Transcript St. kitts conference on Financial Integration

Financial Globalization:
Issues and Challenges for Small States
Saint Kitts, March 27-28, 2001
Benefits and Costs
of International Financial Integration:
Theory and Facts
© Pierre-Richard Agénor
The World Bank
Saint Kitts Poll (ex ante):
Is Financial Integration Beneficial?
Improves
Consumption smoothing
Domestic investment
Growth
Macroeconomic stability
Banking sector efficiency
Financial stability
Worsens
No effect
?
?
?
?
?
?



Benefits and Costs: Theory
Evidence
Policy Lessons
Theory

Benefits
Consumption smoothing
 Higher domestic investment and growth
 Enhanced macroeconomic discipline
 Increased banking efficiency and stability


Costs

Concentration of flows and lack of access
Misallocation of capital flows
 Loss of macroeconomic stability
 Pro-cyclicality of short-term flows

Herding, contagion, and volatility of capital flows
 Risks of entry by foreign banks

Benefits
Consumption smoothing


Access to world capital markets may allow a
country to borrow in “bad” times (e.g.
recession or terms-of-trade deterioration) and
lend in “good” times (expansion or terms-oftrade improvement).
“Counter-cyclical” role of world capital
markets is justified if shocks are temporary
in nature.
Domestic investment and growth

In many developing countries: capacity to
save and invest is constrained by a low level
of income.

As long as the marginal return from
investment is at least equal to the (given) cost
of capital, net foreign resource inflows can
supplement domestic saving, increase levels
of physical capital per worker, and help raise
the rate of economic growth.

Potential benefits are particularly large for
some types of capital inflows (FDI).

By facilitating the transfer of managerial and
technological know-how, and by improving
the skills composition of the labor force, FDI
may have significant positive long-run effects
on growth.
Macroeconomic discipline

By increasing the rewards of good policies
and the penalties for bad policies, financial
openness may induce countries to follow
more disciplined macro policies and reduce
the frequency of policy mistakes.

To the extent that greater policy discipline
translates into greater macro stability, it may
also lead to higher rates of growth.
Banking efficiency and stability
Foreign bank penetration may

improve the quality and availability of
domestic financial services, by increasing
competition and enabling the application of
more sophisticated banking techniques and
technology;

serve to stimulate the development of the
domestic bank supervisory and legal
framework;

enhance a country's access to international
capital, either directly or through their parent
banks;

contribute to the stability of the domestic
financial system if, e.g., during turbulent times
depositors shift their funds to foreign
institutions that are perceived to be stronger
than local banks, instead of transferring their
assets abroad.
Costs
Concentration of flows, lack of access

Capital flows tend to be highly concentrated to
a small number of countries.

e.g., the surge in capital flows in the early
1990s was concentrated among only a small
number of countries of Latin America (Mexico,
Chile, Brazil) and Asia.

Note: some small countries also benefited (in
relative terms).

Moreover, access to world capital markets
tends to be asymmetric for small open
developing countries (including oil producers).

Many of these countries can borrow on world
capital markets only in “good” times, whereas
in “bad” times they face credit constraints.

Access is thus pro-cyclical. Ability to borrow
to smooth consumption in the face of adverse
shocks is limited.
Misallocation of capital flows

When capital inflows are used to finance lowquality investments (e.g. speculation in the
real estate sector), the impact on growth will
be limited.

Low-productivity investments in the
nontradables sector may reduce over time
the economy’s capacity to export and lead to
growing external imbalances.
Loss of macroeconomic stability

Large capital inflows can have undesirable
macroeconomic effects: rapid monetary
expansion, inflationary pressures, real
exchange rate appreciation, and widening
current account deficits.

With a fixed exchange rate: losses in
competitiveness and growing external imbalances can erode confidence in the
sustainability of the peg and precipitate a
currency crisis.
Pro-cyclical short-term flows

Short-term capital flows to developing
countries tend to be pro-cyclical.

This is a problem because it arises on the
supply side of the market; it then magnifies
the impact of an adverse shock.

Two reasons for pro-cyclical behavior.

Adverse shocks cause a country's creditworthiness to be downgraded. Changes in
risk perception and rating downgrades may
lead to rationing of credit to marginally
creditworthy borrowers.

Herding behavior.
Herding, contagion, and volatility

High degree of financial openness tends to
be accompanied by high volatility in capital
flows.

Specific manifestation: abrupt reversals in
short-term flows, often during periods of
speculative pressures on the domestic
currency.

Large reversals may lead to costly financial
crises.

Degree of volatility of capital flows is related
to both actual or perceived movements in
domestic fundamentals and external factors.

Short-term portfolio flows tend to be highly
sensitive to herding and contagion.

Herding can be rational (e.g. limited
information by new entrant).

Sources of contagion:

Financial contagion (capital outflows
triggered by a perceived increase in the
vulnerability of a country's currency);

Confidence loss in the country's prospects,
as a result of developments elsewhere;

Other channels, with indirect effects on
volatility of capital flows: terms-of-trade
shocks or competitiveness effects.
Risks of entry by foreign banks

Foreign banks may ration credit to small firms
to a larger extent than domestic banks, and
concentrate instead on larger ones (often in
the tradables sector).

Rationing of small firms may have an adverse
effect on output and employment.

Lower operational costs of foreign banks can
create pressures on local banks to merge to
remain competitive;

concentration could create banks that are too
big to fail and exacerbate moral hazard.

Entry of foreign banks may not lead to
enhanced stability if they have a tendency to
“cut and run” during a crisis.
What is the Evidence?




Volatility of capital flows
Impact on investment and growth
Macroeconomic effects
Entry by foreign banks
Volatility of Capital Flows

Short-term capital flows tend to be more
volatile than FDI.

Volatility in capital flows has led to exchange
rate instability (under flexible exchange rates)
or (under pegged exchange rates) large
fluctuations in reserves and at times currency
crises.

Evidence of large reversals during crises.
The rise and fall
of international capital flows
Billions of U.S.$
160
140
120
100
80
Portfolio equity
Total loans
60
40
Bonds
20
Source:
GDF 2000.
0
1990
91
92
93
94
95
96
97
98
99
Large reversals
in net private capital flows I
Mexico,
Korea,
Mexico,
Thailand,
Venezuela,
Turkey,
Venezuela,
Argentina,
Malaysia,
Indonesia,
Argentina,
'93-95
'96-97
'81-83
'96-97
'87-90
'93-94
'92-94
'88-89
'86-89
'84-85
'82-83
12% of GDP
9% of GDP
18% of GDP
15% of GDP
11% of GDP
6% of GDP
10% of GDP
7% of GDP
10% of GDP
5% of GDP
4% of GDP
0
10
20
30
40
Billion dollars
Source: Finance and Development, September 1999.
50
60
Large reversals
in net private capital flows II
Short-term debt inflows turned into outflows in 1998
(billion dollars)
All developing countries
East Asia and Pacific
Korea
Thailand
Indonesia
Malaysia
Latin America and Caribbean
1997
1998
43.5
0.8
–8.0
–6.9
1.1
3.4
24.1
–85.0
–68.0
–29.9
–15.1
–11.8
–5.3
–5.7
Source: Bank for International Settlements.
Investment and Growth

Size of capital flows as a proxy for the degree
of financial openness.

FDI flows appear to have a significant
positive impact on investment; portfolio flows
have no discernible effect.

The link between FDI and growth appears to
be positive and significant.
However: studies lack robustness.

Endogeneity problems.

How to measure the impact of capital flows
on the quality of investment, as opposed to
its quantity only.

No tests for the existence of an adverse
effect of the volatility of capital flows (as
opposed to their level); issue of uncertainty
and irreversibility in investment decisions.

Feedback effects (see paper).
Macroeconomic Effects

Experience of the 1990s: major recipients of
inflows suffered from rapid increase in
liquidity, inflationary pressures, real exchange
rate appreciation, and growing external
imbalances.

More pronounced in Latin America.

Deterioration in competitiveness raised
questions about the sustainability of pegged
exchange rate regimes.
Entry by Foreign Banks

Sharp increase in Latin America and Eastern
Europe.

Empirical studies: some based on panel data.

Increased foreign penetration (measured in
terms of either numbers or share of bank
assets) appears to be associated with a
reduction in both profitability and overhead
costs for domestic banks.
Table 1: Foreign Bank Ownership in Selected Emerging Markets (in percent) 1
Foreign Control2
December 1994
Central Europe
Czech Republic
Hungary
Poland
Total
Turkey
Latin America
Argentina
Brazil
Chile
Colombia
Mexico
Peru
Venezuela
Total
Total excluding Brazil
and Mexico
Asia
Korea
Malaysia
Thailand
Total
Foreign Control2
December 1999
5.8
19.8
2.1
7.8
49.3
56.6
52.8
52.3
2.7
1.7
17.9
8.4
16.3
6.2
1.0
6.7
0.3
7.5
48.6
16.8
53.6
17.8
18.8
33.4
41.9
25.0
13.1
44.8
0.8
6.8
0.5
1.6
4.3
11.5
5.6
6.0
Source: IMF, World Capital Markets Report 2000 (p.153).
1
Ownership data reflect changes up to December 1999 while balance sheet data are the most recent available in
Fitch IBCA's BankScope.
2
Ratio of assets of banks where foreigners own more than 50 percent of total equity to total bank assets.

Effect on net interest margins (efficiency
indicator) is not significant.

However: the fact that these conclusions hold
“on average” cannot be construed as
supportive evidence for any particular group of
countries—e.g. “small states”—or for any
specific country.

Studies: no tests for adequacy of “pooling.”

See paper for a discussion of some scatter
diagrams for small states.

Need for more detailed case studies.

No firm evidence to suggest that a greater
presence of foreign banks contributes to a
more stable domestic financial system and
less volatility in the credit.

Why? Foreign banks may shift funds abruptly
from one market to another as the perceived
risk-adjusted returns in these markets
change—possibly as a result of herding.
Policy Lessons

Despite possibility of crises, financial
integration holds significant benefits in terms
of higher rates of growth (especially FDI).

Key issue: preventive measures to be put in
place.

Emphasis on macroeconomic discipline;
information disclosure, and the possibility of
throwing “sand in the wheels” of capital
markets.

Avoiding real exchange rate misalignment,
correcting fiscal imbalances and preventing
an excessive buildup of domestic debt,
maintaining a monetary policy consistent with
low inflation, and ensuring that the ratio of
unhedged foreign-currency debt over official
reserves remains sufficiently low (under a
fixed exchange rate regime) are all
preventive measures that are likely to reduce
the risk that sudden changes in market
sentiment may turn into large capital
outflows.

Strengthening supervision and prudential
regulation, and fostering risk management
capacities in banks and non-financial firms,
are also important.

It is important to put all preconditions in
place, insofar as possible, before the capital
account is fully opened. Thus, in some
cases, the transition may need to be gradual.

Fostering financial integration also has
implications for reform of the international
financial system.
Saint Kitts Poll (ex post):
Is Financial Integration Beneficial?
Improves
Consumption smoothing
Private investment
Growth
Macroeconomic stability
Banking sector efficiency
Financial stability
Worsens
No effect