What Is Financial Integration - Report Example

FINANCIAL INTEGRATION by Student's Name Course Code and Name Professor’s Name University Name City, State Date of Submission Financial Integration Financial integration is a phenomenon whereby financial markets in neighboring, regional and global economies are closely linked together. Financial integration takes various forms including: sharing of best practices among financial institutions; sharing of information among financial institutions; sharing of cutting edge technologies through licensing among financial institutions; borrowing of funds and raising of funds directly in the international capital markets; investing directly in the international capital markets and foreign participation in the domestic financial markets (Johnson,p52,2006). The benefits accruing to financial integration include the efficient allocation of capital, better governance, high investment and growth and risk sharing. The financial integration of financial capital benefits does not reduce the benefits of integration because it builds strong local financial systems for greater growth and investment chances as well as good resource allocation. Financial integration brings forth, gains from efficiency that can be produced among domestic companies due to foreign competition with rivals and this competition therefore can lead to better corporate governance. Financial integration also facilitates the capital flows from well established economies with massive capital to needy economies with limited capital as a solution for a broader base of capital for economic growth of the country (Fabozzi & Modigliani, p33, 2009). The inflows of capital can significantly reduce the cost of capital in the capital poor economies leading to higher investments. Likewise, financial integration reduces macroeconomic activity by helping developing countries move away from the usual production methods that rely greatly on agricultural activities or extractions of the natural resources such as fossil fuels and coal. Financial integration does not help reduce international investments because of its increase since it helps to predict consumption volatility because consumers are risk- averse and need to use financial capital markets as insurance for the risk of their income and so the influence of temporary shocks to income growth on consumption can be lessened. Cross-border flows of capital in industrial nations result from increased financial integration. This increase in financial integration pulls global financial markets close together and exacerbates the presence of foreign financial institutions across the world. A literature review that supports the notion that increasing financial integration can lead to reduction in international investments is that a much higher degree of financial integration can generate a severe financial crisis in neighboring, regional and global economies. In addition, outflows of capital can move from developing countries with poor policies and organizations to countries with well established institutions and better policies (Kolb & Overdahl, p42, 2010). Consequently, financial integration affects capital seeking countries with poor institutional quality and lousy policies. Financial integration can lead to reduction in international investments upon increase of large banks acquiring small banks hence a concentration of capital flows and inadequate funding for developing firms due to unavailability when firms require it most; an inadequate domestic allocation of the capital flows which hinder their growth effects and increase pre-existing domestic distortions; the loss of macroeconomic stability; a high degree of volatility of capital flows and pro-cyclical movements in the short-term capital flows. When it comes to capital flows and lack of access to funds, a number of developing countries are simply left out of the world capital markets since the increases of the flows of capital across borders may be highly concentrated to a small number of recipient countries. Despite increasing integration of national capital markets, they still do not add up to the expectations. Some economies and their markets will do better than others at certain time periods in many countries and this helps to extend the risks. However, the financial integration could lead to more co movement in common risk factors e.g. the real interest changes. If this is so, there will be a significant mutual relationship of the financial capital markets nationally and reduce benefits associated with risk by moving globally. The inefficient allocation of flows of capital comes from pre-existing distortions in the local financial sector. In countries with weak banks i.e. banks with a lower or a net worth that is negative and a poor supervision of the finance system and a low ratio of funds compared to the assets adjusted for risk could lead to an increase in the moral hazard problems associated with deposit insurance (Bodie, Kane & Marcus, p62, 2010). This means that lenders may want to indulge in risky and great concentrated loan operations. The financial integration increase may result in the loss of macroeconomic stability leading to a reduction in international investment due to large capital inflows that have undesirable macroeconomic impacts such as monetary expansion that is massive, pressures from inflation and appreciation of real interest changes and the widening of current account deficits. Pro-cyclicality of short term flows may have adverse effects and increase macroeconomic instability due to advantageous shocks which may bring massive inflows of capital and stimulate consumer usage and expenditure levels that are unattainable in the long run and making countries to adjust in times of unfavorable shocks. Due to the pro-cyclical nature of short-term flows of capital, the economic impacts tend to be bigger and more often in developing countries, showing the relatively narrow production base and greater reliance on basic product exports (Bodie, Kane &Marcus, p46, 2010). A common hostile shock to a group of countries may cause a fall in some countries’ ability to repay loans due to sudden changes in the perception of risk. This can lead to borrowers who are only marginally creditworthy to be removed out of the world financial capital markets. Perceived risk appears to exacerbate more in periods of a large hostile shock than it reduces during a small or a positive shock. Also, asymmetric information problems may trigger herding behavior because partially informed investors may rush to withdraw their cash in response to a hostile shock whose economic consequences for the country are not fully understood. Foreign bank penetration has some disadvantages. First, foreign banks may limit credit to the small firms which tend to operate in the non-tradable industry to a greater extent than local banks and concentrating instead on larger and stronger banks involved in the production of tradable and this leads to a reduction of international investment. If the foreign banks embark on a strategy to concentrate their lending operations only to the most credit worthy corporate and a few household borrowers, their presence will hardly to contribute to an overall increase in the efficiency in the financial sector and reduce international investment. More importantly, by limiting the amount of credit available to small firms to a big extent, they may have an adverse effect on output, job creation and the distribution of income. Foreign banks entry can put pressure on small banks to enter into mergers so as to retain competition. The concentration process which arises as a result of foreign banks acquiring local banks could build monopoly power reducing the general efficiency of the banking system and the availability of loans (Johnson, p22, 2006). A higher degree concentration of banking system in particular may adversely affect output and growth by yielding both higher interest rates spreads with higher loan notes and fewer rates of deposit in comparison to competitive loans and market deposits and a less amount of credit than in a less concentrated more competitive system. Lastly, foreign banks entry cannot stabilize the financial situation of the local banking sector since it hardly causes systemic banking crises less to occur. This leads to foreign banks cutting lines of credit to domestic borrowers during a crisis and many countries have very few options to prevent that occurrence. There are academic literature reviews that are against the notion that increasing integration of financial capital markets will lead to reduce the benefits of international investments. The supporting arguments revolve around four main considerations mainly; the rewards of global sharing of risks and consumption smoothing ; intensified macroeconomic discipline; exacerbated efficiency and stability; positive capital flows on local expansion and investment of the local financial sector associated with the entry of foreign banks. The benefits of risk sharing and consumption smoothing arise by allowing a country to for example, borrow during hard financial times or in declining times for the terms of trade for the country an lend in favorable economic situations such as expansion or following an improvement in the country’s terms of trade. International investments benefits are felt whereby domestic households smooth their consumption path overtime and therefore capital inflows can increase welfare. This role of financial integration is crucial if shocks are temporary in nature. The domestic growth and investment arises where net resources from foreign countries can substitute national saving, raising the capital physical levels for every laborer, high economic growth as well as increasing the living standards of the people. This ability to draw upon the international pool of resources that result from increased financial integration determines the level of domestic investment and growth. The enhanced discipline that arises from the free flow of capital across borders results from increased rewards of good policies and penalties for bad policies inducing countries to follow more disciplined macroeconomic policies and thus minimizes the frequency of policy mistakes. Increased financial integration can act as a signal that a country is willing and ready to adopt sound macroeconomic policies for instance, by reducing budget deficits and forgoing the use of the inflation tax (Pike, Neal & Linsley, p25, 2007). From that perspective, having an open capital account as a result of increased financial integration may encourage macro economic and financial wellness resulting in efficient allocation of resources and higher rates of economic growth. According to the literature review above, the notion that is against the notion that increased financial integration leads to benefits of international investment is more realistic to the main subject. The reason is that the gains achieved from increased financial integration can be rigorous to quantify and hence the notion that supports the notion would be difficult to accomplish. The evidence for this fact is that short term capital flows tend to be more unstable than long term capital flows and hence more conducive to a financial crisis. For example, short term capital flows respond more dramatically to financial disturbances than FDI flows. Also, there is evidence that short term capital flows tend to be pro-cyclical for the developing countries. In regards to countries domestic investment and growth, the evidence shows that countries with open capital accounts experienced a larger increase of financial integration than countries with closed capital accounts and through that channel higher rates of economic growth arise. There is also evidence of a connection between the capital account openness index and expansion but this happens only if countries are already sufficiently open commercially and face limited macroeconomic imbalances. This is a noteworthy result aspect since it brings to the surface the issue of sequencing of reforms. References List 1. Fabozzi F J and Modigliani F (2009) Capital Markets: Institutions and Instruments. Prentice Hall 2. Mishkin F S and Eakins S G (2012) Financial Markets and Institutions. Pearson Higher Education 4. Johnson H J (2006) Global Financial Institutions and Markets. Blackwell Publishers Inc 5. Kolb R W and Overdahl J A (2007) Futures, Options and Swaps. Blackwell Publishing 6. Pike R, Neale B and Linsley P (2012) Corporate Finance and Investment: Decisions and Strategies. Financial Times Press Read More