Financial Globalisation

Financial Globalisation

1. Benefits

   • It will likely lead to a more financially interconnected world and a deeper degree of financial integration of developing countries and international financial markets
   • Development of the financial system in developing countries
     • More complete, deeper, more stable, and better-regulated financial markets

2. Risks

   • Risks are more likely to appear in the short run, when countries open up
   • Can be related to financial risk
     • Brazil 1999, Ecuador 2000, Turkey 2001, etc. are just some examples
     • If the right infrastructure is not in place while integrating, liberalisation followed by capital inflows can debilitate the health of the local financial system
     • For successful integration, economic fundamentals need to be and remain strong

3. Gains from consumption smoothing

   • Financial globalisation can reduce the risk of undesirable fluctuations in aggregate consumption
   • Consumption tends to be more volatile than output

4. Gains from efficient investment

   • Financial globalisation can improve a country's ability to increase its capital stock and take advantage of new production opportunities
   • When investment opportunities arise, a closed economy cannot smooth consumption but an open economy can

5. Gains from diversification of risk

   • Financial globalisation can improve a country's ability to reduce the volatility of its income by promoting diversification/risk sharing
   • Common vs. idiosyncratic shocks: capital income
     • When shocks are not common to both countries, they are said to be idiosyncratic
     • Risk is undiversifiable when shocks are only common and perfectly symmetric because both countries' output move in the same way and the same amplitude
     • When both types of shocks are combined, there are still gains to be made from diversification because incomes of both countries are not perfectly correlated

6. Conclusions

   • In practice, consumption is extremely volatile, including in financially open countries
   • Productivity is low in poor countries, limiting the gains from financial integration
     • This could be due to poor infrastructure
     • An optimistic view would be that developing countries would gain from financial globalisation by simultaneously getting more financially integrated and improving their governance
   • In practice, gains from international diversification are not fully exploited