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Financial Globalization: a Reappraisal; M. Ayhan Kose, Eswar Prasad

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Financial Globalization: a Reappraisal; M. Ayhan Kose, Eswar Prasad WP/06/189 Financial Globalization: A Reappraisal M. Ayhan Kose, Eswar Prasad, Kenneth Rogoff, and Shang-Jin Wei © 2006 International Monetary Fund WP/06/189 IMF Working Paper Research Department Financial Globalization: A Reappraisal Prepared by M. Ayhan Kose, Eswar Prasad, Kenneth Rogoff, and Shang-Jin Wei1 August 2006 Abstract This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. The literature on the benefits and costs of financial globalization for developing countries has exploded in recent years, but along many disparate channels and with a variety of apparently conflicting results. For instance, there is still little robust evidence of the growth benefits of broad capital account liberalization, but a number of recent papers in the finance literature report that equity market liberalizations do significantly boost growth. Similarly, evidence based on microeconomic (firm- or industry-level) data shows some benefits of financial integration and the distortionary effects of capital controls, while the macroeconomic evidence remains inconclusive. We attempt to provide a unified conceptual framework for organizing this vast and growing literature. This framework allows us to provide a fresh synthetic perspective on the macroeconomic effects of financial globalization, in terms of both growth and volatility. Overall, our critical reading of the recent empirical literature is that it lends some qualified support to the view that developing countries can benefit from financial globalization, but with many nuances. On the other hand, there is little systematic evidence to support widely cited claims that financial globalization by itself leads to deeper and more costly developing country growth crises. JEL Classification Numbers: F02, F21, F36, F4 Keywords: Capital Account Liberalization, Financial Integration, Growth and Volatility, Financial Crises, Developing Countries Author(s) E-Mail Address: [email protected], [email protected], [email protected], [email protected] 1 Kenneth Rogoff is with Harvard University. We are grateful for helpful comments from seminar participants at the Bank for International Settlements (BIS), European Central Bank (ECB), Hong Kong Monetary Authority (HKMA), Center for Economic Policy Research (CEPR), Cornell University, and the University of Houston, where earlier versions of this paper were presented. Lore Aguilar, Cigdem Akin, Dionysios Kaltis, and Ashley Taylor provided excellent research assistance. - 2 - Contents Page Executive Summary.........................................................................................................................4 I. Introduction ............................................................................................................................7 II. A Brief Overview of Theory ...............................................................................................10 A. Growth ....................................................................................................................10 B. Volatility..................................................................................................................10 C. Comovement ...........................................................................................................11 III. Measuring Financial Openness..........................................................................................12 A. De Jure Measures Based on IMF Indicators ...........................................................12 B. Shortcomings of De Jure Measures.........................................................................13 C. De Facto Measures Based on Price Differentials....................................................13 D. De Facto Measures Based on Quantities.................................................................14 IV. Patterns of Financial Globalization ...................................................................................15 A. Evolution of Financial Globalization Across Different Country Groups ...............15 B. Composition of Stocks and Flows...........................................................................16 C. Volatility of Inflows................................................................................................16 V. Macroeconomic Evidence on Effects of Financial Globalization ......................................17 A. Effects on Growth ...................................................................................................17 B. Effects on Volatility ................................................................................................20 C. Comovement ...........................................................................................................22 VI. How Does the Composition of Capital Flows Matter?......................................................23 A. Portfolio Equity Flows............................................................................................23 B. Foreign Direct Investment (FDI).............................................................................27 C. Debt Flows ..............................................................................................................30 D. Synthesis .................................................................................................................31 VII. Organizing Principles.......................................................................................................33 A. Collateral Benefits...................................................................................................33 B. Thresholds ...............................................................................................................34 C. A Corollary: Collateral Benefits Enhance Productivity Growth.............................36 D. Summary .................................................................................................................37 VIII. Collateral Benefits of Financial Globalization................................................................37 A. Financial Sector Development................................................................................38 B. Institutional Quality and Governance .....................................................................39 C. Macroeconomic Policies .........................................................................................40 D. Implications.............................................................................................................42 IX. Threshold Effects in Outcomes of Financial Globalization ..............................................42 A. Interaction Between Financial Sector Development and Financial Integration .....43 B. Role of Institutions and Governance in Driving Growth ........................................44 C. Why Do Macroeconomic Policies Affect the Outcomes of Financial Integration?46 D. Does the Level of Trade Openness Matter for the Effects of Financial Openness?49 - 3 - E. Threshold Effects and Composition of Inflows: A Summary.................................50 X. Concluding Remarks...........................................................................................................51 A. Main Findings .........................................................................................................51 B. Issues for Further Research.....................................................................................52 Tables 1. International Financial Integration: Gross Stocks of Foreign Assets and Liabilities ..........54 2. International Financial Integration: Gross Inflows..............................................................55 3. Volatility of Different Types of Inflows: 1985–2004..........................................................56 4A. Summary of Key Empirical Studies on Financial Integration and Growth ......................57 4B. Summary of Key Empirical Studies on Equity Market Liberalization and Growth .........61 4C. Summary of Key Empirical Studies on FDI and Growth .................................................62 Figures 1. Gross International Financial Assets and Liabilities: 1970–2004 .......................................63 2. Gross International Financial Liabilities of Developing Economies: 1970–2004...............64 3. Evolution of International Financial Integration: 1970–2004 .............................................65 4. GDP (per capita, PPP weighted): 1970–2004......................................................................66 5A. Level of Financial Openness and GDP Growth, 1985–2004............................................67 5B. Change in Financial Openness and GDP Growth, 1985–2004 .........................................67 6A. Financial Openness and Financial Development: 1985–2004..........................................68 6B. Financial Openness and Institutional Quality: 1985–2004 ...............................................68 6C. Financial Openness and Macroeconomic Policies: 1985–2004........................................69 Appendixes I: Capital Controls....................................................................................................................70 II. Data Appendix.....................................................................................................................74
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