Global Trade Liberalization and the Developing Countries - Issues Brief

Globalization: A Framework for IMF Involvement - Issues Brief

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O C C A S I O N A L   P A P E R      
Effects of Financial Globalization on Developing Countries
Some Empirical Evidence

Eswar S. Prasad, Kenneth Rogoff, Shang-Jin Wei, and M. Ayan Kose

©2003 International Monetary Fund
September 9, 2003

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Full text of March 17, 2003 IMF Board document is also available.

I   Overview
Definitions and Basic Stylized Facts
Does Financial Globalization Promote Growth in Developing Countries?
What Is the Impact of Financial Globalization on Macroeconomic Volatility?
Role of Institutions and Governance in Effects of Globalization
II   Basic Stylized Facts
Measuring Financial Integration
North-South Capital Flows
Factors Underlying the Rise in North-South Capital Flows
III   Financial Integration and Economic Growth
Potential Benefits of Financial Globalization in Theory
Empirical Evidence
IV   Financial Globalization and Macroeconomic Volatility
Macroeconomic Volatility
Crises as Special Cases of Volatility
Has Financial Globalization Intensified the Transmission of Volatility?
Some Factors That Increase Vulnerability to Risks of Globalization
V   Absorptive Capacity and Governance in the Benefits/Risks of Globalization
Threshold Effects and Absorptive Capacity
Governance as an Important Element of Absorptive Capacity
Domestic Governance and the Volatility of International Capital Flows
I   The First Era of International Financial Integration, 1870–1913
II   Estimating the Benefits of International Financial Integration on Income Levels for Developing Countries Using a Neoclassical Economic Model
III   Calculating the Potential Welfare Gains from International Risk Sharing
IV   Contingent Securities for International Risk Sharing
V   Small States and Financial Globalization
VI   Data
3.1.   Effects of Different Types of Capital Flows on Growth
3.2.   Do Financial and Trade Integration Have Different Effects on Economic Development? Evidence from Life Expectancy and Infant Mortality
4.1.   Effects of Globalization on Volatility: A Review of Empirical Evidence
4.2.   Herding and Momentum Trading by International Investors
5.1.   Transparency and International Mutual Funds
Text Figures
2.1.   Measures of Financial Integration
2.2.   Gross Capital Flows
2.3.   Net Private Capital Flows
2.4.   Foreign Ownership Restrictions in More Financially Integrated Developing Economies
3.1.   Channels Through Which Financial Integration Can Raise Economic Growth
3.2.   Increase in Financial Openness and Growth of Real Per Capita GDP
3.3.   Increase in Financial Openness and Growth of Real Per Capita GDP: Conditional Relationship, 1982–97
3.4.   Differential Effects of Financial and Trade Integration on Improvements in Health
4.1.   Volatility of Income and Consumption Growth
5.1.   Corruption and Foreign Direct Investment
5.2.   Difference Between Actual International Mutual Fund Investment and MSCI Benchmark: Transparent Versus Opaque Countries
5.3.   Herding and Opacity
5.4.   Corruption Tilts the Composition of Capital Flows Toward Borrowing from Foreign Banks
Appendix Figure
A3.1.   Potential Welfare Gains from International Risk Sharing
Text Tables
2.1.   Volatility of Different Types of Capital Inflows
3.1.   Fastest- and Slowest-Growing Economies During 1980–2000 and Their Status of Financial Openness
3.2.   Summary of Recent Research on Financial Integration and Economic Growth
4.1.   Volatility of Annual Growth Rates of Selected Variables
Appendix Tables
A2.1.   Non-OECD Countries: Gains from International Financial Integration
A3.1.   Summary of Studies on Welfare Gains from International Risk Sharing
A5.1.   Are Small States Different? Some Summary Statistics, 1960–2000

I. Overview

The recent wave of financial globalization that has occurred since the mid-1980s has been marked by a surge in capital flows among industrial countries and, more notably, between industrial and developing countries. Although capital inflows have been associated with high growth rates in some developing countries, a number of them have also experienced periodic collapses in growth rates and significant financial crises that have had substantial macroeconomic and social costs. As a result, an intense debate has emerged in both academic and policy circles on the effects of financial integration on developing economies. But much of the debate has been based on only casual and limited empirical evidence.

The main purpose of this paper is to provide an assessment of empirical evidence on the effects of financial globalization for developing economies. It will focus on three related questions:

(i) Does financial globalization promote economic growth in developing countries?;

(ii) What is its impact on macroeconomic volatility in these countries?; and

(iii) What are the factors that appear to help countries obtain the benefits of financial globalization?

The principal conclusions that emerge from the analysis are sobering but, in many ways, informative from a policy perspective. It is true that many developing economies with a high degree of financial integration have also experienced higher growth rates. It is also true that, in theory, there are many channels through which financial openness could enhance growth. A systematic examination of the evidence, however, suggests that it is difficult to establish a robust causal relationship between the degree of financial integration and output growth performance. From the perspective of macroeconomic stability, consumption is regarded as a better measure of well-being than output; fluctuations in consumption are therefore regarded as having negative impacts on economic welfare. There is little evidence that financial integration has helped developing countries to better stabilize fluctuations in consumption growth, notwithstanding the theoretically large benefits that could accrue to developing countries if such stabilization were achieved. In fact, new evidence presented in this paper suggests that low to moderate levels of financial integration may have made some countries subject to greater volatility of consumption relative to that of output. Thus, while there is no proof in the data that financial globalization has benefited growth, there is evidence that some countries may have experienced greater consumption volatility as a result.

Although the main objective of this paper is to offer empirical evidence, and not to derive a set of definitive policy implications, some general principles nevertheless emerge from the analysis about how countries can increase the benefits from, and control the risks of, globalization. In particular, the quality of domestic institutions appears to play a role. A growing body of evidence suggests that it has a quantitatively important impact on a country's ability to attract foreign direct investment and on its vulnerability to crises. Although different measures of institutional quality are no doubt correlated, there is accumulating evidence of the benefits of robust legal and supervisory frameworks, low levels of corruption, a high degree of transparency, and good corporate governance.

A review of the available evidence does not, however, provide a clear road map for countries that have either started on or desire to start on the path to financial integration. For instance, there is an unresolved tension between having good institutions in place before capital market liberalization and the notion that such liberalization in itself can help a country import best practices and provide an impetus to improve domestic institutions. Furthermore, neither theory nor empirical evidence has provided clear-cut general answers to related issues, such as the desirability and efficacy of selective capital controls. Ultimately, these questions can be addressed only in the context of country-specific circumstances and institutional features.

The remainder of this section provides an overview of the structure of this paper. Section II documents some salient features of global financial integration from the perspective of developing countries. Sections III and IV analyze the evidence on the effects of financial globalization on growth and volatility, respectively, in developing countries. Section V discusses the relationship between the quality of institutions and the benefit-risk trade-off involved in undertaking financial integration.

Definitions and Basic Stylized Facts

Financial globalization and financial integration are, in principle, different concepts. Financial globalization is an aggregate concept that refers to increasing global linkages created through cross-
border financial flows. Financial integration refers to an individual country's linkages to international capital markets. Clearly, these concepts are closely related. For instance, increasing financial globalization is perforce associated with increasing financial integration on average. In this paper, therefore, the two terms are used interchangeably.

Of more relevance for the purposes of this paper is the distinction between de jure financial integration, which is associated with policies on capital account liberalization, and actual capital flows. For example, indicator measures of the extent of government restrictions on capital flows across national borders have been used extensively in the literature. On the one hand, using this measure, many countries in Latin America would be considered closed to financial flows. On the other hand, the volume of capital actually crossing the borders of these countries has been large relative to the average volume of such flows for all developing countries. Therefore, on a de facto basis, these Latin American countries are quite open to global financial flows. By contrast, some countries in Africa have few formal restrictions on capital account transactions but have not experienced significant capital flows. The analysis in this paper will focus largely on de facto measures of financial integration, as it is virtually impossible to compare the efficacy of various complex restrictions across countries. In the end, what matters most is the actual degree of openness. However, the paper will also consider the relationship between de jure and de facto measures.

A few salient features of global capital flows are relevant to the central themes of the paper. First, the volume of cross-border capital flows has risen substantially in the last decade. There has been not only a much greater volume of flows among industrial countries but also a surge in flows from industrial to developing countries. Second, this surge in international capital flows to developing countries is the outcome of both "pull" and "push" factors. Pull factors arise from changes in policies and other aspects of opening up by developing countries. These include liberalization of capital accounts and domestic stock markets, and large-scale privatization programs. Push factors include business-cycle conditions and macroeconomic policy changes in industrial countries. From a longer-term perspective, this latter set of factors includes the rise in the importance of institutional investors in industrial countries and demographic changes (for example, the relative aging of the population in industrial countries). The importance of these factors suggests that notwithstanding temporary interruptions during crisis periods or global business-cycle downturns, the past twenty years have been characterized by secular pressures for rising global capital flows to the developing world.

Another important feature of international capital flows is that the components of these flows differ markedly in terms of volatility. In particular, bank borrowing and portfolio flows are substantially more volatile than foreign direct investment. Although accurate classification of capital flows is not easy, evidence suggests that the composition of capital flows can have a significant influence on a country's vulnerability to financial crises.

Does Financial Globalization Promote Growth in Developing Countries?

This subsection of the paper will summarize the theoretical benefits of financial globalization for economic growth and then review the empirical evidence. Financial globalization could, in principle, help to raise the growth rate in developing countries through a number of channels. Some of these directly affect the determinants of economic growth (augmentation of domestic savings, reduction in the cost of capital, transfer of technology from advanced to developing countries, and development of domestic financial sectors). Indirect channels, which in some cases could be even more important than the direct ones, include increased production specialization owing to better risk management, and improvements in both macroeconomic policies and institutions induced by the competitive pressures or the "discipline effect" of globalization.

How much of the advertised benefits for economic growth have actually materialized in the developing world? As documented in this paper, average per capita income for the group of more financially open (developing) economies grows at a more favorable rate than that of the group of less financially open economies. Whether this actually reflects a causal relationship and whether this correlation is robust to controlling for other factors, however, remain unresolved questions. The literature on this subject, voluminous as it is, does not present conclusive evidence. A few papers find a positive effect of financial integration on growth. The majority, however, find either no effect or, at best, a mixed effect. Thus, an objective reading of the results of the vast research effort undertaken to date suggests that there is no strong, robust, and uniform support for the theoretical argument that financial globalization per se delivers a higher rate of economic growth.

Perhaps this is not surprising. As noted by several authors, most of the cross-country differences in per capita incomes stem not from differences in the capital-labor ratio but from differences in total factor productivity, which could be explained by "soft" factors such as governance and the rule of law. In this case, although embracing financial globalization may result in higher capital inflows, it is unlikely, by itself, to cause faster growth. In addition, as is discussed more extensively later in this paper, some of the countries with capital account liberalization have experienced output collapses related to costly banking or currency crises. An alternative possibility, as noted earlier, is that financial globalization fosters better institutions and domestic policies but that these indirect channels can not be captured in standard regression frameworks.

In short, although financial globalization can, in theory, help to promote economic growth through various channels, there is as yet no robust empirical evidence that this causal relationship is quantitatively very important. This points to an interesting contrast between financial openness and trade openness, since an overwhelming majority of research papers have found that the latter has had a positive effect on economic growth.

What Is the Impact of Financial Globalization on Macroeconomic Volatility?

In theory, financial globalization can help developing countries to better manage output and consumption volatility. Indeed, a variety of theories imply that the volatility of consumption relative to that of output should decrease as the degree of financial integration increases; the essence of global financial diversification is that a country is able to shift some of its income risk to world markets. Since most developing countries are rather specialized in their output and factor endowment structures, they can, in theory, obtain even bigger gains than developed countries through international consumption risk sharing—that is, by effectively selling off a stake in their domestic output in return for a stake in global output.

How much of the potential benefits, in terms of better management of consumption volatility, has actually been realized? This question is particularly relevant in terms of understanding whether, despite the output volatility experienced by developing countries that have undergone financial crises, financial integration has protected them from consumption volatility. New research presented in this paper paints a troubling picture. Specifically, although the volatility of output growth has, on average, declined in the 1990s relative to the three preceding decades, the volatility of consumption growth relative to that of income growth has, on average, increased for the emerging market economies in the 1990s, which was precisely the period of a rapid increase in financial globalization. In other words, as is argued in more detail later in the paper, procyclical access to international capital markets appears to have had a perverse effect on the relative volatility of consumption for financially integrated developing economies.

Interestingly, a more nuanced look at the data suggests the possible presence of a threshold effect. At low levels of financial integration, an increment in the level of financial integration is associated with an increase in the relative volatility of consumption. Once the level of financial integration crosses a threshold, however, the association becomes negative. In other words, for countries that are sufficiently open financially, relative consumption volatility starts to decline. This finding is potentially consistent with the view that international financial integration can help to promote domestic financial sector development, which, in turn, can help to moderate domestic macroeconomic volatility. Thus far, however, these benefits of financial integration appear to have accrued primarily to industrial countries.

In this vein, the proliferation of financial and currency crises among developing economies is often viewed as a natural consequence of the "growing pains" associated with financial globalization. The latter can take various forms. First, international investors have a tendency to engage in momentum trading and herding, which can be destabilizing for developing economies. Second, international investors may (together with domestic residents) engage in speculative attacks on developing countries' currencies, thereby causing instability that is not warranted based on their economic and policy fundamentals. Third, the risk of contagion presents a major threat to otherwise healthy countries, since international investors could withdraw capital from these countries for reasons unrelated to domestic factors. Fourth, a government, even if it is democratically elected, may not give sufficient weight to the interest of future generations. This becomes a problem when the interests of future and current generations diverge, causing the government to incur excessive amounts of debt. Financial globalization, by making it easier for governments to incur debt, might aggravate this "overborrowing" problem. These four hypotheses are not necessarily independent and can reinforce each other.

There is some empirical support for these hypothesized effects. For example, there is evidence that international investors do engage in more herding and momentum trading in emerging markets than in developed countries. Recent research also suggests the presence of contagion in international financial markets. In addition, some developing countries that open their capital markets appear to accumulate unsustainably high levels of external debt.

To summarize, one of the theoretical benefits of financial globalization, other than enhancing growth, is allowing developing countries to better manage macroeconomic volatility, especially by reducing consumption volatility relative to output volatility. The evidence suggests, instead, that countries in the early stages of financial integration have been exposed to significant risks in terms of higher volatility of both output and consumption.

Role of Institutions and Governance in Effects of Globalization

Although it is difficult to find a simple relationship between financial globalization and growth or consumption volatility, there is some evidence of nonlinearities or threshold effects in the relationship. Financial globalization, in combination with good macroeconomic policies and good domestic governance, appears to be conducive to growth. For example, countries with good human capital and governance tend to do better at attracting foreign direct investment (FDI), which is especially conducive to growth. More specifically, recent research shows that corruption has a strongly negative effect on FDI inflows. Similarly, transparency of government operations, which is another dimension of good governance, has a strong positive effect on investment inflows from international mutual funds.

The vulnerability of a developing country to the risk factors associated with financial globalization is also not independent of the quality of macroeconomic policies and domestic governance. For example, research has demonstrated that an overvalued exchange rate and an overextended domestic lending boom often precede a currency crisis. In addition, lack of transparency has been shown to be associated with more herding behavior by international investors, which can destabilize a developing country's financial markets. Finally, evidence shows that a high degree of corruption may affect the composition of a country's capital inflows, thereby making it more vulnerable to the risks of speculative attacks and contagion effects.

Thus, the ability of a developing country to derive benefits from financial globalization and its relative vulnerability to the volatility of international capital flows can be significantly affected by the quality of both its macroeconomic framework and its institutions.


The objective of the paper is not so much to derive new policy propositions as it is to inform the debate on the potential and actual benefit-risk trade-offs associated with financial globalization by reviewing the available empirical evidence and country experiences. The main conclusions are that, so far, it has proven difficult to find robust evidence supporting the proposition that financial integration helps developing countries to improve growth rates and reduce macroeconomic volatility.

Of course, the absence of robust evidence on these dimensions does not necessarily mean that financial globalization has no benefits and carries only great risks. Indeed, most countries that have initiated financial integration have continued along this path despite temporary setbacks. This observation is consistent with the notion that the indirect benefits of financial integration, which may be difficult to pick up in regression analysis, could be quite important. Also, the long-run gains, which in some cases have not yet been realized, may exceed the short-term costs. For instance, although Europe's efforts to achieve monetary integration resulted in its being buffeted by severe and costly crises in the early 1990s, these efforts eventually brought about the transition to the single currency in use throughout much of Europe today.

Although it is difficult to distill new and innovative policy messages from the review of the evidence, there appears to be empirical support for some general propositions. Empirically, good institutions and quality of governance are important not only in their own right but also in helping developing countries derive the benefits of globalization. Similarly, macroeconomic stability appears to be an important prerequisite for ensuring that financial integration is beneficial for developing countries. In this regard, the IMF work in promulgating standards and codes for best practices on transparency and financial supervision, as well as sound macroeconomic frameworks, is crucial. These points may already be generally accepted; the contribution of this paper is to show that there is some systematic empirical evidence to support them. In addition, the analysis suggests that financial globalization should be approached cautiously and with good institutions and macroeconomic frameworks viewed as preconditions.

This paper does not tackle the appropriate choice of an exchange rate regime or of monetary and fiscal policies. It is worth noting, however, that fixed or de facto fixed exchange rate regimes and excessive government borrowing appear to be major factors that have compounded the problems that some developing countries have had in managing capital flows. We leave a systematic examination of these issues for future research.