The recent wave of financial globalization got started in earnest in the mid-1980s, with rising cross-border financial flows among industrial economies and between industrial and developing economies. This was spurred by liberalization of capital controls in many of these countries, in anticipation of the benefits that cross-border flows would bring in terms of better global allocation of capital and improved international risk-sharing possibilities. The strong presumption was that these benefits ought to be large, especially for developing countries that tend to be relatively capital-poor and have more volatile income growth.
With the surge in financial flows, however, came a spate of currency and financial crises in the late 1980s and 1990s. There is a widely held perception that developing countries that opened up to capital flows have been more vulnerable to these crises than industrial economies, and have been much more adversely affected. These developments have sparked a fierce debate among both academics and practitioners on the costs and benefits of financial globalization. The current global financial crisis has added fuel to this debate as the crisis has threatened the stability of financial systems in a number of industrial countries.
What do we know about the macroeconomic implications of financial globalization? And what policy measures can be employed to improve the benefits of financial opening? The papers presented in this special issue attempt to address these questions utilizing a wide array of results from the frontiers of research on financial globalization. In particular, the special issue includes seven papers focusing on various aspects of financial integration. The first four papers review the large literature on financial globalization. The first two of the four provide detailed surveys of recent research about the implications of financial integration for economic growth and macroeconomic stability. The next two analyze the implications of broad policy responses to financial integration. These are followed by a pair of papers on the implications of banking sector globalization and on the consequences of financial integration for monetary policy discipline, respectively. The final paper introduces a new data set on capital account restrictions.
After briefly documenting the rapid growth of international financial flows, the papers by M. Ayhan Kose, Eswar Prasad, Kenneth Rogoff, and Shang-Jin Wei (“Financial Globalization: A Reappraisal”) and Maurice Obstfeld (“International Finance and Growth in Developing Countries: What Have We Learned?”) survey a large sample of theoretical and empirical studies. The survey by Kose and others provides a unified conceptual framework for organizing the vast literature about the costs and benefits of financial globalization. The authors argue that their framework constitutes a fresh synthetic perspective on the macroeconomic effects of financial globalization, both in terms of growth and volatility. Although they document that most empirical studies are unable to find robust evidence in support of the growth benefits of capital account liberalization, they claim that studies that use measures of de facto integration or finer measures of de jure integration tend to find more positive results. Their survey also documents that studies using micro data are better able to detect the growth and productivity gains stemming from financial integration. Moreover, they conclude that there is little formal empirical evidence to support the oft-cited claims that financial globalization in and of itself is responsible for the spate of financial crises that the world has seen over the past three decades.
The conceptual framework they present suggests that in addition to the traditional channels (for example, capital accumulation), the growth and stability benefits of financial globalization are also realized through a broad set of “collateral benefits.” These benefits affect growth and stability dynamics indirectly, implying that the associated macroeconomic gains may not be fully evident in the short run and may be difficult to uncover in cross-country regressions. The potential indirect benefits of financial globalization are likely to be important in three key areas: financial sector development, institutional quality, and macroeconomic policies. Kose and others also argue that various threshold effects—financial sector development, institutional quality, governance, trade openness, and sound monetary and fiscal policies—all play important roles in shaping the macroeconomic outcomes of financial globalization. They conclude that countries meeting these threshold conditions are better able to reap the growth and stability benefits of financial globalization.
Their framework also points to a fundamental tension between the costs and benefits of financial globalization that may be difficult to avoid. Financial globalization appears to have the potential to play a catalytic role in generating an array of collateral benefits that may help boost long-run growth. At the same time, premature opening of the capital account in the absence of some basic supporting conditions can delay the realization of these benefits, while making a country more vulnerable to sudden stops of capital flows.
The survey by Maurice Obstfeld also reports that, although there is a large amount of literature analyzing the benefits and costs of financial globalization, there is little convincing empirical evidence of its direct growth effects. He observes that the empirical literature on the effects of financial globalization has to cope with a multitude of challenges, including the measurement of integration, the coincidence of capital account liberalization with a number of other growth enhancing reforms, and the endogeneity of the liberalization decision itself. Although studies using microeconomic data may provide less ambiguous evidence, even in the micro context, identification problems can remain. After providing a discussion of various challenges associated with monetary policy formulation in emerging markets using several country cases, he concludes that managing flexible exchange rate regimes in financially integrated countries has been a particularly difficult task.
Obstfeld argues that, despite the ambiguous benefits of financial integration, policymakers in emerging markets have embraced financial openness and this trend is likely to continue in the future primarily because domestic financial development can promote economic growth and welfare. Deeper domestic financial systems and stronger trade linkages make it difficult to resist financial opening that can in turn accelerate the development of domestic financial system. Obstfeld claims that while potential adverse effects of financial integration can be mitigated by domestic financial sector development, other institutional reforms—relating to the rule of law, corruption, contract enforcement, corporate governance, reductions in liability dollarization, and stable macroeconomic policies—are also needed to maximize the growth and stability benefits of financial liberalization.
These two surveys clearly show that the relationship between financial integration and macroeconomic outcomes is complex, and that there are inescapable tensions inherent in evaluating the risks and benefits associated with financial globalization. Although there is evidence in support of the broad policy conclusions in these surveys, even these policies often need to be tailored to take into account country-specific circumstances in light of the tensions. Nevertheless, the surveys conclude that it is essential to see financial integration not just as an isolated policy goal but as part of a broader package of reforms and supportive macroeconomic policies.
The next two papers reach somewhat opposite conclusions about the nature of policy responses to financial integration. Dani Rodrik and Arvind Subramanian (“Why Did Financial Globalization Disappoint?”) conclude that the benefits of financial globalization are hard to document and it would be useful to consider policies to restrict capital inflows, if country-specific conditions deserve such a response. In contrast, Frederic S. Mishkin (“Why We Shouldn’t Turn Our Backs on Financial Globalization”) argues that, in order to attain better standards of living, emerging market economies need to become more integrated with the global financial system while employing policies that can improve their institutional frameworks to facilitate the growth and stability enhancing effects of international financial flows. In other words, although Rodrik and Subramanian argue that it might be better to have less financial integration for some developing countries, Mishkin concludes that developing economies need more financial integration, not less.
Rodrik and Subramanian first present a critical review of the recent literature that provides arguments in support of financial globalization. They claim that the main assumptions of this literature are misplaced. First, the literature assumes that developing countries are saving constrained, but they argue that these economies are more likely to be investment constrained. In investment-constrained economies, financial flows can appreciate the real exchange rate and accentuate problems stemming from the investment constraint. This can reduce investment opportunities and can in turn have a negative impact on economic growth. In particular, they argue that there is strong and robust evidence suggesting that real exchange rate overvaluation hampers growth, but undervaluation improves it.
Second, they disagree with another premise of recent literature that the problems associated with financial globalization can be mitigated by undertaking institutional reforms. They claim that, in light of the obvious capacity constraints developing countries face, it is difficult for them to undertake all the necessary reforms to enjoy the benefits of integration. Moreover, if the binding constraint on growth is not access to international financial flows, it is not sensible to employ a wide range of reform programs to attract foreign capital to these countries, most of which are still coping with the challenges of underdevelopment.
Rodrik and Subramanian argue that there is a need for a new paradigm on financial globalization that acknowledges that more financial integration is not necessarily a better policy objective for developing countries. Crises stemming from vagaries of international capital flows are more likely to take place in a world of politically divided sovereign and regulatory bodies. They conclude that, depending on country-specific circumstances, it would be wise to employ policies to limit these flows.
Mishkin first provides a brief review of various stylized facts associated with the two eras of globalization: 1870–1914 and 1960—present. He notes that international flows of capital grew annually at 4.8 percent and increased from 7 percent of GDP in 1870 to close to 20 percent in 1914 during the first era. He argues that the breakdown of this first era of globalization shows that the process of globalization can be reversed, which can lead to disastrous outcomes, as evidenced by the severe economic and political problems of the interwar period. These are particularly important observations as we evaluate the implications of the current financial crisis for the future of global financial architecture.
Mishkin claims that the new era of financial globalization is associated with rapid economic growth and poverty alleviation. Although the association does not necessarily imply causation, he argues that causality is likely to run from globalization to high economic growth and reduction in poverty. Drawing parallels between the current era of globalization and the first era, he concludes that it is possible to observe another episode of reversal that could curtail the process of trade and financial integration around the globe.
Mishkin argues that financial globalization can be a powerful force, through its positive impact on financial development in promoting economic growth and the reduction of poverty in emerging market countries. Financial globalization facilitates domestic financial sector development by weakening the power of groups such as government and entrenched private special interests. Moreover, it encourages support for institutional reforms to make the domestic financial system work more efficiently. He recognizes that it is not easy to undertake the necessary complementary reforms to utilize the benefits of financial integration. However, he concludes that financial globalization can lead to substantial growth and stability benefits when it is supplemented by good policies and strong institutional frameworks.
Linda Goldberg provides a survey (“Understanding Banking Sector Globalization”) of the evolution and implications of cross-border integration of banking sector, which has become an important conduit of financial globalization during the past two decades. After briefly reviewing various stylized facts about the rapid growth of banking sector globalization, Goldberg turns her attention to its three major implications. First, she examines the role of banks in the international transmission of shocks, synchronization of business cycles, financial crises, and economic growth. Depending on whether host markets are served through cross-border flows or in the host markets by branches and subsidiaries of the parent bank, she concludes that the globalized banks can affect how business cycles are transmitted across borders. She also documents that banking globalization may moderate the amplitude of host country cycles if the presence of foreign banks helps reduce the frequency of crises and dampens the output contractions that are often associated with such crises.
Second, she reviews the implications of foreign bank entry for host markets. She documents that financial sector foreign direct investment (FDI), like real-side FDI, can be instrumental in transferring new technologies and generating productivity benefits for host countries. She concludes that the growth effects of financial sector FDI depend on whether the investment is greenfield or merger and acquisition. In the latter case, the effects also depend on whether the acquired institution is financially sound or in need of restructuring. She concludes that, if financial intermediation improves, financial sector FDI should support greater employment and growth prospects.
In addition, Goldberg considers the implications of financial sector FDI for institutional development and crisis avoidance. She argues that financial sector FDI from well-regulated and well-supervised source countries can support institutional development and governance and improve a host country’s mix of financial services and risk management tools. These potentially reduce the incidence of crises associated with financial underdevelopment in emerging markets. However, she also recognizes that this type of investment can initially pose problems to local supervisors, who will need to develop expertise in the new practices and products introduced into their economies.
Does financial globalization have a “disciplining effect” on monetary policy? Although some recent papers argue that financial openness has been associated with better monetary policy outcomes, the evidence for such claims has been quite limited. Mark M. Spiegel (“Financial Globalization and Monetary Policy Discipline: A Survey with New Evidence from Financial Remoteness”) provides new empirical evidence on this question. He first analyzes the normative implications of financial globalization for monetary policy. He documents that financial globalization has decreased the relative desirability of using monetary policy to stabilize output in favor of increasing attention toward the pursuit of price stability. In response, policymakers have shifted their emphasis toward achieving price stability, with many formally adopting inflation targeting regimes.
For his empirical analysis, Spiegel examines the relationship between financial globalization and median inflation levels over an 11-year cross-section from 1994 through 2004, as well as a panel of five-year median inflation levels between 1980 and 2004. He uses financial remoteness as a plausibly exogenous instrument for financial integration. His findings indeed confirm a negative relationship between de facto financial openness and inflation for a univariate specification with or without instrumenting. However, these results do not appear to be robust to conditioning for country wealth or simply for introducing country fixed effects. In particular, both financial integration and monetary stability appear to be characteristics of well-functioning economies, but so are a large set of other factors examined in the literature, such as the level of development of the domestic financial sector, the quality of institutions, and an economy’s level of GDP per capita.
Finally, Martin Schindler (“Measuring Financial Integration: A New Data Set”) introduces a new data set containing measures of de jure restrictions on cross-border financial transactions. Although de facto measures of financial globalization have been available for a large number of countries and years, there has been a lack of detailed and reliable measurement of countries’ de jure policies toward financial globalization. In particular, existing measures of capital account restrictions are often too coarse and have limited time and/or country coverage.
Schindler’s data add value to existing capital control indices by providing information at a more disaggregated level for 91 countries from 1995 to 2005. Like most of the earlier de jure capital control indices, the new database relies on information contained in the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER). Although the new indices strike a relatively favorable balance regarding country coverage and the level of detail, they are constrained by a somewhat short time series dimension due to the limited information provided by the AREAER prior to 1995.
The new database allows for the construction of various subindices, including those for individual asset categories, for inflows vs. outflows, and for residents vs. nonresidents. Disaggregations of this kind open up new ways to address questions of interest about financial integration. For example, a key strength of the new indices is their ability to provide information on a country’s composition of capital account restrictions in addition to simply measuring the country’s overall restrictiveness. Moreover, their relatively fine gradation allows researchers to identify large changes in de jure regimes, thus making it possible to date reform events.
Recent events in global financial markets have once again shown the critical importance of understanding the effects of financial globalization. Although there has been an intensive debate about the implications of financial globalization, the evidence on which the debate is based has not been uniform and unambiguous. The papers in this special issue provide a systematic and critical analysis of recent empirical and theoretical studies on this subject. They also show that the challenges financial globalization poses will continue to be fertile ground for future research.
M. Ayhan Kose is a senior economist with the IMF Research Department.