Abstract
The literature on the benefits and costs of financial globalization for developing countries has exploded in recent years, but along many disparate channels with a variety of apparently conflicting results. 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, but the macroeconomic evidence remains inconclusive. At the same time, some studies argue that financial globalization enhances macroeconomic stability in developing countries, but others argue the opposite. This paper attempts to provide a unified conceptual framework for organizing this vast and growing literature, particularly emphasizing recent approaches to measuring the catalytic and indirect benefits to financial globalization. Indeed, it argues that the indirect effects of financial globalization on financial sector development, institutions, governance, and macroeconomic stability are likely to be far more important than any direct impact via capital accumulation or portfolio diversification. This perspective explains the failure of research based on cross-country growth regressions to find the expected positive effects of financial globalization and points to newer approaches that are potentially more useful and convincing.
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Notes
The working paper version of this paper provides a comprehensive list of references (see Kose and others, 2006). In this paper, we limit ourselves to mentioning some key papers and do not aim to be exhaustive in our citations.
Eichengreen (2001), who focuses on the relationship between growth and measure of restrictions on capital account transactions, argues that the evidence is quite mixed. A subsequent survey by us on the broader dimensions of financial globalization deepens the puzzle (Prasad and others, 2003). We conclude that the vast empirical literature provides little robust evidence of a causal relationship between financial integration and growth. Moreover, we find that, among developing countries, the volatility of consumption growth relative to income growth appears to be positively associated with financial integration, the opposite of what canonical theoretical models would predict.
We emphasize up front that our analysis focuses largely on private capital flows and does not encompass the effects of official flows, including foreign aid, and other flows such as remittances (which should, strictly speaking, appear in the current account of the balance of payments).
Indeed, from 2004 to 2006, developing countries and emerging markets collectively averaged a large current account surplus, rather than a deficit. Lucas himself offered a new growth model based on increasing returns to human capital to explain what was then a low volume of net flows to developing countries, though recent work has tended to focus more on the financial channel emphasized contemporaneously by Gertler and Rogoff (1990). Mendoza, Quadrini, and Rios-Rull (2007) and Alfaro, Kalemli-Ozcan, and Volosovych (2007) argue that institutional failures more generally may lead to capital flow reversals. Reinhart and Rogoff (2004) suggest that recurrent defaults and financial crises in developing countries may depress investment there. Gordon and Bovenberg (1996) focus on the role played by information asymmetries.
Henry (2007) argues that, even in the context of the basic neoclassical model, the financing channel should imply only a temporary, rather than permanent, pickup in growth from financial integration. It is not clear, however, how important this nuance is likely to be empirically in studies that look at growth experiences over periods of just two to three decades.
Among developed countries and across regions within developed countries, better risk sharing is associated with greater specialization (Obstfeld, 1994; Acemoglu and Zilibotti, 1997; and Kalemli-Ozcan, Sorensen, and Yosha, 2003).
See Kose, Prasad, and Terrones (2004) for a more detailed exposition.
In particular, the welfare gains depend on the volatility of output shocks, the rate of relative risk aversion, the risk-adjusted growth rate, and the risk-free interest rate in these models (see the discussion in Obstfeld and Rogoff, 2004, Chapter 5; Lewis, 1999; and van Wincoop, 1999). Lucas's (1987) claim that macroeconomic stabilization policies that reduce consumption volatility can have only minimal welfare benefits continues to be influential in the literature (see Barlevy, 2004).
Share measures have been created by Grilli and Milesi-Ferretti (1995), Rodrik (1998), and Klein and Olivei (2006). Finer measures of openness based on the AREAER have been developed by Quinn (1997, 2003), Miniane (2004), Chinn and Ito (2006), Mody and Murshid (2005), and Edwards (2005). Edison and Warnock (2003) construct measures of capital account restrictions related to just equity flows. Bekaert and Harvey (2000) and Henry (2000a) compile dates of equity market liberalizations for developing countries. We briefly discuss some of these narrower measures in more detail later.
Other measures of integration include saving-investment correlations and, related to the price-based approach discussed above, various interest parity conditions (see Frankel, 1992; and Edison and others, 2002). However, these measures are also difficult to operationalize and interpret for an extended period of time and for a large group of countries.
These authors substantially extend their External Wealth of Nations database (Lane and Milesi-Ferretti, 2001) using a revised methodology and a larger set of sources. Although their benchmark series are based on the official estimates from the International Investment Position, they compute the stock positions for earlier years using data on capital flows and account for capital gains and losses.
FDI refers to direct investment in a domestic company, giving the foreign investor an ownership share. Portfolio equity inflows refer to foreign investors’ purchases of domestically issued equity in a company. Debt inflows include foreign investors’ purchases of debt issued by corporates or the government, and also foreign borrowing undertaken by domestic banks.
An earlier wave of financial globalization (1880–1914) has been analyzed by Bordo, Taylor, and Williamson (2003), Obstfeld and Taylor (2004), and Mauro, Sussman, and Yafeh (2006).
The sample of countries used in our analysis is listed in the Data Appendix.
Certain measures of de jure integration do track the de facto measures better. For instance, the Edison-Warnock measure of restrictions on equity inflows does change more in line with de facto integration in emerging markets, but this measure is available for only a limited number of countries and for a short time interval. Moreover, equity inflows constitute only a small portion of total inflows.
Some countries underwent financial integration during this period, especially in the latter half of the 1990s. Therefore any result based on the average growth over this period should be interpreted with caution. The list of countries in our sample is listed in the Data Appendix.
We excluded from these plots a few countries that were outliers, mostly those with very high levels of financial openness relative to GDP (see the Data Appendix). Using the full sample of countries made little difference to the correlations shown here. We do not systematically examine the effects of outliers as these plots are meant to be descriptive and do not constitute formal empirical evidence.
See Kraay (1998), O’Donnell (2001), and Edison and others (2002).
On the last point, see Edwards (2001) and Edison and others (2004). Quinn (1997) and Arteta, Eichengreen, and Wyplosz (2003) report uniform results for all groups of countries.
These authors use a binary capital account openness indicator based on the IMF's AREAER. Whether this relationship holds up with de facto measures remains to be seen.
On the output costs of banking crises, see Hutchinson and Noy (2005) and Bonfiglioli and Mendicino (2004).
The evidence cited on this point by some prominent critics of globalization in fact turns out to be about how domestic financial sector liberalization, rather than financial integration, has in some cases precipitated financial crises (see footnote 5 in Stiglitz, 2004).
A number of recent theoretical papers have attempted to explain the hump-shaped relationship between financial integration and the relative volatility of consumption growth. Levchenko (2005) and Leblebicioglu (2006) consider dynamic general equilibrium models where only some agents have access to international financial markets. In both models, financial integration leads to an increase in the volatility of aggregate consumption because agents with access to international financial markets stop participating in risk-sharing arrangements with those who lack such access. Bekaert, Harvey, and Lundblad (2005) find that consumption volatility declines following equity market liberalizations. Kose, Prasad, and Terrones (forthcoming) show that emerging market economies, which have experienced large increases in cross-border capital flows, have seen little change in their ability to share risk during the globalization period.
Recent surveys of this literature include Lipsey (2004) and Moran, Graham, and Blomström (2005).
Along similar lines, it should be noted that Morocco and Venezuela were relatively closed to trade during the periods covered by the country-specific panel data sets used in the influential studies by Haddad and Harrison (1993) and Aitken and Harrison (1999), respectively, both of which concluded that FDI has minimal growth benefits (see Moran, Graham, and Blomström, 2005).
Blonigen and Wang (2005) discuss the pooling issue but Aykut and Sayek (2005) analyze the effects of sectoral composition of FDI inflows. The importance of the three initial conditions is shown by Borensztein, De Gregorio, and Lee (1998), Hermes and Lensink (2003), Alfaro and others (2006), and Balasubramanyam, Salisu, and Sapsford (1996), respectively. On the last point, also see Melitz (2005).
Lipsey and Sjöholm (2005) provide a survey of the evidence on FDI spillovers. Also see Görg and Greenaway (2004). For more evidence on FDI spillovers through backward linkages, see López-Córdova (2003), Alfaro and Rodríguez-Clare (2004), and Blalock and Gertler (2005).
Also see Li (2003). Equity market liberalizations are defined as events that make shares of common stock of local firms available to foreign investors. Commonly used dates, drawn from Henry (2000a) and Bekaert and Harvey (2000), include official liberalization dates and dates of “first sign” of liberalization based on events such as the launching of a country fund or American Depository Receipt (ADR) announcement. ADRs are securities that are traded in the United States but represent underlying stocks listed in a foreign country.
Recent research also provides some cross-country evidence about the empirical relevance of various channels linking equity market liberalization to economic growth. There is evidence, consistent with the predictions of international asset pricing models, that stock market liberalizations reduce the cost of capital and boost investment growth. For evidence on the first point, see Stulz (1999a, 1999b), Bekaert and Harvey (2000), Henry (2000a), and Kim and Singal (2000). On the latter, see Henry (2000b) and Alfaro and Hammel (2006).
See Diamond and Rajan (2001) and Jeanne (2003), respectively, on these two points about the potential benefits of debt flows. For a survey of the empirical literature on the risks associated with short-term debt, see Berg, Borenzstein, and Pattillo (2004).
Johnson and Mitton (2002) argue that capital controls reduced market discipline among Malaysian firms and fostered cronyism. Desai, Foley, and Hines (2004) use firm-level data to argue that the cost of capital is higher for multinationals when capital controls are in place. Based on the cross-country investment patterns of multinationals, they conclude that the level of FDI inflows into a country is adversely affected by capital controls. Forbes (2005b) concurs that the costs of capital controls include not just efficiency losses and lower market discipline but also reduced inflows. Magud and Reinhart (2007) discuss the difficulty of using macro data to measure the costs of capital controls.
A number of papers have explicitly taken the tack that the costs of financial globalization—including crises—are in the nature of growing pains that will recede once globalizing economies achieve fuller integration (Krugman, 2002; Martinez, Tornell, and Westermann, 2004).
Recent literature has emphasized the importance of TFP growth as the main driver of long-term GDP growth (see, for example, Hall and Jones, 1999; Jones and Olken, 2008; Gourinchas and Jeanne, 2006). Edwards (2001), Bonfiglioli (2006), and Kose, Prasad, and Terrones (2008) have assembled some preliminary evidence suggesting that financial integration raises TFP growth. Kose, Prasad, and Taylor (forthcoming) provide a detailed analysis of various threshold factors that help promote the growth benefits of financial integration.
As with Figure 3a, we excluded a few countries that were outliers. Inclusion of all the countries in our sample strengthened the unconditional cross-sectional correlations shown here.
In a cross-county regression framework, Chinn and Ito (2006), however, identify one possible caveat. Financial openness contributes to equity market development only once at least a moderate level of legal and institutional development has been attained (a hurdle cleared by most emerging markets); less developed countries do not necessarily gain this benefit.
Another threshold effect, on which the literature is still rather limited, is related to human capital. Borensztein, De Gregorio, and Lee (1998) and Blonigen and Wang (2005) find that countries that have more human capital get larger growth benefits from FDI.
Austria and Hungary, for example, were able to avoid crises after they liberalized their capital accounts since they had relatively stable macroeconomic policies. Mexico and Turkey ran into difficulties in the mid-1990s after liberalizing their capital accounts because they had tightly managed exchange rates for a prolonged period, along with uncertain policy settings and growing imbalances.
See Husain, Mody, and Rogoff (2004) and Aghion and others (2006). For a discussion of how fixed exchange rate regimes and open capital accounts can together spell disaster, see Obstfeld and Rogoff (1995) and Wyplosz (2004).
Calvo and Talvi (2005) claim that this is why the collapse of capital flows to Argentina and Chile in the 1990s had a smaller impact on Chile. Kose, Meredith, and Towe (2005) argue that trade integration has made the Mexican economy more resilient to shocks and contributed to its faster recovery from the 1994–95 peso crisis than from the 1982 debt crisis.
For presentational reasons, in Figures 3a and 6 we excluded the following countries that were outliers: United Kingdom (GBR), Netherlands (NLD), Belgium (BEL), Singapore (SGP), Switzerland (CHE), Ireland (IRL), Zambia (ZMB), and China (CHN). Inclusion of outliers did not change our qualitative findings.
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Additional information
*M. Ayhan Kose is a senior economist with the IMF Research Department; Eswar Prasad is the Nandlal P. Tolani Senior Professor of Trade Policy at Cornell University and a Senior Fellow at the Brookings Institution; Kenneth Rogoff is the Thomas D. Cabot Professor of Public Policy and Professor of Economics at Harvard University; and Shang-Jin Wei is the N.T. Wang Professor of Chinese Business and Economy in the Graduate School of Business at Columbia University. The authors are grateful for helpful comments from numerous colleagues and participants at various seminars where earlier versions of this paper were presented. Lore Aguilar, Cigdem Akin, Dionysios Kaltis, and Ashley Taylor provided excellent research assistance.
Data Appendix
Data Appendix
This appendix lists the countries included in the analysis and also indicates the acronyms used for each country. The full sample of 71 countries is divided into three groups.Footnote 48
Advanced Economies
The 21 advanced industrial economies in our sample are Australia (AUS), Austria (AUT), Belgium (BEL), Canada (CAN), Denmark (DNK), Finland (FIN), France (FRA), Germany (DEU), Greece (GRC), Ireland (IRL), Italy (ITA), Japan (JPN), Netherlands (NLD), New Zealand (NZL), Norway (NOR), Portugal (PRT), Spain (ESP), Sweden (SWE), Switzerland (CHE), United Kingdom (GBR), and the United States (U.S.A.).
Emerging Market Economies
This group includes 20 countries—Argentina (ARG), Brazil (BRA), Chile (CHL), China (CHN), Colombia (COL), Egypt (EGY), India (IND), Indonesia (IDN), Israel (ISR), Korea (KOR), Malaysia (MYS), Mexico (MEX), Pakistan (PAK), Peru (PER), Philippines (PHL), Singapore (SGP), South Africa (ZAF), Thailand (THA), Turkey (TUR), and Venezuela (VEN).
Other Developing Economies
This group has 30 countries—Algeria (DZA), Bangladesh (BGD), Bolivia (BOL), Cameroon (CMR), Costa Rica (CRI), Dominican Republic (DOM), Ecuador (ECU), El Salvador (SLV), Fiji (FJI), Ghana (GHA), Guatemala (GTM), Honduras (HND), Iran (IRN), Jamaica (JAM), Kenya (KEN), Malawi (MWI), Mauritius (MUS), Nepal (NPL), Niger (NER), Papua New Guinea (PNG), Paraguay (PRY), Senegal (SEN), Sri Lanka (LKA), Tanzania (TZA), Togo (TGO), Trinidad and Tobago (TTO), Tunisia (TUN), Uruguay (URY), Zambia (ZMB), and Zimbabwe (ZWE).