Financial markets and capital flows

The Financial System

  • Financial markets: where households invest their current and accumulated past savings (wealth) by purchasing financial/physical assets
  • Financial asset: a paper claim (currency, stocks, bonds, loans, etc) entitling a buyer to future income from the seller
  • Loans are financial assets owned by a lender (typically a bank)
  • Physical asset: claim on tangible object that gives own the right to rent or sell the object as desired
  • Financial intermediary: an institution extending credit to borrowers using funds raised from saves e.g. banks, savings and loan associations, credit unions, mutual funds, pension funds, etc
    • Specialize in evaluation of borrower quality
    • Principle of comparative advantage advantage

Types of Financial Assets

  • Loans: lending agreement between a lender and a borrower, harder to resell, not as standardized as bonds
  • Loan-backed securities: assets created by pooling individual loads and selling shares in that pool, called securitization of those assets
    • This is essentially a way for owners of these assets (which can’t normally be sold themselves) to generate more cash on the assets and make them marketable
    • Can be preferred because they are more diverse and very liquid
    • However can be difficult to assess risk and true quality of the asset since so many loans are packed together, one of the reasons for 2008 crisis
  • Mortgage-backed securities: subset of loan backed, mortgages are pooled and sold as shares to investors
  • Bond: legal IOU issues by borrower. Bond seller pays fixed sum of interest (coupon rate) each year to repay principle amount (face value). Bonds are highly tradeable, unlike loans e.g. they can be sold before maturity
  • Stocks: share in the ownership of a company; stockholders receive capital gains when price of stock increases
    • Why don’t owners just sell bonds for investment needs, and keep 100% of the company themselves? Risk aversion and they raise capital through ownership; once those people own that part of the company, the company doesn’t owe them anything, that individual has accepted the risk of owning the company. Contrast with the company having to pay interest on loans to a bank

Diversification

  • Makes risky but potentially valuable projects possible; no individual bears the whole risk
  • Mutual fund is financial intermediary that sells shares in itself to the public, then uses funds to buy variety of financial assets
    • Diversified asset for saver
    • Less costly than buying many stocks/bonds directly

Rise and Fall of Stock Market

  • Increase in stock prices could be result of increased optimism about future gains, or a fall in required rate of return
  • In 1990s optimism was high with strong dividends and new technology promised, resulting in lower risk premium (premium required for holding the risk of the asset)
  • Trend reversed after 2000: tech firms less profitable than expected, corporate accounting scandals of 2002, recession

International Capital Flows

  • Financial markets with borrowers and lenders from different countries and international financial markets
  • Size of international markets depends on economic and political cooperation between those countries

Lending is the same as buying

  • Savers lend to firms by purchasing stocks and bonds, lending here is the same as acquiring a real or financial asset
  • Savers can also lend by buying as real asset like land from a borrower; don’t get interest or dividends, but get to actually own the land and can rent it

Borrowing is the same as selling

  • Firms borrow from citizens by selling stocks and bonds

Capital Flows

  • Under the domestic economy of the US
  • Capital inflow: funds flowing into US, when foreign saves by domestic (US) assets
  • Capital outflow: funds flowing out of US, when US savers purchase foreign assets
  • Net capital outflow: capital inflow - capital outflow
  • Net capital outflow: capital outflow - capital inflow
  • Capital inflows and outflows not counted as exports and imports because they refer to purchase of existing assets rather than currently produced goods and services
  • Two roles:
    1. Allow countries whose productive investment opportunities are greater than their domestic savings to fill in the gap by borrowing abroad (i.e. need to tap into foreign savings when domestic is not enough to capitalize on profitable investments)
    2. Allow countries to run trade imbalances because every trade surplus implies net capital outflow while every trade deficit implies net capital inflow.
      • If exports > imports, have a trade surplus
      • If imports > exports, have a trade deficit
  • Higher domestic real interest rate attracts capital inflows from abroad, implying high capital inflow. Also deters domestic funds from leaving country, so low capital outflow
  • Overall, higher domestic real interest rates imply high net capital inflows. Foreigners want their funds to appreciate at faster rate inside US

The Financial Account

  • Records investment flows between US and other countries. Possible outflows include:
    • US deposits in foreign banks
    • Loans to foreign people
    • Purchases of foreign stocks
    • Funding of foreign affiliates of US multinationals

Trade Balance and Net Flows

  • Trade balance = NX = X - M
  • Net capital inflow = KI = capital inflow - capital outflow = purchase of US assets by foreigners - foreign purchase by US residents
  • NX + KI = 0
  • Recall Y=C+I+G+NXY = C + I + G + NX
  • Domestic savings are S=YCGS = Y - C - G, and thus S=I+NXS = I + NX, which implies S+KI=IS + KI = I
  • So domestic savings (S) plus foreign saving (KI) equals domestic investment (I)

Risk and Capital Inflows

  • Domestic real interest rate (r) and net capital inflows (KI) chart shows as (r) increases, (KI) increases (roughly) logarithmically
  • For a given real interest rate, an increase in riskiness of domestic assets decreases capital inflows, shifting this curve to the left
    • This is trivial; foreigners less willing to buy domestic assets due to increased risk
    • A decrease in risk shifts the curve the other way
  • At low interest rates we have KI<0KI < 0, thus S+KI<SS + KI < S or total savings is less than domestic savings
  • At high interest rates we have KI>0KI > 0, thus S+KI>SS + KI > S or total savings is more than domestic savings
  • Can plot the SS and II curves, and we will see an equilibrium interest rate rr^* where S+KIS+KI curve equals the II curve

Saving Rate and Trade Deficit

  • Low rate of national saving is primary reason for trade deficits
    • With SI=NXS - I = NX, with low level of domestic savings (S) we have low level of net exports (NX). Since we have trade deficit when imports exceed exports, this low domestic savings implies a trade deficit (or at least when SS is low enough such that S<IS < I)
  • This is fairly intuitive: with low domestic savings i.e. greater overall spending by the population
    • Some of that spending will be done on imports, implying high imports
    • Some (or most) of that spending will be on domestically produced goods, leaving less to be exported
  • Hence, high imports and low exports results in a trade deficit as a result of low domestic spending (as is seen in the US)

Low Saving and High Net Capital Inflows

  • Country with low saving rate will not have enough funds to finance domestic investment expenditures
  • This leaves good opportunities for foreigners, resulting in net capital inflows
  • Low domestic savings will raise real interest rates and attract capital inflows that way as well
  • Thus, low saving economy will see both a trade deficit and high rates of net capital inflows

But is this a problem?

  • Trade deficit and high net capital inflows means US relies heavily on foreign savings to finance domestic capital formation
  • These foreign loans have to be repaid with interest, and can be a problem is US economy does not grow at a healthy rate to keep up
  • Another drawback is that higher levels of foreign inflow (KI) to finance capital formation means that returns to capital go to foreign investors rather than domestic residents