Is it worthwhile for developing countries to pursue policies which increase integration of their financial markets?.
Financial globalisation by increasing cross-border capital flows can increase systemic risk in financial systems around the globe. That is, when markets become closely integrated, instability generated in one market rapidly spreads to other markets. The current market turmoil, seen as a consequence of financial globalisation, has revived the debate about the pros and cons of financial globalisation. The key question is: is it worthwhile for developing countries to purse policies which increase integration of their financial markets with those of the other countries. In other words, do the benefits from financial globalisation outweigh the risks?
A recent paper from Her Majesty’s Treasury* argues that financial globalisation can deliver significant benefits to countries in terms of economic growth and macroeconomic stability. Specifically, the paper claims that the main channel through which financial globalisation contributes to economic growth is by improving allocative efficiency of capital. In open financial markets, capital would tend to flow into economies where it can be put to its most productive use, thereby increasing its efficiency. Moreover, increased availability of capital lowers the cost of raising capital. This in turn encourages firms to take on more investment, thereby enhancing growth.
Furthermore, financial globalisation can enhance growth by spreading technology and managerial expertise, promoting development of secondary markets and aiding productivity growth because of increased competition. In addition, financial globalisation is likely to provide impetus to financial sector development, help promote institutions and contribute to total factor productivity growth by improving economy-wide efficiency. The paper argues that it is for these reasons a return to financial protectionism would damage global economic prospects.
In contrast, in a recent paper Dani Rodrik and Arvind Subramanian** argue that in the case of developing economies it is difficult to empirically establish a robust causal relationship between financial integration and economic growth. The paper goes on to argue that the presumed benefits of financial globalisation, such as, increased investment and better consumption smoothing opportunities have simply not materialised for emerging markets. It turns out that countries that have grown most rapidly have been those that rely less on foreign capital.
Rodrik and Subramanian argue that whether financial liberalisation and globalisation is beneficial or not depends on country specific factors. For example, in a country where the return on investment is low, additional foreign capital will not increase growth, but instead will drive up the value of the domestic currency. This might hinder exports and hence growth. This argument raises an interesting question. Why would there be an influx of foreign capital in the first place if return on investment is low? The paper fails to shed light on this issue.
The treasury paper also acknowledges that there are significant risks from financial globalisation. For example, increased cross-border transactions can increase systemic risk by increasing the correlation of asset prices across countries. Furthermore, it makes emerging economies vulnerable to the sudden reversal in international capital flows, which can cause exchange rate volatility and asset price bubbles. It is for this reason that both papers acknowledge that capital controls may be necessary for emerging countries at certain times.
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In sum, both papers argue that the benefits from financial globalisation depend on a country meeting certain pre-requisites, although Rodrik and Subramanian appear to be more pessimistic about its potential benefits. Good institutions, appropriate regulatory and supervisory framework, responsible macroeconomic policies, financial sector development and trade integration determine the extent to which a country benefits from financial globalisation.
The current financial meltdown is bound to intensify scepticism about markets and globalisation. Neither of the papers reviewed here argue in favour of financial protectionism, but rather the message is, countries should accelerate reforms to strengthen their regulatory and supervisory systems, and should satisfy the pre-conditions for opening up of their financial markets before embarking on financial globalisation. Or else the risk-return trade off associated with financial globalisation would turn unfavourable.
*Embracing financial globalisation, HM Treasury, UK, May 2008
**Why did the financial globalisation disappoint? Dani Rodrik and Arvind Subramanian, Harvard, March 2008. The author is senior economist, CRISIL