IMF Survey: Why is the IMF looking at financial integration and globalization at this juncture? Is it having second thoughts about their benefits?
Rogoff: Our study could be viewed as building on work that was carried out by the Research Department as far back as 40 years ago. The benefits of financial integration and globalization are an issue whose nuances the IMF is continuously rethinking. People who have followed our work over the past 20 years won’t find anything strikingly new in our paper. You might find many similar results—at least at a theoretical level and, to some extent, at an empirical level—in my 1996 study with Maurice Obstfeld.
Financial globalization’s benefits include cheaper access to capital, transfer of technology, and development of the banking system.
IMF Survey: How do you measure financial integration? Have developing economies been active participants?
Prasad: Measuring financial integration is a rather complicated issue. We take two approaches. One is to look at measures of capital account restrictions or legal controls on capital inflows or outflows. But a more important measure is realized capital flows. These two measures, while closely related, are quite different for some countries. For example, a few countries in Latin America that restricted capital flows in the 1980s actually experienced fairly large capital outflows. They were financially integrated with the global economy in some respects, although they did not entirely intend to be so. In contrast, some countries in Africa that do not have capital account restrictions have, nevertheless, not received significant capital inflows.
During the past decade and a half, developing countries have become much more involved in financial globalization. In fact, capital flows from the industrial countries to developing countries have skyrocketed, but they have gone to a relatively small number of countries. Around 20 of the developing economies we studied—the ones that we refer to as more financially integrated—account for a substantial portion of these flows.
So participation in financial globalization has varied across countries, as has the nature of the capital flows. Some countries have seen great surges in foreign direct investment, while others have received more capital inflows in the form of bank lending or portfolio inflows. These differences have important implications. In particular, foreign direct investment flows tend to be much more stable and thus may be more beneficial for the economies that receive them. By contrast, bank lending and portfolio flows tend to be more volatile and, especially in turbulent times, can be reversed much more quickly. So it’s not just the aggregate amount of capital inflows but also their nature that eventually determine the quality of a country’s experiences with financial globalization.
IMF Survey: What has spurred increased capital flows to developing countries during the past two decades? In view of recent financial crises in many developing countries, are they likely to be left behind as financial globalization advances?
Wei: Broadly speaking, both pull and push factors influence capital flows. Pull factors are policies and developments in developing countries that tend to draw in capital from rich, industrial countries. They include liberalization of domestic stock markets and other financial markets, lifting of controls on capital inflows, and privatization programs. Push factors refer to policies in industrial countries or developments in global financial markets that increase capital outflows. These include macroeconomic policies, business cycle developments, and, in recent years, the rise of institutional investors, such as the increased popularity of mutual funds as savings vehicles.
Whether developing countries will be left behind depends in large part on whether they manage to put in place sound macroeconomic policies, improved governance (including controlling corruption), and strengthened banking supervision. Those that do so will have a fairly good chance of continuing to receive not only a large share of capital inflows but also the more beneficial types of capital flows, such as foreign direct investment.
IMF Survey: Why is financial globalization considered good for developing countries?
Kose: In theory, there are numerous direct and indirect channels through which financial globalization can increase potential growth in developing countries. When we think about the direct channels, it is easy to see how capital flows could increase investment in capital-poor developing countries, reduce the cost of capital, help stimulate domestic financial sector development, and generate technology spillovers from industrial countries. These direct channels have been extensively studied in the theoretical literature.
While acknowledging the importance of direct channels, our study also emphasizes the critical role played by indirect channels, which have been becoming an important research area in recent years. We describe three indirect channels in our study. First, financial globalization provides a set of instruments for risk sharing, which would, in turn, indirectly encourage specialization and raise the growth rate. Second, a country’s willingness to undertake financial integration has a signaling value, as it indicates that the country is going to implement investment-friendly policies. Third, and probably most important, financial integration is a commitment device in the sense that a country makes a promise to discipline its future course of policies. Recent research has shown that this type of commitment to “good” policies could shift investment to more productive activities and increase aggregate productivity in a developing economy.
IMF Survey: How much of these advertised benefits have actually materialized in the developing world?
Wei: From the available data, it is difficult to prove that financial integration leads to faster growth in the developing world or that the positive effect, if any, is quantitatively significant. For example, out of 14 recent studies looking into the question, 3 found positive relationships between these two variables. Most studies have failed to find a positive effect for developing countries.
IMF Survey: Does this weaken the argument in favor of financial integration?
Wei: It certainly is consistent with the view that one needs to be cautious in approaching financial integration.
IMF Survey: Does the exchange rate system play a role in financial integration?
Rogoff: We did not look at exchange rate regimes in this paper. One lesson from the Asian crisis was that fixed exchange rates, or de facto fixed exchange rates, can be a lightning rod for catastrophe in economies with very integrated capital markets and open financial markets. Further studies need to separate these issues—it was too much for us to tackle here.
IMF Survey: What is the impact of financial globalization on macroeconomic volatility in developing countries?
Prasad: Economic theory is less clear about the impact of financial integration on output volatility than on growth. However, it does predict that international financial integration should reduce consumption volatility because countries and individuals with access to international capital markets can use financial instruments to diversify the risk that is specific to their own income or output.
One interesting result we report is that, contrary to the predictions of theory, consumption volatility, in fact, rose in the 1980s and 1990s in the more financially integrated economies. Much more research is needed to understand exactly why. One possibility is that many of these countries liberalized their financial sectors and capital accounts at the same time, and that may have fueled consumption booms. In addition, these countries’ access to capital markets has proved to be somewhat procyclical. When they were hit by adverse economic shocks, these countries lost access to capital markets and the ability to reduce fluctuations in consumption.
A particularly egregious manifestation of volatility is a financial crisis. During the 1990s, developing countries—particularly the more financially integrated ones—were especially vulnerable to them. The industrial countries had their fair share in previous decades. It looks like some of the industrial countries have now managed to achieve the benefits of financial integration in terms of lower volatility, while developing countries have not yet done so.
IMF Survey: So financial globalization has increased the risk that developing countries will face economic crises?
Kose: Yes, it is hard to argue that capital account liberalization has not often been accompanied by increased vulnerability to crises. Financial globalization has heightened these risks, since cross-country financial linkages amplify the effects of various shocks and transmit them more quickly across national borders. Having said this, we need to acknowledge that being a part of a financially integrated world economy is quite a new phenomenon for these countries. It is natural that there has been a period of adjustment and learning. While financial globalization has increased these countries’ vulnerability to crises in the short run, one would expect that being a financially integrated economy helps them deal with crises in the long run.
Unfortunately, there is no magic policy prescription for alleviating the risks associated with financial globalization. It is always critical to implement sound fiscal, monetary, and exchange rate policies and to create an environment that could attract more stable capital flows. Recent research shows the importance of implementing sustainable fiscal policies in open economies, as the maturity structure of external debt seems to be a critical factor. More important, the exchange rate regime becomes a crucial policy choice in a financially integrated economy. As Ken mentioned, while fixed, or de facto fixed, exchange rate regimes may have some advantages, they very often unravel abruptly and disruptively, a problem that appears to have played a major role, for example, in the Asian crisis of the late 1990s. Our study has also provided empirical evidence about the importance of good governance practices and the quality of institutions in helping developing countries derive the benefits of financial globalization while minimizing the risks associated with it.
IMF Survey: Have India and China been wise to move slowly on capital account liberalization? Was Malaysia right to slap on capital controls during the Asian crisis?
Rogoff: It’s hard to argue with China’s growth performance over the past 20 years, and it’s not easy to second-guess the authorities’ efforts to manage the difficult economic, social, and political challenges they faced in moving from an extremely poor, rural agrarian economy in the 1970s to essentially a middle-income economy, at least for the 450 million people living in coastal China. That said, at some point, as the Chinese economy becomes more integrated with the global economy, and especially through its recent WTO [World Trade Organization] commitments, it will face many economic pressures to gradually liberalize its capital markets further. Put another way, coastal China has an annual income of about $2,500 a person at purchasing power parity prices. But if it is to move to a level that rich countries enjoy, it will have to work toward something very different. No industrial country today has any significant capital controls.
India is another matter. I don’t think one would want to argue that it should have pursued greater capital market liberalization in isolation from other reforms. In fact, trade liberalization should be given greater priority. Whereas China’s trade now accounts for 5 percent of world trade, India’s still accounts for only 0.5 percent. There is tremendous scope for India to liberalize its markets and trade and, after it has made significant advances in these areas, to think further about capital market liberalization.
Regarding Malaysia, studies argue both for and against its imposition of capital controls. It’s hard to argue that Malaysia was wrong, but some countries that have tried to imitate it have not done so well. I would draw special attention to Argentina, where the cost of its 2001 debt crisis was greatly exacerbated by its decision to freeze bank accounts and introduce exchange controls. These measures really locked up the economy and deepened the postcrisis recession.
IMF Survey: Is there a right time to liberalize capital accounts? How should countries assess the risks?
Prasad: Certain preconditions—notably good macroeconomic frameworks, sound institutions, and well-developed domestic financial markets—can help countries reduce the risks associated with financial integration. Well-regulated and supervised financial markets are very important for ensuring that capital inflows are channeled to productive uses.
Some of the volatility countries face when they liberalize capital accounts is intrinsic to financial globalization, because international capital flows do tend to be volatile. And, for some smaller countries, volatile capital flows can have fairly large macroeconomic effects. By putting in place some supporting conditions before capital account liberalization takes place and, to some extent, controlling the nature of capital inflows, countries can, in fact, reduce the risks.
IMF Survey: Once they liberalize their capital account, countries rarely seem to reverse that decision. Does that suggest that, once done, liberalization’s benefits outweigh its costs?
Wei: Countries that have liberalized their capital accounts seldom reverse course, at least not more than temporarily. This suggests that, in these countries’ own assessment, the cost of reversing outweighs the benefits. This does not contradict the idea that a set of preconditions needs to be put in place before a country embraces financial globalization. It’s like going whitewater rafting—it may be better to go forward once you are in the water. At the same time, if you have not yet gotten into the water, it’s always better to make sure that you have the right gear before you plunge in.
IMF Survey: Do your findings support those who have been critical of the policies the IMF has been pursuing over recent decades?
Rogoff: All advanced economies have open capital markets. In Asia, developing countries are still moving toward more liberalized capital markets—even countries that experienced great problems during the 1990s—but with refinements having to do with macroeconomic stability, flexible exchange rates, and improved regulation and governance. It’s a bit farfetched to view our study as questioning everything that has been done over the past decades. Development is a multidimensional process, and no one has the answer to everything. The IMF’s core advice is sound, and it is constantly being refined as the world advances. Our job in the Research Department is to ask how we can learn from experience and how things can be improved.
IMF Survey: How can the IMF help developing countries get the most out of globalization while reducing its inherent risks?
Prasad: Compared with a couple of decades ago, when financial markets across the world were not as closely linked as they are now, the IMF is looking at policies in a broader perspective, one that includes structural policies and institution building as well as macroeconomic policies. The IMF is helping developing countries build their capacity in these dimensions through technical assistance and such tools as Financial Sector Assessment Programs and the Reports on the Observance of Standards and Codes. Nevertheless, a delicate balance needs to be found between building the right institutions and opening up to financial globalization. Financial integration brings with it some benefits in terms of improving those institutions, for instance, via the transfer of technical and managerial knowledge. Our perspective is that a country does not need to have perfect institutions before it embarks on financial globalization, but it should have at least basic, adequate policies and institutions in place.
The full text of “Effects of Financial Globalization on Developing Countries: Some Empirical Evidence,” by Eswar Prasad, Kenneth Rogoff, Shang-Jin Wei, and M. Ayhan Kose, is available on the IMF’s website (http://www.imf.org). The material will also be published in August 2003 as Occasional Paper No. 220.