Financial integration and Economic growth

1. Financial integration and Economic growth Outcomes and policies for developing countries Select references: Prasad, Rogoff, Wei, Kose (2003); Kaminsky, Reinhart (1999); Obstfeld and Rogoff (1998); Kaminsky, Reinhart, Vegh (2004)

2. The second era of globalization • 1985- present • Unprecedented increases in the trade and financial integration • Based on the sample of 76 countries (Prasad Rogoff, Wei, Kose (2003)) • Volume of trade as a share of GDP increased from 75% in 1980s to 150% at the end of 1990s • Countries with liberalized trade regimes increased from 30% to 85% with open financial accounts increased from 20% to 55% • Increase in the capital flows from Industrialized to Developing countries

4. Financial globalization and growth: theory and evidence • How did financial integration affect economic outcomes? • Things to keep in mind: • Experience with globalization is relatively recent for many countries– empirical evidence can be misleading. • The “growing pains” of countries learning to live in globalized world can result in both success and failure • The current data may reflect the “short run” as opposed to the “long run” effect of financial integration. • The big question: what can we learn from countries experience to reap the benefits of financial integration while minimizing the costs?

5. Financial globalization and growth: theory perspective • Growth theory: one of the key ingredients in economic growth is domestic private investment It (contributes to capital stock) • Production function general form : Y = A*(KaL1-a) • Were Y – output (GDP); A – technology ; K- capital stock; L – quantity of labor used in production; • a – parameter that tells us by how much (in percent) output will increase if K increases by 1% • Production function exhibits “diminishing returns to capital” – each unit of capital increases output, but at a decreasing rate

6. Implications for developing economies • Openness to foreign capital flows has several important benefits • Directly • - provides an additional source of savings (the country does not have to sacrifice current consumption for the sake of future output growth) • Closed economy: Y = C + I + G • => Y-C-G = I • In the closed economy investment must equal to national savings ( Y-C-G). This creates potential for a poverty trap when Y is very low. • Open economy : Y = C + I + G + CA • CA – indicates how much the country is lending/borrowing from the rest of the world • => ( Y-C-G) – CA = I • IN ORDER TO INVEST THE OPEN ECONOMY DOES NOT NEED TO RELY ON NATIONAL SAVINGS ALONE.

7. Implications for developing economies • In theory countries with lowest capital stock should attract the most capital. • Why? Due to diminishing returns, the return on capital is much higher when the stock of capital is low. • Financially open economies should be better able to diversify country-specific risk • Better risk-sharing results in the lower cost of capital, increases domestic investment. • Competitiveness improves the quality of DOMESTIC financial institutions (better, more efficient domestic banks)

8. Implications for developing economies • Indirectly: • Financial integration ENCOURAGES SPECIALIZATION by allowing better risk diversification options • Financial integration may constrain the country’s government to pursue better policies (the cost of bad policy decisions is greatly increased in financially integrated economies) • Signaling effect: liberalization of financial markets may signal broader policy reforms favorable to foreign investment

9. Empirical evidence • At first glance there seems to be a positive correlation between financial openness and economic growth. • BUT correlation does not imply causation • Could growth be caused by other factors unrelated to financial openness? • Could it be that economies which are fast growing to begin with also tend to experience higher financial openness? • Most recent empirical studies: accounting for other factors, financial openness has at best weak association with economic growth. • CONCLUSION: FINANCIAL OPENNESS ON ITS OWN DOES NOT GUARANTEE HIGHER ECONOMIC GROWTH

10. EXPLAINING THE THEORY- EMPIRICs DISCONNECT • Capital accumulation alone can increase growth but only up to a point • Solow growth model: because capital breaks down/becomes obsolete, the country must invest every year just to keep the capital stock at the existing level. • The larger the capital stock, the more investment is needed just to keep it up. • At some point the country’s entire savings will be devoted just to replace the obsolete and worn out capital stock. (at that point the growth of capital stock would stop) • Example: USSR in the 1960s – growth driven by capital accumulation • Modern day China – output growth driven in part by factors other than capital and labor (technology improvements?) • Strong institutions and productivity improvements, rather than capital accumulation, are responsible for differences in the growth rates and levels of output per capita between countries

11. EXPLAINING THE THEORY- EMPIRICs DISCONNECT • Financial openness and economic volatility: • Financial openness is often accompanied by financial crises – currency, banking and twin crises (all of them are damaging to output in the short run and some of them possibly in the long run). • Financial openness promotes specialization, which can make the country more vulnerable to output shocks. • This is not a problem if a country can borrow in bad times and repay in good times. BUT: • Developing countries often experience SUDDEN STOPS - abrupt reversals of capital flows from abroad during bad times. This amplifies the cost of financial crises and output shocks.

13. EXPLAINING THE THEORY- EMPIRICs DISCONNECT • Capital flows into developing countries depend on both external and internal factors: • External: • - macroeconomic conditions and shocks in industrialized countries. Example: low US interest rates usually imply heavy investment flows to emerging markets (can create credit bubbles). • (The most volatile types of capital: short-term portfolio investments and bank lending. FDI is less sensitive to external conditions) • - contagion (when investors pull out capital from the country after a crises happens in another developing country). Financial globalization increases the risk of financial contagion. • - herding behavior on the financial markets • Internal: country’s own shocks and macroeconomic conditions

14. What can the country do to minimize risk? • Structure of debt and strength of financial institutions is important: • although financial crises can happen even in the economy with more or less good economic fundamentals, the severity of financial crises increases when • - country borrows in foreign currency • - country can only borrow short-term • - ratio of (bank borrowing + other debt) to FDI is high. • - high government spending (together with fixed exchange rate regime can lead to currency crisis) • - opening financial markets when institutions (for example banking regulations are weak). • - counter-cyclical fiscal policies

15. Other policy options to benefit from financial integration • The theoretical channels through which financial integration improves growth can work only under certain conditions: • Empirical evidence: • - FDI improves growth, for countries with high level of human capital • - The level of FDI inflows is highly correlated with low corruption, higher transparency of macroeconomic policies and corporate finance • - Higher levels of financial integration reduce volatility of output and consumption but only beyond a certain threshold ( which has not been reached by most developing countries). • - Having good financial supervision in place BEFORE the country opens up to capital inflows from abroad is essential for minimizing the risk of devastating financial crises.