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The purpose of this paper is to review concepts and measurements related to financial
globalization such as financial openness, financial integration, monetary interdependence, and the
mobility and movement of capital
Journal of Financial Economic Policy
Measures of financial openness and interdependence
William R. Clark Mark Hallerberg Manfred Keil, Thomas D. Willett
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To cite this document:
William R. Clark Mark Hallerberg Manfred Keil, Thomas D. Willett, (2012),"Measures of financial openness
and interdependence", J ournal of Financial Economic Policy, Vol. 4 Iss 1 pp. 58 - 75
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Linyue Li, Nan Zhang, Thomas D. Willett, (2012),"Measuring macroeconomic and financial market
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Measures of ?nancial openness
and interdependence
William R. Clark
University of Michigan, Ann Arbor, Michigan, USA
Mark Hallerberg
Hertie School of Governance, Berlin, Germany and Emory University,
Atlanta, Georgia, USA
Manfred Keil
Claremont McKenna College & Claremont Graduate University, Claremont,
California, USA, and
Thomas D. Willett
Claremont Graduate University & Claremont McKenna College &
Claremont Institute for Economic Policy Studies, Claremont, California, USA
Abstract
Purpose – The purpose of this paper is to review concepts and measurements related to ?nancial
globalization such as ?nancial openness, ?nancial integration, monetary interdependence, and the
mobility and movement of capital.
Design/methodology/approach – This paper surveys the theoretical and empirical literature on
monetary interdependence and ?nancial globalization. The major ways in which these concepts are
measured empirically are presented and critiqued.
Findings – Disagreements about the degree of ?nancial integration and capital mobility are, in part,
explained by the different approaches to measuring these concepts. One major challenge in obtaining a
good measures is controlling for other major factors that may in?uence observed correlations among
?nancial variables. While these relationships still cannot be estimated precisely, it can be safely said
that while high for many countries, few if any ?nancial markets are perfectly integrated across
countries.
Originality/value – By offering a comprehensive analysis of these different measurements, the
paper underscores the different implications for national policies and the operation of the international
monetary system of different dimensions of globalization. In particular, the proposition that ?nancial
globalization has left most countries with little autonomy for domestic monetary policy is subject to
serious debate, at least in the short run.
Keywords Monetary policy, Globalization, International ?nance, Financial markets, Capital controls,
Financial integration, Capital mobility, Interest rate interdependence
Paper type Research paper
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
This paper bene?ted greatly from the research assistance that Puspa Amri, Han Chen,
Yoonmin Kim, and Amy Yuen provided the authors. Clark and Hallerberg thank David Andrews
for useful comments on a related paper entitled “How should political scientists measure
international capital mobility?” The authors thank Angkinand, Eric Chiu, and Levan Efremidze
for their helpful comments but take responsibility for all errors.
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Journal of Financial Economic Policy
Vol. 4 No. 1, 2012
pp. 58-75
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576381211206497
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1. Introduction
The increased globalization of the world economy has had major and in some cases
dramatic effects on the interaction among national economies, the effectiveness of
national economic policies, and the in?uence of global economic and ?nancial
developments on national economies and ?nancial markets. Through international
feedbacks globalization can even in?uence how domestic monetary and ?scal policies
affect the domestic economy. Globalization also has important implications for the
operation of business ?rms and investors.
To better understand these effects and their implications we need to have good
measures of the various aspects of globalization. While many popular discussions
sound as if there has been a dichotomous pre- and post-globalization, this is a gross
oversimpli?cation. Globalization is a matter of degree, not an either/or condition, and
these degrees can vary across different dimensions of globalization as well as across
countries and time.
In this paper, we focus on the measurement of the ?nancial aspects of globalization.
The effects of developments in this area can go far beyond their technical economic and
?nancial aspects. There has been an abundance of research in the last several decades
that investigates how increasing internationalization in its many forms affects
government policies. Many of these analyses either implicitly or explicitly assume that
increasing capital mobility will cause major changes in the capabilities of nation-states.
Governments lose some level of autonomy over policy because the “invisible hand” of
capital movements rewards those states that pursue capital-friendly policies and
punishes those states that favor other factors of production. In most extreme form
some have predicted that “globalization” more generally will ultimately spell the end of
the nation-state as the discipline of international markets replaces the government as
the ultimate policy maker on economic issues (Ohmae, 1995).
At less drastic view is that particular policy options will no longer be available in a
world of increasing economic integration. For example, European social democrats
express concern that greater integration will spell the end of the welfare state.
States with more developed policies to protect workers’ rights will be more expensive
places to locate investments and will lose out on their more Anglo-Saxon competitors
unless they too enact policies more favorable to capital (Sinn, 1994). Still others have
argued that the constraints on government action already exist and are merely
becoming more binding as capital mobility increases (Frieden and Rogowski, 1996).
In the economics literature considerable attention is given to howthe degree of capital
mobility and choice of exchange rate regime affects the strength of monetary and ?scal
policies, how well alternative exchange rate regimes act as automatic macroeconomic
stabilizers in the face of shocks, how economic disturbances are transmitted
internationally, the workability of adjustably pegged exchange rate regimes[1],
the effectiveness of of?cial intervention in the foreign exchange market, the ability of
central banks to sterilize the effects of payments imbalances on the domestic money
supply, and the extent to which it is desirable to coordinate national monetary and ?scal
policies internationally[2].
While there has certainly been a substantial increase in the degree of capital
mobility facing most countries in recent decades, high-capital mobility need not imply
perfect capital mobility. In part because of the mathematical convenience of assuming
perfect capital mobility in open economy models there has been an unfortunate
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tendency to assume that we now live in a world of virtually perfect capital mobility.
The evidence that we review, however, suggests that it is not generally the case. This
in turn has quite important implications for policy. Thus, for example, while it is
accurate to say that US monetary policy can have an important impact on other
countries, it is quite an exaggeration to say, as some have, that the US sets monetary
policy for the world.
The following section offers a brief overview of the development of increased
?nancial globalization in the period after Second World War. Section 3 presents various
concepts of ?nancial openness and interdependence, and their interrelationships. We
then review and critique empirical measures of various aspects of ?nancial
globalization. We ?rst look at savings-investment correlations and their implications.
This is followed by discussions of measures of capital controls and of the magnitudes of
capital ?ows. Section 7 focuses ondifferent measures of interest interdependence. A?nal
section concludes.
2. The development of increased ?nancial globalization
Recent work has identi?ed a number of major sources of the increase in capital
mobility. These include advances in communications and information technologies, the
creation of innovative ?nancial instruments that help facilitate cross border capital
?ows, the removal of legal barriers to trade by national authorities, and the rapid
increase in trade ?ows (Webb, 1991). Since only one of these recognized sources of
capital mobility is under the direct control of policy makers (namely, deregulation) it
seems reasonable to concluded that the levels of capital mobility and ?nancial
integration are largely structural characteristics of the international system (Andrews,
1994; Webb, 1991).
While there is broad consensus that there was a tremendous increase in the degree of
?nancial integration among advanced capitalist nations between the 1960s and the
1980s, it is not clear that this has constituted a stark transition from Frieden’s (1991)
before capital mobility (BCM) world to the after capital mobility (ACM) world[3].
Empirical studies generally ?nd that for advanced and emerging market (EM)
economies capital mobility is high but not perfect. The 1970s were clearly a decade of
transition for the advanced economies. The ?nancing of increase in trade ?ows that
resulted from the reduction of tariff barriers in the 1960s required an almost immediate
increase in capital ?ows. This initial increase in capital ?ows did not require state action
to liberalize capital controls, and in fact the ?ows often occurred despite the best efforts
of governments to curtail them[4]. Webb (1991, p. 309) argues that by 1978 the nature of
the international system had changed to a point where there was a “striking
unwillingness of governments to use trade and capital controls to limit the external
imbalances generated by different macroeconomic politics in different countries”. Akey
development was the breakdown of the Bretton Woods exchange rate system in the
early 1970s. One of the major causes was the increasing capital mobility that “made it
impossible for governments to stabilize exchange rates without subordinating monetary
policy to that end” (Webb, 1991; Gowa, 1983; Odell, 1982).
Large increases in ?ows of ?nancial capital to EM and developing countries not
surprisingly began later than for advanced economies. In the late 1970s and early
1980s this particularly occurred in the form of bank lending to governments. With the
Latin American debt crisis of the 1980s such ?ows came to a screeching halt.
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With the move toward both domestic and international ?nancial liberalization in many
of these countries, large ?nancial ?ows began to re-emerge in the late 1980s and early
1990s. Again these sharply fell off to many regions in the wake of ?nancial and
currency crises in the mid and late 1990s. Since then there have been several periods of
increased ?ows followed by sharp reversals. These have given rise to considerable
policy and research focusing on capital ?ow surges and sudden stops, a topic
addressed by Efremidze et al. (2011) in the ?rst part of this special issue.
3. An overview of the concepts of ?nancial openness and interdependence
The interrelationships among the concepts of ?nancial openness, integration, and
interdependence, and capital mobility and capital ?ows can be confusing. Like trade
openness, there are two major concepts of ?nancial openness. The ?rst and broader
concept refers to howmuch a country is dependent on and/or in?uenced by international
?nancial ?ows. The second and narrower concept refers to a country’s policies. Here
greater openness refers to fewer government imposed constraints such as various forms
of taxes and capital controls. With respect to the latter there is a ?ne and often
ambiguous line between some forms of capital controls and prudential regulation.
Capital mobility is the mechanism that links together countries’ ?nancial markets.
The mobility of ?nancial capital in its technical sense is not identical to the magnitude
of capital ?ows. It refers rather to the quantity of capital that would ?ow in response to
a given change in incentives[5]. Where capital mobility is less than perfect, i.e. ?nancial
markets are less than perfectly integrated, there may be an important time dimension.
Thus, it will sometimes be important to consider not only the magnitude of the full
response but also how quickly it occurs. With fully ef?ciently integrated markets the
response would be instantaneous (or at least very quick).
The major categories of incentives that in?uence ?nancial capital ?ows are interest
rate differentials, expectations of changes in exchange rates, expectations of the
appreciation or depreciation of the prices of stocks and bonds, and perceptions of
political risk[6]. In this paper, we focus primarily on the ?rst two sets of incentives. The
accompanying paper by Li et al. (2012) deals with international ?nancial ?ows
associated with stocks and bonds. These are often lumped together under the heading
of portfolio investment[7].
The actual international movement of capital is the product of the incentives to move
capital and the degree of capital mobility. Thus, a lowlevel of capital ?ows between two
countries does not necessarily indicate that capital mobility between them is low.
Likewise substantial capital ?ows may result from large incentives such as occurred
during episodes of capital ?ight, even though capital mobility is moderate. We should
note that due to the bene?ts of diversi?cation two-way ?ows of capital between
countries can be quite rational. Generally capital mobility refers to changes is net ?ows.
Assumingno riskof default or changes incapital controls, the difference inthe rates of
return between countries on short-term ?nancial investments is the interest rate
differential plus anychange inexchange rates. To protect themselves fromexchange rate
risk international investors often cover themselves by buying forward contracts. This is
calledcoveredinterest arbitrage andresponds tocoveredinterest rate differentials, i.e. the
interest rate differential adjusted for the cost of buying forward cover[8]. If investors do
not buy cover then they are engaging in uncovered interest arbitrage. This is a form
of speculation since investors have an open position in foreign currency. In the language
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of traders it is often misleadingly called risk arbitrage or the carry trade. As will be
discussed in Section 7, it is the existence of uncovered interest rate differentials (i.e. the
interest differential plus the expected change in the exchange rate) that is a valid
indicator of the degree of capital mobility, not the covered differential.
Like ?nancial openness, the degree of ?nancial integration among countries refers
in the broad sense to the degree of capital mobility among them and in the narrower
sense to the degree of government imposed barriers to capital movements. These are
not limited to outright capital controls but can also include differences in regulatory
requirements and tax systems. Discussions of a particular country are generally
phrased in terms of how integrated it is with global ?nancial markets. There are also
frequent discussions of the degree of integration among particular sets of countries
such as the Eurozone.
Technically the degree of ?nancial integration and the degree of ?nancial
interdependence in the broad sense are the same thing. The more integrated are ?nancial
markets, the greater is their interdependence. Note that the degree of interdependence
among different segments of the ?nancial sector can also be an important consideration.
For example, in the recent ?nancial crisis, the problems in the market for securities based
on subprime mortgages in the USA spread both domestically and internationally into
markets for bank credit and money market funds. This type of spread is often called
contagion and will be discussed in the accompanying paper by Li et al. (2012). Non-crises
related interdependence can also be important. An example is how a change in a central
bank’s short-termpolicy rate chains through to effects onthe interest rates on bank loans
or banks’ short-term borrowing from each other.
The degree of international ?nancial interdependence is usually discussed in terms
of how strongly ?nancial developments in one country, including changes in monetary
policy, affect the ?nancial sectors in other countries and vice versa. The degree of
?nancial interdependence is often asymmetric. Generally larger countries will have a
bigger effect on smaller countries than vice versa. Thus, for example, ?nancial
developments in the USA usually have much larger effects on Canada and Mexico than
developments in these countries have on the USA. Thus, even perfect capital mobility
need not imply that the degree of ?nancial interdependence among countries will be the
same. Furthermore, for a given country there may be differences in responsiveness of
capital ?ows to changes in incentives for in?ows versus out?ows, generated for
example by different perceptions of riskiness of home versus foreign investment.
In the extreme many of the concepts coincide. Perfect capital mobility implies full
?nancial openness and market integration. These in turn are closely related to the
concept of exchange market ef?ciency. Simple exchange market ef?ciency assumes that
speculators are risk neutral so that there is no risk premium. This concept of ef?ciency in
both foreign exchange and stock markets are frequently investigated by testing whether
the predictions implied by factors such as interest rate differentials and forward rates
are unbiased predictors of future spot rates. Perfect capital mobility implies rational
expectations and exchange market ef?ciency such that international interest rate
differentials, forward premiums or discounts, and expected changes in exchange rates
are all equal[9]. As noted above, this does not mean that there will always be large capital
?ows, however. For example, there is now often a global component to expectations
about stock and bond prices. This is brought about in part by the anticipation of the
effects of economic developments in some countries on economic activities in other
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countries through the effects on trade ?ows. Thus, news about the outlook for the major
economies in Europe may have a direct expectations effect on equity prices in Asia
without there being a need for any capital ?ows.
The effects of ?nancial interdependence are not limited to effects on ?nancial
markets. The resulting effects on exchange rates, interest rates, and trade ?ows can
have substantial impacts on economic activity in many countries. And in equilibrium
changes in capital ?ows will induce changes in trade balances. This leads to a ?nancial
concept of capital mobility called real capital mobility. This refers to the extent to
which trade or current account balances are affected by the ?ows of ?nancial capital. In
balance of payments equilibrium net capital ?ows and the current account are equal in
magnitude and opposite in sign. A net transfer of resources among countries only
occurs through current account surpluses and de?cits. Thus, for example, capital and
foreign aid ?ows from advanced to low-income economies give rise to net resource
transfers only to the extent that they result in current account imbalances. This is
referred to as the transfer problem; how ?nancial ?ows are converted into ?ows of real
goods and services. This is discussed further in the next section.
Finally there is an important distinction between monetary and ?nancial
integration. Monetary integration is a very different type of concept which refers to
the uni?cation of exchange rates through various forms of ?xed exchange rates such
as the formation of common currency areas such as the Eurozone. A high level of
capital mobility (?nancial integration) is often considered one of the important criteria
for determining how well a common currency area would work, although this view has
been the subject of criticism[10]. Monetary interdependence is more directly related to
the measures discussed in this paper and refers to the degree to which changes
in monetary policy in one country affects the exchange rate and monetary conditions in
other countries. Thus, it is a subset of ?nancial interdependence.
4. Savings-investment correlations
In contrast to those scholars who argue that capital became much more mobile sometime
in the mid-1970s, many studies employing the savings-investment correlation approach
concluded that capital remained immobile at the systemic level. Feldstein and Horioka
(1980) popularized this approach which has spurred a vast literature on, ?rst, whether or
not such correlations exist, and second, what the implications are.
The original Feldstein-Horioka argument is quite simple: savings will be invested in
whatever place it can receive the highest rate of return. When capital is perfectly
immobile, domestic savings fully determine the level of domestic investment[11]. There
is no other way to ?nance the investment in real terms. In contrast, when capital is
completely mobile, an increase in savings in a given country should not necessarily
result in any additional domestic investment because that money can go abroad without
cost. Similarly, domestic investments will not depend ondomestic savings because ?rms
that need funds can easily get them on world capital markets. Feldstein and Horioka
therefore presume that, in a world of perfect capital mobility, the correlation between a
country’s saving and investment should be equal to zero, while in the world of perfect
capital immobility the correlation should be exact at one. Of course we would generally
expect capital mobility to lie between these extremes with increases in capital mobility
reducing the correlation.
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A system-wide measure of capital mobility can be created by regressing domestic
investment on domestic savings (country-speci?c correlations can also be estimated):
I
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S
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i
where b
1
is an indicator of capital mobility in the system such that capital is perfectly
immobile when it equals one and perfectly mobile when it equals zero. Feldstein and
Horioka ?nd a coef?cient of close to 0.9 for the sample period 1960-1974. This strongly
suggests that capital was not very mobile in real terms. Feldstein and Bacchetta (1991)
updated the study to the immediate years after the collapse of the Bretton Woods
system (1974-1986), and ?nd an almost identical coef?cient.
The use of savings investment coef?cients as an indicator for capital mobility has
been criticised (Schuler and Heinemann, 2002)[12]. Since both savings and investment
are pro-cyclical, estimates of the relationship between them may be biased upward.
Second, because world interest rates are likely to be in?uenced by changes in the
savings rates of large countries, the assumption that capital mobility will lead to a
substantial decoupling of domestic investment from domestic savings need not hold
for large countries[13].
The correlations may also be in?uenced by the pattern of shocks that hit. This is also
a major problem with measures that focus on co-variations of interest rates and stock
prices. Feldstein and Horioka were well aware of the pro-cyclicality issue and sought to
ameliorate it by averaging savings and investment over a suf?ciently long period to
remove the cyclical component. It is useful to consider the correlations over time. The
period before First World War is considered to be one of high-capital mobility, and,
consistent with expectations. Bayoumi (1990) ?nds no correlation between savings and
investment for the period 1880-1913. Obstfeld’s (1995, p. 250) conclusion for this period is
broadly similar. He also analyzes the period 1926-1938 when capital mobility was
expected to be lowand ?nds a coef?cient that is statistically indistinguishable fromone.
Frankel (1986, 1993) suggests that a reason for the high relations during periods
considered to have high-?nancial mobility. He argues that the high correlations re?ect
more the lower levels of integration of goods markets than of ?nancial markets. This
makes sense since it is imbalances in current accounts that generate transfers of real
resources that allow real domestic investment to differ from real domestic savings.
This is the concept of real capital mobility discussed in Section 3. There is clear
evidence that goods markets generally adjust more slowly than ?nancial markets and
this makes good economic sense based on relative costs of adjustment.
In general the estimates of capital mobility based on savings-investment correlations
?nd a lower increase in capital mobility than is suggested by observations that by the
late 1960s and early 1970s the mobility of short termcapital had risen greatly. Efforts to
maintain the Bretton Woods type adjustable pegs had become quite dif?cult because of
the sizes of the funds that ?owed when exchange rate parities became widely viewed in
the private markets as being substantially over or under valued – the famous one-way
speculative option. Here we see the importance of different types of measures for
different purposes. While real capital mobility was fairly low, ?nancial capital mobility
was suf?ciently high to help bring down the Bretton Woods system.
A somewhat similar type of approach to that of savings-investment correlations
focuses on the extent to which consumption co-moves between countries.
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This approach was pioneered by Obstfeld (1989). The intuition behind tests of
consumption correlations (international risk sharing) is that ?nancial openness ought
to afford individuals the opportunity to smoothen consumption over time as they can
borrow and lend on international ?nancial markets. Thus, consumption in any one
country should co-move less with income over time, and, if preferences are similar,
consumption should be correlated across countries[14]. Such measures are subject to
objections similar to those raised against the savings-investment correlations, the most
important being that the correlations will be in?uenced by the pattern of shocks in
addition to the degree of capital mobility. Again they often suggest lower levels of
capital mobility than studies that focus directly on the behavior of ?nancial ?ows.
5. Capital controls
Perhaps the most popular method to measure capital mobility across countries in
empirical work is to look at the restrictions governments place on capital in?ows and
out?ows. The reliability of such data relies on several assumptions – that
governments can regulate capital ?ows; that they are equally enforced from country to
country; that their effectiveness does not change in the time period for which they are
examined; and that the relevant measures are included in the data analysis while the
omitted measures are not. Findings that capital controls have no signi?cant impact on
economic growth, for example, may be just as interesting as results that indicate that
their use is correlated with the degree of independence of the central banks[15]. Their
very presence raises interesting questions. For example, why do some states adopt
them while others do not? Likewise the relationships between capital controls and
currency crises have generated considerable interest. While one frequently mentioned
argument for capital controls is to reduce the incidence of currency crises, several
studies have found a positive association between capital controls and crises. More
recent work on controls on capital out?ows versus in?ows ?nds a positive association
for controls on out?ows but a negative effect of controls on in?ows[16].
The earliest studies on the effects of capital controls used dichotomous measures that
simply indicated whether countries hadanyformof restrictions ontheir capital accounts
based on data published by the International Monetary Fund (IMF) since 1950 in
“Exchange arrangements and exchange restrictions”. Such studies proved to be of quite
limited value since almost all of the interesting questions about the effects of controls
depend on the extent and intensity of their coverage, not just whether there are any
controls or not.
There are also questions of whether control measures should be limited to capital
account items or also include restrictions on payments for current account transactions.
To deal with these problems several large data sets have been compiled which provide
more graduated measures. One type pioneered by Quinn (1997, 2003) develops measures
of the degree of tightness on intensity of capital controls. Another type developed by
researchers at the IMF, most recently (Schindler, 2009), looks at the breath of coverage of
capital controls[17]. Unfortunately there have been only limited attempts to combine
these two approaches for large data sets. An exception is Potchamanawong et al. (2008).
One large data set that has become quite popular has been constructed by Chinn
and Ito (2008). This is based on calculations of the principal components of several sub
measures of capital controls. The rationale for using principal components in this
context is not clear, however.
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Studies that compare the measures from these new data sets with detailed
qualitative studies of the history of capital controls for particular countries often ?nd
substantial failures of the large N measures to capture important changes in control
programs. For example, while one of the standard explanations for the generation of
the Asian crisis in 1997-1998 was substantial liberalization of capital accounts without
suf?cient regulatory supervision many of the major data sets code these years for the
Asian economies as having high levels of capital controls (Willett et al., 2005). For more
recent analyses along these lines for India and Korea, see Ghosh (2011) and Willett et al.
(2009). Thus, we conclude that while recent large N data sets on capital controls have
improved substantially, they are still far from the levels of accuracy that would be
desirable (for more detailed analysis of the different capital measures and the uses to
which they have been put see Potchamanawong et al. (2008) and the section on capital
controls on the CIEPS web site (www.cgu.edu/pages/1380.asp).
6. Actual stocks and ?ows of capital
While capital account restrictions tell us something about government behavior,
capital ?ows and stock tell us about the behavior of investors (Rajan et al., 2003). While
there is merit in examining actual movements of cross-border capital ?ows, especially
when analyzing particular episodes, these have limitations as measures of ?nancial
integration. As noted in Section 3, a country that is highly integrated with international
capital markets – in the sense of there being no signi?cant difference in domestic and
international rates of return – may experience little if any international portfolio
capital ?ows (at least debt related ?ows).
While there has been a tendency of researchers to focus on net ?ows for some
purposes it is important to look at both in?ows and out?ows. For example, when
looking at capital ?ow surges and sudden stops this is crucial (see Efremidze et al.,
2011 in part one of this special issue). Recent work has focused instead on capital
stocks that countries have, which in practice estimate gross stocks of foreign assets
and liabilities as a percent of GDP. Lane and Milesi-Ferretti (2007) have the most
comprehensive dataset, covering 145 countries over the time period 1970-2004.
Beginningwiththe Organizationfor Economic Co-operationandDevelopment (OECD)
countries where there are data for most countries, Quinn’s data indicate a steadydecline in
the use of capital controls, with the pace picking up in the late 1980s. The Lane and
Milesi-Ferretti data, in contrast, has a U-shaped curve. Foreign assets and liabilities
averaged about 40 percent of GDP in 1970, and, after collapsing in the mid-1970s, did not
reach the 1970 level again until the late 1990s. Patterns in Latin and Central America are
different – capital restrictions increase steadilyfromthe 1950s through 1980, thenreverse
but generally remain in place. The 1990s see a rapid repudiation of capital controls, with
both Latin and Central America reaching OECD levels by 1998. In terms of assets and
liabilities, data are more limited, but the trend indicates a jump in the late 1990s.
7. Measures of interest rate interdependence
The most straight forward way to test for whether ?nancial markets are fully
integrated, i.e. capital mobility between them is perfect, is to investigate whether there
are unexploited pro?t opportunities for moving funds from one to the other. We can
also adapt this approach to studying how strongly interest rate changes in one country
affect those in other countries, i.e. the degree of their ?nancial interdependence.
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The starting point for such analyses are the interest rate parity conditions. The
basic intuition behind parity conditions is that in perfectly integrated ?nancial
markets, arbitrage equalizes the prices of identical assets, i.e. the law of one price holds.
Hence we could, in principle, use measures of interest rate interdependence as an
indicator of the degree of ?nancial integration between markets.
Fully ef?cient risk-neutral markets would be fully integrated and there would be no
abnormal pro?t opportunities for arbitrage between them. There are many tests for
?nancial and foreign exchange market ef?ciency. These generally look for whether
there are predictable patterns in variables that provide pro?t opportunities. A strong
disadvantage of many of these types of tests from the standpoint of measuring
?nancial interdependence is that they have a zero-one nature and do not provide
measures of the degree of imperfect capital mobility.
Using measures of the degree to which interest rates in one market are affected by
changes in another has the advantage of giving us a metric of the degree
of interdependence running from one when the adjust is full to zero when there is no
interdependence.
Interest rates may differ between countries for a host of reasons besides imperfect
capital mobility. Examples are different rates of in?ation and expected changes in the
exchange rate, various risk premia, and different types of shocks. Thus, it is important
to add a number of controls when estimating such relationships.
A convenient starting point to understand the conditions under which the interest
rates of two countries may differ is the interest rate parity condition:
R
t
¼ R
f
t
þ E
t
ðs
tþn
2s
t
Þ þ rp
t
ð7:1Þ
where R
t
is the domestic nominal interest rate, R
f
t
is the foreign (“base”) nominal
interest rate, s
t
is the current spot rate (exchange rate is in logs)[18], and rp
t
is a risk
premium re?ected in the difference between the forward rate and the expected future
spot rate. Both the expected exchange rate and the risk premium are unobservable, in
general, and we therefore have to use proxies for them.
The two most commonly used interest parity conditions are covered interest rate
parity (CIP) condition and uncovered parity (UIP)[19]. CIP basically states that
the difference between the current spot rate and the forward rate will equal the interest
rate differential between similar assets measured in local currencies:
R
t
¼ R
f
t
þ ð f
tþn
2s
t
Þ ð7:2Þ
where f is the (log of the) forward exchange rate.
The nexus between the UIP and the CIP is apparent by decomposing equation (7.2).
Following Frankel (1991):
R
t
2R
f
t
2E
t
ðs
tþn
2s
t
Þ ¼ ½R
t
2R
f
t
2ð f
tþn
2s
t
Þ? þ ð f
tþn
2E
t
s
tþn
Þ ð7:3Þ
where the ?rst bracketed term on the right hand side is the CIP (sometimes referred to
as country or political risk premium) and the second term is the currency risk premium.
CIP must hold if UIP holds but not vice versa. If CIP holds but UIP is rejected, this
implies that forward rates are biased predictors of future spot rates. This can be caused
by risk premia or by inef?cient speculation. Not surprisingly CIP is found to hold much
more often than UIP.
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The extent to which CIP holds is often, but incorrectly, taken as an indicator of the
degree of capital mobility. The failure of CIP to hold a good indicator but due to risk
aversion it can hold even when capital mobility is low (Willett et al., 2002). UIP does not
suffer from this problem and the extent to which it holds is the appropriate measure of
the degree of capital mobility. In change form it can be used as a valuable indicator of
how changes in interest rates in one country affect those in other countries, i.e. of their
degree of ?nancial interdependence.
7.1 The uncovered interest parity condition
Thus, UIP has become popular as a tool of measuring monetary policy independence
(Frankel et al., 2004; Shambaugh, 2004). As indicated in Table I, we would expect UIP
to hold better with credibly ?xed exchange rates and the absence of capital controls.
ObstfeldandTaylor (2004, pp. 185-6) ?ndsupportive evidence of the suggestedpatterns
in the table when comparing the slope coef?cient and exchange rate classi?cations using a
panel of countries over long periods of time with various switches in regimes.
One dif?culty in using the UIP equation is that it relies on an unobservable variable:
the expected future exchange rate. There are there common speci?cations for the
expected change in the exchange rate based on the behavior of exchange rates:
.
Perfect foresight.
.
Extrapolative expectations.
.
Static expectations.
No one of these is unambiguously best so it is important to test for the sensitivity of
estimates to all three proxies. In some cases survey data of expectations have been
available (Frankel and Froot, 1989).
Testing seems, at ?rst, straightforward. Consider the following thought experiment
involving a sample of East Asiancountries: assume that there were fewer capital controls
or that there was more capital mobility for the post Asian Financial Crisis period than
before. In such a situation, we would expect those countries that opted more towards a
?oating (?xed) exchange rate regime to show a smaller (larger) slope coef?cient than
before the crisis. On the other hand, we would expect, if nothing else, no change in the
slope for countries that stayed in the same exchange rate regime (Keil, 2011).
While looking at the extent UIP holds is conceptually the most appropriate measure
of the extent of ?nancial integration, for many policy issues one of the most important
policy questions involves how changes in monetary policy in one country affect other
countries, i.e. how great is the degree of ?nancial interdependence. For this purpose,
the most relevant approach is to estimate how much policy induced changes in interest
Peg (?x) Non-peg (?oat)
Free (more) capital mobility
or (less or) no capital
controls
No independent monetary policy
(b
1
closer to 1; highest value)
More independent monetary policy
(b
1
closer to 0; second highest
value)
No (less) capital mobility or
(more) capital controls
More independent monetary policy
(b
1
closer to 0; second lowest
value)
More independent monetary policy
(b
1
closer to 0; lowest value)
Table I.
Closeness of interest
rate co-movements
and policy regimes
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rates in one country affect the interest and exchange rates of other countries. Note that
these relationships will often be asymmetric: changes in interest rates in Japan should
have a bigger effect on Taiwan than vice versa.
As with estimates of UIP in general, a major dif?culty in such estimation is adjusting
suf?ciently for the other factors that may in?uence interest rate correlations across
countries. The correlations between the interest rates of two smaller economies may
re?ect more the in?uence of global monetary conditions affecting both rather than direct
?nancial interdependence between the two. It is often argued that this is the case among
many Asian economies. Thus, one needs to control for global interest rates (Keil, 2011).
Moreover, changing levels of in?ation rates can also be an important factor. It is
easy to transform the UIP speci?cation into a relationship between the respective
in?ation rates, as long as the differences between real interest rates does not vary
greatly. As a result, UIP results can be driven by in?ation rate convergence which has
been observed at different periods across countries in the past (Keil, 2011).
Matters become even more complicated when adjustments are not instantaneous
and dynamics must be taken into account. There are also questions about whether the
moments of the probability distributions of in?ation and interest rates remain
invariant over time[20]. Given these problems it is not surprising that estimates of this
type are often quite unstable. Thus, at this point we should not give great weight to
any one particular set of estimates.
8. Concluding remarks
Given the wide variety of approaches to estimating capital mobility and the degree of
?nancial interdependence it is not surprising that there is so much disagreement
among economists on these questions. As noted a major dif?culty is in trying to control
for the major factors other than direct ?nancial interdependence that may in?uence the
correlations among ?nancial variables such as interest rates. The better job we can do
in controlling for such factors, the more reliable our estimates will become. For now we
do not have the consistency of results necessary for us to have con?dence in anything
like precise estimates of the degree of ?nancial interdependence among different sets of
countries. This does not mean that we do not know anything, however or that there is
not a great deal more highly productive research that can be done.
We can be highly con?dent that for most countries the level of capital mobility has
been much in the last decades of the twentieth century and early twenty-?rst century
than in the ?rst few decades after the establishment of the Bretton Woods international
monetary system at the end of Second World War. We can also safely say that while
high for many countries and close to perfect among the offshore Eurocurrency
markets, few if any ?nancial markets are perfectly integrated across countries.
Consequently, most countries have some scope to sterilize the monetary effects of
international ?nancial ?ows, at least in the short-run.
We should also note that there are many important aspects of international ?nancial
?ows beyond the extent to which they are integrated. For example, we have learned from
sad experience that international ?nancial markets have often been too trusting and
failed to give strong early warning signs of growing ?nancial problems (Willett, 2000).
The Asian, Argentine, US subprime, and Euro crises give vivid examples.
Likewise there is much to learn about the causes of the sudden stops of ?nancial
?ows (Efremidze et al., 2011).
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Notes
1. The higher is capital mobility the greater is the problem of the one-way speculative option
under pegged exchange rates.
2. The relationships of these issues to the degree of capital mobility are covered in almost any
text on international economics or international money and ?nance. Underlying many of
these relationships is the trilemma or impossible trinity which shows that over the long run
countries cannot have all three of ?xed exchange rates, no controls, and independent
monetary policy. With imperfect capital mobility, however, all three may be pursued in the
short run. Government efforts to continue violated the trilemma constraints for too long are a
frequent cause of currency crises (Willett, 2007). For empirical estimates of these
relationships see Aizenman et al. (2010).
3. The acronyms used here are borrowed from Frieden (1991). See Frieden (1991), Webb (1991,
1995), Andrews (1994), and Cohen (1993) on the timing and signi?cance of the increase in
capital mobility.
4. Webb (1995, p. 336, no. 80) cites a 1973 Bundesbank report that recent experience had “made
it abundantly clear that even stronger administrative action against capital ?ows from
foreign countries [. . .] does not suf?ce when speculative expectations run particularly high”.
Similarly, Cohen (1993) argues that “restrictions merely invite more and more sophisticated
forms of evasion, as governments from Europe to South Asia to Latin America have learned
to their regret”.
5. In the 1960s and 1970s, it was popular to estimate capital ?ow equations where the
coef?cients on interest rate variables would give measures of the degree of capital mobility
(Branson, 1968). This type of study has gone out of fashion but a close analog is frequently
estimated today, however. Here an “offset coef?cient” is estimated which measures the
extent to which an autonomous change in the domestic monetary base is offset by
international capital ?ows. This provides a continuous measure between zero and one where
zero implies no offset. This approach is discussed in the accompanying paper by Willett et al.
(2011) on currency policies.
6. Credit risk refers to the possibility that debtors will not be able to meet their obligations such as
occurred with Lehman Brothers during the US subprime crisis. Political risk refers to the
possibility that governments may impose policies such as capital controls or nationalization
that impede repayments. The combinationof these two types of risks is oftencalledcountryrisk.
7. Direct investment responds to expected pro?t opportunities to lower costs and/or raise
revenue and is not directly covered in these papers. However, greater direct investment as
with the activities of multinational corporations more generally tend to increase the degree of
?nancial capital mobility through the ?nancing and hedging activities of these corporations.
8. Note that forward exchange may sell at either a premium or a discount relative to spot rates.
Thus, if the forward pound is selling at a premium relative to the dollar, then the forward
dollar is selling at a discount relative to the pound. The covered interest differential is zero
when this premium or discount just offsets the difference in interest rates. The true net cost
of forward cover is the transactions cost which usually occurs in the form of the spread
between buying and selling rates.
9. A second concept of market ef?ciency allows for the possibility of risk premia which in turn
implies that interest rate differentials and forward rates can be biased predictors of future
spot rates even in ef?cient markets. While many efforts have been made it is not an easy
matter to distinguish what proportion of biased prediction are due to risk premia versus
biased expectations are dif?cult to determine, although this does not keep some experts from
having strongly held views on the subject.
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10. These criteria are discussed in the literature on optimum currency areas, a key conclusion of
which is that the relative costs and bene?ts of monetary integration vary systematically
across countries so that there is no one exchange rate regime that is best for all currencies.
For recent discussion and references to the literature see Willett (2003).
11. Note that domestic savings are the combination of private savings plus net public savings
which will be positive if the government is running a budget surplus and negative if it is
running a de?cit.
12. A few authors have also questioned what the exact nature of the savings-investment
correlations is. Frankel (1986, 1993) in particular argues that the correlation indicates the low
integration of material goods markets instead of capital markets.
13. See, among others, Harberger (1980).
14. A weaker form of risk sharing states that the degree of cross-country consumption
co-movements exceeds that of output co-movements.
15. Both results are reported in Alesina et al. (1994). Using a more comprehensive measure,
however, Quinn (2003) ?nds a negative association of controls with growth.
16. See the analysis and references in Chiu and Willett (2011) and Potchamanawong et al. (2008).
17. There are numerous studies that develop more re?ned measures for individual countries or
small group of countries. See, for example, Ghosh (2011).
18. Throughout this section the exchange rate is quoted as the domestic price of foreign
currency. Properly, we should set up the relationship as
ð1 þ R
t
Þ ¼ ð1 þ R
f
t
Þ £ ððE
t
ðS
tþn
ÞÞ=S
t
Þ £ ð1 þ rp
t
Þ. Taking logs this results approximately
in equation (7.1).
19. There are two additional arbitrage conditions which we will not consider in detail here: the
real interest rate parity (RIP) condition and the closed interest parity condition. The RIP
combines UIP and purchasing power parity together with the Fisher equation to yield
equality of the respective real interest rates (Obstfeld and Taylor, 2004; Meese and Rogoff,
1988; Edison and Pauls, 1993). The closed interest parity condition states that the returns on
identical instruments of the same currency but traded in different markets (such as onshore
and offshore markets) should be equalized (Obstfeld, 1998; Frankel and Okongwu, 1996).
20. Discussion of these issues becomes rather technical. Shambaugh (2004) and Frankel et al.
(2004) are a good starting point for the interested reader. A longer version of this paper,
which is placed on our web site, deals with these issues in more detail.
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No. 577, Instituto de Pesquisa Econoˆmica Aplicada (IPEA), Brasilia.
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results based on survey data”, The Manchester School, Vol. 57 No. 2, pp. 142-53.
About the authors
William R. Clark is Professor of Political Science at College of Literature, Arts and Sciences at the
University of Michigan, Ann Arbor. Much of his research work has focused on the effect of
central bank independence, capital mobility, and ?xed exchange rates on monetary and ?scal
policy choices made by survival-maximizing incumbents and the choice of monetary institutions
in a world of mobile capital.
Mark Hallerberg teaches Public Management and Political Economy at the Hertie School of
Governance in Berlin. He also maintains an af?liation with the Political Science Department at
Emory University, Atlanta. He has published over 25 articles and book chapters on ?scal
governance, tax competition, exchange rate choice, and European politics. He has held academic
positions previously at Emory University, the University of Pittsburgh, and the Georgia Institute
of Technology.
Manfred Keil is Associate Professor of Economics at the Robert Day School of Economics and
Finance, Claremont McKenna College. He also teaches at Claremont Graduate University. His
areas of expertise are banking, comparative economic performance, macroeconomics, and
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statistics and he has published numerous articles in these topics in refereed journals. Having
taught various courses on Econometrics, including at the Central Banks of Zambia and Malawi,
he has also published a Testbank to accompany Introduction to Econometrics textbook by James
Stock and Mark Watson.
Thomas D. Willett is the Horton Professor Economics and Director of the Claremont Institute
for Economic Studies in the Department of Economics, Claremont Graduate University and
Claremont McKenna College. A former Deputy Assistant Secretary of the Treasury for
International Research, he is the author or co-author of nine books, over 200 articles in journals
and the editor of 18 books. His previous teaching appointments include Cornell University and
Harvard University. Thomas D. Willett is the corresponding author and can be contacted at:
[email protected]
Financial
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This article has been cited by:
1. Abdullah Noman, Mohammad Nakibur Rahman, Atsuyuki Naka. 2015. Portfolio investment outflow and
the complementary role of direct investment. Journal of Financial Economic Policy 7:3, 190-206. [Abstract]
[Full Text] [PDF]
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doc_764133111.pdf
The purpose of this paper is to review concepts and measurements related to financial
globalization such as financial openness, financial integration, monetary interdependence, and the
mobility and movement of capital
Journal of Financial Economic Policy
Measures of financial openness and interdependence
William R. Clark Mark Hallerberg Manfred Keil, Thomas D. Willett
Article information:
To cite this document:
William R. Clark Mark Hallerberg Manfred Keil, Thomas D. Willett, (2012),"Measures of financial openness
and interdependence", J ournal of Financial Economic Policy, Vol. 4 Iss 1 pp. 58 - 75
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Linyue Li, Nan Zhang, Thomas D. Willett, (2012),"Measuring macroeconomic and financial market
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Measures of ?nancial openness
and interdependence
William R. Clark
University of Michigan, Ann Arbor, Michigan, USA
Mark Hallerberg
Hertie School of Governance, Berlin, Germany and Emory University,
Atlanta, Georgia, USA
Manfred Keil
Claremont McKenna College & Claremont Graduate University, Claremont,
California, USA, and
Thomas D. Willett
Claremont Graduate University & Claremont McKenna College &
Claremont Institute for Economic Policy Studies, Claremont, California, USA
Abstract
Purpose – The purpose of this paper is to review concepts and measurements related to ?nancial
globalization such as ?nancial openness, ?nancial integration, monetary interdependence, and the
mobility and movement of capital.
Design/methodology/approach – This paper surveys the theoretical and empirical literature on
monetary interdependence and ?nancial globalization. The major ways in which these concepts are
measured empirically are presented and critiqued.
Findings – Disagreements about the degree of ?nancial integration and capital mobility are, in part,
explained by the different approaches to measuring these concepts. One major challenge in obtaining a
good measures is controlling for other major factors that may in?uence observed correlations among
?nancial variables. While these relationships still cannot be estimated precisely, it can be safely said
that while high for many countries, few if any ?nancial markets are perfectly integrated across
countries.
Originality/value – By offering a comprehensive analysis of these different measurements, the
paper underscores the different implications for national policies and the operation of the international
monetary system of different dimensions of globalization. In particular, the proposition that ?nancial
globalization has left most countries with little autonomy for domestic monetary policy is subject to
serious debate, at least in the short run.
Keywords Monetary policy, Globalization, International ?nance, Financial markets, Capital controls,
Financial integration, Capital mobility, Interest rate interdependence
Paper type Research paper
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
This paper bene?ted greatly from the research assistance that Puspa Amri, Han Chen,
Yoonmin Kim, and Amy Yuen provided the authors. Clark and Hallerberg thank David Andrews
for useful comments on a related paper entitled “How should political scientists measure
international capital mobility?” The authors thank Angkinand, Eric Chiu, and Levan Efremidze
for their helpful comments but take responsibility for all errors.
JFEP
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Journal of Financial Economic Policy
Vol. 4 No. 1, 2012
pp. 58-75
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576381211206497
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1. Introduction
The increased globalization of the world economy has had major and in some cases
dramatic effects on the interaction among national economies, the effectiveness of
national economic policies, and the in?uence of global economic and ?nancial
developments on national economies and ?nancial markets. Through international
feedbacks globalization can even in?uence how domestic monetary and ?scal policies
affect the domestic economy. Globalization also has important implications for the
operation of business ?rms and investors.
To better understand these effects and their implications we need to have good
measures of the various aspects of globalization. While many popular discussions
sound as if there has been a dichotomous pre- and post-globalization, this is a gross
oversimpli?cation. Globalization is a matter of degree, not an either/or condition, and
these degrees can vary across different dimensions of globalization as well as across
countries and time.
In this paper, we focus on the measurement of the ?nancial aspects of globalization.
The effects of developments in this area can go far beyond their technical economic and
?nancial aspects. There has been an abundance of research in the last several decades
that investigates how increasing internationalization in its many forms affects
government policies. Many of these analyses either implicitly or explicitly assume that
increasing capital mobility will cause major changes in the capabilities of nation-states.
Governments lose some level of autonomy over policy because the “invisible hand” of
capital movements rewards those states that pursue capital-friendly policies and
punishes those states that favor other factors of production. In most extreme form
some have predicted that “globalization” more generally will ultimately spell the end of
the nation-state as the discipline of international markets replaces the government as
the ultimate policy maker on economic issues (Ohmae, 1995).
At less drastic view is that particular policy options will no longer be available in a
world of increasing economic integration. For example, European social democrats
express concern that greater integration will spell the end of the welfare state.
States with more developed policies to protect workers’ rights will be more expensive
places to locate investments and will lose out on their more Anglo-Saxon competitors
unless they too enact policies more favorable to capital (Sinn, 1994). Still others have
argued that the constraints on government action already exist and are merely
becoming more binding as capital mobility increases (Frieden and Rogowski, 1996).
In the economics literature considerable attention is given to howthe degree of capital
mobility and choice of exchange rate regime affects the strength of monetary and ?scal
policies, how well alternative exchange rate regimes act as automatic macroeconomic
stabilizers in the face of shocks, how economic disturbances are transmitted
internationally, the workability of adjustably pegged exchange rate regimes[1],
the effectiveness of of?cial intervention in the foreign exchange market, the ability of
central banks to sterilize the effects of payments imbalances on the domestic money
supply, and the extent to which it is desirable to coordinate national monetary and ?scal
policies internationally[2].
While there has certainly been a substantial increase in the degree of capital
mobility facing most countries in recent decades, high-capital mobility need not imply
perfect capital mobility. In part because of the mathematical convenience of assuming
perfect capital mobility in open economy models there has been an unfortunate
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tendency to assume that we now live in a world of virtually perfect capital mobility.
The evidence that we review, however, suggests that it is not generally the case. This
in turn has quite important implications for policy. Thus, for example, while it is
accurate to say that US monetary policy can have an important impact on other
countries, it is quite an exaggeration to say, as some have, that the US sets monetary
policy for the world.
The following section offers a brief overview of the development of increased
?nancial globalization in the period after Second World War. Section 3 presents various
concepts of ?nancial openness and interdependence, and their interrelationships. We
then review and critique empirical measures of various aspects of ?nancial
globalization. We ?rst look at savings-investment correlations and their implications.
This is followed by discussions of measures of capital controls and of the magnitudes of
capital ?ows. Section 7 focuses ondifferent measures of interest interdependence. A?nal
section concludes.
2. The development of increased ?nancial globalization
Recent work has identi?ed a number of major sources of the increase in capital
mobility. These include advances in communications and information technologies, the
creation of innovative ?nancial instruments that help facilitate cross border capital
?ows, the removal of legal barriers to trade by national authorities, and the rapid
increase in trade ?ows (Webb, 1991). Since only one of these recognized sources of
capital mobility is under the direct control of policy makers (namely, deregulation) it
seems reasonable to concluded that the levels of capital mobility and ?nancial
integration are largely structural characteristics of the international system (Andrews,
1994; Webb, 1991).
While there is broad consensus that there was a tremendous increase in the degree of
?nancial integration among advanced capitalist nations between the 1960s and the
1980s, it is not clear that this has constituted a stark transition from Frieden’s (1991)
before capital mobility (BCM) world to the after capital mobility (ACM) world[3].
Empirical studies generally ?nd that for advanced and emerging market (EM)
economies capital mobility is high but not perfect. The 1970s were clearly a decade of
transition for the advanced economies. The ?nancing of increase in trade ?ows that
resulted from the reduction of tariff barriers in the 1960s required an almost immediate
increase in capital ?ows. This initial increase in capital ?ows did not require state action
to liberalize capital controls, and in fact the ?ows often occurred despite the best efforts
of governments to curtail them[4]. Webb (1991, p. 309) argues that by 1978 the nature of
the international system had changed to a point where there was a “striking
unwillingness of governments to use trade and capital controls to limit the external
imbalances generated by different macroeconomic politics in different countries”. Akey
development was the breakdown of the Bretton Woods exchange rate system in the
early 1970s. One of the major causes was the increasing capital mobility that “made it
impossible for governments to stabilize exchange rates without subordinating monetary
policy to that end” (Webb, 1991; Gowa, 1983; Odell, 1982).
Large increases in ?ows of ?nancial capital to EM and developing countries not
surprisingly began later than for advanced economies. In the late 1970s and early
1980s this particularly occurred in the form of bank lending to governments. With the
Latin American debt crisis of the 1980s such ?ows came to a screeching halt.
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With the move toward both domestic and international ?nancial liberalization in many
of these countries, large ?nancial ?ows began to re-emerge in the late 1980s and early
1990s. Again these sharply fell off to many regions in the wake of ?nancial and
currency crises in the mid and late 1990s. Since then there have been several periods of
increased ?ows followed by sharp reversals. These have given rise to considerable
policy and research focusing on capital ?ow surges and sudden stops, a topic
addressed by Efremidze et al. (2011) in the ?rst part of this special issue.
3. An overview of the concepts of ?nancial openness and interdependence
The interrelationships among the concepts of ?nancial openness, integration, and
interdependence, and capital mobility and capital ?ows can be confusing. Like trade
openness, there are two major concepts of ?nancial openness. The ?rst and broader
concept refers to howmuch a country is dependent on and/or in?uenced by international
?nancial ?ows. The second and narrower concept refers to a country’s policies. Here
greater openness refers to fewer government imposed constraints such as various forms
of taxes and capital controls. With respect to the latter there is a ?ne and often
ambiguous line between some forms of capital controls and prudential regulation.
Capital mobility is the mechanism that links together countries’ ?nancial markets.
The mobility of ?nancial capital in its technical sense is not identical to the magnitude
of capital ?ows. It refers rather to the quantity of capital that would ?ow in response to
a given change in incentives[5]. Where capital mobility is less than perfect, i.e. ?nancial
markets are less than perfectly integrated, there may be an important time dimension.
Thus, it will sometimes be important to consider not only the magnitude of the full
response but also how quickly it occurs. With fully ef?ciently integrated markets the
response would be instantaneous (or at least very quick).
The major categories of incentives that in?uence ?nancial capital ?ows are interest
rate differentials, expectations of changes in exchange rates, expectations of the
appreciation or depreciation of the prices of stocks and bonds, and perceptions of
political risk[6]. In this paper, we focus primarily on the ?rst two sets of incentives. The
accompanying paper by Li et al. (2012) deals with international ?nancial ?ows
associated with stocks and bonds. These are often lumped together under the heading
of portfolio investment[7].
The actual international movement of capital is the product of the incentives to move
capital and the degree of capital mobility. Thus, a lowlevel of capital ?ows between two
countries does not necessarily indicate that capital mobility between them is low.
Likewise substantial capital ?ows may result from large incentives such as occurred
during episodes of capital ?ight, even though capital mobility is moderate. We should
note that due to the bene?ts of diversi?cation two-way ?ows of capital between
countries can be quite rational. Generally capital mobility refers to changes is net ?ows.
Assumingno riskof default or changes incapital controls, the difference inthe rates of
return between countries on short-term ?nancial investments is the interest rate
differential plus anychange inexchange rates. To protect themselves fromexchange rate
risk international investors often cover themselves by buying forward contracts. This is
calledcoveredinterest arbitrage andresponds tocoveredinterest rate differentials, i.e. the
interest rate differential adjusted for the cost of buying forward cover[8]. If investors do
not buy cover then they are engaging in uncovered interest arbitrage. This is a form
of speculation since investors have an open position in foreign currency. In the language
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of traders it is often misleadingly called risk arbitrage or the carry trade. As will be
discussed in Section 7, it is the existence of uncovered interest rate differentials (i.e. the
interest differential plus the expected change in the exchange rate) that is a valid
indicator of the degree of capital mobility, not the covered differential.
Like ?nancial openness, the degree of ?nancial integration among countries refers
in the broad sense to the degree of capital mobility among them and in the narrower
sense to the degree of government imposed barriers to capital movements. These are
not limited to outright capital controls but can also include differences in regulatory
requirements and tax systems. Discussions of a particular country are generally
phrased in terms of how integrated it is with global ?nancial markets. There are also
frequent discussions of the degree of integration among particular sets of countries
such as the Eurozone.
Technically the degree of ?nancial integration and the degree of ?nancial
interdependence in the broad sense are the same thing. The more integrated are ?nancial
markets, the greater is their interdependence. Note that the degree of interdependence
among different segments of the ?nancial sector can also be an important consideration.
For example, in the recent ?nancial crisis, the problems in the market for securities based
on subprime mortgages in the USA spread both domestically and internationally into
markets for bank credit and money market funds. This type of spread is often called
contagion and will be discussed in the accompanying paper by Li et al. (2012). Non-crises
related interdependence can also be important. An example is how a change in a central
bank’s short-termpolicy rate chains through to effects onthe interest rates on bank loans
or banks’ short-term borrowing from each other.
The degree of international ?nancial interdependence is usually discussed in terms
of how strongly ?nancial developments in one country, including changes in monetary
policy, affect the ?nancial sectors in other countries and vice versa. The degree of
?nancial interdependence is often asymmetric. Generally larger countries will have a
bigger effect on smaller countries than vice versa. Thus, for example, ?nancial
developments in the USA usually have much larger effects on Canada and Mexico than
developments in these countries have on the USA. Thus, even perfect capital mobility
need not imply that the degree of ?nancial interdependence among countries will be the
same. Furthermore, for a given country there may be differences in responsiveness of
capital ?ows to changes in incentives for in?ows versus out?ows, generated for
example by different perceptions of riskiness of home versus foreign investment.
In the extreme many of the concepts coincide. Perfect capital mobility implies full
?nancial openness and market integration. These in turn are closely related to the
concept of exchange market ef?ciency. Simple exchange market ef?ciency assumes that
speculators are risk neutral so that there is no risk premium. This concept of ef?ciency in
both foreign exchange and stock markets are frequently investigated by testing whether
the predictions implied by factors such as interest rate differentials and forward rates
are unbiased predictors of future spot rates. Perfect capital mobility implies rational
expectations and exchange market ef?ciency such that international interest rate
differentials, forward premiums or discounts, and expected changes in exchange rates
are all equal[9]. As noted above, this does not mean that there will always be large capital
?ows, however. For example, there is now often a global component to expectations
about stock and bond prices. This is brought about in part by the anticipation of the
effects of economic developments in some countries on economic activities in other
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countries through the effects on trade ?ows. Thus, news about the outlook for the major
economies in Europe may have a direct expectations effect on equity prices in Asia
without there being a need for any capital ?ows.
The effects of ?nancial interdependence are not limited to effects on ?nancial
markets. The resulting effects on exchange rates, interest rates, and trade ?ows can
have substantial impacts on economic activity in many countries. And in equilibrium
changes in capital ?ows will induce changes in trade balances. This leads to a ?nancial
concept of capital mobility called real capital mobility. This refers to the extent to
which trade or current account balances are affected by the ?ows of ?nancial capital. In
balance of payments equilibrium net capital ?ows and the current account are equal in
magnitude and opposite in sign. A net transfer of resources among countries only
occurs through current account surpluses and de?cits. Thus, for example, capital and
foreign aid ?ows from advanced to low-income economies give rise to net resource
transfers only to the extent that they result in current account imbalances. This is
referred to as the transfer problem; how ?nancial ?ows are converted into ?ows of real
goods and services. This is discussed further in the next section.
Finally there is an important distinction between monetary and ?nancial
integration. Monetary integration is a very different type of concept which refers to
the uni?cation of exchange rates through various forms of ?xed exchange rates such
as the formation of common currency areas such as the Eurozone. A high level of
capital mobility (?nancial integration) is often considered one of the important criteria
for determining how well a common currency area would work, although this view has
been the subject of criticism[10]. Monetary interdependence is more directly related to
the measures discussed in this paper and refers to the degree to which changes
in monetary policy in one country affects the exchange rate and monetary conditions in
other countries. Thus, it is a subset of ?nancial interdependence.
4. Savings-investment correlations
In contrast to those scholars who argue that capital became much more mobile sometime
in the mid-1970s, many studies employing the savings-investment correlation approach
concluded that capital remained immobile at the systemic level. Feldstein and Horioka
(1980) popularized this approach which has spurred a vast literature on, ?rst, whether or
not such correlations exist, and second, what the implications are.
The original Feldstein-Horioka argument is quite simple: savings will be invested in
whatever place it can receive the highest rate of return. When capital is perfectly
immobile, domestic savings fully determine the level of domestic investment[11]. There
is no other way to ?nance the investment in real terms. In contrast, when capital is
completely mobile, an increase in savings in a given country should not necessarily
result in any additional domestic investment because that money can go abroad without
cost. Similarly, domestic investments will not depend ondomestic savings because ?rms
that need funds can easily get them on world capital markets. Feldstein and Horioka
therefore presume that, in a world of perfect capital mobility, the correlation between a
country’s saving and investment should be equal to zero, while in the world of perfect
capital immobility the correlation should be exact at one. Of course we would generally
expect capital mobility to lie between these extremes with increases in capital mobility
reducing the correlation.
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A system-wide measure of capital mobility can be created by regressing domestic
investment on domestic savings (country-speci?c correlations can also be estimated):
I
GDP
i
¼ b
0
þb
1
S
GDP
i
þu
i
where b
1
is an indicator of capital mobility in the system such that capital is perfectly
immobile when it equals one and perfectly mobile when it equals zero. Feldstein and
Horioka ?nd a coef?cient of close to 0.9 for the sample period 1960-1974. This strongly
suggests that capital was not very mobile in real terms. Feldstein and Bacchetta (1991)
updated the study to the immediate years after the collapse of the Bretton Woods
system (1974-1986), and ?nd an almost identical coef?cient.
The use of savings investment coef?cients as an indicator for capital mobility has
been criticised (Schuler and Heinemann, 2002)[12]. Since both savings and investment
are pro-cyclical, estimates of the relationship between them may be biased upward.
Second, because world interest rates are likely to be in?uenced by changes in the
savings rates of large countries, the assumption that capital mobility will lead to a
substantial decoupling of domestic investment from domestic savings need not hold
for large countries[13].
The correlations may also be in?uenced by the pattern of shocks that hit. This is also
a major problem with measures that focus on co-variations of interest rates and stock
prices. Feldstein and Horioka were well aware of the pro-cyclicality issue and sought to
ameliorate it by averaging savings and investment over a suf?ciently long period to
remove the cyclical component. It is useful to consider the correlations over time. The
period before First World War is considered to be one of high-capital mobility, and,
consistent with expectations. Bayoumi (1990) ?nds no correlation between savings and
investment for the period 1880-1913. Obstfeld’s (1995, p. 250) conclusion for this period is
broadly similar. He also analyzes the period 1926-1938 when capital mobility was
expected to be lowand ?nds a coef?cient that is statistically indistinguishable fromone.
Frankel (1986, 1993) suggests that a reason for the high relations during periods
considered to have high-?nancial mobility. He argues that the high correlations re?ect
more the lower levels of integration of goods markets than of ?nancial markets. This
makes sense since it is imbalances in current accounts that generate transfers of real
resources that allow real domestic investment to differ from real domestic savings.
This is the concept of real capital mobility discussed in Section 3. There is clear
evidence that goods markets generally adjust more slowly than ?nancial markets and
this makes good economic sense based on relative costs of adjustment.
In general the estimates of capital mobility based on savings-investment correlations
?nd a lower increase in capital mobility than is suggested by observations that by the
late 1960s and early 1970s the mobility of short termcapital had risen greatly. Efforts to
maintain the Bretton Woods type adjustable pegs had become quite dif?cult because of
the sizes of the funds that ?owed when exchange rate parities became widely viewed in
the private markets as being substantially over or under valued – the famous one-way
speculative option. Here we see the importance of different types of measures for
different purposes. While real capital mobility was fairly low, ?nancial capital mobility
was suf?ciently high to help bring down the Bretton Woods system.
A somewhat similar type of approach to that of savings-investment correlations
focuses on the extent to which consumption co-moves between countries.
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This approach was pioneered by Obstfeld (1989). The intuition behind tests of
consumption correlations (international risk sharing) is that ?nancial openness ought
to afford individuals the opportunity to smoothen consumption over time as they can
borrow and lend on international ?nancial markets. Thus, consumption in any one
country should co-move less with income over time, and, if preferences are similar,
consumption should be correlated across countries[14]. Such measures are subject to
objections similar to those raised against the savings-investment correlations, the most
important being that the correlations will be in?uenced by the pattern of shocks in
addition to the degree of capital mobility. Again they often suggest lower levels of
capital mobility than studies that focus directly on the behavior of ?nancial ?ows.
5. Capital controls
Perhaps the most popular method to measure capital mobility across countries in
empirical work is to look at the restrictions governments place on capital in?ows and
out?ows. The reliability of such data relies on several assumptions – that
governments can regulate capital ?ows; that they are equally enforced from country to
country; that their effectiveness does not change in the time period for which they are
examined; and that the relevant measures are included in the data analysis while the
omitted measures are not. Findings that capital controls have no signi?cant impact on
economic growth, for example, may be just as interesting as results that indicate that
their use is correlated with the degree of independence of the central banks[15]. Their
very presence raises interesting questions. For example, why do some states adopt
them while others do not? Likewise the relationships between capital controls and
currency crises have generated considerable interest. While one frequently mentioned
argument for capital controls is to reduce the incidence of currency crises, several
studies have found a positive association between capital controls and crises. More
recent work on controls on capital out?ows versus in?ows ?nds a positive association
for controls on out?ows but a negative effect of controls on in?ows[16].
The earliest studies on the effects of capital controls used dichotomous measures that
simply indicated whether countries hadanyformof restrictions ontheir capital accounts
based on data published by the International Monetary Fund (IMF) since 1950 in
“Exchange arrangements and exchange restrictions”. Such studies proved to be of quite
limited value since almost all of the interesting questions about the effects of controls
depend on the extent and intensity of their coverage, not just whether there are any
controls or not.
There are also questions of whether control measures should be limited to capital
account items or also include restrictions on payments for current account transactions.
To deal with these problems several large data sets have been compiled which provide
more graduated measures. One type pioneered by Quinn (1997, 2003) develops measures
of the degree of tightness on intensity of capital controls. Another type developed by
researchers at the IMF, most recently (Schindler, 2009), looks at the breath of coverage of
capital controls[17]. Unfortunately there have been only limited attempts to combine
these two approaches for large data sets. An exception is Potchamanawong et al. (2008).
One large data set that has become quite popular has been constructed by Chinn
and Ito (2008). This is based on calculations of the principal components of several sub
measures of capital controls. The rationale for using principal components in this
context is not clear, however.
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Studies that compare the measures from these new data sets with detailed
qualitative studies of the history of capital controls for particular countries often ?nd
substantial failures of the large N measures to capture important changes in control
programs. For example, while one of the standard explanations for the generation of
the Asian crisis in 1997-1998 was substantial liberalization of capital accounts without
suf?cient regulatory supervision many of the major data sets code these years for the
Asian economies as having high levels of capital controls (Willett et al., 2005). For more
recent analyses along these lines for India and Korea, see Ghosh (2011) and Willett et al.
(2009). Thus, we conclude that while recent large N data sets on capital controls have
improved substantially, they are still far from the levels of accuracy that would be
desirable (for more detailed analysis of the different capital measures and the uses to
which they have been put see Potchamanawong et al. (2008) and the section on capital
controls on the CIEPS web site (www.cgu.edu/pages/1380.asp).
6. Actual stocks and ?ows of capital
While capital account restrictions tell us something about government behavior,
capital ?ows and stock tell us about the behavior of investors (Rajan et al., 2003). While
there is merit in examining actual movements of cross-border capital ?ows, especially
when analyzing particular episodes, these have limitations as measures of ?nancial
integration. As noted in Section 3, a country that is highly integrated with international
capital markets – in the sense of there being no signi?cant difference in domestic and
international rates of return – may experience little if any international portfolio
capital ?ows (at least debt related ?ows).
While there has been a tendency of researchers to focus on net ?ows for some
purposes it is important to look at both in?ows and out?ows. For example, when
looking at capital ?ow surges and sudden stops this is crucial (see Efremidze et al.,
2011 in part one of this special issue). Recent work has focused instead on capital
stocks that countries have, which in practice estimate gross stocks of foreign assets
and liabilities as a percent of GDP. Lane and Milesi-Ferretti (2007) have the most
comprehensive dataset, covering 145 countries over the time period 1970-2004.
Beginningwiththe Organizationfor Economic Co-operationandDevelopment (OECD)
countries where there are data for most countries, Quinn’s data indicate a steadydecline in
the use of capital controls, with the pace picking up in the late 1980s. The Lane and
Milesi-Ferretti data, in contrast, has a U-shaped curve. Foreign assets and liabilities
averaged about 40 percent of GDP in 1970, and, after collapsing in the mid-1970s, did not
reach the 1970 level again until the late 1990s. Patterns in Latin and Central America are
different – capital restrictions increase steadilyfromthe 1950s through 1980, thenreverse
but generally remain in place. The 1990s see a rapid repudiation of capital controls, with
both Latin and Central America reaching OECD levels by 1998. In terms of assets and
liabilities, data are more limited, but the trend indicates a jump in the late 1990s.
7. Measures of interest rate interdependence
The most straight forward way to test for whether ?nancial markets are fully
integrated, i.e. capital mobility between them is perfect, is to investigate whether there
are unexploited pro?t opportunities for moving funds from one to the other. We can
also adapt this approach to studying how strongly interest rate changes in one country
affect those in other countries, i.e. the degree of their ?nancial interdependence.
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The starting point for such analyses are the interest rate parity conditions. The
basic intuition behind parity conditions is that in perfectly integrated ?nancial
markets, arbitrage equalizes the prices of identical assets, i.e. the law of one price holds.
Hence we could, in principle, use measures of interest rate interdependence as an
indicator of the degree of ?nancial integration between markets.
Fully ef?cient risk-neutral markets would be fully integrated and there would be no
abnormal pro?t opportunities for arbitrage between them. There are many tests for
?nancial and foreign exchange market ef?ciency. These generally look for whether
there are predictable patterns in variables that provide pro?t opportunities. A strong
disadvantage of many of these types of tests from the standpoint of measuring
?nancial interdependence is that they have a zero-one nature and do not provide
measures of the degree of imperfect capital mobility.
Using measures of the degree to which interest rates in one market are affected by
changes in another has the advantage of giving us a metric of the degree
of interdependence running from one when the adjust is full to zero when there is no
interdependence.
Interest rates may differ between countries for a host of reasons besides imperfect
capital mobility. Examples are different rates of in?ation and expected changes in the
exchange rate, various risk premia, and different types of shocks. Thus, it is important
to add a number of controls when estimating such relationships.
A convenient starting point to understand the conditions under which the interest
rates of two countries may differ is the interest rate parity condition:
R
t
¼ R
f
t
þ E
t
ðs
tþn
2s
t
Þ þ rp
t
ð7:1Þ
where R
t
is the domestic nominal interest rate, R
f
t
is the foreign (“base”) nominal
interest rate, s
t
is the current spot rate (exchange rate is in logs)[18], and rp
t
is a risk
premium re?ected in the difference between the forward rate and the expected future
spot rate. Both the expected exchange rate and the risk premium are unobservable, in
general, and we therefore have to use proxies for them.
The two most commonly used interest parity conditions are covered interest rate
parity (CIP) condition and uncovered parity (UIP)[19]. CIP basically states that
the difference between the current spot rate and the forward rate will equal the interest
rate differential between similar assets measured in local currencies:
R
t
¼ R
f
t
þ ð f
tþn
2s
t
Þ ð7:2Þ
where f is the (log of the) forward exchange rate.
The nexus between the UIP and the CIP is apparent by decomposing equation (7.2).
Following Frankel (1991):
R
t
2R
f
t
2E
t
ðs
tþn
2s
t
Þ ¼ ½R
t
2R
f
t
2ð f
tþn
2s
t
Þ? þ ð f
tþn
2E
t
s
tþn
Þ ð7:3Þ
where the ?rst bracketed term on the right hand side is the CIP (sometimes referred to
as country or political risk premium) and the second term is the currency risk premium.
CIP must hold if UIP holds but not vice versa. If CIP holds but UIP is rejected, this
implies that forward rates are biased predictors of future spot rates. This can be caused
by risk premia or by inef?cient speculation. Not surprisingly CIP is found to hold much
more often than UIP.
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The extent to which CIP holds is often, but incorrectly, taken as an indicator of the
degree of capital mobility. The failure of CIP to hold a good indicator but due to risk
aversion it can hold even when capital mobility is low (Willett et al., 2002). UIP does not
suffer from this problem and the extent to which it holds is the appropriate measure of
the degree of capital mobility. In change form it can be used as a valuable indicator of
how changes in interest rates in one country affect those in other countries, i.e. of their
degree of ?nancial interdependence.
7.1 The uncovered interest parity condition
Thus, UIP has become popular as a tool of measuring monetary policy independence
(Frankel et al., 2004; Shambaugh, 2004). As indicated in Table I, we would expect UIP
to hold better with credibly ?xed exchange rates and the absence of capital controls.
ObstfeldandTaylor (2004, pp. 185-6) ?ndsupportive evidence of the suggestedpatterns
in the table when comparing the slope coef?cient and exchange rate classi?cations using a
panel of countries over long periods of time with various switches in regimes.
One dif?culty in using the UIP equation is that it relies on an unobservable variable:
the expected future exchange rate. There are there common speci?cations for the
expected change in the exchange rate based on the behavior of exchange rates:
.
Perfect foresight.
.
Extrapolative expectations.
.
Static expectations.
No one of these is unambiguously best so it is important to test for the sensitivity of
estimates to all three proxies. In some cases survey data of expectations have been
available (Frankel and Froot, 1989).
Testing seems, at ?rst, straightforward. Consider the following thought experiment
involving a sample of East Asiancountries: assume that there were fewer capital controls
or that there was more capital mobility for the post Asian Financial Crisis period than
before. In such a situation, we would expect those countries that opted more towards a
?oating (?xed) exchange rate regime to show a smaller (larger) slope coef?cient than
before the crisis. On the other hand, we would expect, if nothing else, no change in the
slope for countries that stayed in the same exchange rate regime (Keil, 2011).
While looking at the extent UIP holds is conceptually the most appropriate measure
of the extent of ?nancial integration, for many policy issues one of the most important
policy questions involves how changes in monetary policy in one country affect other
countries, i.e. how great is the degree of ?nancial interdependence. For this purpose,
the most relevant approach is to estimate how much policy induced changes in interest
Peg (?x) Non-peg (?oat)
Free (more) capital mobility
or (less or) no capital
controls
No independent monetary policy
(b
1
closer to 1; highest value)
More independent monetary policy
(b
1
closer to 0; second highest
value)
No (less) capital mobility or
(more) capital controls
More independent monetary policy
(b
1
closer to 0; second lowest
value)
More independent monetary policy
(b
1
closer to 0; lowest value)
Table I.
Closeness of interest
rate co-movements
and policy regimes
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rates in one country affect the interest and exchange rates of other countries. Note that
these relationships will often be asymmetric: changes in interest rates in Japan should
have a bigger effect on Taiwan than vice versa.
As with estimates of UIP in general, a major dif?culty in such estimation is adjusting
suf?ciently for the other factors that may in?uence interest rate correlations across
countries. The correlations between the interest rates of two smaller economies may
re?ect more the in?uence of global monetary conditions affecting both rather than direct
?nancial interdependence between the two. It is often argued that this is the case among
many Asian economies. Thus, one needs to control for global interest rates (Keil, 2011).
Moreover, changing levels of in?ation rates can also be an important factor. It is
easy to transform the UIP speci?cation into a relationship between the respective
in?ation rates, as long as the differences between real interest rates does not vary
greatly. As a result, UIP results can be driven by in?ation rate convergence which has
been observed at different periods across countries in the past (Keil, 2011).
Matters become even more complicated when adjustments are not instantaneous
and dynamics must be taken into account. There are also questions about whether the
moments of the probability distributions of in?ation and interest rates remain
invariant over time[20]. Given these problems it is not surprising that estimates of this
type are often quite unstable. Thus, at this point we should not give great weight to
any one particular set of estimates.
8. Concluding remarks
Given the wide variety of approaches to estimating capital mobility and the degree of
?nancial interdependence it is not surprising that there is so much disagreement
among economists on these questions. As noted a major dif?culty is in trying to control
for the major factors other than direct ?nancial interdependence that may in?uence the
correlations among ?nancial variables such as interest rates. The better job we can do
in controlling for such factors, the more reliable our estimates will become. For now we
do not have the consistency of results necessary for us to have con?dence in anything
like precise estimates of the degree of ?nancial interdependence among different sets of
countries. This does not mean that we do not know anything, however or that there is
not a great deal more highly productive research that can be done.
We can be highly con?dent that for most countries the level of capital mobility has
been much in the last decades of the twentieth century and early twenty-?rst century
than in the ?rst few decades after the establishment of the Bretton Woods international
monetary system at the end of Second World War. We can also safely say that while
high for many countries and close to perfect among the offshore Eurocurrency
markets, few if any ?nancial markets are perfectly integrated across countries.
Consequently, most countries have some scope to sterilize the monetary effects of
international ?nancial ?ows, at least in the short-run.
We should also note that there are many important aspects of international ?nancial
?ows beyond the extent to which they are integrated. For example, we have learned from
sad experience that international ?nancial markets have often been too trusting and
failed to give strong early warning signs of growing ?nancial problems (Willett, 2000).
The Asian, Argentine, US subprime, and Euro crises give vivid examples.
Likewise there is much to learn about the causes of the sudden stops of ?nancial
?ows (Efremidze et al., 2011).
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Notes
1. The higher is capital mobility the greater is the problem of the one-way speculative option
under pegged exchange rates.
2. The relationships of these issues to the degree of capital mobility are covered in almost any
text on international economics or international money and ?nance. Underlying many of
these relationships is the trilemma or impossible trinity which shows that over the long run
countries cannot have all three of ?xed exchange rates, no controls, and independent
monetary policy. With imperfect capital mobility, however, all three may be pursued in the
short run. Government efforts to continue violated the trilemma constraints for too long are a
frequent cause of currency crises (Willett, 2007). For empirical estimates of these
relationships see Aizenman et al. (2010).
3. The acronyms used here are borrowed from Frieden (1991). See Frieden (1991), Webb (1991,
1995), Andrews (1994), and Cohen (1993) on the timing and signi?cance of the increase in
capital mobility.
4. Webb (1995, p. 336, no. 80) cites a 1973 Bundesbank report that recent experience had “made
it abundantly clear that even stronger administrative action against capital ?ows from
foreign countries [. . .] does not suf?ce when speculative expectations run particularly high”.
Similarly, Cohen (1993) argues that “restrictions merely invite more and more sophisticated
forms of evasion, as governments from Europe to South Asia to Latin America have learned
to their regret”.
5. In the 1960s and 1970s, it was popular to estimate capital ?ow equations where the
coef?cients on interest rate variables would give measures of the degree of capital mobility
(Branson, 1968). This type of study has gone out of fashion but a close analog is frequently
estimated today, however. Here an “offset coef?cient” is estimated which measures the
extent to which an autonomous change in the domestic monetary base is offset by
international capital ?ows. This provides a continuous measure between zero and one where
zero implies no offset. This approach is discussed in the accompanying paper by Willett et al.
(2011) on currency policies.
6. Credit risk refers to the possibility that debtors will not be able to meet their obligations such as
occurred with Lehman Brothers during the US subprime crisis. Political risk refers to the
possibility that governments may impose policies such as capital controls or nationalization
that impede repayments. The combinationof these two types of risks is oftencalledcountryrisk.
7. Direct investment responds to expected pro?t opportunities to lower costs and/or raise
revenue and is not directly covered in these papers. However, greater direct investment as
with the activities of multinational corporations more generally tend to increase the degree of
?nancial capital mobility through the ?nancing and hedging activities of these corporations.
8. Note that forward exchange may sell at either a premium or a discount relative to spot rates.
Thus, if the forward pound is selling at a premium relative to the dollar, then the forward
dollar is selling at a discount relative to the pound. The covered interest differential is zero
when this premium or discount just offsets the difference in interest rates. The true net cost
of forward cover is the transactions cost which usually occurs in the form of the spread
between buying and selling rates.
9. A second concept of market ef?ciency allows for the possibility of risk premia which in turn
implies that interest rate differentials and forward rates can be biased predictors of future
spot rates even in ef?cient markets. While many efforts have been made it is not an easy
matter to distinguish what proportion of biased prediction are due to risk premia versus
biased expectations are dif?cult to determine, although this does not keep some experts from
having strongly held views on the subject.
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10. These criteria are discussed in the literature on optimum currency areas, a key conclusion of
which is that the relative costs and bene?ts of monetary integration vary systematically
across countries so that there is no one exchange rate regime that is best for all currencies.
For recent discussion and references to the literature see Willett (2003).
11. Note that domestic savings are the combination of private savings plus net public savings
which will be positive if the government is running a budget surplus and negative if it is
running a de?cit.
12. A few authors have also questioned what the exact nature of the savings-investment
correlations is. Frankel (1986, 1993) in particular argues that the correlation indicates the low
integration of material goods markets instead of capital markets.
13. See, among others, Harberger (1980).
14. A weaker form of risk sharing states that the degree of cross-country consumption
co-movements exceeds that of output co-movements.
15. Both results are reported in Alesina et al. (1994). Using a more comprehensive measure,
however, Quinn (2003) ?nds a negative association of controls with growth.
16. See the analysis and references in Chiu and Willett (2011) and Potchamanawong et al. (2008).
17. There are numerous studies that develop more re?ned measures for individual countries or
small group of countries. See, for example, Ghosh (2011).
18. Throughout this section the exchange rate is quoted as the domestic price of foreign
currency. Properly, we should set up the relationship as
ð1 þ R
t
Þ ¼ ð1 þ R
f
t
Þ £ ððE
t
ðS
tþn
ÞÞ=S
t
Þ £ ð1 þ rp
t
Þ. Taking logs this results approximately
in equation (7.1).
19. There are two additional arbitrage conditions which we will not consider in detail here: the
real interest rate parity (RIP) condition and the closed interest parity condition. The RIP
combines UIP and purchasing power parity together with the Fisher equation to yield
equality of the respective real interest rates (Obstfeld and Taylor, 2004; Meese and Rogoff,
1988; Edison and Pauls, 1993). The closed interest parity condition states that the returns on
identical instruments of the same currency but traded in different markets (such as onshore
and offshore markets) should be equalized (Obstfeld, 1998; Frankel and Okongwu, 1996).
20. Discussion of these issues becomes rather technical. Shambaugh (2004) and Frankel et al.
(2004) are a good starting point for the interested reader. A longer version of this paper,
which is placed on our web site, deals with these issues in more detail.
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About the authors
William R. Clark is Professor of Political Science at College of Literature, Arts and Sciences at the
University of Michigan, Ann Arbor. Much of his research work has focused on the effect of
central bank independence, capital mobility, and ?xed exchange rates on monetary and ?scal
policy choices made by survival-maximizing incumbents and the choice of monetary institutions
in a world of mobile capital.
Mark Hallerberg teaches Public Management and Political Economy at the Hertie School of
Governance in Berlin. He also maintains an af?liation with the Political Science Department at
Emory University, Atlanta. He has published over 25 articles and book chapters on ?scal
governance, tax competition, exchange rate choice, and European politics. He has held academic
positions previously at Emory University, the University of Pittsburgh, and the Georgia Institute
of Technology.
Manfred Keil is Associate Professor of Economics at the Robert Day School of Economics and
Finance, Claremont McKenna College. He also teaches at Claremont Graduate University. His
areas of expertise are banking, comparative economic performance, macroeconomics, and
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statistics and he has published numerous articles in these topics in refereed journals. Having
taught various courses on Econometrics, including at the Central Banks of Zambia and Malawi,
he has also published a Testbank to accompany Introduction to Econometrics textbook by James
Stock and Mark Watson.
Thomas D. Willett is the Horton Professor Economics and Director of the Claremont Institute
for Economic Studies in the Department of Economics, Claremont Graduate University and
Claremont McKenna College. A former Deputy Assistant Secretary of the Treasury for
International Research, he is the author or co-author of nine books, over 200 articles in journals
and the editor of 18 books. His previous teaching appointments include Cornell University and
Harvard University. Thomas D. Willett is the corresponding author and can be contacted at:
[email protected]
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This article has been cited by:
1. Abdullah Noman, Mohammad Nakibur Rahman, Atsuyuki Naka. 2015. Portfolio investment outflow and
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