Global Economy Journal

Volume 6, Issue 1

2006

Article 2

Globalization in the World of Finance: An

Analytical History
Dilip K. Das

Professor of International Economics, School of Business, Conestoga College, Ontario,

Canada, dilip.das@sympatico.ca
c
Copyright 2006
The Berkeley Electronic Press. All rights reserved.

Globalization in the World of Finance: An

Analytical History
Dilip K. Das

Abstract
One of the many definitions of financial globalization is integration of domestic financial
system of a country with the global financial markets and institutions. Enabling framework of
financial globalization essentially includes liberalization and deregulation of the domestic financial sector as well as liberalization of the capital account. As economies progressively integrate
globally, pari passu the financial structures of markets and the world of finance change. Financial
globalization cannot be considered a novel phenomenon. Trans-country capital movements are
centuries old.
The oil shock of 1973 and the collapse of the Bretton Woods system, both of these developments were momentous and were responsible for laying the foundation of the contemporary era of
financial globalization. After the collapse of the Bretton Woods system, some middle-income developing economies began to liberalize and open up for greater capital mobility, while keeping an
autonomous control over their monetary policy. Advances in IT and computer technology are cited
as one of the most important factors driving and supporting financial globalization. Transnational
corporations (TNCs) also helped in global financial integration. They expanded their networks by
merging with or acquiring other national and international firms. The prime movers in financial
globalization are governments, borrowers, investors, and financial institutions. Each one of these
market participants propelled economies towards financial integration in a proactive manner.
Financial globalization has caused dramatic changes in the structure of national and international
capital markets. The most significant change in the capital markets was in the banking system,
which went through a process of dis-intermediation. This was a market transformation of fundamental nature.
Contagions and crises are the downsides of financial globalization. Economic and financial crises
of the 1990s portend to the fact that financial globalization is not a win-win game, and that it can
potentially lead to serious disorder and high cost in terms of bank failures, corporate bankruptcies,
stock market turbulence, depletion of foreign exchange reserves, currency depreciation and increased fiscal burden. A unique characteristic of globalized financial markets is reversal of capital
flows when market perception regarding the creditworthiness of the borrowing entity changes.
Cross-country financial flows to the emerging market economies were low, at during the mid1970s. They increased at a healthy clip during the decades of 1980s and 1990s, peaking in 1997.
They suffered a sharp decline after that because of the Asian and Russian financial and economic

crises. The composition of external capital underwent a dramatic transformation during this period. Official flows either stagnated or declined. As a result their relative significance in global
capital flows dwindled. In their place, private capital flows became the major source of external
finance for a good number of emerging market economies. FDI became an important and dependable source of finance for the emerging markets and other middle-income economies during the
decade of the 1980s and 1990s. Portfolio investment in stocks and bond markets also increased
substantially. Global institutional investors found this channel of investment functional and profitable. Mutual funds, insurance companies, and pension funds channeled large amounts through
portfolio investment into the emerging market economies.
As financial globalization progressed, presence of international financial intermediaries has expanded considerably. This applies more to international commercial banks than to investment
banks, insurance companies and mutual funds. It is incorrect to say that their global expansion has
been uniform because this has occurred unevenly. International bond issuance activity by emerging market economies recorded a sharp spurt in 1993. Emerging market economies began using
ADRs and GDRs for raising capital from the global capital markets in 1990 in a small way.

Das: Globalization in the World of Finance

GLOBALIZATION
Although the contemporary wave of globalization is a quarter century old,
during the last decade, the concept of globalization acquired a great deal of
currency and emotive force. Many scholars have attempted to define globalization
from their own respective perspectives. It can simply and functionally be defined
as a gradually evolving interaction and integration of economies and societies
around the world. Keohane and Nye (2001) defined globalization as "a state of the
world involving networks of interdependence at multicontinental distances".
These networks need to be spatially extensive. They can interact through the flow
of finance, goods, services, information, ideas, and people.
As economies are progressively integrating globally, pari passu the
financial structures of markets and the world of finance is changing. This applies
to both domestic and international financial markets. Although the history of
international financial flows is centuries old, its widespread adoption by
businesses is relatively recent.1 Only a quarter century ago, borrowing from his or
her domestic market was one of the few limited options open to a business person.
Several options are open in a globalized financial market. For instance, he or she
can choose between issuing stocks and bonds in domestic or foreign financial
markets. He or she can reduce his or her cost of capital if foreign currency loans
are available at more attractive terms than the domestic loans. These loans can be
hedged by using a variety of financial products. He or she can also consider
selling equity at foreign bourses.
The contemporary global financial system is the new institutional
structure that has evolved over a long period. One of the many definitions of
financial globalization is integration of domestic financial system of a country
with the global financial markets and institutions. It has strengthened
interdependencies between markets and market participants across national
boundaries. Enabling framework of financial globalization, first, includes
liberalization and deregulation of the domestic financial sector as well as
liberalization of the capital account. Integration between domestic and global
financial markets occurs when trans-border capital flows take place. In a
globalized financial environment domestic lenders and borrowers participate in
the global markets, and utilize global financial intermediaries for borrowing and
lending.
Secondly, rapid progress in information and communication technology
(ICT) and computer-based technologies and products was the other enabling
feature. It was responsible for dramatic expansion in cross-border financial flows.
The ICT-based developments in the financial markets have expanded both the
1

Scholars like Angus Maddison have earned a good name by followed historical
developments in this regard dating back a millennium.

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breadth and depth of markets appreciably. Advances in ICT and computer-based

technologies reduced the cost of communications, increased power of computers,
shrunk the globe and made national boundaries less significant. New
developments in IT facilitated collection and processing of information for the
market participants as well as for monetary and banking authorities and banks.
They made it possible to measure, monitor and manage financial risk for the
market participants. Without computers pricing and trading of complex new
financial instruments was not feasible. Managing of large and rapid transactions,
and then managing books for these transactions, which are widely spread across
continents, and countries, could not be accomplished without the support of ICT
and computers. In addition, the new instruments and risk-management techniques
have enabled a large range of financial and non-financial firms to manage their
financial risks more efficiently. Consequently, world financial markets in the
contemporary period are far more efficient than ever before. While liberalization
in the area of multilateral trade went on for a much longer period, changes and
developments in the financial markets are regarded as more dramatic.
A caveat is necessary here. Financial globalization is not truly global.
Initially, members of the Organization for Economic Co-operation and
Development (OECD) used to be the most active participants in the financial
globalization process. They also used to be the principal players in the global
financial markets. Over the last quarter century, financial globalization has
expanded to the emerging-market economies (EMEs). This set of economies are
somewhat imprecisely defined as the newly industrialized economies2 (NIEs) and
middle-income developing countries in which governments and corporations have
access to private international capital markets, or can attract institutional portfolio
investment, or both. Different international institutions include slightly different
sets of countries in this category. For example, the Institute of International
Finance (IIF) includes 29 countries from Asia, Africa, Europe, Latin America,
and the Middle East. The International Monetary Fund (IMF) includes all the
NIEs and the middle-income developing countries in its definition of the
emerging market economies. The Economist classifies 25 developing and
transitional economies as the emerging market economies (Das, 2004a).3
NOVELTY OF FINANCIAL GLOBALIZATION
Neither the concept nor the phenomenon of financial globalization can be
considered novel. As stated in the preceding section, trans-country capital
movements are centuries old. One of the early eras of well-documented financial
2

Chile, Hong Kong SAR, Korea (Republic of), Singapore, and Taiwan. Hong Kong is a
special administrative region (SAR) of the Peoples Republic of China.
3
See in particular Chapter 2 of Das (2004a) for a detailed treatment of this issue.

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Das: Globalization in the World of Finance

globalization was the 1870-1914 period. To be sure, this was not the first period
of global financial integration. Using different measures and indicators, several
analysts tried to establish that a greater degree of financial globalization existed in
the previous epochs of globalization. Using the share of current account balance
in national income as a proxy for the external capital flows, Obstfeld and Taylor
(1998) established that larger external capital flows were recorded in the previous
periods of financial globalization than during the contemporary period. Their
study also presented evidence on nominal interest rate differential and real interest
rate dispersion as proxies for the financial market integration during various
periods. Relationship between domestic investment and savings has also been
used as a proxy for financial mobility to reach the conclusion that greater
financial globalization existed in earlier periods (Taylor, 1998). Several important
empirical studies analyzed this issue. Baldwin and Martin (1999) have reviewed
this literature at length.
One important distinction between the past and the present periods of
financial globalization was that in the past a limited number of countries, and a
small number of sectors in the participating economies, participated in financial
globalization. Also, in general capital followed the migration of population and it
was inter alia utilized in supporting trade flows. Long-term bonds of varying
maturity were the most popular financial instrument in the past. Financial activity
was highly concentrated in the hands of a small number of large freestanding
companies. Similarly, a small number of wealthy family groups and banks
dominated financial intermediation. This was the era of gold standard, according
to which gold and other precious metals backed the national currency. Therefore
currency value fluctuations were unknown. The gold standard facilitated crosscountry capital movements.
This system functioned smoothly until the eve of the First World War. Its
welfare implications for the global economy were obvious. The First World War
not only ended this era of globalization but also led to serious instability.
Consequently policy makers switched their stance and instead of recreating the
globalized financial markets of the past after the war, they began making policy
moves in the reverse direction by imposing capital controls to regain monetary
policy autonomy. The textbook argument in this regard is that only two out of the
following three can coexist: fixed exchange rates, autonomous monetary policy,
and free capital mobility. As most governments were concerned about their
exchange rate and autonomy in monetary policy, free capital movement had to be
abandoned as a priority policy option.4 The Great Depression of the 1930s and the
Second World War added to crises and instability in the global economy. Crosscountry capital movements reached their historical low level in the 1950s and
4

This is referred to as the impossible trinity.

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failed to pick up during the 1960s. The Bretton Woods era of fixed but adjustable
exchange rates is known for limited capital mobility and for policy makers
preference for adopting autonomy in monetary policy (Das, 2002).
DRIVING FORCES BEHIND FINANCIAL GLOBALIZATION
According to Mundell (2000), the contemporary era of financial globalization
began soon after the oil shock of 1973 and the concurrent collapse of the Bretton
Woods system. Both of these developments were momentous and were
responsible for laying the foundation of the contemporary era of financial
globalization. After the collapse of the Bretton Woods system, some middleincome developing economies began to liberalize and open up for greater capital
mobility, while keeping an autonomous control over their monetary policy. Given
the impossible trinity, fixed exchange rates could no longer be a popular policy
option. Capital flows increased sharply during the 1970s and the early 1980s,
leading to the debt crisis of 1982, which started with Mexico declaring a
moratorium in July 1982 on its external liability. Brady Bonds were invented
towards the late 1980s to resolve the debt crisis of the developing countries (Das,
1989). This development subsequently helped in the development of bond
markets for the emerging market economies. Investors in the industrial countries
found that deregulation, privatization, merger and acquisitions (M&As) and
advances in the ICT (noted in Section 1) was making foreign direct investment
(FDI) and equity investment in the EMEs more attractive than before and easy.
The result was an FDI and equity investment spiked in the EMEs in the 1990s.
Transnational corporations (TNCs) have expanded their networks by
merging with or acquiring other national and international firms. They managed
to slice the value chain and created production and distribution networks
spanning the globe. As noted above, many emerging market economies began
liberalizing their domestic economies in a methodical manner, lowering barriers
to trade and financial flows, consequently increasing both global trade in goods
and services. These developments resulted in heightened demand for trans-border
financial flows. Therefore, an internationally mobile pool of capital and liquidity
was created, which allowed financial globalization to make further advances.
Liberalized domestic economic strategies, advances in ICT, and globalizing
economies coalesced to catalyze financial innovation. It enhanced the process
whereby excess of saving over investment in one country finds an appropriate
outlet in another. The tendency to equate risk-adjusted rate of return on
investment was increased by these developments. As the demand for trans-border
financial flows increased, financial intermediation activity and increasingly
globalized. It was further buttressed by declining barriers to trade in financial
services as well as deregulation and removal of entry restrictions on foreign

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financial institutions into domestic markets in a large number of EMEs. As a

result trans-border financial flows increased at a rapid clip. Huang and Wajid
(2002) estimated that between 1970 and 2000, they increased from less than 3
percent of GDP to 17 percent for the industrial economies and from virtually
nothing to about 5 percent of GDP for the developing economies. Global gross
capital flows in 2000 amounted to $7.5 trillion, a fourfold increase over 1990. The
growth in cross-border capital movements also resulted in larger net capital flows,
rising from $500 billion in 1990 to nearly $1.2 trillion in 2000 (Hausler, 2002).
The regulatory authorities in many countries, particularly the EMEs,
modernized their structure and role. Their new set of regulations facilitated a
broader range of institutions to provide financial services. Also, new categories of
non-bank institutions and institutional investors were launched. Gradually,
investment banks, securities firms, asset managers, mutual funds, insurance
companies, specialty and trade finance companies, hedge funds, and even
telecommunications, software, and food companies began providing services
similar to those traditionally provided by banks. Technological advances and
financial innovation joined hands to increase competition among the institutions
that provided intermediary services. These developments have supported the
advance of financial globalization.
The repeal of the Glass-Steagall Act (GSA), which separated investment
and commercial banking activities, after over six decades and enactment of the
Gramm-Leach-Bliley Act (GLBA) in November 1999, permitted broad banking
in financial services markets in the United States (US). It cannot be considered a
revolutionary measure because the barriers separating banking from other
financial activities have been crumbling for some time. The GLBA is viewed as
ratifying those changes. Broad banking is sure to produce financial services at
greater convenience and lower cost. Financial globalization was an important
force that increased the pressure on the large US banks to lower cost and stay
competitive, which in turn contributed to the need of GLBA. Competition form
other international banks in the global financial market place required the US
banks to build securities business infrastructures abroad. The need for such an
infrastructure is increased by the global financial market that has been 24/7 and
expanding its cross-border asset holding, trading and credit flows. It is also
needed to meet the demands of global customers and to provide global financial
services to the US customers.
The flip side of the coin is that in spite of the progress in financial
globalization, the global financial system is far from being perfectly integrated.
Not all the forces are driving financial globalization onward. Several counterglobalization forces are still at work. Analysts have provided evidence of
inadequate progress in financial integration, imperfections in the global capital
markets, persistent capital market segmentation, continuing home country bias,

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and correlation between domestic savings and investment.5 Yet, a reversal of the
recent trend is difficult to visualize, albeit it is not impossible. It is largely because
of liberalization and deregulation of economies, and technological advances in the
financial services sector. Also, the channels of financial globalization are so many
and so diverse that a reversal of financial globalization will be difficult. This
observation applies to both partially integrated and fully integrated economies.
Having witnessed the recent benefits of financial globalization, policy makers and
economic agents in the emerging market economies are likely to work towards a
more financially integrated world in future and towards achieving a deeper degree
of financial integration. The newest developments in the IT and ineffectiveness of
public policy will further underpin cross-border financial flows (Das, 2004b).
AGENTS OF FINANCIAL GLOBALIZATION
The prime movers in financial globalization are governments, borrowers,
investors, and financial institutions. Each one of these market participants
propelled economies towards financial integration in a proactive manner.
Governments play an indispensable role in promoting financial globalization. By
creating an enabling policy framework, they make financial globalization feasible.
Two policy actions are considered a pre-condition of financial globalization. The
first is liberalization and deregulation of the domestic financial sector, while the
second is liberalization of the capital account of balance-of-payments. Strict
regulation of domestic financial sector, with a vast array of difficult-tocomprehend restrictions, used to be a popular practice in the past. This applied to
most developing economies where governments controlled credit allocation and
kept surveillance over its disbursement through control on prices and quantities.
Multiple bodies were created to enforce a complex body of regulations.
Governments routinely controlled cross-country capital movements in a stringent
manner, both inward and outward. A large number of instruments were devised in
different policy areas to restrict capital account transactions. These areas were
foreign exchange transactions, derivative transactions, lending and borrowing
activities by banks and corporations, as well as entry and participation of foreign
investors in the domestic financial system.
Policy structure in these areas gradually started changing in the 1970s and
the traditional controls and restrictive regulations over the domestic financial
sector and capital account noted above began to be relaxed in many industrial
economies, NIEs and the emerging market economies. Lifting of restrictions was
closely studies by Kaminsky and Schmukler (2001). They selected six restrictions
on the capital account and five restrictions on the financial markets and made two
5

For evidence to this effect, refer to Frankel (2000), Obstfeld and Rogoff (2000), Tesar
and Werner (1998) and Okina, Shirakawa, and Shiratsuka (1999).

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Das: Globalization in the World of Finance

indices: (i) financial restrictions on capital account and (ii) restrictions on the
domestic financial sector. They concluded that over the 1973-2000 period these
restrictions declined to the maximum extent in the industrial economies. In the
Asian emerging market economies they declined significantly, although not as
much as those in the industrial economies. Similarly, Latin American emerging
market economies recorded a decline in these restrictions and controls but it was
less than that in Asian economies. Industrial economies always used more liberal
financial policies than the other economies. For certain, the NIEs and emerging
market economies liberalized the restrictions but they were not only slow to do
that, but there also were periods of policy reversals.
There were several motivating factors behind liberalizing restrictions over
the domestic financial sector and capital account. The World Bank (2001) argues
that policy makers found the vast array of restrictions and controls increasingly
costly and difficult to maintain effectively. Besides, they began to make
distinction between government-led financial systemor a statist financial
systemand the market-led one, and saw that that the government-led, nonmarket system, failed to achieve the desired objectives. The experiences of the
last two decades revealed that there were periods when external capital flows
helped both governments and corporate sector. At the times of crises, external
capital was needed to re-capitalize banks whose capital base had seriously eroded
as well as for conducting corporate restructuring. During the crises of the 1980s
and 1990s, many countries had to rely on external capital flows to tide them over
their crisis periods. During such periods, foreign investors provided capital for
privatization of public sector enterprises in the emerging markets economies
which helped increase financial receipts from these enterprises. Myriad
experiences of this nature changed the mindset of policy makers. At the beginning
of the twenty first century, policy they seem more convinced than ever regarding
a liberalized and deregulated financial system being more efficient for growth and
stability of the economy.
Financial globalization is also proactively promoted by firms and
households, which represent savers, investors and borrowers. By borrowing
abroad households and firms can go beyond their immediate financial constraints
and consume or invest according to their preferences. In particular, by raising
capital abroad through bonds and equity issues firms can potentially reduce the
cost of capital and expand their investor base. Benefits of external resources are
not limited to lower cost. When external capital comes in the form of FDI, the
recipient firms in the home country benefit by way of acquiring technology of
more recent vintage, if not the latest. FDI is also known to ushers in new
management techniques and employee training.
Trans-border capital flows benefit international investors as well. In their
endeavor to find new and more profitable investment opportunities they explore

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the global investment scenario. In addition, financial globalization benefits them

by providing cross-country risk diversion possibilities. As the emerging market
economies grow at a faster clip than the industrial ones, international investors
can reasonably expect to have higher real returns on their investment in these
economies. With the liberalization and deregulation of the financial markets,
institutions and individuals in the industrial economies can easily find
opportunities for profitable investment in the NIEs and the emerging markets only
by buying shares of international mutual funds. There is a wide choice of mutual
funds, which could be global, regional or country-specific. Other easy instruments
are ADRs and GDRs, as well as international corporate and sovereign bonds. All
these modes of global investment are currently in vogue (Schmukler and ZoidoLobaton, 2001).
Financial institutions are important purveyors of financial globalization.
They have helped in deepening financial globalization through the spread of
financial services. In this endeavor the newest advances in IT assisted them. With
the help of IT large financial institutions can serve several markets from one
location. Advances in IT have promoted a more intensive use of international
financial institutions. They also assisted in consolidating and restructuring the
global financial services industry. IT was instrumental in the creation of global
banks and conglomerates that provide a large mix of financial products and
services in several markets and countries (Crockett, 2000; IMF, 2000). As
financial liberalization and deregulation in the NIEs and emerging market
economies progressed, international financial institutions began to participate in
the domestic markets of these economies. Privatization of financial institutions
provided them with opportunities to enter the local financial markets.
Macroeconomic stabilization, improved economic and business environment, and
in general stronger fundamentals in these economies ensured healthier economic
climate and encouraged greater integration of large financial institutions with the
global financial markets.
FINANCIAL GLOBALIZATION AND CAPITAL MARKETS
Financial globalization has caused dramatic changes in the structure of
national and international capital markets. The most significant change in the
capital markets was in the banking system, which went through a process of disintermediation. This was a market transformation of fundamental nature. It has
radically changed the operation of the financial markets6. Tradable securities
increasingly replaced financial intermediation through banks. The role of bank
loans and deposits progressively declined over the last quarter century. Markets
6

Please refer to Krueger (2002) where she discusses this issue in the first half of the
paper.

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participantsfinancial and non-financial institutions and saving and investing

householdswere responsible for ushering in this metamorphosis. They played a
crucial role in bringing it about because they benefited from it. Financial risks,
particularly credit risks, are no longer borne by banks. They are increasingly
moved off balance sheets. Assets are converted into tradable securities, which in
turn eliminates credit risks. Derivative transactions like interest rate swaps also
serve the same purpose. Risk elimination enables banks to improve their riskadjusted returns on capital as well as be more competitive in the market. Reduced
risk also tends to lower their capital requirements according to the regulatory
norms. In the new globalized financial environment a diversified group of
investors has emerged that is willing to own an array of credit and other financial
risks. Improvements in information technology have made these risks easier to
monitor, analyze, and manage (Hausler, 2002). This group of investors is growing
fast.
Second, major financial markets, centers and institutions now serve
borrowers and investors all over the globe, or those in economies that are now
financially globalized. They also serve sovereign borrowers at various stages of
economic development. TNCs and financial intermediaries not only tap financial
resources and raise capital from the globalized financial centers, but they can also
manage risk more flexibly by accessing larger pools of capital in these centers.
Accordingly, the volume of cross-border financial flows has increased
substantially. The importance of institutional investors has grown in the capital
markets because they manage a large and growing share of global financial
wealth. They have become adept at enhancing their risk-adjusted returns by
diversifying their portfolios globally. This diversification is reflected in their
investment in a wide range of economies, industries and currencies. Therefore,
wholesale financial integration in the global economy is far greater than that at the
retail end of the financial market.
Third, due to the changes in the structure of the capital markets,
competition between banks and non-banking financial institutions has intensified.
The two categories of institutions keenly compete for household savings and
corporate finance mandates, forcing prices of financial instruments to decline.
Non-banking financial institutions have succeeded in capturing a rising share of
household savings. For instance, mutual funds provide higher return instruments
to households, encouraging them to ignore the traditional banking saving
channels. They are able to diversify risk better, and have grown enormously in
size and sophistication. Competition between banks and non-banking financial
institutions has slimmed down the profit margin of banks and forced them to find
new sources of revenues and new methods of intermediating funds. They have
also been driven towards fee-based businesses. This applies most to banks in the
European Union, where there was little consolidation of financial institutions.

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However, in North America and the United Kingdom mergers of banks with other
banks and non-banking financial institutions like securities firms enabled them to
exploit economies of scale. It provided banks an opportunity to remain
competitive.
Fourth, changing nature of capital markets, and their deepening and
broadening, created new sources of business for banks. Underwriting of corporate
bond and equity issues was one such business. To meet their liquidity needs for
investment, banks turned to over-the-counter (OTC) derivatives markets. This is a
decentralized market where derivatives, like currency and interest rate swaps, are
privately trades between buyers and sellers.7 Transformations in regulatory
framework and norms enabled banks to venture beyond their traditional array of
activities. They entered into other areas of profitable activities, like investment
banking, asset management, insurance, and the like which allowed them to
diversify their revenue sources and business risk.
DIMENSION OF NET CAPITAL FLOWS TO EMERGING MARKETS
Among the three sets of economies to financially globalize, the EMEs
were the most recent. Cross-country financial flows to this country group were
low, at a paltry $28 billion, during the mid-1970s. Net flows to the emerging
market economies reached $306 billion in 1997 in real terms, at the eve of the
Asian financial crisis (Schmukler and Zoido-Lobaton, 2001). This was their peak
level. Net flows suffered a sharp decline after that because of the Asian and
Russian financial and economic crises. The composition of external capital
underwent a dramatic transformation during this period. Official flows or official
development assistance (ODA) either stagnated or declined. As a result their
relative significance in global capital flows dwindled. In their place, private
capital flows became the major source of external finance for a good number of
emerging market economies. FDI became an important and dependable source of
finance for the emerging markets and other middle-income economies during the
decade of the 1980s and 1990s. Its growth was particularly strong during the
decade of 1990s. A large part of FDI to emerging market economies was utilized
in mergers and acquisitions (M&As) deals. Many large developing economies
were privatizing their public sector enterprise during this period. Those that were
rated as creditworthy by the financial markets succeeded in attracting FDI in the
process (Lipsey, 1999).
While syndicated bank loans were a popular instrument during the 1970s,
they gradually went out of use after the Latin American debt crisis of 1982. In the
1970s, developing countries hardly attracted portfolio investment in stocks and
7

Please refer to Hausler (2002) for greater details on these issues.

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11

bond markets. They were as low as $100 million in 1970. Like the FDI, they
began to increase in the 1980s and peaked at $103 billion in 1996 in real terms
(Schmukler and Zoido-Lobaton, 2001). Global institutional investors found this
channel of investment functional and profitable. Mutual funds, insurance
companies, and pension funds channeled large amounts through portfolio
investment into the emerging market economies. The Asian and Russian crises
had a strong adverse influence over them as well and they sharply declined after
that.
The emerging market economies have been defined above as those where
governments and corporations have access to private international capital markets,
or can attract institutional portfolio investment, or both. However, not all the
emerging market economies have an equal access to the international capital
markets. Their access is directly related to their perceived creditworthiness in the
global financial marketplace. Therefore, distribution of global capital among the
recipient economies is highly uneven. Some economies like the Peoples Republic
of China (hereinafter China), East Asian and Latin American ones have easy
access and receive large amounts of global capital resources, while others like
South Asian ones (India being an exception in this group) have limited access.
Many like the African economies have not been able to attract any global capital.
Using Global Development Finance database, Schmukler and ZoidoLobaton (2001) have shown that low-income developing economies receive very
little amount of net global capital, while some does go to the middle-income
developing economies. In accordance with the creditworthiness concept, lions
share of global capital is attracted by top twelve recipient countries8. All of them
fall in the category of EMEs. These economies are relatively more globalized than
the others. During the 1990s global capital flows to these twelve emerging market
economies accelerated at a steep rate, which in turn affected the composition of
the total global financial resources going to developing economies.
The proportion of global financial flows dedicated to the low- and middleincome developing economies decreased after the Asian crisis of 1997-98. This
decline was so sharp that the financial flows became negative between 1998 and
2001. While some of this decline can be explained by cyclical factors, there also
were structural elements involved. Given the frequency of the crises, international
banks perception of risk of lending to EMEs and the other developing economies
increased considerably. Another structural factor was that banks increasingly
crossed borders to buy local subsidiaries from which they could lend at a smaller
risk in local currency. It resulted in a decline in cross-border lending to the EMEs
and developing countries. Another new development is that, for all appearance,
8

They are Argentina, Brazil, Chile, China, India, Indonesia, Korea (Republic of),
Malaysia, Mexico, Russian Federation, Thailand, and Turkey.

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many EMEs and developing economies that were rapidly financially globalizing
began to diverge from the rest of the developing economies.
Global capital flows in the form of debt and equity are having a healthy
run; the 2004 and 2005 have been good years for the global financial flows. Net
capital flows from the global capital markets to the developing economies
increased by $51 billion in 2004, followed by a $87 billion surge in 2003 (WB,
2005). In mid-2005, the global financial system and markets again gathered
strength. By this time they had acquired greater resilience than before (Section 8).
The new trend was propelled by continued balance sheet improvements in the
financial and corporate sectors in the economies that participate in the global
financial markets. In addition, the continuing global economic expansion, together
with determined efforts to restructure costs enabled many financial institutions to
generate substantial, even record, profits over the past three years. With global
growth likely to continue, inflation under control, and financial markets generally
benign, the IMF expects that the global financial markets will strengthen further
in the foreseeable future (IMF, 2005).
VULNERABILITIES ASSOCIATED WITH FINANCIAL GLOBALIZATION
Contagion-related spillovers from national, regional and global crises are
the downside of financial globalization. Economic and financial crises of the
1990s portend to the fact that financial globalization is not a win-win game, and
that it can potentially lead to serious disorder and high cost in terms of bank
failures, corporate bankruptcies, stock market turbulence, depletion of foreign
exchange reserves, currency depreciation and increased fiscal burden. Together
they tell on the real economy and create an environment of depression and job
losses, leading to social turbulence.
Statistics in section 3 show that households, banks, corporations and
sovereign borrowers utilized the globalizing financial markets well. However, a
unique characteristic of globalized financial markets is reversal of capital flows
when market perception regarding the creditworthiness of the borrowing entity
changes. When financial markets grow skeptical about the viability of domestic
policies and financial institutions, or when they retrench in response to financial
crisis in another part of the world, or when they eschew an economy having
similarities in economic and financial indicators with one in crisis, national and
international financial stability comes under serious threat. The crises of the 1990s
sufficiently testify to these facts. Because of advances in IT, reverse flows of
capital can now be really rapid. It implies that the probability of a contagion
setting in, or an economy suffering from a financial crisis has increased with
progress in financial globalization. Empirical research in this area suggests that
the probability of a randomly selected country experiencing a crisis has doubled

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since 1973 (Eichengreen and Bordo, 2001). The Asian crises of 1997-98 and the
Russian crisis of 1998 demonstrated that financial instability in one country can
destabilize the entire global financial system. When Russia defaulted on its
external liabilities and devalued the ruble, stock markets in emerging market
economies as well as industrial economies tumbled and investors around the
globe suffered large losses.
To avoid recurrences of such scenarios, policy makers must strive to make
their financial systems deep, broad and resilient. They must address financial
weaknesses that make financial structure weak and vulnerable to external shocks.
This needs to be achieved both at national and global levels. To this end, the IMF
and the World Bank have adopted a three-pronged approach which includes
comprehensive assessments of financial sector vulnerabilities for member
countries, strengthening the monitoring and analysis of financial sectors, and
helping countries build strong institutions. They conceived and launched the
Financial Sector Assessment Program (FSAP) in 1999 as a collaborative
endeavor. It is a large program involving the two supranational bodies and
national banking and non-bank financial institutions as well as the financial
markets (securities, foreign exchange, and money markets). The FSAP had to be
country specific and was carefully devised to identify strength and vulnerabilities
of the financial system as well as identify measures to reduce the potential crisis
in that country. Functioning and importance of various financial institutions and
their sensitivity to external shocks are scrutinized under the FSAP. Various
financial soundness indicators (like capital-adequacy ratios, extent of nonperforming loans, earning trends in banks) are also examined. The acceptance of
FSAP was encouraging and over a third of the 183 member countries of the IMF
had begun participating in it by the end of 20019.
For strengthening the monitoring and analysis of financial sector and
making it more transparent, IMF is endeavoring to improve the intelligence and
information systems in the member countries. The objective of this endeavor is to
conduct a deeper and thorough analysis of the financial sector of the economy.
Frequent monitoring of the financial sector should enable policy makers to refine
their stress-testing methodologies. The Bretton Woods twins are also assisting
those countries that lack the institutional capacity to supervise and regulate their
financial sectors. They provide technical assistance for institutional building. The
FSAP and its integrated approach was found to helpful in identifying
vulnerabilities of financial systems and devising stabilizing strategies (Huang and
Wajid, 2002).

For more details on FSAP and its functioning readers are referred to Huang and Wajid
(2002).

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GLOBALLY ACCEPTED STANDARDS AND CODES FOR STABILITY

AND RESILIENCE
Central bankers and monetary authorities of the economies that participate
in the globalized financial markets needed to develop high quality expertise in
supervision and regulation so that they can effectively monitor activities of
complex financial and non-financial institutions in a rapidly globalizing financial
world. A wide agreement evolved among the central bankers and monetary
authorities that in order to achieve systemic stability and ex ante resilience there
should be globally accepted codes of standards, norms and best practices. They
ranged from promotion of transparency in fiscal, monetary and financial policies
on the one hand to adoption of core principles for bank supervision on the other.
The Basle Capital Accord process, that started in mid-1988 and resulted in Basel
Accord I and II, was the concrete outcome of this agreement among the global
policy-making community.
The Basle Accord I, of July 1988, set down the agreement among the
Group-of-Ten (G-10) central banks to apply common minimum standards to their
banking industry. The standards were addressed almost entirely to credit risk and
the norms set by the Basel Accord I were to be achieved by the end of 1992. The
Accord was amended in 1996 with the introduction of standards of capital
requirements for market risk. Although the Basel I concepts were originally
designed for the G-10 central banks, EMEs and the other developing economies
saw its value and utility and it was popularly embraced by banks in these
economies. The Basel I was regarded as an important advance over the past
practices. However, advances in ICT, creation of new innovative products and
rapid globalization of financial markets, discussed in Sections 1 and 2,
considerably affected the ways banks needed to manage their credit risk, market
risk and operational risk. Basel I was overtaken by events of the 1990s and
considered inadequate for the rapidly globalizing financial world.
The objective of Basel II framework was to have a new and improved
accord that responded to the evolving global banking scenario and globally active
banks. It was more flexible than Basel I, forward looking and appropriate for the
management of risks and minimum capital requirement standards of the globally
active banks in the twenty-first century. In view of the frequent financial crises of
the 1990s and early 2000s and near bankruptcy of the hedge fund Long-Term
Capital Management (LTCM), one of its principal objectives was to promote ex
ante resilience of the financial system. The Basel II framework reinforced the
risk-sensitive minimum capital requirements for banks by laying out principles for
banks to assess the adequacy of their capital and for supervisors to review such
assessments so that they can ensure that banks have adequate capital to support
their risks. It also sought to strengthen market discipline by enhancing

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transparency in banks financial reporting. It laid down the basis of national rule
making this regard (Jeanneau, 2004).
Resolving the financial and currency crises has continued to be an
unsettled issue in the Basel Committee on Banking Supervision (BCBS). While
there was a strong consensus on the need to create a system that contributes to ex
ante resilience, there was little agreement on how best to handle the crises as well
as the role of public and private institutions in resolving a crisis. A magic bullet
recipe could not be found. Therefore, assuming that Basel II is the end of the
process may well be a world class stretch. This process of innovation needs to go
on until effective ways are found for a market improvement in the global financial
system.
GLOBALIZING FINANCIAL SERVICES
As alluded to earlier, when domestic savers (or lenders) and borrowers
make use of the global financial markets, intermediaries and institutions, financial
services are said to be globalizing. Over the 1990s, presence of international
financial intermediaries has expanded considerably. This applies more to
international commercial banks than to investment banks, insurance companies
and mutual funds. It is incorrect to say that their global expansion has been
uniform because this has occurred unevenly. Conversely, globalization of
financial services also occurs when domestic savers (or lenders) and borrowers
are able to make use of financial intermediaries located globally. For instance,
financial services are said to be globalized when domestic stocks are traded on
large international bourses abroad.
During the 1990s, presence of foreign banks increased in three regions,
namely, East Asia, Eastern Europe and Latin America. Foreign bank ownership of
assets increased rapidly. Total assets held by them increased maximum in the
emerging market economies in Latin America, particularly in Argentina, Brazil,
Mexico, Peru, and Venezuela. In the emerging market economies in Eastern
European (Czech Republic, Hungary, and Poland) share of total assets controlled
by foreign banks crossed 50 percent of the total. As compared to these two
regions, the activities of the foreign banks expanded less rapidly in the emerging
markets of East Asia, like Korea (Republic of), Malaysia, and Thailand
(Schmukler and Zoido-Lobaton, 2001). However, it must be stated that to begin
with foreign bank activity was greater in the emerging markets of East Asia than
in the other emerging markets.
International bond issuance activity by emerging market economies
recorded a sharp spurt in 1993, crossing $50 billion for the first time. It stabilized
around this level until 1996 when it nearly doubled. Both 1993 and 1996 were the
years of high global capital flows. In 1997, issuance activity by emerging market

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economies peaked at $120 billion. Due to Asian financial crisis and its contagion
effects, international bond issuance dropped to around $75 billion over the next
three years.10
Emerging market economies began using American Depository Receipts
(ADRs) and Global Depository Receipts (GDRs) for raising capital from the
global capital markets in 1990 in a small way. ADRs and GDRs are negotiable
certificates representing ownership of shares in a corporation in another country.
They are held by a depository, which in turn issues a certificate that can be traded
in another country, for example, the United States. The middle-income
developing countries began using them in 1992. Firms from both emerging
market and middle-income developing economies increased their participation in
the US equity markets using ADRs and GDRs. The top six emerging market
economies that had the highest participation over the decade of the 1990s were:
Argentina, Brazil, China, India, Korea (Republic of) and Mexico. They accounted
for most of the activity by developing countries in the US equity markets. In
terms of capital flows, this country group may be creating a divergence among the
developing countries. This group benefited more from the global capital markets
by way of lower cost of capital and longer maturity structure of its debt
(Schmukler and Zoido-Lobaton, 2001).
FINANCIAL GLOBALIZATION: THE INDECOROUS SIDE
Organized crime groups generate huge sums of dirty money. Movements
of this dirty money and money laundering are the unseemly side of financial
globalization and are considered a threat to the global monetary system. Dirty
money has been used by terrorists in the recent past for financing terrorism
around the globe. Dirty money has three sources, namely, corruption, criminal
activities and commercial business. Corrupt officials who dip their hand in the till,
hide their dirty financial gains offshore to escape any evidence of its ownership.
Criminal dirty money is generated by narcotic trade, racketeering, securities fraud
and the like. Many dishonest businesses try to hide their revenues from the tax
authorities by diverting it to foreign bank account. According to the estimates of
the Global Financial Flows Project (GFFP), the magnitude of the flow of dirty
money is as large as $1 trillion per year (GFFP, 2005). Such large amounts flows
annually from the developing and transition economies to the banks in the
industrial economies and it seldom returns. If it stays in the poor source countries,
it could be used for consumption or investment, generating a multiplier effect
through the domestic economies.
10

Statistics used here come from Schmukler and Zoido-Lobaton (2001).

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Money laundering is a serious criminal issue faced by the international

financial community. Estimates of the present scale of money laundering
transactions vary. They range from 2 percent of global GDP to 5 percent. The two
principal risks posed by these transactions are prudential and macroeconomic.
These operations can destabilize small economies, and adversely affect the
medium-sized ones. There is evidence to show that money subject to laundering is
less productive and contributes minimally to economic growth. Macroeconomic
consequences of money laundering include inexplicable changes in money
demand and supply in the economy, increase in the prudential risks for the banks
and contamination of legal financial transactions.
The United Nations (UN) makes crucial contribution in fighting against
organized crime and money laundering. The Global Program against Money
Laundering (GPML) is the key institution of the UN for preventing this kind of
financial crime. The UN also helps members in introducing legislation against
money laundering and to develop mechanism to combat this crime. The Financial
Action Task Force (FATF) of the IMF also deals with financial crime; it
recommended that countries should monitor cross-border financial transactions of
cash and bearer instruments. However, it needs to be done in such a manner that
the freedom of capital movement is not impeded.
SUMMARY AND CONCLUSIONS
The contemporary wave of globalization is around a quarter century old.
One of the many definitions of financial globalization is integration of domestic
financial system of a country with the global financial markets and institutions.
Enabling framework of financial globalization essentially includes liberalization
and deregulation of the domestic financial sector as well as liberalization of the
capital account. As economies progressively integrate globally, pari passu the
financial structures of markets and the world of finance change. This applies to
both domestic and international financial markets. Integration between domestic
and global financial markets occurs when trans-border capital flows take place. It
needs to be stressed that financial globalization is not truly global. During the
contemporary period, only the industrial economies, the NIEs and the emerging
market economies are financially globalizing.
Financial globalization cannot be considered a novel phenomenon. Transcountry capital movements are centuries old. Greater degree of financial
globalization existed in the previous epochs of globalization. Larger external
capital flows were recorded in the previous periods of financial globalization than
during the contemporary period. One important distinction between the past and
the present periods of financial globalization was that in the past a limited number

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of countries, and a small number of sectors in the participating economies,

participated in financial globalization.
The oil shock of 1973 and the collapse of the Bretton Woods system, both
of these developments were momentous and were responsible for laying the
foundation of the contemporary era of financial globalization. After the collapse
of the Bretton Woods system, some middle-income developing economies began
to liberalize and open up for greater capital mobility, while keeping an
autonomous control over their monetary policy. Advances in IT and computer
technology are cited as one of the most important factors driving and supporting
financial globalization. Transnational corporations (TNCs) also helped in global
financial integration. They expanded their networks by merging with or acquiring
other national and international firms. Liberalized domestic economic strategies,
advances in IT, and globalizing economies coalesced to catalyze financial
innovation. Responding to the demand for trans-border financial flows, financial
intermediation activity globalized. It was further buttressed by declining barriers
to trade in financial services as well as deregulation and removal of entry
restrictions on foreign financial institutions into domestic markets in a large
number of emerging market economies. The regulatory authorities in many
countries, particularly the emerging market economies, modernized their structure
and role.
The prime movers in financial globalization are governments, borrowers,
investors, and financial institutions. Each one of these market participants
propelled economies towards financial integration in a proactive manner.
Restrictive regulations, so popular in the past, were relaxed in many countries.
There were several motivating factors behind liberalizing restrictions over the
domestic financial sector and capital account. Policy makers found the vast array
of restrictions and controls increasingly costly and difficult to maintain
effectively. Besides, the experiences of the last two decades revealed that there
were periods when external capital flows helped both governments and corporate
sector. Financial globalization was also proactively promoted by firms and
households. Trans-border capital flows tend to benefit international investors as
well.
Financial globalization has caused dramatic changes in the structure of
national and international capital markets. The most significant change in the
capital markets was in the banking system, which went through a process of disintermediation. This was a market transformation of fundamental nature. Second,
major financial markets, centers and institutions now serve borrowers and
investors all over the globe, or those in economies that are now financially
globalized. They also serve sovereign borrowers at various stages of economic
development, TNCs and financial intermediaries. Accordingly, the volume of
cross-border financial flows has increased substantially. The importance of

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institutional investors has grown in the capital markets because they manage a
large and growing share of global financial wealth.
Contagions and crises are the downsides of financial globalization.
Economic and financial crises of the 1990s portend to the fact that financial
globalization is not a win-win game, and that it can potentially lead to serious
disorder and high cost in terms of bank failures, corporate bankruptcies, stock
market turbulence, depletion of foreign exchange reserves, currency depreciation
and increased fiscal burden. A unique characteristic of globalized financial
markets is reversal of capital flows when market perception regarding the
creditworthiness of the borrowing entity changes. The probability of a randomly
selected country experiencing a crisis has doubled since 1973. To avoid
recurrences of such scenarios, policy makers must strive to make their financial
systems deep, broad and resilient. They must address financial weaknesses that
make financial structure weak and vulnerable to external shocks. This needs to be
achieved both at national and global levels. To this end, the IMF and the World
Bank have adopted a three-pronged approach which includes comprehensive
assessments of financial sector vulnerabilities for member countries,
strengthening the monitoring and analysis of financial sectors, and helping
countries build strong institutions. They conceived and launched the Financial
Sector Assessment Program (FSAP) in 1999 as a collaborative endeavor.
Cross-country financial flows to the emerging market economies were
low, at during the mid-1970s. They increased at a healthy clip during the decades
of 1980s and 1990s, peaking in 1997. They suffered a sharp decline after that
because of the Asian and Russian financial and economic crises. The composition
of external capital underwent a dramatic transformation during this period.
Official flows either stagnated or declined. As a result their relative significance
in global capital flows dwindled. In their place, private capital flows became the
major source of external finance for a good number of emerging market
economies. FDI became an important and dependable source of finance for the
emerging markets and other middle-income economies during the decade of the
1980s and 1990s. Portfolio investment in stocks and bond markets also increased
substantially. Global institutional investors found this channel of investment
functional and profitable. Mutual funds, insurance companies, and pension funds
channeled large amounts through portfolio investment into the emerging market
economies.
As financial globalization progressed, presence of international financial
intermediaries has expanded considerably. This applies more to international
commercial banks than to investment banks, insurance companies and mutual
funds. It is incorrect to say that their global expansion has been uniform because
this has occurred unevenly. International bond issuance activity by emerging
market economies recorded a sharp spurt in 1993. Emerging market economies

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Vol. 6 [2006], No. 1, Article 2

began using ADRs and GDRs for raising capital from the global capital markets
in 1990 in a small way.

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