funds than did U.S. firms. This translated into a lower cost of capital for Japanese firms, because other components of the cost of capital, such as the tax treatment of corporate income, did not differ dramatically between the two countries. As national markets for fixed-income securities (government and corporate bonds) became more integrated during the 1980s, the disparity between the costs of borrowing in the two nations has declined to the point where there is little difference today. Floating exchange rates will have an important effect on the perceptions of longer term investors, who can see anticipated returns offset by declines in the value of their principal in the investor’s currency. Hedging is difficult over longer periods and is expensive, which is why residential housing mortgages, for example, tend to be financed domestically.

The integration of equity markets is moving much more slowly for the understandable reasons that equities are more numerous and more complicated and their integration requires a much greater information flow. Although the pace has quickened, U.S. assets in international mutual funds are still less than 2 percent of the total value of U.S. equities (Poterba and French, 1991).12 There is little doubt that integration on the equity side will continue, accelerate, and eventually eliminate cost of equity differences. Nevertheless, because tax laws in various countries may still differ, international integration of equity and debt markets will not necessarily equalize the costs of capital across countries.

The board is most concerned about persistent differences in the cost of equity because of its bearing on relative rates of investment in technology. Corporate investments in certain intangible assets such as research and development, new business development, and development of human capital or training are most often financed with equity, partly because they do not give rise in the short run to an easily visible asset that can be measured. As a result, they cannot be used to collateralize debt in the way that tangible assets can be used. In many industries, intangible investments are increasingly the decisive factor in establishing and maintaining a competitive position in an internationally competitive industry. Even in the absence of external markets, intangible investments are essential to raise growth rates and the standard of living. Furthermore, these types of investments tend to have long time horizons, so that a disadvantage in the cost of the particular kind of capital that is used to finance them has a bigger negative effect than it would have for invest-


The growth of intermediaries in both the debt and equity areas is likely to continue and accelerate, causing the process of integration to continue in this decade.

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