IMF Survey: Putting Financial Globalization to Work

IMF News, August 16, 2007

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Capital flows to emerging market and developing countries are soon expected to top $1 trillion.
Publication: IMF Survey by Paolo Mauro and Jonathan D. Ostry, IMF Research Department, August 16, 2007.
The central question: Is financial globalization primarily an opportunity to share risk internationally and finance investment projects that are good for growth, or is it a source of possible volatility and crises caused by sudden reversals in capital flows?

The issue: Balance risks and benefits of financial globalization for different country groups.
Policy considerations:
- Opening up to FDI at an early stage is likely to benefit all countries.
- Liberalizing short-term debt-creating inflows should account for a country's financial market development, perceived institutional quality, and macroeconomic policies.
- Delays in opening up also carry costs.
Policy implications: Capital account liberalization should be pursued as part of a broader reform package encompassing a country's macroeconomic policy framework, domestic financial system, and prudential regulation.

Lesson 1:
- Advanced economies largely benefit from free movement of capital.
- Emerging market and developing countries should meet certain thresholds—quality of institutions and policymaking and level of domestic financial development—before opening up the capital account; otherwise financial liberalization can lead to macroeconomic volatility.
Lesson 2:
- There are costs to being overly cautious about capital flows: opening up may stimulate domestic financial sector development and efficiency improvements that support growth.

Theoretical benefits:
- Encourages international risk sharing.
- Stabilizes spending by households and the government by allowing international capital to supplement domestic capital.
- Fosters economic growth.
Empirical findings:
- Advanced countries have benefited from risk sharing; emerging market and developing countries show little evidence of similar benefits.
- International financial integration has increased volatility, but mainly in countries with relatively weak domestic financial sectors and institutions.
- Impact on growth:
- FDI encourages long-run growth: an increase in FDI of 10 percentage points of GDP increases growth by 0.3 percentage points on average.
- The impact of debt on growth depends on whether the money is put to good use, influenced by the quality of policies and institutions.
- Financial globalization does not seem to make countries more vulnerable to crisis; crises are, if anything, less frequent in financially open economies.
- Financially open countries with well-developed domestic financial systems, strong institutions, sound policies, and open trade have an even lower risk of experiencing a crisis.

Financial sector development: Well-developed financial markets help moderate boom-bust cycles triggered by surges and sudden stops in financial flows.
Institutional quality: Strong institutions—including the rule of law, freedom from corruption, and government efficiency—direct financial flows toward FDI and portfolio equity, facilitating international risk sharing and growth.
Sound macroeconomic policies: Weak macroeconomic policies can lead financial openness to result in excessive borrowing and debt accumulation, increasing crisis risk.
Trade integration: Openness to trade reduces likelihood of sudden stops in inflows and current account reversals and can mitigate crisis effects by facilitating recovery.

Lower international trade:
- Capital controls encourage fraud through mis-invoicing.
- New research suggests capital controls increase the cost of engaging in international trade even for firms that do not seek to evade controls.
Higher cost of capital:
- Capital controls make it more difficult and expensive for small firms to raise capital.
- The cost of borrowing is also higher (about 5 percent on average) for multinationals located in countries with capital controls than in countries without them.
Distortions in the economy:
- Economic behavior is likely to be distorted as individuals and firms seek ways to evade measures, potentially favoring well-connected firms over more efficient ones.
Administrative costs:
- Governments spend significant resources on monitoring compliance with capital controls and on updating them to close loopholes and limit evasion.

Pursue capital account liberalization as part of a broader reform package covering macroeconomic policy, domestic financial system, and prudential regulation.
Liberalize long-term, non-debt-creating flows (such as FDI) before liberalizing short-term, debt-creating inflows.
Before liberalizing other types of flows, ensure the country meets thresholds where net benefits of financial globalization become positive.
Assess readiness of the financial sector and level of institutional development before opening the capital account, while weighing risks of opening against efficiency costs of capital controls.

Net benefits from financial integration are likely to become more substantial in the future because:
- Markets are moving toward a more equity-based structure, which tends to benefit international risk sharing and growth.
- Many emerging market countries have reformed their economies, bringing them up to thresholds where benefits of financial globalization begin to outweigh risks.
These developments should make it easier for countries to reap the benefits of financial globalization in the years ahead.

IMF Survey: Putting Financial Globalization to Work — IMF Research Department, Paolo Mauro and Jonathan D. Ostry, August 16, 2007.