Effects of Financial Globalization on Developing Countries

220 O C C A S I O N A L PA P E R

Effects of Financial Globalization on Developing Countries:

Some Empirical Evidence

Eswar S. Prasad, Kenneth Rogoff, Shang-Jin Wei, and M. Ayhan Kose

INTERNATIONAL MONETARY FUND Washington DC 2003

220 O C C A S I O N A L PA P E R

Effects of Financial Globalization on Developing Countries:

Some Empirical Evidence

Eswar S. Prasad, Kenneth Rogoff, Shang-Jin Wei, and M. Ayhan Kose

INTERNATIONAL MONETARY FUND Washington DC 2003

? 2003 International Monetary Fund Production: IMF Multimedia Services Division

Typesetting: Alicia Etchebarne-Bourdin

Cataloging-in-Publication Data Effects of financial globalization on developing countries: some empirical evi-

dence/Eswar S. Prasad . . . [et al.].--[Washington, D.C.: International Monetary Fund], 2003.

p. cm.--(Occasional paper; no. 220) Includes bibliographical references. ISBN 1-58906-221-3

1. Developing countries. 2. Globalization. I. Prasad, Eswar S. II. International Monetary Fund. III. Occasional paper (International Monetary Fund); no. 220. HC59.7.E43 2003

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Contents

Preface

vii

Summary

ix

I

Overview

1

Definitions and Basic Stylized Facts

2

Does Financial Globalization Promote Growth in Developing Countries? 2

What Is the Impact of Financial Globalization on Macroeconomic

Volatility?

3

Role of Institutions and Governance in Effects of Globalization

4

Summary

4

II Basic Stylized Facts

6

Measuring Financial Integration

6

North-South Capital Flows

8

Factors Underlying the Rise in North-South Capital Flows

9

III Financial Integration and Economic Growth

13

Potential Benefits of Financial Globalization in Theory

13

Empirical Evidence

14

Synthesis

17

IV Financial Globalization and Macroeconomic Volatility

21

Macroeconomic Volatility

21

Crises as Special Cases of Volatility

24

Has Financial Globalization Intensified the Transmission of Volatility? 25

Some Factors That Increase Vulnerability to Risks of Globalization

27

V Absorptive Capacity and Governance in the Benefits/Risks

of Globalization

29

Threshold Effects and Absorptive Capacity

29

Governance as an Important Element of Absorptive Capacity

29

Domestic Governance and the Volatility of International Capital Flows 31

Summary

32

Appendixes

I

The First Era of International Financial Integration, 1870?1913 35

II Estimating the Benefits of International Financial Integration

on Income Levels for Developing Countries Using a

Neoclassical Economic Model

36

III Calculating the Potential Welfare Gains from International

Risk Sharing

38

iii

CONTENTS

IV Contingent Securities for International Risk Sharing

42

V Small States and Financial Globalization

43

VI Data

45

Bibliography

46

Boxes

3.1. Effects of Different Types of Capital Flows on Growth

18

3.2. Do Financial and Trade Integration Have Different Effects on

Economic Development? Evidence from Life Expectancy

and Infant Mortality

19

4.1. Effects of Globalization on Volatility: A Review of Empirical

Evidence

22

4.2. Herding and Momentum Trading by International Investors

27

5.1. Transparency and International Mutual Funds

32

Text Figures

2.1. Measures of Financial Integration

7

2.2. Gross Capital Flows

8

2.3. Net Private Capital Flows

9

2.4. Foreign Ownership Restrictions in More Financially Integrated

Developing Economies

11

3.1. Channels Through Which Financial Integration Can Raise

Economic Growth

13

3.2. Increase in Financial Openness and Growth of Real Per

Capita GDP

16

3.3. Increase in Financial Openness and Growth of Real Per

Capita GDP: Conditional Relationship, 1982?97

16

3.4. Differential Effects of Financial and Trade Integration on

Improvements in Health

20

4.1. Volatility of Income and Consumption Growth

24

5.1. Corruption and Foreign Direct Investment

30

5.2. Difference Between Actual International Mutual Fund Investment

and MSCI Benchmark: Transparent Versus Opaque Countries

31

5.3. Herding and Opacity

33

5.4. Corruption Tilts the Composition of Capital Flows Toward Borrowing

from Foreign Banks

33

Appendix Figure

A3.1. Potential Welfare Gains from International Risk Sharing

39

Text Tables

2.1. Volatility of Different Types of Capital Inflows

10

3.1. Fastest- and Slowest-Growing Economies During 1980?2000

and Their Status of Financial Openness

15

3.2. Summary of Recent Research on Financial Integration and

Economic Growth

17

4.1. Volatility of Annual Growth Rates of Selected Variables

23

Appendix Tables

A2.1. Non-OECD Countries: Gains from International Financial

Integration

37

iv

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