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# **I. Introduction**

The worldwide financial crisis has dramatically driven home the downside of financial globalization. Many emerging market and developing economies had to grapple with surges of capital inflows earlier in this decade and are now experiencing a sharp reversal of those inflows. Financial linkages have served as a channel for the global financial turmoil to reach their shores. This will no doubt re-ignite the fierce debate about the merits of financial globalization and its implications for growth and volatility, especially for developing countries.

In theory, financial globalization should facilitate efficient international allocation of capital and promote international risk sharing. These benefits should be much greater for developing countries. These countries are relatively capital scarce and labor rich, so access to foreign capital should help them increase investment and grow faster. Developing countries also have more volatile output growth than advanced industrial economies, which makes their potential welfare gains from international risk sharing much greater.

However, the empirical literature has not been able to conclusively establish the growth and stability benefits of financial integration. In particular, cross-country studies have not yielded robust evidence that financial openness has a positive effect on growth. Studies using microeconomic (firm- or industry-level) data or those that look at specific events such as equity market liberalizations do detect significant growth effects, but it remains an open question whether these effects scale up when one considers the more general concept of financial openness and its effects on growth. Moreover, for developing countries with low to intermediate levels of financial openness, there is equally sparse evidence that financial integration has delivered its other presumed benefit--improved risk sharing and better consumption smoothing.

Kose, Prasad, Rogoff, and Wei (2009) survey this extensive literature and propose an alternative framework for analyzing the macroeconomic implications of financial globalization in order to pull together the different strands of evidence. These authors point out that in theory financial globalization should catalyze domestic financial market development, improve corporate and public governance, and provide incentives for greater macroeconomic policy discipline. Such indirect benefits may be more important than the traditional financing channel emphasized in previous analyses. Indeed, recent work stimulated by the phenomenon of global current account imbalances suggests that developing countries that are more open to certain types of financial flows but overall are less reliant on foreign capital and finance more of their investment through domestic savings have on average experienced better growth performance.<sup>2</sup> A major complication, however, is that there seem to be certain “threshold” levels of financial and institutional development that an economy needs to attain before it can get the full indirect benefits and reduce the risks of capital account liberalization. It has generally been the case that industrial countries—which typically have better institutions, more stable macro policies, and deeper financial markets than developing countries—have been the main beneficiaries of financial globalization. This has led many authors to argue that

> 2 See Aizenman, Pinto and Radziwill (2007), Gourinchas and Jeanne (2007) and Prasad, Rajan, and Subramanian (2007).