9. Effects of Financial Globalization on Developing Countries: Some Empirical Evidence
- Wanda Tseng, and David Cowen
- Published Date:
- May 2007
The recent wave of financial globalization since the mid-1980s has been marked by a surge in capital flows among industrial countries and, more notably, between industrial and developing countries. While these capital flows have been associated with high growth rates in some developing countries, a number of countries have experienced periodic collapse in growth rates and significant financial crises over the same period, crises that have exacted a serious toll in terms of macroeconomic and social costs. As a result, an intense debate has emerged in both academic and policy circles on the effects of financial integration for developing economies. But much of the debate has been based on only casual and limited empirical evidence.
The main purpose of this chapter is to provide an assessment of empirical evidence on the effects of financial globalization for developing economies. The chapter will focus on three related questions: (i) does financial globalization promote economic growth in developing countries? (ii) what is its impact on macroeconomic volatility in these countries? (iii) what are the factors that appear to help harness the benefits of financial globalization?
The principal conclusions that emerge from the analysis are sobering, but in many ways informative from a policy perspective. It is true that many developing economies with a high degree of financial integration have also experienced higher growth rates. It is also true that, in theory, there are many channels by which financial openness could enhance growth. However, a systematic examination of the evidence suggests that it is difficult to establish a robust causal relationship between the degree of financial integration and output growth performance. From the perspective of macro-economic stability, consumption is regarded as a better measure of well-being than output; fluctuations in consumption are therefore regarded as having a negative impact on economic welfare. There is little evidence that financial integration has helped developing countries to better stabilize fluctuations in consumption growth, notwithstanding the theoretically large benefits that could accrue to developing countries in this respect. In fact, new evidence presented in this chapter suggests that low to moderate levels of financial integration may have made some countries subject to even greater volatility of consumption relative to that of output. Thus, while there is no proof in the data that financial globalization has benefited growth, there is evidence that some countries may have experienced greater consumption volatility as a result.
This chapter offers mainly empirical evidence, rather than definitive policy implications. Nevertheless, some general principles emerge from the analysis about how countries can increase the benefits from, and control the risks of, globalization. In particular, the quality of domestic institutions appears to play a role in this respect. A growing body of evidence suggests that it has a quantitatively important impact on a country’s ability to attract foreign direct investment (FDI), and on its vulnerability to crises. While different measures of institutional quality are no doubt correlated, there is accumulating evidence of the benefits of robust legal and supervisory frameworks, low levels of corruption, high degree of transparency, and good corporate governance.
The review of the available evidence does not, however, provide a clear road map for countries that have started on or desire to start on the path to financial integration. For instance, there is an unresolved tension between having good institutions in place before capital market liberalization and the notion that such liberalization in itself can help import best practices and provide an impetus to improve domestic institutions. Furthermore, neither theory nor empirical evidence has provided clear-cut general answers to related issues such as the desirability and efficacy of selective capital controls. Ultimately, these questions can be addressed only in the context of country-specific circumstances and institutional features.
This paper does not tackle the appropriate choice of an exchange rate regime or of monetary and fiscal policies. It is worth noting, however, that fixed or de facto fixed exchange rate regimes and excessive government borrowing appear to be major factors that have compounded the problems that some developing countries have had in managing capital flows. We leave a systematic examination of these issues for future research.
9.2 Basic stylized facts
9.2.1 Measuring financial integration
Capital account liberalization is typically considered an important precursor to financial integration. Most formal empirical work analyzing the effects of capital account liberalization has used a measure based on the official restrictions on capital flows as reported to the International Monetary Fund (IMF) by national authorities. However, this binary indicator directly measures capital controls but does not capture differences in the intensity of these controls.2 A more direct measure of financial openness is based on the estimated gross stocks of foreign assets and liabilities as a share of gross domestic product (GDP).3 The stock data constitutes a better indication of integration, for our purposes, than the underlying flows since they are less volatile from year to year and are less prone to measurement error (assuming that such errors are not correlated over time).4
While these two measures of financial integration are related, they denote two distinct aspects. The capital account restrictions measure reflects the existence of de jure restrictions on capital flows while the financial openness measure captures de facto financial integration in terms of realized capital flows. This distinction is of considerable importance for the analysis in this chapter and implies a 2 x 2 set of combinations of these two aspects of integration. Many industrial countries have attained a high degree of financial integration in terms of both measures. Some developing countries with capital account restrictions have found these restrictions ineffective in controlling actual capital flows. Episodes of capital flight from some Latin American countries in the 1970s and the 1980s are examples of such involuntary de facto financial integration in economies that are de jure closed to financial flows (i.e. integration without capital account liberalization). On the other hand, some countries in Africa have few capital account restrictions but have experienced only minimal levels of capital flows (i.e. liberalization without integration). And, of course, it is not difficult to find examples of countries with closed capital accounts that are also effectively closed in terms of capital flows.
How has financial integration evolved over time for different groups of countries based on alternative measures?5 By either measure, the difference in financial openness between industrial and developing countries is quite stark. Industrial economies have had an enormous increase in financial openness, particularly in the 1990s. While this measure also increased for developing economies in that decade, the level remains far below that of industrial economies.
For industrial countries, unweighted cross-country averages of the two measures are mirror images and jointly confirm that these countries have undergone rapid financial integration since the mid-1980s (Figure 9.1). For developing countries, the average restriction measure indicates that, after a period of liberalization in the 1970s, the trend toward openness reversed in the 1980s. Liberalization resumed in the early 1990s but at a slow pace. On the other hand, the average financial openness measure for these countries, based on actual flows, shows a modest increase in the 1980s, followed by a sharp rise in the 1990s. The increase in the financial openness measure for developing economies reflects a more rapid de facto integration than is captured by the relatively crude measure of capital account restrictions.
Figure 9.1Measures of financial integration
Sources: International Monetary Fund, World Economic Outlook (various issues) and Lane and Milesi-Ferreti (2001).
However, the effects of financial integration in terms of increased capital flows have been spread very unevenly across developing countries. For examining the extent of these disparities, it is useful to begin with a very coarse classification of the developing countries in the sample into two groups based on a ranking according to the average of the financial openness measure over the last four decades (as well as an assessment of other indicators of financial integration).
The first group, which comprises 22 countries, is henceforth labeled as the set of More Financially Integrated (MFI) countries and the latter, which includes 33 countries, as the Less Financially Integrated (LFI) countries.6 This distinction must be interpreted with some care at this stage. In particular, it is worth repeating that the criterion is a measure of de facto integration based on actual capital flows rather than a measure of the strength of policies designed to promote financial integration. Indeed, a few of the countries in the MFI group do have relatively closed capital accounts in a de jure sense. In general, as argued below, policy choices do determine the degree and nature of financial integration. Nevertheless, for the analysis in this paper, the degree of financial openness based on actual capital flows is a more relevant measure.
It should be noted that the main conclusions of this paper are not crucially dependent on the particulars of the classification of developing countries into the MFI and LFI groups. This classification is obviously a static one and does not account for differences across countries in the timing and degree of financial integration. It is used for some of the descriptive analysis presented below but only in order to illustrate the conclusions from the more detailed econometric studies that are surveyed in the paper. The areas where this classification yields results different from those obtained from more formal econometric analysis will be clearly highlighted in the paper. The regression results reported in this paper are based on the gross capital flows measure described earlier, which does capture differences across countries and changes over time in the degree of financial integration.
The vast majority of international private gross capital flows of developing countries, especially in the 1990s, are accounted for by the relatively small group of MFI economies. By contrast, private capital flows to and from the LFI economies have remained very small over the last decade and, for certain types of flows, have even fallen relative to the late 1970s.
9.2.2 North–South capital flows
One of the key features of global financial integration over the last decade has been the dramatic increase in net private capital flows from industrial countries (the “North”) to developing countries (the “South”). The main increase has been in terms of FDI and portfolio flows, while the relative importance of bank lending has declined somewhat. In fact, net bank lending turned negative for a few years during the time of the Asian crisis.
The bulk of the surge in net FDI flows from the advanced economies has gone to MFI economies, with only a small fraction going to LFI economies. Net portfolio flows show a similar pattern, although both types of flows to MFI economies fell sharply following the Asian crisis and have remained relatively flat since then. LFI economies have been much more dependent on bank lending (and, although not shown here, on official flows including loans and grants). There were surges in bank lending to this group of countries in the late 1970s and the early 1990s.
Another important feature of these flows is that they differ substantially in terms of volatility (Wei, 2001). FDI flows are the least volatile of the different categories of private capital flows to developing economies, which is not surprising given their long-term and relatively fixed nature. Portfolio flows tend to be far more volatile and prone to abrupt reversals than FDI. These patterns hold when the MFI and LFI economies are examined separately. Even in the case of LFIs, the volatility of FDI flows is much lower than that of other types of flows. This difference in the relative volatility of different categories has important implications that will be examined in more detail later.
9.2.3 Factors underlying the rise in North–South capital flows
The surge in net private capital flows to MFIs, as well as the shifts in the composition of these flows, can be broken down into “pull” and “push” factors. These are related to, respectively, (i) policies and other developments in the MFIs and (ii) changes in global financial markets. The first category includes factors such as stock market liberalizations and privatization of state-owned companies that have stimulated foreign inflows. The second category includes the growing importance of depositary receipts and cross-listings and the emergence of institutional investors as key players driving international capital flows to emerging markets.
The investment opportunities afforded by stock market liberalizations, which have typically included the provision of access to foreign investors, have enhanced capital flows to MFIs. Since the late 1980s, stock market liberalizations in MFI economies in different regions have proceeded rapidly, in terms of both intensity and speed.
Mergers and acquisitions, especially those resulting from the privatization of state-owned companies, were an important factor underlying the increase in FDI flows to MFIs during the 1990s. The easing of restrictions on foreign participation in the financial sector in MFIs has also provided a strong impetus to this factor.
Institutional investors in the industrial countries—including mutual funds, pension funds, hedge funds, and insurance companies—have assumed an important role in channeling capital flows from industrial to developing economies. They have helped individual investors overcome the information and transaction cost barriers that previously limited portfolio allocations to emerging markets. Mutual funds, in particular, have served as an important instrument for individuals to diversify their portfolios into developing country holdings. Although international institutional investors devote only a small fraction of their portfolios to holdings in MFIs, they have an important presence in these economies, given the relatively small size of their capital markets. Funds dedicated to emerging markets alone hold on average 5–15 percent of the Asian, Latin American, and transition economies’ market capitalization.
Notwithstanding the moderation of North–South capital flows following recent emerging market crises, certain structural forces are likely to lead to a revival of these flows over the medium and long term. Demographic shifts, in particular, constitute an important driving force for these flows. Projected increases in old-age dependency ratios reflect the major changes in demographic profiles that are underway in industrial countries. This trend is likely to intensify further in the coming decades, fueled both by advances in medical technology that have increased average life spans and the decline in fertility rates. Financing the post-retirement consumption needs of a rapidly aging population will require increases in current saving rates, both national and private, in these economies. However, if such increases in saving rates do materialize, they are likely to result in a declining rate of return on capital in advanced economies, especially relative to that in the capital-poor countries of the South. This will lead to natural tendencies for capital to flow to countries where it has a potentially higher return.
All of these forces imply that, despite the recent sharp reversals in North–South capital flows, developing countries will eventually once again face the delicate balance of opportunities and risks afforded by financial globalization. Are the benefits derived from financial integration sufficient to offset the costs of increased exposure to the vagaries of international capital flows? The chapter now turns to an examination of the evidence on this question.
9.3 Financial integration and economic growth
9.3.1 Potential benefits of financial globalization
In theory, there are a number of direct and indirect channels through which embracing financial globalization can help enhance growth in developing countries. Figure 9.2 provides a schematic summary of these possible channels. These channels are interrelated in some ways, but this delineation is useful for reviewing the empirical evidence on the quantitative importance of each channel.
Figure 9.2Channels through which financial integration can raise economic growth
North–South capital flows in principle benefit both groups. They allow for increased investment in capital-poor countries by augmenting domestic savings and, at the same time, provide a higher return on capital than is available in capital-rich countries. This effectively reduces the risk-free rate in the developing countries.
The second direct channel comes from the reduction in the cost of capital through better global allocation of risk. International asset pricing models predict that stock market liberalization improves the allocation of risk. First, increased risk sharing opportunities between foreign and domestic investors might help to diversify risks. This ability to diversify in turn encourages firms to take on more total investment, thereby enhancing growth. Third, as capital flows increase, the domestic stock market becomes more liquid, which could further reduce the equity risk premium, thereby lowering the cost of raising capital for investment.
Transfer of technological and managerial know-how is another direct channel. Financially integrated economies seem to attract a disproportionately large share of FDI inflows, which have the potential to generate technology spillovers and to serve as a conduit for passing on better management practices. These spillovers can raise aggregate productivity and, in turn, boost economic growth.
Stimulation of domestic financial sector development is also promoted by financial integration. It has already been noted that international portfolio flows can increase the liquidity of domestic stock markets. Increased foreign ownership of domestic banks can also generate a variety of other benefits. First, foreign bank participation can facilitate access to international financial markets. Second, it can help improve the regulatory and supervisory framework of the domestic banking industry. Third, foreign banks often introduce a variety of new financial instruments and techniques and also foster technological improvements in domestic markets. The entry of foreign banks tends to increase competition which, in turn, can improve the quality of domestic financial services as well as allocative efficiency.
The notion that specialization in production may increase productivity and growth is intuitive. However, without any mechanism for risk management, a highly specialized production structure will produce high output volatility and, hence, high consumption volatility. Concerns about exposure to such increases in volatility may discourage countries from taking up growth-enhancing specialization activities; the higher volatility will also generally imply lower overall savings and investment rates. In principle, financial globalization could play a useful role by helping countries to engage in international risk sharing and thereby reduce consumption volatility. This point will be taken up again in Section 9.4. Here, it should just be noted that risk sharing would indirectly encourage specialization, which in turn would raise the growth rate.
International financial integration could also increase productivity in an economy through its impact on the government’s ability to credibly commit to a future course of policies. More specifically, the disciplining role of financial integration could change the dynamics of domestic investment in an economy to the extent that it leads to a reallocation of capital toward more productive activities in response to changes in macroeconomic policies. National governments are occasionally tempted to institute predatory tax policies on physical capital. The prospect of such policies tends to discourage investment and to reduce growth. Financial opening can be self-sustaining and constrains the government from engaging in such predatory policies in the future since the negative consequences of such actions are far more severe under financial integration.
A country’s willingness to undertake financial integration could also be interpreted as a signal that it is going to practice more friendly policies toward foreign investment in the future. The removal of restrictions on capital outflows can, through its signaling role, lead to an increase in capital inflows. Many countries, including Colombia, Egypt, Italy, New Zealand, Mexico, Spain, Uruguay, and the United Kingdom have received significant capital inflows after removing restrictions on capital outflows.
9.3.2 Empirical evidence
On the surface, there seems to be a positive association between embracing financial globalization and the level of economic development. Industrial countries in general are more financially integrated with the global economy than developing countries. So embracing globalization is apparently part of being economically advanced.
Within the developing world, it is also the case that MFI economies grew faster than LFI economies over the last three decades. From 1970 to 1999, average output per capita rose almost threefold in the group of MFI developing economies, almost six times greater than the corresponding increase for LFI economies. This pattern of higher growth for the former group applies over each of the three decades and also to consumption and investment growth.
However, there are two problems with concluding a positive effect of financial integration on growth from this data pattern. First, this pattern may be fragile upon closer scrutiny. Second, these observations only reflect an association between international financial integration and economic performance rather than necessarily a causal relationship. In other words, these observations do not rule out the possibility that there is reverse causation: countries that manage to enjoy a robust growth may also choose to engage in financial integration even if financial globalization does not directly contribute to faster growth in a quantitatively significant way.
To obtain an intuitive impression of the relationship between financial openness and growth, Table 9.1 presents a list of the fastest growing developing economies during 1980–2000 and a list of the slowest growing (or fastest declining) economies during the same period. Some countries have undergone financial integration during this period, especially in the latter half of the 1990s.7 Therefore, any result based on total changes over this long period should be interpreted with caution. Nonetheless, several features of the table are noteworthy.
|Total percentage change (in percent of GDP)||More financially integrated?||Slowest growing economies 1980–2000||Total percentage change (in percent of GDP)||More financially integrated?|
|Hong Kong SAR||114.5||Yes||Venezuela||‒17.3||Yes/No|
Growth rate of real per capita GDP, in constant local currency units.
Growth rate of real per capita GDP, in constant local currency units.
An obvious observation that can be made from the table is that financial integration is not a necessary condition for achieving a high growth rate. China and India have achieved high growth rates despite somewhat limited and selective capital account liberalization. For example, while China became substantially more open to FDI, it was not particularly open to most other types of cross-border capital flows. Mauritius and Botswana have managed to achieve very strong growth rates during the period, although they are relatively closed to financial flows.
The second observation that can be made is that financial integration is not a sufficient condition for a fast economic growth rate either. For example, Jordan and Peru had become relatively open to foreign capital flows during the period; yet, their economies suffered a decline rather than enjoying positive growth during the period. On the other hand, Table 9.1 also suggests that declining economies are more likely to be financially closed, though the direction of causality is not clear as explained before.
This way of looking at country cases with extreme growth performance is only informative up to a point; it needs to be supplemented by a comprehensive examination of the experience of a broader set of countries using a more systematic approach to measuring financial openness. To illustrate this relationship more broadly, Figure 9.3 presents a scatter plot of the growth rate of real per capita GDP against the increase in financial integration over 1982–97. There is essentially no association between these variables. This picture remains unchanged if one controls for the effects of a country’s initial income, initial schooling, average investment-to-GDP ratio, political instability, and regional location. In fact, this finding is not unique to the particular choice of the time period or the country coverage as reflected in a broad survey of other research papers on the subject.
Figure 9.3Correlation between financial openness and real per capita GDP growth 1982–97a
A number of empirical studies have tried to systematically examine whether financial integration contributes to growth using various approaches to dealing with the difficult problem of proving causation. We surveyed the 14 most recent studies on this subject. Three out of the 14 papers report a positive effect of financial integration on growth. However, the majority of the papers tend to find no effect or a mixed effect for developing countries. This suggests that, if financial integration has a positive effect on growth, it is probably not strong or robust.
Of the papers we surveyed, the one by Edison, Levine, Ricci, and Sløk (2002) is perhaps the most thorough and comprehensive in terms of measures of financial integration and in terms of empirical specifications. These authors measure a country’s degree of financial integration both by the government’s restrictions on capital account transactions as recorded by the IMF and by the observed size of capital flows crossing the border, normalized by the size of the economy. The data set in that paper goes through 2000, the latest year analyzed in any existing study on this subject. Furthermore, the authors also employ a statistical methodology that allows them to deal with possible reverse causality—that is, any observed association between financial integration and economic growth could result from the mechanism that faster growing economies are also more likely to choose to liberalize their capital accounts. After a battery of statistical analyses, that paper concludes that, overall, there is no robustly significant effect of financial integration on economic growth.
Why is it so difficult to find a strong and robust effect of financial integration on economic growth for developing countries, when the theoretical basis for this result is apparently so strong? Perhaps there is some logic to this outcome after all. A number of researchers have now concluded that most of the differences in income per capita across countries stem not from differences in capital-labor ratios, but from differences in total factor productivity (TFP), which, in turn, could be explained by “soft” factors or “social infrastructure” like governance, rule of law, and respect for property rights. In this case, while financial integration may open the door for additional capital to come in from abroad, it is unlikely to offer a major boost to growth by itself. In fact, if domestic governance is sufficiently weak, financial integration could cause an exodus of domestic capital and, hence, lower the growth rate of an economy.
This logic can be illustrated using the results reported in Senhadji (2000). Over the period 1960 to 1994, the average growth rate of per capita output for the group of countries in sub-Saharan Africa was the lowest among regional groupings of developing countries. The difference in physical and human capital accumulation is only part of the story for why growth rates differ across countries. The gap in TFP is the major element in explaining the difference in the growth rates.
Another possible explanation for why it is difficult to detect a causal effect of financial integration on growth is the costly banking crises that some developing countries have experienced in the process of financial integration. The results in Kaminsky and Reinhart (1999) suggest that a flawed sequencing of domestic financial liberalization, when accompanied by capital account liberalization, increases the chance of domestic banking crises and/or exchange rate crises. These crises are often accompanied by output collapses.
As a result, the benefits from financial integration may not be evident in the data. It is interesting to contrast the empirical literature on the effects of financial integration with that on the effects of trade integration. Although there are some skeptics, an overwhelming majority of empirical papers reach the conclusion that trade openness helps to promote economic growth. These studies employ a variety of techniques, including country case studies as well as cross-country regressions. In a recent paper that surveys all the prominent empirical research on the subject, Berg and Krueger (2002) conclude that “[v]aried evidence supports the view that trade openness contributes greatly to growth.” Furthermore, “[c]ross-country regressions of the level of income on various determinants generally show that openness is the most important policy variable.” The contrast between financial and trade openness may have important lessons for policies. While there appear to be relatively few prerequisites for deriving benefits from trade openness, obtaining benefits from financial integration requires several conditions to be in place. This is discussed in more detail later.
It is useful to note that there may be a complementary relationship between trade and financial openness. For example, if a country has severe trade barriers protecting some inefficient domestic industries, then capital inflows may end up being directed to those industries, thereby exacerbating the existing misallocation of resources. Thus, there is a concrete channel through which financial openness without trade openness could lower a country’s level of efficiency.
Of course, the lack of a strong and robust effect of financial integration on economic growth does not necessarily imply that theories that make this connection are wrong. One could argue that the theories are about the long-run effects, and most theories abstract from the nitty-gritty of institutional building, governance improvement, and other “soft” factors that are necessary ingredients for the hypothesized channels to take effect. Indeed, developing countries may have little choice but to strengthen their financial linkages eventually in order to improve their growth potential in the long run. The problem is how to manage the short-run risks apparently associated with financial globalization. Financial integration without a proper set of preconditions might lead to few growth benefits and more output and consumption volatility in the short run, a subject that is taken up in the Section 9.4.
9.4 Financial globalization and macroeconomic volatility
9.4.1 Macroeconomic volatility
One of the potential benefits of globalization is that it should provide better opportunities for reducing volatility by diversifying risks. Indeed, these benefits are presumably even greater for developing countries that are intrinsically subject to higher volatility on account of their being less diversified than industrial economies in terms of their production structures. However, recent crises in some MFIs suggest that financial integration may in fact have increased volatility.
What is the overall evidence of the effect of globalization on macroeconomic volatility? In addressing this question, it is important to make a distinction between output and consumption volatility. In theoretical models, the direct effects of global integration on output volatility are ambiguous. Financial integration provides access to capital that can help capital-poor developing countries to diversify their production base. On the other hand, rising financial integration could also lead to increasing specialization of production based on comparative advantage considerations, thereby making economies more vulnerable to shocks that are specific to industries.
Irrespective of the effects on output volatility, theory suggests that financial integration should reduce consumption volatility. The ability to reduce fluctuations in consumption is regarded as an important determinant of economic welfare. Access to international financial markets provides better opportunities for countries to share macroeconomic risk and, thereby, smooth consumption. The basic idea here is that, since output fluctuations are not perfectly correlated across countries, trade in financial assets can be used to delink national consumption levels from the country-specific components of these output fluctuations (see Obstfeld and Rogoff (1998), chapter 5).
Notwithstanding the importance of this issue, the empirical evidence on the effects of globalization on macroeconomic volatility is rather sparse and, in particular, the evidence concerning the effects of financial integration on volatility is limited and inconclusive. In addition, the existing literature has largely been devoted to analyzing the effects of financial integration on output volatility, with little attention paid to consumption volatility. Hence, this paper now provides some new evidence on this topic.
Table 9.2 examines changes in volatility for different macroeconomic aggregates over the last four decades. Consistent with evidence presented in the IMF’s September 2002 World Economic Outlook, MFI economies on average have lower income volatility than LFI economies. Interestingly, there is a significant decline in average income volatility in the 1990s for both industrial and LFI economies but a far more modest decline for MFI economies.
(percentage standard deviations, medians for each group)a
|More financially integrated||5.44||3.60||5.43||5.45||4.78|
|Less financially integrated||7.25||4.42||9.64||7.56||4.59|
|Ratio of total consumption volatility to income volatilityb|
Standard errors are reported in parentheses.
For the bottom panel, the ratio of total consumption growth volatility to that of income growth volatility is first computed separately for each country. The reported numbers are the within-group medians of these ratios.
Standard errors are reported in parentheses.
For the bottom panel, the ratio of total consumption growth volatility to that of income growth volatility is first computed separately for each country. The reported numbers are the within-group medians of these ratios.
The third panel of this table shows that average consumption volatility in the 1990s has declined in line with output volatility for both industrial economies and LFI economies. By contrast, for MFI economies, the volatility of consumption has in fact risen in the 1990s relative to the 1980s for MFI economies. Could this simply be a consequence of higher income volatility for MFI economies?
Strikingly, for the group of MFI countries, the volatility of total consumption relative to that of income has actually increased in the 1990s relative to earlier periods. The bottom panel of Table 9.2 shows the median ratio of the volatility of total consumption growth to that of income growth for each group of countries. For MFI economies, this ratio increases from 0.76 in the 1980s to 0.92 in the 1990s, while it remains essentially unchanged for the other two groups of countries. Thus, the increase in the 1990s of the volatility of consumption relative to that of income for the MFI economies suggests that financial integration has not provided better consumption smoothing opportunities for these economies.8
More formal econometric evidence is presented by Kose et al. (2003), who use measures of capital account restrictions as well as gross financial flows to capture different aspects of financial integration, as well as differences in the degree of integration across countries and over time. This analysis confirms the increase in the relative volatility of consumption for countries that have larger financial flows, even after controlling for macroeconomic variables as well as country characteristics such as trade openness and industrial structure. However, these authors also identify an important threshold effect—beyond a particular level, financial integration significantly reduces volatility. Most developing economies, including MFI economies, are unfortunately well below this threshold.9
Why has the relative volatility of consumption increased precisely in those developing countries that are more open to financial flows? One explanation is that positive productivity and output growth shocks during the late 1980s and early 1990s in these countries led to consumption booms that were willingly financed by international investors. These consumption booms were accentuated by the fact that many of these countries undertook domestic financial liberalization at the same time that they opened up to international financial flows, thereby loosening liquidity constraints at both the individual and national levels. When negative shocks hit these economies, however, they rapidly lost access to international capital markets.
Consistent with this explanation, a growing literature suggests that the procyclical nature of capital flows appears to have had an adverse impact on consumption volatility in developing economies.10 One manifestation of this procyclicality is the phenomenon of “sudden stops” of capital inflows (see Calvo and Reinhart (2000)). More generally, access to international capital markets has a procyclical element, which tends to generate higher output volatility as well as excess consumption volatility (relative to that of income). Reinhart (2002), for instance, finds that sovereign bond ratings are procyclical. Since the spreads on bonds of developing economies are strongly influenced by these ratings, this implies that costs of borrowing on international markets are procyclical as well. Kaminsky and Reinhart (2002) present more direct evidence on the procyclical behavior of capital inflows.
9.4.2 Crises as special cases of volatility
Crises can be regarded as particularly dramatic episodes of volatility. In fact, the proliferation of financial crises is often viewed as one of the defining aspects of the intensification of financial globalization over the last two decades. Furthermore, the fact that recent crises have affected mainly MFI economies has led to these phenomena being regarded as hallmarks of the unequal distribution of globalization’s benefits and risks. This raises a challenging set of questions about whether the nature of crises has changed over time, what factors increase vulnerability to crises, and whether such crises are an inevitable concomitant of globalization.
Some aspects of financial crises have indeed changed over time while, in other respects, it is often déjà vu all over again. Calvo (1998) has referred to such episodes in the latter half of the 1980s and 1990s as capital account crises, while earlier ones are referred to as current account crises. Although this suggests differences in the mechanics of crises, it does not necessarily imply differences in some of their fundamental causes. Kaminsky and Reinhart (1999) discuss the phenomenon of “twin crises,” which involve balance of payments and banking crises. These authors also make the important point that, in the episodes that they analyze, banking sector problems typically precede a currency crisis and that the currency crisis then deepens the banking crisis, activating a vicious spiral. In this vein, Krueger and Yoo (2002) conclude that imprudent lending by the Korean banks in the early and mid-1990s, especially to the Chaebols, played a significant role in the 1997 Korean currency crisis. Opening up to capital markets can thus exacerbate such existing domestic distortions and lead to catastrophic consequences.
One key difference in the evolution of crises is that, while the 1970s and the 1980s featured crises that affected both industrial and developing economies, these have become almost exclusively the preserve of developing economies since the mid-1990s.11 This suggests either that advanced economies have been able to better protect themselves through improved policies or that the fundamental causes of crises have changed over time, thereby increasing the relative vulnerability of developing economies. In this context, it should be noted that, while capital flows from advanced economies to MFI economies have increased sharply, these flows among industrial economies have jumped even more sharply in recent years, as noted earlier. Thus, at least in terms of volume of capital flows, it is not obvious that changes in financial integration can by themselves be blamed for crises in MFI economies.
Is it reasonable to accept crises as a natural feature of globalization, much as business cycles are viewed as a natural occurrence in market economies? One key difference between these phenomena is that the overall macroeconomic costs of financial crises are typically very large and far more persistent. Calvo and Reinhart (2000) document those emerging market currency crises typically accompanied by sudden stops or reversals of external capital inflows are associated with significant negative output effects. Such recessions following devaluations (or large depreciations) are also found to be much deeper in emerging markets than in developed economies. In addition, the absence of well-functioning safety nets can greatly exacerbate the social costs of crises, which typically have large distributional consequences.
9.4.3 Financial globalization and volatility transmission
What factors have led to the rising vulnerability of developing economies to financial crises? The risk of sudden stops or reversals of global capital flows to developing countries has increased in importance as many developing countries now rely heavily on borrowing from foreign banks or on portfolio investment by foreign investors. These capital flows are sensitive not just to domestic conditions in the recipient countries but also to macroeconomic conditions in industrial countries. For instance, Mody and Taylor (2002), using an explicit disequilibrium econometric framework, detect instances of “international capital crunch”—where capital flows to developing countries are curtailed by supply-side rationing that reflects industrial country conditions. These North–South financial linkages, in addition to the real linkages described in earlier sections, represent an additional channel through which business cycles and other shocks that hit industrial countries can affect developing countries.
The effects of industrial country macroeconomic conditions, including the stage of the business cycle and interest rates, have different effects on various types of capital flows to emerging markets. Reinhart and Reinhart (2001) document that net FDI flows to emerging market economies are strongly positively correlated with US business cycles. On the other hand, bank lending to these economies is negatively correlated with US cycles. Edison and Warnock (2001) find that portfolio equity flows from the United States to major emerging market countries are negatively correlated with both US interest rates and US output growth. This result is particularly strong for flows to Latin America and less so for flows to Asia. Thus, the sources of capital inflows for a particular MFI can greatly affect the nature of its vulnerability to the volatility of capital flows arising from industrial country disturbances.
The increase in cross-country financial market correlations also indicates a risk of emerging markets being caught up in financial market bubbles. The rise in co-movement across emerging and industrial country stock markets, especially during the stock market bubble period of the late 1990s, points to the relevance of this concern. This is a particular risk for relatively shallow and undiversified stock markets of some emerging economies. For instance, as noted earlier, the strong correlations between emerging and industrial stock markets during the bubble period reflects the preponderance of technology and telecommunication sector stocks in the former set of markets. It is, of course, difficult to say conclusively whether this phenomenon would have occurred even in the absence of financial globalization, since stock market liberalizations in these countries often went hand in hand with their opening up to capital flows.
The increasing depth of stock markets in emerging economies could alleviate some of these risks but, at the same time, could heighten the real effects of such financial shocks. In this vein, some authors have found that a higher degree of financial development makes emerging stock markets more susceptible to external influences (both financial and macroeconomic) and that this effect remains important after controlling for capital controls and trade linkages. Consequently, the effects of external shocks could be transmitted to domestic real activity through the stock market channel.
Even the effects of real shocks are often transmitted faster and amplified through financial channels. There is a large literature showing how productivity, terms of trade, fiscal and other real shocks are transmitted through trade channels. Cross-country investment flows, in particular, have traditionally responded quite strongly to country-specific shocks. Financial channels constitute an additional avenue through which the effects of such real shocks can be transmitted. Furthermore, since transmission through financial channels is much quicker than through real channels, both the speed and magnitude of international spillovers of real shocks are considerably heightened by financial linkages.
Rising financial linkages have also resulted in contagion effects. Potential contagion effects are likely to become more important over time as financial linkages increase and investors in search of higher returns and better diversification opportunities increase their share of international holdings and, due to declines in information and transaction costs, have access to a broader array of cross-country investment opportunities.
There are two broad types of contagion identified in the literature—fundamentals-based contagion and “pure” contagion. The former refers to the transmission of shocks across national borders through real or financial linkages. In other words, while an economy may have weak fundamentals, it could get tipped over into a financial crisis as a consequence of investors reassessing the riskiness of investments in that country or attempting to rebalance their portfolios following a crisis in another country. Similarly, bank lending can lead to such contagion effects when a crisis in one country to which a bank has significant exposure forces it to rebalance its portfolio by readjusting its lending to other countries. This bank transmission channel can be particularly potent since a large fraction of bank lending to emerging markets is in the form of short-maturity loans. While fundamentals-based contagion was once prevalent mainly at the regional level, the Russian crisis demonstrated its much broader international reach.
Pure contagion, on the other hand, represents a different kind of risk since it cannot easily be influenced by domestic policies at least in the short run. There is a good deal of evidence of sharp swings in international capital flows that are not obviously related to changes in fundamentals. Investor behavior during these episodes, which is sometimes categorized as herding or momentum trading, is difficult to explain in the context of optimizing models with full and common information. Informational asymmetries, which are particularly rife in the context of emerging markets, appear to play an important role in this phenomenon. Thus, in addition to “pure contagion,” financial integration exposes developing economies to the risks associated with destabilizing investor behavior that is not related to fundamentals.
9.4.4 Factors increasing vulnerability to globalization risks
Empirical research indicates that the composition of capital inflows and the maturity structure of external debt appear to be associated with higher vulnerability to the risks of financial globalization. The relative importance of different sources of financing for domestic investment, as proxied by the following three variables, has been shown to be positively associated with the incidence and the severity of currency and financial crises: the ratio of bank borrowing or other debt relative to FDI; the shortness of the term structure of external debt; and the share of external debt denominated in foreign currencies. Detragiache and Spilimbergo (2001) find strong evidence that debt crises are more likely to occur in countries where external debt has a short maturity. However, the maturity structure may not entirely be a matter of choice since, as argued by these authors, countries with weaker macro-economic fundamentals are often forced to borrow at shorter maturities since they do not have access to longer-maturity loans. The currency composition of external debt also matters. During the Asian crisis, countries with more yen-denominated debt fared significantly worse. This could be attributed to the misalignment between the countries’ de facto currency pegs and the denomination of their debt.
In addition to basic macroeconomic policies, other policy choices of a systemic nature can also affect the vulnerability of MFIs. Recent currency crises have highlighted one of the main risks in this context. Developing countries that attempt to maintain a relatively inflexible exchange rate system often face the risk of attacks on their currencies. While various forms of fully or partially fixed exchange rate regimes can have some advantages, the absence of supportive domestic policies can often result in an abrupt unraveling of these regimes when adverse shocks hit the economy.
Financial integration can also aggravate the risks associated with imprudent fiscal policies. Access to world capital markets could lead to excessive borrowing that is channeled into unproductive government spending. The existence of large amounts of short-term debt denominated in hard currencies then makes countries vulnerable to external shocks or changes in investor sentiment. The experience of a number of MFI countries that have suffered the consequences of such external debt accumulation points to the heightened risks of undisciplined fiscal policies when the capital account is open.
Premature opening of the capital account also poses serious risks when financial regulation and supervision are inadequate. In the presence of weakly regulated banking systems and other distortions in domestic capital markets, inflows of foreign capital could exacerbate the existing inefficiencies in these economies. For example, if domestic financial institutions tend to channel capital to firms with excessive risks or weak fundamentals, financial integration could simply lead to an intensification of such flows.12 In turn, the effects of premature capital inflows on the balance sheets of the government and corporate sectors could have negative repercussions on the health of financial institutions in the event of adverse macroeconomic shocks.
9.5 Select factors in the benefits and risks of globalization
9.5.1 Threshold effects and absorptive capacity
While it is difficult to find a strong and robust effect of financial integration on economic growth, there is some evidence in the literature of various kinds of “threshold effects.” For example, there is some evidence that the effect of FDI on growth depends on the level of human capital in a developing country. For countries with relatively low human capital, there is at best a small positive effect that can be detected in the data. On the other hand, for countries whose human capital has exceeded a certain threshold, there is some evidence that FDI promotes economic growth.
More generally, one might think of a country’s absorptive capacity in terms of human capital, depth of domestic financial market, quality of governance and macroeconomic policies. There is some preliminary evidence that foreign capital flows do not seem to generate positive productivity spillovers to domestic firms for countries with a relatively low absorptive capacity, but positive spillovers are more likely to be detected for countries with a relatively high level of absorptive capacity. This evidence is consistent with the view that countries need to build up a certain amount of absorptive capacity in order to effectively take advantage of financial globalization.
The next subsection specifically discusses the role of domestic governance as a crucial element of this absorptive capacity. The importance of governance has been asserted repeatedly, particularly since the Asian crisis, but until recently there has been relatively little systematical evidence documented on its relationship with financial globalization.
9.5.2 Governance as an important element of absorptive capacity
The term governance encompasses a broad array of institutions and norms. While many of these are interrelated and complementary, it is nevertheless useful to try and narrow down a core set of governance dimensions most relevant for the discussion on financial integration. These are: transparency, control of corruption, rule of law, and financial sector supervision.
Recent evidence suggests that the quality of governance affects a country’s ability to benefit from international capital flows. As discussed in Section 9.3, of the various types of capital flows, FDI might be among the most helpful in terms of boosting recipient countries’ economic growth.13 There is an intimate connection between a country’s quality of domestic governance and its ability to attract FDI. Recent evidence suggests that FDI tends to go to countries with good governance, if one holds constant the size of the country, labor cost, tax rate, laws, and incentives specifically related to foreign-invested firms and other factors. Moreover, the quantitative effect of bad governance on FDI is quite large.
To reach this conclusion, corruption in the FDI recipient countries can be measured in a variety of ways. These include: a rating by Transparency International, which is a global nongovernmental organization devoted to fight corruption; a measure derived from a survey of firms worldwide as published jointly by Harvard University and the World Economic Forum in the Global Competitiveness Report; and a measure from a survey of firms worldwide conducted by the World Bank. The results from these different measures are quite consistent; all show a negative effect of corruption on the volume of inward FDI.14 The quantitative effect of corruption is significant as well when compared with the negative effect of corporate tax rate on FDI. For example, a one standard deviation increase in host country corruption might be equivalent to an increase of about 30 percentage points in the tax rate in terms of its negative effect on FDI (Wei (1997, 2000a, and 2000b)).15
Many developing countries’ governments are now eager to attract FDI by offering generous tax concessions or exemptions. The previous evidence suggests that an improvement of domestic governance, especially reducing corruption, would be more effective in attracting FDI without having to take measures that could reduce tax revenues, in addition to promoting more domestic investment.
Similarly, transparency of government operations is another dimension of good governance. More portfolio investment from international mutual funds tends to go to countries with a higher level of transparency (Gelos and Wei, 2002). This is true even after one takes into account the liquidity of the market, exchange rate regime, other economic risks, and a host of other factors.
9.5.3 Domestic governance and the volatility of capital flows
Previous sections documented the fact that international capital flows can be very volatile. However, different countries experience different degrees of volatility, and this may be systematically related to the quality of macroeconomic policies and domestic governance. In other words, with regard to the “sudden stops” or “sudden reversals” of international capital flows, developing countries are not purely passive recipients with no influence on the nature of capital inflows. For example, research has demonstrated that an overvalued exchange rate and an overextended domestic lending boom often precede a capital account crisis. In this subsection, attention is focused on the evidence related to the role of local governance in mitigating the volatility of capital inflows that a developing country might experience.
There is plenty of evidence suggesting that weak domestic capacity in financial regulation and supervision is likely to be associated with a high propensity of experiencing banking and currency crisis. Without an adequate financial supervision institution in place, a premature opening of the capital account could increase the risk of a financial crisis as domestic financial institutions may build up excessive risk. On the liability side, they might borrow excessively from international capital markets. On the asset side, they might expand lending to overly risky economic activities, especially where there is an explicit or implicit government guarantee. These factors could result in various types of balance sheet weaknesses, such as mismatch in maturity or currency. Furthermore, due to intersectoral linkages, balance sheet weaknesses of the government and corporate sectors could affect the health of financial institutions as well. The view that supervisory and regulatory capacity need to be sufficiently strengthened before a country engages in full-fledged liberalization of the capital account is now widely accepted.
Transparency of a government’s economic policies is another dimension of domestic governance. Recent evidence suggests that the degree of transparency might affect the degree of volatility of capital inflows that a country experiences. For example, herding behavior by international investors, which is alleged to have contributed to instability in the developing countries’ financial markets, tends to be more severe in countries with a lower degree of transparency.
The literature on currency crises (e.g. Frankel and Rose (1996)) points out that a country’s structure of capital inflows is related to the likelihood of a crisis. More specifically, a country that relies relatively more on foreign bank credits and less on FDI may be more vulnerable to the “sudden stops” of international capital flows and have a higher chance of running into a capital account crisis.
Recent research suggests that macroeconomic policies are an important determinant of the composition of capital inflows. Recent research also presents some evidence that domestic governance as measured by the corruption indexes tilts the composition of capital flows. Specifically, countries with a weaker governance as reflected by a higher perceived level of corruption are more likely to have a structure of capital inflows that is relatively light in FDI and relatively heavy in foreign bank credits, holding other factors constant.
Governance is not the only element of domestic absorptive capacity, but is an important one. Its importance has been emphasized by the IMF Executive Board and in the international policy circles at least since the Asian financial crisis. Recent systematic research documented in this chapter has provided empirical foundation for this view. Of course, the importance of domestic governance goes beyond its role in financial globalization. The quality of governance also affects economic growth and other social objectives through a variety of other channels (documented in Mauro (1997), and Abed and Gupta (2002)).
The objective of the paper was not so much to derive new policy propositions as it is to inform the debate on the potential and actual benefit-risk tradeoffs associated with financial globalization by reviewing the available empirical evidence and country experiences. The main conclusions are that, so far, it has proven difficult to find robust evidence in support of the proposition that financial integration helps developing countries to improve growth and to reduce macroeconomic volatility.
Of course, the absence of robust evidence on these dimensions does not necessarily mean that financial globalization has no benefits and carries only great risks. Indeed, most countries that have initiated financial integration have continued along this path, despite temporary setbacks. This observation is consistent with the notion that the indirect benefits of financial integration, which may be difficult to pick up in regression analysis, could be quite important. Also, the long run gains, in some cases yet unrealized, may far offset the short-term costs. For instance, the European Monetary Union experienced severe and costly crises in the early 1990s as part of the transition to a single currency throughout much of Europe today.
While, it is difficult to find a simple relationship between financial globalization and growth or consumption volatility, there is some evidence of nonlinearities or threshold effects in the relationship. That is, financial globalization, in combination with good macroeconomic policies and good domestic governance, appears to be conducive to growth. For example, countries with good human capital and governance tend to do better at attracting FDI, which is especially conducive to growth. More specifically, recent research shows that corruption has a strongly negative effect on FDI inflows. Similarly, transparency of government operations, which is another dimension of good governance, has a strong positive effect on investment inflows from international mutual funds.
The vulnerability of a developing country to the “risk factors” associated with financial globalization is also not independent from the quality of macroeconomic policies and domestic governance. For example, research has demonstrated that an overvalued exchange rate and an overextended domestic lending boom often precede a currency crisis. In addition, lack of transparency has been shown to be associated with more herding behavior by international investors that can destabilize a developing country’s financial markets. Finally, evidence shows that a high degree of corruption may affect the composition of a country’s capital inflows in a manner that makes it more vulnerable to the risks of speculative attacks and contagion effects. Thus, the ability of a developing country to derive benefits from financial globalization and its relative vulnerability to the volatility of international capital flows can be significantly affected by the quality of both its macroeconomic framework and institutions.
In summary, while it is difficult to distill new and innovative policy messages from the review of the evidence, there appears to be empirical support for some general propositions. Empirically, good institutions and quality of governance are important not only in their own right, but in helping developing countries derive the benefits of globalization. Similarly, macroeconomic stability appears to be an important prerequisite for ensuring that financial integration is beneficial for developing countries. In this regard, the IMF’s work in promulgating codes and standards for best practices on transparency and financial supervision, as well as sound macroeconomic frameworks is crucial. In addition, the analysis suggests that financial globalization should be approached cautiously and with good institutions and macroeconomic frameworks viewed as preconditions.
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