Financial globalization has been one of the most intensely debated topics of our times. Some academic economists view increasing capital account liberalization and unfettered capital flows as a serious impediment to global financial stability (e.g., Rodrik, 1998; Bhagwati, 1998; Stiglitz, 2002), leading to calls for capital controls and the imposition of frictions such as “Tobin taxes” on international asset trade. In contrast, others argue that increased openness to capital flows has, by and large, proven essential for countries aiming to upgrade from lower to middle income status, while significantly enhancing stability among industrialized countries (e.g., Fischer, 1998; Summers, 2000).
Financial globalization is clearly a matter of considerable policy relevance, especially with major economies like China and India recently taking steps to open up their capital accounts. A number of developing countries are still in the early stages of financial globalization facing numerous ongoing policy decisions about the timing and pace of further integration. The stakes for such policy decisions are high because financial globalization 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.
Moreover, financial globalization is also a fascinating topic to study for researchers of development economics not only because of its compelling policy relevance, but because of the enormous variation of approaches and experiences across countries. Differences in speed and approach to financial globalization have often been driven as much by philosophy, regional fads and political circumstances as by economic factors. Hence, cross-country studies of the effects of financial integration can potentially exploit a wide array of natural variation in experiences.
There has been an explosion of research in this area over the past two decades. Most of this work is of relatively recent vintage, since the latest wave of financial globalization got started in earnest only in the mid-1980s. However, the research program on financial globalization has proceeded along a number of disparate paths, with the results from some of these strands seeming at odds with each other. The inconclusive nature of the debate about the merits of financial globalization has reflected itself on the design of economic policies aiming to manage the process of financial integration. While consensus on the outcomes of financial globalization and the complex policy issues surrounding them may be too much to hope for, some clarity on what theory and data do tell us and what they do not tell us—is important for informing the ongoing debate.
The objective of this chapter is to review the large literature focusing on various economic policies that could help developing economies effectively manage the process of financial globalization. In particular, we try to identify structural and macroeconomic policies that can improve the growth and stability benefits of financial globalization for developing countries. In section II, we present some basic stylized facts about the temporal volution of financial flows. Studying policy issues surrounding financial globalization necessarily requires an analysis of the associated measurement issues and this section starts with a brief summary of those. We then analyze how the volume and composition of financial flows have changed over time. The volume of flows has risen substantially during the past two decades. Not only has there been a much greater volume of flows among advanced countries over this period but there has also been a surge in flows between advanced and developing countries. There are important differences across country groups in the relative importance of different types of inflows, although there has been a broad shift away from debt financing towards FDI and equity flows in all groups.
In section III, we survey the theoretical arguments and empirical evidence about the macroeconomic outcomes associated with financial globalization. This section largely relies on the framework put forward by Kose et al. (2006). We focus on the implications of financial integration for the dynamics of growth, volatility and risk-sharing patterns. Although our overall take is that the literature is still inconclusive, we argue that newer approaches that attempt to focus more on the indirect effects of financial globalization hold considerable promise. At the same time, we find that there is scant empirical support to underpin the more polemic claims of those who argue that capital account liberalizations (as opposed to, say, inappropriately rigid exchange rate regimes) are the root problem behind most developing country financial crises of the past two decades (Bhagwati, 1998; Stiglitz, 2002).
The survey of the rapidly evolving literature on the merits of financial globalization also reveals that newer approaches depart from the standard neoclassical framework that largely guided the earlier studies. In particular, the earlier literature viewed the key benefit of financial globalization as arising from long-term net flows of capital from advanced to developing economies. Since the former group of countries is capital rich while the latter is relatively capital poor, this should generate higher growth in developing economies and welfare gains for both groups. Perhaps not surprisingly, in light of the corresponding literature on growth in closed economies, this literature often found conflicting result.
The fundamental conceptual point that guides our interpretation of the newer literature is that the main benefits to successful financial globalization are probably catalytic and indirect. The benefits are not simply, or even primarily, the result of enhanced access to financing for domestic investment. We document that there is modest but increasing evidence that financial openness can in many circumstances 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 public and corporate governance. That is, it can generate significant indirect or “collateral” benefits which, in quantitative terms, are likely to be the most important sources of enhanced growth and stability for a country engaged in financial globalization.
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