The Benefits of Financial Globalization

The Benefits of Financial Globalization :-

Increased international capital mobility has both potential benefits and costs. Most economists agree that the two main benefits are inter-temporal trade and risk diversification. Inter-temporal trade allows for smoothing spending over time.

For example during his working life a person may reduce his current income and save in order to maintain a high level of consumption during retirement, or a student may take out a loan so he can consume comfortably today and pay back this loan by foregoing future consumption when his income is high.

In a similar fashion a poor country like Bangladesh or Nigeria can borrow funds in the global capital market in order to spend more than its current national income level and repay these funds in the future when domestic income is higher. Rich countries on the hand can lend funds through the global capital market so that they can maintain the high level of consumption they enjoy now into the future.

Inter-temporal trade only helps to smooth consumption if the funds a country borrows or lends are invested in profitable projects that bring a higher future income. A student may take out a loan to get an education to provide a higher future income and the means to pay back the loan. This is less likely if she squanders the money on the high life. In the same manner funds that flow into a low income country must also be partly invested in the domestic economy in a way that promotes future growth. Of course lenders are also concerned about the soundness of these investments since they expect to be repaid.

But, why should wealthy countries provide capital to less fortunate countries? The four decades preceding World War–I show why international capital should flow from rich to poor countries and highlight the benefits of inter-temporal trade. The main economic powers at that time included the United Kingdom, Germany, and France. They had built up high levels of capital through industrialization but the returns on domestic investment had tapered off. This so called diminishing returns to capital is a natural occurrence in an economy.

Consider the effects of the first machine provided to a worker – it makes him much more productive but with each additional machine provided the worker’s additional output declines. When a worker who already operates ten machines is given an extra machine it will not make him much more productive.

As returns on investment declined in Europe, lenders started to look elsewhere. The emerging economies of the Americas such as Canada, Argentina, and the U.S were in dire need of funds to build railroads and ports and link agricultural production to cities. So capital flowed in vast amounts from the U.K, Germany, and France directly into the Americas. In 1880 the U.K’s net outflow of capital was about 5% of its total income which by today’s measures is very large. By 1913 it had grown to almost 10%. As a result Argentina became one of the world’s richest countries. Her per-capita income grew from 40% that of the U.K in 1870 to 75% in 1913. This episode of financial integration from 1870 to 1913 is referred to as the “First Age of Globalization” and is used as an example of how inter-temporal trade led to increased world growth.

The second benefit from financial globalization is portfolio diversification. This refers to the reduced risk to a lender who places his savings in various assets of different characteristics not putting all his eggs in one basket.

A global capital market means savers are not restricted to domestic assets but can diversify their portfolio by investing abroad. This makes investors less vulnerable to fluctuations in the domestic economy. Portfolio diversification has increased dramatically since the 1970s as many countries have reduced restrictions on cross-border capital mobility. Banks and mutual funds allow even small lenders such as private citizens to invest in foreign stocks and bonds. In 2004 the U.S foreign assets position was valued at almost 10 trillion dollars. That figure is staggering considering it corresponds to more than 80% of total U.S income in 2004. Compare that to 1982 when the U.S foreign assets position was only around one-fourth of the country’s income. Proponents of financial globalization argue that this increased diversification in asset holdings has greatly reduced risk in financial markets.