THE BENEFITS OF FINANCIAL INNOVATION

HAZARDSANDPRECAUTIONS:TALESOFINTERNATIONALFINANCEGaryClydeHufbauerandErikaWadaInstituteforInternationalEconomicsSeptember1999InthewakeoffinancialcrisesinMexico(1994-95),Asia(1997-98),Russia(1998)andBrazil(1998-99),respectedobservershavequestionedthebenefitsofwide-openinternationalcapitalmarkets(Bhagwati,1998;Krugman,1998;Rodrik,1998;Eichengreen,1999).Ourpurposeistoidentifytruehazardsandsuggestappropriateprecautions.THEBENEFITSOFFINANCIALINNOVATIONInternationalfinancialmagnitudeshaveexpandedfarmorerapidlyoverthepasttwentyyearsthaninternationalmerchandisetrade(seethecomparisonsinTable1).Moreover,financialcriseshavebeenfrequent(byhistoricalstandards)duringthesetwodecades.Ontheotherhand,financialinnovationranksamongthefoundationsofstrongeconomicperformance,alongsidehighsavings,disciplinedbudgets,lowinflation,goodeducation,andinformationtechnology.Countriesdifferenormouslyintheirdegreeoffinancialmaturity.Atoneextreme,incountriesatalowstageoffinancialdevelopment,banksdominatethefinancialsystemandeachbanklendsmostofitsfundstorelatedbusinessfirms.Thestockandbondmarketsaresmall,futuresandoptionsmarketsdonotexist,privatemutualfundsandpensionfundsaretiny,securitizedmortgagesandequipmentleasingareunknown,andconceptofamarketforcorporatecontrol(throughhostilemergersandacquisitions)seemsalien.Inthesesettings,itisnosurprisethatscarcecapitalispoorlyallocated,whilebankspaylowornegativerealratesofinteresttohouseholds.Attheotherextreme,incountrieswithmaturefinancialsystems,the“missing”financialmarketsarewellestablished.Capitalisallocatedmoreefficientlybetweencompetingusesandhouseholdsearnbetterreturnsontheirsavings.Asimpleexampleillustratesthevalueofefficientcapitalmarkets.IfcountryAhasnetannualsavingsequalto20percentofGDP,andfinancialintermediariesallocatethosesavingssoGaryHufbaueristheReginaldJonesSeniorFellowandErikaWadaisaResearchAssociateattheInstitute.2thatthereturnoncapitalis5percentonaverage,capitalformationwillcontribute1.0percentannuallytonationalgrowth(20percenttimes5percentequals1.0percent).Bycontrast,ifcountryBhasnetannualsavingsequalto15percentofGDP,butfinancialintermediariesallocatethosesavingssothatthereturnoncapitalis15percentonaverage,capitalformationwillcontribute2.25percentannuallytonationalgrowth(15percenttimes15percentequals2.25percent).Inroughterms,thedifferencebetweencountryAandcountryBisthedifferencebetweenJapanandtheUnitedStates,orbetweenKoreaandAustralia,overthepastdecade.JapanandKoreasavefarlargeproportionsofGDPthantheUnitedStatesandAustralia,buttheirfinancialsystemsarerelativelyimmature,andcapitalispoorlyallocated.HighsavingsarenottranslatedintofasterGDPgrowth,orevengoodreturnstothriftyhouseholds.LIBERALIZEDFINANCIALSERVICEMARKETSWhilethebenefitsoffinancialinnovationandefficientcapitalmarketsarestraightforward,inordertoacquirethesebenefitsacountrymustliberalizeitsfinancialservicemarkets,allowingnewfirmstoenterandcompete.Effectivecompetitionoftenrequiresthepresenceofforeignfinancialfirms.Theprocessofliberalizationandcompetitionentailscosts–coststhathavealargerpoliticalthaneconomicdimension.Inparticular,thepowerinherentinfinancialintermediationcanbetranslatedintowiderbusinessandpoliticalinfluence.Theleadersinsomesocietiesareunwillingtoseethisfinancialpowertransferredto“themarket”,especiallynotamarketwithsubstantialforeignpresence.Inaddition,competitionwillresultintheabsorptionandclosureofestablished,butpoorlyrun,banks,insurancecompanies,andotherfinancialservicefirms.But,ineconomicterms,thebenefitsfarexceedthecosts.DobsonandJacquet(1998)estimatethat,onaglobalbasis,overa10yearperiod,liberalizationandcompetitioninfinancialservicemarketscouldbringbenefitsof$1.3trilliontohouseholds,businessfirmsandgovernmentsintheformoflowercosts,higherqualityservices,andmorechoice.Table2portraysjustonesliceofthesebenefits–thereductioninnetinterestmarginsresultingfromforeignbankcompetitioninlocalmarkets.Usingcountrycross-sectionanalysis,FrancoisandShuknecht(1999)findthatmovingfromaclosedtoarelativelyopenfinancialserviceregimeisassociatedwithanincreaseinnationalGDPgrowthrateof1.3to1.6percentannually.Tosummarize,economicevidenceisbeginningtoshowthatopenmarketsforfinancialservicestranslateintohighernationalincome,muchthesameasopenmarketsforgoods.Thecontroversysurroundingrecentfinancialcrisishasfocusednotsomuchonfinancialservicemarketsasfreeinternationalcapitalflows.Tothatsubjectwenowturn.3FREECAPITALFLOWSRisksareinherentinthefreeinflowandoutflowofcapital.InthewakeoftheAsian,RussianandBraziliancrises,manycommentatorsblameshort-termcapitalmovements.Specifically,itisclaimedthatbanksandportfoliomanagersexhibitstrongherdinstincts;thattheseinstinctscreatemaniasandpanicsinequity,debtandforeignexchangemarkets;andthatfinancialcrashesinonecountrycanspreadlikebubonicplaguetoanother.Withthesehazardsinmind,manycommentatorswanttolimittheinflowandoutflowofshort-termcapital,whilekeepingtheadvantagesoffinancialinnovationthroughliberalandcompetitivefinancialservicesmarkets.Inprinciple,itmightbepossibleforacountrytodevelopamaturefinancialsyste