Towards financial integration

May 14,2017

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In the recent years, the world has been witnessing an unprecedented increase in financial globalisation and international capital flows among developed countries and between the advanced countries and the emerging market economies.

This rise in financial integration involves the upshot of the emergence of the neoliberal economic paradigm, with its focus on promoting the open market and market mechanisms, the liberalisation of capital accounts and large-scale privatisation programmes in developing countries. There has also been macroeconomic policy changes, a rise in institutional investors and demographic changes in the developed world, which can be seen as an impetus for financial globalisation.

In general terms, financial globalisation refers to the strong expansion of capital across countries and the integration of a domestic financial system with international markets and financial institutions. According to an IMF report, global capital flows have increased to 14.8 percent from six percent of the world’s GDP. In 2006, it amounted to $7.2 trillion, making it three times more than what it was since 1995.

Financial globalisation primarily helps to spur economic growth transmitted through various direct and indirect channels. It increases the rate of savings, reduces the cost of capital, transfers technology from the developed world to the developing countries, establishes a strong financial sector and enhances the financing opportunities within a country. Furthermore, it also creates competition, increases production specialisation and facilitates better risk management that results in macroeconomic stability and the development of efficient institutions.

Nevertheless, globalisation has benefited the developed economies more than the developing world in terms of high trade, competitive advantage, and West-based big multinational companies. The rapid increase in financial integration has also helped emerging economies strengthen their capital markets through more investment, develop a broader entrepreneurial class, maintain a suitable allocation of resources, share global risks and thereby foster economic growth.

Opening the financial system to the world for foreign capital inflows could have various benefits for the developing countries like Pakistan. Economic growth in the emerging economies has been constrained due to the lack of capital. By extracting global savings capital, developing countries can lower the cost of capital and thereby encourage investment, which promotes growth. Foreign capital inflows can improve the allocation of resources and make financial institutions work better in ensuring the productive use of capital. It further helps to develop better property rights to counter asymmetric information problems.

The benefits of financial globalisation are twofold. First, well-developed financial markets serve to moderate the boom and bust cycles that have characterised international capital flows. Second, strong financial institutions help to attract capital, such as portfolio equity flows and FDI, which are the cornerstone of growth. However, it is important to understand that capital inflows differ markedly in terms of volatility. For instance, FDI is considered to be less volatile as compared to bank borrowing and financial portfolios since the latter is pro-cyclical and can have a substantive impact in increasing a country’s vulnerability to a financial crisis. This was evident from the 2007-8 global financial crisis.

While the neoliberal school of economics sees international financial integration as a catalyst for economic growth and stability, criticism against the economic wisdom of openness to capital flows have also been put forward by many scholars and economists. It is argued that a high rate of capital inflows has led to a decline in growth rates sporadically and caused substantial financial crises that have had extensive macroeconomic and social costs, particularly in developing countries.

As a result, opening up to the financial system is not necessarily a driving force for economic growth as it can lead to economic collapses and instability. In this regard, the effectiveness and efficiency of domestic institutions to carry out financial transactions seems to play an important role.

The countries with adequate institutions and political development are integrating smoothly and are benefiting from what financial integration can bring. This prevents macroeconomic periodic fluctuations which inevitably results in financial crises.

But since most of the developing economies lack many of the necessary prerequisites for such a move, integration harms them instead of making them do better. Getting the financial system to work is critical to the success of an economy and is a key element in economic development. Various studies have shown that countries have experienced different impacts of financial globalisation on economic growth and prosperity. For instance, countries with a developed financial system, good institutions, sound macroeconomic policies and adequate trade liberalisation are more likely to gain from financial integration and are less susceptible to systematic risks.

As a coordinating process, the global financial system creates a productive investment climate. It is argued that if capital does not flow or is misallocated, it will deter economic growth and the economy will function inefficiently. Financial globalisation is not just a matter of being beneficial or harmful for the economy. Instead, it is a matter of whether it has been carried out correctly or not.

Financial globalisation, therefore, cannot be accomplished successfully without the support of well-functioning institutions that would otherwise cause financial instability, particularly for the developing countries. Technical assistance and incentives from international financial institutions could encourage these emerging economies to bring out institutional reforms. Such assistance was provided to South Korea after it was hit by financial crises. Despite the fact that there are possible risks attached with financial globalisation, adopting complete protectionist policies would be an obstacle to economic progress and poverty alleviation.

In addition, long-term capital flow, such as FDI, should be opened before short-term capital as they are non-debt creating inflows. As a result, an openness to globalisation in this today’s world is not sufficient. Instead, it is a necessary requisite for countries to achieve economic development under certain conditions, such as sound domestic and foreign policies, good institutions and developed financial markets.

The writer is pursuing an MPhil in development studies at the Lahore School of Economics. Email:


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