Maurice Obstfeld has written a nice literature survey on the subject for Growth Commission. The paper is here. What are the main findings?
Particularly at the macro level, it is hard to find unambiguous evidence that financial opening yields a net improvement in economic performance for emerging countries. The major problems in empirical evaluation are the bundling of financial opening with a potential host of other growth-friendly reforms, and the endogeneity of the liberalization decision itself. Microeconomic evidence may provide less ambiguous evidence, but even in the micro context identification problems can remain.
In sum, empirical evidence is not conclusive that opening up financial markets leads to growth. What is the practical reality?
Nonetheless, policymakers in emerging markets have displayed a remarkable revealed preference for financial openness, and the trend is likely to continue (perhaps with occasional seizures when global economic conditions sour). Why?
Domestic financial development is attractive from several perspectives – it promotes growth, can enhance welfare more generally, allows easier government borrowing, and eases the conduct of a domestically oriented monetary policy. Such domestic financial deepening, along with merchandise trade expansion, makes capital controls ever costlier to enforce. Furthermore, financial opening is likely to promote, through several channels, a more competitive and resilient domestic financial system.
The findings are quite similar to what Rogoff et al say in their paper. In that paper they review tons of literature and say the same – Though, there is little evidence whether capital flows help in growth, one should go ahead with financial globalisation. Why? Because it has 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.
Then Obstfeld says:
Domestic financial development itself is likely to make external financial liberalization easier to live with. But there are other institutional reforms that ultimately are also helpful – relating to the rule of law, corruption, contract enforcement, corporate governance, and the like. These reforms cannot be accomplished overnight, and in the process, a phased and cautious piecemeal approach to liberalization is in order.
Again we have the complete list of reforms needed to make financial globalisation work. Hence the first focus has to be on setting domestic things right as that is the main problem.
The conclusion that financial integration is inevitable, and eventually even helpful, is in line with a classic insight from the trade policy literature: the efficient way to correct a distortion is to attack it at to its source. In the present setting, domestic financial market imperfection and institutional weakness, not financial openness, is the primary problem. The ideal response would be a correction of domestic imperfections plus intervention to address the specific additional issues raised by the international margin. Only if this approach is unworkable might a closed financial account be the answer.
This is pretty well-known and nothing new really. Actually the nature of financial globalisation is itself so complex, that any concrete analysis is difficult to arrive. These literature surveys are very useful to get a picture of what different studies have found. In this regard, this Obstfeld paper is very useful.