Abstract

Measures of de jure restrictions on capital flows and actual capital flows across national borders are two indicators of the extent of a country’s financial integration with the global economy. Understanding the differences between them is important when evaluating the effects of financial integration. By either measure, developing countries’ financial linkages with the global economy have risen in recent years.1 A relatively small group of developing countries, however, has garnered the lion’s share of private capital flows from industrial to developing countries, which surged in the 1990s. Structural factors, including demographic shifts in industrial countries, are likely to provide an impetus to these North-South flows over the medium and long terms.

Measures of de jure restrictions on capital flows and actual capital flows across national borders are two indicators of the extent of a country’s financial integration with the global economy. Understanding the differences between them is important when evaluating the effects of financial integration. By either measure, developing countries’ financial linkages with the global economy have risen in recent years.1 A relatively small group of developing countries, however, has garnered the lion’s share of private capital flows from industrial to developing countries, which surged in the 1990s. Structural factors, including demographic shifts in industrial countries, are likely to provide an impetus to these North-South flows over the medium and long terms.

Measuring Financial Integration

Capital account liberalization is typically considered an important precursor of financial integration. Most formal empirical work analyzing the effects of capital account liberalization has used a measure based on the official restrictions on capital flows as reported to the IMF by national authorities. This binary indicator, however, directly measures capital controls but does not capture differences in the intensity of these controls.2 A more direct measure of financial openness is based on the estimated gross stocks of foreign assets and liabilities as shares of GDP. The stock data constitute a better indication of integration, for our purposes, than the underlying flows, since they are less volatile from year to year and are less prone to measurement error (assuming that such errors are not correlated over time).3

Although these two measures of financial integration are related, they denote two distinct aspects. The capital account restrictions measure reflects the existence of de jure restrictions on capital flows while the financial openness measure captures de facto financial integration in terms of realized capital flows. This distinction is of considerable importance for the analysis in this paper and implies a 2x2 set of combinations of these two aspects of integration. Many industrial countries have attained a high degree of financial integration in terms of both measures. On the one hand, some developing countries with capital account restrictions have found these restrictions ineffective in controlling actual capital flows. Episodes of capital flight from some Latin American countries in the 1970s and 1980s are examples of such involuntary de facto financial integration in economies that are de jure closed to financial flows (that is, where integration has occurred without capital account liberalization). On the other hand, some countries in Africa have few capital account restrictions but have experienced only minimal levels of capital flows (that is, where liberalization has occurred without integration).4 And, of course, it is not difficult to find examples of countries with closed capital accounts that are also effectively closed in terms of actual flows.

How has financial integration evolved over time for different groups of countries based on alternative measures?5 By either measure, the difference in financial openness between industrial and developing countries is quite stark. Industrial economies have had an enormous increase in financial openness, particularly in the 1990s. Although this measure also increased for developing economies in that decade, its level remains far below that for industrial economies.

Unweighted cross-country averages of the two measures for industrial countries are mirror images and jointly confirm that these countries have undergone rapid financial integration since the mid-1980s (Figure 2.1).6 For developing countries, the average restriction measure indicates that after a period of liberalization in the 1970s, the trend toward openness was reversed in the 1980s. Liberalization resumed in the early 1990s, but at a slow pace. In contrast, the average financial openness measure for these countries, based on actual flows, shows a modest increase in the 1980s, followed by a sharp rise in the 1990s. The increase in the financial openness measure for developing economies reflects a more rapid de facto integration than is captured by the relatively crude measure of capital account restrictions.

Figure 2.1.
Figure 2.1.

Measures of Financial Integration

Sources: IMF (2001 and 2002); and Lane and Milesi-Ferretti (2003).Notes: In each panel, the left-hand vertical axis displays scores on an index of capital account restrictions and the right-hand vertical axis displays ratios of foreign assets and liabilities to GDP.

The effects of financial integration in terms of increased capital flows, however, have been spread very unevenly across developing countries.7 To examine the extent of these disparities, it is useful to begin with a very coarse classification of the developing countries in the sample into two groups by ranking them according to the average of the financial openness measure over the last four decades and an assessment of other indicators of financial integration.

The first group, which comprises 22 countries, will hereinafter be referred to as the more financially integrated (MFI) countries and the second group, which includes 33 countries, as the less financially integrated (LFI) countries.8 This distinction must be interpreted with some care at this stage. In particular, it is worth repeating that the criterion used for classifying countries is a measure of de facto integration based on actual capital flows rather than a measure of the strength of policies designed to promote financial integration. Indeed, a few of the countries in the MFI group do have relatively closed capital accounts in a de jure sense. In general, as argued later in the paper, policy choices determine the degree and nature of financial integration. Nevertheless, for purposes of the analysis described in this paper, the degree of financial openness based on actual capital flows is a more relevant measure.

It should be noted that our main conclusions are not crucially dependent on the particulars of the classification of developing countries into the MFI and LFI groups. This classification is obviously a static one and does not account for differences across countries in the timing and degree of financial integration. It is used for some of the descriptive analysis presented here, but only in order to illustrate the conclusions from the more detailed econometric studies surveyed in the paper. The areas where this classification yields results different from those obtained from more formal econometric analysis are clearly highlighted. The regression results reported are based on the gross capital flows measure, which does capture differences across countries and changes over time in the degree of financial integration.

Figure 2.2 shows that the vast majority of international private gross capital flows of developing countries, especially in the 1990s, are accounted for by the relatively small group of MFI economies.9 By contrast, private capital flows to and from the LFI economies have remained very small over the last decade and, for certain types of flows, even fallen below the levels of the late 1970s.

Figure 2.2.
Figure 2.2.

Gross Capital Flows

(Percent of GDP)

Sources: International Monetary Fund, World Economic Outlook and International Financial Statistics, various issues.Notes: The left scales on the two panels are different. FDI denotes foreign direct investment.

North-South Capital Flows

One of the key features of global financial integration over the last decade has been the dramatic increase in net private capital flows from industrial countries (the North) to developing countries (the South). Figure 2.3 breaks down the levels of these flows into the three main constituent categories. The main increase has been in terms of FDI and portfolio flows, while the relative importance of bank lending has declined somewhat. In fact, net bank lending turned negative for a few years during the Asian crisis.

Figure 2.3.
Figure 2.3.

Net Private Capital Flows

(Billions of U.S. dollars)

Source: IMF, World Economic Outlook, various issues.Notes: Bank lending to the more financially integrated economies was negative between 1997 and 1999. FDI denotes foreign direct investment.

The bulk of the surge in net FDI flows from the advanced economies has gone to MFI economies, with only a small fraction going to LFI economies (Figure 2.3, lower panels). Net portfolio flows show a similar pattern, although both types of flows to MFI economies fell sharply following the Asian crisis and have remained relatively flat since. LFI economies have been much more dependent on bank lending (and, although this is not shown in the figure, on official flows including loans and grants). There were surges in bank lending to this group of countries in the late 1970s and early 1990s.

Another important feature of these flows is that they differ substantially in terms of volatility. Table 2.1 shows the volatility of FDI, portfolio flows, and bank lending to developing economies. FDI flows constitute the least volatile category of private capital flows to developing economies, which is not surprising given their long-term and relatively fixed nature. Portfolio flows tend to be far more volatile and prone to abrupt reversals than FDI. These patterns hold when the MFI and LFI economies are examined separately. Even for LFIs, the volatility of FDI flows is much lower than those of other types of flows.10 These differences in the relative volatility of different categories have important implications that will be examined in more detail later.

Table 2.1.

Volatility of Different types of Capital Inflows

article image
Source: Wei (2001).Notes: Computed over the period 1980-96. Only countries with at least eight nonmissing observations during the period for all three variables and a population greater than or equal to one million in 1995 were kept in the sample. MFI denotes more financially integrated, and LFI less financially integrated, economies. Total inward foreign direct investment (FDI) flows, total bank loans, and total inward portfolio investments are from the IMF’s Balance of Payments Statistics (Washington), various issues.

Factors Underlying the Rise in North-South Capital Flows

The surge in net private capital flows to MFIs, as well as the shifts in the composition of these flows, can be broken down into pull and push factors (Calvo, Leiderman, and Reinhart, 1993). These are related to, respectively, (i) policies and other developments in the MFIs, and (ii) changes in global financial markets. The first category includes factors, such as stock market liberalizations and privatization of state-owned companies, that have stimulated foreign inflows. The second category includes the growing importance of depositary receipts and cross-listings, and the emergence of institutional investors as important sources of international capital flows to emerging markets.

The investment opportunities afforded by stock market liberalizations, which have typically included the provision of access to foreign investors, have enhanced capital flows to MFIs. How much have restrictions on foreign investors’ access to local stock markets in MFIs changed over time? To answer this question, it is useful to examine a new measure of stock market liberalization that captures restrictions on foreign ownership of domestic equities. This measure, constructed by Edison and Warnock (2001), is obviously just one component of capital controls, but an appropriate one for modeling equity flows. Figure 2.4 shows that stock market liberalizations in MFI economies in different regions have proceeded rapidly, in terms of both intensity and speed.11

Figure 2.4.
Figure 2.4.

Foreign Ownership Restrictions in More Financially Integrated Developing Economies

Source: Edison and Warnock (2001).Note: This index measures the intensity of restrictions on the access that foreign investors have to a particular country’s equity markets.

Mergers and acquisitions, especially those resulting from the privatization of state-owned companies, were an important factor underlying the increase in FDI flows to MFIs during the 1990s. The easing of restrictions on foreign participation in the financial sectors of MFIs have also provided a strong impetus for such activity.12

Institutional investors in the industrial countries—including mutual funds, pension funds, hedge funds, and insurance companies—have assumed an important role in channeling capital flows from industrial to developing economies. They have helped individual investors overcome the information and transaction cost barriers that previously limited portfolio allocations to emerging markets. Mutual funds, in particular, have served as an important instrument individuals can use to diversify their portfolios into developing country holdings.13 Although international institutional investors devote only a small fraction of their portfolios to holdings in MFIs, they have an important presence in these economies, given the relatively small size of their capital markets. Funds dedicated to emerging markets alone hold, on average, 5-15 percent of the Asian, Latin American, and transition economies’ market capitalizations.

Notwithstanding the moderation of North-South capital flows following recent emerging market crises, certain structural forces are likely to lead to a revival of these flows over the medium and long terms. Demographic shifts, in particular, have had an important effect on these flows. Projected increases in old-age dependency ratios reflect the major changes in demographic profiles under way in industrial countries. This trend is likely to intensify further in the coming decades, fueled both by advances in medical technology that have increased average life spans and the decline in fertility rates. Financing the post-retirement consumption needs of a rapidly aging population will require increases in current saving rates, both national and private, in these economies. If such increases in saving rates do materialize, however, they are likely to result in a declining rate of return on capital in advanced economies, especially relative to those in the capital-poor countries of the South. This will encourage capital flows to countries where higher returns are available.14

All of these forces imply that despite the recent sharp reversals in North-South capital flows, developing countries will eventually once again face the delicate balance of opportunities and risks afforded by financial globalization. Are the benefits derived from financial integration sufficient to offset the costs of increased exposure to the vagaries of international capital flows? The paper now turns to an examination of the evidence on this question.

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