Why is financial globalization so important for emerging market economies?
It’s critical for emerging market countries to have an institutional framework that allows their financial systems to work well. For an economy to grow, you need money channeled to productive investments. [Mauritius has low productivity] If that doesn’t happen, a country will never make it. One of the serious problems in emerging market countries is their financial systems don’t work well: they don’t have good property rights, and they don’t have a legal system that allows enforcement of contracts — things that we take for granted in places like the United States. As a result, businesses and households often can’t get the funds they need.
Mauritius does have a good legal system and respect for property rights - however it's access to those which are somewhat out of reach to the participants that need it the most. The bigger question is does Mauritius have an innovation problem? Since access to capital either from the government through it's various lending schemes for small entrepreneurs and businesses seems to suggest the financial system is working. Although there are complaints though from those working in the banking industry that the system of loans [non transparence, onerous terms, lack of financial knowledge by those getting loans] has stunted the growth of SME's. The legal and financial system appear on the face of it to work from a institutional sense - all the institutions are there, the laws are on the books - numerous banks - government programs, yet it doesn't seem to working that well.
Financial globalization is an important part of helping financial systems develop. First, there is the direct effect: access to foreign capital, which lowers the cost of capital and makes it easier to do investment. Then there are all of the secondary benefits for a country’s institutional framework. Financial globalization, like globalization in general, increases competition. If you bring in foreign capital, domestic financial institutions have to do a better job in order to survive. And with competition, these institutions will realize that they have to have a better legal system, with property rights and so forth.
What are the risks of this influx of foreign capital?
Frequently, when a country begins to open up to financial globalization, it is done in a way that benefits the same elites that have been repressing the financial system. And this can be dangerous for their countries.
For example, when Mexico privatized its banks and opened its financial system to the outside world, the business elites took over the banks, putting very little money of their own into them. In addition, they made sure the system allowed the banks to take on huge risk. If the banks got in trouble, the taxpayers would bail them out. The result was the banks blew up and the financial system faced a devastating crisis. Similar problems happened in Korea. Banking institutions were essentially lending machines for the businesses that owned them.
This pattern is a very common one. Although financial globalization is critical to growth, it’s frequently mismanaged. There are many examples where it has been successful and many examples of when it has been a disaster.How is Mauritius managing this transition - economically and more importantly also socially?
What about income inequality? Some say that globalization will increase the gap between the rich and the poor.
There’s always been a concern that globalization might increase income inequality. But for poor countries, globalization tends to be one of the most important ways of eradicating poverty. Look at what’s happened in India and China. They entered the global trading system, and as a result a huge number of people have been lifted out of extreme poverty.
In advanced countries like the United States, globalization may have led to increased income inequality in recent years. There’s a lot of debate about this, and there is no clear-cut answer. It’s one reason why some people are opposed to globalization, because they feel that some elements of society may not do as well.
One of the key issues is that a country must supervise its financial sector to make sure it doesn’t take on excessive risk. This is something that is done very actively in advanced countries, though not always well. We’ve had our crises too. The United States had a savings-and-loan crisis because regulators weren’t doing a good job. But when an advanced country makes a mistake, it usually fixes it.
Another important issue is what’s called currency mismatch. Frequently, businesses in emerging market countries borrow money in foreign-denominated currencies because it’s easier. But their revenue and the value of their assets are denominated in domestic currency. If the value of the domestic currency declines, it blows up the value of their debt and blows up the companies, and that blows up the country. So one issue is how to limit currency mismatch.
Also, trade liberalization actually helps prevent financial crises. If an economy is open to trade, many companies are exporting and a lot of their revenue will be in foreign currency. When they then borrow in foreign currency, it doesn’t create a problem.
Frederic Mishkin is the Alfred Lerner Professor of Banking and Financial Institutions at Columbia Business School. His new book, The Next Globalization, will be published by Princeton University Press in September 2006
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