Managing financial integration and capital
Joshua Aizenman Brian Pinto
4 October 2011, VOX.EU
With the merits of global financial integration in question, this column reviews the policy responses
and lessons from two decades of experience in emerging markets in connection with opening up
their economies. It also outlines the steps countries have taken to reduce exposure to financial
crises and argues that these may be the best option until the collective resolution of global
imbalances and capital flow regulation by the G20.
Had fiscal and financial volatility not spiked in the US and Eurozone this August, it is a safe bet that
the topic of how emerging markets should manage the capital inflows unleashed by quantitative
easing would have featured prominently at the 2011 Annual Meetings of the IMF and World Bank.
As events transpired, the Eurozone debt crisis stole the show, but the issue of capital flows has not
been buried. Indeed, the September 2011 issue of the Global Financial Stability Report (IMF 2011,
p 28) notes: “…with the increase in global stability risks, emerging markets may face an external
shock in the form of a sharp reduction in global growth and a reversal in capital flows….”
In short, the spectre of a sudden stop has not been exorcised. In fact, the Brazilian real dropped
some 9% against the US dollar the week of 14-21 September 2011, the biggest weekly plunge
since 2008. Nevertheless, based on a recent survey (Aizenman and Pinto 2011), we submit that,
this time, things are different. This is mainly because emerging markets crossed a threshold after
their own string of crises during 1997-2001 and that, this time, there are well-defined pressure
points emerging-market policymakers need to worry about in managing capital inflows.
According to Bretton Woods II, global imbalances were mutually beneficial because emerging
market current-account surpluses provided the US with a cheap source of funding for its deficits
while the US in turn allocated emerging-market savings efficiently and powered emerging-market
growth as the demander of last resort (Dooley et al. 2003). But the global financial crisis of 2008-09
has chipped away at the viability of this interpretation by exposing the weaknesses of the US
financial system. Besides, emerging markets have become the engine of global growth even as the
US and the Eurozone are faltering. But, as we caution in the opening paragraph, emerging markets
have by no means decoupled from the advanced economies and are still vulnerable to capital flow
Capital flows: Growth versus crisis
In looking anew at how emerging markets should respond to the resurgence of capital inflows, a
good starting point is the past two decades. Over this period, financial integration is less likely to
have supported fast growth than fuelled a costly macroeconomic crisis. Four results are worth
noting on the growth front.
First, fast-growing countries tend to self-finance their growth (Aizenman, Pinto, Radziwill
2007, Prasad et al. 2007) and on average run current-account surpluses.
Second, this finding does not change over the 1990s in spite of the massive financial
liberalisation within emerging markets.
Third, in addition to these empirical findings which contradict the predictions of neoclassical
growth theory, simulations based on a neoclassical model find paltry gains in switching from
autarky to full capital mobility – unless financial integration somehow contrives to significantly
bridge the large gap in total factor productivity levels (or technology) between advanced and
emerging-market economies, which is by no means automatically assured (Gourinchas and Jeanne
And fourth, perhaps not surprisingly, the type of financial inflow matters. Net portfolio debt
and equity inflows tend to have a negative effect on manufacturing growth, although the effect
varies over time and depends upon whether a given sector is financially constrained or not. FDI
inflows tend to have the most positive effects overall, on aggregate manufacturing as well as
financially-constrained sectors (Aizenman and Sushko 2011).
On the crisis front, the most eloquent testimony on the tendency of financial integration to end up in
tears is the series of emerging-market crises which began with Mexico in 1994-95, Thailand and
East Asia in 1997, and then went on to engulf Russia (1998), Brazil (1999), and Argentina and
Turkey (2000-01). Without a doubt, these crises also laid bare the domestic vulnerabilities in these
countries. What is impressive is the recognition by emerging markets that they were on their own –
high flying proposals about a sovereign debt restructuring mechanism and debt instruments with
equity-type features did not take root. These countries accepted that they would have to assume
primary responsibility for correcting the situation.
How did emerging markets react to their crises?
In the 1980s, most emerging markets exhibited low financial integration, rampant capital controls
combined with fixed exchange rates and active monetary policy, and low levels of international
reserves to GDP. This configuration changed dramatically as emerging markets learnt first from the
crises of the 1980s, and then from those of 1997-2001.
First, they moved to the middle ground of the policy space defined by the macroeconomic policy
trilemma, which refers to the ability to accomplish at most two out of the following three policy
objectives: financial integration (or an open capital account), exchange-rate stability (or a fixed
exchange rate), and monetary policy autonomy (or the ability to choose interest rates). They
sharply increased their degree of financial integration after 1990, while settling for moderate levels
of exchange-rate flexibility and monetary policy autonomy (Aizenman et al. 2009). In contrast,
industrialised countries opted for a very high degree of financial integration, relatively stable
exchange rates (especially after the adoption of the euro in 1999) and correspondingly lower
Second, emerging markets embarked on a massive accumulation of international reserves, from
single-digit percentage levels of GDP in the 1980s to 15-30% for most with some, like China, Hong
Kong, and Singapore, exceeding 50% by 2007. Leading factors accounting for the large hoarding,
beyond mercantilism, include self-insurance, especially after the crises of 1997-2001 when the
scale and speed of capital flow reversals shocked most observers and exposed hidden balance-
sheet vulnerabilities in domestic banks and the corporate sector, leading to severe recessions and
huge fiscal bailout costs. In response, emerging markets moved to the trilemma middle ground,
built up reserves and adopted what we label a “public finance approach” to financial integration and
managing macroeconomic risks; their evolving response is outlined in Table 1 below. The public
finance approach has three elements:
One, putting the fiscal house in order to create space for addressing tail risks.
Two, recognising that good management of the public finances is not enough – steps have
to be taken to minimise contingent liabilities from private sector balance sheets, especially in the
Three, strengthening financial sector regulation and supervision.
The efficacy of self-insurance combined with the public finance approach has been demonstrated
by the surprising resilience of emerging markets during the global crisis of 2008-09 (Development
Committee 2010). To put this in context, considerable scepticism had been expressed (Caballero
2003) about whether it was feasible at all for emerging markets to self-insure against a sudden
Managing risks from capital flows
How should emerging markets respond to the resumption of large capital inflows in the wake of
quantitative monetary easing in the advanced economies? The fact that the global crisis originated
in the financial sector of the US underlines the need for policymakers to balance the interests of the
financial and real sectors. With vulnerability from capital inflows endogenous to what the private
sector does, an optimal approach calls for a mixture of partial insurance and preventive methods.
Emerging markets must supplement reserve accumulation with policies to reduce the risk of sudden
stops and deleveraging shocks. Three particular pressure points are worth highlighting.
First, keeping public debt on a sustainable trajectory will limit borrowing requirements and
Second, through a combination of supervision and macro-prudential regulation, decisive
steps must be taken to ensure commercial banks remain largely deposit-based and limit their
reliance on external, wholesale funding. This will also minimise currency mismatches, which had
ruinous effects during the 1997-2001 crises.
Third, monitoring lending to the real estate and housing sectors to minimise the occurrence
of bubbles and bad loans is of vital importance; if things go wrong here, the negative externalities
for the rest of the economy, not to mention the size of the fiscal costs, are immense.
Chances are that dynamic imposition of loan-to-value ceilings (LTVC) as in China, Hong Kong, and
Singapore could reduce the probability of a bubble. Similarly, taxing external borrowing surges by
commercial banks recognises that the social benefits to the real sector may fall short of the social
cost to the taxpayers of bailing out systemic financial players when times turn bad. Indeed,
emerging markets have been adopting various measures to tax external borrowing and hot money.
The key is to have a framework for regulation and supervision which evolves dynamically over time
to avoid a situation where regulations lose their bite.
The steps emerging markets took to reduce their exposure to the 2008-09 crisis included sound
management of the public finances to achieve sustainable debt trajectories, building up
international reserves, prudential steps to reduce contingent liabilities from private sector balance
sheets, and moving to the trilemma middle ground with its emphasis on controlled exchange-rate
flexibility. This package of self-insurance combined with the public finance approach to financial
integration may well be an optimal second-best while emerging markets wait for the G20 to
collectively resolve global imbalances and under-regulated capital flows.
Aizenman, Joshua, Brian Pinto, and Artur Radziwill (2007), “Sources for Financing Domestic Capital –
Is Foreign Saving a Viable Option for Developing Countries?”, Journal of International Money and
Aizenman J and V Sushko (2011), “Capital Flow Types, External Financing Needs, and Industrial
Growth: 99 countries, 1991-2007”,NBER Working Paper No. 17228.
Aizenman, Joshua and Brian Pinto (2011), “Managing Financial Integration and Capital Mobility: Policy
Lessons from the Past Two Decades”, Policy Research Working Paper WPS5786, The World Bank.
Caballero, Ricardo (2003), “On the International Financial Architecture: Insuring Emerging
Markets”, NBER Working Paper No. 9570.
Development Committee (2010), How Resilient Have Developing Countries Been During the Global
Crisis? DC2010-0015, September 30.
Dooley, Michael, David Folkerts-Landau, and Peter Garber (2003), “An Essay on the Revived
Bretton Woods System”, NBER Working Paper No. 9971.
Gourinchas, Pierre-Olivier, and Olivier Jeanne (2006), “The Elusive Gains from International
Financial Integration”, Review of Economic Studies, 73:715-741.
Pinto, Brian (forthcoming), Sovereign Debt and Growth: Practical Lessons from Developing Country
Prasad Eswar S, Raghuram G Rajan, and Arvind Subramanian (2007), “Foreign Capital and
Economic Growth”, Brookings Papers on Economic Activity, The Brookings Institution, 38(1): 153-
Table 1. Evolving crisis response of emerging markets
Goal Policies Comments
• Raise primary fiscal
surpluses for prolonged
period Might have to cut even good public investments in order to
1. Restore sustainable
• Improve expenditure raise primary surpluses (similar to external debt overhang of
composition and tax regime 1980s)
• Strengthen fiscal
• Shift to flexible exchange
Flexible exchange rates will reduce incentive for currency
2. Lower contingent • Monitor private external
mismatches but direct controls may also be needed by centr
liabilities associated with borrowing and currency
bank on volume of private external debt and loan-to-deposit
private sector mismatches
ratios of commercial banks
• Strengthen financial
• Build up foreign exchange
3. Insure against shifting reserves “Ideal” level of reserves will depend upon short-term externa
market sentiment and • Restrict currency debt, flexibility of exchange rates and extent of currency
possible sudden stops mismatches on government mismatches
and private balance sheets.
Source: Chapter 7, Pinto (forthcoming).