**Decoupling and recoupling**

# **a. Financial globalization: What do we talk about?**<sup>**15**</sup>

Despite being the subject of a rich and growing literature, the concept of financial globalization has been defined in various, often-uncorrelated ways in the academic work. As a result, assessing a country’s integration with international financial markets remains a complicated and controversial task.

Today it is well accepted that the extent to which globalization affects asset prices and, more generally, is related to the actual intensity and sensitivity of cross-border flows, regardless of existing controls and restrictions usually at the core of de jure globalization measures.<sup>16</sup> For example, many tightly regulated economies are the recipients and sources of important capital flows (and are therefore financially globalized), whereas other control-free economies are shunned by international investors and, as a result, are isolated from global market swings and trends. In turn, the empirical literature typically measured de facto globalization as the ratio of foreign asset positions (relative price-adjusted cumulative balance of payments flows) to GDP, as in Lane and Milessi-Ferreti (2006 and 2007; henceforth, LMF).<sup>17</sup> It should be noted, however, that the stock size of cross border holdings, while probably a good indicator of geographical diversification and international risk sharing, may not be the best summary statistic of de facto FG in the traditional sense of capital mobility and international arbitrage, since important gross flows in and out of a country over a given year are perfectly consistent with a relatively small net –as well as with small cumulative flows over longer periods. As a result, to the extent that foreign asset holdings largely reflect cumulative flows, intense flows could be consistent with a limited geographical diversification of assets and liabilities. Conversely, the existence of large foreign asset holdings (for example, as a result of capital flight) does not necessarily imply frequent rebalancing and cross-market arbitrage. Thus,

> 15 This section borrows from Levy Yeyati and Williams (2010).

> 16 The literature generally distinguishes between de jure and de facto financial globalization (Kose, Prassad, Rogoff, Wei, 2009): where the former is based on regulations, restrictions and controls over capital flows and asset ownership, the latter is related to the intensity of capital flows and cross-market correlation and arbitrage.

> 17Kraay, Loayza and Ventura (2005) report a similar dataset on country ́s asset positions. An alternative approach to FG relies on price convergence, an application of the Law of one Price to financial markets. Measures within this group point at transaction costs and regulation that inhibit market arbitrage, and usually compare prices of identical or similar assets trading in different markets. On this, see Levy Yeyati, Schmukler and Van Horen (2008) and references therein. LMF and the Chinn-Ito index are the de facto and de jure measures of choice in recent work on determinants and implications of FG (see, i.a., Kose, Prasad, Taylor, 2009 and Rodrik, and A. Subramanian, 2009).

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