- Giovanni Dell'Ariccia, Paolo Mauro, Andre Faria, Jonathan Ostry, Julian Di Giovanni, Martin Schindler, Ayhan Kose, and Marco Terrones
- Published Date:
- December 2008
Financial globalization—defined as the extent to which countries are linked through cross-border financial holdings, and proxied in this paper by the sum of countries' gross external assets and liabilities relative to GDP (see Box 2.1)—has made the interaction between international financial flows and domestic financial and macroeconomic stability an increasingly central issue for Fund surveillance.1 In discharging its mandate, a key issue for the IMF is to advise member countries about how they can reap the benefits of international financial integration while limiting its potentially harmful effects on macroeconomic volatility and crisis propensity. On various occasions—including in the context of discussions of recent Biennial Surveillance Reviews (IMF, 2004) and the Independent Evaluation Office's report on the Fund's approach to capital account liberalization (IEO, 2005)—Executive Directors have called upon staff to undertake further research into the issue of managing the risks associated with international financial integration in a way that maximizes the net benefits. The present paper focuses on policies and reforms that can be carried out by recipient countries (and especially emerging market and developing countries), with issues related to the role of macroeconomic and prudential policies in source countries being left to later analysis.2
Over the past three decades, de facto financial globalization has increased in most member countries, but integration has moved furthest in member countries of the Organization for Economic Cooperation and Development (OECD), where it has primarily taken the form of two-way (“diversification”) asset trade, with large gross holdings of external assets and liabilities, but relatively small net external asset positions. More moderate increases are apparent among middle-income countries, with benign worldwide financial conditions and abundant liquidity having supported the process in recent years. The smallest increases have been experienced by low-income countries.
The analysis presented below suggests that these trends reflect a number of factors. First, country-specific policies—in particular the relative strength of countries' de jure capital controls—are correlated with relative de facto financial globalization. Controls that are maintained for many years seem to have a significant effect in slowing integration, even if controls aimed at fine-tuning the timing or composition of financial flows tend to lose their effectiveness beyond the short run. Early external financial liberalization by advanced countries seems, for example, to be a key factor behind their greater degree of de facto integration. Second, beyond financial account policies, the extent of financial integration among emerging market and developing countries—including those with relatively open de jure regimes—has been constrained by other factors, including lower degrees of perceived institutional quality (a factor that also seems to affect the composition of a country's external liabilities) and lower domestic financial sector development. Third, while the bilateral pattern of a country's external portfolio of assets/liabilities is strongly influenced by geographical distance (as in a standard “gravity” trade model), as well as by linkages related to language and colonial history, domestic policies aimed at reducing informational asymmetries—for example, by making local stock markets more transparent—can help to mitigate the role of persistent “gravity” factors. Financial transparency is thus a potentially important vehicle for boosting financial integration in the presence of a variety of persistent constraints.
Regarding the consequences of greater financial integration, economic theory suggests that financial globalization confers a number of potential benefits. Increases in international asset trade may foster economic growth, particularly if assets are used to finance worthwhile projects, or if they facilitate technology transfer (for example, through FDI), thereby underpinning increases in economic efficiency. In addition, such trade may lead to enhanced international risk sharing—indeed, the sizable gross external stock positions of advanced countries seem indicative of large potential risk-sharing gains, while an enhanced ability of emerging market and developing countries to borrow abroad in cases of natural disaster or temporary recessions would seem likely to contribute to greater consumption-smoothing. Looking ahead, large potential risk-sharing gains are apparent for emerging market and developing countries in light of their relatively large economic fluctuations while, from the standpoint of advanced-country residents, the ability to invest in emerging market and developing countries would be especially welcome, given the low correlation of these countries' economic fluctuations with the global economic cycle.
Box 2.1Measuring Financial Globalization
A country's degree of financial globalization/integration/openness (terms used interchangeably in this paper) is a multifaceted concept, usually referring to the size of gross stocks of external assets and liabilities, the potential for large net flows (that is, differences in saving and investment flows), or the absence of arbitrage opportunities between returns on assets in different countries. Correspondingly, the various measures of this concept can be divided into three broad categories.
Quantity-based measures. The most widely applicable, and now generally accepted, measure of international financial integration is the sum of gross external assets and liabilities, relative to GDP (Lane and Milesi-Ferretti, 2006). This paper relies mainly on this measure, reflecting the need for a broad cross-country coverage over an extended time span. An alternative stock-based measure compares the size and geographic allocation of a country's external asset holdings with the portfolio predicted by an optimal risk-return frontier. Country coverage of such a measure is, however, limited. Still other quantity-based measures focus on gross financial inflows plus outflows (analogous to measures of trade openness based on imports plus exports). However, stock-based measures—which are less affected by short-term economic fluctuations—are preferable in the context of this paper in light of its long-term focus.
Saving-investment correlations. While investment can differ from domestic saving for countries with access to international financial markets, investment must equal saving under financial autarky. Saving-investment correlations have thus been used to measure the degree of international financial integration for groups of countries in different historical periods. Measures based on the size of net flows are also closely related, the current account surplus being the difference between saving and investment. A drawback of all such measures is that saving and investment are highly correlated even for groups of countries that seem to be fully open to international flows (the “Feldstein-Horioka puzzle”), and a warranted, or benchmark, correlation against which to compare actual correlations is difficult to identify empirically (but see Ghosh and Ostry, 1995; and Obstfeld and Taylor, 2004).
Price-based indices. Under financial integration, there should not be unexploited arbitrage opportunities from trade in similar assets. Comparisons of prospective returns on financial instruments in different countries (for example, covered or uncovered interest parity) thus provide a natural gauge of the extent of international financial integration. Alternative measures focus on real interest rate comparisons across countries. The applicability of these measures to emerging market and developing countries is hampered not only by difficulties in controlling for cross-country differences in risk or liquidity premia but also by the possibility that inefficient arbitrage may reflect domestic rather than international financial frictions.
While there seem to be sizable potential gains from international financial integration, these will need to be set against the possible costs in the form of greater macroeconomic volatility and vulnerability to crisis. Indeed, the emerging market crises of the 1990s have only served to highlight the potential for sudden reversals of capital inflows in financially open economies, and the associated large and abrupt recessions, often with serious social consequences. External financial liberalization has more generally been seen as amplifying vulnerabilities to possible contagion/herd effects, particularly in cases where domestic institutions and policies are not strong enough to steer through bad times.
Against the background of the large potential gains and costs, what can be said of the actual effects of trends in de facto financial globalization? The results presented below suggest that the impact has varied depending on country characteristics:
- With respect to risk sharing, evidence based on data for the past three decades suggests that, while some gains have accrued to advanced economies, this has not been the case for emerging market and developing countries, perhaps reflecting the more limited increase in financial integration for these countries.
- With respect to volatility, the findings suggest that for countries with sufficiently developed domestic financial systems, relatively open trade systems, good governance, and sound macroeconomic policies (that is, for countries that meet a number of “thresholds” to use the jargon from the globalization literature), greater integration has not been associated with increased macroeconomic volatility or more frequent crises. Volatility is adversely affected for countries that fail to meet such thresholds, though the broad trend toward improved policies and greater trade openness may point to diminishing policy relevance of volatility concerns over time.
- The relationship between financial globalization and economic growth is more complex—consistent with the difficulties the economic literature has encountered in establishing robust empirical evidence linking growth to economic fundamentals more generally. The results presented below point to the importance of unbundling financial globalization into different components in order to uncover its effects. FDI and other nondebt forms of financial globalization are found to be positively and significantly associated with economic growth for all countries, whereas the impact of debt seems to depend on whether borrowers meet certain policy and institutional thresholds. While empirical analysis based on macroeconomic data fails to establish a robust relationship between economic growth and all types of financial integration, it does suggest that greater integration is associated with factors that in turn have been found to support economic growth. Examples of such “collateral benefits” are development of the domestic financial sector, macroeconomic policy discipline, faster trade growth, and improvements in economic efficiency. Indeed, recent microeconomic evidence suggests that the efficiency costs of maintaining capital controls are significant.
In determining an appropriate pace of external financial liberalization, an important consideration is the extent to which countries meet the preconditions, or thresholds, for a favorable impact. However, it bears emphasizing that, even for countries that currently fall somewhat short of meeting the thresholds, greater financial integration—if it engenders collateral benefits as discussed above—may itself facilitate over time progress in attaining relevant policy and institutional thresholds. Moreover, two broad developments suggest that the impact of financial globalization may be more beneficial in coming years than in the past: first, FDI and other nondebt forms of international asset trade constitute a higher share of external financing today than in recent decades; and second, steps taken by countries to raise their game in relation to policy and institutional fundamentals are likely to imply greater net benefits from financial integration than would be apparent from empirical analysis of past data. The paper's results are broadly supportive of the “integrated” approach, which envisages a gradual and orderly sequencing of external financial liberalization and emphasizes the desirability of complementary reforms in the macroeconomic framework and the domestic financial system as essential components of a successful liberalization strategy (Ishii, Habermeier, and others, 2002).
The remainder of the paper is structured as follows. Section III summarizes developments in de facto financial globalization for various groups of countries and types of assets and liabilities, and considers a possible relationship with changes in de jure capital controls. Section IV analyzes the determinants of cross-country differences in de facto financial globalization, including the role of both highly persistent factors (such as institutional quality) and factors that can be substantially affected by policies in the relatively near term (such as capital controls). Section V estimates the potential gains from international risk sharing for different segments of the IMF's membership and reports evidence on the extent to which such gains have been realized in practice. Section VI estimates the impact of financial globalization on macroeconomic volatility, the frequency of crises, and long-run economic growth. Section VII concludes.