I read breathless financial press stories predicting foreigners will lose confidence in U.S. dollar assets, leading to higher U.S. interest rates. What other store of value will global liquidity go to besides U.S. bonds and earn comparable yields? Europe's demographics and "stability and growth pact" ensure it will not issue enough debt to steal the U.S.' "borrower of last resort" mantle. Yen real rates remain at zero. No other currency has a big enough market to compete with the dollar. (Shawn McFarlane, St. Paul, MN, USA)

While it is certainly the case that the dollar bond market remains the deepest and most liquid, the growth in the euro bond market has been impressive. In particular, the level of corporate bond issuance is much greater than in the pre-EMU period - even if European governments turn out to be limited issuers of debt, the growth of private-sector issuance is not similarly constrained. (Incidentally, US agencies have issued a considerable amount of euro-denominated debt.

So, while the dollar market remains the largest, the euro market provides a highly credible alternative.

What is your opinion about the Feldstein-Horioka puzzle - that the strong observed dependence of domestic investment on domestic savings is evidence of low capital mobility? Do you think it is still relevant? (Christian Bordes, Paris, France)

The correlation between the domestic investment rate and domestic savings rate has certainly weakened over the last decade. Even if this magnitude of this correlation is not the best method to measure capital mobility (a high correlation can be rationalized by a preponderance of global over local economic shocks), I think it is fair to interpret the weakening correlation as partly driven by an increase in international capital mobility.

However, there remain natural reasons for a degree of investor “home bias” to persist. At one level, differences in consumption patterns means that an optimal portfolio will have a greater weighting towards domestic assets; this is re-inforced by information differentials and a lower transaction cost for domestic trades. Put differently, there is a lack of consensus on what is the natural end-point for financial globalization - it is unlikely to reach the point in which all investors, regardless of nationality, hold the same portfolio.

I have recently heard it said that the external trade imbalance doesn't matter and listened to reasoning like: "We don't have to pay if we don't want to", or "Using available cheap labor overseas to sell at a higher profit is good for the US regardless what happens to the external currency exchange rate." Do we have to pay or do we only pay on US terms when it's convenient? How does exchange rate fluctuation affect low-cost labor, the cost of goods sold and corporate profitability? (Donald B Robinson)

A country that accumulates external liabilities over time must provide a return to the foreign investor - dividend payments on equities (portfolio or foreign direct investment), interest payments on debt or through the repurchase of the assets. The transfer of these resources to foreign investors means that fewer resources are available for consumption by domestic residents, which weakens relative purchasing power and drives the dollar down. In this way, part of US production activity is directed towards paying foreign investors and the economy is re-orientated towards exporting sectors and away from sectors that are focused on serving domestic consumption demand.

However, there is a clear difference between the US and indebted developing countries. The US in essence transfers significant investment risk to the foreign investor by using equity finance and issuing debt in dollars rather than in a foreign currency. If the US economy does poorly and US asset values decline, these losses are borne by the foreign investors; similarly, if a weak economy drives down the dollar, the return earned by the foreign investor goes down. In contrast, a typical developing country has a lot of foreign-currency debt, such that a weak domestic economy and a weak currency raises the real burden of repayment - the polar opposite of the US case.

It is also true that the US could in essence default on its dollar debt by engineering a large depreciation of the dollar. However, this would be very costly in terms of its adverse impact on US inflation; moreover, if foreign investors no longer trusted the security of the US dollar, the US would find it very expensive in the future if it ever wished to borrow again.

Both the US Fed and the European Central Bank are raising interest rates, while the Bank of England stays put. Should we expect the pound to depreciate? (Samuel Deer, Cambridge, UK)

It is true that, all else equal, a lower interest rate makes a currency less attractive. However, it is not so simple to read the data - for instance, if a country raises its interest rate, this may signal that domestic inflationary pressures are strong and/or the potential output growth rate of the economy is low, such that an interest rate increase actually causes the currency to depreciate.

Everybody derided the euro as it sharply fell against the dollar after being introduced in 1999. Later on the euro more than recovered its initial value. Does this mean the euro is finally succeeding? Is this due to the euro’s strength or to the dollar’s weakness? (Björn Bengtsson, Sweden)

This question views the external value of the euro against other currencies as the means to assess whether it is a success. Rather, the most important criteria to judge the euro experiment is in terms of its internal value – that is, is it proving to be a good means of exchange, a store of value and offering low transactions costs, with the ECB delivering price stability without sacrificing output. On those criteria, the euro has been extremely successful, even if individual member countries sometimes face a monetary environment that does not perfectly match local macroeconomic conditions.

The current strength of the euro against the dollar (especially compared to the 2000-2001 period) largely reflects concerns about the US current account deficit, with participants taking the view that the dollar must ultimately weaken as part of the transition from the current large trade deficit to a more sustainable regime. As such, the strength of the euro can be attributed more to dollar weakness than to euro strength (indeed, we may anticipate the euro depreciating against a range of Asian currencies, reflecting the large trade surpluses and strong growth prospects of emerging Asia).

Is financial globalization extending to emerging countries or does it remain confined to rich economies? Does financial globalization matter for emerging countries’ ability to attract capital to invest? In Brazil some fear that it is only a way for the US to finance its trade deficit at our expenses. (Joao Suarte, Sao Paulo, Brazil)

Emerging countries are succeeding in attracting ever-greater volumes of foreign direct investment and portfolio equity investment, with also some improvement in their ability to issue local-currency debt to foreign investors. An important trend has been for firms in these countries to acquire overseas assets - the level of outward FDI has been impressive in recent years.

What is true is that we currently have the unorthodox situation of many developing countries offering low-interest loans (through the accumulation of dollar reserves) to the US, the world’s richest large economy. However, financial globalization involves large two-way flows, such that it is possible for a country at the same time to be a recipient of large equity and FDI inflows and an accumulator of low-yielding reserve assets.

The current debate is focused on what is the optimal level of reserves that should be held by a developing country in order to provide insurance against financial shocks and re-assure investors about the strength of its currency. I expect many developing countries to slow down the pace of reserves accumulation, allow greater currency appreciation and run larger current account deficits over the next 5-10 years.

I am a currency strategist at a Singapore-based asset manager. My clients are quite concerned about an increase in yuan’s future volatility if the US gets serious about forcing China to revaluate. What is your take?

There are several issues to consider. First, in the near term, it is possible for China to revalue the yuan without moving to a “free-float” environment with zero capital controls - so volatility and revaluation can be delinked at a conceptual level.

The longer-term issue is the correct monetary regime for China and its implications for currency stability. As a large-sized economy, an “inflation-targeting” regime makes sense as the long-term goal - with the external value of the yuan fluctuating in the same way that the dollar is volatile against the euro.

In the transition to this regime, the key stage in terms of volatility is when China fully lifts capital controls. In order to avoid the excess volatility associated with thin and under-developed markets, it is important for China to develop deep spot and derivative markets for the yuan and domestic securities - which is a current priority in their financial strategy.

Behind this, the other source of fundamental volatility is the stability of the Chinese political system. Uncertainty about the transition to a democratic system could lead to swings in the yuan, as market participants continually adjust expectations about the future course of the Chinese economy and political system.

With a depreciating dollar, are Bernanke’s policies more constrained than Greenspan’s?

Dollar depreciation has several implications for US monetary policy. First, it provides a boost to US exporters, such that provides a looser monetary environment. Second, if producers pass along the currency change, it raises import prices. Both of these forces would point towards a higher interest rate for the US.

However, if the economy is not at full capacity and if inflationary pressures are low, these effects may be dominated by other considerations. Moreover, foreign producers will be reluctant to raise dollar prices in such an environment - there will be low “pass through” in the jargon. Accordingly, Greenspan faced a large depreciation of the dollar against the euro during 2002-2004, which had little apparent impact on aggregate price level dynamics in the US or on Fed policy.

Further depreciation of the dollar may have a larger effect today. First, the US economy is closer to full capacity and foreign producers may be more willing to raise dollar prices. This would point to a stronger Fed response - but still quite limited, in view of the small role of imports in the US aggregate consumption basket.

Perhaps a greater worry is that a very rapid weakening of the dollar could generate problems in financial markets (for instance, institutions that may have borrowed in foreign currencies) - if financial stability were threatened, the Fed may move in the opposite direction by cutting interest rates in order to provide liquidity.

What is the role of hedge funds in driving financial integration? Is this all a speculative investment phenomenon which will help the exploitation of emerging countries - like the globalization that took place a century ago? (Lee Ching Yen, Singapore)

Hedge funds are to the forefront of financial integration - by seeking out unexploited arbitrage opportunities, these firms are helping to equalize risk-adjusted returns across countries. International “carry trades” are a good example, with hedge funds borrowing in low-interest rate countries and investing in higher-return economies.

However, the open question is whether the funds are properly evaluating the risks in their portfolios. If risk is under-priced, such funds could take large losses with the investors in such funds (increasingly, pension funds and other institutional investors with liabilities at the retail level) taking the hit.

There are certainly issues to do with the regulation and taxation of such funds, that typically make full use of the organizational flexibility provided by offshore financial centers in the Caribbean and elsewhere. This poses a challenge to tax authorities around the world, as Korea has recently discovered in relation to the Lucky Star case.