Since the late 1980s, global capital market integration has experienced an exponential surge. Although its benefits for economic growth were touted, evidence of their effectiveness remains mixed.
Financial market integration helps investors maximize their capital allocation by providing access to more investment options; however, this also heightens sensitivity of domestic investments to global economic fluctuations and risks.
Theoretical Background
The recent financial crisis, brought on by rapid spreading tensions originating in one segment of the international financial system and impacting numerous economies and lives worldwide, has reignited debate about globalization. While global financial system development has created unprecedented international capital flows, opinions vary regarding whether this has resulted in benefits to developing nations as intended.
One extreme view asserts that greater market integration promotes growth by improving resource allocation, encouraging entrepreneurship and innovation, improving market discipline and disseminating best practices. Conversely, another extreme view holds that increased market integration increases consumption and output volatility by encouraging herding behavior, fuelling contagion, risk taking and cross-border transmission of financial shocks. Unfortunately neither theory nor empirical evidence offers clear-cut answers; outcomes depend on factors like degree of market integration, quality of domestic institutions as well as other country specific variables.
Theoretical Models
Financial integration enables capital markets to serve as forums where buyers and sellers of various forms of capital such as foreign currency, corporate bonds, government bonds and bank loans meet to negotiate prices for different investment products such as foreign currency, corporate bonds, government bonds or bank loans – thus diversifying investors’ investment options and increasing returns.
Recent experiences of the global financial crisis may have left some questioning whether increased global market integration contributes to greater instability. This is especially the case if its driving forces reflect global economic imbalances.
Model participants from both countries engage in precautionary savings as a response to international financial market volatility, leading to lower domestic consumption levels and an increase in business investment and labor demand in foreign sectors. With greater integration across nations comes closer correlation of responses leading to greater synchronization of business cycles; furthermore this model tests whether neglecting financial volatility shocks leads to underestimation of how integration affects cyclical comovement.
Theoretical Applications
Financial market integration gives investors greater diversification options by providing access to foreign markets, which facilitates risk sharing between domestic economies and those abroad and can smooth economic cycles and financial cycles. It may also lead to improved credit ratings and reduced capital costs; however, no clear causal link can be drawn between integration levels in one country and its growth rate.
Numerous studies have attempted to pinpoint the key elements that drive investor appetite for international investments. Some authors, like Bekaert et al., use an approach which dates the onset of global equity market integration by recognizing “breaks” in important economic series as indicators.
In theory, countries with well-developed institutions and macroeconomic policies could take advantage of increased liquidity provided by international finance. Unfortunately, this has not always been the case in practice – some developing nations that liberalized their capital markets experienced high variability in consumption and output growth rates.
Practical Applications
Financial globalization and deepened market integration has presented new challenges that require international coordination, hence the growth of G20 and FSB as tangible manifestations of these fundamental forces which have transformed global economies.
Empirical studies on global market integration’s effects on emerging economies are numerous and include those by Qiu and Lokhande 2023 and Boamah 2022). To name just two such works.
Studies have demonstrated that more integrated markets are less likely to experience severe financial crises, lending credence to the hypothesis that international financial integration benefits economic growth by encouraging domestic financial sector development and mitigating macroeconomic volatility. At lower levels, however, increasing integration may actually increase consumption growth volatility instead – suggesting it’s imperative to establish good institutions and sound macroeconomic policies before reaping the full advantages of global market integration.
