The Impact of Financial Deregulation and Capital Control on Financial Globalization and International Diversification

INTRODUCTION
The growth and survival of most international companies lie in their ability to operate within a marketplace that allows free movement and competition of labour, capital, technology and the spirit of innovation and entrepreneurship. For a company to be successful it got to win in every corner of the world as proposed by Jeffrey Immelt the head of GE hence agreeing with Mr Mills to have a boundary-less way of thinking. Governments are aware that companies would like to produce where it is most cost effective, selling where it is most profitable and sourcing capital where it is cheapest with little worry about national boundaries. Governments are obliged to accept a number of changes in the law through simplification, removal or allowing more freedom in how financial institutions compete. This reduction in governmental control that constrains the operations of market forces are term deregulation. (Sullivan, January 2002). An example of deregulation is financial deregulation which does not remove the control on all regulations against say property rights or fraud. It is an on-going debate whether such changes are beneficial or costly to the economy as a whole.
SECTION A
Financial Deregulation Any dilution which could result to removal of governmental regulations that keeps checks and balances on the activities of market forces within financial institutions is termed financial deregulation. There are a good number of financial regulations which governments tried to flex particularly in US and the UK which affected the international trade as a whole in the past decades. The policy recommendation for the 108th congress in US looked at the following; Repeal the Community Reinvestment Act (CRA) of 1977 Reject the Federal Deposit Insurance Reform Act of 2002 (H.R. 3717) that calls for increasing the deposit insurance limit to $130,000 and gives the Federal Deposit Insurance Corporation greater discretion in the setting of insurance premiums, Enact the Bankruptcy Abuse Prevention and Consumer Protection Act of 2002 with stronger provisions, and Revoke Fannie Mae’s and Freddie Mac’s federal charters and fully privatize those two government-sponsored enterprises. (Rodriguez, CATO HANDBOOK)

In UK variation in earlier laws led to the privatisation of the following; Express coach (Transport Act 1980), British Telecom (completed in 1984), Privatisation of London bus services (1984), Local bus services (Transport Act 1985) and The railways (1993).
The banking files, Juliet Samuel stated that
‘THE CITY has taken a major step towards becoming the first offshore trading centre for the Chinese renminbi after the FSA began work on loosening up regulations for Chinese banks’(City A.M. page 8 issue 1506, 2011). The goal is to set up a 24-hour renminbi market in the UK which the Treasury has been keen to speed up the progress as part of a major charm offensive to lure Chinese trade through London rather than the Eurozone.
The European Union’s deregulation of the air industry in Europe in 1992 empowered EU carriers to operate scheduled services between neighbour EU states.
Governments encourage financial deregulations because it increases competition, which improves the efficiency, leading to higher productivity and a reduction in prices as a whole. Some academicians see financial deregulation as a means for companies to grow in size and become more cost effective.
Many schools of thought against the idea of financial deregulation also argue that it leads to the removal of barriers between different types of financial institutions causing conflicts of interest. Below is an illustration of one of the financial deregulation before evaluating the whole impact.
Gramm-Leach-Bliley Act in 1999
The Gramm-Leach-Bliley Act in 1999 is one of the most important regulatory changes in United States which repealed the remaining sections of the Glasss-steagall Act of 1933, but could not end the Community Reinvestment Act (CRA) of 1977. The Act removed barriers to competition between commercial banks (who could only offer savings and loans), investment banks (selling securities, trading in foreign currencies and assisting firms in mergers), and insurance companies (insurance services), and allowed the participation of all three markets by firms.
It is belief the act will help to limit the effects of economic cycles on individual firms. People are more likely to save during a downturn but more likely to invest when they are better off. It will also be cheaper for companies to obtain capital funding for investing. Positive synergies could result through mergers.
Critics of financial deregulation believe that it contributed to the U.S. financial crisis of 2007-2009 and the Global financial crisis of 2008-2009. (Taibbi, Matt (19 March 2009).
Capital Control
Capital control is any form of action taken by a government, the central bank , or other authorize (regulatory) body to limit the flow of foreign capital in and out of the domestic economy. The regulation can be in the form of taxes, tariffs, exchange controls that prevent or restrict the buying and selling of a national currency at the market rate, caps on the allowed volume for the international sale or buying of various financial assets, requirement for mandatory approval, minimum stay requirements, and limits on the amount of money a private citizen is allowed to remove from the country. Developing economies are mostly associated with tight capital controls and lower capital reserves which more prone to volatility. Majority of the largest economies have a liberal policy of capital control as well as basic preventive measures against excessive movement of capital in times of crisis. The benefits and the risks of capital control have been a subject of much debate and several shifts of opinion have taken place as to the appropriate time to use them.
Brief history of world events
The notable periods are; Pre-World War 1: there was practically no need for capital control before the 19th century due to minimum international trade and financial integration. (Helleiner et al, 2005} 1914-1945: highly restricted capital controls were introduced with the outbreak of World War 1. The flight tax introduce in 1931 by Chancellor BÜning helped to limit the removal of capital from the country by wealthy residents. (Rogoff, 2008-94-16) The Bretton Woods Era: 1945-1971: international capital was ‘’caged’’ by imposition of strong and wide ranging capital controls with view of protecting the interests of ordinary people and the economy. Free market economists become successful in persuading their colleagues that capital controls were in the main harmful in the 1970s. the U. S, other western governments, and the international financial institutions IMF and the world bank began to persuade many counties to abandon them. In 1960 British families were not allowed to take more than £50 on them out of the country for their foreign holidays. (Wyplosz, 2005). Transition period and Washington consensus: 1971-2009: most countries abolished their capital controls joining the Keynesianism in favour of free market orientated policies and theories with the opinion that capital controls were to be avoided except perhaps in a crisis (1980-1990). Over 50 countries retained their controls on capital. After the Asian Financial crisis of 1997-98, there was a shift back to the view that capital controls can be appropriate and essential in times of financial crisis. (Anton, 2011). The IMF had endorsed the use of capital controls as response by 2008-09 crises. In late 2009 several countries imposed capitals even though their economies had recovered. Post Washington Consensus: 2009 and after: capital inflows’ limitation was imposed by several countries. By February 2010 the IMF had almost entirely reversed the position it had adopted in the 80s and 90s, saying that capital controls can be useful as a regular policy tool even when there is no crisis to react to, though it still cautions against their overuse. The IMF, G20, the UN, World Bank and Asian Development Bank all now consider that capital controls are an acceptable way for states to regulate potentially harmful capital flows.

Benefit of free capital movement It enhances the general economic welfare by allowing savings to be channelled to their most productive use. (2001! Galbraith,) By encouraging foreign direct investment it helps developing economies to benefit from foreign expertise, Allows states to raise funds from external markets to help them mitigate a temporary recession. Enables both savers and borrowers to secure the best available market rate, When controls include taxes, funds raised are sometimes siphoned off by corrupt government officials for their use. Hawala-type traders across Asia have always been able to evade currency movement controls, Computer and satellite communication technologies have made Electronic funds transfer a convenience for increasing numbers of bank customers. Benefit of capital controls Capital controls may represent an optimal Macro prudential policy that reduces the risk of financial crises and prevents the associated externalities (Anton, 2010-05-01). Global economic growth was on average considerably higher in the Bretton Woods periods where capital controls were widely in use. Using Regression analysis, economists such as Dani Rodrik have found no positive correlation between growth and free capital movement (Galbraith, Ed (2001)). Capital controls limiting a nation’s residents from owning foreign assets can ensure that domestic credit is available more cheaply than would otherwise be the case. This sort of capital control is still in effect in both India and China. In India the controls encourage residents to provide cheap funds directly to the government, while in China it means that Chinese businesses have an inexpensive source of loans (Rogoff, 2010). Economic crises have been considerably more frequent since the Bretton Woods capital controls were relaxed. Even economic historians who class capital control as repressive have concluded capital controls, more than the period’s high growth, were responsible for the infrequency of crisis (Rogoff, 2010). Studies have found that large uncontrolled capital inflows have frequently damaged a nation’s economic development by causing its currency to appreciate, by contributing to inflation, and by causing unsustainable economic booms which often precede financial crises-caused when the inflows sharply reverse and both domestic and foreign capital flee the country. The risk of crisis is especially high in developing economies where the inbound flows become loans denominated in foreign currency, so that the repayments become considerably more expensive as the developing country’s currency depreciates. This is known as original Sin (economics) Subramanian, 2007-04-16).
Financial Globalisation
Financial globalization is an aggregate concept that refers to rising global linkages through
Cross-border financial flows, whereas financial integration refers to an individual country’s linkages to international capital markets. These concepts are closely related; for instance, increasing financial globalization is perforce associated with rising financial integration on average. In this presentation, the two terms are used interchangeably. (Eswar Prasad, 2003). The international financial system has grown in importance as the U.S. economy has become more interdependent with the economies of the rest of the world. (Mishkin, 2000) The recent wave of financial globalization since the mid-1980s has been marked by a surge in capital flows among industrial countries and, more notably, between industrial and developing counties. While these capital flows have been associated with high growth rates in some developing countries, a number of countries have experienced periodic collapse in growth rated and significant financial crises over the same period, crises that have exacted a serious toll in terms of macroeconomic and social costs (Eswar Prasad, 2003). It is important to note the distinction between policies associated with capital accounts liberalization and the actual capital flows with respect to indicators measuring the extent of government restrictions on capital flows across national borders. The volume of actual capital crossing the borders of many countries in Latin America have been large relative to the average volume of flow across all developing countries. These Latin American countries are said to be quite open to global financial flows but by contrast, some African countries have few formal restrictions on capital account transactions without experiencing significant capital flows. In conclusion, it is good for a country to have financial deregulation and capital control policies but what actually matters most is the degree of ‘’openness’’ rather than comparing complex restrictions. (See appendix for illustration).
International Diversification
Due to the riskiness of stock market investments both theoreticians and practitioners recommend the holding of a well-diversified portfolio. One of the ways to reduce the political and economic risks associated with investing solely within the home country is through international diversification. The purpose is to have a well balanced portfolio by finding investments that will move in the opposite direction of the domestic investments.
International diversification helps to reduce risks such as currency risk but this basic fact is challenged as globalization is causing markets to move in similar trends with a high correlation. ‘’International market correlations increase after unexpected exogenous shocks’’. The implication is that diversification benefits may be reduced after such events of September 11, 2001, terrorist events in the United States. Knowing the correlations between the returns of various national markets is important for the process of allocating investments among these markets (B. F. Yavas, 2007).
Foreign investment is more complex because of: Language and cultural issues, different accounting standards, expropriation risk, disclosure issues, poor corporate governance, inability to get fair redress in the courts, exchange controls, wars and foreign trading cost if not listed in the US. An effective assessment of financial deregulation and capital control on financial globalization is of great importance. During the financial crisis of 2008, professionals observed that portfolios with international diversification did not protect investors for risk. The 2006 ended having all the major U. S. indices logged double digit gains. However, even the though standard & Poor’s 500 index turned in a 13.6% performance, an investor would have done better had he or she ventured outside the U. S. Using averages, domestic stock funds gained 12.6% in 2006 compared to 25.5% for international stock funds. Emerging countries are considered the top choice for diversifying risk since they do not follow the same cyclical patterns as industrialized nations. The challenge therefore is to understand what will drive the relative forward interest rate policy between countries. It might be better internationally to invest in currencies where the central bank is tightening, particularly if there are any ‘’surprises’’. The basic rule is that in the long run, international diversification is an effective means of spreading risk. However, it does not protect the investor if there is a global crisis.

SECTION B
Financial innovations and technology
The creating and marketing of new types of securities is termed financial innovation. Modigliani-Miller theorem interpreted that taxes and regulation are the only reasons for investors to care of the types of securities issued by a firm. On the other hand the capital asset pricing model suggested that investors should fully diversify and their portfolios should be a mixture of the ‘’market’’ and a risk-free investment. Richard Roll concluded that there should be demand for instruments that open up new types of investment opportunities. Firms prefer to finance investments out of retained earnings first, then debt, and finally equity, because investors are reluctant to trust any firm that needs to issue equity. (Myers and Majluf (1984))
The following financial instrument became prominent after macroeconomic conditions forced investors to be more aware of the need to hedge certain types of risk.

The development of interest rate swaps in early 1980s after interest rates skyrocketed The development of credit default swaps in 2000s after the recession beginning in 2001 led to the highest corporate-bond default rate in 2002 since the Great Depression. The market in options exploded after the development of the Black-Scholes model in 1973. The development of CDO was heavily influenced by the popularization of the copula technique (Li 2000) Flash trading exists since 2000 at the Chicago Board Options Exchange and 2006 in the equities market. In July 2010, Direct Edge became a U. S. Futures Exchange. Nasdaq and Bats Exchange, Inc. created their own flash market in early 2009.
Futures, options and many other types of derivatives have been around for centuries; however, recent decades have seen an explosion use of derivatives and mathematically-complicated securitization techniques. Some investors use total return swaps to convert dividends into gains, which are taxed at a lower rate (10&PUBID=35&ISS=2445&SID). Mackenzie (2006) argues from a sociological point of view that mathematical formulas actually change the way that economic agents use and price assets. Technological advancements can reduce barriers between countries and regions. The use of the World Wide Web enables firms to quickly dispatch information from one country to another without much restriction, hence massive use of the internet in relating information globally at a space of no time which otherwise could have taken longer duration. Computer-based information systems are used to devise better methods of converting data into information, and for the creation of enhanced data gathering methods. The lunched of smartphones into the cell phone market is commonly derived from a demand among consumers for more technologically advanced products. A failure for a firm to adopt/ignore technological innovations will make it lose out to its competitors within the industry.
Some kinds of financial innovation are driven by improvements in computer and telecommunication technology. Paul Volcker suggested that for most people, the creation of the ATM was a greater financial innovation than assets-backed securitization. Other types of financial innovation affecting the payments system include credit and debit cards and online payment systems like Pay Pal. These types of innovations are notable because they reduce transaction costs. Households need to keep lower cash balances contributing to higher efficiency in a cash-in-advance constraints economy.
SECTION C
THE BENEFITS AND RISKS OF THE CARRY TRADE STRATEGY
In a carry trade, the speculator borrows money in a low interest rate currency and buys higher yielding assets in a different currency (i.e. selling currency with low interest rate to purchase a currency that pays a higher interest rate). The Japanese yen, now a days is the low interest rate currency and the higher yielding assets are usually US dollar bonds, sometimes Icelandic housing bonds or emerging market equities or commodities. The difference in the interest rate between the two currencies is called the interest rate differential. The carry trade has the potential to significantly enhance a trader’s return through a high interest rate differential. The carry trade is appealing to money managers and hedge fund managers because of its benefits of earning steady and consistent returns on their investments. Below is an illustration of the type of returns:
Below is a typical example where the carry trade strategy shows a steady increase of the GBP/JPY pair in 2005 and 2006 (www.fxwords.com/c/curry-trade.htmi) GBP/JPY | Interest | Bought 204.73 | GBP Return 4.50%-5.00% | Sold 221.25 | JPY Costs 0.00%-0.25% | Profit in pips 1,652 | Approx. Daily Return $22.35 | Profit in Dollars $13,909.84 | Profit from interest $8,157.75 | Total profit $8,157.75 + $13.909.84 = | $22,067.59 |
The biggest risk in a carry trade strategy is the absolute uncertainty of the exchange rates. If the exchange rate moves against you- the higher interest rate currency rapidly devalues, reducing the value of your assets relative to your borrowing-there is the possibility of a very large and very sudden loss. There are two objectives with the carry trade. Obviously the first is to make money on the interest rate differential. The second is to gain on the capital appreciation. A better return on the initial investment is got if the carry trade pair appreciates in value. There is the risk of not meeting one objective or the other, or both. The risk of losing money with a carry trade is a definite one, but smart traders use Forex trading strategies to minimize these risks. It is important to look at more than just the interest rates on the currencies before you trade. Looking at the directional bias of the pairs that you are considering is a good way to determine if trading in those pairs is a smart move for you. Investors should never risk more than they can afford to lose on the market.
SECTION D
APPRAISAL OF CAPITAL MARKETS AND FOREIGN STOCK MARKETS
International capital market serves as an important intermediary for foreign investors and participants where funds can be transferred from surplus hands to deficit counterparts. It provides opportunity to borrow and/or invest beyond home country thus smoothening fund distribution globally. The financing decision of a company is very crucial since it enables sustainable growth and existence into the foreseeable future. Financing must be critically appraised to ensure that it helps achieve reduction in cost of capital while increasing company’s share capital.

A company’s operations are affected as its likelihood to default increases due to increases in finance cost which raises company’s cost of capital. The impact is felt on the cost of equity (Ke) as company battles to survive. Any future borrowing is also affected as default risk, sovereign risk and company rating is considered during Kb pricing. All these have adverse effect on cost of capital and share price as both always go together.
However, cross-listing on a foreign stock exchange especially that of a US-based have proved positive in the past. It has led to higher company valuation compared to non-cross-listed companies thereby leading to a better appreciation of its share price and cheaper access to capital across the globe.

Although it may be costly to get cross-listed due to additional reporting requirements and fees, it is however true that it brings the company to limelight. Increased information and popularity boosts share price while making financing on different stock exchanges easier and cheaper. In addition, raising fund in high currency economy like UK, to use in low currency economy will be beneficial since equity is a permanent source of financing with no financial obligation thus eliminating finance cost and currency risk compared to issuing international corporate bond. A company must not solely depend on debt or equity only to finance its operations but considerable mixture of both is advisable in order to have a healthy long-term solvency. The weighted average cost of capital (WACC) is best minimized when cheap Kb is used in conjunction with expensive Ke. Care must be taken not to take too high proportion of debt as it neutralizes its advantage when finance cost increases, leading to shareholders’ dissatisfaction which can lead to huge sale and low valuation of equity on secondary markets.

The company can borrow from international bond markets which have low interest rate and hedge in a future contract against any possible Forex fluctuation. This provides a safe financing thus reducing cost of capital of a company. The WACC falls as corporate bond is less risky and tax efficient, increasing company’s operations and positively impacting on its share price. A well balanced capital structure positively impacts on a company’s cost of capital as it makes both equity and debt cheaper. This goes a long way to increase company’s reputation as its equity or bond on international market is liquid, making the security more desirable which ultimately impacts on its share price.

CONCLUSION AND RECOMMENDATION
International markets have grown rapidly in the last few decades, interlinking economies, nations and financial markets. The impacts of globalization, free capital movement, financial innovation, and technological advancement on economies and financial institutions cannot be over-emphasized.

REFERENCE
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