Financial Globalization in Emerging Economies: Much Ado About Nothing?

INTRODUCTION

Financial globalization (FG), understood as the deepening of cross border capital flows and asset holdings, has become increasingly relevant for the developing world for a number of reasons, including the consequences of its changing composition on countries' balance sheets, its role in the transmission of global financial shocks, its benefits in terms of financial development, international risk sharing and business cycle smoothing, and the implication of all of the above for macroeconomic and prudential policies. In this paper, we focus on these issues from an empirical perspective, building on, updating, and specializing the existing literature to characterize the evolution and implications of FG in emerging economies.

As conventional wisdom has it, the globalization process has been growing steadily since the mid-1980s, particularly in developing countries (Kose et al, 2010) and has accelerated in the 2000s, with a dramatic increase in cross-border portfolio flows as a fraction of global wealth (Karolyi, 2010). However, this pattern depends on the measure of FG — usually proxied in the literature by the average of cross border assets and liabilities over GDP (FG-to-GDP ratios). As we show in the first part of the paper, a more natural normalization of foreign holdings by host market size (to control for financial market deepening and spurious relative price effects) reveals a more stable FG pattern during the 2000s. In turn, normalizing foreign portfolio asset holdings by total portfolio holdings by residents show that, despite the growing FG ratios, international portfolio diversification in the emerging world are still remarkably low, and have remained stable or declined.