1 Financial Globalization and Crises: Overview T. Beck * , S. Claessens † , S.L. Schmukler ‡ * CentER and European Banking Center, Tilbug University, The Netherlands and CEPR, London, UK † International Monetary Fund, Washington DC, USA; University of Amsterdam, Amsterdam, The Netherlands; and CEPR, London, UK ‡ The World Bank, Washington DC, USA A final version of this paper is forthcoming as the overview chapter in: The Evidence and Impact of Financial Globalization , Gerard Caprio, Thorsten Beck, Stijn Claessens, and Sergio Schmukler (Eds.), Elsevier. INTRODUCTION Financial globalization, the integration of countries with the global financial system, has increased substantially since the 1970s and particularly with more force since the 1990s. In fact, the gold standard period of 1880-1914 saw a major wave of financial globalization, as cross-border capital flows surged, incorporating countries in the center and the periphery at that time into a worldwide network of finance and investment. With the advent of World War I, global growth halted and international financial integration was disrupted as barriers were erected, with minimal capital movements between 1914 and 1945. Although domestic financial markets remained heavily regulated and control were typically imposed on capital flows, a slow reconstruction of the world financial system took place during the Bretton Woods era of 1945-71. It was not until the late 1970s, however, that the world witnessed the beginning of a new wave of international financial integration, reflecting the dismantling of capital controls, the deregulation of domestic financial systems, and a technological revolution, not just in information and telecommunications, but also in financial product engineering. Newly emerging markets joined this wave of financial globalization with vigor starting in the latter part of the 1980s and mostly in the 1990s. This process of financial globalization has shown to pose both benefits and risks to developed and developing countries alike, sometimes with similar and at other times with different consequences. On the one hand, analyses and experiences have shown that countries can benefit in several ways from financial globalization. Conceptually, the most straightforward advantage is having a greater supply of external financing available at lower costs. By having access to a wider range of instruments that can better serve their circumstances, financial integration also allows for better risk diversification. Moreover, as in the case of foreign direct investment (FDI), foreign capital can allow for the import of knowledge and technology that can help to boost national productivity. And as countries allow foreigners to participate in their domestic banking systems and capital markets, they can expect improvements in the quality of financial services.
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1
Financial Globalization and Crises: Overview
T. Beck*, S. Claessens†, S.L. Schmukler‡
* CentER and European Banking Center, Tilbug University, The Netherlands and CEPR, London, UK † International Monetary Fund, Washington DC, USA; University of Amsterdam, Amsterdam, The
Netherlands; and CEPR, London, UK ‡ The World Bank, Washington DC, USA
A final version of this paper is forthcoming as the overview chapter in:
The Evidence and Impact of Financial Globalization, Gerard Caprio, Thorsten Beck, Stijn Claessens, and Sergio Schmukler (Eds.), Elsevier.
INTRODUCTION
Financial globalization, the integration of
countries with the global financial system, has
increased substantially since the 1970s and
particularly with more force since the 1990s. In fact,
the gold standard period of 1880-1914 saw a major
wave of financial globalization, as cross-border
capital flows surged, incorporating countries in the
center and the periphery at that time into a
worldwide network of finance and investment. With
the advent of World War I, global growth halted and
international financial integration was disrupted as
barriers were erected, with minimal capital
movements between 1914 and 1945. Although
domestic financial markets remained heavily
regulated and control were typically imposed on
capital flows, a slow reconstruction of the world
financial system took place during the Bretton
Woods era of 1945-71. It was not until the late
1970s, however, that the world witnessed the
beginning of a new wave of international financial
integration, reflecting the dismantling of capital
controls, the deregulation of domestic financial
systems, and a technological revolution, not just in
information and telecommunications, but also in
financial product engineering. Newly emerging
markets joined this wave of financial globalization
with vigor starting in the latter part of the 1980s and
mostly in the 1990s.
This process of financial globalization has
shown to pose both benefits and risks to developed
and developing countries alike, sometimes with
similar and at other times with different
consequences. On the one hand, analyses and
experiences have shown that countries can benefit
in several ways from financial globalization.
Conceptually, the most straightforward advantage is
having a greater supply of external financing
available at lower costs. By having access to a wider
range of instruments that can better serve their
circumstances, financial integration also allows for
better risk diversification. Moreover, as in the case
of foreign direct investment (FDI), foreign capital
can allow for the import of knowledge and
technology that can help to boost national
productivity. And as countries allow foreigners to
participate in their domestic banking systems and
capital markets, they can expect improvements in
the quality of financial services.
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On the other hand, financial globalization can
also entail important risks. As countries become
more intertwined with the international financial
system, adverse shocks in foreign countries can be
threats to domestic stability through contagion
effects, potentially making countries prone to crises.
Furthermore, financial globalization can pose
challenges for the management of external assets
and liabilities and can complicate the operations of
banks and corporations. Several crisis episodes in
the 1990s and the global financial crisis that began
in 2009 serve as vivid reminders of these risks.
This book The Evidence and Impact of Financial
Globalization aims at analyzing this process of
financial globalization, from its driving forces to its
consequences. This overview chapter provides a
brief summary of the chapters, reviewing the
empirical evidence on globalization and crises. All
chapters in this book are listed in the table below.
Chapter Author(s) Title
1 Beck, T., S. Claessens, S. Schmukler
Financial Globalization and Crises: Overview
Evidence on Financial Globalization
2 Quinn, M., M Schlinder, A. Toyoda
Measurements of Capital and Financial Current Account Openness
3 Lundblad, C. Measurement and Impact of Equity Market Liberalization
4 Sa, F. Bilateral Financial Links 5 Chinn, M. Global Imbalances 6 Cassimon, D., D.
Essers, R. REnard, K.Verbeke
Aid Flows
Forces Behind Globalization
7 Kirabaeva, K., A. Razin
Composition of International Capital Flows: A Survey
8 Ratha,D., S. Mohapatra
Migrant Remittances and Development
9 Gelos, G. International Mutual Funds, Capital Flow Volatility, and Contagion –A Survey
10 Hale, G Capital Raisings
11 Gagnon, L., A. Karolyi
International Cross-Listings
12 McCahery, J., E. Vermeulen
Disclosure of Ownership and Public Companies
13 Love, I. Role of Trade Finance 14 Cull, R., M.S.
Martinez Peria Foreign Bank Participation in Developing Countries
15 McBrady, M., M. Schill
Opportunistic Foreign Currency Debt Issuance
16 Panizza, U., F. Sturzenegger, J. Zettelmeyer
International Government Debt
17 Jorda, O. Carry Trade
Effects of Financial Globalization
18 Cline, W. Capital Market Integration 19 Aykut, D., A. Kose Collateral Benefits of Financial
Globalization 20 Alfaro, L., M.
Johnson Foreign Direct Investment and Growth
21 Javorcik, B.S. International Technology Transfer and Foreign Direct Investment
22 Kalemli-Ozcan, S., C. Villegas-Sánchez
Role of Multinational Corporations in Financial Globalization
23 Shah, A., I. Patniak India’s Reintegration into the World Economy in the 1990s
24 Barth, J., L. Li, T. Li, F. Song
Reforms of China’s Banking System
25 Barth, J., L. Li, T. Li, F. Song
Policy Issues of China’s Financial Globalization
26 Jappelli, T., M. Pagano
Financial Integration in Europe
Monetary and Exchange Rate Policy under Financial Globalization
27 Aizenman, J. The Impossible Trinity (aka The Policy Trilemma)
28 Kamin, S. Financial Globalization and Monetary Policy
29 Levich, R. Interest Rate Parity 30 Levy Yeyati, E. Exchange Rate Regimes 31 Santos Silva, J.M.C.,
S. Tenreyro Currency Unions
32 Ize, A. Financial Dollarization
Crises
33 Glick, R., M. Hutchison
Models of Currency Crises
34 Chamon, M., C. Crowe
Predictive Indicators of Financial Crises
35 Flood, R., N. Marion, J. Yepez
A Perspective on Predicting Currency Crises
36 Goldstein, I. Empirical Literature on Financial Crises: Fundamentals vs. Panic
37 Izquierdo, A. Sudden Stops in Capital Flows 38 Pritsker, M. Definitions and Types of
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Financial Contagion 39 Wall, L. Cross-Border Banking:
Regulation, Supervision, and Crisis Resolution
40 Underhill, G. Market-Based Approach to Financial Architecture
41 Leamer, E. Housing is the Business Cycle 42 Carlson, M. US Stock Market Crisis of 1987 43 Musacchio, A. Mexican Financial Crisis of
1994-1995 44 Ghosh, S.R East-Asian Crisis of 1997 45 Pinto, B., S. Ulanov Financial Globalization and
the Russian Crisis of 1998 46 Takagi, S. Argentina’s Default of 2001 47 Ho, C., F. Signoretti Assessment of Solutions to US
Financial Crisis of 2008-09 48 Claessens, S., G.
Dell’Ariccia, D. Igan, L. Laeven
A Cross-Country Perspective on the Causes of the Global Financial Crisis
49 Claessens, S., G. Dell’Ariccia, D. Igan, L. Laeven
Lessons and Policy Implications from the Global Financial Crisis
This overview summarizing the different
chapters is organized in sections. The section
‘Evidence on Financial Globalization’ describes
chapters that present evidence on the process of
financial globalization, ways to measure it, and the
evolution of financial globalization over time and
across countries. The section ‘Forces behind
Globalization’ discusses chapters that offer accounts
of some of the drivers behind the process of global
financial integration. The section ‘Effects of
Financial Globalization’ deals with chapters that
discuss the effects of financial globalization and
analyze the experiences of some important
countries and regions, namely, China, India, and the
European Monetary Union. The section ‘Monetary
and Exchange Rate Policy under Financial
Globalization’ summarizes chapters that analyze
monetary and exchange rate policy under financial
globalization, considering the restrictions imposed
by the ‘Impossible Trinity,’ amount others. The
section ‘Crises’ describes chapters that present
evidence on financial crises, many of which are
related to financial integration, considering their
predictability, causes, consequences, and policy
responses. Finally, the section ‘Final Words’ offers
some final thoughts. It is important to stress that
the discussion of some chapters under a specific
heading is arbitrary as some authors touch on
several dimensions.
EVIDENCE ON FINANCIAL GLOBALIZATION
The first step in analyzing the causes and
consequences of financial globalization is to
construct appropriate measures of it in order to
analyze its depth and score. But the metric of
financial openness and globalization are elusive, as
countries tend to escape a straightforward and easy
categorization, and the formulation of a
standardized system of classification proves to be
difficult. Nevertheless, the literature on financial
globalization has developed various measures that
can be broadly classified into to basic categories: de
jure and de facto measures. The de jure variables
tend to measure the extent of financial liberalization
and are typically either binary or on a gradual scale
based on the extent and severity of capital controls,
which are basically the inverse of liberalization. The
primary source for de jure openness has been the
IMF’s Annual Report on Exchange Arrangements
and Exchange Restrictions (AREAER), which is
typically made into a binary measure until 1996 with
subcategories thereafter.
De jure measures can have the disadvantage of
mismeasurement, evidenced in the case of
countries with supposedly substantial controls but
nonetheless relatively large capital flows or large
external assets and liabilities (obtained through the
4
accumulation of capital flows over time). The
literature has, therefore, developed de facto
measures, such as the ratio of total capital flows or
assets and liability stocks to Gross Domestic Product
(GDP). These, however, also carry complications. In
particular, there is a tendency of small economies to
have extremely high ratios even though many larger
economies known to be fully open to capital have
lower ratios, perhaps as they are less in need of
international capita. The use of net flows for de
facto measures, rather than gross, can further
complicate the measurements, for example, when
the saving behavior and fiscal policies of a country
result in low net capital flows despite complete
capital openness and large gross flows.
In ‘Measurements of Capital and Financial
Current Account Openness’ Quinn, Schindler, and
Toyoda provide a historical account of the
development of key indicators and indices of
financial openness, including a review of the
problems in defining, measuring, and
operationalizing capital account indicators. The
chapter presents a specific discussion of the
differences between the de jure and the facto
measures, provides a comparison on the coding and
data properties of some commonly used financial
globalization measures, and gives suggestions on
which measures are most appropriate for different
types of empirical research projects. In particular,
the authors suggest that when deciding on which
type of measure to use, researches should consider
the de jure measures at ‘treatment’ variables
because they reflect the influences of many political
economic forces and decisions by policymakers,
whereas de facto measures can be seen as the
‘outcome’ variables of capital account liberalization.
‘Measurement and Impact of Equity Market
Liberalization’ by Lundblad summarized research on
the measurement of equity market liberalization,
the implication for market integration, and the
fundamental impact on both the financial and real
sectors of countries. Equity market liberalization can
provide access to domestic equity securities to
foreign investors and/or the right to transact in
foreign equity securities to domestic investors. If
liberalization is effective, it leads to market
integration –the notion that assets of comparable
risk are priced comparably regardless of the country
of origin or trading. The author stresses that it is
important to distinguish the concepts of
liberalization and financial openness from market
integration. A country pursuing a regulatory change
that seemingly drops all barriers to foreign
participation in local capital markets is said to have
liberalized, and the resulting market is deemed fully
open. However, there is no guarantee that the
liberalization is effective, as it may fail to affect de
facto market integration. Indeed, there are two
possibilities in this respect. First, markets might
have already been integrated before the regulatory
liberalization. Second, the liberalization might have
little or no effect because foreign investors do not
believe the regulatory reforms will be long-lasting or
other market imperfections remain. In other words,
regulatory liberalization is not necessarily a defining
event for market integration. The former is a
regulatory decision, whereas the latter is an
outcome.
The composition of countries’ ‘balance sheets’
vis-à-vis specific countries provides another
perspective on the evidence on financial
globalization. In ‘Bilateral Financial Links,’ Sa takes
stock of the current state of knowledge on this
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issue. She reviews the main sources of data on
bilateral financial assets and liabilities distinguishing
various types, discusses the use of gravity models to
explain the determinants of those bilateral holdings,
and presents some key stylized facts on the
international financial network. The author
highlights that there is still a long way to go to
understand the geographic composition of
countries’ external balance sheets. Increased
availability of data on bilateral external positions
would help provide a more complete picture of
cross-border financial linkages, improving our
understanding of the international transmission of
shocks.
The composition of countries’ external balance
sheets has received extensive attention in the
literature, mostly because of the growing global
imbalances (the expansion of current account
deficits and surpluses) that arose in the 2000s.
Many economists have focused their work on the
causes and consequences of these large imbalances.
‘Global Imbalances’ by Chinn reviews the various
explanations developed in the literature. These
explanations include (1) trends in saving and
investment balances, (2) a productivity surge in the
United States, (3) East Asian mercantilist behavior,
(4) the global saving glut, and (5) distortions in
financial markets.
The first explanation relies on the definition of
the current account as the difference between
national saving and investment, driven by real,
fiscal, and demographic effects. The second entails a
productivity surge as explanation for lending and
borrowing =namely the tendency to smooth
consumption in the face of time variation in output.
The third explanation focuses on the export-
oriented development path taken by East Asian
countries as an explanation for the pattern of
deficits and surpluses. The fourth explanation
assumes that there is a distortion in financial
markets of less-developed countries, insofar as they
are not able to channel capital from savers to
borrowers domestically. The financial
intermediation activity is thus outsources to
developed countries. The fifth explanation locates
the key distortion in financial markets of the United
States, and to a lesser extent, other developed
countries. Different implications regarding the
nature of the global financial crisis result from each
approach, which this chapter discusses.
The final chapter of this section ‘Aid Flows’ by
Cassimon, Essers, Renard, and Verbeke, reviews the
empirical evidence and ongoing research on official
aid flows, which are still an important source of
financing for many of the poorer countries, and the
evolving international aid architecture. The chapter
focuses on the recent evolution of different types of
aid flows. It also discusses important changes in aid
architecture during the 2000s as well as the
principles and implementation of the new aid
approach that is emerging. In addition, the chapter
analyzes the extent to which aid flows interact with
the broader global financial architecture and the
role of aid flows during the 2008-09 global crisis.
FORCES BEHIND GLOBALIZATION
There are many forms of financial globalization,
including international capital raising, international
cross-listings, trade finance, foreign bank
participation, and foreign debt issuance. Besides
liberalization and technology, there are also many
forces behind the process of financial globalization
6
including agents such as international banks, mutual
funds and other institutional investors, and
multinational corporations. Disentangling these
various forms of international capital flows an
analyzing the behavior of these various actors are
relevant for gaining a better understanding of the
mechanisms behind the transmission of financial
shocks across countries and how to respond to
them.
‘Composition of International Capital Flows:
A Survey’ by Kirabaeva and Razin provides an
analysis of several different mechanisms that
explain the composition of international capital
flows in FDI, foreign portfolio investment, and debt
flows (bank loans and bonds). The chapter focuses
on information friction, resulting in adverse
selection, moral hazard, and exposure to liquidity
shocks, and discusses the implications of these
frictions and shocks for the composition of capital
flows. This chapter provides a relevant benchmark
for understanding the emergence of the different
types of flows and their advantages and
disadvantages from an informational point of view.
The movement of people across national
borders has become an integral part of global
development, alongside international trade and
investment flows. Remittances, the money sent
home by immigrants, have proven to be a large and
stable source of capital flows for developing
countries. In ‘Migrant Remittances and
Development,’ Ratha and Mohapatra provide a
general review of the current trends on remittances
and discuss the impact they have on the recipient
household and countries, such as changes in
poverty rates, education, health, and small business
development, among others.
One salient feature of financial globalization has
been the growth of international mutual funds. To a
significant extent, this reflects the fact that
investors in mature markets have increasingly
sought to diversify their assets by investing in
emerging markets, often through the so-called
dedicated emerging market funds or through
increased emerging market investments by globally
active funds. This development has been facilitated
by technological change, privatization in emerging
markets, far-reaching deregulation of financial
markets in industrial countries in the 1980s and
early 1990s, the growth of institutional investors in
advanced countries, and macroeconomic and trade
reforms in developing countries, which have
rendered emerging markets more attractive.
‘International Mutual Funds, Capital Flow
Volatility, and Contagion –A Survey’ by Gelos
provides a brief account of the literature on the
behavior of international mutual funds, focusing on
the empirical evidence for emerging markets.
Overall, the behavior of international mutual funds
is complex and overly simplistic characterizations
are misleading. However, there is broad-based
evidence for momentum trading among funds, that
is, the practice of buying (selling) assets that had a
positive (negative) performance in the recent past.
Moreover, funds tend to avoid opaque markets and
assets, and this behavior becomes more
pronounced during volatile times. Portfolio
rebalancing mechanisms are clearly important in
explaining contagion patterns even in the absence
of common macroeconomic fundamentals. From a
surveillance point of view, this implies that
monitoring the exposures of large investors at a
microlevel is crucial to assess vulnerabilities.
7
Another of the forces behind financial
globalization is that of foreign capital raisings by
firms. This practice has increased substantially since
the early 1990s in terms of equity as well as debt.
‘Capital Raisings’ by Hale reviews the literature on
the determinants and patters of cross-border capital
raisings by private firms and their effects on the
development of domestic markets, highlighting the
differences between mature and emerging
economies. As is always the case, benefits of
international capital raisings come with costs.
Financial globalization and cross-border capital
raisings have created channels for financial
contagion that were not present otherwise. For
example, as the Asian crisis of 1997-1998 and the
global financial crisis highlighted, excessive leverage
may lead to costly collapses. Preventing foreign
capital raisings, however, is not a solution. With
more globalized capital markets, financial regulation
will hopefully become more harmonized across
countries and will help prevent excessive leverage in
the future.
One strategy that firms use for international
capital raisings is the international cross-listings of
shares. With the rapid globalization of financial
markets increasingly more firms from around the
world began cross-listing their shares on major
overseas stock markets. During the 2000s, however,
the number of new international cross-listings on
major exchanges around the world has diminished
even though financial globalization continued to
increase. ‘International Cross-listings’ by Gagnon
and Karolyi asks whether international cross-listing
still matters for global capital markets and answers
this question by critically reviewing the most recent
research on international cross-listings that focuses
on multimarket trading, liquidity, and arbitrage. The
chapter concludes that cross-listings continue to be
a vibrant force influencing price discovery, trading,
and capital-raising for many companies around the
world and thus still represent an important force for
integration of global financial markets.
An issue related to international cross-listings is
that of transparency and better reporting practices
that are required to have access to major
exchanges. Investor confidence in financial markets
depends in large part on the existence of an
accurate disclosure and reporting regime that
provides transparency in the beneficial ownership
and control structures of publicly listed companies.
‘Disclosure of Ownership and Public Companies’ by
McCahery and Vermeulen provides an examination
of the current trends in disclosure and reporting
rules, analyzing whether detailed, stringent, and
mandatory reporting rules could have a
counterproductive effect on the financial markets.
The authors conclude that a well-balanced regime
that is flexible and proportional and allows for a
case-by-case determination is preferred, and that
the most obvious challenge for regulators is to
design a legal framework that is adaptable to
technological change and its impact on financial
instruments.
Trade finance is another of the forces behind
financial globalization. Trade finance is the set of
financial arrangements, instruments, and
mechanisms that supports international trade.
These mechanisms evolved to ensure that exporters
get the money for their goods and importers receive
what they have purchased. The importance of trade
finance is underscored by the fact that more than
90% of trade transactions involve some form of
8
credit, insurance, or guarantee.1 Producers and
traders in developing or least-developed countries
need to have access to affordable flows of trade
financing and insurance to be able to import and
export, and hence integrate in world trade. From
that perspective, an efficient financial system is one
indispensable underpinning for international trade.
‘The Role of Trade Finance’ by Love takes a
close look at trade finance, discussing first what
constitutes it, and reviewing theoretical and existing
empirical work related to it. It then presents a new
dataset on trade finance usage around the world
and discusses some summary statistics. Because of
the important role that trade finance is perceived to
play during financial crises, special attention is given
to the discussion of the role of trade finance and
bank finance during financial crisis. Finally, the
evidence from the recent global financial crisis is
presented and the rationale for policy interventions
is discussed. The author concludes that the evidence
suggests that there is some rationale for supporting
trade finance during crises. Such support may come
in the form of liquidity injection, risk mitigation,
addressing specific market failures, providing
information and mitigating externalities that exist in
credit supply chains.
Foreign ownership of banks is another practice
that contributes to financial internationalization.
This practice has increased steadily across
developing countries since the mid-1990s, and is
particularly large en Eastern Europe, where the
share of foreign owned banks was above 80% for
most countries in 2006.2 ‘Foreign Bank Participation
in Developing Countries’ by Cull and Martinez Pería
1 See Auboin (2007)
2 See Arvai et al (2009).
documents the global trends in foreign bank
ownership and surveys the existing literature to
explore the drivers and consequences of this
phenomenon, paying particular attention to the
differences observed across regions, both in the
degree of foreign bank participation and in the
impact of this process. The authors find that local
profit opportunities, the absence of barriers to
entry, and the presence of mechanisms to mitigate
information problems are the main factors driving
foreign bank entry across developing countries. In
general, foreign bank participation exerts a positive
influence on banking sector efficiency and
competition. Also, the weight of the evidence
suggests that foreign bank presence does not
endanger, but rather enhances banking sector
stability. Finally, while cross-country studies suggest
that foreign bank entry does not limit access to
finance, some case studies offer evidence to the
contrary.
One of the oldest and more widely used forms
of financial globalization is that of issuance of
foreign debt, either by sovereigns or by firms.
Numerous papers have shown that cross-border
issuance of financial securities has been growing at
a rapid pace. There is also a well-established
literature on the decision by firms to cross-list their
equity securities (as also discussed by Hale).
‘Opportunistic Foreign Currency’ by McBrady and
Schill provides a selective review of the work that
has been done on this subject, with a particular
focus on the relatively new research on
opportunistic debt issuance. The authors underline
that there is relatively little theoretical and
empirical work on the decision by firms in advanced
economies to issue bonds outside their home
markets. This is particularly surprising given that
9
international debt issues are substantially more
common than equity issues, accounting for more
than 90% of all international security issues.
‘International Government Debt’ by Panizza,
Sturzenegger and Zettelmeyer presents a survey of
the modern literature on international government
debt, aiming to match prediction made by
theoretical models with the existing empirical
evidence and to identify the models that best
explain the real world experience of sovereign debt
and default. Although this chapter focuses on the
experience of the last 40 years, sovereign debt and
default have been present for a very long time. It
presents some broad regional trends in
international government debt, and describes the
recent switch from international to domestic
government borrowing. It also reviews economic
theories of sovereign debt, whose defining
characteristic is the impossibility of enforcing
repayment. At the center of this literature is the
question of how governments can issue debt
internationally in spite of this enforcement problem.
The chapter also tries to match theory with the
data, and discusses the role of debt structure and
presents two alternative views on the relationship
between debt structure and debt crises.
Another important part of financial
globalization is the arbitrage that happens in the
fixed income markets between countries with
different currencies. ‘Carry Trade’ by Jorda provides
a discussion and analysis of the incentives for
investors to involve in carry trade, the practice of
borrowing low-yielding currencies and lending in
high-yielding ones. The author focuses the
discussion on the period of unfettered arbitrage in
the current era of financial globalization, that is,
from the mid-1980s for mayor currencies, analyzing
the design of carry trade strategies and its
applications. He shows the prevalence of arbitrage
gains from borrowing low interest rate currencies
and investing in high interest ones.
EFFECTS OF FINANCIAL GLOBALIZATION
Financial openness and globalization brings
both potential gains and risks. There is much debate
among economists questioning the gains from
financial openness or integration into world capital
markets, than there is about gains from open trade.
However, conceptually, there are many parallels
between the two. The classic diagram of ‘welfare
triangles’ obtained by eliminating a tariff on goods
has a direct parallel for gains from eliminating
barriers to capital inflows. Instead of placing the
price on the vertical axis and the import quantity on
the horizontal axis, the interest rate is placed on the
vertical axis and the quantity of capital available on
the horizontal axis. Essentially, from the user
perspective, just as goods can be obtained more
cheaply, so can capital become cheaper if foreign
supply is permitted. The static gains to a capital-
scarce country arise from ‘capital deepening,’ or
increase in availability of the relatively scarce factor
of production, capital.
Similar to the dynamic gains from open trade,
which arise from the acceleration of total factor
productivity growth, capital openness can also
boost productivity growth. One channel is through
improvement in the domestic financial sector,
another is through transfer of technology and skills
through foreign direct investment. But despite these
potential gains, some leading economists have
opposed open capital markets on grounds that they
10
can inflict severe crises and, more generally,
increase risks.3 Others have acknowledged the risks
but argued that the gains far outweigh them.4
‘Capital Market Integration’ by Cline presents a
review on this discussion about the gains and risks
from international financial integration. The chapter
includes an analysis of various statistical tests for
the crisis impact of openness, a review of studies on
historical crises incidence and costs, and evidence
from the recent global financial crisis. The author
shows that the most direct tests find that crises are
not more frequent in open economies than in
closed ones. He concludes that the evidence does
not support the view that increased vulnerability to