Financial globalisation — the phenomenon of rising cross-border financial flows — is often blamed for the string of damaging economic crises that rocked a number of emerging markets in the late 1980s in Latin America, and in the 1990s in Mexico and a handful of Asian countries. The market turmoil and resulting bankruptcies prompted a rash of finger-pointing by those who suggested that developing countries had dismantled capital controls too hastily — leaving themselves vulnerable to the harsh dictates of rapid capital movements and market herd effects. Some were openly critical of international institutions that they saw as promoting capital account liberalisation without stressing the necessity of building up the strong institutions needed to steer markets through bad times.
In contrast to the growing consensus among academic economists that trade liberalisation is by and large beneficial for both industrial and developing economies, debate rages among academics and practitioners about the costs and benefits of financial globalisation. Some economists (for example, Dani Rodrik, Jagdish Bhagwati, and Joseph Stiglitz) view unfettered capital flows as disruptive to global financial stability, leading to calls for capital controls and other curbs on international asset trade. Others (including Stanley Fischer and Lawrence Summers) argue that increased openness to capital flows has, in general, proved essential for countries seeking to rise from lower- to middle-income status and that it has strengthened stability among industrial countries. This debate clearly has considerable relevance for economic policy, especially given that major economies like China and India have recently taken steps to open up their capital accounts.
To get beyond the polemics, we put together a framework for analysing the vast and growing body of studies about the costs and benefits of financial globalisation.1 Our framework offers a fresh perspective on the macroeconomic effects of these ramped-up flows, in terms of both growth and volatility. We systematically sift through various pieces of evidence on whether developing countries can benefit from financial globalisation and whether financial globalisation, in itself, leads to economic crises. Our findings suggest that financial globalisation appears to be neither a magic bullet to spur growth, as some proponents would claim, nor an unmanageable risk, as others have sought to portray it.
Making sense of the evidence: A collateral benefits perspective
A basic building block of our framework is the notion that successful financial globalisation does not simply enhance access to financing for domestic investment, but that its benefits are catalytic and indirect. Far more important than the direct growth effects of access to more capital is how capital flows generate what we label financial integration’s potential collateral benefits (so-called because they may not be countries’ primary motivations for undertaking financial integration). A growing number of studies are showing that financial openness can promote development of the domestic financial sector, impose discipline on macroeconomic policies, generate efficiency gains among domestic firms by exposing them to competition from foreign entrants, and unleash forces that result in better government and corporate governance. These collateral benefits could enhance efficiency and, by extension, total factor productivity growth.
The notion that financial globalisation influences growth mainly through indirect channels has powerful implications for an empirical analysis of its benefits. Building institutions, enhancing market discipline, and deepening the financial sector take time, as does the realisation of growth benefits from such channels. This may explain why, over relatively short periods, it seems much easier to detect the costs but not the benefits of financial globalisation. More fundamentally, even at long horizons, it may be difficult to detect the productivity-enhancing benefits of financial globalisation in empirical work if one includes structural, institutional, and macroeconomic policy variables in cross-country regressions that attempt to explain growth. After all, it is through these very channels that financial integration generates growth benefits.
One should not, of course, overstate the case that financial integration generates collateral benefits. It is equally plausible that, all else being equal, more foreign capital flows to countries with better-developed financial markets and institutions. We do not dismiss the importance of traditional channels—that financial integration can increase investment by relaxing the constraints imposed by low levels of domestic saving and by reducing the cost of capital. But our view is that these traditional channels may have been overemphasized in previous research.
Evidence on collateral benefits
The potential indirect benefits of financial globalisation are likely to be important in three key areas: financial sector development, institutional quality, and macroeconomic policies. Is there empirical merit to our conceptual framework?
A good deal of research suggests that international financial flows serve as an important catalyst for domestic financial market development, as reflected both in straightforward measures of the size of the banking sector and equity markets and in broader concepts of financial market development, including supervision and regulation.
Research based on a variety of techniques, including country case-studies, supports the notion that the larger the presence of foreign banks in a country, the better the quality of its financial services and the greater the efficiency of financial intermediation. As for equity markets, the overwhelming theoretical presumption is that foreign entry increases efficiency, and the evidence seems to support this channel. Stock markets do, in fact, tend to become larger and more liquid after equity market liberalisations.
The empirical evidence suggests that financial globalisation has induced a number of countries to adjust their corporate governance structures in response to foreign competition and demands from international investors. Moreover, financial sector FDI from well-regulated and well-supervised source countries tends to support institutional development and governance in emerging market economies.
Capital account liberalisation, by increasing the potential costs associated with weak policies and enhancing the benefits associated with good ones, should also impose discipline on macroeconomic policies. Precisely because capital account liberalisation makes a country more vulnerable to sudden shifts in global investor sentiment, it can signal the country’s commitment to better macroeconomic policies to mitigate the likelihood of such shifts and their adverse effects. Although the empirical evidence on this point is suggestive, however, it is sparse. Countries with higher levels of financial openness appear more likely to generate better monetary policy outcomes in terms of lower inflation, but there is no evidence of a systematic relationship between financial openness and better fiscal policies.
The evidence is hardly decisive, but it does consistently point to international financial integration as a catalyst for a variety of productivity-enhancing benefits. Given the difficulties that we have identified in interpreting the cross-country growth evidence, it is encouraging to see that financial market integration seems to be operating through some of the indirect channels.
Threshold effect as a complication
Some studies have tackled the question of initial conditions needed for financial openness to generate good growth benefits while lowering the risks of a crisis. What are these initial conditions? Financial sector development, Institutional quality, quality of domestic macroeconomic policies, and Trade integration are found in empirical studies to be some basic supporting conditions, or thresholds that determine where on the continuum of potential costs and benefits a country ends up. It is the interaction between financial globalisation and this set of initial conditions that determines growth and volatility outcomes.
Readers would recognise a fundamental tension between the costs and benefits of financial globalisation. Most of the threshold conditions are similar to the collateral benefits. In other words, financial globalisation is a catalyst for a number of important collateral benefits but can greatly elevate the risk-to-benefit ratio if the initial conditions in these dimensions are inadequate.
Making the risk-benefit calculus
Our synthesis of the literature on financial globalisation, while guardedly positive about the overall benefits of financial globalisation, suggests that as countries make the transition from less integrated to more integrated, they are likely to encounter major complications. For developing countries, financial globalisation appears to have the potential to generate an array of collateral benefits that may help boost long-run growth and welfare. At the same time, if a country opens its capital account without having some basic supporting conditions in place, the benefits can be delayed and the country can be more vulnerable to sudden stops of capital flows. This tension between the costs and benefits of financial globalisation may be difficult to avoid.
Does this imply that a country that wants the collateral benefits of financial globalisation has no alternative but to expose itself to substantial risks of crises? Or, alternatively, would developing countries do best to shield themselves from external influences while trying to improve the quality of their domestic policies and institutions to some acceptable level? Our view is that, although the risks can never be totally avoided, there are ways to improve the benefit-risk calculus of financial globalisation. There is, however, unlikely to be a uniform approach to opening the capital account that will work well for all countries.
The collateral benefits perspective may provide a way for moving forward on capital account liberalisation that takes into account individual country circumstances (initial conditions) as well as the relative priorities of different collateral benefits for that country. If one can identify which reform priorities are the key ones for a particular country, then one can, in principle, design an approach to capital account liberalisation that could generate specific benefits while minimising the associated risks. Further research is clearly needed in a number of areas before one can derive strong policy conclusions about the specifics of such an approach. Meanwhile, we should recognise that some of the more extreme polemic claims made about the effects of financial globalisation on developing countries, both pro and con, are far less easy to substantiate than either side generally cares to admit.