Costs and Benefits of Financial Globalization for Developing Countries - Case Study Example

Introduction Financial globalization is incorporation of the domestic economic system with global markets. This is done by governments through opening up of the local economic sector as well as the domestic capital for foreign investors to engage in business within the economy. When there is a rise in capital movement within several countries, integration is achieved, leading to financial globalization. Domestic lenders and borrowers take part in the international market with the use of global financial intermediaries. Financial globalization in developing countries is mainly favored by the availability of cheap labor and the fact that, return on capital is relatively high. In the recent years, there has been a rise in the amount of capital that has been flowing in to developing countries. Foreign companies investing in developing countries are significant in development (Ayhan Kose, Eswar Prasad, Kenneth Rogoff, and Shang-Jin Wei 2006: 15-19) The developing countries are normally faced by problems of population explosion and insufficient resources to support the high populations. This creates the need for foreign capital to be introduced in to the economy in order to take care of the deficit. Developing nations are also faced with lack of skills and the appropriate technology to extract natural resources to boost the economy. Foreign investors are needed in order to bring the desired skills and technology. This indicates that there are several benefits that developing countries derive from financial globalization. However, there are disadvantages that are associated with this globalization. Developing countries tend to allow foreign investors after a comprehensive assessment of the costs and benefits financial globalization to the economy. Direct of Benefits of Financial Globalization in developing countries When multinational organizations invest in developing countries, they promote economic development. They tend to introduce competition in the existing market system, compelling the domestic industry to become more effective in production in order to be competitive in the market. They help in alleviation of monopolies within an economy, which may not be effective enough to satisfy the local demand. With this competition, industries tend to be innovative in order to keep their products a head of the other competitors, which eventually leads to production of high quality goods in the developing economy. Multinational companies bring in to market’s best practices in to the developing economy. This comes in form of technology transfer, due to the fact that they tend to be innovative and possess high levels of experience in various developed and developing economies where they have invested in the past. Domestic managers and supervisors learn from the foreign investors, some management practices such as techniques for risk management as well as production supervisory techniques (Frederic S. Mishkin, 2005: 13-16). The domestic industries benefit from the information gathered by foreign investors who have access to plenty of information concerning production and marketing through their foreign subsidiaries. They are therefore able to make the necessary reforms in order to cope with the changing marketing environment. Introduction of foreign capital in to the financial markets of a developing country raises the accessibility of finances locally, thereby lowering the cost of capital while raising liquidity. This motivates local entrepreneurs to invest in the domestic market thereby promoting economic growth. An example of this is where developing economies allowed foreign capital in to their markets. Fang Zhao (2005: 27) states that, “On average dividend yields fall by 2.4 %, while the growth rate of investment increases by 1.1 % when foreign capital is introduced.” The developing economy is also boosted by the employment opportunities that are offered by the foreign investors. There has occurred a radical change in the economic system over the last thirty years. These changes have brought about cheaper lending rates, and currently, countries are able to borrow sufficient capital at reduced rates than they could before the changes in the financial system. Risks are now shared globally, and alliances have been formed between many countries in order to augment business between them. These are benefits that have been derived from financial globalization. Financial systems in developing countries have become better in terms of financial management because of the experience gained through their involvement in international business (Raghuram G. Rajan, 2005:1-3). Foreign companies play a major role in converting the natural resources of developing economies in to utilizable products. In most cases, they provide the equipment, skills and finances for extraction. The product is made available locally at a reduced price. This led to advancement in economic growth of many developing countries that possess mineral resources. Foreign companies in developing economies remit taxes to the government, thereby increasing its total tax collection (Frederic S. Mishkin, 2005: 27-31). Indirect benefits of financial globalization The competition that arises in the market through entry of foreign companies and products tends to reduce the total revenue of the existing industries. They therefore tend to introduce more capital in to the business to counter the reduction in revenue collection. Since all the capital needed is not available locally, local companies solicit capital from financial institutions outside the economy. External financial systems will only provide assistance to borrowers from an economy that has the capability of solving asymmetric problems. Local industries are therefore compelled to advocate for reforms that improve the performance of the financial system of a developing economy (Geoffrey, 2004: 47). The acquired capital by local industries adds to the size of the financial sector, which promotes economic growth in the developing country. The globalization of financial institutions introduces credit facilities to local investors. If their rates are favorable or lower than those of local financial institutions, customers will tend to seek the services of the foreign institutions. This leads to a change in the working of the local financial institutions which resort to promoting their products in order to attract more customers. They tend to lend money to their customers in a profitable way in order for them to uphold their business. With lending comes the need for risk assessment. This culminates in reforms within the financial institutions of an economy that enhances profitable lending. Such reforms are beneficial to the economy, and can help in the avoidance of miscalculated lending risks that can cause financial crisis, such as the banking crisis that occurred in the United States in 2007 (John, 2001: 46-51). When local financial institutions support reforms in order to benefit in terms of credit facilities and profit, property rights are strengthened, encouraging direct investments in the economy. This is a positive outcome of the reforms. It leads to international agreements which result in the formation of international organizations such as World Trade Organization. These present the developing countries with an opportunity to market their products globally as well as making global financial systems available to them. The Word Bank is one such financial institution that was formed to provide loans to developing countries in a bid to alleviate poverty through development programs. The IMF was also formed with an aim of fostering global financial cooperation, ensure that economies maintain their financial stability, and enhance international trade as well as provision of employment to aid in poverty reduction especially in developing countries. The United Nations Conference on Trade and Development (UNCTAD) offers the technological support to developing countries in their attempt to get incorporated into the global financial system and to handle their external liabilities. This is an important organization that assists developing countries which are normally faced with external debts (Geoffrey, 2004: 47). . The need for financial globalization in developing countries can not be ignored. However, it has some costs and disadvantages attached. Many developing countries have suffered economically due to the presence of foreign investors in the economy. Financial globalization tends to pose threats to the economic sovereignty of developing countries. It mainly occurs when these countries are steadfast to a flat exchange rate. In this case, they tend not to make changes in the exchange rate. The reason of financial globalization is to augment the flexibility of exchange between risk-adapted rates of return on domestic resources and liabilities and those in international markets, until the domestic central depository has no margin in which it is open to establish domestic interest rates (James Tobin 1998: 27 Nov. 2005). The domestic financial system can be adversely affected if the right channels of integration. Capital in flows and liberalization can hamper the domestic market. A worsening of the market basics leads to tentative attacks which culminate to the withdrawal of the domestic as well as foreign investors. This can adversely affect the domestic economy. Brazil and Argentina were faced by economic crisis attributed to financial globalization. Financial crises in Brazil The crisis occurred in 1999 and was mainly caused by financial globalization. The country retained soaring interest rates to draw investment, with the rationale of protecting the permanent exchange rate attached to the dollar. This resulted in an enormous inflow of unstable capital. This increased Brazil’s susceptibility to foreign economic problems. The crisis amplified the country’s threat, which has an express consequence on the interest rate at which developing countries borrow loans in the global money markets. This raised the expenditure of the Brazil’s foreign financing significantly, to more than 14% per annum. Investors could no longer have confidence to venture in the country due to the predictable risks attributed to the crisis. The conditions of bond release maturity in the country declined to an average of 5 years. The decline reduced economic returns and most foreign governments opted to decrease collective support programs. The crisis of Brazil presents an example of the severe consequences of financial globalization in a developing country (Fang Zhao 2005: 37-44). Financial crises in Argentina The crises occurred in 2001 and were also attributed to financial globalization. The country had many international debts that had to be settled, while at the same time, the country needed to borrow more from foreign countries. Importation was cheap due to the permanent exchange rate. This caused a progressive outflow of dollars from the economy. Consequently, the industrial infrastructure was faced with a major loss. This caused a significant rise in the level of unemployment in the economy. Banks were faced with mass withdrawals by customers who had lost confidence in the domestic economy. They opted to deposit their money in foreign banks. This is another example of how financial globalization can severely impact on an economy (Fang Zhao 2005: 45-49). Financial globalization has a tendency to strengthen an economy’s response to outside shocks. Deficiencies in the international market such as the unpredictable nature of capital inflows and outflows can result in crises and an economy can be affected by instability in another economy. Financial globalization is associated with segmentation of an economy even with the existence of proper financial fundamentals. This occurs between those who are capable of participating in the international economic system and the ones that need to depend on local economic sectors. Liberalization of the economic system makes a country to be subjected to the market discipline of foreign investors. On the other hand, the domestic investors exert their market discipline on the economy. An economy without a liberalized market has its investors monitoring the economy alone, reacting to unsteady financial fundamentals (Kaufmann A. 1995: 72-75). The introduction of foreign market discipline can destabilize the functioning of this system, especially if the market systems are divergent. Globalization has a tendency of causing crises in cases where there exist limitations in global fiscal markets. This can cause financial failures, illogical behavior, attacks based on speculation, and collapse, among other things. Crises can result due to the influence of external factors exerted on a developing economy due to financial globalization. This happens even where countries practice strong economic fundamentals. This is because when a developing country becomes reliant on outside capital, it may plunge in to financial problems in case the foreign capital is withdrawn from the economy (Howard 1999: 21-25). This is because the sudden capital withdrawal does not take in to consideration of the country’s financial fundamentals. This has caused many countries to fail especially if the foreign capital is used to provide essential products. In the case of two countries doing business or competing in one foreign market, depression of the exchange rate in one weakens the other’s ability to compete. This is because the market may tend to lean towards the weaker currency in order to take advantage of the deficit. The whole phenomenon leads to the devaluation exchange to achieve equilibrium in both economies. This has been a major problem in developing countries that have unstable currencies that are engaged in international trade. Conclusion Financial globalization has led to the integration of many economies around the world. Many have achieved a lot in terms of development in the financial sector. Financial systems become complicated when they are integrated in the international markets. Many domestic market systems have changed due to exchange of experiences within the international markets. The financial institutions that provide assistance to domestic borrowers have increased, consequently raising the probability of acquiring assistance by developed countries. Economic markets working in the international background facilitate international risk multiplicity and smooth the progress of consumption. This enhances the ability of countries to manage risks effectively to avoid recessions. Even though financial globalization is beneficial to developing countries, it is associated with bringing in new challenges to the economies. The crises witnessed in many developing countries such as Brazil and Argentina after liberalization of their economic systems had detrimental effects on the economies. In such cases, the benefits of globalization are questionable. Developing countries are at the risk of foreign shocks and the frequent crises that come as a result of infectivity from partnering countries. Policy makers are supposed to continuously assess the impact of liberalization before a country suffers the consequences of financial globalization. The financial crises of 1990s in Latin America are significant examples that policy makers should focus on in order to avoid such crisis. Bibliography 1. Ayhan Kose, Eswar Prasad, Kenneth Rogoff, and Shang-Jin Wei (2006) “Financial Globalization: A Reappraisal, WP/06/189, Research Department © 2006 International Monetary Fund. 2. Fang Z. (2005) “Entrepreneurship and Innovation” International Journal of Entrepreneurial Behavior & Research. Vol. 11 No. 1, July, pp. 25-41 18 Sep 2008 3. Frederic S. Mishkin (2005) “Is Financial Globalization Beneficial?” Working Paper 11891, National Bureau of Economic Research, Cambridge 4. Howard P. (1999) “Innovations in Telecommunication: Effective Service Delivery” Journal on Communication. vol. 5, no. 3, September, pp. 121-126 5. Kaufmann A. (1995) “Entrepreneurship” Journal on Entrepreneurship and Innovation Management, Vol. 1, No. 1, December, p.229 6. James T. 2005, Financial Globalization: Can National Currencies Survive?, viewed 3 Dec. 2008 7. 8. John B. (2001) Innovation, Entrepreneurship and the Firm: a Post-Schumpeterian Approach, University of Birmingham, Edgbaston, Birmingham B15 2TT, England, UK 9. Raghuram G. Rajan (2005) “Has Financial Development Made The World Riskier?” Working Paper 11728, National Bureau of Economic Research, Cambridge Read More