Advantages of Financial Globalization

There are loads of advantages that the world is enjoying today due to Financial
Globalization. First and foremost, it has enhanced capital flow in each and every country
with which a country may always remain prepared to counter any financial crisis.
Another most important factor is that, due to Financial Globalization the capital flows
between nations increase which causes well-organized world allocation of money.
Another important fact is that globalization of finance has improved living standards of
the people. Simply speaking, Financial Globalization is the safeguard to defend against
national shocks, and an excellent system for more efficient global allocation of resources.

This subsection of the paper will summarize the theoretical benefits of financial
globalization for economic growth and then review the empirical evidence. Financial
globalization could, in principle, help to raise the growth rate in developing countries
through a number of channels. Some of these directly affect the determinants of
economic growth (augmentation of domestic savings, reduction in the cost of capital,
transfer of technology from advanced to developing countries, and development of
domestic financial sectors). Indirect channels, which in some cases could be even more
important than the direct ones, include increased production specialization owing to
better risk management, and improvements in both macroeconomic policies and
institutions induced by the competitive pressures or the "discipline effect" of
globalization.

How much of the advertised benefits for economic growth have actually materialized in
the developing world? As documented in this paper, average per capita income for the
group of more financially open (developing) economies grows at a more favorable
rate than that of the group of less financially open economies. Whether this actually
reflects a causal relationship and whether this correlation is robust to controlling for other
factors, however, remain unresolved questions. The literature on this subject, voluminous
as it is, does not present conclusive evidence. A few papers find a positive effect of
financial integration on growth. The majority, however, find either no effect or, at best, a
mixed effect. Thus, an objective reading of the results of the vast research effort
undertaken to date suggests that there is no strong, robust, and uniform support for the
theoretical argument that financial globalization per se delivers a higher rate of economic
growth.
Perhaps this is not surprising. As noted by several authors, most of the cross-country
differences in per capita incomes stem not from differences in the capital-labor ratio but
from differences in total factor productivity, which could be explained by "soft" factors
such as governance and the rule of law. In this case, although embracing financial
globalization may result in higher capital inflows, it is unlikely, by itself, to cause faster
growth. In addition, as is discussed more extensively later in this paper, some of the
countries with capital account liberalization have experienced output collapses related to
costly banking or currency crises. An alternative possibility, as noted earlier, is that
financial globalization fosters better institutions and domestic policies but that these
indirect channels can not be captured in standard regression frameworks.

In short, although financial globalization can, in theory, help to promote economic

growth through various channels, there is as yet no robust empirical evidence that this
causal relationship is quantitatively very important. This points to an interesting contrast
between financial openness and trade openness, since an overwhelming majority of
research papers have found that the latter has had a positive effect on economic growth.

The real benefits of financial globalization to an emerging market economy have less to
do with the raw financing provided by foreign capital. Instead, the indirect "collateral"
benefits associated with such capital are far more important. These indirect benefits may
be crucial for India's development.

One of the key benefits is that openness to foreign capital catalyzes financial market
development. Foreign investment in the financial sector tends to enhance competition,
raise efficiency, improve corporate governance standards and stimulate the development
of new financial products. For instance, in India, even the limited entry of foreign banks
has already given domestic banks a much-needed kick in the rearside and forced them to
improve their efficiency in order to compete and stay viable.

Liberalizing outflows has the salutary effect of giving domestic investors an opportunity
to diversify their portfolios internationally. This means greater competition for domestic
financial institutions but also an opportunity for them to cultivate the financial savvy to
offer products that would help their customers invest abroad.

Other indirect benefits associated with foreign capital include transfers of expertise --
technological and managerial -- from more advanced economies. When supported by
liberal trade policies, foreign investment can help boost export growth. Foreign-invested
firms also tend to have spillover effects in generating efficiency gains among domestic
firms.

I find these arguments not to be compelling, because they overlook what is in effect the
most important collateral damage that openness to financial capital inflicts: the tendency
for the currency to appreciate, with the usual adverse consequences for investment in
tradables and for economic growth. If we should have learned anything from the last two
decades, it is that the exchange rate is too important a price to leave to financial markets.
Countries that open up to financial capital lock themselves into an inescapable dilemma.
Either they let the currency float freely in response to the whims of financial markets, or
they have to undertake very costly actions, such as sterilized intervention. Is this what
India wants or needs?

No, according to Arvind Subramanian, Prasad's co-author and former IMF colleague, and
I agree. For another take on India's policy options, and a much more sensible one, turn to
Subramanian:

So, India cannot really follow China [and undertake costly sterilization on an ongoing
basis] and yet, India cannot afford to neglect the real exchange rate. Commentators
suggest that currency appreciation is less of a problem today either because exports are
mostly of IT-services, where profit margins are large enough to absorb adverse currency
movements; or because exchange rate changes reflect productivity developments and
hence are not a matter for concern. But we have to beware of the “Bangalore Bug,”
whereby currency appreciation driven by the productivity of skill-intensive services
undermines the competitiveness of low-margin, labour-intensive manufacturing, which is
going to be crucial for India’s long-run ability to boost employment creation. Here, we
should be thinking of the incentives facing not just existing low-skilled manufacturing
firms but also firms that are potential entrants into this sector. We have not yet sorted out
the regulatory problems that would allow Indian unskilled manufacturing to come into its
own but a necessary condition for that to happen is a competitive exchange rate, and one
that is not determined entirely by the performance of skill-intensive services.

What should India do? Three policy responses, one each in the short, medium and long
run, might be considered. All of these will make clear that "doing something" about the
exchange rate is a call that is easier made than implemented. We should not harbour any
illusion of easy, painless solutions.

The first follows from a lesson that is essential to absorb: India’s ability to manage the
real exchange rate has been severely undermined by capital flows. There is no need for
India to take further policy actions that will lead to greater capital inflow. Indeed, there
may even be a case for tightening, especially of external commercial borrowings, which
were surprisingly relaxed in the last year, and, if feasible, some tightening of other short-
term (hot) flows. It has to be recognised, though, that major restrictions on capital flows
will damage market confidence, and minor ones, while helping minimise future
problems, cannot fully address current ones.

In the medium run, improving the fiscal position remains one of the key policy tools that
can help counter real appreciation. Unlike monetary policy and sterilisation, which
largely affect nominal variables, fiscal consolidation can increase domestic savings and
hence exert downward pressure on the real interest rate, causing a depreciation of the real
exchange rate. Fiscal consolidation is desirable in its own right, but the government
should consider making a special effort at improving government finances in response to
episodes of sustained appreciation.

In the longer run, the ability to sustain a competitive exchange rate will require
strengthening the key factor that underlies value creation in India—its labour. This
includes attacking the last bastion of the licence raj—higher education—to augment the
supply of skilled labour. Wage increases averaging 12-14 per cent in the last few years
signal emerging shortages in the supply of skilled labour. Policy actions also include,
crucially, addressing the impediments—labour laws and better basic education—that
prevent the utilisation of India’s vast pool of unskilled labour. Perhaps a deeper reason
for China’s competitive exchange rate might simply be that it has used—more effectively
than India—its vast pool of labour, which has kept a lid on wage growth and inflationary
pressures.

India's continued growth will depend in no small measure on playing its exchange-rate
card well, and that in turn will require that it take a very cautious attitude towards capital
inflows.

UPDATE: Formatting problem with the Subramanian quote has been fixed. Thanks to
happyjuggler0 for the pointer. I am beginning to hate Typepad... Truth be told, I picked
Typepad because of Brad DeLong's site, but he seems to be able to do things with it that I
could never imagine doing....

Who could have imagined 12 years ago, when India had

its 1990–91 debt crisis and was forced to turn to the
International Monetary Fund (IMF) under extreme duress,
that today the Reserve Bank of India would have
accumulated over 80 billion dollars in reserves, that India’s
external position could have been so strengthened that India
is now lending us, the IMF, money. And who could have
imagined that the IMF would appoint an Indian national as
its new Chief Economist.

Implicit or explicit bail-out guarantees, moreover, induce too much risk-

taking. Large financial intermediaries endanger the entire financial system
when they use the wrong risk model and make bad decisions. Regulation is
at best a partial remedy for such problems. So the prices that financial
markets generate are as likely to send the wrong signals as they are to send
the right ones.
Financial markets discipline governments. This is one of the most
commonly stated benefits of financial markets, yet the claim is patently
false. When markets are in a euphoric state, they are in no position to exert
discipline on any borrower, let alone a government with a reasonable credit
rating. If in doubt, ask scores of emerging-market governments that had no
difficulty borrowing in international markets, typically in the run-up to an
eventual payments crisis.

In many of these cases - Turkey during the 1990's is a good example -

financial markets enabled irresponsible governments to embark on
unsustainable borrowing sprees. When "market discipline" comes, it is
usually too late, too severe, and applied indiscriminately.
The spread of financial markets is an unmitigated good. Well, no. Financial
globalization was supposed to have enabled poor, undercapitalized countries
to gain access to the savings of rich countries. It was supposed to have
promoted risk-sharing globally.
In fact, neither expectation was fulfilled. In the years before the financial
crash, capital moved from poor countries to rich countries, rather than vice
versa. (This may not have been a bad thing, since it turns out that large (net)
borrowers in international markets tend to grow less rapidly than others.)
And economic volatility has actually increased in emerging markets under
financial globalization, owing in part to frequent financial crises spawned by
mobile capital.

Financial innovation is a great engine of productivity growth and economic

well-being . Again, no. Imagine that we had asked five years ago for
examples of really useful kinds of financial innovation. We would have
heard about a long-list of mortgage-related instruments, which supposedly
made financing available to home buyers who would not have been able to
purchase homes otherwise. We now know where that led us. The truth lies
closer to Paul Volcker's view that for most people the automated teller
machine (ATM) has brought bigger benefits than any financially-engineered
bond.

The world economy has been run for too long by finance enthusiasts. It is
time that finance skeptics began to take over.