Empirical Evidence on the Role of Geography and History in International Finance - Literature review Example

EMPIRICAL EVIDENCE ON THE ROLE OF GEOGRAPHY AND HISTORY IN INTERNATIONAL FINANCE by State Date of submission Introduction The International economics is a field which is focused on the effects upon which the economic activities of international differences in consumer preferences, productive resources and the entire institutions that affect them. The field also takes the responsibilities of explaining the consequences and patterns of interactions and transactions between different countries and the inhabitants. These activities include the migration, investment and also trade. In addition, the international finance involves in monitoring the flow of capital across all the international financial markets and the impacts of these movements on rates of exchange (Maurice, 2008). This paper, therefore, explains the empirical evidence on different roles played by the history and geography on the international finance and how they are inter-connected in improving the investors desires in the market. Over the recent years, geography has been seen as the growing interests of the international finance, particularly, on the studies of using the gravity models. The models were being used to determine the direction of the cross border financial flows and stocks. Using this approach, the bilateral trade in assets is deemed to increase depending with the size of the country and also decline with information asymmetries and transaction costs. This is because they are being captured by geographical distance and the variables relating to it (Portes and Rey, 2005). Furthermore, there has been a lot of empirical work on the gravity but has taken place without a theoretical foundation which can stand firm on the matter of financial holdings for cross-border. Anderson and van Wincoop (2003) gave an analysis that the estimated gravity equations which are not being founded in economic theory can result to biased estimations since some variables are omitted. It also leads to comparatives with an incorrect static analysis which doesn’t consider the general equilibrium effects of changing the cross border barriers. Different sources of literature such as Clemens and Williamson (2004) highlight the important trend and progress of the financial globalization since 1990s although it has not analyzed the historical forces which have influenced the international investment for a longer period of time. The existing literature also doesn’t highlight the applicability and generality over time of the emphasized factors on the standard framework. These shortcomings aroused the interests of writing this paper in order to be addressed accordingly. The paper gives a clear discussion on the issue by estimating the gravity model the international investment using an example of information on Us investors’ holdings. The history an effect is being tested through the past holdings influenced the current holdings (Eichengreen and Irwin, 1998). The aspect on how the past investment influences the current investment is through the fixed costs. The empirical evidence and literature theories have shown the permanent impacts on trade patterns as a result of mart penetration. This is due to the fixed costs incurred by firms when entering into the new market which they can’t get when exiting the same market (Dixit, 1989). The passing shocks of literatures can be cumulated to impact a more powerful still which can lead firms to penetrating the market and have the ability to learn more about the market in question thereby, have the advantage of having the initial information of the market. This helps many organizations to analyze the conditions of the current market with the information contained of the past before deciding on which strategy to be used in penetrating the larger market. In simple terms, the historical theories and literature helps many companies to be prepares on the impacts as many firms have been penetrated in the past. As it is currently penetrating, hence, there are possibilities of having the same impacts depending on the revolution and the changing of the same market (Nieuwerburg and Veldkamp, 2009). It is a fact that, the truth about the international trade is the truth of the international investments. This is because many financial companies face the fixed costs especially when assessing their credit worth of foreign bonds in order to invest according to their capabilities. When marketing these foreign bonds to the domestic investors, they also face the set up costs. History shows that, during the 20th century, the Commercial banks in the US had been prohibited from establishing the branches of foreign financial institutions under the National Bank Act provisions. When the ban was lifted under the Federal Reserve Act, any of the banks in the US had no other options but to sink the costs of setting up a foreign branch. This is in order to give themselves more time and gather the required information on foreign markets and prepare the possibilities of under writing the issues of bonds on borrowers from foreign countries. According to Eichengreen (1989), the commercial banks of the US had to sink the setting of the store front brokerages and other different tools of marketing in order to sell the bonds to all investors. The pattern used by the US banks to penetrate the foreign market was uneven because they did not a proportional focus on different geographical backgrounds such that, they mostly focused on Western Europe and Latin America leaving the British Empire. They did not also focus on the Eastern Europe and Scandinavia. Although the structure was eventually frozen by the advancement of the World War II and the capital controls during the post-war period. The restrictions imposed on foreign branching by the destination countries also caused the marketing structure to stall. In this case, therefore, can have the basis at which the geography of international investments as it was shaped during the interwar period existed in the history and there are different indications of its legacy. The fixed costs only need to be different on each country but its size; either small or large have no persistent effects on the geography of holding the assets in a bilateral aspect. This is regarded as an implication to the asymmetric information on learning the literature surrounding the theorem. According to the Nieuwerburg and Veldkamp (2009), a significant home bias can even be cased by any associated informational advantage, however small it is, it means a lot to the marketing strategies of the company. This is because the advantageousness of the information received reduces the risks and perception to the investors in order to hold and invest in more domestic assets due to the encouragements. The analogy of having the lower initial fixed costs of investing in some of the countries may be significantly tilting the investment towards those countries over time. In addition, this pattern may persist and be amplified over the period of time by endogenous learning. However, one can ideally outline and invest in direct measures of these fixed costs, especially in the different between the fees set by various brokers, either on domestic or on foreign investments. One can also focus on the differences in tax treatment, and policies related to costs. The examples are those countries associated with the limitation to the foreign investments and control of the required capital. Unfortunately, no any paper work has been done, as far as we know, and has been able to provide the comprehensive measures of costs which are direct in investing in the foreign assets. Even there are no single documentary records which have been written for the contemporary period, or much less for earlier historical eras that could be helping the current as well as future generations to interpret various theorems. However, Coeurdacier and Rey (2011) found it necessary to make the inferences of demonstrating the importance of history in international finance. Contemporaries were well informed that the undertaking of financial activities in foreign countries required significant initial investments in order to yield in the current competitive international market. For example, during the period of interwar, it was recognized that US was unable to produce the managers who have the ability of managing the foreign banks’ branches in a single day. Hence, there showing that Canadian banks and British banks are superior in the sector. Phelps (1927) concluded that the success in the field of banking in the oversee countries required a special managerial capacity which can only be achieved by long term service in actual foreign branch banking in order to have more skills and knowledge. He continued to explain that “It is by this long drawn out method that the British and The Canadian banks have built up the personnel of their foreign branches, and there seems to be no shorter road to real success in overseas banking”. Nowadays, with the advent and invention of electronic trading e.g. online marketing where one can buy or sell different products globally, either local or foreign countries. In this, one can summarize that the terrain of the global finances is not perfectly flat since some costs such as online marketing is uncontrollable. For example, most online platforms offer only a limited set of securities, forcing different investors to bear an array of the fixed costs. This can be specifically justified by the IT requirement and compatibility costs, organizational costs, registration costs, and also the multiple brokerage service costs, among other. This is because the buyers want to use several platforms or keep switching from one platform to another. This paper analyzes the past holdings of bond by a country as an indirect indicator of the fixed costs which is in question due to the fact the investors have sunk the costs incurred in acquiring the relevant information and even other costs which arise about the class of bonds. It can be found that the US holdings of the bonds of a country in 1943. Year 1943 is being focused because it was a year on which there is existence of detailed data. This significantly influences the US holdings of the foreign bonds of the individual country especially in 2010 even after controlling for the other standard determinants. The 15% allocation of the US investors’ holdings can also be explained by the holdings which were invested seven decades ago. In addition, this history effect is twice as large for the foreign currency bonds which were denominated as for the dollar bonds. The allocation of 30% of the US investors’ holdings around the globe of the non-dollar bonds as it can be explained henceforth. Today it can thus be explained by the pattern of such holdings seven decades ago. In the spite of different cases of non dollar bonds, the investors have to learn and take precaution not just about the foreign branch issuing the bonds, but also about the currency. This currency is the home currency of the investor, however strong or weak. There also needs of the adequate markets or such institutions in order to hedge the currency risk. This implies that the larger the costs sunk then, in turn, the larger the history effect. In conclusion, the findings can conclude that, the impacts of the history on US foreign bond holdings depended on the denomination of currency in those bonds. This strengthens a point made by Lane and Shambaugh (2010) about the needs for more thorough analysis of not just the currency composition of foreign assets and liabilities but also analyze their determinants. The Lane and Shambaugh discusses about the little and remarkable knowing for most countries. This gap will start to be filled when it comes to a specific aspect of US foreign assets which is foreign security holdings. In summary, history and geography plays an important role in contributing to the international finance as it shapes the strategic plans of investors through provision of relevant market information. References List Phelps, C. W. (1927), The foreign expansion of American banks: American branch banking abroad, The Ronald Press Company (New York). Portes, R. and H. Rey (2005), The Determinants of Cross-Border Equity Flows, Journal of International Economics, 65, pp. 269-296. Lane, P. and J. Shambaugh (2010), Exchange Rates and International Currency Exposures, American Economic Review, 100(1), pp. 518-540. Maurice Obstfeld (2008), International Finance, The New Palgrave Dictionary of Economics, 2nd Edition Eichengreen, B. (1989), The U.S. Capital Market and Foreign Lending, 1920-1955, in J. Sachs (Ed.), Developing Country Debt and Economic Performance, Volume 1, The International Financial System, Chicago: University of Chicago Press, pp.107-158 Dixit, A. (1989), Hysteresis, Import Penetration and Exchange Rate Pass-through, Quarterly Journal of Economics, 104, pp. 205-228. Eichengreen, B. and D. Irwin (1998), The Role of History in Bilateral Trade Flows, in The Regionalization of the World Economy, J. Frankel (Ed.), University of Chicago Press, pp.33-57. Anderson, J. and E. van Wincoop (2003), Gravity with Gravitas: a Solution to the Border Puzzle, American Economic Review, 93(1), pp. 170-192 Coeurdacier, N. and H. Rey (2011), Home Bias in Open Economy Financial Macroeconomics, Journal of Economic Literature, Forthcoming Read More