GLOBALIZATION OF FINANCIAL MARKETS: IMPLICATIONS, VULNERABILITIES, AND OPPORTUNITIES

• Document Type: CREST
• Collection: General CIA Records
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• Original Classification: S
• Document Page Count: 47
• Document Creation Date: December 22, 2016
• Document Release Date: March 15, 2011
• Sequence Number: 3
• Publication Date: October 1, 1986
• Content Type: REPORT

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Directorate of Bret
Intelligence
Globalization of Financial Markets:
Implications, Vulnerabilities,
and Opportunities
GI 86-10073
October 1986
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Directorate of Secret
Intelligence
Globalization of Financial Markets:
Implications, Vulnerabilities,
and Opportunities
This paper was prepared by the Office of Global
Issues. Comments and queries are welcome and may
be directed to the Chief, Economics Division, OGI,
Reverse Blank Secret
GI 86-10073
October 1986
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Globalization of Financial Markets:
Implications, Vulnerabilities,
and Opportunities
economic phenomena worldwide.
Summary The globalization of financial markets has been one of the most revolution-
Information available ary structural changes in the world economy over the past decade. Since
as of 1 October 1986 late in the last decade, we have seen an unprecedented restructuring of
was used in this report.
these markets: traditional distinctions have been blurred between domestic
and international markets, between different types of financial transac-
tions, and between who is a market participant and who is not. At the same
time, there has been an explosive increase in the speed, size, and scope of
international money transactions. As a result, international financial
markets have become a connective medium that interlocks political and
We believe this globalization of financial markets has been the result of the
confluence of three underlying trends. First, the oil shocks of the 1970s en-
abled the capital markets to recycle billions of petrodollars out of the
Persian Gulf, through Western money centers, to Third World borrowers;
more recently, the Japanese have exported a large share of their capital
surplus to the United States. Second, the rapid advances in computer and
telecommunication technologies- have enabled financial traders to integrate
and accelerate international transactions. Finally, a wave of financial
deregulations has swept through the Western money centers, bringing with
it greater competitive pressures that have led to widespread market
innovations.
Financial integration caused by the globalization process has not only been
accelerating but has outstripped any corresponding political integration or
evolution of economic policy coordination. The transformation of interna-
tional financial markets is demonstrated by several statistics: foreign
exchange transactions now exceed $100 billion per day; interbank deposits
stood at $1.4 trillion last year, twice the 1981 level; and international bank
financing rose 43 percent in 1984, and another 26 percent last year. The
number of international banks is now in the hundreds, up from just a
handful in the 1970s; offshore banks have multiplied each year for the last
few years; and the volume of Euromarket transactions has probably tripled
since the 1970s. Finally, new financial instruments are appearing on the
markets faster than either the traders or the regulators can fully under-
stand them.
Secret
GI 86-10073
October 1986
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The increased capabilities of the financial system have facilitated greater
growth and efficiency of the world economy. For the United States, these
changes have made it easier to tap Japanese and European surplus capital
for financing large US trade and fiscal deficits and have brought produc-
tive investment to US soil. The resulting growth of the US economy has, in
turn, fueled increased economic activity worldwide. Despite such broad
positive consequences, we believe the new financial environment is creating
some potential risks.
Directly, the globalization of financial markets has created a highly fluid
medium through which political and economic shocks in one area are
quickly and forcefully transmitted to the rest of the globe. As a result, mar-
kets are increasingly sensitive to news, and, therefore, have become more
volatile. This volatility, in turn, can cause broader economic and political
fluctuations, both internationally and within countries. Sudden shifts in
exchange rates as a result of political events can stimulate further
speculative attacks on a country's currency-quickly draining foreign
exchange reserves if a government chooses to insulate itself from currency
changes.
Indications are that the international financial system may be becoming
less stable. While some observers argue that the broadening of the investor
base and enhanced information flows have bolstered the overall system,
there are worrisome trends. First, sharp competition has lowered the risk
threshold that some lenders are willing to accept. Second, the declining
power of regulators is encouraging institutions to take greater risks and is
eroding regulatory authorities' ability to foresee potential stability prob-
lems and react to them. Third, the vulnerability of the international
electronic funds-clearing system is on the rise as the volume and speed of
transactions increase. Finally, the spread of new financial instruments is
outpacing the ability of both regulators and traders to understand the
underlying risk or value of the transactions.
Along with the globalization of international finance has come the greater
use of the financial system by governments and groups whose objectives
threaten Western security interests. Aside from the multibillion-dollar
international narcotics money-laundering industry, terrorist activities, gray
arms purchases, technology transfer, and nuclear proliferation are often
funded through the world's financial networks. Participants in these
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activities find the speed, ease, and anonymity associated with the use of the
system attractive for their purposes. In addition, the increased size and
sensitivity of the markets have raised the opportunities for tampering,
increasing the vulnerabilities of small countries.
Less directly, the globalization of financial markets has tended to acceler-
ate longer term trends in resource flows. The large foreign exchange needs
caused by the LDC debt problem have forced many Third World countries
to boost exports, which has raised protectionist sentiments in the developed
countries. By facilitating the large flow of capital into the US economy, in-
ternational financial markets have made possible massive imports of
foreign goods into the United States. Along with the shift of some
industries offshore, such shifts in trade balances have contributed to
protectionist pressures
International financial markets are also contributing to a reconfiguration
of international cooperation. At the policy level, the increased integration
of the various domestic economies with world markets has made fiscal and
monetary cooperation more important, yet more difficult. At the industrial
level, cross investment between countries is blurring the corporate owner-
ship picture-raising concerns about the production of strategic goods and
broader control of the economy. As a result, we believe there may be a
backlash against foreign investment in such areas as Western Europe and,
perhaps, some restrictions on capital outflows, which may raise internation-
al tensions over an emerging "investment protectionism."
How these emerging ramifications will affect any given region will depend
largely on the magnitude of resource flows through the region and on the
extent the region participates in the international financial system:
? Japan is likely to continue to be the source of massive capital outflows.
This could lead to greater Japanese leverage over countries in which it in-
vests. At the same time, the role of the yen in the world economy is likely
to increase as the Japanese economy grows-again leading to a greater
importance for Japanese economic policy.
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? Western Europe wants to ensure its place as a world financial center, and
several West European countries are taking steps to deregulate their
capital markets to achieve this goal-despite the problems this may raise
for large international capital movements. Western Europe's exports and
economic growth benefited during the first half of the 1980s from the
strong dollar. If the more recently falling dollar begins to impair their
trade position, West European countries will show some concern about
US policy, and protectionist pressure may increase. West Europeans also
claim that US budget deficits are keeping interest rates unnecessarily
high and almost certainly would become worried about capital flows if
US interest rates started moving back up to the levels of the early 1980s.
? The Third World has been most affected by the evolution of the
international financial scene. The foreign debt situation has become the
most important single influence on both the economic and political
stability of many LDCs important to the United States. While there
could be increased domestic unrest as a result of poor economic
performance, relations with the United States are likely to be strained as
Latin America focuses on the debt issue, the Africans on aid, and the
Asians on protectionism.
? The Middle East is facing rapidly growing financial problems as the
major oil exporters must draw down their external assets to fund current
expenditures. Moreover, surrounding economies will continue to suffer as
the Persian Gulf countries-normally the region's economic power-
houses-no longer provide stimulus. Although this will mean less Saudi
aid, it could also mean severe financial problems for Iran, Iraq, Libya,
Syria, and groups such as the Palestine Liberation Organization.
? In the Soviet sphere, Moscow is facing declining earnings from its
premier export-oil. The USSR's hard currency surplus dropped from
$4.4 billion in 1984 to $1 billion last year. These shortfalls will put
greater pressure on domestic food programs, as well as Soviet acquisition
of foreign technologies. Similarly, Moscow's belt-tightening, coupled
with the benefits provided by participation in the international financial
community, may lead to a greater Western orientation by Eastern
Europe and the Soviet-supported LDCs.
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? China's future participation in the international financial markets could
become one of the most important issues of the last half of this decade.
Some observers believe China could quickly become a large capital
importer-radically altering capital flow patterns worldwide. Moreover,
China will have sovereignty over a major financial center when it
assumes control of Hong Kong.
In each of these cases, US leverage is affected by shifts in the financial
flows, and the importance of the US economy at the global level will mean
continued pressure by foreign governments on Washington to keep external
impacts in mind when formulating US policy.
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Capital Flows: Swelling the Financial Markets
2
Information Technology: Enabling a Revolution
2
Deregulation: Unleashing the Free Market
2
Reshaping the Global Economy
3
Linkages to the Global Economy
5
Evolving Ram
ifications
6
Commodity Market Manipulation 14
The Global Financial System: The Future Role of the Major Players 23
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Scope Note This study is one of a series the Directorate of Intelligence is undertaking
on the question of structural change in the global economy. It addresses
shifts occurring in international financial markets, the way the internation-
al financial system is now used, and the implications for economic and
political balances. While financial globalization has had an overwhelming-
ly positive impact, it has also created new risks and vulnerabilities that this
speculative study tries to highlight. We also recognize that financial
globalization is part of a larger process of internationalization that is
occurring. With this in mind, we are currently preparing a report on the
globalization of industry, including the movement of technology from
country to country. Other issues we intend to examine include the impact
of globalization on agriculture where markets are also undergoing dramat-
ic structural change.
Xi Secret
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Globalization of Financial Markets:
Implications, Vulnerabilities,
and Opportunities
Structural changes in the world economy set into
motion by the technology revolution and its accompa-
nying forces are having a profound impact on a wide
range of national security issues. While much of the
emphasis has been on such issues as industrial compe-
tition and shifts in global economic balances, a funda-
mental and less understood change is occurring in the
international financial realm. Technology has created
the global, nearly instantaneous communications net-
work that has globalized national financial markets
into a cohesive whole.
The consequences pf this globalization reach far
beyond the financial arena as both economic and
political pressures are transmitted through the in-
creasingly fluid international financial system. At one
level, the emerging global market has simply raised
the speed and magnitude of economic changes
brought about by other forces-the internationaliza-
tion of production, for example. At a more immediate
level, the globalization of financial markets has creat-
ed its own vulnerabilities and opportunities for gov-
ernments, groups, and individuals worldwide. The
delicate nature of the international financial network,
for example, has created the potential for relatively
small groups to use the international financial system
to damage entire nations and to disrupt strategic
balances in certain regions.
Factors such as the explosion in the types and variet-
ies of financial instruments have also raised new
vulnerabilities. A case in point is the growing volume
of trading on the options markets where billions of
dollars change hands on a daily-even hourly-basis.
Beyond this, the level of risk taking that occurs in
these markets is being driven by aggressive, young
individuals with little stake in the system. In this
environment, the risk of accidents because of simple
miscalculations or lack of historical perspective is only
intensified. Unlike the stock exchange, these new
markets-sometimes called synthetic markets-are
high-risk environments because there are no real
assets backing the transactions.
The global financial system is a complex matrix that
interlocks individuals, businesses, and governments
worldwide. Its components range from the major
Western money-center banks with their satellite tele-
communications networks to massive black-market
foreign exchange operations that flourish throughout
the Third World. This system is the connective medi-
um that enables the constant flow of global resources
and has consequently become the world's central
information clearinghouse.
During most of the post-World War II period, the
international financial system was largely a facilitator
of international trade, and its growth closely matched
that of trade volumes. The dominant organizational
influences in the international financial markets were
a few large banking institutions in the developed
West,;which largely operated apart from the domestic
financial markets. The 1970s saw an unprecedented
globalization of these markets: differences were
blurred between international and domestic markets,
between the different kinds of financial transactions,
and between who was a market participant and who
was not.
This globalization of financial markets, which contin-
ues to accelerate in the 1980s, has been brought about
by a confluence of evolving forces. As the size of the
capital markets increased, the technology revolution
enabled funds to move more rapidly. At the same
time, deregulation helped ensure that many of the
obstacles to financial growth and acceleration were
eliminated.
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Capital Flows: Swelling the Financial Markets
The oil price increases of the 1970s caused massive
shifts in capital from the developed economies to the
emerging Third World economies. New strains were
put upon the financial system to channel these funds.
At first, capital flowed from the oil importers of
Japan, Europe, and the United States to the newly
rich oil exporters-mostly in the Middle East. The
large trade surpluses-in the form of petrodollars-
were deposited in Western banks, which turned to
Third World borrowers to soak up the growing vol-
ume of loanable funds. Prior to the onset of the Third
World debt crisis in late 1982, the rising profits of
international banking were attracting new, larger
players into the market. As the 1980s unfolded,
capital flows were again expanding sharply-this time
from revenue-rich Japan to the growing US economy.
Indeed, Japan's capital surpluses have overtaken
OPEC's surplus peaks of the early 1980s.
Information Technology: Enabling a Revolution
The exponential globalization of the financial system
has been rendered possible by the development and
implementation of information technologies through-
out the finance industry:
? Computer technology has allowed the number of
transactions the international system can process to
expand by several orders of magnitude over the past
decade. For example, new computers installed in the
Hong Kong Stock Exchange in April tripled the
capacity of that market: it now takes only seven
seconds to complete a multimillion-dollar sale there,
according to local press reports. Moreover, comput-
ers have enhanced the quality of news and technical
information available to investors and speculators-
enabling them to shift funds more quickly as world
events unfold.
? Telecommunications technology has allowed great-
er access to international financial markets by
speeding the flow of price and other information.
The global communications network makes possible
a higher volume of instantaneous transactions
among finance and commodity markets on every
continent. The Sydney Stock Exchange, for exam-
ple, is linked to Amsterdam, Montreal, and Vancou-
ver exchanges to trade listed options in gold, silver,
and selected foreign currencies, according to trade
reports.
The convergence of computers with telecommunica-
tions has produced the infrastructure for the truly
global marketplace. Within the next three years, for
example, eight of the top 10 stock markets in the
world will be operating some form of computerized
trading system capable of integrating into a single
global market. Traders report that talks are now
under way to link the British, French, West German,
and Japanese stock listings.
While these technological advancements provide obvi-
ous efficiencies for the larger financial institutions,
the smaller financial players formerly on the fringe of
the market are also afforded greater access. Such
players may ultimately prove to be the most critical
phenomenon of globalization as even individuals in
LISCs gain access to high-quality information and are
able to execute large-scale financial transactions that,
until recently, were reserved for the major financial
centers in the developed West.
Deregulation: Unleashing the Free Market
Although many observers cite government deregula-
tion as a driving force behind globalization, we believe
that government regulatory efforts were overwhelmed
by free market innovations and the inevitable integra-
tion of the maturing world markets. Nevertheless,
liberalization of financial regulations has removed
many of the obstacles to globalization:
? Japan has moved to open its domestic financial
market to foreign banks. Foreign institutions are
now allowed to trade government securities and
underwrite new Euroyen offerings, and last year
Tokyo gave nine foreign banks licenses to operate in
Japan. Japanese banking power is also moving
abroad. The Ministry of Finance has given its
approval for six major Japanese banks to move into
the US pension-fund industry. This will solidify
many links between the Japanese and US finance
industries.
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? Following the US lead in July 1984, West Germany
and France abolished withholding taxes on domestic
bonds owned by foreigners, encouraging foreign
financial players to move in and out of those
markets. Moreover, France recently reopened its
Eurofranc market, and Germany eased restrictions
on issuances of deutsche mark-denominated bonds
by foreigners, while allowing creation of several new
financial instruments.
? The United Kingdom is in the process of implement-
ing the "big bang"-a broad liberalization of its
financial markets in an effort to remold London's
long overprotected institutions into full-service con-
glomerates capable of competing worldwide. Lon-
don banks, as well as banks from the United States
and Europe, have taken over almost all of the
London Exchanges' two dozen largest firms. This
year London will begin to allow foreign competition
in its government bond market-the second largest
in the world.
Reshaping the Global Economy
The sheer magnitude of financial globalization has
had far-reaching effects. In the day-to-day operations
of the markets, the financial revolution can be seen in
the tremendous growth of the speed, size, and scope of
financial transactions. This revolution has, in turn,
facilitated the massive capital movements across the
globe that have changed the current landscape of the
entire global economy.
The Financial Markets
The international financial system, together with the
domestic financial sectors, is rapidly becoming a
unified international marketplace. This new global
industry has radically altered the traditional dimen-
sions of international money trading:
? Continuous and immediate. The larger banks now
operate their own international telecommunications
networks. These links, coupled with expanded trad-
ing in every region of the Western world, have
resulted in a 24-hour market. Besides making large
transactions possible at any time, it is now possible
to transfer control over hundreds of millions of
dollars in a matter of minutes. The first indications
of breaking world events are often seen in the
immediate movements of interest rates, exchange
rates, and capital flows.
? Large and growing. The volume of capital flows
across national borders now greatly exceeds the
value of international trade. Foreign exchange
transactions alone, for example, exceeded $100 bil-
lion per day last year. By comparison, one week of
funds transfers on the international market is
roughly the size of the Third World debt. It is not
uncommon for millions of dollars to flow out of a
country's money center on rumors of a major event,
just to flow back in again when the rumors subside
minutes later. Moreover, capital transfers from
country to country for industrial expansion and
import financing are now greater than the peak of
petrodollar flows in the 1970s. According to OECD
statistics, total international bank financing rose 43
percent in 1984, and another 26 percent last year.
The amount held in interbank deposits stood at $1.4
trillion last year-more than double the 1981 level.
The market structure of the world's finance industry
is also being reshaped as globalization takes hold:
? The number of international banks is now in the
hundreds-up from just a handful in the early
1970s. These banks operate an interlocking network
of more than 4,000 regional offices worldwide. In
Miami alone, there are now 40 foreign-owned bank
branches, with deposits of nearly $4 billion-up 45
percent last year. More important, these numbers
significantly understate the profusion of market
players: deregulation has allowed the entry of previ-
ously locked-out institutions, including such untra-
ditional financiers as General Motors.
? The explosive rise of offshore money centers. The
flight of trading activity to less regulated markets
in Third World countries has been tremendous. For
example, the number of banks in Anguilla grew
from two in 1983 to 200 last year. Panamanian
banks now hold $35 billion in foreign deposits-an
amount eight times the size of Panama's annual
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gross national product-and have virtually no re-
porting requirements. In addition, such places as
Bahrain, the Channel Islands, the Caicos Islands,
the Turks Islands, and The Bahamas have become
significant second-tier banking centers trying to
match the growth of the better known centers of
Singapore, Hong Kong, Luxembourg, and
Liechtenstein.
? The Euromarkets have moved to the fore of inter-
national trading by more than tripling in size since
the mid-1970s, according to Bank for International
Settlements (BIS) statistics (figure 1). These mar-
kets-in which money instruments, bonds, and secu-
rities are denominated in the currencies of foreign
countries-are abstractions that have no physical
locations and are therefore an important element of
globalization because their supranational nature
makes effective control by government regulators
very difficult. As a result, the Euromarkets have
been described as "the new battleground of compe-
tition" between traditional banks and new financial
institutions. Competition on the Euroyen market
has been particularly bloody, as that sector of the
market has grown exponentially over the last few
years.
Threaded throughout these new structures has
been the geometric growth of new financial instru-
ments. Indeed, the amount of money involved in
"traditional" lending has actually declined over the
last several years and is being more than compensated
by lending using new techniques:
? `Securitization" is overtaking traditional bank
loans as the primary means of borrowing. One such
new financing scheme-called the note issuance
facility (NIF), by which the instrument of debt can
be traded away by both the borrower and the
lender-grew from near zero in 1982 to an estimat-
ed $45 billion last year. NIFs have supplanted
syndicated loans-the type given to LDCs before
the debt crisis-and along with the new floating-
rate notes (FRNs) now account for a quarter of all
international loan activity. These instruments were
almost unknown in 1980.
Figure 1
New Issues of Eurodollar Bonds,
1978-84
? Currency swaps and interest swaps, allow investors
and speculators to change the currency-of-
denomination of financial instruments on short
notice. In 1984 $150 billion of interest swaps was
executed-a sixfold increase in one year (figure 3).
Industry analysts predict that currency swaps will
double this year to about $40 billion and cover 25
percent of all nondollar international bonds, up from
under 1 percent in 1981.
? Combinations of instruments are creating a dizzy-
ing array of new mechanisms of international fi-
nancing. New acronyms, such as SNIFs, GUNs,
and RUFs, are appearing on the Euromarkets every
few days. Given the speed of global trading in this
new environment, industry analysts report that very
few players have even a modest understanding of
what many of these new financial contracts involve.
It is sometimes unclear, for example, exactly who is
on the other side of some of these transactions.
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Figure 2
Trade Imbalances: A Proxy for Capital
Flows, 1968-86
? Negative balances ? Positive balances
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
1969
1968
Note: Trade imbalances must be financed by either a depletion of reserves
in the deficit country, or a net inflow of capital through investment or
borrowing. The bars on the left side of the chart indicate the sum of trade
deficits that were mostly financed by capital inflows through the
international system. The constant and explosive growth of these flows
through three recession-recovery cycles shows the structural nature of the
change. Such trade imbalances would not have been possible without the
conduit of the international financial system.
Linkages to the Global Economy
The globalization of financial markets has also played
a role in the changes we have seen in the world
economy over the last decade. The magnitude of
capital shifts that have occurred since 1980 has taken
most observers by surprise. For example, few observ-
ers would have predicted that the international finan-
cial system could deliver enough capital to the United
States to support its multihundred-billion-dollar trade
and federal budget deficits. Without the flow capacity
the capital market has developed, such deficits proba-
bly would have driven US interest rates to unprece-
dented levels; or, more accurately, such deficits would
not have occurred. On the flip side, the global market
has afforded Japan a new outlet for its surplus capital.
In general, the capacity the international financial
market has given countries to run larger trade imbal-
ances has grown enormously: the absolute level of
trade imbalances of OECD economies this year is
estimated at more than $250 billion, or 20 times what
it was before 1970 (figure 2).
The ties that have been forged between the interna-
tional financial market and the various domestic
markets have irreversibly linked the monetary and
financial policies of governments. Today more than
ever, the evaporation of financial borders, coupled
with the dollar's role as the world currency, means
that the world's interest rates are "set in Washing-
ton." Because of the ease with which capital now
flows across borders, foreign central banks find it
increasingly difficult to pursue an independent policy
of, say, lower interest rates: such policies would
quickly drive capital to seek higher returns on foreign
soil.
All of these factors have combined to change the way
businessmen think worldwide. Now traders can move
massive amounts of funds across borders to take
advantage of momentary shifts in exchange rates.
Because of the high costs of being caught in the wrong
currency during a sudden exchange rate shift, rumors
about even relatively small news events can send
markets reeling. Over the longer term, businessmen
must take the global economy into account when
considering what were previously domestic business
Continued Globalization
We foresee a further acceleration of the globalization
process. International banks are in a fierce struggle
with each other and with new competitors to expand
their volume and scope of business. The technologies
that made possible this globalization are likely to
undergo more revolutionary advances. These trends,
along with the growing competition from the new,
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Secret
Figure 3
Financial Instruments: The New Importance of Swaps
The Growth of Currency Swaps,
1984-86
The Rise of Swap-Driven Lending as a
Share of International Bonds
Swap-driven
The Growth of Interest Swaps,
1983-84
loosely regulated money centers in the LDCs, would
overwhelm any possible backpeddling by Western
governments in their efforts to liberalize the global
financial system. Short of global crisis, we see nothing
that can stop this process.
Evolving Ramifications
Because the role of the international financial market
in facilitating greater growth and efficiency of the
world economy is widely recognized, we will focus
here on the evolving concerns and opportunities raised
by the new financial environment. We believe there
are important ramifications on several global issues.
Directly, financial globalization has raised short-term
economic instability problems for both the market and
individual countries. Moreover, it has created oppor-
tunities for exploitation of the financial system by
groups whose goals may threaten US security inter-
ests. In a more indirect fashion, the international
financial system has accentuated problems in related
areas, including protectionism and US competitive-
ness, and has generated some national sovereignty
problems that may heighten international tensions.
Short-Term Economic Stability
The international financial market now provides a
highly fluid medium through which political and
economic shocks in one area are transmitted quickly
and forcefully to the rest of the globe. As a result,
markets are increasingly sensitive to news. This vola-
tility, in turn, can cause broader economic and politi-
cal fluctuations, both internationally and within coun-
tries through exchange rates, interest rates, and
capital flight.
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Where Will the Financial Power Center
Be in the Year 2000?
As the international financial system becomes an
increasingly important element in the world economy,
speculation increases about where the center of the
system will be. Observers cite three major contenders:
? London has historically been the world sfnnancial
capital. If an international bank has any foreign
offices, it is likely to have at least one in "The
City. " Strong relations between the British Govern-
ment and private institutions have kept financiers'
confidence high in London's ability to carry the
flag. Moreover, the bulk of the growing Euromar-
ket and venture capital activity is in London. The
"big bang" deregulatory moves are intended to keep
London in the forefront for the foreseeable future.
? NewYork, many believe, may have already over-
taken London as the real center of power. In the
past three years, the combination of US prolifera-
tion of innovative instruments and the expansion of
the US economy has brought Wall Street to great
prominence. The dollar is already considered the
global currency. Moreover, New York is outpacing
London in creating 24-hour trading rooms and
acquiring foreign financial institutions. As a result,
New York may be better prepared for the emerging
global marketplace.
? Tokyo is quickly rising as a financial center and
may present a serious challenge to both London and
New York in the next decade. The increasing
importance of the Japanese economy on the world
scene, deregulation of Tokyo markets, and the
large surpluses of Japanese capital are likely to
catapult Tokyo to a prime position and lead to a
rapid internationalization of the yen. Japanese
banks' total international lending overtook that of
the United States last year-with roughly $60
billion more in assets and liabilities.
The idea of physical location for the 21 st-century
financial power center may be an illusion of 20th-
century thinking, however. The globalization of the
financial system could result in just that: a "meta-
physical marketplace" whereby the true power re-
sides in the electronic links between countries and the
dominant currency is the wide array offinancial
instruments, such as swaps that allow investors to
switch back and forth between denominations instan-
taneously and continually from any location.
There have been instances of the use offoreign
financial decisions to affect political policies in a
target country. The most visible example of this is
the investment sanctions placed on South Africa by
Japan, Australia, Austria, the Nordic countries, and
the EC. These sanctions range from divestiture to
bans on new loans and investment and are aimed at
putting pressure on the South African Government to
change its apartheid stance.
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The Soviet Union has recently taken actions to
become a more active member of the international
financial community-reversing the pattern of rela-
tive Soviet isolation from the global financial mar-
kets. Moscow is making greater use of the Western
financial markets and is trying to join international
financial organizations, such as the IMF and the
World Bank. We believe this new policy to break into
these arenas stems from the broader Soviet initiative
to take a more active role in international affairs-
particularly in the Third World-and from the sharp
decrease in the USSR's hard currency earnings re-
sulting from the oil price collapse.
Evidence in the financial markets indicates that
Moscow is testing new financial waters:
? The Soviets have invited Western banking officials
to Moscow to discuss joint financing for medium-
term credits and financial paper and have expressed
interest in new forms of financial instruments.
Foreign exchange rates are the primary mechanism
of shock transmission and can reflect-and cause-
major changes in other sectors. For example, on
27 February 1986 a rumor spread through the market
that there would be an emergency Group of Five
meeting to stabilize the US dollar. Within 30 minutes
the deutsche mark and the yen dropped more than 2
percent against the dollar. Given the size of outstand-
ing foreign exchange positions, the drop represented a
shift in wealth of about $1 billion on the market.
The volatility of LDC currencies can be especially
great. The table shows the reaction of exchange rates
to selected events of sociopolitical instability within
Third World countries. The table also indicates the
? The Soviets have expressed interest, since late
1985, in establishing joint ventures with Western
firms that could for the first time since the
1920s-allow direct foreign capital investments on
Soviet soil.
In August the Soviets established a bank in the
Cayman Islands-an emerging offshore financial cen-
ter-to circumvent restrictions that preclude their
bank in the Netherlands from arranging floating rate
notes (FRN5) and note issuance facilities (NIFs). This
move is a significant step toward Soviet use of these
newer, more sophisticated financial instruments.
ence worldwide.
The Soviet Union is the only major country not
currently a member of the IMF and the World Bank.
Membership in these organizations would end Mos-
cow's outcast role in the international financial are-
na; other Eastern Bloc countries-Hungary, Roma-
nia, and Poland-already belong to the IMF. Should
the Soviets join the Fund, they are likely to receive
the third-largest voting share, after the United States
and the United Kingdom, which would put them in
the position to disrupt the traditional activities of the
organization while raising Moscow's level of influ-
difficulty LDC central banks have ii defending ex-
change rates in time of crisis. Believing-or hoping-
the speculative attack on their currencies is tempo-
rary, central banks often rapidly deplete foreign ex-
change reserves to bolster the exchange rate. Such
action is often futile, and within weeks market pres-
sure causes an official devaluation, leaving the central
bank seriously drained. This failure, in turn, often
feeds further speculative attacks on the currency as
traders perceive the central bank too weakened to
support the exchange rate even at its lower level.
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Sociopolitical Instability: The Response of
Exchange Rates and Central Reserves a
Exchange Rate Drop
(percent)
Reserves Drop
(percent)
18 February 1982
Government declares halt to exchange intervention
35 b
20 August 1982
Government declares a debt principal moratorium
62 c
7 July 1985/12 July 1985
Midterm election/secret Cartegena meeting
South Africa
13 July 1984/15 July 1984
Squatter homes destroyed/rent and tax riots
3d
22 August 1984
New parliament elections amid widespread vote
boycotting
56
a The time period for the response is one month, unless otherwise
rated.
b Month preceding event.
c Four months.
d South Africa's reserve numbers understate the extent of govern-
ment gold reserves.
Interest rates are now more closely linked worldwide
than ever before. This stems not only from the
increased efficiency of the financial market but also
from the large cross liabilities between economies.
For example, the London Interbank Offer Rate
(LIBOR)-the world's interest rate benchmark-is a
primary determinant of changes in Brazil's debt
service payments. These payments, in turn, are a
significant portion of Brazil's balance of payments
(figure 4). A small rise in LIBOR, therefore, puts
immediate pressure on the individual debtor econo-
mies, the ability of these economies to service foreign
debt, and, in turn, the international financial system
as a whole.
The damage this can cause is best seen in the
Brazilian experience. Despite sometimes severe bud-
get austerity measures, the government deficit has
continued to soar. The Brazilian central government's
expenditures on goods and services now closely match
its revenues. The overall government deficit, however,
now absorbs nearly one-fourth of Brazil's gross do-
mestic product because of debt service obligations. A
slight wobble in world interest rates is transmitted to
the domestic economy, which, in turn, has a large
impact on the Brazilian deficit.
even further.
Capitalfight from the Third World is facilitated in
two ways by the new environment. First, the increased
volatility of exchange and interest rates creates strong
incentives for individuals in LDCs to quickly move
their funds abroad when an event occurs that may
affect these rates. Indeed, this has a dangerous feed-
back effect: the market has become sensitive to
capital flight, and this drives down exchange rates
Second, the globalization of markets has provided an
efficient mechanism for the quick, quiet transfer of
funds to safehavens overseas. The favorite first stop of
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Figure 4
Savings to Selected LDC Debtor
Economies From a 1-Percentage-
Point Drop in LIBOR-
Million US $
Argentina
Brazil
Chile
Ecuador
Egypt
Indonesia
Mexico
Nigeria
Peru
Philippines
South Korea
Venezuela
a Because of their relatively large debt service payments, the health of
LDC economies is partly a function of the level of interest rates in the
developed countries-principally the London Interbank Offered Rate
(LIBOR) and the US Prime Rate.
these funds is usually LDC offshore money centers.
Panama and the Caribbean are heavily used by Latin
American individuals and businesses, while Hong
Kong is the clearinghouse for much of the flight
capital from Asia-particularly the Philippines. The
final destination for the money-after it is laundered
in these offshore centers-is often the United States.
Efforts are also made to convert the liquid assets into
real estate or deposits in secure countries, particularly
Switzerland.
As a result, the damage done by capital flight has
been twofold. In the last decade more than $200
billion has fled the 18 largest LDC debtors, according
to Morgan Guaranty estimates. During this same
period, and partially as a result of this capital flight,
these same LDCs accumulated an additional $450
billion in new debt. Now that the inflow of new
capital to LDCs has slowed tremendously, LDC gov-
ernments are facing difficulty repaying their debts
because the $200 billion was not invested in produc-
tive domestic assets.
There are some positive aspects of capital flight,
however. The $200 billion has been earning returns
overseas for citizens in LDCs at a greater rate
presumably than that obtainable in the home country.
many LDC businesses have
used the earnings on their stock of overseas funds to
finance operations when domestic funding gets tight.
On the consumption side, observers note that repatri-
ated earnings from flight capital often allow even
middle-class LDC citizens to maintain living stan-
dards above what their purely domestic incomes
would allow. Finally, funds remaining overseas repre-
sent a stock that could return to boost growth if LDC
policies ever become more favorable to domestic
investment.
Financial stability-the strength of the entire system
.to withstand volatility and occasional crises-is being
questioned more within financial circles. Most observ-
ers argue that the broadening of the investor base and
the enhanced information flows have bolstered the
overall system. There are emerging, however, trends
in international finance that we believe raise concerns:
? The sharp competition among lending institutions,
especially after the 1973 oil price hikes, led to what
many believe was a steady lowering of the risk
threshold lenders were willing to accept. If this
trend continues, another global recession could put a
raft of debtors in default. Unlike the troubled LDC
debtors, these endangered debtors would be decen-
tralized-making a coordinated effort among lend-
ers, creditors, and governments to resolve a crisis
more difficult.
? The declining power of regulators could also en-
courage financial institutions to take greater risks.
In Hong Kong, for example, where regulation is
almost nonexistent, several banks failed last year-
causing waves throughout the Asian financial com-
munity. On a broader scale, the speed, size, and
complexity of markets are reducing the regulatory
authorities' ability to foresee potential stability
problems and react to them.
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? The fragility of the financial network has increased
as, at any given moment, the billions of dollars
floating in the system are susceptible to disruption.
An example of such a disruption occurred in the US
banking system in November 1985 when a comput-
er software failure caused an overnight delay in the
clearing of a middle-size bank's settlements. As a
result, the Federal Reserve quickly lent the bank
$22.6 billion to prevent what Chairman Paul
Volcker called "potentially serious implications for
the payments system and securities markets." Ob-
servers emphasize that the rescue mechanism is not
as solid for the international funds transfer system.
? The spread of new instruments has brought new
uncertainties about the risk and underlying value
associated with the transactions. Of greatest con-
cern is the exponential increase in note issuance
facilities (figure 5). Observers note that many of
these instruments do not entail direct liability, as
does a regular loan, but simply risk exposure.
Currency and interest swaps, as well as NIFs,
commit the bank to accept liability only if the
market "turns against" the bank's customer. Al-
though the bank earns a fee in the short run,
widespread financial panic could overwhelm the
international banking community's ability to meet
its "triggered" liabilities. One observer wrote that
there is a "son of debt crisis" waiting to happen.
Taken together; we believe the most important impli-
cation of these stability factors is that a bond has been
forged between the financial market's perceptions and
the economic and political well-being of individual
countries. Before the globalization of finance markets,
economies were less tied together, meaning that exter-
nal events-such as a shift in exchange rates or
LIBOR-would have less impact on a country's well-
being. Conversely, domestic turmoil would have little
impact on world markets. Today, a shock to any
element of the global financial web can send repercus-
sions throughout the system.
Exploitation of the International Financial System
Along with the globalization of international finance
has come greater use of international financial com-
munications networks and banking facilities by gov-
ernments and groups whose objectives threaten West-
ern security interests. Aside from the multibillion-
dollar international narcotics money-laundering
Figure 5
The Rise of Note Issuance Facilities:
Overtaking the International Bond Market
NIFs
Bonds
1985
310684 1086 25X1
industry, funding of terrorist activities, gray arms
purchases, and nuclear proliferation are often accom-
plished through the world's international financial
networks. The governments and groups participating
in these activities find the speed, ease, and anonymity
associated with use of the international financial
system attractive for their purposes. These transac-
tions are normally fully legitimate in form, using
international letters of credit and interbank transfers
as payment mechanisms, and usually legal in the
countries where they are conducted. This enables the
arms or proliferation merchant to carry out his busi-
ness in a conventional manner while using the proven
reliability and security of the international financial
transfer networks.
Narcotics. With several billion dollars in earnings to
process each month, narcotics traffickers have
emerged as key users of the international financial
system. The Colombian drug traffickers have used US
exchange-house operators and their representatives to
establish an underground financial system linking the
US market to the northern-tier Latin American coun-
tries, the source of some 75 percent of the marijuana
and cocaine sold in the United States. By relying on a
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combination of exchange houses, offshore banking
facilities, and cash smuggling, the system has been
highly effective in shielding the drug-money flow
from interdiction by US authorities and in evading
exchange controls along the drug-money trail.
Although methods of money handling have shifted in
response to the focus of US enforcement efforts, the
pattern of the Colombian drug-money trail has re-
mained fairly stable over time. Miami and New York
function as principal collection and disbursement
points in the United States. Management of payments
to suppliers of raw materials in a number of countries
occurs primarily in Colombia. The most important
intermediate repository and payment center is
Panama, which also functions as a procurement site
for goods and services required by the cocaine indus-
try and which may serve as an investment banking
center for profits.
We believe the huge, erratic flows of narcodollars
offer pluses and minuses for the countries involved.
Directly, the inflow of narcodollars has boosted in-
comes in recipient countries. Only a small share of the
population benefits, however, and much of this money
flows back out. Moreover, in those countries where a
precarious economic and financial situation has
prompted curbs on currency exchange, the availability
of cheap narcodollars on the black market can frus-
trate controls by providing a virtually open door for
capital flight. In those countries with free-floating
exchange rates, periodic floods of narcodollars can
cause the value of local currencies to soar-reducing
the competitiveness of all legitimate exports. As the
world market for cocaine expands, satellite Colombi-
an drug-forwarding centers are springing up in West-
ern Europe and other affluent areas. As a result of
geographic diversification, profit accumulation, inten-
sified enforcement in traditional locations, and grow-
Because of its lax banking laws and large Arab
population, we believe Nigeria could be a money
center for laundering Tripoli's subversive support.
ing sophistication, traffickers are beginning to invest Ever since the US freeze on Libyan assets, Qadhafi
outside Hispanic areas-which raises additional polit- has used interbank transfer mechanisms to send US
ical problems. dollars to terrorists.
Terrorism. Among state sponsors of terrorism, the
Libyan regime stands out for the size and blatancy of
its use of international banking arrangements to
finance terrorists.
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according to Embassy reporting,
Libyan nationals transferred a large sum of money
from a bank in the United Arab Emirates to terrorists
for a sabotage operation in Egypt.
Governments and individuals involved in illegal trans-
fers of weapons, technology, and nuclear materials
also find the international financial system an effi-
cient mechanism to make payments for their goods
and services.
Political Corruption. Corruption by Western stan-
dards among political elites in Third World coun-
tries-no matter what their ideology-appears rela-
tively commonplace. While the consequences of these
activities for Western security interests is ambiguous,
they can seriously add to the debilitation of the Third
World economies subjected to this skimming. Leaders
of countries whose interests have paralleled those of
the United States
have proved in some cases to be as corrupt as leaders
of some countries with which the United States has
largely confrontational relations. Political elites
throughout time have been able to amass personal
fortunes. Financial globalization has made it easier
for these elites to move their profits quickly and
secretly out of the country into financial safehavens
and untraceable, but profitable, investments in indus-
trialized countries.
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Commodity Market Manipulation. The sharp rise of
funds flowing internationally has increased the possi-
bility that other markets, particularly commodity
markets, may be manipulated by governments or
individuals who can quickly and quietly draw together
funds for their activities. Despite the current com-
modity glut, some spot markets are thin enough in
relation to their associated futures markets to be
manipulated-or even cornered.
In February 1982 there was a massive manipulation
of the tin market (figure 6). A "mystery buyer"
bought an estimated 25,000 metric tons-more than
half the existing market stocks-at a cost of nearly
$0.5 billion. We suspect this buying was financed by
Middle Eastern oil interests on behalf of predomi-
nantly Islamic Malaysia-the largest tin exporter.
This effort to corner the market failed largely because
of actions by the London Metals Exchange (LME),
the predominant tin-trading center. But the serious-
ness of this manipulation lies in its effect on tin prices:
the manipulation drove prices to record highs, and its
failure pushed prices down more than 20 percent in a
matter of days.
A year earlier the LME stepped in and put restric-
tions on zinc and lead trading when "confusing,"
highly volatile price movements suggested manipula-
tion of those markets. Again, prices fell when actions
were taken to thwart a cornering of the market.
Silver, an even larger market, was nearly cornered in
the 1970s by the Hunt brothers. The price of silver
more than doubled during this episode, then lost more
than 60 percent of its value after the attempt failed.
More recently, there were rumors that the mid-April
1986 rebound of spot oil prices may have been driven
by Saudi activity in the oil futures market.
The political implications of such manipulations may
outweigh the economic consequences. Indeed, in the
cases of tin and silver, the manipulators lost money on
the transactions when they failed to corner the mar-
ket. The dependence of Third World economies on
commodity prices, however, makes volatility of these
markets important to LDC governments. The recent
growth in international financial flows has raised the
possibility of a group's quickly entering the financial
market, obtaining control over a large amount of
funds, and then using these funds to enter a commod-
ity spot market. As futures contracts come due, the
market could be cornered-which is good for export-
ers. Or, as we have seen in these other episodes, the
group could deliberately or accidently drive prices
down-inflicting economic damage on exporting
LDCs.
Exchange Rate Terrorism. We believe that the
strengthening bonds between the international finan-
cial system and individual countries are raising the
possibility of a new terrorist weapon: attacking a
country by damaging its exchange rates through a
concerted terrorist campaign on its sources of foreign
exchange. For example, on 3 April 1986 The Wall
Street Journal reported that concern was raised in the
international financial community over the 2 April
TWA bombing over Greece. The specific concern was
over the potential foreign exchange losses resulting
from a decline in tourism. Egypt is also vulnerable
because tourism is its third-largest source of hard
currency.
Although the recent terrorist activity was not to
explicitly affect exchange rates, the situation has
reached a point where even the threat of a country's
being targeted for a terrorist campaign can depress its
currency and raise the government's risk premium.
Such activity would contribute to a self-perpetuating
deterioration of the economy-as is happening in
Egypt. Terrorists could use this strategy to target a
country at critical times, such as during a debt
rescheduling.
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Figure 6
Manipulation of Select Metal Markets
0 J A S O N D J F M A M J J
1979 1980
a Monthly averages, July 1979-July 1980.
bMonthly averages, July 1981-July 1982.
Large purchases by
"mystery buyer"
Regulatory restric-
tions imposed to stop
any corner effort
I I I I I I I I I I I I I
0 J A S O N D J F M A M J J
1981 1982
Assaults on the System Itself. The importance of the
international financial system to the world has made
the system an attractive target for assault by terrorists
or other groups. The billions of dollars flowing
through the financial system every hour are vulnera-
ble to disruption or, perhaps worse, manipulation. As
discussed above, growing interdependence of the elec-
tronic interbank-transfer network increases the sever-
ity of a potential disruption. Morgan Guaranty has
estimated that the amount of "outstanding" funds on
the international wires at midday New York time can
reach $100 billion. A serious funds-clearing problem
at a major bank could transmit defaults throughout
the system. A concerted assault on key banking
centers or telecommunications points at a critical time
would have even wider consequences.
The increasingly anonymous electronic nature of the
international banking network has also raised specula-
tion that the system is highly susceptible to manipula-
tion-either to deny funds to certain groups or to earn
a profit for the manipulating party. Multimillion-
dollar foreign exchange transactions between New
York and London are made on the basis of a tele-
phone call and a confirming telex-several hundred
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International Financial Communications Networks:
Potential Choke Points
The rapidly growing volume of international transac-
tions handled on sophisticated financial networks
may be an area of increased vulnerability for the
international financial system in the years ahead.
Specialized telecommunications systems are captur-
ing an increasing share of this international banking
communications and clearing activity. Hundreds of
billions of dollars pass through these networks daily
in transfers of dollars, pounds, and francs. The
failure of such systems could, in our judgment,
jeopardize the smooth functioning of the internation-
al payments system and the creditworthiness of indi-
vidual banks.
From a US perspective, the most essential of these
specialized networks for international financial activ-
ity are SWIFT and CHIPS.
? SWIFT (Society for Worldwide Interbank Finan-
cial Telecommunications) is a standardized global
interbank information system. The system trans-
mits such things as customer or bank transfer
instructions, foreign exchange confirmations, and
reconciliation messages, but it has no clearing
mechanism or funds transfer capability. In 1985 the
SWIFT system processed an average of 665,000
messages a day between some 1,300 member banks
in more than 45 countries, and system use is
growing at a rate of 20 percent per year. A larger
and more decentralized system, SWIFT II, was
scheduled for introduction this year but has been
delayed for at least one year.
times an hour. The speed and volume of such funds
transfers could make tracing any accounting anomaly
very difficult-and certainly time consuming-even if
they were discovered.
Some Broader Connections
Looking at the longer term, the globalization of
financial markets has speeded the flow of resources
worldwide. As is the case with the United States over
the past few years, imports now can be drastically
increased without a concomitant rise in exports-with
the difference being funded by capital transfers. This
? CHIPS (Clearing House Interbank Payments Sys-
tem) is a computerized network in New York that
links the major banks for the clearing of interna-
tional dollar payments. In 1985 this -network han-
dled about 95,000 interbank transfers valued at
$280 billion daily, some 90percent of all interbank
transfers relating to international dollar payments.
Both of these networks are physically and electroni-
cally well secured, but nonetheless there is some risk
that their operations could be disrupted at some key
choke points.
? While fully backstopped, damage to the CHIPS'
central computer system in New York would, at
least temporarily, make it extremely difficult for
the money center banks to clear their international
accounts, jeopardizing their fiflancial condition.
? All communications on the SWIFT network involv-
ing the United States pass through the network's
operating center in Culpeper, Virginia, and its loss
would also cause temporary confusion in interna-
tional banking communications. Disruption of
SWIFT's other operating centers in Leidens, the
Netherlands, and Brussels, Belgium, would also
broadly impact SWIFT network operations, but
would have less impact on those activities involving
US banks.
change, along with the growing importance of the
service sectors, has caused capital movements to
overtake trade patterns as the principal determinant
of economic power balances. The fallout from the
redirection of capital flows through the financial
system since 1982 has shaped the global economy and
spawned many of the considerable problems we see
today. In particular, changes in capital markets have
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a significant impact on two central issues-the Third
World debt problem and the globalization of industry.
Through its impact on these developments, the finan-
cial globalization also affects such key issues as trade
imbalances and protectionism.
Internationalization of Production. Through its im-
pact on exchange rates, financial globalization is
influencing the shift of industry and technology from
one country to another. Although underlying profit-
ability remains the driving force behind these shifts,
the dollar exchange rate is an important variable,
determining where profits are highest. The problem is
that massive capital flows boosted the US dollar's
value substantially higher than would have otherwise
been the case. In this environment, many of the
previously competitive US operations were moved
overseas or closed down.
While the linkages to financial factors including
exchange rates are not well defined, industrialized
economies-especially the United States-are experi-
encing the.impact of internationalization of produc-
tion. In mature industries:
? The major commercial aircraft companies continue
to seek foreign partners not only to defray the huge
development cost and risks associated with the
launching of new designs but also to assure an
entree to their partners' market.
? Increasing linkups of automobile firms have been
spawned by market access restrictions and the need
for low-cost production bases. In Western Europe,
financial pressures are forcing automakers to in-
crease the use of cooperative ventures to achieve
economies of scale and to rationalize production.
? Growing international competition has led to a
shakeout of machine tool producers. Small, margin-
al producers are dropping out, and US firms have
sought links to Japanese and West European com-
petitors to survive.
Although most visible in the mature industries, the
same process is.rapidly occurring in the high-
technology sector:
? Many semiconductor firms, particularly in the
United States, are dropping out of the high-volume
memory market and/or forming joint ventures with
Japanese or European firms because they are un-
able to continue the high investment in research
and development (R&D) and capital equipment
with shortening life cycles.
? To survive, once fiercely independent computer
companies are scrambling to form alliances and
partnerships to broaden their product ranges. More-
over, R&D costs have become too large for most
computer firms to bear alone.
? In telecommunications, growing deregulation and
rapid advance in technology are prompting dramatic
changes in the structure of the industry. Firms are
forming alliances to offer complete product lines
and services at competitive prices and to gain access
to restricted foreign markets.
The motivations for entering strategic alliances can
differ widely across countries, industries, and compa-
nies. Not only economic factors, such as exchange
rates, but also government trade and investment
policies play a major role. In general, the Japanese
are increasingly entering international alliances to
maintain or improve market access while tempering
protectionist sentiment. For their part, West European
governments and firms have banded together in region-
al R&D programs, such as EUREKA and ESPRIT, to
regain competitiveness and greater independence. At
the same time, however, many large European firms,
such as Olivetti and Philips, have formed alliances
with US and Japanese firms to acquire product and
process technologies to gain access to their markets.
US companies, squeezed by high capital costs, low
profits, and foreign competition, are looking abroad to
defray R&D and investment costs.
Third World Debt. The LDC debt buildup that
accelerated in the late 1970s was in part made
possible by the globalization of financial markets. In
particular, it became increasingly easy for Third
World parastatals as well as private companies to tap
capital markets. Third World parastatals were espe-
cially aggressive in this regard. We estimate that
these entities accounted for the lion's share of the
Third World debt buildup during the late 1970s and
early 1980s. In some Third World countries, Brazil
for example, parastatals accounted for all or most of
the government's budget deficit as well as the bulk of
foreign borrowing.
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The capital flight discussed earlier combined with the
repayment needs associated with past heavy borrow-
ing represents the, principal drain on Third World
financial resources. The response has included import
restrictions by LDC governments to save foreign
exchange for debt service payments and so-called
critical imports. As the crisis hit, total LDC imports
fell 7 percent-the first drop in nearly a quarter
century-with nearly 60 percent of the reduction
concentrated in debt-troubled LDCs. The imports of
these countries fell $24 billion-nearly 18 percent-in
the first year of the debt crisis alone. The impact was
greatest in Latin America-which is closely linked to
the US economy-where declines of about 40 percent
were reported by Argentina, Mexico, and Chile. The
resulting contraction of Western exports led to a
decline in developed country import capacity and
spread debt problems to other, previously sound,
LDCs.
While vastly expanded financial networks helped ac-
commodate growth in Third World debt, the closure
of capital markets to many Third World countries is
forcing major policy changes. In many respects this
highlights the vulnerability of domestic policy to
developments in capital markets. Specifically, because
they cannot borrow what they need, a growing num-
ber of Third World countries are finally paring once
unconstrained spending programs, reducing the role
of parastatals, and, in some instances, encouraging
foreign investment for the first time in decades. More
than anything else, these policy adjustments reflect
the domestic impact of foreign capital market deci-
sions over which the LDCs have little or no control.
Five years ago, largely unlimited access to those same
capital markets enabled Third World countries to
finance economic statism.
Trade Deficits and Protectionism. Ironically, while
the dearth of capital and foreign exchange in the
LDCs has contributed to protectionist sentiment, the
large inflow of capital to the United States from
Japan and Europe has also strained trade relations as
the US trade deficit expanded. The trade imbalance
has focused attention on the import restrictions that
exist in countries with which the United States has
large trade deficits-particularly Japan and the newly
industrializing countries (NICs). The nearly $50 bil-
lion, US-Japanese trade imbalance in 1985 is the
largest on record, Japan's overall trade surplus of over
$50 billion annually, however, is both a friction point
and a major source of international financial liquidity.
On the Atlantic side, the United States and Western
Europe are competing for shares of several declin-
ing-but still important-world markets, such as steel
and agriculture. The US share of the world market
for five key agricultural commodities slid from 54
percent in 1980 to 41 percent last year. The European
Economic Community (EC), also feeling competitive
pressures, implemented protectionist policies in 1985
that may cost the United States more than $1 billion
in lost agricultural exports. Again, the LDCs have
played an important role by no longer being a ready
outlet for OECD goods, and by actually emerging as
new competitors to OECD exporters. Indeed, the
LDCs' share of the world agricultural export market
has risen in the last five years from 10 to 17 percent,
and we expect LDCs to increase their steel output by
35 percent by 1990 (figure 7).
Globally, according to a World Bank report, the rise
of protectionist sentiment in developed countries in
this decade may have made protectionism more re-
spectable. These forces could very well undermine the
coming new round of the General Agreement on
Tariffs and Trade (GATT). The last GATT round,
which was negotiated with some difficulty, occurred
in a much more favorable economic environment:
world trade was rising rapidly and there was healthy
growth in imports by the LDCs, the East Bloc, and
the developed West. These conditions are now absent.
Now governments feel pressure to "lock in" their
market share through protectionist actions.
Policy Interdependence. An emerging political issue
is the increased economic interdependence that has
resulted from the financial globalization and the
associated growth of industrial integration. As dis-
cussed above, the United States is becoming more
dependent on foreign countries for some manufac-
tured goods and many of its key strategic technol-
ogies. Other countries are facing similar issues, which
may strain relations with US allies and other govern-
ments important to the United States. As domestic
financial markets around the world become integrated
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Figure 7
World Agricultural Exports: Loss of
US Markets to LDCs, 1980 and 1985
LDC share
Other
Figure 8
Commodity Price Indexes: British
Pound vs. US Dollar, 1980-84
20
I I
3'?686'?86 0 1980 81 82 83 84
sions during recent economic summits.
with the international financial system, foreign gov-
ernments find it increasingly difficult to formulate
and execute their own, independent monetary and
fiscal policies. Moreover, the dominating influence of
the dollar in the world economy, coupled with the
transmission effects of the international markets, has
put US economic policy in the limelight. As a result,
US policy has frequently come under fire by allied
governments and has been repeatedly raised at discus-
West Europeans have been complaining since the
early 1980s that high interest rates in the United
States have drained Europe of capital, dampened
investment there, and hampered their monetary poli-
cies. They attribute these high rates largely to the
burgeoning US budget deficit. Although European
central banks are not powerless to control interest
rates in their own countries, they fear that reducing
rates on their own in an attempt to stimulate growth
would result in a flow of capital to the United States.
Some West European governments also fear that a
stimulative policy would ignite inflation rather than
growth in their countries. They believe the result
would be scarcer capital in Western Europe and
upward pressure on interest rates. Consequently,
European leaders blame the United States for boxing
them in to tight, low-growth policies. LDCs have
faced similar problems and have blamed the United
States for interest rates that raise debt service pay-
ments and encourage capital flight. These debtors
have raised US economic policy as an issue in North-
South discussions on the debt problem.
The strong dollar increased the import bills faced by
European economies dependent upon dollar-
denominated commodity imports. As the rise of oil
prices eased in dollar terms between 1980 and 1985,
the strength of the dollar continued to push oil costs
up for Europe and Japan. Other commodity prices
also rose sharply despite price drops for US importers
(figure 8). The dominance and volatility of the US
dollar has, at times, added to the difficulties faced by
central banks in the operation of the European Mone-
tary System-a priority with EC governments-
which has caused some friction between the United
States and Europe. Illegal immigration of Mexicans
into the United States has been fueled in large part by
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the strong dollar-a point Mexican authorities have
not overlooked in their discussions with US officials
vote on Tory economic programs by the international
on this politically sensitive issue.
At the industry level, the greater integration of capital
markets has reduced the government's control over its
productive base. The rise of multinational corpora-
tions has speeded the response of the free market to
any one government's attempt to put restrictions on a
company's activity. Previously, when international
capital flows were smaller, capital-intensive manufac-
turing' industry grew in capital-rich countries. Today,
low wages and a favorable regulatory environment
have become the dominant factors in location deci-
sions. Such competitive pressures have undermined
efforts in developed countries to institute environmen-
tal, health, labor, safety, and strategic-production
regulations; the subjected companies simply move to a
less restrictive environment. For LDCs, such shifts
have drained capital from economies where the poli-
cies are heavyhanded or ill conceived.
Frustrated by this loss of power, governments may
react with shortsighted nationalistic policies. On a
popular political level, there may be a rising tide of
protectionist sentiments-this time on foreign invest-
ment. Japanese capital has been moving into businesses
in the United States and Europe, both by building
new plants and by acquiring stock in existing compa-
nies. Europe, despite its recent privatization efforts,
may expand efforts to keep European industry under
European ownership-while keeping European capital
on European soil. A stated policy of the large-scale,
European technology development programs, such as
EUREKA and ESPRIT, is to keep technology invest-
ment at home, rather than letting it go to the United
States or to the NICs.
In another example, in the wake of the Westland and
British Leyland affairs, the US Embassy in London
reports that sentiment is rapidly rising that US
investment in the United Kingdom is "excessive." The
Embassy believes that a bid by a US firm for a prime
British financial institution after the "big bang," or a
plant closure by a US firm, would cause political
troubles for the Thatcher government. Paradoxically,
the opposition Labor Party has pointed to capital
outflows from the United Kingdom as a no-confidence
financial markets.
Regional Perspectives
From a regional perspective, the evolution of the
international financial scene will be a key determinant
of the strategic political and economic positions of
countries worldwide. The financial markets will con-
tinue to play an expanding role as the foremost
medium through which interactions between the re-
gional groups occur. The increasing integration of the
domestic markets with the global markets, moreover,
implies that the international flow of resources will
become even more important to the domestic stability
and political orientations of individual countries.
We believe there are two key issues that will deter-
mine the impacts of the international financial system
on the various regions:
? The direction and magnitude of capital resource
flows to and from the region. The past few years
have demonstrated that the flow of resources into,
or out of, a given region can reverse almost over-
night and cause widespread shocks-both regionally
and globally. Recent examples are the rapid shift of
resources from the developed West to OPEC, and in
turn to the Third World. The current flow of capital
from Japan to the United States has fueled the US
economy as the engine of growth for the entire
world. Future flows of capital facilitated by the
globalized financial system are likely to be quicker
and at least equally as important.
? The extent to which the region participates in the
system. In the past, some countries participated
fully in the global financial markets-such as
Europe and the United States-while others partici-
pated only tentatively-such as the USSR. As the
importance of the financial system grows, countries
will find it increasingly costly to abstain from
becoming involved. Those governments that try to
remain apart will find themselves on the periphery
of international economics and politics-"Albanian"
of the international community.
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Regardless of the impact on a given region, the
central position the United States occupies in the
global scheme means that US interests will be closely
linked to the regional consequences of the evolving
worldwide financial situation.
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Appendix
The Global Financial System:
The Future Role of the
Major Players
This appendix examines briefly the future role of the
major players-Japan, Western Europe, the Third
World debtors, the Middle East, the Soviet sphere,
and China-in the global financial system in terms of
level of participation and the impact on US policy. A
list of selected related publications for each area is
included.
Japan's role-both in terms of providing capital and
financial services-is likely to remain of major impor-
tance to the evolution of the world economy.
could quickly boost their holdings of foreign securities
by $25 billion, according to Japanese Government
estimates.
Participation
As a result of large capital flows and financial
liberalization, Japanese banks and securities compa-
nies are playing larger roles in the international
financial system. Already, four of the five largest
banks in the world are Japanese. In 1982 only two
banks had more than $100 billion in assets and both
were US banks. By 1985, however, the number of
banks with assets over $100 billion had grown to 12-
six of which were Japanese. Likewise, Nomura Secur-
ities is already the world's largest securities house and
is rapidly increasing its presence in both the New
Resource Flows
Excess savings at home and high interest rates abroad
have turned the Japanese into huge capital exporters.
Net overseas asset acquisition has increased rapidly
during the last five years so that the stock of overseas
financial assets at the end of 1985 was nearly $440
billion-70 percent of which was held in the form of
long-term assets, according to Japanese Government
statistics.' Indeed, long-term US Government securi-
ties have been a favorite of Japanese investors in
recent years-primarily because the high yields and
long maturity of the bonds are attractive to Japanese
insurance companies and pension and postal funds
that have long-term liabilities to cover.
Japan is likely to remain an excess saver and thus a
large capital exporter at least through the early 1990s.
In addition, we believe that numerous factors-in-
cluding international pressure-will compel Japanese
policymakers to accelerate the pace of financial de-
regulation during the rest of this decade. Such dereg-
ulation will, among other things, allow financial insti-
tutions to hold a larger share of their growing
portfolios overseas. For example, the Finance Minis-
try's recent easing of regulations governing the hold-
ings of foreign securities by Japanese insurance com-
panies, trust banks, and small financial institutions
York and London markets.
In our view, further deregulation of the financial
system will aid the efforts of the Japanese banks and
securities houses that are determined to be as success-
ful in exporting financial services as the Japanese
firms were in capturing international markets for
manufactures. For example, the opening of an off-
shore banking center in Tokyo this December may
over time shift business from the established Euro-
market in London and international banking facilities
in New York, Singapore, and Hong Kong to Tokyo-
although strict regulations will initially limit the scope
of the offshore market's activities. In addition, the
Japanese will almost certainly garner a larger share of
the international bond underwriting market. In fact,
Japan's four big securities houses are working dili-
gently to convince the US Federal Reserve Board to
grant them primary dealerships in US Government
bonds.
US Policy Implications
US financial institutions are likely to feel the brunt of
this new competition from Japanese banks and securi-
ties houses. Aggressive behavior and success on the
part of these institutions may lead to tensions between
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Washington and Tokyo similar to those that now exist
over auto parts, machine tools, and telecommunica-
tions.
Nevertheless, Japanese purchases of US securities,
as well as direct investment in the United States,
indicate to us that the Japanese have a long-term
interest in the US economy. Indeed, the Japanese
stake in the United States is broad based, and increas-
ingly Japan's own prosperity-in the form of profit
repatriation, exports, and interest earnings-will be
geared toward the health of the US economy
The growing importance of the US economy to the
Japanese suggests that the Japanese Government will
play a key factor in influencing the behavior of
Japanese businessmen in the United States. For ex-
ample, we believe that if Japanese investors move to
sell off securities in large quantities-a move that
could in several years drive up US interest rates and
thus choke off investment and economic growth in the
United States-Tokyo would quickly apply pressure
such as administrative guidance to prevent such a
rapid shift in Japanese portfolios. Japanese investors
would be tempted to ignore Tokyo's desires if they felt
that their US investments were seriously threat-
ened-an expectation that could develop, we believe,
from an international financial crisis.
In any case, Tokyo's official approach to overseas
investment bears watching. Just as Tokyo will closely
watch its investments in the United States, we believe
that Japan's foreign policy may become more geared
toward protecting its increasing investments in devel-
oping countries. For example, Japan in time is likely
to demand a political role in multilateral institutions,
such as the World Bank and the International Mone-
tary Fund (IMF), that is equal to its growing financial
contributions to such organizations.
Western Europe
Most of the major financial issues that Western
Europe will face over the next decade will represent a
continuation of the financial difficulties it has under-
gone over the past decade. But unlike the first half of
the 1980s, which buffeted Europe with a strong
dollar, the primary exchange rate issue may very well
be the possibility of a further decline of the US dollar
from its 1985 peak.
nese exporters' attention to European markets.
Resource Flows
Net capital flows from Western Europe in the early
1980s-a major factor in the dollar's rise-substan-
tially affected the West European economies. The
reduction in the supply of capital in Europe created
upward pressure on domestic interest rates, which cut
investment and-to a lesser extent-consumption.
Whether this was net minus, however, is uncertain
because the strong dollar has also helped European
growth by making exports more price competitive. A
dollar decline could stall economic growth because
the governments largely have relied on exports to
stimulate economic expansion without taking mean-
ingful structural adjustment measures in other sec-
tors. Inflation would decline, but unemployment
would increase. The European Monetary System-
which undergoes stress with a movement of the dollar
in either direction-may face difficulties if the dollar
is volatile in the future. With the increased globaliza-
tion of markets, the dollar-yen relationship also has
strong impacts on the European economies. An appre-
ciation of the yen against the dollar will shift Japa-
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Participation
Because Europe is already at the center of the
international financial system, the extent of European
participation in the system is not likely to change a
great deal. Important linkages between the European
economies and the international financial markets
have been strengthened in the past several years,
however. Heavy borrowing by 12 West European
governments-notably France, Spain, Greece, and
Belgium-has made foreign debt a critical factor in
the European outlook. Between 1978 and last year,
this debt nearly doubled and now stands at around
$400 billion.
This debt is a double-edged sword. On the one hand,
it is an often overlooked aspect of the fragile interna-
tional debt situation; the amount of outstanding Euro-
pean public debt rose as fast as that of the LDCs and
is only half as large. This puts added pressure on the
system, and there is a possibility a spark from Europe
could set off the financial crisis observers thought
might originate from the Third World. On the other
hand, this debt-which is 80 percent dollar-denomi-
nated-puts the domestic economies of Europe more
at the mercy of the international economy via the
world interest rates. We estimate that for every
single-percentage-point increase in LIBOR, European
annual debt servicing probably rises almost $3.5
billion. Moreover, these effects will be transmitted
quickly because of the heavy European use of a new
financial instrument-the floating rate note (FRN}-
which varies the interest payments with LIBOR.
US Policy Implications
The importance to the United States of the financial
well-being of European economies can be seen in a
number of arenas:
? Trade. A further weakening of the dollar would put
severe strains on the US-EC trade relationship. A
strong dollar has boosted European exports and
helped keep down the cost of the EC's massive
agricultural subsidy program. Already, we are see-
ing increased trade friction on this front. This could
very well spread to other sectors and undermine the
upcoming GATT round.
? Political orientation. The current conservative gov-
ernments of northern Europe are likely to face
increased opposition pressure if they reduce the
popular social-spending programs in their attempts
to restrain budget deficits and strengthen the role of
the private sector in the economy.
? Defense spending. These governments may, as a
result, further shave their defense-spending goals.
NATO countries have already fallen short of the 3-
percent annual growth rates agreed upon for the
1980s. Consequently, the United States would be
called upon to carry a heavier burden in the defense
of Europe.
? Solidarity toward the East. Weaker finances in
Western Europe could easily lead to a greater
willingness on the part of these countries to expand
trade with the Soviet Union and Eastern Europe.
Such action could undermine allied technology-
denial efforts such as COCOM-as occurred during
the Soviet pipeline construction. Moreover, the
West Europeans may step up offers of subsidized
credit to the East to finance such trade.
As in the past, the dependence of the European
economies on the dollar, US-led world interest rates,
and US trade will mean that these issues are likely to
continue to dominate US-European dialogue, as diplo-
matic pressures are put on the United States to
formulate its economic policies with Europe in mind.
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Of all the regions, the Third World has been the most
affected by the evolution of the international financial
scene. The foreign debt situation has become the most
important single influence on both the economic and
political stability of many LDCs critical to the United
States. The massive inflows of capital to the develop-
ing regions in the last decade were abruptly halted
and, in many cases, have been reversed as LDCs must
run large trade surpluses in order to send the capital
surpluses back to the developed West to service their
debts.
Resource Flow
Although the growth of the Third World foreign
indebtedness is likely to slow, the financial problems
are not expected to diminish during the remainder of
the decade. In our judgment, a major obstacle to an
improved financial outlook is the potential reduction
in the net flow of financial resources from Western
and OPEC sources. Aside from credits extended in
conjunction with IMF and World Bank adjustment
and rescheduling packages, new commercial bank
lending to the Third World is expected to remain
minimal through 1990. The rate of growth of com-
mercial bank lending to the major debtors will be
curtailed by reassessment of the Third World
creditworthiness, among other factors. Moreover, the
majority of medium- and long-term lending will go
almost exclusively to the relatively low-risk East
Asian countries.
Participation
As a result of these pressures, we believe that the
LDCs' attitude toward foreign investment will gradu-
ally improve. As the competition for foreign invest-
ment intensifies, many of the Third World countries
can be expected to pursue foreign investors more
aggressively by offering substantial investment incen-
tives. The incentives offered are not expected to
attract a substantial amount of foreign investment,
however. In an attempt to retain some control over
incoming funds, we believe many countries may im-
pose performance requirements, such as export quo-
tas, employment targets, and local content require-
ments, which are a major deterrent to potential
foreign investors.
Again, much of the direct foreign investment is likely
to be concentrated in the safer investment climates of
Asia. At the other end of the spectrum, the poorest
LDCs will continue to rely on official loans and grants
for nearly all of their financing. As a result, we
believe the economic prospects for the very low-
income LDCs-particularly in Africa-are not going
to improve in the near future. In the middle lies Latin
America, which is likely to continue to muddle
through, with periodic financial crises that are not
likely to severely upset the, international financial
system.
US Policy Implications
These wide economic and political differences will
cause an increased stratification of the Third
World-with a consequent divergence in the various
groups' relations with the United States. The NICs
and the second-tier exporters of East Asia are seeking
to further penetrate OECD markets with high-value-
added manufactures. The other developing countries
face onerous debt burdens and feel that some accom-
modation with creditor governments on debt relief is a
necessary condition for future growth and domestic
stability. Meanwhile, many Sub-Saharan African
countries need massive aid to stave off economic
disaster. As a result, US policymakers will face
different groups with differing agendas. The
Cartagena group of Latin American debtors is one
example. Other countries could begin collective action
around such issues as concessional aid or access to US
markets for LDC manufactures. Because these inter-
ests tend to be identified with specific areas of the
world, we expect to see Latin America focusing on
debt, the Africans on aid, and the Asians on
protectionism.
In formulating their own policies, Third World gov-
ernments will be forced by the tightening links be-
tween their domestic economies and the global finan-
cial system to reduce their interventionist tendencies:
? As discussed above, attempts to maintain overval-
ued currencies are becoming more difficult as the
financial globalization process allows the market to
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Secret
overwhelm such policies by quickly draining central
banks' hard currency reserves. The pressure is
increased by the market's perception that long-term
overvaluation is unsustainable, which also encour-
ages capital flight.
? The rise of black foreign exchange markets, itself a
result of financial internationalization, also under-
mines heavyhanded government rules. The US Em-
bassy in Buenos Aires estimated that two-thirds of
the value of currency circulating in Argentina is in
US dollars-critically undermining any monetary
or fiscal policy the government tries to take indepen-
dent of global market conditions.
? Because the debt situation has made the export
sector critical for many LDCs, governments are
taking steps to rationalize the trade sector. Authori-
ties have raised prices for export products in an
effort to boost production, devalued their currencies,
and attempted to bring inflation down closer to the
world level.
And finally, the economic success of the relatively
free market approach practiced by the NICs has not
gone unnoticed by those LDCs that were badly
burned by the debt crisis
Domestically, many LDCs will face serious political
obstacles to taking the necessary steps toward servic-
ing their debts while resuming sustainable economic
growth. The key determinants of political reaction to
prolonged austerity are how much the citizenry ex-
pects of governments, and the flexibility of the given
political systems. Where expectations for governments
are low, or where the population dares not push for
change, strong political reaction to economic hard-
ships is less likely. This is likely to be the case in much
of black Africa and South Asia. When governments
can successfully deflect much of the blame from
themselves to predecessors, international banks, the
IMF, or the United States, they can escape the
potential fallout from political pressures or political
instability. Thus far, the governments in Mexico,
Venezuela, and Argentina have managed to deflect
much of the blame. Brazil's return to civilian govern-
ment has given Brasilia a grace period, and it seems to
be using it well. The Philippines and Nigeria have
both been subject to regime changes stemming from
culpability of the leaders for economic problems.
Regardless of the true capability US policies have to
determine the future well-being of the Third World, it
is important to note that both the governments and
populaces of the LDCs, particularly those in Latin
America, view the United States as being of over-
whelming economic importance. As discussed earlier,
LDCs are straining under the burden of US dollar-
denominated debt, have heavy imports of dollar-
denominated grain and oil, and therefore target US
markets for their exports to acquire US dollars.
Moreover, there is a growing recognition in LDCs
that the United States is the prime source for the
investment and technical skills necessary for sustained
growth. Although these linkages often result in politi-
cal pressures on the United States, they also make US
policies toward the Third World far more potent than
those of other countries. Despite the problems faced
by such US initiatives as the Baker Plan, the United 25X1
States remains the only country capable of taking the
lead in affecting Third World economic and political
behavior.
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The financial future of the Persian Gulf will be
primarily shaped by the future of oil prices. And by
extension, the economics and politics of the entire
Middle East will be significantly affected by the
volume of financial flows through the Persian Gulf.
Resource Flows
The large current account surpluses of the Persian
Gulf have evaporated. Although Kuwait and the
United Arab Emirates are likely to continue to survive
on current revenues, Saudi Arabia-the economic
engine for much of the region-began drawing on its
huge external assets in 1984 when its 1983, $16.3
billion current deficit rose to a $20 billion-deficit. The
Saudis have also begun to cut expenditures. In con-
trast to the peak OPEC years, the Middle East on
balance is likely to be a net capital consumer through
at least 1990.
Other countries in the region are suffering a double
blow from the reduced oil prices. Directly, non-Gulf
states, such as Egypt and Syria, are also facing falling
oil revenues. Indirectly, many of these countries de-
pend on Gulf states for aid and economic stimulus
through trade. Pakistan and Egypt, for example,
depend heavily on foreign exchange sent home by
expatriate work forces in Gulf states. Many of these
workers are now being sent back-further swelling
the underemployed populations of cities like Cairo.
Participation
The Saudis, despite a roughly $100 billion foreign
asset base, are not likely to continue to draw down
these reserves at the current rate. Riyadh has stepped
up its borrowing from Western sources in recent years
in an effort to maintain both spending and assets.
A large accumulation of floating-rate debt, however,
would link the Saudi balance of payments to
LIBOR-a linkage that the Saudis would have to
consider before taking any action to raise oil prices,
which would boost worldwide inflation and interest
rates. Regardless of whether Riyadh chooses to bor-
row or draw down on external assets, capital would be
pulled from Western Europe-further dampening in-
Egypt is also likely to increase its participation in the
international financial system-by going to the IMF
and the Paris Club to seek debt rescheduling. Egypt's
1986 estimated drop in revenues roughly equals its
debt service payments. A rescheduling would almost
certainly entail a cut in domestic food subsidies. We
believe this could dramatically increase the likelihood
of civil disorder and widespread rioting if handled
badly by the politically weak Mubarak regime. More-
over, anti-Western sentiments, already on the rise,
could skyrocket as the populace views the economic
readjustments as capitulation to foreign, and particu-
larly US, pressure.
US Policy Implications
The drop in Saudi revenues could particularly affect
US interests in the region. Saudi Arabia's primary
means of responding to regional pressures is foreign
aid, which Riyadh uses to reward moderates and
placate radicals, but in both cases encourages consen-
sus. Saudi Arabia is the world's second-largest aid
donor, after the United States. Much of this aid has
gone to serve overlapping US-Saudi interests in the
region. For example, Saudi aid has strengthened
Jordan, Pakistan, Turkey, Somalia, Morocco,
Lebanon, Bahrain, and Oman, and the Afghan and
Eritrean resistances.
Conversely, there has been a steady flow of Saudi aid
to Syria and the PLO
Libya too may find itself unable to buy influence with
other Third World countries as revenue shortfalls
erode its ability to send economic and military aid to a
wide range of countries
Both Iran and Iraq, moreover, will find it increasingly
difficult to finance large offensives as their protracted
war drags on.
vestment and growth in that region.
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and the size of the Soviet economy.' In addition to 25X1
taking advantage of short-term borrowing and suppli-
er credits, the USSR has raised about $2.8 billion in
syndicated loans. Heavy borrowing continued during
the first half of this year-we estimate that the USSR
arranged more than $1 billion in syndicated borrow-
ings-as Moscow sought to offset the sudden decline
in oil revenues as oil prices plunged. Moscow may also
be taking advantage of favorable interest rates to
lengthen the maturity structure of its debt to the
West.
Known Soviet activity in global financial markets is
almost exclusively linked to facilitating trade flows.
The soft world oil market is sharply cutting Moscow's
export earnings and, by implication, Soviet financial
flows in international capital markets over the next
few years. Although the dollar magnitude of Soviet
transactions may fall, the scope of Soviet financial
activity will probably expand as Moscow increases the
use of new international financial instruments to
maximize the return on its smaller pool of funds.
Resource Flows
The USSR uses the international banking system to
transfer funds in support of its bilateral trans-
actions. Payments are made either directly through
Vneshtorgbank, the Soviet Foreign Trade Bank, or
one of six Soviet-owned banks in the West. In addi-
tion, Vneshtorgbank and these Soviet-owned banks
are active players in the interbank market.' Because
of their short-term nature, the Soviet deposits are
probably used to facilitate financial transactions rath-
er than to provide a net of new funds.
Moscow also taps international credit markets to
finance trade. Declining Soviet export revenues since
1984 have resulted in increased borrowing activity.
The USSR's net borrowing increased by about $4
billion last year, raising total net debt to $14 billion-
quite small compared with the world's major debtors
3 The Soviet-owned banks were established to facilitate Soviet trade
with the West. In addition to handling many routine trade transac-
tions, these banks place interbank deposits in Vneshtorgbank and
extend credit to the USSR. Their activities are reported to and
regulated by the host countries.
Although Moscow's initial response to its deteriorat-
ing financial position resulted in increased activity on
financial markets, the long-term adjustment could
work to reduce Soviet involvement. The Soviets al-
ready are moving to decrease imports to redress the
financial imbalance, with Foreign Trade Minister
Boris Aristov stating that imports from the West
could be cut by one-fourth to one-third this year. We
estimate that, even with average net new borrowing of
$1 billion per year and increased gold sales, the USSR
will have to reduce annual average imports through
1990 by 30 percent in real terms from the 1984 level.
Participation
The inherent conservatism of Soviet managers has
made them relatively passive players in the interna-
tional banking arena and leery of adopting many of
the new international financial mechanisms. In addi-
tion, an appreciating dollar and rising revenues from
oil sales during the early 1980s reduced the need to
tap these secondary financial markets. With fortunes
reversed, there is some evidence that the Soviets are
willing to test new financial waters:
? Vneshtorgbank invited officials of two major French
banks to Moscow in June to discuss joint financing
for medium-term credits and financial paper. The
bank was also interested in using new financial
instruments in its international operations.
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? The Soviets may be becoming more attuned to the
impact of foreign exchange movements and are
looking for ways to offset the effect of the dollar
depreciation.
? Moscow also appears on the brink of expanding the
scope of bilateral relations. Since late last year the
Soviets have expressed interest in establishing joint
ventures with Western firms that could-for the
first time since the 1920s-allow direct foreign
ca ital investments.
? Soviet acquiescence last year to an acceptance
facility in a syndication with US and Canadian
bankers reflects greater Soviet flexibility in light of
hard currency problems.
Soviet-owned banks in the West are beginning to
adapt to the new condition in the global banking
community, in part as a response to changing de-
mands of their Western customers. These banks are
participating in currency swaps, debt swaps, and
interest rate swaps. Moscow Narodny Bank, for the
first time, recently launched some floating rate note
instruments
One consequence of the global-
ization process would be to provide a less expensive
and less visible way for the USSR to acquire funds-
by using the vast interbank market more aggressively
than it has to date.
US Policy Implications
With the volume of Soviet trade and financial activi-
ties likely to decline, US banking activity with the
USSR will probably also contract from an already
low level. While US banks may look to the USSR for
new lending opportunities-US banks participated in
commercial loan syndications last year for the first
time since the invasion of Afghanistan-the US pref-
erence for trade financing will limit the extent of such
activity. Should the USSR permit joint ventures with
Western firms, US banks may help finance US
participation in such ventures, although this type of
financing probably carries higher risks than tradition-
al trade credits.
Increased competition among West European firms
for the reduced number of Soviet contracts could
undermine US efforts for a unified Western policy for
lending to the USSR. Western governments, anxious
to maintain the competitiveness of their nations'
exports, could become more receptive to pressures for
low interest rates and longer repayment terms. The
Soviets are currently demanding interest rates of no
more than 7.8 percent and have even pressed for rates
under 7 percent in negotiations for government-
backed project loans. On commercial borrowings, the
Soviets will probably continue to obtain loans at
margins slightly over LIBOR as long as Western
bankers perceive the USSR as an excellent credit risk
and opportunities for lending elsewhere remain limited.
Nonetheless, the hard currency shortage could put
pressure on Moscow that would benefit US foreign
policy interests:
? Economic initiatives. Soviet planners will need to
revise the five-year plan to account for reduced
imports. Moreover, should current efforts to boost
productivity and efficiency falter, they might con-
sider bolder economic reforms to carry out Gorba-
chev's ambitious capital renewal policy without
drawing heavily on resources slated for defense.
25X1
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? Western involvement in the Soviet economy. Prior
to the fall in oil prices, Soviet planners, including
Gorbachev, were reportedly considering altering the
nature of the relationship between Soviet entities
and Western firms to enhance the effectiveness of
the technology and equipment that the USSR will
be able to afford. They recently have shown an
interest in joint ventures entailing Western profit
sharing and managerial presence, closer engineering
and production consultations with Western firms,
and the creation of more training facilities with
Western participation.
From their perspective, Soviet-supported LDCs and
Eastern Europe are likely to find greater benefits
from participating in the Western financial system.
Mozambique, for example, has strengthened its West-
ern financial ties by joining the IMF and World Bank
in 1984. Moreover, Maputo has signed an investment
insurance agreement with the United States and has
recently solicited private investment from US and
other Western firms. The increased participation in
the Western financial system by governments within
the Soviet sphere could also encourage greater use of
free market mechanisms domestically. In the case of
Mozambique, the government has distributed state-
owned land to private owners and has returned some 25X1
nationalized manufacturing firms to private owner-
ship as part of its effort to lure Western money. In the
long run, such trends strenghten Western influence to
25X1
25X1
25X1
25X1
? Political relations with the developed West. We
believe the Soviets will consider ways-short of real
concessions on significant political or security issues
-to foster a climate conducive to attracting cheap
government-backed credits and Western involve-
ment in the Soviet economy. The Soviets could
consider, for example, toning down anti-US rheto-
ric, relaxing restraints on Jewish emigration, and
allowing expanded intra-German ties. Flexibility
would be strongly constrained, however, by an
expressed Soviet policy aim of reducing long-term
vulnerability to Western economic leverage.
? Relations with Eastern Europe. Moscow is likely to
increase pressure on its East European allies to fill
some of the gap in hard currency imports; it may
also divert some of its oil exports away from the
region. But Eastern Europe is not in a position to
provide support on the scale that the Soviets require.
Moreover, as falling oil prices reduce the value of
planned Soviet exports to Eastern Europe, the latter
will be in a stronger position to resist Soviet pres-
sures for increased exports.
boost hard currency sales.
We expect the Soviets to be more aggressive
on the international arms market, including an
increased willingness to part with state-of-the-art
arms and to provide military technicians, in order to
has gone only to Cuba
? Relations with the Third World. Moscow's policies
toward the Third World, including its clients, are
not likely to be significantly affected. The hard
currency component of military and economic aid
the detriment of Soviet ties.
The direction of the Chinese economy, and its impact
on the international trade and finance markets, could
well become one of the most important issues in the
last half of this decade.
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Resource Flows
Last year China's outstanding foreign debt stood at
$5.7 billion. Official commercial borrowing has been
limited as the Chinese have focused on borrowing for
development purposes, often at concessionary rates.
Although traditionally Beijing is fiscally conservative,
China is seen by many Western observers as a
potentially mammoth importer of capital to finance
its long-term development. China has one of the
highest credit ratings of any country and would be
welcomed as a customer by nearly every Western
financial institution. Should Beijing suddenly decide
to take advantage of its borrowing power, capital-flow
patterns from Japan could be radically altered.
Participation
Even barring such a scenario, Beijing has been taking
significant steps toward attracting more foreign
investment. The central Chinese Government has
offered tax holidays and is providing more decision-
making autonomy for foreign ventures there. More-
over, China has tried to expand its offshore leasing
program for petroleum rights.
In the international financial sector itself, China in
1997 is to take political control of a prime Asian
financial center-Hong Kong-although it nominally
plans to permit economic autonomy. Already, China
has a very visible financial foothold on the island. In
Hong Kong there are branches of the Bank of China
and its 12 associated banks, 31 other financial institu-
tions, and five insurance companies. These institutions
are using Hong Kong as a training ground for manag-
ers and a test market for financial instruments that
have yet to be offered on the Mainland. They have
performed very well; financial journals report that the
Bank of China has outdistanced many European- and
US-owned banks in some areas and is facilitating
trade and financial ties between the international
markets and the Mainland. Many bankers predict an
ever-increasing amount of investment funds for China
coming from the world markets through the Hong
Kong connection.
US Policy Implications
Increased Chinese activity in the international mar-
kets-whether through heavy borrowing, by allowing
increased foreign-investor access, or by becoming a
major financial broker-would be likely to enhance
Chinese influence throughout Asia. Control of Hong
Kong, moreover, is likely to give Beijing greatly
enhanced information on-and leverage over-indi-
viduals, groups, businesses, and countries conducting
their financial transactions through the island. Hong
Kong is a preferred financial center for trade-both
legal and illegal-for the Pacific Basin, as well as a
magnet for regional investment and flight capital.
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25X1
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