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One of the striking facts about the international economy is the high degree of
integration among financial markets the markets in which bonds and stocks are traded. In most
industrial countries today, there are no restrictions on holding assets abroad. Residents in the US,
Germany or the UK can hold their wealth either at home or abroad. They, therefore, search around
the world for the highest return, thereby linking together yields in financial markets in
different countries. For example, if the interest rate in Malaysia rose relative to interest rate in
Singapore, investors would turn to lending in Malaysia, while borrowers would turn to Singapore.
With lending and borrowing increasing in Malaysia and
Singapore respectively, yields would quickly fall into line.
The high degree of capital market integration implies that any country's interest
rates cannot get too far out of line without bringing about capital inflows, that tend to restore
yields to the world level. For example, if Singaporean yields fall relative to Malaysian yields,
there would be capital outflow from Singapore, because lenders would take their funds out
of Singapore and borrowers would try to raise funds in Singapore. In respect of the balance
of payments, this implies that a relative decline in interest ratea decline in our rates
relative to those abroadwill tend to worsen the balance of payments because of the capital
outflow resulting from lending abroad by Malaysians (Dornbusch et al., 2004). |
