Using offshore markets to measure financial globalisation and introducing Emerging Markets Call Option

Bank of Thailand organised a high profile seminar in November 2008. It has now put all the  papers for a free download. The theme was Financial Globalisation and Emerging Markets which looks like an evergreen topic now. I think we should just let it be financial globalisation and not make it specific for emerging markets. This problem is critical to this crisis as well (see this by Bergstrom and Eichengreen as well). The speakers have all who’s who- Raghu Rajan, Dani Rodrik, Arvind Subramanian etc. (I will try and cover the papers in subsequent posts)

I was reading this excellent paper from Robert McCauley from BIS. The paper looks at analysing financial globalisation from a completely different angle.

What has happened over a period of time is we have both onshore and off shore financial markets. So we have forex markets within the country and outside the country (the settlement etc may be different, for instance in Indian Rupee case, we have non-deliverable forwards etc) . The same applies to equity markets (Nifty trading happens in Singapore exchange), bond markets etc. 

The off-shore markets have developed as theer could be certain restrictions on trading etc in the domestic markets. For instance, in India foreign investors are not allowed fully to play in government bond market. Hence, off-shore market is expected to be be like a free efficient market with minimal restrictions.

So, what McCauley does is to estimate the spreads between the two markets (onshore and offshore) in 4 Asian countries – Korea, India, China and Thailand. The logic is the countries which have the largest spreads between the two markets are resisting financial globalisation the most. He chooses 4 types of markets- forex, money market (3 month interest rate market), government bond market and equity markets.

The summary is:

Average Absolute Value of onshore and offshore gaps (in bps)
  China India Korea Thailand
Twelve-month forward, % of spot 1.45 0.58 0.38
Three-month yield, basis points 367 182 85 157
Twelve-month yield, basis points 375 144 92 94
Bond yield, basis points 234 142 65 95
Equity price, per cent 50 14 4 4

Korea has the least spread across markets implying it is least resistant to financial globalisation. Thailand is also quite open to financial globalisation and has wide spreads only in money markets. China is at the other extreme with wide spreads across all types of financial markets. India is somewhere in the middle with lower spreads than China and higher than Korea and Thailand. Read the paper for more details.

Again, one might draw different inferences from the paper. Some might say let us have freer capital inflows and outflows as it would lead to lower arbitrage. This is often the case for India (see for instance Raghu Rajan report on India) and China. Others like Dani Rodrik would say:

The extent to which countries have been hit by the recent crisis follows this ranking (in reverse order) almost exactly. In particular, Korea has been the country hardest hit despite many other preventive policies (including large reserve build-up) before the onset of the turmoil.

…..And if you think all of this is just academic stuff which does not capture what is really going on on the ground, I would recommend a short conversation with the governor of Taiwan’s central bank. You would quickly shed any doubts you may have harbored on the ability of determined policy to manage their capital accounts.

The paper gives an even more interesting dimension:

It is worth noting how different this regularity of emerging markets taking back their equity risk at times of high volatility is from the textbook image of international diversification.

In the real world, global investors want exposure to emerging market equities in good times and want to cash out in bad times. This resembles more a call option on the emerging market harvest than a long position. This is the international risk sharing that India, Korea and Thailand participate in, and in which China resists participation.

Hmm. I had only heard of so called Greenspan put (now also called as Bernanke put). There seems to be a new term – Emerging Markets Call Option !

Another point is how important are these off-shore markets. True, they help you tell the arbitrage differences but they are very difficult to regulate as well. I recall a speechby CFTC Commissioner, Bart Chillton who points how difficult it is to regulate these markets creating loopholes. These markets can be created out of thin air as the paper points:

Access to the domestic bond markets by foreign investors has been heavily restricted hitherto in China and India. ….Given these restrictions, foreign investment in these fixed income markets often takes place in a virtual manner, in the form of receive positions in cross-currency swaps. In such swaps, the investor receives a fixed coupon over an agreed period in exchange for making payments of US dollar Libor.

It after all is just exchange of paper and can be done anywhere. These markets may be far away from reality as well as clearly lot more is needed apart from just allowing free capital flows. So, should we really care about the arbitrage opportunities and instead be worried about these off-shore markets?

Excellent paper nevertheless. Plenty of food for thought.

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