Information about Asia and the Pacific Asia y el Pacífico
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V Absorptive Capacity and Governance in the Benefits/Risks of Globalization

Author(s):
Ayhan Kose, Kenneth Rogoff, Eswar Prasad, and Shang-Jin Wei
Published Date:
September 2003
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Information about Asia and the Pacific Asia y el Pacífico
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There is some evidence of a “threshold effect” in the relationship between financial integration and economic growth. Moreover, there is some preliminary evidence supporting the view that better national governance is associated with lower volatility and enhanced benefits from financial integration.

Threshold Effects and Absorptive Capacity

Although it is difficult to find a strong and robust effect of financial integration on economic growth, there is some evidence in the literature of various kinds of “threshold effect.” For example, there is some evidence that the effect of foreign direct investment on growth depends on the level of human capital in a developing country. On the one hand, for countries with relatively low amounts of human capital, there is at best a small positive effect that can be detected in the data. On the other hand, for countries whose human capital has exceeded a certain threshold, there is some evidence that FDI promotes economic growth (Borenzstein, De Gregorio, and Lee, 1998).

More generally, one might think of a country’s absorptive capacity in terms of its human capital, depth of domestic financial market, quality of governance, and macroeconomic policies. There is some preliminary evidence that foreign capital flows do not generate positive productivity spillovers to domestic firms for countries with relatively low absorptive capacities, but positive spillovers are more likely to be detected for countries with relatively high absorptive capacities (Aitken and Harrison, 1999; World Bank, 2001; Bailliu, 2000; Arteta, Eichengreen, and Wyplosz, 2001; and Alfaro and others, 2002). This evidence is consistent with the view that countries need to build up a certain amount of absorptive capacity in order to effectively take advantage of financial globalization.

The next subsection specifically discusses the role of domestic governance as a crucial element of this absorptive capacity. The importance of governance has been asserted repeatedly, particularly since the Asian crisis, but until recently relatively little systematic evidence has been documented on its relationship with financial globalization.

Governance as an Important Element of Absorptive Capacity

The term governance encompasses a broad array of institutions and norms. Although many of these are interrelated and complementary, it is nevertheless useful to try to narrow them down to a core set of governance dimensions most relevant for the discussion on financial integration. These are transparency, control of corruption, the rule of law, and financial sector supervision.

Recent evidence suggests that the quality of governance affects a country’s ability to benefit from international capital flows. As discussed in Section III, of the various types of capital flows, FDI might be among the most helpful in boosting recipient countries’ economic growth (Reisen and Soto, 2001).44 There is an intimate connection between a country’s quality of domestic governance and its ability to attract foreign direct investment. Recent evidence suggests that foreign direct investment tends to go to countries with good governance, if one holds constant the size of the country, labor costs, tax rate, laws, and incentives specifically related to foreign-invested firms and other factors. Moreover, the quantitative effect of bad governance on FDI is large.

To reach this conclusion, corruption in the FDI recipient countries can be measured in a variety of ways. These include a rating by Transparency International, which is a global nongovernmental organization devoted to fighting corruption; a measure derived from a survey of firms worldwide as published jointly by Harvard University and the World Economic Forum in the Global Competitiveness Report; and a measure from a survey of firms worldwide conducted by the World Bank. The results from these different measures are consistent: all show a negative effect of corruption on the volume of inward foreign direct investment.45 The quantitative effect of corruption is also significant when compared with the negative effect of the corporate tax rate on FDI. For example, an increase in host country corruption of one standard deviation might be equivalent to an increase of about 30 percentage points in the tax rate in terms of its negative effect on FDI (see Figure 5.1 and Wei (1997, 2000a, and 2000b) for details).46

Figure 5.1.Corruption and Foreign Direct Investment

Source: IMF staff calculations based on Wei (2001), Table 2, Column 2.

Notes: Bilateral foreign direct investment from 14 major source countries to 41 host countries, averaged over 1996-98. Index of host country corruption is derived by combining the measures from the World Economic Forum and Harvard University’s Global Competitiveness Report for 1997 and the World Bank’s World Development Report for 1997. Coef = –0.29; Robust SE = 0.08; and t-statistic = –3.53. More details can be found in Wei (2001).

Using firm-level data on foreign investment in Central and Eastern Europe, a different study suggests that poor quality of local governance, in addition to reducing the quantity of inward FDI, might also reduce the quality of FDI by discouraging technologically more advanced, wholly foreign-owned firms (Smarzynska and Wei, 2000).

Many developing country governments are now eager to attract FDI by offering generous tax concessions or exemptions. The previous evidence suggests that improving domestic governance, especially reducing corruption, would be more effective in attracting FDI, in addition to promoting more domestic investment, than taking measures that could reduce tax revenues.

Transparency of government operations is another dimension of good governance. More portfolio investment from international mutual funds tends to go to countries with a higher level of transparency (Gelos and Wei, 2002; and Figure 5.2). This is true even after one takes into account the liquidity of the market, exchange rate regime, other economic risks, and a host of other factors (see Box 5.1 for more details).47

Figure 5.2.Difference Between Actual International Mutual Fund Investment and MSCI Benchmark: Transparent Versus Opaque Countries

Source: IMF staff calculations based on Gelos and Wei (2002).

Notes: On the horizontal axis on each figure is the difference between the share of global investment funds’ actual investments in a country in their total portfolios, averaged across the funds, and the share of that country’s stock market capitalization, adjusted for availability to foreign investors, in a global market portfolio based on the Morgan Stanley Capital International (MSCI) index (in percentage points). For information on macropolicy opacity, macrodata opacity, or corporate opacity, see Box 5.1.

Domestic Governance and the Volatility of International Capital Flows

Previous sections of this paper have documented the fact that international capital flows can be very volatile. Different countries experience different degrees of volatility, however, and this may be systematically related to the quality of macroeconomic policies and domestic governance. In other words, with regard to the sudden stops or sudden reversals of international capital flows, developing countries are not purely passive recipients with no influence on the nature of capital inflows. For example, re-search has demonstrated that an overvalued exchange rate and an overextended domestic lending boom often precede a capital account crisis (Frankel and Rose, 1996; Schneider and Tornell, 2001). In this subsection, attention is focused on the evidence related to the role of local governance in mitigating the volatility of capital inflows that a developing country might experience.

There is plenty of evidence suggesting that weak domestic capacity in financial regulation and supervision is likely to be associated with a high propensity for banking and currency crises (Kaminsky and Reinhart, 1999; Arteta, Eichengreen, and Wyplosz, 2001). Without adequate financial supervision institutions in place, a premature opening of the capital account could increase the risk of a financial crisis, since domestic financial institutions might build up excessive risk. On the liability side, they might borrow excessively from international capital markets. On the asset side, they might expand lending for overly risky economic activities, especially where there are explicit or implicit government guarantees. These factors could result in various types of balance sheet weaknesses, such as mismatches in maturity or currency. Furthermore, owing to intersectoral linkages, balance sheet weaknesses of the government and corporate sectors could affect the health of financial institutions. The view that supervisory and regulatory capacities need to be strengthened before a country engages in full-fledged liberalization of the capital account is now widely accepted.

Transparency of a government’s economic policies is another dimension of domestic governance. Recent evidence suggests that the degree of transparency might affect the degree of volatility of capital inflows that a country experiences. For example, herding behavior by international investors, which is alleged to have contributed to instability in developing countries’ financial markets, tends to be more severe in countries with a lower degree of transparency (see Figure 5.3 and Box 5.1).

Figure 5.3.Herding and Opacity

Source: Gelos and Wei (2002).

Note: Opacity index is a composite measure of corruption, legal opacity, economic opacity, accounting opacity and regulatory opacity (PriceWaterhouseCoopers (PWC), 2000).

Box 5.1.Transparency and International Mutual Funds

Gelos and Wei (2002) examine the investment behavior of international equity funds from January 1996 to December 2000—specifically whether and how their asset allocations across countries may be related to the transparency features of the countries.

Government transparency and corporate transparency are considered separately (even though they are somewhat related). On government transparency, the authors examine, in turn, two separate aspects: transparency of macroeconomic data release and transparency of macroeconomic policies.

Macro data transparency is measured by using the average of two indices developed by the IMF on the frequency and timeliness of national authorities’ macroeconomic data dissemination (Allum and Agca, 2001).

Macro policy transparency was developed by Oxford Analytica based, in part, on the IMF’s reports on standards and codes (ROSCs). The latter are largely an assessment of the degree to which a government’s macro policies conform with the prescribed standards and codes (as opposed to actually realized inflation rates or fiscal deficits).

The corporate transparency index was derived by the authors based on the information in the Global Competitiveness Report produced by Harvard University’s Center for International Development and the World Economic Forum. It measures the level of financial disclosure and the availability of information about business opportunities in a country.

The first major finding is that international equity investment tends to avoid less transparent countries (relative to the prediction of an international capital asset pricing model). This qualitative result holds when the authors control for the liquidity of the market, income level, and a host of other factors. This effect is also quantitatively important. For countries whose opacity (lack of transparency) exceeds the sample median, there would be a reduction in their weighting in the international funds by between 7 and 39 percentage points (relative to their actual weights in the world market portfolio).

The second major finding is that the tendency for international funds to engage in herding, a behavioral pattern that is sometimes blamed for contributing to instability in developing countries’ financial markets, is, in fact, related to a country’s transparency features. There is some evidence that herding by international funds is more severe in less transparent countries.

Third, there is also some evidence that capital flight during a financial crisis tends to be more severe in less transparent developing countries.

Overall, the data suggest that an improvement in transparency might very well reduce the “sudden stop” phenomenon of hot money and, hence, increase the stability of the domestic financial market in a developing country.

Source: Gelos and Wei (2002).

The literature on currency crises (for example, Frankel and Rose, 1996) points out that a country’s structure of capital inflows is related to the likelihood of a crisis. More specifically, a country that relies more on foreign bank credits and less on foreign direct investment may be more vulnerable to the sudden stops of international capital flows and have a greater chance of experiencing a capital account crisis.

Recent research suggests that macroeconomic policies are an important determinant of the composition of capital inflows (Carlson and Hernandez, 2002). Recent research also presents some evidence that domestic governance, as measured by the corruption indices, tilts the composition of capital flows. Specifically, holding other factors constant, countries with weaker governance, as reflected by a higher perceived level of corruption, are more likely to have a structure of capital inflows that is relatively light in FDI and relatively heavy in foreign bank credits (Wei, 2001). Figure 5.4 visually describes this relationship.

Figure 5.4.Corruption Tilts the Composition of Capital Flows Toward Borrowing from Foreign Banks

(Controlling for recipient country fixed effects; size: level of development: policy incentives for, and restrictions on, FDI; and geographic and linguistic connection)

Source: IMF staff calculations based on Wei (2001).

Notes: Index of host country corruption is derived by combining the measures from the World Economic Forum and Harvard University’s Global Competitiveness Report for 1997 and the World Bank’s World Development Report for 1997. FDI denotes foreign direct investment.

Governance is not the only element of domestic absorptive capacity, but it is an important one. Its importance has been emphasized by the IMF’s Executive Board and in international policy circles at least since the Asian financial crisis. Recent systematic research documented in this paper has provided an empirical foundation for this view. Of course, the importance of domestic governance goes beyond its role in financial globalization. The quality of governance also affects economic growth and other social objectives through a variety of other channels (as documented in Mauro, 1995 and 1997 and Abed and Gupta, 2002).

Summary

The empirical evidence has not provided definitive proof that financial integration has enhanced growth for developing countries. Furthermore, financial integration may be associated with higher consumption volatility. Therefore, it may be worthwhile for developing countries to experiment with different paces and strategies in pursuing financial integration. Empirical evidence does suggest that improving governance, in addition to conducting sound macroeconomic frameworks and developing domestic financial markets, should be an important element of such strategies.

It might not be essential for a country to develop a full set of sound institutions matching the best practices in the world before embarking on financial integration. Doing so might strain the capacity of the country. An intermediate and more practical approach could be to focus on making progress on the core indicators noted previously—namely transparency, control of corruption, the rule of law, and financial supervisory capacity. The IMF and the World Bank—through financial sector assessment programs (FSAPs) and ROSCs, among other ways—help promulgate codes and standards on best practices for financial supervision and transparency, so that countries can implement the needed changes, supported by technical assistance.

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