spectrum tend to become more closely correlated with the global rate, or the rate of the largest trading partner, and less correlated with the domestic policy rate. this means that monetary transmission tends to go increasingly through the exchange rate channel, which is only a problem, however, if the exchange rate behaves badly. unfortunately, there is copious evidence to suggest that it is a problem. uncovered interest rate parity ( uip ) does not hold except over long horizons. on the contrary : interest rate differentials give rise to widespread carry trading, which is by nature a bet against uip. exchange rates thus diverge from fundamentals for protracted periods, followed by sharp corrections. so the exchange rate often seems to be as much a source of shocks and instability as a tool for adjustment and stabilisation. ultimately, these cycles take the boom - bust form and, in extreme cases, result in serious financial instability or crisis. so this is basically a macroeconomic problem that can turn into a financial stability problem. another reason is related to vulnerabilities deriving from the size and composition of countries ’ gross capital positions and, behind that, of banks, governments, corporations and households. these are currency mismatches and maturity mismatches in terms of foreign currency. while current account imbalances and wayward exchange rates can be termed the net capital flow problem, we can call this the gross capital problem. of course, the second of bis central bankers ’ speeches these will turn into a net flow problem at the critical moment, thus affecting the exchange rate ; for instance, when there is a run on foreign - denominated gross liabilities that were previously matched with more illiquid gross assets. but the difference is that, prior to the crisis, the net capital flow problem was there for everybody to see, in the form of global current account imbalances – or, in my country, huge capital inflows, a double - digit current account deficit, excessive credit growth, and an asset price bubble. but the gross capital problem was hidden and not much talked about. to take an example, the euro area as a whole had a more or less balanced current account position. a factor that garnered little attention before the crisis, however, was that european banks had built up huge usd - denominated balance sheets that were also balanced to a large extent – except, of course, in maturity. this became a major problem when there was a run on such dollarden

mar guðmundsson : capital flows and fragmentation of the international financial system speech by mr mar guðmundsson, governor of the central bank of iceland, in session i in the conference “ fragmentation in the international financial system – can the global economy become one again? ”, organised by the central bank of the republic of turkey and the reinventing bretton woods committee, cappadocia, turkey, 14 july 2012. * * * for the most part, i will discuss some flaws in the international monetary and financial system ( s ) ( imfs ) and in the european union ( eu ) framework for cross - border banking and financial stability as they relate to both net capital flows and vulnerabilities in gross capital positions. my perspective on these issues is that of a policy - maker from a very small, open, and what used to be financially integrated economy, but it is also informed by the work i was involved in during my tenure at the bank for international settlements. the current international and monetary and financial system is in some sense a non - system, a hybrid of miscellaneous exchange rate regimes and diverse rules on cross - border capital flows and activities of financial institutions. this opens the door to country choices that, in the aggregate, cause and perpetuate global current account imbalances. this problem and its solution have been discussed extensively, and i will not dwell on that topic here. instead, i want to pose this question : supposing that all countries had free capital movements, freely floating exchange rates, and first - rate macroeconomic policies aimed at internal balance, would everything then be fine, at both the national and global level? i think there are strong indications that it would not be. there are a few reasons for this. first of them is the tendency of exchange rates to move away from equilibrium values for extended periods, with sharp corrections at the end of the process and with excess volatility throughout. the research on this phenomenon is still ongoing, but there are strong indications a number of factors suggest that the process is related at least partly to how asset markets function and how expectations are formed, and would not disappear even if macroeconomic policies were perfect. there will be net capital flows associated with this process, as well as swings in current accounts and effects on domestic financial systems that can ultimately lead to serious financial instability. in a small, open, and increasingly financially integrated economy, the process runs as follows : domestic interest rates at the longer end of the maturity