Financial Globalization: Beyond the Blame Game

AuthorM. Ayhan Kose/Shang-Jin Wei
PositionEconomist/Division Chief in the IMF's Research Department

A new way of looking at financial globalization reexamines its costs and benefits

Financial globalization-the phenomenon of rising cross-border financial flows-is often blamed for the string of damaging economic crises that rocked a number of emerging markets in the late 1980s in Latin America and in the 1990s in Mexico and a handful of Asian countries. The market turmoil and resulting bankruptcies prompted a rash of finger-pointing by those who suggested that developing countries had dismantled capital controls too hastily-leaving themselves vulnerable to the harsh dictates of rapid capital movements and market herd effects. Some were openly critical of international institutions they saw as promoting capital account liberalization without stressing the necessity of building up the strong institutions needed to steer markets through bad times.

In contrast to the growing consensus among academic economists that trade liberalization is, by and large, beneficial for both industrial and developing economies, debate rages among academics and practitioners about the costs and benefits of financial globalization. Some economists (for example, Dani Rodrik, Jagdish Bhagwati, and Joseph Stiglitz) view unfettered capital flows as disruptive to global financial stability, leading to calls for capital controls and other curbs on international asset trade. Others (including Stanley Fischer and Lawrence Summers) argue that increased openness to capital flows has, in general, proved essential for countries seeking to rise from lower- to middle-income status and that it has strengthened stability among industrial countries. This debate clearly has considerable relevance for economic policy, especially given that major economies like China and India have recently taken steps to open up their capital accounts.

To get beyond the polemics, we put together a framework for analyzing the vast and growing body of studies about the costs and benefits of financial globalization. Our framework offers a fresh perspective on the macroeconomic effects of global financial flows, in terms of both growth and volatility. We systematically sift through various pieces of evidence on whether developing countries can benefit from financial globalization and whether financial globalization, in itself, leads to economic crises. Our findings suggest that financial globalization appears to be neither a magic bullet to spur growth, as some proponents would claim, nor an unmanageable risk, as others have sought to portray it.

Unanswered questions

The recent wave of financial globalization began in earnest in the mid-1980s, spurred by the liberalization of capital controls in many countries in anticipation of the better growth outcomes and increased stability of consumption that cross-border flows would bring. It was presumed that

these benefits would be large, especially for developing countries, which tend to be more capital- poor and have more volatile income growth than other countries.

Emerging market economies, the group of developing countries that have actively participated in financial globalization, have clearly registered better growth outcomes, on average, than those countries that have not participated (see Chart 1). Yet the majority of studies using cross-country growth regressions to analyze the relationship between growth and financial openness have been unable to show that capital account liberalization produces measurable growth benefits. One reason may be traced to the difficulty of measuring financial openness. For example, widely used measures of capital controls (restrictions on capital account transactions) fail to capture how effectively countries enforce those controls and do not always reflect the actual degree of an economy's integration with international capital markets. In recent years, considerable progress has been made on developing better measures of capital controls and better data on flows and stocks of international assets and liabilities. Studies that are based on these improved measures of financial integration are beginning to find evidence of positive growth effects of financial integration. The evidence, however, is still far from conclusive.

Nor is there systematic evidence that financial integration is the proximate determinant of financial crises. Authors who have looked at different manifestations of such crises-including sudden stops of capital inflows, current account reversals, and banking crises-have found no evidence that countries that are more open to...

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