The IMF recently published a research paper discussing the effects of financial globalization on developing countries. The new study, “Effects of Financial Globalization on Developing Countries—Some Empirical Evidence”, by Eswar Prasad, Kenneth Rogoff, Shang-Jin Wei, and M. Ayhan Kose contributes to a more nuanced understanding of the role played by international capital flows in promoting development. It also contains some important implications for the policy framework of developing countries.

The study set out to answer the following three questions:

* Does financial globalization promote economic growth in developing countries?
* What is its impact on macroeconomic volatility in these countries?
* What factors can help harness the benefits of financial globalization?

Economic theory states that developing countries can accrue large benefits from financial integration. By opening their economies to capital inflows such as foreign direct investment, portfolio investments, and bank borrowing, countries not only encourage economic growth, they also help stabilize consumption, which is an important measure of economic well-being.

What the study found was that this theory doesn’t always hold true in practice. Even though income per capita is higher for developing countries that have more open economies, it is difficult to find strong evidence that suggests this is due to the fact that they have liberalized their capital account. In fact, some of these countries have experienced very costly banking or currency crises, when investors suddenly decided to withdraw their money.

However—and this is important—the study also found that once financial integration crosses a certain threshold, the positive effects of international capital flows (cheaper access to capital, transfer of new technology, development of the banking system) begin to cancel out the negative effects. Furthermore, countries with good economic policies and low corruption stand to gain from financial integration. These countries do a good job at attracting foreign direct investment, which is especially conducive to economic growth. In contrast, countries that are perceived by investors as lacking in transparency and/or as having poor economic policies, tend to rely more on “hot money”, such as short-term bank loans, and less on foreign direct investment. This makes them more prone to crisis.

To give an example, financial integration can encourage countries to overspend. Access to world capital markets makes it easier for governments to borrow—often excessively and on a short term basis. The accumulation of short-term debt in foreign currencies makes such countries more vulnerable to external shocks or changes in investor sentiment.

However, such risks offer reason to proceed with liberalization carefully; they are not reasons for turning away from it altogether. The IMF continues to believe that developing countries can reap significant advantages from opening up to the outside world. In this respect, it is important to keep in mind that this study looked at only one aspect of globalization—the role played by international capital flows in the economic development of developing countries. Other aspects of globalization, such as international trade and labor mobility, were not included in the analysis. An overwhelming majority of research papers have found that trade liberalization has a positive effect on economic growth. The financial-liberalization study therefore should not be seen as providing an answer to the broader question of whether globalization is “good” or “bad” for developing countries.

For more information on the IMF and capital account liberalization, please refer to:

Capital Account Liberalization and Financial Sector Stability, Shogo Ishii and Karl Habermeier, Occasional Paper 211, IMF, Washington DC 2002.

Capital Controls: Country Experiences with their Use and Liberalization, Akira Ariyoshi, Karl Habermeier, et. al., Occasional Paper 190, IMF, Washington DC, 2000.

Posted on May 22nd, 2003 by jl
Filed under: Economic Theory & Research, IMF, Intl Economics, Intl Financial System