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TIMES BOARD OF ADVISERS / JOSE DE LA TORRE

International Finance Has Become the Dog-Wagging Tail of '90s

March 20, 1994|JOSE DE LA TORRE | Jose de la Torre is a professor of international business strategy in UCLA's Graduate School of Management and director of the university's Center for International Business Education and Research

World financial markets once again have suffered a bad case of the jitters. Large speculative flows are pushing interest rates up and causing exchange rates to bounce about with increased volatility. For most of us who work in the "real" economy, the resulting changes in relative prices and demand can have serious repercussions.

Those seeking someone to blame have an ample choice of villains: Alan Greenspan for reining in the U.S. economy too soon, the German Bundesbank for acting selfishly, the Japanese for their indecision, or George Soros and other "hedge funds" operators who--having bet wrongly on the direction of interest rates and bond prices--are scurrying to cover their huge exposed positions.

The fact is, we live in a new world of international finance that is scarcely a decade old. As recently as 1984, financial markets remained essentially domestic. Since then, new telecommunications and information technologies--coupled with advances in financial theory, radical innovation in financial products and a universal process of market deregulation--have transformed financial markets dramatically.

The 1984 dollar-yen agreement allowed Japanese investors greater access to foreign markets and removed barriers to yen convertibility. The Plaza Accord of 1985 encouraged a trend toward market-opening measures throughout the industrialized world. The deregulation of London's securities market--the Big Bang of 1986--was followed by similar, if less dramatic, actions in other European capitals, as well as in many emergent markets.

The combined effects of these forces can be illustrated by a few key figures:

* Market capitalization of the world's major stock exchanges grew from $1.7 trillion in 1978 to $10.6 trillion in 1993, increasing significantly the world's stock of risk capital.

* Cross-border trading in corporate equities has grown from about $120 billion in 1979 to $1.3 trillion in 1992.

* Transactions involving foreign securities listed in domestic markets boomed from less than $50 billion in 1979 to nearly $900 billion in 1990. On Wall Street alone, trading in the American Depository Receipts of foreign firms went from 1.3 billion shares in 1985 to more than 5 billion in 1992.

* The share of U.S. initial public offerings abroad increased from 1.4% in 1985 to 19.3% in 1992.

* In spite of the near collapse of international lending to developing countries following the 1982 debt crisis, the international portfolios of major banks have grown dramatically during the decade. From 1980 to 1992, the stock of international loans ballooned from $324 billion to $7.5 trillion.

* And the market in derivatives--which barely existed before 1980--grew to nearly $9 trillion by 1992, much of that in interest and currency swaps.

Thus, one in every five transactions in equity markets today involves cross-border trading. Such investors are estimated to own 10% of world equities, a proportion that will rise to 15% to 20% by the end of the decade. Financial transactions with foreigners have grown by a factor of 10 or more for all major industrial economies since the early 1980s.

There is no denying that freer international capital markets have functioned precisely as expected, leveling differences in the return on--and therefore in the cost of--capital between similar risks. No longer can U.S. companies complain that Japanese or German firms have access to cheaper capital.

But these developments pale in comparison to the explosion that has characterized foreign exchange markets in recent years.

From an annual volume of roughly $18 trillion in 1979, foreign exchange transactions doubled to about $35 trillion by 1984. Thereafter, the rate of growth only accelerated, with current estimates citing a daily volume of more than $1.2 trillion, the equivalent of 5% of the world's total production of goods and services.

To put it in perspective, the ratio of transactions in foreign exchange to those in international trade in goods and services increased during the decade from just above 8 to 1 to more than 80 to 1.

The determination of real exchange rates, and therefore cost competitiveness, is increasingly divorced from underlying fundamentals in the real sectors of the economy. Large variations in effective exchange rates, often 30% to 40% above or below "parity" rates, can be sustained for five years or more; witness the persistent overvaluation of the dollar from 1981 to 1985 and its subsequent undervaluation since 1991.

These long swings in currency values have been accompanied by increased volatility in foreign exchange rates. As governments manipulate financial variables for domestic purposes, massive flows of short-term capital act to exploit any opportunity for gain. Exporters and importers are caught in the vise.

How can business escape this dilemma?

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