6 - Volatility and the welfare costs of financial market integration

Summary

Introduction

The view that international financial market integration brings significant long-term benefits is hardly a controversial one among mainstream economists. Financial openness, for instance, increases opportunities for portfolio risk diversification and consumption smoothing through borrowing and lending; and producers who are able to diversify risks on world capital markets may invest in more risky (and higher-yield) projects, thereby raising the country's rate of economic growth (Obstfeld, 1994, 1998). Increased access to the domestic financial system by foreign banks is often viewed as raising the efficiency of the intermediation process between savers and borrowers, thereby lowering the cost of investment. Higher foreign direct investment flows (FDI) often have a direct, positive effect on productivity and the efficiency of domestic resource utilisation (through transfers of technology and other intangible assets), thereby raising the rate of economic growth.

But it is increasingly recognised that a high degree of financial openness may entail significant short-term costs as well. The magnitude of the capital flows recorded by some developing countries in recent years, and the abrupt reversals that such flows have displayed at times, have raised serious concerns among policy makers. The Mexican peso crisis of December 1994 led to financial instability throughout Latin America, particularly in Argentina. The collapse of the pegged exchange rate regime in Thailand on 2 July 1997 led to currency turmoil throughout Asia, particularly in Indonesia, Korea, Malaysia and the Philippines.