The Integration of World Capital Markets

IMF Working Papers, December 1, 1993

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Discusses the extent to which national capital markets have become linked and identifies several important consequences of increased integration.
Reviews alternative approaches to the measurement of capital market integration, including:
- deviations from the law of one price,
- differences between actual and optimally diversified portfolios,
- correlations between domestic investment and domestic saving,
- cross-country links in consumption behavior.
Examines two recent episodes of large-scale international capital flows for insights into global capital market workings:
- the turmoil in the European Monetary System in the fall of 1992,
- the surge of capital inflows into Latin America during the last three years.

Capital market integration has multiple measurable dimensions; no single metric suffices. The paper emphasizes complementary measures:
- law of one price deviations as indicators of asset price convergence or segmentation,
- portfolio diversification gaps to assess cross-border investment barriers or preferences,
- investment–saving correlations to evaluate international capital mobility,
- consumption links to capture cross-country risk-sharing and financial market completeness.
Case studies provide empirical and institutional lessons:
- European Monetary System turmoil (fall of 1992) illustrates how integrated markets transmit shocks and affect exchange rate dynamics.
- Latin American capital inflows (surge during the last three years) illuminate the macroeconomic and policy challenges posed by large-scale international capital movements.
Concluding analytical remarks address:
- future development of international capital markets,
- implications for exchange rate management,
- alternative approaches to living with larger and more influential financial markets,
- financing of investment in the formerly centrally planned economies.

Exchange rate management: integration increases the transmission of external shocks, implying greater exchange-rate policy considerations in an integrated capital market environment.
Market-based discipline and regulation: larger, more influential financial markets require policy frameworks that acknowledge cross-border linkages and potential for rapid capital flow reversals.
Investment financing for transition economies: as formerly centrally planned economies engage with global capital markets, policy attention to appropriate financing instruments and market development is necessary.
No single policy prescription is offered; the paper sketches alternative approaches to managing the risks and opportunities from deeper international capital market integration.