Thierry Tressel

Over the past decades, financial globalization has progressed in many countries, sometimes motivating bold statements in favor of or against integration of capital markets. A growing body of evidence shows that assessing the benefits of financial globalization requires a more precise understanding of the role of country-specific influences—in particular, the two-way interactions between the forces of integration, on the one hand, and domestic policies and institutions, on the other hand. This article reviews the most recent IMF research on the role of domestic financial institutions in helping countries realize the benefits of financial globalization.

Financial globalization has advanced at a solid pace over the past decades. Lane and Milesi-Ferretti (2006) have constructed a comprehensive database of external positions of nations, and of the composition of external assets and liabilities. They document the increasing importance of equity financing and the improvement in the external position for emerging markets, and the differing pace of financial integration between advanced and developing economies.

In a recent paper, Gourinchas and Jeanne (2006a) argue that the permanent welfare gains from financial integration are rather limited for the typical emerging market country if one is guided only by the textbook neoclassical growth models. In particular, they are negligible relative to the domestic productivity takeoffs that have been observed in some of those countries over the past decades. This implies that most of the gains from financial integration are indirect and depend on the two-way interactions between financial globalization, on the one hand, and domestic policies and institutional structures, on the other hand. Gourinchas and Jeanne (2005) show, for example, that capital mobility can enhance the benefits of reforms but also facilitates self-fulfilling capital flight, which can destroy the political support for reform.

In their survey, Kose and others (2006) conclude that the growth and stability benefits of financial globalization are realized mainly through a broad set of “collateral benefits”—for example, financial market development, better institutions and governance, and macroeconomic discipline. They argue, however, that the macroeconomic gains are not fully evident in the short run and may be difficult to uncover in cross-country regressions, partly for methodological reasons. They also remark that benefits are likely to occur only in countries having reached sufficiently high levels of institutional development, including in their domestic financial markets.

It is now well established that the short-run effects of capital flows depend on domestic financial conditions. For example, in the worst-case scenario, a credit boom associated with a surge in capital flows precedes a sudden reversal that precipitates a credit crunch, which is followed by a fall in real credit to the private sector. (Demirgüç-Kunt and Detragiache (2005) summarize the literature on banking crises.) Rancière, Tornell, and Westermann (2005) find that countries that have experienced occasional financial crises have, on average, grown faster than countries with stable financial conditions. To explain this finding, they present a model in which systemic risk guarantees help relax borrowing constraints and increase investment, thus stimulating growth but also entailing a greater incidence of crises. These shocks are very costly, however: Becker and Mauro (2006) find that external financial shocks (“sudden stops”) have been the most costly for emerging markets (which are the more financially integrated economies among non-industrialized countries). According to Levchenko and Mauro (2006), sudden stops in financial flows are driven mainly by bank lending flows and official flows.

Two recent theories try to explain why a fall in the cost of external finance (which could be driven by financial integration) can have unintended consequences through the domestic banking system. Dell’Ariccia and Marquez (2006) show that when a shock leads to greater access to credit markets, a lending boom can develop and lead to a deterioration of credit quality as banks reduce their screening standards. This results in more output but can also increase the probability of a banking crisis. In the model of Tressel and Verdier (2006), a reduction in the cost of external finance can induce collusion between domestic banks and firms, particularly in countries where connected lending is prevalent. In such countries with weak bank supervision, financial integration negatively affects productivity, output, and bank governance.

To improve the soundness of their banks, many developing countries have strengthened their bank supervision and regulation and have endorsed and tried to comply with the Basel Core Principles of good banking supervision and regulation. Recent research confirms that there is a strong and positive relationship between bank soundness and compliance with principles related to information provision, even after controlling for macroeconomic stability and the overall institutional quality (Demirgüç-Kunt, Detragiache, and Tressel (2006)).

Two new papers also identify long-run pathological patterns in capital flows. Gourinchas and Jeanne (2006b) explain that although the Lucas paradox can easily be solved by a combination of frictions on international capital markets and slow domestic productivity growth, there remains an even bigger puzzle: the allocation among developing countries of capital flows from rich countries is the opposite of the one predicted by standard textbook models: more capital seems to go to the countries that invest less and have lower marginal products of capital. They suggest two potential, non-mutually exclusive explanations for this puzzle: (1) “mercantilist” behaviors of fast-growing countries (export-led development strategies combined with undervalued real exchange rates), and (2) underdevelopment of the domestic financial system.

Similarly, Prasad, Rajan, and Subramanian (2006) find a positive correlation between current account surpluses and long-run growth in non-industrialized countries. In contrast, they find that growth and foreign financing were positively correlated in industrial countries, as predicted by the theory. They argue that the behavior of savings is key to understanding this pattern of capital flows and could result from underdevelopment of the domestic financial sectors of developing countries. Another explanation is that manufacturing sectors geared toward export markets (an engine of growth) have been stronger in countries that avoided overvalued real exchange rates. A competitive real exchange rate, in turn, has been associated with smaller net inflows of foreign capital.

Ju and Wei (2006) offer a solution to two paradoxes: the Lucas paradox of “too little capital flows” and the paradox that according to a two-sector trade model with factor price equalization, cross-border capital flows should not occur. Their explanation is based on differences in the quality of financial systems and investor protection across countries, which can result simultaneously in South-North portfolio capital flows and North-South foreign direct investment (FDI).

Not all types of capital flows have been volatile in the short run, nor have they gone “upstream” in the long run. Gourinchas and Jeanne (2006b), as well as Prasad, Rajan, and Subramanian (2006), find that long-run FDI flows seem to be more consistent with the basic theory. They are also more stable in the short run, in particular during episodes of sudden stops (Levchenko and Mauro (2006)). Threshold effects, however, could matter for FDI as well: for example, Alfaro and others (2004) find that the growth impact of FDI is stronger in countries with well-developed financial sectors. A potential explanation is that that direct positive effects of FDI could be dampened in countries with weak bank governance by inducing more collusion between domestic banks and firms (Tressel and Verdier (2006)).

As a complement to capital mobility, institutional mobility can help maximize the gains from globalization. Indeed, many foreign banking institutions have opened branches or subsidiaries in developing countries to be able to reach local firms (Cerutti, Dell’Ariccia, and Martinez Peria (2006)). Foreign bank entry can bring many benefits to host countries: it can improve the efficiency of domestic banks by fostering competition, and it can help spread new technologies, better management techniques, and good governance practices. Foreign banks are also perceived as safer than private domestic banks, especially in times of economic difficulties. Unfortunately, there is no free lunch: Detragiache, Tressel, and Gupta (2006) find evidence that a larger foreign bank presence is associated with shallower banking systems in low-income countries, which is consistent with cream-skimming of the better firms by foreign banks. Tressel and Verdier (2006) show theoretically that competition by foreign banks can induce better governance of the domestic banking system. But this prediction can be reversed in countries in which a large proportion of opaque firms are financed only by domestic banks.