Risks and Benefits of Financial Globalization - Essay Example

Risks and Benefits of Financial Globalization Name: Instructor: Institution: Date: Abstract The coverage of this study will analyze the risks and benefits that come along the way with financial globalization specifically to developing countries. Various studies have indicated that financial globalization can bring huge benefits specifically to the development and generation of the financial system. There are high chances in the long-run that financial globalization could have positive impacts, with levels of risks being more pronounced right after liberalization of nations. The existing state of financial globalizations seems to benefits only a few nations, industries and companies. With financial globalization, government tends to lose financial policy instruments. Therefore there is an increasing need for global cooperation in the formulation of an integrated global financial policy that will cut across the board all nations in the world. Table of Content 1 Risks and Benefits of Financial Globalization 1 Abstract 2 Introduction 4 Challenge Financial Globalization Has Faced Over the Years 4 Principal Agents of Financial Globalization 6 Risks and Benefits of Financial Globalization 7 Contemporary Development in Financial Globalization 9 Cost Benefit Analysis of Financial Globalization 9 Available Policy Instruments 12 Exchange Rate and Monetary Policy 13 Management of Risk 14 Conclusion 15 References 16 Introduction Globalization is the process of amalgamating a business's strategies and operations across an extensive array of ideas, products, and cultures (Schmukler, 2004). The modern perception of globalization has attracted a strong argument that apeals to a variety of people with diverse views. This study will analyze the risks and benefits generated by financial globalization while keeping focus to developing countries. The study will also re-examine the pros and cons of globalization and the related policy options. Kenan (2007) defined financial globalization as the incorporation of the local financial system of a nation with the global markets and financial institutions. This incorporation system mainly needs the liberalization of the government’s financial segments and capital account. Incorporation of happens when liberalized nations undergo an intensified capital movement between states encompassing an dynamic involvement of domestic borrowers and lenders in the international markets and an extensive application of global financial mediators. Developed countries have lived to dominate financial globalization for a long period, but in recent years the participation of developing countries have increased significantly (Epstein, 2005). Challenge Financial Globalization Has Faced Over the Years The last fifty years have a diverse changes in the idea of financial globalization. New development has been spurred by modernization in technology, liberalization of capital accounts as well local financial sectors have resulted to significant development in the financial globalization. Agents identified to be behind such development have governments, financial institutions, private borrowers, and investors. Based on history, financial globalization has been existing for years but looking at the current breadth and depth; the whole idea is unmatched. Financial globalization received its first blow following the aftermaths of the First World War which was preceded crises and instability that lasted for a significant period. What followed was the Second World War and the Great Depression. To reclaim and control monetary policy, the governments decided to reverse the financial globalization through imposing capital control. As a result between the periods, 1950 to 1970 recorded the lowest capital flows. The international system was characterized by a fixed but adjustable systems from Bretton Woods Systems, self-directed monetary policy, and limited capital mobility (Cerny, 1994). Following the disintegration of Bretton Woods, a novel period of globalization was commenced. Commercial banks were provided with capital to invest in nations that were developing. Investments were made specifically through the financing of public debts that came as syndicated loans. The breakup of the Bretton Woods implied that nations had the capacity to open up to larger capital flexibility since the fix exchange rate of the system was no longer operational. The levels of capital flows to developing nations witnessed between the 1970s to 1980s led to the debt crisis that was first reported in Mexico. The Brady Bonds was later created to curb the crisis. This resulted in the development of bonds markets for developing economies (Baldwin, & Martin, 1999). Later the emerging markets became more attractive to Foreign Direct Investments (FDI) to households and firms following the privatization, technology advancement and deregulations witnessed. An investment boom in Foreign Direct Investments, as well as portfolio flow of capital, was recorded in the 1990s to emerging markets of developing economies. The current global financial system can be said to be far from being considered perfectly integrated despite the increasing financial globalizations. Home country bias, the correlation between investments and savings and persistent capital market dissection are some of the observable attributes of the current global systems that make it far from being perfect (Bekaert, Harvey, & Lundblad, 2005). The likelihood of financial globalization to be overturned for moderately integrated markets seems uncertain despite the likelihood of that occurring still seem achievable. Principal Agents of Financial Globalization The government, financial institutions, investors, and borrowers are the four principal agents of financial globalization. The role of government in financial obligations is allowed liberalization of constraints on the local financial market as well as the capital account of the BoP (Balance of Payment). Government use to control local financial markets and sectors in the past by placing restrictions on the allotments of credit via a control of quantities and prices. Also, the government used to place restrictions on the flow of capital between nations. Restrictions placed on the capital account was deemed far-reaching which included restrictions placed on derivative transactions, forex exchanges, borrowing and lending undertakings by corporations and banks and the involvement of external investors in the domestic financial markets (Lane, & Milesi-Ferretti, 2008). The financial institution has also played a crucial part in fostering financial globalization via the internalization of the main financial services. Changes experienced in the developing and developed nations, as well as those at the global scale, is used to offer insights on the role financial institutions have played in the realizing globalization. The technological advancement in the field of information provision has lessened the importance attached to geographical separations thus empowering global corporations to service multiple markets from a single location. Increased competitions witnessed in developing nations has resulted in commercial banks as well as other non-financial institutions to seek means of expanding their market shares into novel markets and businesses, developing foreign customer base; factors that have empowered them to diversify their risks. Reducing costs through technical improvements and deregulations resulted into intense competition. Furthermore, the participation of global firms in the local market has increased following the liberalization of the regulatory framework. An appealing climate for foreign investment was fostered by the existence of a better working environment coupled with stabilization of macroeconomic factors and stronger market fundamentals (Lane, & Milesi-Ferretti, 2008). Investors and borrowers including firms and households have emerged to become the principal agent of financial globalization. Organizations can upsurge their financing options by acquiring additional funds straight from equity and bond issues in global financial markets thus minimizing the subsequent cost of capital, improve their liquidity levels and enlarge their investment base. Through borrowing individuals as well as firms can lessen their financial restrictions thus ending up smoothing investments and consumptions. Having a diverse financing options supports foreign investors to curb indirect and direct obstacles (Lane, & Milesi-Ferretti, 2008). Risks and Benefits of Financial Globalization Financial globalization can generate the world that is financially stable as well as an advanced level of financial integration of nations considered to be developing with the global financial market. To developing nations, financial globalization will foster the development of the financial systems with a deeper, complete, stable and with a better-regulated markets (Rodrik, & Subramanian, 2009). Even with crucial benefits, it generates financial globalization comes with some substantial risks. The risks are expected more in the short run possibly because the economies will be opening up. Financial crisis is the most prevalent risk associated with financial globalization. There is some correlation between crises and globalization. Where the right financial structure doesn’t exist while incorporating financial systems, liberalization and capital inflows have the capacity to weaken the domestic financial system’s health. Where market fundamentals worsen, speculative spells will happen with capital leakages from foreign and domestic investments. Integration will only be successful provided market fundamentals are capable of withstanding pressure both from internal and external sources. Financial globalization has a tendency of increasing a state’s pliability to external shocks, and thus this is the main reason for the need of strong fundamentals. Segmentation of various parties; those that needs to depend on local financial sectors and those able to take part in the international financial system, is also another risk of financial globalization (Kenan, 2007). Developing nations stand a chance to benefit a lot from financial globalization despite the risks that come along way with the idea. A new challenge presented by globalization is how to manage it to reap this enormous benefits. Another challenge that developing nations will encounter while taking part in financial globalization is that the state will be left with limited policy instrument as the world becomes more integrated. Therefore some level of cooperation from global financial bodies and systems needed (Kenan, 2007). Contemporary Development in Financial Globalization The growing use of global financial intermediaries and novel nature of capital flows makes up the two basic latest development in the financial globalization. The disposable private capital flows have increased to developing nations in current years even though no evenly distributed within this countries. If capital flow generated in global capital markets improves the welfare of recipient nations for instance because of the cost to access capital is reduced or rather due to a prolonged maturity financial arrangement can be realized, few middle-income nations have been gaining more than other developing countries. Globalization of financial services has to do with the application of global financial intermediaries by domestic investors and borrower. Such globalization is reached via the use of global financial intermediaries situated outside the country by domestic investors and borrowers and increasing the availability of the global financial intermediaries particularly foreign banks in domestic markets. Cost Benefit Analysis of Financial Globalization An initial coverage done was on the potential risks and benefits of financial globalization. The contemporary stream of events of financial impurity and crisis following the liberalization of financial systems by nations and later incorporation of these systems with global financial markets might result to some perceptions by people to reason that globalization can create financial volatility and thus crises. There exist a range of means upon which financial globalization can be linked to an occurrence of crises even though local concerns tends to be a critical contributing factor of a crises event. Among the means includes; when a state decides to liberalize its financial systems, discipline exercised by both domestic and foreign investors take effect to the nation. Suppose an economy becomes closed, local investors takes responsibility of monitoring the economy performance and attend to unacceptable fundamentals, in the case of an open economy the both local and foreign investors might create a crisis in instances when market fundamental weakens. Individual nations may settle to pursue efforts to realize sound fundamental. Another reason why globalization may result in crises is on the existence of market imperfection at the global scale. Such imperfections at a global scale in the financial markets can create herding characters, bubbles, crash and speculative attacks among other concerns. Market imperfections have the capacity to generate imperfections even when sound market fundamentals exist. Crisis can also be attributed to globalization because of the significance of factors from outside even in nations with sound market fundamentals and where financial market imperfections don't exist. An example is provided that suppose a nation over-relies on foreign investments then suppose an instant shift in foreign capital flow happens the country is likely to experience economic downturns and difficulties in financing. The evidence to support whether globalization, contagion, and crises are significant enough to outweigh the advantages and thus the benefits of globalization is scarce. But still, the look of things if far from clear that nation with open economies suffer more from crises and are considered more volatile. Several kinds of literature indicate that volatility tends to lessen in the long run following liberalizations and a further integration of financial systems with the global market (Ang, & McKibbin, 2007). Any possible upsurge in market volatility have a tendency to happen in the short-run immediately after the liberalization process. Inadequate supervision and regulations of the local markets followed by limited preparation to adapt to foreign capital flow can result in domestic financial crises. Among the most prevalent welfares of financial globalization is the development and generation of financial sectors. Such improvement results into a less volatile yet deeper financial markets. The gains of financial globalization seem to felt in the long-run while the cost or risk are more pronounced in the short-run. Considering position the government holds in financial globalization its actions can have significant impacts in mitigating the costs and intensify the benefits. The government has close to three roles it can intervene through to achieve more befits and minimize the risk factors. The first view argues that nations have a fully liberalized financial systems coupled with limited government interventions would benefit a lot from financial globalization. Some techniques of interventions by the government are likely to generate distortion which eventually results in crises and moral hazard. For instance guarantees from the government have the ability to induce companies to be declared bankrupt at the expense of the society; that is through looting. An established looting in one sector of the economy has the potential of distorting production levels in other sectors. Cross-country flow of capital has to be restricted and controlled. From this view, ineffective global financial markets hamper the debate for uncontrolled financial incorporation. Anomalies like moral hazard, information asymmetry, asset bubbles, herding behavior, contagion and speculative attacks exist in global financial markets. Thus open economies that permit unrestricted capital flows to experience the consequences of such market imperfections. Economists believe that government can mitigate or rather reduce cost generated by the volatility of capital flows, minimize the surplus risk taking and lessen the vulnerability of markets to exterior surprises while still seeking incorporation with global financial markets. The third view focuses on how to manage risk factors. Here, the emphasis is on sequencing financial liberalization as well as strengthening the local financial sectors. Supporters of this assessment believed that allowing a weak local financial sector to huge capital flows is significantly dangerous. If a local financial sector fails to control and manage risk appropriately, have limited capital and reserves, or has inadequate capital outflow and inflow, incentives have the capacity to generate challenges in the local financial sector. With a huge financial cost that financial crises can generate, proponents of this view propose a sufficient supervision and regulation of local financial systems with limited difference placed between local capital and foreign capital. Available Policy Instruments Among the stated challenges of financial globalization for policymakers is that the policy mechanisms at the state level tend to lessen when the markets becomes incorporated. It becomes more challenging when local financial systems are incorporated with those at the global level. Specifically, challenges come in the regulation and monitoring the transaction that occurs outside the confines of the local financial markets. Also, the ease at which capital flows in and out of the country make it more challenging and difficult for the state to intervene. As the degree of integration intensifies between nations, the urge and need for some of the level of global financial cooperation between nations and systems grow. Among the identifiable policy instruments widely covered in various literature is the need for capital control. The proposal for such controls is to mitigate or rather minimize the impacts of an instant foreign capital shift. The effectiveness of this policy instrument has attracted divided support with some literature arguing the instruments woks to control while those against highlights the negative impacts of control of flows over time. However, a focal point has been established among significant economists and other policymakers on the instruments deemed necessary to help reduce the various risks of globalization. These policies and instrument includes; Exchange Rate and Monetary Policy The choice of a fixed is floating or a mix of exchange rate policy has been an area of concern in the global monetary economics. When nations settle for a simultaneous target of the exchange rates regime and apply monetary instruments in seeking to realize local market goals such as to curb a downturn o economic activities during political crises like inter-wars, then they are forced to implement restrictions to curtail capital flow and movement. Economists and other policymakers have been in favor of a flexible or a fixed exchange rate regime that operates without pre-commitments after the crises of 19990s. Operating with a self-made fixed exchange tend to minimize the exchange rate risk and subsequent cost of the transaction that discourages investment and trade. Also, a fixed exchange rate has been applied as crucial nominal support for monetary policy and instruments. Application of flexible exchange rate permits the nation to follow a self-governing monetary policy. Also, it helps countries to effectively respond and combat economic shocks via a variation in the interest rate and exchange rate systems to mitigate the occurrence of a recession (Milesi-Ferretti, & Lane, 2005). Monetary policy becomes powerless when a combined force of integrated financial market and a fixed exchange rate work together. Irrespective of exchange rate regime pursued by nations factors like foreign exchange rate liabilities, exchange rate pass-out and inadequate credibility have restricted nations from flowing an independent monetary policy. If nations of the world make a decision of pursuing an inflation targeting policy and work with the suitable monetary systems then there exist credible ways of implementing a flexible exchange rate regime. There is strong need to focus on the challenges of a weak currency that is more pronounced in developing nations and on the need to develop a strong, healthy connections between financial and money intermediations while generating sufficient flexibility specifically in financial contracting to enable easy adjustment to various economic shocks. Emphasis on institutional restructuring and reforms instead of on the exchange rate regime may end fostering the healthy aspect of emerging economies and thus make them less vulnerable to crises (Milesi-Ferretti, & Lane, 2005). Management of Risk Some economists and policy makes are in favor of risk management by supervising and regulating the financial systems without separating foreign capital from the domestic capital. With the partial integration of the economy with the global economies, differentiating foreign and domestic capital becomes more challenging and thus difficult that this is the main reason illustrating why control of capital flow may turn out to be ineffective. Government stands to benefit in such cases by aiming at the strength of the entire financial sector to evade possibilities of financial crunches or rather make predicaments less expensive. In the existence of market imperfections, it becomes more crucial to run away from increasing risk taking specifically currency risks, and maturity risks which have been attributed to the occurrence of recent crises and thus risk management become necessary (Sassen, 1999). The government may decide to supervise and control the workings of financial systems to make sure that the management of risk by financial sectors is well done. The government may also try to evade huge asset-liability incongruity thus subjecting commercial banks to the vulnerability of surge in the interest rate and depreciations in exchange rates. Supervision and control also work to make sure that commercial banks are adequately capitalized with suitable loan loss provisions and loan classification. The existence of a culture of transparency in the part of depositors and investors via a compulsory disclosure of financial statements that have been audited by an independent entity will foster market discipline. Moral hazard is likely to reduce if the implicit and explicit guarantees from the government are removed. Such policies will only be effective if the appropriate incentives of a sound corporate governance in integrated within the working of the system. The existence of sufficient financial disclosure and clear rules supports financial market participants and regulators keep watch of the working of corporations; an issue that pushes firms to realize better working practices (Taylor, 2009). Conclusion Financial integration witnessed in the last decades across the globe is significant. This has been driven significantly by the possible benefits and welfares generated by financial sectors. Domestic financial systems and markets become sophisticated and deeper when they integrate with those at a global scale. Global financial markets foster diversification of global risk and enable consumption smoothing. Even though financial globalization comes with significant benefits and welfares especially to emerging economies nations that made a decision of pursuing it and thus liberalize their financial systems have cast doubt in the parts of benefits and gains of the idea. Novel challenges have emerged from financial globalization. Following the massive liberalization of financial by nations in the 1990s, the benefits of globalizations have been questioned. This is because nations have ended up becoming more vulnerable to foreign crises and shocks that are generated by the nations themselves as well as the impacts of contagion (Sassen, 1999). From the various coverage of the study, a conclusion can be drawn that suppose the appropriate financial infrastructure and framework is not implemented or pursued then financial liberalization by nations can intensify the risk levels of countries. Also, in an economy that is financially integrated, economists and policymaker have limited policy instruments to implement various economic policies (Kregel, 1996). Some of the important lessons learned from financial globalization is that nations across the world stand a better chance to benefit from financial globalization provided the appropriate financial infrastructure is installed, the working of financial globalization requires strong institutions that operate with sound market fundamentals, Also, there is a strong need for global financial cooperation to guarantee significant benefits of financial globalization are realized especially by emerging nations which have had limited experience with the working of this globalization aspect and that risk challenges generated by financial globalization can be reduced or mitigated significantly via an appropriate choice of monetary and exchange rate policies and effective risk management policies (Kose, Prasad, Rogoff, & Wei, 2009 References Ang, J. B., & McKibbin, W. J. (2007). Financial liberalization, financial sector development, and growth: Evidence from Malaysia. 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