Globalization of Financial Markets

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The trend over the past few decades has been towards greater financial globalization. In other words, the ties between the economies of different countries have grown stronger over time as markets for goods and services, as well as those for financial assets, have been liberalized to greater trade. Cross-border financial flows have increased tremendously, bringing with them benefits in terms of growth from new investment and export opportunities, as well as potential costs in terms of increased uncertainty, financial market volatility, and possibly even a greater probability and size of financial crises. The characteristics and size of the overall net benefits from this process are still the subject of much debate. Hence, this becomes the focus of this paper that is to analyse and evaluate the role of financial globalization in triggering the financial crisis of 2008-09, in form of a literature review of this topic.
First of all, the paper will discuss the events that led to the instant globalization of financial markets and the disruptions that it caused which then activated the worst ever financial crisis after the Great Depression of 1935. In the process, the paper will also shed light on the regulatory mechanisms of national governments that became an integral part in aggravating the whole episode (Lane & Milesi-Ferretti, 2008).

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Second of all, the paper will turn towards the lessons that the governments around the world learned from the devastation of the global economy forming the basis of their future plan of action in ensuring balanced approach towards the matter.
Finally, the paper will present a conclusion summarising the past and future of the financial globalization by outlining the recommended strategies to save the world economy from such grave shocks in future.
The paper, Benefits and Risks of Financial Globalization: Challenges for Developing Countries, highlighted the significant improvements in the financial structure that persuaded many countries to globalise their financial institutions.  Greater provision of funds, increased efficiency, more transparency in international accounting standards, improved corporate governance are just some of the convincing factors for institutions to globalize (Stulz, 1999). In addition to that, diversified portfolios of foreign banks carry less risk bringing down the negative shocks to the home country; adopt best practices in every field enhancing the overall standard of the banking sector; possess power over the governments saving them from bail outs in times of solvency (Mishkin, 2003).
Another paper, Evidence on Financial Globalization and Crisis: Capital Raisings, talked about some more economic factors for the financial globalization. The low cost of capital and an increase in capital raisings were especially prominent, relatively speaking, for developing countries because of a rapid pace of financial liberalization in emerging markets of Latin America, East Asia, and Eastern Europe. The introduction of the euro in 1999, in addition, contributed to internalization of developed countries’ capital markets. Between 1991 and 2005, 28 percent of developing countries’ equity and 47 percent of their debt securities were issued abroad.  For the same period, 8 percent of developed countries’ equity and 35 percent of their debt securities were issued abroad (Gozzi, 2010).
Mishkin’s book, The Next Great Globalization, presents an exceptionally well-written and clearly argued case in favor of the benefits of financial globalization. Mishkin views a sound financial system as the sine qua non of economic growth. Without appropriate financial intermediation, savers cannot channel their resources to investors and capital does not get allocated efficiently. Hence the potential gains of financial globalization are too large to pass up. Mishkin does recognize that international financial integration is incomplete; that international financial markets work imperfectly; that capital flows can create all sorts of mischief when financial institutions take excessive risks; that capital-account liberalization can misfire when done badly; and that there are no one-size fits all policies when it comes to prudential regulation. In fact, much of his book is about financial globalization gone bad. He devotes considerable space to the financial crises in Mexico, South Korea, and Argentina, and to the difficulties of undertaking financial reform. Nonetheless, the appropriate reaction to these complications is not to delay liberalization or throw sands in the wheels of international finance, but to ensure that the requisite complementary reforms are also undertaken.
Moving on, the paper, Financial Globalisation and the Crisis, focused on the point that the global financial crisis provides an important testing ground for the financial globalisation model. First, did financial globalisation materially contribute to the origination of the global financial crisis? Second, once the crisis occurred, how did financial globalisation affect the incidence and propagation of the crisis across different countries? Third, how has financial globalisation affected the management of the crisis at national and international levels?
In view of the limited time span, it is difficult to quantify the drivers of time variation in international financial integration. Of course, financial globalisation has been facilitated by the secular decline in legal barriers to cross-border financial flows. Empirical work points to financial innovation and the liberalisation of the European financial system as important factors in the acceleration of cross-border financial trade among the advanced economies (Lane P. R.-F., 2008). In relation to financial innovation, new investment classes (such as asset-backed securities), new investment vehicles (such as special purpose vehicles [SPVs]) and the rise of lightly-regulated types of asset managers (hedge funds) all promoted cross-border financial trade. The liberalisation of the European financial system and the launch of the euro provided further impetus to cross-border financial trade (Lane P. R., 2010). Regulatory harmonisation and freedom of establishment facilitated the integration of European financial markets, while the single currency led to especially rapid growth in cross-border trade in money and credit markets.
Did the rise in cross-border financial trade contribute to the origination of the global financial crisis? It is possible to identify two main channels by which financial globalisation contributed to the financial conditions that ultimately gave rise to the crisis. First, the participation of foreign investors (especially foreign banks) fuelled the accelerated growth of the asset-backed securities markets in the United States that were central in the original market panic in 2007-2008. As documented by (Acharya, 2010) and (Bernanke, 2011), European banks were major purchasers of asset-backed securities. Second, financial globalisation permitted rapid growth in the balance sheets of many banks. This took place at two levels. In relation to globally-active banks, the size and complexity of these banks grew rapidly, making it difficult for national regulators to adequately police risk profiles. In addition, the capacity of local banks to expand lending by tapping international wholesale markets fuelled credit growth in a number of countries. Third, the growing role of emerging markets in the world financial system may also have contributed to the build up of weaknesses in credit markets. In particular, the general equilibrium impact of the demand for low-risk debt assets from emerging-market official sources and the increased supply of equity opportunities in these countries may have added fuel to the securitisation boom (see, amongst many others, Bernanke et al 2011).
In these ways, although there is no easy way to quantify its importance relative to other factors, financial globalisation plausibly contributed to the credit market vulnerabilities that were at the origin of the global financial crisis. In essence, financial globalisation magnified the impact of underlying distortions, such as inadequate regulation of credit markets and banks, by allowing the scaling-up of financial activities that might have faced capacity limits in autarkic financial systems (Borio, 2011).
Once the crisis occurred, financial globalisation provided a buffer against the crisis for some countries, whereas it amplified the crisis for others. By and large, the structure of the international balance sheets of emerging economies provided valuable insulation against the crisis.
Coming now to the public policy, the paper, Global financial crisis and emerging issues for public policy, examines its role in aggravating the financial crisis. These noteworthy features warrant an examination of the role of public policy in causing the crisis. First, there is a recognition that the global economic balances characterized by persistent high levels of current account surplus in some countries and current account deficits in the US provided a fertile ground for the crisis. Some analysts attribute global imbalances to the excessive dependence on a single reserve currency (the US dollar). Second, the rising inequalities in several countries could have resulted in deficiency in stability of aggregate consumer demand. Third, there was a prolonged period of loose monetary policies, which led to serious under pricing of risks, and possibly asset bubbles. Fourth, the central bankers were aware of the under pricing of risks but they believed in the self-connecting mechanism of market forces and they also believed that in any case risks were truly dispersed due to financial innovation. Fifth, the public policy did not assign a priority to financial stability and the central banks were generally mandated to focus on prices stability. More generally, monetary policies were perhaps pro-cyclical. Hence it is argued that there was either a failure of ideology and understanding or other political economy considerations that led to the crisis.
In addition to failures on macro-front which facilitated the crisis, the more proximate and immediate causes relate to regulation of the financial sector. First, the regulatory framework tended to be pro-cyclical rather than counter-cyclical. Second, the regulators did not have the skill to cope with financial innovations, especially those related to securitiation. Third, there was an excessive reliance on principlebased regulation or only self-regulation. Fourth, the regulators were content with regulating individual institutions on asset quality, thus ignoring the systemic issues such as liquidity and funding of assets. Fifth, they ignored the off balance sheet items of banks and shadow banking was indulged in the poorly regulated segment of nonbanking financial companies, which included investment banks. In particular, originate and distribute models of banking encouraged irresponsible lending. Finally there was a competitive race to the bottom in regulation by the financial centres, especially in the US and UK, who were keen to attract financial activity. More generally, it can be argued that while financial markets and institutions were global, regulations were national.
The global crisis has reinforced the importance of an array of policy reforms at international and national levels. There are two broad categories - reforms that can reduce the likelihood and severity of future crises and reforms that can improve macroeconomic and financial resilience in the event of a crisis. At the international level, the most direct challenge is to improve the regulation of the global financial system. Here, the reform agenda is well known and includes the co-ordinated regulation of the group of global banks that form the backbone of the international financial system. At a basic level, this would be facilitated by a much deeper knowledge base about the international activities of these banks, which in turn requires much richer data collection, including the full integration of offshore international financial centres into the data matrix on cross-border financial activities (Lane & Milesi-Ferretti, 2008). In related fashion, better analytical models of international systemic risk are needed in order to usefully interpret such data and develop appropriate preventive policy responses (Gourinchas & Obstfeld, 2012). The other main element in international policy reform is the construction of stronger international safety nets. Even with the recent increases in its resources, the lending capacity of the IMF has not kept pace with the growth in cross-border financial positions.
Given the costliness of avoidable defaults to the debtor country and, through contagion effects, to the global system, international liquidity provision has to remain a fundamental component in the international financial architecture. In additional to global-level institutional reform, the very high level of financial integration in Europe (especially within the euro area) calls for the development of regional-level institutions that can help to improve macroeconomic and financial stability. Still, even if the global and regional financial architectures were much improved, it would remain the case that domestic residents bear the largest costs in the event of a financial crisis. Accordingly, the main responsibility for adapting policy regimes to cope with financial globalisation lies with national governments. In general, domestic policy reforms should be complementary to parallel reforms at the international level. In terms of national macroeconomic policy frameworks, two key principles should guide the implementation of monetary and fiscal policies. First, the global crisis has provided further evidence of the costs of excessive imbalances (whether excessive domestic credit growth or excessive external deficit. While accepting that it is difficult to draw the line between sustainable and excessive imbalances, a prudential approach would suggest greater activism to lean against the wind. This includes operating a countercyclical fiscal policy that takes into account financial cycles as well as the output cycle (Benetrix, 2011).
Second, it is important to have in place national buffers that can cope with adverse shocks. In terms of monetary regimes for countries with independent currencies, the crisis has revised upwards the prudential level of foreign-currency reserves, even if that level remains far below the scale of reserves currently maintained by some countries. In relation to fiscal policy, a basic message is that the crisis has revised downwards the level of public debt that can be considered “safe ”in normal times, in view of the scope for rapid growth in public debt during financial crises (Reinhart, 2009).
Another way forward is presented in the paper, Global financial crisis and emerging issues for public policy. First, what is the right balance between the state and the market? That unfettered markets, especially in financial sector, can cause havoc is now established. But it is not clear that empowering the state will necessarily be right, since the crisis is a reflection of the failure of public policy also.
Second, how to evaluate costs and benefits of the regulation of the financial sector, and in the process, how to redesign the domestic framework for regulation? It is evident that the costs of compliance with regulations incurred by market participants were exaggerated and the benefits to the economic system and society at large of more active regulations seriously underestimated
Third, what should be the appropriate links between growth, functioning of the financial sector and the other sectors of the economy? It is clear that the financial sector cannot be an end itself and that it has an incentive towards multiplicity of transactions, since the incomes of many market participants are enhanced in the process.
Further, how globalized should finance be in view of the fact that the welfare of citizens continues to be the responsibility of the government? What is the appropriate policy space needed at the national level to discharge the responsibility? Globalization of finance provides scope for interest rate arbitrage, regulatory arbitrage and tax arbitrage
Finally, public policies are essentially products of political economy considerations at the national level, and such public policies tend to reflect the national interests in their interaction with other countries.
Summing the whole discussion up, history reaffirms the value of not relying blindly on the strengths of either.  The crisis showed again that both markets and governments can fail spectacularly, and that while markets must ultimately be the drivers of growth, good government is needed to create the conditions for markets to work well and to reduce volatility and vulnerability. On macroeconomic management, the crisis has exposed new risks and underscores both the difficulty of managing them and the need to buffer shocks.  With the end of the Great Moderation, the developing countries will need to take into account risks in developed economies as they set their own policies.  On global integration too, the lesson is that even growth-promoting integration brings risks even as it mitigates others, and that countries may need to adapt their export-led growth strategies to accommodate global rebalancing.  In the area of finance for development, the crisis underscores the dangers of relying excessively on debt financing and may reduce the allure of foreign finance and financial liberalization.  And in the area of public spending, it will further strengthen the move toward a focus on the efficiency and quality of spending in the social sectors.  In short, the global crisis does provide new information in key policy areas, but it need not provoke any crisis of confidence in the current state and direction of development thinking. 

Works Cited

Acharya, V. V. (2010). Do Global Banks Spread Global Imbalances? Asset-Backed Commercial Paper During the Financial Crisis of 2007-09. IMF Economic Review , 37-73.
Benetrix, A. a. (2011). “Financial Cycles and Fiscal Cycles. Trinity College Dublin.
Bernanke, B. S. (2011). International Capital Flows and the Returns to Safe Assets in the United States, 2003-2007. Banque de France Financial Stability Review , 13-26.
Borio, C. a. (2011). Global Imbalances and the Financial Crisis: Link or No Link? BIS Working Paper No. 346 .
Gourinchas, P.-O., & Obstfeld, M. (2012). ìStories of the Twentieth Century for the Twenty-First. American Economic Journal: Macroeconomics , 4 (1), 226-265.
Gozzi, J. C. (2010). Patterns of International Capital Raisings. Journal of International Economics , 45-57.
Lane, P. R. (2010). Financial Exchange Rates and International Currency Exposures. American Economic Review , 518-540.
Lane, P. R., & Milesi-Ferretti, G. M. (2008). The Drivers of Financial Globalization. American Economic Review , 98 (2), 327-332.
Lane, P. R.-F. (2008). The Drivers of Financial Globalization. American Economic Review , 327-332.
Mishkin. (2003). Financial Policies and the Prevention of Financial Crises in Emerging Market Countries. Economic and Financial Crises in Emerging Market Countries, University of Chicago Press. .
Reinhart, C. M. (2009). This Time Is Di¤erent: Eight Cen-. Princeton University Press .
Stulz. (1999). Globalization, Corporate Finance and the Cost of Capital. Journal of Applied Corporate Finance , 8-25.

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