Regional Economic Integration and Global Markets
Regional Economic Integration
Regional economic integration refers to agreements between countries in a geographic region to reduce tariff and non-tariff barriers to the free flow of goods, services, and factors of production between each other. These agreements foster interdependence and increased influence. There are five levels of economic integration:
- Free Trade Area: Eliminates all barriers to the trade of goods and services among member countries. Examples include the European Free Trade Association (EFTA) and the North American Free Trade Agreement (NAFTA).
- Customs Union: Eliminates trade barriers between member countries and adopts a common external trade policy. The Andean Pact is an example.
- Common Market: Has no barriers to trade between member countries, a common external trade policy, and allows factors of production to move freely between members. Mercosur is an example.
- Economic Union: Involves the free flow of products and factors of production between members, a common external trade policy, a common currency, harmonization of members’ tax rates, and a common monetary and fiscal policy. The European Union (EU) is an example.
- Political Union: A central political apparatus coordinates the economic, social, and foreign policy of member states. The United States is an example.
NAFTA and Other Trade Agreements
NAFTA abolished tariffs on most goods traded between North American countries, removed barriers on the cross-border flow of services, removed restrictions on foreign direct investment (FDI), and protects intellectual property rights. Other agreements include CAFTA, CARICOM, CSME, and ASEAN (which led to AFTA). The proposed Free Trade Area of the Americas remains a topic of discussion. Africa has numerous trade blocs, but progress toward established regional economic integration has been slow. Regional economic integration opens new markets but also presents threats due to increased competition.
Global Capital Markets
Thanks to deregulation and liberalization, financial markets have become increasingly globalized. Cross-border capital flows have increased, facilitating the buying and selling of financial instruments. There are two main categories:
- Equity Securities: Also known as stocks, representing ownership in a company.
- Debt Securities: Also known as bonds, representing loans that must be repaid.
For investors, the global capital market offers reduced risk through diversification. For borrowers, it provides a lower cost of capital. The global equity market, where shares are issued and traded, gives companies access to capital and investors a slice of ownership.
Bond Market
The bond market (also known as the debt market or credit market) is a financial market where participants buy and sell debt in the form of bonds. There are two key types:
- Foreign Bonds: Sold outside the borrower’s country and denominated in the currency of the country where they are issued.
- Eurobonds: Underwritten by an international syndicate of banks and placed in countries other than the one in whose currency the bond is denominated.
Eurocurrency Market
The Eurocurrency market involves any currency banked outside of its country of origin. It is largely unregulated.
Foreign Exchange Market
The foreign exchange (Forex or FX) market is a market for converting the currency of one country into that of another country. It has no central location and operates electronically. The exchange rate is the rate at which one currency is converted into another. The Forex market serves two main functions:
- Currency conversion
- Providing insurance against foreign exchange risk (hedging).
How the Market Works
- Spot Exchange Rate: The rate at which a foreign exchange dealer converts one currency into another currency on a particular day.
- Forward Exchange: Occurs when two parties agree to exchange currency and execute the deal at some specific date in the future.
- Currency Swap: The simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.
If exchange rates quoted in different markets are not the same, arbitrage (buying a currency low and selling it high) becomes possible.
Impacts on Currency
Factors impacting currency values include inflation, interest rates, and market psychology. Relative monetary growth, relative inflation rates, and nominal interest rate differentials are moderately good predictors of long-run changes in exchange rates. Countries can limit currency convertibility to preserve foreign exchange reserves and prevent capital flight.
Types of Foreign Exchange Risk
- Transaction Exposure: The extent to which the income from individual transactions is affected by fluctuations in foreign exchange values.
- Translation Exposure: The impact of currency exchange rate changes on the reported financial statements of a company.
- Economic Exposure: The extent to which a firm’s future international earning power is affected by changes in exchange rates.
To minimize transaction and translation exposure, firms can buy forward, use swaps, or employ other hedging strategies.
International Monetary System
The international monetary system refers to the institutional arrangements that countries adopt to govern exchange rates.
- Floating Exchange Rate: Currency values are determined by market forces (supply and demand).
- Pegged Exchange Rate: A country fixes the value of its currency to that of another major currency.
- Dirty Float: A system where a country’s currency is nominally allowed to float freely against other currencies, but in which the government will intervene, buying and selling currency, if it believes that the currency has deviated too far from its fair value.
- Fixed Exchange Rate: Countries fix their currencies against each other at a mutually agreed-upon value.
The Jamaica Agreement
The Jamaica Agreement (1976) established that floating rates were acceptable, gold was abandoned as a reserve asset, and total annual IMF quotas were increased.
IMF and World Bank
- IMF (International Monetary Fund): Aims to ensure the stability of the international monetary system. It monitors the global economy, lends to countries with balance-of-payments difficulties, and provides practical assistance.
- World Bank: Provides technical assistance, financial products, and helps to share and apply knowledge and solutions to development challenges.