I happened to read another excellent survey last week. This time it was on Financial Globalization and it covers all the studies that have been done so far to understand whether capital flows have resulted in economic growth. I had posted on the same topic earlier as well.
It has been done by a very influential team of Economists – Ken Rogoff, Eswar Prasad etc and is aptly titled Financial Globalization: A reappraisal This paper is interesting in many aspects:
1. Effects on Growth: It says the evidence so far has been mixed as some papers have used de jure (as per the law) measures of financial openness and some have used de facto (as per practice) measures. Here is a summary:
“By both measures, advanced economies have become substantially integrated into global financial markets. For emerging market economies, average de jure openness has not changed much based on the IMF measure, but de facto integration has increased sharply over the last two decades. For other developing economies, de jure openness on average rose sharply over the last decade, to a level higher than that for emerging market economies, but the de facto measure has stayed flat over this period.
Further, the paper has a very interesting table which summarises most of the research on the subject so far and just a rough counting tells me out of 26 cited studies 18 show mixed evidence.
2. Effects on Volatility: The paper suggests more research in this area and says “there is little empirical evidence to support the view that capital account liberalization by itself increases vulnerability to crises. Indeed, the literature on the effects of financial integration on volatility (and crises) is much sparser than the literature on its growth effects. Further research is warranted in this area.”
3.Composition of Capital Flows: This is the most interesting part of the paper. The basic idea is that it is not right to dump all kinds of flows (i.e. equity vs debt, Portfolio investment vs FDI) as one and analyse the impact. Here are some major findings:
a) Impact of FDI on growth: The usual belief is that FDI is beneficial for growth as “it has a positive impact on productivity through transfers of technology and managerial expertise. It has also been argued that FDI is less volatile than other inflows, making countries less vulnerable to sudden stops or reversals of these flows.“
But empirical evidence does not show the effect. Out of 11 studies in the paper 10 show mixed effect where FDI alone could not be held responsible for growth.
Even empirical evidence on horizontal spillovers ( i.e. from a foreign company to another company in the same sector) is inconclusive, however, in case of vertical spillovers ( i.e. from the foreign company to its suppliers etc) we have some positive evidence.
b) Impact of Portfolio Equity flows on growth: Most papers cited show that evidence is positive i.e. equity flows lead to growth.
c) Impact of Debt flows on growth: Well, this is an interesting finding. The paper says that debt flows are the riskier variety-
“The procyclical and highly volatile nature of these flows, especially short-term bank loans, can magnify the adverse impact of negative shocks on economic growth. Debt flows lack the positive attributes of equity-like flows. They do not solve certain agency problems, can lead to inefficient capital allocation if domestic banks are poorly supervised, and generate moral hazard as debt is implicitly guaranteed by the government (in the case of corporate debt) and/or international financial institutions (both corporate and sovereign debt).The empirical literature on financial globalization is decisive that debt flows generate the greatest risks from financial openness. In particular, there is a systematic empirical link between exposure to short-term debt and the likelihood (and severity) of financial crises.”
This also explains why RBI has put a cap on the amount Foreign investors can invest in government and corporate bonds. To argue whether the limit should be increased is another issue,
4. The paper further discusses a new framework to understand the impact of capital flows.
“A key component of our argument is that it is not just the capital inflows themselves, but what comes along with the capital inflows, that drives the benefits of financial globalization for developing countries.
The paper says that there are many indirect benefits of financial integration which they call “collateral benefits” -development of the domestic financial sector, improvements in institutions, better macroeconomic policies etc. These collateral benefits then result in higher growth, usually through gains in allocative efficiency.
Overall, it is an excellent summary of the work done on the subject so far. A Must read!