receive it at home within seven working days (Mishkin, 2007). The evolution of networks has led to the emergence of groups of shadow business, rendering futile the notion of national borders and distances for many economic activities (Mishkin, 2007).

Whilst advances in technological development and the all pervasive growth of the internet and the World Wide Web have driven economic globalisation from operational and practical angles, the occurrence of market based reforms and liberalisation across the world, many times at the behest of the IMF and the World Bank, by dismantling trade and physical barriers, are also accelerating the process significantly (Mishkin, 2007).

“China’s sweeping economic reforms since the end of the 1970s, the peaceful dissolution of communism in the Soviet bloc at the end of the 1980s, and the taking root and steady growth of market based reforms in democratic India in the 1990s is among the most striking examples of this trend” (What is …, 2007). Whilst the transition of centrally planned economies to market economies has facilitated market integration, GATT and WTO deliberations have led to demolition of trade barriers, opening of capital and non capital accounts, and movement of funds, making intercontinental trade far easier.

Being able to plan production and sales on the basis of profit maximisation, Multinational Corporations have grown enormously in the last two decades and significantly impacted the working of the global economy. “In 1996, there were altogether only more than 44,000 MNCs in the whole world, which had 280,000 overseas subsidiaries and branch offices. In 1997, the volume of the trade of only the top 100 MNCs already came up to 1/3 of the world’s total and that between their parent companies and their subsidiaries took up another 1/3.

In the US$ 3,000 billion balance of foreign direct investment at the end of 1996, MNCs owned over 80%. Furthermore, about 70% of international technological transfers were conducted among MNCs. This type of cross-border economic activities within same enterprises has posed a challenge for the traditional international trade and investment theories. ” (Shangquan, 2000) Economic globalisation has led to widespread and intensive economic and industrial restructuring across the globe, in the advanced as well as developing countries.

Growth of equal skill and lesser cost production and service centres in the developing countries, along with increase in knowledge, advancement of scientific, technological, and educational resources have led to a large scale shift of production and service activities to developing countries with consequent increase in GDP and personal incomes (Das, 2004). Millions of people in China and India have moved ahead of the poverty line (Das, 2004). Like most other phenomena, globalisation carries with it many dangers that have the potential to grow into major problems.

To illustrate, whilst shifts in jobs reduce manufacturing and service costs in the advanced nations, they also lead to greater unemployment in home economies and to the development of sweatshops in the developing world (Das, 2004). Again whilst demolition of trade barriers leads to free movement of goods, it also leads to the erosion of fledgling and vulnerable industries in poorer countries who have no way of combating the panzers unleashed by the MNCs and die out without giving a fight (Das, 2004).

Increased industrial activity also leads to overutilisation of natural resources, lesser time for replenishment, and environmental damage (Das, 2004). Very clearly globalisation is definitely not a one-way street to global prosperity and its progress needs to be watched very carefully by global policymakers. Globalisation, Capital Flows, Investment Opportunities, and Attendant Risks The overview contained in the previous section helps in establishing the various processes engaged in and driving globalisation, as well as in providing a hint of the various risks and dangers that can arise from the process.

Globalisation of the financial segment is today the fastest evolving and most powerful component of economic globalisation. Whilst international finance emerged in response to the demands of global trade and investment operations, it has over the years become truly autonomous, especially in comparison with commodity trade and labour utilisation. International capital flows, those that flow across borders of different countries have been constantly increasing from the 1970, the volume of foreign exchange transactions increasing from 200 billion USD per day in the mid 1980s to 1.

2 trillion USD in the mid 1990s to more than 3 trillion USD today (Gianaris, 2001). The total movement of cross-border capital, which in advanced western economies, used to be less than 10% of their national GDP in the 1970s has since grown to surpass their complete GDPs (Gianaris, 2001). To be fair globalisation of financial services is not a recent phenomenon and has been taking place at a steady, if much slower, clip during the last two centuries.

The geographical scope of international finance was comparatively limited in the 19th century, having originated from the funding activities of Italian banks that came up during the Renaissance to finance trade in the regions surrounding the Mediterranean, and growing later through expansion of trade within Europe, and spreading to Northern Europe through the development of innovations like Letters of Credit, the establishment of banks in Antwerp and Bruges and the evolution of London and Amsterdam into financial centres (Cameron, 1993).

The emergence of the industrial revolution and its progressive evolution into the defining economic phenomenon of the 19th century led to a quantum leap in the development of international financial transactions, the development of financial centres with financial markets, institutions, governance and regulation, especially in Germany, France and east coast United States, and their integration into global financial networks, which spread to North and South America and as far as Australia (Cameron, 1993).

The global adoption of the gold standard in the early years of the 20th century, along with technological advances in the shape of telegraph and telephone and an era of free market economy led to further advances characterised by the application of up to date communication systems for transmission of prices, the evolution of a wide range of private debt and equity instruments, the broadening span of insurance services, the increasing role of government bond markets across the globe, and escalating usage of forward and futures contracts, and derivative instruments (Cameron, 1993).

With major currencies used freely everywhere, the use of financial instruments percolated into numerous countries across continents and aided the formation of a global financial network, as also the use of bills of exchange, bond financing, stock issues and foreign direct investments (Cameron, 1993). The international growth and progressive regulation of banks helped in instilling widespread consumer confidence, and significant integration of the financial systems of West Europe and North America (Cameron, 1993).

As can be seen globalisation of financial markets moved independently of and much faster than internationalisation of trade, as well as political and social globalisation. International financial markets, especially those of the United States, the UK, Western Europe, and Japan had by the 1980s already achieved a substantial amount of integration, with MNC shares listed in various exchanges and cross border investment happening quite regularly (Gianaris, 2001).

The process however accelerated substantially in the last ten years, the financial sector growing locally and internationally on the back of major advances in communication technology, virtually borderless financial markets, deregulation of economies, employment opportunities in many economies, unprecedented level of country interdependency, and increased vulnerability of domestic economies, as evidenced by the financial crises that spread across borders (Gianaris, 2001).

In recent years, world financial flows have developed at swift rates and quicker than global trade, there being a swing in the constitution of flows from government to private businesses, banks to non-banking organisations, and from loans to securities (Gianaris, 2001). Sharply increased liquidity and innovation in design of instruments has resulted in sharp and swift growth in credit, escalating private and domestic debt leverage and greater exposure to risk, as well as enhanced credit risk in the case of banks and other financial institutions (Gianaris, 2001).

The new global financial network is characterised by increases in cross border borrowings between private parties without any governmental intermediation, greater financial exposure of the corporate sector, greater risk exposure of foreign investors in local currency investments in emerging markets, and the emergence and prevalent use of carefully constructed products such as securities backed by mortgages and collateralised debt responsibilities (Shangquan, 2001).

New financial instruments and innovations include the practice of securitisation, where various different types of securitised assets are constructed in one place and dispersed widely, using specific business models (Shangquan, 2001). Different kinds of financial threats, (for example those from risks associated with credit, market, and volatility), are ripped apart and rearranged to satisfy particular investor needs, carved and chopped to the desires of specific types of investors (Shangquan, 2001).

Different relationships between entities subject to different levels of regulation are also growing, both in the advanced, emerging and transition economies (Shangquan, 2001). Modern day financial environments are characterised by growth in new investor categories like hedge funds, private equity, and sovereign wealth funds, as well as the growth of internationally vigorous investor groups (Shangquan, 2001). The extensive use of derivatives, a feature of the globalised financial sector, can sometimes result in lack of clarity and ambiguity with regard to where the liability of risk actually devolves and the extent of exposure.

Some nations have received extensive capital flows due to carry trade, an activity dependent upon positions of derivatives. Foreign direct investment has become critical to the global process of industrial rearrangement, infrastructural investment, and for the economies of developing nations. Concerns have been expressed that direct investment in holding companies or in special purpose vehicles may mask the complete economic effect upon the eventual recipient nations.

Worries also remain that expansion in investment income flows, whilst leading to a self financing source of direct investment, could lead to the volatility and shakiness that could be created by the turnaround of such investments (Shangquan, 2001). Lessons from the Financial Crisis Northern Rock, a British bank that collapsed in 2007 and had to be saved through governmental intervention epitomises the risks that can arise from cross border investments In the UK, Northern Rock was the first major financial institution to be hit by the sub prime crisis and the ensuing credit crunch (Rock, 2007).

In September 2007, the Newcastle based bank, the 8th largest in Britain announced negative profits guidance on account of the sub prime crisis and informed that it was finding it difficult obtain credit to meet its debt commitments, in the aftermath of the subprime crisis (Rock, 2007). The crisis at Northern Rock arose because of the policy of securitisation, followed by American Banks to facilitate large scale lending in the US home mortgage market and then transfer risks through the construction of collaterised debt obligations and special purpose vehicles (Polyak, 2007).

With instruments like these banks were able to shift risks that should have naturally devolved upon them by grouping loans and then selling them as securities to other banks and financial institutions across the world. The ensuing downturn in the real estate sector of the United states, which normally should have been an issue only with American banks, affected finance, banking, and investment banking institutions across the world and sent the global financial system into a tailspin and affected the financial conditions of all financial institutions that were networked into American investment and banking activities (Polyak, 2007).

The main lesson that comes through from the financial crisis, like the financial crisis of the 1990s, concerns the extent of deregulation in global financial markets, which experts feel has undoubtedly gone too far. There is a definite need for financial strengthening, especially in the context of the large scale governmental intervention that has been required in western economies to rescue the current financial system.

Banks in Britain are in credit tightening mode, a counterproductive situation when credit is most needed. Cross country investors have also been surprised by the American banks that have become enveloped in the crisis. Names like UBS, Merrill Lynch, Citigroup, Societe Generale, AIG, RBS, and Morgan Stanley are known for their reliability and are well respected and investors can be pardoned for believing in their internal processes and risk management mechanisms, whilst making investments (Siddiqi, 2007).

Risk management, both of credit and of liquidity appears to have been inadequate, and investors will have to make efforts to understand the reasons for this and the measures needed for correcting the situation. The banks and financial institutions have been failed both by their managers and by credit rating agencies. Whilst banks have to work out their management inadequacies on their own, possibly through a restructuring of their remuneration policies, credit rating agencies need to realise that their reports are depended upon for major investments by a body of international investors.

3. Conclusion Economic, or rather financial globalisation, despite being a continuing process that started with the Italian renaissance, has grown by quantum leaps during the last two decades, primarily on the back of technological and communication advances, global economic reforms, the adoption of market economies, aided by the ingenuity and the innovative ability of the global, particularly the American and to some extent European financial and investment structure.

Whilst economic globalisation has led to enormous growth in investment opportunities, the current financial crisis, and the numerous bankruptcies and enormous financial losses that have accompanied it have led to numerous apprehensions and worries about the process. Individuals and organisations who castigate globalisation as being at the root of all modern day financial problems tend to forget that financial crises have occurred often, more so in the last three decades.

Financial crises and investor losses occur because of a number of reasons that include inadequate risk management measures, inadequate regulatory structures, and simple investor greed. The present crisis is larger in volume, implication, and extent of losses because of the much greater volumes that globalisation has spawned. Very obviously the crisis is leading to much soul searching and the implementation of a number of remedies.

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