Global financial integration
is a double edged sword that can be both beneficial and detrimental to the
world economy, depending on the policies of each country.
Short-term capital flow
Short term capital flow has
a destabilizing effect on an economy, as brought up by John Maynard Keynes.
With reference to the Open Economy Trilemma, an economy cannot maintain all
three of these: capital control, independent monetary policy and fixed exchange
rate. Hence, global financial integration resulted in the undermining of a
countries’ ability to maintain fixed exchange rates or to use monetary and
fiscal policies to maintain full employment. Hence the financial instability
occurs as the financial markets are subject to bouts of euphoria and pessimism.
Firstly, free flow of short
term capital flow makes financial products more exportable because they are
accessible to foreign investors and the total assets held by foreigners
increased over the years as financial borders evaporated. This happened as
banks became global players, financing corporate and individual activities
worldwide and operating on world financial markets. On its own, this is not
such a bad thing. However, financial globalization occurred in parallel with
the rise of risky financial practices. In order to sustain growth and to
increase revenue, major banks expanded their activities to include all
financial transactions, even the most speculative and risky ones, taking more
risks while removing them from the balance sheets just because it was allowed
by the banking regulations at that time. The banks created complex financial
products and hedging instruments that allowed them to sell a portion of risky
subprime securities.
What is the role of policies in this?
Along with national
policies, one distinct example of global financial integration showing
financial instability is the case of the 2008-2009 subprime crisis in the
United States, where half of all U.S. individual loans were granted without
income verification, as banks were increasingly deregulated, hence encouraging
further speculation in the asset market and led to the eventual bursting of the
bubble. People defaulted on their loans and banks soon went bankrupt. This not
only affected the American economy, but that of the entire world as investors
in multiple countries held identical assets. It affected international trade
too as letters of credit did not get financing. As the US economy suffers, it
affected those highly dependent on exports to US, hence further exporting the
financial problem to other parts of the world, resulting in financial
instability due to global financial integration.
Abrupt withdrawal of foreign financing
Secondly, the free flow of
short term capital mobility could lead to a countries’ vulnerability to sudden
withdrawal of foreign financing, which is detrimental to the country because of
the drastic depreciation of the exchange rate that will result. For example, there
was a false alarm in China about the prospect of an economic meltdown due to a
poorly handles shift in currency policy and bursting of an equity bubble. As
China tweaked the exchange rate peg with the dollar, making renminbi (RMB)
float in a wider band, it resulted in market panic that China was entering in
to a currency war, resulting in capital outflow and the stock market was
affected. China then had to intervene to prop up the RMB through drawing from
reserves to stop it from falling too fast.
Whether or not we like it, global financial integration is a fact of the 21st century. We can only hope for global leaders to have enough foresight to maneuver the tricky economic landscape and create effective policies that benefit as many people as possible, if not everyone. On that note, there are many things awaiting us as America elects her new president. Talk about global financial integration - we are not spared from this drama since our currencies and investments are at stake.
