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Financial Globalization in Emerging Countries: Diversification vs. Offshoring

Sergio Schmukler's picture

Starting in the early 1990s many emerging economies have embraced financial sector reforms and liberalization. As a consequence, they have become more financial globalized, triggering an important debate about the pros and cons of this process and its relation to financial crises. Notwithstanding all the attention, there are different dimensions of globalization, which are many times not clearly defined and which might add noise to the discussion.

In a recent World Bank policy research working paper and VoxEU column, we argue that there are at least two interconnected, albeit essentially distinct facets of financial globalization. The first one is financial diversification, that is, the cross-country holdings of foreign assets and liabilities. The second one is financial offshoring, that is, the use of foreign jurisdictions to conduct financial transactions. While the former focuses on who holds the assets, the latter deals with where the assets are transacted.

During the period 2000-09, emerging countries continued their process of financial globalization through diversification. Foreign assets and liabilities increased, as domestic residents invested more abroad and foreigners invested more at home. Moreover, the nature of the integration into the global financial system changed in several important respects. Emerging countries in particular reduced the extent of credit risk, making themselves less vulnerable to external financial shocks.

Despite this increase in diversification, the extent of offshoring did not expand as consistently across markets or across emerging countries. Whereas in the 1990s emerging countries increased their use of international markets for their financial transactions, in the following decade mixed patterns were observed. There is significant heterogeneity in the trends regarding the use of foreign markets as a percentage of GDP as well as relative to the use of domestic markets. For example, while the corporate sector of many countries increasingly used foreign debt markets, governments started using domestic debt markets more intensively. Domestic equity markets in some regions, but not in others, also gained more relevance.
The continuing integration of emerging countries into the global financial system poses many questions to policymakers. What are the net effects of globalization? On the one hand, it allows agents to diversify risk and tap into other investment opportunities. It also allows firms and governments to reduce the cost of capital by accessing funds that would otherwise be hard to obtain. On the other hand, globalization has several potential negative spillovers, which need to be understood in more detail (let alone netted out from the benefits). One possible negative spillover is the migration of activity to international markets, thereby reducing the financing and trading activity at home. Since not all companies can access international markets, this migration can generate negative domestic spillover effects. However, the underdevelopment of local markets is unlikely due to the globalization process alone.

Does financial globalization entail more risk? On the equity side, the answer appears to be negative. On the debt side, globalization might entail exchange rate risk, though in some cases it might reduce maturity risk. Hence to reduce exchange rate risk, domestic markets seem to play an important role. Moreover, what is the relation between domestic and international markets? Do domestic and international capital markets act as complements or substitutes? The evidence suggests that they are complementary.

More broadly, though, what is the driver of the globalization process? Is it just a search for more and cheaper capital from segmented markets? Is it a quest for better corporate governance? The literature puts forward arguments supporting both, and some evidence suggests that the former cannot be rejected. Furthermore, because several of the trends are similar across countries, what is the role for domestic policymaking given these secular forces? These questions remain unanswered and call for further research.