Abstract
Despite an abundance of cross-sectional, panel, and event studies, there is strikingly little convincing documentation of direct positive impacts of financial opening on the economic welfare levels or growth rates of developing countries. The econometric difficulties are similar to those that bedevil the literature on trade openness and growth though, if anything, they are more severe in the context of international finance. There is also little systematic evidence that financial opening raises welfare indirectly by promoting collateral reforms of economic institutions or policies. At the same time, opening the financial account does appear to raise the frequency and severity of economic crises. Nonetheless, developing countries continue to move in the direction of further financial openness. A plausible explanation is that financial development is a concomitant of successful economic growth, and a growing financial sector in an economy open to trade cannot long be insulated from cross-border financial flows. This survey discusses the policy framework in which financial globalization is most likely to prove beneficial for developing countries. The reforms developing countries need to carry out to make their economies safe for international asset trade are the same reforms they need to carry out to curtail the power of entrenched economic interests and liberate the economy's productive potential.
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Notes
See World Bank (2008, p. 2). The capital inflow figure that I cite refers to “net external financing,” or the net resources foreign investors provide in order to finance a country's current account deficit, its net international reserve accumulation, and its residents’ own net purchases of assets located abroad. The measure includes errors and omissions.
Stulz (2005) discusses some of the measures described below, as well as others.
Edwards (2007) constructs his index by augmenting earlier work of Quinn (2003) and Mody and Murshid (2005) with information from national sources.
“Net external financing” is defined in footnote 1.
If errors and omissions are neglected, developing country private residents’ net acquisition of claims on industrial countries equals net external financing less reserve accumulation plus the current account surplus. Thus, on average over 2003–08, private residents of developing countries added a net sum of about $600 billion every year to their assets held abroad.
Earlier this point was emphasized by Díaz Alejandro (1985), whose account of the early 1980s Chilean crisis put at center stage the folly of believing “that financial markets, domestic and international, were no different from the markets for apples or meat” (p. 9). One is tempted to observe, however, that in many countries food production processes are heavily regulated by government due to the possibility of disease transmission through the supply chain. In the United States, Upton Sinclair's indictment of laissez-faire in the meat-processing industry, The Jungle (1906), led to a partial “sudden stop” in U.S. meat exports—as has happened more recently to several countries in response to outbreaks of mad cow disease. Quickly the United States passed the legislation setting up the Food and Drug Administration. Issuers of subprime-related financial products in the United States during the mid-2000s certainly were not subject to oversight comparably stringent to that applied to American meat products.
Even the hypothesis that openness to trade promotes growth is supported by quite limited statistical evidence. Harrison and Rodríguez-Clare (2007) survey the econometric literature on trade and growth and conclude, contrary to the positive reading of Fischer (2003, p. 14), that “the empirical work on this question is surprisingly mixed.” The interpretive obstacles that Harrison and Rodríguez-Clare identify are exactly the same as those that bedevil studies of the effects of financial openness on growth. Although the obstacles are qualitatively the same, however, their resolution often seems even more problematic in the financial sphere. One problem, already mentioned, is the absence of reliable measures of the height of barriers to financial trade. In the sphere of merchandise trade one can turn to data on statutory tariff rates and quotas and even shipping costs, but financial barriers are likely to be more exotic and difficult to quantify. To the extent that capital-flow barriers involve unobservable informational asymmetries that are less severe in nonfinancial markets, for example, they will be much harder to measure than are trade barriers. I discuss other problems of empirical interpretation below.
Of course, this rather mild indictment of capital-account fundamentalism is not inconsistent with Rogoff's (2007) more recent comment that “Too many policymakers still believe that externally imposed opening to international capital flows was the main culprit behind the financial crises of the 1990s—a view that unfortunately is lent some intellectual respectability by a small number of left-leaning academics…. Pushing for greater capital market liberalization after the debacle of the 1990's will be controversial. But the core of the idea was right then, and it is right now.” An interesting discussion of the IMF staff's shifting attitudes toward capital account restrictions in the context of actual country advice is in Independent Evaluation Office (2005).
Fiscal cost estimates for past banking crises are tabulated by Ergungor and Thomson (2005). Fiscal costs are naturally far below total economic costs, including repercussions on the broader economy.
For a recent general survey of financial stability issues, see Schinasi (2006).
Some studies suggest that in many cases it is domestic financial liberalization that has been the main driver of lending booms and subsequent crises, with capital inflows playing a secondary supporting role. This perspective suggests a primary policy focus on the oversight and stress-testing of domestic financial intermediation. See, for example, Gourinchas, Valdés, and Landerretche (2001).
Former IMF Managing Director Michel Camdessus characterized the 1994 Mexican crisis as “the first financial crisis of the twenty-first century.” Boughton (2001) has suggested that the 1956 Suez crisis may really have been the first 21st century crisis. On different grounds one might well identify the 1890 Baring Crisis as the first 21st century crisis.
Joyce and Nabar (2008) argue on empirical grounds that sudden stops affect investment only when they coincide with banking-system crises, and that openness to capital flows accentuates the negative investment effect of banking crises. Edwards (2007) finds no evidence that countries with higher capital mobility face an increased risk or incidence of crisis, but concludes that crises tend to reduce economic growth more in countries that are more open financially.
Consistent with these concerns is the finding of Kose, Prasad, and Terrones (2007) that emerging markets have not benefited much from enhanced opportunities to share consumption risks. Also consistent is the cross-sectional finding of Klein and Olivei (2008) that any positive effect of financial openness on financial depth and growth applies mainly to longstanding OECD countries.
In evaluating cross-country differences in returns to capital, more work at the micro level, such as Minhas’ (1963) study, would be illuminating.
For a discussion of similar issues in cross-sectional tests of the trade-growth link, and a proposed alternative approach, see Estevadeordal and Taylor (2008). The interpretation of pure cross-sectional tests becomes even murkier if the underlying growth regression specification includes the investment rate as a regressor, as often is the case, although Henry's basic point still holds true. By controlling for the investment rate, the econometrician forecloses an estimated effect of financial opening on growth through the capital-deepening channel.
Harrison and Rodríguez-Clare (2007) call for further micro studies to resolve questions about the effects of trade openness on growth.
Klein's (2008) results, which show a positive impact of liberalization on growth only after a critical initial income threshold has been passed (but not for high-income capital-rich countries), could be interpreted as pointing in this direction. See also Arteta, Eichengreen, and Wyplosz (2003) and Klein and Olivei (2008).
A finding in the theoretical literature is that open economies might be most susceptible to financial instability at intermediate levels of financial development. See, for example, Aghion, Bacchetta, and Banerjee (2004).
See also the case studies included in Ishii and others (2002), as well as Mishkin (2008).
“Thailand Scraps Capital Controls after Stocks Plummet,” International Herald Tribune, December 9, 2006.
An interesting discussion of the Australian experience is in McCauley (2006).
Some of the following material draws on Obstfeld (2007).
The emphases on both the balance sheet effects of currency movements and the differing marginal consumption propensities of different economic groups are salient in the classic literature on contractionary devaluations. For lucid discussions, see Díaz Alejandro (1963 and 1965, p. 31).
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Additional information
*Maurice Obstfeld is the Class of 1958 Professor of Economics, University of California, Berkeley. This article was prepared as a background paper for the Commission on Growth and Development and originally published as “International Finance and Growth in Developing Countries: What Have We Learned?” World Bank Growth Commission Working Paper Series Number 34. The author is grateful for assistance from Gabriel Chodorow-Reich, José Antonio Rodríguez-Lopez, Lorenz Küng, and Mary Yang. The current draft has benefited from discussions with Sara Guerschanik Calvo, Julian di Giovanni, Barry Eichengreen, Gian Maria Milesi-Ferretti, Peter Blair Henry, Ayhan Kose, Alan M. Taylor, Roberto Zagha, and an anonymous referee, as well as from comments at the April 9, 2007 conference in New York organized by the Commission. Thanks go as well to Sebastian Edwards for supplying the updated Edwards (2007) data on capital controls.