Description
The objective of this paper is to provide a macroeconomic assessment of the impact of
global financial integration over the economies that are undergoing financial integration.
Journal of Financial Economic Policy
Financial globalization: a macroeconomic angle
Dilip K. Das
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To cite this document:
Dilip K. Das, (2010),"Financial globalization: a macroeconomic angle", J ournal of Financial Economic
Policy, Vol. 2 Iss 4 pp. 307 - 325
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Financial globalization:
a macroeconomic angle
Dilip K. Das
SolBridge International School of Business, The Institute of Asian Business,
Woosong University, Daejeon, Republic of Korea
Abstract
Purpose – The objective of this paper is to provide a macroeconomic assessment of the impact of
global ?nancial integration over the economies that are undergoing ?nancial integration.
Design/methodology/approach – The paper focuses on several issues. It begins with examining
the evidence whether ?nancial globalization elevates growth performance of the integrating economy
and supports it macroeconomic stability. It takes a nuanced view and divides the impact of ?nancial
integration into direct and indirect bene?ts. Second, it scrutinizes whether there are some threshold
conditions, that is, in their presence and with their support, ?nancial globalization underpins growth
and stability of the capital importing economy and in their absence it cannot. Third, it delves into the
oft-cited allegation of ?nancial globalization being a source of macroeconomic volatility and
eventually ?nancial crises. Fourth, as the evidence that emerged regarding ability of ?nancial
globalization to underpin growth was unambiguous. Policy mandarins’ options are examined.
Findings – The paper ?nds that from a theoretical perspective, it is easy to state that integration of
?nancial markets an potentially faster growth. Whether it happens in reality is a different matter.
Originality/value – The paper explores a new theme. While there are many relevant themes in
?nancial globalization, the author has not seen any article on this theme and this paper may well be the
?rst.
Keywords Globalization, Macroeconomics, Finance and accounting, Economic integration
Paper type Research paper
1. Stylized theoretical perspective
As global ?nancial integration progressed during the contemporary phase of ?nancial
globalization, the following queries logically became progressively prominent and
meaningful: does integrating into the global ?nancial market spur growth and stability
in an economy that is endeavoring to do so? Is ?nancial globalization, or integration of
global ?nancial markets, bene?cial and growth-promoting for the globalizing economy
in particular and for the global economy in general? From a theoretical perspective, one
can state that ?nancial globalization implies access to a large reservoir of capital, which
if invested prudently and pragmatically increases growth. A second equally plausible
answer could be that integration of ?nancial markets can potentially foster ef?cient
global resource allocation, provide opportunities for risk diversion and underpin the
?nancial sector development, which in turn can potentially underpin growth endeavors.
The emphasis here is on “theoretical” perspective. Theoretical, and for the most part,
empirical researches have found that while ?nancial globalization can be
growth-promoting and welfare-enhancing, it need not necessarily be so.
Theoretical literature in this regard is ambiguous. Whether growth bene?ts
outweigh the costs and risks is an unsettled issue. No doubt, several major channels can
be identi?ed through which ?nancial globalization can raise output and productivity in
the globalizing economy. While it can be growth-promoting in an ideal or highly
The current issue and full text archive of this journal is available at
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Financial
globalization
307
Journal of Financial Economic Policy
Vol. 2 No. 4, 2010
pp. 307-325
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576381011100847
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disciplined macroeconomic policy environment, in a real life policy environment which
may entail macroeconomic distortions, its impact may well be negative and result in
costly crises (Stiglitz, 2004). Negative side effects frequently spin off from ?nancial
globalization in economies that suffer from macroeconomic distortions. The principal
curiosity for policy mandarins is why does ?nancial globalization work favorably in
some cases, while is counterproductive in others.
The objective of this paper is to provide a macroeconomic assessment of the impact
of global ?nancial integration over the economies that are undergoing ?nancial
integration. The principal issues it focuses on are as follows: it begins with examining the
evidence whether ?nancial globalization elevates growth performance of the integrating
economy and supports it macroeconomic stability. It takes a nuanced viewand divides the
impact of ?nancial integration into direct and indirect bene?ts. Second, it scrutinizes
whether there are some threshold conditions, that is, in their presence and with their
support, ?nancial globalization underpins growth and stability of the capital importing
economy and in their absence it cannot. Third, it delves into the oft-cited allegation of
?nancial globalizationbeinga source of macroeconomic volatilityandeventually?nancial
crises. Fourth, as the evidence that emerged regarding ability of ?nancial globalization to
underpin growth was unambiguous, I examine the policy mandarins’ options.
1.1 Macroeconomic policy relevance
Financial globalization or global integration is a subject having compelling
macroeconomic and policy relevance for both the economy that is undertaking these
policy measures as well as the global economy. The driving forces of ?nancial
globalization have varied from changes in economic philosophy in the policy-making
community to apt domestic political circumstances in the economy adopting global
?nancial integration. It is an intriguing and engrossing area of academic research
because of the large array of approaches taken by economies in integrating with the
global ?nancial markets. They resulted in a wide range of experiences and outcomes
across countries and groups thereof. As the present phase of ?nancial globalization is of
recent vintage, the academic research in this area is for the most part relatively new.
That said, the accepted wisdom on ?nancial globalization has rapidly evolved and
output of scholarly research during the last two decades is nothing short of massive.
A large empirical literature analyzes the impact of ?nancial globalization on output
and volatility, albeit relatively less dwells on productivity growth.
There is little unanimity in views regarding the macroeconomic implications of
?nancial globalization in the economic profession. Positions have ranged from decidedly
favorable to entirely unfavorable. There are many who reached mixed conclusions. The
debate on this imperious subject is yet to end on any one side of the divide. Failure of the
empirical studies to come to an agreement has made those who oppose ?nancial
globalization and regard it as a source of macroeconomic and ?nancial instability more
certain in their negative perspective. One group of noted economists considers swift
liberalizationof capital account and unrestrained in?ows of capital fromthe global private
capital markets as serious impediments to growth and macroeconomic and ?nancial
stability. Jagdish Bhagwati, a proponent of economic globalization, is thoroughly
skeptical about bene?ts of ?nancial globalization. Distinguishedscholars like Dani Rodrik
and Joseph Stiglitz have written at length on this theme and advocated both caution in
opening up of the capital account and drawn attention to the macroeconomic bene?ts of
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maintaining capital controls. The string of crises that occurred in individual and regional
economies made their case rationally strong, as did the on-going global recession, which
was christened by the ?nancial media as the crash of 2008.
Contrary to this opinion, there are equally eminent economists who regard ?nancial
integration as growth-promoting and welfare-enhancing. They hold the contradictory
view that free trans-border ?ows of global capital can made decisive contribution to
economic growth and strongly support up-gradation of economies from low- to middle-
and then eventually to a high-income status. This group subscribes to the allocative
ef?ciency logic and is convinced that ?nancial integration supports macroeconomic
stabilization of the global, regional and individual economies. Kenneth Rogoff, Stanley
Fischer, Frederic Mishkin and Larry Summers are prominent among this group of
thinkers.
1.2 Leaders and followers in ?nancial integration
The advanced industrial economies, or majorityof the 30 members of the Organization for
Economic Cooperation and Development (OECD), were the leaders in liberalizing capital
account over the preceding three decades. Consequently, they globalized their economies,
including their ?nancial markets before the other economies. Many attribute ef?ciency
gains in the advanced industrial economies, increased diversi?cation and robust
development of the ?nancial sector to liberalization of capital accounts and markets
(Edison, 2002). This group of economies is presently ?nancially well-integrated into the
global economy. However, the exceptions inthis regard are the following OECDmembers:
the Czech Republic, Hungary, Mexico, Poland, Slovakia and Turkey. All of these
economies fall under the category of the emerging-market economies (EMEs). Although
these and other EMEs cannot be regarded as well-integratedinto the global economy, they
have been taking de?nitive policy measures to liberalize their capital accounts and
?nancially globalize.
The European EMEs accelerated their move towards ?nancial globalization in the
present decade. Some of themare considered to be impetuous in decision making in this
regard. They liberalized their capital accounts somewhat hastily and therefore were
open to accusation of making themselves macroeconomically vulnerable. Conversely,
China and India have also been taking steps towards capital account liberalization, but
cautiously and in a calibrated manner. Some regard them as overly cautious.
Essentially due to persisting weaknesses in their ?nancial markets, the two economies
did not plunge headlong into capital account liberalization process (Das, 2008; Prasad,
2009). Many other EMEs and middle-income developing economies are following suit
and are in initial stages of capital account liberalization and ?nancial globalization.
All these economies are coming to grips with the policy decisions regarding the timing
and pace of ?nancial globalization.
There is an imperious need for clear thinking and meticulous policy moves
regarding these issues. Experience shows that global ?nancial integration is a
contentious and error prone policy area. When errors do occur, they have high economic
and social costs. Unregulated capital in?ows, regardless of the liberalization process,
did facilitate precipitations of crises. Asurvey of empirical cross-country studies on the
effect of capital account liberalization on growth reported mixed results from various
country exercises (Edison, 2002). One reason for ambiguity in conclusions of various
empirical studies is the dif?culty in identifying and quantifying capital account
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liberalization in a consistent manner across a sprawling range of countries. Appropriate
and sequential macroeconomic and ?nancial policies are essential for effectively
managing capital account liberalization and ?nancial globalization. These measures
are warranted for ensuring growth and stability bene?ts in the economies that are
endeavoring to ?nancially globalize as well as for minimizing the potential costs. This
paper delves into and explores such a policy structure.
1.3 Neoclassical logic versus the recent nuanced ideas
As regards the effect of ?nancial globalization, the well-trodden neoclassical line of logic
is simple and direct. Trans-border capital ?ows from the countries that have surplus
savings and are capital rich to those where capital is scarce and is badly needed. They
argue that liberalization of capital account allows global capital into the capital-scarce
economies, which lowers the cost of capital for them; it increases domestic investment,
growth and welfare-gains in the capital-scarce economies. As capital is regarded as a
necessary, albeit not suf?cient, ingredient for growth, external capital from the global
private capital markets is indeed valuable and contributes to growth endeavors of the
recipient developing economy by augmenting their rate of investment. This viewdraws
heavily on the predictions of the standard neoclassical growth model pioneered by
Solow (1956). The capital-rich economies that are the source of trans-border capital
?ows, also register welfare gains from higher rates of returns on their investment. This
is because the marginal product of capital is higher in the capital-scarce less developed
economies. The source economies also enjoy the bene?ts of reduced risk through
international portfolio diversi?cation. One basic point in this context is that the state of
development and ef?ciency of legal and market institutions differ from country to
country. As these differences affect the rate of return on foreign investments, they
determine ex ante behavior of global investing community.
The newer ideas on this vital issue are fairly different from the simple neoclassical
thinking set out in the preceding paragraph. Recent literature takes issue with this
seemingly simplistic line of logic in a fundamental manner. It takes a more subtle line
than the one-channel impact of ?nancial globalization and posits that ?nancial
globalization and economic growth and stability link is not so direct. Although there is
a link, it is indirect (Section 2). In its indirect role, ?nancial globalization plays a
catalytic role and thereby underpins economic growth. Bene?ts of global ?nancial
integration do not primarily ?ow through access to global ?nancial markets, as the
neoclassical economies hypothesized. The newer viewis that there are myriad plausible
channels through which indirect bene?ts can materialize.
2. Direct and indirect channels of macroeconomic impact: empirical
evidence
Numerous cross-sectional, panel and event studies were conducted during the
recent past to examine whether ?nancial sector liberalization and integration into
the global ?nancial markets have a de?nitive and convincing positive impact on the
growth rates of recipient developing and EMEs. Explorations of a macroeconomic
link between ?nancial liberalization and economic growth have resulted in a large
research harvest. As a representative study Gourinchas and Jeanne (2006, p. 716) can be
cited, who used a calibrated neoclassical model that conventionally measured gains
from this type of convergence. They found that the gains from international ?nancial
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integration “elusive”. These empirical studies failed to clinch the case for capital
account liberalization. For the most part their conclusions were mixed, occasionally
even paradoxical. An exhaustive and meticulous literature reviewby Kose et al. (2009d)
concluded that the evidence regarding global ?nancial integration and growth is
inconclusive. When it is there, it lacks robustness.
The end result is that at the macroeconomic level, it has been dif?cult to ?nd
“unambiguous evidence that ?nancial opening yields a net improvement in economic
performance” Obstfeld (2009, p. 103). Econometric dif?culties in studying this
relationship are of the same kind that beleaguered the study of trade-growth link for
decades, only they are more severe in case of international ?nance-growth link.
Empirical evaluation is rendered more dif?cult by lumping together of ?nancial
reforms and liberalization with a host of other growth-supporting macroeconomic
reforms as well as the endogeneity of the ?nancial liberalization process itself. One way
of squaring this circle was to study direct and indirect impact of global capital ?ows
independently on the ?nancially integrating economies.
At the outset the direct macroeconomic impact of capital in?ows was regarded as
favorable and substantive. This view was essentially premised on the neoclassical
economic logic. However, it subsequently underwent a dramatic transformation. In this
section we shall analyze the direct and indirect macroeconomic impact of capital ?ows.
2.1 Direct bene?t
Beginning with the direct, single-channel, bene?t of ?nancial globalization, prima facie
evidence is available to show that ?nancial globalization did lead to rapid gross
domestic product (GDP) growth. Theoretically, it is the ?nancial channel through which
the direct bene?t of global capital in?ows can be reaped. That is to say that the global
capital in?ows and GDP growth do seem to have a positive association. The very fact
that since 1970 the EMEs have achieved much higher cumulative growth than the other
two country groups and have made an economic niche for themselves in the global
economy, portends to the fact that liberalizing an economy, particularly capital account
and the ?nancial sector, does lead to rapid GDP growth.
Notwithstanding such broad evidence, numerous scatter diagrams plotting
long-term average growth rates and de facto ?nancial sector openness show little
systematic relationship between the two variables. As stated above (Section 2),
macroeconomic evidence of ?nancial integration leading to systematic higher GDP
growth in the developing economies is weak, particularly when one controls for other
variables for growth. Additionally, an early in?uential empirical study by Rodrick
(1998) has been extensively cited in the literature to demonstrate the insigni?cant
impact of capital account liberalization and ?nancial integration on economic growth.
When an association is found between the two variables, it is as usual exceedingly
weak. Several computations of cross-country growth regressions in the literature
remained either inconclusive or produced weak results in con?rming that economies
that integrate into global ?nancial markets grew faster.
However, among the empirical studies that focused on the direct channel of impact of
?nancial globalization, those that selected ?ner de jure measures of ?nancial openness
as the independent variable came up with relatively more positive results of ?nancial
globalization on economic growth. For instance, Quinn and Toyoda (2008) selected
re?ned de jure measures of capital account openness for 94 countries for the 1950-2004
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period; they did come up with a positive link between the two variables, that is, capital
account liberalization and ?nancial openness and growth. They asserted that
measurement errors, differing time periods used and collinearity among independent
variables accounted for con?icting conclusions in the earlier empirical studies. They
also con?rmed that equity market liberalization has an independent positive effect on
economic growth. In addition, the empirical studies that utilized both de jure and de
facto measures as independent variables found greater support for the direct effect of
?nancial integration on growth. Conclusions of these empirical exercises also varied
due to differences in methodology, time periods, sample countries, the data sets and
collinearity among independent variables.
Growth bene?ts from ?nancial globalization also depend on the composition of
?nancial ?ows. Global capital in?ows that are equity like, that is foreign direct
investment (FDI) and portfolio equity investments, were known for the following two
characteristics. First, they are more stable and second they are less prone to reversals.
In addition, as stated in the following section, addition bene?ts accompany this type of
?nancial ?ows. Conversely, debt ?ows, particularly those that come in the form of
short-term bank loans, tend to be volatile and enlarge negative impact of external
shocks on the GDP growth.
Turning to FDI, the transnational corporations as major FDI investors bring in
knowledge and expertise, which in turn spills over into the domestic industrial ?rm,
and increases their productivity. This intra-industry spillover is known as horizontal
spillover and is the micro channel of positive productivity impact. It can also occur
through contacts between the foreign af?liate and their local suppliers and customers,
which is called the vertical linkage. Although evidence of horizontal spillover in
transmission of productivity bene?ts was found to be inconclusive, Javorcik (2004)
found evidence of productivity spillover through vertical linkages.
Several empirical studies found productivity enhancing effects of FDI using
microeconomic – both ?rm- and sector-level – statistical data (Haskell et al., 2007). FDI
was found to favorably affect an economy’s productive ef?ciency (Xu, 2000). Using an
annual panel dataset of 83 developing and advanced industrial economies, Noy and Vu
(2007) found that liberalizing capital account was not a suf?cient condition to generate
increases in FDI in?ows. It was the domestic economic environment in the host
economy, which in?uenced the quantity of FDI far more. In particular, variables like
lowlevel of corruption in the government systems and political stability mattered most.
Equity markets witnessed a general liberalizing trend across a number of economies.
Consequently, portfolio equity component of the global ?nancial ?ows has expanded
rapidly, particularly into the EMEs. These equity ?ows were found to favorably impact
GDP growth rate and other macroeconomic variables like consumption, investment,
exports and imports. Henry and Sasson (2008) also provided evidence of favorable
impact of global capital in?ows through equity markets. Using a sample of 18
developing countries that opened their equity markets to global capital in?ows, they
reported an increase in both growth rate of labor productivity and the real wages.
Bekaert and Lundblad (2005) found that global capital ?ows by way of portfolio equity
increased growth rate by approximately 1 percent in the recipient economy. For the
most part, empirical research in this area reported notable positive effect of equity
market liberalization. When global capital ?ows through stock markets, the cost of
capital in recipient economy declines, boosting domestic investment and eventually
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spurring growth (Alfaro and Hammel, 2007). However, these estimates of growth effect
are not beyond doubt. Positive growth effect could well emanate from the general
macroeconomic reforms that go with equity market liberalization. Some studies related
global ?nancial ?ows through equity markets to microeconomic bene?ts and
improvements in total factor productivity (TFP; Chari and Henry, 2008; Mitton, 2006).
There is a general agreement among the empirical studies regarding the deleterious
effect of debt ?ows. Substantive empirical literature on this issue has been surveyed by
Berg et al. (2004). These empirical studies are by and large unanimous in their
conclusion that global capital in?ows in the form of short-term debt categorically
deteriorated the bene?t-risk tradeoff. Many found a direct and systemic relationship
between exposure to short-term debt and odds of a crisis. In addition, some of them
inferred that the larger the short-temdebt the more severe the crisis caused by it. Apoint
to note in this context is that often countries with low-credit ratings are left with few
options but relying on short-term debt (Eichengreen et al., 2006).
Thus, viewed, the overall empirical evidence regarding the direct, single-channel
impact of ?nancial globalization on growth is weak, tentative and inconclusive. The
neoclassical theory is not buttressed by empirical evidence. Financial integration does
not robustly support GDP growth and stability in the globally integrating economy.
2.2 Uphill capital ?ows: a question mark on the neoclassical proposition
There is a twenty-?rst century phenomenon, which puts a question mark on the
neoclassical proposition. It is the recent change in direction of capital ?ows. Financial
globalization took an unusual turn over the past several years. Since 2002, sizable sums
of capital have been ?owing from the non-industrial countries to the advanced
industrial countries. Capital ?ows from the economies having a low capital-labor ratio
to those having a high capital-labor ratio is an apparent perversion fromthe perspective
of neoclassical economic thought. Lucas (1990) was the ?rst focus on the capital ?ows
between countries with different capital-labor ratios, and the perverse capital ?ows
were termed the Lucas paradox. During the recent period, capital ?ows from the EMEs,
particularly those from Asia, and the members of the Gulf Cooperation Council
to the advanced industrial economies, particularly the USA, went on increasing. This
so-called “uphill” ?ow of ?nance was largely between governments (Wolf, 2008).
The USA went on a borrowing binge and the saving glut in the global economy,
particularly the EMEs, stoked asset prices (Rodrik, 2008). This uphill ?owof capital has
weakened and obscured the logic of direct impact.
A good part of this uphill capital ?ow from the non-industrial to the advanced
industrial economies is the of?cial international reserves of these capital exporting
developing countries, particularly the EMEs. However, from a solely ?nancial
perspective the net effect is that of reducing the availability of capital for investment in
a developing economy or an EME. Flow of capital is in the direction of the richer
economies where, given the relative abundance of capital, its marginal productivity will
necessarily be lower. An appropriate question is whether this perverse ?owof capital is
adversely affecting the growth performance in the capital exporting economies. In the
preceding section, I have noted that the EMEs have achieved much higher cumulative
growth than the other two country groups (Prasad, 2007). This demonstrates that the
perverse capital ?ows did not deteriorate the growth performance in the capital
exporting developing economies.
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2.3 Indirect bene?t
The indirect channels work as follows. By liberalizing the domestic ?nancial sector the
economies facilitate proper and methodological development of their domestic ?nancial
sector. In many developing economies this development of ?nancial sector began from a
rather lowlevel. Financial sector development makes a decisive contribution to economic
growth (Levine, 2005; Mishkin, 2009). Second, to liberalize and ?nancially globalize,
economies launch into macroeconomic reforms and restructuring. These measures render
macroeconomic policies more disciplined than before and thus are conducive to rapid
economic growth. Macroeconomic distortions and their pernicious effect become more
obvious in an open liberalized economy, making it easy to identify and eliminate them
(Gourinchas and Jeanne, 2005). By liberalizing economically and ?nancially, economies
commit to well-ordered and disciplined macroeconomic policies. This is their signal to the
world that they are changing tack and their economic future is more than likely to be
different from their past, when they followed sub-optimal macroeconomic strategies and
paidhighcost intermof tepid growth anddecrepitude (Bartolini and Drazen, 1997). Third,
opening up of the economy creates ef?ciency gains in the domestic corporate sector.
As business and ?nancial ?rms are exposed to competition from the more ef?cient
businesses in the advanced industrial economies they are forced to become more ef?cient.
Fourth, studies based on different methodologies demonstrate that as more foreign banks
enter the domestic banking sector, competing with them made the domestic banks more
ef?cient, reduced overhead costs and improved pro?ts (Claessens and Laeven, 2004;
Schmukler, 2004). Fifth, Likewise, stock markets become larger and more liquid after they
are liberalized for the entry of global investors (Levine and Zervos, 1998). Liberalization
also catalyzes legal and institutional developments in the equity markets (Chinn and
Ito, 2006). Finally, an environment of better public and corporate governance gradually
evolves which works towards underpinning growth rate in the liberalizing and
globalizing economy (Stulz, 2005).
Thus, ?nancial globalization can indirectly impact through catalyzing different
growth supporting areas of macroeconomic policy and institutions. The principal
channels of indirect impact are the domestic ?nancial sector, ef?ciency gains in the
public and corporate governance and macroeconomic policy discipline. This indirect
effect, or multiple-channel bene?ts, may well be more important than the tradition
?nancing-channel effect emphasized in neoclassical economics[1].
Together, these indirect effects add up to a signi?cant range of bene?ts that begin to
transformthe ?nancially globalizing economy. Kose et al. (2009c, p. 3) designated themas
“collateral” bene?ts and regard them as quantitatively “most important sources
of enhanced growth and stability for a country engaged in ?nancial globalization”.
In addition, the single-channel impact that works by way of augmentation of ?nance
and investment could be a mere short-tem economic impact. On the contrary, the
multiple-channel or indirect effect of ?nancial globalization can have a long-term impact
over the economy (Henry, 2007). Furthermore, certain kinds of global ?nancial ?ows are
accompanied with advance technology, managerial skills and marketing pro?ciency,
sorely needed in a developing economy. They again have a healthy growth promoting
effect over the ?nancially globalizing economy. Once technological and other know-how
reach the recipient economies, they begin to develop capacity to absorb and adapt them.
With the passage of time, they develop capabilities to generate their own technological
competencies and managerial skills, indispensable for a modern economy.
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Although not many empirical studies addressed the issue of impact on ?nancial
institutions, some indications of improvements in them is available. For instance,
countries were found to have made adjustments in their corporate governance in
response to demands from international investors (Cornelius and Kogut, 2003).
Economies open to ?nancial integration do need to prepare macroeconomically by
designing and implementing reforms and restructuring. They generally pay a lot of
attention to monetary policy and keep in?ation low (Gupta and Yuan, 2009; Spiegel,
2008). No relationship was found between ?nancial integration and ?scal discipline.
One cannot assume a positive or a negative link here, albeit is always a possibility of
running higher ?scal de?cits for a longer period with global capital in?ows.
The indirect channels of macroeconomic impact can coalesce to:
[. . .] enhance the growth outcome through their impact on TFP. If ?nancial integration is to
have a lasting effect on growth, it must be by moving economies closer to their production
possibilities frontiers by eliminating various distortions and creating ef?ciency gains, for
example, in ?nancial intermediation, technological adoption, etc. (Kose et al., 2009c, p. 18).
There are empirical studies that have established a link between ?nancial integration
and TFP growth (Bon?glioli, 2008; Kose et al., 2009b). Economies with more open
capital accounts were found to have higher TFP growth. However, overall de facto
?nancial integration did not seem to have an impact on TFP growth.
By using a wide array of de jure and de facto measures of ?nancial openness and by
disaggregating ?nancial integration into stocks and liabilities of different kinds of
?nancial ?ows, Kose et al. (2009b) reached an interesting and valuable conclusion. They
discerned strong evidence of FDI and portfolio equity on TFP growth. In contrast, debt
?ows were negatively correlated with GDP growth. The negative relationship between
stocks of debt liabilities from the global capital markets and TFP was found to be weak
in economies with better developed ?nancial markets due to ?nancial liberalization and
better institutional quality. The impact of ?nancial integration on factor productivity is
more important than effect on capital growth, which in turn can come through
improvements in the banking sector and stock markets. Higher investment ef?ciency
can logically be a source of higher GDP growth (Bekaert et al., 2009). An amber signal is
essential here. That ?nancial globalization affects growth largely through indirect
channels is a substantive and meaningful proposition. Yet, it is not a consensus view
and not gone unchallenged (Rodrik and Subramanian, 2009).
3. Prerequisite threshold conditions
The indirect bene?ts of global ?nancial integration, while more signi?cant than direct,
cannot be taken for granted. They do not come through in a mandatory manner. Until
complementary domestic policies and reforms are in place to sustain stability and
growth, merely opening up the capital accounts and integrating globally does little
good. The complementary policies essentially cover principal macroeconomic policy
areas, institutional development and the domestic ?nancial system. Until the
prerequisite of certain threshold conditions of ?nancial system and institutional
development in the economy are not attained, the globally integrating economies cannot
pro?t fully from the indirect bene?ts of global ?nancial integration (Kose et al., 2009a).
One reason why the advanced industrial economies have continued to be the
principal bene?ciaries of ?nancial globalization is that they have more matured
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institutions, more stable macroeconomic policy structure as well as deeper and more
developed ?nancial markets than the EMEs or the developing economies. If these
preconditions are met, the ?nancially integrating economy would have far better
prospects for bene?ting from it. Therefore, it seemlogical for the EMEs and developing
economies to ?rst pay policy attention and devote resources to strengthening their
?nancial sector as well as institutional development before considering liberalization of
capital accounts.
The ?nancial sector inthe EMEs anddevelopingeconomies is typicallynot deep, which
becomes a serious hurdle in their attempt of deriving bene?ts from?nancial globalization.
A deep, adequately supervised and well-regulated ?nancial sector is essential for
effectively channeling the incoming global capital into productive sectors of the economy.
A well-developed ?nancial sector enables an economy to bene?t from capital in?ows
and reduce its vulnerability to crises. Thus, the development, dexterity and re?nement
of the ?nancial sector in an economy are the sine qua non for gaining from ?nancial
globalization. Likewise, the stage of institutional development is the second important
threshold condition for bene?ting from ?nancial integration. Countries that have
developed their institutions to a near maturity level and therefore have no or little
corruption and red tape in their public administration and professionalized level of
corporate governance, they tend to attract more FDI and portfolio investment from the
global capital markets. Such economies are far more likely to bene?t from indirect
channels of bene?t discussed in the preceding section.
The insightfulness of the domestic macroeconomic policy is third threshold condition.
The quality of macroeconomic policy designed and pursued by policy mandarins in a
countryin?uences both, its level andcompositionof capital in?ows fromthe global capital
markets. It also determines its vulnerability to a macroeconomic, ?nancial or currency
crisis. The importance of ?scal and monetary policies followed is exceedingly high in this
context. A soundly and pragmatically devised macroeconomic policy structure increases
the growth bene?ts of capital account liberalization. It also diminishes the possibility of
precipitationof a crisis inanenvironment of liberalizedcapital account. These are the three
necessary threshold conditions. In their absence, an economy can derive little economic
bene?t – direct or indirect – from ?nancial globalization.
4. Macroeconomic volatility
At an early stage of development ?nancial integration helps a developing economy in
augmenting its investment and diversifying its economic base away from the primary
sector, which in turn expands its real economy as well as reduces its macroeconomic
volatility. When a certain amount of development has taken place, and the economy has
grown to a higher stage of economic development, liberalizing the economy for
globalization and ?nancial integration spurs specialization. This expands the external
sector and trade. This can make a middle-income economy vulnerable to external
shocks in the industrial and services sectors in which it develops its specialization and
trade. Thus, ?nancial globalization may or may not lead to output volatility. Whether it
will be cause for output volatility will necessarily be economy-speci?c.
Most of the advanced industrial world enjoyed an era of unprecedented economic
stability in post-1983 period. Although the causal factors are open to debate,
improvements in monetary policy have probably been one of the important sources of
the Great Moderation. The era of Grate Moderation in macroeconomic volatility
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provided a favorable and nurturing ambiance for deepening of ?nancial globalization.
Output volatility declined in the EMEs and the developing economies as well. However,
intriguingly empirical literature failed to provide statistically signi?cant evidence on
relationship between ?nancial globalization and macroeconomic volatility.
Using panel data for the 30 OECD countries, Buch et al. (2005) concluded that the
impact of ?nancial openness and integration on the volatility of business cycle depended
on, ?rst, the nature of external shock and, second, on the links between macroeconomic
policy. The absence of a link between ?nancial globalization and output volatility is not
without reason. There is no clear theoretical explanation regarding how ?nancial
globalization should affect output volatility. However, the developing economies were
more vulnerable to output volatility due to the structural weaknesses in their economies
thanthe advancedindustrial economies. Another more comprehensive empirical study by
Kose et al. (2003) worked with data for a much large groups of advanced industrial and
developing economies over 1960-1999 period. They found that ?nancial globalization had
a non-linear relationship with volatility of consumption, not output.
In a more recent study, van Hagen and Zhang (2006) developed a dynamic general
equilibrium model of a small open economy and explained the lack of empirical
evidence on the linkage between ?nancial openness and macroeconomic volatility. As
?nancial integration increased, they found non-monotonic patterns with respect to the
three shocks, namely, the foreign-interest-rate shocks, the productivity shock and the
terms-of-trade shocks. In the absence of any direct or indirect effect, they concluded that
?nancial openness has non-monotonic implications for macroeconomic volatility. This
non-monotonic link could either be U-shaped or reverse U-shaped.
The con?guration of ?nancial globalization process determines whether there could
be volatility of output in the economy. If economy relies excessively on debt in its
?nancial integration process, it makes itself vulnerable to variations in global interest
rates, which could decisively cause serious output volatility. Rodrik and Velasco (2000)
established that the ratio of short-term debt to foreign exchange reserves or GDP can
provide a reliable indication of output volatility and crisis-proneness of an economy.
Short-term maturity of debt was found to be a helpful gauge of vulnerability of the
Tequila effect in the 1994-1995 in Mexican crisis. Short-term maturity of debt also
proved highly risk-laden in Asia in 1997. Economies with large short-maturity debt in
comparison to GDP quickly suffer fromdebt crises. If the stock of short-maturity debt is
larger than the forex reserves, the economy is three times more likely to suffer a sudden
reversal of ?nancial ?ows. Also, in several crises an empirical link was found between
domestic lending booms and ?nancial crises. The former preceded the latter in many
instances of output volatility.
4.1 Volatility leading to crisis
One extraordinary development of the 1990s was a surge of private capital ?ows to the
developing economies and widespread borrowings by economies. Both developing
and advanced industrial economies had participated in large borrowing from the
global capital markets. Central banks and governments were also an important part of
this game. The US Treasury and household sector was a large borrower in the USA,
while the corporate and ?nancial sector was a large borrower in Japan. Not all these
borrowings went into productive high-return investments. The European and
Monetary Union (EMU) was an exception in this regard, its borrowings remained low.
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Likewise, in the developing world, there was a surge of private capital ?ows to the
developing economies in the early and mid-1990s. Particularly, noteworthy was the
?ows to East Asian economies. Indonesia, Malaysia, the Philippines, Korea (Republic
of) and Thailand were large borrowers. The business corporations and banks in these
countries were the principal borrowers in the short-term debt market, albeit
governments did not. Unlike them, in Argentina, Brazil, the Russian Federation and
Turkey Governments accumulated large foreign currency debts. They did so without
regard to their repayment capabilities. This sub-group of economies also made itself
vulnerable by prematurely liberalizing its capital markets to free entry of short-term
capital. They somewhat hastily, if imprudently, liberalized their ?nancial and capital
account transactions.
The crises of the 1990s and early 2000s were dramatic episodes of volatility. They
originated fromthe borrowing behavior described above. The Asian crisis was a severe
one and mauled a region that had earned a favorable opinion of being home of several
dynamic economies. Following the crisis a professional opinion emerged that ?nancial
globalization pushes a stable and well-functioning economy towards macroeconomic
volatility and increases vulnerability to sudden stops. In addition, there was the major
crisis that was ignited by the sub-prime mortgage debacle on Autumn 2007 and that
became global in late 2008. The global economic recession it caused was continuing in
2009, at the time of writing. It further buttressed the harmful image of ?nancial
globalization. It is routinely blamed for the crises of the recent past.
The question is frequently asked whether such crises are an inevitable element of
?nancial globalization. The antagonists of ?nancial globalization go so far as regarding
proliferation of ?nancial crises as a de?ning characteristic of ?nancial globalization.
Crises validated their different negative positions, that ?nancial and capital account
transaction should not be liberalized, or their liberalization should be delayed, and that
?nancial globalization is a villainous economic force that must be contained, if not
scotched, at the ?rst opportunity.
However, academic literature came up with inconclusive results on this issue as well.
Empirical evidence suggested that that the relationship between ?nancial integration and
volatility, measured by consumption volatility, depends more on an economy’s domestic
?nancial development and other so-called threshold conditions alluded to above. In the
panel regression results, the estimated slope coef?cient on de facto ?nancial integration
was positive and signi?cant for economies that had relatively weak institutional
qualityandlowdegree of domestic ?nancial sector development. However, the impact was
not found to be signi?cantly different from zero for the economies with stronger
institutions and better developed domestic ?nancial systems (IMF, 2008).
It was possible to estimate thresholds for institutional quality and domestic ?nancial
sector development from the regression results. Given the uncertainty regarding the
estimates, the values of these thresholds was needed to be interpreted with caution.
Based on the average data for the 2000-2004, virtually all advanced industrial countries
and many, almost a third, EMEs met the threshold levels beyond which the estimated
effect of ?nancial integration on consumption volatility was insigni?cant. All the other
countries were found to be below the threshold levels (IMF, 2008). This was a valuable
empirical exercise that reveals which economies can be vulnerable to volatility and
crisis caused by ?nancial globalization, and which are relatively safe from it. It takes
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the wind out of the generalized assertion that ?nancial globalization should cause
macroeconomic volatility and crisis.
If crises are an inevitable component of ?nancial globalization, not liberalizing
?nancial and capital accounts should be the apt strategy to ward themoff. However, for
all appearances capital controls is not the answer. Recent analysis has revealed that
countries that maintain stringent capital controls are more susceptible to crises than the
one that liberalize it. This result needs to be taken with a degree of skepticism because
countries that place capital controls are usually the ones whose macroeconomic
fundamentals are weak. Their essential objective of clamping capital controls is to try
to insulate themselves from possibilities of a crisis. There is empirical evidence to show
that opening up of the capital accounts reduces an economy’s vulnerability to a crisis
(Glick et al., 2006). In addition, there is little empirical evidence to “support the oft-cited
claim that ?nancial globalization in and of itself is responsible for the spate of ?nancial
crises that the world has seen over the last three decades” (Kose et al., 2009c, p. 24). In
short, not liberalizing capital account need not necessarily work as a defensive strategy
for warding off a ?nancial crisis and ?nancially globalizing need not be a cause for one.
4.2 Risk sharing implications
As regards the risk-sharing implications of ?nancial globalization, empirical studies
found little supportive evidence. Kose et al. (2009b) focused on cross-country
correlations of output and consumption while calibrating the impact of ?nancial
integration. They reported that, contrary to the theoretical predictions, there was
limited evidence of improvement in risk-sharing across countries due to ?nancial
globalization. Only the advanced industrial economies were able to clearly bene?t from
?nancial integration in terms of improved risk sharing. Astonishingly, even the EMEs
were not found to have reaped bene?cial results in this dimension, notwithstanding the
fact that many of them took initiative in liberalizing their capital accounts and were
able to attain a much higher degree of ?nancial integration with the global economy
than the other developing economies. These are sobering conclusions. A caveat is
necessary here. These results depend on county-speci?c conditions and the level and
composition of capital ?ows from the global capital markets.
As regards why no risk-sharing bene?t was reported in the EMEs by empirical
studies, there can be several theoretical explanations. One possible explanation is that
different types of global capital ?ows are conducive to differing degrees of risk sharing.
It is possible that the EMEs have not been getting appropriate types of capital ?ows to
be able to achieve the objective of risk sharing. Other theoretical explanations for low
degree of risk sharing include the importance of non-traded goods in this group of
economies, the scarcity of ?nancial instruments for ef?ciently sharing macroeconomic
risk and typically large transaction costs associated with international trade in goods
and assets. These are all realistic possibilities that exist in the EMEs.
5. Policy options in the backdrop of unambiguous evidence
In the preceding decades, policy makers in the developing economies and EMEs were in
general convinced about the bene?ts of ?nancial sector reforms. They demonstrated an
increasing penchant for its liberalization. These policy makers could have been justly
impressed by the ef?cient ?nancial sectors of the advanced industrial economies, run
with a high degree of pro?ciency and corporate governance. Consequently, in general
the ?nancial sector in the advanced industrial economies made an enormous
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contribution to the growth and stability of the economy. There is likelihood for this
policy preference to persist in many developing economies and EMEs, even grow
stronger. The periods of global or regional economic turmoil could be exceptions in this
regard. There are obvious bene?ts in implementing reforms and adopting liberalization
of the domestic ?nancial sector. The most direct bene?t of having a strong and
well-regulated ?nancial sector is its ability to underpin growth, which in turn is
poverty-alleviating and welfare-enhancing (Levine, 2005; Mishkin, 2009).
A well-developed ?nancial sector facilitates public and private sector borrowings.
As it grows and become deeper, conduct of the domestic monetary policy becomes
easier. The costs of maintaining and enforcing capital controls in a deep ?nancial sector
are high, particularly when merchandise trade is expanding in an economy. Finally,
growth in domestic ?nancial sector reforms assists in its external liberalization, which
in turn results in collateral bene?ts (Section 1.3) and institutional growth in the
economy. These channels of bene?ts are essential for making an open ?nancial and
capital account less crisis-prone (Section 3).
Experiences of the last two decades have convincingly demonstrated that embracing
globalization and ?nancial integration entails both, high costs and sumptuous bene?ts.
Obstfeld (2009, p. 104) prudently observed that, “Taken all alone, ?nancial openness is not
a panacea – it canbe poison”. Notwithstandingthe weakevidence of direct contributionto
growth, stability and welfare gains from the liberalization and globalization of the
?nancial sector, its cautious and well-planned adoption under appropriate domestic
economic and ?nancial conditions, can for certain be a productive, growth-supporting,
proposition. When ?nancial globalization is adopted incrementally and sequentially as
well as in association with the complementary range of domestic policies and institutional
reforms, during a period when the reserve position of the ?nancially globalizing economy
is sound, it can be a legitimate instrument of enhancing stability and growth.
In addition, enormous long-term bene?ts can accrue from ?nancial globalization. It
renders the domestic ?nancial system more competitive, transparent and ef?cient than
the one that develops in a controlled and restriction-ridden environment. The other side
of this assertion is that capital account liberalization and ?nancial integration with the
global capital markets need never be a priority policy objective for all the countries.
Low-income developing economies, having a poorly developed domestic ?nancial
sector, pursuing macroeconomic policies of questionable soundness and having small
foreign exchange reserves, need not consider it until their macroeconomic and ?nancial
circumstances change dramatically.
6. Summary and conclusions
This paper addresses the question whether integration with the global ?nancial
markets spurs growth and stability in an economy. It also addresses the related
quandaries like the close association between ?nancial globalization and
macroeconomic volatility. From a theoretical perspective, it is easy to state that,
theoretically speaking, integration of ?nancial markets can potentially foster growth.
Whether it happens in reality, is a different matter. There is little agreement in the
economic profession on the implications of ?nancial globalization. Positions have
ranged from decidedly favorable to entirely unfavorable. There are many who reached
mixed conclusions. Financial globalization is an important policy area and there is an
imperious need for clear thinking and meticulous policy moves regarding these issues.
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The neoclassical line of logic is simple, direct and positive. Trans-border capital
?ows from the countries that have surplus savings and are capital rich to those where
capital is scarce and is badly needed has nothing but favorable rami?cations. However,
the present thinking on this issue is fairly different. It takes a more subtle line than the
direct one-channel impact of ?nancial globalization and posits that ?nancial
globalization and economic growth and stability link is not so direct. Although there
is a link, it is indirect. The cross-sectional, panel and event studies conducted in the
recent past found that the gains from international ?nancial integration “elusive”. For
the most part, the results of these studies were mixed and inconclusive, at times even
paradoxical. At the macroeconomic level, it has been dif?cult to ?nd unambiguous
evidence that ?nancial opening yields a net improvement in economic performance.
Study of indirect and multi-channel impact of ?nancial globalization presented several
possibilities of favorable growth impact and economic stabilization. The indirect impact
can deliver favorable results through catalyzing different growth supporting areas of
macroeconomic policy and institutions. The principal channels of indirect impact are the
domestic ?nancial sector, ef?ciency gains in the public and corporate governance and
macroeconomic policy discipline. This indirect effect, or multiple-channel bene?ts, may
well be more important than the tradition ?nancing-channel effect emphasized in
neoclassical economics.
Although the indirect bene?ts of global ?nancial integration are more signi?cant
than direct, cannot be taken for granted. They would not have much impact unless
certain complementary policies are in place. They essentially cover principal
macroeconomic policy areas, institutional development and the ?nancial system.
Unless these threshold conditions are not achieved, the globally integrating economies
cannot pro?t fully from the indirect bene?ts of global ?nancial integration.
Global ?nancial integration is often blamed for causing macroeconomic volatility.
However, no clear empirical link could be established between ?nancial globalization
and output volatility. There is no clear theoretical explanation regarding how ?nancial
globalization should affect output volatility. However, the developing economies were
more vulnerable to output volatility due to the structural weaknesses in their economies
than the advanced industrial economies. However, ?nancial globalization was found to
have a non-linear relationship with volatility of consumption, not output. The
con?guration of ?nancial globalization process determines whether there could be
volatility of output in the economy. If economy relies excessively on debt in its ?nancial
integration process, it makes itself vulnerable to variations in global interest rates,
which could decisively cause serious output volatility.
The crises of the 1990s andearly2000s were dramatic episodes of volatility. After these
crises, a professional opinion emerged that ?nancial globalization pushes a stable and
well-functioning economy towards macroeconomic volatility and increases vulnerability
to sudden stops. Crises began to be treated as an inevitable element of ?nancial
globalization. In this area also, academic researchers came to inconclusive results.
Empirical evidence suggested that that the relationship between ?nancial integration and
volatility, measured by consumption volatility, depends more on an economy’s domestic
?nancial development and other so-called threshold conditions alluded to above.
As regards the risk-sharing implications of ?nancial globalization, empirical studies
found little supportive evidence. Cross-country correlations of output and consumption
showed that contrary to the theoretical predictions, there was limited evidence of
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improvement in risk-sharing across countries due to ?nancial globalization. Only the
advanced industrial economies were able to clearly bene?t from?nancial integration in
terms of improved risk sharing. Astonishingly, even the EMEs were not found to have
reaped bene?cial results in this dimension.
Embracing globalization and ?nancial integration entails both, high costs and
sumptuous bene?ts. That being said, notwithstanding the weak evidence of direct
contribution to growth, stabilityand welfare gains fromthe liberalization, its cautious and
well-planned adoptionunder appropriate domestic economic and ?nancial conditions, can
for certain be a productive, growth-supporting, proposition. When ?nancial globalization
is adopted incrementally and sequentially as well as in association with the
complementary range of domestic policies and institutional reforms, during a period
when the reserve position of the ?nancially globalizing economy is sound, it can be a
legitimate instrument of enhancing stability and growth.
Note
1. See, for instance, Aizenman et al. (2007) and Gourinchas and Jeanne (2007).
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World Bank Economic Review, Vol. 15 No. 2, pp. 341-65.
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Kose, M.A., Prasad, E.S. and Terrones, M.E. (2006), “How do trade and ?nancial integration
affect the relationship between growth and volatility?”, Journal of International
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Prasad, E.S., Rogoff, K., Wei, S.J. and Kose, M.A. (2003), “Effects of ?nancial globalization on
developing countries: some empirical evidence”, Occasional Paper No. 220, International
Monetary Fund, Washington, DC.
Corresponding author
Dilip K. Das can be contacted at: [email protected]
Financial
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doc_398256267.pdf
The objective of this paper is to provide a macroeconomic assessment of the impact of
global financial integration over the economies that are undergoing financial integration.
Journal of Financial Economic Policy
Financial globalization: a macroeconomic angle
Dilip K. Das
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To cite this document:
Dilip K. Das, (2010),"Financial globalization: a macroeconomic angle", J ournal of Financial Economic
Policy, Vol. 2 Iss 4 pp. 307 - 325
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Financial globalization:
a macroeconomic angle
Dilip K. Das
SolBridge International School of Business, The Institute of Asian Business,
Woosong University, Daejeon, Republic of Korea
Abstract
Purpose – The objective of this paper is to provide a macroeconomic assessment of the impact of
global ?nancial integration over the economies that are undergoing ?nancial integration.
Design/methodology/approach – The paper focuses on several issues. It begins with examining
the evidence whether ?nancial globalization elevates growth performance of the integrating economy
and supports it macroeconomic stability. It takes a nuanced view and divides the impact of ?nancial
integration into direct and indirect bene?ts. Second, it scrutinizes whether there are some threshold
conditions, that is, in their presence and with their support, ?nancial globalization underpins growth
and stability of the capital importing economy and in their absence it cannot. Third, it delves into the
oft-cited allegation of ?nancial globalization being a source of macroeconomic volatility and
eventually ?nancial crises. Fourth, as the evidence that emerged regarding ability of ?nancial
globalization to underpin growth was unambiguous. Policy mandarins’ options are examined.
Findings – The paper ?nds that from a theoretical perspective, it is easy to state that integration of
?nancial markets an potentially faster growth. Whether it happens in reality is a different matter.
Originality/value – The paper explores a new theme. While there are many relevant themes in
?nancial globalization, the author has not seen any article on this theme and this paper may well be the
?rst.
Keywords Globalization, Macroeconomics, Finance and accounting, Economic integration
Paper type Research paper
1. Stylized theoretical perspective
As global ?nancial integration progressed during the contemporary phase of ?nancial
globalization, the following queries logically became progressively prominent and
meaningful: does integrating into the global ?nancial market spur growth and stability
in an economy that is endeavoring to do so? Is ?nancial globalization, or integration of
global ?nancial markets, bene?cial and growth-promoting for the globalizing economy
in particular and for the global economy in general? From a theoretical perspective, one
can state that ?nancial globalization implies access to a large reservoir of capital, which
if invested prudently and pragmatically increases growth. A second equally plausible
answer could be that integration of ?nancial markets can potentially foster ef?cient
global resource allocation, provide opportunities for risk diversion and underpin the
?nancial sector development, which in turn can potentially underpin growth endeavors.
The emphasis here is on “theoretical” perspective. Theoretical, and for the most part,
empirical researches have found that while ?nancial globalization can be
growth-promoting and welfare-enhancing, it need not necessarily be so.
Theoretical literature in this regard is ambiguous. Whether growth bene?ts
outweigh the costs and risks is an unsettled issue. No doubt, several major channels can
be identi?ed through which ?nancial globalization can raise output and productivity in
the globalizing economy. While it can be growth-promoting in an ideal or highly
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
Financial
globalization
307
Journal of Financial Economic Policy
Vol. 2 No. 4, 2010
pp. 307-325
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576381011100847
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disciplined macroeconomic policy environment, in a real life policy environment which
may entail macroeconomic distortions, its impact may well be negative and result in
costly crises (Stiglitz, 2004). Negative side effects frequently spin off from ?nancial
globalization in economies that suffer from macroeconomic distortions. The principal
curiosity for policy mandarins is why does ?nancial globalization work favorably in
some cases, while is counterproductive in others.
The objective of this paper is to provide a macroeconomic assessment of the impact
of global ?nancial integration over the economies that are undergoing ?nancial
integration. The principal issues it focuses on are as follows: it begins with examining the
evidence whether ?nancial globalization elevates growth performance of the integrating
economy and supports it macroeconomic stability. It takes a nuanced viewand divides the
impact of ?nancial integration into direct and indirect bene?ts. Second, it scrutinizes
whether there are some threshold conditions, that is, in their presence and with their
support, ?nancial globalization underpins growth and stability of the capital importing
economy and in their absence it cannot. Third, it delves into the oft-cited allegation of
?nancial globalizationbeinga source of macroeconomic volatilityandeventually?nancial
crises. Fourth, as the evidence that emerged regarding ability of ?nancial globalization to
underpin growth was unambiguous, I examine the policy mandarins’ options.
1.1 Macroeconomic policy relevance
Financial globalization or global integration is a subject having compelling
macroeconomic and policy relevance for both the economy that is undertaking these
policy measures as well as the global economy. The driving forces of ?nancial
globalization have varied from changes in economic philosophy in the policy-making
community to apt domestic political circumstances in the economy adopting global
?nancial integration. It is an intriguing and engrossing area of academic research
because of the large array of approaches taken by economies in integrating with the
global ?nancial markets. They resulted in a wide range of experiences and outcomes
across countries and groups thereof. As the present phase of ?nancial globalization is of
recent vintage, the academic research in this area is for the most part relatively new.
That said, the accepted wisdom on ?nancial globalization has rapidly evolved and
output of scholarly research during the last two decades is nothing short of massive.
A large empirical literature analyzes the impact of ?nancial globalization on output
and volatility, albeit relatively less dwells on productivity growth.
There is little unanimity in views regarding the macroeconomic implications of
?nancial globalization in the economic profession. Positions have ranged from decidedly
favorable to entirely unfavorable. There are many who reached mixed conclusions. The
debate on this imperious subject is yet to end on any one side of the divide. Failure of the
empirical studies to come to an agreement has made those who oppose ?nancial
globalization and regard it as a source of macroeconomic and ?nancial instability more
certain in their negative perspective. One group of noted economists considers swift
liberalizationof capital account and unrestrained in?ows of capital fromthe global private
capital markets as serious impediments to growth and macroeconomic and ?nancial
stability. Jagdish Bhagwati, a proponent of economic globalization, is thoroughly
skeptical about bene?ts of ?nancial globalization. Distinguishedscholars like Dani Rodrik
and Joseph Stiglitz have written at length on this theme and advocated both caution in
opening up of the capital account and drawn attention to the macroeconomic bene?ts of
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maintaining capital controls. The string of crises that occurred in individual and regional
economies made their case rationally strong, as did the on-going global recession, which
was christened by the ?nancial media as the crash of 2008.
Contrary to this opinion, there are equally eminent economists who regard ?nancial
integration as growth-promoting and welfare-enhancing. They hold the contradictory
view that free trans-border ?ows of global capital can made decisive contribution to
economic growth and strongly support up-gradation of economies from low- to middle-
and then eventually to a high-income status. This group subscribes to the allocative
ef?ciency logic and is convinced that ?nancial integration supports macroeconomic
stabilization of the global, regional and individual economies. Kenneth Rogoff, Stanley
Fischer, Frederic Mishkin and Larry Summers are prominent among this group of
thinkers.
1.2 Leaders and followers in ?nancial integration
The advanced industrial economies, or majorityof the 30 members of the Organization for
Economic Cooperation and Development (OECD), were the leaders in liberalizing capital
account over the preceding three decades. Consequently, they globalized their economies,
including their ?nancial markets before the other economies. Many attribute ef?ciency
gains in the advanced industrial economies, increased diversi?cation and robust
development of the ?nancial sector to liberalization of capital accounts and markets
(Edison, 2002). This group of economies is presently ?nancially well-integrated into the
global economy. However, the exceptions inthis regard are the following OECDmembers:
the Czech Republic, Hungary, Mexico, Poland, Slovakia and Turkey. All of these
economies fall under the category of the emerging-market economies (EMEs). Although
these and other EMEs cannot be regarded as well-integratedinto the global economy, they
have been taking de?nitive policy measures to liberalize their capital accounts and
?nancially globalize.
The European EMEs accelerated their move towards ?nancial globalization in the
present decade. Some of themare considered to be impetuous in decision making in this
regard. They liberalized their capital accounts somewhat hastily and therefore were
open to accusation of making themselves macroeconomically vulnerable. Conversely,
China and India have also been taking steps towards capital account liberalization, but
cautiously and in a calibrated manner. Some regard them as overly cautious.
Essentially due to persisting weaknesses in their ?nancial markets, the two economies
did not plunge headlong into capital account liberalization process (Das, 2008; Prasad,
2009). Many other EMEs and middle-income developing economies are following suit
and are in initial stages of capital account liberalization and ?nancial globalization.
All these economies are coming to grips with the policy decisions regarding the timing
and pace of ?nancial globalization.
There is an imperious need for clear thinking and meticulous policy moves
regarding these issues. Experience shows that global ?nancial integration is a
contentious and error prone policy area. When errors do occur, they have high economic
and social costs. Unregulated capital in?ows, regardless of the liberalization process,
did facilitate precipitations of crises. Asurvey of empirical cross-country studies on the
effect of capital account liberalization on growth reported mixed results from various
country exercises (Edison, 2002). One reason for ambiguity in conclusions of various
empirical studies is the dif?culty in identifying and quantifying capital account
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liberalization in a consistent manner across a sprawling range of countries. Appropriate
and sequential macroeconomic and ?nancial policies are essential for effectively
managing capital account liberalization and ?nancial globalization. These measures
are warranted for ensuring growth and stability bene?ts in the economies that are
endeavoring to ?nancially globalize as well as for minimizing the potential costs. This
paper delves into and explores such a policy structure.
1.3 Neoclassical logic versus the recent nuanced ideas
As regards the effect of ?nancial globalization, the well-trodden neoclassical line of logic
is simple and direct. Trans-border capital ?ows from the countries that have surplus
savings and are capital rich to those where capital is scarce and is badly needed. They
argue that liberalization of capital account allows global capital into the capital-scarce
economies, which lowers the cost of capital for them; it increases domestic investment,
growth and welfare-gains in the capital-scarce economies. As capital is regarded as a
necessary, albeit not suf?cient, ingredient for growth, external capital from the global
private capital markets is indeed valuable and contributes to growth endeavors of the
recipient developing economy by augmenting their rate of investment. This viewdraws
heavily on the predictions of the standard neoclassical growth model pioneered by
Solow (1956). The capital-rich economies that are the source of trans-border capital
?ows, also register welfare gains from higher rates of returns on their investment. This
is because the marginal product of capital is higher in the capital-scarce less developed
economies. The source economies also enjoy the bene?ts of reduced risk through
international portfolio diversi?cation. One basic point in this context is that the state of
development and ef?ciency of legal and market institutions differ from country to
country. As these differences affect the rate of return on foreign investments, they
determine ex ante behavior of global investing community.
The newer ideas on this vital issue are fairly different from the simple neoclassical
thinking set out in the preceding paragraph. Recent literature takes issue with this
seemingly simplistic line of logic in a fundamental manner. It takes a more subtle line
than the one-channel impact of ?nancial globalization and posits that ?nancial
globalization and economic growth and stability link is not so direct. Although there is
a link, it is indirect (Section 2). In its indirect role, ?nancial globalization plays a
catalytic role and thereby underpins economic growth. Bene?ts of global ?nancial
integration do not primarily ?ow through access to global ?nancial markets, as the
neoclassical economies hypothesized. The newer viewis that there are myriad plausible
channels through which indirect bene?ts can materialize.
2. Direct and indirect channels of macroeconomic impact: empirical
evidence
Numerous cross-sectional, panel and event studies were conducted during the
recent past to examine whether ?nancial sector liberalization and integration into
the global ?nancial markets have a de?nitive and convincing positive impact on the
growth rates of recipient developing and EMEs. Explorations of a macroeconomic
link between ?nancial liberalization and economic growth have resulted in a large
research harvest. As a representative study Gourinchas and Jeanne (2006, p. 716) can be
cited, who used a calibrated neoclassical model that conventionally measured gains
from this type of convergence. They found that the gains from international ?nancial
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integration “elusive”. These empirical studies failed to clinch the case for capital
account liberalization. For the most part their conclusions were mixed, occasionally
even paradoxical. An exhaustive and meticulous literature reviewby Kose et al. (2009d)
concluded that the evidence regarding global ?nancial integration and growth is
inconclusive. When it is there, it lacks robustness.
The end result is that at the macroeconomic level, it has been dif?cult to ?nd
“unambiguous evidence that ?nancial opening yields a net improvement in economic
performance” Obstfeld (2009, p. 103). Econometric dif?culties in studying this
relationship are of the same kind that beleaguered the study of trade-growth link for
decades, only they are more severe in case of international ?nance-growth link.
Empirical evaluation is rendered more dif?cult by lumping together of ?nancial
reforms and liberalization with a host of other growth-supporting macroeconomic
reforms as well as the endogeneity of the ?nancial liberalization process itself. One way
of squaring this circle was to study direct and indirect impact of global capital ?ows
independently on the ?nancially integrating economies.
At the outset the direct macroeconomic impact of capital in?ows was regarded as
favorable and substantive. This view was essentially premised on the neoclassical
economic logic. However, it subsequently underwent a dramatic transformation. In this
section we shall analyze the direct and indirect macroeconomic impact of capital ?ows.
2.1 Direct bene?t
Beginning with the direct, single-channel, bene?t of ?nancial globalization, prima facie
evidence is available to show that ?nancial globalization did lead to rapid gross
domestic product (GDP) growth. Theoretically, it is the ?nancial channel through which
the direct bene?t of global capital in?ows can be reaped. That is to say that the global
capital in?ows and GDP growth do seem to have a positive association. The very fact
that since 1970 the EMEs have achieved much higher cumulative growth than the other
two country groups and have made an economic niche for themselves in the global
economy, portends to the fact that liberalizing an economy, particularly capital account
and the ?nancial sector, does lead to rapid GDP growth.
Notwithstanding such broad evidence, numerous scatter diagrams plotting
long-term average growth rates and de facto ?nancial sector openness show little
systematic relationship between the two variables. As stated above (Section 2),
macroeconomic evidence of ?nancial integration leading to systematic higher GDP
growth in the developing economies is weak, particularly when one controls for other
variables for growth. Additionally, an early in?uential empirical study by Rodrick
(1998) has been extensively cited in the literature to demonstrate the insigni?cant
impact of capital account liberalization and ?nancial integration on economic growth.
When an association is found between the two variables, it is as usual exceedingly
weak. Several computations of cross-country growth regressions in the literature
remained either inconclusive or produced weak results in con?rming that economies
that integrate into global ?nancial markets grew faster.
However, among the empirical studies that focused on the direct channel of impact of
?nancial globalization, those that selected ?ner de jure measures of ?nancial openness
as the independent variable came up with relatively more positive results of ?nancial
globalization on economic growth. For instance, Quinn and Toyoda (2008) selected
re?ned de jure measures of capital account openness for 94 countries for the 1950-2004
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period; they did come up with a positive link between the two variables, that is, capital
account liberalization and ?nancial openness and growth. They asserted that
measurement errors, differing time periods used and collinearity among independent
variables accounted for con?icting conclusions in the earlier empirical studies. They
also con?rmed that equity market liberalization has an independent positive effect on
economic growth. In addition, the empirical studies that utilized both de jure and de
facto measures as independent variables found greater support for the direct effect of
?nancial integration on growth. Conclusions of these empirical exercises also varied
due to differences in methodology, time periods, sample countries, the data sets and
collinearity among independent variables.
Growth bene?ts from ?nancial globalization also depend on the composition of
?nancial ?ows. Global capital in?ows that are equity like, that is foreign direct
investment (FDI) and portfolio equity investments, were known for the following two
characteristics. First, they are more stable and second they are less prone to reversals.
In addition, as stated in the following section, addition bene?ts accompany this type of
?nancial ?ows. Conversely, debt ?ows, particularly those that come in the form of
short-term bank loans, tend to be volatile and enlarge negative impact of external
shocks on the GDP growth.
Turning to FDI, the transnational corporations as major FDI investors bring in
knowledge and expertise, which in turn spills over into the domestic industrial ?rm,
and increases their productivity. This intra-industry spillover is known as horizontal
spillover and is the micro channel of positive productivity impact. It can also occur
through contacts between the foreign af?liate and their local suppliers and customers,
which is called the vertical linkage. Although evidence of horizontal spillover in
transmission of productivity bene?ts was found to be inconclusive, Javorcik (2004)
found evidence of productivity spillover through vertical linkages.
Several empirical studies found productivity enhancing effects of FDI using
microeconomic – both ?rm- and sector-level – statistical data (Haskell et al., 2007). FDI
was found to favorably affect an economy’s productive ef?ciency (Xu, 2000). Using an
annual panel dataset of 83 developing and advanced industrial economies, Noy and Vu
(2007) found that liberalizing capital account was not a suf?cient condition to generate
increases in FDI in?ows. It was the domestic economic environment in the host
economy, which in?uenced the quantity of FDI far more. In particular, variables like
lowlevel of corruption in the government systems and political stability mattered most.
Equity markets witnessed a general liberalizing trend across a number of economies.
Consequently, portfolio equity component of the global ?nancial ?ows has expanded
rapidly, particularly into the EMEs. These equity ?ows were found to favorably impact
GDP growth rate and other macroeconomic variables like consumption, investment,
exports and imports. Henry and Sasson (2008) also provided evidence of favorable
impact of global capital in?ows through equity markets. Using a sample of 18
developing countries that opened their equity markets to global capital in?ows, they
reported an increase in both growth rate of labor productivity and the real wages.
Bekaert and Lundblad (2005) found that global capital ?ows by way of portfolio equity
increased growth rate by approximately 1 percent in the recipient economy. For the
most part, empirical research in this area reported notable positive effect of equity
market liberalization. When global capital ?ows through stock markets, the cost of
capital in recipient economy declines, boosting domestic investment and eventually
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spurring growth (Alfaro and Hammel, 2007). However, these estimates of growth effect
are not beyond doubt. Positive growth effect could well emanate from the general
macroeconomic reforms that go with equity market liberalization. Some studies related
global ?nancial ?ows through equity markets to microeconomic bene?ts and
improvements in total factor productivity (TFP; Chari and Henry, 2008; Mitton, 2006).
There is a general agreement among the empirical studies regarding the deleterious
effect of debt ?ows. Substantive empirical literature on this issue has been surveyed by
Berg et al. (2004). These empirical studies are by and large unanimous in their
conclusion that global capital in?ows in the form of short-term debt categorically
deteriorated the bene?t-risk tradeoff. Many found a direct and systemic relationship
between exposure to short-term debt and odds of a crisis. In addition, some of them
inferred that the larger the short-temdebt the more severe the crisis caused by it. Apoint
to note in this context is that often countries with low-credit ratings are left with few
options but relying on short-term debt (Eichengreen et al., 2006).
Thus, viewed, the overall empirical evidence regarding the direct, single-channel
impact of ?nancial globalization on growth is weak, tentative and inconclusive. The
neoclassical theory is not buttressed by empirical evidence. Financial integration does
not robustly support GDP growth and stability in the globally integrating economy.
2.2 Uphill capital ?ows: a question mark on the neoclassical proposition
There is a twenty-?rst century phenomenon, which puts a question mark on the
neoclassical proposition. It is the recent change in direction of capital ?ows. Financial
globalization took an unusual turn over the past several years. Since 2002, sizable sums
of capital have been ?owing from the non-industrial countries to the advanced
industrial countries. Capital ?ows from the economies having a low capital-labor ratio
to those having a high capital-labor ratio is an apparent perversion fromthe perspective
of neoclassical economic thought. Lucas (1990) was the ?rst focus on the capital ?ows
between countries with different capital-labor ratios, and the perverse capital ?ows
were termed the Lucas paradox. During the recent period, capital ?ows from the EMEs,
particularly those from Asia, and the members of the Gulf Cooperation Council
to the advanced industrial economies, particularly the USA, went on increasing. This
so-called “uphill” ?ow of ?nance was largely between governments (Wolf, 2008).
The USA went on a borrowing binge and the saving glut in the global economy,
particularly the EMEs, stoked asset prices (Rodrik, 2008). This uphill ?owof capital has
weakened and obscured the logic of direct impact.
A good part of this uphill capital ?ow from the non-industrial to the advanced
industrial economies is the of?cial international reserves of these capital exporting
developing countries, particularly the EMEs. However, from a solely ?nancial
perspective the net effect is that of reducing the availability of capital for investment in
a developing economy or an EME. Flow of capital is in the direction of the richer
economies where, given the relative abundance of capital, its marginal productivity will
necessarily be lower. An appropriate question is whether this perverse ?owof capital is
adversely affecting the growth performance in the capital exporting economies. In the
preceding section, I have noted that the EMEs have achieved much higher cumulative
growth than the other two country groups (Prasad, 2007). This demonstrates that the
perverse capital ?ows did not deteriorate the growth performance in the capital
exporting developing economies.
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2.3 Indirect bene?t
The indirect channels work as follows. By liberalizing the domestic ?nancial sector the
economies facilitate proper and methodological development of their domestic ?nancial
sector. In many developing economies this development of ?nancial sector began from a
rather lowlevel. Financial sector development makes a decisive contribution to economic
growth (Levine, 2005; Mishkin, 2009). Second, to liberalize and ?nancially globalize,
economies launch into macroeconomic reforms and restructuring. These measures render
macroeconomic policies more disciplined than before and thus are conducive to rapid
economic growth. Macroeconomic distortions and their pernicious effect become more
obvious in an open liberalized economy, making it easy to identify and eliminate them
(Gourinchas and Jeanne, 2005). By liberalizing economically and ?nancially, economies
commit to well-ordered and disciplined macroeconomic policies. This is their signal to the
world that they are changing tack and their economic future is more than likely to be
different from their past, when they followed sub-optimal macroeconomic strategies and
paidhighcost intermof tepid growth anddecrepitude (Bartolini and Drazen, 1997). Third,
opening up of the economy creates ef?ciency gains in the domestic corporate sector.
As business and ?nancial ?rms are exposed to competition from the more ef?cient
businesses in the advanced industrial economies they are forced to become more ef?cient.
Fourth, studies based on different methodologies demonstrate that as more foreign banks
enter the domestic banking sector, competing with them made the domestic banks more
ef?cient, reduced overhead costs and improved pro?ts (Claessens and Laeven, 2004;
Schmukler, 2004). Fifth, Likewise, stock markets become larger and more liquid after they
are liberalized for the entry of global investors (Levine and Zervos, 1998). Liberalization
also catalyzes legal and institutional developments in the equity markets (Chinn and
Ito, 2006). Finally, an environment of better public and corporate governance gradually
evolves which works towards underpinning growth rate in the liberalizing and
globalizing economy (Stulz, 2005).
Thus, ?nancial globalization can indirectly impact through catalyzing different
growth supporting areas of macroeconomic policy and institutions. The principal
channels of indirect impact are the domestic ?nancial sector, ef?ciency gains in the
public and corporate governance and macroeconomic policy discipline. This indirect
effect, or multiple-channel bene?ts, may well be more important than the tradition
?nancing-channel effect emphasized in neoclassical economics[1].
Together, these indirect effects add up to a signi?cant range of bene?ts that begin to
transformthe ?nancially globalizing economy. Kose et al. (2009c, p. 3) designated themas
“collateral” bene?ts and regard them as quantitatively “most important sources
of enhanced growth and stability for a country engaged in ?nancial globalization”.
In addition, the single-channel impact that works by way of augmentation of ?nance
and investment could be a mere short-tem economic impact. On the contrary, the
multiple-channel or indirect effect of ?nancial globalization can have a long-term impact
over the economy (Henry, 2007). Furthermore, certain kinds of global ?nancial ?ows are
accompanied with advance technology, managerial skills and marketing pro?ciency,
sorely needed in a developing economy. They again have a healthy growth promoting
effect over the ?nancially globalizing economy. Once technological and other know-how
reach the recipient economies, they begin to develop capacity to absorb and adapt them.
With the passage of time, they develop capabilities to generate their own technological
competencies and managerial skills, indispensable for a modern economy.
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Although not many empirical studies addressed the issue of impact on ?nancial
institutions, some indications of improvements in them is available. For instance,
countries were found to have made adjustments in their corporate governance in
response to demands from international investors (Cornelius and Kogut, 2003).
Economies open to ?nancial integration do need to prepare macroeconomically by
designing and implementing reforms and restructuring. They generally pay a lot of
attention to monetary policy and keep in?ation low (Gupta and Yuan, 2009; Spiegel,
2008). No relationship was found between ?nancial integration and ?scal discipline.
One cannot assume a positive or a negative link here, albeit is always a possibility of
running higher ?scal de?cits for a longer period with global capital in?ows.
The indirect channels of macroeconomic impact can coalesce to:
[. . .] enhance the growth outcome through their impact on TFP. If ?nancial integration is to
have a lasting effect on growth, it must be by moving economies closer to their production
possibilities frontiers by eliminating various distortions and creating ef?ciency gains, for
example, in ?nancial intermediation, technological adoption, etc. (Kose et al., 2009c, p. 18).
There are empirical studies that have established a link between ?nancial integration
and TFP growth (Bon?glioli, 2008; Kose et al., 2009b). Economies with more open
capital accounts were found to have higher TFP growth. However, overall de facto
?nancial integration did not seem to have an impact on TFP growth.
By using a wide array of de jure and de facto measures of ?nancial openness and by
disaggregating ?nancial integration into stocks and liabilities of different kinds of
?nancial ?ows, Kose et al. (2009b) reached an interesting and valuable conclusion. They
discerned strong evidence of FDI and portfolio equity on TFP growth. In contrast, debt
?ows were negatively correlated with GDP growth. The negative relationship between
stocks of debt liabilities from the global capital markets and TFP was found to be weak
in economies with better developed ?nancial markets due to ?nancial liberalization and
better institutional quality. The impact of ?nancial integration on factor productivity is
more important than effect on capital growth, which in turn can come through
improvements in the banking sector and stock markets. Higher investment ef?ciency
can logically be a source of higher GDP growth (Bekaert et al., 2009). An amber signal is
essential here. That ?nancial globalization affects growth largely through indirect
channels is a substantive and meaningful proposition. Yet, it is not a consensus view
and not gone unchallenged (Rodrik and Subramanian, 2009).
3. Prerequisite threshold conditions
The indirect bene?ts of global ?nancial integration, while more signi?cant than direct,
cannot be taken for granted. They do not come through in a mandatory manner. Until
complementary domestic policies and reforms are in place to sustain stability and
growth, merely opening up the capital accounts and integrating globally does little
good. The complementary policies essentially cover principal macroeconomic policy
areas, institutional development and the domestic ?nancial system. Until the
prerequisite of certain threshold conditions of ?nancial system and institutional
development in the economy are not attained, the globally integrating economies cannot
pro?t fully from the indirect bene?ts of global ?nancial integration (Kose et al., 2009a).
One reason why the advanced industrial economies have continued to be the
principal bene?ciaries of ?nancial globalization is that they have more matured
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institutions, more stable macroeconomic policy structure as well as deeper and more
developed ?nancial markets than the EMEs or the developing economies. If these
preconditions are met, the ?nancially integrating economy would have far better
prospects for bene?ting from it. Therefore, it seemlogical for the EMEs and developing
economies to ?rst pay policy attention and devote resources to strengthening their
?nancial sector as well as institutional development before considering liberalization of
capital accounts.
The ?nancial sector inthe EMEs anddevelopingeconomies is typicallynot deep, which
becomes a serious hurdle in their attempt of deriving bene?ts from?nancial globalization.
A deep, adequately supervised and well-regulated ?nancial sector is essential for
effectively channeling the incoming global capital into productive sectors of the economy.
A well-developed ?nancial sector enables an economy to bene?t from capital in?ows
and reduce its vulnerability to crises. Thus, the development, dexterity and re?nement
of the ?nancial sector in an economy are the sine qua non for gaining from ?nancial
globalization. Likewise, the stage of institutional development is the second important
threshold condition for bene?ting from ?nancial integration. Countries that have
developed their institutions to a near maturity level and therefore have no or little
corruption and red tape in their public administration and professionalized level of
corporate governance, they tend to attract more FDI and portfolio investment from the
global capital markets. Such economies are far more likely to bene?t from indirect
channels of bene?t discussed in the preceding section.
The insightfulness of the domestic macroeconomic policy is third threshold condition.
The quality of macroeconomic policy designed and pursued by policy mandarins in a
countryin?uences both, its level andcompositionof capital in?ows fromthe global capital
markets. It also determines its vulnerability to a macroeconomic, ?nancial or currency
crisis. The importance of ?scal and monetary policies followed is exceedingly high in this
context. A soundly and pragmatically devised macroeconomic policy structure increases
the growth bene?ts of capital account liberalization. It also diminishes the possibility of
precipitationof a crisis inanenvironment of liberalizedcapital account. These are the three
necessary threshold conditions. In their absence, an economy can derive little economic
bene?t – direct or indirect – from ?nancial globalization.
4. Macroeconomic volatility
At an early stage of development ?nancial integration helps a developing economy in
augmenting its investment and diversifying its economic base away from the primary
sector, which in turn expands its real economy as well as reduces its macroeconomic
volatility. When a certain amount of development has taken place, and the economy has
grown to a higher stage of economic development, liberalizing the economy for
globalization and ?nancial integration spurs specialization. This expands the external
sector and trade. This can make a middle-income economy vulnerable to external
shocks in the industrial and services sectors in which it develops its specialization and
trade. Thus, ?nancial globalization may or may not lead to output volatility. Whether it
will be cause for output volatility will necessarily be economy-speci?c.
Most of the advanced industrial world enjoyed an era of unprecedented economic
stability in post-1983 period. Although the causal factors are open to debate,
improvements in monetary policy have probably been one of the important sources of
the Great Moderation. The era of Grate Moderation in macroeconomic volatility
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provided a favorable and nurturing ambiance for deepening of ?nancial globalization.
Output volatility declined in the EMEs and the developing economies as well. However,
intriguingly empirical literature failed to provide statistically signi?cant evidence on
relationship between ?nancial globalization and macroeconomic volatility.
Using panel data for the 30 OECD countries, Buch et al. (2005) concluded that the
impact of ?nancial openness and integration on the volatility of business cycle depended
on, ?rst, the nature of external shock and, second, on the links between macroeconomic
policy. The absence of a link between ?nancial globalization and output volatility is not
without reason. There is no clear theoretical explanation regarding how ?nancial
globalization should affect output volatility. However, the developing economies were
more vulnerable to output volatility due to the structural weaknesses in their economies
thanthe advancedindustrial economies. Another more comprehensive empirical study by
Kose et al. (2003) worked with data for a much large groups of advanced industrial and
developing economies over 1960-1999 period. They found that ?nancial globalization had
a non-linear relationship with volatility of consumption, not output.
In a more recent study, van Hagen and Zhang (2006) developed a dynamic general
equilibrium model of a small open economy and explained the lack of empirical
evidence on the linkage between ?nancial openness and macroeconomic volatility. As
?nancial integration increased, they found non-monotonic patterns with respect to the
three shocks, namely, the foreign-interest-rate shocks, the productivity shock and the
terms-of-trade shocks. In the absence of any direct or indirect effect, they concluded that
?nancial openness has non-monotonic implications for macroeconomic volatility. This
non-monotonic link could either be U-shaped or reverse U-shaped.
The con?guration of ?nancial globalization process determines whether there could
be volatility of output in the economy. If economy relies excessively on debt in its
?nancial integration process, it makes itself vulnerable to variations in global interest
rates, which could decisively cause serious output volatility. Rodrik and Velasco (2000)
established that the ratio of short-term debt to foreign exchange reserves or GDP can
provide a reliable indication of output volatility and crisis-proneness of an economy.
Short-term maturity of debt was found to be a helpful gauge of vulnerability of the
Tequila effect in the 1994-1995 in Mexican crisis. Short-term maturity of debt also
proved highly risk-laden in Asia in 1997. Economies with large short-maturity debt in
comparison to GDP quickly suffer fromdebt crises. If the stock of short-maturity debt is
larger than the forex reserves, the economy is three times more likely to suffer a sudden
reversal of ?nancial ?ows. Also, in several crises an empirical link was found between
domestic lending booms and ?nancial crises. The former preceded the latter in many
instances of output volatility.
4.1 Volatility leading to crisis
One extraordinary development of the 1990s was a surge of private capital ?ows to the
developing economies and widespread borrowings by economies. Both developing
and advanced industrial economies had participated in large borrowing from the
global capital markets. Central banks and governments were also an important part of
this game. The US Treasury and household sector was a large borrower in the USA,
while the corporate and ?nancial sector was a large borrower in Japan. Not all these
borrowings went into productive high-return investments. The European and
Monetary Union (EMU) was an exception in this regard, its borrowings remained low.
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Likewise, in the developing world, there was a surge of private capital ?ows to the
developing economies in the early and mid-1990s. Particularly, noteworthy was the
?ows to East Asian economies. Indonesia, Malaysia, the Philippines, Korea (Republic
of) and Thailand were large borrowers. The business corporations and banks in these
countries were the principal borrowers in the short-term debt market, albeit
governments did not. Unlike them, in Argentina, Brazil, the Russian Federation and
Turkey Governments accumulated large foreign currency debts. They did so without
regard to their repayment capabilities. This sub-group of economies also made itself
vulnerable by prematurely liberalizing its capital markets to free entry of short-term
capital. They somewhat hastily, if imprudently, liberalized their ?nancial and capital
account transactions.
The crises of the 1990s and early 2000s were dramatic episodes of volatility. They
originated fromthe borrowing behavior described above. The Asian crisis was a severe
one and mauled a region that had earned a favorable opinion of being home of several
dynamic economies. Following the crisis a professional opinion emerged that ?nancial
globalization pushes a stable and well-functioning economy towards macroeconomic
volatility and increases vulnerability to sudden stops. In addition, there was the major
crisis that was ignited by the sub-prime mortgage debacle on Autumn 2007 and that
became global in late 2008. The global economic recession it caused was continuing in
2009, at the time of writing. It further buttressed the harmful image of ?nancial
globalization. It is routinely blamed for the crises of the recent past.
The question is frequently asked whether such crises are an inevitable element of
?nancial globalization. The antagonists of ?nancial globalization go so far as regarding
proliferation of ?nancial crises as a de?ning characteristic of ?nancial globalization.
Crises validated their different negative positions, that ?nancial and capital account
transaction should not be liberalized, or their liberalization should be delayed, and that
?nancial globalization is a villainous economic force that must be contained, if not
scotched, at the ?rst opportunity.
However, academic literature came up with inconclusive results on this issue as well.
Empirical evidence suggested that that the relationship between ?nancial integration and
volatility, measured by consumption volatility, depends more on an economy’s domestic
?nancial development and other so-called threshold conditions alluded to above. In the
panel regression results, the estimated slope coef?cient on de facto ?nancial integration
was positive and signi?cant for economies that had relatively weak institutional
qualityandlowdegree of domestic ?nancial sector development. However, the impact was
not found to be signi?cantly different from zero for the economies with stronger
institutions and better developed domestic ?nancial systems (IMF, 2008).
It was possible to estimate thresholds for institutional quality and domestic ?nancial
sector development from the regression results. Given the uncertainty regarding the
estimates, the values of these thresholds was needed to be interpreted with caution.
Based on the average data for the 2000-2004, virtually all advanced industrial countries
and many, almost a third, EMEs met the threshold levels beyond which the estimated
effect of ?nancial integration on consumption volatility was insigni?cant. All the other
countries were found to be below the threshold levels (IMF, 2008). This was a valuable
empirical exercise that reveals which economies can be vulnerable to volatility and
crisis caused by ?nancial globalization, and which are relatively safe from it. It takes
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the wind out of the generalized assertion that ?nancial globalization should cause
macroeconomic volatility and crisis.
If crises are an inevitable component of ?nancial globalization, not liberalizing
?nancial and capital accounts should be the apt strategy to ward themoff. However, for
all appearances capital controls is not the answer. Recent analysis has revealed that
countries that maintain stringent capital controls are more susceptible to crises than the
one that liberalize it. This result needs to be taken with a degree of skepticism because
countries that place capital controls are usually the ones whose macroeconomic
fundamentals are weak. Their essential objective of clamping capital controls is to try
to insulate themselves from possibilities of a crisis. There is empirical evidence to show
that opening up of the capital accounts reduces an economy’s vulnerability to a crisis
(Glick et al., 2006). In addition, there is little empirical evidence to “support the oft-cited
claim that ?nancial globalization in and of itself is responsible for the spate of ?nancial
crises that the world has seen over the last three decades” (Kose et al., 2009c, p. 24). In
short, not liberalizing capital account need not necessarily work as a defensive strategy
for warding off a ?nancial crisis and ?nancially globalizing need not be a cause for one.
4.2 Risk sharing implications
As regards the risk-sharing implications of ?nancial globalization, empirical studies
found little supportive evidence. Kose et al. (2009b) focused on cross-country
correlations of output and consumption while calibrating the impact of ?nancial
integration. They reported that, contrary to the theoretical predictions, there was
limited evidence of improvement in risk-sharing across countries due to ?nancial
globalization. Only the advanced industrial economies were able to clearly bene?t from
?nancial integration in terms of improved risk sharing. Astonishingly, even the EMEs
were not found to have reaped bene?cial results in this dimension, notwithstanding the
fact that many of them took initiative in liberalizing their capital accounts and were
able to attain a much higher degree of ?nancial integration with the global economy
than the other developing economies. These are sobering conclusions. A caveat is
necessary here. These results depend on county-speci?c conditions and the level and
composition of capital ?ows from the global capital markets.
As regards why no risk-sharing bene?t was reported in the EMEs by empirical
studies, there can be several theoretical explanations. One possible explanation is that
different types of global capital ?ows are conducive to differing degrees of risk sharing.
It is possible that the EMEs have not been getting appropriate types of capital ?ows to
be able to achieve the objective of risk sharing. Other theoretical explanations for low
degree of risk sharing include the importance of non-traded goods in this group of
economies, the scarcity of ?nancial instruments for ef?ciently sharing macroeconomic
risk and typically large transaction costs associated with international trade in goods
and assets. These are all realistic possibilities that exist in the EMEs.
5. Policy options in the backdrop of unambiguous evidence
In the preceding decades, policy makers in the developing economies and EMEs were in
general convinced about the bene?ts of ?nancial sector reforms. They demonstrated an
increasing penchant for its liberalization. These policy makers could have been justly
impressed by the ef?cient ?nancial sectors of the advanced industrial economies, run
with a high degree of pro?ciency and corporate governance. Consequently, in general
the ?nancial sector in the advanced industrial economies made an enormous
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contribution to the growth and stability of the economy. There is likelihood for this
policy preference to persist in many developing economies and EMEs, even grow
stronger. The periods of global or regional economic turmoil could be exceptions in this
regard. There are obvious bene?ts in implementing reforms and adopting liberalization
of the domestic ?nancial sector. The most direct bene?t of having a strong and
well-regulated ?nancial sector is its ability to underpin growth, which in turn is
poverty-alleviating and welfare-enhancing (Levine, 2005; Mishkin, 2009).
A well-developed ?nancial sector facilitates public and private sector borrowings.
As it grows and become deeper, conduct of the domestic monetary policy becomes
easier. The costs of maintaining and enforcing capital controls in a deep ?nancial sector
are high, particularly when merchandise trade is expanding in an economy. Finally,
growth in domestic ?nancial sector reforms assists in its external liberalization, which
in turn results in collateral bene?ts (Section 1.3) and institutional growth in the
economy. These channels of bene?ts are essential for making an open ?nancial and
capital account less crisis-prone (Section 3).
Experiences of the last two decades have convincingly demonstrated that embracing
globalization and ?nancial integration entails both, high costs and sumptuous bene?ts.
Obstfeld (2009, p. 104) prudently observed that, “Taken all alone, ?nancial openness is not
a panacea – it canbe poison”. Notwithstandingthe weakevidence of direct contributionto
growth, stability and welfare gains from the liberalization and globalization of the
?nancial sector, its cautious and well-planned adoption under appropriate domestic
economic and ?nancial conditions, can for certain be a productive, growth-supporting,
proposition. When ?nancial globalization is adopted incrementally and sequentially as
well as in association with the complementary range of domestic policies and institutional
reforms, during a period when the reserve position of the ?nancially globalizing economy
is sound, it can be a legitimate instrument of enhancing stability and growth.
In addition, enormous long-term bene?ts can accrue from ?nancial globalization. It
renders the domestic ?nancial system more competitive, transparent and ef?cient than
the one that develops in a controlled and restriction-ridden environment. The other side
of this assertion is that capital account liberalization and ?nancial integration with the
global capital markets need never be a priority policy objective for all the countries.
Low-income developing economies, having a poorly developed domestic ?nancial
sector, pursuing macroeconomic policies of questionable soundness and having small
foreign exchange reserves, need not consider it until their macroeconomic and ?nancial
circumstances change dramatically.
6. Summary and conclusions
This paper addresses the question whether integration with the global ?nancial
markets spurs growth and stability in an economy. It also addresses the related
quandaries like the close association between ?nancial globalization and
macroeconomic volatility. From a theoretical perspective, it is easy to state that,
theoretically speaking, integration of ?nancial markets can potentially foster growth.
Whether it happens in reality, is a different matter. There is little agreement in the
economic profession on the implications of ?nancial globalization. Positions have
ranged from decidedly favorable to entirely unfavorable. There are many who reached
mixed conclusions. Financial globalization is an important policy area and there is an
imperious need for clear thinking and meticulous policy moves regarding these issues.
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The neoclassical line of logic is simple, direct and positive. Trans-border capital
?ows from the countries that have surplus savings and are capital rich to those where
capital is scarce and is badly needed has nothing but favorable rami?cations. However,
the present thinking on this issue is fairly different. It takes a more subtle line than the
direct one-channel impact of ?nancial globalization and posits that ?nancial
globalization and economic growth and stability link is not so direct. Although there
is a link, it is indirect. The cross-sectional, panel and event studies conducted in the
recent past found that the gains from international ?nancial integration “elusive”. For
the most part, the results of these studies were mixed and inconclusive, at times even
paradoxical. At the macroeconomic level, it has been dif?cult to ?nd unambiguous
evidence that ?nancial opening yields a net improvement in economic performance.
Study of indirect and multi-channel impact of ?nancial globalization presented several
possibilities of favorable growth impact and economic stabilization. The indirect impact
can deliver favorable results through catalyzing different growth supporting areas of
macroeconomic policy and institutions. The principal channels of indirect impact are the
domestic ?nancial sector, ef?ciency gains in the public and corporate governance and
macroeconomic policy discipline. This indirect effect, or multiple-channel bene?ts, may
well be more important than the tradition ?nancing-channel effect emphasized in
neoclassical economics.
Although the indirect bene?ts of global ?nancial integration are more signi?cant
than direct, cannot be taken for granted. They would not have much impact unless
certain complementary policies are in place. They essentially cover principal
macroeconomic policy areas, institutional development and the ?nancial system.
Unless these threshold conditions are not achieved, the globally integrating economies
cannot pro?t fully from the indirect bene?ts of global ?nancial integration.
Global ?nancial integration is often blamed for causing macroeconomic volatility.
However, no clear empirical link could be established between ?nancial globalization
and output volatility. There is no clear theoretical explanation regarding how ?nancial
globalization should affect output volatility. However, the developing economies were
more vulnerable to output volatility due to the structural weaknesses in their economies
than the advanced industrial economies. However, ?nancial globalization was found to
have a non-linear relationship with volatility of consumption, not output. The
con?guration of ?nancial globalization process determines whether there could be
volatility of output in the economy. If economy relies excessively on debt in its ?nancial
integration process, it makes itself vulnerable to variations in global interest rates,
which could decisively cause serious output volatility.
The crises of the 1990s andearly2000s were dramatic episodes of volatility. After these
crises, a professional opinion emerged that ?nancial globalization pushes a stable and
well-functioning economy towards macroeconomic volatility and increases vulnerability
to sudden stops. Crises began to be treated as an inevitable element of ?nancial
globalization. In this area also, academic researchers came to inconclusive results.
Empirical evidence suggested that that the relationship between ?nancial integration and
volatility, measured by consumption volatility, depends more on an economy’s domestic
?nancial development and other so-called threshold conditions alluded to above.
As regards the risk-sharing implications of ?nancial globalization, empirical studies
found little supportive evidence. Cross-country correlations of output and consumption
showed that contrary to the theoretical predictions, there was limited evidence of
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improvement in risk-sharing across countries due to ?nancial globalization. Only the
advanced industrial economies were able to clearly bene?t from?nancial integration in
terms of improved risk sharing. Astonishingly, even the EMEs were not found to have
reaped bene?cial results in this dimension.
Embracing globalization and ?nancial integration entails both, high costs and
sumptuous bene?ts. That being said, notwithstanding the weak evidence of direct
contribution to growth, stabilityand welfare gains fromthe liberalization, its cautious and
well-planned adoptionunder appropriate domestic economic and ?nancial conditions, can
for certain be a productive, growth-supporting, proposition. When ?nancial globalization
is adopted incrementally and sequentially as well as in association with the
complementary range of domestic policies and institutional reforms, during a period
when the reserve position of the ?nancially globalizing economy is sound, it can be a
legitimate instrument of enhancing stability and growth.
Note
1. See, for instance, Aizenman et al. (2007) and Gourinchas and Jeanne (2007).
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Corresponding author
Dilip K. Das can be contacted at: [email protected]
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