Historical Development of Main International Financial Markets - Essay Example

Historical Development of Main International Financial Markets Financial crises that happened during the late 1980s and 1990s have led to serious debates on the costs and benefits resulting from the development of international financial markets. Economists like Bhagwati, (1998) and Stiglitz, (2000) consider capital account liberalization as an impediment to global financial stability and thus would result in financial crises. They are of the view that there must be stricter norms for controlling the flow of capital. However, other economic experts like Fischer, (1998) and Summers, (2000) argue that development of international financial markets would lead to improvement in the economies of developing, less developed countries, and it would automatically enhance stability among developed countries. The major benefit accruing from international financial markets is more financial interconnection among different nations of world. It can also lead to a deeper integration of developing economies with the international financial markets. Especially the developing economies would be able to revamp and develop their financial system with the introduction of more complete, deeper, stable and better-regulated domestic financial markets because of their affiliation to international financial markets. Levine, (2001) suggests a better functioning financial system with more credit is likely to lead to faster economic growth. Apart from direct growth benefits, development of international financial markets is likely to result in other collateral benefits like promotion of the development of domestic financial sector and imposing disciplines on the macroeconomic policies of the governments. It also leads to generation of more efficiency by encouraging competition and results in enhanced corporate governance and functioning of better governments. Since these benefits occur over a longer period, it is usual that the costs of globalization are detected more easily. The collateral long-term benefits of international financial markets can be traced through equity inflow and increased foreign direct investments into the domestic financial markets. However, it is difficult to identify the benefits of international financial markets, which enhance the productivity through empirical studies. An analysis of structural, institutional and macroeconomic policies across the country leading to growth of GDP or productivity would prove the benefits resulting from international financial markets. At the micro level, the positive impact of international financial markets can be felt in the capital account liberalization, which benefits the firms, banks and industry operating in the economy. Thus, international financial markets can provide indirect benefits in three key areas. These are: (i) financial sector development, (ii) institutional quality and (iii) macroeconomic policies. This paper analyzes the effect of historical development of international financial markets on the global economic condition. Economic Growth through the Development of International Financial Markets A number of direct and indirect channels can be identified through which international financial markets can help the advancement of economic growth in different countries. The figure below presents a schematic summary of the channels that help the economic growth. There seems to be a positive association between adopting international financial markets and the level of economic development in which the countries that are industrially advanced get financially integrated more than the developing countries. This leads to the point that international financial markets works towards the economic advancement of different nations. However, the possibility of a reverse relationship cannot be ruled out. This implies that the countries, which are industrially advanced, might choose to involve themselves more in financial integration, even in case where there is no direct positive impact of international financial markets on the advancement of such economies. Macroeconomic Effects of International financial markets Two most important developments in international financial markets have been caused by the nature of capital flows and the increased use of financial intermediaries. They are: (i) increase of net capital flows to emerging economies since 1970s and (ii) internationalization of financial services. During the period commencing from 1970 private capital flows into the emerging economies have started increasing although there was no uniformity of such inflows into all countries. While some countries like China received large amount of capital inflows in the form of Foreign Direct Investments (FDI) some other countries could attract only little amount of capital inflows. However, there had been a sharp decline in the capital inflows to emerging economies as an aftermath of Asian and Russian crises during 1997-98 and the financial crisis of Argentina in the year 2001. While a small group of developing economies reaped the benefits of the development of international financial markets through increased capital inflows, there were the low income and middle-income countries, which have received lesser amount of capital inflows over time and have not enjoyed the benefits of the emergence of international financial markets. Therefore, the unequal distribution of capital flows can be found consistent with the divergence of income among developing countries, although no relationship between both could be established (Schmukler, 2004). The increased use of international financial intermediaries by local borrowers and investors is the second major influence of the development of international financial markets. The internationalization process is achieved by the enlarged presence of international financial intermediaries. Foreign banks representing the intermediaries proliferated in the local markets encouraging the local borrowers and lenders to take active participation in the international markets. Another channel, which aided the internalization of financial services, involves the use of international financial intermediaries by local players. Essentially such intermediaries are located in foreign countries and help the local borrowers and investors to deal in international markets. Trading of shares in any of the major world stock exchange in the form of depository receipts represents one of the examples of the internationalization process of financial services (Schmukler, 2004). Increase in Capital Inflows Development of international financial markets leads to improvement in the functioning of the financial system through increase in the availability of more funds at the disposal of different economies. In a world, which is financially integrated there are greater possibilities for the free flow of funds from those countries which have excess funds to other countries where the marginal product of capital is higher. In this context, there is the likelihood that the foreign institutions and individuals might direct the flow of their excess funds to the developing countries if they anticipate that these economies would develop at a faster rate than the developed economies. This enables the developing countries to smooth the domestic consumption and to resort to larger capital investments financed by foreign sources. The current account deficits observed in the case of many of the developing nations represent the capital flow from the developed to developing countries. Because of availability of new sources of funds and excess capital, the capital flows lead to better economic development. With the available sources, the borrowers can depend more on foreign sources of funds apart from the domestic sources. Market discipline becomes stronger both at macroeconomic level and at the financial sector level with the excess capital at the disposal of firms and individuals. This is because of the fact that a stricter market discipline is enforced by both local and foreign investors on both private and public borrowers. Foreign capital has the ability to shift the investments easily across countries, while domestic capital tends to have more restrictions to invest in international markets. Liberalization of Financial Services One of the developments of international financial markets is the internalization of financial services and this is achieved by liberalizations of such services by the individual countries. Al Markazi, (2005) observed that liberalization of financial services is an important factor for the economic growth and employment in industrially advanced countries as well as in developing countries. The liberalization of trade in financial services in general would result in growth of economic development on a global basis. In respect of individual countries, such liberalization would strengthen the financial system and economy by bringing about improvements to the financial system infrastructure. One of the avenues for liberalization of financial services is to allow foreign banks to operate in a country. Presence and functioning of foreign banks in a country have several distinct advantages. Foreign banks encourage competition and increase the management efficiency of the entities operating in the banking system. There are chances of greater innovations in providing services to the customers and lower product pricing, which is advantageous to the customers. The customers are provided with a wide range of choice of products to be chosen by the customers. However, there must be some preconditions met by the country in order that liberalization of the financial services to be effective. The country should provide for adequate prudential regulations governing the liberalization in addition to providing for enhanced transparency. The corporate governance should be at its top form with an effective competition policy. The accounting and legal systems prevalent in the country should support the liberalization policies. Methods of Measuring the Development of International financial markets Traditionally financial openness was measured by the legal restrictions on cross-border capital inflows. The capital controls could take the form of controls on inflows against control on outflows. Quantity controls or price controls and restrictions on foreign equity holdings also measure the financial openness. One of the other approaches for measuring financial integration is to look at price-based measure of asset market integration. Karolyi & Stulz, (2003) observe that common prices across national borders of similar financial instruments would be reflected by the integration of capital markets. However, emerging economies and low-income developing economies would find it difficult to use such techniques to measure financial integration. Quantity-based measures of integration based on actual flows can be regarded as the best available technique for measuring the financial integration. Gross inflows and outflows in general would prove to be a less volatile and more sensible measure of integration. This method has the distinct advantage of measuring the two-way flows. However, the volatility attached to the gross inflows and outflows present measurement errors. In order to mitigate these problems the sum of gross stocks and foreign stocks of foreign assets and liabilities as a ratio to GDP can be used as a better measure of financial integration. Composition of Capital Flows Effects of the development of international financial markets can be assessed based on the notion that the capital flows have been created on unequal setting. This has led to substantial changes in the composition of financial inflows and outflows over the period. Stock market liberalization is one of the ways in which the composition of capital flow can be controlled. Stock Market Liberalization Henry (2000) state that stock market liberalization because of the development of international financial markets has a positive effect on growth and they conclude that stock market liberalization could increase GDP growth by 1%. According to the study by Henry (2000), a reduction in the cost of capital can be accomplished through (i) liberalization increase the volume of capital inflows leading to decreased domestic risk rate, (ii) increase in risk sharing opportunities between foreign and domestic investors could diversify risk – reducing the stock risk premium, (iii) the stock risk premium could be reduced further with the increased capital flows and liquidity in the domestic stock market increase. Gupta & Yuan, (2005) and Hammel, (2006) provide evidence that stock market liberalization has a growth effect on industries which depend on external sources of finance for their business. According to Mitton, (2006) stock market liberalization enables the firms in emerging markets to experience increased access to new financing channels, enlarged opportunities for investment and growth. Since the foreign investors demand higher governance standards, it would have a positive impact on profitability, efficiency and other measures of operating performance. Study by Mitton shows that firms with stocks, which are open to foreign investors normally register higher levels of sales growth, investments and efficiency. Foreign Direct Investments (FDI) According to theoretical presumptions, FDIs have the ability to yield more benefits than any other types of financial flows. This is because FDI not only contributes to increased investment in domestic capital stock but also has a positive impact on productivity achieved through technology transfers and application of managerial skills. FDI is also considered as less volatile than other forms of inflows, which make the countries less vulnerable to sudden withdrawal of the investments. Studies based on empirical data have not been able to provide conclusive evidence about the positive impact of FDI on the economic growth of countries. Carkovic & Levine, (2005) conclude that FDI has no significant casual effect on the growth of the economies. Benefits of FDI include augmenting domestic capital stock and improvements in productivity and these benefits would lead to economic growth subject to meeting certain conditions like availability of high level of human capital, financial sector development and formulation of policies fostering free trade. FDI growth benefit depends on sectoral composition. FDI helps improving manufacturing activities by influencing the GDP growth while on sectors such as tourism it has only limited effect. FDI has its positive influence on productivity and improves by imitating new production methods and acquisition of new and improved skills. It also enhances competition through efficient use of resources by domestic firms. FDI increases exports by expanding the export potential of domestic firms. Debt Flow Debt flow including portfolio bond flow and commercial bank loans always generate risks from financial openness. Debt flows is the most volatile type of flow and easily reversible. Short-term bank loans to developing economies are pro-cyclical. This implies that these loans tend to increase during boom and such loans would decrease during the economic slowdown. The pro-cyclical and volatile nature of debt flows can magnify the adverse impact of shocks on economic growth. According to McKinnon & Pill, (1997), opening up of debt inflows increase vulnerability of shocks to countries and financial systems. The problem of over-borrowing by banks is that moral hazard in domestic financial markets and unrestricted capital flow can together create a potential for disaster. This study shows that open capital accounts can exacerbate the adverse effects of poor financial sector supervision. High level of short-term external debt of foreign currencies increases vulnerability of financial crisis. Reisen & Soto, (2001) state FDI and portfolio stock flows facilitate increased growth while bond flows and debt flows do not support growth as effectively. Short term and long-term foreign bank lending is negatively associated with growth except in countries where local banks are capitalized. Need for Transforming Debt-based Monetary System in the 21st Century Discussions on both academic and policy bases support the need for financial flows from the developed to developing countries in the form of FDI or debts for effecting international transfer of resources and for supporting the developing economies. However, historical experience points out to the fact, that it is usually the reverse flows of resources from the developing countries to the developed countries that has been the rule, especially during the periods following financial crises. These reverse flows because of repayments of debts are clearly detrimental to the amount of domestic resources available, which have the potential of enhancing the living conditions and per capital growth rates in different countries. This is the result of the use of relatively short-term lending by both multilateral and private financial institutions at market rates of interest or applicable penal rates of interest when there is delay in meeting the deadlines for interest payments or repayments of principal. One can apply the theory of financial fragility associated with the work of Minsky, (1990) and Domar, (1950) can be engaged to assess the plausibility of a development policy based on external resources. “Domar notes that since a trade surplus will require a capital-account outflow that will eventually generate a reverse flow of interest payments and profit remittances, the policy can only succeed as long as increases in capital outflows balance the increasing inflows for capital services.” (Kregel, 2004) The formal condition necessary for the success of such a policy is that the rate of increase in the capital outflows must at least be equal to the rate of interest applicable to such foreign lending. Therefore, it follows that it is possible for a developing country to maintain positive external resource inflows only when such inflows become equal to or more than the interest payments to the developed country lenders. However, even under these circumstances the resource inflows can be equated to an extremely fragile condition with the possibility of a reverse flow of resources. There is the likelihood of financial crises irrespective of the fact that such borrowed funds are used for productive purposes or not. The robustness of the domestic financial systems or the attractiveness of the domestic investment environment does not make a difference in case where the reversal of capital flow takes place. Therefore, it can reasonably be stated that using external capital flows in the form of debts for developmental purposes is a two edged-sword, which must be managed in the form of generating positive benefits in the form of higher rates of growth of per capita incomes. 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