A Pragmatic Approach to Coping with Financial Globalization

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A Pragmatic Approach to Coping with Financial
Globalization
Eswar Prasad Cornell University

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Benefits of Financial Integration Theory

• Efficient international allocation of capital
• Consumption smoothing via international risk
  sharing
• Large welfare effects for developing economies

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Growth Benefits of Financial Integration Evidence

• About 25 studies of growth effects
• No effect 4
• Mixed 18
• Positive 3
• No robust macroeconomic evidence
• of growth benefits

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Correlation between Growth and Current A/c
Balance Non-industrial Countries, 1970-2004
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Volatility and Risk Sharing

• No evidence that financial integration by itself
  is proximate determinant of financial crises
• Developing economies, including emerging markets,
  have not attained better risk sharing

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Other Ways of Looking at the Data

• Effects of different types of private capital
  flows
• gt Equity flows
• gt FDI
• gt Debt
• Macroeconomic vs. microeconomic evidence

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Summary of New Evidence

• Equity market liberalization seems to work
• FDI benefits becoming more apparent
• Benefits more evident in micro data

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The Traditional View
More efficient international allocation of
capital Capital deepening International
risk-sharing
GDP growth Consumption volatility
Financial Globalization
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A Different Perspective
Traditional Channels
Potential Collateral Benefits Financial market
development Institutional development Better
governance Macroeconomic discipline
GDP / TFP Growth Consumption volatility
Financial Globalization
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FG and Financial Development

• Foreign ownership of banks improves efficiency of
  domestic banking system
• Inflows add to depth of equity markets
• Financial sector FDI has benefits

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FG and Quality of Institutions, Governance

• Openness to foreign capital provides incentives
  for improving corporate governance
• Corruption, lack of transparency discourage FDI,
  portfolio flows gt
• incentives for improving public governance

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Complication Threshold Effects
GDP / TFP growth Risks of Crises
Above Thresholds
Threshold Conditions Financial market
development Institutional Quality,
Governance Macroeconomic policies Trade
integration
X
Financial Globalization
?
GDP / TFP growth Risks of Crises
Below Thresholds
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Why Do Thresholds Matter?

• Financial Market Development
• - Allocates financial flows efficiently
• - Enhances macroeconomic stability
• Institutional Quality
• - Affects the volume and stability of financial
  flows
• - Shifts the composition of flows towards FDI
  and equity
• Trade Openness
• - Makes less vulnerable to sudden stops
• - Mitigates the adverse effects of financial
  crises

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TENSION !!

• Financial integration can catalyze financial
  development, improve governance, impose
  discipline on macro policies...
• But, in the absence of a basic pre-existing level
  of these supporting conditions, financial
  integration can wreak havoc

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Collateral Benefits Framework May Help Make
Progress

• Unified conceptual framework
• Country-specific requirements, initial conditions
  can be taken into account
• Selective approach to liberalization based on
  prioritization of collateral benefits
• Can manage risks during transition to thresholds,
  but can not eliminate them

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Has the Benefit-Cost Tradeoff Improved?

• Composition of inflows and stocks of external
  liabilities has become more favorable

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Has the Benefit-Cost Tradeoff Improved?

• Composition of inflows and stocks of external
  liabilities has become more favorable
• High levels of foreign exchange reserves

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Has the Benefit-Cost Tradeoff Improved?

• Composition of inflows and stocks of external
  liabilities has become more favorable
• High levels of foreign exchange reserves
• Greater exchange rate flexibility, with inflation
  targeting
• Rising trade openness

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Has the Benefit-Cost Tradeoff Improved?

• Composition of inflows and stocks of external
  liabilities has become more favorable
• High levels of foreign exchange reserves
• Greater exchange rate flexibility, with inflation
  targeting
• Rising trade openness
• New players, new instruments have made
  international financial markets deeper and more
  efficient

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But

• Many developing economies still below threshold
  levels of financial, institutional development
• Still de facto fixed or tightly-managed exchange
  rates
• Inflation targeting creates problems when there
  are surges in inflows
• Real exchange rate appreciations hurts poor and
  undeveloped economies
• Herding behavior of unregulated investors such as
  hedge funds risks in system harder to trace

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Reality on the Ground

• De facto financial openness increasing over time
• Capital controls becoming less effective
• gt Expansion of trade
• gt Larger international financial flows
• gt Rising sophistication of international
  investors
• Trying to maintain rigid capital controls doesnt
  solve inflows problem creates distortionary
  costs

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Implications

• Best to actively manage the process of capital
  account liberalization rather than fight the
  inevitable
• Seize windows of opportunity when benefit-risk
  tradeoff improves but coast is never completely
  clear.
• Capital account liberalization not an end in
  itself
• needs to be put in the context of a more
  complete
• policy/reform agenda

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Broader Policy Messages

• Need more room for macro policies to respond to
  domestic and external shocks
• Broader range of financial markets, greater
  financial depth can help deal with shocks, make
  transmission of macro policies more efficient
• Financial integration can support and catalyze
  other reforms, especially financial development
• Make room for financial innovations--incentives
  and flexible regulatory structures
• Excessive caution may have its own cost

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International Business Cycles

• Convergence among industrial and emerging market
  economies divergence between them
• Nonlinearities
• gt Large shocks in U.S. may have
  large spillover effects smaller shocks may not
• (recessions vs. slowdowns)
• Financial convergence real decoupling ?
• gt Financial shocks get transmitted quickly
• gt Do deeper financial markets insulate real
  economy from financial shocks?