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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

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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

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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.

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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

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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

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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

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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

crises from financial openness should cause

policymakers in emerging market economies to

maintain closed financial markets.

As mentioned earlier, there are various ways

through which financial globalization can improve

domestic financial markets. First, foreign ownership

of banks can ease access to international markets

and introduce new financial instruments and

technologies, which in turn can increase

competition and improve the quality of financial

services. Second, foreign participation in capital

markets can increase their liquidity, which improves

their attractiveness to other investors. Moreover,

well-developed equity markets contribute to

transparency as firms are incentivized to release

better quality information to attract capital, a

process that ultimately improves the efficiency with

which investment in allocated.

Another collateral benefit of financial

integration is associated with better institutional

3 See Bhagwati (1998) and Stiglitz (2002).

4 See Fischer (1998) and Summers (2000).

quality and governance practices. For example,

foreign investors may have skills and information

technologies that allow them to monitor

management better than local investors. Similarly,

cross-listing in advanced countries’ equity markets

can force the import of higher governance

standards. And foreign financial institutions can help

to improve domestic regulatory and supervisory

frameworks. Financial globalization can also exert a

disciplinary effect on the conduct of macroeconomic

policies: if international financial markets respond

negatively to unsustainable policies, governments

may be induced to conduct better policies.

‘Collateral Benefits of Financial Globalization’

by Aykut and Kose surveys theoretical and empirical

studies analyzing different types of collateral

benefits from financial globalization, including

development of domestic financial markets,

improvements in institutional governance, and

discipline on macroeconomic policies. The authors

also assess the evidence on the impact of financial

globalization on total factor productivity, the

channel through which the collateral benefits are

expected to produce better growth outcomes. This

review suggests that there is modest but increasing

evidence that financial globalization can generate

collateral benefits.

Among the different channels of financial

globalization, FDI is considered as providing more

types of benefits than other capital flows. Because it

embodies technology and know-how as well as

foreign capital, FDI can benefit host countries

through knowledge spillovers as well as linkages

between domestic and foreign firms. Potential

positive effects include productivity gains,

technology transfer, exposure of domestic firms to

new processes, managerial skills and know-how,

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enhancements to employee training, development

of international production networks, and broader

access to markets. When new products or processes

are introduced to the domestic market by foreign

firms, domestic firms may benefit from accelerated

diffusion of new technology. In some cases, this

might occur simply by domestic firms observing

foreign firms, or in other cases through labor

turnover as employees hired by foreign firms move

to domestic firms. These benefits together with

direct capital financing suggest an important role for

FDI in modernizing national economies and

promoting economic development. But, the

empirical evidence that FDI generates positive

effects for the host country is ambiguous at both

micro and macro levels.

‘Foreign Direct Investment and Growth’ by

Alfaro and Johnson takes stock on this discussion by

reviewing the literature on the relationship between

FDI and growth in host countries, particularly

developing countries. The authors stress that

although data availability remains a constrain,

evidence shows that FDI can play an important role

in economic growth, most likely via suppliers of

foreign firms. Nonetheless, local conditions matter

and can limit the extent to which the benefits of FDI

materialize.

‘International Technology Transfer and Foreign

Direct Investment’ by Javorcik takes a closer look at

the related microevidence and review the

arguments and evidence for FDI as a channel of

knowledge transfer across international borders. It

also presents evidence on knowledge transfer from

headquarters of multinational companies to its

foreign affiliates, and discusses the literature on

intra-industry, interindustry, and exporting

spillovers. The chapter concludes that FDI is, in fact,

an important channel for transmitting technologies

and know-how across countries. It ends with

providing some policy recommendations.

‘Role of Multinationals in Financial

Globalization’ by Kalemli-Ozcan and Villegas-

Sánchez describes both macro and micro evidence

on the determinants of FDI and on the effects of FDI

on economic growth. In addition, the chapter

reviews the literature on financial integration,

volatility, and financial crises, focusing on the role of

multinational corporations on host country recovery

during crises. The authors stress that the literature

so far has found evidence that financial sector

development, openness to trade, and human capital

matter for FDI spillovers, but that there is still plenty

of room for further research on the exact

mechanisms through which these factors come

about.

The effects of financial globalization are likely to

vary across countries. This variation arises not only

from the depth of globalization achieved by a

country but also from the speed of integration and

the timing at which it happens. Providing an all-

encompassing account of the experiences of

individual countries with their process of integration

is beyond the scope of this volume. But the next

chapters provide an analysis of three noteworthy

experiences, India, China, and the European Union,

given their previous history, role in current global

economic setting, and depth of financial integration.

The integration of India from autarky into the

world economy since the early 1990s is reviews by

Shah and Patniak in ‘India’s Reintegration into the

world Economy in the 1990s.’ They provide an

account of this integration by describing the

composition of capital flows, the

12

internationalization of firms, foreign portfolio

investment in equity markets, and the role of FDI,

foreign borrowing, and capital controls among

others. The chapter also assesses monetary policy,

the exchange rate regime (ERR), and some related

policy question.

‘Reforms of China’s Banking System’ and ‘Policy

Issues of China’s Financial Globalization’ by Barth, Li,

Li, and Song provide a comprehensive overview of

China’s evolving financial systems and its integration

into the global market. They also discuss some

important policy issues, including China’s current

and capital accounts surpluses (part of the global

imbalances discussed above), the exchange rate

regime and reserve accumulation, and the banking

system.

Finally, ‘Financial Integration in Europe’ by

Jappelli and Pagano takes stock of the great steps

forward given by Europe since the adoption of the

Economic and Monetary Union (EMU) in 1999. The

chapter reviews how the associated process of

regulatory reform was expected to lead to actual

financial integration, and how integration was to

affect the development of financial markets and the

performance of the real economy in Europe. To

answer these questions, the chapter analyzes them

in light of the literature on the links between

regulation, financial, and real economic activity.

MONETARY AND EXCHANGE RATE POLICY

UNDER FINANCIAL GLOBALIZATION

The issue of financial globalization and

openness is closely related to that of the exchange

rate regime and monetary policy. The essence of

this relation was developed in the 1960s by Mundell

and Fleming as the ‘impossible trinity’ or ‘policy

trilemma.’5 The trilemma states that it is only

possible to attain only two out of three desirable

policy goals: financial integration, exchange rate

stability, and monetary autonomy. A country can

have closed financial markets, and be able to

conduct autonomous monetary policy and have a

fixed exchange rate. Or, it can have a floating

exchange rate regime in association with monetary

independence and financial integration. Or, finally,

it can give up monetary policy and pursue exchange

rate stability (pegged ERR) and financial integration.

Therefore, if a country chooses the path of financial

integration it has to either give up monetary

independence or choose a floating ERR. ‘The

Impossible Trinity (aka The Policy Trilemma)’ by

Aizenman discusses this policy trilemma by

reviewing the configurations chosen by countries

since 1970 and surveying empirical literature

dealing with the evolution of ERRs. He also discusses

the challenges faced by countries that have been

navigating the trilemma throughout the

globalization process. The author concludes with

remarks on the future financial architecture and the

challenge posed by the trilemma in this context.

‘Financial Globalization and Monetary Policy’ by

Kamin addresses two important questions regarding

monetary policy in the light of the restrictions

imposed by the policy trilemma. First, has financial

globalization materially increased the influence of

external developments on domestic monetary

conditions? And second, has it reduced the

influence of central banks over economic conditions

in their own country? The chapter focuses on a key

channel of the monetary transmission mechanism:

5 The foundations of the Mundell-Fleming model can be found

in Mundell (1968) and Fleming (1962)

13

the control of long-term interest rates. It reviews

the evidence of whether globalization is causing

domestic long-term rates to be more vulnerable to

external shocks, and, as well, less amenable to

influence by the national monetary authorities. It

also addresses the short-term interest rate and

considers the extent to which that control is

affected by the exchange rate regime and by

international financial integration. The author

stresses that even though the evidence does not

show that central banks have lost their ability to

affect short-term and thus long-term interest rates

in their economy, globalization does appear to by

complicating their monetary policy choices by more

forcefully subjecting domestic economic and

financial conditions to external shocks.

The Interest Rate Parity (IRP) relation is one of

the most relied upon indicators of financial

globalization. When the parity holds, covered yields

are identical on assets that are similar in all

important aspects (such as risk, liquidity, etc.)

except currency denomination. ‘Interest Rate Parity’

by Levich reviews the theoretical basis and historical

origins of the IRP relationship, and introduces the

idea of Limited to Arbitrage and other factors often

associated with parity deviations and present

empirical evidence on the parity. Also, more recent

evidence of deviations during the global financial

crisis, and possible explanations are discussed. The

author concludes that in the aftermath of the global

financial crisis, currency bid-ask spread have

widened, counterparty risks seem greater and more

uncertain, and in many cases risk capital is more

scarce and expensive. In this setting, deviations

from covered interest parity (CIP) have widened

considerably relative to a decade ago.

The challenge for researches as well as

practitioners is to accurately measure and price the

costs of strategies based on deviations from CIP. All

observed deviations from CIP are not necessarily

market efficiency violations. Instead, they can

reflect the implicit additional cost and risk of trying

to utilize the lower cost, or higher yielding currency

on a covered basis. Measuring those costs, and

recalibrating the efficiency and mobility of

international capital markets is a new challenge for

financial economists.

The choice of the ERR is another side of the

policy trilemma and has direct implications on the

evolution of key nominal variables (inflation,

relative prices) and, as a result, on output growth

and volatility, and income distribution. Moreover, it

might affect many other areas, such as trade

(through real exchange rate levels and stability) and

finance (as a peg might foster financial

intermediation at the cost of building currency

imbalances). ‘Exchange Rate Regimes’ by Levy-

Yeyati deals with the identification of de facto ERR

(understood as the policy maker’s decision rather

than the empirical characterization of the exchange

rate behavior), the channels through which ERR

might influence economic outcomes, and traces the

history of ERR into post Breton Woods years and

takes stock of the current state of the ERR debate.

The author states that the debate on exchange rate

regimes is far from closed, as the pros and cons of

alternative systems evolve with both country

characteristics and the global context. In the past,

exchange rate anchors were popular in developing

countries in the context of high inflation and partial

dollar indexation. But the recent deleveraging and

dedollarization process in those economies

increased the scope for flexible exchange rates to

14

recover a countercyclical role. The fact that most

medium and large developing economies prefer a

flexible exchange rate simply reflects this evolution.

In practice, many countries prefer a fixed ERR.

This choice might have to do with attempts to

reduce macroeconomic volatility of to avoid risks of

currency fluctuation, including appreciations. But

some countries take a step forward and not only fix

their currencies, but actually adopt the currency of a

neighbor or several countries adopt a new currency

altogether, thus creating a currency union. Currency

unions may induce gains in trade and financial

integration, as transaction costs and currency risks

are eliminated.

‘Currency Unions’ by Santos Silva and Tenreyro

critically reviews the recent literature on currency

unions and discusses the methodological challenges

posed by empirical assessment of their costs and

benefits. The authors find that in terms trade gains,

currency unions are associated with large increases

in the volume of international trade for small and

relatively less developed countries, but that the

evidence for the countries in the eurozone (the

largest currency block) has generated small effects.

Nonetheless, the introduction of the euro has

produced important changes in financial

integration, particularly for cross-border holdings of

bonds and equity. The authors conclude that a

unified framework needs to be developed to help

move the theory of currency unions beyond an

enumeration of the gains and costs into a broader

assessment of their desirability.

As mentioned earlier, financial dollarization

plays a role in the monetary and exchange rate

policy adopted by countries with large dollarization,

creating challenges that need to be addressed.

‘Financial Dollarization’ by Ize takes on this subject,

reviewing recent trends and comparing the relative

magnitudes of different types of dollarization. It also

discusses the factors underpinning dollarization

using a taxonomy derived from a bicurrency lending

equilibrium, as well as the potential costs and risks

of dollarization and its policy implications. The

author concludes that the recent gradual decline in

financial dollarization is good news. It confirms what

the theory would predict and relieves some of the

anxiety about how to contain the costs and risks of

dollarization.

CRISES

The process of financial globalization entails

both benefits and risks. These risks are mostly

associated with the occurrence of financial crises.

After each wave of financial crises the interest in

them is renewed. Much of the crisis literature was

developed in the aftermath of the emerging market

crises of the 1990s. As before, the recent global

financial crises once again triggered an interest in

financial crises, from their prediction and causes to

policy responses and crisis resolution. The following

chapters present some insights into this booming

literature

A currency crisis is defined as a speculative

attack on the foreign exchange value of a currency,

resulting in a sharp depreciation or forcing the

authorities to sell foreign exchange reserves and

raise domestic interest rates to defend the currency.

Currency crises are highly correlated with ‘sudden

stops,’ that is, a sharp reversal in capital flows.

‘Models of Currency Crises; by Glick and Hutchison

discusses analytical models of the causes of

15

currency (and associated) crises, presents basic

measures of the incidence of crises, evaluates the

accuracy of empirical models in predicting them,

and review work measuring the consequences of

crises on the real economy.

One of the aspects that the crises literature has

explored is that of prediction. Early Warning Models

were developed in the aftermath of the emerging

market crisis of the 1990s. But interest in them soon

began to face, driven in part by a combination of

inherent difficulty in predicting crises, particularly

the timing of financial crises. This interest was

renewed after the global financial crisis. Broadly

speaking, there are three main ingredients to an

early warning model: the crisis definition (what is it

that it is trying to predict), the list of explanatory

indicator variables, and the approach through which

the information in those indicators is combined to

predict crises.

Most of the literature has focused on measures

of currency crises. This can be defined either based

on sufficiently large nominal and real movements in

the exchange rate or on the basis indices of

currency market pressure. Other crisis definitions

considered include the drop in GDP, and a measure

of capital account crises. As for the explanatory

variables a wide range has been considered,

covering the external, financial, real and fiscal

sector, as well as institutional and political variables,

and measures of contagion. Nonetheless, the

indicators found to be most frequently statistically

significant in the literature are foreign exchange

reserves, the real exchange rate, the growth rate of

credit, GDP growth, and the current account to GDP

balance. In terms of the techniques that combine

information from these indicators to explain the

prevalence of crises, most of the approaches can be

grouped into two broad categories: those that use a

regression approach and those that rely on

nonparametric techniques.

‘Predictive Indicators of Crises’ by Chamon and

Crowe discusses some of the key contributions of

this literature, but mainly focusing on the line of

work that has been applied at the IMF, whose

mandate involves surveillance and who is often a

key player in crises resolution. The authors also

discuss the key lessons that can be learned by

applying these classes of tools in a policy

environment. The authors find that many different

strands of work seem to point to a handful of

variables playing a leading role in explaining crises in

emerging markets. But predicting the timing of

crises has remained very challenging. For market

participants, timing is of the essence. But for

policymakers it is more preferable to focus on

identifying vulnerabilities, preferably with enough

advance so they can be tackled before turning into a

crisis. This is the direction that some institutions,

including the IMF, have moved towards.

As mentioned earlier, most of the literature has

focused on currency crises. Developing techniques

to assess the vulnerability of fixed exchange rates

and predict their collapse has been a research

program at least since the 1980s. But currency

crises are difficult to predict. It could be that the

wrong variables or models are being chosen, or that

the measurement techniques adopted are not up to

the task. In ‘A Perspective on Predicting Currency

Crises,’ Flood, Marion, and Yepez survey the

empirical literature on predicting this particular type

of crisis. It analyzes the three most important

branches developed in this area: structural models,

discrete-variable techniques, and signaling methods.

The authors find that all methods perform well

16

when fundamentals are explosive, but that all do

badly when fundamentals are merely highly volatile.

A related stand of the literature aims at

explaining financial crises and shedding light on how

they occur. There are two basic approaches: one

argues that crises are driven by bad fundamentals,

while the other argues that they reflect panic or

coordination failures among investors.

Differentiating between panic-based and

fundamentals-based crises is crucial for policy

purposes. Many of the policies adopted against

financial crises –such as deposit insurance, lender of

last resort, and suspension of convertibility –are

predicated on the idea that crises are panic-based

and result from coordination failure. If however,

financial crises are largely due to weak

fundamentals, then these policies may help little or

even work adversely.

‘Empirical Literature on Financial Crises:

Fundamentals vs. Panic’ by Goldstein reviews some

of the empirical papers on financial crises and their

conclusion on whether crises result from

fundamentals or panic. While the evidence certainly

speaks to the importance of fundamentals, it does

not say much about the panic-based approaches.

Even if crises are linked to fundamentals, it can still

be the case that they would not have occurred

without coordination failures or self-fulfilling beliefs.

The chapter also asks if there is way to validate the

panic-based approach in the data, and describes

recent progress in this direction.

The vulnerabilities brought about by current

account deficits is not new, and they have became

apparent following the collapse of several emerging

market economies in the early 1980s, and then

again at the time of the 1990s crises. Vulnerability

to current account deficits due to sustainability

issues or reforms lacking credibility has been largely

explored in the literature, accompanied by several

empirical studies of the anatomy of current account

reversals and their consequences. ‘Sudden Stops in

capital Flows’ by Izquierdo analyzes sudden stops in

capital flows, defined as large and an unexpected

stops in the financing of the current account deficit,

mostly occurring in emerging markets a frequently

triggered by systemic external financial turmoil. This

chapter provides a rationale for the occurrence of

these supply-side financial shocks focusing on the

costs of sudden stops –including balance-sheet

effects and their impact on output loss, as well as

downward deviations from pre-crisis trends. The

empirical determinants of the likelihood of sudden

stops are identified, including domestic liability

dollarization, current account deficits and financial

integration. Ex-ante policies to reduce the likelihood

of sudden stops are discussed, together with policy

responses –fiscal, monetary and reserve

management –in the aftermath of a sudden stop.

The collapse of U.S. housing markets that began

at the end of 2006 was followed by the most severe

economic and financial crisis since the Great

Depression. But through what channels did the

shocks spread? ‘Definitions and Types of Financial

Contagion’ by Pritsker discusses how contagion is

defined and the main channels through which

shocks get transmitted from one economy to

another. Three main channels of contagion between

countries can be named: financial markets, banking,

and trade linkages. Contagion through financial

markets may occur because of correlated

information: a price shock in one market may

trigger a reassessment of asset values in other

markets because it is understood that the asset

17

values in the two markets are correlated. A second

channel of contagion based in financial markets is

related to wealth effects and risk aversion. As a

negative shock hits one country it reduces its net

wealth and investors in that country may become

more risk averse. This may cause investors in the

home country to decline their holdings of foreign

assets, thus transmitting the shock abroad. Finally,

deleveraging and margin calls are another channel

for financial markets crisis transmission.

An issue closely related to contagion, is that of

banks operating across the boundaries. Cross

border banking of developed countries is important

both to the stability of national financial systems

and to the global financial system, as the recent

global financial crisis highlighted. ‘Cross-border

Banking: Regulation, Supervision, and Crisis

Resolution’ by Wall focuses on the issues associated

with micro- and macroprudential supervision,

regulation and crisis resolution systems for cross-

border banking groups in developed countries. The

chapter establishes the importance of cross-border

banking groups and explains why the structure of

the agencies responsible for financial supervision,

regulation and crisis resolution is important and

why ultimate responsibility for these tasks is

unlikely to be delegated to international bodies. It

also considers the mechanisms for dealing with

banks that are illiquid or insolvent.

A relevant issue in the era of financial

globalization is the ability by governments and

institutions to prevent the occurrence of a crisis

episode. “Market Based Approach to Financial

Architecture’ by Underhill analyzes the role of

regulatory and supervisory institutions as a means

to avoid or diminish herd behavior and market

failure in a liberal financial system. The chapter

analyzes the emergence of the current international

financial ‘architecture’ and its diverse institutions in

relation to the growth of global financial markets,

arguing that fundamental shifts in the nature of the

financial system and its governance were closely

linked to increased financial instability.

‘Housing is the Business Cycle’ by Leamer

assesses the importance of the housing cycle over

the business cycle and its special relation to crises. It

stresses that nine out of the last eleven recessions

in the U.S. were preceded by substantial problems

in housing and consumer durables. The article

assets that housing prices are usually very inflexible

downward, and that when demand softens there is

very little price adjustment but a huge volume drop,

this being the most important way in which housing

affects GDP during crises. The article also discusses

the financial cycle that supports the housing cycle

and an analysis of the downturn of 2008-2009, as

well as some policy recommendations, especially as

to the behavior of the Federal Reserve and the

monetary policy to follow.

The final chapters of this volume are devoted to

the analysis a various episodes of financial crises,

namely, the 1987 Stock Market Crisis, Mexico’s

Financial Crisis of 1994-95, the East Asian Financial

Crisis, the Russian Crisis of 1998, the argentine

default of 2001, and recent global financial crisis.

‘US 1987 Stock Market Crisis’ by Carlson takes on

the first of these episodes, presenting a useful

history of the stock market crash of 1987, the

factors contributing to its severity, and an account

of some of the tools the Federal Reserve has at its

disposal to deal with financial crises. ‘Mexican Crisis

of 1994-95’ by Musacchio explains the causes

leading to the Tequila crisis and its short- and long-

term consequences and examines the subsequent

18

development of the Mexican banking system. ‘East-

Asian Crisis of 1997’ by Ghosh highlights three

aspects of the East Asian Crisis: its causes and

manifestations of vulnerability, the factors that

triggered the crisis, and the factors and dynamics

that led to a more severe downturn than was

generally anticipated. ‘Financial Globalization and

the Russian Crisis of 1998” by Pinto and Ulatov

analyzes why six months after the almost

completion of the privatization of its manufacturing

and natural resource sectors and the conquest of

inflations did Russia suffered a massive debt-

exchange rate-banking crisis. ‘Argentina’s Default of

2001’ by Takagi considers the economic and political

background for the Argentina default of December

2001, analyzing the economic developments of the

country from 1991, to the buildup of the crisis, and

into the aftermath of it.

‘Assessment of Solution to US Financial Crisis of

200809’ by Ho and Signoretti documents the wide

array of measures adopted by advanced industrial

economies after the bankruptcy of Lehman Brothers

in September 2008 to support banks and other

financial institutions. In provides a timeline of

government interventions up to June 2009 as well

as a snapshot of the status of government support

at that date, comparing the adoption, magnitude,

and participation rates of these measures across

countries. It also discusses the effects of

government measures on the behavior of banks’

Credit Default Swap (CDS) premia, stock prices, and

financing activity and includes a brief account of

how these measures evolved in the 12 months after

June 2009.

‘A Cross-Country Perspective on the Causes of

the Global Financial Crisis; by Claessens, Dell’Ariccia,

Igan, and Laeven, review that causes of the global

financial crisis, by looking at historical and cross-

country perspectives and discussing especially its

international dimensions. It reviews the multiple

causes of the crisis, the many channels and

mechanisms through which it spread globally, and

the policy interventions designed to deal with them,

highlighting that though the crisis may appear

unique, it shares many features common with other

financial crises.

Finally, ‘Lessons and Policy Implications from

the Global Financial Crisis’ by Claessens, Dell’Ariccia,

Igan, and Laeven draws the lessons from the global

financial crisis for reforming financial systems,

including lessons for macroeconomic policy,

financial regulation, and the global financial

architecture. In particular, the authors focus on the

failures in macroeconomic policy and in the

regulation and supervision of banks and financial

institutions.

FINAL WORDS

This book The Evidence and Impact of Financial

Globalization presents the current status of the

literature on financial globalization and crises. The

first global financial crisis of the twenty-first

century, however, has questioned many of the old

paradigms and posed new challenges for

researchers. Global imbalances are of ongoing

concerns, with some countries continuously running

high current account surpluses of deficits. These

imbalances have also led to a shift in the geography

of capital flows and the socioeconomic power

structure toward emerging markets. Cross-border

banking with national regulators leads to new

regulatory challenges, a topic which is of immediate

19

and great concern within the European Union. The

literature on currency unions will receive a new

boost with the on-going problems within the

Eurozone. Moreover, the overall model of financial

globalization, dominant for the past 30 years, is

being increasingly questioned in terms of its impact

on volatility and thus its costs. Calls for a new global

financial architecture are being herd! While the

existing literature can speak of these questions and

debates based on previous experiences and

theoretical insights, further explorations and

contributions can be expected. This is a very active

field.

Acknowledgement

The authors are highly indebted to Lucas Núñez for excellent research assistance and great help in assembling the overview and they thank him dearly

References

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Fleming, J. 1962. Domestic Financial Policies under Fixed and under Floating Exchange Rates. IMF Staff Papers 9 (3), 369-379.

Mundell, R. 1968. International Economics. The MacMillan Company, New York

Stiglitz, J. 2002. Globalization and Discontent. W. W. Norton, New York

Summers, L. 2000. International Financial Crises: Causes, Prevention, and Cures. American Economic Review 90 (2), 1-16.