International financial integration has increased dramatically in the global economy over the past three decades, though this process has affected advanced countries to a much greater extent than other segments of the IMF's membership, in particular the developing countries. The differing trends in de facto financial integration reflect in part countries' different policies with respect to the strength of de jure capital controls—notably the relatively early liberalization of the financial account in advanced countries. In addition, relative institutional quality and domestic financial development have also acted as constraints on the extent of de facto financial integration among emerging market and developing countries. Notwithstanding differences across segments of the IMF's membership, the global trend toward increased international financial integration has affected all segments of the Fund's membership, and even—if to a lesser degree—those countries that have sought to lean against the wind through relatively restrictive financial account regimes.
In principle, greater financial openness holds promise: gains may come from greater risk sharing, a more efficient worldwide allocation of capital, and broader technology transfer. Sizable gross external asset and liability positions in advanced countries seem to be reflected in significant risk-sharing gains and, to the extent that international asset trade expands further in emerging market and developing countries in the years ahead, risk-sharing gains should be at least as large, in view of the relatively high current degree of consumption volatility in this segment of the IMF's membership. Closer integration of emerging market and developing countries into global financial markets may also provide significant benefits to advanced country residents through enhanced opportunities for portfolio diversification.
Empirical evidence on the stability benefits of international financial integration is mixed. The results reported in the paper suggest that, for countries with relatively strong institutions, well-developed domestic financial systems, and sound macroeconomic policy frameworks, greater integration has not been accompanied by significantly higher macroeconomic volatility, whereas for countries without those conditions in place, volatility has tended to increase with greater openness. Likewise, within a sample of financially open countries, crisis frequency is found to be lower for countries that are relatively open to international trade, and with strong institutions, sound policies, and well-developed financial sectors.
The empirical relationship between international financial integration and long-run economic growth is complex. Evidence presented above stresses the importance of unbundling financial integration into different components: FDI and other nondebt forms of financing are found to be positively and significantly associated with economic growth, whereas the impact of debt seems to depend on the strength of a country's institutions and policies. It bears noting, however, that even for countries that do not meet relevant thresholds, policymakers will need to take into account—in framing their strategies in relation to financial liberalization—that greater financial openness is associated with a number of “collateral benefits” that in turn seem to foster economic growth. In other words, when assessing the merits of liberalization, policymakers will need to be cautious, but also consider the costs of caution implied by efficiency losses related to capital controls.
The policy relevance of thresholds for country fundamentals is likely to differ across segments of the IMF's membership (Table 7.1). For countries that do not yet meet the relevant thresholds, the appropriate focus of policymakers is likely to be on improving fundamentals—such as domestic financial sector development, macroeconomic policy frameworks, and institutions. This said, opening up to inward FDI—a type of flow whose benefits do not seem to hinge on such preconditions—would appear to be desirable at an early stage, given FDI's favorable impact on growth and no adverse effect on stability; liberalization of other types of flow should be delayed until country fundamentals are raised to be more in line with relevant thresholds, and growth-stability trade-offs are more favorable. For countries that are small or geographically isolated, greater financial market transparency can be an important vehicle for attracting foreign capital and reaping corresponding benefits.
Summary of Findings and Policy Implications
Summary of Findings and Policy Implications
| Estimated Effects of Financial Integration | |||
|---|---|---|---|
| Country Characteristics | Benefits | Costs | Recommended Focus of Policies |
| Countries with well-developed financial markets, high perceived institutional quality; sound macroeconomic policies. | Risk sharing benefits apparent. Higher TFP growth. Higher economic growth (FDI). Reduction in distortions associated with controls. Faster financial sector development. Macroeconomic policy discipline. | No significant increase in macroeconomic volatility. No detrimental effect from debt-creating flows. | Continued capital account liberalization. Promote financial market transparency and sound governance practices. |
| Countries close to meeting the thresholds in terms of financial market development, perceived institutional quality, and macroeconomic policies. | Potential for large increase in risk sharing. Higher TFP growth. Higher economic growth (FDI). Reduction in distortions associated with controls. Reduction in the cost of capital. Faster financial sector development. Greater macroeconomic policy discipline. | Moderate increase in macroeconomic volatility and the probability of financial crises. Growth effects of debt flows uncertain. | Inward FDI liberalization. Case-by-case evaluation of opportunity for broader liberalization. Strengthening of domestic fundamentals. |
| Countries far from meeting thresholds. | Greatest potential for increases in risk sharing. Higher TFP growth. Higher economic growth (FDI). Reduction in distortions associated with controls. Reduction in the cost of capital. Faster financial sector development. Greatest benefits for macroeconomic policy discipline. | Potential for significant increase in macroeconomic volatility and the probability of financial crises. Negative effect of debt-creating flows on growth. | Strengthening of domestic fundamentals. Inward FDI liberalization. |
Summary of Findings and Policy Implications
| Estimated Effects of Financial Integration | |||
|---|---|---|---|
| Country Characteristics | Benefits | Costs | Recommended Focus of Policies |
| Countries with well-developed financial markets, high perceived institutional quality; sound macroeconomic policies. | Risk sharing benefits apparent. Higher TFP growth. Higher economic growth (FDI). Reduction in distortions associated with controls. Faster financial sector development. Macroeconomic policy discipline. | No significant increase in macroeconomic volatility. No detrimental effect from debt-creating flows. | Continued capital account liberalization. Promote financial market transparency and sound governance practices. |
| Countries close to meeting the thresholds in terms of financial market development, perceived institutional quality, and macroeconomic policies. | Potential for large increase in risk sharing. Higher TFP growth. Higher economic growth (FDI). Reduction in distortions associated with controls. Reduction in the cost of capital. Faster financial sector development. Greater macroeconomic policy discipline. | Moderate increase in macroeconomic volatility and the probability of financial crises. Growth effects of debt flows uncertain. | Inward FDI liberalization. Case-by-case evaluation of opportunity for broader liberalization. Strengthening of domestic fundamentals. |
| Countries far from meeting thresholds. | Greatest potential for increases in risk sharing. Higher TFP growth. Higher economic growth (FDI). Reduction in distortions associated with controls. Reduction in the cost of capital. Faster financial sector development. Greatest benefits for macroeconomic policy discipline. | Potential for significant increase in macroeconomic volatility and the probability of financial crises. Negative effect of debt-creating flows on growth. | Strengthening of domestic fundamentals. Inward FDI liberalization. |
The need to make early progress with respect to country fundamentals in order to reap net benefits from financial liberalization is highlighted, in particular, by the potentially large costs associated with maintaining a pervasive structure of capital account restrictions. Recent empirical studies based on micro-economic data suggest that controls may increase the difficulty and cost of corporate finance, particularly for small firms. The evidence also suggests that capital controls insulate domestic firms from competitive forces and thereby undercut economic efficiency, induce distortions in the “playing field” for local firms, carry significant administrative costs, and reduce international trade. Indeed, a promising area for future research is to quantify the macroeconomic implications of financial globalization beginning from estimates based on this more illuminating microeconomic evidence.
Looking forward, the net benefits from financial integration are likely to be larger than in the past, in view of a more equity-based structure of international asset and liability positions, as well as policy and institutional reforms that increasingly are bringing emerging market countries up to the thresholds where net benefits associated with liberalization are likely to turn positive. These developments bode well for member countries' ability to fully reap the benefits of financial globalization in the years ahead.