Trace the development of the International Capital Markets

The financial revolution has been characterized by both a tremendous quantitative expansion and an extraordinary qualitative transformation in the institutions, instruments and regulatory structures.

Global financial markets are a relatively recent phenomenon. Prior to 1980, national markets were largely independent of each other and financial intermediaries in each country operated principally in that country. The foreign exchange market and the Eurocurrency and Eurobond markets based in London were the only markets that were truly global in their operations.

Financial markets everywhere serve to facilitate transfer of resources from surplus units (savers)todeficit units (borrowers), the former attempting to maximize the return on their savings while the latter looking to minimize their borrowing costs. An efficient financial market thus achieves an optimal allocation of surplus funds between alternative uses. Healthy financial markets also offer the savers a range of instruments enabling them to diversify their portfolios.

Globalization of financial markets during the eighties has been driven by two underlying forces. Growing (and continually shifting) imbalance between savings and investment within individual countries, reflected in their current account balances, has necessitated massive cross-border financial flows. For instance, during the late seventies, the massive surpluses of the OPEC countries had to be recycled, i.e. fed back into the economies of oil importing nations. During the eighties, the large current account deficits of the US had to be financed primarily from the mounting surpluses in Japan and Germany. During the nineties, developing countries as a group have experienced huge current account deficits and have also had to resort to international financial markets to bridge the gap between incomes and expenditures, as the volume of concessional aidfrom official bilateral and multilateral sources has fallen far short of their perceived needs.

The other motive force is the increasing preference on the part of investors for international diversification of their asset portfolios. This would result in gross cross-border financial flows. Investigators have established that significant risk reduction is possible via global diversification of portfolios.

These demand-side forces accompanied by liberalization and geographical integration of financial markets has led to enormous growth in cross-border financial transactions. In virtually all major industrial economies, significant deregulation of the financial markets has already been effected or is under way. Functional and geographic restrictions on financial institutions, restrictions on the kind of securities they can issue and hold in their portfolios, interest rate ceilings, barriers to foreign entities accessing national markets as borrowers and lenders and to foreign financial intermediaries offering various types of financial services have been already dismantled or are being gradually eased away. Finally, the markets themselves have proved to be highly innovative, responding rapidly to changing investor preferences and increasingly complex needs of the borrowers by designing new instruments and highly flexible risk management products. 

The result of these processes has been the emergence of a vast, seamless global financial market transcending national boundaries. But control and government intervention have not entirely disappeared. E.g. South East Asia- Korea, Taiwan, etc- permit only limited access to foreign investors. However, despite these reservations, the dominant trend is towards globalization of financial markets.

International financial markets can develop anywhere, provided that local regulations permit the market and potential users are attracted to it. The most important international financial centers are London, Tokyo and New York. All the major industrial countries have important domestic financial markets as well but only some such as Germany and France are also important international financial centers. On the other hand, even though some countries have relatively unimportant domestic financial markets, they are important world financial centers such as Switzerland, Luxembourg, Singapore and Hong Kong.

International Capital Markets, also called Euro markets, are the markets on which Euro currencies; Euro bonds, Euro equity and Euro bills are exchanged. International financing in the form of short-, medium- or long-term securities or credits has become necessary for the international economy. Financing techniques have diversified, volumes dealt have increased and the process is continuing to grow.

Notable developments in international capital markets can be traced to the end of 1950s. There are several reasons for their growth. The significant ones are:

Transfer of assets of erstwhile Soviet Union to Europe. In the 1950s and early 1960s, the former Soviet Union and Soviet-bloc countries sold gold and commodities to raise hard currency. Because of anti-Soviet sentiment, these Communist countries were afraid of depositing their US dollars in US banks for fear that the deposits could be frozen or taken. Instead they deposited their dollars in a French Bank whose telex address was Euro-Bank. Since that time, dollar deposits outside the US have been called Eurodollars and banks accepting Eurocurrency deposits have been called Euro banks. International capital markets subsequently came to be known as Euro markets.

Restrictive measures taken by the administration. Several regulatory measures (initiated particularly in the USA) also contributed (in an indirect manner) to the development of International capital markets. The important ones are as follows:

Regulation ‘Q’. In 1960, Regulation ‘Q’ in the USA fixed a ceiling on interest rates offered by American banks on term deposits and prohibited them to remunerate the deposits whose term was less than 30 days. Besides, at the end of the 1960s, the Federal Reserve reduced the growth of total monetary mass. The money market rate went up. American banks borrowed on the Euro dollar market, which resulted in:

• The increase of indebtedness of these banks on the Euro dollar market;

• The flight of American Capital, attracted by the interest rate on Euro market.

Tax of interest equalization. In 1963, tax was imposed on the purchase of foreign securities (portfolio investments) by American residents. The objective was to reduce the deficit of BOP of the USA and to establish equilibrium in international structure of interest rates. In fact, in order to avoid tax payment, some companies launched the issue of dollar bonds outside the USA. This contributed to the growth of Euro dollar market. Realizing its adverse effects, subsequently, the tax was withdrawn in 1974.

Program of voluntary restrictions on investments. The USA initiated/imposed various restrictions on its financial system to tackle BOP problems. For instance, banks were directed not to lend or invest in foreign operations beyond the limits of theprevious year(s). As a result, the business community felt a scarcity of funds. This in turn led them to take recourse to the Euro dollar market.

Differential of American lending and borrowing rates. The interest rate paid by American banks was low, vis-à-vis, the expected rate from borrowers. European banks availed of this opportunity; they offered higher rates of interest at the cost of contenting themselves with smaller margins than those offered by American banks, to attract investors. They could do so by operating on Euro dollar markets, which were not subject to interest-rate and other regulations. For instance, banks were neither constrained to respect a certain compulsory reserve ratio on their deposits in Euro dollars nor constrained to maintain their interest rates below a certain ceiling.

There may be other reasons as well for development of Euro dollars. Globalization of big multinationals has further boosted this development. The financing system practiced hitherto also was not able to respond to capital needs of the international economy.

Indian entities began accessing external capital markets towards the end of the seventies as gradually the amount of concessional assistance became inadequate to meet the increasing needs of the economy. The initial forays were low-key. The pace accelerated around mid-eighties, but even the authorities adopted a selective approach and permitted only a few select banks, all India financial institutions and large public and private sector companies to access the market. After liberalization, during 1993-94 there was a sharp increase in the amount of funds raised by corporate entities form the global debt and equity markets.

India’s borrowings have mainly been by way of syndicated bank loans, buyers’ credits and lines of credits. Other instruments such as foreign and Euro bonds have been employed less frequently though a number of companies made issues of Euro convertible bonds after 1993. Prior to that only apex financial institutions and the public sector giant ONGC had tapped the German, Swiss, Japanese, and Euro dollar bond markets. Throughout the eighties, there was a steady improvement in the market’s perception of the creditworthiness of Indian borrowers (manifested in the steady decline in the spreads they had to pay over LIBOR in the case of Euro loans). The 1990-91 crisis sent India’s sovereign rating below investment grade and the foreign debt markets virtually dried up to be opened up again after 1993.