International Capital Mobility and Asset Substitutability: Some Theory and Evidence on Recent Structural Changes

This study examines different aspects of the international integration of capital markets. In particular, it attempts to determine whether the changes in controls and regulatory policies that have occurred in the past decade have been associated with a greater degree of market integration. The pertinent empirical literature is surveyed and some new estimates are provided. These estimates are principally for Canada, France, Germany, Japan, the United Kingdom, and the United States for the 1973-85 period as a whole and for the subperiods of the 1970s and 1980s. The issues examined are the degree of international mobility and substitutability of financial assets, the role of transactions costs in explaining deviations from covered interest parity, and the international equality (or inequality) of short-term real interest rates.

The results are consistent with a high degree of mobility of financial assets in periods when capital controls are absent. Capital controls are the main identifiable barrier to mobility. Factors other than controls and regulations that have been thought to impede mobility are found not to be empirically significant. Most notably, political risk has not had significant effects in the expected direction on the differential between Euromarket and domestic interest rates, and transactions costs are too small to account for sizable deviations from covered interest parity. Tests of a portfolio-balance model of the exchange risk premium give results that are also consistent with a high degree of substitutability for financial assets. But despite the high degree of capital mobility and substitutability, short-term real interest rates are not equalized internationally. The empirical evidence indicates that, although removal of controls in various countries over the past ten years has stimulated mobility, there is no evidence that substitutability has tended to increase during the 1980s, nor have real interest rates generally moved towards international equality.