Financial integration revisited

The author is the coordinator of Action for Economic Reforms, a policy
research and advocacy non-governmental organization that focuses on
macroeconomic policy and governance issues.

A significant development that demands wider public dissemination is
the revival of the discourse on the issue of financial integration,
involving highly influential institutions and personalities. A paper
from the International Monetary Fund (IMF) discusses this topic, titled
Effects of Financial Globalization on Developing Countries: Some
Empirical Evidence, dated 17 March 2003 and authored by Eswar Prasad,
Kenneth Rogoff, Shang-Jin Wei, and M. Ayhan Kose.

For those who are very critical of the IMF, this paper may turn out to be a surprise, and a pleasant one at that.

Financial integration, including the debate on capital controls, is a
topic that cannot excite the wider public. It is an esoteric topic that
obviously cannot compete with developments such the US invasion and
occupation of Iraq and the spread of the deadly severe acute
respiratory syndrome (SARS) virus in capturing public attention.

Yet, the implications of financial integration – not only for
developing countries but on globalization itself – are far-reaching.
The cumulative effect of the series of financial crises that have beset
East Asia, Latin America, Russia, Turkey and other emerging markets is
an important factor behind the slowdown of the global economy.
The recent IMF paper expresses caution over the unswerving belief that
financial integration helps promote growth and reduce macroeconomic
volatility in developing countries. In the heyday of the Washington
Consensus (defined simplistically as the agenda of liberalization,
privatization and deregulation), the IMF was the most avid advocate of
financial globalization, including the liberalization of capital
accounts in developing countries. In the later half of the 1990s, a
move to have capital account liberalization incorporated as a main IMF
objective and included as a chapter to the Bretton Woods agreement
gained ground.

The authors of the recent IMF paper on financial integration state that
“a systematic examination of the evidence suggests that it is difficult
to establish a strong causal relationship between the degree of
financial integration and output growth performance.”

In the same vein, the authors state that “available evidence suggests
that developing countries have not fully attained this potential
benefit” (i.e., reducing macroeconomic volatility) from financial
integration. More to the point: “Indeed, the process of capital account
liberalization appears to have been accompanied in some cases by
increased vulnerability to crises. Globalization has heightened these
risks since cross-country financial linkages amplify the effects of
various shocks and transmit them more quickly across national borders.”

Taking together the supposed benefits of increasing growth and reducing
macroeconomic volatility, the authors note that “while there is no
proof in the data that financial globalization has benefited growth,
there is evidence that some countries may have experienced greater
consumption volatility as a result.” (Consumption growth is seen as a
better measure of economic welfare than output).

All this is not to say that the IMF has rejected financial integration
in toto. The authors describe what it calls a “threshold effect”- at a
mature level of financial integration, a reduction of macroeconomic
volatility is observed. But the difficult question is how to get to
that threshold level, for it entails a number of prerequisites,
especially having good institutions and good governance.

Such threshold implies a developing economy being transformed into a
mature economy. Even the authors acknowledge that they cannot “provide
a clear road map for the optimal pace and sequencing of integration.”
They also recognize that the issues and problems attendant to financial
integration “can best be addressed only in the context of
country-specific circumstances and institutional features.”

It may appear that the IMF is no longer doctrinaire about financial
integration and capital account liberalization. It also seems that the
IMF is ready to give up “one-size-fits all” prescriptions to developing
countries. The IMF paper carries a lot of weight – note that a
co-author is Kenneth Rogoff, the IMF’s chief economist and director of
research since September 2001.

This is the same Mr. Rogoff who, in late June 2002, debated with Joseph
Stiglitz about globalization and the IMF role. Mr. Stiglitz, who was
awarded the Nobel prize in economics in 2001, is a staunch and
consistent critic of the IMF’s push for accelerated financial

In that debate, according to a friend who had the opportunity to
witness the debate, Mr. Rogoff “painted Stiglitz to be an arrogant guy
who never admits that he may have made mistakes.” My friend said that
she quietly squirmed and fidgeted, as Mr. Rogoff’s speech “got too

This time, Mr. Rogoff as co-author of the IMF study, is humble. The
paper, in a candid tone, states that “the principal conclusions that
emerge from this analysis are sobering, but in many ways informative
from a policy perspective.”

There nevertheless remains skepticism over what may be perceived as an
IMF turnabout. C.P. Chandra-sekhar contends in a paper titled Financial
Liberalization: Revisiting the Defense (2003) that “the IMF has decided
to accommodate the growing evidence of the adverse consequences of
financial liberalization in developing countries not so much to learn
from it and revise its positions but to provide what some are seeing as
a more ‘nuanced’ defense of financial liberalization.”

To illustrate his point, Mr. Chandrasekhar cites the IMF view regarding
the “threshold effect” (cited above), in which a certain level of
financial integration leads to desirable results.

The point is: “To be like the developed, developing countries have to
cross the ‘threshold,’ since the greater financial integration that
this requires would automatically lead to improvements in institutional
quality as well. So the implication is not that developing countries
should give up on financial liberalization but that they should go far
enough to ensure that it is accompanied with reform that delivers the
institutional quality needed to realize the virtuous relationship
between financial liberalization and economic performance.”

Despite such “nuanced” analysis of the IMF, developing countries may
well view it as allowing them more leeway to slow down on financial
integration and the attendant capital account liberalization.

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