Effects of Financial Globalization on Developing Countries: Some Empirical Evidence

INTERNATIONAL MONETARY FUND









Effects of Financial Globalization on Developing Countries:
Some Empirical Evidence



Eswar Prasad, Kenneth Rogoff, Shang-Jin Wei and M. Ayhan Kose



March 17, 2003

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Acknowledgements

We are grateful to Eduardo Borensztein, Robin Brooks, Gaston Gelos, Paolo Mauro and
Marco Terrones for their contributions to this paper. For their comments and for many
helpful discussions, we are also grateful to Tamim Bayoumi, Andrew Berg, Peter Clark, Hali
Edison, Aasim Husain, Olivier Jeanne, Manmohan Kumar, Ashoka Mody, James Morsink,
Carmen Reinhart, David J. Robinson, Ratna Sahay, Miguel Savastano, and numerous other
colleagues. Priya Joshi, Young Kim, Pedro Rodriquez and Yi Wu provided efficient research
assistance. Hali Edison and Gian Maria Milesi-Ferretti were generous in sharing their data
with us. Finally, we thank Maria Orihuela, and especially Marlene George and Dawn Heaney
for their able assistance in the preparation of this manuscript.

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Contents
Page


Summary....................................................................................................................................5
I. Overview ................................................................................................................................6
A. Definitions and Basic Stylized Facts ........................................................................7
B. Does Financial Globalization Promote Growth in Developing Countries? ..............8
C. What Is the Impact of Financial Globalization on Macroeconomic Volatility? .......9
D. The Role of Institutions and Governance on the Effects of Globalization .............10
E. Summary..................................................................................................................11
II. Basic Stylized Facts ............................................................................................................12
A. Measuring Financial Integration .............................................................................12
B. North-South Capital Flows......................................................................................16
C. Factors Underlying the Rise in North-South Capital Flows ...................................20
III. Financial Integration and Economic Growth.....................................................................23
A. Potential Benefits of Financial Globalization in Theory ........................................23
B. Empirical Evidence .................................................................................................26
C. Synthesis..................................................................................................................31
IV. Financial Globalization and Macroeconomic Volatility....................................................37
A. Macroeconomic Volatility ......................................................................................38
B. Crises as Special Cases of Volatility.......................................................................44
C. Has Financial Globalization Intensified the Transmission of Volatility? ...............45
D. Some Factors That Increase Vulnerability to the Risks of Globalization...............49
V. Absorptive Capacity and Governance in the Benefits/Risks of Globalization ...................50
A. Threshold Effects and Absorptive Capacity ...........................................................50
B. Governance As an Important Element of Absorptive Capacity..............................51
C. Domestic Governance and the Volatility of International Capital Flows ...............55
D. Summary .................................................................................................................58

Text Tables

1. Volatility of Different types of Capital Inflows...................................................................18
2. Fastest and Slowest Growing Economies During 1980–2000 and Their
Status of Financial Openness ...........................................................................................28
3. Summary of Recent Research on Financial Integration and Economic Growth .................32
4. Volatility of Annual Growth Rates of Selected Variables...................................................40
5. Summary of Studies on Welfare Gains from International Risk Sharing............................67
6. Are Small States Different? Some Summary Statistics .......................................................71

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Figures

1. Measures of Financial Integration .....................................................................................15
2. Gross Capital Flows...........................................................................................................17
3. Net Capital Flows ..............................................................................................................19
4. Foreign Ownership Restrictions ........................................................................................21
5. Channels Through Which Financial Integration Can Raise Economic Growth................24
6. Increase in Financial Openness and Growth of Real Per Capital GDP .............................29
7. Increase in Financial Openness and Growth of Real Per Capita GDP: Conditional
Relationship, 1982–97 .....................................................................................................30
8. Differential Effects of Financial and Trade Integration on Improvements in Health........36
9. Volatility of Income and Consumption Growth ................................................................42
10. Corruption and Foreign Direct Investment ........................................................................53
11. Difference Between Actual Internationa Mutual Fund Investment and the MSCI
Benchmark: Transparent versus Opaque Countries.......................................................54
12. Herding and Opacity..........................................................................................................56
13. Corruption Tilts the Compoition of Capital Flows Towards Borrowing...........................59
14. Welfare Gains from International Risk Sharing ................................................................63

Boxes

1. The Effects of Different Types of Capital Flows on Growth ..............................................33
2. Do Financial and Trade Integration Have Different Effects on Economic Development?
Evidence from Life Expectancy and Infant Mortality .....................................................35
3. The Effects of Globalization on Volatility: A Review of the Empirical Evidence .............39
4. Herding and Momentum Trading by International Investors ..............................................48
5. Transparency and International Mutual Funds ....................................................................57

Appendices

I. The First Era of International Financial Integration, 1870–1913.........................................60
II. Calculating the Potential Wesfare Gains from International Risk Sharing.........................62
III. Contingent Securities for International Risk Sharing ........................................................68
IV. Small States and Financial Globalization..........................................................................70
V. Data Appendix ....................................................................................................................72

References................................................................................................................................73

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SUMMARY
This paper provides a review of recent empirical evidence, including some new
research, on the effects of financial globalization for developing economies. The paper
focuses on three questions:
(i)
Does financial globalization promote economic growth in developing countries?
(ii)
What is its impact on macroeconomic volatility in these countries?
(iii)
What factors can help to harness the benefits of financial globalization?


Developing economies’ financial linkages with the global economy have risen
significantly in recent decades. However, a relatively small group of these countries has
garnered a lion’s share of private capital flows from industrial to developing countries, which
surged in the 1990s. Despite the recent sharp reversals in such “North-South” capital flows,
various structural forces are likely to lead to a revival of these flows, and to continued
financial globalization, over the medium and long term.


Theoretical models have identified a number of channels through which international
financial integration can promote economic growth in developing countries. However, a
systematic examination of the evidence suggests that it is difficult to establish a strong causal
relationship. In other words, if financial integration has a positive effect on growth, there is
as yet no clear and robust empirical proof that the effect is quantitatively significant.


There is some evidence of a “threshold effect” in the relationship between financial
globalization and economic growth. The beneficial effects of financial globalization are more
likely to be detected when the developing countries have a certain amount of absorptive
capacity. Preliminary evidence also supports the view that, in addition to sound
macroeconomic policies, improved governance and institutions have an important impact on
a country’s ability to attract less volatile capital inflows, and on its vulnerability to crises.


International financial integration should, in principle, also help countries to reduce
macroeconomic volatility. The available evidence suggests that developing countries have
not fully attained this potential benefit. Indeed, the process of capital account liberalization
appears to have been accompanied in some cases by increased vulnerability to crises.
Globalization has heightened these risks since cross-country financial linkages amplify the
effects of various shocks and transmit them more quickly across national borders. A type of
threshold effect appears here as well—reductions in volatility are observed only after
countries have attained a particular level of financial integration.

The evidence presented in this paper suggests that financial integration should be
approached cautiously, with good institutions and macroeconomic frameworks viewed as
important. The review of the available evidence does not, however, provide a clear road map
for the optimal pace and sequencing of integration. For instance, there is an unresolved
tension between having good institutions in place before undertaking capital market
liberalization and the notion that such liberalization can itself help import best practices and
provide an impetus to improve domestic institutions. Such questions can best be addressed
only in the context of country-specific circumstances and institutional features.

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I. OVERVIEW
1. The recent wave of financial globalization since the mid-1980s has been marked by a
surge in capital flows among industrial countries and, more notably, between industrial and
developing countries. While these capital flows have been associated with high growth rates
in some developing countries, a number of countries have experienced periodic collapse in
growth rates and significant financial crises over the same period, crises that have exacted a
serious toll in terms of macroeconomic and social costs. As a result, an intense debate has
emerged in both academic and policy circles on the effects of financial integration for
developing economies. But much of the debate has been based on only casual and limited
empirical evidence.
2. The main purpose of this paper is to provide an assessment of empirical evidence on
the effects of financial globalization for developing economies. The paper will focus on three
related questions: (i) does financial globalization promote economic growth in developing
countries? (ii) what is its impact on macroeconomic volatility in these countries? (iii) what
are the factors that appear to help harness the benefits of financial globalization?
3. The principal conclusions that emerge from the analysis are sobering, but in many
ways informative from a policy perspective. It is true that many developing economies with a
high degree of financial integration have also experienced higher growth rates. It is also true
that, in theory, there are many channels by which financial openness could enhance growth.
However, a systematic examination of the evidence suggests that it is difficult to establish a
robust causal relationship between the degree of financial integration and output growth
performance. From the perspective of macroeconomic stability, consumption is regarded as a
better measure of well-being than output; fluctuations in consumption are therefore regarded
as having a negative impact on economic welfare. There is little evidence that financial
integration has helped developing countries to better stabilize fluctuations in consumption
growth, notwithstanding the theoretically large benefits that could accrue to developing
countries in this respect. In fact, new evidence presented in this paper suggests that low to
moderate levels of financial integration may have made some countries subject to even
greater volatility of consumption relative to that of output. Thus, while there is no proof in
the data that financial globalization has benefited growth, there is evidence that some
countries may have experienced greater consumption volatility as a result.
4. While the main objective of this paper is to offer empirical evidence, not to derive a
set of definitive policy implications, some general principles nevertheless emerge from the
analysis about how countries can increase the benefits from, and control the risks of,
globalization. In particular, the quality of domestic institutions appears to play a role in this
respect. A growing body of evidence suggests that it has a quantitatively important impact on
a country’s ability to attract foreign direct investment, and on its vulnerability to crises.
While different measures of institutional quality are no doubt correlated, there is
accumulating evidence of the benefits of robust legal and supervisory frameworks, low levels
of corruption, high degree of transparency and good corporate governance.
5. The review of the available evidence does not, however, provide a clear road map for
countries that have started on or desire to start on the path to financial integration. For

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instance, there is an unresolved tension between having good institutions in place before
capital market liberalization and the notion that such liberalization in itself can help import
best practices and provide an impetus to improve domestic institutions. Furthermore, neither
theory nor empirical evidence has provided clear-cut general answers to related issues such
as the desirability and efficacy of selective capital controls. Ultimately, these questions can
be addressed only in the context of country-specific circumstances and institutional features.
6. The remainder of this section provides an overview of the structure of this board
paper. In brief, Section II begins with a documentation of some salient features of global
financial integration from the perspective of developing countries. Sections III and IV
analyze the evidence on the effects of financial globalization on growth and volatility,
respectively, in developing countries. Section V discusses the relationship between the
quality of institutions and the benefit-risk tradeoff from financial integration.
A. Definitions and Basic Stylized Facts
7. Financial globalization and financial integration are, in principle different concepts.
Financial globalization is an aggregate concept that refers to rising global linkages through
cross-border financial flows. Financial integration refers to an individual country’s linkages
to international capital markets. Clearly, these concepts are closely related. For instance,
increasing financial globalization is perforce associated with rising financial integration on
average. In this paper, the two terms are used interchangeably.
8. Of more relevance for the purposes of this paper is the distinction between de jure
financial integration, which is associated with policies on capital account liberalization, and
actual capital flows. For example, indicator measures of the extent of government restrictions
on capital flows across national borders have been used extensively in the literature. By this
measure, many countries in Latin America would be considered closed to financial flows. On
the other hand, the volume of capital actually crossing the borders of these countries has been
large relative to the average volume of flows across all developing countries. Therefore, on a
de facto basis, these countries are quite open to global financial flows. By contrast, some
countries in Africa have few formal restrictions on capital account transactions but have not
experienced significant capital flows. The analysis in this paper will focus largely on de facto
measures of financial integration, as it is virtually impossible to compare the efficacy of
various complex restrictions across countries. In the end, what matters most is the actual
degree of openness. However, the paper will also consider the relationship between de jure
and de facto measures.
9. A few salient features of global capital flows are relevant for the central themes of the
paper. First, the volume of cross-border capital flows has risen substantially in the last
decade. Not only has there been a much greater volume of flows among industrial countries
but there has also been a surge in flows between industrial and developing countries. Second,
this surge in international capital flows to developing countries is the outcome of both “pull”
and “push” factors. “Pull factors” arise from changes in policies and other aspects of opening
up by developing countries. These include liberalization of capital accounts and domestic
stock markets, and large-scale privatization programs. “Push factors” include business cycle
conditions and macroeconomic policy changes in industrial countries. From a longer-term

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perspective, this latter set of factors includes the rise in the importance of institutional
investors in industrial countries and demographic changes (e.g., relative aging of the
population in industrial countries). The importance of these factors suggests that,
notwithstanding temporary interruptions in crisis periods or during global business cycle
downturns, the past twenty years have been characterized by secular pressures for rising
global capital flows to the developing world.

10. Another important feature of international capital flows is that the components of
these flows differ markedly in terms of volatility. In particular, bank borrowing and portfolio
flows are substantially more volatile than foreign direct investment. In spite of a caveat that
accurate classification of capital flows is not easy, evidence suggests that the composition of
capital flows can have a significant influence on a country’s vulnerability to financial crises.
B. Does Financial Globalization Promote Growth in Developing Countries?
11. This section 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 due to better risk management, and
improvements in both macroeconomic policies and institutions induced by the competitive
pressures or the “discipline effect” of globalization.
12. How much of the advertised benefits for economic growth have actually materialized
in the developing world? As documented in this paper, the average income per capita for the
group of more financially open (developing) economies does grow at a more favorable rate
than that of the group of less financially open economies. However, whether this actually
reflects a causal relationship and whether this correlation is robust to controlling for other
factors remain unresolved questions. The literature on this subject, voluminous as it is, does
not present a conclusive picture. A few papers find a positive effect of financial integration
on growth. However, the majority find no effect or at best a mixed effect. Thus, an objective
reading of the vast research effort 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.
13. 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 like
governance and rule of law. In this case, while embracing financial globalization may result

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in higher capital inflows, it is unlikely to cause faster growth by itself. In addition, some of
the countries with capital account liberalization have experienced output collapses related to
costly banking or currency crises. This is elaborated below. 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.

14. In short, while 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 point to an interesting contrast between
financial openness and trade openness, since an overwhelming majority of research papers
have found a positive effect of the latter on economic growth.
C. What Is the Impact of Financial Globalization on Macroeconomic Volatility?
15. In theory, financial globalization can help developing countries to better manage
output and consumption volatility. Indeed, a variety of theories implies that the volatility of
consumption relative to that of output should go down as the degree of financial integration
increases; the essence of global financial diversification is that a country is able to offload
some of its income risk in world markets. Since most developing countries are rather
specialized in their output and factor endowment structures, they can, in theory, obtain even
bigger gains than developed countries through international consumption risk sharing, that is,
by effectively selling off a stake in their domestic output in return for a stake in global
output.
16. How much of the potential benefits in terms of better management of consumption
volatility has actually been realized? This question is particularly relevant in terms of
understanding whether, despite the output volatility experienced by developing countries that
have undergone financial crises, financial integration has protected them from consumption
volatility. New research presented in this paper paints a troubling picture. Specifically, while
the volatility of output growth has, on average, declined in the 1990s relative to the three
earlier decades, the volatility of consumption growth relative to that of income growth has on
average increased for the emerging market economies in the 1990s, which was precisely the
period of a rapid increase in financial globalization. In other words, as argued in more detail
later in the paper, procyclical access to international capital markets appears to have had a
perverse effect on the relative volatility of consumption for financially integrated developing
economies.
17. Interestingly, a more nuanced look at the data suggests the possible presence of a
threshold effect. At low levels of financial integration, an increment in financial integration is
associated with an increase in the relative volatility of consumption. However, once the level
of financial integration crosses a threshold, the association becomes negative. In other words,
for countries that are sufficiently open financially, relative consumption volatility starts to
decline. This finding is potentially consistent with the view that international financial
integration can help to promote domestic financial sector development, which in turn can
help to moderate domestic macroeconomic volatility. However, thus far these benefits of
financial integration appear to have accrued primarily to industrial countries.

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18. In this vein, the proliferation of financial and currency crises among developing
economies is often viewed as a natural consequence of the “growing pains” associated with
financial globalization. These can take various forms. First, international investors have a
tendency to engage in momentum trading and herding, which can be destabilizing for
developing economies. Second, international investors may (together with domestic
residents) engage in speculative attacks on developing countries currencies, thereby causing
instability that is not warranted based on the economic and policy fundamentals of these
countries. Third, the risk of contagion presents a major threat to otherwise healthy countries
since international investors could withdraw capital from these countries for reasons
unrelated to domestic factors. Fourth, a government, even if democratically elected, may not
give sufficient weight to the interest of future generations. This becomes a problem when the
interests of future and current generations diverge, causing the government to incur excessive
amounts of debt. Financial globalization, by making it easier for governments to incur debt,
might aggravate this “over-borrowing” problem. These four hypotheses are not necessarily
independent, and can reinforce each other.
19. There is some empirical support for these hypothesized effects. For example, there is
evidence that international investors do engage in herding and momentum trading in
emerging markets, more so than in developed countries. Recent research also suggests the
presence of contagion in international financial markets. In addition, some developing
countries that open their capital markets do appear to accumulate unsustainably high levels of
external debt.
20. To summarize, one of the theoretical benefits of financial globalization, other than to
enhance growth, is to allow developing countries to better manage macroeconomic volatility,
especially by reducing consumption volatility relative to output volatility. The evidence
suggests that, instead, countries that are in the early stages of financial integration have been
exposed to significant risks in terms of higher volatility of both output and consumption.
D. The Role of Institutions and Governance in the Effects of Globalization
21. While it is difficult to find a simple relationship between financial globalization and
growth or consumption volatility, there is some evidence of nonlinearities or threshold
effects in the relationship. That is, financial globalization, in combination with good
macroeconomic policies and good domestic governance, appears to be conducive to growth.
For example, countries with good human capital and governance tend to do better at
attracting foreign direct investment (FDI), which is especially conducive to growth. More
specifically, recent research shows that corruption has a strongly negative effect on FDI
inflows. Similarly, transparency of government operations, which is another dimension of
good governance, has a strong positive effect on investment inflows from international
mutual funds.
22. The vulnerability of a developing country to the “risk factors” associated with
financial globalization is also not independent from the quality of macroeconomic policies
and domestic governance. For example, research has demonstrated that an overvalued
exchange rate and an overextended domestic lending boom often precede a currency crisis. In
addition, lack of transparency has been shown to be associated with more herding behavior

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Document Outline

• Contents
  • Summary
  • I. Overview
    • A. Definitions and Basic Stylized Facts
    • B. Does Financial Globalization Promote Growth in Developing Countries?
    • C. What Is the Impact of Financial Globalization on Macroeconomic Volatility?
    • D. The Role of Institutions and Governance on the Effects of Globalization
    • E. Summary
  • II. Basic Stylized Facts
    • A. Measuring Financial Integration
    • B. North-South Capital Flows
    • C. Factors Underlying the Rise in North-South Capital Flows
  • III. Financial Integration and Economic Growth
    • A. Potential Benefits of Financial Globalization in Theory
    • B. Empirical Evidence
    • C. Synthesis
  • IV. Financial Globalization and Macroeconomic Volatility
    • A. Macroeconomic Volatility
    • B. Crises as Special Cases of Volatility
    • C. Has Financial Globalization Intensified the Transmission of Volatility?
    • D. Some Factors That Increase Vulnerability to the Risks of Globalization
  • V. Absorptive Capacity and Governance in the Benefits/Risks of Globalization
    • A. Threshold Effects and Absorptive Capacity
    • B. Governance As an Important Element of Absorptive Capacity
    • C. Domestic Governance and the Volatility of International Capital Flows
    • D. Summary
  • Text Tables
    • 1. Volatility of Different types of Capital Inflows
    • 2. Fastest and Slowest Growing Economies During 1980?2000 and Their Status of Financial Openness
    • 3. Summary of Recent Research on Financial Integration and Economic Growth
    • 4. Volatility of Annual Growth Rates of Selected Variables
    • 5. Summary of Studies on Welfare Gains from International Risk Sharing
    • 6. Are Small States Different? Some Summary Statistics
  • Figures
    • 1. Measures of Financial Integration
    • 2. Gross Capital Flows...........................................................................................................
    • 3. Net Capital Flows
    • 4. Foreign Ownership Restrictions
    • 5. Channels Through Which Financial Integration Can Raise Economic Growth
    • 6. Increase in Financial Openness and Growth of Real Per Capital GDP
    • 7. Increase in Financial Openness and Growth of Real Per Capita GDP: Conditional Relationship, 1982?97
    • 8. Differential Effects of Financial and Trade Integration on Improvements in Health........
    • 9. Volatility of Income and Consumption Growth
    • 10. Corruption and Foreign Direct Investment
    • 11. Difference Between Actual Internationa Mutual Fund Investment and the MSCI Benchmark: Transparent versus Opaque Countries.......................................................
    • 12. Herding and Opacity..........................................................................................................
    • 13. Corruption Tilts the Compoition of Capital Flows Towards Borrowing...........................
    • 14. Welfare Gains from International Risk Sharing
  • Boxes
    • 1. The Effects of Different Types of Capital Flows on Growth
    • 2. Do Financial and Trade Integration Have Different Effects on Economic Development? Evidence from Life Expectancy and Infant Mortality
    • 3. The Effects of Globalization on Volatility: A Review of the Empirical Evidence
    • 4. Herding and Momentum Trading by International Investors
    • 5. Transparency and International Mutual Funds
  • Appendices
    • I. The First Era of International Financial Integration, 1870?1913
    • II. Calculating the Potential Welfare Gains from International Risk Sharing
    • III. Contingent Securities for International Risk Sharing
    • IV. Small States and Financial Globalization
    • V. Data Appendix
  • References

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