The Changing Environment of International Financial Markets: Issues and Analysis.

Li, Jane-yu Ho

This book contains papers presented at a conference under the auspices of the International Trade and Finance Association in Laredo, Texas, in April 1992. The conference was motivated by the need to take stock of both theoretical and empirical work in the subject areas, after decades of rapid changes in global financial market. These changes include the emergence of financial markets in developing economies and the changing political landscape after the dissolution of the Soviet Union.

Papers included in this volume are of three basic types: analytical, descriptive, and empirical. Subjects covered are broad and encompassing, organized into seven parts: exchange rate markets, international interest rates, balance of payments and international reserves, foreign debt and country risk analysis, capital markets, and tax distortions and international banking. A good introductory chapter links these areas.

Most papers include a literature review, methodology, analysis, research findings and policy implications on risk management. Some papers stretch to include general public policy recommendations. What seem lacking are discussants' comments on the validity of research findings or methodology. And, less technically trained readers will have difficulties following discussion details.

General speaking, I found the papers in the capital markets section rich in background content, especially the paper about risk management and corporate governance in imperfect capital markets (by Klaus P. Fischer, Edgar Ortiz and A. P. Palasvirta). In the absence of arm's length financial markets, risk management leads to different strategies - some are reflected in the reluctance to separate management control from the ownership. Final outcomes of strategies often reflect difference in market environment. Various aspects of less developed financial markets are discussed at length. Several propositions are developed as strategies. However, the discussion about public policy implications to further develop the financial markets is rather weak. It would be better to limit the discussion to market strategies and not to venture into economic development strategies since that requires more discussions of the institutional and cultural background. This flaw also is shared by several other papers in this volume.

The capital market section also contains a paper testing international capital market efficiency with a statistical analysis of real rate of return, comparing mean-variance frontiers (by Shahriar Khaksari and Neil Seitz). The paper concludes that international capital markets are not fully integrated. Two other papers are about Korean financial sector reform and the French quotation system of equity markets.

The foreign debt and country risk analysis section is also pragmatically useful. Ghosh presented a theoretical framework to explain the persistent fall of the Mexican peso during 1976-82 and how that triggered a real and fundamental disequilibrium. This paper also seems to serve as the general background for the section. The next paper presents a powerful analysis of foreign debt by introducing agency costs into the model. As long as some entrepreneurs are incompletely collateralized, the analysis concluded that the optimum government policy is to borrow the maximum possible amount internationally and transfer the proceeds to the private sector. The paper about country risk analysis introduces an analytic hierarchy process that can systematically incorporate both qualitative and quantitative indicators in rating credit worthiness. The last paper in this section deals with political risk using the rational expectation approach.

This volume seems to have something to offer on all major aspects of modern financial theories, i.e., market efficiency, portfolio theory, and agency theory. The first paper in the exchange rate markets section tested for market efficiency with London market data from 1988 to 1991. Data were analyzed using Granger's co-integration technique and the zero cointegration hypothesis was accepted as a result. This finding is consistent to some earlier studies but contradicts others. Another paper uses ARIMA model to examine the patterns of exchange rate fluctuations with 1973-89 data. Using dally data, it concluded that market forces overshadow Central Banks' interventions. However, weekly and monthly data led to mixed results. No explanation is provided as to why the data frequency should matter. Both papers are written for readers who are familiar with the time-series methodology.

The international interest rates section contains two statistical papers, one analyzes Eurocurrency and Treasury rates, the other compares consumer discount rates across countries. The second paper also develops a conceptual model to determine how to measure the consumer discount rate. The third paper written by Ghosh presents various expressions of interest rate parities that are quite useful for applied researchers or risk managers. Some of these expressions allow market imperfections. This paper draws on his two earlier papers on similar subjects published elsewhere.

The balance of payments and international reserves section is weaker. It includes a reasonably good analysis on demand for reserves for three Central American countries (Costa Rica, El Salvador and Panama). But, another paper presenting an analytical model to explain the U.S. current account deficit phenomenon says little which is new. The third paper about the balance of payment difficulties of former Soviet states and Eastern European nations is a descriptive analysis.

The last section about tax distortions and international banking is also weak. The background information and analysis about international banking can he useful. I am somewhat puzzled by the paper about Mexican municipal finance. I fall to see the connection between the different institutions of countries and the limited benefits from NAFTA integration, a diagnosis by the paper. My understanding is that countries with differences can better benefit from international trade or integration, since there can be more opportunities to improve efficiency and apply the principle of comparative advantage.

Jane-yu Ho Li U. S. General Accounting Office