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Globalization of Financial Markets

Even the most cursory review of major international economic trends over the past several decades shows there have been revolutionary changes in world financial markets. During the 1950s and 1960s, financial institutions and their regulatory structures in major industrial countries evolved in relative isolation from external developments. During those years, most countries, including the United States, imposed restrictions on international capital movements. Major international institutional agreements after World War II, such as the Bretton Woods agreement and the General Agreement on Tariffs and Trade, liberalized world trade but did little to free the movement of international capital. After the financial disruptions of the 1930s, many had questioned whether free capital flows and liberalized capital markets were even desirable. In the International Monetary Fund, the basic obligation of member nations—their code of good behavior—was framed exclusively in terms of avoiding restrictions on current account payments: that is, payments for merchandise trade, international services, investment incomes and payments, remittances, and official government transfers. Meanwhile, the rules and the philosophy with respect to capital transactions were far different: many countries restricted outward capital transfers either because they preferred their capital to be invested within their domestic economies or because they wished to prevent downward pressure on their exchange rates.



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Following the Money: U.S. Finance in the World Economy 1 Globalization of Financial Markets Even the most cursory review of major international economic trends over the past several decades shows there have been revolutionary changes in world financial markets. During the 1950s and 1960s, financial institutions and their regulatory structures in major industrial countries evolved in relative isolation from external developments. During those years, most countries, including the United States, imposed restrictions on international capital movements. Major international institutional agreements after World War II, such as the Bretton Woods agreement and the General Agreement on Tariffs and Trade, liberalized world trade but did little to free the movement of international capital. After the financial disruptions of the 1930s, many had questioned whether free capital flows and liberalized capital markets were even desirable. In the International Monetary Fund, the basic obligation of member nations—their code of good behavior—was framed exclusively in terms of avoiding restrictions on current account payments: that is, payments for merchandise trade, international services, investment incomes and payments, remittances, and official government transfers. Meanwhile, the rules and the philosophy with respect to capital transactions were far different: many countries restricted outward capital transfers either because they preferred their capital to be invested within their domestic economies or because they wished to prevent downward pressure on their exchange rates.

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Following the Money: U.S. Finance in the World Economy That situation and those views changed dramatically in the 1970s, and the pace of change accelerated in the 1980s.1 The interaction of several powerful forces has produced massive capital flows across national boundaries. At the same time, the structure and operation of world financial markets have been transformed. Today, world financial markets are highly integrated, and transactions have become increasingly complex. These phenomena are reflected in cross-listing of securities in several countries, cross-country hedging and portfolio diversification, and 24-hour trading in financial instruments at exchanges around the world. Many of the channels used for financial transactions have also changed. There has been a major shift, relatively, from banks to nonbank financial intermediaries, such as brokerage houses, securities firms, insurance companies, and pension funds. There has also been a shift from loans to securities and a rise in the use of foreign financial centers. In addition, there has been a surge in the use of new financial instruments and, in particular, of derivative products (such as financial options, futures, and swaps on interest rates, foreign currencies, stocks, bonds, and commodities). These instruments have been developed to meet the needs and preferences of different customers, including their desire to hedge risks in an environment of fluctuating exchange rates, interest rates, stock prices, and commodity prices. The unprecedented changes in world financial markets have had significant implications for public policy and data collection. Because of international capital movements, policies and developments in other countries increasingly influence domestic economic performance. As a consequence, there is a need for information about the new and emerging global financial environment. Yet changes that have taken place in world financial markets themselves compound the difficulty of acquiring the information. Given the difficulties involved and the budgetary constraints faced by statistical agencies in the public sector, several questions arise: What is the current need for data on international capital transactions? In what ways are current U.S. collection systems adequate or inadequate? Are there conceptual flaws or data defi- 1   A number of significant international financial developments have occurred over the past half century, including the emergence of the Euromarkets in the early 1960s, which circumvented domestic financial regulations. This report focuses on changes in world capital markets associated with financial deregulations in major industrial countries since the late 1970s.

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Following the Money: U.S. Finance in the World Economy ciencies that should be corrected? Are there alternative ways to gather the data that would be more accurate, more useful, more timely, more technologically advanced, or less burdensome and costly? THE STUDY AND THE REPORT With the support of the Bureau of Economic Analysis (BEA) of the U.S. Department of Commerce, the Panel on International Capital Transactions was convened to examine the changes in the global financial environment, assess public and private needs for data on international capital transactions, review the adequacy of existing data, and consider alternative collection methods. Subsequent research grants from the Federal Reserve Board and the U.S. Department of State also supported the study. The panel's goal has been to develop recommendations for the collection of data on U.S. international capital transactions to help ensure that the data are accurate, timely, relevant, cost-effective, and useful for decision making in the years to come. This study is a follow-on to the one completed by a previous panel of the Committee on National Statistics. That report, Behind the Numbers: U.S. Trade in the World Economy (Kester, 1992), reviewed the adequacy of data on U.S. merchandise trade and international services transactions. It recommended steps to correct the problems of underreporting of U.S. merchandise exports and inadequate coverage of U.S. international services transactions. It also proposed measures to improve monitoring of sales and purchases by U.S. firms at home and abroad, as well as those by foreign firms in the United States. It pointed out that, of all U.S. international transactions (in goods, services, and capital flows), transactions representing capital flows are the least adequately documented. That report concluded that improving the data on U.S. international capital transactions would yield high payoffs, and this report addresses that issue. Although the changing global trade and financial environment has led several international organizations to undertake initiatives to improve the concepts and methods of compiling international economic statistics, none of the resulting studies focuses specifically on data on U.S. international capital transactions. Nevertheless, improving the quality of U.S. data would have major implications for international financial statistics. Better U.S. data would greatly enhance the usefulness of information on global capital flows because the United States accounts for a large

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Following the Money: U.S. Finance in the World Economy part of all international transactions. Other countries would also benefit if improved U.S. statistics were available, since U.S. transactions involve many other developed and developing countries, and the statistical problems of the U.S. data are not unique. Refining U.S. data concepts, definitions, and methodologies and harmonizing them with international ones would promote international data comparability. This improvement in comparability, of course, would apply to the data of other countries as well. Data comparability is important not only for international economic policy coordination, but also for data exchanges between the United States and other countries. The panel believes this report will contribute to a better understanding of the global financial flows that have come to characterize the rapidly evolving global economy. In conducting this study, the panel extensively reviewed existing literature, including recent studies by the International Monetary Fund (1987, 1992b), the Federal Reserve Board (Stekler, 1991; Stekler and Truman, 1992), and the Bank for International Settlements (1986, 1992a, 1992b). It examined the concepts, methods, and procedures that U.S. federal agencies use to collect data on international capital transactions, as well as those used by other industrial countries. It drew on the insights and expertise of many individuals in federal agencies, international organizations, foreign government agencies, businesses, trade associations, and research organizations, including those from the U.S. Department of Commerce, the U.S. Department of the Treasury, and the U.S. Federal Reserve system, as well as the International Monetary Fund, the Bank for International Settlements, the Bank of England, the Bank of Japan, and the Deutsche Bundesbank. It con-suited experts in the accounting profession and other expert groups currently examining the changes in global financial markets and the treatment of complex financial transactions. The panel heard expert testimony and reviewed written comments from numerous government, academic, and industry users on the adequacy of the existing data. The panel also canvassed data filers from commercial and investment banks, securities firms, brokerage houses, and multinational corporations to learn their views on data reporting requirements. In developing its recommendations, the panel took into account the current budgetary constraints that face statistical agencies, as well as the rapidly evolving world financial environment and the advent of innovative information and telecommunications technologies. Recommendations in this report are ranked in terms of

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Following the Money: U.S. Finance in the World Economy their relative importance; the most important are listed first in each section. The rest of this chapter reviews the forces that have dramatically transformed world financial markets over the last decade or so and their implications for U.S. economic and financial policies. Chapter 2 describes the existing system for compiling data on U.S. international capital transactions, noting its concept, coverage, and methods of collection. Chapter 3 examines the adequacy of the existing system, taking into account the views of data collection agencies, data filers, and data users, and makes recommendations for improvements. Chapter 4 reviews the surge of transactions in financial derivatives and discusses their implications for the coverage and the interpretation of existing data on U.S. international capital transactions. Chapter 5 explores the feasibility of using alternative data sources and collection methods to improve the coverage and accuracy of existing data, including automation, the use of global custodians, exchanges, settlement and clearing houses, and databases of international organizations. Appendix A highlights key features of the data collection systems of the United Kingdom, Germany, and Japan and discusses actions being taken by these countries to improve information on their international capital transactions. Appendix B summarizes the results of the panel's canvass of data compilers, filers, and users on the adequacy of the existing data system. Throughout this report, following the balance-of-payments framework for current U.S. data, ''foreign" means non-U.S. resident, and international capital transactions are those between residents and nonresidents (foreigners). Other terms commonly used in the field, and in this report, are "offshore," "abroad," and "overseas," all of which are the same as foreign for purposes of international capital transactions, which are also sometimes called cross-border transactions. FACTORS CONTRIBUTING TO GLOBALIZATION The rapid expansion and integration of world financial markets since the late 1970s can be attributed to several factors. They include a worldwide move toward deregulation of financial institutions and transactions; macroeconomic imbalances among countries, which have induced capital flows; improved knowledge about market and economic conditions around the world; and breakthroughs in information and communications technology that have increased exponentially the capacity for handling large volumes

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Following the Money: U.S. Finance in the World Economy of financial transactions while significantly reducing unit transaction costs and making possible the use of new financial instruments. In addition, competition has grown among financial institutions of various types and in various countries, whose portfolio management strategies in volatile markets have resulted in new products and new modes of operation. The development of world financial markets in response to these forces and the U.S. experience can be traced back about two decades. DEREGULATION AND LIBERALIZATION OF FINANCIAL ACTIVITIES The trend toward financial deregulation accelerated in the early 1970s, when the government controls on financial activities that had been established in the 1950s and 1960s and earlier were proving ineffective and causing serious inefficiencies in the allocation of capital and the operation of monetary policy. The United States removed its last capital controls in 1973; Germany significantly reduced its restrictions on capital movements in the 1970s; and the United Kingdom dismantled its exchange controls in 1979, Japan in the early 1980s, and France and Italy in the late 1980s. Countries embraced deregulation because it was thought that free flows of capital would open up both saving and investment opportunities for firms and individuals and better match the changing needs of suppliers and users of funds, thereby facilitating the efficient allocation of capital and promoting growth in income and output. In the United States, the liberalization of domestic financial markets since the late 1970s has further facilitated international capital flows. The phaseout of interest rate ceilings (Regulation Q),2 the easing of portfolio restrictions on pension funds and insurance companies, and the removal of a variety of restrictions on the permissible activities of banks3 have facilitated large transfers of money, both within national borders and across them. The lowering of institutional barriers was intended to allow firms and individuals to adjust their claims and liabilities with greater ease in order to improve the liquidity of their portfolios and diversify 2   Regulation Q set the maximum level of interest rates that banks and savings and loan companies could pay on deposits. 3   Banks are still limited in the extent to which they can diversify into insurance, investment, and underwriting services. As of mid-1994, banks, unlike enterprises in other industries, were prohibited from branching freely across state lines. However, under recently enacted legislation, this prohibition will be removed over the next few years.

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Following the Money: U.S. Finance in the World Economy their risks. The drive toward international diversification by U.S. institutional investors (especially pension funds, insurance companies, and mutual funds) has been a major force behind the internationalization and integration of U.S. financial markets. The process of integration has also intensified as foreign investors and financial institutions have been allowed relatively freely to enter domestic markets in different parts of the world. Between 1978 and 1991, for example, the number of foreign banks in the United States rose from about 122 to 280. Branches and agencies of foreign banks held aggregate assets of $626 billion in 1991, up from $90 billion in 1978. In 1991 foreign banks accounted for 18 percent of total banking assets in this country and operated 565 offices (Federal Reserve Board of Governors, 1993:1).4 Meanwhile, at the time of the "big bang" of 1986—the deregulation of securities markets in the United Kingdom—many U.S. securities firms and banks expanded their presence in London through acquisitions and other means. There are other measures of increased integration of financial markets: over the same 1978-1991 period, the value of U.S. assets abroad rose more than three-fold while the value of foreign assets in the United States showed an even more dramatic six-fold increase. (Bureau of Economic Analysis, 1993a; 1994a). MACROECONOMIC CONDITIONS In an environment of deregulated and liberalized financial markets, international capital movements have been driven mainly by economic fundamentals. The macroeconomic conditions of various countries and their trade and tax policies, for example, affect the expected rates of return on various investments in different markets. In the mid- to late 1970s, large capital flows resulted from the recycling of the oil export surpluses of the Organization of Petroleum Exporting Countries, many of them through international banks to sovereign borrowers in the developing countries. During the late 1970s and early 1980s, there was considerable capital flight from many developing countries as uncompetitive interest rates and exchange rates, large fiscal deficits, and high 4   Foreign banks with U.S. branches and agencies first became subject to federal regulation with the adoption of the International Banking Act of 1978. Additional regulatory authority was provided by the Foreign Bank Supervision Enhancement Act in 1991.

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Following the Money: U.S. Finance in the World Economy external debt burdens took a toll in those countries. Beginning in the early 1980s, large capital inflows into the United States were an important source of financing for the sizable federal budget deficits being incurred. Differences in the mix of fiscal and monetary policies between the United States and other industrial countries over the past decade have directly affected exchange rates for the dollar. The large movements of the dollar against other major currencies since the 1980s, in turn, have contributed to increases in sales and purchases of dollar-denominated securities and the expansion of foreign-currency trading. In 1992, differentials approaching 6 percentage points or more in interest rates between the United States and Germany attracted capital to Germany from the United States (and other countries). Following unification, Germany relied on high interest rates to dampen inflationary pressures arising from the huge costs of revitalizing the economy of the former East Germany. Also in the early 1990s, rapid economic growth in East Asian countries and large export surpluses in those countries have generated pools of savings that flow into the global economy to finance the investments that offer the highest rates of return. TECHNOLOGICAL INNOVATIONS Technology is another force that has changed the operation and structure of international financial markets. Information and telecommunications technologies have greatly increased the speed with which information is processed and disseminated. Around the world, market participants are bombarded with a plethora of information and a cacophony of opinions, reports, and rumors, much of which is communicated by computers. In addition, electronic trading has allowed orders to move across continents, directly from customers to brokers and dealers. Automated trade execution and international clearing and settlement have also encouraged cross-listing of securities and further integrated world financial markets. Today, traders have access to instruments and overseas markets after U.S. trading hours have ended. If they choose to, they can also "pass the book" to their affiliates in foreign markets, who can continue trading in daylight hours overseas. Automated trading execution systems provide a 24-hour trading market, allowing traders to enter buy and sell orders that are automatically matched according to price and time preferences.

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Following the Money: U.S. Finance in the World Economy One example of such systems is GLOBEX, an electronic trading system launched by the Chicago Mercantile Exchange and the Chicago Board of Trade in conjunction with Reuter, the British information services firm. Key U.S. government securities and foreign exchange are traded in global markets. Round-the-clock trading is expanding because increases in speed and control over the direction of information flows can result in large profits or reduced losses in financial markets. The greater ease with which financial traders can gain access to different markets and their reduced costs have enabled them to take advantage of even small profit margins around the world. Furthermore, interactions among markets, which have been facilitated by technological innovations, have provided market participants with opportunities to diversify, hedge, and increase profits on their investments, thereby promoting the use of new financial products and instruments. Over the past several years, there has been rapid growth in financial derivatives, such as forwards, futures, options, swaps, and sophisticated combinations of them on interest rates, exchange rates, stocks, and bonds. A primary purpose of these instruments is to hedge exposure against risk, and many are traded across borders. Accompanying this rise in derivatives has been the rapid expansion of over-the-counter markets that involve trading over computer networks in securities tailored to the specific needs of individual investors, borrowers, and intermediaries. (A detailed discussion of financial derivatives is presented in Chapter 4.) COMPETITION AMONG FINANCIAL AND NONFINANCIAL INSTITUTIONS The easing of capital controls, the liberalization of financial markets, and technological innovations have stimulated competition among financial and nonfinancial institutions in various countries. This, in turn, has further transformed the structure of world financial markets. Over the past 25 years, a notable development in international finance has been the growth of securitization—a process of converting assets that would normally serve as collateral for a bank loan into securities that are more liquid and can be traded at a lower cost than the underlying asset. This process has been fostered, among other things, by technological innovations. With computers and electronic record-keeping, financial institutions can cheaply bundle together a portfolio of loans (originally, mortgage loans) with small denominations, collect the interest and princi-

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Following the Money: U.S. Finance in the World Economy pal payments, and sell the claims to these payments to a third party as a security. This process of pooling loans and selling securities backed by the loans has been found by financial institutions to be more efficient than traditional financing through financial intermediaries in certain situations, and it has been used, for example, for auto loans and credit card obligations. In an environment of deregulation, nonbank financial companies have devised new and different ways to move money from savers to borrowers. In recent years in the United States, for example, pension funds, money market funds, and insurance companies, among others, have increasingly lured savings away from bank deposits. In turn, these institutional investors, which are better able than individuals to acquire the needed information for foreign investment, have heavily invested in foreign securities, fostering the rapid expansion of international bond and equity markets.5 Under these circumstances, there now are diverse institutions competing to provide financial services; securities have become an increasingly important element in international capital flows. Meanwhile, multinational corporations that produce and sell goods and services on a global scale seek worldwide sources for their financing and investment needs. To serve these clients, financial institutions have diversified the services they offer, among which are transactions in foreign exchange, money market instruments, and derivative products, all on a worldwide scale. These sophisticated financial instruments allow investors an array of alternatives for hedging and shifting risks, which, at a cost, can provide greater certainty of international receipts and payments, or, in some cases, for taking on exposure with a highly leveraged position. There is a large market for such instruments in today's environment, as international businesses, speculators, and investors are faced with volatile exchange rates, interest rates, and commodity prices. The rise in new financial instruments has added flexibility to 5   A 1993 study by a private financial consulting firm estimated that holdings of foreign stocks by U.S. public pension funds rose from $28.9 billion in 1991 to $48.1 billion in 1992; those of corporate pension funds rose from $59.3 billion to $70.7 billion during the same period. In 1992, foreign stocks accounted for almost 8 percent of assets of corporate pension funds and about 5.6 percent of assets of public pension funds. A survey of pension funds reported in the study showed that public and corporate pension funds expected to increase their holdings of foreign stocks to $100 billion and $116 billion, respectively, by 1995 (Greenwich Associates, 1993).

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Following the Money: U.S. Finance in the World Economy portfolio management operations. As a result, more and more debt and equity products now originate and are traded in several world financial centers and in different currencies. For example, hedging and other position taking can be carried out with financial and commodity futures and options; they can also be undertaken with interest rate swaps and forward agreements for major exchange rates and commodity prices. Hedging operations can also be combined with other lending arrangements (for example, in a commodity swap) to secure—at a cost—both access to additional funds and greater protection from changing international interest rates and commodity prices. In addition, some multinational corporations act, in effect, as their own in-house financial intermediaries, raising funds wherever they are cheapest and moving them through diverse channels (including offshore—foreign—holding companies) to where they are needed. To some extent, these organizations can be thought of as arbitraging national financial markets. Overall, these private firms, both financial and nonfinancial, now rely heavily for their funding on marketable instruments; the use of commercial paper,6 floating rate notes, bonds, convertible bonds, shares, and related instruments has grown rapidly in recent years at the expense of traditional bank deposits and loans in financing big businesses. According to a recent Federal Reserve study (Post, 1992), the U.S. commercial paper market since the early 1980s has become an important source of short-term funds for manufacturers, commercial concerns, and utilities to finance increased production, new inventories, or new receivables. Business enterprises turned to commercial paper to avoid high interest rates on long-term funds and bank loans in an expanding economy. Two other developments in the late 1980s also increased the issuance of commercial paper: the numerous mergers and acquisitions and the expansion of the swaps market, as borrowers combined commercial paper with swaps to create liabilities in other currencies. Asset-backed commercial paper also came into use, providing off-balance-sheet financing for trade and credit card receivables. 7 Money market 6   Commercial paper consists of short-term unsecured promissory notes, which are issued mostly by corporations. 7   Off-balance-sheet activities are business transactions that do not generally involve recording assets or liabilities in the balance sheet: examples include trades in swaps, options, futures, and foreign exchange forwards and the granting of standby commitments and letters of credit.

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Following the Money: U.S. Finance in the World Economy cause major disruptions in international financial systems. International capital mobility not only has led to growing linkages of world financial markets, but also has increased the extent to which macroeconomic policies and market conditions of one country can significantly affect those of others. Meanwhile, the securitization of transactions and growth in the use of financial derivative instruments have made international financial flows more complex and less transparent, complicating supervision of financial institutions. This section discusses several aspects of the effect of new global realities in financial markets on a nation's economic policies and financial oversight. MACROECONOMIC POLICIES Interest rates and the availability of capital in an industrial country are now much more influenced than in the past by interest rates and credit availability in other countries. A corollary is that monetary (and fiscal) developments in a major industrial country have larger macroeconomic effects on other countries than they did when capital was less mobile internationally. A vivid example was the effect in 1992 of high interest rates in Germany on other members of the European Monetary System, as well as on other industrial countries, including the United States. The freer flow-of-funds among countries does not necessarily bring their interest rates into line with one another. Interest rates can differ among countries when there exists an expectation that exchange rates will change or when there is a premium related to other types of risk. Nonetheless, a change in interest rates in a major industrial country can strongly affect both interest rates and exchange rates in other countries. The growth in cross-border deposits also has implications for monetary policies. When cross-border deposits were small and relatively stable, they could be ignored when examining the behavior of domestic monetary aggregates. In recent years, however, the growth in these deposits has added to questions about the usefulness of monetary aggregates as indicators of the tightness or slack of U.S. monetary conditions, in part because measures of U.S. monetary aggregates do not fully capture deposits held by U.S. residents in banks located in foreign countries.11 In 11   The three major measures are M1, M2, and M3. M1 includes currency outside the Treasury Department, Federal Reserve banks, and the vaults of depository institutions; traveler's checks of nonbank issuers; demand deposits at all commercial

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Following the Money: U.S. Finance in the World Economy addition, because of foreign offerings of dollar-denominated obligations, net U.S. international capital flows do not fully indicate exchange market pressures on the dollar (Cooper, 1986). Furthermore, it is argued that under floating exchange rates, increased international capital mobility can quicken the speed with which tight monetary policies slow inflation, since currencies tend to appreciate in response to higher interest rates. The unusual speed of the U.S. disinflation in the early 1980s is an example (Willett and Wihlborg, 1990). Enhanced capital mobility also affects fiscal policy. In the past, when a country's fiscal policy led to a large budget deficit, the effect was primarily domestic, in the form of more rapid expansion of national income and output and possibly also in some crowding out of private investment as the government borrowed more and interest rates rose. Now a significant result may be a large trade deficit, if high interest rates attract funds from abroad and the exchange rate appreciates. This phenomenon was evident in the United States in the 1980s, when large federal budget deficits were accompanied by large trade deficits. Today, external imbalances are in many cases more easily financed than in the past by movements of foreign capital. As a result, large trade surpluses and deficits may cause less concern to market participants and to policy makers. From another perspective, the more ready availability of international capital may provide domestic officials with more time to undertake the adjustments needed to correct domestic and external imbalances. Changes in current account balances do, of course, affect domestic income and employment. And sustained imbalances can lead to the build-up of large international debtor and creditor positions that affect the real incomes and debt burdens of future generations. Yet another effect of capital mobility on domestic macroeconomic policies is that tax incentives to boost domestic savings (for example, through increased tax deductions for individual retirement accounts) may be less likely than in the past to generate a rise in capital for domestic investment. Uncertainty about effects has     banks other than those due to depository institutions, the U.S. government, and foreign banks and official institutions; and other checkable deposits including share draft accounts in credit unions and demand deposits at thrift institutions. Overnight Eurodollar deposits of U.S. residents at foreign branches of U.S. banks are included in M2. Term Eurodollar deposits held by U.S. residents at foreign branches of U.S. banks and at all banking offices in the United Kingdom and Canada are included in M3.

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Following the Money: U.S. Finance in the World Economy risen because institutional investors and other professional money managers can move large pools of savings abroad. They increasingly do so when they calculate they can earn higher rates of return, after allowing for exchange risk. ASSESSING THE STABILITY OF FINANCIAL MARKETS As funds move more easily and more readily from one country to another, the prices of financial instruments (for example, securities and foreign exchange) may be subject to greater volatility. Increasingly, exchange rates (the prices of foreign exchange) are affected by ''news"—the flow of new information—and by the expectations it engenders. The prices of bonds and stocks are similarly influenced. And exchange rates and securities prices interact with each other. Hence, securities prices in one country can now be affected by the behavior of foreign as well as domestic lenders and investors, although the degree of influence differs from one situation to another, depending on a variety of circumstances. Thus, when the U.S. stock market declined sharply in October 1987, there were worldwide effects, but the large drop in the prices of Japanese stocks in 1991-1992 had little discernible impact on stock markets in the United States and other countries. In principle, enhanced capital mobility could lead to more stable markets rather than to greater volatility of securities prices and exchange rates, since it makes markets less "thin" in terms of numbers of participants and potential flows of funds. Nonetheless, the information revolution, which has increased familiarity with economic, financial, and political conditions around the world and thereby encouraged international lending and investing, also brings a constant flow of news that can cause lenders and investors to make abrupt changes in their holdings in their own and other countries. Thus, markets are vulnerable to larger swings—both in the short and medium term—in a world of integrated financial markets and enormous worldwide liquidity. 12 12   The price dynamics created by derivative instruments can also exacerbate this potential. In foreign exchange markets, such swings in prices have led at times to coordinated intervention by central banks aimed at dampening the short-and medium-term volatility of exchange rates. Since the February 1987 meeting of the Group of Seven finance ministers and central bank governors at the Louvre, the monetary authorities of those countries have attempted to maintain their exchange rates within broad ranges.

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Following the Money: U.S. Finance in the World Economy MONITORING THE SOLVENCY AND LIQUIDITY OF MARKET PARTICIPANTS The enormous volume of funds flowing across national boundaries and from one currency to another creates a risk that a breakdown in one financial system could spread across the world. The U.S. stock market crash of October 1987 demonstrated the speed with which major financial shocks can reverberate across global markets, and it drew attention to the types of liquidity, settlement, and clearance problems that can arise in money and equity markets.13 Many financial intermediaries receive and send extremely large sums, relative to their capital and liquid assets, through payments networks. To make the required payments, they are dependent on receipts from others. If one intermediary in the payments mechanism finds itself unable, for whatever reason, to make the payments for which it is liable and others will not lend to it, problems for other institutions and in other centers can develop quickly. In the commercial banking system, central banks have long been prepared to act as lenders of last resort to enable banks to cope with liquidity problems. The bank examination process also aims to guard against insolvency in commercial banks, and there is close international cooperation among supervisors of commercial banks, who meet regularly at the Bank for International Settlements at Basle. But there are questions as to whether nonbank financial intermediaries—including brokers and dealers and investment banks—are equally well supervised and, if these nonbank institutions are adequately supervised, whether central banks should also act as their lenders of last resort.14 13   There have been some initiatives in the United States and abroad to improve the clearing and settlement systems since then. 14   The Technical Committee of the International Organization of Securities Commissions has been working toward international risk-based capital adequacy standards for securities firms. Efforts are being made to reconcile the differences between the capital requirements applicable to nonbank securities firms and those applicable to banks that engage in securities activities. In the United States, Congress recently provided authority to the Commodity Futures Trading Commission to more fully share information and cooperate with foreign regulators. In addition, the Securities and Exchange Commission is considering adjusting U.S. securities firms' capital standards to recognize more foreign markets and to collect data necessary to assess the need for additional regulation of the financial activities of U.S. securities firms' unregulated affiliates and broker-dealer holding companies.

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Following the Money: U.S. Finance in the World Economy Central banks and financial regulators have also become concerned about the risk exposure of participants engaging in derivatives transactions. Risks are posed in many ways, including by the volatility of the underlying markets. A market participant's exposure can change drastically with fluctuations in interest rates or equity prices: a small shift in share prices, for example, can result in a big change in the value of a stock-index option. Other risks pertain to the management of sizable positions by large financial institutions and the credit quality of these "wholesale" enterprises and their customers. Still another risk concerns illiquidity. Although derivatives traded on exchanges have many buyers and sellers, those tailored to specific customers' needs (such as those traded in the over-the-counter markets) are more difficult to liquidate since they are more difficult to value and to hedge against. In addition, the opaqueness of some of these transactions, especially over-the-counter contracts, compounds the difficulty for regulators of monitoring market participants in derivatives. Furthermore, as more and larger traders, driven by technical trading methods, seek to move increasingly large sums between markets, market volatility is likely to increase. The closer linkages among markets that are fostered by the growth of derivatives mean that financial shocks can be transmitted across markets quickly. The growth in derivative instruments has created not only complex chains of counterparty (buyer or seller) exposures but also, in the case of exchange rate contracts, a significant expansion of international payment and settlement activities. To reduce risks and guard against payment "gridlock," the Federal Reserve and other central banks are closely monitoring their payment and settlement mechanisms. In addition, the Basle Committee has focused on ways of expanding the Basle Capital Accord to cover credit risk and various types of market risks, such as foreign exchange rate risk, interest rate risk, and position risks in traded equity securities. (For a discussion of the various types of risks arising from derivatives transactions, see Federal Reserve Board of Governors et al., 1993; Bank for International Settlements, 1992b; Group of Thirty, 1993.) In sum, the interactions among countries' interest rates, exchange rates, and securities prices, hastened by the increase in capital mobility and the linkages of world financial markets, have major policy implications. The economic performance of one country—especially an industrial one with high capital mobility—will be affected by policies and market developments in other coun-

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Following the Money: U.S. Finance in the World Economy tries. There is a blurring of the traditional distinction between domestic and international economic policy. Policy makers in major industrial countries need to take account of policies and policy intentions elsewhere. In a world of growing interdependence among nations, enhanced capital mobility will, in some cases, help policy makers achieve their domestic macroeconomic objectives; in other cases, however, it may undercut the effect of national policies on domestic economic performance. IMPLICATIONS OF GLOBALIZATION FOR DATA COLLECTION In this new global economic environment, to better formulate U.S. macroeconomic policy, monitor financial market performance, and oversee the stability of the domestic financial system, comprehensive information on U.S. international capital transactions will be required. At the same time, the unprecedented changes in global financial markets have reduced the effectiveness of traditional data collection methods and the adequacy of the existing data. This section provides an overview and some examples of the deficiencies of the existing data. The rest of the report addresses the shortcomings in detail and presents the panel's recommendations for data improvement. The present U.S. data collection system for international capital transactions originated some 50 years ago (see Chapter 2). At that time, portfolio investment was largely channeled through such traditional financial instruments as bank loans and deposits, denominated mostly in U.S. dollars, and handled by a relatively small number of large banks and financial institutions. The current system, as it has evolved, still emphasizes the collection of data on traditional international banking transactions. But the rise in nonbank market participants (in particular, institutional investors), the surge in international financial flows and their diversification across currencies, the increase in offshore financial activities, and the burgeoning international trade in derivative financial instruments have outstripped the coverage of the U.S. data system. Rapid technological innovations have also allowed numerous transactions to bypass domestic financial intermediaries, and such transactions are beyond the reach of the traditional reporting mechanisms, thus raising questions about the adequacy of relying largely on domestic data filers. Meanwhile, as U.S. international capital transactions have proliferated and become more complex, the work required to compile comprehensive in-

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Following the Money: U.S. Finance in the World Economy formation on them has greatly expanded and become much more costly for both statistical agencies and those who report the raw data. The conceptual framework under which the existing data are collected, that of the balance of payments, defines U.S. international transactions as those between U.S. residents and those outside U.S. boundaries. (See Chapter 2 for a detailed discussion of the U.S. balance-of-payments accounts.) The purpose of this framework is to compile information on economic exchanges that cross the border between the United States and the rest of the world. These data provide vital information needed to understand the external sector of the economy and how it affects domestic economic activity. International transactions, defined in this way, are a component of the national accounts (which include the national income and product accounts, the flow-of-funds accounts, and the balance sheets of the U.S. economy). However, as financial activities have become global in nature, the resident-nonresident distinction has become inadequate to fully depict all facets of these activities. Increasingly, cross-border financial exchanges represent capital transfers among the worldwide offices and branches of U.S. financial institutions, rather than transactions largely between U.S. firms and foreign firms. There is also a growing presence of foreign-owned firms in the U.S. domestic markets and of U.S.-owned firms in markets abroad. These developments have complicated the identification of resident versus nonresident transactions. More important, as discussed above, internationalization of financial transactions has given rise to policy concerns about the liquidity, solvency, and stability of the U.S. financial system insofar as it is affected by foreign markets. These are issues the balance-of-payments framework was not designed to treat. There is need to supplement the existing balance-of-payments data with other information on U.S. financial activities to guide the decisions to be made on myriad emerging public policies. In its report (Kester, 1992), the Panel on Foreign Trade Statistics recommended supplementing the existing trade statistics, collected under the balance-of-payments framework, with economic information collected outside it to better depict the globalized U.S. business activities in goods and services. Such a broader framework would greatly assist in addressing such issues as U.S. international competitiveness and the impact of foreign trade and direct investment on U.S. employment and production. This report makes recommendations to improve the coverage and accuracy of the existing data, but it also proposes ways to supplement them

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Following the Money: U.S. Finance in the World Economy with data on the burgeoning financial derivatives transactions collected outside the traditional balance-of-payments framework. The need for improved data is further evidenced by the incomplete accounting of the sizable U.S. international capital flows in recent years and the uncertainty associated with it about the U.S. financial position in the world economy and other economic and financial developments. A few examples follow. U.S. statistics for 1982 indicate that the rate at which nonresidents were acquiring assets in the United States was less than the rate at which U.S. residents were securing assets abroad. But the statistical discrepancy of the U.S. balance-of-payments accounts in that year was larger than the difference between these two totals: current account receipts or net inflows of capital of about $41 billion were not identified or recorded. Thus, the direction of the net capital flow could have been the opposite of that reported in the 1982 U.S. balance-of-payments accounts. When initially released, data for 1985 on the U.S. net international investment position showed that foreign assets of U.S. residents were less than their liabilities to foreigners. The press referred to the United States as being "a debtor nation" for the first time since before World War I. The cumulating liabilities, whose burden could fall on the next generation as well, were deemed to imply the obligation to pay future interest, dividends, profits, and amortization to foreign investors. However, the U.S. data on U.S. residents' direct investments and claims on foreigners was listed at book value, omitting any increase in market value of the investment over time. Some analysts believed that this source of understatement in the U.S. international investment position was so large that U.S. liabilities to foreigners for 1985 were, in fact, smaller than U.S. holdings of foreign assets. Yet others pointed out a measurement error in the other direction: the cumulative statistical discrepancy in the U.S. balance-of-payments accounts as reported at the same time totaled $117 billion for the years 1981-1985 alone, indicating possibly sizable unreported capital inflows. These data have subsequently undergone several revisions, and BEA has also begun publishing market value as well as historical cost estimates of total asset values. According to recently published data (Bureau of Economic Analysis, 1994a:71), foreign assets owned by U.S. residents in 1985 exceeded foreigners' ownership of U.S. assets, measured either by historical cost or market value. Since 1989 however, foreigners' ownership of U.S. assets

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Following the Money: U.S. Finance in the World Economy has exceeded the foreign holdings of U.S. residents', using either the historical cost or market value measures. Even the revised data may tend to more closely track foreigners' investments in the United States than U.S. residents' investments abroad, however. Until 1994, U.S. holdings of foreign securities had not been comprehensively surveyed since World War II.15 In addition, despite the recorded "net indebtedness," official statistics show that U.S. earnings (interest and profits) on investments abroad continue to be larger than the earnings paid by the United States to foreigners on their U.S. investments. Until the 1980s, as noted above, banks dominated the international financial system, but securitization has occurred rapidly since then. U.S. official statistics show foreign purchases of U.S. securities as exceeding bank-reported liabilities as the largest component of the capital inflow in 1985. But a recent study by the Federal Reserve Bank of New York (1992a) indicates that as much as $70 billion of foreign lending to U.S. business that took place offshore in the 1980s was not included in the official statistics of U.S. international capital transactions. This funding raises the question of whether official statistics have overstated securities as a source of financing and understated the major role still played by banks.16 U.S. statistics show that 1985 sales of U.S. Treasury securities to foreigners, although many times greater than those in 1980, were still relatively small ($20.5 billion, of which 83 percent was sold to Japanese residents) (Frankel, 1988:592). Yet official Japanese statistics show that the value of U.S. Treasury securities bought by Japanese residents was much larger than was shown in the U.S. data. For 1986, the discrepancy between U.S.-reported sales of U.S. Treasury securities to Japan and Japanese-reported purchases of U.S. Treasury securities was $37 billion ($12.8 billion and $49.4 billion, respectively). Since U.S. Treasury securities are sold in global markets and the U.S. official data do not identify the ultimate owner of the securities, the holdings of U.S. 15   The survey was conducted in 1994, but as of mid-1994 there was no firm schedule for data release. 16   Recently published revised data (Bureau of Economic Analysis, 1994a) contain dramatic upward revisions in estimates of U.S. nonbanks liabilities to foreigners for the years 1983-1993. These revisions result largely from BEA's continuing program to use data reported by foreign banks. Much of the revision is based on data from the Bank for International Settlements (BIS) on bank claims reported in Caribbean and Asian banking centers.

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Following the Money: U.S. Finance in the World Economy Treasury securities held by particular countries remain unclear. In addition, U.S. data on capital transactions do not identify the extent to which U.S. assets held by foreigners are in practice hedged in foreign currencies. This deficiency has hampered the analysis of the vulnerability of the dollar to foreign portfolio shifts. The United States was able to continue financing large trade deficits in 1987 and thereafter without major depreciation of the dollar: one explanation is that foreign central banks stepped in to buy dollars when private investors had become wary of trading. Although official statistics on central bank transactions are believed to be better than those on private transactions, even the official statistics are problematic. When a foreign central bank acquires dollars and deposits them in a commercial bank abroad, the dollar holdings will not show up in the U.S. statistics as foreign official holdings of dollars. They will appear as U.S. liabilities to foreign commercial banks. The published figures of foreign official holdings of dollars, therefore, may understate the extent of foreign government intervention in foreign exchange markets; this happened in 1987. The Federal Reserve Bank of New York, using its own data and other sources, has estimated that foreign official purchases of dollars in 1987, including the private channeling of official capital, may have been almost three times higher than the $45 billion that was recorded in the U.S. balance-of-payments accounts. In the late 1980s, Americans became more concerned about another sizable component of the capital inflow: foreign direct investment in the United States. The news media carried stories that Japanese and other foreign investors were building factories and buying assets in the United States, including such national symbols as Rockefeller Center and the Seattle Mariners baseball team. How extensive is foreign direct investment in the United States and what is its economic impact? The availability of data bearing on these questions has expanded in the last few years, but gaps remain (see Chapter 3). In 1990 and 1991, with the American economy in recession, the question arose as to whether monetary policy had been too tight. During 1990, M1 grew at 4.0 percent, and it grew 8.7 percent in 1991. On the face of it, this might have appeared to be adequate money growth to finance the economy. In 1990, however, an increase in currency outstanding constituted three-quarters of the increase in M1 ($24.2 billion of $32.0 billion). Some estimates suggest that over half of U.S. dollar currency outstanding is held in Latin America and other foreign countries, where it

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Following the Money: U.S. Finance in the World Economy is often a good shelter from local inflation and taxation. A Federal Reserve analysis suggests that there was a large unmeasured outflow of U.S. currency in 1990 (perhaps $15 billion of the $47.4 billion errors and omissions in the U.S. international transaction accounts 17) and that, as a result, the observed M1 growth gave a misleadingly expansionary indication of monetary conditions (Stekler and Truman, 1992:5). In 1991, the increase in currency explains only 28 percent of the increase in M1 ($20.5 billion of $72.0 billion). Clearly, better data on international shipments of U.S. currency would help the Federal Reserve to design monetary policies for the goals it seeks. In summary, U.S. financial activities are becoming increasingly globalized. The formulation of U.S. macroeconomic and financial supervisory policies and the public debate over U.S. external indebtedness depend on reliable statistics that accurately depict the nature and extent of U.S. international financial transactions. They are also needed to evaluate exchange market conditions and potential pressures, to examine the risk exposure of U.S. financial institutions, and to assess foreign ownership of U.S. business. Without such statistics, informed decisions will be difficult to make and sound policies will at times be lacking. It should be noted here that the United States produces as much detailed data on its international capital transactions as any country in the world. The United States is not alone in facing problems of collecting and integrating data on such transactions. Other countries are confronted with similar problems and are working to improve their data (see Appendix A). In principle, global outflows should equal global inflows. However, as reported by the International Monetary Fund (1993b), the statistical discrepancy in the global capital account averaged nearly $120 billion a year during 1989-1992: that is, recorded capital inflows exceeded outflows by that amount, on average, for every year during that period. 17   The errors and omissions for 1990 have since been revised downward to $40 billion (Bureau of Economic Analysis, 1994a:95).