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There are benefits to a financial system that's open to foreign competition: a global market for bonds, a floating currency and foreign direct investment. But it's a mistake to assume these benefits are without risks or costs.
"Liberalisation is not a shortcut for development, certainly not in the financial sector. With regard to financial sector development in particular, make sure your prudential regulations are in place, and you deal with corporate governance issues before you try to undertake any large-scale financial liberalisation," says Ramkishen S. Rajan, Yong Pung How Professor at the Lee Kuan Yew School of Public Policy.
Inefficient financial systems
Complexities of Financial Globalisation, which Prof Rajan wrote along with his co-authors Tony Cavoli and Sasidaran Gopalan, is a broad survey on the effects of a push towards more globalised financial systems in Asia's emerging markets, a subject area often neglected in the literature.
"Most work on international finance tends to take an advanced country approach. So the assumption is the system is working well and that there are no frictions, or other problems with the financial system," says Prof Rajan.
While the book doesn't offer sweeping policy prescriptions, it does document the complicating factors many developing economies face.
"Most of the emerging market economies don't have efficient financial systems, so even if capital flows come into the country, they don't necessarily get mediated well, either because of poor internal corporate governance or because of poor prudential regulation," he adds.
A cautious approach
Prof Rajan suggests that Singapore’s experience might be something of an example for emerging markets in the region. The city state was cautious about liberalising its financial sector, even as it loosened the strings on other sectors. And it still pegs its currency to a trade-weighted basket of other currencies.
While many western governments tout the value of a floating currency, there are reasons why many Asian countries are less inclined to do so, Prof Rajan explains. Bitter experience from the 1998 Asian Financial Crisis has made some risk-averse. For many firms in the region, invoicing takes place in US dollars, which means a fluctuating currency can be a problem.
Many buildings were left unfinished after construction was halted during the 1997-1998 Asian Financial Crisis. (photo: neajjean)
“Australia, New Zealand used to say ‘look, look at us, we have moved to an era of flexible exchange rates, we hardly intervene, we’re like advanced economies, no problem’. But emerging Asia has generally been very concerned about it. Even today, they still intervene very significantly,” Prof Rajan says.
Governments in developing economies should also be more careful about how they evaluate the impact of foreign direct investment (FDI), which is an investment in the form of a controlling ownership in a business in one country by an entity based in another country. Too often, FDI is seen as a proposition with little downside: a foreign company comes in, builds a factory, and jobs and government revenue inevitably follow. Increasingly, though, FDI comes in the form of mergers and acquisitions, which doesn’t always have the same benefits.
“You could certainly make an argument that if I buy a stake in a Thai company and the owner decides to set up a new company, wouldn’t that lead to greater investment and growth? Sure, but that’s an assumption. They could take that money and throw themselves a party,” Prof Rajan adds.
Financial globalisation in the COVID-19 era
The global financial turmoil brought on by the COVID-19 pandemic reinforces the need to tread carefully. Bond markets are a key example. Open bond markets have benefited many emerging economies, but many overseas investors have simply sold off their holdings now that troubled times have hit.
Prof Rajan believes the key for both bond markets and for other areas of any financial system is to come up with policies that help to maximise the benefits, while minimising the risk.
“It’s really an issue of how we move from the extremes of global investment generally, whether it’s trade, investment or finance. It could be beneficial potentially. But how do we harness these benefits while minimising the cost is what is important,” he says.
Photo by Braden Jarvis on Unsplash