"Financial Integration Without A Proper Set Of Preconditions Might Lead To Few Growth Benefits And More Output And Consumption Volatility." (Prasad, Rogoff, Wei, And Kose, 2003) Discuss.

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"Financial integration without a proper set of preconditions might lead to few growth benefits and more output and consumption volatility." (Prasad, Rogoff, Wei, and Kose, 2003) Discuss.

Introduction

The question refers to financial integration which is basically a country's links to international capital markets (Prasad, Rogoff, Wei, and Kose, 2003). This can be identified by Capital account liberalization (CAL) as well as Actual capital flows

(ACF). It is important to note that one does not ultimately require the other although in many industrialized countries i.e. western countries there is evidence of both ACF and CAL. It is a generally accepted fact that financial integration has increased over the last few decades both in developed and developing nations with capital account restrictions been lifted in many countries (Lane and Milesi-Ferretti, 2003).

The question states that increased financial integration can, without the proper pre condition in place, lead to increased volatility. This is mainly in reference to the developing world where increased financial integration as a result of globalisation has not only led to increased growth and economic activity but has also in some cases preceded economic crisis and output and consumption volatility. The paper cited in the question found that countries could increase the benefits gained from financial integration and protect themselves against crisis by adopting better policies. According to the study these include sound property rights and rule of law as well as good supervisory frameworks, low levels of corruption, high degree of transparency and good corporate governance (Prasad, Rogoff, Wei, and Kose, 2003).

However these conclusions are based on the assumption that these pre conditions must be in place before financial integration. Could it not be the case that increasing financial integration leads to better policies and practices, through adoption of best practice from the west or that only some of these pre conditions such as developed financial sector important pre requisites? Is it a case that the countries which have experienced consumption and output volatility have been resistant to change and have ignored the advice of western firms and countries and continued with a "we know best" style approach to policy? Or could these periods of volatility be in effect teething problems and apart of a learning curve? This essay will now analyse economic theory and empirical evidence to see if there is theoretical and empirical evidence to support the views expressed by Prasad, Rogoff, Wei, and Kose, 2003.

Analysis of Theory

Financial integration is basically talking about an individual country's links to international capital markets (Prasad, Rogoff, Wei, and Kose 2003). As stated in the introduction there are two ways of measuring this Capital account liberalization (CAL) and Actual capital flows (ACF). CAL refers to a change in policy that opens a country up to capital flows from other countries i.e. reduces restrictions. This is also some times referred to as De jure restrictions on capital flows. Actual capital flow is basically the actual amount of capital flowing across borders and is also referred to as de facto financial integration. Basically this is measured by taking how much, percentage wise, the sum of capital in flows and out flows in terms of foreign assets and liabilities make up of a country's GDP (Lane and Milesi-Ferretti, 2001). This is the preferred method of measuring financial integration as it makes cross country comparisons easier as there could be restrictions on paper that are in actual fact easy to get round and so in actual fact there is a lot of capital flowing across the border such as in South America. On the other hand there could be relatively few restrictions but in actual fact not very much cross boarder flow of capital, as found in parts of Africa (Prasad, Rogoff, Wei, and Kose 2004).

In theory gains from increasing financial integration can include an increase economic growth, through direct and indirect channels and also reduce macroeconomic volatility. The following diagram illustrates how financial integration can increase economic growth:

Direct channels

In a closed economy the only money available for investment is the domestic savings, in theory when a country opens itself up to the international financial markets the money available for investment increases. This is because of the difference in returns on capital between the north and south. This was illustrated by Lucas (1990) who showed that the marginal productivity of capital was far greater in the southern under developed economies than those in the Northern, developed economies. The Lucas paradox is in reference to the fact that in actual fact there is far less capital moving from North to South than one would expect considering the differences in returns. However theoretically financial integration should lead to a mutually beneficial situation where by the capital short economies which become increasingly more financially integrated with the international economy receive increased investment and thus are able to increase productivity and achieve economic growth. This is because the richer more developed countries receive a far greater return on their investment than they would in more capital intensive economies. This has the effect of reducing the risk free rate of capital in developing nations.

Henry (2000) showed using international asset pricing models that by opening up stock markets risk allocation is improved. This is because of the benefit of opening markets up enables investors to diversify more and to share risk. This helps protect against volatility and encourages companies to increase investment as the risk is reduced by spreading assets across countries. This increased investment stimulates growth and also as more capital is moving around this increases the domestic stock markets liquidity further reducing risk again thus lowering the cost of acquiring capital for investment purposes.

A more financially integrated economy is also more attractive to foreign direct investment (FDI). This results in a sort of copying the best approach where by the developing nation benefits from interactions with the developed economy and can imitate the current best managerial approaches as well as benefiting from technology from abroad without having to develop it themselves from scratch. This can, provided human capital is high enough, result in increases in efficiency and thus