Financial globalization is not a new phenomenon, but today’s depth and breath are unprecedented. Capital flows have existed for a long time. In fact, according to some measures, the extent of capital mobility and capital flows a hundred years ago is comparable to today’s. At that time, however, only few countries and sectors participated in financial globalization, and capital flows tended to follow migration and were generally directed towards supporting trade flows. It was not until the 1970s that the world witnessed the beginning of a new wave of financial integration. Decreasing capital controls and increasing capital mobility with a growing participation of a wide range of developing countries in the global financial system characterized the post-Bretton Woods era, leading to a more integrated world economy towards the 1990s.
There are different forces that are pushing towards an increasing financial globalization. These forces are governments, borrowers, investors, and financial institutions. Governments allow globalization by liberalizing restrictions on the domestic financial sector and the capital account of the balance of payments. As shown in Kaminsky and Schmukler (2003), there has been a gradual lifting of restrictions in developed and emerging countries during the last 30 years. Firms and even households have been increasingly participating of financial globalization by borrowing abroad and thus relaxing their financial constrains and smoothing consumption and investment.
International investors have taken advantage of financial globalization to achieve cross country risk diversification. As a consequence of the liberalization of financial markets, both institutions and individuals in developed countries can now easily invest in emerging markets through different instruments. Financial institutions have also played an important role in globalization. The gains in information technology have diminished the importance of geography, allowing international corporations to service several markets from one location. Moreover, the increased competition in developed countries has led banks and other non-bank financial firms to look for expanding their market shares into new businesses and markets, and the liberalization of the regulatory systems in developing countries has opened the door for international firms to participate in local markets.
The forces that are pushing towards globalization are driven by the benefits that this process can yield. The main potential benefit of financial globalization for developing countries is the development of their financial system; that is, more complete, deeper, more stable, and better-regulated financial markets. There are two main channels through which financial globalization promotes financial development. First, financial globalization implies that new sources of capital and more capital become available allowing countries to better smooth consumption, deepening financial markets, and increasing the degree of market discipline. Second, financial globalization leads to a better financial infrastructure, which can mitigate information asymmetries and thus reduce problems of adverse selection and moral hazard. A large literature provides evidence on the positive effect of financial globalization on the development of the financial sector. For example, several papers show that the liberalization of the stock market increases equity prices and investment. Other works using firm-level evidence find that firms that participate in international capital markets, mainly through cross listing, benefit from abnormal returns and lower cost of capital, as well as increased liquidity and lower volatility. 6,7 Studies on foreign bank entry show that the competitive pressure created by foreign banks lead to improvements in banking system efficiency.
Despite the driving forces and potential benefits, financial globalization also carries some risks, especially for developing countries. This paper reviews the literature on crisis and contagion in the context of financial globalization. Financial globalization can lead to crises in countries with weak fundamentals as the economies become subject to the reaction of domestic and foreign investors. Globalization can also lead to crises in countries with sound fundamentals. Imperfections in international financial markets and external factors that determine capital flows make open economies more prone to crises. Furthermore, countries that integrate into world financial markets become exposed to contagion. Crises can spillover to other countries through real links, financial links, or capital market imperfections such as herding behavior or panics.
Even with the larger exposure to crises and contagion, the evidence suggests that the net effects of financial globalization are still positive, at least in the long run. The main challenge for policy makers is therefore to manage the integration process as to take full advantage of the opportunities, while minimizing its risks. This task is not easy, particularly because financial globalization influences the instruments available to policymakers. In a more integrated world, governments are left with fewer policy tools and thus international financial coordination becomes more important.
The organization of this paper is as follows. Section II and III study how globalization can lead to financial crises and contagion. Section IV presents evidence on the net effects of globalization. Section V discusses the policy options and section VI concludes.
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