International Financial Integration Models, Policy Debates, and Evidences

GLOBAL FINANCE: INTERNATIONAL FINANCIAL INTEGRATION1

InternationalFinancial Integration: Models, Policy Debates, and Evidences

Global finance isinterlinked with financial integration in which the later refers to aspecific phenomenon whereby financial markets in regional and globaleconomies are intertwined together. Financial integration includevarious forms which include sharing of financial information amongmajor financial institutions, raising and borrowing of funds directlyamong financial institutions within international capital markets,sharing of sophisticated technologies through licensing, andparticipating in the domestic financial markets through cross-borderforeign capital flows.

There are financial markets imperfections and because of that,international financial integration globally is thus imperfect. Anexample of this may stem from marginal rate inequality in the casedifferent agents substitutions. Additionally, legal restrictions mayalso hinder international financial integration (Giannetti &ampOngena, 2009). As a result, this could be achieved through theremoval of restrictions that pertains cross-border global financeoperations, which will allow financial institutions to handle theirfinancial operations freely, allow businesses to contribute andborrow funds directly, and also investment of bond and equityinvestors across stale line with minimal restrictions.

The paper therefore, will attempt to examine the topic ofinternational financial integration, which is related to globalfinance, while integrating it with analysis of economic forces andcertain mechanisms that determines foreign exchange rates, the use ofspecific financial derivatives to hedge out foreign exchange risksand exposure, the effects of international financing on financialinstitutions, reasons why multinational enterprise is going global,analysis of balance of payments, differences between cross-borderacquisitions, Foreign Direct Investment (FDI), and Finance ForeignTrade (FFT), and finally the evaluation of International MonetarySystem (IMS) and IMS effect on a country’s economic conditions.

InternationalFinancial Integration: Financial Crisis, Policy Debates, andEvidences

Over thepast few years, financial crisis appear to have become frequent anddisruptive than it had been anticipated in the past. The crises alsoappear to propagate rapidly. The experience has since spur intenseinterest and debates among policy makers in trying to understand therelation between financial integration and financial crises, whiletrying to better assess in general the merits of internationalfinancial integration (Caballero &amp Krishnamurthy, 2009). Thepolicy debates on the merits of integrational financial integrationare proven to be controversial. This is because:

  • One extremely thought out opinion could sustain Integrated Financial Systems (IFS) to improve productive resources allocation, enhance market discipline, foster innovation and entrepreneurship, and assist countries in acquiring insurance against fluctuations in global macroeconomics.

  • On the other extreme end, argument has it that capital free flow widens the gap between the rich and poor countries in terms of wealth, while exposing domestic financial systems to the instability risk.

In recent times, financial crisis experienced in 2008 and itsaftermath revealed that increase in financial markets’ geographicalinterconnection and deepening of the cross-market integration, wascoupled with securitization under-regulation and other financialactivities (Caballero &amp Krishnamurthy, 2009). Subsequently,significant complexities were designed with financial instrumentsthat could end up contributing fuel systemic risk, market efficiency,and exacerbation of cross-border financial shocks transmissions.

  1. Economic Forces and Mechanisms that Determine Foreign Exchange

With regardto international financial integration, there are certain economicforces, which determine global currency rates and how it affectsforeign exchange. Foreign exchange markets dictate exchange ratesthrough a wide range of buyers and sellers. In global retail market,international travel is often predominantly purchased in globalfinancial institutions through brokerages and other Bureau de Changeforms. Foreign exchange is determined through market-based rates ofexchange, especially when the values of two components of exchange,change (Kalemli-Ozcan et al., 2003). A particular currency is likelyto be valuable there is a higher demand for it that is supplied.Subsequently, its value is likely to drop when the demand drops thanits supply.

The mechanismrevolves around the purchasing power of the said currency. The RealExchange Rate should be relative to another currency in response toits purchasing power. Inflation is also one of the economic forces,which dictates global exchange rates, especially in regard toshipping of foreign goods in regard to competition between countries,and as a result, the citizens of a particular country will be forcedto buy fewer commodities than is needed (Caballero &ampKrishnamurthy, 2009). It is thus true to say that countriesexperiencing lower inflation rates than others tend to viewappreciation of value in their currency.

Thirdly,speculation is again another mechanism where future projectionsaffect the current foreign exchange rates. The current increase indemand results in the value of the currency to rise. Exchange ratesmovement, does not always result in economic fundamentals, but aredriven oftenly by financial markets sentiments (Caballero &ampKrishnamurthy, 2009). Change in competitiveness also dictates foreignexchange rates in that the level of competitive for currency valuewould either cause it to drop or rise. Other forces include relativestrengths in relation to other currency forms, government debt of aspecific country, and the balance of payments.

  1. The Effects of International Financing

The capital flows surge among globally industrialized countriesrepresent a wave of global finance even though capital flows havesince been associated with higher growth rates within developingcountries. These countries, however, experience periodic financiallapses and significant crises in global finance (Kalemli-Ozcan etal., 2003). Because of this, it has led to intense policy debates inboth policy and academic cycles on the need to identify the effectsof international financial integration. Some of these effects includeoverextending of domestic lending and undervalued rates of exchange,which is likely to precede global currency crises. There is also thecase of corruption, which is more likely to affect the composition ofcapital flow within a country (Kalemli-Ozcan et al., 2003). There isalso the case of lack of transparency, which is often associated withinvestors. The investors are viewed to destabilize a country’sfinancial strength.

Prosand Cons of International Financial Integration

Academiccycles and policy debates in response to the crisis has inrecent times gained momentum, especially in response to how toenhance the global financial system resilience, while at the sametimes retaining the importance of free, competitive, and integratedglobal financial markets (Kalemli-Ozcan et al., 2003). It isimportant not to assume that international financial integration canyield a lot of benefits in the global economy, and particular throughrendering global financial institutions with stability andresilience.

First,international financial integration elevates global financialsystem’s resilience through risk sharing. Financial opennessenhances both the income risk-sharing and consumption, while itreduces consumption volatility growth (Giannetti &amp Ongena, 2009).With global banking integration, improved risk-sharing offerfinancial integration and increase in foreign capital flows, whichalso benefits giant global economies.

Secondly,economic diversification and allocative efficiency ensures improvedmacroeconomic stability through financial integration. Overalleconomic performance for example, tends to be improved by thecross-border banking (Bekaert et al. 2006). This is done throughensuring productive capital is used in most efficient global firms,and thus reduces the risk of financial crises that stems from theinvestment mispricing risk.

Internationalfinancial integration generally assists financial systems throughallocation of resources across the industrial sectors. This is donein a manner that it improves the overall economic diversification,while it lowers its market volatility. Through this, a diversifiedeconomy will be less prone to global economic recessions, and as aresult, its actual sector thus responds to less as it was anticipatedbefore (Bekaert et al., 2006). While this may not be direct, theresults provides a stable ground to a popular belief that thosecountries that relies excessively on a specific sector of theeconomy, may likely to suffer more at the time of enormous economiccrises.

There are a lotabout the financial integration stabilizing effects. However,financial crises in recent times have since sharpened globalunderstanding of the potential financial integration. Some of thequestions in this regard, may beg for an answer:

  • Does international financial integration elevates the likelihood of financial crises?

  • Does financial integration exacerbate the impact of financial crises?

The answer to both questions is answered with a “yes”. This isbecause first, international financial integration is viewed to be astabilizing force. It is also because stabilizing risks could ariseif IFI driving forces underlies a reflection of global economicimbalances (Giannetti &amp Ongena, 2009). For example, it isreasonable to say that in the United States, securitization marketsand real estate may be argued to reflect on some of the extent ofhigher foreign markets demand, which could result in persistentglobal imbalances through the context of persistence.

Consequently, another of its cons involve foreign asset demand, whichnot only discourage, in the case the United States interests rates,but also push down the risk premium, especially on the risky assets.Additionally, financing low costs increases in turn, the leveragelevels that would lead to exacerbation of systemic risks (Giannetti &ampOngena, 2009). This event for example, proves an important point,which increases global financial system stability, and it should notbe done by pushing back the financial globalization, but by firsthandling the problem that result from global imbalances.

Another of the nuances involves global banking integration.Principally, while it is associated with improved efficiency, anumber of circumstances, for example regulatory arbitrage and a lackof openness in transactions, may result in misaligned incentives,underestimation of social contagion costs, and excessive handling ofrisks (Caballero &amp Krishnamurthy, 2009). It is also evident thatwhile global banking integration is of importance to global financialfirms through lowering costs of external finances, a rapidintegration has help induce these global firms with excessiveleverage (Bekaert et al. 2006). As a result, exacerbate the effectsof financial crises, especially within global corporate sector.

PolicyResponses and Debates to Increased International FinancialIntegration

Global policy debates that comprise the G20, Financial StabilityBoard (FSB), International Monetary Fund (IMF), InternationalOrganization of Securities (IOS), and the Bank of InternationalSettlements (BIS), are all involved with global forum forcoordination, which all signed an agreement on the measures thatshould be followed by the international standard setters and nationalauthorities (Bekaert et al. 2006). For further enhancement of theprocess, these policy debaters, especially the FSB, is entrusted witha task to oversee concrete regulatory advancement in theimplementation of financial agenda. Participation of otherinstitutions such as the IMF, BIS, and IOSCO, proves that they areinstrumental in guaranteeing cross-sectorial coordination.

Some of the challenges posed by global integrated financial systemand the need for international coordination have since beenrecognized. Again, the establishment of policy makers for allcross-border international financial institutions provides a clearinstance whereby there is enhancement in co-operation among globalfinancial authorities (Caballero &amp Krishnamurthy, 2009). There isalso the development of peer reviews in member countries for examplewith the FSB, which aims at ensuring international harmonization(Giannetti &amp Ongena, 2009). The harmonization comprises boththematic and single-country reviews that helps assess the progressand convergence during the implementation of policies andinternational financial standards agreed by financial policy debates.

Policy responsesalso concerns multinational enterprise and balance of payments on theimpact it has on the host country. These multinational enterprisesprovide the country with important financial infrastructure to aid infinancial and social infrastructure. However, the impact is also feltwhen these institutions bring with them ethical conduct relaxed codes(Kalemli-Ozcan et al., 2003). These helps them in the exploitation ofneediness in the, especially in the developing countries.Additionally, is goes against the expectation of providing criticalsupport, which is necessary in the country’s economic and socialimprovement.

When amultinational corporation invest in the host country, the investmentscale is more likely to offer significance. Governments in this case,are indeed more likely to provide incentives to global financialinstitutions in form of incentives, subsidies, grants, and taxbreaks. These are aimed at attracting more investments from investorsinto the host country (Giannetti &amp Ongena, 2009). Consequently,this Foreign Direct Investment (FDI) is however, likely to have someadvantages and disadvantages for the country in question.

The advantagesinclude improvement of balance of payments, which in this case, theinvestment itself will be viewed as a direct capital flow into thehost country. Another advantage will be to provide employment, sourceof tax revenue, transfer of technology, offer national reputation,and increase choices (Caballero &amp Krishnamurthy, 2009). Some ofthe disadvantages will revolve around environmental impact,difficulty in accessing natural resources, increase in competition,and uncertainty in global markets.

  1. International Monetary Fund and its Effects on Economy

Taking IMF to represent a multinational corporation, some of itseffects impact on the host country positively. The quality ofgovernance in these institutions, for example the IMF, helps the hostcountry to derive globalization benefits. Similarly, stability thatthese multinational corporations have on the country revolves aroundmacroeconomic stability (Bekaert et al. 2006). This stability is aprerequisite in ensuring that international financial integrationoffer substantial benefits on the developing countries. IMF, in thisregard, aims at promulgating codes and standards for financialsupervision and transparency, and at the same time, crucialmacroeconomic frameworks.

Conclusion

Internationalfinancial integration, its models, policy debates, and evidences onrelated topics on multinational corporations help in realizing fulleconomic potential in the global market. Even though financial criseshave in the past curtail developing countries, for instance, indeveloping its economy, financial integration has been viewed to helpin lowering intermediation costs, while offering efficient capitalallocation. This has in turn raises economic potential for increasingthese countries growth in their economy.

Finally, financialcrises is a tough reminder that, even though financial integrationmay help improve access to global financial markets, while it reducesthe risk of economic diversification, it may again increase financialcontagion scope across industrialized countries. It is thereforeimportant that arrangement of financial stability keep pace with theinternational financial integration degree of improvement.

References

Bekaert, G., Harvey, C., &amp Lundblad, C. (2006). Growth volatilityand financial liberalization. Journal of International Money andFinance 25, 370-403.

Caballero, R., &amp Krishnamurthy, A. (2009). Global imbalances andfinancial fragility. American Economic Review 99, 584-588.

Giannetti, M., &amp Ongena, S. (2009). Financial integration andfirm performance: Evidence from foreign bank entry in emergingmarkets. Review of Finance 13, 181-223.

Kalemli-Ozcan, Sorensen, B., &amp Yosha O. (2003). Risk sharing andindustrial specialization: Regional and international evidence.American Economic Review 93, 903-918.