Select references: Prasad, Rogoff, Wei,
Kose (2003); Kaminsky, Reinhart (1999);
Obstfeld and Rogoff (1998); Kaminsky,
Reinhart, Vegh (2004)
THE SECOND ERA OF GLOBALIZATION
1985- present
Unprecedented increases in the trade and financial integration
Based on the sample of 76 countries (Prasad Rogoff, Wei, Kose (2003))
•
Volume of trade as a share of GDP increased from 75% in 1980s to
150% at the end of 1990s
•
Countries with liberalized trade regimes increased from 30% to 85%
with open financial accounts increased from 20% to 55%
•
Increase in the capital flows from Industrialized to Developing countries
Figure 2.3. Net Private Capital Flows
(Billions of U.S. dollars)
180
All Developing Economies
160
Bank lending
140
Portfolio flows
120
FDI
100
80
60
40
20
0
–20
1970
180
160
75
80
85
9
More Financially Integrated Economies
140
120
100
90
7
Portfolio flows
6
FDI
5
Bank lending
Portfolio flows
FDI
4
80
3
60
2
40
1
20
0
0
–1
–20
Less Financially Integrated Economies
8
Bank lending
95
1970
75
80
85
90
95
–2
1970
75
80
85
90
95
Source: IMF, World Economic Outlook, various issues.
Notes: Bank lending to the mor e financially integrated economies was negativ e between 1997 and 1999. FDI denotes foreign direct investment.
FINANCIAL GLOBALIZATION AND GROWTH:
THEORY AND EVIDENCE
How did financial integration affect economic outcomes?
Things to keep in mind:
Experience with globalization is relatively recent for many countries– empirical
evidence can be misleading.
The “growing pains” of countries learning to live in globalized world can result in
both success and failure
The current data may reflect the “short run” as opposed to the “long run” effect
of financial integration.
The big question: what can we learn from countries experience to reap the
benefits of financial integration while minimizing the costs?
FINANCIAL GLOBALIZATION AND GROWTH:
THEORY PERSPECTIVE
Growth theory: one of the key ingredients in economic growth is
domestic private investment It (contributes to capital stock)
Production function general form : Y = A*(KaL1-a)
Were Y – output (GDP); A – technology ; K- capital stock; L – quantity
of labor used in production;
a – parameter that tells us by how much (in percent) output will
increase if K increases by 1%
Production function exhibits “diminishing returns to capital” – each
unit of capital increases output, but at a decreasing rate
IMPLICATIONS FOR DEVELOPING ECONOMIES
Openness to foreign capital flows has several important benefits
Directly
- provides an additional source of savings (the country does not have to sacrifice
current consumption for the sake of future output growth)
Closed economy: Y = C + I + G
=> Y-C-G = I
In the closed economy investment must equal to national
savings ( Y-C-G). This creates potential for a poverty trap when Y is very low.
Open economy : Y = C + I + G + CA
CA – indicates how much the country is lending/borrowing from
the rest of the world
=> ( Y-C-G) – CA = I
IN ORDER TO INVEST THE OPEN ECONOMY DOES NOT NEED TO RELY ON NATIONAL SAVINGS
ALONE.
IMPLICATIONS FOR DEVELOPING ECONOMIES
In theory countries with lowest capital stock should attract the most
capital.
Why? Due to diminishing returns, the return on capital is much
higher when the stock of capital is low.
Financially open economies should be better able to diversify
country-specific risk
Better risk-sharing results in the lower cost of capital, increases
domestic investment.
Competitiveness improves the quality of DOMESTIC financial
institutions (better, more efficient domestic banks)
IMPLICATIONS FOR DEVELOPING ECONOMIES
Indirectly:
Financial integration ENCOURAGES SPECIALIZATION by allowing
better risk diversification options
Financial integration may constrain the country’s government to
pursue better policies (the cost of bad policy decisions is greatly
increased in financially integrated economies)
Signaling effect: liberalization of financial markets may signal
broader policy reforms favorable to foreign investment
EMPIRICAL EVIDENCE
At first glance there seems to be a positive correlation between financial openness
and economic growth.
BUT correlation does not imply causation
Could growth be caused by other factors unrelated to financial openness?
Could it be that economies which are fast growing to begin with also tend to
experience higher financial openness?
Most recent empirical studies: accounting for other factors, financial openness has at
best weak association with economic growth.
CONCLUSION: FINANCIAL OPENNESS ON ITS OWN DOES NOT GUARANTEE HIGHER
ECONOMIC GROWTH
EXPLAINING THE THEORY- EMPIRICS
DISCONNECT
Capital accumulation alone can increase growth but only up to a point
Solow growth model: because capital breaks down/becomes obsolete, the country
must invest every year just to keep the capital stock at the existing level.
The larger the capital stock, the more investment is needed just to keep it up.
At some point the country’s entire savings will be devoted just to replace the obsolete
and worn out capital stock. (at that point the growth of capital stock would stop)
Example: USSR in the 1960s – growth driven by capital accumulation
Modern day China – output growth driven in part by factors other than
capital and labor (technology improvements?)
Strong institutions and productivity improvements, rather than capital accumulation, are
responsible for differences in the growth rates and levels of output per capita between
countries
EXPLAINING THE THEORY- EMPIRICS
DISCONNECT
Financial openness and economic volatility:
Financial openness is often accompanied by financial crises – currency, banking and twin
crises (all of them are damaging to output in the short run and some of them possibly
in the long run).
Financial openness promotes specialization, which can make the country more vulnerable
to output shocks.
This is not a problem if a country can borrow in bad times and repay in good times.
BUT:
Developing countries often experience SUDDEN STOPS - abrupt reversals of
capital flows from abroad during bad times. This amplifies the cost of financial crises
and output shocks.
Figure 4.1. Volatility of Income and
Consumption Growth
(10-year rolling standard deviations; medians for each group of
countries)
0.10
0.09
Income
LFI countr ies
0.08
0.07
0.06
MFI countr ies
0.05
0.04
0.03
0.02
Industr ial countr ies
0.01
0
1970
74
78
82
86
90
94
national lev
economies,
ternational c
Consisten
ture sugges
flows appea
sumption vo
manifestatio
non of “sud
and Reinhar
national cap
which tends
well as exc
that of incom
that sovereig
spreads on
strongly infl
costs of bor
cyclical as w
sent more d
ior of capita
98
Crises as
0.10
0.09
Total Consumption
0.08
LFI countr ies
0.07
0.06
0.05
0.04
MFI countr ies
0.03
0.02
Industr ial countr ies
0.01
0
1970
74
78
82
86
90
94
98
Source: Kose, Prasad, and Terrones (2003a).
Note: MFI denotes more financially integrated, and LFI less
financially integrated, economies.
Crises ca
episodes of
nancial crise
aspects of th
over the last
recent crises
led to these
of the unequ
and risks. T
about wheth
time, what f
whether suc
globalization
Some as
changed ove
vu all over a
episodes in
capital acco
to as curren
EXPLAINING THE THEORY- EMPIRICS
DISCONNECT
Capital flows into developing countries depend on both external and internal factors:
External:
- macroeconomic conditions and shocks in industrialized countries. Example: low
US interest rates usually imply heavy investment flows to emerging markets (can
create credit bubbles).
(The most volatile types of capital: short-term portfolio investments and bank
lending. FDI is less sensitive to external conditions)
- contagion (when investors pull out capital from the country after a crises
happens in another developing country). Financial globalization increases the risk
of financial contagion.
- herding behavior on the financial markets
Internal: country’s own shocks and macroeconomic conditions
WHAT CAN THE COUNTRY DO TO MINIMIZE
RISK?
Structure of debt and strength of financial institutions is important:
although financial crises can happen even in the economy with more or less good
economic fundamentals, the severity of financial crises increases when
- country borrows in foreign currency
- country can only borrow short-term
- ratio of (bank borrowing + other debt) to FDI is high.
- high government spending (together with fixed exchange rate regime can
lead to currency crisis)
- opening financial markets when institutions (for example banking
regulations are weak).
- counter-cyclical fiscal policies
OTHER POLICY OPTIONS TO BENEFIT FROM
FINANCIAL INTEGRATION
The theoretical channels through which financial integration improves growth can
work only under certain conditions:
Empirical evidence:
- FDI improves growth, for countries with high level of human capital
- The level of FDI inflows is highly correlated with low corruption, higher
transparency of macroeconomic policies and corporate finance
- Higher levels of financial integration reduce volatility of output and
consumption but only beyond a certain threshold ( which has not been reached
by most developing countries).
- Having good financial supervision in place BEFORE the country opens up
to capital inflows from abroad is essential for minimizing the risk of devastating
financial crises.