Benefits and Costs of International Financial Integration: Theory and Facts © Pierre-Richard Agénor The World Bank Financial Globalization: Issues and Challenges for Small States Saint Kitts, March 27-28, 2001

Saint Kitts Poll (ex ante): Is Financial Integration Beneficial? Improves Worsens No effect Consumption smoothing ? Domestic investment ? Growth ? Macroeconomic stability ? Banking sector efficiency ? Financial stability ?

l Benefits and Costs: Theory l Evidence l Policy Lessons

Theory

l Benefits è Consumption smoothing è Higher domestic investment and growth è Enhanced macroeconomic discipline è Increased banking efficiency and stability l Costs è Concentration of flows and lack of access è Misallocation of capital flows è Loss of macroeconomic stability è Pro-cyclicality of short-term flows è Herding, contagion, and volatility of capital flows è Risks of entry by foreign banks

Benefits Consumption smoothing l 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-of- trade improvement). l “Counter-cyclical” role of world capital markets is justified if shocks are temporary in nature.

Domestic investment and growth l In many developing countries: capacity to save and invest is constrained by a low level of income. l 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.

l Potential benefits are particularly large for some types of capital inflows (FDI). l 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 l 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. l 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 l improve the quality and availability of domestic financial services, by increasing competition and enabling the application of more sophisticated banking techniques and technology; l serve to stimulate the development of the domestic bank supervisory and legal framework;

l enhance a country's access to international capital, either directly or through their parent banks; l 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 l Capital flows tend to be highly concentrated to a small number of countries. l 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. l Note: some small countries also benefited (in relative terms).

l Moreover, access to world capital markets tends to be asymmetric for small open developing countries (including oil producers). l Many of these countries can borrow on world capital markets only in “good” times, whereas in “bad” times they face credit constraints. l Access is thus pro-cyclical. Ability to borrow to smooth consumption in the face of adverse shocks is limited.

Misallocation of capital flows l When capital inflows are used to finance low- quality investments (e.g. speculation in the real estate sector), the impact on growth will be limited. l 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 l Large capital inflows can have undesirable macroeconomic effects: rapid monetary expansion, inflationary pressures, real exchange rate appreciation, and widening current account deficits. l With a fixed exchange rate: losses in competitiveness and growing external im- balances can erode confidence in the sustainability of the peg and precipitate a currency crisis.

Pro-cyclical short-term flows l Short-term capital flows to developing countries tend to be pro-cyclical. l This is a problem because it arises on the supply side of the market; it then magnifies the impact of an adverse shock.

l Two reasons for pro-cyclical behavior. è Adverse shocks cause a country's credit- worthiness to be downgraded. Changes in risk perception and rating downgrades may lead to rationing of credit to marginally creditworthy borrowers. è Herding behavior.

Herding, contagion, and volatility l High degree of financial openness tends to be accompanied by high volatility in capital flows. l Specific manifestation: abrupt reversals in short-term flows, often during periods of speculative pressures on the domestic currency. l Large reversals may lead to costly financial crises.

l Degree of volatility of capital flows is related to both actual or perceived movements in domestic fundamentals and external factors. l Short-term portfolio flows tend to be highly sensitive to herding and contagion. l Herding can be rational (e.g. limited information by new entrant).

l Sources of contagion: è Financial contagion (capital outflows triggered by a perceived increase in the vulnerability of a country's currency); è Confidence loss in the country's prospects, as a result of developments elsewhere; è Other channels, with indirect effects on volatility of capital flows: terms-of-trade shocks or competitiveness effects.

Risks of entry by foreign banks l 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). l Rationing of small firms may have an adverse effect on output and employment.

l Lower operational costs of foreign banks can create pressures on local banks to merge to remain competitive; l concentration could create banks that are too big to fail and exacerbate moral hazard. l 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?

l Volatility of capital flows l Impact on investment and growth l Macroeconomic effects l Entry by foreign banks

Volatility of Capital Flows l Short-term capital flows tend to be more volatile than FDI. l 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. l Evidence of large reversals during crises.

The rise and fall of international capital flows Source: GDF 2000.

Large reversals in net private capital flows I

Large reversals in net private capital flows II

Investment and Growth l Size of capital flows as a proxy for the degree of financial openness. l FDI flows appear to have a significant positive impact on investment; portfolio flows have no discernible effect. l The link between FDI and growth appears to be positive and significant.

However: studies lack robustness. l Endogeneity problems. l How to measure the impact of capital flows on the quality of investment, as opposed to its quantity only. l 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. l Feedback effects (see paper).

Macroeconomic Effects l Experience of the 1990s: major recipients of inflows suffered from rapid increase in liquidity, inflationary pressures, real exchange rate appreciation, and growing external imbalances. l More pronounced in Latin America. l Deterioration in competitiveness raised questions about the sustainability of pegged exchange rate regimes.

Entry by Foreign Banks l Sharp increase in Latin America and Eastern Europe. l Empirical studies: some based on panel data. l 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.

l Effect on net interest margins (efficiency indicator) is not significant. l 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. l Studies: no tests for adequacy of “pooling.” l See paper for a discussion of some scatter diagrams for small states. l Need for more detailed case studies.

l 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. l 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

l Despite possibility of crises, financial integration holds significant benefits in terms of higher rates of growth (especially FDI). l Key issue: preventive measures to be put in place. l Emphasis on macroeconomic discipline; information disclosure, and the possibility of throwing “sand in the wheels” of capital markets.

l 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.

l Strengthening supervision and prudential regulation, and fostering risk management capacities in banks and non-financial firms, are also important. l 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. l Fostering financial integration also has implications for reform of the international financial system.

Saint Kitts Poll (ex post): Is Financial Integration Beneficial? Improves Worsens No effect Consumption smoothing Private investment Growth Macroeconomic stability Banking sector efficiency Financial stability