Financial Liberalization and Crisis in the Age of Globalization

by Muzaffer Vatansever & Mustafa Kutlay (courtesy Turkish Weekly opinion)

“Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically.” Reinhart and Rogoff[1]

 Globalization has turned out to be one of the most controversial topics of our time. It is almost impossible to conclude a debate without touching upon at least one aspect of globalization. Moreover, it is not an easy job to make a comprehensive and adequate definition of it that leads to overselling of this term. Notwithstanding the definitional ambiguity, there is more or less consensus on what economic globalization is: It briefly refers to the abolishment of customs and trade barriers, the surge in technological developments and knowledge, the widespread liberalization and integration of financial markets, and the movements in labour markets (Figure-1)

 Arguably, the most dynamic and unstable part of economic globalization is the financial side of the story. The recent financial crises have clearly demonstrated this fact, and proved that the deterioration in the financial system has the potential to plunge the overall economy into a crisis, per se. For instance, the perversion of the financial globalization had caused huge economic meltdown in Mexico and South Korea even these countries have solid macroeconomic fundamentals at the very beginning of the crises. For example, before the crisis in Mexico, the inflation fell from 130% in 1987 to 7% by 1994; economy was growing at an annual rate of 4.4%; while the government budget was -0.7%. The only problem was the current account deficit with 7.2% of GDP[2]. The uncontrolled and very fast liberalization of the Mexican financial system has paved the way to full-fledged financial crisis. These and the similar other crises brought up one important point into the agenda of world economy: What are the risks associated with capital market liberalization, and in which ways: 

Basic pillars of risk accompanied with capital market liberalization

 1.      The surge in risks due to asymmetric information

 The neo-classical economic theory, which is the main theory that the International Financial Institutions (IFIs) such as IMF and WB rely on, assumes the information in the markets is perfect in the sense that each side of the financial transaction have the same and, moreover, full information about the nature of the transaction in question. Since “all-available information” is used in markets, the funds will move to those with the best investment opportunities, which mean there will not be a misallocation of resources. However, asymmetric information theory, one of the most important contributions to the financial literature, explains why this may not be the case in reality. Asymmetric information is a situation in which one party to a transaction has more or less undistorted information than the other side. For instance, a possible loan seeker knows more on his/her possibility to make monthly re-payments than the possible lender. According to asymmetric information two problems avoid efficient allocation of resources: Adverse selection and moral hazard problems.

 Adverse selection is the problem exists before the transaction occurs. This problem occurs in the marketplace due to the potential borrowers those are the most likely ones to create bad credits risks are selected to be lend. Since they seek out actively for the loan more than the others, because they need the money more than the latter, they have the highest possibility to take the loan, which in turn leads to credit risks and the misallocation of capital.

Moral hazard is the problem exists after the transaction occurs. In financial markets this problem refers to the risk that the borrower might involve in the activities that are immoral from the lender’s viewpoint since they decrease the re-payment possibility of the loan. Again, due to the asymmetric information associated with the financial markets it is not possible for the lender to know the end of his/her money fully.

 As mentioned above the feverish adherents of capital market liberalization ignore the potential of adverse selection and moral hazard problems to impede the well-functioning of financial markets[3]. In fact, the recent financial crises[4] and the already sub-prime mortgage crisis can be seen as the result of asymmetric information. If the information asymmetries are the fact of financial markets, it implies that there always exists the possibility of misallocation of capital; thereby there is room for regulatory institutions and financial controls. It also implies that capital market liberalization is not a panacea for market inefficiencies; on the contrary it may be another impediment to market efficiency and economic growth.              

 2.      Off-balance sheet activities

The second pillar of the risk associated with the capital market liberalization came into being due to the widespread use of off-balance sheet activities. As known, the traditional sources of profit for the banks are the difference between the interest rates they pay to their depositors and charge to their borrowers. However within the two decades mainly due to the capital market liberalization, the very competitive nature of this traditional banking segment urge banks to seek out non-traditional ways to exploit extraordinary profit opportunities. This leads to “financial innovation”, and one most common type of financial innovation is the “off-balance sheet activities” that the banks engaged. For example, non-interest income derived from off-balance sheet activities increased from 7% of the total income of the banks in 1980 to more than 45% today. Briefly off-balance sheet activities refer to the trading of financial instruments and generating income from fees and loan sales. These are the activities that contribute to the profitability of the bank but do not recorded in the balance sheet of the banks. However, the off-balance sheet activities not only enable high profits, but expose the banks to extra risks since it becomes difficult to measure the actual level of the risk. With the wind of capital market liberalization and with the help of lax governmental regulations all around the world, the financial innovation has forced the boundaries of risk taking and increase the adverse selection and moral hazard problems. Once the Collateralized Debt Obligations (CDOs), the financial derivatives, the junk bonds and the swaps are added to the already complex nature of the banking system, it becomes really difficult for regulators to assess the risk levels of the financial system. These risky instruments, when accompanied with the information asymmetries, carry the potential to create a “domino effect” as it is the case in the latest mortgage crisis.

 3.      The difficulties in establishing economic governance mechanisms

What we have today is a really integrated and thereby complicated financial market. This often leads to instability and chaos. As explained above the information asymmetries increase with the capital account liberalization and the conventional IFIs are not only inadequate in dealing with financial fluctuations, but also suffer from the lack of legitimacy. This situation underlines the deadly need for “new economic governance” mechanisms. As a matter of fact, establishing these kinds of institutions is big hurdle due to the huge differences between emerging and developed countries. As Rodrik and Subramanian emphasize, institutional reform process is of great difficulty due to diversified interests and benefits of nations[5]. Moreover, “one-size fits all” types of institutions are not the appropriate ones to challenge the risks directed by capital market liberalization.  

Looking Ahead

 It can, plausibly, be said that the capital market liberalization has created three important unexpected/unwanted consequences. First, it increased the asymmetric information problems in the marketplace, which in turn caused instability[6] and impeded economic growth[7]. Second, it contributed to the excessive risk taking by financial institutions. Thirdly, it created a deep “economic governance” problem due to inadequate prudential supervision systems. Especially this one, establishing the appropriate risk assessment systems, stands as one of the major challenges in front of the world economy in the age of globalization.   
Muzaffer Vatansever, ISRO, muzaffer.vatansever@gmail.com

Mustafa Kutlay, ISRO, mkutlay@usak.org.tr

 

Footnotes:
——————————————————————————–

[1] Reinhart, Carmen M, and Kenneth S. Rogoff, 2008, “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises,” National Bureau of Economic Research, Working Paper No. 13882.

[2] Mishkin F. S, “The Next Great Globalization,” Princeton University Press, 2006, pp: 76–77.

[3] Stiglitz J. E, 2004, “Capital-Market Liberalization, Globalization, and the IMF,” Oxford Rewiev of Economic Policy, vol. 20 no. 1

[4] Mishkin F. S, 1999, “Lessons from the Asian Financial Crisis,” National Bureau of Economic Research, Working Paper No. 7102.

[5] Rodrik D, Subramanian A, 2008, “Why Did Financial Globalization Disappoint?”, http://ksghome.harvard.edu/~drodrik/Why_Did_FG_Disappoint_March_24_2008.pdf

[6] Actually, capital market Liberalization has contributed to the rise of consumption volatility as Kose, Prasad, and Terrones demonstrated, which is clearly against the neo-classical theory. See: Kose, M. Ayhan, Eswar S. Prasad, and MarcoE. Terrones, “Growth and Volatility in an Era of Globalization,” IMF Staff Papers, 52, Special Issue, September 2005.

[7] Stiglitz J. E, 2004, “Capital-Market Liberalization, Globalization, and the IMF,” Oxford Rewiev of Economic Policy, vol. 20 no. 1, p. 59.

Copyright © 2005     Journal of Turkish Weekly     http://www.turkishweekly.net/comments.php?id=2882

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